dynamiclearnersforum.files.wordpress.com · ii © The Institute of Chartered Accountants in England and Wales, March 2009 Financial Accounting The Institute of Chartered Accountants

The Institute of Chartered Accountants of Bangladesh

FINANCIAL ACCOUNTINGProfessional Stage Application Level

www.icab.org.bd

Study Manual

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ii © The Institute of Chartered Accountants in England and Wales, March 2009

Financial AccountingThe Institute of Chartered Accountants of Bangladesh Professional Stage

These learning materials have been prepared by the Institute of Chartered Accountants in England and Wales

ISBN: 978-1-84152-837-3First edition 2009

All rights reserved. No part of this publication may be reproduced in any formor by any means or stored in any retrieval system, or transmitted in any formor by any means, electronic, mechanical, photocopying, recording or otherwisewithout prior permission of the publisher.

© The Institute of Chartered Accountants in England and Wales, March 2009 iii

Welcome

iv © The Institute of Chartered Accountants in England and Wales, March 2009

© The Institute of Chartered Accountants in England and Wales, March 2009 v

Contents

Introduction vii

Specification grid for Financial Accounting viii

The learning materials ix

Study guide x

Getting help xix

Syllabus and learning outcomes xix

Skills assessment guide xxii

Accounting and reporting concepts

1. Conceptual and regulatory framework 1

Preparation of single entity financial statements

2. Format of financial statements 41

3. Cash flow statements 81

4. Reporting financial performance 119

5. Property, plant and equipment 157

6. Intangible assets 211

7. Revenue and inventories 239

8. Leases 273

9. Provisions, contingencies and events after the balance sheet date 317

Preparation of consolidated financial statements

10. Group accounts: basic principles 361

11. Group accounts: consolidated balance sheet 385

12. Group accounts: consolidated statements of financial performance 435

13. Group accounts: associates 479

14. Group accounts: disposals 519

15. Business combinations, consolidated financial statements andassociates 563

16. Group cash flow statements 611

Appendix: BFRS financial statements 647

vi © The Institute of Chartered Accountants in England and Wales, March 2009

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 vii

1 Introduction

1.1 What is Financial Accounting and how does it fit within theProfessional Stage?

Structure

The syllabus has been designed to develop core technical, commercial, and ethical skills and knowledge in astructured and rigorous manner.

The diagram below shows the fourteen modules at the Professional Stage, where the focus is on theacquisition and application of technical skills and knowledge, and the Advanced Stage which comprises threetechnical modules and the Case Study.

The knowledge base

In the Accounting paper you will have been introduced to the double entry system of recordingtransactions and the preparation of non-complex financial statements.

Progression to application level

The Financial Accounting module develops these basic principles covered in Accounting, looking at thepreparation of single entity financial statements in more complex situations and also introduces the issue ofgroup financial statements.

Progression to advanced stage

The Financial & Corporate Reporting paper then takes these issues a step further, enabling students toprepare extracts from financial statements for entities undertaking a wide range of accounting transactions.The emphasis is also on understanding financial information as well as preparation with analysis andinterpretation a key feature.

This paper also aims to ensure that students can apply technical knowledge and professional skills to resolvereal-life compliance issues faced by businesses – including the accounting treatment of complex corporatereporting issues, for financial instruments and mergers and acquisitions.

The above illustrates how the knowledge of financial accounting gives a platform from which a progressionof skills and accounting expertise is developed.

Financial accounting

viii © The Institute of Chartered Accountants in England and Wales, March 2009

1.2 Services provided by professional accountants

Professional accountants should be able to:

Explain the contribution and inherent limitations of financial statements in meeting stakeholders’ needsfor financial information and apply the International Accounting Standards Board’s (IASB) conceptualframework for financial reporting

Prepare and present financial statements from accounting data for single entities, whether organised incorporate or in other forms, in conformity with BFRS

Identify the circumstances in which entities are required to present consolidated financial statementsand prepare and present them in conformity with BFRS

2 Specification grid for Financial Accounting

2.1 Module aim

To enable students to prepare a complete set of financial statements for single entities and for groups inconformity with International Financial Reporting Standards (BFRS).

2.2 Specification grid

This grid shows the relative weightings of subjects within this module and should guide the relative studytime spent on each. Over time the marks available in the assessment will equate to the weightings below,while slight variations may occur in individual assessments to enable suitably rigorous questions to be set.

Weighting (%)1 Accounting and reporting concepts 102 Preparation of single entity financial statements 553 Preparation of consolidated financial statements 35

100

Your exam will consist of

Part one – 5 - 15 short form questions(worth 1 - 4 marks each)

20 marks

Part two – 4 questions(each worth around 20 marks each)

80 marks

Time available 2.5 hours

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 ix

3 The learning materials

You will find the learning materials are structured as follows:

Title page Contents page Introduction. This includes

– a review of the subject to set the context

– a list of the top level learning outcomes for this subject area entitled 'Services provided byprofessional accountants' (set with reference to what a newly qualified accountant would beexpected to do as part of their job)

The specification grid for Financial Accounting

A brief note about the learning materials

Study Guide. This includes

– hints and tips on how to approach studying for your CA exams

– guidance on how to approach studying with this study manual

– a detailed study guide suggesting how you should study each chapter of this study manual andidentifying the essential points in each chapter

Information on how to obtain help with your studies

The detailed syllabus and learning outcomes

Information on the Faculties and special interest groups

Each chapter has the following components where relevant:

Introduction

– Learning objectives– Practical significance– Stop and think– Working context– Syllabus links

Examination context

Chapter topics

Summary and Self-test

Technical reference

Answers to Self-test

Answers to Interactive questions

The technical reference section is designed to assist you when you are working in the office. It should helpyou to know where to look for further information on the topics covered. You will not be examined onthe contents of this section in your examination.


x © The Institute of Chartered Accountants in England and Wales, March 2009

4 Study guide

4.1 Help yourself study for your CA exams

Exams for professional bodies such as the ICAB are very different from those you have taken at college oruniversity. You will be under greater time pressure before the exam – as you may be combining yourstudy with work. Here are some hints and tips.

The right approach

1 Develop the right attitude

Believe in yourself Yes, there is a lot to learn. But thousands have succeededbefore and you can too.

Remember why you're doing it You are studying for a good reason: to advance your career.

2 Focus on the exam

Read through the Syllabus andStudy Guide

These tell you what you are expected to know and aresupplemented by Examination context sections in thetext.

3 The right method

See the whole picture Keeping in mind how all the detail you need to know fits intothe whole picture will help you understand it better.

The Introduction of each chapter puts the material incontext.

The Learning objectives, Section overviews andExamination context sections show you what youneed to grasp.

Use your own words To absorb the information (and to practise your writtencommunication skills), you need to put it into your ownwords.

Take notes. Answer the questions in each chapter. Draw mindmaps. Try 'teaching' a subject to a colleague or friend.

Give yourself cues to jog yourmemory

The Study Manual uses bold to highlight key points.

Try colour coding with a highlighter pen. Write key points on cards.

4 The right recap

Review, review, review Regularly reviewing a topic in summary form can fix it in yourmemory. The Study Manual helps you review in many ways.

Chapter summary will help you to recall each studysession.

The Self-test actively tests your grasp of the essentials.

Go through the Examples in each chapter a second orthird time.

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 xi

4.2 Study cycle

The best way to approach this Study Manual is to tackle the chapters in order. We will look in detail at howto approach each chapter below but as a general guide, taking into account your individual learning style,you could follow this sequence for each chapter.

Key study steps Activity

Step 1Topic list

The topic list is shown in the contents for each chapter and helps you navigateeach part of the book; each numbered topic is a numbered section in the chapter.

Step 2Introduction

This sets your objectives for study by giving you the big picture in terms of thecontext of the chapter. The content is referenced to the Study guide, andExamination context guidance shows what the examiners are looking for. TheIntroduction tells you why the topics covered in the chapter need to be studied.

Step 3Section

overviews

Section overviews give you a quick summary of the content of each of the mainchapter sections. They can also be used at the end of each chapter to help youreview each chapter quickly.

Step 4Explanations

Proceed methodically through each chapter, particularly focusing on areashighlighted as significant in the chapter introduction or study guide.

Step 5Note taking

Take brief notes, if you wish. Don't copy out too much. Remember that beingable to record something yourself is a sign of being able to understand it. Yournotes can be in whatever format you find most helpful; lists, diagrams, mindmaps.

Step 6Examples

Work through the examples very carefully as they illustrate key knowledge andtechniques.

Step 7Answers

Check yours against the suggested solutions, and make sure you understand anydiscrepancies.

Step 8Chapter summary

Review it carefully, to make sure you have grasped the significance of all theimportant points in the chapter.

Step 9Self-test

Use the Self-test to check how much you have remembered of the topicscovered.

Step 10Learning objectives

Ensure you have ticked off the Learning Objectives.

Moving on...

When you are ready to start revising, you should still refer back to this Study Manual.

As a source of reference.

As a way to review (the Section overviews, Examination context, Chapter summaries and Self-testquestions help you here).

Remember to keep careful hold of this Study Manual – you will find it invaluable in your work. The technicalreference section has been designed to help you in the workplace by directing you to where you can findfurther information on the topics studied.


xii © The Institute of Chartered Accountants in England and Wales, March 2009

4.3 Detailed study guide

Use this schedule and your exam timetable to plan the dates on which you will complete each study periodbelow:

Studyperiod

Approach Essential points Duedate

1 Chapter 1 sets out the conceptual and regulatoryframework which will form the basis of the rest ofthe chapters in this manual. As you read throughthe chapter try to ensure that you understand howthe various elements of the framework fit togetherrather than getting bogged down in the specificdetails.

Read section 8 carefully which deals with not-for-profit entities. You will not have come across thistype of entity before in your accounting studies.

Complete the Interactive questions and attemptthe Self-test questions.

Bases of accounting

BFRS Framework:qualitativecharacteristics

BFRS Framework:definitions of assetsand liabilities

2 Chapter 2 is an important chapter as it introducesformats for the balance sheet, income statementand statement of changes in equity. These will formthe basis of all accounts preparation questions.Read through the chapter carefully payingparticular attention to the formats. You must beable to reproduce these. You may also find ituseful to refer to the Appendix at the end of themanual which includes a proforma set of financialstatements.

Also notice sections 4.2 and 5.2. This type of detailmay be tested in OT questions.

Section 9 deals with the presentation of not-for-profit entities. Read through this section carefully.

Proformas for:

– Balance sheet

– Income statement

– Statement ofchanges in equity

3 Chapter 3 deals with the preparation of the cashflow statement. The emphasis here is on techniqueso you must work through the worked examplesand Interactive questions.

Read through section 8 carefully and review theworked example. You may also find it useful torefer to the cash flow statement in the Appendixat the end of the manual.

Finally, you should attempt the Self-test questionsto confirm your understanding of this topic.

Presentation of a cashflow statement

Technique forpreparation of a cashflow statement

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 xiii

Studyperiod


4 Chapter 4 is a very technical chapter so you willneed to work through it methodically. Readthrough sections 1-8 carefully, noting thedifference in treatment in a change of accountingpolicy and a change in accounting estimate.

Section 7 deals with the treatment of discontinuedoperations. Make sure that you understand whatconstitutes a discontinued operation and how thisis presented in the financial statements. AttemptInteractive question 1 to confirm yourunderstanding of this topic.

Read through section 8 and 9. In section 8 noticethe link between BAS 32 Financial Instruments:Presentation and BFRS Framework.

You should then attempt all the Self-test questions.

Treatment of a changein accounting policy

Definition andpresentation of adiscontinued operation

5 You will have covered the basic accountingtreatment of property, plant and equipment inyour Accounting studies. Chapter 5 however, putsthe topic into the context of the relevantaccounting standards.

Read through the chapter carefully taking particularnote of the Worked examples and Interactivequestions as these demonstrate how the standardsshould be applied. Also note the disclosurerequirements. These are important as written testquestions are likely to focus on the preparation offinancial statements or extracts.

Read section 10. These differences may beexamined in OT questions.

Accounting forrevaluations

Accounting forimpairments

Disposals

Disclosure

6 Read through Chapter 6 carefully. In section 1note how the underlying principles of BFRSFramework are reflected in BAS 38. Make sure youunderstand the accounting treatment of bothpurchased and internally generated assets.

Section 9 introduces the topic of goodwill whichwill be covered in more detail in Chapters 10-15.

You should attempt all Interactive questions andSelf-test questions to confirm your understandingof this topic.

Treatment ofpurchased intangibles

Treatment of internallygenerated intangibles

Goodwill


xiv © The Institute of Chartered Accountants in England and Wales, March 2009

Studyperiod


7 Read through sections 1 and 2 of Chapter 7 andattempt Interactive question 1. Pay particularattention to section 2.8 which demonstrates howthe concepts of BAS 18 Revenue apply to specifictypes of transactions. Then try Interactivequestions 2 and 3.

The remainder of this chapter then deals withinventories. You will have covered the basicprinciples involved in your Accounting studies somuch of this will be revision. Notice however thatthe manual puts the topic into the context of BAS2 Inventories. Complete Interactive question 4.

You should also try all the Self-test questions toconfirm your understanding of these topics.

Revenue recognition

Definition of cost ofinventories

Cost formulae

Definition of netrealisable value

8 Chapter 8 deals with the accounting treatment ofleases. Make sure that you can distinguish betweena finance lease and an operating lease and that youunderstand the importance of the concept ofsubstance over form. Much of the rest of thechapter concerns the accounting treatment offinance leases. Work through the Workedexamples and Interactive questions carefully asthese demonstrate the key points. Note inparticular the impact of the timing of the paymentsof the finance lease instalments, i.e. in arrears or inadvance. You also need to be familiar with thedisclosure requirements as a written test questionon this topic is likely to require extracts from thefinancial statements.

The treatment of operating leases is morestraightforward. Read through section 7, againpaying particular attention to the disclosurerequirements.

Attempt all the Self-test questions paying particularattention to the written test question from theSample Paper.

Definition of a financelease

Treatment anddisclosure of a financelease

Treatment anddisclosure of anoperating lease

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 xv

Studyperiod


9 Read through sections 1-5 of Chapter 9 onprovisions, noting in particular the definition of aliability and the link with BFRS Framework. Makesure you understand the recognition criteria insection 2.2. Section 4 introduces a number ofspecific applications of the principles of thestandard. You should read through these carefullyand attempt Interactive question 3.

Sections 6 and 7 deal with contingencies. Review thedefinitions of a contingent asset and a contingentliability and ensure that you understand theaccounting treatment of these. Interactive questions4 and 5 will help you to confirm your understanding.

Then move on to Section 8. This topic isreasonably straightforward. The key point is thedistinction between adjusting and non-adjustingevents after the balance sheet date. Also note thetreatment of dividends on equity shares proposedor declared after the balance sheet date.

You should attempt all the Self-test questionsincluding the written test question from theSample Paper.

10 Chapter 10 is the first in a series of chapters ongroup accounts. The aim of this chapter is to setdown the broad principles which are applied whenpreparing group financial statements. Workthrough this chapter carefully reviewing theWorked examples and completing the Interactivequestions. It is important that you do not move onto the next chapter until you have a goodunderstanding of these concepts.

Attempt the Self-test questions and review thesolutions carefully.

Definition of a group

Single entity concept

Reflecting control andownership

11 Chapter 11 applies the principles introduced inChapter 10 to the consolidated balance sheetspecifically. It is a detailed but important chapter soyou will need to work through it carefully. As youread through the individual sections and workthrough the Interactive questions notice the way inwhich a technique is developed. This technique isthe key to answering written test questions on thistopic. This is summarised in section 3.

Sections 5-8 introduce a number of consolidationadjustments. These may feature in both writtentest and the OT sections of the paper so reviewthese carefully. Review the Worked examples andattempt the Interactive questions to ensure thatyou have a good grasp of these adjustments.

Then attempt the Self-test questions to confirmyour understanding.

Treatment of goodwill

Consolidated balancesheet workings

Cancellation of intra-group balances

Unrealised profit onintra-group trading

Fair value adjustments


xvi © The Institute of Chartered Accountants in England and Wales, March 2009

Studyperiod


12 Chapter 12 applies the basic principles introducedin Chapter 10 to the consolidated incomestatement and consolidated statement of changesin equity.

Read through sections 1-6 on the consolidatedincome statement. Notice that the issues raisedare essentially the same as those you will havecovered in the previous chapter but nowconsidered from the perspective of theconsolidated income statement. Also notice theemphasis on technique. Proforma workings areprovided in section 3 which you should follow forall written test questions.

Then move on to section 7. Review the workedexample carefully taking particular note of theminority interest column. Work throughInteractive questions 5 and 6.

Attempt the Self-test questions to confirm yourunderstanding of the topics covered in thischapter.

Consolidated incomestatement workings

Intra-grouptransactions andunrealised profit ontrading transactions

Mid-year acquisitions

Consolidatedstatement of changes inequity

13 Chapter 13 deals with the treatment of theassociate in the consolidated financial statements.Read through section 1, paying particular attentionto the definition of significant influence. Then moveon to the equity method in sections 2 and 3.Review these sections carefully working throughInteractive question 1 and 2. Make sure that youunderstand the difference between this methodand the consolidation technique used forsubsidiaries.

Then move on to section 4. This covers thespecific issue of associate’s losses which could beexamined in a short-form question.

Work through section 5. This is a little tricky soreview this carefully and use the Interactivequestions to help you. Make sure that youappreciate that the treatment of unrealised profitswill depend on whether the associate or the parentis the selling company.

Definition of associate/significant influence

Equity method inconsolidated incomestatement/balancesheet

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 xvii

Studyperiod


14 Chapter 14 covers a lot of technical detail, dealingwith the disposal of subsidiaries and associates.You may find the summary table at the end of thechapter useful as it provides an overview of thetopic. Refer back to it as you work through thechapter.

Sections 2-6 cover the disposal of a subsidiary.Read through the notes but pay particularattention to the Worked examples and theInteractive questions as these demonstrate the keyissues. For each of the disposal possibilities try toensure that you can calculate the group profit orloss on disposal and that you understand theimplications for the consolidated financialstatements. Also notice that the full disposal of asubsidiary constitutes a discontinued activity whichshould be disclosed as such.

You should find section 7 more straightforward asmany of the principles are similar to those you willhave seen in sections 1-6. Read section 7.2carefully, in particular the way in which theresulting trade investment is calculated in theconsolidated statement of financial position.Review the Worked example.

Attempt the Self-test questions to confirm that youhave a good grasp of this topic.

Calculation of groupprofit or loss ondisposal

Impact of full and partdisposal on theconsolidated financialstatements


xviii © The Institute of Chartered Accountants in England and Wales, March 2009

Studyperiod


15 In Chapters 10-14 the emphasis has been on themechanics of preparing consolidated financialstatements. Chapter 15 puts this method into thecontext of the relevant financial reportingstandards. As such you will find that you arefamiliar with many of the points which are made.

Sections 2-8 cover BFRS 3 Business Combinations.Note in particular the definition of the acquirer insection 3 and the ways in which one entity maycontrol another. Sections 4-7 then go on to dealwith fair values and goodwill including the way inwhich fair value is attributed to the cost of thecombination and the assets acquired. Thesesections are important so work through themcarefully. Attempt Interactive questions 1and 2 toconfirm your understanding.

Briefly review section 9. As you will see many ofthe points made in BAS 27 Consolidated andSeparate Financial Statements are very similar tothose in BFRS 3.

Then move on to section 10. You should befamiliar with the points made here from your studyof Chapter 13.

You should attempt the Self-test questions toconfirm your understanding of this topic.

Identifying the acquirerand the means bywhich control isachieved

Fair value ofconsideration

Fair value of net assetsacquired

Goodwill

16 In Chapter 16 the topic of the cash flow statementis revisited but from the group perspective. Section1 provides a brief revision of the material coveredin Chapter 3. Read over this and/or return toChapter 3 if you require more detailed revision.Section 1 also introduces the impact of financeleases in the individual cash flow statement. TryInteractive question 1.

Then go on to section 2 which covers the groupcash flow statement. Notice that many of theissues addressed in Chapter 3 are still relevant,however in the consolidated cash flow statementthere are a number of additional matters toconsider. The technique of calculating the cashflow information required, primarily through theuse of T accounts is important so make sure thatyou work through the Worked examples andInteractive questions carefully.

Attempt the Self-test questions to confirm yourunderstanding of this topic.

Impact of finance leases

Dividends paid to theminority interest

Dividends receivedfrom associates

Acquisitions/disposals ofsubsidiaries/associates

Revision phase

Your revision will be centred around using the questions in the ICAB Revision Question Bank.

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 xix

5 Getting help

Firstly, if you are receiving structured tuition, make sure you know how and when you can contact yourtutors for extra help.

Identify a work colleague who is qualified, or has at least passed the paper you are studying for, who iswilling to help if you have questions.

Form a group with a small number of other students, you can help each other and study together, providinginformal support.

Call +88 (02) 9112672 or 9115340, or email [email protected] with non-technical queries.

Watch the ICAB website for future support initiatives.

6 Syllabus and learning outcomes

The following learning outcomes should be read in conjunction with the Financial Reporting table inSection 6.1.

1 Accounting and reporting concepts

Candidates will be able to explain the contribution and inherent limitations of financial statements inmeeting stakeholders’ needs for financial information and apply the International Accounting StandardsBoard’s conceptual framework for financial reporting.

In the assessment, candidates may be required to:

(a) discuss the purpose of accounting regulations, standards and other requirements

(b) explain the objectives of financial statements, giving appropriate examples

(c) explain the qualitative characteristics of financial information and the constraints on such information,using appropriate examples to illustrate the explanation

(d) identify the financial effects of transactions in accordance with the IASB Framework, which has beenadopted by ICAB as BFRS Framework

(e) explain the differences between financial statements produced using the accrual basis and thoseproduced using the bases of cash accounting and break-up, performing simple calculations to illustratethe differences

(f) explain, in non-technical language, the different bases of measurement of the elements of the financialstatements and the different definitions of capital and capital maintenance used in accrual basis financialstatements, illustrating the explanation with simple calculations and examples

(g) explain and demonstrate the concepts and principles surrounding the consolidation of financialstatements.

2 Preparation of single entity financial statements

Candidates will be able to prepare and present financial statements from accounting data for single entities,whether organised in corporate or in other forms, in conformity with BFRS requirements.


(a) identify and describe the circumstances in which an entity is required to prepare and present statutoryfinancial statements

(b) identify the laws, regulations, accounting standards and other requirements applicable to the statutoryfinancial statements of an entity

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xx © The Institute of Chartered Accountants in England and Wales, March 2009

(c) prepare and present the financial statements, or extracts therefrom, of an entity according to itsaccounting policies and appropriate international financial reporting standards

(d) identify the circumstances in which the use of BFRS and International Public Sector AccountingStandards (IPSASs) for not-for-profit entities might be required

(e) calculate from financial and other data the amounts to be included in the equity section of the balancesheet of a not-for-profit entity in accordance with its accounting policies and the appropriate financialreporting framework.

3 Preparation of consolidated financial statements

Candidates will be able to identify the circumstances in which entities are required to present consolidatedfinancial statements and prepare and present them in conformity with BFRS.


(a) identify and describe the circumstances in which an entity is required to prepare and presentconsolidated financial statements

(b) identify the laws, regulations, accounting standards and other requirements applicable to the legalentity and consolidated financial statements of an entity

(c) identify from financial and other data any subsidiary or associate of an entity according to theinternational financial reporting framework

(d) calculate from financial and other data the amounts to be included in an entity’s consolidated financialstatements in respect of its new, continuing and discontinuing interests in subsidiaries and associatesaccording to the international financial reporting framework

(e) prepare and present the consolidated financial statements (including a consolidated cash flowstatement), or extracts therefrom, of an entity in accordance with its accounting policies and theinternational financial reporting framework, using calculated amounts and other information.

6.1 Technical knowledge

The tables contained in this section show the technical knowledge covered in the CA syllabus by module.

The level of knowledge required in the relevant Professional Stage module and at the Advanced Stage isshown.

The knowledge levels are defined as follows:

Level D

An awareness of the scope of the standard.

Level C

A general knowledge with a basic understanding of the subject matter and training in its applicationsufficient to identify significant issues and evaluate their potential implications or impact.

Level B

A working knowledge with a broad understanding of the subject matter and a level of experience in theapplication thereof sufficient to apply the subject matter in straightforward circumstances.

Level A

A thorough knowledge with a solid understanding of the subject matter and experience in the applicationthereof sufficient to exercise reasonable professional judgement in the application of the subject matter inthose circumstances generally encountered by Chartered Accountants.

Key to other symbols:

the knowledge level reached is assumed to be continued

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 xxi

ProfessionalStage

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Preface to Bangladesh Financial Reporting Standards A

Framework for Preparation and Presentation of Financial Statements A

BAS 1 Presentation of Financial Statements B A

BAS 2 Inventories A

BAS 7 Cash Flow Statements A

BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors B A

BAS 10 Events after the Balance Sheet Date A

BAS 11 Construction Contracts A

BAS 12 Income Taxes C A

BAS 14 Segment Reporting (see note 1) A

BAS 16 Property, Plant and Equipment A

BAS 17 Leases A

BAS 18 Revenue A

BAS 19 Employee Benefits A

BAS 20 Accounting for Government Grants and Disclosure ofGovernment Assistance

A

BAS 21 The Effects of Change in Foreign Exchange Rates A

BAS 23 Borrowing Costs (see note 2) A

BAS 24 Related Party Disclosures A

BAS 26 Accounting and Reporting by Retirement Benefit Plans D

BAS 27 Consolidated and Separate Financial Statements A

BAS 28 Investments in Associates A

BAS 29 Financial Reporting in Hyperinflationary Economies D

BAS 31 Interests in Joint Ventures A

BAS 32 Financial Instruments: Presentation C A

BAS 33 Earnings per Share B A

BAS 34 Interim Financial Reporting A

BAS 36 Impairment of Assets B A

BAS 37 Provisions, Contingent Liabilities and Contingent Assets A

BAS 38 Intangible Assets B A

BAS 39 Financial Instruments: Recognition and Measurement C C A

BAS 40 Investment Property A


xxii © The Institute of Chartered Accountants in England and Wales, March 2009

ProfessionalStage

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BAS 41 Agriculture D

BFRS 1 First-Time Adoption of BFRS A

BFRS 2 Share-based Payment A

BFRS 3 Business Combinations A

BFRS 4 Insurance Contracts D

BFRS 5 Non-current Assets Held for Sale and Discontinued Operations B A

BFRS 6 Exploration for and Evaluation of Mineral Resources D

BFRS 7 Financial Instruments: Disclosures B A

BFRS 8 Operating Segments (see note 1) C C

Note 1 Candidates are expected to have knowledge to level A of BAS 14 Segment Reporting and to havea C level knowledge of BFRS 8 Operating Segments. Knowledge of BFRS 8 is limited to the keypoints of the standard and the principal changes from BAS 14 as outlined in 2010/2011 editionof the learning materials.

Note 2 The version of BAS 23 Borrowing Costs in issue on 1 January 2007 is examinable. Candidates areexpected to know the key points of the revised standard issued on 29 March 2007 and thechanges from the earlier version as outlined in the 2010/2011 edition of the learning materials.

7 Skills assessment guide

7.1 Introduction

As a Chartered Accountant in the business world, you will require the knowledge and skills to interpretfinancial and other numerical and business data, and communicate the underlying issues to your clients. In asimilar way to the required knowledge, the CA syllabus has been designed to develop your professionalskills in a progressive manner. These skills are broadly categorised as:

Assimilating and using information Structuring problems and solutions Applying judgement Drawing conclusions and making recommendations

7.2 Assessing your professional skills

Set out below is a pictorial representation of the different mix of knowledge and skills that will be assessedin the examinations that comprise the CA qualification.

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© The Institute of Chartered Accountants in England and Wales, March 2009 xxiii

Skills

Case Study

Initial ProfessionalDevelopment

F&CR

AA&A

ETHICSBA

TAX

ITA

FA CL&P A&A

FM

BSPS - K

In the seven Knowledge Modules of the Professional Stage, you will have experienced a limited amount ofskills assessment, generally 'Assimilating and using information'. Most of the questions were set in a contextthat required you to identify the piece of knowledge that was being assessed. In the Application Modules ofthe Professional Stage, the context of the examination will be simple business situations, from which youwill be required to determine the relevant information to answer the questions.

To be successful in the Financial Accounting examination, you will need a strong core of subject knowledgeand a good understanding of how this knowledge should be applied in simple situations. You will beexpected to apply your judgement to determine the relevance and importance of the different informationprovided and to recommend suitable courses of action.

7.3 Assessment grids

The following pages set out the learning outcomes for Financial Accounting that are addressed under eachof the four skills areas. In addition, for each skills area, there is a description of:

The specific skills that are assessed How these skills are assessed

Using these grids will enable you to determine how the examination paper will be structured and toconsider whether your knowledge of Financial Accounting is sufficiently strong to enable you to apply it inthe required manner.

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xxiv © The Institute of Chartered Accountants in England and Wales, March 2009

Learning outcomes Assessed skills How skills are assessed

Assimilating and using information

1a Discuss the purpose ofaccounting regulationsand standards

1b and 1c

Explain the objectives andcharacteristics of financialstatements

1e and 1f

Explain the different basesfor preparing, andmeasuring elements of,financial statements

1g Explain the principlessurrounding theconsolidation of financialstatements

Reading and understandingsubject matter

Accessing, evaluating andmanaging information providedin a few defined sources

Operating to a brief instructured situations

Questions will contain bothstructured and unstructured detailthat candidates have todemonstrate an understanding of

Requirements will include:

Explaining the contribution andinherent limitations of financialstatements

Applying elements of the BFRSframework for financial reporting

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 xxv


Structuring problems and solutions

1d Identify the financialeffects of transactions

2a and 3a

Identify when an entity isrequired to preparestatutory financialstatements

2b and 3b

Identify the accountingstandards etc applicableto statutory financialstatements

2e Identify the circumstancesin which the use of BFRSand IPSASs might berequired for not-for-profit entities

3c Identify a subsidiary orassociate of an entity

2c and 3e

Prepare and present thefinancial statements, orextracts, of an entity

2f Calculate the amounts tobe included in the equitysection of the balancesheet of a not-for-profitentity

3d Calculate the amounts tobe included in an entity’sconsolidated financialstatements in respect ofits new, continuing anddiscontinuing interests insubsidiaries andassociates

Understanding data andinformation given: identifyingand understanding issuesarising in straight forwardscenarios

Using the data andinformation given:understanding requirements,analysing data andinformation to supportrequirement

Drawing upon technical andprofessional knowledgelearnt to analyse issues

Applying knowledge fromdifferent technical areas:analysing problems thatcombine technical skills in asingle disciplinaryenvironment

Using new concepts:evaluating new ideas andconcepts

Requirements will include:

Explaining the contribution andinherent limitations of financialstatements in meeting users’needs

Applying elements of the BFRSframework for financial reporting

Applying knowledge of financialreporting standards:

– Financial statementpresentation, including cashflow statements

– Business combinations

– Intangibles

– Tangible non-current assets

– Valuations and impairments

– Associates

– Provisions and contingencies

– Capital instruments

– Post-balance sheet events

– Accounting policies andestimates

– Leases

– Revenue recognition

Adjusting and presenting financialdata for single entity andconsolidated financial statementsunder BFRS

Preparing and presenting financialstatements from accounting datain conformity with BFRS for:

– Single entities, whetherorganised in corporate or inother forms

– Entities requiringconsolidated financialstatements


xxvi © The Institute of Chartered Accountants in England and Wales, March 2009


Applying judgement

Not assessed

Drawing conclusions and making recommendations

Preparing, describing,outlining the advice, report,notes required in a givenstraight-forward situation

Presenting a basic or routinememorandum or briefingnote in writing in a clear andconcise style

Explaining accounting and reportingconcepts in non-technical languageto non-financial management.

© The Institute of Chartered Accountants in England and Wales, March 2009 1

Contents

Introduction

Examination context

Topic List

1 Financial statements

2 Purpose and use of financial statements

3 Bases of accounting

4 BFRS Framework

5 International Accounting Standards CommitteeFoundation (IASCF)

6 Bangladesh Financial Reporting Standards (BFRS)

7 Inherent limitations of financial statements

8 Not-for-profit entities


Technical reference



chapter 1

Conceptual and regulatoryframework

Administrator

Text Box

CA in Bangladesh www.facebook.com/CAinBD


2 © The Institute of Chartered Accountants in England and Wales, March 2009

Introduction

Learning objectives Tick off

Explain the nature of financial reporting

Explain the objectives of financial statements

Discuss the conceptual and regulatory framework affecting the preparation of financialstatements

Discuss the importance of BFRS Framework

Apply the principles of BFRS Framework, including the qualitative characteristics of financialinformation, the elements of financial statements, recognition and measurement of theelements

Explain and demonstrate the differences between financial statements produced using:

– The accrual basis

– Cash accounting

– The break-up basis

Explain and illustrate the different definitions of capital and capital maintenance

Explain the regulatory framework affecting not-for-profit entities

Specific syllabus references for this chapter are: 1a, b, c, d, e, f, 2e.

Practical significance

The way that items and transactions are treated and presented in the financial statements may affect aninvestor's perception of the position and performance of an entity. Whilst individual accounting standardscan be developed to deal with specific issues it is also important that there is a framework that sets out thewider purposes that accounting standards are intended to achieve. This helps to ensure that standards areconsistent and not overly affected by political influence or self-interest groups. The International AccountingStandards Board's Framework for the Preparation and Presentation of Financial Statements (IASB Framework),which has been adopted by ICAB without any changes is known as BFRS Framework. The frameworkattempts to provide this framework in the context of International Accounting Standards and InternationalFinancial Reporting Standards (jointly referred to from this point as 'IFRS'/ BFRS in Bangladesh). It does soby setting out consistent principles which form the basis for the development of detailed requirements inIFRS.

Stop and think

What do you think are the advantages of a principles based approach to the setting of accounting standards?

Working context

In the working environment you are unlikely to be consciously aware of the effect of the issues covered bythis chapter. They are important nevertheless as these principles underpin all the financial statements whichyou will prepare or audit.

CONCEPTUAL AND REGULATORY FRAMEWORK


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Syllabus links

The issues covered by this chapter and particularly the principles introduced by BFRS Framework are afundamental part of the Financial Accounting syllabus.

Throughout the rest of the text we will make reference to the way that the Framework affects the way thatspecific transactions are accounted for and presented. These principles will be further developed in FinancialReporting and at the Advanced Stage.



Examination context

Exam requirements

Accounting and reporting concepts constitute 10% of the syllabus. This area of the syllabus is likely to beexamined in the written test section of the paper in conjunction with another topic, rather than in its ownright. For example, in a question on tangible non-current assets you could be asked to consider how thedefinition of an asset affects the recognition of certain expenses as capital or revenue items. Part (a) ofquestion 4 in the sample paper required an explanation and discussion of the concept of substance overform in the context of the topic of leasing.

You could also be asked to discuss the objectives of financial information and the qualitative characteristicswhich make information useful. Again this would typically be part (b) or (c) of a longer question rather thanthe main focus of the question.

Alternatively, or in addition, this topic could be examined in the short-form questions in the paper.

In the examination, candidates may be required to:

Discuss the purpose of accounting regulations and standards for both profit-making and not-for-profitentities

Explain, with examples, the objectives of financial statements

Explain the qualitative characteristics of financial information and the constraints on such information

Describe the financial effects of the application of the definitions of BFRS Framework

Perform simple calculations to demonstrate the difference between the accrual basis, cash accountingand the break-up basis

Explain the different concepts of capital maintenance



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1 Financial statements

Section overview

In Bangladesh financial statements must:

– Be prepared in accordance with Companies Act and BFRS– Give a true and fair view

1.1 What is financial accounting?

Financial accounting is the process of identifying, measuring and communicating economic information toothers so that they may make decisions on the basis of that information and assess the stewardship of theentity's management.

Financial accounting involves:

Recording transactions undertaken by a business entity Grouping similar transactions together which are appropriate to the business Presenting periodic results.

The Financial Accounting syllabus focuses on the preparation of published financial information. Typically,this information is made available annually or half-yearly (sometimes quarterly) and is presented in formatslaid down or approved by governments in each national jurisdiction. (The Financial Reporting syllabus dealswith more complex reporting issues and analysis and interpretation.)

By contrast, management accounting or reporting is internal reporting for the use of themanagement of a business itself. Internal management information can be tailored to management's ownneeds and provided in whatever detail and at whatever frequency (e.g. continuous real-time information)management decides.

General principles relating to financial accounting are set out in BFRS Framework for the Preparation andPresentation of Financial Statements (Framework), which is explained further below.

1.2 Entity

Most accounting requirements are written with a view to use by any type of accounting entity, includingcompanies and other forms of organisation, such as partnership. In this text, the term 'company' is oftenused, because the main focus of the Financial Accounting syllabus is on the accounts of companies andgroups of companies.

1.3 Financial statements

The principal means of providing financial information to external users is the annual financial statements.Financial statements are the accountant's summary of the performance of an entity over a particular periodand of its position at the end of that period.

A complete set of financial statements comprises:

The balance sheet (a statement of financial position) The income statement (a statement of financial performance) The statement of changes in equity (another statement of financial performance) The statement of changes in financial position (usually in the form of a cash flow statement) Notes to the financial statements

The notes to the financial statements include:

Accounting policies, i.e. the specific principles, conventions, rules and practices applied in order toreflect the effects of transactions and other events in the financial statements.



Detailed financial and narrative information supporting the information in the primary financialstatements.

Other information not reflected in the financial statements, but which is important to users in makingtheir assessments.

The individual elements that are included in the financial statements are covered in detail later in this chapter.

1.4 Requirement to produce financial statements

Limited liability companies are required by law to prepare and publish financial statements annually. Theform and content may be regulated primarily by national legislation, and in most cases must also complywith Financial Reporting Standards.

In Bangladesh, all companies must comply with the provisions of the Companies Act 1994 (CA 1994).The provisions of the Act are relevant for the purpose of the Financial Accounting exam and therefore thisStudy Manual refers to the Companies Act 1994 throughout. The key impact of this is as follows:

Every registered company is required to prepare a balance sheet and profit and loss account foreach financial year which gives a true and fair view.

The financial statements must comply with Schedule XI to CA 1994 as regards format andadditional information provided by way of notes. Therefore the only disclosures covered by thistext in Chapter 2 are those currently contained in schedule XI.

Specialised entities, such as financial institutions, insurance companies, co-operatives, NGOs and publicsector entities must comply with the rules, requirements of the relevant regulatory bodies.

1.5 Financial reporting standards

In most cases company financial statements must also comply with relevant Financial Reporting Standardsand other professional guidance. In Bangladesh these are as follows.

Accounting Standards

These include Bangladesh Financial Reporting Standards (BFRSs which are issued by theInternational Accounting Standards Board (IASB) as IASs and IFRSs and adopted by ICAB asBASs and BFRSs.

These learning materials assume the preparation of financial statements in accordance withBFRS.

1.6 True and fair view

In Bangladesh there is a Companies Act requirement that financial statements should present 'a trueand fair view.' This term is not defined in the Companies Act or Accounting Standards.

Truth is usually seen as an objective concept reflecting factual accuracy within the bounds of materiality.

Fairness is usually seen as meaning that the view given is objective and unbiased.

True and fair is usually defined in terms of accounting concepts. This means:

Compliance with Accounting Standards (which can be overridden on true and fair grounds onlyvery rarely)

Adherence to the requirements of the Companies Act 1994, including its true and fairoverride (see below)

In the absence of more specific requirements, application of general accounting principles andfundamental concepts and, where appropriate, adherence to accepted industry practices.



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Points to note

CA 1994 uses the term 'a true and fair view' rather than 'the true and fair view' because it is possiblefor there to be more than one true and fair view. For example, financial statements based on historicalcost can be true and fair, as can financial statements which incorporate revaluations.

What constitutes a true and fair view can then be restricted by stating that where a choice oftreatments or methods is permitted, the one selected should be the most appropriate to thecompany’s circumstances. This restriction is likely to ensure compliance with the spirit and underlyingintentions of requirements, not just with the letter of them.

A further restriction is that financial statements should reflect the economic position of the company,thereby reflecting the substance of transactions (i.e. commercial reality), not merely their legalform. In most cases this will be achieved by adhering to Accounting Standards. (We will look atsubstance in more detail in section 4 below).

The equivalent international term to a true and fair view is 'fair presentation.' We will look at this indetail in Chapter 2.


Section overview

Financial statements are used to make economic decisions by a wide range of users.

All users require information regarding:

– Financial position– Financial performance, and– Changes in financial position.

2.1 Users and their information needs

The form and content of financial statements must be influenced by the use to which they are put. Nearlyeverybody using them does so when making economic decisions such as those to:

Decide when to buy, hold or sell shares. Assess the stewardship or accountability of management. Assess an entity's ability to provide benefits to employees. Assess security for amounts lent to the entity.

Much of the information needed for these different decisions is in fact common to them all. Financialstatements aimed at meeting these common needs of a wide range of users are known as 'generalpurpose' financial statements.

BFRS Framework identifies the following users of financial statements and their specific informationneeds. (We will look at BFRS Framework in more detail in Section 4 of this chapter).

Users Need information to

Present and potentialinvestors

Make investment decisions, therefore need information on:

– Risk and return on investment– Ability of entity to pay dividends

Employees Assess their employer's stability and profitability

Assess their employer's ability to provide remuneration,employment opportunities and retirement and other benefits



Lenders Assess whether loans will be repaid, and related interest will bepaid, when due

Suppliers and other tradepayables

Assess the likelihood of being paid when due

Customers Assess whether entity will continue in existence – importantwhere customers have a long-term involvement with, or aredependent on, the entity, e.g. where there are product warrantiesor where specialist parts may be needed

Governments and theiragencies

Assess allocation of resources and, therefore, activities of entities

Assist in regulating activities

Assess taxation

Provide a basis for national statistics

The public Assess trends and recent developments in the entity's prosperityand its activities – important where the entity makes a substantialcontribution to a local economy, e.g. by providing employmentand using local suppliers

In most cases the users will need to analyse the financial statements in order to obtain the information theyneed. This might include the calculation of accounting ratios. (The calculation of accounting ratios and theanalysis of those ratios is covered in the Financial Reporting syllabus.)

2.2 Objective of financial statements

The objective of financial statements is to provide information about the reporting entity's financialposition and financial performance that is useful to a wide range of users in making economicdecisions.

This objective can usually be met by focusing exclusively on the information needs of present and potentialinvestors. This is because much of the financial information that is relevant to investors will also be relevantto other users.

2.3 Accountability of management

Management also has a stewardship role, in that it is accountable for the safe-keeping of the entity’sresources and for their proper, efficient and profitable use. Providers of risk capital are interested ininformation that helps them to assess how effectively management has fulfilled this role, but again thisassessment is made only as the basis for economic decisions, such as those about investments and thereappointment/ replacement of management.Financial reporting helps management to meet its need to be accountable to shareholders, and also to otherstakeholders (e.g. employees or lenders), by providing information that is useful to the users in makingeconomic decisions.However, financial statements cannot provide the complete set of information required for assessing thestewardship of management (see section 7 ‘Inherent Limitations of Financial Statements’ later in thischapter).

2.4 Financial position, performance and changes in financial position

All economic decisions are based on an evaluation of an entity’s ability to generate cash and of the timingand certainty of its generation. Information about the entity’s financial position, performance and changes infinancial position provides the foundation on which to base such decisions.



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2.4.1 Financial position

An entity's financial position covers:

The economic resources it controls Its financial structure (i.e. debt and share finance) Its liquidity and solvency and Its capacity to adapt to changes in the environment in which it operates

Investors require information on financial position because it helps in assessing:

The entity's ability to generate cash in the future

How future cash flows will be distributed among those with an interest in, or claims on, theentity

Requirements for future finance and ability to raise that finance

The ability to meet financial commitments as they fall due

Information about financial position is primarily provided in a balance sheet.

2.4.2 Financial performance

The profit earned in a period is used as the measure of financial performance, where profit is calculated asincome less expenses. Information about performance and variability of performance is useful in:

Assessing potential changes in the entity's economic resources in the future Predicting the entity's capacity to generate cash from its existing resource base, and Forming judgements about the effectiveness with which additional resources might be employed.

Information on financial performance is provided by:

The income statement, and The statement of changes in equity.

2.4.3 Changes in financial position

Changes in financial position can be analysed under the headings of investing, financing and operatingactivities and are usually shown in a cash flow statement.

Cash flow information is largely free from the more judgemental allocation and measurement issues(i.e. in which period to include things and at what amount) that arise when items are included in the balancesheet or performance statements. For example, depreciation of non-current assets involves judgement andestimation as to the period over which to charge depreciation. Cash flow information excludes non-cashitems such as depreciation.

Cash flow information is therefore seen as being factual in nature, and hence more reliable than othersources of information.

Information on the generation and use of cash is useful in evaluating the entity’s ability to generate cash andits needs to use what is generated.

2.4.4 Notes and supplementary schedules

Notes and schedules attached to financial statements can provide additional information relevant tousers, for example the non-current assets note (see Chapter 2).



3 Bases of accounting

Section overview

There are four bases of accounting which you need to be familiar with:

– Accrual basis– Going concern basis– Cash basis– Break-up basis

The accrual basis of accounting and going concern are referred to by BFRS Framework as 'underlyingassumptions'.

3.1 Accrual basis

Under this basis of accounting, transactions are recognised when they occur, not when the relatedcash flows into or out of the entity. You will be familiar with this basis from your Accounting studies.Examples of the importance of this basis are as follows:

Sales are recorded in the period in which the risks and rewards of ownership pass from sellerto buyer, not when the seller receives full payment. While this basis has no effect on the timing of therecognition of cash sales, it does mean that credit sales are recorded earlier than if the cash basis ofaccounting was used. When credit sales are recognised, a receivable is set up in the entity's books.

Expenses are recognised in the period when the goods or services are consumed, not whenthey are paid for. An amount payable will be set up in the entity's books for credit purchases, againleading to earlier recognition than if the cash basis was used.

The consumption of non-current assets, such as plant and machinery, is recognised over the periodduring which they are used by the entity (i.e. the asset is depreciated), not in the year ofpurchase as they would be under the cash basis of accounting.

Financial statements prepared on this basis provide information both about past transactions involving cashand about future resources flowing into the entity (when customers pay up) and flowing out of it (whensuppliers are paid). They are therefore more useful for the making of economic decisions than thoseproduced on the cash basis.

3.2 Going concern basis

The accrual basis of accounting assumes that an entity is a going concern. Under this basis, financialstatements are prepared on the assumption that the entity will continue in operation for theforeseeable future, in that management has neither the intention nor the need to liquidate the entity byselling all its assets, paying off all its liabilities and distributing any surplus to the owners. Examples of theimportance of this basis are as follows:

The measurement of receivables from trade customers is made on the basis that there is no timelimit over which management will chase slow payers. If the entity were to cease operation in,say, three months, a number of balances might have to be regarded as bad debts

The measurement of non-current assets is made on the basis that they can be utilised throughouttheir planned life. Otherwise, they would have to be valued at what they could immediately be soldfor, which might not be very much, in the case of assets used in markets where there is excesscapacity.

The accrual basis and going concern are referred to by BFRS Framework as 'underlying assumptions'.

3.3 Cash basis

The cash basis of accounting is not used in the preparation of a company balance sheet and incomestatement as it is not allowed by BFRS, although the cash effect of transactions is presented in the form of a



1

cash flow statement. (We will look at the cash flow statement in Chapter 3.) The cash basis may be usedhowever, for small unincorporated entities, for example clubs and societies.

In many ways the cash basis of accounting is very simple. Only the cash impact of a transaction isrecorded. Examples of the impact of this are as follows:

Sales are recorded in the period in which the seller receives full payment. For credit sales this willdelay the recognition of the transaction.

Purchases are recorded in the period in which goods are paid for rather than the period in which thegoods are purchased. For credit purchases this will delay the recognition of the purchase.

The purchase of a capital asset is treated as a cash outflow at the point that the cash consideration ispaid. No subsequent adjustment is made for depreciation as this has no impact on the cash balance ofthe business.

Worked example: Comparison of accrual basis and cash basis

Joe Co buys 100 T-shirts in January at CU3.50 each. The purchase is made for cash. During January 30T-shirts are sold for cash at CU7.00 each.

Using accrual based accounting the results for January would be as follows:

CU CURevenue (30 × CU7) 210

Cost of salesPurchases (100 × CU3.50) 350Closing inventory (70 × CU3.50) (245)

(105)Profit 105

Using cash accounting the results for January would be as follows:CU

Revenue (30 × CU7) 210Cost of sales (100 × CU3.50) (350)Loss (140)

Notice that there is an overall loss of CU140 using cash accounting even though there is a profit for themonth of CU105 using the accrual basis. The difference of CU245 is the value of the closing inventorieswhich is carried forward as an asset under accrual based accounting.

3.4 Break-up basis

As we saw in section 3.2 one of the key assumptions made in accrual based accounting is that the businesswill continue as a going concern. However, this will not necessarily always be the case. There may be anintention or need to sell off the assets of the business. Such a sale typically arises where the business is infinancial difficulties and needs the cash to pay its creditors. Where this is the case an alternative methodof accounting must be used (in accordance with BAS 1 Presentation of Financial Statements). In thesecircumstances the financial statements will be prepared on a break-up basis. The effect of this is seenprimarily in the balance sheet as follows:

Classification of assets

All assets and liabilities would be classified as current rather than non-current.

Valuation of assets

Assets would be valued on the basis of the recoverable amount on sale. This is likely to besubstantially lower than the carrying amount of assets held under historical cost accounting.



4 BFRS Framework

Section overview

BFRS Framework for the Preparation and Presentation of Financial Statements (Framework) is theconceptual framework upon which all BASs and BFRSs are based. It determines:

– How financial statements are prepared, and– The information they contain.

4.1 Conceptual Framework

The Framework consists of a Preface and an Introduction followed by a number of chapters:

The objective of financial statements Underlying assumptions Qualitative characteristics of financial statements The elements of financial statements Recognition of the elements of financial statements Measurement of the elements of financial statements Concepts of capital and capital maintenance

In this chapter we have already introduced some of the concepts dealt with by the Framework.

We will now look specifically at each section in turn.

4.2 Preface

The Preface to the Framework points out the fundamental reason why financial statements are producedworldwide, i.e. to satisfy the requirements of external users, but that practice varies due to theindividual pressures in each country. These pressures may be social, political, economic or legal, but theyresult in variations in practice from country to country including:

The form of the statements The definition of their component parts (assets, liabilities, etc) The criteria for recognition of items Scope and disclosure of financial statements.

It is these differences which the IASB wishes to narrow by harmonising all aspects of financial statements,including the regulations governing accounting standards and their preparation and presentation.

The Preface also emphasises the way the financial statements are used to make economic decisions. Welooked at these decisions previously in Section 2.1.

4.3 Introduction

The Introduction provides a list of the purposes of the Framework:

Provide those who are interested in the work of the IASB with information about its approach tothe formulation of IASs (now IFRSs).

Assist the Board of the IASB in the development of future IASs and in its review of existing IASs.

Assist the Board of the IASB in promoting harmonisation of regulations, accounting standards andprocedures relating to the presentation of financial statements by providing a basis for reducing thenumber of alternative accounting treatments permitted by IASs.

Assist national standard-setting bodies in developing national standards.

Assist preparers of financial statements in applying IASs and in dealing with topics that have yet toform the subject of an IAS.

Assist auditors in forming an opinion as to whether financial statements conform with IASs.



1

Assist users of financial statements in interpreting the information contained in financialstatements prepared in conformity with IASs.

The Framework is not an IFRS and so does not overrule any individual IFRS. In the (rare) case of conflictbetween an IFRS and the Framework, the IFRS will prevail. These cases will diminish over time as theFramework will be used as a guide in the production of future IFRSs. The Framework itself will be revisedoccasionally depending on the experience of the IASB in using it.

The Introduction also considers users and their information needs. We have already looked at this insection 2.1 of this chapter.

4.4 Qualitative characteristics of financial statements

4.4.1 Overview

The Framework states that qualitative characteristics are the attributes that make the information providedin financial statements useful to users.

The four principal qualitative characteristics are understandability, relevance, reliability andcomparability.

The key issues can be summarised as follows:

Qualitative characteristics

Understandability Relevance

Materiality

Reliability Comparability

Faithful

representation

Substance over

formPrudence Completeness

Constraints

Timeliness Cost v benefit Balance between

characteristics

Results in fair

presentation

DisclosureConsistencyNature

4.4.2 Understandability

Users must be able to understand financial statements. They are assumed to have some business, economicand accounting knowledge and to be able to apply themselves to study the information properly. Complex



matters should not be left out of financial statements simply due to its difficulty if it is relevantinformation.

4.4.3 Relevance

Relevant information is both predictive and confirmatory. These roles are interrelated.

Definition

Relevance: Information has the quality of relevance when it influences the economic decisions of users byhelping them evaluate past, present or future events or confirming, or correcting, their past evaluations.

Information on financial position and performance is often used to predict future position and performanceand other things of interest to the user, e.g. likely dividend, wage rises. The manner of presentation willenhance the ability to make predictions, e.g. by highlighting unusual items.

Materiality

The relevance of information is affected by its nature and its materiality.

Definition

Materiality: Information is material if its omission or misstatement could influence the economic decisionsof users taken on the basis of the financial statements.

Information may be judged relevant simply because of its nature (e.g. remuneration of management). Inother cases, both the nature and materiality of the information are important. Materiality is not a primaryqualitative characteristic itself (like reliability or relevance), because it is merely a threshold or cut-off point.

4.4.4 Reliability

Information must also be reliable to be useful. The user must be able to depend on it being a faithfulrepresentation.

Definition

Reliability: Information has the quality of reliability when it is free from material error and bias and can bedepended upon by users to represent faithfully that which it either purports to represent or couldreasonably be expected to represent.

Even if information is relevant, if it is very unreliable it may be misleading to recognise it, e.g. a disputedclaim for damages in a legal action.

Faithful representation

Information must represent faithfully the transactions it purports to represent in order to be reliable. Thereis a risk that this may not be the case, not due to bias, but due to inherent difficulties in identifying thetransactions or finding an appropriate method of measurement or presentation. Wheremeasurement of the financial effects of an item is so uncertain, entities should not recognise such an item.For example, although there is usually no doubt as to the existence of internally generated goodwill, there isconsiderable doubt as to its true value, i.e. it cannot be measured reliably. Therefore BAS 38 IntangibleAssets prohibits the recognition of such goodwill (see Chapter 6).



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Substance over form

Faithful representation of a transaction is only possible if it is accounted for according to its substance andeconomic reality, not with its legal form.

Definition

Substance over form: The principle that transactions and other events are accounted for and presentedin accordance with their substance and economic reality and not merely their legal form.

Most transactions are reasonably straightforward and their substance, i.e. commercial effect, is the same astheir strict legal form. However, in some instances this is not the case as can be seen in the followingworked example.

Worked example: Sale and repurchase agreement

A Ltd sells goods to B Ltd for CU10,000, but undertakes to repurchase the goods from B Ltd in 12 months’time for CU11,000.

The legal form of the transaction is that A has sold goods to B as it has transferred legal title. To reflect thelegal form, A Ltd would record a sale and show the resulting profit, if any, in its income statement. In 12months’ time when legal title is regained, A Ltd would record a purchase. There would be no liability to BLtd in A Ltd’s balance sheet until the goods are repurchased.

The above treatment does not provide a faithful representation because it does not reflect the economicsubstance of the transaction. After all, A Ltd is under an obligation from the outset to repurchase the goodsand A Ltd bears the risk that those goods will be obsolete and unsaleable in a year’s time.

The substance is that B Ltd has made a secured loan to A Ltd of CU10,000 plus interest of CU1,000. Toreflect substance, A Ltd should continue to show the goods as an asset in inventories (at cost or netrealisable value, if lower) and should include a liability to B Ltd of CU10,000 in payables. A Ltd shouldaccrue for the interest over the duration of the loan.

When A Ltd pays CU11,000 to regain legal title, this should be treated as a repayment of the loan plusaccrued interest.

Other examples of accounting for substance:

Leases

Accounting for finance leases under BAS 17 Leases (which is covered in Chapter 8) is an example ofthe application of substance as the lessee includes the asset on its balance sheet even though the legalform of a lease is that of renting the asset, not buying it.

Group financial statements

Group financial statements are covered in detail in Chapters 10 to 16. The central principle underlyinggroup accounts is that a group of companies is treated as though it were a single entity, even thougheach company within the group is itself a separate legal entity.

Neutrality

Information must be free from bias to be reliable. Neutrality is lost if the financial statements areprepared so as to influence the user to make a judgement or decision in order to achieve a predeterminedoutcome.



Prudence

Uncertainties exist in the preparation of financial information, e.g. the collectability of doubtfulreceivables. These uncertainties are recognised through disclosure and through the application of prudence.Prudence involves exercising a degree of caution when making judgements in conditions of uncertainty.Prudence does not, however, allow the creation of hidden reserves or excessive provisions,understatement of assets or income or overstatement of liabilities or expenses.

Completeness

Financial information must be complete, within the restrictions of materiality and cost, to be reliable.Omission may cause information to be misleading.

4.4.5 Comparability

Users must be able to compare an entity's financial statements:

(a) Through time to identify trends.

(b) With other entities’ statements, to evaluate their relative financial position, performance andchanges in financial position.

The consistency of treatment is therefore important across like items over time, within the entity andacross all entities.

The disclosure of accounting policies is particularly important here. Users must be able to distinguishbetween different accounting policies in order to be able to make a valid comparison of similar items in theaccounts of different entities.

Comparability is not the same as uniformity. Entities should change accounting policies if those policiesbecome inappropriate.

Corresponding information for preceding periods should be shown to enable comparison over time.

4.4.6 Constraints on useful information

(a) Timeliness

Information may become irrelevant if there is a delay in reporting it. There is a balance betweentimeliness and the provision of reliable information. Information may be reported on a timelybasis when not all aspects of the transaction are known, thus compromising reliability.

If every detail of a transaction is known, it may be too late to publish the information because it has becomeirrelevant. The overriding consideration is how best to satisfy the economic decision-making needs of theusers.

(b) Balance between benefits and cost

This is a pervasive constraint, not a qualitative characteristic. When information is provided, itsbenefits must exceed the costs of obtaining and presenting it. This is a subjective area and there areother difficulties: others, not the intended users, may gain a benefit; also the cost may be paid bysomeone other than the users. It is therefore difficult to apply a cost-benefit analysis, but preparersand users should be aware of the constraint.

(c) Balance between qualitative characteristics

A trade-off between qualitative characteristics is often necessary, the aim being to achieve anappropriate balance to meet the objective of financial statements. It is a matter for professionaljudgement as to the relative importance of these characteristics in each individual case.

Relevance v reliability

The most relevant information may not always be the most reliable. For example, an entity may befacing a potential liability as a result of a legal claim. The outcome of the claim may not be sufficientlyreliable to recognise a provision in the financial statements. However, information about the claimwould be relevant to the users of the financial statements as it would provide information about future



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liabilities. The conflict between relevance and reliability here is normally resolved through disclosure ofthe facts involved.

Understandability v relevance

Relevant information may not always be the most understandable. This is particularly true where theinformation involves complex issues. In this situation relevance would take priority. It would not beappropriate to omit information simply because it was difficult to understand.

Faithful recognition v completeness

In some cases faithful recognition may override the characteristic of completeness. For example, asdiscussed in section 4.4.4, internally generated goodwill is not recognised as its measurement isuncertain.

4.4.7 True and fair view/fair presentation

The Framework does not attempt to define these concepts directly. It does state, however, that theapplication of the principal 'qualitative' characteristics and of appropriate accounting standardswill usually result in financial statements which show a true and fair view, or are presented fairly. (We willlook at these terms in more detail in Chapter 2).

4.5 The elements of financial statements

4.5.1 Overview

Transactions and other events are grouped together in broad classes and in this way their financial effectsare shown in the financial statements. These broad classes are the elements of financial statements.

The Framework lays out these elements as follows.

Elements of financialstatements

Financial position in thebalance sheet

Performance in theincome statement

Assets Liabilities Equity

Income Expenses

Contributions from equity participants and distributions to them are also shown in the statement ofchanges in equity.

4.5.2 Definitions of elements

Element Definition Comment

Asset A resource controlled by an entity as a result ofpast events and from which future economicbenefits are expected to flow to the entity.

Technically, the asset is the access tofuture economic benefits (e.g. cashgeneration) not the underlying item ofproperty itself (e.g. a machine).

Liability A present obligation of the entity arising frompast events, the settlement of which is expectedto lead to the outflow from the entity ofresources embodying economic benefits.

An obligation implies that the entity isnot free to avoid the outflow ofresources.



Element Definition Comment

Equity The residual amount found by deducting all of theentity’s liabilities from all of the entity’s assets.

Equity = ownership interest = netassets. For a company, this usuallycomprises shareholders’ funds (i.e.capital and reserves).

Income Increases in economic benefits in the form ofasset increases/liability decreases not resultingfrom contributions from equity participants.

Income comprises revenue and gains,including all recognised gains on non-revenue items (e.g. revaluations ofnon-current assets).

Expenses Decreases in economic benefits in the form ofasset decreases/liability increases not resultingfrom distributions to equity participants.

Expenses includes losses, including allrecognised losses on non-revenueitems (such as write-downs of non-current assets).

Note the way that the changes in economic benefits resulting from asset and liability increases anddecreases are used to define:

Income, and Expenses.

This arises from the ‘balance sheet approach’ adopted by BFRS Framework which treats performancestatements, such as the income statement, as a means of reconciling changes in the financial positionamounts shown in the balance sheet.

These key definitions of ‘asset’ and ‘liability’ will be referred to again and again in these learning materials,because they form the foundation on which so many accounting standards are based. It is very importantthat you can reproduce these definitions accurately and quickly.

4.5.3 Assets

We can look in more detail at the components of the definitions given above.

Assets must give rise to future economic benefits, either alone or in conjunction with other items.

Definition

Future economic benefit: The potential to contribute, directly or indirectly, to the flow of cash and cashequivalents to the entity. The potential may be a productive one that is part of the operating activities ofthe entity. It may also take the form of convertibility into cash or cash equivalents or a capability to reducecash outflows, such as when an alternative manufacturing process lowers the cost of production.

In simple terms, an item is an asset if:

It is cash or the right to cash in future, e.g. a receivable, or a right to services that may be used togenerate cash, e.g. a prepayment.

or

It can be used to generate cash or meet liabilities, e.g. a tangible or intangible non-current asset.

The existence of an asset, particularly in terms of control, is not reliant on:

Physical form (hence intangible assets such as patents and copyrights may meet the definition of anasset and appear on the balance sheet – even though they have no physical substance).

Legal ownership (hence some leased assets, even though not legally owned by the company, may beincluded as assets on the balance sheet. (See Chapter 8)).

Transactions or events in the past give rise to assets. Those expected to occur in future do not inthemselves give rise to assets.



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4.5.4 Liabilities

Again we look more closely at some aspects of the definition.

An essential feature of a liability is that the entity has a present obligation.

Definition

Obligation: A duty or responsibility to act or perform in a certain way. Obligations may be legallyenforceable as a consequence of a binding contract or statutory requirement. Obligations also arise,however, from normal business practice, custom and a desire to maintain good business relations or act inan equitable manner.

As seen above, obligations may be:

Legally enforceable as a consequence of a binding contract or statutory requirement. This isnormally the case with amounts payable for goods and services received

The result of business practice. For example, even though a company has no legal obligation to doso, it may have a policy of rectifying faults in its products even after the warranty period has expired.

A management decision (to acquire an asset, for example) does not in itself create an obligation,because it can be reversed. But a management decision implemented in a way which creates expectations inthe minds of customers, suppliers or employees, such as the warranty example above, becomes anobligation. This is sometimes described as a constructive obligation. This issue is covered more fully inChapter 9 in the context of the recognition of provisions.

Liabilities must arise from past transactions or events. For example, the sale of goods is the pasttransaction which allows the recognition of repair warranty provisions.

Settlement of a present obligation will involve the entity giving up resources embodying economicbenefits in order to satisfy the claim of the other party. In practice, most liabilities will be met in cash butthis is not essential.

Interactive question 1: Asset or liability? [Difficulty level: Easy]

Question Fill in your answer

(a) Oak Ltd has purchased a patent for CU40,000. Thepatent gives the company sole use of a particularmanufacturing process which will save CU6,000 ayear for the next five years.

(b) Elm Ltd paid John Brown CU20,000 to set up a carrepair shop, on condition that priority treatment isgiven to cars from the company's fleet.

(c) Sycamore Ltd provides a warranty with everywashing machine sold.

See Answer at the end of this chapter.



4.5.5 Equity

Equity is the residual of assets less liabilities, so the amount at which it is shown is dependent on themeasurement of assets and liabilities. It has nothing to do with the market value of the entity's shares.

Equity may be sub-classified in the balance sheet providing information which is relevant to the decision-making needs of the users. This will indicate legal or other restrictions on the ability of the entity todistribute or otherwise apply its equity.

In practical terms, the important distinction between liabilities and equity is that creditors have the right toinsist that the transfer of economic resources is made to them regardless of the entity's financial position,but owners do not. All decisions about payments to owners (such as dividends or share capital buy-back)are at the discretion of management.

4.5.6 Performance

Profit is used as a measure of performance, or as a basis for other measures (e.g. EPS). It dependsdirectly on the measurement of income and expenses, which in turn depend (in part) on the concepts ofcapital and capital maintenance adopted.

Income and expenses can be presented in different ways in the income statement, to provideinformation relevant for economic decision-making. For example, an income statement could distinguishbetween income and expenses which relate to continuing operations and those which do not.

Items of income and expense can be distinguished from each other or combined with each other.

Income

Both revenue and gains are included in the definition of income. Revenue arises in the course ofordinary activities of an entity. (We will look at revenue in more detail in Chapter 7.)

Definition

Gains: Increases in economic benefits. As such they are no different in nature from revenue.

Gains include those arising on the disposal of non-current assets. The definition of income also includesunrealised gains, e.g. on revaluation of non-current assets.

A revaluation gives rise to an increase or decrease in equity.

Although these increases and decreases meet the definitions of income and expenses they are notincluded in the income statement under certain concepts of capital maintenance, however, but areincluded in equity.

(In your Accounting studies you will have seen that a gain on revaluation is recognised in a revaluationreserve.)

Expenses

As with income, the definition of expenses includes losses as well as those expenses that arise in thecourse of ordinary activities of an entity.

Definition

Losses: Decreases in economic benefits. As such they are no different in nature from other expenses.

Losses will include those arising on the disposal of non-current assets. The definition of expenses will alsoinclude unrealised losses. You will come across examples of these in your Financial Reporting andAdvanced Stage studies.



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4.6 Recognition of elements in financial statements

4.6.1 Meaning of recognised

An item is recognised when it is included in the balance sheet or income statement.

Definition

Recognition: The process of incorporating in the balance sheet or income statement an item that meetsthe definition of an element and satisfies the following criteria for recognition:

It is probable that any future economic benefit associated with the item will flow to or from theentity, and

The item has a cost or value that can be measured with reliability.

Points to note:

(1) Regard must be given to materiality (see section 4.4.3 above).

(2) An item which fails to meet these criteria at one time may meet it subsequently.

(3) An item which fails to meet the criteria may merit disclosure in the notes to the financial statements.(This is dealt with in more detail by BAS 37 Provisions, Contingent Liabilities and Contingent Assets which iscovered in Chapter 9).

4.6.2 Probability of future economic benefits

Probability here refers to the degree of uncertainty that the future economic benefits associated with anitem will flow to or from the entity. This must be judged on the basis of the characteristics of theentity's environment and the evidence available when the financial statements are prepared.

The Framework does not give a definition of 'probable'. A working definition is 'more likely than not'.

4.6.3 Reliability of measurement

The cost or value of an item in many cases must be estimated. The use of reasonable estimates is anessential part of the preparation of financial statements and does not undermine their reliability.Where no reasonable estimate can be made, the item should not be recognised (although its existenceshould be disclosed in the notes.)

4.6.4 Recognition of items

We can summarise the recognition criteria for assets, liabilities, income and expenses, based on thedefinition of recognition given above.

Item Recognised in When

Asset The balance sheet It is probable that the future economic benefits will flow to the entityand the asset has a cost or value that can be measured reliably.

Liability The balance sheet It is probable that an outflow of resources embodying economicbenefits will result from the settlement of a present obligation and theamount at which the settlement will take place can be measuredreliably.

Income The income statement An increase in future economic benefits related to an increase in anasset or a decrease of a liability has arisen that can be measuredreliably.

Expenses The income statement A decrease in future economic benefits related to a decrease in anasset or an increase of a liability has arisen that can be measuredreliably.



Points to note:

(1) There is a direct association between expenses being recognised in the income statement and thegeneration of income. This is commonly referred to as the accrual or matching concept. However, theapplication of the accrual concept does not permit recognition of assets or liabilities in thebalance sheet which do not meet the appropriate definition.

(2) Expenses should be recognised immediately in the income statement when expenditure is notexpected to result in the generation of future economic benefits.

(3) An expense should also be recognised immediately when a liability is incurred without thecorresponding recognition of an asset.

4.7 Measurement in financial statements

For an item or transaction to be recognised in an entity's financial statements it needs to be measured asa monetary amount. BFRS uses several different measurement bases but the Framework refers tojust four.

The four measurement bases referred to in BFRS Framework are:

Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair valueof the consideration given to acquire them at the time of their acquisition. Liabilities are recorded atthe amount of proceeds received in exchange for the obligation, or in some circumstances (forexample, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy theliability in the normal course of business.

Current cost. Assets are carried at the amount of cash or cash equivalents that would have to bepaid if the same or an equivalent asset was acquired currently.

Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be requiredto settle the obligation currently.

Realisable (settlement) value.

– Realisable value. The amount of cash or cash equivalents that could currently be obtained byselling an asset in an orderly disposal.

– Settlement value. The undiscounted amounts of cash or cash equivalents expected to be paidto satisfy the liabilities in the normal course of business.

Present value. A current estimate of the present discounted value of the future net cash flows in thenormal course of business.

Historical cost is the most commonly adopted measurement basis, but this is usually combined with otherbases, e.g. an historical cost basis may be modified by the revaluation of land and buildings.

4.8 Capital and capital maintenance

The final section of BFRS Framework is devoted to a brief discussion of the different concepts of capital andcapital maintenance, pointing out that:

The choice between them should be made on the basis of the needs of users of financial statements. The IASB has no present intention of prescribing a particular model.

4.8.1 Financial capital and capital maintenance

Definition

Financial capital maintenance: Under a financial concept of capital, such as invested money or investedpurchasing power capital is synonymous with the net assets or equity of the entity.



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The financial concept of capital is adopted by most entities.

This concept measures capital as the equity in the balance sheet. Profit is only earned in an accountingperiod if the equity at the end of the period is greater than it was at the start, having excludedthe effects of distributions to or contributions from the owners during the period.

Monetary measure of capital

Financial capital is usually measured in monetary terms, i.e. the CU sterling or the euro. This is theconcept applied in historical cost accounting. This measure can be quite stable over short periods of years,but is debased by even quite low rates of general inflation over longer periods, such as 20 years. Socomparisons between capital now and capital 20 years ago are invalid, because the measurement instrumentis not constant.

Constant purchasing power

A variant on the monetary measure of financial capital is the constant purchasing power measure. On thisbasis, the opening capital (i.e. equity) is uprated by the change in a broadly based price index,often a retail prices index, over the year. Also, the transactions during the year are uprated by the change inthe same index. A profit is only earned if the capital at the end of the year exceeds these upratedvalues. (The value of the uprating is taken to equity, but is not regarded as a profit, merely a ‘capitalmaintenance’ adjustment.) So this capital maintenance adjustment can be thought of as an additionalexpense in the income statement. Comparisons over a 20-year period will be more valid if the capital 20years ago is uprated for general inflation over that 20-year period.

But there is no reason why inflation measured by a retail prices index should be at all close to the inflationexperienced by an individual company.

4.8.2 Physical capital and capital maintenance

Definition

Physical capital maintenance: Under a physical concept of capital, such as operating capability, capital isregarded as the productive capacity of the entity based on, for example, units of output per day.

This concept looks behind monetary values, to the underlying physical productive capacity of theentity. It is based on the approach that an entity is nothing other than a means of producing saleableoutputs, so a profit is earned only after that productive capacity has been maintained by a ‘capitalmaintenance’ adjustment. (Again, the capital maintenance adjustment is taken to equity and is treated as anadditional expense in the income statement.) Comparisons over 20 years should be more valid than under amonetary approach to capital.

The difficulties in this approach lie in making the capital maintenance adjustment. It is basically a current costapproach, normal practice being to use industry-specific indices of movements in non-current assets, ratherthan go to the expense of annual revaluations by professional valuers. The difficulties lie in finding indicesappropriate to the productive capacity of a particular entity.



Worked example: Capital maintenance concepts

Meercat Ltd purchased 20,000 electrical components on 1 January 20X7 for CU10 each. They were all soldon 31 December 20X7 for CU250,000. On that date the replacement cost of an electrical component wasCU11.50. The general rate of inflation as measured by the general price index was 12% during the year.

Profit could be calculated as follows:

Financial capitalmaintenance

(monetary terms)

Financial capitalmaintenance

(constant purchasingpower)

Physical capitalmaintenance

CU CU CU

Revenue 250,000 250,000 250,000

Cost of sales

20,000 × 10

20,000 × 11.2

20,000 × 11.5

(200,000)

(224,000)

(230,000)

Profit 50,000 26,000 20,000

5 International Accounting Standards CommitteeFoundation (IASCF)

Section overview

The IASCF is the parent entity of the IASB. The IASB is responsible for setting accounting standards.

5.1 The IASCF

IASCF was formed in March 2001 as a not-for-profit corporation and is the parent entity of the IASB.The IASCF is an independent organisation and its trustees exercise oversight and raise necessaryfunding for the IASB to carry out its role as standard setter. It also oversees the work of theInternational Financial Reporting, Interpretations Committee (IFRIC) and the StandardsAdvisory Council (SAC). These are organised as follows:



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IASCF is responsible for: Funding Appointment of members of IASB, SAC

and IFRIC

IASB is responsible for: All technical matters in general In particular, the preparation and issue of

international accounting standards

IFRIC is responsible for: Interpretation and application of

international accounting standards

SAC is responsible for: Input on IASB's agenda Input on IASB's project timetable and

priorities Advice on standard-setting projects Supporting IASB in promotion/adoption of

IFRS throughout the world

5.2 Membership

Membership of the IASCF has been designed so that it represents an international group of preparers andusers, who become IASCF trustees. The selection process of the 19 trustees takes into accountgeographical factors and professional background. IASCF trustees appoint the IASB members.

5.3 The IASB

The IASB is responsible for setting accounting standards. It is made up of 14 members (12 full-time and twopart-time members) coming from nine countries. They have a variety of backgrounds and include:

Auditors Preparers of financial statements Users of financial statements, and Academics

5.4 Objectives of the IASB

The Preface to International Financial Reporting Standards states that the objectives of the IASB are as follows:

To develop in the public interest, a single set of high-quality, understandable and enforceableglobal accounting standards that require high quality, transparent and comparable information infinancial statements and other financial reporting to help participants in the various capital markets ofthe world and other users of the information to make economic decisions.

To promote the use and rigorous application of those standards, and

To work actively with national standard-setters to bring about convergence of national accountingstandards and IFRS to high quality solutions.

The issue of convergence is very topical. A number of exercises are being undertaken at the moment aimingto bring national and international accounting standards into line.



6 International Financial Reporting Standards (IFRS)

Section overview

The influence of IFRS is growing.

They aim to ensure that like transactions and events are treated consistently.

In Bangladesh ICAB has adopted all IASs and IFRSs issued by IASB with the exception of IAS 29 as at30/6/2009.

6.1 The purpose of accounting standards

The overall purpose of accounting standards is to identify proper accounting practices for thepreparation of financial statements.

Accounting standards create a common understanding between users and preparers on how particularitems, for example the valuation of property, are treated. Financial statements should therefore complywith all applicable accounting standards.

6.2 Application of IFRS

Within each individual country local regulations govern, to a greater or lesser degree, the issue offinancial statements. These local regulations include accounting standards issued by the national regulatorybodies or professional accountancy bodies in the country concerned.

Over the last 25 years however, the influence of IFRS on national accounting requirements andpractices has been growing. For example:

For accounting periods commencing on or after 1 January 2005, all EU companies whose securities aretraded on a regulated public market such as the London Stock Exchange, must prepare theirconsolidated accounts in accordance with IFRS. (Note that although group financial statementsmust follow IFRS the individual financial statements do not need to.)

In the UK unquoted companies are permitted (but not required) to adopt IFRS (see section 1.5).

In Bangladesh ICAB has adopted all IASs and IFRSs issued by the IASB as BASs and BFRSs, with nochanges, with the exception of IAS 29, Financial Reporting in Hyperinflationary Economies, which hasnot been adopted as at 30/06/2009.

6.3 Setting of IFRS

The overall agenda of the IASB will initially be set by discussion with the SAC. The process for developingan individual standard would involve the following steps.

Step 1During the early stages of a project, IASB may establish an Advisory Committee to give advice on issuesarising in the project. Consultation with the Advisory Committee and the SAC occurs throughout theproject.

Step 2IASB may develop and publish a Discussion Document for public comment.

Step 3Following the receipt and review of comments, IASB would develop and publish an Exposure Draft forpublic comment.



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Step 4Following the receipt and review of comments, the IASB would issue a final International FinancialReporting Standard.

The period of exposure for public comment is normally 90 days. However, in exceptional circumstances,proposals may be issued with a comment period of 60 days. Draft IFRIC Interpretations are exposed for a60-day comment period.

6.4 Scope and authority of IFRS

The Preface to IFRS makes the following points:

IFRS apply to all general purpose financial statements i.e. those directed towards the commoninformation needs of a wide range of users.

The IASB's objective is to require like transactions and events to be accounted for in a likeway.

It recognises that the IASC (the predecessor to the IASB) permitted different treatments(benchmark treatment and allowed alternative treatment) for like transactions and events. Wherethese still exist either treatment would constitute compliance with IFRS.

Standards include paragraphs in bold and plain type. Bold type paragraphs indicate the mainprinciples, but both types have equal authority.

Any limitation of the applicability of a specific IFRS is made clear in that standard. IFRSs are notintended to be applied to immaterial items, nor are they retrospective. Each individual IFRS laysout its scope at the beginning of the standard.

7 Inherent limitations of financial statements

Section overview

There are limitations inherent in financial statements, including the fact that they are:

– A conventionalised representation, involving classification, aggregation and the allocation ofitems to particular accounting periods

– Historical (backward-looking), and

– Based almost exclusively on financial data.

7.1 Conventionalised representation

Financial statements are highly standardised in terms of their overall format and presentation althoughbusinesses are very diverse in their nature. This may limit the usefulness of the information.

Financial statements are highly aggregated in that information on a great many transactions and balancesis combined into a few figures in the accounts, which can often make it difficult for the reader to evaluatethe components of the business.

Allocation issues include, for example, the application of the accrual concept and depreciation of non-current assets, where management’s judgements and estimates affect the period in which expenses orincome are recognised.

7.2 Backward-looking

Financial statements are backward-looking whereas most users of financial information base theirdecisions on expectations about the future. Financial statements contribute towards this by helping to



identify trends and by confirming the accuracy of previous expectations, but cannot realistically provide thecomplete information set required for all economic decisions by all users.

7.3 Omission of non-financial information

By their nature, financial statements contain financial information. They do not generally include non-financial data such as:

Narrative description of the major operations. Discussion of business risks and opportunities. Narrative analysis of the entity’s performance and prospects. Management policies and how the business is governed and controlled.

Financial statements include the elements as defined in BFRS Framework. This means that items which donot meet those definitions are not included. For example, the value of the entity’s internally generatedgoodwill i.e. through its reputation, loyalty and expertise of its management and employees, or its clientportfolio. While some companies do experiment with different types of disclosure for such items, thesedisclosures are considered unsuitable for inclusion in the financial statements (precisely because such itemsdo not fall within its definition of assets).

7.4 Other sources of information

Some of the limitations of financial statements are addressed in the other information which is oftenprovided along with the financial statements, especially by large companies, such as operating and financialreviews and the Chairman’s statement. Note that other information provided with financial statements isoutside the scope of the Financial Accounting syllabus.

There are also many other sources of information available to at least some users of financial statements,for example:

In owner-managed businesses, the owners have access to internal management information becausethey are the management. This information is, potentially, available on a continuous real-time basis andmay include:

– Future plans for the business– Budgets or forecasts– Management accounts, including, for example, divisional analysis

Banks will often obtain additional access to entity information under the terms of loan agreements.

Potential investors (e.g. if they are planning to take a major stake or even a controlling interest) willoften negotiate additional access to corporate information.

Publicly available information, such as entity brochures and publicity material (e.g. press releases)

Brokers’ reports on major companies, and

Press reports and other media coverage (e.g. television or internet).



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Section overview

Not-for-profit entities include NGOs, clubs, and public sector organisations. Reporting requirements will vary depending on the nature of the entity.

8.1 Not-for-profit entities

The objective of most company directors is to manage the shareholders' investment. In a majority of casesthis will mean creating a profit. However, this is not always the case. For some entities their primarypurpose is to provide a service rather than to make a profit.

Interactive question 2: Not-for-profit entities [Difficulty level: Easy]

List as many types of not-for-profit organisations as you can.


As this exercise has demonstrated not-for-profit entities include a broad range of organisations involved invery different activities. Not-for-profit entities also vary considerably in size from the local rugby club to aninternationally renowned charity.

8.2 Reporting requirements

Many of the organisations mentioned above may be companies. In this case they will need to preparefinancial statements and have them audited in accordance with local legislation and accountingregulation. In Bangladesh this would include compliance with the Companies Act and BFRSs.

For unincorporated entities the reporting requirements are normally less onerous, although best practicewould be to follow BFRSs.

In addition, many not-for-profit organisations will need to comply with regulations specific to their sector.For example in Bangladesh, NGOs are required to comply with the Foreign Donations Rules (FDRs),1978.

8.3 International public sector accounting standards

International Public Sector Accounting Standards (IPSAS) are issued by the International Public SectorAccounting Standards Board (IPSASB). The objective of IPSASB is to:

Develop high quality public sector financial reporting standards.

Facilitate convergence of international and national standards.

Enhance the quality and uniformity of financial reporting.

Currently there is no requirement for IPSAS to be adopted and in jurisdictions where national standardsalready exist since it is the local regulation which will be applied. The IPSASB however, envisage anincreasing role for IPSAS in future, particularly in the following areas:

Assisting national standard-setters in the development of new standards and the revision ofexisting standards.

Being applied in jurisdictions where there is no national legislation.




Summary

Regulated by:Local legislationFDRsIPSAS

Self-test

Answer the following questions

1 Which of the following is the best description of why BFRS Framework requires financial statements tobe prepared on the basis of accrual accounting?

A As a result of the 'substance over form' requirementB So as to be prudentC Because it is the most objective basisD Because it presents both past transactions and future obligations



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2 The following relate to the going concern assumption.

(1) The entity has no need to liquidate(2) The entity has no intention to liquidate(3) The entity has no need to curtail materially its scale of operations(4) The entity has no intention to curtail materially its scale of operations

Which of the above are the best description of the conditions which BFRS Framework identifies asnecessary if the going concern basis is to be used for the preparation of financial statements?

A (1), (2) and (3) onlyB (1), (2) and (4) onlyC (1), (3) and (4) onlyD (1), (2), (3) and (4)

3 According to BFRS Framework which of the following is one of the qualitative characteristics whichmake information in financial statements useful?

A True and fair viewB ComparabilityC TimelinessD Historical cost

4 Which of the following is the closest approximation to BFRS Framework’s definition of an asset?

A A resource controlled by the entity from which future economic benefits are expected which canbe measured reliably

B A resource controlled by the entity as a result of past events from which future economicbenefits are expected which can be measured reliably

C A resource controlled by the entity from which future economic benefits are expected

D A resource controlled by the entity as a result of past events from which future economicbenefits are expected

5 Which of the following is the closest approximation to BFRS Framework’s definition of a liability?

A A legal obligation arising from past events, the settlement of which is expected to result in anoutflow of resources embodying economic benefits

B An obligation arising from past events, the settlement of which is expected to result in an outflowof resources embodying economic benefits which can be measured reliably

C An obligation arising from past events, the settlement of which is expected to result in an outflowof resources embodying economic benefits

D A legal obligation arising from past events, the settlement of which is expected to result in anoutflow of resources embodying economic benefits which can be measured reliably

6 Future settlement is an essential part of BFRS Framework’s definition of a liability. Which of thefollowing best describes the way that settlement may occur?

A Payment of cash

B Payment of cash or transfer of other assets

C Payment of cash or transfer of other assets or replacement of the obligation with anotherobligation

D Payment of cash or transfer of other assets or replacement of the obligation with anotherobligation or conversion of the obligation to equity



7 Which of the following is the closest approximation to BFRS Framework’s definition of income?

A Increase in assets

B Increase in assets or decrease in liabilities

C Increase in assets or decrease in liabilities, other than those relating to transactions with equityparticipants

D Increase in assets, other than those relating to transactions with equity participants

8 Which of the following is the closest approximation to BFRS Framework’s requirement as to when anasset or liability should be recognised?

A It is probable that future economic benefits will flow to or from the entity and the item’s cost orvalue can be estimated

B It is probable that future economic benefits will flow to or from the entity and the item’s cost orvalue can be measured reliably

C The item’s cost or value can be measured reliably

D The item’s cost or value can be estimated

9 Which of the following statements is true in respect of International Public Sector AccountingStandards (IPSAS)?

A Currently there is no requirement for IPSAS to be adopted by public sector entitiesB IPSAS must be adopted by public sector entities where there are no national standardsC Both IPSAS and national standards must be adopted by public sector entitiesD None of the above statements is correct

10 TRADITIONAL FRUITS LTD

Traditional Fruits Ltd, a Herefordshire based fruit bottling and canning company, is looking to expandits operations. The directors are hoping to increase the range of preserved fruit products and in doingso will need to invest in new equipment. They are also hoping to open a new facility in the South Eastnear to the fruit farms of Kent and Surrey.

The finance director has been asked to prepare a résumé of the financial performance of the companyin order that possible providers of finance can assess the future potential of the company.

The finance director wants to address all issues in her résumé and has asked for your assistance.

Requirements

Prepare brief notes for the finance director, addressing each of the following and using BFRSFramework as a source of reference.

(a) Identify potential providers of finance for Traditional Fruits Ltd and their informationrequirements in respect of financial statements.

(b) Explain the terms 'performance' and 'position' and identify which of the financial statements willassist the user in evaluating performance and position.

(c) Indicate why, for decision-making purposes, the financial statements alone are insufficient.



1

11 DAVIES AND SAYERS LTD

Davies and Sayers Ltd (D&S Ltd) is a well-known publisher of children’s educational books. Thefinance director, Carol Roberts, is known for her commercial acumen rather than her technical ability.She is therefore seeking your advice on two particular accounting issues.

(1) Value of head of publishing

D&S Ltd have recently appointed a new head of publishing, Jane Lindsay. Jane recently worked fora key competitor, Surridge and Hughes Ltd (S&H Ltd). Jane is extremely popular amongst theleading authors in the market and is sure to attract the services of certain authors currentlyworking for S&H Ltd. Carol believes that Jane is therefore of great value to D&S Ltd and thatsuch value should therefore be recognised in the balance sheet in the form of an asset.

(2) Provision for alleged breach of copyright

Carol is aware that Poppy Anderson, one of D&S Ltd’s authors, is being accused of 'includingideas in her texts that have previously been published'. Carol is certain a legal case will ensue andtherefore, being prudent, wishes to recognise a liability in the accounts now for any damages thatare likely to arise.

Requirements

Using BFRS Framework

(a) Define the terms 'asset', 'liability' and 'recognised'.

(b) Prepare brief notes for Carol Roberts, discussing whether the above result in an asset or liabilityand whether or not they should be recognised in the financial statements.

Note: You are not required to refer to specific BFRSs that may be relevant.

Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved theseobjectives, please tick them off.



Technical reference

Point to note: The whole of BFRS Framework (Frame) and Preface to International Financial ReportingStandards (Preface) is examinable. The paragraphs listed below are the key references you should be familiarwith.


Users’ core need is for information for making economic decisions Frame (Preface)

Objective is to provide information on financial position, financial performance andchanges in financial position

Frame (12)

Financial position: Frame (16)

– Resources controlled– Financial structure– Liquidity and solvency– Capacity to adapt to changes

Financial performance, measured as profit = income less expenses: Frame (17)

– Potential changes to resources in the future– Capacity to generate cash from existing resource base– Effectiveness with which additional resources might be employed

Changes in financial position: Frame (18)

– Ability to generate cash– Needs to use what is generated

Notes and schedules: Frame (21)

– Risks and uncertainties– Resources and obligations not recognised in financial statements

2 Underlying assumptions

Accrual basis Frame (22)

Going concern Frame (23)

3 Qualitative characteristics of financial statements

To be useful, information needs to have the attributes of:

– Understandability Frame (25)

– Relevance, to include: Frame (26)

Materiality Frame (29)

– Reliability, to include: Frame (31)

Faithful representation Frame (33)

Substance over form Frame (35)

Neutrality Frame (36)

Prudence Frame (37)

Realised/unrealised

– Comparability Frame (39)

Application of these should result in a true and fair view/fair presentation Frame (46)



1

4 Elements of financial statements

Asset: a resource controlled by the entity as a result of past events and fromwhich future economic benefits are expected to flow to the entity

Frame (49)

Liability: a present obligation of the entity arising from past events, thesettlement of which is expected to lead to the outflow from the entity ofresources embodying economic benefits

Frame (49)

Equity: the residual interest in assets less liabilities, i.e. net assets Frame (49)

Income (comprising revenue and gains): increases in economic benefits in theform of asset increases/liability decreases, other than contributions from equity

Frame (70, 74-

75)

Expenses (including losses): decreases in economic benefits in the form of assetdecreases/liability increases, other than distributions to equity

Frame (70, 78-

79)

5 Recognition

Assets and liabilities are recognised in financial statements if: Frame (83)

– It is probable that any future economic benefit associated with the item willflow to or from the entity, and

– Its cost or value can be measured with reliability

6 Measurement

Historical cost Frame (100)

Current cost Realisable value Present value

7 Capital maintenance

Financial capital: Frame (104)

– Monetary– Constant purchasing power

Physical capital

8 IASB

Objectives Preface (6)

Scope and authority Preface (7-17)

Process Preface (18)




1 D

2 D

3 B

4 D

5 C

6 D

7 C

8 B

9 A

10 TRADITIONAL FRUITS LTD

(a) Potential providers of finance Information requirements

The existing shareholders of thecompany and potential newshareholders – through a new issueof share capital.

The profit before interest of Traditional FruitsLtd (TF Ltd), to determine risk.

The trend of profitability of TF Ltd togetherwith a history of dividend payments. This willenable them to assess return and risk of theirinvestment.

The financial structure of TF Ltd, to determinethe level of debt finance as a measure of risk.

TF Ltd's liquidity or ability to pay out dividendsand redeem share capital.

TF Ltd's ability to generate cash and the timingand certainty of its generation.

Existing and future lenders andcreditors to the company.

The liquidity of TF Ltd and its ability to repayinterest and capital instalments.

The existing level of debt and any security overthat debt.

(b) Performance and position and the financial statements which assist in evaluation

Performance

The financial performance of a company comprises the return it obtains on the resources itcontrols. Performance can be measured in terms of the profits of the company and its ability togenerate cash flows.

Management will be assessed on their skill in achieving the highest level of performance, given theresources available to them.

Information on performance can be found in

The income statement. The statement of changes in equity. The cash flow statement.



1

Position

The financial position of the company is evaluated by reference to

The economic resources (assets and liabilities) it controls. Its capital structure, i.e. its level of debt finance and shareholders’ funds. Its liquidity and solvency.

The user of the financial statements can then make assessments on the level of risk, ability togenerate cash, the likely distribution of this cash and the ability of the company to adapt tochanging circumstances.

The balance sheet is the prime source of information on a company’s position but the cash flowstatement will also indicate a company’s cash position over a period of time.

(c) Financial statements – inherent limitations as a tool of decision-making

Financial statements are prepared by reference to a relatively rigid set of accounting standardsapplicable to all companies, regardless of the sectors of the economy they operate in. As a result,information for individual and specialised companies may not be forthcoming. Further, thepreparation of financial statements is based on estimates and judgements by the management andtherefore are not a source of totally reliable information.

Financial statements primarily use the historical cost convention. They can identify trends fromthe past which may be relevant to the future, but they are not forecasts and are therefore lesshelpful when making predictions.

In deciding whether or not to invest in a company, a decision-maker will also want access to non-financial data not contained in the financial statements such as

A discussion of business risks and opportunities An evaluation of the quality of management A narrative analysis of position and performance

11 DAVIES AND SAYERS LTD

(a) Terms

Asset

An asset is

A resource controlled by the entity As a result of past events, and From which future economic benefits are expected to flow into the entity.

Legal ownership is not an essential part of the definition of an asset, even though such ownershipis indicative that the control criterion has been met. But the key is whether the entity controls aresource, so having the continued use of an item will often be sufficient evidence of control.

Liability

A liability is

A present obligation of the entity

Arising from past events

The settlement of which is expected to result in an outflow from the entity of resourcesembodying economic benefits.

An obligation arises from a legally-enforceable contract, but it may also result from an entity’snormal business practices.



Recognised

Recognition means that an item is recorded in the financial statements. An asset or liability isrecognised if

It is probable that any future economic benefit associated with the item will flow to or fromthe entity, and

The cost or value can be measured with reliability.

(b) Notes for Carol Roberts

(1) Value of head of publishing

Existence of an asset

If you apply the definition of an asset from BFRS Framework to the head of publishing, JaneLindsay, it is possible to argue that she has the characteristics of an asset.

As a full-time employee, Jane is likely to have a contract which was signed prior to thebalance sheet date. The legal contract will prevent Jane working for any other company,giving D&S Ltd unrestricted access to any benefits she may provide.

If Jane is able to persuade new authors to join the D&S team, she is creating a flow of futureeconomic benefits – on the assumption that the authors’ new work will prove salesworthy.

However, there is uncertainty over

The enforceability of Jane’s contract: she may recruit new authors to D&S Ltd, butwithin a short period of time might leave and join a new company; her authors arethen likely to follow her.

The revenue stream to result from the new authors: they have not as yet beenrecruited and it is only possible that they will be; there are also no guarantees as to thequality of their future work and therefore the level of revenue they are likely togenerate.

Therefore, at this stage we cannot conclude that an asset exists.

Recognition of the asset

An item is recognised when it is included in the financial statements at a monetary value.Carol Roberts is proposing to include Jane Lindsay as an asset in the balance sheet.However, certain criteria should be applied prior to recognition.

Is there sufficient evidence of the existence of the asset? Can the asset be measured at a monetary amount with sufficient reliability?

(2) Provision for breach of copyright

Existence of a liability

At this stage Poppy Anderson has been accused of breach of copyright. From theinformation given, there is no opinion from lawyers as to the strength of the case orestimate of the possible value of any claim. Therefore, whilst a past transaction has allegedlyoccurred, there is insufficient evidence of, and uncertainty over, whether an obligationexists.

Recognition of the liability

To recognise the liability in the financial statements there must be sufficient evidence of theexistence of the liability and it should be probable that economic benefit will flow from theentity. In this case, there is insufficient evidence of a liability and we are unable to reliablymeasure any potential liability.

The case is at far too early a stage to estimate the possible loss. It would therefore be over-prudent and inappropriate to recognise the liability in the financial statements.



1


Answer to Interactive question 1

Question Answer

(a) Oak Ltd has purchased a patent for CU40,000.The patent gives the company sole use of aparticular manufacturing process which will saveCU6,000 a year for the next five years.

This is an asset, albeit an intangible one. Thereis a past event, control and future economicbenefit (through cost saving).

(b) Elm Ltd paid John Brown CU20,000 to set up acar repair shop, on condition that prioritytreatment is given to cars from the company'sfleet.

This cannot be classed as an asset. Elm Ltd hasno control over the car repair shop and it isdifficult to argue that there are futureeconomic benefits.

(c) Sycamore Ltd provides a warranty with everywashing machine sold.

This is a liability. The business has an obligationto fulfil the terms of the warranty. The liabilitywould be recognised when the warranty isissued rather than when a claim is made.


NGOs Friendly societies Public sector hospitals Public sector schools Clubs Associations Local councils Public services Trade unions Societies Housing associations




Contents

Introduction

Examination context

Topic List

1 BAS 1 Presentation of Financial Statements

2 Overall considerations

3 Structure and content: general points

4 Balance sheet

5 Income statement

6 Statement of changes in equity

7 Notes to the financial statements

8 Minority interest



Technical reference

Answers to self-test

chapter 2

Format of financialstatements



Introduction


Explain the purpose and principles underlying BAS 1 Presentation of Financial Statements

Prepare and present the financial statements (or extracts), of an entity according to itsaccounting policies and appropriate BFRSs

Prepare simple extracts from financial statements in accordance with Companies Act andBFRS

Calculate the amounts to be included in the equity section of the balance sheet of a not-for-profit entity

Specific syllabus references for this chapter are: 2b, c, e.


The way that financial information is presented to shareholders and other users is a fundamental part offinancial accounting. Recent corporate scandals have increased public concern as to the adequacy oftransparency in financial statements. Accounting standards provide guidance on presentation, although nosystem of rules can cover all eventualities.

To ensure that financial statements are prepared to an adequate level it is important that entities areprovided with a basic framework for the preparation of their financial statements. The informationproduced needs to reflect fairly the results of the business but also enable the shareholders to makecomparisons year on year and with the results of other companies. Therefore, information needs to bepresented in an understandable and consistent manner. This is achieved through the broad standardisationof the structure of financial statements. BAS 1 Presentation of Financial Statements provides a basicframework but still allows a degree of flexibility so that formats and headings can be adapted so thatinformation is presented in a way that aids understanding.

Stop and think

Can you think of any advantages and disadvantages of standardised formats for financial statements?

Working context

You will have come across financial statements in the context of your working life. They are a fundamentalpart of accounting, audit and tax services. It is less likely these days that you will have had to preparefinancial statements yourselves as this process is largely computerised. However, in order to understandfinancial information you need to know the basis on which the information has been prepared.

Some of you may have come across not-for-profit organisations including NGOs, clubs and societies. Thistype of entity may have to comply with additional regulations, for example the Foreign Donations Rules1978.

Syllabus links

You will have been introduced to the basics of company accounts in the Accounting paper. In this paperhowever, you are expected to have a much more detailed understanding of the preparation of financialstatements and a thorough knowledge of the regulation in this area. This knowledge will be assumed in boththe Financial Reporting paper and at the Advanced Stage.

FORMAT OF FINANCIAL STATEMENTS


2

Examination context

Exam requirements

The ability to prepare financial statements for an individual entity is a fundamental part of the FinancialAccounting syllabus and has a syllabus weighting of 55% (including the cash flow statement). It will thereforebe examined in the written test section of the paper in some form at every sitting and would also beexamined in OTs.

A typical written test question would involve the preparation of a company balance sheet or incomestatement from a trial balance. You may also be asked to make adjustments based on additional informationand/or to produce notes.

Alternatively you could be asked to produce extracts to the financial statements. For example, as part of aquestion on non-current assets you could be asked to produce the disclosure note which would supportthe balance in the balance sheet.

Not-for-profit entities are likely to be examined less frequently as you are only expected to have anoverview of this topic. This topic could be examined in the OT section or as part of a broader question onthe balance sheet presentation of equity.


Discuss the way BAS 1 builds on the principles contained in BFRS Framework, including the followingmatters:

– Fair/faithful presentation– Accrual basis– Going concern– Materiality

Draft, in accordance with BAS 1:

– A balance sheet, distinguishing between current and non-current items– An income statement– A statement of changes in equity– Notes to the financial statements

Prepare the equity section of the balance sheet of a not-for-profit entity from financial and other data

Prepare extracts from the financial statements in accordance with Companies Act and BFRS



1 BAS 1 Presentation of Financial Statements

Section overview

BAS 1 applies to all general purpose financial statements.

Financial statements provide information about:

– Financial position– Financial performance– Cash flows.

1.1 Objective

BAS 1 Presentation of Financial Statements prescribes the basis for the presentation of financial statements, soas to ensure comparability with:

The entity's own financial statements of previous periods, and The financial statements of other entities.

BAS 1 must be applied to all general purpose financial statements prepared in accordance with BFRSs,i.e. those intended to meet the needs of users who are not in a position to demand reports tailored totheir specific needs. BAS 1 is concerned with overall considerations about the minimum content of a setof financial statements; detailed rules about recognition, measurement and disclosures of specifictransactions are then contained in other standards.

Whilst the terminology used was designed for profit-orientated businesses, it can be used, withmodifications, for not-for-profit activities.

1.2 Purpose of financial statements

The objective of general purpose financial statements is to provide information about the financialposition, financial performance and cash flows of an entity that is useful to a wide range of users inmaking economic decisions. They also show the result of management stewardship of the resources ofthe entity. (This is very similar to the purpose stated by the Framework covered in Chapter 1).

In order to achieve this, information is provided about the following aspects of the entity's results:

Assets Liabilities Equity Income and expenses (including gains and losses) Other changes in equity, and Cash flows

Additional information is contained in the notes.



2

1.3 Components of financial statements

Summary ofmajor cashinflows andoutflows. Dealtwith in BAS 7(see Chapter 3)

Although the financial statements may be included as part of a wider document BAS 1 requires that theyshould be clearly identified and distinguished from other information presented.

2 Overall considerations

Section overview

Much of the material in this section details the specific application within financial statements of thegeneral principles dealt with in the BFRS Framework which was introduced in Chapter 1. Theseinclude:

– Fair presentation– Going concern– Accrual basis of accounting– Materiality

The technical summary at the end of this chapter refers you to both the relevant paragraphs of BAS 1and of the Framework.

2.1 Fair presentation

Financial statements should present fairly the financial position, financial performance and cash flows of anentity.

Definition

Fair presentation: Requires the faithful representation of the effects of transactions, other events andconditions in accordance with the definitions and recognition criteria for assets, liabilities, income andexpenses set out in the Framework.

Compliance with BFRS is presumed to result in financial statements that achieve a fair presentation.



BAS 1 expands on this principle as follows:

Compliance with BFRS should be disclosed.

Financial statements can only be described as complying with BFRS if they comply with all therequirements of BFRS.

Use of inappropriate accounting policies cannot be rectified either by disclosure or explanatorymaterial.

In rare circumstances management may conclude that compliance with a requirement of a BFRS wouldbe misleading. When the regulatory framework allows, the entity should depart from this requirementand disclose this fact and provide details of its effect. There are very few, if any, circumstances wherecompliance will be as fundamentally misleading.

Where the regulatory framework does not allow departure disclosure is required to reduce theperceived misleading aspects of compliance. In practice this would be extremely rare.

2.2 Going concern

As we saw in Chapter 1 going concern is referred to by the Framework as an underlying assumption. Itmeans that an entity is normally viewed as continuing in operation for the foreseeable future. Financialstatements are prepared on the going concern basis unless management either intends to liquidate theentity or to cease trading or has no realistic alternative but to do so.

BAS 1 makes the following points:

In assessing whether the entity is a going concern management must look at least twelve monthsinto the future measured from the balance sheet date (not from the date the financial statementsare approved.)

Uncertainties that may cast significant doubt on the entity's ability to continue should be disclosed.

If the going concern assumption is not followed that fact must be disclosed together with:

– The basis on which financial statements have been prepared– The reasons why the entity is not considered to be a going concern

2.3 Accrual basis of accounting

Financial statements other than the cash flow statement, must be prepared on the accrual basis ofaccounting. This is the Framework's other underlying assumption.

Definition

Accrual basis of accounting: Items are recognised as assets, liabilities, equity, income and expenses whenthey satisfy the definitions and recognition criteria for those elements in the Framework.

Point to note: The definition refers to the definitions and recognition criteria of the Framework. The effectis that:

Transactions are recognised when they occur (and not when the relevant cash is received or paid). They are recorded in the financial statements of the periods to which they relate.

According to the accrual assumption, then, in computing profit, revenue earned must be matched againstthe expenditure incurred in earning it. (This issue will be considered further when BAS 18 Revenue is dealtwith in Chapter 7.)



2

2.4 Consistency of preparation

To maintain consistency, the presentation and classification of items in the financial statements should staythe same from one period to the next. There are two exceptions to this:

There is a significant change in the nature and operations or a review of the financial statementspresentation which indicates a more appropriate presentation. (This change is only allowed if theresulting information is reliable and more relevant than the previous presentation. If two presentationsare equally appropriate then the current presentation must be retained.)

A change in presentation is required by a BFRS.

Where a change of presentation and classification is made, figures for the previous period must be restatedon the new basis, unless this is impracticable (i.e. not possible 'after making every reasonable effort').

Worked example: Consistency

Compare the following two income statements prepared for a sole trader who wishes to show them to thebank manager to justify continuation of an overdraft facility.

Year ended 31 December 20X6CU CU

Sales revenue 25,150Less production costs 10,000

selling and administration 7,00017,000

Gross profit 8,150Less interest charges 1,000Profit after interest 7,150

Year ended 31 December 20X7CU

Sales revenue less selling costs 22,165Less production costs 10,990

Gross profit 11,175Less administration and interest 3,175Net profit 8,000

Which accounting concept is being ignored here? Justify your choice.

How do you think the changes in the format of these financial statements affect the quality of theaccounting information presented?

Solution

The accounting assumption breached here is that of consistency. This concept holds that accountinginformation should be presented in a way that facilitates comparisons from period to period.

In the income statement for 20X6 sales revenue is shown separately from selling costs. Also interest andadministration charges are treated separately.

The new format is poor in itself, as we cannot know whether any future change in 'sales revenue less sellingcosts' is due to an increase in sales revenue or a decline in selling costs. A similar criticism can be levelled atthe lumping together of administration costs and interest charges. It is impossible to divide the two. (In factBAS 1 states that material balances should not be aggregated (see section 2.5 below).

It is not possible to 'rewrite' 20X6's accounts in terms of 20X7, because we do not know the breakdown in20X6 between selling and administration costs.

The business's bank manager will not, therefore, be able to assess the business's performance, and mightwonder if the sole trader has 'something to hide'. Thus the value of this accounting information is severelyaffected.



2.5 Materiality and aggregation

Each material class of items should be presented separately in the financial statements.

Amounts which are immaterial can be aggregated with amounts of a similar nature or function and neednot be presented separately.

Definition

Materiality: Omissions or misstatement of items are material if they could, individually or collectively,influence the economic decisions of users taken on the basis of the financial statements. Materiality dependson the size and nature of the omission or misstatement judged in the surrounding circumstances. The sizeor nature of the item, or a combination of both, could be the determining factor.

An error which is too trivial to affect anyone's understanding of the financial statements is referred to asimmaterial. However, the cumulative effects of many errors should also be taken into account. A numberof immaterial errors taken together could be material to the financial statements as a whole. In preparingfinancial statements it is important to assess what is material and what is not, so that time and money arenot wasted in the pursuit of excessive detail.

Determining whether or not an item is material is a very subjective exercise. There is no absolutemeasure of materiality. It is common to apply a convenient rule of thumb (for example to define materialitems as those with a value greater than 5% of the net profit disclosed by the financial statements). Butsome items disclosed in financial statements are regarded as particularly sensitive and even a very smallmisstatement of such an item would be regarded as a material error. An example in the financial statementsof a limited liability company might be the amount of remuneration paid to directors of the company.

The assessment of an item as material or immaterial may affect its treatment in the financialstatements. For example, the income statement of a business will show the expenses incurred by thebusiness grouped under suitable captions (heating and lighting expenses, rent and property taxes etc).However, in the case of very small expenses it may be appropriate to lump them together under a captionsuch as 'sundry expenses', because a more detailed breakdown would be inappropriate for such immaterialamounts.

In assessing whether or not an item is material, it is not only the amount of the item which needs to beconsidered. The context is also important.

Worked example: Materiality

If a balance sheet shows non-current assets of CU2 million and inventories of CU30,000 an error ofCU20,000 in the depreciation calculations might not be regarded as material, whereas an error ofCU20,000 in the inventory valuation probably would be. In other words, the total of which the erroneousitem forms part must be considered.

If a business has a bank loan of CU50,000 and a CU55,000 balance on bank deposit account, it might well beregarded as a material misstatement if these two amounts were displayed on the balance sheet as 'cash atbank CU5,000'. In other words, incorrect presentation may amount to material misstatement even if thereis no monetary error.

Users are assumed to have a personal knowledge of business and economic activities and accounting and awillingness to study the information with reasonable diligence.



2

2.6 Offsetting

BAS 1 does not allow assets and liabilities to be offset against each other unless such a treatment isrequired or permitted by another BFRS.

Income and expenses can be offset only when:

A BFRS requires/permits it, or

Gains, losses and related expenses arising from the same/similar transactions are not material (inaggregate).

2.7 Comparative information

BAS 1 requires comparative information to be disclosed for the previous period for all numericalinformation, unless another BFRS permits/requires otherwise. Comparatives should also be given innarrative information where relevant to an understanding of the current period's financial statements.

Comparatives should be reclassified when the presentation or classification of items in the financialstatements is amended.

2.8 Disclosure of accounting policies

There should be a specific section for accounting policies in the notes to the financial statements and thefollowing should be disclosed there.

Measurement bases used in preparing the financial statements Each specific accounting policy necessary for a proper understanding of the financial statements

To be clear and understandable it is essential that financial statements should disclose the accountingpolicies used in their preparation. This is because policies may vary, not only from entity to entity, butalso from country to country. As an aid to users, all the major accounting policies used should be disclosedin the same place. This is normally referred to as the accounting policy note.

3 Structure and content: general points

Section overview

In addition to giving substantial guidance on the form and content of published financial statementsBAS 1 also covers a number of general points:

– The profit or loss must be calculated after taking account of all income and expense in theperiod (unless a standard or interpretation requires otherwise)

– Recommended formats are given but they are not mandatory

– Readers of annual reports must be able to distinguish between the financial statements andother information

– Financial statements should be prepared at least annually

– Financial statements should be produced within six months of the balance sheet date.

3.1 Profit or loss for the period

The income statement is the most significant indicator of a company's financial performance. So it isimportant to ensure that it is not misleading.

BAS 1 stipulates that all items of income and expense recognised in a period shall be included in profit orloss unless a Standard or an Interpretation requires otherwise.

Circumstances where items may be excluded from profit or loss for the current year include the correctionof errors and the effect of changes in accounting policies. These are covered in BAS 8 Accounting Policies,Changes in Accounting Estimates and Errors (which is covered in Chapter 4).



3.2 How items are disclosed

BAS 1 specifies disclosures of certain items in certain ways:

Some items must appear on the face of the balance sheet or income statement

Other items can appear in a note to the financial statements instead

Illustrative formats are given which enterprises may or may not follow, depending on theircircumstances.

Obviously, disclosures specified by other standards must also be made, and we will mention thenecessary disclosures when we cover each BAS or BFRS in turn. Disclosures in both BAS 1 and other BASor BFRS must be made either on the face of the statement or in the notes unless otherwise stated, i.e.disclosures cannot be made in an accompanying commentary or report.

3.3 Identification of financial statements

As a result of the above point, it is most important that enterprises distinguish the financialstatements very clearly from any other information published with them. This is because all BASs/BFRSsapply only to the financial statements (i.e. the main statements and related notes), so readers of the annualreport must be able to differentiate between the parts of the report which are prepared under BFRS, andother parts which are not.

The enterprise should identify each component of the financial statements very clearly. BAS 1 alsorequires disclosure of the following information in a prominent position. If necessary it should be repeatedwherever it is felt to be of use to the reader in his understanding of the information presented.

Name of the reporting enterprise (or other means of identification) Whether the accounts cover the single entity only or a group of entities The balance sheet date or the period covered by the financial statements (as appropriate) The reporting currency The level of rounding used in presenting the figures in the financial statements

Judgement must be used to determine the best method of presenting this information. In particular, thestandard suggests that the approach to this will be very different when the financial statements arecommunicated electronically.

The level of rounding is important, as presenting figures in thousands or millions of units makes thefigures more understandable. The level of rounding must be disclosed, however, and it should not obscurenecessary details or make the information less relevant.

3.4 Reporting period

It is normal for entities to present financial statements annually and BAS 1 states that they should beprepared at least as often as this. If (unusually) an entity's balance sheet date is changed, for whateverreason, the period for which the statements are presented will be less or more than one year. In such casesthe entity should also disclose:

The reason(s) why a period other than one year is used, and

The fact that the comparative figures given are not in fact comparable (in particular for the incomestatement, changes in equity, cash flows and related notes).

3.5 Timeliness

If the publication of financial statements is delayed too long after the balance sheet date, their usefulness willbe severely diminished. The standard states that entities should be able to produce their financialstatements within six months of the balance sheet date. An entity with consistently complexoperations cannot use this as a reason for its failure to report on a timely basis. In addition, local legislationand market regulation may impose specific deadlines on certain enterprises.



2

3.6 Proforma accounts

BAS 1 looks at the balance sheet and the income statement. We will not give all the detailed disclosures assome are outside the scope of your syllabus. Instead we will look at a 'proforma' set of accounts basedon the Guidance on Implementing BAS 1 which accompanies the Standard. Note the description of thisguidance as 'not part' of BAS 1 which means that it is not mandatory. So it shows ways in which financialstatements may be presented.

4 Balance sheet

Section overview

BAS 1 provides guidance on the layout of the balance sheet. BAS 1 specifies that certain items must be shown on the face of the balance sheet. Other information is required on the face of the balance sheet or in the notes. Both assets and liabilities must be separately classified as current and non-current.

4.1 Balance sheet format

BAS 1 suggests a format for the balance sheet although it does not prescribe the order or format in whichthe items listed should be presented. The balance sheet layout below is consistent with the minimumrequirements of BAS 1 and will be used throughout this study manual.

PROFORMA BALANCE SHEETXYZ Ltd – Balance sheet as at [date]

CUm CUm

ASSETSNon-current assets

Property, plant and equipment XIntangibles XInvestments X

XCurrent assets

Inventories XTrade and other receivables XInvestments XCash and cash equivalents X

XNon-current assets held for sale X

XTotal assets X



CUm CUmEQUITY AND LIABILITIESCapital and reserves

Ordinary share capital XPreference share capital (irredeemable) XShare premium account XRevaluation reserve XGeneral reserve XRetained earnings X

Attributable to equity holders of XYZ Ltd X

Minority interest X

Equity X

Non-current liabilitiesPreference share capital (redeemable) XFinance lease liabilities XBorrowings X

XCurrent liabilities

Trade and other payables XTaxation XProvisions XBorrowings XFinance lease liabilities X

XTotal equity and liabilities X

4.2 Information which must appear on the face of the balance sheet

BAS 1 specifies various items which must appear on the face of the balance sheet as a minimum disclosure.

Property, plant and equipment Investment property Intangible assets Financial assets Investments accounted for using the equity method (see Chapter 13) Assets classified as held for sale Inventories Trade and other receivables Cash and cash equivalents Trade and other payables Provisions Financial liabilities Current tax liabilities Minority interest Issued capital and reserves

Any other line items, headings or sub-totals should be shown on the face of the balance sheet whenit is necessary for an understanding of the entity's financial position.

This decision depends on judgements based on the assessment of the following factors.

Nature and liquidity of assets and their materiality. Thus goodwill and assets arising fromdevelopment expenditure will be presented separately, as will monetary/non-monetary assets andcurrent/non-current assets.

Function within the entity. Operating and financial assets, inventories, receivables and cash andcash equivalents are therefore shown separately.

Amounts, nature and timing of liabilities. Interest-bearing and non-interest-bearing liabilities andprovisions will be shown separately, classified as current or non-current as appropriate.



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The standard also requires separate presentation where different measurement bases are used forassets and liabilities which differ in nature or function. According to BAS 16 Property, Plant and Equipment,for example, it is permitted to carry certain items of property, plant and equipment at cost or at a revaluedamount. Property, plant and equipment may therefore be split to show classes held at historical costseparately from those that have been revalued.

4.3 Information presented either on the face of the balance sheet orby note

Certain pieces of information may be presented either on the face of the balance sheet or in the notes tothe financial statements.

These comprise:

Further sub-classification of line items on the face. Disclosures will vary from item to item, which willin part depend on the requirements of BFRS. For example, tangible assets are classified by class asrequired by BAS 16 Property, Plant and Equipment.

Details about each class of share capital.

Details about each reserve within equity.

4.4 The current/non-current distinction

An entity must present current and non-current assets and liabilities as separate classifications onthe face of the balance sheet. This is to separate current assets from fixed assets and amounts due withinone year from amounts due after more than one year.

An alternative liquidity presentation which lists assets by reference to how closely they approximate to cashis permitted but only where this provides more reliable information, e.g. in the case of a financial institutionsuch as a bank.

For all businesses which have a clearly identifiable operating cycle, it is the current/non-currentpresentation which is more meaningful, so this is the one which must be used. (See section 4.5 below).

In either case, the entity should disclose any portion of an asset or liability which is expected to berecovered or settled after more than twelve months.

Worked example: Amount receivable

For an amount receivable which is due in instalments over 18 months, the portion due after more thantwelve months must be disclosed.

4.5 Operating cycle

Definition

Operating cycle: The time between the acquisition of assets for processing and their realisation in cash orcash equivalents.



The typical operating cycle of a manufacturing business is shown in Figure 2.1.

WIP

Finishedgoods

Figure 2.1: Operating cycle of a manufacturing business

This is an important term as it forms part of the definitions of current assets and current liabilities.

4.6 Current assets

Definition

Current asset: An asset shall be classified as current when it satisfies any of the following criteria:

It is expected to be realised in, or is intended for sale or consumption in, the entity's normal operatingcycle

It is held primarily for the purpose of being traded

It is expected to be realised within twelve months after the balance sheet date, or

It is cash or a cash equivalent (as defined in BAS 7 Cash Flow Statements), unless it is restricted frombeing exchanged or used to settle a liability for at least twelve months after the balance sheet date.

All other assets should be classified as non-current assets.

Current assets therefore include inventories and trade receivables that are sold, consumed and realised aspart of the normal operating cycle. This is the case even where they are not expected to berealised within twelve months. It is the operating cycle which is the key.

Current assets will also include marketable securities if they are expected to be realised within twelvemonths of the balance sheet date. If expected to be realised later, they should be included in non-currentassets.

Point to note: There is no specific definition of non-current assets. These are merely all assets which arenot current assets.



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4.7 Current liabilities

Definition

Current liability: A liability shall be classified as current when it satisfies any of the following criteria:

It is expected to be settled in the entity's normal operating cycle

It is held primarily for the purpose of being traded

It is due to be settled within twelve months after the balance sheet date, or

The entity does not have an unconditional right to defer settlement of the liability for at least twelvemonths after the balance sheet date.

All other liabilities should be classified as non-current liabilities.

The categorisation of current liabilities is very similar to that of current assets. Thus, some current liabilitiesare part of the working capital used in the normal operating cycle of the business (i.e. trade payables andaccruals for employee and other operating costs). Such items will be classed as current liabilities evenwhere they are due to be settled more than twelve months after the balance sheet date.

There are also current liabilities which are not settled as part of the normal operating cycle, but which aredue to be settled within twelve months of the balance sheet date. These include bank overdrafts, incometaxes, other non-trade payables and the current portion of interest-bearing liabilities. Any interest-bearingliabilities that are used to finance working capital on a long-term basis, and that are not due for settlementwithin twelve months, should be classed as non-current liabilities.

5 Income statement

Section overview

BAS 1 suggests two formats for the income statement. BAS 1 specifies that certain items must be shown on the face of the income statement. Other information is required on the face of the income statement or in the notes.

5.1 Income statement formats

BAS 1 suggests two possible formats for the income statement, the difference between them being theclassification of expenses:

By function, or By nature

Point to note: The income statement classifying expenses by function is more common in practiceand will therefore be tested more frequently in the exam than the income statement classifyingexpenses by nature.



XYZ Ltd – Income Statement for the year ended [date]Illustrating the classification of expenses by function

Continuing operations CUmRevenue XCost of sales (X)Gross profit XOther operating income XDistribution costs (X)Administrative expenses (X)Profit/loss from operations XFinance cost (X)Investment income XShare of profit/(losses) of associates XProfit/(loss) before tax XIncome tax expense (X)Profit/(loss) for the period from continuing operations XDiscontinued operationsProfit/(loss) for the period from discontinued operations (X)Profit/(loss) for the period X

Attributable to:Equity holders of XYZ Ltd XMinority interest X

XX

Point to note: The sub-total 'profit/loss from operations' is not a current requirement of BAS 1. TheseLearning Materials use this description as it is used in practice and is not prohibited by BAS 1.

PROFORMA INCOME STATEMENTXYZ Ltd – Income Statement for the year ended [date]Illustrating the classification of expenses by nature

Continuing operations CUmRevenue XOther operating income XChanges in inventories of finished goods and work in progress (X)Work performed by the enterprise and capitalised XRaw materials and consumables used (X)Employee benefits expense (X)Depreciation and amortisation expense (X)Impairment of property, plant and equipment (X)Other expenses (X)Profit/loss from operations XFinance costs (X)Investment income XShare of profit/(losses) of associates XProfit/(loss) before tax XIncome tax expense (X)Profit/(loss) for the period from continuing operations XDiscontinued operationsProfit/(loss) for the period from discontinued operations (X)Profit/(loss) for the period X

Attributable to:Equity holders of XYZ Ltd XMinority interest X

X



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5.2 Information presented on the face of the income statement

The standard lists the following as the minimum to be disclosed on the face of the income statement.

