FINANCIAL REPORTING ANSWERS PROFESSIONAL STAGE APPLICATION EXAMINATION. Mock Exam 1. June 2012

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1 PROFESSIONAL STAGE APPLICATION EXAMINATION Mock Exam 1 June 2012 FINANCIAL REPORTING ANSWERS The answers set out below should be used to mark these questions. Markers are encouraged to use discretion and to award partial marks where a point was either not explained fully or made by implication. More marks are available than could be awarded for each requirement, where indicated. This allows credit to be given for a variety of valid points, which are made by candidates. The mark plan is detailed to reflect the wide range of relevant points that a candidate can make. It is a marking aid, it does not represent a sample answer and is more detailed than candidates would be expected to prepare in the examination. The Institute of Chartered Accountants in England and Wales 2012

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3 1 World In Motion plc ('WIM') Marking guide Marks ½ mark for each ratio (plus ½ for its comparative) Maximum 5 ½ or 1 mark for each valid point (see examiner s guidance) Maximum 23 Report to: Xin Dang From: A. Consultant Subject: WIM plc Date: XX/XX/XX This report covers the financial performance and position of WIM plc. The report has been based on limited information obtained from WIM s annual report. Additional ratios (AR) are included at the end of this report. Financial performance The company has expanded substantially during 2011 in terms of total revenue, which has increased by 31.8% (( ) 1), but this has not resulted in increased profits. Indeed, gross profit has fallen by 20% ((56 70) 1) and operating profit by 30.6% ((25 36) 1). The fall in gross and operating margins is substantially due to the increase in fuel costs per seat, but other costs per seat have also risen (see below). Passenger revenue has risen by 22.8% (( ) 1). This is mainly due to increased volume, because the number of seats sold increased by 17.0% (( ) (AR) 1) in the year. The remainder of the passenger revenue increase (and the 4.9% (( ) 1) increase in passenger revenue per seat) will be due to either or both of price increases and increased length of routes flown. (An increase in the average route length would be expected to lead to an increase in revenue per seat, even if the price charged per mile remains unchanged.) The increase in ancillary revenue of 117.6% ((74 34) 1) is most impressive and is likely to have a dramatic effect on profitability. Costs will previously have been incurred for services such as carrying baggage in aircraft holds; if these are now charged for, there is unlikely to be any material increase in costs to offset against the increased revenue, with all or almost all of the latter feeding through to the bottom line. The increase in ancillary revenue can be reviewed as a price rise; revenue per seat increases but the headline fare remains unchanged. The 44.3% (( ) 1) increase in cost of sales is almost double the percentage increase in passenger revenue; cost of sales now represents 104.5% (AR) of passenger revenue, up from 88.9% in 2010 (as noted, the increase in ancillary revenue is unlikely to lead to a material increase in cost of sales). Fuel costs in 2011 can be estimated at 142m (13.65 fuel costs per seat 10.39m seats sold) (AR), as against 85m ( m seats sold) (AR) in This represents an increase of 57m, against a total increase in cost of sales of 128m ( ). No information is available to explain this residual 71m increase, which is 34.8% ((( ) (289 85)) 1) of the 2010 non-fuel cost of sales. Fuel cost per seat has increased by 4.08, while total cost per seat has increased by 6.73 ( ). So non-fuel cost per seat has increased by The increase is surprising when distribution and marketing expenses as a % of total revenue are almost unchanged (AR) and will have fallen in per seat terms, given the increase in seats sold. Administrative expenses as a % of total revenue have fallen substantially, from 6.1% to 3.2% (AR) and will have fallen even more in per seat terms. So the increase in non-fuel costs per seat must be driven by increased cost of sales per seat, but no information as to the cause is available. Both the load factor and the aircraft utilisation have increased slightly year on year, indicating greater success in filling the available seats and more efficient use of the expensive aircraft assets. 3 of 16

