International financial reporting

International Financial Reporting A Practical Guide second edition As the International Accounting Standards Board (IASB) makes progress towards widespread acceptance and use of its standards and practices, the need to become familiar with the IASB standards is rapidly increasing Melville provides the tools for understanding the international standards and offers expert guidance on how to implement them This second edition brings the book completely up-to-date and covers all international standards issued as at January 2009 Features of the book include interpretive guidance, coverage of every key International Financial Reporting Standard (IFRS) and International Accounting Standard (IAS), together with an unparalleled level of student interactivity and assessment The book provides a unique practical introduction to the international standards, outlining how these standards are used on a daily basis by companies in the preparation of their financial statements The author examines the recognition, measurement, presentation and disclosure requirements of each IFRS and IAS and every attempt has been made to explain the standards as clearly and concisely as possible Examples and practice questions are provided throughout the book to aid student understanding and to provide a framework for grasping the key aspects of this complex and fast-moving subject FEATURES • unique practical approach, combining theoretical and technical issues • class-tested with both professional and degree students • every chapter contains a variety of worked examples with solutions • every chapter concludes with a set of exercises, some of which are drawn from the past examination papers of the key professional accountancy bodies • comprehensive answers to most of the exercises are provided at the back of the book • supporting website for lecturers’ use, containing answers to the remaining exercises and PowerPoint slides for each chapter International Financial Reporting A Practical Guide Alan Melville Alan Melville second edition second edition International Financial Reporting A Practical Guide Alan Melville This text is essential reading for all undergraduate and professional courses on international financial reporting Alan Melville FCA BSc Cert Ed is a bestselling author and Senior Lecturer with many years’ experience of teaching accounting and financial reporting an imprint of CVR_MELV0118_02_SE_CVR.indd Front cover image: © Getty Images www.pearson-books.com 10/6/09 11:21:44 International Financial Reporting Melville prelims 09.indd 4/6/09 13:59:53 We work with leading authors to develop the strongest educational materials in accounting, bringing cutting-edge thinking and best learning practice to a global market Under a range of well-known imprints, including Financial Times Prentice Hall, we craft high quality print and electronic publications which help readers to understand and apply their content, whether studying or at work To find out more about the complete range of our publishing please visit us on the World Wide Web at: www.pearsoned.co.uk Melville prelims 09.indd 4/6/09 13:59:54 International Financial Reporting A Practical Guide Second edition Alan Melville FCA, BSc, Cert Ed Melville prelims 09.indd 4/6/09 13:59:54 Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: www.pearsoned.co.uk First published 2008 Second edition published 2009 © Pearson Education Limited 2008, 2009 The right of Alan Melville to be identified as author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988 All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS All trademarks used herein are the property of their respective owners The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement of this book by such owners ISBN: 978-0-273-73011-8 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloguing-in-Publication Data A catalog record for this book is available from the Library of Congress 10 13 12 11 10 09 Printed and bound by Ashford Colour Press Ltd, Gosport The publisher's policy is to use paper manufactured from sustainable forests Website A website to accompany International Financial Reporting can be found at www.pearsoned.co.uk/melville Melville prelims 09.indd 4/6/09 13:59:54 Contents Preface Acknowledgements List of international standards ix x xi Part INTRODUCTION TO FINANCIAL REPORTING The regulatory framework The need for regulation Sources of regulation Generally accepted accounting practice The International Accounting Standards Board (IASB) The standard-setting process The structure of an international standard The purpose of accounting standards Worldwide use of international standards First-time adoption of international standards 4 9 10 11 17 Presentation of financial statements Objective of financial statements Components of financial statements General features 35 36 36 37 18 19 21 21 24 26 27 28 39 40 45 48 50 51 Accounting policies, accounting estimates and errors Accounting policies Accounting estimates Prior period errors 59 59 64 64 Part FINANCIAL REPORTING IN PRACTICE 11 The IASB conceptual framework Purpose and scope of the IASB Framework Objective of financial statements Underlying assumptions Qualitative characteristics of financial statements Elements of financial statements Recognition of the elements of financial statements Measurement of the elements of financial statements Concepts of capital and capital maintenance Structure and content of financial statements The statement of financial position The statement of comprehensive income The statement of changes in equity The notes to the financial statements Interim financial reporting Property, plant and equipment Definition of property, plant and equipment Recognition of property, plant and equipment Initial measurement