Revenue

Finance costs

Share of profits and losses of associates accounted for using the equity method (we will look atassociates in Chapter 13)

Income tax expense

A single amount comprising the total of:

– The post-tax profit or loss of discontinued operations

– The post-tax gain or loss recognised on the measurement to fair value less costs to sell or on thedisposal of the assets constituting the discontinued operation

Profit or loss

The following items must be disclosed on the face of the income statement as allocations of profit or lossfor the period.

Profit or loss attributable to minority interest Profit or loss attributable to equity holders of the parent

The allocated amounts must not be presented as items of income or expense. (These issues relate to groupaccounts, covered later in this text.)

Point to note: Income and expense items can only be offset in certain circumstances (see section 2.6).

5.3 Analysis of expenses

An analysis of expenses must be shown either on the face of the income statement (as above, whichis encouraged by the standard) or by note, using a classification based on either the nature of the expensesor their function. This sub-classification of expenses indicates a range of components of financialperformance; these may differ in terms of stability, potential for gain or loss and predictability.

Function of expense/cost ofsales method

Expenses are classified according to their function as part of cost ofsales, distribution or administrative activities. This method often givesmore relevant information for users, but the allocation ofexpenses by function requires the use of judgement and can bearbitrary. Consequently, perhaps, when this method is used, entitiesshould disclose additional information on the nature of expenses,including staff costs, and depreciation and amortisation expense.

Nature of expense method Expenses are not reallocated amongst various functions within theentity, but are aggregated in the income statement according totheir nature (e.g. purchase of materials, depreciation, wages andsalaries, transport costs). This may be the easiest method for smallerentities.

Which of the above methods is chosen by an entity will depend on historical and industry factors, andalso the nature of the organisation. The choice of method should fairly reflect the main elements of theentity's performance. These Learning Materials will use the functional analysis in accordance with pastUK practice. (It is also more likely to be examined than the nature of expenses method.)



5.4 Other information presented either on the face of the incomestatement or in the notes

These comprise:

'Exceptional items'

These are material items of income and expense which should be disclosed separately. These include:

– Write downs of inventories to NRV

– Write down of property, plant and equipment to recoverable amount

– Disposals of property, plant and equipment

– Restructuring of the activities of an entity and reversals of any provisions for the cost ofrestructuring

– Disposals of investments

– Discontinued operations

– Litigation settlements

– Other reversals of provisions

Details, including per share amounts, of dividends recognised in the financial statements.

Point to note: It is now best practice that dividends paid are not shown in the income statement;instead they are shown in the statement of changes in equity.


Section overview

The statement of changes in equity shows the total recognised income and expenses for the period.

6.1 Statement of changes in equity

The income statement is framed as a straightforward measure of financial performance, in that it showshow the profit or loss for the period has arisen. It is then necessary to link this result with income/expensesin the period which are not shown in the income statement to arrive at the total recognised incomeand expense for the period. The statement making the link is the statement of changes in equity. Thismust be presented as a separate component of the financial statements not just included in the notes.

The following should be shown on the face of the statement:

The profit or loss for the period

Each item of income and expense for the period that, as required by other standards, has beenrecognised directly in equity rather than in the income statement

The total income or expense for the period (being the sum of the first two items listed above)showing separately the total amounts attributable to equity holders of the parent and to the minorityinterest, and

The effect of changes in accounting policy or correction of errors for each component of equity wherethese have been recognised during the period in accordance with BAS 8 (see Chapter 4).

There is also a need to report transactions between the entity and its shareholders, so dividendspaid out and any new capital paid in. This can be included in the notes or in the statement of changes inequity. These Learning Materials follow the second alternative and a suggested the layout is shown below.



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Section overview

Certain items need to be disclosed by way of note.

7.1 Contents of notes

The notes to the financial statements will amplify the information given in the balance sheet, incomestatement and statement of changes in equity. We have already noted above the information which BAS 1allows to be shown by note rather than on the face of the statements. To some extent, then, the contentsof the notes will be determined by the level of detail shown on the face of the statements.

7.2 Structure

The notes to the financial statements should perform the following functions:

Provide information about the basis on which the financial statements were prepared andwhich specific accounting policies were chosen and applied to significant transactions/events.

Disclose any information, not shown elsewhere in the financial statements, which is required byBFRSs.

Show any additional information that is necessary for a fair presentation which is not shown on theface of the financial statements.

The way the notes are presented is important. They should be set out in a systematic manner andcross-referenced back to the related figure(s) in the balance sheet, income statement, cash flowstatement or statement of changes in equity.

Notes to the financial statements will amplify the information shown therein by giving the following:

More detailed analysis or breakdowns of figures in the statements.

Narrative information explaining figures in the statements.

Additional information where items are not included in the financial statements, e.g. contingentliabilities and commitments.

BAS 1 suggests a certain order for the notes to the financial statements. This will assist users whencomparing the statements of different entities. (Remember, comparability is one of the qualitativecharacteristics of useful information.)

Statement of compliance with BFRSs.

Summary of significant accounting policies applied.

Supporting information for items presented on the face of each financial statement in the sameorder as the financial statements and each line item within them.

Other disclosures, e.g.:

– Contingent liabilities, commitments and other financial disclosures– Non-financial disclosures

The order of specific items may have to be varied occasionally, but a systematic structure is still required.



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7.3 Disclosure of accounting policies

The accounting policies section should describe the following.

The measurement basis (or bases) used in preparing the financial statements.

The other accounting policies used, as required for a proper understanding of the financialstatements.

The judgements, apart from those involving estimations, made by management in applying theaccounting policies.

The key assumptions made about the future and other key sources of estimation uncertainty whichcarry a significant risk of causing a material adjustment to the carrying amounts of assets and liabilitieswithin the next financial year.

This information may be shown in the notes or sometimes as a separate component of the financialstatements.

The information on measurement bases used is obviously fundamental to an understanding of the financialstatements. Where more than one basis is used, it should be stated to which assets or liabilities eachbasis has been applied.

7.4 Other disclosures

An entity must disclose in the notes:

The amount of dividends proposed or declared before the financial statements were authorised forissue but not recognised as a distribution to equity holders during the period, and the amount pershare.

The amount of any cumulative preference dividends not recognised.

BAS 1 ends by listing some specific disclosures which will always be required if they are not shownelsewhere in the financial statements.

The domicile and legal form of the entity, its country of incorporation and the address of theregistered office (or, if different, principal place of business).

A description of the nature of the entity's operations and its principal activities.

The name of the parent entity and the ultimate parent entity of the group.

8 Minority interest

Section overview

The following amounts must be split between the minority interest and the amount attributable tothe equity holders of the parent:

– Equity– Profit or loss for the period– Total income and expense for the period.

A parent company may own less than 100% of a subsidiary, in which case the amount not owned isdescribed as the minority interest. The detail of how to account for such holdings is dealt with in Chapter10 onwards, so for the moment it is only necessary to note that:

On the face of the balance sheet, equity must be split between the minority interest and the amountattributable to the equity holders of the parent.

On the face of the income statement, the allocation must be shown of the profit or loss for the periodbetween the minority interest and the equity holders of the parent.



In the statement of changes in equity, the total income and expense for the period must be splitbetween the minority interest and the amount attributable to the equity holders of the parent.

This treatment is consistent with the BFRS Framework's definitions of the elements within financialstatements. As there is no present obligation arising out of past events to settle the amount due to theminority interest, it cannot be classified as a liability; instead it must be part of equity, which is the residualonce liabilities have been deducted from assets.


Section overview

IPSAS 1 Presentation of Financial Statements provides guidance on the presentation of financialinformation for public sector bodies.

9.1 Presentation of financial statements

A complete set of financial statements produced in accordance with IPSAS 1 comprise:

Statement of financial position Statement of financial performance Statement of changes in net assets/equity Cash flow statement, and Accounting policies and notes to the financial statements.

9.2 Statement of financial position

This is essentially a balance sheet. The following example is provided by IPSAS 1.

Public Sector Entity – Statement of Financial Position as of 31 December 20X2

20X2 20X2 20X1 20X1CU’000 CU’000 CU’000 CU’000

AssetsCurrent assetsCash and cash equivalents X XReceivables X XInventories X XPrepayments X XInvestments X X

X XNon-current assetsReceivables X XInvestments X XOther financial assets X XInfrastructure, plant and equipment X XLand and buildings X XIntangible assets X XOther non-financial assets X X

X XTotal assets X X



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20X2 20X2 20X1 20X1CU’000 CU’000 CU’000 CU’000

LiabilitiesCurrent liabilitiesPayables X XShort-term borrowings X XCurrent portion of borrowing X XProvisions X XEmployee benefits X X

X XNon-current liabilitiesPayables X XBorrowings X XProvisions X XEmployee benefits X X

X XTotal liabilities X XNet assets X X

Net Assets/EquityCapital contributed by other government entities X XReserves X XAccumulated surpluses/(deficits) X X

X XMinority interest X XTotal net assets/equity X X

9.3 Statement of financial performance

This is essentially an income statement. The following example is provided by IPSAS 1.

Public sector entity – Statement of Financial Performance for the year ended 31 December20X2 (illustrating the classification of expenses by function)

20X2 20X1CU’000 CU’000

Operating revenueTaxes X XFees, fines, penalties and licences X XRevenue from exchange transactions X XTransfers from other government entities X XTotal operating revenue X X

Operating expensesGeneral public services X XDefence X XPublic order and safety X XEducation X XHealth X XSocial protection X XHousing and community amenities X XRecreational, cultural and religion X XEconomic affairs X XEnvironmental protection X XTotal operating expenses X X

Surplus/(deficit) from operating activities X XFinance costs (X) (X)Gains on sale of property, plant and equipment X XTotal non-operating revenue/(expenses) (X) (X)

Surplus/(deficit) from continuing activities X XMinority interest share of surplus/(deficit) (X) (X)

Net surplus/(deficit) for the period X X



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Self-test


1 According to BAS 1 Presentation of Financial Statements, which of the following must be recognised inthe income statement?

A Equity dividends paidB Revaluation gainsC DepreciationD Effects of a change in accounting policy

2 Which of the following form the components of a full set of financial statements according to BAS 1Presentation of Financial Statements?

(1) Balance sheet(2) Income statement(3) Statement of changes in equity(4) Cash flow statement(5) Accounting policy note(6) Explanatory notes

A All of themB (1), (2), (3) and (4) onlyC (1), (2), (3), (4) and (5) onlyD (1), (2) and (4) only

3 Which of the following must be presented on the face of the income statement according to BAS 1Presentation of Financial Statements?

(1) Tax expense(2) Revenue(3) Finance cost(4) Depreciation expense

A (1), (2), (3) and (4)B (1), (2) and (3) onlyC (1), (3) and (4) onlyD (2) and (4) only

4 In accordance with BFRS what typically comprises the first line of the income statement and profit andloss account?

A RevenueB TurnoverC SalesD Income



5 The income statement of Bell Holdings Ltd showed a profit of CU183,000 for the year ended 30 June20X7. During the year the following transactions occurred.

(1) Equity dividends of CU18,000.

(2) Capitalised borrowing costs of CU45,000 were written off directly to retained earnings as aresult of a change in accounting policy.

(3) Property with a carrying amount of CU60,000 was revalued to CU135,000, which gave rise toadditional depreciation of CU8,000.

The total equity balance brought forward at 1 July 20X6 from the statement of changes in equity wasCU2,123,000.

In accordance with BAS 1 Presentation of Financial Statements what is the total equity balance at 30 June20X7 in the statement of changes in equity?

A CU2,336,000B CU2,318,000C CU2,381,000D CU2,310,000

6 Which of the following constitutes a complete set of financial statements in accordance with IPSAS 1Presentation of Financial Statements?

(1) Statement of financial position(2) Statement of financial performance(3) Statement of changes in net assets/equity(4) Cash flow statement(5) Accounting policies and notes to the financial statements

A (1) and (3) onlyB (1), (2) and (4) onlyC (3) and (5) onlyD All of them



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7 RADICAL LTD (Note: this question is included to provide practice of basic techniques)

After closing off the profit and loss account for the year ended 30 September 20Y2 the following draftbalance sheet was extracted from the nominal ledger of Radical Ltd.

Balance sheet at 30 September 20Y2

CreditsCU

Ordinary share capital 250,000Preference share capital (irredeemable) 100,0009% Loan stock 150,000Trade creditors 64,700Aggregate depreciation at 1 October 20Y1

Freehold buildings 2,500Motor vehicles 117,830

Provision for bad debts 13,420Profit and loss account 198,885Share premium account 52,400Corporation tax at 31% 26,750Disposals of fixed assets (see note (2)) 8,000

984,485

DebitsCU

Stocks on hand, at cost 192,734Trade debtors 172,062Cash in hand 2,431Balance at bank 42,735Fixed assets at cost 1 October 20Y1


Ordinary shares in Midland Bank Ltd, at cost 22,632Prepayments 2,596Additions to fixed assets (see note (2)) 66,450

984,485

You also obtain the following information.

(1) The balance on corporation tax account was due for payment nine months after the year end.

(2) Additional motor vehicles were purchased during the year at a cost of CU40,450, and additionsto freehold property were CU26,000. Cars which had cost CU11,500 had been disposed of forCU8,000 when their book value had been CU6,200.

(3) Depreciation has still to be charged for the year as follows.

Freehold buildings CU2,500Motor vehicles CU84,000

Requirement

Prepare the company’s balance sheet as at 30 September 20Y2.



8 HENDON LTD (Note: this question is included to provide practice of basic techniques)

For the year ended 15 July 20Y8 the accountant of Hendon Ltd has closed each of the ledger accountsto arrive at the following balances.

CUAt 16 July 20Y7

Inventories 180,900Profit and loss account 170,555Provision for depreciation


Plant and machinery 22,100Rental income 12,120Sales 962,300Trade receivables 112,870Purchases 777,200Trade payables 210,800Discounts

Allowed 53,400Received 27,405

Sundry business expensesWages 73,500Salaries 74,000Office 10,000Directors’ remuneration 30,000

DividendsDeclared and paid 40,000Received 20,000

InterestPaid 12,500Received 10,000

Freehold land 70,000Freehold buildings 160,000Motor vehicles 124,200Plant and machinery 74,30010% debentures

14 July 20Y9 35,00014 July 20Z5 90,000

Share premium account 66,00025p ordinary shares 200,000Investments 58,000Bank (debit) 61,410New share issue account 38,000

Following a physical count closing inventories were determined to be CU210,000.

In addition the accountant discovers the following.

(1) The debenture interest is payable in arrears on 14 July until maturity.

(2) One motor vehicle, stated in the accounts at cost of CU8,000 with accumulated depreciation ofCU2,000, was stolen during the year. The insurance company has agreed to pay CU7,000 in fullsettlement. No entries have been made in the books in respect of this matter.

(3) The company depreciates assets using the reducing balance method. The relevant rates are asfollows.

Freehold buildings 2%Plant and machinery 10%Motor vehicles 25%

Freehold land is not depreciated.

(4) During the year the company issued 40,000 25p ordinary shares at 95 pence each. The proceedshave been credited to the new shares issue account and still need to be properly accounted for.



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Requirements

Prepare an income statement for the year ended 15 July 20Y8 and a balance sheet as at 15 July 20Y8.

Note: Ignore comparatives and taxation.

9 OSCAR LTD

The following trial balance has been extracted from the books of account of Oscar Ltd as at 31 March20X8.

CU'000 CU'000Administrative expenses 210Ordinary share capital 600Trade receivables 470Bank overdraft 80Provision for warranty costs 205Distribution costs 420Non-current asset investments 560Investment income 75Finance cost 10Freehold land and buildings at cost 200Plant and equipment

At cost 550Accumulated depreciation (at 31 March 20X8) 220

Retained earnings (at 1 April 20X7) 180Purchases 960Inventories (at 1 April 20X7) 150Trade payables 260Revenue 2,01020X7 final dividend paid 6520X8 interim dividend paid 35

3,630 3,630

Additional information

(1) Inventories at 31 March 20X8 were valued at CU160,000.

(2) The following items are already included in the balances listed in this trial balance.

Distribution Administrativecosts expenses

CU'000 CU'000Depreciation charge for the year 27 5Employee benefits 150 80

(3) The income tax charge for the year is estimated at CU74,000.

(4) The warranty provision is to be increased by CU16,000, charged to administrative expenses.

(5) Staff bonuses totalling CU40,000 are to be provided for, charged equally to distribution costs andadministrative expenses.

(6) The freehold land and buildings were bought on the last day of the accounting period at a bargainprice. They are to be revalued to CU280,000.

(7) In May 20X8 a final dividend for 20X8 of 10p per share was proposed on each of the company’s600,000 ordinary shares.

Requirement

Prepare Oscar Ltd’s income statement and statement of changes in equity for the year to 31 March20X8, a balance sheet at that date and notes in accordance with the requirements of BAS 1Presentation of Financial Statements to the extent the information is available. (12 marks)



10 MORTIMER LTD

The following trial balance was extracted from the books of Mortimer Ltd, a manufacturing company,as at 31 August 20X9.

CU CUAccruals 4,000Administrative expenses 153,000Bank deposit 20,000Bank current account 4,000Bank loan 58,000Bank interest 5,000Warranty provision 19,000Distribution expenses 175,000Land and buildings

Cost 840,000Depreciation 166,000

Loan interest 8,000Mortgage 90,000Mortgage interest 14,000Plant and machinery

Cost 714,000Depreciation 368,000

Prepayments 2,000Retained earnings 138,000General reserve 21,000Purchases 2,678,000Trade payables 80,000Revenue 3,290,000Trade receivables 105,000Ordinary share capital 382,000Share premium account 199,000Inventories, as at 31 August 20X8 107,000

4,820,000 4,820,000

You also obtain the following information.

(1) Depreciation is to be provided on the straight-line method on buildings at 2% per annum and onplant and machinery at 20% pa. The cost of buildings at 31 August 20X9 was CU650,000.

(2) Inventories at 31 August 20X9 comprised raw materials CU113,000, work in progress CU12,000and finished goods CU54,000.

(3) The original mortgage of CU225,000 was taken out on 1 September 20X0 for a term of 15 years,repayable in equal monthly instalments on the 25th day of each month.

(4) The bank loan was granted on 1 May 20X6 for a fixed term of ten years.

(5) Provision is to be made for income tax of CU68,000, based on the results of the year.

(6) A transfer of CU21,000 was made to the general reserve during the year.

Requirements

(a) Prepare Mortimer Ltd's income statement and statement of changes in equity for the year ended31 August 20X9 and balance sheet at that date in accordance with the requirements of BAS 1Presentation of Financial Statements to the extent the information is available. You are not requiredto produce any notes thereto. (18 marks)

(b) Explain the concept of 'fair presentation'. (3 marks)

(21 marks)




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Technical reference

Point to note: The whole of BAS 1 is examinable with the exception of paragraphs 124A-124C and IG5and IG6. The paragraphs listed below are the key references you should be familiar with.

1 BAS 1

Applies to all general purpose financial statements. BAS 1 (2-5)

Links back to much in the BFRS Framework:

– Fair/faithful presentationBAS 1 (13) Frame

(33-35, 46)

– Going concernBAS 1 (23-24)

Frame (23)

– Accrual basis of accountingBAS 1 (25-26)

Frame (22)

– Consistency of presentationBAS 1 (27-28)

Frame (39-41)

– Materiality and aggregationBAS 1 (29-31)

Frame (29-30)

– Offsetting BAS 1 (32-35)

– Comparative informationBAS 1 (36-41)

Frame (42)

Presentation and disclosure rules apply only to material items BAS 1 (31 and 11)

Balance sheet:

– Layout as in proforma above

– Distinction between current and non-current BAS 1 (51)

– Linked to the operating cycle of the business, not just the next 12 months

– Some items must be on the face, others can be in the notes BAS 1 (68-76)

Income statement:

– Layout as in proformas above

– Some items must be on the face, others can be in the notes BAS 1 (81-87)

– No extraordinary items BAS 1 (85)

– No dividends paid or payable

– Allocate net profit for the period between parent company equity holdersand minority interest

BAS 1 (82)

Statement of changes in equity: BAS 1 (96-99)

– Layout as in proforma above

– Revaluation surpluses shown here

– Dividends declared by balance sheet date



Notes

– What must be included BAS 1 (103)

– The systematic manner in which it must be disclosed BAS 1 (104)

– The disclosure of the measurement bases (e.g. historical cost, fair value)and the other accounting policies used. Note the matters which an entitymust consider when deciding what to disclose

BAS 1 (108)

– The judgements made by management in applying the accounting policies BAS 1 (113)

– The key measurement assumptions made about the future which carry thesignificant risk of causing a material adjustment to assets and liabilities

BAS 1 (116)

– The disclosure of ordinary dividends proposed or declared after the periodend and not recognised in the accounting period. Such dividends do not fallwithin the definition of a liability at the period end, so cannot be recogniseduntil the next accounting period

BAS 1 (125)

– The disclosure of registration details about the entity, its operations andactivities and, if it is in a group of companies, its parent and ultimate parentcompany

BAS 1 (126)



2


1 C Depreciation should be charged to the income statement, the other items should be taken to thestatement of changes in equity.

2 A Per BAS 1 paragraph 8.

3 B All items should be shown on the face of the income statement except depreciation which maybe disclosed in a note (BAS 1 paragraph 88).

4 A Although BAS 1 allows amendment according to the entity's transactions (BAS 1 paragraph 81and 71(b)).

5 B The additional depreciation of CU8,000 will have already been charged in the income statement.

EquityCU

B/f (2,123,000 – 45,000) 2,078,000Profit 183,000Dividends (18,000)Revaluation (135,000 – 60,000) 75,000

2,318,000

6 D Per IPSAS 1

7 RADICAL LTD

Balance sheet as at 30 September 20Y2CU CU

ASSETS

Non-current assets

Property, plant and equipment (W5) 336,265Investments 22,632

358,897

Current assets

Inventories 192,734Trade and other receivables (W1) 158,642Prepayments 2,596Cash and cash equivalents (W3) 45,166

399,138Total assets 758,035

EQUITY AND LIABILITIES

Capital and reserves

Ordinary share capital 250,000Preference share capital 100,000Share premium 52,400Accumulated profits/losses (W2) 114,185

516,585

Non-current liabilities

Interest-bearing borrowings 150,000

Current liabilities

Trade and other payables 64,700Tax payable 26,750

91,540Total equity and liabilities 758,035



WORKINGS

(1) Trade and other receivables

CUTrade debtors 172,062Less Provision (13,420)

158,642

(2) Accumulated profits/losses

CUPer draft 173,885Less Depreciation charge (2,500 + 84,000) (86,500)Add Profit on sale of cars (8,000 – 6,200) 1,800

89,185

(3) Cash and cash equivalents

CUIn hand 2,431At bank 42,735

45,166

(4) Property, plant and equipment

Freehold

buildings

Motor

vehiclesCost or valuation CU CUB/f 105,000 377,845Additions 26,000 40,450Disposals – (11,500)C/f 131,000 406,795

Accumulated depreciation CU CUB/f 2,500 117,830Charge 2,500 84,000Disposals – (5,300)C/f 5,000 96,530

(5) Analysis of property, plant and equipment

Cost or valuation Accumulated

depreciation

Net book value

(W4) (W4)CU CU CU

Fixed assetsFreehold buildings 131,000 5,000 126,000Motor vehicles 406,795 196,530 210,265

537,795 201,530 336,265

8 HENDON LTD

Income statement for the year ended 15 July 20Y8

CURevenue 962,300Cost of sales (W8) (753,320)Gross profit 208,980Other operating income 39,525Distribution costs (W8) (21,550)Administrative expenses (W8) (243,700)Profit/loss from operations (16,745)Finance cost (W2) (12,500)Investment income 30,000Net profit/loss for the period 755



2

Balance sheet as at 15 July 20Y8

CU CU

ASSETS

Non-current assetsProperty, plant and equipment 321,830Investments 58,000

379,830Current assetsInventories 210,000Trade and other receivables (W9) 119,870Cash and cash equivalents 61,410


EQUITY AND LIABILITIES

Capital and reservesOrdinary share capital (W4) 210,000Share premium (W5) 94,000Accumulated profits/losses (W6) 131,310

435,310Non-current liabilitiesInterest-bearing borrowings 90,000

Current liabilitiesTrade and other payables 210,800Short-term borrowings 35,000


WORKINGS

(1) Accumulated depreciation

B/f Disposals C/fCU CU CU

Freehold (160,000 – 20,000) 2%) 2,800 20,000 – 22,800

Vehicles (((124,200 – 8,000) – (28,000 – 2,000)) 25%) 22,550 28,000 (2,000) 48,550

Plant (74,300 – 22,100) 10% 5,220 22,100 – 27,320

(2) Finance cost

CU20Y9 debentures (35,000 10%) 3,500

20Z5 debentures (90,000 10%) 9,00012,500

All interest due has been paid in year.

(3) Cost of property, plant and equipment

CUFreehold (70,000 + 160,000)) 230,000Vehicles (124,200 – 8,000) 116,200

(4) Ordinary share capital

CUPer TB 200,000New issue (40,000 25p) 10,000

210,000



(5) Share premium

CUPer TB 66,000New issue ((95p – 25p) 40,000) 28,000

94,000

(6) ACCUMULATED PROFITS/LOSSES

CU CUDividends 40,000 B/d 170,555C/d 131,310 Profit for the period 755

171,310 171,310

(7) Trade and other receivables

CUTrade receivables 112,870Insurance claim 7,000

119,870

(8) Analysis of expenses

Cost of sales Distribution

costs

Administrative

expensesCU CU CU

Opening stock 180,900Purchases 777,200Discounts allowed 53,400Closing stock (210,000)Plant and machinery – depreciation charge (W1) 5,220Motor vehicles – depreciation charge (W1) 22,550Freehold buildings – depreciation charge (W1) 2,800Profit on disposal of fixed assets (1,000)Expenses 187,500

753,320 21,550 243,700

(9) Analysis of property, plant and equipment

Cost or

valuation

Accumulated

depreciation

Net book

value(W3) (W1)

Fixed assets CU CU CUFreehold buildings 230,000 22,800 207,200Motor vehicles 116,200 48,550 67,650Plant and machinery 74,300 27,320 46,980

420,500 98,670 321,830

9 OSCAR LTD

Financial statementsIncome statement for the year ended 31 March 20X8

CU'000Revenue 2,010Cost of sales (960 + 150 – 160) (950)Gross profit 1,060Distribution costs (420 + 20) (440)Administrative expenses (210 + 16 + 20) (246)Profit from operations 374Finance cost (10)Investment income 75Profit before tax 439Income tax (74)Profit for the year 365



2

Statement of changes in equity for the year ended 31 March 20X8Ordinary share Revaluation Retained

capital reserve earningsCU'000 CU'000 CU'000

Attributable to the equity holders of Oscar LtdRecognised directly in equity

Revaluation of non-current assets – 80 –Profit for the year – – 365Total recognised income and expense for

the period – 80 36520X7 final dividend – – (65)20X8 interim dividend – – (35)

– 80 265Balance brought forward 600 – 180Balance carried forward 600 80 445

Notes

(1) The profit from operations is arrived at after charging

CU'000Depreciation (27 + 5) 32Employee benefits (150 + 80 + 40) 270

(2) A final dividend for 20X8 of CU60,000 (10p per share) is proposed.

Balance sheet as at 31 March 20X8

CU'000 CU'000ASSETSNon-current assets

Property, plant and equipment (200 + 550 + 80 – 220) 610Investments 560

1,170Current assets

Inventories 160Trade and other receivables 470

630Total assets 1,800

EQUITY AND LIABILITIESCapital and reserves

Ordinary share capital 600Revaluation reserve 80Retained earnings 445

Equity 1,125

Non-current liabilitiesProvision for warranty costs (205 + 16) 221

Current liabilitiesTrade and other payables (260 + 40) 300Taxation 74Borrowings 80

454

Total equity and liabilities 1,800



10 MORTIMER LTD

(a) Financial statementsIncome statement for the year ended 31 August 20X9

CURevenue 3,290,000Cost of sales (W1) (2,748,800)

Gross profit 541,200

Distribution costs (W1) (175,000)Administrative expenses (W1) (166,000)

Profit from operations 200,200

Finance cost (W1) (22,000)Investment income 5,000

Profit before tax 183,200

Income tax (68,000)

Profit for the period 115,200

Statement of changes in equity for the year ended 31 August 20X9

Ordinary ShareAttributable to the equity holders share premium General Retainedof Mortimer Ltd capital account reserve earnings Total

CU CU CU CU CURecognised directly in equity

Transfer between reserves – – 21,000 (21,000) –Total recognised directly in – – 21,000 (21,000) –equityProfit for the period – – – 115,200 115,200Total recognised income and – – 21,000 94,200 115,200expense for the periodBalance brought forward (W3) 382,000 199,000 – 159,000 740,000Balance carried forward 382,000 199,000 21,000 253,200 855,200

Balance sheet as at 31 August 20X9

CU CUASSETSNon-current assets

Property, plant and equipment (W2) 864,200

Current assets

Inventories (W1) 179,000

Trade and other receivables (105,000 + 2,000) 107,000Cash and cash equivalents (20,000 + 4,000) 24,000

310,000

Total assets 1,174,200



2

EQUITY AND LIABILITIES CU CUCapital and reserves

Ordinary share capital 382,000Share premium account 199,000General reserve 21,000Retained earnings 253,200

Attributable to equity holders of Mortimer Ltd 855,200

Non-current liabilitiesBorrowings (90,000 – 15,000 + 58,000) 133,000

Current liabilitiesTrade and other payables (4,000 + 80,000) 84,000Tax 68,000Provisions 19,000

Borrowings15

225,000 15,000 186,000

Total equity and liabilities 1,174,200

(b) Fair presentation and a true and fair view

BAS 1 Presentation of Financial Statements describes the concept of fair presentation. Fairpresentation involves:

Representing faithfully the effect of transactions, other events and conditions, and In accordance with the definitions and recognition criteria in BFRS Framework.

This is developed by stating that the application of BFRS, Interpretations and additionaldisclosures will result in fair presentation.

True could be approximated to ‘represent faithfully’ and fair to ‘fair presentation’. BAS 1 linksthem by stating that compliance with standards will give a fair presentation.

BAS 1 requires the financial statements to present fairly the financial position and performance ofan entity rather than a true and fair view. 'Present fairly' is further described as representingfaithfully the effects of transactions and as a result there is unlikely to be a difference between thetwo.

Whilst not dealing with the concepts directly, BFRS Framework uses the descriptions of fairpresentation and true and fair view interchangeably in its discussion of the application of theprincipal qualitative characteristics of financial information.

WORKINGS

(1) Allocation of expenses

Cost of Financesales Distribution Administration costCU CU CU CU

Per Q 2,678,000 175,000 153,000Loan interest 8,000Mortgage interest 14,000Opening inventories 107,000Depreciation

Plant (714,000 x 20%) 142,800Buildings (650,000 x 2%) 13,000

Closing inventories(113,000 + 12,000 + 54,000) (179,000)

2,748,800 175,000 166,000 22,000




Land and Plant andbuildings machinery Total

CU CU CU

Cost 840,000 714,000

Depreciation

At 1 September 20X8 166,000 368,000Charge for the year (W1) 13,000 142,800

At 31 August 20X9 179,000 510,800

Carrying amount 661,000 203,200 864,200

(3) Retained earnings b/f

CUPer trial balance 138,000Add transfer to general reserve already made 21,000

Retained earnings at start of year 159,000


Contents

Introduction

Examination context

Topic List

1 Cash flow information

2 Presentation of a cash flow statement

3 Operating activities

4 Investing activities

5 Financing activities

6 Disclosures

7 Preparing a cash flow statement


Technical reference



chapter 3

Cash flow statements



Introduction


Prepare the cash flow statement of an individual entity in accordance with BAS 7

Specific syllabus references for this chapter are: 2a, b, c.


It has been argued that 'profit' does not always give a useful or meaningful picture of a company'soperations. Readers of a company's financial statements might even be misled by a reported profitfigure.

(a) Shareholders might believe that if a company makes a profit after tax of, say, CU100,000 then this isthe amount which it could afford to pay as a dividend. Unless the company has sufficient cashavailable to stay in business and also to pay a dividend, the shareholders' expectations would be wrong.

(b) Employees might believe that if a company makes profits, it can afford to pay higher wages nextyear. This opinion may not be correct: the ability to pay wages depends on the availability of cash.

(c) Survival of a business entity depends not so much on profits as on its ability to pay its debts whenthey fall due. Such payments might include 'revenue' items such as material purchases, wages,interest and taxation etc, but also capital payments for new non-current assets and the repayment ofloan capital when this falls due (for example on the redemption of debentures).

From these examples, it may be apparent that a company's performance and prospects depend not so muchon the 'profits' earned in a period, but more realistically on liquidity or cash flows.

Stop and think

Can you think of some possible disadvantages of cash flow accounting?

Working context

As we will see the preparation of the cash flow statement is very dependent on information contained inthe income statement and balance sheet. This is not just an accounting issue however, but will also have animpact on the amount of audit work which will need to be carried out on these balances. Audit work onthe cash flow statement can be more limited than that carried out on the income statement and balancesheet as the cash flows are derived from balance sheet and income statement balances which have alreadybeen subjected to detailed audit procedures.

CASH FLOW STATEMENTS


3

Syllabus links

This is the first time that you will have come across a cash flow statement in your studies. However, as youwill see in the rest of the chapter, most of the information needed to produce a cash flow statement iscontained in the income statement and balance sheet, both of which you will be familiar with from yourAccounting studies.

The topic also relates to the underlying assumptions of accounting which were discussed in Chapter 1, inparticular the distinction between accrual accounting and cash accounting.

In this chapter we introduce the preparation of the cash flow statement of the individual company. Chapter16 covers the preparation of group cash flow statements. Both of these aspects are also highly relevant inthe Financial & Corporate Reporting paper and at the Advanced Stage, where the emphasis will change frompreparation to analysis and interpretation.



Examination context

Exam requirements

As 55% of the syllabus deals with the preparation of single company financial statements, and this includesthe cash flow statement, it is likely that this topic will be examined regularly.

In an examination you would either be asked to prepare a full cash flow statement or to prepare cash flowstatement extracts and/or to answer a number short-form questions.


Prepare and present a cash flow statement for an individual entity in accordance with BAS 7 Cash FlowStatements

Prepare extracts from the cash flow statement of an individual entity.



3

1 Cash flow information

Section overview

The cash flow statement shows movements in cash and cash equivalents. All entities are required to produce a cash flow statement.

1.1 Objective of BAS 7

The objective of BAS 7 Cash Flow Statements is to provide historical information about changes in cash andcash equivalents, classifying cash flows between operating, investing and financing activities. This willprovide information to users of financial statements about the entity's ability to generate cash and cashequivalents, as well as indicating the cash needs of the entity.

Definition

Cash flows: These are inflows and outflows of cash and cash equivalents.

1.2 Scope

A cash flow statement should be presented as an integral part of an entity's financial statements. All typesof entity can provide useful information about cash flows as the need for cash is universal, whatever thenature of their revenue-producing activities. Therefore all entities are required by the standard toproduce a cash flow statement.

1.3 Benefits of cash flow information

Cash flow statements should be used in conjunction with the rest of the financial statements. Users cangain further appreciation of:

The change in net assets

The entity's financial position (liquidity and solvency)

The entity's ability to adapt to changing circumstances and opportunities by affecting the amount andtiming of cash flows

Cash flow statements enhance comparability as they are not affected by differing accounting policiesused for the same type of transactions or events.

Cash flow information of a historical nature can be used as an indicator of the amount, timing and certaintyof future cash flows. Past forecast cash flow information can be checked for accuracy as actual figuresemerge. The relationship between profit and net cash flow and the impact of changing prices can beanalysed over time.

1.4 Cash and cash equivalents

The cash flow statement shows movements in cash and cash equivalents.

Definitions

Cash: Comprises cash on hand and demand deposits.

Cash equivalents: Short-term, highly liquid investments that are readily convertible to known amounts ofcash and which are subject to an insignificant risk of change in value.



BAS 7 expands on the definition of cash equivalents: they are not held for investment or other long-termpurposes, but rather to meet short-term cash commitments. To fulfil the above definition, an investment'smaturity date should normally be within three months from its acquisition date. It would usuallybe the case then that equity investments (i.e. shares in other companies) are not cash equivalents. Anexception would be where preference shares were acquired with a very close maturity date.

Points to note:

(1) Loans and other borrowings from banks are classified as financing activities. In some countries,however, bank overdrafts are repayable on demand and are treated as part of an entity's total cashmanagement system. In these circumstances an overdrawn balance will be included in cash and cashequivalents. Such banking arrangements are characterised by a balance which fluctuates betweenoverdrawn and credit.

In the absence of other information you should assume, in the exam, that bank overdrafts arerepayable on demand and should therefore be classed as cash and cash equivalents.

(2) Movements between different types of cash and cash equivalent are not included in cash flows. Theinvestment of surplus cash in cash equivalents is part of cash management, not part of operating,investing or financing activities.

2 Presentation of a cash flow statement

Section overview

Cash flows are classified as:

– Operating activities– Investing activities, and– Financing activities.

2.1 Presentation

BAS 7 requires cash flow statements to report cash flows during the period classified by:

Operating activities: These are primarily derived from the principal revenue-producing activities ofthe entity and other activities that are not investing or financing activities.

Investing activities: These are the cash flows derived from acquisition and disposal of non-currentassets and other investments not included in cash equivalents.

Financing activities: These are activities that result in changes in the size and composition of theequity capital and borrowings of the entity.

2.2 Example of a cash flow statement

We will look at the procedure for preparing a cash flow statement later in this chapter, but first, we willlook at a proforma adapted from the example given in the standard.



3

Cash flow statementYear ended 31 December 20X7

CUm CUmCash flows from operating activities

Cash generated from operations 2,730Interest paid (270)Income taxes paid (900)

Net cash from operating activities 1,560

Cash flows from investing activitiesPurchase of property, plant and equipment (900)Proceeds from sale of property, plant and equipment 20Interest received 200Dividends received 200

Net cash used in investing activities (480)

Cash flows from financing activitiesProceeds from issue of share capital 250Proceeds from issue of long-term borrowings 250Dividends paid (1,290)

Net cash used in financing activities (790)Net increase in cash and cash equivalents 290Cash and cash equivalents at beginning of period 120Cash and cash equivalents at end of period 410

Points to note

1 The headings in italics are necessary to comply with the standard.

2 The information to prepare a cash flow statement can be obtained from the figures in the

Balance sheet at the start of the period Balance sheet at the end of the period Income statement for the period Supporting notes



3 Operating activities

Section overview

Cash flows from operating activities are primarily derived from the principal revenue producingactivities of the entity.

There are two methods for calculating and analysing cash generated from operations:

– The direct method– The indirect method

Cash generated from operations is adjusted for payments of interest and income tax to arrive at netcash from operating activities.

3.1 Operating activities

This is perhaps the key part of the cash flow statement because it shows whether, and to what extent,companies can generate cash from their operations as other cash inflows may be non-recurring. It isthese operating cash flows which must, in the end pay for all cash outflows relating to other activities, i.e.paying loan interest, dividends and so on.

Most of the components of cash flows from operating activities will be those items which determine thenet profit or loss of the entity, i.e. they relate to the main revenue-producing activities of the entity.The standard gives the following as examples of cash flows from operating activities.

Cash receipts from the sale of goods and the rendering of services. Cash receipts from royalties, fees, commissions and other revenue. Cash payments to suppliers for goods and services. Cash payments to and on behalf of employees.

Cash flows from interest paid and income taxes paid are also dealt with here.

3.2 Cash generated from operations

BAS 7 allows two possible layouts for cash generated from operations

The indirect method The direct method.

The direct method is preferred by BAS 7 but not required. In practical terms the indirect method islikely to be easier and less time consuming to prepare and is more likely to be examined. In the exam youshould use the indirect method unless the question specifies otherwise.

3.3 Indirect method

Using the indirect method, cash generated from operations is calculated by performing a reconciliationbetween:

Profit before tax as reported in the income statement, and Cash generated from operations.

This reconciliation is produced as follows:



3

Reconciliation of profit/loss before tax to cash generated from operations for the year ended 31 December20X7

CUProfit/(loss) before tax XFinance cost XInvestment income (X)Depreciation charge XAmortisation charge XLoss/(profit) on disposal of non-current assets X/(X)(Increase)/decrease in inventories (X)/X(Increase)/decrease in trade and other receivables (X)/X(Increase)/decrease in prepayments (X)/XIncrease/(decrease) in trade and other payables (X)/XIncrease/(decrease) in accruals (X)/XIncrease/(decrease) in provisions (X)/XCash generated from operations X

You should show this reconciliation as a note to the cash flow statement.

3.4 Explanation

It is important that you understand why certain items are added and others are subtracted. Note thefollowing points:

Depreciation is not a cash expense, but is deducted in arriving at the profit figure in the incomestatement. It makes sense, therefore, to eliminate it by adding it back.

By the same logic a loss on disposal of a non-current asset (arising through underprovision ofdepreciation) needs to be added back, and a profit deducted.

An increase in inventories means less cash – the company has spent cash on buying inventory.

An increase in receivables means the company's debtors have not paid as much, and therefore there isless cash.

If the entity pays off payables, causing the figure to decrease, again there is less cash.

Worked example: Indirect method

A business has the following balance sheet balances.

30 June 20X7 30 June 20X6CU CU

Inventories 3,200 4,000Trade and other receivables 2,900 2,500Trade and other payables 800 1,000

For the year ended 30 June 20X7 you also have the following information:

CUProfit before tax 6,100Finance cost 200Investment income 100



Solution

Cash generated from operations would be calculated and disclosed as follows.

Reconciliation of profit before tax to cash generated from operations for the year ended 30 June 20X7

CUProfit before tax 6,100Finance cost 200Investment income (100)Decrease in inventories 800Increase in trade and other receivables (400)Decrease in trade and other payables (200)Cash generated from operations 6,400

3.5 Direct method

Using the direct method, cash generated from operations would be analysed as follows and shown as a noteto the cash flow statement:

Gross operating cash flows for the year ended 31 December 20X7

CUCash receipts from customers XCash paid to suppliers and employees (X)Cash generated from operations (X)

Worked example: Direct method

Hail Ltd commenced trading on 1 January 20X7 following a share issue which raised CU35,000. During theyear the company entered into the following transactions:

Purchases from suppliers were CU19,500, of which CU2,550 was unpaid at the year end. Wages and salaries amounted to CU10,500, of which CU750 was unpaid at the year end. Sales revenue was CU29,400, including CU900 receivables at the year end.

Solution

Cash generated from operations would be calculated and disclosed as follows:

Gross operating cash flows for the year ended 31 December 20X7

CUCash received from customers (29,400 – 900) 28,500Cash paid to suppliers and employees (26,700) (W)Cash generated from operations 1,800

WORKINGCU

Cash paid to suppliers (19,500 – 2,550) 16,950Cash paid to and on behalf of employees (10,500 – 750) 9,750Cash paid to suppliers and employees 26,700



3

3.6 Payments of interest and tax

The adjustments in the cash flow statement to 'cash generated from operations' to arrive at 'netcash from operating activities' consist of payments of interest and income tax.

A similar method can be used to calculate the cash flows for interest paid and income tax paid. For eachitem, the information available might be:

Opening balance at the start of the period (opening balance sheet) Income statement (the amount of the item, as reported) Closing balance at the end of the period (closing balance sheet)

The cash flow is a balancing figure obtained from these three figures.

A T account can be used as a working.

Worked example: Interest paid

A company’s financial statements show the following information:

At 1 Jan At 31 Dec For the year20X2 20X2 20X2

CU CU CUInterest payable 54,000 63,000Interest charge 240,000

Interest paid is calculated as follows.

INTEREST PAID

CU CUCash payment (balancing figure) 231,000 Balance b/d 54,000Balance c/d 63,000 Income statement 240,000

294,000 294,000

Alternatively, this could be calculated as follows:

(54,000 + 240,000 – 63,000) = CU231,000

A similar technique can be used to calculate payments of income tax in the year. The taxation paymentrefers to payments of income tax, not to payments of sales tax (VAT) or tax paid by employees.

The opening and closing balance sheets will show a liability for income tax. The income tax charge for theyear is shown on the face of the income statement. The figure for income taxes paid during the year isderived as a balancing figure.

Interactive question 1: Income tax [Difficulty level: Easy]

A company had a liability for income tax at 31 December 20X6 of CU940,000 and a liability for income taxat 31 December 20X7 of CU1,125,000. The income tax charge for the year to 31 December 20X7 wasCU1,270,000. What amount of income tax was paid during the year?

INCOME TAX PAID

CU CU




4 Investing activities

Section overview

The cash flows in this section are those related to the acquisition or disposal of any non-currentassets, and returns received in cash from investments.

4.1 Investing activities

The cash flows classified under this heading show the extent of new investment in assets which willgenerate future income and cash flows. The standard gives the following examples of cash flowsarising from investing activities.

Cash payments to acquire property, plant and equipment, intangibles and other non-current assets,including those relating to capitalised development costs and self-constructed property, plant andequipment

Cash receipts from sales of property, plant and equipment, intangibles and other non-current assets

Cash payments to acquire equity or debt of other entities

Cash receipts from sales of equity or debt of other entities

Interest received

Dividends received

4.2 Cash receipts from sales of property, plant and equipment

A T account can be used for calculating the cash receipts from sales of property, plant and equipment (PPE).The company's accounts will include the amount of any profit or loss on disposal. A note to the accounts onnon-current assets will show the cost and the accumulated depreciation for property, plant and equipmentdisposed of during the year. The cash received from the sale is the balancing figure in the T account.

PROPERTY, PLANT AND EQUIPMENT – DISPOSAL ACCOUNT

CU CUCost/valuation of asset disposed of X Accumulated depreciation XProfit on disposal X Loss on disposal X

Cash received (balancing figure) XX X

Worked example: Cash receipts from sale of PPE

A company's balance sheet as at the beginning and the end of the year showed the following.

Property, plant and equipment

Cost CUAt 1 January 20X7 760,000Disposals (240,000)At 31 December 20X7 520,000

DepreciationAt 1 January 20X7 270,000Disposals (180,000)Charge for year (50,000)At 31 December 20X7 140,000

Carrying amountAt 31 December 20X7 380,000At 31 December 20X6 490,000



3

The property, plant and equipment was disposed of at a loss of CU7,000. What was the cash flow from thedisposal?

Solution

The balancing figure can be obtained by constructing a disposal of property, plant and equipment account asa working.

PROPERTY, PLANT AND EQUIPMENT – DISPOSAL ACCOUNT

CU CUCost 240,000 Accumulated depreciation 180,000

Loss on disposal 7,000Cash received (balancing figure) 53,000

240,000 240,000

4.3 Cash payments for purchase of property, plant and equipment

Purchase of property, plant and equipment during a period can be calculated by means of a T account or aworking table.

PROPERTY, PLANT AND EQUIPMENT

CU CUBalance b/d X Disposals XRevaluation reserve XAdditions (balancing figure) X Balance c/d X

X X

Interactive question 2: Cash payments for PPE [Difficulty level: Intermediate]

A company's accounts show that at 31 December 20X7, it had property, plant and equipment at cost orvaluation of CU6,800,000. During the year, it disposed of assets that had a cost of CU850,000. It alsorevalued a freehold property upwards by CU300,000. At 31 December 20X6, the company's property,plant and equipment at cost or valuation had been CU5,100,000.

What were purchases of property, plant and equipment during the year?


CU CU




4.4 Interest and dividends received

Returns received in cash from investments will include interest and dividends received. The cash flows canbe calculated by using an interest received or dividends received T account. Both T accounts are verysimilar and are prepared as follows:

INTEREST/DIVIDENDS RECEIVED

CU CUBalance b/d (receivable) X Cash receipt (balancing figure) XIncome statement X Balance c/d (receivable) X

X X

Interactive question 3: Interest received [Difficulty level: Easy]

A company had interest receivable of CU35,000 at the start of the year and interest receivable ofCU42,000 at the end of the year. The income statement for the year shows interest income of CU90,000.What were the cash receipts for interest received in the year?

INTEREST RECEIVED

CU CU


5 Financing activities

Section overview

Financing cash flows comprise receipts from or repayments to external providers of finance.

5.1 Financing activities

This section of the cash flow statement shows the share of cash which the entity's capital providers haveclaimed during the period. This is an indicator of likely future interest and dividend payments. Thestandard gives the following examples of cash flows which might arise under this heading.

Cash proceeds from issuing shares

Cash payments to owners to acquire or redeem the entity's shares

Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short or long-termborrowings

Repayments of capital of amounts borrowed under finance leases (We will look at this issue inChapter 16.)

Dividends paid



3

5.2 Cash received from issuing shares

The amount of cash received from new issues of shares can usually be calculated from the opening andclosing balance sheet figures for share capital and share premium.

As a general rule:

SHARE CAPITAL AND PREMIUM

CU CUBalance b/d X

Balance c/d X Cash receipt (balancing figure) XX X

This rule does not apply fully when the company makes a bonus issue of shares during the year, and someof the new share capital is obtained by means of reducing a reserve account other than the share premium.To calculate cash receipts from share issues in the year, the amount transferred to share capital from theother reserve account should be subtracted.

Worked example: Cash received from share issue

Rustler Ltd's annual accounts for the year to 31 December 20X7 show the following figures.

At 31.12.X7 At 31.12.X6CU CU

Share capital: Ordinary shares of 50p 6,750,000 5,400,000Share premium 12,800,000 7,300,000

There were no bonus issues of shares during the year. What amount of cash was raised from shares issuedduring the year?

Solution


CU CUBalance b/d(5,400,000 + 7,300,000) 12,700,000

Balance c/d 19,550,000(6,750,000 + 12,800,000) Cash receipt (balancing figure) 6,850,000

19,550,000 19,550,000

Interactive question 4: Bonus issue [Difficulty level: Intermediate]

Groat Ltd's accounts for the year to 31 December 20X7 show the following figures.

At 31.12.X7 At 31.12.X6CU CU

Share capital: Ordinary shares of 10p 22,500,000 10,000,000Share premium 900,000 4,800,000

The company made a one for two bonus issue of shares during the year. It used the share premium accountand CU200,000 from retained earnings to do this.

What amount of cash was raised from share issues during the year?




CU CU


5.3 Cash from issuing loan stock or raising a loan

The cash derived from obtaining a new loan during the year or from issuing new loan stock ordebentures should be apparent from a comparison of the opening and closing balance sheet figures fornon-current interest-bearing borrowings. An increase during the year represents new financing, andshould be taken as the amount of cash received from financing.

It is important that all loans in the balance sheet should be taken into consideration in thecalculation. There may be a loan that is within 12 months of repayment. If so, it will be included withincurrent liabilities in the year-end balance sheet as ‘short-term borrowings’, when it would have been a non-current liability in the balance sheet at the start of the year. The loan has not been repaid during the year,merely re-classified from non-current liability to current liability.

5.4 Repayment of non-current interest-bearing borrowings

In the same way, a reduction in interest-bearing borrowings indicates that a loan has been repaid, orthat loan stock or debentures have been redeemed. It should be assumed that the loans are repaid or loanstock is redeemed for cash.

5.5 Dividends paid

Cash flows from dividends paid should be disclosed separately.

Dividends paid by the entity can be classified in one of two ways.

(a) As a financing cash flow, showing the cost of obtaining financial resources (as in the example cashflow statement in section 2 above). This is the presentation adopted in these Learning Materials.

(b) As a component of cash flows from operating activities so that users can assess the entity's abilityto pay dividends out of operating cash flows.

Cash flows for dividends paid can be calculated using a T account.

Worked example: Dividends paid

A company has declared preference dividends for the year of CU7,000 (based on its 7% CU100,000preference shares in issue). At the start of the year the balance sheet included a liability of CU3,500 forpreference dividends payable. At the end of the year no amount was owing to preference shareholders inrespect of dividends.

The preference dividend paid for the year is not simply the CU7,000 declared and reflected in retainedearnings as this amount needs to be adjusted for any opening and closing liabilities.



3

DIVIDENDS PAID

CU CUCash payment (balancing figure) 10,500 Balance b/d 3,500Balance c/d 0 Retained earnings 7,000

10,500 10,500

The cash paid during the year of CU10,500 is the second half year preference dividend due from last yearand the whole of this year’s preference dividend (all paid during the year).

Point to note: Any dividends for the year will be disclosed in the statement of changes in equity.

6 Disclosures

Section overview

BAS 7 requires certain additional disclosures to accompany the cash flow statement.

6.1 Components of cash and cash equivalents

The following disclosures are required:

The components of cash and cash equivalents.

A reconciliation showing the amounts in the cash flow statement reconciled with the equivalent itemsreported in the balance sheet.

The accounting policy used in deciding the items included in cash and cash equivalents (BAS 1).


All entities should disclose, together with a commentary by management, any other information likelyto be of importance, for example:

Restrictions on the use of or access to any part of cash equivalents.

The amount of undrawn borrowing facilities which are available.

Cash flows which increased operating capacity compared to cash flows which merely maintainedoperating capacity.

6.3 Significant non-cash transactions

Many investing and financing activities do not have a direct impact on current cash flows although they doaffect the capital and asset structure of an entity. Significant 'non-cash transactions' should bedisclosed.

Examples include:

The acquisition of assets either by assuming directly related liabilities or by means of a finance lease The acquisition of an entity by means of an issue of equity shares



6.4 Example: Notes to the cash flow statement

The following shows how the required disclosures would be presented.

Note: Cash and cash equivalents

Cash and cash equivalents consist of cash on hand and balances with banks, and investments in moneymarket instruments. Cash and cash equivalents included in the cash flow statement comprise the followingbalance sheet amounts.

20X7 20X6CUm CUm

Cash on hand and balances with banks 40 25Short-term investments 370 95Cash and cash equivalents 410 120

The company has undrawn borrowing facilities of CU2,000m of which only CU700m may be used for futureexpansion.

Note: Property, plant and equipment

During the period the company acquired property, plant and equipment with an aggregate cost ofCU1,250m of which CU900m was acquired by finance lease. Cash payments of CU350m were made topurchase property, plant and equipment.

7 Preparing a cash flow statement

Section overview

This section gives you a step by step approach for preparing a cash flow statement.

7.1 Technique

Worked example: Preparing a cash flow statement

Able Ltd’s income statement and statement of changes in equity for the year ended 31 December 20X7 andbalance sheets at 31 December 20X6 and 31 December 20X7 were as follows.

ABLE LTDIncome statement for the year ended 31 December 20X7

CU'000 CU'000Revenue 720Raw materials consumed 70Staff costs 94Depreciation 118Loss on disposal of non-current asset 18

(300)Profit from operations 420Finance cost (28)Profit before tax 392Income tax (124)Profit for the period 268



3

ABLE LTDBalance sheets as at 31 December

20X7 20X6CU'000 CU'000 CU'000 CU'000

ASSETSNon-current assetsCost 1,596 1,560Depreciation 318 224

1,278 1,336Current assetsInventory 24 20Trade receivables 76 58Bank 48 56

148 134Total assets 1,426 1,470

EQUITY AND LIABILITIESEquityShare capital 360 340Share premium 36 24Retained earnings 686 490

1,082 854Non-current liabilitiesLong-term loans 200 500

Current liabilitiesTrade payables 12 6Taxation 102 86Proposed dividend 30 24

144 116Total equity and liabilities 1,426 1,470

ABLE LTD

Statement of changes in equity (extract) for the year ended 31 December 20X7

RetainedearningsCU'000

Profit for the period 268Dividends on ordinary shares (72)Balance brought forward 490Balance carried forward 686

During the year, the company paid CU90,000 for a new piece of machinery.

Prepare a cash flow statement for Able Ltd for the year ended 31 December 20X7 in accordance with therequirements of BAS 7, using the indirect method. The reconciliation of profit before tax to cash generatedfrom operations should be shown as a note.

Solution

Step 1Set out the proforma cash flow statement with the headings required by BAS 7 and the reconciliationnote. You should leave plenty of space. Ideally, use three or more sheets of paper, one for the mainstatement, one for the notes and one for your workings. It is obviously essential to know the formats verywell.

Step 2Begin with the cash flows from operating activities as far as possible. You will usually have to calculatesuch items as depreciation, loss on sale of non-current assets, interest paid and tax paid.



Step 3Calculate the cash flow figures for dividends paid, purchase or sale of non-current assets, issue ofshares and repayment of loans if these are not already given to you (as they may be).

Step 4If you are not given the profit figure, open up a working for the income statement. Using the openingand closing balances of retained earnings, the taxation charge and dividends paid and proposed, you will beable to calculate profit for the year as the balancing figure to put in the cash flows from operating activitiessection.

Step 5You will now be able to complete the statement by slotting in the figures given or calculated.

ABLE LTDCash flow statement for the year ended 31 December 20X7

CU'000 CU'000Cash flows from operating activities

Cash generated from operations (see note) 540Interest paid (28)Tax paid (86 + 124 – 102) (108)

Net cash from operating activities 404Cash flows from investing activities

Purchase of property, plant and equipment (90)Proceeds from sale of property, plant and equipment (W) 12

Net cash used in investing activities (78)Cash flows from financing activities

Proceeds from issue of share capital (360 + 36 340 24) 32

Long-term loans repaid (500 200) (300)

Dividends paid (72 – 30 + 24) (66)Net cash used in financing activities (334)Decrease in cash and cash equivalents (8)Cash and cash equivalents at 1.1.X7 56Cash and cash equivalents at 31.12.X7 48

Note to the cash flow statement

Reconciliation of profit before tax to cash generated from operations for the year ended 31 December20X7

CU'000Profit before tax 392Depreciation charges 118Loss on sale of tangible non-current assets 18Interest expense 28Increase in inventories (4)Increase in receivables (18)Increase in payables 6Cash generated from operations 540

WORKING

Non-current asset disposalsCOST

CU'000 CU'000Balance b/d 1,560 Balance c/d 1,596Purchases 90 Disposals (balancing figure) 54

1,650 1,650



3

ACCUMULATED DEPRECIATION

CU'000 CU'000Balance c/d 318 Balance b/d 224Depreciation on disposals Charge for year 118(balancing figure) 24

342 342

NBV of disposals (54 – 24) 30Net loss reported (18)

Proceeds of disposals 12




Summary

Cash and Cash equivalents

- Cash comprises cash on hand and ondemand deposits

- Cash equivalents are short-term, highlyliquid investments that are readilyconvertible to known amounts of cashand which are subject to an insignificant

risk of change in value

BAS 7 requires cash flows to be classified

as follows

Self-test


1 Which one of the following options best describes the objective of BAS 7 Cash Flow Statements?

A To aid comparison of cash flows between entitiesB To assist users to understand the cash management and treasury practices of an entityC To assist users to confirm the going concern of an entityD To enable entities to report cash inflows and outflows analysed under standard headings

2 Which one of the following statements gives the best definition of cash equivalents as set out in BAS 7Cash Flow Statements?

A Cash equivalents are cash, overdrafts, short-term deposits, options and other financialinstruments and equities traded in an active market

B Cash equivalents are short-term highly liquid investments subject to insignificant risks of changein value

C Cash equivalents are readily disposable investments

D Cash equivalents are investments which are traded in an active market



3

3 In a company's cash flow statement prepared in accordance with BAS 7 Cash Flow Statements, arevaluation of non-current assets during the year will be:

A Entirely excludedB Shown under cash flows from operating activitiesC Disclosed under investing activitiesD Shown as a cash inflow

4 Information concerning the non-current assets of Ealing Ltd is detailed in the table. During the yearnon-current assets which had cost CU80,000 and which had a net book value of CU30,000 were soldfor CU20,000. Net cash from operating activities for the year was CU300,000.

Start of year End of yearCU CU

Cost 180,000 240,000Aggregate depreciation (120,000) (140,000)Carrying amount 60,000 100,000

There was no other cash activity. As a result of the above, cash increased over the year by

A CU240,000B CU260,000C CU320,000D CU180,000

5 Waterloo Ltd acquired a freehold building for cash, financed in full by issuing for cash 166,000 CU1ordinary shares at a premium of CU2 per share.

In its cash flow statement prepared in accordance with BAS 7 Cash Flow Statements this transactionshould be stated as:

A Inflow CU498,000, outflow nilB Inflow nil, outflow nilC Inflow CU498,000, outflow CU498,000D Inflow nil, outflow CU498,000

6 Information from the cash flow statement and related notes of Gresham Ltd for the year ended 31December 20X1 can be found in the table below.

CUDepreciation 30,000Profit on sale of property, plant and equipment 5,000Proceeds from sale of property, plant and equipment 20,000Purchase of property, plant and equipment 25,000

If the net book value of property, plant and equipment was CU110,000 on 31 December 20X0, whatwas it on 31 December 20X1?

A CU85,000B CU90,000C CU70,000D CU80,000

7 In a cash flow statement prepared under BFRS under which category of cash flow would interest paidusually be classified?

A Cash flows from operating activitiesB Cash flows from financing activitiesC Returns on investments and servicing of financeD Financing



8 ROXY LTD (Note: this question is included to provide practice of basic techniques)

The financial statements of Roxy Ltd at 30 June were as follows.

Balance sheet at 30 June 20Y820Y8 20Y7

CU CU CU CUASSETSNon-current assets

Property, plant and equipment 20,750 14,000

Current assetsInventories 16,000 11,000Trade and other receivables 9,950 2,700Cash and cash equivalents - 1,300

25,950 15,000Total assets 46,700 29,000


Ordinary share capital 3,000 3,000Accumulated profits/losses 16,200 3,800

19,200 6,800Non-current liabilities

Interest-bearing borrowings 6,000 10,000

Current liabilitiesBank overdrafts 11,000 -Trade and other payables 8,000 11,000Accruals 700 200Tax liabilities 1,800 1,000

21,500 12,20046,700 29,000

Income statement (extracts)

20Y8 20Y7CU CU

Profit from operations 15,400 5,900Finance cost (1,000) (1,400)Profit before tax 14,400 4,500Tax (2,000) (1,500)Net profit for the year 12,400 3,000

Additional Information

(1) An analysis of property, plant and equipment shows the following.

20Y8 20Y7CU CU CU CU

BuildingCost 22,000 12,000Depreciation (4,000) (1,000)

18,000 11,000Plant and machinery

Cost 5,000 5,000Depreciation (2,250) (2,000)

2,750 3,00020,750 14,000

(2) Machinery with a net book value of CU250 was sold at the beginning of 20Y8 for CU350. Thismachinery had originally cost CU1,000.

(3) No dividends have been declared or paid in recent years.



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(4) The accruals are in respect of interest payable.

Requirement

Under the indirect method, prepare a clash flow statement, together with a note reconciling profitbefore tax to cash generated from operations for the year ended 30 June 20Y8.

9 MIDDLESEX LTD (Note: this question is included to provide practice of basic techniques)

The balance sheet of Middlesex Ltd as at 30 June 20Y8, including comparative figures, is given below.

20Y8 20Y7CU CU CU CU


Property, plant and equipment 333,000 311,000Less Depreciation (70,000) (69,000)

263,000 242,000Investment 50,000 -

313,000 242,000Current assets

Inventories 12,000 11,000Trade and other receivables 29,000 27,000

Cash and cash equivalents 20,000 10,00061,000 48,000

Total assets 374,000 290,000


Ordinary share capital (CU1 shares) 95,000 50,000Share premium 15,000 10,000Revaluation reserves 12,000 12,000Accumulated profits 149,000 115,000

271,000 187,000

Non-current liabilitiesInterest-bearing borrowings (12%

debentures 20Z1)

50,000 60,000

Current liabilitiesProvisions - 2,000Trade and other payables 27,000 19,000Tax liabilities 7,000 3,000Accruals 19,000 19,000

53,000 43,000Total equity and liabilities 374,000 290,000

You are also given the following information which is already reflected correctly in the accounts.

(1) During the year a bonus issue of 1 for 10 was made on the ordinary shares in issue at 30 June20Y7, utilising available profits.

(2) New shares were issued on 1 July 20Y7. Part of the proceeds was used to redeem CU10,00012% debentures 20Z1 at par.

(3) During the year certain tangible non-current assets were disposed of for CU20,000. The assetshad originally cost CU40,000 and had a net book value at the disposal date of CU18,000.

(4) Trade and other payables include CU5,000 for 20Y8 relating to the fixed asset purchases.

(5) The corporation tax charge for the year is CU7,000.



Requirement

Prepare a cash flow statement for the year ended 30 June 20Y8 and the note reconciling profit beforetax with cash generated from operations.

10 Set out below are the financial statements of Emily Ltd. You are the financial controller, faced with thetask of implementing BAS 7 Cash Flow Statements.

EMILY LTDIncome statement for the year ended 31 December 20X7

CU'000Revenue 2,553Cost of sales (1,814)Gross profit 739Distribution costs (125)Administrative expenses (264)Profit from operations 350Investment income 25Finance cost (75)Profit before tax 300Income tax expense (140)Profit for the period 160

Balance sheets as at 31 December20X7 20X6

ASSETS CU'000 CU'000Non-current assets

Property, plant and equipment 380 305Intangibles 250 200Investments – 25

Current assetsInventories 150 102Receivables 390 315Short-term investments 50 –Cash in hand 2 1

Total assets 1,222 948

EQUITY AND LIABILITIESEquity

Share capital (CU1 ordinary shares) 200 150Share premium 160 150Revaluation reserve 100 91Retained earnings 160 100

Non-current liabilitiesLong-term loan 170 50

Current liabilitiesTrade payables 127 119

Bank overdraft 85 98

Taxation 120 110

Dividends proposed 100 80

Total equity and liabilities 1,222 948

Statement of changes in equity for the year ended 31 December 20X7 (extract)


Profit for the period 160Dividends on ordinary shares (100)Balance brought forward 100Balance carried forward 160



3

The following information is available.

(a) The proceeds of the sale of non-current asset investments amounted to CU30,000.

(b) Fixtures and fittings, with an original cost of CU85,000 and a net book value of CU45,000, weresold for CU32,000 during the year.

(c) The following information relates to property, plant and equipment.

31.12.20X7 31.12.20X6CU'000 CU'000

Cost 720 595Accumulated depreciation 340 290Net book value 380 305

(d) 50,000 CU1 ordinary shares were issued during the year at a premium of 20p per share.

(e) The short-term investments are highly liquid and are close to maturity.

Requirement

Prepare a cash flow statement for the year to 31 December 20X7 using the indirect method laid outin BAS 7 Cash Flow Statements. The reconciliation of profit before tax to cash generated fromoperations should be shown as a note. Your answer should also include an analysis of cash and cashequivalent balances.

11 HATCHBACK MOTOR COMPONENTS LTD

Hatchback Motor Components Ltd has prepared the summarised accounts as set out below.

Income statements for the years ended 30 April

20X7 20X6CU'000 CU'000

Revenue 74,680 69,937Cost of sales (51,595) (47,468)Gross profit 23,085 22,469Distribution and administrative costs (17,681) (16,920)Profit before tax 5,404 5,549Tax (2,634) (1,093)Net profit for the period 2,770 4,456

Balance sheets at 30 April

20X7 20X6CU'000 CU'000 CU'000 CU'000


Property, plant and equipment 30,946 25,141Investments 7,100 –

38,046 25,141

Current assetsInventories 16,487 15,892Trade and other receivables 12,347 8,104Cash and cash equivalents 863 724

29,697 24,720Total assets 67,743 49,861



20X7 20X6EQUITY AND LIABILITIES CU'000 CU'000Capital and reserves

Ordinary share capital (CU1 ordinary shares) 13,000 10,000Share premium 12,500 5,000Revaluation reserve 7,450 2,650Retained earnings 24,776 22,856

57,726 40,506Non-current liabilities 3,250 4,250

Current liabilities 6,767 5,105Total equity and liabilities 67,743 49,861

Notes relating to the accounts

(1) Analysis of property, plant and equipment20X7 20X6

CU'000 CU'000Freehold buildings 25,100 19,780Fixtures and fittings 5,846 5,361

30,946 25,141

(2) Depreciation has not been provided on freehold buildings. During the year a professionalrevaluation – taking account of additions during the year – has been incorporated into the booksof account. There were no disposals during the year.

(3) Additions to fixtures and fittings during the year totalled CU1,365,000 at cost. There were nodisposals.

(4) Current liabilities

20X7 20X6CU'000 CU'000

Trade and other payables 2,771 2,632Accruals 1,200 1,235Tax liability 2,796 1,238

6,767 5,105

Taxation provided at 30 April 20X6 was settled at a figure lower than the amount provided.

(5) During the year the company made a rights issue of shares on the basis of three new shares forevery ten shares held at a price of CU3.50 per share. Pending the purchase of new plant part ofthe proceeds of the issue has been invested in shares in other UK companies.

Requirement

Prepare a cash flow statement in accordance with BAS 7 Cash Flow Statements under the indirectmethod, for the year ended 30 April 20X7.

Now go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved theseobjectives, please tick them off.



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Technical reference

Point to note: All of BAS 7 is examinable with the exception of paragraphs 24-28, 38 and Appendix B. Theparagraphs listed below are the key references you should be familiar with. (Paragraph references relatingto the treatment of leased assets in the cash flow statement and consolidated cash flow statements aredealt with in Chapter 16).

1 Objective of the cash flow statement

The cash flow statement should show the historical changes in cash and cashequivalents.

Cash comprises cash on hand and demand deposits. BAS 7(6)

Cash equivalents are short-term, highly liquid investments that are readilyconvertible to known amounts of cash and which are subject to an insignificantrisk of change in value.

BAS 7(6)

2 Presentation of a cash flow statement Appendix A

Cash flows should be classified by operating, investing and financing activities. BAS 7(10)

Cash flows from operating activities are primarily derived from the principalrevenue-producing activities of the entity.

BAS 7(13–14)

There are two methods of presentation for cash flows from operating activities

– Direct method BAS 7(19)

– Indirect method BAS 7(20)

Cash flows from investing activities are those related to the acquisition or disposalof any non-current assets, or trade investments together with returns received incash from investments (i.e. dividends and interest received).

Financing activities include: BAS 7(16)

– Cash proceeds from issuing shares

– Cash proceeds from issuing debentures, loans, notes, bonds, mortgages andother short or long-term borrowings

– Cash repayments of amounts borrowed

– Repayment of capital of amounts borrowed under finance leases

– Dividends paid to shareholders

3 Disclosures BAS 7(50)

Components of cash and cash equivalents. Appendix A

Reconciliation of the amounts in the cash flow statement with the equivalentbalance in the balance sheet.

Information (together with a commentary) which may be relevant to the users.

The cash flow statement does not record non-cash transactions. Significant non-cash transactions should be disclosed.

BAS 7(43)




1 D To enable entities to report cash inflows and outflows analysed under standard headings. (BAS 7).

2 B Cash equivalents are short-term highly liquid investments subject to insignificant risks of changesin value.

3 A A revaluation of non-current assets during the year will be entirely excluded.

Revaluations have no cash flow implications.

4 D The correct answer is CU180,000.

NON-CURRENT ASSETS – COST

CU CUBalance b/d 180,000 Disposals 80,000Therefore purchases 140,000 Balance c/d 240,000

320,000 320,000

DEPRECIATION

CU CUBalance b/d 120,000

Disposals 50,000 Therefore charge 70,000Balance c/d 140,000

190,000 190,000

DISPOSALS

CU CUCost 80,000 Accumulated depreciation 50,000

Proceeds 20,000Therefore loss 10,000

80,000 80,000

CUCash from operations 300,000Cash inflow:Disposal proceeds 20,000

320,000Cash outflow: purchases of non-current assets (140,000)Therefore net cash increase 180,000

Note that adjustments for depreciation and loss on disposal will already be included in net cashfrom operating activities.

5 C Inflow CU498,000, outflow CU498,000.

The outflow is classified under 'Purchase of property, plant and equipment'.

The inflow is classified under 'Proceeds from issuance of share capital'.



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6 B CU90,000

PROPERTY (NBV)

CU CUBalance b/d 110,000 Depreciation 30,000Additions 25,000 Disposals (NBV) 15,000

Balance c/d 90,000135,000 135,000

7 A (BAS 7)

8 ROXY LTD

Cash flow statement for year ended 30 June 20Y8

CU CUCash flows from operating activities

Cash generated from operations 4,050Interest paid (W5) (500)Tax paid (W4) (1,200)

Net cash from operating activities 2,350Cash flows from investing activities

Purchase of property, plant and equipment (W1) (11,000)Proceeds from sale of property, plant and equipment (W3) 350

Net cash used in investing activities (10,650)Cash flows from financing activities

Redemption of non-current interest-bearing borrowings (4,000)Net cash used in financing activities (4,000)Net change in cash and cash equivalents (12,300)Cash and cash equivalents brought forward 1,300Cash and cash equivalents carried forward (11,000)

Reconciliation of profit/loss before tax to cash generated from operations fro theyear ended 30 June 20Y8

CUProfit/loss before tax 14,400Finance cost 1,000Property, plant and equipment – depreciation charge (W2) 4,000Profit/loss on disposal of property, plant and equipment (W3) (100)Change in inventories (W6) (5,000)Change in trade and other receivables (W6) (7,250)Change in trade and other payables (3,000)Cash generated from operations 4,050

WORKINGS

(1) PROPERTY, PLANT AND EQUIPMENT – COST OR VALUATION

CU CUB/f (5,000 + 12,000) 17,000 Disposal 1,000Additions (β) 11,000 C/f (5,000 + 22000) 27,000

28,000 28,000

(2) PROPERTY, PLANT AND EQUIPMENT – ACCUMULATED DEPRECIATION

CU CUDisposal (1,000 – 250) 750 B/f (1,000 + 2000 3,000C/f (4,000 + 2,250 6,250 Depreciation charge for the year (β) 4,000

7,000 7,000



(3) PROPERTY, PLANT AND EQUIPMENT – DISPOSAL ACCOUNT

CU CUCos 1,000 Accumulated depreciation 750Profit on sale 100 Proceeds 350

1,100 1,100


CU CUCash paid (β) 1,200 B/f 1,000C/f 1,800 Income statement 2,000

3,000 3,000


CU CUCash paid (β) 500 B/f 200C/f 700 Income statement 1,000

1,200 1,200

(6) Changes in current itemsCU

Inventories (16,000 – 11,000) (5,000)Receivables (9,950 – 2700) (7,250)Payables (11,000 – 8,000) (3,000)

9 MIDDLESEX LTD

Cash flow statement for the year ended 30 June 20Y8

CU CUCash flows from operating activitiesCash generated from operations 71,000Interest paid (6,000)Tax paid (W2) (3,000)Net cash from operating activities 62,000

Cash flows from investing activitiesPurchase of property, plant and equipment (W3) (57,000)Proceeds from sale of property, plant and equipment (W3) 20,000Purchase of investments (50,000)

Net cash used in investing activities (87,000)

Cash flows from financing activitiesIssues of ordinary shares (W4) 45,000Redemption of non-current interest-bearing borrowings (10,000)Net cash used in financing activities 35,000Net change in cash and cash equivalents 10,000Cash and cash equivalents brought forward 10,000Cash and cash equivalents carried forward 20,000



3

Reconciliation's of profit/loss before tax to net cash generated from operations for theyear ended 30 June 20Y8

CUProfit/loss before tax (W7) 46,000Finance cost (W6) 6,000Property, plant and equipment – depreciation charge (W1) 23,000Profit/loss on disposal of property, plant and equipment (2,000)Change in inventories (W5) (1,000)Change in trade and other receivables (W5) (3,000)Change in trade and other payables (W5) (2,000)Change in provision (2000)Cash generated from operations 71,000

WORKINGS(1) PROPERTY, PLANT AND EQUIPMENT – ACCUMULATED DEPRECIATION

CU CUDisposal (40,000 – 18,000) 22,000 B/f 69,000C/f 70,000 Charge for year (β) 23,000

92,000 92,000

(2) TAX PAID

CU CUCash (β) 3,000 B/f 3,000C/f 7,000 Charge for year 7,000

10,000 10,000


CU CUB/f 311,000 Disposal 40,000Additions (β) 57,000 C/f 333,000C/f 5,000

373,000 373,000

(4) SHARE CAPITAL AND PREMIUM

CU CUB/f (50,000 + 10,000) 60,000Accumulated profit/losses(bonus issue) (50,000 ÷ 10) 5,000

C/f (95,000 + 15,000) 110,000 Cash (β) 45,000373,000 110,000

(5) Changes in current itemsCU

Inventories (12,000 – 11,000) (1,000)Receivables (29,000 – 27,000) (2,000)Payables (27,000 – 5,000 – 19,000) 3,000

(6) Finance costCU50,000 x 12% = CU6,000



(7) ACCUMULATED PROFIT/LOSS

CU CUBonus issue 5,000 B/f 115,000Corporation tax 7,000 Net profit for the period (β) 46,000C/f 149,000

161,000 161,000

10 EMILY LTD

Cash flow statement for the year ended 31 December 20X7

CU'000 CU'000Cash flows from operating activities

Cash generated from operations 333Interest paid (75)Tax paid (110 + 140 – 120) (130)

Net cash from operating activities 128Cash flows from investing activities

Purchase of property, plant and equipment (W2) (201)Purchase of intangible non-current assets (50)Proceeds from sale of property, plant and equipment 32Proceeds from sale of non-current asset investments 30Interest received 25

Net cash used in investing activities (164)Cash flows from financing activities

Proceeds from issue of share capital 60Long-term loan 120Dividends paid (100 + 80 – 100) (80)

Net cash from financing activities 100Increase in cash and cash equivalents (Note) 64Cash and cash equivalents at 1.1.X7 (Note) (97)Cash and cash equivalents at 31.12.X7 (Note) (33)

Notes to the cash flow statement

Reconciliation of profit before tax to net cash generated from operations for the year ended 31December 20X7

CU'000Profit before tax 300Depreciation charge (W1) 90Loss on sale of property, plant and equipment (45 – 32) 13Profit on sale of non-current asset investments (5)Investment income (25)Finance cost 75Increase in inventories (48)Increase in receivables (75)Increase in payables 8Cash generated from operations 333

Analysis of the balances of cash and cash equivalents as shown in the balance sheet

Change20X7 20X6 in year

CU'000 CU'000 CU'000Cash in hand 2 1 1Short term investments 50 – 50Bank overdraft (85) (98) 13

(33) (97) 64



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WORKINGS

(1) Depreciation chargeACCUMULATED DEPRECIATION

CU’000 CU’000Depreciation on assets sold Balance b/d 290(85 – 45) 40 Charge for yearBalance c/d 340 (balancing figure) 90

380 380

(2) Purchase of property, plant and equipment

PROPERTY, PLANT AND EQUIPMENT (COST)

CU'000 CU'0001.1.X7 Balance b/d 595 Disposals 85

Revaluation (100 91) 9

Purchases (balancing figure) 201 31.12.X7 Balance c/d 720805 805

11 HATCHBACK MOTOR COMPONENTS LTD

Cash flow statement for the year ended 30 April 20X7

Cash flows from operating activities CU CUCash generated from operations 1,550,000Tax paid (W4) (1,076,000)

Net cash from operating activities 474,000Cash flows from investing activities

Purchase of property, plant and equipment (W3) (1,885,000)Purchase of investments (7,100,000)

Net cash used in investing activities (8,985,000)Cash flows from financing activities

Proceeds from issue of ordinary shares (W2) 10,500,000Redemption of non-current interest-bearing borrowings (1,000,000)Dividends paid (W5) (850,000)

Net cash from financing activities 8,650,000

Net change in cash and cash equivalents 139,000Cash and cash equivalents brought forward 724,000Cash and cash equivalents carried forward

863,000

Note to the cash flow statement

Reconciliation of profit before tax to cash generated from operations for the year ended 30 April 20X7

CUProfit before tax 5,404,000Property, plant and equipment – depreciation charge (W1) 880,000Increase in inventories (W6) (595,000)Increase in trade and other receivables (W6) (4,243,000)Increase in trade and other payables (W6) 139,000Decrease in accruals (35,000)Cash generated from operations 1,550,000

WORKINGS

(1) FIXTURES AND FITTINGS (AT NBV)

CU CUBalance b/d 5,361,000 Balance c/d 5,846,000Additions 1,365,000 Depreciation charge () 880,000

6,726,000 6,726,000



(2) SHARE CAPITAL AND PREMIUM

CU CUBalance b/d

Balance c/d (10,000,000 + 5,000,000) 15,000,000(13,000,000 + 12,500,000) 25,500,000 Cash received () 10,500,000

25,500,000 25,500,000

(3) FREEHOLD BUILDINGS

CU CUBalance b/d 19,780,000 Balance c/d 25,100,000Revaluation surplus(7,450 – 2,650) 4,800,000

Additions () 520,00025,100,000 25,100,000

Total additions = 520,000 + 1,365,000 = CU 1,885,000

(4) TAX PAID

CU CUCash paid () 1,076,000 Balance b/d 1,238,000Balance c/d 2,796,000 Income statement 2,634,000

3,872,000 3,872,000

(5) RETAINED EARNINGS

CU CUDividends paid () 850,000 Balance b/d 22,856,000Balance c/d 24,776,000 Net profit for the period 2,770,000

25,626,000 25,626,000

(6) Changes in current items

CUInventories (16,487 – 15,892) (595,000)Receivables (12,347 – 8,104) (4,243,000)Payables (2,771 – 2,632) 139,000Accruals (1,235 – 1,200) (35,000)



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INCOME TAX PAID

CU CUCash payment (balancing figure) 1,085,000 Balance b/d 940,000Balance c/d 1,125,000 Income statement 1,270,000

2,210,000 2,210,000

Alternatively this could be calculated as follows:

(CU940,000 + CU1,270,000 – CU1,125,000) = CU1,085,000



CU CUBalance b/d 5,100,000 Disposals 850,000Revaluation reserve 300,000Additions (balance) 2,250,000 Balance c/d 6,800,000

7,650,000 7,650,000

The company started the year with PPE at cost or valuation of CU5,100,000 and revalued an asset upwardby CU300,000. It bought a further CU2,250,000 of PPE, giving a total of CU7,650,000 at cost or valuation.However, there was disposals of PPE with a cost of CU850,000, bringing the year-end figure down toCU6,800,000.


INTEREST RECEIVED

CU CUBalance b/d 35,000 Cash received (balancing figure) 83,000Income statement 90,000 Balance c/d 42,000

125,000 125,000



CU CUBalance b/d 14,800,000

Balance b/d 23,400,000 Accumulated profits/losses 200,000Cash received (balance) 8,400,000

23,400,000 23,400,000




Contents

Introduction

Examination context

Topic List

1 BAS 8 Accounting Policies, Changes in Accounting Estimates andErrors

2 Accounting policies

3 Changes in accounting policies

4 Changes in accounting estimates

5 Prior period errors

6 Impracticability

7 BFRS 5 and discontinued operations

8 BAS 32 Financial Instruments: Presentation


Technical reference


Answers to Interactive question

chapter 4

Reporting financialperformance



Introduction


Understand the purpose and principles underlying BAS 8 Accounting Policies, Changes inAccounting Estimates and Errors

Understand how accounting policies are selected and applied

Apply accounting requirements for:

– Changes in accounting policies

– Changes in accounting estimates

– Prior period errors

Disclose the results of a discontinued operation in accordance with BFRS 5 Non-current AssetsHeld for Sale and Discontinued Operations

Classify financial instruments in accordance with BAS 32 Financial Instruments: Presentation as:

– Financial assets

– Financial liabilities

– Equity instruments

Prepare simple extracts from financial statements in accordance with Companies Act andBFRS

Specific syllabus references for this chapter are: 2d.


Shareholders are interested in the future performance of the business in which they have invested. Thedifficulty they have is in obtaining reliable information. It could be argued that a profit forecast would be themost relevant information to a shareholder in this situation due to its predictive nature but this will oftenbe unreliable.

The compromise is to present historic information in a way that enables the user to identify the recurringtrend in the profits of the entity's continuing activities. This is achieved by BFRS 5 Non-current Assets Held forSale and Discontinued Operations as it requires the results of activities which will not be continued into thefuture to be shown separately.

It is also important that financial information is presented in such a way that it is not misleading. This couldhappen through an inadvertent lack of consistency or it could arise as a result of deliberate manipulation.BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors addresses this issue by restricting thecircumstances in which accounting policies can be changed, for example, it is not possible to change thepolicy to achieve a particular accounting outcome.

BAS 32 Financial Instruments: Presentation also addresses the issue of consistency in the guidance it provideson the classification of financial instruments. Under BAS 32 financial instruments are classified according totheir substance, with the related finance costs to match, either as debt or equity.

Stop and think

Separate disclosure of discontinued operations enables the user to assess the impact of this on current andfuture results. Can you think of any other ways that historical information can be used predictively?

REPORTING FINANCIAL PERFORMANCE

© The Institute of Chartered Accountants in England and Wales, March 2009g 121

4

Working context

You are likely to come across accounting policies in your work, particularly in the context of the auditengagement. For example, in the audit of non-current assets you would be expected to consider whetherthe accounting policy:

Is appropriate for the type of asset Has been applied consistently Has been applied correctly Has been adequately disclosed

Many of you may also have been involved in the audit of inventories. Again here, the accounting policyadopted by the company is a key consideration.

Syllabus links

In the Accounting paper you will have looked briefly at BAS 8 in the context of preparing companyaccounts. In this paper those basic principles are developed. A detailed understanding of this standard willbe assumed in the Financial & Corporate Reporting paper.

Both BFRS 5 and BAS 32 are introduced at this level. The more complex aspects of these standards will becovered in Financial & Corporate Reporting.



Examination context

Exam requirements

The topics covered in this chapter are unlikely to be the main focus of an individual written test questionbut they could be examined in combination with a number of other matters or as part of a mixed topicquestion. For example, changes in accounting estimates could be examined as part of a question on non-current assets. Prior period adjustments or an analysis of discontinued operations could be included in aquestion where you are asked to draft financial statements. These topics could also feature in the short-form question section of the paper.


Prepare financial statements or extracts including adjustments for:

– Changes in accounting policies– Changes in accounting estimates– Prior period adjustments

Identify the circumstances in which an operation would meet the BFRS 5 definition of a discontinuedoperation.

Prepare financial statements or extracts including simple financial instruments.



4

1 BAS 8 Accounting Policies, Changes in AccountingEstimates and Errors

Section overview

BAS 8 is intended to enhance:

– Relevance– Reliability– Comparability.

1.1 Introduction

The objective of BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors is to prescribe thecriteria for selecting and changing accounting policies, together with the accounting treatment anddisclosure of changes in accounting policies, changes in accounting estimates and correction of error. Thisenhances relevance, reliability and comparability. BAS 8 achieves this objective by ensuring that:

Information is available about the accounting policies adopted by different entities.

Different entities adopt a common approach to the distinction between a change in accounting policyand a change in an accounting estimate.

The scope for accounting policy changes is constrained.

Changes in accounting policies, changes in accounting estimates and corrections of errors are dealtwith in a comparable manner by different entities.


Section overview

Management is responsible for selecting accounting policies which are relevant, reliable andconsistent.

2.1 Selecting accounting policies

Definition

Accounting policies: The specific principles, bases, conventions, rules and practices applied by an entity inpreparing and presenting financial statements.

Accounting policies are normally developed by reference to the applicable BFRS or Interpretationtogether with any relevant Implementation Guidance issued by the IASB. The exception to this is where theeffect of applying the accounting policy set out in the BFRS is immaterial.

Where there is no applicable BFRS or Interpretation management should use its judgement in developing anaccounting policy ensuring that the resulting information is relevant and reliable. In practical termsmanagement should refer to:

The requirements and guidance in BFRS/Interpretations dealing with similar and related issues.

The basic principles set down in the Framework, for example, the recognition criteria and measurementconcepts for assets, liabilities and expenses.



Management may also consider the most recent pronouncements of other standard setting bodies that usea similar conceptual framework to develop standards, other accounting literature and accepted industrypractices if these do not conflict with the sources above.

2.2 Consistency of accounting policies

Once selected, accounting policies should be applied consistently for similar transactions, other eventsand conditions. The exception to this is where a BFRS requires or allows categorisation of items wheredifferent policies may be applied to each category.

3 Changes in accounting policies

Section overview

A change in accounting policy must be applied retrospectively.

3.1 Introduction

The same accounting policies are usually adopted from period to period, to enhance comparability therebyallowing users to analyse trends over time in profit, cash flows and financial position. Changes inaccounting policy will therefore be rare and should only be made if the change

Is required by a BAS or a BFRS (or an Interpretation of a BAS or BFRS)

Will result in a more appropriate presentation of events or transactions in the financialstatements of the entity (a voluntary change).

The standard highlights two types of event which do not constitute changes in accounting policy.

Adopting an accounting policy for a new type of transaction or event not dealt with previously bythe entity.

Adopting a new accounting policy for a transaction or event which has not occurred in the past orwhich was not material.

In the case of tangible non-current assets, if a policy of revaluation is adopted for the first time then this istreated, not as a change of accounting policy under BAS 8, but as a revaluation under BAS 16 Property, Plantand Equipment (see Chapter 5). The following paragraphs do not therefore apply to a change in policy toadopt revaluations.

3.2 Changes in accounting policy

A change in accounting policy must be applied retrospectively.

Definition

Retrospective application: Applying a new accounting policy to transactions, other events andconditions as if that policy had always been applied.

In other words, at the earliest date such transactions or events occurred, the policy is applied from thatdate.

Any resulting adjustment should be reported as an adjustment to the opening balance of retainedearnings. Comparative information should be restated unless it is impracticable to do so (see section 6below).



4

This means that all comparative information must be restated as if the new policy had always been inforce, with amounts relating to earlier periods reflected in an adjustment to opening reserves of theearliest period presented.

The steps needed to make the retrospective adjustment are:

Step 1Restate the opening balances for the current year, by applying the new policy to the opening balance sheet(i.e. the previous period's closing balance sheet).

Step 2Calculate the difference between the figure for capital and reserves in the revised opening balance sheet andthe figure as originally published. This difference is the amount of the adjustment made in the statement ofchanges in equity to the reserves brought forward at the start of the current period.

Step 3Apply the new policy in the current period and to the closing balance sheet.

Step 4Restate the comparatives for the prior period by applying steps (1) to (3) to the prior period values.

Step 5Prepare the note explaining the reason for the change and giving other details (see section 3.4 below).

Although BAS 8 requires retrospective adjustment for changes in accounting policy it recognises that theremay be circumstances where it is impracticable to determine the effect in a specific period or on acumulative basis. Where this is the case the policy should be applied retrospectively to the earliest periodfor which it is practicable to do so.

In the rare circumstance where it is impracticable to restate retrospectively any financial results thenew policy should be applied prospectively. (Impracticality is dealt with in more detail in section 6 below.)

Definition

Prospective application of a change in accounting policy: applying the new accounting policy totransactions, other events and conditions occurring after the date as at which the policy is changed.

3.3 Adoption of a new BFRS

Where a new BFRS is adopted, BAS 8 requires any transitional provisions in the new BFRS itself to befollowed. If none are given in the BFRS which is being adopted, then the entity should follow the generalprinciples of BAS 8.

3.4 Disclosure

Certain disclosures are required when a change in accounting policy has a material effect on the currentperiod or any prior period presented, or when it may have a material effect in subsequent periods.

Nature of the change

Reasons for the change (why more reliable and relevant)

Amount of the adjustment for the current period and for each prior period presented for each lineitem

Amount of the adjustment relating to periods prior to those included in the comparative information

The fact that comparative information has been restated or that it is impracticable to do so

An entity should also disclose information relevant to assessing the impact of new BFRS on the financialstatements where these have not yet come into force.



3.5 Borrowing costs

In recent years the IASB has revised a number of accounting standards removing the majority of accountingpolicy choices. The only remaining choice is in respect of finance costs on borrowing. Under BAS 23Borrowing Costs, borrowing costs may be capitalised as part of a qualifying asset in specific circumstances (asopposed to being expensed in the period in which they are incurred).

BAS 23 per se is not examinable in the Financial Accounting paper but you should be aware of this issuein the context of accounting policy choices. The following worked example demonstrates the treatment ofthe change in accounting policy for borrowing costs.

Worked example: Change in accounting policy

Multi Ltd commenced trading three years ago, on 1 January 20X5. Its draft balance sheet at 31 December20X7 and its final balance sheets for the two previous years are as follows:

20X7 20X6 20X5CUm CUm CUm

Non-current assetsProperty, plant and equipment 231 230 180Other 169 120 120

400 350 300Current assets 800 800 800

1,200 1,150 1,100

Capital 100 100 100Reserves 450 400 350

550 500 450Non-current liabilities 200 200 200Current liabilities 450 450 450

1,200 1,150 1,100

Additional information is available as follows:

1 The profit for each of the three years was CU50m.

2 The movements on property, plant and equipment were as follows:


Brought forward 230 180 0Direct cost of additions 80 90 180Interest capitalised 10 10 20

320 280 200Depreciation (89) (50) (20)Carried forward 231 230 180

3 Property, plant and equipment is depreciated at the rate of 10% of cost per annum.

The directors now believe that more relevant information would be provided if interest was notcapitalised, so the decision has been made to change the accounting policy and to recognise all interestas an expense in the year in which it is incurred.

Prepare the revised balance sheets at 31 December 20X7 and 20X6, together with extracts from thestatement of changes in equity for each of the two years then ended.



4

Solution

BALANCE SHEET 20X7 20X6CUm CUm

Non-current assetsProperty, plant and equipment (W3) 200 205Other 169 120

369 325Current assets 800 800

1,169 1,125

Capital 100 100Reserves (per SCE extract below) 419 375

519 475Non-current liabilities 200 200Current liabilities 450 450

1,169 1,125

Statement of changes in equity 20X7 20X6(extracts) CUm CUmReserves brought forward – as reported 400 350Adjustment – to write off capitalised interest brought forward (W1) (25) (18)As restated 375 332Profit for the year (W2) 44 43Reserves carried forward 419 375

WORKINGS

(1) Adjustment re capitalised interest


Amount capitalised in the year 10 10 20Depreciation charge (10% 20) (2)

Depreciation charge (10% (20 + 10)) (3)

Depreciation charge (10% (20 + 10 + 10)) (4)Reserves adjustment/asset write-down 6 7 18

Cumulative 31 25 18

(2) Adjustment to reported profits

20X7 20X6CUm CUm

Profit for year before adjustment 50 50Profit adjustment (W1) (6) (7)Profit for year restated 44 43

(3) PPE restated

20X7 20X6CUm CUm

As originally stated 231 230Write-down (7 + 18) (25)Write-down (6 + 7 + 18) (31)Restated 200 205



Point to note

The five steps referred to in section 3.2 above have been applied in this example as follows:

Step 1The opening balance for PPE is revised by recalculating the 20X6 closing balance sheet balance (W3).

Step 2The difference between the figure for capital and reserves in the revised opening balance sheet and thefigure as originally published is calculated in W1. Note that the cumulative adjustment at the end of 20X6appears as the adjustment to reserves brought forward at the beginning of 20X7 in the statement ofchanges in equity.

Step 3The new policy is applied in the current period and the closing balance sheet. In W2 20X7 profits arereduced by CU6m. In W3 PPE is reduced by the cumulative additional depreciation (CU31m).

Step 4Comparatives are restated.

The closing PPE balance for 20X6 is restated (see W3).

Reserves brought forward are restated for 20X6 in the statement of changes in equity by CU18m.

Profit for 20X6 is restated by CU7m (see W2).

Step 5Disclosures as described in section 3.4 would be provided.


Section overview

A change in accounting estimates should be applied prospectively.

4.1 Accounting estimates

Definition

Change in accounting estimate: An adjustment of the carrying amount of an asset or a liability or theamount of the periodic consumption of an asset, that results from the assessment of the present status of,and expected future benefits and obligations associated with, assets and liabilities. Changes in accountingestimates result from new information or new developments and, accordingly, are not corrections oferrors.

Estimates arise in relation to business activities because of the uncertainties inherent within them.Judgements are made based on the latest available, reliable information. The use of such estimates is anecessary part of the preparation of financial statements and does not undermine their reliability. Here aresome examples of accounting estimates.

A necessary bad debt allowance Useful lives of depreciable assets Adjustment for obsolescence of inventory



4

4.2 Accounting treatment

The rule here is that the effect of a change in an accounting estimate should be included in thedetermination of net profit or loss in:

The period of the change, if the change affects that period only, or The period of the change and future periods, if the change affects both

Changes may occur in the circumstances which were in force at the time the estimate was calculated, orperhaps additional information or subsequent developments have come to light.

An example of a change in accounting estimate which affects only the current period is the bad debtestimate. However, a revision in the life over which an asset is depreciated would affect both the currentand future periods, via the amount of the depreciation expense.

The effect of a change in an accounting estimate should be included in the same income statementclassification as was used previously for the estimate. This rule helps to ensure consistency between thefinancial statements of different periods.

The effect of a change in an accounting estimate is to be recognised prospectively.

Definition

Prospective application of recognising the effect of a change in accounting estimate:Recognising the effect of the change in the accounting estimate in the current and future periods affected bythe change.

4.3 Disclosure

Where a change in an accounting estimate has a material effect in the current period (or which isexpected to have a material effect in subsequent periods) the following should be disclosed.

Nature of the change in accounting estimate Amount of change (if impracticable to estimate, this fact should be disclosed)

Worked example: Change in accounting estimate

Taking the example of a machine tool with an original cost of CU100,000, an originally estimated useful lifeof 10 years and an originally estimated residual value of CUnil, the annual straight line depreciation chargewill be CU10,000 per annum and the carrying amount after three years will be CU70,000. If in the fourthyear it is decided that as a result of changes in market conditions the remaining useful life is only three years(so a total of six years), then the depreciation charge in that year (and in the next two years) will be thecarrying amount brought forward ÷ the revised remaining useful life, so CU70,000 ÷ 3 = CU23,333. Thereis no question of going back to restate the depreciation charge for the past three years.

The effect of the change (in this case an increase in the annual depreciation charge from CU10,000 toCU23,333) in the current year and the next two years must be disclosed.

4.4 Changes in policy versus changes in estimate

It can be difficult sometimes to distinguish between changes in accounting policies and changes in accountingestimates.

When there is doubt as to which type of change it is, BAS 8 requires it to be treated as a change inaccounting estimate based upon new information.




Section overview

Prior period errors should be corrected by retrospective restatement.

5.1 Introduction

Errors may be discovered during a current period which relate to a prior period.

If immaterial, these errors can be corrected through net profit or loss for the current period.Where they are material prior period errors, however, this is not appropriate.

Definition

Prior period errors: Are omissions from, and misstatements in, the entity's financial statements for oneor more prior periods arising from a failure to use, or misuse of, reliable information that:

Was available when financial statements for those periods were authorised for issue.

Could reasonably be expected to have been obtained and taken into account in the preparation andpresentation of those financial statements.

Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversightsor misinterpretations of facts, and fraud.


Prior period errors should be corrected retrospectively.

Definition

Retrospective restatement: Correcting the recognition, measurement and disclosure of amounts ofelements of financial statements as if a prior period error had never occurred.

This involves:

Either restating the comparative amounts for the prior period(s) in which the error occurred,

Or, if the error occurred before the earliest prior period presented, restating the opening balances ofassets, liabilities and equity for the earliest prior period presented

so that the financial statements are presented as if the error had never occurred.

Only where it is impracticable to determine the cumulative effect of an error on prior periods can anentity correct a prior period error prospectively. (See section 6.)



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5.3 Disclosures

Various disclosures are required:

Nature of the prior period error.

For each prior period, to the extent practicable, the amount of the correction for each financialstatement line item affected.

The amount of the correction at the beginning of the earliest prior period presented.

If retrospective restatement is impracticable for a particular prior period, the circumstancesthat led to the existence of that condition and a description of how and from when the error has beencorrected.

Subsequent periods need not repeat these disclosures.

6 Impracticability

Section overview

There may be practical limitations on retrospective application of changes in accounting policy andprior period errors.

6.1 Issue

As we have already mentioned, in some cases it may be impracticable to make retrospectiveadjustments for changes in accounting policies or prior period errors.

Definition

Impracticable: Applying a requirement is impracticable when the entity cannot apply it after making everyreasonable effort to do so. It is impracticable to apply a change in an accounting policy retrospectively or tomake a retrospective restatement to correct an error if one of the following apply.

The effects of the retrospective application or retrospective restatement are not determinable.

The retrospective application or retrospective restatement requires assumptions about whatmanagement's intent would have been in that period.

The retrospective application or retrospective restatement requires significant estimates of amountsand it is impossible to distinguish objectively information about those estimates that:

– Provides evidence of circumstances that existed on the date(s) at which the transaction, otherevent or condition occurred; and

– Would have been available when the financial statements for that prior period were authorisedfor issue, from other information.

Where it is impracticable to determine the period-specific or cumulative effects of:

Retrospective application of a changed accounting policy Prior period errors ranking for retrospective restatement

then no retrospective adjustments are made. 'Impracticable' is defined in the same way as in BAS 1.

It is important not to use hindsight but to identify information for earlier periods which not only reflects thecircumstances at the earlier date but also would have been available at that earlier date. If such informationis not identifiable, then it is impracticable to make retrospective application or restatement.



7 BFRS 5 and discontinued operations

Section overview

The results of discontinued operations should be presented separately on the face of the incomestatement.

7.1 The problem

The ability to predict the future performance of an entity is hampered when the financial statements includeactivities which as a result of sale or closure will not continue into the future. While figures inclusive ofthose activities are a fair measure of past performance, they do not form a good basis for predicting thefuture cash flows, earnings-generating capacity and financial position. Separating out data about discontinuedactivities benefits users of financial statements, but leads to difficulties in defining such operations and indeciding when a discontinuance comes about. This problem is addressed by BFRS 5 Non-current Assets Heldfor Sale and Discontinued Operations.

7.2 The objectives of BFRS 5 regarding discontinued operations

Part of BFRS 5 is designed to deal with the problem by requiring entities to disclose in the income and cashflow statements the results of discontinued operations separately from those of continuing operations andto make certain balance sheet disclosures. This chapter only deals with BFRS 5's definition of discontinuedoperations and its disclosure requirements; the other aspects are concerned with measurement andrecognition of profits and losses on non-current assets held for sale and these are covered in Chapter 5.

There are two parts of the Chapter 5 coverage which are relevant to the disclosure rules dealt with in thischapter:

The key criterion for the classification of a non-current asset as held for sale is that it is highlyprobable that it will be finally sold within 12 months of classification.

A non-current asset held for sale is measured at the lower of carrying amount and fair value lesscosts to sell. The effect is that if fair value less costs to sell is lower than the carrying amount of theasset, then the loss is recognised at the time the decision is made to dispose of the asset, not whenthe disposal actually takes place.

7.3 Discontinued operations

Definitions

Discontinued operation: A component of an entity that has either been disposed of, or is classified asheld for sale, and

Represents a separate major line of business or geographical area of operations,

Is part of a single co-ordinated plan to dispose of a separate major line of business or geographicalarea of operations, or

Is a subsidiary acquired exclusively with a view to resale.

Component of an entity : Operations and cash flows that can be clearly distinguished, operationally andfor financial reporting purposes, from the rest of the entity.



4

As already noted, the separation of information about discontinued activities benefits users of financialstatements by providing them with information about continuing operations which they can use as the basisfor predicting the future cash flows, earnings-generating capacity and financial position. Management istherefore faced with the temptation to classify continuing, but underperforming, operations as discontinued,so that their performance does not act as a drag on the figures used as a basis for future predictions. This iswhy the definition of a discontinued operation is so important, but applying that definition requires difficultjudgements.

Consider the following:

The abrupt cessation of several products within an ongoing line of business: presumably a line ofbusiness must be defined by reference to the requirement in the definition for a component to be'distinguished operationally and for financial reporting purposes'. But how many products have to bestopped before the line of business itself is stopped?

Selling a subsidiary whose activities are similar to those of other group companies: how should 'similar'be defined?

7.4 When does a discontinuance come about?BFRS 5 does not set out specific criteria for when a discontinuance comes about, despite its importance interms of defining the accounting period in which disclosures must first be made. Instead, it relies on thedefinition of a discontinued operation, but this comes in two parts; it is a component of the entity which:

Has been disposed of. In this case, the disclosures will first be made in the accounting period inwhich the disposal takes place, or

Is held for sale. In this case the disclosures will first be made in the accounting period in which thedecision to dispose of it is made, provided that it is highly probable that it will be sold within 12months of classification.

If a business decides to discontinue operations and the non-current assets supporting these operations areto be abandoned (so scrapped or just closed down) rather than sold, the carrying amount of the assets willnot be recovered principally through sale. So these assets cannot be classified as held for sale. As a result,these operations should not be disclosed as discontinued until the underlying assets actually cease to beused.

Points to note

Operations supported by assets which become idle because they are temporarily taken out of use may notbe described as discontinued. This includes, for example, assets that are mothballed and may be broughtback into use if market conditions improve.

7.5 Presenting discontinued operations: income statement and cashflow statement

An entity should disclose a single amount on the face of the income statement comprising the totalof:

The post-tax profit or loss of discontinued operations, and Any post-tax gain or loss on related assets

An entity should also disclose an analysis of this single amount into

The revenue, expenses and pre-tax profit or loss of discontinued operations The related income tax expense Post-tax gain or loss on related assets

This analysis may be presented either:

On the face of the income statement, or In the notes



If it is presented on the face of the income statement it should be presented in a section identified asrelating to discontinued operations, i.e. separately from continuing operations. (This analysis is not requiredwhere the discontinued operation is a newly acquired subsidiary that has been classified as held for sale.)

The disclosure of discontinued operations adopted in these Learning Materials is in line with Example 11 inthe (non-mandatory) Guidance on Implementing BFRS 5. The main part of the income statement isdescribed as 'continuing operations', with the single amount in respect of 'discontinued operations' beingbrought in just above 'profit/(loss) for the period'.

XYZ LTD – Income statement for the year ended [date]

CUmContinuing operationsRevenue XCost of sales (X)… …… …Share of profits/(losses) of associates XProfit/(loss) before tax XIncome tax expense (X)Profit/(loss) for the period from continuing operations XDiscontinued operationsProfit/(loss) for the period from discontinued operations (X)Profit/(loss) for the period X

The additional information is then included in a note to the income statement.

In the cash flow statement an entity should disclose the net cash flows attributable to the:

Operating Investing, and Financing

activities of discontinued operations.

These disclosures may be presented either on the face of the cash flow statement or in the notes.

Points to note

1 The results and cash flows for any prior periods shown as comparative figures must be restated to be consistent with the continuing/discontinued classification in the current period. As an example,operations discontinued in the year ended 31 December 20X7 will have been presented as continuingin the 20X6 financial statements but will be re-presented as discontinued in the 20X6 comparativefigures included in the 20X7 financial statements.

2 Some narrative descriptions are also required. Although this part of the BFRS does not specificallymention discontinued operations, it includes them through its requirement for these narratives inrespect of non-current assets disposed of or classified as held for sale; many discontinued operationswill include such non-current assets.

3 If in the current period there are adjustments to be made to operations discontinued in prior periods,their effect must be shown separately from the figures for operations discontinued in the currentperiod. Examples are given of the sort of adjustments which may have to be made.

4 If a part of the business is discontinued but it does not meet the criteria for a discontinued operation(i.e. it cannot be clearly distinguished), then its results must be included in those from continuingoperations.

7.6 Presenting discontinued operations: balance sheet

If the operation has finally been discontinued and all its assets have been disposed of, there will benothing relating to the discontinued operation still in the balance sheet. So there will be nobalance sheet disclosures.



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If non-current assets held for sale have not been finally disposed of, they must be shown in the balancesheet separately from all other assets. In these circumstances there will be a separate line itemimmediately below the sub-total for current assets for the non-current assets held for sale. If anoperation is being discontinued, then any non-current assets related to it will now be held with a view todisposal and it will be inappropriate for them to be shown as non-current assets.

The previous classification is retained for non-current assets being abandoned because, by definition, theyare not held for sale.

Point to note: any non-current assets now held for sale are not reclassified as held for sale in the balancesheets for any prior periods shown as comparative figures.

7.7 Link with other BASs

As has already been noted, the part of BFRS 5 dealt with in this chapter is concerned purely with disclosure,not about recognition or measurement. But a decision to discontinue an operation would normally requiremanagement to immediately consider the recognition and measurement requirements of:

BAS 36 Impairment of Assets (dealt with in Chapter 5) which may require an immediate reduction inthe carrying amount of non-current assets.

BAS 37 Provisions, Contingent Liabilities and Contingent Assets (dealt with in Chapter 9) which may requirethe recognition of provisions for reorganisation and restructuring costs.

It is also the case that, even if a component being disposed of or abandoned has to be treated as acontinuing operation (because it does not meet all of the conditions for being classified as a discontinuedoperation), management should still consider whether the requirements of BAS 36 and BAS 37, togetherwith that of BAS 1 (dealt with in Chapter 3) to make separate disclosure of 'exceptional' items, should beapplied to that continuing operation.

Worked example: Business closure

On 20 October 20X7 the directors of a parent company made a public announcement of plans to close asteel works. The closure means that the group will no longer carry out this type of operation, which untilrecently has represented about 10% of its total revenue. The works will be gradually shut down over aperiod of several months, with complete closure expected in July 20X8. At 31 December output had beensignificantly reduced and some redundancies had already taken place. The cash flows, revenues andexpenses relating to the steel works can be clearly distinguished from those of the subsidiary’s otheroperations.

How should the closure be treated in the financial statements for the year ended 31 December 20X7?

Solution

Because the steel works is being closed, rather than sold, it cannot be classified as ‘held for sale’. In addition,the steel works is not a discontinued operation. Although at 31 December 20X7 the group was firmlycommitted to the closure, this has not yet taken place and therefore the steel works must be included incontinuing operations. Information about the planned closure should be disclosed in the notes to thefinancial statements.

Interactive question 1: Grey Ltd [Difficulty level: Exam standard]

The income statement for Grey Ltd for the year ended 31 December 20X7 is as follows:

CURevenue 300,000Cost of sales (100,000)Gross profit 200,000Distribution costs (40,000)Administrative expenses (90,000)



Profit before tax 70,000Income tax expense (21,000)Profit for the period 49,000

On 30 September 20X7 the company classified a manufacturing division as held for sale. It satisfies thedefinition of a discontinued operation in accordance with BFRS 5.

The results of the division are as follows:

CU

Revenue 32,000Cost of sales (15,000)Distribution costs (12,000)Administrative expenses (10,000)

These balances have been included in the income statement of Grey Ltd above.

Requirement

Show how the discontinued operation would be treated in the income statement.

Fill in the proforma below.

CUContinuing operationsRevenueCost of salesGross profitDistribution costsAdministrative expensesProfit before taxIncome tax expenseProfit for the period from continuing operationsDiscontinued operationsLoss for the period from discontinued operationsProfit for the period

WORKING

Continuing Discontinuedoperations operations Total

CU CU CURevenueCost of salesGross profitDistribution costsAdministrative expensesProfit /(loss) from operationsIncome taxNet profit/(loss) for period


8 BAS 32 Financial Instruments: Presentation

Section overview

Financial instruments should be classified as financial assets, financial liabilities or equity. Classification should be based on the substance of the contractual arrangement.



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8.1 The issue

If you read the financial press you will probably be aware of the rapid international expansion in the use offinancial instruments. These vary from straightforward, traditional instruments, e.g. bonds, through tovarious forms of so-called derivative instruments. As these instruments have been developed over timedifficulties have arisen regarding their presentation and measurement.

8.2 Elements of financial statements

BFRS Framework defines the elements of financial statements which relate to the measurement of financialposition as:

Assets, which are resources controlled by the entity as a result of past events and from which futureeconomic benefits are expected to flow to the entity.

Liabilities, which are present obligations of the entity arising from past events, the settlement ofwhich is expected to lead to the outflow from the entity of resources embodying economic benefits.

Equity, which is the residual of assets less liabilities.

The key to applying these definitions is being able to distinguish one from the other in practical terms. Insome cases, this will be straightforward, so for example, it is easy to see that a bank loan would be aliability. However, in more complex cases (which will be covered in Financial Reporting) making thisdistinction may be more difficult.

8.3 BAS 32 Financial Instruments: Presentation

BAS 32 Presentation is designed to address the kind of problem mentioned above.

Definition

Financial instrument: Any contract that gives rise to both a financial asset of one entity and a financialliability or equity instrument of another entity.

Financial instruments should be classified as either:

Financial assets Financial liabilities, or Equity

Definition

Financial asset: Any asset that is:

Cash

An equity instrument of another entity

A contractual right to receive cash or another financial asset from another entity; or to exchangefinancial instruments with another entity under conditions that are potentially favourable to the entity,or

A contract that will or may be settled in the entity's own equity instruments and is:

– A non-derivative for which the entity is or may be obliged to receive a variable number of theentity's own equity instruments, or

– A derivative that will or may be settled other than by the exchange of a fixed amount of cash oranother financial asset for a fixed number of the entity's own equity instruments.



Financial liability: Any liability that is:

A contractual obligation:

– To deliver cash or another financial asset to another entity, or

– To exchange financial instruments with another entity under conditions that are potentiallyunfavourable, or

A contract that will or may be settled in the entity's own equity instruments and is:

– A non-derivative for which the entity is or may be obliged to deliver a variable number of theentity's own equity instruments, or

– A derivative that will or may be settled other than by the exchange of a fixed amount of cash oranother financial asset for a fixed number of the entity's own equity instruments.

Equity instrument: Any contract that evidences a residual interest in the assets of an entity afterdeducting all of its liabilities.

We should clarify some points arising from these definitions. Firstly, one or two terms above should bethemselves defined.

A 'contract' need not be in writing, but it must comprise an agreement that has 'clear economicconsequences' and which the parties to it cannot avoid, usually because the agreement is enforceablein law.

An 'entity' here could be an individual, partnership, incorporated body or government agency.

The definitions of financial assets and financial liabilities may seem rather circular, referring as they doto the terms financial asset and financial instrument. The point is that there may be a chain of contractualrights and obligations, but it will lead ultimately to the receipt or payment of cash or the acquisition or issueof an equity instrument.

Examples of financial assets include:

Trade receivables Options Shares (when held as an investment)

Examples of financial liabilities include:

Trade payables Debenture loans payable Redeemable preference (non-equity) shares Forward contracts standing at a loss

As we have already noted, financial instruments include both of the following.

Primary instruments: e.g. receivables, payables and equity securities.

Derivative instruments: e.g. financial options, futures and forwards, interest rate swaps andcurrency swaps.

BAS 32 makes it clear that the following items are not financial instruments.

Physical assets, e.g. inventories, property, plant and equipment, leased assets and intangible assets(patents, trademarks etc).

Prepaid expenses, deferred revenue and most warranty obligations.

Liabilities or assets that are not contractual in nature.

Contractual rights/obligations that do not involve transfer of a financial asset, e.g. commodityfutures contracts.



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Worked example: Definitions

List the reasons why physical assets and prepaid expenses do not qualify as financial instruments.

Solution

Refer to the definitions of financial assets and liabilities given above.

(a) Physical assets: control of these creates an opportunity to generate an inflow of cash or otherassets, but it does not give rise to a present right to receive cash or other financial assets.

(b) Prepaid expenses, etc: the future economic benefit is the receipt of goods/services rather than theright to receive cash or other financial assets.

8.4 Liabilities and equity

Financial instruments should be presented according to their substance, not merely their legal form.This classification is made at the time the instrument is first issued and is not revised subsequently.

The classification of a financial instrument as a liability or as equity depends on the following:

The substance of the contractual arrangement on initial recognition The definitions of a financial liability and an equity instrument

How should a financial liability be distinguished from an equity instrument? The critical feature of a liability isan obligation to transfer economic benefit. Therefore, the financial instrument is a financial liability if thereis:

A contractual obligation on the issuer to deliver cash/another financial asset, or A contractual right for the holder to receive cash/another financial asset.

Where this feature is not met, then the financial instrument is an equity instrument.

Worked example: Classification of financial instruments

Alpha Ltd issues 100,000 CU1 ordinary shares.

These would be classified as an equity instrument:

The shareholders own an equity instrument because although they own a residual interest in thecompany, they have no contractual right to demand any of it to be delivered to them, e.g. by way ofdividend.

The company has issued an equity instrument because it has no contractual obligation to distributethat residual interest.

8.5 Preference shares

Preference shares provide the holder with the right to receive:

An annual dividend (usually a predetermined and unchanging amount).

A fixed amount on the ultimate liquidation of the company or at an earlier date if the shares areredeemable.

BAS 32 treats most preference shares as liabilities. This is because they are, in substance, loans.

Fixed annual dividend = 'interest'Fixed amount on redemption/liquidation = 'repayment of loan'



In practical terms preference shares are only treated as part of equity when:

They will never be redeemed, or

The redemption is solely at the option of the issuer and the terms are such that it is very unlikely atthe time of issue that the issuer will ever decide on redemption.

For the purposes of your exam, if you are told that preference shares are irredeemable you should treatthem as equity.

8.6 Interest and dividends

The costs of servicing the financing of a company must be treated consistently with the way that theunderlying instrument has been treated:

Dividends on ordinary shares and irredeemable preference shares will be shown as an appropriationof profit (in the statement of changes in equity)

The cost of servicing loans will be shown as interest payable (in the income statement)

Dividends on redeemable preference shares will be shown alongside interest payable as part of thefinance cost (in the income statement).

8.7 Offsetting a financial asset and a financial liability

It may be the case that one entity both owes money to and is due money from another entity. A frequentlyoccurring example of this is where a company has several accounts with a single bank, some of which are incredit and some overdrawn. The presentation issue is whether these amounts should be shown separatelyor whether they should be netted off against each other and a single figure for the resulting net asset (orliability) shown.

BAS 32 looks to see whether there is a legally enforceable right to make the set off. But it then goesfurther, by taking account of the entity’s intentions. If there is a legal right to make a set off and the entityintends to settle the amounts on a net basis, then the set off must be made.

On this basis an entity with credit and overdrawn bank balances would not set them off against each other(even if it had the legal right to do so) because in the normal course of business it is keeping these accountsseparate, so it cannot claim that it 'intends' to settle on a net basis.

8.8 Other points

Instead of cancelling any of its own shares it may have bought back, an entity may hold them forreissue. In this case they are described as ‘treasury shares’ and are deducted from equity, not shownamongst the entity’s assets.

Transaction costs associated with the issue of equity are to be deducted from equity, but only wherethese costs are incremental. So the fixed cost of in-house legal and/or finance teams cannot be treatedin this way, but should be recognised in profit or loss as incurred.

8.9 Measurement of financial instruments

Measurement of financial instruments is dealt with by BAS 39 Financial Instruments: Recognition andMeasurement.

In simple terms, financial instruments are initially measured at the fair value of the consideration given orreceived (i.e. cost) plus (in most cases) transaction costs that are directly attributable to theacquisition of the financial instrument.

The detail of this accounting standard is outside the scope of the Financial Accounting syllabus.



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Summary

BAS 8 BFRS 5 BAS 32



Self-test


1 During the year to 30 September 20X6, the following events occurred in relation to Pipe Ltd.

(1) A claim for tax relief, submitted in 20X3, was rejected by the General Commissioners of HMRC.No appeal will be made. The resulting liability of CU15,000 was not provided at 30 September20X5, since the company had expected the claim to succeed.

(2) The company had decided to capitalise borrowing costs in the cost of its non-current assets forthe first time in 20X6. The net effect at 30 September 20X5 would have been CU5,000.

(3) A cut-off error in respect of inventories at 30 September 20X5 was discovered which wouldhave reduced the carrying amount of inventories by CU24,000. This error is material but notfundamental.

(4) Non-current assets which had been written down to their estimated realisable value ofCU17,000 at 30 September 20X5 were sold for CU7,000.

How much should be accounted for retrospectively as an adjustment to retained earnings broughtforward at 1 October 20X5?

A CU10,000 (decrease)B CU19,000 (decrease)C CU29,000 (decrease)D CU34,000 (decrease)

2 When considering BFRS 5 Non-current Assets Held for Sale and Discontinued Operations, which of thefollowing statements is true?

(1) A discontinued operation must have been disposed of by the balance sheet date.

(2) A discontinued operation must be a separate major line of business or geographical area ofoperation.

(3) A discontinued operation must be clearly distinguished operationally and for financial reportingpurposes.

A (1), (2) and (3)B (1) and (2) onlyC (2) and (3) onlyD (1) and (3) only

3 During the financial year Alphabet Ltd carried out a reorganisation as follows.

Division X, a Dhaka division whose operations are being terminated and transferred to another Dhakadivision producing the same product.

Division Y, the sole operator in Asia whose business is being sold externally to the group.

Activity W, (part of Division Z) whose operations have been closed down. W's results have not beenreported separately.

Which of the following could be a discontinued operation according to BFRS 5 Non-current Assets Heldfor Sale and Discontinued Operations?

A Division X onlyB Division Y onlyC Division X and Division Y onlyD Division X, Division Y and Activity W



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4 When an entity decides to classify an operation as discontinued in accordance with BFRS 5 Non-currentAssets Held for Sale and Discontinued Operations, what factors must be considered?

(1) Whether there is a need for any restructuring provisions.(2) Whether there is a need for an impairment review of assets being disposed of.(3) The effect of termination on employees such as redundancy and pension costs.(4) The effect of disposal on tangible non-current assets.

A All factors must be consideredB Only factors (1) and (2) must be consideredC Only factors (2) and (4) must be consideredD Only factors (1), (2) and (4) must be considered

5 During the year to 30 April 20X9 Grant Ltd carried out a major reorganisation of its activities asfollows.

Maynard was closed down on 1 January 20X9. Maynard was the only manufacturing division of thecompany, and as a result of the closure Grant's only activity will be the retail of artists equipment.

On 30 March 20X9 it was decided to sell Lytton, the only division that operated in Europe. Thecompany were confident of a sale within the year. The sale actually took place on 15 July 20X9.

