CORPORATE REPORTING TOPIC: END OF THE DIET MOCK REVIEW SOLUTION

CORPORATE REPORTING TOPIC: END OF THE DIET MOCK REVIEW SOLUTION QUESTION 1 (a) Consolidated balance sheet at 31 December 20X5 $'000 Non-current assets Property, plant and equipment (2,870 + (W2) 1,350) 4,220 Goodwill (W4) 147 4,367 Current assets Inventories (1,990 + (W2) 2,310) 4,300 Trade receivables (1,630 + (W2) 1,270) 2,900 Cash at bank and in hand (240 + (W2) 560) 800 8,000 12,367 Equity attributable to equity holders of the parent Share capital ($1) 118 Retained earnings (W5) 2,613 STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 1

Translation reserve (W6) 406 3,137 Minority interest ((W2) 4,280 25%) 1,070 4,207 Non-current liabilities Loans 1,920 Current liabilities Trade payables (5,030 + (W2) 1,210) 6,240 12,367 (b) Consolidated income statement for year ended 31 December 20X5 $'000 Revenue (40,425 + (W3) 25,900) 66,325 Cost of sales (35,500 + (W3) 20,680) (56,180) Gross profit 10,145 Distribution and administrative expenses (4,400 + (W3) 1,560) (5,960) Profit before tax 4,185 Income tax expense (300 + (W3) 1,260) (1,560) Profit for the period 2,625 Attributable to: Equity holders of the parent 2,025 Minority interest ((W3) 2,400 25%) 600 STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 2

2,625 Statement of changes in equity for the year ended 31 December 20X5 (extract) $'000 $'000 Translation Retained Reserve earnings Balance at 31 December 20X4 (W6)/ (W5) 168 1,288 Currency translation differences [(W7) (297 75%) + (W4) 15)] 238 Net income recognised directly in equity 238 1,288 Profit for the period 2,025 Total recognised income and expense for the period 238 3,313 Dividends (700) Balance at 31 December 20X5 (W6)/ (W5) 406 2,613 Workings 1 Group structure Harvard IN k 31.12.X2 1,011/1,348 = 75% Pre-acq'n ret'd earnings = PLN 2,876,000 2 Translation of Krakow balance sheet PLN Rate $'000 STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 3

'000 Property, plant and equipment 4,860 3.6 1,350 Inventories 8,316 3.6 2,310 Trade receivables 4,572 3.6 1,270 Cash 2,016 3.6 560 19,764 5,490 Share capital 1,348 4.4 306 Retained earnings pre-acquisition 2,876 4.4 654 20X3 20X4 (given) 5,936 1,372 20X5 Profit 9,000 3.75 2,400 20X5 Dividends (3,752) 3.92 (957) 14,060 3,469 Translation reserve (100%, excludes goodwill) brought forward (given) - 208 for year (W7) - β or (W7) 297 15,408 4,280 Trade payables 4,356 3.6 1,210 19,764 5,490 STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 4

3 Translation of Krakow income statement PLN Rate $'000 '000 Revenue 97,125 3.75 25,900 Cost of sales (77,550) 3.75 (20,680) Gross profit 19,575 5,220 Distribution and administrative expenses (5,850) 3.75 (1,560) Profit before tax 13,725 3,660 Income tax expense (4,725) 3.75 (1,260) Profit for the period 9,000 2,400 4 Goodwill PLN PLN Rate $'000 '000 '000 Cost of combination (840 4.4) 3,696 Less: Share of net assets acquired Share capital 1,348 Retained earnings 2,876 4,224 Group share (75%) (3,168) STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 5

Goodwill at acquisition 528 4.4 120 Exchange gain 20X3 20X4 - β 12 Goodwill at 31 December 20X4 528 4.0 132 Exchange gain 20X5 - β 15 Goodwill at balance sheet date 528 3.6 147 5 Proof of retained earnings $'000 $'000 (i) At 31 December 20X5 Harvard Krakow Per question/(w2) 502 3,469 Less: retained earnings at acquisition (W2) (654) 2,815 Group share (75%) 2,111 Goodwill impairment losses to date (0) 2,613 $'000 $'000 (ii) At 31 December 20X4 Harvard Krakow Harvard (502 (943 700))/Krakow (W2) (654 + 1,372) 259 2,026 Less: retained earnings at acquisition (W2) (654) 1,372 Group share (75%) 1,029 STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 6

