acca p2 express notes

ACCA Paper P2 (INT) Corporate Reporting For exams in 2011

Notes

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ExPress NotesACCA P2 Corporate Reporting

Page | 2 © 2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group.

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Contents

About ExPress Notes 3

1. Group Accounting 7

2. Foreign currency: IAS 21 15

3. Statements of cash flow: IAS 7 21

4. Provisions and contingencies: IAS 37 26

5. Taxation: IAS 12 28

6. Employment costs: IAS 19 32

7. Financial instruments: IAS 32 and IAS 39 37

8. Share based payment: IFRS 2 44

9. Tangible non-current assets 51

10. Intangible non-current assets: IAS 38 54

11. Impairment of assets: IAS 36 58

12. Revenue: IAS 18 61

13. Estimates, errors and accounting policies: IAS 8 63

14. Equity reconstructions (insolvency) 66



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START About ExPress Notes

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Chapter 1

Group Accounting

START The Big Picture

Group accounting will form the backbone of the compulsory question 1 in the exam, and will be worth approximately a third of the marks in the exam.

Most people do rather better in the groups part of the exam. Without doubt, groups are important, but be careful not to over-estimate the importance of groups in your preparation. Paper P2 is mostly not about group accounting!

Although question 1 will be a groups question at its core, there will be lots of other adjustments in the individual accounts that require correction before the consolidation.

These notes focus on the areas of groups that are new to paper P2 from paper F7, though we start with some core definitions and workings that should be familiar from paper F7.

Consolidation is the process of replacing the single figure for “investment in subsidiary” in the individual financial statements of the parent with more useful information about what assets, liabilities, income and expenditure the parent company controls via its investment, ie:



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Net assets in the subsidiary’s financial statements (ie equity or capital plus reserves) at the acquisition date.

Consideration transferred to buy subsidiary (as shown in the parent company’s individual accounts)

Non-controlling interests’ share of the net assets of the subsidiary.

Goodwill arising on acquisition (premium paid to acquire the subsidiary).

Consolidation is basically a double entry to derecognise the carrying value of the investment (Cr Investment in subsidiary) and recognise the individual assets (Dr PP&E, etc), the liabilities (Cr Payables, etc), the non-controlling interest (CR NCI) and recognise goodwill as a balancing, residual, item (normally DR Goodwill).

Key definitions What group accounting is trying to do

Subsidiary Any entity that is controlled by another entity, normally by having more than 50% of the voting power, though there is no minimum shareholding.

Parent The entity at the top of the group structure, controls the subsidiaries and has a significant interest in associates.

Associate A company in which the parent has significant influence, but not control nor joint control (as with a joint venture).

Control The power to control the financial and operating policies of another entity, so as to obtain benefit from its activities.

Significant influence The power to control the financial and operating policies of another entity, so as to obtain benefit from its activities.

Equity Equity is defined in the Framework document as assets less liabilities. By definition, this is the same as capital and reserves of any company at any date in time. In group accounting, we very frequently use the capital + reserves = net assets. For example, this is used to work out the net assets on the date of acquiring control of a company (as part of the goodwill working) and to



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work out post-acquisition growth in a subsidiary’s assets (ie post-acquisition profit).

Group reserves The cumulative gains made under the control of the parent. The parent company’s reserves, plus the post-acquisition retained gains of all subsidiaries, joint ventures and associates.

Non-controlling interest

Formerly called minority interest. The share of the net assets and gains of a subsidiary that is not owned by the parent.

Goodwill The premium paid by the parent to acquire its interest in a subsidiary or associate.

Key workings Hopefully familiar from paper F7, but revise thoroughly

Group retained earnings

This working is a core means of earning good marks in the exam. Produce one column for each company under the parent company’s influence. Then work down the rows methodically, perhaps using the mnemonic TOP TIP PET to make sure you haven’t forgotten anything. If the question has different types of reserves (eg revaluation reserve as well as retained earnings) you will need to do a separate working like the one below for each reserve to be shown in the group SOFP.

Parent

$’000

Sub 1

$’000

Sub 2

$’000

Assoc

$’000

Today 10,000 4,000 3,000 4,500

Omissions/ errors to correct in the individual financial statements of each company

400 200 (50)

Provision (eg for unrealised profit) (20) (50) -

Time passage effects (eg write-off of fair value adjustments)

(40) 20

Impairments of goodwill (cumulative) (30)

Sub-total 10,350 4,110 2,970 4,500

Pre-acquisition reserves (2,000) (1,800) (4,200)

Post-acquisition 10,350 2,110 1,170 300

x Effective ownership x 100% x 60 % x 40% x 40%



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**

10,350 1,266 468 120

TOTAL 12,204

** This is not a typo! A subsidiary may still be a subsidiary if an effective ownership of less than 50% still gives the parent control. See multiple groups below.

Non-controlling interests These show the net assets controlled by the parent and so part of the group, but not actually owned by the parent. There is no need to consider pre- and post-acquisition profits when calculating non-controlling interests in the SOFP.

Sub 1

$’000

Sub 2

$’000

Capital and share premium at SOFP date 800 400

Reserves, as consolidated (see eg above) 4,110 2,970

Fair value adjustments at acquisition 250 (80)

Less: Any items in the individual company’s SOFP not recognised in the group SOFP (see below)

(50) -

Net assets (ie equity) as consolidated in the group SOFP

5,110 3,290

x NCI % 40% 60%

Non-controlling interest 2,044 1,974

Total non-controlling interest 4,018

Goodwill on a business combination Fair value of consideration transferred 2,240 Less: Fair value of identifiable net assets acquired, calculated as: Capital and share premium of target 800 Reserves of target at acquisition date 2,000 Net assets (equity) of target at target’s book value 2,800 Fair value adjustments to target’s net assets 250



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Net assets (equity) of target at fair value 3,050 X % acquired (60%) (1,830) Goodwill arising in books of parent for consolidation 410

Goodwill: gross (“total”) or net (“partial”)?

The standard double entry working above produces a goodwill figures as it relates to the parent’s share. Imagine that the fair value paid for the subsidiary was the fair value for a 60% stake. Then we deduct 60% of the net assets. This logically gives 60% or thereabouts of the total implied goodwill (eg reputation, client list, motivated staff) of the subsidiary.

IFRS 3 allows groups a choice with each acquisition whether to leave goodwill net as above, or gross it up to show the implied total value of goodwill. In order to do the gross up, it is necessary to be given the fair value of the non-controlling interests’ stake in the business at the acquisition date. This would be given in the exam.

EXAMPLE

Non-controlling interest at fair value at acquisition date 1,350 Fair value of consideration transferred for 60% stake 2,240 Implied total value of company 3,590 Less: Fair value of identifiable net assets (3,050) Implied total goodwill 540 Partial goodwill automatically recognised (see above) 410 Gross-up required for total goodwill recognition 130 This gross up, if chosen as the accounting policy, would be recognised as:

Dr Goodwill 130 Cr Non-controlling interests 130

Fair values

When buying a company, its previous owner will only accept the fair value of the company as consideration, or they will not sell!



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In order to give a true and fair picture of the actual goodwill purchased, it is therefore necessary to record all the assets and liabilities acquired in the subsidiary at their fair value.

Fair value is generally arm’s length value.

A few notable fair value adjustments are:

Consideration paid includes the market value of any shares paid. Any contingent consideration is valued assuming that it will be paid, even if this is not certain.

Acquisition costs are written off immediately.

Contingent liabilities of the subsidiary will be shown in the individual accounts at zero value (see notes on IAS 37), but their existence would reduce the amount the acquirer is willing to pay. They are therefore revalued as if they were provisions in the fair value exercise.