The activities carried on by Hobhouse were terminated during the period. Hobhouse was one of anumber of smaller divisions which operated from the same location as the main headquarters ofGrant. All these divisions use the same central accounting system and operating costs are allocatedbetween them for the purpose of the management accounts.

The accounts for the year ended 30 April 20X9 were approved on 7 July 20X9.

Which of these divisions should be classified as discontinued operations in accordance with BFRS 5Non-current Assets Held for Sale and Discontinued Operations in the financial statements of Grant Ltd forthe year ended 30 April 20X9?

A Maynard onlyB Maynard and Lytton onlyC Maynard, Lytton and HobhouseD None of them

6 Under the definitions in BAS 32 Financial Instruments: Presentation, which of the following is not afinancial instrument?

A InventoriesB Trade receivablesC Redeemable preference sharesD Forward contracts

7 A company has CU500,000 4% redeemable preference shares in issue. According to BAS 32 FinancialInstruments: Presentation, where will the dividend charge for the year be shown in the incomestatement?

A Dividends receivedB Interest receivedC Dividends paidD Interest paid

8 According to BAS 32 Financial Instruments: Presentation, what is the correct treatment for dividends onredeemable preference shares and dividends on ordinary shares in financial statements?

A All dividends are recognised in the income statement as an expense

B All paid dividends are recognised in the income statement as an expense and no proposeddividends are recognised

C Preference dividends and equity dividends paid are recognised in the statement of changes inequity

D Preference dividends are recognised in the income statement and equity dividends paid arerecognised in the statement of changes in equity



9 Oxford Ltd has CU6m of 6% redeemable preference shares in issue. They are redeemable on 31December 20X5. In accordance with BAS 32 Financial Instruments: Presentation where are thesedisclosed on the balance sheet in the year ended 31 December 20X3?

A Non-current liabilitiesB Current liabilitiesC EquityD Non-current assets

10 WESTERN ENTERPRISES LTD

Western Enterprises Ltd wholesales and distributes toys and models and provides distribution servicesto other organisations. The following balances have been extracted from its books of account of at 31December 20X3.

CU'000Ordinary shares 8005% redeemable preference shares 200Share premium account 350Revaluation reserve 400Retained earnings at 1 January 20X3 2,000Revenue 11,899Purchases 8,935Inventories at 1 January 20X3 974Staff costs – distribution 270Staff costs – administration 352Depreciation charge for the year

Freehold land and buildings 30Distribution equipment 116Other plant and equipment 160

General expenses 432Interest receivable 41Interest payable 35Taxation – charge for the year 336Paid dividends

Ordinary shares – final regarding 20X2 60Ordinary shares – interim regarding 20X3 305% redeemable preference shares – for 20X3 10

Patent rights 200

Freehold land and buildings 1,500Distribution equipment – cost 800Other plant and equipment – cost 1,400Accumulated depreciation at 31 December 20X3

Freehold land and buildings 30Distribution equipment 320Other plant and equipment 250

Trade receivables 1,600Trade payables 850Cash and cash equivalents 300Tax liability 400


(1) Included in revenue are invoices totalling CU120,000 in relation to distribution servicesrendered under a contract to a customer who is very unhappy with the quality of the servicesprovided. The overall outcome of the contract is uncertain and management believes that of theCU90,000 costs incurred to date under the contract, probably only CU65,000 will be reimbursedby this customer.

(2) The patent was acquired during the year. Amortisation of CU20,000 should be charged toadministrative expenses.



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(3) Inventories at 31 December 20X3 were valued at CU1,304,000.

(4) Costs not specifically attributable to one of the income statement expense headings should besplit 50:50 between distribution costs and administrative expenses.

(5) The freehold land and buildings were revalued on 1 January 20X3 and the surplus of CU400,000over its previous carrying amount of CU1,100,000 (cost CU1,200,000 and accumulateddepreciation CU100,000) has been recognised in the revaluation reserve. The depreciationcharge for the year increased by CU8,000 as a result of the revaluation.

(6) General expenses include a material bad debt write off of CU100,000.

(7) A final ordinary share dividend for 20X3 of CU50,000 was proposed in May 20X4, payable on 28June 20X4.

(8) CU450,000 cash was received during the year as a result of a rights issue of ordinary shares. Thenominal value of the shares issued was CU100,000.

(9) On 1 June 20X3 the company made the decision to sell its loss-making soft toy division as aresult of severe competition from the Far East. The company is confident that the closure will becompleted by 30 April 20X4. The division’s operations represent in 20X3 10% of revenue (afterall adjustments), 15% of cost of sales, 10% of distribution costs and 20% of administrativeexpenses. No balance sheet disclosures are necessary.

Requirement

Prepare Western Enterprises Ltd’s income statement and statement of changes in equity for the yearto 31 December 20X3, a balance sheet at that date and movements schedules and notes in accordancewith the requirements of BFRS, to the extent the information is available. (20 marks)

11 WOODSEATS LTD

There are issues about the presentation of financial instruments in the balance sheet of an entity inrelation to their classification as liabilities and equity and to the related interest, dividends, losses andgains.

The objective of BAS 32 Financial Instruments: Presentation is to address this problem by establishingprinciples for presenting financial instruments as liabilities or equity and for offsetting financial assetsand financial liabilities.

On 1 January 20X3 Woodseats Ltd had only ordinary shares in issue. During the year ended 31December 20X3 Woodseats Ltd entered into the following financing transactions.

(1) On 1 January 20X3 Woodseats Ltd issued 20 million 8% CU1 preference shares at par. Thepreference shares are redeemable at par on 30 June 20X8. The appropriate dividend in respect ofthese shares was paid on 31 December 20X3.

(2) On 30 June 20X3 Woodseats Ltd issued 10 million 12% CU1 irredeemable preference shares atpar. The appropriate dividend in respect of these shares was paid on 31 December 20X3.

On 31 December 20X3 Woodseats Ltd decided to change its accounting policy in respect of thecapitalisation of interest. Previously, Woodseats Ltd had capitalised interest within property, plant andequipment and amortised those costs. It has now decided to write off such costs to cost of sales asincurred. The net book value of such interest included in the draft balance sheet was as follows.

At 1 January 20X3 CUmCosts incurred 4.5Amortisation charge 2.0At 31 December 20X3 (0.5)

6.0

The draft profit for 20X3, before adjusting for capitalised interest, was CU15 million. Retainedearnings at 1 January 20X3 were CU75 million.



Requirements

(a) Describe the concept of 'substance over form' and its application to the presentation of financialliabilities under BAS 32 Financial Instruments: Presentation. (4 marks)

(b) Prepare extracts from the financial statements of Woodseats Ltd for the year ended 31December 20X3 to the extent the information is available, showing how the above would bereflected in those financial statements.

Notes to the accounts are not required. Ignore taxation. (8 marks)

(12 marks)




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Technical reference

Point to note: The following sets out the examinability of the standards covered in this chapter.

BAS 8 All examinable

BFRS 5 References to disposal groups and implementation guidance (except11 and 12) are not examinable

BAS 32 Only paragraphs 2, 4, 8-11, 13-18, 35-46, Appendix paragraphs AG1-AG12 and AG25-AG26 are examinable.

The paragraphs listed below are the key references you should be familiar with.


Definition BAS 8 (5)

Developed by reference to the relevant Standard/Interpretation where this isapplicable

BAS 8 (7)

Otherwise judgement applied BAS 8 (10)

Selection and application should be consistent BAS 8 (13)

2 Change in accounting policies

Only allowed if: BAS 8 (14)

– Required by a Standard/Interpretation, or

– Results in relevant and more reliable information

Changes should be applied: BAS 8 (19-22)

– In accordance with transitional provisions, or

– Retrospectively if there are no transitional provisions or the change isvoluntary

Retrospective application is applying a new accounting policy as if that policy hadalways been applied

BAS 8 (5)

If impracticable to determine the period specific effects: BAS 8 (23-27)

– Apply the new accounting policy from the earliest period for whichretrospective application is practicable

– Disclose this fact



Changes relating to assets, liabilities or equity are adjusted in the period of change BAS 8 (37)

All other changes should be applied prospectively: BAS 8 (36)

– In the period of change

– In the period of change and future periods if both are affected

Disclosure: BAS 8 (39)

– Nature of change

– Amount





Correct retrospectively in the first set of financial statements authorised for issueafter their discovery

BAS 8 (42)

Disclose BAS 8 (49)

– Nature of the prior period error

– Amount of the correction for each prior period presented

– Amount of the correction at the beginning of the earliest period presented If impracticable to determine the period-specific effects or the cumulative effect of

the error:BAS 8 (49)

– Correct the error from the earliest period/date practicable

– Disclose this fact

5 Discontinued operations

Definition BFRS 5 (31-32)

Disclosures on the face of the income statement: BFRS 5 (33(a))

– A single amount comprising the total of:

The post-tax profit or loss of discontinued operations, and

The post-tax gain or loss recognised on related assets

Disclosures on the face or in the notes: BFRS 5 (33(b) (c))

– An analysis of the single amount on the face

Comparative figures must be restated BFRS 5 (34)

Narrative disclosures are also required BFRS 5 (41)

If part of the business is discontinued but it does not meet the criteria then itsresults must be included in those from continuing operations

BFRS 5 (37)

6 Financial instruments


Financial instruments should be classified as: BAS 32 (11)

– Financial assets

– Financial liabilities

– Equity

Classification should take account of the substance of the instrument BAS 32 (15)

The critical feature of a liability is an obligation to transfer economic benefit BAS 32 (17)

Where there is no contractual obligation to deliver cash or another asset theinstrument is an equity instrument

BAS 32 (16(a))

A preference share that: BAS 32 (16(a))

– Provides for mandatory redemption by the issuer, or

– Gives the holder the right to require the issuer to redeem the instrument

is a financial liability



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A preference share that:

– Is irredeemable, or

– Is redeemable but redemption is solely at the option of the issuer and isunlikely to take place

is an equity instrument

Interest and dividends

– These must be treated consistently with the way that the underlyinginstrument has been treated

Offsetting a financial asset and a financial liability BAS 32 (42)

– set off must be made where there is a legal right to set off and the entityintends to settle on a net basis

Other issues

– Incremental transaction costs are deducted from equity BAS 32 (37)

7 Measurement of financial instruments

Financial instruments are initially measured at fair value




1 B Under BFRS items (1) and (4) arise from normal estimation errors and are recognised in thecurrent accounting period. Item (2) results from a change of accounting policy and increasesretained earnings brought forward by CU5,000. Item (3) results from an error which reducesretained earnings brought forward by CU24,000. There is a net reduction of CU19,000.

2 C In order to be classified as discontinued, a component must either have been disposed of or beheld for sale (provided that it is highly probable that it will be sold within 12 months ofclassification (BFRS 5 paragraph 8)).

3 B Division X is not a discontinued operation as a separate line of business is not being terminated –production is shifting from one division to another.

Division Y could be a discontinued operation as a geographical area of operations is being sold.

Activity W is not discontinued, as it cannot be separately distinguished for financial reportingpurposes.

4 A The effect of the discontinuance can be far reaching and may trigger reviews required by otherstandards.

5 B Maynard amounts to the withdrawal from a particular line of business. Lytton amounts to thewithdrawal from a geographical area of operation. The date of sale is irrelevant.

6 A Per BAS 32 paragraph 11

7 D The cost of servicing the financing company are treated consistently with the way the underlyinginstrument has been treated. Per BAS 32 paragraph 36.

8 D Equity dividends paid are recognised in the statement of changes in equity. Equity dividendsproposed after the year-end are not a liability at the balance sheet date so are not recognised.Dividends on redeemable preference shares are recognised in the income statement as a financecost.

9 A Redeemable preference shares are treated as a financial liability, not as part of equity. They areredeemable more than 12 months after the balance sheet date.

10 WESTERN ENTERPRISES LTD

Income statement for the year ended 31 December 20X3

CU'000Continuing operationsRevenue (W3) 10,660Cost of sales (W3) (7,314)Gross profit 3,346Distribution costs (W3) (627)Administrative expenses (W3) (546)Profit from operations 2,173Finance cost (35 + 10) (45)Investment income 41Profit before tax 2,169Income tax (336)Profit for the period from continuing operations 1,833Discontinued operationsLoss for the period from discontinued operations (W3) (314)Profit for the period 1,519



4

Statement of changes in equity for the year ended 31 December 20X3

Ordinaryshare Share Revaluation Retainedcapital premium reserve earnings Total

CU'000 CU000 CU000 CU000 CU000Recognised directly in equity

Revaluation ofnon-current assets – – 400 – 400Transfer regardingdepreciation on revaluation – – (8) 8 –

Total recognised directly in equity – – 392 8 400Profit for the period – – – 1,519 1,519Total recognised income andexpenditure for the period – – 392 1,527 1,919Issue of shares 100 350 – – 45020X2 final dividend – – – (60) (60)20X3 interim dividend – – – (30) (30)

100 350 392 1,437 2,279Balance brought forward 700 – – 2,000 2,700Balance carried forward 800 350 392 3,437 4,979

Notes

(1) The profit from operations is arrived at after charging

CU'000Depreciation (30 + 116 + 160) 306Amortisation of intangibles 20Employee benefits (270 + 352) 622Exceptional bad debt 100

(2) A final ordinary share dividend for 20X3 of CU50,000 is proposed for payment on 28 June 20X4.

(3) On 1 June 20X3 the company classified its soft toy division as held for sale. The division had beenloss-making for some time due to severe competition from the Far East. It is expected that theclosure will be complete by 30 April 20X4.

Amounts in CU000 attributable to this division in 20X3 were: revenue CU1,184, expensesCU1,498 and pre-tax loss CU314.

Balance sheet as at 31 December 20X3

CU'000 CU'000ASSETSNon-current assets

Property, plant and equipment (see note) 3,100Intangibles (see note) 180

3,280Current assets

Inventories 1,304Trade and other receivables (1,600 – 55 (W1)) 1,545Cash and cash equivalents 300




CU000 CU000


Ordinary share capital 800Share premium 350Revaluation reserve 392Retained earnings 3,437

Equity 4,979Non-current liabilities

Preference share capital 200Current liabilities

Trade and other payables 850Taxation 400



Other plantFreehold land Distribution andand buildings equipment equipment Total

CU'000 CU'000 CU'000 CU'000Cost or valuation

At 1 January 20X3 1,200 800 1,400 3,400Revaluation 300 – – 300At 31 December 20X3 1,500 800 1,400 3,700

DepreciationAt 1 January 20X3 100 204 90 394Revaluation adjustment (100) – – (100)Charge for the year 30 116 160 306At 31 December 20X3 30 320 250 600

Carrying amountAt 31 December 20X3 1,470 480 1,150 3,100At 1 January 20X3 1,100 596 1,310 3,006

CU'000INTANGIBLESCost at 31 December 20X3 200Amortisation (20)Carrying amount at 31 December 20X3 180

This patent was acquired during the year

WORKINGS

(1) Revenue and trade receivables

CU'000 CU'000Per list of balances 11,899Adjustment regarding contract under disputeIncluded in revenue 120Costs recoverable (65)Adjustments to revenue and trade receivables (55)

11,844



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(2) Analysis of expenses

Cost of Distribution Administrativesales costs expenses

CU'000 CU'000 CU'000Opening inventories 974Purchases 8,935Staff costs 270 352Depreciation

Land and buildings 15 15Distribution equipment 116Other PPE 80 80

General expenses 216 216Amortisation of patent 20Closing inventories (1,304)

8,605 697 683

(3) Continuing/discontinued analysis

Continuing Discontinuedoperations operations TotalCU'000 CU'000 CU'000

Revenue (W1 – 90:10) 10,660 1,184 11,844Cost of sales (W2 – 85:15) (7,314) (1,291) (8,605)Gross profit 3,346 (107) 3,239Distribution costs (W2 – 90:10) (627) (70) (697)Administrative expenses (W2 – 80:20) (546) (137) (683)Profit/(loss) from operations 2,173 (314) 1,859Finance cost (35 + 10) (45) – (45)Investment income 41 – 41Profit/(loss) before tax 2,169 (314) 1,855Income tax (336) – (336)Net profit/(loss) for the period 1,833 (314) 1,519

11 WOODSEATS LTD

(a) Substance over form and the presentation of financial liabilities under BAS 32Financial Instruments: Presentation

Under BFRS Framework for the Preparation and Presentation of Financial Statements, if information isto faithfully represent transactions, it is necessary for transactions to be presented in accordancewith their substance and economic reality.

The substance is not always consistent with the legal form of a transaction. This is often the casewhen an arrangement involves a number of linked transactions or components.

BAS 32 uses the substance of a financial liability rather than its legal form to determine thebalance sheet classification. Some financial instruments take the legal form of equity but areliabilities in substance as they include contractual obligations to transfer economic benefits to theholder. This approach is consistent with the definition of a liability in BFRS Framework and suchfinancial liabilities are classified in liabilities and not equity.

More complex financial instruments may combine features of both equity instruments andfinancial liabilities. BAS 32 looks at the substance of the components of the instrument andclassifies them separately.



(b) Financial statement extracts

Balance sheet as at 31 December 20X3

CUmEQUITY AND LIABILITIESCapital and reserves

Preference share capital (irredeemable) 10

Non-current liabilitiesPreference share capital (redeemable) 20

Income statement for the year ended 31 December 20X3

CUmCost of sales (2.0)Finance cost (20m × 8%) (1.6)

Statement of changes in equity for the year ended 31 December 20X3

Preferenceshare

Attributable to the equity holders capitalof Woodseats Ltd (irredeemable) Retained earnings

CUm CUm CUmProfit for the period (15 + 0.5 – 2) – 13.5Total recognised income and expense for – 13.5the periodIssue of share capital 10.0 –Final dividends on irredeemable – (0.6)preference shares (10 × 12% × 6/12)

10.0 12.9Balance brought forward – as reported – 75.0Adjustment to write off capitalisedinterest brought forward (4.5)As restated 70.5Balance carried forward 10.0 83.4



4

Answers to Interactive question


CUContinuing operationsRevenue (300 – 32) 268,000Cost of sales (100 – 15) (85,000)Gross profit 183,000Distribution costs (40 – 12) (28,000)Administrative expenses (90 – 10) (80,000)Profit before tax 75,000Income tax expense (21,000)Profit for the period from continuing operations 54,000Discontinued operationsLoss for the period from discontinued operations (32 – 15 – 12 – 10) (5,000)Profit for the period 49,000

WORKING

Continuing Discontinuedoperations operations Total

CU CU CURevenue 268,000 32,000 300,000Cost of sales (85,000) (15,000) (100,000)Gross profit 183,000 17,000 200,000Distribution costs (28,000) (12,000) (40,000)Administrative expenses (80,000) (10,000) (90,000)Profit /(loss) before tax 75,000 (5,000) 70,000Income tax (21,000) – (21,000)Net profit/(loss) for period 54,000 (5,000) 49,000




Contents

Introduction

Examination context

Topic List

1 Property, plant and equipment

2 Recognition of PPE

3 Measurement at recognition

4 Measurement of PPE after initial recognition

5 Accounting for revaluations

6 Depreciation

7 Impairment of assets

8 Derecognition of PPE

9 Disclosures


Technical reference



chapter 5

Property, plant andequipment



Introduction


Relate the treatment of property, plant and equipment to the principles in BFRS Framework

Identify the accounting standards which apply to the treatment of property, plant andequipment

Apply the accounting requirements for property, plant and equipment, including the effects ofthe following:

– Property, plant and equipment measured under the cost model

– Property, plant and equipment measured under the revaluation model

– Depreciation of property, plant and equipment

– Impairment

– Derecognition

– Disclosure

Specific syllabus references for this chapter are: 1b, 2b, c.


Businesses operating in certain industries, for example manufacturing, typically have the use of substantialitems of property, plant and equipment in their balance sheets. These are tangible assets (i.e. assets whichhave physical substance) such as freehold and leasehold land and buildings, plant and machinery and officeequipment. They are used in the production or supply of goods and services or for administrative purposes.The management of these resources underpins the continued viability of a business and thereforerepresents a key feature of business prosperity.

Depending on the nature of the business, property, plant and equipment can have a significant impact on thefinancial statements. Many of the associated decisions will involve the use of judgement. This is true, forexample, of the distinction between revenue and capital expenditure. One of the principal manipulationsalleged during the WorldCom scandal was the inappropriate capitalisation of expenses. Overstating of thevalue of non-current assets, either intentionally or unintentionally, can lead to the inflation of currentearnings, which in turn can affect key performance indicators. It is important therefore that users offinancial statements understand how the business uses its property, plant and equipment and how suchassets are treated in the financial statements.

Stop and think

Can you think of any other aspects of the accounting treatment of property, plant and equipment wherejudgement would be applied?

Working context

If you are involved in audit it is highly likely that you have come across the audit of property, plant andequipment. The technical detail of auditing this area is covered in the Assurance paper. Typically the auditorwill need to consider the following issues:

Does the balance sheet include all the assets owned by the business (completeness)? Do all of the assets belong to the business (ownership)? Do all of the assets exist (existence)? Have the assets been valued correctly (depreciation, impairment, revaluation)?



5

Have adequate disclosures been made?

Syllabus links

In the Accounting paper you will have covered the basic double entry for the purchase of property, plantand equipment. You will have also covered basic depreciation, impairment and disposals.

The main difference in the Financial Accounting paper is that these treatments are placed in the context ofthe accounting standards that relate to this topic. These include:

BAS 16 Property, Plant and Equipment BAS 36 Impairment of Assets BFRS 5 Non-current Assets Held for Sale and Discontinued Operations.

The Financial Accounting syllabus also covers in detail the alternative basis of accounting for property, plantand equipment referred to as the revaluation model. In the Accounting paper you will have covered thecost model, and will have been introduced to basic revaluations. BAS 36 and BFRS 5 will be covered inmore detail in Financial & Corporate Reporting at the Advanced Stage.



Examination context

Examination commentary

Property, plant and equipment is likely to be a popular exam topic in the new syllabus in both the short-form question and written test sections of the paper. In the written test section this topic could beexamined as part of a trial balance question where adjustments are required before the preparation of thebalance sheet. It could also be examined in a question covering a number of accounting issues with therequirement to produce extracts from the financial statements. Alternatively it could be examined in itsown right, allowing for a more detailed focus on the relevant accounting standards or a discussion of therelated principles from BFRS Framework.


Explain how BFRS Framework applies to the recognition of property, plant and equipment.

Prepare and present financial statements or extracts therefrom in accordance with:

– BAS 16 Property, Plant and Equipment– BAS 36 Impairment of Assets– BFRS 5 Non-current Assets Held for Sale and Discontinued Operations

Prepare simple extracts from the financial statements in accordance with Companies Act and BFRS.



5


Section overview

BAS 16 Property, Plant and Equipment provides guidance on the accounting treatment of non-currenttangible assets.

1.1 What are property, plant and equipment?

Definition

Property, plant and equipment: Tangible items that are both:

Held for use in the production or supply of goods or services, for rental to others or foradministrative purposes.

Expected to be used during more than one period.

In practice this definition causes few problems. Property, plant and equipment (PPE) includes freehold andleasehold land and buildings and plant and machinery, and forms the major part of assets of certaintypes of business, such as manufacturing and transport businesses.

1.2 Non-current v current

The main issue arising is whether the assets are used on a continuing basis in the company’s activities.

For example, cars held for resale by a motor dealer are inventories (a current asset) whereas cars held foruse by employees on company business are PPE.

1.3 BAS 16 Property, Plant and Equipment

You will be familiar with some of the basic accounting issues affecting PPE from your Accounting syllabus. Inthe Financial Accounting syllabus you need to be able to deal with these in the context of BAS 16.

The objective of BAS 16 is to prescribe in relation to PPE the accounting treatment for:

The recognition of assets The determination of their carrying amounts The depreciation charges and impairment losses relating to them.

This provides the users of financial statements with information about an entity's investment in its PPE andchanges in such investments.

BAS 16 should be followed when accounting for PPE unless another BAS or BFRS requires a differenttreatment, e.g. BFRS 5 Non-current Assets Held for Sale and Discontinued Operations.

1.4 Underlying principles

The key elements in financial statements, identified in BFRS Framework, which are relevant to PPE are:

Assets Resources controlled by the entity as a result of past events and from whichfuture economic benefits are expected to flow into the entity.

Gains, which are apart of income

Increases in economic benefits through enhancements of assets or decreasesin liabilities other than contributions from equity.

Losses, which areincluded in expenses

Decreases in economic benefits through depletions of assets or additionalliabilities other than distributions to equity participants.

Gains and losses relate to the subsequent depreciation, revaluation, impairment and disposal of PPE.



2 Recognition of PPE

Section overview

Items of PPE should be recognised where it is probable that future economic benefits will flow to theentity and their cost can be measured reliably.

Subsequent costs:

– Repairs and maintenance expenditure should not be capitalised.– Replacement parts should be capitalised.

Items of PPE may be separated into components, each with a separate useful life.

2.1 Recognition

In this context, recognition simply means incorporation of the item in the entity's financial statements, inthis case as a non-current asset. The recognition of PPE depends on two criteria both of which must besatisfied.

It is probable that future economic benefits associated with the item will flow to theentity.

The item's cost can be measured reliably.

Points to note:

1 The asset is not defined in terms of the tangible piece of PPE (e.g. a building or a piece of productionmachinery) but in terms of the economic benefits flowing from it:

So items acquired for safety or environmental reasons can be classed as PPE because they enablegreater economic benefits to flow from other assets.

Legal ownership of an item of PPE is not necessary, as long as the economic benefitsflowing from it are enjoyed. An item held under a finance lease (see Chapter 8) is treated as anasset belonging to the user of the item.

2 There is no definition of what constitutes an 'item of PPE'. It will be for each entity to developits own definitions. It will be straightforward to decide that an individual motor vehicle shouldconstitute an item. But when it comes to a blast furnace, should that be a single item or several items?

3 There is no mention of the 'acquisition' of an item of PPE. The whole of the definition revolves roundthe 'cost' of such an item. This means that the definition must be applied at any time over thelife of the item of PPE when expenditure on it is incurred; it is not only applied on the initialacquisition or construction of the item.

2.2 Subsequent costs

In terms of costs incurred subsequently to add to, replace part of, or service the item, the practicalapplication is that:

Repairs and maintenance expenditure should be recognised in profit or loss as incurred,because it is not probable that there will be future economic benefits flowing from it, over and abovethe benefits flowing from the cost originally recognised when the item was first acquired.

Replacement parts should be capitalised, provided the original cost of the items theyreplace is derecognised (i.e. treated as disposed of) at the time of the replacement.BAS 16 explains this in terms of the relining of a blast furnace at times when the remainder of thefurnace does not need replacing and the replacement of the interior of an aircraft several times overthe life of the airframe itself.



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2.3 Separate components

This leads to the practice of treating the different parts of a bigger asset as separate components, withseparate lives. These are then depreciated separately (see section 6 below), so that they are carried attheir residual value over their useful lives, not the useful life of the overall asset.

This component approach is also applied where regular major inspections of an asset are a conditionof continuing to use it. The cost of each inspection is treated as a separate item of PPE, provided onoriginal acquisition part of the purchase price was allocated as the cost of inspection and recognised in profitor loss over the period to the next inspection. If no separate inspection cost was incurred on originalacquisition, this allocation may be made by reference to the estimated cost of the first inspection that isactually made.


Section overview

PPE should be measured at cost at recognition.

Elements of cost include:

– Purchase price– Directly attributable costs– Estimate of dismantling and site restoration costs

Cost is measured as:

– Cash or– Fair value if PPE items are exchanged

3.1 Measurement at recognition

An item of PPE qualifying for recognition is initially measured at its cost.

Definitions

Cost: This is the amount of cash or cash equivalents paid or the fair value of the other considerationgiven to acquire an asset at the time of its acquisition or construction.

Fair value: This is the amount for which an asset could be exchanged between knowledgeable, willingparties in an arm's length transaction.

3.2 Elements of cost of PPE

The cost of a PPE item comprises:

Purchase price, including all non-recoverable duties and taxes but net of discounts.

Costs directly attributable to bringing the asset to the location and condition necessary forit to be capable of operating in the manner intended by the management.

The initial estimate of dismantling and site restoration costs.

Directly attributable costs include:

Employee benefits arising directly from construction or acquisition of the item.

Site preparation, delivery, installation and assembly costs, costs of testing, andprofessional fees (e.g. legal costs and architects' fees).



But note that certain costs associated with the item cannot be included in its cost:

Some costs are excluded because they are not directly attributable to the item. Examplesinclude:

– The costs of opening a new facility– The cost of introducing new products– The cost of conducting business in a new location or with a new class of customer– Administration and general overhead costs

Capitalisation ceases when the item is capable of operating in the manner intended. Costsincurred after this date have to be excluded. Examples include:

– Costs incurred when the item is not yet in use or is operated at less than full capacity– Operating losses while demand for the output builds up (e.g. a new hotel)– Reorganisation costs

Points to note

1 Costs of testing would include flight testing a new aircraft and testing for the satisfactory output of anew plant. In this latter case, any proceeds from selling product generated during testing are deductedfrom the cost of the plant.

2 Where activities are undertaken that are incidental to the development of the PPE item, any revenueand expenses are recognised in profit or loss, not taken into account in arriving at the cost of the item.

3 Where as a result of the acquisition of an item of PPE an obligation arises to dismantle it at the end ofits useful life and/or to restore its site then that obligation must be recorded as a liability at the sametime as the asset is recognised (e.g. the decommissioning costs of nuclear power stations). We willlook at this issue again in Chapter 9.

4 In the case of self-constructed assets:

Internal profits and abnormal costs (e.g. those relating to design errors, wasted resourcesor industrial disputes) are excluded from cost.

Interest costs incurred during the course of construction may be included under BAS 23Borrowing Costs, but inclusion is not mandatory (BAS 23 is not examinable in FinancialAccounting).

Interactive question 1: Measuring cost [Difficulty level: Intermediate]

A business incurs the following costs in relation to the construction of a new facility and the introduction tothe market of its output:

CU'000Site preparation 400Net income while site used as a car park, prior to construction commencing (50)Materials used, inclusive of CU0.3m recoverable VAT 2,000Labour costs, inclusive of CU0.5m incurred when a labour dispute meant that no constructionwork was carried out 4,000Testing of facility's processes 300Sale of by-products produced as part of testing process (60)Consultancy fees re installation and assembly 500Professional fees 450Opening of facility 100Overheads incurred:– Construction 800– General 600Relocation of staff to new facility 350

The following estimates have been made:

1 The cost of having to dismantle the facility at the end of its useful life 750

2 The costs of each statutory safety inspection – the first due in 3 years 150



5

3 While the overall life of the facility is 20 years, 40% of the costs other than those of safety inspectionsrelate to items that will need replacing in 8 years.

Requirement

Identify the total cost of the facility in accordance with BAS 16 and allocate it over the facility's components.


Solution

Cost of facilityCU'000

Site preparationNet income while site used as a car parkMaterials usedLabour costsTesting of facility's processesSale of by-productsConsultancy fees re installation and assemblyProfessional feesOpening of facilityOverheads incurred:– Construction– GeneralRelocation of staff to new facilityCost of dismantling facility

Allocated to components:


3.3 Measurement of cost

Cost is measured as the cash price at the time of recognition, with discounting if payment isdeferred beyond normal credit terms.

Where there is an exchange of items of PPE such that there is no cash price, cost should be measuredat fair value.

The exception to this is where:

The exchange transaction lacks commercial substance, for example where, the risk, timing andamount of the cash flows of the asset received differs from the risk, timing and amount of the cashflows of the asset transferred.

or

The fair value of neither asset exchanged can be measured reliably

In this case the asset is measured at the carrying amount of the asset given up.



4 Measurement of PPE after initial recognition

Section overview

After initial recognition an item of PPE may be carried under:

– The cost model, or– The revaluation model

4.1 The two models

BAS 16 sets out two models, without expressing a preference for either:

The cost model. An item of PPE is carried at cost (i.e. initial cost plus subsequent expenditure) lessaccumulated depreciation and impairment losses.

The revaluation model. An item of PPE is carried at the revalued amount, being fair value lessaccumulated depreciation and impairment losses.

The choice of model is an accounting policy choice, which must be applied across an entire class ofPPE.

4.2 Fair value

Fair value is normally taken to be market value:

Land and buildings Fair value is determined from market-based evidence byappraisal by professionally qualified valuers

Plant and equipment Fair value is usually their market value determined byappraisal

Specialised items of property, plantand equipment (which are rarely sold)

Fair value is determined by using a depreciated replacementcost (as there is no market-based evidence of fair value)

Worked example: Depreciated replacement cost

An asset that originally cost CU30,000 and is halfway through its useful life will have a carrying amount of50% of cost = CU15,000; if it would cost CU40,000 to buy a replacement asset with the same operatingcharacteristics, then the depreciated replacement cost would be 50% of the replacement cost = CU20,000.

4.3 Frequency of valuations

Revaluations should be made with sufficient regularity to ensure that the carrying amount does notdiffer materially from that which would be determined using fair value at the balance sheetdate.

So, the frequency of the valuation depends on the volatility of the fair values of individual items ofPPE. The more volatile the fair value, the more frequently revaluations should be carried out.

The maximum interval mentioned is five years, but longer could be justified if movements were verysmall and slow.

The requirement for periodic revaluations is designed to prevent companies from revaluing assetsselectively.



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4.4 Classes of assets

Definition

Class of property, plant and equipment: A grouping of assets of a similar nature and use in an entity’soperations.

Where an item of PPE is revalued, all other assets in the same class should also be revalued.

Again, this is designed to stop companies being selective about which items to revalue and to avoid financialstatements including a mixture of costs and values for like items.

BAS 16 provides examples of separate classes including the following:

Land Land and buildings Machinery Motor vehicles Furniture and fixtures Office equipment


Section overview

Revaluation gains are taken directly to equity as part of the revaluation surplus.

Revaluation losses are recognised as an expense in profit or loss (i.e. in the income statement) unlessthey relate to an earlier revaluation surplus.

After revaluation, depreciation is based on the revalued amount.

An annual reserves transfer is allowed amounting to the excess of actual depreciation over thehistorical cost depreciation.

5.1 Increases in value

The basic rule is that increases in value on a revaluation are credited directly to equity. The effect ofthis is that they:

Do not appear in the income statement. Do appear in the statement of changes in equity.

The exception is that where such an increase reverses an earlier revaluation decrease on the same assetthat was recognised in profit or loss (see section 5.3 below), then the surplus should be recognised in profitor loss, but only to the extent of the previous decrease. In practice, the surplus is treated so that theoverall effect is the same as if the original downward revaluation recognised in profit or loss had notoccurred.

5.2 Accounting for increases in value

The commonly adopted method of accounting for upward revaluations to fair value is to write theoriginal cost to fair value and write back the accumulated depreciation to revaluation reserve.



Worked example: Revaluation increase

An entity acquires an item of PPE for CU50,000, which is depreciated over 20 years. Three years later theasset is revalued to CU60,000. The useful life has not changed.

The revaluation will be accounted for as follows:CU CU

DR Asset value (balance sheet) 10,000DR Accumulated depreciation 7,500

(50,000/20 3)CR Revaluation reserve 17,500

Interactive question 2: Revaluation [Difficulty level: Exam standard]

On 1 January 20X2, an asset has a carrying amount of CU100 and a remaining useful life of 10 years, with anil residual value. The asset is revalued on that date to CU50 and the loss is recognised in profit or loss.

The asset is depreciated straight-line over the next five years, giving a carrying amount of CU25 at 31December 20X6. Then, on 1 January 20X7 when the remaining useful life is the unexpired 5 years, the assetis revalued to CU60.

Requirement

State how much of the revaluation gain on 1 January 20X7 is recognised directly in equity and how much isrecognised in profit or loss.


Solution

The revaluation gain on 1 January 20X7 is CU........................................

If the previous downward revaluation had not taken place the carrying amount on 31 December 20X6would have been CU........................................

The 'excess' revaluation gain recognised directly in equity is CU........................................

The amount recognised in profit or loss is CU........................................


5.3 Decreases in value

The basic rule is that decreases in value on a revaluation are recognised as an expense and charged tothe income statement.

The exception is where such a decrease reverses an earlier revaluation increase on the same assetthat was recognised directly in equity and is held in the revaluation reserve, then the deficit should berecognised directly in equity, but only to the extent of the previous increase.



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Worked example: Revaluation decrease

An item of land originally cost CU15,000. Two years ago it was revalued to CU20,000. Now the value hasfallen to CU13,000.

The double entry would be:CU CU

DR Revaluation reserve 5,000DR Income statement 2,000CR Asset value (balance sheet) 7,000

5.4 Depreciation of revalued assets

Where an asset has been revalued, the depreciation charge is based on the revalued amount, lessresidual value, from the date of revaluation. The asset’s residual value should also be re-estimatedon revaluation.

Definition

Residual value: 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 conditionexpected at the end of its useful life.

The whole of the depreciation charge is recognised in profit or loss. None is recognised directly in therevaluation reserve. However, BAS 16 permits, and it is best practice to make, a transfer betweenreserves.

The overall effect is that the income statement shows the economic benefit consumed, measured byreference to the revalued figure for the asset, but distributable profits (i.e. those out of which dividends maybe declared) are not affected by extra depreciation on revalued assets.

The transfer is recorded as follows:

Amount of transfer = actual depreciation charged less equivalent charge based on original historical cost ofasset

Entry to record transfer:

DR Revaluation reserve XCR Retained earnings X

This transfer is shown in the statement of changes in equity.

Worked example: Reserve transfer

An item of PPE was purchased for CU800,000 on 1 January 20X6. It is estimated to have a useful life of 20years and is depreciated on a straight-line basis. On 1 January 20X8 the asset is revalued to CU850,000.The useful life is unchanged. (Ignore residual value.)

CU

Actual depreciation for 20X8 based on revalued amount

18

850,000 47,222

Depreciation for 20X8 based on historical cost

20

800,000 (40,000)

Difference 7,222



In the income statement for 20X8 a depreciation expense of CU47,222 will be charged. A reserve transfermay be performed as follows:

CU CUDR Revaluation reserve 7,222CR Retained earnings 7,222

The closing balance on the revaluation reserve will therefore be as follows:

CUBalance arising on revaluation (850 – 720) 130,000Transfer of retained earnings (7,222)

122,778

5.5 Disposal of revalued assets

This is dealt with in section 8.4 below.

6 Depreciation

Section overview

Depreciation is a means of spreading the cost of a non-current asset over its useful life.

Each significant part of an item of PPE must be depreciated separately.

Land should be accounted for separately from buildings.

Residual values and useful lives must be reviewed annually. Any change must be treated as a change inaccounting estimate.

There are a number of different methods of depreciation:

– Straight-line– Diminishing balance (= reducing balance)– Sum of the units

6.1 Objective of depreciation

Depreciation is an application of the accrual concept. Its objective is to charge to operating profit thecost of using PPE in each period, so that at the end of its useful life the whole of the cost has been writtenoff. The cost of using an asset is the amount of economic benefits consumed.

Depreciation does not relate to the value of an asset as it is a cost-allocation concept, not a measure ofvalue changes. An increase in the current value of an asset does not itself justify not depreciating that asset.The means of recognising an increase in value of an asset is to revalue the asset, which is a separate issuefrom depreciation.

Definitions

Depreciation: This is the systematic allocation of the depreciable amount of an asset over its useful life.

Depreciable amount: The cost of an asset, or other amount substituted for cost, less its residual value.

Useful life: This is:

The period over which an asset is expected to be available for use by an entity, or The number of production or similar units expected to be obtained from the asset by an entity.



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6.2 Calculation and recognition

Each significant part of an item of PPE must be depreciated separately, although they may be groupedtogether for depreciation charge purposes if they have the same useful lives and depreciation methods. Soan aircraft's engines will be depreciated separately from its airframe when they have different useful lives.This is a natural consequence of the initial process of analysing the cost of an asset over its componentparts (see section 2 above).

Land and buildings are separable assets and accounted for separately, even when acquiredtogether. Land usually has an infinite life, whereas buildings do not. So buildings are always depreciableassets, but land is not; the exception is that if the initial cost of land includes a provision fordismantlement and restoration (see section 3.2 above), then that part of its cost is depreciated over theperiod expected to benefit.

The depreciation charge is recognised in profit or loss, unless it can be included in the cost of anasset. The valuation of inventories under BAS 2 Inventories includes depreciation charges on manufacturingPPE.

Interactive question 3: Calculating depreciation [Difficulty level: Intermediate]

Requirement

Using the costs from Interactive question 1 and assuming there are no residual values, calculate the annualdepreciation charges for the facility.


CU’000


6.3 Depreciable amount and depreciation period

The residual value and useful life of an asset must be reviewed at least each year end; any change is achange in accounting estimate and must be accounted for prospectively under BAS 8 Accounting Policies,Changes in Accounting Estimates and Errors. The accounting policy remains one of taking account of residualvalues and useful lives; all that changes are the judgements as to what the values for these are.

Interactive question 4: Depreciation period [Difficulty level: Intermediate]

An asset has a cost of CU1,000, useful life of 10 years and residual value of CU200. At the end of year 2 ofits life, the remaining useful life was revised to 4 years, the residual value being unchanged.

Requirement

Calculate the depreciation charge for each of years 1 to 3 on the straight-line basis.




SolutionYear 1 Year 2 Year 3(CU) (CU) (CU)

CostAccumulated depreciationCarrying amountCharge for the year (W)

WORKING


Points to note:

1 Depreciation continues to be recognised even if fair value (i.e. the open market price) is greater thanthe carrying amount. This is for two reasons: the entity has no intention of selling the asset (so marketprice is not relevant) and depreciation is, as has been noted, a cost-allocation concept, not a means ofrevaluing an asset;

2 Depreciation ceases if residual value exceeds the carrying amount. The reason is that there is nolonger a depreciable amount.

6.4 Commencement of depreciation

Depreciation should commence when the asset is in the location and condition necessary for it tobe capable of operating in the manner intended. This is the case even if the asset is actually put intouse at a later date. Depreciation continues even if the asset lies idle, for example as a result of a fall inmarket demand for its output. Depreciation only ceases when the asset is derecognised; thetreatment of assets held for sale is dealt with in section 8 below.

6.5 Factors affecting useful life

There are many factors affecting the useful life of an asset.

These include:

Expected usage of the asset measured by reference to the asset's expected capacity or physicaloutput.

Expected physical wear and tear.

Technical or commercial obsolescence arising from changes or improvements in production, orfrom a change in market demand.

Legal or similar limits on the use of the asset, such as expiry dates of related leases.

These factors should be considered by management on the initial assessment of the asset's useful life and oneach subsequent annual review.



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6.6 Depreciation method

BAS 16 requires that a systematic basis should be used to allocate the depreciable amount over theasset's useful life; the method should reflect the pattern in which the future economic benefits areconsumed. A number of methods are identified, which you should be familiar with from your Accountingstudies:

Straight-line, whereby there is a constant charge each year, on the assumption that equal amounts ofeconomic benefit are consumed in each year of the asset's life.

Diminishing (or reducing) balance, whereby the depreciation rate is applied to the openingcarrying amount. This method, which charges more depreciation in the early years of an asset's lifethan in later years, could be appropriate in circumstances where over its life the asset becomes lesscapable of producing a high-quality product.

Sum of the units, whereby the charge is calculated by reference to the output each year as aproportion of the total expected output over the asset's useful life.

Where the pattern of consumption of an asset's economic benefits is uncertain, a straight-line methodof depreciation is usually adopted. In practice, this method is by far the most widely used.

6.7 Change in method

Depreciation methods must be reviewed at least at each financial year end. A change in the pattern ofconsumption of economic benefits may demand a change to the method. Any changes are changes in anaccounting estimate and are accounted for prospectively. The carrying amount of the asset isdepreciated under the new method over the remaining useful life, beginning in the period in which thechange is made in accordance with BAS 8.

Worked example: Change in depreciation method

Bord Ltd has a 31 December year end. On 1 January 20X3 it bought a machine for CU100,000 anddepreciated it at 15% per annum on the reducing balance basis. The residual value is nil.

On 31 December 20X6, the machine will be included in Bord Ltd's accounts at the following amount:

CUCost 100,000Accumulated depreciation (47,800)Carrying amount 52,200

During 20X7, the company decided to change the basis of depreciation to straight-line over a total life of 10years, i.e. six years remaining from 1 January 20X7.

New annual charge from 20X7 =52,200

6= CU8,700 per annum.

6.8 Impairment

BAS 16 requires the provisions of BAS 36 Impairment of Assets to be applied.

The provisions of BAS 36 are dealt with in the next section. Any compensation received from third partiesfor impaired PPE is recognised in profit or loss (where the impairment loss is charged), not set against thecost of the PPE item.



7 Impairment of assets

Section overview

An asset is impaired if its recoverable amount is less than its carrying amount.

The recoverable amount is the higher of:

– The asset's fair value less costs to sell, and– Its value in use.

Internal and external sources provide indications of possible impairment.

For assets held at historical cost an impairment loss should be charged in profit or loss (i.e. as anexpense in the income statement).

For assets held at a revalued amount the impairment loss is treated as a revaluation decrease.

7.1 Objective and scope of BAS 36 Impairment of Assets

Whenever an asset's recoverable amount falls to an amount less than its carrying amount, itis said to be impaired. Its carrying amount in the balance sheet is therefore reduced to this recoverableamount and, in most cases, an expense is recognised in the income statement. BAS 36 puts in place adetailed method for carrying out impairment reviews and related accounting treatments and disclosures.

BAS 36 applies to all assets apart from those specifically excluded from the standard. It most commonlyapplies to assets such as property, plant and equipment accounted for in accordance with BAS 16 andintangible assets accounted for in accordance with BAS 38 Intangible Assets (we will look at intangibleassets in Chapter 6). The standard also apples to some financial assets, namely subsidiaries, associates andjoint ventures. Impairments of all other financial assets are accounted for in accordance with BAS 39Financial Instruments: Recognition and Measurement, the detail of which is outside your syllabus.

7.2 Basic principle

The basic principle underlying BAS 36 is relatively straightforward. If an asset's value in the financialstatements is higher than its realistic value, measured as its 'recoverable amount', the asset is judged to havebeen impaired.

The value of the asset should be reduced by the amount of the impairment loss. This loss should bewritten off against profit immediately.

The main accounting issues to consider are therefore as follows:

1 How is it possible to identify when an impairment loss may have occurred?2 How should the recoverable amount of the asset be measured?3 How should an impairment loss be reported in the financial statements?

7.3 Indications of impairment

An entity should assess at each balance sheet date whether there are any indications of impairment to anyassets. The concept of materiality applies, and only material impairment needs to be identified.

If there are indications of possible impairment, the entity is required to make a formal estimate of therecoverable amount of the assets concerned.

In assessing such indications of a possible impairment, BAS 36 requires an entity to consider, as a minimum,the following:

External sources of information:

– A fall in the asset's market value that is more significant than would normally be expected frompassage of time over normal use.

– A significant change in the technological, market, legal or economic environment of the businessin which the assets are employed.



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– An increase in market interest rates or market rates of return on investments likely to affect thediscount rate used in calculating value in use.

– The carrying amount of the entity's net assets being more than its market capitalisation.

Internal sources of information:

– Evidence of obsolescence or physical damage.

– Adverse changes in the use to which the asset is put.

– Indications that the economic performance of an asset is, or will be, worse than expected.

Even if there are no indications of impairment, the following assets must always be tested for impairmentannually:

An intangible asset with an indefinite useful life Goodwill acquired in a business combination

(Intangible assets are covered in Chapter 6).

7.4 Measuring the recoverable amount of the asset

Definition

Recoverable amount of an asset: is the higher of:

Its fair value less costs to sell, and Its value in use

7.4.1 Fair value less costs to sell

Definition

Fair value less costs to sell: the amount obtainable from the sale of an asset in an arm's lengthtransaction between knowledgeable, willing parties, less costs of disposal.

In other words an asset's fair value less costs to sell is the amount net of selling costs that could beobtained from the sale of the asset. Selling costs include sales transaction costs, such as legal expenses.

A binding sales agreement is the best evidence of an asset’s fair value less costs to sell. Where there isno binding sales agreement the following bases will be used:

If there is an active market in the asset, the net selling price should be based on the market priceless costs to sell, or on the price of recent transactions in similar assets.

If there is no active market in the asset it might be possible to estimate a net selling price usingbest estimates of what 'knowledgeable, willing parties' might pay in an arm's length transaction anddeducting costs of disposal.

Selling costs cannot include any restructuring or reorganisation expenses, or any costs that havealready been recognised in the financial statements as liabilities.

7.4.2 Value in use

An asset's fair value less costs to sell is compared with its value in use in order to determine therecoverable amount (see section 7.4 above).



Definition

Value in use: the present value of the future cash flows expected to be derived from an asset.

The detailed guidance provided as to how to arrive at this value is not in the Financial Accounting syllabus,but the following general points should be noted:

Calculations should be based on reasonable and supportable assumptions.

Projections should be based on the most recent budgets etc approved by management over amaximum of five years, unless a longer period can be justified.

Inflows and outflows should be estimated separately, based upon the asset's current condition(so ignoring the benefits of restructurings not committed to and future performance enhancements).

Financing and tax costs should be excluded.

Account should be taken of net cash flows expected to arise on the asset's ultimate disposal.

Note the practical point that if one of the two elements in the recoverable amount has beenestimated as in excess of the asset’s carrying amount, then the asset is not impaired and thereis no need to estimate the value of the other element. So if fair value less cost to sell exceedscarrying amount, as it well might in the case of freehold and leasehold properties, then there is no need toestimate value in use. This is useful in relation to assets for which there is an active market, because fairvalues can be estimated quickly and cheaply.

7.5 Accounting treatment of impairments

If the recoverable amount of an asset is less than the carrying amount, the difference is the impairment loss.

It should be described as such in the financial statements but the accounting treatment is similar toincreases and decreases arising on a revaluation (see section 5 above) whereby:

An impairment loss for assets at a historical cost is treated as a decrease on revaluation and isrecognised as an expense in the income statement.

If the impairment loss relates to an asset that has previously been revalued, then it is treated asa revaluation decrease and not as an impairment loss. So in line with section 5.3 above it can firstbe set against any balance relating to the same asset standing on the revaluation reserve, with anyexcess being recognised in profit or loss.

Depreciation charges in future accounting periods will be set to write off the revised carryingamount, less residual value, over its remaining useful life.

In certain circumstances impairment losses incurred in one accounting period may be reversed in a laterperiod, but the relevant rules are outside the Financial Accounting syllabus.

Worked example: Impairment

The following details relate to a freehold property:

CUCarrying amount (at date of revaluation) 1,000,000Revalued to 1,600,000Amount recognised in the revaluation reserve 600,000Current carrying amount 1,500,000Fair value 600,000Value in use 800,000

The recoverable amount of the asset is CU800,000 (i.e. the higher of fair value and value in use).

An impairment loss of CU700,000 has occurred (1,500,000 – 800,000)



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The impairment will be accounted for as follows:

CU CUDR Revaluation reserve 600,000DR Income statement 100,000CR Property (carrying amount) 700,000

7.6 Disclosure

For all impairments, disclosure must be made for each class of assets of:

The amount of any impairment loss recognised in profit or loss and the line item where it has beenincluded.

The equivalent information about any impairment loss recognised directly in equity.

Note that compliance with the values part of this requirement will come through the BAS 16 reconciliationof opening and closing balance sheet asset values (see section 9 below).

If an impairment loss for an individual asset is material to the financial statements as a whole, theremust be additional disclosure of:

The events that led to the recognition of the loss.

The amount.

The nature of the asset.

Whether the recoverable amount is fair value less costs to sell or value in use.

The basis used to determine fair value less costs to sell (where the recoverable amount is fair valueless costs to sell).

The discount rate used in the current estimate and any previous estimate of value in use (where therecoverable amount is value in use).

If impairment losses are material only in aggregate, then a reduced amount of additional informationshould be given. The following details must be disclosed:

The main classes of assets affected by impairment losses. The main events and circumstances that led to the recognition of these impairment losses.

8 Derecognition of PPE

Section overview

When the decision is made to sell a non-current asset it should be classified as 'held for sale'.

An asset held for sale is valued at the lower of:

– Its carrying amount.– Its fair value less costs to sell.

No depreciation is charged on a held for sale asset.

8.1 General rule

An item of PPE shall be removed from the balance sheet (i.e. derecognised) when it is disposed of orwhen no future economic benefits are expected from its use or disposal (i.e. it is abandoned).

The gain or loss on the disposal of an item of PPE is included in the income statement of the periodin which the derecognition occurs. The gain or loss is calculated as the difference between the net sale



proceeds and the carrying amount, whether measured under the cost model or the revaluation model.Gains may not be included in revenue in the income statement.

The process of selling an item of PPE involves the following stages:

Making the decision to sell the item. Putting the item on the market, agreeing the selling price and negotiating the contract for sale. Completing the sale.

The issue is at what stage through this process should any gain or loss on the sale be recognised. Thesematters are dealt with in BFRS 5 and there are different required treatments depending on whether theitem of PPE is measured under the cost model or the revaluation model.

8.2 Disposal of PPE measured under the cost model

Following the principle that any loss should be recognised immediately but any gain should only berecognised when it is realised, BFRS 5's requirements in respect of PPE measured under the cost model arethat:

When the carrying amount of a non-current asset will be recovered principally through sale(rather than through continuing use), the asset must be classified as held for sale. In most cases, thisclassification will be made at the time of the decision to sell.

A non-current asset held for sale is measured at the lower of:

– Its carrying amount– Its fair value less costs to sell (i.e. its net selling price)

The effect is that any loss (i.e. where the former value exceeds the latter) is recognised at the time ofclassification as held for sale. But any gain (i.e. where the latter value exceeds the former) is not;instead it is recognised according to the general rule in section 8.1 above.

A non-current asset held for sale is presented separately from all other assets in the balancesheet. BFRS 5 does not specify where this 'separate presentation' should be made, but these learningmaterials follow the IASB's (non-mandatory) guidance on implementing BFRS 5 by presenting itimmediately below the sub-total for current assets.

No depreciation is charged on a held for sale asset. The new valuation basis of fair value less coststo sell approximates to residual value, so there is now no depreciable amount.

The loss is an impairment loss, dealt with in the same way as other impairment losses under BAS36.

On ultimate disposal, any difference between carrying amount and disposal proceeds is treated as a loss orgain under BAS 16, not as a further impairment loss or reversal of the original impairment loss.

Interactive question 5: Asset held for sale I [Difficulty level: Intermediate]

An item of PPE was acquired on 1 January 20X5 at a cost of CU100,000. A residual value of CU10,000 anda useful life of 10 years was assumed for the purpose of depreciation charges.

On 1 January 20X8 the asset was classified as held for sale. Its fair value was estimated at CU40,000 and thecosts to sell at CU2,000.

The asset was sold on 30 June 20X8 for CU38,000.

Requirements

(a) Show the journal entry to record the classification as held for sale.(b) Show the entry in the income statement for the year ended 31 December 20X8.(c) Describe how the answer to (b) would change if the sales proceeds on 30 June 20X8 were CU32,000.




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Solution

(a) Journal entry to record the classification as held for saleCU'000 CU'000

1 January 20X8DR PPE – accumulated depreciationDR Non-current assets held for saleDR Income statement (ß)CR PPE – cost

(b) Income statement for the year ended 31 December 20X8CU

Impairment loss on reclassification of non-current assets as held for sale

(c) Income statement for the year ended 31 December 20X8

In the income statement:


Interactive question 6: Asset held for sale II [Difficulty level: Intermediate]

These facts are as detailed in Interactive question 5, except that on classification as held for sale, the fairvalue was estimated at CU80,000 and the costs to sell at CU3,000.

The asset was sold on 30 June 20X8 for CU77,000.

Requirements

(a) Show the journal entry to record the classification as held for sale.(b) Show the entry in the income statement for the year ended 31 December 20X8.


Solution


1 January 20X8DR PPE – accumulated depreciationDR Non-current assets held for saleCR PPE – cost

(b) Income statement for the year ended 31 December 20X8CU'000

Gain on disposal of non-current assets held for sale




8.3 Classification as held for sale

For the classification as held for sale to be made detailed criteria must be met:

The asset must be available for immediate sale in its present condition. Its sale must be highly probable (i.e. significantly more likely than probable).

For the sale to be highly probable:

Management must be committed to a plan to sell the asset.

There must be an active programme to locate a buyer.

The asset must be marketed for sale at a price that is reasonable in relation to its current fairvalue.

The sale should be expected to take place within one year from the date of classification.

It is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.

Other points to note:

1 An asset can still be classified as held for sale, even if the sale has not actually taken placewithin one year. However, the delay must have been caused by events or circumstances beyond theentity's control and there must be sufficient evidence that the entity is still committed to sell the asset.

2 If a balance sheet date intervenes between the classification as held for sale and the final disposal, fairvalue less costs to sell may have fallen below or risen above the figure used on original classification.Any fall is accounted for as a further impairment loss, while any rise goes to reduce the amountof the original impairment loss, but cannot write the asset's carrying amount above its originallevel.

3 The rules for disposal groups (where an operation comprising assets and liabilities is being sold) falloutside the Financial Accounting syllabus.

8.4 Disposal of PPE measured under the revaluation model

For an item of PPE measured after recognition under the revaluation model and subsequently classified asheld for sale, there is a different accounting treatment of the difference between carrying amount and fairvalue less costs to sell at the time of classification:

Consistently with the accounting policy chosen, the asset must be revalued at fair value under BAS16 immediately before the classification.

'Revaluation' means that either a gain or loss will be recognised (whereas, as explained in section8.2, for assets measured under the cost method, only a loss is recognised at the time of classification).If the previous carrying amount is greater than fair value, there will be a loss; if it is less than fair value,there will be a gain.

Such a gain or loss is dealt with under BAS 16 (see section 5 above), so a gain is recognised inrevaluation reserve (except to the extent it reverses a loss previously charged to the incomestatement) and a loss in the income statement (except to the extent it reverses a gain held inrevaluation reserve).

Once revalued in this way, the measurement is then adjusted to the normal basis for held for saleassets, so fair value less costs to sell. The effect is that the costs to sell are immediatelyrecognised in profit or loss as an impairment loss.



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Interactive question 7: Disposal of revalued PPE [Difficulty level: Exam standard]

Land, which is not depreciated, was acquired on 1 January 20X2 at a cost of CU200,000 and revalued toCU250,000 on 1 January 20X5. On 1 January 20X8 the asset was classified as held for sale. Its fair value wasestimated at CU235,000 and the costs to sell at CU5,000.

Requirements

(a) Show the journal entry to record the revaluation on 1 January 20X5.(b) Show the journal entry to record the classification as held for sale on 1 January 20X8.


Solution

(a) Journal entry to record the revaluationCU'000 CU'000

1 January 20X5DR PPE – at valuationCR Revaluation reserve

(b) Journal entry to record the classification as held for saleCU'000 CU'000

1 January 20X8DR Non-current assets held for sale – fair value less costs to sellDR Income statement – costs to sellDR Revaluation reserveCR PPE – at valuation


8.5 Disposal and gains held in revaluation reserve

If there is still a credit balance on the revaluation reserve relating to an asset that has been disposed of, thisbalance should be transferred to retained earnings as a reserve transfer (the same treatment andpresentation as for the reserve transfer in respect of extra depreciation). The accounting entry is:

DR Revaluation reserve CUX

CR Retained earnings CUX

Note that some argue that as the income statement is the document in which the profits of an entity areshown, it should, over time, include all the gains realised by an entity. They argue that the transfer of anycredit balance on the revaluation reserve should therefore be to the income statement, not retainedearnings, so the accounting entry should be:

DR Revaluation reserve CUX

CR Income statement CUX

This technique of taking gains previously recognised in the statement of changes in equity back through theincome statement is known as 'recycling' and is not permitted by BAS 16.



Interactive question 8: Summary [Difficulty level: Intermediate]

On 1 January 20X1, Tiger Ltd buys for CU120,000 an item of property, plant and equipment which has anestimated useful life of 20 years with no residual value. Tiger Ltd depreciates its non-current assets on astraight-line basis. Tiger Ltd's year-end is 31 December.

On 31 December 20X3, the asset will be carried in the balance sheet as follows:CU

Property, plant and equipment at cost 120,000Accumulated depreciation (3 (120,000 ÷ 20)) (18,000)

102,000

On 1 January 20X4, the asset is revalued to CU136,000. The total useful life remains unchanged.

On 1 January 20X8 the asset is classified as held for sale, its fair value being CU140,000 and its costs to sellCU3,000. On 1 May 20X8 the asset is sold for CU137,000.

Requirements

(a) Show the journal to record the revaluation.

(b) Calculate the revised depreciation charge and show how it would be accounted for, including anypermitted reserve transfers.

(c) Show the journal to record the classification as held for sale.

(d) Explain how these events will be recorded in the financial statements for the year ended 31 December20X8.


Solution

(a) Journal to record the revaluation

1 January 20X4 CU CUDR PPE cost/valuationDR PPE accumulated depreciationCR Revaluation reserve

(b) Revised depreciation charge

Annual charge from 20X4 onwards CU CUDR Income statement depreciation expenseCR PPE accumulated depreciationAnnual reserve transferDR Revaluation reserveCR Retained earnings

Being the difference between the actual depreciation charge and the charge based on historical cost(........................................).

Shown in the statement of changes in equity as follows:Revaluation Retained

reserve earningsCU CU

Brought forward X XProfit for the year – XTransfer of realised profitsCarried forward X X



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(c) Journal to record classification as held for sale

At 1 January 20X8, balances relating to the asset will be as follows:CU

Property, plant and equipment at valuationAccumulated depreciationCarrying amountRevaluation reserve

CU'000 CU'0001 January 20X8DR PPE – accumulated depreciationDR Non-current assets held for sale – fair value less costs to sellDR Income statement – costs to sellCR PPE – cost/valuationCR Revaluation reserve (ß)

(d) Financial statements for the year ended 31 December 20X8


Remaining balance on revaluation reserve is transferred to accumulated profits reserve as a reservetransfer in the statement of changes in equity:

Revaluation Retainedreserve earnings

CU CUBrought forward X XRetained profit for the year – XTransfer of realised profitsCarried forward X X


8.6 Abandonment of non-current assets

All these requirements within BFRS 5 which we have looked at so far apply to non-current assets classifiedas held for sale because their carrying amounts will be recovered principally through a sale transaction.They do not apply to non-current assets which are to be abandoned, for example by beingscrapped. Because there will be no sales proceeds, any recovery of the carrying amounts of such assets willprincipally be through continued use.

Such assets continue to be measured and presented under BAS 16, with the effect that:

The assets remain classified within their existing non-current asset category.

Depreciation charges continue to be recognised.

Any profit or loss on abandonment is recognised at the time of abandonment rather than atthe (usually earlier) time of the decision to abandon them.

BAS 16, not BFRS 5, also applies to the measurement and presentation of an asset taken out of use but notscheduled for disposal; this might be the case if demand for its outputs has temporarily fallen away.



9 Disclosures

Section overview

BAS 16 requires a number of detailed disclosures.

9.1 BAS 16 requirements

As might be expected for items that form such a large part of many entities' balance sheets and wheremanagement has to make so many important judgements (e.g. re residual values and useful lives), thefinancial statements disclosure provisions are wide-ranging. All of the following may be shown for each classof PPE by way of note:

The measurement basis used (either cost model or revaluation model).

The depreciation methods.

The useful lives or depreciation rates.

Gross carrying amounts and accumulated depreciation at the start and end of the period.

A reconciliation of the net carrying amounts at the start and end of the period by reference to:

– Additions– Disposals– Acquisitions through business combinations– The effects of revaluations– Impairment losses– Exchange differences (these fall outside the Financial Accounting syllabus)– Other changes, e.g. assets classified as held for sale

Details of assets pledged as security for loans and of contractual commitments to acquire PPE.

Changes in accounting estimates in accordance with BAS 8.

For assets which have been revalued:

– The effective date(s).

– Whether an independent valuer was involved.

– The methods and significant assumptions underlying the fair value estimates.

– The extent to which fair values were determined by reference to prices in active markets orrecent arm's length transactions.

– The carrying amount under the cost model.

– The total revaluation surplus, together with any movements in the period.

There are further, voluntary disclosures. These include:

The carrying amount of temporarily idle PPE

The gross carrying amount of any fully depreciated PPE that is still in use

The carrying amount of PPE retired from active use and not classified as held for sale in accordancewith BFRS 5

When the cost model is used, the fair value of PPE when this is materially different from the carryingamount



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Interactive question 9: Disclosure [Difficulty level: Exam standard]

1 RSBH Ltd’s balance sheet at its year end 31 December 20X6 includes the following property, plant andequipment amounts:

Cost AccumulatedDepreciation

CU'000 CU'000Freehold property 1,000 300Plant and machinery 700 330Fixtures and fittings 300 180

2 On 1 January 20X7 RSBH Ltd revalued its existing freehold property to its market value of CU1.2mand bought additional freehold property at a cost of CU100,000. As a result of no depreciation beingcharged on the land element, the effective rate of depreciation is 2% per annum on cost/valuation,assuming no residual value.

3 On 1 April 20X7 RSBH Ltd classified as held for sale plant and machinery with an original cost ofCU360,000 and a carrying amount at 31 December 20X6 of CU100,000. It also bought plant andmachinery at a cost of CU400,000. Depreciation is to be charged at the rate of 10% per annum oncost, assuming no residual value.

4 On 1 July 20X7 RSBH Ltd scrapped fixtures and fittings with an original cost of CU40,000 andaccumulated depreciation at 31 December 20X6 of CU25,000 and bought new fixtures at a cost ofCU80,000. Depreciation is to be charged at 15% per annum on cost, assuming no residual value.

Requirement

Prepare the reconciliation of the carrying amount of property, plant and equipment at 1 January 20X7 withthat at 31 December 20X7.

Fill out the proforma below.

Solution

RSBH Ltd: Reconciliation of opening and closing property, plant and equipment

Freehold Plant and Fixtures TotalProperty Machinery and FittingsCU'000 CU'000 CU'000 CU'000

Cost/valuationI January 20X7RevaluationAdditionsClassified as held for saleDisposalsAt 31 December 20X7

DepreciationI January 20X7RevaluationCharge for the year (W)Classified as held for sale (W)Disposals (W)At 31 December 20X7

Carrying amount31 December 20X71 January 20X7



WORKINGSPlant and FixturesMachinery and FittingsCU'000 CU'000

Depreciation charge for the yearItems reclassified/disposed of during yearItems owned throughout yearItems acquired during year

Accumulated depreciation on items reclassified/disposed ofBrought forwardCharge for year

See Answer at the end of the chapter Summary and Self-test



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Summary



Self-test

Answer the following questions.

1 Per BAS 16 Property, Plant and Equipment, which of the following should be capitalised as part of thecost of an asset?

(1) Stamp duty(2) Employee costs related to site selection activities(3) Cost of site preparation and clearance(4) Installation costs

A (1), (2) and (4) onlyB (1) and (4) onlyC (1), (3) and (4) onlyD (2) and (3) only

2 Max Ltd has incurred the following expenditure in 20X0 in respect of its non-current assets.

CUServicing of plant and equipment 25,000Repainting of warehouse 40,000Modification of an item of plant in order to increase its capacity 12,000Upgrading of machine parts to improve quality of product 7,500

In 20X0 what will be the charge for repairs and maintenance in the income statement in accordancewith BAS 16 Property, Plant and Equipment?

A CU19,500B CU25,000C CU65,000D CU59,500

Questions 3 and 4

Using the following information, answer questions 3 and 4.

Lakeland purchased freehold land and buildings on 1 July 20W3 for CU380,000 including CU80,000 for theland. The buildings had been depreciated at the rate of 4% per annum on cost for each of the ten years to30 June 20X3. On 1 July 20X3 the property was professionally revalued at CU800,000 including CU200,000for the land, an amount which was reflected in the books. At 1 July 20X3 it was estimated that the buildinghad a remaining useful life of twenty years and a residual value of CU100,000.

3 In accordance with BAS 16 Property, Plant and Equipment what should the surplus on revaluation be on1 July 20X3?

A CU420,000B CU540,000C CU572,000D CU620,000

4 In accordance with BAS 16 Property, Plant and Equipment what is the carrying amount of the freeholdland and buildings on 30 June 20X4?

A CU760,000B CU765,000C CU770,000D CU775,000



5

5 Baboon Ltd adopts the revaluation model for its property, plant and equipment. It has collected thefollowing information.

Existing Openuse market

value valueCU CU

Office building 250,000 300,000Warehouse (1) 175,000 200,000Warehouse (2) (which is classified as held for sale) 150,000 210,000

None of the above assets are considered to be impaired and costs to sell are immaterial.

In accordance with BAS 16 Property, Plant and Equipment, at what total amount should the threeproperties be carried in Baboon Ltd’s balance sheet?

A CU575,000B CU710,000C CU660,000D CU635,000

6 Paris Ltd has a freehold property carried at a revalued amount of CU175,000. Due to a slump inproperty prices its recoverable amount is now estimated to be only CU150,000. Its historical costcarrying amount is CU160,000.

How should the above fall in value be reflected in the financial statements in accordance with BAS 16Property, Plant and Equipment?

Income Statementstatement of changes

in equityA DR CU25,000 –B – DR CU25,000C DR CU10,000 DR CU15,000D DR CU15,000 DR CU10,000

7 On 1 June 20X6 Dempster Ltd bought a new factory. The building has an estimated useful life of 50years, but the roof will require replacing after 25 years. The cost of replacement is currentlyCU100,000. The total price of the factory was CU1,000,000.

In accordance with BAS 16 Property, Plant and Equipment what should the depreciation charge be forthe year ended 31 May 20X7?

A CU20,000B CU22,000C CU24,000D CU40,000



8 The following figures relate to an asset with a five-year life purchased on 1 January 20X1.CU

Cost 100,000Residual value at acquisition 10,000Residual value at the end of 20X1 (taking into account current price changes) 15,000

What amount will be recognised in the income statement as depreciation in the year to 31 December20X1 in accordance with BFRS?

A CU15,000B CU17,000C CU18,000D CU20,000

9 Thames Ltd depreciates plant and equipment at 20% per annum on a diminishing balance basis. Allassets were purchased on 1 April 20X3. The carrying amount on 31 March 20X6 is CU20,000.

In accordance with BAS 16 Property, Plant and Equipment what is the accumulated depreciation to thenearest thousand pounds as at that date?

A CU15,000B CU19,000C CU30,000D CU39,000

10 On 1 January 20X1 Lydd Ltd purchased production machinery costing CU100,000, having an estimateduseful life of twenty years and a residual value of CU2,000. On 1 January 20X7 the remaining useful lifeof the machinery is revised and estimated to be twenty-five years, with an unchanged residual value.

In accordance with BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors what should thedepreciation charge on the machinery be in the year ended 31 December 20X7?

A CU3,226B CU3,161C CU2,824D CU2,744

11 Upton Ltd makes up its financial statements to 31 December each year. On 1 January 20X0 it bought amachine with a useful life of ten years for CU200,000 and started to depreciate it at 15% per annumon the diminishing balance basis. On 31 December 20X3 the accumulated depreciation was CU95,600and the carrying amount CU104,400. During 20X4 the company changed the basis of depreciation tostraight line.

In accordance with BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors what is thecorrect accounting treatment to be adopted in the financial statements of Upton Ltd for the yearended 31 December 20X4?

A Depreciation charge CU10,440 Prior period adjustment NilB Depreciation charge CU17,400 Prior period adjustment NilC Depreciation charge CU20,000 Prior period adjustment CU15,600D Depreciation charge CU20,000 Exceptional item CU15,600



5

12 During the year ended 31 March 20X3, Quark Ltd revalued its buildings by CU200,000 giving rise toan increase in the annual depreciation charge of CU5,000.

In accordance with BAS 16 Property, Plant and Equipment which of the following statements about thedisclosure of these items is true?

A The statement of changes in equity will show an increase in the revaluation reserve ofCU200,000 and a reserves transfer of CU5,000

B The revaluation reserve in the statement of changes in equity will only disclose CU200,000 inrespect of the revaluation

C The income statement will only disclose an amount of CU200,000 in respect of the revaluation

D The income statement will disclose an amount of CU200,000 in respect of the revaluation and anadditional depreciation expense of CU5,000

13 Propane Ltd are undertaking an impairment review of assets following BAS 36 Impairment of Assets.Investigations have uncovered the following:

Asset R has a carrying amount of CU60,000, a value in use of CU65,000 and a fair value less costs tosell of CU30,000.

Asset Q has a carrying amount of CU100,000, a value in use of CU92,000 and a fair value less costs tosell of CU95,000.

In accordance with BAS 36 Impairment of Assets what amount should be recognised as an impairmentloss in relation to these two assets?

R QCU CU

A 30,000 3,000B 25,000 8,000C 5,000 –D – 5,000

14 Gandalf Ltd has a year end of 31 December. On 30 October 20X4 it classified an item of plant as heldfor sale. At that date the plant had a carrying amount of CU13,200 and had been accounted foraccording to the cost model. Its fair value was estimated at CU11,100 and the costs to sell at CU500.

On 15 December 20X4 the plant was sold for CU10,500.

In accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations what amountsshould be recognised as impairment loss and loss on disposal in the income statement for the year to31 December 20X4?

Impairment loss Loss on disposalCU CU

A Nil 2,700B 2,100 600C 2,600 100D 2,700 Nil



15 Merlin Ltd has a year end of 30 June. On 1 October 20X3 it classified one of its leasehold propertiesas held for sale. At that date the property had a carrying amount of CU98,500 and had beenaccounted for according to the cost model. Its fair value was estimated at CU120,100 and the costs tosell at CU2,500.

On 15 June 20X4 the property was sold for CU115,500.

In accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations what amountsshould be recognised as gain on reclassification and gain on disposal in the income statement for theyear to 30 June 20X4?

Gain on Gain onreclassification disposal

CU CUA Nil 17,000B 9,100 7,900C 11,600 5,400D 17,000 Nil

16 Dumbledore Ltd has a year end of 30 June. On 1 June 20X5 it classified one of its freehold propertiesas held for sale. At that date the property had a carrying amount of CU567,000 and had beenaccounted for according to the revaluation model. Its fair value was estimated at CU725,000 and thecosts to sell at CU3,000.

In accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations what amountsshould be recognised in the financial statements for the year to 30 June 20X5?

Income statement Revaluation reserveGain on Impairment Revaluation

reclassification loss gainCU'000 CU'000 CU'000

A Nil 3 158B Nil Nil 155C 155 3 NilD 158 Nil Nil

Questions 17 and 18

Using the following information, answer questions 17 and 18.

Arnold Ltd bought an asset on 1 October 20X1 for CU200,000. It was being depreciated over 20 years onthe straight-line basis. On 1 October 20X3, the asset was revalued to CU270,000. Subsequently, on 30September 20X7 the asset was classified as held for sale. Its fair value was estimated at CU190,000 withcosts to sell of CU5,000.

17 In accordance with BAS 16 Property, Plant and Equipment what should the balance on the revaluationreserve be at the year end of 30 September 20X4?

A CU70,000B CU85,000C CU86,500D CU90,000

18 In accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations what should theloss recognised in the income statement for the year ended 30 September 20X7 be on classification asheld for sale?

A CUNilB CU5,000C CU20,000D CU25,000



5

19 The following information was disclosed in the financial statements of Maine Ltd for the year ended 31December 20X2.

Plant and equipment20X2 20X1

CU CUCost 735,000 576,000Accumulated depreciation (265,000) (315,000)Carrying amount 470,000 261,000

During 20X2 CUExpenditure on plant and equipment 512,000Impairment loss on reclassification of old plant as held for sale 50,000Loss on the disposal of old plant 57,000Depreciation charge on plant and equipment 143,000

In accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations what were thesales proceeds received on the disposal of the old plant?

A CU53,000B CU153,000C CU246,000D CU267,000

20 The following information relates to the classification as held for sale of two machines by Halwell Ltd.

Machine 1 Machine 2CU CU

Cost 120,000 100,000Fair value less costs to sell 90,000 40,000Anticipated gain/(loss) on sale (based on fair value) 30,000 (20,000)

In accordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations what was thetotal accumulated depreciation on both machines classified as held for sale?

A CU80,000B CU100,000C CU120,000D CU140,000

21 On 1 January 20X2 Dulson Ltd purchased a freehold office block for CU2.5 million. At the date ofacquisition the useful life was estimated to be 50 years and the residual value CU250,000. Thecompany policy is to depreciate freehold property on the straight-line basis. On 31 December 20X7the residual value of the offices was estimated at CU450,000 due to an increase in commercialproperty prices. The estimated useful life of the property remained unchanged.

What amount will be recognised in the income statement as depreciation in respect of the freeholdproperty in the year to 31 December 20X7 in accordance with BFRS?

A CU45,000B CU40,556C CU50,000D CU36,500

22 Lakes Ltd owns an item of plant that has previously been revalued. There is currently a balance ofCU50,000 in the revaluation reserve relating to this asset. At the end of December 20X7 the companyperformed an impairment review, which indicated that the item of plant was impaired as a result of theconsumption of economic benefits. The impairment is estimated to be CU35,000.

How will the impairment be recognised in the financial statements of Lakes Ltd for the year ended 31December 20X7 in accordance with BFRS?

A Charged as an expense in the income statementB Set off against the balance on the revaluation reserve



23 PORSCHE LTD

Porsche Ltd has the following non-current assets at 1 January 20X7.

Cost Accumulated Carryingdepreciation amount

CU'000 CU'000 CU'000Freehold factory 1,440 144 1,296Plant and equipment 1,968 257 1,711Motor vehicles 449 194 255Office equipment and fixtures 888 583 305

4,745 1,178 3,567

You are given the following information for the year ended 31 December 20X7.

(1) The factory was acquired on 1 January 20X2 and is being depreciated over 50 years.

(2) Depreciation is provided on cost on a straight-line basis. The rates used are 20% for fixtures andfittings, 25% for cars and 10% for equipment.

(3) On 1 January 20X7 the factory was revalued to an open market value of CU2.2 million and anextension costing CU500,000 became available for use.

(4) The directors decided to change the method of depreciating motor vehicles to 30% reducingbalance to give a more relevant presentation of the results and of the financial position.

(5) Two cars costing CU17,500 each were bought on 1 January 20X7. Plant and fittings for thefactory extension cost CU75,000 and CU22,000 respectively.

(6) When reviewing the expected lives of its non-current assets, the directors felt that it wasnecessary to reduce the remaining life of a two year old grinding machine to four years when it isexpected to be sold for CU8,000 as scrap. The machine originally cost CU298,000 and at 1January 20X7 had related accumulated depreciation of CU58,000.

Requirements

(a) Prepare the disclosure notes for property, plant and equipment for the year ended 31 December20X7 required by the BFRSs. (16 marks)

(b) Briefly explain the qualitative characteristics of financial information contained in BFRS Frameworkillustrating your answer with references to the provisions of BAS 16 Property, Plant and Equipment.(8 marks)

(24 marks)

24 PLOVER LTD

Plover Ltd is a car manufacturing group and during the year ended 30 September 20X9 the followingtransactions relating to property, plant and equipment took place.

1 New factory premises were finally completed and were ready for occupation on 1 March 20X9.Production was not transferred to the factory until 31 August 20X9 due to a dispute with thelabour force arising from proposed redundancies.

Capitalised costs relating to the factory were CU1.1 million (including land of CU600,000) at 1October 20X8 and the following costs have been incurred since then.

CU'000Further construction costs 125Additional legal fees 25Management and supervision costs (allocation) 75

2 On 1 March 20X9, plant and machinery for a new highly computerised production and assemblyline became available for use in the factory. The external costs relating to this were CU800,000and in addition the company also incurred the following.

Labour costs of CU80,000 in installing the line (these were 20% higher than budgetedbecause of the impact of industrial disputes).



5

Management and supervision costs (allocation) of CU15,000.

Start-up costs of CU30,000 incurred in testing the new process. CU20,000 of these werenecessary to ensure the line operated correctly. The remaining CU10,000 was incurredwhen the directors held an 'open day' for their bankers to demonstrate the efficiency of thenew system.

3 The company still owns and uses part of the old factory but on 30 September 20X9 it wasclassified as held for sale. It is expected to be sold by 31 December 20X9 for CU200,000 (afterspending CU25,000 to generally improve the property). The carrying amount of the factory at 1October 20X8 is CU310,000 (cost CU500,000).

Depreciation rates are:

Freehold land and buildings – 2% per annumPlant and machinery – 20% per annum

Requirements

(a) Prepare balance sheet extracts in relation to the above as at 30 September 20X9 and draft thebalance sheet note showing the movements on property, plant and equipment for the year(working to the nearest CU000). (10 marks)

(b) Calculate the impairment loss arising on classifying the old facility as held for sale. (2 marks)

(12 marks)




Technical reference


BAS 16 All examinable

BAS 36 Paragraphs 1-64 (excluding paragraph 54), 126-128, and 130-131 areexaminable. The Appendices are not examinable.

BFRS 5 References to disposal groups and implementation guidance (exceptparagraphs 11 and 12) are not examinable.


1 Property, plant and equipment recognition

Recognise items of PPE, provided future economic benefits and reliablemeasurement of cost.

BAS 16 (7)

– Initial costs to acquire or construct. BAS 16 (10)

– Subsequent costs to add to, replace part of, or service.

Separate into components, with different lives, e.g. inspections. BAS 16 (13)


At cost. BAS 16 (15)

– Purchase price. BAS 16 (16)

– Costs directly attributable to bringing asset into location and conditionnecessary for it to be capable of working as intended, including testing.

BAS 16 (16-17)

– Costs to dismantle/restore. BAS 16 (16)

Some costs excluded because not directly attributable or after item iscapable of working as intended, e.g. abnormal costs, general overheads, initiallosses, internal profits.

BAS 16 (19-22)

Can include interest, but not compulsory. BAS 16 (22)

3 Measurement after recognition

Choice of model: cost or revaluation to fair value. BAS 16 (29-31)

Frequency: to ensure carrying amount not materially different from updatedfair value.

BAS 16 (31)

– Maximum interval 5 years? BAS 16 (34)

All assets in a single class must be treated in the same way. BAS 16 (36)


Gain direct to equity as part of revaluation reserve, so in statement ofchanges in equity, not income statement.

BAS 16 (39)

– If reverse previous decrease, take to income statement to extent of thatdecrease.

Loss direct to income statement. BAS 16 (40)

– If reverse previous increase, take to revaluation reserve to extent ofthat increase.

Depreciation charge based on revalued amount.



5

Annual reserve transfer re excess of actual depreciation over historical costdepreciation.

BAS 16 (41)

5 Depreciation

Each significant part of PPE item depreciated separately. BAS 16 (43)

Charge to profit or loss, unless included in inventory, construction contractor other PPE.

BAS 16 (48)

Depreciate depreciable amount (i.e. cost less residual value (RV)) overestimated useful life (UL).

BAS 16 (6)

– RV is current estimate of disposal proceeds, net of disposal costs, ifitem already of the age and in the condition expected at the end of UL.

BAS 16 (6)

– UL is period over which asset expected to be available for use,commencing with when asset is available for use.

BAS 16 (6 and 55)

Method should allocate depreciable amount systematically over useful life, soas to reflect consumption of future economic benefits.

BAS 16 (60-61)

Annual reviews of RVs, ULs and depreciation methods. BAS 16 (51 and 61)

– Any changes accounted for prospectively. BAS 16 (51 and 61)

6 Derecognition

Derecognise non-current asset when classified as held for sale or when nofuture economic benefits expected.

BAS 16 (67)

– Separate procedures where held for sale – see below

Proceeds less carrying amount (current NBV) taken to income statement. BAS 16 (68)

Revalued assets:

– Recycling of gains on disposal not permitted. BAS 16 (41)

– Reserve transfer re previously recognised gains now realised.

7 Disclosures BAS 16 (73,74 and 77)

Measurement bases.

Depreciation methods.

Useful lives or depreciation rates.

Gross, accumulated depreciation and net amounts at start and end of period.

Additions, disposals, acquisitions through business combinations,revaluations, impairments, depreciation, classification as held for sale.

Assets pledged as security for loans and contractual commitments to acquirePPE.

For revalued assets, the dates, whether independent valuer used,assumptions, reference to active markets/recent transactions, carryingamount under historical cost convention, revaluation surplus.



8 Impairment

At each reporting date assess whether indication of impairment: BAS 36 (9)

– If so, estimate recoverable amount (RA).

– RA is higher of fair value less costs to sell and value in use (presentvalue of future cash flows in use and on disposal).

BAS 36 (6)

Review both external and internal information for evidence of impairment. BAS 36 (12)

Calculation of value in use to be on reasonable and supportable bases. BAS 36 (33)

Impairment loss where carrying amount exceeds RA. BAS 36 (59)

Treat impairment loss as a revaluation loss: BAS 36 (60-61)

– Treat as revaluation gain if impairment loss subsequently reversed.

Depreciate revised carrying amount over remaining useful life. BAS 36 (63)

Disclosures:

– All impairments: BAS 36 (126)

The amount of any impairment loss recognition/reversal in theincome statement (and the line item where included) and instatement of changes in equity.

If relevant, the reportable segment(s) to whichrecognition/reversal relates.

– For a material impairment on an individual asset: BAS 36 (130)

The events which led to the recognition/reversal.

The amount.

The nature of the asset and, if relevant, the reportable segment towhich it belongs.

Whether the recoverable amount is the fair value less costs to sellor its value in use, with information about how it was calculated.

9 Non-current assets held for sale

Non-current asset classified as held for sale when carrying amount recoveredprincipally through sale.

BFRS 5 (6)

– Must be available for immediate sale and sale (within 12 months ofclassification) must be highly probable.

BFRS 5 (7)

– If meet criteria after balance sheet date, a non-adjusting event underBAS 10.

BFRS 5 (12)

Measured at lower of carrying amount and fair value less costs to sell. BFRS 5 (15)

– Any loss accounted for under BAS 36 (any gain is recognised on actualdisposal).

BFRS 5 (20)

– Not depreciated. BFRS 5 (25)

Presented separately from all other assets, immediately below the sub-totalfor current assets.

BFRS 5 (38)

Different rules if asset previously revalued: BFRS 5 (18)

– Revalue before classification, with gain/loss accounted for under BAS 16.

– Costs to sell = impairment loss.

Measurement and presentation of non-current assets to be abandoned perBAS 16, not BFRS 5.

BFRS 5 (13)



5


1 C Per BAS 16 paragraph 16.

2 CCU

Servicing 25,000Repainting 40,000

65,000

Plant modification and upgrading creates future economic benefits from the asset and should becapitalised (BAS 16 paragraph 7).

3 B

4 DLand Buildings Total

CU'000 CU'000 CU'000Cost on 1 July 20W3 80 300 380Ten years' depreciation(300 4% 10) (120) (120)

80 180 260Revaluation surplus 120 420 540

200 600 800Depreciation (600 – 100) / 20 (25) (25)

200 575 775

5 B Per BAS 16, under the revaluation model assets should be carried at fair value, which is usuallyopen market value (BAS 16, paragraph 32).

CUOffice building 300,000Warehouse 1 200,000Warehouse 2* 210,000

710,000

* Since classified as held for sale, this would be presented separately from all other assets.

6 C If an asset has previously been revalued, recognise the revaluation loss down to depreciatedhistoric cost (175,000 – 160,000 = CU15,000) in the statement of changes in equity, the balance(160,000 – 150,000 = CU10,000) in the income statement (BAS 16 paragraph 40).

7 B Each significant part of an item of PPE must be depreciated separately (BAS 16 paragraph 43).

CU900,000/50 years = CU18,000

CU100,000/25 years = CU4,000

Total depreciation CU18,000 + CU4,000 = CU22,000



8 B Residual value is the year-end estimate of the disposal value of the asset (BAS 16.51 and BAS8.36(b)).

(CU100,000 – CU15,000)/5 years = CU17,000

9 B 31 March 20X6 Carrying amount = CU20,000

31 March 20X5 20,000/0.8 = CU25,000

31 March 20X4 25,000/0.8 = CU31,250

31 March 20X3 31,250/0.8 = CU39,062

Accumulated depreciation = (39,062 – 20,000)

= 19,062, i.e. approximately CU19,000

10 D Depreciable amount at 31 December 20X6 = (100,000 – 2,000) 14/20 = 68,600

Depreciation charge in 20X7 = 68,600 1/25 = CU2,744

11 B At 1 January 20X4 the carrying amount was CU104,400 and remaining useful life was six years.

Depreciation charge for 20X4 should be CU104,400/6 = CU17,400

12 A The revaluation gain is taken to the revaluation reserve. The additional depreciation istransferred from retained earnings to the revaluation reserve.

13 D An asset is impaired when the recoverable amount is lower than the carrying amount of theasset. To determine whether an asset is impaired, compare the recoverable amount to thecarrying amount. The recoverable amount is the greater of the value in use and the fair value lesscosts to sell.

Asset R is not impaired as recoverable amount is greater than carrying amount. Asset Q isimpaired as recoverable amount of CU95,000 is lower than the carrying amount of CU100,000.

14 C An impairment loss should be recognised when the asset is classified as held for sale. This will bethe difference between the carrying amount (CU13,200) and its fair value less costs to sell(CU11,100 – CU500 = CU10,600). An impairment loss of CU2,600 (13,200 – 10,600) istherefore recognised at this point.

When the asset is actually sold any further loss or gain is treated as a loss or gain on disposal.Here there is a further loss of CU100 (10,600 – 10,500).

15 A Although an impairment loss is recognised when a non-current asset measured under BAS 16'scost model is classified as held for sale, any gain is only recognised when the asset is actuallyderecognised (i.e. sold). Hence the only gain recognised is that on sale of CU17,000 (115,500 –98,500).

16 A Where an asset has been held under the revaluation model and is subsequently classified as heldfor sale the asset must be revalued to fair value immediately before the reclassification. Any gainwill be taken to the revaluation reserve and any loss to the income statement (except to theextent that it reverses a gain held in the revaluation reserve). So here, a revaluation gain isrecognised of CU158,000 (725,000 – 567,000).

Once revalued in this way, the measurement is then adjusted to the normal basis for held for saleassets, so fair value less costs to sell. The effect is that the costs to sell (here CU3,000) arerecognised in the income statement as an impairment loss.



5

17 BRevaluation

reserveCU

Gain on revaluation (W) 90,000Reserve transfer

New depreciation – old depreciation to 30/9/X4

270,000 200,000–

18 20

(5,000)

Balance at 30/9/X4 85,000

WORKING

CUCost 200,000Less Depreciation (200,000 2/20) (20,000)NBV at revaluation 180,000Gain on revaluation 90,000Valuation 270,000

18 B

At 30/9/X7Revalued amount 270,000Depreciation (270,000 4/18) (60,000)Carrying amount at disposal 210,000Revalue to fair value (190,000)Loss to revaluation reserve 20,000

Revaluation reserve at 30/9/X4 85,000Reserve transferNew depreciation – old depreciation (5,000 3) (15,000)Revaluation reserve at 30/9/X7 70,000Impairment loss (20,000)Balance c/f (transfer to retained earnings on disposal) 50,000

Because there was a sufficient balance on the revaluation reserve in respect of this asset to whichthe loss could be charged, the only impairment loss taken to the income statement are the coststo sell of CU5,000.

19 APLANT ACCOUNT (CARRYING AMOUNT)

CU CUB/f 261,000 Depreciation 143,000Additions 512,000 Loss on disposal 57,000

Impairment loss 50,000Disposal proceeds (ß) 53,000C/f 470,000

773,000 773,000

20 BMachine 1 Machine 2

CU CUFair value less costs to sell 90,000 40,000Carrying amount (ß) (60,000) (60,000)Anticipated gain/(loss) on sale 30,000 (20,000)Cost 120,000 100,000Carrying amount (60,000) (60,000)Accumulated depreciation 60,000 40,000

Total accumulated depreciation CU60,000 + CU40,000 = CU100,000



21 B Under BFRS

Depreciation 20X7

2,500,000 – 225,000 – 450,000

45= CU40,556

22 B

23 PORSCHE LTD

(a) Notes to the financial statements for the year ended 31 December 20X7 (extracts)


Property, plant and equipment

Freehold land and buildings are stated at a valuation. Other tangible non-current assets arestated at cost, together with any incidental expenses of acquisition.

Depreciation is calculated so as to write off the net cost or valuation of tangible non-current assets over their expected useful lives. Depreciation charges commence when anasset becomes available for use. The rates and bases used are as follows.

Asset % pa Basis

Freehold land and buildings 2% Straight-line

Plant and equipment 10% Straight-line

Office equipment and fixtures 20% Straight-line

Motor vehicles 30% Reducing-balance

2 Profit from operations is stated after chargingCU

Depreciation of property, plant and equipment 562,000


Freehold Plant and Motor Office Totalland and equipment vehicles equipmentbuildings and

fixturesCost or valuation CU000 CU000 CU000 CU000 CU000

At 1 January 20X7 1,440 1,968 449 888 4,745Additions 500 75 35 22 632Revaluations (W1) 760 – – – 760At 31 December 20X7 2,700 2,043 484 910 6,137

DepreciationAt 1 January 20X7 144 257 194 583 1,178Revaluation

adjustment (W1) ((144) – – – (144)Charge for year 60 (W2) 233

(W5)

87 (W3) 182 (W4) 562

At 31 December 20X7 60 490 281 765 1,596Carrying amount

At 31 December 20X7 2,640 1,553 203 145 4,541At 1 January 20X7 1,296 1,711 255 305 3,567

(i) Freehold land and buildings were valued for the purposes of the 20X7 accounts atopen market value, with subsequent additions at cost. Their historical cost isCU1,940,000 (W6) and the related accumulated depreciation is CU183,000 (W6).

(ii) The company’s depreciation policy on motor vehicles has been changed from a rate of25% per annum on cost to a rate of 30% per annum on reducing balance in order to



5

give a more relevant presentation of the results and of the financial position. The effectof this change has been to reduce the depreciation charge for the year by CU34,000(CU121,000 – CU87,000).

(b) Qualitative characteristics and BAS 16

Understandability

Information must be readily understandable to users so that they can perceive its significance.This is dependent on how information is presented and how it is categorised.

For example, BAS 16 requires disclosures to be given by each class of property, plant andequipment so it will be clear what type of assets have been purchased during the year and whattypes of assets have been sold. If this information were merged over one class it would be lessunderstandable.

Relevance

Information is relevant if it influences the economic decisions of users.

The choice of the revaluation model as a measurement model in BAS 16 provides relevantinformation by showing up-to-date values. This will help give an indication as to what the entity'sunderlying assets are worth.

Reliability

Information is reliable if it is free from error or bias, complete and portrays events in a way thatreflects their reality.

Although the revaluation model gives relevant information this information is generally seen to beless reliable than the cost model – the other measurement model allowed by BAS 16. The costmodel is based on historic costs, which are not the most relevant costs on which to base futuredecisions. However, historic cost is reliable being based on fact.

Comparability

Users must be able to compare information with that of previous periods or with that of anotherentity. Comparability is achieved via consistency and disclosure.

BAS 16 allows comparability between the cost and the revaluation model (for example, tofacilitate comparisons between two companies who have adopted different models) by requiringequivalent cost information to be disclosed under the revaluation model. It also requiresdisclosures (in accordance with BAS 8) of the effect of a change in an accounting estimate such asuseful lives or depreciation rates. This facilitates comparison between different periods.

WORKINGS

(1) Freehold land and buildings revaluationCU'000 CU'000

DR Freehold land and buildings (ß) 760DR Accumulated depreciation (1,440 5 ÷ 50) 144

Cr Revaluation reserve (2,200 – 1,296) 904

(2) Freehold land and buildings depreciation charge

Valuation/cost at 1 January 20X7CU2,700,000

Remaining useful life 45 years

Annual depreciation charge =

2,700,000

45 yearsCU60,000



(3) Motor vehicles depreciation chargeCU'000

Carrying amount at 1 January 20X7 255Additions 35

290Depreciation – reducing balance method @ 30% 87

(4) Fixtures and fittings depreciation charge

CU'000Cost at 31 December 20X7 910Depreciation – straight-line method @ 20% 182

(5) Plant and equipment depreciation chargeCU'000

Cost at 1 January 20X7 1,968Less Grinding machine (298)Add Purchases for factory extension 75

1,745Depreciation – straight-line method @ 10% 175

Grinding machine – cost less residual value (298 – 8) 290Accumulated depreciation at 1 January 20X7 (58)Carrying amount 232

The carrying amount must be written off over the machine's remaining useful life of four years.

CU

Depreciation charge

232,000

4 years58,000

Total depreciation charge for plant CU000Grinding machine 58Other plant 175

233

(6) Historical cost depreciation on freehold land and buildingsCU'000

Cost at 1 January 20X7 1,440Addition – extension 500Cost at 31 December 20X7 1,940Accumulated depreciation at 1 January 20X7 144Depreciation charge at 2% 39Accumulated depreciation at 31 December 20X7 183

24 PLOVER Ltd

(a) Financial statement extracts

Balance sheet as at 30 September 20X9CU'000 CU'000


Property, plant and equipment 2,026X

Current assets XNon-current assets held for sale 175 X

X



5

Notes to the financial statements

Property, plant and equipmentFactory Plant Assets in Total

premises and the courseequipment of

constructionCU'000 CU'000 CU'000 CU'000

CostAt 1 October 20X8 500 – 1,100 1,600Additions (W1 & W2) – 887 150 1,037Transfers 1,250 – (1,250) –Classified as held for sale (500) – – (500)At 30 September 20X9 1,250 887 – 2,137

DepreciationAt 1 October 20X8 (W4) 190 – – 190Charge for the year (W3) 18 103 – 121Classified as held for sale (W4) (200) – – (200)At 30 September 20X9 8 103 – 111

Carrying amountAt 30 September 20X9 1,242 784 – 2,026At 1 October 20X8 310 – 1,100 1,410

(b) Impairment lossCU'000

Carrying amount brought forward 310Depreciation to 30 September (W3) (10)

300Recoverable amount (200 – 25) (175)Charge to income statement 125

WORKINGS

(1) Additions to new factoryCU'000

Construction costs 125Legal fees 25

150

(2) Additions to plant and equipmentCU'000

External costs 800Labour (80,000 100/120) 67Start-up costs 20

887

(3) DepreciationCU'000

New factory ((1,250 – 600) 2% 7/12) 8

Old factory (500 2%) 1018

Plant and equipment (887 20% 7/12) 103

(4) Old factory accumulated depreciationCU'000

Brought forward at 1 October 20X8 (500 – 310) 190Charge for year (W3) 10

200





Cost of facilityCU'000

Site preparation 400Net income while site used as a car park Incidental, so taken to profit or loss –Materials used (2,000 – 300) 1,700Labour costs (4,000 – 500) 3,500Testing of facility's processes 300Sale of by-products (60)Consultancy fees re installation and assembly 500Professional fees 450Opening of facility –Overheads incurred:– Construction 800– General –Relocation of staff to new facility –Cost of dismantling facility 750

8,340Allocated to components:Safety inspection 150To be replaced in 8 years (40% (8,340 – 150)) 3,276Remainder 4,914

8,340


The revaluation gain on 1 January 20X7 is CU35 (60 – 25).

If the previous downward revaluation had not taken place the carrying amount on 31 December 20X6would have been CU50 (CU100 less five years' depreciation at CU10 each year).

The 'excess' revaluation gain recognised directly in equity is CU10 (60 – 50).

The amount recognised in profit or loss is CU25 (50 – 25).


CU'000Annual charge re:Over 3 years (150 ÷ 3) 50Over 8 years (3,276 ÷ 8) 410Over 20 years (4,914 ÷ 20) 245

705



5

Answers to Interactive question 4

Year 1 Year 2 Year 3CU CU CU

Cost 1,000 1,000 1,000Accumulated depreciation (80) (160) (320)Carrying amount 920 840 680

Charge for the year (W) 80 80 160

WORKING

1,000 - 200

10

1,000 - 200

10

840 - 200

4



1 January 20X8DR PPE – accumulated depreciation (30% (100 – 10)) 27DR Non-current assets held for sale (40 – 2) 38DR Income statement () 35CR PPE – cost 100


Impairment loss on reclassification of non-current assets as held for sale 35

(c) Income statement for the year ended 31 December 20X8

With sales proceeds of CU32,000

The impairment loss would remain the same Loss on disposal of CU6,000 would be included.



1 January 20X8DR PPE – accumulated depreciation (30% (100 – 10)) 27

DR Non-current assets held for sale () 73CR PPE – cost 100

As fair value less costs to sell is greater than carrying amount, there is no impairment loss at the timeof classification.


Gain on disposal of non-current assets held for sale (77 – 73) 4




(a) Journal entry to record the revaluationCU'000 CU'000

1 January 20X5DR PPE – at valuation 50CR Revaluation reserve 50

(b) Journal entry to record the classification as held for saleCU'000 CU'000

1 January 20X8DR Non-current assets held for sale – fair value less costs to sell (235 – 5) 230DR Income statement – costs to sell 5DR Revaluation reserve (250 – 235) 15CR PPE – at valuation 250


(a) Journal to record the revaluationCU CU

1 January 20X4DR PPE cost/valuation (136,000 - 120,000) 16,000DR PPE accumulated depreciation 18,000CR Revaluation reserve (136,000 - 102,000) 34,000

(b) Revised depreciation charge

Annual charge from 20X4 onwardsCU CU

DR Income statement depreciation expense (136,000 ÷ 17) 8,000CR PPE accumulated depreciation 8,000Annual reserve transferDR Revaluation reserve 2,000CR Retained earnings 2,000

Being the difference between the actual depreciation charge and the charge based on historical cost(CU6,000).

Shown in the statement of changes in equity as follows:Revaluation Retained

reserve earningsCU CU

Brought forward X XProfit for the year – XTransfer of realised profits (2,000) 2,000Carried forward X X

(c) Journal to record classification as held for sale

At 1 January 20X8, balances relating to the asset will be as follows:CU

Property, plant and equipment at valuation 136,000Accumulated depreciation (4 8,000) (32,000)Carrying amount 104,000Revaluation reserve (34,000 – (4 2,000)) 26,000

CU'000 CU'0001 January 20X8DR PPE – accumulated depreciation 32DR Non-current assets held for sale – fair value less costs to sell 137DR Income statement – costs to sell 3CR PPE – cost/valuation 136CR Revaluation reserve (ß) 36

172 172



5

(d) Financial statements for the year ended 31 December 20X8


A charge of CU3,000 will be made for the costs to sell, classified as an impairment loss. No profit or loss on disposal will be shown, as the asset is sold for its fair value less costs to sell.

Remaining balance on revaluation reserve is transferred to retained earnings as a reserve transfer inthe statement of changes in equity:

Revaluation Retainedreserve earnings

CU CUBrought forward X XRetained profit for the year – XTransfer of realised profits (26 + 36) (62,000) 62,000Carried forward X X


RSBH Ltd: Reconciliation of opening and closing property, plant and equipment

Freehold Plant and Fixtures TotalProperty Machinery and FittingsCU'000 CU'000 CU'000 CU'000

Cost/valuationI January 20X7 1,000 700 300 2,000Revaluation 200 – – 200Additions 100 400 80 580Classified as held for sale – (360) – (360)Disposals – – (40) (40)At 31 December 20X7 1,300 740 340 2,380

DepreciationI January 20X7 300 330 180 810Revaluation (300) – – (300)Charge for the year (W) 26 73 48 147Classified as held for sale (W) – (269) – (269)Disposals (W) – – (28) (28)At 31 December 20X7 26 134 200 360

Carrying amount31 December 20X7 1,274 606 140 2,0201 January 20X7 700 370 120 1,190

WORKINGSPlant and FixturesMachinery and FittingsCU'000 CU'000

Depreciation charge for the yearItems reclassified/disposed of during year(360 10% 1/4) and (40 15% 1/2) 9 3Items owned throughout year((700 – 360) 10%) and ((300 – 40) 15%) 34 39

Items acquired during year (400 10% 3/4) and (80 15% 1/2) 30 673 48

Accumulated depreciation on items reclassified/disposed ofBrought forward 260 25Charge for year (360 10% 3/12) 9 3

269 28




Contents

Introduction

Examination context

Topic List

1 What are intangible assets?

2 BAS 38: objective and scope

3 The definition of intangible assets

4 Initial recognition and measurement

5 Internally generated assets

6 Measurement of intangible assets after recognition

7 Disposals

8 Disclosure

9 Goodwill


Technical reference


Answer to Interactive question

chapter 6

Intangible assets



Introduction


Relate the treatment of intangible assets to the principles in BFRS Framework

Identify the accounting standards which apply to the treatment of intangible assets

Apply the accounting requirements for intangible assets, including the effects of the following:

– Separately acquired intangible assets

– Intangible assets acquired as part of a business combination

– Internally generated intangible assets including research and development expenditure

– Internally generated and purchased goodwill



In recent years the recognition and measurement of intangible assets has been one of the mostcontroversial areas of financial reporting. As the nature of business has changed intangible assets havebecome a significant part of the value of an entity. The most important assets for many businesses are nowbrands, market positions, knowledge capital and people, but these are rarely recognised in financialstatements. Brand names such as Coca-Cola and Microsoft are, in many cases, an entity’s most valuableasset, but they are extremely difficult to value when they have been generated internally and over a periodof time. Internally generated intangible assets that cannot be measured reliably are not recognised in thebalance sheet because of the difficulties that surround their valuation. Bill Gates is said to estimate that 97%of the value of Microsoft is not recognised in the balance sheet as a result.

In contrast to the treatment of internally generated intangibles, acquired intangibles are normally recognisedin the balance sheet. For example, an entity that has acquired a brand, as opposed to internally generated anequally valuable brand, will recognise it, since a fair value can be attributed to it. As the acquirer has paid aprice to acquire this brand, that price provides a reliable measure. This type of inconsistency has led tocriticism that accounting practice in this area is unhelpful to users of financial statements and is out of date.

Stop and think

Can you think of any other types of intangible assets that might add value to a business apart from thoselisted above?

Working context

At this stage of your training it is less likely that you will have had practical experience of the issues affectingintangible assets. You may have come across some of the more common examples including developmentexpenditure, patents and goodwill. However, the issues affecting recognition and valuation of these assetsare often complex and would normally be dealt with by more senior members of the audit team.

Syllabus links

In the Accounting paper you will have had an introduction to accounting for intangible assets. In this paperyou are required to develop a sound understanding of the accounting guidance in this area, provided byBAS 38 Intangible Assets. The Financial Reporting syllabus will then develop some of the issues raised and inparticular the impact that intangible assets can have on the way that financial information is interpreted.

INTANGIBLE ASSETS


6

Examination context


Intangible assets could be examined in the written test section of the paper in the context of a questionwhere there are a number of accounting issues to be considered in order to draft the relevant extracts tothe accounts. Such a question could feature the treatment of research and development expenditure,goodwill or other intangibles.

Intangibles could feature in an accounts question where financial statements are produced from a trialbalance or could be examined within the context of group accounts (covered in Chapters 10-16 of thismanual). Group accounts are most likely to focus on goodwill but the group accounts question in thesample paper also examined development expenditure in the context of group accounts.

Questions could also focus on the way in which the accounting treatment of intangibles applies theprinciples of BFRS Framework.

Alternatively, this topic could be examined via short-form questions.


Explain how BFRS Framework applies to the recognition of intangible assets


– BAS 38 Intangible Assets– BAS 36 Impairment of Assets



1 What are intangible assets?

Section overview

The key issues affecting intangible assets are:

– Recognition – is the definition of an asset met?– Measurement – can cost or value be measured reliably?

1.1 Intangibles

Definition

Intangible asset: An identifiable non-monetary asset without physical substance.

One of the principal distinctions between PPE and intangible assets is that whilst the former have physicalsubstance, the latter do not.

The following are examples of categories of expenditure that might be capitalised as an intangible asset:

Brand names Publishing titles Computer software Patents Copyrights Motion picture films Customer lists Fishing licences Import quotas Franchises Customer or supplier relationships Customer loyalty Market share Marketing rights

The key issue affecting the treatment of this type of expenditure is whether it should be recognised as anasset and if so, how it should be valued. BAS 38 Intangible Assets provides guidance in this area.


The underlying principles of BFRS Framework are reflected in BAS 38.

The key element in financial statements, identified in BFRS Framework, which is relevant to intangible assetsis:

Asset: a resource controlled by the entity as a result of past events and from which future economicbenefits are expected to flow to the entity.

Also relevant are the definitions of:

Gains, which are a part of income: increases in economic benefits through enhancements of assets ordecreases in liabilities other than contributions from equity

Losses, which are included in expenses: decreases in economic benefits through depletions of assets oradditional liabilities other than distributions to equity

INTANGIBLE ASSETS


6

and the recognition criteria set out in the Framework whereby an element is only recognised if:

It is probable that any future economic benefit associated with the item will flow to or from the entity The item has a cost or value that can be measured with reliability.

2 BAS 38: objective and scope

Section overview

BAS 38 applies to all intangibles, the key exception being goodwill arising on a business combination.

2.1 Objective

The objective of BAS 38 is to prescribe the treatment of intangible assets not covered by other BFRS, interms of:

Recognition if, and only if, certain criteria are met Measurement provisions Disclosures

2.2 Scope

BAS 38 applies to all intangible assets with certain exceptions. Examples of assets specifically excludedfrom BAS 38 include:

Goodwill arising on a business combination, which is accounted for under BFRS 3 BusinessCombinations.

Financial assets as defined in BAS 39 Financial Instruments: Recognition and Measurement.

Mineral rights, related exploration and development expenditure incurred.

3 The definition of intangible assets

Section overview

An intangible asset must be:

– 'Identifiable'– Under the control of the entity.

3.1 Identifiability

As we saw in the definition in section 1.1 above an intangible asset must be 'identifiable'. BAS 38 includesthis identifiability requirement to distinguish intangible assets from goodwill, which arises on the acquisitionof a subsidiary. (We will look at the issue of goodwill in more detail in section 9 of this chapter.)

An intangible asset is identifiable if it meets at least one of the two following criteria:

It is separable It arises from contractual or other legal rights

An asset is separable if it can be sold, transferred, exchanged, licensed or rented to another party on itsown rather than as part of the business.

It is likely that all of the examples of intangibles listed in section 1.1 are separable, in that the owner can sellthem to others (even though some of them may fail other parts of the recognition test).



Most of these examples also meet the second condition, that of arising from contractual or other legalrights. Clearly, patents, copyrights, motion picture films, fishing licences and import quotas arise from suchrights. But this second condition is designed to cover items that are not separable, but are neverthelessvaluable. The argument is that:

If in a group of assets most are tangible

If economic benefits cannot be obtained from the tangible assets without the transfer of a legal rightand

If the legal right is of no benefit without the tangible assets to which they relate

then that legal right is non-separable but is still identifiable.

Worked example: Identifiability

A company has a group of assets comprising unique PPE to produce a unique product and the right to besole manufacturer and distributor of that product in a particular territory; the unique PPE is worthlesswithout the distribution rights and vice versa, so the distribution rights are non-separable but stillidentifiable.

3.2 Control

An intangible asset must also satisfy the basic definition of an asset.

One of the characteristics of an asset (according to the definition in BFRS Framework) is that it is under thecontrol of the entity. The entity must therefore be able to enjoy the future economic benefits from theasset, and prevent the access of others to those benefits. A legally enforceable right is evidence of suchcontrol, but not always a necessary condition. The following should be noted:

Control over technical knowledge or know-how only exists if it is protected by a legal right.

The skill of employees, arising out of the benefits of training costs, are most unlikely to be recognisableas an intangible asset, because an entity does not control the future actions of its staff.

Similarly, an entity normally has insufficient control over market share and customer loyalty for thoseto meet the definition of an intangible asset. However, the exception to this would be where theentity has the ability to exchange a customer relationship, for example, where a customer list can betraded, or separate rights provided for its use by a third party. This provides reliable evidence that theentity has control over the future economic benefits flowing from that relationship, and thereforemeets the definition of an intangible asset.

4 Initial recognition and measurement

Section overview

An intangible asset should be recognised if:

– It is probable that future economic benefits from the asset will flow to the entity.– The cost of the asset can be measured reliably.

At recognition the intangible should be recognised at cost.

Separately acquired intangibles and intangibles acquired as part of a business combination are normallyconsidered to meet the recognition criteria of BAS 38.

The key exception is goodwill recorded in the acquiree's balance sheet at the date of acquisition.

An intangible asset acquired as part of a business combination is recognised at fair value.

INTANGIBLE ASSETS


6

4.1 Recognition: basic principle

An item can only be recognised as an intangible asset if economic benefits are expected to flow in thefuture from ownership of the asset. Economic benefits may result in increased revenue, but may also resultin the reduction of costs (cost savings).

An intangible asset should be recognised if, and only if, both the following occur:

It is probable that the future economic benefits that are attributable to the asset will flow to theentity.

The cost can be measured reliably.

Management has to exercise judgement in assessing the degree of certainty attached to the flow ofeconomic benefits to the entity, giving greater weight to external evidence.

An intangible asset should be initially recognised at its cost.

4.2 Subsequent expenditure

Subsequent expenditure is rarely recognised in the carrying amount of an asset. This is because in mostcases the expenditure is incurred to maintain the expected future economic benefits embodied in anexisting asset. In addition it is often difficult to attribute subsequent expenditure directly to a particularintangible asset rather than to the business as a whole.

4.3 Separately acquired intangible assets

In most cases, separately acquired intangibles satisfy the BAS 38 recognition criteria.

Brands, mastheads, publishing titles, licences, computer software, copyrights, patents and airport landingslots are all examples of assets that can be acquired externally and should be capitalised.

As we saw in section 4.1 above an intangible asset is initially recorded at cost.

Cost for these purposes comprises:

Purchase price (including duties and non-refundable taxes). Any directly attributable costs of preparing the asset for its intended use.

Directly attributable costs include:

Costs of employees working directly to bring the asset to its working condition. Legal and professional fees. Costs of testing.

The following expenditure is excluded from the cost of the intangible asset:

Costs of introducing a new product or service including costs of advertising and promotional activities.

Costs of conducting business in a new location or with a new class of customer (including stafftraining).

Administration and other general overhead costs.

(These expenses are also excluded from the cost of PPE.)

Capitalisation of costs should cease when the asset is ready for use, irrespective of whether it is put intouse immediately or not.



Worked example: Cost of separately acquired intangibles

Data Ltd acquires new technology that will revolutionise its current manufacturing process. Costs incurredare as follows:

CUOriginal cost of new technology 1,200,000Discount provided 120,000Staff training incurred in operating the new process 60,000Testing of the new manufacturing process 12,000Losses incurred whilst other parts of the plant stood idle 24,000

The cost that should be capitalised as part of the intangible asset is:CU

Cost 1,200,000Less discount (120,000)Plus testing of process 12,000Total 1,092,000

4.4 Intangible assets acquired as part of a business combination

When an entity purchases another business entity the proceeds paid will normally exceed the value of theindividual assets and liabilities bought. This excess is normally referred to as goodwill.

BFRS 3 Business Combinations includes a list of items acquired in a business combination that should berecognised as intangible assets separately from goodwill, under five headings:

Marketing-related intangible assets, such as trademarks. Customer-related intangible assets, such as customer lists. Artistic-related intangible assets, such as motion picture films. Contract-based intangible assets, such as franchise agreements. Technology-based intangible assets, such as computer software.

The effect of recognising these intangible assets is to reduce to a minimum the amount ascribed to thegoodwill arising on a business combination. (We will look at goodwill arising on a business combination inmore detail in section 9.)

Intangible assets acquired as part of a business combination are normally considered to meet therecognition criteria of BAS 38. The key exception to this is any goodwill recorded in theacquiree's balance sheet at the acquisition date.

The cost of an intangible asset acquired as part of a business combination should be assessed at its fairvalue at the date it was acquired.

Definition

Fair value: The amount for which an asset could be exchanged between knowledgeable, willing parties inan arm’s length transaction.

Fair value may be observable from an active market or recent similar transactions. Other methods may alsobe used. If fair value cannot be ascertained reliably, then the asset has failed to meet the recognition criteria.In this situation no separate intangible asset would be recognised, resulting in an increase in the value ofgoodwill arising on the business combination.

INTANGIBLE ASSETS


6

4.5 Recognition of an expense

Expenditure on intangibles must be recognised as an expense unless:

It is part of the cost of an asset which meets the recognition criteria; or

The item is acquired on a business combination and cannot be recognised as an asset. (This will formpart of the goodwill arising at the acquisition date.)

Examples of expenditure which should be treated as an expense include:

Start up costs Training costs Advertising and promotional costs Business relocation and reorganisation costs

5 Internally generated assets

Section overview

Internally generated goodwill should not be recognised.

Expenditure incurred in the research phase should be expensed as incurred.

Expenditure incurred in the development phase must be recognised as an intangible asset providedcertain criteria are met.

BAS 38 prohibits the recognition of internally generated brands.

If recognised, internally generated assets should be recognised at cost.

5.1 Recognition of internally generated assets

Internally generated goodwill should not be recognised as an asset.

The key difficulties in deciding whether other internally generated intangible assets are to berecognised are:

Fixing the time when an identifiable asset comes into existence.

Measuring its costs reliably, as it is difficult to distinguish the costs of generating it from those ofmaintaining or enhancing the day-to-day operations of the business.

So additional requirements and guidance apply.

The evolution of such assets is split into the research phase and the development phase. Note thatthese phases relate to all intangibles, not just what would normally be regarded as 'research anddevelopment expenditure'.

Also note that when there is doubt regarding into which phase expenditure falls, it must be allocated to theresearch phase. This is an example of the application of the prudence concept.

5.2 Research phase

All expenditure that arises in the research phase should be recognised as an expense when itis incurred. No costs will be recognised as an intangible asset. The rationale for this treatment is that atthis stage there is insufficient certainty that the expenditure will generate future economic benefits.

Examples of research costs include:

Activities aimed at obtaining new knowledge.

The search for, evaluation and final selection of applications of research findings or other knowledge.



The search for alternatives for materials, devices, products, processes, systems or services.

The formulation, design, evaluation and final selection of possible alternatives for new or improvedmaterials, devices, products, processes, systems or services.

5.3 Development phase

Development costs may qualify for recognition as intangible assets provided that the following strictcriteria can be demonstrated by the entity:

The technical feasibility of completing the intangible asset so that it will be available for use or sale.

Its intention to complete the intangible asset and use or sell it.

Its ability to use or sell the intangible asset.

How the intangible asset will generate probable future economic benefits. Among other things, theentity should demonstrate the existence of a market for the output of the intangible asset or theintangible asset itself or, if it is to be used internally, the usefulness of the intangible asset.

The availability of adequate technical, financial and other resources to complete the development andto use or sell the intangible asset.

Its ability to measure reliably the expenditure attributable to the intangible asset during itsdevelopment.

If the above conditions are met development expenditure must be capitalised. In contrast with researchcosts, development costs are incurred at a later stage in a project, and the probability of success should bemore apparent. Examples of development costs include the following.

The design, construction and testing of pre-production or pre-use prototypes and models.

The design of tools, jigs, moulds and dies involving new technology.

The design, construction and operation of a pilot plant that is not of a scale economically feasible forcommercial production.

The design, construction and testing of a chosen alternative for new or improved materials, devices,products, processes, systems or services.

5.4 Other internally generated intangible assets

The standard prohibits the recognition of internally generated brands, mastheads, publishing titlesand customer lists and similar items as intangible assets. The reason for this is that these costs cannot beidentified separately from the cost of developing the business as a whole. They can be seen as beingcomponent parts of internally generated goodwill, the recognition of which is also prohibited (see section 5.1).

5.5 Cost of an internally generated intangible asset

If an internally generated intangible asset is recognised it should be measured at cost. The costs allocated toan internally generated intangible asset should be only costs that can be directly attributed or allocatedon a reasonable and consistent basis to creating, producing or preparing the asset for its intended use. Suchcosts include:

Materials and services consumed Employment costs of those directly engaged in generating the asset Legal and patent or licence registration fees

The principles underlying the costs that may or may not be included are similar to those for other non-current assets and inventory.

The cost of an internally generated intangible asset is the sum of the expenditure incurred from thedate when the intangible asset first meets the recognition criteria. If, as often happens, considerablecosts have already been recognised as expenses before management could demonstrate that the criteriahave been met, this earlier expenditure should not be retrospectively recognised at a later date aspart of the cost of an intangible asset.

INTANGIBLE ASSETS


6

Worked example: Treatment of expenditure

Douglas Ltd is developing a new production process. During 20X7, expenditure incurred was CU100,000,of which CU90,000 was incurred before 1 December 20X7 and CU10,000 between 1 December 20X7 and31 December 20X7. Douglas Ltd can demonstrate that, at 1 December 20X7, the production process metthe criteria for recognition as an intangible asset. The recoverable amount of the know-how embodied inthe process is estimated to be CU50,000.

How should the expenditure be treated?

Solution

At the end of 20X7, the production process is recognised as an intangible asset at a cost of CU10,000. Thisis the expenditure incurred since the date when the recognition criteria were met, that is, 1 December20X7. The CU90,000 expenditure incurred before 1 December 20X7 is expensed, because the recognitioncriteria were not met. It will never form part of the cost of the production process recognised in thebalance sheet.

6 Measurement of intangible assets after recognition

Section overview

After initial recognition an entity can choose between two models:

– The cost model– The revaluation model

In practice few intangible assets are revalued.

An intangible asset with a finite useful life should be amortised over this period.

An intangible asset with an indefinite useful life should not be amortised.

6.1 Cost model

The standard allows two methods of valuation for intangible assets after they have been first recognised.

Applying the cost model, an intangible asset should be carried at its cost, less any accumulatedamortisation and any accumulated impairment losses.

6.2 Revaluation model

The revaluation model allows an intangible asset to be carried at a revalued amount, which is its fairvalue at the date of revaluation, less any subsequent accumulated amortisation and any subsequentaccumulated impairment losses.