4 The OFR statement that 2.44 of the increase in fuel costs was offset in the year might be taken as meaning that non-fuel costs were reduced by this amount. In fact the 2.44 results from the increase in total revenue per seat of 5.09 ( ) less the increase in non-fuel cost per seat of 2.65 (see above). So the total revenue per seat increase has been critical, a fact which is not made explicit in the OFR. Because the company sells tickets over the Internet, it has substantial investment income from spare funds, as customers pay for flights in advance. This income more than offset the interest payable on the borrowings to finance the aircraft. The 44.9% (( ) 1) fall in the return on capital employed is partly due to the 30.6% fall in operating profit (see above). The remainder of the fall will be due to an increase in capital employed. Return on shareholders funds is lower than the return on capital employed because the company has net cash of 72 million ( ) in 2011 and 84 million ( ) in 2010, so no net debt in either year. EBITDA has fallen by 20.9% ((34 43) 1) but EBITDAR has fallen by only 8.2% ((56 61) 1). This indicates WIM s reliance on operating leases, the cost of which is added back for EBITDAR but not for EBITDA. The current economic environment may well have a detrimental impact on foreign travel and therefore on revenues. The combination of reduced revenue, the possible lower aircraft utilisation and the effect of fixed costs such as staff costs could place a further squeeze on margins. Financial position The present financial position of WIM is sound. In both years the company has net cash rather than net debt. This is likely to be the result of the practice of low cost airlines of requiring full payment for flights at the time of booking, which may be many months in advance of the flight date. Cash taken for bookings may be non-refundable, depending on the terms of the bookings. But if at least some of it is refundable, then the recession may cause some customers to cancel bookings and request refunds, which would reduce the company s cash position. The commitment to buy new aircraft will result in very substantial cash outflows in the future. The unpaid amount is 532 million (570 commitment 38 already paid), which will transform the present net cash into substantial net debt. This could result in WIM becoming very highly geared, a worst case of 180% (460 ( end-2011 net cash ) 256 end-2011 equity). Such a level of gearing could be viewed as unsustainable for a company which operates on such narrow margins. The 39 million proceeds expected from the sale of the non-current assets held for sale will improve the cash position of the company. But the comment to the effect that a greater number of aircraft are available on the second hand market raises questions about the recoverability of this carrying amount. The fall in trade and other receivables collection period from 45.8 days to 36.3 days (AR) shows good housekeeping on the part of the company and reduces the risk of outstandings being irrecoverable. But if all bookings are made over the Internet and usually in advance of travel, why does WIM have such substantial receivables? The trade and other payables payment period is not much changed over the two years, at around 150 days (AR). But the trade and other payables balance is likely to include payments in advance by customers flying at future dates (there is no separate presentation of such amounts), so this payment period is almost certainly meaningless. Further investigation required Information about average route lengths flown, to establish whether there was any increase in passenger revenue prices. Information about the increase in non-fuel cost of sales, to understand what has driven the 34.8% increase in the total and the 2.65 increase per seat. Details of the booking terms, to establish whether cash already received is refundable in the event of passenger cancellation. 4 of 16

5 Details of the timing of the cash flows in respect of aircraft purchases, together with the terms of any loans agreed with lenders, to establish the extent to which cash resources will be sufficient to cover future commitments. Industry averages for all the ratios would be of assistance when trying to benchmark WIM. A statement of cash flows to give a detailed analysis of how WIM has generated and used cash, especially in relation to the expansion of the fleet. In particular, an analysis of operating cash flows would be of assistance in determining whether WIM has the resources to service the borrowings in relation to the new aircraft. Analysis of trade and other receivables to understand why a payment in advance business has such substantial amounts due. Analysis of trade and other payables to separate out the prepaid bookings. More trade magazine information, especially if there are any estimates for the rate of future growth of low cost airlines. This will help to establish whether the investment in the aircraft fleet will be supported by customer demand. Additional ratios (five maximum) Net asset turnover (revenue/(equity + net debt)) (473 (256 equity and 11 borrowings 197 cash)) and (359 (230 equity + 96 and 8 borrowings 188 cash)) 2.6x 2.5x Non-current asset turnover ( ) and ( ) 1.4x 1.3x Current ratio (ex non-current assets held for sale) (244:182) and (233:124) 1.3:1 1.9:1 Trade and other receivables collection period (days) ((47 473) 365) and ((45 359) 365) Trade and other payables payment period (days) (( ) 365) and (( ) 365) Cost of sales as a % of passenger revenue (417 as % of 399) and (289 as % of 325) 104.5% 88.9% Distribution and marketing expenses as a % of total revenue (16 as % of 473) and (12 as % of 359) 3.4% 3.3% Administrative expenses as a % of total revenue (15 as % of 473) and (22 as % of 359) 3.2% 6.1% Fuel costs per seat (cost per seat cost per seat ex fuel) ( ) and ( ) Millions of seats sold (passenger revenue/average passenger revenue per seat) (399m 38.40) and (325m 36.60) NOTE: Any other relevant ratios prepared by candidates would be given credit. 5 of 16

