161 FINANCIAL STATEMENTS Walk in the footsteps of a top tutor
(a) The IASB’s Framework Conceptual Framework for Financial Reporting requires financial statements to be prepared on the basis that they comply with certain accounting concepts, underlying assumptions and (qualitative) characteristics. Five of these are:
Matching/accruals Faithful representation Prudence
Comparability Materiality Required:
Briefly explain the meaning of each of the above concepts/assumptions. (5 marks) (b) For most entities, applying the appropriate concepts/assumptions in accounting for
inventories is an important element in preparing their financial statements.
Required:
Illustrate with examples how each of the concepts/assumptions in (a) may be
applied to accounting for inventory. (10 marks)
(Total: 15 marks)
162 FINO Walk in the footsteps of a top tutor
(a) An important requirement of the IASB’s Conceptual Framework for Financial Reporting is that an entity’s financial statements should represent faithfully the transactions and events that it has undertaken.
Required:
Explain what is meant by faithful representation according to the IASB’s Conceptual
Framework for Financial Reporting. (5 marks)
(b) On 1 April 2007, Fino increased the operating capacity of its plant. Due to a lack of liquid funds it was unable to buy the required plant which had a cost of $350,000.
On the recommendation of the finance director, Fino entered into an agreement to lease the plant from the manufacturer. The lease required four annual payments in advance of $100,000 each commencing on 1 April 2007. The plant would have a useful life of four years and would be scrapped at the end of this period. The finance director, believing the lease to be an operating lease, commented that the agreement would improve the company’s return on capital employed (compared to outright purchase of the plant).
Required:
(i) Discuss the validity of the finance director’s comment and describe how IAS 17 Leases ensures that leases such as the above are faithfully represented
in an entity’s financial statements. (4 marks)
(ii) Prepare extracts of Fino’s statement of profit or loss and statement of financial position for the year ended 30 September 2007 in respect of the rental agreement assuming:
(1) It is an operating lease (2 marks)
(2) It is a finance lease (use an implicit interest rate of 10% per annum).
(4 marks) (Total: 15 marks) 163 WARDLE
(a) An important aspect of the International Accounting Standards Board’s Conceptual Framework for Financial Reporting is that transactions should be recorded on the basis of faithful representation.
Required:
Explain why it is important that financial statements should show faithful representation, and describe circumstances where the recognition criteria for assets and liabilities may differ from the passing of legal title over items. (5 marks) (b) Wardle’s activities include the production of maturing products which take a long
time before they are ready to retail. Details of one such product are that on 1 April 2009 it had a cost of $5 million and a fair value of $7 million. The product would not
On 1 April 2009 Wardle entered into an agreement to sell the product to Easyfinance for $6 million. The agreement gave Wardle the right to repurchase the product at any time up to 31 March 2012 at a fixed price of $7,986,000, at which date Wardle expected the product to retail for $10 million. The compound interest Wardle would have to pay on a three-year loan of $6 million would be:
Year 1 600,000 $
Year 2 660,000
Year 3 726,000
This interest is equivalent to the return required by Easyfinance.
Required:
Assuming the above figures prove to be accurate, prepare extracts from the statement of profit or loss of Wardle for the three years to 31 March 2012 in respect of the above transaction:
(i) Reflecting the legal form of the transaction (2 marks) (ii) Reflecting the faithful representation of the transaction. (3 marks) Note: Statement of financial position extracts are NOT required.
(c) Comment on the effect the two treatments have on the statement of profit or loss and the statements of financial position and how this may affect an assessment of
Wardle’s performance. (5 marks)
(Total: 15 marks) 164 TUNSHILL
(a) IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors contains guidance on the use of accounting policies and accounting estimates.
Required:
Explain the basis on which the management of an entity must select its accounting policies and distinguish, with an example, between changes in accounting policies
and changes in accounting estimates. (5 marks)
(b) The directors of Tunshill are disappointed by the draft profit for the year ended 30 September 2010. The company’s assistant accountant has suggested two areas where she believes the reported profit may be improved:
(i) A major item of plant that cost $20 million to purchase and install on 1 October 2007 is being depreciated on a straight-line basis over a five-year period (assuming no residual value). The plant is wearing well and at the beginning of the current year (1 October 2009) the production manager believed that the plant was likely to last eight years in total (i.e. from the date of its purchase).
