Advanced Financial Accounting and Corporate Reporting (Study Text)

Advanced Financial Accounting and Corporate Reporting (Study Text)

 ALL RIGHTS RESERVED
This book and material including write-up, tables, graphs, figures,
etc., therein are copyright material and are protected under
Copyright Laws of Pakistan. No part of this publication can be
reproduced, stored in a retrieval system or transmitted in any
physical photocopying, recording or otherwise without prior written
permission or the ICMA Pakistan’s Head Office.

Institute of Cost and Management Accountants of Pakistan

Published by:

Institute of Cost and Management Accountants of Pakistan

Email : education@icmap.com.pk
Website : www.icmap.com.pk
Phone : + 92-21-99243900
Fax : + 92-21-99243342

First Edition 2014

Contents developed by a consortium lead by KAPLAN.

Second Edition 2020

Contents updated by the ICMA Pakistan.

Disclaimer
This document has been developed to serve as a comprehensive study
and reference guide to the faculty members, examiners and students. It is
neither intended to be exhaustive nor does it purport to be a legal
document. In case of any variance between what has been stated and
that contained in the relevant act, rules, regulations, policy statements
etc., the latter shall prevail. While utmost care has been taken in the
preparation / updating of this publication, it should not be relied upon as a
substitute of legal advice.

Any deficiency found in the contents of study text can be reported to the
Education Department at education@icmap.com.pk

Advanced Financial Accounting and Corporate Reporting (Study Text)

 CONTENTS
1 SUBSTANCE OVER FORM 01

2 FINANCIAL INSTRUMENTS 16

3 EMPLOYEE BENEFITS 58

4 SHARE BASED PAYMENTS 87

5 FAIR VALUE MEASUREMENT 109

6 INTRODUCTION TO GROUP ACCOUNTING 122

7 CONSOLIDATED STATEMENT OF FINANCIAL POSITION 132

CONSOLIDATED STATEMENT OF
8 COMPREHENSIVE INCOME
185

9 INVESTMENT IN ASSOCIATES AND JOINT VENTURES 214

Advanced Financial Accounting and Corporate Reporting (Study Text)

10 CHANGES IN GROUP STRUCTURE 247

11 COMPLEX GROUP STRUCTURES 293

GROUP ACCOUNTING – FOREIGN CURRENCY

12 333
428

13 GROUP STATEMENT OF CASH FLOWS 381

14 RATIOS AND TREND ANALYSIS 436

15 EARNINGS PER SHARE 471

16 SEGMENT REPORTING 499

17 NON-FINANCIAL REPORTING 518

18 INTERNATIONAL HARMONIZATION 544

Advanced Financial Accounting and Corporate Reporting (Study Text)

 HOW TO USE THE MATERIAL
The main body of the text is divided into a number of chapters, each of which is
organized on the following pattern: 400

 Detailed learning outcomes. You should assimilate these before beginning

detailed work on the chapter, so that you can appreciate where your studies
are leading.

 Step-by-step topic coverage. This is the heart of each chapter, containing

detailed explanatory text supported where appropriate by worked examples
and exercises. You should work carefully through this section, ensuring that
you understand the material being explained and can tackle the examples and
exercises successfully. Remember that in many cases knowledge is
cumulative; if you fail to digest earlier material thoroughly; you may struggle to
understand later chapters.

 Examples. Most chapters are illustrated by more practical elements, such as

relevant practical examples together with comments and questions designed
to stimulate discussion.

 Self-Test question. The test of how well you have learned the material is your
ability to tackle standard questions. Make a serious attempt at producing your
own answers, but at this stage don’t be too concerned about attempting the
questions in exam conditions. In particular, it is more important to absorb the
material thoroughly by completing a full solution than to observe the time
limits that would apply in the actual exam.

 Solutions. Avoid the temptation merely to ‘audit’ the solutions provided. It is an

illusion to think that this provides the same benefits as you would gain from a
serious attempt of your own. However, if you are struggling to get started on a
question you should read the introductory guidance provided at the beginning
of the solution, and then make your own attempt before referring back to the
full solution.

Advanced Financial Accounting and Corporate Reporting (Study Text)

 STUDY SKILLS AND REVISION GUIDANCE
Planning

To begin with, formal planning is essential to get the best return from the time
you spend studying. Estimate how much time in total you are going to need
for each subject you are studying for the Strategic Level. Remember that you
need to allow time for revision as well as for initial study of the material. This
book will provide you with proven study techniques. Chapter by chapter it
covers the building blocks of successful learning and examination techniques.
This is the ultimate guide to passing your ICMA Pakistan written by a team of
developers and shows you how to earn all the marks you deserve, and
explains how to avoid the most common pitfalls.

With your study material before you, decide which chapters you are going to
study in each week, and which weeks you will devote revision and final
question practice.

Prepare a written schedule summarizing the above and stick to it.

It is essential to know your syllabus. As your studies progress you will become
more familiar with how long it takes to cover topics in sufficient depth. Your
timetable may need to be adapted to allocate enough time for the whole
syllabus.

Tips for effective studying

(1) Aim to find a quiet and undisturbed location for your study, and plan as
far as possible to use the same period of time each day. Getting into a
routine helps to avoid wasting time. Make sure that you have all the
materials you need before you begin so as to minimize interruptions.

(2) Store all your materials in one place, so that you do not waste time
searching for items around your accommodation. If you have to pack
everything away after each study period, keep them in a box or even a
suitcase, which will not be disturbed until the next time.

(3) Limit distractions. To make the most effective use of your study periods
you should be able to apply total concentration, so turn off all
entertainment equipment, set your phones to message mode and put
up your ‘do not disturb’ sign.

Advanced Financial Accounting and Corporate Reporting (Study Text)

 (4) Your timetable will tell you which topic to study. However, before
dividing in and becoming engrossed in the finer points, make sure you
have an overall picture of all the areas that need to be covered by the
end of that session. After an hour, allow yourself a short break and
move away from your study text. With experience. You will learn to
assess the pace you need to work at.

(5) Work carefully through a chapter, note imported points as you go.
When you have covered a suitable amount of material, vary the
pattern by attempting a practice question. When you have finished
your attempt, make notes of any mistakes you make, or any areas that
you failed to cover or covered more briefly.

Advanced Financial Accounting and Corporate Reporting (Study Text)

Advanced Financial Accounting and Corporate Reporting (Study Text) 1
SUBSTANCE OVER FORM
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

• Explain and demonstrate the importance of recording the commercial

substance rather than the legal form of transactions.
• Describe the features which may indicate that the substance of transactions
differs from their legal form.
• Apply the principle of substance over form to recognition and derecognition of
assets and liabilities.

Advanced Financial Accounting and Corporate Reporting (Study Text) 2

1 Reporting the Substance of Transactions

1.1 Introduction
IAS 1 requires that financial statements:

• must represent faithfully the transactions that have been carried out
• must reflect the economic substance of events and transactions and
not merely their legal form.

1.2 The Historical Problem

Historically, many companies tried to keep items off the statement of financial
position by ignoring their real substance.

Examples include:
• leasing of assets – prior to the issue of IAS 17, leases were not
capitalised, i.e. the asset and its related financial commitment were not
shown on the lessee’s statement of financial position

• controlled non-subsidiaries – under the definitions of a subsidiary prior

to IAS 27, companies could control other companies by legal
arrangements under which technically they were not subsidiaries, so
they were not consolidated in the group accounts.

Example 1

Off Balance Sheet Finance

Note down two or three reasons why companies might wish to keep financing
liabilities off their statements of financial position.

Solution
There are a number of reasons why companies might wish to avoid showing
financing liabilities on their statements of financial position:

• to maintain a level of gearing similar to their counterparts in other

countries (having regard to comparable permissible borrowing levels)

• to maintain the share price on the basis that the market would place a
lower value on a company whose borrowings are considered by the
analysts to be high

• to maintain ROCE by keeping the asset and the related liability out of
the statement of financial position until the asset starts to produce
income

Advanced Financial Accounting and Corporate Reporting (Study Text) 3

 • in groups of companies to keep activities which have different
characteristics (e.g. high gearing ratios) separate (by keeping them off
the statement of financial position) in order not to distort the financial
ratios of the remainder of the group.

1.3 Determining the substance of a transaction

Common features of transactions whose substance is not readily apparent are:

• the legal title to an asset may be separated from the principal benefits
and risks associated with the asset (such as is the case with finance
leases)

• a transaction may be linked with other transactions which means that

the commercial effect of the individual transaction cannot be
understood without an understanding of all of the transactions

• options may be included in a transaction where the terms of the option

make it highly likely that the option will be exercised.

Identifying assets and liabilities

Key to determining the substance of a transaction is to identify whether assets
and liabilities arise subsequent to that transaction by considering:

• who enjoys the benefits of any asset

• who is exposed to the principal risks of any asset.

Assets are defined in the Framework as resources controlled by the entity as

a result of past events and from which future economic benefits are expected
to flow to the entity.

Liabilities are defined in the Framework as present obligations of the entity

arising from past events, the settlement of which is expected to result in an
outflow of resources from the entity.

2 Examples Where Substance and Form may Differ

2.1 Introduction
Examples of areas where substance and form may differ include:

• consignment inventory and goods on sale or return

• sale and repurchase agreements
• sale and leaseback agreements
• factoring of receivables.

Advanced Financial Accounting and Corporate Reporting (Study Text) 4

2.2 Consignment inventory

Consignment inventory is inventory which:

• is legally owned by one party

• is held by another party, on terms which give the holder the right to sell
the inventory in the normal course of business or, at the holder’s
option, to return it to the legal owner.
This type of arrangement is common in the motor trade.

Accounting for consignment inventory

Key question:
In which company’s statement of financial position should the car appear as
inventory between 1 May 20X9 and 30 June 20X9?

Factors to consider are:

• Who bears the risks of the inventory?

• Who has the benefits or rewards of the inventory?

Whoever bears the risks of the inventory should recognise it in the statement
of financial position.

Advanced Financial Accounting and Corporate Reporting (Study Text) 5

 Consignment inventory further detail
Legal title may pass when one of a number of events has occurred, e.g. when
the holder has held the inventory for a specified period such as six months, or
when the holder has sold the goods.

The sales price (to the holder of the inventory) may be determined at the date
of supply, or it may vary with the length of the period between supply and
purchase, or it may be the legal owner’s factory price at sale.

Other terms of such arrangements can include a requirement for the holder to
pay a deposit, and responsibility for insurance.

The arrangement should be analysed to determine whether the holder has in

substance acquired the inventory before the date of transfer of legal title.

The key factor will be who bears the risk of slow moving inventory. The risk
involved is the cost of financing the inventory for the period it is held.

In a simple arrangement where inventory is supplied for a fixed price that will
be charged whenever the title is transferred and there is no deposit, the legal
owner bears the slow movement risk. If, however, the price to be paid
increases by a factor that varies with interest rates and the time the inventory
is held, then the holder bears the risk.

If the price charged to the dealer is the legal owner’s list price at the date of
sale, then again the risks associated with the inventory fall on the legal owner.
Whoever bears the slow movement risk should recognise the inventory in
their accounts.

Example 2

Consignment Inventory
Hafeez Carmart, a car dealer, obtains stock from ABC Ltd, its manufacturer,
on a consignment basis. The purchase price is set at delivery and is
calculated to include an element of finance. Usually, Hafeez Carmart pays
ABC Ltd for the car the day after Carmart sells to a customer. However, if the
car remains unsold after six months then Carmart is obliged to purchase the
car. There is no right of return. Further, Carmart is responsible for insurance
and maintenance from delivery.

Advanced Financial Accounting and Corporate Reporting (Study Text) 6

 Describe how Hafeez Carmart should account for the above
transactions.

Solution
• Dealer faces the risk of slow movement as it is obliged to purchase the
car and has no right of return.
• Dealer insures and maintains the cars.
• Dealer faces risk of theft.
• Dealer can sell the cars to the public.

Recognise the cars on dealer’s statement of financial position at delivery.

2.3 Sale and repurchase agreements

Introduction
Sale and repurchase agreements are situations where an asset is sold by one
party to another. The terms of the sale provide for the seller to repurchase the
asset in certain circumstances at some point in the future.

Sale and repurchase agreements are common in property developments

Accounting for sale and repurchase agreements

Hamid Ltd Arif Habib Bank

Sells some machines to

The Bank for Rs 600,000
On 1 Jan 20XX and promises
to repurchase them 10 years
later for Rs 750,000

Key question:
Is the commercial effect of the transaction that of a sale or of a secured loan?

Factors to consider, whether

• right to use asset

• obligation / likely to repurchase
• sales price below market price

Advanced Financial Accounting and Corporate Reporting (Study Text) 7

 Example 3

Sale And Repurchase

X sold a building to Z an investment company, for Rs1 million when the
current market value was Rs2 million.

X can repurchase the property at any time within the next three years for the
original selling price (Rs1 million) plus a sum, added quarterly, based on the
bank base lending rate plus 2%.

How should X account for this transaction?

Solution
The substance of this deal is a secured loan from Z to X, with the expectation
being that X will exercise its option to repurchase the building.

No sale should therefore be recognised; the Rs1 million is a loan received

from Z.

2.4 Sale and leaseback

Introduction
A sale and repurchase agreement can be in the form of a sale and
leaseback.

• Under a sale and leaseback transaction, an entity sells one of its own
assets and immediately leases the asset back.
• This is a common way of raising finance whilst retaining the use of the
related assets. The buyer / lessor is normally a bank.
• The leaseback is classified as finance or operating in accordance with
the usual IAS 17 criteria.

Accounting for sale and leaseback

Sale and finance leaseback:

• asset derecognised, with any profit or loss deferred over the lease term.
• asset then reinstated in accordance with IAS 17 finance lease rules
(i.e. recognise finance leased asset and liability at the lower of fair
value or present value of minimum lease payments).
• asset value depreciated over lease term and lease interest charged to
statement of comprehensive income in accordance with actuarial
method.

Advanced Financial Accounting and Corporate Reporting (Study Text) 8

 Sale and operating leaseback:
• a sale is recorded and asset derecognised.
• Operating lease rentals are recorded in the statement of
comprehensive income.

2.5 Factoring of receivables

Introduction
Factoring of receivables is where a company transfers its receivables
balances to another organisation (a factor) for management and collection
and receives an advance on the value of those receivables in return.

Accounting for the factoring of receivables

Key question:
Is the seller in substance receiving a loan on the security of his receivables, or
are the receipts an actual sale of those receivable balances?

Factors to consider:
• who bears the risk (of slow payment and irrecoverable debts).

Factoring of receivables further detail

In most forms of factoring, receivables balances are sold to the factor, but the
latter’s degree of control over, and responsibility for, those debts will vary from
one arrangement to another.

A significant accounting question is only likely to arise where the factoring

arrangement leads to the receipt of cash earlier than would have been the
case had the receivables been unfactored. If this is so, the question to be
answered is whether the seller has in substance received either a loan on the
security of his receivables, or has actually sold the receivable.

If the seller is in essence a borrower, and the factor a lender, then the
arrangements will be such as to provide that the seller pays the equivalent of
interest to the factor on the timing difference between amounts received by
him from the factor and those collected by the factor from the receivable.
Such payment would be in addition to any other charges.

The key factor in the analysis will be who bears the risk (of slow payment)
and the benefit (of early payment) by the receivable. If the finance cost
reflects events subsequent to transfer, then the transfer is likely to be
equivalent to obtaining finance because the seller is bearing the risks and
rewards of the receivable. If the cost is determined when the transfer is made,
with no other variable costs, then it is likely to be a straightforward sale.

Advanced Financial Accounting and Corporate Reporting (Study Text) 9

 Chapter Summary

Advanced Financial Accounting and Corporate Reporting (Study Text) 10

 Self-Test Questions

1. On 1 January 20X6 Carmaker Ltd, a manufacturer, entered into an

agreement to provide Sunrise Ltd, a retailer, with machines for resale.
The terms of the agreement were as follows.

• Sunrise Ltd pays a fixed rental per month for each machine that it holds.
• Sunrise Ltd pays the cost of insuring and maintaining the machines.
• Sunrise Ltd can display the machines in its showrooms and use them
as demonstration models.
• When a machine is sold to a customer, Sunrise Ltd pays Carmaker Ltd
the factory price at the time the machine was originally delivered.
• All machines remaining unsold six months after their original delivery
must be purchased by Sunrise Ltd at the factory price at the time of
delivery.
• Carmaker Ltd can require Sunrise Ltd to return the machines at any
time within the six months period. In practice, this right has never been
exercised.
• Sunrise Ltd can return unsold machines to Carmaker Ltd at any time
during the six month period, without penalty. In practice, this has never
happened.

At 31 December 20X6 the agreement is still in force and Sunrise Ltd holds
several machines which were delivered less than six months earlier.

How should these machines be treated in the accounts of Sunrise Ltd

for the year ended 31 December 20X6?

2. Zaviar sells its head office, which cost Rs 10 million, to Pearl Ltd , a bank, for
Rs 10 million on 1 January. Zaviar has the option to repurchase the property
on 31 December, four years later at Rs 12 million. Zaviar will continue to use
the property as normal throughout the period and so is responsible for the
maintenance and insurance. The head office was valued at transfer on 1
January at Rs 18 million and is expected to rise in value throughout the four-
year period.

Advanced Financial Accounting and Corporate Reporting (Study Text) 11

 Giving reasons, show how Zaviar should record the above during the
first year following transfer

3. Bright Ltd sold an item of machinery and leased it back over a five year
finance lease. The sale took place on 1 January 20X4 and the company has a
31 December year end. The details of the scheme are as follows:

Rs
Proceeds of sale 1,000,000
Fair value of machine at date of sale 1,000,000
Carrying value of asset at date of sale 750,000
Annual lease payments (in arrears) 277,409
Remaining useful life of machine at date of sale 5 years
Implicit rate of interest 12%

Prepare the statement of comprehensive income and statement of

financial position extracts for Bright at 31 December 20X4

4. An entity has an outstanding receivables balance with a major customer

amounting to Rs 12 million and this was factored to Finance Co on 1
September 20X7. The terms of the factoring were:

Finance Co will pay 80% of the gross receivable outstanding account to the
entity immediately.

• The balance will be paid (less the charges below) when the debt is
collected in full. Any amount of the debt outstanding after four months
will be transferred back to the entity at its full book value.

• Finance Co will charge 1.0% per month of the net amount owing from
the entity at the beginning of each month. Finance Co had not collected
any of the factored receivable amount by the yearend.

• the entity debited the cash from Finance Co to its bank account and
removed the receivable from its accounts. It has prudently charged the
difference as an administration cost.

How should this arrangement be accounted for in the financial

statements for the year ended 30 September 20X7?

Advanced Financial Accounting and Corporate Reporting (Study Text) 12

 Answers

1. The key issue is whether Sunrise Ltd has purchased the machines from
Carmaker Ltd or whether they are merely on loan.

It is necessary to determine whether Sunrise Ltd has the benefits of holding

the machines and is exposed to the risks inherent in those benefits.

Carmaker Ltd can demand the return of the machines and Sunrise Ltd is able
to return them without paying a penalty. This suggests that Sunrise Ltd does
not have the automatic right to retain or to use them.

Sunrise Ltd pays a rental charge for the machines, despite the fact that it may
eventually purchase them outright. This suggests a financing arrangement as
the rental could be seen as loan interest on the purchase price. Sunrise Ltd
also incurs the costs normally associated with holding inventories.

The purchase price is the price at the date the machines were first delivered.
This suggests that the sale actually takes place at the delivery date. Sunrise
Ltd has to purchase any inventory still held six months after delivery.
Therefore the company is exposed to slow payment and obsolescence risks.
Because Sunrise Ltd can return the inventory before that time, this exposure
is limited.
It appears that both parties experience the risks and benefits. However,
although the agreement provides for the return of the machines, in practice
this has never happened.

Conclusion: the machines are assets of Sunrise Ltd and should be included
in its statement of financial position.

Note: The profit on disposal cannot be taken to the statement of

comprehensive income completely in year 1 as must be deferred over the
lease term i.e. Dr bank Rs 1,000,000 Cr carrying value of asset Rs 750,000
Cr deferred income Rs 250,000).

Deferred income

Release to income Profit on disposal

Statement 50,000 deferred 250,000
Bal c/d 200,000
––––––– –––––––
250,000 250,000
––––––– –––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 13

2. Pearl faces the risk of falling property prices.
• Zaviar continues to insure and maintain the property.
• Zaviar will benefit from a rising property price.
• Zaviar has the benefit of use of the property.

Zaviar should continue to recognise the head office as an asset in the

statement of financial position. This is a secured loan with effective interest of
Rs 2 million (Rs 12 million – Rs 10 million) over the four-year period.

3. Statement of comprehensive income extract

Rs
Depreciation (W1) 200,000
Finance lease interest (W2) 120,000
Profit on disposal (W3) 50,000

Statement of financial position Noncurrent assets

Finance leased asset: 800,000

(1,000,000 - 200,000(W1))

Noncurrent liabilities
Finance lease obligation (W2) 666,293
Deferred income (W3) 150,000

Current liabilities
Finance lease obligation 176,298
Deferred income (W3) 50,000

Workings:

(W1) Depreciation

(Rs1,000,000 × 1/5 200,000

(W2) Finance lease obligation

Year Bal Int Rental Bal
b/fwd 12% c/fwd
20X4 1,000,000 120,000 (277,409) 842,591
20X5 842,591 101,111 (277,409) 666,293

Advanced Financial Accounting and Corporate Reporting (Study Text) 14

 (W3) Profit on disposal of asset (deferred over lease term)

Carrying value of asset 750,000

Proceeds 1,000,000
–––––––
Profit on disposal 250,000

Note: The profit on disposal cannot be taken to the statement of

comprehensive income completely in year 1 as must be deferred over
the lease term i.e. Dr bank Rs 1,000,000 Cr carrying value of asset Rs
750,000 Cr deferred income Rs 250,000).

Deferred income

Release to income Profit on disposal

Statement 50,000 deferred 250,000
Bal c/d 200,000
––––––– –––––––
250,000 250,000
––––––– –––––––

4. As the entity still bears the risk of slow payment and irrecoverable debts, the
substance of the factoring is that of a loan on which finance charges will be
made. The receivable should not have been derecognised nor should all of
the difference between the gross receivable and the amount received from the
factor have been treated as an administration cost.

The required adjustments can be summarised as follows:

Dr Cr
Rs 000 Rs 000
Receivables 12,000
Loan from factor 9,600
Administration Rs(12,000 – 9,600) 2,400
Finance costs: accrued interest (Rs 9.6 million 1.0%) 96
Accruals 96
–––––– ––––––
12,096 12,096
–––––– ––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 15

Advanced Financial Accounting and Corporate Reporting (Study Text) 16
FINANCIAL INSTRUMENTS
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

• Apply and discuss the recognition and de-recognition of a financial asset or
financial liability.
• Apply and discuss the classification of a financial asset or financial liability and
their measurement.
• Apply and discuss the treatment of gains and losses arising on financial
assets and financial liabilities.
• Apply and discuss the treatment of impairment of financial assets.
• Record the accounting for derivative financial instruments, and simple
embedded derivatives.
• Outline the principle of hedge accounting, and account for fair value hedges
and cash flow hedges including hedge effectiveness.

Advanced Financial Accounting and Corporate Reporting (Study Text) 17

1. Introduction

1.1 Definitions
A financial instrument is any contract that gives rise to a financial asset of
one entity and a financial liability or equity instrument of another entity.

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 instruments with another entity

under conditions that are potentially favourable.

• a contract that will or may be settled in the entity’s own equity

instruments, and is a non-derivative for which the entity is or may be
obliged to receive a variable number of the entity’s own equity
instruments.

• a contract that will or may be settled in the entity’s own equity

instruments, and is a derivative that will or may be settled other than by
the exchange of a fixed amount of cash or another financial asset for a
fixed number of the entity’s own equity instruments.

A financial liability is any liability that is a contractual obligation:

• to deliver cash or another financial asset to another entity.

• to exchange financial instruments with another entity under conditions
that are potentially un-favourable.
• a contract that will or may be settled in the entity’s own equity
instruments, and is a non-derivative for which the entity is or may be
obliged to deliver a variable number of the entity’s own equity
instruments.
• a contract that will or may be settled in the entity’s own equity
instruments, and is a derivative that will or may be settled other than by
exchange of a fixed amount of cash or another financial asset for a
fixed number of the entity’s own equity instruments.

An equity instrument is any contract that evidences a residual interest in the

assets of an entity after deducting all of its liabilities.

Advanced Financial Accounting and Corporate Reporting (Study Text) 18

1.2 Accounting standards

There are four reporting standards that deal with financial instruments:
• IAS 32 Financial instruments: presentation
• IAS 39 Financial instruments: recognition and measurement
• IFRS 7 Financial instruments: disclosures
• IFRS 9 Financial instruments

IAS 32 deals with the classification of financial instruments and their

presentation in financial statements.

IAS 39 deals with how financial instruments are measured and when they
should be recognised in financial statements.

IFRS 7 deals with the disclosure of financial instruments in financial

statements.

Note
IFRS 9 was issued in November 2009 and will eventually replace IAS 39.
IFRS 9 is effective for accounting periods commencing from 1 January 2015,
although earlier adoption is permitted. Where early adoption is taken up, to
the extent that IFRS 9 has not yet been fully updated, the provisions of the
earlier standards continue to apply. IFRS 9 was updated in October 2010 to
include accounting for financial liabilities. IAS 39 will be withdrawn in due
course following further additions to IFRS 9 dealing with impairment and
derivatives.

Entities applying IFRS 9 for the first time therefore have a choice as to when
to apply the standard as follows:

• For accounting periods commencing before 1 January 2015:

– IAS 39 can continue to be applied in full, or
– IFRS 9 (2009) dealing only with financial assets can be applied,
together with the remaining provisions of IAS 39 not yet
replaced, or
– IFRS 9 (2010) dealing with both financial assets and financial
liabilities can be applied, together with the remaining provisions
of IAS 39 not yet replaced.

• For accounting periods commencing on or after 1 January 2015, IFRS

9 must be applied in full, together with any remaining provisions of IAS
39 not yet replaced.

Advanced Financial Accounting and Corporate Reporting (Study Text) 19

2 Classification of Financial Instruments

2.1 IAS 32 Financial instruments: presentation provides the rules on

classifying financial instruments as liabilities or equity. These are detailed
below.

Presentation of Liabilities and Equity

The issuer of a financial instrument must classify it as a financial liability,
financial asset or equity instrument on initial recognition according to its
substance.

Financial liabilities
The instrument will be classified as a liability if the issuer has a
contractual obligation:

• to deliver cash (or another financial asset) to the holder.

• to exchange financial instruments on potentially unfavourable terms.

A redeemable preference share will be classified as a liability, because the

issuer has the contractual obligation to deliver cash to the holders on the
redemption date.

Equity instruments
A financial instrument is only an equity instrument if both of the following
conditions are met:

(a) The instrument includes no contractual obligation to deliver cash or

another financial asset to another entity; or to exchange financial
assets or liabilities with another under conditions that are potentially
unfavourable to the issuer.

(b) If the instrument will or may be settled in the issuer’s own equity
instruments, it is a non-derivative that includes no contractual
obligation for the issuer to deliver a variable number of its own equity
instruments; or it is a derivative that will be settled only by the issuer
exchanging a fixed amount of cash or another financial asset for a fixed
number of its own equity shares.

2.2 Interest, dividends, losses and gains

• The accounting treatment of interest, dividends, losses and gains
relating to a financial instrument follows the treatment of the instrument
itself.

Advanced Financial Accounting and Corporate Reporting (Study Text) 20

 • For example, dividends paid in respect of preference shares classified
as a liability will be charged as a finance expense through profit or loss.

• Dividends paid on shares classified as equity will be reported in the

statement of changes in equity.

2.3 Offsetting a financial asset and a financial liability

IAS 32 states that a financial asset and a financial liability may only be offset
in very limited circumstances. The net amount may only be reported when the
entity:

• has a legally enforceable right to set off the amounts.

• intends either to settle on a net basis, or to realise the asset and settle
the liability simultaneously.

3. Recognition and Measurement of Financial Assets

3.1 Initial recognition of financial assets

IFRS 9 deals with recognition and measurement of financial assets. An entity
should recognise a financial asset on its statement of financial position when,
and only when, the entity becomes party to the contractual provisions of the
instrument.

Examples of this principle are as follows:

• Unconditional receivables are recognised when the entity becomes a
party to the contract. At that point the entity has a legal right to receive
cash.

• Commitments to sell goods etc. are not recognised until one party has
fulfilled its part of the contract. For example, a sales order will not be
recognised as revenue and a receivable until the goods have been
delivered.

• Forward contracts are recognised as assets on the commitment date,

not on the date when the item under contract is transferred from seller
to buyer. (A forward contract is a commitment to buy or sell a financial
instrument or a commodity)

The four classifications of financial assets previously recognised under IAS 39

no longer apply.

Advanced Financial Accounting and Corporate Reporting (Study Text) 21

 Initial measurement of financial assets
At initial recognition, all financial assets are measured at fair value. This is
likely to be purchase consideration paid to acquire the financial asset and will
normally exclude transactions costs.

Subsequent measurement of financial assets

Subsequent measurement then depends upon whether the financial asset is a
debt instrument or an equity instrument as follows:

3.2 Debt instruments

Debt instruments would normally be measured at fair value through profit or
loss (FVTPL), but could be measured at amortised cost if the entity chooses
to do so, provided the following two tests are passed:

• the business model test, and

• the contractual cash flow characteristics test.

The business model test establishes whether the entity holds the financial
asset to collect the contractual cash flows or whether the objective is to sell
the financial asset prior to maturity to realise changes in fair value. If it is the
former, it implies that there will be no or few sales of such financial assets
from a portfolio prior to their maturity date. If this is the case, the test is
passed.

Where this is not the case, it would suggest that the assets are not being held
with the objective to collect contractual cashflows, but perhaps may be
disposed of to respond to changes in fair value. In this situation, the test is
failed and the financial asset cannot be measured at amortised cost.

Where an entity changes its business model, it may be required to reclassify

its financial assets as a consequence, but this is expected to be infrequent
occurrence. If reclassification does occur, it is accounted for from the first day
of the accounting period in which reclassification takes place.

The contractual cash flow characteristics test determines whether the

contractual terms of the financial asset give rise to cash flows on specified
dates that are solely payments of principal and interest based upon the
principal amount outstanding. If this is not the case, the test is failed and the
financial asset cannot be measured at amortised cost. For example,
convertible bonds contain rights in addition to the repayment of interest and
principal (the right to convert the bond to equity) and therefore would fail the
test and must be accounted for as fair value through profit or loss.

Advanced Financial Accounting and Corporate Reporting (Study Text) 22

 In summary, for a debt instrument to be measured at amortised cost, it will
therefore require that:

• the asset is held within a business model whose objective is to hold the
assets to collect the contractual cashflows, and

• the contractual terms of the financial asset give rise, on specified

dates, to cash flows that are solely payments of principal and interest
on the principal outstanding.

Even if a financial instrument passes both tests, it is still possible to designate

a debt instrument as FVTPL if doing so eliminates or significantly reduces a
measurement or recognition inconsistency (i.e. accounting mismatch) that
would otherwise arise from measuring assets or liabilities or from recognising
the gains or losses on them on different bases. Therefore, it is now possible to
have financial assets that meet the criteria above and which will now be
measured at amortised cost, even if they are quoted in an active market.

3.3 Equity instruments

Equity instruments are measured at either:
• fair value either through profit or loss, or
• fair value through other comprehensive income.

The normal expectation is that equity instruments will have the designation of
fair value through profit or loss, with the price paid to acquire the financial
asset initially regarded as fair value. This could include unquoted equity
investments, which may present problems in arriving at a reliable fair value at
each reporting date.

However, IFRS 9 does not include a general exception for unquoted equity
investments to be measured at cost; rather it provides guidance on when cost
may, or may not, be regarded as a reliable indicator of fair value.

It is possible to designate an equity instrument as fair value through other

comprehensive income, provided specified conditions have been complied
with as follows:

• the equity instrument cannot be held for trading, and

• there must be an irrevocable choice for this designation upon initial
recognition.

In this situation, initial recognition will also include directly attributable

transactions costs. This may apply, for example, to strategic investments to
be held on a continuing basis which are not held to take advantage of

Advanced Financial Accounting and Corporate Reporting (Study Text) 23

 changes in fair value. Equity derivatives are excluded from adopting this
designation.

Dividends on financial assets through other comprehensive income must be

taken to profit or loss, unless they represent a recovery of part of the
investment. Changes in fair value will be recognised in other comprehensive
income.

If an equity instrument has been designated as fair value through other

comprehensive income, the requirements in IAS 39 to undertake an
assessment of impairment no longer apply as all fair value movements now
remain in equity. Note that there is no recycling or reclassification to profit or
loss in subsequent periods of any gains and losses taken to other
comprehensive income, although upon de-recognition there may be a transfer
within equity. Consequently, in accordance with IAS 1, amended in 2011, any
amounts in other comprehensive income relating to remeasurement of
financial assets should be clearly identified as items which will not be subject
to recycling or reclassification in future periods.

Overview of recognition and measurement of financial assets

Advanced Financial Accounting and Corporate Reporting (Study Text) 24

4. Recognition and Measurement of Financial Liabilities

4.1 IFRS 9 was updated in October 2010 to include accounting for financial
liabilities. In principle, the recognition and measurement criteria contained in
IAS 39 have been retained within IFRS 9.

IFRS 9 has two classes of financial liability as follows:

(1) Financial liabilities at fair value through profit or loss, and

(2) Other financial liabilities. This is the default class for financial liabilities if
they are not at fair value through profit or loss; these financial liabilities
are measured at amortised cost. Borrowings would normally be classed
under this heading.

Financial Measurement Subsequent Recognition in statement

Instrument at recognition measurement of Comprehensive income

Financial Fair value Measured at fair Fair value gains and

liabilities at value with changes losses recognized in
fair value in value taken profit or loss
through profit through profit or
or loss loss

Other Amortised Cost Measured at The interest calculated

financial amortised cost using the effective rate
liabilities through effective is charged to profit or
interest rate state- loss within the income
ment as a finance
cost

Two forms of financial instrument which need to be considered are deep

discounted bonds and compound instruments.

4.2 Deep discounted bonds measured at amortised cost

• One common form of financial instrument for many entities will be
loans payable. These will be measured at amortised cost. The
amortised cost of a liability equals: initial cost plus interest less
repayments. (We will also use this method with compound instruments)
• The interest will be charged at the effective rate or level yield. This is
the internal rate of return of the instrument.

An example of a loan that uses an effective rate of interest is a deep discount

bond.

Advanced Financial Accounting and Corporate Reporting (Study Text) 25

 It has the following features:
• This instrument is issued at a significant discount to its par value.

• Typically it has a coupon rate much lower than market rates of interest,
e.g. a 2% bond when market interest is 10% pa.

• The initial carrying amount of the bond will be the net proceeds of
issue.

• The full finance cost will be charged over the life of the instrument so
as to give a constant periodic rate of interest.

• The full cost will include:

– issue costs
– deep discount on issue
– annual interest payments
– premium on redemption

The constant periodic rate of interest (sometimes called the effective rate) can
be calculated in the same way that the internal rate of return is calculated. In
questions, the effective rate of interest will normally be given.

Example 1
On 1 January 20X1 Jamil issued a deep discount bond with a Rs 50,000
nominal value.

The discount was 16% of nominal value, and the costs of issue were Rs
2,000.

Interest of 5% of nominal value is payable annually in arrears.

The bond must be redeemed on 1 January 20X6 (after 5 years) at a premium

of Rs 4,611.

The effective rate of interest is 12% p.a.

Required
How will this be reported in the financial statements of Jamil over the period to
redemption?

Advanced Financial Accounting and Corporate Reporting (Study Text) 26

 Solution
Firstly, we must establish at what amount the bond will be initially recognised
in the statement of financial position. The calculation set out below also works
out the total finance cost to be charged to profits.

Rs
Net proceeds
Face value 50,000
Less: 16% discount (8,000)
Less: Issue costs (2,000)
––––––
40,000

Initial recognition of liability:

Repayments
Capital 50,000
Premium on redemption 4,611
––––––
Principal to be redeemed 54,611
Interest paid: Rs 50,000 × 5% × 5 years 12,500
––––––
67,111
––––––
Total finance cost 27,111

Secondly, we set up a table (similar to that used for compound instruments) to

work out the balance of the loan at the end of each period.

Year Opening Effective Payments Closing

Balance interest 5% balance
rate 12%
Rs Rs Rs Rs

1 40,000 4,800 (2,500) 42,300

2 42,300 5,076 (2,500) 44,876
3 44,876 5,385 (2,500) 47,761
4 47,761 5,731 (2,500) 50,992
5 50,992 6,119 (2,500) 54,611
–––––– ––––––
27,111 (12,500)

To: Income To: Statement of To: Statement of

Statement Cash flows financial
position

Advanced Financial Accounting and Corporate Reporting (Study Text) 27

 The finance charge taken to the income statement is greater than the actual
interest paid, and so the balance shown as a liability increases over the life of
the instrument until it equals the redemption value at the end of its term.

In Years 1 to 4 the balance shown as a liability is less than the amount that
will be payable on redemption. Therefore the full amount payable must be
disclosed in the notes to the accounts.

4.3 Presentation of compound instruments

The issuer of a financial instrument must classify it as a financial liability or
equity instrument on initial recognition according to its substance.

• A compound instrument is a financial instrument that has

characteristics of both equity and liabilities, for example debt that can
be converted into shares.

• The bondholder has the prospect of acquiring cheap shares in an

entity, because the terms of conversion are normally quite generous.
Even if the bond-holder wants cash rather than shares, the deal may
still be good. On maturity the cash-hungry bondholder will accept the
conversion, and then sell the shares on the market for a tidy profit.

• In exchange though, the bondholders normally have to accept a below

market rate of interest, and will have to wait some time before they get
the shares that form a large part of their return. There is also the risk
that the entity’s shares will under-perform, making the conversion
unattractive.

• IAS 32 requires compound financial instruments be split into their

component parts:
– a financial liability (the debt)
– an equity instrument (the option to convert into shares).

• These must be shown separately in the financial statements.

Example 2
On 1 January 20X1 DD issued a Rs 50m three-year convertible bond at par.
• There were no issue costs.
• The coupon rate is 10%, payable annually in arrears on 31 December.
• The bond is redeemable at par on 1 January 20X4.
• Bondholders may opt for conversion. The terms of conversion are 1 Rs
10 equity shares for every Rs 10 owed to each bondholder on 1
January 20X4.

Advanced Financial Accounting and Corporate Reporting (Study Text) 28

 • Bonds issued by similar entities without any conversion rights currently
bear interest at 15%.
• Assume that all bondholders opt for conversion in full.

How will this be accounted for by DD?

Solution
On initial recognition, the method of splitting the bond between equity and
liabilities is as follows.

• Calculate the present value of the debt component by discounting the

cash flows at the market rate of interest for an instrument similar in all
respects, except that it does not have conversion rights.
• Deduct the present value of the debt from the proceeds of the issue.

(1) Splitting the proceeds

The cash payments on the bond should be discounted to their present
value using the interest rate for a bond without the conversion rights,
i.e. 15%.

Date Cash flow Discount Present

factor @ 15% value
Rs. ‘000’ Rs. ‘000’

31DecX1 Interest 5,000 1/1.15 4,347.8

31DecX2 Interest 5,000 1/1.152 3,780.7
31DecX3 Interest 5,000 1/1.153 3,287.6
1JanX4 Principal 50,000 1/1.153 32,875.8
–––––––
Present value (the liability component) A 44,291.9
As the net proceeds of issue were B 50,000.0
So the equity component is B–A 5,708.1

(2) The annual finance costs and year end carrying amounts

Opening Effective Payments Closing

Balance interest Balance
rate 15%
Rs. ‘000’ Rs. ‘000’ Rs. ‘000’ Rs. ‘000’

20X1 44,291.9 6,643.8 (5,000) 45,935.7

20X2 45,935.7 6,890.4 (5,000) 47,826.1
20X3 47,826.1 7,173.9 (5,000) 50,000.0

Advanced Financial Accounting and Corporate Reporting (Study Text) 29

 (3) The conversion of the bond
Rs. ‘000’

Equity 5,708.1
Liability – bond 50,000.0
–––––––
55,708.1

The conversion terms are one Rs 10 equity shares for every Rs 10, so Rs
50m × 0.1 = 5m shares, which have a nominal value of Rs 50m. The
remaining Rs 5,708,100 should be classified as the share premium, also
within equity. There is no remaining liability, because conversion has
extinguished it.

4.4 Fair value option for financial liabilities

Own credit risk definition

Own credit risk can be considered to be similar to the risk of default on a
liability – it is the risk that an entity will be unable to discharge a particular
liability. It will not necessarily be the same for all liabilities incurred by an
entity. For example, if an entity issues both secured and unsecured debt, the
risk of default on the secured debt is likely to be low and relatively stable,
particularly if the loan agreement includes performance and other criteria
which protect the position of the lender.

However, the risk of default attaching to the unsecured debt will certainly be
higher and will almost certainly vary over time, due to trading performance
and other factors, until the liability is settled.

Accounting treatment
IFRS 9 permits entities to opt to designate liabilities which would normally fall
to be measured at amortised cost, to be designated at fair value through profit
or loss (Fair value Option (FVO)). This designation, if made, must be made
upon initial recognition and is irrevocable. Where an entity opts for this
treatment, any change in fair value of the liability must be separated into two
elements as follows:

 Changes in fair value due to own credit risk, which are taken to other
comprehensive income, and

 Other changes in fair value, which are taken to profit or loss.

One possible approach to identifying the two elements is to separate the

interest rate charged on the financial liability into a benchmark rate (e.g. such

Advanced Financial Accounting and Corporate Reporting (Study Text) 30

 as KIBOR) and an instrument-specific rate. Any change in the fair value of the
liability which is not wholly due to the change in the benchmark rate must
therefore be due to a change on own credit risk. The movement in fair value
can then be split into the two separate elements.

Note that IFRS 9 does not define what a “benchmark” interest rate is, nor
does it specify a required basis for separating the two elements of the change
in fair value; entities are therefore able to use an alternative basis from that
which is included in the guidance to IFRS 9 which they believe provides a
better representation of the change in fair value due to changes in own credit
risk. If there is no standard basis for accounting for own credit risk, this may
lead to problems of inconsistency and lack of comparability in reported
information.

It is possible that the FVO may be appropriate to financial institutions, rather

than other entities generally. Accordingly, most entities will continue to
account for financial liabilities in accordance with IFRS 9 with no practical
change from the requirements of IAS 39. The FVO is not available if it will
create or enlarge an accounting mis-match or for financial liabilities that are
held for trading; any change in the fair value of such liabilities will be taken to
profit or loss as before.

Example 3
On 1 January 20X8 an entity issues a 7 year bond at par value of Rs 300,000
and annual fixed coupon rate of 9%, which is also the market rate, when KIBOR
is 6%. Therefore the instrument-specific element of IRR = (9% - 6%) is 3%.

At 31 December 20X8, KIBOR has moved to 5.5%, thus making the

benchmark interest rate (5.5% + 3%) 8.5% (i.e. KIBOR plus the instrument-
specific element of IRR). If the fair value of the liability is consistent with a
market interest rate of, say, 8.3%, then any change in the fair value of the
liability from the benchmark rate to fair value must be due to something other
than the change in the benchmark rate – i.e. it must be due to the change in
the liability’s credit risk.

Required

Calculate the amounts to be included within the financial statements for

the year ended 31 December 20X8.

Advanced Financial Accounting and Corporate Reporting (Study Text) 31

 Solution
It can be quantified by calculating the present value (PV) of the liability using
the benchmark rate and comparing it with the PV of the liability using the
market rate as follows:

PV at benchmark rate 8.5% Cash flow Factor PV

Year Rs Rs
1–6 27,000 4.5533 122,939
6 300,000 0.6129 183,870
–––––––
306,809

Year
1–6 27,000 4.5808 123,684
6 300,000 0.6197 183,870
–––––––
306,809

Therefore, the change in the fair value of the liability which is not due to the
change in the benchmark rate must be due to the change in the liability’s credit
risk.

Rs

PV of liability at market rate of 8.3% (on SOFP at

reporting date) 309,594
PV of liability at benchmark rate of 8.5% 306,809
––––––
Other comprehensive income 2,785

IFRS 9 requires that this change in fair value relating to the change in the
liability’s credit risk is taken to Other Comprehensive Income. In the above
situation, it will be reflected by a reduction in equity as the carrying value of
the liability is increased.

There are likely to be different models or bases of determination adopted by

different entities as they prepare annual financial statements to implement
fully the requirements relating to both financial assets and financial liabilities.
From a corporate reporting perspective, perhaps the best way to consider the
total movement in the fair value of financial liabilities from one reporting date
to the next, is to split it into two elements:

Advanced Financial Accounting and Corporate Reporting (Study Text) 32

 • to the extent that the change in fair value relates to a change in own
credit risk, this is taken to OCI, and
• to the extent that the change in fair value is related to anything else,
this is recognised in profit or loss for the year.

The only exception to this accounting treatment arises where the outcome
would create or enlarge an accounting mismatch in profit or loss. If this is the
case, then an entity will present all changes in fair value on that liability in
profit or loss.

5. Derecognition of Financial Instruments

The derecognition requirements of IAS 39 have been transferred to IFRS 9.

Derecognition is currently part of the IASB work plan for the development of
reporting standards, which includes a continuing commitment to convergence
of IFRS with US GAAP. These requirements may be changed at some future
date, as practical issues associated with derecognition of financial assets and
financial liabilities become apparent.

