'b

Cost of production plant - NB: All reasons come from lAS 16 - Property, Plant and Equipment Component Basic costs Sales taxes Employment costs Other overheads Payments to advisors Dismantling costs Amount $'000 10,000 800 600 500 1,360 13,260 Depreciation charge (income statement - operating cost) Per lAS 16 the asset is split into two depreciable components: 3,000 with a useful economic life (UEU of four years 10,260 (the balance) with a UEL of eight years So the charge for the year ended 31 March 2007 is 3,000 x 1/4 x 10/12 Carrying value of asset (balance sheet - non current assets) 13,260 - 1,694 = 11,566 Unwinding of discount (income statement - finance cost) 1,360 x 5% x 10/12 = 57 Provision for dismantling (balance sheet - non-current liabilities) 1,360 + 57 = 1,417 Reason Purchase costs included Recoverablesales taxes not included Employment costs in period of getting the plant ready for use. Abnormal costs excluded Directly attributable cost Recognised at present value where an obligation exists

+ 10,260 x 1/8 x 10/12

=

1,694

.,

(a)

Depreciation is an expense which is charged to reflect the value of economic benefits which have been consumed due to the use of a fixed asset during the accounting period. This is an application of the accruals principle, under which profit is calculated by charging expenses against profit as they are incurred. The annual charge is normally calculated on the basis of a predetermined policy. When accounts are prepared, the total depreciation to date is deducted from the cost to arrive at the net book value. It is this value that is reported on the balance sheet.

Impairment is the term used when the value (effectively the market value) of a fixed asset falls below the net book value. Impairment arises for a reason other than the consumption of economic benefits, for instance damage to an asset, or a change in market conditions. From the above it follows that the value of economic benefits consumed by using assets should be charged as an expense to the profit and loss account. It is accepted that freehold land is not consumed by the activities of the business (unless the land is physically damaged, as would be the case in a mining company) and therefore need not be depreciated. On the assumption that the normal activities of Alfield do not damage the land, the policy of not depreciating would appear to be appropriate. The directors are required to choose the method which is used to charge depreciation. In doing so, they should seek to reflect the consumption of economic benefits which occurs. Once chosen, a method of depreciation should be consistently applied to all assets in a class. It is often the case that companies depreciate machinery on a straight line basis and vehicles on a reducing balance basis. The straight line basis means that the depreciation charge is the same from year to year, whilst the reducing balance basis leads to reducing charges in each successive year. As vehicles tend to require increasing maintenance expenditure as they become older, the company's policies for these classes of assets would seem to be appropriate. Mark allocation: (b) 1 mark per valid point, to a MAXIMUM of 6

Depreciation: Buildings Cost £180,000, depreciation SL over 30 years Thus depreciation charge is £6,000 per annum, and the net book value at 30 November 2005 is: Cost £180,000 Less Depreciation to date £72,000 (£66,000 + £6,000) Net book value £108,000

1

However, the value of the buildings is £100,000, As this is less than the net book value, there has been impairment, and the value must be reduced to £100,000. 1 Plant and Machinery Depreciation charge is Vehicles Depreciation charge is £248,000 x 15% = £37,200 £160,000 less £98,000 NBV £62,000 x 20% £12,400 1

1 1

Revaluation of land: (Note to candidates: The directors are not required to reflect the increase in the value of the land in the financial statements, but may choose to do so. However, as the land has not been sold, the increase is not a realised gain. As such it cannot be reported in the profit and loss account, but instead is taken to a Revaluation Reserve.) Increase in value of land £480,000 - £450,000
=

£30,000

1 6

(c)

Alfield Ltd Revised Draft Balance Sheet at 30 November 2005 Fixed assets (WI) Current assets Creditors: amounts falling due within one year Creditors: amounts falling due in more than one year Total net assets Capital and reserves: Share capital Retained profit (W2) Revaluation reserve £000 1,636-4 347·0 (264,0) 1,719-4 (150'0) 1,569,4 300,0 1,239-4 30,0 1,569-4

Working 1 Fixed asset value as given add: Revaluation less: Depreciation/Impairment

£000 1,670·0 30·0 (63·6) (14 + 37·2 + 12-4) 1,636·4

1

2

Working 2 Retained profit as given less: Depreciation/Impairment

1,303·0 (63·6) 1,239-4

Ii

(a)

DAWES CORRECTED SCHEDULE OF THE MOVEMENTS ON PLANT Cost $m 81.20 21.50 (15.00) 87.70

At 1 October 20X6 Addition to cost (see below) Disposals (see below) Depreciation charge for year Balance 30 September 20X7 Workings 1 Additions Basic cost Installation Testing

Depreciation $m 32.50 (9.00) 17.54 -41.04

$m 20.00 1.00 0.50 -21.50

Note. The sales tax on the plant can be reclaimed by Dawes and therefore does not form part of its cost. The company policy for government grants does not allow them to be offset against the cost of the asset. Insurance and maintenance are revenue items.

2

Disposal The accumulated depreciation on the plant disposed of would be 20% of $15 million for three years = $9 million. The depreciation charge for the year is 20% of the corrected cost of the plant at the year end, ie 20% x $87.7 million = $17.54 million.