6 2 Laxton plc Marking guide Marks Impairment of assets and proposed sale of Bingham Ltd: Narrative 8 Calculation 2 Investment in Hawksworth 4 Issue of convertible bonds: Narrative 4 Calculation 3 21 Maximum 19 Impairment of assets and proposed sale of Bingham Ltd The entrance of a competitor into the market and the resulting fall in sales and profits is evidence that the assets of Bingham Ltd may be impaired. Therefore an impairment review should be carried out as required by IAS 36 Impairment of Assets. Although Laxton plc s directors were committed to the sale of Bingham Ltd from 1 March 2012 and were actively seeking a buyer, the 11.5 million price being negotiated around was not reasonable in relation to the 10 million estimated by professional advisers. Therefore Bingham Ltd does not meet the conditions under IFRS 5 Non-current Assets Held for Sale and Discontinued Operations for classification as held for sale, at either 1 March or 31 March This means that the assets of Bingham Ltd should be measured under IAS 36 at the lower of their recoverable amount and their carrying amount. Another effect of Bingham Ltd not being classified as held for sale is that its results should be presented within continuing activities, not as those of a discontinued operation. The 10.5 million estimated as the recoverable amount of the assets of Bingham Ltd at 31 March 2012 is lower than their 13.4 million carrying amount, so the group should recognise an impairment loss of the difference, ie 2.9 million. Assuming that Bingham Ltd is a cash generating unit (the smallest group of assets that generate cash inflows that are largely independent of those of other assets), the loss should be allocated first to goodwill and then to the other assets on a pro-rata basis. Under IAS 36 no asset can be written down below its recoverable amount. Assuming that costs to sell are insignificant, none of the impairment loss should be allocated to the property (measured at its open market value), to the inventory (measured at the lower of cost and net realisable value) or to availablefor-sale financial assets (which are measured at fair value). Under IAS 36 the first 1.4 million of the impairment loss should be allocated to goodwill, reducing it to nil. The remaining 1.5 million should be allocated as: 825,000 (1,500 (3,740 (3, ,060))) to other intangibles 675,000 (1,500 (3,060 (3, ,060))) to plant and equipment The result is shown below: Carrying Revised amount Impairment amount Goodwill 1,400 (1,400) Other intangible assets 3,740 (825) 2,915 Property at valuation 2,200 2,200 Plant and equipment at cost 3,060 (675) 2,385 Inventory 1,900 1,900 Available-for-sale financial assets 1,100 1,100 13,400 (2,900) 10,500 The whole of the impairment loss should be recognised as an expense in profit or loss. 6 of 16

