SUGGESTED ANSWERS AND EXAMINER S COMMENTARY

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1 SUGGESTED ANSWERS AND EXAMINER S COMMENTARY Assignment 1 Diploma in IFRSs 17 March 2014 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: 40 Examiner comments Parts (a), (b), (d), (e) and (f) were generally well done. In part (a) the sales tax was occasionally incorrectly calculated as 10% rather than 10%/110% of the gross figure including sales tax. Some candidate answers to part (c) simply stated the current process for standard setting rather than critically appraising the process. Candidate answers to part (g) often lacked depth, sufficient separate points and analysis. (a) The desktop computer and Windows 8 licence are treated as tangible assets, given that the computer cannot operate without an operating system (IAS 38 paragraph 4). The other software (Microsoft Office and AutoCAD) will be treated as intangible assets and depreciated over their useful lives (2 years for Microsoft Office and 4 years for AutoCAD). The sales tax is recognised as a separate receivable as it is recoverable. At 31 December 2013, per computer: Property, plant and equipment: Computer equipment ((1, ) 100%/110%) = 1,388 (1,388/4 /12)) 1, Intangible assets: Software - MS Office (( %/110%) = 508 (508/2 /12)) AutoCAD (( %/110%) =,925 (,925/4 /12)), ,54.88 $ (b) Classic film Website Total $'000 $'000 $'000 Carrying amount at 1 January , ,00 Additions (W1) Amortisation (W2) (185) (20) (205) Disposals (0 (W2) 15) (45) (45) Carrying amount at 31 December , ,095 Copyright ICAEW All rights reserved Page 1 of 14

2 Workings At 31 December 2013 Cost/valuation (10, )/(W1) 10, ,285 Accumulated amortisation ((10,000/5 x 3) + (W2) 185)/(W2) (,185) (5) (,190) Carrying amount 3, ,095 1 Website development costs $'000 Planning expensed as akin to research per SIC-32 Registration of various domain names 18 Internal design costs 85 External contractor design costs 112 New content development - expensed because developed to market the entity's own products (SIC-32 para 8) Advertising of new website - marketing expensed as no intangible asset is created (IAS 38 para 9(c)) Amortisation $'000 Classic film (4, )/22 years 185 Website: Old website (150/5 years x /12) 15 New website ((W1) 215/21½ years x /12) ½ 8 (c) The current approach to standard setting involves a series of steps, not all of which are compulsory. The compulsory steps are: (1) Consultation with the Trustees and Advisory Council about the advisability of adding a topic to the IASB's agenda (2) Publication of an Exposure Draft for public comment, normally including a Basis for Conclusions and the alternative views of dissenting IASB Board members (3) Consideration of comments received on discussion documents and Exposure Drafts (4) Approval of final standards by at least 10 of the 1 IASB members (or by 9 members if there are fewer than 1 members) (5) Publication of final standards with a Basis for Conclusions and dissenting opinions of IASB Board members. Criticisms of the current approach include: (1) The IASB are slow to act. For example, the G20 pressed the IASB to act on impairment of financial assets in April 2009, however revised proposals have not yet been finalised and they are unlikely to be mandatory before (2) The plethora of documents and exposure drafts is confusing and could be organised more effectively, eg in quarterly batches given the timescales involved Copyright ICAEW All rights reserved Page 2 of 14