The assistant accountant has calculated that, based on an eight-year life (and no residual value) the accumulated depreciation of the plant at 30 September 2010 would be $7.5 million ($20 million/8 years × 3). In the financial statements for the year ended 30 September 2009, the accumulated depreciation was $8 million ($20 million/5 years × 2). Therefore, by adopting an eight-year life, Tunshill can avoid a depreciation charge in the current year and instead credit $0.5 million ($8 million – $7.5 million) to the statement of profit or loss in the current year to improve the reported profit. (5 marks)
(ii) Most of Tunshill’s competitors value their inventory using the average cost (AVCO) basis, whereas Tunshill uses the first in first out (FIFO) basis. The value of Tunshill’s inventory at 30 September 2010 (on the FIFO basis) is $20 million, however on the AVCO basis it would be valued at $18 million. By adopting the same method (AVCO) as its competitors, the assistant accountant says the company would improve its profit for the year ended 30 September 2010 by
$2 million. Tunshill’s inventory at 30 September 2009 was reported as
$15 million, however on the AVCO basis it would have been reported as
$13.4 million. (5 marks)
Required:
Comment on the acceptability of the assistant accountant’s suggestions and quantify how they would affect the financial statements if they were implemented under IFRS. Ignore taxation.
(Total: 15 marks)
165 PROMOIL Walk in the footsteps of a top tutor
(a) The definition of a liability forms an important element of the International Accounting Standards Board’s Conceptual Framework for Financial Reporting which, in turn, forms the basis for IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
Required:
Define a liability and describe the circumstances under which provisions should be recognised. Give two examples of how the definition of liabilities enhances the faithful representation of financial statements. (5 marks) (b) On 1 October 2007, Promoil acquired a newly constructed oil platform at a cost of
$30 million together with the right to extract oil from an offshore oilfield under a government licence. The terms of the licence are that Promoil will have to remove the platform (which will then have no value) and restore the sea bed to an environmentally satisfactory condition in 10 years’ time when the oil reserves have been exhausted. The estimated cost of this on 30 September 2017 will be
$15 million. The present value of $1 receivable in 10 years at the appropriate discount rate for Promoil of 8% is $0.46.
Required:
(i) Explain and quantify how the oil platform should be treated in the financial statements of Promoil for the year ended 30 September 2008; (7 marks) (ii) Describe how your answer to (b)(i) would change if the government licence did not require an environmental cleanup. (3 marks) (Total: 15 marks)
166 WAXWORK
(a) The objective of IAS 10 Events after the Reporting Period is to prescribe the treatment of events that occur after an entity’s reporting period has ended.
Required:
Define the period to which IAS 10 relates and distinguish between adjusting and
non-adjusting events. (5 marks)
(b) Waxwork’s current year end is 31 March 2009. Its financial statements were authorised for issue by its directors on 6 May 2009 and the AGM (annual general meeting) will be held on 3 June 2009. The following matters have been brought to your attention:
(i) On 12 April 2009 a fire completely destroyed the company’s largest warehouse and the inventory it contained. The carrying amounts of the warehouse and the inventory were $10 million and $6 million respectively. It appears that the company has not updated the value of its insurance cover and only expects to be able to recover a maximum of $9 million from its insurers. Waxwork’s trading operations have been severely disrupted since the fire and it expects large trading losses for some time to come. (4 marks) (ii) A single class of inventory held at another warehouse was valued at its cost of
$460,000 at 31 March 2009. In April 2009 70% of this inventory was sold for
$280,000 on which Waxworks’ sales staff earned a commission of 15% of the
selling price. (3 marks)
(iii) On 18 May 2009 the government announced tax changes which have the effect of increasing Waxwork’s deferred tax liability by $650,000 as at
31 March 2009. (3 marks)
Required:
Explain the required treatment of the items (i) to (iii) by Waxwork in its financial statements for the year ended 31 March 2009. Note: Assume all items are material and are independent of each other. (10 marks as indicated) (Total: 15 marks) 167 DARBY
(a) Your assistant has been criticised over a piece of assessed work that he produced for his study course for giving the definition of a non-current asset as ‘a physical asset of substantial cost, owned by the company, which will last longer than one year’.
Required:
Explain the weaknesses in the assistant’s definition of non-current assets. (4 marks) (b) The same assistant has encountered the following matters during the preparation of the draft financial statements of Darby for the year ending 30 September 2009. He has given an explanation of his treatment of them.
