SUGGESTED ANSWERS AND EXAMINER S COMMENTARY

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1 SUGGESTED ANSWERS AND EXAMINER S COMMENTARY The suggested answers set out below were used to mark this question. Markers were encouraged to use discretion and to award partial marks where a point was either not explained fully or made by implication. In some questions, more marks were available than could be awarded for each requirement. This allowed credit to be given for a variety of valid points or alternative calculations (based on valid assumptions) which were made by candidates. Question 1 Total Marks: 38 Examiner comments This question was generally very well done. Many candidates scored full marks in parts (a), (d) and (g). In part (a) a few candidates identified valid weaknesses in the IFRS definition of income, but did not go on to say how the definition could be improved. Answers to part (c) were disappointing given the basic nature of the topic. A number of candidates did not calculate depreciation and allocate the impairment losses correctly. In part (f) the question asked for an explanation of the accounting treatment, whereas a number of candidates simply did the calculations. Another issue was that the question asked for the accounting treatment for the year ended 30 June, which required a remeasurement of the liability element at 30 June. This was excluded from some candidate answers. Many answers were unnecessarily long. These suggested answers are indicative of the length of answers expected. (a) Income is defined in the Conceptual Framework for Financial Reporting as 'increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contribution from equity participants.' The definition focuses on changes in assets and liabilities rather than defining income directly. While this works well for some areas, it does not work so well for more standard items such as sales revenue, and some consider that it adds an unnecessary complication. For example, in the Revenue Exposure Draft ED/2011/6, revenue is recognised when a performance obligation is satisfied, however those performance obligations are not liabilities recognised in the financial statements. Income encompasses both revenue and gains (Conceptual Framework para 4.29), and revenue includes different types of income such as sales, interest, royalties and dividends. However, in the statement of profit or loss and other comprehensive income, income is divided into two categories. A conceptual foundation for determining which types of income are reported in profit or loss and other comprehensive income categories would improve the classification. For income to be recognised, it must also meet the recognition criteria, ie there must be a probable inflow of economic benefits which can be reliably measured. This means that the income is either recognised or not, rather than taking into account the probability in the amount recognised. Other valid methods of determining income may be appropriate such as expected amount receivable, which is more akin to fair value which is used in some standards. The definition of income does not distinguish between realised and unrealised income. A new definition could allow these to be classified and analysed separately 4½ 4 Copyright ICAEW All rights reserved Page 1 of 12

2 (b) $'000 Purchase of production line equipment 4,200 Sales tax on production line not recoverable IAS 16 para 16(a) 840 Advertising of new products expensed IAS 38 para 69(c) - Training of staff to operate the production line expensed IAS 38 para 69(b) - Cost of materials used to test the production line (20 30) shown net of selling proceeds but capped at zero cost, IAS 16 para 17(c) 0 Cost of reinforcing the factory floor site preparation IAS 16 para 17(b) 78 Dismantling and discarding old factory equipment site preparation IAS 16 para 17(b) 15 Relocation of staff to work on the new production line IAS 16 20(c) - Factory rent (2 months) during period of installation when factory idle not a directly attributable cost as incurred anyway (IAS 16 para 16(b) - 5, (c) Land Buildings Rev'n surplus OCI P/L $'000 $'000 $'000 $'000 $'000 1 January ,000 25,000 Dep'n 2010 (25,000/50) (500) (500) Dep n 2011 (25,000/50) (500) (500) 15,000 24,000 Rev'n (balance) 1,600 2,400 4,000 4, December ,600 26,400 Dep'n 2012 (26,400/48) (550) (550) Transfer (2,400/48) (50) 16,600 25,850 3,950 Rev'n (balance) (2,600) (4,850) (3,950) (3,950) (3,500) 31 December ,000 21, ,000 (500) 2012 (3,950) (4,050) 6 6 (d) The proposed changes to IFRS 9 bring in a new objective-based approach to effectiveness testing. The effectiveness test would be met where: (i) (ii) (iii) there is an economic relationship between the hedged item and the hedging instrument, ie the hedging instrument and the hedged item have values that generally move in the opposite direction because of the same risk, which is the hedged risk the effect of credit risk does not dominate the value changes that result from that economic relationship, and the hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item. A criticism of the IAS 39 approach to hedging is that some instruments that businesses entered into for hedging purposes could not be accounted for as such under the IAS 39 numerical effective test rules. Copyright ICAEW All rights reserved Page 2 of 12