3 (3) The IASB promised a period of calm between major standard changes, with major standard changes being effective for annual periods beginning on or after 1 January 2005, 1 January 2009 and 1 January However, smaller changes effective from different dates have confused preparers and users of the financial statements. It has been suggested that a review every 3 years like the proposals for the IFRS for SMEs would be sufficient. (4) Long introduction periods combined with a general policy of permitting early application creates inconsistency between financial statements. Early application could be prohibited in the interests of consistency between companies. (5) The use of Interpretations adds complexity to understanding IFRSs. As Interpretations tend to be short, they could be included as an amendment to the particular standard. () The current standard setting approach has not worked well with the piecemeal replacement of the financial instruments standard. The result has been multiple versions of the standard, each with early application permitted, but not requiring application of the subsequent changes until the whole project is complete, creating confusion of which rules can and have been applied by entities. (7) Standards are grouped based on numbers determined by when they were issued rather than by logical topics. The topics could be organised more logically like in the IFRS for SMEs. (8) The IASB has bowed to political pressure, most notably from the United States, European Union and financial institutions, that have promoted their own agendas (eg greater use of fair values) which often conflict with the needs of other users of the financial statements (eg domestic tax collection and the needs of smaller economies). 9 (d) $'m Property being constructed by Applet for future use as investment property investment property in the course of construction is investment property (IAS 40 para 8(e) Factory building let under an operating lease to Partlet owner-occupied in consolidated financial statements Former warehouse, unoccupied at the year end future use to be determined investment property by default Vacant land intended for the construction of a new warehouse for use by Applet in 2014 not investment property (IAS 40 para 9(c)) Property owned by Partlet (subsidiary) let under an operating lease 3.0 to unrelated third parties consolidated 100% as investment property Copyright ICAEW All rights reserved Page 3 of 14

4 (e) US standards are currently a mixture of principles-based standards (some harmonised with IFRSs) and traditional rules-based standards and are very complex. Replacing them with IFRSs would simplify the system with a consistent principles-based system, reducing unnecessary detail. US companies seeking global recognition are currently at a competitive disadvantage. Costs are incurred in converting US GAAP to IFRSs for analysis purposes outside the US and an investor risk premium may be attached to businesses not reporting under IFRSs. Most other international important stock markets now use IFRSs. The USA is a notable exception. Switching to IFRSs could boost investor confidence in US companies, and allow comparison with the performance of other international companies without the need for reconciliations. Use of IFRSs by US companies would have the side effect of educating US account preparers and investors in IFRSs. This would make them more open to understanding international companies with the potential for investment in them. Use of IFRSs could represent a significant cost saving in not needing to develop detailed standards and disclosures for listed companies. At the same time the US could play a bigger role in the development of future IFRSs. 5 4 (f) DEF Tobacco Inc should be consolidated with a 20% non-controlling interest, despite the fact that its business is very different from the rest of the group. As DEF International plc's equity is traded in a public market, IFRS 8 segment disclosures for DEF Tobacco Inc will be required. Adjustments must also be made to align its accounting policies with IFRSs. DEF Technick GmbH is a subsidiary reporting under IFRSs and as such should be consolidated, with a 40% non-controlling interest. Potenz GmbH is only 45% (0% x 75%) owned by DEF International plc. However it is controlled by DEF International plc through its control of DEF Technik GmbH and therefore should be consolidated with a 55% non-controlling interest. DEF Mining Limited is jointly controlled with the Chinese government and should therefore be equity accounted as a joint venture. 5 5 (g) (1) An 'incurred loss' model rather than an 'expected loss' model approach could be introduced, whereby expected impairment losses factored into the pricing of the instrument are recognised on initial recognition. This would allow entities (and particularly financial institutions) to recognise impairment losses earlier than under IAS 39 which requires 'objective evidence' to exist before an impairment loss can be recognised. This approach has been criticised, particularly in the light of the financial crisis, as being 'too little, too late'. (2) For simple financial assets such as trade receivables, a different approach could be followed such as recognising lifetime expected credit losses on initial recognition. Copyright ICAEW All rights reserved Page 4 of 14

5 This would simplify impairment tests for many companies, as companies could use the traditional approach of determining allowances for impairment losses by age and historical loss rates. (3) A common approach between IFRSs and US GAAP could be introduced. This would allow comparability between entities reporting under the two GAAPs. However, it looks like there will be a divergent accounting treatment between the two standard setters, based on current proposals. The FASB favours upfront recognition of lifetime expected losses and the IASB plans to limit impairment losses recognised on initial recognition to lifetime expected losses multiplied by the probability of default in the following 12 months (ie, to act as a proxy for the expectation of losses factored into the pricing of the instrument), and adjust them later as necessary. Maximum for the question 40 Copyright ICAEW All rights reserved Page 5 of 14