(i) Darby spent $200,000 sending its staff on training courses during the year. This has already led to an improvement in the company’s efficiency and resulted in cost savings. The organiser of the course has stated that the benefits from the training should last for a minimum of four years. The assistant has therefore treated the cost of the training as an intangible asset and charged six months’
amortisation based on the average date during the year on which the training
courses were completed. (3 marks)
(ii) During the year the company started research work with a view to the eventual development of a new processor chip. By 30 September 2009 it had spent $1.6 million on this project. Darby has a past history of being particularly successful in bringing similar projects to a profitable conclusion. As a consequence the assistant has treated the expenditure to date on this project as an asset in the statement of financial position.
Darby was also commissioned by a customer to research and, if feasible, produce a computer system to install in motor vehicles that can automatically stop the vehicle if it is about to be involved in a collision. At 30 September 2009, Darby had spent $2.4 million on this project, but at this date it was uncertain as to whether the project would be successful. As a consequence the assistant has treated the $2.4 million as an expense in the statement of profit
or loss. (4 marks)
(iii) Darby signed a contract (for an initial three years) in August 2009 with a company called Media Today to install a satellite dish and cabling system to a newly built group of residential apartments. Media Today will provide telephone and television services to the residents of the apartments via the satellite system and pay Darby $50,000 per annum commencing in December 2009. Work on the installation commenced on 1 September 2009 and the expenditure to 30 September 2009 was $58,000. The installation is expected to be completed by 31 October 2009. Previous experience with similar contracts indicates that Darby will make a total profit of $40,000 over the three years on this initial contract. The assistant correctly recorded the costs to 30 September 2009 of $58,000 as a non-current asset, but then wrote this amount down to
$40,000 (the expected total profit) because he believed the asset to be impaired.
The contract is not a finance lease. Ignore discounting. (4 marks) Required:
For each of the above items (i) to (iii) comment on the assistant’s treatment of them in the financial statements for the year ended 30 September 2009 and advise him how they should be treated under International Financial Reporting Standards.
(Total: 15 marks)
168 REBOUND
(a) Your assistant has been reading the IASB’s Conceptual Framework for Financial Reporting and as part of the qualitative characteristics of financial statements under the heading of ‘relevance’ he notes that the predictive value of information is considered important. He is aware that financial statements are prepared historically (i.e. after transactions have occurred) and offers the view that the predictive value of financial statements would be enhanced if forward-looking information (e.g.
forecasts) were published rather than backward-looking historical statements.
Required:
By the use of specific examples, provide an explanation to your assistant of how IFRS presentation and disclosure requirements can assist the predictive role of historically prepared financial statements. (6 marks) (b) The following summarised information is available in relation to Rebound, a publicly
listed company:
Statement of profit or loss extracts years ended 31 March:
2011 2010
Continuing Discontinued Continuing Discontinued
$000 $000 $000 $000
Profit after tax
Existing operations 2,000 (750) 1,750 600
Operations acquired on 1 August 2010 450 nil
Analysts expect profits from the market sector in which Rebound’s existing operations are based to increase by 6% in the year to 31 March 2012 and by 8% in the sector of its newly acquired operations.
On 1 April 2009 Rebound had:
$3 million of 25 cents equity shares in issue.
$5 million 8% convertible loan stock 2016; the terms of conversion are 40 equity shares in exchange for each $100 of loan stock. Assume an income tax rate of 30%.
On 1 October 2010 the directors of Rebound were granted options to buy 2 million shares in the company for $1 each. The average market price of Rebound’s shares for the year ending 31 March 2011 was $2.50 each.
Required:
(i) Calculate Rebound’s estimated profit after tax for the year ending 31 March 2012 assuming the analysts’ expectations prove correct; (3 marks) (ii) Calculate the diluted earnings per share (EPS) on the continuing operations of
Rebound for the year ended 31 March 2011 and the comparatives for 2010.
(6 marks) (Total: 15 marks)
169 BOROUGH
(a) IAS 37 Provisions, contingent liabilities and contingent assets prescribes the accounting and disclosure for those items named in its title.
Required:
Define provisions and contingent liabilities and briefly explain how IAS 37 improves
consistency in financial reporting. (6 marks)
(b) The following items have arisen during the preparation of Borough’s draft financial statements for the year ended 30 September 2011:
(i) On 1 October 2010, Borough commenced the extraction of crude oil from a new well on the seabed. The cost of a 10-year licence to extract the oil was
$50 million. At the end of the extraction, although not legally bound to do so, Borough intends to make good the damage the extraction has caused to the seabed environment. This intention has been communicated to parties external to Borough. The cost of this will be in two parts: a fixed amount of
$20 million and a variable amount of 2 cents per barrel extracted. Both of these amounts are based on their present values as at 1 October 2010 (discounted at 8%) of the estimated costs in 10 years’ time. In the year to 30 September 2011 Borough extracted 150 million barrels of oil.
