IAS TEST

1. General Trading plc is a manufacturing company which prepares accounts to 31 August

each year. The accounts for the year to 31 August 2004 cannot be finalised until the
following matters have been dealt with:

1 A factory machine was acquired on 1 September 2001 for $250,000. At that time, the
machine was expected to have a useful life of 5 years with a residual value of $100,000
at the end of those 5 years. The company depreciates factory machines on the straight
line basis. However, on 1 September 2003, the company reviewed the expected useful
lives and residual values of its plant and machinery and estimated that this machine's
useful life would extend only until 31 August 2005, on which date its residual value would
be $50,000.

2 On 1 September 1993, the company acquired land and buildings for $750,000 (including
land $400,000). The land was not depreciable but it was decided to depreciate the
buildings over 50 years on the straight line basis, assuming a zero residual value.
However, on 1 September 2003, the land was revalued at $650,000 and the buildings
were revalued at $300,000. It was decided to incorporate these valuations into the
company's financial statements. The original estimates of the useful life and residual
value of the buildings remain unchanged.

3 The company's inventory at 31 August 2004 includes partly-manufactured goods (at cost)
of $172,400. It is estimated that a further $50,000 will need to be spent in order to
complete these goods and that they will then be sold for $260,000, less selling expenses
of $12,000.

Required:

(a) State the main purpose of accounting standards. [3]

(b) With reference to the relevant accounting standards, explain how each of the above
matters should be dealt with in the company's accounts for the year to 31 August 2004
[9]
(c) Explain the circumstances in which companies are allowed to show tangible non
current assets at a valuation.
[3]
(d) Explain the circumstances in which companies are allowed not to depreciate tangible
non current assets.
[3]
2. Accounting standard IAS16 Property, Plant and Equipment makes a number of recognition,
measurement and disclosure requirements with regard to tangible non-current assets. The
term "non-current asset" is defined in accounting standard IAS1 Presentation of Financial
Statements. The information given below relates to three companies, each of which
prepares accounts to 31 December.

Alpha Ltd
Alpha Ltd bought a factory machine on 30 June 2007 and paid a total of $420,000. The
supplier's invoice showed that this sum was made up of the following items:

$
Manufacturer's list price 380,000
Less: Trade discount 38,000
342,000
Delivery charge 6,800
Installation costs 29,600
Maintenance charge for year to 30 June 2008 27,000
Spare parts 14,600
420,000

Beta Ltd
On 1 January 1997, Beta Ltd bought freehold property for $800,000. This figure was made
up of land $300,000 and buildings $500,000. The land was non-depreciable but it was
decided to depreciate the buildings on the straight-line basis, assuming a useful life of 40
years and a residual value of nil. On 1 January 2007, the land was revalued at $400,000 and
the buildings were revalued at $450,000. The company decided to incorporate these
valuations into its accounts. The previous estimates of the building's useful life and residual
value remain unchanged.

Gamma Ltd
In August 2007, Gamma Ltd paid $250,000 to acquire the business of a local sole trader.
The fair value of the net assets acquired was $175,000.

Required:

(a) Explain, with appropriate examples, the difference between capital expenditure and
revenue expenditure. If a company incorrectly classified an item of capital expenditure
as revenue expenditure, what effect would this have on the company's accounts in the
year of the expenditure and in subsequent years? [4]

(b) In accordance with the rules of IAS16, calculate the cost figure at which the machine
bought by Alpha Ltd should initially be measured. Also explain the correct accounting
treatment of any component of the $420,000 expenditure which cannot be treated as
part of the machine's cost.
[3]
(c) Write journal entries for the revaluation of Beta Ltd's freehold property on 1 January
2007. (Narratives are not required). Also calculate the amount of depreciation which
should be charged in relation to the building for the year to 31 December 2007.
[4]
(d) Explain why Gamma Ltd was willing to pay $250,000 for net assets worth only
$175,000, and explain how the difference of $75,000 should be shown in the accounts.
[3]
(a) The main purpose of accounting standards is to introduce a degree of uniformity into financial
statements. Some of the standards prescribe a standard accounting treatment of the relevant
items, so ensuring that all companies deal with these items in the same way. Others allow
companies a choice of accounting treatments but require disclosure of the treatment adopted.
Accounting standards improve the comparability of financial statements and make it more likely
that financial statements will show a true and fair view.

(b) Item 1 Accounting standard IAS 16 requires that the estimated useful life and residual value of
non current assets should be reviewed at the end of each accounting period. If expectations
are significantly different from previous estimates, the change should be accounted for over the
remainder of the asset’s useful life. Depreciation of $30,000 will have been charged in each of
the years to 31 August 2002 and 2003, giving a written-down value of $190,000 on 1
September 2003. This amount (less a residual value of $50,000) must now be written off over
the next two years, giving an annual depreciation charge of $70,000. Therefore the income
statement for the year to 31 August 2004 should show depreciation of $70,000. The effect of
this change should be disclosed in the notes to the accounts.