Points to note

1 The fair value must be able to be measured reliably with reference to an active market in that typeof asset. (See definition of an active market below.)

2 The entire class of intangible assets of that type must be revalued at the same time (to preventselective revaluations).

3 If an intangible asset in a class of revalued intangible assets cannot be revalued because there is noactive market for this asset, the asset should be carried at its cost less any accumulatedamortisation and impairment losses.



4 Revaluations should be made with such regularity that the carrying amount does not differ from thatwhich would be determined using fair value at the balance sheet date.

5 Where an intangible asset is revalued, subsequent amortisation is based on the revalued amount.

Definition

Active market: A market in which all the following conditions exist:

The items traded are homogeneous Willing buyers and sellers can normally be found at any time Prices are available to the public

In practice there will not usually be an active market in an intangible asset; therefore the revaluationmodel will usually not be available. For example, although copyrights, publishing rights and film rightscan be sold, each has a unique sale value. In such cases, revaluation to fair value would be inappropriate. Afair value might be obtainable, however, for assets such as fishing rights or quotas or taxi cab licences,where one is identical to the next.

6.3 Revaluation: accounting treatment

The treatment of revaluation gains and losses for intangibles follow the same rules as for PPE (see Chapter5). This can be summarised as follows:

Revaluation

Upwards Downwards

Assetrevalued downward

previously

Increase up to value ofprevious downward

revaluation:

recognise in incomestatement

Excess: recognise inrevaluation reserve

Asset previouslyrevalued downwards

not

Recognise increase inrevaluation reserve

Assetrevalued upwards

previously

Decrease to value ofprevious upwards

revaluation:

recognise inrevaluation reserve

Excess: recognise inincome statement

Asset previouslyrevalued upwards

not

Recognise decrease inincome statement

Worked example: Revaluation

An intangible asset is carried by a company under the revaluation model. The asset was revalued by CU800in 20X6, and there is a revaluation surplus of CU800 in the balance sheet. At the end of 20X7, the asset isvalued again, and a downward revaluation of CU1,000 is required.

State the accounting treatment for the downward revaluation.

INTANGIBLE ASSETS


6

Solution

In this example, the downward valuation of CU1,000 can first be set against the revaluation surplus ofCU800. The revaluation surplus will be reduced to zero and a charge of CU200 made as an expense in theincome statement in 20X7.

6.4 Useful life

Under both measurement models an entity should assess the useful life of an intangible asset, which may befinite or indefinite. An intangible asset has an indefinite useful life when there is no foreseeable limit tothe period over which the asset is expected to generate net cash inflows for the entity.

Many factors are considered in determining the useful life of an intangible asset, including:

Expected usage Typical product life cycle Technical, technological, commercial or other types of obsolescence The stability of the industry Expected actions by competitors The level of maintenance expenditure required Legal or similar limits on the use of the asset, such as the expiry dates of related leases.

Computer software and many other intangible assets normally have short lives because they are susceptibleto technological obsolescence. However, uncertainty does not justify choosing a life that is unrealisticallyshort.

The useful life of an intangible asset that arises from contractual or other legal rights should notexceed the period of the rights, but may be shorter depending on the period over which the entity expectsto use the asset.

6.5 Amortisation period and amortisation method

An intangible asset with a finite useful life should be amortised over its expected useful life.

Amortisation should start when the asset is available for use.

Amortisation should cease at the earlier of the date that the asset is classified as held for sale inaccordance with BFRS 5 Non-current Assets Held for Sale and Discontinued Operations and the date thatthe asset is derecognised.

The amortisation method used should reflect the pattern in which the asset's future economicbenefits are consumed. If such a pattern cannot be predicted reliably, the straight-line methodshould be used.

The amortisation charge for each period should normally be recognised in profit or loss.

The residual value of an intangible asset with a finite useful life is assumed to be zero unless a thirdparty is committed to buying the intangible asset at the end of its useful life or unless there is an activemarket for that type of asset (so that its expected residual value can be measured) and it is probable thatthere will be a market for the asset at the end of its useful life.

The amortisation period and the amortisation method used for an intangible asset with a finite useful lifeshould be reviewed at each financial year end.

6.6 Intangible assets with indefinite useful lives

An intangible asset with an indefinite useful life should not be amortised. Instead the asset is reviewedannually to assess whether there has been a fall in its value in accordance with BAS 36 Impairment of Assets.



7 Disposals

Section overview

On disposal of an intangible asset the gain or loss is recognised in profit or loss.


An intangible asset should be eliminated from the balance sheet when it is disposed of or when there is nofurther expected economic benefit from its future use. On disposal the gain or loss arising from thedifference between the net disposal proceeds and the carrying amount of the asset should betaken to the income statement as a gain or loss on disposal.

8 Disclosure

Section overview

BAS 38 requires detailed disclosures:

– For each class of intangible asset– For intangibles recorded at revalued amounts.

8.1 Disclosure requirements

The standard has fairly extensive disclosure requirements for intangible assets. The financial statementsshould disclose the accounting policies for intangible assets that have been adopted.

For each class of intangible assets, disclosure is required of the following distinguishing betweeninternally-generated intangibles and other intangibles.

The method of amortisation used.

The useful life of the assets or the amortisation rates used.

The gross carrying amount, any accumulated amortisation (aggregated with accumulated impairmentlosses) as at the beginning and the end of the period.

The line item(s) of the income statement in which any amortisation of intangible assets is included.

A reconciliation of the carrying amount as at the beginning and at the end of the period (additions,retirements/disposals, revaluations, impairment losses, amortisation charge for the period).

The financial statements should also disclose the following.

In the case of intangible assets that are assessed as having an indefinite useful life, the carrying amountsand the reasons supporting the assessment of an indefinite useful life.

The carrying amount, nature and remaining amortisation period of any individual intangible asset that ismaterial to the financial statements of the entity as a whole.

The existence (if any) and amounts of intangible assets whose title is restricted and of intangibleassets that have been pledged as security for liabilities.

The amount of any contractual commitments for the future acquisition of intangible assets.

Where intangible assets are accounted for under the revaluation model, disclosure is required of thefollowing by class of intangible assets.

The effective date of the revaluation.

The carrying amount of revalued intangible assets.

INTANGIBLE ASSETS


6

The carrying amount that would have been shown if the cost model had been used, and theamount of amortisation that would have been charged.

Also:

The amount of any revaluation surplus on intangible assets, as at the beginning and end of theperiod, and movements in the surplus during the year (and any restrictions on the distribution of thebalance to shareholders).

The methods and significant assumptions applied in estimating the assets' fair values.

The amount of research and development expenditure that has been charged as an expense in theperiod.

Interactive question 1: Intangible assets [Difficulty level: Intermediate]

In preparing its accounts for the year ended 30 June 20X7 NS Ltd has to deal with a number of matters.

1 An advertising campaign has just been completed at a cost of CU1.5m. The directors authorised thiscampaign on the basis of the evidence from NS Ltd's advertising agency that it would create CU4m ofadditional profits over the next two years.

2 A staff training programme has been carried out at a cost of CU250,000, the training consultantshaving demonstrated to the directors that the additional profits to the business over the next 12months will be CU400,000.

3 A new product has been developed during the year. The expenditure totals CU1.2m, of whichCU750,000 was incurred prior to 31 December 20X6, the date on which it became clear the productwas technically feasible. The new product will be launched in the next three months and itsrecoverable amount is estimated at CU600,000.

Requirement

Calculate the amounts which will appear as assets in NS Ltd's balance sheet at 30 June 20X7.


Solution

The treatment in NS Ltd’s consolidated balance sheet at 30 June 20X7 will be as follows:

1 Advertising campaign:

..........................................................................................................................................................................

..........................................................................................................................................................................

2 Staff training programme:

..........................................................................................................................................................................

..........................................................................................................................................................................

3 New product:

..........................................................................................................................................................................

..........................................................................................................................................................................

See Answer at the end of the chapter.



9 Goodwill

Section overview

Internally generated goodwill is not recognised. Purchased goodwill is recognised in the balance sheet of the acquirer at cost. Purchased goodwill is not amortised but is tested for impairment at least annually.

9.1 What is goodwill?

Goodwill is created by good relationships between a business and its customers, for example:

By building up a reputation (by word of mouth perhaps) for high quality products or high standardsof service.

By responding promptly and helpfully to queries and complaints from customers.

Through the personality of the staff and their attitudes to customers.

The value of goodwill to a business might be extremely significant. However, goodwill is not usuallyvalued in the accounts of a business at all, and we should not normally expect to find an amount forgoodwill in its balance sheet.

On reflection, we might agree with this omission of goodwill from the accounts of a business.

(a) The goodwill is inherent in the business but it has not been paid for, and it does not have an'objective' value. We can guess at what such goodwill is worth, but such guesswork would be a matterof individual opinion, and not based on hard facts.

(b) Goodwill changes from day to day. One act of bad customer relations might damage goodwill andone act of good relations might improve it. Staff with a favourable personality might retire or leave tofind another job, to be replaced by staff who need time to find their feet in the job, etc. Since goodwillis continually changing in value, it cannot realistically be recorded in the accounts of the business.

The result of this as we saw in section 5.1 is that internally generated goodwill should not berecognised as an asset.

9.2 Purchased goodwill

There is one exception to the general rule that goodwill has no objective valuation. This is when abusiness is sold. People wishing to set up in business have a choice of how to do it – they can either buytheir own long-term assets and inventory and set up their business from scratch, or they can buy up anexisting business from a proprietor willing to sell it. When a buyer purchases an existing business, he willhave to purchase not only its long-term assets and inventory (and perhaps take over its accounts payableand receivable too) but also the goodwill of the business.

Purchased goodwill is shown in the acquirer's balance sheet because it has been paid for. It has no tangiblesubstance, and so it is an intangible non-current asset.

INTANGIBLE ASSETS


6

Worked example: Goodwill

Andrew is a sole trader. At 31 December 20X7 he has total net assets in his balance sheet amounting toCU150,000. On 1 January 20X8 Brian purchases Andrew’s business for CU175,000.

The summarised balance sheet of Brian at 1 January 20X8 would be as follows:CU

Total net assets 150,000Intangible asset – goodwill 25,000(175 – 150) 175,000

Capital introduced 175,000

Goodwill is calculated as the difference between the purchase consideration of CU175,000 and the value ofthe net assets acquired of CU150,000. The goodwill is recognised in the balance sheet of Brian as it ispurchased goodwill. It would not have been recognised in the financial statements of Andrew.

9.3 BFRS 3 Business Combinations

BFRS 3 covers the accounting treatment of goodwill acquired in a business combination.

This includes goodwill arising on the purchase of both incorporated and unincorporated entities.

Definition

Goodwill: Represents a payment made by the acquirer in anticipation of future economic benefits arisingfrom assets that are not capable of being individually identified and separately recognised.

Points to note

1 Goodwill acquired in a business combination is recognised as an asset and is initially measured atcost. Cost is the excess of the cost of the combination over the acquirer's interest in the net fairvalue of the acquiree's identifiable assets, liabilities and contingent liabilities.

2 After initial recognition goodwill acquired in a business combination is measured at cost less anyaccumulated impairment losses. It is not amortised. Instead it is tested for impairment at leastannually, in accordance with BAS 36 Impairment of Assets.

3 A discount (i.e. 'negative' goodwill) arises when the acquirer's interest in the net fair value of theacquiree's identifiable assets, liabilities and contingent liabilities exceeds the cost of the businesscombination.

4 A discount can arise as the result of errors in measuring the fair value of either the cost of thecombination or the acquiree's identifiable net assets. It can also arise as the result of a bargainpurchase.

5 Where there is an apparent discount, an entity should first reassess the amounts at which it hasmeasured both the cost of the combination and the acquiree's identifiable net assets. This exerciseshould identify any errors.

6 Any discount remaining should be recognised immediately in profit or loss (that is, in the incomestatement).

We will look in more detail at the accounting treatment of goodwill in the context of group accounts inChapters 10 – 15.




Summary

BAS 38Intangible

Assets

BFRS 3Business

Combinations

Not goodwill onbusinesscombination(BFRS 3)

INTANGIBLE ASSETS


6

Self-test


1 The following statements relate to intangible assets.

1 An intangible asset should be amortised on a systematic basis over the asset’s useful life.

2 Internally generated goodwill may be carried on the balance sheet if the value can be determinedwith reasonable certainty.

3 Internally generated brands can never be recognised as intangible assets.

Which of the above statements are consistent with BAS 38 Intangible Assets?

A 1 and 2 onlyB 1 and 3 onlyC 2 onlyD 3 only

2 During 20X7 War Ltd incurred the following expenditure on research and development activities,none of which related to the cost of tangible non-current assets.

1 CU20,000 on investigating methods of separating raw materials into chemicals A, B and C.

2 After the technical viability of converting chemical B into a new medicine for sensitive teeth hadbeen proved, CU150,000 on the conversion process.

Commercial production and sales of the medicine commenced on 1 April 20X7 and are expected toproduce steady profitable income during a 10-year period before being replaced. Adequate resourcesexist to achieve this. No commercial uses have been discovered for chemicals A and C.

What is the maximum amount of development expenditure that may be carried forward at 31December 20X8 in accordance with BAS 38 Intangible Assets?

A CU123,750B CU129,250C CU138,750D CU144,917

3 Which of the following should be included in a company’s balance sheet as an intangible non-currentasset under BAS 38 Intangible Assets?

A Payment on account for patentsB Expenditure on completed researchC Brands developed by the companyD Internally-generated goodwill

4 Henna Ltd was incorporated on 1 January 20X6. At 31 December 20X6 the following items hadarisen.

1 Purchase of laboratory equipment for research purposes CU80,0002 Goodwill purchased for valuable consideration CU100,0003 Goodwill created by the company CU80,0004 Patents purchased for valuable consideration CU70,0005 Costs incurred by the company in developing brands CU60,000

Prior to amortisation, what amount should be carried as assets in the balance sheet of Henna Ltd at 31December 20X6 in accordance with BAS 38 Intangible Assets?

A CU310,000B CU250,000C CU230,000D CU170,000



5 In accordance with BAS 38 Intangible Assets which of the following conditions would preclude any partof the development expenditure to which it relates being capitalised?

A The development is incompleteB The benefits flowing from the completed development are expected to be greater than its costC Funds are unlikely to be available to complete the developmentD The development is expected to give rise to more than one product

6 In accordance with BAS 38 Intangible Assets which of the following types of expenditure must berecognised as an expense in the year in which incurred?

A Tangible assets acquired in order to provide facilities for research and development activitiesB Legal costs in connection with the registration of a patentC Costs of searching for possible alternative productsD Salaries of personnel solely engaged in finalising a new product

7 Which of the following statements relating to internally generated intangibles are true in accordancewith BAS 38 Intangible Assets?

1 Expenditure on training staff to operate the asset should not be capitalised2 Salaries of personnel directly engaged in generating the asset should be capitalised3 Internally generated customer lists should not be capitalised4 Costs of evaluating alternatives for new materials should be capitalised

A 3 and 4 onlyB 2 and 3 onlyC 1 and 4 onlyD 1, 2 and 3 only

8 MINBAD LTD

Minbad Ltd is a company operating in media and communications. It owns a number of newspapersand monthly magazine titles, which were acquired when the company acquired the assets ofNewsmedia. The consideration totalled CU130 million, of which CU100 million was attributed toidentifiable net assets (CU60 million specifically for the newspaper and magazine titles). The acquisitionoccurred on 1 January 20X7. The newspaper and magazine titles are assessed as having indefinite lives.Goodwill arising on the acquisition is estimated to have a useful life of 20 years. However, animpairment review at 31 December 20X7 showed that goodwill had fallen in value by CU1 millionduring 20X7.

The newspapers and magazines have all shown increasing circulation since the acquisition. Accordingly,in considering the financial statements to 31 December 20X7 the directors wish to revalue the titlesto CU133 million, which represents the sum of amounts it is estimated could be realised if each titleand its associated rights were sold separately in the market at 31 December 20X7. The directorsestimate that this approximates closely to current cost.

On 1 January 20X7 the company decided to expand its printing capacity by investing in new high techmachinery costing CU20 million. This machinery had been developed by a French company andMinbad Ltd had to pay CU20 million to acquire the patent allowing it sole use of the technology forten years. In addition Minbad Ltd has also developed a range of greeting cards to be sold alongside, andadvertised in, the monthly magazines. These cards will all be sold under a newly developed brand namewhich Minbad Ltd has spent CU6 million developing.

Requirements

(a) Assuming that BAS 38 Intangible Assets and BFRS 3 Business Combinations are complied with,prepare the table of movements and accounting policy notes for intangible assets for inclusion inthe financial statements of Minbad Ltd for the year ended 31 December 20X7. (6 marks)

(b) Comment on your treatment of Minbad Ltd's intangible assets in (a) above in the light of BFRSFramework. (5 marks)

(11 marks)

INTANGIBLE ASSETS


6

9 PHARMORIA LTD

Pharmoria Ltd operates in the pharmaceutical business. The following information relates to thecompany's activities in research and development for the year ended 31 October 20X7.

1 Commercial production started on 1 June 20X3 for Formula A. By 31 October 20X6 CU43,000had been capitalised in respect of development expenditure on this product. During the year afurther CU10,000 was spent on development of this product.

Pharmoria Ltd has taken out a patent in respect of Formula A which will last for ten years. Legaland administrative expenses in relation to this were CU2,000.

In the current year, sales of Formula A amounted to CU50,000. Sales over the next three yearsare expected to be CU150,000, CU200,000 and CU100,000 respectively.

2 The development of Formula B is at an earlier stage. Although the company believes it has areasonable expectation of future benefits from this project it has not as yet been able todemonstrate this with sufficient certainty. Expenditure on this project in the current year wasCU20,000.

Requirements

(a) Calculate the total amount to be written off to the income statement in respect of the above inthe year ended 31 October 20X7. (3 marks)

(b) Draft the table showing the movement on intangible assets which would appear in the notes tothe financial statements of Pharmoria Ltd for the year ended 31 October 20X7. (6 marks)

(9 marks)




Technical reference


BAS 38 All examinable except paragraphs 42-47 and the illustrative examples.

BFRS 3 All examinable except the following: paragraphs 10-13, 20-23, 58-60 and 65.Appendix B1-B3, B5, B7-B15 and the illustrative examples are also excluded.


1 Scope and definition

Scope of BAS 38: excludes what other BFRSs cover, e.g. goodwill on acquisition(BFRS 3).

BAS 38 (3)

Intangible asset: an identifiable, non-monetary asset without physical substance. BAS 38 (8)

Identifiability the key: BAS 38 (3)

– Separable – could be sold separately from entity which owns BAS 38 (8)

– Arises from contractual or other legal rights. BAS 38 (12)

Control is an essential part of the definition of an asset. Many items excludedbecause not controlled by a business:

BAS 38 (13)

– Staff (always)

– Customers (very often).

2 Recognition and initial measurement

Reliable measurement – the recognition criteria disallow: BAS 38 (21)

– Internally generated goodwill BAS 38 (48)

– Similar items such as internally generated brands, mastheads andcustomer lists

BAS 38 (63)

– Advertising. BAS 38 (69)

Initial measurement at cost. BAS 38 (24)

Separate acquisition: BAS 38 (25)

– Always – future economic benefits are probable

– Usually – cost reliably measurable BAS 38 (26)

– Cost includes licences, etc. BAS 38 (27)

Part of business combination BAS 38 (33)

– Always – future economic benefits are probable

– Almost always – cost reliably measurable BAS 38 (35)

– Cost = fair value BAS 38 (33)

– Includes acquiree's unrecognised intangibles, such as in-process researchand development.

BAS 38 (34)

INTANGIBLE ASSETS


6

Internally generated: at cost, but:

– Research expenditure (seeking new knowledge) written off as incurred(including subsequent expenditure on business combination research)

BAS 38 (65 and 42)

– Development expenditure (application of research findings) capitalised ifit meets stringent conditions as to future economic benefit

BAS 38 (57 and 42)

– Development expenditure includes materials, staff costs and licences butnot general overheads

– Only development expenditure incurred after recognition criteria met isto be capitalised. No subsequent capitalisation of earlier expenditurealready recognised in profit or loss.

BAS 38 (65 and 71)

Subsequent expenditure almost always written off, because most expenditurerelates to maintenance, not enhancement, and is non-separable from that onbusiness as a whole.

BAS 38 (20)

3 Measurement after recognition

Cost or revaluation models BAS 38 (72)

– Revaluation only if active market (homogeneous products, always trading,prices available to public)

BAS 38 (75)

Useful life:

– Indefinite – no amortisation, but annual impairment and useful life reviews BAS 38 (107-109)

– Finite – annual amortisation, with impairment review if indication ofimpairment. Residual value almost always nil

BAS 38 (97)

4 Disclosure

Disclosures specific to intangibles (otherwise follow BAS 16):

– Whether useful lives are indefinite or finite (in which case amortisationrates must be disclosed)

BAS 38 (118(a))

– For intangibles with indefinite useful lives, their carrying amount and thereasons supporting the indefinite life assessment

BAS 38 (122(a))

– Individual assets material to financial statements as a whole BAS 38 (122(b))

– Amount of research and development expenditure recognised as anexpense in the period.

BAS 38 (126)

5 Goodwill

Purchased goodwill: non-current asset at cost BFRS 3 (51)

No amortisation but subject to annual impairment reviews BFRS 3 (54)




1 D

1 False – If the asset’s life is assessed as finite, this would be the case. However, if it is assessedas indefinite, there are no amortisation charges but annual impairment reviews.

2 False – Such goodwill may never be recognised.

3 True – Since these costs cannot be identified separately from the cost of developing thebusiness as a whole (paragraphs 63-64).

2 A

1 Relates to research so must be written off as an expense.

2 Relates to development so should be capitalised once the recognition criteria (BAS 38paragraph 57) are met.

CUCapitalised as at 1 April 20X7 150,000Amortised up 31 December 20X8 (21/120 ×150,000) (26,250)C/f as at 31 December 20X8 123,750

3 A

Under BAS 38 B, C and D must be expensed.

4 B

1 Will be carried forward as property, plant and equipment under BAS 16.2 and 4

Will be carried forward as intangible assets under BAS 38.3 and 5

Cannot be carried forward – per BAS 38 (paragraphs 48 and 63).

5 C

BAS 38 paragraph 57.

6 C

A Capitalised under BAS 16.

B and D

Capitalised as part of the cost of an internally-generated intangible (BAS 38 paragraphs 66-67).

7 D

1, 2 and 3 are true per BAS 38 paragraphs 66-67 and 63.

4 Constitutes part of a research phase, so the costs cannot be capitalised (BAS 38 paragraph 54).

INTANGIBLE ASSETS


6

8 MINBAD LTD

(a) Notes to the financial statements at 31 December 20X7 (extracts)

Intangible assetsGoodwill Patents Publishing Total

titlesCUm CUm CUm CUm

CostAt 1 January 20X7 – – – –Additions 30 20 60 110At 31 December 20X7 30 20 60 110

Amortisation/impairmentAt 1 January 20X7 – – – –Charge for year (20 ÷ 10) 1 2 – 3At 31 December 20X7 1 2 – 3

Carrying amountAt 1 January 20X7 – – – –At 31 December 20X7 29 18 60 107

Note. Of the additions during the year totalling CU110 million the goodwill and publishing titlesresulted from a business combination. The patents were separately acquired.

Accounting policy note

Purchased intangibles are recognised at the fair value of consideration paid and separately fromgoodwill.

Patents are amortised on a straight-line basis over the life of the legal agreement.

Publishing titles are considered to have an indefinite life and are not amortised but are subject toannual impairment reviews.

Goodwill is not amortised but is subject to annual impairment reviews.

Note. This analysis shown under the heading 'Note' is required by BAS 38 paragraph 118 (e) (i)

(b) BFRS Framework

Under BFRS Framework an asset is a resource controlled by the entity as a result of past eventsfrom which future economic benefits are expected.

Here, Minbad Ltd has control over all the intangibles as it has either legally purchased them (thegoodwill, newspaper titles and patents) or developed them internally (the brand).

However, an additional requirement of the Framework is that items can only be recognised if

There is a probable inflow of economic benefits, and The cost/value can be measured reliably.

Acquired intangibles meet this requirement, but, as BAS 38 clearly identifies, it is not possible toseparate out reliably the cost of internally generated brands from the costs to develop thebusiness as a whole.

Other sections of the Framework highlight the importance of providing relevant information tousers of financial statements. It could be argued that users would find the value of internalintangibles of great relevance when assessing/evaluating a business. It would appear that withregard to intangibles, reliability has superseded relevance.

With regard to the proposed revaluation, although under BAS 38 either the cost or revaluationmodel can be used, intangibles can only be revalued where there is an 'active market' for them.This must be a market where all items traded are homogeneous, which clearly cannot be true forassets such as magazine titles. Again this is consistent with the qualitative characteristic ofreliability.



9 PHARMORIA LTD

(a) Total amount to be written off to the income statement in the year ended 31October 20X7

CUFormula B (not yet qualifying as development phase) 20,000Amortisation of development costs (Formula A) (W) 5,300Amortisation of patent (2,000 ÷ 10) 200

25,500

(b) Notes to the financial statements as at 31 October 20X7 (extracts)

Intangible assetsDevelopment Patents Total

costsCU CU CU

CostAt 1 November 20X6 43,000 – 43,000Additions 10,000 2,000 12,000At 31 October 20X7 53,000 2,000 55,000

AmortisationAt 1 November 20X6 – – –Charge for year 5,300 200 5,500At 31 October 20X7 5,300 200 5,500

Carrying amountAt 1 November 20X6 43,000 – 43,000At 31 October 20X7 47,700 1,800 49,500

WORKING

Amortisation of development costs for Formula A

Sales in year ÷ total sales CU53,000 5 months

50,000/(50,000 + 150,000 + 200,000 + 100,000) CU53,000 = CU5,300

INTANGIBLE ASSETS


6

Answer to Interactive question


The treatment in NS Ltd’s consolidated balance sheet at 30 June 20X7 will be as follows:

1 Advertising campaign: no asset will be recognised, because it is not possible to identify futureeconomic benefits that are attributable only to this campaign. The whole expenditure is recognised inprofit or loss.

2 Staff training programme: no asset will be recognised, because staff are not under the control of NSLtd and when staff leave, the benefits of the training, whatever they may be, also leave. The wholeexpenditure is recognised in profit or loss.

3 New product: the development expenditure appearing in the balance sheet will be measured atCU450,000.

The expenditure prior to the date on which the product becomes technically feasible is recognised inprofit or loss. The remaining CU450,000 is less than the recoverable amount, so no impairment issuesarise.




Contents

Introduction

Examination context

Topic List

1 Introduction

2 BAS 18 Revenue

3 BAS 2 Inventories


Technical reference



chapter 7

Revenue and inventories



Introduction


Relate the treatment of revenue to the principles in BFRS Framework

Understand and apply the main provisions of BAS 18 Revenue, which sets out therequirements in relation to the recognition and measurement of revenue, in particular

– Sale of goods– Rendering of services– Investment income

Understand and apply the main provisions of BAS 2 Inventories, which sets out requirementsin relation to the measurement of inventories



Revenue

The principal reason why profit-making businesses operate is to generate revenue. Revenue oftenrepresents one of the largest figures in the financial statements, and growth in revenue is often used as akey performance indicator by investors. In more traditional businesses the point at which revenue shouldbe recognised is usually straightforward. However, in recent years as business transactions have becomemore complex this area of accounting has become more controversial with some companies adoptingaggressive, and in some cases questionable, accounting policies for revenue recognition.

The result of these policies can be seen in many of the high profile accounting scandals that we have seen inrecent years. For example, the early success of many of the dot.com companies in the 1990s was the resultof the manipulation of revenue leading to inflated profits.

Capital markets need to have confidence in financial statements. This means that there must be a consistentapproach to revenue recognition but also an approach which is able to deal with the wide range oftransactions which currently exist.

BAS 18 Revenue aims to provide this guidance.

Inventories

The significance of inventories to a business will largely depend on the nature of the business. For amanufacturing entity, for example, inventories are likely to be one of the most significant balances on thebalance sheet, typically representing 10%-20% of total assets. By contrast a company in the services sectorwould typically hold small amounts of inventories.

Where inventory does represent a significant asset one of the key business issues is risk. This includes therisk of poor inventory management leading to excessive amounts of capital being tied up, which in turnaffects the cash flow of the business. Entities operating in a dynamic environment, such as the technologyindustry, can also face the problem of obsolescence.

These business risks can cause issues for the valuation of inventories for accounting purposes. The valuationof inventories will involve management judgement. For example, decisions will need to be made aboutwhich costs to allocate to individual items of inventory and estimates may need to be made regardingestimated selling prices in order to establish net realisable value. These decisions will have an impact notonly on the balance sheet value of the asset but will also have a direct impact on reported profits.

BAS 2 Inventories provides guidance in this area.

REVENUE AND INVENTORIES


7

Stop and think

What is the relationship between revenue recognition and inventories?

Working context

Accounting for revenue and inventories is a complex area as there are many judgemental decisions whichneed to be made. As a result of this it is likely that more senior members of staff will be involved. If youwork in audit you may have been involved in some aspects of this work, for example attending inventorycounts.

Syllabus links

Revenue

You will have come across the accounting treatment of revenue in your earlier studies without necessarilybeing aware of this. In your Accounting studies you will have been introduced to the basic double entry forboth a cash and a credit sale. With a credit sale the revenue is recognised in advance of the cash beingreceived.

The Financial Accounting syllabus builds on this basic knowledge by putting the topic into the context ofBAS 18 Revenue. This sets out the basic principles of revenue recognition and introduces more complextransactions.

Inventories

In the Accounting paper you will have covered the basic principles of inventory valuation, i.e. inventory isvalued at the lower of cost and net realisable value. You will also have dealt with the accounting entry forinventories as a year-end adjustment to a trial balance being:

DR Inventories (Balance sheet asset)CR Cost of sales (Income statement)

The Financial Accounting syllabus looks in more detail at the guidance provided by BAS 2 Inventories,particularly the calculation of cost and net realisable value.

The related topic of construction contracts will be covered in the Financial & Corporate Reporting syllabus.



Examination context


Revenue is most likely to feature in a mixed question or in a company accounts question where an incomestatement is produced from a trial balance. It may also be tested in the short-form question section of thepaper.

Inventories could be examined in both the short-form questions and the written test section of the paper.In the written test section it is possible that it could be examined in its own right although it is more likelyto feature in a mixed question or a published accounts question.



– BAS 18 Revenue– BAS 2 Inventories



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1 Introduction

Section overview

Both revenue recognition and accounting for inventories are affected by the application of the accrualbasis of accounting.

The key issue affecting revenue is the timing of recognition.

The key issue affecting inventories is the identification of which costs should be:

– Carried forward in the balance sheet– Expensed as part of cost of sales.

1.1 Background issues

Financial statements are prepared on the underlying assumption of the accrual basis of accounting,whereby effects of transactions are recognised when they occur and not when the cash associated withthem is received or paid.

But this raises questions about when a transaction 'occurs':

Is it when the buyer takes possession of the goods, in circumstances where the contract for salecontains clauses that seek to ensure that ownership does not pass to the customer until the seller hasbeen paid in full?

It is when services are provided, in circumstances where the seller undertakes to come back to doadditional work without charge if needed, e.g. remedial work carried out by a building contractor?

When does the profit arise on the contract for the provision of services to a customer over time,such as under a maintenance contract of two years' duration? Only at the start, only in the middle,only at the end, or over the period of two years?

In addition there are issues about which costs to include in the balance sheet carrying amount forinventories.

Should the amount include only those variable costs that are incurred in the manufacture? After all,fixed costs are incurred regardless of volume of activity and perhaps should be recognised in profit orloss as incurred.

Or should the amounts include fixed costs? And if so, which? Should general administration costs beincluded?

Finally there is the issue of how to identify the cost of goods which must be removed from the carryingamount of inventories when they are sold:

Should it be the cost of the goods manufactured longest ago? Should it be the cost of those manufactured most recently? Or should some sort of average cost be used?

The timing of the recognition of revenue is critical to the timing of profits, while the amount of year-end inventories has a CU for CU effect on the profits earned in the period. So the way these arecalculated is vital to any real understanding of the financial performance in the period.



2 BAS 18 Revenue

Section overview

Revenue is income arising in the normal course of an entity’s activities.

Revenue should be recognised when it is probable that future economic benefits will flow to theentity and when these benefits can be measured reliably.

BAS 18 Revenue provides guidance on the recognition of revenue arising in the following transactions:

– Sale of goods– Rendering of services– The use by others of entity assets yielding interest, royalties and dividends.

Although detailed rules apply to the above, generally revenue is recognised when the entity hastransferred to the buyer the significant risks and rewards of ownership and when that revenue can bemeasured reliably.

2.1 Objective and scope

BAS 18 prescribes the accounting treatment of revenue recognition in common types of transaction. Itstates that in general terms revenue should be recognised:

When it is probable that future economic benefits will flow to the entity and These benefits can be measured reliably.

BAS 18 applies to:

Sale of goods (manufactured items and items purchased for resale).

The rendering of services (which typically involves the performance by the entity of a contractuallyagreed task over an agreed period of time).

The use by others of entity assets yielding interest, royalties and dividends.

The standard specifically excludes various types of revenue arising from leases, insurance contracts, changesin value of financial instruments or other current assets, natural increases in agricultural assets and mineralore extraction.

2.2 Revenue

Income is defined in BFRS Framework as 'increases in economic benefits in the form of inflows orenhancements of assets or decreases of liabilities that result in increases in equity.' Revenue is simplyincome arising in the ordinary course of an entity's activities and it may be called different namessuch as:

Sales Turnover Interest Dividends Royalties

Revenue is defined by BAS 18 as follows:

Definition

Revenue: The gross inflow of economic benefits during the period arising in the course of the ordinaryactivities of an entity when those flows result in increases in equity, other than increases relating tocontributions from equity participants.



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Points to note

1 The reference to 'gross' inflow requires revenue to be shown gross of the costs associated withearning it (an example of the general prohibition against netting off in financial statements).

2 The reference to 'increases in equity' precludes the inclusion in revenue of amounts collected onbehalf of others, e.g. sales tax (VAT in Bangladesh) and amounts collected by agents on behalf ofa principal.

2.3 Measurement

When a transaction takes place, the amount of revenue is usually decided by the agreement of the buyerand the seller. The revenue, however, should be measured at the fair value of the consideration receivedor receivable.

Definition

Fair value: The amount for which an asset could be exchanged, or liability settled, between knowledgeable,willing parties in an arm's length transaction.

Fair value will take into account any trade discounts and volume rebates allowed by the seller.

In straightforward situations the requirement to measure revenue at fair value provides few problems. Sosales on credit terms of 30 days will be measured at the amount receivable in 30 days, net of all salesallowances such as quantity discounts.

Problems can arise where much longer credit intervals are allowed.

Worked example: Deferred payment

Comfy Couches Ltd sells an item of furniture to a customer on 1 September 20X7 for CU2,500 with a one-year interest-free credit period. The fair value of the consideration receivable is CU2,294. (In other words,if the company tried to sell this debt, this is the amount it would expect to receive now.)

In this case the transaction would be split into two components:

Interest revenue of CU206 (2,500 – 2,294), which would be recognised over the period of credit Sales revenue of CU2,294, which would be recognised on 1 September 20X7.

When goods or services are 'swapped' for those of similar nature and value, then no revenue is created(and no additional cost recorded), because all that is really taking place is the substitution of one good orservice by something very similar. Such transactions are quite common in the sale of commodities.

When the goods/services are dissimilar, then there are transactions which generate revenue and cost,measured by reference to the fair value of what is received.

2.4 Sale of goods

Revenue should only be recognised when all of the following conditions are satisfied.

The entity has transferred the significant risks and rewards of ownership of the goods to thebuyer.

The seller no longer has management involvement or effective control over the goods.

The amount of revenue can be measured reliably.

It is probable that the economic benefits associated with the transaction will flow to the entity.

The costs incurred in respect of the transaction can be measured reliably.



Points to note

1 In most cases the transfer of risks and rewards of ownership coincides with the transfer oflegal title, or the passing of possession to the buyer. This is the case for most retail sales.

2 If the entity retains significant risks of ownership, the transaction is not a sale and revenue is notrecognised.

Examples of this type of situation include the following:

When the seller retains some obligation for unsatisfactory performance which is outside anormal warranty cover.

If the receipt of the revenue from a particular sale depends on the buyer receiving revenue fromhis own sale of the goods.

When the goods are shipped subject to installation and the installation is a significant part of thecontract which has not yet been completed by the seller (revenue should not be recognised untilthe installation has been completed).

3 It is possible for the seller to retain only an insignificant risk of ownership and for the sale and revenueto be recognised. Common examples include the following situations:

Where the seller retains title only to ensure collection of what is owed on the goods. Where an item may be returned and a refund provided.

4 The probability of the entity receiving the revenue arising from the transaction must be assessed.For example, in most cases revenue in relation to credit sales is recognised before actual payment isreceived. However, where collectability is called into doubt and recovery has ceased to be probable,the amount should be recognised as an expense and not an adjustment to revenue previouslyrecognised.

5 Matching should take place, i.e. revenue and expenses relating to the same transaction should berecognised at the same time. In some cases expenses may need to be estimated at the date of sale,e.g. warranty costs. Where they cannot be estimated reliably, then revenue cannot be recognised; anyconsideration that has already been received is treated as a liability.

Worked example: Sale of goods

Morgan Motors Ltd sells a car for CU15,000 with one year's free credit. There is a three-yearmanufacturer’s warranty on the vehicle.

Revenue will be recognised at the time of sale, but:

The CU15,000 receivable will be split between interest earned and the cash sale price.

The cash sale price will be recognised in the period the sale is made.

The interest income will be recognised over the period of free credit.

The production and selling costs of the car will be set against the cash sale price. At the same time acharge to the income statement will be made to set up a warranty provision for the expected costs ofcarrying out the expected amount of warranty work over the three-year warranty period.

Costs incurred on the warranty work over the three years will be charged to the provision, with anyover-provision being written back (and any under-provision being charged) to the income statement.



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2.5 Rendering of services

When the outcome of a transaction involving the rendering of services can be estimated reliably, theassociated revenue should be recognised by reference to the stage of completion of the transaction atthe balance sheet date. The outcome of a transaction can be estimated reliably when all of the followingconditions are satisfied.

The amount of revenue can be measured reliably

It is probable that the economic benefits associated with the transaction will flow to the entity

The stage of completion of the transaction at the balance sheet date can be measured reliably

The costs incurred for the transaction and the costs to complete the transaction can be measuredreliably

The recognition criteria above are similar to those for the sale of goods. One of the key differences is theneed to be able to determine the stage of completion of the transaction. This is of particular relevancewhen the completion of a contract for services straddles more than one accounting period. Thefollowing methods of assessing the stage of completion are referred to in BAS 18:

Surveys of work performed Services performed to date as a percentage of total services to be performed The proportion that costs incurred to date bear to the estimated total costs of the transaction.

Progress payments and advances received from customers often do not reflect the services performed. As aresult it is normally inappropriate to recognise revenue based on payments received.

If the overall outcome of a services transaction cannot be estimated reliably, then revenue is onlyrecognised to the extent of those costs incurred that are recoverable from the client.

Interactive question 1: Rendering of services [Difficulty level: Easy]

A CU210,000 fixed-price contract is entered into for the provision of services. At the end of 20X7, the firstaccounting period, the contract is thought to be 33% complete and costs of CU45,000 have been incurredin performing that 33% of the work.

Requirements

Calculate the revenue to be recognised in 20X7 on the alternative assumptions that:

(a) The costs to complete are reliably estimated at CU90,000; and

(b) The costs to complete cannot be reliably estimated and it is thought that CU40,000 of the costsincurred are recoverable from the customer.


(a) Cost to complete are CU90,000

(b) Cost to complete cannot be estimated reliably




2.6 Investment income

When others use the enterprise's assets yielding interest, royalties and dividends, the revenue should berecognised when:

(a) It is probable that the economic benefits associated with the transaction will flow to the enterpriseand

(b) The amount of the revenue can be measured reliably.

The revenue is recognised on the following bases.

Interest is recognised on a time proportion basis that takes into account the effective yield on theasset.

Royalties are recognised on an accrual basis in accordance with the substance of the relevantagreement.

Dividends are recognised when the shareholder's right to receive payment is established. This isusually when the dividends are declared.

2.7 Disclosure

The following items should be disclosed.

The accounting policies adopted for the recognition of revenue, including the methods used todetermine the stage of completion of transactions involving the rendering of services

The amount of each significant category of revenue recognised during the period includingrevenue arising from:

– The sale of goods– The rendering of services– Interest– Royalties– Dividends

The amount of revenue arising from exchanges of goods or services included in each significantcategory of revenue

Any contingent gains or losses, such as those relating to warranty costs, claims or penalties should betreated according to BAS 37 Provisions, Contingent Liabilities and Contingent Assets (covered in Chapter 9).

2.8 Practical application

BAS 18 includes an appendix which demonstrates the application of its concepts to particular types oftransactions. These include the following:

Consignment sales Under such arrangements, the buyer of the goods undertakes to sell them on,but on behalf of the original seller. So the buyer is effectively acting as an agenton behalf of the original seller. The original seller only recognises his salewhen his buyer sells them on to a third party.

This treatment also applies to sale and return transactions.

Lay away sales Under these arrangements, the goods are only delivered once the finalinstalment has been received, so it is only then that the risks and rewards ofownership move from seller to buyer and revenue can be recognised.

For example, with the recent launches of Harry Potter books, it has beencommon for customers to put down some money to reserve a copy. This willbe recognised as revenue when the balance is paid up and the book isdelivered to the customer.



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Sale and repurchaseagreement

This is an agreement whereby the seller concurrently agrees to repurchase thesame goods at a later date, or where there are call or put options in place.

The terms of the agreement need to be considered to determine whetherthere is a sale in substance. Where legal title has been transferred but therisks and rewards of ownership have been retained by the seller revenue is notrecognised and the transaction is treated as a financing arrangement. (Welooked at the principle of substance over form in Chapter 1.)

Subscriptions topublications

Where a series of publications is subscribed to and each publication is of asimilar value, e.g. a monthly magazine, revenue is recognised on a straight-line basis over the period in which the publications are despatched.

Where the value of each publication varies revenue is recognised on the basisof the sales value of the item despatched in relation to the estimated salesvalue of all items covered by the subscription.

Servicing feesincluded in the priceof the product

When an item's sales price includes 'free' servicing, revenue in relation to thatservicing should be deferred and recognised over the servicing period.The amount deferred should be sufficient to cover both the cost of servicingand a reasonable profit.

Tuition fees Revenue should be recognised over a period of time (the period ofinstruction), in line with the way the services are provided over thatperiod of time.

Advertisingcommissions

Media commissions, e.g. payment for a series of adverts, should be recognisedwhen the related advertisement or commercial appears before thepublic.

Note that the whole of this Appendix falls within the scope of the Financial Accounting syllabus, with theexception of paragraphs 9, 10, 13 and 14.

Interactive question 2: Sale and repurchase [Difficulty level: Exam standard]

Builder Ltd specialises in building high quality executive flats in city centres. On 1 March 20X6 it sells a plotof building land to Finance Ltd, an unconnected company, for CU1.5m. Builder Ltd retains rights of accessand supervision over the plot, the right to build on this land until 28 February 20X8 and the right to buy theplot back again on that date for CU1.9m. On 1 March 20X6 the plot is valued at CU2.5m.

Requirement

Explain how this sale transaction would be dealt with in Builder Ltd's financial statements for the year ended28 February 20X7.




Interactive question 3: Servicing fees [Difficulty level: Exam standard]

On the last day of its current accounting period, Computer Ltd completes the handover of a new system toa client and raises an invoice for CU800,000. This price includes after-sales support for the next two years,which is estimated to cost CU35,000 each year. Computer Ltd normally earns a gross profit margin of17.5% on such support activity.

Requirement

Calculate the revenue to be included in Computer Ltd’s current year income statement in respect of this sale.

Fill in the proforma below.CU

After-sales supportRemainderTotal selling priceSo the revenue in the current year is


3 BAS 2 Inventories

Section overview

Inventories should be measured at the lower of cost and net realisable value (NRV).

Cost comprises the costs of:

– Purchase– Conversion– Bringing the inventories to their present location and condition.

The comparison of cost and NRV should be performed on an item-by-item basis although similaritems may be grouped together.

Where the cost of individual items cannot be determined a cost formula may be used. These are:

– First-in, first-out (FIFO)– Weighted average cost.

When an item is sold it is recognised as an expense in the income statement together with therelated revenue.

3.1 Objective and scope

The objective of BAS 2 Inventories is to prescribe the accounting treatment for inventories. In particular itprovides guidance on the determination of cost and its subsequent recognition as an expense, includingany write-down to net realisable value.

BAS 2 applies to all inventories except the following:

Work in progress under construction contracts Financial instruments (e.g. shares, bonds) Biological assets

The treatment of the above are all outside the scope of the Financial Accounting syllabus.

Certain inventories are exempt from the standard's measurement rules, i.e. those held by:

Producers of agricultural, forest and mineral products Commodity-broker traders.



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3.2 Inventories

Definition

Inventories. Assets:

Held for sale in the ordinary course of business

In the process of production for such sale; or

In the form of materials or supplies to be consumed in the production process or in the rendering ofservices.

Inventories can include:

Goods purchased and held for resale Finished goods Work in progress being produced Raw materials awaiting use

3.3 Measurement of inventories

Inventories should be measured at the lower of cost and net realisable value (NRV).

Definitions

Cost: Comprises all costs of purchase, costs of conversion and other costs incurred in bringing theinventories to their present location and condition.

Net realisable value: The estimated selling price in the ordinary course of business less the estimatedcosts of completion and the estimated costs necessary to make the sale.

A write-down of inventories would normally take place on an item-by-item basis, but similar or relateditems may be grouped together. This grouping is acceptable for, say, items in the same product line, butit is not acceptable to write-down inventories based on a whole classification (e.g. finished goods) or awhole business.



Worked example: Measurement of inventories

The following information relates to the inventories of a business with a year end of 31 December 20X5:

Product A Product BCUm CUm

Manufacturing cost in 20X5 80 60

Revenue on sale in January 20X6 110 50Selling costs incurred in January 20X6 (8) (4)Net realisable value 102 46

Profit/(loss) 22 (14)Inventory value at 31 December 20X5, thelower of cost and net realisable value 80 46

Taking the lower of the two values ensures that:

Any profit earned is not recognised in advance of the item being sold

Any loss otherwise incurred in the future is recognised in the current accounting period through thiswrite-down to below cost.

Points to note

The comparison of cost and NRV is performed for each product separately.

3.4 Cost of inventories

As we have seen from the definition of cost in section 3.3:

The cost of inventories will consist of:

Cost of purchase Costs of conversion Other costs incurred in bringing the inventories to their present location and condition

Costs of purchase

BAS 2 lists the following as comprising the costs of purchase of inventories.

Purchase price plus

Import duties and other taxes plus

Transport, handling and any other costs directly attributable to the acquisition of finished goods,services and materials less

Trade discounts, rebates and other similar amounts.

Costs of conversion

Costs of conversion of inventories consist of two main parts.

Costs directly related to the units of production, e.g. direct materials, direct labour

Fixed and variable production overheads that are incurred in converting materials into finishedgoods, allocated on the basis of normal production capacity.

You may have come across the terms 'fixed production overheads' or 'variable production overheads'elsewhere in your studies.



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Definitions

Fixed production overheads: Those indirect costs of production that remain relatively constantregardless of the volume of production, such as depreciation and maintenance of factory buildings andequipment, and the cost of factory management and administration.

Variable production overheads: Those indirect costs of production that vary directly, or nearly directly,with the volume of production, such as indirect materials and labour.

BAS 2 emphasises that fixed production overheads must be allocated to items of inventory on the basis ofthe normal capacity of the production facilities. This is an important point.

Normal capacity is the expected achievable production based on the average over severalperiods/seasons, under normal circumstances.

The above figure should take account of the capacity lost through planned maintenance.

If it approximates to the normal capacity then the actual level of production can be used.

The allocation of variable production overheads to each unit is based on the actual use of productionfacilities.

As a result:

Low production or idle plant will not result in a higher fixed overhead allocation to each unit.

Unallocated overheads must be recognised as an expense in the period in which they wereincurred.

When production is abnormally high, the fixed production overhead allocated to each unit will bereduced, so avoiding inventories being stated at more than cost.

Worked example: Fixed production overheads

A business plans for fixed production overheads of CU50,000 and annual production of 100,000 items in itsfinancial year. So the planned overhead recovery rate is 50p per item.

A fire at the factory results in production being only 75,000 units, with no saving in fixed productionoverheads.

Inventory should still be valued on the basis of 50p per item, leading to a recovery of CU37,500 ofoverheads. The CU12,500 balance of overhead cost must be recognised as an expense in the year.

Other costs

Any other costs should only be recognised if they are incurred in bringing the inventories to their presentlocation and condition.

BAS 2 lists types of cost that would not be included in cost of inventories. Instead, they should berecognised as an expense in the period in which they are incurred.

These include:

Abnormal amounts of wasted materials, labour or other production costs

Storage costs (except costs that are necessary in the production process before a furtherproduction stage)

Administrative overheads not incurred to bring inventories to their present location and condition

Selling costs.



Interactive question 4: Cost of inventories [Difficulty level: Exam standard]

A manufacturing business incurs the following expenditure.

Include in costof inventories

Recognised as anexpense as incurred

Supplier's gross price for raw materials

Quantity discounts allowed by supplier

Purchase taxes and duties charged by supplierand recoverable from taxing authorities

Costs of transporting materials to thebusiness' premises

Labour costs directly incurred in theprocessing of raw materials

Variable costs, such as power, incurred in theprocessing of raw materials

Fixed production costs/overheads, such asrent for the processing factory anddepreciation charges on the plant used in theprocessing

Costs of holding finished goods in inventory

Costs of transporting goods to customer onsale

Purchase taxes charged to customer on sale

Commission payable to salesmen on sale ofthe goods

Allowance for bad and doubtful debts inrelation to trade receivables

Costs of accounts department

Head office costs relating to the overallmanagement of the business

Requirement

Identify in the table above the expenditures to be included in the cost of inventories and those to berecognised as an expense as incurred.

Fill in the proforma above.

Commentary on Interactive question 4

In terms of the normal operating cycle of a business, all costs up to the time goods are taken intoinventory will be costs incurred in bringing items to their present location and condition. But allcosts of holding goods in inventory, selling the goods and collecting outstanding receivables are notincurred for this reason; nor are the general costs of accounting for and managing the business.

Fixed production costs/overheads are to be included in inventory values, but only at the rates basedupon normal levels of output. These rates should not be increased as a result of production beingbelow expected levels, as a result of plant failures, for example.




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Techniques for the measurement of cost

Two techniques are mentioned by the standard, both of which produce results that approximate to cost,and so both of which may be used for convenience.

(a) Standard costs: these are set up to take account of normal levels of raw materials used, labour timeetc. They are reviewed and revised on a regular basis.

(b) Retail method: this is often used in the retail industry where there is a large turnover of inventoryitems, which nevertheless have similar profit margins. The only practical method of inventory valuationmay be to take the total selling price of inventories and deduct an overall average profit margin, thusreducing the value to an approximation of cost. The percentage will take account of reduced pricelines. Sometimes different percentages are applied on a departmental basis.

Worked example: Retail method

A retailer identifies inventories at the end of an accounting period as follows:

Department A: inventories with a selling price of CU30,000. This department makes a 25% grossprofit on its sales

Department B: inventories with a selling price of CU21,000. This department sets its selling prices atcost plus 50%.

Requirement

Calculate the value of inventories in each department.

Solution

Department A: Selling price of inventories CU30,000 less gross profit 25% = CU22,500

Department B: If selling price is cost plus 50%, then selling price must be 150% of costand the gross profit margin must be 50/150 = 33.3%Selling price of inventories CU21,000 less gross profit 33.3% = CU14,000

3.5 Cost formulae

It is possible to attribute specific costs to items that are not interchangeable and to items produced forspecific projects or customers and it is these costs which are used in arriving at inventory valuations.

But many inventories include items that are interchangeable with each other, in which case it isnot possible to identify a specific cost for a specific item. In these cases, cost formulae should beused, which make assumptions about which of the items produced have been sold and which are still held ininventory, and therefore about the cost of inventory.

Only two cost formulae are allowed under BAS 2:

First-in, first-out (FIFO) Weighted average cost

This assumes a physical flow of items wherebythose produced earliest are the first to besold. The items produced most recently are theones in inventory, to be measured at the mostrecent production cost.

This formula calculates an average cost ofproduction (either at the end of each period orafter each new batch has been produced,depending on the circumstances of the company)and measures inventories at that average cost.

Points to note

1 The last-in, first-out (LIFO) formula (which makes an assumption about the physical flows of items thatis the opposite of FIFO) is not permitted by BAS 2. The reasoning, not included in the BAS, is thatLIFO is not a reliable representation of the actual flow of items into and out of inventory.

2 The same cost formula must be used for all inventories having a similar nature. This limitation onmanagement choice is aimed to ensure that like items are accounted for in like ways.



Worked example: Cost formulae

A business produces and sells the following quantities of a product:

Date Tonnes CU Total CU per tonne1 July Opening inventory 10 200 204 July Production 8 176 226 July Sale -915 July Production 6 144 2418 July Sale -1123 July Production 4 104 2631 July Closing inventory 8

The FIFO cost formula will result in closing inventory being made up of the most recent production, i.e. the4 tonnes produced on 23 July (costing CU104) and 4 of the 6 tonnes produced in 15 July (at CU24 = CU96cost). So closing inventory will be valued at CU200.

Using the weighted average cost formula and calculating the average cost at the end of the period, the totalcost of CU624 (CU200 + CU176 + CU144 + CU104) is divided by the total number of units of 28 (openinginventory of 10 plus production of 8 + 6 + 4), giving a weighted average cost of CU22.29 per tonne. Appliedto closing inventory of 8 tonnes, this gives a valuation of CU178.

As average production costs are rising, the weighted average cost formula, which smoothes changes out,results in a slightly lower inventory value (and therefore lower period profit) than the FIFO formula whichdoes not include any smoothing.

3.6 Net realisable value

As a general rule assets should not be carried at amounts greater than those to be realised fromtheir sale or use. This applies to inventory where NRV falls below cost. There are a number ofreasons why this may be the case, including the following:

An increase in costs or a fall in selling price A physical deterioration in the condition of inventory Obsolescence of products A strategic decision to manufacture and sell products at a loss Errors in production or purchasing

Where NRV falls below cost the inventory is written down to its recoverable amount and the fall invalue is charged to profit or loss, i.e. to the income statement. The write-down may be of suchsize, incidence or nature that it must be disclosed separately.

Points to note

1 In the case of incomplete items, NRV must take account of costs to complete.

2 In the absence of a contractually agreed selling price, the best estimate must be made of the likelyselling price and then appropriate deductions made from it.

3 Materials to be incorporated into a finished product should only be written down if that finishedproduct will be sold at below its cost.

4 Net realisable value must be reassessed at the end of each period and compared again with cost.This may result in the reversal of all or part of the original write-down.

3.7 Recognition as an expense

Once an item has been sold, it cannot remain in inventories as it no longer meets BFRS Frameworkdefinition of an asset. Its carrying amount is recognised as an expense in the accounting period in whichthe item is sold and the related revenue recognised.



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3.8 Disclosure

The financial statements should disclose the following:

Accounting policies adopted in measuring inventories, including the cost formula used

Total carrying amount of inventories and the carrying amount in classifications appropriate tothe entity (e.g. merchandise, production supplies, materials, work in progress, finished goods)

Carrying amount of inventories carried at fair value less costs to sell

The amount of inventories recognised as an expense in the period

The amount of any write-down of inventories recognised as an expense in the period

The amount of any reversal of any write-down that is recognised as a reduction in the amount ofinventories recognised as an expense in the period

Circumstances or events that led to the reversal of a write-down of inventories

Carrying amount of inventories pledged as security for liabilities

The financial statements must also disclose one of two things:

The cost of inventories recognised as an expense during the period.

The operating costs, applicable to revenues, recognised as an expense during the period, classifiedby their nature.

The choice reflects differences in the way the income statement can be presented (see Chapter 2).




Summary



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Self-test


1 Caplin sells two types of product to Webber, the sleigh and the sled. Webber sells the sleigh as anagent of Caplin receiving commission of 15% on selling price. Caplin sells the sled as principal at agross margin of 30%.

The following information relates to the year ended 30 September 20X8.Sleigh Sled

CU CURevenue 200,000 75,000Gross profit 60,000 22,500

According to BAS 18 Revenue what revenue should Webber recognise in total for sleighs and sleds forthe year ended 30 September 20X8?

A CU52,500B CU82,500C CU105,000D CU275,000

2 On 1 January 20X0, Alexander Ltd supplied goods to David Ltd for an agreed sum of CU600,000. Thisamount becomes payable on 31 December 20X2. David Ltd could have bought the goods for cash ofCU450,000 on 1 January 20X0. The imputed rate of interest to discount the receivable to the cashsales price is 10%.

In accordance with BAS 18 Revenue what should Alexander Ltd record in the income statementrelating to this transaction for the year ended 31 December 20X0?

Revenue Interest incomeCU CU

A 450,000 45,000B 600,000 –C 600,000 60,000D 450,000 –

3 Oxford Ltd publishes a monthly magazine, which is sold for CU4.00 per issue with costs of CU2.00per issue to produce. Oxford Ltd received CU48,000 in annual subscriptions and had produced fourissues by the year end of 31 January 20X8.

In accordance with BAS 18 Revenue what revenue in relation to the magazines should be recognised byOxford Ltd for the year ended 31 January 20X8?

A CU8,000B CU16,000C CU24,000D CU48,000

4 Southwell Ltd, a manufacturing company, sold a property with a carrying amount of CU4.5m forCU5m to Financier Ltd on 1 January 20X4. Southwell Ltd retains the right to occupy the property andhas an option to repurchase the property in two years' time for CU6 million. Property prices areexpected to rise and the current market value is CU8 million. The annual rate for 20% over two yearsis 9.5%.

In accordance with BAS 18 Revenue what should be recognised in the financial statements relating tothis transaction for the year ended 31 December 20X4?

A Revenue CU5 million, profit on sale of asset CU0.5 millionB Non-current liability CU5 million, interest expense CU0.475 millionC Non-current liability of CU6 millionD Non-current liability CU5.475 million, interest CU0.475 million



5 Space Ltd sells a specialised piece of equipment to Planet Ltd on 1 September 20X7 for CU1.5m. Dueto the specialised nature of the equipment, Space Ltd has agreed to provide a support service for thenext two years. The cost to Space Ltd of providing this service will be CU120,000. Space Ltd usuallyearns a gross margin of 20% on such contracts.

What revenue should be included in the income statement of Space Ltd for the year ended31 December 20X7 according to BAS 18 Revenue?

A CU1,500,000B CU1,525,000C CU1,620,000D CU1,650,000

6 DIY Ltd is a hardware store about to stock a new type of drill. Customer demand is high and DIY Ltdhas started taking advance orders for the drill. The selling price of the drill will be CU50.00 and so far100 customers have paid an initial advance deposit of CU5.00 per drill. DIY Ltd expects to make a 10%margin on the drill.

At the year end, the drill is not yet in stock. What revenue should DIY Ltd recognise in the incomestatement for this transaction according to BAS 18 Revenue?

A CUnilB CU50C CU500D CU5,000

7 Major Ltd has entered into a contract for the provision of services over a two-year period. The totalcontract price is CU150,000. In the first year costs of CU60,000 have been incurred and 50% of thework has been completed. The contract has not progressed as expected and Major Ltd is not sure ofthe ultimate outcome, but believes that the costs incurred to date will be recovered from thecustomer. Major Ltd initially expected to earn a profit of CU20,000 on the contract.

According to BAS 18 Revenue what revenue should be recognised in the first year of the contract?

A CU40,000B CU60,000C CU65,000D CU75,000

8 White Goods Ltd sells an electrical appliance for CU2,400 on 1 October 20X7 making a mark up oncost of 20%. The customer is given a one-year interest-free credit period. The fair value of theconsideration receivable in one year's time is CU2,202.

In accordance with BAS 18 Revenue, what amount should the company recognise as revenue from thesale of the appliance in the income statement for the year ended 31 December 20X7?

A CUnilB CU2,000C CU2,202D CU2,400

9 Taunton Ltd manufactures spare parts for a range of agricultural equipment. These are sent from itsChittagong factory to its various distribution centres in Bangladesh and East Asia.

According to BAS 2 Inventories, which of the following expenses should be included as part of the costof finished goods inventories?

A Rectification costs of a lorry-load of parts that were badly damaged in an accident en route toone of the distribution centres

B Expenses paid to the firm's lorry-drivers for transporting parts from the distribution centres tocustomers

C Shipping costs for drivers and lorries to East Asia distribution centre

D Subsistence and accommodation expenses relating to the return journey from East Asia



7

10 Quick Ltd absorbs its production overheads on the basis of units produced. Cost data relating to unitsof production for the year to 31 December 20X3 are as follows.

Material (for 10,000 units actually produced) CU10,000Sub-contract labour CU20,000Fixed production overheads CU50,000

There are 1,000 units in inventories at the year end. Production was half the normal activity level.

In accordance with BAS 2 Inventories the figure for inventories in the balance sheet on 31 December20X3 should be:

A CU4,000B CU4,500C CU5,500D CU8,000

11 There are a number of methods for determining purchase price or production cost of inventories.

In addition to FIFO, BAS 2 Inventories allows

A Both LIFO and weighted average costB Only LIFOC Only weighted average costD Neither LIFO nor weighted average cost

12 For a retail trading company using a FIFO basis for the valuation of inventories, which of the followingstatements is correct according to BAS 2 Inventories?

A If the volume of inventories is unchanged in the year, and purchase prices are rising, there will bea net debit in the income statement in relation to changes in inventories during the year

B If the volume of inventories increases during the year, and purchase prices are rising, there willbe a net debit in the income statement in relation to changes in inventories during the year

C If the volume of inventories decreases during the year, and purchase prices are falling, there willbe a net credit in the income statement in relation to changes in inventories during the year

D If the volume of inventories is unchanged during the year, and purchase prices are rising, therewill be a net credit in the income statement in relation to changes in inventories during the year

13 In 20X5 when purchase prices are rising but physical inventory levels are remaining constant, GarthLtd changes its accounting policy for identifying inventories from weighted average cost to FIFO. Willthe 20X5 gross trading loss and net current liabilities at the end of the period be higher or lowerunder the new policy than if the previous policy had been retained?

Gross trading loss Net current liabilitiesA Lower LowerB Lower HigherC Higher LowerD Higher Higher

14 The normal selling price of an item included in year end inventories is CU21 per unit. The itemoriginally cost CU15 per unit, but could only be sold at the normal selling price after modificationswere made after the year end at a cost of CU5 per unit. The scrap value of the item is CU11 per unit.

Under BAS 2 Inventories the item should be included in the financial statements at

A CU16 per unitB CU15 per unitC CU11 per unitD CU10 per unit



15 Hunt Ltd has prepared the following schedule of its inventories.

Purchase Attributable Attributable Expectedprice of production distribution selling

raw overheads overheads to pricematerials incurred be incurredCU CU CU CU

Item X 80 10 12 85Item Z 20 5 10 40

100 15 22 125

According to BAS 2 Inventories what is the aggregate amount at which inventories should be stated inthe balance sheet of Hunt Ltd?

A CU98B CU103C CU120D CU125

16 Greenmore Ltd is making a product for a customer. The cost to date is CU35,000. Owing to a changein government regulations an additional CU12,000 will need to be spent before the product can besold. The customer agrees to pay half of this. The initially agreed selling price was CU40,000.

At what amount should inventories be carried in the financial statements of Greenmore Ltd accordingto BAS 2 Inventories?

A CU40,000B CU35,000C CU34,000D CU28,000

17 On 31 December 20X8 Miskin Ltd had closing inventories of widgets that cost CU400,000. Thesewere sold in February 20X9 for CU500,000. The following costs were incurred on disposal.

Marketing costs CU50,000Selling costs CU50,000Distribution costs CU50,000

On 31 December 20X8 Miskin Ltd also had closing work in progress of grommets with a standardcost of CU900,000. Relating to this work in progress were favourable variances of CU20,000 andadverse variances of CU10,000, neither relating to efficiency.

In accordance with BAS 2 Inventories what is the total amount of inventories in the closing balancesheet?

A CU1,240,000B CU1,260,000C CU1,290,000D CU1,310,000

18 PARSON LTD

Parson Ltd has entered into the following transactions during the year ended 31 December 20X3.

(1) On 1 October 20X3 Parson Ltd received CU400,000 in advance subscriptions. The subscriptionsare for 20 monthly issues of a magazine published by Parson Ltd. Three issues of the magazinehad been despatched by the year end. Each magazine is of the same value and costsapproximately the same to produce.

(2) A batch of unseasoned timber, which had cost CU250,000, was sold to Banko Ltd for CU100,000on 1 January 20X3. Parson Ltd has an option to repurchase the timber in 10 years' time. Therepurchase price will be CU100,000 plus interest charged at 8% per annum from 1 January 20X3to the date of repurchase. The market value of the timber is expected to increase as it seasons.



7

(3) Parson Ltd made a major sale on 1 January 20X3 for a fee of CU450,000, which related to acompleted sale and after-sales support for three years. The cost of providing the after-salessupport is estimated at CU50,000 per annum, and the mark-up on similar after-sales onlycontracts is 20% on cost.

(4) The food division of Parson Ltd operates its retail outlets on a franchise basis. On 1 January 20X3a new outlet was opened, the franchisee paying a fee of CU500,000 to cover the initial services.The franchise is for five years, and the franchisee will pay an additional annual fee of CU60,000commencing on 1 January 20X3 to cover marketing, managerial and other support servicesprovided by Parson Ltd during the franchise period. Parson Ltd has estimated that the cost ofproviding these services is CU80,000 per annum, and has achieved a gross margin of 20% onproviding similar services on other contracts.

Requirements

(a) Prepare extracts from Parson Ltd's financial statements for the year ended 31 December 20X3,clearly showing how each of the above would be reflected. Notes to the financial statements arenot required. (12 marks)

(b) With reference to transaction (2) above explain the concept of 'substance over form'. (5 marks)

(17 marks)

19 LATENTILE LTD

Latentile Ltd is a newly-formed company, which uses a chemical process to manufacture arevolutionary new roof covering, which it sells at a mark up of 25% on cost. Its inventories consist ofraw material, work in progress and finished goods, and at the end of its first year of trading it is havingproblems valuing inventories.

You ascertain the following information.

(1) Raw material

(i) The process needs at least 100,000 kgs of clay to continue working, but a physical inventorycount reveals that the machinery contains 108,000 kgs.

(ii) The original cost of the initial 100,000 kgs to set up the process was 30p per kg and you findan invoice to show that the last consignment of 20,000 kgs cost 31p per kg. All otherconsignments in the year (a total of 200,000 kgs) cost 32p per kg.

(2) Work in progress

(i) The work in progress is currently all 60% complete and you discover that there are 50,000units currently going through the process.

(ii) The total number of complete units for the period was, as anticipated, 800,000.

(iii) The costs for the process for the period were as follows.CU'000

Raw materials 200Direct labour 242Factory overheads 191Administrative expenses attributable to production 114Distribution costs 90

(3) Finished goods

(i) There were 70,000 units in inventories.

(ii) Of (i) above, it was intended to sell 20,000 units at 75p per unit, a discount of one third onnormal selling price, in a future promotional campaign (a further 10p per unit distributioncost is to be incurred).



Requirements

(a) Explain how BAS 2 Inventories applies the accrual and the going concern bases of accounting.(6 marks)

(b) For each of the above categories of inventory, suggest a method of valuation and show the valueas it would appear in the balance sheet. (6 marks)

(c) If the information regarding costs for the period were not available, suggest an alternativemethod of valuing finished goods. (2 marks)

(14 marks)




7

Technical reference


BAS 18 All paragraphs examinable except examples 9, 10, 13 & 14 in the Appendix.

BAS 2 All paragraphs examinable.


1 BAS 18 Revenue

Revenue recognised when: BAS 18 Objective

– Probable that future economic benefits will flow to the entity; and

– These benefits can be measured reliably.

Apply principle of substance over form.

Revenue defined as gross inflows that result in increase in equity. BAS 18 (7)

– Sales taxes (e.g. VAT) and amounts collected by agent on behalf of principalare excluded.

BAS 18 (8)

Measured as fair value of consideration – discounted where appropriate. BAS 18 (9-11)

Recognition of sale of goods: when buyer has obtained significant risks/rewardsof ownership.

BAS 18 (14)

Recognition of rendering of services: can take account of stage of completion, ifover a long period:

BAS 18 (20)

– Include pro-rata costs and consider costs to complete;

– If overall outcome cannot be estimated reliably, revenue limited to costsrecoverable from customer.

BAS 18 (26)

Practical considerations, including 'free' servicing, where revenue deferred tocover both cost and reasonable profit.

BAS 18 Appendix A

(all but 9, 10, 13

and 14)

2 BAS 2 Inventories

Measurement and disclosure, but not recognition. BAS 2 (1)

Inventories are to be measured at the lower of cost and net realisable value. BAS 2 (9)

Cost = expenditure incurred in bringing the items to their present location andcondition, so the cost of purchase and the cost of conversion.

BAS 2 (10)

– Fixed costs included by reference to normal levels of activity. BAS 2 (13)

Cost formulae: FIFO or weighted average. BAS 2 (25)

– Use same formula for all inventories with similar nature.

Net realisable value takes costs to complete into account, as well as selling costs. BAS 2 (6)

Disclosures include accounting policies, carrying amounts and amountsrecognised as an expense.

BAS 2 (36 and 38)




1 CCU

Revenue recognised as agent (CU200,000 15%) 30,000Revenue recognised as principal 75,000Total revenue 105,000

2 A At the time of supply, revenue is recognised for the cash sale price of CU450,000. Interest willthen be accrued until payment is made. For the year ended 31 December 20X0 the interestcharge is

CU450,000 10% = CU45,000.

3 B Revenue for the magazines should be recognised over the period in which the magazines aredespatched, provided the items are of similar value in each time period. Thus revenue recognised

in the year ended 31 January 20X8 is CU48,000 4/12 = CU16,000.

4 D The substance of this transaction is that of a secured loan as Southwell Ltd retain the risks andrewards of ownership and given that property prices are rising, it is highly likely that therepurchase option will be exercised.

Initial loan: DR Cash CU5mCR Loan CU5m

Interest: DR Interest (Income statement) (5m x 9.5%) CU0.475mCR Loan CU0.475m

Total loan liability is CU5.475m

5 B The sale of equipment of CU1.5m is recognised immediately.

The provision of the support service is recognised over the period of service: 2 years.

CU120,000/0.80 = CU150,000 total value of service contract.

Recognised in current period: CU150,000/2 years 4/12 = CU25,000

Total revenue: CU1.5m + CU0.025m = CU1.525m

6 A Revenue is recognised when the drills are delivered to customers on payment of the finalinstalment. Until then no revenue should be recognised.

7 B If the outcome cannot be estimated reliably then recognise revenue to the extent that expensesincurred are recoverable.

8 C The fair value of the income receivable is recognised as income on 1 October 20X7. Thedifference between this and the sale proceeds (2,400 – 2,202 = 198) is treated as interest and willbe recognised over the 12 month interest-free credit period.

9 C Cost comprises all costs of purchase, conversion and other costs incurred in bringing theinventories to their present location and condition (BAS 2 paragraph 10). Only C meets thisdefinition of costs. Abnormal costs such as A are effectively excluded by BAS 2 paragraph 16(a).



7

10 CCU

Material10,000

CU10,000 = 1.0

Labour10,000

CU20,000 = 2.0

Overheads*50%)(10,000

CU50,000

= 2.5

CU5.5 1,000

CU5,500

* based on normal production capacity (BAS 2 paragraph 13)

11 C BAS 2 (paragraph 25) only allows FIFO and weighted average cost.

12 D

13 A Because prices are rising and physical inventory levels are constant, FIFO will produce a higherinventory figure than weighted average cost. Thus the trading loss and net current liabilities willboth be lower than if the previous policy had been retained.

14 B Inventories should be measured at the lower of cost and NRV.

Cost = CU15

NRV = (21 – 5)= CU16

15 A Inventories should be measured at the lower of cost and NRV.

Cost NRV LowerCU CU CU

Item X 90 73 73Item Z 25 30 25

98

16 C Cost = CU 35,000

NRV = 40,000 – 12,000 costs to complete + 6,000 customer contribution

= CU 34,000

17 ACU'000

NRV of widgets (500 – 50 – 50 – 50) 350Actual cost of grommets (900 – 20 + 10) 890Total inventories 1,240

18 PARSON LTD

(a) Financial statement extracts

Balance sheet as at 31 December 20X3CU

EQUITY AND LIABILITIESNon-current liabilities

Borrowings (100,000 + 8,000) 108,000Deferred income (W2) 280,000

Current liabilitiesDeferred income (W2) 340,000

Income statement for the year ended 31 December 20X3CU

Revenue (W1) 790,000Finance cost (8% 100,000) 8,000



(b) Transaction (2) and substance over form

In a straightforward transaction its commercial effect is the same as its legal form. However, inmore complex transactions the true substance of the transaction may be different from its legalform, with one party having the risks and rewards of ownership but another party having legaltitle to the asset.

In such circumstances recording the legal form of the transaction would not be sufficient toprovide a fair presentation in the financial statements. The financial statements must be presentedfairly in order to meet the qualitative characteristic of reliability.

This transaction appears unusual as the initial sale is below fair value, which raises questionsabout its substance. Parson Ltd has a call option significantly below the current fair value which isexpected to increase over time. The terms of the transaction are that it is almost certain that thetimber will be reacquired, hence this is essentially a sale and repurchase agreement.

Parson Ltd has retained the risks and rewards of ownership, even though legal title has passed.The transaction is effectively a financing agreement secured on the timber, and does not give riseto revenue. The proceeds of CU100,000 are therefore recognised as borrowings in non-currentliabilities. In the year to 31 December 20X3 Parson Ltd should recognise a finance cost ofCU8,000 (8% of CU100,000) which will increase the borrowings.

WORKINGS

(1) RevenueCU

Transaction (1) (3/20 400,000) 60,000Transaction (3)

Sale (450,000 – (50,000 120% 3)) 270,000

After-sales support Year 1 (50,000 120%) 60,000Transaction (4)

Initial fee (500,000 – (40,000 (W2) 5)) 300,000

Continuing fee Year 1 (80,000 100/80) 100,000790,000

(2) Deferred incomeCurrent Non-current

CU CUTransaction (1) (400,000 12/20, 5/20) 240,000 100,000

Transaction (3) (50,000 120% for Years 2 and 3) 60,000 60,000Transaction (4) (100,000 – 60,000 for Years 2 to 5) 40,000 120,000

340,000 280,000

19 LATENTILE LTD

(a) BAS 2

Accrual basis of accounting

The cost of unsold or unconsumed inventories is incurred in the expectation of future economicbenefits. When such benefits will not arise until a subsequent accounting period, the related costsshould be carried forward and matched with the revenue when it arises. The recognition of year-end inventories achieves this carry forward.

Going concern basis of accounting

The very act of recognising closing inventories as assets implies that the business intends tocontinue in operational existence for the foreseeable future.

If the business did not intend to continue trading, its inventories would have to be written off asan item of expenditure during the period, unless there was clear evidence that they could be soldas part of the breaking up of the business. In this case, the selling price should be determined andinventories measured at the lower of cost and net realisable value in the usual way.



7

(b) Suggested methods of valuing inventories

Given the limited information the following methods would be appropriate in the circumstances.

Raw material

BAS 2 allows either a first in, first out (FIFO) formula or a weighted average cost (WAC)formula.

Given the fact that clay is presumably continually added to the machinery, WAC would seem themost appropriate basis.

CU100,000 kgs @ 30p 30,000200,000 kgs @ 32p 64,00020,000 kgs @ 31p 6,200

320,000 100,200

= 31.3p per kg

Closing raw materials would therefore be measured at CU33,804 (108,000 31.3p).

Work in progress

This could be measured using a weighted average cost, given that total cost and total output areknown.

Total output (800,000 + (60% 50,000) 830,000 unitsTotal costs (excluding distribution costs) CU747,000

Thus average cost per unit000,830

000,747CU = 90p

Carrying amount of WIP (50,000 60% 90p) CU27,000

Finished goods

Again, a weighted cost could be used of 90p per unit. This would be applicable to 50,000 units,with the remaining 20,000 units being measured at net realisable value of 65p (75p – 10p).

CU50,000 at 90p 45,00020,000 at 65p 13,000

58,000

Thus inventories would appear as follows.CU

Raw material 33,804Work in progress 27,000Finished goods 58,000

118,804

(c) Alternative valuation method for finished goods

If details regarding total costs were not known, adjusted selling price could be used since the coststructure is known.

pNormal selling price (75p discounted price 3/2) 112.5

Less Gross profit (112.5 25/125) (22.5)Cost re 50,000 90.0

Thus finished goods inventories would be measured as before.

BAS 2 allows the above practice, used by the retail industry, on the basis that the result can be avery close approximation to cost.





(a) Costs to complete are CU90,000

As each of the total revenue, the costs incurred and the costs to complete can be estimated reliably,revenue can be recognised by the percentage of completion method, so 33.3% of CU210,000 =CU70,000.

Note. The project is profitable overall (total revenue CU210,000, total costs CU135,000), so noprovision for a contract loss need be made.

(b) Costs to complete cannot be estimated reliably

As the outcome of the overall contract cannot be estimated reliably, revenue is recognised to theextent of the costs incurred which are recoverable, i.e. CU40,000. The current period thereforerecognises the contract loss to date of CU5,000.


In substance, this is a secured loan; no revenue should be recognised in the income statement.

Through the rights of access and supervision, together with the right to build on the land, Builder Ltdhas retained the risks and rewards of ownership over the building plot, so should show it as an asset inits balance sheet.

The fact that the consideration for the sale on 1 March 20X6 is so far below the valuation is furtherevidence that the transaction is in substance a two-year loan, with the CU400,000 difference betweenthe selling and repurchase prices being interest on the loan.

The right to repurchase in the future for much less than the current valuation (making the exercise ofthe repurchase right almost a certainty) is further evidence that this is not a real sale.

So Builder Ltd will show the building plot in its 28 February 20X7 balance sheet as a current asset (asit will be realised in the normal course of its operating cycle) at its original acquisition cost (not givenin the Interactive Question).

In the same balance sheet it will show the CU1.5m received on 1 March 20X6 as a current liability (asit will be settled in the normal course of its operating cycle – the fact that it is repayable more than 12months of the balance sheet date is not relevant), together with any unpaid part of the CU400,000interest which is attributable to the first year of the loan.

The appropriate part of the total interest will be charged to the income statement for the year ended28 February 20X7.


CUAfter-sales support (2 (35,000/82.5%)) 84,848Remainder 715,152Total selling price 800,000

So the revenue in the current year is 715,152

This allocation is in line with BAS 18 Appendix paragraph 11.



7


Include in cost ofinventories

Recognised as anexpense asincurred

Supplier's gross price for raw materials Yes

Quantity discounts allowed by supplier Yes

Purchase taxes and duties charged by supplier andrecoverable from taxing authorities

n/a, becauserecoverable

n/a, becauserecoverable

Costs of transporting materials to the business' premises Yes

Labour costs directly incurred in the processing of rawmaterials

Yes

Variable costs, such as power, incurred in the processingof raw materials

Yes

Fixed production costs/overheads, such as rent for theprocessing factory and depreciation charges on the plantused in the processing

Yes, but seecommentary in text

Costs of holding finished goods in inventory Yes

Costs of transporting goods to customer on sale Yes

Purchase taxes charged to customer on sale Yes

Commission payable to salesmen on sale of the goods Yes

Allowance for bad and doubtful debts in relation to tradereceivables

Yes

Costs of accounts department Yes

Head office costs relating to the overall management ofthe business

Yes




Contents

Introduction

Examination context

Topic List

1 Obtaining non-current assets

2 Types of lease

3 Accounting for finance leases

4 Allocating and calculating finance charges

5 Disclosure

6 Finance leases: other issues

7 Operating leases


Technical reference



chapter 8

Leases



Introduction


Understand the purpose and principles underlying BAS 17 Leases

Classify leases as finance or operating and explain the classification

Apply accounting requirements for:

– Finance leases, including initial recognition, allocation of finance charges andpresentation and disclosure

– Operating leases, including disclosures

Prepare simple extracts from the financial statements in accordance with Companies Act andBFRS.

Specific syllabus references for this chapter are: 2c.


Many companies spend large amounts of money on buildings, fittings and equipment, in order to carry ontheir business.

However, it is possible to obtain the use of such assets in a number of different ways. The asset might bepurchased outright for cash or by obtaining long or short-term finance. Alternatively, the asset might simplybe rented. The commercial nature and accounting treatment of these transactions differ.

In a leasing arrangement, a company acquires the use of an asset but also obtains financial support in theform of finance from the company which owns the asset. Historically, the accounting treatment of leaseshas been controversial.

In the past some lease agreements were introduced by financing organisations that were made to look likerental agreements but where in fact the substance of the transaction was that a non-current asset waspurchased on credit. These companies effectively 'owned' an asset and 'owed' a debt for its purchase, butshowed neither the asset nor the liability on the balance sheet because they were not required to do so.

Leasing transactions are extremely common so this is an important practical subject. Lease accounting isnow regulated by BAS 17, which was introduced because of abuses in the use of lease accounting bycompanies described above. The debate on the accounting for leases, however, is ongoing and fundamentalchanges are expected in the future.

Stop and think

Why do you think a company's management might wish to use leasing arrangements to give the appearanceof renting rather than owning an asset?

Working context

You may well come across leasing (and hire purchase) in the context of audit engagements. The technicaldetail of auditing leases is covered in the Audit and Assurance paper. However, typical procedures mightinvolve verifying the agreements, reviewing the substance of the transactions and ensuring that these arecorrectly stated in the financial statements.

LEASES


8

Syllabus links

In the Accounting paper, you covered the purchase of non-current assets and the relevant balance sheetentries. You will have also dealt with renting such assets and the relevant entries to the income statement.

As you will see, many of these accounting entries will be relevant as you go on to consider finance leasesand operating leases in this paper.

In Financial Accounting you are only expected to be familiar with the accounting treatment of leases fromthe lessee's point of view (i.e. the user of the asset).

Lessor accounting and sale and leaseback arrangements are covered in the Financial & Corporate Reportingsyllabus.

Lease accounting also raises the issue of substance over form which you will encounter in various contextsin this paper and in Financial & Corporate Reporting at the Advanced Stage.



Examination context

Exam requirements

Leasing could be examined as part of a mixed question, requiring you to calculate the value of finance leasesin the balance sheet and the appropriate finance costs in the income statement. However, it could also beexamined in its own right, perhaps including a discussion of the principle of substance over form. (Thesample paper included this style of question on leasing.)

This topic may also be examined by short-form question.


Explain and apply the principle of substance over form. Prepare and present financial statements or extracts therefrom in accordance with BAS 17 Leases.

LEASES


8

1 Obtaining non-current assets

Section overview

Certain types of contracts where a company leases an asset from another company are very similar insubstance to the outright purchase of that asset.

If these leases are accounted for in accordance with their strict legal form, a company’s assets andliabilities are likely to be understated.

Failing to record the true substance of the transaction is an example of 'off-balance sheet' financing.

BAS 17 Leases states that the substance of the transaction takes precedence over the legal form evenif the legal title never passes from lessor to lessee.

1.1 Using assets

There are many different ways of gaining use of an asset: for example, you can buy a car or hire it. In bothcases, you are able to drive the car, but your rights over the car differ in each case.

As far as this chapter is concerned in effect you have two choices.

Buy the asset Simply, you pay to own the asset, in order to access the benefits it can give you.

You are legally the owner of the asset (i.e. you have legal title.)

You can do what you like with it, and you get all the risks and rewards ofowning the asset.

In the financial statements, the asset will be treated as a non-current asset. Forrelevant accounting issues, see Chapter 5.

Of course, the company might pay for the asset a couple of months later, onstandard credit terms. This is then a simple credit purchase.

Hire or lease theasset

If you hire or lease an asset, you are paying someone else for the use of that asset.It is the owner’s property, but you are getting the benefits from using it. (In a hirepurchase agreement, ownership only transfers to you once you have paid for it,and this is typically over a long period.)

The accounting treatment depends on the circumstances:

(a) Say a company hires a car for one of its staff for a couple of days; the car isnot an asset of the company, it is just being hired for a couple of days, andthe owner retains the benefit of owning the car (e.g. to hire it out to otherpeople) over the rest of the asset's useful life.

(b) However, a company might lease the car for a guaranteed period of threeyears or so, and has sole use of it, be responsible for maintaining it and so on.The company may also be obliged to enter a long-term agreement to pay thesupplier. The company might end up owning the car at the end of the period.

The example in (b) above shows that, for practical purposes, the company has acquired the use of a non-current asset, and all the risks and rewards of owning it. The car is being used as if it is a non-current asset,even though, legally speaking, it belongs to a third party. In many ways this is similar to purchasing the assetoutright.



1.2 Leasing agreements

As we have said, one way by which businesses can obtain the use of an asset is by a leasing agreement.

Definition

Lease: An agreement whereby the lessor conveys to the lessee in return for a payment or series ofpayments the right to use an asset for an agreed period of time.

In a leasing transaction, there is a contract between the lessor and the lessee for the hire of an asset.

The lessor is owner and supplier of the asset. The lessee is the user of the asset.

The lessor retains legal ownership but transfers to the lessee the right to use the asset for an agreed periodof time in return for specified payments.

1.3 Substance over form

It is a principle of accounting that the commercial substance of a transaction should be reflected infinancial statements rather than the legal form. This is a consequence of BFRS Framework requirement torepresent transactions faithfully.

There are many types of leasing arrangements. By entering into certain sorts of lease, a company is, ineffect, gaining the use of a non-current asset whilst incurring a long-term liability. Where the commercialsubstance of the transaction is the purchase of a non-current asset, this should be reflected in theaccounting treatment despite the legal form of the rental agreement.

BAS 17 gives guidance as to the accounting treatment depending on the terms of the leasing transaction,which are discussed in section 2.

2 Types of lease

Section overview

BAS 17 recognises two types of lease:

– Finance leases, in which the risks and rewards of ownership are transferred from the lessor tothe lessee, and

– Operating leases: all other leases.

Inception is when the provisions are agreed: commencement is when the lessee can use the leasedasset (and when the values agreed at inception are recognised in the financial statements).

For leases of land and buildings, land is normally treated as an operating lease, buildings as a financelease.

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2.1 Classification of a lease

As mentioned above, there are two types of leases.

Definition

Finance lease: A lease that transfers substantially all the risks and rewards incidental to ownership of anasset. Title may or may not eventually be transferred.

Operating lease: A lease other than a finance lease.

From these definitions you can see that the classification of a lease is based on the extent to which the risksand rewards of ownership lie with the legal owner, the lessor, or are transferred to the user, the lessee.

If a lease transfers substantially all the risks and rewards normally associated with the ownership ofan asset it should be classified as a finance lease. All other leases should be classified as operatingleases.

BAS 17 provides the following examples of the key risks and rewards incidental to ownership of an asset.

Risk Possibility of losses arising from:

Idle capacity Technological obsolescence Falls in value due to changing economic conditions

Rewards Potential gains arising from:

Profitable use of the asset over its economic life Future sale of the asset where it has increased in value

2.2 Identifying finance leases

BAS 17 also provides examples of situations that individually or in combination would normally lead to alease being classified as a finance lease.

These include the following circumstances where:

The terms of the lease are such that ownership of the asset transfers to the lessee by the endof the lease term e.g. a hire purchase agreement

The lessee has the option to purchase the asset at such a price that it is reasonably certainfrom the outset that the option will be exercised

The lease term is for the major part of the economic life of the asset even if legal title is nevertransferred (see section 2.5 below).

At the inception of the lease the present value of the minimum lease payments amountsto at least substantially all of the fair value of the leased asset (see sections 2.3 and 2.4 below)

The leased assets are of such a specialised nature that only the lessee can use them without majormodifications

Other indicators listed by BAS 17 that could also lead to the lease being classified as a finance leaseare:

Whether cancellation losses are borne by the lessee

Whether fluctuations in fair value at the end of the lease accrue to the lessee

Whether the lessee has the option to extend the lease for a secondary period at a'peppercorn rent'. (i.e. below market rent)



2.3 Present value of the minimum lease payments

A persuasive factor in classifying a lease as a finance lease is if at the inception of the lease the presentvalue of the minimum lease payments amounts to at least substantially all of the fair value ofthe leased asset.

Definition

Minimum lease payments: Payments over the lease term that the lessee is or can be required to make,excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, togetherwith any amounts guaranteed by the lessee or by a party related to the lessee.

The minimum lease payments are what the lessee (or a party related to the lessee) has to makeover the life of the lease. However, as these payments are some time in the future, a discount factor isapplied to reach a 'present value' of these amounts, in other words a cash equivalent.

This is then compared to the asset's fair value.

Definition

Fair value: The amount for which an asset could be exchanged, or a liability settled, betweenknowledgeable, willing parties in an arm's length transaction.

Worked example: Fair value

Alpha Ltd agrees to pay Beta Ltd a sum of CU1,000 each year for four years, a total of CU4,000. Assumingprevailing interest rates at the time of the agreement were 5%, the present value would be CU3,546. If thepresent value at the date of the agreement is more than or 'substantially all' of the fair value then this wouldindicate a finance lease. Effectively, Alpha Ltd is buying an asset from Beta Ltd, who is providing loan finance.

Point to note

In the examination you will not be expected to calculate the present value of the minimum lease payments.Where relevant the information in the question will include the discounted figure.

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Interactive question 1: What type of lease? [Difficulty level: Easy]

Classify the following situations as finance or operating leases. You will have to do some thinking here.

Question Fill in your answer

(a) A company leases machine tools. Legal title istransferred after three years.

(b) A company leases a photocopier. The presentvalue of minimum lease payments is CU2,000but the fair value of the asset is CU10,000.

(c) A company leases a car for a salesrepresentative for a five-year period, afterwhich the car will have come to the end of itsuseful economic life.

(d) A company acquires some equipment madebespoke to its specifications. To sell theequipment to a third party would requiresubstantial modification.


2.4 When does a lease actually begin?

A lease should be classified as operating or finance at inception.

There is a difference between commencement and inception.

Inception. This is when the terms of the lease, including the financial settlement, are agreed (which may bethe contract signing date or, if earlier, the date when the main terms were agreed).

For example, a company might agree to lease equipment, with agreed payments every year. However, itmay be some time before the company uses the equipment – especially if it is new.

At inception: – the lease is classified as a finance or operating lease– the values, in the case of a finance lease, are determined.

Commencement. This is the date when the lessee can use the leased asset. For example, a companyleasing a building may move in several months after the lease contract was agreed. The commencementdate is also the date when the values determined at inception are recognised in the financial statements.

In many cases, the dates are not far apart. Remember, however, that the value of the leased asset andconsequent liability shown in the financial statements are normally those at the inception of the lease.

2.5 The lease term

Once classified, the classification should remain throughout the lease term.

In a leasing transaction, the lease term is the length of the agreement between lessor and lessee.

Definition

Lease term: The non-cancellable period for which the lessee has contracted to lease the asset togetherwith any further terms for which the lessee has the option to continue to lease the asset, with or withoutfurther payment, when at the inception of the lease it is reasonably certain that the lessee will exercise theoption.



With a finance lease the lease term might be divided into two periods.

Primary period During the primary period the lease will either be non-cancellable or will becancellable only under certain conditions, for example on the payment of a heavysettlement figure.

The rentals payable during the primary period will be sufficient to repay tothe lessor the cost of the equipment plus interest thereon.

Secondary period The secondary period is usually cancellable at any time at the lessee's option.

The rentals during the secondary period will be of a nominal amount.(sometimes referred to as a 'peppercorn rent')

If the lessee wishes to terminate the lease during the secondary period, theequipment will be sold and substantially all of the sale proceeds will be paid tothe lessee as a rebate of rentals.

2.6 Land and buildings

Leases of land and buildings are classified as operating or finance leases in the same way as the leases ofother assets. However due to the differing characteristics of land and buildings BAS 17 requires that theland and buildings elements of a single lease are considered separately for classificationpurposes.

Land A characteristic of land is that it normally has an indefinite economic life. As a result, alease of land is normally treated as an operating lease (unless ownership of the landpasses to the lessee during the lease term) as the lessee does not receive substantially all ofthe risks and rewards of ownership.

Where land has a limited life e.g. where it is used as a landfill site it may be classified as afinance lease (depending on the assessment of any other relevant factors).

Buildings As buildings normally have a finite economic life a lease of a building may be treated asa finance lease depending on the full terms of the lease (see sections 2.1 and 2.2 above).

Problem Solution

How do you work out how much of the minimumlease payments to allocate to buildings and howmuch to land?

Work out the relative fair values of the leaseholdinterests at the inception of the lease, and split thepayment according to these proportions.

What happens if you cannot allocate the minimumlease payments between land and buildings?

Treat everything as a finance lease (unless clearthat both elements are operating leases.)

What happens if the land is immaterial? Treat everything as buildings.

(See Worked example: Lease of land and buildings in section 8.)

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3 Accounting for finance leases

Section overview

In the balance sheet, assets held under finance leases are treated as non-current assets and payablesor finance lease liabilities.

The asset is depreciated and otherwise treated as any other non-current asset.

Lease payments reduce the liability and cover any accrued interest.

The lessee has to allocate the finance charge between accounting periods.

The finance charge is charged to the income statement.

3.1 Setting up balance sheet accounts

BAS 17 requires that, when an asset changes hands under a finance lease, the accounting treatmentshould reflect the substance of the transaction. In the lessee's books therefore:

DEBIT Asset accountCREDIT Payables: Finance lease liabilities

The amount to be recorded in this way is the lower ofthe fair value and the present value of the minimumlease payments at the inception of the lease

The initial deposit, if any, counts as one of the lease payments and hence is included in the cost of the asset.

Points to note

1 The entries are made at the commencement of the lease term, with the values determined atinception (see section 2.4 above).

2 The present value of the minimum lease payments is derived by discounting them at the interest rateimplicit in the lease. If it is not practicable to determine the interest rate implied in the lease, thenthe lessee's incremental borrowing rate can be used.

3 Initial direct costs can be treated as part of the cost of the asset – provided they are directlyattributable to activities performed by the lessee to obtain the finance lease.

4 Although interest is payable under the lease, this is accrued over time. The justification is that thecapital could, in theory, be paid off at any time, with cancellation charges. These charges could beavoided, so they are not a 'true' long term liability. Interest is therefore recognised as it accrues.

3.2 Depreciating the asset

DEBIT Depreciation expenseCREDIT Accumulated depreciation

The asset should be depreciated over the shorter of thelease term or the asset's useful life

Points to note

1 Depreciation policies adopted should be consistent with other non-current assets.

2 As with other non-current assets, impairment reviews must be conducted in accordance with BAS 36Impairment of Assets.

3 If there is reasonable certainty that the lessee will eventually own the asset, then it should bedepreciated over its estimated useful life.

4 The lease term comprises the period for which the lessee has contracted to lease the asset and anyfurther terms for which there is reasonable certainty at the inception of the lease that the lessee willexercise the option. (See section 2.5)



3.3 Making the payment

Every period, the payments are accounted for as follows.

DEBIT Payables: Finance lease liabilitiesCREDIT Cash

Each lease payment is comprised partly of a repayment ofcapital and partly of an interest charge for the period.(See section 3.4 below)

3.4 Finance charge

The finance charge is dealt with as follows.

DEBIT Income statement: Finance cost

CREDIT Payables: Finance lease liabilitiesWith the amount of the interest accrued over the period

4 Allocating and calculating finance charges

Section overview

The two main methods of calculating the finance charge and allocating it to accounting periods are:

– The actuarial method– The sum of digits method.

4.1 How much interest is payable in total?

This is relatively easy to calculate.CU

Total lease payments XLess initial cost of asset (as calculated in section 3.1) (X)Total finance charge (= interest) (X)

The finance charge is allocated to the income statement over the period for which the finance is provided,from the commencement of the lease term until the last payment is made. (If payments are made inadvance, the last payment might be made before the end of the lease term.)

4.2 Allocating the interest charge to accounting periods

BAS 17 requires the total finance charge to be allocated to each period during the lease term so as toproduce a constant periodic rate of interest on the outstanding lease obligation.

As the lessee pays off the capital sum, the total capital owed falls from period to period. You wouldtherefore also expect a reduction in the total interest payable, too, on the outstanding balance.

For example, if you owe CU10,000 and pay 15%, the interest will be CU1,500. After you have paid off, say,CU8,000 of the capital, interest would be CU300 (on CU2,000). The monthly payments remain the same,but the mix of interest and capital changes over the life of the loan.

There are three possible methods of allocating the interest.

Actuarialmethod

Interest is charged at a constant percentage on the outstanding liability, thus matchinginterest to the 'loan' balance.

This method is specified by BAS 17, as it is the most accurate. However, to apply it,the rate of interest implicit in the lease is required.

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'Sum of digits'method

This method is a 'reasonable' approximation to the actuarial method where theimplicit rate of interest is not known.

The sum of digits method splits the total interest (without reference to a rate ofinterest) in such a way that the greater proportion falls in the earlier years. Theprocedure is as follows.

(a) Assign a digit to each instalment. The digit 1 should be assigned to the finalinstalment, 2 to the penultimate instalment and so on.

(b) Add the digits. A quick method of adding the digits is to use the formula

2

1)n(n where n is the number of periods of borrowing. If there are twelve

instalments paid in arrears, then the sum of the digits will be 78. For this reason,the sum of the digits method is sometimes called the rule of 78.

(c) Calculate the interest charge included in each instalment. Do this by multiplyingthe total interest accruing over the lease term by the fraction:

digitstheofSum

instalmentthetoapplicableDigit

Straight linemethod

A constant amount of interest is charged each period, hence interest does not matchthe amount outstanding of the loan. Therefore this method is not normally allowed,except where the amounts involved are immaterial.

Worked example: Rentals in arrears

A Ltd has a year end of 31 December.

A finance lease commences on 1 January 20X1. Lease payments comprise three payments of CU10,000annually, commencing on 31 December 20X1. The asset would have cost CU24,869 to buy outright.

The implicit interest rate is 10%.

You are required to calculate the interest charge and the year-end liability for each year of the lease under:

(a) Straight line method(b) Actuarial method(c) Sum of digits method.

Solution

Total finance charges to be allocated:CU

Total lease payments 30,000Less initial cost of asset (24,869)Total finance charge (interest) 5,131

(a) Straight line method

Allocation of interest to periods:

20X1-20X3 =3

5,131= 1,710

LEASE LIABILITYCR CR DR CR

Balance b/f Interest Payment Capitalaccrued balance

1 Jan 31 Dec 31 Dec c/f 31 DecCU CU CU CU

20X1 24,869 1,710 (10,000) 16,57920X2 16,579 1,710 (10,000) 8,28920X3 8,289 1,711 (10,000) –

5,131 30,000



(b) Actuarial methodLEASE LIABILITY

CR CR DR CRBalance Interest Payment Balance

b/f accrued 31 Dec c/f1 Jan @10% 31 Dec

31 DecCU CU CU CU

20X1 24,869 2,487 (10,000) 17,35620X2 17,356 1,736 (10,000) 9,09220X3 9,092 908 (10,000) –

5,131 30,000

(c) Sum of digits method

Each period of borrowing is allocated a digit as follows:

Period of borrowing Digit1st (20X1) 32nd (20X2) 23rd (20X3) 1

6

Or using the formula2

43= 6

Point to note

In this example, as the instalments are paid in arrears the number of periods of borrowing (n in theformula) are equal to the number of instalments.

The CU5,131 interest charges can then be apportionedCU

1st period of borrowing CU5,131 3/6 2,5662nd period of borrowing CU5,131 2/6 1,7103rd period of borrowing CU5,131 1/6 855

5,131LEASE LIABILITY

CR CR DR CRBalance b/f Interest Payment Capital

1 Jan accrued 31 Dec balance c/f31 Dec 31 Dec

CU CU CU CU20X1 24,869 2,566 (10,000) 17,43520X2 17,435 1,710 (10,000) 9,14520X3 9,145 855 (10,000) -

5,131 30,000

Point to note

The year-end liability for 20X1 is CU17,435. This balance is all capital. Any interest which hasaccrued during the year has been settled by the first instalment because the instalment was paid onthe last day of the year.

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4.3 Instalments in advance

As we have seen in the examples above, interest accrues over time and is included in the payment at theend of each period of borrowing. However, where instalments are paid in advance:

The first instalment repays capital only as no time has yet elapsed for interest to accrue.

At the end of each accounting period the year-end liability will include capital and interest that hasaccrued to date but which has not been paid.

Worked example: Rentals in advance

A Ltd has a year end of 31 December.

A finance lease commences 1 January 20X1. Lease payments comprise four payments of CU10,000 annually,commencing on 1 January 20X1. The asset would have cost CU34,869 to buy outright.

The interest rate implicit in the lease is 10%.

Requirements

Calculate the lease interest charge for each year of the lease under

(a) Actuarial method(b) Sum of digits method.

Using the actuarial method also calculate the year end liability for each year of the lease.

Solution

CUTotal payments (4 10,000) 40,000Less cost of asset 34,869Total interest 5,131

Point to note

The last payment is made on 1.1.X4. This is three years after the start of the lease. Therefore the ‘loan’ isin existence for three years and interest is charged over this period, i.e. in the income statement for 20X1,20X2 and 20X3.

(a) Actuarial method

LEASE LIABILITYCR DR CR CR CR

Balance Payment Capital Interest Balanceb/f 1 Jan balance accrued c/f

1 Jan remaining @10% 31 Dec1 Jan 31 Dec

CU CU CU CU CU20X1 34,869 (10,000) 24,869 2,487 27,35620X2 27,356 (10,000) 17,356 1,736 19,09220X3 19,092 (10,000) 9,092 908 10,00020X4 10,000 (10,000) – – –

40,000 5,131

Points to note

1 As the first instalment is paid on 1 January 20X1 it is purely a repayment of capital as no timehas passed for interest to accrue.

2 The year-end liability is made up of the capital outstanding plus any interest accrued todate.

3 The payment of CU10,000 on 1 January 20X2 will pay the interest accrued in 20X1(CU2,487) with the balance repaying capital.



(b) Sum of digits

Total interest = CU5,131

Each period of borrowing is allocated a digit as follows:

Period of borrowing Digit1st (20X1 – settled by instalment 2) 32nd (20X2 – settled by instalment 3) 23rd (20X3 – settled by instalment 4) 1

6

Or using the formula,2

43= 6

Point to note

In this case as the instalments are paid in advance the periods of borrowing (n in the formula) are thenumber of instalments minus one.

The CU5,131 interest charges can then be apportioned.CU

1st period of borrowing CU5,131 3/6 2,5662nd period of borrowing CU5,131 2/6 1,7103rd period of borrowing CU5,131 1/6 855

5,131

The year-end liability would then be calculated using the same method as has been used for theactuarial method above. So for example at the end of 20X1 the liability would be CU27,435 calculatedas follows:

LEASE LIABILITY

CR DR CR CR CRBalance b/f

1 JanPayment 1 Jan Capital balance

remaining 1 JanInterest accrued

at 31 DecBalance c/f

31 DecCU CU CU CU CU

20X1 34,869 (10,000) 24,869 2,566 27,435

5 Disclosure

Section overview

The key balance sheet disclosures are:

– The split and analysis of the finance lease liability.– The carrying amount of non-current assets held under finance leases.

5.1 Balance sheet liability

The balance sheet liability needs to be split between:

The current liability The non-current liability

Point to note

The non-current liability will comprise only capital outstanding. No interest will be included as any interestdue at the end of the next year will not yet have accrued.

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The steps to split the liability are therefore:

Step 1Identify the capital balance remaining in one year's time. (This can be found in the lease calculation table.)

Step 2Deduct the capital balance remaining in one year's time from the total liability at the balance sheet date.This will give the amount due within one year as a balancing figure.

Interactive question 2: Rentals in arrears [Difficulty level: Exam standard]

Using the facts from the Worked example: Rentals in arrears, part (b), show the split of the lease liability atthe end of 20X1.

Fill in the gaps in the extract below.

The lease liability extract from the Worked example: Rentals in arrears, part (b) is as follows:

Lease liabilityCR CR DR CR

Balance Interest Payment Capitalb/f accrued 31 Dec balance

1 Jan @10% c/f31 Dec 31 Dec

CU CU CU CU20X1 (current period) 24,869 2,487 (10,000) 17,35620X2 (future periods) 17,356 1,736 (10,000) 9,092

Solution

Total lease liability at 31 December 20X1 = CU

Capital > 1 year

= CU

< 1 year ()

= CU


Interactive question 3: Rentals in advance [Difficulty level: Exam standard]

Requirement

Using the facts from the Worked example: Rentals in advance, part (a), show the split of the lease liability atthe end of 20X1.

Fill in the gaps in the extract below.

The lease liability extract from the Worked example: Rentals in advance, part (a) is as follows:

Lease liabilityCR DR CR CR CR



CU CU CU CU CU20X1 (current period) 34,869 (10,000) 24,869 2,487 27,35620X2 (future periods) 27,356 (10,000) 17,356 1,736 19,092



Solution

Total lease liability at 31 December 20X1 = CU

Capital > 1 year

= CU

< 1 year ()

= CU



Point to note

The leased assets and lease liabilities may not be netted off against each other.

Non-current assets

Disclosure must be made of the carrying amount of assets held under finance leases as follows:

'Of the total carrying amount of CUX, CUY relates to assets held under finance leases.'

All other BAS 16 Property, Plant and Equipment disclosures are required, together with BAS 36impairment tests (both dealt with in Chapter 5).

Liabilities

Finance lease liabilities must be split between their current and non-current components (as wesaw in section 5.1).

BAS 17 also requires disclosure of future lease payments, split between amounts due:

– Within one year– Within two to five years– After more than five years

This disclosure must be given both:

On a gross basis, i.e. showing gross future lease payments for each of the three categories, thendeducting as a single figure the future periods’ finance charges to arrive at the net figure included inliabilities.

On a net basis, i.e. excluding from each of the three categories the finance charges allocated to futureperiods (and hence not yet accrued).

Interactive question 4: Disclosure [Difficulty level: Exam standard]

The facts are as detailed in Interactive question 3.

Requirement

Show the disclosure of the analysis of finance lease liabilities at the end of 20X1 required by BAS 17.

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Complete the proforma below.

(a) Gross basis

CU

Finance lease liabilities include:

Gross lease payments due within:

One year

Two to five years

Less finance charges allocated to future periods

(b) Net basis

CU

Finance lease liabilities include:

Amounts due within:

One year

Two to five years


Other disclosures

In the case of most entities, the BAS 1 Presentation of Financial Statements requirement to disclosesignificant accounting policies would result in the disclosure of the policy in respect of finance leases.

BAS 17 requires a general description of material leasing arrangements to be included.

6 Finance leases: other issues

Section overview

Other issues include:

– Secondary periods and peppercorn rentals– Non-annual payments– Initial deposit.

6.1 Secondary periods and peppercorn rentals

A finance lease may contain an option for the lessee to extend the lease for a secondary period at a nominal(‘peppercorn’) rental. This rental will be immaterial and can be ignored in the calculations.

However, the optional extension period counts as part of the lease term if the lessee is reasonablycertain at the outset to exercise the option to extend the lease. This therefore impacts on thedepreciation calculations, because the secondary period is counted when identifying the asset's usefullife. (See section 3.2)

6.2 Non-annual payments

Many leases in practice have monthly, quarterly or six-monthly payments. The lease calculations must beperformed for each credit period (interval between payments).



6.3 Initial deposit

A lease may include an initial deposit payment prior to the commencement of the regular lease payments.This initial payment counts as part of the minimum lease payments and therefore as part of the cost ofthe asset.

In the lease calculations, deduct the initial deposit from the initial liability.

The recording at the commencement of the lease term will therefore be in two steps:

Step 1Record liability and non-current asset

CU CU

DR Non-current assets – cost XCR Payables: Finance lease liabilities X

Step 2Reduce initial liability by amount of deposit paid

CU CU

DR Payables: Finance lease liabilities XCR Cash X

Interactive question 5: Summary [Difficulty level: Exam standard]

A company leases an asset on 1 January 20X1. The terms of the lease are to pay a non-refundable depositof CU575 followed by seven annual instalments of CU2,000 payable in arrears. The fair value of the asset(equivalent to the present value of minimum lease payments) on 1 January 20X1 is CU10,000.

Requirements

Calculate the interest charge in the income statement and the finance lease liability in the balance sheet forthe year ended 31 December 20X1 using the:

(a) Actuarial method, where the interest rate implicit in the lease is 11%.(b) Sum of digits method.



CU

Income Statement (extract)

Finance costs (Working)

Balance Sheet (extract)


Finance lease liability (Working)

Current liabilities

Finance lease liability (Working)

WORKINGS

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(b) Sum of digits method

CU

Income Statement (extract)

Finance costs (W)

Balance Sheet (extract)


Finance lease liability (W)

Current liabilities

Finance lease liability (W)

WORKINGS


7 Operating leases

Section overview

Operating lease rentals are charged to the income statement on a straight-line basis over the leaseterm.

7.1 Accounting for operating leases

As we saw in section 2 an operating lease is a lease other than a finance lease.

Operating leases do not really pose an accounting problem as the substance and the legal situation arethe same, i.e. the lessee does not own the leased asset either legally or in substance. The lessee is simplyrenting the asset and the rental expense is charged to the income statement.

7.2 Balance sheet display and income statement charge

BAS 17 requires the lease payments under an operating lease to be charged on a straight-line basis overthe lease term, even if the payments are not made on such a basis, unless another systematic andrational basis is more representative of the time pattern of the user’s benefit. Hence, if lease payments arenot made evenly, an accrual or prepayment will be recorded in the balance sheet.



Worked example: Operating leases

Under an operating lease agreement, Williamson Ltd pays a non-returnable deposit of CU100,000 and thenthree years’ rental of CU100,000 per annum on the first day of each year.

You are required to calculate the charge to the income statement for each year, and any balance in thebalance sheet at the end of the first year.

Solution

Income statement charge =years3

300,000100,000

= CU133,333

Balance sheet at end of year 1:CU

Paid in year 200,000Charged in income statement (133,333)Prepayment 66,667

Point to note

A premium paid for the lease of land and buildings would be treated in the same way as this non-returnabledeposit.

7.3 Disclosures

BAS 17 and other BASs require disclosure of:

The accounting policy for operating leases.

Operating lease payments charged as an expense for the period.

In respect only of non-cancellable operating leases, a commitments note showing the totallease payments that the lessee is committed to paying in the coming years, analysed by amountsdue:

– Within one year

– Within two to five years

– After more than five years

Note that this disclosure is both the same as and different from that for finance leases in section 5.2above:

– The disclosures are the same in terms of the time periods over which the payments must beanalysed.

– They are different in that for finance leases the analysis is of amounts appearing in the balancesheet within liabilities, whereas for operating leases the analysis is just of commitments. Notealso that for operating leases there can be no separate disclosure of any equivalent of thefinance charges for finance leases.

A general description of significant leasing arrangements.

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Interactive question 6: Operating leases [Difficulty level: Exam standard]

Stone Ltd has the following outstanding non-cancellable operating lease commitments at its balance sheetdate:

Rental on buildings of CU100,000 per annum for 15 years Rental on plant of CU30,000 per annum for three years Rental on cars of CU40,000 for 11½ months.

Requirement

Complete the operating lease commitment note to be included in Stone Ltd’s accounts.


The minimum lease payments under non-cancellable operating leases are:CU

Within one yearWithin two to five yearsAfter five years





Summary

BAS 17 Leases standardises the accounting treatment and disclosure ofassets held under lease. It follows the substance over form principle.

BAS 17 recognises two types of lease.

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Self-test


1 Henry acquired a lorry on a finance lease. The details were as follows.

Date of acquisition 1 January 20X8Cash price CU20,000Deposit CU5,000Quarterly lease payments 12 @ CU1,800

The charge for interest is to be spread over the three year period on the sum of digits basis. Thepayments are made on the last day of each quarter.

In accordance with BAS 17 Leases how much interest would be allocated to the fifth quarterlypayment?

A CU700B CU677C CU550D CU423

2 Sam acquired a motor car on a finance lease. The details were as follows.

Date of acquisition 1 July 20X6Cash price CU5,000Deposit CU1,000Monthly lease payments 24 @ CU200

The charge for interest, which is not material, is to be spread evenly over the 24 month period. Thepayments are made on the last day of each month.

What is the total liability outstanding as on 1 January 20X7 in accordance with BAS 17 Leases?

A CU4,000B CU3,600C CU3,000D CU2,800

3 On 1 January 20X7 Melon Ltd bought a machine on a finance lease. The terms of the contract were asfollows.

CUCash price 18,000Deposit (6,000)

12,000Interest (9% for two years) 2,160Balance – two annual payments commencing 31 December 20X7 14,160

The rate of interest implicit in the contract is approximately 12%.

Applying the provisions of BAS 17 Leases the finance charge in the income statement for the yearended 31 December 20X7 is

A CU1,080B CU1,440C CU1,620D CU2,160

4 BAS 17 Leases requires a lessee to capitalise a finance lease at the amount of the

A Fair valueB Present value of the minimum lease paymentsC Higher of fair value or present value of minimum lease paymentsD Lower of fair value or present value of minimum lease payments



5 Alpha Ltd enters into a lease with Omega Ltd for an aircraft, which had a fair value of CU240,000 atthe inception of the lease. The terms of the lease require Alpha Ltd to make ten annual lease paymentsof CU36,000 in arrears. Alpha Ltd is totally responsible for the maintenance of the aircraft, which has auseful life of approximately eleven years.

The present value of the ten annual lease payments of CU36,000 discounted at the interest rateimplicit in the lease is CU220,000.

Applying the provisions of BAS 17 Leases to this lease, the property, plant and equipment of Alpha Ltdwill increase by


6 Cambridge Ltd leases an asset on a five-year lease. The fair value of the asset is CU500,000, while thepresent value of the minimum lease payments derived by discounting at the rate of interest implicit inthe lease is CU480,000. The asset has a five-year life, with Cambridge Ltd responsible for maintenanceand insurance. The asset will be scrapped at the end of five years.

Cambridge Ltd uses the sum of digits method of depreciation.

In accordance with BAS 17 Leases what is the carrying amount of the asset in the accounts ofCambridge Ltd at the end of the second year?


7 On 1 January 20X3 Tile Ltd took out a finance lease to purchase production equipment with a cashprice of CU750,000. The terms of the lease required five lease payments of CU200,000 to be paidannually in advance. These lease payments have been charged to the income statement asadministrative expenses. The equipment is expected to have a five-year life with no residual value. Theerror in the treatment of the finance lease was discovered when preparing the financial statements forthe year ended 31 December 20X5.

Tile Ltd allocates interest on finance leases using the sum of digits method. All depreciation is on astraight-line basis.

Applying the provisions of BAS 17 Leases to this lease what amount will be shown as an adjustment toretained earnings brought forward?

A CU70,000 debitB CU75,000 debitC CU105,000 debitD CU225,000 debit

8 Pont Ltd enters into a four-year operating lease on 1 January 20X6. Although the annual leasepayments were originally agreed at CU50,000 a year, Pont Ltd managed to negotiate a lease 'holiday'and will pay nothing in 20X6.

In accordance with BAS 17 Leases what should appear in the financial statements of Pont Ltd as at 31December 20X7 in respect of the following?

Rental Accrualcharge to in the

the income balancestatement sheet

A CUnil CUnilB CU50,000 CUnilC CU37,500 CU37,500D CU37,500 CU25,000

LEASES


8

9 SNOW LTD

On 1 January 20X1 Snow Ltd entered into the following finance lease agreements.

(1) Snow machine

To lease a snow machine for five years from Slush Ltd. The snow machine cost Slush LtdCU150,000 and is estimated to have a useful life of five years.

Snow Ltd has agreed to make five annual payments of CU35,000, payable in advance,commencing on 1 January 20X1.

The interest rate implicit in the lease is 8.36%.

(2) Snowplough

To lease a snowplough for three years from Ice Ltd. The machine had cost Ice Ltd CU35,000.

A deposit of CU2,000 was payable on 1 January 20X1 followed by six half yearly payments ofCU6,500, payable in arrears, commencing on 30 June 20X1. Finance charges are to be allocatedon a sum of digits basis.

Requirements

(a) Calculate the amounts to be included in the financial statements of Snow Ltd for the year ended31 December 20X1 and draft the reconciliation note for property, plant and equipment, and theanalysis of finance lease liabilities note required by BAS 17 Leases. (15 marks)

(b) Snow Ltd is also considering leasing new office buildings, built from low cost modular units, undera twenty year lease, paying CU21,000 annually on 1 January. The buildings have a useful life oftwenty five years and Snow Ltd would be responsible for their upkeep and insurance. The fairvalues of the leasehold interest at the start of the lease are CU300,000 for the land andCU100,000 for the office units.

Explain and illustrate how the above would be treated in accordance with BFRS. Any interestshould be allocated using a sum of digits basis. (6 marks)

(21 marks)

10 FEENEY LTD

Feeney Ltd is considering replacing a piece of machinery that is coming towards the end of its life. Itsvalue is negligible. The finance director has asked you for your advice as to the financial accounting anddisclosure implications of each of the options. The new machine has a purchase price of CU80,000 andan estimated life of five years and will be acquired on the first day of next year. The options are givenbelow.

(1) Lease the machine for a two year period for a lease payment of CU2,000 per month in arrears. Anon-refundable deposit of CU6,000 has to be paid on order. The lessor remains liable formaintenance.

(2) Lease the machine for a five year period for a lease payment of CU9,900 half yearly in advance.

Requirements

Prepare a memorandum to the finance director, which:

(a) Explains the concept of 'substance over form' as set out in BFRS Framework and applied in BAS 17Leases. (3 marks)

(b) Sets out the extent to which BAS 17 Leases provides information that is relevant, reliable,comparable and understandable. (4 marks)

(c) Briefly explains how each of the options should be accounted for and shows the figures to beincluded in the income statement and balance sheet for the first year. Allocate interest on anactuarial basis using an interest rate of 5% per half year. (11 marks)

(18 marks)



11 RICHARDS LTD (Sample Paper)

You are the financial controller for Richards Ltd a company listed on the London Stock Exchange.

The Chairman has asked you to explain a number of matters relating to the substance of transactionsand the reporting of lease transactions in financial statements. He has approached you as you haverecently attended a number of training courses on BFRS and are in the process of preparing the draftfinancial statements for the year ended 31 May 20X6 in accordance with BFRS.

Richards Ltd recently entered into a lease contract for a new piece of machinery. The new machinecould have been purchased for a cash price of CU150,000. The terms of the lease are:

the lease is for four years

an initial deposit of CU30,000 was payable on 1 June 2005 followed by eight half-yearly paymentsthereafter of CU20,000 payable on the 1 December and 1 June each year, commencing on 1December 20X5.

The estimated useful life of the equipment is four years. Richards Ltd uses the sum of the digitsmethod to allocate finance charges on finance leases.

Richards Ltd’s factory premise is held on a 25 year lease. The period of the lease is expected to besimilar to the life of the factory building and at the end of the 25 years the land reverts back to thelessor.

Requirements

(a) Prepare notes for a meeting with the Chairman, which:

(i) Explain the concept of 'substance over form', and

(ii) Discuss the application of 'substance over form' and asset recognition to:

The accounting by a lessee for a finance lease; and The accounting by a lessee for an operating lease. (7 marks)

(b) Prepare financial statement extracts and supporting disclosure notes that show how themachinery lease transaction should be presented in the financial statements of Richards Ltd forthe year ended 31 May 20X6. (8 marks)

(15 marks)


LEASES


8

Technical reference

Point to note: The following aspects of BAS 17 are not examinable: lessor accounting, sale and leasebacktransactions, paragraphs 36-66 and the implementation guidance. The paragraphs listed below are the keyreferences you should be familiar with.

1 Lease classification

If substantially all of the risks and rewards of ownership are transferred to thelessee, then a lease is a finance lease. Factors:

BAS 17(4)

– Ownership passing at end of term BAS 17(10-11)

– Bargain purchase option

– Lease term the major part of asset's life

– Very substantial charges for early cancellation

– Peppercorn rent in secondary period

– PV of minimum lease payments substantially all of asset’s fair value. BAS 17(10(d))

Otherwise, an operating lease. BAS 17(4)

Classify at inception. BAS 17(13)

Land and buildings elements within a single lease are classified separately. BAS 17(15)

Can be a lease even if lessor obliged to provide substantial services. BAS 17(3)

2 Finance lease

Non-current asset and liability for the asset's fair value (or PV of minimum leasepayments, if lower):

BAS 17(20)

– Measured at inception of lease BAS 17(4)

– Recognised at commencement of lease term. BAS 17(4)

Depreciate asset over its useful life, or the lease term if shorter and noreasonable certainty that lessee will obtain ownership at end of lease.

BAS 17(27)

Consider whether BAS 36 impairment procedures needed. BAS 17(30)

Debit lease payments to liability, without separating into capital and interest.

Charge lease interest to income statement and credit lease liability.

Charge interest so as to produce constant periodic rate of charge on reducingliability – approximations allowed.

BAS 17(25)

Disclosures:

– Show carrying value of each class of leased assets BAS 17(31)

– In the balance sheet split the liability between current and non-current BAS 17(23)

– In a note, show analysis of total liability over amounts payable in 1, 2 to 5 andover 5 years, both gross and net of finance charges allocated to futureperiods

BAS 17(31(d))

– General description of material leasing arrangements BAS 17(31(e))

– Other BAS 16 disclosures re leased PPE assets. BAS 17(32)



3 Operating lease

Charge lease payments to income statement on straight-line basis, unless someother systematic basis is more representative of user’s benefit.