of property, plant and equipment Subsequent measurement of property, plant and equipment Depreciation Disclosure requirements Borrowing costs Government grants Investment property 73 Intangible assets Definition of an intangible asset Initial recognition and measurement of intangible assets Subsequent measurement of intangible assets Amortisation of intangible assets Derecognition Disclosure requirements 98 99 74 74 77 78 80 84 85 88 91 100 104 106 108 108 v CONTE NTS Goodwill IFRS3 Business Combinations 109 110 Impairment of assets Indications of impairment Recoverable amount Recognition and measurement of an impairment loss Cash-generating units Reversal of impairment losses Disclosure requirements 116 117 118 Non-current assets held for sale and discontinued operations Classification of non-current assets as held for sale Measurement of non-current assets held for sale Presentation of non-current assets held for sale Discontinued operations Leases Classification of leases Accounting for operating leases Accounting for finance leases Disclosure requirements 10 Inventories and construction contracts Inventories Cost of inventories Cost formulas Net realisable value Disclosures relating to inventories Construction contracts Contract revenue and costs Recognition of contract revenue and expenses Presentation and disclosure for construction contracts 11 Financial instruments Definitions Classification of financial instruments Recognition of financial assets and liabilities Initial measurement of financial assets and liabilities vi 121 122 126 127 132 133 135 139 140 146 147 148 148 152 157 158 158 160 163 164 165 166 166 169 177 178 179 182 182 Subsequent measurement of financial assets Subsequent measurement of financial liabilities Disclosure requirements 12 Provisions and events after the reporting period Recognition of a provision Measurement of a provision Application of the recognition and measurement rules Contingent liabilities and contingent assets Disclosure requirements Scope of IAS37 Events after the reporting period 182 186 187 193 194 196 197 199 200 201 201 13 Revenue Definition of revenue Measurement of revenue Recognition of revenue: Sale of goods Recognition of revenue: Rendering of services Recognition of revenue: Interest, royalties and dividends Disclosure requirements Guidance to the implementation of IAS18 207 208 208 209 14 Employee benefits Short-term employee benefits Post-employment benefits Accounting for defined contribution plans Accounting for defined benefit plans Other long-term employee benefits Termination benefits 218 219 221 15 Taxation in financial statements Current tax Deferred tax The tax base concept IAS12 requirements with regard to deferred tax Disclosure requirements 233 234 236 238 16 Statement of cash flows Cash and cash equivalents Classification of cash flows by activity 248 249 250 210 211 211 212 221 222 228 228 243 243 CONTE NTS Interest, dividends and taxes Reporting cash flows from operating activities Disclosures 17 Financial reporting in hyperinflationary economies Historical cost accounting and its weaknesses Strengths of historical cost accounting Alternatives to historical cost accounting Hyperinflationary economies The restatement of financial statements Disclosures required by IAS29 251 252 256 267 268 273 274 275 275 277 Part CONSOLIDATED FINANCIAL STATEMENTS 18 Groups of companies (1) Requirement to prepare consolidated financial statements Group statement of financial position at date of acquisition Group statement of financial position in subsequent years Partly-owned subsidiaries Preference shares Elimination of intra-group balances Unrealised profits Reporting period and accounting policies 283 19 Groups of companies (2) Group statement of comprehensive income Subsidiary acquired part way through an accounting period 309 20 Associates and joint ventures Significant influence The equity method Application of the equity method IAS28 disclosure requirements Joint ventures Accounting for an interest in a jointly controlled entity IAS31 disclosure requirements 324 325 326 326 332 333 284 285 289 292 295 297 298 299 310 316 334 338 21 Related parties and changes in foreign exchange rates Related parties Definition of related party and related party transaction Disclosures required by IAS24 Foreign exchange accounting Reporting foreign currency transactions Translation to a presentation currency 344 345 345 346 348 349 350 Part ANALYSIS OF FINANCIAL STATEMENTS 22 Ratio analysis Accounting ratios Profitability ratios Liquidity ratios Efficiency ratios Investment ratios Limitations of ratio analysis Multivariate ratio analysis 357 358 359 363 365 367 375 376 23 Earnings per share Significance of EPS Calculation of basic EPS Shares issued during the period Bonus issues Rights issues Calculation of diluted EPS Presentation and disclosure requirements 384 384 385 387 389 390 393 24 Segmental analysis IFRS8 Operating Segments Reportable segments Disclosures required by IFRS8 IAS14 Segment Reporting Primary and secondary segment reporting formats Reportable segments Disclosures for the primary format Disclosures for the secondary format Other disclosures 400 401 401 403 407 395 408 408 409 410 412 Part ANSWERS Answers to exercises Index 419 481 vii Preface The aim of this book is to explain International Financial Reporting Standards (IFRSs) and International Accounting Standards (IASs) at a level which is appropriate for students who are undertaking an intermediate course of study in financial reporting It is assumed that the reader has already completed an introductory accounting course and is familiar with the basics of financial accounting The book has not been written with any particular syllabus in mind but should be useful to second-year undergraduates