Professional Level Essentials Module

Time allowedReading and planning: 15 minutesWriting: 3 hours

This paper is divided into two sections:

Section A This ONE question is compulsory and MUST be attempted

Section B TWO questions ONLY to be attempted

Do NOT open this paper until instructed by the supervisor.During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.This question paper must not be removed from the examination hall.

Pape

r P2 (

INT)

Corporate Reporting(International)

Tuesday 11 December 2007

The Association of Chartered Certified Accountants

This is a blank page.The question paper begins on page 3.

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Section A This ONE question is compulsory and MUST be attempted

1 Beth, a public limited company, has produced the following draft balance sheets as at 30 November 2007. Lose andGain are both public limited companies:

Beth Lose Gain$m $m $m

AssetsNon current assetsProperty, plant and equipment 1,700 200 300Intangible assets 300Investment in Lose 200Investment in Gain 180

2,380 200 300

Current assetsInventories 800 100 150Trade receivables 600 60 80Cash 500 40 20

1,900 200 250

Total assets 4,280 400 550

Share capital of $1 1,500 100 200Other reserves 300Retained earnings 400 200 300

Total equity 2,200 300 500

Non-current liabilities 700Current liabilities 1,380 100 50

Total liabilities 2,080 100 50

Total equity and liabilities 4,280 400 550

The following information is relevant to the preparation of the group financial statements of the Beth Group:

(i) Date of acquisition Holding Retained earnings Purchaseacquired at acquisition consideration

$m $mLose: 1 December 2005 20% 80 40

1 December 2006 60% 150 160Gain: 1 December 2006 30% 260 180

Lose and Gain have not issued any share capital since the acquisition of the shareholdings by Beth. The fairvalues of the net assets of Lose and Gain were the same as their carrying amounts at the date of the acquisitions.

Beth did not have significant influence over Lose at any time before gaining control of Lose, but does havesignificant influence over Gain. There has been no impairment of goodwill on the acquisition of Lose since itsacquisition, but the recoverable amount of the net assets of Gain has been deemed to be $610 million at 30 November 2007.

(ii) Lose entered into an operating lease for a building on 1 December 2006. The building was converted into officespace during the year at a cost to Lose of $10 million. The operating lease is for a period of six years, at the endof which the building must be returned to the lessor in its original condition. Lose thinks that it would cost $2 million to convert the building back to its original condition at prices at 30 November 2007. The entries thathad been made in the financial statements of Lose were the charge for operating lease rentals ($4 million perannum) and the improvements to the building. Both items had been charged to the income statement. Theimprovements were completed during the financial year.

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(iii) On 1 October 2007, Beth sold inventory costing $18 million to Gain for $28 million. At 30 November 2007,the inventory was still held by Gain. The inventory was sold to a third party on 15 December 2007 for $35 million.

(iv) Beth had contracted to purchase an item of plant and equipment for 12 million euros on the following terms:

Payable on signing contract (1 September 2007) 50%Payable on delivery and installation (11 December 2007) 50%

The amount payable on signing the contract (the deposit) was paid on the due date and is refundable. Thefollowing exchange rates are relevant:

2007 Euros to 1 dollar1 September 07530 November 08511 December 079

The deposit is included in trade receivables at the rate of exchange on 1 September 2007. A full years chargefor depreciation of property, plant and equipment is made in the year of acquisition using the straight line methodover six years.

(v) Beth sold some trade receivables which arose during November 2007 to a factoring company on 30 November2007. The trade receivables sold are unlikely to default in payment based on past experience but they are longdated with payment not due until 1 June 2008. Beth has given the factor a guarantee that it will reimburse anyamounts not received by the factor. Beth received $45 million from the factor being 90% of the trade receivablessold. The trade receivables are not included in the balance sheet of Beth and the balance not received from thefactor (10% of the trade receivables factored) of $5 million has been written off against retained earnings.

(vi) Beth granted 200 share options to each of its 10,000 employees on 1 December 2006. The shares vest if theemployees work for the Group for the next two years. On 1 December 2006, Beth estimated that there would be1,000 eligible employees leaving in each year up to the vesting date. At 30 November 2007, 600 eligibleemployees had left the company. The estimate of the number of employees leaving in the year to 30 November2008 was 500 at 30 November 2007. The fair value of each share option at the grant date (1 December 2006)was $10. The share options have not been accounted for in the financial statements.

(vii) The Beth Group operates in the oil industry and contamination of land occurs including the pollution of seas andrivers. The Group only cleans up the contamination if it is a legal requirement in the country where it operates.The following information has been produced for Beth by a group of environmental consultants for the year ended 30 November 2007:

Cost to clean up contamination Law existing in country$m5 No7 To come into force in December 20074 Yes

The directors of Beth have a widely publicised environmental attitude which shows little regard to the effects onthe environment of their business. The Group does not currently produce a separate environmental report and noprovision for environmental costs has been made in the financial statements. Any provisions would be shown asnon-current liabilities. Beth is likely to operate in these countries for several years.

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Other informationBeth is currently suffering a degree of stagnation in its business development. Its domestic and international marketsare being maintained but it is not attracting new customers. Its share price has not increased whilst that of itscompetitors has seen a rise of between 10% and 20%. Additionally it has recently received a significant amount ofadverse publicity because of its poor environmental record and is to be investigated by regulators in several countries.Although Beth is a leading supplier of oil products, it has never felt the need to promote socially responsible policiesand practices or make positive contributions to society because it has always maintained its market share. It isrenowned for poor customer support, bearing little regard for the customs and cultures in the communities where itdoes business. It had recently made a decision not to pay the amounts owing to certain small and medium entities(SMEs) as the directors feel that SMEs do not have sufficient resources to challenge the non-payment in a court oflaw. The management of the company is quite authoritarian and tends not to value employees ideas andcontributions.

Required:

(a) Prepare the consolidated balance sheet of the Beth Group as at 30 November 2007 in accordance withInternational Financial Reporting Standards. (35 marks)

(b) Describe to the Beth Group the possible advantages of producing a separate environmental report.(8 marks)

(c) Discuss the ethical and social responsibilities of the Beth Group and whether a change in the ethical andsocial attitudes of the management could improve business performance. (7 marks)

Note: requirement (c) includes 2 professional marks for development of the discussion of the ethical and socialresponsibilities of the Beth Group.

(50 marks)

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Section B TWO questions ONLY to be attempted

2 Macaljoy, a public limited company, is a leading support services company which focuses on the building industry.The company would like advice on how to treat certain items under IAS19, Employee Benefits and IAS37 Provisions,Contingent Liabilities and Contingent Assets. The company operates the Macaljoy (2006) Pension Plan whichcommenced on 1 November 2006 and the Macaljoy (1990) Pension Plan, which was closed to new entrants from31 October 2006, but which was open to future service accrual for the employees already in the scheme. The assetsof the schemes are held separately from those of the company in funds under the control of trustees. The followinginformation relates to the two schemes:

Macaljoy (1990) Pension Plan

The terms of the plan are as follows:

(i) employees contribute 6% of their salaries to the plan(ii) Macaljoy contributes, currently, the same amount to the plan for the benefit of the employees(iii) On retirement, employees are guaranteed a pension which is based upon the number of years service with the

company and their final salary

The following details relate to the plan in the year to 31 October 2007:

$mPresent value of obligation at 1 November 2006 200Present value of obligation at 31 October 2007 240Fair value of plan assets at 1 November 2006 190Fair value of plan assets at 31 October 2007 225Current service cost 20Pension benefits paid 19Total contributions paid to the scheme for year to 31 October 2007 17

Actuarial gains and losses are recognised in the statement of recognised income and expense.

Macaljoy (2006) Pension Plan

Under the terms of the plan, Macaljoy does not guarantee any return on the contributions paid into the fund. Thecompanys legal and constructive obligation is limited to the amount that is contributed to the fund. The followingdetails relate to this scheme:

$mFair value of plan assets at 31 October 2007 21Contributions paid by company for year to 31 October 2007 10Contributions paid by employees for year to 31 October 2007 10

The discount rates and expected return on plan assets for the two plans are:

1 November 2006 31 October 2007Discount rate 5% 6%Expected return on plan assets 7% 8%

The company would like advice on how to treat the two pension plans, for the year ended 31 October 2007, togetherwith an explanation of the differences between a defined contribution plan and a defined benefit plan.

Warranties

Additionally the company manufactures and sells building equipment on which it gives a standard one year warrantyto all customers. The company has extended the warranty to two years for certain major customers and has insuredagainst the cost of the second year of the warranty. The warranty has been extended at nil cost to the customer. Theclaims made under the extended warranty are made in the first instance against Macaljoy and then Macaljoy in turnmakes a counter claim against the insurance company. Past experience has shown that 80% of the buildingequipment will not be subject to warranty claims in the first year, 15% will have minor defects and 5% will requiremajor repair. Macaljoy estimates that in the second year of the warranty, 20% of the items sold will have minor defectsand 10% will require major repair.

