ACCA financial reporting F7LSBF TEXT f7 section 2

LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:56 Page 145 Tangible Non-Current Assets LSB_F7 Financial Reporting_Section 2:297mm x 210mm FINANCIAL REPORTING (INTERNATIONAL) 146 10/8/09 11:56 Page 146 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:56 Page 147 TANGIBLE NON-CURRENT ASSETS Context Tangible non-current assets were introduced in detail at the F3 level This chapter provides a reminder of the material which you have seen before, and also introduces the more complex accounting issues of • Borrowing costs relating to non-current assets • Government grants (which may or may not relate to the purchase of non-current assets), and • Investment properties – a particular type of non-current asset which has its own accounting rules Exam Hints This area of the syllabus is examined either as part of the published accounts question (Q2) or in its own right within question or of the paper Key Learning Points IAS 16 Property, Plant and Equipment • A tangible non-current asset is initially recorded at cost which may include: purchase price after any trade discounts, transport and handling costs, non-refundable tax such as import duties, site preparation, installation costs, professional fees, labour costs of the entity’s own employees (Where asset is self constructed), borrowing costs, future dismantling and restoration costs • Any abnormal costs such as wastage and costs arising from errors not form part of the cost of the asset, and must be expensed as incurred • Subsequent expenditure on a non-current asset may be capitalised where it enhances the economic benefits of the asset in excess of its current standard of performance • A complex asset is one which is made up of several constituent parts, each with a different useful life Each part of the complex asset is depreciated over its useful life and, after this time, the cost of the replacement part is capitalised • Where the useful life or residual value of an asset changes, the change is applied on a prospective basis • A change in the method of depreciation is allowed only where the new method is more appropriate The change is applied prospectively • IAS 16 allows non-current assets to be measured using either the cost model or the revaluation model • Where the revaluation model is applied, it must be applied consistently to all assets in the same class, and the valuation must be kept sufficiently up to date so that it is not significantly different from fair value • An upwards revaluation is credited to other comprehensive income (other than where it reverses a previous downwards revaluation recognised in the income statement) • A downwards revaluation is charged to the income statement (other than where it reverses a previous upwards revaluation recognised in other comprehensive income) • Depreciation is charged on a revalued asset as normal, based on a depreciable amount of valuation less residual value spread over the remaining useful life • A reserves transfer may be made to transfer the difference between the actual depreciation charge and the historical cost depreciation charge from the revaluation reserve to retained earnings • Where a previously revalued asset is disposed of, any balance remaining in the revaluation reserve relating to this asset is transferred to retained earnings and disclosed in the statement of changes in equity IAS 23 Borrowing Costs • IAS 23 requires that borrowing costs associated with the acquisition, construction or production of a qualifying asset are be capitalised as part of the cost of that asset • Interest related to specific borrowings is capitalised net of income generated by the investment of surplus funds • Interest related to general borrowings is capitalised based on the amount of borrowings used on the qualifying asset and the weighted average cost of general borrowings 147 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:56 Page 148 FINANCIAL REPORTING (INTERNATIONAL) • • • Capitalisation commences when expenditure is being incurred on the asset, borrowing costs are being incurred and activities to prepare the asset for its intended purpose are in progress Capitalisation ceases when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete Capitalisation is suspended when work on the asset is suspended IAS 20 Accounting for Government Grants and Disclosure of Government Assistance • A grant is recognised in the financial statements only when there is reasonable assurance that: o The entity will comply with the conditions attached to the grant, and o The grants will be received • A revenue grant is held as deferred income and released to the income statement over the period in which the related expenditure is incurred • A capital grant is either : o netted off against the cost of the asset with the net amount spread over the asset’s useful life and charged to the income statement as depreciation; or o held as deferred income and released to the income statement over the useful life of the asset • Grants which relate to costs already incurred should be recognised in the income statement in the period in which they become receivable IAS 40 Investment Property • Investment properties are defined as property (land or a building – or part of a building – or both) held to earn rentals or for capital appreciation or for both rather than for use or sale in the ordinary course of business • They are accounted for according to either the cost model of IAS 16 or the fair value model of IAS 40 • Where the cost model is applied, investment property is held at cost less depreciation It is not revalued • Where the fair value model is applied, investment property is re-measured to fair value each year with any changes in fair value recognised in the income statement It is not depreciated Relevant Accounting Standards IAS 16 Property, Plant and Equipment IAS 23 Borrowing Costs IAS 20 Accounting for Government Grants and Disclosure of Government Assistance IAS 40 Investment Property Technical Articles The following article (in two parts) explains property, plant and equipment and is available on ACCA’s website http://www.accaglobal.com/pubs/students/publications/student_accountant/archive/robins0607.pdf