6 Question 2 Total Marks: 21 Examiner comments Part (a) was well done although some answers did not appraise the current impairment process and simply explained the existing rules. Part (b) was also well done. Common issues were incorrect treatment of the restructuring costs and interest payments, and allocation of the impairment losses to the trade receivables (which are outside the scope of IAS 3). Suggested solution (a) The purpose of an impairment test is to ensure assets and groups of inter-related assets (cashgenerating units) are stated at no more than their recoverable amount, being the higher of fair value less costs of disposal and value in use (present value of net cash inflows relating to the asset), ie the best return the entity could generate by selling the asset or by retaining it to generate cash flows in the business. The value in use figure is very subjective given that it is determined by cash budgets from the business, which by their nature, can only be audited in terms of their assumptions rather than the actual cash flows. The value in use figure is also influenced by the discount rate used. IAS 3 requires an entity to discount at a rate that reflects the 'current market assessments of (a) the time value of money, and (b) the risks specific to the asset for which future cash flow estimates have not been adjusted'. Further guidance is given in Appendix A of IAS 3 (paras A15-A21) however the selection of the discount rate is very much a matter of judgement which could lead to inconsistency between, and manipulation by, companies. Being a 'market assessment' it is also subject to market fluctuations. Fair value is determined using the criteria in IFRS 13 Fair Value Measurement and represents the market value of the assets at a point in time, normally the year end, rather than a long-term value. Some argue that this can cause short-term volatility in financial statements, given that assets are normally held in a continuing business, not intending to sell them. Both of these issues have been particularly evident recently as a result of changing asset values and other financial variables in the wake of the financial crisis. Practical difficulties may arise in determining the entity's cash-generating units and the allocation of assets, corporate assets and goodwill between them. Copyright ICAEW All rights reserved Page of 14

7 (b) Carrying Carrying amount Impairment Reallocation* amount (before (after Impairment) (impairment) $'000 $'000 $'000 $'000 Property, plant and equipment,800 (W3)(253) 53,00 Goodwill 980 (W3)(980) Other intangible assets 1,700 (W3) (3) (53) 1,584 Trade receivables Inventories ,280 (1,29) (W1) 8,984 * Assets cannot be reduced below their fair value less costs of disposal (if known). Workings 1 Recoverable amount Higher of: $'000 Fair value less costs of disposal - overall 7,400 - individual separable assets (,00 + 1, ) 8,900 Value in use (W2) 8,984 2 Value in use calculation Discount rate adjusted for inflation = /1.03 = $'000 $'000 $'000 $'000 $'000 Cash from sales 4,200 4,400 4,00 4,200 3,800 Cash paid to acquire inventories (1,80) (1,70) (1,840) (1,80) (1,520) Wages and salaries costs (420) (420) (420) (420) (380) Apportioned overheads attributable (200) (200) (200) (200) (200) to division assets Disposal on 31 December ,100 Payment of restructuring costs, provided for at 31 December 2013 (1) Interest payments on loans (2) Tax payments (3) 1,900 2,020 2,140 1,900 2,800 Discount rate Discounted cash flows 1,792 1,798 1,797 1,505 2,092 Value in use $8,984,000 (to the nearest $1,000) Notes: (1) Interest cash flows are not included in the calculation because the cash flows are discounted. (2) Tax payments are not included as the impairment loss appears above the tax line in profit or loss (IAS 3 para 50). (Instead, impairment losses could generate a deferred tax adjustment if not recognised at the same time by the tax authorities). Copyright ICAEW All rights reserved Page 7 of 14