A financial asset should be derecognised if one of the following criteria

occur:

• the contractual rights to the cash flows of the financial asset have
expired, e.g. when an option held by the entity has expired worthless.

• the financial asset has been sold and the transfer qualifies for de-
recognition because substantially all the risks and rewards of
ownership have been transferred from the seller to the buyer.

The analysis of where the risks and rewards of ownership lie after the
transaction is critical. For example if an entity sells an investment in shares
and enters into a total return swap with the buyer, the buyer will return any
increases in value to the entity or the entity will pay the buyer for any
decrease in value. In this case the entity has retained substantially all of the
risks and rewards of the investment, which therefore should not be
derecognised.

A financial liability should be derecognised when, and only when, the

obligation specified in the contract is discharged, cancelled or expires.

On de-recognition, the difference between the carrying amount of the asset or

liability and the amount received or paid for it should be recognised in the
profit or loss for the period.

Advanced Financial Accounting and Corporate Reporting (Study Text) 33

6. Impairment of Financial Assets

6.1 Impairment of financial assets will, in due course, be included within updated
requirements of IFRS 9. Until that occurs, impairment requirements are as
specified in IAS 39, subject to minor amendment following the publication of
IFRS 9 containing revised classification of financial assets. Current
developments relating to impairment of financial assets are considered
elsewhere in this chapter.

The present situation as at August 2010 is as follows:

• Financial assets that are measured at fair value through profit or loss
are not subject to an impairment review. Remeasurement of fair value
at each reporting date will automatically take account of any
impairment.

• Similarly, financial assets measured at fair value through other

comprehensive income are not subject to an impairment review. Any
changes in fair value, including those which may relate to impairment,
are recognised in other comprehensive income. There is no recognition
or recycling of impairment to profit or loss.

• For financial assets measured at amortised cost, IAS 39 requires that

an assessment be made, at every reporting date, as to whether there is
any objective evidence that a financial asset is impaired, i.e. whether
an event has occurred that has had a negative impact on the expected
future cash flows of the asset.

• The event causing the negative impact must have already happened.
An event causing an impairment in the future shall not be anticipated.

– For example, on the last day of its financial year a bank lends a
customer Rs 100,000. The bank has consistently experienced a
default rate of 5% across all its loans. The bank is not permitted
immediately to write this loan down to Rs 95,000 based on its
past experience, because no default has occurred at the
reporting date.

6.2 Impairment review of financial assets measured at amortised cost

Examples of objective evidence of impairment at the reporting date include:
significant financial difficulty of the borrower, and the failure of the borrower to
make interest payments on the due date.

An impairment loss on financial assets measured at amortised cost is

determined as follows:

Advanced Financial Accounting and Corporate Reporting (Study Text) 34

 Rs

Carrying value of the asset per the financial statements X

Less:
PV of the estimated future cash flows discounted
at the original effective interest rate (X)
–––
Impairment loss X

Any impairment loss is recognised as an expense in profit or loss.

If recoverable amount exceeds carrying value, the asset is not impaired.

Example 4
On 1 February 20X6, E Ltd makes a four-year loan of Rs 10,000 to F Ltd. The
coupon rate on the loan is 6%, the same as the effective rate of interest.
Interest is received at the end of each year.

During February 20X9, it becomes clear that F is in financial difficulties. This

is the necessary objective evidence of impairment. At this time the current
market interest rate is 8%.

It is estimated that the future remaining cash flows from the loan will be only
Rs 6,000, instead of Rs 10,600 (the Rs 10,000 principal plus interest for the
fourth year of Rs 600).

Solution
Because the coupon and the effective interest rate are the same, the carrying
amount of the principal will remain constant at Rs 10,000.

On 1 February 20X9, the carrying amount of the loan should be restated to

the present value of the estimated cash flows of Rs 6,000, discounted at the
original effective interest rate of 6% for one year.

6,000 × 1/1.06 = Rs 5,660

The result is an impairment loss of Rs 4,340 (Rs 10,000 – Rs 5,660).

The impairment loss is recognised as an expense in profit or loss.

The asset will continue to be accounted for using amortised cost, based on
the revised carrying amount of the loan. In the last year of the loan, the
interest income of Rs 340 (5,660 × 6%) will be recognised in profit or loss.

Advanced Financial Accounting and Corporate Reporting (Study Text) 35

 6.3 Reversals of impairment losses
Reversal of an impairment loss is only permitted as a result of an event
occurring after the impairment loss has been recognised. An example would
be the credit rating of a customer being revised upwards by a credit rating
agency.

Reversal of impairment losses in respect of financial assets measured at

amortised cost are recognised in profit or loss.

7 Derivatives

7.1 Definitions
A derivative is a financial instrument with the following characteristics:

(a) Its value changes in response to the change in a specified interest rate,
security price, commodity price, foreign exchange rate, index of prices
or rates, a credit rating or credit index or similar variable (called the
‘underlying’).

(b) It requires little or no initial net investment relative to other types of

contract that have a similar response to changes in market conditions.

(c) It is settled at a future date.

7.2 Typical derivatives

Derivatives include the following types of contracts:

Forward contracts
• The holder of a forward contract is obliged to buy or sell a defined
amount of a specific underlying asset, at a specified price at a specified
future date.

• For example, a forward contract for foreign currency might require

£10,000 to be exchanged for Rs 1,050,000 in three months’ time. Both
parties to the contract have both a financial asset and a financial
liability. For example, one party has the right to receive Rs 1,050,000
and the obligation to pay £10,000.

• Forward currency contracts may be used to minimise the risk on

amounts receivable or payable in foreign currencies.

Advanced Financial Accounting and Corporate Reporting (Study Text) 36

 Forward rate agreements

• Forward rate agreements can be used to fix the interest charge on a

floating rate loan.

• For example, an entity has a Rs 1m floating rate loan, and the current
rate of interest is 7%. The rates are reset to the market rate every six
months, and the entity cannot afford to pay more than 9% interest. The
entity enters into a six-month forward rate agreement (with, say, a
bank) at 9% on Rs 1m. If the market rates go up to 10%, then the bank
will pay them Rs 5,000 (1% of Rs 1m for 6 months) which in effect
reduces their finance cost to 9%. If the rates only go up to 8% then the
entity pays the bank Rs 5,000. The forward rate agreement effectively
fixes the interest rate payable at 9% for the period.

Future Contracts
• Futures contracts oblige the holder to buy or sell a standard quantity of
a specific underlying item at a specified future date.

• Futures contracts are very similar to forward contracts. The difference

is that futures contracts have standard terms and are traded on a
financial exchange, whereas forward contracts are tailor-made and are
not traded on a financial exchange. Also, whereas forward contracts
will always be settled, a futures contract will rarely be held to maturity.

Swaps
• Two parties agree to exchange periodic payments at specified intervals
over a specified time period.

• For example, in an interest rate swap, the parties may agree to

exchange fixed and floating rate interest payments calculated by
reference to a notional principal amount.

• This enables companies to keep a balance between their fixed and

floating rate interest payments without having to change the underlying
loans.

Options
• These give the holder the right, but not the obligation, to buy or sell a
specific underlying asset on or before a specified future date.

Advanced Financial Accounting and Corporate Reporting (Study Text) 37

7.3 Measurement of derivatives
• On recognition, derivatives should initially be measured at fair value.
Transaction costs may not be included.

• Subsequent measurement depends on how the derivative is

categorised. In many cases, this will involve the derivative being
measured at fair value with changes in the fair value recognised in
profit or loss. However if the derivative is used as a hedge (see later in
this chapter), then the changes in fair value should be recognised in
equity.

Example 5
Entity A enters into a call option on 1 June 20X5, to purchase 10,000 shares
in another entity on 1 November 20X5 at a price of Rs 10 per share. The cost
of each option is Rs 1. A has a year end of 30 September.

By 30 September the fair value of each option has increased to Rs 1.30 and
by 1 November to Rs 1.50, with the share price on the same date being Rs
11. A exercises the option on 1 November and the shares are classified as at
fair value through profit or loss.

Solution
On 1 June 20X5 the cost of the option is recognised:

Debit Call option (10,000 × Rs 1) Rs 10,000

Credit Cash Rs 10,000

On 30 September the increase in fair value is recorded:

Debit Call option (10,000 × (Rs 1.30 – 1)) Rs 3,000

Credit Profit or loss Rs 3,000

On 1 November the option is exercised, the shares recognised and the call
option derecognised. As the shares are financial assets at fair value through
profit or loss, they are recognised at Rs 110,000 (10,000 × the current market
price of Rs 11)

Debit Investment in shares at fair value Rs 110,000

Debit Expense – loss on call option
((10,000 + 3,000 + 100,000) – 110, 000) Rs 3,000
Credit Cash (10,000 × Rs 10) Rs 100,000
Credit Call option (10,000 + 3,000 carrying amount) Rs 13,000

Advanced Financial Accounting and Corporate Reporting (Study Text) 38

7.4 Embedded derivatives
IAS 39 required separation of certain embedded derivates. IFRS 9 removes
this requirement when the host contract is a financial asset within the scope of
IAS 39.

As a result, embedded derivatives that would have been separately

accounted for at fair value through profit or loss under IAS 39 because they
were not closely related to the financial asset host will no longer be separated.
Instead, the contractual cash flows of the financial asset are assessed as a
whole and the asset is measured as fair value through profit or loss if any of
its cash flows do not represent payments of principal and interest as outlined
in IFRS 9.

For example

An entity has an investment in a convertible bond, which can be converted

into a fixed number of equity shares at a specified future date. Normally,
under IAS 39, the convertible bond is bifurcated (i.e. separated) into the host
debt instrument and the conversion option which is the embedded derivative.
This was required as risks attaching to the conversion option were not closely
matched to those of the debt instrument. They were also measured differently
as the debt instrument under IAS 39 would normally be measured at
amortised cost with the conversion option measured at fair value through
profit or loss.

IFRS 9 now requires that embedded derivatives, such as the convertible

bond, are evaluated for correct classification in their entirety due to the
presence of the conversion option. In practical terms it would mean that the
bond would fail the contractual cash flow characteristics test and would
therefore be measured at fair value through profit or loss.

7.5 The need for a financial reporting standard

Derivatives can be easily acquired, often for little or no cost, but their values
can change very rapidly, exposing holders to the risk of large profits or losses.
Because many derivatives have no cost, they may not appear in a traditional
historical cost statement of financial position, even if they represent
substantial assets or liabilities of the entity. Gains and losses have
traditionally not been recorded until cash is exchanged.

Gains and losses can be easily realised, often simply by making a telephone
call. If gains and losses are recognised on a cash basis, then management
can choose when to report these gains and losses.

Advanced Financial Accounting and Corporate Reporting (Study Text) 39

 Derivatives can rapidly transform the position, performance and risk profile of
an entity. Consequently, there is great debate regarding the accounting for
derivatives, together with ensuring that there are adequate disclosures for
users to fully understand and appreciate their impact upon the reported
financial performance and position of an entity.

8. Hedge Accounting

8.1 Definitions
Hedging is a method of managing risk by designating one or more hedging
instruments so that their change in fair value is offset, in whole or in part, to
the change in fair value or cash flows of a hedged item. A hedged item is an
asset or liability that exposes the entity to risks of changes in fair value or
future cash flows (and is designated as being hedged).

A hedging instrument is a designated derivative whose fair value or cash

flows are expected to offset changes in fair value or future cash flows of the
hedged item.

So the item generates the risk and the instrument modifies it.

8.2 Introduction
As at August 2010, IFRS 9 does not contain any specific requirements
relating to hedge accounting; this constitutes the third phase of the project to
replace IAS 39 with IFRS 9. Accordingly, the requirements specified in IAS 39
continue to apply until withdrawn.

• Hedging is a means of reducing risk.

• One simple hedge is where an entity takes out a foreign currency loan
to finance a foreign currency investment. If the foreign currency
strengthens, then the value of the asset and the burden of the liability
will increase by the same amount. Any gains or losses will be cancelled
out.

• Hedge accounting recognises symmetrically the offsetting effects, on

net profit or loss, of changes in the fair values of the hedging
instrument and the related item being hedged.

• The hedging instrument will often be a derivative.

• Hedge accounting is allowed under IAS 39 provided that the hedging

relationship is clearly defined, measurable, and actually effective.

Advanced Financial Accounting and Corporate Reporting (Study Text) 40

 IAS 39 identifies three types of hedge, two of which are mentioned below:

(1) Fair value hedge –This hedges against the risk of changes in the fair
value of a recognised asset or liability. For example, the fair value of
fixed rate debt will change as a result of changes in interest rates.

(2) Cash flow hedge – This hedges against the risk of changes in
expected cash flows. For example, an entity may have an
unrecognised contractual commitment to purchase goods in a year’s
time for a fixed amount of US dollars.

8.3 Accounting for a fair value hedge

Under IAS 39 hedge accounting rules can only be applied to a fair value
hedge if the hedging relationship meets four criteria.

(1) At the inception of the hedge there must be formal documentation

identifying the hedged item and the hedging instrument.
(2) The hedge is expected to be highly effective.

(3) The effectiveness of the hedge can be measured reliably (i.e. the fair
value/cash flows of the item and the instrument can be measured
reliably).

(4) The hedge has been assessed on an ongoing basis and is determined
to have been effective.

Accounting treatment
• The hedging instrument will be remeasured at fair value, with all gains
and losses being reported in profit or loss for the year.

• The hedged portion of the hedged item will be remeasured at fair

value, with all gains and losses being reported in profit or loss for the
year.

One consequence of introducing redefined classifications of financial assets

under IFRS 9 is that some financial assets, previously measured at amortised
cost, would now be measured at fair value through profit or loss under IFRS 9.
If this is the case, both the hedged item and the hedging instrument would fall
to be measured at fair value through profit or loss. Any change in fair value
would therefore be matched in profit or loss and hedge accounting would be
discontinued.

It is possible for a financial asset measured at amortised cost to be part of a

fair value hedge. If this is the case, it would be measured at fair value, with

Advanced Financial Accounting and Corporate Reporting (Study Text) 41

 any change in fair value taken to profit or loss as part of the hedge
arrangement as identified above.

A further issue arises with the designation of items as fair value through other
comprehensive income under IFRS 9. This designation must be made at
initial recognition and is irrevocable. Similarly, any hedging arrangement must
also be clearly designated at the point of inception. One reason for
designation as fair value through other comprehensive income is to eliminate
an accounting mismatch, where assets and liabilities are recognised or
measured on different bases. It would appear possible that a fair value hedge
arrangement could include a financial asset at fair value through other
comprehensive income, with the remeasurement of both the hedged item and
the hedging instrument both reported in either profit or loss (the current
situation under IAS 39) or in other comprehensive income.

This may arise following the elimination of the available-for-sale category of

financial asset identified under IAS 39.

It is expected that eligibility conditions for the fair value option will be
reconsidered again as the hedge accounting phase of the project to replace
IAS 39 is progressed.

Example 6
On 1 January 20X8 an entity purchased an equity instrument at a fair value of
Rs 900,000. As it was not acquired with the intention of taking advantage of
short-term changes in fair value, it would normally be designated upon initial
recognition to be classified as fair value through other comprehensive income.

Due to the exposure to risk of changes in fair value of the equity instrument,
the entity entered into an interest rate swap, identifying the swap contract as a
hedging instrument as part of a fair value hedging arrangement. The fair value
hedge has been correctly documented and designated upon initial recognition
and is expected to be an effective hedging arrangement. Consequently,
changes in fair value to both the equity instrument (hedged item) and the
swap contract (hedge instrument)will be matched in profit or loss, rather than
accounted for separately.

At the reporting date 31 December 20X8, the fair value of the equity
instrument has fallen to Rs 800,000, and there has been an increase in the
fair value of the interest rate swap contract of Rs 90,000.

Advanced Financial Accounting and Corporate Reporting (Study Text) 42

 Required
Illustrate and explain the accounting treatment for the fair value hedge
arrangement based upon the available information.

Solution
The fall in fair value of the equity interest of Rs 100,000 is taken to profit or
loss. This is matched with the increase in fair value of the interest rate swap
contact of Rs 90,000, resulting in a small net loss of Rs 10,000.

The effectiveness in the hedge arrangement (see later within section in

Complete Text) can be evaluated by comparing the change in the hedged
item and the hedged instrument as follows:

Change in hedged item Rs 100,000

Change in hedging instrument Rs 90,000
Either: 100,000/90,000 = 111%
Or: 90,000/100,000 = 90%

As long as either one of the two measures above falls within the range 80% –
125%, the hedge is regarded as effective.

The above fair value hedge arrangement would therefore be regarded as

effective.

8.4 Accounting for a cash flow hedge

Before the IAS 39 hedge accounting rules can be applied to a cash flow
hedge, the hedging relationship must meet five criteria. These are the four
listed for a fair value hedge, plus:

• the transaction giving rise to the cash flow risk is highly probable and
will ultimately affect profitability.

Accounting treatment
• The hedging instrument will be remeasured at fair value. The gain (or
loss) on the portion of the instrument that is deemed to be an effective
hedge will be taken to equity and recognised in the statement of
changes in equity.

• The ineffective portion of the gain or loss will be reported immediately

in the income statement.

• If the hedged item eventually results in the recognition of a nonfinancial

asset or liability, the gain or loss held in equity must be recycled in one
of the two following ways

Advanced Financial Accounting and Corporate Reporting (Study Text) 43

 – the gain / loss goes to adjust the carrying amount of the
nonfinancial assets/liability.
– the gain / loss is transferred to profit and loss in line with the
consumption of the nonfinancial assets / liability.

8.5 Hedge effectiveness

One of the requirements of IAS 39 is that to use hedge accounting, the hedge
must be effective. IAS 39 describes this as the degree to which the changes
in fair value or cash flows of the hedged item are offset by changes in the fair
value or cash flows of the hedging instrument.

A hedge is viewed as being highly effective if actual results are within a range
of 80% to 125%.

Illustration
JJ uses hedging transaction to minimise the risk of exposure to foreign
exchange fluctuations. He buys goods from overseas and takes out forward
contracts to fix the price of his inputs.

The gain on his forward contract for November was Rs 570. The loss on a
foreign currency creditor was Rs 600.

The effectiveness of the hedge is determined by dividing 570 by 600 or 600

by 570.

This gives an effectiveness percentage of 95% and 105% respectively.

The hedge meets the criteria of 80–125% and is effective.

9. Disclosure of Financial Instruments

9.1 IFRS 7 Financial instruments: disclosures provide the disclosure

requirements for financial instruments. A summary of the requirements is
detailed below.

The two main categories of disclosures required are:

(1) Information about the significance of financial instruments.
(2) Information about the nature and extent of risks arising from financial
instruments.

The disclosures made should be made by each class of financial instrument.

Advanced Financial Accounting and Corporate Reporting (Study Text) 44

 9.2 Significance of financial instruments
• An entity must disclose the significance of financial instruments for
their financial position and performance. The disclosures must be
made for each class of financial instruments.

• An entity must disclose items of income, expense, gains, and losses,

with separate disclosure of gains and losses from each class of
financial instrument.

9.3 Nature and extent of risks arising from financial instruments need to be
disclosed

Qualitative disclosures
The qualitative disclosures describe:
• risk exposures for each type of financial instrument.
• management’s objectives, policies, and processes for managing those
risks.
• changes from the prior period.

Quantitative disclosures
The quantitative disclosures provide information about the extent to which the
entity is exposed to risk, based on information provided internally to the
entity’s key management personnel. These disclosures include:
• summary quantitative data about exposure to each risk at the reporting
date.
• disclosures about credit risk, liquidity risk, and market risk as further
described below.
• concentrations of risk.

10 IFRS 7 Disclosures

10.1 Introduction
In principle, there should be sufficient information to enable users of financial
statements to fully understand:

• how financial assets and liabilities have been designated.

• the date, reason and effect of any reclassification of financial assets.

The main categories of disclosures required are:

(1) Accounting policies applied in respect of accounting for financial
instruments.
(2) Information about the significance of financial instruments upon the
financial performance and position of the entity.

Advanced Financial Accounting and Corporate Reporting (Study Text) 45

 (3) Information about the nature and extent of risks arising from financial
instruments.
(4) Detailed disclosures relating to the nature and extent of accounting for
fair value and cash flow hedging arrangements.

10.2 Types of risk

There are four types of financial risk:

(1) Market risk – This refers to the possibility that the value of an asset (or
burden of a liability) might go up or down. Market risk includes three types of
risk: currency risk, interest rate risk and price risk.

(a) Currency risk is the risk that the value of a financial instrument
will fluctuate because of changes in foreign exchange rates.

(b) Fair value interest rate risk is the risk that the value of a
financial instrument will fluctuate due to changes in market
interest rates. This is a common problem with fixed interest rate
bonds. The price of these bonds goes up and down as interest
rates go down and up.

(c) Price risk refers to other factors affecting price changes. These
can be specific to the enterprise (bad financial results will cause
a share price to fall), relate to the sector as a whole or relate to
the type of security (bonds do well when shares are doing badly,
and vice versa).

Market risk embodies not only the potential for a loss to be made but
also a gain to be made:

(2) Credit risk – The risk that one party to a financial instrument fails to
discharge its obligations, causing a financial loss to the other party. For
example, a bank is exposed to credit risk on its loans, because a borrower
might default on its loan.

(3) Liquidity risk – This is also referred to as funding risk. This is the risk that an
enterprise will be unable to meet its commitments on its financial
instruments. For example, a business may be unable to repay its loans
when they fall due.

(4) Cash flow interest rate risk – This is the risk that future cash flows
associated with a monetary financial instrument will fluctuate in amount due
to changes in market interest rates. For example, the cash paid (or received)
on floating rate loans will fluctuate in line with market interest rates.

Advanced Financial Accounting and Corporate Reporting (Study Text) 46

 Chapter Summary

Advanced Financial Accounting and Corporate Reporting (Study Text) 47

 Self-Test Questions

1. AB has the following financial assets:

(1) Investments held for trading purposes.
(2) Interest-bearing debt instruments that will be redeemed in five
years; AB intends to collect the contractual cash flows which
consist solely of repayments of interest and capital.
(3) A trade receivable.
(4) Derivatives held for speculation purposes.
(5) Equity shares that AB has no intention of selling.
(6) A convertible bond which is due to be converted into equity
shares in three years’ time.

Required

How should AB classify its financial assets?

2. GG issues three debt instruments, each with a nominal value of Rs
10,000 and redeemable in two years. The effective interest rate for all
three is 10%.
D1 has a coupon rate of 0%, is issued at par and is redeemed at a
premium of Rs 2,100.
D2 has a coupon rate of 0%, is issued at a discount of Rs 1,736 and is
redeemed at par.
D3 has a coupon rate of 2%, is issued at a discount of Rs 500 and is
redeemed at a premium of Rs 1,075.

Required

How should these debt instruments be accounted for?

3. CG issues a Rs 100,000 4% three-year convertible loan on 1 January
20X6. The market rate of interest for a similar loan without conversion
rights is 8%. The conversion terms are one equity share (Rs 10
nominal value) for every Rs 20 of debt. Conversion or redemption at
par takes place on 31 December 20X8.

Advanced Financial Accounting and Corporate Reporting (Study Text) 48

 Required

How should this be accounted for:

(a) if all holders elect for the conversion
(b) no holders elect for the conversion?

4. MN has two receivables that it has factored to a bank in return for

immediate cash proceeds of less than the face value of the invoices.
Both receivables are due from long standing customers who are
expected to pay in full and on time. MN has agreed a three-month
credit period with both customers.

The first receivable is for Rs 200,000 and in return for assigning the
receivable MN has just received from the factor Rs 180,000. Under the
terms of the factoring arrangement this the only money that MN will
receive regardless of when or even if the customer settles the debt, i.e.
the factoring arrangement is said to be "without recourse ".

The second receivable is for Rs 100,000 and in return for assigning the
receivable MN has just received Rs 70,000. Under the terms of this
factoring arrangement if the customer settles the account on time then
a further Rs 5,000 will be paid by the factoring bank to MN, but if the
customer does not settle the account in accordance with the agreed
terms then the receivable will be reassigned back to MN who will then
be obliged to refund the factor the original Rs 70,000 plus a further Rs
10,000. This factoring arrangement is said to be "with recourse".

Required

Discuss MN's accounting treatment of the monies received under

the terms of the two factoring arrangements.

5. KL bought an investment for Rs 40 million plus associated transaction

costs of Rs 1 million. The asset was designated upon initial recognition
as fair value through other comprehensive income. At the reporting
date the fair value of the financial asset had risen to Rs 60 million.
Shortly after the reporting date the financial asset was sold for Rs 70
million.

Advanced Financial Accounting and Corporate Reporting (Study Text) 49

 Required

(1) How should this be accounted for?

(2) How would the answer have been different if the investment had
been classified as at fair value through profit and loss?

6. On 1 January 20X2, HL makes a five-year loan of Rs 10,000 with an

interest rate of 10% (the same as the effective rate of interest), with the
principal being repaid at the end of five years.

During January 20X6, the borrower is in financial difficulty and it is

estimated that the future cash flows will be Rs 4,000 rather than Rs
11,000 (Rs 10,000 principal plus Rs 1,000 interest). At this date the
current market interest rate is 9%.

Required

How should this be accounted for?

7. HH buys a call option on 1 January 20X6 for Rs 5 per option that gives
the right to buy 100 shares in RM on 31 December at a price of Rs 10
per share.

Required

How should this be accounted for, given the following outcomes?

(a) The options are sold on 1 July 20X6 for Rs 15 each.
(b) On 31 December 20X6, RM’s share price is Rs 8 and HH lets
the option lapse unexercised.
(c) The option is exercised on 31 December when RM’s share price
is Rs 25. The shares are classified as held for trading.

8. On 1 January 20X9 ST purchased an equity instrument at a fair value

of Rs 5,000,000. As it was not acquired with the intention of taking
advantage of short-term changes in fair value, it would normally be
designated upon initial recognition to be classified as fair value through
other comprehensive income.

Due to the exposure to risk of changes in fair value of the equity

instrument, the entity entered into an interest rate swap, identifying the
swap contract as a hedging instrument as part of a fair value hedging
arrangement. The fair value hedge has been correctly documented and
designated upon initial recognition and is expected to be an effective
hedging arrangement.

Advanced Financial Accounting and Corporate Reporting (Study Text) 50

 At the reporting date 31 December 20X9, the fair value of the equity
instrument has fallen to Rs 4,200,000, and there has been an increase
in the fair value of the interest rate swap contract of Rs 750,000.

Required

Illustrate and explain the accounting treatment for the fair value
hedge arrangement based upon the available information.

1 – AB

Financial asset Classification

Investments held for trading purposes Financial assets at fair value through
profit or loss
Interest bearing debt instruments that will Debt instrument which passes both the
be redeemed in five years; AB intends business model test and the
to collect the contractual cash flows which consist contractual cash flow characteristics
solely of repayments of interest and capital. test. It can be measured at amortised
cost.
A trade receivable. Debt instrument presumably held to
collect cash flows due. This should
pass both the business model test and
the contractual cash flow
characteristics test; it can be
measured at amortised cost.
Derivatives held for speculation purposes. Financial assets at fair value through
profit or loss.
Equity shares that AB has no intention. Financial assets at fair value through
selling profit or loss, although it can
be designated upon initial recognition
to be fair value through other
comprehensive income.
A convertible bond which is due to be converted As the bond contains rights in addition
into equity shares in three years’ time. to the repayment of interest and
principal, the contractual cash flow
characteristics test is failed; it cannot
be measured at amortised cost. The
financial asset as a whole must be
measured at fair value through profit
or loss.

Advanced Financial Accounting and Corporate Reporting (Study Text) 51

2 – GG
These are financial liabilities to be measured at amortised cost. Each financial
liability is initially recorded at the fair value of the consideration received, i.e.
the cash received. This amount is then increased each year to redemption by
interest added at the effective rate and reduced by the interest actually paid,
with the result that the carrying amount at the end of the first year is at
amortised cost.

These are financial liabilities to be measured at amortised cost. Each financial

liability is initially recorded at the fair value of the consideration received, i.e.
the cash received. This amount is then increased each year to redemption by
interest added at the effective rate and reduced by the interest actually paid,
with the result that the carrying amount at the end of the first year is at
amortised cost.

Closing
Balance interest balance
rate 10%
Rs Rs Rs Rs

D1 Year 1 10,000 1,000 Nil 11,000

Year 2 11,000 1,100 (12,100) (including
Rs 2,100 premium) Nil
D2 Year 1 8,264 826 Nil 9,090
(10,000 –
1,736)
Year 2 9,090 910 (10,000) (no premium) Nil

D3 Year 1 9,500 950 (200) 10,250

(10,000 –
500)
Year 2 10,250 1,025 (11,275) (including Nil
Rs 200 interest and
Rs 1,075premium)
3 – CG
Up to 31 December 20X8, the accounting entries are the same under both
scenarios.

The cash payments on the bond should be discounted to their present value
using the interest rate for a bond without the conversion rights, i.e. 8%.

Advanced Financial Accounting and Corporate Reporting (Study Text) 52

 (1) :

Date Cash Discount Present

Flow factor @ 8% value
_____ _______ Rs ___________ Rs

31DecX6 Interest 4,000 1/1.08 3,704

31DecX7 Interest 4,000 1/1.082 3,429
31DecX8 Interest
and
principal 104,000 1/1.083 82,559
––––––
Present value (the liability component) A
89,692
As the net proceeds of issue were B 100,000
So the equity component is B–A 10,308

(2) The annual finance costs and year end carrying amounts

Opening Effective Payments Closing

Balance interest 4% balance
rate 8%
Rs Rs Rs Rs

20X6 89,692 7,175 (4,000) 92,867

20X7 92,867 7,429 (4,000) 96,296
20X8 96,296 7,704 (4,000) 100,000

(3) (a) Conversion:

The carrying amounts at 31 December 20X8 are:

Rs

Equity 10,308
Liability – bond 100,000
–––––––
110,308

If the conversion rights are exercised, then 5,000 (Rs 100,000 ÷ 20)
equity shares of Rs 10 are issued and Rs 60,308 is classified as share
premium.

Advanced Financial Accounting and Corporate Reporting (Study Text) 53

 (b) Redemption:
The carrying amounts at 31 December 20X8 are the same as under
3a. On redemption, the Rs 100,000 liability is extinguished by cash
payments. The equity component remains within equity, probably as a
non-distributable reserve.

4 – MN
The principle at stake with derecognition or otherwise of receivables is
whether, under the factoring arrangement, the risks and rewards of ownership
pass from the trading company i.e. MN. The principal risk with regard to
receivables is the risk of bad debt.

In the first arrangement the Rs 180,000 has been received as a one off, non-
refundable sum. This is factoring without recourse for bad debts. The risk of
bad debt has clearly passed from MN to the factoring bank. Accordingly MN
should derecognise the receivable and there will be an expense of Rs 20,000
recognised. No liability will be recognised.

In the second arrangement the Rs 70,000 is simply a payment on account.

More may be received by MN implying that MN retains an element of reward.
The monies received are refundable in the event of default and as such
represent an obligation. This means that the risk of slow payment and bad
debt remains with MN who is liable to repay the monies so far received. As
such despite the passage of legal title the asset (i.e. receivable) should
remain recognised in the accounts of MN. In substance MN has borrowed Rs
70,000 and this loan should be recognised immediately. This will increase the
gearing of MN.

5 – KL
(1) On purchase the investment is recorded at the consideration paid
including, as the asset is classified as fair value through other
comprehensive income, the associated transaction costs:

Rs. in Million

Dr Asset 41
Cr Cash 41

At the reporting date the asset is remeasured and the gain is

recognised in other comprehensive income and taken to equity:

Dr Asset 19
Cr Other components of equity 19

Advanced Financial Accounting and Corporate Reporting (Study Text) 54

 On disposal, the asset is derecognised, the gain or loss on disposal is
determined by comparing disposal proceeds and carrying value, with
the result taken to profit or loss.

Dr Cash 70
Cr Asset 60
Cr Profit 10

Note that the any gains or losses previously taken to equity are not
recycled upon derecognition, although they may be reclassified within
equity.

(2) If KL had designated the investment as fair value through profit and
loss, the transaction costs would have been recognised as an expense
in profit or loss. So on purchase:

Dr Asset 40m
Cr Cash 40m
Dr Expense 1m
Cr Cash 1m

Subsequent measurement – at fair value through profit or loss:

Dr Asset 20m
Cr Profit 20m

On disposal the asset is derecognised with the gain taken to income

Dr Cash 70
Cr Asset 60
Cr Profit 10

Note that the reported profit on derecognition of Rs 10 million is the

same, whether designated as fair value through profit or loss or fair
value through other comprehensive income. This is one change
brought about by IFRS 9 as recycling of gains and losses previously
recognised in other comprehensive income is no longer done.
6 – HL
Because the coupon and the effective interest rate are the same, the carrying
amount of the principal will remain constant at Rs 10,000.

On 1 January 20X6 the impairment loss is calculated as:

Advanced Financial Accounting and Corporate Reporting (Study Text) 55

Rs

Carrying amount 10,000

Recoverable amount (being the present value of the future cash
flows discounted at the original effective interest rate:
i.e. 4,000× 1/1.1) (3,636)
–––––
Impairment loss 6,364

The impairment loss is recognised as an expense in profit or loss.

The asset will continue to be accounted for using amortised cost, based on
the revised carrying amount of the loan. In the last year of the loan, the
interest income of Rs 364 (3,636 × 10%) will be recognised in profit or loss.

7 – HH
In all scenarios the cost of the derivative on 1 January 20X6 is Rs 500 (Rs 5 ×
100) and an asset is recognised in the statement of financial position.

Dr Asset – option Rs 500

Cr Cash Rs 500

Outcome A
If the option is sold for Rs 1,500 (100 × Rs 15) before the exercise date, it is
derecognised at a profit of Rs 1,000.

Dr Cash Rs 1,500
Cr Asset – option Rs 500
Cr Profit Rs 1,000

Outcome B
If the option lapses unexercised, then it is derecognised and there is a loss to
be taken to profit or loss:

Dr Expense Rs 500
Cr Asset – option Rs 500

Outcome C
If the option is exercised, the option is derecognised, cash paid upon exercise
and the investment in shares is recognised at fair value. An immediate profit is
recognised:

Advanced Financial Accounting and Corporate Reporting (Study Text) 56

 Dr Asset – investment (100 × Rs 25) Rs 2,500
Cr Cash 100 × Rs 10) Rs 1,000
Cr Asset – option Rs 500
Cr Profit Rs 1,000

8 – ST
The fall in fair value of the equity interest of Rs 800,000 is taken to profit or
loss. This is matched with the increase in fair value of the interest rate swap
contact of Rs 750,000, resulting in a small net loss of Rs 50,000.

The effectiveness in the hedge arrangement can be evaluated by comparing

the change in the hedged item and the hedged instrument as follows:

Change in hedged item Rs 800,000

Change in hedging instrument Rs 750,000

Either: 800,000/750,000 = 107%

Or: 750,000/800,000 = 94%

As long as either one of the two measures above falls within the range 80% –
125%, the hedge is regarded as effective.

The above fair value hedge arrangement would therefore be regarded as

effective.

Advanced Financial Accounting and Corporate Reporting (Study Text) 57

Advanced Financial Accounting and Corporate Reporting (Study Text) 58
EMPLOYEE BENEFITS
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

• Apply and discuss the accounting treatment of defined contribution plans.

• Apply and discuss the accounting treatment of defined benefit plans.
• Account for gains and losses on settlements and curtailments.
• Apply and discuss the reporting of re-measurement gains and losses and the
‘Asset Ceiling’ test.
• Apply and discuss the accounting for short-term employee benefits.
• Apply and discuss the accounting for termination benefits.
• Apply and discuss the accounting for long-term Employee benefits.

Advanced Financial Accounting and Corporate Reporting (Study Text) 59

1 Introduction

1.1 IAS 19 Employee Benefits was issued in 1983 with the objective of specifying
the accounting treatment and associated disclosure requirements when
accounting for employee benefits. The original standard permitted a degree of
choice when accounting for employee benefits, which consequently resulted
in a lack of comparability between the financial statements of different entities.

IAS 19 has been subject to periodic amendment, with the most recent
significant amendments dated June 2011. The objectives of these
amendments are to improve users' understanding of how defined benefit
obligations and assets are reported, together with improving comparability of
reported information by eliminating some accounting treatment choices and
standardizing supporting disclosures. The revised version of IAS 19 is
effective for accounting periods commencing on or after 1 January 2013, with
early adoption permitted.

1.2 Types of employee benefit

IAS 19 identifies four types of employee benefit as follows:

• Post-employment benefits This normally relates to retirement

benefits, which will typically take the form of either a defined
contribution plan or a defined benefit plan (sometimes referred to as a
defined benefit scheme).

• Short-term employee benefits This includes wages and salaries,

bonuses and other benefits.

• Termination benefits Termination benefits arise when benefits

become payable upon employment being terminated, either by the
employer or by the employee accepting terms to have employment
terminated.

• Other long-term employee benefits This comprises other items not

within the above classifications and will include long-service leave or
awards, long-term disability benefits and other long-service benefits.

Each will be considered within this chapter, with particular emphasis upon
Post-employment defined benefit schemes.

Advanced Financial Accounting and Corporate Reporting (Study Text) 60

2 Post-Employment Benefit Plans

2.1 Introduction
A pension plan (sometimes called a postemployment benefit plan or scheme)
consists of a pool of assets, together with a liability for pensions owed to
employees. Pension plan assets normally consist of investments, cash and
(sometimes) properties. The return earned on the assets is used to pay
pensions.

There are two main types of pension plan:

• defined contribution plans
• defined benefit plans.

2.2 Defined contribution plans

The pension payable on retirement depends on the contributions paid into the
plan by the employee and the employer:

• The employer’s contribution is usually a fixed percentage of the

employee’s salary. The employer has no further obligation after this
amount is paid.
• Therefore, the annual cost to the employer is reasonably predictable.
• Defined contribution plans present few accounting problems, other than
ensuring that an accrual is made, where required, for contributions due,
but not yet paid, at the reporting date.

In this situation, the employee bears the uncertainty regarding the value of the
pension that will be paid upon retirement.

2.3 Defined benefit plans

The pension payable on retirement normally depends on either the final salary
or the average salary of the employee during their career.

• The employer undertakes to finance a pension income of a certain

amount,
– e.g. 2/3 × final salary × (years of service / 40 years)
• The employer has an ongoing obligation to make sufficient
contributions to the plan to fund the pensions.
• An actuary calculates the amount that must be paid into the plan each
year in order to provide the promised pension. The calculation is based
on various estimates and assumptions including:

– life expectancy
– investment returns
– wage inflation

Advanced Financial Accounting and Corporate Reporting (Study Text) 61

 • Therefore, the cost of providing defined benefit pensions will vary year
by year over the working life of employees due to changes in
circumstances, estimates and assumptions.

The actual contribution paid by the employer into a plan during an

accounting period does not usually represent the true cost to the
employer of providing pensions in that period. The financial statements
must reflect the true cost of providing pensions, rather than accounting
only for the cash contributions made into the pension plan.

2.4 Multi-employer plans

Often a small entity does not have the resources to run a pension plan in-
house, so it pays pension contributions over to an insurance company which
runs a multi-employer plan. Such a plan can be either of a defined
contribution nature or a defined benefit nature. Alternatively, a group may
operate a plan for the employees of all subsidiaries within the group.

3 Accounting for Post-Employment Benefit Plans

3.1 Defined contribution plans

The expense of providing pensions in the period is normally the same as the
amount of contributions paid.

• The entity should charge the agreed pension contribution to profit or

loss as an employment expense in each period.

• An asset or liability for pensions only arises if the cash paid does not
equal the value of contributions due for the period.

• IAS 19 requires disclosure of the amount recognised as an expense in

the period.

3.2 Defined benefit plans: the basic principles

The entity recognises both the liability for future pension payments, together
with the plan assets.

• If the liability exceeds the assets, there is a plan deficit (the usual
situation) and a liability is reported in the statement of financial position.

• If the plan assets exceed the liability, there is a surplus and an asset is
reported in the statement of financial position.

Advanced Financial Accounting and Corporate Reporting (Study Text) 62

 • In simple terms, the movement in the net liability (or asset) from one
reporting date to the next is reflected in the statement of
comprehensive income for the year.

Within the statement of total comprehensive income for the year, the
movement is separated into three components as follows:

• Service cost component, which includes current and past service

costs, together with any gains or losses on curtailments and
settlements. This is charged to profit or loss for the year.

• Net interest component, which is computed by applying the discount

rate to measure the plan obligation to the net defined benefit liability or
asset. This is charged (or credited) to profit or loss for the year.

• Remeasurement component comprises actuarial gains and losses

during the reporting period, including the returns on plan assets less
any amount taken to profit or loss as part of the net interest
component. This is taken to other comprehensive income for the year
and identified as item which will not be reclassified to profit or loss in
future periods.

3.3 Measuring the liability and the assets

In practice, the actuary measures the plan assets and liabilities by applying
carefully developed estimates and assumptions relevant to the defined benefit
pension plan.

• The plan liability is measured at the present value of the defined benefit
obligation, using the Projected Unit Credit Method. This is an actuarial
valuation method.

• Discounting is necessary because the liability will be settled many

years in the future and, therefore, the effect of the time value of money
is material. The discount rate used should be determined by market
yields on high quality corporate bonds at the end of the reporting
period, and applied to the net liability or asset as at the start of the
reporting period.

• Plan assets are measured at fair value. This is normally market value.
Where no market value is available, fair value is estimated (for
example, by calculating the present value of expected future cash
flows). Note that IFRS 13 Fair Value measurement (issued in May
2011) now provides a framework for determining how fair value should
be established.

Advanced Financial Accounting and Corporate Reporting (Study Text) 63

 • Valuations should be carried out with sufficient regularity to ensure that
the amounts recognised in the financial statements do not differ
materially from actual fair values at the reporting date. In other words,
IAS 19 does not prescribe a maximum time interval between
valuations.

• Where there are unpaid contributions at the reporting date, these are
not included in the plan assets. Unpaid contributions are treated as a
liability; they are owed by the entity/employer to the plan.

3.4 Recognising the amounts in the financial statements

Explanation of the terms used.

• Current service cost is the increase in the present value of the

defined benefit obligation resulting from employee service in the
current period. This is part of the service cost component.

• Past service cost is the change in the present value of the defined
benefit obligation for employee service in prior periods, resulting from a
plan amendment or a curtailment. In this context, a plan amendment is
defined as the introduction of, or withdrawal of, or changes to a
postemployment benefit plan. It may either increase or decrease
present value of the defined benefit obligation. Past service costs could
arise, for example, when there has been an improvement in the
benefits to be provided under the plan. This will apply whether or not
the benefits have vested (i.e. whether or not employees are
immediately entitled to those enhanced benefits), or whether they are
obliged to provide additional work and service to become eligible for

Advanced Financial Accounting and Corporate Reporting (Study Text) 64

 those enhanced benefits. They are part of the service cost component
for the year and are recognized at the earlier of:

• when the related restructuring costs are recognised, where it

is part of a restructuring, or
• when the related termination benefits are recognised, where
it is linked to termination benefits, or
• when the curtailment occurs; this is a matter of judgement –
it could be, for example, when the change is announced, or
when it is implemented.

• A curtailment occurs when there is a significant reduction in the

number of employees covered by the plan. This may be a
consequence of an individual event such as plant closure or
discontinuance of an operation, which will typically result in employees
being made redundant. Any gain or loss on curtailment is part of the
service cost component.

• A settlement occurs when an entity enters into a transaction to

eliminate the obligation for part or all of the benefits under a plan. For
example, an employee may leave the entity for a new job elsewhere,
and a payment is made from that pension plan to the pension plan
operated by the new employer. Any gain or loss on settlement is part of
the service cost component.

• Net interest component relates to the change in measurement in both

the plan obligation and plan assets arising from the passage of time. It
is computed by applying the discount rate used to measure the plan
obligation to the net liability (or asset) at the start of the reporting
period, irrespective of whether this results in net interest expense (or
interest income) for the year. Net interest is charged (or credited) as a
separate component to profit or loss for the year. In practical terms, the
discount rate will be used when reconciling the movements in the plan
obligation and plan assets for the year, whether this is done separately,
or on a combined net basis. This is because the principal issue when
accounting for defined benefit schemes is how to account for what is
effectively a longterm liability and how it is funded.

• Remeasurement component comprises actuarial gains and losses

arising during the reporting period, including the actual returns on plan
assets less any amount taken to profit or loss as part of the net interest
component. Actuarial gains and losses are increases and decreases in
the net pension asset or net liability that occur either because the
actuarial assumptions have changed or because of differences

Advanced Financial Accounting and Corporate Reporting (Study Text) 65

 between the previous actuarial assumptions and what has actually
happened (experience adjustments). This component is recognised in
other comprehensive income for the year and will not be recycled or
reclassified to profit or loss in future periods.

Note that this treatment of actuarial gains and losses is one of the key points
of the revisions made to IAS 19 in 2011. The revised standard eliminates the
choice of three possible accounting treatments for actuarial gains and losses
which was available under the original standard. This will help to improve
consistency and comparability of reported results.

Example 1

Defined Benefit Plan

The following information is provided in relation to a defined benefit plan
operated by Hamza Ltd. All transactions are assumed to occur at the
reporting date of the relevant year. At 1 January 20X4, the present value of
the obligation was Rs 140 million and the fair value of the plan assets
amounted to Rs 80 million.

