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ContentsA. REGULATORY ENVIRONMENT AND CORPORATE GOVERNANCE 31. Regulatory environment 32. External audit and the audit report 93. Corporate Governance 13

B. FINANCIAL ACCOUNTING AND REPORTING 154. Conceptual Framework for Financial Reporting 15

C. ACCOUNTING STANDARDS 195. IAS 1 Presentation of Financial Reporting 196. IAS 7 Statement of Cash Flows 237. IAS 16 Property, Plant and Equipment 318. IAS 23 Borrowing costs 379. IAS 20 Government Grants 3910. IAS 40 Investment Properties 4111. IAS 38 Intangible Assets 4312. IAS 36 Impairment of Assets 4513. IFRS 5 Non-current assets held for sale and discontinued operations 4914. IAS 19 Employee Benefits 5315. IAS 21 Foreign Currency Transactions 5716. IAS 10 Events after the reporting period 5917. IAS 2 Inventories 6118. IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors 6319. IAS 12 Income Taxes 6520. IFRS 8 Operating Segments 6721. IAS 34 Interim financial Reporting 6922. IFRS 13 Fair value Measurement 71

D. CONSOLIDATED FINANCIAL STATEMENTS (Group Accounts) 7323. Consolidated Statement of Financial Position 7324. Consolidated Statement of Profit or Loss 8325. Associates 87

E. MANAGEMENT OF WORKING CAPITAL, CASH AND SOURCES OF SHORT-TERM FINANCE 8926. Cash Management 8927. Short-term finance and cash investment 9328. Working Capital 9529. Working Capital Management 101

F. FUNDAMENTALS OF BUSINESS TAXATION 10930. Taxation 10931. Regulatory Environment and International Taxation Issues 119

Answers to Examples 125

2016 Examinations CIMA F1 1

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A. REGULATORY ENVIRONMENT AND CORPORATE GOVERNANCE

Chapter 1

REGULATORY ENVIRONMENT

1. Regulation of financial reporting information

The financial performance (profit/loss) and position (assets/liabilities) of an incorporated entity are essential parts of a business that need to be understood by the users of the accounts, primarily the shareholders.

Shareholders will need to ensure that the financial performance and position of the entity show useful information. Through regulation of the accounting standards the shareholders will be confident that the information presented to them gives the information needed.

2. Regulatory environment

The key elements of the regulatory environment are

๏ Local corporate law – Accounting regulations must follow the legal requirement of the country where it is registered

๏ Local and international conceptual frameworks – Accounting standards are driven by conceptual frameworks, the fundamental principles/ideas that must be followed in developing accounting standards.

๏ Local and international financial reporting standards – Accounting standards are developed both locally and internationally. Companies will follow either local rules or international rules depending on the local corporate laws.


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3. Sources of professional codes for ethics

Codes of ethics have developed in the accounting profession to ensure that their professional reputation is upheld.

The key to a respected code of ethics is that it must evolve over time as beliefs and principles change in society.

Sources of ethical codes are as follows:

๏ Law

๏ Religion

๏ Social attitudes

๏ Professional bodies

๏ Businesses

4. CIMA Code of Ethics for Professional Accountants

CIMA is a member of the International Federation of Accountants (IFAC), whose aim is to develop a set of high quality principles-based ethical standards that govern ethical behaviour within the accounting profession.

IFAC’s established an ethics committee (International Ethical Standards Board of Accountants (IESBA), which has published the Code of Ethics for Professional Accountants.

CIMA and many other professional bodies have used the principles within this conceptual framework to develop their own code of ethics.

The following are the fundamental principles contained in CIMA’s code of ethics:

1. Integrity

2. Objectivity

3. Professional competence and due care

4. Confidentiality

5. Professional behaviour

4.1. Integrity

A professional accountant should be straightforward and honest in all professional and business relationships.

Integrity also implies fair dealing and truthfulness.

A professional accountant should not be associated with reports, returns, communications or other information where they believe that the information:

๏ Contains a materially false or misleading statement;

๏ Contains statements or information furnished recklessly; or

๏ Omits or obscures information required to be included where such omission or obscurity would be misleading.

4.2. Objectivity

A professional accountant should not allow bias, conflict of interest or undue influence of others to override professional or business judgments.


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Relationships that bias or unduly influence the professional judgment of the professional accountant should be avoided.

4.3. Professional Competence and Due Care

A professional accountant has a continuing duty to maintain professional knowledge and skill at the level required to ensure that a client or employer receives competent professional service based on current developments in practice, legislation and techniques. A professional accountant should act diligently and in accordance with applicable technical and professional standards when providing professional services.

The principle of professional competence and due care imposes the following obligations on professional accountants to:

๏ Maintain professional knowledge and skill at the level required to ensure that clients or Employers receive competent professional service; and

๏ Act diligently in accordance with applicable technical and professional standards when providing professional services.

4.4. Confidentiality

A professional accountant should respect the confidentiality of information acquired as a result of professional and business relationships and should not disclose any such information to third parties without proper and specific authority unless there is a legal or professional right or duty to disclose.

A professional accountants should therefore refrain from:

๏ Disclosing outside the firm or employing organization confidential information acquired as a result of professional and business relationships without proper and spec

๏ Using confidential information acquired as a result of professional and business relationships to their personal advantage or the advantage of third parties.

4.5. Professional behaviour

A professional accountant should comply with relevant laws and regulations and should avoid any action that discredits the profession.

Example 1 – Ethics

Which ONE of the following is NOT a fundamental principle identified in CIMA’s code of ethics?

A Professional competenceB Professional behaviourC IntegrityD Independence


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5. Threats to ethical behaviour

The ethical code identifies five areas that provide a threat to the fundamental principles.

๏ Self-interest – a 'conflict of interest' which may inappropriately influence judgement or behaviour.

๏ Self-review – When you are required to evaluate the results of a previous judgement or service

๏ Advocacy threat – Arising if promoting a position or opinion to the point that your subsequent objectivity is compromised.

๏ Familiarity – When you become so sympathetic to the interests of others as a result of a close relationship that your professional judgement becomes compromised.

๏ Intimidation – When you are deterred from acting objectively by actual or perceived pressure or influence

6. Regulatory bodies

The regulatory bodies ensure that both local and international frameworks and standards are upheld to take account of the ever changing nature of corporate business.

6.1. Financial reporting standards

๏ International Financial Reporting Standards (IFRSs) – A global set of accounting standards that are prepared on international conceptual frameworks

๏ Local Generally Accepted Accounting Principles (Local GAAP) – Accounting standards that are prepared following local conceptual frameworks.

6.2. Principles of financial reporting standards

๏ Principles based – the preparation of the accounting standards follows the principles/idea laid out in the conceptual framework, which results in more judgement in the preparation of the financial statements

๏ Rules based – the preparation of the accounting standards follows rules, as there are no fundamental principles to follow.

6.3. Role and structure of regulatory bodies

IFRSs are developed and published by the International Accounting Standards Board (IASB).

The IASB has 14 members, 12 of whom are full-time employees. Appointment of members is primarily based on their having sufficient technical expertise to ensure the IASB has the experience to tackle the relevant business and economic issues.

Seven of the full-time members of staff are responsible for liaising with national standard-setters in order to promote the convergence of accounting standards.

The IASB has complete responsibility for all technical matters, including the preparation and publication of international financial reporting standards (IFRS) and exposure drafts; withdrawal of IFRSs and final approval of interpretations.


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IFRS Foundation oversees the processes of the IASB. Its objectives are:

๏ Develop a set of high, quality, understandable, enforceable and globally accepted international accounting standards.

๏ Promote the use and application of those standards

๏ Take account of the financial reporting needs of emerging economies and small and medium-sized entities

๏ Bring about convergence on national accounting standards and IFRSs

IFRS Advisory Council will consult with local standard setters, academics and other interested parties to determine their views on a range of issues.

IFRS Interpretations Committee is responsible for reviewing new financial reporting issues and issuing guidance on the application of IFRSs.

As well as the IASB and its associated bodies, other bodies can also influence the setting of IFRSs.

International Organisation of Securities Commissions (IOSCO) – represent the worlds’ securities markets regulators

Financial Accounting Standards Board (FASB) – US accounting standards setting body

6.4. Standard setting process for IFRS

Since 2002 both the FASB and IASB have been working closely to bring together both US GAAP and IFRSs, in what has been known as the Convergence Project.

This has led to the development of several new/updated IFRSs, notably IFRS 9 Financial Instruments and IFRS 13 Fair Value.

The process of developing a new accounting standard follows a four step process.

1. Advisory Committee

2. Discussion Papers

3. Exposure Draft

4. Issue new IFRS

Example 2 – Regulatory bodies

Which ONE of the following would NOT be regarded as a responsibility of the IASB?

A Responsible for all IFRS technical mattersB Publish IFRSsC Overall supervisory body of the IFRS organisationsD Final approval of interpretations by the IFRS Interpretations

Committee


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Chapter 2

EXTERNAL AUDIT AND THE AUDIT REPORT

An audit is an independent review of a company’s financial statements by external auditors

The auditors produce a report to the shareholders that gives their opinion on the financial statements.

1. Powers and duties of the external auditors

The primary duties of the external auditor are to report on truth and fairness and fair presentation of the financial statements.

Fair presentation is taken as being factual, free from bias and reflecting the commercial substance of the business’ transactions.

Auditors will express their opinion that the financial statements are free from material misstatement in their audit report.

In preparing their report the auditors are required to consider the following:

๏ Compliance with legislation

๏ Truth and fairness of accounts

๏ Adequate records and returns

๏ Agreement of accounts to records

๏ Consistency of other information

In order to carry out the duties, the auditors have the following rights:

๏ Access to records

๏ Information and explanation

๏ Attendance at general meetings

๏ Right to speak at general meetings

๏ Rights in relation to written resolutions

๏ Right to require laying of accounts


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2. Content of the audit report

1. Title – addressing the report (usually the shareholders)

2. Introduction – identifying what has been audited. Accounts are often published as part of a larger Annual Report, not all of which is subject to audit

3. Respective responsibilities of directors and auditors – making it clear that directors are responsible for producing the Accounts, whilst auditors are responsible for forming opinions on them

4. Basis of Opinion – explaining how the audit work was done and the opinions reached

5. Opinion – whether the Accounts are true and fair, and whether they have been properly prepared

6. Date and Signature

3. Types of audit opinion

Unmodified

๏ True and fair

๏ Materiality

๏ Emphasis of matter paragraph

Modified

๏ Qualified opinion – arises when there is either a material misstatement of insufficient appropriate audit evidence but it is not pervasive

๏ Adverse opinion – financial statements are not free from material misstatement and therefore do not give a true and fair view

๏ Disclaimer of opinion – insufficient audit evidence and is pervasive.

Emphasis of matter paragraphAn emphasis of matter paragraph draws the attention of the shareholders to a specific event that usually occurs before the end of the year that will not be resolved until after the date that the audit report will be signed.

The event is important so the external auditor needs to highlight it by including an emphasis of matter paragraph in the audit report. This usually goes before the opinion, refers to the note prepared by the directors that is in the financial statement and states that the opinion is not qualified in this respect.


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Example 1 – Audit opinion (1)

The external auditors of AB have completed their year-end audit and disagree with the accounting treatment of a material item in the financial statements. They have concluded that the effect of the issue is material, but not pervasive to the financial statements.

Which ONE of the following audit opinion will the external auditors use for AB’s financial statements?A An unmodified opinionB An adverse opinionC An emphasis of matterD A qualified opinion

Example 2 – Audit opinion (2)

If an external auditor does not agree with the directors’ accounting treatment of a material item in the accounts, the first action they should take is to FORCE/PERSUADE the directors to change the accounting treatment of the item in the accounts.

Delete as appropriate.


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Chapter 3

CORPORATE GOVERNANCE

Directors are acting as agents of the entity as they run the business on behalf of the shareholders.

Shareholders need to ensure that the systems and processes that are in place to control the running of the entity are regularly monitored and controlled.

Corporate governance is the process that ensures the systems and processes are monitored and controlled.

Corporate Governance has come to the attention of many over recent years following major corporate scandals.

๏ Enron

๏ WorldCom

๏ Co-Operative Group

๏ Volkswagen Group

All of the above corporate scandals came about due to inappropriate corporate governance in place.

1. Approach to Corporate Governance

Principles based

๏ Focuses on the objectives

๏ Can be applied across different legal jurisdictions

๏ Can stress areas where rules cannot easily be applied

๏ Puts the emphasis on investors making up their own minds.

Rules based

๏ Emphasises measurable achievements by companies

๏ Can easily be applied in jurisdictions where the letter of the law is stressed.

2. Corporate governance regulation in different markets

UK – voluntary code based upon principles of openness, integrity and accountability that has developed to include some specific guidelines, whereby if there is no compliance then explanations for non-compliance are required.

US – a rules based approach as the culture is on obeying the letter of the law and therefore the code becomes part of legislation.


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B. FINANCIAL ACCOUNTING AND REPORTING

Chapter 4

CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING

1. The role of the framework

The role of the framework is to:

๏ Assist the IASB in its development of future accounting standards and in its review of existing accounting standards

๏ Assist the IASB by providing a basis for reducing the number of alternative accounting treatments permitted by law and accounting standards

๏ Assist preparers of financial statements in applying accounting standards and in dealing with topics that do not form the subject of an accounting standard

๏ Assist auditors in forming an opinion as to whether financial statements conform with accounting standards

๏ Help users of financial statements to interpret the information contained in financial statements prepared in conformity with accounting standards

๏ Provide those who are interested in the work of the IASB with information about its approach to the formulation of accounting standards.

The framework is not itself an accounting standard nor can it override the requirements of any existing accounting standard.

2. The objective of financial statements

To provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making decisions.

3. Underlying assumption

Going concern – the financial statements are prepared on the basis that an entity will continue in operation for the foreseeable future.


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4. Fundamental qualitative characteristics of financial statements

๏ Relevance – to be useful, information must be relevant to the decision making needs of the user. Information is relevant if it is material (size and nature).

๏ Faithful Representation – to be useful must faithfully represent the phenomena that it purports to represent, which is only possible if accounted for substance and economic reality.

‣ Neutral – free from bias‣ Complete – includes all necessary information, descriptions and explanations.‣ Free from error – in the descriptions and processes the financial information is

produced

5. Enhancing qualitative characteristics

๏ Understandability – assuming users have a reasonable knowledge of business and a willingness to study information with reasonable diligence, the financial statements should be readily understandable to users.

๏ Comparability – users must be able to compare the financial statements of an entity from period to period and from company to company

๏ Timeliness - Information produced quickly makes it more useful as a basis for current decisions.

๏ Verifiability - Information needs to be supported by representation (either written or verbal) to allow us to confirm its validity.

6. The elements of financial statements

๏ Asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise.

๏ Liabilities are an entity’s obligations to transfer economic benefits as a result of past transactions or events.

๏ Equity is the residual amount found by deducting all liabilities of the entity from all of the entity’s assets.

๏ Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from equity participants.

๏ Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.


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7. Recognition of the elements of financial statements

To recognise an element of the financial statements it must meet all three of the following criteria:

๏ Probable future economic benefit will flow to or from the entity

๏ The item can be measured reliably

8. Measurement of the elements of financial statements

๏ Historical cost – cash price or fair value at acquisition or obligation. Most commonly used but widely criticised

๏ Current cost – what would be the cash price today

๏ Realisable value – what could be realised/satisfied today

๏ Present value – discounted future cash flows

Example 1 – Framework (1)

The International Accounting Standards Board (IASB) Framework for the Preparation and Presentation of Financial Statements (Framework) is the IASB’s conceptual framework.

Which one of the following does the Framework not cover?A The format of financial statementsB The objective of financial statementsC Concepts of capital maintenanceD The elements of financial statements

Example 2 – Framework (2)

The IASB’s Framework identifies faithful representation as one of its fundamental qualitative characteristics of financial information.

Which one of the following is not an element of faithful representation?A Information should be timelyB Information should be free from material errorC Information should be free from biasD Information must be complete


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C. ACCOUNTING STANDARDS

Chapter 5

IAS 1 PRESENTATION OF FINANCIAL REPORTING

IAS 1 sets out overall requirements for the presentation of financial statements, guidelines for their structure and minimum requirements for their content.

Financial statements will present to the users of accounts:

๏ Statement of financial position

๏ Statement of profit or loss and other comprehensive income

๏ Statement of changes in equity

๏ Statement of cash flows

๏ Notes to the accounts

๏ Comparatives

Financial statements should provide a fair presentation of the results, which is achieved by compliance with IFRSs.