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In the year to 31 October 2007, the following information is relevant:

Standard warranty Extended warranty Selling price per unit(units) (units) (both)($)

Sales 2,000 5,000 1,000

Major repair Minor defect$ $

Cost of repair (average) 500 100

Assume that sales of equipment are on 31 October 2007 and any warranty claims are made on 31 October in theyear of the claim. Assume a risk adjusted discount rate of 4%.

Required:

Draft a report suitable for presentation to the directors of Macaljoy which:

(a) (i) Discusses the nature of and differences between a defined contribution plan and a defined benefit planwith specific reference to the companys two schemes. (7 marks)

(ii) Shows the accounting treatment for the two Macaljoy pension plans for the year ended 31 October 2007under IAS19 Employee Benefits. (7 marks)

(b) (i) Discusses the principles involved in accounting for claims made under the above warranty provision.(6 marks)

(ii) Shows the accounting treatment for the above warranty provision under IAS37 Provisions, ContingentLiabilities and Contingent Assets for the year ended 31 October 2007. (3 marks)

Appropriateness of the format and presentation of the report and communication of advice. (2 marks)

(25 marks)

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3 Ghorse, a public limited company, operates in the fashion sector and had undertaken a group re-organisation duringthe current financial year to 31 October 2007. As a result the following events occurred:

(a) Ghorse identified two manufacturing units, Cee and Gee, which it had decided to dispose of in a singletransaction. These units comprised non-current assets only. One of the units, Cee, had been impaired prior to thefinancial year end on 30 September 2007 and it had been written down to its recoverable amount of $35 million.The criteria in IFRS5, Non-current Assets Held for Sale and Discontinued Operations, for classification as heldfor sale, had been met for Cee and Gee at 30 September 2007. The following information related to the assetsof the cash generating units at 30 September 2007:

Depreciated Fair value less Carrying valuehistorical cost costs to sell under IFRS

and recoverableamount

$m $m $mCee 50 35 35Gee 70 90 70

120 125 105

The fair value less costs to sell had risen at the year end to $40 million for Cee and $95 million for Gee. Theincrease in the fair value less costs to sell had not been taken into account by Ghorse. (7 marks)

(b) As a consequence of the re-organisation, and a change in government legislation, the tax authorities have alloweda revaluation of the non-current assets of the holding company for tax purposes to market value at 31 October2007. There has been no change in the carrying values of the non-current assets in the financial statements.The tax base and the carrying values after the revaluation are as follows:

Carrying amount Tax base at Tax base atat 31 October 31 October 2007 31 October 2007

2007 after revaluation before revaluation$m $m $m

Property 50 65 48Vehicles 30 35 28

Other taxable temporary differences amounted to $5 million at 31 October 2007. Assume income tax is paid at30%. The deferred tax provision at 31 October 2007 had been calculated using the tax values before revaluation.

(6 marks)

(c) A subsidiary company had purchased computerised equipment for $4 million on 31 October 2006 to improvethe manufacturing process. Whilst re-organising the group, Ghorse had discovered that the manufacturer of thecomputerised equipment was now selling the same system for $25 million. The projected cash flows from theequipment are:

Year ended 31 October Cash flows$m

2008 132009 222010 23

The residual value of the equipment is assumed to be zero. The company uses a discount rate of 10%. Thedirectors think that the fair value less costs to sell of the equipment is $2 million. The directors of Ghorse proposeto write down the non-current asset to the new selling price of $25 million. The companys policy is to depreciateits computer equipment by 25% per annum on the straight line basis. (5 marks)

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(d) The manufacturing property of the group, other than the head office, was held on an operating lease over 8 years. On re-organisation on 31 October 2007, the lease has been renegotiated and is held for 12 years at arent of $5 million per annum paid in arrears. The fair value of the property is $35 million and its remainingeconomic life is 13 years. The lease relates to the buildings and not the land. The factor to be used for an annuityat 10% for 12 years is 68137. (5 marks)

The directors are worried about the impact that the above changes will have on the value of its non-current assetsand its key performance indicator which is Return on Capital Employed (ROCE). ROCE is defined as operating profitbefore interest and tax divided by share capital, other reserves and retained earnings. The directors have calculatedROCE as $30 million divided by $220 million, i.e. 136% before any adjustments required by the above.

Formation of opinion on impact on ROCE. (2 marks)

Required:

Discuss the accounting treatment of the above transactions and the impact that the resulting adjustments to thefinancial statements would have on ROCE.

Note: your answer should include appropriate calculations where necessary and a discussion of the accountingprinciples involved.

(25 marks)

4 The International Accounting Standards Board (IASB) has begun a joint project to revisit its conceptual framework forfinancial accounting and reporting. The goals of the project are to build on the existing frameworks and converge theminto a common framework.

Required:

(a) Discuss why there is a need to develop an agreed international conceptual framework and the extent to whichan agreed international conceptual framework can be used to resolve practical accounting issues.

(13 marks)

(b) Discuss the key issues which will need to be addressed in determining the basic components of aninternationally agreed conceptual framework. (10 marks)

Appropriateness and quality of discussion. (2 marks)

(25 marks)

End of Question Paper

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Answers

Professional Level Essentials Module, Paper P2 (INT)Corporate Reporting (International) December 2007 Answers

1 (a) Beth GroupConsolidated Balance Sheet at 30 November 2007

Beth$m

AssetsNon-current assetsProperty, plant and equipment (1,900 + 12 2) 1,910Intangible assets 300Goodwill 14Investment in associate 183

2,407

Current assetsInventories 900Trade receivables (600 + 60 1 + 50) 709Cash and cash equivalents 540

2,149

Total assets 4,556

Share capital of $1 1,500Other reserves (300 + 9) 309Retained earnings 447Minority interest 62

2,318

Non-current liabilities (700 + 11 + 2) 713Current liabilities (1,380 + 100 + 45) 1,525

Total liabilities 2,238

Total equity and liabilities 4,556

Working 1

Goodwill calculation Lose

IFRS3, Business Combinations requires that each share exchange transaction be treated separately by the acquirer using thecost of the transaction and the fair value of the assets, liabilities, and contingent liabilities at the date of each transaction todetermine goodwill.

1 Dec 2005 1 Dec 2006$m $m $m $m

Purchase consideration 40 160less net assets acquiredShare capital 100 Share capital 100Retained earnings 80 Retained earnings 150

180 250

20% thereof (36) 60% thereof (150)

Goodwill 4 Goodwill 10

Total Goodwill ($4 million + $10 million) i.e. $14 million

Working 2

Minority Interest

20% of $(100 + 200 + 10 2) million $616 million

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Working 3

Group Reserves at 30 November 2007$m

Retained earnings Beth 400Post acquisition reserves Lose(200 + 10 2 80) x 20% 256(200 + 10 2 150) x 60% 348Impairment of associate (working 4) (6)Associates profit less inter company (12 3) 9Loss on monetary item foreign currency (working 6) (1)Factor reversal of entry (working 7) 5Share options (working 8) (9)Provision (working 9) (11)

Retained earnings at 30 November 2007 4474

Working 4

Associate investment in Gain

Equity Method $mCost of investment 180Profit $(300 260)m x 30% 12

192

less inter company profit (working 5) (3)

Carrying value in balance sheet 189

Goodwill is not recognised separately in the carrying amount of the investment and not tested for impairment separately. Thecarrying amount of the investment and the recoverable amount are compared.

$mCarrying value 189Recoverable amount ($610m x 30%) (183)

Impairment 6

Working 5: Inter company profitIAS28 requires profits and losses resulting from transactions between the investor and an associate to be recognised in theinvestors financial statements only to the extent of the unrelated investors interests in the associate. Effectively part of Bethsprofit on the sale is eliminated to the extent of the companys shareholding in Gain.

$mInventory: selling price 28Cost (18)

Profit 10

Profit eliminated $10 million x 30%, i.e. $3 millionDR Income statement/retained earnings $3 millionCR Investment in associate $3 million

Working 6 Deposit paidIf the payment to the supplier is a deposit and is refundable, then the amount is deemed to be a monetary amount whichshould be retranslated at the year end.

Deposit paid 50% x 12 million euros 075 = $8 million

At 30 November 2007, the deposit would be retranslated at 6 million euros 085, i.e. $7 million. Therefore, there will bean exchange loss of $(8 7) million, i.e. $1 million.