BAS 17(33)

Disclosures:

– Lease payments charged as expense in the period BAS 17(35(c))

– In a 'commitment' note, show analysis of amounts payable in 1, 2 to 5 andover 5 years, even though not recognised in balance sheet

BAS 17 (35(a))

– General description of significant leasing arrangements BAS 17(25(d))

LEASES


8


1 B Sum of the digits for payments in arrears =2

1)(1212

= 78

CUTotal lease payments (12 CU1,800) 21,600Deposit 5,000Less capital (cash price) (20,000)

6,600

Fifth payment – Interest = 8/78 CU6,600

= CU677

2 CCU

Total lease payments (24 CU200) 4,800Deposit 1,000Less capital (cash price) (5,000)Total interest 800

Interest per payment = 800/24 = CU33.3

CUCash price 5,000Deposit 1,000

4,000Interest – 6 CU33.3 200

Payments – 6 CU200 (1,200)Liability at 1 January 20X7 3,000

3 B Interest charge for 20X7 = 12% 12,000= CU1,440

4 D BAS 17 paragraph 20.

5 B The information suggests that a transference of risks and rewards has taken place. Therefore thelease is a finance lease and should be capitalised at present value of minimum lease payments (asthis is lower than fair value), i.e. CU220,000.

6 B The terms of the agreement indicate that this is a finance lease.

CU

Initially recorded at present value of minimum lease payments 480,000

Years 1 and 2 depreciation*15

45 (288,000)

* SOTD =2

1)(55 = 15 192,000



7 B

CU000Lease payments (5 200) 1,000Cash price (750)Finance charge 250

Sum of the digits over four periods = 10

Cumulative adjustment to profit at 1 January 20X5

CU'000 CU'000Lease payments charged to date (2 200) 400

Depreciation to date (2 750/5) (300)Finance charges to date20X3 (250 4/10) (100)

20X4 (250 3/10) (75)(475)(75)

8 D

Year Cash Expense AccrualCU CU CU

20X6 – 37,500 37,50020X7 50,000 37,500 25,00020X8 50,000 37,500 12,50020X9 50,000 37,500 –

150,000 150,000

9 SNOW LTD

(a) (i) Amounts to be included in the financial statements of Snow Ltd for the yearended 31 December 20X1

Income statementCU

Depreciation of leased assets 41,667Finance lease interest (1,714 + 1,429 + 9,614)(W1 & W2) 12,757

Balance sheetNon-current assets

Property, plant and equipment 143,333Current liabilities

Finance lease liabilities (W3) 46,000Non-current liabilities

Finance lease liabilities (W3) 101,757

LEASES


8

(ii) Notes

Property, plant and equipmentPlant andmachinery

Cost CUAt 1 January 20X1 –Additions (35,000 + 150,000) 185,000

At 31 December 20X1 185,000

Accumulated depreciationAt 1 January 20X1 –

Charge for year

5

150,000

3

35,000 41,667

At 31 December 20X1 41,667

Carrying amountAt 31 December 20X1 143,333

At 1 January 20X1 –

Analysis of finance lease liabilities

CUGross basisFinance lease liabilities includeGross lease payments due within:

One year (CU35,000 + CU13,000) 48,000Two to five years (3 CU35,000) + CU13,000 118,000

166,000Less finance charges allocated to future periods () (18,243)

Net basis 147,757Finance leases liabilities includeAmounts due within:

One year (W3) 46,000Two to five years (W3) 101,757

147,757

(b) Lease of land and buildings – BFRS

BAS 17 requires that the two elements of the lease (land and buildings) are classified separately.Because land has an infinite life that part of the lease will be classified as an operating lease. Thebuildings look to be a finance lease since Snow Ltd is responsible for upkeep and insurance andleases for twenty out of a twenty-five year useful life.

No split is given for the lease payments of CU21,000 pa but BAS 17 provides that in this case thelease payments should be allocated according to fair values of the leasehold interests at the startof the lease. Therefore the CU21,000 will be split one quarter to the buildings (CU5,250) andthree quarters to the land (CU15,750).

Under BAS 17, at the end of Year 1 the financial statements will reflect the following in respect ofthis lease.

Income statementCU

Depreciation (100,000 ÷ 20) 5,000Operating lease rental 15,750Interest charge (W4) 500



Balance sheetCU

Non-current assetsProperty, plant and equipment (100,000 – 5,000) 95,000

Non-current liabilitiesFinance lease liabilities (W4) 90,000

Current liabilitiesFinance lease liabilities (W4) 5,250

WORKINGS

(1) Snow machine

Period ended B/f Payment Capital Interest C/f@ 8.36%

CU CU CU CU CU31 December 20X1 150,000 (35,000) 115,000 9,614 124,61431 December 20X2 124,614 (35,000) 89,614 7,492 97,106

Total liabilityCU124,614

Capital > 1 yrCU89,614

< 1 yr

CU35,000 ()

(2) Snowplough

(a) Calculation of finance charge

CUDeposit 2,000Lease payments (6 6,500) 39,000Fair value of asset (35,000)Finance charge 6,000

(b) Interest allocation

SOD =2

1)(nn

=2

76

= 21

Period endedCU

30 June 20X1 6/21 x 6,000 = 1,71431 December 20X1 5/21 x 6,000 = 1,42930 June 20X2 4/21 x 6,000 = 1,14331 December 20X2 3/21 x 6,000 = 857

LEASES


8

(c) Liability table

Period ended B/f Interest Payment Capital(W2b)

CU CU CU CU30 June 20X1 33,000 1,714 (6,500) 28,21431 December 20X1 28,214 1,429 (6,500) 23,14330 June 20X2 23,143 1,143 (6,500) 17,78631 December 20X2 17,786 857 (6,500) 12,143



< 1 yr

CU11,000 ()

(3) Finance lease liabilities

Snow machine Snowplough Total(W1) (W2)

CU CU CU< 1 year 35,000 11,000 46,000> 1 year 89,614 12,143 101,757

124,614 23,143 147,757

(4) Lease of buildings

Year B/f Payment Capital Interest C/fCU CU CU CU CU

1 100,000 (5,250) 94,750 19/190 5,000 = 500 95,2502 95,250 (5,250) 90,000 18/190 5,000 = 474 90,474



< 1 yr

CU5,250()

Total interest = (20 5,250) – 100,000 = CU5,000

SOD =2

1)(nn

=2

2091

= 190



10 FEENEY LTD

MEMORANDUM

To Finance Director, Feeney LtdFrom Financial AccountantDate 30 March 20X4Subject Accounting and disclosure implications of replacement of machinery

a) 'Substance over form'

Leasing is an example of the application of the concept of 'substance over form' – a concept thatBFRS Framework requires should be applied to all accounting areas. To account for substance, acompany must record transactions so as to reflect their economic reality rather than merelytheir legal form.

BAS 17 does this by requiring an analysis of who carries the risks and rewards of ownership; ifthe company's obligation as lessee to make payments under the lease has a similar commercialeffect to borrowing the money and buying the asset outright, both BAS 17 and BFRS Frameworkrequire the accounts to reflect the asset and 'the related loan'.

(b) Information provided

The key words 'relevant', 'reliable', 'comparable' and 'understandable' are concerned with thequality of financial information as discussed in BFRS Framework. They can be applied to BAS 17 asfollows.

Relevant. Information is relevant if it can influence the economic decisions of users. Byshowing the true substance of finance leases, companies are forced to bring debt onto thebalance sheet and this could influence other potential lenders. Also, the commitments notefor operating leases and the liabilities note for finance leases have predictive value bywarning lenders of existing contractual obligations and how long they are likely to last.

Reliable. To be reliable, information must faithfully represent a transaction, i.e. all therights and liabilities arising from a transaction must be identified and assessed. BAS 17clearly does this via its overriding requirement to account for substance.

Comparable. Comparability implies consistency between different companies and fromyear to year. BAS 17 gives detailed guidance on how to identify a finance lease. However,there will always be a certain element of subjectivity in assessing 'risks and rewards'.

A key benefit of BAS 17 is that the financial statements of a company acquiring the use of anasset through a finance lease will be comparable, in terms of tangible assets, borrowings,gearing, return on capital employed, etc, with those of a company taking out a loan toacquire legal title to an asset.

In addition, disclosure of the detailed accounting policy (including how interest is allocated)will assist in comparability.

Understandable. Although some users might assume that the assets in the balance sheetare owned by the company, the accounting policy note should explain the inclusion ofleased assets. Also, preparers of accounts are entitled to assume that users have areasonable level of knowledge.

LEASES


8

(c) Accounting for each option

Option (1)

Because the lease is only for two years and the asset has a life of five years, Feeney Ltd isnot obtaining substantially all the rewards of ownership.

Because the lessor is liable for maintenance, Feeney Ltd is not bearing substantially all therisks of ownership.

This lease is therefore an operating lease and thus the asset is not capitalised nor the liabilityrecognised in the balance sheet.

Income statementCU

Operating lease rental (W1) 27,000

Balance sheetCU

Trade and other receivables (W2) 3,000

Option (2)

As the machine will be leased for the whole of its life, it is an asset acquired under a financelease.

BAS 17 requires the non-current asset to be capitalised (and depreciated over the shorterof the lease term and its useful life), a liability to be created, and certain detailed disclosuresto be made.

Income statementCU

Depreciation (W3) 16,000Interest charge ((3,505 + 3,185) W4) 6,690

Balance sheet

Total property, plant and equipment held under finance leases CUCost 80,000Depreciation (W3) (16,000)

Carrying amount 64,000

Non-current liabilitiesFinance lease liabilities (W4) 49,940

Current liabilitiesFinance lease liabilities (W4) 16,950

WORKINGS

(1) Rental

years2

)000,224(000,6

leaseofLife

payableTotal = CU27,000 per annum

(2) Operating lease prepayment

CU CUDR Income statement 27,000DR Trade and other receivables 3,000

CR Cash (6,000 + (12 2,000)) 30,000



(3) Depreciation

years5

000,80CU= CU16,000

(4) Lease creditor

Year Period B/f Payment Capital Interest C/f@ 5%

CU CU CU CU CU1 1 80,000 (9,900) 70,100 3,505 73,605

2 73,605 (9,900) 63,705 3,185 66,8902 1 66,890 (9,900) 56,990 2,850 59,840

2 59,840 (9,900) 49,940 2,497 52,437



< 1 yr

CU16,950 ()

11 RICHARDS LTD

(a) (i) In a straightforward transaction its commercial effect is the same as its legal form. However,in more complex transactions the true substance of the transaction may be different fromits legal form, with one party having the risks and rewards of ownership but another partyhaving legal title to the asset.

In such circumstances recording the legal form of the transaction would not be sufficient toprovide a fair presentation in the financial statements. The financial statements must bepresented fairly in order to meet the qualitative characteristic of reliability.

Where a transaction gives rise to an asset that asset should be recognised even if legally theentity does not own it. For example, where an entity has the sole use of an asset for themajority of its economic life the asset should be recognised in the entity’s financialstatements even if legally it is owned by a third party.

(ii) Finance lease

Under a finance lease, the lessor retains the legal title to the asset. However, the lessee hasuse of the asset during substantially the whole of the asset’s useful life. During this periodthe lessee is controlling the asset and has the benefit of the economic benefits beinggenerated from the asset’s use.

In addition, the present value of the minimum lease payments amount to at least the fairvalue of the leased asset, thereby suggesting that the lessee is actually paying the currentmarket price for the asset under a financing arrangement. The cost of the asset is thereforeknown. The legal title of the asset may or may not pass to the lessee at the end of the leaseterm.

In essence the lessee has all the risks and rewards of ownership and therefore shouldrecognise the leased asset on its balance sheet along with a liability even though it may nothave legal title to the asset.

Operating lease

Under an operating lease, the lessee will have use of the asset for only part of its useful lifeand does not therefore have access to the economic benefits generated by the asset over itsuseful life.

LEASES


8

Under an operating lease the lease payments will be substantially less than the fair value ofthe asset and at the end of the lease term the asset may be used by the owner or leased toanother third party.

The lessee does not have the substantial risks and rewards of ownership and therefore thelessee does not recognise the asset or liability in its financial statements. The lessee willinstead recognise the lease rentals on a straight-line basis over the period of the lease in itsincome statement.

(b) Property, plant and equipment

CUCost 150,000Accumulated depreciation (150,000 / 4 years) (37,500)Net book value 112,500

Current liabilitiesFinance lease liability (W3) 33,333

Non-current liabilitiesFinance lease liability (W3) 83,334

Gross basis

Finance leases liabilities include: CUGross lease payments due within:

One year 40,000Two to five years 100,000

140,000Less finance charges allocated to future periods () (23,333)

116,667 (W3)

Net basis

Finance leases liabilities include: CUAmounts due within:

One year (W3) 33,333Two to five years (balancing figure) 83,334

116,667 (W3)

WORKING

(1) Finance charge

CUDeposit 30,0008 bi-annual payments (20,000 x 8) 160,000

190,000Fair value 150,000Finance cost 40,000

Sum of digits is 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 = 362

1)n(n

(2) Allocation of interest

Period InterestCU

1 8/36 40,000 = 8,889

2 7/36 40,000 = 7,778

3 6/36 40,000 = 6,667

4 5/36 40,000 = 5,556



(3) Liability table

Period commencing B/f Payment Capital Interest (W2) C/fCU CU CU CU CU

1 June 20X5 150,000 (30,000) 120,000 8,889 128,8891 Dec 20X5 128,889 (20,000) 108,889 7,778 116,6671 June 20X6 116,667 (20,000) 96,667 6,667 103,3341 Dec 20X6 103,334 (20,000) 83,334 5,556 88,890

Total lease liability at 31 May 20X6 = CU116,667

Capital > 1 yr= CU83,334

< 1 yr ()= CU33,333

LEASES


8



(a) A company leases machine tools. Legal title istransferred after three years.

Finance lease, because title is transferred and thecompany enjoys the risks and rewards ofownership before-hand.

(b) A company leases a photocopier. The PV ofminimum lease payments is CU2,000 but thefair value of the asset is CU10,000.

Operating lease, as the fair value of the asset is alot more than the minimum lease payments.

(c) A company leases a car for a salesrepresentative for a five-year period, afterwhich the car will have come to the end ofits useful economic life.

Finance lease

(d) A company acquires some equipment madebespoke to its specifications. To sell theequipment to a third party would requiresubstantial modification.

Finance lease


Lease liabilityCR CR DR CR

Balance Interest Payment Capitalb/f accrued 31 Dec balance

1 Jan @10% c/f31 Dec 31 Dec

CU CU CU CU20X1 (current period) 24,869 2,487 (10,000) 17,35620X2 (future periods) 17,356 1,736 (10,000) 9,092

Total lease liability at 31 December 20X1 = CU17,356

Capital > 1 year

= CU9,092

< 1 year ()

= CU8,264


Lease liabilityCR DR CR CR CR



CU CU CU CU CU20X1 (current period) 34,869 (10,000) 24,869 2,487 27,35620X2 (future periods) 27,356 (10,000) 17,356 1,736 19,092




Capital > 1 year

= CU17,356

< 1 year ()

= CU10,000


(a) Gross basisCU

Finance lease liabilities include:Gross lease payments due within:


30,000Less finance charges allocated to future periods 2,644

27,356

(b) Net basisCU

Finance lease liabilities include:Amounts due within:


27,356



Income statement (extract)

CU

Finance costs (Working) 1,037

Balance sheet (extract)

CU


Finance lease liability (Working) 7,393

Current liabilities

Finance lease liability (Working) 1,069

WORKINGCR CR DR CR

Bal b/f 1 Jan Interest accrued at 11% Payment 31 Dec Bal c/f 31 DecCU CU CU CU

20X1 (10,000 – 575) = 9,425 1,037 (2,000) 8,46220X2 8,462 931 (2,000) 7,393

LEASES


8


Capital > 1 year

= CU7,393

< 1 year

= CU1,069 (balancingfigure)

(b) Sum of digits method

Income statement (extract)CU

Finance costs (W3) 1,144

Balance sheet (extract)CU

Non-current liabilitiesFinance lease liability (W3) 7,549

Current liabilitiesFinance lease liability (W3) 1,020

WORKINGS

(1) Finance charge

CU

Total payments (7 2,000) + 575 14,575

PVMLP (10,000)4,575

(2) Digit2

1)n(n n = number of interest bearing instalments

2

8x7= 28

(3) Finance lease liability

CR CR DR CRBal b/f 1 Jan Interest Payment 31 Dec Bal c/f 31 Dec

CU CU CU CU20X1 (10,000 - 575) = 9,425 (7/28 x 4,575) = 1,144 (2,000) 8,56920X2 8,569 (6/28 x 4,575) = 980 (2,000) 7,549


Capital > 1 year

= CU7,549

< 1 year

= CU1,020 (balancingfigure)


The minimum lease payments under non-cancellable operating leases are:

CUWithin one year (CU100,000 + CU30,000 + CU40,000) 170,000Within two to five years ((CU100,000 x 4) + CU30,000 x 2) 460,000After more than five years (CU100,000 x 10) 1,000,000

1,630,000




Contents

Introduction

Examination context

Topic List

1 Provisions and contingencies

2 Provisions: definition and recognition

3 Measurement and subsequent treatment

4 Specific applications

5 Disclosures relating to provisions

6 Contingent liabilities

7 Contingent assets

8 BAS 10 Events After the Balance Sheet Date


Technical reference



chapter 9

Provisions, contingenciesand events after the balancesheet date



Introduction


Explain the definitions and recognition criteria of BAS 37 Provisions, Contingent Liabilities andContingent Assets within the context of BFRS Framework

Apply the accounting and disclosure requirements of BAS 37 including:

– Recognition, measurement and disclosure of provisions; and

– Disclosure of contingent liabilities and contingent assets

Apply the accounting and disclosure requirements of BAS 10 Events After the Balance SheetDate including the distinction between:

– Events after the balance sheet date that require adjustment; and

– Those that require disclosure only

Specific syllabus references for this chapter are: 1d, 2b,c.


In the past the manipulation of provisions has been seen as a means of managing earnings. This practicecould be undertaken for a number of different reasons including the smoothing of earnings, meeting lenders’expectations and enhancing business valuations.

For example, in periods where performance has exceeded expectations an entity might be tempted to makea ‘rainy day’ provision. The provision set up in prosperous times would be released to increase profits inperiods when results were not quite up to expectations.

So called ‘Big bath’ provisions were common in the 1980s and 1990s. This involved making excessiveprovisions for future costs, particularly those involving a fundamental restructuring. When the costs wereactually incurred the costs were charged against the provisions. Any excess provision could then becredited back to earnings uplifting future results. This practice often accompanied a change in seniormanagement allowing the past management to be blamed for the need to restructure and the newmanagement to be given credit for the apparently improved performance.

BAS 37 Provisions, Contingent Liabilities and Contingent Assets provides guidance in this area and has restrictedthe use of provisions for creative accounting purposes. Guidance is provided on the type of provisions thatcan be made and the general principles surrounding recognition.

Information which is relevant to the assessment of a business’s performance may occur after the balancesheet date. In most cases events which occur after this cut-off point would not be reflected in the financialstatements. However, there are circumstances where the financial statements are adjusted to reflect eventswhich took place after the balance sheet date. BAS 10 Events After the Balance Sheet Date provides guidanceon this area.

Stop and think

Can you think of any other ways in which accounting information can be manipulated?

PROVISIONS, CONTINGENCIES AND EVENTS AFTER THE BALANCE SHEET DATE


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Working context

Although we have said that the advent of BAS 37 has restricted the use of creative accounting in this areathe recognition of provisions and contingencies still involves a significant amount of judgement, in particularover what might happen in the future. It is likely that the audit of these will be carried out by more seniormembers of the audit team.

Review of subsequent events is also a key audit procedure as information obtained after the balance sheetdate often provides valuable evidence regarding the circumstances at the year end. For example,information regarding the insolvency of a debtor which only came to light after the year end providesevidence regarding the recoverability of the receivables balance at the year end.

Syllabus links

This topic is examinable at level A in the Financial Accounting syllabus so you will be expected to have athorough knowledge and sound understanding of the subject matter. This level of knowledge will also berelevant to the Financial & Corporate Reporting paper at Advanced Stage.



Examination context

Exam requirements

Provisions, contingencies and events after the balance sheet date may be examined in the written testsection of the paper or via short-form questions. Both types of questions are likely to be scenario based.Provisions and contingencies may also be examined in the context of BFRS Framework definitions andprinciples.


Explain BFRS Framework definitions and recognition principles and explain how they relate to BAS 37

Prepare extracts from the financial statements and notes to the financial statements in respect ofprovisions and contingencies

Prepare financial statements or extracts taking into account the effect of events after the balance sheetdate



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1 Provisions and contingencies

Section overview

BAS 37 Provisions, Contingent Liabilities and Contingent Assets provides guidance on when provisions andcontingencies should be recognised and if so, at what amount.

1.1 Issues

As we have seen in many of the previous chapters, amounts in the financial statements often result from theexercise of judgement, for example the carrying amount of property, plant and equipment. Accounting forprovisions and contingencies, however, is particularly problematic due to the increased level ofuncertainty. The key issues include:

Whether a provision or contingency should be recognised If it is recognised at what amount it should be recorded

The situation is further complicated by the fact that these decisions may be affected by events occurringafter the balance sheet date.

1.2 BAS 37 Provisions, contingent liabilities and contingent assets

Objective

BAS 37 aims to ensure that:

Appropriate recognition criteria and measurement bases are applied to provisions,contingent assets and contingent liabilities; and

Sufficient information is disclosed in the notes to the financial statements to enable users tounderstand their nature, timing and amount.

Scope

Although BAS 37 has wide scope, there are two limited exceptions:

Executory contracts,except where thecontract is onerous

Executory contracts are contracts under which neither party hasperformed any of its obligations or both parties have partially performedtheir obligations to an equal extent. For example, an unfulfilled order forthe purchase of goods, where at the balance sheet date, the goods haveneither been delivered nor paid for.

Onerous contracts are dealt with in more detail in section 4.2 of thischapter.

Where the accountingtreatment is coveredby another accountingstandard

For example, BFRS 3 Business Combinations deals with the recognition of anacquiree’s contingent liabilities at the time of a business combination (seeChapter 15).



2 Provisions: definition and recognition

Section overview

A provision is recognised when all of the following conditions are met:

– A present obligation exists as a result of a past event– An outflow of resources is probable– The amount can be estimated reliably

2.1 Definition

The key aim of BAS 37 is to ensure that provisions are only recognised when there are valid grounds fordoing so.

Definitions

A provision: is a liability of uncertain timing or amount.

A liability: is a present obligation of the entity arising from past events, the settlement of which isexpected to result in an outflow from the entity of resources embodying economic benefits.

Points to note

1 BAS 37 views provisions as a sub-class of liabilities.

2 Provisions can be distinguished from other liabilities such as trade payables and accruals, because ofthe degree of uncertainty as to their timing or amount.

3 The definition of a liability used in BAS 37 is the same as the definition contained in BFRSFramework (see Chapter 1).

2.2 Recognition

BAS 37 states that a provision should be recognised when:

An entity has a present obligation (legal or constructive) as a result of a past event

It is probable that an outflow of resources embodying economic benefits will be required to settlethe obligation; and

A reliable estimate can be made of the amount of the obligation.

Points to note

1 If one or more of these criteria is not met, a provision is not recognised (although as we will seelater in this chapter a contingent liability may exist).

2 The recognition criteria of BAS 37 are very similar to the criteria for the recognition of aliability contained in BFRS Framework (see Chapter 1). These also refer to the probable outflowof economic benefit and the need for reliable measurement.

2.3 A present obligation as a result of a past event

To establish whether an entity has a present obligation which arose from a past event, identification of an'obligating event' is required.

An obligating event occurs where the entity has no realistic alternative to settling the obligation created bythe event. BAS 37 recognises that this can occur:



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Where the settlement can be enforced by law; or

In the case of a constructive obligation, where the event creates valid expectations in otherparties that the entity will discharge the obligation (see section 2.4 below).

Points to note

1 The event must be past, i.e. it must have occurred at the balance sheet date. No provision is made forcosts that may be incurred in the future but where no obligation yet exists.

2 Only obligations arising from past events existing independently of an entity’s future actions(i.e. the future conduct of its business) are recognised as provisions. If management can avoid incurringexpenditure by changing the entity’s future operations, no provision arises.

3 An obligation always involves another party to whom the obligation is owed. However, theexact identity of that other party need not be known, e.g. the obligation may be to the public at large.

4 A board or management decision does not give rise to an obligation unless it has beencommunicated before the balance sheet date to those affected by it so as to raise a validexpectation that the entity will discharge its responsibilities. In the absence of such communication,the board could change its mind and hence would be under no obligation.

5 Sometimes, the existence of an obligation will be uncertain, e.g. where there is a legal dispute. In thesecases, BAS 37 applies prudence by deeming a past event to give rise to a present obligation if it ismore likely than not that an obligation exists at the balance sheet date. However, if it is possiblerather than probable that an obligation exists, a contingent liability will exist, not a provision (seesection 6 below).

Worked example: Present obligation as a result of a past event

Company A carries out quarrying activities. A condition of the planning consent is that environmentaldamage caused by quarrying must be remedied on completion of the quarrying. In this case, an obligationexists independently of the company's future conduct in relation to damage already caused at the balancesheet date, because the company cannot avoid having to pay for remedial action. By contrast, no obligationexists in relation to expected further damage from continued quarrying because the company could decidenot to quarry in the future.

Company B operates aircraft that need periodic overhauls if they are to continue in operation. Noobligation exists in relation to future overhauls because the company could decide to sell or scrap theaircraft rather than overhaul them.

2.4 Legal and constructive obligations

You should be familiar with the concept of a legal obligation.

Definition

Legal obligation: is an obligation that derives from:

A contract (through explicit or implicit terms) Legislation; or Other operation of law.

An example of a legal obligation would be a warranty provided at the time of sale to undertake necessaryrepairs for a specified period of time.

A constructive obligation may be a less familiar term.



Definition

Constructive obligation: is an obligation that derives from an entity’s actions where:

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

As a result, the entity has created a valid expectation on the part of those other parties that it willdischarge those responsibilities.

Constructive obligations are more difficult to identify with certainty than legal obligations. In practice theyare recognised where the situation has much the same commercial effect as a legal obligation.In other words, in practice, the entity cannot avoid settling the obligation.

For example there is likely to be a constructive obligation where failure to do something would result inunacceptable damage to an entity’s reputation or future business.

Worked example: Constructive obligation

A retail store operates a policy of giving refunds to customers that goes beyond the company’s legalobligations. The policy is long established and widely known. It is likely that this policy creates aconstructive obligation, as a significant breach of the policy would damage the company’s reputationconsiderably.

2.5 Probable outflow of resources

A provision is recognised only where the obligation will lead to a probable outflow of resources. Probableis defined for these purposes as more likely than not to occur. In practical terms this means that there isa greater than 50% chance that an entity will have to transfer resource to another party.

Point to note

Where there are a number of similar obligations (e.g. product warranties) the probability should be basedon considering the class of obligation as a whole.

Worked example: Probable outflow

If a company has entered into a warranty obligation then the probability of outflow of economic benefitsmay well be extremely small in respect of one specific item. However, when considering the class ofobligation as a whole, the probability of some outflow of economic benefits is likely to be much higher. Ifthere is a greater than 50% probability of some transfer of economic benefits then a provision shouldbe made for the expected amount.

2.6 Reliable estimate

A provision should be recognised only if a reliable estimate of the obligation can be made.

Points to note

1 Where an entity can determine a range of possible outcomes, a sufficiently reliable estimate can bemade, even if the exact amount cannot be quantified.

2 In the extremely rare case where no reliable estimate can be made, a liability exists that cannot berecognised. That liability is disclosed as a contingent liability. BAS 37 provides no example of such anextremely rare case. In effect, 'extremely rare' means, 'almost never'.



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3 Measurement and subsequent treatment

Section overview

A provision should be measured at the best estimate of the expenditure required to settle theobligation.

Where there is a large population an expected value will be calculated.

The amount of the provision should be discounted where the time value of money is material.

Reimbursement should be recognised as a separate asset when it is virtually certain that it will bereceived.

3.1 Basic rule

The amount provided should be the best estimate of the expenditure required to settle the presentobligation at the balance sheet date. This is the amount that an entity would rationally pay to settle theobligation at the balance sheet date or to transfer it to a third party at that time. In making a best estimateaccount should be taken of:

Information provided by events after the balance sheet date

Management judgement/experience of similar transactions

Guidance from independent experts

The risks and uncertainties surrounding the situation. Care is needed both to avoid understatingprovisions and to avoid excessively prudent provisioning.

3.2 Single obligation

Uncertainties surrounding the amount to be recognised as a provision are dealt with by various meansaccording to the circumstances.

Worked example: Single obligation

If the expenditure for a single obligation is estimated at CU10,000 and there is a 55% chance of theexpenditure being incurred, then CU10,000 is provided for. The process of estimating the amount involvestwo separate steps:

Step 1

Is it probable that there will be an outflow of economic resources (arising from a present obligation)?Yes, there is in this case, as there is a 55% probability.

Step 2

What reliable estimate can be made? CU10,000 in this case.

Points to note

1 An expected value calculation (see next section) is not relevant for a single obligation.

2 In measuring a single obligation, the single most likely outcome may be the best estimate, but if otherpossible outcomes are mostly higher (or mostly lower), the best estimate will be higher (or lower)than the individual most likely outcome.



3.3 Expected values

Where there is a large population of items, the obligation is estimated by weighting all possibleoutcomes by their associated probabilities, to arrive at the expected value.

Interactive question 1: Expected values [Difficulty level: Exam standard]

X Ltd sells goods which carry a one-year repair warranty. If minor repairs were to be required for all goodssold in 20X7, the cost would be CU100,000. If major repairs were to be needed for all goods sold in 20X7,the cost would be CU500,000.

X Ltd estimates that 80% of goods sold in 20X7 will have no defects, 15% will have minor defects and 5%will have major defects.

Requirement

Calculate the provision for repairs required at 31 December 20X7.


3.4 Discounting

Where the effect of the time value of money is material, the amount of the provision should bediscounted. In other words it should be recorded at the present value of the expenditure required tosettle the obligation. This is likely to be an issue when there is a significant period of time between thebalance sheet date and settlement of the obligation.

The discount rate used should be the pre-tax rate that reflects current market assessments of thetime value of money and the risks specific to the liability.

Point to note

In the exam any present value figures would be given in a question. Discounting calculations will not berequired until the Financial Reporting paper.

3.5 Future events

Future events such as changes in technologies, efficiency improvements and changes in legislation may havea significant impact on the measurement of provisions. These should be taken into account where thereis sufficient objective evidence that they will occur.

3.6 Expected disposal of assets

Gains from the expected disposal of assets should not be taken into account in measuring aprovision even if the expected disposal is closely linked to the event giving rise to the provision. Instead,such gains are accounted for under the relevant BFRS, i.e. BAS 16 Property, Plant and Equipment and BFRS 5Non-current Assets Held for Sale and Discontinued Operations for PPE.

3.7 Reimbursements

In some cases, an insurance company or a supplier under a warranty may reimburse all or part of acompany’s expenditure to settle a provision. If so the reimbursement should be recognised onlywhen it is virtually certain that reimbursement will be received if the entity settles theobligation. BAS 37 requires that the reimbursement should be:

Treated as an asset in the balance sheet separate from the provision; and Recognised in the balance sheet at an amount not exceeding the amount of the provision.



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Points to note

1 Where an asset is recognised, it is presented separately from the liability, because in the unlikely eventthat the asset is not recovered, the company would still remain liable for its obligation.

2 In the income statement, the expense relating to a provision may be presented net of the amountrecognised for a reimbursement.

3 Note the different approaches to the recognition of assets and liabilities throughout this standard. Anasset can be recognised only if an inflow of resources is virtually certain (and therefore notcontingent), whereas a liability is recognised if an outflow of resources is more likely than not tooccur.

If the likelihood of receiving reimbursement is not virtually certain then the amount should be disclosed as acontingent asset, assuming that receipt is probable (see section 6 below).

3.8 Changes in provisions

Provisions are inherently uncertain and BAS 37 requires that they should be reviewed at each balancesheet date and adjusted to reflect the current best estimate. If a transfer of economic benefit is no longerprobable, the provision should be reversed.

3.9 Use of provisions

BAS 37 specifies that a provision should be used only for expenditures for which the provision wasoriginally recognised.

If a provision is no longer required for its originally intended purpose, it should be reversed and not used toconceal the impact of other unrelated expenditure. The reversal is a change of accounting estimate andis recognised in profit or loss in the year of reversal. The entry to record the reversal is:

DR Provisions X

CR Income statement for the year X

3.10 Recognising an asset when recognising a provision

In some cases, an obligation may arise from a past event before an entity has obtained economic benefitsfrom the event concerned, but the entity reasonably expects to obtain such future benefits.

In this case the amount of the provision is also recognised as an asset, to be written off over theperiod of the asset’s useful life. An example of this is the way that under BAS 16 a provision for the initialestimates of dismantling and removing an item of PPE and restoring the site on which it is located isincluded in the cost of the item.

Interactive question 2: Provision for environmental damage[Difficulty level: Exam standard]

A company establishes a new quarry and has a legal obligation to restore environmental damage oncequarrying is completed. Before rock can be extracted for sale, the overlying material (the overburden) mustbe removed, causing environmental damage. The overburden itself has no commercial value. The estimatedcost of remedying the damage caused by removal of the overburden is CU50,000 (ignore discounting).

Requirement

Show and explain the accounting entry to record the provision for environmental damage rectificationarising out of removal of the overburden.




The entry to record the provision for environmental damage on removal of the overburden will be:

DR

CR


4 Specific applications

Section overview

Future operating losses should not be provided for.

A provision should be made for the unavoidable costs of meeting an onerous contract.

Provisions for a restructuring should only be made where there is an obligation at the balance sheetdate.

4.1 Future operating losses

Provisions should not be recognised for future operating losses as they do not meet the definitionof a liability (as they arise from future, not past events) or the general recognition criteria set out in BAS 37.

Point to note

This treatment is consistent with that required under BFRS 3 for expected future losses of an acquiredbusiness (see Chapter 15). BFRS 3 specifies that such losses should not be taken into account whencalculating any goodwill acquired in a business combination but must be dealt with as post-acquisition itemsin the group accounts.

4.2 Onerous contracts

Definitions

An onerous contract is a contract in which the unavoidable costs of meeting the obligationsunder the contract exceed the economic benefit expected to be received under it.

The unavoidable costs under a contract are the lower of the cost of fulfilling the contract and anycompensation or penalties arising from failure to fulfil it. In other words, it is the lowest net cost ofexiting from the contract.

If an entity has a contract that is onerous, the present obligation under the contract should be recognisedand measured as a provision. An example might be vacant leasehold property.

Worked example: Onerous contract

A company rents a building under an operating lease, but vacates the building shortly before its year end,due to business relocation. The lease on the vacated building has three years to run and cannot becancelled. The building cannot be sub-let.



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In this case, the conditions for making a provision are met as:

A present obligation exists as a result of a past event (the signing of the lease)

An outflow of resources embodying economic benefit in settlement is probable (rentals for theremainder of the lease term); and

The amount can be measured reliably (the future rentals, discounted if material).

4.3 Restructuring

Definition

A restructuring is a programme that is planned and controlled by management, and materially changeseither:

The scope of a business undertaken by an entity; or The manner in which that business is conducted.

Examples of events that may fall under the definition of restructuring include:

Sale or termination of a line of business

Closure of business locations or the relocation of business activities

Changes in management structure

Fundamental reorganisations that have a material effect on the nature and focus of the entity’soperations.

Point to note

The BAS 37 requirements apply to the recognition and measurement of provisions on discontinuance, aswell as other restructurings. In the case of a discontinuance, BFRS 5 (dealt with in Chapter 4) providesadditional disclosure requirements.

4.3.1 Criteria for making a provision

The key accounting issue is whether, and if so, when, to recognise a provision for a planned restructuring.

BAS 37 treats a restructuring as creating a constructive obligation (and therefore as requiringrecognition as a provision) only when an entity:

Has a detailed formal plan identifying at least:

– The business concerned– The principal locations– The employees affected– The expenditure required– The timing; and

Has raised a valid expectation in those affected that it will carry out the restructuring by startingimplementation or announcing its main features.

A management or board decision taken before the year end in itself does not give rise to aconstructive obligation at the balance sheet date unless the entity has:

Already begun implementation; or Made a public announcement of the main features sufficient to establish a constructive obligation.



Point to note

A similar decision taken after, not before, the year end will normally require disclosure as a non-adjustingevent after the balance sheet date, under BAS 10 (see section 8 below).

4.3.2 Measurement

A provision should include only the direct expenditures arising from the restructuring, which are both:

Necessarily entailed by the restructuring; and Not associated with ongoing activities.

This therefore excludes indirect costs, for example retraining or relocating staff in a continuing operation.Provisions for future losses of the restructured operation are also not permitted, unless they relate toonerous contracts.

4.3.3 Sale of an operation

Where an operation is to be sold, no obligation arises for the sale until the entity is committed to the sale,i.e. there is a binding sale agreement.

A decision to sell does not itself create an obligation. Without a binding agreement, there is no past eventindependent of the entity’s future actions, as management may change its mind or be unable to find apurchaser.

4.4 Other examples

Appendix C of BAS 37 includes a number of examples of the way in which the recognition criteria would beapplied to specific situations. Several of these have already been referred to in this chapter. You should readthrough the Appendix and attempt Interactive question 4 below to confirm your understanding.

Interactive question 3: Provisions [Difficulty level: Exam standard]

In which of the following circumstances might a provision be recognised?

(a) On 13 December 20X9 the board of an entity decided to close down a division. The accounting dateof the company is 31 December. Before 31 December 20X9 the decision was not communicated toany of those affected and no other steps were taken to implement the decision.

(b) As (a) above except that the board agreed a detailed closure plan on 20 December 20X9 and detailswere given to customers and employees.

(c) A company is obliged to incur clean up costs for environmental damage (that has already been caused).

(d) A company intends to carry out future expenditure to operate in a particular way in the future.


5 Disclosures relating to provisions

Section overview

BAS 37 requires a number of numerical and narrative disclosures.

BAS 37 disclosures are examinable in full. The main requirements in relation to provisions are set outbelow. Note also that BAS 37 Appendix D includes disclosure examples.



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Key BAS 37 numerical disclosures for each class of provision are:

Carrying amounts at the beginning and end of the period

Movements during the period, including:

– Amounts provided– Amounts used (i.e. incurred and charged against the provision)– Unused amounts reversed– Increases due to unwinding of a discount– Effect of changes in the discount rate

Key BAS 37 narrative disclosures for each class of provision are:

A brief description of the obligation and expected timing of any outflows of resourcesembodying economic resources

An indication of the uncertainties involved

The amount of any expected reimbursement, including the amount of any asset that has beenrecognised

Point to note

In extremely rare cases, disclosure may seriously prejudice the company’s position in a dispute withother parties on the subject matter of the provision. In such cases, the information need not bedisclosed, but the general nature of the dispute, together with the reason why the information has notbeen disclosed, should be stated.


Section overview

Contingent liabilities should not be recognised but may require disclosure.

6.1 Definitions

Definition

A contingent liability is either:

A possible obligation that arises from past events and whose existence will be confirmed only by theoccurrence or non-occurrence of one or more uncertain future events not wholly within the controlof the entity, or

A present obligation that arises from past events but is not recognised because:

– It is not probable that an outflow of resources embodying economic benefits will be required tosettle the obligation; or

– The amount of the obligation cannot be measured with sufficient reliability.

Points to note

1 Note the distinction between a provision and a contingent liability. A contingent liability arises whensome, but not all, of the criteria for recognising a provision are met. The criteria for recognising aprovision were covered in section 2.2 above.

2 If an obligation is probable it is not a contingent liability – instead a provision is needed.



6.2 Treatment of contingent liabilities

Contingent liabilities should not be recognised in the financial statements, but may requiredisclosure (see section 6.3 below).

Because contingent liabilities are inherently uncertain, they should be assessed continually to identifywhether the criteria for recognising a provision have been met. If this occurs, a provision should berecognised in the period in which the criteria are met. This would represent a change of accountingestimate regarding the likely outcome of an uncertain situation.

6.3 Disclosure of contingent liabilities

Unless the possibility of any outflow in settlement is remote, the following disclosures should be made foreach class of contingent liability at the balance sheet date:

A brief description of its nature; and

Where practicable:

– An estimate of the financial effect (measured in the same way as a provision)– An indication of the uncertainties; and– The possibility of any reimbursement.

No specific guidance is provided in BAS 37 on the meaning of ‘remote’. In line with prudence, 'remote'should be interpreted as meaning extremely unlikely. This means that the probability of an eventoccurring should be so small that it can be ignored.

Worked example: Contingent liability

A company has provided a guarantee to a third party which, if it were to be called on to honour it, wouldundermine the going concern basis. In such a situation, even a 5% or 10% chance that the guarantee will beenforced should not be considered remote as this could potentially destroy the entire company.

6.4 Exemption

If the disclosure requirements of BAS 37 are not met because it is not practicable to do so, this fact shouldbe stated. The same ‘seriously prejudicial’ disclosure exemption applies for contingent liabilities as forprovisions (see section 5 above).



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6.5 Relationship between provisions and contingent liabilities

This can be summarised in the following flow chart which has been reproduced from Appendix B of BAS 37.

7Contingent assets

Section overview

A contingent asset should not be recognised but should be disclosed where an inflow of benefits isprobable.

7.1 Definition

Definition

A contingent asset is a possible asset that arises from past events and whose existence will be confirmedonly by the occurrence or non-occurrence of one or more uncertain future events not wholly within thecontrol of the entity.

An example of a contingent asset is the possible gain arising from a pending legal action or other claim.



7.2 Treatment of contingent assetsA contingent asset must not be recognised. Only when the realisation of the related economic benefitsis virtually certain should recognition take place because, at that point, the asset is no longer contingent.

This is an application of the prudence concept.

Contingent assets should be assessed continually to identify whether the uncertainty has been removed.If events confirm the existence of an asset, it should be recognised provided that it can be measuredreliably.

7.3 Disclosure of contingent assetsWhere an inflow of economic benefits is probable, i.e. more likely than not, the contingent asset must bedisclosed.

The following information is required:

A brief description of the nature of the contingent asset An estimate of the financial effect

As for contingent liabilities, these disclosures may be avoided on the grounds that it is impractical toprovide the information or would be seriously prejudicial to the entity.

Interactive question 4: BAS 37 definitions [Difficulty level: Easy]

Identify which, if any, of the following circumstances falls within BAS 37's definitions of a provision, acontingent liability or a contingent asset, explaining your answer:

Circumstance Position under BAS 37

A contract of employment

A legal claim being pursued by an entity and whichit is confident of winning

A legal claim being pursued against an entity butwhich the entity is confident of winning

A legal claim against an entity where the entity hasaccepted liability but the amount to be paid has notyet been agreed

Legislation enacted but coming into effect nextyear which will require substantial retraining ofstaff

The reinstatement of land once quarrying hasceased, where there is no legal obligation. Theentity’s published policy in relation toenvironmental protection is that it will reinstateany environmental damage caused by its activities

The reinstatement of land once quarrying hasceased, where there is no legal obligation, theentity has no published policy in relation toenvironmental protection and this is the firstquarrying venture it has entered into



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Restructurings where the detailed plan has beendeveloped, announced and agreed with employees’representatives

Restructurings where the detailed plan has beendeveloped and announced

Restructurings where the detailed plan has beendeveloped and agreed by the board, but noannouncement has been made

Future reinstatement work under guarantees to beprovided to customers in relation to future sales


Interactive question 5: Application of BAS 37 [Difficulty level: Easy]

For each of the following circumstances identify when, if ever, an asset or liability should be recognisedunder BAS 37. In each case, is any disclosure required by BAS 37 prior to any asset/liability recognition?

Circumstance Application of BAS 37

A legal claim in relation to a past event is pursuedagainst an entity over several years. The entitymakes the following judgements about outflows ofresources in settlement:

Year 1: there will be no outflow

Year 2: an outflow is remote

Year 3: an outflow is possible

Year 4: an outflow is probable

Year 5: an outflow is virtually certain

A legal claim in relation to a past event is pursuedby an entity over several years. The entity makesthe following judgements about inflows ofresources in settlement:

Year 1: there will be no inflow

Year 2: an inflow is remote

Year 3: an inflow is possible

Year 4: an inflow is probable

Year 5: an inflow is virtually certain




8 BAS 10 Events After the Balance Sheet Date

Section overview

Events after the balance sheet date may be:

– Adjusting events– Non-adjusting events.

The effect of adjusting events should be reflected in the year end financial statements.

Where the effect of non-adjusting events is material they should be disclosed.

8.1 Purpose of BAS 10

Financial statements are prepared to the balance sheet date. The preparation of financial statements,however, will normally continue for a period after this date. During this time lag, events may occur whichprovide additional information that is relevant to the preparation of the financial statements. Theobjective of BAS 10 Events After the Balance Sheet Date is to prescribe when financial statements should beadjusted for these events and any disclosures that may be required.

8.2 Events after the balance sheet date

Definition

Events after the balance sheet date are those events, favourable and unfavourable, that occur betweenthe balance sheet date and the date when the financial statements are authorised for issue.

Points to note

1 The date the financial statements are authorised for issue is the key cut off point. Any event whichtakes place after this date is outside the scope of BAS 10.

2 The process involved in authorising the financial statements may vary:

Where an entity is required to submit its financial statements to its shareholders for approvalafter the financial statements have been issued, the financial statements are authorised for issueon the date of issue (not the date when the shareholders approve the financial statements)

Where the management is required to issue the financial statements to a supervisory board(made up solely of non-executives) for approval, the financial statements are authorised for issuewhen the management authorises them for issue to the supervisory board

3 The date of authorisation may be after a preliminary announcement has been made of profits orother information.

4 The date on which the financial statements are authorised for issue must be disclosed, so that usersknow the date up to which events and transactions have been taken into account.

There are two different classes of events after the balance sheet date:

Adjusting events; and Non-adjusting events.

We will look at these in detail below.



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8.3 Adjusting events

Definition

Adjusting events: Those that provide evidence of conditions that existed at the balance sheet date.

As the name suggests adjusting events lead to the adjustment of the financial statements. They requireeither:

Adjustments to amounts already recognised in the financial statements; or Recognition of items which did not previously meet the recognition criteria.

Examples include:

The settlement of a court case outstanding at the balance sheet date. (This is an example of anevent which might require either adjustment to an amount already recognised in the financialstatements as a liability or the recognition of something which prior to that would have been only acontingent liability)

Bankruptcy of a customer, requiring adjustment to the amount receivable

Proceeds or other evidence concerning the net realisable value of inventories

Subsequent determination of the purchase price or of the proceeds of sale of assets purchasedor sold before the year end

Worked example: Adjusting event

A pressing machine with a budgeted carrying amount at 31 December 20X6 of CU20,000 is classified asheld for sale in December 20X6. Its fair value less costs to sell is then estimated as CU18,000 and it is soldfor CU16,500 on 28 February 20X7. The 20X6 financial statements are authorised for issue by the boardon 15 March 20X7.

The machine should be measured at CU16,500 in the 20X6 financial statements.

Point to note

As the financial statements will have been adjusted for an adjusting event there is no specificrequirement to disclose the event.

However, where the adjusting event affects an item which was not previously recognised but was disclosed,the disclosure will need to be updated. For example, the contingent liability for damages under a court casemay need to be updated for new information.

8.4 Non-adjusting events

Definition

Non-adjusting events. Those that are indicative of conditions that arose after the balance sheet date.

Examples include:

A fall in the market value of investments Plans to discontinue operations announced after the year end Major purchases of assets



Losses on non-current assets or inventories as a result of a catastrophe such as fire or flood; Restructurings not provided for as they were announced after the year end.

Adjustments to amounts in the financial statements are not made to reflect non-adjusting events.

However, where the effect of the non-adjusting event is material, such that non-disclosure could influenceusers’ economic decisions the following information should be provided in the notes to the financialstatements for each event:

The nature of the event; and An estimate of the financial effect.

8.5 Dividends

Dividends on equity shares proposed or declared after the balance sheet date should be treated as follows:

They cannot be shown as a liability as there is no obligation at the balance sheet date. The amount of dividends payable must be disclosed in the notes to the financial statements.

Interactive question 6: Dividends [Difficulty level: Exam standard]

The recent financial calendar of RSB Ltd, a company with a 31 December year end, has included thefollowing:

Authorised by Approved in annualdirectors for issue general meeting

Financial statements for 20X5 28 February 20X6 3 May 20X6Financial statements for 20X6 28 February 20X7 4 May 20X7

Dividends on ordinary shares Proposed by directors Declared by directors Approved in annualgeneral meeting

20X5 final 28 February 20X6 No Yes20X6 interim 31 August 20X6 Yes No20X6 final 28 February 20X7 No Yes

Requirement

Identify how these dividends will be dealt with in RSB Ltd’s financial statements for 20X5, 20X6 and 20X7.


Financial statements for: 20X5 20X6 20X7

20X5 final dividend

20X6 interim dividend

20X6 final dividend




9

8.6 Going concern

If management determines after the balance sheet date that it intends to liquidate the entity or tocease trading, or that it has no realistic alternative but to do so, then the financial statementsmust not be prepared on the going concern basis.

Points to note

1 Management intentions are taken into account.

2 A change from the going concern basis is so all-pervasive in its effects on financial statements that afundamental change to the basis of accounting is required, not just adjustments to the figures preparedon the going concern basis. No guidance is given in any BFRS as to the basis of accounting whichshould be used in these circumstances, but it is likely that the break-up basis will be adopted (seeChapter 1). All assets will need to be measured at their net realisable values; amounts receivable fromcustomers will need to take account of the period available for their collection – the shorter theperiod, the lower the value.




Summary

If not – outsidescope of BAS 10



9

Self-test


1 The directors of Robin Ltd (year end 31 December 20X6) were informed on 27 February 20X7 that aserious fire at one of the company’s factories had stopped production there for at least six months tocome. On 3 March 20X7 the directors of Robin Ltd were informed that a major customer had goneinto liquidation. The liquidator was pessimistic about the prospect of recovering anything forunsecured creditors. The financial statements for the year ended 31 December 20X6 were authorisedfor issue on 20 March 20X7.

In accordance with BAS 10 Events After the Balance Sheet Date how should the two events be treated inthe financial statements?

Fire LiquidationA Accrued in accounts Disclosed in notesB Disclosed in notes Disclosed in notesC Accrued in accounts Accrued in accountsD Disclosed in notes Accrued in accounts

2 The following events took place between the balance sheet date and the date on which the financialstatements were authorised for issue.

Which event should be classified as an adjusting event in accordance with BAS 10 Events After theBalance Sheet Date?

A The disclosure of a fraud that shows the financial statements were incorrect.B The acquisition of a subsidiaryC A rights issueD A dramatic fall in the value of an overseas investment due to movements in the exchange rate

3 Brick Ltd, Cement Ltd and Mortar Ltd are independent companies, each with a year end of 31December. Each company is owed a substantial amount by Ladder Ltd. The debts arose on thefollowing dates.

Brick Ltd 20 December 20X1Cement Ltd 20 January 20X2Mortar Ltd 25 January 20X2

On 31 January 20X2 Ladder Ltd went into liquidation, and on 2 February 20X2, as a result of theamount which Ladder Ltd owed to it, Mortar Ltd went into liquidation.

Ladder Ltd’s default will be regarded as an event requiring adjustment under BAS 10 Events After theBalance Sheet Date by

A Brick LtdB Brick Ltd and Cement LtdC Brick Ltd and Mortar LtdD Brick Ltd, Cement Ltd and Mortar Ltd



4 The directors of Laurel Ltd are reviewing the draft balance sheet at 31 December 20X2. The followingevents after the balance sheet date have been identified.

(i) On 1 February 20X3 a fraud perpetrated by the accounts receivable controller was discovered.Receivables recorded in November 20X2 were overstated by CU30,000.

(ii) Property, plant and equipment with a carrying amount of CU25,000 was destroyed by a fire on15 January 20X3. No insurance recovery is expected.

(iii) A claim brought by a customer which was under negotiation at the balance sheet date wassettled in court on 12 January 20X3. A payment of CU20,000 in full settlement was made on 24January 20X3.

Which of these events would be regarded as an adjusting event according to BAS 10 Events After theBalance Sheet Date?

A (i) and (ii) onlyB (ii) and (iii) onlyC (i) and (iii) onlyD All three events

5 Which of the following would be a non-adjusting event after the balance sheet date when preparingfinancial statements at 31 December 20X9 according to BAS 10 Events After the Balance Sheet Date?

(i) A firework destroys part of the warehouse inventory in the early hours of 1 January 20Y0.

(ii) An insurance claim is agreed on 3 January 20Y0 for a fire in December 20X9 which destroyedpart of the inventory in another warehouse.

(iii) A customer goes into receivership as a result of a catastrophic fire in January 20Y0.

(iv) Some inventory damaged by the fire in (i) above is sold in January 20Y0 at 10% of its cost price.

A (i), (ii) and (iv)B (i), (iii) and (iv)C (ii), (iii) and (iv)D (i), (ii) and (iii)

6 The following describe potential provisions.

(i) A provision to cover refunds. The company is in the retail sector and has a reputation for a 'noquestions asked' policy on refunds.

(ii) A provision to cover an onerous contract on an operating lease. The lease was on a buildingwhich the company has subsequently vacated. The lease cannot be terminated and cannot be re-let.

Following BAS 37 Provisions, Contingent Liabilities and Contingent Assets, in which of the above situationswould a company be required to recognise a provision in their accounts for the year ended 30September 20X7?

A Neither situationB Both situationsC Situation (i) onlyD Situation (ii) only



9

7 Porter Ltd is finalising its financial statements for the year ended 30 September 20X3.

A former employee of Porter Ltd has initiated legal action for damages against the company after beingsummarily dismissed in October 20X3. Porter Ltd’s legal advisers feel that the employee will probablywin the case and have given the company a reasonably accurate estimate of the damages which wouldbe awarded. Porter Ltd has not decided whether to contest the case.

In accordance with BAS 37 Provisions, Contingent Liabilities and Contingent Assets this item should beclassified in the financial statements of Porter Ltd for the year ended 30 September 20X3 as

A A non-adjusting event after the balance sheet dateB An adjusting event after the balance sheet dateC A contingent liability disclosed by way of noteD A provision

8 A company has a year end of 31 March 20X6. On 10 April 20X6 a decision is taken to sell a subsidiarycompany, creating a profit in the books of the parent company.

Which of the statements below reflects the correct treatment of this item in the accounts of thecompany for the year ended 31 March 20X6?

A The sale is an 'exceptional' item not expected to recur, and accordingly the profit should bedisclosed in the income statement after the figure for profit/(loss) for the period

B The sale of a subsidiary is a normal business decision taken by the main board of directors, andaccordingly the profit arising should be included in the income statement but not separatelydisclosed

C The sale is an event after the balance sheet date, and accordingly, in view of the potential impacton next year’s results, details of the event and the profit arising should be disclosed as a note tothe financial statements

D The sale is a contingency in view of the fact that it was uncertain at the balance sheet date, andaccordingly details of the contingency and the profit arising should be disclosed as a note to thefinancial statements

9 Mulroon Ltd, a publishing company, is being sued for CU1 million in a libel action in respect of a bookpublished in January 20X4. On 31 October 20X4, the balance sheet date, the directors believed thatthe claim had a 10% chance of success. On 30 November 20X4, the date the accounts wereauthorised for issue, the directors believed that the claim had a 30% chance of success.

In accordance with BAS 37 Provisions, Contingent Liabilities and Contingent Assets in the financialstatements to 31 October 20X4 the amount which should be accrued is

A CUnilB CU100,000C CU300,000D CU1,000,000



10 Construction Ltd was awarded a contract to build a tunnel under the Thames river by a governmentdepartment. Construction Ltd delegated some aspects of the contract to other companies. One of thesub-contractors, Underwater Ltd, was negligent in the performance of its contract with ConstructionLtd, which caused delay in the completion of the tunnel.

As a result of the delay, the government department is claiming damages of CU10 million againstConstruction Ltd. In turn, Construction Ltd has commenced proceedings against Underwater Ltd. Thelawyers have advised Construction Ltd that both actions are likely to be successful.

In accordance with BAS 37 Provisions, Contingent Liabilities and Contingent Assets how shouldConstruction Ltd account for the legal claims?

Claim against Claim againstConstruction Ltd Underwater Ltd

A Provide AccrueB Provide DiscloseC Disclose Do nothingD Do nothing Do nothing

11 Where some or all of the expenditure required to settle a provision is expected to be reimbursed byanother party and it is virtually certain that reimbursement will be received if the entity settles theprovision, which of the following statements is true in accordance with BAS 37 Provisions, ContingentLiabilities and Contingent Assets?

(i) The reimbursement may be offset against the provision in the balance sheet and the charge in theincome statement.

(ii) The reimbursement is recognised as a separate asset in the balance sheet and may be offsetagainst the charge in the income statement.

(iii) The amount recognised for the expected reimbursement may not exceed the liability.

(iv) The amount recognised for the expected reimbursement may exceed the liability.

A (i) and (iii) onlyB (i) and (iv) onlyC (ii) and (iii) onlyD (ii) and (iv) only

12 As a result of new banking regulations, Intrepid Ltd will need to retrain a large proportion of itsfinancial services division in order to ensure continued compliance with banking regulations. At thebalance sheet date no retraining of staff has taken place. However, the head of the financial servicesdivision has announced that he is committed to a completion of the retraining programme by the endof the following year.

Carefree Ltd is also subject to the same banking regulations. By the year end Carefree Ltd hascontracted a training organisation to undertake the retraining programme with a start date of 15January, two weeks after the year end. Staff have been notified of their training session dates.

In accordance with BAS 37 Provisions, Contingent Liabilities and Contingent Assets how should eachcompany account for the cost of retraining their staff?

Intrepid Ltd Carefree LtdA Provide ProvideB Disclose ProvideC Do nothing ProvideD Do nothing Do nothing



9

13 Woodhall Ltd supplies customers with major pieces of equipment. During 20X2 it supplied one itemof equipment to Spa Ltd. The item failed and Spa Ltd has initiated a legal claim for damages againstWoodhall Ltd. At 31 December 20X2 the matter remains unresolved. Woodhall Ltd’s legal advisorshave advised that there is a 40% chance that the claim can be defended at no cost. Otherwise,damages are estimated at CU1 million.

What provision should be recorded in the balance sheet at 31 December 20X2 in accordance withBAS 37 Provisions, Contingent Liabilities and Contingent Assets?

A CUnilB CU400,000C CU600,000D CU1,000,000

14 On 1 January 20X2 Delta Ltd began working a new mine. Legislation requires the owner to restoreany environmental damage at the end of the 3-year licence. The cost of restoration includes:

(i) The replacement of the landscape, which had to be removed before mining could commence.The restoration cost is estimated at CU6 million.

(ii) Damage that is progressively created as mining progresses. The total cost of this damage isestimated at CU3 million. Environmental experts believe that the damage is createdproportionately with time.

What provision for environmental remediation should be created at 31 December 20X2 inaccordance with BAS 37 Provisions, Contingent Liabilities and Contingent Assets?

A CU3 millionB CU5 millionC CU6 millionD CU7 million

15 VACS LTD

Vacs Ltd is a manufacturing company which prepares financial statements to 30 September each year.Before the draft financial statements for the year ended 30 September 20X3 can be finalised andapproved by the directors, the following points need to be addressed. Draft net assets at 30September 20X3 were CU2 million.

(i) Vacs Ltd has renewed the unlimited guarantee given in respect of the bank overdraft of acompany in which it holds a significant investment. That company's overdraft amounted toCU300,000 at 30 September 20X3 and it has net assets of CU1 million.

(ii) A former director, who was dismissed from the company’s service on 1 September 20X3 foracting outside his authority, has given notice of his intention to claim substantial damages for lossof office. On 1 November 20X3 a claim was received for CU150,000. The company’s legaladvisers have been negotiating with the former director and believe that the claim will probablybe settled at CU100,000.

(iii) On 15 November 20X3 the company sold its former head office building, Whitley Wood, forCU2.7 million. At the year end the building was unoccupied and Vacs Ltd had not intended to sellthe property for at least another year. The building's carrying amount (based on cost lessaccumulated depreciation) was CU3.1 million at the year end.

(iv) An overseas division of Vacs Ltd was nationalised in December 20X3. The overseas authoritieshave refused to pay any compensation. The net assets of the division have been valued atCU200,000 at the year end.



Requirements

(a) Explain the definition of a liability from BFRS Framework in the context of accounting forprovisions and contingencies. (6 marks)

(b) Prepare extracts from the balance sheet of Vacs Ltd as at 30 September 20X3, including anyrelevant notes to the financial statements. (10 marks)

(16 marks)

16 PROVISO LTD

Proviso Ltd is organised into several divisions. The following events relate to the year ended 31December 20X2.

(i) The computer division supplied a computer to a customer during the year that exploded, causinga fire. Proviso Ltd is being sued for damages. Lawyers have advised that there is a 30% chance ofsuccessfully defending the claim. Otherwise the damages are expected to cost CU10 million(present value CU9.5 million). The lawyers have investigated the cause of the problem with ateam of accident consultants. They have concluded that parts supplied to the computer divisionby Moor Ltd contributed to the fire. Lawyers have estimated that Moor Ltd’s contributorynegligence amounted to 40% of the total damages. Negotiations have started with Moor Ltd andthe lawyers believe that a claim is likely to succeed.

(ii) On 15 December 20X2, the directors of Proviso Ltd minuted their decision to close theoperations of the loss making space technology division. The decision and an outline of a planwere immediately announced to employees and a press release was issued. The closure, whichbegan on 4 January 20X3, has an estimated date for completion, including the sale of the non-current assets of the division, of 30 June 20X3. The costs associated with the closure include thefollowing.

CU'000Employee redundancy costs 12,000Lease termination costs 4,000Relocating continuing staff to other divisions 3,000Impairment losses 2,000

21,000

(iii) Proviso Ltd’s retail division provides two-year warranties to its customers. Experience has shownthat, on average, 10% of sales from this division result in a warranty claim. Revenue from thisdivision in 20X2 was CU8 million. At 1 January 20X2 Proviso Ltd had a warranty provision inplace of CU1 million. During the year claims of CU600,000 were settled by the company.

Requirement

Prepare the provisions and contingencies notes for the financial statements of Proviso Ltd for the yearended 31 December 20X2. (10 marks)



9

17 ARCHY LTD (Sample Paper)

An extract from Archy Ltd’s nominal ledger at 30 April 20X6 is as follows:

CUAdministrative expenses 950,000Distribution costs 509,000Other operating costs 22,000Purchases 2,875,000Corporation tax charge for period 227,000Finance costs 9,000Sundry operating income 5,700Revenue 5,350,000Ordinary share capital - CU1 nominal value 1,000,000Trade and other receivables 55,700Inventories at 1 May 20X5 1,670,000Bank account 15,000Freehold land and buildings

Cost 900,000Accumulated depreciation at 30 April 20X5 36,000

Plant and equipmentCost 102,800Accumulated depreciation at 30 April 20X5 36,400

Intangible asset – carrying amount at 30 April 20X6 68,000Retained earnings at 1 May 20X5 813,300Bank loan (repayable on 1 June 20Y0) 100,000Trade and other payables 62,100

The following additional information is available:

(1) One of Archy Ltd's customers was declared bankrupt following the year end. The customerowed Archy Ltd CU12,500 at the year end.

(2) A piece of plant costing CU56,000 on 1 May 20X3 had been sold on 30 April 20X6 forCU36,600. It first met the BFRS 5 Non-current Assets Held for Sale and Discontinued Operationscriteria as a held for sale asset on the date of disposal. The proceeds were received on 10 May20X6 and no adjustments have been made in respect of the disposal. The plant was beingdepreciated straight-line over eight years.

Depreciation is charged on the remaining plant and machinery at 20% on cost and is presented aspart of cost of sales.

(3) Inventories at 31 May 20X6 were valued at CU1,820,000 before any adjustment for damageditems.

At the year end inventory count it was discovered that one line of goods in the warehouse hadbeen damaged. The count showed that 1,250 items had been damaged. The inventory wasrecorded at its cost of CU150 per item. However, following the damage the items have a scrapvalue of CU40 each.

(4) The intangible asset is a brand which was acquired in 20X4 for CU68,000. The useful life of thebrand is considered to be indefinite and therefore Archy Ltd carries out an annual impairmenttest each year to ensure that the brand’s carrying amount is recoverable. An expert hasestimated the brand’s fair value less costs to sell is CU60,000 and the financial controller hasestimated that the brand’s value in use is CU62,000.

(5) The land and buildings were originally acquired on 1 May 20X2 for CU900,000 of whichCU300,000 was allocated to the land element and this is the first valuation following theacquisition. Depreciation is charged straight-line on the property element based on a 50-year lifeand is presented as part of administrative expenses.

A valuation of the land and buildings took place at the beginning of the period and has not yetbeen recognised in the nominal ledger. They were valued at CU1,400,000 of which CU460,000relates to the land element. The remaining useful life remains unchanged.



Archy Ltd makes a transfer between the revaluation reserve and retained earnings each period asa result of the revaluation in accordance with best practice.

(6) A dividend of 15p per share was declared on 25 April 20X6 and paid shortly after the year end.

Requirement

Prepare an income statement for Archy Ltd for the year ended 30 April 20X6 and a balance sheet asat that date.

(22 marks)

Point to note

You are not required to prepare notes to the financial statements.

Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achievedthese objectives, please tick them off.



9

Technical reference

Point to note

All of BAS 10 and BAS 37 are examinable. The paragraphs listed below are the key references you shouldbe familiar with.

1 Provisions – recognition

Provisions are liabilities of uncertain timing or amount. BAS 37 (10)

A provision is recognised only when all of the following are met at balance sheetdate:

BAS 37 (14)

– A present obligation exists (legal or constructive) as a result of a past event

– An outflow of resources embodying economic benefits in settlement isprobable

– Amount can be estimated reliably

There is a useful decision tree in Appendix B BAS 37 (App B)

2 Provisions – measurement and use

Measure at best estimate of expenditure required to settle obligation at BS date. BAS 37 (36)

Discount where material. BAS 37 (45)

Do not take into account gains from expected disposal of assets. BAS 37 (51)

Treat reimbursements as separate assets, recognised only where virtually certain,and only up to amount of provision.

BAS 37 (53)

– Expense in income statement may be shown net of reimbursement BAS 37 (54)

Review provisions at each BS date and adjust to current best estimate. BAS 37 (59)

Use a provision only for the expenditures for which it was created. BAS 37 (61)

3 Provisions – specific applications

Do not provide for future operating losses. BAS 37 (63)

Provide for unavoidable costs of meeting onerous contracts. BAS 37 (66)

Provide for restructuring only where legal or constructive obligation exists at BSdate, and provision covers only costs:

BAS 37 (72 &

80)

– Necessarily entailed by restructuring; and

– Not associated with ongoing activities.

No obligation arises on sale of an operation until there is a binding sale agreement. BAS 37 (78)

A useful set of examples is given in Appendix C. BAS 37 (App C)


A contingent liability is either: BAS 37 (10)

– A possible obligation arising from past events whose existence will beconfirmed only by uncertain future events not wholly within the entity’scontrol; or

– A present obligation arising from past events not recognised because anoutflow of resources embodying economic benefit is not probable or amountcannot be measured reliably.



Do not recognise contingent liabilities but disclose unless possibility of outflow isremote.

BAS 37 (27 &

86)

5 Contingent assets

A contingent asset is a possible asset arising from past events whose existence willbe confirmed only by uncertain future events not wholly within the entity’scontrol.

BAS 37 (10)

Do not recognise contingent assets but disclose where inflow is probable (i.e.more likely than not).

BAS 37 (31 &

89)

6 Events after the balance sheet date

Events after BS date are events occurring between BS date and date ofauthorisation of FS. Two categories are:

BAS 10 (3)

– Adjusting events, which provide evidence of conditions existing at BS date

– Non-adjusting events, which are indicative of conditions arising after BS date

FS are adjusted for:

– Adjusting events BAS 10 (8)

– Non-adjusting events that indicate that going concern assumption is notappropriate

BAS 10 (14)

Disclose, without adjustment, material non-adjusting events which could affectusers’ economic decisions taken on the basis of the FS.

BAS 10 (21)

Disclose proposed equity dividends not declared by BS date – do not meetdefinition of liabilities.

BAS 1 (125)

Disclose date on which FS authorised for issue. BAS 10 (17)



9


1 D The fire is non-adjusting, whereas the liquidation is adjusting.

2 A Only 'A' affects the conditions existing at the balance sheet date.

3 C Brick Ltd The debt arose before the year end, so this would be an adjusting event.

Cement Ltd The debt arose after the year end, so that this would be a non-adjusting event.

Mortar Ltd As for Cement Ltd – a non-adjusting event, but of such significance that MortarLtd is no longer a going concern. Thus adjustments will be made to theaccounts.

4 C BAS 10 paragraphs 9 and 22.

5 B (i) The destruction of the warehouse is caused by an event which took place after the balancesheet date therefore it is non-adjusting.

(ii) The claim was outstanding at the balance sheet date, because the fire took place inDecember 20X9. The agreement on 3 January 20Y0 provides information about theoutcome of the claim, therefore it is an adjusting event.

(iii) The cause of the customer going into receivership is due to an event which took place afterthe balance sheet date i.e. the fire in January 20Y0. This is therefore a non-adjusting event.

(iv) The fall in value of the inventory is again due to the fire which occurred after the balancesheet date. At the balance sheet date the inventory was undamaged. Therefore the event isnon-adjusting.

6 B (i) A constructive obligation exists as the company has built up a valid expectation incustomers.

(ii) The signing of the lease is a past event and when the lease becomes onerous, a provisionshould be made.

7 A The legal action does not relate to conditions existing at the year end as the cause arosesubsequently.

8 C BAS 10 paragraph 22(a).

9 A Loss is not probable, therefore no accrual required.

10 B The claim against Construction Ltd represents a probable loss and should be provided for. Theclaim against Underwater Ltd represents a contingent asset which is probable and should bedisclosed.

11 C BAS 37 paragraph 53.

12 D At the year end neither company has an obligation to pay for training as no training has beencarried out.

13 D If there is a 40% chance that the claim can be defended, there is a 60% (i.e. probable) chance thatthe company will have to pay damages of CU1 million.

14 D BAS 37 paragraph 19.



15 VACS LTD

(a) Definition of a liability and accounting for provisions and contingencies

BFRS Framework defines a liability as:

A present obligation of the entity

Arising from past events

The settlement of which is expected to result in an outflow of resources which can bemeasured reliably.

This definition can be illustrated by looking at item (ii) in the question.

The claim is a present obligation because settlement of the claim can be enforced by law.Ultimately, a court will decide whether or not an outflow of resources will result.

The claim has arisen from past events because the action which gave rise to the claim (i.e. thedismissal) took place before the year end (even though the company was not aware of this claimuntil after the year end). Hence this claim potentially needs recognising as a provision (a liabilityof uncertain timing and amount) in the financial statements as at 30 September 20X3.

If the event had not taken place until after the year end then it would not arise from past eventsand so no liability would be recognised (though disclosure as a non-adjusting post balance sheetevent may be necessary).

For the claim to be recognised it must be expected to result in an outflow of resources whichcan be measured reliably. BAS 37 effectively defines 'expected' as 'more likely than not'. Here, theclaim is recognised at an amount of CU100,000 because the legal advisors believe the claim will'probably be settled at CU100,000'.

If the legal advisers believed that it was unlikely that the case would succeed (i.e. settlement isnot probable) then the matter would not be recognised as a liability in the financial statements.However, disclosure as a contingent liability (contingent on the outcome of the future courtcase) would be necessary if the possibility of settlement was other than “remote”. A contingentliability therefore arises when some, but not all, of the criteria for recognising a provision aremet.

(b) Financial statement extracts

Balance sheet as at 30 September 20X3 (extract)

CUASSETS

Non-current assetsProperty, plant and equipment 3,100,000

EQUITY AND LIABILITIESNon-current liabilities

Provisions (Note 1) 100,000

Notes to the financial statements as at 30 September 20X3 (extracts)

(1) Provisions

Compensation claimCU

At 1 October 20X2 –Income statement charge 100,000At 30 September 20X3 100,000

This provision is in respect of a claim made by a director who was dismissed on 1September 20X3 for acting outside his authority. It represents the amount at which thecompany’s legal advisers believe the claim will be settled.



9

(2) Contingent liabilities

The company has guaranteed the overdraft in respect of a company in which it holds asignificant investment. It is not considered likely that this guarantee will be called upon. Thatcompany’s overdraft was CU300,000 at 30 September 20X3.

(3) Events after the balance sheet date

Following an offer made to the company after the year end, on 15 November 20X3 thecompany sold its former head office building for CU2.7 million, realising a loss ofCU400,000. This loss will be reflected in the company’s financial statements to 30September 20X4.

In December 20X3 an overseas division was nationalised without compensation. A loss ofCU200,000, in respect of the division’s net assets at 30 September 20X3, will be reflected inthe company’s financial statements to 30 September 20X4.

Point to note

In part (a) it is not essential to use item (ii) in the question to illustrate. Any other appropriateexample could have been used.

16 PROVISO LTD

Notes to the financial statements as at 31 December 20X2 (extracts)

(i) Provisions

Warranty Compensation Provision for Totalprovision claim closure of

divisionCU'000 CU'000 CU'000 CU'000

At 1 January 20X2 1,000 – – 1,000Utilised in the year (600) – – (600)Income statement charge (bal fig) 400 9,500 18,000 27,900At 31 December 20X2 (Ws 1 and 2) 800 9,500 18,000 28,300

The warranty provision is in respect of two-year warranties provided to customers. Theprovision is based on the level of past claims.

The compensation claim provision is in respect of a claim made by a customer for damages as aresult of a faulty computer supplied by the company. It represents the present value of theamount at which the company’s legal advisers believe the claim is likely to be settled.

On 15 December 20X2, Proviso Ltd announced that it would be closing its loss making spacetechnology division. Details of the closure have been fully communicated to those affected. Thecost of the closure, which began on 4 January 20X3, is estimated at CU18 million and completionis expected by 30 June 20X3.

(ii) Contingent assets

A counter-claim in respect of the compensation claim provided for above has been made againstthe supplier of parts for the affected computer. Lawyers have advised that this claim is likely tosucceed and should amount to around 40% of the total damages (CU3.8 million).

WORKINGS

(1) Provision for closure of division

CU'000Employee redundancy costs 12,000Lease termination costs 4,000Impairment losses 2,000

18,000

(2) Warranty provision

CU8 million x 10% = CU800,000



17 ARCHY LTD

(a) Archy Ltd – Balance Sheet as at 30 April 20X6


Property, plant & equipment((1,400,000 – 20,000) + (46,800 – 31,760)) (W4) 1,395,040Intangible asset (W6) 62,000

1,457,040Current assets

Inventories (1,820,000 – 137,500 (W1)) 1,682,500Trade receivables (55,700 – 12,500) 43,200Other receivables 36,600Cash and cash equivalents 15,000

1,777,300Total assets 3,234,340

EQUITY & LIABILITIESCapital & Reserves

Ordinary share capital 1,000,000Revaluation reserve (536,000 – 8,000 (W2)) 528,000Retained earnings (W7) 1,394,240

Equity 2,922,240Non-current liabilities

Bank loan 100,000Current liabilities

Trade and other payables 62,100Dividend payable (15p x 1,000,000) 150,000

212,100Total equity and liabilities 3,234,340

Archy Ltd – Income Statement for year ended 30 April 20X6

CURevenue 5,350,000Cost of sales (W5) (2,878,860)Gross profit 2,471,140Administrative expenses (950,000 + 20,000) (970,000)Distribution costs (509,000)Other operating costs (22,000 - 5,700 + 12,500 - 1,600 (W3) + 6,000 (W6)) (33,200)

958,940Finance costs (9,000)Profit before tax 949,940Taxation (227,000)Net profit for the period 722,940

WORKINGS

(1) Inventory

1,250 x (CU150 - CU40) = CU137,500 write down

(2) Revaluation reserve

CUFreehold land & buildings 900,000Accumulated depreciation (36,000) (12,000 x 3 years)Net book value 864,000Valuation at 1 May 20X5 1,400,000Revaluation reserve 536,000



9

Depreciation on cost 600,000 / 50 years = 12,000 pa

Depreciation on revalued amount (1,400,000 – 460,000) 940,000 / 47 years = 20,000 pa

Transfer between reserves for additional depreciation 20,000 – 12,000 = 8,000 pa

(3) Disposal of piece of machinery

Machinery – cost CU56,000

Accumulated depreciation CU56,000 / 8 years = CU7,000 paCU7,000 x 3 years = CU21,000

Net book value at disposal CU56,000 - CU21,000 = CU35,000

CUProceeds 36,600Less: NBV (35,000)Profit on disposal 1,600


Freehold land and buildings

CUValuation 1,400,000Less depreciation (W2) (20,000)Net book value 1,380,000

Plant and equipment

CUCost 102,800Less disposal (56,000)At 30 April 20X6 46,800

Accumulated depreciation 36,400Less disposal (21,000)Depreciation in year 16,360At 30 April 20X6 31,760

Depreciation charge in the year for plant and equipment:

CU20% x CU46,800 9,360Plant disposed of 7,000Charge in year 16,360

(5) Cost of sales

CUPurchases 2,875,000Add: opening inventory 1,670,000Less: closing inventory (1,820,000)Add: write down (W1) 137,500

2,862,500Add: plant & machinery depreciation 16,360

2,878,860

(6) Intangible asset - impairment

Recoverable amount is higher of:

CUValue in use 62,000Fair value less costs to sell 60,000



Recoverable amount is therefore CU62,000 which is greater than carrying amount andhence an impairment has occurred.

CU68,000 - CU62,000 = CU6,000 impairment loss

(7) Retained earnings

CUTrial balance 813,300Transfer from revaluation reserve 8,000Dividend declared (150,000)

671,300Add: Profit for period 722,940

1,394,240



9



The expected cost of repairs will be:

(80% 0) + (15% 100) + (5% 500) = CU40,000


The entry to record the provision for environmental damage on removal of the overburden will be:

DR Non-current asset – Cost of establishing quarry CU50,000CR Provision for environmental costs CU50,000

When the overburden is removed, the company has yet to realise the economic benefits from extraction ofthe rock. However, the removal of the overburden is a past event giving rise to an obligation. Therefore aprovision for restoration costs is recognised at this point. The debit entry is added to the non-current assetfor the cost of establishing the quarry rather than being expensed immediately. The cost passes to theincome statement as the asset for the establishment of the quarry is depreciated over its life.


(a) No provision would be recognised as the decision had not been communicated by the year end.

(b) A provision would be made in the 20X9 financial statements.

(c) A provision for such costs would be made as the damage has already been caused.

(d) No present obligation exists and under BAS 37 no provision would be appropriate. This is because theentity could avoid the future expenditure by its future actions, maybe by changing its method ofoperation.



A contract of employment Obligations still have to be performed by bothparties, so it is an executory contract. As there isno indication that it is an onerous contract, it fallsoutside the scope of BAS 37

A legal claim being pursued by an entity and whichit is confident of winning

There is a possible asset and as the claim is beingpursued, it must arise from past events. So acontingent asset

A legal claim being pursued against an entity butwhich the entity is confident of winning

There is a possible obligation and as the claim isbeing pursued, it must arise from past events. So acontingent liability




A legal claim against an entity where the entity hasaccepted liability but the amount to be paid has notyet been agreed

Liability has been admitted so the obligation existsand arises from past events. A provision

Legislation enacted but coming into effect nextyear which will require substantial retraining ofstaff

The obligation arises from future events (thelegislation comes into force in the future) and bothprovisions and contingent liabilities require theobligation to arise from past events. Outside thescope of BAS 37

The reinstatement of land once quarrying hasceased, where there is no legal obligation. Theentity’s published policy in relation toenvironmental protection is that it will reinstateany environmental damage caused by its activities

There is a constructive obligation. A provision

The reinstatement of land once quarrying hasceased, where there is no legal obligation. Theentity has no published policy in relation toenvironmental protection and this is the firstquarrying venture it has entered into

There is no obligation. Outside the scope ofBAS 37

Restructurings where the detailed plan has beendeveloped, announced and agreed with employees’representatives


Restructurings where the detailed plan has beendeveloped and announced


Restructurings where the detailed plan has beendeveloped and agreed by the board, but noannouncement has been made

There is no obligation as the board could reverseits decision and not announce it. Outside the scopeof BAS 37

Future reinstatement work under guarantees to beprovided to customers in relation to future sales

The obligation arises from future sales. Outside thescope of BAS 37


Circumstance Application of BAS 37

A legal claim in relation to a past event is pursuedagainst an entity over several years. The entitymakes the following judgements about outflows ofresources in settlement:

This claim may result in the existence of a liability

Year 1: there will be no outflow Year 1: neither recognition nor disclosure

Year 2: an outflow is remote Year 2: neither recognition nor disclosure

Year 3: an outflow is possible Year 3: contingent liability disclosed

Year 4: an outflow is probable Year 4: provision recognised

Year 5: an outflow is virtually certain Year 5: provision retained



9

A legal claim in relation to a past event is pursuedby an entity over several years. The entity makesthe following judgements about inflows ofresources in settlement:

This claim may result in the existence of an asset

Year 1: there will be no inflow Year 1: neither recognition nor disclosure

Year 2: an inflow is remote Year 2: neither recognition nor disclosure

Year 3: an inflow is possible Year 3: neither recognition nor disclosure

Year 4: an inflow is probable Year 4: contingent asset disclosed

Year 5: an inflow is virtually certain Year 5: asset recognised


Financial statements for: 20X5 20X6 20X7

20X5 final dividend In the notes Charged to statementof changes in equity

N/a

20X6 interim dividend N/a Charged to statementof changes in equity

N/a

20X6 final dividend N/a In the notes Charged tostatement of changesin equity




Contents

chapter 10

Group accounts: basicprinciples

Introduction

Examination context

Topic List

1 Context for group accounts

2 The single entity concept

3 Control and ownership


Technical reference





Introduction


Identify the financial effects of group accounting in the context of BFRS Framework

Explain and demonstrate the concepts and principles surrounding the consolidation offinancial statements including:

– The single entity concept

– Substance over form

– The distinction between control and ownership

Identify and describe the circumstances in which an entity is required to prepare and presentconsolidated financial statements

Identify the laws, regulations and accounting standards applicable to the consolidated financialstatements of an entity

Identify whether an entity should be treated as a subsidiary of a parent entity

Illustrate the application of the concepts and principles of consolidation through the preparationof simple consolidated balance sheets and consolidated income statements

Specific syllabus references for this chapter are: 1d,e,g, 2a,b,c


In very simple terms a group is a collection of entities, where one, the parent, controls the activities of theothers, its subsidiaries. In these circumstances the group is required to produce ‘consolidated’ financialstatements. These present the position and results of the individual companies as if they were one entity.

Due to the nature of the business structure of a group, group accounts tend to be produced by largerorganisations, many of which are listed companies. This increases the sensitivity of group accounts and thescrutiny to which they are subjected. The process by which financial statements are consolidated is arelatively mechanical procedure which in itself is not particularly contentious. However, there are manydecisions which need to be made prior to the consolidation being executed. These have historicallyinvolved the application of judgement and in some cases have allowed for deliberate manipulation of thefinancial information. Examples of the issues include:

Whether an investment meets the definition of a subsidiary and should be accounted for as such

Whether there are circumstances when it might be appropriate to exclude a subsidiary from theconsolidation process

The value at which the net assets and results of the subsidiary should be incorporated into the groupaccounts

Two accounting standards aim to deal with these issues:

BFRS 3 Business Combinations BAS 27 Consolidated and Separate Financial Statements

Stop and think

From the shareholders’ point of view what do you think the benefits are of consolidated financialstatements?

GROUP ACCOUNTS: BASIC PRINCIPLES


10

Working context

If you work in a small or medium-sized firm you may have been involved in the preparation of consolidatedfinancial statements. This is normally a largely mechanical procedure involving the combination of theindividual financial statements of the members of the group. A consolidation package may be preparedwhich presents the information contained in the individual financial statements in such a way thatcombination is straightforward. This process is often computerised.

If you work in a large audit firm the a significant number of audit assignments are likely to involve the auditof a group of companies. In simple terms the audit of a group involves two key steps:

The financial statements of each individual entity within the group will be audited. The financialstatements of the parent entity are audited by the ‘principal’ auditors. Those of the subsidiaries will beaudited by ‘other’ auditors.

The consolidated financial statements (which are an amalgamation of the individual sets of financialstatements) will be audited by the principal auditor. The principal auditor is responsible for the overallaudit opinion on the consolidated financial statements.

You may have been involved in either of these steps.

Syllabus links

Group accounts is a key part of the Financial Accounting syllabus with a syllabus weighting of 35%. TheFinancial Accounting syllabus covers:

Consolidated balance sheet (Chapter 11) Consolidated statements of financial performance (Chapter 12) Associates (Chapter 13) Disposals (Chapter 14) Consolidated cash flow statement (Chapter 16).

More complex issues are covered in the Financial Reporting paper and at the Advanced Stage including jointventures and overseas subsidiaries, and the analysis and interpretation of group financial statements.

This chapter introduces some of the key principles of group accounting. The concept of ‘substance overform’ is an important principle which we have already introduced as follows:

Chapter 1 in the context of BFRS Framework Chapter 7 in relation to sale and repurchase agreements Chapter 8 in relation to finance leases

This chapter also introduces some of the basic techniques of the preparation of consolidated accounts. It isimportant that you have a sound understanding of these as they are developed in subsequent chapters.



Examination context

Exam requirements

Because of the 35% weighting, group accounts will be examined in both the short-form question andwritten test sections of the paper. There will be at least one full question on group accounts in the writtentest section and group accounting could also form part of a mixed topic question and/or be tested viashort-form questions. Whilst the majority of the marks are likely to be for the preparation of consolidatedfinancial statements you could be asked to explain the principles of consolidation and the way in which theyapply to the consolidation process. You may also be asked to explain these issues in the context of BFRSFramework.


Explain and demonstrate the concepts and principles surrounding the consolidation of financialstatements including:

– The single entity concept– Substance over form– The distinction between control and ownership

Prepare the consolidated balance sheet or income statement (or extracts) including the results of theparent entity and one or more subsidiaries.



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1 Context for group accounts

Section overview

A group includes a parent and one or more subsidiaries. A subsidiary is an entity controlled by the parent. Forming a group is a means of organising a business. Group accounts ‘consolidate’ the results of the individual companies.

1.1 What is a group?

In simple terms a group is created where one company, the parent (P) buys shares in another company,the subsidiary (S), such that the parent company controls the subsidiary. A group may include one ormany subsidiaries.

Shareholders

P Ltd

S1 Ltd S2 Ltd S3 Ltd

The shareholders (owners) of P Ltd may be individuals and/or institutions such as pension funds.

1.2 What is a subsidiary?

Definition

A subsidiary is an entity, including an unincorporated entity such as a partnership, that is controlled byanother entity (known as the parent).

Control is the power to govern the financial and operating policies of an entity so as to obtainbenefits from its activities.

Control is presumed where the parent acquires more than 50% of the other entity’s voting rights,unless it can be demonstrated otherwise.

In certain circumstances control may be achieved by other means. We will look at these circumstances inChapter 15. For now we will assume that if a parent holds more than 50% of the ordinary shares inanother entity this constitutes control. (Voting rights are normally attached to ordinary shares.)

1.3 Why form a group?

A business may operate in several different markets with different characteristics. These differentmarkets will present different issues for management to address in terms of operations and finance and soon.

It would be possible for different activities to be carried out within a single limited company, whereseparate divisions could be established for each activity. The owners would then receive one set ofaccounts for that company, reflecting all its activities.



Alternatively, each activity could be carried out within a separate company (the subsidiaries), each ofwhich is controlled by the parent.

There are a number of reasons why the business might be structured in this way:

Accountability of each group of managers can be made more precise, as they can beidentified more easily with the activities of the subsidiary which employs them

Financing may be made easier, as lenders can see audited financial statements for the individualcompany for which they are providing finance

The assets of one subsidiary can be pledged as security for its borrowings, leaving the assets ofother subsidiaries unpledged

Disposal of a business may be made easier

1.4 Why prepare group accounts?

This is best illustrated by the following worked example.

Worked example: Why prepare group accounts?

P Ltd (the parent) does not trade on its own account. Its only major asset is the ownership of all the sharesin S Ltd (the subsidiary) and its only income is dividends from S Ltd.

Income statements for the last 12 months (ignoring tax):

P Ltd S LtdCUm CUm

Revenue – 100Cost of sales – (85)

Gross profit – 15Other costs (1) (40)

Loss from operations (1) (25)Dividends receivable 11 –

Profits/(loss) for the period 10 (25)

Statement of changes in equity (extract) for the last 12 months:

P Ltd S LtdCUm CUm

Net profit/(loss) 10 (25)Dividends declared (6) (11)

Retained profit/(loss) for the period 4 (36)Brought forward 1 45

Carried forward 5 9

Without provisions requiring the preparation of group accounts (which put together, i.e. 'consolidate', theactivities of the parent and subsidiaries), the owners would only legally be entitled to receive the financialstatements of the parent company as an individual company.

In this case, they could well think that things were going well, because the dividend income for the periodcovers the expenses of P Ltd and provides for a CU6m dividend. They would not be aware that:

The CU11m dividend income all came from profits earned by S Ltd in previous years The trading activity controlled by P Ltd's management is currently loss-making

As will be demonstrated later in this chapter, the effect of consolidation is to produce a fair picture of P Ltdand S Ltd taken together, which is that on revenue of CU100m (S Ltd only), there is a loss for the year ofCU26m (S Ltd's net loss of CU25m plus P Ltd's other costs of CU1m).



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1.5 Accounting principles

The key issue underlying group accounts is therefore the need to reflect the economic substance (seeChapter 1) of the relationship between companies where one (a parent) has control over another (asubsidiary), which together comprise a group.

Producing consolidated accounts that present the group as though it were a single economic entityreflects this economic substance.

As we will see in section 3, the consolidated accounts also reflect another key principle (dealt with in BFRSFramework – see Chapter 1), that of the distinction between:

The resources controlled and the results they produce; and The ownership of those resources and results.

Point to note

The terms ‘group accounts’, 'consolidated accounts’, ‘group financial statements’ and ‘consolidated financial statements’ can be thought of as meaning the same thing and are used interchangeably in the accountingworld.

1.6 Composition of group accounts

Group accounts comprise:

Consolidated balance sheet (CBS) Consolidated income statement (CIS) Consolidated statement of changes in equity (CSCE) Consolidated cash flow statement Notes to the accounts and comparative figures

Points to note

1 The consolidated balance sheet is presented in addition to the parent’s own individual balance sheet.

2 The consolidated income statement is usually presented instead of the parent’s own individualincome statement.

3 The parent’s own balance sheet shows its investment in subsidiaries in non-current assetinvestments (usually at cost).

4 The parent’s own individual income statement shows the dividend income received and receivablefrom subsidiaries.

1.7 Summary of investments

A parent may hold other investments apart from subsidiaries. These can be summarised as follows:

Investment Criterion Treatment in groupaccounts

Subsidiary Control (>50%) Consolidation

Associate (See Chapter 13) Significant influence (20%+) Equity method

Investment Asset held for accretion of wealth Usually at cost

This chapter and Chapters 11-14 and 16 deal with the underlying principles and techniques involved in thepreparation of group accounts.

Chapter 15 deals with the relevant accounting standards which provide the regulatory backing for theprinciples illustrated. These include:

BFRS 3 Business Combinations BAS 27 Consolidated and Separate Financial Statements BAS 28 Investments in Associates



2 The single entity concept

Section overview

Group accounts are prepared on the basis that the parent and subsidiaries are a single entity.

This reflects the economic substance of the group arrangement.

The investment in a subsidiary’s shares shown in the parent’s own balance sheet is replaced in theconsolidated balance sheet by the net assets of the subsidiary.

The dividend income from the subsidiary recorded in the parent’s own income statement is replacedin the consolidated income statement by the subsidiary's revenues and costs.

2.1 The effect of consolidation

Group accounts consolidate the results and net assets of group members to present the group to theparent’s shareholders as a single economic entity. This reflects the economic substance and contrastswith the legal form, where each company is a separate legal person.

Parent

Subsidiary

Controls(>50%)

GROUP – Single Entity

The effect of consolidation can be illustrated by comparing buying an unincorporated business from itsexisting proprietor with buying a controlling interest in a company from its existing shareholders.

2.2 Buying an unincorporated business

When a company invests in an unincorporated business, it pays cash to the proprietor and in exchangeacquires legal title to all the assets and all the liabilities (i.e. the net assets) of the business.

Worked example: Buying an unincorporated business

Draft balance sheets of Panther Ltd and Seal, a sole trader, at 31 December 20X1 are as follows:

Panther Ltd SealCU CU

Cash 4,000 –Sundry other assets 13,000 6,000

17,000 6,000

Share capital/Capital 2,000 4,000Retained earnings 12,000 –Equity 14,000 4,000Liabilities 3,000 2,000

17,000 6,000

Panther Ltd then buys the net assets and business of Seal on 31 December 20X1 for CU4,000 in cash.

In 20X2 Panther Ltd itself made sales of CU6,000 with costs of CU4,500. Panther Ltd also carried on Seal'strade, which made sales of CU3,000 with costs of CU1,000. There are no other changes in net assets in20X2.

You are required to prepare the income statement of Panther Ltd for the year ended 31 December 20X2,reflecting the above information.



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Solution

Panther LtdIncome statement for the year ended 31 December 20X2

CURevenue (6,000 + 3,000) 9,000Costs (4,500 + 1,000) (5,500)Profit 3,500

Balance sheets as at 31 December

20X1 20X2CU CU

Sundry other assets (20X1: 13,000 + 6,000) 19,000 22,500(20X2: P (13,000 + 6,000 – 4,500) +

S (6,000 + 3,000 – 1,000))Share capital (P only) 2,000 2,000Retained earnings (20X1: P only) 12,000 15,500

(20X2: P (12,000 + 6,000 – 4,500) +S post-acq (3,000 – 1,000))

Equity 14,000 17,500Liabilities 5,000 5,000Total equity and liabilities 19,000 22,500

Points to note

1 Seal's net assets at the date of acquisition are incorporated into Panther Ltd's books and Panther Ltd'scash is reduced by the cost of the acquisition.

2 All Seal's trading in 20X2 (and the increase in net assets attributable to it) is recorded in Panther Ltd'sbooks.

2.3 Buying a company

When a company (A Ltd) invests in another company (B Ltd) the legal position is very different. Companieshave their own legal identity separate from that of their owners. The investing company therefore pays cashto B Ltd’s shareholders to buy their shares. It does not acquire legal title to the net assets of B Ltd; thisremains with B Ltd.

Worked example: Buying a company

Draft balance sheets of Panther Ltd and Seal Ltd at 31 December 20X1 are as follows:

Panther Ltd Seal LtdCU CU

Cash 4,000 –Sundry other assets 13,000 6,000

17,000 6,000

Share capital 2,000 1,000Retained earnings 12,000 3,000Equity 14,000 4,000Liabilities 3,000 2,000

17,000 6,000

Panther Ltd then buys all the shares of Seal Ltd on 31 December 20X1 for CU4,000 in cash. In 20X2Panther Ltd itself made sales of CU6,000 with costs of CU4,500. Seal Ltd continued to trade and made salesof CU3,000 with costs of CU1,000. There are no other changes to net assets in 20X2.



You are required to:

(a) Prepare the balance sheets as at 31 December 20X1 and 20X2 for Panther Ltd, Seal Ltd and thePanther Ltd group, reflecting the above information.

(b) Prepare the income statements for the year ended 31 December 20X2 for Panther Ltd, Seal Ltd andthe Panther Ltd group, reflecting the above information.

Solution

(a) Balance sheets as at

31 December 20X1 31 December 20X2Panther Seal Consoli- Panther Seal Consoli-

Ltd Ltd dated Ltd Ltd datedCU CU CU CU CU CU

Investment in Seal Ltd 4,000 – – 4,000 – –Sundry other assets 13,000 6,000 19,000 14,500 8,000 22,500

17,000 6,000 19,000 18,500 8,000 22,500

Share capital 2,000 1,000 2,000 2,000 1,000 2,000Retained earnings 12,000 3,000 12,000 13,500 5,000 15,500Equity 14,000 4,000 14,000 15,500 6,000 17,500Liabilities 3,000 2,000 5,000 3,000 2,000 5,000Total equity and liabilities 17,000 6,000 19,000 18,500 8,000 22,500

(b) Income statements for the year ended 31 December 20X2

Panther Ltd Seal Ltd ConsolidatedCU CU CU

Revenue 6,000 3,000 9,000Costs (4,500) (1,000) (5,500)Profit 1,500 2,000 3,500

Points to note

1 The investment in the shares of Seal Ltd in Panther Ltd's books has been replaced by theunderlying net assets of Seal Ltd. The net assets of Seal Ltd at the date of acquisition (representedby its share capital and reserves at that date) are cancelled out against the investment in PantherLtd's books. (Note that the situation where the net assets of a subsidiary at acquisition do not equalthe cost of investment is covered in Chapter 11.)

2 As the net assets of Seal Ltd increase post-acquisition (an increase attributable to Panther Ltd'scontrol of Seal Ltd) this increase has been reflected in net assets and retained earnings.

3 The profits of Seal Ltd are combined with those of Panther Ltd in the consolidated accounts fromthe date of acquisition, as post-acquisition profits of the subsidiary are earned under the parent'scontrol. This is also reflected in the consolidated balance sheet, where group retained earningsinclude Seal Ltd's post-acquisition retained earnings.

4 Consolidated balance sheets and income statements have been produced.

5 These are the same as those produced when Seal Ltd was unincorporated. This is because Panther Ltdand Seal Ltd have been treated, not as two separate legal entities, but as a single entity.

6 The two companies can be viewed as a single entity because Panther Ltd (the parent) controls SealLtd, its subsidiary. Together the companies form a group.



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2.4 Summary

So far we have looked at the following key points:

Group = parent (P) + subsidiary(ies) (S) Subsidiary(ies) = undertaking(s) under P’s control The objective of group accounts is to present a true and fair view of the group to P's shareholders Mechanics of consolidation:

– The investment in S shown in P’s own balance sheet is replaced in the consolidated balance sheet(CBS) by the line-by-line addition of S’s net assets to P’s to show the group’s resources

– Dividend income in P’s own income statement is replaced in the consolidated income statement(CIS) by the line-by-line addition of S’s revenue and costs to P’s to show the group’s performance

– The investment in S in P’s balance sheet is cancelled out against S’s share capital and reserves atacquisition

3 Control and ownership

Section overview

Group accounts reflect both control and ownership.

Ownership of more than 50% of the ordinary shares in a subsidiary normally gives control to theparent.

The net assets and results not owned by the parent are reflected in the minority interest.

3.1 Control

Usually a holding of over 50% of the ordinary shares in S will give P control of S.

As we saw in Section 1, control means the ability to direct financial and operating policies of S witha view to gaining economic benefits from its activities. This is an extension of the basic concept of control, introduced in Chapter 1 in the context of the definition of assets.

In an individual company, the assets are under the direct control of the company. In a group, thesubsidiary’s assets are under indirect control through the parent’s control of the subsidiary.

3.2 Ownership

Equity, as defined in Chapter 1, is the residual amount found by deducting all of the entity’s liabilitiesfrom all of the entity’s assets. It is also described as the ownership interest.

In an individual company’s accounts, there is only one ownership interest, i.e. that of the shareholders inthat individual company, represented by the capital and reserves (which equals net assets).

In a group, it is possible for the parent to have control of a subsidiary without owning 100% of it.

That part of S’s net assets and results included in the consolidation which is not owned by P is owned bythe minority interest (MI).

Worked example: Ownership

P Ltd owns 75% of the ordinary shares of S Ltd.

In this case, P Ltd controls 100% of S Ltd as it owns more than 50% of the ordinary shares.

However, P Ltd only owns 75%. The MI owns the remaining 25%.



In group accounts, the ownership interest of both P’s shareholders and the MI needs to be reflected, and the part of the group net assets in which P’s shareholders do not have the ownership interest needs to bedistinguished from that in which they do.

As both P’s shareholders and the MI own equity (in (P + S) and S, respectively), the sum of their respectiveownership interests is described as equity in the consolidated balance sheet.

3.3 Reflecting control and ownership in group accounts

When preparing the consolidated accounts, P’s control of S and the ownership interest of P and MI in Sneed to be reflected.

Group accounts reflect both control and ownership.

Consolidated balance sheet (CBS)

CUAssets X(P + S (100%) – intra-group items)

Control X

OwnershipCapital and reserves

Share capital (P only) X

Reserves(P + (P% × S post-acquisition)) X

Attributable to equity holders of P X

Minority interest X(MI% × S's net assets)

Equity XLiabilities X

X

(Ownership: P% = P's share; MI% = MI share)

Consolidated income statement (CIS)

CURevenue X(P + S (100%) – intra-group items)

Profit after tax (PAT) (Control) X

OwnershipAttributable to:Equity holders of P (ß) XMinority interest (MI% × S's PAT) X

X

(Ownership: P% = P's share; MI% = MI share)

CBS

Shows resourcesunder group's controlas a single entity; and

Shows ownership split

between

Parent co'sshare

Minorityinterest share

CIS

Shows PAT split

between

Parent co'sshare

Minorityinterest share

Shows revenue andexpenses under

group's control as a

single entity and



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3.4 Reserves

The CBS includes P's reserves plus P’s share of S’s post acquisition reserves, as these reserves aregenerated under P’s control. S’s reserves at acquisition (pre-acquisition reserves), along with its sharecapital, are cancelled against P’s cost of investment in S.

The same basic calculation is used for each reserve separately (e.g. revaluation reserve, retained earnings).

The following interactive question brings together the points we have made so far.

Interactive question 1: Control and ownership [Difficulty level: Easy]

The balance sheets of two companies at 31 December 20X7 are as follows:

Austin Ltd Reed LtdCU CU

Non-current assetsProperty, plant and equipment 80,000 8,000Investments: Shares in Reed Ltd 12,000 –

92,000 8,000Current assets 58,000 13,000Total assets 150,000 21,000

Capital and reservesCalled up share capital 100,000 10,000Retained earnings 30,000 5,000


Austin Ltd acquired 80% of Reed Ltd on 31 December 20X7.

Requirement

Prepare the consolidated balance sheet of Austin Ltd as at 31 December 20X7.


Austin Ltd: Consolidated balance sheet as at 31 December 20X7

CUNon-current assets

Property, plant and equipmentCurrent assetsTotal assets

Capital and reservesCalled up share capital (Austin Ltd only)Retained earnings

Attributable to equity holders of Austin LtdMinority interest

EquityLiabilities

Total equity and liabilities

Points to note

1 Austin Ltd controls the assets and liabilities of Reed Ltd. The CBS reflects this.

2 The equity section of the CBS reflects ownership (80% by Austin Ltd and 20% by the minorityinterest).

3 Austin Ltd's investment is cancelled against the net assets (i.e. assets less liabilities) of Reed Ltd at

acquisition (12,000 – (80% (10,000 + 5,000))).



4 The remaining net assets are owned by the minority interest.

5 Retained earnings are Austin Ltd's only, because Reed Ltd has, as yet, earned nothing under AustinLtd's control. All of Reed Ltd's retained earnings are pre-acquisition.


Interactive question 2: Control and ownership [Difficulty level: Easy]

Continuing from the facts in Interactive question 1, in the year ended 31 December 20X8 the twocompanies traded as follows.


Revenue 20,000 5,000Costs (15,000) (3,000)Profit 5,000 2,000

The balance sheets as at 31 December 20X8 are as follows.


Non-current assetsProperty, plant and equipment 82,000 9,000Investments: Shares in Reed Ltd 12,000 –


Capital and reservesCalled up share capital 100,000 10,000Retained earnings 35,000 7,000


Requirement

Prepare the consolidated income statement of Austin Ltd for the year ended 31 December 20X8 and theconsolidated balance sheet at that date.


Austin LtdConsolidated income statement for the year ended 31 December 20X8

CURevenueCostsProfitAttributable to:

Equity holders of Austin LtdMinority interest



10

Consolidated balance sheet as at 31 December 20X8


Property, plant and equipmentCurrent assetsTotal assets

Capital and reservesCalled up share capitalRetained earnings

Attributable to equity holders of Austin LtdMinority interestEquityLiabilitiesTotal equity and liabilities

Points to note

Consolidated income statement

1 Down to 'Profit after tax' this reflects control.

2 To reflect ownership, this profit is then allocated between the minority interest (in Reed Ltd) andthe equity holders of Austin Ltd (Austin Ltd's profit plus that part of Reed Ltd's profit (80%) owned byAustin Ltd).

Consolidated balance sheet

1 The assets and liabilities in the balance sheet represent control.

2 The equity part of the CBS represents ownership. This time the retained earnings are Austin Ltd'splus that part of Reed Ltd's (80%) that has arisen since acquisition, i.e. post-acquisition earnings.The minority interest owns their share of Reed Ltd's equity at the balance sheet date.





Summary



10

Self-test

1 Vaynor Ltd acquired 100,000 ordinary shares in Weeton Ltd and 40,000 ordinary shares in Yarlet Ltdsome years ago.

Extracts from the balance sheets of the three companies as on 30 September 20X7 were as follows.

Vaynor Ltd Weeton Ltd Yarlet LtdCU'000 CU'000 CU'000

Ordinary shares of CU1each

500 100 50

Retained earnings 90 40 70

At acquisition Weeton Ltd had retained losses of CU10,000 and Yarlet Ltd had retained earnings ofCU30,000.

The consolidated retained earnings of Vaynor Ltd on 30 September 20X7 were

A CU162,000B CU170,000C CU172,000D CU180,000

2 Constable Ltd owns 10% of Turner Ltd which it treats as a trade investment. Constable Ltd also owns60% of Whistler Ltd. Constable Ltd has held both of these shareholdings for more than one year.Revenue of each company for the year ended 30 June 20X2 was as follows.

CUmConstable Ltd 400Turner Ltd 200Whistler Ltd 100

What figure should be shown as revenue in the consolidated income statement of Constable Ltd?

A CU460mB CU500mC CU520mD CU700m

3 ANDRESS LTD

The income statement and balance sheet for the year 20X0 for Andress Ltd and Bacall Ltd are givenbelow.

Income statements for the year ended 31 December 20X0

Andress Ltd Bacall LtdCU CU

Revenue 10,000 7,000Cost of sales (6,000) (2,000)Gross profit 4,000 5,000Expenses and tax (3,000) (2,000)Profit 1,000 3,000

Balance sheets as at 31 December 20X0



Property, plant and equipment 25,300 9,000Investments (3,200 shares in Bacall Ltd at cost) 3,200 –






Ordinary share capital 10,000 4,000Share premium account 4,000 –Retained earnings 2,000 7,000

Equity 16,000 11,000Non-current liabilities 10,000 2,000Current liabilities 25,000 3,000Total equity and liabilities 51,000 16,000

Andress Ltd has owned 80% of Bacall Ltd since incorporation.

Requirement

Prepare, for Andress Ltd, the consolidated income statement for the year ended 31 December 20X0and the consolidated balance sheet at that date.

4 CRAWFORD LTD PART 1

The balance sheets and income statements for Crawford Ltd and Dietrich Ltd are given below.

Balance sheets as at 30 June 20X0

Crawford Ltd Dietrich LtdCU CU


Property, plant and equipment 27,000 12,500Investments (2,000 CU1 shares in Dietrich Ltd atcost)

2,000 –


EQUITY AND LIABILITIESCapital and reservesOrdinary share capital 20,000 3,000Share premium account 6,000 –Retained earnings 9,000 14,000Equity 35,000 17,000Non-current liabilities 12,000 –Current liabilities 7,000 7,500Total equity and liabilities 54,000 24,500

Crawford Ltd acquired its shares in Dietrich five years ago when Dietrich's earnings were nil. At thestart of the current year retained earnings were CU2,000 and CU4,000 respectively.

Income statement for the year ended 30 June 20X0

Crawford Ltd Dietrich LtdCU CU

Revenue 24,000 30,000Cost of sales (9,000) (11,000)Gross profit 15,000 19,000Distribution costs (2,300) (1,300)Administrative expenses (1,500) (2,700)Profit from operations 11,200 15,000Finance cost (1,200) –Profit before tax 10,000 15,000Tax (3,000) (5,000)Profit for the period 7,000 10,000



10

Requirement

(a) Briefly explain the objectives of producing group accounts. (3 marks)

(b) Briefly explain the following words/phrases.

(i) Single entity(ii) Control(iii) Equity (6 marks)

(c) Prepare, for Crawford Ltd, the consolidated income statement and the statement of changes inequity (in so far as it relates to retained earnings and the minority interest) for the year ended 30June 20X0 and the consolidated balance sheet at that date. (12 marks)

(21 marks)




Technical reference

For a comprehensive Technical reference section, covering all aspects of group accounts (except group cashflow statements) see Chapter 15.



10


1 C

CU'000Vaynor Ltd 90Weeton Ltd ((40 + 10) × 100%) 50Yarlet Ltd ((70 – 30) × 80%) 32

172

2 B

CUmConstable Ltd 400Whistler Ltd 100

500

3 ANDRESS LTD

Consolidated income statement for the year ended 31 December 20X0

CURevenue (10,000 + 7,000) 17,000Cost of sales (6,000 + 2,000) (8,000)Gross profit 9,000Expenses and tax (3,000 + 2,000) (5,000)Profit 4,000Attributable to

Equity holders of Andress Ltd (ß) 3,400Minority interest (20% × 3,000) 600

4,000


CUASSETSNon-current assets

Property, plant and equipment (25,300 + 9,000) 34,300Current assets (22,500 + 7,000) 29,500Total assets 63,800


Ordinary share capital 10,000Share premium account 4,000Retained earnings (2,000 + (80% × 7,000)) 7,600

Attributable to equity holders of Andress Ltd 21,600Minority interest (20% × 11,000) 2,200Equity 23,800Non-current liabilities (10,000 + 2,000) 12,000Current liabilities (25,000 + 3,000) 28,000Total equity and liabilities 63,800

Point to note

No goodwill arises on the acquisition of Bacall Ltd as the shares were acquired at nominal value (80%x 4,000 = CU3,200) on incorporation.



4 CRAWFORD LTD

(a) The objectives of producing group accounts

Group accounts aim to reflect substance, i.e. if one company controls another, they effectivelyoperate as a single economic entity.

Therefore, the parent, or controlling company, should provide information about the economicactivities of the group by preparing consolidated accounts. These will show the economicresources controlled by the group, the obligations of the group and the results achieved withthose resources.

The overall aim is to present the results and state of affairs of the group as if they were those ofa single entity.

(b) Terms

(i) Single entity

The single entity concept focuses on the existence of the group as an economic unit (asdiscussed above). This contrasts with legal form where each group company is actually aseparate legal person.

(ii) Control

Control is the ability to direct the financial and operating activities of another company. Inan individual company the assets are under the direct control of that company. However,where a company becomes a subsidiary, the assets are under indirect control of the parentvia its control of the subsidiary.

Control can be achieved in a number of ways, the most obvious being a holding of over 50%of the ordinary, i.e. vote-carrying, shares.

(iii) Equity

Equity is defined in BFRS Framework (Elements) as the residual amount found by deductingall of the entity's liabilities from its assets. In an individual company those net assets areowned by one ownership interest – the company's shareholders. However, in consolidatedaccounts the consolidated net assets will include 100% of the subsidiary even though someof those net assets are not owned by the group. Therefore, the equity interest is splitbetween

The parent company's shareholders The minority shareholders in the subsidiary

(c) Consolidated balance sheet as at 30 June 20X0

CUASSETSNon-current assets

Property, plant and machinery (27,000 + 12,500) 39,500Current assets (25,000 + 12,000) 37,000Total assets 76,500


Ordinary share capital 20,000Share premium account 6,000Retained earnings (9,000 + (2/3 × 14,000)) 18,333

Attributable to equity holders of Crawford Ltd 44,333Minority interest (1/3 × 17,000) 5,667Equity 50,000Non-current liabilities 12,000Current liabilities (7,000 + 7,500) 14,500Total equity and liabilities 76,500



10

Consolidated income statement for the year ended 30 June 20X0

CURevenue (24,000 + 30,000) 54,000Cost of sales (9,000 + 11,000) (20,000)Gross profit 34,000Distribution costs (2,300 + 1,300) (3,600)Administrative expenses (1,500 + 2,700) (4,200)Profit from operations 26,200Finance cost (1,200)Profit before tax 25,000Income tax (3,000 + 5,000) (8,000)Profit after tax 17,000Attributable to

Equity holders of Crawford Ltd (ß) 13,667Minority interest (1/3 × 10,000) 3,333

17,000

Consolidated statement of changes in equity for the year ended 30 June 20X0(extract)

Attributableto the equityholders of Minority

Crawford Ltd interest TotalCU CU CU

Net profit for the period 13,667 3,333 17,000Balance b/f (2,000 + (2/3 × 4,000)) (1/3 × 4,000) 4,667 1,333 6,000Balance carried forward 18,334 4,666 23,000

Point to note

No goodwill arises on the acquisition of Dietrich Ltd as the shares were acquired at net assetvalue, i.e. their nominal value when retained earnings were CUnil.





Austin Ltd: Consolidated balance sheet as at 31 December 20X7



Capital and reservesCalled up share capital (Austin Ltd only) 100,000Retained earnings (Austin Ltd only) 30,000

Attributable to equity holders of Austin Ltd 130,000Minority interest (20% × Reed Ltd's 15,000) 3,000Equity 133,000Liabilities (20,000 + 6,000) 26,000Total equity and liabilities 159,000

(Retained earnings are Austin Ltd's only, because Reed Ltd has, as yet, earned nothing under Austin Ltd'scontrol.)


Austin Ltd


CURevenue (20,000 + 5,000) 25,000Costs (15,000 + 3,000) (18,000)Profit 7,000Attributable to:

Equity holders of Austin Ltd (ß) 6,600Minority interest (20% × 2,000) 400

7,000




Capital and reservesCalled up share capital (Austin Ltd only) 100,000Retained earnings

(35,000 + (80% × (7,000 – 5,000)) 36,600(i.e. Austin Ltd + its share of Reed Ltd post-acquisition)

Attributable to equity holders of Austin Ltd 136,600Minority interest (20% × Reed Ltd's 17,000) 3,400Equity 140,000Liabilities (40,000 + 12,000) 52,000Total equity and liabilities 192,000


Contents

Introduction

Examination context

Topic List

1 Context

2 Goodwill

3 Consolidated balance sheet workings

4 Mid-year acquisitions

5 Intra-group balances

6 Unrealised intra-group profit

7 Fair value adjustments

8 Other consolidation adjustments


Technical reference



chapter 11

Group accounts:consolidated balance sheet



Introduction




– The single entity concept– Substance over form– The distinction between control and ownership

Calculate the amounts to be included in an entity’s consolidated balance sheet in respect ofits new and continuing interests in subsidiaries in accordance with the international financialreporting framework

Prepare and present a consolidated balance sheet (or extracts therefrom) includingadjustments for intra-group transactions and balances, goodwill, minority interests and fairvalues

Specific syllabus references for this chapter are: 1d,g, 3d,e.


The consolidated balance sheet provides the owners of the group with important information over andabove that which is available in the parent’s own balance sheet. The cost of the investment made in thesubsidiary is replaced with the net assets controlled by the parent company. This application of substanceover form provides a more realistic representation of what their investment is really worth as the balancesheets of the parent and subsidiary are produced as if they were a single entity. The single entity concepthas more detailed implications for the preparation of the balance sheet which we will look at in thischapter.

Stop and think

Why is information about the assets and liabilities of the subsidiary of more use to the shareholders thanthe cost of their investment?

Working context

The preparation of the consolidated balance sheet involves the combination of the individual balance sheetsof the group members. As we said in Chapter 10, this process is often computerised. However, detailedwork will be needed on the consolidation adjustments. This might include for example, establishing fairvalues at the date of acquisition so that goodwill can be correctly calculated and the identification andelimination of intra-group balances. In this chapter, we will look at consolidation adjustments from theperspective of the consolidated balance sheet. Chapter 12 considers the same consolidation adjustmentsfrom the perspective of the consolidated income statement.

Syllabus links

This chapter looks in detail at the preparation of the consolidated balance sheet and is fundamental to theFinancial Accounting syllabus. It builds on the principles introduced in Chapter 10 and applies them to morecomplex situations. A detailed knowledge and understanding of this topic will also be assumed in Financial &Corporate Reporting at the Advanced Stage.

GROUP ACCOUNTS: CONSOLIDATED BALANCE SHEET


11

Examination context

Exam requirements

Each Financial Accounting paper is likely to feature either a written test question on the consolidatedbalance sheet or the consolidated income statement (or, more rarely, the consolidated cash flowstatement). In a consolidated balance sheet question the majority of marks are likely to be awarded for thepreparation of the balance sheet or extracts therefrom including a number of consolidation adjustments.Typically, the group structure will include more than one subsidiary or a subsidiary and an associate(associates are covered in Chapter 13). However, you may also be required to explain the consolidationprocess in relation to the principles of substance over form and/or the single entity concept.

Short-form questions on this area, including goodwill calculations, fair value adjustments and the eliminationof intra-group transactions and balances are also likely to appear regularly in the exam.


Prepare a consolidated balance sheet (or extracts therefrom) including the results of the parent entityand one or more subsidiaries including adjustments for the following:

– Acquisition of a subsidiary, including mid-year acquisitions– Goodwill– Intra-group items– Unrealised profits– Fair values– Other consolidation adjustments

Explain the process of consolidating the balance sheet in the context of the single entity concept,substance over form and the distinction between control and ownership.



1 Context

Section overview

This chapter considers the preparation of the consolidated balance sheet in more detail.

1.1 Consolidated balance sheet

This chapter builds on the basic principles of group accounts (dealt with in Chapter 10) by applyingthem in more detail to the preparation of the consolidated balance sheet. In particular it covers thefollowing issues:

Goodwill Intra-group balances Unrealised intra-group profit Standardised workings Fair value adjustments

All of the above relate to the application of the single entity concept and reflect the distinction betweencontrol and ownership.

2 Goodwill

Section overview

Goodwill on acquisition is recognised in the consolidated balance sheet as an intangible non-currentasset.

An annual impairment review is performed.

Any discount on acquisition is recognised in profit or loss in the period in which the acquisition ismade.

2.1 Calculation

In the previous chapter we said that the investment in the parent’s balance sheet is cancelled against thenet assets of the subsidiary at acquisition.

Worked example: Cancellation

Using the facts from Interactive question 1 in Chapter 10, we had the following information:

CUCost of 80% investment in Reed Ltd 12,000(in Austin Ltd’s balance sheet)Net assets of Reed Ltd at acquisition 15,000

If you compare the cost of the investment (CU12,000) with the net assets acquired (80% CU15,000 =CU12,000) you can see that this cancels exactly. Austin Ltd has paid an amount which is equal to its shareof the assets and liabilities of Reed Ltd at acquisition.

In practice this is not likely to be the case. The parent company will often pay more for the subsidiary thanthe net assets would suggest, in recognition that the subsidiary has attributes that are not reflected in itsbalance sheet. The extra amount paid by the parent is goodwill. (We looked at some of the factors whichcreate goodwill in Chapter 6.)



11

Interactive question 1: Goodwill [Difficulty level: Easy]

P Ltd pays CU10,000 to buy 75% of the share capital of S Ltd. The balance sheet of S Ltd shows thefollowing.

CUAssets 16,000

Share capital 1,000Retained earnings 11,000Equity 12,000Liabilities 4,000

16,000

Requirement

Calculate the goodwill arising on P Ltd's acquisition of S Ltd.


CUConsiderationLess: Share of net assets acquiredGoodwill

Point to note

For the purposes of calculating goodwill net assets at acquisition are normally calculated as equity plusretained earnings (and other reserves, if any) at the acquisition date.



Goodwill arising on consolidation is recognised in the consolidated balance sheet as an intangiblenon-current asset.

Goodwill is not amortised through the income statement in annual instalments. Instead an annualimpairment review will be performed to ascertain whether part of its value has been lost as a result offactors external or internal to the business. (Impairment losses under BAS 36 Impairment of Assets werecovered in Chapter 5.)

If goodwill has suffered an impairment the loss will be recognised in the consolidated incomestatement. Retained earnings in the consolidated balance sheet will also be reduced.

Point to note

Retained earnings will be reduced by the impairment recognised to date, not just the fall in value whichrelates to the current year.

This is because goodwill is a consolidation adjustment, i.e. it only affects the group accounts. The singleentity accounts which are used as the basis of the consolidated balance sheet will not reflect any previousimpairments in goodwill.

2.3 Acquisition at a discount

In certain circumstances the parent entity may pay less to acquire a subsidiary than represented by its shareof the subsidiary’s net assets.

These circumstances might include the following:

The subsidiary has a poor reputation It suffers from inherent weaknesses not reflected in its assets and liabilities The parent company has negotiated a good deal



This negative balance or ‘discount on acquisition’ is recognised in profit or loss in the period in whichthe acquisition is made.

3 Consolidated balance sheet workings

Section overview

A number of standard workings should be used when answering consolidation questions.

3.1 Question technique

As questions increase in complexity a formal pattern of workings is needed. Review the standard workingsbelow, then attempt Interactive question 2 which puts these into practice.

