SUGGESTED ANSWERS AND EXAMINER S COMMENTARY. Question 1. Final exam Diploma in IFRSs 2 July 2012

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1 SUGGESTED ANSWERS AND EXAMINER S COMMENTARY Final exam Diploma in IFRSs 2 July 2012 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: 43 Examiner comments In part (a), the basic translation, goodwill calculation and adjustments for the provision and asset held for sale were well done, however the calculation of the translated retained earnings and exchange differences were problematic for many candidates. The other adjustments, particularly those relating to fair values, the postacquisition revaluation and the debentures loans caused more difficulty. The deferred tax adjustments (where attempted) were normally done well. Part (b) was generally well answered. Copyright The Institute of Chartered Accountants in England and Wales 2012 Page 1 of 12

2 (a) Parent Sub (W2) FV adj at acq'n (W3) Goodwill (W4) FV changes (W3) FX (W3) Acc pol (W5) Adj (W6-10) Postacq'n (80:20) Consol Non-current assets Property, plant & equipment 240,390 46,800 9,504 (1,584) 1,000 (1,500) (5,500) 289,110 Investment in Sub 44,000 (44,000) Goodwill 12,136 (2,023) 10,113 Other intangible assets 3,496 (460) (874) (760) (309) 1, ,316 Current assets 118,690 16, ,190 Non-current assets held for sale 5,390 5, ,896 Equity attributable to owners of the parent Share capital 4, (500) 4,000 Share premium 34,560 2,100 (2,100) 34,560 Ret'd earnings Parent 125,780 (380) (4,695) 1,409 (110) 33 (220) 9, ,295 Sub 43,555 (28,440) (2,094) (1,565) 391 (11,847) Revaluation surplus Parent 33,600 (1,500) ,150 Sub 750 (750) Translation reserve Parent (8,540) (8,540) Sub (7,155) (3,520) 10,675 Fair value adjustments 10,624 (10,624) 194,465 Non-controlling interests 9,800 2, (2,135) 204,649 Non-current liabilities Loans 90,400 10, ,220 Deferred tax 20,400 2,300 2,376 (396) 250 (450) (33) (1,800) 22,647 Current liabilities 94,340 11, , , ,896 10,184 Copyright The Institute of Chartered Accountants in England and Wales 2012 Page 2 of 12

3 Workings 1 Group structure Platinum k/((10m/10)) = 80% Cost 44,000k Ret'd earnings 28,440k Silver 2 Translation of financial statements F'000 Rate Property, plant and equipment 1,123, ,800 Current assets 396, ,500 1,519,200 63,300 Share capital 10, Share premium 42, ,100 Retained earnings acq'n 568, ,440 31, , , , ,815 dividend 2010 (36,000) 20 (1,800) , ,500 dividend 2011 (46,000) 23 (2,000) 46,155 Translation differences bal (7,155) 936, ,000 Loans 254, ,600 Deferred tax 55, ,300 Current liabilities 273, ,400 1,519,200 63,300 Note: Sub retained earnings = (46, ,100) = 43,555 3 Fair value adjustments/ accounting policy alignments at acquisition Acq'n Amort Amort Amort FX Year end 1/7/ /12/2011 F 000 F 000 F 000 F'000 F'000 F'000 Land and buildings 190, ,080 Customer relationships 69,920 (8,740) (17,480) (17,480) 26,220 Deferred tax (47,520) (47,520) 212,480 (8,740) (17,480) (17,480) 168,780 Rate $ 000 $ 000 $ 000 $ 000 (bal) Land and buildings 9,504 (1,584) 7,920 Customer relationships 3,496 (460) (874) (760) (309) 1,093 Deferred tax (2,376) 396 (1,980) 10,624 (460) (874) (760) (1,497) 7,033 Copyright The Institute of Chartered Accountants in England and Wales 2012 Page 3 of 12