DR Retained earnings $1 millionCR Trade receivables $1 million

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Working 7 Factored trade receivablesIAS39 requires derecognition of a financial asset if the contractual rights to the cash flows have expired or the financial assethas been transferred and so have the risks and rewards of ownership of the asset. In the case of the sale of the tradereceivables, the first criterion above has been met, but the second has not necessarily been met. Although the tradereceivables are high quality debts, there is still a risk of default particularly as they are long dated, and that risk still lies withBeth. Therefore, the trade receivables should continue to be recognised and the monies received shown as a current liability.The reversing entries should be:

$mDR Trade receivables 50

CR Current liabilities 45Retained earnings 5

Working 8 Share options200 options x (10,000 1,100) x 1/2 x $10 = $89 million

DR Retained earnings $9 million (rounded)CR Equity $9 million

At the grant date, the fair value of the award is determined, but then at each reporting date until vesting, a best estimate ofthe cumulative charge to the income statement is made, taking into account:

(i) the grant date fair value of the award ($10 per option)(ii) the current best estimate of the number of awards that will vest (89%)(iii) the expired portion of the vesting period (1 year)

Working 9 Environmental provisionAn enterprise must recognise a provision if, and only if:

(i) a present obligation (legal or constructive) has arisen as a result of a past event (the obligating event)(ii) payment is probable (more likely than not), and(iii) the amount can be estimated reliably

In this case, a provision should be made to include the costs of contamination in the countries where the law is to be enactedor has been enacted as there will be a legal obligation in those countries. Moral obligations to rectify environmental damagedo not justify making a provision. Therefore, a provision of $(7 + 4) million, i.e. $11 million, should be made.

DR Retained earnings $11 millionCR Non-current liabilities $11 million

Working 10 Operating LeaseLose should capitalise the leasehold improvements of $10 million and depreciate them over the term of the lease inaccordance with IAS16 Property, plant and equipment. Because the improvements have occurred, an obligation arises outof the past event, and a provision of $2 million should be made for the conversion of the building back to its original condition.

Thus the following entries should be made in Loses financial statements:

$mDR Property, plant and equipment 10CR Income statement 10DR Property, plant and equipment 2CR Provision for decommissioning 2

Depreciation on the capitalised amounts should be charged over the term of the lease as depreciation is charged in full onproperty, plant and equipment in the year of acquisition. Thus depreciation will be accounted for as follows:

$mDR Income Statement ($10m + $2m) 6 years 2

CR Property, plant and equipment 2

(b) An environmental report allows an organisation to communicate with different stakeholders. The benefits of an environmentalreport include:

(i) evaluating environmental performance can highlight inefficiencies in operations and help to improve managementsystems. Beth could identify opportunities to reduce resource use, waste and operating costs.

(ii) communicating the efforts being made to improve social and environmental performance can foster community supportfor a business and can also contribute towards its reputation as a good corporate citizen. At present Beth has a poorreputation in this regard.

(iii) reporting efforts to improve the organisations environmental, social and economic performance can lead to increasedconsumer confidence in its products and services.

(iv) commitment to reporting on current impacts and identifying ways to improve environmental performance can improverelationships with regulators, and could reduce the potential threat of litigation which is hanging over Beth.

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(v) investors, financial analysts and brokers increasingly ask about the sustainability aspects of operations. A high qualityreport shows the measures the organisation is taking to reduce risks, and will make Beth more attractive to investors.

(vi) disclosing the organisations environmental, social and economic best practices can give a competitive market edge.Currently Beths corporate image is poor and this has partly contributed to its poor stock market performance.

(vii) the international trend towards improved corporate sustainability is growing and access to international markets willrequire increasing transparency, and this will help Beths corporate image.

(viii) large organisations are increasingly requiring material and service suppliers and contractors to submit performanceinformation to satisfy the expectations of their own shareholders. Disclosing such information can make the company amore attractive supplier than their competitors, and increase Beths market share.

It is important to ensure that the policies are robust and effective and not just compliance based.

(c) Corporate social responsibility (CSR) is concerned with business ethics and the companys accountability to its stakeholders,and about the way it meets its wider obligations. CSR emphasises the need for companies to adopt a coherent approach toa range of stakeholders including investors, employees, suppliers, and customers. Beth has paid little regard to the promotionof socially and ethically responsible policies. For example, the decision to not pay the SME creditors on the grounds that theycould not afford to sue the company is ethically unacceptable. Additionally, Beth pays little regard to local customs andcultures in its business dealings.

The stagnation being suffered by Beth could perhaps be reversed if it adopted more environmentally friendly policies. Thecorporate image is suffering because of its attitude to the environment. Environmentally friendly policies could be cost effectiveif they help to increase market share and reduce the amount of litigation costs it has to suffer. The communication of thesepolicies would be through the environmental report, and it is critical that stakeholders feel that the company is beingtransparent in its disclosures.

Evidence of corporate misbehaviour (Enron, World.com) has stimulated interest in the behaviour of companies. There hasbeen pressure for companies to show more awareness and concern, not only for the environment but for the rights andinterests of the people they do business with. Governments have made it clear that directors must consider the short-termand long-term consequences of their actions, and take into account their relationships with employees and the impact of thebusiness on the community and the environment. The behaviour of Beth will have had an adverse effect on their corporateimage.

CSR requires the directors to address strategic issues about the aims, purposes, and operational methods of the organisation,and some redefinition of the business model that assumes that profit motive and shareholder interests define the core purposeof the company. The profits of Beth will suffer if employees are not valued and there is poor customer support.

Arrangements should be put in place to ensure that the business is conducted in a responsible manner. The board shouldlook at broad social and environmental issues affecting the company and set policy and targets, monitoring performance andimprovements.

2 Report to the Directors of Macaljoy plc

Terms of ReferenceThis report sets out the differences between a defined contribution and defined benefit plan, and the accounting treatment of thecompanys pension plans. It also discusses the principles involved in accounting for warranty claims, and the accounting treatmentof those claims.

(a) Pension plans IAS19A defined contribution plan is a pension plan whereby an employer pays fixed contributions into a separate fund and has nolegal or constructive obligation to pay further contributions (IAS19 paragraph 7). Payments or benefits provided to employeesmay be a simple distribution of total fund assets, or a third party (an insurance company) may, for example, agree to providean agreed level of payments or benefits. Any actuarial and investment risks of defined contribution plans are assumed by theemployee or the third party. The employer is not required to make up any shortfall in assets and all plans that are not definedcontribution plans are deemed to be defined benefit plans.

Defined benefit, therefore, is the residual category whereby, if an employer cannot demonstrate that all actuarial andinvestment risk has been shifted to another party and its obligations limited to contributions made during the period, then theplan is a defined benefit plan. Any benefit formula that is not solely based on the amount of contributions, or that includes aguarantee from the entity or a specified return, means that elements of risk remain with the employer and must be accountedfor as a defined benefit plan. An employer may create a defined benefit obligation where no legal obligation exists if it has apractice of guaranteeing the benefits. An employers obligation under a defined benefit plan is to provide the agreed amountof benefits to current and former employees. The differentiating factor between defined benefit and defined contributionschemes is in determining where the risks lie.

In a defined benefit scheme it is the employer that underwrites the vast majority of costs so that if investment returns are pooror costs increase the employer needs to either make adjustments to the scheme or to increase levels of contribution.Alternatively, if investment returns are good, then contribution levels could be reduced. In a defined contribution scheme the

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contributions are paid at a fixed level and, therefore, it is the scheme member who is shouldering these risks. If they fail totake action by increasing contribution rates when investment returns are poor or costs increase, then their retirement benefitswill be lower than they had planned for.

For defined contribution plans, the cost to be recognised in the period is the contribution payable in exchange for servicerendered by employees during the period. The accounting for a defined contribution plan is straightforward because theemployers obligation for each period is determined by the amount to be contributed for that period. Often, contributions arebased on a formula that uses employee compensation in the period as its base. No actuarial assumptions are required tomeasure the obligation or the expense, and there are no actuarial gains or losses.

The employer should account for the contribution payable at the end of each period based on employee services renderedduring that period, reduced by any payments made during the period. If the employer has made payments in excess of thoserequired, the excess is a prepaid expense to the extent that the excess will lead to a reduction in future contributions or a cashrefund.

For defined benefit plans, the amount recognised in the balance sheet should be the present value of the defined benefitobligation (that is, the present value of expected future payments required to settle the obligation resulting from employeeservice in the current and prior periods), as adjusted for unrecognised actuarial gains and losses and unrecognised pastservice cost, and reduced by the fair value of plan assets at the balance sheet date. If the balance is an asset, the amountrecognised may be limited under IAS19

In the case of Macaljoy, the 1990 plan is a defined benefit plan as the employer has the investment risk as the company isguaranteeing a pension based on the service lives of the employees in the scheme. The employers liability is not limited tothe amount of the contributions. There is a risk that if the investment returns fall short the employer will have to make goodthe shortfall in the scheme. The 2006 plan, however, is a defined contribution scheme because the employers liability islimited to the contributions paid.

