LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 271 13 Substance over Form LSB_F7 Financial Reporting_Section 3:297mm x 210mm FINANCIALREPORTING (INTERNATIONAL) 272 10/8/09 12:01 Page 272 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 273 SUBSTANCE OVER FORM 13 Context Application of the concept of substance over form is a requisite for fair presentation within the financial statements Throughout this text, we have already seen examples of its application, such as the preparation of group accounts and accounting for finance leases This chapter explores further applications of substance over form, and also considers revenue recognition rules, to which the concept also relates Exam Hints Practical applications of substance over form may be examined as part of the published accounts question (Q2) or in their own right within question or of the paper Key Learning Points • • • • The accounting principle of ‘substance over form’ means that the commercial substance of a transaction should be reflected in the accounts rather than its legal form This is necessary in order to achieve fair presentation The importance of substance is recognised within the definitions of assets and liabilities within the Framework, for example an asset should be controlled, but not necessarily owned Examples of the application of substance over form are: o The preparation of group accounts (chapter 1) o Finance leases (chapter 8) o Redeemable preference shares (chapter 15) o Consignment inventory o Sale and leaseback o Sale and repurchase o Factoring of receivables Consignment Inventory • Consignment inventory is inventory held by a selling party on behalf of a manufacturer until such time as it is sold to a customer During the period in which the inventory is held by the selling party, it will be recorded as an asset in either the manufacturer or the selling party’s accounts, depending on who has the risks and rewards of ownership Sale and Leaseback • A company may sell an asset in order to release funds and then lease it back for continued use • A sale and operating leaseback is recorded as a sale, with the resultant profit or loss recognised according to the following rules: Sale price > fair value Recognise ‘fair value’ profit or loss immediately Recognise any excess profit over the lease term Sale price < fair value Recognise profit or loss on sale immediately unless a loss is compensated for by future below market lease payments, in which case the loss is recognised over the lease term Sale price = fair value • Recognise profit or loss on sale immediately The substance of a sale and finance leaseback arrangement is that it is a secured loan Therefore the asset is not derecognised, and the proceeds received are recorded as a loan 273 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 274 FINANCIALREPORTING (INTERNATIONAL) Sale and Repurchase • A company may sell an asset and agree to repurchase it at a future date The sale is recorded only where the risks and rewards of ownership of the asset are transferred on the date of the sale If the selling company retains the risks and rewards of ownership of the asset until the repurchase date, no sale is recorded and instead the proceeds are accounted for as a secured loan Factoring of Receivables • A further method by which a company may release funds is to sell its receivables ledger to a factor The selling company should only derecognise its receivables where it transfers the risks and rewards associated with them to the factor • The principles of revenue recognition are also based on the concept of substance over form: • Revenue from the provision of services is recognised by reference to the stage of completion when all of the following conditions are met: The amount of revenue can be measured reliably It is probable that the economic benefits of the transaction will flow to the entity The stage of completion of the transaction at the reporting date can be measured reliably The costs incurred in relation to the transaction can be measured reliably • Revenue from the sale of goods is recognised when all of the following conditions are met: The selling company has transferred the significant risks and rewards of ownership of the goods to the buyer The selling company no longer has managerial involvement in the goods sold nor effective control over them The amount of revenue can be measured reliably It is probable that the economic benefits of the transaction will flow to the entity The costs incurred in relation to the transaction can be measured reliably • When all of these conditions are not satisfied, revenue is recognised only to the extent that expenses recognised are recoverable Relevant Accounting Standards IAS Presentation of Financial Statements IAS 17 Leases IAS 18 Revenue IAS 27 Consolidated and Separate Financial Statements IAS 32 Financial Instruments: Presentation IAS 38 Financial Instruments: Recognition and Measurement Technical Articles The following article explains IAS 18 Revenue and is available on ACCA’s website http://www.accaglobal.com/pubs/students/publications/student_accountant/archive/sa_jan08_clendon.pdf 274 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 275 SUBSTANCE OVER FORM 13 Substance Over Form – An Introduction IAS requires that financial statements represent faithfully the effects of transactions and events In order to achieve this, the commercial substance of transactions should be represented, rather than the legal reality This accounting principle is known as ‘substance over form’ At the F3 exam and in earlier chapters, we have met the following examples of substance over form: Redeemable preference shares Groups of companies Finance leases Legal Form Commercial Substance Individual companies which must prepare individual company statutory accounts Operate as a single entity and therefore consolidated accounts are prepared (IAS 27) Shares Asset is leased by lessee for a period of time Possess the characteristics of debt and so are accounted for as a liability (IAS 32) Risks and rewards of asset are transferred to lessee and so the asset should be accounted for as if owned by the lessee (IAS 17) Exam Hint Redeemable preference shares often feature in the published company accounts question (Q2) Ensure that you account for them as a liability in accordance with IAS 32 1.1 THE IMPORTANCE OF RECORDING SUBSTANCE OVER FORM If the legal form of the transactions listed above was reflected in the financial statements, rather than the commercial substance, then the overall objective of fair presentation would not be achieved In particular, users of the accounts: • may not appreciate that redeemable preference shares amount to a liability and have cash flow implications in the year of redemption • would have difficulties understanding the operations of a group of companies based on numerous individual company accounts • may not understand that a finance lease is generally a long term arrangement with an associated liability and ongoing costs for the upkeep of the leased asset 1.1.1 THE PROBLEM OF OFF-BALANCE SHEET FINANCE The problem of off-balance sheet finance provides a further example of the importance of recording substance over form Historically, preparers of financial statements have tried to keep financing liabilities out of their accounts, using the legal form of these liabilities as the underlying reason for this This strategy meant that companies appeared to be healthier that they actually were It is most famously exemplified in the case of Enron The application of the substance over form principle, and continually tightening accounting regulations reduces the issue of off-balance sheet finance 275 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 276 FINANCIALREPORTING (INTERNATIONAL) Substance Over Form: General Principles Taking a backward step, we can see how the concept of substance over form is linked to the definition of assets and liabilities within the Framework: • An asset is defined as: A resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity Note that this definition uses the word ‘controlled’ rather than ‘owned’, therefore meaning that assets such as those held under a finance lease fall within its scope • 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 Again, this definition is worded to include instruments such as redeemable preference shares which possess the characteristics of debt The recognition criteria of the Framework promote the concept of substance over form in a similar way: An asset or liability should be recognised if: • It is probable that any future economic benefit associated with the item will flow to or from the entity • The item can be measured reliably The first of these recognition criteria encompasses the idea of ‘rewards’.You will remember from chapter that the main criteria for classifying a lease as a finance lease was whether the ‘risks and rewards’ of ownership had transferred 2.1 FEATURES WHICH MAY INDICATE THAT SUBSTANCE DIFFERS FROM FORM The following features of a transaction may indicate that substance differs from form: it is linked to a number of other transactions, and should be viewed as a part of those rather than individually the legal title of an asset is separated from the risks and rewards of that asset (e.g finance leases) Further Practical Examples The following are further examinable examples where the substance of a transaction may differ from its legal form: • Consignment inventory • Sale and leaseback • Sale and repurchase • Factoring of receivables 3.1 CONSIGNMENT INVENTORY The issue of consignment inventory is common in the motor industry Often the manufacturer will enter into an arrangement with a car dealer to take and display some vehicles with a view to selling them to a customer Legal title remains with the manufacturer until the date of the sale to the customer, at which point the vehicle is sold to the dealer who in turn sells it on to the customer The issue is whether the manufacturer or dealer owns the vehicles for the period of time that they are displayed in the dealer’s showroom 276 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 277 SUBSTANCE OVER FORM 3.1.1 13 ACCOUNTING TREATMENT The risks and rewards of ownership must be assessed: • If the risks and rewards of ownership have passed to the dealer when the vehicles were transferred to the showroom, then the manufacturer has sold the vehicles and the dealer should recognise the vehicles as inventory in its accounts • If the risks and rewards of ownership have not passed to the dealer, but have been retained by the manufacturer, then no sale has been made and the manufacturer should continue to recognise the vehicles as assets Indicators that risks and rewards have transferred to the dealer Indicators that risks and rewards have been retained by the manufacturer • • • • • Manufacturer can not require dealer to return vehicles without compensation Dealer is unable to return vehicles to manufacturer without penalty Price charged to the dealer is based on list price on delivery date Price charged to the dealer increases with the length of time for which vehicles held • • • Manufacturer can require dealer to return vehicles Dealer can return vehicles to manufacturer without penalty Price charged to the dealer is based on list price on date of sale to customer Price charged to the dealer does not vary with the length of time for which the vehicles are held Learning Example 13.1 McCulloch is a car dealership in the north of Scotland On 17 September 20X8, a manufacturer delivers 10 new cars to McCulloch on the following terms: - - - - The manufacturer may require the cars to be returned if they are needed to meet an order from another dealer, although in practice this has never happened Mc Culloch is required to insure the vehicles from the date of delivery Mc Culloch will be charged $10,000 per vehicle on the earlier of 31 January 20X9 or the date of a sale to a third party This is the list price on 17 September 20X8 Mc Culloch may use the cars for test drive purposes Should Mc Culloch record the cars as inventory in its statement of financial position at 31 December 20X8? Exam Hint Where consignment inventory features in an exam, make sure that you read the question carefully, understand the arrangement, discuss the risks and rewards and conclude that the owner of the asset is the party who has these risks and rewards 3.2 SALE AND LEASEBACK The issue of sale and leaseback arises where a company wishes to release funds, and in order to so, sells a large asset, such as a property, to a bank It then leases the property back on an annual rental basis, and continues to occupy it The issue is whether this is a true sale, and subsequent lease, or whether the substance of the arrangement is a secured loan rather than a sale 277 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 278 FINANCIALREPORTING (INTERNATIONAL) 3.2.1 ACCOUNTING TREATMENT The type of lease should be determined in accordance with IAS 17 Leases, by considering the transfer of risks and rewards The following rules then apply: Sale and Operating Leaseback A sale is recorded and the subsequent operating lease is accounted for in line with IAS 17 The profit or loss arising on sale is dealt with as follows: Sale price > fair value Sale price = fair value Sale price < fair value Recognise ‘fair value’ profit or loss immediately Recognise any excess profit over the lease term Recognise profit or loss on sale immediately Recognise profit or loss on sale immediately unless a loss is compensated for by future below market lease payments, in which case the loss is recognised over the lease term Sale and Finance Leaseback The substance of the transaction is a secured loan Therefore no sale is recorded and the receipt on ‘sale’ is recorded as a loan Annual repayments are allocated between repayment of capital and interest Learning Example 13.2 On 30 June 20X8, Morningside sells two assets to a bank: - - A property sold for $400,000 is leased back under a finance lease with annual repayments in arrears The property had a carrying value of $270,000 at 30 June 20X8 Land sold for $600,000 is leased back under a 10 year operating lease The land had a carrying value of $300,000 and a fair value of $550,000 How should these transactions be accounted for in the financial statements of Morningside for the year ended 31 December 20X8? How would this differ if the land was sold for $500,000, and the future lease rentals were at less than market value? 3.3 SALE AND REPURCHASE In order to release funds, a company may sell an asset to a finance house, with an agreement that it will be repurchased at a future date, often at a higher price This is common in industries where stocks take a period of time to mature, such as malt whisky production In this case, vats of whisky are sold to a bank for the period that they take to mature The issue is whether this is a true sale, and should be accounted for as such, or whether in substance it is a loan secured on the asset 3.3.1 ACCOUNTING TREATMENT As before, the risks and rewards of ownership should be considered, and in particular whether these have transferred to the finance house - If the risks and rewards of ownership have been transferred to the finance house, the transaction should be accounted for as a sale - If the risks and rewards are retained by the seller, the transaction should be accounted for as a secured loan 278 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 279 SUBSTANCE OVER FORM Indicators that the transaction should be recorded as a sale • • • There is no commitment to a repurchase Finance house benefits from any increase in the market value of the asset (through a repurchase price related to market value) Seller has no rights over the asset after the sale 13 Indicators that the transaction should be recorded as a secured loan • Sale price is not equal to market value of asset at sale date • There is commitment to the repurchase, normally through the seller having a call option and the finance house a put option such that one will exercise their option and the repurchase will occur • The repurchase price is not related to the market value of the asset and is simply the initial sale price plus interest • Seller retains the right to use the asset as they wish Learning Example 13.3 Edinglow imports special whisky ingredients which take five years to mature before being used in the manufacturing process During the year ended 31 May 20X8, it imported material at a cost of $40million Edinglow then sold this inventory to Northrock Bank for $40 million, agreeing to buy it back in five years’ time for $56.1million The materials not leave the premises of Edinglow Assuming an effective rate of interest of 7%, how should the above transaction be accounted for? 3.4 FACTORING OF RECEIVABLES A further method by which a company may release funds is to sell its receivables ledger to a factor, often a bank The issue is whether the company should derecognise the receivables when they are transferred to the factor, or retain them as assets, recognising the bank advance as a loan 3.4.1 