3 A further change is that hedging of investments in equity instruments held at fair value through other comprehensive income is planned, permitting gains and losses on fair value hedges to be recognised in other comprehensive income in such circumstances. Previously, hedge accounting could not be applied to investments in equity instruments held at fair value through other comprehensive income. Disclosures relating to hedging will be required to be shown in a single note (or separate section of the financial statements). The aim of this is that the effects of all of the entity's hedging activities can be seen together in one place. Marking note: other valid comments were also accepted, such as that IFRS 9 permits any financial asset or liability measured at fair value through profit or loss to be designated as a hedging instrument or that only prospective hedge effectiveness testing is required. 7 7 (e) The 'true and fair over-ride' is the name commonly given to a requirement of paragraph 19 of IAS 1 Presentation of Financial Statements which states 'In the extremely rare circumstances in which management concludes that compliance with a requirement in an IFRS would be so misleading that it would conflict with the objective of financial statements set out in the Framework, the entity shall depart from that requirement in the manner set out in paragraph 20 if the relevant regulatory framework requires, or otherwise does not prohibit, such a departure. This requirement, although not intended to be used frequently, is intended to cover the unusual situation where compliance with of IFRSs would not give a true and fair view and allows entities to adapt their accounting policies for such areas as necessary (with full disclosure). Practically such situations may also arise where there is a conflict between the accounting treatment of an area where there is an overlap between standards, or standards where one has been updated, but another not (eg hedging of investments in equity instruments held at fair value through other comprehensive income). It can also arise where IFRSs do not cover a particular area. Where companies applying IFRSs are also required to comply with national company accounting law (or elements of it), and that law requires an accounting treatment not permitted by IFRSs, an issue can also arise. An example of a true and fair over-ride is Go-Ahead Group plc, a public transport operator in the UK. As part of its franchise arrangements as a rail operator, it participates in the UK Railways Pension Scheme. The Group is required to fund the relevant sections of the scheme for the period for which the franchise is held. A true and fair over-ride of IAS 19 is applied because the full liability is recognised in the statement of financial position and this is reduced by a franchise adjustment ; to reflect the Group s constructive rather than legal obligation to fund the scheme only during the period of the franchise, based on the Group s experience that all obligations cease on expiry of the franchise despite legal obligations not being limited. Another example is French bank Société Générale. In its 2007 IFRS financial statements it recognised a 6.4 billion loss actually incurred in 2008 as a result of positions taken by a 'rogue trader' in late 2007 and early 2008 closed out by the bank in The bank over-rode IAS 10 and IAS 37 to recognise the loss and a provision for the loss in its 2007 rather than The company argued that due to its size it should be recognised as early as possible as otherwise the company would have reported a 1.5 billion pre-tax profit in 2007 with a 6.4 billion loss disclosed as an event after the reporting period. The bank felt that doing so would be misleading and conflict with the Conceptual Framework objective of financial statements. However, it has been argued that this was not a valid use of the true and fair over-ride. 7 5 Copyright ICAEW All rights reserved Page 3 of 12