(b)

Depreciation is the process of allocating the cost (or revalued amount) less the estimated residual value of a non-current asset over the periods that are expected to benefit. It is an example of the use of the accruals and matching concept. It is not meant to be a process of valuing assets. The directors of Dawes are confusing the two issues. Even though the value of an asset may have increased, it does not mean depreciation is unnecessary. Each year a portion (1/25th) of the value of the leased property is consumed, and the depreciation charge reflects this cost. The carrying value of the leased property is a different issue. The question states that the company is based in a country where the regulatory requirements permit the directors to choose to value the property on the historical cost basis, or they can choose a 'current value' - in this case the current replacement cost. This situation is allowed for in lAS 16 Property, plant and equipment. Regardless of which valuation method is chosen, depreciation must still be charged arid be based on the chosen value. Some regulatory requirements take the view that where a company can demonstrate that the life of an asset (which is of a type whose life is normally considered to be finite) can be considered to be infinite, perhaps due to exceptionally high standards of maintenance, then no depreciation may be necessary. In effect the maintenance costs become a substitute for the depreciation. Hotel properties have sometimes been treated this way. This argument would not be applicable to this leased property. lAS 8 Accounting policies, changes in accounting estimates and errors says the initial adoption of a policy to carry property at a revalued amount is a change in accounting policy, but that it should be treated as a revaluation in accordance with lAS 16. If the directors decide to revalue the property then all of Dawes' properties (within the same class) must be simultaneously revalued, and these valuations must be kept up to date. In this case the alternatives are:

(i)

No revaluation of the property BALANCE SHEET Non-current assets: property, plant and equipment Cost Accumulated depreciation Net book (carrying) value INCOME STATEMENT Depreciation of leased property 4,000 x 1/25 $'000 4,000 ~ 3,040 $'000 160

(ii)

The property is revalued to BALANCE SHEET

$ 6 million at 1 October 20X6
$'000 6,000 (300) 5,700 $'000 2,660

Non-current assets: property, plant and equipment Cost Accumulated depreciation Net book (carrying) value Reserves Revaluation surplus (see below)

INCOME STATEMENT $'000 Depreciation of leased property 6,000 x 1/20 Working: revaluation surplus Net book value 1 October 20X6 ($4,000 less 5 years at 4% pa) Revalued amount Revaluation surplus 1 October 20X6 Transferred to realised profits (1/20th) Revaluation surplus 30 September 20X7 300

$'000 3,200 (6,000) 2,800

__l!1Q) 2,66_Q

.,

(a)

The accruals basis requires transactions (or events) to be recognised when they occur (rather than on a cash flow basis). Revenue is recognised when it is earned (rather than when it is received) and expenses are recognised when they are incurred (i.e. when the entity has received the benefit from them), rather than when they are paid. Recording the substance of transactions (and other events) requires them to be treated in accordance with economic reality or their commercial intent rather than in accordance with the way they may be legally constructed. This is an important element of faithful representation. Prudence is used where there are elements of uncertainty surrounding transactions or events. Prudence requires the exercise of a degree of caution when making judgements or estimates under conditions of uncertainty. Thus when estimating the expected life of a newly acquired asset, if we have past experience of the use of similar assets and they had had lives of (say) between five and eight years, it would be prudent to use an estimated life of five years for the new asset. Comparability is fundamental to assessing the performance of an entity by using its financial statements. Assessing the performance of an entity over time (trend analysis) requires that the financial statements used have been prepared on a comparable (consistent) basis. Generally this can be interpreted as using consistent accounting policies (unless a change is required to show a fairer presentation). A similar principle is relevant to comparing one entity with another; however it is more difficult to achieve consistent accounting policies across entities. Information is material if its omission or misstatement could influence (economic) decisions of users based on the reported financial statements. Clearly an important aspect of materiality is the (monetary) size of a transaction, but in addition the nature of the item can also determine that it is material. For example the monetary results of a new activity may be small, but reporting them could be material to any assessment of what it may achieve in the future. Materiality is considered to be a threshold quality, meaning that information should only be reported if it is considered material. Too much detailed (and implicitly immaterial) reporting of (small) items may confuse or distract users.

(b)

Accounting for inventory, by adjusting purchases for opening and closing inventories is a classic example of the application of the accruals principle whereby revenues earned are matched with costs incurred. Closing inventory is by definition an example of goods that have been purchased, but not yet consumed. In other words the entity has not yet had the 'benefit' (i.e. the sales revenue they will generate) from the closing inventory; therefore the cost of the closing inventory should not be charged to the current year's income statement. Consignment inventory is where goods are supplied (usually by a manufacturer) to a retailer under terms which mean the legal title to the goods remains with the supplier until a specified event (say payment in three months time). Once the goods have been transferred to the retailer, normally the risks and rewards relating to those goods then lie with the retailer. Where this is the case then (in substance) the consignment inventory meets the definition of an asset and the goods should appear as such (inventory) on the retailer's statement of financial position (along with the associated liability to pay for them) rather than on the statement of financial position of the manufacturer. At the year end, the value of an entity's closing inventory is, by its nature, uncertain. In the next accounting period it may be sold at a profit or a loss. Accounting standards require inventory to be valued at the lower of cost and net realisable value. This is the application of prudence. If the inventory is expected to sell at a profit, the profit is deferred (by valuing inventory at cost) until it is actually sold. However, if the goods are expected to sell for a (net) loss, then that loss must be recognised immediately by valuing the inventory at its net realisable value. There are many acceptable ways of valuing inventory (e.g, average cost or FIFO). In order to meet the requirement of comparability, an entity should decide on the most appropriate valuation method for its inventory and then be consistent in the use of that method. Any change in the method of valuing (or accounting for) inventory would break the principle of comparability. For most businesses inventories are a material item. An error (omission or misstatement) in the value or treatment of inventory has the potential to affect decisions users may make in relation to financial statements. Therefore (correctly) accounting for inventory is a material event. Conversely there are occasions where on the grounds of immateriality certain 'inventories' are not (strictly) accounted for correctly. For example, at the year end a company may have an unused supply of stationery. Technically this is inventory, but in most cases companies would charge this 'inventory' of stationery to the income statement of the year in which it was purchased rather than show it as an asset. Note: other suitable examples would be acceptable.