20X4 20X5
Discount rate at start of year 4% 3%
Current and past service cost (Rs m) 30 32
Benefits paid (Rs m) 20 22
Contributions into plan (Rs m) 25 30
Present value of obligation at 31 December (Rs m) 200 230
Fair value of plan assets at 31 December (Rs m) 120 140

Required:
Reconcile the movement for the year in the plan asset and obligation;
determine the amounts to be taken to profit or loss and other comprehensive
income for the year, together with the net plan obligation or asset at 31
December 20X4 and 20X5.

Solution

Step 1: Determine the amount of the remeasurement component on the

assets and liabilities for the period.
This is done by analysing the change in the plan obligation and plan assets
for the period; the remeasurement components are balancing figures. The
current and past service cost increases the plan obligation. The benefits paid
during the year reduce both the plan obligation and plan assets. The
contributions into the scheme increase the plan assets. The net interest return

Advanced Financial Accounting and Corporate Reporting (Study Text) 66

 or charge reflects the growth in the plan assets and obligation due to the
passage of time.

Assets – stated at fair value

20X4 20X5
Rs m Rs m
Balance b/fwd at 1 Jan 80.0 120.0
Interest return (4% 20X4; 3% 20X5) 3.2 3.6
Benefits paid (20.0) (22.0)
Contributions into plan 25.0 30.0
Remeasurement component on assets (bal. fig) 31.8 8.4
––––– –––––
Balance c/fwd at 31 December 120.0 140.0
––––– –––––

Obligation – stated at present value

20X4 20X5
Rs m Rs m
Balance b/fwd at 1 January 140.0 200.0
Interest charge (4% 20X4; 3% 20X5) 5.6 6.0
Current and past service cost 30.0 32.0
Benefits paid (20.0) (22.0)
Remeasurement (gain) loss on plan
obligation (balancing figure) 44.4 14.0
––––– –––––
Balance c/fwd at 31 December 200.0 230.0
––––– –––––

Note that the interest return on the plan assets uses the same rate as used for
the plan obligation. This means that any difference between interest return
and actual return is included within the remeasurement component.

Advanced Financial Accounting and Corporate Reporting (Study Text) 67

 Step 2: Determine the net obligation or asset to be included in the
statement of financial position at the reporting date

20X4 20X5
Rs m Rs m
PV of plan obligation 200.0 230.0
FV of plan assets (120.0) (140.0)
––––– –––––
Closing net liability 80.0 90.0
––––– –––––

Step 3: Calculate the charge to profit or loss, together with other

comprehensive income for the year
Both the current service cost and the net interest cost are charged to profit or
loss for the year. The remeasurement component, which comprises actuarial
gains and losses, together with returns on plan assets to the extent that they
are not included within the net interest component, is taken to other
comprehensive income.

20X4 20X5
Profit or loss: Rs m Rs m
Service cost component:
Current and past service cost 30.0 32.0
Net interest component:
4% × Rs 60m 2.4
3% × Rs 80m 2.4
––––– –––––
32.4 34.4
Other comprehensive income

Net remeasurement component (W1) 12.6 5.6

––––– –––––
Total comprehensive income charge for year 45.0 40.0
––––– –––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 68

 Step 4: Reconcile the movement in the net obligation or asset for the year:
20X4 20X5
Rs m Rs m
Obligation bal. b/fwd 1 January 140.0 200.0
Asset bal. b/fwd at 1 January (80.0) (120.0)
––––– –––––
Net obligation b/fwd at 1 January 60.0 80.0
Current and past service cost 30.0 32.0
Net interest charge
4% × Rs 60m 2.4
3% × Rs 80m 0.4
Contributions into plan (25.0) (30.0)
Net remeasurement component on obligation
(W1) 12.6 5.6
––––– –––––
Net obligation c/fwd at 31 December 80.0 90.0
––––– –––––

(W1) Summary of remeasurement components for the year

This statement reconciles the figures in the statement of financial position

using the charges to profit or loss.
20X4 20X5
Rs m Rs m
Remeasurement component on obligation – loss 44.4 14.0
Remeasurement component on assets – gain (31.8) (8.4)
––––– –––––
Net remeasurement component 12.6 5.6
––––– –––––

3.5 The impact of revisions to IAS 19

The revisions made to IAS 19 in 2011 have gone some way to overcoming
weaknesses of the previous version of IAS 19 as follows:

• The classification of amounts to be included in profit or loss for the year

have been standardised into two components; the service cost
component and the net interest component.

• The net interest charge is recognition of the time value of money for
what is essentially a longterm net obligation. Any returns on plan
assets earned due to factors other than the time value of money are
accounted for as part of other comprehensive income.

Advanced Financial Accounting and Corporate Reporting (Study Text) 69

 • The choice of three possible accounting treatments of actuarial gains
and losses has now been removed. Actuarial gains and losses on the
plan obligation and plan assets are now referred to as remeasurement
components, and are accounted for as part of other comprehensive
income.

• Accounting for past service costs has been simplified, in that any such
costs incurred during an accounting period, which result in
amendments to the defined benefit plan which increase or decrease
the future obligation, are now immediately recognised either when the
related restructuring costs or termination benefits are recognised, or
when the plan amendment occurs. Previously, any such costs would
have been spread and recognised over the vesting period which
employees had to provide additional work and service to become
entitled to the enhanced benefits.

• Accounting for a curtailment gives rise to a gain or loss which is

included as part of past service cost.

• There should be improved consistency and comparability of information

as a consequence of the increased standardisation and simplification
of accounting treatments introduced by IAS 19 (revised).

3.6 Multi-employer plans

Multi-employer plans are classified as either defined contribution plans or
defined benefit plans. Defined contribution multi-employer plans do not pose a
problem because the employer’s cost is limited to the contributions payable.

Defined benefit multi-employer plans expose participating employers to the

actuarial risks associated with the current and former employees of other
entities. There are also potential problems because an employer may be
unable to identify its share of the underlying assets and liabilities.

IAS 19 states that where a multi-employer plan is a defined benefit plan, the
entity accounts for its proportionate share of the obligations, benefits and
costs associated with the plan in the same way as usual. However, where
sufficient information is not available to do this, the entity accounts for the plan
as if it were a defined contribution plan and discloses:

• the fact that the plan is a defined benefit plan.

• the reason why sufficient information is not available to account for the
plan as a defined benefit plan.

Advanced Financial Accounting and Corporate Reporting (Study Text) 70

 In this situation, the revised standard requires additional disclosures to be
made regarding the defined benefit plan, some of which may be quite onerous
for preparers of financial statements.

3.7 Past Service Costs

Past service costs arise either where a new retirement benefit plan is
introduced, or where the benefits under an existing plan are improved.

Where a new plan is introduced, employees are often given benefit rights for
any years of service before commencement of the plan.

• If employees have the right to receive benefits under the plan

immediately, the benefits are said to be ‘vested’ and the cost must be
recognised immediately.
• If employees become entitled to benefits only at some later date, the
benefits become vested at that later date, with the costs still recognized
immediately following revision of IAS 19 in June 2011.

Example 2

Accounting for Pension Plans

An entity operates a pension plan that provides a pension of 2% of final salary
for each year of service. The benefits become vested after five years of
service. On 1 January 20X5, the entity improves the pension to 2.5% of final
salary, for each year of service starting from 1 January 20X1. At the date of
the improvement, the present value of the additional benefits for service from
1 January 20X1 to 1 January 20X5, is as follows:
Rs 000
Employees with more than five years’ service at 1.1.X5 150
Employees with less than five years’ service at 1.1.X5
(average period until vesting: three years) 120
––––
270
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 71

 Required:

Explain how the additional benefits are accounted for in the financial
statements of the entity.

Solution
The entity recognises all Rs 270,000 immediately as an increase in the
defined benefit obligation following the amendment to the plan on 1 January
20X5. Whether or not the benefits have vested at that date is not relevant to
their recognition as an expense in the financial statements.

3.8 Curtailments and settlements

A curtailment occurs when there is a significant reduction in the number of
employees covered by a defined benefit plan. This may occur when there is
closure of a plant or discontinuance of an operation. A curtailment gives rise
to a past service cost which is recognised at the earlier of three possible
dates:

• when the related restructuring costs are recognised, if it is part of a

restructuring, or

• when the related termination benefits are recognised, if it is linked to

termination, or

• when the curtailment occurs.

A settlement is a transaction that eliminates all further legal or constructive

obligations for part or all of the benefits provided under a defined benefit plan.

For example, an employee leaves the entity for a new job elsewhere, and a
payment is made on behalf of the employee into the defined benefit plan of
the new employer.

The gain or loss arising on a curtailment or settlement should be recognized

when the curtailment or settlement occurs.

The gain or loss comprises the difference between the fair value of the plan
assets paid out and the reduction in the present value of the defined benefit
obligation.

Curtailments and settlements do not affect profit or loss if they have already
been allowed for in the actuarial assumptions; any impact would be
considered part of the remeasurement component.

Advanced Financial Accounting and Corporate Reporting (Study Text) 72

 Example 3

Curtailment and Settlement AB

AB decides to close a business segment. The segment’s employees will be
made redundant and will earn no further pension benefits after being made
redundant. Their plan assets will remain in the scheme so that the employees
will be paid a pension when they reach retirement age (i.e. this is a
curtailment without settlement).

Before the curtailment, the scheme assets had a fair value of Rs 500,000, and
the defined benefit obligation had a present value of Rs 600,000. It is
estimated that the curtailment will reduce the present value of the future
obligation by 10%, which reflects the fact that employees will have fewer
years of work and service with AB before retirement, and therefore be entitled
to a smaller pension than previously estimated or accounted for.

Required:

What is net gain or loss on curtailment and how will this be treated in
the financial statements?

Solution
The obligation is to be reduced by 10% x Rs 600,000 = Rs 60,000, with no
change in the fair value of the assets as they remain in the plan. The
reduction in the obligation represents a gain on curtailment which should be
included as part of the service cost component and taken to profit or loss for
the year. The net position of the plan following curtailment will be:

Before On After
curtailment
Rs 000 Rs 000 Rs 000
Present value of obligation 600 (60) 540
Fair value of plan assets (500) – (500)
––––– ––––– –––––
Net obligation in SOFP 100 (60) 40
––––– ––––– –––––
The gain on curtailment is Rs 60,000 and this will be included as part of the
service cost component in profit or loss for the year.

Advanced Financial Accounting and Corporate Reporting (Study Text) 73

4 The Asset Ceiling

4.1 Sometimes the deduction of plan assets from the pension obligation results in
a negative amount: i.e. an asset. IAS 19 states that pension plan assets
(surpluses) are measured at the lower of:

• the amount calculated as normal per earlier examples and illustrations.

or

• the total of the present value of any economic benefits available in the
form of refunds from the plan or reductions in future contributions to the
plan.

Applying the ‘asset ceiling’ means that a surplus can only be recognised to
the extent that it will be recoverable in the form of refunds or reduced
contributions in future. This would make it compatible with the definition of an
asset as included within the 2010 Conceptual Framework for Financial
Reporting.

Example 4

The Asset Ceiling

The following information relates to a defined benefit plan: Rs 000
Fair value of plan assets 950
Present value of pension liability 800
Present value of future refunds and reductions in future
Contributions 70

Required:

What is the value of the asset that recognised in the financial

statements?

Solution
The amount that can be recognised is the lower of:
Rs 000
Present value of plan obligation 800
Fair value of plan assets (950)
–––––
(150)
–––––
Rs 000
PV of future refunds and/or reductions in future contributions (70)
––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 74

 Therefore the amount of the asset recognised is restricted to Rs 70,000.

4.2 IFRIC 14 – The limit on a defined benefit asset, minimum funding

requirements and their interaction
The subject matter of IFRIC 14 was not incorporated into the 2011 revisions
of IAS 19, and therefore is still relevant where there may be a net asset for the
defined benefit plan at the reporting date. Although IFRICs are not
examinable documents for the syllabus, the principles applied by IFRIC 14 are
consistent with the Framework for Financial Reporting 2010 and are therefore
considered relevant to your studies in that context.

IFRIC 14 addresses areas of IAS 19 where detailed guidance is lacking,

namely:

• How to determine the asset ceiling.

• The effect of a minimum funding requirement (MFR) on that
calculation.
• When an MFR creates an onerous obligation that should be recognised
as a liability.

It therefore only applies to those entities which have a plan surplus or are
subject to minimum funding requirements.

IAS 19 states that pension plan surpluses are limited to the total of the
present value of any economic benefits available in the form of refunds from
the plan or reductions in future contributions to the plan. IFRIC 14, clarifies
this by defining ‘available’ as having an unconditional right to realise the
benefit at some point during the life of the plan or when the plan is settled,
even if the benefit is not realisable immediately at the reporting date. If such a
right is conditional, then no asset in respect of refunds or reductions in
contributions can be recognised.

5 Disclosure Requirements

IAS 19 has extensive disclosure requirements, which were added to when it

was revised in 2011. In summary, an entity should disclose the following
information about defined benefit plans:

• explanation of the regulatory framework within which the plan operates,

together with explanation of the nature of benefits provided by the plan.

• explanation of the nature of the risks the entity is exposed to as a

consequence of operating the plan, together with explanation of any
plan amendments, settlements or curtailments in the year.

Advanced Financial Accounting and Corporate Reporting (Study Text) 75

 • the entity’s accounting policy for recognising actuarial gains and
losses, together with disclosure of the significant actuarial assumptions
used to determine the net defined benefit obligation or assets. Although
there is no longer a choice of accounting policy for actuarial gains and
losses, it may still be helpful to users to explain how they have been
accounted for within the financial statements.

• a general description of the type of plan operated.

• a reconciliation of the assets and liabilities recognised in the statement

of financial position.

• a reconciliation showing the movements during the period in the net

liability (or asset) recognised in the statement of financial position.

• the charge to total comprehensive income for the year, separated into
the appropriate components.

• analysis of the remeasurement component to identify returns on plan

assets, together with actuarial gains and losses arising on the net plan
obligation.

• sensitivity analysis and narrative description of how the defined benefit

plan may affect the nature, timing and uncertainty of the entity’s future
cash flows.

6 Other Employee Benefits

6.1 IAS 19 covers a number of other issues in addition to post-employment

benefits as follows:

Short-term employee benefits – This includes a number of issues including:

• Wages and salaries and bonuses and other benefits. The general
principle is that wages and salaries costs are expenses as they are
incurred on a normal accruals basis, unless capitalisation is permitted
in accordance with another reporting standard, such as IAS 16 or IAS
38. Bonuses and other short-term payments are recognised using
normal criteria of establishing an obligation based upon past events
which can be reliably measured.

• Compensated absences. This covers issues such as holiday pay, sick

leave, maternity leave, jury service, study leave and military service.

Advanced Financial Accounting and Corporate Reporting (Study Text) 76

 The key issue is whether the absences are regarded as being
accumulating or non-accumulating:

– accumulating benefits are earned over time and are capable of

being carried forward. In this situation, the expense for future
compensated absences is recognised over the period services
are provided by the employee. This will typically result in the
recognition of a liability at the reporting date for the expected
cost of the accumulated benefit earned but not yet claimed by
an employee. An example of this would be a holiday pay accrual
at the reporting date where unused holiday entitlement can be
carried forward and claimed in a future period.

– for non-accumulating benefits, an expense should only be

recognised when the absence occurs. This may arise, for
example, where an employee continues to receive their normal
remuneration whilst being absent due to illness or other
permitted reason. A charge to profit or loss would be made only
when the authorised absence occurs; if there is no such
absence, there will be no charge to profit or loss.

• Benefits in kind. Recognition of cost should be based on the same

principles as benefits payable in cash; it should be measured based upon
the cost to the employer of providing the benefit and recognised as it is
earned.

6.2 Termination benefits

The definition of what constitutes termination benefits, and how they should
be accounted for, was included in the revised edition of IAS 19 issued in June
2011. Termination benefits may be defined as benefits payable as a result of
employment being terminated, either by the employer, or by the employee
accepting voluntary redundancy. Such payments are normally in the form of a
lump sum; entitlement to such payments is not accrued over time, and only
become available in a relatively short period prior to any such payment being
agreed and paid to the employee. The obligation to pay such benefits is
recognised either when the employer can no longer withdraw the offer of such
benefits (i.e. they are committed to paying them), or when it recognises
related restructuring costs (normally in accordance with IAS 37). Payments
which are due to be paid more than twelve months after the reporting date
should be discounted to their present value.

Advanced Financial Accounting and Corporate Reporting (Study Text) 77

6.3 Other long-term employee benefits
This comprises other items not within the above classifications and will
include long-service leave, long-term disability benefits and other long-service
benefits. These employee benefits are accounted for in a similar manner to
accounting for post-employment benefits, typically using the projected unit
credit method, as benefits are payable more than twelve months after the
period in which services are provided by an employee.

Advanced Financial Accounting and Corporate Reporting (Study Text) 78

Chapter Summary

Advanced Financial Accounting and Corporate Reporting (Study Text) 79

 Self-Test Questions

1. An entity makes contributions to the pension fund of employees at a rate of

5% of gross salary. The contributions made are Rs 10,000 per month for
convenience with the balance being contributed in the first month of the
following accounting year. The wages and salaries for 20X6 are Rs 2.7m.

Required:

Calculate the pension expense for 20X6, and the accrual/prepayment at

the end of the year.
2. The following information is provided relating to a defined benefit plan
operated by JS Ltd. All transactions are assumed to occur at the reporting
date. At 1 January 20X1, the present value of the obligation was Rs 1,000,000
and the fair value of the plan assets amounted to Rs 900,000.

20X3 20X1 20X2

Discount rate at start of year 10% 9% 8%

Current and past service cost (Rs 000) 125 130 138
Benefits paid (Rs 000) 150 155 165
Contributions paid into plan (Rs 000) 90 95 105
PV of obligation at 31 December (Rs 000) 1,350 1,340 1,450
FV of plan assets at 31 December (Rs 000) 1,200 1,150 1,300

Required:

Show how the defined benefit plan would be shown in the financial
statements for each of the years ended 31 December 20X1, 20X2 and
20X3 respectively
3. TC has a defined benefit pension plan and prepares financial statements to
31 March each year. The following information is relevant for the year ended
31 March 20X3:

• The net pension obligation at 31 March 20X3 was Rs 55 million. At 31

March 20X2, the net obligation was Rs 48 million, comprising the
present value of the plan obligation stated at Rs 100 million, together
with plan assets stated at fair value of Rs 52 million.

• The discount rate relevant to the net obligation was 6.25% and the
actual return on plan assets for the year was Rs 4 million.

• The current service cost was Rs 12 million.

Advanced Financial Accounting and Corporate Reporting (Study Text) 80

 • At 31 March 20X3, TC granted additional benefits to those currently
receiving benefits that are due to vest over the next four years and
which have a present value of Rs 4 million at that date. They were not
allowed for in the original actuarial assumptions.

 During the year, TC made pension contributions of Rs 8 million into the

scheme and the scheme paid pension benefits in the year amounting
to Rs 3 million.

Required:

Prepare a summary of the movement in the net obligation for the year to
31 March 20X3, together with supporting explanation.
4. The following information relates to the defined benefit plan operated by
M.J Ltd for the year ended 30 June 20X4:
Rs m
FV of plan assets b/fwd at 30 June 20X3 2,600
PV of obligation b/fwd at 30 June 20X3 2,000
Current service cost for the year 100
Benefits paid in the year 80
Contributions into plan 90
FV of plan assets at 30 June 20X4 3,100
PV of plan obligation at 30 June 20X4 2,400

Discount rate for the defined benefit obligation – 10%

4 M.J Ltd has identified that the asset ceiling at 30 June 20X3 and 30 June
20X4, based upon the present value of future refunds from the plan and/or
reductions in future contributions amounts to Rs 200m at 30 June 20X3 and
30 June 20X4.

Required:
(a) Reconcile the movement in the plan assets and obligation, to
determine what is charged in the statement of comprehensive income
for the year ended 30 June 20X4, together with identification of the
balance reported on the statement of financial position at 30 June
20X4.

(b) Explain the purpose of the asset ceiling, together with its impact upon
accounting for the defined benefit plan operated by M.J Ltd.

Advanced Financial Accounting and Corporate Reporting (Study Text) 81

Answers

1. This appears to be a defined contribution scheme.

The charge to income should be:

Rs 2.7m × 5% = Rs 135,000

The statement of financial position will therefore show an accrual of Rs

15,000, being the difference between the Rs 135,000 and the Rs 120,000
paid in the year.

2. Step 1 – Calculate remeasurement gains and losses

On obligations 20X1 20X2 20X3

Rs 000 Rs 000 Rs 000
Obligation at start of the year 1,000 1,350 1,340
Interest charge (10% X1/ 9% X2/ 8% X3) 100 122 107
Current and past service cost 125 130 138
Benefits paid (150) (155) (165)
Remeasurement component (gain) loss – bal. fig 275 (107) 30
––––– ––––– –––––
Obligation at end of the year 1,350 1,340 1,450
––––– ––––– –––––

On assets 20X1 20X2 20X3

Rs 000 Rs 000 Rs 000
Fair value at start of the year 900 1,200 1,150
Interest return: (10% X1/ 9% X2/ 8% X3) 90 108 92
Contributions into plan 90 95 105
Benefits paid (150) (155) (165)
Remeasurement component gain (loss) – bal. fig 270 (98) 118
––––– ––––– –––––
Market value at end of the year 1,200 1,150 1,300
––––– ––––– –––––

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 Step 2 – The statement of financial position
20X1 20X2 20X3
Rs 000 Rs 000 Rs 000
PV of obligation at 31 December 1,350 1,340 1,450
FV of assets at 31 December (1,200) (1,150) (1,300)

Net pension (asset) liability 150 190 150

Step 3 – Profit or loss and other comprehensive income for the year

20X1 20X2 20X3

Service cost component Rs 000 Rs 000 Rs 000
Current and past service cost 125 130 138
Net interest component 10 14 15
––––– ––––– –––––
Charge to profit or loss 135 144 153
Other comprehensive income:
Net remeasurement component (W1) 5 (9) (88)
––––– ––––– –––––
Total charge to comprehensive income 140 135 65
––––– ––––– –––––

Step 4 – Reconcile the movement in the net obligation or asset for the
year

20X1 20X2 20X3

Rs 000 Rs 000 Rs 000
Obligation bal. b/fwd at 1 January 1,000 1350 1,340
Asset bal. b/fwd at 1 January (900) (1,200) (1,150)
––––– ––––– –––––
Net obligation at 1 January 100 150 190
Net interest:
10% × 100 10
9% × 150 14
8% × 190 15
Current and past service cost 125 130 138
Contributions into plan (90) (95) (105)
Net remeasurement component 5 (9) (88)
––––– ––––– –––––
Net obligation at reporting date 150 190 150
––––– ––––– –––––

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 (W1) Net remeasurement component:
20X1 20X2 20X3
Rs 000 Rs 000 Rs 000
Remeasurement component in
obligation (gain)/loss 275 (107) 30
Remeasurement component in
assets (gain)/loss (270) 98 (118)
––––– ––––– –––––
Net remeasurement (gain)/loss 5 (9) (88)
––––– ––––– –––––

3. Rs m
Net obligation brought forward 48
Net interest component @ 6.25% 3
Service cost component:
Current service cost 12
Past service cost 4 16
––––
Contributions into the plan (8)
Remeasurement component (bal. fig) (4)
––––
Net obligation carried forward 55
––––
Explanation:
• The discount rate is applied to the net obligation brought forward and
will be charged to profit or loss for the year as the net interest
component.

• The current year service cost, together with the past service cost forms
the service cost component which is charged to profit or loss for the
year. Past service cost is charged in full, usually when the scheme is
amended, rather than when the additional benefits vest.

• To the extent that there has been a return on assets in excess of the
amount identified by application of the discount rate to the fair value of
plan assets, this is part of the remeasurement component (i.e. Rs 4m –
Rs 3.25m (Rs 52m x 6.25%) = Rs 0.75m).

• Contributions paid into the scheme during the year will reduce the net
obligation.

• Benefits paid of Rs 3 million will reduce both the scheme assets and
the scheme obligation, so will have no impact on the net obligation.

Advanced Financial Accounting and Corporate Reporting (Study Text) 84

 (a) PV FV Ceiling Net Note
Obligation Assets Adjust Defined
Benefit
asset

Rs m Rs m Rs m Rs m
Balance b/fwd 2,000 (2,600) 400 (200) 1
Interest @10% 200 (260 40 (20) 2
Service cost 100 100 3
Benefits paid (80) 80 4
Contributions in (90) (90) 5
––––– ––––– ––––– –––––
Subtotal: 2,220 (2,870) 440 (210)
Remeasurement
component:
Obligation – loss 180 (180)
Asset – gain (230) 230
10 10 6
––––– ––––– ––––– –––––
Balance c/fwd 2,400 (3,100) 500 (200)
––––– ––––– ––––– –––––

* note that this is effectively a balancing figure.

Explanation
(1) The asset ceiling adjustment at the previous reporting date of 30 June
20X3 measures the net defined benefit asset at the amount
recoverable by refunds and/or reduced future contributions, stated at
Rs 200m. In effect, the value of the asset was reduced for reporting
purposes at 30 June 20X3.

(2) Interest charged on the obligation or earned on the plan assets is

based upon the discount rate for the obligation, stated at 10%. This will
then require adjustment to agree with the net return on the net plan
asset at the beginning of the year. Net interest earned is taken to profit
or loss for the year.

(3) The current year service cost increases the plan obligation, which
therefore reduces the net plan asset. The current year service cost is
taken to profit or loss for the year.

(4) Benefits paid in the year reduce both the plan obligation and the plan
assets by the same amount.

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 (5) Contributions into the plan increase the fair value of plan assets, and
also the net plan asset during the year.

(6) The remeasurement component, including actuarial gains and losses

for the year, is identified to arrive at the present value of the plan
obligation and the fair value of the plan assets at 30 June 20X4. As
there is a net asset of Rs 700m (Rs 3,100m – Rs 2,400m) for the
defined benefit pension plan, the asset ceiling test is applied to restrict
the reported asset to the expected future benefits in the form of refunds
and/or reduced future contributions, which is stated in the question to
be Rs 200m. To the extent that an adjustment is required to the net
asset at the reporting date, this is part of the net remeasurement
component.

(b) The asset ceiling test is designed to ensure that any net pension asset
is not overstated on the statement of financial position. If it can be
reliably measured based upon the present value of future economic
benefits to be received, either in the form of reduced future
contributions or refunds of contributions already paid, this will comply
with the definition of an asset from the 2010 Conceptual Framework for
Financial Reporting.

If the asset ceiling test was not applied, at 30 June 20X4, there would
be a net asset for the defined benefit plan amounting to Rs 700 m (Rs
3,100 – Rs 2,400). However, this amount would not be fully
represented by the right to receive future economic benefits in the form
of refunds of amounts already paid or reductions in future contributions
into the plan. Consequently, the asset would be overstated as, even
though the plan assets are stated at fair value, they are held to meet
future payments in respect of a long-term obligation.

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Advanced Financial Accounting and Corporate Reporting (Study Text) 87
SHARE BASED PAYMENTS
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

• Apply and discuss the recognition and measurement criteria for Share based
payment transactions.
• Account for modifications, cancellations and settlements of Share based
payment transactions.

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1 Share-Based Payment

1.1 Introduction
Share-based payment has become increasingly common. Share-based
payment occurs when an entity buys goods or services from other parties
(such as employees or suppliers), and settles the amounts payable by issuing
shares or share options to them.

• Part of the remuneration of directors is often in the form of shares or

options. Employees may also be granted share options.
• Many new ‘e-businesses’ do not expect to be profitable in their early
years, so try to attract quality staff by offering to employees share
schemes rather than high cash salaries.

1.2 The problem

If a company pays for goods or services in cash, an expense is recognized in
profit or loss. If a company ‘pays’ for goods or services in share options, there
is no cash outflow and under traditional accounting, no expense would be
recognised.

• But when a company issues shares to acquire an investment in

another entity, it is accepted that the acquirer has incurred a cost that
should be recognised in the financial statements at fair value. Issuing
shares to acquire goods or services is arguably no different.
• When a company issues shares to employees, a transaction has
occurred; the employees have provided a valuable service to the entity,
in exchange for the shares/options. It is illogical not to recognise this
transaction in the financial statements.
• IFRS 2 Share-based payment was issued to deal with this accounting
anomaly. IFRS 2 requires that all Share-based payment transactions
must be recognised in the financial statements.

2 Types of Transaction

2.1 IFRS 2 applies to all types of Share-based payment transaction. There are
two main types:

The most common type of Share-based payment transaction is where share

options are granted to employees or directors as part of their remuneration.

Advanced Financial Accounting and Corporate Reporting (Study Text) 89

 • in an equity settled share based payment transaction, the entity
receives goods or services in exchange for equity instruments of the
entity (e.g. shares or share options).

• in a cash settled Share-based payment transaction, the entity

acquires goods or services in exchange for amounts of cash measured
by reference to the entity’s share price.

Illustration : How options work

2.2 The basic principles

When an entity receives goods or services as a result of a share based
payment transaction, it recognises either an expense or an asset.

• If the goods or services are received in exchange for equity (e.g., for
share options), the entity recognises an increase in equity.
– The double entry is: Dr Expense/Asset; Cr Equity (normally a
special reserve).
• If the goods or services are received or acquired in a cash settled
share based payment transaction, the entity recognises a liability.
– The double entry is: Dr Expense/Asset; Cr Liability.

All share based payment transactions are measured at fair value.

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3 Equity-Settled Share-Based Payment Transactions

3.1 Measurement
The basic principle is that all transactions are measured at fair value.

Fair value is the amount for which an asset could be exchanged, a liability
settled, or an equity instrument granted could be exchanged, between
knowledgeable, willing parties in an arm’s length transaction.

How fair value is determined:

The grant date is the date at which the entity and another party agree to the
arrangement.

3.2 Determining Fair Value

Where a share-based payment transaction is with parties other than
employees, it is assumed that the fair value of the goods and services
received can be measured reliably, at their cash price for example.

Where shares or share options are granted to employees as part of their

remuneration, it is not usually possible to arrive at a reliable value for the
services received in return. For this reason, the entity measures the
transaction by reference to the fair value of the equity instruments granted.

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 The fair value of equity instruments is market value, if this is available. Where
no market price is available (for example, if the instruments are unquoted), a
valuation technique is used.

The fair value of share options is harder to determine. In rare cases there may
be publicly quoted traded options with similar terms, whose market value can
be used as the fair value of the options we are considering. Otherwise, the fair
value of options must be estimated using a recognised option pricing model.
IFRS 2 does not require any specific model to be used. The most commonly
used is the Black Scholes model.

3.3 Allocating the expense to reporting periods

Some equity instruments granted vest immediately, meaning that the holder is
unconditionally entitled to the instruments. In this case, the transaction should
be accounted for in full on the grant date.

The vesting date is the date on which the counterparty (e.g., the employee)
becomes entitled to receive the cash or equity instruments under the
arrangement.

• Note the difference in meaning between the grant date of options and
the vesting date.

However, when share options are granted to employees as part of their

remuneration package, the employees usually have to meet specified
conditions before actually becoming entitled to the shares. For example, they
may have to complete a specified period of service or to achieve particular
performance targets.

• For this reason, the transaction normally has to be recognised over

more than one accounting period.

IFRS 2 states that an entity should account for services as they are rendered
during the vesting period.

• The vesting period is the period during which all the specified vesting
conditions are satisfied.

Equity-settled Share-based payment transactions

On 1 January 20X1, A awards 1,000 share options to an employee, on
condition that he is still working for the company in two years’ time. The grant
date is 1 January 20X1. The vesting period is from 1 January 20X1 to 31
December 20X2. The vesting date is 31 December 20X2.

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 The entity should recognise an amount for the goods or services received
during the vesting period based on the best available estimate of the number
of equity instruments expected to vest.

• Each year it should revise that estimate of the number of equity

instruments expected to vest if subsequent information indicates that
this number differs from previous estimates.

• On vesting date, the entity should revise the estimate to equal the
number of equity instruments that actually vest.

• Sometimes one of the vesting conditions is a ‘market condition’, for

example, where the share price must be above a certain amount on the
vesting date. Market conditions are taken into account when estimating
the fair value of the option at the grant date. Failure to satisfy a market
condition is not taken into account when subsequently calculating the
amounts recognised in profit and loss and equity over the vesting
period.

Before the shares vest, the amount recognised in equity is normally credited
to a special reserve called (for example) ‘shares to be issued’.

• After the share options vest and the shares are issued, the relevant
amount is usually transferred to share capital.

Example 1
On 1 January 20X1 an entity grants 100 share options to each of its 500
employees. Each grant is conditional upon the employee working for the entity
until 31 December 20X3. At the grant date the fair value of each share option
is Rs15.

During 20X1, 20 employees leave and the entity estimates that a total of 20%
of the 500 employees will leave during the three year period.

During 20X2, a further 20 employees leave and the entity now estimates that
only a total of 15% of its 500 employees will leave during the three year
period.

During 20X3, a further 10 employees leave.

Calculate the remuneration expense that will be recognised in respect of the

Share-based payment transaction for each of the three years ended 31
December 20X3.

Advanced Financial Accounting and Corporate Reporting (Study Text) 93

 Solution
The entity recognises the remuneration expense as the employees’ services
are received during the three year vesting period. The amount recognised is
based on the fair value of the share options granted at the grant date (1
January 20X1).

Assuming that no employees left, the total expense would be Rs750,000 (100
× 500 × 15) and the expense charged to profit or loss for each of the three
years would be Rs250,000 (750,000/3).

In practice, the entity estimates the number of options expected to vest by

estimating the number of employees likely to leave. This estimate is revised at
each year end. The expense recognised for the year is based on this re-
estimate. On the vesting date (31 December 20X3), it recognises an amount
based on the number of options that actually vest.

A total of 50 employees left during the three year period and therefore 45,000
options (500 – 50 × 100) vested.

The amount recognised as an expense for each of the three years is

calculated as follows:

Expense for year Cumulative Expense

(change in Cumulative) at year end
____ ________________________ Rs Rs

20X1 100 × (500 × 80%) × 15 × 1/3 200,000 200,000

20X2 100 × (500 × 85%) × 15 × 2/3 225,000 425,000
20X3 45,000 × 15 250,000 675,000

The financial statements will include the following amounts:

Income statement 20X1 20X2 20X3

Rs Rs Rs

Staff costs 200,000 225,000 250,000

––––––– ––––––– –––––––

Statement of financial position Year 1 Year 2 Year 3

Included with equity 200,000 425,000 675,000

––––––– ––––––– –––––––

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 Example 2

Equity-settled Share-based payment transactions:

JJ grants 100 share options to each of its 20 employees providing they meet
performance targets for each of the next two years. At the end of the first
year, it was estimated that 80% of the employees would meet the targets over
both years. Improved performance meant that at the end of the second year it
turned out that 85% of employees had done so.

The fair value of the option at the grant date was Rs10.

Calculate the charge to profits for each year.

Solution
At the end of year 1, 16 employees are eligible for the shares (20 × 80%).

The fair value of the options is: 100 × 16 × Rs10 = Rs16,000

This is spread over the two year vesting period, so the charge to profits Rs
8,000 (Rs16,000/2).

Dr Staff costs (income statement) Rs 8,000

Cr Equity Rs 8,000

At the end of the second year, 17 employees are eligible for shares (20 ×
85%). This is the vesting date, so these 17 employees will receive share
options.

The fair value of the options is: 100 × 17 × Rs10 = Rs 17,000

Rs 8,000 has already been charged to profits in the previous year, so to

increase the charge and the corresponding equity balance, the charge for the
second year is Rs 9,000.

Dr Staff costs Rs 9,000

Cr Equity Rs 9,000

Accounting after vesting date

IFRS 2 states that no further adjustments to total equity should be made after
vesting date. This applies even if some of the equity instruments do not vest
(for example, because some of the employees do not exercise their right to
buy shares).

Advanced Financial Accounting and Corporate Reporting (Study Text) 95

 • But for those who do not vest, a transfer may be made from shares to
be issued to retained earnings.

4 Cash-Settled Share-based Payment Transactions

4.1 Examples of cash-settled share-based payment transactions include

• share appreciation rights (SARs), where employees become entitled to
a future cash payment based on the increase in the entity’s share price
from a specified level over a specified period of time.

• those where employees are granted a right to shares that are

redeemable. This gives them a right to receive a future payment of
cash.

The basic principle is that the entity measures the goods or services acquired
and the liability incurred at the fair value of the liability.

• Until the liability is settled, the entity remeasures the fair value of the
liability at each reporting date until the liability is settled and at the date
of settlement. (Notice that this is different from accounting for equity
Share-based payments, where the fair value is fixed at the grant date)

• Changes in fair value are recognised in profit or loss for the period.

Example 3
On 1 January 20X1 an entity grants 100 cash share appreciation rights (SAR)
to each of its 300 employees, on condition that they continue to work for the
entity until 31 December 20X3.

During 20X1, 20 employees leave. The entity estimates that a further 40 will
leave during 20X2 and 20X3.

During 20X2, 10 employees leave. The entity estimates that a further 20 will
leave during 20X3.

During 20X3, 10 employees leave.

Fair value
Rs

20X1 10.00
20X2 12.00
20X3 15.00

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 Calculate the amount to be recognised as an expense for each of the three
years ended 31 December 20X3 and the liability to be recognized in the
statement of financial position at 31 December for each of the three years.

Solution
Year Liability at Expense
Year-end for year
Rs. ‘000’ Rs. ‘000’

20X1 ((300 – 20 – 40) × 100 × 10 × 1/3) 80 80

20X2 ((300 – 20 – 10 – 20) × 100 × 12 × 2/3) 200 120
20X3 ((300 – 20 – 10 – 10) × 100 × 15) 390 190

4.2 Hybrid Transactions

Some Share-based payment transactions give either the reporting entity or
the other party the choice of settling in cash or in equity instruments.

IFRS 2 states that if the entity has incurred a liability to settle in cash or other
assets, the transaction should be accounted for as a Cash-settled Share-
based payment transaction. Otherwise, it should be accounted for as an
equity-settled share-based payment transaction.

5 Disclosures

Entities should disclose information that enables users of the financial

statements to understand the nature and extent of Share-based payment
arrangements that existed during the period. The main disclosures are as
follows:

• a description of each type of Share-based payment arrangement that

existed at any time during the period.

• the number and weighted average exercise prices of share options:

(i) outstanding at the beginning of the period.
(ii) granted during the period.
(iii) forfeited during the period.
(iv) exercised during the period.
(v) expired during the period.
(vi) outstanding at the end of the period.
(vii) exercisable at the end of the period.

• for share options exercised during the period, the weighted average
share price at the date of exercise.

Advanced Financial Accounting and Corporate Reporting (Study Text) 97

 • for share options outstanding at the end of the period, the range of
exercise prices and weighted average remaining contractual life.

IFRS 2 also requires disclosure of information that enables users of the

financial statements to understand how the fair value of the goods or services
received, or the fair value of the equity instruments granted, during the period
was determined.

Entities should also disclose information that enables users of the financial
statements to understand the effect of Share-based payment transactions on
the entity’s profit or loss for the period and on its financial position, that is:
• the total expense recognised for the period arising from Share-based
payment transactions.
• for liabilities arising from Share-based payment transactions:
– the total carrying amount at the end of the period.
– the total intrinsic value at the end of the period of liabilities for
which the counterparty’s right to cash or other assets had vested
by the end of the period.

6 Modifications, Cancellations and Settlements

6.1 Modifications to the terms on which equity instruments are granted

An entity may alter the terms and conditions of share option schemes during
the vesting period.
• For example, it might increase or reduce the exercise price of the
options, which makes the scheme less favourable or more favourable
to employees.

• It might also change the vesting conditions, to make it more likely or

less likely that the options will vest.

The general rule is that, apart from dealing with reductions due to failure to
satisfy vesting conditions, the entity must always recognise at least the
amount that would have been recognised if the terms and conditions had not
been modified (that is, if the original terms had remained in force).

• If the change reduces the amount that the employee will receive, there
is no reduction in the expense recognised in profit or loss.

• If the change increases the amount that the employee will receive, the
difference between the fair value of the new arrangement and the fair
value of the original arrangement (the incremental fair value) must be
recognised as a charge to profit. The extra cost is spread over the
period from the date of the change to the vesting date.
Advanced Financial Accounting and Corporate Reporting (Study Text) 98
 Example 4
An entity grants 100 share options to each of its 500 employees, provided that
they remain in service over the next three years. The fair value of each option
is Rs20.

During year one, 50 employees leave. The entity estimates that a further 60
employees will leave during years two and three.

At the end of year one the entity reprices its share options because the share
price has fallen. The other vesting conditions remain unchanged. At the date
of repricing, the fair value of each of the original share options granted (before
taking the repricing into account) was Rs10. The fair value of each repriced
share option is Rs15.

During year two, a further 30 employees leave. The entity estimates that a
further 30 employees will leave during year three.

During year three, a further 30 employees leave.

Calculate the amounts to be recognised in the financial statements for each of

the three years of the scheme.

Solution
The repricing means that the total fair value of the arrangement has increased
and this will benefit the employees. This in turn means that the entity must
account for an increased remuneration expense. The increased cost is based
upon the difference in the fair value of the option, immediately before and
after the repricing. Under the original arrangement, the fair value of the option
at the date of repricing was Rs10, which increased to Rs15 following the
repricing of the options, for each share estimated to vest. The additional cost
is recognised over the remainder of the vesting period (years two and three).

Advanced Financial Accounting and Corporate Reporting (Study Text) 99

 The amounts recognised in the financial statements for each of the three
years are as follows:
Amount Expense
included
in equity
Rs Rs
Year one Original (500 – 50 – 60)
× 100 × 20 × 1/3 260,000 260,000
––––––– ––––––

Year two Original (500 – 50 – 30 – 30)×100×20×2/3 520,000 260,000

Incremental (500 – 50 – 30 – 30) × 100 × 5 × ½ 97,500 97,500
––––––– –––––––
617,500 357,500
––––––– –––––––
Year three (500 – 50 – 30 – 30)
Original × 100 × 20 780,000 260,000
Incremental (500 – 50 – 30 – 30)
× 100 × 5 195,000 97,500
––––––– –––––––
975,000 357,500
––––––– –––––––
Example 5
An entity grants 100 share options to each of the 15 employees in its sales
team, on condition that they remain in service over the next three years.
There is also a performance condition: the team must sell more than 40,000
units of a particular product over the three year period. At the grant date the
fair value of each option is Rs20.

During Year 2, the entity increases the sales target to 70,000 units. By the
end of Year 3, only 60,000 units have been sold and the share options do not
vest.

All 15 employees remain with the entity for the full three years.

Calculate the amounts to be recognised in the financial statements for

each of the three years of the scheme.

Solution
IFRS 2 states that when a share option scheme is modified, the entity must
recognise, as a minimum, the services received, measured at the fair value at
the grant date. The employees have not met the modified sales target, but did
meet the original target set on grant date.

Advanced Financial Accounting and Corporate Reporting (Study Text) 100

 This means that the entity must recognise the expense that it would have
incurred had the original scheme continued in force.

The total amount recognised in equity is Rs30,000 (15 × 100 × 20). The entity
recognises an expense of Rs10,000 for each of the three years.

6.2 Cancellations and settlements

An entity may also cancel or settle a share option scheme before vesting
date. In a settlement, the employees receive compensation because the
scheme is cancelled.

• If the cancellation or settlement occurs during the vesting period, the

entity immediately recognises the amount that would otherwise have
been recognised for services received over the vesting period (an
acceleration of vesting).

• Any payment made to employees up to the fair value of the equity

instruments granted at cancellation or settlement date is accounted for
as a deduction from equity (repurchase of an equity interest).

• Any payment made to employees in excess of the fair value of the

equity instruments granted at cancellation or settlement date is
accounted for as an expense.

7 Recent Developments

The amendments to IFRS 2 clarify the definition of vesting conditions and

provide guidance on the accounting treatment of cancellations by parties
other than the entity.

7.1 Vesting conditions

Vesting conditions are defined in IFRS 2 as:

‘The conditions that must be satisfied for the counterparty to become entitled
to receive cash, other assets or equity instruments of the entity under a share-
based payment arrangement. Vesting conditions include service conditions,
which require the other party to complete a specified period of service, and
performance conditions, which require specific performance conditions to be
met.’

Previously, IFRS 2 was silent on whether features of a share-based payment

transaction other than service conditions and performance conditions were
vesting conditions. In the 2008 amendment to the standard, the IASB has
clarified that only service and performance conditions are vesting conditions.

Advanced Financial Accounting and Corporate Reporting (Study Text) 101

 Other features of a share-based payment are not, but should be included in
the grant date fair value of the share-based payment.

7.2 Cancellations
IFRS 2 specified the accounting treatment when an entity cancels a grant of
equity instruments. However, it did not state how cancellations by a party
other than the entity should be accounted for.

The amended standard clarifies that all cancellations, whether by the entity or
by other parties, should receive the same accounting treatment. The
amendments above are effective for annual periods beginning on or after 1
January 2009, with earlier adoption permitted.

7.3 Amendments to IFRS 2 – dated June 2009

In June 2009, the IASB issued a clarification of accounting for group Cash-
settled Share-based payment transactions. The amendments respond to
requests the IASB received to clarify how an individual subsidiary in a group
should account for some share-based payment arrangements in its own
financial statements.

In these arrangements, the subsidiary receives goods or services from

employees or suppliers but its parent or another entity in the group must pay
those suppliers. The amendments issued today clarify:

• the scope of IFRS 2. An entity that receives goods or services in a share-

based payment arrangement must account for those goods or services no
matter which entity in the group settles the transaction, and no matter
whether the transaction is settled in shares or cash.

