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ACCA

Paper P2 (INT)

Corporate Reporting

June 2011

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.

PAPER P2 ( INT ) : CORPORATE REPO RTIN G

2 KAPLAN PU BL ISHING

© Kaplan Financial Limited, 2011

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REVIS ION MOCK : QU EST IO N S

KAPLAN PU BL ISHING 3

ANSWER 1 – LAHORE GROUP

(a) Consolidated statement of financial position at 31 May 2011

$000 $000 Marks Non-current assets Tangible assets (117,250 + 55,125 + 40,000 + 3,000 – 150(FVA) 215,225 2 Investments (173 + 15 – 142 – 12.5, – 31 + 3.5(FV re fin assets) 6,000 1 Intangible assets - Goodwill (84,000 + 22,625)(W3) 106,625 4 –––––––

327,850 Current assets Inventories (65,342 + 51,136+ 31,000 – 650 (W7)) 146,828 2 Receivables (33,297 + 39,288+ 23,000 – 20,000) (W8) 75,585 1 Cash and cash equivalents (10,361 + 5,576 + 2,000 + 1,000(W8)) 18,937 1 ––––––

241,350 –––––––

569,200 –––––––

Equity attributable to equity holders of the parent Share capital (W10 ) (120,000 – 20,000) 100,000 1 Other Components of Equity (W11) (5,000) 1 Retained earnings (W5) 103,448 5 –––––––

198,448 Non-controlling interest (W4) 102,177 5 –––––––

Total equity of the group 300,625 Non-current liabilities Long-term loans (100,000 + 26,000) + 20,000 (W10) + 3,000 (W11) 149,000 2 Deferred tax (20% × 3,500) 700 1 Current liabilities Trade payables (25,100+ 18,100+ 13,000 – 19,000 (W8) – 2,000 (W9))

35,200 2

Taxation (9,150 + 5,025 + 3,000) 17,175 1 Bank overdraft (45,500 + 7,000 + 14,000) 66,500 1 ––––––

118,875 ––––––– –––

569,200 30 –––––––

Net assets marks per workings 5

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35

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Workings

(W1) Group structure

Lahore

Kunming

60,000 100,000 60% 1/2/11

6,600 22,000 30% 1/2/11

Barcelona

5,500 22,000 25% 1/2/11

Lahore's effective group interest in Kunming's profits Direct 30% Indirect (60% × 25%) 15% 45% sub from 1.2.11 Kunming: effective NCI (bal fig) 55%

(W2) Net assets workings

Barcelona At acquisition At rep date Marks $000 $000 Equity capital 100,000 100,000 Retained earnings 23,000 36,000 FVA – property 3,000 3,000 0.5 FVA – Dep’n (1/20) (150) 0.5 Financial assets at FV (6.0 – 2.5) 3,500 1 Deferred tax (20% × 3,500) (700) 1 ––––––– ––––––– 126,000 141,650 ––––––– –––––––

The post acquisition profit of Barcelona is ($141,650 – $126,000) = $15,650

Kunming At acquisition At rep date Marks $000 $000 Equity capital 22,000 22,000 Retained earnings (W6) 17,000 18,000 1 Inventory URP (W7) (650) 1 –––––– –––––– 39,000 39,350 –––––– ––––––

The post acquisition profit of Kunming is ($39,350 – $39,000) = $350



(W3) Goodwill

Barcelona $000 Marks Cost of investment 142,000 0.5 FV of NCI at acquisition 78,000 0.5 –––––– 220,000 Less: FV of NA at acquisition (W2) (126,000) –––––– Goodwill at acquisition 94,000 Less impairment loss (10,000) 0.5 –––––– To the S of FP 84,000 ––––––

Kunming (part of Lahore group from 01/02/10) $000 Marks Indirect investment incurred by Barcelona 12,500 Less the indirect holding adjustment (40% × 12,500) to NCI (5,000) 1 Cost incurred directly by Lahore 31,000 0.5 FV of NCI (direct and indirect) 31,125 0.5 –––––– 69,625 Less: FV of NA at acquisition (W2) (39,000) –––––– Goodwill at acquisition 30,625 Less impairment loss (8,000) 0.5 –––––– To the S of FP 22,625 ––––––