ACCOUNTING TREATMENT As before, the risks and rewards associated with the receivables should be considered: - - If the selling company has transferred the risks and rewards to the factor, then the receivables should be derecognised If the selling company has not transferred the risks and rewards to the factor, then the receivables should not be derecognised Indicators that the risks and rewards have been transferred to the factor • • • There is no recourse to the selling company for any irrecoverable debts The transfer is for a non-returnable sum Selling company has no right to further payment from the factor Indicators that the risks and rewards have not been transferred to the factor • • • There is recourse to the selling company for irrecoverable debts The selling company is required to pay finance costs to the factor based on unpaid debt costs to the factor based on unpaid debt 279 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 280 FINANCIALREPORTING (INTERNATIONAL) Learning Example 13.4 Telenorth factored the outstanding account receivable of a major customer amounting to $12million to Kwikfinance on September 20X8 The terms of the factoring were as follows: Kwikfinance paid 80% of the outstanding amount to Telenorth immediately The balance will be paid (less the charges below) when the account is collected in full Any amount of the account outstanding after four months will be transferred back to Telenorth at its full book value Kwikfinance will charge 1% per month of the net amount owing from Telenorth at the beginning of each month Kwikfinance had not collected any of the amounts receivable at the 31 December year end Telenorth debited the cash from Kwikfinance to its bank account and removed the amount receivable from its sales ledger It has prudently charged the difference as an administration cost How should the factoring arrangement be accounted for in the financial statements of Telenorth? Exam Hint A full exam question on one of the substance over form topics is likely to have a large written element Write your whole thought process down, making sure that your points are clear and succinct and in bullet point format Sales Revenue 18 Revenue provides guidance on accounting for revenue, which it defines as: The gross inflow of economic benefits arising in the course of the ordinary activities of an entity, other than contributions from equity participants In other words, the standard addresses income other than that from the issue of shares, including: - Revenue from the sale of goods - Revenue from the provision of services - Dividends receivable - Interest receivable - Royalties receivable IAS 18 requires that all income is recognised at its fair value and goes on to provide criteria for the recognition of each type of income as detailed in the following sections These criteria take into account the concept of substance over form in considering when revenue should be recorded 4.0.1 SALE OF GOODS Revenue from the sale of goods is recognised when all of the following conditions are met: The selling company has transferred the significant risks and rewards of ownership of the goods to the buyer The selling company no longer has managerial involvement in the goods sold nor effective control over them The amount of revenue can be measured reliably It is probable that the economic benefits of the transaction will flow to the entity 10 The costs incurred in relation to the transaction can be measured reliably 280 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 281 SUBSTANCE OVER FORM 13 Learning Example 13.5 Southside sells sofas with year’s interest free credit During the month of January 20X8, Southside sells 150 sofas with a price of $600 A subsidiary of Southside sells the same sofas for $560 without providing credit facilities How should Southside recognise the revenue in relation to the sofas? Learning Example 13.6 Corstorphine recorded $200,000 sales revenue during the month of May 20X9, making a draft profit of $40,000 based on a mark up on 25% $120,000 of revenue related to sales made to Dalkeith, who Corstorphine transact with on a sale or return basis Dalkeith had sold two thirds of the goods on to customers by the end of the month, but had the right of return over the remaining third What revenue and profits should Corstorphine recognise for the month of May? Exam Hint A sale or return transaction featured in the June 2008 paper as part of the published accounts question, where candidates were required to adjust a profit figure for a number of items The examiner commented that candidates commonly struggled with the adjustment for sale or return goods 4.0.2 PROVISION OF SERVICES Revenue from the provision of services is recognised by reference to the stage of completion when all of the following conditions are met: The amount of revenue can be measured reliably It is probable that the economic benefits of the transaction will flow to the entity The stage of completion of the transaction at the reporting date can be measured reliably The costs incurred in relation to the transaction can be measured reliably When all of these conditions are not satisfied, revenue is recognised only to the extent that expenses recognised are recoverable Learning Example 13.7 Gyle sells processing machines to the food industry Each one comes with a two year service agreement included within the price of $300,000 After the two year period, annual service agreements may be purchased at a standard cost of $30,000 Half way through the year ended 31 December 20X8, Gyle sold 40 machines in a single order to a Russian farm co-operative How should the related revenue be recorded in Gyle’s financial statements for the year? 4.0.3 DIVIDENDS, INTEREST AND ROYALTIES - Dividends are recognised when there is a right to receive payment Interest is recognised using the effective interest method (see chapter 15) Royalties are recognised on an accruals basis in accordance with the royalty agreement 281 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 282 FINANCIALREPORTING (INTERNATIONAL) 4.1 DISCLOSURE REQUIREMENTS The following should be disclosed in relation to revenue: • • 282 The accounting policies adopted for the recognition of revenue The amount of each significant category of revenue recognised during the period, including o The sale of goods o The provision of services o Dividends o Interest o Royalties LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 283 SUBSTANCE OVER FORM 13 Solution 13.1 The risks and rewards of ownership have transferred to McCulloch: - McCulloch must meet insurance costs - the price charged to McCulloch is set on the date of delivery - McCulloch is bound to buy the cars on 31 January 20X8 if they remain unsold - McCulloch has access to use the cars for test drives The fact that the manufacturer can require the cars to be returned is an indicator that the risks and rewards have not transferred to McCulloch However, this has never happened in practice, and is outweighed by the factors suggesting that the risks and rewards have transferred to McCulloch Therefore the cars should be reflected as inventory in its statement of financial position at the 31 December 20X8 Learning Example 13.2 Property This is a sale and finance lease back Therefore: - The property remains in the statement of financial position and continues to be depreciated At 31 December 20X8 it is therefore held at $270,000 less six months’ depreciation - $400,000 is recognised as a loan, split between current and non-current amounts - Interest accruing on the first six months of the loan should be recorded as a current liability Land This is a sale and operating lease back Therefore: - A sale is recorded: the profit of $250,000 based on fair value ($550,000 - $300,000) is recognised immediately; the profit in excess of fair value of $50,000 ($600,000 - $50,000) is spread over the 10 years of the lease, with $5,000 recognised as income each year - Operating lease payments are recognised as normal in accordance with IAS 17 Solution 13.3 Edinglow has retained the risks and rewards associated with the inventory: - - Edinglow is obliged to repurchase the inventory at the pre-determined price of $56.1million (being the $40million capital repayment plus interest thereon) This price is fixed regardless of the market value or condition of the inventory, meaning that Edinglow bears the risk of falls in market value or damage The inventory does not leave the premises of Edinglow Therefore, the $40m advance is treated as a loan secured on inventory No sale will be recorded and inventory will not be derecognised from the statement of financial position 283 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 284 FINANCIALREPORTING (INTERNATIONAL) The loan is recorded as follows throughout the year term: y/e 31.5.X8 y/e 31.5.X9 y/e 31.5.Y0 y/e 31.5.Y1 y/e 31.5.Y2 Balance b/f $000 Finance cost 7% $000 Balance c/f $000 42,800 2,996 45,796 40,000 45.796 49,002 52,432 2,800 42,800 3,206 49,002 3,430 52,432 3,670 56,100 Income statement finance cost Year end balance in statement of financial position Solution 13.4 - - - - - Kwikfinance has paid $9.6million (80% x $12million) to Telenorth, however if Telenorth’s customers not pay within four months, this is recoverable from Telenorth in full Kwikfinance will only pay the balance of $2.4 million if Telenorth’s customers pay Kwikfinance charges 1% of the outstanding balance (i.e the amount not recovered from customers) per month for this service The risks and rewards relating to the $12m receivables ledger are therefore retained by Telenorth The receivables should not be derecognised, and the $9.6million advance should be treated as a secured loan, which is the substance of the transaction Interest charged by Kwikfinance should be recorded as a finance cost relating to the loan Accounting Entries Telenorth has: Dr Dr Cr Cash Admin expenses Receivables $9.6m $2.4m $12m In order to correct this entry and put through the correct entry: Dr Receivables $12m Cr Admin expenses $2.4m Cr Loan $9.6m Interest at 1% per month must also be charged: $9.6m x 1% x months (Sept / Oct/ Nov/ Dec) = Dr Finance costs Cr Accrued interest 284 384,000 $384,000 $384,000 (to reinstate the receivables) (to reverse the expenses charged) (to create a loan account) LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 285 SUBSTANCE OVER FORM Financial Statements Statement of Financial Position at 31 December 20X8 Receivables Accrued interest Loan Income Statement for the Year Ended 31 December 20X8 Finance costs 13 $000 12,000 384 9,600 $000 384 Solution 13.5 - - The fair value of the sofas is $560 Therefore the extra $40 per sofa charged by Southside represents interest relating to the credit Southside should therefore record revenue and corresponding receivables of $84,000 (150 x $560) This revenue should be recorded when the goods are delivered to the customer as this is likely to be the date on which the risks and rewards of ownership pass, and Southside cease to have effective control over the sofas The $6,000 balance (150 x $40) is recorded as a finance cost spread over the two years of credit Learning Example 13.6 Where goods are sold on the basis of sale or return, the risks and rewards of ownership not transfer from the seller until the goods are sold on to a third party Therefore, Corstorphine should not have recorded revenue in relation to the goods over which Dalkeith still has a right of return The revised amounts for inclusion within Corstorphine’s financial statements are therefore: Revenue ($200,000 – (1/3 x $120,000) Profits ($40,000 – (25/125 x 1/3 x $120,000) $000 160 32 Solution 13.7 - The revenue associated with the machines must be split from that associated with the service agreements: Machine years service agreement - $000 240 60 300 The machines were sold mid year and therefore revenue relating to 6months should be recorded The balance of the revenue relating to the service agreements should be recorded as deferred income in the statement of financial position Income Statement Revenue (40 x $240,000) + (40 x 6/12 x $30,000) Statement of Financial Position Deferred income (40 x $45,000) $000 10,200 1,800 285 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 286 FINANCIALREPORTING (INTERNATIONAL) Learning Summary • • • 286 Ensure that you understand the examples of substance over form, and how risks and rewards may be assessed Practise writing answers in bullet point format to questions on this topic Learn the recognition criteria for revenue relating to the sale of goods and provision of services LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 287 14 Conceptual and Regulatory LSB_F7 Financial Reporting_Section 3:297mm x 210mm FINANCIALREPORTING (INTERNATIONAL) 288 10/8/09 12:01 Page 288 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 289 CONCEPTUAL AND REGULATORY 14 Context In previous chapters we have considered the application of a number of accounting standards In this chapter, we now takes a step back and consider where the rules and principles governing accounting practice come from This is a topic previously seen at the F3 level, although it remains very examinable at F7 This chapter includes discussion of: • the regulatory bodies governing international financialreporting • underlying concepts which are relevant to all financialreporting • accounting policies, estimates and errors Exam Hints The regulatory and conceptual framework are normally examined within question or of the paper The conceptual framework may be examined as a standalone theoretical topic or through its application to scenarios Key Learning Points Regulatory Framework • • • • A regulatory framework may include IFRS, local laws, securities exchange rules, EU directives and local GAAP It is necessary in order to ensure that financial statements are useful, reliable and comparable, and companies operate in an accountable way The IASCF oversees, funds and monitors the work of : o The IASB who are responsible for issuing new accounting standards and promoting convergence o The SAC who advise the IASB on their agenda and the impact of new standards o The IFRIC who provide support to the IASB and guidance on emerging accounting issues o There is a six step due process to the setting of an accounting standard: Setting the agenda Project planning Development and publication of a discussion paper Development and publication of an exposure draft Development and publication of an IFRS Procedures after the IFRS National standard setters interact with international bodies through the adoption of IFRS into local GAAP, collaborative work, and the inclusion of national standard setters on the IASB Conceptual Framework • • • • • a principles based system of accounting is based on a conceptual framework and accounting standards set within the parameters of this conceptual framework a rules based system is one where accounting standards are simply a set of rules which companies must follow International GAAP is based on a principles based system, with a conceptual framework known as the Framework The IASB’s Framework provides general guidelines and principles for preparing financial statements The qualitative characteristics of financial statements are understandability, relevance, reliability and comparability 289 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 290 FINANCIALREPORTING (INTERNATIONAL) • • • • • Reliability refers to faithful representation, substance over form, neutrality, prudence and completeness Qualitative characteristics may conflict.Where this is the case, a balance should be achieved The Framework requires that fair presentation is achieved within financial statements This is achieved where accounting standards are followed Departure is only allowed in rare circumstances where following guidance within a standard would be misleading Such departures (a ‘true and fair override’) must be disclosed The Framework provides definitions of assets, liabilities, equity, income and expenses These elements of the financial statements are recognised where: o it is probable that any economic benefit associated with the item will flow to or from the entity, and o the item has a cost or value that can be measured with reliability IAS Accounting Policies, Changes in Accounting Estimates and Errors • • • • • • • An accounting policy is a specific principle or rule applied by a company in preparing its financial statements Accounting policies can only be changed where required by an accounting standard or where the new policy results in more reliable and relevant information A change in accounting policy is applied retrospectively by way of a prior period adjustment An accounting estimate is a judgment required in the application of accounting policies If an accounting estimate changes, the new estimate is applied prospectively If a prior period error is made, this is corrected retrospectively by way of a prior period adjustment A prior period adjustment results in restatement of the opening balance on retained earnings and restatement of comparatives to reflect the amounts that would have been reported had the new accounting policy always been in place or the error never occurred Relevant Accounting Standards and Guidance Framework for the Preparation and Presentation of Financial Statements IAS Presentation of Financial Statements IAS Accounting Policies, Changes in Accounting Estimates and Errors 290 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 291 CONCEPTUAL AND REGULATORY Regulatory Framework 1.0.1 WHY IS A REGULATORY FRAMEWORK NEEDED? 