• the interaction of IFRS 2 and other standards. The Board clarified that in
IFRS 2 a ‘group’ has the same meaning as in IAS 27 Consolidated and
Separate Financial Statements, that is, it includes only a parent and its
subsidiaries.

Advanced Financial Accounting and Corporate Reporting (Study Text) 102

 Chapter Summary

Advanced Financial Accounting and Corporate Reporting (Study Text) 103

 Self-Test Questions

1. Alpha Ltd offered directors an option scheme based on a three year period of
service. The number of options granted to directors at the inception of the
scheme was 10 million. The options were exercisable shortly after the end of
the third year. The fair value of the options and the estimates of the number of
options expected to vest were:

Year Right expected Fair value

to vest of option

Start of Year One 8m 30paisas

End of Year One 7m 33paisas
End of Year Two 8m 37paisas
End of Year Three 9m 74paisas

Show how the option scheme will affect the financial statements for
each of the three years.

2. Asif has set up an employee option scheme to motivate its sales team of ten
key sales people. Each sales person was offered 1 million options exercisable
at 10paisas, conditional upon the employee remaining with the company
during the vesting period of 5 years. The options are then exercisable three
weeks after the end of the vesting period.

This is year two of the scheme. At the end of year one, two sales people
suggested that they would be leaving the company during the second year.
However, although one did leave, the other recommitted to the company and
the scheme. The other employees have always been committed to the
scheme and stated their intention to stay with the company during the 5 years.
Relevant market values are as follows:

Date Share price Option price

Grant date 10p 20 paisa
End of Year One 24p 38 paisa
End of Year Two 21p 33 paisa

The option price is the market price of an equivalent marketable option on the
relevant date.

Advanced Financial Accounting and Corporate Reporting (Study Text) 104

 Show the effect of the scheme on the financial statements of Asif for
Year Two.

3. Bahzad has singled out the inventory control director for an employee option
scheme. He has been offered 3 million options exercisable at 20paisas,
conditional upon him remaining with the company for three years and
improving inventory control by the end of that period. The proportion of the
options that vest is dependent upon the inventory days on the last day of the
three years. The schedule is as follows:
Inventory days Proportion vesting

5 100%
6 90%
7 70%
8 40%
9 10%

The options also have a vesting criteria related to market value. They only
vest if the share price is above 25paisas on the vesting day, i.e. at the end of
the third year.

This is the second of the three years. At the end of year one it was estimated
that the inventory days at the end of the third year would be 7. However,
during year two inventory control improved and at the end of the year the
estimate of inventory days at the end of the third year was 6. The relevant
market data is as follows:

Date Share price Option price

Grant date 20paisas 10paisas

End of Year One 19paisas 6paisas
End of Year Two 37paisas 19paisas

The option price is the market price of an equivalent marketable option on the
relevant date.

Show the effect of the scheme on the financial statements of Bahzad for
Year Two.

4. On 1 January 20X4 Growler granted 200 cash share appreciation rights

(SARs) to each of its 500 employees, on condition that they continue to work
for the entity for four years. At 1 January 20X4, the entity expects that, based
upon past experience, 5% of that number is expected to leave each year.

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 During 20X4, 20 employees leave, and the entity expects that this number will
leave in each future year of the scheme.

During 20X5, 24 employees leave, and the entity expects that a total of 44
employees will leave over the remaining two-year period of the scheme.

During 20X6, eighteen employees leave, with a further 20 expected to leave

in the final year. During 20X7, only 10 employees leave

The fair value of each SAR was as follows:

31 December 20X4 – Rs 5
31 December 20X5 – Rs 7
31 December 20X6 – Rs 8
31 December 20X7 – Rs 9

Required
Calculate the amount to be recognised as a remuneration expense in the
statement of comprehensive income, together with the liability to be
recognised in the statement of financial position for each of the four
years of the scheme, commencing with the reporting date 31 December
20X4.

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 Answers

1. Year Expense Amount included in equity

Rs. ‘000’ Rs. ‘000’

One (7m × 30paisas × 1/3) 700 700

Two (8m × 30paisas × 2/3) 900 1,600
Three (9m × 30paisas) 1,100 2,700

Note: the expense is measured using the fair value of the option at the grant
date, i.e. the start of year one.

2. The expense is measured using the fair value of the option at the grant date,
i.e. 20 paisas.

At the end of year two the amount recognised in equity should be Rs 720,000
(1m × (10 – 1) × 20 paisas × 2/5).

At the beginning of year two the amount recognised in equity would have
been Rs 320,000 (1m × 8 × 20 paisas × 1/5).

The charge to profit for Year Two is the difference between the two: Rs
400,000 (720 – 320).

3. One of the conditions of vesting is a ‘market condition’ (the share price must
be above 25 paisas on the vesting day). This should already have been taken
into account when the option price was fixed and it does not affect the
calculations below.

At the end of year two the amount recognised in equity is Rs 180,000 (3m ×
10 paisas × 90% × 2/3).
At the beginning of year two the amount recognised in equity should have
been Rs 70,000 (3m × 10 paisas × 70% × 1/3).

Therefore the charge to profit for year two is Rs 110,000 (180,000 – 70,000).

4. The liability is remeasured at each reporting date, based upon the current
information available relating to known and expected leavers, together with
the fair value of the SAR at each date. The remuneration expense recognised
is the movement in the liability from one reporting date to the next as
summarised below:

Advanced Financial Accounting and Corporate Reporting (Study Text) 107

Reporting Workings SOFP – liability Change in SOCI
Date Liability Expense
Rs Rs Rs____

31/12/20X4 (500 – 20 – 20 – 20 105,000 105,000

– 20) = 420 × 200 ×
Rs 5 × ¼

31/12/20X5 (500 – 20 – 24 –44) 288,400 288,400 –105,000 183,400

= 412 × 200 × Rs7 ×
2/4

31/12/20X6 (500 – 20 – 24 – 18 501,600 501,600 –288,400 213,200

– 20) = 418 × 200 ×
Rs 8 × 3/4

31/12/20X7 (500 – 20 – 24 – 18 770,400 770,400 –501,600 268,800

– 10) = 428 × 200 ×
Rs 9 × 4/4

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Advanced Financial Accounting and Corporate Reporting (Study Text) 109
FAIR VALUE MEASUREMENT
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

 Explain the reasons for the introduction of IFRS 13 Fair value measurement
together with application of the key principles to determine fair value
measurement in specific situations.
 Understand disclosure requirements of IFRS 13.

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1 Fair Value Measurement – IFRS 13

1.1 Introduction
The objective of IFRS 13 is to provide a single source of guidance for fair
value measurement where it is required by a reporting standard, rather than it
being spread throughout several reporting standards. There is now a uniform
framework for measurement of fair value for entities around the world who
apply either US GAAP or IFRS GAAP. IFRS 13 does not extend the use of
fair value – it provides guidance on how it should be determined when an
initial or subsequent fair value measurement is required by a reporting
standard.

Note that IFRS 13 does not apply to share-based payment transactions

accounted for by IFRS 2 Share-based Payment and IAS 17 Leases. IFRS 13
also does not apply to situations where different measurements are required,
such as net realisable value or value in use which may be required by other
reporting standards, such as IAS 2 Inventories and IAS 36 Impairment
respectively.

IFRS 13 is effective for accounting periods commencing on or after 1 January

2013, with early adoption permitted

Reasons for the issue of IFRS 13

• To standardise the definition of fair value.
• To help users by providing additional disclosures relating to how fair value
has been determined.
• To improve consistency of reported information; this will also help to reduce
complexity in application of measurement of fair value.
• To increase the extent of convergence between IFRS and US GAAP

1.2 Definitions relevant to fair value.

Fair value is defined as the price that would be received to sell an asset or
paid to transfer a liability in an orderly transaction between market participants
at the measurement date; i.e. it is an exit price, whether observable in an
active market (level one inputs – see later), or estimated using a valuation
technique (with the use of level 2 and/or level three inputs – see later).

Market participants comprise independent buyers and sellers who are

informed and willing and able to enter into a transaction in the principal or the
most advantageous market as appropriate. Fair value is the price that would
apply between market participants, whether observable in an active market
(use of level 1 inputs – see later), or estimated using a valuation technique
(with the use of level 2 and 3 inputs – see later).

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 Fair value of an asset or a liability may be required to be measured in a
variety of circumstances as follows:

(a) Fair value on a recurring basis arises when a reporting standard requires
fair value to be measured on an ongoing basis. Examples of this include IAS
40 Investment Property, or IFRS 9 Financial Instruments which require some
financial assets and liabilities to be measured at fair value.

(b) Fair value on a nonrecurring basis arises when a reporting standard

requires fair value to be measured at fair value only in certain specified
circumstances. For example, IFRS 5 requires that assets classified as held for
sale are measured at fair value.

(c) Fair value upon initial recognition arises when a reporting standard
requires fair value to be measured upon initial recognition. For example, IFRS
3 Business Combinations (Revised) requires that the separable net assets of
the acquired entity are measured at fair value to determine goodwill at
acquisition.

The price paid to acquire an asset or received to assume a liability (i.e. an

entry price) may (or may not) be fair value. If it is not, there should be an
adjustment to fair value, with a gain or loss recognised immediately, or when
specified by the relevant standard. In the case of a financial instrument, this
may only be done when fair value is evidenced by a data from observable
inputs (see later).

To determine whether fair value at initial recognition equals transaction price,

an entity must consider factors specific to the transaction and factors specific
to the asset or liability to be measured; – is there any evidence to suggest that
the transaction may not be at fair value? One situation where the price paid to
acquire an asset may not be a reliable indicator of fair value arises when the
asset is purchased from a related party

1.3 The basis of a fair value measurement

The following factors should be taken into consideration when measuring fair
value:

(a) The asset or liability to be measured may be an individual asset (e.g. plot
of land) or liability, or a group of assets and liabilities (e.g. a cash
generating unit or business), depending upon exactly what is required to be
measured.

Advanced Financial Accounting and Corporate Reporting (Study Text) 112

 (b) The measurement should reflect the price at which an orderly transaction
between willing market participants would take place under current market
conditions – i.e. not a distress transaction.

(c) The entity must determine the market in which an orderly transaction
would take place. This will be the principal market or, failing that, the most
advantageous market that an entity has access to at the measurement date.
They will often, but not always, be the same.

(d) Unless there is evidence otherwise, the market that an entity would
normally enter into is presumed to be the principal or most advantageous
market.

(e) It is quite possible that different entities within a group or different

businesses within an entity may have different principal or most advantageous
markets, for example, due to their location.

(f) The valuation or measurement should reflect the characteristics of the

asset or liability (age, condition, location, restrictions on use or sale etc) if
they are relevant to market participants.

(g) It is not adjusted for transaction costs – they are not a feature of the
asset or liability, but may be relevant when determining the most
advantageous market. If location, for example, is a characteristic of the asset,
then price may need to be adjusted for any costs that may be incurred to
transport an asset to or from a market.

Numerical Illustration
An asset is sold in two different active markets at different prices. An entity
enters into transactions in both markets and can access the price in those
markets for the asset at the measurement date as follows:

Market 1 Market 2
Rs Rs
Price 26 25
Transactions cost (3) (1)
Transport cost (2) (2)
––––– –––––
Net price received 21 22
––––– –––––

If Market 1 is the principal market for the asset (i.e. the market with the
greatest volume and level of activity for the asset), the fair value of the asset
would be measured using the price that would be received in that market,

Advanced Financial Accounting and Corporate Reporting (Study Text) 113

 after taking into account transport costs is (Rs 26 – Rs 2) Rs 24.
Transactions costs are ignored as they are not a characteristic of the asset.

If neither market is the principal market for the asset, the fair value of the
asset would be measured using the price in the most advantageous market.
The most advantageous market is the market that maximises the amount that
would be received to sell the asset, after taking into account transaction costs
and transport costs (i.e. the net amount that would be received in the
respective markets).

Because the maximum net amount that the entity would receive is Rs 22 in
Market 2 (Rs 25 – Rs 3), the fair value of the asset would be measured using
the price in that market (Rs 25), less transport costs of Rs 2, resulting in a fair
value measurement of Rs 23. Although transaction costs are taken into
account when determining which market is the most advantageous market,
the price used to measure the fair value of the asset is not adjusted for those
costs (although it is adjusted for transport costs).

1.4 Valuation techniques

Valuation techniques should be used which are appropriate to the asset or
liability at the measurement date and for which sufficient data is available,
applying the fair value hierarchy to maximise the use of observable inputs as
far as possible. IFRS 13 identifies three valuation approaches:

(1) Income approach – e.g. where estimated future cash flows may be
converted into a single, current amount stated at present value.

(2) Market approach – e.g. where prices and other market-related data is
used for similar or identical assets, liabilities or groups of assets and liabilities.

(3) Cost approach – e.g. to arrive at what may be regarded as current

replacement cost to determine the cost that would be incurred to replace the
service or operational capacity of an asset.

More than one valuation technique may be used in helping to determine fair
value in a particular situation. Note that a change in valuation technique is
regarded as a change of accounting estimate in accordance with IAS 8 which
needs to be properly disclosed in the financial statements.

Advanced Financial Accounting and Corporate Reporting (Study Text) 114

2 Fair Value Hierarchy

2.1 IFRS 13 establishes a hierarchy that categorises the inputs to valuation

techniques used to measure fair value. As follows:

(a) Level 1 inputs comprise quoted prices (‘observable’) in active markets for
identical assets and liabilities at the measurement date This is regarded as
providing the most reliable evidence of fair value and is likely to be used
without adjustment.

(b) Level 2 inputs are observable inputs, other than those included within
Level 1 above, which are observable directly or indirectly. This may include
quoted prices for similar (not identical) asset or liabilities in active markets, or
prices for identical or similar assets and liabilities in inactive markets.
Typically, they are likely to require some degree of adjustment to arrive at a
fair value measurement.

(c) Level 3 inputs are unobservable inputs for an asset or liability, based
upon the best information available, including information that may be
reasonably available relating to market participants. An asset or liability is
regarded as having been measured using the lowest level of inputs that is
significant to its valuation.

2.2 Selection and use of inputs into valuation techniques

• Inputs into a valuation technique should be consistent with those which
would be used by market participants, including control premiums or
discounts for lack of control. Prices based upon bid-ask spreads should be the
most representative of fair value from within that spread.

• Prices may be provided by third parties, such as brokers, but the prices must
be determined in accordance with the requirements of IFRS 13; e.g. they may
be regarded as either observable or unobservable data.

• If markets are not active, then further analysis of transactions actually taking
place, and/or the prices, may be required. This may result in an adjustment of
such prices to establish fair value.

Advanced Financial Accounting and Corporate Reporting (Study Text) 115

2.3 Inputs to determine fair value
Examples of inputs used to determine fair value include:

Asset or liability Example

Level 1 Equity shares in a listed Unadjusted quoted prices
entity in an active market
Level 2 Finished goods inventory Price paid by retail
at a retail outlet customers
Licence acquired as part of The royalty rate contained
a business combination within the contract
which as recently
negotiated with an
unrelated party
Cash generating unit Valuation multiple from
observed transactions
involving similar
businesses
Building held and used Price per square metre for
the building from
observable market data,
such as observed
transactions for similar
buildings in similar
locations
Level 3 Interest rate swap Adjustment made to a
midmarket nonbinding
price using data that
cannot be directly
observed or corroborated
Decommissioning liability Use of own data to make
assumed upon a business estimates of expected
combination future cash outflows to
fulfil the obligation used to
estimate the present value
of that future obligation.
Cash-generating Profit or cash flow forecast
Unit using own data.

Advanced Financial Accounting and Corporate Reporting (Study Text) 116

3 Specific Application Principles

3.1 Non-financial assets

Fair value of a nonfinancial asset is based upon highest and best use of that
asset that would maximise its value, based upon uses which are physically
possible, legally permissible and financially feasible. This is considered from
the perspective of market participants, even if they may use the asset
differently. Current use of a nonfinancial asset is presumed to be its highest
and best use, unless there are factors that would suggest otherwise.

• Used in combination with other assets – fair value of an asset will be based
upon what would be received if the asset was sold to another market
participant, and that the complementary assets and liabilities they needed for
highest and best use would be available to them.

• Used on a standalone basis – the price that would be received to sell the
asset to a market participant who would use it on a stand-alone basis.

In either situation, it is assumed that the asset is sold individually, rather than
as part of a collection of assets and liabilities.

Illustration — Land
An entity acquires land in a business combination. In accordance with IFRS 3
(revised), this must be stated at fair value at the date of acquisition to help
determine the value of goodwill at that date. The land is currently developed
for industrial use as a site for a factory. Alternatively, the site could be
developed into a block of residential flats which, based upon evidence relating
to adjoining plots of a similar size, appears to be a practical use of the site.

The current use of land is presumed to be its highest and best use unless
market or other factors suggest a different use. In this situation, there is a
possible alternative use which should be considered as follows:

The highest and best use of the land would be determined by taking the
higher measurement from the two possible outcomes:

(a) the value of the land as currently developed for industrial use (i.e. the land
would be used in combination with other assets, such as the factory, or with
other assets and liabilities).

(b) the value of the land as a vacant site for residential use, taking into
account the costs of demolishing the factory and other costs (including the
uncertainty about whether the entity would be able to convert the asset to the
alternative use, such as legal and planning issues) necessary to convert the

Advanced Financial Accounting and Corporate Reporting (Study Text) 117

 land to a vacant site (i.e. the land is to be used by market participants on a
stand-alone basis).

Illustration – Research and development project

An entity acquires a research and development (R&D) project in a business
combination. The entity does not intend to complete the project as, if
completed, the project would compete with one of its own projects (to provide
the next generation of the entity’s commercialised technology). Instead, the
entity intends to hold (i.e. lock up) the project to prevent its competitors from
obtaining access to the technology. In doing this the project is expected to
provide defensive value, principally by improving the prospects for the entity’s
own competing technology and preventing access by competitors to the
technology.

To measure the fair value of the project at initial recognition, the highest and
best use of the project would be determined on the basis of its use by market
participants. For example, the highest and best use of the R&D project could
be:

(a) to continue development if market participants would continue to

develop the project and that use would maximise the value of the group of
assets or of assets and liabilities in which the project would be used (i.e. the
asset would be used in combination with other assets or with other assets and
liabilities). The fair value of the project would be measured on the basis of the
price that would be received in a current transaction to sell the project,
assuming that the R&D would be used with its complementary assets and the
associated liabilities and that those assets and liabilities would be available to
market participants.

(b) to cease development for competitive reasons if market participants

would lock up the project and that use would maximise the value of the group
of assets or of assets and liabilities in which the project would be used. The
fair value of the project would be measured on the basis of the price that
would be received in a current transaction to sell the project, assuming that
the R&D would be used (i.e. locked up) with its complementary assets and the
associated liabilities and that those assets and liabilities would be available to
market participants.

(c) to cease development if market participants would discontinue its

development. The fair value of the project would be measured on the basis
of the price that would be received in a current transaction to sell the project
on its own (which might be zero).

Advanced Financial Accounting and Corporate Reporting (Study Text) 118

3.2 Financial assets and financial liabilities – offsetting positions
If an entity manages a group of financial assets and liabilities within the scope
of IFRS 9 Financial Instruments, which are measured at fair value based upon
their net exposure to particular risks, then it is permitted to value the net
exposure at fair value, provided this is in accordance with documented
strategy and information is reported on this basis to key management.

3.3 Liabilities and equity instruments

Ideally, fair value is measured using quoted prices for identical instruments –
i.e. level one observable inputs. If this is not possible, it may be possible to
use prices in an inactive market – level two observable inputs. If this is not
possible, a valuation model should be used e.g. present value measurement.

Note that any fair value measurement of a liability should include

nonperformance or default risk. This may be different for different types of
liability held by an entity; for example, default risk for a secured loan is less
than default risk of an unsecured loan at any point in time. Also, be aware that
this risk may change over time as an entity may or may not encounter
financial and other commercial difficulties.

Fair value measurement of a liability or equity instrument assumes that it is

transferred at the measurement date, and that both a liability and/or equity
instrument would remain outstanding, rather than being settled or redeemed.

When a quoted price is not available for such an item, an entity shall measure
fair value from the perspective of a market participant who holds the identical
item as an asset at the measurement date. If there are no such observable
prices, then an alternative valuation technique must be used.

3.4 Measurement of liabilities

Consider two entities, A and B, who each have a legal obligation to pay Rs
1000 cash to another entity, C, in ten years.

Entity A has an excellent credit rating and can borrow at 5 per cent, whereas
Entity B has a lower credit rating and is able to borrow at 8 per cent. Entity A
will receive approximately Rs 614 in exchange for its promise (the present
value of Rs 1,000 in ten years using a discount factor of 5%). Entity B will
receive approximately Rs 463 in exchange for its promise (the present value
of Rs 1,000 in ten years using a discount factor of 8%).

The fair value of the liability to each entity (i.e. the proceeds) therefore
incorporates that entity’s credit standing

Advanced Financial Accounting and Corporate Reporting (Study Text) 119

4 Disclosures

Disclosures should provide information that enables users of financial

statements to evaluate the inputs and methods used to determine how fair
value measurements have been arrived at.

The level in the three-tier valuation hierarchy should be disclosed, together

with supporting details of valuation methods and inputs used where
appropriate. As would be expected, more detailed information is required
where there is significant use of level three inputs to arrive at a fair value
measurement to enable users of financial statements to understand how such
fair values have been arrived at.

Disclosure should also be made when there is a change of valuation

technique to measure an asset or liability. This will include any change in the
level of inputs used to determine fair value of particular assets and/or
liabilities.

Advanced Financial Accounting and Corporate Reporting (Study Text) 120

Chapter Summary

Advanced Financial Accounting and Corporate Reporting (Study Text) 121

Advanced Financial Accounting and Corporate Reporting (Study Text) 122
INTRODUCTION TO GROUP ACCOUNTING
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

 Describe the concept of a group as a single economic unit.
 Explain and apply the definition of a subsidiary according to IFRS 10.
 Identify circumstances in which a group is required to prepare consolidated
financial statements in accordance with IAS 27.
 Describe the circumstances when a group may claim exemption from the
preparation of consolidated financial statements in accordance with IAS 27.
 List the circumstances where it is permitted not to consolidate a subsidiary
according to IAS 27.
 Explain why it is necessary to eliminate intra-group transactions.

Advanced Financial Accounting and Corporate Reporting (Study Text) 123

1. The Concept of Group Accounts

1.1 What is a group?

If one company owns more than 50% of the ordinary shares of another
company:

• this will usually give the first company ‘control’ of the second company
• the first company (the parent company, P) has enough voting power to
appoint majority of directors of the second company (the subsidiary
company, S)
• P is, in effect, able to manage S as if it were merely a department of P,
rather than a separate entity
• in strict legal terms P and S remain distinct, but in economic substance
they can be regarded as a single unit (a ‘group’).

1.2 Group Concept

Although from the legal point of view, every company is a separate entity,
from the economic point of view several companies may not be separate.

In particular, when one company owns enough shares in another company to

have a majority of votes at that company’s annual general meeting (AGM), the
first company may appoint majority of the directors of, and decide what
dividends should be paid by, the second company.

This degree of control enables the first company to manage the trading
activities and future plans of the second company as if it were merely a
department of the first company.

International accounting standards recognise that this state of affairs often

arises, and require a parent company to produce consolidated financial
statements showing the position and results of the whole group.

Advanced Financial Accounting and Corporate Reporting (Study Text) 124

1.3 Group Accounts
The key principle underlying group accounts is the need to reflect the
economic substance of the relationship.

Controls

S Groups

 P is an individual legal entity.

 S is an individual legal entity.

P controls S and therefore they form a single economic entity – the Group.

1.4 The Single Economic Unit Concept

The purpose of consolidated accounts is to:

• present financial information about a parent undertaking and its

subsidiary undertakings as a single economic unit
• show the economic resources controlled by the group
• show the obligations of the group, and
• show the results the group achieves with its resources

Business combinations consolidate the results and net assets of group

members so as to display the group’s affairs as those of a single economic
entity. As already mentioned, this conflicts with the strict legal position that
each company is a distinct entity. Applying the single entity concept is a good
example of the accounting principle of showing economic substance over
legal form.

1.5 Consolidated financial statements under the entity concept

This is by far the most common form of group accounts. Consolidated
financial statements are prepared by replacing the cost of investments with
the individual assets and liabilities underlying that investment. If the subsidiary
is only partly owned, all the assets and liabilities of the subsidiary are
consolidated, but the non-controlling shareholders’ interest in those net assets
is presented.

Advanced Financial Accounting and Corporate Reporting (Study Text) 125

 The single economic unit concept focuses on the existence of the group as
an economic unit rather than looking at it only through the eyes of the
dominant shareholder group. It concentrates on the resources controlled by
the entity.

1.6 Group Financial Statements

Group financial statements could be prepared in various ways, but in normal
circumstances much the best way of showing the results of a group is to
imagine that all the transactions of the group had been carried out by a single
equivalent company and to prepare a statement of financial position, an
income statement and a statement showing other comprehensive income for
that company.

Each company in a group prepares its own accounting records and annual
financial statements in the usual way. From the individual companies' financial
statements, the parent prepares consolidated financial statements.

2. Definitions

2.1 IFRS 10 Consolidated Financial Statements uses the following

definitions:
• parent – an entity that controls one or more entities

• subsidiary – an entity that is controlled by another entity (known as

the parent)

• control of an investee – an investor controls an investee when the

investor is exposed, or has rights, to variable returns from its
involvement with the investee and has the ability to affect those returns
through its power over the investee.

Requirements for consolidated financial statements

IFRS 10 outlines the circumstances in which a group is required to prepare
consolidated financial statements.

Consolidated financial statements should be prepared when the parent

company has control over the subsidiary (for examination purposes control is
usually established based on ownership of more than 50% of voting power).

Control is identified by IFRS 10 as the sole basis for consolidation and

comprises the following three elements:

Advanced Financial Accounting and Corporate Reporting (Study Text) 126

 • power over the investee
• exposure, or rights, to variable returns from its involvement with the
investee
• the ability to use its power over the investee to affect the amount of the
investor's returns

2.2 Control
IFRS 10 adopts a principles based approach to determining whether or not
control is exercised in a given situation, which may require the exercise of
judgement. One outcome is that it should lead to more consistent judgements
being made, with the consequence of greater comparability of financial
reporting information.

IFRS 10 states that investors should periodically consider whether control

over an investee has been gained or lost and goes on to consider that a range
of circumstances may need to be considered when determining whether or
not an investor has power over an investee, such as:

 Exercise of the majority of voting rights in an investee;

 Contractual arrangements between the investor and other parties;
 Holding less than 50% of the voting shares, with all other equity interests
held by a numerically large, dispersed and unconnected group;
 Potential voting rights (such as share options or convertible loans) may
result in an investor gaining or losing control at some specific date.

3. Exemption from Preparation of Group Financial Statements

3.1 A parent need not present consolidated financial statements if and only if:
• the parent itself is a wholly owned subsidiary or a partially-owned
subsidiary and its owners, (including those not otherwise entitled to
vote) have been informed about, and do not object to, the parent not
preparing consolidated financial statements;

• the parent's debt or equity instruments are not traded in a public

market;

• the parent did not file its financial statements with a securities
commission or other regulatory organisation for the purpose of issuing
any class of instruments in a public market;

• the ultimate parent company produces consolidated financial

statements that comply with IFRS and are available for public use.

Advanced Financial Accounting and Corporate Reporting (Study Text) 127

 If this is the case, IAS 27 Separate Financial Statements (revised) requires
that the following disclosures are made:

• the fact that consolidated financial statements have not been

presented;

• a list of significant investments (subsidiaries, associates etc.) including

percentage shareholdings, principle place of business and country of
incorporation;

• the bases on which those investments listed above have been

accounted for in its separate financial statements.

3.2 Reasons for Wanting to Exclude a Subsidiary

The directors of a parent company may not wish to consolidate some
subsidiaries due to:

• poor performance of the subsidiary

• poor financial position of the subsidiary
• differing activities of the subsidiary from the rest of the group.

These reasons are not permitted according to IFRSs.

3.3 Excluded Subsidiaries IFRS 10 and IAS 27 (revised) do not specify any
other circumstances when subsidiaries must be excluded from consolidation.
However, there may be specific circumstances that merit particular
consideration as follows:

Reason for Accounting treatment

exclusion
Subsidiary held Held as current asset investment at the lower of carrying
for resale amount and fair value less costs to sell.
Materiality Accounting standards do not apply to immaterial items;
therefore an immaterial item need not be consolidated.

3.4 Subsidiary held for resale

If on acquisition a subsidiary meets the criteria to be classified as ‘held for
sale’ in accordance with IFRS 5, then it must still be included in the
consolidation but accounted for in accordance with that standard. The parent's
interest will be presented separately as a single figure on the face of the
consolidated statement of financial position, rather than being consolidated
like any other subsidiary.

Advanced Financial Accounting and Corporate Reporting (Study Text) 128

 This might occur when a parent has acquired a group with one or more
subsidiaries that do not fit into its long-term strategic plans and are therefore
likely to be sold. In these circumstances the parent has clearly not acquired
the investment with a view to long-term control of the activities, hence the
logic of the exclusion.

3.5 Materiality
If a subsidiary is excluded on the grounds of immateriality, the case must be
reviewed from year to year, and the parent would need to consider each
subsidiary to be excluded on this basis, both individually and collectively.
Ideally, a parent should consolidate all subsidiaries which it controls in all
accounting periods, rather than report changes in the corporate structure from
one period to the next.

4 Non-Coterminous Year Ends

4.1 Some companies in the group may have differing accounting dates. In
practice such companies will often prepare financial statements up to the
group accounting date for consolidation purposes.
For the purpose of consolidation, IFRS 10 states that where the reporting date
for a parent is different from that of a subsidiary, the subsidiary should
prepare additional financial information as of the same date as the financial
statements of the parent unless it is impracticable to do so.

If it is impracticable to do so, IFRS 10 allows use of subsidiary financial

statements made up to a date of not more than three months earlier or later
than the parent's reporting date, with due adjustment for significant
transactions or other events between the dates.

4.2 Uniform Accounting Policies

If a member of a group uses accounting policies other than those adopted in
the consolidated financial statements for like transactions and events in
similar circumstances, appropriate adjustments are made to that group
member's financial statements in preparing the consolidated financial
statements to ensure conformity with the group's accounting policies

4.3 Related Parties

Two parties are considered to be related if:

• one party has the ability to control the other party, or

• one party has the ability to exercise significant influence over the other
party, or
• the parties are under common control.

Advanced Financial Accounting and Corporate Reporting (Study Text) 129

 Therefore:

• a company that is a subsidiary is a related party of its parent company

• this means that the financial statements may have been affected by
related party transactions.

The types of transaction that may occur between parent and subsidiary
(related parties) and their impact on the financial statements of the individual
company and the group are:

Transaction Potential impact

Sales and purchases Favourable prices, affecting profits.

Advantageous settlement terms,
affecting receivables and payables
days.

Finance Favourable rates of interest, affecting

profits.

Non-current assets Favourable terms for cost or

financing.

Provision of services At minimal or no cost, affecting

profits.

Guarantees for loans Without which they wouldn’t have

and overdrafts been granted.

Such transactions may or may not be at ‘arm’s length’, i.e. on normal

commercial terms. Even where related party transactions are at arm’s length,
it is still important to realise that they are related party transactions.

Using ‘single economic unit’ concept while preparing consolidated financial

statements such related party transactions need to be adjusted, adjustment of
such transactions is given in detail in following chapters.

Advanced Financial Accounting and Corporate Reporting (Study Text) 130

 Chapter Summary

GROUP
DEFINATION

PARENT = SUBSIDAIRY
CONTROLLING CONTROLLED
ENTITY ENTITY

Show position of
group as single
economic entity
by way of group
accounts.

Exclusion from consolidation acceptable where

 materiality
 subsidiary held for resale

Principles of consolidation
 Non-coterminous year ends
 Uniform accounting polices
 Elimination of intra – group transactions

Advanced Financial Accounting and Corporate Reporting (Study Text) 131

Advanced Financial Accounting and Corporate Reporting (Study Text) 132
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

• Prepare a consolidated statement of financial position for a simple group (parent

and one subsidiary).
• Deal with non-controlling interests (at fair value or proportionate share of net
assets).
• Describe the required accounting treatment of consolidated goodwill.
• Explain the consolidation of other reserves (e.g. share premium and revaluation).
• Account for the effects of intra-group trading in the statement of financial position
together with their effects in non-controlling interest.
• Explain why it is necessary to use fair values when preparing consolidated
financial statements.
• Explain the treatment of reserves of subsidiary acquired during the accounting
period.
• Prepare consolidated statement of changes in Equity.

Advanced Financial Accounting and Corporate Reporting (Study Text) 133

1 Principles Of The Consolidated Statement Of Financial Position

1.1 Basic principle

The basic principle of a consolidated statement of financial position is that it shows
all assets and liabilities of the parent and subsidiary. Intra-group items are
excluded, e.g. receivables and payables shown in the consolidated statement of
financial position only include amounts owed from/to third parties.

Method of preparing a consolidated statement of financial position

(1) The investment in the subsidiary (S) shown in the parent’s (P’s) statement
of financial position is replaced by the net assets of S.

(2) The cost of the investment in S is effectively cancelled with the ordinary
share capital and reserves of the subsidiary.
This leaves a consolidated statement of financial position showing:

• the net assets of the whole group (P + S)

• the share capital of the group which always equals the share capital of P
only and

• the retained profits, comprising profits made by the group (i.e. all of P’s
historical profits + profits made by S post-acquisition).

Example 1
Statements of financial position at 31 December 20X4
P S
Rs. ‘000’ Rs. ‘000’

Non-current assets 60 50
Investment in S at cost 50
Current assets 40 40
___ ___
150 90
___ ___
Ordinary share capital (Rs 10 shares) 100 40
Retained earnings 30 10
Current liabilities 20 40
___ ___
150 90
___ ___

Advanced Financial Accounting and Corporate Reporting (Study Text) 134

 Required
P acquired all the shares in S on 31 December 20X4 for a cost of Rs 50,000.
Prepare the consolidated statement of financial position at 31 December 20X4.

Solution

Approach
(1) The balance on ‘investment in subsidiary account’ in P’s accounts will be
replaced by the underlying assets and liabilities which the investment
represents, i.e. the assets and liabilities of S.

(2) The cost of the investment in the subsidiary is effectively cancelled with the
ordinary share capital and reserves of S. This is normally achieved in
consolidation workings (discussed in more detail below). However, in this
simple case, it can be seen that the relevant figures are equal and opposite
(Rs 50,000), and therefore cancel directly.

This leaves a consolidated statement of financial position showing:

• the net assets of the whole group (P + S)

• the share capital of the group, which equals the share capital of
P only - Rs 100,000

• retained earnings comprising profits made by the group. Here this

will only include the Rs 30,000 retained earnings of the parent
company. S is purchased on the reporting date, therefore there are
no post-acquisition earnings to include in the group amount.

By cross-casting the net assets of each company, and cancelling the

investment in S against the share capital and reserves of S, we arrive at the
consolidated statement of financial position given below.

Advanced Financial Accounting and Corporate Reporting (Study Text) 135

 P consolidated statement of financial position at 31 December 20X4:

Rs. ‘000’

Non-current assets Rs (60,000 + 50,000) 110

Current assets Rs (40,000 + 40,000) 80
___
190
___
Share capital (Rs 10 ordinary shares) 100
Retained earnings 30
Current liabilities Rs (20,000 + 40,000) 60
___
190
___

Note: Under no circumstances will any share capital of any subsidiary company
ever be included in the figure of share capital in the consolidated statement of
financial position

1.2 The Mechanics of Consolidation

A standard group accounting question will provide the accounts of P and the
accounts of S and will require the preparation of consolidated accounts.
The best approach is to use a set of standard workings.

(W1) Establish the group structure

Date of This indicates that P owns 80% of the ordinary shares of S and
when they were acquired
Acquisition

Advanced Financial Accounting and Corporate Reporting (Study Text) 136

 (W2) Net assets of subsidiary

At date of acquisition At the reporting date

Rs Rs
Share capital X X
Reserves:
Share premium X X
Retained earnings X X
–– ––
X X
–– ––

(W3) Goodwill
Rs

Parent holding (investment) at fair value X

NCI value at acquisition (*) X
—
X
Less:
Fair value of net assets at acquisition (W2) (X)
—
Goodwill on acquisition X
Impairment (X)
—
X
(*) If fair value method adopted, NCI value = fair value of NCI's holding at
acquisition (number of shares NCI own × subsidiary share price).

(*) If proportion of net assets method adopted, NCI value = NCI % × fair
value of net assets at acquisition (from W2).

(W4) Non controlling interest

Rs

NCI value at acquisition (as in W3) X

NCI share of post-acquisition reserves (W2) X
NCI share of impairment (fair value method only) (X)
—
X
—

Advanced Financial Accounting and Corporate Reporting (Study Text) 137

 (W5) Group retained earnings
Rs

P's retained earnings (100%) X

P's % of sub's post-acquisition
retained earnings X
Less: Parent share of impairment (W3) (X)
—
X
—
2 Goodwill

2.1 Goodwill on acquisition

In example 1 the cost of the shares in S was Rs 50,000. Equally the net assets
of S were Rs 50,000. This is not always the case.

The value of a company will normally exceed the value of its net assets. The
difference is goodwill. This goodwill represents assets not shown in the
statement of financial position of the acquired company such as the reputation
of the business.

Goodwill on acquisition is calculated by comparing the value of the subsidiary

acquired to its net assets.

Where 100% of the subsidiary is acquired, the calculation is therefore:

Rs

Cost of investment (= value of the subsidiary) X

Net assets of subsidiary (X)
___
Goodwill X

Where less than 100% of the subsidiary is acquired, the value of the subsidiary
comprises two elements:

• The value of the part acquired by the parent

• The value of the part not acquired by the parent, known as the non-
controlling interest

There are 2 methods in which Goodwill may be calculated:

(i) Proportion of net assets method (as seen in consolidation workings).
(ii) Fair value method (as seen in consolidation workings).

Advanced Financial Accounting and Corporate Reporting (Study Text) 138

 The proportion of net assets method calculates the portion of goodwill attributable
to the parent only, while the fair value method calculates the goodwill attributable
to the group as a whole. This is known as the gross goodwill i.e. goodwill is shown
in full as this is the asset that the group controls.

Example 2
Hafeez acquired 80% of the ordinary share capital of Atlas on 31 December 20X6
for Rs 78,000. At this date the net assets of Atlas were Rs 85,000.

What goodwill arises on the acquisition

(i) if the NCI is valued using the proportion of net assets method
(ii) if the NCI is valued using the fair value method and the fair value of the NCI
on the acquisition date is Rs 19,000?

Solution

Rs
(i)
Parent holding (investment) at fair value 78,000
NCI value at acquisition (20% × Rs 85,000) 17,000
————
95,000
Less:
Fair value of net assets at acquisition (85,000)
————
Goodwill on acquisition 10,000
————
(ii) Parent holding (investment) at fair value 78,000
NCI value at acquisition 19,000
————
97,000
Less:
Fair value of net assets at acquisition (85,000)
————
Goodwill on acquisition 12,000
————

2.2 IFRS 3 Business Combination

IFRS 3 revised governs accounting for all business combinations other than joint
ventures and a number of other unusual arrangements not included in this
syllabus. The definition of goodwill is:

Advanced Financial Accounting and Corporate Reporting (Study Text) 139

 Goodwill is an asset representing the future economic benefits arising from other
assets acquired in a business combination that are not individually identified and
separately recognised.

Goodwill is calculated as the excess of the consideration transferred and amount

of any non-controlling interest over the net of the acquisition date identifiable
assets acquired and liabilities assumed.

2.3 Treatment of Goodwill

Positive goodwill

• Capitalised as an intangible non-current asset.

• Tested annually for possible impairments.
• Amortisation of goodwill is not permitted by the standard.

Impairment of positive goodwill

If goodwill is considered to have been impaired during the post-acquisition
period it must be reflected in the group financial statements. Accounting for the
impairment differs according to the policy followed to value the non controlling
interests.

Proportion of net assets method:

Dr Group reserves (W5)
Cr Goodwill (W3)

Fair value method:

Dr Group reserves (% of impairment attributable to the parent – W5)
Dr NCI (% of impairment attributable to NCI – W4)
Cr Goodwill (W3)

Negative goodwill
• Capitalised as an intangible Non-current asset.
• Tested annually for possible impairments.
• Amortisation of goodwill is not permitted by the standard.
• Arises where the cost of the investment is less than the value of net assets
purchased.
• IFRS 3 does not refer to this as negative goodwill (instead it is referred to as a
bargain purchase), however this is the commonly used term.
• Most likely reason for this to arise is a misstatement of the fair values of assets
and liabilities and accordingly the standard requires that the calculation is
reviewed.
• After such a review, any negative goodwill remaining is credited directly to the
income statement.

Advanced Financial Accounting and Corporate Reporting (Study Text) 140

3 Pre And Post-Acquisition Profits

3.1 Pre-acquisition profits are the reserves which exist in a subsidiary company at
the date when it is acquired.

They are capitalised at the date of acquisition by including them in the goodwill
calculation.

Post-acquisition profits are profits made and included in the retained earnings of
the subsidiary company following acquisition. They are included in group retained
earnings.

3.2 Group reserves

When looking at the reserves of S at the year end, e.g. revaluation reserve, a
distinction must be made between:

• those reserves of S which existed at the date of acquisition by P (pre-

acquisition reserves) and
• the increase in the reserves of S which arose after acquisition by P (post-
acquisition reserves).

As with retained earnings, only the group share of post-acquisition reserves of S

is included in the group statement of financial position

The following statements of financial position were extracted from the books of
two companies at 31 December 20X9.

Hamza Ltd Orient Ltd

Rs Rs
Non-current assets
Property, plant & equipment 75,000 11,000
Investments
Shares in Orient Ltd 27,000
–––––––
102,000
Current assets 214,000 33,000
––––––– –––––––
316,000 44,000
–––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 141

 Equity
Share capital 80,000 4,000
Share premium 20,000 6,000
Retained earnings 40,000 9,000
––––––– –––––––
140,000 19,000
––––––– –––––––
Current liabilities 176,000 25,000
––––––– –––––––
316,000 44,000
––––––– –––––––

Hamza Ltd acquired all of the share capital of Orient Ltd one year ago. The
retained earnings of Orient Ltd stood at Rs 2,000 on the day of acquisition.
Goodwill is calculated using the proportion of net asset method. There has been
no impairment of goodwill since acquisition.

Required
Prepare the consolidated statement of financial position of Hamza Ltd as at 31
December 20X9.

Solution

Hamza Ltd consolidated statement of financial position at 31 December

20X9:

Non-current assets Rs. ‘000’

Goodwill (W3) 15
PPE Rs (75,000 + 11,000) 86
Current assets Rs (214,000 + 33,000) 247
–––
348
–––
Share capital (Hamza Ltd only) 80
Share premium (Hamza Ltd only) 20
Group retained earnings (W5) 47
–––
147
Current liabilities Rs (176,000 + 25,000) 201
–––
348
–––

Advanced Financial Accounting and Corporate Reporting (Study Text) 142

 (W1) Establish the group structure

Hamza Ltd

100% 1 Jan 20X9

Orient Ltd

(W2)

At date of acquisition At the reporting date

Rs Rs

Share capital 4,000 4,000

Reserves:
Share premium 6,000 6,000
Retained earnings 2,000 9,000
–––––– ––––––
12,000 19,000
–––––– ––––––
(W3) Goodwill

Rs

Parent holding (investment) at fair value 27,000

Less:
Fair value of net assets at acquisition (W2) (12,000)
————
Goodwill on acquisition 15,000
————

(W4) NCI

Not applicable to this example as Orient Ltd is 100% owned.

Advanced Financial Accounting and Corporate Reporting (Study Text) 143

 (W5) Group retained earnings

Rs

Hamza Ltd retained earnings (100%) 40,000

Orient Ltd – group share of post-acquisition
retained earnings 100% × Rs (19,000 – 12,000 (W2)) 7,000
–––––
47,000
–––––

4 Non-Controlling Interest

4.1 What is a non-controlling interest?

In some situations a parent may not own all of the shares in the subsidiary, e.g.
if P owns only 80% of the ordinary shares of S, there is a non-controlling interest
of 20%.

Note, however, that P still controls S.

4.2 Accounting treatment of a non-controlling interest

As P controls S:
• in the consolidated statement of financial position, include all of the net
assets of S (to show control).
• give back’ the net assets of S which belong to the non-controlling interest
within the equity section of the consolidated statement of financial
position (calculated in W4).

5 Fair Values

5.1 Fair value of consideration and net assets

To ensure that an accurate figure is calculated for goodwill:
• the consideration paid for a subsidiary must be accounted for at fair value

• the subsidiary’s identifiable assets and liabilities acquired must be

accounted for at their fair values.

Fair value of assets and liabilities is defined in IFRS 13 Fair value measurement
as the price that would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants at the measurement date (i.e.
an exit price).

Advanced Financial Accounting and Corporate Reporting (Study Text) 144

 In order to account for an acquisition, the acquiring company must measure the
cost of what it is accounting for, which will normally represent:

• the cost of the investment in its own statement of financial position

• the amount to be allocated between the identifiable net assets of the

subsidiary, the non-controlling interest and goodwill in the consolidated
financial statements.

The subsidiary’s identifiable assets and liabilities are included in the consolidated
accounts at their fair values for the following reasons.