4 4 Goodwill F 000 F 000 Rate Consideration transferred 880,000 Non-controlling interests 196, ,800 Fair value of identifiable assets acq d & liabilities assumed at acq n: Share capital 10,000 Share premium 42,000 Retained earnings 568,800 Fair value adjustments/acc'g policy alignments (W3) 212,480 (833,280) 1 July , ,136 FX differences (bal) (2,022.7) 31 December , , Post acquisition accounting policy alignment DR Land and buildings (24m Flots/24) 1,000 CR Other comprehensive income 1,000 DR Other comprehensive income (1,000 x 25%) 250 CR Deferred tax liability Platinum's foreign land and buildings Valuation 31/12/2011 (912m/24) 38,000 Valuation 31/12/2010 (869m/22) 39,500 Revaluation loss (1,500) DR Other comprehensive income 1,500 CR Land and buildings 1,500 Reverse existing deferred tax liability: DR Deferred tax liability (1,500 x 30%) 450 CR Other comprehensive income Holiday pay accrual Carried forward amount: Employees with less than or equal to 4 days (2,600 x 3 x $120) 936 Employees with more than 4 days (1,200 x 4 max x $120) 576 1,512 Less: brought down (1,132) 380 DR Cost of sales and expenses 380 CR Current liabilities Restructuring provision Staff redundancies 6,200 Legal costs 60 Relocation costs cannot include as relate to ongoing activities 0 Factory sale fees (deducted from carrying amount of factory) 0 6,260 Copyright The Institute of Chartered Accountants in England and Wales 2012 Page 4 of 12

5 DR Cost of sales and expenses (P) 4,695 DR Cost of sales and expenses (S) 1,565 CR Current liabilities 6,260 Deferred tax: DR Deferred tax asset (reduce DT liability) 1,800 CR Income tax expense (P) (4,695 x 30%) 1,409 CR Income tax expense (S) (1,565 x 25%) Non-current assets held for sale Carrying amount 5,500 Selling costs (110) Fair value less costs to sell 5,390 DR Cost of sales and expenses 110 DR Non-current assets held for sale 5,390 CR Property, plant and equipment 5,500 The valuation of $6million is conjecture so the fair value is the year end fair value of $5.5million. Deferred tax: DR Deferred tax liability (110 x 30%) 33 CR Income tax expense Fixed rate debenture loans 1 January 2011 (40, issue costs) 39,600 Effective interest at 3.295% 1,305 Coupon payment (2.5%) 30 June 2011 (1,000) 39,905 Effective interest at 3.295% 1,315 Coupon payment (2.5%) 31 December 2011 (1,000) c/d at 31 December ,220 Charged to P/L in draft financial statements: Issue costs 400 Coupon payments (40,000 x 5%) 2,000 2,400 Correct charge (1, ,315) 2,620 Correction: DR Finance costs 220 CR Loans (b) IFRS 10 Consolidated Financial Statements replaces the consolidation parts of IAS 27 Consolidated and Separate Financial Statements (which is renamed Separate Financial Statements) and SIC-12 Consolidation Special-purpose Entities. It is effective for accounting periods beginning on or after 1 January 2013, with earlier application permitted. Copyright The Institute of Chartered Accountants in England and Wales 2012 Page 5 of 12

6 The IASB felt that revision of the standard was necessary due to divergence in the application of the definition of control in IAS 27 and SIC-12. IAS 27 focussed on the power to govern the financial and operating policies, whereas its Interpretation (SIC-12) placed greater emphasis on risks and rewards. Recent financial scandals, such as Enron, also highlighted the need for a more robust definition of control to provide better information about vehicles that may or may not be accounted for 'off balance sheet'. Under IFRS 10, 'control of an investee' is when the investor 'is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee'. This arises only when the investor has all three of the following criteria: (1) power over the investee; (2) exposure, or rights, to variable returns from its involvement with the investee; and (3) the ability to use its power over the investee to affect the amount of the investor s returns. A subsidiary is defined as 'an entity controlled by another entity' so consolidation occurs where this definition of control is met. This new definition of control includes 'structured' entities, entities in which the parent may not have a direct ownership, but are in substance subsidiaries of the entity and should be consolidated. IFRS 10 contains extensive guidance on the assessment of 'power' and 'returns', the key components of the new definition of control. Maximum for the question Copyright The Institute of Chartered Accountants in England and Wales 2012 Page 6 of 12