(W4) Non-controlling interest

$000 Marks Barcelona: FV of NCI at acquisition 78,000 0.5 Plus NCI % of the post acq profits 40% × (15,650) 6,260 1 less NCI % of the impairment loss (40% × 10,000) (4,000) 0.5 Kunming: FV of NCI at acquisition 31,125 0.5 Plus NCI % of the post acq profits 55% × (39,350 – 39,000) 192 1 less NCI % of the impairment loss (55% × 8,000) (4,400) 0.5 Less NCI % indirect holding adjustment regarding the cost of investment by Barcelona in Kunming (40% × 12,500)

(5,000) 1

–––––– ––– 102,177 5 ––––––



(W5) Retained earnings

$000 Marks Lahore 99,500 0.5 Plus correction pension (W11) 2,000 1 Disallowed provision added back (W9) 2,000 1 Barcelona (60% × 15,650) (W2) 9,390 1 Less impairment loss (60% × 10,000) (6,000) Kunming (45% × 350) (W2) 158 1 Less impairment loss (45% × 8,000) (3,600) 0.5 –––––– ----- 103,448 5 ––––––

(W6) Retained earnings of Kunming at 1 February 2011

$000 Retained earnings at 1 Feb 2011 (balance) 17,000 Post acquisition profit (4/12 × 3,000) 1,000 –––––– Retained earnings at 31 May 2011 18,000 ––––––

(W7) Unrealised profit in inventory

Kunming is the seller and is a subsidiary so the adjustment is made against Kunming's post acquisition profits in w2 at year end to ensure that the adjustment will impact the NCI.

$000 $3,900 × 20/120 = 650

An alternative presentation that achieves the same overall result would be instead to exclude this amount from the net assets working of Kunming and split the purp between the retained earnings and the NCI on a 45% & 55% basis and include those amounts in (W5) and (W4) respectively.

(W8) Intercompany balances

$000 Dr Trade payables (11,000 + 8,000) 19,000 Cr Trade receivables (11,000 + 9,000) 20,000 Cr Bank (balance) 1,000

(W9) Disallowed provision

There is no indication that there is either a legal or constructive obligation for Lahore to undertake the rationalisation of the group. Whilst this may be a business or commercial priority, there is no legal or constructive obligation at the reporting date to incur these costs. Consequently, IAS 37 forbids such a provision. Trade payables and retained earnings are therefore adjusted by $2 million.

(W10) Redeemable shares

The shares held by the directors are redeemable shares. As such they do not meet the criteria of being classified as equity. Redeemable shares should be classifies as debt. Equity share capital and Non-current liabilities are therefore adjusted by $20 million.



(W11) Defined Benefit Pension scheme.

The $11 million paid is not the expense rather it creates a pension fund asset, The expense to be charged to profit – and hence retained earnings – is the current service cost of $9 million, thus a net adjustment of $2 million being added back to retained earnings is appropriate. The deficit under the pension scheme represents a non current liability that had not being previously recognised. There is no actuarial gain or loss in respect of the pension fund assets but as the scheme has a deficit of $3 million – when one expected a surplus of $2 million ($11 million less $9 million) then a actuarial loss has arisen of $ 5 million. This creates the negative other components of equity.

Dr Other components of equity – actuarial loss $5 million

Cr Retained earnings – correction $2 million

Cr Noncurrent liabilities – deficit $3 million

(b) Whilst each of the three transactions may be considered to be not material, based upon the limited information available, all three transactions have an impact upon the reported performance and position of the group at 31 May 2011.

IAS 21 requires that unsettled monetary items are retranslated at the reporting date using the exchange rate at that date. This will result in an exchange gain or loss on retranslations which is taken to income for the year ended 31 May 2011 as follows:

At initial recognition of the Euro-denominated payable, it would be stated at (Euro 3,000 / 1.6) $1,875. At the reporting date, using the exchange rate at that date, the payable would be restated to (Euro 3,000 / 1.5) $2,000. There is an exchange loss of $125 as the dollar value of the payable is greater than initially recorded and this loss should be taken to income for the year.