• Consolidated accounts are prepared from the perspective of the group,

rather than from the perspectives of the individual companies. The book
values of the subsidiary’s assets and liabilities are largely irrelevant,
because the consolidated accounts must reflect their cost to the group
(i.e. to the parent), not their original cost to the subsidiary. The cost to the
group is their fair value at the date of acquisition.

• Purchased goodwill is the difference between the value of an acquired

entity and the aggregate of the fair values of that entity’s identifiable
assets and liabilities. If fair values are not used, the value of goodwill will
be meaningless.

Identifiable assets and liabilities recognised in the accounts are those of the
acquired entity that existed at the date of acquisition.

Assets and liabilities are measured at fair values reflecting conditions at the date of
acquisition.

The following do not affect fair values at the date of acquisition and are therefore
dealt with as post-acquisition items.

• Changes resulting from the acquirer’s intentions or future actions.

• Changes resulting from post-acquisition events.
• Provisions for future operating losses or re-organisation costs incurred as a
result of the acquisition.

Advanced Financial Accounting and Corporate Reporting (Study Text) 145

5.2 Calculation of cost of investment
The cost of acquisition includes the following elements:
• cash paid
• fair value of any other consideration i.e. deferred/contingent considerations
and share exchanges.

Incidental costs of acquisition such as legal, accounting, valuation and other

professional fees should be expensed as incurred. The issue costs of debt or
equity associated with the acquisition should be recognised in accordance with
IFRS 9/IAS 32.

5.3 Deferred and contingent consideration

In some situations not all of the purchase consideration is paid at the date of the
acquisition, instead a part of the payment is deferred until a later date – deferred
consideration.

• Deferred consideration should be measured at fair value at the date of

the acquisition (i.e. a promise to pay an agreed sum on a pre-determined
date in the future taking into account the time value of money).

• The fair value of any deferred consideration is calculated by discounting

the amounts payable to present value at acquisition.

• Any contingent consideration should always be included as long as it can

be measured reliably. This will be indicated where relevant in an exam
question. (A contingent consideration is an agreement to settle in the
future provided certain conditions attached to the agreement are met.
These conditions vary depending on the terms of the settlement).

There are two ways to discount the deferred amount to fair value at the acquisition
date:

(1) The examiner may give you the present value of the payment based on a given
cost of capital.

(For example, Rs 1 receivable in three years time based on a cost of capital of

10% = Rs 0.75)

(2) You may need to use the interest rate given and apply the discount fraction
where r is the interest rate and n the number of years to settlement
1
––––––
(1 + r ) n

Advanced Financial Accounting and Corporate Reporting (Study Text) 146

 Each year the discount is then "unwound". This increases the deferred
liability each year (to increase to future cash liability) and the discount is
treated as a finance cost.

Contingent Consideration

Shares
Where contingent consideration involves the issue of shares, there is no liability
(obligation to transfer economic benefits). This should be recognised as part of
shareholders' funds under a separate caption representing shares to be issued.

Changes in fair value

The fair value of the contingent consideration at acquisition could be different to
the actual consideration transferred. Any differences are normally treated as a
change in accounting estimate and adjusted prospectively in accordance with
IAS 8.

5.4 Share exchange

Often the parent company will issue shares in its own company in return for the
shares acquired in the subsidiary. The share price at acquisition should be used
to record the cost of the shares at fair value.

Example 4

Cost of Investment
J Ltd acquires 2.4 million Rs 10 shares (80%) of the ordinary shares of B Ltd by
offering a share-for-share exchange of two shares for every three shares
acquired in B Ltd and a cash payment of Rs 1 per share payable three years
later. J Ltd's shares have a nominal value of Rs 10 and a current market value
of Rs 20. The cost of capital is 10% and Rs 1 receivable in 3 years can be taken
as Rs 0.75

Required
(i) Calculate the cost of investment and show the journals to record it in J Ltd's
accounts.
(ii) Show how the discount would be unwound.

Advanced Financial Accounting and Corporate Reporting (Study Text) 147

 Solution:

(i) Cost of investment

Rs
Deferred cash (at present value)
Rs 0.75 × (Rs 10 × 2.4m) 18m
Shares exchange
(2.4m × 2/3) × Rs 20 32m
___
50m

Rs 50m is the cost of investment for the purposes of the calculation of

goodwill

Journals in J Ltd's individual accounts

Dr Cost of investment in subsidiary Rs 50m
Cr Non-current liabilities deferred
Consideration Rs 18m
Cr Share capital (1.6 million shares issued × Rs 10
nominal value) Rs 16m
Cr Share premium (1.6 million shares issued × Rs 10
premium element) Rs 16m

(ii) Unwinding the discount

Rs 18m × 10% = Rs 1.8m

Dr Finance cost Rs 1.8m

Cr Non-current liabilities deferred
Consideration Rs 1.8m

For the next three years the discount will be unwound, taking the interest to
finance cost until the full Rs 24 million payment is made in Year 3.

6 Fair Value of Net Assets Acquired

6.1 IFRS 3 revised requires that the subsidiary’s assets and liabilities are recorded at
their fair value for the purposes of the calculation of goodwill and production of
consolidated accounts.

Adjustments will therefore be required where the subsidiary’s accounts themselves

do not reflect fair value.

Advanced Financial Accounting and Corporate Reporting (Study Text) 148

 (1) Adjust both columns of W2 to bring the net assets to fair value at acquisition
and reporting date.

This will ensure that the fair value of net assets is carried through to the
goodwill and non-controlling interest calculations.

At acquisition At reporting
date
Rs. ‘000’ Rs. ‘000’

Ordinary share capital + reserves X X

Fair value adjustments X X
___ ___
X X
___ ___

(2) At the reporting date make the adjustment on the face of the SOFP when
adding across assets and liabilities.

6.2 Uniform Accounting Policies

All group companies should have the same accounting policies.

If a group member uses different accounting policies, its financial statements

must be adjusted to achieve consistency before they are consolidated.

This is achieved by:

(1) adjusting the relevant asset or liability balance in the subsidiary’s individual
statement of financial position prior to adding across on a line by line basis,
and
(2) adjusting W2 to reflect the impact of the different policy on the subsidiary’s
net assets.

7 Intra-Group Trading

7.1 Types of intra-group trading

P and S may well trade with each other leading to the following potential
problem areas:

• current accounts between P and S

• loans held by one company in the other
• dividends and loan interest.
• unrealised profits on sales of inventory
• unrealised profits on sales of Non-current assets

Advanced Financial Accounting and Corporate Reporting (Study Text) 149

7.2 Current accounts
If P and S trade with each other then this will probably be done on credit leading to:

• a receivables (current) account in one company’s SOFP

• a payables (current) account in the other company’s S)FP.

These are amounts owing within the group rather than outside the group and
therefore they must not appear in the consolidated statement of financial position.

They are therefore cancelled (contra’d) against each other on consolidation.

7.3 Cash/goods in transit

At the year end, current accounts may not agree, owing to the existence of in-
transit items such as goods or cash.

The usual rules are as follows:

• If the goods or cash are in transit between P and S, make the adjusting
entry to the statement of financial position of the recipient:

– cash in transit adjusting entry is:

– Dr Cash in transit
– Cr Receivables current account

– goods in transit adjusting entry is:

– Dr Inventory
–Cr Payables current account this adjustment is for the purpose
of consolidation only.

• Once in agreement, the current accounts may be contra’d and cancelled as

part of the process of cross casting the assets and liabilities.

• This means that reconciled current account balance amounts are removed
from both receivables and payables in the consolidated statement of
financial position .

Advanced Financial Accounting and Corporate Reporting (Study Text) 150

 Example 5

Current accounts and cash in transit

Draft SOFPs of P Ltd and S Ltd on 31 March 20X7 are as follows.

P Ltd S Ltd
Rs. ‘000’ Rs. ‘000’

Property, Plant & equipment 100 140

Investment in S at cost 180
Current assets
Inventory 30 35
Trade receivables 20 10

Cash 10 5
___ ___
340 190
Equity and liabilities
Share capital: Ordinary Rs 10 shares 200 100
Share premium 10 30
Retained earnings 40 20
___ ___
250 150
Non-current liabilities
10% loan notes 65 -
Current liabilities 25 40
___ ___
340 190
Notes
• P Ltd bought 8,000 shares in S Ltd in 20X1 when S Ltd ’s reserves included a
share premium of Rs 30,000 and retained profits of Rs 5,000.

• P Ltd.’s accounts show Rs 6,000 owing to S Ltd ; S Ltd 's accounts show Rs
8,000 owed by P Ltd . The difference is explained as cash in transit.

• No impairment of goodwill has occurred to date.

• P Ltd uses the proportion of net assets method to value the non-controlling
interest.

Advanced Financial Accounting and Corporate Reporting (Study Text) 151

 Required
Prepare a consolidated statement of financial position as at 31 March 20X7.

Solution

P Ltd Group Consolidated statement of financial position as at 31 March 20X7

Assets Rs 000 Rs 000

Non-current assets
Intangible assets – goodwill (W3) 72
Property, Plant & equipment
(100 + 140) 240 312
–––
Current assets
Inventory Rs (30 + 35) 65
Trade receivables
(20 + 10 2(CIT) – 6 (inter-co)) 22
Cash (10 + 5 + 2 (CIT)) 17
–––
104
–––
416

Equity
Share capital 200
Share premium 10
Retained earnings (W5) 52
Non-controlling interest (W4) 30
–––
292
–––
Non-current liabilities
10% loan notes
65
Current liabilities
Payables Rs (25 + 40 – 6 (inter-co)) 59
–––
416

Advanced Financial Accounting and Corporate Reporting (Study Text) 152

 Workings

Note: Cash in transit

The Rs 2,000 cash in transit should be adjusted for in S Ltd 's accounts prior to
consolidation.

Assume that the cash has been received and therefore:

• increase S Ltd 's cash balance by Rs 2,000 to Rs 7,000

• decrease S Ltd 's receivables balance by Rs 2,000 to Rs 8,000

The outstanding intercompany balance requiring cancelling is therefore Rs 6,000.

(W1) Group structure

20X1 80%

(W2) Net assets of S Ltd

At date of acquisition At reporting date

Rs. ‘000’ Rs. ‘000’

Share capital 100 100

Share premium 30 30
Retained earnings 5 20
–––– ––––
135 150
–––– ––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 153

 (W3) Goodwill
Rs. ‘000’

Parent holding (investment) at fair value 180

NCI value at acquisition
(20% × Rs 135 (W2) 27
____
207
Less:
Fair value of net assets at acquisition (135)
____
Goodwill on acquisition 72
____

(W4) Non-controlling interest Rs. ‘000’

NCI value at acquisition (as in W3) 27

NCI share of post-acquisition reserves
(20% × (20-5)) 3
–––
30
___

(W5) Group retained earnings Rs. ‘000’

P Ltd retained earnings 40

80% of S Ltd 's post-acquisition
retained earnings
(80% × Rs (20,000 – 5,000) (W2)) 12
–––
52
–––

8 Unrealised Profit

8.1 Profits made by members of a group on transactions with other group members
are:

• recognised in the accounts of the individual companies concerned, but

• in terms of the group as a whole, such profits are unrealised and must be
eliminated from the consolidated accounts.

Advanced Financial Accounting and Corporate Reporting (Study Text) 154

 Unrealised profit may arise within a group scenario on:

• inventory where companies trade with each other

• Non-current assets where one group company has transferred an asset to

another.

8.2 Intra-group trading and unrealised profit in inventory

When one group company sells goods to another a number of adjustments may be
needed.

• Current accounts must be cancelled (see earlier in this chapter).

• Where goods are still held by a group company, any unrealised profit
must be cancelled.

• Inventory must be included at original cost to the group (i.e. cost to the
company which then sold it).

Where goods have been sold by one group company to another at a profit and
some of these goods are still in the purchaser’s inventory at the year end, then
the profit loading on these goods is unrealised from the viewpoint of the group
as a whole.

This is because we are treating the group as if it is a single entity. No one can
make a profit by trading with himself. Until the goods are sold to an outside party
there is no realised profit from the group perspective.

For example, if Alpha purchased goods for Rs 400 and then sold these goods
onto Beta during the year for Rs 500, Alpha would record a profit of Rs 100 in
their own individual financial statements. The statement of financial position of
Beta will include closing inventory at the cost to Beta i.e. Rs 500.

This situation results in two problems within the group:

(1) The profit made by Alpha is unrealised. The profit will only become realised
when sold on to a third party customer.

(2) The value in Beta’s inventory (Rs 500) is not the cost of the inventory to the
group (cost to the group was the purchase price of the goods from the
external third party supplier i.e. Rs 400).

Advanced Financial Accounting and Corporate Reporting (Study Text) 155

 An adjustment will need to be made so that the single entity concept can be
upheld i.e. The group should report external profits, external assets and
external liabilities only.

Adjustments for unrealised profit in inventory

The process to adjust is:
(1) Determine the value of closing inventory included in an individual company’s
accounts which has been purchased from another company in the group.

(2) Use markup or margin to calculate how much of that value represents profit
earned by the selling company.

(3) Make the adjustments. These will depend on who the seller is.

If the seller is the parent company, the profit element is included in the holding
company’s accounts and relates entirely to the group.

Adjustment required
Dr Group retained earnings (deduct the profit in W5)
Cr Group inventory

If the seller is the subsidiary, the profit element is included in the subsidiary
company’s accounts and relates partly to the group, partly to non-controlling
interests (if any).

Adjustment required
Dr Subsidiary retained earnings (deduct the profit in W2 at reporting date)
Cr Group inventory

8.3 Non-Current Assets

If one group member sells Non-current assets to another group member,
adjustments must be made to recreate the situation that would have existed if the
sale had not occurred:

• There would have been no profit on the sale.

• Depreciation would have been based on the original cost of the asset to the
group.

Any profit on sale that is made by the selling entity is unrealised and eliminated as
with inventory. Unlike inventory, which is usually sold shortly after the reporting
date, goods that become Non-current assets of the receiving entity are likely to be
included in the consolidated SOFP for a number of years.

Advanced Financial Accounting and Corporate Reporting (Study Text) 156

 Where there is unrealised profit on property, plant and equipment in Non-current
assets the necessary provision for unrealised profit will reduce as the Non-current
asset is depreciated. Therefore it must be recomputed at the end of each period in
which the asset appears in the consolidated SOFP.

Adjustments for unrealised profit in Non-current assets

The easiest way to calculate the adjustment required is to compare the carrying
value (CV) of the asset now with the CV that it would have been held at had the
transfer never occurred:

CV at reporting date with transfer X

CV at reporting date without transfer (X)
–––
Adjustment required X

The calculated amount should be:

(1) deducted when adding across P’s Non-current assets + S’s Non-current
assets

(2) deducted in the retained earnings of the seller (W2 if the seller is the
subsidiary; W5 if it is the parent company)

Example 6

Unrealised profit in NCA

Parent company (P) transfers an item of Plant to its subsidiary (S) for Rs 6,000 at
the start of 20X1. The Plant originally cost P Rs 10,000 and had an original useful
economic life of 5 years when purchased 3 years ago. The useful economic life of
the asset has not changed as a result of the transfer.

What is the unrealised profit on the transaction at the end of the year of transfer
(20X1)?
NBV Before NBV After Difference
Transfer Transfer

Rs Rs Rs

Cost 10,000
Depreciation (3 yrs) (6,000)
–––––
Carrying value 4,000 6,000 2,000
Depreciation (2,000) (3,000) (1,000)
Carrying value 2,000 3,000 1,000

Advanced Financial Accounting and Corporate Reporting (Study Text) 157

 The overall adjustment would be Rs 1,000 at the reporting date. To adjust the
accounts:

Dr Consolidated retained earnings (W5) Rs 1,000

Cr Property, Plant and equipment Rs 1,000

9 Mid-Year Acquisitions

9.1 Calculation of reserves at date of acquisition

If a parent company acquires a subsidiary midyear, the net assets at the date of
acquisition must be calculated based on the net assets at the start of the
subsidiary's financial year plus the profits of up to the date of acquisition.

To calculate this, it is normally assumed that S’s profit after tax accrues evenly
over time

10 Consolidated Statement Of Changes In Equity

Consolidated statement of changes in equity reflects the combined ‘Net Asset’

position of Parent company and its Subsidiary companies. Proforma of
Consolidated statement of changes in equity is :

Share Share Retained Total

Capital Premium Earnings ______

Opening xxx xxx

Share Issue during the year xxx xxx xxx
Total comprehensive income for the year xxx xxx
Dividends* (xxx) (xxx)

* Dividends include only Parent Company’s dividends to its shareholders

Advanced Financial Accounting and Corporate Reporting (Study Text) 158

Chapter Summary

CSPF

Non-controlling
Pre-acquisition interest
profit and group = non-group
reserves CONSOLIDATION owners of
Only include post- WORKINGS subsidiary
acquisition (W 1) Group structure ‘Return’ their share
movement in (W 2) Net assets of subs net assets
reserve of (W 3) Goodwill at reporting date in
subsidiary in group (W 4) Non-controlling interest non-controlling
account. (W 5) Group retained earnings interest line in
CSPF

Goodwill Mid-year
Fair value (IFRS3) acquisitions
Of cost Calculation Need reserves
Of assets Treatment of of subsidiary at
acquired. positive goodwill date of
Treatment of acquisition (W 2).
negative
goodwill.

Unrealized
profits
in inventory and
non-current
assets
Fair Value
Of cost
of assets
acquired.

Advanced Financial Accounting and Corporate Reporting (Study Text) 159

 Self-Test Questions

1. Draft SOFPs of Paper Ltd and Swan Ltd on 31 December 20X1 are as follows:

Paper Ltd Swan Ltd

Rs. ‘000’ Rs. ‘000’

Property, Plant & equipment 90 100

Investment in Swan Ltd at cost 110
Current assets 50 30
–––– ––––
250 130
–––– ––––
Equity and liabilities
Equity
Ordinary share capital Rs 10 100 100
Retained earnings 120 20
––– –––
220 120
––– –––
Current liabilities 30 10
––– –––
250 130
––– –––

Paper Ltd had bought 8,000 of the ordinary shares of Swan Ltd on 1 January
20X1 when the retained profits of Swan Ltd were Rs 15,000. No impairment of
goodwill has occurred to date.

Prepare a consolidated statement of financial position as at 31 December 20X1,

assuming that the Paper Ltd group values the non-controlling interest using the
proportion of net assets method.

Advanced Financial Accounting and Corporate Reporting (Study Text) 160

2. The following SOFPs have been prepared at 31 December 20X8:

H Ltd J Ltd
Rs Rs
Non-current assets:
Property, Plant & equipment 85,000 18,000
Investments:
Shares in J Ltd 60,000
––––––
145,000
Current assets 160,000 84,000
–––––– ––––––
305,000 102,000
–––––– ––––––

Equity

Ordinary Rs 10 shares 65,000 20,000

Share premium 35,000 10,000
Retained earnings 70,000 25,000
–––––– ––––––
170,000 55,000
Current liabilities 135,000 47,000
––––– –––––
305,000 102,000
–––––– ––––––

H Ltd acquired 1,600 ordinary Rs 10 shares in J Ltd on 1 January 20X8, when J

Ltd’ retained earnings stood at Rs 20,000.On this date, the fair value of the 20%
non-controlling shareholding in J Ltd was Rs 12,500.

The H Ltd Group uses the fair value method to value the non-controlling interest.

Prepare the consolidated statement of financial position of H Ltd as at 31

December 20X8.

Advanced Financial Accounting and Corporate Reporting (Study Text) 161

3.
Statements of Financial Position of P and S as at 30 June 20X8 are given below:

P S
Rs Rs

Property, Plant & equipment 15,000 9,500

Investments 5,000
Current assets 7,500 5,000
–––––– ––––––
27,500 14,500
–––––– ––––––
Share capital Rs 10 6,000 5,000
Share premium 4,000
Retained earnings 12,500 7,200
–––––– ––––––
22,500 12,200
Non-current liabilities 1,000 500
Current liabilities 4,000 1,800
–––––– ––––––
27,500 14,500
–––––– ––––––

P acquired 60% of S on 1 July 20X7 when the retained earnings of S were Rs

5,800. P paid Rs 5,000 in cash. P also issued 2 Rs 10 shares for every 5
acquired in S and agreed to pay a further Rs 2,000 in 3 years’ time. The market
value of P’s shares at 1 July 20X7 was Rs 18. P has only recorded the cash paid
in respect of the investment in S. Current interest rates are 6%.

The P group uses the fair value method to value the non-controlling interests. At
the date of acquisition the fair value of the non-controlling interest was Rs 5,750.

Required:

Prepare the consolidated Statement of Financial Position of P group as

at 30 June 20X8.

4. Hazelnut acquired 80% of the share capital of Peppermint two years ago, when the
reserves of Peppermint stood at Rs 125,000. Hazelnut paid initial cash
consideration of Rs 1 million. Additionally Hazelnut issued 20,000 shares with a
nominal value of Rs 10 and a current market value of Rs 18. It was also agreed
that Hazelnut would pay a further Rs 500,000 in three years’ time. Current interest
rates are 10% pa. The appropriate discount factor for Rs 1 receivable three years

Advanced Financial Accounting and Corporate Reporting (Study Text) 162

 from now is 0.751. The shares and deferred consideration have not yet been
recorded.

Below are the statements of financial position of Hazelnut and Peppermint as at 31

December 20X4:

Hazelnut Peppermint
Rs. ‘000’ Rs. ‘000’

Investment in Peppermint at cost 1,000

Property, Plant & equipment 5,500 1,500

Current assets
Inventory 550 100
Receivables 400 200
Cash 200 50
––––– –––––
7,650 1,850
––––– –––––
Share capital 2,000 500
Retained earnings 1,400 300
––––– –––––
3,400 800
Non-current liabilities 3,000 400
Current liabilities 1,250 650
––––– –––––
7,650 1,850
––––– –––––
At acquisition the fair values of Peppermint’s Plant exceeded its book value by Rs
200,000. The Plant had a remaining useful life of five years at this date.

For many years Peppermint has been selling some of its products under the brand
name of ‘Supermint’. At the date of acquisition the directors of Hazelnut valued this
brand at Rs 250,000 with a remaining life of 10 years. The brand is not included in
Peppermint’s statement of financial position.

The consolidated goodwill has been impaired by Rs 258,000.

The Hazelnut Group values the non-controlling interest using the fair value
method. At the date of acquisition the fair value of the 20% non-controlling interest
was Rs 380,000

Prepare the consolidated statement of financial position as at 31 December 20X4.

Advanced Financial Accounting and Corporate Reporting (Study Text) 163

5.
Statements of Financial Position of P and S as at 30 June 20X8 are given below:
P S
Rs Rs
Non-current assets
Land 4,500 2,500
Plant & equipment 2,400 1,750
Investments 8,000
–––– ––––––
14,900 4,250
Current assets
Inventory 3,200 900
Receivables 1,400 650
Bank 600 150
–––––– ––––––
5,200 1,700
–––––– ––––––
20,100 5,9500
–––––– ––––––
Ordinary share capital Rs 10 each 5,000 1,000
Retained earnings 8,300 3,150
–––––– ––––––
13,300 4,150
Non-current liabilities
8% loan stock 4,000 500
Current liabilities 2,800 1,300
–––––– ––––––
20,100 5,950
–––––– ––––––

P acquired 75% of S on 1 July 20X5 when the balance on S’s retained earnings
was Rs 1,150. P paid Rs 3,500 for its investment in the share capital of S. At the
same time, P invested in 60% of S’s 8% loan stock.

At the reporting date P recorded a payable to S of Rs 400. This did not agree to
the corresponding amount in S's financial statements of Rs 500. The difference is
explained as cash in transit.

At the date of acquisition it was determined that S’s land, carried at cost of Rs
2,500 had a fair value of Rs 3,750. S’s Plant was determined to have a fair value of
Rs 500 in excess of its carrying value and had a remaining life of 5 years at this
time. These values had not been recorded by S.

Advanced Financial Accounting and Corporate Reporting (Study Text) 164

 The P group uses the fair value method to value the non-controlling interest. For
this purpose the subsidiary share price at the date of acquisition should be used.
The subsidiary share price at acquisition was Rs 44 per share.

Goodwill has impaired by Rs 100.

Required
Prepare the consolidated statement of financial position of the P group as at
30 June 20X8.

6.
Health (H) bought 90% of the equity share capital of Safety (S), two years ago on 1
January 20X2 when the retained earnings of Safety stood at Rs 5,000. Statements
of financial position at the year end of 31 December 20X3 are as follows:

Health Safety
Rs. ‘000’ Rs. ‘000’ Rs. ‘000’ Rs. ‘000’
Non-current assets:
Property, Plant & equipment 100 30
Investment in Safety at cost 34
–––– ––––
134 30
Current assets:
Inventory 90 20
Receivables 110 25
Bank 10 5
–––– ––––
210 50
–––– ––––
344 80
–––– ––––

Equity
Share capital 15 5
Retained earnings 159 31
–––– ––––
174 36
Non-current liabilities 120 28
Current liabilities 50 16
–––– ––––
344 80
–––– ––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 165

 Safety transferred goods to Health at a transfer price of Rs 18,000 at a markup of
50%. Two-thirds remained in inventory at the year end. The current account in
Health and Safety stood at Rs 22,000 on that day. Goodwill has suffered an
impairment of Rs 10,000.

The Health group uses the fair value method to value the non-controlling interest.
The fair value of the non-controlling interest at acquisition was Rs 4,000

Prepare the consolidated statement of financial position at 31/12/X3.

7. Consolidated Statement of Financial Position

On 1 May 2007 K Ltd bought 60% of S Ltd paying Rs 76,000 cash. The
summarised Statements of Financial Position for the two companies as at 30
November 2007 are:

Non-current assets
Property, Plant & equipment 138,000 115,000
Investments 98,000 -
Current assets
Inventory 15,000 17,000
Receivables 19,000 20,000
Cash 2,000 -
–––––– ––––––
272,000 152,000
Share capital 50,000 40,000
Retained earnings 189,000 69,000
–––––– ––––––
239,000 109,000

Non-current liabilities
8% Loan notes - 20,000
Current liabilities 33,000 23,000
–––––– ––––––
272,000 152,000
–––––– ––––––

The following information is relevant

(1) The inventory of S Ltd includes Rs 8,000 of goods purchased from K Ltd at
cost plus 25%.

(2) On 1 June 2007 S Ltd transferred an item of Plant to K Ltd for Rs 15,000. Its
carrying amount at that date was Rs 10,000. The asset had a remaining
useful economic life of 5 years.

Advanced Financial Accounting and Corporate Reporting (Study Text) 166

 (3) The K Ltd Group values the non-controlling interest using the fair value
method. At the date of acquisition the fair value of the 40% non-controlling
interest was Rs 50,000.

(4) An impairment loss of Rs 1,000 is to be charged against goodwill at the year

end.

(5) S Ltd earned a profit of Rs 9,000 in the year ended 30 November 2007.

(6) The loan note in S Ltd.’s books represents monies borrowed from K Ltd
during the year. All of the loan note interest has been accounted for.

(7) Included in K Ltd.’s receivables is Rs 4,000 relating to inventory sold to S

Ltd during the year. S Ltd raised a cheque for Rs 2,500 and sent it to K Ltd
on 29 November 2007. K Ltd did not receive this cheque until 4 December
2007.

Advanced Financial Accounting and Corporate Reporting (Study Text) 167

 Answers

1. Paper Ltd consolidated statement of financial position as at 31 December 20X1

Rs. ‘000’
Non-current assets
Goodwill (W3) 18
PPE Rs (90,000 + 100,000) 190
–––
208
Current assets Rs (50,000 + 30,000) 80
–––
Total assets 288
–––
Equity
Ordinary share capital Rs 10 (100% P only) 100
Retained earnings (W5) 124

Non-controlling interest (W4) 24

–––
248
Current liabilities Rs (30,000 + 10,000) 40
–––
Total equity and liabilities 288
___

Workings

(W1) Establish the group structure

(percentage of shares purchased 8,000 / 10,000 = 80%)

1 Jan X1 80%

Advanced Financial Accounting and Corporate Reporting (Study Text) 168

 (W2) Net assets of Swan Ltd
At date of At the
Acquisition reporting
date
Rs. ‘000’ Rs. ‘000’

Ordinary share capital 100 100

Retained earnings 15 20
___ ___
115 120
___ ___

(W3) Goodwill Rs. ‘000’

Parent holding (investment) at fair value 110

NCI value at acquisition
(20% × 115 (W2)) 23
————
133
Less:
Fair value of net assets at acquisition (W2) (115)
————
Goodwill on acquisition 18
————

(W4) NCI

NCI value at acquisition (as in W3) 23

NCI share of post-acquisition reserves (W2) 1
(20% × (120 – 115) (W2))
–––––
24
–––––
(W5) Group retained earnings

Paper Ltd (100%) 120

80% of Swan Ltd post-acquisition retained earnings 4
(80% × (120 – 115) (W2))
124
___

Advanced Financial Accounting and Corporate Reporting (Study Text) 169

2. H Ltd consolidated statement of financial position as at 31 December 20X8:

Rs
Goodwill (W3) 22,500
PPE
(85,000 + 18,000) 103,000
Current assets
(160,000 + 84,000) 244,000
______
369,500
______
Equity:
Share capital 65,000
Share premium 35,000
Group retained earnings (W5) 74,000
Non-controlling interest (W4) 13,500
______
187,500
Current liabilities
(135,000 + 47,000) 182,000
______
369,500
______
(W1) Group structure

(percentage of shares purchased 1,600 / 2,000 = 80%)

D

1 Jan X8 80%

(W2) Net assets of J Ltd

At date of acquisition At reporting

date

Share capital 20,000 20,000

Share premium 10,000 10,000
Retained earnings 20,000 25,000
______ ______
Net assets 50,000 55,000
______ ______

Advanced Financial Accounting and Corporate Reporting (Study Text) 170

 (W3) Goodwill
Parent holding (investment) at fair value 60,000
NCI value at acquisition 12,500
______
72,500
Less:
Fair value of net assets at acquisition (50,000)
______
Goodwill on acquisition 22,500
______

(W4) Non-controlling interests

NCI value at acquisition (as in W3) 12,500
NCI share of post-acquisition reserves (W2) 1,000
(20% × (25,000 - 20,000))
———
13,500
———

(W5) Group retained earnings

H Ltd 70,000
80% J Ltd post-acquisition profit 4,000
(80% × Rs (25,000 -20,000
(W2))
–––––
74,000
–––––

3.
Goodwill (W3) 3,790
Property, Plant & equip (15,000 + 9,500) 24,500
Investments (5,000 – 5,000) -
Current Assets (7,500 + 5,000) 12,500
––––––
40,790
––––––
Share capital (6,000 + 1,200) 7,200
Share premium (4,000 + 960) 4,960
Retained earnings (W5) 13,239

Non-controlling Interest (W4) 6,310

––––––
31,709

Advanced Financial Accounting and Corporate Reporting (Study Text) 171

 Non-current liabilities (1,000 + 500 + 1,680 +101) 3,281
Current liabilities (4,000 + 1,800) 5,800
––––––
40,790
––––––

Workings

(W1) Group structure

60%

S
1 July 20x7 i.e. 1 yr

(W2) Net Assets

@ acq'n @ rep date

Share capital 5,000 5,000

Retained earnings 5,800 7,200
–––––– ––––––
10,800 12,200
–––––– ––––––

(W3) Goodwill

Parent holding (investment) at fair value:

Cash paid 5,000
Share exchange 2,160

(60% × 500 × 2/5 × Rs 18)

Deferred consideration 1,680
(2,000 × 1/1.063)
––––––
8,840
NCI value at acquisition 5,750
––––––
14,590

Advanced Financial Accounting and Corporate Reporting (Study Text) 172

 Less:
Fair value of net assets at acquisition (W2) (10,800)
––––––
Goodwill on acquisition 3,790
––––––
Shares
P has issued 120 shares valued at Rs 18 each. These have not yet been
recorded and so an adjustment is required to:

Cr Share capital 1,200

Cr Share premium 960

Deferred consideration
P has a liability to pay Rs 2,000 in 3 yrs time which has not yet been
recorded. The liability is being measured at its present value of Rs 1,680
at the date of acquisition and so the adjustment required is:
Cr Non-current liabilities Rs 1,680

The Statement of Financial Position date is 1 year after the date of

acquisition and so the present value of the liability will have increased by
6% (i.e. it is unwound by 6%) by the Statement of Financial Position date.
An adjustment is therefore required to reflect this increase:

Dr Finance cost i.e. Retained earnings of P (6% x 1,680) Rs 101

Cr Deferred consideration i.e. Non-current liabilities Rs 101

(W4) Non-controlling interests

NCI value at acquisition (as in W3) 5,750
NCI share of post-acquisition reserves (W2) 560
(40% × (7,200- 5,800))
––––––
6,310
––––––
(W5) Retained earnings
P retained earnings 12,500
Deferred consideration finance cost (101)
S (60% × (12,200 – 10,800 (W2))) 840
–––––
13,239
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 173

4. Hazelnut consolidated statement of financial position at 31 December 20X4:
Rs. ‘000’

Goodwill (W3) 783

Brand name (W2) 200
Property, Plant & equipment (5,500 + 1,500 + 200 80) 7,120
Current assets:
Inventory (550 + 100) 650
Receivables (400 + 200) 600
Cash (200 + 50) 250
–––––
9,603
–––––
Share capital (2,000 + 200) 2,200
Share premium (0 + 160) 160
Retained earnings (W5) 1,151
–––––
3,511
Non-controlling interest (W4) 337
–––––
3,848
Non-current liabilities (3,000 + 400) 3,400
Current liabilities (1,250 + 650) 1,900
Deferred consideration (376 + 79) 455
–––––
9,603
–––––
Workings
(W1) Group structure

Hazelnut

2 years ago 80%

Peppermint

Advanced Financial Accounting and Corporate Reporting (Study Text) 174

 (W2) Net assets of Peppermint

At date of acquisition At reporting date

Share capital 500 500

Retained earnings 125 300
Plant fair value adjustment 200 200
Depreciation adjustment (80)
(200 / 5 years × 2 years)
Brand fair value adjustment 250 250
Amortisation adjustment
(250 / 10 years × 2 years) (50)
_____ _____
1,075 1,120
_____ _____
(W3) Goodwill
Parent holding (investment) at fair value:
Cash paid 1,000
Share exchange (20 × Rs 18) 360
Deferred consideration (500 × 0.751) 376
———
1,736
NCI value at acquisition 380
———
2,116
Less:
Fair value of net assets at acquisition (W2) (1,075)
———
Goodwill on acquisition 1,041
Impairment (258)
———
Carrying goodwill 783
———

Note: the cost of the investment in Hazelnut’s SOFP is Rs 1 million, i.e. the
cash consideration paid. Hazelnut has:

Dr Investment Rs 1 million
Cr Bank Rs 1 million

Hazelnut has not yet recorded the share consideration or the deferred
consideration. The journals required to record these are:

Advanced Financial Accounting and Corporate Reporting (Study Text) 175

 Dr Investment Rs 360,000
Cr Share capital (nominal element) Rs 200,000
Cr Share premium (premium element) Rs 160,000
And
Dr Investment Rs 376,000
Cr Deferred consideration Rs 376,000

In the CSOFP, since the cost of the investment does not appear there is no
need to worry about the debit side of the entries. The credit entries do,
however, need recording.

(W4) Non-controlling interest

NCI value at acquisition (as in W3) 380
NCI share of post-acquisition reserves 9
(20% × (1,120 -1,075) (W2))
——
389
NCI share of impairment (52)
(258 × 20%)
——
337
——
(W5) Group retained earnings
Hazelnut retained earnings 1,400
Unwind discount (W6) (79)
Peppermint (80% × (1,120 – 1,075)) 36
Impairment of goodwill (W3)
(80% × 258) (206)
_____
1,151
_____
(W6) Unwinding of discount
Present value of deferred consideration at acquisition 376
Present value of deferred consideration at reporting date 455
___
79
At acquisition, Hazelnut should record a liability of 376, being the present
value of the future cash flow at that date.
The reporting date is two years’ liability and there is only one year to go until
the deferred consideration will be paid. Therefore the liability in Hazelnut’s
SOFP at this date is 376 × 1.102.

Advanced Financial Accounting and Corporate Reporting (Study Text) 176

 So, Hazelnut needs to:
Dr Income statement 79
Cr Deferred consideration liability 79

5.
Non-current assets
Rs
Goodwill (W3) 600
Land (4,500 + 2,500 + 1,250) 8,250
Plant & equipment (2,400 + 1,750 + 500 – 300) 4,350
Investments (8,000 – 3,500 – (60% × 500)) 4,200
––––––
17,400
Current Assets
Inventory 4,100
(3,200 + 900)
Receivables
(1,400 + 650- 100 (CIT) – 400 (interco)) 1,550

Bank (600 + 150 + 100 (CIT)) 850

––––––
6,500
––––––
23,900
––––––
Equity
Share capital 5,000
Retained earnings (W5) 9,500
Non-controlling
Interest (W4) 1,500
––––––
16,000
Non-current liabilities (4,000 + 500 – (60% × 500)) 4,200
Current liabilities (2,800 + 1,300 400) 3,700
––––––
23,900
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 177

Workings

(W1) Group structure

P

75%

S
1 July 20x5 i.e. 3 yrs

(W2) Net assets

At Acquisition Date At Reporting
Date

Share capital 1,000 1,000

Retained earnings 1,150 3,150
FV Adj Land (3,750 – 2,500) 1,250 1,250
FV Adj Plant 500 500
Dep'n Adj (500 × 3/5) (300)
––––– –––––
3,900 5,600
––––– –––––
(W3) Goodwill
Parent holding (investment) at fair value 3,500
NCI value at acquisition 1,100
((100 shares × 25%) × Rs 44)
–––––
4,600
Less:
Fair value of net assets at acquisition (W2) (3,900)
–––––
Goodwill on acquisition 700
Impairment (100)
–––––
Carrying goodwill 600
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 178

 (W4) Non-controlling interest
NCI value at acquisition (as in W3) 1,100
NCI share of post-acquisition reserves (W2) 425
(25% × (5,600 - 3,900))
Less:
NCI share of impairment (25)
(25% × 100)
–––––
1,500
–––––

(W5) Group retained earnings

100% P 8,300
75% of S post acq retained earnings
(75% × (5,600 – 3,900)) 1,275
75% Impairment (75)
(75% × 100)
–––––
9,500
–––––
6. Consolidated SOFP for Health as at 31/12/X3:

Non-current assets Rs. ‘000’

Goodwill (W3) 18
Property, Plant & equipment
(100 + 30) 130
——
148
Current Assets
Inventory
(90 + 20 4 (W6)) 106
Receivables 113
(110 + 25 22 intra-co receivable)

Bank 15
(10 + 5)
—— 234
——
382
——

Advanced Financial Accounting and Corporate Reporting (Study Text) 179

 Equity
Share capital 15.0
Group retained earnings (W5) 169.8
NCI (W4) 5.2
——
190.0
Non-current liabilities
(120 + 28) 148.0
Current liabilities
(50 + 16 22 intra-co payable) 44.0
———
382.0
———

Working paper

(W1) Group structure

H
90% 01/01/X2
2 years ago
S

(W2) Net assets

At Acquisition Date At Reporting

Date

Share capital 5 5
Retained earnings 5 31
Provision for unrealized profit (W6) (4)
— —
10 32
— —

(W3) Goodwill

Parent holding (investment) at fair value 34

NCI value at acquisition 4
––––
38

Advanced Financial Accounting and Corporate Reporting (Study Text) 180

 Less:
Fair value of net assets at acquisition (W2) (10)
––––
Goodwill on acquisition 28
Impairment (10)
––––
Carrying goodwill 18
––––
(W4) Non-controlling interest
NCI value at acquisition (as in W3) 4
NCI share of post-acquisition reserves (W2) 2.2
(10% × (32 - 10))
Less:
NCI share of impairment (1)
(10% × Rs 10)
–––––
5.2
–––––
(W5) Group reserves
100% Health 159
90% safety Post Acq
(90% × (Rs 32 - Rs 10 (W2)) 19.8
Impairment (W3) (9)
(90% × Rs 10)
——
169.8
——
(W6) Provision for unrealized profit
Sales Rs 18 150%
COS 100%
––––– –––––
Gross profit Rs 6 50%
––––– –––––
×2/3
Provision for unrealized profit = Rs 4

7. Consolidated Statement of Financial Position as at 30 November 2007

Rs
Non-current assets
Goodwill (W3) 21,250
PPE
(138,000 + 115,000 – 4,500) 248,500
Investments
(98,000 – 76,000 – 20,000) 2,000

Advanced Financial Accounting and Corporate Reporting (Study Text) 181

 Current Assets
Inventory
(15,000 + 17,000 – 1,600) 30,400
Receivables
(19,000 + 20,000, 2,500 - 1,500) 35,000
Cash
(2,000 + 2,500) 4,500
–––––––
341,650
–––––––
Share capital 50,000
Group retained earnings (W5) 187,250
Non-controlling
Interest (W4) 49,900
–––––––
287,150
Non-current liabilities
(20,000 – 20,000)
Current liabilities 54,500
(33,000 + 23,000 – 1,500)
–––––––
341,650
–––––––
Workings

(W1) Group structure

60%

S
1 May 20x7 i.e. 7 months

Advanced Financial Accounting and Corporate Reporting (Study Text) 182

 (W2) Net assets
@ acq @ rep

Date

Share capital 40,000 40,000

Retained earnings 63,750 69,000
Provision for unrealized profits (W7) (4,500)
––––––– –––––––
103,750 104,500
––––––– –––––––
RE @ acq'n (balance) (ß) 63,750
Post acq profit (7/12 × 9,000) 5,250
–––––––
RE @ reporting date 69,000
–––––––

(W3) Goodwill
Parent holding (investment) at fair value 76,000
NCI value at acquisition 50,000

126,000
Less:
Fair value of net assets at acquisition (W2) (103,750)
––––––
Goodwill on acquisition 22,250
Impairment (1,000)
––––––
Carrying goodwill 21,250
––––––
(W4) Non-controlling interest
NCI value at acquisition (as in W3) 50,000
NCI share of post-acquisition reserves (W2) 300
(40% × (104,500 - 103,750))
Less:
NCI share of impairment (400)
(40% × Rs 1,000)
–––––
49,900
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 183

 (W5) Group retained earnings
100% K Ltd 189,000
Provision for unrealized profits (1,600)
60% S Ltd post-acq profit
(60% × (104,500 – 103,750 (W2))) 450
Impairment group share
(60% × 1,000 (W3)) (600)
–––––––
187,250
–––––––
(W6) Provision for unrealized profit – Inventory
Profit in inventory (25/125 × 8,000) = 1,600

(W7) Provision for unrealized profit – Plant

NBV in books (15,000 – (15,000 × 1/5 × 6/12)) 13,500
NBV should be (10,000 – (10,000 × 1/5 × 6/12)) (9,000)
–––––
Provision for unrealized profit 4,500
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 184

Advanced Financial Accounting and Corporate Reporting (Study Text) 185
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

• Prepare a consolidated statement of comprehensive income for a simple

group and a non-controlling interest.
• Account for the effects of intra-group trading in the statement of
comprehensive income.
• Prepare a consolidated statement of comprehensive income for a simple
group with an acquisition in the period and non-controlling interest.
• Account for impairment of goodwill.
• Prepare a consolidated statement of comprehensive income.

Advanced Financial Accounting and Corporate Reporting (Study Text) 186

1 Principles of the Consolidated Statement of Comprehensive Income

1.1 Basic principle

The consolidated statement of comprehensive income shows the profit
generated by all resources disclosed in the related consolidated statement of
financial position, i.e. the net assets of the parent company (P) and its
subsidiary (S).

The consolidated statement of comprehensive income follows these basic

principles:

• From revenue to profit for the year include all of P’s income and
expenses plus all of S’s income and expenses (reflecting control of S).
• After profit for the year show split of profit between amounts
attributable to the parent's shareholders and the non-controlling interest
(to reflect ownership).

1.2 The mechanics of consolidation

As with the statement of financial position, it is common to use standard
workings when producing a consolidated statement of comprehensive
income:

• group structure diagram

• net assets of subsidiary at acquisition (required for goodwill calculation
if asked to calculate)
• goodwill calculation (if asked to calculate goodwill or if you are required
to calculate an impairment that is to be charged to profits (see below))
• non-controlling interest (NCI) share of profit (see below)

1.3 Non-controlling interest

This is calculated as:

NCI % × subsidiary’s profit after tax X
Less:
NCI % × fair value depreciation (X)
NCI % × Provision for unrealized profit (sub = seller only) (X)
NCI % × impairment (fair value method) (X)
–––––
X
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 187

2 Intra-Company Trading

2.1 Sales and purchases

The effect of intra-group trading must be eliminated from the consolidated
statement of comprehensive income.

Such trading will be included in the sales revenue of one group company and
the purchases of another.

• Consolidated sales revenue = P’s revenue + S’s revenue – intra-group

sales.
• Consolidated cost of sales = P’s COS + S’s COS – intra-group sales.

2.2 Interest
If there is a loan outstanding between group companies the effect of any loan
interest received and paid must be eliminated from the consolidated
statement of comprehensive income.

The relevant amount of interest should be deducted from group investment

income and group finance costs.

2.3 Dividend
A payment of a dividend by S to P will need to be cancelled. The effect of this
on the consolidated financial statements is:

• only dividends paid by P to its own shareholders appear in the consolidated

financial statements. These are shown within the consolidated statement of
changes in equity

• any dividend income shown in the consolidated statement of comprehensive

income must arise from investments other than those in subsidiaries or
associates

Example 1
The statement of comprehensive incomes for P Ltd and S Ltd for the year
ended 31 August 20X4 are shown below. P Ltd acquired 75% of the ordinary
share capital of S Ltd several years ago.