studying for a degree in accounting and finance and to those who are preparing for the examinations of the professional accounting bodies IFRSs and IASs (referred to in this book as "international standards") are rapidly gaining acceptance around the world and most accounting students are now required to become familiar with these standards The problem is that the standards comprise approximately 2,500 pages of fine print and much of this content is highly technical and difficult to understand What is needed is a textbook which explains the main features of each standard as clearly and concisely as possible and provides students with plenty of worked examples and exercises This book tries to satisfy that need The standards are of international application but, for the sake of convenience, most of the monetary amounts referred to in the worked examples and exercises in this book are denominated in £s Other than this, the book contains very few UK-specific references and should be relevant in any country which has adopted international standards Each chapter of the book concludes with a set of exercises which test the reader's grasp of the topics introduced in that chapter Some of these exercises are drawn from the past examination papers of professional accounting bodies Solutions to most of the exercises are located at the back of the book but solutions to those exercises which are marked with an asterisk (*) are intended for lecturers' use and are provided on a supporting website This second edition is in accordance with all international standards or amendments to standards issued as at January 2009 Alan Melville May 2009 ix PAR T 5: AN SW ERS Only the investor's share of the associate's profit is shown in the investor's statement of comprehensive income and only the investor's share of the associate's net assets in shown in the investor's statement of financial position These items are each shown as a single line item and there is no need to account for a non-controlling interest This differs from the acquisition method used for subsidiaries, whereby all of a subsidiary's assets, liabilities, income and expenses are incorporated line by line into the consolidated financial statements and then the non-controlling interest (if any) is accounted for 20.2 Pi Ltd Pi Ltd is a 90% subsidiary The fair value adjustment creates a revaluation reserve of £80,000 and this increases the equity of Pi Ltd on 31 July 2010 to £560,000 10% of this (£56,000) is attributable to the non-controlling interest The equity of Pi Ltd at 31 July 2007 was £400,000 (£100,000 + £220,000 + £80,000) so the price paid for goodwill was £50,000 (£410,000 – 90% of £400,000) The retained earnings of Pi Ltd have increased by £160,000 since acquisition The group's 90% share of this increase is £144,000 Rho Ltd Rho Ltd is an associate of Mu Ltd On 31 July 2009, the company's equity was £320,000 (£80,000 + £240,000) so the price paid for goodwill was £10,000 (£90,000 – 25% of £320,000) This is not negative and so is not recognised separately The retained earnings of Rho Ltd have increased by £40,000 since Mu Ltd acquired its holding The group's 25% share of this increase is £10,000, so the investment should be carried at £100,000 (£90,000 + £10,000) The consolidated statement of financial position is as follows: £000 Assets Non-current assets Property, plant and equipment (2,580 + 370 + 80) Goodwill Investment in associate Current assets (1,150 + 220) Equity Ordinary share capital Retained earnings (2,420 + 144 + 10) Non-controlling interest Liabilities Current liabilities (810 + 110) 470 3,030 50 100 ––––– 3,180 1,370 ––––– 4,550 ––––– 1,000 2,574 ––––– 3,574 56 ––––– 3,630 920 ––––– 4,550 ––––– ANS WER S TO EXE RCISES 20.3 (a) A joint venture is a contractual arrangement whereby two or more parties undertake an economic activity that is subject to joint control Joint control exists only when decisions relating to the joint venture require the unanimous consent of the venturers (b) A jointly controlled operation does not involve setting up a new entity that is separate from the venturers Instead, the venturers use their own assets for the purposes of the operation and bear their own costs Each venturer takes a share of the operation's revenue This raises no accounting difficulties The assets, liabilities, expenses and revenues associated with the operation are recognised in the individual financial statements of the venturers Financial statements are not prepared for the joint venture itself Jointly controlled assets also not involve the establishment of a new business entity The assets are jointly controlled or jointly owned by the venturers Each venturer takes a share of the revenue derived from these assets and bears an agreed share of any expenses Each venturer's financial statements should show the venturer's share of the jointly controlled assets, together with any associated liabilities, and the venturer's share of the revenue derived from the assets, together with any associated expenses A jointly controlled entity is a business entity which operates in the same way as any other entity, except that the venturers have joint control over its activities A jointly controlled entity presents its own financial statements Each venturer contributes cash or other resources to the entity and is entitled to a share of its profits Jointly controlled entities are accounted for in the financial statements of the venturers by the equity method or by proportionate consolidation 20.4 The equity of Chi Ltd at 31 December 2004 was £540,000 (£300,000 + £180,000 + £60,000) so the price paid for goodwill was £20,000 (£200,000 – one-third of £540,000) The company's retained earnings have increased by £150,000 since Nu Ltd acquired its holding A one-third share