A curtailment occurs when an entity either

(a) is demonstrably committed to making a material reduction in the number of employees covered by a plan, or

(b) amends the terms of a defined benefit plan.

An amendment would be such that a material element of future service by current employees will no longer qualify for benefitsor qualify for reduced benefits. Curtailments, by definition, have a material impact on the entitys financial statements. Thefact that no new employees are to be admitted to the 1990 plan does not constitute a curtailment because future servicequalifies for pension rights for those in the scheme prior to 31 October 2006.

The accounting for the two plans is as follows. The company does not recognise any assets or liabilities for the definedcontribution scheme but charges the contributions payable for the period ($10 million) to operating profit. The contributionspaid by the employees will be part of the wages and salaries cost and when paid will reduce cash. The accounting for thedefined benefit plan results in a liability of $15 million as at 31 October 2007, a charge in the statement of recognised incomeand expense of $53 million, and an expense in the income statement of $167 million for the year (see Appendix 1).

(b) Provisions IAS37

An entity must recognise a provision under IAS37 if, and only if:

(a) a present obligation (legal or constructive) has arisen as a result of a past event (the obligating event)

(b) it is probable (more likely than not), that an outflow of resources embodying economic benefits will be required to settlethe obligation

(c) the amount can be estimated reliably

An obligating event is an event that creates a legal or constructive obligation and, therefore, results in an enterprise havingno realistic alternative but to settle the obligation. A constructive obligation arises if past practice creates a valid expectationon the part of a third party. If it is more likely than not that no present obligation exists, the enterprise should disclose acontingent liability, unless the possibility of an outflow of resources is remote.

The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligationat the balance sheet date, that is, the amount that an enterprise would rationally pay to settle the obligation at the balancesheet date or to transfer it to a third party. This means provisions for large populations of events such as warranties, aremeasured at a probability weighted expected value. In reaching its best estimate, the entity should take into account the risksand uncertainties that surround the underlying events.

Expected cash outflows should be discounted to their present values, where the effect of the time value of money is materialusing a risk adjusted rate (it should not reflect risks for which future cash flows have been adjusted). If some or all of theexpenditure required to settle a provision is expected to be reimbursed by another party, the reimbursement should berecognised as a separate asset when, and only when, it is virtually certain that reimbursement will be received if the entitysettles the obligation. The amount recognised should not exceed the amount of the provision. In measuring a provision futureevents should be considered. The provision for the warranty claim will be determined by using the expected value method.

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The past event which causes the obligation is the initial sale of the product with the warranty given at that time. It would beappropriate for the company to make a provision for the Year 1 warranty of $280,000 and Year 2 warranty of $350,000,which represents the best estimate of the obligation (see Appendix 2). Only if the insurance company have validated thecounter claim will Macaljoy be able to recognise the asset and income. Recovery has to be virtually certain. If it is virtuallycertain, then Macaljoy may be able to recognise the asset. Generally contingent assets are never recognised, but disclosedwhere an inflow of economic benefits is probable.

The company could discount the provision if it was considered that the time value of money was material. The majority ofprovisions will reverse in the short term (within two years) and, therefore, the effects of discounting are likely to be immaterial.In this case, using the risk adjusted rate (IAS37), the provision would be reduced to $269,000 in Year 1 and $323,000 inYear 2. The company will have to determine whether this is material.

Appendix 1The accounting for the defined benefit plan is as follows:

31 October 2007 1 November 2006$m $m

Present value of obligation 240 200Fair value of plan assets (225) (190)

Liability recognised in balance sheet 15 10

Expense in Income Statement year ended 31 October 2007:

$mCurrent service cost 20Interest cost 10Expected return on assets (133)

Expense 167

Analysis of amount in Statement of Recognised Income and Expense:

$mActuarial loss on obligation (w2) 29Actuarial gain on plan assets (w2) (237)

Actuarial loss on obligation (net) 53

Appendix 2

Year 1 warrantyDiscounted

expected value Expected value (4%)

$000 $00080% x Nil 015% x 7,000 x $100 1055% x 7,000 x $500 175

280 269

Year 2 extended warrantyDiscounted

expected value Expected value (4%)

$000 $00070% x Nil 020% x 5,000 x $100 10010% x 5,000 x $500 250

350 323

Working 1

Movement in net liability in balance sheet at 31 October 2007:

$mOpening liability 10Expense 167Contributions (17)Actuarial loss 53

Closing liability 15

18

Working 2

Changes in the present value of the obligation and fair value of plan assets.

31 October 2007$m

Present value of obligation at 1 November 2006 200Interest (5% of 200) 10Current service cost 20Benefits paid (19)Actuarial loss on obligation 29

Present value of obligation at 31 October 2007 240

Fair value of plan assets at 1 November 2006 190Expected return on assets (7% of 190) 133Contributions 17Benefits paid (19)Actuarial gain on plan assets 237

Fair value of plan assets at 31 October 2007 225

3 The company should account for the events as follows:

(a) The two manufacturing units meet the criteria for classification as held for sale and are, therefore, deemed to be a disposalgroup under IFRS5 Non-current Assets Held for Sale and Discontinued Operations as the assets are to be disposed of in asingle transaction.

The measurement basis required for non-current assets held for sale is applied to the group as a whole and any impairmentloss will reduce the carrying amount of the non-current assets in the disposal group in the order of allocation required byIAS36 Impairment of Assets (IFRS5 paragraph 4). Before classification as held for sale, evidence of impairment will be testedon an individual cash generating unit basis, but after classification it will be done on a disposal group basis.

Immediately before the initial classification of the asset as held for sale, the carrying amount of the asset will be measured inaccordance with applicable IFRSs.

On classification as held for sale, disposal groups that are classified as held for sale are measured at the lower of carryingamount and fair value less costs to sell. Impairment must be considered both at the time of classification as held for sale andsubsequently. Immediately prior to classifying a disposal group as held for sale, it must measure and recognise impairmentin accordance with the applicable IFRSs. Any impairment loss is recognised in profit or loss unless the asset had beenmeasured at a revalued amount under IAS16 Property, Plant and Equipment or IAS38 Intangible Assets, in which case theimpairment is treated as a revaluation decrease. On classification as held for sale, any impairment loss will be based on thedifference between the adjusted carrying amounts of the disposal group and fair value less costs to sell. Any impairment lossthat arises by using the measurement principles in IFRS5 must be recognised in profit or loss (IFRS5 paragraph 20).

Thus Ghorse should not increase the value of the disposal group above $105 million at 30 September 2007 as this is thecarrying amount of the assets measured in accordance with applicable IFRS immediately before being classified as held forsale (IAS36 and IAS16). After classification as held for sale, the disposal group will remain at this value as this is the lowerof the carrying value and fair value less costs to sell, and there is no impairment recorded as the recoverable amount of thedisposal group is in excess of the carrying value. At a subsequent reporting date following initial classification as held for salethe disposal group should be measured at fair value less costs to sell. However, IFRS5 (paragraphs 2122) allows anysubsequent increase in fair value less costs to sell to be recognised in profit or loss to the extent that it is not in excess of anyimpairment loss recognised in accordance with IFRS5 or previously with IAS36. Thus any increase in the fair value less coststo sell can be recognised as follows at 31 October 2007:

$mFair value less costs to sell Cee 40Fair value less costs to sell Gee 95

135

Carrying value (105)

Increase 30

Impairment recognised in Cee (50 35) 15

Therefore, the carrying value of the disposal group can increase by $15 million and profit or loss can be increased by thesame amount, where the fair value rises. Thus the value of the disposal group will be $120 million. These adjustments willaffect Return on Capital Employed (ROCE).

19

(b) The differences between the IFRS carrying amounts for the non-current assets and tax bases will represent temporarydifferences.

The general principle in IAS12 Income Taxes is that deferred tax liabilities should be recognised for all taxable temporarydifferences. A deferred tax asset should be recognised for deductible temporary differences, unused tax losses and unused taxcredits to the extent that it is probable that taxable profit will be available against which the deductible temporary differencescan be utilised.

A deferred tax asset cannot be recognised where it arises from negative goodwill or the initial recognition of an asset/liabilityother than in a business combination. The carrying amount of deferred tax assets should be reviewed at each balance sheetdate and reduced to the extent that it is no longer probable that sufficient taxable profit will be available to allow the benefitof part or all of that deferred tax asset to be utilised. Any such reduction should be subsequently reversed to the extent thatit becomes probable that sufficient taxable profit will be available (IAS12 paragraph 37)

The recognition of deferred tax assets will result in the recognition of income, in the income statement. This amount cannotbe reported in equity as IAS12 only allows deferred tax to be recognised in equity if the corresponding entry is recognised inequity. This is not the case in this situation as the revaluation was not recognised for IFRS purposes.

