acca p2 int revision mock - answers j14

ACCA

Paper P2 INT

Corporate Reporting

June 2014

Revision Mock – Answers

To gain maximum benefit, do not refer to these answers until you have completed the revision mock questions and submitted them for marking.

ACCA P2 INT : CORPORATE REPORTING

2 KAPLAN PUBLISHING

© Kaplan Financial Limited, 2014

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All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing.

REVIS ION MOCK : ANSWERS

KAPLAN PUBLISHING 3

1 COOKIE

Key answer tips

Part (a) of this question is a typical group accounting question. There are several consolidation adjustments, such as fair value uplifts and intra-group trading. During the year, the parent company purchases more shares in one of its subsidiaries. Remember, goodwill is calculated on the date control is received and is not recalculated. Instead, this purchase of shares is accounted for within equity.

Part (b) tests knowledge of the measurement period. If information about acquisition date fair values is received within twelve months of acquiring a subsidiary, retrospective adjustment must be made. This means that goodwill must be recalculated.

Part (c) covers ethics, and this is something which should be expected in the examination. Make specific comments about the relevant accounting standards and refer to the ACCA ethical code. Clear and concise comments will score one mark each, whilst wordy and imprecise answers score very little.

(a) Consolidated statement of financial position for the Cookie group as at 30 April 2014

$m Marks Property, plant and equipment

($80 + $85 + $67 – $4.2 (W9) + $0.4 (W9)) 228.2 2.0

Goodwill ($1 + $7 (W3)) 8.0 W Other intangible assets ($15 – $3 (W2)) 12.0 1.0 Investments ($10 + ($15 – $10)) 15.0 1.0 –––––– 263.2 Inventories ($19 + $6 + $25 – $0.5 (W7)) 49.5 1.0 Trade receivables ($17 + $13 + $33 – $4 (W7)) 59.0 1.0 Cash and cash equivalents ($22 + $3 + $14) 39.0 –––––– 401.7 –––––– Share capital ($21 + $5 (W3)) 26.0 1.5 Other components of equity (W5) 67.8 W Retained earnings (W5) 115.9 W –––––– 209.7 Non-controlling interest (W4) 57.6 W –––––– 267.3

Non-current liabilities ($40 + $10 + $18 – $0.5 (W8)) 67.5 1 Current liabilities ($23 + $18 + $38 – $4 (W7) + $1 (W10))

76.0 2

–––––– 410.7

––––––


4 KAPLAN PUBLISHING

Marking guidance:

No marks for P + S + S

1 mark per adjustment

Extra calculation marks given in workings

W = mark allocation shown in workings

Workings:

(W1) Group structure

Cookie

55% 70% (1 May 2013 – 1 November 2013) 90% (1 November 2013 – 30 April 2014)

Biscuit Cracker

(W2) Net assets

Biscuit

Year end Acq’n Post-acq’n Marks $m $m $m Share capital 10 10 Retained earnings 79 70 Investments ($15 – $10)

5 – 1

Brand (bal. fig) 15 15 Excess amortisation (($15/5) × 1 year)

(3) – 1

–––––– –––––– –––––– 106 95 11 –––––– –––––– ––––––

Cracker

Year end Acq’n Post-acq’n Marks $m $m $m Share capital 20 20 – Other components 20 20 – Retained earnings 43 30 13 –––––– –––––– –––––– 83 70 13 –––––– –––––– ––––––


KAPLAN PUBLISHING 5

(W3) Goodwill

Biscuit:

$m MarksCash consideration 30.0 0.5Share consideration (5m × $4.5) 22.5 1.0FV of NCI at acquisition 45.0 0.5FV of net assets at acquisition (W2) (95.0) 0.5 –––––– ––––––Goodwill at acquisition 2.5 2 maxImpairment (W6) (1.5) 0.5 –––––– Goodwill at reporting date 1.0 ––––––

The share consideration has not been accounted for. In the above calculation, $22.5 is being debited to goodwill. Adjustments will need to be made to share capital for $5m (5m shares × $1 nominal) and to other components of equity for $17.5m (5m shares × ($4.5 – $1.0)).