Goodwill impairment losses to 31.12.X4 (0) 1,288 6 Translation reserve $'000 (i) At 31 December 20X5 Translation of Krakow ((208 + (W7) 297) 75%) 379 Translation of goodwill (12 + (W4) 15) 27 406 (i) At 31 December 20X4 Translation of Krakow (208 75%) 156 Translation of goodwill (W4) 12 168 7 Exchange differences $'000 Net assets of Krakow at 31 December 20X5 4,280 Less: net assets of Krakow at 31 December 20X4 (15,408 9,000 + 3,752) @ 4.0 (2,540) Increase over the year 1,740 Less: retained profit for the year (W2) (2,400 957) (1,443) Exchange differences 297 Group share (75%) 223 STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 7

QUESTION 2 The impairment losses are allocated as required by IAS 36 Impairment of assets. Asset @ 1st loss Asset @ 2 ND loss Revised 1.1.20X0 (W1) 1.2.20X0 (W2) Asset $'000 $'000 $'000 $'000 $'000 Goodwill 200 (200) Operating licence 1,200 (200) 1,000 (100) 900 Property: stations/land 300 (50) 250 (50) 200 Rail track/coaches 300 (50) 250 (50) 200 Steam engines 1,000 (500) 500 500 3,000 (1,000) 2,000 (200) 1,800 Workings 1 First impairment loss STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 8

$500,000 relates directly to an engine and its recoverable amount can be assessed directly (ie zero) and it is no longer part of the cash generating unit. IAS 36 then requires goodwill to be written off. Any further impairment must be written off the remaining assets pro rata, except the engine which must not be reduced below its net selling price of $500,000. 2 Second impairment loss The first $100,000 of the impairment loss is applied to the operating licence to write it down to net selling price. The remainder is applied pro rata to assets carried at other than their net selling prices, ie $50,000 to both the property and the rail track and coaches. QUESTION 3 Memorandum The need for and impact of possible revaluations of assets by Greensmith Co To : FD, Greensmith Co From : Accountant For the private use of the company I have considered the issues you raised and would advise you of the following matters: (1) Need to revalue IAS 36 Impairment of Assets indicates that impairments losses such as that for Conway Square must be reflected in the financial statements in the year that they occur. There is no need to revalue the Berkshire Training Centre if you do not wish to, but if you were to revalue this asset, all assets of the same class would need to be revalued, per IAS 16 Property, Plant and Equipment. Furthermore, the revaluations need to be kept up to STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 9

date so that the carrying amount is not materially different to the asset's fair value at the balance sheet date. IAS 16 suggests that every three to five years may be sufficient if prices are not too volatile. (2) Pooling/Accounting Treatment When you take account of the impairment of Conway Square and if you revalue the Training Centre they will have to be accounted for separately. You could not pool the net movement. The fall in the value of Conway Square of $0.7 million would go through the income statement as it has not been previously revalued. The $3.5 million increase in the Training Centre's value would go through the revaluation surplus and it would therefore be reflected in the Statement of Recognised Income and Expense. (3) Effect on the income statement of future disposals The reported profit sale would be lower if an upward revaluation had occurred as the profit on disposal is calculated as proceeds less book value as it must be calculated by reference to the new carrying value. The previously recognised revaluation surplus, would be credited directly to retained earnings. The profit on any disposal of Conway Square would conversely be higher (or any loss lower). (4) Effect on EPS, ROCE and NAPS (i) EPS reflecting the impairment of Conway Square would almost certainly need to be disclosed (under IAS 1) given its size and would reduce earnings and therefore EPS. Revaluing the Training Centre will lead to an increased amortisation charge $'000 new 8m/18 444 per annum existing 5m/20 250 per annum STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 10