The subsequent settlement of the liability after the reporting date is not relevant for the financial statements for the year ended 31 May 2011; it is a non-adjusting event per IAS 10. The dollar cost of (Euro 3,000/1.7) of $1,765, giving rise to an exchange gain of $235 on settlement is accounted for in the financial statements to 31 May 2012.

IAS 23 requires that borrowing costs are capitalised if they are incurred during the construction or purchase of a non-current asset. If they have been written off as finance costs during the year, the consequence is that the profit or loss for the year is understated by $10,000, and that the carrying value of non-current assets is understated by the same amount.

There is also likely to be incorrect analysis within the statement of cash flows as the finance costs paid should be classified as interest paid, rather than as additions to non-current assets.

The treatment of lease payments inappropriately gives rise to several misstatements as follows:

• Operating lease rental charges are overstated, leading to a reduction in the reported profit of the year. Finance lease assets have been omitted from the statement of financial position, which will understate the carrying value of assets. There will also be omission of depreciation charges on the finance lease assets which should be charged to income for the year. Items in the statement of cash flows are likely to be misstated as the depreciated charge added back within operating activates will be wrong.



• Finance lease obligations will also be omitted from the statement of financial position (off balance sheet finance) so gearing will be understated and capital employed incorrect. Together with omission of finance costs in the income statement on the omitted liability. Cash flows in the statement of cash flows will also be incorrect as finance lease payments would not be identified as financing cash outflows.

• To some extent, these errors are likely to be compensating, with omission of depreciation and finance charges going some way to match the incorrect operating lease charges in the income statement. However, there are several errors of principle which should not have happened.

(c) Consequently, there are errors in the way that financial and operating performance, together with financial position has been reported. This results in ethical and professional considerations as follows:

• The competence of those involved in the preparation of the financial statements can be queried. There should be individuals who have sufficient technical knowledge (i.e. knowledge of financial reporting standards and accounting treatments) to ensure that financial statements are properly prepared. Competence may be obtained from a combination of exam-based qualifications, in-house training, and Continuing Professional Development.

• If responsible persons have the underlying competence, they should apply this competence to ensure that they discharge their responsibilities with appropriate due care and skill. This will ensure that they do not discharge their responsibilities in a negligent manner.

• There is also the possibility that those responsible for the preparation of financial statements have chosen to deliberately misrepresent the financial performance and position of the entity. For example, deliberately treating lease payments as operating lease payments would result in omission of liabilities from the statement of financial position. In this situation, the professional integrity of those responsible could be questioned.

• Finally, if any of these ethical principles have not been upheld, then the professional behaviour of those responsible can be questioned. Professional accountants would be expected to know and understand the appropriate accounting treatment for such items. Even if they were unsure, they should still have sufficient professional responsibility to seek appropriate advice to ensure that financial performance and position was reported fairly. This is important as third parties are likely to rely upon information they produce, whether it be management for decision-making and control purposes, or outside third parties for investment-based decisions.

ACCA marking scheme

Marks

(a) Group statement of financial position per marking scheme 35

(b) Discussion re accounting issues 7

(c) Professional and ethical issues 6

Professional marks 2

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Total 50

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ANSWER 2 – AZTEC

(a) (i) Journal entries to close books of Aztec

Dr Cr $ $ Capital reduction and reorganisation a/c 1,167,000 Leasehold premises 397,000 Vehicles and equipment 105,000 Machinery 250,000 Inventory 295,000 Receivables 120,000 Transferring assets

Finance lease obligation 25,000 Payables 288,000 Wages, etc 80,000 Finance lease obligation 20,000 Bank overdraft 112,000 To capital reduction and reorganisation a/c 525,000 Transferring liabilities

Aztec (Europe) 540,000 To capital reduction and reorganisation a/c 540,000 Liability for the agreed purchase consideration