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Statement of financial position as at [date]$’000s $’000s

ASSETSNon-current assetsProperty, plant and equipment XIntangibles XInvestments X

XCurrent assetsInventories XTrade and other receivables XCash and cash equivalents X

XTotal assets X

EQUITY AND LIABILITIESEquityEquity shares ($1) XShare premium XIrredeemable preference share capital XRevaluation surplus XRetained earnings XTotal equity X

Non-current liabilitiesRedeemable preference share capital XBorrowings X

XCurrent liabilitiesTrade and other payables XDividends payable XOverdraft XTax payable X

XTotal equity and liabilities X


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Statement of profit and loss and other comprehensive income for the year ended [date]

$’000sRevenue XCost of sales (X)Gross profit XDistribution expenses (X)Administrative expenses (X)Profit before interest and tax XFinance costs (X)Investment income XProfit before tax XIncome tax expense (X)Profit for the year X

Other comprehensive incomeGain on non-current asset revaluations X

Total comprehensive income for the period X


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Statement of changes in equity for the year ended [date]

Equity shares

Share premium

Revaluation surplus

Retained earnings

Total

$’000s $’000s $’000s $’000s $’000sB/f X X X X XIssue of share capital X X - - XDividends - - - (X) (X)Total comprehensive income for the year - - X X X

Transfer to retained earnings - - (X) X -C/f X X X X X


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Chapter 6

IAS 7 STATEMENT OF CASH FLOWS

Statement of cash flows for the year ended [date]$m $m

Operating Activities Profit before tax X Depreciation X Impairment X Gain/loss on disposal of PPE (X)/X Finance cost X Inventory (X)/X Receivables (X)/X Payables X/(X)Cash generated from operations X Interest paid (X) Tax paid (X)Cash generated from operating activities XInvesting Activities Proceeds from sale of PPE X Purchase of PPE (X) Dividends received XCash generated from investing activities XFinancing Activities Proceeds from issue of shares X Loan issue/repayment X/(X) Dividend paid (X)Cash generated from financing activities X

Change in cash and cash equivalents X/(X)Opening cash and cash equivalents XClosing cash and cash equivalents X


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1. Cash and cash equivalents

Cash – Cash on hand and demand deposits

Cash equivalents – Short term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.

Example 1 – Cash and cash equivalents

Statement of financial position at 31 December 20X5 (extract)

20X5$’000

20X4$’000

Current assetsGovernment bonds 1,200 1,000Cash 400 -

Current liabilitiesOverdraft - 150

Calculate the movement in cash and cash equivalents


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2. Operating activities

The principal revenue producing activities of the entity and other activities that are not investing or financing activities.

IAS 7 allows two methods to calculate the cash generated from operations.

๏ Direct method – using nominal ledger T-accounts

๏ Indirect method – using the financial statements

2.1. Direct method

$000Cash received from customers XCash payments to suppliers and employees X

Cash from operating activities X

Example 2 – Direct method

Extracts from a company’s general ledger show the following information:

$’000Sales for the year 4,700Purchases for the year 3,300Wages and salaries 580Other operating expenses 430Receivables @ start year 400Receivable @ year-end 500Payables @ start year 300Payables @ year-end 450

Calculate the cash from operating activities to appear in the company’s statement of cash flows.


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2.2. Indirect method

$000Profit before taxation XDepreciation XInvestment income (X)Finance cost XIncrease in inventories (X)Increase in receivables (X)Increase in payables

X

Cash from operating activities X

Example 3 – Indirect method

Statement of profit or loss (extract) for the year-ended 31 December 20X5

$’000Profit before interest and tax 3,200Finance cost (500)Investment income 150Profit before tax 2,850Income tax (350)Profit for the year 2,500

Statement of financial position (extract) as at 31 December 20X5

20X5 20X4$’000 $’000

Current assetsInventory 6,500 7,200Receivables 4,300 3,900Cash 250 500

Current liabilitiesTrade payables 5,200 6,500

Depreciation for the year was $850,000.

Calculate the cash from operating activities to appear in the company’s statement of cash flows.


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2.3. Interest and tax paid

Interest payableInterest payableInterest payableInterest payableInterest payableInterest payableInterest payableB/f X

Bank (β) X Finance cost (SPL) X

C/f X

X X

Tax payableTax payableTax payableTax payableTax payableTax payableTax payableB/f – current tax X

Bank (β) X Tax expense (SPL) X

C/f – current tax X

X X

Example 4 – Interest/tax paid

Statement of profit or loss (extract) for the year-ended 31 December 20X5

$’000Profit before interest and tax 3,200Finance cost (500)Investment income 150Profit before tax 2,850Income tax (350)Profit for the year 2,500


20X5$’000

20X4$’000

Current liabilitiesTrade payables 5,200 6,500Tax payable 180 210Interest payable 120 90

Calculate the interest paid and tax paid to appear in the company’s statement of cash flows.


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3. Investing activities

The acquisition and disposal of non-current assets (PPE, intangibles and investments)

3.1. Disposal of PPE

Profit/loss on disposal = Proceeds − Carrying value

Example 5 – Profit or loss on disposal

DBA disposed of a piece of plant and equipment in the year for $250,000 with a carrying value of $225,000.

Show how this would be presented in the statement of cash flows for DBA.

3.2. Acquisition of PPE

PPE (CV)PPE (CV)PPE (CV)PPE (CV)PPE (CV)PPE (CV)PPE (CV)B/f X

Depreciation XRevaluation X

Disposal XCash - additions (β)

C/f X

X X

Example 6 – Acquisition of PPE


20X5$’000

20X4$’000

Non-current assetsProperty, plant and equipment 13,200 12,500

EquityRevaluation surplus 500 150

Additional information:

1. Depreciation of $850,000 has been charged in the year

2. An item of machinery was disposed of for $120,000 with a carrying value of $100,000

Calculate the cash outflow for the purchase of property, plant and equipment to appear in the statement of cash flows.


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3.3. Interest received

Interest receivableInterest receivableInterest receivableInterest receivableInterest receivableInterest receivableInterest receivableB/f X

Interest income (SPL) X Bank (β) X

C/f X C/f X

X X

4. Financing activities

Activities that result in changes in the size and composition of the contributed equity and borrowings of the entity

Debt

Issue of debt = increase in borrowings

Repayment of debt = decrease in borrowings

Equity

Issue of shares = movement in share capital and share premium

Dividend paid

Retained earningsRetained earningsRetained earningsRetained earningsRetained earningsRetained earningsRetained earningsB/f X

Dividend paid (β) X PFY (SPL) X

C/f X

X X


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Example 7 – Statement of cash flows

Statement of profit or loss for the year ended 31 December 20X5

$000Revenue 360Cost of sales and other expenses 150Profit from operations 210Finance costs 14Profit before tax 196Income tax expense 62Profit after tax 134

Statement of financial position as at 31 December 20X531 December 20X531 December 20X5 31 December 20X431 December 20X4

$000 $000 $000 $000Non-current assets Cost 798 780 Depreciation 159 112

639 668Current assets Inventory 12 10 Trade receivables 34 26 Bank 24 70 28 64

709 732

Share capital 180 170Share premium 18 12Retained earnings 343 245

541 427Non-current liabilities Bank loan 100 250

Current liabilities Trade payables 21 15 Income tax 47 68 40 55

709 732


1. During the year, the company paid a dividend of $36,000

2. Included within expenses are a loss on disposal of $9,000 and depreciation of $59,000

3. Property, plant and equipment includes $45,000 for the purchase of a new piece of machinery

Prepare a statement of cash flow for the year ended 31 December 20X5 in accordance with the requirements of IAS 7.


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Chapter 7

IAS 16 PROPERTY, PLANT AND EQUIPMENT

Property plant and equipment are tangible items that are:

๏ Held for use in the production or supply of goods or services, for rental to others, or for administrative purposes, and

๏ Expected to be used during more than one period.

1. Initial Recognition

The cost of an item of property, plant and equipment is made up of:

๏ Purchase price, including irrecoverable taxes and after deducting trade discounts (not cash/settlements discounts)

๏ Costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management (e.g. site preparation, delivery and handling costs, installation and assembly, testing, professional fees)

Note: Initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located where a present obligation exists are included in the cost of the asset at present value.

The following costs are not included in the cost of an item of property, plant and equipment:

๏ Costs that are incidental to the construction (e.g. errors)

๏ Start-up costs

๏ General overhead costs

๏ Initial losses before the asset reaches its intended use


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Example 1 – Initial recognition

Jones purchases a machine that had a list price of $100,000 but was offered a trade discount of 10%.

A further settlement discount of 5% is available if payment is made within 15-days.

Jones also incurred the following charges in getting the asset ready for its intended use:

$Shipping & handling charges 3,500Pre-production testing 12,000Site preparation costs 17,000General overheads 4,500

Included in the site preparation costs is $3,000 which is as a result of Jones providing incorrect requirements for the asset.

Calculate the initial cost of the machine to be recorded in accordance with IAS 16 Property, plant and equipment.

2. Subsequent Expenditure

Subsequent expenditure on property, plant and equipment should only be capitalised if it improves the asset beyond its originally assessed standard of performance e.g. faster production or higher quality output. All other subsequent expenditure should be written off.

Separate components, inspection and overhaul costs

If items of property, plant and equipment comprise separate components with different useful lives the separate components should be capitalised as separate assets and each depreciated over their useful lives.

Normally all inspection and overhaul costs are expensed as they are incurred. However, to the extent that they satisfy the IAS 16 rules for separate components, such costs should be capitalised separately as a non-current asset and depreciated over their useful lives.


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3. Depreciation

๏ Straight line

๏ Reducing balance

Depreciation starts when the asset is ready for its intended use and not from when it starts to be used.

Any change in estimate is applied prospectively by applying the new estimates to the carrying value of the PPE at the date of change.

Example 2 – Change in useful life

Ecuador bought an item of property, plant and equipment for $25 million on 1 January 2012 and depreciated over its useful life of 10 years.

On 31 December 2014, the assets remaining life was estimated as 5 years.

Calculate the amounts to shown in the financial statements of Ecuador for the year-ended 31 December 2015.

Example 3 – Change in method

A lorry was purchased for $80,000 on 1 January 20X4 when its useful life was estimated to be ten years with a residual value of $10,000. The depreciation policy of 20% reducing balance was selected.

On 1 January 20X9 the directors have now decided that to give a fair presentation a depreciation policy of straight line over the useful economic life should be followed. There has been no change in the estimated useful economic life of the asset as a result.

What would be the depreciation charge for the year ended 31 December 20X9?


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4. Subsequent measurement

Revaluations

Cost Model

Carried at cost less accumulated depreciation

and impairment losses

Revaluation Model

Carried at revalued amount(fair value less accumulated

depreciation and impairment losses)

๏ Review periodically and keep revaluations up to date

๏ Consistent policy for each class of asset (avoids cherry-picking of assets)

๏ Revalue at fair value

๏ Depreciate the revalued asset less residual value over its remaining useful life

5. Accounting for a revaluation

Dr Non-current assets cost/valuation

Dr Accumulated depreciation

Cr Other comprehensive income

The figure posted to the revaluation surplus can be calculated quickly as follows:

Note: A company has the option to make an annual reserve transfer for any excess depreciation charged as a result of the revaluation.

Dr Revaluation surplus

Cr Retained earnings

Example 4 - Revaluation

Charlie bought a building on 1 January 20X5 for $500,000 with an estimated useful economic life of twenty five years and no residual value. A straight line method of depreciation was adopted.

On 1 January 20X7 Charlie decided to revalue all non- current assets in line with IAS 16. The building was revalued at $600,000. The useful economic life is unchanged.

Show how the revaluation would be accounted for in the financial statements for the year ended 31 December 20X7.


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6. Disposal of a previously revalued asset

The profit or loss on disposal is calculated as previously and any gains held in reserves are transferred to retained earnings in the statement of changes in equity.

Dr Revaluation surplus

Cr Retained earnings

Example 5 – Disposal of revalued asset

William bought a building on 1 January 20X5 for $400,000 with an estimated useful economic life of twenty five years and no residual value. A straight line method of depreciation was adopted.

On 1 January 20X7 William decided to revalue all non-current assets in line with IAS 16. The building was revalued at $500,000. The useful economic life is unchanged.

On 1 January 20X9 William disposed of the oven for $550,000.

Calculate the profit or loss on disposal of the building at 1 January 20X9 and record the journal entry for the previously held gains to be transferred within reserves.


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Chapter 8

IAS 23 BORROWING COSTS

Borrowing costs, net of income received from the investment of the money borrowed, on a qualifying asset must be capitalised over the period of construction.

Capitalisation starts when:

๏ Expenditure on the asset commences

๏ Borrowing costs are being incurred

๏ Activities necessary to prepare the asset are in progress

Capitalisation must stop when the asset is ready for its use (whether or not it is being used) or when there is no active construction.

Capitalisation for specific borrowings is capitalised using the effective rate of interest.

Example 1– Specific borrowings

Columbia commenced the construction of an item of property, plant and equipment on 1 March 2015 and funded it with a $10 million loan. The rate of interest on the borrowings was 5%.

Due to a strike no construction took place between 1 October and 1 November.

Calculate the amount of interest to be capitalised as part of the non-current assets.

Example 2 – General borrowings

Venezuela had the following bank loans in issue during 2015.

$m

4% bank loan 253% bank loan 40

Venezuela commenced the construction of an item of property, plant and equipment on 1 January 2015 for which it used its existing borrowings. $10 million of expenditure was used on 1 January and $15 million was used on 1 July.

Calculate the amount of interest to be capitalised as part of the non-current assets.


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Chapter 9

IAS 20 GOVERNMENT GRANTS

Recognise the grant when the:

๏ Entity will comply with the conditions attached to the grant

๏ Entity will actually receive the grant

Grants should be recognised according to the deferred income approach, using a systematic basis. This spreads the income over the period in which the related expenditure is recognised.

If the grant is used to buy depreciating assets, the grant must be spread over the same life and using the same method.

Example 1 – Grants and depreciable assets

Tweddle bought an item of property, plant and equipment for $10 million and received a government grant of $2 million. The PPE has a useful life of 10 years and has no residual value.

Explain how the purchase of the property, plant and equipment and government grant would be dealt with in the financial statements of Tweddle.

Note: If a government grant becomes repayable, it is treated as a change in accounting estimate. The payment is first shown against any remaining deferred income balance. If the payment exceeds the deferred income balance then the excess payment is treated as an expense.


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Chapter 10

IAS 40 INVESTMENT PROPERTIES

Investment property is property (land or a building – or part of a building – or both) held) to earn rentals or for capital appreciation or both, rather than for:

๏ Use in the production or supply of goods and services or for administrative purposes (IAS 16); or

๏ Sale in the ordinary course of business (IAS 2); or

๏ Future use as an investment property (IAS 16 until completed)

Initial measurementInvestment properties should initially be measured at cost plus directly attributable costs.

Subsequent measurementFair value model Cost model

๏ The investment properties are revalued to fair value at each reporting date

๏ Gains or losses on revaluation are recognised directly through profit or loss

๏ The properties are not depreciated

๏ The investment properties are held using the benchmark method in IAS 16 (cost)

๏ The properties are depreciated like any other asset

Transfers into and out of investment property should only be made when supported by a change of use of the property.

๏ IP to owner occupied (IAS 16) – Fair value at date of change

๏ IP to inventory (IAS 2) – Fair value at date of transfer

๏ Owner occupied (IAS 16) to IP – Revalue under IAS 16 and then treat as IP

๏ Inventory (IAS 2) to IP – Fair value on change and gain/loss to profit or loss

Example 1 – Investment property and change of use

Addlington owns a property that it is using as its head office. At 1 January 2015, its carrying value was $20 million and its remaining useful life was 20 years. On 1 July 2015 the business was reorganised cheaper premises were found for use as a head office. It was therefore decided to lease the property under an operating lease.

The property was valued by a qualified professional, who assessed the property’s value as $21 million on 1 July and $21.6 million on 31 December 2015.

Explain the accounting treatment of the property in the financial statements for the year-ended 31 December 2015.


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Chapter 11

IAS 38 INTANGIBLE ASSETS

An identifiable, non-monetary asset with no physical substance but has value to the business.

๏ patents

๏ brand names

๏ licences

3 factors to consider

Identifiability

i.e. can sell separately

RecognitionControl

Framework

IAS 38

Separate acquisitionCapitalise at cost (purchase price, import duties and non-refundable purchase taxes less any trade discounts) plus any directly attributable costs (e.g. legal fees, testing costs). Amortisation is charged over the useful life of the asset, starting when it is available for use.

ResearchResearch expenditure is charged immediately to profit or loss in the year in which it is incurred.

DevelopmentDevelopment expenditure must be capitalised when it meets all the criteria.

๏ Sell/use

๏ Commercially viable

๏ Technically feasible

๏ Resources to complete

๏ Measure cost reliably (expense)

๏ Probable future economic benefits (overall)

Internally generatedInternally generate brands, mastheads cannot be capitalised as their cost cannot be separated from the overall cost of developing the business.


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RevaluationsAn intangible asset can only be revalued if there exists an active market.

An active market is one where the following conditions are all met:

๏ The items traded are homogenous

๏ Willing buyers and sellers can normally be found at any time

๏ Prices are available to the public

AmortisationIf an intangible has a finite life then it should be amortised over its useful economic life.

Residual value is normally assumed to be zero unless there is a commitment from a buyer or an active market exists.

An intangible could be considered to have an indefinite useful life if there is no foreseeable limit to the period over which the asset is expected to generate net cash flows for the entity. It will therefore be subject to annual impairment reviews.

Example 1 – Intangibles

GKS is a large pharmaceutical business involved in the research and development of viable new drugs. It commenced initial investigation into the viability of a new drug on 1 February 20X5 at a cost of $40,000 per month. On 1 August 20X5 GSK were able to demonstrate the commercial viability of the new drug and intend to sell it on the open market once fully complete.

Costs subsequent to 1 August 20X5 remained at $40,000 per month. At 31 December 20X5, GSK’s reporting date, the drug was not yet complete but it is believed that by mid-20X6 the drug will be available for sale.

The finance director is confident of the success of the drug’s sales that he wishes to revalue the intangible at the reporting date, using a discounted future cash flow model to establish the fair value.

Explain the treatment of the above costs in GSK’s financial statements for the year-ended 31 December 20X5.