4 (f) This arrangement is a share-based payment with a choice of settlement. As the counterparty (the supplier) has the choice of settlement terms, a compound instrument has been issued and needs to be split into liability and equity components at the grant date. The equity component is calculated as a residual after measuring the liability component at the grant date: $m DR Plant (12 x 90%) 10.8 CR Liability (500,000 x $19.80) 9.9 CR Equity (balancing figure) 0.9 The liability component is subsequently revalued to fair value at the year end: Fair value of liability at year end (500,000 x $20.40) = $10.2m $m DR Profit or loss ( ) 0.3 CR Liability (g) ABC Ltd need not prepare consolidated financial statements because its parent ABC Holdings prepares consolidated IFRS financial statements. ABC France SA is a quoted company and as such is not exempt from preparing consolidated IFRS financial statements. ABC Malta Ltd need not prepare consolidated financial statements because its parent ABC Holdings prepares them. However, ABC Malta must obtain agreement from all of its other shareholders. ABC Americas is a US company and as such must prepare its consolidated financial statements in accordance with US GAAP. It can additionally prepare consolidated IFRS financial statements if it chooses to. ABC Slovakia s.r.o. is owned by the US company. However as its ultimate parent ABC Holdings plc prepares consolidated IFRS financial statements it need not prepare consolidated IFRS financial statements, providing agreement is obtained from its other 40% owners. Maximum for the question Copyright ICAEW All rights reserved Page 4 of 12

5 Question 2 Total Marks: 24 Examiner comments Part (a) asked for an explanation of the financial reporting treatment of the three different forms of financial assistance in the question. However a number of candidates only did the calculations and did not explain the financial reporting treatment. Part (a)(1) stated that the grant was treated as a reduction in the carrying amount of the asset. Nevertheless a number of candidates treated it as deferred income. Part (a)(2) was well answered. In part (a)(3) most candidates correctly calculated the grant element, but some did not apply the unwinding of the discount to it. Part (b) was in general very well answered and there was some excellent analysis of the issues. Suggested solution (a) (1) The grant was recognised in the financial statements on 1 February 2011 as deferred income on that date. It is credited to the asset's value on 1 April 2011, the date of the asset's initial recognition. The carrying amount of the asset is calculated as follows: $ Asset value on initial recognition (1 April 2011) 12,000,000 Grant ($12m x 40%) credited to asset on 1 April 2011 (4,800,000) 7,200,000 Depreciation 2011 ($7.2m/10 years x 9/12) (540,000) 31 December ,660,000 Depreciation 2012 ($7.2m/10 years) (720,000) 5,940,000 Grant repayment ($4.8m x 10%) 480,000 Additional depreciation (480,000 x 1¾/10 years) (84,000) 31 December ,336,000 The double entry is: $ DR Asset (480,000 84,000) 396,000 DR Profit or loss 84,000 CR Grant repayable liability 480, (a) (2) The definition of a government grant is 'assistance by government in the form of transfers of resources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity'. The contribution of $200,000 by the regional government is not dependent on any particular activities of the entity. However SIC-10 Government Assistance No Specific Relation to Operating Activities clarifies that such payments are in the scope of IAS 20 and should be accounted for by applying IAS 20. The $200,000 should be credited directly to profit or loss as it does not compensate specific expenses. 3 3 Copyright ICAEW All rights reserved Page 5 of 12