Shares in Aztec (Europe) 270,000 13% Loan notes in Aztec (Europe) 270,000 To Aztec (Europe) 540,000 Settlement of the agreed purchase consideration

Equity shareholders 60,000 7% Debentures 160,000 11% Debentures 320,000 To shares in Aztec (Europe) 270,000 13% Loan notes in Aztec (Europe) 270,000 Distribution of the purchase consideration

Note to students and tutors:

The answer to this question is considerably longer and more detailed than could reasonably be produced under examination conditions. However, it is a new examination topic in the 2011 syllabus and must be regarded as more likely to be examined than other topics in the syllabus.

This question and comprehensive answer is a good learning tool. Even within this, it is possible to earn marks with the application of good exam technique; for example, most of the opening statement of financial position for Aztec (Europe) can be compiled relatively quickly and easily. The narrative element reflects the expectation that at Professional Level, application and understanding is examined.



Dr Cr $ $ Capital reduction and reorganisation a/c 102,000 Equity shareholders 42,000 Preference shareholders 25,000 11% Loan note holders 85,000

Closing the share and loan accounts

Capital Reorganisation and Reconstruction Account

$ $ Assets transferred in 1,167,000 Liabilities transferred in 525,000 Retained earnings deficit 513,000 7% debentures 135,000 Consideration issued to: 11% Debentures 405,000 7% Deb holders 160,000 Equity shares 675,000 11% Deb holders 320,000 Total consideration from sale 540,000 Equity holders 60,000

–––––––– –––––––– 2,280.000 2,280,000 –––––––– ––––––––

Consideration paid to providers of capital:

Aztec (Europe) 13%

debenture Equity shares @

$0.10 Total

Aztec plc $ $ $ $ Equity shares @ $1 675,000 60,000 60,000 7% Debenture 135,000 70,000 90,000 160,000 11% Debenture 405,000 200,000 120,000 320,000

(ii) For information only – Journal entries to open books of Aztec (Europe)

Dr Cr $ $ Leasehold premises 360,000 Vehicles and equipment 85,000 Machinery 225,000 Inventory 285,000 Receivables 110,000 Hire-purchase liability 25,000 Payables 288,000 Wages and related taxation 80,000 Hire-purchase liability 20,000 Bank overdraft 112,000 Aztec 580,000 Goodwill 40,000 Introducing assets and liabilities

Aztec 580,000 Equity shares 270,000 13% Loan notes 270,000 Cost of reorganisation 40,000 Settlement of the purchase consideration Costs of reorganisation 40,000 Bank 40,000 Payment of reorganisation costs



Statement of financial position of Aztec (Europe) as at 31 December 20X3

(following the transfer of assets and liabilities)

$ $ Non-current assets Intangible assets: goodwill 40,000 Tangible assets: Leasehold premises 360,000 Vehicles and equipment 85,000 Machinery 225,000 ––––––––– 710,000

Current assets: Inventory 285,000 Receivables 110,000 –––––––––

395,000 –––––––––

1,105,000 –––––––––

$ $ Equity shares of 10c each 270,000 Non-current liabilities 13% Loan notes 270,000 Hire-purchase liability 25,000 –––––––––

295,000 Current liabilities Payables 288,000 Wages and related taxation 80,000 Hire-purchase liability 20,000 Bank overdraft 152,000 –––––––––

540,000 –––––––––

1,105,000 –––––––––

(b) MEMORANDUM

To: Finance Director

From: Advisor

Re: Draft proposals for scheme of capital reduction and reorganisation of Aztec as at 31 December 2003

Thank you for a copy of the draft scheme.

In our view, one of the key considerations for the court and the various parties whose rights are being varied is whether the scheme is fair to all parties.

We have therefore reviewed how the scheme will affect the rights of the equity shareholders, and the two classes of debenture holder with regard to their entitlement to capital repayment and to interest/dividends.