Intangibles and business combinationsIf an intangible asset is acquired in a business combination (i.e. acquisition of a subsidiary, that has a previously unrecognised internally generated brand), the cost of that intangible asset is recognised at fair value in the consolidated financial statements.

If a fair value cannot be established the intangible is not recognised separately and becomes part of the overall goodwill established on acquisition of the subsidiary..


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Chapter 12

IAS 36 IMPAIRMENT OF ASSETS

1. Identify possible impairments (external vs. internal)

2. Perform impairment review (if identified possible impairments)

3. Record the impairment

1. Indicators of Impairment

External sources

๏ A significant decline in the asset’s market value more than expected by normal use or passage of time

๏ A significant adverse change in the technological, economic or legal environment

Internal sources

๏ Obsolescence or physical damage

๏ Significant changes, in the period or expected, in the way the asset is being used e.g. asset becoming idle, plans for early disposal or discontinuing/ restructuring the operation where the asset is used

๏ Evidence that asset’s economic performance will be worse than expected

๏ Operating losses or net cash outflows for the asset

๏ Loss of key employee


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2. Impairment review

If the carrying value of the asset is greater than its recoverable amount, it is impaired and should be written down to its recoverable amount.

Recoverable amount - the greater of fair value less cost to sell and value in use.

Fair value less costs to sell - the amount receivable from the sale of the asset less the costs of disposal.

Value in use - the present value of the future cash flows from the asset.

Example 1 - Impairment

A machine was acquired on 1 January 20X5 at a cost of $50,000 and has a useful economic life of ten years.

At 31 December 20X9 an impairment review was performed. The fair value of the machine is $26,000 and the selling costs are $2,000.

The expected future cash flows are $5,000 per annum for the next five years. The current cost of capital is 10%. An annuity factor for this rate over this period is 3.791

Prepare extract from the financial statement for the year-ended 31 December 20X9.

3. Record the impairment

Individual assetThe reduction in carrying value is taken through profit or loss unless related to a revalued asset, in which case it is taken to any revaluation surplus first.

Once the impairment has been accounted for the recoverable amount is then depreciated over the remaining useful economic life.

Cash generating unit (CGU)It is not always possible to allocate cash flows to an individual asset. To overcome this problem a cash generating unit can be used.

A cash generating unit is the smallest identifiable group of assets that cash flows can be allocated to. This could include intangible assets like goodwill as well as tangible and other assets.

1. Specific assets

2. Goodwill

3. Remaining assets (pro-rata)

Note: No single asset in the CGU should be reduced below its recoverable amount.


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Example 2 – Impairment (GCU)

Siobhan fully owns a company called Harry. Extracts from Siobhan’s statement of financial position relating to Harry are as follows:

$000Goodwill 90,000Franchise costs 50,000Restored furniture (at cost) 90,000Buildings 100,000Other net assets 50,000

370,000

The restored furniture has an estimated realisable value of $115 million. The franchise agreement contains a ‘sell back’ clause, which allows Harry to cease using the franchise and receive a repayment of $30 million from the franchisor. An impairment review at 31 March 20X5 has estimated that the value of Harry as a going concern is only $250 million.

Demonstrate how the impairment would be accounted for in the financial statements.


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Chapter 13

IFRS 5 NON-CURRENT ASSETS HELD FOR SALE AND DISCONTINUED OPERATIONS

1. Non-current assets held for sale

Must be available for immediate sale and sale must be highly probable (sell < 1 year, active programme to locate buyer, actively marketing).

Non-current asset held for sale is valued at the lower of the carrying value and fair value less costs to sell. Any reduction in value is recorded as an impairment through profit or loss.

IFRS 5

Cost Model Revaluation Model

Asset is revalued to fair value immediately before classification as held for sale

๏ Once classified as a non-current asset held for sale it is no longer depreciated.

๏ The subsequent sale of the asset will give rise to a profit/loss on disposal.

Example 1 – NCA-HFS

At 1 January 2014, Namibia carried a property in its statement of financial position at its revalued amount of $14 million in accordance with IAS 16 Property, Plant and Equipment. Depreciation is charged at $300,000 per year on the straight line basis.

In April 2014, the management decided to sell the property and it was advertised for sale. By 31 April 2014, the sale was considered to be highly probable and the criteria for IFRS 5 Non-current Assets Held for Sale and Discontinued Operations were met at this date. At that date, the asset’s fair value was $15·4 million. Costs to sell the asset were estimated at $300,000.

On 31 January 2015, the property was sold for $15·6 million.

Explain how the above transaction should be dealt with in the financial statements of Namibia for the year-ended 31 December 2014 and 31 December 2015.


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2. Discontinued operations

Disclosure

P or LPFY → face

Revenue, expenses, pre-tax profit, tax expense → face or notes

SFPFully disposed of → none

Not fully disposed of → ‘assets held for sale’

SCFNet cash flows → face or notes

Discontinued

Disposed of in the year Held for sale

Disclose in year of disposal

Disclose in year held for sale

Definition๏ Disposed of, or๏ Held for sale, and:

Separate major line of business or geographical

area of operations

Is a subsidiary acquired exclusively with a view to re-sale

Single co-ordinated plan to dispose of a

separate line of business/geographical

area

IFRS 5Discontinued Operations

Definition DisclosureWhen discontinued


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Statement of profit or loss for the year-ended [date]$’000

Continuing operationsRevenue XCost of sales (X)Gross profit XDistribution costs (X)Administration expenses (X)Operating profit XFinance costs (X)Profit before tax XIncome tax expenses (X)Profit for the period from continuing operations X

Discontinued operationsProfit for the period from discontinued operations* XTotal profit for the period X

* Detail given in the notes

Example 2 – Discontinued operations

Angola’s car manufacturing operation has been making substantial losses. Following a meeting of the board of directors, it was decided to close down the car manufacturing operation on 31 March 20X6. The company’s reporting date is 31 December and the car manufacturing operation is treated as a separate operating segment.

Explain how the decision to close the car manufacturing operation should be treated in Angola’s financial statements for the years ending 31 December 20X5 and 20X6.


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Chapter 14

IAS 19 EMPLOYEE BENEFITS

๏ Short-term benefits

๏ Long-term benefits

๏ Post-employment benefits

1. Pensions

๏ Defined Contribution Scheme (money purchase)

This does not present any accounting problems as the income statement charge will equal the contributions payable into the scheme.

Contributions are accrued in the financial statements with an expense recognised in profit or loss.

๏ Defined Benefit Scheme (final salary)

At any point in time (usually each year) we need to know the value of the scheme so that we can decide whether or not it is worth enough (i.e. the assets will be enough to cover the liabilities.)

Statement of financial position (extract)

$mFair value of scheme assets XFair value of scheme liabilities (X)Net pension asset/(liability) X/(X)

The valuation of a defined benefit scheme will be carried out by an actuary who will decide if the scheme is in surplus (net pension asset) or deficit (net pension liability)

This is done by making a number of assumptions:

๏ Level of investment return

๏ Number of leavers

๏ Number of new members

๏ Number of people who die

As time goes by the actual outcome will not be the same as the assumed outcome.

The differences are known as actuarial differences (remeasurement component).


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Statement of profit or loss and other comprehensive income (extract)

$mProfit or lossOperating costs Current service costs (X) Past service costs (X)

Financing costs Interest expense (X) Return on investment X

Other comprehensive incomeRe-measurement gain/(loss) (W) X/(X)

๏ Current service cost – increase in the value of the scheme liabilities as a result of employee service during the period.

๏ Past service cost – increase in the value of the scheme liabilities as a result of employee service in previous periods.

๏ Interest cost – represents the unwinding of the discount factor- the nearer you get to paying off a liability the bigger it gets.

๏ Return on investment – this is the interest or dividends receivable on the pension fund assets.

Note: Actuarial differences are recognised in other comprehensive income, hence no impact on profit or loss.

Workings

Assets $m Liabilities $m

Opening X Opening X

Return on investment X Interest X

Contributions paid in X Service costs X

Benefits paid out (X) Benefits paid out (X)

Expected X Expected X

Re-measurement component (β) X/(X) Re-measurement component (β) X/(X)

Closing (per actuary) X Closing (per actuary) X


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Example 1 – Defined benefit scheme

Finland operates a defined benefit pension scheme for all of its employees. The closing balances on the scheme assets and liabilities, at 31 December 2014, were $60 million and $64 million respectively.

Finland’s actuary has provided the following information that has yet to be accounted for in the year-ended 31 December 2015.

$m

Current service cost 9Past service cost 8Contributions paid in 5Benefits paid out 6

Fair value of plan asset 66Fair value of plan liabilities 75

Yield on high quality corporate bonds 5%

Calculate the amounts that will appear in the financial statements of Finland for the year-ended 31 December 2015.

2. Curtailment

A curtailment occurs when there are a significant number of employees who leave the scheme, commonly seen if there is a re-organisation of the business or change in scheme from defined benefit to defined contribution.

The asset and liability are re-measured to fair value and any change is taken to profit or loss.

Example 2 – Curtailment

Flannagan announces the re-organisation of its business, resulting in the loss of jobs within the business.

The fair value of the plan assets and liabilities, immediately before the re-organisation, were $48 million and $60 million respectively.

The plan assets do not change following the curtailment but the pension liabilities are measured at $55 million.

Explain the accounting treatment of the curtailment in the financial statements.


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3. Asset ceiling

If a company has an overall pension asset on its statement of financial position then the asset can only be recognised up to the level of the asset ceiling. The asset ceiling is the present value of any future cash savings of not having to contribute to the scheme as it is in surplus. If the asset needs to be reduced to the asset ceiling limit then the reduction in the asset is shown as an expense in profit or loss.

Example 3 – Asset ceiling

Brannagan has a net pension asset in its statement of financial position of $30 million. It therefore anticipates that it will not have to pay its usual contributions into the scheme for the next few years. It is estimated that the present value of the future reduction in contributions will be $26 million.

Explain how the net pension asset will be treated in the financial statements.


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Chapter 15

IAS 21 FOREIGN CURRENCY TRANSACTIONS

If an entity has foreign currency transactions then the amount will need to be translated into the functional currency before it is recorded within the general ledger.

The functional currency is the currency of the primary economic environment in which the entity operates. This is deemed to be where the entity generates and expends cash.

Management should consider the following factors in determining the functional currency:

๏ The currency that dominates the determination of the sales prices

๏ The currency that most influences operating costs

๏ The currency in which an entity’s finances are denominated is also considered.

Individual company accountsRecord the transaction at the exchange rate in place on the date the transaction occurs.

Monetary assets and liabilities are retranslated using the closing rate at the reporting date, with any gains or losses going through profit or loss.

Non-monetary assets and liabilities are not retranslated at the reporting date, unless carried at fair value, whereby translate at the rate when fair value was established.

Note: No specific guidance is given as to where any exchange differences are recorded within profit or loss. The general accepted practice is:

๏ Trading transaction – operating costs

๏ Financing transaction – financing costs

Example 1 – Functional currency

Jones Inc. has its functional currency as the $USD. It trades with several suppliers overseas and bought goods costing 400,000 Dinar on 1 December 20X5. Jones paid for the goods on 10 January 20X6. Jones’s year-end is 31 December. The exchange rates were as follows:

1 December 20X5 4.1 Dinar : $1USD31 December 20X5 4.3 Dinar : $1USD10 January 20X6 4.4 Dinar : $1USD

Show how the transaction would be recorded in Jones’s financial statements.


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Chapter 16

IAS 10 EVENTS AFTER THE REPORTING PERIOD

IAS 10

Adjusting

Information relating to a condition that existed at the reporting date

๏ Settlement of outstanding court case

๏ Bankruptcy of a customer

๏ Sale of inventory at below cost

๏ Determination of purchase/sale price of PPE

Non-adjusting

Doesn’t reflect conditions that existed at the reporting date

๏ Fall in value of investments

๏ Major purchase of assets

๏ Announcing a discontinued operation

๏ Announcing a restructuring

Disclose nature and financial effect if MATERIAL

Example 1 – Events after the reporting period

The following events took place between the 31 December 20X5 reporting date and the date the financial statements were authorised for issue.

1. The company makes an issue of 100,000 shares which raises $200,000 shortly after the Statement of Financial Position date.

2. A legal action had been brought against the company for breach of contract prior to the year end. The outcome was decided shortly after the Statement of Financial Position date, and as a result the company will have to pay costs and damages totalling $80,000. No provision has currently been made for this event.

3. Inventory included in the accounts at the year end at cost $25,000 was subsequently sold for $15,000.

4. A building in use at the Statement of Financial Position date and valued at $500,000 was completely destroyed by fire. Unfortunately, only half of the value was covered by insurance. The insurance company has agreed to pay $250,000 in accordance with the company’s policy.

Explain how each of the above items should be treated in the financial statements for the year ended 31 December 20X5.


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Chapter 17

IAS 2 INVENTORIES

Measure @ lower of

CostCosts incurred in bringing inventory to its present condition and location

๏ Materials

๏ Labour

๏ Manufacturing overheads (based on normal output)

๏ Transport costs

๏ Irrecoverable taxes

Costs specifically excluded include:

๏ Abnormal costs

๏ Storage costs

๏ Administration costs

๏ Selling expenses

NRV

Selling price XLess:

Costs to complete (X)Costs of selling (X)NRV X

Line-by-line basis

Example 1 – Inventory Valuation

Neil paid $3 per unit for the raw materials of its products. To complete each unit incurred $2 per unit in direct labour.

Production overheads for the year based on normal output of 12,000 units was $72,000.

Due to industrial action only 10,000 units were produced and 1,000 units were in inventory at the end of the year.

As a result of the industrial action some units were badly stored and became damaged. It’s is estimated that 200 of the units will now only be sold for $12 each after minor repairs of $2 each

What figure for closing inventory would be shown in the Statement of Financial Position?


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Chapter 18

IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS

IAS 8

Accounting Estimates Prior Period ErrorsAccounting Policies

1. Accounting policies

The specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting the financial statements.

Selection

Apply the standard that specifically deals with the transaction

Apply a policy that gives relevant and reliable information

๏ Standard of a similar item

๏ IASB Framework definitions

Change in accounting policy

New IFRS Apply a new policy that gives more relevant and reliable information

Follow treatment given in new IFRS Voluntary change

Retrospective application

๏ Adjust b/f figures

๏ Restate comparatives


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2. Accounting estimates

Changes in accounting estimate are recognised prospectively:

๏ Period of change

๏ Period of change and future periods

Example 1 – Accounting Estimates

If a company decides to change its method of depreciation from straight line method to reducing balance method.

If a company decides to change from capitalising finance costs to immediate write off.

Would the following be a change in accounting policy or revision of an estimate?

3. Prior period error

Accounting errors (omissions and misstatements) include:

๏ Errors in applying accounting policies

๏ Oversights

๏ Fraud and the effects of fraud

Material errors are corrected retrospectively, the same as for a change in accounting policy.


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Chapter 19

IAS 12 INCOME TAXES

1. Current tax

Current tax is the amount of income taxes payable (recoverable) in respect of the taxable profit (tax loss) for a period.

2. Recognition

Current tax should be recognised based on the year-end estimate of the tax payable.

The income tax expense though profit or loss is adjusted for any under/over provision from the prior year.

Example 1 – Current tax

The following trail balance (extract) relates to Claire as at 31 December 20X5:

$’000 $’000Current tax 500

The following notes are also relevant:

1. A provision for current tax for the year ended 31 December 20X5 of $4.2 million is required.

2. The balance on current tax in the trial balance represents the under/over provision of the tax liability for the year ended 31 December 20X4.

Prepare extracts from the statement of profit or loss for Claire for the year ended 31 December 20X5 and from the statement of financial position as at the same date with regards tax.


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Chapter 20

IFRS 8 OPERATING SEGMENTS

IFRS 8 Operating segments aims to assist users to:

๏ Understand past performance

๏ Understand the risk and returns of each segment

๏ Make better informed judgements

An operating segment is one whose results are regularly reviewed by the chief operating decision maker (CODM), thus giving the users of the accounts an internal view of the company and how the results are reviewed.

Operating segments can be aggregated where they have similar economic characteristics and are similar in each of the following:

๏ the nature of the products or services;

๏ the nature of the production process;

๏ the type of customer for the products or services;

๏ the methods used to distribute the products or services;

๏ the nature of the regulatory environment (banking, insurance, etc.).

1. Disclosure

An operating segments results must be disclosed if:

๏ Segment revenue is greater than 10% of the total revenue (internal and external)

๏ Segment profits are greater than 10% of the total profits (excluding losses)

๏ Segment assets are greater than 10% of total assets

If the total reportable segment revenue does not make up at least 75% of external revenue then additional segment will need to be disclosed.

Two or more operating segments may be combined if they have similar economic characteristics with regards to the following:

๏ The nature of the products or services

๏ The nature of the production process

๏ The type or class of customer

๏ The methods used to distribute the products/services

๏ The nature of the regulatory environment


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Each reportable segment should then disclose:

๏ Segment revenue

๏ Segment results

๏ Segment assets

๏ Segment liabilities

๏ Capital expenditure

๏ Depreciation/amortisation

๏ Other non-cash expenses

General disclosures are:

๏ How the operating segments have been identified

๏ The products and services that the group provides

๏ Reliance on major customers

๏ Geographical information (limited to revenue and non-current assets)

Example 1 – Operating segments

Gulf is preparing is operating segment disclosure note for the first time following its listing on the local stock exchange during the year. Its chief operating decision maker (CODM) regularly reviews the results of its three separate divisions:

• Domestic railway operations

• International railway operations

• Railway construction

Gulf is intending to report two operating segments in its disclosure note as opposed to the three reviewed by the CODM. The domestic and international operations are to be combined because it is felt that they have similar economic characteristics due to the services that they offer.