(1) Establish group structure

P Ltd

80%

S Ltd

(2) Set out net assets of S Ltd

At BS date At acquisition Post acquisitionCU CU CU

Share capital X X XRetained earnings X X X

X X

(3) Calculate goodwill

CUCost XLess: Share of net assets at acquisition (see W2) (X)

XImpairment to date (X)Balance c/f X

(4) Calculate minority interest (MI)

CUShare of net assets at BS date (W2) X

(5) Calculate retained earnings

CUP Ltd (100%) XS Ltd (share of post-acquisition retained earnings (see W2)) XGoodwill impairment to date (see W3) (X)

X



11

Interactive question 2: Consolidated balance sheet workings [Difficulty level: Easy]

The following are the summarised balance sheets of a group of companies as at 31 December 20X1.

Rik Ltd Viv Ltd Neil LtdNon-current assets CU CU CUProperty, plant and equipment 100,000 40,000 10,000InvestmentsShares in Viv Ltd (75%) 25,000Shares in Neil Ltd (2/3) 10,000

Current assets 45,000 40,000 25,000180,000 80,000 35,000

Capital and reservesCalled up share capital 50,000 20,000 10,000(CU1 ordinary)

Retained earnings 100,000 40,000 15,000Equity 150,000 60,000 25,000Liabilities 30,000 20,000 10,000

180,000 80,000 35,000

Rik Ltd acquired its shares in Viv Ltd and Neil Ltd during the year, when their retained earnings wereCU4,000 and CU1,000 respectively.

At the end of 20X1 the goodwill impairment review revealed a loss of CU3,000 in relation to theacquisition of Viv Ltd.

Requirement

Prepare the consolidated balance sheet of Rik Ltd at 31 December 20X1.


Rik Ltd: Consolidated balance sheet as at 31 December 20X1

CUNon-current assetsProperty, plant and equipmentIntangibles (W3)

Current assets

Capital and reservesCalled up share capitalRetained earnings (W5)

Attributable to equity holders of Rik LtdMinority interest (W4)EquityLiabilities

WORKINGS

(1) Group structure

Rik Ltd

75% 2/3

Viv Ltd Neil Ltd



(2) Net assets

Balance sheet date Acquisition Post-acquisitionCU CU CU

Viv LtdShare capitalRetained earnings

Balance sheet date Acquisition Post-acquisitionCU CU CU

Neil LtdShare capitalRetained earnings

(3) Goodwill

Viv Ltd Neil Ltd TotalCU CU CU

Cost of investmentLess: Share of net assetsacquired

Viv LtdNeil Ltd

GoodwillImpairment to dateBalance c/f

(4) Minority interest

CUViv Ltd – Share of net assets at BS dateNeil Ltd – Share of net assets at BS date


CURik LtdViv Ltd – Share of post-acquisition retained earningsNeil Ltd – Share of post-acquisition retained earningsGoodwill impairment to date (W3)



Section overview

If a subsidiary is acquired mid-year, net assets at acquisition will need to be calculated. Unless told otherwise assume profits of the subsidiary accrue evenly over time.

4.1 Calculation

A parent entity might not acquire a subsidiary at the start or end of a year. If the subsidiary is acquired mid-year, it is necessary to calculate reserves, including retained earnings, at the date of acquisition.



11

This is necessary in order to:

Calculate net assets at acquisition (which is required as part of the goodwill calculation) Calculate consolidated reserves, e.g. retained earnings

Points to note

1 It is usually assumed that a subsidiary’s profits accrue evenly over time.

2 However, unless otherwise stated, it should be assumed that any dividends paid by the subsidiary areout of post acquisition profits.

Interactive question 3: Mid-year acquisition [Difficulty level: Easy]

P Ltd acquired 80% of S Ltd on 31 May 20X2 for CU20,000. S Ltd's retained earnings had stood atCU15,000 on 1 January 20X2.

S Ltd's net assets at 31 December 20X2 were as follows.

CUShare capital 1,000Retained earnings 15,600Equity 16,600

Requirements

(a) Produce the standard working for S Ltd's net assets (W2).

(b) Produce the standard working for goodwill on consolidation (W3).

(c) Calculate S Ltd's retained earnings which will be included in the consolidated retained earnings.

(d) Calculate S Ltd's (i) pre-acquisition and (ii) post acquisition earnings assuming that S Ltd has paid adividend of CU2,000 on 30 June 20X2.


Solution

(a) Net assets (W2)

Balance sheet date Acquisition Post acquisitionCU CU CU

Share capitalRetained earnings

(b) Goodwill (W3)

CUCost of investmentLess: Share of net assets acquired

(c) Profit from S Ltd included in consolidated retained earnings

CUShare of post-acquisitionretained earnings of S Ltd

(d) (i) Pre-acquisition earnings

CURetained earnings per balance sheetAdd back: Dividend paidTotal earnings before dividend

Pre-acquisition earnings



(ii) Post-acquisition earnings

CUTotal earnings before dividend =× 7/12 =

Less: Dividend paid


5 Intra-group balances

Section overview

Group accounts reflect transactions with third parties only. The effect of transactions between group members are cancelled on consolidation. This is an application of the single entity concept.

5.1 The single entity concept

The objective of group accounts is to present the group as a single entity. Hence the effects oftransactions between group members need to be eliminated, as the group has not transacted withany third party.

PEliminate effectof transactionsbetween groupmembers

Single entity concept

S

Reflecting the group as a single entity means that items which are assets in one group company and liabilitiesin another need to be cancelled out, otherwise group assets and liabilities will be overstated.

Intra-group balances result from, for example,

One group company's loans, debentures or redeemable preference shares held by another groupcompany

Intra-group trading

Dividends from a subsidiary to a parent

5.2 Loans, debentures and redeemable preference shares

Cancel the credit balance in one company against the debit balance in the other before adding assetsand liabilities line-by-line.



11

5.3 Intra-group trading

Outstanding amounts in respect of intra-group trading are usually recorded in the balance sheet in currentaccounts (= receivable or payable account for a fellow group company).

Step 1Check that current accounts agree before cancelling. They may not agree if goods or cash are in-transit atyear end.

Step 2Make balances agree by adjusting for in-transit items in the receiving company’s books.

Step 3Cancel intra-group balances.

Worked example: Intra-group trading

Extracts from the balance sheets of Impala Ltd and its subsidiary Springbok Ltd at 31 March 20X4 are asfollows.

Impala Ltd Springbok LtdCU CU

Receivable from Springbok Ltd 25,000 –Payable to Impala Ltd – (20,000)

Springbok Ltd sent a cheque for CU5,000 to Impala Ltd on 28 March 20X4, which Impala Ltd did notreceive until 2 April 20X4.

Solution

Steps 1 and 2Assume that Impala Ltd had received the cash from Springbok Ltd.

Impala Ltd Springbok LtdCU CU

Receivable from Springbok Ltd (25-5) 20,000 –Cash and cash equivalents 5,000 –Payable to Impala Ltd – (20,000)

Step 3Cancel inter-company balances on consolidation, leaving in the consolidated balance sheet

CUCash and cash equivalents 5,000

5.4 Dividends

As with intra-group balances such as loans, these must be cancelled out. The parent’s dividend receivablefrom the subsidiary needs to be cancelled against the subsidiary's declared dividend payable, leaving in theconsolidated balance sheet that part of the subsidiary’s dividend payable to the minority. This will be inaddition to the parent's own dividend payable.

Step 1Check that all companies have recorded all declared dividends (you may be given draft balance sheetsbefore such closing adjustments). Read the question carefully to establish this.



Step 2If declared dividends payable have not been recorded

CU CUDR Retained earnings (via retained earnings working for P, net assets working for S) XCR Payables – declared dividends X

with declared dividend payable

Step 3If S has declared a dividend which has not yet been paid, P must record its share. If this has not been done,record P’s dividend receivable from S.

CU CUDR Receivables – dividends receivable XCR P's retained earnings (via retained earnings working) X

with share of dividend receivable from S

Step 4Cancel the dividends receivable and dividends payable intra-group balances.

This will leave that part of S’s dividend payable to the minority in addition to P’s own dividend payable.

Interactive question 4: Dividends [Difficulty level: Intermediate]

Impala Ltd acquired 75% of Springbok Ltd when the retained earnings of Springbok Ltd stood at CU20,000.Balance sheets as at 31 March 20X4 are as follows.

ImpalaLtd

SpringbokLtd

CU CUAssets (including receivables) 130,000 90,000

Share capital 40,000 25,000Retained earnings 60,000 45,000Equity 100,000 70,000Liabilities (including payables) 30,000 20,000

130,000 90,000

At 31 March 20X4 the two companies have declared dividends, which have not been accounted for, asfollows.

CUImpala Ltd 10,000Springbok Ltd 5,000

Requirement

Show the adjustments necessary to record the above information and how it will be presented in theconsolidated balance sheet and consolidation workings at 31 March 20X4.


(a) Recording of dividends in individual companies' books

Impala Ltd's dividend CU CUImpala Ltd's booksDRCR

Springbok Ltd's dividend CU CUSpringbok Ltd's booksDRCR



11

(b) In consolidation workings

(1) Group structure

Impala Ltd

75%

Springbok Ltd

(2) Net assets of Springbok Ltd

Balance sheet date Acquisition Post-acquisition

CU CU CU CUShare capitalRetained earnings

Per questionDividends


CU


CUImpala Ltd per question

Dividends proposedDividends from Springbok Ltd

Share of Springbok Ltd post-acquisition

(c) In consolidated balance sheet

CUPayables: Declared dividends payable

Parent companyMinority interest

Point to note

There is no standard working 3 as goodwill is not required in this instance.




6 Unrealised intra-group profit

Section overview

The consolidated balance sheet must show assets at their cost to the group.

Any profit arising on intra-group transactions must be eliminated from the group accounts until it isrealised by a sale outside the group.

6.1 Introduction

One of the implications of the application of the single entity concept is that group accounts should onlyreflect profits generated from transactions which have been undertaken with third parties, i.e. entitiesoutside the group.

Where intra-group activities give rise to profits these are unrealised as far as the group as a whole isconcerned. These profits can result from:

Intra-group trading Intra-group transfers of non-current assets

Unrealised profits must be eliminated from the balance sheet on consolidation to prevent theoverstatement of group profits.

6.2 Inventories

As we have seen in section 5.3 any receivable/payable balances outstanding between group companies,resulting from trading transactions, are cancelled on consolidation. If these transactions have beenundertaken at cost no further problem arises.

However, each company in a group is a separate trading entity and may sell goods to another groupmember at a profit. If these goods remain in inventories at the year end this profit is unrealised fromthe group’s point of view.

In the consolidated balance sheet, applying the single entity concept, inventories must be valued at thelower of cost and net realisable value to the group. Where goods transferred at a profit are still held atthe year end the unrealised profit must be eliminated on consolidation. This is achieved by creating aprovision for unrealised profit (PURP).

The way in which this adjustment is made depends on whether the company making the sale is the parentor the subsidiary.

6.2.1 Parent sells goods to subsidiary

The issues are best illustrated by an example.

Worked example: Intra-group profit (PS)

Ant Ltd, a parent company, sells goods which cost CU1,600 to Bee Ltd for CU2,000. Ant Ltd owns 75% ofthe shares in Bee Ltd. Bee Ltd still hold the goods in inventories at the year end.

In the single entity accounts of Ant Ltd the profit of CU400 will be recognised. In the single entity accountsof Bee Ltd the inventory will be valued at CU2,000.

If we simply add together the figures for retained reserves and inventory as recorded in the individualbalance sheets of Ant Ltd and Bee Ltd the resulting figures for consolidated reserves and consolidatedinventory will each be overstated by CU400. A consolidation adjustment is therefore necessary as follows:



11

CU CUDR Seller's (Ant Ltd's) retained earnings

(i.e. adjust in retained earnings working)400

CR Inventories in consolidated balance sheet 400

Point to note

In this example, as the parent was the seller the unrealised profit is all 'owned' by the shareholders ofAnt Ltd. None is attributable to the minority interest.

6.2.2 Subsidiary sells goods to parent

Where the subsidiary is the selling company the profit on the transfer will have been recorded in thesubsidiary’s books.

Worked example: Intra-group profit (SP)

Using the worked example above, if we now assume that Bee Ltd sold the goods to Ant Ltd the adjustmentwould be as follows:

CU CUDR Seller's (Bee Ltd's) retained earnings

(i.e. adjust in net assets working)400

CR Inventories in consolidated balance sheet 400

Points to note

1 The net assets of the subsidiary at the balance sheet date will be reduced by the amount of theunrealised profit. Any subsequent calculations based on this net assets figure will therefore beaffected as follows:

The group share of the post-acquisition retained earnings of the subsidiary will be reduced, i.e.the group will bear its share of the adjustment.

The minority interest will be based on these revised net assets i.e. the minority interestwill bear its share of the adjustment.

2 Inventories in the consolidated balance sheet are reduced by the full amount of the unrealised profitirrespective of whether the parent or the subsidiary is the selling company.

Interactive question 5: Unrealised profits [Difficulty level: Intermediate]

P Ltd owns 80% of S Ltd, which it acquired when the retained earnings of S Ltd were CU20,000. Nogoodwill was acquired. Balance sheets at the end of the current accounting period are as follows.

P Ltd S LtdCU CU

Assets 170,000 115,000

Share capital 30,000 10,000Retained earnings 100,000 65,000Equity 130,000 75,000Liabilities 40,000 40,000

170,000 115,000

During the current accounting period S Ltd sold goods to P Ltd for CU18,000, which gave S Ltd a profit ofCU6,000. At the balance sheet date half of these goods were included in P Ltd's inventories.



Requirement

Show how the adjustment to eliminate unrealised profits will appear in the consolidation workings for PLtd.

Fill in the pro forma below.

CU CUDRCR

WORKINGS

(1) Group structure

P Ltd

80%

S Ltd

(2) S Ltd net assets

Balance sheet date Acquisition Post-acquisition

CU CU CU CUShare capitalRetained earnings

Per questionLess: PURP


CUShare of net assets


CUP LtdShare of S Ltd


6.3 Non-current asset transfers

As well as trading with each other, group companies may wish to transfer non-current assets (NCA).

If the asset is transferred at a profit two issues arise:

The selling company will have recorded a profit or loss on sale

The purchasing company will have recorded the asset at the amount paid to acquire it, and willuse that amount as the basis for calculating depreciation.

On consolidation, the single entity concept applies. The consolidated balance sheet must show assets attheir cost to the group, and any depreciation charged must be based on that cost. In other words,the group accounts should reflect the non-current asset as if the transfer had not been made.



11

The adjustment in the consolidated balance sheet is calculated as follows:

CUNBV of NCA at year end XLess: NBV of NCA at year end if transfer had not been made (X)Unrealised profit X

The adjustment is then made as:

CU CUDR Selling company retained earnings XCR NCA NBV in consolidated balance sheet X

This treatment is consistent with that of inventories.

6.3.1 Parent sells non-current asset to subsidiary

As with inventories the impact of the adjustment will depend on whether the parent company or thesubsidiary makes the sale.

Interactive question 6: Non-current asset transfers [Difficulty level: Easy]

P Ltd owns 80% of S Ltd. P Ltd transferred to S Ltd a non-current asset at a value of CU15,000 on 1January 20X7. The original cost to P Ltd was CU20,000 and the accumulated depreciation at the date oftransfer was CU8,000. Both companies depreciated such assets at 20% per year on cost to the company.

Requirement

Calculate the consolidated balance sheet adjustment at 31 December 20X7.


Solution

Following the transfer the asset will be included at

CUCostLess: Depreciation

Had the transfer not been made, the asset would stand in the books atCU

CostLess: Accumulated depreciation at date of transfer

Provision for current year

Overall adjustment in CBSCU CU

DR Seller's (P Ltd's) retained earnings(i.e. adjust in retained earnings working)

CR Non-current assets

Point to note

In this question, as the parent is the selling company, none of the adjustment is attributed to theminority interest.




6.3.2 Subsidiary sells non-current asset to parent

Again a consolidation adjustment is made to reflect the situation that would have existed if the transfer hadnot been made.

The amount of the adjustment is calculated as before (see section 6.3 above).

The adjustment is then made as follows:

CU CUDR Seller's (S Ltd) retained earnings X

(i.e. adjust in net assets working)CR NCA NBV in consolidated balance sheet X

Points to note

1 As the subsidiary is the seller the adjustment to retained earnings will be made in the netassets working.

2 Any subsequent calculations based on this net assets figure will therefore be affected as follows:

The group share of the post-acquisition retained earnings of the subsidiary will be reduced i.e..as for sale of inventories

The minority interest will be based on these revised net assets, i.e. as for sale of inventories.

7 Fair value adjustments

Section overview

In calculating the goodwill acquired, the net assets of the subsidiary should be measured at their fairvalue.

A consolidation adjustment will be required for the difference between the book value and fair valueof the net assets.

7.1 Calculation of goodwill

In section 2 of this chapter we said that goodwill is calculated by comparing the cost of the investment inthe subsidiary with the net assets acquired. Strictly speaking the net assets brought into this calculationshould be at fair value, which may be different to book value.

This raises two issues:

How do we measure the fair value of the subsidiary’s net assets? How are fair values reflected in the consolidation?

How we measure the fair value of a subsidiary’s net assets will be dealt with in detail in Chapter 15. Thissection looks at the way that the fair values are incorporated into the consolidated balance sheet.

7.2 Reflecting fair values

The identifiable assets, liabilities and contingent liabilities of a subsidiary are brought into theconsolidated financial statements at their fair value. Normally these fair values are not reflected in thesingle entity financial statements. Therefore the difference between fair values and book values istreated as a consolidation adjustment made only for the purposes of the consolidated financialstatements.

The increase (or decrease) in value is treated as a revaluation at acquisition and also applies in subsequentyears if the asset is still held.



11

Revaluation upwards Create a revaluation reserve in the net assets working at acquisitionand at the balance sheet date.

Revaluation downwards Create a provision against retained earnings in the net assetsworking at acquisition and at the balance sheet date.

Points to note

1 Post-acquisition depreciation may need to be adjusted so that it is based on the revaluedamount.

2 Goodwill in the subsidiary’s individual balance sheet is not part of the identifiable assets andliabilities acquired. If the subsidiary’s own balance sheet at acquisition includes goodwill, this must notbe consolidated. In the net asset working retained earnings at acquisition and at the balance sheetdate should be reduced by the amount of the goodwill.

Interactive question 7: Fair value adjustments [Difficulty level: Easy]

P Ltd acquires 60% of S Ltd on 31 December 20X4 for CU80,000. The balance sheet of S Ltd at this date isas follows.

CUFreehold land (fair value CU30,000) 20,000Goodwill arising on the acquisition of a sole trader 5,000Sundry assets (book value = fair value) 130,000

155,000

Share capital 20,000Retained earnings 85,000Equity 105,000Liabilities 50,000

155,000

Requirement

Calculate the goodwill arising on the acquisition of S Ltd.


(1) Group structure

P Ltd

60%

S Ltd

(2) Net assets of S Ltd

BS date = Acquisition dateCU CU

Share capitalRevaluationRetained earningsPer question

Less: Goodwill



(3) Goodwill

CUCost of investment

Less: Share of FV of net assets acquired

Point to note

In the asset section of the balance sheet the freehold land will be consolidated at CU30,000. The goodwill inthe subsidiary's balance sheet of CU5,000 will not be recognised as an intangible asset in the consolidatedbalance sheet.


8 Other consolidation adjustments

Section overview

If a subsidiary has reserves other than retained earnings, the group share of post-acquisition reservesshould be consolidated.

The balances of the subsidiary should be adjusted to reflect the accounting policies of the parentcompany prior to consolidation.

8.1 Other reserves in a subsidiary

As we have already mentioned, a subsidiary may have other reserves apart from retained earnings in itsbalance sheet, e.g. a revaluation reserve. If this is the case, such reserves should be treated in exactly thesame way as retained earnings.

Other reserves at acquisition form part of the net assets at acquisition, i.e. they should berecorded in the net assets working at acquisition.

The group share of any post acquisition movement in other reserves should be recognised inthe consolidated balance sheet.

Points to note

1 A separate working should be used for each reserve; do not mix retained earnings with otherreserves as the other reserves may include amounts which are not distributable by way of dividend.

2 If a subsidiary is loss-making or has any other negative reserves the group will consolidate itsshare of the post-acquisition losses/negative reserves.

8.2 Accounting policy alignments

On consolidation uniform accounting policies must be applied for all amounts. This is anotherconsequence of the single entity concept.

If the parent company and subsidiary have different accounting policies the balances in the subsidiary’sfinancial statements must be adjusted to reflect the accounting policies of the parent company.

Point to note

These adjustments are made in the net assets working.



11

Interactive question 8: Accounting policy alignments [Difficulty level: Easy]

William Ltd has been 85% owned by Mary Ltd for some years. On 1 January 20X4 William Ltd acquired anitem of plant for CU40,000. William Ltd depreciates this item of plant at 15% on a reducing balance basis,while Mary Ltd's policy for this class of plant is 10% per annum on a straight-line basis.

Requirement

Set out the adjustment required in the preparation of the consolidated balance sheet at 31 December20X5.


Following the transfer the asset will be included at:

CUCarrying amount of plant in CBS

Carrying amount in William Ltd's BSIncrease in carrying amount

CU CU

DR Non-current assetsCR Consolidated retained earningsCR Minority interest





Summary



11

Self-test

1 The summarised balance sheets of Peep Ltd and Pitti Ltd at 31 December 20X6 are as follows.

Peep Ltd Pitti LtdCU CU

Net assets 300,000 160,000

Share capital (CU1 shares) 100,000 100,000

Retained earnings 200,000 60,000300,000 160,000

On 31 December 20X6 Yum Ltd purchased for cash 90% of Peep Ltd’s shares for CU360,000 and 75%of Pitti Ltd’s shares for CU100,000. The carrying amounts of the assets in both companies areconsidered to be fair values.

In the consolidated balance sheet at 31 December 20X6, goodwill and discount on acquisition will beshown as

Goodwill Discount on acquisition

A CUnil CUnilB CU60,000 CU60,000C CU90,000 NilD CU90,000 CU20,000

2 The summarised balance sheets of Black Ltd and Red Ltd at 31 December 20X6 were as follows.

Black Ltd Red LtdCU'000 CU'000

Total assets 60,000 29,000

Share capital 20,000 10,000Retained earnings 24,000 4,000Equity 44,000 14,000Current liabilities 16,000 15,000Total equity and liabilities 60,000 29,000

On 1 January 20X7 Black Ltd bought all the share capital of Red Ltd for CU17,000,000 in cash. Thecarrying amount of Red Ltd’s assets are considered to be fair values.

The amount of retained earnings to be included in the consolidated balance sheet as at 1 January 20X7 are

A CU21,000,000B CU24,000,000C CU25,000,000D CU28,000,000

3 Milton Ltd owns all the share capital of Keynes Ltd. The following information is extracted from theindividual company balance sheets as on 31 December 20X1.

Milton Ltd Keynes LtdCU CU

Current assets 500,000 200,000Current liabilities 220,000 90,000

Included in Milton Ltd’s purchase ledger is a balance in respect of Keynes Ltd of CU20,000. Thebalance on Milton Ltd’s account in the sales ledger of Keynes Ltd is CU22,000. The difference betweenthose figures is accounted for by cash in transit.

If there are no other intra-group balances, what is the amount of current assets less current liabilitiesin the consolidated balance sheet of Milton Ltd and its subsidiary?

A CU368,000B CU370,000C CU388,000D CU390,000



4 Laker Ltd owns 80% of the ordinary shares of Hammond Ltd. The following amounts have beenextracted from their draft financial statements at 31 December 20X0.

Laker Ltd Hammond LtdCU CU

Current liabilitiesTrade payables 5,200 7,100Amount owed to subsidiary 500 –Income tax 100 150Amounts owed to trade investments 150 200Other payables 50 70

6,000 7,520

Hammond Ltd shows an amount receivable from Laker Ltd of CU620 and the difference is due to cashin transit.

What is the total carrying amount of current liabilities in the consolidated balance sheet of Laker Ltd?

A CU11,900B CU12,400C CU13,020D CU13,170

5 Austen Ltd has owned 100% of Kipling Ltd and 60% of Dickens Ltd for many years. At 31 December20X5 the trade receivables and trade payables shown in the individual company balance sheets were asfollows.

Austen Ltd Kipling Ltd Dickens LtdCU'000 CU'000 CU'000

Trade receivables 50 30 40Trade payables 30 15 20

Trade payables are made up as follows.Amounts owing to

Austen – – –Kipling 2 – 4Dickens 3 – –Other suppliers 25 15 16

30 15 20

The intra-group accounts agreed after taking into account the following.

(1) An invoice for CU3,000 posted by Kipling Ltd on 31 December 20X5 was not received byAusten Ltd until 2 January 20X6

(2) A cheque for CU2,000 posted by Austen Ltd on 30 December 20X5 was not received byDickens Ltd until 4 January 20X6.

What amount should be shown as trade receivables in the consolidated balance sheet of Austen Ltd?

A CU56,000B CU106,000C CU109,000D CU111,000



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6 The following is the draft balance sheet information of Ho Ltd and Su Ltd, as on 30 September 20X2.

Ho Ltd Su LtdCU'000 CU'000

Ordinary CU1 shares 2,600 1,000Retained earnings 750 700Trade payables 350 900Other payables – 100

3,700 2,700

Total assets 3,700 2,700

Ho Ltd acquired 60% of the share capital of Su Ltd several years ago when Su Ltd’s retained earningswere CU300,000. Su Ltd has not yet accounted for the estimated audit fee for the year ended 30September 20X2 of CU40,000.

The consolidated retained earnings on 30 September 20X2 are

A CU950,000B CU966,000C CU990,000D CU1,450,000

7 Tottenham Ltd owns 95% of Chelsea Ltd and 97.5% of Leyton Ltd.

Dividends for the year ended 31 December 20X8 are as follows.

Interim paid Final proposedCU CU

Tottenham Ltd 10,000 40,000 (declared 15 December 20X8)Chelsea Ltd – 10,000 (declared 15 December 20X8)Leyton Ltd – 18,000 (declared 14 February 20X9)

What is the total amount shown for dividends payable appearing in the consolidated balance sheet asat 31 December 20X8?

A CU40,500B CU41,150C CU68,000D CU50,950

8 Bass Ltd acquired its 70% holding in Miller Ltd many years ago. At 31 December 20X7 Miller Ltd hadinventory with a carrying amount of CU15,000 purchased from Bass Ltd at cost plus 25%.

The effect on consolidated retained earnings and minority interests as stated in the consolidatedbalance sheet is

A No effect on minority interest Reduce group retained earnings by CU1,000B No effect on minority interest Reduce group retained earnings by CU3,000C Reduce minority interest by CU250 Reduce group retained earnings by CU750D Reduce minority interest by CU750 Reduce group retained earnings by CU2,250

9 Oxford Ltd owns 100% of the issued share capital of Cambridge Ltd, and sells goods to its subsidiaryat a profit margin of 20%. At the year end their balance sheets showed inventories of

Oxford Ltd CU290,000Cambridge Ltd CU160,000

The inventory of Cambridge Ltd included CU40,000 of goods supplied by Oxford Ltd and there wasinventory in transit from Oxford to Cambridge amounting to a further CU20,000. At what amountshould inventory be carried in the consolidated balance sheet?

A CU438,000B CU442,000C CU458,000D CU462,000



10 Rugby Ltd has a 75% subsidiary, Stafford Ltd, and is preparing its consolidated balance sheet as on 31December 20X6. The carrying amount of property, plant and equipment in the two companies at thatdate is as follows.

Rugby Ltd CU260,000Stafford Ltd CU80,000

On 1 January 20X6 Stafford Ltd had transferred some equipment to Rugby Ltd for CU40,000. At thedate of transfer the equipment, which had cost CU42,000, had a carrying amount of CU30,000 and aremaining useful life of five years. The group accounting policy is to depreciate equipment on a straight-line basis down to a nil residual value. It is also group policy not to revalue equipment.

What is the figure that will be disclosed as the carrying amount of property, plant and equipment inthe consolidated balance sheet of Rugby Ltd as on 31 December 20X6?

A CU340,000B CU332,000C CU330,000D CU312,000

11 Makepeace Ltd owns 70% of Dempsey Ltd. Draft balance sheets of the two companies at 31December 20X7 show the following.

Makepeace Ltd Dempsey LtdCU CU

Property, plant and equipment at cost 101,000 75,000Accumulated depreciation (25,000) (30,000)Carrying amount 76,000 45,000

On 1 January 20X7 Makepeace Ltd sold to Dempsey Ltd a machine which had originally costCU24,000 and was 75% depreciated. The profit on sale was CU4,000.

Both companies depreciate at 25% per annum on cost.

What is the carrying amount of property, plant and equipment for inclusion in the consolidatedbalance sheet at 31 December 20X7?

A CU117,000B CU123,500C CU111,000D CU113,500

12 Lynton Ltd acquired 75% of the 200,000 CU1 ordinary shares and 50% of the 100,000 CU1redeemable preference shares of Pinner Ltd when its retained earnings were CU24,000. The retainedearnings of Lynton Ltd and Pinner Ltd are now CU500,000 and CU60,000 respectively.

What are the figures for minority interest and consolidated retained earnings in the consolidated balance sheet?

Minority interest Consolidated retained earningsA CU65,000 CU527,000B CU65,000 CU545,000C CU115,000 CU527,000D CU115,000 CU545,000

13 Wolf Ltd acquired 80,000 CU1 ordinary shares in Fox Ltd on 1 April 20X5 at a cost of CU77,000. FoxLtd’s retained earnings at that date were CU50,000 and its issued ordinary share capital wasCU100,000.

What is the amount of the discount on acquisition arising on the acquisition?

A CU35,000B CU43,000C CU63,000D CU73,000



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14 Sansom Ltd has two subsidiaries, Mabbutt Ltd and Waddle Ltd. It purchased 10,000 CU1 shares inMabbutt Ltd on 1 January 20X1 for CU35,000 when the retained earnings of Mabbutt Ltd stood atCU21,000. It purchased 15,000 CU1 shares in Waddle Ltd for CU20,000 on 31 December 20X1 whenthe retained earnings of Waddle Ltd stood at CU16,000.

The issued share capital of the two subsidiaries is as follows.

Mabbutt Ltd CU15,000Waddle Ltd CU20,000

By the end of 20X4 goodwill impairment losses totalled CU4,400.

What is the carrying amount of goodwill in the consolidated balance sheet at 31 December 20X4?

A CU11,000B CU10,800C CU6,600D CUnil

15 Tring Ltd acquired 60% of the share capital of Hessle Ltd on 31 March 20X6. The share capital andretained earnings of Hessle Ltd as on 31 December 20X6 were as follows.

CUOrdinary 25p shares 400,000Retained earnings at 1 January 20X6 120,000Net profit for 20X6 60,000

580,000

The profits of Hessle Ltd have accrued evenly throughout 20X6.

The discount arising on acquisition was CU3,000.

What is the cost of the investment in Hessle Ltd in the balance sheet of Tring Ltd as on 31 December20X6?

A CU318,000B CU324,000C CU336,000D CU342,000

16 Hill Ltd owns 60% of the ordinary share capital of Down Ltd and all of its 10% borrowings. Thefollowing transactions have been recorded by Down Ltd as at 31 December 20X3.

Half year’s interest due CU15,000Interim dividend paid CU50,000

Hill Ltd has not yet accounted for the interest receivable from Down Ltd.

In preparing the consolidated balance sheet for Hill Ltd and its subsidiary at 31 December 20X3, whichof the following adjustments is required in respect of intra-group dividends and debenture interest?

Debit CreditA Current liabilities

CU45,000Current assets CU15,000Retained earnings CU30,000

B Current liabilitiesCU45,000

Current assets CU30,000Retained earnings CU15,000

C Current liabilitiesCU15,000

Retained earnings CU15,000

DCurrent liabilitiesCU30,000 Current assets CU30,000



17 Heron Ltd owns 80% of Sparrow Ltd and 75% of Swift Ltd. Sparrow Ltd has made a non-current loanof CU500,000 to Swift Ltd.

In the financial statements of Heron Ltd group, the loan will appear

A As a non-current asset in the balance sheet of the parent company and nowhere in theconsolidated balance sheet

B As a non-current asset in the balance sheet of the parent company and as a non-current asset inthe consolidated balance sheet

C Nowhere in the balance sheet of the parent company but as a non-current asset in theconsolidated balance sheet

D Nowhere in the balance sheet of the parent company and nowhere in the consolidated balancesheet

18 Nasty Ltd is a wholly-owned subsidiary of Ugly Ltd. Inventory in their individual balance sheets at theyear end is shown as follows.

Ugly Ltd CU40,000Nasty Ltd CU20,000

Sales by Ugly Ltd to Nasty Ltd during the year were invoiced at CU15,000, which included a profit to Ugly Ltd of 25% on cost. Two thirds of these goods were in inventory at the year end.

At what amount should inventory appear in the consolidated balance sheet?

A CU50,000B CU57,000C CU57,500D CU58,000

19 On 31 December 20X3 Easby Ltd purchased 80% of the share capital of Haddon Ltd for CU226,000when the retained earnings of the latter stood at CU60,000.

The fair value of Haddon Ltd’s property was CU70,000 more than the carrying amount, but thisrevaluation had not been incorporated in Haddon Ltd’s books.

The goodwill arising on consolidation was CU42,000.

What is the carrying amount for minority interest in the consolidated balance sheet of Easby Ltd as at31 December 20X3?

A CU36,800B CU46,000C CU63,500D CU67,000

20 Fallin Ltd acquired 100% of the share capital of Gaydon Ltd for CU150,000 on 1 May 20X6. Equity at30 April was as follows.

Fallin Ltd Gaydon Ltd20X7 20X7 20X6

CU'000 CU'000 CU'000Ordinary share capital 100 50 50Revaluation reserve – 25 15Retained earnings 340 135 25

440 210 90

An impairment review at 30 April 20X7 revealed that goodwill arising on the acquisition of GaydonLtd had become impaired by CU6,000 in the year.

What were the consolidated capital and reserves of the Fallin Ltd group on 30 April 20X7?

A CU500,000B CU548,000C CU554,000D CU560,000



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21 Wilsons Ltd purchased 70% of Watneys Ltd for CU20,000 on 30 June 20X2. The balance sheets ofWatneys Ltd are as follows.

30 September20X2 20X1

CU CUOrdinary share capital 1,000 1,000Share premium 2,000 2,000Retained earnings 21,000 12,000

24,000 15,000

You ascertain that there have been no issues of shares since the above purchase.

What is the goodwill acquired in the business combination?

A CU4,775B CU3,200C CU9,500D CU4,600

Data for questions 22 to 26

With reference to the information below, answer questions 22 to 26 with respect to the consolidatedfinancial statements of VW Ltd.

Summarised balance sheets as at 30 September 20X7

VW Ltd Polo Ltd Golf LtdASSETS CU'000 CU'000 CU'000Property, plant and equipment 200 40 30Investments100,000 shares in Polo Ltd 150 – –40,000 shares in Golf Ltd 70 – –

Current assetsInventories 150 90 80Trade receivables 250 40 20Cash 50 20 10

870 190 140EQUITY AND LIABILITIESCapital reservesOrdinary shares of CU1 each 500 100 50Retained earnings 90 40 70

Equity 590 140 120Current liabilities 280 50 20

870 190 140

Notes

(1) VW Ltd acquired its shares in Polo Ltd on 1 October 20X5 when Polo Ltd’s retained earnings wereCU30,000.

(2) VW Ltd acquired its shares in Golf Ltd on 30 September 20X6. Golf Ltd’s net profit for the year ended 30 September 20X7 was CU30,000.

(3) Included in Polo Ltd’s inventory at 30 September 20X7 was CU15,000 of goods purchased from VWLtd during the year. VW Ltd invoiced Polo Ltd at cost plus 50%.

(4) During the year ended 30 September 20X7 Polo Ltd sold goods costing CU50,000 to Golf Ltd forCU70,000. Golf Ltd still had half of these goods in inventory at 30 September 20X7.

(5) The following intra-group balances are reflected in the above balance sheet of VW Ltd at 30September 20X7.

CU20,000 receivable from Polo Ltd

CU10,000 payable to Golf Ltd



22 Minority interest will be carried at

A CU52,000B CU24,000C CU18,000D CU10,000

23 Inventories will be carried at

A CU320,000B CU305,000C CU302,500D CU295,000

24 Trade receivables will be carried at

A CU295,000B CU290,000C CU285,000D CU280,000

25 What is the amount of goodwill to be included under intangible assets?

A CU22,000B CU20,000C CU18,000D CUnil

26 The consolidated retained earnings will be presented at

A CU114,000B CU113,000C CU111,000D CU109,000

27 CRAWFORD LTD PART II

Following on from the facts in Chapter 10 Self-test question 4 (Crawford Ltd part 1), assume thatCrawford Ltd paid CU2,500 (not CU2,000) for the 2,000 shares in Dietrich Ltd and that CrawfordLtd’s property, plant and equipment were CU26,500 (not CU27,000), all other information remainingthe same. An impairment review at 30 June 20X0 revealed that goodwill in respect of Dietrich Ltd hadfallen in value over the year by CU40. By 1 July 20W9 goodwill had already been written down byCU210.

Requirement

Prepare the consolidated balance sheet of Crawford Ltd as at 30 June 20X0. (7 marks)

28 DUBLIN LTD

The following are the summarised balance sheets of a group of companies as at 31 December 20X9.

Dublin Shannon BelfastLtd Ltd LtdCU CU CU

ASSETSNon-current assetsProperty, plant and equipment 90,000 60,000 50,000Investments: 40,000 CU1 shares in Shannon 50,000 – –

30,000 CU1 shares in Belfast 45,000 – –

185,000 60,000 50,000Current assets 215,000 50,000 30,000

Total assets 400,000 110,000 80,000



11

EQUITY AND LIABILITIESCapital and reservesOrdinary share capital 190,000 50,000 40,000Revaluation reserve – 10,000 –Retained earnings 60,000 30,000 16,000

Equity 250,000 90,000 56,000

Current liabilities 150,000 20,000 24,000

Total equity and liabilities 400,000 110,000 80,000

Dublin Ltd purchased its shares in Shannon Ltd five years ago when there were retained earnings of CU20,000 and a balance on its revaluation reserve of CU10,000.

Belfast Ltd had retained earnings of CU16,000 when Dublin Ltd acquired its shares on 1 January 20X9.

At the end of 20X9 the goodwill impairment review revealed a loss of CU300 in relation to thegoodwill acquired in the business combination with Belfast Ltd.

Requirement

Prepare the consolidated balance sheet as at 31 December 20X9 of Dublin Ltd and its subsidiaries.(12 marks)

29 EDINBURGH LTD

The following are the draft balance sheets of Edinburgh Ltd and its subsidiary Glasgow Ltd as at 31December 20X5.

Edinburgh Ltd Glasgow LtdCU CU CU CU

ASSETSNon-current assetsProperty, plant and equipment 147,000 82,000Investments 80,000 –

227,000 82,000Current assetsInventories 73,200 35,200Trade and other receivables 82,100 46,900Glasgow Ltd current account 14,700 –Cash and cash equivalents 8,000 25,150

178,000 107,250Total assets 405,000 189,250

EQUITY AND LIABILITIESCapital and reservesOrdinary share capital (CU1 shares) 250,000 50,000Share premium account – 6,250Revaluation reserve – 15,000Retained earnings 32,000 40,000Equity 282,000 111,250Non-current liabilitiesBorrowings 20,000Current liabilitiesTrade and other payables 123,000 50,000Edinburgh Ltd current account – 8,000




Points to note

1 Edinburgh Ltd acquired 40,000 shares in Glasgow Ltd on 1 January 20X5 for a cost of CU63,000 whenthe balance on Glasgow Ltd’s reserves were as follows.

CUShare premium account 6,250Revaluation reserve –Retained earnings 10,000

Edinburgh Ltd also acquired CU12,000 of Glasgow Ltd’s non-current borrowings at par on the samedate.

2 The current account difference is due to cash in transit.

3 At the end of 20X5 the goodwill impairment review revealed a loss of CU1,250 in relation to thegoodwill acquired in the business combination with Glasgow Ltd.

Requirement

Prepare the consolidated balance sheet of Edinburgh Ltd at 31 December 20X5. (15 marks)

30 CLOSE LTD

The summarised balance sheets of Close Ltd and Steele Ltd as at 31 December 20X9 were as follows.

Close Ltd Steele LtdCU CU CU CU

ASSETSNon-current assetsProperty, plant and equipment 80,000 58,200Investments 84,000 –

164,000 58,200Current assetsInventories 18,000 12,000Trade and other receivables 62,700 21,100Investments – 2,500Cash and cash equivalents 10,000 3,000Current account – Close Ltd – 3,200

90,700 41,800Total assets 254,700 100,000

EQUITY AND LIABILITIESCapital and reservesOrdinary share capital (CU1 shares) 120,000 60,000Share premium account 18,000 –Revaluation reserve 23,000 16,000Retained earnings 56,000 13,000

Equity 217,000 89,000Current liabilitiesTrade and other payables 35,000 11,000Current account – Steel Ltd 2,700 –


The following information is relevant.

(1) On 1 January 20X7 Close Ltd acquired 48,000 shares in Steele Ltd for CU84,000 cash when theretained earnings of Steele Ltd were CU8,000 and the balance on the revaluation reserve wasCU16,000.

(2) The inventories of Close Ltd include CU4,000 of goods from Steele Ltd invoiced to Close Ltd atcost plus 25%.

(3) A cheque for CU500 from Close Ltd to Steele Ltd, sent before 31 December 20X9, was notreceived by the latter company until January 20Y0.



11

(4) An impairment review at 31 December 20X9 revealed that goodwill in respect of Steele Ltd hadfallen in value over the year by CU500. By 1 January 20X9 this goodwill had already sufferedimpairments totalling CU1,700.

Requirements

(a) Prepare the consolidated balance sheet of Close Ltd and its subsidiary Steele Ltd as at 31December 20X9. (12 marks)

(b) Explain the adjustments necessary in respect of intra-group sales when preparing theconsolidated balance sheet of the Close Ltd group. (6 marks)

(18 marks)




Technical reference




11


1 C

Yum Ltd

90% 75%

Peep Ltd Pitti Ltd

CUShares in Peep Ltd 360,000Net assets acquired (90% 300,000) (270,000)Goodwill 90,000

Shares in Pitti Ltd 100,000Net assets acquired (75% 160,000) 120,000Discount on acquisition (20,000)*

* Credited to the consolidated income statement in the period in which the acquisition is made(i.e. on 31 December 20X6).

2 B

CU'000Black Ltd only 24,000

No post-acquisition profits have yet arisen in Red Ltd.

3 D

Milton Keynes Adjustment ConsolidatedCU'000 CU'000 CU'000 CU'000

Current assets 500 200 –22 + 2 680Current liabilities (220) (90) +20 (290)

280 110 390

4 C

CULaker 6,000Hammond 7,520Less: Intra-group indebtedness (500)

13,020

5 B

CU'000 CU'000Austen Ltd 50Kipling Ltd 30Dickens Ltd 40Less: Cash in transit (2)

38118

Less: Intra-group receivablesOwed to Kipling Ltd (2 + 3 + 4) 9Owed to Dickens 3

(12)106



6 B

CUHo Ltd 750Su Ltd – Ho Ltd’s share of post-acquisition retained earnings (60% ((700 – 40) – 300)) 216

966

7 A

CUTottenham Ltd 40,000Chelsea Ltd (10,000 5%) 500

40,500

Dividends declared after the year end will be recognised in the following year’s financialstatements. Only the MI’s percentage of dividends payable will appear in consolidated currentliabilities.

8 B

CUCarrying amount 15,000Profit element (25/125) (3,000)Cost 12,000

Bass Ltd (the parent company) is the seller of the inventory. Therefore the adjustment does notaffect the minority interest.

9 C

CU'000Oxford Ltd 290Cambridge Ltd 160In transit to Cambridge Ltd 20Less: PURP ((40 + 20) 20%) (12)

458

10 B

Is Should beCU CU

Cost 40,000 42,000Accumulated depreciation (8,000) (18,000)NBV 32,000 24,000

Adjustment required Dr Stafford Ltd retained earnings CU8,000, Cr Property, plant andequipment NBV CU8,000.

Property, plant and equipment in consolidated balance sheet

= 260,000 + 80,000 – 8,000

= CU332,000 (B)

11 D

CUCarrying amount at 1 January 20X7 (1/4 24,000) 6,000Add: Profit on disposal 4,000Sale price 10,000

Is Should beCU CU

Cost 10,000 24,000Accumulated depreciation (2,500) (24,000)Carrying amount 7,500 –



11

CUConsolidated property, plant and equipmentMakepeace Ltd 76,000Dempsey Ltd 45,000Less: Intra-group profit (7,500)

113,500

12 A

CUMinority interestOrdinary shares (25% (200,000 + 60,000)) 65,000

Consolidated retained earningsLynton Ltd 500,000Pinner Ltd (75% (60,000 – 24,000)) 27,000

527,000

Point to note

Redeemable preference shares are classified as liabilities.

13 B

CUCost 77,000Net assets acquired (80% 150,000) (120,000)Discount on acquisition (43,000)

14 C

CU CUMabbutt LtdCost of investment 35,000Less: Share of net assets acquiredShare capital 15,000Retained earnings 21,000

36,000 × 2/3 (24,000)Goodwill 11,000Impairment to date (4,400)Balance c/f 6,600

Waddle Ltd CU CUCost of investment 20,000Less: Share of net assets acquiredShare capital 20,000Retained earnings 16,000

36,000 × 75% (27,000)(7,000) *

* Recognised in the consolidated income statement in the year in which the acquisition wasmade.

15 A

CU'000Share of net assets acquired (60% (400 + 120 + (3/12 60))) 321Less: Discount arising on acquisition (3)Cost of investment 318



16 C

CU'000 CU'000(1) DR Current assets in H with interest receivable 15

CR Retained earnings of H 15

To account for the interest receivable by Hill Ltd

CU'000 CU'000(2) DR Current liabilities in D 15

CR Current assets in H 15

To cancel intra-group balances for interest – there will be no o/s balances for the dividends asthey have been paid

Summary

CU'000 CU'000DR Current liabilities 15CR Retained earnings of H 15

17 D

The loan is not in Heron’s accounts. On consolidation Sparrow’s asset will cancel with Swift’sliability.

18 D

CUUgly Ltd 40,000Less: PURP (2/3 15,000 25/125 ) (2,000)Net assets acquired 20,000

58,000

19 B

CUCost of investment 226,000Less: Goodwill (42,000)Nasty Ltd 184,000

× 100/80Fair value of net assets 230,000Minority interest (20% 230,000) 46,000

20 C

CU'000 CU'000Consolidated capital and reservesOrdinary share capital 100Revaluation reserve (25 – 15) 10Retained earningsFallin Ltd 340Gaydon Ltd (135 – 25) 110Goodwill impairment to date (6)

444554



11

21 A

CU CUCost of investment 20,000Less: Share of net assets acquired

Share capital 1,000Share premium 2,000Retained earnings

1 October 20X1 12,000Nine months ( 9/12 9,000) 6,750

21,750× 70%(15,225)

Goodwill 4,775

Questions 22 to 26

VW Ltd

100% 80%

Polo Ltd Golf Ltd

22 B

Minority interest = 20% (50,000 + 70,000) = CU24,000

23 B

CU'000VW Ltd 150Polo Ltd 90Golf Ltd 80

320

Less: PURPNote (3) (15,000 50/150 in VW Ltd's retained earnings) (5)

Note (4) (1/2 70,000 - 50,000 in Polo Ltd's retained earnings) (10)305

24 D

CU'000VW Ltd 250Less: Intra-group receivable (20)Polo Ltd 40Golf Ltd 20Less: Intra-group receivable (10)

280



25 B

CU CUShares in Polo Ltd 150,000Net assets acquiredShare capital 100,000Retained earnings 30,000

(130,000)Goodwill 20,000

Shares in Golf Ltd 70,000Net assets acquiredShare capital 50,000Retained earnings (70 – 30) 40,000Group share ( 80%) 90,000

(72,000)Discount on acquisition (2,000)– Credited to CIS in period of acquisition

26 C

CUVW Ltd 90,000Less: PURP (5,000)

85,000Polo Ltd ((40,000 – 10,000 PURP) – 30,000) –Golf Ltd (80% 30,000) 24,000Discount on acquisition of Golf Ltd 2,000

111,000

27 CRAWFORD LTD PART II

Consolidated balance sheet as at 30 June 20X0

CUASSETSNon-current assetsProperty, plant and equipment (26,500 + 12,500) 39,000Intangibles (W1) 250

39,250Current assets (25,000 + 12,000) 37,000Total assets 76,250

EQUITY AND LIABILITIESCapital and reservesOrdinary share capital 20,000Share premium account 6,000Retained earnings (W3) 18,083

Attributable to equity holders of Crawford Ltd 44,083Minority interest (W2) 5,667Equity 49,750Non-current liabilities 12,000Current liabilities (7,000 + 7,500) 14,500Total equity and liabilities 76,250

WORKINGS

(1) Goodwill

CUCost of shares 2,500Net assets acquired (2/3 3,000) (2,000)

500Impairment to date (210 + 40) (250)Balance c/f 250



11


CU1/3 × 17,000 5,667


CUCrawford Ltd 9,000Dietrich Ltd (2/3 14,000) 9,333Less: Goodwill impairment to date (W1) (250)

18,083

28 DUBLIN LTD


CUASSETSNon-current assetsProperty, plant and equipment (90,000 + 60,000 + 50,000) 200,000Intangibles (W3) 2,700

202,700Current assets (215,000 + 50,000 + 30,000) 295,000Total assets 497,700

EQUITY AND LIABILITIESCapital and reservesOrdinary share capital 190,000Retained earnings (W5) 81,700

Attributable to equity holders of Dublin Ltd 271,700Minority interest (W4) 32,000Equity 303,700Current liabilities (150,000 + 20,000 + 24,000) 194,000Total equity and liabilities 497,700

WORKINGS

(1) Group structure

Dublin Ltd

80% 75%

Shannon Ltd Belfast Ltd

(2) Net assets

Balance

sheet date

Acquisition

date

Post-

acquisitionShannon Ltd CU CU CUShare capital 50,000 50,000 –Revaluation reserve 10,000 10,000 –Retained earnings 30,000 20,000 10,000

90,000 80,000Belfast LtdShare capital 40,000 40,000 –Retained earnings 16,000 16,000 –

56,000 56,000



(3) Goodwill

Shannon Ltd Belfast LtdCU CU

Cost of shares 50,000 45,000Net assets acquiredShannon Ltd (80% 80,000) (W2) (64,000)

Belfast Ltd (75% 56,000) (W2) (42,000)(Discount on acquisition)/goodwill (14,000) 3,000Credited/(impairment) to date 14,000 (300)Balance c/f – 2,700


CUShannon Ltd (20% 90,000 (W2)) 18,000Belfast Ltd (25% 56,000 (W2)) 14,000

32,000


CUDublin Ltd 60,000Shannon Ltd (80% 10,000 (W2)) 8,000

Belfast Ltd (75% nil (W2)) –Less: Goodwill impairment to date (W3) (300)Add: Discount on acquisition (W3) 14,000

81,700

29 EDINBURGH LTD


ASSETS CU CUNon-current assetsProperty, plant and equipment (147,000 + 82,000) 229,000Intangibles (W3) 8,750Investments (80,000 – 63,000 – 12,000) 5,000

242,750Current assetsInventories (73,200 + 35,200) 108,400Trade and other receivables (82,100 + 46,900) 129,000Cash and cash equivalents (8,000 + 25,150 + 6,700) 39,850


EQUITY AND LIABILITIESCapital and reservesOrdinary share capital 250,000Revaluation reserve (W6) 12,000Retained earnings (W5) 54,750

Attributable to equity holders of Edinburgh Ltd 316,750Minority interest (W4) 22,250Equity 339,000Non-current liabilitiesBorrowings (20,000 – 12,000) 8,000

Current liabilitiesTrade and other payables (123,000 + 50,000) 173,000Total equity and liabilities 520,000



11

WORKINGS

(1) Group structure

Edinburgh Ltd

80%

Glasgow Ltd

(2) Net assets of Glasgow Ltd

Balance

sheet date

Acquisition

date

Post-

acquisitionCU CU CU

Share capital 50,000 50,000 –Share premium 6,250 6,250 –Revaluation reserve 15,000 – 15,000Revaluation earnings 40,000 10,000 30,000

111,250 66,250

(3) Goodwill

CUCost of shares 63,000Net assets acquired (80% 66,250) (W2) (53,000)

10,000Impairment to date (1,250)Balance c/f 8,750


CU20% × 111,250 (W2) 22,250


CUEdinburgh Ltd 32,000Glasgow Ltd (80% 30,000 (W2)) 24,000Less: Goodwill impairment to date (W3) (1,250)

54,750

(6) Revaluation reserve

CUGlasgow Ltd (80% 15,000 (W2)) 12,000

30 CLOSE LTD

(a) Consolidated balance sheet as at 31 December 20X9

ASSETS CU CUNon-current assetsProperty, plant and equipment (80,000 + 58,200)) 138,200Intangibles (W3) 14,600

152,800Current assetsInventories (18,000 + 12,000 – 800)) 29,200Trade and other receivables (62,700 + 21,100) 83,800Investments 2,500Cash and cash equivalents (10,000 + 3,000 + 500) 13,500

129,000

Total assets 281,800



EQUITY AND LIABILITIESCapital and reservesOrdinary share capital 120,000Share premium account 18,000Revaluation reserve 23,000Retained earnings (W5) 57,160

Attributable to equity holders of Close Ltd 218,160Minority interest (W4) 17,640Equity 235,800Current liabilitiesTrade and other payables (35,000 + 11,000)) 46,000

Total equity and liabilities 281,800

(b) Adjustments

When group companies have been trading with each other two separate adjustments may berequired in the consolidated balance sheet.

(i) Elimination of unrealised profits

If one company holds inventories at the year end which have been acquired from anothergroup company, this will include a profit element that is unrealised from a group perspective.

Here Steele Ltd has sold goods to Close Ltd at cost plus 25%. The mark-up of 25% will onlybecome realised when the goods are sold to a third party. Therefore if any intra-groupinventory is still held at the year end, it must be eliminated from the consolidated accounts.

This will require an adjustment of CU800 (4,000 25/125) which is always made against theselling company’s retained earnings, i.e.

DR CRCU CU

Steele Ltd’s retained earnings (W2) 800Consolidated inventory 800

As well as eliminating the unrealised profit, this reduces inventory back to its original cost to the group.

(ii) Contra out intra-group balances

As group companies are effectively treated as one entity, any intra-group balances must beeliminated on consolidation. Here, intra-group current accounts have arisen as a result ofthe intra-group trading and these must be contra’d out. Before this can be done the currentaccounts must be brought into agreement by adjusting the accounts of the 'receiving'company (here Steele Ltd) for the cheque in-transit, i.e.

DR CRCU CU

Cash 500Current account 500

This will reduce the current account receivable to CU2,700, which means that it nowagrees with the payable balance shown in the accounts of Close Ltd. The balance can thenbe contra’d out, i.e.

DR CRCU CU

Current account in Close Ltd 2,700Current account in Steele Ltd 2,700



11

WORKINGS

(1) Group structure

Close Ltd

80%

Steele Ltd

(2) Net assets of Steele Ltd

Balance sheetdate

Acquisitiondate

Post-acquisition

CU CU CU CUShare capital 60,000 60,000 –Revaluation reserve 16,000 16,000 –Retained earningsPer question 13,000Less: PURP (4,000 × 25/125) (800)

12,200 8,000 4,20088,200 84,000

(3) Goodwill

CUCost of shares 84,000Less: Net assets acquired (80% × 84,000 (W2)) (67,200)

16,800Impairment to date (500 + 1,700) (2,200)Balance c/f 14,600


CUShare of net assets (20% × 88,200 (W2)) 17,640


CUClose Ltd 56,000Steele Ltd (80% 4,200 (W2)) 3,360Less Goodwill impairment to date (W3) (2,200)

57,160





P Ltd has paid CU10,000 to buy 75% of S Ltd's net assets of (16,000 – 4,000) = CU12,000

CUConsideration 10,000Less: Share of net assets acquired (75% × 12,000) (9,000)Goodwill 1,000


Rik Ltd: Consolidated balance sheet as at 31 December 20X1

CUNon-current assetsProperty, plant and equipment (100,000 + 40,000 + 10,000) 150,000Intangibles (W3) 6,667

156,667Current assets (45,000 + 40,000 + 25,000) 110,000

266,667Capital and reservesCalled up share capital 50,000Retained earnings (W5) 133,334

Attributable to equity holders of Rik Ltd 183,334Minority interest (W4) 23,333Equity 206,667Liabilities (30,000 + 20,000 + 10,000) 60,000

266,667

WORKINGS

(1) Group structure

Rik Ltd

75% 2/3

Viv Ltd Neil Ltd

(2) Net assets

Balance Post-sheet date Acquisition acquisition

CU CU CUViv LtdShare capital 20,000 20,000 –Retained earnings 40,000 4,000 36,000

60,000 24,000Neil LtdShare capital 10,000 10,000 –Retained earnings 15,000 1,000 14,000

25,000 11,000



11

(3) Goodwill

Viv Ltd Neil Ltd TotalCU CU CU

Cost of investment 25,000 10,000Less: Share of net assets acquired

Viv Ltd (75% × 24,000 (W2)) (18,000)Neil Ltd (2/3 × 11,000 (W2)) (7,333)

Goodwill 7,000 2,667 9,667Impairment to date (3,000) – (3,000)Balance c/f 4,000 2,667 6,667


CUViv Ltd – Share of net assets at BS date (25% × 60,000 (W2)) 15,000Neil Ltd – Share of net assets at BS date (1/3 × 25,000 (W2)) 8,333

23,333


CURik Ltd 100,000Viv Ltd – Share of post-acquisition retained earnings (75% × 36,000 (W2)) 27,000Neil Ltd – Share of post-acquisition retained earnings (2/3 × 14,000 (W2)) 9,334Goodwill impairment to date (W3) (3,000)

133,334


(a) Net assets (W2)

Balance

sheet date

Acquisition Post-

acquisitionCU CU CU

Share capital 1,000 1,000 –Retained earnings (15,000 + (5/12 × (15,600 – 15,000))) 15,600 15,250 350

16,600 16,250

(b) Goodwill (W3)

CUCost of investment 20,000Less: Share of net assets acquired (80% × 16,250 (W2)) (13,000)

7,000

(c) Profit from S Ltd included in consolidated retained earnings

CUShare of post-acquisition retained earnings of S Ltd (80% × 350 (W2)) 280

(d) (i) Pre-acquisition earnings

CURetained earnings per balance sheet 15,600Add back: Dividend paid 2,000Total earnings before dividend 17,600Pre-acquisition earnings (5/12 × 17,600) 7,333

(ii) Post-acquisition earnings

Total earnings before dividend = 17,600× 7/12 = 10,267

Less: Dividend paid (2,000)8,267




(a) Recording of dividends in individual companies' books

Impala Ltd's dividend CU CUImpala Ltd's booksDR Retained earnings 10,000 1

CR Payables 10,000

Springbok Ltd's dividendSpringbok Ltd's booksDR Retained earnings 5,000 2

CR Payables 5,000(Due to minority interest CU1,250)

Impala Ltd's booksDR Receivables (75% × 5,000) 3,750CR Retained earnings 3,7501

Notes

1 Include in retained earnings working (W5).

2 Include in net assets working (W2).

(b) In consolidation workings

(1) Group structure

Impala Ltd

75%

Springbok Ltd

(2) Net assets of Springbok Ltd

Balance sheet date Acquisition Post-

acquisitionCU CU CU CU

Share capital 25,000 25,000 –Retained earningsPer question 45,000Dividends (5,000)

40,000 20,000 20,00065,000 45,000


CU25% × 65,000 (W2) 16,250


CUImpala Ltd per question 60,000Dividends declared (10,000)Dividends from Springbok Ltd 3,750

Share of Springbok Ltd post-acquisition (75% × 20,000) (W2) 15,00068,750



11

(c) In consolidated balance sheet

CUPayables: Declared dividends payable

Parent company 10,000Minority interest 1,250


CU CUDR Seller's (S Ltd's) retained earnings (adjust in net assets working) 3,000CR Inventories in CBS (1/2 × 6,000) 3,000

WORKINGS

(1) Group structure

P Ltd

80%

S Ltd

(2) S Ltd net assets

Balance sheet date Acquistion Post-acquisition

CU CU CU CUShare capital 10,000 10,000Retained earningsPer question 65,000Less: PURP (3,000)

62,000 20,000 42,00072,000 30,000

(4) Minority interest CUShare of net assets (20% × 72,000) 14,400

(5) Retained earnings CUP Ltd 100,000Share of S Ltd (80% × 42,000) 33,600

133,600



CUCost 15,000Less: Depreciation – 20% (3,000)

12,000

Had the transfer not been made, the asset would stand in the books at

CUCost 20,000Less: Accumulated depreciation at date of 'transfer' (8,000)

Provision for current year (CU20,000 × 20%) (4,000)8,000



Overall adjustment in CBS

CU CUDR Seller's (P Ltd's) retained earnings 4,000CR Non-current assets 4,000


(1) Group structure

P Ltd

60%

S Ltd

(2) Net assets of S Ltd

BS date = Acquisition dateCU CU

Share capital 20,000Revaluation (30,000 – 20,000) 10,000Retained earningsPer question 85,000Less: Goodwill (5,000)

80,000110,000

(3) Goodwill

CUCost of investment 80,000Less: Share of FV of net assets acquired (60% × 110,000 (W2)) (66,000)

14,000



CUCarrying amount of plant in CBS (40,000 80%) 32,000

Carrying amount in William Ltd's BS (40,000 85% 85%) 28,900Increase in carrying amount 3,100

CU CUDR Non-current assets 3,100CR Consolidated retained earnings (85%) 2,635CR Minority interest (15%) 465


Contents

chapter 12

Group accounts:consolidated statements offinancial performance

Introduction

Examination context

Topic List

1 Consolidated income statement

2 Intra-group transactions and unrealised profit

3 Consolidated income statement workings


5 Dividends

6 Other adjustments

7 Consolidated statement of changes in equity


Technical reference





Introduction




– The single entity concept

– Substance over form

– The distinction between control and ownership

Calculate the amounts to be included in an entity’s consolidated statements of financialperformance in respect of its new and continuing interests in subsidiaries in accordance withthe international financial reporting framework

Prepare and present a consolidated income statement (or extracts therefrom) includingadjustments for intra-group transactions and balances, goodwill, minority interests and fairvalues

Prepare and present a consolidated statement of changes in equity (or extracts therefrom) inaccordance with Bangladesh financial reporting framework

Specific syllabus references for this chapter are: 1d,g, 3d,e.


The consolidated income statement provides the owners of the group with important information over andabove that which is available in the parent’s own income statement. The investment income receivable fromthe subsidiary is replaced with the profits controlled by the parent company. This application of substanceover form provides a more realistic representation of the performance of the group as the combinedincome statements of the parent and subsidiary are produced as if they were a single entity. The singleentity concept has more detailed implications for the preparation of the consolidated income statementwhich we will look at in this chapter.

The consolidated statement of changes in equity provides a ‘bridge’ between the consolidated balance sheetand consolidated income statement. It achieves this by reconciling the group’s opening equity (capital,reserves and minority interest) to the closing position.

Stop and think

Why is information about the profits of the subsidiary of more use to the shareholders than informationabout the investment income received?

Working context

In very simple terms, the preparation of the consolidated income statement and consolidated statement ofchanges in equity involves the combination of the individual statements of the group members. As we said inChapter 10, this process is often computerised. However, detailed work will be needed on theconsolidation adjustments, particularly in respect of the consolidated income statement. This might includethe identification and elimination of intra-group transactions and the elimination of unrealised profit. Wewill look at a number of consolidation adjustments in this chapter.

GROUP ACCOUNTS: CONSOLIDATED STATEMENTS OF FINANCIAL PERFORMANCE


12

Syllabus links

This chapter looks in detail at the preparation of the consolidated income statement and is fundamental tothe Financial Accounting syllabus. It builds on the principles introduced in Chapter 10 and applies them tomore complex situations. A detailed knowledge and understanding of this topic and of the consolidatedstatement of changes in equity will also be assumed in Financial & Corporate Reporting at the AdvancedStage.



Examination context

Exam requirements

Preparation of a consolidated income statement could be examined in either the short-form questions orwritten test section of the paper. In either case the focus of the questions will normally be on consolidationadjustments including intra-group trading, unrealised profits and irredeemable preference shares. In writtentest questions a mid-year acquisition is likely to be incorporated, so any dates given should be readcarefully.

The consolidated statement of changes in equity could be examined in conjunction with the consolidatedincome statement. Alternatively, it could appear as part of a mixed question or as a short-form question.


Prepare a consolidated income statement (or extracts therefrom) including the results of the parententity and one or more subsidiaries including adjustments for the following:

– Acquisition of a subsidiary, including a mid-year acquisition– Intra-group transactions– Unrealised profits– Interest and management charges

Explain the process of consolidating the income statement in the context of the single entity concept,substance over form and the distinction between control and ownership.

Prepare a consolidated statement of changes in equity (or extracts therefrom) including the effects ofnew and continuing interests in subsidiaries.



12

1 Consolidated income statement

Section overview

The preparation of the consolidated income statement is consistent with the consolidated balancesheet.

1.1 Basic principles

In Chapter 10 we introduced the basic principles and mechanics involved in the consolidation of the incomestatement as follows:


CURevenue X(P + S (100%) – intra-group items)

Profit after tax (PAT) (CONTROL) X

(OWNERSHIP)Attributable to:Equity holders of P (ß) XMinority interest (MI% × S's PAT) X

X

The consolidated income statement is prepared on a basis consistent with the consolidated balance sheet.Therefore:

The consolidated income statement shows incomegenerated from the net assets under the parentcompany’s control

In the consolidated income statement dividendincome from the subsidiary is replaced with thesubsidiary’s income and expenses on a line-by-linebasis as far as profit after tax (PAT)

The single entity concept is applied The effects of transactions between groupmembers are eliminated on consolidation

The ownership of profits is shared between theowners of the parent and any minority interest

Profit after tax is split between the profitattributable to the parent’s shareholders (balancingfigure) and the profit attributable to the minorityinterest (calculated as the MI’s share of S’s PAT)

In sections 2-6 of this chapter we will consider a number of consolidation adjustments. We have alreadyseen many of the issues raised in the context of the consolidated balance sheet. In this chapter we will lookat how the adjustment is made from the point of view of the consolidated income statement.

2 Intra-group transactions and unrealised profit

Section overview

The value of intra-group sales is deducted as a consolidation adjustment from consolidated revenueand cost of sales.

A provision for unrealised profit is set against the selling company’s profit.

Profits or losses on non-current asset transfers should be eliminated against the selling company’sprofit.

A depreciation adjustment may be required so that depreciation is based on the cost of the asset tothe group.



2.1 Intra-group trading

When one company in a group sells goods to another group member an identical amount is added to thesales revenue of the first company and to the cost of sales of the second. Yet as far as the entity’s dealingswith third parties are concerned no sale has taken place.

The consolidated figures for sales revenue and cost of sales should represent sales to, and purchasesfrom third parties. An adjustment is therefore necessary to reduce the sales revenue and cost of salesfigures by the value of intra-group sales made during the year.

This adjustment is made as follows:

Step 1Add across P and S revenue and P and S cost of sales.

Step 2Deduct value of intra-group sales from revenue and cost of sales.

Point to note

This adjustment has no effect on profit and hence will have no effect on the minority interest shareof profit.

2.2 Unrealised profits on trading

If any items sold by one group company to another are included in inventories (i.e. have not been sold onoutside the group by the year end), their value must be adjusted to the lower of cost and NRV to thegroup (as for CBS), again applying the single entity concept.

Steps to set up the provision for unrealised profit (PURP) are the same as for the consolidated balancesheet (covered in Chapter 11):

Step 1Calculate the amount of inventories remaining at the year end.

Step 2Calculate the intra-group profit included in it.

Step 3Make a provision against the inventories to reduce them to cost to the group (or NRV if lower).

Points to note

1 In practical terms the provision is set up by increasing cost of sales by the amount of theunrealised profit. (If closing inventory is reduced, cost of sales is increased).

2 This provision must always be set against the selling company’s profit. As a result, where the seller is asubsidiary that is not wholly owned, it reduces the profit for the year for MI calculations.

3 Where P has sold on some of the goods purchased from S to a third party, any profit earned by S (aswell as that earned by P) on those goods will have been realised as far as the group is concerned, sono adjustment is necessary.

Interactive question 1: Unrealised profits [Difficulty level: Exam standard]

Whales Ltd owns 75% of Porpoise Ltd. The gross profit for each company for the year ended 31 March20X7 is calculated as follows:

Whales Ltd Porpoise LtdCU CU

Revenue 120,000 70,000Cost of sales (80,000) (50,000)Gross profit 40,000 20,000



12

During the year Porpoise Ltd made sales to Whales Ltd amounting to CU30,000. CU15,000 of these saleswere in inventories at the year end. Profit made on the year end inventories items amounted to CU2,000.

Requirement

Calculate group revenue, cost of sales and gross profit.


Whales Ltd Porpoise Ltd Adj ConsolCU CU CU CU

RevenueC of S – per Q

– PURPGP


2.3 Non-current asset transfers

The consolidated income statement should include depreciation of non-current assets based on cost tothe group, and should exclude any profit or loss on non-current asset transfers between group members.This is consistent with the treatment in the consolidated balance sheet.

The adjustment is made as follows:

Eliminate the profit or loss on transfer and adjust depreciation in full (control)

The profit or loss is eliminated against the seller. This automatically affects the minority interestwhere S was the seller who recorded the original profit or loss (ownership)

Depreciation is adjusted against the seller even though it is the purchaser who recorded it. This isbecause the depreciation adjustment reflects the realisation of the profit over time, i.e. over the asset’s life (ownership)

Worked example: Non-current asset transfers

(Based on Interactive question 6 in Chapter 11)

P Ltd owns 80% of S Ltd. P Ltd transferred to S Ltd a non-current asset (NCA) at a value of CU15,000 on 1January 20X7. The original cost to P Ltd was CU20,000 and the accumulated depreciation at the date oftransfer was CU8,000. Both companies depreciate such assets at 20% per year on cost to the company.

At 31 December 20X7 the adjustment in the consolidated balance sheet (CBS) was calculated bycomparing

CUCarrying amount of NCA with transfer (15,000 × 80%) 12,000Carrying amount of NCA without transfer

((20,000 – 8,000) – (20,000 × 20%)) (8,000)4,000

Adjustment made in CBS was:

CU CUDR Selling company retained earnings 4,000CR Non-current assets at carrying amount in CBS 4,000



In the consolidated income statement (IS) for the year:

(a) Eliminate the profit (or loss) on transfer at 1 January 20X7 since it is unrealised

CU CUDR Selling company IS for year (heading where profit credited) (15,000 –

12,000)3,000

CR NCA carrying amount in CBS 3,000

Point to note

For the non-current asset note to the consolidated balance sheet, the credit to non-current assetcarrying amounts will be split into a debit of CU5,000 to the non-current asset cost account and acredit of CU8,000 to the non-current asset accumulated depreciation account.

(b) Increase/(decrease) the depreciation charge, so that it is calculated on the asset's cost to thegroup. In this case, increase the charge by

CUDepreciation without transfer (20,000 × 20%) 4,000Depreciation with transfer (15,000 × 20%) (3,000)

1,000

CU CUDR Selling company IS for year (heading where depreciation charged) 1,000CR NCA carrying amount in CBS 1,000

Point to note

The non-current asset note to the consolidated balance sheet will include this credit in accumulateddepreciation. The overall effect is an adjustment of CU4,000 in both the consolidated incomestatement and consolidated balance sheet.

Interactive question 2: Non-current asset transfers[Difficulty level: Exam standard]

P Ltd owns 80% of S Ltd. P Ltd transferred a non-current asset to S Ltd on 1 January 20X7 at a value ofCU15,000. The asset originally cost P Ltd CU12,000 and depreciation to the date of transfer was CU4,800.The profit on transfer has been credited to depreciation expense. Both companies depreciate their assets at20% per annum on cost. Total depreciation for 20X7 was CU35,000 for P Ltd and CU25,000 for S Ltd.

Requirement

Show the adjustments required for the above transaction in the consolidated income statement.


Solution

P Ltd S Ltd Adj ConsolCU CU CU CU

Depreciation – per QNCA PURPDepreciation adjustment



© The Institute of Chartered Accountants in England and Wales, M

12

3 Consolidated income statement workings

Section overview

The key working for the preparation of the consolidated income statement is the consolidationschedule.

3.1 Pro forma workings

As questions increase in complexity a formal pattern of workings is needed.

(1) Establish group structure

P

S

80%

(2) Prepare consolidation schedule

P S Adj ConsolCU CU CU CU

Revenue X X (X) XC of S – Per Q (X) (X) X

– PURP (seller's books) (X) or (X)Exps – Per Q (X) (X)

– GW impairment (if any) (X)Tax – Per Q (X) (X)

Profit X

May need workings for (e.g.)

– PURPs– GW impairment

(3) Calculate minority interest (MI)

S PAT × MI% MI% × X =

Interactive question 3: Income statement workings [Difficulty

Pathfinder Ltd owns 75% of Sultan Ltd. Income statements for the two companies for the yearSeptember 20X7 are as follows.

Pathfinder

LtdCU

Revenue 100,000Cost of sales (60,000)Gross profit 40,000Expenses (20,000)Investment income from Sultan Ltd 1,500Profit before tax 21,500Income tax expense (6,000)Profit after tax 15,500

(X)}

arch 2009 443

(X)

(X)

CUX

level: Easy]

ending 30

Sultan

LtdCU

50,000(30,000)20,000

(10,000)–

10,000(3,000)7,000

}



During the year one group company sold goods to the other for CU20,000 at a gross profit margin of 40%.Half of the goods remained in inventories at the year end.

Requirements

(a) Prepare extracts from the consolidated income statement for the year ended 30 September 20X7showing revenue, cost of sales, gross profit and minority interest, assuming that the intra-group saleshave been made by Pathfinder Ltd to Sultan Ltd.

(b) Prepare the consolidated income statement of Pathfinder Ltd for the year ended 30 September 20X7,assuming that the intra-group sales have been made by Sultan Ltd to Pathfinder Ltd.


295

Solution

(a) Consolidated income statement (extracts) for the year ended 30 September 20X7

CURevenueCost of salesGross profitMinority interest (W3)

WORKINGS

(a) (1) Group structure

P

S

75%

(2) Consolidation schedule

PathfinderLtd

Sultan Ltd Adj Consol

CU CU CU CURevenueC of S – per Q

– PURP (W4)ExpensesIncome taxProfit


CUSultan Ltd

(4) PURP

% CU CUSelling priceCostGross profit



12

(b) Consolidated income statement for the year ended 30 September 20X7

CURevenueCost of salesGross profitExpensesProfit before taxIncome tax expenseProfit after tax

Attributable to:Equity holders of Pathfinder Ltd ()Minority interest (W3)

WORKINGS

(b) (1) Group structure

As part (a)


Pathfinder

Ltd

Sultan Ltd Adj Consol

CU CU CU CURevenueC of S – per Q

– PURP (W4)

Income taxProfit


CUSultan Ltd

(4) PURP

As part (a)



Section overview

The results of the subsidiary are consolidated from the date of acquisition.

The income statement amounts of the subsidiary are time apportioned.

4.1 Method of apportionment

When we looked at the balance sheet we saw that consolidated retained earnings included only the post-acquisition profits of the subsidiary. This principle also applies to the consolidated income statement. Ifthe subsidiary is acquired during the accounting period, the entire income statement of thesubsidiary is split between pre-acquisition and post-acquisition proportions. Only the post-acquisitionfigures are included in the consolidated income statement.



Points to note

1 Assume revenue and expenses accrue evenly over the year unless the contrary is indicated – thereforetime-apportion results of the subsidiary from the date of acquisition.

2 Time-apportion totals for revenue, cost of sales, expenses and tax first, then deduct post-acquisitionintra-group items.

3 Recognise as an expense any goodwill impairment losses arising on the acquisition (calculation ofgoodwill was dealt with in Chapter 11).

Interactive question 4: Mid-year acquisitions [Difficulty level: Easy]

P Ltd acquired 75% of S Ltd on 1 April 20X7. Extracts from the companies’ income statements for the yearended 31 December 20X7 are as follows.

P Ltd S LtdCU CU


Since acquisition P Ltd has made sales to S Ltd of CU15,000. None of these goods remain in inventories atthe year end.

Requirement

Calculate revenue, cost of sales and gross profit for the group for the year ending 31 December 20X7.

Solution

P Ltd Consolidated income statement for the year ended 31 December 20X7


RevenueCost of salesGross profit


5 Dividends

Section overview

Intra-group dividends should be cancelled on consolidation.

The uncancelled amount should be disclosed in the consolidated statement of changes in equity.

5.1 Treatment

Dealing with intra-group dividends is made a bit more complicated by the fact that:

Dividends received and receivable are shown as income in the income statement; but Dividends paid and payable are shown in the statement of changes in equity.



12

Nevertheless the single entity concept must be applied to dividends paid/payable by the subsidiary, by:

Cancelling P’s dividend income from S in P’s income statement against S’s dividends in S’s statement ofchanges in equity

Leaving the uncancelled amount of S’s dividends to be shown as the dividends to the minority interestin the consolidated statement of changes in equity (see section 8 below).

If P has not yet accounted for its dividends from S, then P’s income will need to be recorded before thiscancellation takes place.

6 Other adjustments

Section overview

The effect of all other intra-group transactions is cancelled on consolidation.

6.1 Redeemable preference shares

Redeemable preference shares are treated as a financial liability (under BAS 32 Financial Instruments:Presentation) rather than as part of equity. Consequently, distributions to shareholders are classed asfinance costs rather than as dividends.

On consolidation finance income received/receivable in the parent’s books is cancelled against theamount paid/payable in the subsidiary’s books, leaving only the portion paid/payable to third parties as afinance cost.

6.2 Interest and management charges

Interest or management charges paid/payable in the income statement of the subsidiary (expense)should be cancelled against the interest or management charges received/receivable in theincome statement of the parent company (income).

7 Consolidated statement of changes in equity

Section overview

The consolidated statement of changes in equity (CSCE) shows the change in group equity reconcilingthe position at the start of the year with the position at the end of the year.

There are separate analysis columns for each type of share capital and reserves in respect of theparent's equity holders.

Changes in the minority interest in share capital and reserves are presented in a single column.

7.1 Structure of CSCE

The CSCE is the link between the consolidated income statement and the figures for equity shown in theconsolidated balance sheet, in that it shows the movement between the retained earnings brought forwardat the start of the year and those carried forward at the end of the year. As can be seen in the proformalayout included in section 6 of Chapter 2, the CSCE also shows movements on other reserves and on sharecapital. Listed below are the main points.

Equity holders of the parent: there are separate analysis columns for each type of sharecapital and reserves, together with a total column.

– There will nearly always be entries for net profit/(loss) for the period and dividends paid/payable.



– There will sometimes be entries for issues of share capital and revaluations of non-current assets(dealt with in Chapter 5).

– Where there are such revaluations or have been in the past, there will usually be a transferbetween reserves for the additional depreciation charge on the increase in value. As this ismerely a transfer between reserves, they contra out against each other and no value appears inthe total column.

Minority interest in subsidiaries: there is only a single column, which is the equivalent of thetotal column for the equity holders of the parent.

– There will nearly always be entries for the MI’s share of S’s net profit/(loss) for the period anddividends paid/payable.

– There will sometimes be entries for S’s revaluations of non-current assets (dealt with in Chapter 5).

– In practice there will sometimes be entries for issues of share capital by S, but these fall outsidethe Financial Accounting syllabus.

– There will never be a value for transfers between reserves in S, because they contra out againsteach other.

– If a non wholly-owned subsidiary is acquired during the year there will be an entry for MI addedon the acquisition of a subsidiary (see section 7.4).

Worked example: CSCE

The following are extracts from the financial statements for the year ended 30 June 20X8 of William Ltdand Rufus Ltd.

WilliamLtd

Rufus Ltd

CU CUProfit from operations 196,000 95,000Dividends from Rufus Ltd 24,000 –Profit before tax 220,000 95,000Income tax expense (70,000) (30,000)Profit after tax 150,000 65,000

Dividends declared 20,000 30,000

Share capital of CU1 200,000 50,000

William Ltd purchased 40,000 shares in Rufus Ltd some years ago.

Prepare the consolidated income statement and the consolidated statement of changes in equity for WilliamLtd for the year ended 30 June 20X8, as far as the information permits.

Solution


CUProfit from operations (196 + 95) 291,000Income tax expense (70 + 30) (100,000)Profit after tax 191,000

Attributable to:

Equity holders of William Ltd ( 178,000

Minority interest (20% × 65) 13,000191,000


© The Institute of Chartere

12

Point to note

The amount attributable to the equity holders of William Ltd can be separately calculated, omitting theintra-group dividend (as William Ltd’s shareholders are given their share of Rufus Ltd’s profits, they cannotalso be given their share of a dividend paid out of those profits):

100% of (150,000 – 24,000) + 80% of CU65,000 = CU178,000.

Consolidated statement of changes in equity for the year ended 30 June 20X8

Attributable to equity holdersof William Ltd

Share Retained Minoritycapital earnings Total interest TotalCU CU CU CU CU

Net profit for the year – 178,000 178,000 13,000 191,000Dividends declared (W) – (20,000) (20,000) (6,000) (26,000)

– 158,000 158,000 7,000 165,000Brought forward (W) 200,000 – 200,000 10,000 210,000Carried forward 200,000 158,000 358,000 17,000 375,000

WORKING

MI share of Rufus Ltd’s: dividend 20% × 30,000 = CU6,000

share capital 20% × 50,000 = CU10,000

7.2 Transfers to reserves

Some companies transfer amounts from retained earnings to named reserves. Such transfers are madein the analysis columns in the CSCE and are therefore shown net of MI.

In the analysis columns in the CSCE:

= +

This matches with the treatment of reserves attributable to the equity holders of P in the consolidated

balance sheet, i.e. they include P’s reserves and P’s share of S’s post-acquisition reserves. 6

7.3 Retained earnings brought forward

To calculate each of the group reserves brought forward, simply do a working, as you would for theconsolidated balance sheet, but at the start of the year. Therefore each group opening reserve will be:

= +

Point to note

The MI amount brought forward will be the MI share of S'reserves) brought forward.

Grouptransfers between

reserves

P's transfersbetween

reserves

P% of S'stransfers between

reserves

Groupreserve

b/f

P’s

reserve

b/f

Goodwill impairment(to start of year) andany other adjustments

to opening position

P% of S’spost-

acquisitionreserve b/f

d Accountants in England and Wales, March 2009 449

s equity (i.e. MI’s share of S’s capital and



Interactive question 5: Retained earnings brought forward[Difficulty level: Exam standard]

Continuing the facts from worked example: CSCE, the following further information is now available inrelation to the financial statements for the year ended 30 June 20X8 of William Ltd and Rufus Ltd.

WilliamLtd

Rufus Ltd

CU CURetained earnings brought forward 270,000 120,000

When William Ltd purchased its 40,000 shares in Rufus Ltd, Rufus Ltd's retained earnings stood atCU70,000.

Three years ago a goodwill impairment loss of CU10,000 was recognised in William Ltd's consolidatedfinancial statements.

Requirement

Adjust the previously drafted consolidated statement of changes in equity for William Ltd for the yearended 30 June 20X8 to take account of the additional information.


Solution




Net profit for the yearDividends declared

Brought forward (W)

Carried forward

WORKING

CUGroup reserves b/fWilliam LtdRufus LtdGoodwill impairment to date

CUMI b/fShare capitalRetained earnings




12

7.4 Acquisition during the year

Section 4 explained that the results for the new subsidiary are only brought into the consolidated incomestatement from the date of acquisition. Any minority interest in the results of the newly-acquiredsubsidiary will similarly be calculated from that date and the amount included as profit for the year inthe minority interest column in the CSCE in the normal way.

But in the year end consolidated balance sheet, the minority interest in the new subsidiary will be calculatedas their share of the year end equity in the new subsidiary. This will include not only the profit for thepost-acquisition period but also their share of the newly-acquired subsidiary’s:

Share capital; plus Retained earnings brought forward at the start of the current year; plus Current year profits to the date of acquisition.

Their share of the total of these amounts will have to be brought into the CSCE, as a single line describedas ‘Added on acquisition of subsidiary’.

Interactive question 6: Acquisition during the year[Difficulty level: Exam standard]

Joseph Ltd acquired an 80% interest in Mary Ltd on 1 October 20X8. The following figures relate to theyear ended 31 March 20X9.

Joseph Ltd Mary LtdCU'000 CU'000

Income statementRevenue 800 550Costs (400) (350)Profit before tax 400 200Income tax expense (140) (50)Profit after tax 260 150

Statements of changes in equity Retained earningsCU'000 CU'000

Profit for the year 260 150Brought forward 400 300Carried forward 660 450

Additional informationCU'000 CU'000

Share capital 500 100

Requirement

Prepare the consolidated income statement and the consolidated statement of changes in equity for theJoseph Ltd group for the year ended 31 March 20X9.




Solution

Consolidated income statement for the year ended 31 March 20X9

CU'000RevenueCostsProfit before taxIncome tax expenseProfit after tax

Attributable to:Equity holders of Joseph LtdMinority interest (W1)

Consolidated statement of changes in equity for the year ended 31 March 20X9

Attributable to equity holdersof Joseph Ltd


Net profit for the yearAdded on acquisition ofsubsidiary (W2)

Brought forward

Carried forward

WORKINGS

(1) Minority interest in profit for the year

CU'000

(2) Minority interest added on acquisition

CU'000 CU'000Share capitalRetained earnings b/fProfit for first half of current year20% of




12


Summary



Self-test

1 Barley Ltd has owned 100% of the issued share capital of Oats Ltd for many years. Barley Ltd sellsgoods to Oats Ltd at cost plus 20%. The following information is available for the year.

RevenueCU

Barley Ltd 460,000Oats Ltd 120,000

During the year Barley Ltd sold goods to Oats Ltd for CU60,000, of which CU18,000 were still held ininventory by Oats Ltd at the year end.

At what amount should total revenue appear in the consolidated income statement?

A CU520,000B CU530,000C CU538,000D CU562,000

2 Ufton Ltd is the sole subsidiary of Walcot Ltd. The cost of sales figures for 20X1 for Walcot Ltd andUfton Ltd were CU11 million and CU10 million respectively. During 20X1 Walcot Ltd sold goodswhich had cost CU2 million to Ufton Ltd for CU3 million. Ufton Ltd has not yet sold any of thesegoods.

What is the consolidated cost of sales figure for 20X1?


Using the following information answer questions 3 and 4

Patience Ltd has a wholly owned subsidiary, Bunthorne Ltd. During 20X1 Bunthorne Ltd sold goods toPatience Ltd for CU40,000 which was cost plus 25%. At 31 December 20X1 CU20,000 of these goodsremained unsold.

3 In the consolidated income statement for the year ended 31 December 20X1 the revenue will bereduced by

A CU20,000B CU30,000C CU32,000D CU40,000

4 In the consolidated income statement for the year ended 31 December 20X1 the profit will be reduced by

A CU4,000B CU6,000C CU8,000D CU10,000

Using the following trading accounts and related notes answer questions 5 and 6 for the yearended 30 April 20X6

For the year ended 30 April 20X6 Hop Ltd and its 90% subsidiary Skip Ltd had the following tradingaccounts.

Hop Ltd Skip LtdCU CU




12

Notes

(1) In each company all sales were made at the same percentage mark-up.

(2) Goods purchased by Skip Ltd at a cost of CU9,000 were sold to Hop Ltd. This transaction is reflected in the above trading accounts.

(3) Hop Ltd had sold two-thirds of these purchases at the year end.

(4) There had been no trading between Skip Ltd and Hop Ltd in previous years.

5 The consolidated revenue for the year was

A CU146,000B CU143,000C CU137,000D CU134,000

6 The consolidated gross profit for the year was

A CU40,500B CU40,350C CU39,450D CU38,500

7 Fosters Ltd in 20X7 invoiced CU120,000 of goods to its 75% subsidiary, Stella Ltd, at cost plus 30%.Stella Ltd had 25% of these in inventory at the year end. At the start of the year Stella Ltd hadCU15,000 worth of inventory invoiced from Fosters Ltd on the same pricing basis, all of which wassold in 20X7.

The consolidation adjustment to group gross profit in respect of inventory is debit

A CU3,461B CU4,500C CU6,923D CU9,000

8 Shaw Ltd owns 75% of the ordinary share capital and 40% of the CU125,000 of 8% debt of Wilde Ltd.

The following details are extracted from the books of Wilde Ltd.

Income tax expense CU24,000Profit after tax CU70,000

Shaw Ltd has profit before tax of CU80,000 in its own accounts and has no paid or proposeddividends.

Neither company has yet accounted for interest payable or receivable.

What is the total consolidated profit before tax for the year?

A CU148,000B CU150,000C CU164,000D CU168,000

Using the following information answer questions 9 to 11

The statement of changes in equity of Suton Ltd shows the following in respect of retained earnings

CU'000Profit for the period 10Interim dividend paid (7)

3Balance brought forward 21Balance carried forward 24

80% of the share capital of Suton Ltd was acquired by Teigh Ltd when Suton Ltd’s retained earningsamounted to CU5,000.



9 How much of Suton Ltd’s retained earnings will be included in closing consolidated retained earnings?

A CU20,800B CU19,200C CU19,000D CU15,200

10 How much of Suton Ltd’s profit for the period is included in the consolidated profit for the financial year attributable to the equity holders of Teigh Ltd?

A CU10,000B CU8,000C CU5,600D CU2,400

11 If the minority shareholders’ interest in Suton Ltd amounted to CU5,200 at the start of the year, howmuch will it be at the end of the year?

A CU7,200B CU6,600C CU5,800D CU4,600

12 On 1 May 20X2 Small Ltd acquired its sole subsidiary, Tiny Ltd, when the net assets of the latter wereCU250,000.

In the consolidated financial statements of Small Ltd for the year ended 30 April 20X3 the minority’s share of profit for the year was CU10,000 and the minority interest in the consolidated balance sheetwas CU56,000. During the year the minority interest received a dividend of CU4,000.

What is the minority interest in Tiny Ltd to the nearest whole percentage point?

A 25%B 24%C 20%D 18%

13 Cherry Ltd own 75% of Plum Ltd. For the year ended 31 December 20X1 Plum Ltd reported a netprofit of CU118,000. During 20X1 Plum Ltd sold goods to Cherry Ltd for CU36,000 at cost plus 50%.At the year end these goods are still held by Cherry Ltd.

In the consolidated income statement for the year ended 31 December 20X1 the minority interest is

A CU25,000B CU26,500C CU27,250D CU29,500



12

14 The following figures related to Sanderstead Ltd and its subsidiary Croydon Ltd for the year ended 31December 20X9.

SandersteadLtd

CroydonLtd

CU CURevenue 600,000 300,000Cost of sales (400,000) (200,000)Gross profit 200,000 100,000

During the year Sanderstead Ltd sold goods to Croydon Ltd for CU20,000, making a profit of CU5,000. These goods were all sold by Croydon Ltd before the year end.

What are the amounts for total revenue and gross profit in the consolidated income statement ofSanderstead Ltd for the year ended 31 December 20X9?

Revenue Gross profit

A CU900,000 CU300,000B CU900,000 CU295,000C CU880,000 CU300,000D CU880,000 CU295,000

15 Chicken Ltd owns 80% of Egg Ltd. Egg Ltd sells goods to Chicken Ltd at cost plus 50%. The totalinvoiced sales to Chicken Ltd by Egg Ltd in the year ended 31 December 20X1 were CU900,000 and,of these sales, goods which had been invoiced at CU60,000 were held in inventory by Chicken Ltd at31 December 20X1.

What is the reduction in aggregate group gross profit?

A CU16,000B CU20,000C CU24,000D CU30,000

16 Marlowe Ltd owns 60% of the ordinary share capital and 25% of the CU200,000 5% loan stock ofSouthey Ltd. Neither company has yet accounted for interest payable or receivable.

The following details are extracted from the books of Southey Ltd.

Profit CU100,000Dividend (declared prior to the year-end) CU40,000

What amount should be shown as the minority interest in the consolidated income statement ofMarlowe Ltd?

A CU20,000B CU36,000C CU37,600D CU54,000

17 Several years ago Horace Ltd acquired 75% of the ordinary share capital of Sylvia Ltd. The incomestatement of Sylvia Ltd for the year ended 28 February 20X7 showed profit after tax of CU4,000.During the year Horace Ltd sold goods to Sylvia at a mark up on cost of 50%. 75% of these goods hadbeen sold to third parties by the year end.

What is the minority interest in the consolidated income statement of Horace Ltd for the year ended28 February 20X7?

A CU625B CU750C CU938D CU1,000



18 Set out below are the summarised income statements of Dennis Ltd and its 80% subsidiary Terry Ltd.

Dennis Ltd Terry LtdCU CU

Profit from operations 89,000 45,000Dividend from Terry Ltd 16,000 –Profit before tax 105,000 45,000Income tax expense (42,000) (15,000)Profit after tax 63,000 30,000

What is the profit for the financial year attributable to the equity holders of Dennis Ltd to bedisclosed in the consolidated income statement?

A CU63,000B CU71,000C CU77,000D CU87,000

19 HUMPHREY LTD

The following are the draft income statements for the year ended 30 September 20X5 of HumphreyLtd and its subsidiary Stanley Ltd.

Humphrey StanleyLtd Ltd

CU'000 CU'000Revenue 1,100 400Cost of sales (600) (240)Gross profit 500 160Distribution costs (60) (50)Administrative costs (65) (55)Profit from operations 375 55Investment income 20 5Finance cost (25) (6)Profit before tax 370 54Income tax expense (160) (24)Profit after tax 210 30

The following information is relevant

(1) Humphrey Ltd acquired 80% of Stanley Ltd many years ago, when the retained earnings of thatcompany were CU5,000. Both companies have only ordinary shares in issue.

(2) Total intra-group sales in the year amounted to CU100,000, Humphrey Ltd selling to Stanley Ltd.

(3) At the year end the balance sheet of Stanley Ltd included inventory purchased from HumphreyLtd. Humphrey Ltd had recognised a profit of CU2,000 on this inventory.

(4) The retained earnings of Humphrey Ltd and Stanley Ltd as at 30 September 20X4 wereCU90,000 and CU40,000 respectively. Stanley Ltd’s share capital is comprised of CU50,000 CU1ordinary shares.

(5) Humphrey Ltd paid an interim dividend of CU100,000 in the year. Stanley Ltd paid an equivalentdividend of CU20,000.

Requirement

Prepare a consolidated income statement and extracts from the consolidated statement of changes inequity for the year ended 30 September 20X5. (10 marks)



12

20 HIGH LTD

High Ltd acquired its 80% interest in the ordinary shares and 25% interest in the redeemablepreference shares of Tension Ltd for CU9,000 and CU1,000 respectively on 1 April 20X3 whenTension Ltd’s retained earnings were CU4,000. There were no other reserves at that date. Thepreference shares carry no votes.

The following are the draft income statements of High Ltd and Tension Ltd for the year ended 31March 20X9.

High Ltd Tension LtdCU CU CU CU

Revenue 274,500 181,250Dividends from Tension Ltd

Ordinary 4,800 –Preference 150 –

Bank deposit interest 250 100279,700 181,350

Less Cost of sales 126,480 86,520Distribution costs 67,315 42,885Administrative costs 25,555 17,295Preference dividend paid – 600

(219,350) (147,300)60,350 34,050

Income tax expense (29,000) (15,100)Profit after tax 31,350 18,950

The following information is also available.

(1) The inventory of High Ltd at 31 March 20X9 includes goods purchased from Tension Ltd at aprofit to that company of CU700. Total intra-group sales for the year amounted to CU37,500.

(2) On 1 April 20X8 High Ltd sold plant costing CU7,000 to Tension Ltd for CU10,000. The profiton sale has been taken to cost of sales. Depreciation has been provided by Tension Ltd at 10%per annum on the cost of CU10,000.

(3) Included in Tension Ltd’s administrative costs is an amount for CU3,500 in respect ofmanagement charges invoiced and included in revenue by High Ltd.

(4) Tension Ltd’s issued share capital comprises 10,000 50p ordinary shares and 4,000 CU1 15%redeemable preference shares.

(5) Four years ago a goodwill impairment loss was recognised in High Ltd’s consolidated financial statements leaving goodwill in the consolidated balance sheet at CU1,200. A further CU180impairment loss needs to be recognised in the current year.

(6) Retained earnings at 1 April 20X8 were CU576,000 for High Ltd and CU72,600 for Tension Ltd.

Requirements

(a) Prepare the consolidated income statement for the year ended 31 March 20X9 and calculate theretained earnings brought forward attributable to the equity holders of High Ltd and to theminority interest. (10 marks)

(b) For each adjustment you have made in the consolidation schedule explain why you have made it(include in your answer the journal adjustment and the impact on consolidated profit).

(10 marks)

(20 marks)



21 ETHOS LTD

The following draft income statements and statements of changes in equity were prepared for the yearended 31 March 20X9.

Income statements Ethos Ltd Pathos LtdCU CU

Revenue 303,600 217,700Cost of sales (143,800) (102,200)Gross profit 159,800 115,500Operating costs (71,200) (51,300)Profit from operations 88,600 64,200Investment income 2,800 1,200Profit before tax 91,400 65,400Income tax expense (46,200) (32,600)Profit after tax 45,200 32,800

Statements of changes in equity (extracts)

Ethos Ltd Pathos LtdGeneral

reserve

Retained

earnings

General

reserve

Retained

earningsCU CU CU CU

Net profit for the year – 45,200 – 32,800Transfer between reserves 15,000 (15,000) 5,000 (5,000)Interim dividends on ordinary shares – (30,000) – –

15,000 200 5,000 27,800Balance brought forward – 79,300 – 38,650Balance carried forward 15,000 79,500 5,000 66,450

On 30 November 20X8 Ethos Ltd acquired 75% of the issued ordinary capital of Pathos Ltd forCU130,000. Pathos Ltd has in issue 100,000 CU1 ordinary shares. Ethos Ltd has 500,000 CU1ordinary shares in issue.

Profits of both companies accrue evenly over the year.

Requirements

(a) Prepare the consolidated income statement and consolidated statement of changes in equity forthe year ended 31 March 20X9. (10 marks)

(b) Explain why only four months of Pathos Ltd’s income statement is included in the consolidatedincome statement. (3 marks)

(13 marks)

22 HIGG LTD

The following summarised income statements have been prepared for the year ended 30 June 20X5 byHigg Ltd and its subsidiary undertaking Topp Ltd.

Higg Ltd Topp LtdCU CU CU

Revenue 647,200 296,800Cost of sales (427,700) (194,100)Gross profit 219,500 102,700Operating costs (106,300) (42,300)Profits from operations 113,200 60,400Investment incomeDividends from Topp Ltd 7,000 –Dividends from quoted investments 3,000 2,000Interest from Topp Ltd 1,600 –

11,600Finance cost – (8,000)Profit before tax 124,800 54,400Income tax expense (58,300) (27,300)Profit after tax 66,500 27,100



12

The following information is relevant.

(1) Higg Ltd acquired 70% of the CU100,000 issued ordinary shares of Topp Ltd for CU95,000 on 1 July20X1 when retained earnings of Topp Ltd were CU13,200. On the same date Higg Ltd acquired 20%of the 8% loan stock of Topp Ltd. The total loan stock issued at par is CU100,000.

(2) The revenue of Higg Ltd includes sales to Topp Ltd of CU36,000, all invoiced at cost plus 25%. On 30June 20X5 the inventory of Topp Ltd included CU9,000 in respect of such goods.

(3) Three years ago a goodwill impairment loss of CU5,910 was recognised in Higg Ltd’s consolidatedfinancial statements. A further loss of CU1,970 needs to be reflected in the current year consolidated financial statements.

(4) Higg Ltd paid an interim ordinary dividend of CU20,000 and total dividends to irredeemablepreference shareholders of CU8,000. Topp Ltd paid an interim ordinary dividend of CU10,000.

(5) The retained earnings of Higg Ltd and Topp Ltd as at 1 July 20X4 were CU72,400 and CU29,600respectively. The share capital of Higg Ltd comprises 500,000 CU1 ordinary shares and 100,000 CU1irredeemable preference shares.

Requirement

Prepare the consolidated income statement and consolidated statement of changes in equity for the yearended 30 June 20X5. (10 marks)




Technical reference




12


1 A Revenue = 460,000 + 120,000 – 60,000

= CU520,000

2 C

WalcotLtd

UftonLtd

Adj Consol

CUm CUm CUm CUmCost of sales (11) (10) 3

(19)PURP (1)

3 D Reduce revenue by intra-group sales of CU40,000.

4 A Reduce consolidated profit by provision for unrealised profit.

20,000 ×125

25= CU4,000

5 D

CU'000Hop Ltd 100Skip Ltd 46

Less: Intra-group sales (9 ×34.5

46) (12)

134

6 A

CU'000Hop Ltd 30.0Skip Ltd 11.5

Less: PURP ((12 – 9 ×3

1) (1.0)

40.5

7 A

CU

Closing PURP (120,000 × 25% × 130

30) 6,923

Opening PURP (15,000 × 130

30) (3,462)

Increase required 3,461

8 D

Shaw Ltd Wilde Ltd Adj ConsCU CU CU CU

Interest receivable (40% × 10,000) 4,000 (4,000) –Interest payable (10,000) 4,000 (6,000)PBT 80,000 94,000 174,000

168,000



9 D Share of Suton's post-acquisition retained earnings = 24,000 – 5,000

= 19,000 × 80%

= CU15,200

10 B Profit after tax = 10,000 × 80%

= CU8,000

11 C

CU'000B/f 5.2Share of IS (10 × 20%) 2.0Less Share of dividends (7 × 20%) (1.4)C/f 5.8

12 C

CUC/f 56,000Dividend 4,000Profit (10,000)At acquisition 50,000

Minority interest at acquisition =250,000

50,000

= 20%

13 B

CUShare of consolidated profit (25% ×118,000) 29,500Less Share of PURP (25% × 36,000 × 50/150) (3,000)

26,500

14 C

Sanderstead

Ltd

Croydon

Ltd

Adj Consol

CU CU CU CURevenue 600,000 300,000 (20,000) 880,000Cost of sales (400,000) (200,000) 20,000 (580,000)Gross profit 300,000

15 B

% CUSP 150 60,000Cost (100) (40,000)Gross profit 50 20,000

16 B

CUProfit prior to finance cost 100,000Finance cost (200,000 × 5%) (10,000)

90,000× 40% 36,000



12

17 D

CUShare of profit after tax (25% × 4,000) 1,000

Point to note

As the inventory was sold by Horace Ltd, the PURP adjustment would be to Horace Ltd's profitsand would have no impact on the MI.

18 B

CUProfit from operations – Dennis Ltd 89,000Less income tax expense (42,000)

47,000Group share of Terry Ltd (80% × 30,000) 24,000

71,000

19 HUMPHREY LTD

Consolidated income statement for the year ended 30 September 20X5

CU'000Revenue (W2) 1,400Cost of sales (W2) (742)Gross profit 658Distribution costs (W2) (110)Administration expenses (W2) (120)Profit from operations 428Finance cost (W2) (31)Investment income (W2) 9Profit before tax 406Income tax expense (W2) (184)Profit after tax 222Attributable to

Equity holders of Humphrey Ltd ( 216

Minority interest (W3) 6222

Consolidated statement of changes in equity for the year ended 30 September 20X5(extracts)

Retained earnings

attributable toequity holders ofHumphrey Ltd

Minority

interest TotalCU'000 CU'000 CU'000

Net profit for the period 216 6 222Interim dividend on ordinary shares (W5) (100) (4) (104)

116 2 118Balance brought forward (W4 and W6) 118 18 136Balance carried forward 234 20 254



WORKINGS

(1) Group structure

Humphrey Ltd

80%

Stanley Ltd


HumphreyLtd

StanleyLtd

Adj Consol

CU'000 CU'000 CU'000 CU'000Revenue 1,100 400 (100) 1,400C of S

Per Q (600) (240) 100PURP (2) – – (742)

Distribution (60) (50) (110)Administrative (65) (55) (120)Finance cost (25) (6) (31)Inv income (20 – 16) 4 5 9Income tax (160) (24) (184)PAT 30


CU'00020% × 30,000 (W2) or as per PAT in question 6


CU'000GroupHumphrey Ltd 90Stanley Ltd (80% × (40 – 5)) 28

118

(5) Intra-group dividend

Check consistency between companies.

CU'000Received by Humphrey Ltd (80% × 20) 16Received by M1 (20% × 20) 4Paid by Stanley Ltd 20

(6) Minority interest b/f

CU'000Share capital 50Retained earnings 40

90× 20% 18



12

20 HIGH LTD

(a) Consolidated income statement for the year ended 31 March 20X9

CURevenue (W2) 414,750Cost of sales (W2) (178,900)Gross profit 235,850Distribution costs (W2) (110,200)Administration expenses (W2) (39,530)Profit from operations 86,120Finance cost (W2) (450)Investment income (W2) 350Profit before tax 86,020Income tax expense (W2) (44,100)Profit after tax 41,920Attributable to

Equity holders of High Ltd ( 38,270

Minority interest (W3) 3,65041,920

Retained earnings brought forward CUAttributable to equity holders of High Ltd (W5) 630,280Minority interest (W5) 14,520

(b) Adjustments in consolidation schedule

(i) Intra-group sales of inventory

As the consolidated accounts treat High Ltd and Tension Ltd as one entity, the total intra-group trading needs to be eliminated on consolidation. The total of CU37,500 will be inboth Tension Ltd’s revenue and High Ltd’s cost of sales. The adjustment required is

DR CRCU CU

Revenue 37,500Cost of sales 37,500

This has no impact on net consolidated profit.

For the same reason, it is also necessary to eliminate the unrealised profit on the inventory held by High Ltd at the year end. This adjustment will also reduce inventory to original costto the group.

The adjustment is

DR CRCU CU

Cost of sales of Tension Ltd 700Inventory in the consolidated balance sheet 700

This will reduce consolidated profit.

(ii) Intra-group sale of plant

For the same reasons as given for inventory above, it is necessary to eliminate theunrealised profit and reduce the plant to its original cost.

The adjustment is

DR CRCU CU

Cost of sales of High Ltd 3,000Cost of plant in the consolidated balance sheet 3,000

This will have a one-off impact on consolidated profit this year.



In current and future years (until the plant has been fully depreciated by Tension Ltd) it willalso be necessary to adjust the depreciation charge by 10% of the PURP, to reflect the gradual realisation of the above profit through the annual depreciation charge. This willrequire the following.

DR CRCU CU

Accumulated depreciation in the consolidated balance sheet 300Cost of sales of High Ltd 300

Therefore the net impact is to reduce current year consolidated profit by CU2,700.

(iii) Management charges

As with intra-group trading, this charge must be contra’d out on consolidation to reflect the single entity concept.

The adjustment required is

DR CRCU CU

Revenue of High Ltd 3,500Administrative costs of Tension Ltd 3,500

This has no impact on consolidated profit.

(iv) Impairment of goodwill

Goodwill only exists in the consolidated accounts and therefore the individual incomestatements include no impairment of goodwill. The impairment charge for the year is dealtwith as follows.

DR CRCU CU

Administration costs 180Goodwill in the consolidated balance sheet 180

This will reduce consolidated profit.

(v) Redeemable preference shares

These are in substance liabilities and the net 'dividend' payable outside the group should beincluded as part of the consolidated finance cost.

Effectively the 'dividends' paid by Tension Ltd are contra’d against the dividends received byHigh Ltd and the adjustment required is

DR CRCU CU

Dividends received 150Dividends paid (25% × CU600) 150

This leaves CU450 payable to third parties.

WORKINGS

(1) Group structure

High Ltd

80% ords (25% prefs)

Tension Ltd



12


High Ltd TensionLtd

Adj Consol

CU CU CU CURevenue 274,500 181,250 (37,500) 414,750

(3,500)C of S

Per Q (126,480) (86,520) 37,500Inventory PURP (700)NCA PURP (3,000)Depreciation (10% 3,000) 300 (178,900)

Distrib (67,315) (42,885) (110,200)Admin

Per Q (25,555) (17,295) 3,500Impairment of GW (180) (39,530)

Preference dividends received 150 (150)Preference dividends paid (600) 150 (450)Inv income – interest 250 100 350Income tax (29,000) (15,100) (44,100)PAT 18,250


20% CU18,250 = CU3,650

(4) Goodwill

CUCost 9,000Less Share of net assets at acquisitionOrdinary shares (80% 5,000) (4,000)

Retained earnings (80% 4,000) (3,200)On acquisition 1,800NBV at last impairment (1,200)Impairment loss previously recognised 600


CUHigh Ltd 576,000Tension Ltd ((72,600 – 4,000) × 80%) 54,880Less: Impairment loss to date (W4) (600)

630,280Minority interest (72,600 × 20%) 14,520

Point to note

Alternative calculation for PAT of Tension Ltd (W2)

CUPAT per question 18,950Less Inventory PURP (700)

18,250



21 ETHOS LTD

(a) Consolidated income statement for the year ended 31 March 20X9

CURevenue (W2) 376,167Cost of sales (W2) (177,867)Gross profit 198,300Operating costs (W2) (88,300)Profit from operations 110,000Investment income (W2) 3,200Profit before tax 113,200Income tax expense (W2) (57,067)Profit after tax 56,133Attributable to

Equity holders of Ethos Ltd ( 53,400



Attributable to equity holders of Ethos LtdOrdinary

share General Retained Minoritycapital reserve earnings Total interest Total

CU CU CU CU CU CUNet profit forthe period – – 53,400 53,400 2,733 56,133Transfer betweenreserves (W4) – 16,250 (16,250) – – –Added onacquisition ofsubsidiary (W5) – – – – 40,129 40,129Interim dividendon ordinaryshares – – (30,000) (30,000) – (30,000)

– 16,250 7,150 23,400 42,862 66,262Balance broughtforward 500,000 – 79,300 579,300 – 579,300Balance carriedforward 500,000 16,250 86,450 602,700 42,862 645,562

(b) Time apportionment

The results of a subsidiary are included in the consolidated accounts only from the date control isachieved.

Ethos Ltd acquired 75% of the issued ordinary capital of Pathos Ltd on 30 November 20X8. This is thedate on which control passed and hence the date from which the results of Pathos Ltd should bereflected in the consolidated income statement.

Therefore only profits earned by Pathos Ltd in the four months since that date are post-acquisitionprofits.

The remaining previous eight months profit from 1 April 20X8 to 30 November 20X8 are all pre-acquisition profits and will be included in the calculation of goodwill on consolidation.



12

WORKINGS

(1) Group structure

Ethos Ltd

75% (acq 30 November 20X8 4/12 in)

Pathos Ltd


Ethos Ltd Pathos Ltd Adj ConsolCU CU CU CU

Revenue 303,600 72,567 – 376,167C of S (143,800) (34,067) – (177,867)Op costs (71,200) ((17,100) (88,300)Inv income 2,800 400 3,200Income tax (46,200) (10,867) (57,067)PAT 10,933


CU25% x 10,933 (W2) 2,733

(4) Transfer to general reserve

CUEthos Ltd 15,000Pathos Ltd (75% × 5,000 × 4/12) 1,250

16,250


CUShare capital 100,000Retained earningsAt 1 April 20X8 38,650In current year (32,800 x 8/12) 21,867

160,517× 25% 40,129

Point to note

Alternative calculation for PAT of Pathos Ltd (W2)

CUPAT per question 32,800 × 4/12 10,933



22 HIGG LTD


CURevenue 908,000Cost of sales (587,600)Gross profit 320,400Operating costs (150,570)Profit from operations 169,830Finance cost (6,400)Investment income 5,000Profit before tax 168,430Income tax expense (85,600)Profit after tax 82,830Attributable to

Equity holders of Higg Ltd ( 74,700



Attributable to equity holders of Higg LtdOrdinary Preference

share share capital Retained Minoritycapital (irredeemable) earnings Total interest TotalCU CU CU CU CU CU

Net profit for the period – – 74,700 74,700 8,130 82,830Interim dividendon ordinaryshares (W5) – – (20,000) (20,000) (3,000) (23,000)Total dividends onpreference shares(irredeemable) – – (8,000) (8,000) – (8,000)

– – 46,700 46,700 5,130 51,830Balance broughtforward (W4, W6) 500,000 100,000 77,970 677,970 38,880 716,850Balance carriedforward 500,000 100,000 124,670 724,670 44,010 768,680

WORKINGS

(1) Group structure

Higg Ltd

70%

Topp Ltd



12


Higg Ltd Topp Ltd Adj ConsolCU CU CU CU

Revenue 647,200 296,800 (36,000) 908,000C of S

Per Q (427,700) (194,100) 36,000PURP (25/125 9,000) (1,800) (587,600)

Op costsPer Q (106,300) (42,300)Impairment of GW (1,970) (150,570)

Inv incomeDividends from quoted investments 3,000 2,000 5,000Interest received 1,600 (1,600) –Finance cost (8,000) 1,600 (6,400)

Income tax (58,300) (27,300) (85,600)PAT 27,100


CU30% × 27,100 8,130


CUGroupHigg Ltd 72,400Topp Ltd (70% (29,600 – 13,200)) 11,480Less: Goodwill impaired to 1 July 20X4 (5,910)

77,970

(5) Intra-group dividends and interest

CUPaid by Topp LtdDividends 10,000Interest 8,000

Received by Higg LtdDividends (70% × 10,000) 7,000Interest (20% × 8,000) 1,600

Dividends received by MI (30% 10,000) 3,000


CUShare capital 100,000Retained earnings 29,600

129,600× 30% 38,880



Answer to Interactive questions


Whales PorpoiseLtd Ltd Adj ConsolCU CU CU CU

Revenue 120,000 70,000 (30,000) 160,000C of S – per Q (80,000) (50,000) 30,000

– PURP (2,000) (102,000)GP 40,000 18,000 – 58,000

Points to note

1 The intra-group sale is eliminated in the adjustments column. It has no effect on the overall profit.

2 The unrealised profit is eliminated by increasing the cost of sales of the selling company. Where theselling company is the subsidiary this will reduce the profit figure on which the calculation of minorityinterest is subsequently based.



Depreciation – per Q (35,000) (25,000)NCA PURP (15,000 – (12,000 – 4,800)) (7,800)Depreciation adjustment ((15,000 – 12,000) 20%) 600 (67,200)


(a) Consolidated income statement (extracts) for the year ended 30 September 20X7

CURevenue 130,000Cost of sales (74,000)Gross profit 56,000Minority interest (W3) (1,750)

WORKINGS

(1) Group structure

P

75%

S



12


Pathfinder SultanLtd Ltd Adj ConsolCU CU CU CU

Revenue 100,000 50,000 (20,000) 130,000C of S – per Q (60,000) (30,000) 20,000

– PURP (W4) (4,000) (74,000)Expenses (10,000)Income tax (3,000)Profit 7,000


CUSultan Ltd 25% 7,000 (W2) 1,750

(4) PURP

% CU CUSelling price 100 20,000Cost (60) (12,000)Gross profit 40 8,000 1/2 = 4,000

(b) Consolidated income statement for the year ended 30 September 20X7

CURevenue 130,000Cost of sales (74,000)Gross profit 56,000Expenses (30,000)Profit before tax 26,000Income tax expense (9,000)Profit after tax 17,000

Attributable to:Equity holders of Pathfinder Ltd () 16,250Minority interest (W3) 750

17,000

WORKINGS

(1) Group structure

As part (a)


Pathfinder SultanLtd Ltd Adj Consol

CU CU CU CURevenue 100,000 50,000 (20,000) 130,000C of S – per Q (60,000) (30,000) 20,000

– PURP (W4) (4,000) (74,000)Expenses (20,000) (10,000) (30,000)Income tax (6,000) (3,000) (9,000)Profit 3,000


CUSultan Ltd 25% 3,000 (W2) 750

(4) PURP

As part (a)




P Ltd Consolidated income statement for the year ended 31 December 20X79/12


Revenue 100,000 56,250 (15,000) 141,250C of S (70,000) (45,000) 15,000 (100,000)Gross profit 30,000 11,250 – 41,250




Share Retained Minoritycapital earnings Total interest Total

CU CU CU CU CUNet profit for the year – 178,000 178,000 13,000 191,000Dividends declared – (20,000) (20,000) (6,000) (26,000)

– 158,000 158,000 7,000 165,000Brought forward (W) 200,000 300,000 500,000 34,000 534,000Carried forward 200,000 458,000 658,000 41,000 699,000

WORKING

CUGroup reserves b/fWilliam Ltd 270,000Rufus Ltd (80% (120,000 – 70,000)) 40,000Goodwill impairment to date (10,000)

300,000

CUMI b/fShare capital (20% 50,000) 10,000

Retained earnings (20% 120,000) 24,00034,000



CU000Revenue (Joseph + half Mary) 1,075Costs (Joseph + half Mary) (575)Profit before tax 500Income tax (Joseph + half Mary) (165)Profit after tax 335

Attributable to:Equity holders of Joseph Ltd () 320Minority interest (W1) 15

335



12


Attributable to equity holdersof Joseph Ltd

Share Retained Minoritycapital earnings Total interest Total

CU'000 CU'000 CU'000 CU'000 CU'000Net profit for the year – 320 320 15 335Added on acquisition of subsidiary (W2) – – – 95 95Brought forward 500 400 900 – 900Carried forward 500 720 1,220 110 1,330

WORKINGS


CU00020% of (150,000 50%) 15


CU000 CU000Share capital 100Retained earnings b/f 300Profit for first half of current year (150,000 50%) 7520% of 475 95




Contents

chapter 13

Group accounts: associates

Introduction

Examination context

Topic List

1 Investment in an associate

2 Equity method: consolidated balance sheet

3 Equity method: consolidated income statement

4 Associate's losses

5 Transactions between a group and its associate


Technical reference





Introduction


Explain the relationship between a group and its associate

Explain the principles behind the treatment of the associate

Reflect an associate in group accounts by means of equity accounting

Deal with transactions between a group and its associate

Specific syllabus references for this chapter are: 1g, 3c,d,e.


In Chapters 10-12 we have seen that companies may acquire other entities as a means of achieving growthand meeting corporate objectives. We have been looking at situations where an investor obtains control of aninvestee through the ownership of a majority of the ordinary share capital. However, there are other ways inwhich an investment may be made. A minority stake could be obtained such that the investor can influence,rather than control, the key decisions made by the entity. This is normally achieved through the acquisition of20% or more of the voting rights (normally attached to ordinary shares). This type of investment is referredto as an associate.

But why would an entity wish to obtain a minority stake only? In many cases the acquisition of a minoritystake is part of a wider plan. The investor is able to be involved in the strategy of the target company,through representation on the board whilst at the same time limiting its financial commitment. It is able toevaluate whether the target company would fit in with its existing activities and, if appropriate, to make initialplans for a merger. The target company may also benefit from this process as the investing entity can oftenprovide expertise such as management and logistics services. This approach is common in high technologyand developing industries. Typically these involve small, newly-established entities which require capitalfunding.

If the readers of financial information are to understand the level of influence an entity can exercise it isessential that the method of reporting reflects this adequately. BAS 28 Investments in Associates aims to ensurethat this is the case.

Stop and think?

How do you think a simple trade investment differs from an investment in an associate?

Working context

If you have worked on a client which involves a group of companies the investments made by the parentcompany may have included an associate. As we saw in Chapter 10 the subsidiaries in a group are normallyconsolidated by preparing a consolidation package. Typically the same type of procedure is used in respect ofthe associate. The key issues which would need to be addressed specifically include the correct identificationof the investment as an associate and the appropriate accounting treatment in the financial statements.

Syllabus links

More complex aspects of group financial statements will be examined in the Financial Reporting paper and atthe Advanced stage. It is therefore important that you have a sound understanding of the accountingtreatment of associates to carry forward to these other papers.

GROUP ACCOUNTS: ASSOCIATES


13

Examination context


Associates could be examined in both the short-form question and written test sections of the paper. In thewritten test section it is likely that the associate will be examined in the context of the preparation of aconsolidated balance sheet or income statement, within a group structure which includes at least onesubsidiary. A written element of such a question could focus on an explanation of equity accounting byreference to the underlying principles or a comparison of the treatment of associates under BFRS.

In the examination candidates could be required to:

Incorporate the results of an associate in the consolidated financial statements using the equity method

Explain the equity method and the principles behind it



1 Investment in an associate

Section overview

An associate is an entity over which the parent exercises significant influence.

Significant influence is presumed where the parent holds 20% or more of the voting rights.

An associate is not part of the group.

An investment in an associate should be accounted for in the consolidated financial statements usingthe equity method of accounting.

1.1 Introduction

In the previous chapters we have seen that where a parent entity controls another entity (normally byholding over 50% of the ordinary share capital) it is said to have a subsidiary. The results of the parent andsubsidiary are consolidated in group accounts as if they were a single entity.

However, investments can take a number of different forms. An investing entity may obtain sufficient sharessuch that the investment is of significant importance to it, without achieving control. This type ofinvestment is referred to as an associate and is dealt with by BAS 28 Investments in Associates.

In this chapter we will look at how to account for an associate. (The detailed provisions of BAS 28 are dealtwith in Chapter 15.)

1.2 Associate

Definition

Associate: An entity, including an unincorporated entity such as a partnership, over which the investor hassignificant influence and that is neither a subsidiary nor an interest in a joint venture.