This will obviously lower EPS for the remainder of the lease term. (ii) ROCE The revaluation upwards would worsen ROCE by increasing capital employed. Additionally, the revaluation will increase the amortisation and thus reduce the return. Reflecting the impairment of Conway Square would reduce the return in the year in question but would also reduce capital employed for the indefinite future. (iii) NAPS The revaluations upwards would strengthen NAPS. The impairment in Conway Square would weaken it. (5) Summary and recommendations Conway Square must be reduced in value to reflect its impairment in value. This will have the effect of making all of the measures of concern look worse this year. ROCE will be improved in the future. The Training Centre should not be revalued upwards. It will reduce EPS for the next 18 years and worsen ROCE. The increase in NAPS does not seem a reasonable trade-off as it is likely to be the least used of the three measures. (6) Advice on accounting for franchise and brand valuation (i) Purchase of a franchise IAS 38 Impairment of Assets states that an intangible asset acquired separately from a business should be capitalised at its cost, which in this case is $500,000. Given that the franchise is for a fixed period, it should be amortised on a systematic basis over its 15-year useful life. (ii) Brand value The Standard is clear on this area and states that internally generated brands should not be recognised as intangible assets. This is because expenditure on internally generated brands cannot be distinguished from the cost of developing the business as a whole. STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 11

Costs of developing the business as a whole represent internally generated goodwill which is also not capitalised as it is not an identifiable resource that can be measured reliably at cost. The brand value cannot therefore be recognised in the balance sheet. I hope this assists you in your decision taking. These are complex issues so please contact me if any points in my report need clarifying or if there is any other way I can help out. T. Brown 1 December 20X2 QUESTION 4 (a) Creative accounting, the manipulation of figures for a desired result, takes many forms. Offbalance sheet finance is a major type of creative accounting and it probably has the most serious implications. It is very rare for a company, its directors or employees to manipulate results for the purpose of fraud. The major consideration is usually the effect the results will have on the share price of the company. If the share price falls, the company becomes vulnerable to takeover. Analysts, brokers and economists, whose opinions affect the stock markets, are often perceived as having an outlook which is both short-term and superficial. Consequently, companies will attempt to produce the results the market expects or wants. The companies will aim for steady progress in a few key numbers and ratios and they will aim to meet the market's stated expectation. The number of methods available for creative accounting and the determination and imagination of those who wish to perpetrate such acts are endless. It has been seen in the past that, wherever an accounting standard or law closes a loophole, another one is found. This has produced a change of approach in regulators and standard setters, towards general principles rather than detailed rules. STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 12

Here are a few examples of creative accounting. (i) Income recognition and cut-off Manipulation of cut-off is relatively straightforward. For instance a company may delay invoicing in order to move revenue into the following year. (ii) Revaluations The optional nature of the revaluation of non-current assets leaves such practices open to manipulation. The choice of whether to revalue can have a significant impact on a company's statement of financial position. (iii) Window dressing This is where transactions are passed through the books at the year end to make figures look better, but in fact they have not taken place and are often reversed after the year end. An example is where cheques are written to creditors, entered in the cash book, but not sent out until well after the year end. (iv) Change of accounting policies This tends to be a last resort because companies which change accounting policies know they will not be able to do so again for some time. The effect in the year of change can be substantial and prime candidates for such treatment are depreciation, inventory valuation, changes from current cost to historical cost (practised frequently by privatised public utilities) and foreign currency losses. (v) Manipulation of accruals, prepayments and contingencies These figures can often be very subjective, particularly contingencies. In the case of impending legal action, for example, a contingent liability is difficult to estimate, the case may be far off and the lawyers cannot give any indication of likely success, or failure. In such cases companies will often only disclose the possibility of such a liability, even though the eventual costs may be substantial. STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 13