Cracker:

$m MarksConsideration 56 0.5NCI at acquisition (30% × $70 (W2)) 21 0.5FV of net assets at acquisition (W2) (70) 0.5 ––––– ––––––Goodwill 7 1 max ––––– ––––––

Remember that goodwill is calculated on the date control is achieved. It is not recalculated if further shares are purchased.

(W4) Non-controlling interest

$m MarksBiscuit NCI at acquisition 45.0 0.545% of Biscuit’s post- acquisition profits (45% × ($11 (W2))

4.95 0.5

Cracker NCI at acquisition (W3) 21.0 0.530% of Cracker’s post acquisition profits between 1 May 2013 and 1 November 2013 (30% × (($13 (W2) × 6/12))

1.95 1.0

10% of Cracker’s post acquisition profits between 1 November 2013 and 30 April 2014 (10% × (($13 (W2) × 6/12))

0.65 0.5

Goodwill impairment (W6) (0.7) 1.0Increase in ownership (W11) (15.3) 1.0 ––––––– ––––––– 57.6 4 max ––––––– –––––––


6 KAPLAN PUBLISHING

(W5) Retained earnings

$m MarksCookie 105.0 0.5 55% of Biscuit’s post- acquisition profits (55% × ($11 (W2))

6.05 0.5

70% of Cracker’s post acquisition profits between 1 May 2013 – 1 November 2013 (70% × (($13 (W2) × 6/12))

4.55 0.5

90% of Cracker’s post acquisition profits between 1 November 2013 – 30 April 2014 (90% × (($13 (W2) × 6/12))

5.85 0.5

PURP (W7) (0.5) 0.5 Loan retranslation gain (W8) 0.5 0.5 Goodwill impairment (W6) (0.8) 1.0 PPE capital expenditure error (W9) (4.2) 0.5 PPE depreciation error (W9) 0.4 0.5 Provision (W10) (1.0) 0.5 ––––––– ––––––– 115.9 5 max ––––––– –––––––

Other components of equity

$m Marks Cookie 50.0 0.5 Share issue (W3) 17.5 1.0 Increase in ownership (W11) 0.3 1.0 ––––––– 67.8 –––––––

(W6) Goodwill impairment – Biscuit

$m Marks Year-end net assets (W2) 106.0 0.5 Goodwill (W3) 2.5 0.5 –––––– 108.5 Recoverable amount (107.0) 0.5 –––––– Impairment 1.5 ––––––

Under the full goodwill method, this must be allocated between the group and the NCI based on their shareholdings.

Group share: 55% × $1.5m = $0.8m (W5)

NCI share: 45% × $1.5m = $0.7m (W4)


KAPLAN PUBLISHING 7

(W7) Intra-group trading

There has been trading between Cookie and Biscuit. The profit remaining in inventory of $0.5m ($2m × 25%) must be eliminated:

Dr Retained earnings (W5) $0.5m Cr Inventory $0.5m

The invoice for the sales transaction remains outstanding. Therefore, the intra-group receivable and payable must be eliminated:

Dr Payables $4.0m Cr Receivables $4.0m

(W8) Loan

The loan would have been initially recorded at $4.3m (DN10m/2.3).

As a monetary liability, it must be retranslated at the year end using the closing rate. This will result in a liability of $3.8m (DN10m/2.6).

The loan therefore needs to be reduced by $0.5m ($4.3m – $3.8m) with a gain of $0.5m being recorded in profit or loss. (1 mark)

Dr Non-current liabilities $0.5m Cr Retained earnings (W5) $0.5m

(W9) Plant

Per IAS 16, general overheads and training are not allowed to be included within the cost of property, plant and equipment. Therefore $4.2m ($3.7m + $0.5m) should be written off to profit or loss. (1 mark)

Dr Retained earnings (W5) $4.2m Cr PPE $4.2m

As a result of the error above, the depreciation charge for the year will be incorrect.