When deciding whether an investment should be treated as an associate the critical feature is whether theinvesting entity has significant influence over the investee.

Definition

Significant influence: The power to participate in the financial and operating policy decisions of theinvestee but is not control or joint control over those policies.

Significant influence can be determined by the holding of voting rights (usually attached to shares) in theentity. BAS 28 states that:

If an investor holds 20% or more of the voting power of the investee (directly or indirectly) it ispresumed that the investor has significant influence; therefore associate status will be presumedunless it can be demonstrated otherwise.

If an investor holds less than 20% of the voting power of the investee (directly or indirectly) it ispresumed that the investor does not have significant influence; therefore there is no associatestatus unless demonstrated otherwise.



13

BAS 28 also states that significant influence can be shown by one or more of the following:

Representation on the board of directors Participation in policy making decisions Material transactions between the investor and investee Interchange of managerial personnel Provision of essential technical information

Point to note

For examination purposes you should assume that a holding of 20% or more of the ordinary sharecapital constitutes significant influence.

1.3 Relationship with the group

An associate is not part of the group as a group comprises the parent and its subsidiaries only. In terms ofthe Financial Accounting syllabus, the group investment in the associate is always held by the parent company,not a subsidiary. So:

Group

P

S

80% 40%

A

1.4 Treatment in investing company's own accounts

The balance sheet of the investing company shows the investment in the associate in non-current assetinvestments, usually at cost.

The investing company's income statement shows dividend income received and receivable from theassociate as 'income from associates'.

The question is whether this provides the shareholders of the parent company with sufficient information. Itcould be argued that to reflect fairly the nature of the investor's interest where it is in a position toexercise significant influence the group's interest in the net assets and results of the associateshould be reflected.

This is achieved by the use of the equity method of accounting.

1.5 Treatment in consolidated financial statements: accountingprinciples

An investment in an associate should be accounted for in the consolidated financial statements using theequity method of accounting. This method reflects the substance of the relationship between the entitiesrather than their legal form. The group's share of the associate's profits, assets and liabilities areincluded in the consolidated financial statements rather than the cost of the investment and dividend incomereceived.

(Exceptions to the general requirement to apply the equity method of accounting are described in Chapter 15.)

Point to note

The equity method is only used in the group accounts i.e. the parent company holds investments insubsidiaries as well as associates. If the investor does not issue consolidated financial statements theinvestment will be shown in the investor's individual financial statements as described in section 1.4 above.



2 Equity method: consolidated balance sheet

Section overview

The investment in the associate is shown as a single line entry in the consolidated balance sheet.

If the carrying amount of the investment has suffered an impairment it should be written down to itsrecoverable amount.

2.1 Basic principle

An associate is accounted for as follows:

The interest in the associate is presented as a single line under non-current assets described as'Investments in Associates'.

It is initially recognised at cost and is subsequently adjusted in each period for changes in the parent'sshare of the net assets.

In group reserves the parent's share of the associate's post-acquisition reserves are included (asfor a subsidiary).

Point to note

The assets and liabilities of the associate are not included on a line-by-line basis.

2.2 Calculation of balance sheet carrying amount

The investment in the associate is calculated as follows:

CUOriginal cost (in P's books) XShare of post acquisition change in net assets X

XLess: Impairment losses to date (X)

X

Point to note

If the parent company has made any long term loans to the associate which are not expected to be repaidin the foreseeable future these should be included as part of the investment in the associate.

2.3 Impairment losses

At the date of acquisition the investment in the associate is recognised at cost (see section 2.1). Thisrepresents the parent's share of the fair value of the net assets acquired plus goodwill arising onacquisition. This goodwill is not separately calculated or disclosed (as with a subsidiary) but instead isincluded as part of the carrying amount of the investment. This presentation aims to avoid giving themisleading impression that the investor has acquired a goodwill asset through control over its share of theassociate’s individual assets, liabilities and contingent liabilities. It has only gained significant influence overthe affairs of the associate so no goodwill is calculated at the date the investment is made.

As a result impairment tests are performed in relation to the investment as a whole. If the investmenthas suffered an impairment it is written down to its recoverable amount (see section 2.2).

Point to note

If there is a discount on the purchase of the investment (i.e. the cost is less than the fair value of the netassets acquired) it must be recognised in profit or loss for the period in which the investment is made.

In practice this is unlikely to occur.



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2.4 Application of the equity method in the consolidated balance sheet

Remember that the equity method is only used in group accounts. This means that the parent has subsidiariesas well as an associate. In an examination question the practical implication of this is that you will need toproduce the consolidation workings for the subsidiaries (See Chapter 11). These workings are adapted forthe inclusion of the associate as follows:

Working1: Group structure Include the associate in the group structurediagram

Working 2: Net assets Produce a net assets working for the associate(as for a subsidiary)

This should include any fair value or accountingpolicy adjustments to the associate's net assets

The post acquisition change in net assets willform part of the 'Investments in Associates'balance

Working 5: Consolidated retained earnings(reserves)

Include the parent's share of the associate'spost acquisition retained earnings

The calculation of the carrying amount of the investment in the associate will usually be Working6.

Interactive question 1: Equity method (CBS) [Difficulty level: Easy]

P Ltd owns 80% of S Ltd and 40% of A Ltd. Balance sheets of the three companies at 31 December 20X8 areas follows.

P S ACU CU CU

Investment: shares in S 800 – –Investment: shares in A 600 – –Sundry assets 6,600 5,800 5,400

8,000 5,800 5,400

Share capital – CU1 ordinary shares 1,000 400 800Retained earnings 4,000 3,400 3,600Equity 5,000 3,800 4,400Liabilities 3,000 2,000 1,000

8,000 5,800 5,400

P acquired its shares in S when S's retained earnings were CU520, and P acquired its shares in A when A'sretained earnings were CU400.

In 20X7 an impairment loss of CU20 was recognised in relation to the investment in A.

Requirement

Prepare the consolidated balance sheet at 31 December 20X8.




Solution

P Ltd: Consolidated balance sheet as at 31 December 20X8

CUIntangibles (W3)Investments in associates (W6)Sundry assets

Share capitalRetained earnings (W5)Attributable to equity holders of P LtdMinority interest (W4)EquityLiabilities

WORKINGS

(1) Group structure

(2) Net assets

Balance Postsheet date Acquisition acquisition

CU CU CUS LtdShare capitalRetained earnings

A LtdShare capitalRetained earnings

(3) Goodwill

S Ltd CUCost of investmentNet assets acquiredBalance c/f


CUS Ltd


CUP LtdS LtdA LtdImpairment to date



13

(6) Investments in associates

CUOriginal costShare of post-acquisition change in net assets (W2)

Impairment losses to date


3 Equity method: consolidated income statement

Section overview

Share of profit of associates is recognised as a single line entry in the consolidated income statement.

3.1 Basic principle

The associate is accounted for as follows:

The group's share of the associate's profit after tax is recognised in the consolidated incomestatement as a single line entry.

This is disclosed immediately before the group profit before tax as 'Share of profit ofassociates'.

If the associate is acquired mid-year its results should be time-apportioned.

Points to note

(1) It may seem odd to include an after tax balance in arriving at the profit before tax, but this is in line withthe Guidance on Implementing BAS 1 Presentation of Financial Statements.

(2) The revenues and expenses of the associate are not consolidated on a line-by-line basis.

3.2 Impairment review

Where an impairment review in the current period has revealed an impairment loss to be charged to theincome statement, the loss is deducted from the parent's share of the profit after tax of theassociate (or added to the parent's share of a post-tax loss.)

3.3 Application of the equity method in the consolidated incomestatement

An additional working will be required to calculate the parent's share of the associate's profit after tax.

Point to note

The consolidation schedule (Working 2) will only include the parent and any subsidiaries as the associate isnot consolidated.



Interactive question 2: Equity method (CIS) [Difficulty level: Easy]

P Ltd has owned 80% of S Ltd and 40% of A Ltd for several years. Income statements for the year ended 31December 20X8 are as follows.

P Ltd S Ltd A LtdCU CU CU

Revenue 14,000 12,000 10,000Cost of sales (9,000) (4,000) (3,000)Gross profit 5,000 8,000 7,000Administrative expenses (2,000) (6,000) (3,000)Profit from operations 3,000 2,000 4,000Investment income 1,000 – 400Profit before tax 4,000 2,000 4,400Income tax expense (1,000) (1,200) (2,000)Profit after tax 3,000 800 2,400

An impairment loss of CU120 is to be recognised in 20X8 in relation to the investment in A Ltd.

Requirement

Prepare the consolidated income statement for the year ended 31 December 20X8.


Solution

P Ltd: Consolidated income statement for the year ending 31 December 20X8

CURevenueCost of salesGross profitAdministrative expensesProfit from operationsInvestment incomeShare of profit of associates (W4)Profit before taxIncome tax expenseProfit after tax

Attributable to:Equity holders of P Ltd ()Minority interest (W3)

WORKINGS

(1) Group structure

Group

P

S

80% 40%

A



13



RevenueCost of salesAdmin expenseInv. incomeTax

(3) Minority interestCU

S Ltd

(4) Share of profit of associatesCU

A Ltd


4 Associate's losses

Section overview

Losses recognised in respect of the associate are limited to the carrying amount of the associate.


Where an associate makes a loss the following treatment should be adopted:

Consolidated balance sheet The group's share of the loss should berecognised as a reduction in the carryingamount of the associate.

Consolidated income statement The group share of the post-tax loss shouldbe recognised.

Point to note

Once the carrying amount of the investment in the associate has been reduced to zero, no further lossesare recognised by the group. The parent is only required to make a provision for any additional lossesincurred by the associate to the extent that the parent has a legal or constructive obligation to make goodthese amounts.

Worked example: Associate's losses

At 31 December 20X6, the carrying amount of P Ltd's 40% interest in A Ltd is CU600,000.In the year ended 31 December 20X7 A Ltd makes a post-tax loss of CU2,000,000.The associate will be recognised in the consolidated financial statements at 31 December 20X7 as follows:

Consolidatedincome

Consolidatedbalance

statement sheetCU CU

40% x CU2,000,000 = CU800,000 (600,000) Nil

The loss recognised is limited to the carrying amount of the investment i.e. CU600,000.



5 Transactions between a group and its associate

Section overview

Transactions between the group and its associates are not cancelled on consolidation.

An adjustment is required for any unrealised profit.

5.1 Basic principle

As we said in section 1 the associate is not part of the group. This means that whilst the single entity conceptapplies to the parent and subsidiaries it does not apply to any associates. One of the consequences of this isthat transactions between a group member and an associate are not cancelled on consolidation.

5.2 Trading transactions

Trading transactions are not cancelled on consolidation.

Consolidated income statement No adjustment is made to revenue or cost ofsales for transactions between the group and theassociate.

Consolidated balance sheet Receivables and payables balances duefrom/to the associate in the individual balancesheet of the parent or its subsidiaries are carriedacross into the consolidated balance sheet.

Point to note

In the consolidated balance sheet balances relating to loans and trading balances between the group and theassociate should be shown separately.

5.3 Dividends

Balances in respect of dividends from the associate are not cancelled on consolidation. However itwould still be necessary to ensure that all dividends payable/receivable have been fully accountedfor in the books of the individual companies (as for a subsidiary.)

Consolidated income statement Dividend income from the associate is notrecorded in the consolidated incomestatement. This is because under the equitymethod the group's share of the associate's profitbefore dividends has been recognised. If thedividend income was also recognised the sameprofits would be recognised twice.

Consolidated balance sheet A receivable will be recognised in theconsolidated balance sheet for dividendsdeclared by the associate due to the group.

Interactive question 3: Dividends [Difficulty level: Easy]

P Ltd (which also has a subsidiary) has a 40% associate A Ltd. A Ltd has declared a dividend of CU100.

Requirement

Show the entries to record this dividend in the books of A Ltd and P Ltd and set out its impact on theconsolidated balance sheet and workings.




13

Solution

1 Account for the dividend in the books of the individual companies

A's books CU CUDRCR

P's books CU CUDRCR

2 Impact on CBS and workings

(1)

(2)

(3)

(4)


5.4 Unrealised profits

Whilst transactions between the group and the associate are not cancelled on consolidation any unrealisedprofit on these transactions should be eliminated.

In this respect the principle applied is similar to that applied to a subsidiary (see Chapters 11 and 12).

Worked example: Unrealised profits

A sale is made by A Ltd to P Ltd. P Ltd has a 25% holding in A Ltd. All of the goods remain in inventory at theyear-end.

75% of the profit made from the sale relates to interests held by other investors therefore only 25% of theprofit (that part which belongs to the group) should be eliminated.

The adjustment is made in the books of the seller. The way that the adjustment is made depends onwhether the selling company is the parent or the associate.

Points to note

1 Unrealised profit will only arise if the goods transferred are still held by the parent or associate. Ifthe goods have been sold to a third party there is no unrealised profit.

2 Unrealised profit adjustments apply to the transfer of non-current assets as well as the transfer ofgoods.

5.4.1 Parent sells goods to the associate

Consolidated balance sheet:

Reduce P's retained earnings by its share of the unrealised profit. Reduce the carrying amount of the investment in A by P's share of the unrealised profit.

Point to note

The carrying amount of the associate is adjusted rather than inventory as the inventory of the associate isnot consolidated.



Consolidated income statement:

Reduce P's revenue by its share of the sale on which profit is unrealised Reduce P's cost of sales by its share of the cost of goods transferred on which profit is unrealised.

Point to note

The net effect of these two adjustments reduces group profit by its share of the unrealised profit.

Interactive question 4: Unrealised profits (P A) [Difficulty level: Exam standard]

P Ltd owns 35% of A Ltd. During the current financial year P Ltd sold goods to A Ltd for CU300,000 onwhich its gross margin was 40%. A Ltd held CU50,000 of these goods in its inventories at the year end.

Requirement

Show the journal entries necessary to adjust for the PURP in P Ltd's consolidated balance sheet and set outthe adjustments necessary to P Ltd's consolidated income statement.


Solution

Consolidated balance sheet journal

CU CUDRCR



5.4.2 Associate sells goods to the parent


Reduce P's share of A's retained earnings by its share of the unrealised profit. Reduce P's inventory on consolidation by its share of the unrealised profit.

Point to note

The effect on retained earnings is normally dealt with by adjusting the associate's net assets at thebalance sheet date in the net assets working (working 2) by 100% of the unrealised profit. Thegroup share of post-acquisition retained earnings will then be based on this revised figure.


Reduce P's share of A's profits after tax by its share of the unrealised profit.

Point to note

This is normally achieved by reducing the associate’s profit after tax by 100% of the unrealisedprofit. The group share is then taken of the revised balance.



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Interactive question 5: Unrealised profits (A P) [Difficulty level: Exam standard]

Assume the same facts as in Interactive Question 4 except that A Ltd is the seller and P Ltd holds theCU50,000 goods in inventory.

Requirements

(a) Show the journal entries to adjust for the PURP in P Ltd's consolidated balance sheet.

(b) If A Ltd has profit after tax of CU75,000 calculate the share of profit of associates figure which wouldappear in the consolidated income statement.


Solution

(a) Consolidated balance sheet journal

CU CUDRCR

(b) Share of profit of associates for consolidated income statement

CU

Associate’s PATLess: Unrealised profit group share





Summary



13

Self-test


1 Durie Ltd has many subsidiary companies. On 1 January 20X6 Durie Ltd bought 30% of the share capitalof Edberg Ltd for CU6,660. The retained earnings of Edberg Ltd at that date were CU13,000 and thefair value of its assets less liabilities was CU20,000. The excess of fair value over carrying amount relatedto a plot of land which was still owned at 31 December 20X9. The fair value was not reflected in thebooks of Edberg Ltd.

The summarised draft balance sheet of Edberg Ltd on 31 December 20X9 includes the following.

CUShare capital – CU1 ordinary shares 5,000Retained earnings 17,000Total equity 22,000

By the end of 20X9 the investment in Edberg Ltd had been impaired by CU264.

At what amount should the investment in Edberg Ltd be shown using the equity method on 31December 20X9?

A CU6,996B CU7,596C CU7,656D CU8,256

2 Extracts from the income statements of Pik Ltd and its subsidiaries and Wik Ltd, its associate, for theyear ended 31 March 20X6 are as follows.

Pik Ltd Wik(inc Ltd

subsidiaries)CU'000 CU'000

Gross profit 2,900 1,600Administrative expenses (750) (170)Distribution costs (140) (190)Dividends from Wik Ltd 20 –Profit before tax 2,030 1,240Income tax expense (810) (440)Profit after tax 1,220 800

Pik Ltd acquired 25% of the ordinary shares in Wik Ltd on 1 April 20X3 when the retained earnings ofWik Ltd were CU80,000.

At what amount should the profit before tax be shown in the consolidated income statement of Pik Ltdfor the year ended 31 March 20X6?

A CU2,010,000B CU2,210,000C CU2,340,000D CU3,270,000

3 Albert Ltd owns many subsidiaries and 25% of Victoria Ltd. In the year ended 31 December 20X5Albert Ltd sold goods to Victoria for CU400,000, earning a gross profit of 20%. Victoria Ltd heldCU120,000 of them in its inventories at the year end.

By what amount should Albert Ltd's revenue be reduced when preparing its consolidated incomestatement?

A CU400,000B CU120,000C CU100,000D CU30,000



4 Austen Ltd has owned 100% of Kipling Ltd and 30% of Dickens Ltd, an associate, for many years. At 31December 20X5 the trade receivables and trade payables shown in the individual company balancesheets were as follows.

Austen Kipling DickensLtd Ltd Ltd

CU'000 CU'000 CU'000Trade receivables 50 30 40Trade payables 30 15 20Trade payables included amounts owing to

Austen Ltd – – –Kipling Ltd 2 – 4Dickens Ltd 7 – –Other suppliers 21 15 16

30 15 20

The inter-company accounts agreed after taking into account the following.

(1) An invoice for CU3,000 posted by Kipling Ltd on 31 December 20X5 was not received by AustenLtd until 2 January 20X6.

(2) A cheque for CU6,000 posted by Austen Ltd on 30 December 20X5 was not received by DickensLtd until 4 January 20X6.

What amount should be shown as trade receivables in the consolidated balance sheet of Austen Ltd?

A CU75,000B CU79,000C CU87,000D CU115,000

5 At 31 December 20X8, Beed Ltd, Transformer Ltd and Berlin Ltd each have share capital of CU10,000,retained earnings of CU20,000 and net assets at fair value of CU30,000.

Beed Ltd subscribed at par value for 60% of Transformer Ltd on its incorporation seven years ago andhas acquired 40% of Berlin Ltd for CU32,000 on 31 December 20X8.

What amounts will be identical in the consolidated balance sheet at 31 December 20X8?

A Minority interest and investments in associates, but not consolidated retained earningsB Minority interest and consolidated retained earnings, but not investments in associatesC Consolidated retained earnings and investments in associates, but not minority interestD Minority interest, consolidated retained earnings and investments in associates

6 H Ltd and its subsidiaries (S1 and S2) and associate (A) have the following inter-company balances at theyear end.

H S1 S2 ACU'000 CU'000 CU'000 CU'000

H with A 50 CR 50 DRS2 with A 75 DRS1 with A 80 CR 80 DR

All the differences related to cash in transit and where this is the case adjustments are to be made in thebooks of the receiving company.

After making the necessary adjustments to reflect the above, the consolidated financial statements of HLtd will include

A No balances due to or from associatesB An amount due from associates of CU75,000C An amount due to associates of CU55,000D An amount due to associates of CU130,000



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7 Hot Ltd owns 80% of the issued share capital of Warm Ltd and 40% of the issued share capital of ColdLtd. In the individual accounts the income tax expenses for the year are as follows.

Hot Ltd CU40,000Warm Ltd CU36,000Cold Ltd CU20,000

At what amount should the income tax expense appear in the consolidated income statement?

A CU68,800B CU76,000C CU84,000D CU96,000

8 House Ltd owns 80% of the issued share capital of Window Ltd and 25% of the issued share capital ofDoor Ltd. The revenues for the year are as follows.

House Ltd CU750,000Window Ltd CU500,000Door Ltd CU80,000

What amount for revenue should appear in the consolidated income statement for the year?

A CU1,150,000B CU1,250,000C CU1,270,000D CU1,330,000

9 Helen Ltd acquired 35% of Troy Ltd on 1 January 20X6 for CU90,000. At that date Troy Ltd had sharecapital of CU70,000 and retained earnings of CU96,000. It also owned a plot of land which had a fairvalue of CU60,000 compared to a carrying amount of CU42,000; this fair value has not beenincorporated into the books of Troy Ltd and this land is still held at the current year end 31 December20X9. Since acquisition, Troy Ltd has made total profits after tax of CU118,000 including CU110,000made in the current year. The investment in Troy Ltd has become impaired by CU2,560 during thecurrent year.

What is the net amount to be included in the consolidated income statement in respect of Troy Ltd?

A CU35,310B CU35,940C CU38,500D CU41,300

10 Grape Ltd holds 80% of the ordinary shares of Pear Ltd and 40% of those of Plum Ltd. The threecompanies' profits after tax for the current year, before accounting for dividends receivable, and theirtotal dividends payable for the year are as follows.

Profit after Dividendstax payableCU CU

Grape Ltd 100,000 50,000Pear Ltd 100,000 50,000Plum Ltd 100,000 50,000

In Grape Ltd's consolidated income statement, what amount will be disclosed as the profit/(loss) for theperiod?

A CU220,000B CU240,000C CU280,000D CU300,000

11 On 1 January 20X0 Adam Ltd purchased 30% of Eve Ltd for CU55,000. At this date the retainedearnings of Eve Ltd stood at CU60,000 and the fair value of net assets, which was subsequently reflected



in the books, was CU170,000. The excess of fair value over carrying amount related to a plot of landwhich was still owned at 31 December 20X4.

The balance sheet of Eve Ltd on 31 December 20X4 showed the following.

CUShare capital 100,000Revaluation reserve 10,000Retained earnings 200,000Total equity 310,000

At what amount should Adam Ltd's investment in Eve Ltd be stated in its consolidated balance sheet at31 December 20X4?

A CU93,000B CU96,000C CU97,000D CU100,000

12 On 31 December 20X3 Salisbury Ltd owned 30% of Balfour Ltd, 90% of Gladstone Ltd and 80% of PeelLtd.

During the year Gladstone Ltd sold goods to Peel Ltd for CU4,000,000 making a profit of CU1,000,000.25% of these goods remained in Peel Ltd's inventory as at the year end.

Total equity of each company at 31 December 20X3 was as follows.

CUmBalfour Ltd 1Gladstone Ltd 12Peel Ltd 24

What amount should be shown as minority interest in the consolidated balance sheet of Salisbury Ltd at31 December 20X3?

A CU5.960mB CU5.975mC CU6.660mD CU6.675m

13 At 30 June 20X6, the carrying amount of Penguin Ltd's 30% investment in Antelope Ltd was CU750,000.

In the year ended 30 June 20X7 Antelope made a post-tax loss of CU3,000,000.

What amount will be recognised in the consolidated income statement for the year ended 30 June 20X7as share of associate’s losses?

A NilB (CU900,000)C (CU750,000)D (CU3,000,000)



13

14 HALEY LTD

The draft balance sheets of three companies as at 31 December 20X9 are set out below.

Haley Socrates AristotleLtd Ltd Ltd

CU CU CUProperty, plant and equipment 300,000 100,000 160,000Investments at cost

18,000 shares in Socrates Ltd 75,000 – –18,000 shares in Aristotle Ltd 30,000 – –

Current assets 345,000 160,000 80,000750,000 260,000 240,000

Ordinary shares of CU1 each 250,000 30,000 60,000Retained earnings 400,000 180,000 100,000Equity 650,000 210,000 160,000Current liabilities 100,000 50,000 80,000

750,000 260,000 240,000

The retained earnings of Socrates Ltd and Aristotle Ltd when the investments were acquired eight yearsago were CU70,000 and CU30,000 respectively.

Impairment reviews to date have resulted in the need for the following amounts to be written off HaleyLtd's investments.

CUSocrates Ltd 12,000Aristotle Ltd 2,400

Requirement

Prepare the consolidated balance sheet as at 31 December 20X9. (10 marks)

15 CORFU LTD

Corfu Ltd holds 80% of the ordinary share capital of Zante Ltd (acquired on 1 February 20X9) and 30%of the ordinary share capital of Paxos Ltd (acquired on 1 July 20X8).

The draft income statements for the year ended 30 June 20X9, are set out below.

Corfu Zante PaxosLtd Ltd Ltd

CU'000 CU'000 CU'000Revenue 12,614 6,160 8,640Cost of sales and expenses (11,318) (5,524) (7,614)Trading profit 1,296 636 1,026Dividends receivable from Zante Ltd 171 – –Profit before tax 1,467 636 1,026Income tax expense (621) (275) (432)Profit after tax 846 361 594

Included in the inventory of Paxos Ltd at 30 June 20X9 was CU150,000 for goods purchased from CorfuLtd in May 20X9, which the latter company had invoiced at cost plus 25%. These were the only goodsCorfu Ltd sold to Paxos Ltd but it did make sales of CU50,000 to Zante Ltd during the year. None ofthese goods remained in Zante Ltd's inventory at the year end.

Requirement

Prepare a consolidated income statement for Corfu Ltd for the year ended 30 June 20X9.

(10 marks)



16 KING LTD

King Ltd acquired shares in two other companies as follows.

Goodwill RetainedShares on earnings at

Company Acquisition date acquired acquisition acquisition% CU CU

Prawn Ltd 1 October 20X7 80 90,000 260,000Madras Ltd 31 December 20X5 25 340,000

The results and changes in equity of the three companies for the year ended 30 September 20X9 are asfollows.

King Prawn MadrasLtd Ltd Ltd

CU'000 CU'000 CU'000Revenue 800 430 600Cost of sales and expenses (550) (255) (440)Profit before tax 250 175 160Income tax expense (80) (45) (60)Profit after tax 170 130 100

Retained earningsKing Prawn MadrasLtd Ltd Ltd

CU'000 CU'000 CU'000Net profit for the period 170 130 100Final dividends declared (70) (50) (40)

100 80 60Balance brought forward 600 320 540Balance carried forward 700 400 600

You are also given the following information.

(1) King Ltd has yet to account for dividends receivable.

(2) During the year King Ltd made sales of CU80,000 to Prawn Ltd at a gross profit of 25%. At theyear end Prawn Ltd still held CU36,000 of these goods in inventory. Madras Ltd made sales ofCU150,000 to Prawn Ltd; all of those goods had been sold to third parties by the year end.

(4) Impairment reviews at the following dates revealed the following amounts to be written off inrespect of King Ltd's investment in Prawn Ltd and Madras Ltd.

Prawn Ltd Madras LtdCU'000 CU'000

Review at30 September 20X8 9 1730 September 20X9 9 6

Requirements

Prepare the consolidated income statement and the retained earnings column in the consolidatedstatement of changes in equity of the King Ltd group for the year ended 30 September 20X9. Work tothe nearest CU000. (15 marks)



13

17 WATER LTD

The draft balance sheets of three companies as at 30 September 20X5 are as follows.

Water Hydrogen OxygenLtd Ltd Ltd

CU CU CUNon-current assets

Property, plant and equipment 697,210 648,010 349,400Investments

160,000 shares in Hydrogen Ltd 562,000 – –80,000 shares in Oxygen Ltd 184,000 – –

1,443,210 648,010 349,400

Current assetsInventories 495,165 388,619 286,925Trade receivables 415,717 320,540 251,065Cash 101,274 95,010 80,331

Total assets 2,455,366 1,452,179 967,721

Capital and reservesOrdinary share capital 600,000 200,000 200,000Retained earnings 1,015,000 820,000 463,000

Equity 1,615,000 1,020,000 663,000Non-current liabilities 400,000 150,000 100,000Current liabilities

Trade payables 440,366 282,179 204,721Total equity and liabilities 2,455,366 1,452,179 967,721

You are given the following additional information.

(1) Water Ltd purchased the shares in Hydrogen Ltd on 1 October 20X0 when the retained earningsof Hydrogen Ltd were CU500,000.

(2) The shares in Oxygen Ltd were acquired on 1 October 20X2 when the retained earnings wereCU242,000.

(3) Included in the inventory figure for Water Ltd is inventory valued at CU20,000 which had beenpurchased from Hydrogen Ltd at cost plus 25%.

(4) Included in the trade payables figure of Water Ltd is CU18,000 payable to Oxygen Ltd, the amountreceivable being recorded in the trade receivables figure of Oxygen Ltd.

(5) Impairment reviews to date have revealed a total of CU1,000 to be written off goodwill in respectof Hydrogen Ltd and CU2,000 off in respect of Water Ltd's investment in Oxygen Ltd.

Requirements

(a) Prepare the consolidated balance sheet for Water Ltd as at 30 September 20X5. (15 marks)

(b) Identify the required accounting treatment for different levels of investment in undertakings forconsolidated accounts purposes, explaining why these are appropriate. (5 marks)

(c) Set out a brief explanation in note form of how subsidiaries and associates are accounted for in theconsolidated balance sheet. (5 marks)

(25 marks)



18 NOTLEY LTD

The board of directors of Notley Ltd have asked you, as financial controller, to prepare someinformation in relation to the company’s draft financial statements for the year ended 30 June 20X6.Details are as follows.

(1) Notley Ltd acquired 30% of the ordinary share capital of Blackmore Ltd on 1 February 20X6 forCU285,000. Blackmore Ltd had retained earnings of CU328,000 at the date of acquisition andCU415,750 at 30 June 20X6. Blackmore Ltd had share capital of CU500,000 at the date ofacquisition and this has remained unchanged. The recoverable amount of the investment in theassociate has been assessed at 30 June 20X6 as CU300,000.

(2) Notley Ltd has recognised a number of provisions in its financial statements. Details are as follows:

Notley Ltd had a problem with faulty goods being delivered to a number of its customersduring the period. The fault was identified after the first customer complaint. Goodspotentially affected were only those produced in March 20X6. Sales during this periodtotalled CU75,000 and the company estimated that approximately 70% of these would havebeen affected by the fault. Notley Ltd is likely to have to pay compensation of around CU3per CU1 of revenue affected. It is hoped that all claims will be settled in the next three years.

Warranty agreements are sold with a number of Notley Ltd’s products. At the beginning ofthe year the provision was CU125,000. Of this amount CU60,000 was utilised during theperiod. A weighted average method is used to calculate the required warranty provisionbased on past claims history and future expectations. There is a 55% chance that goods willnot develop a defect, a 35% chance that goods will develop minor defects costing a total ofCU300,000 and a 10% chance that a major fault will arise estimated at costing a total ofCU450,000. Warranties are provided to customers for periods of between two and fiveyears.

The board publicly announced during the period that as part of the company’s reorganisationprogramme, it would close one of its loss making divisions. The details of the closure havebeen fully communicated to employees. The directors started to run down the operations ofthe division during the period but full closure is likely to take another 12 to 18 months.Future costs associated with the closure are estimated at:

CUEmployee redundancies 2,500,000Lease termination costs 800,000Staff relocation costs 250,000Retraining costs 175,000

(3) Notley Ltd had 100,000 CU1 ordinary shares in issue at the beginning of the year. The shares hadbeen issued at their nominal value. Additional financing was raised in October through a furthershare issue. 20,000 CU1 ordinary shares were issued at CU1.50 each.

The group’s other reserves, before adjusting for the issues in (1) and (2) above and dividends,shown in its draft balance sheet at the beginning and end of the year were:

At 1 July20X5

At 30 June20X6

CU CU

Retained earnings 780,000 3,484,000Revaluation reserve 275,000 450,000

The following dividends were declared by Notley Ltd

3 August 20X5 25p per share8 August 20X6 32p per share.



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Requirements

(a) Calculate the amounts that will be shown for the investment in Blackmore Ltd in the incomestatement for the year ended 30 June 20X6 and in the balance sheet as at that date.

(3 marks)

(b) Prepare the provisions note for the financial statements for the year ended 30 June 20X6, includingnarrative commentary. Note: Ignore discounting. (9 marks)

(c) Prepare the consolidated statement of changes in equity for Notley Ltd for the year ended 30 June20X6. (6 marks)

(18 marks)




Technical reference




13


1 B

CUCost of investment in Edberg Ltd 6,660Share of post acquisition change in net assets

(calculated as 30% change in retained earnings (17,000 – 13,000)) 1,2007,860

Impairment losses to date (264)7,596

Tutorial note: if

(a) The amount of the fair value adjustment is the same at the balance sheet date and the datethe investment is made; and

(b) It has not been reflected in the associate's books then it can be omitted from the calculationof the post-acquisition change in the associate's net assets.

2 B

CU'000Pik Ltd (incl subsidiaries)

Gross profit 2,900Less Administrative expenses (750)

Distribution costs (140)Share of profit of associates (25% 800) 200

2,210

3 D Albert Ltd's share of the revenue it recognised in respect of the goods held in inventories must be

eliminated, so 25% CU120,000 = CU30,000.

4 A

CU'000 CU'000Austen Ltd 50Kipling Ltd 30Less Intra group (2 + 3) (5)

2575

Do not cancel balances with Dickens Ltd as Dickens Ltd is an associate.

5 C

CU'000Minority interest (40% 30,000) 12,000

Investments in associates 32,000

Consolidated retained earningsBeed Ltd 20,000Transformer Ltd (60% 20,000) 12,000Berlin Ltd (no post-acquisition profits) –

32,000



6 D All balances with associates are retained on consolidation.

CUH 50 CRS1 80 CR

130 CR

The CU75,000 DR in S2 disappears once adjustment has been made for cash in transit.

7 B

CUHot Ltd 40,000Warm Ltd 36,000

76,000

8 B

CUHouse Ltd 750,000Window Ltd 500,000

1,250,000

9 B

Share of PAT (110,000 35%) 38,500Less Impairment (2,560)

35,940

10 B

CUGrape Ltd 100,000Pear Ltd 100,000Plum Ltd (40% 100,000) 40,000

240,000

11 C

CUCost of investment in Eve Ltd 55,000Share of post acquisition change in net assets (30% (310,000 - 170,000)) 42,000

97,000

As the excess of fair value over carrying amount at the date the investment was made wassubsequently reflected in Eve Ltd's books, no fair value adjustment needs to be made at 31December 20X4.

12 B

CUmMinority interest

Peel (20% 24) 4.800

Gladstone (10% (12 – 0.25)) 1.1755.975

13 C

Under BFRS the amount of the loss is restricted to the carrying amount of the investment.



13

14 HALEY LTD


CUASSETSNon-current assetsProperty, plant and equipment (30,000 + 100,000) 400,000Intangibles (W3) 3,000Investments in associates (W6) 48,600

451,600Current assets (345,000 + 160,000) 505,000Total assets 956,600


Ordinary share capital 250,000Retained earnings (W5) 472,600

Attributable to equity holders of Haley Ltd 722,600Minority interest (W4) 84,000Equity 806,600Current liabilities (100,000 + 50,000) 150,000Total equity and liabilities 956,600

WORKINGS

(1) Group structure

(2) Net assets

Socrates LtdBalance Post

sheet date Acquisition acquisitionCU CU CU

Share capital 30,000 30,000 –Retained earnings 180,000 70,000 110,000

210,000 100,000

Aristotle LtdBalance Post

sheet date Acquisition acquisitionCU CU CU

Share capital 60,000 60,000 –Retained earnings 100,000 30,000 70,000

160,000 90,000

Haley Ltd

60%

Socrates Ltd Aristotle Ltd

30%



(3) Goodwill

SocratesLtd

CUCost of investment 75,000Share of net assets acquired (60% 100,000 (W2)) (60,000)



CU'000Socrates Ltd (40% 210) 84


CUHaley Ltd 400,000Socrates Ltd (60% 110,000 (W2)) 66,000

Aristotle Ltd (30% 70,000 (W2)) 21,000Less Impairment to date (12,000 + 2,400) (14,400)

472,600

(6) Investment in associates

CUCost of investment in Aristotle Ltd 30,000Share of post acquisition change in net assets (30% 70,000 (W2)) 21,000

51,000Impairment to date (2,400)

48,600

15 CORFU LTD


CU'000Revenue (W2) 15,086Cost of sales and expenses (W2) (13,534)

1,552Share of profit of associates (W4) 178Profit before tax 1,730Income tax expense (W2) (736)Profit after tax 994

Attributable toEquity holders of Corfu Ltd () 964Minority interest (W3) 30

994



13

WORKINGS

(1) Group structure

Corfu Ltd

Zante Ltd

80% 30%

Paxos Ltd


Corfu Ltd Zante Ltd Adj Consol5/12

CU'000 CU'000 CU'000 CU'000Revenue 12,614 2,567 (50) 15,086

Re Paxos (30% 150,000) (45)C of S

Per Q (11,318) (2,302) 50 (13,534)Re Paxos (30% (150,000 100/125)) 36

Income tax (621) (115) (736)150


CU'000Zante Ltd (20% 150,000 (W2)) 30

(4) Share of profit of associates

CU'000Paxos Ltd (30% 594) 178

16 KING LTD

(a) Consolidated income statement for the year ended 30 September 20X9

CU'000Revenue (W2) 1,150Cost of sales and expenses (W2) (743)

407Share of profit of associates (W5) 19Profit before tax 426Income tax expense (W2) (125)Profit after tax 301

Attributable toEquity holders of King Ltd () 275Minority interest (W3) 26

301



Consolidated statement of changes in equity for the year ended 30 September 20X9(extract)


Net profit for the period 275Final dividends on ordinary shares (70)

205Balance brought forward (W4) 672Balance carried forward 877

WORKINGS

(1) Group structure

King Ltd

Prawn Ltd

80% 25%

Madras Ltd


King PrawnLtd Ltd Adj Consol

CU'000 CU'000 CU'000 CU'000Revenue 800 430 (80) 1,150C of S and expenses

Per Q (550) (255) 80PURP (36 25%) (9)Impairment of goodwill re Prawn Ltd (9) (743)

Income tax (80) (45) (125)PAT 130


CU'000Prawn Ltd (130,000 20%) 26

(4) Retained earnings brought forward

CU’000King Ltd 600Prawn Ltd (80% (320 – 260)) 48

Madras Ltd (25% (540 – 340)) 50Less Impairment to date (9 + 17) (26)

672


CU000Madras Ltd ((25% 100) – 6) 19

Tutorial note

The trading between Madras Ltd and Prawn Ltd is not cancelled as Madras Ltd is not part of the 'singleentity'.



13

17 WATER LTD

(a) Consolidated balance sheet as at 30 September 20X5


Property, plant and equipment (697,210 + 648,010) 1,345,220Intangibles (W3) 1,000Investments in associates (W7) 270,400

1,616,620Current assets

Inventories (495,165 + 388,619 – 4,000 (W6)) 879,784Trade and other receivables (415,717 + 320,540) 736,257Cash and cash equivalents (101,274 + 95,010) 196,284

1,812,325Total assets 3,428,945


Ordinary share capital 600,000Retained earnings (W5) 1,353,200

Attributable to equity holders of Water Ltd 1,953,200Minority interest (W4) 203,200Equity 2,156,400Non-current liabilities

Borrowings (400,000 + 150,000) 550,000Current liabilities

Trade and other payables (440,366 + 282,179) 722,545Total equity and liabilities 3,428,945

(b) Required accounting treatment for different levels of investment

(i) Control

The investment will be treated as a subsidiary and consolidated in accordance with BAS 27Consolidated and Separate Financial Statements.

The ability to direct the decision making of the undertaking means that full consolidation isappropriate. The assets/liabilities and income/expenses under group control are shown asone.

The minority share is shown in order to indicate the proportion not owned by the group.

(ii) Significant influence

Many investments involve the influencing of decisions rather than outright control.

Such investments are treated as associates and equity accounted on consolidation inaccordance with BAS 28 Investments in Associates.

This level of involvement is reflected by showing the underlying value of the investment in thebalance sheet and the share of profit in the income statement.

(iii) Simple investment

Here the investor has no significant involvement in the investee undertaking.

Consequently only amounts paid/payable or received/receivable are reflected in the groupaccounts.

The cost of such investments is shown in the balance sheet, whilst dividend income isreflected in the income statement.



(c) Explanation of accounting methods used

(i) Subsidiary – Impact on balance sheet

100% of the net assets of a subsidiary will be included on a line-by-line basis.

Intra-group balances will be contra'd out.

Unrealised profits on intra-group sales of inventory and property, plant and equipmentwill be removed.

Goodwill is recognised if the cost of the acquisition exceeds the share of the fair value ofthe net assets acquired.

Consolidated retained earnings will include

– Parent company's percentage of subsidiary's post-acquisition profits– Cumulative goodwill impairments to date.

The minority interest will show the value of the net assets included in the consolidatedbalance sheet but owned by 'outside' interests.

(ii) Associate – Impact on balance sheet

The cost of the investment is increased by the share of the post acquisition increase inthe associate's net assets and decreased by any impairment losses.

Consolidated retained earnings will include

– The parent company's percentage of the associate's post-acquisition profits– Cumulative investment impairments to date.

WORKINGS

(1) Group structure

Water Ltd

Hydrogen Ltd

80% 40%

Oxygen Ltd



13

(2) Net assets

Hydrogen Ltd

Balance sheet Post-date Acquisition acquisition

CU CU CU CUShare capital 200,000 200,000 –Retained earnings

Per question 820,000Less: PURP (W6) (4,000)

816,000 500,000 316,0001,016,000 700,000

Oxygen Ltd


CU CU CUShare capital 200,000 200,000 –Retained earnings 463,000 242,000 221,000

663,000 442,000

(3) Goodwill

Hydrogen Ltd

CUCost of shares 562,000Share of net assets acquired (80% 700,000 (W2)) (560,000)



CUShare of net assets (20% 1,016,000 (W2)) 203,200


CUWater Ltd 1,015,000Hydrogen Ltd (80% 316,000 (W2)) 252,800

Oxygen Ltd (40% 221,000 (W2)) 88,400Less Impairment to date (1,000 + 2,000) (3,000)

1,353,200

(6) PURP

% CUSP 125 20,000Cost (100) (16,000)GP 25 4,000


CUCost of investment in Oxygen Ltd 184,000Share of post acquisition change in net assets (40% 221,000 (W2)) 88,400


270,400



18 NOTLEY LTD

(a) Investment in Blackmore Ltd

Income statement for the year ended 30 June 20X6 – Share of profit of associates

CUGroup share of profit 1 Feb X6-30 June X6 ((CU415,750 - CU328,000) x 30%) 26,325Less: Impairment (W1) (11,325)

15,000

Balance sheet as at 30 June 20X6 – Investment in associates

CUOriginal cost 285,000Share of post acquisition change in net assets (87,750 (W2) x 30%) 26,325

311,325Less: Impairment losses to date (W1) (11,325)Recoverable amount 300,000

Tutorial note

The recoverable amount of the associate is assessed at CU300,000 and therefore an impairment ofCU11,325 should be recognised against the associate investment in the balance sheet andrecognised as an expense in the income statement.

(b) Provisions for liabilities and charges

Provision forWarranty closure Otherprovision of division provisions Total

CU CU CU CUAt 1 July 20X5 125,000 - - 125,000Utilised in the year (60,000) - - (60,000)Income statement charge (β) 85,000 3,300,000 157,500 3,542,500At 30 June 20X6 (W3) 150,000 3,300,000 157,500 3,607,500

The warranty provision is in respect of warranties provided to customers, for periods betweentwo and five years. The provision is based on a weighted average calculation taking into accountpast claims history and future expectations.

Notley Ltd announced during the period that it would be closing a loss making division. Details ofthe closure have been fully communicated to those affected. The provision should be utilised in thenext twelve to eighteen months.

Other provisions consist of compensation claims made by customers. This amount is an estimatebased on claims made to date. The provision should be utilised in the next three years.

(c) Consolidated statement of changes in equity

Share Share Revaluation Retainedcapital premium reserve earnings Total

CU CU CU CU CUBalance at 30 June 20X5 100,000 - 275,000 780,000 1,155,000Gain on revaluation(450 – 275)

- - 175,000 - 175,000

Net loss for the period (W4) - - - (823,500) (823,500)Total recognised income and 100,000 - 450,000 (43,500) 506,500expense for the periodDividends - - - (25,000) (25,000)Share issue 20,000 10,000 - - 30,000Balance at 30 June 20X6 120,000 10,000 450,000 (68,500) 511,500



13

WORKINGS

(1) Impairment

CUCost plus share of post-acquisition change in net assets (CU285,000 + CU26,325) 311,325Recoverable amount (per Q) (300,000)Impairment 11,325

(2) Net assets


CU CU CUShare capital 500,000 500,000 –Retained earnings 415,750 328,000 87,750

915,750 828,000 87,750

(3) Warranty provision

(55% x nil) + (35% x CU300,000) + (10% x CU450,000) = CU150,000

Division closure: CUEmployee redundancies 2,500,000Lease termination costs 800,000Total provision 3,300,000

Other provision CU75,000 x 70% x CU3 = CU157,500

(4) Net profit for period

CUPer question (3,484,000 – 780,000) 2,704,000Adjustment (1) – associate 15,000Adjustment (2) – provisions (3,542,500)Loss for period (823,500)





P Ltd: Consolidated balance sheet as at 31 December 20X8

CUIntangibles (W3) 64Investments in associates (W6) 1,860Sundry assets (6,600 + 5,800) 12,400

14,324

Share capital 1,000Retained earnings (W5) 7,564Attributable to equity holders of P Ltd 8,564Minority interest (W4) 760Equity 9,324Liabilities (3,000 + 2,000) 5,000

14,324

WORKINGS

(1) Group structure

Group

P

S

80% 40%

A

(2) Net assets

Balancesheet Post-date Acquisition acquisitionCU CU CU

S LtdShare capital 400 400 –Retained earnings 3,400 520 2,880

3,800 920

A LtdShare capital 800 800Retained earnings 3,600 400 3,200

4,400 1,200

(3) Goodwill

CUS LtdCost of investment 800Net assets acquired (80% 920 (W2)) (736)Balance c/f 64


CUS Ltd (20% 3,800) 760



13


CUP Ltd 4,000S Ltd (80% 2,880 (W2)) 2,304

A Ltd (40% 3,200 (W2)) 1,280Impairment to date (20)

7,564


CUOriginal cost 600Share of post acquisition change in net assets (40% 3,200 (W2)) 1,280

1,880Impairment losses to date (20)

1,860


P Ltd: Consolidated income statement for the year ending 31 December 20X8

CURevenue (W2) 26,000Cost of sales (W2) (13,000)Gross profit 13,000Administrative expenses (W2) (8,000)Profit from operations 5,000Investment income (W2) 1,000Share of profit of associates (W4) 840Profit before tax 6,840Income tax expense (W2) (2,200)Profit after tax 4,640

Attributable to:Equity holders of P Ltd () 4,480Minority interest (W3) 160

4,640

WORKINGS

(1) Group structure

Group

P

S

80% 40%

A



Revenue 14,000 12,000 26,000Cost of sales (9,000) (4,000) (13,000)Admin expenses (2,000) (6,000) (8,000)Inv. income 1,000 – 1,000Tax (1,000) (1,200) (2,200)

800


CUS Ltd (20% 800 (W2)) 160




CUA Ltd ((40% 2,400) – 120) 840


1 Account for the dividend in the books of the individual companies

CU CUA's booksDR Retained earnings (1) 100CR Payables (2) 100

CU CUP's booksDR Receivables (40% 100) (3) 40CR Income statement (4) 40

2 Impact on CBS and workings

(1) = Adjust in A's net assets working (i.e. W2).(2) = Can effectively ignore as net assets part of A's balance sheet is not used in the workings.(3) = Include in receivables in consolidated balance sheet.(4) = Include in retained earnings schedule (i.e. W5).


Consolidated balance sheet journal

CU CUDR P's retained earnings (35% (50,000 40%)) 7,000CR Investment in A 7,000


In the consolidation schedule (W2) reduce P's revenue by CU17,500 (35% 50,000) and its cost of sales by

CU10,500 (17,500 (100 – 40)%). The effect is to reduce P's profit by CU7,000.


(a) Consolidated balance sheet journal

CU CUDR P's share of A's post acquisition retained earnings (35% (50,000 40%)) 7,000CR P's inventories 7,000

The effect on retained earnings can best be dealt with by adjusting A's net assets in the net assets working

(W2) by 100% of the PURP (so CU20,000 (50,000 40%)) before calculating P's 35% share of A's postacquisition retained earnings.

(b) Share of profit of associates for consolidated income statement

CU

Associate’s PAT 75,000Less: Unrealised profit (20,000)

55,000Group share 35% 19,250

Contents

chapter 14

Group accounts: disposals

Introd

Exam

Topi

1

2

3

4

5

6

7

Summ

Techn

Answ

Answ

uction

ination context

c List

Introduction

Treatment of disposal in parent company'sown financial statements

Full disposal of a subsidiary

Partial disposal of a subsidiary: retention ofcontrol

Partial disposal of a subsidiary: retention ofsignificant influence

Partial disposal of a subsidiary: retention of noinfluence

Disposal of an associate

ary and Self-test

ical reference

ers to Self-test


ers to Interactive questions



Introduction


Account for the complete and partial disposal of a subsidiary in the parent's books and in thegroup accounts

Account for the complete and partial disposal of an associate in the parent's books and in thegroup accounts

Explain how the underlying principles of group accounts are applied in accounting fordisposals

Specific syllabus references for this chapter are: 1g, 3d,e.


So far, we have been looking at the circumstances in which one entity acquires an investment in anotherentity. However, the decision to dispose of an investment is an equally important decision. A company maydecide to dispose of an investment for a number of reasons, including:

The need to generate cash The fact that the investment does not fit in with future strategic plans Underperformance of the investment

This chapter considers the accounting treatment of the disposal of a subsidiary or associate.

Stop and think

What kinds of strategic decisions might lead to the disposal of an investment?

Working context

Where a subsidiary has been disposed of there are a number of key issues which the accountant will needto consider. The most important of these considerations will include establishing the date of disposal andthe net assets of the subsidiary at the disposal date. The disposal must be appropriately accounted for anddisclosed.

Syllabus links

This topic is introduced in Financial Accounting and is also relevant to the Financial & Corporate Reportingpaper. More complex aspects are covered at the Advanced Stage.

GROUP ACCOUNTS: DISPOSALS


14

Examination context


Preparation of consolidated financial statements represents 35% of the syllabus and disposals of subsidiariesand associates forms part of this. This topic could be examined in either the written test or the short-formquestion section of the paper. Short-form questions are likely to focus on the calculation of the group profitor loss on disposal. Written test questions are more likely to focus on the impact of the disposal on theconsolidated financial statements as a whole.

In the examination candidates may be required to:

Prepare consolidated financial statements including the effects of the disposal of a subsidiary or anassociate

Prepare extracts to the consolidated financial statements including the calculation of the group profitor loss on disposal of a subsidiary or an associate

Explain the principles behind the treatment of the disposal of a subsidiary or an associate.



1 Introduction

Section overview

An entity may dispose of all or some of its shares in a subsidiary.

1.1 Disposal possibilities

When a group disposes of all or part of its interest in a subsidiary this needs to be reflected in the parent'sindividual financial statements and in the group financial statements.

The disposal may be:

A full disposal i.e. the entire shareholding is sold A partial disposal i.e. some interest is retained in the entity

Partial disposals could include the following situations:

Retention of control i.e. the entity remains a subsidiary Retention of significant influence i.e. the entity becomes an associate Retention of no influence i.e. the entity becomes a trade investment

Similarly a group may dispose of an associate. It may dispose of all of its interest or retain a small tradeinvestment.

Both full disposal and partial disposals of subsidiaries and associates are examinable in the FinancialAccounting syllabus.

2 Treatment of disposal in parent company's ownfinancial statements

Section overview

A profit or loss will be calculated by comparing the sale proceeds with the carrying amount of theproportion of the investment disposed of.

2.1 Recording the disposal

In the individual financial statements of the parent company the investment in the subsidiary or associatewill have been recorded as follows:

Balance sheet

Non-current asset investment (normally at cost)

Income statement

Dividend income receivable from the subsidiary or associate

When all or part of the investment is sold this will be treated as a non-current asset disposal. This willusually give rise to a profit or loss on disposal in the parent's individual financial statements.The disposal will be recorded as follows:

CU CUDR Cash/receivables (proceeds) XCR Investment in S or A (Carrying amount – usually cost) XDR or CR Income statement loss/profit on disposal X or X



14

3 Full disposal of a subsidiary

Section overview

The subsidiary disposed of will not be included in the consolidated balance sheet.

In the consolidated income statement.

– The results of the subsidiary should be time-apportioned and consolidated up to the date ofdisposal

– The minority interest will be based on the subsidiary’s results up to the date of disposal– The group profit or loss on disposal should be recognised

In the consolidated statement of changes in equity the balances relating to the minority interest in thesubsidiary sold will be removed.

3.1 Consolidated balance sheet

The consolidated balance sheet (like any other balance sheet) shows the financial position at a particularpoint in time (i.e. the balance sheet date.) As a result, if a subsidiary has been disposed of during the year,that subsidiary will not be reflected in the consolidated balance sheet. A consolidated balance sheetwill only need to be prepared if the parent has other subsidiaries and will be prepared as though thesubsidiary disposed of had never existed.

3.2 Consolidated income statement

When a subsidiary is disposed of, its resources cease to be controlled by the group at the date of disposal.Prior to that point, they are under the group's control and therefore the results of the subsidiary up tothe disposal date must be included in the consolidated income statement. So there will always be aconsolidated income statement in the year of disposal, even if the parent has no other subsidiaries. Theconsolidated income statement will include:

S's results up to the date of disposal

If there is a minority interest in the subsidiary, their share of S's results up to the date ofdisposal

The profit or loss arising on the disposal

3.3 Group profit/loss on disposal

The profit or loss on disposal is the difference between the sales proceeds and the parent's totalinvestment in the subsidiary, i.e. the values in respect of the subsidiary which would appear in aconsolidated balance sheet prepared immediately before the disposal. These values are the sum of:

P's share of S's net assets at the date of disposal. These net assets will be the net assets at thestart of the year in which the disposal takes place, plus/minus the net asset increase/decrease arisingthrough S's profit/loss in the period up to the disposal and minus any dividends paid by S in thatperiod; and

The goodwill acquired in the business combination with S, to the extent that it has not alreadybeen recognised as an expense as a result of impairment reviews.



So the calculation is as follows:

CU CUProceeds XLess:

Share of net assets at disposalNet assets brought forward XProfit/(loss) to date of disposal X/(X)Dividends paid (see points to note 1) (X)

XP's share (X)

XLess:Carrying amount of goodwill at date of disposal

Cost of investment XShare of net assets at acquisition (X)Goodwill at acquisition XImpairment to date (X)

(X)Profit/(loss) on disposal X/(X)

Points to note

1 The retained reserves/net assets at the date of disposal of the subsidiary should be calculateddeducting only those dividends to which the parent is entitled i.e. dividends paid up to the date ofdisposal (and dividends declared if the shares are sold ex-dividend).

2 In examination questions you should assume that a subsidiary which is fully disposed of is a separatelyreportable business segment and meets the BFRS 5 Non-current Assets Held for Sale and DiscontinuedOperations definition of a discontinued activity (the presentation of discontinued operations wasdiscussed in Chapter 4). As such the disposal should be disclosed in accordance with BFRS 5.

These learning materials adopt the approach illustrated in BFRS 5 1G example 11. This includes a one lineentry in the income statement which incorporates both the subsidiary's results up to the date of disposaland the group profit or loss arising on disposal. You should adopt this approach in the examination.

Interactive question 1: Profit/loss on disposal [Difficulty level: Exam standard]

Champion Ltd has held a 70% investment in Hercules Ltd for many years. On 31 December it disposed ofall of this investment. Further details are as follows:

CUCost of investment 2,000Hercules Ltd's net assets at the date of acquisition 1,900Sale proceeds 2,100Hercules Ltd's net assets at the date of disposal 2,400

Requirement

Calculate the profit/loss on disposal:

(a) In Champion Ltd's individual accounts

(b) In the consolidated accounts assuming that in respect of goodwill

(i) There has been no impairment(ii) There has been an impairment loss of CU470




14

Solution

(a) Champion Ltd's separate financial statements

CUProceedsCostProfit on disposal

(b) Consolidated financial statements

No impairment Impairment of CU470CU CU CU CU

ProceedsLess: Share of net assets at date of disposal

Less: Carrying amount of goodwill at dateof disposalCost of investmentShare of net assets at acquisition

Goodwill at acquisitionImpairment to date

Profit/(loss) on disposal


3.4 Consolidated statement of changes in equity

There will almost always be a need for a consolidated statement of changes in equity (CSCE) in the year ofdisposal (the only exception would be if the parent had no other subsidiaries and there had been nominority interest in the subsidiary now disposed of). In relation to the subsidiary disposed of, the CSCE willcontain the following in the minority interest column:

S's current period profit (to the date of disposal) attributable to the minority interest. This reflects theminority interest amount shown in the consolidated income statement

The minority interest in S's share capital and retained earnings brought forward, i.e. the minorityinterest as shown in the previous period's consolidated balance sheet

A deduction for the total of the above amounts. This deduction must be made because at theend of the current period there will be no minority interest in relation to S, which has now beendisposed of

Point to note

There is no need to make a similar deduction in the CSCE for P's share of S's post-acquisition retainedearnings brought forward plus P's share of S's current period profits. That deduction has in effect alreadybeen made by the profit or loss on disposal calculation.

Worked example: Full disposal

Ben Ltd bought 80% of the share capital of Bill Ltd for CU950,000 on 1 October 20X1. At that date BillLtd's retained earnings stood at CU510,000.

Ben Ltd has several other subsidiaries, which are wholly owned.



The balance sheets at 30 September 20X8 and the summarised income statements to that date are givenbelow:

Balance sheetsBen Ltd Bill LtdGroup

CU'000 CU'000Property, plant and equipment 2,050 600Investment in Bill Ltd 950 –Current assets 2,700 1,300

5,700 1,900

Share capital (CU1 ordinary shares) 2,000 300Retained earnings 2,500 1,100

4,500 1,400Current liabilities 1,200 500

5,700 1,900

Income statementsCU'000 CU'000

Profit before interest and tax 1,400 180Income tax expense (400) (50)Profit for the period 1,000 130

Statement of changes in equity (extract)CU'000 CU'000

Profit for the period 1,000 130Retained earnings at 30 September 20X7 1,500 970Retained earnings at 30 September 20X8 2,500 1,100

No entries have been made in the accounts for any of the following transactions.

Assume that profits accrue evenly throughout the year. To date no impairment losses on goodwill havebeen recognised. The Box Ltd group figures exclude any amounts for Bill Ltd.

Requirement

Prepare the consolidated balance sheet, income statement and statement of changes in equity extract at 30September 20X8 on the basis that Ben Ltd sells its entire holding in Bill Ltd for CU2,100,000 on 30September 20X8.

You should assume that the disposal is a discontinued operation in accordance with BFRS 5 Non-currentAssets Held for Sale and Discontinued Operations.

Solution

Ben and Bill

Consolidated balance sheet as at 30 September 20X8

CU'000Property, plant and equipment 2,050Current assets (2,700 + 2,100) 4,800

6,850

Share capital 2,000Retained earnings (W4) 3,650

5,650Current liabilities 1,200

6,850



14


CU'000Continuing operationsProfit before tax 1,400Income tax expense (400)Profit for the period from continuing operations 1,000Discontinued operationsProfit for the period from discontinued operations (678 + 130) (W1 + W2) 808Profit for the period 1,808

Attributable to:Equity holders of Ben Ltd (β) 1,782Minority interest (20% 130) 26

1,808

Consolidated statement of changes in equity (extract)

Ben Ltd MinorityRetained interestearnings (Bill Ltd)CU'000 CU'000

Profit for the year 1,782 26Eliminated on disposal of subsidiary (26 + 254 (W5)) – (280)

1,782 (254)Balance at 30 September 20X7 (W3 + W5) 1,868 254Balance at 30 September 20X8 (W4) 3,650 –

WORKINGS

(1) Profit of Bill Ltd for year to disposal

CU'000PAT 130 12/12 130

(2) Profit on disposal of Bill Ltd

CU'000 CU'000Sale proceeds 2,100

Less: Share of net assets at disposal (1,400 80%) (1,120)

980

Less: Carrying amount of goodwill at date of disposalCost of investment 950

Share of net assets at acquisition (80% (300 + 510)) (648)

(302)678

(3) Retained earnings brought forward

CU'000Ben Ltd 1,500Bill Ltd (80% x (970 – 510)) 368

1,868



(4) Retained earnings carried forward

CU'000Ben Ltd 2,500Profit on disposal (2,100 – 950) 1,150

3,650

(5) MI b/f

CU'000Share capital 300Retained earnings b/f 970

1,270 20% 254

Point to note

The profit on disposal figure in the retained earnings carried forward balance is the profit which wouldappear in Ben Ltd's own income statement.

This adjustment is required as Ben Ltd's own financial statements do not reflect the disposal. (We are toldthat no entries have been made in respect of this transaction.)

Interactive question 2: Full disposal [Difficulty level: Exam standard]

Daring Ltd has a number of subsidiaries, one of which, Glory Ltd, was sold in the current year. The draftaccounts for the Daring Group (being Daring Ltd and the subsidiaries it still has) and Glory Ltd at 31 March20X1 are as follows:

Balance sheets

Daring GloryGroup LtdCUm CUm

Intangibles – goodwill 4,000 –Investment in Glory Ltd at cost 3,440 –Sundry assets 42,450 9,500

49,890 9,500

Share capital (CU1 ordinary shares) 8,000 3,000Retained earnings 11,000 3,500Attributable to equity holders of Daring Ltd 19,000 6,500Minority interest 12,000 –Equity 31,000 6,500Liabilities 10,000 3,000Sales proceeds account 8,890 –

49,890 9,500

Income statements

Daring GloryGroup LtdCUm CUm

Profit before tax 12,950 3,800Income tax expense (5,400) (2,150)Profit after tax 7,550 1,650

Attributable to:Equity holders of Daring Ltd 5,050Minority interest 2,500

7,550



14

Statements of changes in equity

Daring Group Glory LtdAttributable to equity holders of

DaringLtd

Share Retained Minoritycapital earnings Total interest TotalCUm CUm CUm CUm CUm CUm

Profit for the year – 5,050 5,050 2,500 7,550 1,650Balance b/f 8,000 5,950 13,950 9,500 23,450 4,850Balance c/f 8,000 11,000 19,000 12,000 31,000 6,500

Daring Ltd acquired 90% of Glory Ltd when the retained earnings of Glory Ltd were CU700m. In an earlieraccounting period an impairment loss of CU20m was recognised in relation to the goodwill arising on theacquisition of Glory Ltd.

On 31 December 20X0 Daring Ltd sold all its shares in Glory Ltd for CU8,890m. Daring Ltd has debitedcash and credited a sales proceeds account in the balance sheet with this amount, as it is unsure whatentries are needed.

Requirement

Prepare the Daring Group consolidated balance sheet, consolidated income statement and consolidatedstatement of changes in equity for the year ended 31 March 20X1.

You should assume that the disposal of Glory Ltd constitutes a discontinued operation in accordance withBFRS 5 Non-current Assets Held for Sale and Discontinued Operations.

Solution

Daring Group

Consolidated balance sheet at 31 March 20X1

CUmIntangibles – goodwillSundry assets

Share capital (CU1 ordinary shares)Retained earningsAttributable to equity holders of Daring LtdMinority interestEquityLiabilities


CUmContinuing operationsProfit before tax (W2)Income tax expense (W2)Profit for the period from continuing operationsDiscontinued operationsProfit for the period from discontinued operations (W4 and W5)Profit for the period

Attributable to:Equity holders of Daring Ltd ()Minority interest




Attributable to equity holders ofDaring Ltd

Share Retained Minoritycapital earnings Total interest TotalCUm CUm CUm CUm CUm

Profit for the yearEliminated on disposalof subsidiary (W9)Balance b/f (W7 and W8)Balance c/f

WORKINGS

(1) Group structure

(2) Consolidation schedule for CIS

DaringGroup ConsolCUm CUm

Profit before taxTax

(3) Minority interests in Glory Ltd for CIS

CUm

(4) Profit of Glory Ltd for year to disposal

CUm

(5) Profit on disposal of Glory Ltd for CIS

CUm CUmSale proceedsLess: Share of net assets at disposal

Less: Carrying amount of goodwill at date of disposalCost of investmentShare of net assets at acquisitionGoodwill at acquisitionImpairment to date

(6) Net assets at disposal

CUmShare capitalRetained earnings b/fProfit for year to disposal (W4)



14

(7) Group retained earnings b/f for CSCE

CUmDaring GroupGlory LtdGoodwill impairment to date

(8) Minority interest b/f for CSCE

CUm

(9) Minority interest eliminated on disposal

CUm


4 Partial disposal of a subsidiary: retention of control

Section overview

In the consolidated balance sheet the subsidiary should be consolidated based on the year-endholding.

In the consolidated income statement:

– The minority interest should be time apportioned reflecting the pre and post disposal stake.– The group profit or loss on disposal should be recognised and separately presented

In the CSCE an amount will be added representing the increase in the minority interest in the netassets at the date of disposal.

4.1 Subsidiary to subsidiary

A parent entity may sell some of its shares in a subsidiary but still retain control. For example, a 90% stakecould be reduced to a 60% stake.

Point to note

For disclosure purposes you should assume that this does not constitute a discontinued operation.


The accounting treatment would be as follows:


– As the parent company still holds a subsidiary at the balance sheet date the assets and liabilities ofthe subsidiary should be consolidated as normal.

– The minority interest should be calculated based on the year-end holding.


– As the parent has held a subsidiary throughout the period the revenues and expenses should beconsolidated as normal (i.e. 100% for the whole year).



– The change in % holding is reflected in the minority interest calculation. This should becalculated to reflect the pre and post disposal situation.

– The group profit or loss should be calculated and recognised.

Worked example: Minority interest

At the start of its year, on 1 January 20X7, Pine Ltd owned 90% of Sycamore Ltd. On 30 June 20X7 PineLtd disposed of 1/3 of its shares in Sycamore Ltd. Sycamore Ltd has a profit after tax for the year ended 31December 20X7 of CU600,000.

In the consolidated income statement the minority interest will be calculated as follows:

Minority interest

CUCU600,000 x 10% x 6/12 = 30,000CU600,000 x 40% x 6/12 = 120,000

150,000

Point to note

In the above worked example Pine Ltd disposed of 1/3 of its 90% shareholding i.e. 30% of the company.Pine Ltd's holding was therefore reduced from 90% to 60% increasing the minority interest from 10% to40%.

4.3 Group profit or loss

The group profit or loss is calculated in essentially the same way as for the full disposal (see section 3.3above). Care must be taken, however, to ensure that the correct proportions of net assets and goodwillare brought in to the calculation.

Worked example: Partial disposal: profit/loss on disposal

Leeds Ltd has held a 90% investment in York Ltd for many years. On 31 December it disposed of 1/3 of itsinvestment. Further details are as follows:

CU’000 CU’000Cost of investment 2,500York Ltd net assets at acquisition 1,900Sale proceeds 900York Ltd net assets at disposal 2,400

There has been no impairment of goodwill.

The profit or loss in the group accounts would be calculated as follows:

CU’000 CU’000Proceeds 900Less: Share of net assets at disposal disposed of (30% x 2,400) (720)

180Less: Carrying amount of goodwill at disposal relating to disposal

Cost of investment 2,500Share of net assets at acquisition (90% x 1,900) (1,710)Goodwill at acquisition 790Relating to disposal (790 x 1/3) (263)

Loss on disposal (83)



14

30% of the net assets at disposal are brought in to the above calculation as the net assets relate to thecompany as a whole.

1/3 of the goodwill is brought in to the above calculation as the goodwill only relates to the 90% share inYork Ltd originally held by Leeds Ltd.

In other words, Leeds Ltd has disposed of 30% of York Ltd but 1/3 of its investment.

Point to note

The profit or loss on disposal will normally be presented separately on the face of the consolidatedincome statement.

Consolidated income statement (extract)

CU'000Profit from operations XLoss on sale of interest in subsidiary (83)Profit before tax XIncome tax expense (X)Profit for period X

4.4 Consolidated statement of changes in equity

In relation to the subsidiary partly disposed of, the CSCE will contain the following in the minority interestcolumn:

S's current period profit attributable to the minority interest.

The minority interest in S's share capital and retained earnings brought forward i.e. theminority interest as shown in the previous period's consolidated balance sheet.

An adjustment representing the increase in the minority interest (due to the part disposal) in thenet assets at the date of the change in stake. This must be added because the minority interestat the end of the current period will be based on the year-end position.

Worked example: Adjustment representing increase in the minority interest

Apple Ltd owned 80% of Orange Ltd on 1 January 20X7 when the net assets of Orange Ltd wereCU675,000. Apple Ltd disposes of one quarter of its shares in Orange Ltd on 31 December 20X7 when thenet assets of Orange Ltd are CU750,000. The net profit of Orange Ltd for the year is CU75,000.

The minority interest, which increases from 20% to 40% during the year as Apple Ltd’s shareholdingdecreases from 80% to 60%, would be reflected in the consolidated statement of changes in equity asfollows:


MinorityinterestCU'000

Profit for year (75,000 x 20% x 12/12) 15,000Partial disposal of subsidiary (20% x 750,000) 150,000

165,000Balance at 31 December 20X6 (675,000 x 20%) 135,000Balance at 31 December 20X7 (750,000 x 40%) 300,000



5 Partial disposal of a subsidiary: retention ofsignificant influence

Section overview

In the consolidated balance sheet the investment is accounted for as an associate based on the year-end holding.

In the consolidated income statement:

– The results are consolidated up to the date of disposal– The equity method is used for the post-disposal period– The group profit or loss on disposal should be recognised and separately presented

In the CSCE the balances relating to the minority interest in the subsidiary sold will be removed.

5.1 Subsidiary to associate

A parent entity may sell some of its shares in a subsidiary but still retain significant influence. Forexample, an 80% stake could be reduced to a 40% stake.

Point to note

For disclosure purposes you should assume that this does not constitute a discontinued operation.




– The investment is accounted for using the equity method based on the year-end holding.


– This reflects the pre and post disposal situation therefore the subsidiary's results are timeapportioned and:

Consolidated up to the date of disposal

Equity accounted for in the post-disposal period.

– The group profit or loss on disposal should be calculated and recognised and is normallyseparately presented on the face of the income statement (see section 4.3 above).

Consolidated statement of changes in equity

In relation to the subsidiary partly disposed of, the CSCE will contain the following in the minority interestcolumn:

– S's current period profit (to the date of disposal) attributable to the minority interest. Thisreflects the minority interest shown in the consolidated income statement.

– The minority interest in S's share capital and retained earnings brought forward i.e.the minority interest shown in the previous period's consolidated balance sheet.

– A deduction for the total of the above amounts. This deduction must be made because at theend of the current period there will be no minority interest in relation to the subsidiary as it isnow an associate.



14

6 Partial disposal of a subsidiary: retention of noinfluence

Section overview

In the consolidated balance sheet the investment is frozen at its level under the equity method.

In the consolidated income statement

– The results are consolidated up to the date of disposal– The group profit or loss on disposal should be recognised and separately presented

In the CSCE the balances relating to the minority interest in the subsidiary sold will be removed.

6.1 Subsidiary to trade investment

A parent entity may sell a majority of its shares in a subsidiary such that it holds a small investment,without retaining control or significant influence.

For example, a 90% stake could be reduced to a 10% stake.

Point to note

For disclosure purposes you should assume that this does constitute a discontinued operation inaccordance with BFRS 5.




– The investment is recorded in the consolidated balance sheet at its value under the equitymethod, i.e. the group share of net assets and goodwill retained by the group at the date ofdisposal.

– The investment remains in the consolidated balance sheet at this value unless impaired i.e. thevalue is not updated at each subsequent year-end.


– The results of the subsidiary are time apportioned and consolidated up to the date of disposal.

– After disposal only dividend income is recognised.

– The group profit or loss on disposal is included in the presentation of the profit or loss fromdiscontinued operations as required by BFRS 5.

Consolidated statement of changes in equity

In relation to the subsidiary partly disposed of, the CSCE will contain the following in the minorityinterest column:

– S's current period profit (to the date of disposal) attributable to the minority interest. Thisreflects the minority interest shown in the consolidated income statement.

– The minority interest in S's share capital and retained earnings brought forward i.e.the minority interest shown in the previous period's consolidated balance sheet.

– A deduction for the total of the above amounts. This deduction must be made because at theend of the current period there will be no minority interest in relation to the subsidiary as it isnow a trade investment.



Point to note

This study manual makes the working assumption that the trade investment in the consolidatedbalance sheet should be recorded at its equity method value at the date of disposal. The recognitionand measurement of equity investments which are not accounted for as subsidiaries or associates, inaccordance with BAS 39 Financial Instruments: Recognition and Measurement, will be covered in moredetail in the Financial Reporting syllabus.

Interactive question 3: Partial disposal: impact on financial statements[Difficulty level: Intermediate]

Requirement

Based on the information provided in Worked example: Full disposal (see section 3 above) prepare theconsolidated balance sheet, consolidated income statement and extracts from the consolidated statement ofchanges in equity at 30 September 20X8 in the following circumstances:

(a) Ben Ltd sells one quarter of its holding in Bill Ltd for CU380,000 on 30 June 20X8.

(b) Ben Ltd sells one half of its holding in Bill Ltd for CU1,350,000 on 30 June 20X8, and the remainingholding is to be dealt with as an associate.

(Work to the nearest CU'000.)


Solution

(a) Partial disposal (subsidiary to subsidiary) mid year


CU’000Property, plant and equipmentGoodwill

Current assets

Share capital (CU1 ordinary shares)Retained earnings

Minority interest

Current liabilities



14


CU’000Profit from operationsProfit on sale of interest in subsidiaryProfit before taxIncome tax expenseProfit for the period

Attributable to:Equity holders of Ben LtdMinority interest


Ben Ltd MinorityRetained interestearnings (Bill Ltd)CU’000 CU’000

Profit for the yearPartial disposal of subsidiary

Balance at 30 September 20X7Balance at 30 September 20X8

WORKINGS

(1) Group structure


CU’000 CU’000Sale proceedsLess: Share of net assets at disposal

Less: Carrying amount of goodwill at date of disposalCost of investmentShare of net assets at acquisitionGoodwill at acquisitionRe disposal



(3) Minority interest in Bill Ltd for CIS

CU'000 CU'000

(4) Retained earnings/MI brought forward

As per worked example 1,868 254


CU'000Ben LtdAdd: Profit on disposal

Bill Ltd

(6) MI c/f

CU'000Share capitalRetained earnings

%

(b) Partial disposal (subsidiary to associate) mid year


CU'000Property, plant and equipmentInvestments in associates

Current assets

Share capital (CU1 ordinary shares)Retained earnings

Current liabilities


CU'000Profit from operationsProfit on sale of interest in subsidiaryShare of profit of associatesProfit before taxIncome tax expenseProfit for the period

Attributable to:Equity holders of Ben LtdMinority interest



14

Consolidated statement of changes in equity (extract)Ben Ltd MinorityRetained interestearnings (Bill Ltd)CU'000 CU'000

Profit for the yearEliminated on disposal of subsidiary

Balance at 30 September 20X7Balance at 30 September 20X8

WORKING

(1) Group structure

(2) Investments in associatesCU'000

Cost of associatesShare of post acquisition retained earnings

(3) Profit on disposal of Bill LtdCU'000 CU'000

Sale proceedsLess: Share of net assets at disposal

Less: Carrying amount of goodwill at date of disposal

Cost of investmentShare of net assets at acquisitionGoodwill at acquisitionRe disposal

(4) Minority interest in Bill Ltd for CISCU'000

(5) Retained earnings/MI brought forwardCU'000 CU'000

As per worked example 1,868 254

(6) Retained earnings carried forwardCU'000

Ben LtdAdd: Profit on disposal

Bill Ltd




7 Disposal of an associate

Section overview

The principles involved are similar to those relating to the disposal of a subsidiary.

7.1 Full disposal



– As the parent no longer holds an investment in the associate at the year-end the associate willnot be recognised in the consolidated balance sheet.


– Up to the date of disposal the profits of the associate will be recognised in the consolidatedincome statement using the equity method of accounting.

– The group profit or loss on disposal will be calculated as per the disposal of a subsidiary (seesection 3.3 above) and will usually be separately presented on the face of the income statement,immediately underneath the share of the associate’s profit for the pre-disposal part of the period.

7.2 Partial disposal

A parent may sell some of its shares in an associate such that it loses significant interest but still retains asmall trade investment.



– At the year end the parent company simply holds a trade investment. The investment in theformer associate is brought in to the consolidated balance sheet at its equity method value, i.e.the group share of net assets and goodwill retained by the group at the date of disposal.


– Up to the date of disposal the profits of the associate will be recognised in the consolidatedincome statement using the equity method.

– After the disposal the parent will record any dividends received, which are paid out of profitsearned after the change of status, as investment income.

– The group profit or loss on disposal will be calculated and recognised and will usually beseparately presented on the face of the income statement, immediately underneath the share ofthe associate’s profit for the pre-disposal part of the period.

Worked example: Disposal of an associate

An investor has had an investment of 40% in an associate for a number of years. During the year the groupdisposes of ¾ of its investment and no longer has significant influence. The following information isavailable:

CUCost of 40% investment 220,000Goodwill on original acquisition 20,000Proceeds received 210,000Net asset value of associate at date of sale 620,000

The goodwill was capitalised on the acquisition of the associate and has not been impaired.



14

In the consolidated balance sheet the former associate would be valued as follows:

CURemaining share of net assets (620,000 x 10%) 62,000Goodwill retained (20,000 x 1/4) 5,000

67,000

In the consolidated income statement the group profit on disposal would be calculated as follows:

CUProceeds 210,000Less: Net assets disposed of (620,000 x 30%) (186,000)

Goodwill associated with disposal (20,000 x ¾) (15,000)9,000




Summary

CBS CIS CSCE

Full disposal of S Reflect year endposition - nosubsidiary

Consolidate results todate of disposal

MI based on S’s resultsup to date of disposal

Recognise group profitor loss (combine withS’s results to date ofdisposal)

Remove balancesrelating to MI in Ssold

Partial disposal ofS: control retained

Consolidate basedon year endposition

Consolidate results forthe entire period

Time apportion MI

Recognise group profitor loss separately

Will include anadjustmentrepresenting theincrease in theminority interest inthe net assets at thedate of change

Partial disposal ofS: retention ofsignificant influence

Equity account forinvestment

Consolidate up to dateof disposal

Use equity method forpost disposal period


MI balances relatingto subsidiary soldwill be deducted

Partial disposal ofS: trade investmentheld

Include investmentat its value underthe equity method

Consolidate up to dateof disposal (then onlyrecord dividendsreceived)


MI balances relatingto subsidiary soldwill be deducted

Full disposal of A Reflect year endposition – noassociate

Equity method up todate of disposal


Partial disposal ofA: tradeinvestment held

Include investmentat its value underthe equity method

Equity method up todate of disposal (thenonly record dividendsreceived)




14

Self-test


1 On 1 January 20X1 Rainbow Ltd acquired all of Zippy Ltd's 1,000 CU1 ordinary shares. The goodwillacquired in the business combination was CU10,000 of which 40% had been written off as impaired bythe end of 20X2.

On 1 January 20X3 Rainbow Ltd sold all the shares for CU140,000 when Zippy Ltd's retained earningsamounted to CU112,000.

What is the profit on disposal which should be included as part of the profit for the period fromdiscontinued operations figure in the consolidated income statement of Rainbow Ltd?

A CU15,000B CU21,000C CU27,000D CU28,000

2 Yogi Ltd has held an 80% investment in Bear Ltd for many years. On 31 December 20X6 it disposed ofall of its investment. Details for the acquisition and disposal are as follows.

CU'000Cost of investment 7,380Fair value of Bear Ltd's net assets at acquisition (reflected in Bear Ltd's books) 9,000Sale proceeds on 31 December 20X6 9,940

Goodwill acquired in the business combination has been fully written off as a result of impairmentreviews.

The summarised balance sheet of Bear Ltd on 31 December 20X6 showed the following.

CU'000Called up share capital 3,000Retained earnings 7,350Equity 10,350

What is the profit/(loss) on disposal of the shares in Bear Ltd that will be included as part of the profitfor the period from discontinued operations figure in the consolidated income statement of Yogi Ltdfor the year ended 31 December 20X6?

A (CU410,000)B (CU1,220,000)C CU1,480,000D CU1,660,000

3 The Bill Group disposed of its 60% interest in Ben Ltd after owning it for five years. Original cost wasCU120,000 and goodwill acquired in the business combination was CU50,000. Sales proceeds wereCU250,000, and this has been posted to a suspense account in Bill Ltd's individual accounts. Ben Ltdhad net assets of CU100,000 on disposal and 50% of the original amount of the goodwill had beenwritten off as impaired.

What is the profit on disposal which will be included as part of the profit for the period fromdiscontinued operations figure within the consolidated income statement of the Bill Group?

A CU100,000B CU130,000C CU165,000D CU185,000



4 On 1 September 20X1 the Villa Group acquired 70% of Charlton Ltd's 1,000 CU1 ordinary shares.The goodwill acquired in the business combination was CU1,200.

On 1 September 20X5 the Villa Group sold all the shares for CU50,000 when Charlton Ltd's retainedearnings were CU89,000.

What is the loss on disposal which will be included as part of the profit for the period fromdiscontinued operations figure in the consolidated income statement of the Villa group?

A CU13,000B CU13,500C CU14,000D CU14,200

5 The Gill Group disposed of the following mid way through the financial year.

Tracey Ltd (100% subsidiary) for CU150,000Debbie Ltd (55% subsidiary) for CU70,000

Goodwill acquired in the business combinations has been fully written off as a result of impairmentreviews. The retained earnings of the companies are as follows.

At acquisition At disposalTracey Ltd CU70,000 CU100,000Debbie Ltd CU25,000 CU40,000

The consolidated retained earnings of the remaining Gill Group, including the profit made on thedisposal of the investments in the year were CU230,000 at 31 December 20X6.

What will be the amount for consolidated retained earnings included in the consolidated balance sheetfor the Gill Group as at 31 December 20X6?

A CU230,000B CU260,000C CU266,000D CU275,000

6 Tom Ltd acquired 75% of Bill Ltd on 1 January 20X4. The goodwill acquired in the businesscombination was CU125,000.

On 1 January 20X9 Tom Ltd disposed of its entire holding in Bill Ltd for CU820,000. On this date thenet assets of Bill Ltd amounted to CU790,000 and goodwill impairment write offs to date totalled toCU31,250.

What is the profit/(loss) on disposal which should be included as part of the profit for the period fromdiscontinued operations figure in the consolidated income statement of Tom Ltd?

A CU(63,750)B CU102,500C CU196,250D CU133,750

7 Chelsea Ltd has held an 80% investment in Hammersmith Ltd for a number of years. On 31 December20X7 it disposed of ¼ of its investment. Details of the original acquisition and disposal are as follows:

CU'000Cost of investment 8,856Fair value of Hammersmith Ltd's net assets at acquisition

(reflected in Hammersmith's books) 10,800Sale proceeds on 31 December 20X7 11,928

50% of the goodwill acquired in the business combination has been written off as a result ofimpairment reviews.



14

The summarised balance sheet of Hammersmith Ltd on 31 December 20X7 showed the following:

CU'000Called up share capital 3,600Retained earnings 8,820Equity 12,420

What is the profit on disposal of the shares in Hammersmith Ltd that will be included as part of theprofit for the period from discontinued operations figure in the consolidated income statement ofChelsea Ltd for the year ended 31 December 20X7?

CU'000A 8,796B 9,390C 9,417D 9,714

8 Maple Ltd has had a 30% investment in an associate, Ash Ltd for a number of years. The goodwill wascapitalised on acquisition of the associate and has not been impaired.

During the year the group disposed of 50% of its investment and could no longer exercise significantinfluence. The following information is available:

CUCost of investment 165,000Goodwill on acquisition 15,000Proceeds received 157,500Net asset value of associate at date of sale 620,000

What is the profit/(loss) on disposal of the shares in Ash Ltd that will be included in the consolidatedincome statement of Maple Ltd for the year ended 31 December 20X7?

A CU57,000B CU64,500C CU75,000D CU(160,000)

9 The Blair Group purchased 75% of Brown Ltd a number of years ago for CU5,000,000. The goodwillarising on that business combination was CU1,250,000. On 31 December 20X7 the Blair Groupdisposed of 80% of its shares in Brown Ltd for CU7,500,000. On this date the net assets of Brown Ltdamounted to CU8,200,000 and the amount of goodwill impairment to date was CU375,000.

In the consolidated balance sheet of the Blair Group at 31 December 20X7 at what amount will theremaining investment in Brown Ltd be stated?

A CU750,000B CU1,230,000C CU1,361,000D CU1,405,000



10 The Greatheed Group purchased a 70% investment in Gaveston Ltd on 1 January 20X4 forCU8,500,000. At that date the retained earnings of Gaveston Ltd stood at CU9,800,000. On 31December 20X7 the Greatheed Group disposed of half of its investment in Gaveston Ltd forCU5,200,000. Share capital and retained earnings of Gaveston Ltd at that date were as follows.

CU'000Share capital 1,000Retained earnings 14,500

15,500

In the consolidated balance sheet of Greatheed Ltd for the year ended 31 December 20X7 at whatamount would the remaining interest in Gaveston Ltd be shown?

CU’000A 4,250B 5,190C 5,895D 10,145

11 On 1 September 20X4 the Moorefields Group acquired 40% of Davenport Ltd’s 1,000 CU1 ordinaryshares. The goodwill was capitalised on acquisition of this associate and 50% has been written off as aresult of impairment.

During the year ended 31 December 20X7 the Moorefields Group disposed of all of its shares inDavenport Ltd. The following information is available.

CUCost of original investment 198,000Goodwill on acquisition 18,000Proceeds received on disposal 189,000Davenport Ltd’s net assets at date of sale 744,000

What is the loss on disposal of Davenport Ltd that will be included in the consolidated incomestatement of the Moorefields Group for the year ended 31 December 20X7?

A CU9,000B CU108,600C CU117,600D CU126,600

12 PARABLE LTD

Parable Ltd is a holding company with a number of subsidiaries. The consolidation for the year ended31 December 20X8 has been carried out to include all subsidiaries except Story Ltd. Story Ltd hasbeen 80% owned by Parable Ltd since 20X2, at which date Story Ltd's retained earnings amounted toCU50,000, but on 30 June 20X8 Parable Ltd sold all of its shares in Story Ltd.

Details are as follows.

CUCost of original investment (80,000 out of 100,000 CU1 ordinary shares) 150,000Goodwill acquired in the business combination fully recognised as an

expense as a result of impairment reviews 30,000Sales proceeds 500,000

Because Parable Ltd is unsure how to deal with its investment in Story Ltd in the 20X8 consolidation,it has not yet consolidated Story Ltd into the group financial statements.



14

Income statements for the year ended 31 December 20X8 are set out below.

Parable Ltd Storygroup LtdCU CU

Profit from operations 875,500 325,600Sales proceeds on disposal of Story Ltd 500,000 –Profit before tax 1,375,500 325,600Income tax expense (405,000) (102,500)Profit for the year 970,500 223,100

Attributable toEquity holders of Parable Ltd 870,300Minority interest 100,200

970,500

The Parable Ltd group and Story Ltd had retained earnings brought forward of CU1,926,300 andCU326,400 respectively. Other minority interests brought forward were CU507,500.

Requirements

(a) Prepare the consolidated income statement and the retained earnings and minority interestcolumns for the statement of changes in equity for the Parable Ltd group for the year ended 31December 20X8 in so far as the information is available. (8 marks)

(b) Redraft the above on the basis that

(i) Parable Ltd sells only a quarter of its shares in Story Ltd for CU200,000 and that thedisposal does not constitute a discontinued operation in accordance with BFRS 5.(5 marks)

(ii) Parable Ltd sells all but a 20% holding of its shares in Story Ltd, for CU400,000, retainssignificant influence and that the disposal does not constitute a discontinued operation inaccordance with BFRS 5. (5 marks)

(18 marks)

13 ARBITRARY LTD

Arbitrary Ltd holds 80% of the ordinary shares of Contrary Ltd which it purchased five years ago, on 1July 20X0, for CU175,000. On 1 July 20X5 Arbitrary Ltd sold all of these shares and used theproceeds (CU212,000) to purchase 65% of the ordinary shares of Enthusiast Ltd on the same date.Share capital of Contrary Ltd and Enthusiast Ltd has remained constant for many years at CU100,000and CU200,000 respectively. Net assets of Contrary Ltd and Enthusiast Ltd were as follows.

Contrary Ltd Enthusiast LtdAt At At

acquisition 1 January 1 January20X5 20X5

CU CU CUNet assets 187,000 150,000 280,000

Income statements and statements of changes in equity for all three companies for the year ended 31December 20X5 were as follows.



Income statements

Arbitrary Contrary EnthusiastLtd Ltd Ltd

CU CU CURevenue 1,926,500 521,600 792,400Cost of sales (1,207,200) (386,200) (405,900)Gross profit 719,300 135,400 386,500Distribution costs (207,500) (79,200) (198,200)Administrative expenses (192,600) (26,100) (107,100)Interim dividend received from Contrary Ltd 8,000 – –Profit before tax 327,200 30,100 81,200Income tax expense (110,000) (9,500) (27,500)Profit after tax 217,200 20,600 53,700

Statements of changes in equity

Retained earningsArbitrary Contrary Enthusiast

Ltd Ltd LtdCU CU CU

Net profit for the period 217,200 20,600 53,700Interim dividends on ordinary shares (paid 1 May 20X5) (50,000) (10,000) –Final dividends on ordinary shares

(declared 1 December 20X5) – (5,000) –167,200 5,600 53,700

Balance brought forward 671,300 50,000 80,000Balance carried forward 838,500 55,600 133,700

No entries have been made in Arbitrary Ltd's income statement relating to the sale of Contrary Ltd.

In an earlier accounting period an impairment loss of CU12,700 was recognised in relation to thegoodwill arising on the acquisition of Contrary Ltd.

Requirements

(a) Prepare the consolidated income statement and the retained earnings and minority interestcolumns for the statement of changes in equity for Arbitrary Ltd for the year ended 31December 20X5 in so far as the information is available. (15 marks)

Note. You should assume that the disposal of Contrary Ltd constitutes a discontinued operationin accordance with BFRS 5 Non-current assets held for sale and discontinued operations.

(b) Calculate the profit on disposal that would be shown in the individual accounts of Arbitrary Ltdand explain how and why this differs from group profit on disposal. (4 marks)

(c) Briefly discuss the concepts of control and ownership in the context of this disposal. (4 marks)

(23 marks)




14

Technical reference





1 B

CUSale proceeds 140,000Less: Share of net assets at disposal (1,000 + 112,000) (113,000)

Carrying amount of goodwill (10,000 60%) (6,000)21,000

2 D

CU'000Sale proceeds 9,940Less: Share of net assets at disposal (80% 10,350) (8,280)

1,660

If any initial goodwill has been fully written off, net assets at disposal date can be used in thiscalculation.

3 C

CUSale proceeds 250,000Less: Share of net assets at disposal (100,000 60%) (60,000)

Carrying amount of goodwill (50,000 50%) (25,000)165,000

4 D

CUSale proceeds 50,000Less: Share of net assets at disposal (70% (1,000 + 89,000)) (63,000)

Carrying amount of goodwill (1,200)(14,200)

5 A As the profit on disposal has been included within the remaining Gill Group retained earnings, nofurther adjustment is necessary.

6 D

CUSale proceeds 820,000Less: Share of net assets at disposal (790,000 75%) (592,500)

Carrying amount of goodwill (125,000 – 31,250) (93,750)133,750

7 C

CU'000Sale proceeds 11,928Less: 20% x 12,420 (2,484)

25% x 108 (see below) (27)9,417

CU'000GoodwillCost of investment 8,856Share of NA at acquisition (80% x 10,800) (8,640)

216Impaired (50%) (108)

108



14

8 A

CUProceeds 157,500NA disposed of (15% x 620,000) (93,000)Goodwill (15,000 x 50%) (7,500)

57,000

9 D

CU’000Share of net assets at disposal (15% x CU8.2m) 1,230Goodwill re remaining shares (15/75 x (1,250 – 375)) 175

1,405

10 C

CU’000Cost of investment (50% x 8,500) 4,250Increase in retained earnings (14,500 – 9,800) x 35% 1,645

5,895

11 C

CUProceeds 189,000

Less: Net assets disposed of (744,000 x 40%) (297,600)Goodwill not yet written off (18,000 x 50%) (9,000)

(117,600)

12 PARABLE LTD

(a) Consolidated income statement for the year ended 31 December 20X8

CUContinuing operationsProfit before tax 875,500Income tax expense (405,000)Profit for the period from continuing operations 470,500

Discontinued operationsProfit for the period from discontinued operations (111,550 + 69,640) (W2, W3) 181,190Profit for the period 651,690

Attributable toEquity holders of Parable Ltd () 529,180Minority interest (W4) 122,510

651,690

Consolidated statement of changes in equity for the year ended 31 December 20X8(extracts)

Equity holdersof Parable Ltd

Retained Minorityearnings interestCU CU

Net profit for the period 529,180 122,510Eliminated on disposal of subsidiary (85,280 (W6) + 22,310 (W4)) – (107,590)

529,180 14,920Balance brought forward (W5 and W6) 2,117,420 592,780Balance carried forward 2,646,600 607,700



(b) (i) Consolidated income statement for the year ended 31 December 20X8

CUOperating profit (875,500 + 325,600) 1,201,100Profit on sale of interest in subsidiary (W3) 92,410Profit before tax 1,293,510Income tax expense (405,000 + 102,500) (507,500)Profit for the period 786,010

Attributable to:Equity holders of Parable Ltd () 618,880Minority interest (W4) 167,130

786,010

Consolidated statement of changes in equity for the year ended 31 December20X8 (extracts)



Net profit for the period 618,880 167,130Partial disposal of subsidiary (W7) – 107,590Balance brought forward (W5, W6) 2,117,420 592,780Balance carried forward 2,736,300 867,500

(ii) Consolidated income statement for the year ended 31 December 20X8

CUOperating profit (875,500 + (325,600 6/12)) 1,038,300Profit on sale of interest in subsidiary (W3) 77,230Share of profit of associate (223,100 6/12 20%) 22,310Profit before tax 1,137,840Income tax expense (405,000 (102,500 6/12)) (456,250)Profit for the period 681,590

Attributable to:Equity holders of Parable Ltd () 559,080Minority interest (W4) 122,510

681,590

Consolidated statement of changes in equity for the year ended 31 December20X8 (extracts)



Net profit for the period 559,080 122,510Eliminated on disposal of subsidiary (as (a)) – (107,590)

559,080 14,920Balance brought forward (W5 and W6) 2,117,420 592,780Balance carried forward 2,676,500 607,700



14

WORKINGS

(1) Group structure

Parable Ltd group Parable Ltd group Parable Ltd group

(2) Profit for year to disposal

CUPAT of S Ltd 223,100

6/12 = 111,550

(3) Profit on disposal of operations

Partial disposal Partial disposalComplete disposal (subsidiary retained) (associate retained)

(a) (b)(i) (b)(ii)CU CU CU CU CU CU

Sale proceeds 500,000 200,000 400,000Less: Share of net assets at disposalNet assets at 1 January 20X8 426,400Profit to 30 June 20X8 (W2) 111,550

537,950 537,950 537,950 80% (430,360) 20% (107,590) 60% (322,770)

69,640 92,410 77,230

(4) Minority interest for year

Nosubsidiary Subsidiaryretained retained

(a) and (b)(ii) (b)(i)CU CU

Story Ltd (223,100 6/12 20%)((223,100 6/12 20%) + (223,100 6/12 40%)) 22,310 66,930

Other 100,200 100,200122,510 167,130


CUParable Ltd group 1,926,300Add Story Ltd (80% (326,400 – 50,000)) 221,120Less Goodwill impairment to date (30,000)

2,117,420


CUStory Ltd ((100,000 + 326,400) 20%) 85,280Other 507,500

592,780



(7) Partial disposal of subsidiary

CUNet assets at date of disposal (100,000 + 326,400 + (6/12 223,100)) 537,950

20% 107,590

13 ARBITRARY LTD

(a) Consolidated income statement for the year ended 31 December 20X5

CUContinuing operationsRevenue (W2) 2,322,700Cost of sales (W2) (1,410,150)Gross profit 912,550Distribution costs (W2) (306,600)Administrative expenses (W2) (246,150)Profit before tax 359,800Income tax expense (W2) (123,750)

Profit for the period from continuing operations 236,050

Discontinued operationsProfit for the period from discontinued operations (10,300 + 79,060) (W3 + W4) 89,360Profit for the period 325,410

Attributable toEquity holders of Arbitrary Ltd () 313,952Minority interest (W5) 11,458

325,410

Consolidated statement of changes in equity for the year ended 31 December 20X5(extracts)

Equity holdersof Arbitrary Ltd


Net profit for the period 313,952 11,458Added on acquisition of subsidiary (W8) – 107,397Eliminated on disposal of subsidiary (W9) – (32,060)Interim dividend on ordinary shares (50,000) –

263,952 86,795Balance brought forward (W6) + (W7) 629,000 30,000Balance carried forward 892,952 116,795

(b) Calculation of profit in individual accounts of Arbitrary Ltd

CUSale proceeds 212,000Less Cost (175,000)Profit 37,000

The different calculations of profit on disposal reflect the different way in which the subsidiary(Contrary Ltd) is accounted for in the individual and consolidated accounts.

In the individual balance sheet of Arbitrary Ltd Contrary Ltd is carried at cost of CU175,000. Theprofit on disposal is therefore the sale proceeds less this cost.

In the consolidated financial statements the cost of Contrary Ltd is replaced with its underlyingnet assets and with goodwill acquired in the business combination. The profit on disposal istherefore based on sale proceeds less the percentage of net assets being sold (here 80%) less theunimpaired goodwill which is being sold in full (as it only ever related to the 80% share of netassets acquired).



14

(c) Application of control and ownership ideas

Control

Up to 1 July 20X5 Arbitrary Ltd owns 80% of Contrary Ltd and therefore controls it. So theconsolidated income statement should include 100% of Contrary Ltd's profits up to that date.

After 1 July 20X5 Arbitrary Ltd no longer controls Contrary Ltd. Its results should be excludedfrom the consolidated income statement for the last six months of the year and also from theconsolidated balance sheet.

This treatment reflects the fact that once Contrary Ltd has been sold its resources are no longerunder group control.

Ownership

For the first six months of the year 100% of Contrary Ltd's profits are included in theconsolidated income statement. However, 20% of its profits are owned by the minority interestand this has to be deducted in arriving at the group's share of profit (CU20,600 x 6/12 x 20%).

When the disposal occurs the group is selling its ownership interest in the net assets and itsgoodwill. Therefore the group profit on disposal is calculated from the point of view ofownership.

WORKINGS

(1) Group structure


Arbitrary EnthusiastLtd Ltd Consol

6/12CU CU CU

Revenue 1,926,500 396,200 2,322,700C of S (1,207,200) (202,950) (1,410,150)Distrib cost (207,500) (99,100) (306,600)Admin exp (192,600) (53,550) (246,150)Tax (110,000) (13,750) (123,750)PAT 26,850

(3) Profit for year to disposal

CUPAT of C Ltd 20,600 6/12 10,300

Arbitrary Ltd

Contrary Ltd Enthusiast Ltd

65%(acq 1 July 20X5

6/12 in)

80%(sold 1 July 20X5

6/12 in)



(4) Profit on disposal of Contrary Ltd operations

CU CUSale proceeds 212,000Less: Share of net assets at disposal

Net assets at 1 January 20X5 150,000Profit to 1 July 20X5 (W3) 10,300Dividends paid (10,000)

150,300 80% (120,240)

91,760Less: Carrying amount of goodwill

Cost of investment 175,000Share of net assets at acquisition (80% 187,000) (149,600)


(12,700)79,060

(5) Minority interest in year

CUContrary Ltd (20% x 10,300 (W3)) 2,060Enthusiast Ltd (35% x 26,850 (W2)) 9,398

11,458


CUArbitrary Ltd 671,300Contrary Ltd (80% x (50,000 – (187,000 – 100,000)) (29,600)Goodwill impairment to 31 December 20X4 (12,700)

629,000


CUContrary Ltd (150,000 20%) 30,000

(8) Minority interest added on acquisition of subsidiary

CUEnthusiast Ltd ((200,000 + 80,000 + 26,850 (W2)) 35%) 107,397

(9) Minority interest eliminated on disposal of subsidiary

CUContrary Ltd

B/f (W7) 30,000Current year (W5) 2,060

32,060



14



(a) Champion Ltd's individual accounts

CUProceeds 2,100Cost (2,000)Profit on disposal 100

(b) Consolidated accounts

No impairment Impairment of CU470CU CU CU CU

Proceeds 2,100 2,100Less: Share of net assets at date of disposal (70% 2,400) (1,680) (1,680)

420 420Less:Carrying amount of goodwill at date

of disposalCost of investment 2,000 2,000Share of net assets at acquisition (1,330) (1,330)(70% 1,900)Goodwill at acquisition 670 670Impairment to date – (470)

(670) (200)Profit/(loss) on disposal (250) 220


Daring Group

Consolidated balance sheet at 31 March 20X1

CUmIntangibles – goodwill 4,000Sundry assets 42,450

46,450

Share capital (CU1 ordinary shares) 8,000Retained earnings (from CSCE) 16,450Attributable to equity holders of Daring Ltd 24,450Minority interest 12,000Equity 36,450Liabilities 10,000

46,450


CUmContinuing operationsProfit before tax (W2) 12,950Income tax expense (W2) (5,400)Profit for the period from continuing operations 7,550Discontinued operationsProfit for the period from discontinued operations (1,238 + 3,321) (W4 and W5) 4,559Profit for the period 12,109Attributable to:Equity holders of Daring Ltd () 9,485Minority interest (2,500 + 124 (W3)) 2,624

12,109




Attributable to equity holders ofDaring Ltd

Share Retained Minoritycapital earnings Total interest TotalCUm CUm CUm CUm CUm

Profit for the year – 9,485 9,485 2,624 12,109Eliminated on disposalof subsidiary (W9) – – – (609) (609)

– 9,485 9,485 2,015 11,500Balance b/f (W7 and W8) 8,000 6,965 14,965 9,985 24,950Balance c/f 8,000 16,450 24,450 12,000 36,450

WORKINGS

(1) Group structure

Daring

Glory

90% for 9/12 of year

(2) Consolidation schedule for CIS

Daring Group ConsolCUm CUm

Profit before tax 12,950 12,950Tax (5,400) (5,400)

Tutorial note. In this case the consolidation schedule only includes the results of the parent group asthose of Glory Ltd are to be treated as discontinued. (See working 4.) In an examination question it islikely that you will have to deal with another subsidiary still retained at the year end as well as thecompany disposed of so this working will be required.

(3) Minority interests in Glory Ltd for CIS

CUm1,238 (W4) 10% 124

(4) Profit of Glory Ltd for year to disposal

CUmPAT 1,650 9/12 1,238

(5) Profit on disposal of Glory Ltd for CIS

CUm CUmSale proceeds 8,890Less: Share of net assets at disposal (90% 6,088 (W6)) (5,479)

3,411Less: Carrying amount of goodwill at date of disposal

Cost of investment 3,440Share of net assets at acquisition (90% (3,000 + 700)) (3,330)Goodwill at acquisition 110Impairment to date (20)

(90)Profit on disposal 3,321



14

(6) Net assets at disposal

CUmShare capital 3,000Retained earnings b/f (4,850 – 3,000) 1,850Profit for year to disposal (W4) 1,238

6,088

(7) Group retained earnings b/f for CSCE

CUmDaring Group 5,950Glory Ltd (90% (1,850 – 700)) 1,035Goodwill impairment to date (20)

6,965

(8) Minority interest b/f for CSCE

CUmGlory Ltd (4,850 10%) = 485 + other subsidiaries 9,500 9,985

(9) Minority interest eliminated on disposal

CUmB/f amount 485 (W8) + current year 124 (W3) 609


(a) Partial disposal (subsidiary to subsidiary) mid year


CU'000Property, plant and equipment 2,650Goodwill (302-75) 227

2,877Current assets (2,700 + 1,300 + 380) 4,380

7,257

Share capital (CU1 ordinary shares) 2,000Retained earnings (W5) 2,997

4,997Minority interest (W6) 560

5,557Current liabilities (1,200 + 500) 1,700

7,257


CU'000Profit from operations 1,580Profit on sale of interest in subsidiary (W2) 31Profit before tax 1,611Income tax expense (400 + 50) (450)Profit for the period 1,161

Attributable to:Equity holders of Ben Ltd (β) 1,128Minority interest (W3) 33

1,161





Profit for the year 1,129 33Partial disposal of subsidiary – 273

1,129 306Balance at 30 September 20X7 (W4) 1,868 254Balance at 30 September 20X8 (W5 + W6) 2,997 560

WORKINGS

(1) Group structure

Ben plc

Bill Ltd

80% x 9/1260% x 3/12


CU'000 CU'000

Sale proceeds 380Less: Share of net assets at disposal ((300 + 970 + 9/12 130) 20%) (274)

106

Less: Carrying amount of goodwill at date of disposalCost of investment 950Share of net assets at acquisition (80% (300 + 510)) (648)

Goodwill at acquisition 302Re disposal (1/4) (75)

31


CU'000 CU'00020% 130 9/12 = 20

40% 130 3/12 = 1333


CU000 CU000As per Worked example 1,868 254


CU'000Ben Ltd 2,500Add: Profit on disposal (380 – (950 25%)) 143

2,643Bill Ltd (60% (1,100 – 510)) 354

2,997



14

(6) MI c/f

CU'000Share capital 300Retained earnings 1,100

1,400 40% 560

(b) Partial disposal (subsidiary to associate) mid year


CU'000Property, plant and equipment 2,050Investments in associates (W2) 711

2,761Current assets (2,700 + 1,350) 4,050

6,811

Share capital (CU1 ordinary shares) 2,000Retained earnings (W6) 3,611

5,611Current liabilities 1,200

6,811


CU'000

Profit from operations (1,400 + (9/12 180)) 1,535

Profit on sale of interest in subsidiary (W3) 652

Share of profit of associates (130 3/12 40%) 13

Profit before tax 2,200

Income tax expense (400 + (9/12 50)) (438)

Profit for the period 1,762

Attributable to:Equity holders of Ben Ltd (β) 1,743Minority interest (W4) 19

1,762



Profit for the year 1,743 19Eliminated on disposal of subsidiary (19 + 254) (273)

1,743 (254)

Balance at 30 September 20X7 (W5) 1,868 254Balance at 30 September 20X8 (W6) 3,611 –



WORKINGS

(1) Group structure


CU'000Cost of associate (950 ½) 475

Share of post acquisition retained earnings (40% (1,100 – 510)) 236711


CU'000 CU'000

Sale proceeds 1,350Less: Share of net assets at disposal (300 + 970 + (9/12 130)) 40% (547)

803Less: Carrying amount of goodwill at date of disposal

Cost of investment 950Share of net assets at acquisition (80% (300+510)) (648)

Goodwill at acquisition 302Re disposal (1/2) (151)

652


CU'00020% 130 9/12 19


CU'000 CU'000As per worked example 1,868 254


CU'000Ben Ltd 2,500Add: Profit on disposal (1,350 – (950 50%)) 875

3,375Bill Ltd (40% (1,100 – 510)) 236

3,611

Ben Ltd

Bill Ltd

80% x 9/12 40% x 3/12

Bill Ltd

c

Bcs

I

E

T

S

T

A

A

hapter 15

usiness combinations,onsolidated financial


Contents

tatements and associates

ntroduction

xamination context

opic List

1 Sources of requirements

2 BFRS 3 Business Combinations

3 Identifying the acquirer

4 Measuring the cost of a business combination

5 Allocating the cost of the business combination

6 Goodwill

7 Practical issues

8 Disclosures

9 BAS 27 Consolidated and Separate Financial Statements

10 BAS 28 Investments in Associates

ummary and Self-test

echnical reference

nswers to Self-test

nswers to Interactive questions



Introduction


Identify and explain the relationship between companies as parent, subsidiary or associate

Determine whether group accounts are required

Calculate goodwill including the measurement of identifiable assets, liabilities and contingentliabilities in relation to the acquisition of a subsidiary

Explain the accounting treatment of goodwill in the consolidated balance sheet andconsolidated income statement

Explain the accounting treatment in consolidated financial statements of:

– Subsidiaries

– Associates

Specific syllabus references for this chapter are: 1g, 3a,b,c,d,e.


One of the key topics covered in this chapter is goodwill, particularly the way in which fair values affect thecalculation of goodwill on acquisition of a subsidiary. Goodwill arising in these circumstances can be asignificant asset, particularly for acquisitive groups. For example, the UK Vodafone Group plc recognisedCU69,118 million of goodwill in its 2006 financial statements. This represented over three quarters ofshareholders’ equity.

Accounting standards emphasise the need to recognise identifiable intangible assets rather than subsumingthem within goodwill. This has become an increasingly important issue as the nature of business haschanged. At acquisition a subsidiary may have intangible assets such as brands as key business assets as wellas the more traditional tangible assets of property, plant and equipment.

Stop and think

What would be the potential benefits of subsuming identifiable intangible assets within goodwill?

Working context

Goodwill and fair values are key factors affecting consolidated accounts. Although accounting standardsprovide guidance, the assessment of fair values still involves judgement. As a result, this aspect of theconsolidation process is likely to be carried out by more senior members of staff.

Syllabus links

This chapter puts the treatment of a subsidiary and an associate covered in Chapters 10 to 14 into thecontext of the relevant accounting standards. It is important that you are familiar with the principles whichunderpin the purchase method and equity method described in this chapter as well as being able to producethe consolidated financial statements.

More complex aspects of group accounts are dealt with in Financial & Corporate Reporting at theAdvanced Stage.

BUSINESS COMBINATIONS, CONSOLIDATED FINANCIAL STATEMENTS AND ASSOCIATES


15

Examination context

Exam commentary

Accounting and reporting concepts constitute 10% of the syllabus, and an ability to explain and demonstratethe concepts and principles surrounding the consolidated financial statements would be included here. Thisis likely to be tested in the written test section of the paper. Typically a question would require preparationof some consolidated information followed by an explanation of the principles behind the method.Alternatively you could be asked to justify your treatment of an investment as a subsidiary or an associate.

Goodwill and fair values are also popular exam topics and would be tested within the 35% groups part ofthe paper. This area could be examined in the written test section but is also likely to be examined in short-answer questions.

In the exam candidates may be required to:

Explain the following concepts:

– Control– Substance over form– Single entity concept– Significant influence

Distinguish between a subsidiary, an associate and a trade investment and explain the accountingtreatment of each of these

Calculate goodwill incorporating fair values of:

– Consideration– Assets, liabilities and contingent liabilities acquired

Demonstrate the subsequent accounting treatment of goodwill

Prepare simple extracts from financial statements in accordance with Companies Act and BFRS



1 Sources of requirements

Section overview

This chapter considers group accounts in the context of BFRS Framework and the relevant BangladeshFinancial Reporting Standards.

1.1 Context

Previous chapters have dealt with the mechanics of preparing consolidated financial statements. Thischapter covers the International Financial Reporting Standards relating to business combinations (theacquisition of one business by another), subsidiaries and associates which form the basis of theconsolidation process dealt with earlier. The standards covered in this chapter are as follows:

BFRS 3 Business Combinations (sections 2-8) BAS 27 Consolidated and Separate Financial Statements (section 9) BAS 28 Investments in Associates (section 10)


The key elements in financial statements, identified in BFRS Framework, which are relevant to businesscombinations, subsidiaries and associates are:

Assets: resources controlled by the entity as a result of past events and from which future economicbenefits are expected to flow to the entity

Liabilities: present obligations of the entity arising from past events, the settlement of which isexpected to result in an outflow of resources embodying economic resources.

Also relevant are the definitions of:

Gains, which are a part of income: increases in economic benefits through enhancements of assets ordecreases in liabilities other than contributions from equity

Losses, which are included in expenses: decreases in economic benefits through depletions of assetsor additional liabilities other than distributions to equity

The recognition criteria:

– It is probable that any future economic benefit associated with the item will flow to or from theentity; and

– The item has a cost or value that can be measured with reliability

and the need to account for matters in accordance with their substance and economic reality, notmerely their legal form.



15

2 BFRS 3 Business Combinations

Section overview

All business combinations should be accounted for using the purchase method.

2.1 Objective

The objective of BFRS 3 is to set out the accounting and disclosure requirements for a businesscombination. In practice business combinations can be structured in all sorts of different ways, usually forreasons which are peculiar to the parties to the combination and/or to suit the legal and tax environmentsin which they operate.

In an area of such potential complexity BFRS 3 looks beyond the legal form of the transaction to theunderlying substance, in line with BFRS Framework. This can be seen in the definitions below.

Definitions

Business combination. The bringing together of separate entities or businesses into one reporting entity.

Business. An integrated set of activities and assets conducted and managed for the purpose of providing:

(a) A return to investors; or

(b) Lower costs or other economic benefits directly and proportionately to policyholders or participants.

A business generally consists of inputs, processes applied to those inputs, and resulting outputs that are, orwill be, used to generate revenues. If goodwill is present in a transferred set of activities and assets, thetransferred set is presumed to be a business.

Nearly all business combinations result in one entity, the acquirer, obtaining control of one or more otherbusinesses. We will look at the issue of control in section 3.

The type of business combination with which you need to be familiar is the acquisition of one companyby another resulting in a parent-subsidiary relationship. (We have looked at the practicalapplication of this relationship in Chapters 10-12.)

Point to note

If assets alone are purchased, such as a fleet of motor vehicles these will be accounted for under BAS 16Property, Plant and Equipment not BFRS 3.

Definitions

Parent. An entity that has one or more subsidiaries.

Subsidiary. An entity, including an unincorporated entity such as a partnership, that is controlled byanother entity (known as the parent).

2.2 Scope

BFRS 3 applies to all business combinations except those for which there are or will be separateBFRSs. None of these excluded combinations fall within the Financial Accounting syllabus.



2.3 Purchase method of accounting

All business combinations must be accounted for by applying the purchase method. This involvesthree key steps:

Identifying an acquirer

Measuring the cost of the business combination; and

Allocating the cost of the business combination to the identifiable assets and liabilities (includingcontingent liabilities) acquired.

We will look at these three steps in more detail in the following sections 3-5 of this chapter.

3 Identifying the acquirer

Section overview

The acquirer should be identified for all business combinations.

The acquirer is the entity which obtains control of the other entity.

There are a number of ways in which control can be achieved.

Control is normally assumed where the acquirer obtains more than 50% of the voting rights in theacquiree.

BFRS 3 states that the acquirer should be identified for all business combinations.

Definitions

Acquirer. The combining entity that obtains control of the other combining entities or businesses.

Control. The power to govern the financial and operating policies of an entity or business so as to obtainbenefits from its activities.

In practical terms the simplest way in which control can be achieved is where the acquirer (P) gains morethan half of the voting rights in the acquiree (S) i.e. rights relating to votes of the shareholders ingeneral meeting. These rights are normally attached to the ordinary shares BFRS 3 states that in this casecontrol should be assumed unless it can be demonstrated otherwise.

Control also exists, however, where P has power:

Over a majority of the voting rights, through an agreement with others

To govern the financial and operating policies of S under statute or agreement (this is similar tothe definition of control above)

To appoint or remove the majority of the members of the board of directors (or equivalenttop management) of S, or

To cast the majority of votes at S's board meetings.

In most business combinations it should be relatively straightforward to identify the acquirer. Where this isnot the case BFRS 3 provides a number of additional indicators as follows:

If the fair value of one of the entities is significantly greater than the other entity, the entity with thelarger fair value is likely to be the acquirer



15

Where the business combination is effected through an issue of shares for cash or other assets, theentity giving up the cash or other assets is likely to be the acquirer

Where one of the entities is able to select the management team of the combined entity, thatparty is likely to be the acquirer.

4 Measuring the cost of a business combination

Section overview

The cost of a business combination includes the fair values at the date of exchange of assets given,liabilities incurred or assumed and equity instruments issued by the acquirer.

Quoted equity investments should be valued at their published price.

Deferred consideration should be discounted.

Costs directly attributable to the combination should be recognised as part of the cost of thecombination.

4.1 General rule

The cost of the business combination is

The total of the fair values of the consideration given; and Any costs directly attributable to the business combination.

4.2 Fair value of consideration

BFRS 3 requires that consideration given should be measured at fair value at the date of exchange.

Definition

Fair value. The amount for which an asset could be exchanged, or a liability settled, betweenknowledgeable, willing parties in an arm's length transaction.

The Financial Accounting syllabus includes only combinations achieved through a single exchangetransaction (not a gradual build up of control through successive transactions to acquire shares in theacquiree) so for our purposes the date of exchange is the acquisition date.

Definition

Acquisition date. The date on which the acquirer effectively obtains control of the acquiree.



This is the same date as that which would be used to split pre and post-acquisition profits.

Points to note

1 Consideration given may be in the form of cash or other assets, liabilities assumed or incurred andequity instruments (e.g. shares) issued by the acquirer.

2 The fair value of any quoted equity investments (marketable securities) forming part of thepurchase consideration would be the published price at the date of exchange, except in rarecircumstances.

3 Future losses or other costs expected to be incurred as a result of the combination are not includedas part of the cost of the combination.

4.3 Deferred consideration

Where settlement of the consideration is deferred to a later date, it is valued at its discountedpresent value at the time of acquisition. For marketable securities this is their market value at theacquisition date (market value being the best estimate of the present value of all future benefits accruingon the securities).

4.4 Contingent consideration

Part of the consideration for the acquisition may be contingent on the acquired business meeting certaintargets in the future, or may be dependent on other uncertain future events.

The normal principles of BAS 37 Provisions, Contingent Liabilities and Contingent Assets (dealt with in Chapter9) are applied. Therefore, the additional cost of investment is recognised if it is probable (more likely thannot) that the additional consideration will be paid and if its amount can be estimated reliably. If this is notthe case, a contingent liability for the additional consideration will be disclosed.

The assessment of whether contingent consideration is likely to be paid is an accounting estimate, notan accounting policy. Hence, if the assessment needs to be revised in the light of subsequent experience(because, for example, the acquired business beats or falls short of its targets) and the revision arises afterthe completion of the initial accounting (see section 6.4 below), the consequential effect on goodwill isaccounted for in the period of the revision, not retrospectively.

Point to note

There is no time limit within which such adjustments to goodwill must be made.

4.5 Directly attributable costs

Costs directly attributable to the acquisition can be included in the cost of the combination.These will include professional and other fees relating specifically to the individual transaction e.g.accountants’ fees and legal costs. It will not include general administrative costs and internal costs e.g. staffcosts relating to employees in the acquisitions department. These costs relate to all transactions, thereforethey are not directly attributable to an individual acquisition.

The costs of arranging financial liabilities (e.g. loans) and issuing equity are deducted from theliability/equity, rather than being added to the cost of the business combination.

Worked example: Issue costs

Fir Ltd acquired 100% of Pine Ltd by issuing 200,000 new CU1 ordinary shares at a fair value of CU2 pershare. The issue costs associated with these shares were CU20,000. Professional fees were also incurred inrespect of the acquisition amounting to CU25,000.



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The cost of the business combination would be as follows:

CUFair value of shares issued (200,000 × CU2) 400,000Professional fees 25,000

425,000

The issue costs do not form part of the cost of the combination but are deducted from the share premiumarising on the issue of the new share capital as follows:

CUShare premium (200,000 × CU1) 200,000Less: Issue costs (20,000)

180,000

5 Allocating the cost of the business combination

Section overview

The acquiree's identifiable assets, liabilities and contingent liabilities should be recognised at fair valueat the date of acquisition.

Where certain criteria are met the acquiree's assets, liabilities and contingent assets should berecognised separately.

Provisions for future reorganisation plans and future losses should not be recognised as liabilities atthe acquisition date.

Contingent liabilities which can be measured reliably should be recognised as liabilities at theacquisition date.

An intangible asset may only be recognised if it is separable or arises from contractual or other legalrights and can be measured reliably.

BFRS 3 provides guidance on the measurement at fair value of specific assets, liabilities and contingentliabilities.

5.1 Basic principle

BFRS 3 requires that the acquiree's identifiable assets, liabilities and contingent liabilities shouldbe recognised at fair value at the date of acquisition.

The exception to this is non-current assets that are classified as held for sale in accordance with BFRS 5Non-current Assets Held for Sale and Discontinued Operations. These are recognised at fair value less coststo sell.

Point to note

What constitutes the acquiree's identifiable assets, liabilities and contingent liabilities is important as thedifference between the cost of the business combination and the acquirer's share of these representsgoodwill. (The mechanics of this calculation were covered in Chapters 10-12.) The higher the total valueof net assets acquired, the lower the total value of goodwill and vice versa.

5.2 Identification of net assets acquired

Separate recognition of the acquiree's assets, liabilities and contingent liabilities is required where they meetspecific criteria at the acquisition date. The criteria are based on BFRS Framework definitions of an asset anda liability, covered in Chapter 1. These are as follows:



Assets other than intangible assets Where it is probable that any associated futureeconomic benefits will flow to the acquirer, andtheir fair value can be measured reliably.

Liabilities other than contingent liabilities

(see section 5.3 below)

Where it is probable that an outflow ofresources embodying economic benefits will berequired to settle the obligation, and its fair valuecan be measured reliably.

Intangible assets

(see section 5.4 below)

Where they meet the definition of anintangible asset in accordance with BAS 38Intangible assets and their fair value can bemeasured reliably.

Contingent liabilities Where their fair value can be measured reliably.