20

Accounting correctly for the convertible loan note in accordance with lAS 32 Financial Instruments: Presentation and lAS 39 Financial Instruments: Recognition and Measurement would mean that virtually all the financial assistant's observations are incorrect. The convertible loan note is a compound financial instrument containing a (largely) debt component and an equity component - the value of the option to receive equity shares. These components must be calculated using the residual equity method and appropriately classified (as debt and equity) on the statement of financial position. As some of the proceeds of the instrument will be equity, the gearing will not be quite as high as if a non-convertible loan was issued, but gearing will be increased. However, if the loan note is converted to equity in March 2010, gearing will be reduced. The interest rate that would be applicable to a non-convertible loan (8%) is representative of the true finance cost and should be applied to the carrying amount of the debt to calculate the finance cost to be charged to the income statement thus giving a much higher charge than the assistant believes. Accounting treatment: financial statements year ended 31 March 2008 Income statement: Finance costs (see working) Statement of financial position: Non-current liabilities 3% convertible loan note (8,674 Equity Option to convert Working (figures in brackets in $'000) year 1 interest year 2 interest year 3 interest and capital total value of debt component proceeds of the issue equity component (residual amount) cash flows 300 300 10,300 factor at 8% 0·93 0·86 0'79 present value $'000 279 258 8,137 8,674 10,000 1,326 $693,920

+ 393·92)

$9,067,920 $1,326,000

The interest cost in the income statement should be $693,920 (8,674 x 8%), requiring an accrual of $393,920 (693·92 - 300 i.e. 10,000 x 3%). This accrual should be added to the carrying value of the debt.

2'
(a)

MARKUS INC

Depreciation is defined in lAS 16, Property, plant and equipment, as, the systematic allocation of the depreciable amount of an asset over its useful life. It is not, as many people think, an attempt at putting a current value on the asset or a means of setting aside funds for the replacement of the asset at a later date. Examples of depreciation being capitalised on the balance sheet include: • depreciation of manufacturing plant and equipment included in the cost of conversion of inventories; depreciation of PPE used for developing activities may be included in the development costs which are capitalised in accordance with lAS 38; depreciation of PPE which is being used to help construct an asset that the business will be using itself and will be classified as a non-current asset.

(b)

Note to balance sheet Tangible non current assets

Land and buildings $ Cost At 1 January 2002 Additions Disposals At 31 December 2002 710,000

Plant and equipment $ 948,500 45,000

Motor vehicles $ 77,000 15,400 (10,000) 82,400

Total $ 1,735,500 60,400 (10,000) 1,785,900

710,000

993,500

Accumulated depreciation At 1 January 2002 Charge for year (W 1) Disposals (W3) At 31 December 2002 Net book value At 31 December 2002

43,000 8,600

571,400 68,300

44,100 16,480 (4,000) 56,580

658,500 93,380 (4,000) 747,880

51,600

639,700

658,400

353,800

25,820

1,038,020

At 31 December 2001

667,000

377,100

32,900

1,077,000

(c)

Change in annual depreciation The overall aim of the depreciation charge is to match revenue with expense. This means apportioning the cost less any residual value over the life of the assets as fairly as possible. The accounting policy adopted is to depreciate on a straight-line basis over the useful life of the asset. To change the period over which an asset is depreciated (because it is recognised that its useful economic life is greater than hitherto thought) does not constitute a change of that accounting policy, but only a change in the estimate of the useful economic life. Hence, merely by changing the estimate, the company is still consistently applying its accounting policy. If the change made a significant difference to the company's results, it should be referred to in a note. The doctrine of prudence should only be applied where it is uncertain what the outcome of a set of circumstances will be. In this case there is little uncertainty and the usual overriding of the matching concept by the prudence concept will not apply.

WORKINGS (1) Depreciation charges $ 8,600

Buildings (2% x 430,000) Plant and equipment - Revised VEL (-'16

x

100,000 (W2»

6,250 62,050 68,300

- Other plant (10% x (993,500 - 173,000 - 200,000»

Motor vehicles (20% x 82,400)

16,480

(2)

Book value of plant and revised life Cost in 1998 Less 5 years depreciation (5 x 20,000) $ 200,000 (100,000) 100,000

(3)

Lada disposal Cost in 2000 Accumulation depreciation (2 years x 10,000 x 20%) NBV on disposal $ 10,000 (4,000) 6,000

2~
(a)

BALOOINC

A finance lease is a lease which transfers substantially all risks and rewards incidental to ownership of an asset. Title mayor may not eventually be transferred. An operating lease is any lease other than a finance lease. The main difference in accounting terms between the two types of leases is that with a finance lease lAS 17 requires the lessee to capitalise the lease, thereby recognising the asset and corresponding liability within the balance sheet, whereas the treatment of the operating lease would be to expense any rental payment to the income statement. Once the asset has been capitalised then it should be depreciated like all other non current assets. Any rental payment made need to split between capital, which will reduce the outstanding liability, and interest, which will be charged to the income statement. (b) The income statement would show an expense of $30,000 for the year. Assuming tat payment was made on the due date then no balance would appear in the balance sheet as the lease has not been capitalised.

(c)

Balance sheet and income statement treatments
Balance bid Payment Capital outstanding 44,746 24,590 0 Interest @22% 9,844 5,410 0 Balance clf

1 2 3

74,746 54,590 30,000

(30,000) (30,000) (30,000)

54,590 30,000 0

Balance sheet extracts As at 30 June Non current assets Accumulated depreciation NBV Current liabilities Non current liabilities Income statement extracts Year ending 30 June Interest payable Depreciation

2001 74,746 24,916 49,830 20,156 24,590

2002 74,746 49,832 24,914 24,590 0

2003 74,746 74,746 0 0 0

2001 9,844 24,916

2002 5,410 24,916

2003 0 24,916

23(a)

lAS 37 defines a provision as a liability of uncertain timing or amount. They can only be recognised when: (i) there is a present obligation as a result of a past event. The obligation may be legal l.e. enforceable by law, or it may be constructive. This is a new concept in lASs. A constructive obligation arises where an entity has indicated that it will accept certain responsibilities even though it does not have a legal obligation to do so. This may be by a pattern of past practice or by some form of published statement it is probable that an outflow of economic resources (usually cash) will be required to settle the obligation; and