(b) The phrase 'substance over form' has been described as follows. 'Transactions and other events should be accounted for and presented in accordance with their substance and financial reality and not merely with their legal form.' This is a very important concept and it has been used to determine accounting treatment in financial statements through accounting standards and so prevent off balance sheet transactions. (i) Group accounting is perhaps the most important area of off balance sheet finance which has been prevented by the application of the substance over form concept. A number of IASs have tackled abuses by enforcing the substance over form concept. The most important point is that the definition of a subsidiary (under IAS 27) is based upon the principle of control rather than purely ownership. Where an entity is controlled by another, the controlling entity can ensure that the benefits accrue to itself and not to other parties. Similarly, one of the circumstances where a subsidiary may be excluded from consolidation is where there are severe long-term restrictions that prevent effective control. (ii) Finance leases and their accounting treatment under IAS 17 Leases are an example of the application of substance over form. Operating leases do not really pose an accounting problem. The lessee pays amounts periodically to the lessor and these are charged to the income statement. The lessor treats the leased asset as a non-current asset and depreciates it in the normal way. Rentals received from the lessee are credited to the income statement in the lessor's books. For assets held under finance leases this accounting treatment would not disclose the reality of the situation. If a lessor leases out an asset on a finance lease, the asset will probably never be seen on his premises or used in his business again. It would be STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 14

inappropriate for a lessor to record such an asset as a non-current asset. In reality, what he owns is a stream of cash flows receivable from the lessee. The asset is a receivable rather than a non-current asset. Similarly, a lessee may use a finance lease to fund the 'acquisition' of a major asset which he will then use in his business perhaps for many years. The substance of the transaction is that he has acquired a non-current asset, and this is reflected in the accounting treatment prescribed by IAS 17, even though in law the lessee may never become the owner of the asset. (iii) With regard to measurement or disclosure of current assets, a common example where substance over form is relevant are sale and repurchase agreements. There are arrangements under which the company sells an asset to another person on terms that allow the company to repurchase the asset in certain circumstances. A common example of such a transaction is the sale and repurchase of maturing whisky inventories. The key question is whether the transaction is a straightforward sale, or whether it is, in effect, a secured loan. It is necessary to look at the arrangement to determine who has the rights to the economic benefits that the asset generates, and the terms on which the asset is to be repurchased. If the seller has the right to the benefits of the use of the asset, and the repurchase terms are such that the repurchase is likely to take place, the transaction should be accounted for as a loan. Another example is the factoring of trade receivables. Where debts are factored, the original creditor sells the receivables to the factor. The sales price may be fixed at the outset or may be adjusted later. It is also common for the factor to offer a credit facility that allows the seller to draw upon a proportion of the amounts owed. In order to determine the correct accounting treatment it is necessary to consider whether the benefit of the receivables has been passed on to the factor, or whether the factor is, in effect, providing a loan on the security of the receivables. If the seller has to pay interest on the difference between the amounts advanced to him and the amounts that the factor has received, and if the seller bears the risks of non-payment by the debtor, then the indications would be that the transaction is, in effect, a loan. STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 15

(c) (i) The Finance Director may be right in believing that renewing the non-current assets of the company will contribute to generating higher earnings and hence improved earnings per share. However, this will not happen immediately as the assets will need to have been in operation for at least a year for results to be apparent. Earnings will be higher because of the loan being at a commercially unrealistic rate, namely 5% instead of 9%. As regards gearing, the Finance Director may well wish to classify the convertible loan stock as equity rather than debt; thus gearing will be lower. He may argue that because the loan is very likely to be converted into shares, the finance should be treated as equity rather than as debt. (ii) IAS 33 Earnings per share requires the calculation of basic earnings per share. The Finance Director believes that the convertible loan he is proposing will not affect EPS and that an interest cost of 5% will not impact heavily on gearing. However, IAS 32 will require the interest cost to be based on 9% and IAS 33 also requires the calculation and disclosure of diluted EPS. The need to disclose diluted earnings per share arose because of the limited value of a basic EPS figure when a company is financed partly by convertible debt. Because the right to convert carries benefits, it is usual that the interest rate on the debt is lower than on straight debt. Calculation of EPS on the assumption that the debt is non-convertible can, therefore, be misleading since: (1) Current EPS is higher than it would be under straight debt (2) On conversion, EPS will fall diluted EPS provides some information about the extent of this future reduction, and warning shareholders of the reduction which will happen in the future. IAS 32 Financial instruments: presentation affects the proposed scheme in that IAS 32 requires that convertible loans such as this should be split in the statement of financial position and presented partly as equity and partly as debt. Thus the company's gearing will probably increase as the convertible loan cannot be 'hidden' in equity. STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 16