http://www.accaglobal.com/pubs/students/publications/student_accountant/archive/sa_aug07_robins.pdf 148 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:56 Page 149 TANGIBLE NON-CURRENT ASSETS Introduction Tangible non-current assets is one of the biggest balances in the statement of financial position Although IAS 16 Property, Plant and Equipment is the main accounting standard which provides guidance on this topic, others are also relevant: IAS 23 Borrowing Costs provides rules as to when borrowing costs should be capitalised as part of the cost of a non-current asset IAS 20 Accounting for Government Grants and Disclosure of Government Assistance considers how support received from the government, and often related to the purchase of non-current assets, should be reflected in the financial statements IAS 40 Investment Properties provides specific guidance on how to account for properties held only for investment purposes rather than to use within a business IAS 16 Property, Plant and Equipment Property, plant and equipment (PPE) is defined as: Tangible items that: (a) are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and (b) are expected to be used during more than one period IAS 16 requires that PPE is shown in the statement of financial position at its carrying value, defined as: The amount at which an asset is recognised after deducting any accumulated depreciation and any accumulated impairment losses IAS 16 provides guidance on the calculation of an asset’s carrying value, and in particular: the initial measurement of PPE, and treatment of any subsequent expenditure the depreciation of PPE the revaluation of PPE the disposal of PPE Guidance on accounting for impairments is provided in IAS 36 This is covered in detail in chapter 2.1 TANGIBLE NON-CURRENT ASSETS: MEASUREMENT 2.1.1 INITIAL MEASUREMENT A tangible non-current asset is initially recorded at cost This may include: • • purchase price after any trade discounts (but before settlement discounts) transport and handling costs • non-refundable tax such as import duties • installation costs • • • • • site preparation professional fees such as legal costs If the asset is self-constructed, labour costs of the entity’s own employees Borrowing costs (see section of this chapter) Future dismantling and restoration costs 149 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:56 Page 150 FINANCIAL REPORTING (INTERNATIONAL) Illustration Future dismantling and restoration costs are included as part of the cost of a non-current asset only where these costs are recorded as a provision under IAS 37 (see chapter 12) An entity builds a research centre in the rainforest at a cost of $250,000, having signed a contract with local government to dismantle the centre and restore the land after 10 years at an estimated cost of $100,000 Assuming a discount rate of 5%, a provision is made for: $100,000/1.0510 = $61,391 The debit entry is to the non-current asset cost account, such that the total cost of the research centre is: Building cost Restoration cost $ 250,000 61,391 311,391 Each year, the discount is unwound, and recorded as interest: Year Dr Interest expense Cr Provision $61,391 x 5% = $3,070 $3,070 $3,070 The measurement of the non-current asset is not affected by the unwinding of the discount Any abnormal costs such as wastage and costs arising from errors not form part of the cost of the asset, and must be expensed as incurred Exam Hint In December 08, marks were available for discussion of the treatment of a non-current asset and future clean up costs.The examiner reported that common problems were: - failure to include the clean up costs as part of the cost of the asset - failure to discount the clean up costs Even more common was a failure by those candidates who had discounted the clean up costs to unwind the discount and arrive at a finance cost In a different question on the same exam paper, 10 marks were available for the production of extracts of financial statements relating to a non-current asset over years The examiner commented that a number of candidates calculated the initial cost of the asset wrongly because they deducted a settlement discount from cost This amount should have been recorded as income The initial measurement of non-current assets may also appear in the published company accounts question (Q2), as it did in December 07 2.1.2 SUBSEQUENT COSTS Subsequent expenditure on a non-current asset may be capitalised where: • The expenditure enhances the economic benefits of the asset in excess of its current standard of performance This may be through o Extension of the asset’s life o Increase in production capacity o Improved quality of output 150 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:56 Page 151 TANGIBLE NON-CURRENT ASSETS • • A component of an asset is treated separately for depreciation purposes and is replaced or restored A major overhaul restores the asset and the cost of previous overhauls have been reflected in past depreciation charges Any other subsequent expenditure, including repairs, must be expensed to the income statement in the period in which it is incurred Learning Example 5.1 Broadoak has recently purchased an item of plant from Plantco The details of this are: $ 240,000 Basic list price of plant Trade discount applicable to Broadoak 12.5% on list price Ancillary costs: Shipping and handling 2,750 Estimated pre-production testing 12,500 Maintenance contract for years 24,000 Site preparation costs: Electrical cable installation 14,000 Concrete reinforcement 4,500 Own labour costs 7,500 Broadoak paid for the plant (excluding the ancillary costs) within four weeks of order, thereby obtaining an early settlement discount of 3% Broadoak had incorrectly specified the power loading of the original electrical cable to be installed by the contractor The cost of correcting this error of $6,000 is included in the above figure of $14,000 The plant is expected to last for 10 years At the end of this period there will be compulsory costs of $15,000 to dismantle the plant and $3,000 to restore the site to its original use condition Calculate the amount at which the initial cost of the plant should be measured, ignoring discounting 2.2 TANGIBLE