(ll)

(iii) the amount of the obligation can be reliably estimated. The last item might appear to give some scope to avoid making a provision, but the Standard makes it clear that the occasions where a reliable estimate cannot be made will be extremely rare. The Standard also says that a provision cannot be made unless all of the above conditions are present. This may seem an obvious point, being the converse of when a provision should be made, but this does lie at the heart of some previous abuses. Previous abuses: Profit smoothing - this is a technique whereby companies attempt to even out the trend of profits over several accounting periods, or possibly 'create' a trend of modestly rising profit when the true underlying profits may be volatile. This is achieved relatively simply; a company may make a provision in one accounting period (say when profits are high) and then release the provision in later periods (to improve poor profits). A feature of such a technique was often that the provision was made for a particular expenditure, but then released to offset different expenditures. This has been referred to a 'big bath' provisioning. lAS 37 prevents this in two ways: firstly a provision can only be made where an actual liability exists (often the initial provision was made for an item that does not meet the current definition of a liability), and secondly a provision made for one expenditure can no longer be used to offset different expenditures. Creating profits - in some ways this is similar to the above, except that the original provision was not charged to income. This generally occurred during an acquisition. An acquiring company may make a large provision for reorganisation costs relating to an acquired subsidiary, and possibly to other parts of the group affected by the acquisition. This provision was treated as a liability of the acquired company thus reducing the fair value of its net assets and increasing its purchased goodwill. The overall effect would be that the original provision bypassed the income statement (it was added to goodwill) and post acquisition profits were increased by the timely release of the provision. Ultimately the amortisation of the goodwill would be charged against income, but often over a very long period. lAS 37 specifically prohibits such reorganisation provisions, except where the acquired company's previous management had already announced a formal plan of restructuring.
(b)

There are two groups of liability in this example and they require different treatments. The decommissioning of the plant and removal of the temporary site buildings are liabilities that must be recognised immediately the assets are put on site, as this is the obligating event. Note this is before quarrying begins. They should be measured at the present value of the best estimate of the expenditures expected to settle the obligation. The 'unwinding' of the present value is treated as a finance cost. The most controversial aspect of this type of provision is that it is not initially charged to the income statement, but instead it is added to the cost of the assets (in this case the plant and the quarry). This has the effect of immediately recognising an obligation when it occurs, but charging it to income over the periods expected to benefit. The second group of liability is for the landscaping and roadway damage. These are costs that occur and increase through the extraction of stone. These should be charged to income annually in proportion to the amount of stone extracted and damage caused. The condition of the licence makes the above liabilities legally binding and thus cannot be avoided. If the licence had been granted without any conditions, there would be no legal obligation. However, this does not necessarily mean there is no obligation. It may be that Stonemaster has created a constructive obligation, perhaps by its past practice with similar environmental costs, or by a published policy made in its financial statements or other public announcement. If this has created a valid expectation that Stonemaster will incur these costs, then the situation is the same as in part (i). Ifthere is no constructive obligation, there would be no liability and no provisions should be made.

2. 4
(a)

PROVISIONS lAS 37 terms Provisions are liabilities of uncertain timing or amount A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. An obligating event is an event that creates a legal or constructive obligation that results in an enterprise having no realistic alternative to settling that obligation. A restructuring is a programme that is planned and controlled by management, and materially changes either: • • the scope of a business undertaken by an enterprise; or the manner in which that business is conducted.

(b)

Recognition criteria A provision should be recognised when, and only when: • an enterprise has a present legal or constructive obligation to transfer economic benefits as a result of past events; and, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and, a reliable estimate of the obligation can be made.

If these conditions are not met a provision should not be recognised. A provision in respect of a liability for restructuring should only be recognised when the general recognition criteria are met. These are applied as follows. A constructive obligation to restructure arises only when an enterprise has a detailed formal plan for the restructuring identifying as a minimum: • • • the business or part of a business concerned; the principal locations affected; the location, function, and approximate number of employees who will be compensated for terminating their services; the expenditures that will be undertaken; and when the plan will be implemented; and has raised a valid expectation that it will carry out the restructuring by starting to implement the plan or by announcing its main features to those effected by it.

• • •

A management decision to restructure does not give rise to constructive obligation unless the enterprise has (before the balance sheet date) started to implement the restructuring plan eg by the sale of assets; or, announced the main features of the plan to those effected in a sufficiently specific manner to raise a valid expectation in them that the restructuring will occur. (c) Norris group Tully Present obligation as a result of a past obligating event - The construction of the oil rig creates a legal obligation under the terms of the licence to remove the rig and restore the seabed and is thus an obligating event. At the balance sheet date, however, there is no obligation to rectify the damage that will be caused by extraction of the oil. An outflow of resources embodying economic benefits in settlement - Probable.

Conclusion - A provision is recognised for the best estimate of ninety per cent of the eventual costs that relate to the removal of the oil rig and restoration of damage caused by building it. These costs are included as part of the cost of the oil rig. At the balance sheet date the best estimate of the costs would be $180m(90% of $200m). The ten per cent of costs that arise through the extraction of oil ($20m) will be recognised as a liability when the oil is extracted. Charles In financial statements for the year ended 30th June 2000 Charles should not have made a provision in its accounts. Atthat date the analysis should have been: Present obligation as a result of a past obligating event and so there is no obligation. event - There has been no obligating

Conclusion - No provision should have been recognised under this lAS 37. The analysis in the financial statements for the year ending 30th June 2001 is as follows: Present obligation as a result of a past obligating event - The obligating event is the communication of the decision to the customers and employees, which gives rise to a constructive obligation from that date, because it creates a valid expectation that the division will be closed. An outflow of resources embodying economic benefits in settlement - Probable.