14 Regulations governing the preparation of financial statements are required in order to ensure that: - Financial statements can be relied upon by their various users - The information provided within financial statements is useful and relevant - The financial information of entities is comparable - Companies behave in a proper fashion towards their investors - Market confidence in companies and their accounts is maintained 1.0.2 WHAT IS A REGULATORY FRAMEWORK? Accounting standards alone can not provide a regulatory framework; particularly since they not have legal standing The regulatory framework of a jurisdiction adopting IFRS may therefore include all of the following: - IFRS themselves - Local company law - Local securities exchange regulations - EU directives (where relevant) - Local GAAP (Generally Accepted Accounting Principles) where relevant Within the UK, for example, listed companies are regulated by IFRSs, the Companies Act 2006, the Stock Exchange rules and EU directives Unlisted companies are regulated by UK GAAP (UK accounting standards), the Companies Act 2006 and EU directives The International stream of F7 is concerned with the international regulatory framework, and the various bodies involved in the setting of international accounting guidance 291 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 292 FINANCIALREPORTING (INTERNATIONAL) 1.1 THE STRUCTURE OF THE INTERNATIONAL REGULATORY FRAMEWORK The international regulatory framework includes main bodies, structured as follows: International Accounting Standards Committee Foundation (IASCF) 22 trustees from varied professional backgrounds and geographical locations Oversees, funds and monitors the operational effectiveness of: Standards Advisory Council (SAC) About 40 members • advice to IASB on - their agenda and work prioritisation - the impact of proposed standards International Accounting Standards Board (IASB) 14 members from varied professional backgrounds and geographical locations • Develop new accounting standards (known as IFRS) • Liaise with national standard-setting bodies to promote convergence of international and national accounting standards International FinancialReporting Interpretations Committee (IFRIC) 12 voting members plus a non-voting chair • Assist the IASB to establish and improve standards • Issues Interpretations (known as IFRICs) which provide timely guidance on emerging accounting issues not addressed in full standards • Assist in the international / national convergence process 1.1.1 THE OBJECTIVES OF THE IASCF AND IASB The objectives of both the IASCF and IASB are : to develop a single set of high quality, understandable and enforceable global accounting standards to help users make economic decisions; to promote the use and rigorous application of those standards; to take account of the special needs of SMEs and emerging economies to bring about the convergence of national and international accounting standards to high quality solutions 292 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 293 CONCEPTUAL AND REGULATORY 1.1.2 14 THE STANDARD SETTING PROCESS The IASCF has identified six stages in the standard setting process: Setting the agenda Project planning Development and publication of a discussion paper (DP) Development and publication of an exposure draft (ED) Development and publication of an IFRS Procedures after an IFRS is issued 1.1.3 Possible new projects are identified by: - IASB staff members - Other IASCF bodies - Requests from practising accountants The IASB will add projects to its agenda by reference to meeting the needs of users of the financial statements A decision is made as to whether the project should be worked on in collaboration with a national standard setter and a working party is established A DP is not a mandatory step in the due process, however the IASB normally issues a DP where a project addresses a major issue The DP explains the issue and possible accounting solutions and invites constituents to comment After the comment period (normally 120 days) comments are analysed and further discussions and round tables may take place An ED is a mandatory step in due process and sets out the draft proposals for a standard When of the members of the IASB have approved the ED, it is published for public comment This comment period normally lasts 120 days, and afterwards, comments are analysed, and if required, the ED is amended and re-exposed When any issues arising from the ED are concluded, the final IFRS is subject to approval by the IASB Nine members must approve it before it is issued After an IFRS is issued, the IASB monitors its application and any areas that may need clarification, and addresses these when the standard is revised or as part of its annual improvements project cycle THE INTERACTION OF INTERNATIONAL AND NATIONAL STANDARD SETTERS National standard setters may interact with the IASCF and its bodies in the following ways: - - - through the adoption of IFRS into local GAAP (for example UK FRS 21 is a rebranded IFRS 10) through collaborative work: the initial research stages of the IASB standard setting due process are often conducted by a national standard setter (for example the UK ASB has been involved in the IASB’s Leasing project) through the inclusion of most of the important national standard setters within the membership of the IASB Learning Example 14.1 Historically, financialreporting throughout the world has differed widely The International Accounting Standards Committee Foundation (IASCF) is committed to developing, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require transparent and comparable information in general purpose financial statements The various pronouncements of the IASCF are sometimes collectively referred to as IFRS GAAP (a) describe the functions of the various internal bodies of the IASCF, and how the IASCF interrelates with other national standard setters (b) describe the IASCF’s standard setting process including how standards are produced, enforced and occasionally supplemented (c) comment on whether you feel the move to date towards global accounting standards has been successful 293 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 294 FINANCIALREPORTING (INTERNATIONAL) Conceptual Framework As well as issuing accounting standards specific to particular issues, the IASB has issued a general conceptual framework for financialreporting This is referred to as the Framework It provides the concepts that underlie financial statements and the qualitative characteristics that a set of financial statements should possess, as well as key definitions of the elements of financial statements and recognition criteria to be applied to them IFRS are set within the parameters of this Framework, adopting the principles within it 2.0.1 WHY IS A CONCEPTUAL FRAMEWORK REQUIRED? A conceptual framework is required in order that: - certain basic issues such as the definition of an asset are addressed, and then applied consistently throughout standards - new standards can be developed along the same principles as existing standards - complex and unusual transactions, not addressed within an IFRS can be accounted for according to basic principles - the number of alternative accounting treatments is reduced 2.0.2 PRINCIPLES V RULES BASED SYSTEMS OF ACCOUNTING International GAAP is an example of a principles based system of accounting, which is based on a conceptual framework (the Framework) and accounting standards set within the parameters of this conceptual framework An alternative system of accounting is a rules based system whereby accounting standards are simply a set of rules which companies must follow This is the case in the US Advantages Disadvantages Principles Based Flexible with regard to changing environments Entities may not interpret and apply principles consistently Individuals may interpret principles in such a way as to manipulate results 2.1 Rules Based More consistent and comparable results across entities Less flexible and adaptable to change May lead to problems when rules are applied literally without regard to the spirit of a standard, resulting in mis-representation of balances This is particularly true in the light of accounting scandals such as Enron, Worldcom and Parmalat QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS Qualitative characteristics are the attributes of financial statements that make them useful to users There are four main characteristics: Characteristics which make financial statements useful Understandability 294 Relevance Reliability Comparability LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 295 CONCEPTUAL AND REGULATORY 14 These characteristics should be present in financial statements subject to a materiality threshold Items in the financial statements are material if their omission or misstatement could influence users of the accounts It is therefore particularly important that the characteristics above are applied to material items 2.1.1 UNDERSTANDABILITY Financial statements should be understandable to users For this purpose, users are assumed to have reasonable knowledge of business and economics However, items should not be excluded from the financial statements simply because they are perceived to be complex Practical Examples of Understandability 2.1.2 financial instruments are included in the financial statements despite being perceived as complex RELEVANCE Financial statements are relevant where they provide information which is useful to users for decision making purposes Such information may have a confirmatory value (and so confirm the users’ understanding of past events) or a predictive value (and so help them to predict future events) Practical Examples of Relevance - - 2.1.3 properties may be revalued to market value discontinued operations are reported separately RELIABILITY The financial statements must be reliable in order to be useful Reliability can be subdivided into: • • • • • Faithful Representation Information must faithfully represent transactions and events, in accordance with their economic substance rather than legal form Substance Over Form The commercial substance of a transaction is more important than its legal form As far as possible, the financial statements should reflect commercial substance Neutrality In order to be reliable, financial statements should be free from bias Prudence Prudence means to exercise caution when recording transactions Assets and income should not be overstated, and liabilities and expenses not understated Completeness Information presented in the financial statements should be complete Practical Examples of Reliability - inventory is valued at the lower of cost and NRV (prudence) - irrecoverable debts are derecognised (prudence) - development costs are only recognised as an asset when the recognition criteria are met (prudence) - an asset under a finance lease is recognised as a non-current asset (substance over form) - redeemable preference shares are recognised as debt (substance over form) 295 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 296 FINANCIALREPORTING (INTERNATIONAL) 2.1.4 COMPARABILITY In order for financial statements to be useful, they should be comparable: • With the financial statements of other businesses • With the financial statements of the same business over time This is achieved by consistency of accounting policies and disclosure of accounting policies, including any changes in them for fairer presentation Practical Examples of Comparability - IAS formats enable the comparison of entities - disclosure of accounting policies enables the financial statements of two entities to be compared taking into account different policies - depreciation estimates should be applied consistently 2.1.5 THE BALANCE BETWEEN QUALITATIVE CHARACTERISTICS Conflicts between qualitative characteristics may be apparent For example: • Financial statements may be less understandable if they are more complete (i.e including a complex transaction) • Relevant information may not be reliable The Framework requires that in these cases, a balance is achieved Learning Example 14.2 (a) The qualitative characteristics of relevance, reliability and comparability identified in the IASB’s Framework for the Preparation and Presentation of Financial Statements are some of the attributes that make financial information useful to the various users of financial statements Explain what is meant by relevance, reliability and comparability and how they make financial information useful (b) During the year ended 31 March 20X6, Porto experienced the following: (i) entered into a finance lease to rent an asset for substantially the whole of its useful economic life (ii) the company’s income statement prepared using historical costs showed a loss from operating its hotels, but the company is aware that the increase in value of its properties during the period far outweighed the operating loss Explain how you would treat the items above in Porto’s financial statements and indicate on which of the Framework’s qualitative characteristics your treatment is based (F7 Pilot paper) Exam Hints In December 2007, marks were available for an explanation of faithful representation and how it enhances reliability The examiner commented that some candidates regurgitated what they had been taught about comparability, relevance and so on rather than answering the question Weaker candidates were unable to link faithful representation with substance over form In June 2008, candidates were required to explain the meaning of matching/accruals, substance over form, prudence, comparability and materiality The examiner felt that this was an F3 level question, but a significant number of candidates displayed poor knowledge of these basic concepts Furthermore, several candidates did not ‘explain’ the concepts but instead gave examples of them or stated their importance 296 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 297 CONCEPTUAL AND REGULATORY 2.2 14 FAIR PRESENTATION The Framework requires that financial statements give a ‘fair presentation’ of financial position and performance In the UK this is referred to as a ‘true and fair view’ of financial position and performance Fair presentation has no legal definition but is assumed to be achieved where accounting standards and the Framework are followed 2.2.1 TRUE AND FAIR OVERRIDE Departure from accounting standards is allowed in the rare circumstance that compliance with a requirement of a standard would be so misleading that it would conflict with the Framework’s objectives of financial statements This departure is commonly known as a ‘true and fair override’ IAS requires the following to be disclosed when the requirements of a standard are departed from: - the nature of the departure, including the treatment required by the standard, the reason why this would be misleading, and the treatment adopted - the financial impact of the departure 2.3 ELEMENTS OF FINANCIAL STATEMENTS AND THEIR RECOGNITION The elements of financial statements are: - Assets - Liabilities - Equity - Income, and - Expenses The definitions of each are as follows: Asset Liability Equity Income Expense 2.3.1 A resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity 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 The residual interest in the assets of the entity after deducting all its liabilities Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants 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 RECOGNITION OF ELEMENTS OF THE FINANCIAL STATEMENTS An item that meets the definition of an element should be recognised if: - it is probable that any economic benefit associated with the item will flow to or from the entity, and - the item has a cost or value that can be measured with reliability These recognition criteria are used as a basis for the specific recognition criteria within certain standards, such as: IAS 37 Provisions, Contingent Liabilities and Contingent Assets (provisions) IAS 38 Intangible assets (development costs) 297 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 298 FINANCIALREPORTING (INTERNATIONAL) Exam Hint In December 2008, marks were available for the definition of a liability, explanation of when a provision should be recognised and two examples of how the definition of a liability enhances reliability The examiner commented that candidates were generally able to provide definitions, however their examples were ‘rather trivial’ rather than concentrating on areas where a definition was key to reliability, such as provisions Accounting Policies and Estimates An accounting policy is a specific principle or rule applied by a company in preparing its financial statements They are generally driven by accounting standards and the Framework.The following are examples of accounting policies: • The capitalisation of development costs meeting the recognition criteria • The depreciation of non-current assets • The revaluation of certain classes of non-current assets An accounting estimate is a judgement required in the application of accounting policies For example • The method of and rate at which non-current assets are depreciated 3.1 CHANGE IN ACCOUNTING POLICY In order to achieve comparability, accounting policies should be applied consistently over time and across similar assets/liabilities A change in accounting policy is only allowed if it: • Is required by an accounting standard, or • Results in more reliable and relevant financial statements A change in accounting policy is evident if there is a change in: recognition (e.g an item previously recognised as an expense is now capitalised as an asset) presentation (e.g an amount previously recognised within distribution costs is now recognised within cost of sales), or measurement basis (e.g assets held at historical cost are now held at a revalued amount) Where an accounting policy is changed, the change is applied retrospectively i.e the financial statements are changed so that balances are as they would be had the new policy always been in place This is achieved through a prior period adjustment (see section 3.4) 3.2 CHANGE IN ACCOUNTING ESTIMATES By its nature, an estimate may need to be revised if circumstances change For example, 10% straight line depreciation of a non-current asset is based upon an estimated 10 year useful life It may however become apparent after using the asset for a few years that the total useful life is less than 10 years IAS 10 therefore allows changes in accounting estimates, and requires that they are accounted for prospectively In other words, the revised estimate is applied going forward but does not result in a prior period adjustment Learning Example 14.3 Farsyde starts depreciating a new non-current asset which cost $90,000 at a rate of 5% straight line After two years, it is decided that the asset has just ten years of use left What is the old, and the new, depreciation charge? 