NON-CURRENT ASSETS: DEPRECIATION Depreciation is: The systematic allocation of the depreciable amount of an asset over its useful life The depreciable amount is: The cost of an asset, or other amount substituted for cost, less its residual value 2.2.1 METHODS OF DEPRECIATION There are two key methods of depreciation, both of which are examined frequently: the straight line method the reducing balance method Straight Line Method This method results in a constant annual charge over the asset’s useful life It is calculated as Cost – residual value Useful life 151 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:56 Page 152 FINANCIAL REPORTING (INTERNATIONAL) Reducing Balance Method This method results in a decreasing annual charge over the asset’s useful life It is appropriate for assets such as motor vehicles and IT equipment which provide greater benefit in earlier years In both cases, depreciation is charged from the time that the asset becomes available for use in the normal manner (even if it is not yet being used) Learning Example 5.2 The following figures are extracted from the trial balance of Telenorth 25 year leasehold building – cost Plant and equipment – cost Computer system – cost Depreciation October 20X7 (note) Leasehold building Plant and equipment Computer system $000 56,250 55,000 35,000 $000 18,000 12,800 9,600 Note: Telenorth has the following depreciation policy: Leasehold building – straight line over lease term Plant and equipment – five years straight line with residual values estimated at $5m Computer system – 40% per annum reducing balance Depreciation of the leasehold building and plant is treated as cost of sales; depreciation of the computer system is an administration cost Calculate the depreciation charge and amounts to be included in the statement of financial position for the year ended 31 September 20X8 2.2.2 DEPRECIATION OF COMPLEX ASSETS Complex assets are those which are made up of various component parts, each of which has a different useful life In this case, each part of the complex asset is treated separately for depreciation purposes The part is depreciated over its useful life and, after this time, the cost of the replacement part is capitalised 2.2.3 CHANGE IN DEPRECIATION ESTIMATES IAS 16 requires that the residual value and useful life of an asset is reviewed at least at each financial year-end, together with the depreciation method applied to the asset If the residual value or useful life has changed, or the depreciation method applied to the asset is no longer appropriate to the pattern of consumption of economic benefits associated with the asset, then these are changed The change in estimate is applied to the carrying value of the asset on the date of the change on a prospective basis No adjustment is required to previously reported amounts 152 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:56 Page 153 TANGIBLE NON-CURRENT ASSETS Learning Example 5.3 Addingham has owned a non-current asset for years, depreciating the cost of $40,000 on a straight line basis over 20 years The company has conducted a review of its assets and now believes the asset to have a remaining useful life of 12 years, and a scrap value at the end of that life of $800 What is the old and new depreciation charge? 2.3 TANGIBLE NON-CURRENT ASSETS: REVALUATION IAS 16 allows non-current assets to be measured using either the cost model or the revaluation model Where the revaluation model is applied, the carrying value of a non-current asset is Valuation Accumulated depreciation Impairment losses $000 X (X) (X) X The standard requires that where the revaluation model is applied: o It is applied consistently to all assets of a class of property, plant and equipment o Assets are revalued sufficiently regularly that their carrying amount is not significantly different from their fair value 2.3.1 ACCOUNTING FOR A REVALUATION Upwards Revaluation Where an asset is revalued upwards, this is accounted for by: Dr Non-current asset Dr Accumulated depreciation Cr Other comprehensive income (revaluation surplus) the difference between cost and revalued amount all depreciation on the revalued asset to date β Therefore the credit to other comprehensive income is equal to the difference between the carrying amount of the asset prior to revaluation and its revalued amount Downwards Revaluation Where an asset is revalued downwards, the accounting entries depend on whether the asset has previously been revalued upwards: Not previously revalued upwards Dr Cr Income statement Non-current asset Previously revalued upwards Dr Dr Cr Other comprehensive income (to extent revaluation surplus exists in relation to the asset) Income statement Non-current asset Where an asset has been revalued downwards and is subsequently revalued upwards, the revaluation surplus is credited to the income statement to the extent that the downwards revaluation was previously charged against profit or loss 153 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:56 Page 154 FINANCIAL REPORTING (INTERNATIONAL) 2.3.2 DEPRECIATION OF A REVALUED ASSET Depreciation is charged on a revalued asset as normal, based on a depreciable amount of valuation less residual value spread over the remaining useful life Depreciation is charged to the income statement, but a reserves transfer may be made to transfer the difference between the actual depreciation charge and the historical cost depreciation charge from the revaluation reserve to retained earnings: Dr Cr Revaluation reserve Retained earnings excess depreciation excess depreciation Learning example 5.4 Allisterco buys property on January 20X1 at a cost of $400,000, and commences depreciation on the basis of 5% straight line On 31 December 20X4, the property is revalued to $750,000 Depreciation continues to be charged over the remaining useful life of 21 years On 31 December 20X8, the property is sold for $780,000 Prepare extracts from the statements of changes in equity and statement of comprehensive income for the year ended 31 December 20X8 Exam hint The published accounts questions (Q2) in the December 07, June 08 and December 08 exam papers all included a revaluation which had not yet been accounted for After each of these