8 3 Allocation of impairment losses $'000 Carrying amount 10,280 Recoverable amount (W2) (8,984) Impairment loss 1,29 $'000 (1) Goodwill 980 (2) Property, plant and equipment (1, = 31 x,800/(,800+ 1,700)) 253 Other intangible assets (31 x 1,700/(, ,700)) 3 1,29 The full amounts allocated above are allocated to the property, plant and equipment and other intangible assets as doing so does not reduce them below their fair value less costs to sell of $. million and $1.5 million respectively. The trade receivables and inventories are outside the scope of IAS 3 (as any impairment is covered by other standards). Maximum for the question 15½ Copyright ICAEW All rights reserved Page 8 of 14

9 Question 3 Total Marks: 12 Examiner comments This question was the question with the lowest average mark on the paper. Candidate answers often lacked analysis of the scenario and a number of answers missed the key issues, ie that (a) was a financial liability (rather than cash-settled share-based payment) and that (b) included an embedded derivative. Credit was however awarded for reasoned analysis of other conclusions. Suggested solution (a) The first issue here is whether the transaction should be accounted for as cash-settled share-based payment or as a financial liability. Cash-settled share-based payment is where 'the entity acquires goods or services by incurring a liability to transfer cash or other assets to the supplier of those goods or services for amounts that are based on the price (or value) of the entity s shares or other equity instruments of the entity' (IFRS 2 Appendix A). The liability is not based on the price of the entity's shares. Instead it is fixed and is simply settled by delivering one type of financial asset (equity instruments) rather than another (cash). Consequently the arrangement is a financial liability as there is 'a contractual obligation to deliver cash or another financial asset' (the equity instruments) (IAS 32 paragraph 11). The financial liability will be measured at amortised cost as it is not held for trading purposes. The $4 million should therefore be discounted to its present value and the equipment and liability initially recognised at $3.3 million ($4m x 1/ ). Interest will be applied to the liability over the year and the interest of $ million ($3.28m x 5%) should be recognised as a finance cost in profit or loss. 5 (b) This is an example of an embedded derivative arrangement. An embedded derivative is 'a component of a hybrid contract that also includes a non-derivative host with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative'. (IFRS 9 para 4.3.1). Here the 'host' contract is the property sale contract. However, the house-builder also has the potential liability to refund the payment received if house prices fall. This is dependent on an underlying variable (expected house prices) and is therefore derivative as it meets the three criteria for a derivative in IFRS 9 Appendix A: (a) (b) (c) Its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the underlying ). It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. It is settled at a future date.' Copyright ICAEW All rights reserved Page 9 of 14

10 IFRS 9 requires embedded derivatives to be separated from host contracts which are not financial assets and measured at fair value through profit or loss (like other derivatives) providing: (a) (b) (c) the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host; a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and the hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss. The economic characteristics and risks of the sales contract and potential repurchase are not closely related to each other, a derivative instrument could be entered into to give the same market risk and the contract is not a financial liability measured at fair value through profit or loss. Therefore, the embedded derivative must be separated from the property sale host contract. Consequently the amounts received from the customer are separated into: Fair value of the option to put (i.e. sell) the property back to the developer Fair value of the property without the option The sale of the house can be recognised as revenue as the IAS 18 Revenue criteria for revenue recognition have been met as the significant risks and rewards of ownership have been transferred to the buyer, and the house-builder does not retain continuing managerial involvement to the degree normally associated with ownership nor effective control over the house sold, and the amounts involved can be measured reliably. The embedded option must be recognised as a liability at its fair value and remeasured to its fair value at the 31 December 2013 year end, with changes being reported in profit or loss. Maximum for the question Copyright ICAEW All rights reserved Page 10 of 14

11 Question 4 Total Marks: 27 Examiner comments This question was entirely computational and similar to questions set in past assignments, with some candidates earning very high scores. Common problems areas included the fair value adjustments, calculation of the post-acquisition reserves up to the date of the disposal and the profit on the disposal. Some weak answers continued to consolidate the subsidiary at the year end, even though control had been lost. Copyright ICAEW All rights reserved Page 11 of 14