The depreciation charged on this asset will have been $1.5m ($15m/5 years × 6/12). The depreciation that should have been charged is $1.1m (($15m – $4.2m)/5 years × 6/12). Depreciation must therefore be reduced by $0.4m. (1 mark)

The correcting entry is:

Dr PPE $0.4m Cr Retained earnings (W5) $0.4m

(W10) Provision

An obligation exists for Cookie to repair units that develop defects and that are still under warranty. Per IAS 37, where a provision involves a large population of items, the expected value of the outflow should be determined.

The expected value of the cost of the repairs is:

($6m × 7%) + ($14m × 4%) = $1.0m (1 mark)

The entry for this is:

Dr Retained earnings (W5) $1.0m Cr Current liabilities $1.0m


8 KAPLAN PUBLISHING

(W11) Increase in ownership

Cookie obtained control over Cracker on 1 May 2013.

On 1 November 2013, Cookie increases its holding of shares. Goodwill is not recalculated and no gain or loss arises. Instead, this is deemed to be a transaction within equity.

There will be a decrease in the NCI. The difference between the consideration paid and the decrease in the NCI is taken to retained earnings.

$m Marks Decrease in NCI (W12) 15.3 Cash paid (15.0) –––––– Increase in shareholders’ equity 0.3 1 ––––––

(W12) Decrease in NCI

The NCI in Cracker has decreased from 30% to 10%, a decline of two-thirds.

$m $m Marks NCI at acquisition 21.0 NCI share of post acquisition profits (30% × $13 × 6/12)

1.95

NCI at 30 June 20X1 23.0 1 Decrease in NCI ((20/30) × $23.0m)

15.3 1

(b) During the measurement period, an acquirer should retrospectively adjust the provisional amounts recognised at the acquisition date to reflect new information obtained about facts that existed as at the acquisition date. (1 mark)

The measurement period does not exceed one year from the acquisition date. (1 mark)

(IFRS 3 knowledge: 2 marks max)

(i) 15 April 2014 is within 12 months of acquisition so falls within the measurement period. Cookie must therefore value Biscuit’s brand at $10m as at the valuation date. (1 mark)

This means that the amortisation charged on the brand will be $2m ($10m/5 years). (1 mark)

The carrying value of the brand at the reporting date will be $8m ($10m – $2m). (1 mark)

Lowering the brand valuation by $5m will increase the goodwill arising on the acquisition of Biscuit by $5m to $7.5m ($2.5m + $5.0m). (1 mark)

At year end, goodwill will be impaired by $2.5m (W1). (2 marks)

Goodwill as at the reporting date will therefore be $5.0m ($7.5m – $2.5m). (1 mark)

(IFRS 3 application in b (i): 5 marks max)


KAPLAN PUBLISHING 9

(ii) 10 May 2014 falls outside of the measurement period. Therefore, no adjustment is made to the value of the brand as at the acquisition date.

The brand will therefore be recognised at $15 million and goodwill on acquisition will be $2.5 million. (as per part (a)). (1 mark)

The reduced estimate of the brand’s fair value is an indicator that the brand is impaired. An impairment review should be conducted. (1 mark)

If the brand is impaired, it will be written down to its recoverable amount and the impairment loss will be charged to profit or loss. (1 mark)

(IFRS 3 application in b (ii): 2 marks max)

(W1) Impairment review

$m $m Goodwill 7.5 Net assets at y/end: Share capital (per part a) 10.0 Retained earnings (per part a) 79.0 Investment (per part a) 5.0 Brand 10.0 Excess amortisation (2.0) ––––– 102.0 ––––– 109.5 Recoverable amount (107.0) ––––– Impairment 2.5 –––––