The domestic operations involve a competitive tender process to run the railway service, which is then awarded by the local transport authority. The local transport authority then sets the ticket prices and collects the fares which are then distributed amongst the various operators running the contracts.

The international operations’ ticket prices are set by Gulf, who collects the fares from the passengers directly.

Advise Gulf as to whether the proposed combination of the two operating segments is appropriate.


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Chapter 21

IAS 34 INTERIM FINANCIAL REPORTING

IAS 34 requires only condensed financial statements (headings and sub-totals) and selected explanatory note disclosures, with particular focus on new events, activities and circumstances. The minimum content specified is as follows:

๏ Statement of financial position at interim date and previous reporting date.

๏ Statement of profit or loss and other comprehensive income for both interim/cumulatively to date for the year and previous interim/cumulatively to date for previous year (incl. EPS and diluted EPS)

๏ Statement of changes in equity cumulatively to interim date and direct comparative

๏ Statement of cash flows cumulatively to date and comparable period.


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Chapter 22

IFRS 13 FAIR VALUE MEASUREMENT

DefinitionThe price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

The IFRS says that you should always use market value wherever possible and gives more detailed guidance on measurement of items that do not have a readily available market price.

Level one inputs: quoted pricesIf there is an active market then the market price should be used.

Level two inputs: similar quoted pricesIf there is no quoted price available then market data should be used to find a similar estimated market value.

Level three inputs: unobservable inputsI neither of the first two work then financial modelling( such as discounted present value) should be used to obtain an estimated market value.


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D. CONSOLIDATED FINANCIAL STATEMENTS (GROUP ACCOUNTS)

Chapter 23

CONSOLIDATED STATEMENT OF FINANCIAL POSITION

1. Introduction to Group Accounts

P

100%

S

๏ P Ltd and S Ltd – separate legal entities

๏ P Group Ltd – one single entity, prepare accounts using substance

Control and ownership

๏ Control (power to direct activities) – 100%P + 100%S

๏ Ownership – Non-controlling interest (NCI%)

Basic principles

A parent is an entity that has one or more subsidiaries.

A subsidiary is an entity which is controlled by another entity (known as the parent).

The key concept in determining whether or not an investment constitutes a subsidiary is that of control.


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Control is the power to govern the financial and operating policies of an entity so as to obtain benefit from its activities.

Control is usually achieved by the purchase of more than 50% of a company’s equity share capital.

2. Basic consolidation

2.1. Basic steps

100% P + 100% S assets and liabilities, ignoring the investments in subsidiary

100% P share capital and share premium only (reporting to parent’s shareholders)

Retained earnings (balancing figure)

Example 1 – Basic consolidation

Peter acquired 100% of the equity share capital of Steven on 31 December 20X4 for $1,000,000.

The financial statements of the two companies at that date were as follows:

Peter$000

Steven $000

Investment in Steven Co 1,000 -Other assets 1,500 1,200Total assets 2,500 1,200

Equity share capital 1,000 250Retained earnings 1,100 750

2,100 1,000Liabilities 400 200Total equity and liabilities 2,500 1,200

Prepare the consolidated statement of financial position for the Peter Group at 31 December 20X4.


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Example 2 – Basic consolidation (continued)

Following Peter’s acquisition of the 100% of Steven’s equity share capital of Steven on 31 December 20X4, both companies continued to trade. The financial statements of the two companies at the end of the following year 31 December 20X5 were as follows:

Peter$000

Steven $000

Investment in Steven Co 1,000 -Other assets 1,900 1,450Total assets 2,900 1,450



Prepare the consolidated statement of financial position for the Peter Group at 31 December 20X5.

2.2. Non-controlling interest

Control is exerted through a shareholding of greater than 50%, so therefore it is not always necessary to fully own a subsidiary.

Shareholdings of 75% will still give the parent the power to direct the activities of the subsidiary and therefore it must prepare consolidated financial statements.

As the parent’s 75% holding still maintains control, the assets and liabilities of the subsidiary are consolidated 100% on a line-by-line basis.

It is necessary to account for 25% ownership interest in the subsidiary which is referred to as the non-controlling interest. It is shown in the equity section of the consolidated statement of financial position.

The non-controlling interest is measured using either of the following methods:

๏ Proportionate share of net assets

๏ Fair value


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Example 3 – Non-controlling interest

Pierre acquired 80% of Stefan’s equity share capital on 31 December 20X4 when Stefan’s retained earnings were $750,000. The financial statements of the two companies at the end 31 December 20X5 were as follows:

Pierre$000

Stefan$000

Investment in Stefan Co 800 -Other assets 1,900 1,450Total assets 2,700 1,450



Prepare the consolidated statement of financial position for the Pierre Group at 31 December 20X5 assuming the non-controlling interest is measured using the proportionate share of net assets method

2.3. Goodwill

On acquisition of a subsidiary, the parent will usually pay more for the subsidiary than the value of the net assets (assets less liabilities). Why?

๏ Customer loyalty

๏ Good reputation

The difference between what the parent pays and what the net assets are truly worth is referred to as goodwill.

Example 4 - Goodwill

A parent company buys 75% of the equity shares in a subsidiary company for $156,000.

The remaining shares were valued at $56,000 and the net assets at acquisition were $170,000.

Calculate the goodwill arising on acquisition assuming that:1. Non-controlling interest is measured using the proportionate share of net assets method

2. Non-controlling interest is measured using the fair value method.


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2.4. Other reserves (e.g. revaluation reserve)

Each reserve has a separate calculation still based on ownership so the calculation is the same as for group retained earnings

Group revaluation reserve

100% P XAdd: P’s % of S’s post acqn revaluation reserve X

X

Workings

W1) Group Structure

P

S

>50%

A

20-50%

W2) Net assets of subsidiary

At reporting date

At acquisition

Post acquisition

Equity shares X XSP X XRet. earnings X X

X X X

W3) Goodwill

FV of consideration (shares/cash) XNCI at acquisition X

XFV of net assets at acquisition (W2) (X)Goodwill at acquisition X

W4) Non-controlling interests

NCI @ acquisition (W3) XAdd: NCI% x S’s post-acqn profits (W2) X

X

W5) Group retained earnings

100% P XAdd: P’s % of S’s post acqn retained earnings (P’s% x (W2)) X

X


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Example 5 - Workings

Matthews purchased 80% of Jones for $600,000 two years ago when Jones’s retained earnings showed a balance of $100,000.

Matthews$000

Jones$000

Non-current assets 1,000 500Investment in Jones 600 -Current assets 800 600Total assets 2,400 1,100

Equity share capital ($1) 500 200Retained earnings 800 400

1,300 600Liabilities 1,100 500Total equity and liabilities 2,400 1,100


Matthews measures the non-controlling interest using the fair value method.

The fair value of Jones’s equity shares was $200,000 at acquisition

Prepare the consolidated statement of financial position for the Matthews group for the year-ended 31 December 20X5.

2.5. Mid-year acquisition

If a subsidiary is acquired mid-year the issue revolves around calculating the retained earnings at the acquisition date. To calculate the retained earnings figure at the acquisition date we assume, unless told otherwise, that the profits for the year made by the subsidiary have accrued evenly and adjust either the opening or closing retained earnings figure.

Illustration – Mid-year acquisition

Richard acquired 80% of Andy’s equity share capital on 1 August 20X5. Both have a year end of 31 December 20X5.

Andy’s retained earnings at the end of the year were $600,000 and its profit for the year was $120,000.

Assuming the profit accrued evenly during the year then the Andy’s retained earnings figure at 1 August 20X5 is calculated as follows:

$600,000 − (5/12 x $120,000) = $540,000


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3. Adjustments – Group

3.1. Intra-company balances

The intragroup receivable balance and intragroup payable balance should not be shown in the consolidated accounts as we treat the group as a single entity.

๏ Remove the payable

๏ Remove the receivable

3.2. Cash in transit

The intragroup receivable and intragroup payable balance should be equal. If they are not then it will be due to cash in transit.

Illustration – Cash in transit

P has an intra-company trade receivable of $1,500 at the year-end due form S. This does not agree with the corresponding $1,000 trade payable in S due to a cheque of $500 sent by S immediately prior to the year-end, which P did not receive until after the start of the new accounting year.

To account for the cash in transit and intra-company balances we need to:

1. Record the cash in transit in the group accounts

DR Bank $500

CR Receivables $500

2. Eliminate the equal intra-company balances

DR Payables $1,000

CR Receivables $1,000


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3.3. Unrealised profits

Inventory PUP - Need to remove the intra-group profit included in inventory held @ year-end (cost structures)

Cr Inventory (CSFP) X

Dr Retained earnings (of seller) X

๏ If S is seller → Adjust (W2)

๏ If P is seller → Adjust (W5)

Illustration – Unrealised profits

P sells $100 goods to S at $125 and S has not sold the goods on by the end of the year.

Example 6 – Unrealised profits

Statements of financial position as at 31 December 20X5

James Molly$’000 $’000

Non-current assets PPE 900 500 Investment in Molly 800 -

Current Assets 700 600

2,400 1,100

Share Capital 500 200Retained earnings 800 400Current liabilities 1,100 500

2,400 1,100


1. James bought 80% of the equity shares in Molly for $800,000 when the retained earnings were $150,000.

2. Non-controlling interest is measured using the fair value method.

3. During the year Molly sold goods to James at $120,000 based on a mark-up of 20%. Half of the goods remain in inventory at the year-end.

Prepare the James Group consolidated statement of financial position as at 31 December 20X5.


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3.4. Consideration

A parent may acquire a controlling interest in a subsidiary in other fashions as opposed to just a cash payment.

Other considerations are as follows:

๏ Share for share exchange

๏ Deferred cash consideration

๏ Contingent consideration

Share for share exchange

1. Calculate the number of subsidiary shares acquired

2. Calculate the number of P shares issued

3. Value the P shares issued

4. Record the journal entry

Example 7 – Share exchange

Harry acquired 80% of the 10 million ordinary $1 shares of Sally by offering a share exchange of one for every four shares acquired. The fair value of Harry’s shares is $3 per share.

Calculate the cost of investment for the acquisition and prepare the journal entry to record the share issue.


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3.5. Deferred consideration

A parent may agree to pay cash in the future following the acquisition of the subsidiary. This deferred consideration is recorded on acquisition at present value.

Example 8 – Deferred consideration

Pony acquired 80% of the 30 million $1 equity shares of Star on 1 January 20X5. The consideration was through the offer of a share exchange of two shares issued for every three shares acquired and a cash payment of $1 per share payable on 31 December 20X5. The fair value of the Pany’s equity shares was $2 at 1 January 20X5.

The present value of $1 received in one year’s time is $0.91 at a rate of 10%.

Calculate the cost of the investment in Star at 1 January 20X5

The deferred consideration needs to be unwound to its final value and is done so using the interest rate originally applied to discount back the original entry and is recorded as follows:

Dr Finance cost

Cr Deferred consideration liability

NOTE: The adjustment does not impact the fair value of consideration.


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Chapter 24

CONSOLIDATED STATEMENT OF PROFIT OR LOSS

X/12

P S Adj. GroupRevenue X X (X) XCOS (X) (X) X-PUP (Inventory ) (X) (X) (X)Gross profit XDist costs (X) (X) (X)Admin exp. (X) (X) (X)Finance cost (X) (X) X (X)Investment income X X (X) X-Dividend from S (X)Profit before tax XTaxation (X) (X) (X)PFY X X

Parent (β)Parent (β) XNCI = NCI% x S’s PFYNCI = NCI% x S’s PFY X


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Example 1 – Basic consolidation

Statements of profit or loss for the year-ended 31 December 20X5

Vader$’000

Maul$’000

Revenue 1,645 1,280Cost of sales (1,205) (990)Gross profit 440 290Distribution costs (100) (70)Administrative expenses (90) (50)Profit before interest and tax 250 170Finance costs (55) (30)Investment income 10Profit before tax 205 140Taxation (35) (28)Profit for the year 170 112


1. On 1 July 20X5, Vader acquired 80% of the equity shares of Maul. It is the group policy to measure the non-controlling interest at acquisition at fair value.

2. Maul declared a dividend during the year of $10,000.

3. Assume that profits accrue evenly during the year.

Prepare a consolidated statement of profit or loss for the Vader group for the year-ended 31 December 20X5


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1. Adjustments

1.1. Intra-group trading transactions

E.g. sales, loans/debenture interest and management charges

Remove the expense – adjustment column

Remove the income – adjustment column

1.2. Unrealised profits

PUP adjustment on goods unsold at year-end (cost structures) by increasing C’o’S in seller’s column.

Example 2 – Unrealised profits

Statement of profit or loss for the year ended 31 December 20X5

Gary Nick $000 $000Revenue 120,000 90,000Cost of sales (70,000) (40,000)Gross profit 50,000 50,000Operating expenses (20,000) (35,000)Profit from operations 30,000 15,000Finance cost (2,000) (500)Profit before tax 28,000 14,500Income tax expense (6,000) (3,000)Profit for the year 22,000 11,500

Additional information

1. Gary acquired 80% of Nick on 1 January 20X5. Goodwill on acquisition has been impaired by $1m during the year and should be charged to operating expenses.

2. During the year Nick sold $10m goods to Gary at a mark-up of 25% on cost. One quarter of those goods are in inventory at the year end.

Prepare the Gary Group consolidated statement of profit or loss for the year to 31 December 20X5.


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IFRS 10 Consolidated Financial Statements defines control and tells us how to consolidate.

A parent/subsidiary relationship can exist even where the parent owns less than 50% of the voting power of the subsidiary since the key to the relationship is control and the power to direct the activities.

The following instances are where control is exerted:

๏ power over more than half of the voting rights by virtue of an agreement with other investors;

๏ power to govern the financial and operating policies of the entity under a statute or agreement;

๏ power to appoint or remove the majority of the members of the board of directors or equivalent governing body and control of the entity is by that board or body; or

๏ power to cast the majority of votes at meetings of the board of directors or equivalent governing body and control of the entity is by that board or body.


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Chapter 25

ASSOCIATES

A shareholding of between 20% and 50% is assumed to give the investing company significant influence over its investment.

This means it is treated as an associate and is equity accounted for in accordance with IAS 28

1. Group Statement of financial position – ‘Investment in associate’

The investment in associate is calculated as follows:

$Cost of investment in A XAdd: % of A’s post acquisition reserves XLess: impairment of goodwill (X)

X

Example 1 – Associate (SFP)

Penny bought 30% of the equity share capital of Alex on 1 January 20X5 for $250,000. Alex’s profits for the year were $170,000.

An impairment review was carried out at the end of the year and the investment in Alex was found to be impaired by $20,000.

Calculate the investment in associate to appear in Penny’s financial statements at 31 December 20X5.


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2. Group Statement of profit or loss – ‘Share of profit of associate’

A share of profit of associate is calculated as shown below and shown immediately before profit before tax.

% of A’s profit for the year XLess: goodwill impaired during the year (X)

X

IAS 28 Investment in Associates evidences the following additional ways in which significant influence can arise:

๏ Representation on the board of directors

๏ Participation in the policy making decision

๏ Material transaction between the investor and investee

๏ Interchange of managerial personnel

๏ Provision of essential technical maintenance


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E. MANAGEMENT OF WORKING CAPITAL, CASH AND SOURCES OF SHORT-TERM FINANCE

Chapter 26

CASH MANAGEMENT

A business can be profitable whilst at the same time be losing cash. It is vitally important for a business therefore to ensure that it does not just focus on profitability but also manage its cash position.

To ensure that the business can determine if it is generating or spending cash overall it will need to prepare cash flow forecasts.

A cash flow forecast will identify exactly when the cash inflows and outflows will arise which can then help identify when the business will have either cash surpluses or cash deficits.

1 2 3Inflows

Cash sales X X XCash from credit customers X X X

OutflowsCash purchases (X) (X) (X)Cash payments to credit suppliers (X) (X) (X)Cash expenses (X) (X) (X)Capital expenditure (X) - -Interest (X) (X) (X)Taxation (X) (X) (X)

Net movement X/(X) X/(X) X/(X)Opening balance X X XClosing balance X X X


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1. Cash receipts from credit customers

Information from predicted future sales and the cash settlement by customer is used to calculate the cash received from credit customers.

Example 1 – Cash inflows

Sales in December were $10,000 and are expected to increase by 10% each month from the start of the year

90% of the sales are made on credit terms, the remainder for cash, and credit customers settle the balance as follows:

1. 60% in the month of sale

2. 40% in the month following sale

Calculate the cash inflows for January and February.

2. Cash payments to credit suppliers

Information from predicted sales can be used to calculate the cost of sales using cost structures.

Stock holding policies can be used to determine purchases and from this we can determine the cash payments to credit suppliers.

Example 2 - Cash outflows

Sales in December were $10,000 and are expected to increase by 10% each month from the start of the year

A constant gross profit margin on 40% is expected

Inventory levels are maintained at 20% of the following month’s sales

Suppliers are paid in the month following purchase.

Calculate the cash payments to credit suppliers for January and February.


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Example 3 – Cash flow forecasts

CF manufactures a single product and is preparing monthly budgets for the first three months of 20X5. The cash balance at the end of December 20X4 is expected to be $50,000.