sittings, the examiner commented that many candidates had accounted for the revaluation as though it had arisen at the start of the period, even though the question clearly stated that it had occurred at the end If the question states that a revaluation occurs at the end of an accounting period, ensure that you charge depreciation for the year before revaluing the asset 2.4 TANGIBLE NON-CURRENT ASSETS: DISPOSAL The gain or loss on disposal of a non-current asset is calculated as the difference between proceeds and the asset’s carrying value on the date of disposal This applies to assets held under both the cost and revaluation model Any resulting gain or loss on disposal is recognised in the income statement Where a previously revalued asset is disposed of, any balance remaining in the revaluation reserve relating to this asset is transferred to retained earnings and disclosed in the statement of changes in equity Learning Example 5.5 Hunt buys a building on March 20X4 costing $500,000 It is depreciated monthly on a straight line basis over 40 years On 31 December 20X8, Hunt carries out a revaluation exercise and assesses the fair value of the building to be $640,000, and its remaining useful life to be 38 years How is the building reflected in the financial statements of Hunt for the year ended 31 December 20X8? 154 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:58 Page 255 PROVISIONS AND CONTINGENCIES 12 Context This chapter revises and expands on two topics previously seen at the F3 level The topic of provisions and contingencies deals with the issue of accounting for uncertainty Events after the reporting period deals with the issue of whether events occurring after the reporting date but before the accounts are signed off should be reflected in those accounts Both provisions and events after the reporting period may be considered to be ‘grey’ areas of accounting, and accordingly, numerous examples are given for each topic These are taken from the text of the relevant standards and often form the basis of exam questions Exam Hints These topics often feature in the published accounts question (Q2) Alternatively they may be examined as part of question or 5, with or without numbers Key Learning Points • • • • • • • • • A provision is a liability of uncertain timing or amount A provision is recorded in the financial statements where: o An entity has a present obligation (legal or constructive) as a result of a past event, and o It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, and o A reliable estimate can be made of the amount of the obligation A present obligation may be legal or constructive A legal obligation derives from a contract, legislation or other operation of law A constructive obligation derives from an entity’s actions where: o by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and o as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities A provision should be measured at the best estimate of required expenditure Expected values may be used to measure the provision where a large population of items are involved Where the time value of money is material, the amount of provision should be discounted to its present value Examples: Warranties Provide at time of sale using expected values Onerous contracts Provide when contract becomes onerous Guarantees Provide if payment is probable Environmental provisions Provide if IAS 37 recognition criteria are met Restructuring Provide if IAS 37 recognition criteria are met For a constructive obligation to exist, there must be a formal plan which has been announced to those affected by it Repairs / refurbishing Future operating losses Unlikely to meet IAS 37 recognition criteria May not be provided for 255 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:58 Page 256 FINANCIAL REPORTING (INTERNATIONAL) • • • A contingent liability is a possible obligation arising from past events A contingent asset is possible asset arising from past events The likely outcome should be assessed, and the event accounted for as follows: Remote Possible Probable Virtually Certain • • • • Contingent Liability Contingent Asset disclose ignore Ignore Provide Disclose Record asset An event after the reporting period is an event that occurs between the accounting period end and the date on which the financial statements are authorised for issue Adjusting events provide information about conditions existing at the period end.The financial statements should be adjusted to reflect these events Non-adjusting events are not relevant to conditions at the period end.These should be disclosed if material If a non-adjusting event affects going concern, the financial statements should be prepared on the break-up basis Relevant Accounting Standards IAS 37 Provisions, Contingent Liabilities and Contingent Assets IAS 10 Events after the Reporting Period 256 Ignore LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:58 Page 257 PROVISIONS AND CONTINGENCIES 12 IAS 37 Provisions, Contingent Liabilities and Contingent Assets IAS 37 deals with uncertain future transactions The issue is whether these uncertain future transactions should be reflected in the financial statements IAS 37 provides detailed guidance on both provisions and contingent liabilities (uncertain expenses or losses) and contingent assets (uncertain income or gains) 1.1 OBJECTIVE OF IAS 37 Historically companies often used uncertainty to manipulate accounts in their favour IAS 37 does away with this practice by: • Ensuring that appropriate measurement criteria and measurement bases are applied to provisions and contingencies, and • Ensuring that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount Provisions A provision is defined as: A liability of uncertain timing or amount A liability is defined as: A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits 2.1 RECOGNITION CRITERIA A provision is recorded in the financial statements where: • An entity has a present obligation (legal or constructive) as a result of a past event, and • It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, and • A reliable estimate can be made of the amount of the obligation 2.1.1 PRESENT OBLIGATION AS A RESULT OF PAST EVENT IAS 37 states that a present