(Part b: 9 marks max)

(c) Financial statements are important to a range of user groups, such as shareholders, banks, employees and suppliers. (1 mark)

Prudence is important because over-stated assets or under-stated liabilities could mislead potential or current investors. (1 mark)

However, excessive cautiousness may means that the financial performance and position of an entity is not faithfully represented. (1 mark)

A faithful representation is often presumed to have been provided if accounting standards have been complied with. (1 mark)

Whilst financial statements should exhibit prudence, they must be prepared in accordance with relevant standards. It would appear that the directors are not calculating the provision in line with the requirements of IAS 37. (1 mark)

This may mean that profit is understated in the current period and then over-stated in subsequent periods. (1 mark)

According to IAS 37, provisions should be measured at the best estimate of the expenditure needed to settle the obligation at the end of the reporting period. (1 mark)


10 KAPLAN PUBLISHING

Estimates are, by their very nature, judgemental. Estimates must be supplemented by experience of similar transactions or, where relevant, independent experts. (1 mark)

Professional ethics is a vital part of the accountancy profession and ACCA members are bound by its Code of Ethics and Conduct. This sets out the importance of the fundamental principles of confidentiality, objectivity, professional behaviour, integrity, and professional competence and due care. (1 mark)

Integrity is defined as being honest and straight-forward. Over-estimating a provision in order to shift profits from one period to another demonstrates a lack of integrity. (1 mark)

If the provision is being over-stated in order to achieve bonus targets in the next financial period, then this demonstrates a lack of objectivity. (1 mark)

If the directors are unaware of the requirements of IAS 37, then they may not be sufficiently competent. (1 mark)

(Part c: 6 marks max)

ACCA Marking scheme

Marks (a) Group SFP 35 (b) Measurement period 9 (c) Ethical issues 6 ––– Total 50 –––

2 MIRROR

Key answer tips

This question tests a range of accounting standards. Part (a) covers revenue, a very popular topic in the P2 exam. When dealing with a revenue scenario, always establish whether the entity is selling a good or selling a service because the recognition criteria are different.

Part (b) is concerned with rules around transactions in a foreign currency. Inventory is not a monetary asset and therefore its cost is not retranslated at the reporting date. However, NRV must be translated at the date it was determined.

Part (c) tests deferred tax and losses. Do not forget that deferred tax assets must still meet the definition of an ‘asset’. If no benefits are expected, then a deferred tax asset cannot be recognised.

Part (d) is about leases and related party transactions. Look out for key indications of related party relationships – such as two companies being under the common control of an individual or another company.

Make sure that you get the 2 presentation marks available by answering all parts of the question in a clear and understandable manner.


KAPLAN PUBLISHING 11

(a) Revenue should be recognised from the rendering of a service when:

• The amount of revenue can be measured reliably

• It is probable that economic benefits associated with the transaction will flow to the entity

• The stage of completion can be measured reliably

• The costs incurred and to complete the transaction can be measured reliably. (2 marks)

(Knowledge of IAS 18: 2 marks max)

Total contract revenue of $1m has been received meaning that there are no doubts about its measurement or the likelihood of receipt. The entity can also measure the costs reliably. Stage of completion could be measured, based on either the number issues provided or the costs incurred. Therefore, the entity can recognise revenue from this transaction. (1 mark)

The contract is for 12 issues, and 3 issues have been printed. The contract could be said to be 25% complete (3 issues out of 12). On this basis, revenue of $250,000 ($1m × 25%) should be recognised). (1 mark)

This approach is arguably too simplistic particularly as the magazine will increase in popularity over the year. More work will therefore be involved in printing the latter issues. It may therefore be more accurate to estimate the stage of completion on a basis of the proportion of total contract costs incurred. (1 mark)