Advanced Financial Accounting and Corporate Reporting (Study Text) 188

 P Ltd S Ltd
Rs. ‘000’ Rs. ‘000’

Revenue 2,400 800

Cost of sales and expenses (2,160) (720)
–––––––– –––––––
Trading profit 240 80
Investment income:
Dividend received from S Ltd 1.5
–––––––– –––––––
Profit before tax 241.5 80
Tax (115) (38)
–––––––– –––––––
Profit for the year 126.5 42

Required
Prepare the consolidated statement of comprehensive income for the year.
Solution

P Ltd consolidated statement of comprehensive income for year ended

31 August 20X4
Rs. ‘000’
Revenue
(2,400 + 800 3,200
Cost of sales and expenses
(2,160 + 720) (2,880)
––––––
Profit before tax 320
Tax
(115 + 38) (153)
––––––
Profit for the year 167

Attributable to:
Group (167 – NCI) 156.5

Non-controlling interest (W1)

10.5

Advanced Financial Accounting and Corporate Reporting (Study Text) 189

 (W1) Non-controlling interest
NCI share of subsidiary profit for the year
25% × Rs 42 = Rs 10.5

2.4 Provision for unrealised profit (PURP)

Inventory
If any goods sold intra-group are included in closing inventory, their value
must be adjusted to the lower of cost and net realisable value (NRV) to the
group (as in the CSOFP).

The adjustment for unrealised profit should be shown as an increase to cost

of sales (return inventory back to true cost to group and eliminate unrealized
profit).

In the previous chapter, the treatment of unrealised trading profits in the

consolidated SOFP was dealt with. In producing the consolidated statement of
comprehensive income, a rather more involved adjustment is required.

If, in a certain year:

• A buys an inventory item for Rs 60

• A sells it to B for Rs 80, B being a member of the same group as A
• B still holds the item at the reporting date, then the statement of
comprehensive incomes of the two companies will include, in respect
of these events:

A B
Rs Rs

Sales revenue 80 –
Cost of sales (60) –
___
Profit 20 –
___

Note that B's cost of sales is nil since the goods are still held at the year end,
hence they do not qualify as 'cost of sales'. The Rs 20 is the unrealised profit
whose cancellation in the SOFP was discussed in the previous chapter. In the
statement of comprehensive income, we must

(1) eliminate sales of Rs 80 in A's books and purchases of Rs 80 in B's

books
(2) cancel the unrealised profit of Rs 20 in A (the seller's) books.

Advanced Financial Accounting and Corporate Reporting (Study Text) 190

 If B had sold the item for Rs 95 by the reporting date, the statement of
comprehensive incomes of the two companies would have shown:

A B
Rs Rs

Sales revenue 80 95
Cost of sales (60) (80)
__ __
Gross profit (and other subtotals) 20 15
__ __

Both companies would have realised their profits and so these should not be
adjusted. However, a single equivalent company would show in its statement
of comprehensive income:
Rs

Sales revenue 95
Cost of sales (60)
__
Gross profit (and other subtotals) 35
__

In this case, we need to eliminate only the Rs 80 from sales revenue and the
Rs 80 from cost of sales in order to establish the correct revenue and cost of
sales figures. No adjustment would be required for unrealised profit since all
profits are now realised.

Effect on non-controlling interests

If the unrealised profit originally arose in the subsidiary, the non-controlling
interest must be adjusted for its share in the unrealised profit. To achieve this,
in the first instance all the unrealised profit must be eliminated to determine
the correct amount of gross profit earned by the group trading as if it were a
single entity. Then the NCI’s share is calculated by reference to the reduced
amount of the subsidiary's post-tax profits. Provision for unrealized profit is
added in to cost of sales and remove NCI share in the NCI working.

Example 2
On 1 January 20X9 Zee Ltd acquired 60% of the ordinary shares of Bee Ltd.

The following statement of comprehensive incomes have been produced by

Zee Ltd and Bee Ltd for the year ended 31 December 20X9.

Advanced Financial Accounting and Corporate Reporting (Study Text) 191

 Zee Ltd Bee Ltd
Rs. ‘000’ Rs. ‘000’

Revenue 1,260 520

Cost of sales (420) (210)
––––– –––––
Gross profit 840 310
Distribution costs (180) (60)
Administration expenses (120) (90)
––––– –––––

Profit from operations 540 160

Investment income from Bee Ltd 36
––––– –––––
Profit before taxation 576 160
Taxation (130) (26)
Profit for the year 446 134
––––– –––––

During the year ended 31 December 20X9 Zee Ltd had sold Rs 84,000 worth
of goods to Bee Ltd. These goods had cost Zee Ltd Rs 56,000. On 31
December 20X9 Bee Ltd still had Rs 36,000 worth of these goods in
inventories (held at cost to Bee Ltd).

Prepare the consolidated statement of comprehensive income to incorporate

Zee Ltd and Bee Ltd for the year ended 31 December 20X9.

Note: Goodwill on consolidation has not been impaired.

Solution
Zee Ltd consolidated statement of comprehensive income for the year ended
31 December 20X9
Rs 000

Revenue 1,696
(1,260 + 520 - 84)
Cost of sales (558)
(420 + 210 - 84 + 12)
–––––
Gross profit 1,138

Advanced Financial Accounting and Corporate Reporting (Study Text) 192

 Distribution costs
(180 + 60) (240)
Administrative expenses (210)
(120 + 90)
–––––
Profit from operations 688
Taxation (156)
(130 + 26)
–––––
Profit for the year 532

Amount attributable to
Equity holders of the parent (532 – NCI) 478.4
Non-controlling interests (W3) 53.6

Workings

(W1) Group structure

Zee Ltd

1 Jan x 9 60%

Bee Ltd

(W2) Unrealised profit in inventory

Rs. ‘000’

Selling price 84
Cost (56)
–––
Total profit 28
–––
The profit markup is therefore one third of the selling price

28 1
=
84 3

Advanced Financial Accounting and Corporate Reporting (Study Text) 193

 Since closing inventory at selling price is Rs 36,000 the unrealised profit is

1
x Rs 36,000 = Rs 12,000
3

(W-3) Non-controlling interest

Rs. ‘000’

NCI share of subsidiary’s profit after tax 40% x Rs 134,000 53.6

Transfers of non-current assets

If one group company sells a non-current asset to another group company the
following adjustments are needed in the statement of comprehensive income
to account for the unrealised profit and the additional depreciation.

• Any profit or loss arising on the transfer must be removed from the
consolidated statement of comprehensive income.
• The depreciation charge must be adjusted so that it is based on the
cost of the asset to the group.

Non-current assets may be sold between group companies. If the selling price
of such an asset is the same as the carrying value in the books of the seller at
the time of the sale, then no adjustments are necessary as the buyer will
account for (and depreciate) the asset by reference to its original cost to the
group.

If, however the seller makes a profit on the sale, the buyer will account for the
asset at a value higher than the depreciated cost to the group. The profit
made by the seller is gradually realised over the asset’s remaining life by the
buyer’s depreciation charges being calculated on a value higher than original
cost to the group. So at the time when the buyer has fully depreciated the
acquired asset, the whole of the seller’s profit has been realised and no
adjustments are necessary.

However, as long as the buyer is still depreciating the acquired asset, the
amount of the seller’s unrealised profit must be eliminated from both earnings
and the carrying value of the asset. Adjustments are needed in order to return
to the situation if the sale had not taken place:

• any remaining unrealised profit or loss arising on the transfer is

eliminated
• the asset’s cost and accumulated depreciation are adjusted so that
they are based on the cost of the asset to the group.

Advanced Financial Accounting and Corporate Reporting (Study Text) 194

3 Other Consolidated Income Statement Adjustments

3.1 Impairment of goodwill

Once any impairment has been identified during the year, the charge for the
year will be passed through the consolidated statement of comprehensive
income. This will usually be through operating expenses, however always
follow instructions from the examiner.

If non-controlling interests have been valued at fair value, a portion of the

impairment expense must be removed from the non-controlling interest's
share of profit.

3.2 Fair values

If a depreciating Non-current asset of the subsidiary has been revalued as
part of a fair value exercise when calculating goodwill, this will result in an
adjustment to the consolidated statement of comprehensive income.

The subsidiary's own statement of comprehensive income will include

depreciation based on the value the asset is held at in the subsidiary's own
SOFP.

The consolidated statement of comprehensive income must include a

depreciation charge based on the fair value of the asset, included in the
consolidated SOFP.

Extra depreciation must therefore be calculated and charged to an

appropriate cost category (usually in line with examiner requirements).

4 Midyear acquisitions

4.1 Midyear acquisition procedure

If a subsidiary is acquired part way through the year, then the subsidiary’s
results should only be consolidated from the date of acquisition, i.e. the date
on which control is obtained.
In practice this will require:

• Identification of the net assets of S at the date of acquisition in order to

calculate goodwill.

• Time apportionment of the results of S in the year of acquisition. For

this purpose, unless indicated otherwise, assume that revenue and
expenses accrue evenly.

Advanced Financial Accounting and Corporate Reporting (Study Text) 195

 • After time-apportioning S’s results, deduction of post-acquisition intra-
group items as normal.

Example 3
The following statement of comprehensive incomes were prepared for the
year ended 31 March 20X9.

E Ltd F Ltd
Rs. ‘000’ Rs. ‘000’

Revenue 303,600 217,700

Cost of sales (143,800) (102,200)
_______ _______
Gross profit 159,800 115,500
Operating expenses (71,200) (51,300)
_______ _______
Profit from operations 88,600 64,200
Investment income 2,800 1,200
_______ _______
Profit before tax 91,400 65,400
Taxation (46,200) (32,600)
_______ _______
Profit for the year 45,200 32,800

On 30 November 20X8 E Ltd acquired 75% of the issued ordinary capital of F

Ltd. No dividends were paid by either company during the year. The
investment income is from quoted investments and has been correctly
accounted for.

The profits of both companies are deemed to accrue evenly over the year.

5 The Consolidated Statement of Comprehensive Income

5.1 The consolidated statement of comprehensive income may be asked for in

the exam instead of a consolidated income statement. The consolidated
statement of comprehensive income is the starting point and the other
comprehensive income items are then recorded.

The items that you may need to consider for items of other comprehensive
income include revaluations gains or losses and fair value through other
comprehensive income gains or losses. To demonstrate how these items
should be dealt with we will take Self-Test Question No 3 and add items of
comprehensive income to illustrate this.

Advanced Financial Accounting and Corporate Reporting (Study Text) 196

 Illustration
The answer to Self-Test Question No 3 shows the consolidated statement of
comprehensive income of the Steel Ltd group.

In addition Steel Ltd recorded a revaluation gain on its land of Rs 500 at the
year end and a loss on fair value through other comprehensive income
financial assets for the year of Rs 100. All items are deemed to accrue evenly
over time except where otherwise indicated.

Consolidated Statement of comprehensive income for the Steel Ltd

group for the year ended 31 March 20X7:
Rs

Revenue 34,600
Cost of Sales (18,150)
––––––
Gross profit 16,450
Operating expenses (10,980)
––––––
Profit from operations 5,470
Investment Income 1,650
––––––
Profit before tax 7,120
Tax (2,475)
––––––
Profit for the year 4,645
––––––
Other comprehensive income

Gain on revaluation of land 500

Loss on financial assets (100 × 9/12) (75)
––––––
425
––––––
Total comprehensive income 5,070
––––––
Profit attributable to:
NCI 58.5
Group 4,586.5
––––––
4,645
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 197

 Total comprehensive income attributable to:
NCI (58.5 + (500 ( 100 x 9/12) x 30%)) 186
Group (4586.5 + (500 ( 100 x 9/12) x 70%)) 4,884
––––––
5,070
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 198

Chapter Summary

Advanced Financial Accounting and Corporate Reporting (Study Text) 199

 Self-Test Questions

1. Set out below are the draft statement of comprehensive incomes of S Ltd and
its subsidiary company F Ltd for the year ended 31 December 20X7.

On 1 January 20X6 S Ltd purchased 75,000 ordinary shares in F Ltd from an

issued share capital of 100,000 Rs 1 ordinary shares.

Statement of comprehensive incomes for the year ended 31 December 20X7:

S Ltd F Ltd
Rs. ‘000’ Rs. ‘000’

Revenue 600 300

Cost of sales (360) (140)
–––– ––––
Gross profit 240 160
Operating expenses (93) (45)
–––– ––––
Profit from operations 147 115
Finance costs (3)
–––– ––––
Profit before tax 147 112
Tax (50) (32)
–––– ––––
Profit for the year 97 80

The following additional information is relevant:

(1) During the year F Ltd sold goods to S Ltd for Rs 20,000, making a
markup of one third. Only 20% of these goods were sold before the
end of the year, the rest were still in inventory.

(2) Goodwill has been subject to an impairment review at the end of each
year since acquisition and the review at the end of this year revealed
another impairment of Rs 5,000. The current impairment is to be
recognised as an operating cost.

(3) At the date of acquisition a fair value adjustment was made and this
has resulted in an additional depreciation charge for the current year of
Rs 15,000. It is group policy that all depreciation is charged to cost of
sales.

Advanced Financial Accounting and Corporate Reporting (Study Text) 200

 (4) S Ltd values the non-controlling interests using the fair value method.

Prepare the consolidated statement of comprehensive income for the year

ended 31 December 20X7.

2. Given below are the statement of comprehensive incomes for P Ltd and its
subsidiary L Ltd for the year ended 31 December 20X5.
P Ltd L Ltd
Rs. ‘000’ Rs. ‘000’

Revenue 3,200 2,560

Cost of sales (2,200) (1,480)
––––– –––––
Gross profit 1,000 1,080
Distribution costs (160) (120)
Administrative expenses (400) (80)
––––– –––––
Profit from operations 440 880
Investment income 160 –
––––– –––––
Profit before tax 600 880
Taxation (400) (480)
––––– –––––
Profit for the year 200 400

Additional information
• P Ltd paid Rs 1.5 million on 31 December 20X1 for 80% of L Ltd’s
800,000 ordinary shares.

• Goodwill impairments at 1 January 20X5 amounted to Rs 152,000. A

further impairment of Rs 40,000 was found to be necessary at the year
end. Impairments are included within administrative expenses.

• P Ltd made sales to L Ltd, at a selling price of Rs 600,000 during the

year. Not all of the goods had been sold externally by the year end.
The profit element included in L Ltd’s closing inventory was Rs 30,000.

• Fair value depreciation for the current year amounted to Rs 10,000. All
depreciation should be charged to cost of sales.

• L Ltd paid an interim dividend during the year of Rs 200,000.

• P Ltd values the non-controlling interests using the fair value method.

Advanced Financial Accounting and Corporate Reporting (Study Text) 201

 Required
Prepare Consolidated Income statement for the year ended 31 Dec 20x5

3. Steel Ltd bought 70% of Salt on 1 July 20X6. The following are the Statement
of comprehensive incomes of Steel Ltd and Salt for the year ended 31 March
20X7:

Steel Ltd Salt

Rs Rs

Revenue 31,200 10,400

Cost of sales (17,800) (5,600)
–––––– ––––––
Gross profit 13,400 4,800
Operating expenses (8,500) (3,200)
–––––– ––––––
Profit from operations 4,900 1,600
Investment Income 2,000 -
–––––– ––––––
Profit before tax 6,900 1,600
Tax (2,100) (500)
–––––– ––––––
Profit for the year 4,800 1,100
–––––– ––––––

The following information is available:

(1) On 1 July 20X6, an item of plant in the books of Salt had a fair value of
Rs 5,000 in excess of its carrying value. At this time, the plant had a
remaining life of 10 years. Depreciation is charged to cost of sales.

(2) During the post-acquisition period Salt sold goods to Steel Ltd for Rs
4,400. Of this amount, Rs 500 was included in the inventory of Steel
Ltd at the yearend. Salt earns a 35% margin on its sales.

(3) Goodwill amounting to Rs 800 arose on the acquisition of Salt, which

had been measured using the fair value method. Goodwill is to be
impaired by 10% at the yearend. Impairment losses should be charged
to operating expenses.

(4) Salt paid a dividend of Rs 500 on 1 January 20X7.

Advanced Financial Accounting and Corporate Reporting (Study Text) 202

 Required
Prepare the consolidated statement of comprehensive income for the year
ended 31 March 20X7.

4. Paper Ltd acquired 70% of Wood Ltd three years ago, when Wood Ltd’s
retained earnings were Rs 430,000.

The Financial Statements of each company for the year ended 31 March
20x7are as follows:

Statements of Financial Position as at 31 March 2007:

Paper Wood
Ltd Ltd
Rs. ‘000’ Rs. ‘000’
Non-current assets
Property, plant and equipment 900 400
Investment in S at cost 700 -
Current assets 300 600
––––– –––––
1,900 1,000
––––– –––––

Share capital (Rs 10) 200 150

Share premium 50 -
Retained earnings 1,350 700
––––– –––––
1,600 850
Non-current liabilities 100 90
Current liabilities 200 60
––––– –––––
1,900 1,000
––––– –––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 203

 Statement of comprehensive incomes for the year ended 31 March 2007:
Paper Wood
Ltd Ltd
Rs 000 Rs 000

Revenue 1,000 260

Cost of Sale (750) (80)
––––– –––––
Gross profit 250 180
Operating expenses (60) (35)
––––– –––––
Profit from operations 190 145
Finance costs (25) (15)
Investment Income 20 -
––––– –––––
Profit before tax 185 130
Tax (100) (30)
––––– –––––
Profit for the year 85 100
––––– –––––

You are provided with the following additional information:

(1) Wood Ltd had plant in its Statement of Financial Position at the date of
acquisition with a carrying value of Rs 100,000 but a fair value of Rs
120,000. The plant had a remaining life of 10 years at acquisition.
Depreciation is charged to cost of sales.

(2) The Paper Ltd group values the non-controlling interests at fair value.
The fair value of the non-controlling interests at the date of acquisition
was Rs 250,000. Goodwill is to be impaired by 30% at the reporting
date, of which one third related to the current year.

(3) At the start of the year Paper Ltd transferred a machine to Wood Ltd for
Rs 15,000. The asset had a remaining useful economic life of 3 years
at the date of transfer. It had a carrying value of Rs 12,000 in the books
of Paper Ltd at the date of transfer.

(4) During the year Wood Ltd sold some goods to Paper Ltd for Rs 60,000
at a markup of 20%. 40% of the goods remained unsold at the
yearend. At the yearend, Wood Ltd’s books showed a receivables
balance of Rs 6,000 as being due from Paper Ltd. This
disagreed with the payables balance of Rs 1,000 in Paper Ltd’s books

Advanced Financial Accounting and Corporate Reporting (Study Text) 204

 due to Paper Ltd having sent a cheque to Wood Ltd shortly before the
yearend which Wood Ltd had not yet received.

(5) Wood Ltd paid a dividend of Rs 20,000 on 1 March 2007.

Required
Prepare the consolidated Statement of Financial Position and consolidated
Statement of comprehensive income for the year ended 31 March 2007.

Advanced Financial Accounting and Corporate Reporting (Study Text) 205

 Answers

1. S Ltd consolidated statement of comprehensive income for the year

ended 31 December 20X7:
Rs. ‘000’

Revenue 880
(600 + 300 - 20)
Cost of sales (499)
(360 + 140 20 + 4 (W2) + 15 (fv dep'n))
–––––
Gross profit 381
Operating expenses (143)
(93 + 45 + 5 (impairment))
–––––
Profit from operations 238
Finance costs (3)
–––––
Profit before tax 235
Tax (82)
(50 + 32)
–––––
Profit for the year 153
–––––
Attributable to:
Non-controlling interest (W3) 14
Group (153 – 14) 139
–––––
153
–––––
Workings

(W1) Group structure

75%

Advanced Financial Accounting and Corporate Reporting (Study Text) 206

 (W2) Unrealised profit
Rs. ‘000’

(80% × Rs 20) × 33% /133% 4

(W3) Non-controlling interest

NCI share of subsidiary's profit for the year 20

(25 % × Rs 80)

Rs. ‘000’
Less:
NCI share of Provision for Unrealized profit (1)
(25% × Rs 4 (W2))
NCI share of impairment (1.25)
(25% × Rs 5)
NCI share of fair value dep'n (3.75)
(25% × Rs 15)
–––––
14.00
–––––

2. P Ltd consolidated statement of comprehensive income for the year

ended 31 December 20X5:

Rs. ‘000’

Revenue 5,160
(3,200 + 2,560 600)
Cost of sales (3,120)
(2,200 + 1,480 600 + 30 + 10 (fv dep'n)
_____
Gross profit 2,040
Investment income (external only) –
Distribution costs (280)
(160 + 120)
Administrative expenses (520)
(400 + 80 + 40) _____
Profit before tax 1,240
Taxation (880)
(400 + 480)
_____
Profit for the year 360
_____

Advanced Financial Accounting and Corporate Reporting (Study Text) 207

 Attributable to:
Equity holders of the parent 290
Non-controlling interests (W2) 70
_____
360
_____
Workings
(W1) Group structure
P Ltd

31 Dec x 1 80%

L Ltd

(W2) Non-controlling interest

NCI share of profit after tax 80

(20% × Rs 400)
Less:
NCI share of impairment (8)
(20% × Rs 40)

NCI share of fair value dep'n (2)

(20% × Rs 10)
–––––
70
–––––

3 Consolidated Statement of comprehensive income for the Steel Ltd

group for the year ended 31 March 20X7

Revenue (31,200 + (9/12 × 10,400) – 4,400 (W4)) 34,600

Cost of Sales (17,800 + (9/12 × 5,600) + 375 (W3) – 4,400 (18,150)
(W4)+ 175 (W4))
Gross profit 16,450
Operating expenses (8,500 + (9/12 × 3,200) + 80 (W5)) (10,980)
––––––
Profit from operations 5,470
Investment Income (2,000 – 350 (W6)) 1,650
––––––
Profit before tax 7,120
Tax (2,100 + (9/12 × 500) (2,475)
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 208

 Profit for the year 4,645
––––––
Profit attributable to:
NCI (W2) 58.5
Group 4,586.5
––––––
4,645
––––––

(W-1) Group structure

Steel

70%

Salt
1 July 20x6 i.e. 9 months

(W2) Non-controlling Interests

Rs
NCI share of sub's profit for the year
(30% × (9/12 × Rs 1,100) 247.5

Less:
NCI share of fair value depreciation (112.5)
(30% × Rs 375 (W3))

NCI share of Provision for Unrealized profit (52.5)

(30% × Rs 175 (W4))

NCI share of impairment (24)

(30% × Rs 80 (W5))
––––
58.5
––––
(W3) Fair value depreciation

FV Adj = Rs 5,000
Dep'n Adj Rs 5,000 × 1/10 × 9/12 = Rs 375

Advanced Financial Accounting and Corporate Reporting (Study Text) 209

 (W4) Intercompany sales / Provision for Unrealized profit

Inter-co-sales of Rs 4,400 need eliminating from revenue and cost of

sales.

Provision for Unrealized profit in inventory 35% × Rs 500 = Rs 175

The Provision for Unrealized profit will increase cost of sales and since
the sub sold the goods will reduce the NCI's share of profits.

(W5) Impairment
Impairment Rs 800 × 10% = Rs 80

(W6) Dividend
The sub paid a dividend of Rs 500 and so the parent will have recorded
investment income of 70% × 500 = 350. As an intra-group transaction
this needs eliminating.

4 Consolidated Statement of Financial Position as at 31 March 2007

Rs 000
Noncurrent assets 245
Goodwill (W3)
Property, plant and equipment 1,312
(900 + 400 + 20 – 6 – 2)
Current assets (300 + 600 – 4 – 6+ 5) 895
–––––
2,452
–––––
Share capital 200
Share premium 50
Retained earnings (W5) 1,456.5
––––––
1,706.5
Non-controlling Interests (W4) 296.5
–––––
2,003
Noncurrent liabilities (100 + 90) 190
Current liabilities (200 + 60 – 1) 259
–––––
2,452
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 210

 Consolidated Statement of comprehensive income for the year ended 31
March 2007:

Rs. ‘000’

Revenue (1,000 + 260 – 60) 1,200

Cost of Sales (750 + 80 – 60 + 2(Dep'n) + 4+ 2 (778)
––––
Gross profit 422
Operating expenses (60 + 35 + 35 (IMP)) (130)
––––
Profit from operations 292
Finance costs (25 + 15) (40)
Investment Income (20 – (70% × 20)) 6
––––
Profit before tax 258
Tax (100+30) (130)
––––
Profit after tax 128
––––
Attributable to
Non-controlling interests (W4) 17.7
Parent shareholders 110.3
––––
128
––––

Workings

70%
3 yrs
W

Advanced Financial Accounting and Corporate Reporting (Study Text) 211

 (W2) Net Assets of sub
Acq'n Reporting date
Rs Rs

Share capital 150 150

RE 430 700
FV – machine (120 – 100) 20 20
Dep'n (20 × 3/10) (6)
Provision for Unrealized profit (W7) (4)
––– –––
600 860
––– –––

(W3) Goodwill
Parent holding (investment) at fair value 700
NCI value at acquisition 250
–––––
950
Less: Fair value of net assets at acquisition (W2) (600)
–––––
350
Impairment (105)
–––––
245
–––––
Of the total impairment of Rs 105, a third i.e. Rs 35 is to be charged to
this years consolidated statement of comprehensive income.

(W4) NCI's – CSOFP

NCI value at acquisition (as in W3) 250
NCI share of post-acquisition reserves (W2) 78
(30% × (860 – 600))
NCI share of impairment (31.5)
(30% × 105)
–––––
296.5
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 212

 NCI’s – CIS
Profit after tax 100
Dep'n (20 × 1/10) (2)
Provision for Unrealized profit (W7) (4)
–––––
94
NCI share × 30% 28.2
Impairment (30% × 35) (10.5)
–––––
17.7
–––––
(W5) Group retained earnings
Parent retained earnings 1,350
Provision for Unrealized profit (W6) (2)
Sub post acq profit 182
(70% × (860 – 600))
Impairment (73.5)
(70% × 105)
––––––
1,456.5
––––––
(W6) Provision for Unrealized profit – Fixed asset
CV in books (15 – (15 × 1/3yrs)) 10
CV should be (12 × (12 × 1/3 yrs)) (8)
–––
Provision for Unrealized profit 2

(W7) Provision for Unrealized profit – Inventory

Profit on sale (20/120 × 60) 10
Profit in Inventory (40% × 10) 4

Advanced Financial Accounting and Corporate Reporting (Study Text) 213

Advanced Financial Accounting and Corporate Reporting (Study Text) 214
INVESTMENT IN ASSOCIATES AND JOINT VENTURES
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

• Define an associate according to IAS 28.
• Explain the principles and reasoning for the use of equity accounting.
• Define forms of joint venture.
• Explain accounting treatment of jointly controlled entities.

Advanced Financial Accounting and Corporate Reporting (Study Text) 215

1 IAS 28 Investments in Associates and Joint Ventures

1.1 Definitions
IAS 28 defines an associate as:

An entity over which the investor has significant influence and that is neither a
subsidiary nor an interest in joint venture.

Significant influence is the power to participate in the financial and operating

policy decisions of the investee but is not control or joint control over those
policies.

Significant influence is assumed with a shareholding of 20% to 50%.

1.2 Principles of equity accounting and Reasoning Behind It

Equity accounting is a method of accounting whereby the investment is
initially recorded at cost and adjusted thereafter for the post-acquisition
change in the investor’s share of net assets of the associate.
The effect of this is that the consolidated statement of financial position
includes:

• 100% of the assets and liabilities of the parent and subsidiary company
on a line by line basis

• an ‘investments in associates’ line within noncurrent assets which

includes the group share of the assets and liabilities of any associate.

The consolidated statement of comprehensive income includes:

• 100% of the income and expenses of the parent and subsidiary

company on a line by line basis

• one line ‘share of profit of associates’ which includes the group share
of any associate’s profit after tax.

Note: in order to equity account, the parent company must already be

producing consolidated financial statements (i.e. it must already have at least
one subsidiary).

Advanced Financial Accounting and Corporate Reporting (Study Text) 216

 1.3 Equity Method Exemption

Accounting for associates according to IAS 28

The equity method of accounting is normally used to account for associates in
the consolidated financial statements.
The equity method should not be used if:

• the investment is classified as held for sale in accordance with IFRS 5

or
• the parent is exempted from having to prepare consolidated accounts
on the grounds that it is itself a wholly, or partially, owned subsidiary of
another company (IFRS 10).

2 Associates in the consolidated Statement of Financial Position

2.1 Preparing the CSFP including an associate

The CSFP is prepared on a normal line-by-line basis following the acquisition
method for the parent and subsidiary.
The associate is included as a non-current asset investment calculated as:

Rs 000
Cost of investment X
Add : Share of post-acquisition profits X
Less: impairment losses (X)
___
X
___

The group share of the associate’s post-acquisition profits or losses and the
impairment of goodwill will also be included in the group retained earnings
calculation.

Standard workings
The calculations for an associate (A) can be incorporated into standard CSFP
workings as follows.

(W1) Group structure

P 30% This indicates that

A P owns 80% of the ordinary shares of S
80% and P also owns 30% of the shares in A
S

Advanced Financial Accounting and Corporate Reporting (Study Text) 217

 (W2) Net assets of subsidiary
At date of acquisition At reporting date
Rs Rs
Share capital X X
Retained earnings X X
___ ___
X X
___ ___

(W3) Goodwill – subsidiary

Parent holding (investment) at fair value X

NCI value at acquisition X
—
X

Less:
Fair value of net assets at acquisition (W2) (X)
—
Goodwill at acquisition X
Impairment (X)
—
Carrying goodwill X
—
(W4) Non controlling interest (NCI)

NCI value at acquisition (as in W3) X

NCI share of subsidiary post- aquisition reserves (W2) X
NCI share of impairment (W3) (fair value method only) (X)
—
X
—
(W5) Group retained earnings
Rs
Parent retained earnings (100%) X
Group % of sub's post-acquisition retained earnings X
Group % of assoc post-acquisition retained earnings X
Less: Impairment losses to date (S + A) (W3) X
—
X
—

Advanced Financial Accounting and Corporate Reporting (Study Text) 218

 (W6) Investment in associate company

Rs
Cost of investment X
Post-acquisition profits (W5) X
Less: impairment X
—
X
—
Example 1

Associates in CSFP
Below are the statements of financial position of three companies as at 31 December
20X9.

Dee Lee Po
Rs 000 Rs 000 Rs 000
Noncurrent assets
Property, plant & equipment 1,120 980 840
Investments
672,000 shares in Lee 644 - -
168,000 shares in Po 224 - -
––– ––––– –––

1,988 980 840

Current assets
Inventory 380 640 190
Receivables 190 310 100
Bank 35 58 46
––––––– ––––––– –––––––
605 1,008 336
––––––– ––––––– –––––––
2,593 1,988 1,176
––––––– ––––––– –––––––

Equity
Rs 10 ordinary shares 1,120 840 560
Retained earnings 1,232 602 448
––––––– ––––––– –––––––
2,352 1,442 1,008

Advanced Financial Accounting and Corporate Reporting (Study Text) 219

Current liabilities
Trade payables 150 480 136
Taxation 91 66 32
––––––– ––––––– –––––––
241 546 168
––––––– ––––––– –––––––
2,593 1,988 1,176
––––––– ––––––– –––––––

You are also given the following information:

(1) Dee acquired its shares in Lee on 1 January 20X9 when Lee had retained
losses of Rs 56,000.

(2) Dee acquired its shares in Po on 1 January 20X9 when Po had retained
earnings of Rs 140,000.

(3) An impairment test at the year end shows that goodwill for Lee remains
unimpaired but the investment in Po has impaired by Rs 2,800.

(4) The Dee Group values the non controlling interest using the fair value
method. The fair value on 1 January 20x9 was Rs 60,000.

Prepare the consolidated statement of financial position for the year ended 31
December 20X9.

Solution
Dee consolidated statement of financial position as at 31 December 20X9

Rs 000 Rs 000
Noncurrent assets
Goodwill (W3) 20.0
Property, plant & equipment 2,100.0
(1,120 + 980)
Investment in associate (W6) 313.6
–––––––
2,433.6

Advanced Financial Accounting and Corporate Reporting (Study Text) 220

 Current assets
Inventory (380 + 640) 1,020.0
Receivables (190 + 310) 500.0
Cash (35 + 58) 93.0
–––––––
1,613.0
–––––––
4,046.6
–––––––
Equity
Rs 10 ordinary shares 1,120.0
Retained earnings (W5) 1,848.0
–––––––
2,968.0
Non-controlling interest (W4) 291.6
–––––––
3,259.6
Current liabilities
Trade payables (150 + 480) 630.0
Taxation (91 + 66) 157.0
––––
787.0
–––––––
4,046.6
–––––––

Workings

(W1) Group structure

Dee

80% 30%
PO

Lee

Advanced Financial Accounting and Corporate Reporting (Study Text) 221

(W2) Net assets – Lee
At date of acquisition At reporting date
Rs 000 Rs 000
Share capital 840.0 840.0
Retained earnings (56.0) 602.0
––––– –––––
784.0 1,442.0
––––– –––––
Note that Lee has retained losses at the date of acquisition rather than the
more usual retained earnings or profits.

2.2 Fair values and the associate

If the fair value of the associate’s net assets at acquisition are materially
different from their book value the net assets should be adjusted in the same
way as for a subsidiary.

2.3 Balances with the associate

Generally the associate is considered to be outside the group. Therefore
balances between group companies and the associate will remain in the
consolidated statement of financial position.

If a group company trades with the associate, the resulting payables and
receivables will remain in the consolidated statement of financial position.

2.4 Unrealised profit in inventory

Unrealised profits on trading between group and associate must be eliminated
to the extent of the investor's interest (i.e. % owned by parent).

Adjustment must be made for unrealised profit in inventory as follows.

(1) Determine the value of closing inventory which is the result of a sale to or
from the associate.

(2) Use markup/ margin to calculate the profit earned by the selling company.

(3) Make the required adjustments. These will depend upon who the seller is:

Parent company selling to associate — the profit element is included in the

parent company’s accounts and associate holds the inventory.

Dr Group retained earnings (W5)

Cr Investment in associate (W6)

Advanced Financial Accounting and Corporate Reporting (Study Text) 222

 Associate selling to parent company— the profit element is included in the
associate company’s accounts and the parent holds the inventory.

Dr Group retained earnings (W5)

Cr Group inventory

3 Associates in the Consolidated Statement of Comprehensive Income

3.1 Equity accounting

The equity method of accounting requires that the consolidated statement of
comprehensive income:

• does not include dividends from the associate

• instead includes group share of the associate’s profit after tax less any
impairment of the associate in the year (included below group profit
from operations).

Trading with the associate

Generally the associate is considered to be outside the group. Therefore any
sales or purchases between group companies and the associate are not
normally eliminated and will remain part of the consolidated figures in the
statement of comprehensive income.

It is normal practice to instead adjust for the unrealised profit in inventory.

Dividends from associates

Dividends from associates are excluded from the consolidated statement of
comprehensive income; the group share of the associate’s profit is included
instead.

Advanced Financial Accounting and Corporate Reporting (Study Text) 223

 Example 2
Below are the statement of comprehensive incomes for P, S and A for the
year ended 30 September 20X8

Statement of comprehensive incomes for the year ended 30 September 20X8

P S A
Rs 000 Rs 000 Rs 000
Revenue 8,000 4,500 3,000
Operating expenses (4,750) (2,700) (2,050)
––––– ––––– –––––
Profit from operations 3,250 1,800 950
Finance costs (750) (100) (50)
––––– ––––– –––––
Profit before tax 2,500 1,700 900
Tax (700) (500) (300)
––––– ––––– –––––
Profit for the year 1,800 1,200 600
––––– ––––– –––––

Further information:

• P acquired 80% of S several years ago.

• P acquired 30% of the equity share capital of A on 1 October 20X6.

• During the year, P sold goods to A for Rs 1 million at a markup of 25%.

At the yearend, A still held one quarter of these goods in inventory.

• At 30 September 20X8, it was determined that the investment in the

associate was impaired by Rs 35,000, of which Rs 20,000 related to
the current year.

Required:
Prepare the consolidated statement of comprehensive income for the P group
for the year ended 30 September 20X8.

Advanced Financial Accounting and Corporate Reporting (Study Text) 224

 Solution:
Consolidated statement of comprehensive income for the year ended 30
September 20X8

Rs 000
Revenue
(8,000 + 4,500) 12,500
Operating expenses
(4,750 + 2,700 + 15 (W2)) (7,465)
–––––

Profit from operations 5,035

Share of associate:
((30% × 600) – 20 impairment) 160
Finance costs
(750 + 100) (850)
–––––
4,345
Taxation
(700 + 500) (1,200)
–––––
Profit for the year 3,145
–––––

(W2) Provision for Unrealized Profits

Intercompany balances between the parent and associate are not eliminated
as the associate is outside the group. Therefore, no adjustment in respect of
the sale for Rs 1 million needs to be made.

Provision for unrealized profit = P's % × Profit in inventory

Profit on sale:
(25 / 125 × Rs 1,000 ) Rs 200
Profit in inventory
(1/4 × Rs 200) Rs 50
Provision for unrealized profit
(30% × Rs 50) Rs 15
In the CIS, Provision for unrealized profit will increase cost of sales since the
parent is selling company.

Advanced Financial Accounting and Corporate Reporting (Study Text) 225

4 IFRS 11 – Joint Arrangements

4.1 IFRS 11 Joint Arrangements was issued in 2011 to replace IAS 31. IFRS 11
provides new or updated definitions to determine whether there is a joint
arrangement and, if so, the nature of that arrangement together with
associated accounting requirements. It adopts the definition of control as
included in IFRS 10 as a basis for determining whether there is joint control

4.2 Definitions
Joint arrangements are defined as arrangements where two or more parties
have joint control, and that this will only apply if the relevant activities require
unanimous consent of those who collectively control the arrangement. They
may take the form of either joint operations or joint ventures. The key
distinction between the two forms is based upon the parties’ rights and
obligations under the joint arrangement

Joint operations are defined as joint arrangements whereby the parties that
have joint control have rights to the assets and obligations for the liabilities.
Normally, there will not be a separate entity established to conduct joint
operations. IFRS 11 requires that joint operators each recognise their share of
assets, liabilities, revenues and expenses of the joint operation over which
they have rights and obligations. This may consist of maintaining a joint
operation account to record transactions undertaken on behalf of the joint
operation, together with balances due to or from other parties to the joint
operation.

Example of a joint operation

A and B decide to enter into a joint operation to produce a new product. A
undertakes one manufacturing process and B undertakes the other. A and B
have agreed that decisions regarding the joint operation will be made
unanimously and that each will bear their own expenses and take an agreed
share of the sales revenue from the product.

Joint ventures are defined as joint arrangements whereby the parties have
joint control of the arrangement and have rights to the net assets of the
arrangement. This will normally be established in the form of a separate entity
to conduct the joint venture activities. The equity method of accounting must
be used in this situation. The accounting policy choice of proportionate
consolidation or equity accounting previously allowed by IAS 31 is no longer
available; all interests in joint ventures must now be equity accounted.

IAS 28 deals with accounting for associates and joint ventures and is
considered elsewhere within this chapter.

Advanced Financial Accounting and Corporate Reporting (Study Text) 226

 Example of a joint venture
A and B decide to set up a separate entity, C, to enter into a joint venture. A
will own 55% of the equity capital of C, with B owning the remaining 45%. A
and B have agreed that decision-making regarding the joint venture will be
unanimous. Neither party will have direct right to the assets, or direct
obligation for the liabilities of the joint venture; instead, they will have an
interest in the net assets of entity C set up for the joint venture.

Joint control is defined as contractually agreed sharing of control of an

arrangement which exists only when the decisions about the relevant
activities require the unanimous consent of the parties sharing control.

The key aspects of joint control are described as follows:

• Contractually agreed – contractual arrangements are usually, but not

always, written, and provide the terms of the arrangement.

• Control and relevant activities – IFRS 10 describes how to assess whether a

party has control, and how to identify the relevant activities.

• Unanimous consent – exists when the parties to an arrangement have

collective control over the arrangement and no single party has control.

4.3 Accounting For Joint Arrangements

Joint operations
Arrangements defined as joint operations by IFRS 11 were previously
classified as either jointly controlled operations or jointly controlled assets by
IAS 31. In principle, there is no change for the accounting for such
arrangements in accordance with IFRS 11. The individual financial statements
of each joint operator will recognise:

• the assets that it controls and the liabilities that it incurs, and
• the expenses that it incurs, and
• share of the revenue that it earns from the sale of goods or services by the
joint venture.

This may also include amounts due to and from the other joint operators.

As the income, expenses, assets and liabilities of the joint venture are
included in the individual financial statements they will automatically flow
through to the consolidated financial statements.

Advanced Financial Accounting and Corporate Reporting (Study Text) 227

 Joint ventures
Joint arrangements classified as joint ventures by IFRS 11 are accounted for
in a separate entity. The individual financial statements of each joint venture
party will recognise:

• the cost of the investment in the joint venture entity (e.g. the share capital
subscribed for), and
• any returns received in the form of dividends from the joint venture entity.

In the consolidated financial statements, the interest in the joint venture entity
will be equity accounted as required by IAS 28.

In situations where there are transactions between a joint venture party and
the separate joint venture entity, the joint venture party should recognise only
that part of any gain attributable to the interests of the other joint venture
parties – it cannot make a profit out of transactions with itself.

To the extent that a loss arises on transactions between a joint venture party
and the separate joint venture entity, the full amount of the loss should be
recognised as this is likely to reflect a fall in the net realisable value of a
current asset and/or impairment of a noncurrent asset (investment in the joint
venture entity).

Note that if an interest in a joint venture meets the definition of held for sale as
specified in IFRS 5, it should be accounted for accordingly

5 IFRS 12 Disclosure of Interests in Other Entities

IFRS 12 was issued in May 2011 and is now the single source of disclosure
requirements that were previously contained within IAS 27 (group accounts),
IAS 28 (associates) and IAS 31 (joint ventures). This reporting standard has
also extended the disclosure requirements to include additional information
which is regarded as being helpful to users of financial statements, including:

• disclosure of significant assumptions and judgements made in determining

whether an investor has control, joint control or significant influence over an
investee

• disclose the nature, extent and financial effects of its interests in joint
arrangements and associates

• additional disclosures relating to subsidiaries with Non-controlling interests,

joint arrangements and associates that are individually material,

Advanced Financial Accounting and Corporate Reporting (Study Text) 228

 • significant restrictions on the ability of the parent to access and use the
assets or to settle the liabilities of its subsidiaries, and

• extended disclosures relating to "structured entities", previously referred to

as special purpose entities, to enable a full understanding of the nature of
the arrangement and associated risks, such as the terms on which an
investor may be required to provide financial support to such an entity.

IFRS 12 is effective for accounting periods commencing on or after 1 January

2013, but early adoption of IFRS 12 is permitted, either as an individual
standard, or in conjunction with IFRS 10, IFRS 11, IFRS 12 and revised
standards IAS 27 and IAS 28.

6 IAS 27 Separate Financial Statements

IAS 27 (revised) applies when an entity has interests in subsidiaries, joint

ventures or associates and either elects to, or is required to, prepare
separate non-consolidated financial statements.

Disclosures required when separate, nonconsolidated, Financial statements

have been prepared by the parent entity:

• the fact that exemption from consolidation has been used (usually as an
intermediate holding company), together with the name, place of business
and country of incorporation of the ultimate holding company who have
prepared group financial statements in compliance with IFRS, and an address
from which those financial statements can be obtained

• in other cases than being an intermediate holding company, the fact that
they are separate financial statements, together with the reason why separate
financial statements have been prepared

• a list of names, interests in equity capital and principal place of business for
each significant subsidiary, associate and joint venture, including details of
how they have been accounted for in the separate financial statements

If the financial statements are not consolidated, they must therefore present
interests in other entities at cost or in accordance with IFRS 9 Financial
Instruments.

In the previous version of IAS 27, disclosure requirements relating to group

accounts where included within this reporting standard. These requirements
have been transferred to IFRS 12 Disclosure of Interests in Other Entities
which are considered elsewhere within this chapter.

Advanced Financial Accounting and Corporate Reporting (Study Text) 229

 Chapter Summary

Advanced Financial Accounting and Corporate Reporting (Study Text) 230

 Self-Test Questions

1. Below are the statements of financial position of three entities as at 30

September 20X8
P S A
Rs 000 Rs 000 Rs 000
Noncurrent assets
Property, plant and equipment 14,000 7,500 3,000
Investments 10,000 - -
––––– ––––– –––––
24,000 7,500 3,000
Current assets 6,000 3,000 1,500
––––– ––––– –––––
30,000 10,500 4,500
––––– ––––– –––––
Equity
Share capital (Rs 10 ordinary shares) 10,000 1,000 500
Retained earnings 7,500 5,500 2,500
––––– ––––– –––––
17,500 6,500 3,000
Noncurrent liabilities 8,000 1,250 500
Current liabilities 4,500 2,750 1,000
––––– ––––– –––––
30,000 10,500 4,500
––––– ––––– –––––
Further information
• P acquired 75% of the equity share capital of S several years ago,
paying Rs 5 million in cash. At this time the balance on S's retained
earnings was Rs 3 million.

• P acquired 30% of the equity share capital of A on 1 October 20X6,

paying Rs 750,000 in cash. At 1 October 20X6 the balance on A's
retained earnings was Rs 1.5 million.