Item 2 If a non current asset with a finite useful life is revalued, accounting standard IAS 16
requires that the revalued amount should be depreciated over the remainder of the asset’s
useful life.The land (which is not depreciable) should be shown at its valuation of $650,000 and
the surplus on revaluation ($250,000) should be credited to a revaluation reserve.The buildings
cost $350,000 and depreciation of $7,000 will have been charged in each of the ten years to 31
August 2003, giving a written-down value on 1 September 2003 of $280,000. The buildings are
revalued at $300,000, giving a surplus on revaluation of $20,000, which should be credited to a
revaluation reserve. The revalued amount should then be depreciated over the remaining 40
years of the buildings' useful life. Therefore the income statement for the year to 31 August
2004 will show depreciation of $7,500.

Item 3 Accounting standard IAS 2 requires that inventory is valued at the lower of cost and net
realisable value. The cost of this inventory is $172,400. Its net realisable value is $198,000
(260,000 - 50,000 - 12,000). The lower of cost and NRV is $172,400 so the inventory should be
shown at this figure in the balance sheet at 31 August 2004.

(c) Accounting standard IAS 16 allows companies to revalue non current assets rather than
showing the assets at historical cost. However, if such a policy is adopted it must be applied
consistently to all assets of the same class and the valuations must be kept up-to-date. This is
generally achieved by a five-yearly full valuation by a qualified external valuer, with an interim
valuation in year 3 (and further interim valuations in the other intervening years if it is likely that
there has been a material change in value). The interim valuations may be performed by a
qualified internal or external valuer.

(d) With the exception of non-depreciable land, non current assets should be depreciated over their
useful economic lives. However, if the useful economic life of an asset is very long (or its
residual value is very high) the depreciation charge for a period may be immaterial. In this case,
it is permissible not to charge depreciation. However, impairment reviews must be carried out
at the end of each period for such assets and for all assets with a remaining useful life
exceeding 50 years.
(a) Capital expenditure is expenditure which results in the acquisition of a non-current asset or in an
improvement to the earning capacity of an existing non-current asset. For example, expenditure
on acquiring business premises (or building an extension to existing premises) would be classed
as capital expenditure. Revenue expenditure is expenditure which results in the acquisition of a
current asset (eg inventory) or expenditure on items such as selling and distribution expenses,
administrative expenses and finance charges. The cost of repairs or maintenance to a non-
current asset (but not the cost of improvements) would be classed as revenue expenditure.
Capital expenditure is shown initially in the balance sheet and is then charged to the income
statement over a period of years by means of depreciation charges. In contrast, revenue
expenditure is wholly written off to the income statement in the year to which it relates. Therefore,
if an item of capital expenditure was incorrectly classified as revenue expenditure, this would
reduce the reported profit of the company for the year in which the expenditure was incurred (and
would also reduce the amount of non-current assets shown on the balance sheet). However, if
the non-current asset is depreciable the absence of depreciation charges in future years would
increase the reported profit of those years so that the company's total profits over the entire
useful life of the asset would in fact be unaffected by the error.

(b) The cost of the machine (and therefore the amount which should be treated as capital
expenditure) is $378,400 (342,000 + 6,800 + 29,600). One-half of the maintenance charge (ie
$13,500) should be shown as an expense in the company's income statement for the year to 31
December 2007. The other half should be treated as a prepayment and should be shown as a
current asset in the balance sheet at 31 December 2007. This £13,500 will then be shown as an
expense in the company's income statement for the year to 31 December 2008. The cost of the
spare parts ($14,600) should be treated as the acquisition of a current asset (inventory) and
should be shown as such in the balance sheet. As the spares are used, their cost should be
removed from inventory and shown as an expense in the income statement.
(c)
Journal
$000 $000

Freehold land 100

Revaluation reserve 100

Allowance for depreciation of buildings 125

Freehold buildings 50
Revaluation reserve 75

Depreciation of buildings for the year to 31 December 2007 is $15,000 ($450,000 ÷ 30).

(d) If the price paid for a business exceeds the fair market value of the net assets acquired, the
excess is the cost of "goodwill". Goodwill may arise (for example) because a business has an
established reputation for providing a high standard of customer service. The $75,000 of
"purchased goodwill" should be shown as an intangible non-current asset on the balance sheet
of Gamma Ltd and then written down in future years if there is evidence of impairment.