of this increase is £50,000 The consolidated statement of financial position is as follows: £000 Assets Non-current assets Property, plant and equipment (1,650 + 1/3rd of 480) Goodwill Current assets (810 + 1/3rd of 390) Equity Ordinary share capital Retained earnings (990 + 50) Liabilities Current liabilities (470 + 1/3rd of 180) 1,810 20 ––––– 1,830 940 ––––– 2,770 ––––– 1,200 1,040 ––––– 2,240 530 ––––– 2,770 ––––– 471 PAR T 5: AN SW ERS 20.5 Lambda Ltd is an associate of Kappa Ltd When Kappa Ltd acquired its holding, the company's equity was £300,000 (£200,000 + £100,000) so the price paid for goodwill was £20,000 (£140,000 – 40% of £300,000) This is not negative and so is not recognised separately The retained earnings of Lambda Ltd have increased by £220,000 since Kappa Ltd acquired its holding A 40% share of this increase is £88,000, so the investment in Lambda Ltd should be carried at £228,000 (£140,000 + £88,000) However, there is unrealised profit of £1,000 (40% of one-quarter of £10,000) and this reduces the carrying amount of the investment to £227,000 The profit after tax of Lambda Ltd for the year to 30 September 2010 is £110,000, of which a 40% share is £44,000 The unrealised profit reduces this to £43,000 On 30 September 2009, the retained earnings of Lambda Ltd had increased by £160,000 (£260,000 – £100,000) since Kappa Ltd acquired its holding A 40% share of this is £64,000, so the retained earnings of Kappa Ltd at 30 September 2009 were £774,000 (£710,000 + £64,000) On 30 September 2010, the retained earnings of Kappa Ltd are £1,297,000 (£1,210,000 + £88,000 – £1,000 unrealised profit) The financial statements of Kappa Ltd are as follows: Statement of comprehensive income for the year to 30 September 2010 Operating profit Share of profit of associate Profit before tax Taxation Profit for the year £000 650 43 –––– 693 170 –––– 523 –––– Statement of changes in equity (retained earnings only) for the year to 30 September 2010 Balance at 30 September 2009 Profit for the year Balance at 30 September 2010 472 £000 774 523 –––––– 1,297 –––––– ANS WER S TO EXE RCISES Statement of financial position as at 30 September 2010 £000 Assets Non-current assets Property, plant and equipment Investment in associate Current assets Equity Ordinary share capital Retained earnings Liabilities Current liabilities 1,600 227 ––––– 1,827 780 ––––– 2,607 ––––– 1,000 1,297 ––––– 2,297 310 ––––– 2,607 ––––– Chapter 21 21.1 The list of related parties includes parents, subsidiaries, fellow subsidiaries, associates, joint ventures, members of key management personnel, the entity's pension scheme and close family members of other related parties The full list is given in Chapter 21 21.2 (a) Alan is a related party unless it can be demonstrated that his shareholding does not give him significant influence over Z plc If Alan is a related party, then Elaine is also a related party (b) Z plc controls Y plc, so Y plc is a related party (c) Z plc does not control X plc and (presumably) does not exert significant influence over the company or jointly control it Therefore X plc is not a related party (d) Barbara is a member of the key management personnel of Z plc and is a related party David is a close family member of Barbara and so is also a related party Barbara controls W Ltd, so W Ltd is a related party of Z plc David does not control V Ltd and there is no indication of significant influence or joint control Therefore V Ltd is not a related party of Z plc (e) Colin may or may not be a related party It depends upon whether he is a member of the key management personnel of Z plc If he is a related party, then so is Fiona (f) The pension scheme is a related party 473 PAR T 5: AN SW ERS 21.3 Apex plc There is a parent-subsidiary relationship between Apex plc and Mitchell Ltd Although there are no transactions between these companies, the existence of the relationship must be disclosed in the financial statements of Apex plc Brown Ltd It is presumed that Brown Ltd has significant influence over Mitchell Ltd, although this might not be the case since the company is controlled by Apex plc If significant influence exists, Mitchell Ltd is a related party of Brown Ltd and that fact must be disclosed in the financial statements of Brown Ltd (since there have been transactions between the companies) Details of the transactions and any outstanding balances must also be disclosed Mitchell Ltd Mitchell Ltd must disclose the fact that Apex plc is its parent If Brown Ltd is a related party (see above) the nature of the relationship must be disclosed, together with details of the transactions between the companies and any outstanding balances 21.4 (a) An entity's functional currency is the currency of the primary economic environment in which the entity operates This is usually the main economic environment in which the entity generates and expends cash (b) Assets and liabilities are translated at the closing rate at the end of the period Income and expenses are translated at the exchange rates which applied on the dates of the transactions concerned Resulting exchange differences are recognised in other comprehensive income 21.5 (a) January 2010 £115,000 (€143,750 ÷ 1.25) is debited to equipment and credited to X February 2010 £40,000 (€48,000 ÷ 1.20) is debited to purchases and credited to Y 28 February 2010 £115,000 is debited to X and £125,000 (€143,750 ÷ 1.15) is credited to bank The difference of £10,000 is debited to exchange differences 15 March 2010 £11,000 (€13,200 ÷ 1.20) is debited to Y £12,000 (€13,200 ÷ 1.10) is credited to bank The difference of £1,000 is debited to exchange differences 15 March 2010 £70,000 (€77,000 ÷ 1.10) is debited to Z and credited to sales (b) On 31 March 2010, there is no adjustment to equipment or