Entitlement to capital repayment

The rights of the shareholders and loan note holders assuming different values are as follows:

Existing Forced Draft book Fair sale proposed values values values scheme Note 1 Note 2 Note 3 Note 4

$ $ $ $

Equity shareholders 102,000 − − 60,000 7% Debenture holders 135,000 135,000 − 160,000 11% Debenture holders 405,000 405,000 280,000 320,000

Note 1: Equity shareholders have an asset backing of 15c per $1 share using book values as shown in the statement of financial position.

Note 2: Equity shareholders have a nil asset backing if fair values are substituted for the book values shown in the statement of financial position.

Note 3: Values under forced sale are calculated as follows:

$ $

Machinery 122,000 Less: Bank charge (112,000) _______

10,000 Vehicles and equipment 35,000 Less: Hire-purchase creditors (45,000) ______ (10,000)

_______

Nil Premises 100,000 Inventory 150,000 Receivables 100,000 _______

360,000 Less: Liquidation costs (55,000) _______

305,000 Less: Preferential creditors (wages and related taxation) (80,000) _______

Available for floating charge 225,000 _______

Tutorial note

It would be acceptable to use $225,000 as the figure for forced sale values available to the loan note holders.



Note 4: Whilst recognising that it is proposed to offer the 11% debenture holders a 44% shareholding in the new company, it would appear from the above that the loan note holders are not being fairly treated in relation to the shareholders from the capital entitlement viewpoint. This will undoubtedly be raised by the 11% debenture holders and require amendment if it is to obtain the approval of the court.

It is particularly relevant because the 11% debenture holders would, from the figures produced, be in a better position by exercising their right to appoint an administrative receiver.

Income entitlement − 20X3 − 20X6

(see workings below)

Rights Rights in Aztec (Europe) in assuming a pre-tax profit

Aztec plc $70,000 $140,000 $ $ $

Equity shareholders − 5,041 15,153 7% Debenture holders 9,450 16,662 31,828 11% Debenture holders 44,550 36,082 56,304

Workings

Calculating income in Aztec plc at two levels of profit without reorganisation and capital reduction:

$ $

Profit before tax 70,000 140,000 Less: 11% debenture interest (44,550) (44,550) Less: 7% debenture interest (9,450) (9,450) ______ _______

16,000 86,000 Tax at 35% (5,600) (30,100) ______ ______

Profit after tax 10,400 55,900 ______ ______

Years to eliminate debit balance 55 years 10 years

For comparison purposes let us assume that there is a distribution without making good the debit balance:

$ $

Profit after tax (as above) 10,400 55,900

All available for equity shareholders ______ ______

Rights in Aztec plc assuming a pre-tax profit

$70,000 $140,000 $ $

Equity shareholders 10,400 55,900 7% debenture holders 9,450 9,450 11% debenture holders 44,550 44,550



Calculating the income in Aztec (Europe) at two levels of profit: $ $

Profit before tax 70,000 140,000 Less: Loan note interest ($270,000 @ 13%) (35,100) (35,100) ______ _______

34,900 104,900 Tax at 35% (12,215) (36,715) ______ _______

22,685 68,185 ______ _______

Assuming all profit is distributed: Dividend per share $0.84 $2.53 Income for loan note holders: $ $

Loan note interest 26,000 26,000 1,200,000 shares 10,082 30,304

______ ______

36,082 56,304 ______ ______

Income for providers of capital in Aztec plc:

Pre-tax profit of $70,000 Pre-tax profit of $140,000 Loan Int Dividend Total Loan

Int Dividend Total

$ $ $ $ $ $ 7% Debs 9,100 7,562 16,662 9,100 22,728 31,828 11% Debs 26,000 10,082 36,082 26,000 30,304 56,304 Shareholders 5,041 5,041 15,153 15,153

The above indicates that the 11% debenture holders will receive less than their current income entitlement at the $70,000 level of pre-tax profits whereas the 7% debenture holders will receive more income at that level than might be considered equitable.

With regard to the three parties:

The scheme is unfair to the 11% debenture holders in respect of both the capital and income entitlement and should be revised.