The following standard revenue and cost data is available:

Selling price $15·00 per unit

Materials 2 kg per unit at $2·40 per kg

Labour $1·60 per unit

Direct expenses $1·40 per unit

Sales in January and February 20X5 are forecast to be 10,000 units in each month. As a direct result of marketing expenditure of $95,000 in March 20X4, sales are expected to be 11,000 units in March and to increase by 1,000 units in each subsequent month.

30% of sales are paid for when they occur and 70% of sales are paid for in the month following sale.

Stocks of finished goods at the end of each month are required to be 20% of the expected sales for the following month. Stocks of materials at the end of each month are required to be 50% of the materials required for the following month’s production.

Materials are paid for in the month following purchase.

Labour and direct expenses are paid for in the month in which they occur. Overheads for production, administration and distribution will be $32,000 per month, including depreciation of $10,000 per month. These overheads are payable in the month in which they occur.

CF has a $500,000 bank loan at 5% per annum on which it pays interest twice per year, in March and September.

Prepare the cash flow forecast for CF for the three months of 20X5.


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Chapter 27

SHORT-TERM FINANCE AND CASH INVESTMENT

On preparation of the cash flow forecast the businesses can then identify whether it needs to raise short-term finance is there is a cash deficit or alternatively deposit cash if it has a surplus cash balance.

1. Short-term finance

1.1. Trade payables

A company can delay the payment due to suppliers, which effectively acts as a source of finance. It is therefore using the credit terms on offer by its supplier.

This is a risky strategy as if cash flow difficulties occur then the supplier may no longer supply the company.

1.2. Overdrafts

An overdraft is a facility provided to the company by a bank whereby the company can borrow up to a predetermined limit on its bank account.

Interest is paid on any amounts of cash lent by the bank and the bank has the right to recall the overdraft facility on demand.

1.3. Short-term loans

A short-term loan is an agreement between the company and the bank to borrow a set amount of cash that is then repayable over a fixed period.

1.4. Debt factoring

Debt factoring is where a company’s receivables are sold to a third party (a debt factoring company) for cash. The debt factoring company then collects the cash on behalf of the company for an agreed fee.

The factor is often more successful at enforcing credit terms leading a lower level of debts outstanding. Factoring is therefore not only a source of short-term finance but also an external means of controlling or reducing the level of debtors.

2. Short-term cash investment

A company needs to consider the following principles of investing when deciding on how to invest short-term cash:

๏ Maturity๏ Risk๏ Security๏ Yield


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2.1. Interest bearing deposits

A company can deposit excess funds at a high street bank and receive interest on the amounts deposited.

It is very low risk as banks will be able to repay the amounts deposited but also carries a low level of return.

The liquidity of the funds depends on the specific nature of the deposit account offered.

2.2. Short-term treasury bills

A company can purchase treasury bills which are issued weekly by governments. The bills do not pay interest but the company pays less than the face value that is repaid on maturity.

They are highly liquid as they can be sold before their maturity date.

2.3. Bills of exchange

A bill of exchange is simply an agreement to pay a certain amount at a certain date in the future, in essence an IOU. No interest is payable on the note but is implicit in the terms of the bill.

2.4. Certificates of deposit

A fixed-term (one-month, three-month, six-month) investment with a bank or credit union, carrying a fixed rate of interest. The deposit is usually insured and so carries minimal risk, making it similar to a bank deposit.

2.5. Commercial paper

A fixed-term investment of less than 270 days, which is purchased at a discount and carries lower interest rates than bonds. The interest rate is higher for longer dated commercial papers.

Example 1 – Short-term cash investment

A company has surplus funds to invest for a short-term period of 3 months and has the two following investments to consider:

Treasury bills

Purchase the central bank’s treasury bills for $995 per $1,000 today for a period of 91 days.

Bank deposit account

Invest in a 30 day notice bank deposit account with a variable rate of interest of 2.5% per annum, payable quarterly.

Explain the advantages and disadvantages to the company of each of the investments, using calculations where relevant.


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Chapter 28

WORKING CAPITAL

1. Definition

Working capital is the amount of current assets (inventory, receivables and payables) that a business needs to maintain in order to fund its debts as they fall due.

The ability of a company to pay its obligations as and when they fall due (its liquidity) is a major concern of any credit analysis.

Short term liquidity can be assessed by comparing current assets with current liabilities in a variety of forms:

Working Capital = Current Assets - Current Liabilities.

A working capital surplus represents a cushion of protection for current creditors; it indicates the amount by which the value of current assets could decrease still leaving enough to repay current liabilities from the sale of current assets.

The optimum amount of working capital varies considerably from company to company and from industry to industry, thus the nature of the company's business and the quality of its assets must be considered.

Companies functioning within industry sectors with short production/sales cycles (e.g. supermarkets) can generally function satisfactorily with a much smaller amount of working capital than those with a long production cycle (e.g. heavy engineering).

2. Working capital policies

Inventory needs to be managed to ensure the correct amount is held to meet customer demand, without holding too much that results in additional costs to the business.

Cash from credit customers needs to be collected on a regular basis to ensure the risk of irrecoverable debts is kept to a minimum.

Payment made to credit suppliers need to be made on a regular basis as any delay or default could lead to the loss of supplier goodwill.

The business needs to finely balance the requirements of having the correct level of current assets, whilst ensuring the finance used to fund the investment in current assets is appropriate.

A HIGH level of working capital will mean the business is always able to respond to changes in requirements but holding high levels of inventory/receivables/cash is expensive.

A LOW level of working capital is less expensive but the company may not be able to respond to a change in demand.


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A company’s policy on working capital will be influenced by the risk relating to working capital and will lead to one of the following approaches:

๏ Conservative – Attempts to reduce the risk by holding high levels of working capital.

‣ High levels of finished goods‣ Generous customer payment terms‣ Prompt payment to suppliers

Unproductive assets, increased finance cost and cash flow issues

๏ Aggressive – Attempts to reduce the finance cost and increase profitability.

‣ Reduction in inventory levels‣ Improved credit control‣ Delaying payment to suppliers

Increased risk of system breakdown and loss of goodwill with suppliers and customers

3. Working capital financing

The financing of working capital is done with either short-term or long-term financing, with short-term financing being usually cheaper.

๏ Permanent current assets – a core level of investment in inventory and receivables e.g. a buffer level of inventory, a minimum level of cash kept in the bank

๏ Fluctuating current assets – the increases/decreases in receivables/payables

Assets ($)

Time

Non-current assets

Permanent current assets

Short-term funds

Short-term funds or long-term funds?

Long-term funds

Fluctuating current assets

๏ Conservative - Mostly long term finance used. All permanent and most fluctuating current assets are funded using long term finance.

‣ Short-term finance when current assets increase‣ Cash surplus if current assets are low

๏ Aggressive - Mostly short term finance used. All fluctuating and part of the permanent current assets are funded using short term finance.

‣ Increased risk of liquidity problems‣ Cheaper and flexible


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๏ Moderate - Permanent current assets are funded using long term finance. Fluctuating current assets are funded using short term finance.

4. Measuring working capital

Working capital ratios can be calculated to determine how much working capital a business is holding and to see if it has too much or too little.

4.1. Current ratio

Current ratio = Current assets

Current ratio = Current liabilities

A current ratio of over one indicates that a company has a higher level of current assets than current liabilities and should, therefore, be in a position to meet its short term obligations as and when they fall due. However, some companies function adequately on current ratios of less than one whilst others need a much higher ratio. Generally the more liquid the current assets are the higher this ratio will be.

Trends are difficult to analyse but generally higher ratios indicate greater liquidity. However, an increase may reflect a high level of unsaleable stock or overdue receivables whereas a decrease may result from greater efficiency.

Some factors to consider:

๏ Asset quality

๏ Seasonality

4.2. Quick ratio (acid test)

Quick ratio (acid test) =Current assets - inventory

Quick ratio (acid test) =Current liabilities

This quick ratio shows how easily a company can meet its current obligations using funds raised from quick assets (those assets which can be converted quickly into cash).

A comparison of the quick ratio and current ratios which shows increases in both, but with the current ratio increasing more, would indicate that the company has been building up stock.

4.3. Inventory days

Inventory days =Inventory

x 365Inventory days =Cost of sales

x 365

Shows how long a business is holding its inventory. A higher number of days inventory might indicate holdings of obsolete or unsaleable inventory, but it might also signify a purchase of raw materials now in anticipation of an increase in price later.


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4.4. Trade receivables collection period

Trade receivables collection period =Trade receivables

x 365Trade receivables collection period =Revenue

x 365

Providing revenue is evenly spread throughout the year the ratio will indicate how effectively debts are being collected.

An increase in the ratio of receivables to revenue could, providing the proportion of cash sales has not increased, indicate one of the following:

๏ Receivables are being given or are taking longer to pay. What are the terms of trade?

๏ The total receivables figure includes long outstanding debts. Should provisions be made?

4.5. Trade payables payment period

Trade payables payment period =Trade payables

x 365Trade payables payment period =Cost of sales

x 365

If purchases are spread evenly throughout the year, this ratio will show the length of credit the company is taking. An increase in the ratio may indicate that more reliance is being placed upon the payables to finance the business. A drop in days may indicate that a company is taking cash discounts or may indicate suppliers are cutting credit terms because of the company's decreased creditworthiness.

Example 1 – Liquidity ratios

Ariel has the following balances under current assets and current liabilities:

$Current assetsInventory 50,000Trade receivables 70,000Bank 10,000Current liabilitiesTrade payables 88,000Interest payable 7,000

Calculate the current ratio and the quick ratio.


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Example 2 – Efficiency ratios

Extracts from a company’s trial balance at the end of its financial year are given below:

$’000Sales revenue (85% on credit) 2,600 Cost of sales 1,800 Purchases (90% on credit) 1,650 Inventory of finished goods 220 Trade receivables 350 Trade payables 260

Calculate the following working capital ratios: (i) Inventory days (ii) Trade receivables days (iii) Trade payables days

Example 3– Working capital requirement

Profit and loss account extract

$000

Revenue 250

Gross profit 90

The operating cycle has been calculated as:

Inventory 68 days

Receivables 88 days

Payables 114 days

Calculate the investment in working capital.


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5. Cash operating cycle

The operating cycle is the length of time between the company’s outlay on raw materials, wages and other expenditures and the inflow of cash from the sale of goods.

Credit purchase Cash receipt

Inventory days Receivable days

Payable days

Cash payment

Credit sale

Operating cycle

An increase in the operating cycle shows that cash is not being recovered as quickly from business activities, which can cause cash flow problems.

A business will try to reduce the length of the cash operating cycle through careful management of inventory, receivables and payables.


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Chapter 29

WORKING CAPITAL MANAGEMENT

1. Inventory management

Many companies, particularly those involved in manufacturing, will hold levels of stock to meet expected customer demand. It is an important consideration as holding stock incurs costs but in order to reduce level of inventory and the associated cost the risk of stock out arises.

The costs of inventory management that will need to be controlled are as follows:

๏ Ordering costs (independent of order size)

‣ Administrative ‣ Delivery

๏ Holding costs

‣ cost of the investment in stock‣ Storage ‣ Insurance ‣ Deterioration‣ Obsolescence‣ Theft

๏ Stock shortage costs

‣ Lost sales/contribution‣ Loss of customers‣ Purchase costs of new supply‣ Production stoppages

๏ Purchase cost

‣ Bulk discounts


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2. Economic order quantity (EOQ)

The order quantity that minimizes the total annual cost (annual holding cost plus annual ordering cost).

Annual ordering cost = no. orders per annum x cost per order

Annual holding cost = average stock x annual holding cost per unit

Cost

Order size

TAC

holding cost

ordering cost

Q =

2CoDCh

Co = Cost per order

D = Annual demand

Ch = Cost of holding one unit for one year

Example 1 - EOQ

The annual demand for an item of inventory is 32,000 units. The item costs $40 per unit to purchase with order costs of $15 per order. The annual inventory holding costs are $1.20 per unit.

Calculate the economic order quantity for this item and the total annual cost of inventory.


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3. Bulk discounts

If a quantity discount is offered by a supplier, we can evaluate the discount simply by comparing the total annual cost that would arise if the discount were accepted, against the corresponding total annual cost at the EOQ.

Example 2 – Bulk discounts

Annual demand is 120,000 units. Ordering costs are $30 per order and holding costs are $20/unit/annum. The material can normally be purchased for $10/unit, but if 1,000 units are bought at one time they can be bought for $9,800. If 5,000 units are bought at one time, they can be bought for $47,500.

What reorder quantity would minimize the total cost?

4. Trade receivables

A company will offer credit to its customers to increase the level of sales but this then introduces an increased level of risk as the customer may default on payment.

To ensure that the business grants the correct amount of credit it should:

๏ Assessing the credit status of its customer

๏ Consider the specific terms it offers its customers

๏ Plan on how it will management the collection of cash on a day to day basis.

4.1. Assessing credit status

The creditworthiness of all new customers must be assessed before credit is offered.

Existing customers must also be re-assessed on a regular basis.

The following may be used to assess credit status of a company:

๏ Bank references

๏ Trade references

๏ Published accounts

๏ Credit rating agencies

๏ Company’s own sales record.

4.2. Offering credit terms

Upon deciding to grant a customer credit status a business must then determine the specific credit terms to be offered, which may include:

๏ Credit limit value

๏ Number of days credit

๏ Discount on early payment

๏ Interest on overdue account.


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4.3. Collecting debts

The collection of the debt is dependent on the credit controllers implementing a set of simple but rigorous procedures.

Consideration should be given to the following actions at specific points in time following initial invoicing and despatch of goods:

๏ Send statement of account

๏ Reminder letter

๏ Send a second reminder letter

๏ Threaten legal action

๏ Take action to recover funds

Control of trade receivable information

Trade receivables are usually analysed by the age of the debt to monitor the specific level and amount of outstanding debt and aid collection.

This is simply a list of the customers who currently owe money, showing the total amount owed, and the period of time for which money has been owed.

There is no set proforma for an age analysis of trade receivables, but a typical exam question is shown below.


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5. Costs of financing receivables

Consideration needs to be given to the two costs that arise from offering customers trade credit:

๏ Interest cost

๏ Settlement discounts

5.1. Interest cost

The receivables balance needs to be financed, usually via short-term finance. Any change to the receivables balance will lead to a change in the financing cost of the business.

Interest cost = Receivables balance × Interest rate

Example 3 – Interest cost

EFG has year-end receivable of $10m based on total sales for the year of $42m. Any increase in the receivables is financed from an overdraft carrying an interest rate of 10%.

(a) Calculate EFG’s receivable days(b) Calculate the interest cost associated with financing the receivables.

5.2. Settlement discounts

Cash discounts are often given to encourage early payment by customers.

Advantages

๏ Decrease in receivables and interest charge.

๏ Reduction of irrecoverable debts.

Disadvantages

๏ Difficulty in setting the terms.

๏ Increased uncertainty with regards the cash receipts being received.

๏ May not reduce bad debt in practice.

๏ Customers may pay over normal terms but still take the cash discount.

Example 4 – Settlement discounts

EFG has year-end receivable of $10m based on total sales for the year of $42m. Any increase in the receivables is financed from an overdraft carrying an interest rate of 10%.

EFG offers a discount of 2% for payment within 10 days.

Using the compound interest method, calculate the effective annualised cost of offering the discount.


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Example 5 – Annual interest

Dory’s customers all pay their accounts at the end of 60 days. To try and improve its cash flow, Dory is considering offering all customers a 1.5% discount for payment within 14 days. Assume overdraft interest is 15%.

Calculate the implied annual (interest) cost to Dory of offering the discount, using compound interest methodology and assuming a 365 day year and an invoice value of $500.

6. Factoring

6.1. CIMA Official Definition

The sale of debts to a third party (the factor) at a discount, in return for prompt cash. A factoring service may be with recourse, in which case the supplier takes the risk of the debt not being paid, or without recourse, when the factor takes the risk.

Advantages

๏ Saving in internal administration costs.

๏ Reduction in the need for day to day management control.

๏ Particularly useful for small and fast growing businesses where the credit control department may not be able to keep pace with volume growth.

Disadvantages

๏ Should be more costly than an efficiently run internal credit control department.

๏ Factoring has a bad reputation associated with failing companies, using a factor may suggest your company has money worries.

๏ Customers may not wish to deal with a factor.

๏ Once you start factoring it is difficult to revert easily to an internal credit control.

๏ The company may give up the opportunity to decide to whom credit may be given.

6.2. Invoice discounting

Selected invoices are used as security against which the company may borrow funds. This is a temporary source of finance repayable when the debt is cleared. The key advantage of invoice discounting is that it is a confidential service, the customer need not know about it. The service is also provided by a factoring company.

Example 6 - Factoring

Coral limited currently has turnover of $25m. Receivables turnover is currently 40 days. Interest is charged on the overdraft at 12%.

A factoring company has offered its services for an annual fee of 1% of turnover. The factoring company can reduce receivables turnover to 15 days.

The factor will also generate an admin saving for the company of $15,000.

Should Coral limited accept the factors offer?


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7. Payables

Payables may be used as a source of short-term finance. If a company delays payment by a further month then they now have a further months use of the cash.

However, delaying payment may lose the company it’s credit status with the supplier and could result in supplies being stopped.

Additionally, the company could lose the benefit of any settlement discount offered by the supplier for early payment.

In exactly the same way as for receivables, we can calculate the annual effective cost of refusing any settlement discount offered, and compare this with the cost of financing working capital.

Example 4

A supplier offers a 2% discount if invoices are paid within 10 days of receipt. Currently we take 30 days to pay invoices and therefore do not receive the discount.Calculate the annual % effective cost of refusing the discount.