inventory, since both of these are carried at historical cost The amount owed to Y (€34,800) is translated to £34,800 (using an exchange rate of £1 = €1.00) This debt was previously carried at £29,000 (€34,800 ÷ 1.20) so there is an adverse exchange difference of £5,800 The amount owed by Z (€77,000) is translated to £77,000, giving rise to a favourable exchange difference of £7,000 Total exchange difference for the period is £9,800 (£10,000 + £1,000 + £5,800 – £7,000) This is an adverse difference and is recognised as an expense in the statement of comprehensive income 474 ANS WER S TO EXE RCISES 21.6 (a) A related party is a party to which the reporting entity is sufficiently closely related to make it possible that transactions between the entity and the party are not conducted on normal commercial terms IAS24 Related Party Disclosures lists the parties that are deemed to be related to an entity (see Chapter 21) Transactions with related parties should be disclosed because such transactions may not have been conducted on arm's length terms and this could affect the entity's financial performance and financial position (b) (i) In general, an employee is not presumed to be a related party simply because he or she is employed by the company (ii) A 30% shareholding normally gives significant influence over a company If this is the case, the shareholder is a related party of Prebnez plc (iii) A director is a member of the company's key management personnel and is a related party of the company (iv) The brother of a director is a close family member of a related party and is therefore also considered to be a related party of the company (v) The fact that Orter plc is economically dependent on Prebnez plc does not in itself mean that Orter plc is a related party of Prebnez plc Chapter 22 22.1 The main assumptions made when calculating the ratios for Roscoe Ltd are: (i) The figures shown in the statement of financial position are representative of the year as a whole and so can be used instead of average figures (which are not available for most items) (ii) All sales and purchases are made on credit terms (iii) Cost of sales can be used as a reasonable approximation to purchases The ratios are as follows: (a) ROCE = 60/279 × 100% = 21.5% (b) ROE = (35 – 1)/119 × 100% = 28.6% (c) Gross profit margin = 175/410 × 100% = 42.7% (d) Net profit margin = 45/410 × 100% = 11.0% (e) Current ratio = 147/76 = 1.9 (f) (g) Quick assets ratio = (147 – 82)/76 = 0.9 Inventory holding period = 82/235 × 365 = 127 days (h) Trade receivables collection period = 58/410 × 365 = 52 days (i) Trade payables payment period = 45/235 × 365 = 70 days (j) Capital gearing ratio = (150 + 10)/279 × 100% = 57.3% (k) Interest cover = 60/15 = (l) Dividend cover = (35 – 1)/20 = 1.7 (m) Earnings per share = (35 – 1)/100 × 100p = 34p 475 PAR T 5: AN SW ERS 22.2 Company X will have a high gross profit margin but much of the gross profit will be absorbed by overhead expenses so that the net profit margin might be disappointingly low The inventory holding period and the trade receivables collection period will both be comparatively long The company will often have to pay for supplies of clothing well before the clothing is sold to customers and this may cause some liquidity problems As a consequence, the company may have needed to obtain a source of long-term finance This would be reflected in the capital gearing ratio and might depress the return obtained on equity Company Y will have a low gross profit margin but the lack of overhead costs may result in a surprisingly high net profit margin The inventory holding period and trade receivables collection period will both be short The company will often be able to sell goods and receive payment for them before having to pay its own suppliers, so that liquidity should not be a major problem 22.3 (a) Earnings per share = (90,000 – 15,000)/1,000,000 × 100p = 7.5p (b) (c) Dividend cover = (90,000 – 15,000)/55,000 = 1.4 Dividend yield = 5.5/70 × 100% = 7.9% (d) Price earnings ratio = 70/7.5 = 9.3 22.4 Profitability ratios (a) ROCE 2009 820/6,508 × 100% = 12.6% 2008 745/5,583 × 100% = 13.3% (b) ROE 475/5,508 × 100% = 8.6% 500/5,433 × 100% = 9.2% (c) Gross profit margin 907/5,327 × 100% = 17.0% 820/3,725 × 100% = 22.0% (d) Net profit margin 690/5,327 × 100% = 13.0% 725/3,725 × 100% = 19.5% These ratios all show a deterioration in the year 2009 The reduction in the gross profit margin was deliberate and was presumably responsible (in part) for the 43% increase in sales, but overall the company was substantially less profitable in the year 2009 than in 2008 In absolute terms, the company's profit actually fell in the year 2009 It appears that the company's attempts to stimulate sales have been successful but the objective of increasing profits has not been achieved Liquidity ratios (e) Current ratio (f) Quick assets ratio 2009 2008 2,623/1,235 = 2.12 1,726/843 = 2.05 (2,623 – 1,334)/1,235 = 1.04 (1,726 – 730)/843 = 1.18 The current ratio has improved slightly in 2009 but this is entirely due to the large (and deliberate) increase in the company's inventories The quick assets ratio fell in 2009 It is important to realise that the company had virtually no cash left at the end of 2009, despite raising an extra £850,000 during the year from long-term loans Given that the company is now offering longer credit to its customers, the liquidity position looks poor Efficiency ratios (g) Inv holding period 2009 1,334/4,420 × 365 = 110 days 2008 730/2,905 × 365 = 92 days (h) 1,278/5,327 × 365 = 88 days 596/3,725 × 365 = 58 days Rec collection period The increases in these ratios are expected, given the company's policy of holding larger inventories and offering longer credit to customers 476 ANS WER S TO EXE RCISES Gearing ratio (i) Capital gearing ratio 2009 1,000/6,508 × 100% = 15.4% 2008 150/5,583 × 100% = 2.7% The company has moved from being a very low-geared company in 2008 to being a moderately low-geared company in 2009 The interest cover is still adequate but the ordinary dividend is barely covered by the profit after tax If the company is forced by its liquidity position to increase borrowings still further and become more high-geared, it may be that the dividend paid to the ordinary shareholders will have to be reduced Chapter 23 23.1 (a) Basic EPS is (£390,000 – £80,000)/4,000,000 × 100p = 7.75p (b) If the company's profit after tax includes £50,000 from a discontinued operation, a second basic EPS figure must be presented, based on the profit from continuing operations This is (£390,000 – £50,000 – £80,000)/4,000,000 × 100p = 6.5p 23.2 (a) (b) £188,000/100,000 = £1.88 The weighted average number of ordinary shares outstanding during the year is (100,000 × 5/12) + (115,000 × 7/12) = 108,750 Therefore basic EPS is £217,500/108,750 = £2.00 23.3 (a) The bonus issue is treated as if it was made at the start of the year to 31 October 2008 Basic EPS for the year to 31 October 2009 is £341,000/550,000 × 100p = 62p (b) Restated basic EPS for the year to 31 October 2008 is £330,000/550,000 × 100p = 60p This would have been originally stated as £330,000/500,000 × 100p = 66p but is restated so as to be comparable with the figure for 2009 23.4 (a) Just before the rights issue, five shares had a market value of £4.00 So the market value of six shares just after the rights issue should be £4.00 + £0.50 = £4.50 This gives a theoretical market value after the issue of 75p per share If the share price had fallen from 80p to 75p as the result of a bonus issue, the number of shares outstanding after this issue would have been 150,000 × 80/75 = 160,000, so a bonus issue of 10,000 shares would have caused such a fall in value Therefore the rights issue is treated as a bonus issue of 10,000 shares plus an issue of 20,000 shares at full price The weighted average number of ordinary shares outstanding during the year to 30 September 2009 is (160,000 × 9/12) + (180,000 × 3/12) = 165,000 Therefore basic EPS for the year is £52,800/165,000 × 100p = 32p (b) Restated basic EPS for the year to 30 September 2008 is £50,000/160,000 × 100p = 31.25p 477 PAR T 5: AN SW ERS 23.5 (a) Basic EPS is £640,000/800,000 × 100p = 80p (b) If the loan stock had been converted into ordinary shares, profit before tax would have risen by £100,000 and profits after tax would have risen by £70,000 to £710,000 The number of extra shares would be 200,000 so that the total number of shares outstanding would become one million Therefore diluted EPS is £710,000/1,000,000 × 100p = 71p (c) Basic EPS is still 80p The extra 200,000 shares that would arise if the loan stock is converted are treated as if issued on October 2009 The weighted average number of ordinary shares outstanding during the year to 31 March 2010 would become (800,000 × 6/12) + (1,000,000 × 6/12) = 900,000 Only half a year's interest would be saved so profit after tax would rise by £35,000 to £675,000 Therefore diluted EPS is £675,000/900,000 × 100p = 75p Chapter 24 24.1 (a) Many entities (especially large companies) engage in a wide range of business activities and operate in several economic environments Each business activity and each environment may be subject to differing risks and returns Therefore an analysis of an entity's results by business activity or by economic environment will help users to understand the entity's past performance, assess the entity's risks and returns and make more informed judgements Such an analysis is required by IFRS8 (and by IAS14 which it replaces) (b) IFRS8 and IAS14 apply to entities whose shares or securities are publicly traded (c) IFRS8 Operating Segments supersedes IAS14 for accounting periods which begin on or after January 2009 Earlier application is permitted Whereas IAS14 requires an entity to identify its business segments and geographical segments (and regard one of these as primary) IFRS8 adopts a management approach to the identification of segments Operating segments are defined as those components of an entity for which separate financial information is available that is evaluated regularly by the chief operating decision maker when allocating resources and assessing performance The primary/secondary concept no longer applies 24.2 (a) An operating segment (as defined by IFRS8) is a component of an entity that meets all of the following criteria: – it is engaged in business activities from which it may earn revenues and incur expenses – its operating results are regularly reviewed by the chief operating decision maker – separate financial information is available for it (b) IFRS8 states that an operating segment is reportable if it satisfies at least one of a number of quantitative thresholds In broad terms, the segment's sales must be at least 10% of total sales, or its profit must be at least 10% of total profit or its assets must be at least 10% of total assets (See Chapter 24 for more details) If the external revenue of reportable segments is less than 75% of the entity's total external revenue, additional operating segments must be identified as reportable (even though they fail the 10% tests) until at least 75% of total external revenue is included in reportable segments 478 ANS WER S TO EXE RCISES 24.3 (a) IAS14 states that if an entity's risks and returns are affected mainly by differences in the products or services which it supplies, then its primary format will be business segments and its secondary format will be geographical segments Conversely, if risks and returns are affected mainly by the fact that the entity operates in different geographical