obligation may be legal or constructive A legal obligation is defined as: An obligation that derives from: (a) a contract (through its explicit or implicit terms); (c) other operation of law (b) legislation; or A constructive obligation is defined as: An obligation that derives from an entity’s actions where: (a) (b) by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities 257 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:58 Page 258 FINANCIAL REPORTING (INTERNATIONAL) Learning Example 12.1 In each of the following cases, is there a present obligation as a result of a past event, and if so, is the obligation legal or constructive? Awesome Marine operates a number of freight shipping lines The company is advertised as ‘The Green Shipping Line’ and promotes the fact that it uses ‘clean’ fuels and avoids routing ships through environmentally sensitive parts of the ocean One of Awesome’s ships has accidentally run aground, causing damage to plant and animal life There is no legal requirement for Awesome to put right the damage An ex-employee is suing Amazing Technologies for unfair dismissal Ace Clothing operates a number of retail stores in the London area I t is required by statute to provide refunds to customers who return unwanted goods in their original condition, and with a receipt, within 28 days of purchase In line with its founder’s wishes to provide exemplary customer service, Ace accepts returns up to months after purchase It does not, however advertise this fact, as the current MD is not in favour of the practice 2.1.2 PROBABLE IAS 37 states that an event is probable if the event is more likely than not to occur Practically this means that if an event has more than a 50% likelihood of occurring, then it is probable 2.1.3 RELIABLE ESTIMATE A reliable estimate of the amount of the obligation is a practical requirement in order that a provision can be made Measurement IAS 37 states that a provision should be measured at the best estimate of the expenditure required to settle the present obligation at the reporting date Where the provision involves a large population of items, expected values may be used to measure the required provision Where the time value of money is material, the amount of provision should be discounted to its present value using a pre-tax rate Learning Example 12.2 Random White Goods sells goods with a warranty under which customers are covered for the cost of any repairs as a result of manufacturing defects for the first year after purchase If all products sold required minor repairs, this would cost $1 million If all products sold required major repairs, this would cost $4 million Past experience indicates that for the coming year, 75% goods sold will not require repair, 20% goods sold will require minor repair and 5% will require major repair Should Random White Goods make a provision for warranties, and if so for how much? 258 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:58 Page 259 PROVISIONS AND CONTINGENCIES 12 Exam hint Where a scenario is presented within an exam question and you are required to say whether a provision should be made, ensure that you take each of the recognition criteria into account in your written answer: - is there a present obligation as a result of a past event? What is the past event? Is the obligation legal or constructive? - Is an outflow probable? What is the evidence? - Is there a reliable estimate? What? Jumping straight to the conclusion without writing down your thought process will mean that you miss most of the available marks Don’t worry if the question is unclear whether the outflow is probable – simply explain the accounting treatment if it is, and then explain the different treatment if it is not 2.2 ACCOUNTING FOR PROVISIONS • A provision is created by: Dr Expense (IS) Cr Provision (SFP) • At subsequent period ends, only the movement in provision required should be recorded: An increase in provision is recorded by: Dr Relevant expense category (e.g legal expenses) Cr Provision A decrease in provision is recorded by: Dr Provision Cr Relevant expense category (e.g legal expenses) • Where a provision is discounted, the increase in provision as a result of the passage of time is recorded by: Dr Interest expense Cr Provision • When a provision is used for the purpose it was created, the expenditure is charged against the provision: Dr Provision (SFP) Cr Cash Learning Example 12.3 Included in revenue in the trial balance of Eden is an amount of $3million relating to sales made under a special promotion in the last month of the year These goods were sold with an accompanying voucher equal to the selling price Five years after the sale, these vouchers will be exchanged for goods of the customer’s choosing The profit margin on these goods is expected to be about 30% of selling price, and market research suggests that 50% of the vouchers will be redeemed The present value (at the year end) of $1 at the time the vouchers will be exchanged can be taken as 60c What journal entry is required at the year end in respect of the promotion, and what is the resultant effect on the financial statements? 259 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:58 Page 260 FINANCIAL REPORTING (INTERNATIONAL) Exam Hint In the published company accounts question in the December 08 paper, candidates were required to reverse a provision for costs which did not meet the recognition criteria, and also make another provision for costs which did meet the criteria The examiner reported confusion with this, with many candidates only making one or the other adjustment 2.3 DISCLOSURE OF PROVISIONS For each class of provision the following should be disclosed, normally in the format of a reconciliation between opening and closing balances: • The carrying amount at the beginning and end of the period • Additional provisions made in the period • Amounts charged against provisions in the period • Amounts reversed in the period • The unwinding of any discount in the period In addition, for each class of provision, the following should be disclosed: • A brief description of the nature of the obligation and expected timing of any outflows of economic benefits • An indication of the uncertainties