Changes in group structure

Disposals

The gain or loss on disposal of anything is the increase or decrease in net assets recognised as a result of the transaction.

Proceeds (what is coming into the SOFP in the transaction) X

Less: Carrying value derecognised (what leaves the SOFP) (X)

Profit or loss on disposal (the increase or decrease in net assets) X

The carrying value of a subsidiary in a group SOFP comprises:

Individual assets and liabilities of the subsidiary at the SOFP date Goodwill remaining from the purchase by the parent Non-controlling interests at the SOFP date.

Therefore, the gain or loss on derecognition of a subsidiary is:


Less:

Individual assets and liabilities of the subsidiary at the SOFP date (X)

Goodwill remaining from the purchase by the parent (X)



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Non-controlling interests at the SOFP date (X)

Group gain or loss on disposal XX

The same working can be used to calculate gain or loss on partial disposal, where non-controlling interest increases (eg where ownership goes from 80% to 60%).

Where a holding goes from 80% to 40%, the calculation is amended slightly, as in addition to sales proceeds for the partial stake, there will also be a new associate recognised.


Value of new associate recognised X

Less:

Individual assets and liabilities of the subsidiary at the SOFP date (X)

Goodwill remaining from the purchase by the parent (X)

Non-controlling interests at the SOFP date (X)

Group gain or loss on disposal XX

Step acquisitions

Where an acquisition happens in stages (as it often does in reality), the treatment is to treat the acquisition as a purchase on the date when control happens. Also derecognise any previous holding, which might have been an available-for-sale financial asset or an associate.

This results in an acquisition of a subsidiary and a gain or loss on disposal as part of the same transaction.

In effect, step acquisitions use much the same logic as disposals, but in reverse.



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Multiple group structures

You should expect the structure of the group in question 1 in the exam to be a multiple group structure, such as:

Parent

60%

Subsidiary 1

60%

Subsidiary 2

The main additional maters to consider here are:

What is the nature of the relationship between parent and subsidiary 2? Even if the effective ownership is less than 50% (as it is here), it may still be a subsidiary, as there is effectively a chain of command by which the parent can control subsidiary 2. Parent has control of subsidiary 1, which has control of subsidiary 2.

In this example, the parent has an effective ownership of 36%, but has control. Subsidiary 2 is therefore consolidated as part of the Parent group, with non-controlling interests of 64%.

The dates of acquisition determine whether there is one goodwill calculation, or more. If Parent acquired Subsidiary 1 on 1.1.x1 and Subsidiary 1 acquired Subsidiary 2 on 1.1.x2, then there would be two transactions under Parent’s control, using resources controlled by Parent. This would require two goodwill calculations. However, if Subsidiary 1 had acquired Subsidiary 2 on 1.1.x1 and Parent acquired Subsidiary 1 on 1.1.x2, there would only be one transaction under Parent’s control, using Parent’s resources. This would give one goodwill calculation

In the group SOFP, any historical costs of investments in subsidiaries are not included in the group SOFP, as the subsidiary’s individual assets and liabilities are consolidated instead. This means that any cost of investment in Subsidiary 2 in the SOFP in Subsidiary 1 are excluded from the group SOFP and therefore NCI calculation.



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Chapter 2

IAS 21


An entity cannot mix currencies when producing financial statements!

Eg USD + EUR = Nothing useful.

There are two sets of rules to know, depending upon where in the flow of transactions something is happening.

Foreign currency

Functional currency

Presentation

currency Translation

rules Presentation

rules

Functional currency

Generally, the currency that the entity’s trial balance is produced in. The currency of the primary economic environment in which the company operates. Effectively the currency that the company “thinks in”.



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May not be the currency of the country in which the company operates, especially if the company is more like a branch of a foreign parent and depends upon the foreign parent for day-to-day support.

All other currencies other than the functional currency are a foreign currency.

Key workings/ methodsTranslation rules

1 Record all transactions in the functional currency. Record all purchases, sales, etc at the spot rate ruling on the date of the translation.

2 At the period end:

Translate monetary assets and liabilities at the closing rate.

Don’t retranslate non-monetary items.

3A Exchange difference arising in the year on retranslation of foreign currency loans is reported in profit in finance income/ finance cost.

3B

Exchange difference arising in the year on retranslation of foreign currency trade payables and receivables is reported in profit in other operating income/ other operating expenses.

Key workings/ methodsPresentation rules

This is normally examined in the context of group accounting, but it could be examined as a single company only.

An entity may choose any currency it likes for the presentation of its financial statements. Eg a company with a dual listing in the USA and in the European Union is likely to choose the US dollar as its presentation currency and also the euro as its presentation currency.

The basic rules are simple: translate the financial statements using these rules:

All items in the SOFP: translate at the closing rate. All items in the SOCI: translate at the average rate for the period, or spot rate for

any large one-off items.



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Exchange differences will arise, eg imagine the position of Lear Co for the year ended 31 Dec 20x1:

Date Euro

Net assets (equity) at 1 Jan 20x1 10,000 Profit for the year to 31 Dec 20x1 2,000 Other comprehensive income for the year to 31 Dec 20x1

1,000

Dividend declared for the year (1,500) Net assets (equity) at 31 Dec 20x1 11,500

Assume these exchange rates USD/ EUR

1 Jan 20x1 1.2

Average for 20x1 1.25

31 Dec 20x1 1.15

Date Euro

Exchange rate

USD

Net assets (equity) at 1 Jan 20x1 10,000 1.2 12,000 Profit for the year to 31 Dec 20x1 2,000 1.25 2,500 Other comprehensive income for the year to 31 Dec 20x1

1,000 1.25 1,250

Dividend declared for the year (1,500) 1.15 (1,725) Net assets (equity) at 31 Dec 20x1 11,500 1.15 13,225

The error is an exchange difference arising in the year.

This is not considered to be a realised gain or loss, so is reported directly in equity in the statement of changes in equity. It is not reported as part of other comprehensive income.

This does not add up!



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So Lear Co’s statement of changes in equity for the year ended 31 Dec 20x1 will show:

Date USD

This exchange gain or loss

arising on translation in the year is a gain in the

reserves of the subsidiary for consolidation. It is therefore split between

parent and non-controlling interests.

Net assets (equity) at 1 Jan 20x1 12,000 Profit for the year to 31 Dec 20x1 2,500 Other comprehensive income for the year to 31 Dec 20x1

1,250

Dividend declared for the year (1,725) Exchange gain on translation arising in the year (balancing item)

800

Net assets (equity) at 31 Dec 20x1 13,225

Groups and foreign currency It is common to have to translate the financial statements of a subsidiary into the reporting currency of the parent prior to consolidation.

This is simply an additional stage to complete prior to the process of consolidation.

Approach to questions with foreign subsidiaries:

1 Correct the individual accounts of each company for errors/ omissions in the individual accounts.

2 Translate the subsidiary’s financial statements into the presentation currency of the parent using the presentation rules.

3 Consolidate as normal.



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Further aspects of foreign currency groups

Goodwill

Goodwill on consolidation always arises in the books of the acquirer (ie parent) since it is the property of the parent company. The cost of buying the subsidiary from its previous owners can be broken down into:

Net assets in the subsidiary’s financial statements (ie equity or capital plus reserves) at the acquisition date.

Consideration transferred to buy subsidiary (as shown in the parent company’s individual accounts)

Non-controlling interests’ share of the net assets of the subsidiary.

Goodwill arising on acquisition (premium paid to acquire the subsidiary).

The goodwill’s value will vary with the exchange rate as the value of the subsidiary’s future earnings in the parent’s currency will vary with the exchange rate. This means that goodwill must be revalued each year with a consequent revaluation gain or loss.