(ii) Borough owns the whole of the equity share capital of its subsidiary Hamlet.
Hamlet’s statement of financial position includes a loan of $25 million that is repayable in five years’ time. $15 million of this loan is secured on Hamlet’s property and the remaining $10 million is guaranteed by Borough in the event of a default by Hamlet. The economy in which Hamlet operates is currently experiencing a deep recession, the effects of which are that the current value of its property is estimated at $12 million and there are concerns over whether Hamlet can survive the recession and therefore repay the loan.
Required:
Describe, and quantify where possible, how items (i) and (ii) above should be treated in Borough’s statement of financial position for the year ended 30 September 2011.
In the case of item (ii) only, distinguish between Borough’s entity and consolidated financial statements and refer to any disclosure notes. Your answer should only refer to the treatment of the loan and should not consider any impairment of Hamlet’s property or Borough’s investment in Hamlet.
Note: the treatment in the income statement is NOT required for any of the items.
The following mark allocation is provided as guidance for this requirement:
(i) 5 marks
(ii) 4 marks (9 marks)
(Total: 15 marks)
170 TELEPATH Online question assistance
(a) The objective of IAS 36 Impairment of assets is to prescribe the procedures that an entity applies to ensure that its assets are not impaired.
Required:
Explain what is meant by an impairment review. Your answer should include reference to assets that may form a cash generating unit.
Note: you are NOT required to describe the indicators of an impairment or how impairment losses are allocated against assets. (4 marks) (b) (i) Telepath acquired an item of plant at a cost of $800,000 on 1 April 2010 that is used to produce and package pharmaceutical pills. The plant had an estimated residual value of $50,000 and an estimated life of five years, neither of which has changed. Telepath uses straight-line depreciation. On 31 March 2012, Telepath was informed by a major customer (who buys products produced by the plant) that it would no longer be placing orders with Telepath. Even before this information was known, Telepath had been having difficulty finding work for this plant. It now estimates that net cash inflows earned from the plant for the next three years will be:
$000 year ended: 31 March 2013 220
31 March 2014 180
31 March 2015 170
On 31 March 2015, the plant is still expected to be sold for its estimated realisable value. Telepath has confirmed that there is no market in which to sell the plant at 31 March 2012. Telepath’s cost of capital is 10% and the following values should be used:
value of $1 at: $
end of year 1 0.91
end of year 2 0.83
end of year 3 0.75
(ii) Telepath owned a 100% subsidiary, Tilda that is treated as a cash generating unit. On 31 March 2012, there was an industrial accident (a gas explosion) that caused damage to some of Tilda’s plant. The assets of Tilda immediately before the accident were:
$000
Goodwill 1,800
Patent 1,200
Factory building 4,000
Plant 3,500
Receivables and cash 1,500
–––––––
12,000 –––––––
As a result of the accident, the recoverable amount of Tilda is $6.7 million The explosion destroyed (to the point of no further use) an item of plant that had a carrying amount of $500,000.
Tilda has an open offer from a competitor of $1 million for its patent. The receivables and cash are already stated at their fair values less costs to sell (net realisable values).
Required:
Calculate the carrying amounts of the assets in (i) and (ii) above at 31 March 2012 after applying any impairment losses.
Calculations should be to the nearest $1,000.
The following mark allocation is provided as guidance for this requirement:
(i) 4 marks
(ii) 7 marks (11 marks)
(Total: 15 marks)
Online question assistance
171 LOBDEN
(a) Two of the qualitative characteristics of information contained in the IASB’s Conceptual Framework for Financial Reporting are understandability and comparability.
Required:
Explain the meaning and purpose of the above characteristics in the context of financial reporting and discuss the role of consistency within the characteristic of comparability in relation to changes in accounting policy. (6 marks) (b) Lobden is a construction company involved in building commercial properties. Its
current policy for determining progress is based on the proportion of cost incurred to date compared to the total expected cost of the contract.
The performance obligation on these contracts are satisfied over time.
One of Lobden’s contracts has an agreed price of $250 million and estimated total costs of $200 million. The cumulative progress of this contract is:
Year ended: 30 September 2011 30 September 2012
$million $million
Costs incurred 80 145
Work certified and billed 75 160
Billings received 70 150