7 Question 2 Total Marks: 24 Examiner comments Part (a) was well answered. In part (b), only a minority of candidates recognised that the transaction was a lease, however some credit was given for other well argued points. In part (c), a number of candidates stated that the division was a discontinued operation even though the criteria had not been met at the year end. Answers to part (d) were disappointing and sometimes could have benefited from taking a step back and applying a 'real life' review: only a threat had been made after the year end, but some answers suggested radical action such as accounting for the entity on a non-going concern (break-up) basis and/or qualifying the audit opinion. In real life, such unnecessary accounting disclosures could actually cause the business to fail even if the threat itself never became a reality due to their effect on the perception of the company. Candidates need to pay attention to the mark allocation in deciding how much to write. In parts (a) and (d) some candidates wrote more than they needed to, while in parts (b) and (c) often too little was written to earn the full marks available. (a) The debt issue must be accounted for under IFRS 9 Financial Instruments. Initial recognition is at fair value. However this would ordinarily be the amount of cash received. As the debt is Foxtrot's own debt and is not held for trading purposes, it should ordinarily be held at amortised cost. The change in fair value of the debt on the market due to change in credit risk is not therefore adjusted in Foxtrot's financial statements. However, it will be disclosed under IFRS 7 Financial Instruments: Disclosures. Any interest relating to the construction of qualifying assets as a result of the expansion would need to be capitalised in accordance with IAS 23 Borrowing Costs. Tutorial note: If the debt were held at fair value through profit or loss (which is unlikely in this case), the change in fair value relating to changes in the entity's own credit risk would be recognised in other comprehensive income rather than profit or loss. 4 4 (b) The substance of this arrangement needs to be analysed and accounted for rather than the legal form. The payments cover both the machine and the tablet PCs produced. As the equipment is specialised and specific to the customer, it appears that the substance of the arrangement is that it contains a lease (IFRIC 4 Determining whether an Arrangement Contains a Lease), providing: - fulfilment of the arrangement is dependent on the use of the specific asset, and - the arrangement conveys the right to use the asset. These criteria appear to be met in this case and therefore the arrangement should be accounted for as a lease. It appears to be a finance lease as the equipment is specialised and can only be used to produce tablet PCs for this client. Consequently, Foxtrot should derecognise the equipment from its financial statements and instead recognise a lease receivable at the present value of the payments to be received to cover the cost of construction of the equipment. Copyright The Institute of Chartered Accountants in England and Wales 2012 Page 7 of 12

8 A profit or loss on derecognition may arise if the carrying amount and lease receivable do not match exactly. Payments received from the customer will need to be divided into lease payments reducing the capital outstanding on the lease and revenue from the wholesale of tablet PCs. Interest income will also be accrued on the lease receivable. 7 7 (c) The issue here is whether the closure of the division should be accounted for as a discontinued operation under IFRS 5 Non-current Assets Held For Sale and Discontinued Operations. A discontinued operation is defined as 'a component of an entity that either has been disposed of or is classified as held for sale and: (a) (b) (c) represents a separate major line of business or geographical area of operations, or is part of a single coordinated plan to dispose of a separate major line of business or geographical area of operations, or is a subsidiary acquired exclusively with a view to resale.' As the discontinued operation has not been disposed of at the year end, it can only be classified as discontinued in the 2012 financial statements if it meets the definition of 'held for sale'. Disposal groups are classified as held for sale if 'their carrying amount will be recovered principally through a sales transaction rather than through continuing use'. This is not the case here as most of the assets are being redeployed elsewhere in the business. The small assets could potentially be classified as held for sale if all the relevant criteria, but not as a discontinued operation. Provision should be made for a redundancy costs if a constructive obligation exists at the year end. This appears to be the case as, assuming a detailed formal plan for the restructuring has been made, the entity has raised a valid expectation in those affected that the restructuring will be carried out by notifying them of the redundancy before the year end. As the annual financial statements were not scheduled to be released until after the closure of the division, the closure should be disclosed as a non-adjusting event after the reporting period due to its significance to the business (it is a separate operating segment). 9 8 (d) The drop in customer orders is an impairment indicator. Impairment tests should therefore be done at the level of the cash-generating units affected by the drop in orders. The threat by the major customer is a going concern issue. However, at present it is simply a threat, and, as such, does not affect the going concern assumption. Any losses as a result of the drop in orders will need disclosure. However the finance director is right not to disclose the threat to going concern as, at this stage, it is not an accounting issue. Maximum for the question Copyright The Institute of Chartered Accountants in England and Wales 2012 Page 8 of 12