12 Pointer Group Consolidated statement of financial position as at 31 December 2013 Parent Sub Reverse FV gain FV adj (W2) Goodwill (W3) FV changes (W2) Postacq'n (W4) (80:20) Disposal Profit on disposal (W5) $'000 $'000 $'000 $'000 $'000 $'000 $'000 $'000 $'000 $'000 $'000 $'000 Non-current assets Property, plant & equipment 30,400 77,400 (77,400) 30,400 Investment in Sub - Cost 48,000 (48,000) - FV change 13,900 (13,900) - Disposal (51,000) 51,000 Goodwill 4,900 (4,900) Other intangible assets 18,000,400 2,700 (1,50) (7,450) 18,000 Investment in associate 17, , ,940 Current assets 131,400 20,00 1,400 (1,400) (20,00) 131, ,340 Equity attributable to owners of the parent Share capital 100,000 20,000 (20,000) 100,000 Share premium 84,000 8,00 (8,00) 84,000 Ret'd earnings Parent 132,800 13,480 3,800 2, ,180 (4,200) (4,200) Sub 37,800 (1,500) (2,550) (1,850) (1,900) Investments in equity instruments reserve 13,900 (13,900) Revaluation surplus Parent 4,000 2,720 (2,720) 10 4,10 Sub 9,00 (5,400) (3,400) (800) Fair value adjustments 3,00 (3,00) 401,340 Non-controlling interests 11,000 3, (15,050) 401,340 Liabilities 12,000 28, (500) (28,400) 12, ,340 Realised rev'n Assoc (W) Consol Copyright ICAEW All rights reserved Page 12 of 14

13 Workings 1 Group structure Pointer m 12m = 4m 80% 0% = 20% $'000 $'000 Cost 48,000 Ret'd earnings 1,500 35,900 (37,800 (5,700 x 4/12)) Rev'n surplus 5,400 8,800 (9,00 (2,400 x 4/12)) Solita 2 Fair value adjustments Measured at date of control At acquisition Movement At disposal 1/1/ /8/2013 $ 000 $ 000 $ 000 Brands 2,700 (1,50) * 1,050 Inventories 1,400 (1,400) Contingent liability (500) 500 3,00 (2,550) 1,050 * 2,700/ x 3 8 / 12 years 3 Goodwill $ 000 $ 000 Consideration transferred 48,000 Non-controlling interests (fair value) 11,000 Fair value of identifiable assets acq d & liabilities assumed at acq n: Share capital 20,000 Share premium 8,00 Retained earnings 1,500 Revaluation surplus 5,400 Fair value adjustments (W2) 3,00 (54,100) 4,900 4 Solita s post acquisition reserves to 31 August 2013 Retained earnings $ 000 Retained earnings at 31 August 2013 (W1) 35,900 Fair value movement (W2) (2,550) Retained earnings at acquisition (W1) (1,500) 1,850 Revaluation surplus $ 000 Revaluation surplus at 31 August 2013 (W1) 8,800 Revaluation surplus at acquisition (W1) (5,400) 3,400 Copyright ICAEW All rights reserved Page 13 of 14

14 5 Profit on disposal of 0% of Solita $'000 $ 000 Fair value of consideration received 51,000 Fair value of investment remaining 17,000 Less: Net assets at date of disposal (7,000 (8,100 x 4/12)) 73,300 Goodwill (W3) 4,900 Fair value adjustments (W2) 1,050 Less: Non-controlling interests [(W3) 11,000 + (((W4) 1, ,400) x 20%)] (15,050) (4,200) 3,800 Investment in associate $ 000 Cost (fair value at date control lost) 17,000 Share of post acquisition retained earnings (5,700 x 4/12 x 20%) 380 Share of post acquisition revaluation surplus (2,400 x 4/12 x 20%) 10 17, Copyright ICAEW All rights reserved Page 14 of 14