Conclusion - A provision is recognised at closing the division.

so" June

2001 for the best estimate of the costs of

The transitional rules in the standard encourage but do not require the retrospective application of the rules. Charles could either remove the provision in last years accounts by an adjustment to opening reserves and then provide for the whole amount in the 2001 accounts or it could retain the provision in last years comparatives and increase it to the required amount ($30m) in this years financial statements. This would result in a charge of $5m to the 2001 income statement.

Bradbury There was no need to make a provision in the accounts for the year ending 30th June 2000. The analysis would have been: Present obligation as a result of a past obligating event - There is no obligation because there is no obligating event either for the costs of fitting smoke filters or for fines under the legislation. Conclusion - No provision is recognised for the cost of fitting the smoke filters. For the year ending

so" June

2001 the analysis is as follows:

Present obligation as a result of a past obligating event - There is still no obligation for the costs of fitting smoke filters because no obligating event has occurred (the fitting of the filters). However, an obligation might arise to pay fines or penalties under the legislation because the obligating event has occurred (the non-compliant operation of the factory). An outflow of resources embodying economic benefits in settlement - Assessment of probability of incurring fines and penalties by non-compliant operation depends on the details of the legislation and the stringency of the enforcement regime. Conclusion - No provision is recognised for the costs of fitting smoke filters. However, a provision is recognised for the best estimate of any fines and penalties that are more likely than not to be imposed. Rye There was no need to make a provision in the accounts for the year ending 30th June 2000. The analysis would have been: Present obligation as a result of a past obligating event - The obligating event was the giving of the guarantee, which gives rise to a legal obligation. An outflow of resources embodying benefits is probable at 30th June 2000. economic benefits in settlement - No outflow of

Conclusion - No provision need have been recognised. The guarantee is disclosed as a contingent liability unless the probability of any outflow is regarded as remote. The situation has changed at the year ending 30th June 2001. The analysis is now as follows: Present obligation as a result of a. past obligating event - The obligating event is the giving of the guarantee, which gives rise to a legal obligation. An outflow of resources embodying economic benefits in settlement - At the balance sheet date it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation. Conclusion - A provision is recognised for the best estimate of the obligation.

Ashworth Present obligation as a result of a past obligating event - There is no present obligation. Conclusion - No provision is recognised. The cost of replacing the lining is not recognised because, at the balance sheet date, no obligation to replace the lining exists independently of the company's future actions - even the intention to incur the expenditure depends on the company deciding to continue operating the furnace or to replace the lining. Instead of a provision being recognised, the depreciation of the lining takes account of its consumption, i.e. it is depreciated over five years. The relining costs then incurred are capitalised with the consumption of each new lining shown by depreciation over the subsequent five years.

25

Transaction 1 Cost of production plant - NB: All reasons come from lAS 16 - Property, Plant and Equipment Component Basic costs Sales taxes Employment costs Other overheads Payments to advisors Dismantling costs Amount $'000 10,000 800 600 500 1,360 13,260 Depreciation charge (income statement - operating cost) Per lAS 16 the asset is split into two depreciable components: 3,000 with a useful economic life (UEL) of four years 10,260 (the balance) with a UEL of eight years So the charge for the year ended 31 March 2007 is 3,000 x 1/4 x 10/12 + 10,260 x 1/8 x 10/12 Carrying value of asset (balance sheet - non current assets) 13,260 1,694 = 11,566 Unwinding of discount (income statement - finance cost) 1,360 x 5% x 10/12 = 57 Provision for dismantling (balance sheet - non-current liabilities) 1,360 + 57 = 1,417 Transaction 2 Under the provisions of IFRS 5 - Non-current Assets Held for Sale and Discontinued Operations - the property would be classified as held for sale at 31 December 2006. This is because the intention to sell the property is clear and active steps are being taken to locate a buyer, with the property being marketed at a reasonable price. In addition there is a clear expectation that the sale will be completed within 12 months. Where non-current assets are held for sale they need to be initially measured using up-to-date values under the current measurement basis that is being applied. In this case this basis is the revaluation model. The carrying value based on the latest valuation is $14'76 million ($15 million - ($8 million x 1/25 x 9/12». This needs to be updated to market value at the date of classification as held for sale - $16 million. Therefore $1'24 million ($16 million - $14·76 million) is credited to the revaluation reserve. When the asset is classified as held for sale it is removed from non-current assets and presented in a separate caption on the balance sheet. The (non-mandatory) guidance in IFRS 5 shows this immediately below the current assets section of the balance sheet. The asset is measured at the lower of its existing carrying value ($16 million) and its fair value less costs to sell ($16 million $500,000 = $15'5 million). In this case the asset is written down by $500,000 and this is recognised as an impairment loss in the income statement. No further depreciation is charged. At the year end the carrying value of the asset is the lower of the previously computed amount ($15'5 million) and the latest estimate of fair value less costs to sell ($15·55 million - the actual net proceeds). In this case no further impairment is necessary. The sale is recognised (and the revaluation reserve realised) on 30 April 2007 and will therefore impact on next year's financial statements. Reason Purchase costs included Recoverable sales taxes not included Employment costs in period of getting the plant ready for use. Abnormal costs excluded Directly attributable cost Recognised at present value where an obligation exists

=

1,694

26 {a}

{i}

lAS 32 defines a financial instrument as a 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 financial asset from another entity. A contractual right to exchange financial assets or financial liabilities under conditions that are potentially favourable. A financial liability is any contract that is: A contractual obligation to deliver cash or another financial asset to another entity. A contractual obligation to exchange financial assets or financial liabilities under conditions that are potentially unfavourable. An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

(ii)

1 2 3

A portfolio of investments that is held for trading would be presented as a financial asset under current assets. An investment in the shares of a supplier that is held for the long term would be presented as a financial asset under non-current assets. A loan that is repayable over five years in equal instalments would be presented as a financial liability. The amount repayable within one year of the balance sheet date would be presented in current liabilities, with the remainder in non-current liabilities. Preference shares that carry a fixed rate of dividend and is redeemable at the option of the investor would be presented as a non-current liability, in accordance with their substance.