5.3 Recognition of liabilities

An acquirer may only recognise an acquiree's liabilities if they exist at the acquisition date.This application of the normal BFRS Framework definition of a liability prohibits any account being taken atthat time of two factors which will have depressed the price the acquirer is prepared to pay for theacquiree:

Reorganisation plans devised by the acquirerwhich will only be put into effect once controlover the acquiree is gained.

Acquirers often plan to create value bychanging the cost structure of the acquiree sothat the post-acquisition cost base is less thanthe sum of the acquirer's and acquiree's existingcost bases. The acquirer will evaluate the one-off costs of making these changes whendeciding what lower price to offer for theacquiree, but as these costs are neither aliability nor a contingent liability of theacquiree prior to the date control is gained,they cannot be set up as provisions at thetime of acquisition.

Future losses to be incurred as a result of thebusiness combination (this covers future lossesto be incurred by the acquirer as well as by theacquiree).

An acquirer will often target a loss-makingbusiness, in the expectation that afterreorganisation and with new management it willbecome profitable. But it often takes some timefor the benefits of such changes to emerge,during which time further trading losses will beincurred. The reorganisation process may alsocause short-term losses within the acquirer.The total of such losses will depress the priceto be offered by the acquirer. But no accountcan be taken of them, because future lossesrelate to future, not past, events.

Point to note

Contrast the first of these situations with contractual obligations put in place by the acquiree (not theacquirer) prior to the acquisition date and conditional on being taken over. (Such contractual obligationsare sometimes put together on a large scale by the acquiree's management, precisely to deter acquirers. Inthese cases they are often described as 'poison pill' defences.) Prior to the acquisition date these arepresent obligations arising from past events but outflows of resources are not probable. So they will bedealt with as contingent liabilities by the acquiree up to the moment when a business combinationbecomes probable. At that point they meet the recognition criteria for a liability and must be recognised asone of the acquiree's liabilities in allocating the cost of the combination.



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5.4 Recognition of intangible assets

As already noted in section 5.2 above, intangible assets must be recognised when they can be reliablymeasured. But even before that test, they must meet the definition of an intangible asset underBAS 38 Intangible Assets. This BAS was dealt with in detail in Chapter 6, but the following points are relevanthere:

An intangible asset is a non-monetary asset without physical substance. It must be separable or arisefrom contractual or other legal rights. 'Separable' means that the asset can be sold separatelyfrom the entity owning the asset, while 'contractual or other legal rights' provides evidence of theexistence of the asset. Contrast an intangible defined in this way with goodwill arising on anacquisition, which is not separable and does not arise from contractual or other legal rights

The illustrative examples which accompany BFRS 3 (but which are not an integral part of it) list thefollowing examples of intangible assets which could be recognised on a business combination:

– Separable assets:

Customer lists Non-contractual customer relationships Databases

Customer lists are often leased (i.e. used for a period without ownership being gained) formailing purposes by entities wanting to try to acquire new customers. Customer relationshipsare details of customers together with their past buying profiles which can be sold, on the basisthat even though these customers have no outstanding commitments to make purchases, theprobability is that a number of them will place future orders. A value can then be put on thisprobability.

– Assets arising from contractual or other legal rights:

Trademarks Internet domain names Newspaper mastheads Non-competition agreements Unfulfilled contracts with customers Copyrights over plays Books, music, videos, etc Leases Licences to broadcast television and/or radio programmes Licences to fish in certain waters Licences to provide taxi services Patented technology Computer software

The definition also covers research and development projects which are in process at theacquisition date. These will often not be recognised in the acquiree's balance sheet as we saw inChapter 6.

5.5 Measurement of net assets acquired

Where the BFRS 3 recognition criteria are met the assets, liabilities and contingent liabilitiesacquired should be measured at fair value as follows:

Asset, liability or contingent liability Fair value

Financial instruments traded in an active market Current market values

Financial instruments not traded on an activemarket

Estimated values based on comparableinstruments of entities with similar characteristics

Receivables Present value of amounts to be received.



Asset, liability or contingent liability Fair value

(Discounting is not required for short-termreceivables where the effect is likely to beimmaterial.)

Inventories of finished goods Selling price less:

The costs of disposal and

A reasonable profit allowance for theselling effort of the acquirer.

Inventories of work-in-progress Selling price of finished goods less:

Costs to complete

Costs of disposal and

A reasonable profit allowance for thecompleting and selling effort.

Inventories of raw materials Current replacement costs

Land and buildings Market values

Plant and equipment Market values

Depreciated replacement cost should beused where the asset is of a specialised natureand there is no market-based evidence offair value (see worked example below).

Intangible assets Market value by reference to an active market.

If no active market exists the amounts theacquirer would have paid in an arm's lengthtransaction between knowledgeable willingparties, based on the best information available.

Accounts and notes payable, long-term debt,liabilities and accruals

Present values of amounts to be paid.

(Discounting is not required for short-termpayables where the effect is likely to beimmaterial.)

Onerous contracts (see Chapter 9) Present values of amounts to be paid.

Contingent liabilities (see section 5.6 below) The amounts that a third party would chargeto assume those contingent liabilities.



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Worked example: Depreciated replacement cost

Gareth Ltd is being acquired by Roz Ltd. Gareth Ltd owns specialised plant for which no market value isavailable. This plant originally cost CU3m, is one-third of the way through its useful life and has no residualvalue. So it stands in its books at cost CU3m less accumulated depreciation CU1m, i.e. CU2m. New plantwith a similar capacity would cost CU3.6m.

'Depreciated' replacement cost means that the same proportionate amount of accumulated depreciation isapplied to the replacement cost. The replacement plant would cost CU3.6m, accumulated depreciation ofone-third would be CU1.2m, so the depreciated replacement cost is CU2.4m.

5.6 Contingent liabilities

BFRS 3 requires an acquirer to recognise an acquiree's contingent liabilities where their amountcan be measured reliably. This is in spite of the fact that they will not have been recognised in thebalance sheet of the acquiree (under BAS 37 ).

Once recognised, contingent liabilities must be carried at the higher of the amount under BAS 37(which will be nil until they become liabilities) and their value at the acquisition date, less anysubsequent amortisation.

Points to note

1 If these cannot be measured reliably, their value, whatever it is, will be subsumed within goodwillor discount on acquisition. But full disclosure must still be made.

2 Even if recognised, the normal BAS 37 disclosures re contingent liabilities must be made.

5.7 Consequences of recognition at fair value

The consequences of the recognition of the acquiree's assets, liabilities and contingent liabilities at theacquisition date are that:

The acquirer's consolidated income statement must include the acquiree's profits and losses from thesame date

The fair values of the acquiree's net assets form the basis of all the subsequent accounting in theconsolidated financial statements even where fair values are not incorporated into the acquiree's singleentity financial statements. For example, depreciation will be based on the fair values of property, plantand equipment which may not be the same as the carrying amount in the acquiree's balance sheet

Any minority interest in the acquiree is based on the minority interest share of the net assets attheir fair values

5.8 Summary

The allocation of the cost of a business combination is made as follows:CU CU

Fair value of assets given, liabilities assumed and equity instruments issued XLess: Fair value of tangible assets acquired X

Fair value of intangible assets acquired XFair value of assets acquired XFair value of liabilities acquired (X)Fair value of contingent liabilities acquired (X)Fair value of net assets acquired XShare of net assets acquired at fair value (X)

Goodwill/(discount on acquisition) X/(X)

We will look at goodwill in more detail in section 6 below.



Interactive question 1: Measuring fair value [Difficulty level: Exam standard]

Kelly Ltd acquired 75% of Eclipse Ltd on 1 July 20X7. The consideration comprised:

5 million 25p ordinary shares of Kelly Ltd (market value 60p) to be issued on 1 July 20X7 (issue costsof CU10,000 were paid to a merchant bank)

CU1 million cash payable on 1 July 20X7

A further 1 million 25p ordinary shares of Kelly Ltd to be issued on 1 July 20X8, provided that EclipseLtd achieves a profit for the year ended 31 March 20X8 of CU10 million.

Professional fees to bankers and advisers relating to the acquisition totalled CU20,000 (excluding the issuecosts stated above). The directors of Kelly Ltd estimate that the value of their time spent working on theacquisition was CU25,000.

The fair value of the identifiable assets and liabilities recognised by Eclipse Ltd at 1 July 20X7 isCU3,628,000. The financial statements of Eclipse Ltd have for some years disclosed a contingent liabilitywith a potential amount of CU2 million. The fair value of this contingent liability at 1 July 20X7 has beenestimated at CU200,000.

Current forecasts indicate that Eclipse Ltd will probably make profits of at least CU12 million for the yearto 31 March 20X8.

Requirement

Show the entries in Kelly Ltd's books to record the investment in Eclipse Ltd, and calculate goodwillacquired in the business combination.


Solution

CU'000 CU'000Recording investment in Eclipse LtdShares to be issued 1 July 20X7DRCRCRCR

CashDRCR

Professional feesDRCR

Shares to be issued 1 July 20X8DRCR

Goodwill on consolidation of Eclipse Ltd

CU'000 CU'000Cost of investment

SharesCashFeesShares to be issued

Identifiable assets and liabilities acquiredPer books of Eclipse LtdContingent liability

Group share (75%)




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6 Goodwill

Section overview

Goodwill is calculated as the excess of the fair value of the acquisition cost over the acquirer'sinterest in the fair value of the net assets acquired.

Goodwill arising on a business combination is recognised as an intangible asset in the consolidatedbalance sheet.

Goodwill should be tested for impairment at least annually.

If a discount arises the measurement of the fair value of net assets acquired should be checked.

If the discount remains it should be recognised in profit or loss in the accounting period in which theacquisition is made.

6.1 Goodwill at acquisitionIn accordance with BFRS 3 any excess of the acquisition cost over the acquirer's interest in the fair value ofthe net assets acquired should be:

Described as goodwill; and Recognised as an asset (as it meets the recognition criteria)

Definition

Goodwill. Future economic benefits arising from assets that are not capable of being individually identifiedand separately recognised.

Point to note

Any goodwill carried in the acquiree's balance sheet becomes subsumed in the goodwillarising on acquisition, because:

It is excluded from identifiable assets (see section 5.4 above) This reduces the net assets acquired; and Must therefore increase the goodwill arising on consolidation.

6.2 Goodwill subsequent to acquisitionAfter initial recognition, goodwill should be:

Carried in the balance sheet at cost less accumulated impairment losses; Tested for impairment at least annually in accordance with BAS 36 Impairment of Assets.

6.3 Discount on acquisitionA discount on acquisition arises if the acquirer’s share of the fair value of the net assets acquiredexceeds the cost of the acquisition, i.e. there is 'negative goodwill'.

BFRS 3 is based on the assumption that this usually arises because of errors in the measurement of theacquiree's net assets (i.e. assets, liabilities and contingent liabilities) and/or of the cost of thecombination. So the first action is always to reassess the identification and measurement of the netassets and the measurement of the cost of the combination, checking in particular whether the fairvalues of the net assets acquired correctly reflect future costs arising in respect of the acquiree.

If the discount still remains once these reassessments have been made, then it is attributable to a bargainpurchase, i.e. the acquirer has managed to get away with paying less than the full value for the acquiree.This discount does not meet BFRS Framework's definition of a liability, so it must be part of equity. It musttherefore be recognised in profit or loss in the same accounting period as the acquisition is made.



6.4 Initial accounting

Initial accounting is the process of identifying and determining the fair values of:

The acquiree's identifiable assets, liabilities and contingent liabilities; and The cost of the combination, i.e. of the assets given, liabilities assumed and equity instruments issued.

Whilst every effort should be made to complete this process by the end of the accounting period in whichthe combination is effected, it may be that in some cases only provisional values can beestablished by that time. This is often true of the valuation of non-current assets, including intangibles.In such cases:

Provisional values should initially be used

Adjustments to the values of the net assets and/or the cost of the combination made within oneyear of the acquisition date should be backdated to the acquisition date. Changes in both thesesets of values may therefore lead to a restatement of the provisional values for goodwill or thediscount on acquisition

Comparative figures for the previous period (the one in which the combination was effected)must be restated as if these adjustments had been made as part of the initial accounting. Sodepreciation charges in the previous period in respect of PPE may have to be restated.

Point to note

This one year period can only be used to reassess fair values. It cannot be used to backdate therecognition of acquired assets and liabilities which did not meet the recognition criteria at theacquisition date but do so during this period, because this would involve taking account of events after theacquisition date. As an example, major pollution damage resulting from an accident taking place within theone year period may result in new types of liabilities being identified, types which were unknown at theacquisition date. No such liabilities can be recognised at the acquisition date as they were not known at thattime.

6.5 Subsequent adjustments

The need for further adjustments may emerge later but to allow them to be backdated to the acquisitiondate might result in continual changes to previously published data, in a way which is not helpful to users offinancial statements. For example, a large group might make several acquisitions every year; adjustments tofair values at the date of each acquisition might result in annual adjustments to comparative figures and notjust for acquisitions in the immediate prior period. So fair value adjustments made after the end of the oneyear period are to be treated as follows:

In limited circumstances, they are backdated to the acquisition date with restatement of goodwill ordiscount on acquisition and all comparative figures. These circumstances are if they arise as a result ofan error, as defined by BAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (dealt with inChapter 4). But such errors will be very rare

If they are adjustments to the fair value of the cost of the combination (see section 4 above), thengoodwill or discounts on acquisition are adjusted, but in the current period only. There is nobackdating to the acquisition date and no restatement of the comparative figures

In all other circumstances, such adjustments are to be treated as changes in accountingestimates, as defined in BAS 8. There is no backdating to the acquisition date and norestatement of comparative figures. These adjustments are recognised as income or expenses inthe accounting period in which they arise. So if a debt which had a fair value of nil at theacquisition date (i.e. it had been recognised as an expense in profit or loss) is recovered in full twoyears afterwards, it is treated as income, not as a reduction in goodwill.



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7 Practical issues

Section overview

Where a subsidiary has not reflected fair values in its single entity financial statements, adjustmentswill need to be made as part of the consolidation process.

7.1 Fair value adjustments

The way fair value adjustments are taken up in the initial calculation of goodwill is dealt with in Chapter 11.But such adjustments may also have to be taken up subsequently, because there is no requirement thatthe acquiree should recognise in its own accounting records the fair values attributed to itsassets and liabilities at the acquisition date. If these fair values have been recognised by the acquiree,then its financial statements are suitable for the consolidation process. But if they have not, it will benecessary to make adjustments for fair values as part of the consolidation process:

In the consolidated balance sheet changes will often be necessary to the acquiree's carryingamounts for non-current assets and the accumulated depreciation/amortisation

In the consolidated income statement such changes will affect the current period'sdepreciation/amortisation charges.

Other adjustments may have to be made, depending on the circumstances. An adjustment will always benecessary for any contingent liabilities recognised at the acquisition date, to the extent they are onlydisclosed in the acquiree's financial statements.

Interactive question 2: Fair value adjustments [Difficulty level: Exam standard]

Chris Ltd acquired 60% of Andy Ltd for CU8m on 1 July 20X2 when Andy Ltd's balance sheet showed netassets of CU5m. The fair value of Andy Ltd's property, plant and equipment was CU1m higher than carryingamount, but this was not reflected in Andy Ltd's books. At 30 June 20X5 Andy Ltd's balance sheet showsnet assets of CU10m. Chris Ltd's policy is to depreciate property, plant and equipment over 10 years. AndyLtd's financial statements still disclose a contingent liability for a claim for damages against it. At theacquisition date its fair value was estimated at CU100,000, which was its carrying amount until 30 June20X5 when it was re-estimated at CU80,000.

Requirement

Calculate as at 30 June 20X5 Chris Ltd's share of Andy Ltd's post-acquisition reserves and the goodwillarising on consolidation and the adjustment to be made to Andy Ltd's depreciation charge for theconsolidated income statement for the year ended 30 June 20X5.


Solution

CU'000Chris Ltd's share of Andy Ltd's post-acquisition reserves (W1)

Goodwill arising on consolidation (W2)

Adjustments to Andy Ltd's depreciation charge (W3)



WORKINGS

(1) Net assets and post-acquisition reserves

Balance At Post-sheet date acquisition acquisitionCU'000 CU'000 CU'000

Andy LtdNet assetsPPE fair value upliftDepreciation thereonContingent liability

Chris Ltd's share

(2) Goodwill

CU'000Cost of sharesShare of net assets

(3) Depreciation charge

CU'000Additional charge


8 Disclosures

Section overview

BFRS 3 requires a number of disclosures.

As business combinations may result in very significant changes to the nature of a group of companies,substantial disclosures are required under three headings, to enable users to evaluate the nature andeffects of:

1 Business combinations effected in the accounting period or after its finish but before the financialstatements are authorised for issue (in the latter case, there will just be disclosures by way of note,with no amounts actually being recognised in the financial statements)

2 Gains, losses, errors and other adjustments which relate to combinations effected in the currentor previous periods

3 Changes in the carrying amount of goodwill during the period.

In respect of new business combinations there must be disclosure of:

The names and descriptions of the combining entities

The acquisition date

The percentage of the voting shares acquired

The cost of the combination, together with a description of the components of that cost

Details of any operations which have been or will be disposed of

The amounts recognised at the acquisition date for each class of assets, liabilities and contingentliabilities



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Any discount on acquisition, together with the line item in the income statement within which ithas been recognised

Descriptions of the factors which led to the recognition of goodwill or discount on acquisition

The post-acquisition profit or loss included in the consolidated income statement

For combinations during the period, estimates of the consolidated revenue and profit or losswhich would have been recognised if the acquisition date for all combinations had been the first day ofthe accounting period.

In respect of gains, losses etc re combinations effected in the current or previous periods, there must bedisclosure of:

Gains or losses on acquired net assets

Adjustments to provisional values in the initial accounting for combinations effected in theimmediately preceding period

Errors corrected under BAS 8.

In respect of goodwill there must be a reconciliation of the opening carrying amount (gross amount lessaccumulated impairment losses) with the closing amount, in terms of

Additions Amounts recognised as an expense as a result of disposals Any impairment losses incurred Any other adjustments.

9 BAS 27 Consolidated and Separate FinancialStatements

Section overview

With limited exceptions, all parents must present consolidated financial statements.

Consolidated financial statements must include the parent and all the entities under its control.

BAS 27 sets down key consolidation procedures (which we have demonstrated in Chapters 10-14).

The investment in the subsidiary is carried at cost in the parent's balance sheet.

9.1 Scope definitions

BAS 27 is to be applied in the preparation of the consolidated financial statements (CFS) of thegroup. It is also to be applied in accounting for subsidiaries (and associates – see section 10.1 below) inthe parent company's individual financial statements.

The definitions used in BAS 27 are the same as those discussed in relation to BFRS 3. The followingadditional definitions should be noted:

Definitions

A group. A parent and all its subsidiaries.

Consolidated financial statements. The financial statements of a group presented as those of a singleeconomic entity.

Minority interest. That portion of the profit or loss and net assets of a subsidiary attributable to theequity interests that are not owned, directly or indirectly through subsidiaries, by the parent.



9.2 Control

The factors identified by BAS 27 which would indicate that one entity controls another are very similar tothose identified by BFRS 3. However, BAS 27 also requires an assessment of whether any potentialvoting rights that are currently exercisable or convertible contribute to control. Potential votingrights are considered not currently exercisable or convertible when they cannot be exercised or converteduntil:

A future date or The occurrence of a future event.

For example, an entity may own share warrants or debt or equity instruments that are convertible intoordinary shares that if exercised or converted would give the entity additional voting power.

In making this assessment the entity should examine all the facts and circumstances that affect the potentialvoting rights (e.g. terms of exercise, contractual arrangements). However, the intention of management andthe financial ability to exercise or convert should not have an effect on the assessment.

9.3 Presentation of CFS

With one exception, a parent must present CFS.

A parent need not prepare CFS if:

Either it is a wholly-owned subsidiary or the owners of the minority interest have all beeninformed of the proposal that CFS are not prepared and none have objected (note that it is notnecessary for them all to vote positively in favour – non-objection is sufficient); and

Its securities are neither publicly traded nor in the process of being issued to the public; and

CFS are prepared by the immediate or ultimate parent company.

9.4 Scope of CFS

The CFS must include the parent and all the companies under its actual control, i.e. itssubsidiaries. The guidance as to what constitutes control is the same as in BFRS 3 (see section 3 above).

Exclusion from the CFS is not permitted on the grounds that a subsidiary's business is dissimilar fromthose of the other companies in the group.

There is only one circumstance in which an entity falling within the definition of a subsidiary is notconsolidated in the normal way. This is when a new subsidiary is acquired but the 'held for sale'criteria of BFRS 5 are met, e.g. it is expected to be sold within 12 months of acquisition (BFRS 5 as itapplies to individual assets held for sale is covered in Chapter 5).

Accounting for this situation is outside the scope of the Financial Accounting syllabus.

Point to note

In some other circumstances it may look as though a 'subsidiary' has not been consolidated, for examplewhere it comes under the control of a government or goes into administration as part of a financialrestructuring. But BAS 27 takes the position that because such an entity is no longer controlled, it is nolonger a subsidiary. It is not a question of omitting such an entity from the CFS; the absence of controlmeans that it is not eligible for inclusion.

9.5 Consolidation procedures

BAS 27 makes specific reference to those consolidation procedures necessary to present the group as asingle economic entity. These were explained in earlier chapters, i.e.:

Eliminating the carrying amount of the parent's investment against its share of the equity inits subsidiaries, with goodwill being the resultant figure

Eliminating intra-group balances, transactions, profits and losses in full (i.e. not just theparent's share)



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Calculating the minority interest and presenting it as a separate figure:

– In the balance sheet, within total equity but separately from the parent shareholders' equity– In the income statement.

Point to note

The balance sheet amount for the minority interest cannot go below nil (any excess being charged againstthe parent shareholders' equity) unless there is a binding obligation on the minority interest to makeadditional investments in the subsidiary to cover the losses. If there is a minority interest in cumulativepreference shares which are classified as equity, the minority interest must be allocated their share of therelevant dividends even if they have not been declared.

There are additional requirements that:

Where the parent and subsidiary have different reporting dates, that difference must be not morethan three months (remember that, because it has control, the parent can dictate a reporting dateto the subsidiary) and adjustments must be made for major transactions between the twodates. An example of such an adjustment would be if the subsidiary with cash appearing in its balancesheet at the earlier date lent it to the parent so that the same cash was in the parent's balance sheet atthe later date. An adjustment must be made to eliminate this double-counting.

Uniform accounting policies must be applied to all companies in preparing the CFS. If they arenot adopted in the subsidiaries' own financial statements, then adjustments must be made as partof the consolidation. It might be the case that certain group companies take advantage of thealternative accounting treatments allowed in some areas by BFRSs, but these must be made uniformon consolidation.

Changes in the composition of the group are accounted for as follows:

Acquisitions are accounted for under BFRS 3, by bringing into the consolidated incomestatement the new subsidiary's income and expenses from the date of acquisition

In the case of disposals, the income and expenses to the date of disposal (i.e. the date control islost) are included in the CFS, as is the difference between the proceeds of sale and the carryingamount in the consolidated balance sheet at that date (which will be the parent's share of thesubsidiary's net assets at the date of disposal plus any remaining goodwill relating to that subsidiary).

9.6 Parent's separate financial statements

The investment in a subsidiary is carried at cost in the parent's balance sheet, cost being the fairvalue of the consideration given as computed under BFRS 3. Note that the same treatment is used forassociates (dealt with in section 10 below).

The knock-on effect is that the only income included in the parent's income statement are the distributionsreceived of profits earned after the date of acquisition; distributions out of earlier profits are accounted foras return of the investment made and are deducted from cost.

9.7 Disclosures in CFS

Disclosure must be made of:

The nature of the relationship between parent and subsidiary when the parent does not own,directly or indirectly, more than half of the voting power in the subsidiary

Reasons why a parent does not have control over an investee, even though it holds more thanhalf of the voting power in it

A subsidiary's reporting date if different from that of the parent, together with the reason for usinga different date

The nature of any restrictions on a subsidiary's ability to transfer funds to the parent



10 BAS 28 Investments in Associates

Section overview

An associate is an entity over which the investor has significant influence.

A holding of 20% or more of the voting power in an investee is presumed to provide the investorwith significant influence.

Associates must be accounted for in the consolidated financial statements using the equity method.

10.1 Scope and definitions

BAS 27 is to be applied in accounting for investments in associates in the investor's ownfinancial statements as an individual company.

So BAS 28 is to be applied in the CFS only. The requirements of BAS 28 are very similar to those of BAS27, adjusted for the fact that the investor company has significant influence over the associate, rather thanthe control it has over a subsidiary.

The definition of an associate is as follows:

Definition

Associate. An entity, including an unincorporated entity such as a partnership, over which the investor hassignificant influence and that is neither a subsidiary nor an interest in a joint venture.

Significant influence. The power to participate in financial and operating policy decisions of the investee,but is not control or joint control over those policies.

Points to note

1 A holding of 20% or more of the voting power in an investee (but less than the 50.1% whichwould create a parent/subsidiary relationship) is presumed to provide the investor with thatsignificant influence, while a holding of less than that is presumed not to do so. Both of thesepresumptions are rebuttable on the facts of the case.

2 It is the mere holding of 20% which is sufficient.

3 It is possible for an investee to be the associate of one investor and the subsidiary of another,because the former investor can still have significant influence when the latter has control. A holder ofmore than 75% can do most things in a company, such as passing a special resolution, without payingmuch attention to the other shareholders, so someone else holding 20% is unlikely to have significantinfluence. But it is always necessary to have regard to the facts of the case.

4 Significant influence is evidenced in a number of ways, such as representation on the board ofdirectors, participation in the policy-making process and material transactions with the investee. (SeeChapter 9.)

5 Significant influence may be lost in the same circumstances as a parent may lose control overwhat was a subsidiary.



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10.2 Equity method

The equity method must be carried out in relation to associates, the rationale being that it reflects thesignificant influence the investor holds by making the investor answerable for the associate's overallperformance, not just for the distributions received. So the investor's share of the associate must beincluded in the investor's financial statements.

Under the equity method, the investment in the associate is initially recognised at cost, but the carryingamount is then increased or decreased by the investor's share in the post-acquisition change in theassociate's net assets.

Shares of post-acquisition profits/losses will be recognised in the investor's consolidated income statement,but shares of revaluations of non-current assets will be recognised directly in the consolidated statement ofchanges in equity.

When an investment in an associate meets the 'held for sale' criteria of BFRS 5, e.g. it is expected to be soldwithin 12 months of acquisition, it is still classified as an associate, but it is not subject to equity accounting;BFRS 5 is applied instead.

Once significant influence is lost, the investee is no longer an associate, so the investor's income statementssubsequently include only distributions received.

The procedures used in consolidation are applied wherever possible to accounting for associates. So:

Profits and losses on transactions between the investor and the associate are eliminatedto the extent of the investor's share

There are provisions as to reporting dates, adjustments for material transactions when they do notcoincide and uniform accounting policies which are very similar to those for subsidiaries

Recognition of a share of an associate's losses can only result in the investor's interest being writtendown below nil (so as to become a liability) if the investor has incurred obligations on behalf ofthe associate.

The differences are that:

There is no cancellation of the investment against the share of the associate's net assets.This is because there is no line-by-line addition to balance sheet items of the investor's share of theassociate's assets and liabilities. Such addition is appropriate under conditions of control, but not underthose of significant influence

There is no goodwill calculation at the date the investment is made

Instead, the investor's interest in the associate is shown in the balance sheet, as a single line undernon-current assets

The whole of that interest is subjected to an impairment review if there is an indicator ofimpairment

That interest includes items which are in substance a part of the investment, such as long-termloans to the associate. But short-term receivables which will be settled in the ordinary course ofbusiness remain in current assets

The investor's interest in the associate's post-tax profits less any impairment loss isrecognised in its consolidated income statement.

10.3 Investor's separate financial statements

Under BAS 27, the investment in the associate is carried at cost in the investor's balance sheet.

The knock-on effect is that the only income included in the investor's income statement are thedistributions received out of profits earned after the date of acquisition.



10.4 Disclosures

The minimum disclosures are:

The fair value for an investment in any associate for which there are published price quotations (i.e.the associate's securities are dealt in on a public market)

Summarised financial statements of the associate

Reasons why the investor thinks the 20% presumptions are overcome, if that is the case

The associate's reporting date, if different from that of the investor

Restrictions on funds transfers from the associate

Losses in the associate, both current period and cumulative, which have not been recognised in theinvestor's financial statements (because the investment has already been written down to nil)

The investment to be shown as a non-current asset in the balance sheet

The investor's share of the associate's:

– After-tax profits, to be shown in the investor's income statement– Discontinued operations– Changes in equity recognised directly in equity, to be shown in the investor's statement of

changes in equity– Contingent liabilities.



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Summary

Allocation of cost:

- Identifiable assets- Identifiable liabilities

- Contingent liabilities

- Goodwill: capitaliseand review forimpairment

- Discount:recognise inincome statement

immediately



Self-test


1 In relation to accounting for goodwill, BFRS 3 Business Combinations permits a company to

A Amortise goodwill over its useful life

B Write off immediately and amortise goodwill relating to different acquisitions

C Revalue goodwill upwards

D Restate goodwill at acquisition as a result of adjustments to values within one year of theacquisition date

2 With regard to goodwill, in accordance with BFRS 3 Business Combinations, which of the followingstatements is true?

A Goodwill should be amortised over its useful lifeB Goodwill will normally have a low positive residual valueC Goodwill should be tested for impairment at least annuallyD Goodwill should be carried in the balance sheet at cost indefinitely

3 With regard to goodwill, in accordance with BFRS 3 Business Combinations, which of the followingstatements is true?

A Negative goodwill should be recognized in the balance sheet on the balance sheet date

B Negative goodwill should be recognized in profit or loss on acquisition date

C Negative goodwill should be adjusted with the existing goodwill

D Negative goodwill should be amortised over its useful life

4 Ovett Ltd acquires the following during the year ended 30 June 20X6.

1 The separable net assets of Elliott, a sole trader.2 100% of the share capital of Moorcroft Ltd.

In accordance with BFRS 3 Business Combinations goodwill may arise in Ovett Ltd's own financialstatements in respect of

A Elliott and Moorcroft LtdB Elliott onlyC Moorcroft Ltd onlyD Neither Elliott nor Moorcroft Ltd

5 Linford Ltd purchased the net assets of the business of Merrow Ltd on 30 June 20X0 for CU750,000.The balance sheet of Merrow Ltd on 30 June 20X0 disclosed the following.

CUGoodwill 50,000Development costs 65,000Property, plant and equipment 340,000Net current assets 200,000

655,000

The fair value of the property, plant and equipment of Merrow Ltd amounted to CU355,000 on theacquisition date; all the other items are stated at their fair values.

The notes to the financial statements of Merrow Ltd disclosed a contingent liability of CU100,000. Thefair value of this at 30 June 20X0 was CU10,000.

In accordance with BFRS 3 Business Combinations, the amount of goodwill arising on the purchase ofthe business of Merrow Ltd is

A CU80,000B CU105,000C CU140,000



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D CU195,000

6 Ling Ltd purchased 80% of the ordinary shares of Moy Ltd on 1 June 20X0 for CU5,400,000. Thesummarised balance sheet of Moy Ltd on this date showed the following.

CU'000Ordinary share capital 1,000Share premium account 500Revaluation reserve 400Retained earnings 2,700

4,600

The fair value of the identifiable net assets of Moy Ltd exceeded their carrying amount by CU150,000.The balance sheet of Moy Ltd included goodwill of CU500,000.

In accordance with BFRS 3 Business Combinations the amount of goodwill acquired in the businesscombination is

A CU650,000B CU1,150,000C CU1,600,000D CU2,000,000

7 Tony Ltd purchased 80% of Simon Ltd during the year. Which of the following would not normally beincluded as part of the fair value of the consideration in accordance with BFRS 3 Business Combinations?

A Further shares in Tony Ltd to be issued in one year's time

B Additional cash to be paid in two years' time if certain targets are met by Simon Ltd. It isconsidered more likely than not that those targets will be met

C Professional fees paid for obtaining legal advice re the acquisition

D A proportion of the salary cost of staff working full time in the general acquisitions department

8 Tom Ltd has purchased all the share capital of Jerry Ltd during the year.

Which of the following items should Tom Ltd take into account when calculating the fair value of thenet assets acquired in accordance with BFRS 3 Business Combinations?

1 A possible loss dependent on the outcome of a legal case which has not been provided for inJerry Ltd's books. The fair value of the loss can be estimated reliably.

2 A provision required to cover the costs of reorganising Jerry Ltd's departments to fit in withTom Ltd's structure.

3 A warranty provision in Jerry Ltd's books to cover the costs of commitments made tocustomers.

A 3 onlyB 2 and 3 onlyC 1 and 3 onlyD 1 only

9 Which of the following is/are acceptable when assessing fair values on acquisition in accordance withBFRS 3 Business Combinations?

1 Valuation of non-current assets at market value where this is different from their carryingamount.

2 Discounting a trade receivable to present value where the debt is not due to be recovered fortwo years.

3 Valuation of specialised plant and machinery at depreciated replacement cost.

A 1 onlyB 2 onlyC 1 and 2



D 1, 2 and 3

10 Leeds Ltd acquired the whole of the issued share capital of Cardiff Ltd for CU12 million in cash. Inarriving at the purchase price Leeds Ltd had taken into account future costs for reorganising CardiffLtd of CU1 million and Cardiff Ltd's anticipated future trading losses of CU2 million. The fair value ofthe net assets of Cardiff Ltd before taking into account these matters was CU7 million.

In accordance with BFRS 3 Business Combinations, what is the amount of goodwill acquired in thebusiness combination?


11 Castor Ltd acquires 75% of the share capital of Pollux Ltd on 1 December 20X1. The considerationgiven is CU1 million in cash and 300,000 CU1 ordinary shares of Castor Ltd. The market value of eachof Castor Ltd's shares on 1 December is 300 pence. On 1 December the fair value of Pollux Ltd's netassets is CU1 million.

In accordance with BFRS 3 Business Combinations what is the amount of goodwill acquired in thebusiness combination to be dealt with in Castor Ltd's consolidated accounts?

A CU300,000B CU550,000C CU900,000D CU1,150,000

12 In accordance with BFRS 3 Business Combinations the timetable for the acquisition of a subsidiary willusually include the following four dates.

1 The date on which consideration passes.

2 The date on which an offer becomes or is declared unconditional.

3 The date from which the acquiring company has the right to share in the profits of the acquiredbusiness under the agreement.

4 The date on which control passes.

The effective date for accounting for the business combination should be

A The earlier of 1 and 2B The earlier of 1 and 4C 3 onlyD 4 only

13 On 31 July 20X6 Yonder Ltd announced an all-cash takeover bid for Fidge Ltd. Subsequently thefollowing events occurred.

7 August 20X6. The board of Fidge Ltd unanimously recommended the offer and announced that alldirectors would be accepting in respect of their own holdings.

14 August 20X6. Yonder Ltd announced that it had received acceptances amounting to more than 50%of the shares in Fidge Ltd.

21 August 20X6. Yonder Ltd declared that the offer had become unconditional.

28 August 20X6. Control of Fidge Ltd passed to Yonder Ltd.

In accordance with BFRS 3 Business Combinations Yonder Ltd should account for the acquisition ofFidge Ltd from

A 7 August 20X6B 14 August 20X6C 21 August 20X6D 28 August 20X6



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14 Sam Ltd has a share capital of CU10,000 split into 2,000 A ordinary shares of CU1 each and 8,000 Bordinary shares of CU1 each. Each A ordinary share has ten votes and each B ordinary share has onevote. Both classes of shares have the same rights to dividends and on liquidation. Tom Ltd owns 1,500A ordinary shares in Sam Ltd. Dick Ltd owns 5,000 B ordinary shares in Sam Ltd.

All three companies conduct similar activities and there is no special relationship between thecompanies other than that already stated. The shareholdings in Sam Ltd are held as long-terminvestments and are the only shareholdings of Tom Ltd and Dick Ltd.

In accordance with BFRS 3 Business Combinations consolidated financial statements must be preparedby

A Neither Tom Ltd nor Dick LtdB Tom Ltd onlyC Dick Ltd onlyD Both Tom Ltd and Dick Ltd

15 According to BAS 28 Investments in Associates under the equity method of accounting the balance sheetof an investing group will include in respect of its associate

A Long-term receivables due from associate, but not its share of net assets of the associate

B Cost of investment plus share of post-acquisition change in associate's net assets plus long-termreceivables due from associate

C Share of net assets of the associate and long-term receivables due from associate

D Cost of investment plus share of post-acquisition change in associate's net assets but notreceivables due from associate

16 Inveresk Ltd has equity shareholdings in three other companies.

Inveresk Ltd NotesRaby Ltd 40% No other holdings larger than 10%Seal Ltd 25% Another company holds 75% of Seal Ltd's equity and

dominates the board of directorsToft Ltd 30% This investment has been classified as held for sale under BFRS 5

Non-current assets held for sale and discontinued operations

According to BAS 28 Investments in Associates the associates of Inveresk Ltd are most likely to be

A Raby Ltd onlyB Raby Ltd and Seal LtdC Raby Ltd and Toft LtdD Raby Ltd, Seal Ltd and Toft Ltd

17 Which of the following statements is/are true when equity accounting for an associate in accordancewith BAS 28 Investments in Associates?

1 Any impairment losses in respect of the investment in the associate will not affect group profitbefore tax in the consolidated income statement.

2 Balances owing to associates should not appear in the consolidated balance sheet.

A 1 onlyB 2 onlyC Both 1 and 2D Neither 1 nor 2



18 Which of the following statements is/are true when accounting for a subsidiary?

1 Provisions for unrealised profits should always be deducted from the parent company's retainedearnings.

2 When a subsidiary prepares its own financial statements, it may adopt the parent company'saccounting policies.

3 When a parent and subsidiary have different reporting dates, that difference must be no morethan three months.

4 A parent may omit a company from the consolidated financial statements where the company isheld for sale in accordance with BFRS 5 Non-current Assets Held for Sale and DiscontinuedOperations.

A 1, 2, 3 and 4B 1, 2 and 4 onlyC 1 and 2 onlyD 2 and 3 only

19 According to BAS 28 Investments in Associates which of the following statements about equityaccounting for an associate is/are true?

1 The consolidated income statement should show separately the group's share of the associate'stax charge.

2 Dividends received from an associate should not be included in the consolidated incomestatement.

3 Any impairment loss relating to the investment in the associate will reduce the minority interest'sshare of profit.

4 Balances payable/receivable between an associate and subsidiary should appear on theconsolidated balance sheet.

A 1, 2 and 4 onlyB 2, 3 and 4 onlyC 1 and 3 onlyD 2 and 4 only

20 Apple Ltd acquired 90% of Banana Ltd on 1 January 20X7 for CU800,000. At the date of acquisitionBanana Ltd had the following assets and liabilities:

CUProperty, plant and equipment 750,000Contingent liability (50,000)Patent allowing sole use of technology for a fixed period of time 25,000

The above values represent fair values all of which can be measured reliably. The useful life of goodwillis estimated to be 10 years. Goodwill has suffered no impairment to date.

At 31 December 20X7 goodwill in the consolidated balance sheet of Apple Ltd would be:

A CU100,000B CU125,000C CU170,000D CU147,500



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21 PAYNE LTD

The draft balance sheets at 31 March 20X5 of Payne Ltd and its 80% subsidiary Glass Ltd, acquired on30 September 20X4, are as follows.

Payne Ltd Glass LtdCU'000 CU'000 CU'000 CU'000


Property, plant and equipment 3,138 552Intangibles (including goodwill of

CU275,000)– 475

Investments: Shares in Glass Ltd 90 –3,228 1,027

Current assetsInventories 927 403Trade and other receivables 975 423Suspense account 128 –Cash and cash equivalents 836 132

2,866 958Total assets 6,094 1,985


Ordinary share capital (50p shares) 2,000 700Revaluation reserve 475 –Retained earnings 1,905 765

Equity 4,380 1,465Current liabilities (trade payables) 1,714 520Total equity and liabilities 6,094 1,985

The following points are relevant.

1 At the acquisition date the balance sheet of Glass Ltd showed net assets with a carrying amountof CU1,265,000. Included in this total were freehold land with a carrying amount of CU250,000(market value CU683,000), goodwill (arising on the acquisition of an unincorporated businesssome years ago) with a carrying amount of CU300,000 and patent rights acquired giving Glass Ltdsole use of certain technology for five years which have a carrying amount of CU100,000. The fairvalues of all other assets and liabilities are approximately equal to their carrying amounts. Acontingent liability at this date (which was not provided for in the financial statements) wasdisclosed as a potential CU300,000. However, its fair value was assessed at CU58,000. A finaldecision on this matter is expected to be reached by the end of 20X5.

2 At the acquisition date the directors of Payne Ltd intended to restructure and reorganise GlassLtd and wished to provide for restructuring costs which are forecast as CU78,000.

3 At the acquisition date an investment in plant and machinery was required to bring the remainingproduction line of Glass Ltd up to date. This will amount to CU290,000 in the next 12 months.

4 The consideration for the acquisition comprised cash of CU90,000 and 800,000 shares with anominal value of 50p and fair value of 130p each. The issue of shares has not yet been reflected inthe books of Payne Ltd.

5 Professional fees to bankers and solicitors in respect of the acquisition amounted to CU75,000.In addition the directors of Payne Ltd estimate that the value of their time spent working on theacquisition amounted to CU53,000.

At the moment these expenses have been posted to a suspense account.

6 Glass Ltd sells part of its output to Payne Ltd. Included in the inventories of Payne Ltd are goodsvalued at CU150,000 purchased from Glass Ltd since acquisition at cost plus 25%.



Requirements

(a) Calculate the value of the goodwill arising on the acquisition of Glass Ltd in accordance withBFRS 3 Business Combinations. (5 marks)

(b) Prepare the consolidated balance sheet for Payne Ltd as at 31 March 20X5. (13 marks)

(18 marks)

22 PRIMAX LTD

Primax Ltd holds the following investments.

1 4,000 of the 10,000 CU1 ordinary shares in Alders Ltd, an engineering company with sevendirectors on the board, five of whom are appointed by Primax Ltd. Of the remaining shares 2,000are held by Yeti Ltd. Primax Ltd is a major supplier to Yeti Ltd and the board of Yeti Ltd haveagreed to vote with Primax Ltd on all matters concerning Alders Ltd.

2 CU3,000 nominal value of the 5,000 CU2 ordinary shares in Bulls Ltd, and 80% of its CU1irredeemable preference shares. The remaining shares are held by other companies in sizeableblocks, but none hold more than Primax Ltd. Each member of Bulls Ltd appoints one person tothe board of directors. The irredeemable preference shares carry no voting rights.

3 3,000 of the 10,000 CU1 ordinary shares in Clyde Ltd. These were recently acquired, as thedirectors of Primax Ltd believe that Clyde Ltd has excellent growth potential in the future.However, the market in which Clyde Ltd operates is very specialised and Primax Ltd has decidedto take no part in the running of Clyde Ltd. Primax Ltd intends to hold its shares for severalyears, but not to influence the board in any way.

4 2,500 of the 12,000 equity shares in Suffolk Ltd. Suffolk Ltd was established ten years ago andmade considerable profits in the first eight years of its existence. During this time Primax Ltdappointed two members to the board of directors and was actively involved in developingoperating and financial policies.

Last year one of the directors on the board of Primax Ltd resigned through ill health and theother directors decided to give Primax Ltd the right to appoint four out of the six directors ofSuffolk Ltd and to remove any director if a dispute is not resolved within one month. Since thenPrimax Ltd has taken a more active role in managing the business.

Requirement

Discuss the nature of each holding, and state the method of accounting in the group accounts underBAS 27 Consolidated and Separate Financial Statements and BAS 28 Investments in Associates.

(16 marks)



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23 HEREFIELD LTD (Sample Paper)

Herefield Ltd prepares its consolidated financial statements in accordance with BFRS. Herefield Ltd hasinvestments in two companies, Wormford Ltd and Stringer Ltd.

The draft summarised balance sheets of the three companies at 30 June 20X6 are shown below.

Herefield Wormford StringerLtd Ltd Ltd

CU CU CUASSETS

Non-current assetsProperty, plant and equipment 1,280,000 1,800,000 5,995,000Investments 10,950,000 – –

12,230,000 1,800,000 5,995,000Current assets

Inventories 785,000 290,000 90,000Trade and other receivables 240,000 440,000 394,000Cash and cash equivalents 57,600 – 300,000

1,082,600 730,000 784,000Total assets 13,312,600 2,530,000 6,779,000


Issued capital - CU1 ordinary shares 9,000,000 2,000,000 4,000,000Retained earnings 2,734,600 (367,000) 2,396,000

Equity 11,734,600 1,633,000 6,396,000Non-current liabilities

Provisions 300,000 – 187,000Loans 620,000 550,000 –

920,000 550,000 187,000Current liabilities

Trade and other payables 378,000 255,000 72,000Bank overdraft – 47,000 –Taxation 280,000 45,000 124,000

658,000 347,000 196,000Total equity and liabilities 13,312,600 2,530,000 6,779,000

Additional information:

(1) On 1 July 20X2, Herefield Ltd acquired 1.7 million CU1 ordinary shares in Wormford Ltd forCU1.50 cash per share. The retained earnings of Wormford Ltd at that date were CU0.25million.

(2) Herefield Ltd acquired 2.8 million CU1 ordinary shares in Stringer Ltd on 31 March 20X6 forCU3 cash per share. The retained earnings of Stringer Ltd at 31 March 20X6 were CU2.0 million.The fair value of land held by Stringer Ltd at the date of acquisition was CU2.5 million in excessof its carrying amount.

(3) At the date of acquisition Stringer Ltd had disclosed in the notes to its financial statements acontingent liability in relation to a customer claim for CU100,000. Herefield Ltd’s legal advisersestimated the fair value of the claim at CU150,000. The claim was settled on 10 June 20X6 for afinal figure of CU160,000 and is payable on 10 September 20X6. Stringer Ltd recognised aprovision for the final claim in its draft balance sheet at 30 June 20X6.

(4) Wormford Ltd has been developing a new product based on revolutionary technology. No othersimilar products currently exist in the market. At 1 September 20X5 Wormford Ltd determinedthat the product development was at a stage where the criteria for capitalisation in accordancewith BAS 38 Intangible Assets had been met. During the year Wormford Ltd incurred CU720,000of development costs, accrued evenly through the year. These costs have been included in theincome statement as operating expenses. The product is still under development at 30 June20X6. An independent valuer has estimated the recoverable amount of the technology at CU1million at 30 June 20X6.



(5) Wormford Ltd sold goods to Herefield Ltd for CU170,000 during the year. At the year end halfof these goods remained in inventory. Wormford Ltd sold the goods based on a transfer price ofcost plus 25%. Wormford Ltd’s receivables included an amount for the goods at the year end,however, Herefield Ltd sent a cash payment for CU170,000 to Wormford Ltd on 25 June 20X6.Wormford Ltd received the payment on 2 July 20X6.

(6) Herefield Ltd has undertaken annual impairment reviews of goodwill. At 30 June 20X6 animpairment loss of CU300,000 in respect of Wormford Ltd needs to be recognised.

Requirement

Prepare the consolidated balance sheet of Herefield Ltd as at 30 June 20X6.

(21 marks)




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Technical reference

Point to note. The following sets out the examinability of the standards covered in this chapter.

BFRS 3 All paragraphs but excluding paragraphs 10-13, 20-23, 58-60 and 65. Appendix B1-B3, B5,B7-B15 and the illustrative examples are also excluded.

BAS 27 All paragraphs but excluding all references to BAS 31, BAS 39 for investments excludedfrom consolidation and references to the separate financial statements of the investor.

BAS 28 All paragraphs but excluding all references to BAS 31, BAS 39 for investments excludedfrom consolidation and references to the separate financial statements of the investor.


1 BFRS 3 BUSINESS COMBINATIONS

Basics

Definitions: control, parent, subsidiary, acquisition date, goodwill. BFRS 3 (App A)

Purchase method: acquirer, cost of combination, allocation over identifiableassets, liabilities and contingent liabilities.

BFRS 3 (16)

Control through: BFRS 3 (19)

– P holds more than half of the voting rights in S

– P holds a majority of voting rights in S, through an agreement with others

– P has power to govern the financial and operating policies of S understatute or agreement

– P has power to appoint or remove the majority of S's top management.

Cost of combination

Cost: BFRS 3 (24)

– Fair value of assets given, liabilities assumed and equity instruments issued

– Costs directly attributable to the acquisition, e.g. professional fees, but notinternal overheads.

Subsequent adjustment to cost:

– Account on acquisition for probable outcomes of future events BFRS 3 (32)

– Subsequent adjustments affect goodwill BFRS 3 (33 – 34)

– If after initial accounting complete, then in current period.

Allocation of cost

Identifiable assets – exist at acquisition date and:

– Tangible – meet normal recognition criteria BFRS 3 (36 – 37)

– Intangible – reliably measurable and either separable or arising fromcontractual/other legal rights

BFRS 3 (45 – 46)

– May or may not have been recognised in the acquiree's own financialstatements

BFRS 3 (36 – 37)

– Detailed rules for measurement at fair value. BFRS 3 (B 16)



Identifiable liabilities – exist at acquisition date and:

– Meet the normal recognition criteria BFRS 3 (41)

– Specific exclusion for acquirer's reorganisation plans and acquirer's oracquiree's future operating losses - recognition criteria not met

BFRS 3 (41)

– Detailed rules for measurement at fair value.

Identifiable contingent liabilities – exist at acquisition date and: BFRS 3 (36 – 37)

– Reliably measurable

– Normal BAS 37 disclosures BFRS 3 (47)

– Subsequently carried at higher of BAS 37 value and value at acquisition date. BFRS 3 (48)

Goodwill

Non-current asset at cost. BFRS 3 (51)

No amortisation but subject to annual impairment reviews. BFRS 3 (54)

Discount on acquisition

Reassess identification and measurement of the net assets acquired andmeasurement of cost of combination.

BFRS 3 (56)

Any remaining amount recognised in profit or loss in period the acquisition ismade.

Initial accounting

At acquisition date or within 12 months thereof. BFRS 3 (62)

Subsequently: errors accounted for retrospectively, everything elseprospectively.

BFRS 3 (63 – 64)

Disclosures

Business combinations effected in the accounting period or after its finish butbefore financial statements authorised for issue (in the latter case, by way ofnote).

BFRS 3 (66)

Gains, losses, errors and other adjustments which relate to combinationseffected in the current or previous periods.

BFRS 3 (72)

Changes in the carrying amount of goodwill during the period. BFRS 3 (74)

2 BAS 27 CONSOLIDATED AND SEPARATE FINANCIALSTATEMENTS

Basic rule

Parent must prepare CFS to include all subsidiaries as if single economic entity. BAS 27 (9)

No control if 'subsidiary' under the control of a government or regulator, etc. BAS 27 (21)

Exception

No need for CFS if wholly owned or all minority shareholders have beeninformed of and none have objected to the plan that CFS need not be prepared.

BAS 27 (10)

If new subsidiary meets held for sale criteria at acquisition date, account for itunder BFRS 5.

BAS 27 (12)



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Procedures

As dealt with in earlier sessions. BAS 27 (12 and 33)

Minority interest shown as a separate figure:

– In the balance sheet, within total equity but separately from the parentshareholders' equity

– In the income statement, the share of the profit after tax.

Accounting dates of group companies to be no more than 3 months apart. BAS 27 (26 – 27)

Uniform accounting policies across group or adjustments to underlying values. BAS 27 (28 – 29)

Bring in share of new subsidiary's income and expenses: BAS 27 (30)

– From date of acquisition, on acquisition

– To date of disposal, on disposal.

Parent's separate financial statements

Account for subsidiary on basis of cost and distributions declared. BAS 27 (37)

Disclosures

Details where own more than 50% but do not consolidate, and vice-versa. BAS 27 (40)

3 BAS 28 INVESTMENTS IN ASSOCIATES

Definitions

The investor has significant influence, but not control. BAS 28 (2)

Significant influence is the power to participate in financial and operating policydecisions of the investee, but is not control over those policies (if the investorhad control, then under BAS 27 the investee would be its subsidiary).

Presumptions re less than 20% and 20% or more. BAS 28 (6)

Can be an associate, even if the subsidiary of another investor.

No significant influence if 'associate' under the control of a government orregulator, etc.

BAS 28 (10)

Equity method

In balance sheet: non-current asset = cost plus share of post-acquisition share inA's net assets.

BAS 28 (38 and

39)

In income statement: share of A's post-tax profits less any impairment loss. BAS 28 (38)

In statement of changes in equity: share of A's changes. BAS 28 (39)

Use cost method of accounting in investor's separate financial statements. BAS 28 (35)

Disclosures

Fair value of associate where there are published price quotations. BAS 28 (37)

Summarised financial statements of the associate.

Reasons why 20% presumptions overcome, if that be the case.

The investment to be shown as a non-current asset in the balance sheet, at costplus/minus share of post acquisition change in associate's net assets plus long-term financing less impairment losses.

BAS 28 (38)



The investor's share of the associate's:

– After-tax profits

– Discontinued operations

– Changes in equity recognised directly in equity BAS 28 (39)

– Contingent liabilities. BAS 28 (40)



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1 D BFRS 3 paragraph 62.

2 C The correct answer is C (BFRS 3 paragraph 55). Goodwill cannot have a residual value as itcannot be sold separately.

3 B BFRS 3, paragraph 34 specifies charging to profit or loss. .

4 B The goodwill arising from the purchase of shares in Moorcroft Ltd will arise on consolidation, notin the individual accounts of Ovett Ltd.

5 C

CU CUFair value of consideration 750,000Less: Fair value of identifiable assets and liabilities acquired

(65,000 + 355,000 + 200,000) 620,000Fair value of contingent liabilities acquired (10,000)

(610,000)140,000

6 D

CU000Fair value of consideration 5,400Less Share of fair value of net assets acquired ((4,600 + 150 – 500) 80%) (3,400)Goodwill 2,000

7 D BFRS 3 paragraph 29.

8 C Contingent liabilities must be recognised even though not provided for in the acquiree's booksand the warranty provision must be recognised as it arises from past events.

Reorganisation plans are only put into effect once control is gained. No liability or contingentliability therefore exists at the time of acquisition.

9 D All are required or permitted by BFRS 3 Appendix B B16.

10 D

CUmFair value of consideration 12Less: Share of fair value of net assets acquired (7)

5

Acquirer's reorganisation plans and acquiree's or acquirer's future operating losses do not meetthe recognition criteria for liabilities as the related liabilities did not exist at the acquisition date.

11 D

CU000Fair value of consideration

Cash 1,000Shares at fair value (300 3) 900

Less Share of fair value of net assets acquired (75% 1,000) (750)1,150

12 D A business combination is accounted for from the acquisition date, which is the date on whichcontrol passes (BFRS 3 paragraph 36 and Appendix A).



13 D A business combination is accounted for from the acquisition date, which is the date on whichcontrol passes (BFRS 3 paragraph 36 and Appendix A).

14 B Total number of votes:

VotesA shares 2,000 10= 20,000

B shares 8,000 1 = 8,00028,000

Tom Ltd controls15,000

28,000= 54% of the votes

15 B Both the cost of investment plus the share of post-acquisition change in associate's net assets andlong-term receivables due from the associate are included. There is no cancellation of inter-company receivables as with a subsidiary.

16 C Raby Ltd – over 20%, significant influence demonstrated.

Seal Ltd – over 20%, but unlikely to have significant influence because of the other company'slevel of control.

Toft Ltd – over 20%, significant influence demonstrated, even though classified as held for sale.

17 D 1 False – impairment write offs in respect of an associate are reflected in share of profits ofassociates, just above the profit before tax sub-total.0

2 False – balances with associates are not contra'd out.

18 D 1 False – PURPs should be eliminated against the selling company's profits.

2 True – uniform accounting policies only have to be adopted in the consolidated financialstatements. They may be adopted in the subsidiary's own financial statements.

3 True – the difference must be no more than three months.

4 False – must be included, even though accounted for under BFRS 5

19 D 1 False – the consolidated income statement just shows share of A's profit after tax.2 True – dividends are not included as this would double count profit.3 False – the MI is based on S's profit not A's.4 True – balances between A and the rest of the group are not contra'd out.

20

As per BFRS

CU CUCost of investment 800,000Fair value of net assetsPPE 750,000Contingent liability (50,000)Patent 25,000

725,000x 90% (652,500)

147,500



15

21 PAYNE LTD

(a) Goodwill arising on the acquisition of Glass Ltd

Calculation

CU CUFair value of consideration

Cash 90,000Shares (800,000 CU1.30) 1,040,000Professional fees 75,000

1,205,000Less:Share of identifiable assets and liabilities acquired

Carrying amount 1,265,000Add: Revaluation of non-current assets to fair value

Freehold land (683,000 – 250,000) 433,000Less: Goodwill in subsidiary's own books (300,000)

Contingent liability (58,000)1,340,000

80% (1,072,000)133,000

(b) Payne Ltd – consolidated balance sheet as at 31 March 20X5

CU000 CU000ASSETSNon-current assets

Property, plant and equipment (3,138 + 552 + 433) 4,123Intangibles (475 – 275 + 133(a)) 333

4,456Current assets

Inventories (927 + 403 – 30) 1,300Trade and other receivables (975 + 423) 1,398Cash and cash equivalents (836 + 132) 968



Ordinary share capital (2,000 + 400) 2,400Share premium account (800 80p) 640Revaluation reserve 475Retained earnings (W4) 2,008

Attributable to the equity holders of Payne Ltd 5,523Minority interest (W3) 307Equity 5,830Current liabilities

Trade and other payables (1,714 + 520) 2,234Acquired contingent liabilities 58


WORKINGS

(1) Group structure

Payne Ltd

80%

Glass Ltd



(2) Net assets

PostBalance sheet date Acquisition acquisition

CU'000 CU'000 CU'000 CU'000 CU'000Share capital 700 700 –Retained earnings

Per Q (1,265 – 700) 765 565Less: PURP (W7) (30) –

Goodwill w/o (275) (300)460 265 195

FV adj to land 433 433Contingent liability (58) (58)

1,535 1,340


CU'00020% 1,535,000 (W2) 307

(4) Retained earnings c/f

CU'000Payne Ltd 1,905Less Acquisition expenses re directors (53)Glass Ltd (80% 195 (W2)) 156

2,008

(5) Issue of shares

CU CUDR Cost of investment (800,000 130p) 1,040,000

CR Share capital (800,000 50p) 400,000

CR Share premium (800,000 80p) 640,000

(6) Acquisition expenses

CU CUDR Administrative expenses 53,000DR Cost of investment 75,000CR Suspense account 128,000

(7) PURP

% CUSP 125 150,000Cost (100) (120,000)GP 25 30,000

Point to note

The calculation in (a) was performed on the following basis, in accordance with BFRS 3.

(i) Fair value of consideration

Cash. Fair value will be the amount actually paid.

Shares. These should be included at their fair value on the date of acquisition (CU1.30 pershare).

Professional fees. These costs have only been incurred as a result of the acquisition and cantherefore be included as part of the cost of acquisition.

Value of directors' time. BFRS 3 does not permit the inclusion of allocated costs whichwould still have been incurred had the acquisition not been entered into.

(ii) Fair value of identifiable assets and liabilities acquired

Freehold land. This should be valued at its market value.



15

Contingent liability. Should be recognised at its fair value, which is the amount a third partywould charge to assume such a liability at the date of acquisition.

Goodwill in subsidiary's own accounts – BFRS 3 only allows identifiable assets to be included(i.e. assets that are capable of being disposed of without disposing of the business of theentity). This goodwill does not meet this definition and must therefore be written off.

Reorganisation provision. This does not meet the definition of a liability at the acquisitiondate (as the reorganisation can only take place once control has been gained) and thereforeshould not be recognised.

Future investment in plant and machinery. This cannot be recognised as the cost will only beincurred after acquisition.

22 PRIMAX LTD

1 Alders Ltd

Primax Ltd holds 40% of the equity shares in Alders Ltd which carry significant influence,suggesting that Alders Ltd is an associate (although this presumption can be rebutted if there isevidence to the contrary).

However, the following indicate that Alders Ltd is in fact a subsidiary of Primax Ltd.

Primax Ltd controls the board of Alders Ltd, appointing five of the seven directors, and thuscan control and direct the operating and financial decision making within the company.

Furthermore, Yeti Ltd, another member of Alders Ltd, has agreed to vote its 20% alongsidePrimax Ltd, thus giving Primax Ltd effective control of the voting shares.

In the absence of any evidence to the contrary, Alders Ltd should be accounted for as asubsidiary and consolidated using the purchase method of accounting.

2 Bulls Ltd

Primax Ltd holds 1,500 of the 5,000 ordinary shares in Bulls Ltd giving Primax Ltd a 30% holding,which carries significant influence and therefore suggests that it is an associate.

The 80% holding of irredeemable preference shares does not affect this decision, as theirredeemable preference shares do not carry any voting rights.

Of the other shareholders none has a greater influence than Primax Ltd; however, all aresizeable. This suggests that whilst Primax Ltd's influence is significant, it is not dominant.

Similarly each member appoints one person to the board of directors, giving each member someinfluence in the operational and financial decision making, but not control.

Having shown significant influence, without actual control, Bulls Ltd would best be classified as anassociate and should be accounted for on consolidation using the equity method of accounting.

3 Clyde Ltd

Primax Ltd holds 30% of the ordinary shares in Clyde Ltd. Under BAS 28 Investments in Associatessignificant influence is presumed when a holding reaches 20%; however, this can be rebutted inthe light of further evidence.

Primax Ltd plays no part in the decision making of Clyde Ltd. The holding is purely held for itsinvestment potential and the substance of the holding is better reflected as a trade investment.

On consolidation Primax Ltd's investment would be shown at cost as a non-current assetinvestment.

4 Suffolk Ltd

Primax Ltd holds 20.8% of the equity shares in Suffolk Ltd, indicating significant influence.

However, the key issue is whether Primax Ltd now exercises control. As it

Can appoint a majority of the board of directors



Can remove directors if there is a dispute

Primax Ltd now controls Suffolk Ltd which should be treated as a subsidiary and consolidatedusing the purchase method of accounting.

23 HEREFIELD LTD

Consolidated balance sheet as at 30 June 20X6


Property, plant & equipment(1,280,000 + 1,800,000 + 5,995,000 + 2,500,000) 11,575,000Goodwill (2,555,000 + 337,500 (W3)) 2,892,500Intangible assets (W7) 600,000

15,067,500

Current assetsInventories (785,000 + 290,000 + 90,000 – 17,000 (W6)) 1,148,000

Trade and other receivables 904,000(240,000 + 440,000 + 394,000 – 170,000)Cash and cash equivalents (57,600 + 300,000 + 170,000) 527,600

2,579,600Total assets 17,647,100


Issued capital 9,000,000Retained earnings (W5) 2,787,900

11,787,900Minority interest (W4) 3,001,200Equity 14,789,100Non-current liabilities

Provisions (300,000 + 187,000) 487,000

Loans (620,000 + 550,000) 1,170,0001,657,000

Current liabilitiesTrade and other payables (378,000 + 255,000 + 72,000) 705,000

Bank overdraft (47,000) 47,000Taxation (280,000 + 45,000 + 124,000) 449,000

1,201,000Total equity and liabilities 17,647,100

WORKINGS

(1) Group Structure

Herefield

85% 70%

(1.7m/2.0m) (2.8m/4.0m)

Wormford Stringer



15

(2) Net assets

Stringer Ltd


CU CU CUShare capital 4,000,000 4,000,000 –Retained earnings 2,396,000 2,000,000 396,000Fair value – land 2,500,000 2,500,000 –Contingent liability – (150,000) 150,000

8,896,000 8,350,000 546,000

Wormford Ltd


CU CU CUShare capital 2,000,000 2,000,000 –Retained earnings (367,000) 250,000 (617,000)Unrealised profit (W6) (17,000) – (17,000)Intangible asset (W7) 600,000 – 600,000

2,216,000 2,250,000 (34,000)

(3) Goodwill

Stringer Ltd

CUCost of acquisition (2,800,000 x CU3) 8,400,000Share of net assets (70% x 8,350,000 (W2)) (5,845,000)

2,555,000

Wormford Ltd

CUCost of acquisition (1,700,000 x CU1.50) 2,550,000Share of net assets (85% x 2,250,000 (W2)) (1,912,500)

637,500Impairment loss (300,000)

337,500


CUShare of net assets (30% x 8,896,000 (W2)) Stringer 2,668,800Share of net assets (15% x 2,216,000 (W2)) Wormford 332,400

3,001,200


CUHerefield Ltd – per question 2,734,600Stringer Ltd (70% x 546,000 (W2)) 382,200Wormford Ltd (85% x 34,000 loss (W2)) (28,900)Impairment (300,000)

2,787,900

(6) Unrealised profit

CU170,000 125%(CU136,000) 100%

CU34,000 25%

CU34,000 x ½ = CU17,000

(7) Intangible asset

Development expenditure of CU720,000. Capitalisation from 1 Sept 20X5.

CU720,000 x (10/12 months) = CU600,000





CU'000 CU'000Recording investment in Eclipse LtdShares to be issued 1 July 20X7DR Investment in Eclipse Ltd (5m 60p) 3,000CR Cash (issue costs) 10CR Share capital (5m 25p) 1,250CR Share premium (3,000 – 1,250 – 10) 1,740

CashDR Investment in Eclipse Ltd 1,000CR Cash 1,000

Professional feesDR Investment in Eclipse Ltd (fees) 20CR Cash 20

Shares to be issued 1 July 20X8DR Investment in Eclipse Ltd (1m 60p) 600CR Shares not issued (heading in capital and reserves) 600

Point to note

The directors' time is not a direct cost of the acquisition and hence cannot be included in the cost ofinvestment.

Goodwill on consolidation of Eclipse Ltd

CU'000 CU'000Cost of investment

Shares 3,000Cash 1,000Fees 20Shares to be issued 600

4,620Identifiable assets and liabilities acquired

Per books of Eclipse Ltd 3,628Contingent liability (200)

3,428Group share (75%) (2,571)

2,049


CU'000Chris Ltd's share of Andy Ltd's post-acquisition reserves (W1) 2,832

Goodwill arising on consolidation (W2) 4,460

Adjustments to Andy Ltd's depreciation charge (W3) 100



15

WORKINGS

(1) Net assets and post-acquisition reserves

Balance At Postsheet date acquisition acquisitionCU'000 CU'000 CU'000

Andy LtdNet assets 10,000 5,000 5,000PPE fair value uplift 1,000 1,000 0Depreciation thereon - 3 years = 30% (300) 0 (300)Contingent liability (80) (100) 20

10,620 5,900 4,720Chris Ltd's share - 60% 2,832

(2) Goodwill

CU'000Cost of shares 8,000Share of net assets (60% 5,900(W1)) (3,540)

4,460

(3) Depreciation charge

CU'000Additional charge (10% 1,000) 100

Point to note

If future events resulted in the contingent liability ceasing to exist (e.g. because it related to a legal claimbeing defended and the court judgement was in favour of the defendant), it would be re-measured at CUniland the whole of the CU100,000 would be recognised in current period profit or loss. If future eventsresulted in the contingent liability crystallising into a liability (e.g. because the court judgement was in favourof the plaintiff), it would be re-measured at CUnil but the carrying amount of the net assets would be afterdeducting the liability.




Contents

chapter 16

Group cash flow statements

Introduction

Examination context

Topic List

1 Individual company cash flow statements

2 Group cash flow statements


Technical reference





Introduction


Prepare a cash flow statement for an individual entity including the effects of payments ofinstalments under finance leases

Prepare a consolidated cash flow statement including the effects of

– Dividends paid to the minority interest

– Dividends received from associates

– Acquisitions/disposals of subsidiaries/associates

Specific syllabus references for this chapter are: 2c, 3e.


As we saw in Chapter 3, a company’s performance and prospects often depend not so much on the profitsearned in a period, but on liquidity and cash flows. This same principle is also true of a group of companies.

Stop and think

What do you think are the benefits of a consolidated cash flow statement to the shareholders of the parentcompany?

Working context

As we saw in Chapter 3, the cash flow statement forms an important part of the financial statements whichwill need to be prepared and audited. The work performed in preparing a consolidated cash flow statementwill be very similar to that performed in preparing an individual cash flow statement. However, the impactof a number of additional issues will need to be considered. These include the impact of minority interests,the treatment of associates and the treatment of acquisitions and disposals of associates or subsidiaries.

Syllabus links

This chapter develops many of the ideas which were introduced in Chapter 3. As you will see, the processinvolved in preparing a consolidated cash flow statement is very similar to that used in the preparation of acash flow statement for an individual entity.

The preparation of individual and consolidated cash flow statements is also highly relevant in the Financial &Corporate Reporting paper at the Advanced Stage, where the emphasis will change to the analysis andinterpretation of these statements.

GROUP CASH FLOW STATEMENT


16

Examination context

Exam requirements

Group accounts represent 35% of the syllabus and it is likely that the consolidated cash flow statement willbe examined regularly either in the written test section of the paper or in the short-form questions section.

In an examination you could either be asked to prepare a full consolidated cash flow statement (fromconsolidated income statement, consolidated balance sheet and notes) or to prepare consolidated cash flowextracts and/or answer a number of short-form questions.

In the examination candidates may be required to:

Prepare and present a consolidated cash flow statement for a group of companies includingsubsidiaries and associates

Prepare extracts from a consolidated cash flow statement

Prepare simple cash flow statement extracts in accordance with BFRS



1 Individual company cash flow statements

Section overview

The cash flow statement of an individual entity was covered in Chapter 3.

An instalment paid under a finance lease must be split between interest and capital repaid and thetwo elements presented separately in the cash flow statement.

1.1 Revision

As we saw in Chapter 3 the objective of a cash flow statement is to provide information about thehistorical changes in cash and cash equivalents during the accounting period.

In accordance with BAS 7 Cash Flow Statements cash flows are classified under the following headings:

Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities

Cash generated from operations is shown as part of cash flows from operating activities. A note to the cashflow statement is then presented showing how the cash generated from operations has been calculatedusing:

The direct method; or The indirect method.

Refer back to Chapter 3 if you need a reminder of the proforma for a cash flow statement and itssupporting note.

1.2 Finance leases

The payment of an instalment under a finance lease represents a cash outflow which must be reflected inthe cash flow statement. As we saw in Chapter 8, however, an individual instalment may representthe repayment of interest accrued to date and a repayment of a proportion of the capitaloutstanding. For the purposes of preparing the cash flow statement these two elements must bepresented separately as follows:

The repayment of interest is presented within interest paid as part of cash flows fromoperating activities

The repayment of capital is presented as a separate item under cash flows from financingactivities.

Points to note

1 The acquisition of assets under a finance lease requires separate disclosure as a non-cash transaction (seeChapter 3 section 6).

2 For the purposes of the cash flow statement additions to PPE should exclude the effects of any new assetsacquired under finance leases as these have not been purchased for cash.

Interactive question 1: Finance lease [Difficulty level: Easy]

Camel Ltd enters into a finance lease on 1 January 20X7. Lease payments comprise three annual paymentsof CU10,000 commencing on 31 December 20X7. The asset would have cost CU24,869 to buy outright.The implicit interest rate is 10%.



16

Requirement

Show the effect of the finance lease on the cash flow statement on the basis that Camel Ltd uses theactuarial method to allocate interest to the periods of borrowing.


Solution

Cash flow (extract) statement for the year ended 31 December 20X7 CU

Cash flows from operating activitiesInterest paid

Cash flows from financing activitiesPayment of finance lease liabilities

WORKING

Interest Payment 31Bal b/f accrued December Bal c/f

Year ended 31 December 20X7 1.1.X7 at 10% 20X7 31.12.X7CU CU CU CU



Section overview

The consolidated cash flow statement shows the cash flows of the group (i.e. parent and subsidiaries)with third parties.

The basis of preparation is essentially the same as for the individual cash flow statement.

Dividends to the minority interest are disclosed separately, classified as cash flows from financingactivities.

Dividends received from associates are disclosed separately classified as cash flows from investingactivities.

The net cash effect of the acquisition/disposal of a subsidiary should be disclosed separately andclassified as cash flows from investing activities.

Cash receipts/payments to acquire/dispose of associates should be classified as cash flows frominvesting activities.

2.1 Basic principle

In principle the preparation of the group cash flow statement is the same as that for the individual entity inthat balance sheet and income statement information is converted into cash flow information, the differencebeing that this source information is consolidated.

The aim of the consolidated cash flow statement is to show the cash flows of the group withthird parties. (This is consistent with the preparation of the consolidated balance sheet and consolidatedincome statement.) This is achieved ‘automatically’ as the information forming the basis of the preparation



of the consolidated cash flow statement (i.e. the consolidated income statement and consolidated balancesheet) has already been adjusted for intra-group transactions.

A number of additional issues do need to be considered however:

Cash flows to the minority interest Cash received from associates Acquisitions/disposals of subsidiaries Acquisitions/disposals of associates

We will consider each of these in the remainder of this chapter.

2.2 Cash flows to the minority interest

The minority interest represents a third party so dividends paid to the minority interest should bereflected as a cash outflow. This payment should be presented separately and classified as ‘Cash flowsfrom financing activities’.

As we saw in Chapter 3 many of the cash flows were calculated by using a T account working. Thistechnique also applies to the consolidated cash flow statement. Dividends paid to the minority interest maybe calculated using a T account as follows:

MINORITY INTEREST

CU CUb/f MI (CBS) XMI (CIS) X

MI dividend paid (balancing figure) Xc/f MI (CBS) X

X X

Interactive question 2: Minority interest [Difficulty level: Exam standard]

Consolidated income statement (extract) for the year ended 31 December 20X7

CU'000Group profit before tax 60Income tax expense (20)Profit for the period 40

Attributable to: 30Equity holders of the parent 10Minority interest 40

Consolidated balance sheet (extract) as at 31 December

20X7 20X6CU'000 CU'000

Minority interest 204 200

Requirement

Calculate the dividend paid to the minority interest during 20X7.

Complete the T account below.



16

MINORITY INTEREST

CU'000 CU'000


2.3 Associates

There are two issues to consider with regard to the associate:

1 The aim of the cash flow statement is to show the cash flows of the parent and any subsidiaries withthird parties, therefore any cash flows between the associate and third parties are irrelevant.As a result, the group share of profit of the associate must be deducted as an adjustment inthe reconciliation of profit before tax to cash generated from operations. This is becausegroup profit before tax includes the results of the associate.

Worked example: Cash flows from operating activities


CU'000Group profit from operations 273Share of profit of associates 60Profit before tax 333Income tax expense (63)Profit for the period 270

Consolidated balance sheet (extracts) as at 31 December

20X7 20X6CU’000 CU’000

Inventories 867 694Receivables 1,329 1,218

Cash generated from operations would be calculated and shown as follows:

CU'000Profit before tax 333Adjustments for:

Share of profit of associates (60)273

Increase in trade receivables (1,329 – 1,218) (111)Increase in inventories (867 – 694) (173)Cash absorbed by operations (11)



2 Dividends received from the associate must be disclosed as a separate cash flow classified as‘Cash flows from investing activities’. The cash receipt can be calculated as follows:

INVESTMENTS IN ASSOCIATES

CU CUb/f Inv in A (CBS) XShare of profit of A (CIS) X Dividend received (balancing figure) X

c/f Inv in A (CBS) XX X

Interactive question 3: Dividends received from associates[Difficulty level: Exam standard]


CU'000Group profit from operations 100Share of profit of associates 20Profit before tax 120Income tax expense (50)Profit for the period 70

Consolidated balance sheet (extract) as at 31 December

20X7 20X6CU’000 CU’000

Investments in associates 184 176

Requirement

Calculate the dividend received from associates during 20X7.

Complete the T account below.


CU'000 CU'000


2.4 Acquisitions and disposals of subsidiaries

If a subsidiary is acquired or disposed of during the accounting period the net cash effect of thepurchase or sale transaction should be shown separately under ‘Cash flows from investingactivities’. The net cash effect will be the cash purchase price/cash disposal proceeds net of any cash orcash equivalents acquired or disposed of.



16

Worked example: Acquisition of a subsidiary

Warwick Ltd acquired 75% of Leamington Ltd by issuing 250,000 CU1 shares at an agreed value of CU2.50and CU200,000 in cash. At the date of acquisition the cash and cash equivalents in Leamington Ltd’s balancesheet amounted to CU30,000.

In the cash flow statement this would be shown as follows:

CU'000Cash flows from investing activitiesAcquisition of subsidiary Leamington Ltd, net of cash acquired (200 – 30) (170)

Disclosure is required in the notes to the cash flow statement of the following in aggregate in respectof both acquisitions and disposals of subsidiaries during the period:

Total purchase price/disposal consideration

Portion of purchase price/disposal consideration discharged by means of cash and cashequivalents

Amount of cash and cash equivalents in the subsidiary acquired or disposed of

Amount of assets and liabilities other than cash and cash equivalents in the subsidiary acquiredor disposed of, summarised by major category.

Examples of these disclosures can be found in BAS 7 Appendix A.

Point to note

As the cash effect of the acquisition/disposal of the subsidiary is dealt with in a single line item as we sawabove, care must be taken not to double count the effects of the acquisition/disposal whenlooking at the movements in individual asset balances.

Each of the individual assets and liabilities of a subsidiary acquired/disposed of during the period must beexcluded when comparing group balance sheets for cash flow calculations as follows:

Subsidiary acquired in the period Subtract PPE, inventories, payables, receivablesetc at the date of acquisition from the movementon these items.

Subsidiary disposed of in the period Add PPE, inventories, payables, receivables etc atthe date of disposal to the movements on theseitems.

This would also affect the calculation of the dividend paid to the minority interest. The T accountworking introduced in section 2.2 above would be modified as follows:

MINORITY INTEREST

CU CUMI in S at disposal X b/f MI (CBS) XMI dividend paid (balancing figure) X MI in S at acquisition Xc/f MI (CBS) X MI (CIS) X

X X



Worked example: Calculating cash flows

Continuing from the worked example above (Acquisition of a subsidiary) you have the following additionalinformation.

Consolidated balance sheet (extract) of Warwick Ltd at 31 December

20X7 20X6CU000 CU000

Property, plant and equipment 500 400

At the date of acquisition Leamington Ltd’s balance sheet included property, plant and equipment at a costof CU75,000.

There were no disposals of property, plant and equipment in the period.

Calculate the amount to be disclosed as ‘Purchase of property, plant and equipment’ under ‘Cash flowsfrom investing activities’.

Solution

Normally, when preparing the cash flow statement, a comparison of the opening and closing assets wouldbe made to determine the cost of additions. In this case if we make the comparison there are CU100,000 ofadditional assets (500 – 400). However, CU75,000 of these additional assets are as a result of theacquisition of the subsidiary. The cash outflow due to the purchase of the subsidiary as a whole is dealtwith separately as we described above, therefore we are only concerned with any other assets purchased.Therefore the information would be presented as follows:

CUCash flows from investing activitiesAcquisition of subsidiary Leamington Ltd, net of cash acquired (170)Purchase of property, plant and equipment (500 – 400 – 75) (25)

Alternatively the adjustment could be made in a T account working as follows:

PROPERTY, PLANT AND EQUIPMENT – COST ACCOUNT

CU'000 CU'000b/f 400On acquisition 75Additions (balancing figure) 25 c/f 500

500 500

Interactive question 4: Acquisition of a subsidiary [Difficulty level: Exam standard]

On 1 October 20X8 P Ltd acquired 90% of S Ltd by issuing 100,000 shares at an agreed value of CU2 pershare and paying CU100,000 in cash.

At that time the net assets of S Ltd were as follows:

CU'000Property, plant and equipment 190Inventories 70Trade receivables 30Cash and cash equivalents 10Trade payables (40)

260



16

The consolidated balance sheets of P Ltd as at 31 December were as follows:20X8 20X7

CU'000 CU'000Non-current assets

Property, plant and equipment 2,500 2,300Goodwill 66 –


Inventories 1,450 1,200Trade receivables 1,370 1,100Cash and cash equivalents 76 50

2,896 2,3505,462 4,650

Capital and reservesOrdinary share capital (CU1 shares) 1,150 1,000Share premium account 650 500Retained earnings 1,791 1,530

Attributable to equity holders of P Ltd 3,591 3,030Minority interest 31 –Equity 3,622 3,030Current liabilities

Trade payables 1,690 1,520Income tax payable 150 100

1,840 1,6205,462 4,650

The consolidated income statement for the year ended 31 December 20X8 was as follows:CU'000

Revenue 10,000Cost of sales (7,500)Gross profit 2,500Administrative expenses (2,080)Profit before tax 420Income tax expense (150)Profit for the period 270

Attributable to:Equity holders of P Ltd 261Minority interest 9

270

The statement of changes in equity for the year ended 31 December 20X8 (extract) was as follows:RetainedearningsCU'000

Balance at 31 December 20X7 1,530Profit for the period 261Balance at 31 December 20X8 1,791

You are also given the following information:

1 All other subsidiaries are wholly owned.2 Depreciation charged to the consolidated income statement amounted to CU210,000.3 There were no disposals of property, plant and equipment during the year

Requirement

Prepare a consolidated cash flow statement for P Ltd for the year ended 31 December 20X8 under theindirect method in accordance with BAS 7 Cash Flow Statements. The only notes required are thosereconciling profit before tax to cash generated from operations and a note showing the effect of thesubsidiary acquired in the period.




Solution

Consolidated cash flow statement for the year ended 31 December 20X8

CU'000 CU'000Cash flows from operating activitiesCash generated from operations (Note 2)Income taxes paidNet cash from operating activities

Cash flows from investing activitiesAcquisition of subsidiary S Ltd, net of cash acquired (Note 2)Purchase of property, plant & equipmentNet cash used in investing activities

Cash flows from financing activitiesProceeds from issue of share capitalDividend paid to minority interestNet cash from financing activities

Net increase in cash and cash equivalentsCash and cash equivalents at the beginning of periodCash and cash equivalents at the end of period


(1) Reconciliation of profit before tax to cash generated from operations

CU'000Profit before taxationAdjustments for:

Depreciation

Increase in trade and other receivablesIncrease in inventoriesIncrease in trade payablesCash generated from operations

(2) Acquisition of subsidiary

During the period the group acquired subsidiary S Ltd. The fair value of assets acquired and liabilitiesassumed were as follows:

CU'000Cash and cash equivalentsInventoriesReceivablesProperty, plant and equipmentTrade payablesMinority interest

GoodwillTotal purchase priceLess: Cash of S LtdLess: Non-cash considerationCash flow on acquisition net of cash acquired



16

WORKINGS

(1)


CU'000 CU'000

(2)

GOODWILL

CU'000 CU'000

(3)

MINORITY INTEREST

CU'000 CU'000

(4)

INCOME TAX PAYABLE

CU'000 CU'000




Interactive question 5: Disposal [Difficulty level: Exam standard]

Below is the consolidated balance sheet of the Othello Group as at 30 June 20X8 and the consolidatedincome statement for the year ended on that date:

Consolidated balance sheet as at 30 June

20X8 20X7CU’000 CU’000

Non-current assetsProperty, plant and equipment 4,067 3,950

Current assetsInventories 736 535Receivables 605 417Cash and cash equivalents 294 238

1,635 1,1905,702 5,140

Capital and reservesShare capital 1,000 1,000Retained earnings 3,637 3,118

Attributable to equity holders of Othello Ltd 4,637 4,118Minority interest 482 512

Equity 5,119 4,630Current liabilities

Trade payables 380 408Income tax payable 203 102

583 5105,702 5,140

Consolidated income statement for the year ended 30 June 20X8 (summarised)

CU’000Continuing operationsProfit before tax 862Income tax expense (((290)Profit for the period from continuing operations 572

Discontinued operationsProfit for the period from discontinued operations 50Profit for the period 622

Attributable to:Equity holders of Othello Ltd 519Minority interest 103

622

You are given the following information:

1 Othello Ltd sold its entire interest in Desdemona Ltd on 31 March 20X8 for cash of CU400,000.Othello Ltd had acquired an 80% interest in Desdemona Ltd on incorporation several years ago. Thenet assets at the date of disposal were:

CU’000Property, plant and equipment 390Inventories 50Receivables 39Cash and cash equivalents 20Trade payables (42)

457



16

2 The profit for the period from discontinued operations figure is made up as follows:

CU’000Profit before tax 20Income tax expense (4)Profit on disposal 34

50

3 The depreciation charge for the year was CU800,000.

There were no disposals of non-current assets other than on the disposal of the subsidiary.

Requirements

With regard to the consolidated cash flow statement for the year ended 30 June 20X8:

(a) Show how the disposal will be reflected in the cash flow statement(b) Calculate additions to property, plant and equipment as they will be reflected in the cash flow

statement.(c) Calculate dividends paid to the minority interest.(d) Prepare the note to the cash flow statement required for the disposal of the subsidiary.(e) Prepare the reconciliation of profit before tax to cash generated from operations.

Work to the nearest CU000


Solution

(a) Cash flows from investing activities

CU'000

(b) Cash flows from investing activities (W1)

CU'000

(c) Cash flows from financing activities (W2)

CU'000

(d) Notes to the cash flow statement

During the period the group disposed of its subsidiary Desdemona Ltd. The book value of assets andliabilities disposed of were as follows:

CU'000Cash and cash equivalentsInventoriesReceivablesProperty, plant and equipmentPayablesMinority interest (W2)

Profit on disposalTotal sale proceedsLess: Cash of Desdemona Ltd disposed ofCash flow on disposal net of cash disposed of



(e) Reconciliation of profit before tax to cash generated from operations

CU'000

Profit before taxAdjustments for:Depreciation

Increase in receivablesIncrease in inventoriesIncrease in payablesCash generated from operations

WORKINGS

(1) PROPERTY, PLANT AND EQUIPMENT – NBV

CU'000 CU'000

(2) MINORITY INTEREST

CU'000 CU'000


2.5 Acquisitions and disposals of associates

Receipts and payments of cash to acquire/dispose of associates should be classified as ‘Cash flowsfrom investing activities.’



16


Summary



Self-test


1 In accordance with BAS 7 Cash Flow Statements what is the net cash flow from financing activities giventhe information below?

Receipts CU Payments CUShare issue 5,000 Loan repayments (including CU300

interest)2,200

Loan 9,000 Expense of share issue 500

A CU7,100B CU11,300C CU11,600D CU12,100

2 Sun Ltd provides the following information:

Consolidated balance sheet as at 31 December

20X8 20X7CU CU

Inventories 550,000 475,000Trade receivables 943,000 800,000Trade payables 620,000 530,000


CUProfit before tax 775,000

During the year Sun Ltd acquired an 80% interest in the equity share capital of Shine Ltd. Extractsfrom Shine Ltd’s balance sheet at acquisition were as follows:

CUInventories 80,000Trade receivables 110,000Trade payables 70,000

In accordance with BAS 7 Cash Flow Statements what is the cash generated from operations in theconsolidated cash flow statement of Sun Ltd for the year ended 31 December 20X8?

A CU647,000B CU743,000C CU757,000D CU767,000

3 Spades Ltd acquired an 80% interest in the share capital of Clubs Ltd on 1 May 20X4, when the netassets of Clubs Ltd were CU600,000. Extracts from the consolidated balance sheet of Spades Ltd as at30 September 20X6 are as follows:

20X6 20X5CU CU

Minority interest 750,000 720,000

Minority interest in the profit for the year was CU100,000.

What is the amount to be included in the consolidated cash flow statement for the dividends paid tothe minority according to BAS 7 Cash Flow Statements?

A CU90,000B CU70,000C CU190,000D CU250,000



16

4 The following are extracts from the balance sheet of Scratch Ltd as at 31 December:

20X4 20X3CUm CUm

Property, plant and equipment (Note 1) 192 175Obligations under finance leases (Note 2)

Within one year 20 10After more than one year 51 45

Notes

1 During 20X4, Scratch Ltd disposed of property, plant and equipment with a net book value ofCU10 million and charged depreciation of CU42 million.

2 Rentals paid under finance leases during 20X4 amounted to CU18 million. Interest charged to theincome statement amounted to CU6 million.

What amount should be included in purchase of property, plant and equipment in the cash flowstatement for the year ended 31 December 20X4 in accordance with BAS 7 Cash Flow Statements?


5 How should an acquisition or disposal of a subsidiary be disclosed in a consolidated cash flowstatement prepared in accordance with BAS 7 Cash Flow Statements?

A On the face of the cash flow statement, giving an analysis of all the cash flows relating to thesubsidiary

B As a note to the cash flow statement, showing a summary of the effects of acquisitions anddisposals of subsidiaries, including how much of the consideration comprised cash

C It need not be disclosed at all

D As a note to the cash flow statement, showing a breakdown of all cash flows relating to thesubsidiary

6 The following extracts relate to Rain Ltd:


CUGroup profit before tax 500,000Income tax expense (150,000)Profit for the period 350,000Attributable to:

Equity holders of Rain Ltd 295,000Minority interest 55,000

350,000

Consolidated balance sheet as at 31 December

20X5 20X4CU CU

Minority interest 550,000 525,000

During the year ended 31 December 20X5 Rain Ltd acquired a 75% interest in the equity shares ofPuddle Ltd when the net assets of Puddle Ltd were CU400,000.

In accordance with BAS 7 Cash Flow Statements what was the amount of dividend paid to the minorityinterest in the year ended 31 December 20X5?

A CU20,000B CU130,000C CU180,000D CU330,000



7 Brink Ltd acquired a 75% interest in the share capital of Edge Ltd on 1 January 20X6. The balance onEdge Ltd's property, plant and equipment at that date was CU500,000.

Extracts from the consolidated balance sheet of Brink Ltd as at 31 December 20X6 are as follows:

20X6 20X5CU CU

Property, plant and equipment 4,100,000 3,700,000

Depreciation charged for the year ended 31 December 20X6 was CU970,000.

What is the amount to be included in the consolidated cash flow statement for purchase of property,plant and equipment in accordance with BAS 7 Cash Flow Statements?

A CU70,000B CU870,000C CU995,000D CU1,370,000

8 The consolidated financial statements of Brad Ltd show the following information:


CU'000Group profit from operations 220Share of profit of associates 44

264Income tax expense (110)Profit for period 154

Consolidated balance sheet (extract) as at 31 December 20X7

20X7 20X6CU'000 CU'000

Investments in associates 405 387

In accordance with BAS 7 Cash Flow Statements what is the dividend receivable from associates?

CU'000A 18B 26C 44D 62

9 Romeo Ltd had acquired 75% of Juliet Ltd for CU750,000 a number of years ago. During the yearended 31 December 20X7 Romeo Ltd disposed of its entire interest in Juliet Ltd for CU1,020,000 incash. The net assets of Juliet Ltd at the date of disposal were:

CU'000Property, plant and equipment 700Inventories and receivables 150Cash and cash equivalents 75Trade payables (47)

878

In accordance with BAS 7 Cash Flow Statements what amount would be disclosed as ‘Disposal ofsubsidiary’ under cash flows from investing activities?

CU'000A 361B 750C 945D 1,020



16

10 TASTYDESSERTS LTD

The following are extracts from the consolidated financial statements of Tastydesserts Ltd and one ofits wholly owned subsidiaries, Custardpowders Ltd, the shares in which were acquired on 31 October20X8.

Balance sheets as atTastydesserts Ltd Custardpowders

Group Ltd31 December 31 December 31 October

20X8 20X7 20X8ASSETS CU'000 CU'000 CU'000Non-current assets

Property, plant and equipment 4,764 3,685 694Goodwill 42 – –Investments in associates 2,195 2,175 –

Current assetsInventories 1,735 1,388 306Receivables 2,658 2,436 185Bank balances and cash 43 77 7

Total assets 11,437 9,761 1,192


Ordinary share capital 4,896 4,776 400Share premium account 216 – –Retained earnings 2,458 2,000 644

Non-current liabilitiesLoans 1,348 653 –

Current liabilitiesPayables 1,915 1,546 148Bank overdrafts 176 343 –Taxation 346 380 –Dividends payable 82 63 –

Total equity and liabilities 11,437 9,761 1,192


CU'000Profit before interest and tax 546Share of profit of associates 120Profit before tax 666Income tax expense 126Profit for the period 540

Attributable to:Equity holders of Tastydesserts Ltd 540Minority interest –

540

The following information is also given:

(1) The consolidated figures at 31 December 20X8 include Custardpowders Ltd.

(2) Depreciation charged on property, plant and equipment during the year was CU78,000.Additions to property, plant and equipment, excluding property, plant and equipment acquiredon the acquisition of Custardpowders Ltd, were CU463,000. There were no disposals.



(3) The cost on 31 October 20X8 of the shares in Custardpowders Ltd was CU1,086,000comprising the issue of CU695,000 unsecured loan stock at par, 120,000 ordinary shares of CU1each at a value of 280p each and CU55,000 in cash.

(4) No write down of goodwill was required during the period.

(5) Total dividends charged to retained earnings by Tastydesserts Ltd during the period amounted toCU82,000.

Requirement

Prepare a consolidated cash flow statement for Tastydesserts Ltd for the year ended 31 December20X8 using the indirect method, a note reconciling profit before tax to cash generated fromoperations and a note showing the effect of the subsidiary acquired in the period. (15 marks)

11 GREENFINGERS LTD

Greenfingers Ltd is a 40 year old company producing wooden furniture. 22 years ago it acquired a100% interest in a timber import company, Arbre Ltd. In 20W9 it acquired a 40% interest in acompetitor, Water Features Ltd and on 1 January 20X7 it acquired a 75% interest in Garden FurnitureDesigns Ltd. The draft consolidated accounts for the Greenfingers Group are as follows.

Draft consolidated income statement for the year ended 31 December 20X7

CU'000Profit from operations 4,455Share of profit of associates 1,050Dividends from long-term investments 465Interest payable (450)Profit before taxation 5,520Income tax expense (1,485)Profit after taxation 4,035

Attributable to:Equity holders of Greenfingers Ltd 3,735Minority interest 300

4,035



16

Draft consolidated balance sheet as at 31 December

20X7 20X6CU'000 CU'000 CU'000 CU'000


Property, plant and equipmentBuildings at net book value 6,225 6,600Machinery: Cost 9,000 4,200

Accumulated depreciation (3,600) (3,300)Net book value 5,400 900

11,625 7,500Goodwill 300 –Investments in associates 3,300 3,000Long-term investments 1,230 1,230


Inventories 5,925 3,000Receivables 5,550 3,825Cash and cash equivalents 13,545 5,460

25,020 12,285Total assets 41,475 24,015EQUITY AND LIABILITIESCapital and reservesOrdinary share capital (25p shares) 11,820 6,000Share premium account 8,649 6,285Retained earnings 10,335 7,500

Attributable to equity holders of Greenfingers Ltd 30,804 19,785Minority interest 345 –Equity 31,149 19,785Non-current liabilitiesFinance lease liabilities 2,130 510Loans 4,380 1,500

6,510 2,010Current liabilities

Trade payables 1,500 840Finance lease liabilities 720 600Income tax payable 1,476 690Accrued interest and finance charges 120 90



1 There have been no acquisitions or disposals of buildings during the year.

Machinery costing CU1.5 million was sold for CU1.5 million resulting in a profit of CU300,000.New machinery was acquired in 20X7, including additions of CU2.55 million acquired underfinance leases.



2 Information relating to the acquisition of Garden Furniture Designs Ltd is as follows:

CU'000Property, plant and equipment 495Inventories 96Trade receivables 84Cash 336Trade payables (204)Income tax (51)

756Minority interest (189)

567Goodwill 300

867

2,640,000 ordinary shares issued as part consideration 825Balance of consideration paid in cash 42

867

Requirement

Prepare a consolidated cash flow statement for the Greenfingers Group for the year ended31 December 20X7 using the indirect method. The only note required is that reconciling profit beforetax to cash generated from operations.

(20 marks)



16

Technical reference

Point to note

All of BAS 7 is examinable with the exception of paragraphs 24-28, 38 and Appendix B. The paragraphslisted below are the key references you should be familiar with.

1 Cash flow statement and finance leases

Disclose the assets acquired via finance leases as a non-cash transaction BAS 7 (43 – 44)


Example of a consolidated cash flow statement BAS 7 Appendix A

Cash flows arising from acquisitions/disposals of subsidiaries and associatesshould be

BAS 7 (39)

– Presented separately

– Classified as investing activities

Additional information should be disclosed in respect of acquisitions anddisposals

BAS 7 (40)

Also see Chapter 3 Technical reference section.




1 CCU

Inflows Share issue 5,000Loan 9,000

14,000Outflows Share expenses (500)

Loan repayments, less interest (2,200 – 300) (1,900)11,600

2 DCU

Profit before tax 775,000Decrease in inventory (550 – 475 – 80) 5,000Increase in receivables (943 – 800 –110) (33,000)Increase in payables (620 – 530 – 70) 20,000

767,000

3 CMINORITY INTEREST

CU'000 CU'000c/f 750 b/f 720

Minority interest in income statement 100Dividend paid to minority () 190 Acquisition of subsidiary (600 20%) 120

940 940

4 B The additions in the cash flow statement should only be additions for cash. The inception of afinance lease is not a cash transaction and must therefore be excluded. The amount of assetsacquired under finance leases is calculated by looking at the movement in the liability for financeleases. As this balance represents capital only, the payment which goes into the working mustexclude the interest element.

NON-CURRENT ASSETS AT NBV

CUm CUmb/f 175 Depreciation 42Total additions () 69 Disposals 10

___ c/f 192244 244

OBLIGATIONS UNDER FINANCE LEASES

CUm CUmPayment 12 b/f 55

Additions () 28c/f 71 __

83 83

Therefore additions for cash (69 – 28) = CU41m

5 B BAS 7 (40)



16

6 B

MINORITY INTEREST

CU CUb/f (CBS) 525,000

MI dividend paid () 130,000 MI (CIS) 55,000

MI in S acquired (400,000 25%) 100,000c/f (CBS) 550,000

680,000 680,000

7 BPPE

CU'000 CU'000b/f 3,700Acquired with Edge 500 Depreciation charge 970Additions () 870 c/f 4,100

5,070 5,070

8 B


CU'000 CU'000b/f (CBS) 387Share of profit (CIS) 44 Dividend received () 26(tax already deducted)

___ c/f (CBS) 405431 431

9 C (1,020 - 75) = CU945,000

10 TASTYDESSERTS LTD

Cash Flow Statement for the year ended 31 December 20X8

CU'000 CU'000Cash flows from operating activitiesCash generated from operations (Note 1) 767Income taxes paid (W1) (160)Net cash from operating activities 607

Cash flows from investing activitiesAcquisition of subsidiary Custardpowders Ltd, net of cash acquired (Note 2) (48)Purchase of property, plant and equipment (463)Dividends received from associates (W2) 100Net cash used in investing activities (411)

Cash flows from financing activitiesDividends paid (63)Net cash used in financing activities (63)Net increase in cash and cash equivalents 133Cash and cash equivalents at beginning of period (266)Cash and cash equivalents at end of period (133)





CU'000Profit before taxation 666Adjustments for:Depreciation 78Share of profit of associates (120)

624Increase in receivables (2,658 – 2,436 – 185) (37)Increase in inventories (1,735 – 1,388 – 306) (41)Increase in payables (1,915 – 1,546 – 148) 221Cash generated from operations 767


During the period the group acquired subsidiary Custardpowders Ltd. The fair value of the assetsacquired and liabilities assumed were as follows:

CU'000Bank balances and cash 7Inventories 306Receivables 185Property, plant and equipment 694Payables (148)

1,044Goodwill 42Total purchase price 1,086Less: Cash of Custardpowders Ltd (7)Less: Non-cash consideration – Loan stock issued (695)

– Shares issued (336)Cash flow on acquisition net of cash acquired 48

WORKINGS

(1)

INCOME TAX PAYABLE

CU'000 CU'000Cash paid (β) 160 b/f 380c/f 346 CIS 126

506 506

(2)


CU'000 CU'000b/f Inv in A 2,175Share of profit 120 Dividends received (β) 100

c/f Inv in A 2,1952,295 2,295



16

(3)


CU'000 CU'000b/f 4,776

c/f (4,896 + 216) 5,112 Issued to acquire S (120,000

CU2.80)

336

5,112 5,112

No shares have been issued for cash during the year.

11 GREENFINGERS LTD


CU'000 CU'000Cash flows from operating activitiesCash generated from operations (note 1) 1,116Interest paid (W2) (420)Income taxes paid (W3) (750)Net cash used in operating activities (54)

Cash flows from investing activitiesAcquisition of subsidiary Garden Furniture Designs Ltd, net of cashacquired (W4)

294

Purchase of property, plant and equipment (W5) (3,255)Proceeds from sale of property, plant and equipment 1,500Dividends received 465Dividends received from associate (W6) 750Net cash used in investing activities (246)

Cash flows from financing activitiesProceeds from issue of ordinary share capital (W7) 7,359Proceeds from issue of loan notes (W8) 2,880Payments under finance leases (W10) (810)Dividends paid (3,735 + 7,500 – 10,335) (900)Dividends paid to minority interests (W9) (144)Net cash from financing activities 8,385Net increase in cash and cash equivalents 8,085Cash and cash equivalents at beginning of year 5,460Cash and cash equivalents at end of year 13,545

Notes


CU'000Profit before tax 5,520Adjustments for:Depreciation (W1) 975Profit on sale of property, plant and equipment (300)Share of profits of associates (1,050)Investment income (465)Interest expense 450

5,130Increase in trade and other receivables (5,550 – 3,825 – 84) (1,641)Increase in inventories (5,925 – 3,000 – 96) (2,829)Increase in trade payables (1,500 – 840 – 204) 456Cash generated from operations 1,116



WORKINGS

(1)ACCUMULATED DEPRECIATION – PLANT

CU'000 CU'000b/f (Plant) 3,300

Disposal 300Depreciation charge (β) 600

c/f (Plant) 3,600 ____3,900 3,900

Total depreciation: CU'000Freehold buildings (6,600 – 6,225) 375Plant 600

975

(2)INTEREST PAYABLE

CU'000 CU'000Cash paid (β) 420 b/f 90c/f 120 CIS 450

540 540

(3)TAXATION

CU'000 CU'000Cash paid (β) 750 b/f 690c/f 1,476 CIS 1,485

On acquisition 512,226 2,226

(4) Purchase of subsidiary

CU'000Cash received on acquisition 336Less: Cash consideration (42)Net cash inflow 294

(5)MACHINERY

CU'000 CU'000b/f 4,200 Disposal 1,500On acquisition 495Leased 2,550Additions (β) 3,255 c/f 9,000

10,500 10,500

(6)INVESTMENTS IN ASSOCIATES

CU'000 CU'000b/f 3,000Share of profit (CIS) 1,050 Dividends received (β) 750

c/f 3,3004,050 4,050



16

(7)SHARE CAPITAL AND PREMIUM

CU'000 CU'000b/f (6,000 + 6,285) 12,285Non-cash consideration (660 + 165) 825

c/f (11,820 + 8,649) 20,469 Proceeds from issue (β) 7,35920,469 20,469

(8)LOAN NOTES

CU'000 CU'000b/f 1,500Proceeds from issue (β) 2,880

c/f 4,3804,380 4,380

(9)MINORITY INTERESTS

CU'000 CU'000b/f –

Dividends to MI (β) 144 Share of profits (CIS) 300c/f 345 On acquisition 189

489 489

(10)OBLIGATIONS UNDER FINANCE LEASES

CU'000 CU'000b/f Current 600

Long-term 510

Capital repayment (β) 810 New lease commitment 2,550

c/f Current 720Long-term 2,130

3,660 3,660





Cash flow statement (extract) for the year ended 31 December 20X7

CUCash flows from operating activitiesInterest paid (2,487)

Cash flows from financing activitiesPayment of finance lease liabilities (7,513)

WORKING

Year ended 31 December 20X7Bal b/f1.1.X7

Interestaccrued at10%

Payment 31December20X7 Bal c/f 31.12.X7

CU CU CU CU24,869 2,487 (10,000) 17,356

The payment of CU10,000 therefore represents:

CUInterest 2,487Capital (10,000 – 2,487) 7,513

10,000


MINORITY INTEREST

CU'000 CU'000b/f MI (CBS) 200MI (CIS) 10

MI dividend paid (balancing figure) 6c/f MI (CBS) 204

210 210

Answer to interactive question 3


CU'000 CU'000

b/f Inv in A 176Share of profit of A 20 Dividend received (balancing figure) 12

c/f Inv in A 184196 196



16



CU'000 CU'000Cash flows from operating activitiesCash generated from operations (Note 1) 340Income taxes paid (W4) (100)Net cash from operating activities 240

Cash flows from investing activitiesAcquisition of subsidiary S Ltd, net of cash acquired (Note 2) (90)Purchase of property, plant and equipment (W1) (220)Net cash used in investing activities (310)

Cash flows from financing activitiesProceeds from issue of share capital (1,150 + 650 – 1,000 – 500 – (100 CU2)) 100Dividend paid to minority interest (W3) (4)Net cash from financing activities 96

Net increase in cash and cash equivalents 26Cash and cash equivalents at the beginning of period 50Cash and cash equivalents at the end of period 76



CU'000Profit before taxation 420Adjustments for:

Depreciation 210630

Increase in trade receivables (1,370 – 1,100 – 30) (240)Increase in inventories (1,450 – 1,200 – 70) (180)Increase in trade payables (1,690 – 1,520 – 40) 130Cash generated from operations 340


During the period the group acquired subsidiary S Ltd. The fair value of assets acquiredand liabilities assumed were as follows:

CU'000Cash and cash equivalents 10Inventories 70Receivables 30Property, plant and equipment 190Trade payables (40)Minority interest (26)

234Goodwill 66Total purchase price 300Less: Cash of S Ltd (10)Less: Non-cash consideration (200)Cash flow on acquisition net of cash acquired 90



WORKINGS

(1)PROPERTY, PLANT AND EQUIPMENT

CU'000 CU'000b/f 2,300 Depreciation 210On acquisition 190 c/f 2,500Additions (balancing figure) 220

2,710 2,710

(2)GOODWILL

CU'000 CU'000b/f –Additions (300 – (90% 260)) 66 Impairment losses (balancing figure) 0

c/f 6666 66

(3)MINORITY INTEREST

CU'000 CU'000Dividend (balancing figure) 4 b/f –c/f 31 On acquisition 26

CIS 935 35

(4)INCOME TAX PAYABLE

CU'000 CU'000b/f 100

Cash paid (balancing figure) 100 CIS 150c/f 150

250 250


Disposal of subsidiary

(a) Cash flows from investing activitiesCU'000

Disposal of subsidiary Desdemona Ltd, net of cash disposed of (400 – 20) 380

(b) Cash flows from investing activitiesCU'000

Purchase of property, plant and equipment (W1) (1,307)

(c) Cash flows from financing activitiesCU'000

Dividend paid to minority interest (W2) (42)



16

(d) Notes to the cash flow statement

During the period the group disposed of subsidiary Desdemona Ltd. The book value of assets andliabilities disposed were as follows:

CU’000Cash and cash equivalents 20Inventories 50Receivables 39Property, plant and equipment 390Payables (42)Minority interest (W2) (91)

366Profit on disposal 34Total sale proceeds 400Less: Cash of Desdemona Ltd disposed of (20)Cash flow on disposal net of cash disposed of 380

(e) Reconciliation of profit before tax to cash generated from operations

CU’000Profit before tax (862 + (20 – 4)) 878Adjustments for:Depreciation 800

1,678Increase in receivables (605 – 417 + 39) (227)Increase in inventories (736 – 535 + 50) (251)Increase in payables (380 – 408 + 42) 14Cash generated from operations 1,214

WORKINGS

(1)PROPERTY, PLANT AND EQUIPMENT – NBV

CU'000 CU'000b/f 3,950 c/f 4,067Additions (balancing figure) 1,307 Disposal of sub 390

Depreciation charge 8005,257 5,257

(2)MINORITY INTEREST

CU'000 CU'000c/f 482 b/f 512Disposal of sub (457 x 20%) 91 CIS 103Dividends to MI (balancing figure) 42

615 615




Contents

Appendix

BFRS financial statements

Topic List

1 Income statement

2 Balance sheet

3 Cash flow statement





BFRS financial statements

This appendix illustrates the layout and presentation of an individual company’s financial statementsin line with the Bangladesh accounting standards which fall within the Financial Accounting syllabus.

It is not a full-scale disclosure checklist and comparative figures have been omitted.

1 Income statement

SPECIMEN LTD

Income statement for the year ended 31 March 20X6

Notes CU’000Continuing operations

2 Revenue XCost of sales (X)Gross profit XOther operating income XDistribution costs (X)Administrative expenses (X)

3 Profit/(loss) from operations X/(X)4 Finance costs (X)5 Investment income X

Profit/(loss) before tax X/(X)Income tax expense (X)Profit/(loss) for the period from continuing operations X/(X)Discontinued operations

20 Profit/(loss) for the period from discontinued operations X/(X)Profit/(loss) for the period X/(X)

APPENDIX


2 Balance sheet

SPECIMEN LTD

Balance sheet as at 31 March 20X6

Notes CU’000 CU’000ASSETSNon-current assets

6 Property, plant and equipment X7 Intangibles X

Investments XX

Current assets8 Inventories X

Trade and other receivables XInvestments XCash and cash equivalents X

X20 Non-current assets held for sale X

XTotal assets X


9 Ordinary share capital X9 Share premium account X

6 Revaluation reserve X10 Retained earnings X

Equity X

Non-current liabilities11 Preference share capital (redeemable) X12 Finance lease liabilities X13 Borrowings X

X

Current liabilitiesTrade and other payables XTaxation X

20 Liabilities held for sale X14 Provisions X13 Borrowings X12 Finance lease liabilities X

XTotal equity and liabilities X

Date authorised by the Executive Board for issue.



3 Cash flow statement

SPECIMEN LTD

Cash flow statement for the year ended 31 March 20X6

Notes CU’000

CU’000

21 Cash flows from operating activitiesCash generated from operations XInterest paid (X)Income taxes paid (X)

Net cash from operating activities X

Cash flows from investing activities

23 Purchase of property, plant and equipment (X)Proceeds from sale of property, plant and equipment XInterest received XDividends received X

Net cash used in investing activities (X)

Cash flows from financing activitiesProceeds from issue of share capital XProceeds from issue of long-term borrowings XDividends paid (X)

Net cash used in financing activities (X)Net increase in cash and cash equivalents XCash and cash equivalents at beginning of period X

22 Cash and cash equivalents at end of period X


SPECIMEN LTD

Statement of changes in equity for the year ended 31 March 20X6

Ordinaryshare Share Revaluation Retained

Attributable to equity holders of Specimen Ltd capital premium reserve earnings TotalNotes CU’000 CU’000 CU’000 CU’000 CU’000

Balance brought forward– as reported X X X X X

10 – correction of error – – – (X) (X)– as restated X X X X XRecognised directly in equity:Revaluation of non-current assets – – X – XTransfer of excess depreciation

on revaluations – – (X) X -Total recognised directly in equity – – X X XProfit for the period – – – X XTotal recognised income and

expense for the period – – X X X15 Dividends on ordinary shares – – – (X) (X)9 Issue of share capital X X – – X

X X X X XBalance carried forward X X X X X

APPENDIX


5 Notes to the financial statements – 31 March 20X6

(1) Accounting policies

(a) Accounting convention

The financial statements are prepared in accordance with Bangladesh Financial ReportingStandards and under the historical cost convention, modified to include the revaluation offreehold and long leasehold land and buildings.

(b) Intangibles

Goodwill is the difference between the fair value of the consideration paid on the acquisition of abusiness and the aggregate of the fair values of its identifiable assets and liabilities and contingentliabilities. It is subject to annual impairment reviews.

Development expenditure is recognised as an intangible asset to the extent it is expected togenerate future economic benefits. It is amortised over its useful life, typically five years.

(c) Property, plant and equipment

Non-current asset properties are valued at least every three years, and in intervening years ifthere is an indication of a material change in value.

Surpluses on valuations of freehold and long leasehold non-current asset properties arerecognised directly in equity in the revaluation reserve, and any deficits below original cost arerecognised in profit or loss.

Plant and equipment is carried at cost.

Any plant and equipment expected to be sold within 12 months of the decision to dispose of it isreclassified as assets held for sale, presented separately in the balance sheet. It is carried at thelower of its carrying amount at the date of the decision to sell and fair value less costs to sell.Any write-down is shown as an impairment loss.

(d) Depreciation

Depreciation is recognised in respect of property, plant and equipment other than freehold landand assets classified as held for sale, at rates calculated to write off the cost or valuation, lessestimated residual value, of each asset evenly over its expected useful life, as follows:

Freehold buildings – over 50 years Leasehold land and buildings – over the lease term Plant and equipment – over 5 to 15 years

The depreciation methods and the useful lives and residual values on which depreciation is basedare reviewed annually.

(e) Leased assets

Assets held under finance leases are included in property, plant and equipment at their fair valueand depreciated over their useful lives. Lease payments consist of capital and interest elementsand the interest is recognised in profit or loss. The annual rentals in respect of operating leasesare recognised in profit or loss.

(f) Borrowings

Borrowings are recognised at the proceeds received. Preference shares which are redeemable ona specific date are classified as long-term liabilities, while the dividends relating to them arerecognised in the finance cost in the income statement.

(g) Provisions

Provisions are recognised when the company has a present obligation which will result in anoutflow of resources. Restructuring provisions mainly comprise lease termination penalties andemployee termination payments.



(h) Revenue

Sales are recognised on delivery of the goods to customers and on the performance of servicesfor customers. They are shown net of VAT and discounts.

(i) Research costs

Research costs are recognised in profit or loss as incurred. Some development costs arecapitalised (see (b) above).

(j) Inventories

The cost of inventories comprises all costs of purchase and conversion and other costs incurredin bringing them to their present location and condition. The FIFO cost formula is applied.

(2) Revenue

CU’000Sale of goods XPerformance of services X

X

(3) Profit/loss from operations

Profit/loss from operations is shown after charging/crediting:

CU’000Research and development costs XDepreciation of property, plant and equipment XProfit/loss on disposal of property, plant and equipment (X)Impairment of assets held for sale XImpairment of goodwill XAmortisation of development costs XOperating lease payments XEmployee benefits XCost of inventories sold, included in cost of sales X

(4) Finance costs

CU’000Interest on borrowings XDividends on redeemable preference shares XInterest on finance lease liabilities X

X

The interest rate for the borrowing costs capitalised was X%.

(5) Investment income

CU’000Interest XDividends X

X

APPENDIX



PropertiesPlant

Free- Long Short Under andhold leasehold leasehold construction equipment Total

CU’000

CU’000 CU’000 CU’000 CU’000 CU’000

Cost or valuationAt 1 April 20X5 X X X X X XRevaluation surplus X – – – – XAdditions X X X X X XAcquired in businesscombination

– – X – – X

Transfers X – – (X) – –Classified as held for sale – – (X) – (X) (X)Disposals (X) (X) (X) – (X) (X)At 31 March 20X6 X X X X X X

DepreciationAt 1 April 20X5 (X) (X) (X) – (X) (X)Classified as held for sale – – X – X XDisposals X X X – X XCharge for year (X) (X) (X) – (X) (X)At 31 March 20X6 (X) (X) (X) – (X) (X)

Carrying amountAt 31 March 20X6 X X X X X XAt 31 March 20X5 X X X X X X

The carrying amounts at 31 March 20X6 on the historical cost basis were CUX for freeholdproperties and CUX for long leasehold properties.

Non-current asset properties were revalued as follows.

Freehold properties were revalued on 1 April 20X5 by Messrs Tottitup, an independent firm ofChartered Surveyors, at CUX, on the basis of existing use value. Open market value is not consideredto be materially different to existing use value.

Long leases were revalued in 20X4 at CUX by Messrs Tottitup, Chartered Surveyors, on the basis ofopen market value. In the directors’ opinion, there has been no indication of a material change in valueduring the year.

The carrying amount of plant and equipment of CUX includes an amount of CUY in respect of assetsheld under finance leases.

Non-current asset properties under construction include total interest capitalised to 31 March 20X6of CUX, of which CUY was capitalised in the current year.

(7) Intangibles

DevelopmentGoodwill costs TotalCU’000 CU’000 CU’000

CostAt 1 April 20X5 X X XAdditions during year X X XAt 31 March 20X6 X X X

Amortisation/impairmentAt 1 April 20X5 X X XCharge for the year X X XAt 31 March 20X6 X X X

Carrying amountAt 31 March 20X6 X X XAt 31 March 20X5 X X X



(8) Inventories

CU’000Raw materials and consumables XWork in progress XFinished goods and goods for resale X

X

(9) Ordinary share capital

Authorised Issued and fully paidOrdinary shares of 50p each Number CU’000 Number CU’0001 April 20X5 X X X XIssued during the year X X X XAt 31 March 20X6 X X X X

On 30 December 20X5 X ordinary shares were issued fully paid for cash at a premium of Xp pershare.

As described in note 19, X ordinary shares were issued at a premium of Xp per share in theacquisition of the trade and assets of A Ltd.


The restatement of the balance brought forward is to correct an error arising out of the overvaluationof inventories at 31 March 20X5. The effect on the profit for the year ended 31 March 20X5 wasCUX. Comparative information has been adjusted accordingly.

(11) Preference share capital

The 10% preference shares of CU1 carry no voting rights and are redeemable at par on 31 March20Z5. Dividends are paid half-yearly and on a winding up these shares rank ahead of the ordinaryshares.

(12) Finance lease liabilities

The minimum lease payments on finance leases are as follows:Minimum

lease Presentpayments valueCU’000 CU’000

Within one year X XTwo to five years X XMore than five years X X

X XFuture finance charges (X) –Present value X X

Being:Current liabilities XNon-current liabilities X

X

(13) Borrowings

Borrowings comprise:CU’000

Bank loans and overdrafts XDebentures X

XBeing:

Current liabilities XNon-current liabilities X

X

The debentures have a coupon of 11% and are redeemable at par on 31 March 20Z5.

APPENDIX


The bank loans are secured by a fixed charge on the freehold property and are repayable on 31 March20Y5. The interest rate is variable, currently 6%.

(14) Provisions

Restructuring Other TotalCU’000 CU’000 CU’000

At 1 April 20X5 X X XAdditions X X XAmounts used during year (X) (X) (X)At 31 March 20X6 X X X

(15) Dividends

The dividends recognised in the statement of changes in equity comprise:

Per share CU’000Final dividend for 20X5 Xp XInterim dividend for 20X6 Xp X

Xp X

A resolution proposing a final dividend for 20X6 of Xp per share, CUX in total, will be put to theAnnual General Meeting.

(16) Events after the balance sheet date

Following a decision of the board, a freehold property was classified as held for sale on 1 May 20X6.The sale was completed on 15 June 20X6, realising a gain of CUX after tax of CUX. The transactionwill be reflected in the company’s financial statements to 31 March 20X7.

(17) Contingent liabilities

The company is being sued in the USA for damages of $X million (approximately CUX million) inrespect of sale of faulty goods. The directors do not expect to lose the case and do not believe anyprovision needs to be made.

(18) Commitments

Capital commitments

Capital expenditure on property, plant and equipment contracted for at the balance sheet date but notrecognised in these financial statements amounted to CUX.

Operating lease commitments

At the year end the company had commitments to make payments under non-cancellable operatingleases, which fall due as follows:

CU’000Within one year XTwo to five years XMore than five years X

X

(19) Goodwill arising during the year

X 50p ordinary shares were issued on 30 December 20X5 to acquire the assets and trade of A Ltd.Details of the consideration and assets acquired were as follows:

CU’000Fair value of assets acquired:Short leasehold property XInventories X

XGoodwill XFair value of consideration X



The income statement includes revenue of CUX and profit of CUX in relation to this trade since thedate of acquisition. If the acquisition had been made on 1 April 20X5, the income statement wouldhave included revenue of CUX and profit of CUX.

(20) Discontinued activities

Division A is being closed down and was classified as held for sale on 1 February 20X6. Completion ofthe closure is expected by the end of September 20X6. The carrying amount of assets held for salewas CUX on 31 March 20X6. The results of Division A for the year ended 31 March 20X6 were:revenue CUX, expenses CUX, pre-tax loss CUX, tax in respect of the pre-tax loss CUX, loss on theremeasurement of assets at fair value less costs to sell CUX and tax in respect of that remeasurementloss CUX.

(21) Reconciliation of profit/loss before tax to cash generated from operations for the yearended 31 March 20X6

CU’000Profit/(loss) before tax X/(X)Finance cost XInvestment income (X)Depreciation charge XAmortisation charge XLoss/(profit) on disposal of non-current assets X/(X)(Increase)/decrease in inventories (X)/X(Increase)/decrease in trade and other receivables (X)/X(Increase)/decrease in prepayments (X)/XIncrease/(decrease) in trade and other payables (X)/XIncrease/(decrease) in accruals (X)/XIncrease/(decrease) in provisions (X)/XCash generated from operations X

(22) Cash and cash equivalents

Cash and cash equivalents consist of cash on hand and balances with banks, and investments in moneymarket instruments. Cash and cash equivalents included in the cash flow statement comprise thefollowing balance sheet amounts.

CU'000Cash on hand and balances with banks XShort-term investments XCash and cash equivalents X

The company has undrawn borrowing facilities of CUXm of which only CUXm may be used for futureexpansion.


During the period the company acquired property, plant and equipment with an aggregate cost ofCUX of which CUX was acquired by finance lease. Cash payments of CUX were made to purchaseproperty, plant and equipment.

(24) Details of Specimen Ltd

The company is incorporated in Bangladesh. In the opinion of the directors, the immediate andultimate controlling party of the company is its parent company, XYZ Ltd, a company incorporated inBangladesh. No transactions took place between the company and XYZ Ltd during the year and thereare no outstanding balances.

Administrator

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