Mirror has incurred $100,000 out of total expected costs of $600,000. Therefore, on this basis, the stage of completion would be 1/6 ($100,000/$600,000) and revenue of $166,667 ($1m × 1/6) should be recognised. (1 mark)

There are some problems with this method. Most notably, it is likely that large up-front costs will have been incurred. Therefore, this method of estimating the stage of completion may still over-estimate the proportion of the printing service performed. (1 mark)

The most accurate method of measuring the stage of completion is likely to be based on the total number of magazines printed to-date as a proportion of the total estimated number of magazines that will be printed. However, there is insufficient information presented to calculate the stage of completion under this method. (1 mark)

(Application of IAS 18: 4 marks max)

(Part a: 6 marks max)

(b) Inventory is initially recorded at cost. At the reporting date, inventory must be valued at the lower of cost and net realisable value (NRV). (1 mark)

Per IAS 21, a foreign currency transaction should be initially recorded by applying the spot rate on the date of the transaction. (1 mark)

As a non-monetary asset, the cost of the inventory is not re-translated. (1 mark)

Per IAS 21, NRV should be translated at the exchange rate ruling on the date when it was determined. (1 mark)

(Knowledge of IAS 2 and IAS 21: 2 marks max)



The inventory should initially be recorded at $95,238 (CU200,000/2.1). (1 mark)

The NRV of the inventory is $83,333 (CU250,000/3.0). (1 mark)

The inventory must therefore be written down from its cost of $95,238 to its NRV of $83,333. This will give rise to an expense of $11,905 ($95,238 – $83,333) in the statement of profit or loss. (1 mark)

(Application of IAS 2 and IAS 21: 3 marks max)


(c) Tax adjusted losses have no carrying value in the financial statements. However, they will reduce taxable profits in the future and therefore they have a tax base. This temporary difference gives rise to a deferred tax asset. (1 mark)

A deferred tax asset can be recognised if it is deemed probable that future taxable profits will be available against which the unused losses can be utilised. (1 mark)

Deferred tax should be calculated using the tax rate that is expected to be in force when the temporary difference reverses based on rates enacted or substantively enacted at the reporting date. (1 mark)


The tax losses have arisen from an exceptional event, suggesting that the entity will return to profitability. Forecasts produced by the accountant confirm this. (1 mark)

Mirror is only able to reliably forecast future profits of $2.5m, therefore limiting the deferred tax asset that can be recognised. (1 mark)

The deferred tax asset that can be recognised is $700,000 ($2.5m × 28%). There will be a corresponding reduction to the tax expense in the statement of profit or loss. (1 mark)



(d) Per 1AS 17, a finance lease is a lease where the risks and rewards of ownership transfer. (1 mark)

(IAS 17 knowledge: 1 mark max)

This lease is only for a fraction of the asset’s remaining useful life and the lease payments are insignificant. It is therefore an operating lease. (1 mark)

Mirror should recognise lease income on a straight line basis over the lease term. Therefore, $5,000 ($10,000 × 6/12) should be recognised in the current year’s statement of profit or loss, as well as corresponding accrued income on the SFP. (1 mark)

(IAS 17 application: 2 marks max)

Per IAS 24, a related party transaction is a transfer of resources, services or obligations between a reporting entity and a related party. (1 mark)

An entity is related to the reporting entity if they are under joint control. (1 mark)

Per IAS 24, an entity must disclose if it has entered into any transactions with a related party. (1 mark)

(IAS 24 knowledge 2 marks max)



Mirror and Frame are under joint control of Joanne Smith and are therefore related parties. Disclosure is therefore required of all transactions between Mirror and Frame during the financial period. (1 mark)

This means that Mirror must disclose details of the leasing transaction and the income of $5,000 from Frame during the year. (1 mark)

Disclosures that related party transactions were made on terms equivalent to an arm’s length transaction can only be made if it can be substantiated. The lease rentals are only 10% of normal market rate and therefore this disclosure cannot be made. (1 mark)