9 Question 3 Total Marks: 21 Examiner comments Part (a) was very well answered. However, some candidates explained the purpose of the basic earnings per share figure, rather than focussing their answer on the requirement to explain the purpose of the diluted earnings per share figure. Part (b) was not so well done, and, as a result, this was the question where candidates scored the lowest overall average mark on the paper. Common errors were not calculating the liability component of the convertible debt and not adjusting the share option exercise price for the effect of the unvested share options. (a) Diluted earnings per share shows the earnings per share figure for the current period if all 'potential ordinary shares', (such as shares which may be issued in future as a consequence of existing share options and convertible debt), had become shares at the later of (i) the beginning of the current period and (ii) the date of issue. It is a 'warning' measure because it indicates to the owners of the business, the current ordinary shareholders, how their future earnings may be diluted if the potential ordinary shares actually become ordinary shares, diluting their shareholding in the business. The diluted earnings per share figure considers the worst case scenario. This is because, where there are multiple dilutive factors, some factors may actually be 'anti-dilutive' (i.e. increase earnings per share) if considered after applying another dilutive factor first. For this reason, potential ordinary shares are ranked and considered in order from most to least dilutive to ensure that the worst case scenario is disclosed to shareholders. Diluted earnings per share is also taken into consideration when performing a company valuation using the price earnings ratio because it is a more inclusive estimate of earnings per share. 5 5 (b) Order of dilution calculation Earnings Shares EPS Basic (86,300 (W2) 5,800) 80, , cents Share options (W3) , , cents Convertible bond (W1) 4,642 20,000 85, , cents Preference shares (W2) 5,800 16,000 90, , cents As the earnings per share rises with the preference shares, they are considered anti-dilutive and ignored for the purposes of calculating diluted earnings per share. Diluted earnings per share is therefore 35.4 cents. Copyright The Institute of Chartered Accountants in England and Wales 2012 Page 9 of 12

10 Workings 1 Convertible bond Cash received 100,000 Liability component: PV principal (100,000 x 1/ ) 81,630 PV interest annuity (100,000 x 5% x ) 13,122 (94,752) Equity component 5,248 b/d 1/1/ ,752 Effective interest (94,752 x 7%) 6,632 Coupon paid (100,000 x 5%) (5,000) c/d 31/12/ ,384 Interest saved, net of tax effect (6,632 x 70%) 4,642 Additional shares (100,000/$1,000 x 200) 20,000 Marginal EPS = 23.2 cents 2 Preference shares Interest saved (80,000 x 7.25%) 5,800 Additional shares (80,000 / 5) 16,000 Marginal EPS = $5,800,000/16,000,000 = 36.3 cents 3 Share options Fair value of services yet to be rendered $1,500,000 (4 x ((2 + 3) x 20,000)) = 400,000 x $4.50 x 30/36) Per option ($1,500,000/400,000) $3.75 Adjusted exercise price ($0 + $3.75) $3.75 Number of shares under option 400,000 No. that would have been issued at average market price [(400,000 $3.75/$5.70] (263,158) No. shares treated as issued for nil consideration 136,842 Marginal EPS = $0/136,842 = 0 cents The options are considered first in the order of dilution calculation as they have the lowest marginal EPS. Maximum for the question 17½ Copyright The Institute of Chartered Accountants in England and Wales 2012 Page 10 of 12