This means that each year, goodwill must be calculated similarly to how the exchange gain or loss is calculated for the translation of the net assets of the subsidiary:

Date Euro

Exchange rate

USD

Goodwill at 1 Jan 20x1 1,000 1.2 1,200 Impairment loss in the year to 31 Dec 20x1

(200) 1.25 (250)

Exchange difference in the year - balance 50 Goodwill at 31 Dec 20x1 800 1.25 1,000

This gain of 50 is a gain

made by the parent, so

part of the parent’s

reserves



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Key workings/ methodsTranslation of subsidiary’s financial statements for consolidation

Statement of financial position of subsidiary at the year-end

Foreign currency

(€)

Exchange rate

Presentation currency ($)

Assets (top half of SOFP) €X Year end rate

$X

Capital of subsidiary €X Rate at

acquisition $X

Reserves of subsidiary @ acquisition €X Rate at acquisition

$X

Post acquisition gains (balancing item) €X balance $X Liabilities €X Year-end

rate $X

Total equity and liabilities €X $X



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Chapter 3

IAS 7


These notes focus on group statements of cash flow. If you are unsure of single company statements of cash flow, you should revise the notes for paper F7 before studying these.

Statements of cash flow for a group show cash and cash equivalents leaving the group of companies and coming into the group of companies. Intra-group cash flows are not reported.

Group statements of cash flow are generally somewhat more straightforward than group statements of comprehensive income in the exam, since most of the adjustments required to group financial statements (eg intra-group balances, allowances for unrealised profit, fair value adjustments) are non-cash adjustments.

Group statements of cash flow generally appear in question 1 of the exam, probably about one sitting in every five. They may alternatively appear in section B of the exam, but this is less common. They are one of the more popular subjects with students and the level of performance in the exam itself is likely to be strong if a cash flow question comes up, so you need to be well prepared for this topic.



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You should study group statements of cash flow after revising single company statements of cash flow from paper F7 and studying groups for paper P2. If you are reasonably comfortable with these two topics, group statements of cash flow are likely to give you few difficulties.

These are the main techniques that you need to be familiar with when preparing a group statement of cash flow over a single company statement of cash flow:

Reconciliation of profit to operating cash flow: impact of purchase/ sale of a subsidiary

Impact of purchase/ sale of subsidiary on T account workings (eg property, plant and equipment)

Cash paid to non-controlling interests Cash received from associates Disclosures on acquisition and disposal of a subsidiary (these are simple).

Key workings/ methods Reconciliation of profit before tax to cash from operations

A reconciliation is a statement explaining why two numbers do not agree. IAS 7 (indirect method) starts with profit before tax and reconciles this to cash flow from operations. The easiest way to do this is to reconcile EBIT (ie operating profit) to operating cash flow. An item will appear in the reconciliation if it does affect EBIT but does not affect operating cash flow, or vice versa. Affects

EBIT?

Affects operating cash flow?

In reconciliation?

Depreciation Yes No Yes

Impairment of goodwill in the year Yes No Yes

Credit sale made but not paid in cash (ie increase in receivables)

Yes No Yes

Write-down of inventory to recoverable value

Yes No Yes

Increase in tax payable No No No

Goods purchased on credit (ie increase in payables)

Yes No Yes

Increase in provision for warranty costs Yes No Yes



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The only addition so far compared with statements of cash flow in paper F7 is the mention of goodwill impairment above.

Normally, an increase in receivables is deducted, since this is a credit sale (which has been credited to revenue) but no cash received.

When a subsidiary is purchased, it is likely that the subsidiary will have receivables in its SOFP at purchase. These will cause an increase in group receivables, but they will not have affected group EBIT. Think about it – if the receivable existed when the subsidiary was purchased, that receivable must have been created by a pre-acquisition sale. Pre-acquisition revenue and expenses are not consolidated.

Affects EBIT?

Affects operating cash flow?

In reconciliation?

Increase in receivables due to purchase of subsidiary

No (pre-acquisition)

No No

Increase in payables/ accruals/ provisions due to purchase of subsidiary


No No

Increase in receivables/ prepayments due to purchase of subsidiary


No No

This means that the usual working capital adjustments when you prepare the reconciliation of profit to operating cash flow needs to be amended. Since the year-end figure will include any receivables (etc) arising on a purchase of subsidiary, but these should be excluded from the reconciliation, they must be deducted in the calculation.

EXAMPLE

Edgar Co purchased a subsidiary Edmund Co on 30 September 20x1. On that date, Edmund Co had receivables in its SOFP of $1,200.

Edgar Co and its subsidiaries at the start of 20x1 had receivables of $9,800 and on 31 December 20x1 had receivables of $11,450.



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The figure in the reconciliation of profit to operating cash flow in the year to 31 December 20x1 will be:

Increase in receivables (11,450 – 1,200 – 9,800) (450)

Key workings/ methods Associates, non-controlling interests

In a group statement of cash flows, cash can come into the group from an associate (an associate is not part of the group, since it’s not controlled by the parent) and cash paid to non-controlling interests. The cash paid to non-controlling interest will be their share of dividend paid by the subsidiary.

Both of these can be calculated using a T-account (or similar presentation), using the figures from the group SOFP.

EXAMPLE

Associate (SOFP) 1.1.x1 b/d 10,000 31.12.x1 Cash received

(balancing item) 1,500

31.12.x1 Share of profit after tax

2,000

31.12.x1 c/d 10,500

12,000 12,000

Non-controlling interests (SOFP) 1.1.x1 b/d 15,000 31.12.x1 Cash paid

(balancing item) 700 31.12.x1 Share of profit of

subsidiaries 2,000

31.12.x1 16,800 31.12.x1 Share of other comprehensive income of subsidiaries

500

17,500 17,500



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Effect of acquisition or disposal of subsidiary

The acquisition of a subsidiary in the year will increase the size of each item in the SOFP, as a result of the parent having control of a greater number of (eg) non-current assets. This increase will not represent a payment in cash directly for those non-current assets (any payment of cash to acquire control of a subsidiary was a payment to acquire shares!)

This will need to be adjusted for in each item in the SOFP, eg:

Property, plant and equipment (SOFP)

1.1.x1 b/d X 31.12.x1 Depreciation expense X

31.12.x1 Finance leases incepting in year

X

31.12.x1 Impairment losses X

31.12.x1 Acquired via control of new subsidiary in year

31.12.x1 Disposals @ NBV X

31.12.x1 Cash paid to acquire new P,P&E in the year (balancing item)

X

31.12.x1 Revaluation surplus in the year

X 31.12.x1 c/d X

XX XX

The actual acquisition itself will be shown as a single cash flow in the investing activities section of the statement of cash flows. This will be the cash paid (if any) by the parent to the previous owners of the subsidiary, less any cash balances of the subsidiary acquired.



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Chapter 4

IAS 37


Provisions are a form of liability, simply one of uncertain timing or amount.

If requires an obligation (something that is legally or constructively impossible to avoid by any means). An intention is never an obligation, so an intention to incur an expense can never generate a provision.

Initial valuation (provisions)

For a series of events (eg multiple goods sold under guarantee), use the expected value of the outflow and discount if the time value of money is material.

For a one-off event (eg a single litigation), use the single most probable outcome and discount if the time value of money is material.

Change in valuation: Update each period to the latest estimate. This is a change in accounting estimates, so an increase of $10,000 would be recorded in profit in the year when the estimate is changed, not as a prior period adjustment:



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Dr Expense $10,000 Cr Provision $10,000

Initial valuation (contingent liabilities)

Given a value of zero, unless on a fair value adjustment on acquisition by another company. See groups notes.