areas, its primary format will be geographical segments and its secondary format will be business segments (b) For each reportable segment in the primary reporting format, IAS14 requires that the entity should disclose segment revenue, segment result, the carrying amount of segment assets, segment liabilities, segment capital expenditure and segment non-cash expenses (c) Broadly, IAS14 requires that an entity's secondary reporting format should disclose segment revenue, the carrying amount of segment assets and segment capital expenditure 24.4 External revenue is £77.4m and internal revenue is £5.6m, so total revenue is £83m An operating segment will satisfy the 10% test with respect to revenue if it has total revenue of at least £8.3m Combined profits are £5.6m and combined losses are £780,000 An operating segment will satisfy the 10% test with respect to segment result if it has a profit or a loss of at least £560,000 Total assets are £38m An operating segment will satisfy the 10% test with respect to assets if it has total assets of at least £3.8m The results of the three 10% tests for each segment are as follows: Total revenue at least £8.3m Segment W Segment X Segment Y Segment Z Y Y N N Profit or loss at least £560,000 Y Y N N Assets at least £3.8m Y Y N Y Reportable segment Y Y N Y Segment Y fails all of the 10% tests and is not a reportable segment The remaining three segments have external revenue totalling £71.2m This exceeds 75% of £77.4m so the 75% test is satisfied The reportable segments are segments W, X and Z 479 PAR T 5: AN SW ERS 24.5 All four segments earn the majority of their revenue from external sales and satisfy the 10% test with regard to revenue Therefore all four segments are reportable segments The primary format segment report is as follows: Total £m Segment revenue External sales revenue Inter-segment sales Total revenue Segment result Unallocated expenses Operating profit Interest income Interest expense Profit before tax Tax expense Profit after tax Segment assets Unallocated assets Total assets Segment liabilities Unallocated liabilities Total liabilities Other segment information Capital expenditure Depreciation Other non-cash expenses 480 Segment A £m Segment B £m Segment C £m Segment D £m 3,025 781 ––––– 3,806 ––––– 727 120 ––––– 607 85 ––––– 692 192 ––––– 500 150 ––––– 350 ––––– 652 127 –––– 779 –––– 176 –––– 764 234 –––– 998 –––– 204 –––– 389 87 –––– 476 –––– 83 –––– 1,220 333 –––– 1,553 –––– 264 –––– 2,475 457 ––––– 2,932 ––––– 530 –––– 653 –––– 310 –––– 982 –––– 1,038 658 ––––– 1,696 ––––– 245 –––– 276 –––– 119 –––– 398 –––– 289 551 65 99 101 17 68 132 12 65 122 253 29 Index Accounting estimates, 64 Accounting policies, 37, 50, 59-63, 299, 332 Accounting ratios, 357-376 Accounting standards, Accrual basis, 21, 38 Actuarial gains and losses, 223, 227 Actuarial method, 149 Adjusting event, 201 Aggregation, 38 Amortisation, 106 Amortised cost, 183 Asset, 24 Asset turnover, 365 Associates, 325-332 Available-for-sale financial asset, 183 Balance sheet, 36, 40 Basic earnings per share, 385 Bonus issues, 389 Borrowing costs, 85-87 Business combinations, 101, 110-111 Business segment, 407 Capital, 28 Capital gearing ratio, 369 Capital maintenance, 28, 268 Capitalisation of borrowing costs, 86 Carrying amount, 74 Cash, 249 Cash equivalent, 41, 249 Cash flow statement, 36 Cash-generating unit, 122, 133, 140 Comparability, 10, 23, 37, 39 Comparative information, 23, 39 Completeness, 23 Compliance with standards, 37, 50 Components of financial statements, 36 Compound financial instruments, 180 Comprehensive income, 45 Conceptual framework, 17 Condensed financial statements, 51 Consignment sales, 212 Consistency, 23, 39 Consolidated financial statements, 284 Construction contracts, 165-171 Constructive obligation, 25, 195, 220 Contingent asset, 199 Contingent liability, 199 Control, 284 Conversion costs, 158 Corporate assets, 124 Cost formulas, 160 Cost model, 78, 92, 104 Credit risk, 189 Currency risk, 189 Current assets, 41 Current cost, 27 Current cost accounting, 274 Current liabilities, 41 Current purchasing power accounting, 274 Current ratio, 363 Current service cost, 222 Current tax, 234-235 Date of transition, 12 Deferred tax, 236-244 Defined benefit obligation, 222 Defined benefit plan, 219 Defined contribution plan, 219 Depreciable amount, 80 Depreciation, 80 Depreciation methods, 82 Development expenditure, 102 Diluted earnings per share, 393 Diminishing balance method, 82 Direct method, 252 Discontinued operations, 140-142 Disposal group, 133 481 INDE X Dividend cover, 368 Dividend yield, 368 Dividends, 48, 201, 211, 310 Downstream transaction, 330 Earnings per share, 367, 384-396 Effective interest method, 183 Efficiency ratios, 365 Elements of financial statements, 24 Employee benefits, 218-229 Entity, Equity, 25 Equity instrument, 178 Equity method, 326, 334 Errors, 64-66 Estimates, 64 Estimation uncertainty, 50 European Union, Events after the reporting period, 201, 234 Exchange differences, 349 Expenses, 26 Exposure draft, Extraordinary items, 46 Fair presentation, 37 Fair value, 78, 148, 181, 182, 186, 208 Fair value less costs to sell, 118, 135 Fair value model, 92 Fair value through profit or loss, 182, 186 Faithful representation, 10, 22 FASB, 5, 16 Finance lease, 147, 148-151 Financial asset, 178 Financial capital maintenance, 28, 268 Financial instruments, 177-189 Financial liability, 178 Financial statements, 19, 36 Financing activities, 251 First-in, first-out (FIFO), 160 First-time adoption, 11 Fixed production overheads, 158 Foreign currency transactions, 349 Format of the financial statements, 42, 46 Framework, 17 Function of expenses, 46 Functional currency, 275, 348 Future operating losses, 197 482 GAAP, Gearing ratio, 369 Generally accepted accounting