4
(iii)

The basis of measurement of financial instruments is stated in lAS 39. The basis depends on the category of financial instruments. lAS 39 divides financial assets into four categories: Financial instruments at fair value through profit and loss are those that are classified as held for trading or alternatively designated as such by the entity at the date of their initial recognition. Such financial instruments are measured at fair value, with changes being recognised in the income statement. Held to maturity financial assets are those that have fixed or determinable payments and fixed maturity attaching to them that the investor has the positive intent and ability to hold to maturity. Such assets are measured at amortised cost rather than fair value. This method takes the effective rate of interest and applies it to the carrying value so as to render the carrying value at the date of redemption equal to the final redemption amount.

Loans and receivables are unquoted financial assets with fixed or determinable payments. These assets are measured using amortised cost. Available for sale financial assets are any assets not classified under any of the other headings. They are measured at fair value, with changes being taken to the statement of changes in equity. When the asset is sold the cumulative fair value changes are recycled through the income statement. Financial liabilities are in two categories: Financial liabilities at fair value through profit and loss are defined and treated in the same way as financial assets. However lAS 39 restricts the ability of entities to use this classification for financial liabilities. All other financial liabilities are measured at amortised cost. (b) Extracts from financial statements for year ended 30 September 2007 - NB all numbers in $'OOOs Extract from the balance sheet: Non-current liabilities: Financial liability (W3) Equity: Option to acquire shares Extract from the income statement: Finance cost Working 1 - split of financial instrument: Under lAS 32 the initial carrying value of the financial liability is the present value of the future cash outflows that would occur if the loan is repaid, discounted at 10%. This is 5,557 (120/0·10) + 120/(1.102) + 7,120/0·10)3) and the equity element is 443 (6,000 - 5,557). The financial liability is not held for trading and so is measured using amortised cost. Working 2 - finance cost for the year to 30 September 2007 10% x 5,557
=

5,993 443 556

556. 5,993.

Working 3 - closing loan amount: 5,557 x 1·1 - 2% x 6,000
=

27 (a)

The Framework defines an asset as a resource controlled by an entity as a result of past transactions or events from which future economic benefits (normally net cash inflows) are expected to flow to the entity. However assets can only be recognised (on the balance sheet) when those expected benefits are probable and can be measured reliably. The Framework recognises that there is a close relationship between incurring expenditure and generating assets, but they do not necessarily coincide. Development expenditure, perhaps more than any other form of expenditure, is a classic example of the relationship between expenditure and creating an asset. Clearly entities commit to expenditure on both research and development in the hope that it will lead to a profitable product, process or service, but at the time that the expenditure is being incurred, entities cannot be certain (or it may not even be probable) that the project will be successful. Relating this to accounting concepts would mean that if there is doubt that a project will be successful the application of prudence would dictate that the expenditure is charged (expensed) to the income statement. At the stage where management becomes confident that the project will be successful, it meets the definition of an asset and the accruals/matching concept would mean that it should be capitalised (treated as an asset) and amortised over the period of the expected benefits. Accounting Standards (lAS 38 Intangible Assets) interpret this as writing off all research expenditure and only capitalising development costs from the point in time where they meet strict conditions which effectively mean the expenditure meets the definition of an asset. 30 September2007 30 September2006 $'000 $'000 335 (w (ji» 135 (w (i» 1,195
(w

(b)

Emerald Income statement: Amortisation of development expenditure Balance sheet Development expenditure

Ilv)

1,130

(w (iii»

Statement of changes in equity Prior period adjustment (credit required to restate retained earnings at 1 October 2005) (cumulative carrying amount at 2005 of 300 + 165)

465

Workings (All figures in $'000. Note: references to 2004, 2005 etc should be taken as for the year ended 30 September 2004 and 2005 etc.) Year Expenditure Amortisation (25%) 2004 300 nil nil nil nil 300 2005 240 2006 800

-

(75) nil nil

-

cumulative 2006 1,340

(75) (60) nil

--

2007 400 (75) (60) (200)
(w (jj)

(50) (60) nil

-

cumulative 2007 1,740

--

(225) (20) (200) (545)

Total amortisation Carrying amount

(75) 165

(w (i) (135)

(210)
(w (iii» 1,130

665

-

(335) 65

(w (iv)) 1,195

28

All numbers in $'000 unless otherwise stated: Transaction (a) As far as the closure provision is concerned the relevant financial reporting standard is lAS 37 - Provisions, contingent liabilities and contingent assets. lAS 37 requires that provisions should be made for the unavoidable consequences of events occurring before the reporting date. The steps taken before the reporting date have effectively committed the entity to the closure. The basic principle laid down in lAS 37 is that provision should be made for the direct costs associated with the closure. On this basis the required provision would be: Redundancy costs (0) in question) Onerous contract ((iv) in question) 30,000 5,500 35,500 Epsilon is committed to paying 8,000 to its pension plan but this will not form part of the closure provision. This is because the payment, when made, will enable the pension plan to discharge actuarial liabilities that are measured at 7 ,000. This one-off additional retirement benefit cost of 1,000 (8,000 - 7 ,000) will be recognised in the income statement of Epsilon in the year to 30 September 2008 and the net retirement benefit obligation increased accordingly. Redeployment costs ((iii) in the question) relate to the ongoing activities of the entity and are not recognised as part of a closure provision. They would only be recognised as liabilities at 30 September 2008 if Epsilon had entered into enforceable obligations to incur the costs. The lease with 10 years left to run ((iv) in the question) is an onerous contract given the lack of sub-letting opportunities. lAS 37 requires that the provision should be the lower of the cost of fulfilling the contract (1,000 x 6'14 = 6,140) and the cost of early termination (5,500). The anticipated loss on sale of plant ((v) in the question) of 9,000 (11,000 - 2,000) is not part of the closure provision. However under the principles of IFRS 5 - Non-current assets held for sale and discontinued operations - the plant would be measured at the lower of the current carrying value (11,000) and fair value less costs to sell (2,000). The plant would be separately displayed in a new statement of financial position caption (non-current assets held for sale). Future operating losses (item (vi) in the question) are not recognised as part of a closure provision as they relate to future events. There is no need to disclose the results of the business segment that is to be closed separately in the current financial year. This is because the business segment does not satisfy the definition of a discontinued operation in the current financial year. IFRS 5 states that a discontinued operation is a component of an entity that is disposed of or classified as held for sale before the year end. This component is being abandoned rather than sold so it will not be classified as discontinued until the closure occurs. In this case this occurs on 31 December 2008 - the year ended 30 September 2009. Transaction (b) Accounting for government grants is dealt with by lAS 20 - Accounting for government grants and disclosure of government assistance. The basic principle of lAS 20 is that grants should be recognised as income over the periods necessary to match them with the related costs for which they are intended to compensate, on a systematic basis. That part of the grant relating to an inducement to begin developing the factory (6,000) was received without any conditions and so can be recognised immediately in the income statement. The 15,000 grant in respect of the plant and equipment should be recognised over the 40 year life of the factory. lAS 20 allows this to be done in two ways: The first way is to net the grant off against the cost of the asset and depreciate the net figure over its useful economic life. In this case only four months depreciation would be charged because the factory was not brought into use until 1 June 2008. Therefore the depreciation would be 375 (45,000 (60,000 - 15,000) x 1/40 x 4/12). PPE of 44,625 (45,000 - 375) would be shown in the statement of financial position.