QUESTION 5 I. A financial instrument is a contract that gives rise to both: one entity, and A financial asset is any asset that is: ty; or A financial liability is any liability that is a contractual obligation: entity. financial liabilities with another entity under conditions that are potentially unfavourable to the ii. Financial instruments include: STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 17

commodity derivatives. iii. Category of financial assets are: - (1) Financial assets at fair value through profit or loss. This includes financial assets that are held for trading. Derivatives that are assets must be included in this category unless held in hedging relationships that qualify for hedge accounting. An entity can choose to treat other financial instruments as at fair value through profit or loss, provided that they meet certain criteria. (2) Held to maturity investments. These are financial assets with fixed payments and a fixed maturity that the entity intends to hold until their maturity. An example is an investment in bonds issued by another entity, where there is no intention to sell the bonds on the market before their maturity. STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 18

Loan stock, redeemable preference shares and bonds issued by other entities would fall into this category, provided that the entity plans to hold the investment to the end of its term (for example, when it is redeemable). (3) Loans and receivables. These are assets with fixed payments but are not quoted in an active market. They include regular bank loans and accounts receivable (trade receivables). They are not expected to be sold in the near future. This category could include loans made to other entities, trade receivables and investments in bonds and other forms of debt, provided that the other conditions are met. (4) Available-for-sale financial assets. These are any other financial assets that do not fall into any of the three categories above. In addition, an entity can designate an asset as available-for-sale when it is first recognised. iv. a) Split of liability and equity on initial recognition 31st December Cash Discount factor 9% Present value ( ) 20X5 - interest 100,000 0.9174 91,743 STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 19

20X6 - interest 100,000 0.8417 84,168 20X7 - interest 100,000 0.7722 77,218 20X7 - principal 2,000,000 0.7722 1,544,367 Fair value of bond 1,797,496 Value of equity (balance) 202,504 Proceeds from issue of bond 2,000,000 b) Journal on initial recognition Dr ( ) Cr ( ) Cash 2,000,000 Liability 1,797,496 Equity 202,504 c) Amortisation table Liability at Finance charge Interest Liability at start of year at 9% Paid the end of the year STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 20

20X5 1,797,496 161,775 (100,000) 1,859,271 20X6 1,859,271 167,334 (100,000) 1,926,605 20X7 1,926,605 173,395 (100,000) 2,000,000 d) Journal on conversion to shares Bond 2,000,000 Equity - option proceeds 202,504 Share capital 1,200,000 Share premium 1,002,504 STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 21

QUESTION 6 a. Deferred tax is an accounting measure used to match the tax effects of transactions with their accounting impact. It is also referred to as the tax on timing difference. b. Deferred tax liabilities are the amounts of income taxes payable in future periods in respect of taxable temporary differences. Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of: rary differences c. (a) Tax charge for the year $ (i) Tax on trading profits (30% of 1,200,000) 360,000 Tax on capital gain (30% of 60,000) 18,000 Deferred taxation 20,000 398,000 STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 22

Underprovision of taxation in previous years $(84,000 80,000) 4,000 Tax charge on profit for the period 402,000 (ii) Note. The statement of profit or loss will show the following. $ Profit before tax (1,200,000 + 60,000) 1,260,000 Income tax expense (402,000) Profit for the year 858,000 (b) $ Deferred taxation Balance brought forward 100,000 Transferred from profit or loss 20,000 Deferred taxation in the statement of financial position 120,000 The tax liability is as follows. Payable on 1 May 20X5 $ Tax on profits (30% of $1,200,000) 360,000 Tax on capital gain (30% of $60,000) 18,000 Due on 1 May 20X5 378,000 Summary $ STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 23

Current liabilities Tax, payable on 1 May 20X5 378,000 Non-current liabilities Deferred taxation 120,000 Note. It may be helpful to show the journal entries for these items. $ $ DEBIT Tax charge (statement of profit or loss) 402,000 CREDIT Tax payable *382,000 Deferred tax 20,000 * This account will show a debit balance of $4,000 until the underprovision is recorded, since payment has already been made: (360,000 + 18,000 + 4,000). The closing balance will therefore be $378.000. STARRY GOLD ACADEMY +2348023428420, +2347038174484, info@starrygoldacademy.com, www.starrygoldacademy.com Page 24