Note: Some students may discuss issues of impairment. Whilst not expected, credit should be awarded for this as follows:

The fact that the warehouse was disused, and the low level of rental income earned by Frame, could be seen as indicators that the warehouse is impaired. (1 mark)

Frame should carry out an impairment review by comparing the carrying value of the warehouse to its recoverable amount. (1 mark)

(Possible IAS 36 issues: 2 marks max)

(Part d: 7 marks max)

ACCA Marking scheme

Marks (a) Revenue 6 (b) Overseas issues 5 (c) Deferred tax 5 (d) Leases/related parties 7 Professional marks 2 ––– Total 25 –––

3 STRAW

Key answer tips

This question requires a good knowledge of financial instruments. Part (a) covers the measurement of financial assets. Part (b) is concerned with rules around impairment. Part (c) tests rules around de-recognition. Part (d) tests hedge accounting.

Students tend to struggle with financial instruments. However, this is a core P2 topic and therefore it important to spend sufficient time obtaining a thorough understanding of this area of the syllabus.

Remember that you can score well in this question without reaching the correct conclusion. Make sure that you state the relevant criteria from the standard for some easy marks. You should then attempt to apply these rules to the scenario. You will find this tricky at first but you will improve with practice.

If you answer each part of the question and write clearly and concisely then you should obtain the 2 marks available for presentation. Do not throw away these easy marks.



(a) A debt instrument can be held at amortised cost if two tests are passed: the business model test and the contractual cash flow characteristics test. (1 mark)

The business model test is passed if the entity intends to hold the financial asset to collect contractual cash flows, rather than selling it to realise fair value changes. (1 mark)

The contractual cash flow characteristics test is passed if the contractual terms of the asset give rise to cash flows that are solely payments of principal and interest based upon the principal amount outstanding. (1 mark)

If these tests are failed, a debt instrument would normally be held at fair value through profit or loss. (1 mark)

(Knowledge of IFRS 9: 3 marks max)

Straw’s objective is to hold the financial assets and collect the contractual cash flows. Making some sales when cash flow deteriorates does not contradict that objective. (1 mark)

A variable interest rate would generally still give rise to interest receipts based on the amount of capital outstanding. (1 mark)

There may be an exception, if the cap is so low that is does not provide adequate compensation for the time value of money or the credit risk associated with the instrument. (1 mark)

In the absence of further information, the business model test and the contractual cash flow characteristics test are both passed and therefore the asset can be measured at amortised cost. (1 mark)

(Application of IFRS 9: 3 marks max)


(b) Under IAS 39, an entity should assess at the end of each reporting period if there is objective evidence that a financial asset has been impaired. (1 mark)

Objective evidence may include the following

• Significant financial difficulties of the issuer

• A breach of contract

• Granting concessions to the borrower

• It becoming probable that the borrower will enter bankruptcy

• The disappearance of an active market for the financial asset (1 mark per example: 2 marks max)

According to IAS 39, losses expected as a result of future events, no matter how likely, must not be recognised. (1 mark)


No objective evidence exists that this particular supplier is experiencing financial difficulties, and no actual default of payments has occurred. (1 mark)

No impairment loss should be accounted for. The asset should be recognised at its fair value of $1 million. (1 mark)





(c) An entity has transferred a financial asset if it has transferred the contractual rights to receive the cash flows of the asset. (1 mark)

If an entity has transferred an asset, it must evaluate the extent to which it has retained the significant risks and rewards of ownership. (1 mark)

If the entity transfers substantially all the risks and rewards of ownership of the financial asset, the entity must derecognise the financial asset. (1 mark)

Gains and losses on the disposal of a financial asset are recognised in the statement of profit or loss. (1 mark)

(IFRS 9 knowledge: 3 marks max)

Straw does not benefit from future share price increases meaning that the rewards of ownership have been transferred. (1 mark)