6 (a) (3) The loan must be recognised initially at its fair value in accordance with IFRS 9 Financial Instruments, discounted at the market rate if interest: $400,000 x = $1,731,791. The remainder is treated as government grant: $m DR Cash 2,000,000 CR Loan 1,731,791 CR Grant (deferred income or reduce cost of roof) 268,209 Interest is applied to the loan up to the 31 December 2012 year end and recognised as a finance cost in profit or loss: ($1,731,791 x 1.05 ½ ) = $1,774,557 - $1,731,791 = $42,767. The grant element is compensating this interest cost and so should be amortised to profit or loss. The most sensible approach would be to recognise the credit on the same basis, ie recognise $42,767 in 2012 rather than on a straight line basis to ensure the interest cost and grant credit compensate each other correctly. 6 6 (b) IAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires government grants to be recognised in profit or loss on a systematic basis over the periods in which the entity recognises as expenses the related costs compensated. Before recognition in profit or loss, the grants are recognised as deferred income until the income arises or asset financed is depreciated, and presented as a liability in the statement of financial position. The alternative treatment of grants relating to assets is to net them off against the asset being financed, reducing future depreciation. The Conceptual Framework of Financial Reporting defines a liability as 'a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits'. It can be argued that this definition is not met for grants that are not potentially repayable and that all grants should be recognised as income. This is because the Conceptual Framework defines income as 'increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.' The treatment of netting grants against the carrying amount of an asset does also not sit well with treated grants receivable as income. Grants are recognised in the financial statements when there is 'reasonable assurance that the entity will comply with the conditions attaching to them and the grants will be received'. This is different to the Conceptual Framework recognition criteria (probable inflow of economic benefits which can be measured reliably). Practically however, it is unlikely that it will make a big difference to when recognition occurs. Maximum for the question Copyright ICAEW All rights reserved Page 6 of 12

7 Question 3 Total Marks: 16 Examiner comments Again, a number of candidates did not follow the rubric of the question and only did the calculations and therefore did not earn the 5 (of 16) marks available for commentary. The calculation part of the question tended to either be done very well or badly. A number of candidates failed to recognise that this was a standard mortgage-type loan. Others complicated it more than necessary by recalculating the variable interest rate (with the result that the capital outstanding on the loan would not be reduced to zero at the end of the loan using the figures calculated). Suggested solution The loan is a financial liability from Cofrid's point of view and therefore must be accounted for in accordance with IFRS 9 Financial Instruments. As it is not held for trading purposes, it is held at amortised cost. IAS 39 (which still contains definitions not yet transferred to IFRS 9) defines transaction costs as 'incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability. An incremental cost is one that would not have been incurred if the entity had not acquired, issued or disposed of the financial instrument.' IAS 39 paragraph AG 13 states, 'transaction costs include fees and commissions paid to agents (including employees acting as selling agents), advisers, brokers and dealers, levies by regulatory agencies and securities exchanges, and transfer taxes and duties. Transaction costs do not include debt premiums or discounts, financing costs or internal administrative or holding costs.' The in-house legal costs are therefore not deducted from the loan as they are not incremental external costs. The loan is initially recorded at its fair value of $2.5million. Interest is then applied which is reduced by the fixed monthly payments: $ 1 May 2012 Cash received 2,500,000 May Interest (2,500,000 x (1.499% + 1%)/12 5, June 2012 Instalment paid (23,566.34) 2,481, June Interest (2,481, x (1.499% + 1%)/12 5, July 2012 Instalment paid (23,566.34) 2,463, July Interest (2,463, x (1.499% + 1%)/12 5, August 2012 Instalment paid (23,566.34) 2,444, August Interest (2,444, x (1.499% + 1%)/12 5, September 2012 Instalment paid (23,566.34) 2,426, September Interest (2,426, x (1.499% + 1%)/12 5, October 2012 Instalment paid (23,566.34) 2,407, October Interest (2,407, x (1.499% + 1%)/12 5, November 2012 Instalment paid (23,566.34) 2,389, Copyright ICAEW All rights reserved Page 7 of 12

8 November Interest (2,389, x (0.74% + 1%)/12 3, December 2012 Instalment paid (22,753.53) 2,369, December Interest (2,369, x (0.74% + 1%)/12 3, December ,373, Total interest of $37, is recognised as a finance cost. Transaction costs of $5,000 are recognised in profit or loss. The loan liability is $2,373, at the year end. Maximum for the question Copyright ICAEW All rights reserved Page 8 of 12

9 Question 4 Total Marks: 22 Examiner comments The question was generally very well done. The main issue in some answers was the incorrect calculation of the retained earnings and revaluation surplus figures pre and post the change in holding. Candidates need to take care when presenting their answers as a printed spreadsheet that the calculation of each element making up a figure (e.g. non-controlling interests) is shown. Copyright ICAEW All rights reserved Page 9 of 12