• During the year, P sold goods to A for Rs 1 million at a markup of 25%.

At the yearend, A still held one quarter of these goods in inventory.

• As a result of this trading, P was owed Rs 250,000 by A at the

reporting date. This agrees with the amount included in A's trade
payables.

• At 30 September 20X8, it was determined that the investment in the

associate was impaired by Rs 35,000.

Advanced Financial Accounting and Corporate Reporting (Study Text) 231

 • Non-controlling interests are valued using the fair value method. The
fair value of the Non-controlling interest at the date of acquisition was
Rs 1.6 million.

Required:
Prepare the consolidated statement of financial position of the P group as at
30 September 20X8.

2. P acquired 80% of S on 1 December 20X4 paying Rs 4.25 in cash per share.

At this date the balance on S’s retained earnings were Rs 870,000. On 1
March 20X7 P acquired 30% of A’s ordinary shares.

The consideration was settled by share exchange of 4 new shares in P for

every 3 shares acquired in A. The share price of P at the date of acquisition
was Rs 50. P has not yet recorded the acquisition of A in its books.

The Statements of Financial Position of the three companies as at 30

November 20X7 are as follows:

P S A
Rs 000 Rs 000 Rs 000
Noncurrent assets
Property 1,300 850 900
Plant & Equipment 450 210 150
Investments 1,825 - -

Current assets
Inventory 550 230 200
Receivables 300 340 400
Cash 120 50 140
––––– ––––– –––––
4,545 1,680 1,790
––––– ––––– –––––

Share capital Rs 10 1,800 500 250

Share premium 250 80 -
Retained earnings 1,145 400 1,200
––––– ––––– –––––
3,195 980 1,450

Advanced Financial Accounting and Corporate Reporting (Study Text) 232

 Noncurrent liabilities
10% Loan notes 500 300 -
Current liabilities
Trade Payables 520 330 250
Income tax 330 70 90
––––– ––––– –––––
4,545 1,680 1,790
––––– ––––– –––––
The following information is relevant
• As at 1 December 20x4, plant in the books of S was determined to
have a fair value of Rs 50,000 in excess of its carrying value. The plant
had a remaining life of 5 years at this time.

• During the post-acquisition period, S sold goods to P for Rs 400,000 at

a markup of 25%. P had a quarter of these goods still in inventory at
the year-end.
• In September A sold goods to P for Rs 150,000. These goods had cost
A Rs 100,000. P had Rs 90,000 (at cost to P) in inventory at the year-
end.

• As a result of the above intercompany sales, P’s books showed Rs

50,000 and Rs 20,000 as owing to S and A respectively at the yearend.
These balances agreed with the amounts recorded in S’s and A’s
books.

• Non-controlling interests are measured using the fair value method.

The fair value of the Non-controlling interest at the date of acquisition
was Rs 368,000. Goodwill has impaired by Rs 150,000 at the reporting
date. An impairment review found the investment in the associate was
to be impaired by Rs 15,000 at the yearend.

• A’s profit after tax for the year is Rs 600,000.

Required:
Prepare the consolidated Statement of Financial Position as at 30 November
2007.

Advanced Financial Accounting and Corporate Reporting (Study Text) 233

3. The summarised statements of financial position of B, T and R as at 31
March 20X7 are as follows:
B T R
Rs 000 Rs 000 Rs 000
Non-current assets
Property, plant & equipment 3,820 4,425 500
Development expenditure – 200 –
Investments 1,600 – –
––––– ––––– –––––
5,420 4,625 500
Current assets
Inventory 2,740 1,280 250
Receivables 1,960 980 164
Cash at bank 1,260 – 86
––––– ––––– –––––
5,960 2,260 500
––––– ––––– –––––
Total assets 11,380 6,885 1,000

Equity
Ordinary shares of Rs 10 each 4,000 500 200
Reserves:
Share premium 800 125
Retained earnings at 31 March 20X6 2,300 380 450
Retained for year 1,760 400 150
––––– ––––– –––––
8,860 1,405 800
––––– ––––– –––––

Current liabilities
Trade payables 2,120 3,070 142
Bank overdraft – 2,260 –
Taxation 400 150 58
––––– ––––– –––––
2,520 5,480 200
––––– ––––– –––––
Total equity and liabilities 11,380 6,885 1,000
––––– ––––– –––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 234

 The following information is relevant
(i) Investments
B acquired 40,000 shares in T on 1 April 20X6 paying Rs 30 per share.
On 1 October 20X6 B acquired 40% of the share capital of R for Rs
400,000.

(ii) Group accounting policies

Development expenditure
Development expenditure is to be written off as incurred as it does not
meet the criteria for capitalisation in IAS 38. The development
expenditure in the statement of financial position of T relates to a
project that was commenced on 1 April 20X5. At the date of acquisition
the value of the capitalised expenditure was Rs 80,000. No
development expenditure of T has yet been amortised.

(iii) Intra-group trading

The inventory of B includes goods at a transfer price of Rs 200,000
purchased from T after the acquisition. The inventory of R includes
goods at a transfer price of Rs 125,000 purchased from B. All transfers
were at cost plus 25%.

The receivables of B include an amount owing from T of Rs 250,000.

This does not agree with the corresponding amount in the books of T
due to a cash payment of Rs 50,000 made on 29 March 20X7, which
had not been received by B at the year end.

(iv) It is group policy to value the Non-controlling interest using the fair
value at the date of acquisition. At the date of acquisition the fair value
of the Non-controlling interest was Rs 95,000.

Required:
Prepare a consolidated statement of financial position of the B group
as at 31 March 20X7.

Advanced Financial Accounting and Corporate Reporting (Study Text) 235

4. Below are the statement of comprehensive incomes of the B group and its
associated companies, as at 31 December 20X8.

B K S
Rs 000 Rs 000 Rs 000
Revenue 385 100 60
Cost of sales (185) (60) (20)
–––– –––– ––––
Gross profit 200 40 40
Operating expenses (50) (15) (10)
–––– –––– ––––
Profit before tax 150 25 30
Tax (50) (12) (10)
–––– –––– ––––
Profit for the year 100 13 20

You are also given the following information.

(1) B acquired 4,500 ordinary shares in K a number of years ago. K has

5,000 Rs 10 ordinary shares.

(2) B acquired 6,000 ordinary shares in S a number of years ago. S has

20,000 Rs 10 ordinary shares.

(3) During the year S sold goods to B for Rs 28,000. B still holds some of
these goods in inventory at the year end. The profit element included in
these remaining goods is Rs 2,000.

(4) Non-controlling interests are valued using the fair value method.

(5) Goodwill and the investment in the associate were impaired for the first
time during the year as follows:
S Rs 2,000
K Rs 3,000

Impairment of the subsidiary’s goodwill should be charged to operating

expenses.

Prepare the consolidated statement of comprehensive income for B

including the results of its associated company.

Advanced Financial Accounting and Corporate Reporting (Study Text) 236

 Answers

1.
Consolidated statement of financial position for P group as at 30 September
20X8.
Rs 000
Non-current assets
Goodwill (W3) 2,600
Property, plant and equipment 21,500
(14,000 + 7,500)
Investments 4,250
(10,000 5,000
(cost of inv in S) 750 (cost of inv in A))

Investment in associate (W6) 1,000

–––––
29,350
Current assets
(6,000 + 3,000) 9,000
–––––
38,350
–––––
Equity
Share capital 10,000
Group retained earnings (W5) 9,625
Non-controlling interest (W4) 2,225
–––––
21,850
Non-current liabilities
(8,000 + 1,250) 9,250
Current liabilities
(4,500 + 2,750) 7,250
–––––
38,350
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 237

 (W1) Group structure
P 30%

75% A

S
Several years ago Two years ago

(W2) Net Assets

at acq rep date
Share capital 1,000 1,000
Retained earnings 3,000 5,500
––––– –––––
4,000 6,500
––––– –––––
(W3) Goodwill
Rs 000
Parent holding (investment) at fair value:
Cash 5,000
Fair value of NCI 1,600
–––––
6,600
Less:
Fair value of net assets at acquisition (W2) (4,000)
–––––
Total goodwill 2,600

(W4) Non-controlling interest

Fair value of NCI 1,600

25% post-acquisition profit 625
(25% × (6,500 - 4,000))
–––––
2,225
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 238

 (W5) Group retained earnings

100% parent 7,500

Sub (75% × (6,500 – 4,000)) 1,875
Assoc (30% × (2,500 – 1,500)) 300
Provision for unrealized profits (W7) (15)
Impairment (35)
–––––
9,625
–––––
(W6) Investment in associate

Cost of investment 750

Share of post-acquisition profit 300
(30% × (2,500 - 1,500))
Impairment (35)
Provision for unrealized profits (W7) (15)
–––––
1,000
–––––

(W7) Provision for unrealized profits – A = seller

Profit on sale (25/125 × 1,000) 200

Profit in inventory (1/4 × 200) 50
Group share (30% × 50) 15

2. Consolidated Statement of Financial Position as at 31 March 2007

Rs 000
Non-current assets
Goodwill (W3) 418
Property (1,300 + 850) 2,150
Plant & Equipment (450 + 210 + 50 – 30) 680
Investments (1,825 – 1,700) 125
Investment in Associate (W6) 620

Current assets

Inventory (550 + 230 – 20 – 9) 751

Receivables (300 + 340 – 50) 590
Cash (120 + 50) 170
–––––
5,504
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 239

 Share capital (1,800 + 100) 1,900
Share premium (250 + 400) 650
Retained earnings (W5) 720
–––––
3,270
Non-controlling Interests (W4) 234
–––––
3,504
Non-current liabilities
10% Loan notes (500 + 300) 800
Current liabilities
Trade payables (520 + 330 – 50) 800
Income Tax (330 + 70) 400
–––––
5,504
–––––

Workings

(W1) Group structure

80 %
3 yrs 30 % 9 months

S A

(W2) Net assets

@ acq @ rep
date
Share capital 500 500
Share premium 80 80
Retained earnings 870 400
FV – plant 50 50
FV Dep (50 × 3/5) (30)
Provision for unrealized profits (W7) (20)
––––– ––––
1,500 980
––––– ––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 240

 (W3) Goodwill
Rs 000
Parent holding (investment) at fair value:
Cash
((80% × 500) × Rs 4.25) 1,700
Fair value of NCI 368
–––––
2,068
Less:
Fair value of net assets at acquisition (1,500)
–––––
Goodwill at acquisition 568
Impairment (150)
–––––
Carrying goodwill 418
–––––

Share exchange:
10 shares issued at Rs 50
Cr Share capital (nominal element) 100
Cr Share premium (premium element) 400

(W4) Non-controlling interest

Fair value of NCI 368

20% post-acquisition loss (104)
(20% × (980 - 1,500))
Impairment (30)
(20% × 150)
–––
234
–––
(W5) Group retained earnings

100% parent 1,145

Provision for unrealized profits (W8) (9)
Sub (80% × (980 – 1,500)) (416)
Assoc (30% × (1,450 – 1,000)) 135
Impairment (150 × 80%) (120)
Impairment (W3) (15)
–––
720
–––

Advanced Financial Accounting and Corporate Reporting (Study Text) 241

 (W6) Investment in associate

Cost of investment (30% × 250) × 4/3 × Rs 5) 500

Share of post-acquisition profit (30% × (1,450 - 1,000) 135
Impairment (15)
–––
620
–––
(W7) Provision for unrealized profits – Sub

Profit on sale (25/125 × 400) 80

Profit in inventory (1/4 × 80) 20

(W8) Provision for unrealized profits – Assoc

Profit on sale (150 – 100) 50

Profit in inventory (90/150 × 50) 30
Group share (30% × 30) 9

3. Consolidated statement of financial position as at 31 March 20X7

Rs 000 Rs 000
Non-current assets:
PPE (3,820 + 4,425) 8,245
Goodwill (W3) 370
Investment in associate (W6) 420
–––––
9,035
Current assets:
Inventory (2,740 + 1,280 – 40) 3,980
Receivables (1,960 + 980 – 250) 2,690
Bank (1,260 + 50 cash in transit) 1,310
––––– 7,980
–––––
Total assets 17,015
–––––
Ordinary shares of Rs 10 each 4,000
Reserves:
Share premium 800
Retained earnings (W5) 4,272
––––– 5,072
–––––
9,072

Advanced Financial Accounting and Corporate Reporting (Study Text) 242

 Non-controlling interest (W4) 143
–––––
9,215
Current liabilities:
Trade payables (2,120 + 3,070 — 200) 4,990
Bank overdraft 2,260
Taxation (400 + 150) 550
––––– 7,800
–––––
Total equity and liabilities 17,015
–––––

Workings
(W1) Group structure

40%
B
R
(6 months ago)
40 80%
50

(1 year ago)

(W2) Net assets in subsidiary

At acquisition At reporting date
Rs 000 Rs 000
Share capital 500 500
Share premium 125 125
Retained earnings 380 780
–––– ––––
1,005 1,405
Development expenditure w/off (80) (200)
Provision for unrealized profits (W2a) (40)
–––– ––––
925 1,165
–––– ––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 243

 (W2a) Provision for unrealized profits

Rs 200,000 × 25 /125 = Rs 40,000 Dr W2 at reporting date Cr Inventory

(W3) Goodwill Rs 000

Parent holding (investment) at fair value 1,200
(30*40)
NCI value at acquisition 95
–––––
1,295
Fair value of net assets at acquisition (W2) (925)
____
Goodwill on acquisition 370
––––

(W4) Non-controlling interest Rs 000

NCI value at acquisition (as in W3) 95
NCI share of post-acquisition reserves (W2) 48
(20% × (1,165 - 925))
____
143
____

(W5) Retained earnings Rs 000

B 4,060
Unrealised profit on inventory (below) (10)
T (1,165 – 925) × 80% 192
R (150 profit for year × 6/12 ) × 40% 30
–––––
4,272
–––––
• Provision for unrealized profits = Sold by B to R, group share only as it
is an associate, 40% of (Rs 125,000 × 25/125) = Rs 10,000
• P = seller, therefore, Dr W5 Cr Investment in associate (W6)
(W6) Investment in associate
Rs 000
Cost of investment 400
Share of post-acquisition profits 30
(150 profit for year × 6/12 ) × 40%
Provision for unrealized profits (10)
–––
420

Advanced Financial Accounting and Corporate Reporting (Study Text) 244

4. Solution
B consolidated statement of comprehensive income for the year ended
31 December 20X8
Rs 000
Revenue 485.0
(385 + 100)
Cost of sales (245.0)
(185 + 60)
–––––
Gross profit 240.0
Investment income (external only)
Operating expenses
(50 + 15 + 3 impairment) (68.0)
–––––
Profit from operations 172.0
Share of profits of associate company (W3) 3.4
–––––
Profit before tax 175.4
Taxation (62.0)
(50 + 12)
–––––
Profit for the year 113.4
Amount attributable to:
Equity holders of the parent 112.4
Non-controlling interests (W2) 1.0
–––––
113

Advanced Financial Accounting and Corporate Reporting (Study Text) 245

 (W1) Group structure
K S
4,500/5,000 = 90% 6,000/20,000 = 30%

90

30%

K S

(W2) NCI in K
NCI share of subsidiary’s profit after tax: 1.3
(10% × Rs 13)
Rs 000
Less:
NCI share of impairment (0.3)
(10% × Rs 3)
–––––
1.0
–––––
(W3) Share of associate
Rs 000
30% of associate profit for the year 6
(30% × Rs 20)
Less:
30% of Provision for unrealized profits (0.6)
(30% × Rs 2)
Impairment (2)
___
3.4
___

Advanced Financial Accounting and Corporate Reporting (Study Text) 246

Advanced Financial Accounting and Corporate Reporting (Study Text) 247
CHANGES IN GROUP STRUCTURE
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

• Prepare group financial statements where activities have been acquired,

discontinued or have been disposed of in the period.
• Discuss and apply the treatment of a subsidiary that has been acquired
exclusively with a view to subsequent disposal.
• Discuss the treatment of business combination achieved in stages.
• Discuss and apply the treatment for transactions between equity holders
where either additional shares have been purchased, or shares have been
disposed of, without any change in control.

Advanced Financial Accounting and Corporate Reporting (Study Text) 248

1 Acquisition of a Subsidiary

1.1 Remember that a parent entity acquires control of a subsidiary from the date
that it obtains a majority shareholding. If this happens midyear, then it will be
necessary to pro-rata the results of the subsidiary for the year to identify the
net assets at the date of acquisition.

Example 1

Mid-Year Acquisition of Subsidiary

On 1 July 20x4 P Ltd purchased 1,600,000 of 2,000,000 equity shares of Rs
1 each in S Ltd for Rs 10,280,000. On the same date it also acquired
1,000,000 of S Ltd.’s 10% loan notes. At the date of acquisition the retained
earnings of S Ltd were Rs 6,150,000. The summarised draft statement of
comprehensive income for each company for the year ended 31 March 20x5
was as follows.

P Ltd S Ltd
Rs 000 Rs 000
Revenue 60,000 24,000
Cost of sales (42,000) (20,000)
––––––– –––––––
Gross profit 18,000 4,000
Distribution costs (2,500) (50)
Administration expenses (3,500) (150)
––––––– –––––––
Profit from operations 12,000 3,800
Interest received/(paid) 75 (200)
––––––– –––––––
Profit before tax 12,075 3,600
Tax (3,000) (600)
––––––– –––––––
Profit for the year 9,075 3,000
––––––– –––––––
Retained earnings b'fwd 16,525 5,400
––––––– –––––––
The following information is relevant:

(1) The fair values of S Ltd.’s assets at the date of acquisition were mostly
equal to their book values with the exception of plant, which was stated
in the books at Rs 2,000,000 but had a fair value of Rs 5,200,000. The
remaining useful life of the plant in question was four years at the date

Advanced Financial Accounting and Corporate Reporting (Study Text) 249

 of acquisition. Depreciation is charged to cost of sales and is time
apportioned on a monthly basis.

(2) During the post-acquisition period P Ltd sold S Ltd some goods for Rs
12 million. The goods had originally cost Rs 9 million. During the
remaining months of the year S Ltd sold Rs 10 million (at cost to S Ltd)
of these goods to third parties for Rs 13 million.

(3) Revenues and expenses should be deemed to accrue evenly

throughout the year.

(4) P Ltd has a policy of valuing non-controlling interests using the full
goodwill method. The fair value of non-controlling interest at the date of
acquisition was Rs 2,520,000.

(5) The fair value of goodwill was impaired by Rs 300,000 at the reporting
date

Required:
Prepare a consolidated statement of comprehensive income for P Ltd group
for the year to 31 March 20X5.

Solution
P Ltd group statement of comprehensive income for the year ended 31 March
20X5:

P Ltd S Ltd Adjusts Group

(9/12) SOCI
Rs 000 Rs 000 Rs 000
Revenue 60,000 18,000 (12,000) 66,000
Cost of sales (42,000) (15,000) 12,000
URPS (W4) (500) (46,100)
FVA adjust dep'n (W2) (600)
––––––
Gross profit 19.900
Distribution costs (2,500) (38) (2,538)
Administration expenses (3,500) (112)
Goodwill impairment (W3) (300) (3,912)
––––––
Profit from operations 13,450
Interest received 75 (75) –
Interest paid (150) 75 (75)
––––––
Profit before tax 13,375

Advanced Financial Accounting and Corporate Reporting (Study Text) 250

 Tax (3,000) (450) (3,450)
––––– ––––––
Profit after tax for the year 1,650 9,925
––––– ––––––
NCI – take 20% of 1,650 330
Less: NCI goodwill
impairment (300 × 20%) (60)
–––––
270
Group share of profit after tax – bal. fig
9,655
––––––
9,925
––––––

(W1) Group structure – P Ltd owns 80% of S Ltd

– the acquisition took place three months into the year
– nine months is post-acquisition

(W2) Net assets Acq'n date Rep date

Rs 000 Rs 000
Equity capital 2,000 2,000
Retained earnings 6,150 8,400
–––––– ––––––
8,150 10,400
FVA – PPE 3,200 3,200
FVA – dep'n adjust 3,200/48 × 9 (600)
–––––– ––––––
11,350 13,000
–––––– ––––––
(W3) Goodwill
S Ltd
Rs 000
Cost of investment 10,280
FV of NCI at acquisition 2,520
–––––––
12,800
FV of net assets at acquisition (W2) (11,350)
–––––––
Total goodwill at acquisition 1,450
Impaired during year (300)
–––––––
Unimpaired goodwill 1,150
–––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 251

 (W4) provision for unrealized profit of parent company
Rs 2,000 × (33.33/133.33 = Rs 500)

2 Step Acquisitions

2.1 Step acquisitions

• A step acquisition occurs when the parent entity acquires control over
the subsidiary in stages. This is achieved by buying blocks of shares at
different times.

• Amendments to IFRS 3 and IAS 27 mean that acquisition accounting

(accounting for recognition of goodwill and non-controlling interests) is
only applied at the date when control is achieved.

• Any preexisting equity interest in an entity is accounted for according to:

– IFRS 9 in the case of simple investments
– IAS 28 in the case of associates and joint ventures
– IFRS 11 in the case of joint arrangement

• At the date when equity interest is increased and control achieved:

(1) remeasure the previously held equity interest to fair value

(2) recognise any resulting gain or loss in profit or loss

(3) calculate goodwill and non-controlling interest on either a partial

(i.e. proportionate) or full (i.e. fair value) basis in accordance
with IFRS 3 Revised. The cost of acquiring control will be the fair
value of the previously held equity interest plus the cost of the
most recent purchase of shares at acquisition date.

• If there has been remeasurement of any previously held equity interest

that was recognised in other comprehensive income, any changes in
value recognised in earlier years are now reclassified from equity to
profit or loss.

• The situation of a further purchase of shares in a subsidiary after

control has been acquired (for example taking the group interest from
60% to 75%) is regarded as a transaction between equity holders;
goodwill is not recalculated. This situation is dealt with separately
within this chapter.

Advanced Financial Accounting and Corporate Reporting (Study Text) 252

 Example 2
A Ltd holds a 10% investment in B Ltd at Rs 24,000 in accordance with IAS
39. On 1 June 20X7, it acquires a further 50% of B Ltd.’s equity shares at a
cost of Rs 160,000.

On this date fair values are as follows:

• B Ltd.’s net assets – Rs 200,000

• The non-controlling interest – Rs 100,000
• The 10% investment – Rs 26,000

How do you calculate the goodwill arising in B Ltd

Note: the non-controlling interest is to be valued using the full method.

Solution

(W1) Group Structure

A Ltd

60%

B Ltd

Note – due to step acquisition – revalue the investment – take gain or loss to
statement of comprehensive income – i.e. an increase in carrying value
from Rs 24,000 to Rs 26,000.

Dr Investment 2,000
Cr Profit on remeasurement 2,000

(W2) Net assets

At date of acquisition
1 June 20X7
Net assets 200,000

Advanced Financial Accounting and Corporate Reporting (Study Text) 253

 (W3) Goodwill – fair value (full goodwill) method

Rs
Purchase consideration (26,000 + 160,000) 186,000
FV of NCI at acquisition date 100,000
–––––––
286,000
–––––––
Total Goodwill 86,000
–––––––

3 Disposal Scenarios

3.1 During the year, one entity may sell some or all of its shares in another
entity.

Possible situations include:

(1) the disposal of all the shares held in the subsidiary.

(2) the disposal of part of the shareholding, leaving a controlling interest
after the sale.
(3) the disposal of part of the shareholding, leaving a residual holding after
the sale, which is regarded as an associate.
(4) the disposal of part of the shareholding, leaving a residual holding after
the sale, which is regarded as a trade investment.

When a group disposes of all or part of its interest in a subsidiary undertaking,

this must be reflected both in the investing entity’s individual accounts and in
the group accounts.

4 Investing Entity’s Accounts

4.1 Gain to investing entity

In all of the above scenarios, the gain on disposal in the investing entity’s
accounts is calculated as follows:
Rs
Sales proceeds X
Carrying amount (usually cost) of shares sold (X)
–––
X
Tax – amount or rate given in question (X)
–––
Net gain to parent X
–––

Advanced Financial Accounting and Corporate Reporting (Study Text) 254

 The gain would often be reported as an exceptional item; if so, it must be
disclosed separately on the face of the parent’s statement of comprehensive
income/statement of comprehensive income after operating profit.

4.2 Tax on gain on disposal

The tax arising as a result of the disposal is always calculated based on the
gain in the investing entity’s accounts, as identified above.

The tax calculated forms part of the investing (parent) entity’s total tax charge.
As such this additional tax forms part of the group tax charge.

5 Group Accounts

5.1 In the group accounts the accounting for the sale of shares in a subsidiary will
depend on whether or not the transaction causes control to be lost, or whether
after the sale control is still maintained.

Where control is lost, there will be a gain or loss to the group which must be
included in the group statement of comprehensive income for the year.
Additionally, there will be derecognition of the assets and liabilities of the
subsidiary disposed of, together with elimination of goodwill and non-
controlling interest from the group accounts. The statement of comprehensive
income of the subsidiary will be consolidated up to the date of disposal.

Where control is of the subsidiary is retained, there is no gain or loss to be

recorded in the group accounts. Instead, the transaction is regarded as one
between equity holders, with the end result being an increase in non-
controlling interest. The group continues to recognise the goodwill, assets and
liabilities of the subsidiary at the year end, and consolidates the statement of
comprehensive income of the subsidiary for the year.

5.2 Accounting for a disposal where control is lost

• Where control is lost (i.e. the subsidiary is completely disposed of or
becomes an associate or investment), the parent:

– Recognises
– the consideration received
– any investment retained in the former subsidiary at fair value on
the date of disposal
– Derecognises
– the assets and liabilities of the subsidiary at the date of disposal
– unimpaired goodwill in the subsidiary

Advanced Financial Accounting and Corporate Reporting (Study Text) 255

 – the non-controlling interest at the date of disposal (including any
components of other comprehensive income attributable to
them)
– Any difference between these amounts is recognised as an
exceptional gain or loss on disposal in the group accounts.
– In the group statement of comprehensive income, it will also be
necessary to pro-rata the results of the subsidiary for the year
into pre-disposal for consolidation, and post-disposal for
accounting as an associate or simple investment as appropriate.

Proceeds X
FV of retained interest X
–––
X
Less interest in subsidiary disposed of:

Net assets of subsidiary at disposal date X

Unimpaired goodwill at disposal date X
Less: carrying value of NCI (X)
–––
(X)
–––
Pretax gain/loss to the group X

Presentation in the group statement of comprehensive income when control is

lost:

Exceptional Gain
The gain to the group would often be reported as an exceptional item, i.e.
presented as an exceptional item on the face of the statement of
comprehensive income after operating profit.

There are two ways of presenting the results of the disposed subsidiary:

(i) Time apportionment line-by-line

In the group statement of comprehensive income, where the sale of the
subsidiary has occurred during the year, basic consolidation principles
will only allow the income and expenses of the subsidiary to be
consolidated up to the date of disposal. The traditional way is to time
apportion each line of the disposed subsidiary’s results in the same
way that a subsidiary’s results that had been acquired part way through
the year would be consolidated.

Advanced Financial Accounting and Corporate Reporting (Study Text) 256

 (ii) Time-apportioned and a discontinued operation
If however the subsidiary that has been disposed qualifies as a
discontinued operation in accordance with “IFRS 5 Accounting for Non-
current Assets held for sale and discontinued operations”, then the
predisposal results of the subsidiary are aggregated and presented in a
single line on the face of the statement of comprehensive income
immediately after profit after tax from continuing operations.

A discontinued operation is a component of an entity that either has

been disposed of or is classified as held for sale, and:

• represents a separate major line of business or geographical

area of operations,

• is part of a single coordinated plan to dispose of a separate

major line of business or geographical area of operations, or

• is a subsidiary acquired exclusively with a view to resale and the

disposal involves loss of control.

Associate time-apportioned
Further if the disposal means control is lost but it leaves a residual interest
that gives that the parent significant influence, this will mean that in the group
statement of comprehensive income there will be an associate to account for,
for example if a parent sells half of its 80% holding to leave it owning a 40%
associate. Associates are accounted for using equity accounting and as the
associate relationship will only be relevant from the date of disposal it will be
time apportioned in the group statement of comprehensive income

Advanced Financial Accounting and Corporate Reporting (Study Text) 257

6 Group Accounts – Entire Disposal

6.1 Entire disposal

Example 3
Rock has held a 70% investment in Cliff for two years. Rock is disposing of
this investment. Goodwill has been calculated using the full goodwill method.
No goodwill has been impaired

Details are:
Rs
Cost of investment 2,000
Cliff – Fair value of net assets at acquisition 1,900
Cliff – Fair value of the non-controlling
interest at acquisition 800
Sales proceeds 3,000
Cliff – Net assets at disposal 2,400

Required:

Calculate the profit/loss on disposal.

(a) In Rock's individual accounts
(b) In the consolidated accounts

Rock is subject to tax at the rate of 25%

Solution.

(a) Gain to Rock

Rs
Sales proceeds 3,000
Cost of shares sold (2,000)
––––––
Gain on disposal 1,000
Tax charge against Rock at 25% 250

Advanced Financial Accounting and Corporate Reporting (Study Text) 258

 (b) Consolidated accounts
Rs Rs
Sales proceeds 3000
Net assets at disposal 2,400
Unimpaired goodwill (W1) 900
Less: carrying value of NCI at disposal date:
FV of NCI at acquisition 800
NCI % of post acq'n retained earnings:
30% × (2,400 – 1,900) 150 (950)
––– –––––
(2,350)
–––––
Gain to group before tax 650
–––––
Tax charge on gain made by Rock (as above) 250

(W1) Goodwill
Rs
Cost of investment 2,000
FV of NCI at acquisition 800
______
2,800
FV of net assets at acquisition (1,900)
______
Total Goodwill 900
______

7 Group Accounts Disposal – Subsidiary to Associate

This situation is where the disposal results in the subsidiary becoming an

associate, e.g. 90% holding is reduced to a 40% holding.

After the disposal the income, expenses, assets and liabilities of the ex-
subsidiary can no longer be consolidated on a line by line basis; instead they
must be accounted for under the equity method, with a single amount in the
statement of comprehensive income/statement of comprehensive income for
the share of the post-tax profits for the period after disposal and a single
amount in the statement of financial position for the fair value of the
investment retained plus the share of post-acquisition retained profits.

Advanced Financial Accounting and Corporate Reporting (Study Text) 259

 Consolidated statement of comprehensive income
• Pro-rate the subsidiary’s results up to the date of disposal and :
– consolidate the results up to the date of disposal
– equity account for the results after the date of disposal.
• Include the group gain on part disposal

Consolidated statement of financial position

• Equity account by reference to the yearend holding, based on the fair
value of the associate holding at disposal date.

Example 4
Copper Ltd disposed of a 25% holding in Zinc Ltd on 30 June 20X6 for Rs
125,000. A 70% holding in Zinc Ltd had been acquired five years prior to this.
Copper Ltd uses the full goodwill method in accordance with IFRS 3 revised.
Goodwill was impaired and written off in full prior to the year of disposal.

Details of Zinc Ltd are as follows:

Rs
Net assets at disposal date 340,000
Fair value of a 45% holding at 30 June 20X6 245,000

If the carrying value of NCI is Rs 80,000 at the date of the share disposal,
what gain on disposal is reported in the Copper Ltd Group accounts for the
year ended 31 December 20X6?
Ignore tax

Solution

(W1) Group Structure

Copper Ltd 70% Copper Ltd

(25%)
75% ––––– 45%
45%
Zinc Ltd Zinc Ltd

Subsidiary Associate
x 6/12 x 6/12

Advanced Financial Accounting and Corporate Reporting (Study Text) 260

 Gain or loss to the group on disposal
Rs
Proceeds 125,000
FV of retained interest 245,000
–––––––
370,000
Net assets recognised at disposal 340,000
Less: NCI at disposal date (80,000) (260,000)
––––––– –––––––
Group gain on disposal 110,000
–––––––

8 Group Accounts – Disposal with Trade Investment Retained

This situation is where the subsidiary becomes a trade investment, e.g. 90%
holding is reduced to a 10% holding.

Consolidated statement of comprehensive income/statement of

comprehensive income

• Pro rate the subsidiary’s results up to the date of disposal and then:

– consolidate the results up to the date of disposal

– only include dividend income after the date of disposal.

• Include the group gain on part disposal.

Consolidated statement of financial position

• Recognise the residual holding retained as an investment, measured at
fair value in accordance with IFRS 9.

9 Disposal where Control is not Lost (Increase in NCI)

9.1 From the perspective of the group accounts, where there is a sale of shares
but the parent still retains control then, in essence, this is an increase in the
non-controlling interest.

For example if the parent holds 80% of the shares in a subsidiary and sells
5%, the relationship remains one of a parent and subsidiary and as such will
remain consolidated in the group accounts in the normal way, but the NCI has
risen from 20% to 25%. Where there is such an increase in the non-controlling
interest:

Advanced Financial Accounting and Corporate Reporting (Study Text) 261

  No gain or loss on disposal is calculated
 No adjustment is made to the carrying value of goodwill
 The difference between the proceeds received and change in the non-
controlling interest is accounted for in shareholders’ equity as follows:

Rs
Cash proceeds received X
NCI % increase x (NAs at date of change + unimpaired goodwill of
sub) (X)
––––
Difference to equity X
––––

Example 5
Until 30 September 20X7, Jupiter held 90% of Mars. On that date it sold a
10% interest in the equity capital for Rs 15,000. At the date of share disposal,
the carrying value of net assets and goodwill of Jupiter were Rs 100,000 and
Rs 20,000 respectively.

How should the disposal transaction be accounted for in the Jupiter Group
accounts?

Solution
Rs
Cash proceeds 15,000
Increase in NCI: 10% × (100,000 + 20,000) 12,000
–––––
Increase in equity 3,000
–––––

There is no gain or loss to the group as there has been no loss of control.
Note that, depending upon the terms of the share disposal, there could be
either an increase or decrease in equity.

9.2 Disposal With No Loss of Control

In this situation, the subsidiary remains a subsidiary, albeit the shareholding is
reduced, e.g. 90% holding is reduced to a 60% holding.

Advanced Financial Accounting and Corporate Reporting (Study Text) 262

 Consolidated statement of comprehensive income / statement of
comprehensive income
• Consolidate the subsidiary’s results for the whole year.
• Calculate the non-controlling interest relating to the periods before and
after the disposal separately and then add together:
• e.g. ( X / 12 × profit × 10%) + ( Y / 12 × profit × 40%)

Consolidated statement of Financial Position

• Consolidate as normal, with the non-controlling interest valued by
reference to the yearend holding
• take the difference between proceeds and the change in the NCI to
shareholders' equity as previously discussed.

10 Subsidiaries Acquired Exclusively with a View to Subsequent Disposal

IFRS 5: non-current assets held for sale and discontinued operations

• A subsidiary acquired exclusively with a view to resale is not exempt
from consolidation.
• But if it meets the criteria in IFRS 5:

– it is presented in the financial statements as a disposal group

classified as held for sale. This is achieved by amalgamating all
its assets into one line item and all its liabilities into another
– it is measured, both on acquisition and at subsequent reporting
dates, at fair value less costs to sell. (IFRS 5 sets down a
special rule for such subsidiaries, requiring the deduction of
costs to sell. Normally, it requires acquired assets and liabilities
to be measured at fair value).

• The criteria include the requirements that:

– the subsidiary is available for immediate sale
– it is likely to be disposed of within one year of the date of its
acquisition.
– the sale is highly probable.

• A newly acquired subsidiary which meets these held for sale criteria
automatically meets the criteria for being presented as a discontinued
operation.

Advanced Financial Accounting and Corporate Reporting (Study Text) 263

 Example 6

IFRS 5
P Ltd acquires R Ltd on 1 March 20X7. R Ltd is a holding entity with two
wholly-owned subsidiaries, M Ltd and J Ltd. J Ltd is acquired exclusively with
a view to resale and meets the criteria for classification as held for sale. P
Ltd’s yearend is 30 September.

On 1 March 20X7 the following information is relevant:

• the identifiable liabilities of J Ltd have a fair value of Rs 40m

• the acquired assets of J Ltd have a fair value of Rs 180m
• the expected costs of selling J Ltd are Rs 5m

On 30 September 20X7, the assets of J Ltd have a fair value of Rs 170. The
liabilities have a fair value of Rs 35m and the selling costs remain at Rs 5m.

Discuss how J Ltd will be treated in the P Ltd Group financial statements
on acquisition and at 30 September 20X7.

Solution
On acquisition the assets and liabilities of J Ltd are measured at fair value
less costs to sell in accordance with IFRS 5’s special rule.
Rs m
Assets 180
Less selling costs (5)
––––
175
Liabilities (40)
––––
Fair value less costs to sell 135
––––

At the reporting date, the assets and liabilities of J Ltd are remeasured to
update the fair value less costs to sell.
Rs m
Assets 170
Less selling costs (5)
––––
165
Liabilities (35)
––––
Fair value less costs to sell 130
––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 264

 The fair value less costs to sell has decreased from Rs 135m on 1 March to
Rs 130m on 30 September. This Rs 5m reduction in fair value must be
presented in the consolidated statement of comprehensive income as part of
the single line item entitled ‘discontinued operations’. Also included in this line
items is the post-tax profit or loss earned/incurred by J Ltd in the March –
September 20X7 period.

The assets and liabilities of J Ltd must be disclosed separately on the face of
the statement of financial position. Below the subtotal for the P Ltd group’s
current assets J Ltd.’s assets will be presented as follows:

Rs m
Non-current assets classified as held for sale 165

Below the subtotal for the P Ltd group’s current liabilities J Ltd.’s liabilities will
be presented as follows:

Rs m
Liabilities directly associated with non-current assets
classified as held for sale 35

No other disclosure is required.

11 Further purchase by group after control obtained (decrease in NCI)

From the perspective of the group accounts where there is a purchase of

more shares in a subsidiary then, in essence, this is not an acquisition – it is a
decrease in the non-controlling interest.

For example if the parent holds 80% of the shares in a subsidiary and buys
5% more the relationship remains one of a parent and subsidiary and as such
will be remain consolidated in the group accounts in the normal way, but the
NCI has decreased from 20% to 15%.

Advanced Financial Accounting and Corporate Reporting (Study Text) 265

 Where there is such a decrease in the NCI:

• There is no change in the goodwill asset

• No gain or loss arises as this is a transaction within equity i.e. with the
NCI
• A difference will arise that will be taken to equity and is determined in
the following proforma.
Rs
Cash paid X
Decrease in NCI (prop'n decrease in NCI x NCI at date of decrease) X
–––
Difference to equity X
–––

Advanced Financial Accounting and Corporate Reporting (Study Text) 266

 Chapter Summary

Advanced Financial Accounting and Corporate Reporting (Study Text) 267

 Self-Test Questions

1. The statements of financial position of two entities, Major and Minor as

at 31 December 20X6 are as follows:
Major Minor
Rs 000 Rs 000
Investment 160
Sundry assets 350 250
––––– –––––
510 250
Equity share capital 200 100
Retained earnings 250 122
Liabilities 60 28
––––– –––––
510 250

Major acquired 40% of Minor on 31 December 20X1 for Rs 90,000. At this

time the retained earnings of Minor stood at Rs 76,000. A further 20% of
shares in Minor was acquired by Major three years later for Rs 70,000. On
this date, the fair value of the existing holding in Minor was Rs 105,000.

Minor’s retained earnings were Rs 100,000 on the second acquisition date, at

which date the fair value of the non-controlling interest was Rs 90,000. It is
group policy to value the non-controlling interest on a full fair value basis.

Required:

Prepare the consolidated statement of financial position for the Major

group as at 31 December 20X6.
2. Hamid Ltd purchased 80% of the shares in PepsiCo for Rs 100,000 when the
net assets of PepsiCo had a fair value of Rs 50,000. Goodwill was calculated
using the proportion of net assets method amounting to Rs 60,000 and has
not suffered any impairment to date. Hamid has just disposed of its entire
shareholding in PepsiCo for Rs 300,000, when the net assets were stated at
Rs 110,000. Tax is payable by Hamid at 30% on any gain on disposal of
shares.

Required:
• Calculate the gain or loss arising to the parent entity on disposal
of shares in PepsiCo.
• Calculate the gain or loss arising to the group on disposal of the
controlling interest in PepsiCo.

Advanced Financial Accounting and Corporate Reporting (Study Text) 268

3. The following information relates to the acquisition by Bridge of a 60%
subsidiary, Walkway, where goodwill and non-controlling interests are
measured on a full fair value basis. At disposal, no goodwill had been
impaired and tax is payable at 30%

Net assets at Net Assets at Fair Value of NCI Cost of Sale Acq
Disposal Date at acquisition Investment Proceeds

Rs m Rs m Rs m Rs m Rs m
500 750 300 900 3,000

Required:
• Calculate the gain arising to the parent entity on disposal.
• Calculate the gain arising to the group on disposal.

4. Paper purchased 80% of the shares in Wood four years ago for Rs 100,000.
On 30 June it sold all of these shares for Rs 250,000. The net assets of Wood
at acquisition were Rs 69,000 and at disposal, Rs 88,000. Fifty per cent of the
goodwill arising on acquisition had been written off in an earlier year. The fair
value of the non-controlling Interest in Wood at the date of acquisition was Rs
15,000. It is group policy to value the non-controlling interest using the full
goodwill method.

Tax is charged at 30%.

Required:
What profits/losses on disposal are reported in Paper’s statement of
comprehensive income and in the consolidated statement of
comprehensive income?

5. H Ltd has held a 60% investment in M Ltd for several years, using the full
goodwill method to value the non-controlling interest. Half of the goodwill has
been impaired prior to the date of disposal of shares by H Ltd. Details are as
follows:
Rs 000
Cost of investment 6,000
M Ltd – Fair value of net assets at acquisition 2,000
M Ltd – Fair value of a 40% investment at acquisition date 1,000
M Ltd – Net assets at disposal 3,000
M Ltd – FV of a 30% investment at disposal date 3,500

Advanced Financial Accounting and Corporate Reporting (Study Text) 269

 Required:
(a) Assuming a full disposal of the holding and proceeds of Rs 10
million, calculate the profit/loss arising:

(i) in H Ltd.’s individual accounts

(ii) in the consolidated accounts

Tax is 25%

(b) Assuming a disposal of half the holding and proceeds of Rs 5

million:

(i) calculate the profit/loss arising in the consolidated

accounts
(ii) explain how the residual holding will be accounted for.

Ignore tax.

6. The statement of comprehensive incomes for the year ended 31

December 20X9 are as follows:
K L
group
Rs Rs
Revenue 553,000 450,000
Operating costs (450,000) (400,000)
––––––– –––––––
Operating profits 103,000 50,000
Dividends receivable 8,000 –
––––––– –––––––
Profit before tax 111,000 50,000
Tax (40,000) (14,000)
––––––– –––––––
Profit after tax 71,000 36,000
––––––– –––––––
Retained earnings b/f 100,000 80,000
Profit after tax 71,000 36,000
Dividend paid (25,000) (10,000)
––––––– –––––––
Retained earnings c/f 146,000 106,000
––––––– –––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 270

 • The accounts of the K group do not include the results of L.

• On 1 January 20X5 K acquired 70% of the shares of L for Rs 100,000

when the fair value of L's net assets were Rs 110,000. L has equity
capital of Rs 50,000. At that date, the fair value of the non-controlling
interest was Rs 40,000.

• L paid its 20X9 dividend in cash on 31 March 20X9.

• Goodwill is to be accounted for based upon the fair value of non-

controlling interest. No goodwill has been impaired.

• K has other subsidiaries participating in the same activities as L, and

therefore the disposal of L shares does not represent a discontinued
operation per IFRS 5.

Required:
(a) (i) Prepare the consolidated statement of comprehensive income
for the year ended 31 December 20X9 for the K group on the
basis that K plc sold its holding in L on 1 July 20X9 for Rs
200,000. This disposal is not yet recognised in any way in K
group’s statement of comprehensive income.

(ii) Compute the group retained earnings at 31 December 20X9.

(ii) Explain and illustrate how the results of L are presented in the
group statement of comprehensive income in the event that L
represented a discontinued activity per IFRS 5.

Ignore tax on the disposal.

(b) (i) Prepare the consolidated statement of comprehensive income
for the year ended 31 December 20X9 for the K group on the
basis that K sold half of its holding in L on 1 July 20X9 for Rs
100,000 This disposal is not yet recognised in any way in K
group’s statement of comprehensive income. The residual
holding of 35% has a fair value of Rs 100,000 and leaves the K
group with significant influence.

(ii) Compute the group retained earnings at 31 December 20X9

Advanced Financial Accounting and Corporate Reporting (Study Text) 271

 Ignore tax on the disposal.

7. P Ltd has owned 90% of G Ltd for many years and is considering selling
part of its holding, whilst retaining control of G Ltd.

At the date of considering disposal of part of the shareholding in G Ltd, the

NCI has a carrying value of Rs 7,200 and the net assets and goodwill have a
carrying value of Rs 70,000 and Rs 20,000 respectively.

(i) P Ltd could sell 5% of the G Ltd shares for Rs 5,000 leaving it holding
85% and increasing the NCI to 15%, or

(ii) P Ltd could sell 25% of the G Ltd shares for Rs 20,000 leaving it
holding 65% and increasing the NCI to 35%.

Required:
Calculate the difference arising that will be taken to equity for each situation

8. H, S and M are three entities preparing their financial statements under

IFRSs.