Example 5

A company currently takes 40 days credit from suppliers on the basis that this is ‘free’ finance.Annual purchases are $100,000 and the company pays overdraft interest of 13%.Payment within 15 days would attract a 1.5% quick settlement discount.Should the company pay sooner in order to take advantage of the discount?


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8. Overtrading

Overtrading is the term applied to a company which rapidly increases its turnover without having sufficient capital backing, hence the alternative term “under-capitalisation”.

Output increase are often obtained by more intensive utilisation of existing fixed assets, and growth tends to be financed by more intensive use of working capital.

Overtrading companies are often unable or unwilling to raise long-term capital and thus tend to rely more heavily on short-term sources such as overdraft and trade creditors. Debtors usually increase sharply as the company follows a more generous trade credit policy in order to win sales, while stock tends to increase as the company attempts to produce at a faster rate ahead of increase demand.

Overtrading is thus characterised by rising borrowings and a declining liquidity position in terms of the quick ratio, if not always according to the current ratio.

Symptoms of overtrading

๏ Rapid increase in turnover

๏ Fall in liquidity ratio or current liabilities exceed current assets

๏ Sharp increase in the sales-to-fixed assets ratio

๏ Increase in the trade payables period

๏ Increase in short term borrowing and a decline in cash balance

๏ Fall in profit margins.

Overtrading is risky because short-term finance may be withdrawn relatively quickly if creditors lose confidence in the business, or if there is general tightening of credit in the economy resulting to liquidity problems and even bankruptcy, even though the firm is profitable.

The fundamental solution to overtrading is to replace short-term finance with long-term finance such as term loan or equity funds.


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F. FUNDAMENTALS OF BUSINESS TAXATION

Chapter 30

TAXATION

1. What is Taxation?

Taxation is a contribution by individuals, property or businesses to state revenue. It can be collected by the state/government either directly or indirectly and is the main way in which it raises money to fund its expenditure.

Taxation can also be used as a means of influencing economic decision making or promoting social values and priorities in a country. Hence, no two countries tax systems will be identical.

Note: Specific tax rules in different countries are not required in F1. Exam questions are focused on fictitious countries and so it is only important to understand the general principles of how taxation works.

Principles of taxationThe general principles of good taxation (Adam Smith) are that it should show:

๏ Equity – Fair to different individuals, reflecting their ability to pay

๏ Efficient – Cheap and easy to administer with regards collection and timing

๏ Economic effects – Consideration to different business sectors should be considered in tax policies

2. Direct Taxation vs. Indirect Taxation

Direct TaxesThese are taxes which fall directly on the person or entity who is expected to pay it .

๏ Tax on trading income – the tax paid by a company based on its taxable profits.

๏ Capital taxes – a tax paid by a company based on taxable gains made on disposing of an asset at above its original cost.

Indirect TaxesAn indirect tax is one that is levied on one part of the economy with the intention that it will be passed on to another e.g. sales tax.

Taxable PersonThis is the person accountable for the payment of a tax. It could be a business entity or an individual.

IncidenceIncidence of tax is the distribution of the tax burden and can be divided into two elements


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๏ Formal incidence – the person or business having direct contact with the tax authorities.

๏ Effective (or actual) incidence – the person or business which actually ends up bearing the cost of the tax.

Competent JurisdictionAn authority whose tax laws apply to an individual or a company is referred to as a competent jurisdiction.

Example 1 – Good taxation

Which one of the following is not one of Adam Smith’s characteristics of good tax?A CertaintyB EquityC SimplicityD Efficiency

Example 2 – Indirect tax

An indirect tax is a tax that:

A Is levied on an individualB Is based on earnings of an individualC Is paid indirectly to the tax authoritiesD Is levied on one person with the intention that it is passed on to another


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3. Types of taxation

๏ Progressive taxes – these take an increasing proportion of income as income rises.

๏ Proportional taxes – these take the same proportion of income as income rises.

๏ Regressive taxes – these take a decreasing proportion of income as income rises.

Example 3 – Types of taxation

ABC and XYZ are two businesses that are resident in the same tax jurisdiction.

ABC has taxable profits of $45,000 and has a tax liability of $4,500.

XYZ has taxable profits of $70,000 and has a tax liability of $8,750.

What type of tax could this be said to be?

4. Indirect taxation๏ Unit taxes – based on either a number or weight of items, e.g. import/

excise duties

๏ Ad valorem taxes – based on the value of the items, e.g. sales tax

๏ Excise duties – a tax charged on the amount of commodity (alcohol, tobacco, oil products and motor vehicles)

๏ Property taxes – a tax charged on the value of an individual’s or company’s property (land and buildings)

๏ Wealth taxes – a tax charged on the value of an individual’s or company’s wealth (asset value)

๏ Consumption taxes – a tax charged on the purchase of goods or services by either an individual or a company.


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5. Value added tax - VAT

The mechanism of VAT is that it is an indirect, consumption tax that is collected in stages along the supply chain.

VAT is applied on the purchase of goods and services (taxable supplies) and is a tax on the final consumer of the goods.

5.1. VAT rates

Each supply of goods or services in the course of business falls into one of the following types of supply:

๏ Standard rated – taxed at the standard rate

๏ Higher rated – taxed at the appropriate higher rate

๏ Zero rated – taxed at the zero rate

๏ Exempt – not taxed

Although it may not be obvious there is a difference between zero rated and exempt supplies. If an entity makes zero rated supplies it can register for VAT and therefore reclaim input VAT incurred relating to those supplies.

If an entity makes wholly exempt supplies it cannot register for VAT and therefore cannot reclaim input VAT incurred relating to the exempt supplies.

5.2. Partially Exempt Trades

If an entity conducts several activities some being standard rated, some zero rated and some exempt, it can register for VAT but its right to offset input tax is restricted.

It can reclaim input tax relating to all standard rated and zero rated supplies. It cannot reclaim input tax relating to exempt supplies.

Other input tax incurred in the production of all supplies e.g. heat/light expenses, is reclaimed on a pro-rata basis.

Example 4 – VAT

AB is resident in County X, where monthly VAT returns are required. At the end of each month, AB pays the net VAT due to the local tax authorities.

In the last month, AB purchase raw material costing $120,000, excluding VAT which is chargeable at the standard rate of 15%.

The raw materials were converted into two products X and T. Produt X is zero rated and product t is standard rated for VAT purposes.

Product X was sold for $90,000 and product T for $130,000, both excluding VAT.

Calculate the amount of VAT that AB should pay, assuming there to be no other VAT-related transactions.


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6. Direct taxation

6.1. Corporate income tax and capital tax computations

Companies pay corporate tax on the following:

๏ Profits from trade and other activities

๏ Gains on the sale of investments and assets

๏ Other non-business income

6.2. Tax on profits from trade and other activities

๏ Taxable profit – The profits calculated by the tax authorities using their rules, on which they will apply the specific rate of tax to calculate the income tax liability.

๏ Accounting profit – The profits calculated under accounting rules using IFRS or local GAAP, which follow accounting conventions (accruals, substance) and are very subjective.

To calculate the corporate income tax liability it will be first necessary to calculate the taxable trading profit from the accounting profit.

Income and expenses for non-trading activities are ignored in the computation.

$Accounting profit XLess: non-trading income (X)

XAdd: disallowable expenditure XAdjusted trading profit XLess capital allowances (X)

Taxable trading profit X

6.3. Non-trading income

The following are classified as non-trading income:

๏ Rental income (taxable under Schedule A)

๏ Interest receivable (taxable under Schedule DIII)

๏ Dividends

๏ Capital profit (e.g. on the sale of an asset)


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6.4. Disallowable expenditure

๏ Items of expenditure incurred by the business that are not allowed as a taxable deduction:

๏ Entertaining (except staff entertaining)

๏ Depreciation and amortisation

๏ Taxes paid to other public bodies

๏ Donations to political parties

6.5. Allowable Expenditure

The following items of expenditure are often allowed:

๏ Interest paid for trading purpose

๏ Staff wages and employer national insurance contributions

๏ Legal expenses

๏ Advertising

๏ Audit and accountancy costs

๏ Trade subscriptions

๏ Repairs

๏ Taxes paid to lower levels of government

Example 5 – Income tax computation (1)

Company M is resident in Country X and makes an accounting profit of $350,000 during the year. This included depreciation of $45,000 and disallowable expenses of $20,000.

If the tax allowable depreciation totals $30,000, what is the tax payable?

Example 6 – Income tax computation (2)

Company B is resident in Country X and makes accounting profit of $360,000 during the year. This includes non-taxable income of $35,000 and depreciation of $40,000. In addition, $10,000 of the expenses are disallowable for tax purposes.

If the tax allowable depreciation totals $30,000, what is the tax payable?


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6.6. Accounting Depreciation vs. Tax Depreciation

Accounting depreciation and amortisation are subjective being applied using straight line or reducing balance methods as well as at different rates.

Accounting depreciation and amortisation are therefore both disallowable trading expense.

Tax depreciation follows the same principles as accounting depreciation but specific rules are laid out by the tax authorities to remove any subjectivity.

Example 7 – Tax depreciation

SunJones commenced business on 1 January 20X7 and entered into the following transactions for plant and machinery:

PurchasesPurchases $1 June 20X7 Industrial Building 260,0001 June 20X7 Stitching machine (plant) 47,00031 May 20X9 Packing machine (plant) 58,000

Sales1 Jun 20X9 Machine bought on 1 June 20X7 9,500

SunJones qualifies for accelerated tax depreciation in the first-year on the plant at the rate of 50%. The second and subsequent years will be at 25% on the reducing balance method.

The industrial building qualifies for an annual tax depreciation allowance of 5% on the straight line basis.

Calculate SunJones’s tax depreciation for the three years ended 31 December 20X7, 20X8 and 20X9.

6.7. Trading Losses

If a business makes a trading loss instead of a trading profit no tax is payable in that year. The loss is then allowed to be offset and loss relief claimed. The methods of loss relief include:

๏ Carry forward of trading loss to offset against future trading income

๏ Offset against other income and gains of the same accounting period

๏ Offset against other income and gains of one or more previous accounting period

๏ Group relief (see later)


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7. Gains on the sale of assets and investments (capital taxes)

Taxable capital gains of a company are subject to corporate tax. A capital gain is the taxable profit on the disposal of an asset or investment.

Most assets or investments being disposed of are chargeable assets, however, some key exemptions exist:

๏ Private motor cars

๏ Qualifying corporate bonds

๏ Chattels bought and sold for less than £6,000

๏ Wasting chattels (tangible moveable property with a life expectance of less than 50 years e.g. a horse)

Some disposals are also exempt from tax:

๏ Gifts to charities of land, buildings and certain works of art

๏ Gifts of any type of asset to government institutions and museums

Capital tax computationsCapital gain = Disposal proceeds less cost of the asset less allowable costs

Note: Some tax jurisdictions allow the initial cost to be adjusted up to its current cost (indexation)

๏ Initial purchase costs incurred

๏ Improvements and enhancements (not repairs)

๏ Costs incurred to sell the asset

Example 8 – Capital tax computation

A company resident in Country X purchases land and buildings in January 20X5 for $155,000, of which $55,000 was attributable to the land. The company incurred in the same month $55,000 for refurbishment of the building, which was classified as capital expenditure according to local tax regulators.

The land and buildings were sold for $425,000 in January 20X9, $100,000 of this price was attributable to the land. The company paid $8,000 in disposal costs which were allowable for tax purposes.

Local tax regulations allow for indexation of the purchase and refurbishment costs of the building. The index has increased by 35% between January 20X5 and January 20X9. Capital gains are taxed at the corporate income tax rate applicable in Country X.

Calculate the taxable gain arising on the sale of the land and buildings and the tax payable.


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Rollover reliefCountries may allow for capital gains to be deferred where a business asset has been sold and subsequently replaced.

Deferral is allowed as businesses often use the cash from the sale of the asset to buy the replacement one thus leaving no cash available to pay any tax liability.

The company is allowed to roll the gain arising on the sale against the base cost of the replacement asset.

The effect is that when the replacement asset is sold in the future, a larger gain will arise at that time, resulting in more tax payable in the future, effectively deferring the tax due on the original gain.

Capital LossesCapital losses are calculated in the same way as capital gains. In most countries capital losses are only ever offset against capital gains arising in the same accounting period or are carried forward and offset against capital gains arising in future accounting period(s). Capital losses are never carried back or offset against other income.

Example 9 – Capital losses

Country X has the following tax regulations:

Taxable profits are subject to tax at 25%.

Capital gains are added to profits from trading to give taxable profits.

Trading losses can be carried forward indefinitely but cannot be carried back to previous years.

Capital gains/losses cannot be offset against trading gains/losses or visa versa.

JKL is resident in Country X and has no brought forward losses as 1 January 20X7. JKL has the following results for 20X7 to 20X8:

Trading profit / (loss) $000 Capital profit/(loss) $00020X7 (300) 40020X8 550 020X9 700 (150)

Calculate JKL’s corporate income tax due for each of the years ended 31 December 20X7 to 20X9.


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Chapter 31

REGULATORY ENVIRONMENT AND INTERNATIONAL TAXATION ISSUES

1. Sources of taxation rules

The nature of tax rules vary considerably from one country to another; however, it is possible to categorise the sources and influences on those rules. Within any country the balance between each source will be different, but in most countries the same elements will be present to a greater or lesser extent. The main sources of tax rules in a country are usually as follows:

All tax systems are based on domestic primary legislation either at the central government level or at the local authority level or both. In some countries the legislation is very detailed and specific, setting out every possible item of income and expense. In other countries the legislation is less detailed and is supplemented by court rulings or case law.

The practice of the relevant taxing authority will create precedents which will be followed in the future. Tax authorities sometimes issue guidelines or interpretations which are aimed at clarifying the taxation legislation.

Supranational bodies may issue directives which the government of a country has to include in the legislation, for example, European Union (EU) directives on VAT.

International tax treaties signed with other states are also a source of tax rules as the agreements often vary from the country’s own tax regulations.

2. Administration of Taxation

2.1. Principles of record keeping

Tax legislation usually required businesses to retain records. Records will usually be kept for:

๏ Corporate tax

๏ VAT or sales tax

๏ Excise duties

๏ Employee taxes

Corporate Income TaxA business must keep all records required to support its financial statements and all records to support adjustments made to the financial statements for tax purpose.


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Sales TaxIn many countries adequate records must be kept including business documentation such as:

๏ Orders and delivery notes

๏ Purchases and sales books

๏ Cash books and other account books

๏ Invoices

๏ Bank statements

Excise dutiesIf a business has an overseas subsidiary, it will also need to retain records relating to transfer pricing policy between the two entities.

Employee Taxes and Social SecurityEmployers keep detailed records of employees pay and amounts of tax and social security deductions.

2.2. Deadlines and Penalties

Deadlines are set by tax authorities, to ensure that taxpayers submit tax returns and pay outstanding tax on time.

In some countries tax is paid by way of self-assessment where the entity prepares the tax return and files that with the amount of tax it thinks is due.

In other countries the tax authorities raise the assessment after the entity has submitted certain information regarding its financial statements etc. to the tax authority.

3. Powers of tax authorities

Revenue authorities generally have powers to inflict penalties for various offences related to corporation tax and sales tax/VAT. In addition to this they have the following powers:

๏ Power to review and query filed returns

๏ Power to request special reports or returns

๏ Power to examine records (generally extending back some years)

๏ Power to enter and search

๏ Power to exchange information with foreign tax authorities


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4. Tax Evasion and Avoidance

4.1. Tax Evasion

Tax evasion is the illegal manipulation of the tax system to avoid paying tax and can include falsifying tax returns and claiming fictitious expenses.

4.2. Tax Avoidance

Tax avoidance is tax planning to minimise the tax liability. It is strictly legal but usually exploits loopholes in legislation.

4.3. Anti-Avoidance Provisions

As well as legislating, tax authorities use other administration methods to minimise evasion and avoidance.

๏ Reducing the opportunity by deducting tax at source and simplifying the tax structure.

๏ Increasing the perceived risk by auditing tax returns and payments.

๏ Reducing the overall gain by regularly reviewing the penalty structure.

๏ Changing social attitudes towards evasion and avoidance by developing an honest, equitable and customer friendly tax administration.

4.4. Ethical considerations

Ethical considerations can arise when businesses try to reduce their tax liability through use of tax legislation.

It is felt that businesses may pursue an aggressive form of tax avoidance to try and reduce their tax liability to amounts that public opinion may consider to be unfair.

Recent examples can be looked at with regards Google, Facebook and Starbucks in the UK.


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5. International Taxation Issues

5.1. Concept of Corporate Residence and Determining Residence

Corporate income tax is usually residence based. The test for establishing residence of an entity varies from one country to another. The main types of test are as follows:

Place of effective management and control – the country from where control of the group is exercised is deemed to be the country of residence for tax purposes.

Place of incorporation – if a country uses this as a basis any entity registered in that country will be deemed to be resident for tax purposes.

Place of permanent establishment (trade carried out or decisions made) – if a business wholly or partly conducts business through a fixed place of business

Permanent establishment includes:

๏ A place of management

๏ A branch

๏ An office

๏ A factory

๏ A workshop

๏ A mine, oil or gas well

๏ A building or construction site

It is therefore possible for an entity to be resident for tax purposes in more than one country which will lead to the problem of double taxation. It is possible that an entity has income taxed in the country it was earned and also in a different company where the company is resident.