Carrying Tax TemporaryAmount Base Difference

$m $m $mProperty 50 65 15Vehicles 30 35 5Other taxable temporary differences (5)

15

The deferred tax asset would be $15 million x 30%, i.e. $45 million subject to there being sufficient taxable profit. Thedeferred tax provision relating to these assets would have been:

Carrying Tax TemporaryAmount Base Difference

$m $m $mProperty 50 48 2Vehicles 30 28 2

4

Other taxable temporary differences 5

9

$9 million at 30%, i.e. $27 million

The impact on the income statement would be significant as the deferred tax provision of $27 million would be released anda deferred tax asset of $45 million credited to it. These adjustments will not affect profit before interest and tax. However anasset of $45 million will be created in the balance sheet which will affect ROCE.

(c) At each balance sheet date, Ghorse should review all assets to look for any indication that an asset may be impaired, i.e.where the assets carrying amount ($3 million) is in excess of the greater of its net selling price and its value in use. IAS36has a list of external and internal indicators of impairment. If there is an indication that an asset may be impaired, then theassets recoverable amount must be calculated (IAS36 paragraph 9).

The recoverable amount is the higher of an assets fair value less costs to sell (sometimes called net selling price) and itsvalue in use which is the discounted present value of estimated future cash flows expected to arise from:

(i) the continuing use of an asset, and from(ii) its disposal at the end of its useful life

If the manufacturer has reduced the selling price, it does not mean necessarily that the asset is impaired. One indicator ofimpairment is where the assets market value has declined significantly more than expected in the period as a result of thepassage of time or normal usage. The value-in-use of the equipment will be $47 million.

Year ended Cash Discounted31 October flows (10%)

$m $m2008 13 122009 22 182010 23 17

Value in use 47

The fair value less costs to sell of the asset is estimated at $2 million. Therefore, the recoverable amount is $47 million whichis higher than the carrying value of $3 million and, therefore, the equipment is not impaired with no effect on ROCE.

20

(d) Under IAS17, Leases, operating lease payments should be recognised as an expense in the income statement over the leaseterm on a straight line basis, unless another systematic basis is more representative of the time pattern of the users benefit.

The provisions of the lease have changed significantly and would need to be reassessed.

The lease term is now for the major part of the economic life of the assets, and at the inception of the lease, the present valueof the minimum lease payments is substantially all of the fair value of the leased asset. (Fair value $35 million, NPV of leasepayments $341 million) Even if title is not transferred at the end of the lease the lease can still be a finance lease. Anychange in the estimate of the length of life of a lease would not change its classification but where the provisions of the leasehave changed, re-assessment of its classification takes place. Thus it would appear that the lease is now a finance lease, andit would be shown in the balance sheet at the present value of the lease payments as this is lower than the fair value. Thischange in classification will not affect ROCE as it will increase non-current assets by $341 million and liabilities by the sameamount.

Effect on ROCE$m

Profit before tax and interest 30add increase in value of disposal group 15

45

Capital employed 220add increase in value of disposal group 15Deferred tax asset (45 + 27) 72

2422

ROCE will rise from 136% to 186% (45/2422) and thus the directors fears that ROCE would be adversely affected areunfounded.

4 (a) The IASB wish their standards to be principles-based and in order for this to be the case, the standards must be based onfundamental concepts. These concepts need to constitute a framework which is sound, comprehensive and internallyconsistent. Without agreement on a framework, standard setting is based upon the personal conceptual frameworks of theindividual standard setters which may change as the membership of the body changes and results in standards that are notconsistent with each other. Such a framework is designed not only to assist standard setters, but also preparers of financialstatements, auditors and users.

A common goal of the IASB is to converge their standards with national standard setters. The IASB will encounter difficultiesconverging their standards if decisions are based on different frameworks. The IASB has been pursuing a number of projectsthat are aimed at achieving short term convergence on certain issues with national standard setters as well as major projectswith them. Convergence will be difficult if there is no consistency in the underlying framework being used.

Frameworks differ in their authoritative status. The IASBs Framework requires management to expressly consider theFramework if no standard or interpretation specifically applies or deals with a similar and related issue. However, certainframeworks have a lower standing. For example, entities are not required to consider the concepts embodied in certainnational frameworks in preparing financial statements. Thus the development of an agreed framework would eliminatedifferences in the authoritative standing of conceptual frameworks and lead to greater consistency in financial statementsinternationally.

The existing concepts within most frameworks are quite similar. However, these concepts need revising to reflect changes inmarkets, business practices and the economic environment since the concepts were developed. The existing frameworks needdeveloping to reflect these changes and to fill gaps in the frameworks. For example, the IASBs Framework does not containa definition of the reporting entity. An agreed international framework could deal with this problem, especially if priority wasgiven to the issues likely to give short-term standard setting benefits.

Many standard setting bodies attempted initially to resolve accounting and reporting problems by developing accountingstandards without an accepted theoretical frame of reference. The result has been inconsistency in the development ofstandards both nationally and internationally. The frameworks were developed when several of their current standards werein existence. In the absence of an agreed conceptual framework the same theoretical issues are revisited on several occasionsby standard setters. The result is inconsistencies and incompatible concepts. Examples of this are substance over form andmatching versus prudence. Some standard setters such as the IASB permit two methods of accounting for the same set ofcircumstances. An example is the accounting for joint ventures where the equity method and proportionate consolidation areallowed.

Additionally there have been differences in the way that standard setters have practically used the principles in the framework.Some national standard setters have produced a large number of highly detailed accounting rules with less emphasis ongeneral principles. A robust framework might reduce the need for detailed rules although some companies operate in adifferent legal and statutory context than other entities. It is important that a framework must result in standards that accountappropriately for actual business practice.

An agreed framework will not solve all accounting issues, nor will it obviate the need for judgement to be exercised in resolvingaccounting issues. It can provide a framework within which those judgements can be made.

21

A framework provides standard setters with both a foundation for setting standards, and concepts to use as tools for resolvingaccounting and reporting issues. A framework provides a basic reasoning on which to consider the merits of alternatives. Itdoes not provide all the answers, but narrows the range of alternatives to be considered by eliminating some that areinconsistent with it. It, thereby, contributes to greater efficiency in the standard setting process by avoiding the necessity ofhaving to redebate fundamental issues and facilitates any debate about specific technical issues. A framework should alsoreduce political pressures in making accounting judgements. The use of a framework reduces the influence of personal biasesin accounting decisions.

However, concepts statements are by their nature very general and theoretical in their wording, which leads to alternativeconclusions being drawn. Whilst individual standards should be consistent with the Framework, in the absence of a specificstandard, it does not follow that concepts will provide practical solutions. IAS8 Accounting Policies, Changes in AccountingEstimates and Errors sets out a hierarchy of authoritative guidance that should be considered in the absence of a standard.In this case, management can use its judgement in developing and applying an accounting policy, albeit by considering theIASB framework, but can also use accounting standards issued by other bodies. Thus an international framework may nottotally provide solutions to practical accounting problems.

(b) There are several issues which have to be addressed if an international conceptual framework is to be successfully developed.These are:

(i) ObjectivesAgreement will be required as to whether financial statements are to be produced for shareholders or a wide range ofusers and whether decision usefulness is the key criteria or stewardship. Additionally there is the question of whetherthe objective is to provide information in making credit and investment decisions.

(ii) Qualitative CharacteristicsThe qualities to be sought in making decisions about financial reporting need to be determined. The decision usefulnessof financial reports is determined by these characteristics. There are issues concerning the trade-offs between relevanceand reliability. An example of this concerns the use of fair values and historical costs. It has been argued that historicalcosts are more reliable although not as relevant as fair values. Additionally there is a conflict between neutrality and thetraditions of prudence or conservatism. These characteristics are constrained by materiality and benefits that justifycosts.

(iii) Definitions of the elements of financial statementsThe principles behind the definition of the elements need agreement. There are issues concerning whether controlshould be included in the definition of an asset or become part of the recognition criteria. Also the definition of controlis an issue particularly with financial instruments. For example, does the holder of a call option control the underlyingasset? Some of the IASBs standards contravene its own conceptual framework. IFRS3 requires the capitalisation ofgoodwill as an asset despite the fact that it can be argued that goodwill does not meet the definition of an asset in theFramework. IAS12 requires the recognition of deferred tax liabilities that do not meet the liability definition. Similarlyequity and liabilities need to be capable of being clearly distinguished. Certain financial instruments could either beliabilities or equity. For example obligations settled in shares.