298 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:01 Page 299 CONCEPTUAL AND REGULATORY 3.3 14 ERRORS If a current period error is discovered during the current period, it can be corrected before the financial statements are issued If, however, a material prior period error is discovered during the current period, it should be corrected retrospectively i.e the financial statements are changed so that they appear as they would had the error never occurred.This is achieved through a prior period adjustment (see section 3.4) 3.4 PRIOR PERIOD ADJUSTMENTS Prior period adjustments are made where: • There is a change in accounting policy, or • There is a prior period error In both cases: the balance on retained earnings at the start of the current period is adjusted (in the SOCE), and comparative information is restated to reflect the situation had the new policy always been in place / the error never occurred Restatement of the opening retained earnings balance is disclosed in the statement of changes in equity: Learning Example 14.4 Monkman has discovered that closing inventory at the end of the previous period was overvalued by $20,000 This is considered to be a material error requiring adjustment The following information is relevant: Retained earnings as reported at previous period end Cost of sales in current period (before adjustment for error) Inventory as reported in previous period’s statement of financial position $433,900 $127,655 $67,000 What adjustments must be made to the current year financial statements in respect of the error? 299 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 300 FINANCIALREPORTING (INTERNATIONAL) Solution 14.1 (a) IASCF – International Accounting Standards Committee Foundation The Trustees of the IASCF oversee the whole organisation They arrange funding, appoint the members of the IASB, IFRIC and SAC, and set the agenda for the IASB The aims of the IASCF are: - to develop a single set of high quality global accounting standards - to promote the use of these standards - to bring about convergence of national and international accounting standards IASB – International Accounting Standards Board The IASB develops and issues IFRS in its own right It reports to the IASCF Members of the IASB are appointed for their technical competence and independence IFRIC – International FinancialReporting Interpretations Committee IFRIC provides rapid guidance on accounting issues where divergent or unacceptable treatments are likely to arise It reports to the IASB Membership of IFRIC is drawn from a diverse range of geographical and professional backgrounds SAC – Standards Advisory Council The SAC provides a forum for organisations or individuals to take part in the standard setting process It advises the IASB on agenda decisions, priorities and its views on standard setting projects Membership is drawn from a diverse range of geographical and professional backgrounds Advisory Committees are set up to advise the IASB On specific issues National Standard Setters (b) Although the IASCF is an independent organisation, it works closely with national standard setters The IASB, SAC and advisory committees draw heavily on personnel from national bodies In return, many national standard setters incorporate IFRSs into their own accounting standards Setting Standards The IASCF sets the agenda for producing accounting standards, but the IASB produces and issues these standards The process is as follows: The IASCF, taking into account advice from the SAC and others, identifies an issue requiring an accounting standard The IASB sets up an Advisory Committee to investigate the issue and report back to the IASB The IASB may issues a Discussion Draft for public comment (this is not a mandatory step in the due process) A Discussion Draft needs a simple majority to be issued Comments must normally be received within 120 days The IASB issues an Exposure Draft; comments must normally be received within 120 days The Exposure Draft must be approved by eight of the 14 members of the IASB If necessary, based on comments received, the ED may be amended and re-exposed The IASB issues an IFRS It must be approved by eight of the 14 members of the IASB Public discussion is encouraged The basis of conclusions for EDs and IFRSs are published along with dissenting opinions Most meetings of the IASB, IFRIC and SAC are open to the public, and they are exploring ways of using technology to make public access easier globally 300 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 301 CONCEPTUAL AND REGULATORY 14 Enforcing Standards The IASB has no legal power to enforce adoption or compliance with standards, but enforcement of a sort is achieved in a number of ways: - Quoted companies within the EU must comply with IFRS, but it is up to each member state to police compliance Some countries have a formal process to review published financial statements and punish non-compliance (for example the FinancialReporting Review Panel in the UK), but this is not universal To a certain extent, the onus is on the auditors to police compliance, but auditing standards themselves are not globally consistent - Companies using IFRS to obtain cross-border listings are required to have their financial statements audited in accordance with International Auditing Standards This will help to ensure that these companies are complying with IFRS - Many countries are bringing their own standards into line with IFRS, but again policing of national standards is inconsistent Supplementing Standards The IFRIC issues interpretations when divergent or unacceptable accounting treatments arise, whether through misinterpreting an existing standard or on an important issue not yet covered by a standard Financial statements must comply with all of these interpretations if they claim to comply with IFRS Has the move towards Global Accounting Standards been successful? On a practical level the move towards global accounting standards has been one of the accounting successes of the last decade The standards themselves have improved, with the elimination of contradictory alternatives and the creation of an open and independent standard setting organisation This in turn has led to greater acceptance of these standards, illustrated by, for example, the adoption of IFRS for consolidated accounts by all quoted companies in the EU in 2005, in Chile in 2009, the upcoming adoption of IFRS for listed companies in Brazil in 2010 and Canada in 201 In all, including the EU countries, 89 jurisdictions currently require the use of IFRS for domestic listed companies However, as mentioned earlier, there is no global system of enforcement, and so it is too early to say if IFRS are being adopted properly Some countries with their own highly developed accounting standards see the adoption of IFRS as a backward step, whereas other countries see IFRS as unnecessarily complicated There is also the assumption that the globalisation of accounting standards is a good thing Recent developments in IFRS have often focussed on quoted companies in the western world; they may not be suitable for all types and sizes of business organisation, or for all stages of economic development, although the IFRS for SMEs, published in June 2009 should address this to some extent Solution 14.2 (a) Relevance The relevance of information must be considered in terms of the decision-making needs of users It is relevant when it can influence their economic decisions or allow them to reassess past decisions and evaluations Economic decisions often have a predictive quality – users may make financial decisions on the basis of what they expect to happen in the future To some degree past performance gives information on expected future performance and this is enhanced by the provision of comparatives, so that users can see the direction in which the company is moving The separate presentation of discontinued operations also shows how much profit or loss can be attributed to that part of the operation which will not be there in the future This can also affect valuation of assets One aspect of relevance is materiality An item is material if its omission or misstatement could influence the economic decisions of users Relevance would not be enhanced by the inclusion of immaterial items which may serve to obscure the important issues 301 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 302 FINANCIALREPORTING (INTERNATIONAL) Reliability Information can be considered to be reliable when it is free from error or bias and faithfully represents what it is expected to represent The income statement must be a reliable statement of the results of the entity for the period in question and the statement of financial position must faithfully represent its financial position at the end of the period Financial statements in which provision had not been made for known liabilities or in which asset values had not been correctly stated could not be considered reliable This also brings in the issue of substance over form Transactions should be represented in accordance with their economic substance, rather than their legal form This principle governs the treatment of finance leases, sale and leaseback transactions and consignment inventory If these types of transactions are not accounted for in accordance with their economic substance, then the financial statements are unreliable Comparability (b) Comparability operates in two ways Users must be able to compare the financial statements of the entity with its own past performance and they must also be able to compare its results with those of other entities This means that financial statements must be prepared on the same basis from one year to the next and that, where a change of accounting policy takes place, the results for the previous year must also be restated so that comparability is maintained Comparability with other entities is made possible by use of appropriate accounting policies, disclosure of accounting policies and compliance with IFRS Revisions to standards have to a large degree eliminated alternative treatments, so this has greatly enhanced comparability (i) The substance of a finance lease is that the lessee has acquired an asset using a loan from the lessor Porto should capitalise the asset and depreciate it over its useful life (which is the same as the lease term) A finance lease liability should be set up for the same amount The liability will be reduced by the lease payments, less the notional finance charge on the loan, which will be charged to profit or loss This presents the transaction in accordance with its substance, which is a key aspect of reliability (ii) This issue has to with relevance It could be said that the use of historical cost accounting dies not adequately reflect the value of assets in this case This can be remedied by revaluing the properties If this is done, all properties in the category will have to be revalued This will probably give rise to a higher revaluation charge, so it will not improve the operating loss in the income statement, but the excess can be credited back to retained earnings in the statement of financial position Solution 14.3 Old depreciation: New depreciation: $90,000 x 5% $90,000 – (2 x $4,500) 10 years = $4,500 = $8,100 Solution 14.4 Income Statement Cost of sales ($127,655 - $20,000) Statement of Changes in Equity Opening balance Prior period adjustment Restated $107,655 Retained earnings $ 433,900 (20,000) 413,900 Statement of Financial Position (Prior Year Comparative) Inventory ($67,000 - $20,000) 302 $47,000 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 303 CONCEPTUAL AND REGULATORY 14 Learning Summary • • • • • Learn the structure of the IASCF and the roles of each of the bodies within it Learn due process for the development of a new standard Ensure that you understand the qualitative characteristics of the Framework, and can identify practical examples of them Learn the definitions of the elements of the financial statements and the associated recognition criteria Ensure that you: o understand the difference between an accounting policy and accounting estimate o Know how to apply a prior period adjustment 303 LSB_F7 Financial Reporting_Section 3:297mm x 210mm FINANCIALREPORTING (INTERNATIONAL) 304 10/8/09 12:02 Page 304 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 305 15 Financial Instruments LSB_F7 Financial Reporting_Section 3:297mm x 210mm FINANCIALREPORTING (INTERNATIONAL) 306 10/8/09 12:02 Page 306 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 307 FINANCIAL INSTRUMENTS 15 Context Financial instruments is a new topic at the F7 level It is a very complex area of financialreporting At the F7 level, it is covered only at a very basic level – more detail and complexity is added at P2 This chapter introduces and defines financial instruments, explains how they are classified for reporting purposes and how each classification of financial instruments should be accounted for Exam Hints Financial Instruments may be examined as: - a consolidation adjustment; - part of the published accounts question (Q2); - with calculation and discussion elements as part of Q4 or Q5 Key Learning Points o A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity o IAS 39 requires that financial assets are classified as one of four types and financial liabilities as one of two types.The accounting treatment of a financial instrument depends on its classification Financial Assets Includes Subsequent Measurement Gains and Losses Amortised cost n/r Amortised cost Other comprehensive income Ordinary shares held for the long-term Re-measured to FV at reporting date n/r Derivatives Re-measured to FV at reporting date Income statement Fair value through profit or loss Shares or debt held for the short term Loans and receivables Receivables Held to maturity Available-for-sale Financial Liabilities Fair value through profit or loss Financial liabilities Fixed interest debt intended to be held to maturity Fixed interest loan to another company Redeemable debt Redeemable preference shares Initial Measurement Cost + transaction costs Proceeds – transaction costs Re-measured to FV at reporting date Amortised cost Income statement n/r Payables 307 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 308 FINANCIALREPORTING (INTERNATIONAL) o Financial assets, other than those classified as fair value through profit or loss should be reviewed for impairment at each reporting date If evidence exists that an impairment has arisen, then the asset should be written down to its recoverable value, and the loss recognised in the income statement o Where a financial asset or liability is sold or discharged, it should be derecognised from the financial statements The difference between the carrying value of the instrument and the proceeds received or amount