7 Investment in Hawksworth Ltd The 15% shareholding in Hawksworth Ltd allied to lack of board representation does not give Laxton plc significant influence over that company. Therefore Hawksworth Ltd should not be classified as an associate. The investment should be classified as an available-for-sale financial asset and included in non-current assets. This is the only classification available when an investment is not in the form of a loan, does not have a fixed maturity and has not been acquired for trading purposes. IAS 39 Financial Instruments: Recognition and Measurement states that available-for-sale financial assets should be recognised initially at fair value (market price), so at 975,000 (150, ). Subsequent gains and losses on remeasurement to fair value should in principle be recognised in other comprehensive income and carried as a separate component within equity. The investment should be measured at 937,500 (150, ) at 31 March 2012 and a loss of 37,500 ( 975, ,500) recognised. If the cash flows expected from this shareholding have been reduced, then the write down should be treated as an impairment loss and recognised in profit or loss. But the fair value of Hawksworth Ltd s net assets has not changed, so it can be assumed that the expected cash flows remain unchanged. In these circumstances the loss should be recognised in other comprehensive income and carried as a debit balance within equity. Issue of convertible bonds Under IAS 32 Financial Instruments: Presentation convertible bonds consist of an equity component and a liability component. Each component should be recognised separately, within equity and liabilities respectively. The liability element should be measured as the present value of the interest and capital payments, discounted at the interest rate for an instrument with the same terms and conditions except for the convertibility (in this case, 10%). The equity element should be measured as the proceeds of the issue less the liability component. The calculation is shown below: Cash outflow Discount factor Present value 31 March 2013 (500 6% 5) 150 1/ March 2014 (500 6% 5) 150 (1/1.1) March 2015 (500 6% 5) + (500 5) 2,650 (1/1.1) 3 1,991 Liability component 2,251 Equity component (balance) 124 Issue proceeds (95% 500,000 5) 2,375 At 31 March 2012 (the issue date) the liability should be measured at million and presented within non-current liabilities, and the equity component should be measured at 124,000. The convertible bonds may result in conversion and therefore to the issue of additional ordinary shares. As a listed company Laxton plc should calculate and disclose diluted earnings per share in the current and future periods, if it does not do so already. IAS 33 Earnings per Share states that the potential shares should be taken into account from the date of issue, in this case the last day of the reporting period. 7 of 16

8 3 Haddon plc Marking guide Marks (a) Style and presentation 2 Construction contract: Narrative 6 Workings 3 Sale and leaseback 7 Investment property 7 25 Maximum 22 (b) ½ mark per adjustment 6 (c) Basic EPS 2 Weighted average number of shares 1 3 (d) 1 mark per valid point 5 36 Memorandum To: The Board of Directors of Haddon plc From: Interim Finance Director Subject: Financial reporting issues for the year ended 31 March 2012 Date: XX/XX/XX As requested, I have considered the financial reporting issues that have been drawn to my attention and their impact on the financial statements for the year ended 31 March I set out my comments below. (a) Financial reporting issues Construction contract: Calke Ltd IAS 11 Construction Contracts requires the company to recognise revenue and costs relating to a contract according to the stage of completion of the contract, provided that the outcome of the contract can be measured reliably. Although the contract is at an early stage, this reliable measurement appears to be possible. The contract price has been agreed and estimates of total contract costs have been provided. The stage of completion of the contract can be estimated by reference to the value of the work carried out to date (as certified by an expert) or the costs incurred to date as a percentage of estimated total costs. As the group has not previously carried out construction contracts, it is necessary to select a suitable method as the accounting policy. There is no information about the value of work certified and so for the purpose of these notes, the calculation is based on costs incurred to date. The remedial costs of 900,000 should be included in contract costs. It seems unlikely that a claim to recover them from the customer will be successful and a claim for reimbursement of costs not included in the contract price should only be recognised as revenue if negotiations with the customer indicate that it is probable that the customer will accept the claim. So the contract price should not be increased. When these additional costs are taken into account, the contract is expected to make a loss of 200,000 ( 5 million contract price less 4.3 million costs originally expected and 0.9 million remedial work). IAS 11 states that if a contract is expected to make a loss, the whole of the loss should be recognised immediately, so presentation in profit or loss should be as follows. 8 of 16