(iv) Recognition and De-recognitionThe principles of recognition and de-recognition of assets and liabilities need reviewing. Most frameworks haverecognition criteria, but there are issues over the timing of recognition. For example, should an asset be recognised whena value can be placed on it or when a cost has been incurred? If an asset or liability does not meet recognition criteriawhen acquired or incurred, what subsequent event causes the asset or liability to be recognised? Most frameworks donot discuss de-recognition. (The IASBs Framework does not discuss the issue.) It can be argued that an item should bede-recognised when it does not meet the recognition criteria, but financial instruments standards (IAS39) require otherfactors to occur before financial assets can be de-recognised. Different attributes should be considered such as legalownership, control, risks or rewards.

(v) MeasurementMore detailed discussion of the use of measurement concepts, such as historical cost, fair value, current cost, etc arerequired and also more guidance on measurement techniques. Measurement concepts should address initialmeasurement and subsequent measurement in the form of revaluations, impairment and depreciation which in turngives rise to issues about classification of gains or losses in income or in equity.

(vi) Reporting entityIssues have arisen over what sorts of entities should issue financial statements, and which entities should be includedin consolidated financial statements. A question arises as to whether the legal entity or the economic unit should be thereporting unit. Complex business arrangements raise issues over what entities should be consolidated and the basisupon which entities are consolidated. For example, should the basis of consolidation be control and what does controlmean?

(vii) Presentation and disclosureFinancial reporting should provide information that enables users to assess the amounts, timing and uncertainty of theentitys future cash flows, its assets, liabilities and equity. It should provide management explanations and the limitationsof the information in the reports. Discussions as to the boundaries of presentation and disclosure are required.

22

Professional Level Essentials Module, Paper P2 (INT)Corporate Reporting (International) December 2007 Marking Scheme

Marks1 (a) Goodwill Lose 5

Minority interest 1Group reserves 2Associate and impairment 5Inter company profit 2Foreign currency 4Debt factoring 4Share options 4Provision 3Operating lease 3Other balance sheet items 2

MAXIMUM 35

(b) Benefits of environmental report 8

(c) Discussion of ethical and social responsibilities 5Professional marks 2

MAXIMUM 7

MAXIMUM 50

2 (a) Pensions (i) explanation 7(ii) calculation 7

(b) Provisions (i) explanation 6(ii) calculation 3

Structure of report 2

MAXIMUM 25

3 (a) Disposal group 7

(b) Deferred tax asset 6

(c) Impairment 5

(d) Lease 5

Formation of opinion of impact on ROCE 2

MAXIMUM 25

4 (a) Subjective 13

(b) up to 2 marks per key issue 10(i) Objectives(ii) Qualitative characteristics(iii) Definitions(iv) Recognition and de-recognition(v) Measurement(vi) Reporting entity(vii) Presentation and disclosure

Appropriateness and quality of discussion 2

MAXIMUM 25

23

Professional Level Essentials Module

Time allowedReading and planning: 15 minutesWriting: 3 hours

This paper is divided into two sections:

Section A This ONE question is compulsory and MUST be attempted

Section B TWO questions ONLY to be attempted

Do NOT open this paper until instructed by the supervisor.

During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.

This question paper must not be removed from the examination hall.

Pape

r P2 (

INT)

Corporate Reporting(International)

Tuesday 10 June 2008

The Association of Chartered Certified Accountants

Section A This ONE question is compulsory and MUST be attempted

1 The following draft statements of financial position relate to Ribby, Hall, and Zian, all public limited companies, as at31 May 2008:

Ribby Hall Zian$m $m Dinars m

AssetsNon-current assets:Property, plant and equipment 250 120 360Investment in Hall 98 Investment in Zian 30 Financial assets 10 5 148Current assets 22 17 120

Total assets 410 142 628

Ordinary shares 60 40 209Other reserves 30 10 Retained earnings 120 80 299

Total equity 210 130 508Non-current liabilities 90 5 48Current liabilities 110 7 72

Total equity and liabilities 410 142 628

The following information needs to be taken account of in the preparation of the group financial statements of Ribby:

(i) Ribby acquired 70% of the ordinary shares of Hall on 1 June 2006 when Halls other reserves were $10 millionand retained earnings were $60 million. The fair value of the net assets of Hall was $120 million at the date ofacquisition. Ribby acquired 60% of the ordinary shares of Zian for 330 million dinars on 1 June 2006 whenZians retained earnings were 220 million dinars. The fair value of the net assets of Zian on 1 June 2006 was 495 million dinars. The excess of the fair value over the net assets of Hall and Zian is due to an increase in thevalue of non-depreciable land. There have been no issues of ordinary shares since acquisition and goodwill onacquisition is not impaired for either Hall or Zian.

(ii) Zian is located in a foreign country and imports its raw materials at a price which is normally denominated indollars. The product is sold locally at selling prices denominated in dinars, and determined by local competition.All selling and operating expenses are incurred locally and paid in dinars. Distribution of profits is determined bythe parent company, Ribby. Zian has financed part of its operations through a $4 million loan from Hall whichwas raised on 1 June 2007. This is included in the financial assets of Hall and the non-current liabilities of Zian.Zians management have a considerable degree of authority and autonomy in carrying out the operations of Zianand other than the loan from Hall, are not dependent upon group companies for finance.

(iii) Ribby has a building which it purchased on 1 June 2007 for 40 million dinars and which is located overseas.The building is carried at cost and has been depreciated on the straight-line basis over its useful life of 20 years.At 31 May 2008, as a result of an impairment review, the recoverable amount of the building was estimated tobe 36 million dinars.

(iv) Ribby has a long-term loan of $10 million which is owed to a third party bank. At 31 May 2008, Ribby decidedthat it would repay the loan early on 1 July 2008 and formally agreed this repayment with the bank prior to theyear end. The agreement sets out that there will be an early repayment penalty of $1 million.

(v) The directors of Ribby announced on 1 June 2007 that a bonus of $6 million would be paid to the employeesof Ribby if they achieved a certain target production level by 31 May 2008. The bonus is to be paid partly incash and partly in share options. Half of the bonus will be paid in cash on 30 November 2008 whether or notthe employees are still working for Ribby. The other half will be given in share options on the same date, providedthat the employee is still in service on 30 November 2008. The exercise price and number of options will befixed by management on 30 November 2008. The target production was met and management expect 10% ofemployees to leave between 31 May 2008 and 30 November 2008. No entry has been made in the financialstatements of Ribby.

2

(vi) Ribby operates a defined benefit pension plan that provides a pension of 12% of the final salary for each yearof service, subject to a minimum of four years service. On 1 June 2007, Ribby improved the pension entitlementso that employees receive 14% of their final salary for each year of service. This improvement applied to all prioryears service of the employees. As a result, the present value of the defined benefit obligation on 1 June 2007increased by $4 million as follows:

$mEmployees with more than four years service 3Employees with less than four years service (average service of two years) 1

4

Ribby had not accounted for the improvement in the pension plan.

(vii) Ribby is considering selling its subsidiary, Hall. Just prior to the year end, Hall sold inventory to Ribby at a priceof $6 million. The carrying value of the inventory in the financial records of Hall was $2 million. The cash wasreceived before the year end, and as a result the bank overdraft of Hall was virtually eliminated at 31 May 2008.After the year end the transaction was reversed and it was agreed that this type of transaction would be carriedout again when the interim financial statements were produced for Hall, if the company had not been sold bythat date.

(viii) The following exchange rates are relevant to the preparation of the group financial statements:

Dinars to $1 June 2006 111 June 2007 1031 May 2008 12Average for year to 31 May 2008 105

Required:

(a) Discuss and apply the principles set out in IAS 21 The effects of changes in foreign exchange rates in orderto determine the functional currency of Zian. (8 marks)

(b) Prepare a consolidated statement of financial position of the Ribby Group at 31 May 2008 in accordancewith International Financial Reporting Standards. (35 marks)

(c) Discuss how the manipulation of financial statements by company accountants is inconsistent with theirresponsibilities as members of the accounting profession setting out the distinguishing features of aprofession and the privileges that society gives to a profession. (Your answer should include reference to theabove scenario.) (7 marks)

Note: requirement (c) includes 2 marks for the quality of the discussion.

(50 marks)

3 [P.T.O.