practice, Geographical segment, 407 Going concern, 21, 38 Goodwill, 109-111, 124, 287 Government grants, 88-90 Gross profit margin, 362 Group, 284 Group comprehensive income, 309-318 Group financial position, 285-299 Group financial statements, 284 Held-to-maturity investments, 183 Historical cost, 27 Historical cost accounting, 268-273 Holding gains, 272 Hyperinflationary economies, 275-277 IAS1, 35-52 IAS2, 157-164 IAS7, 248-256 IAS8, 59-66, 81 IAS10, 201, 234 IAS11, 165-171 IAS12, 234-244 IAS14, 407-412 IAS16, 74-84 IAS17, 146-152 IAS18, 207-214 IAS19, 218-229 IAS20, 88-90 IAS21, 348-351 IAS23, 85-87 IAS24, 345-347 IAS27, 283-299, 309-318 IAS28, 325-332 IAS29, 275-277 IAS31, 333-338 IAS32, 178-181 IAS33, 384-396 IAS34, 51-52 IAS36, 116-128 IAS37, 193-201 IAS38, 98-109 IAS39, 182-187 IAS40, 91-92 INDE X IASB, 5, IASB Framework, 17-29 IASB website, 17 IASC, IASC Foundation, Identifiable asset, 100 Identification of financial statements, 40 IFRIC, IFRS1, 11-13 IFRS3, 101, 110-111, 287, 294 IFRS5, 132-142 IFRS7, 187-189 IFRS8, 401-406 Impairment of assets, 116-128, 185 Income, 25 Income statement, 45 Indirect method, 252 Intangible assets, 98-111 Interest cost, 223 Interest cover, 371 Interest rate risk, 189 Interim financial reporting, 51 Internally generated intangible asset, 101 International Accounting Standards, International Accounting Standards Board, International Financial Reporting Standards, Intra-group items, 297, 310 Inventories, 157-164 Inventory holding period, 366 Investing activities, 250 Investment property, 91-92 Investment ratios, 367 Joint control, 333 Joint ventures, 333-338 Jointly controlled assets, 333 Jointly controlled entities, 334 Jointly controlled operations, 333 Last-in, first-out (LIFO), 161 Leases, 146-152 Legislation, Level spread method, 150 Liability, 24 Liquidity ratios, 363 Liquidity risk, 189 Loans and receivables, 183 Long-term employee benefits, 228 Machine hours method, 82 Market risk, 189 Materiality, 22, 38 Measurement basis, 27 Measurement of an element, 27 Minimum lease payments, 149 Minority interest, 292 Monetary asset, 100 Monetary items, 271 Multivariate ratio analysis, 376 Nature of expenses, 46 Negative goodwill, 110, 287 Net profit margin, 362 Net realisable value, 163 Neutrality, 22 Non-adjusting event, 201 Non-controlling interest, 292 Non-current assets, 41 Non-current assets held for sale, 132-140 Non-current liabilities, 41 Non-monetary asset, 100 Notes to the financial statements, 36, 50 Objective of financial statements, 19, 36 Obligating event, 195 Obligation, 25, 195 Offsetting, 38 Onerous contract, 197 Operating activities, 250 Operating lease, 147, 148 Operating segments, 401-406 Options, 394 Other comprehensive income, 45, 79, 104, 121 Parent, 284 Payables payment period, 367 Permanent difference, 236 Physical capital maintenance, 28, 269 Post-employment benefits, 221 Predictive value, 22 Preference shares, 180, 295 Present obligation, 25, 195, 220 Present value, 27, 31-32, 148, 185 483 INDE X Presentation currency, 275, 348 Presentation of financial statements, 35 Price earnings ratio, 368 Primary reporting format, 408 Prior period errors, 64-66 Private entities, 6, 11 Profitability ratios, 359 Property, plant and equipment, 73-84 Proportionate consolidation, 334 Provisions, 25, 194-201 Prudence, 23 Purchasing power, 28, 268 Purpose of accounting standards, 10 Qualifying asset, 85 Qualitative characteristics, 21 Quick assets ratio, 364 Ratio analysis, 357-376 Realisable value, 27 Receivables collection period, 366 Recognition of an element, 26 Recoverable amount, 118, 138 Redeemable preference shares, 180 Reducing balance method, 82 Regulatory framework, Related parties, 345-347 Relevance, 22, 37 Reliability, 22, 37 Rendering of services, 210 Reportable segment, 401, 408 Research expenditure, 101 Residual value, 80, 107 Restructuring costs, 198 Retail method, 159 Return on capital employed, 360 Return on equity, 361 Revaluation gains, 79, 104 Revaluation losses, 79, 105 Revaluation model, 78, 104 Revenue, 208-214 Rights issues, 390 Royalties, 211 Rule of 78, 149 484 Sale and repurchase agreement, 213 Sale of goods, 209 Secondary reporting format, 408 Segmental analysis, 400-412 Separable asset, 100 Separately acquired intangible asset 100 Short-term compensated absences, 219 Short-term employee benefits, 219 Significant influence, 325 Small and medium-sized entities, Stage of completion, 166 Standard costs, 159 Standards Advisory Council, Statement of cash flows, 36, 248-256 Statement of changes in equity, 36, 48 Statement of comprehensive income, 36, 45 Statement of financial position, 36, 40 Stock exchange, Straight-line method, 82 Subsidiary, 284 Substance over form, 22, 147, 179 Sum of digits method, 149 Tax base, 238 Taxation, 233-244 Temporary difference, 236, 239 Termination benefits, 228 Trade payables, 186 Trade receivables, 183 Underlying assumptions, 21 Understandability, 21, 37 Units of production method, 82 Unrealised profits, 298 Upstream transaction, 330 Useful life, 80, 106 Users of financial statements, 19 Value in use, 118, 138 Venturer, 333 Website, 17 Weighted average cost (AVCO), 161 Worldwide use of international standards, 11 ... website of the International Accounting Standards Board (IASB) at www.iasb.org International Financial Reporting Standards (IFRSs) IFRS First-time Adoption of International Financial Reporting Standards... structure of an international financial reporting standard or international accounting standard explain the main features of IFRS1 First-time Adoption of International Financial Reporting Standards... accounting standards and International Accounting Standards and International Financial Reporting Standards to high quality solutions The IASB's Preface to International Financial Reporting Standards