about the amount or timing of those outflows 2.4 PRACTICAL EXAMPLES As the area of provisions is relatively judgemental, IAS 37 provides guidance on certain situations: 2.4.1 WARRANTIES A warranty is often provided on goods sold It is a guarantee given to the purchaser by a company stating that a product is reliable and free from known defects and that the seller will, without charge, repair or replace defective parts within a given time limit and under certain conditions IAS 37 Treatment There is a present obligation as a result of a past event (the sale of the goods) The obligation is legal as the provision of a warranty is part of the sales contract Therefore a provision should be made at the time of sale The amount of the provision is normally calculated using expected values based on • Past experience with regard to how many repairs will be needed • Estimated repair costs (see learning example 13.2 above) 2.4.2 GUARANTEES Guarantees are common in group scenarios One group company will commonly guarantee the bank loan of another group company In other words, it promises to pay the bank back if the company which received the loan cannot IAS 37 Treatment There is a present obligation as a result of the past event (the taking out of the loan) The obligation is legal If payment of the guaranteed amount is probable, then provision should be made If payment is not probable then disclosure of a contingent liability may be required (see section 3) 260 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:58 Page 261 PROVISIONS AND CONTINGENCIES 2.4.3 12 ONEROUS CONTRACTS An onerous contract is defined by IAS 37 as: A contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it Learning Example 12.4 OddCo signed a 10 year lease for a retail unit on January 20X5, agreeing to pay $50,000 per annum in rental On 31 December 20X8, OddCo changed the focus of its business to websales, and as a result no longer needed the retail unit OddCo’s landlord refused to terminate the lease agreement early, and OddCo was unable to sub-let the unit Is a provision required? 2.4.4 ENVIRONMENTAL PROVISIONS Provision may be made for future environmental costs only where the IAS 37 recognition criteria for a provision are met The present obligation may be • A legal obligation to put right environmental damage caused, or • A constructive obligation A constructive obligation will arise where an entity has a published environmental policy in which it undertakes to meet any necessary clean up costs, and has a history of honouring this policy 2.4.5 PROVISIONS FOR FUTURE REPAIRS OR REFURBISHMENTS Provision may be made only where the IAS 37 recognition criteria are met This is likely to be rare, and the appendix to IAS 37 gives two examples of refurbishment, neither of which meet these criteria Illustrations A furnace has a lining which must be replaced every five years for technical reasons At the reporting date the lining is years old IAS 37 treatment There is no present obligation as the furnace may be sold before the replacement date arrives Therefore no provision is made for the lining Instead the new lining should be capitalised every five years and depreciated to the next replacement date An airline is required by law to overhaul its aircraft once every three years IAS 37 treatment There is no present obligation as the aircraft may be sold before the overhaul date arrives Therefore no provision is made for the overhaul Instead the overhaul should be capitalised every three years and depreciated to the next overhaul date 261 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:58 Page 262 FINANCIAL REPORTING (INTERNATIONAL) 2.4.6 RESTRUCTURING A restructuring may include: • The sale or termination of a line of business • The closure of business locations • Changes in management structure • Fundamental reorganisations IAS 37 Treatment In line with the requirements of IAS 37, restructuring costs are only provided for where: • There is a present obligation as a result of a past event • Outflow of benefits is probable, and • The outflow can be measured reliably A constructive present obligation arises only where: There is a detailed formal plan for the restructuring, and The business has raised a valid expectation in those affected that it will carry out the restructuring This may be because the restructuring has started or has been announced Learning Example 12.5 Smart decided on October 20X8 to withdraw from certain parts of the European market The Board drew up a detailed plan identifying which locations would be closed on what dates and the estimated cost implications A press release was issued on 12 December 20X8, the same day on which staff members were informed of the decision Is a provision required in the year ended 30 November 20X8? 2.4.7 FUTURE OPERATING LOSSES A provision may not be recognised for future operating losses as they not meet the definition of a liability i.e there is no present obligation as a result of a past event Exam Hint Exam questions in this area are likely to be based on scenarios provided in IAS 37 You should therefore familiarise yourself with the examples listed above Contingent Liabilities A contingent liability is defined as: (a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not whole within the control of the entity; or (b) a present obligation that arises from past events but is not recognised because (i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or (ii) the amount of the obligation cannot be measured with sufficient reliability A contingent liability is therefore a possible outflow of economic benefit that does not meet the second or third of the provisions recognition criteria 262 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:58 Page 263 PROVISIONS AND CONTINGENCIES 3.1 ACCOUNTING TREATMENT • • • 3.2 12 A contingent liability should not be recognised in the statement of financial position If a transfer of economic benefits is possible, the contingency should be disclosed in the notes to the financial statements If a transfer of economic benefits is remote, the contingency is ignored for the purposes of the preparation of the financial statements DISCLOSURE The following should be disclosed in respect of a possible