Section B TWO questions ONLY to be attempted

2 (a) Norman, a public limited company, has three business segments which are currently reported in its financialstatements. Norman is an international hotel group which reports to management on the basis of region. It doesnot currently report segmental information under IFRS8 Operating Segments. The results of the regionalsegments for the year ended 31 May 2008 are as follows:

Region Revenue Segment results Segment SegmentExternal Internal profit/(loss) assets liabilities

$m $m $m $m $mEuropean 200 3 (10) 300 200South East Asia 300 2 60 800 300Other regions 500 5 105 2,000 1,400

There were no significant inter company balances in the segment assets and liabilities. The hotels are located incapital cities in the various regions, and the company sets individual performance indicators for each hotel basedon its city location.

Required:

Discuss the principles in IFRS8 Operating Segments for the determination of a companys reportableoperating segments and how these principles would be applied for Norman plc using the information givenabove. (11 marks)

(b) One of the hotels owned by Norman is a hotel complex which includes a theme park, a casino and a golf course,as well as a hotel. The theme park, casino, and hotel were sold in the year ended 31 May 2008 to Conquest, apublic limited company, for $200 million but the sale agreement stated that Norman would continue to operateand manage the three businesses for their remaining useful life of 15 years. The residual interest in the businessreverts back to Norman after the 15 year period. Norman would receive 75% of the net profit of the businessesas operator fees and Conquest would receive the remaining 25%. Norman has guaranteed to Conquest that thenet minimum profit paid to Conquest would not be less than $15 million. (4 marks)

Norman has recently started issuing vouchers to customers when they stay in its hotels. The vouchers entitle thecustomers to a $30 discount on a subsequent room booking within three months of their stay. Historicalexperience has shown that only one in five vouchers are redeemed by the customer. At the companys year endof 31 May 2008, it is estimated that there are vouchers worth $20 million which are eligible for discount. Theincome from room sales for the year is $300 million and Norman is unsure how to report the income from roomsales in the financial statements. (4 marks)

Norman has obtained a significant amount of grant income for the development of hotels in Europe. The grantshave been received from government bodies and relate to the size of the hotel which has been built by the grantassistance. The intention of the grant income was to create jobs in areas where there was significantunemployment. The grants received of $70 million will have to be repaid if the cost of building the hotels is lessthan $500 million. (4 marks)

Appropriateness and quality of discussion (2 marks)

Required:

Discuss how the above income would be treated in the financial statements of Norman for the year ended31 May 2008.

(25 marks)

4

3 Sirus is a large national public limited company (plc). The directors service agreements require each director topurchase B ordinary shares on becoming a director and this capital is returned to the director on leaving thecompany. Any decision to pay a dividend on the B shares must be approved in a general meeting by a majority ofall of the shareholders in the company. Directors are the only holders of B shares.

Sirus would like advice on how to account under International Financial Reporting Standards (IFRSs) for the followingevents in its financial statements for the year ended 30 April 2008:

(a) The capital subscribed to Sirus by the directors and shareholders is shown as follows in the statement of financialposition as at 30 April 2008:

Equity$m

Ordinary A shares 100Ordinary B shares 20Retained earnings 30

Total equity 150

On 30 April 2008 the directors had recommended that $3 million of the profits should be paid to the holders ofthe ordinary B shares, in addition to the $10 million paid to directors under their employment contracts. Thepayment of $3 million had not been approved in a general meeting. The directors would like advice as to whetherthe capital subscribed by the directors (the ordinary B shares) is equity or a liability and how to treat thepayments out of profits to them. (6 marks)

(b) When a director retires, amounts become payable to the director as a form of retirement benefit as an annuity.These amounts are not based on salaries paid to the director under an employment contract. Sirus hascontractual or constructive obligations to make payments to former directors as at 30 April 2008 as follows:

(i) certain former directors are paid a fixed annual amount for a fixed term beginning on the first anniversary ofthe directors retirement. If the director dies, an amount representing the present value of the future paymentis paid to the directors estate.

(ii) in the case of other former directors, they are paid a fixed annual amount which ceases on death.

The rights to the annuities are determined by the length of service of the former directors and are set out in theformer directors service contracts. (6 marks)

(c) On 1 May 2007 Sirus acquired another company, Marne plc. The directors of Marne, who were the onlyshareholders, were offered an increased profit share in the enlarged business for a period of two years after thedate of acquisition as an incentive to accept the purchase offer. After this period, normal remuneration levels willbe resumed. Sirus estimated that this would cost them $5 million at 30 April 2008, and a further $6 million at30 April 2009. These amounts will be paid in cash shortly after the respective year ends. (5 marks)

(d) Sirus raised a loan with a bank of $2 million on 1 May 2007. The market interest rate of 8% per annum is tobe paid annually in arrears and the principal is to be repaid in 10 years time. The terms of the loan allow Sirusto redeem the loan after seven years by paying the full amount of the interest to be charged over the ten yearperiod, plus a penalty of $200,000 and the principal of $2 million. The effective interest rate of the repaymentoption is 91%. The directors of Sirus are currently restructuring the funding of the company and are in initialdiscussions with the bank about the possibility of repaying the loan within the next financial year. Sirus isuncertain about the accounting treatment for the current loan agreement and whether the loan can be shown asa current liability because of the discussions with the bank. (6 marks)

Appropriateness of the format and presentation of the report and quality of discussion (2 marks)

Required:

Draft a report to the directors of Sirus which discusses the principles and nature of the accounting treatment ofthe above elements under International Financial Reporting Standards in the financial statements for the yearended 30 April 2008.

(25 marks)

5 [P.T.O.

4 The transition to International Financial Reporting Standards (IFRSs) involves major change for companies as IFRSsintroduce significant changes in accounting practices that were often not required by national generally acceptedaccounting practice. It is important that the interpretation and application of IFRSs is consistent from country tocountry. IFRSs are partly based on rules, and partly on principles and managements judgement. Judgement is morelikely to be better used when it is based on experience of IFRSs within a sound financial reporting infrastructure. It ishoped that national differences in accounting will be eliminated and financial statements will be consistent andcomparable worldwide.

Required:

(a) Discuss how the changes in accounting practices on transition to IFRSs and choice in the application ofindividual IFRSs could lead to inconsistency between the financial statements of companies. (17 marks)

(b) Discuss how managements judgement and the financial reporting infrastructure of a country can have asignificant impact on financial statements prepared under IFRS. (6 marks)

Appropriateness and quality of discussion. (2 marks)

(25 marks)

End of Question Paper

6

Answers

Professional Level Essentials Module, P2 (INT)Corporate Reporting (International) June 2008 Answers

1 (a) The functional currency is the currency of the primary economic environment in which the entity operates (IAS21). Theprimary economic environment in which an entity operates is normally the one in which it primarily generates and expendscash. An entitys management considers the following factors in determining its functional currency (IAS21):

(i) the currency that dominates the determination of the sales prices; and(ii) the currency that most influences operating costs

The currency that dominates the determination of sales prices will normally be the currency in which the sales prices for goodsand services are denominated and settled. It will also normally be the currency of the country whose competitive forces andregulations have the greatest impact on sales prices. In this case it would appear that currency is the dinar as Zian sells itsproducts locally and the prices are determined by local competition. However, the currency that most influences operatingcosts is in fact the dollar, as Zian imports goods which are paid for in dollars although all selling and operating expenses arepaid in dinars. The emphasis is, however, on the currency of the economy that determines the pricing of transactions, asopposed to the currency in which transactions are denominated.

Factors other than the dominant currency for sales prices and operating costs are also considered when identifying thefunctional currency. The currency in which an entitys finances are denominated is also considered. Zian has partly financedits operations by raising a $4 million loan from Hall but it is not dependent upon group companies for finance. The focus ison the currency in which funds from financing activities are generated and the currency in which receipts from operatingactivities are retained.

Additional factors include consideration of the autonomy of a foreign operation from the reporting entity and the level oftransactions between the two. Zian operates with a considerable degree of autonomy both financially and in terms of itsmanagement. Consideration is given to whether the foreign operation generates sufficient functional cash flows to meet itscash needs which in this case Zian does as it does not depend on the group for finance.

It would be said that the above indicators give a mixed view but the functional currency that most faithfully represents theeconomic effects of the underlying transactions, events, and conditions is the dinar, as it most affects sales prices and is mostrelevant to the financing of an entity. The degree of autonomy and independence provides additional supporting evidence indetermining the entitys functional currency.