paid for the discharge should be recognised in the income statement for the period In addition the cumulative gains or losses relating to AFS investments, which are accumulated in reserves on year-end re-measurement are ‘recycled’ to the income statement o IAS 39 requires that a compound instrument is split into its equity and liability elements and both are recognised in the statement of financial position o The liability element is recognised as the present value of the bond assuming that there were no conversion rights, using an effective interest rate for a similar non-convertible bond o The equity element is the balance of the proceeds Relevant Accounting Standards IAS 32 Financial instruments: Presentation IAS 39 Financial instruments: Recognition and Measurement Technical Articles The following article on financial instruments is available on ACCA’s website: http://www.accaglobal.com/pubs/students/publications/student_accountant/archive/sa_novdec08_clendon.pdf 308 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 309 FINANCIAL INSTRUMENTS 15 Financial Instruments – An Introduction IAS 32 defines financial instruments as: Any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity A financial asset is: Any asset that is: - cash; - an equity instrument of another entity; - a contractual right to receive cash or another asset from another entity; - a contractual right to exchange financial assets or liabilities with another entity under conditions that are potentially favourable; - a contract that will be settled in the entity’s own equity instruments A financial liability is: Any liability that is a contractual obligation: - to deliver cash or another financial asset to another entity; - to exchange financial assets or liabilities with another entity under conditions that are potentially unfavourable; - that will or may be settled in the entity’s own equity instruments An equity instrument is: Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities Practically, these definitions may include the following: Financial Assets Financial Liabilities - - - - cash ordinary shares held in another company loan stock held in another company receivables - payables redeemable loan stock issued Convertible loan stock issued - - Equity ordinary shares issued irredeemable preference shares issued Redeemable preference shares issued The classification of cash, receivables and payables as financial instruments does not change their accounting treatment as seen in your earlier studies Exam Hint The most examinable financial instruments are: - - Loan stock (redeemable and convertible) Preference shares (redeemable and irredeemable) 309 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 310 FINANCIALREPORTING (INTERNATIONAL) Financial Assets IAS 39 requires that financial assets are classified as one of four types: 2.0.1 Fair value through profit or loss (FVTPL) Held to maturity (HTM) Loans and receivables Available-for-sale (AFS) FAIR VALUE THROUGH PROFIT OR LOSS A financial asset is classified as fair value through profit or loss where it is - Held for trading (i.e acquired principally for resale); or - Is designated as fair value through profit or loss at acquisition Examples 2.0.2 A holding of ordinary shares in another company held for the short term A holding of loan stock in another company held for the short term HELD TO MATURITY A financial asset is classified as held to maturity where it has - Fixed or determinable payments - Fixed maturity, and - The entity intends to hold the asset to maturity Example 2.0.3 A holding of fixed interest loan stock in another company intended to be held until redemption LOANS AND RECEIVABLES A financial asset is classified as loans and receivables where it - Has fixed or determinable payments - Is not quoted in an active market - Is not classified as held for trading (as there is no intention to sell in the short term), and - Is not designated as available-for-sale Examples - 310 A trade receivable A fixed interest loan to another company LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 311 FINANCIAL INSTRUMENTS 2.0.4 15 AVAILABLE-FOR-SALE A financial asset which is not classified as FVTPL, HTM or loans and receivables is classified as available-for-sale Example - A holding of ordinary shares in another company held for the long term Financial Liabilities IAS 39 states that financial liabilities may be classified as fair value through profit or loss (FVTPL) Alternatively they may be classified as a simple financial liability 3.0.1 FAIR VALUE THROUGH PROFIT OR LOSS A financial liability is classified as fair value through profit or loss where it is - Held for trading (i.e acquired principally for resale); or - Is designated as fair value through profit or loss at acquisition Examples of financial liabilities classified as FVTPL are derivatives These are not on the F7 syllabus 3.0.2 FINANCIAL LIABILITIES Other financial liabilities which are not classified as FVTPL may include: - Payables - Bank loans Learning Example 15.1 How should the following be classified according to IAS 39? Equity shares in another company, with no intention to sell A loan from a supplier A term loan to another company at 5% interest rate A holding of another company’s quoted corporate bonds with no intention to sell An amount owed by a customer Accounting for Financial Instruments 4.1 INITIAL RECOGNITION Financial instruments are recognised in an entity’s statement of financial position when that entity becomes a party to the contractual provisions of the instrument They are initially measured at fair value In the case of financial asset, this is generally cost; in the case of a liability, it is generally proceeds received For all financial instruments other than those classified as FVTPL, transaction costs form part of the initial measurement Practically, this means that transaction costs are: - added to the fair value of an asset, and - deducted from the fair value of a liability 311 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 312 FINANCIALREPORTING (INTERNATIONAL) Learning Example 15.2 Lambeth issues $500,000 4% redeemable loan stock at a discount of 5% The costs of the issue are $42,000 Southwark buys $100,000 redeemable preference shares in another company at par Southwark intends to hold the shares to redemption Transaction costs amount to $12,500 How are these financial instruments initially measured? 4.2 SUBSEQUENT MEASUREMENT The subsequent measurement of a financial instrument depends on its classification The table below summarises the accounting treatment of each type of instrument: Category Fair value through profit or loss Subsequent Measurement in SFP Re-measured to fair value at each reporting date (financial assets or liabilities) Held to Maturity Measured at amortised (financial assets only) cost Loans and Measured at amortised receivables cost (financial assets only) Available for sale Re-measured to fair value (financial assets only) at each reporting date Financial liabilities Measured at amortised cost Statement of Comprehensive Income Example Gains and losses on re-measurement are recognised in the income statement as part of profit Learning example 16.4 interest credited to income statement as finance income Learning example 16.7 Gains and losses on re-measurement are recognised in other comprehensive income (and charged or credited to reserves) Learning example 16.3 Interest charged to income statement as finance costs Learning examples 16.6, 16.8, 16.9 Interest and dividends are recognised in income statement as part of profit interest credited to income statement as finance income Interest and dividends are recognised in income statement as part of profit Learning Example 15.3 On June 20X8 Balham buys an investment for $13million, incurring transaction costs of $500,000 The investment is classified as available-for sale At the year end, 31 December 20X8, the investment has a fair value of $14million The profit for the year of Balham, before accounting for the investment is $16million How should this be accounted for, and how does it appear in the financial statements of Balham? 312 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 313 FINANCIAL INSTRUMENTS 15 Learning Example 15.4 Putney buys an investment on 31 October 20X8 for $700,000, incurring transaction costs of $30,000 Putney intends to hold the investment for six months at the most At the 30 November 20X8 year end, the value of the investment has dropped to $675,000 How should this be accounted for and how does it appear in the financial statements of Putney? Exam Hint Financial assets classified as FVTPL featured in the published company accounts question (Q2) in the June 2008 paper Candidates were required to calculate the increase in carrying value of the asset and recognise the gain in profit 4.3 IMPAIRMENT LOSSES Financial assets, other than those classified as fair value through profit or loss should be reviewed for impairment at each reporting date There is no need for assets classified as FVTPL to be reviewed for impairment, as the standard IAS 39 accounting treatment discussed above requires that any fall in their value will already have been charged to profits For other classifications of financial asset, if evidence exists that an impairment has arisen, then the asset should be written down to its recoverable value, and the loss recognised in the income statement 4.4 DERECOGNITION Where a financial asset or liability is sold or discharged, it should be derecognised from the financial statements The difference between the carrying value of the instrument and the proceeds received or amount paid for the discharge should be recognised in the income statement for the period 4.4.1 AFS INVESTMENTS In addition the cumulative gains or losses relating to AFS investments, which are accumulated in reserves on year-end re-measurement are ‘recycled’ to the income statement This is achieved by: Dr Cr Cumulative Gain in Reserves Cumulative Loss in Reserves Income statement (recognition of gains now realised) Other comprehensive income (reversal of AFS losses previously recognised) Other comprehensive income (reversal of AFS gains previously recognised) Income statement (recognition of losses now realised) Learning Example 15.5 Continuing with learning example above, assume that Balham sold the AFS investment for $19million on 31 October 20X9 How should this disposal be accounted for? 313 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 314 FINANCIALREPORTING (INTERNATIONAL) Example Financial Instruments Certain financial instruments are specified within the F7 syllabus The following are all discussed from the issuer’s perspective: • Equity (ordinary) shares • Redeemable preference shares • Redeemable debt • Convertible bonds 5.0 ORDINARY SHARES o Ordinary shares are classified as equity o The cost of issuing ordinary shares is charged to the share premium account o Dividends are recognised in the statement of changes in equity when they are declared 5.1 REDEEMABLE PREFERENCE SHARES Redeemable preference shares are preference shares which will be repurchased by the issuing company at a set point in the future In order to encourage investors to buy them, they are usually redeemable at a premium and dividends are paid throughout their term at a set rate 5.1.1 ACCOUNTING TREATMENT Although redeemable preference shares are legally shares, IAS 39 applies the concept of substance over form to classify them as a financial liability In line with IAS 39, they are therefore initially measured at proceeds received less issue costs As redemption is likely to be at a premium, the liability is then ‘wound up’ or gradually increased over its term in order that its carrying value is equal to the redemption amount at the redemption date This subsequent carrying value is referred to by IAS 39 as ‘amortised cost’ Dividends are recognised as part of the finance cost, as is the ‘winding up’ of the liability 314 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 315 FINANCIAL INSTRUMENTS 15 Illustration Fulham issued $1m 5.9% redeemable preference shares on January 20X8 at par The shares are redeemable in years time at a premium of 25% The effective rate of interest is 10% Show what amounts should be recorded in Fulham’s financial statements over the life of the shares Fulham: Redeemable Preference Shares Year 20X8 20X9 20Y0 20Y1 20Y2 Balance b/f Interest at 10% Dividend (5.9%) Balance c/f 1,041,000 104,100 (59,000) 1,086,100 1,000,000 1,086,100 1,135,710 1,190,281 100,000 108,610 113,571 119,028 * there is a rounding error of $309 Finance cost in income statement (includes the dividend paid out plus the winding up of the liability) (59,000) (59,000) (59,000) (59,000) 1,041,000 1,135,710 1,190,281 (1,250,000)* Cash paid out as dividend / on redemption Liability in statement of financial position Exam Hint Redeemable preference shares featured in the published company accounts question (Q2) in the December 2008 paper Candidates were required to calculate the finance cost relating to the period, however many did not notice that the shares were issued mid year and therefore the annual interest required pro-rating The examiner often complicates matters with mid-year issues, so be sure to check dates when reading through a question 5.2 REDEEMABLE DEBT Redeemable debt is classified as a financial liability It is initially measured at proceeds received less issue costs Unlike redeemable preference shares, debt may be issued at a discount to its par value Again, it is normally redeemed at a premium in order to encourage investors to take it up In a similar way to redeemable preference shares, the financial liability is therefore ‘wound up’ over the term of the debt Interest paid (calculated at the coupon rate) is recognised in the income statement as part of the finance cost, together with any ‘winding up’ of the liability Learning Example 15.6 At the start of the current year, Ben Hur issued $80million 8% loan stock at a discount of 10% The issue costs were $1.4million made up of apportioned costs of the finance and acquisitions department of $1million and professional and underwriting costs of $400,000 relating directly to this issue The loan stock will be redeemed in years’ time at a premium of 11.5% The effective rate of interest is 12.75% Calculate the finance charge for each of the five years and provide extracts from the financial statements at the end of year 315 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 316 FINANCIALREPORTING (INTERNATIONAL) Exam Hint Redeemable debt featured in the published company accounts question (Q2) in the December 2007 paper The examiner commented that a number of candidates were obviously confused with regard to the two interest rates presented: many used the coupon rate to calculate the total finance costs 5.2.1 REDEEMABLE DEBT FROM THE INVESTOR’S PERSPECTIVE Where an investing company acquires another company’s debt, and intends to hold it until redemption, the investment would be classified as a financial asset held to maturity IAS 39 requires that assets held to maturity are held at amortised cost Therefore from the investor’s perspective, the accounting for this financial asset would be the mirror of the accounting seen in learning example 16.6: o the asset increases gradually over its term to the redemption value o the winding up of the asset and the interest receivable both form investment income Learning Example 15.7 On January 20X8, Charlton purchased $6million 3.5% redeemable debt The transaction costs amounted to $120,000 The debt is redeemable on 31 December 20Y3 at a premium of 30% What investment income should be recorded each year in respect of the debt instrument? 