10 Punto Group Consolidated statement of financial position as at 31 December 2012 Parent Sub FV adj (W2) Goodwill (W3) FV changes (W2) Post-acq'n (W4) (80:20) Change in NCI (W5) Post-acq'n (W4) (60:40) $'000 $'000 $'000 $'000 $'000 $'000 $'000 $'000 $'000 Non-current assets Property, plant & equipment 340,500 70, ,800 Investment in Sub - Cost 54,400 (54,400) - Disposal (20,000) 20,000 Goodwill 8,000 8,000 Other intangible assets 30,400 12,500 4,200 (2,100) 45, ,800 Current assets 110,200 24,400 1,200 (1,200) 134, ,400 Equity attributable to owners of the parent Share capital 40,000 10,000 (10,000) 40,000 Share premium 90,400 90,400 Ret'd earnings Parent 172,700 8,208 1, ,252 Sub 52,700 (36,900) (3,300) (10,260) (2,240) Revaluation surplus Parent 72,000 5, ,620 Sub 14,300 (5,700) (7,300) (1,300) Other components of equity 4,888 4,888 Fair value adjustments 5,400 (5,400) 396,160 Non-controlling interests 11,600 2,052 1,460 15, Consol 31, ,800 Liabilities 140,400 30, , ,400 Copyright ICAEW All rights reserved Page 10 of 12

11 Workings 1 Group structure Punto % 20% = 60% $'000 $'000 Cost 54,400 Ret'd earnings 36,900 50,250 (52,700 (9,800 x 3/12)) Rev'n surplus 5,700 13,000 (14,300 (5,200 x 3/12)) 2 Fair value adjustments Saxon At acquisition Movement Year end 1/7/ /12/2012 $ 000 $ 000 $ 000 Brands 4,200 (2,100) * 2,100 Inventories 1,200 (1,200) 5,400 (3,300) 2,100 * 4,200/5 x 2½ years 3 Goodwill $ 000 $ 000 Consideration transferred 54,400 Non-controlling interests (58,000 x 20%) 11,600 Fair value of identifiable assets acq d & liabilities assumed at acq n: Share capital 10,000 Retained earnings 36,900 Revaluation surplus 5,700 Fair value adjustments (W2) 5,400 (58,000) 8,000 4 Saxon s reserves pre and post 30 September 2012 Retained earnings Pre Post $ 000 $000 Retained earnings at 31 December 2012 (W1) 52,700 Retained earnings 1 Oct to 31 Dec (9,800 x 3/12) (2,450) 2,450 Fair value movement to 31 December 2012 (W2) (3,300) Fair value movement 1 Oct to 31 Dec (4,200/5 x ¼ year) 210 (210) Retained earnings at acquisition (W1) (36,900) 10,260 2,240 Revaluation surplus $ 000 $'000 Revaluation surplus at 31 December 2012 (W1) 14,300 Revaluation surplus 1 Oct to 31 Dec (5,200 x 3/12) (1,300) 1,300 Revaluation surplus at acquisition (W1) (5,700) 7,300 1,300 Copyright ICAEW All rights reserved Page 11 of 12

12 5 Disposal of 20% of Saxon $ 000 DR Cost of investment (as cash received was credited there) 20,000 CR Non-controlling interests (W6) additional 20% 15,112 CR Other components of equity (balance) 4,888 6 Non-controlling interests at 30 September 2012 (20%) $ 000 Non-controlling interests at acquisition (W3) 11,600 NCI share of post-acq'n ret'd earnings & FV ((W4) 10,260 x 20%) 2,052 NCI share of post acq'n rev'n surplus (W4) 7,300 x 20%) 1,460 15, Copyright ICAEW All rights reserved Page 12 of 12