Summary diagram

Provisions and contingent liabilities for individual companies

Probable: Greater than 50% estimated probability

Possible: Greater than 5% and up to 50% estimated probability

Remote: 5% of lower probability

Reliable: Any estimate which is more reliable than making no estimate

Provide: Provide expected value and discount at an appropriate rate.



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Chapter 5

IAS 12


Current tax: The amount demanded by the tax authority in respect of taxable gains/ losses subject to tax in the current period. Generally an estimate at the year-end.

Deferred tax: Future tax due on gains recognised in the current period but not assessed for tax until some future period. Generally a net liability, but can very occasionally be a net asset.

Deferred tax is pervasive in financial statements, though it is generally examined as either a part of a question or as a stand alone question on its own. Normally, questions instruct you to ignore deferred tax.

In practice, you will need to consider the deferred tax position of every transaction where the accounting policy and the tax base (tax accounting policy – see below) are not the same.



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Key definitions These are ExP’s definitions, which are simplified for exam preparation purposes

Tax base The carrying value of the asset as it would be in the statement of financial position if the tax policy were used as the accounting policy, eg using taxable capital allowances instead of depreciation.

Temporary difference The difference between the IFRS carrying value of an asset/ liability and its tax base. Both tax base and IFRS value start with purchase price and both will become zero when the asset is scrapped.

Permanent difference This is not a phrase used in IAS 12, but it’s helpful in forming an understanding. This is where the tax base and the IFRS value of an asset or liability are always different, as a matter of principle. Eg government grant income received may never be taxable, though it’s income in profit.

Goodwill gives a permanent difference since impairment losses on goodwill are never a tax deductible expense. The tax base of an investment in a subsidiary is historical cost of purchase, so goodwill never appears at all in the tax computation. The fact that it never appears makes it a permanent difference.

Key workings/ methods

Exchange differences will arise, eg imagine the position of Lear Co for the year ended 31 Dec 20x1:

Eg Property

Software Provisions

IFRS value in SOFP 10,000 DR 4,000 DR 3,000 CRLess: Tax base 8,000 DR 500 DR 0 CRTemporary difference 2,000 DR 4,500DR 3,000 CRTax rate expected when the difference reverses

30% 30% 25%

Deferred tax 600 CR 1,350 CR 750 DR

Net deferred tax liability = 1,200 CR



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Exam approach Calculation of deferred tax liability and SOCI effect

1 Go through the accounting policies of the entity and identify each one where the accounting policy (IFRS) is not the same as the tax base.

2 Identify which of these differences are permanent differences, eg:

Business entertaining expenditure Government grants receivable Goodwill arising on consolidation.

State in your exam answer that this is a permanent difference, so has no future tax effects.

3 For each difference (other than permanent difference) calculate the temporary difference at the period end using the working above.

4 Multiply the temporary difference by the tax rate expected to be in force when the item becomes taxable (when it “reverses”).

Note: Cr temporary differences produce Dr deferred tax assets

Dr temporary differences produce Cr deferred tax liabilities

5 Look at all the deferred tax assets for evidence of impairment. Offset deferred tax liabilities against deferred tax assets with the same tax authority.

6 Calculate the movement on the deferred tax liability. This will be the total charge to the statement of comprehensive income for deferred tax.



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7 Split the movement on deferred tax liability in the year into the element reported in other comprehensive income and the rest that will be reported as part of the profit and loss charge for taxation in the period.

This is done by matching the movement on deferred tax (eg caused by a property upward revaluation) with where the gain or loss causing that movement in deferred tax was reported.

7A Work out the movement in deferred tax due to items reported in equity, eg:

Property revaluation gains

Movements in value on available-for-sale financial assets

Take the proportion of deferred tax movement on equity gains to equity.

7B

Show the movement in deferred tax that isn’t shown as gains taken to equity (step 7A) and show this as the deferred tax movement in profit.



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Chapter 6

IAS 19


Promises of pensions payable to staff are an expense of the sponsoring company. The act of making a promise to pay pensions creates an obligation (ie liability). This may be a liability to pay pension funds into a private pension plan, or a liability to pay a pension between retirement and death, depending on the pension type.

There are two types of pension plan: defined contribution and defined benefit.

Pension costs are fairly frequently examined. Although they seem difficult at first, they are surprisingly easy to deal with after working a few examples. To master the subject, you need to have:

A good working understanding of double entry bookkeeping To understand the transaction itself (ie how a promise is made and assets set aside

to cover the cost of honouring that promise) A methodical step-by-step approach to dealing with the numbers in a logical,

chronological, sequence.



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Defined contribution

These are easy. The employer makes contributions into a savings scheme for the employee.

All risks of the fund being inadequate to support the employee between retirement and death rest with the employee, not with the employer. They are therefore much more risky for the employee than for the employer.

The accounting is simple:

Impact on SOFP: None.

Impact on SOCI: Contributions payable into the pension plan are an expense.

Defined benefit plans

These are considerably more complicated for the accountant and considerably more risky for the employer.

Here, the employer promises to make future pension payments (an obligation, therefore a liability).

Impact on SOFP: Pension plan assets (ringfenced assets from which future pensions will be paid).

Pension plan liability (NPV of pensions promised by the year-end)

Deferred costs and income (see below)

Impact on SOCI: The cost of pensions promised in the year (current service cost and past service cost)

The increase in the pensions liability by the passage of time (interest cost)

The long-term growth in pension plan assets in the year (expected return on plan assets)

Recognised actuarial gains and losses (see below).

Actuarial gains/ losses

If a pension plan is perfectly in balance, then the assets will precisely equal the liabilities. This is unlikely ever to happen, as the valuation of investments will be volatile. Also, assumptions about the actuarial liability (ie expected cost of paying an uncertain amount to



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pensioners until they die) will vary year by year. It is normal for a pension plan therefore to be slightly out of balance.

Assets Liabilities

These unexpected movements give an actuarial gain or loss each period and are always a balancing item in the calculations, since (by definition) they are unexpected!

Key definitions These are ExP’s definitions, which are simplified for exam preparation purposes

Current service cost The NPV of the extra pensions promised to staff in return for work they did this period. Defined benefit plans are characterised by offering greater pensions to people who have worked for the company longer, so one extra period of service increases pensions liability.

Past service cost The NPV of the extra pensions promised to staff in return for work they did in the past. This is much less common than current service cost and might happen only if a company needs to eliminate an actuarial surplus on the pension plan.

Interest (expense) The pensions liability is shown at NPV, as there can often be decades between the promise of the pension being paid and it actually being paid. The NPV is therefore a lot less than the actual cash expected to be paid. As time passes, the liability will grow just by passage of time, similar to “unwinding” of discounts on initial recognition of provisions.

Deficit



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EXAMPLE Cordelia Co

Below are given the fictional numbers of Cordelia Co, relating to Cordelia Co’s defined benefit pension plan in the year to 31 December 20x1.

Plan assets

Pensions liability

Profit and loss effect

B/f @ start of period 10,000 DR 9,500 CR -

Current service costs - 500 CR 500 DR

Past service costs - 200 CR 200DR

Interest - 450 CR 450 DR

Contributions paid into the plan

(Dr Plan assets, Cr company cash)

180 DR - -

Pensions paid to pensioners 210 CR 210 DR -

Expected return on assets 600 DR - 600 CR

Expected figure c/f 10,570 DR 10,440 CR

Actual figure c/f 8,650 DR 10,200 CR

=> Actuarial gain in year 240 DR See below

=> Actuarial loss in year 1,920 CR See below

Net actuarial loss in year 1,680 CR See below

Recognition of actuarial gains and losses

Actuarial gains and losses arise each year. Often they are self-correcting over time (eg a short-term stock market crash is likely to recover by it comes time to pay out the pensions promised).

IAS 19 allows an accounting policy choice of dealing with actuarial gains and losses.