The 7% debenture holders have received more than the monetary value of their current interest in Aztec plc, and this may be regarded as an incentive for their continued financial support. That said, it appears unusual that they appear to have benefited from the reconstruction, whereas the 11% debenture holders appear to have lost out and given up their floating charge on the assets of Aztec plc.

The scheme is unfair in that the equity shareholders who would have lost everything in a liquidation are credited with capital of $60,000 to retain a 22% interest in the net assets.



Comments on the statement of financial position of Aztec (Europe)

The statement of financial position shows that there are continuing problems in that the new company has negative net current assets which make the company unattractive to suppliers. In addition there is very high gearing and there have been no proposals for raising further capital with the result that the company will see its overdraft standing at a higher figure than the closing balance in the old company due to reorganisation costs, and no funds to purchase the new warehouse referred to in the question.

ACCA marking scheme Marks

(a) Closing of Aztec and opening of Aztec (Europe) 10

(b) Memorandum to finance director 15

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Total 25

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ANSWER 3 – FINANCIAL INSTRUMENTS

(a) IFRS 9 simplifies the classification and accounting treatment of financial assets in comparison with IAS 39. There are now only three classifications of financial assets, whereas previously there were four. Whilst there is increased emphasis upon fair value accounting, IFRS 9 retains a mixed measurement model, with some financial assets measured at amortised cost, provided certain conditions are complied with.

In due course, the content of IFRS 9 will be updated to deal with liabilities (done in November 2010), impairment and hedging. Unless IFRS 9 has been updated to deal with specific issues, the provisions of IAS 39 continue to apply. IFRS 9 is effective for accounting periods commencing on or after 1 January 2013, although earlier adoption is permitted.

Financial assets that are classified as debt instruments are normally subsequently measured at fair value through profit or loss unless they are designated at the date of initial recognition to be classified in any other way. IFRS9 has an increased emphasis upon fair value accounting as a result. This classification will include any financial assets held for trading purposes and the accounting treatment effectively incorporates an annual impairment review as all changes in fair value are taken to income.

However debt instruments can be subsequently measured at amortised cost. Financial assets can be designated to be measured at amortised cost upon initial recognition. For this to happen, two tests must be passed:

• The business model test – what is the underlying business purpose for having the financial asset? Is it to take advantage of movements in fair value or to collect in the cash flows associated with the asset? In the former case, the test is failed, whereas in the latter case, the test is passed.

• The contractual cash flows characteristics test – do the cash flows associated with the financial asset consist solely of repayments of interest and capital? If the answer is yes, the test is passed; if no, the test is failed.

Where either or both tests are failed, the financial asset must be measured at fair value through profit or loss. This would apply to the holder of convertible debt, as the cashflows are affected by the fact that, upon maturity date, there is a choice to be made between taking cash and converting the convertible debt into equity shares.



Note that, even when both tests have been passed, the financial asset can still be measured at fair value through profit or loss, rather than having it designated to be measured at amortised cost.

Financial assets that are equity instruments are normally subsequently measured at fair value through profit or loss. IFRS9 has an increased emphasis upon fair value accounting.

It is possible that Financial assets that are equity instruments are subsequently measured at fair value through other comprehensive income (FVTOCI).

Financial assets can be designated to be measured at FVTOCI and it can apply only to equity instruments. This may apply to, for example, an equity investment which an entity intends to hold on a continuing basis, rather than to take advantage in changes in fair value. Any increases or decreases in fair value upon remeasurement, including impairment losses, are taken to equity. There is no recycling of amounts previously taken to equity upon disposal. Any impairment losses remain within equity and are not recycled to profit or loss for the year.

Following initial recognition and classification, financial assets should not be reclassified, unless there are exceptional circumstances, such as an entity changing its business model. The standard identifies that such changes are expected to be infrequent.