5.3 CONVERTIBLE DEBT Convertible debt is debt which at a set date in the future may be redeemed for cash or converted in to ordinary shares The conversion option means that this liability has an equity component It is therefore referred to as a compound instrument IAS 39 requires that a compound instrument is split into its equity and liability elements and both are recognised in the statement of financial position 5.3.1 INITIAL MEASUREMENT o The liability element is recognised as the present value of the bond assuming that there were no conversion rights, using an effective interest rate for a similar non-convertible bond o The equity element is the balance of the proceeds 5.3.2 SUBSEQUENT MEASUREMENT o The liability element is measured at amortised cost (as seen in the previous learning example) with interest paid (calculated at the coupon rate) and the ‘winding up’ charged as finance costs o The equity element is held at its initial measurement 316 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 317 FINANCIAL INSTRUMENTS 15 Learning Example 15.8 On January 20X8, Prius issued 10,000 5% convertible bonds at their par value of $50 each The bonds will be redeemed on January 20Y3 Each bond is convertible at the option of the holder at any time during the year period Interest on the bond will be paid annually in arrears The prevailing market interest rate for similar debt without a conversion option is 6% At what value should the equity element of the financial instrument be recognised in the financial statements of Prius at the date of issue and 31 December 20X8? The present value of $1 receivable at the end of the year based on discount rates of 5% and 6% is: End of year 5% 0.952 0.907 0.864 0.823 0.784 6% 0.943 0.890 0.840 0.792 0.747 Learning Example 15.9 At the start of the current year, Heston issued $80million 8% convertible loan stock at par The stock is convertible into equity shares, or redeemable at par, in years’ time at the option of the stockholders The terms of conversion are that each $100 of the loan stock will be convertible into 50 equity shares of Heston A finance consultant has advised that if the option to convert to equity had not been included in the terms of the issue, then a coupon (interest) rate of 12% would have been required to attract subscribers to the stock The value of $1 receivable at the end of each year at a discount rate of 12% can be taken as: Year $ 0.89 0.80 0.71 0.64 0.57 What accounting entry is required to record the issue of the loan stock? Exam Hint In June 2008, question focused on accounting for the issue of a convertible loan The examiner commented that this was, by far, the worst question on the paper for most candidates In particular he noted a great deal of confusion over use of the coupon interest rate and effective interest rate Remember, the coupon (lower) interest rate is used to calculate the actual interest paid out The effective (higher) interest rate is used to calculate the interest charged to the income statement It includes both the actual interest paid out and the winding up of the liability 317 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 318 FINANCIALREPORTING (INTERNATIONAL) Solution 15.1 Available-for-sale financial asset Financial liability Loans and receivables Held to maturity financial asset Loans and receivables Solution 15.2 The loan stock is classified as a financial liability: Proceeds received ($500,000 x 95%) Issue costs $ 475,000 (42,000) 433,000 The redeemable preference shares are a held to maturity financial asset Cost Transaction costs $ 100,000 12,500 112,500 Solution 15.3 On June 20X8 Dr AFS financial asset (13m + 500,000) Cr Cash On 31 December 20X8 Dr AFS financial asset Cr Other comprehensive income $13,500,000 $13,500,000 $500,000 $500,000 Statement of Financial Position at 31 December 20X8 – Extract Non-current assets $000 AFS Investments 14,000 Statement of Comprehensive Income for the Year Ended 31 December 20X8 – Extract $000 Profit for the year 16,000 Other comprehensive income Gain on AFS investments 500 Total comprehensive income 318 16,500 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 319 FINANCIAL INSTRUMENTS 15 Solution 15.4 On 31 October 20X8 Dr FVTPL financial asset (700,000 + 30,000) Cr Cash On 31 December 20X8 Dr income statement FVTPL financial asset Cr $730,000 $730,000 $55,000 $55,000 Statement of Financial Position at 30 November 20X8 – Extract $000 Non-current assets 675,000 FVTPL Investments Income Statement for the Year Ended 30 November 20X8 – Extract $000 Loss on FVTPL investment 55,000 Solution 15.5 o The AFS investment was initially recognised at $13.5million o At 31 December 20X8 the AFS investment is held at $14million o The $500,000 gain was recognised as other comprehensive income in the year ended 31 December 20X8 On disposal (31 October 20X9): Dr Cash Dr Other comprehensive income (reserves) Cr AFS investment Cr Income statement $19million $500,000 $14million $5.5million The credit to the income statement is made up of a $5million profit on disposal ($19m - $14m) and the $500,000 gain previously recognised as other comprehensive income and now recycled to the income statement 319 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 320 FINANCIALREPORTING (INTERNATIONAL) Solution 15.6 Ben Hur Initial Measurement Par value Discount of 10% Allowable transaction costs $000 80,000 (8,000) (400) 71,600 Note: the apportioned internal costs associated with the issue must be expensed to the income statement as incurred Loan Liability year year year year year b/f $000 71,600 75,200 78,800 82,400 86,000 Fin cost $000 12.75% 9,129 9,477 9,869 10,312 10,810 Int paid $000 8% (6,400) (6,400) (6,400) (6,400) (6,400) Income Statement Extracts (End of Year 1) Finance cost Statement of Financial Position Extracts (End of Year 1) 8% loan stock C/f $000 74,329 77,406 80,875 84,787 89,197 $000 9,129 74,329 Solution 15.7 Charlton redeemable debt 20X8 20X9 20Y0 20Y1 20Y2 20Y3 B/f $000 5,880 6,140 6,421 6,725 7,053 7,407 Invt income $000 470 491 514 538 564 593 *There is a rounding difference of 10 320 Interest rec’d $000 (210) (210) (210) (210) (210) (8,010)* C/f $000 6,140 6,421 6,725 7,053 7,407 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 321 FINANCIAL INSTRUMENTS 15 Solution 15.8 $ 500,000 478,800 Proceeds of issue (10,000 x $50) Value of liability element (W) Value of equity element 21,200 The equity element is not re-measured and therefore is $21,200 at the date of issue and 31 December 20X8 Working T1 ($500k x 5%) T2 T3 T4 T5 ($25,000 + $500,000) Cash flow 25,000 25,000 25,000 25,000 525,000 DF 0.943 0.890 0.840 0.792 0.747 Present value 23,575 22,250 21,000 19,800 392,175 478,800 Solution 15.9 Dr Cr Cr Cash Liability $80,000,000 $68,704,000 (W) Shares to be issued Working T1 ($80m x 8%) T2 T3 T4 T5 ($6.4m + $80m) $11,296,000 (β) Cash flow 6.4m 6.4m 6.4m 6.4m 86.4m DF 0.89 0.80 0.71 0.64 0.57 Present value $000 5,696 5,120 4,544 4,096 49,248 68,704 Learning Summary • • • Learn the IAS 39 classifications of financial assets and liabilities and the accounting treatment of each Work through the examples of redeemable debt, convertible debt and redeemable preference shares: these are the most common instruments in the F7 exam Ensure that you understand the distinction between the effective and coupon interest rate 321 LSB_F7 Financial Reporting_Section 3:297mm x 210mm FINANCIALREPORTING (INTERNATIONAL) 322 10/8/09 12:02 Page 322 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 323 16 Earnings Per Share LSB_F7 Financial Reporting_Section 3:297mm x 210mm FINANCIALREPORTING (INTERNATIONAL) 324 10/8/09 12:02 Page 324 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 325 EARNINGS PER SHARE 16 Context Earnings per share is a topic not covered in previous studies It is a standalone topic within this text EPS is a key indicator of performance, used by investors and analysts alike It is therefore key that it is calculated on a reasonable and consistent basis IAS 33 Earnings per Share provides guidance on the calculation of both basic and diluted EPS Exam Hints Earnings per share may be examined as: - the last part of the published accounts question (Q2;) - a ratio calculation within Q3; - with calculation and discussion elements as part of Q4 or Key Learning Points • • • Earnings per share (EPS) is a measure of the performance of an entity over a period EPS is important because it is easy to understand and is a more accurate indicator of performance than profits EPS is also relied on heavily by investors and the stock market Basic EPS is calculated as: Profit (loss) attributable to ordinary equity holders Weighted average number of ordinary shares outstanding • • • • • Profit attributable to ordinary shareholders = profit for the year from the income statement - irredeemable preference share dividends Where there are no share issues during a period, basic EPS is calculated using the number of shares in issue throughout the period Where a full market issue of ordinary shares has taken place during the year, the weighted number of ordinary shares is calculated as a simple pro-rating exercise Where there is a bonus issue during the year: o the shares issued mid year are deemed to have been issued at the start of the year, and o the comparative is restated by x number of shares before bonus issue number of shares after bonus issue Where there is a rights issue during the year: Shares in issue are pro-rated according to the time that they are in issue An adjustment factor is applied to share capital in issue before the rights issue o The rights issue adjustment factor is calculated as: Pre-rights issue price of shares Theoretical ex-rights price (TERP) o The TERP is the theoretical price at which the shares would trade after the rights issue The comparative is restated by x TERP • Pre-rights issue share price Diluted EPS is effectively a ‘worst case scenario’ EPS It calculates EPS on the assumption that the new dilutive ordinary shares that could be issued are issued 325 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 326 FINANCIALREPORTING (INTERNATIONAL) • • • • Potential ordinary shares that are antidilutive are ignored in the calculation of DEPS DEPS where there is convertible debt is calculated as: Profits attributable to ordinary equity holders + interest saved (net of tax) Weighted average number of ordinary shares + extra shares due to conversion DEPS where there are options or warrants is calculated as: Profits attributable to ordinary equity holders Weighted average number of ordinary shares + ‘free’ shares under option Limitations of EPS include the fact that it is based on historic information and is of limited use in predicting future performance; it will vary with accounting policies, it does not take account of inflation and it is only one of many measured of performance Relevant Accounting Standards IAS 33 Earnings per share 326 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 327 EARNINGS PER SHARE 16 Earnings Per Share: A Performance Indicator Earnings per share (EPS) is a measure of the performance of an entity over a period In its most basic form, it is calculated as: Profit Number of ordinary shares 1.1 THE IMPORTANCE OF EPS Earnings per share is the single most significant figure presented in the financial statements to many users This is because: o It is easy for the non-accountant to understand o It is a more accurate indicator of performance than profits Simple profit trend analysis may be distorted by, for example, an issue of shares: it is easy to make higher profits when there is more resource available to make them with EPS strips out this distortion by reporting how much profit is made per share Illustration Year $1million 10,000,000 Profits Number of ordinary shares EPS - 10p Year $1.4 million 10,000,000 14p Year $1.8 million 20,000,000 9p Here the profit trend is positive, showing growth of $400,000 per annum The EPS, however indicates that the year profit increase is the result of better performance, whereas the year profit increase is, at least in part, due to the issue of new shares EPS is also relied on heavily by investors and the stock market Not only is it a stand alone ratio, but it is also used to calculate an entity’s P/E ratio (see chapter 17) 1.1.1 IAS 33 EARNINGS PER SHARE Since EPS is significant to a number of users, IAS 33 Earnings per Share was issued to prescribe principles for the calculation of EPS and enhance consistency of EPS The standard applies only to entities whose ordinary shares are publicly traded Basic Earnings Per Share IAS 33 requires that basic earnings per share is calculated as: Profit (loss) attributable to ordinary equity holders Weighted average number of ordinary shares outstanding 327 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 328 FINANCIALREPORTING (INTERNATIONAL) 2.0.1 PROFIT (LOSS) ATTRIBUTABLE TO ORDINARY EQUITY HOLDERS As the profit figure required is that attributable to ordinary shareholders, the profit for the year from the income statement must be adjusted for irredeemable preference share dividends It need not be adjusted for redeemable preference share dividends, as these have already been charged against profits as part of finance costs Profit for the year (income statement) Irredeemable preference share dividend Profit attributable to ordinary equity holders 2.0.2 $ X (X) X WEIGHTED AVERAGE NUMBER OF ORDINARY SHARES OUTSTANDING Where there are no share issues during a period, basic EPS is calculated using the number of shares in issue throughout the period, as the resources provided by these shares are used to generate profits Where share issues take place during the year, profits are generated using: o The resources provided by the shares which have been in issue throughout the year, and o Extra resources provided by new shares issued part way through the year Therefore in order to compare like with like, the weighted average number of shares must be calculated The following sections consider this calculation where there is: A full market share issue A bonus issue A rights issue Learning Example 16.1 Grayson reports a profit for the year ended 30 June 20X9 of $432,900 Its capital structure throughout the year was as follows: - 1,000,000 ordinary $1 shares - 200,000 $1 8% redeemable preference shares - 250,000 $1 5% irredeemable preference shares What is Grayson’s basic earnings per share for the year ended 30 June 20X9? 2.1 FULL MARKET SHARE ISSUE Where a full market issue of ordinary shares has taken place during the year, the weighted number of ordinary shares is calculated as a simple pro-rating exercise The weighted average number of shares used for the calculation of EPS takes into account the extra resource which contributes towards the generation of profits for part of the year 328 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 329 EARNINGS PER SHARE 16 Illustration Monkhouse had 400,000 ordinary shares in issue at January 20X8 On May 20X8 it issued a further 100,000 to the market for the full market price The weighted average number of shares during the year ended 31 December 20X8 was: Date 1.1.X8 – 30.4.X8 1.5.X8 – 31.12.X8 Number of shares 300,000 400,000 x x Proportion of year 4/12 = 8/12 = 366,667 is the denominator in the basic EPS calculation for Monkhouse Weighted 100,000 266,667 366,667 Alternative calculation Alternatively, the weighted average number of shares can be calculated as: Date 1.1.X8 – 31.12.X8 1.5.X8 – 31.12.X8 Number of shares 300,000 100,000 x x Proportion of year 12/12 = 8/12 = Weighted 300,000 66,667 366,667 Learning Example 16.2 Bennett has a year end of 31 December 20X8 Details of its ordinary $1 shares issued and bought back throughout the year are as follows: January 20X8 31 May 20X8 December 20X8 Shares issued 2,000 800 - Own shares acquired 300 250 Balance 1,700 2,500 2,250 What is the weighted average number of shares for the purpose of calculating EPS for Bennett for the year ended 31 December 20X8? 2.2 BONUS ISSUE A bonus issue is the issue of free shares to shareholders in proportion to their existing shareholding As the shares are issued for no consideration (they are free), then extra resource is not contributed to the business and towards the generation of profits Therefore a weighting exercise is not required Instead: o The bonus shares issued mid year are deemed to have been issued at the start of the year, and o Comparative EPS is restated to allow for the increase in capital caused by the bonus issue 2.2.1 COMPARATIVES The previous year comparative EPS is adjusted as follows: Restated EPS = EPS as originally calculated x shares in issue before bonus issue Shares in issue after bonus issue 329 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 330 FINANCIALREPORTING (INTERNATIONAL) Learning Example 16.3 Crowther reported a profit after tax of $1.8m in the year ended 31 December 20X7 and $2.25m in the following year Since its incorporation, there had been 600,000 $1 ordinary shares outstanding, until 30 September 20X8, when there was a for bonus issue What is Crowther’s reported EPS in 20X7 and 20X8, and the restated amount in 20X7? 