contingent liability: An estimate of its financial effect An indication of uncertainties relating to the amount or timing of any outflow The possibility of any reimbursement Contingent Assets A contingent asset is defined as: A possible asset that arises from past events and whose existence with be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity 4.1 ACCOUNTING TREATMENT • • • 4.2 If the likelihood of economic inflows is considered either possible or remote, a contingent asset is ignored for the purposes of the preparation of the financial statements If the likelihood of economic inflows is considered probable, a contingent asset is disclosed in the notes to the financial statements If economic inflows are virtually certain, the asset is no longer contingent and should be recognised DISCLOSURE The following should be disclosed in respect t of a probable contingent asset: A brief description of the nature of the contingent asset Where practicable, an estimate of its financial effect 4.3 CONTINGENT ASSETS AND LIABILITIES – A SUMMARY Likelihood of Economic Transfer Liability Asset Virtually Certain Probable Provide Possible Provide Recognise Disclose Ignore Remote Ignore Disclose Ignore IAS 10 Events after the Reporting Period Events after the reporting period are defined by IAS 10 as: Those events, favourable and unfavourable, that occur between the end of the reporting period and the date when the financial statements are authorised for issue 263 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:58 Page 264 FINANCIAL REPORTING (INTERNATIONAL) Start of period End of period Accounting period E V E N T Date on which F/S authorised As the financial statements are not yet in the public domain when the event occurs, the question arises as to whether the financial statements should be adjusted to reflect the event, even though it has not occurred during the reporting period Non- adjustment may mislead users of the accounts For example, if company’s warehouse had burnt down two days after the year end resulting in the loss of all inventory, would it be fair to present shareholders with accounts which showed the warehouse as a non-current asset and inventory as a current asset? 5.1 ADJUSTING AND NON-ADJUSTING EVENTS In order to deal with the issue, IAS 10 splits events after the reporting period into adjusting and non-adjusting Adjusting events are defined as: Those events that provide evidence of conditions that existed at the end of the reporting period Non-adjusting events are defined as: Those that are indicative of conditions that arose after the reporting period 5.1.1 ADJUSTING EVENTS – EXAMPLES IAS 10 provides the following examples of adjusting events: • • • • 5.1.2 The settlement after the reporting period of a court case that confirms that the entity had a present obligation at the reporting date The receipt of information after the reporting period indicating that an asset was impaired at the reporting date, for example: o The bankruptcy of a customer after the reporting period usually confirms that a receivable should have been treated as irrecoverable at the reporting date o The sale of inventories for less than their cost after the reporting period confirms that the inventories should have been measured at net realisable value at the reporting date The determination after the reporting period of cost or proceeds of assets bought/sold during the accounting period indicates at what amount they should be recorded in the accounts The discovery of fraud or error showing that the financial statements are incorrect NON-ADJUSTING EVENTS – EXAMPLES IAS 10 provides the following examples of non-adjusting events after the reporting period: • A decline in the market value of investments • The declaration of dividends • A major business combination • The announcement of plans to discontinue an operation • Purchases or sales of assets • Classification of assets as held-for-sale in accordance with IFRS • The destruction of a production plant by fire • Announcement of or commencement of a major restructuring • An issue of shares • An announcement of changes to tax rates or laws • Entering into commitments or contingent liabilities (by, for example, issuing a guarantee) • The commencement of litigation arising from events after the reporting period 264 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:58 Page 265 PROVISIONS AND CONTINGENCIES 12 Learning Example 12.6 Grove, a restaurant and catering chain, prepares its accounts to 31 October 20X8 They are authorised for issue on 13 January 20X9 Are the following adjusting or non-adjusting events? A final dividend is declared on 29 December 20X8 A flood destroyed one of Grove’s ten restaurants on November 20X8 A van used in the catering part of the business was sold on 18 January 20X9 at a considerable loss A the sale price of a refrigeration unit, sold in principle to a competitor before the year end, was agreed on 12 December 20X8 A fraud was discovered on 11 November 20X8 As a result the draft financial statements were incorrect Exam Hint Exam questions in this area are likely to focus on events listed as examples in IAS 10 You should therefore try to learn the lists above 5.2 ACCOUNTING TREATMENT Adjusting Events The financial statements should be adjusted to reflect adjusting events Non-Adjusting Events Do not impact going concern Impact going concern Do not adjust financial statements but disclose material events Financial statements should be presented on break up basis* * financial statements prepared on the break up basis are not on the F7 syllabus 5.3 DISCLOSURE Non-adjusting events should be disclosed if non-disclosure could influence the economic decisions of users taken on the basis of the financial statements An entity should disclose the following for each material category of non-adjusting event after the reporting period: The nature of the event An estimate of its financial effect or a statement that such an estimate cannot be made 265 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:58 Page 266 FINANCIAL REPORTING (INTERNATIONAL) Learning Example 12.7 The directors of GR8, a design and printing company, are considering the treatment of the following issues in their financial