5.2. Double Taxation

Double taxation relief exists to reduce the incidence of tax being paid twice. Often the taxpayer is allowed to deduct form its total tax liability, an amount equal to the tax already paid overseas, thus eliminating tax being paid twice.

The OECD has suggested a model tax convention which states can adopt in their dealings with each other for tax purposes.

The OECD model suggests that business profits of an enterprise can only be taxed in a country where permanent establishment is apparent.


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5.3. Foreign Taxation

Withholding TaxIn many countries, payments made abroad are subject to a ‘withholding tax’. The type of payments normally subject to withholding tax include interest, dividends and capital gains.

Double taxation treaties between countries aim to reduce or eliminate withholding taxes and double taxation.

Underlying TaxDividends are paid out of post-tax profits. If a company in Country A receives a dividend from a company in Country B, the dividend would have been taxed in Country B before receipts. The foreign tax paid in relation to this dividend receipt is called underlying tax.

The overseas dividend would be included as income for corporate tax purposes in the receiving company’s tax computation and would therefore be taxed again. This leads to double taxation.

Example 1 – Withholding and underlying tax (CIMA P7 5/06)

CW owns 40% of the equity share in Z, an entity resident in a foreign country.

CW receives a dividend of $45,000 from Z; the amount received after deduction of withholding tax of 10%. Z had before tax profits for the year of $500,000 and paid corporate income taxes of $100,000

Required(a) Calculate the amount of withholding tax paid by CW.(b) Calculate the amount of underlying tax that relates to CW’s dividend

5.3. Branch vs. Subsidiary

Branch Subsidiary๏ Same legal entity ๏ Separate legal entity๏ Branch profits liable in main entity’s tax

computation๏ Parent liable to tax on foreign dividends

received๏ Branch taxable gains liable in main

entity’s tax computation๏ Parent not subject to capital gains made

by subsidiary๏ Losses can be set off in main entity’s tax

return๏ Losses cannot usually be set off against

the parent’s profits๏ Transfer of assets is not usually subject to

tax on capital gains๏ Transfer of assets may become subject to

tax on capital gains๏ Transfer pricing issues may arise


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ANSWERS TO EXAMPLES

A. Regulatory environment and corporate governance

Chapter 1Regulatory environment

Answer 1 – Ethics

D Independence is not one of the fundamental principles in CIMA’s code of ethics.

Answer 2 – Regulatory bodies

C The IASB is not responsible for overall supervisory body of the IFRS organisations, this is the responsibility of the IFRS Foundation

Chapter 2External audit and the audit report

Answer 1 – Audit opinion (1)

D A qualified opinion is issued when there is either a material misstatement of insufficient appropriate audit evidence but it is not pervasive

Answer 2 – Audit opinion (2)

If an external auditor does not agree with the directors’ accounting treatment of a mterial item in the accounts, the first action they should take is to FORCE/PERSUADE the directors to change the accounting treatment of the item in the accounts.

Chapter 3Corporate Governance

No examples


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B. Financial Accounting and Reporting

Chapter 4Conceptual Framework for Financial Reporting

Answer 1 – Framework (1)

A The format of financial statements is covered in IAS 1 Presentation of Financial Statements

Answer 2 – Framework (2)

A Timely information is not an element of reliability.

Chapter 5IAS 1 Presentation of Financial Reporting

No examples

Chapter 6IAS 7 Statement of Cash Flows

Answer 1 – Cash and cash equivalents

20X5 20X4 Movement$’000 $’000 $’000

Government bonds 1,200 1,000Cash 400 -Overdraft - (150)

Total 1,600 850 750Increase

Answer 2 – Direct Method

$000Cash received from customers (400 + 4,700 – 500) 4,600

Cash payments to suppliers (300 + 3,300 – 450) (3,150)

Cash payments to employees (580)Cash payments for operating expenses (430)

Cash from operating activities 440


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Answer 3 – Indirect Method

$000 $000Operating Activities Profit before tax 2,850 Depreciation 850 Finance cost 500

Inventory ↓ 700

Receivables↑ 400 Payables (1,300)Cash generated from operations 4,000 Interest paid (500) Tax paid (350)Cash generated from operating activities 3,150

Answer 4 – Interest/tax paid

Cash generated from operations X Interest paid (W) (470) Tax paid (W) (380)Cash generated from operating activities X

Workings Interest paid

Interest payableInterest payableInterest payableInterest payableInterest payableInterest payableInterest payableB/f 90

Bank (β) 470 Finance cost (SPL) 500

C/f 120

590 590

Workings Tax paid

Tax payableTax payableTax payableTax payableTax payableTax payableTax payableB/f – current tax 210

Bank (β) 380 Tax expense (SPL) 350

C/f – current tax 180

560 560


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Answer 5 – Profit or loss on disposal

$ $Operating Activities (extract) Gain/loss on disposal of PPE

(Profit = 250,000 – 225,000)

(25,000)

Investing Activities (extract) Proceeds from sale of PPE 250,000

Answer 6 – Acquisition of PPE

PPE (CV)PPE (CV)PPE (CV)PPE (CV)PPE (CV)PPE (CV)PPE (CV)B/f 12,500

Depreciation 850Revaluation(500 – 150)

350

Disposal 100Cash - additions (β) 1,350

C/f 13,200

14,150 14,150


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Answer 7 – Statement of cash flows

Statement of cash flows for the year ended 31 December 20X5$000s $000s

Operating Activities Profit before tax 196 Depreciation 59 Loss on disposal of PPE 9 Finance cost 14

Inventory ↑ (2)

Receivables ↑ (8)

Payables ↑ 6Cash generated from operations 274 Interest paid (14) Tax paid (= 40 + 62 – 47) (55)Cash generated from operating activities 205Investing Activities Proceeds from sale of PPE (W) 6 Purchase of PPE (45)Cash generated from investing activities (39)Financing Activities Proceeds from issue of shares = (180 + 18) – (170 + 12) 16

Loan issue/repayment (150) Dividend paid (36)Cash generated from financing activities (170)

Change in cash and cash equivalents (4)Opening cash and cash equivalents 28Closing cash and cash equivalents 24

Workings

Profit/loss on disposal = Proceeds − Carrying value

(9,000) = Proceeds − (27,000 – 12,000)

Proceeds = 15,000 − 9,000


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PPE (Cost)PPE (Cost)PPE (Cost)PPE (Cost)PPE (Cost)PPE (Cost)PPE (Cost)B/f 780

Disposal (β) 27Cash - additions (β) 45

C/f 798

825 825

PPE (Acc depn)PPE (Acc depn)PPE (Acc depn)PPE (Acc depn)PPE (Acc depn)PPE (Acc depn)PPE (Acc depn)B/f 112

Depreciation 59Disposal (β) 12

C/f 159

171 171


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Chapter 7IAS 16 Property, plant and equipment

Answer 1 – Initial Recognition

$Purchase price (net of trade discount) 90,000Shipping & handling charges 3,500Pre-production testing 12,000Site preparation costs (excl. error) 14,000Total 119,500

Answer 2 – Change in useful life

To calculate the new depreciation charge under the change in usefule life we apply the new life to the carrying value at the date of change.

Annual depreciation (old) =$25,000,000

= $2,500,000 per annumAnnual depreciation (old) =10 years

= $2,500,000 per annum

Carrying value @ 31 December 2014 = $25,000,000 − (3 x $2,500,000)= $17,500,000

Annual depreciation (new) =$17,500,000

= $3,500,000 per annumAnnual depreciation (new) =5 years

= $3,500,000 per annum

Carrying value @ 31 December 2015 = $17,500,000 − $3,500,000= $14,000,000


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Answer 3 – Change in method

To calcualte the new deprecition charge the new method is applied to the carrying value at the date of change.

$Cost (1 Jan X4) 80,000Depn (X4)= 80,000 x 20% (16,000)

Carrying value (31 Dec X4) 64,000Depn (X5)= 64,000 x 20% (12,800)




Carrying value (31 Dec X8) 26,214

Annual depreciation (new) =$26,214

= $5,243Annual depreciation (new) =5 years

= $5,243


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Answer 4 – Revaluation

SFP (extract) SPLOCI(extract)$ $

Non-current assetsPPE (W) 573,913 Depreciation (PL) (26,087)

Equity Revaluation gain (OCI) 140,000Revaluation surplus 133,913

SOCE (extract)Retained earnings

$

Revaluation surplus

$B/F X -Revaluation in the year - 140,000Reserve transfer 6,087 (6,087)

C/F X 133,913

Workings$ $ $

Cost (1.1.X5) 500,000Accumulated depreciation(=500,000/25 x 2 years) (40,000)

Carrying value (31.12.X6) 460,000 600,000 140,000Dereciation (=600,000/23) (20,000) (26,087) (6,087)

Carrying value (31.12.X7) 573,913 133,913


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Answer 5 – Disposal of a revalued asset

SPLOCI(extract)$

Profit on disposal(=550,000 – 456,522 (W)) 93,478

SOCE (extract)Retained earnings

$

Revaluation surplus

$B/F X 120,522

Reserve transfer 120,522 (120,522)

C/F X -

Workings$ $ $

Cost (1.1.X5) 400,000Accumulated depreciation(=400,000/25 x 2 years) (32,000)

Carrying value (31.12.X6) 368,000 500,000 132,000Dereciation (=500,000/23 x 2 years) (32,000) (43,478) (11,478)

Carrying value (31.12.X8) 456,522 120,522


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Chapter 8IAS 23 Borrowing costs

Answer 1 – Specific borrowing

Borrowing costs = $10 million x 5% x 9/12

= $375,000

Answer 2 – General borrowing

% $m Ave.4% bank loan 4% 25 13% bank loan 3% 40 1.2

65 2.2

Weighted average =2.2

x 100%Weighted average =65

x 100%

= 3.38%

Capitalised = ($10m x 3.38%) + ($15m x 3.38% x 6/12)= $0.59m

Chapter 9IAS 20 Government grants

Answer 1 – Grants and depreciable assets

The property, plant and equipment will be capitalised on the statement of financial position as a non-current asset at its cost of $10 million.

It will be depreciated over its 10 year useful life and therefore $1 million of depreciation will be charged through profit or loss each year. The carrying value of the PPE will be reduced by the same amount each year.

The government grant is for a depreciable asset and so the $2 million will be spread over the same life as the PPE.

As Tweddle has met the conditions for the grant the $2 million will be recognised as deferred income on the statement of financial position.

It will be spread/amortised over 10 years and therefore $0.2 million income will be shown in profit or loss each year, with the deferred income being reduced by the same amount each year.

Tweddle will also split the deferred income at the reporting date between current and non-current liabilities.

The statement of cash flows will show a payment to acquire PPE of $10 million and grant income of $2 million in investing activities.

The depreciation and amortisation of government grants are both non-cash items in profit or loss and will need adjusting in operating activities if using the indirect method.


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Chapter 10IAS 40 Investment Properties

Answer 1 – Investment property and change of use

Addlington will treat the property using IAS 16 for the first six-months of the year before applying IAS 40 once the change in use of the property took place.

The property will be depreciated for the first six-months of the year resulting in a depreciation expense through profit or loss of $0.5 million ($20 million/20 years x 6/12), thus reducing the carrying value to $19.5 million ($20 million - $0.5 million).

The property is revalued to its fair value of $21 million on 1 July 2015 under IAS 16, giving a gain through other comprehensive income of $1.5 million ($21 million - $19.5 million).

The property is now classified as investment property and no longer depreciated.

It is revalued to a fair value of $21.6 million at the reporting date with the gain of $0.6 million going through profit or loss.

Chapter 11IAS 38 Intangible Assets

Answer 1 – Intangibles

The purchase of the patent should be capitalised at $15 million and amortised over its useful life.

The $6 million spent on the investigative phase is essentially research and should be expensed through profit or loss as incurred.

The $8 million subsequently spent after completion of the research phase is development expenditure and is capitalised as an intangible non-current asset on the statement of financial position.

It is not yet amortised as the project is not yet complete but an impairment review should be carried out to see if the asset has lost value.

The $1.5 million spent on marketing and training should both be expensed through profit or loss immediately.


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Chapter 12IAS 36 Impairment of Assets

Answer 1 – Impairment

SFP (extract) SPLOCI(extract)$ $

Non-current assets PPE (W) 18,995 Depreciation (W) 5,000

Impairment (W) 6,045

Workings

Annual depreciation =$50,000

= $5,000 per annumAnnual depreciation =10 years

= $5,000 per annum

Carrying value @ 31 December 20X9 = $50,000 − ($5,000 x 5 years)= $25,000

Fair value less costs to sell($26,000 - $2,000) = $24,000

Value in use = $5,000 X 3,791= $18,995

Recoverable amount (lower) = $18,995

Impairment = $25,000 − $18,995= $6,045

Answer 2 – Impairment (CGU)

$000 $000 $000Goodwill 90,000 (90,000) 2 -Franchise costs 50,000 (20,000) 1 30,000Restored furniture (at cost) 90,000 - 90,000Buildings 100,000 (6,667) 3 93,333Other net assets 50,000 (3,333) 3 46,667

370,000 (120,000) 250,000

1The franchise is specifically impaired2The goodwill is fully impaired3The remaining impairment is allocated to the other assets on a pro-rata basis.


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Chapter 13IFRS 5 Non-current assets held for sale and discontinued operations

Answer 1 – NCA-HFS

SFPSFPSFP SPLOCISPLOCISPLOCI$’000 $’000

Current assets Depreciation 100NCA-HFS 15,100

OCI

Gain on revaluation 1,400

Workings

Historic cost$000s

Revaluation model$000s

Revaluation reserve

Revalued amount 14,000Depreciation 300 x 4/12 (100)

13,900 15,100(=15,400 – 300) 1,400

Answer 2 – Discontinued operations

31 December 2015The operation is not being sold so cannot be classified as held for sale and neither is it a discontinued operation as it is still operating until 31 March 2016. Angola is firmly committed to the closure but it hasn’t taken place and so is included in continuing operations. A disclosure in the notes can be made of the intention to close the operation in the following year.

31 December 2016The operation is now classified as a discontinued operation as it has now ceased operating.


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Chapter 14IAS 19 Employee benefits

Answer 1 – Defined benefit scheme

Statement of financial position (extract)$’000

Fair value of scheme assets 66,000Fair value of scheme liabilities (75,000)Net pension asset/(liability) (9,000)

Statement of profit or loss and other comprehensive income (extract)$’000

Profit or lossOperating costs Current service costs (9,000) Past service costs (8,000)

Financing costs Interest expense (3,200) Return on investment 3,000

Other comprehensive incomeRe-measurement gain(= 4,000 + 3,200) (W) 7,200

Workings

Assets $’000 Liabilities $’000Opening 60,000 Opening 64,000Return on investment(5% x 60,000) 3,000 Interest

(5% x 64,000) 3,200

Contributions paid in 5,000 Service costs(9,000 + 8,000) 17,000

Benefits paid out (6,000) Benefits paid out (6,000)Expected 62,000 Expected 78,200Re-measurement gain (β)(↑ asset)

4,000Re-measurement gain (β)(↓ liability)

(3,200)

Closing (per actuary) 66,000 Closing (per actuary) 75,000

Answer 2 – Curtailment

The re-organistion has led to redundancies and therefore a significant number of employees will have left the scheme as they are no longer entitled to earn nay future pension benefits.

The net liability on the statement of financial position will be $7 million ($48 million - $55 million) and a gain will be shown through profit or loss of $5 million, being the reduction in the liability ($60 million - $55 million).


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Answer 3 – Asset ceiling

The asset ceiling is the present value of the reductions in future contributions, above which the value of the net pension asset cannot be recognised above.

The pension asset is currently above the asset ceiling so must be reduce to $26 million and the reduction in value of $4 million ($30 million - $26 million) shown as a loss through profit or loss.

Chapter 15IAS 21 Foreign currency transactions

Answer 1 – Functional currency

1 December 2015DR Purchases $97,561CR Payables $97,561

=400,000 Dinar

= $97,561=4.1

= $97,561

31 December 2015Retranslate the monetary balance (payable) at the closing rate (4.3 Dinar:$1)

=400,000 Dinar

= $93,023=4.3

= $93,023

Reduction in payables = $97,561 - $93,023 = $4,538

DR Payables $4,538CR Profit or loss $4,538

Do not retranslate the non-monetary balance (inventory), and leave it at $97,561 at the reporting date.

10 January 2016Translate the payment at the exchange rate on the day of the transaction

=400,000 Dinar

= $90,909=4.4

= $90,909

DR Payables $93,023CR Bank $90,909CR Profit or loss $2,114


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Chapter 16IAS 10 Events after the reporting period

Answer 1 – Events after the reporting period

(i) Non-adjusting events as the issue of shares does not give evidence of a condition that existed at the year-end. The company would use the issue of shares in its calculation of basic EPS.

(ii) An adjusting event as the legal action and its outcome give evidence of a condition the existed at the reporting date. A provision of $80,000 would be made.

(iii) An adjusting event that reduces the value of year-end inventory by $10,000 as it gives evidence of the fall in value of the inventory held at the reporting date. Inventory included in the accounts at the year-end would now be included at $15,000.

(iv) A non-adjusting event as the condition did not exist at the reporting date. As the item is material a disclosure of its nature and financial impact would be made in the notes.

Chapter 17

IAS 2 Inventories

Answer 1 – Inventory valuation

$/unitMaterial cost 3Labour cost 2Overheads(=72,000/12,000) 6

Total cost 11

NRV = $12 - $2 = $10

Total inventory valuation = (800 undamaged units x $11) + (200 damaged units x $10) = $10,800

Chapter 18IAS 8 Accounting policies, changes in accounting estimates and errors

Answer 1 – Accounting estimates

The change in method is a change in accounting estimate.