The second way is to show the grant as a deferred credit and leave the initial carrying value of the property at 60,000. Therefore the depreciation in the current year would be 500 (60,000 x 1/40 x 4/12). PPE of 59,500 (60,000 - 500) would be shown in the statement of financial position. The deferred credit would be released to the income statement over the same 40 year period as the asset is depreciated so the amount included in the income statement for the current year would be 125 (15,000 x 1/40 x 4/12). The remaining deferred credit of 14,875 (15,000 - 125) would be shown in the statement of financial position as deferred income under liabilities. 375 (15,000 x 1/40) would be in current liabilities and the balance of 14,500 (14,875 - 375) would be in non-current liabilities. The basic recognition principle for the 9,000 employment grant is as for the building grant. This means that 600 (9,000 x 1/5 x 4/12) would be recognised in the income statement for the current period, with the balance of 8,400 (9,000 - 600) shown as deferred income. 1,800 (9,000 x 1/5) would be shown under current liabilities, with the balance of 6,600 (8,400 - 1,800) under non-current liabilities. The issue of possible repayment hinges on how likely, or otherwise, it is that repayment will occur. If, as seems to be the case here, repayment is possible, but unlikely, then the possibility of repayment would be disclosed as a contingent liability. If repayment were considered probable then a liability would need to be recognised. Any amount repayable would create a separate liability, with an equal and opposite transfer from deferred income. If the deferred income balance is insufficient then any excess would be recognised as a cost in the income statement. Transaction (c) Based on the information provided it appears that the future payment of 2,000 is possible, but unlikely. Therefore under the principles of lAS 37 it would be appropriate to disclose the possibility of repayment as a contingent liability, rather than actually recognising it. The issue of recognising an intangible asset is addressed in lAS 38 - Intangible assets. lAS 38 states that before an intangible asset can be recognised it must meet the definition of an intangible asset and have a cost or value that can be measured reliably. The definition of an intangible asset requires that the item is identifiable (can be disposed of separately without disposing of the entire business or arising from contractual or other legal rights) and that the identifiable asset can be expected to produce a source of economic benefits that the entity can control. Training expenditure seems to fail these tests and indeed lAS 38 states specifically that the cost or value of an assembled workforce cannot be recognised as an intangible asset. Therefore the payment of 4,000 to the agency should be recognised as an expense in the income statement.

2'1

Event (1) A key issue for the reporting of this event is whether the lease is a finance lease or an operating lease. In the case of a property lease lAS 17 - Leases - requires entities to make this decision in two parts. Rentals and fair values should be split according to the fair values of the leasehold interests in the lease. Because Omega has no right to purchase the land at the end of the lease then the land element of the lease would be regarded as an operating lease. No underlying asset or liability would be recognised on the statement of financial position but the total lease payments of 11,400 (30% x (6,000 + 800 x 40» would be charged to the income statement on a straight line basis. This has the following impact for the land element: Charge in income statement 285 (11 ,400/40). Prepayment in statement of financial position 1,755 (30% (6,000

+ 800) - 285).

This amount could alternatively be regardedas the unamortised lease deposit relating to the land element (30% x 6,000 x 39/40 = 1,755). Given that the lease is for the whole economic life of the building and Omega is responsible for its repair and maintenance then the buildings lease would be regarded as a finance lease. The impact on the financial statements would be as follows: Initial asset and liability in statement of financial position 12,600 (18,000 x 70%) Depreciation in income statement 315 (12,600/40). Closing asset in PPE 12,285 (12,600 - 315) The finance cost in the income statement for the current period and the closing liability can be found from the following table profiling the liability: Year to 30/9 2008 2009 Sal b/f 12,600 8,344 Deposit (4,200) Sal in Period 8,400 8,344 Finance Cost (6%) 504 501 Rental payment (560) (560) Sal clf 8,344 8,285

The finance cost for the current period is 504, and the closing liability 8,344. 8,285 is non-current, with the balance of 59 (8,344 - 8,285) being current. Event (2) The key issue here is the extent of any provisions that need to be made in respect of the vehicle modifications. This issue is governed by lAS 37 - Provisions, contingent liabilities and contingent assets. lAS 37 states that a provision is required where, at the reporting date: The entity has a present obligation arising out of a past event. There is a probable future outflow of economic benefits. The outflow can be estimated reliably. A key factor in the above criteria is that the obligations must be unavoidable. As far as the modifications are concerned although the legislation took effect from 31 March 2008 the vehicles have nevertheless been used for six months in the current financial year so there cannot be any unavoidable obligation to modify them at the reporting date. One obligation that does appear to be unavoidable is the penalties that will become payable as a result of the illegal use of the vehicles from the effective date of the legislation. Therefore a provision of 400 (200 x 4 x 6/12) would be necessary due to the illegal operation of the vehicles for six months. This provision would be recognised as a liability in the statement of financial position, with a charge of 400 in the income statement.