statements for the year ended 30 June 20X9 On 12 July 20X9, GR8 met the IFRS criteria to classify a printing press as held for sale The carrying amount of the press at 30 June was $45,000 and its fair value was $48,000 Costs to sell would amount to $4,300 On 11 August 20X9, GR8 settled a court case with a former employee, paying them $22,000 At the reporting date, the financial statements included a provision of $15,000 in respect of this case The financial statements were approved on 18 August 20X9 How should the issues above be dealt with? 266 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:58 Page 267 PROVISIONS AND CONTINGENCIES 12 Solution 12.1 Awesome does have a present obligation as a result of a past event: - the obligation is constructive, as Awesome has been advertised as an environmentally aware company Therefore it has created an expectation on the part of other parties that it will put right the damage caused by the grounding of its ship - the past event is the grounding of the ship Amazing does have a present obligation as a result of a past event: - the obligation is legal as Amazing is being pursued by the ex-employee through the court system - the past event is the dismissal Ace does not have a present obligation as a result of a past event As the company does not advertise the generous returns policy, it has not created a constructive obligation Solution 12.2 Should a Provision be made? Present obligation as result of past event? Is outflow probable? Can a reliable estimate be made? Expected Cost of Repairs is: No repairs: 75% x $nil Major repairs: 5% x $4million Minor repairs: 20% x $1million Therefore provision required Yes Present obligation is legal as result of contracted warranty provided on sale of goods (past event) Yes Based on past experience of repairs required Yes Based on expected values $ nil 200,000 200,000 400,000 Solution 12.3 Eden must make a provision for the cost of honouring the vouchers since: - there is a present legal obligation as a result of a past event; - there is a probable outflow of economic resources (in respect of 50% of the vouchers); - the obligation can be measured reliably The amount of the provision is discounted since the obligation arises in approximately five years’ time The best estimate of the provision is calculated as: $3million x 50% (redeemed) x 70/100 (cost of meeting the obligation) x 0.6 (discount factor) = $630,000 Dr Cr Cost of sales Provision $630,000 $630,000 Therefore: - profit is reduced by $630,000, and - net assets are reduced by $630,000 267 LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:58 Page 268 FINANCIAL REPORTING (INTERNATIONAL) Note that in the intervening years until the vouchers are redeemed: the provision should be re-estimated each year, based on the percentage of customers expected to redeem the vouchers; the discounting should be unwound by: Dr finance cost Cr provision Solution 12.4 IAS 37 treatment Yes a provision is required: - There is a present obligation as a result of the past event (the signing of the lease) The obligation is legal as the lease is contractual - An outflow is probable as OddCo is contracted to pay the lease for another six years - the outflow can be measured reliably at x $50,000 = $300,000 Provision should be made for the full amount at 31 December 20X8: Dr Rent expense $300,000 Cr Provision for onerous lease $300,000 When rent is paid in subsequent years: Dr Provision for onerous lease Cr Cash $50,000 $50,000 Note: Any subletting opportunities should be treated separately as a contingent asset (see section 4) Solution 12.5 No, a provision is not required There is no constructive obligation at the year end as the restructuring plans have yet to be announced to the employees Solution 12.6 Declaration of dividend Flood Sale of van Agreement of sale price of refrigeration unit Fraud 268 Non-adjusting Non-adjusting Had Grove owned only one restaurant and the restaurant side of the business had been the major revenue earner, the financial statements may have been adjusted to reflect the business was not a going concern Non-adjusting as the sale is after the authorisation of the financial statements Had the sale been a week earlier this would have been an adjusting event Adjusting Adjusting LSB_F7 Financial Reporting_Section 2:297mm x 210mm 10/8/09 11:58 Page 269 PROVISIONS AND CONTINGENCIES 12 Solution 12.7 Printing Press • This is an event after the reporting period • IAS 10 includes the classification of a non-current asset as held-for-sale within its list of non-adjusting events • In the financial statements for the year ended 30 June 20X9, the press should remain classified as a non-current asset held at its carrying value of $45,000 • Assuming it is considered to be a material event, disclosure should be made of the transfer of the asset to assets held-for-sale and the resulting impairment loss of $1,300 Court Case with Employee • This is an event after the reporting period • The year end provision of $15,000 should therefore be adjusted to $22,000, resulting in a further charge to profits of $7,000 • IAS 10 includes the settlement after the reporting date of a court case within its list of adjusting events Learning Summary • • • • • • Learn the IAS 37 recognition criteria for provisions Learn the summary in section 3.3 of the treatment of contingent liabilities and assets Familiarise yourself with the IAS 37 examples of when a provision is required Learn examples of adjusting and non-adjusting events after the reporting period Complete the quick test for Chapter 12 Watch the video clip called ‘x 269 ...LSB _F7 Financial Reporting_ Section 2: 297mm x 21 0mm FINANCIAL REPORTING (INTERNATIONAL) 146 10/8/09 11:56 Page 146 LSB _F7 Financial Reporting_ Section 2: 297mm x 21 0mm 10/8/09 11:56... Depreciation (25 ,400 x 40%) CV at 30.9.X8 160 $000 $000 56 ,25 0 (18,000) 38 ,25 0 (2, 250) 36,000 2, 250 55,000 ( 12, 800) 42, 200 (10,000) 32, 200 10,000 35,000 (9,600) 25 ,400 (10,160) 15 ,24 0 10,160 LSB _F7 Financial. .. Question and Answer book LSB _F7 Financial Reporting_ Section 2: 297mm x 21 0mm 10/8/09 11:56 Page 165 Intangible Assets LSB _F7 Financial Reporting_ Section 2: 297mm x 21 0mm FINANCIAL REPORTING (INTERNATIONAL)