The changing of the capitalisation of finance costs is a change in accounting policy.


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Chapter 19

IAS 12 Income taxes

Answer 1 – Current tax

SFPSFPSFP SPLSPLSPL$’000 $’000

Current liabilities Profit before tax XTax payable 4,200 Income tax (W) (3,700)

Profit for the year X

Workings

Tax payableTax payableTax payableTax payableTax payableTax payableTax payableTax payableB/f 500

SPL - Tax 3,700

C/f 4,200

4,200 4,200

Chapter 20

IFRS 8 Operating Segments

Answer 1 – Operating Segments

An operating segment is one whose results are regularly reviewed by the chief operating decision maker (CODM). The three segments reviewed by the CODM are therefore three operating segments.

Two or more operating segments may be combined if they have similar economic characteristics. So to combine the domestic operations and the international operations the two segments would need to have similar levels of risk.

The biggest risk that is faced by Gulf within the two segments is the price risk. The revenue from the domestic railways is regulated by the transport authority, so is subject to a different risk from the international railways where it is determined by Gulf itself.

The other risk is from the offering of the contracts. The domestic railway contracts are awarded from the transport authority whereas the international railway contracts are not awarded by any authority and so both are subject to different levels of risk.

The operating segment disclosure note should therefore disclose the three segments separately within the notes to the accounts.

Chapter 21IAS 34 Interim financial Reporting

No examples


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Chapter 22IFRS 13 Fair value Measurement

No examples

Chapter 23

Consolidated Statement of Financial Position

Answer 1 – Basic consolidation

Peter Group$000

Other assets(1,500 + 1,200) 2,700

Total assets 2,700

Equity share capital 1,000Retained earnings 1,100

2,100Liabilities(400 + 200) 600

Total equity and liabilities 2,700

Answer 2 – Basic consolidation (continued)

Peter Group

$000Other assets(1,900 + 1,450) 3,350

Total assets 3,350

Equity share capital 1,000Retained earnings(=1,400 + (100% x (900 – 750)) 1,550

2,550Liabilities(500 + 300) 800



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Answer 3 – Non-controlling interest

Pierre Group$000

Other assets(1,900 + 1,450) 3,350

Total assets 3,350

Equity share capital 1,000Retained earnings(1,200 + (80% x (900 – 750)) 1,320

2,320Non-controlling interest(25% x (250 + 750)) + (25% x (900 – 750)) 230

2,550Liabilities(500 + 300) 800


Answer 4 – Goodwill

(i) Proportionate share of net assets method

$FV of consideration 156,000NCI at acquisition(25% x 170,000) 42,500

FV of net assets at acquisition (170,000)Goodwill at acquisition 28,500

(ii) Fair value method

$FV of consideration 156,000NCI at acquisition 36,000FV of net assets at acquisition (W2) (170,000)Goodwill at acquisition 22,000


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Answer 5 – Workings

Matthews Group

$000Non-current assets(1,000 + 500) 1,500

Goodwill (W3) 500Current assets(800 + 600) 1,400

Total assets 3,400

Equity share capital ($1) 500Retained earnings (W5) 1,040

1,540Non-controlling interest (W4) 260

1,800Liabilities(1,100 + 500) 1,600


Workings

W1) Group Structure

Matthews

Jones

80%

W2) Net assets of subsidiaryAt reporting

dateAt

acquisitionPost

acquisitionEquity shares 200 200Ret. earnings 400 100

600 300 300

W3) Goodwill FV of consideration (shares/cash) 600NCI at acquisition (FV) 200

800FV of net assets at acquisition (W2) (300)Goodwill at acquisition 500


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NCI @ acqn (W3) 200Add: 20% x 300 (W2) 60 260

W5) Group retained earnings100% P 800Add: 80% x 300 (W2) 240 1,040

Answer 6 – Unrealised profits

JamesGroup$’000

Non-current assets PPE(900 + 500) 1,400

Goodwill (W3) 650

Current Assets(700 + 600 – 10 (PUP)) 1,290

3,340

Share Capital 500Retained earnings (W5) 992Non-controlling interest (W4) 248

Current liabilities(1,100 + 500) 1,600

3,340

Workings

W1) Group Structure

James

Molly

80%


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W2) Net assets of subsidiaryAt reporting

dateAt

acquisitionPost

acquisition

Equity shares 200 200Ret. earnings 400 150PUP(20/120 x 120 x ½) (10)

590 350 240

W3) Goodwill

FV of consideration (shares/cash) 800NCI at acquisition (FV) 200

1,000FV of net assets at acquisition (W2) (350)Goodwill at acquisition 650


NCI @ acqn (W3) 200Add: 20% x 240 (W2) 48 248

W5) Group retained earnings100% P 800Add: 80% x 240 (W2) 192 992

Answer 7 – Share exchange

1. No. S shares acquired = 80% x 10,000,000 = 8,000,000

2. No. P shares issued = 8,000,000 x 1 / 4 = 2,000,000

3. Value of P shares issued = 2,000,000 x $3 = $6,000,000 (cost of invrestment)

4. Journal entry

Dr Investment $6,000,000Cr Share capital $2,000,000Cr Share premium (β) $4,000,000


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Answer 7 – Deferred consideration

Share exchange

1. No. S shares acquired = 80% x 30,000,000 = 24,000,000

2. No. P shares issued = 24,000,000 x 2 / 3 = 16,000,000

3. Value of P shares issued = 16,000,000 x $2 = $32,000,000 (cost of investment)

Deferred consideration

PV of consideration = 24,000,000 x $1 x 0.91 = 21,840,000

Total consideration

= 32,000,000 + 21,840,000 = $53,840,000

Chapter 24Consolidated Statement of Pro t or Loss

Answer 1 – Basic consolidation

Vader$’000

Revenue(1,645 + (6/12 x 1,280)) 2,285

Cost of sales(1,205 + (6/12 x 990)) (1,403)

Gross profit 882Distribution costs(100 + (6/12 x 70)) (135)

Administrative expenses(90 + (6/12 x 50)) (115)

Profit before interest and tax 632Finance costs(55 x (6/12 x 30)) (70)

Investment income(10 – (80% x 10)) 2

Profit before tax 564Taxation(35 + (6/12 x 28)) (49)

Profit for the year 515

Profit attributable to:Equity shareholders (β) 503.8Non-controlling interest(20% x (6/12 x 112) 11.2


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Answer 2 – Unrealised profits

P S Adj. GroupRevenue 120,000 90,000 (10,000) 200,000COS (70,000) (40,000) 10,000 (100,500)-

PUP

(25/125 x 10,000 x ¼)

(500)

Gross profit 99,500Op exp. (20,000) (35,000)

(56,000)-Impairment (1,000)

(56,000)

Finance cost (2,000) (500) (2,500)Profit before tax 41,000Taxation (6,000) (3,000) (9,000)PFY 10,000 32,000

Parent (β)Parent (β) 30,000NCI = 20% x 10,000NCI = 20% x 10,000 2,000

Chapter 25Associates

Answer 1 – Associate

$

Cost of investment in A 250,000Add: 30% x 170,000 51,000Less: impairment of goodwill (20,000)

281,000


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E. Management of working capital, cash and sources of short-term finance

Chapter 26Cash Management

Answer 1 – Cash inflows

January FebruaryInflowsCash sales 1,100 1,210Cash from credit customers 9,540 10,494

10,640 11,704

Workings

December January February

Sales 10,000 11,000(10,000 x 1.1)

12,100(11,000 x 1.1)

Cash sales 1,000(10% x 10,000)

1,100(10% x 11,000)

1,210(10% x 12,100)

Credit sales 9,000(90% x 10,000)

9,900(90% x 11,000)

10,890(90% x 12,100)

Cash receipts 5,400(60% x 9,000)

5,940(60% x 9,900)

6,534(60% x 10,890)

3,600(40% x 9,000)

3,960(40% x 9,900)

9,540 10,494

Answer 2 – Cash outflows

December January February March

Sales 10,000 11,000(10,000 x 1.1)

12,100(11,000 x 1.1)

13,310(12,100 x 1.1)

Cost of sales (60%) 6,000 6,600 7,260 7,986

Closing inventory 2,200 2,420 2,662 -Opening inventory 2,000 2,200 2,420 -Purchases 6,200 6,820 7,502 -Payment - 6,200 6,820 7,502


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Answer 3 – Cash flow forecasts

Cash flow forecast January – March 20X5

Jan Feb MarchInflows

Cash sales 45,000 49,500 54,000Credit sales 105,000 105,000 115,500

Total receipts 150,000 154,500 169,500

OutflowsMaterial 48,960 48,960 53,760Labour 16,320 17,920 19,520Direct expenses 14,280 15,680 17,080Fixed overheads 22,000 22,000 22,000Advertising - 95,000 -Interest - - 12,500

Total payments 101,560 199,560 124,860

Net receipts/(payments) 48,440 (45,060) 44,640B/f balance 50,000 98,440 53,380C/f balance 98.440 53,380 98,020

Workings

December January February MarchSales (units) 10,000 10,000 11,000 12,000Sales ($) 150,000 150,000 165,000 180,000

Cash sales 45,000(30% x 150,000)

45,000(30% x 150,000)

49,500(30% x 165,000)

54,000(30% x 180,000)

Credit sales 105,000(70% x 150,000)

105,000(70% x 150,000)

115,500(70% x 165,000)

126,000(70% x 180,000)

December January February MarchProduction (units) 10,200 10,200 11,200 12,200Materials ($)(x 2kg/unit x $2.40/kg) 48,960 48,960 53,760 58,560

Labour(x $1.60/unit) 16,320 16,320 17,920 19,520

Direct expenses( x $1.40/unit) 14,280 14,280 15,680 17,080


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Chapter 27Short-term nance and cash investment

Answer 1 – Short-term cash investment

In general terms, the company should carefully consider the following criteria:

Risk – as these funds can only be invested for 3 months, it would be inappropriate to consider high risk investments.

Return – clearly, the company will wish to maximize return. However, high returns can usually only be achieved with high risk. As noted above, it is therefore likely that only relatively low returns will be possible.

Liquidity – the company needs to consider how easily the funds can be withdrawn. This will depend on: the terms of the investments (ie how long are the funds tied up for?), what penalties are there for early withdrawal and can the investment be sold on before maturity date?

Applying these principles to the specific investments:

Investment 1

Assuming the company is in a country with a stable economy, treasury bills are likely to be very low risk. They are also highly liquid, as they can be readily sold on the money markets. The price achieved would depend on general interest rates at the time of sale.

No interest is paid on bills, so the return will be earned purely by buying at a discount to the redemption value. In this sense, the return is fixed (if held to redemption).

The annualised return = (1 + 5/1000)4 - 1 = 2.02%

Investment 2

A bank deposit is also likely to be very low risk, though maybe slightly higher than the treasury bill.

It is probably less liquid, as there will be penalty charges, and possible loss of interest, for early

withdrawal. Also, the deposit cannot be sold on.

The return can vary, which increases risk.

The effective annual rate, if the 2.5 % rate does not vary is:

(1 + 2.5/4)4 – 1 = 2.52%

This is higher than the return on the treasury bill.

At the end of the 30 day period, the company will then need to review its investment again.


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Chapter 28Working Capital

Answer 1 – Liquidity ratios

Current ratio = (50,000 + 70,000 + 10,000)

= 1.37:1 Current ratio = (88,000 + 7,000)

= 1.37:1

Quick ratio = (70,000 + 10,000)

= 0.84:1 Quick ratio = (88,000 + 7,000)

= 0.84:1

Answer 2 – Efficiency ratios

Inventory days = 220

x 365 = 44.6 daysInventory days = 1,800

x 365 = 44.6 days

Receivable days = 350

x 365 = 57.8 daysReceivable days = 0.85 x 2,600

x 365 = 57.8 days

Payable days = 260

x 365 = 63.9 daysPayable days = 0.90 x 1,650

x 365 = 63.9 days

Answer 3 – Working capital requirement

Working capital investment = $20,493 + $60,274 - $64,356 = $145,123

Payables = 114 days

x 110,000 = $64,356Payables = 365 days

x 110,000 = $64,356

Receivables = 88 days

x 250,000 = $60,274Receivables = 365 days

x 250,000 = $60,274

Inventory = 68 days

x 110,000 = $20,493Inventory = 365 days

x 110,000 = $20,493


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Chapter 29Working Capital Management

Answer 1 – EOQ

Q = 2 x $15 x 32,000$1.20

Q = 894 units

Answer 2 – Bulk discounts

Ordering costCo x D

Holding costCh x Q

Purchase Cost Total Cost

Q 2

Q

600* £6,000 £6,000 £1,200,000 £1,212,000£30 x 120,000 £20 x 600 120,000 x £10.00

600 2

1,000 £3,600 £10,000 £1,176,000 £1,189,600£30 x 120,000 £20 x 1,000 120,000 x £9.80

1,000 2 (£9,800 / 1,000)

5,000 £720 £50,000 £1,140,000 £1,190,720£30 x 120,000 £20 x 5,000 120,000 x £9.50

5,000 2 (£47,500 / 5,000)

*EOQ = √ (2 x £30 x 120,000) / £20 = 600 units

Therefore the company should choose a reorder quantity of 1,000 as this minimizes the total cost.

Answer 3 – Interest cost

Receivable days = 10

x 365 = 86.9 daysReceivable days = 42

x 365 = 86.9 days

Interest cost = 10% x $10 million = $1 million

Answer 4 – Settlement discounts

Effective annual cost = (1 + 2.5/97.5) 365/( 87 – 10) - 1 = 12.8%

Offering the discount costs 12.8% and reduces the investment in receivables but these are financed at a cost of 10%, which is cheaper and therefore the discount should not be offered.


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Answer 5 – Annual interest

r =(1 + 0.02)365/(60 – 14)

− 1 = 0.188 = 18.8%r =0.985

− 1 = 0.188 = 18.8%

Therefore Dory should not offer the customers the discount as it is more expensive than the overdraft at 15%.

Answer 6 – Factoring

Reduction in Receivables

= Sales x (Days / 365)

= $25m x (40-15) / 365

= $1,712,329

$

Reduction in overdraft interest 205,479$1,712,329 x 12%

Admin Saving 15,000Fee (250,000)

(26,521)Therefore Coral Limited should not accept the factors offer.

Answer 7 – Yield to maturity

T CF DF(7%)

PV DF(8%)

PV

0 (92) 1 (92) 1 (92)1 – 4 5 3.387 16.9 3.312 16.6

4 100 0.763 76.3 0.735 73.51.2 (1.9)

IRR = 0.07 +1.2

x (0.08 – 0.07) = 7.4%IRR = 0.07 + (1.2 + 1.9) x (0.08 – 0.07) = 7.4%

Answer 8 – Bond valuation

T CF DF @ 10% PV1 – 5 6 3.791 22.7

5 100 0.621 62.184.8

Bond value = 84.8/100 x $10,000 = $8,480


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D. Fundamentals of business taxation

Chapter 30Taxation

Answer 1 – Good taxation

A

Answer 2 – Indirect taxes

D

Answer 3 – Types of taxation

Progressive tax

Answer 4 – VAT

Input VAT = 15% x $120,000 = $18,000

Output VAT = 15% x $130,000 = $19,500

VAT payable = $1,500

Answer 5 – Income tax computation (1)

$Accounting profit 350,000Add: disallowable expenditure

Depreciation 45,000Disallowable expenses 20,000

Less: tax allowable depreciation (30,000)Taxable trading profit 315,000Tax payable @ 25% 78,750

Answer 6 – Income tax computation (2)

$Accounting profit 360,000Less: non-trading income (35,000)Add: disallowable expenditure

Depreciation 40,000Disallowable expenses 10,000

Less: tax allowable depreciation (30,000)Taxable trading profit 345,000Tax payable @ 25% 86,250


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Answer 7 – Tax depreciation

Building Stitching machine

Packing machine Total

Cost (1.1.X7) 260,000Cost (1.1.X7) 47,000Tax depreciation @ 5% cost (X7) (13,000)Tax depreciation

@ 50% (X7) (23,500) 36,500

247,000 23,500Tax depreciation (X8) (13,000)Tax depreciation

@ 25% (X8) (5,875) 18,875

234,000 17,625Cost (1.1.X9) 58,000

Tax depreciation (X9) (13,000)Balancing

allowance (β) (9.500)Tax depreciation (X9)

(29,000) 51,500

221,000Proceeds 9,500 29,000

Answer 8 – Capital tax computation

Land

Cost = $55,000

Buildings

Cost = 155,000 – 55,000 = 100,000

Refurbishment = $55,000

Total building cost = $155,000

Indexed cost = 155,000 x 1.35 = 209,250

Capital gain

Capital gain = 425,000 – (209,250 + 55,000) – 8,000 = 152,750

Tax payable = 25% x 152,750 = $38,187.5

Answer 9 – Capital losses

20X7 20X8 20X9Trading profit nil 550 700Loss relief nil (300) nilCapital gains 400 nil NilTaxable profit 400 250 700

Tax @ 25% 100 62.50 175

Capital losses c/f 150


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Chapter 31Regulatory Environment and International Taxation Issues

Answer 1 – Withholding and underlying tax

Withholding tax

$Dividend received 45,000Withholding tax(45,000/90 x 10) 5,000

50,000

Underlying tax =50,000

x 100,000 = 12,500Underlying tax =(500,000 – 100,000)

x 100,000 = 12,500


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