30 (a)

lAS 36 definition (i) Recoverable amount Recoverable amount - is the higher of an asset's fair value Jess costs to sell and its value in use. Pair value less costs to sell- is the amount obtainable from the sale of an asset (in an ann's length transaction between knowledgeable, willing parties) less costs of disposal. Value in lise - is the present value of the future cash 110ws expected to be derived from an asset (or cash-generating unit). The recoverable amount of an asset represents the amount of economic benefits that the asset will generate for an entity. If the carrying value of an asset exceeds its recoverable amount this means that the asset will not generate sufficient economic benefits to meet its carrying value, the asset should therefore be written down to the value that is recoverable by either continuing to lise the asset or by selling it. Impairment test
1


• •


(if)

max 2

lAS 36 requires an impairment test to be carried out under the following circumstances: • At each balance sheet date an entity should assess whether there is any indication that an asset (or cash-generating unit) may be impaired. If any such indication exists, the entity should estimate the recoverable amount of the asset. If there are ItO indications of a potential impairment Joss there is 110 need to make a formal estimate of recoverable amount (except for intangible assets with indefinite useful lives). The following intangible assets must be test annually for impairment (irrespective of whether there is any indication of impairment):

o
o

those with an indefinite useful life; those
110t

yet available for use;

Y2 each

o

goodwill acquired in a business combination.

The impairment tests for these assets may be performed at any time during an annual period, provided they are performed at the same time every year. All other assets (including intangibles that are amortised) are tested at the end of the financial period. Where an intangible asset with an indefinite life forms part of a cash-generating unit and cannot be separated, that cash-generating unit must be tested for impairment at least annually, or whenever there is an indication that the cash-generating unit may be impaired. An entity should consider the following indications of potential impairment loss both external and internal - as a minimum.


max 1Y2

External sources. of information
• • Significant decline in market value. Significant adverse changes in the technological, market, economic or legal environment in which the entity operates.

max 1 for examples

• •

Increase in market rates of return on investments likely to affect the discount rate used in calculating value in use. The carrying amount of the net assets of the reporting entity is more than its market capitalisation.
max 1 for examples

Internal sources of in/ormation

• • •

Evidence of obsolescence or physical damage. Significant adverse changes in the use of an asset. Evidence indicates that the economic performance of an asset is, or will be, worse than expected. For example:

o

significantly higher cash needs than budgeted; significantly worse actual net cash flows or operating profit or loss than budgeted.
max5

o

(b)

Equipment

Fair value less costs to sell Selling price Shipping and conversion costs Net proceeds
Value in lise Cash flo w

150,000 ( 10,000) 140,000

s

2005 2006 2007 2008

70,000 40,000 35,000 20,000

0.93
0.86

DF

0.80 0.74

65,100 34,400 28,000 14,800 142,300

s

~
11
'-2

~

The recoverable amount of the asset is the greater amount, i.e. its value in use of $142,300. The asset is carried at a revalued amount in the balance sheet of $162,000, this means that an impairment loss of $19,700 has occurred and must be written off the carrying value of the asset. As the asset is carried at a revalued amount and the depreciated historic cost of the asset is $152,000 there will be a revaluation surplus of $9,700 in respect of the asset, this surplus would initially be utilised for the write down. The remaining impairment loss of $10,410 will be charged to the profit and loss account for the period.
(c) Cash generating unit
(i)

Max 6

Allocation a/impairment

loss I October

Goodwill Licence Runway Aircraft Buildings

400,000 200,000 500,000 1,200,000 300,000 2,600,000

s

Impairment

10 October

S (400,000) (5,000) (30,000) (447,000) (18,000) (900,000)

s

~ l!?
2 h
+-Ma.x

195,000 470,000 753,000 282,000 1,700,000

6

These marks NOT to be double-counted.

The CGU has been impaired in value by $900,000. The aircraft involved in the accident is impaired to start with, allocating $400,000 of tile loss. Goodwill is then impaired by its full value of$400,000. Leaving $100,000 to be allocated amongst the remaining assets on a proportionate basis. The carrying value of the remaining assets are $ I,800,000 in total. Initial allocation of the $100,000 loss would be as follows: $000 200 500 800 300

l? l?

ev

Ratio

Loss

Licence Runway Aircraft Buildings

20011800 50011800
80011800 300/1800

$000
II

28 44
17

Tutorial note: Another party has offered $195,000 for the licence. the licence cannot be
impaired below this amount. As during the proportional allocation the loss allocated to the licence is greater than $5,000 the excess must be re-allocated amongst the remaining assets.

Reallocation of$6,000 excess:

Runway Aircraft Buildings
(ii) Reversal ofimpairment loss

SOOO

ev

Ratio 500/1600

Loss

500 800 300

80011600 30011600

$000 2 3
I

1--:;

'2

l?

Circumstances can occur that may well reverse an impairment loss. If the national aviation authority have absolved Branston of any blame this could lead to a reversal of the original impairment. A reversal of an impairment loss for a cash-generating unit should be allocated to increase the carrying amount of the assets (but never goodwill) pro-rata with the carrying amount of those assets. In allocating a reversal of an impairment loss for a cash-generating unit, the carrying amount of an asset should not be increased above the lower of:

o o

its recoverable amount (if determinable); and the carrying amount that would have been determined (net of amortisation or depreciation) had no impairment loss been recognised for the asset in prior years.

Max 3

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