(b) There are three situations to consider:

• In respect of the sugar beet futures Barking appears to have entered into the derivative as a type of hedge i.e. to minimise the overall risk profile of the company. In other words (as has happened) if the price of the raw material that the company knows that it will have to buy in the future rises it will be covered / compensated by the gain that will occur in respect of the derivative that it has entered into. This type of hedging is known as cash flow hedging as the risk being hedged is a prospective cash flow. In such circumstances it is not possible to have an immediate off set / pairing of a gain and a loss as the future cash has yet to occur. The gain on the derivative acting as a cash flow hedging instrument is therefore recognised in equity i.e. taken to a reserve / other comprehensive income, where in effect it is held pending at some future date the actual cash flow when it can then be recycled out of equity / reserves and taken to be offset in income statement against the cash flow.

• In respect of the forward foreign exchange currency contracts in Dinars the company appears to have entered into the derivative so that it will act like an insurance policy against changes in the value of the asset of receivables. As such this is an example of hedging.

In this case however when retranslated the receivable gives rise to a foreign exchange gain! But as this asset has been hedged with a derivative, the derivative produces the opposite effect i.e. the derivative creates a loss and therefore a liability of $40 million. The liability has been reduced by the cash call of $30 million so at the year end the net liability is $10 million.

This type of hedging is known as a fair value hedge as the risk being hedged is the change in value of a recognised asset or liability. As with all hedging the effect is to reduce the overall risk profile of the company. Assuming that the preconditions of hedge accounting are properly met then the standard applies substance over form and ensures that both the gain and loss are immediately offset against each other in the income statement.



• In respect of the gold options the company has entered into this derivative for speculative purposes. In other words the company is seeking to make a gain on this transaction (though of course it could make a loss as well). It has no existing exposure to the risk of fluctuating gold prices so it cannot be regarded as hedging a risk. This transaction increases the risk profile of the company. It can be argued that it is a simple gamble. In such circumstances the derivative is classified as “Fair value through profit and loss”. The gain of $23 million that has been incurred has to be immediately recognised in the income statement.

Statement of financial position $m

Asset Sugar beet futures 50

Asset Gold options 25

Liability Dinar futures (40 – 30) 10

Statement of comprehensive income $m $m Income statement Operating profit Gain on gold options (25–2) 23 Gain on Dinar Assets 40 Loss on Dinar forward contracts acting as a hedge (40) Nil ––––– Other comprehensive income Gain on sugar beet derivatives acting as a cash flow hedge 50

ACCA marking scheme

Marks

(a) IFRS 9 10

(b) Explanation of derivatives 15

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Total 25

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ANSWER 4 – REVENUE RECOGNITION

(a) IAS 18 defines revenue as the gross inflow of economic benefits in a period arising in the course of the ordinary activities of an entity when those inflows result in an increase in equity, other than increases relating to contributions from equity participants. Revenue does not include amounts collected on behalf of third parties, such as sales taxes.

Revenue should be measured at the fair value of the consideration received or receivable.

Revenue from the sale of goods should be recognised when:

• The entity has transferred to the buyer the significant risks and rewards of ownership of the goods.

• The entity retains neither managerial involvement in, nor effective control over, the goods sold.

• The amount of revenue can be measured reliably.



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

• The costs incurred or to be incurred in respect of the transaction can be measured reliably.

Revenue from the rendering of services should be recognised when:

• The amount of revenue can be measured reliably.

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

• The stage of completion of the transaction at the end of the reporting period can be measured reliably

• The costs incurred or to be incurred in respect of the transaction can be measured reliably.

The main distinction between the two situations is that, with provision of services, the stage of completion can be measured reliably at the reporting date. With the provision of goods, there is the transfer of risks and rewards, together with loss of control over the good sold.

IAS18 Revenue has been criticised on the following grounds:

• The standard is not comprehensive in that it is not the sole source of authority on the timing and recognition of revenue. For example IAS 11 Construction contracts also deals with revenue recognition. Having more than one financial reporting standard dealing with an issue increases the likelihood of inconsistent accounting of similar items.

• The reporting standard is arguably inconsistent with the philosophy of the Framework i.e. it does not take an approach of recognising assets and liabilities; instead it adopts a conceptual approach to determine revenue. This approach is considered rather old fashioned and inconsistent with more recently published financial reporting standards e.g. on financial instruments and provisions. These standards initially regard the accounting problem as “what is the asset or liability that we have here” and as a secondary consideration consider whether there is any gain or loss arising.