(b) Consolidated Statement of Financial Position of Ribby Group at 31 May 2008

$mAssetsNon-current assetsProperty, plant and equipment 415Goodwill 17Financial assets 23

455

Current assets 51

Total assets 506

Ordinary shares 60Other reserves 32Retained earnings 122

Total shareholders equity 214Minority interests 60

Total equity 274Non-current liabilities 89Current liabilities 143

506

9

Workings

(i) Zian translation and calculation of goodwill

ExchangeDinars loss on Fair value

m loan adjustment Rate $mProperty, Plant and Equipment 360 66 12 355Financial assets 148 12 123Current assets 120 12 10

628 578

Ordinary shares 209 11 19Other reserves 66 11 6Retained pre-acquisition earnings 220 11 20

45

Retained post acquisition earnings 79 (8) 21 (balance)Non-current liabilities 48 8 12 47Current liabilities 72 12 6

628 578

Loans between subsidiaries cannot be treated as part of the holding companys net investment in a foreign subsidiary(IAS21). Zian will recognise an exchange difference on the loan from Hall in its income statement and the exchangedifference will flow through to the consolidated income statement and will not be reclassified as a separate componentof equity.

Dinarsm

Loan at 1 June 2007 $4 million at 10 dinars 40Loan at 31 May 2008 $4 million at 12 dinars 48

Exchange loss 8

The loan of $4 million should be eliminated on consolidation.

The fair value adjustment at acquisition is:

Dinarsm

Ordinary shares 209Retained earnings 220Fair value adjustment 66

Fair value of net assets 495

Goodwill

Dm Rate $mCost of acquisition 330 11 30less net assets acquired (60% of 495) (297) 11 (27)

Goodwill 33 3

Goodwill is treated as a foreign currency asset which is retranslated at the closing rate. Therefore, goodwill at 31 May2008 will be 33 million dinars 12, i.e. $28 million

Therefore, an exchange loss of $02 million will be recorded in retained earnings.

10

(ii) Consolidated statement of financial position at 31 May 2008

Ribby Hall Zian Adjustment Total$m $m $m $m $m

Property, plant and equipment 250 120 355 (08) 414710

Goodwill 14 3 (02) 168Financial assets 10 5 123 (4) 233Current assets 22 17 10 (4) 51

65058

Ordinary shares 60 60Other reserves 30 18 318Retained earnings 120 112 13 (02)

(08)(1)(48)(35)

1222Non-current liabilities 90 5 4.7 1

(4)35

(11) 892Current liabilities 110 7 6 3

11 1436

Minority interest 5965058

Retained earnings of Zian is 60% of $21 million, i.e. $13 million

(iii) Minority Interest

$m $mZian: 40% of $(45 + 21)million 188Hall: 30% of total equity 130

Revaluation 10Profit adjustment inventory (4)

136

408596

(iv) Building: Ribby

$mCarrying value at 31 May 2008 38(40 million dinars 10 = $4 million)(Depreciation $02 million)Value after impairment review (36 million dinars 12) (3)

Impairment loss 08

(v) Early repayment of loan

As the company has entered into an agreement to repay the debt early plus a penalty, it should adjust the carrying valueof the financial liability to reflect actual and revised estimated cash flows (IAS39). Therefore, the carrying amount of thedebt should be increased by $1 million and be transferred to current liabilities.

(vi) Past service cost

A past service cost of $3 million should be recognised immediately as those benefits have already vested and should becharged as an expense. The remaining $1 million should be recognised on a straight line basis over the two year periodthat it takes to vest. The pension entitlement has not yet vested fully as it is given in return for services over the remainingtwo year period. Thus the following entries will be required to account for the past service costs.

$mDR Retained earnings $(3 + 05)m 35CR Non-current liabilities (defined benefit obligation) 35

11

(vii) Accounting for sale of inventory (see part (c))

The transaction should not be shown as a sale. Inventory should be reinstated at $2 million instead of $6 million anda decrease in retained earnings of $4 million should occur in the accounting records of Hall.

CR Inventory $4 millionDR Retained earnings of Hall $4 million

The cash position should be reversed also by increasing cash by $6 million and the current liabilities by $6 million.

(viii) Bonus to employees of Ribby

A liability of $3 million should be accrued for the bonus to be paid in cash to the employees of Ribby. The managementshould also recognise an expense of (2/3 x 90% x $3 million) $1.8 million, with a corresponding increase in equity. Theterms of the share options have not been fixed and, therefore, the grant date becomes 30 November 2008 as this isthe date that the terms and conditions will be fixed. However, IFRS2 requires the entity to recognise the services whenreceived and, therefore, adjustment is required to the financial statements. Once the terms are fixed, the fair value canbe calculated and any adjustments made.

$mDR Expense in retained earnings 48CR Equity 18CR Current liabilities 3

(ix) Goodwill: Hall

$m $mCost of investment 98less net assets acquired (70% of $120 million) (84)

Goodwill 14

Alternatively

Cost of investment 98Ordinary shares 40Other reserves 10Retained earnings 60

110

Fair value adjustment 10

Fair value assets x 70% 120 (84)

Goodwill 14

Retained earnings: Hall

70% of $(80 4 60)million, i.e. $112 million

(x) Tangible assets $m $mRibby 250Hall 120Zian 355

4055

Impairment loss (08)Revaluation Hall 10

4147

(xi) Retained earnings

$m $mRibby 120Hall 112Zian 13

1325

Past service costs (35)Exchange loss goodwill (02)Impairment loss building (08)Loan (working v) (1)Bonus to employees (working viii) (48)

1222

12

(xii) Non-current liabilitiesRibby 90Hall 5Zian 47

997

Increase carrying amount of debt 1Elimination of loan (4)Past service cost 35Transfer to current liabilities (11)

892

(c) Accounting and ethical implications of sale of inventory

Manipulation of financial statements often does not involve breaking laws but the purpose of financial statements is to presenta fair representation of the companys position, and if the financial statements are misrepresented on purpose then this couldbe deemed unethical. The financial statements in this case are being manipulated to show a certain outcome so that Hallmay be shown to be in a better financial position if the company is sold. The retained earnings of Hall will be increased by$4 million, and the cash received would improve liquidity. Additionally this type of transaction was going to be carried outagain in the interim accounts if Hall was not sold. Accountants have the responsibility to issue financial statements that donot mislead the public as the public assumes that such professionals are acting in an ethical capacity, thus giving the financialstatements credibility.

A profession is distinguished by having a:

(i) specialised body of knowledge(ii) commitment to the social good(iii) ability to regulate itself(iv) high social status

Accountants should seek to promote or preserve the public interest. If the idea of a profession is to have any significance,then it must make a bargain with society in which they promise conscientiously to serve the public interest. In return, societyallocates certain privileges. These might include one or more of the following:

the right to engage in self-regulation the exclusive right to perform particular functions special status

There is more to being an accountant than is captured by the definition of the professional. It can be argued that accountantsshould have the presentation of truth, in a fair and accurate manner, as a goal.

2 (a) Upon adoption of IFRS8,Operating Segments, the identification of Normans segments may or may not change dependingon how segments were identified previously. IFRS8 requires operating segments to be identified on the basis of internal reportsabout the components of the entity that are regularly reviewed by the chief operating decision maker in order to allocateresources to the segment and to assess its performance. Formerly companies identified business and geographical segmentsusing a risks and rates of return approach with one set of segments being classed as primary and the other as secondary.IFRS8 states that a component of an entity that sells primarily or exclusively to other operating segments of the entity meetsthe definition of an operating segment if the entity is managed that way. IFRS8 does not define segment revenue, segmentexpense, segment result, segment assets, and segment liabilities but does require an explanation of how segment profit orloss, segment assets, and segment liabilities are measured for each segment. This will give entities some discretion indetermining what is included in segment profit or loss but this will be limited by their internal reporting practices. The coreprinciple is that the entity should disclose information to enable users to evaluate the nature and financial effects of the typesof business activities in which it engages and the economic environments in which it operates.

IFRS8 Operating Segments defines an operating segment as follows. An operating segment is a component of an entity:

that engages in business activities from which it may earn revenues and incur expenses (including revenues andexpenses relating to transactions with other components of the same entity)

whose operating results are reviewed regularly by the entitys chief operating decision makers to make decisions aboutresources to be allocated to the segment and assess its performance; and for which discrete financial information isavailable

IFRS8 requires an entity to report financial and descriptive information about its reportable segments. Reportable segmentsare operating segments that meet specified criteria:

the reported revenue, from both external customers and intersegment sales or transfers, is 10% or more of the combinedrevenue, internal and external, of all operating segments; or

the absolute measure of its reported profit or loss is 10% or more of the greater, in absolute amount, of (i) the combinedreported profit of all operating segments that did not report a loss, and (ii) the combined reported loss of all operatingsegments that reported a loss; or

its assets are 10% or more of the combined assets of all operating segments.

13

If the total external revenue reported by operating segments constitutes less than 75% of the entitys revenue, additionaloperating segments must be identified as reportable segments (even if they do not meet the quantitative thresholds set outabove) until at least 75% of the entitys revenue is included in reportable segments. There is no precise limit to the numberof segments that can be disclosed.

As the key performance indicators are set on a city by city basis, there may be information with