9 Proportion complete (2,400)/(4, ) 46% Contract revenue (46% 5,000) 2,300 Contract costs (balancing figure) (2,500) Expected loss (100%) (200) Note that an alternative calculation, also acceptable, would be to exclude the remedial work costs from the stage of completion calculation on the basis that they are unlikely to be recovered from the customer. Proportion complete (1,500/4,300) 35% Contract revenue (35% 5,000) 1,750 Contract costs (balancing figure) (1,950) Expected loss (100%) (200) Taking the remedial costs into account contract revenue should be reduced by 200,000 ( 2.5m progress payments 2.3m) and cost of sales should be increased by a total of 1 million ( 2.5m 1.5m). The net effect on profit is a reduction of 1.2 million. 0.9 million of this should reduce amounts due from customers, while the remaining 0.3 million should be recognised as part of the amount due to customers within current liabilities. This can also be calculated as total costs incurred to date ( 2.4 million) less losses recognised ( 200,000) less amounts received from customers ( 2.5 million). Tutorial Note: The following adjustments to the financial statements are required: Dr Revenue 200 Dr Cost of sales 1,000 Cr Current liabilities: amounts due to customers 300 Cr Current assets: amounts due from customers 900 To correct presentation and to recognise the anticipated loss on the construction contract. Sale and leaseback The five-year lease runs for a small proportion of the remaining useful life of the land (which is normally indefinite) and the present value of the minimum lease payments is only 25% of the fair value of the leased property ( 0.9m as a % of 3.6m). So the leaseback has been correctly classified as an operating lease. Because the leaseback is under an operating lease, a profit on sale should be recognised, but only to the extent that the fair value of the land exceeds its carrying amount, so 400,000 ( 3.6m fair value less 3.2m carrying amount). IAS 17 Leases states that where sale price is greater than fair value, the excess should be deferred and amortised over the period of the lease (this excess is usually recovered by the lessor through the lease payments being above market levels). As a result, the profit on disposal should be reduced by 800,000 ( 4.4m sale proceeds less 3.6m fair value). Of this amount, 120,000 (( 800,000 5) 9/12) should be recognised in profit or loss as a reduction in the lease payment expense and the 680,000 remainder deferred and treated as a liability. Of this amount, 160,000 ( 800,000 5) should be classified as a current liability and the remaining 520,000 as a non-current liability. The offer to reimburse Haddon plc s lease negotiation costs should be classified as an incentive to enter into the lease. SIC 15 states that the lessee should normally recognise the aggregate benefit of such incentives as a reduction of lease payment expense over the lease term, on a straight-line basis. Haddon plc should therefore recognise the 80,000 it has paid as an expense within operating expenses (this amount does not meet the definition of an asset) and then reduce the lease payment expense by 12,000 (( 80,000 5) 9/12). Operating expenses should therefore be increased by a net 68,000 and this amount presented as deferred income within liabilities. 16,000 ( 80,000 5) should be presented within current liabilities and the remainder within noncurrent liabilities. 9 of 16