Full recognition The full loss each year is recognised immediately in other comprehensive income, rather than recognised in profit.



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Partial recognition The “corridor” approach. Each year, the cumulative actuarial gain or loss at the start of the year is compared with the corridor limit at 10% of plan assets or 10% of plan liability, whichever is higher. The actuarial gain or loss outside the 10% corridor is then amortised over the remaining service life of staff in the pension plan and this is charged to profit.



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Chapter 7

IAS 39


Although financial instruments appear frequently in the P2 exam, they are only at “level 2” knowledge within the syllabus. This means that the scenarios in which they are tested are likely to be relatively straightforward.

It’s easy to spend too much time preparing for these accounting standards, since they cover a huge array of different possible transactions, from regular trade receivables to exotic currency and interest rate swaps.

The best way to approach study is to know:

The four different classifications of all financial instruments The difference in fair value and amortised cost accounting The possible ways in which any gain or loss (whether on a financial instrument or

not) may be reported in financial statements.

If you are keen to take this as far as you can, then move on to study hedging, though this has generally only been worth a couple of marks in the exam.



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Held-to-maturity financial assets

Loans and receivables

When used... When have the ability and positive intention to hold a security to its stated maturity date.

When have loaned a third party money (to a maturity date) or have an amount receivable (eg trade receivables).

Example.... Investment in corporate bonds or government bonds.

Originated loan to a third party (eg a bank lending a loan to a homebuyer).

Example that can’t be categorised this way

Ordinary shares, as no maturity date. Nothing can be HTMFA if the entity has reclassified any investment out of HTMFA in the preceding two years.

-

Initial recognised value Cost paid, including transaction costs.

Initial cash advanced, plus transaction costs.

Year-end valuation method Amortised cost, less impairments. Impaired value estimated using revised cash flows, discounted at the original discount rate when the investment was purchased.

Amortised cost, less impairments. Impaired value estimated using revised cash flows, discounted at the original discount rate when the investment was purchased.

Gains or losses reported in... Profit or loss

Profit or loss

Financial asset or liability held at fair value through

profit or loss

Available-for-sale financial assets

When used... Almost anything can be categorised as FVPL at its initial recognition (notably not debt issued by the entity itself). Securities held for “trading” will be classified as FVPL.

A catch-all category. Anything not in either of the other categories will be AFSFA. Typically, where investor stands ready to sell the security but has no immediate plans to.

Example.... Shares held for trading. Shares held for intermediate term investment.

Example that can’t be categorised this way

- -



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Initial recognised value Cash paid to acquire. Transaction costs immediately written off to profit or loss.

Cash paid to acquire. Transaction costs added to initial value of investment.

Year-end valuation method Fair value. Best achievable market price, not deducting anticipated selling costs (though at the lower end of the bid – ask spread).

Fair value. Best achievable market price, not deducting anticipated selling costs (though at the lower end of the bid – ask spread).

Gains or losses reported in... Profit or loss Initially gain or loss reported in equity until sold, when the gain or loss is “recycled” (ie reported again) in profit.


Recognition and derecognition

The recognition criteria for financial instruments are slightly different to the recognition criteria in many other IASs/ IFRSs. The intention is to ensure that as many as recognised as possible, for as long as possible. They are recognised when the entity becomes party to the contract rather than when control is obtained. They are derecognised only when it’s virtually certain that all the risks of a financial instrument have expired or have been transferred to another party.

Fair value accounting

“Fair value” essentially means market value. So if the market is acting irrationally, then fair value may lead to dysfunctional financial reporting. This is a recent criticism of fair value accounting techniques.

Fair values are determined as:

Best achievable market value (but not deducting expected transaction costs), or Valuation using discounted cash flows that consider all matters relevant (eg expected

cash flows, timing of cash flows, credit risk, market interest rates, or Exceptionally if no reliable DCF valuation is possible, historical cost.



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Amortised cost

For held-to-maturity financial assets, both the issuer and the holder of the financial instrument (eg bond) know all the cash flows and the timing of those cash flows. The market value at its issue is known, as is its market value at maturity, since a bond that pays $1,000 on a known date is worth $1,000 on that date!

Any changes in market value in between the date of issue and the maturity date is therefore irrelevant as that gain or loss will not be realised.

The easiest treatment is therefore to spread the total return over the bond over its total life. This is done using the effective rate, which is the total return on the bond. This is the internal rate of return of all the cash flows. In the exam, you would be given the effective rate and be asked to calculate the figures in the financial statements.

EXAMPLE

On 1 January 20x1, Cordelia Co issued a bond with a nominal value of $200,000, a coupon rate (ie cash paid) of 4% of nominal value. The bond is due for redemption on 31 December 20x5 for $200,000 (plus the coupon payable on that date).

In reality, it’s likely that the effective rate would be worked out using a spreadsheet and the IRR function, which is illustrated below.



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This means that by the end of the five year life of the bond, it has been transformed (“amortised”) from its initially recognised value to its redemption value of $200,000.

So the charge or credit to profit for finance costs/ finance income is determined using the effective rate. The difference between interest calculated using the effective rate and the coupon paid/ received is the “rolled up” interest, which is added to the value of the bond each year.

Reclassication

To prevent creative accounting, reclassifying from one category of financial instruments to another is strongly discouraged by IAS 39. If a material held-to-maturity financial asset is reclassified out of held-to-maturity financial assets, then:

All other held-to-maturity financial assets must be immediately reclassified as available for sale, with immediate recognition of all gain or loss (para 52, IAS 39).

For that year and the two years thereafter, it is barred from classifying anything as held-to-maturity financial assets (para 9, IAS 39).

Impairments

All financial assets held at fair value are automatically revalued for impairments. If a held-to-maturity asset appears to be impaired (eg if the credit risk increases a great deal), then the new impaired value must be calculated using:

The revised expected cash flows and expected timing At the original discount rate.

Note that discounting the revised cash flows at the new rate (which would be higher, as the risk has increased) would double count the risk factor and result in undervaluation of the asset.

Hedging

The Big Picture

Hedging has only occasionally been tested in paper P2 and then normally as a relatively minor adjustment in question 1. It is common in practice and useful knowledge. Becoming expert in hedging should not be a top priority for most students studying for paper P2, since it can take a lot of time to master for a relatively low profile in the exam itself.



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Hedged item: The thing the enterprise is worried about changing in value, eg:

Foreign currency investment Foreign currency payable Variable interest rate loan resulting in higher than expected cash outflows Forecast future major purchase in a foreign currency becoming unaffordable due to

changes in the exchange rate.

To remove or reduce this risk, the entity may buy something that is expected to move in value in the opposite direction to the hedged item. This “counterweight” is the hedging instrument and may be an almost infinite number of different financial instruments, though derivatives are common. Understanding the intricacies of how hedging relationships may be set up is not important for paper P2. It’s useful to know how to account for movements in the hedged item and the hedging instrument.

Though three types of hedge are mentioned in IAS 39, there are only two accounting treatments for hedges, so there are basically two types of hedge:

Fair value hedge. The hedging instrument was taken out in order to protect against value changes of an item recognised in the SOFP. Eg a foreign currency loan to protect against a foreign exchange chage in value ofa foreign currency receivable that is being shown in the SOFP.

Cash flow hedge. A hedge that is not a fair value hedge, broadly! This might be to protect against adverse movements in an item not in the SOFP yet. Eg an entity may structure its business plan around buying a ship from a foreign ship builder, but it has not yet placed a binding order. As there is no binding order, there is no obligation, so there is no liability. The forecast/ intended transaction is not yet a liability, though the company will want to ensure that they can afford the expected future cash outflow.