2.3 RIGHTS ISSUE A rights issue is the issue of shares to existing shareholders in proportion to their existing shareholding The price of a rights issue is generally at below market value in order to encourage shareholders to take up their rights This type of issue presents a problem when calculating the weighted average number of shares in that: o Additional resources are available to generate profits, but o the additional resources are not in proportion to the number of new shares (i.e the cash paid for each share, and so available to use to generate profits, is less than the market value of that share) In other words it has characteristics of an issue at full market price and a bonus issue 2.3.1 CALCULATION OF WEIGHTED AVERAGE NUMBER OF SHARES There are two steps to the calculation of weighted average number of shares where there has been a rights issue: Shares in issue are pro-rated according to the time that they are in issue (as seen before in section 2.1) An adjustment factor is applied to share capital in issue before the rights issue The adjustment factor is calculated as: Pre-rights issue price of shares Theoretical ex-rights price (TERP) The TERP sis the theoretical price at which the shares would trade after the rights issue Its calculation is best explained by way of an illustration: Illustration Black’s issued share capital consisted of 5,000,000 ordinary shares on January 20X8 On June 20X8 there was a rights issue of for at $1 per share The rights issue was fully taken up On 31 May 20X8 the market price of a Black share was $2.20 TERP is calculated as: existing shares @ $2.20 new share @ $1 11.50 1.00 12.00 therefore 12.50/6 = TERP of $2 = $2.20 Adjustment factor is therefore calculated as: Pre rights issue price of shares TERP Weighted average number of shares is: Date 1.1.X8 – 31.5.X8 1.6.X8 – 31.12.X8 Number of shares 5,000,000 x 6,000,000 $2.00 Adj factor 2.2/2 x x Proportion of year 5/12 7/12 = = 5,791,667 is the weighted average number of shares used to calculate Black’s basic EPS 330 Weighted ave 2,291,667 3,500,000 5,791,667 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 331 EARNINGS PER SHARE 2.3.2 16 COMPARATIVES As with bonus issues, the previous year comparative EPS must be adjusted for the bonus factor within the rights issue.This is achieved by multiplying the EPS of the previous year by the reciprocal of the adjustment factor: Restated EPS = EPS as originally calculated x TERP Pre-rights issue share price Learning Example 16.4 Hull reported profit after tax in the years ended 31 December 20X7, 20X8 and 20X9 of $30,000, $38,000 and $45,000 respectively At January 20X7, there were 500,000 $1 ordinary shares in issue in Hull On March 20X8, there was a for rights issue for $5.00 per share The rights were fully taken up On 28 February 20X8, the market price of a Hull share was $11 What is the EPS reported in the 20X7, 20X8 and 20X9 accounts, and the 2007 restated comparative? Exam Hint In December 2007, marks were available for the calculation of basic EPS involving a rights issue The examiner reported that answers to this were mixed with a significant number of candidates not attempting this part of the question Of those who did, there was obvious confusion with the weighting exercise 2.4 Summary of Basic EPS Profit for the year – irredeemable preference share dividend Profit (loss) attributable to ordinary equity holders Weighted average number of ordinary shares outstanding Full market price issue Pro-rate shares in issue on basis of time in issue Bonus issue Rights issue Assume bonus issue took place at start of year Pro-rate shares in issue on basis of time in issue + Apply adjustment factor to shares in issue before rights issue 331 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 332 FINANCIALREPORTING (INTERNATIONAL) Learning Example 16.5 Dennis had 800,000 ordinary shares in issue on July 20X8, and no preference shares The following share transactions relate to the year ended 30 June 20X9: December 20X8 March 20X9 31 March 20X9 Issue of 200,000 shares for $2.50 (full market price) for rights issue at $1.50.The share price on 28 February 20X9 was $2.75 Issue of 100,000 $2 6% irredeemable preference shares A profit of $654,000 was made in the year ended 30 June 20X9 What is Dennis’ basic EPS for the year? Diluted Earnings Per Share The number of ordinary shares in issue may change in the future due to o New issues of ordinary shares o The conversion of debt or preference shares to ordinary shares Potential increases in the number of ordinary shares without a proportionate increase in resources will have a negative or dilutive impact on EPS Therefore, where a financial instrument exists at a year end that may result in the issue of ordinary shares which would dilute EPS, IAS 33 requires that diluted EPS is calculated Such financial instruments include: o Convertible debt, and o Share options (or warrants) Diluted EPS is effectively a ‘worst case scenario’ EPS It calculates EPS on the assumption that the new dilutive ordinary shares that could be issued are issued 3.0.1 ANTIDILUTION In some cases, potential ordinary shares are antidilutive In other words their conversion would result in increased EPS These antidilutive shares are ignored in the calculation of DEPS 3.0.2 THE CALCULATION OF DEPS DEPS takes into account not only the extra dilutive shares that may be issued, but also the immediate impact (if any) of these new shares on profits It is calculated as: Profits attributable to ordinary equity holders + notional extra profits Weighted average number of ordinary shares + notional extra shares Profits attributable to ordinary equity holders and the weighted average number of ordinary shares are calculated as for basic EPS 3.1 CONVERTIBLE DEBT Convertible debt is debt that at some specified future date may be converted to ordinary shares or redeemed for cash If converted to ordinary shares, convertible debt would: increase the number of ordinary shares in issue increase profits attributable to ordinary shareholders (as a result of a decrease in interest costs, net of the related tax saving) 332 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 333 EARNINGS PER SHARE 16 DEPS is therefore calculated as: Profits attributable to ordinary equity holders + interest saved (net of tax) Weighted average number of ordinary shares + extra shares due to conversion Learning example 16.6 Beadle made a profit after tax in the year ended 31 December 20X8 of $1,000 During the year, it had 10,000 $1 ordinary shares in issue It also had $1,000 10% bonds in issue, convertible into ordinary shares on the basis of 15 shares for each block of 10 bonds The tax rate is 40% What is the basic and diluted EPS? 3.2 SHARE OPTIONS (WARRANTS) Share options and warrants give the holder the right to buy ordinary shares at a future date at a set price Options and warrants are dilutive when they would result in the issue of ordinary shares for less than the average market price of ordinary shares during the period For the purposes of calculating DEPS, options which may be exercised at below average market price are deemed to consist of: A contract to issue some shares at average market price, and A contract to issue the remaining shares for no consideration Those shares which are deemed to be issued at average market price are neither dilutive nor anti-dilutive, and so are ignored for the purposes of calculating DEPS Those shares which are deemed to be issued for no consideration are dilutive and form part of the DEPS calculation: Profits attributable to ordinary equity holders Weighted average number of ordinary shares + ‘free’ shares under option Learning Example 16.7 Ball made a profit after tax in the year ended 31 December 20X8 of $1.2million The weighted average number of shares outstanding during the year was million, with an average fair value of $4 per share During the year there were 1m shares under option, with an exercise price of $3 each What is the basic and diluted EPS for 20X8? Disclosure IAS 33 requires disclosure of EPS as follows: • Basic and diluted EPS should be presented on the face of the statement of comprehensive income/income statement • Basic and diluted EPS should be presented with equal prominence, even if the amounts are negative • A reconciliation of the profit or loss used in the calculation of basic and diluted EPS to the reported profit for the year • The weighted average number of shares used in the basic and diluted EPS calculations and a reconciliation between the two numbers 333 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 334 FINANCIALREPORTING (INTERNATIONAL) Limitations of EPS Although EPS is considered to be an important indicator of an entity’s performance, it does have a number of limitations: • EPS is based on historic information and is of limited use in predicting future performance • The EPS of two entities may not be comparable as it is based on profits which may be calculated using different accounting policies • EPS does not take account of inflation • DEPS is a measure of past performance: it is based on historic profits and share prices • Reliance on EPS may lead to strategies for short-term improvement • EPS is based on profitability, which is only one measure of performance Exam Hint Limitations of EPS could form a short written part of a question Ensure that the limitations that you state are relevant to the scenario presented in the question 334 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 335 EARNINGS PER SHARE 16 Solution 16.1 Profit attributable to ordinary shareholders: Profit for the year Irredeemable preference share dividend ($250,000 x 5%) Basic EPS: $ 432,900 (12,500) 420,400 Profit attributable to ordinary equity holders 420,400 Weighted average number of ordinary shares 1,000,000 42.0p Solution 16.2 Date 1.1.X8 – 31.5.X8 1.6.X8 – 30.11.X8 1.12.X8 – 31.12.X8 Number of shares 1,700 2,500 2,250 Weighted average number of shares x x x Proportion of year 5/12 6/12 1/12 708 1,250 188 2,146 Solution 16.3 20X7 Reported Accounts EPS = $1.8m 600,000 = $3 20X8 Reported Accounts The 1,200 new shares issued in September 20X8 are deemed to have been issued at the start of the year Therefore EPS (2008) Restated 2007 $3 X 1/3 = $2.25m 1,800,000 = $1.25 $1 Solution 16.4 20X7 Reported Accounts EPS = $30,000 500,000 20X8 Reported Accounts TERP old shares @ $11 new share @ $5 Adjustment factor = = 6c 55 60 therefore TERP of $10 11/10 335 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 336 FINANCIALREPORTING (INTERNATIONAL) Date 1.1.X8 – 28.2.X8 1.3.X8 – 31.12.X8 EPS = Shares 500,000 x 11/10 600,000 $38,000 20X7 Restated 6c x 10/11 = 591,667 = x x Proportion of year 2/12 10/12 6.42c 91,667 500,000 591,667 5.45c 20X9 Reported Accounts EPS = $45,000 = 600,000 7.5c Solution 16.5 Basic EPS = 651,000 (W1) = 1,031,561 (W2) 63.1p (W1) Profit attributable to ordinary shareholders of Dennis Profit for the year Irredeemable preference share dividend $200,000 x 6% x 3/12 (W2) Weighted average number of ordinary shares Date 1.7.X8 – 30.11.X8 1.12.X8 – 28.2.X9 1.3.X9 – 30.6.X9 Number of shares 800,000 x 1,000,000 x 1,200,000 x (W3) Adjustment factor Pre rights issue share price (W4) TERP = TERP (W4) existing shares @ $2.75 new share @ $1.50 $ 654,000 (3,000) 651,000 adjustment factor(W3) 2.75/2.54 2.75/2.54 x x $2.75 $2.54 $13.75 $1.50 $15.25 therefore $15.25/6 = $2.54 Solution 16.6 336 Basic EPS $1,000 Diluted EPS $1,000 + $100 interest - $40 tax saving 10,000 = 10c 10,000 + (1,000/10 x 15) = 9.2c time 5/12 3/12 4/12 weighted 360,892 270,669 400,000 1,031,561 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 337 EARNINGS PER SHARE 16 Solution 16.7 Basic EPS Diluted EPs - - $1.2million million $1.2million 5m + 250,000 = 24c = 22.9c If all options exercised, the issue raises $3m (1m options x $3 exercise price) This equates to 750,000 shares issued at full price ($3m/4) and therefore 250,000 free shares Learning Summary • Review the audit tests suggested in this chapter 337 LSB_F7 Financial Reporting_Section 3:297mm x 210mm FINANCIALREPORTING (INTERNATIONAL) 338 10/8/09 12:02 Page 338 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 339 17 Analysis and Interpretation LSB_F7 Financial Reporting_Section 3:297mm x 210mm FINANCIALREPORTING (INTERNATIONAL) 340 10/8/09 12:02 Page 340 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 341 ANALYSIS AND INTERPRETATION 17 Context The ability to analyse and interpret a set of accounts, as well as prepare them, is a key skill for an accountant This chapter introduces some of the methods of analysing accounts, including the use of ratios It also goes on to consider the limitations of accounts when trying to analyse a company’s performance, and what further information could be of use in such an analysis Exam Hints This area of the syllabus is always examined as question on the paper This question is likely to be an appraisal of an entity’s performance and may involve statements of cash flows Key Learning Points - - Analysis of accounts involves: o A review of amounts already included the financial statements, and o Ratio analysis Comparison may be with: o The previous year’s results of the same company (vertical analysis) o The results of an equivalent company in the same period (horizontal analysis) o industry average Analysis of accounts should also take into consideration why the analysis is being performed, and for whom Ratio analysis involves taking two or more balances from the financial statements and manipulating them to reveal the relationship between them The following ratios should be learnt: Performance Profit margins Profit x 100% Revenue - Asset turnover ROCE Liquidity Ratios Current ratio Revenue Net assets PBIT Capital employed Current assets Current liabilities - - - - Changes in gross margin must be due to selling price or cost of sales or sales mix Gross margin will have a knock on effect on operating profit and net margins Operating profit margin and net margin will be skewed by exceptional items measure of how well the management of a company utilise the net assets at their disposal needs comparison measure of how well assets are used to generate profits can achieve same ROCE through different practices (low margins & high sales vs high margins & low sales) shows whether all current assets (if realised) can cover current liabilities benchmark 1.5:1 – 2:1, but will be lower for service industries 341 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 342 FINANCIALREPORTING (INTERNATIONAL) Quick (acid test) ratio Current assets – inventory Current liabilities Working Capital Ratios Receivables’ days Receivables x 365 Revenue - Inventory days Inventory turnover Payables’ days Inventory x 365 Cost of sales Cost of sales Inventory Payables x 365 Cost of sales - Solvency Ratios Gearing Interest cover Investor Ratios EPS 342 - Compare to credit period Higher = credit control issues or extended terms made available to boost sales Lower = aggressive chasing resulting in loss of customers or customers taking advantage of prompt payment discounts Must be appropriate for industry and type of goods Higher = poor inventory control; risk of obsolete goods; associated costs of holding goods Lower = risk of stock outs High inventory turnover = low inventory days and vice versa Compare to credit period Higher = liquidity problems; loss of supply; reputational issues Lower = poor use of free credit unless taking advantage of discounts No benchmark High gearing = high risk and difficult/ more expensive to raise further finance Low gearing = potential to gear up as debt is cheaper than equity PBIT Interest - Profits Number of ord shares - Lowest acceptable level is - Indicator of market confidence Compare to industry / competitor ratios Varies with industry P/E ratio Market price of share EPS Dividend yield Dividend per share x100% Share price Dividend cover - Debt x 100% Debt + equity Or Debt x 100% equity takes inventory out of the equation on the basis that it is not rapidly realisable Benchmark 0.5: 1- 1: 1, but again, lower for service industries Profit after tax dividends - - Lowest acceptable level is Concentrates on current return (dividend) rather than capital growth prospects Shows ability to pay dividends Take into account new share issues Limitations of financial statement analysis include: o It is based on historic information o Accounts may be distorted by the existence of related party transactions o Amounts presented in accounts may be manipulated LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 343 ANALYSIS AND INTERPRETATION - 17 o Year end accounts may be distorted by seasonality o Different accounting policies and practices make analysis less meaningful In order to complete analysis, further information, both financial and non-financial may be required Technical Articles The following article, written by the examiner explains analysis and interpretation and is available on ACCA’s website http://www.accaglobal.com/students/acca/exams/f7/technical_articles/2951583 343 LSB_F7 Financial Reporting_Section 3:297mm x 210mm FINANCIALREPORTING (INTERNATIONAL) 344 10/8/09 12:02 Page 344 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 345 ANALYSIS AND INTERPRETATION 17 Interpretation of Accounts – An Introduction Interpreting a set of financial statements, or ‘making the numbers speak’ is a key skill for an accountant 1.1 HOW TO ANALYSE ACCOUNTS Analysis of accounts is likely to involve: - A review of amounts already included the financial statements, and - Further manipulation of amounts in the financial statements, using ratio analysis In either case, interpretation of accounts is not meaningful without a comparison A simple statement that a company has achieved turnover of $100,000 means nothing unless we also know that in the previous years, turnover has averaged $60,000, or a same sized competitor turns over $200,000 With this comparative, we are able to make a valid comment about how well the company is performing with a turnover of $100,000 1.0.1 COMPARING RESULTS Comparison may be with: - The previous year’s results of the same company (vertical analysis) - The results of an equivalent company in the same period (horizontal analysis) - industry average All of these comparisons have drawbacks – for example, a company’s previous year results may have been skewed by a significant event making comparison less meaningful Similarly a company of an equivalent size, operating in exactly the same market, may be