Straw is under no obligation to buy back the shares and is therefore protected from future share price declines. (1 mark)

If Straw does repurchase the shares, this will be at fair value rather than a pre-fixed price and therefore they do not retain the risks and rewards related to price fluctuations. (1 mark)

The risks and rewards of ownership have been transferred and the asset should be de-recognised. (1 mark)

A profit of $1m ($5m – $4m) should be recognised in profit or loss. (1 mark)

(IFRS 9 application: 3 marks max)

(IFRS 9: 6 marks max)

(d) According to IAS 39, if a cash flow hedge meets all required conditions then the portion of the gain or loss on the instrument that is determined to be an effective hedge shall be recognised in other comprehensive income and the ineffective portion should be recognised in profit or loss. (1 mark)

Assuming that all hedging documentation is correct, effectiveness must be assessed, at a minimum, at the time an entity prepares its annual financial statements. In order to use hedge accounting, the hedge must be determined to have been highly effective throughout the financial reporting period. (1 mark)

A cash flow hedge is deemed to be highly effective if the movement in the cash flows attributable to the hedged risk is within 80 – 125% of the movement in the fair value of the hedging instrument. (1 mark)

(IAS 39 knowledge: 3 marks max)

Assuming that there was no purchase price for the forward contract, it is initially recognised at $nil. (1 mark)

The movement in the cash flows attributable to the hedged risk is only 70% ($70,000/$100,000) of the movement in the fair value of hedging instrument (the forward). (1 mark)

The hedge is not highly effective and therefore hedge accounting is not permitted. (1 mark)

The derivative will be shown as a financial liability with a value of $100,000. The full loss on revaluation to fair value must be charged to profit or loss. (1 mark)


(Part d: 6 marks max)



ACCA Marking scheme Marks (a) Measurement 6 (b) Impairment 5 (c) De-recognition 6 (d) Hedge accounting 6 Professional marks 2 ––– Total 25 –––

4 WRAP

Key answer tips

Impairments are a very timely issue. Make sure that you know the criteria for carrying out impairment reviews on both financial (IAS 39) and non-financial (IAS 36) assets.

If you are asked about earnings management, try to think about all the judgements used when accounting for the transaction that could be easily manipulated. By over-stating an asset’s recoverable amount, management would be able to reduce impairment losses and maximise current year profits.

Part (c) does not require you to have a detailed knowledge of the disclosure requirements of IAS 36. Pretend that you are a shareholder of Wrap: what useful information about the impairment review is missing?

(a) An asset is impaired if its carrying value exceeds its recoverable amount. Recoverable amount is the higher of the fair value less costs to sell and the value in use. (1 mark)

An entity should carry out an impairment review on an asset if there is an indication that it may be impaired. (1 mark)

Therefore, if any event occurs that indicates a decline in either the asset’s fair value of its value in use, an impairment review should take place. (1 mark)

Such indications would include:

• A decline in an asset’s market value that is greater than would be expected as a result of normal use or the passage of time

• Significant changes in the technological, market, economic or legal environment in which the entity operates

• Increases in market interest rates

• The carrying amount of the net assets of an entity exceeds market capitalisation

• Physical damage or obsolescence of an asset

• An asset becoming idle, or a reduction in the estimate of its total useful economic life

• Poor performance of an asset. (1 mark per indication)



Some assets must be tested for impairment annually, irrespective of whether there are any indications of impairment. These are:

• Intangible assets with an indefinite useful life

• Intangible assets not yet ready for use

• Goodwill acquired in a business combination. (1 mark per asset)


(b) An impairment review involves comparing the carrying value of an asset to its recoverable amount. The recoverable amount is the higher of the value-in-use and the fair value less costs to sell. (1 mark if not stated in part a)

By over-stating the recoverable amount of an asset, impairment losses will be avoided or reduced. (1 mark)

Calculating the recoverable amount of an asset involves a large number of judgements and these can easily be manipulated. (1 mark)

Value in use is the present value of the future cash flows expected to be derived from an asset. This calculation involves a number of judgements, such as:

• The value of the cash inflows and outflows derived from an asset

• The timing of cash inflows and outflows derived from the asset

• The number of years for which cash flows are expected from the asset

• IAS 36 says that cash flow forecasts extending more than five years into the future are not reliable. Therefore cash flows relating to the asset that take place in more than five years should be extrapolated using a steady or declining growth rate.