To protect against adverse exchange movements making the ship unaffordable, the entity may hedge the foreign currency exposure, eg buy buying a foreign currency forward contract.



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Accounting for hedges

A fair value hedge is simple. Both the hedged item and hedging instrument will be in the SOFP and will record a gain and a loss. The accounting rules simply offset the gain on the hedged item with the loss on the hedging instrument, or vice versa.

A cash flow hedge is a bigger challenge for the writers of the IAS! The hedging instrument will be a contract, so will be in the SOFP, but the hedged item will be an intention, so is not in the SOFP. Since the hedging instrument exists only because of the expected existence of the hedged item, the gain or loss on the hedging instrument is “hidden” in equity until the hedged transaction takes place.



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Chapter 8

IFRS 2


Prior to IFRS 2, listed companies often paid senior staff in shares that were issued below market value. These shares were then sold at a profit by the holders, with two effects:

The holder made a profit on sale, which in substance was part of their total remuneration, and

The other shareholders lost wealth (ie suffered an expense) as the share price fell by new shares being issued below market price.

Prior to IFRS 2, this was simply recorded as:

Dr Cash (with actual cash received, below market value)

Cr Capital/ share premium account.

IFRS 2 remedies this by making an estimate of the loss to other shareholders by granting cheap shares and spreading that cost over the period the company gains benefit from the share scheme.

IFRS 2 is an unpopular accounting standard with many preparers of accounts, who say that it generates artificial expenses, brings in highly subjective valuations as expenses and repeats the same information as IAS 33 diluted earnings per share.



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KEY KNOWLEDGESuggested approach to questions

1 Decide whether the scheme is entirely payment in shares, is a payment in cash that is linked to the share price or some mix of the two. This decides how the share based payment is valued, as the rules are different for pure equity schemes and schemes in cash. Equity settled: The holder is paid only in shares. He/ she has no right to a cash alternative.

1A For an equity settled transaction, estimate the total benefit of the share plan to the holders by multiplying the total number of cheap shares to be issued by the option of the share at its grant date. This option value will be given in the exam. It is then frozen at the value per share at the grant date – it is never updated.

1B

For a cash based payment, estimate the total liability that the plan generates. As this is a liability, it must be revalued at the end of each period to its latest value.

2 Work out the vesting period. That is the period that staff must stay in the company’s employment to be able to exercise their options over cheap shares. This is the period over which the cost/ benefit of the share option plan will be spread.

3

Work out the cost of the share based payment each period, as: Latest estimate of total cost of the plan X (Expected total cost) Divided by years between grant and vesting date X (Total cost to date) Less: Costs cumulatively already recognised (X) Current period expense X



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REVIEW AND TEST 1The Crossmen

On 1 January 20x1, Crossmen Coropration granted 5,000 options on shares to each of its 200 most senior staff. Each option is conditional upon each member of staff staying in the company’s employment until 31 December 20x3. On 31 December 20x3, participating staff can continue to hold the share options and may choose to exercise them on 31 December 20x4 or 31 December 20x5. Each option allows the holder to buy Crossmen Co shares at a price of $1 each.

You are given this data and are required to calculate the expense for each of the years in question.

Date Fair value of option ($)

Number of participants expected to stay until 31

Dec 20x3

Share price ($)

1 Jan 20x1 3.30 180 4.00 31 Dec 20x1 3.40 175 4.20 31 Dec 20x2 3.45 180 4.25 31 Dec 20x3 2.95 165 3.80 31 Dec 20x4 3.10 165 3.95 31 Dec 20x5 3.30 165 4.30

Step 1: This is a pure equity settled transaction. Its value per share option is therefore frozen at the grant date.

Total expected cost to the company’s other shareholders: 5,000 x 180 x 3.30 = $2.97 million.

Step 2: The vesting period is three years. Although people may stay longer than that, the company cannot presume that they will voluntarily stay longer than the minimum required.

Step 3: The cumulative cost in each year is now worked out.



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Date Cumulative expense ($)

Expense previously recognised

Expense recognised

in year

31 Dec 20x1 (5,000 x $3.30 x 175 x 1/3) 962,500 0 962,500 31 Dec 20x2 (5,000 x $3.30 x 180 x 2/3) 1,980,000 962,500 1,017,500 31 Dec 20x3 (5,000 x $3.30 x 165 x 3/3) 2,722,500 1,017,500 742,500 31 Dec 20x4 (5,000 x $3.30 x 165 x 3/3) 2,722,500 2,722,500 0 31 Dec 20x5 (5,000 x $3.30 x 165 x 3/3) 2,722,500 2,722,500 0 The expense each year is recognised as:

Dr Expense

Cr Equity.

REVIEW AND TEST 2Wright

On 1 January 20x1, Wright Co granted 15,000 cash appreciation rights to 150 of its staff. These rights gave a bonus in cash based on the price of Wright Co’s shares. The cash appreciation rights offered a cash payment equal to the company’s share price at the exercise date, less the share price at the grant date. Participants have to stay in Wright Co’s employment until 31 December 20x3 in order for the rights to vest, though they may exercise on either 31 December 20x3, 31 December 20x4 or 31 December 20x5.

Date Number of options

exercised in the period

(000’s)


Dec 20x3

Share price ($)

1 Jan 20x1 0 140 1.20 31 Dec 20x1 0 140 1.45 31 Dec 20x2 0 142 1.50 31 Dec 20x3 1,100 144 1.52 31 Dec 20x4 800 144 1.60 31 Dec 20x5 260 144 1.48



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Step 1: This is a cash settled transaction, which therefore gives rise to a liability. As a liability, the expected value must be revalued each year.

Step 2: The vesting period is three years. Although people may stay longer than that, the company cannot presume that they will voluntarily stay longer than the minimum required.

Step 3: The cumulative cost in each year is now worked out, including updates of cost in the last two years after the first vesting period but before the latest possible exercise date.

Date Liability recognised

($’000)

Increase in liability

($’000)

1 Jan 20x1 (15,000 x 140 x (1.20 – 1.20) x 0/3 0 0

31 Dec 20x1 (15,000 x 140 x (1.45 – 1.20) x 1/3 175,000 175,000

31 Dec 20x2 (15,000 x 142 x (1.50 – 1.20) x 2/3 426,000 251,000

31 Dec 20x3 (15,000 x 144 x (1.52 – 1.20) x 3/3 691,200 262,200

Liability for Cash Appreciation Rights 1.1.x1 b/c 0 31.12.x1 Expense 175,000 31.12.x2 Expense 251,000 31.12.x3 c/d 691,200 31.12.x3 Expense 262,000 691,200 691,200 31.12.x3 Cash (1.1m x ($1.52-

$1.20)) 352,000 31.12.x3 b/d 691,200

31.12.x3 c/d 339,200 691,200 691,200 1.1.x4 b/d 339,200 31.12.x4 Cash (800 x (1.60 –

1.20) 320,000

31.12.x4 c/d (260 x (1.60 – 1.20)

104,000 31.12.x4 Profit/ loss 84,800

424,000 424,000 31.12.x5 Cash (260 x (1.48 –

1.20)

72,800 1.1.x5

b/d

104,000

c/d (all expired) 0 31.12.x5 Profit/ loss 31,200

104,000

104,000



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STAR PERFORMERS’ POINTDeferred tax and share based payment

Tax authorities may allow a future tax deduction for the expense created by share based payment, or they may allow nothing.

If there is an allowable deduction from taxable profits for share based payment, then the future tax recovery (ie deferred tax asset) should be recognised systematically alongside the expense.

In exams to date, the examiner for paper P2 has always said to assume that the future tax deduction will be based on the “intrinsic value” of the share based payment. IFRS 2 defines intrinsic value as the difference between the spot price of a share and the exercise price.