11 Question 4 Total Marks: 12 Examiner comments This question was generally very well answered (on average the best answered question on the paper). Some candidates did however fail to extract the various accounting issues from the scenario (e.g. the need to perform an impairment test). Other answers simply repeated the IFRS 6 principles, rather than advising the directors as to their significance by applying them to the company's situation. IFRS 6 Exploration for and Evaluation of Mineral Resources covers exploration and evaluation costs up to the point when commercial viability is established. It is an interim standard and allows an entity to continue to apply its existing accounting policy to exploration and evaluation expenditure, subject to some restrictions. The licence falls within the scope of IFRS 6 as it is 'expenditures incurred by the entity in connection with the exploration for and evaluation of mineral resources before the technical feasibility and commercial viability of extracting a mineral resource are demonstrable'. Exploration and evaluation assets are classified as tangible or intangible assets depending on their nature. The licence should therefore be classified as an intangible exploration and evaluation asset. Amortisation over the licence period is acceptable ($1m in 2011), although a longer amortisation period or capitalisation if the amortisation could be justified as the benefits will not be realised until commercial production begins. It appears that this company has been following what is called the 'successful efforts' approach to capitalisation of exploration and evaluation expenditures whereby costs are capitalised on a field by a field basis. This is acceptable under IFRS 6, however an impairment test may be necessary (see below). Alternative accounting treatments include capitalisation of all costs (often on a country by country basis), subject to amortisation and impairment tests. This increases amortisation charges later. Costs can also be written off as incurred. Impairment tests must be conducted on exploration and evaluation assets where facts and circumstances suggest that the carrying amount may exceed recoverable amount. However, IFRS 6 allows the impairment test to be done slightly differently than to how IAS 36 does it as if IAS 36 was applied to the exploration and evaluation assets before commercial viability is established, they would need to be written off. Instead, IFRS 6 allows the entity to determine its own accounting policy for allocating exploration and evaluation assets to cash-generating units for the purposes of an impairment test, rather than treating them as a separate cash-generating unit if the IAS 36 definition is met. It does however require that the cash-generating unit to which the exploration and evaluation asset is added is not bigger than an operating segment. Shale's current approach of testing for impairment annually at a group level is therefore not acceptable under IFRSs. As IFRS 6 only applies up to the point when commercially viability is established, a transfer out of exploration and evaluation costs is correct. However, exploration and evaluation assets must be classified as either tangible or intangible assets depending on their nature, and this classification must be applied consistently when commercial viability is established. Therefore the drilling costs should be reclassified as tangible assets. The transfer may also trigger an impairment test. The expenditure must be depreciated over its useful life. Depreciation based on oil production is acceptable. Copyright The Institute of Chartered Accountants in England and Wales 2012 Page 11 of 12

12 Development costs cannot be revalued under IAS 38 as there is no active market available to determine a fair value. However, as the drilling costs are classified as tangible items they may be able to be revalued under IAS 16 should the company choose to adopt the revaluation model under IFRSs. IFRS 6 does not cover the oil reserves themselves. They are also outside the scope of IAS 16 Property, Plant and Equipment. It is common for entities to disclose the estimated value of mineral reserves. Recognition under IFRSs is theoretically possible given that the mineral reserves meet the definition of an asset as they are 'a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity'. However, to be recognised the value must be reliably measurable and there is no international consensus on the best method to measure mineral reserves. Under IAS 18 Revenue, revenue from the sales of goods is recognised when there is a transfer of the risks and rewards of ownership. This may occur when the oil is transferred to the vessel or pipeline if the customer takes responsibility for the oil at that point. Otherwise the revenue recognition policy will need to be changed. Maximum for the question Copyright The Institute of Chartered Accountants in England and Wales 2012 Page 12 of 12

(a) Opening retained earnings (1 Jan 2010) $ million $ million. Profit using existing policies - 240

(a) Opening retained earnings (1 Jan 2010) $ million $ million. Profit using existing policies - 240 SUGGESTED ANSWERS AND EXAMINER S COMMENTARY Assignment 2 Diploma in IFRSs 30 April 2012 The suggested answers set out below were those used to mark this question. Markers were encouraged to use discretion