10 Tutorial Note: To correct presentation and to recognise the anticipated loss on The following adjustments to the financial statements are required: Dr Other income 800 Cr Operating expenses 120 Cr Current liabilities: deferred income 160 Cr Non-current liabilities: deferred income 520 To reduce the profit recognised on the sale and leaseback Dr Operating expenses (80 12) 68 Cr Current liabilities: deferred expense reimbursement 16 Cr Non-current liabilities: expense reimbursement 52 To recognise lease negotiation costs as an expense and to spread the lessor s reimbursement of them over the lease term. (The total receivable of 80,000 remains offset against the liability for lease payments because its receipt is enforceable under the terms of the lease.) Kedleston Ltd s investment property In Kedleston s own financial statements the property it rents to Haddon plc should, under IAS 40 Investment Property s fair value model, be measured at fair value and the gain on remeasurement recognised in profit or loss. But because the property is occupied by another group company, it should not be treated as an investment property in the consolidated financial statements. Instead, it should be depreciated for the year ended 31 March 2012 by reference to its acquisition date fair value and revalued to its fair value at the end of the reporting period, in accordance with the group accounting policy which should be applied to properties dealt with under IAS 16 Property, Plant and Equipment. The revaluation gain of 500,000 should be removed from profit or loss (from other income). The depreciation expense for the period should be measured at 140,000 ( 2.8 million 20) and recognised in profit or loss as a reduction in operating profit. The overall effect on profit or loss is a reduction in profit of 640,000 ( 500, ,000). Because Kedleston is a 90% subsidiary, the profit for the year attributable to owners of Haddon should be reduced by 576,000 (90% 640,000) and that attributable to the non-controlling interest reduced by 64,000 (10% thereof). The revaluation gain should be measured at 640,000 (fair value of 3.3 million less (draft carrying amount of 2.8 million less depreciation of 140,000)). Under IAS 16 this should be recognised in other comprehensive income and held as a revaluation surplus within equity. Total comprehensive income is therefore unchanged (the 640,000 revaluation gain offsetting the 640,000 reduction in profit or loss). Tutorial Note: The following adjustments to the financial statements are required: Dr Operating profit profit or loss 140 Dr Other income profit or loss 500 Cr Revaluation gain other comprehensive income 640 To recognise a depreciation charge on the property, and to remove the revaluation gain from profit or loss and recognise it in other comprehensive income. NOTE: the property was correctly measured at fair value in the draft consolidated statement of financial position; it was the revaluation gain that had been treated incorrectly. 10 of 16

11 (b) Revised consolidated statement of comprehensive income for the year ended 31 March 2012 Draft Construction Sale and Acquisition of Revised contract leaseback Kedleston Revenue 22,000 (200) 21,800 Operating profit 3,217 (1,200) (68) (140) 1,929 Other income 2,200 (800) (500) 900 Profit before tax 5,417 (1,200) (748) (640) 2,829 Tax (560) (560) Profit for the period 4,857 (1,200) (748) (640) 2,269 Other comprehensive income Gain on non-current asset revaluation Total comprehensive income for the period 4,857 (1,200) (748) 2,909 Profit attributable to: Owners of Haddon 4,230 (1,200) (748) (576) 1,706 Non-controlling interest 627 (64) 563 4,857 (1,200) (748) (640) 2,269 Total comprehensive income attributable to: Owners of Haddon 4,230 (1,200) (748) 2,282 Non-controlling interest ,857 (1,200) (748) 2,909 (c) Basic earnings per share Earnings attributable to owners of Haddon (calculated by reference to the profit for the period) weighted average number of shares in issue Before the adjustments After the adjustments 4,230,000 6,000,000 (W) = 70.5p 1,706,000 = 28.4p 6,000,000 Working: weighted average number of shares: 1 April 2011 to 30 September 2011 ((3 million 6/12) ((2 + 1)/2) bonus effect) 1 October 2011 to 31 March 2012 (((3 million + 2 million issue) 6/12) ((2 + 1)/2) bonus effect) Number 2,250,000 3,750,000 6,000,000 (d) Ethical issues As explained above, several adjustments to the draft financial statements are required. These adjustments have the effect of reducing basic earnings per share below the level at which directors are entitled to bonuses. The significant size of the errors is very worrying. Some of these may have been oversights, but it is unlikely that all of them were. In particular, the treatment of the remedial contract costs and the failure to recognise depreciation on an own-use property suggest attempts to improve the operating profit figure. The required treatments for the profit on the sale and leaseback and the lease incentive are quite technical, so it may well be that these errors were made innocently. But this must not be allowed to disguise the fact that the net effect of all the adjustments is to reduce profit; this suggests manipulation. The reason for the sudden departure of the previous Finance Director should be investigated. Was he/she pressurised by other directors to produce draft financial statements which would result in bonuses for directors? I hope that these explanations are helpful to you. Please do not hesitate to contact me should you need any further information or assistance. 11 of 16