To return to the example of Crossmen (RAT 1)

Date Fair value of option ($)


Dec 20x3

Share price ($)

Intrinsic value ($)

1 Jan 20x1 3.30 180 4.00 3.00 31 Dec 20x1 3.40 175 4.20 3.20 31 Dec 20x2 3.45 180 4.25 3.25 31 Dec 20x3 2.95 165 3.80 2.80 31 Dec 20x4 3.10 165 3.95 2.95 31 Dec 20x5 3.30 165 4.30 3.30

The maximum tax recoveries are therefore:

Date Number of options

expected to vest (000s)

Intrinsic value per option

Expected future tax saving $ (1)

Deferred tax asset in SOFP

@ 30% (2)

1 Jan 20x1 900 3.00 0 0 31 Dec 20x1 875 3.20 933,333 280,000 31 Dec 20x2 900 3.25 1,950,000 585,000 31 Dec 20x3 825 2.80 2,310,000 693,000

(1) This is calculated as number of options expected to vest x intrinsic value per option x 1/3, 2/3, 3/3 for each year.

(2) This is calculated as the expected future tax saving multiplied by the expected future tax rate.



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Wrapping up this topic

PAUSE

Do something else for a while. Reflect on how you might be able to apply this knowledge to something in your own life or work.

REWIND

Reread and rework the examples in this chapter once or twice until you are comfortable with it.

EJECT

Move on to something else!



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Chapter 9

IAS 16


Property, plant and equipment comprises tangible non-current assets that a business uses in the course of its own business. It excludes investment property.

Issues in accounting for all assets and liabilities

Initial recognition/ classification Initial valuation Write-off period Amortisation/ depreciation/ impairments Revaluation upwards Additions/ enhancements Profit/ loss on disposal calculation.



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Initial recognition/ classication

Recognise when an entity has control over the asset, not necessarily ownership. This complies with the Framework definition of an asset and also enables assets held under finance leases to be shown as property, plant and equipment.

Initial valuation

All costs directly attributable. This includes site preparation, irrecoverable import taxes, inwards delivery charges, professional fees, attributable borrowing costs (IAS 23, below). It excludes training costs, any abnormal costs in installation.

Write-off period

Depreciate the asset so that the pattern of depreciation charges match the income stream generated. Review useful life periodically. Depreciation is not aimed at showing market value of assets in the SOFP.

Impairments

Recognise any losses in profit, unless to reverse any previous upwards revaluation shown in equity. See notes on IAS 36 impairments.

Revaluation

Default accounting policy is simple historical costs. If choose to revalue a non-current asset:

Must revalue all property, plant and equipment in the same class Must keep up to date, generally annually Must disclose details of valuation, which may be done by the directors Cannot return to historical costs later Will charge depreciation on the higher revalued figure Common to make an annual transfer from revaluation reserve to retained earnings of

the difference between deprecation on revalued amount and depreciation on historical costs.

Eventual gain on disposal likely to be lower, as carrying value on derecognition will be higher (see below).



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Additions

Further costs must be added to the asset’s value if the cost enhances the earnings-generating potential of the asset above its original specification, eg upgrade of a server’s memory capacity. Other cost (eg repair of hardware) must be expensed immediately.

Borrowing costs: IAS 23

Finance costs msut be added to the initial value of the asset if directly attributable to the acquisition of the asset.

This can include a fair weighted average of general company finance costs.

Must write off finance costs incurred during periods of extended stoppage when no construction work takes place.

Must write off once the asset is ready for use, even if not brought into use on that date.

Other borrowing costs must be written off as an expense.


Profit or loss on disposal






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Chapter 10

IAS 38


Property, plant and equipment comprises tangible non-current assets that a business uses in the course of its own business. It excludes investment property.

Issues in accounting for all assets and liabilities

Initial recognition/ classification Initial valuation Write-off period Amortisation/ depreciation/ impairments Revaluation upwards Additions/ enhancements Profit/ loss on disposal calculation.

Initial recognition/ classication

An identifiable non-monetary asset without physical substance. This can include the right to use a tangible asset. So premiums paid to acquire services of a person (eg transfer price of a sports player) are intangible assets. Goodwill is an example of an intangible asset.



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Identifiable means that the asset can be seen as separate from the business as a whole, in contrast to goodwill (though goodwill is also accounted for under IAS 38).

An intangible is recognised once it meets the definition of an asset, which means that it’s controlled by the entity and it’s reasonably expected to generate a positive inflow of benefit. So intellectual property (knowledge generally known) is not controlled by an entity and is not an intangible. Intellectual property rights are controlled by the entity (eg patent) and so may be recognised. It includes development costs, brands, licenses, patents, etc.

Research costs are written off as incurred as they either are not controlled by the entity or are not sufficiently certain to generate future benefits. Paragraph 57 of IAS 38 gives the test for deciding if an expenditure is research (write off) or development (treat as an asset). Expenditure is development cost if (mnemonic RAT PIE):

Resources are adequate to complete the project Ability to complete Technically feasible Probable economic benefit (ie expected to be profitable) Intend to complete the project Expenditure on the project can be separately recorded.

An intangible asset may be acquired by an entity individually, or may arise as a result of a business combination (ie goodwill in group accounting).

Initial valuation

All costs directly attributable. Similar rules to IAS 16, Property, Plant and Equipment.

If negative goodwill arises on a business combination, first check all the figures in the calculation. If all the figures appear to be correct, recognise immediately in profit as income.

Write-off period

For intangible assets with a definite (ie known) life, such as patents: similar rules to IAS 16, Property, Plant and Equipment.

For intangible assets with an indefinite (ie unknown) life, such as goodwill, do not amortise, but test annually for impairment.

All intangible assets have a finite (ie limited) useful life.



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Impairments

Recognise any losses in profit, unless to reverse any previous upwards revaluation shown in equity. See notes on IAS 36 impairments.

Revaluation

Default accounting policy is simple historical costs. If choose to revalue a non-current asset, there are similar consequences as for IAS 16 Property, Plant and Equipment.

Intangible assets can be revalued upwards only by reference to a market value in an active market. Paragraph 8 of IAS 38 defines an active market as:

the items traded in the market are homogeneous willing buyers and sellers can normally be found at any time; and prices are available to the public.

It is common for intangible assets to be unique or at least very distinctive (ie not homogenous) or for the market in them to be shallow. Active markets in intangibles are therefore rare so it is rare for intangibles to be revalued upwards. Goodwill relating to a business is unique, so can never be revalued upwards.

Additions

Further costs must be added to the asset’s value if the cost enhances the earnings-generating potential of the asset above its original specification, eg upgrade of a server’s memory capacity. Other cost (eg repair of hardware) must be expensed immediately.


Profit or loss on disposal






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Goodwill on a business combination

Fair value of consideration transferred X

Less: Fair value of identifiable net assets acquired, calculated as:

Capital and share premium of target X

Reserves of target at acquisition date X

Net assets (equity) of target at target’s book value X

Fair value adjustments to target’s net assets X/(X)

Net assets (equity) of target at fair value X

X % acquired (X)

Goodwill arising in books of parent for consolidation X

This figure may then be “grossed up” to full goodwill. See notes on business combinations.



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Chapter 11

IAS 36


An asset cannot be shown in the SOFP at a valuation greater than the economic benefits it’s expected to generate, since this would violate the Framework definition of an asset.


Cash generating unit

A cash generating unit is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. In practical terms, it’s the smallest group of assets which together could be a going concern. CGUs exist since individual assets often do not generate cash inflows on their own.



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Any asset which appears to have been impaired must be reviewed for an impairment, with any loss recognised as given below. Assets with a finite but indefinite life (eg purchased goodwill) must be reviewed for impairment each period, even if there is no indicator of impairment.