difficult to identify – and, again, if one is found, it may have performed particularly well or badly in that year It is therefore true that vertical analysis is best carried out taking the results of a number of years into account, and the possibility of skewed accounts should be considered before performing horizontal analysis 1.0.2 CONSIDERING THE AUDIENCE Analysis of accounts should also take into consideration why the analysis is being performed, and for whom, as the various stakeholders in an organisation will have different needs: - An investor may want to know that his investment is sound and growing in the long term and profits and cash flows are sufficient to pay a dividend in the meantime He is, however, less interested in operational concerns such as whether suppliers are being paid on time - A bank considering whether to lend money to a company wishes to know whether funds will be available to repay the loan, and so is interested in profits and cash flows, but again, less interested in operational issues - The management of a company, on the other hand want to know detail on how well working capital is managed, when tangible non-current assets need replacing, and so on Exam Hint Where an exam question places you in a scenario,THINK about what type of analysis is relevant to that scenario Do not write everything that you can think of down, but FOCUS on the needs of the user within the question A common complaint of markers is the inability of candidates to this In December 2007, analysis was required of one company based on two years’ results, with reference made to the Chief Executive’s published narrative highlights of the accounts and the acquisition of a business in the year The examiner commented that weaker candidates did not take account of the requirement and referred to neither the narrative comments nor the acquisition In December 2008, analysis was required of two similar companies in the context of one of them being taken over The examiner commented that many candidates concentrated on analysis of working capital which was largely irrelevant in this context 345 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 346 FINANCIALREPORTING (INTERNATIONAL) Ratio Analysis Ratio analysis involves taking two or more balances from the financial statements and manipulating them to reveal the relationship between them Often this relationship – normally expressed as a percentage – provides an indication of performance and position in addition to that evident in the financial statements A very simple ratio which you will be familiar with already is gross profit margin: Gross profit Revenue x 100% By taking profits as a percentage of revenue, we are able to undertake a more meaningful comparison of two companies which have different absolute revenues This is a further benefit of ratio analysis – the ability to perform horizontal analysis where two entities are of a similar but not equivalent size The ratios which we shall consider in the next sections of this chapter, grouped by type are: Performance - Gross profit margin - Net profit margin - ROCE - - Liquidity Efficiency - - - Solvency Investor - - - - - 2.1 Operating profit margin Asset turnover Current ratio Quick (acid test) ratio Receivables days Inventory days Inventory turnover Payables days Gearing Interest cover Earnings per share P/E ratio Dividend yield Dividend cover PERFORMANCE RATIOS Performance ratios are also known as profitability ratios They are of interest to most users of accounts 2.1.1 PROFIT MARGINS Almost any profit margin can be calculated, but the most common are the gross, operating and net profit margins, calculated as: Gross profit margin Gross profit x Operating profit margin PBIT 100% Net profit margin Profit for the year Revenue Revenue 346 Revenue x 100% x 100% LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 347 ANALYSIS AND INTERPRETATION 17 Gross Profit Margin An increase in the gross profit margin is due to one (or more) of the following: - An increase in selling price without a corresponding increase in cost of sales - A decrease in cost of sales without a corresponding decrease in selling price - A change in sales mix to include more high margin goods Remember that sales volume will not impact gross margins – selling more goods does not result in a higher margin Gross margins will, however, impact sales volume - an increase in selling price in order to increase gross margins may result in lower sales volume Operating Profit Margin Analysis of the operating margin in conjunction with the gross profit margin will reveal how well a business is controlling its costs Assuming that gross margin is constant year on year, an increase in operating margin indicates good cost control and vice versa Where gross margin is not constant year on year, this will have a knock on effect on operating margin This margin is affected by exceptional items If the amount of such items are known, it is advisable to re-calculate the ratio after eliminating the effect of the exceptional item Net Profit Margin The net profit margin is again affected by the gross and operating profit margins It will only be affected in its own right by investment income, finance costs and tax Any large variations in these amounts year on year will result in variations in the net profit margin 2.1.2 ASSET TURNOVER Asset turnover shows how many times their own value the net assets of a company generate in revenue It is a measure of how well the management of a company utilise the net assets at their disposal It is calculated as: Revenue Net assets For example, a company with revenue of $400,000 and net assets of $100,000 has an asset turnover of 4: the management utilise the net assets sufficiently to generate four times their own value in revenue each year This ratio is meaningless without comparison 2.1.3 RETURN ON CAPITAL EMPLOYED (ROCE) ROCE is a measure of how efficiently the management of a company use the net assets at their disposal in order to make profits It is normally expressed as a percentage, and calculated as: Profit before interest and tax Capital employed (equity + debt) A high ROCE may be achieved by two quite different approaches to business: - Low margins and high sales volume; - High margins and low sales volume For this reason, care must be taken when concluding that two companies are similar because they have the same ROCE 347 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 348 FINANCIALREPORTING (INTERNATIONAL) Learning Example 17.1 Extracts from the financial statements of Highbury, a commercial baker for the years ended 31 October 20X7 and 20X8 are as follows: Revenue Cost of sales Gross profit PBIT 20X7 $000 3,400 (1,200) 20X8 $000 3,620 (1,420) 100 2,300 - 100 3,150 500 Share capital Retained earnings Revaluation reserve 2,200 1,150 2,200 1,300 2,400 3,750 There is no debt in Highbury’s accounts Calculate performance ratios for Highbury and comment on Highbury’s performance in 20X8 as compared to 20X7 2.2 LIQUIDITY RATIOS Liquidity ratios are concerned with a company’s abilities to meet its short term obligations They are of particular interest to management 2.2.1 CURRENT RATIO The current ratio determines whether a company can meet its short term liabilities based on the realisation of its current assets It is calculated as: Current assets Current liabilities = X:1 The acceptable benchmark level for a current ratio is considered to be between 1.5 and 2:1; in other words, current assets are 1.5 to times the level of current liabilities Therefore if all short term liabilities were called in, taking into account the fact that some current assets are not realisable immediately, the realised current assets should cover the current liabilities Problems of the current ratio - The amounts within the ratio are easily manipulated at the period end in order to distort the result (e.g cash can be used to pay suppliers) - The ratio is based on year end amounts which may not be indicative of the position throughout the year - It assumes that inventory can be sold at its cost price Where a quick sale is required, this may not be the case - The benchmark of 1.5 – 2:1 is less relevant to certain service businesses which have no inventory They may therefore have a current ratio of less than 1, but this does not indicate liquidity problems 2.2.2 QUICK (ACID TEST) RATIO One of the deficiencies of the current ratio, the problem of realising cost price for inventory when a quick sale is needed, is overcome by the quick or acid test ratio This ratio strips inventory out of the equation when considering whether the realisation of current assets would enable a company to pay its current obligations It is calculated as: Current assets – inventory Current liabilities 348 = X:1 The generally accepted benchmark level for the quick test ratio is 0.5 – 1:1 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:02 Page 349 ANALYSIS AND INTERPRETATION 17 Problems of the Quick Ratio - As with the current ratio, the amounts within the quick ratio are easily manipulated at the period end in order to distort the result The ratio is based on year end amounts which may not be indicative of the position throughout the year It assumes that inventory will not be sold at all, whereas realistically some will be sold, even if it is for significantly less than cost Learning Example 17.2 Shopmart, a regional supermarket, reports the following amounts in its financial statements for the years ended 31 August 20X7 and 20X8: Inventory Receivables Cash Payables 20X7 $000 340 10 3.6 650 20X8 $000 365 4.5 2.3 712 Calculate the current and quick ratios for both years and comment on them 2.3 WORKING CAPITAL RATIOS Working capital ratios are concerned with how well working capital is managed They are therefore of most interest to management 2.3.1 RECEIVABLES’ DAYS Receivables’ days shows how long, on average, it takes credit customers to pay It is calculated as: Receivables x Revenue 365 days The result should be in line with the credit period offered by a company In many cases this will be 30 days, but where extended credit is available – such as the two years’ credit advertised by some furniture retailers – it could be hundreds of days If an increase in receivables’ days is not explained by an increased credit period (possibly to stimulate sales), then it may be due to a poor credit control function within a company, and indicative of irrecoverable debts If a decrease in receivables’ days is not explained by a decreased credit period, then it may be that the credit control function is chasing customers aggressively In the long run this is detrimental to a company, as customers will be lost An alternative explanation may be more customers taking advantage of early settlement discounts Problems of Receivables’ Days - 2.3.2 the year end receivables figure may be skewed due to seasonality or the timing of orders An average receivables figure may give a more reliable result ideally receivables’ days should be calculated using credit revenue rather than total revenue If a company makes a high number of cash sales, receivables days calculated using total revenue will be higher than it is in reality INVENTORY DAYS Payables’ days shows how long, on average, inventory is held by a company before it is sold It is calculated as: Inventory Cost of sales x 365 days 349 LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:03 Page 350 FINANCIALREPORTING (INTERNATIONAL) An appropriate level of inventory days will depend upon the industry in which a company operates For example, a ship builder will have very high inventory days, as a ship under construction remains work in progress for a number of months, or even years A fishmonger, however should have very low inventory days An increase in inventory days may be explained by a company stocking up prior to a large order, or an agreement with a customer to hold goods on their behalf Alternatively it may be indicative of a fall in demand and obsolete goods A decrease in inventory days may be explained by a new policy to reduce the level of inventory held, and so reduce associated costs such as storage and insurance Alternatively it may be indicative of supply problems and possible stock outs, in which case customer orders may not be met and reputational issues will result Problems of Receivables’ Days 2.3.3 the year end inventory figure may be skewed due to seasonality or the timing of orders An average inventory figure may give a more reliable result INVENTORY TURNOVER An alternative way of looking at inventory is to calculate inventory turnover: Cost of sales Inventory This shows how many times inventory has been ‘turned over’ during a year For example, inventory turnover of means that inventory in the storeroom has been replaced times during the year Therefore on average it remains in the storeroom for months before it is sold High inventory turnover corresponds to low inventory days; low inventory turnover corresponds to high inventory days 2.3.4 PAYABLES’ DAYS Payables’ days shows how long, on average, it takes a company to pay its credit suppliers It is calculated as: Payables Cost of sales x 365 days The result should be in line with the credit period extended to the company If an increase in payables’ days is not explained by an increased credit period offered, then it may be due to slow payment of suppliers This may cause suppliers to stop supply, and in very extreme cases to initiate a liquidation of the company If a decrease in payables’ days is not explained by a decreased credit period offered, then it may be that the company is paying earlier to take advantage of early settlement discounts If this is not the case, it indicates poor working capital management as payables are a source of free finance which is not being exploited Problems of Payables’ Days - 350 the year end payables figure may be skewed due to seasonality or the timing of orders An average payables figure may give a more reliable result ideally, payables days should be calculated using credit purchases rather than cost of sales If there is a big change between opening and closing inventory or a company makes a high number of cash purchases, payables’ days calculated using cost of sales will be unreliable LSB_F7 Financial Reporting_Section 3:297mm x 210mm 10/8/09 12:03 Page 351 ANALYSIS AND INTERPRETATION 17 Learning Example 17.3 The following working capital ratios are relevant to Rattings, a manufacturer of fashion clothing for a number of high street retailers: 20X7 45 32 37 Receivables’ days Payables’ days Inventory days 20X8 30 30 39 20X9 60 28 45 What comments would you make on the working capital management of Rattings? 2.4 SOLVENCY RATIOS Solvency ratios are concerned with a company’s long-term financial stability They are of interest to investors and management 2.4.1 GEARING The gearing ratio assesses how a company is financed – through debt or equity It can be calculated in a number of ways, the most common of which is: Debt x Debt + Equity 100% An alternative calculation is: Debt Equity x 100% When analysing the ratio, it is important to know which calculation has been used, as the resulting percentages will be very different Illustration A company is funded through $500,000 debt and $1,000,000 equity The gearing ratio calculated as debt debt+equity x 100% gives a result of 33%, meaning that a third of the company’s funding is through debt The gearing ratio calculated as debt Equity x 100% gives a result of 50%, meaning that the level of debt in the company is half the level of equity There is no benchmark level of gearing, and it does vary from industry to industry, often depending on the level of security which can be offered For example, a property company can offer numerous assets as security and so ‘gear up’, whereas a service company with few assets can not In general, it is, however true to say that: - A high level of debt and so gearing indicates a high level of risk In particular, the high fixed interest payments may reduce the amount of profits available for distribution to shareholders, and mandatory repayments of loan capital must be met If the company requires more funding in the future, it may find it difficult to issue shares, as investors perceive returns to be at risk, or issue more debt, as lenders are unwilling to lend to an already highly geared company Where lenders agree to provide more debt finance to a highly geared company, they will generally require a higher return or impose restrictive covenants 351 ...LSB _F7 Financial Reporting_ Section 3: 297mm x 210mm FINANCIAL REPORTING (INTERNATIONAL) 272 10/8/09 12:01 Page 272 LSB _F7 Financial Reporting_ Section 3: 297mm x 210mm 10/8/09 12:01 Page 2 73 SUBSTANCE... of services LSB _F7 Financial Reporting_ Section 3: 297mm x 210mm 10/8/09 12:01 Page 287 14 Conceptual and Regulatory LSB _F7 Financial Reporting_ Section 3: 297mm x 210mm FINANCIAL REPORTING (INTERNATIONAL)... y/e 31 .5.X8 y/e 31 .5.X9 y/e 31 .5.Y0 y/e 31 .5.Y1 y/e 31 .5.Y2 Balance b/f $000 Finance cost 7% $000 Balance c/f $000 42,800 2,996 45,796 40,000 45.796 49,002 52, 432 2,800 42,800 3, 206 49,002 3, 430