12 4 Kandy plc Marking guide (a) Required IFRS reporting treatment At acquisition Consideration 5 Goodwill 4 At reporting date Yala profit 2 Other amounts 3 14 Maximum 13 (b) Under UK GAAP At acquisition 4 At reporting date 3 7 Maximum 6 (c) Potential effect 1 mark per valid point, max 3 22 Marks (a) Required IFRS reporting treatment At acquisition IFRS 3 Business Combinations requires the consideration transferred by Kandy for the acquisition of Yala to be measured at fair value as at the acquisition date, cash payable at a future date being discounted to its present value: Fair value Cash payable on acquisition date 8,000 Shares to be issued on 31 March ,000,000 x 75p 3,750 Cash payable on 30 September ,000,000/ ,814 Cash payable on 30 September 2013 contingent consideration 1,800 15,364 The goodwill acquired in the business combination should be calculated at the acquisition date as the consideration transferred plus the non-controlling interest (NCI) less the fair value of the net assets acquired. Because Kandy s preferred measurement basis is fair value, the NCI should be measured at 7 million. Yala does not recognise the value of the three-year contract, but Kandy should do so in its consolidated financial statements. Although the contract is not separable in that it cannot be assigned to a third party, it does arise from legal rights so falls within the definition of an intangible asset. The 2 million internal costs in respect of the acquisition should be recognised as an expense in profit or loss, as should the 1.2 million charged by professional advisers it is not part of the consideration transferred to the vendors. Goodwill at the acquisition date should be measured as follows: Consideration transferred as above 15,364 NCI at fair value 7,000 22,364 Net assets acquired 16,300, ,500,000 17,800 Goodwill at acquisition date 4,564 Goodwill should not be amortised, but reviewed for impairment annually. 12 of 16

13 At the reporting date The contract recognised as an intangible asset should be amortised over its three-year life, so by 250,000 (1,500,000 x 6/36) in the first 6 months. Yala s profit for the period should be calculated as: Net assets at reporting date 18,500, ,500, ,000 19,750 Net assets acquired as above 17,800 Profit 1,950 1,267,500 (65%) should be attributed to the owners of Kandy and 682,500 (35%) to the NCI, which should be measured at the reporting date at 7,682,500 (7,000, ,500). Other amounts to be recognised as expenses in consolidated profit or loss are: Operating expenses: Professional advisers fees 1,200 Employee benefits to include the 2 million staff costs re the acquisition Increase in fair value of contingent consideration 2,700,000 1,800,000 90,000 (810,000) Finance costs: Deferred consideration 1,814,000 x 5% (90,700) Contingent consideration 1,800,000 x 5% (90,000) (180,700) The share component of the consideration is not remeasured. (b) Under UK GAAP At the acquisition date The reporting is the same as under IFRS with the following exceptions: Goodwill should be measured at the cost of the investment less share of net assets acquired Acquisition fees paid to third parties should be recognised as part of the cost of the investment The contract should not be recognised as an asset it is not separable Consideration transferred as above 15,364 Professional fees 1,200 16,564 Share of net assets acquired 65% x 16,300,000 10,595 Goodwill at acquisition date 5,969 Goodwill should then be amortised over its useful life. At the reporting date The reporting is the same as under IFRS with the following exceptions: There is no intangible amortisation The NCI should be measured at its share of the fair value of the net assets acquired plus share of post acquisition profits, so its share of Yala s reporting date net assets = 6,475,000 (35% x 18,500,000) No finance charge should be recognised in respect of the contingent consideration. Instead, the whole of the uplift should be recognised as a re-estimate at the acquisition date and related back, with an effect on goodwill: 5,969,000 + (2,700,000 1,800,000) = 6,869, of 16

14 (c) Potential effect on financial statement analysis As compared with reporting under UK GAAP, reporting under IFRS results in: Higher equity, because the NCI is measured at a higher amount. Gearing will be lower but so will be return on capital employed Higher non-goodwill net assets, because the contract is recognised many analysts take other intangibles into account but write goodwill down to nil when calculating measures such as net asset value Lower profit or higher loss, because amortisation of the intangible is likely to exceed that of goodwill (often amortised over 20 years) Lower profit or higher loss, because the uplift in contingent consideration is recognised as a finance charge. 14 of 16

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