• The discount rate to be used. (1 mark each)

Fair value less costs to sell also involves a number of judgements:

• Costs to sell are an estimate and will only be confirmed when/if the sale occurs • Fair value is highly judgemental, unless there is a binding sales agreement or

an active market • If fair value is calculated using level 3 inputs (per IFRS 13), then these will be

based on internal estimations that can be more easily manipulated. A discount rate will also need to be used, which involves a large degree of judgement.

(1 mark each)

Many assets do not generate cash inflows or outflows independently. Therefore, they must be assessed for impairment as part of a cash generating unit (the smallest identifiable group of assets that generates independent cash flows). (1 mark)

The determination of a CGU is judgemental. By over-aggregating assets into a CGU, impairments are less likely because loss-making business segments may be absorbed into other more profitable segments. (1 mark)

Goodwill arising on a business combination must be allocated to CGUs on a reasonable and consistent basis. Allocating goodwill to well-performing CGUs may therefore reduce the chances of impairment. (1 mark)




(c) Impairment reviews involve judgement and therefore the users of the financial statements must be provided with enough information to assess whether the assumptions used were reliable. (1 mark)

The disclosure note is lacking key information about many of the judgements used.

Cash-generating unit

No information has been provided about how the cash generating unit was determined. (1 mark)

No information has been provided about how goodwill was allocated to the cash generating unit. (1 mark)

Value-in-use

The disclosure note does not describe key assumptions factored into the cash flow forecast and therefore the users cannot assess its reliability. (1 mark)

Important assumptions might include estimates of future margins or, if relevant, foreign currency movements. (1 mark)

The disclosure does not say whether the forecasts represent past experience or future expectations. It also does not state whether there is any consistency with external sources of information. (1 mark)

The disclosure note does not say how many years the cash flow forecasts covered. (1 mark)

This is important because forecasts that cover a longer period are less likely to be reliable. (1 mark)

The note does not say how many years worth of cash flows have been extrapolated beyond the end of the budgeted period. (1 mark)

The longer this period, the less likely it is that the growth rate will be maintained, due to obsolescence issues or the entrance of new competitors to the market. (1 mark)

The disclosure note does not justify the rate of growth used to extrapolate cash flows beyond the period covered by the cash flow forecasts. (1 mark)

This is important because the growth rate used seems unrealistically high, particularly when compared to the current economic climate and the sluggish performance of the industry within which Wrap operates. (1 mark)

The disclosure does not state whether the growth rate used is specific to Unit D. Growth could therefore be over or under-stated. (1 mark)

Wrap have disclosed an average discount rate. They should instead disclose the specific rate used to discount the cash flows of Unit D so that users can assess whether it appears reasonable. (1 mark)

The discount rate used should reflect the time value of money and the risks specific to the CGU for which future cash flow estimates have not been adjusted. (1 mark)



Sensitivity

The market capitalisation of Wrap is below its net asset value, suggesting that the market is expecting impairment in value. (1 mark)

This would contradict the disclosure, which says that a ‘reasonably possible change’ would not cause impairment. (1 mark)

A sensitivity analysis would therefore be of use to the users so that they assess the likelihood and impact of potential future impairments. (1 mark)


ACCA Marking scheme

Marks (a) Impairment reviews 7 (b) Earnings management 8 (c) Impairment disclosure 8 Professional marks 2 ––– Total 25 –––

acca p2 int revision mock - answers j14

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