Determining impaired value

The value in use is calculated using the NPV of expected future net cash flows (profit before interest and tax) from the asset:

In its current condition (ie not allowing for expected enhancements), although there is no prohibition on considering the most profitable potential use of the asset in its current condition (eg switching from making product X to product Y).

Over a period of five years, unless a longer period can be justified by reference to past accuracy in budgeting income streams longer than five years.

Using the latest general market risk-free interest rate. Expected revenue less costs necessarily incurred to generate that revenue. Mutually compatible, eg if future cash flows are “money” flows including expected

inflation, they must be discounted at an appropriate “money” discount rate, not “real” rate.

Foreign currency cash flows must be translated at the spot rate on the date of the impairment review.

Impairment indicators: external to the business include:

Decline in market value Adverse technological or environmental changes Long-term increase in interest rates Obsolescence.

Impairment indicators: internal to the business include:

Change in intended use Poor performance Physical damage.

Reporting impairment losses: individual assets

Reverse any prior revaluation gain in equity (other comprehensive income), then charge to profit.



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Reporting impairment losses: cash generating unit

Any assets physically damaged or otherwise specifically impaired, then Goodwill attributable to the CGU, to a minimum value of zero, ie do not recognise

internally generated negative goodwill, then Other assets pro rata to value but never impair an asset below its potential net sales

value, as the rational thing would be to sell an asset if it appears to have a higher value to somebody else than it does to the current owner.

Reversal of impairments

This is possible if the circumstances creating the impairment no longer exist. The reversal would be reported wherever the initial impairment had been recorded, which is normally as a credit to profit.

BUT impaired goodwill can never be reversed.



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Chapter 12

IAS 18


Adjustments for revenue recognition often appear in the exam, most frequently as adjustments in question 1, but can come up as longer parts of Section B questions.

The key issue is commercial substance over legal form.

The rules are different depending upon whether a sale is for goods or for services.

Goods

Recognise revenue when most of the more important inherent risks and rewards of the goods have passed from the seller to the buyer.

This might well be earlier or later than when legal title passes or when payment occurs.



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Services

Recognise revenue as the costs of providing the service are incurred. Where a service is paid for up front, revenue often must be deferred as a liability in the SOFP until the revenue is earned.

Valuation of revenue

If sales are made with long-term payment terms, recognise the sale and the receivable at its net present value using an appropriate discount rate. This then shows finance income over time.

Bundled sales

Where goods are sold with serviced bundled (eg after-sales servicing for two years), then unbundle into separate components.

EXAMPLE

If a car is sold for $30,000 with three years of free servicing, recognise this as:

$

Total sales value 30,000

Less: Market value of three year servicing agreement

(to be recognised over 3 years)

(3,000)

Value of goods sold (recognise immediately) 27,000



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Chapter 13

IAS 8


Preparation of financial statements involves inclusion of many accounting estimates, such as:

Depreciation method (estimate of how assets generate a revenue stream) Provisions Tax payable for the year.

It is normal for estimates to be wrong. They are normally simply corrected the following year with the following year taking the profit and loss effect of the correction.

Accounting estimates

Normal Expected Affects profit of the year

discovered

≠Accounting errors

Not normal Possibly careless Adjust prior year Normally no effect on profit in

the year the error is discovered



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Accounting estimates and treatment of changes

Changes in accounting estimates result from new information or new developments and, accordingly, are not corrections of errors.

Changes in accounting estimates are simply absorbed the following period as an expense (or income) in that following period. No adjustment is made to the previously published financial statements of the previous period.



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Accounting errors (prior period errors)

These are errors and omissions the entity’s financial statements for prior period(s) arising from a failure to use reliable information that:

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

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

To make an error in an accounting estimate is to be human. To make a general accounting error is to be careless!

Accounting errors are corrected by amending the previously issued financial statements of the previous year, meaning that there is not normally a profit effect in the current year when the error is discovered.



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Chapter 14

Equity reconstructions


Where an entity has become technically insolvent, such as having large retained losses, there may be serious difficulties including:

Going concern being in doubt due to unsustainable cash outflow Inability to pay dividends before retained losses are made up Inability to raise new finance.

The syllabus for paper P2 requires that you be able to identify when an entity may no longer be a going concern. There is a heavy overlap here with papers F8 and P7. ISA 570 assesses going concern indicators under the headings:

Financial Operating Other (eg legal and regulatory).

Where an entity’s going concern status is threatened due to uncertainty in its financing structure, but the underlying business appears to have potential to become stable, there are two possible outcomes that commercially would happen:

1. The business goes bankrupt and a new entity takes over its viable assets in a liquidation, or

2. The business obtains approval of the law courts and providers of finance to restructure its operations.

It’s generally better for investors and all other stakeholders to allow a business to restructure and be given an opportunity for a fresh start, rather than to go bankrupt.



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Mechanics of a reconstruction

The exact mechanism of a financing reconstruction vary greatly between legal systems. The following is based on Part 26 of the UK Companies Act 2006.

A meeting of all the shareholders and creditors is convened. A scheme of arrangement is provided to the providers of finance. Agreement of at least 75% of each class of provider of finance must be obtained. In

practice, each group needs to be convinced that they will be at least as well off under the proposed scheme than if the company were to be liquidated (see below).

If this vote is passed, all providers of finance are bound by the reconstruction scheme.

The scheme then has to be approved by a court of law. This approval is likely to be given if the court is satisfied that the scheme is a viable alternative to liquidation.

The assets and liabilities are all revalued and the old company transferred to a new company, with novation of all contracts, assumption of old company liabilities and continuity of employment contracts.

All existing finance is extinguished and replaced with the new finance.

Legally, the old entity is destroyed and a new entity created that takes on all the assets and liabilities (including trade name, etc) of the old business. For accounting purposes, the easiest way to do this is to retain the existing general ledger but record the replacement of the “old” company’s financing with the new company’s financing. This is normally done by a reconstruction account.

This means that although a new company is taking on assets and liabilities from a legally separate old company, the general ledger recording continues as if it were always the same company.

Reconstruction account

Impairment of assets X Oldco ordinary capital X

Retained earnings (losses)

X Oldco preference capital

X

Oldco debentures X

Oldco payables X

Net worth c/d X Revaluation reserve (including any new revaluations)

X



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XX XX

Net worth b/d X

Newco ordinary capital

X

Newco preference capital

X

Newco debentures X

Newco payables X

XX XX

Selling the plan!

In order to obtain the 75% or more approval of each class of provider of finance, it will be necessary to ensure that each finance provider is at least as well off under the transfer of the old company’s assets to the new company. To get this, it’s necessary to understand the order in which insolvency law typically pays out assets on liquidation of a business. The order is typically:

1. Fees of the lawyer/ liquidator (often described by the misleading euphemism of “costs”)

2. Preferred creditors (eg staff holiday pay, VAT, taxes) 3. Debentures secured with a fixed charges, in date order of creation of fixed charges 4. Debentures secured with floating charges, in date order of creation of floating

charges 5. Other creditors ranked pari passu 6. Unpaid preference dividends 7. Preference capital 8. Ordinary capital.

The fees of a liquidator are often substantial and the assets will be sold in a hurry, so for knock down prices. It is therefore unlikely that much money will be left over to pay much more than the preferred creditors. Providers of equity finance are probably the easiest to please with the reconstruction, as they have little to lose.

If you are required to assess whether a proposed reconstruction is likely to succeed, it is generally best to list all the providers of finance and assess how much they are likely to receive from a liquidation and how much they are likely to receive from the reconstruction. Remember that each provider effectively has a right to veto a reconstruction, so everybody will need to be better off.

(end of ExPress Notes)

acca p2 express notes

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