• The reporting standard is not consistent with US GAAP. As such there would be benefits if both the US GAAP and IAS GAAP were revised as a joint project to create a greater degree of convergence between the two systems. Users would therefore have a greater ability to make comparisons and increase their understanding.

• The standard is not very detailed; as such it is open to interpretation. Whilst this may provide flexibility to tailor revenue recognition to the specific circumstances of an entity, it also creates a problem in that creative accountants can overstate and anticipate revenue to maximise reported earnings. Creative accounting reduces the reliability and hence usefulness of accounting.

(b) For sale transactions with an option or commitment to repurchase IAS 18 requires an analysis of the transaction to ascertain whether, in substance, the seller has transferred the risks and rewards of ownership to the buyer. If this transfer has not occurred, the transaction is treated as a financing arrangement that does not give rise to revenue.

A further consideration is that the transaction has taken place at something other than fair value. This is normally an indication that the substance of the transaction may be something other than it appears to be at first sight, and therefore merits further evaluation.



In this case the terms of the sale leave Kappa occupying the property, with responsibility for its maintenance. Also, it is highly likely that the option to repurchase will be exercised either on 31 March 2011 or 2012 as the option exercise price is less than fair value. Therefore no revenue should be recognised and the ‘sales proceeds’ would be treated as a borrowing.

This means that the asset would remain an asset of Kappa and be subject to depreciation of $40,000 ($1,200,000 × 1/30). The closing carrying value of the asset would be $1,960,000 ($2,000,000 – $40,000).

The longer Kappa takes to repurchase the property the higher the repurchase price. It can be seen that this repurchase is increasing at 10% per annum compound – e.g. $3,300,000/$3,000,000 = 1.10. Therefore the borrowing is treated as a financial liability measured at amortised cost with an effective annual interest rate of 10%.

The finance cost reported in the income statement for the year ended 31 March 2010 would be $300,000 ($3,000,000 × 10%) and the closing borrowings of $3,300,000 ($3,000,000 + $300,000) would be shown as a liability.

(c) The relevant financial reporting standard dealing with this issue is IAS 18 Revenue. The contract will be started, performed and completed in 2011 and as such all of the revenue will be earned in 2011 and should be recognised in the financial statements for the year ending 31 December 2011.

The receipt of what may be regarded as a deposit or down-payment amounting to $50,000 in November 2010 cannot be regarded as revenue during 2010 as there has been no performance under the contract during 2010, nor has anything been done to recognise that this could be regarded as earned revenue during 2010. Consequently, this receipt creates a liability amounting to $50,000 as at 31 December 2010. Whilst these monies are not refundable as such, they represent part of the payment in exchange for meeting the obligation to perform the contract and as such this deferred income should be shown as a current liability in the statement of financial position at the year ended 31 December 2010. In effect, Weller has not done anything to merit recognition of this sum as revenue during 2010.

There is an argument in favour of full recognition of both the asset and liability at 31 December 2010. This would comprise a contract asset for $150,000 plus cash of $50,000, amounting to $200,000, and matched by a liability for $200,000 for the obligation to perform the agreed work during 2011.

(d) If we now consider the Framework definition of assets and liabilities an alternative answer is possible.

An asset is a resource controlled by an entity as a result of past events. It could therefore be argued that the signing of the contract in November is a relevant past event that creates access to future economic benefits and, as such, at the reporting date of 31 December 2010 an asset should be recognised of $200,000 less the $50,000 that has already been received.

A liability is a present obligation to transfer economics benefits arising from past events. As such again it can be argued that the signing of the contract itself creates a liability, as there will be an obligation to fulfil the terms of the contract.

It should be noted that under this alternative approach no revenue is recognised in the 2010 period as, after all, no performance has been achieved.



ACCA marking scheme Marks

(a) Meaning and measurement 13

(b) Sale and repurchase contract 5

(c) Stage lighting contract 3

(d) Application of Framework 4

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Total 25

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