Their statements of financial position as at 30 September 20X5 are given

below:

Statements of Financial Position H S M

Rs 000 Rs 000 Rs 000
Non-current assets:
Property, plant and equipment 160,000 60,000 64,000
Investments 80,000 – –
––––––– ––––––– –––––––
240,000 60,000 64,000
Current assets 65,000 50,000 36,000
––––––– ––––––– –––––––

305,000 110,000 100,000

––––––– ––––––– –––––––

Equity capital (Rs 1 shares) 50,000 20,000 15,000

Retained earnings 185,000 43,000 42,000
––––––– ––––––– –––––––

235,000 63,000 57,000

Advanced Financial Accounting and Corporate Reporting (Study Text) 272

 Non-current liabilities 25,000 18,000 20,000
Current liabilities 45,000 29,000 23,000
––––––– ––––––– –––––––

305,000 110,000 100,000

––––––– ––––––– –––––––

Note 1- Investment by H in S
On 1 October 20X3, H acquired 70% of the equity share capital of S for
Rs 45 million in cash, when the balance on S’s retained earnings was
Rs 28 million. It was determined that at this date, land with carrying
value of Rs 40 million had a fair value of Rs 45 million.

On 30 September 20X5, H acquired a further 10% of the equity shares

of S paying Rs 10 million in cash.

Note 2 – Investment by H in M
On 1 January 20X2, H acquired 60% of the equity shares of M for Rs
21 million in cash, when the balance on M’s retained earnings was Rs
15 million. It was determined that the book value of M’s net assets on 1
January 20X2 were equal to their fair values.

On 30 September 20X5, H disposed of one quarter of its shareholding

in M for Rs 15 million cash. H’s remaining 45% holding enabled H to
exercise significant influence over the operating and financial policies
of M. The fair value of the remaining 45% holding was Rs 35 million at
30 September 20X5. H have recorded the proceeds of Rs 15 million by
debiting cash and crediting investments, but no other entries have
been made.

Note 3 – Intra-group trading

During the year ended 30 September 20X5, H sold goods to S for Rs 8
million. These goods were sold at a profit margin of 25%. Half of these goods
remain in S’s inventory at the reporting date.

Note 4 – NCIs and goodwill

H’s policy is to value NCIs at acquisition at fair value. The fair value of the
non-controlling interest in S was Rs 17.4 million and the fair value of the non-
controlling interest in M was Rs 13 million at the relevant dates of acquisition.
No impairment losses have arisen on goodwill.

Advanced Financial Accounting and Corporate Reporting (Study Text) 273

 Required:

Prepare the consolidated statement of financial position of the H group

as at 30 September 20X5.
9. G Ltd has owned 80% of M Ltd for many years. G Ltd is considering acquiring
more shares in M Ltd, which will decrease the NCI. The NCI of M Ltd currently
has a carrying value of Rs 20,000, with the net assets and goodwill having a
value of Rs 125,000 and Rs 25,000 respectively.

G Ltd is considering the following two scenarios:

(i) G Ltd could buy 20% of the M Ltd shares leaving no NCI for Rs 25,000, or
(ii) G Ltd could buy 5% of the M Ltd shares for Rs 4,000 leaving a 15% NCI.

Required:
Calculate the difference arising that will be taken to equity for each
situation

Advanced Financial Accounting and Corporate Reporting (Study Text) 274

 Answers

1. Consolidated statement of financial position for Major as at 31 December 20X6

Rs
Goodwill (W3) 65,000
Sundry assets (350,000 + 250,000) 600,000
–––––––
665,000
–––––––
Equity and liabilities Rs
Equity share capital 200,000
Retained earnings (W5) 278,200
Non-controlling interest (W4) 98,800
Liabilities (60,000 + 28,000) 88,000
–––––––
665,000
–––––––

W-1 Group structure

Major 40% acquired 5 years ago

20% acquired 2 years ago

Minor

Therefore, Minor becomes a subsidiary of Major from December 20X4.

The investment will need to be revalued

Dr Investment 15,000
(105,000 – 90,000)
Cr Profit 15,000

Advanced Financial Accounting and Corporate Reporting (Study Text) 275

 W-2 Net assets

At Acquisition At Reporting
20X4 date

Rs Rs
Share capital 100,000 100,000
Retained earnings 100,000 122,000
––––––– –––––––
200,000 222,000
––––––– –––––––

W-3 Goodwill

Rs
Consideration paid by parent 175,000
(105,000 + 70,000)
FV of NCI (given) 90,000
–––––––
265,000
Less: FV of NA at acquisition (W2) (200,000)
–––––––
65,000
–––––––

(W4) Non controlling interest

Rs
FV at acquisition date 90,000
NCI % of postacquisition retained earnings
(40% x Rs 22,000) 8,800
–––––––
98,800
–––––––
(W5) Group Retained earnings

Rs
Major 250,000
Gain on remeasurement 15,000
Minor 60% (222,000 – 200,000) 13,200
–––––––
278,200
–––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 276

2.
(a) Gain to Hamid
Rs 000
Sales proceeds 300
Cost of shares sold (100)
––––
Gain on disposal 200
Tax at 30% (60)
––––
Net gain on disposal 140

(a) Consolidated accounts

Rs 000
Proceeds 300
FV of retained interest NIL
––––
300
Less interest in subsidiary disposed of:
Net assets of subsidiary at disposal date 110
Unimpaired goodwill at disposal date 60
Less: NCI carrying value at disposal date (W1) (22)
––––
(148)
––––
152
Tax on gain as per Hamid (part (a)) (60)
––––
Post-tax gain to group 92

(W1) NCI at disposal date

Rs 000
NCI % of net assets at acquisition (20% × 100) 10
NCI % of increase in net assets to disposal (20% × (110 –50))
Date
12
––––
22
––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 277

3.
(a) Gain to parent entity
Rs 000
Sales proceeds 3,000
Cost of shares sold (900)
––––––
Gain on disposal 2,100
Tax at 30% (630)
––––––
Net gain on disposal 1,470

(b) Consolidated accounts

Rs
Proceeds 3,000
FV of retained interest NIL
–––––
3,000
Less interest in subsidiary disposed of:
Net assets of subsidiary at disposal date 750
Unimpaired goodwill at disposal date (W1) 700
Less: NCI at disposal date (W2) (400)
–––– (1,050)
–––––
1,950
Tax on gain as per parent entity (630)
–––––
Post tax
gain to group 1,320
–––––
(W1) Goodwill calculation
Rs m
Cost of investment 900
FV of NCI at acquisition (given) 300
––––
1,200
FV of net assets acquisition (500)
Fair value of goodwill at acquisition ––––
700
––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 278

 (W2) NCI at disposal date
Rs m
FV of NCI at acquisition (given) 300
NCI share of postacquisition retained earnings
(40% x (750 – 500)) 100

––––
400
––––
4. (a) Gain to Paper
Rs 000
Sales proceeds 250
Cost of shares sold (100)
–––––
Gain on disposal 150
Tax at 30% (45)
–––––
Net gain on disposal 105

b. Consolidated accounts
Rs 000 Rs 000
Sales proceeds 250.0
Carrying value of subsidiary at disposal date:
Net assets at disposal date – given 88.0
Unimpaired goodwill at disposal date (W1) 23.0
–––––
111.0
Less: CV of NCI at disposal (W2) (14.2)
––––– (96.8)
–––––
Pretax gain to group on disposal 153.2
Tax (per parent in part (a) (45.0)
–––––
Net gain to group after tax 108.2
–––––

(W1) Goodwill
Rs 000
Cost of investment 100.0
FV of NCI at acquisition 15.0
–––––
115.0
FV of net assets at acquisition (69.0
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 279

 Full goodwill at acquisition 46.0
Goodwill impaired to extent of 50%
Group share – 80% (18.4)
NCI share – 20% (4.6) (23.0)
––––– –––––
Unimpaired goodwill at disposal date 23.0
–––––

(W2) NCI at disposal date

Rs 000
FV at date of acquisition 15.0
NCI % of postacq'n retained earnings
(20% x (88.0 – 69.0)) 3.8

NCI % of impairment (W1) (4.6)

–––––
14.2
–––––

Normally the parent entity profit is greater than the group profit, by the share
of the post-acquisition retained earnings now disposed of. In this case the
reverse is true, because the Rs 23,000 impairment loss already recognised
exceeds the Rs 15,200 ((88,000 – 69,000) × 80%) share of post-acquisition
retained earnings.

5.
(W1) Goodwill
Rs 000
Cost of investment 6,000
FV of the NCI at date of acquisition 1,000
––––––
7,000
FV of net assets at the date of acquisition (given) (2,000)
––––––
Total goodwill 5,000
Impaired (50%) (2,500)
––––––
Unimpaired goodwill 2,500
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 280

 (W2) NCI at disposal date
Rs 000
FV at date of acquisition 1,000
NCI share of post-acquisition retained earnings 400
(40% x (3,000 – 2,000))
Less: NCI share of goodwill impairment (40% x 2500) (1,000)
––––––
400
––––––

Full disposal of shares

Gain in H Ltd's individual accounts

Rs 000

(a) (i) Sale proceeds 10,000

Less Cost of shares sold (6,000)
––––––
Gain to parent 4,000
Tax at 25% × 4,000 (1,000)
––––––
3,000
––––––

Full disposal of shares – gain in H Ltd Group accounts

Rs 000

Sale proceeds 10,000

FV of retained interest nil
CV of subsidiary at disposal:
Net Assets 3,000
Unimpaired goodwill (W1) 2,500
–––––
5,500
Less: NCI at disposal date (W2) (400)
––––– (5,100)
–––––
Gain before tax 4,900
Tax per part (a)(i) (1,000)
–––––
3,900
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 281

 (b) (i) Disposal of half of the holding to leave a residual shareholding:

Rs 000 Rs 000
Disposal proceeds 5,000
FV of retained interest 3,500
–––––
8,500
CV of subsidiary at disposal date:
Net assets 3,000
Unimpaired goodwill (W1) 2,500
–––––
5,500
Less: FV of NCI at disposal date (W2) (400)
–––––
(5,100
–––––
3,400
–––––
(iii) After the date of disposal, the residual holding will be equity
accounted, with a single amount in the statement of
comprehensive income for the share of the post-tax retained
earnings for the period after disposal and a single amount in the
statement of financial position for the fair value at disposal date
of the investment retained plus the group share of post-
acquisition retained earnings.

6.
(a) (i) Consolidated statement of comprehensive income – full disposal
K L
Group Rs Group Rs

Revenue 553,000 (6 / 12 x 450,000) 778,000

Operating costs 450,000 (6 / 12 x 400,000) (650,000)
–––––––
Operating profit 128,000
Dividend 8,000 less Inter-co (70%×10,000) 1,000
Profit on disposal (W4) 80,400
–––––––
Profit before tax 209,400
Tax 40,000 (6 / 12 × 14,000) (47,000)
–––––––
Profit after tax 162,400
–––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 282

 Attributable to:
Equity holders of
K (β) 157,000
Non controlling
Interest (30% × 36,000 × 5,400
6/12)
–––––––
162,400
–––––––

(ii) Group retained earnings at 31 December 20X9 – full disposal

Rs
Brought forward K 100,000
Group % of L's post-acquisition retained
earnings b/f
(70% × (130,000 (W1) – 110,000) (per Q)) 14,000
––––––––
114,000
Profit for year per consolidated statement of
comprehensive income 157,000
Less Dividend paid (25,000)
––––––––
Retained earnings carried forward 246,000
––––––––

(iii) Group statement of comprehensive income – discontinued

operations presentation
K L
Group Rs Group Rs
Revenue 553,000 553,000
Operating costs 450,000 (450,000)
––––––––
Operating profit 103,000
Dividend 8,000 less
Interco (70%
× 10,000) 1,000
Profit on disposal (W4) 80,400
––––––––
Profit before tax 184,400
Tax (40,000)
––––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 283

 Profit after tax – continuing
operations
144,400
Discontinued operations (Rs 36,000 × 6/12) 18,000
––––––––
162,400
––––––––

Attributable to:
Equity holders of 157,000

K (β)
Non controlling
Interest (30% × 36,000 × 6/12) 5,400
––––––––
162,400
––––––––

Notice that the post tax results of the subsidiary up to the date of disposal are
presented as a one line entry in the group statement of comprehensive
income. There is no line-by-line consolidation of results when this method of
presentation is adopted.

b. (i) Consolidated statement of comprehensive income – part disposal

with residual interest

K L
Group Rs Group Rs
Revenue 553,000 (6 / 12 × 450,000) 778,000
Operating costs 450,000 (6 / 12 × 400,000) (650,000)
–––––––
Operating profit 128,000
Dividend 8,000 less
Interco (70%
× 10,000) 1,000
Income from associate (35% × 36,000) 6,300
× 6 / 12)
Profit on disposal (W4) 80,400
–––––––
Profit before tax 215,700
Tax 40,000 (6 / 12 × 14,000) (47,000)
–––––––
Profit after tax 168,700
–––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 284

 Attributable to:
Equity holders of K (β) 163,300
Non controlling interest (30% × 36,000 × 6 / 12) 5,400
–––––––
168,700
–––––––
(ii) Group retained earnings at 31 December 20X9 – part disposal
Rs
K 100,000
Group % of L’s post-acquisition retained earnings b/f
(70% × (130,000 (W1) – 110,000) (per Q)) 14,000
–––––––
114,000

Group income per consolidated statement of

comprehensive income 163,300
Less Dividend paid (25,000)
–––––––
252,300
–––––––

Alternatively:
Rs
K c/fwd 146,000
Parent gain on disposal of shares
(Rs 100,000 – (50% × Rs 100,000) 50,000
Gain on remeasurement of residual holding
(Rs 100,000 – Rs 50,000) 50,000
Share of associate profit (6/12 × 35% × Rs 36,000) 6,300
–––––––
252,300
–––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 285

 Workings

(W1) Net assets – L Net assets Net assets

at disposal b/f
Rs Rs
Share capital 50,000 50,000
Retained earnings
B/f 80,000 80,000
6 / 12 × 36,000 18,000
Less Dividend (10,000) –
––––––– –––––––
138,000 130,000
––––––– –––––––

(W2) Goodwill
Rs
Cost to parent 100,000
FV of NCI at date of acquisition 40,000
–––––––
140,000
FV of net assets at date of acquisition (per question) 110,000
–––––––
Unimpaired goodwill 30,000
–––––––
(W3) NCI at disposal date
FV of NCI at date of acquisition 40,000
NCI share of postacquisition retained earnings
(30% x (138,000 – 110,000) 8,400
–––––––
48,400
–––––––

(W4) Profit on disposal

Full disposal (a)(i) Rs Rs
Proceeds 200,000
Net assets recorded prior to disposal
Net assets 138,000
Full goodwill – unimpaired 30,000
––––––
168,000
NCI at date of disposal (W3) (48,400)
––––––
(119,600)
–––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 286

 Profit on disposal 80,400
–––––––

Part disposal (b)(i)

Proceeds 100,000
FV of retained interest (per question) 100,000
–––––––
200,000
Net assets recorded prior
to disposal
Net assets 138,000
Unimpaired goodwill at disposal date 30,000
–––––––
168,000
NCI at date of disposal (W3) (48,400)
–––––––
(119,600)
–––––––
80,400
–––––––

7. (i) Sale of 5% of G Ltd shares

Rs
Cash proceeds 5,000
Increase in NCI (5% x (70,000 +20,000) (4,500)
–––––
Increase in equity 500
–––––
(ii) Sale of 25% of G Ltd shares
Rs
Cash proceeds 20,000
Increase in NCI (25% x (70,000 + 20,000) (22,500)
––––––
Decrease in equity (2,500)
––––––

Note that in both situations, G Ltd remains a subsidiary of P Ltd after

the sale of shares. There is no gain or loss to the group – the
difference arising is taken to equity. G Ltd would continue to be
consolidated within the P Ltd Group like any other subsidiary; there is
no change to the carrying value of goodwill. The only impact will be the
calculation of NCI share of retained earnings for the year – this would
need to be time-apportioned based upon the NCI percentage pre and
post disposal during the year.

Advanced Financial Accounting and Corporate Reporting (Study Text) 287

8. H – Consolidated Statement of Financial Position at 30 September 20X5
Assets: Rs 000
Goodwill (W3) 9,400
Property, plant & equipment (160,000 + 60,000 + 5,000(FVA)) 225,000
Investments (80,000 – 45,000 (W3) – 10,000(W7) – 19,000
21,000(W3) + 15,000(W8))
Investment in associate 35,000
Current assets (65,000 + 50,000 – 1,000(W6)) 114,000
––––––
402,400
––––––
Equity and liabilities: Rs 000
Equity Capital 50,000
Retained earnings 223,500
(W5)

Other components of equity (W7) (2,700)

Non controlling interest (W4) 14,600
––––––
285,400
Noncurrent
liabilities (25,000 + 18,000) 43,000
Current liabilities (45,000 + 29,000) 74,000
––––––
402,400
––––––

Workings:

(W1) Group structure

H
1 Oct X3 70% 1 Jan X2 60%
30 Sept X5 10% 30 Sept X5 (15%)
––– –––
Rep date 80% Rep date 45%
S M

Note that H controls S from 1 October 20X3. The purchase of additional

shares on 30 September 20X5 does not change this situation. An equity
transfer is required between the group and NCI to reflect the purchase of
additional shares.

Advanced Financial Accounting and Corporate Reporting (Study Text) 288

 Note that H controls M from 1 January 20X2. The sale of shares on 30
September 20X5 results in a loss of control, on which a group gain or loss
disposal should be computed and included in the group statement of
comprehensive income. The fair value of the residual holding should be
included in the calculation of the group gain or loss on disposal and also as
initial recognition of an associate as significant influence is exercised following
the loss of control.

(W2) Net assets

Acquisition Reporting
date date
S Rs 000 Rs 000
Share capital 20,000 20,000
Retained earnings 28,000 43,000
FVA – Land (45,000 – 40,000) 5,000 5,000
–––––– ––––––
53,000 68,000
–––––– ––––––
Acquisition Disposal
date date
M Rs 000 Rs 000
Share capital 15,000 15,000
Retained earnings 15,000 42,000
–––––– ––––––
30,000 57,000
–––––– ––––––

(W3) Goodwill
S
Rs 000
FV of cost of gaining control 45,000
FV of NCI at acquisition 17,400
––––––
62,400
Less: FV of net assets at acquisition (W2) (53,000)
––––––
Goodwill at acquisition – not impaired 9,400
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 289

 M
Rs 000
FV of cost of gaining control 21,000
FV of NCI at acquisition 13,000
––––––

34,000
Less: FV of net assets at acquisition (W2) (30,000)
––––––
Goodwill at acquisition – unimpaired at disposal date 4,000
––––––
(W4) Non – controlling interest

S
Rs 000
NCI at acquisition date (W3) 17,400
NCI share of post acq'n retained earnings 4,500
(30% × (Rs 68,000 – Rs 53,000) (W2))
–––––
NCI before equity transfer 21,900
Equity transfer due to purchase of additional shares by group (W7) (7,300)
–––––
NCI at reporting date 14,600
–––––
M
Rs 000
NCI at acquisition date (W3) 13,000
NCI share of post acq'n retained earnings (40% × (Rs 57,000 – 10,800
Rs 30,000)(W2))
–––––
NCI at disposal date 23,800
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 290

 (W5) Retained earnings

Rs 000
H 185,000
Provision for unrealised profit (W6) (1,000)
S (70% × Rs 15,000 (W2)) 10,500
M (60% × Rs 27,000 (W2)) 16,200
Gain on disposal of M (W8) 12,800
–––––––
223,500
–––––––
(W6) Provision for unrealised profits
Rs 000
Goods in inventory (1/2 × Rs 8,000) 4,000
–––––
Provision for unrealised profit
(25% × Rs 4,000) made by H 1,000
–––––

(W7) Equity transfer between group and NCI

Rs 000
Cash paid by H to buy additional shares 10,000
Decrease in NCI (10/30 × Rs 21,900(W4)) 7,300
–––––
Net decrease in equity of the group 2,700
–––––
Dr NCI (W4) 7,300
Dr Equity 2,700
Cr Investments (reversal of original 10,000
Accounting for receipt of disposal proceeds)

Advanced Financial Accounting and Corporate Reporting (Study Text) 291

 (W8) Group gain/loss on disposal of M

Rs 000 Rs 000
Proceeds 15,000
Fair value of residual interest 35,000
––––––
Less: interest in M disposed of:
Net assets at disposal date (W2) 57,000
Unimpaired goodwill at disposal date (W3) 4,000
Gain on disposal of M (W8) ––––––
61,000
Less: NCI at disposal date (W5) (23,800) (37,200)
–––––– ––––––
Group gain on disposal to retained earnings (W5) 12,800
––––––
At the reporting date, the residual investment is accounted for as an
associate at a deemed cost of Rs 35 million.

9.
(i) Purchase of 20% of M Ltd shares
Rs
Cash paid 25,000
Decrease in NCI ((20% / 20%) x 20,000) 20,000
–––––
Decrease in equity 5.000
–––––
(ii) Purchase of 5% of M Ltd shares
Rs
Cash paid 4,000
Decrease in NCI ((5% / 20%) x 20,000) 5,000
–––––
Increase in equity 1,000
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 292

Advanced Financial Accounting and Corporate Reporting (Study Text) 293
COMPLEX GROUP STRUCTURES
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

Determine appropriate procedures to be used in preparing group financial statements:

• Apply the method of accounting for business combinations, including complex
group structures (vertical and D-shaped/mixed groups).
• Apply the recognition and measurement criteria for identifiable acquired assets and
liabilities and goodwill in step acquisitions.
• Determine the appropriate procedures to be used in preparing group financial
statements. Where parent has direct/indirect holding in sub-subsidiaries.

Advanced Financial Accounting and Corporate Reporting (Study Text) 294

1 Complex Group Structures

1.1 Complex group structures exist where a subsidiary of a parent entity owns a
majority shareholding in another entity which makes that other entity also a
subsidiary of the parent entity.

Complex structures can be classified under two headings:

• vertical groups
• mixed groups.

1.2 Vertical groups

Definition
A vertical group arises where a subsidiary of the parent entity holds shares in a
further entity such that control is achieved. The parent entity therefore controls
both the subsidiary entity and, in turn, its subsidiary (often referred to as a sub-
subsidiary entity). Look at the two situations:

Situation 1: Situation 2:
H H
owns 90% of S owns 70% of S

who, in turn, owns 80% of who, in turn, owns 60% of

T T

In both situations, H controls both S and also T there is a vertical group comprising
three entities. H has a controlling interest in entity S. S has a controlling interest in
entity T. H is therefore able to exert control over T by virtue of its ability to control S.

The normal consolidation principles and workings will be applied to consolidate a

vertical group. Goodwill must be calculated and non-controlling interests recognised
for each subsidiary in the group. Particular care will be needed to apply the holding
entity (H in the two situations above) effective interest in the sub-subsidiary (T in the
two situations above) in the workings.

The narrative which follows explains and illustrates how the group effective interest
and non-controlling effective interest in a sub-subsidiary is determined, together
with workings to calculate goodwill, NCI and group retained earnings as required.
There is also explanation to determine when the sub-subsidiary becomes a
member of the group for consolidation.

Advanced Financial Accounting and Corporate Reporting (Study Text) 295

 Consolidation
Where a parent entity owns a controlling interest in a subsidiary, which in turn owns
a controlling interest in a sub-subsidiary, then the group accounts of the ultimate
parent entity must include the underlying net assets and earnings of both the
subsidiary and the sub-subsidiary companies.
Thus, both entities that are controlled by the parent are consolidated.

The basic techniques of consolidation are the same as seen previously, although
calculations of goodwill and the non-controlling interest become slightly more
complicated.

1.3 Effective shareholding and non-controlling interest

In the two situations identified opposite, H has a direct interest in S and an indirect
interest in T (exercised via S’s holding in T).

In situation 1, H has an effective interest of only 72% (90% × 80%) in T.

Nevertheless, T is a sub-subsidiary of H because H has a controlling interest in
S and S has a controlling interest in T. As H has an effective interest in T of
72%, it follows that the non-controlling interest in T is 28%. This can be
analysed as follows:

%
Owned by outside shareholders in T 20
Owned by outside shareholders in H (100% – 90%) × 80%) 8
–––
Effective non-controlling interest in T 28
–––

Similarly, in situation 2, H has an effective interest of just 42% (70% × 60%) in T.

Nevertheless, T is a sub-subsidiary of H because H has a controlling interest in S
and S has a controlling interest in T. As H has an effective interest in T of 42%, it
follows that the non-controlling interest in T is 58%. This can be analysed as
follows:

%
Owned by outside shareholders in T 40
Owned by outside shareholders in H (100% – 90%) × 80%) 18
–––
Effective non-controlling interest in T 58
–––

The group effective interest in T will be used within the goodwill and group reserve
calculations for the sub-subsidiary. In situation 2, do not be put off by the fact that

Advanced Financial Accounting and Corporate Reporting (Study Text) 296

 the effective group interest in T is less than 50%, and that the effective non-
controlling interest in T is more than 50%. The effective interest calculations are the
result of a two-stage acquisition and are used to simplify the consolidation
workings.

1.4 Group reserves

Only the group or effective percentage of each of the reserves of the sub-subsidiary
are included within group reserves. Often the only reserve will be retained earnings,
but there could be others, such as revaluation reserve.

1.5 Date of acquisition

The date of acquisition of each subsidiary is the date on which H gains control. If S
already held T when H acquired S, treat S and T as being acquired on the same
day. Consider the following situations to determine when the sub-subsidiary
company, T, becomes a member of the H group::

(1) H acquired control of S on 1 January 20x4; S subsequently acquired

control of another entity, T, on 1 July 20x6.
(2) H acquired control of S on 1 July 20x6; S had already acquired control of
another entity, T, on 1 January 20x4.

In the first situation, T does not come under the control of H until S acquires
shares in T – i.e. on 1 July 20x6. In the second situation, H cannot gain control
of T until S acquires shares in T on 1 July 20x6.

To identify the date that the sub-subsidiary becomes a member of the group,
include the dates of share purchases within your group structure when
answering questions: the key date will be the later of the two possible dates of
acquisition.

The following examples consider situations where:

(1) the subsidiary is acquired by the parent first; the subsidiary later acquires the
sub-subsidiary, and
(2) the parent acquires the subsidiary that already holds the sub-subsidiary

Advanced Financial Accounting and Corporate Reporting (Study Text) 297

 Example 1

Vertical Group
The draft statements of financial position of D, C and J, as at 31 December 20X4,
are as follows:

D C J D C J
Rs 000 Rs 000 Rs 000 Rs 000 Rs 000 Rs 000
Sundry assets 280 180 130 Equity capital 200 100 50
Retained 100 60 30
earnings
Cost of investment 120 80 Liabilities 100 100 50
–––– –––– –––– –––– –––– ––––
400 260 130 400 260 130
–––– –––– –––– –––– –––– ––––

You ascertain the following:

 D acquired 75,000 Rs 1 shares in C on 1 January 20X4 when the

retained earnings of C amounted to Rs 40,000. At that date, the fair value
attributable to the non-controlling interest in C was valued at Rs 38,000.

 C acquired 40,000 Rs 1 shares in J on 30 June 20X4 when the retained

earnings of J amounted to Rs 25,000; they had been Rs 20,000 on the
date of D's acquisition of C. At that date, the fair value of the non-
controlling interest in J (both direct and indirect), based upon effective
shareholdings, was valued at Rs 31,000.

 Goodwill has suffered no impairment

Required:
Produce the consolidated statement of financial position of the D group at 31
December 20X4. It is group policy to use the full goodwill method.

1. Solution vertical group

Step 1 – Group structure

Draw a diagram of the group structure and set out the respective interests of the
parent entity and the non-controlling interests, distinguishing between direct (D) and
indirect (I) interests. You may find it useful to include on the diagram the dates of
acquisition of the subsidiary and the sub-subsidiary.

Advanced Financial Accounting and Corporate Reporting (Study Text) 298

 D
75% acquired 1 Jan X4

80% acquired 30 June X4

J

Group and Non Controlling interests

C J
Group interest 75% 60% (75%×80%)
Non Controlling interest 25% 40% (25%×80%)
––––– –––––
100% 100%
––––– –––––

Step 2
Start with the net assets consolidation working as normal.

Care must be taken in determining the date for the split between post-
acquisition and preacquisition retained earnings. The relevant date will be that
on which D (the parent company) acquired control of each entity:

• C: 1 January 20X4
• J: 30 June 20X4
Therefore, the information given regarding J’s retained earnings at 1 January
20X4 is irrelevant in this context.

Net assets of subsidiaries

C J
At acq'n At rep At acq'n At rep
date date
Rs Rs Rs Rs
Equity capital 100,000 100,000 50,000 50,000
Reserves 40,000 60,000 25,000 30,000
––––––– ––––––– –––––– ––––––
140,000 160,000 75,000 80,000

Advanced Financial Accounting and Corporate Reporting (Study Text) 299

 Step 3

Goodwill
• A separate calculation is required to determine goodwill for each subsidiary.

• For the sub-subsidiary, goodwill is calculated from the perspective of the

ultimate parent entity (D) rather than the immediate parent (C). Therefore,
the effective cost of J is only D's share of the amount that C paid for J, i.e. Rs
80,000 × 75% = Rs 60,000.

C J
Rs 000 Rs 000
Cost of investment in subsidiary 120 60 (i.e. 75% × 80,000)
Fair value of NCI 38 31
–––– ––––
158 91
FV of net assets (W2) (140) (75)
–––– ––––
18 16
–––– ––––

Step 4

Non-controlling interest
When taking the non-controlling share of C’s net assets, an adjustment must be
made to take out the cost of investment in J that is included in the net assets of C.

In the group statement of financial position, the cost of investment is replaced by

including all the net assets of J, so no investment must remain.

The non-controlling interest in C are entitled to their (indirect) share of the net
assets of J, but they receive these by virtue of the effective interest that will be
used to calculate the non-controlling interest in J.
Rs 000
C: NCI FV at acquisition 38
C NCI share of post acq'n retained earnings (25% × 20,000) 5
Less: NCI share of cost of investment in J (25% × 80,000) (20)
––––
23
J: NCI FV at acquisition 31
J NCI share of post acq'n retained earnings (40% × 5) 2
––––
56
––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 300

 Step 5
Group retained earnings
Rs 000
D 100
C 75% × 20,000 (post-acquisition retained earnings) 15
J 60% × 5,000 (post-acquisition retained earnings) 3
––––
118
––––

Note that again, only the group or effective interest of 60% is taken of the post-
acquisition retained earnings of J.

Step 6
Summarised consolidated statement of financial position of D its subsidiary
entities as at 31 December 20X4
Rs
Goodwill (18,000 + 16,000) 34,000
Sundry assets (280,000 + 180,000 + 130,000) 590,000
–––––––
624,000
–––––––
Equity and liabilities:
Equity capital 200,000
Retained earnings (Step 5) 118,000
–––––––
318,000
Non-controlling interest (Step 4) 56,000
–––––––
Total equity 374,000
Liabilities (100,000 + 100.000 + 50,000) 250,000
–––––––
624,000
–––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 301

 Example 2 – Vertical group 2
The draft statements of financial position of D, C and J as at 31 December 20X4 are
as follows:

D C J D C J
Rs 000 Rs 000 Rs 000 Rs 000 Rs 000 Rs 000
Sundry 180 80 80 Equity
assets capital 200 100 50
Cost of Investment 120 80 Retained 100 60 30
earnings
––– ––– ––– ––– ––– –––
300 160 80 300 160 80
––– ––– ––– ––– ––– –––

• C acquired 4,000 Rs 10 shares in J on 1 January 20X4 when the retained

earnings of J amounted to Rs 25,000.

• D acquired 7,500 Rs 10 shares in C on 30 June 20X4 when the retained

earnings of C amounted to Rs 40,000 and those of J amounted to Rs
30,000.

It is group policy to value the non-controlling interest using the proportion of net
assets method.

Required:
Produce the consolidated statement of financial position of the D group at 31
December 20X4.

Solution vertical group 2

Solution
Assets: Rs 000
Goodwill (W3) (15 + 12) 27
Assets (180 + 80 + 80) 340
–––––
367
–––––
Equity and liabilities: Rs 000
Equity capital 200
Retained earnings (W5) 115
NCI (W4) 52
–––––
367
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 302

 (W1) Group structure

Draw a diagram of the group structure and set out the respective interests of the
parent entity and the non-controlling interests, distinguishing between direct (D) and
indirect (I) interests. You may find it useful to include on the diagram the dates of
acquisition of the subsidiary and the sub-subsidiary.

D
75% acquired 30 Jun X4

80% acquired 1 Jan X4

J

The relevant acquisition date for both entities is the date that they both joined
the D group, i.e. 30 June 20X4.

(W2) Net assets for each subsidiary – remember correct date of acquisition

C J
At At At At
acquisition reporting acquisition reporting
date date
Rs Rs Rs Rs
Share capital 100,000 100,000 50,000 50,000
Reserves 40,000 60,000 30,000 30,000
——— ——— ——— ———
140,000 160,000 80,000 80,000
——— ——— ——— ———
(W3) Goodwill – proportionate basis

C J
Rs 000 Rs 000
Cost of investment 120 (75% × 80,000) 60
FV of NCI at acquisition:
(25% × 140,000) (W2) 35 (40% × 80,000) (W2) 32
——— ———
155 92
FV of NA at acquisition (W2) (140) (80)
——— ———
Goodwill 15 12
——— ———

Advanced Financial Accounting and Corporate Reporting (Study Text) 303

 (W4) NCI
Rs 000 Rs 000
FV of NCI at acquisition:(25% × 140,000) (W2) 35
Share of postacq'n RE ((25% × (160,000 – 140,000) (W2) 5 40
——
J:
FV of NA at acquisition: (40% × 80,000) (W2) 32
Share of postacq'n
RE ((40% × (80,000 – 80,000) (W2) – 32
——
Less: NCI% of cost of investment by C in J (25% × 80,000) (20)
——
52
——
(W5) Group retained earnings
Rs 000
D 100
C (75% × 20) (post-acquisition retained earnings) 15
J (no post-acquisition retained earnings) –
––––
115
––––

2 Sub-associates

2.1 Sub-associates arise where in vertical group, parent has controlling interest in an
entity which in turns has a significant influence over another entity, such
another entity is sub-associate of parent group, Look at the situation below:

Situation 1:

H
owns 80% of S
who, in turn, owns 35% of
T

In the situation above, H has a direct interest in S and an indirect interest in T

(exercised via S’s holding in T).

In situation 1, H has an effective interest of only 28% (80% × 35%) in T.

Nevertheless, T is a sub-associate of H because H has a controlling interest in S
and S has significant influence in T.

Advanced Financial Accounting and Corporate Reporting (Study Text) 304

 Consolidation
In such situation, the consolidated statement of financial position of parent group
shall include:

• 100% of the assets and liabilities of the parent and subsidiary company on a
line by line basis and
• an ‘investments in sub-associates’ line within non-current assets which
includes the Subsidiary’s interest in the assets and liabilities of any
associate.
 NCI of subsidiary shall include its share in sub-associate’s profit after tax.

The consolidated statement of comprehensive income shall include:

• 100% of the income and expenses of the parent and subsidiary company
on a line by line basis
• one line ‘share of profit of sub-associates’ which includes the group share
in sub-associate’s profit after tax.

Example 3

Vertical Group 3- Sub-associate

The draft statements of financial position of D, C and J, as at 31 December
20X4, are as follows:

D C J D C J
Rs 000 Rs 000 Rs 000 Rs 000 Rs 000 Rs 000
Sundry assets 280 230 130 Equity capital 200 100 50
Retained 100 60 30
earnings
Investment 120 30 Liabilities 100 100 50

–––– –––– –––– –––– –––– ––––

400 260 130 400 260 130
–––– –––– –––– –––– –––– ––––

You ascertain the following:

 D acquired 75,000 Rs 1 shares in C on 1 January 20X4 when the retained

earnings of C amounted to Rs 40,000. At that date, the fair value attributable
to the non-controlling interest in C was valued at Rs 38,000.

 C acquired 15,000 Rs 1 shares in J on 30 June 20X4 when the retained

earnings of J amounted to Rs 25,000; they had been Rs 20,000 on the date
of D's acquisition of C.

Advanced Financial Accounting and Corporate Reporting (Study Text) 305

  Goodwill has suffered no impairment

Required:
Produce the consolidated statement of financial position of the D group at 31
December 20X4. It is group policy to use the full goodwill method.

1. Solution vertical group

Step 1 – Group structure

Draw a diagram of the group structure and set out the respective interests of the
parent entity and the non-controlling interests, distinguishing between direct (D) and
indirect (I) interests. You may find it useful to include on the diagram the dates of
acquisition of the subsidiary and the sub-associate.

D
75% acquired 1 Jan X4

30% acquired 30 June X4

J

Group and Non Controlling interests

C J
Group interest 75% 22.5%(75%x30%)
Non Controlling interest 25% 7.5% (25%x30%)
––––– –––––
100% 30%
––––– –––––
Step 2
Start with the net assets consolidation working.

Care must be taken in determining the date for the split between post-acquisition
and pre-acquisition retained earnings. The relevant date will be that on which D (the
parent company) acquired control or is capable to exert significant influence on
each entity:

• C: 1 January 20X4
• J: 30 June 20X4

Advanced Financial Accounting and Corporate Reporting (Study Text) 306

 Therefore, the information given regarding J’s retained earnings at 1 January 20X4
is irrelevant in this context.

Net assets of subsidiary and sub-associate

C J
At acq'n At rep At acq'n At rep
date date
Rs Rs Rs Rs
Equity capital 100,000 100,000 50,000 50,000
Reserves 40,000 60,000 25,000 30,000
––––––– ––––––– –––––– ––––––
140,000 160,000 75,000 80,000

Step 3
Goodwill

• A separate calculation is required to determine goodwill for subsidiary.

C
Rs 000
Cost of investment in subsidiary 120
Fair value of NCI 38
––––
158
FV of net assets (140)
––––
18
––––
Step 4

Non-controlling interest
The non-controlling interest in C are entitled to their (indirect) share of the post-acq
net assets of J, but they receive these using their own proportion which is
25%x30%=7.5%
Rs 000
C: NCI FV at acquisition 38
C NCI share of postacq'n retained earnings (25% × 20,000) 5
––––
43
J: NCI share of post-acq net assets (7.5%x5000) 0.375
––––
43.375
––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 307

 Step 5
Group retained earnings
Rs 000
D 100
C 75% × 20,000 (post-acquisition retained earnings) 15
J 22.5% × 5,000 (post-acquisition retained earnings) 1.125
––––
116.125
––––
Step 6
Investment in sub-associate
Rs 000
Cost of Investment 30
Share in post acq net assets (30%x5000) 1.5
––––
31.5
––––
Step 7
Summarised consolidated statement of financial position of D its subsidiary
entities as at 31 December 20X4
Rs
Goodwill 18,000
Sundry assets (280,000 + 230,000) 510,000
Investment in sub-associate 31,500
–––––––
559,500
–––––––
Equity and liabilities:
Equity capital 200,000
Retained earnings (Step 5) 116,125
–––––––

316,125
Non-controlling interest (Step 4) 43,375
–––––––
Total equity 359,500
Liabilities (100,000 + 100.000) 200,000
–––––––
559,500
–––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 308

3 Mixed (D-shaped) Groups

3.1 Definition
In a mixed group situation the parent entity has a direct controlling interest in at
least one subsidiary. In addition, the parent entity and the subsidiary together hold a
controlling interest in a further entity.
e.g.

H
60% 30%

S T

30%
• H controls 60% of S; S is therefore a subsidiary of H.
• H controls 30% of T directly and another 30% indirectly via its interest in
S. T is therefore a sub-subsidiary of the H group. H has control of 60%,
either directly or indirectly, of the shares in T and is therefore able to
control it.

Date of Acquisition
As with the vertical group structure considered earlier in this chapter, identify the dates
of the respective share purchases to help determine the date when the entity at the
bottom of the group (often, but not always a sub-subsidiary) becomes a member of the
group. Using the example of H, S & T above, if dates of share purchases are added as
follows:

Suppose H acquired a 60% interest in S on 1 January 20x4, and acquired its 30%
interest on the same date. S subsequently acquired its 30% interest in T on 1 July
20x6.

Initially, from 1 January 20x4, H exercises significant influence over T as an associate

entity. It is only from 1 July 20x6 that H has access to more than 50% of the voting
power in T; T is therefore consolidated into the H group accounts as a subsidiary from
1 July 20x6.

Alternatively, suppose H acquired a 60% interest in S on 1 January 20x6, and acquired

its 30% interest on the same date. S acquired its 30% interest in T on 1 July 20x4.

Advanced Financial Accounting and Corporate Reporting (Study Text) 309

Initially, from 1 January 20x4, S exercises significant influence over T as an associate
entity. It is only from 1 July 20x6 that H has access to more than 50% of the voting
power in T; T is therefore consolidated into the H group accounts from 1 July 20x6.

Consolidation
All three entities in the above mixed group are consolidated. The approach is similar to
dealing with sub-subsidiaries, i.e. an effective interest is computed and used to allocate
share capital and retained earnings.

From the example above:

S Group share 60%

NCI 40%
T Group share
Direct 30%
Indirect 18%
–––––
Total 48%
NCI 52%

All consolidation workings are the same as those used in vertical group
situations, with the exception of goodwill.

The goodwill calculation for the sub-subsidiary differs in that two elements to
cost must be considered, namely:

• the cost of the parent’s direct holding

• the parent’s percentage of the cost of the subsidiary’s holding (the indirect
holding).

Advanced Financial Accounting and Corporate Reporting (Study Text) 310

 Example 4 – Mixed (D-shaped)
The statements of financial position of H, S and M as at 31 December 20X5 were
as follows:
H S M
Rs Rs Rs
4,500 shares in S 72,000
1,600 shares in M 25,000
1,200 shares in M 20,000
Sundry assets 125,000 120,000 78,000
––––––– ––––––– –––––––
222,000 140,000 78,000
––––––– ––––––– –––––––
Equity share capital (Rs 10 shares) 120,000 60,000 40,000
Retained earnings 95,000 75,000 35,000
Liabilities 7,000 5,000 3,000
––––––– ––––––– –––––––
222,000 140,000 78,000
––––––– ––––––– –––––––

All shares were acquired on 31 December 20X2 when the retained earnings of
S amounted to Rs 30,000 and those of M amounted to Rs 10,000.

It is group accounting policy to value non-controlling interest on a proportionate

basis.

Required:
Prepare the statement of financial position for the H group at 31 December 20X5.

Solution
Group statement of financial position – H group at 31 December 20X5
Rs
Intangible – goodwill (4,500 + 8.750) (W3) 13,250
Sundry assets (125,000 + 120,000 + 78,000) 323,000
––––––––
336,250
––––––––
Equity and liabilities: Rs
Equity share capital 120,000
Retained earnings (W5) 144,375
Non-controlling interest (W4) 56,875
––––––––
Total equity 321,250
Liabilities (7,000 + 5,000 + 3,000) 15,000
––––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 311

 336,250
––––––––
(W1) Determine group structure:

In S: 4,500 / 6,000 × 100% = 75%

–––––
In M
Direct 1,600 / 4,000 × 100% = 40.0%
Indirect 75% × 1,200 / 4,000 × 100% = 22.5%
–––––
62.5%

(W2) Net assets

S M
At acq'n At rep date At acq'n At rep date
(W2) Net assets of Rs & M Rs Rs Rs Rs
Equity capital 60,000 60,000 40,000 40,000
Retained earnings 30,000 75,000 10,000 35,000
–––––– –––––– –––––– –––––
90,000 135,000 50,000 75,000
–––––– –––––– –––––– ––––––

(W3) Goodwill S & M

Rs Rs
Cost of investment 72,000 Direct 25,000
Indirect (75% × 20) 15,000
FV of NCI at acquisition (37.5% × 50) 18,750
(25% × 90) 22,500
–––––– ––––––
94,500 58,750
Less: FV of NA at
acquisition (W2) (90,000) (50,000)
–––––– ––––––
4,500 8,750
–––––– ––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 312

 (W4) Non-controlling interest

Rs
S – FV of NCI at acquisition 22,500
Share of post acqu'n retained (25% × (135,000 –
Earnings 90,000)) (W2)
11,250
M – FV of NCI at acquisition 18,750
37.5% × Rs 75,000 (W2)

Share of post acqu'n retained (37.5% × (75,000 – 9,375

Earnings 50,000)) (W2)

Less: NCI share of S cost of (25% × Rs 20,000) (5,000)

investment in M
–––––
56,875
–––––
(W5) Retained earnings
Rs
H 95,000
S – (75% × (135,000 – 90,000)) (W2) 33,750
M – (62.5% × (75,000 – 50,000)) (W2) 15,625
––––––
144,375
––––––

Example 5 – Excellence
The Excellence Group carries on business as a distributor of warehouse equipment
and importer of fruit. Excellence is a listed entity and was incorporated over 20
years ago to distribute warehouse equipment. Since then the group has diversified
its activities to include the import and distribution of fruit, and it expanded its
operations by the acquisition of shares in Melon in 20X1 and in Kiwi in 20X3, both
listed entities.

Accounts for all entities are prepared up to 31 December.

The draft statements of comprehensive income for Excellence, Melon and Kiwi for
the year ended 31 December 20X6 are as follows:

Advanced Financial Accounting and Corporate Reporting (Study Text) 313

 Excellence Melon Kiwi
Rs 000 Rs 000 Rs 000
Revenue 45,600 24,700 22,800
Cost of sales (18,050) (5,463) (5,320)
–––––– –––––– ––––––
Gross profit 27,550 19,237 17,480
Distribution costs (3,325) (2,137) (1,900)
Administrative expenses (3,475) (950) (1,900)
–––––– –––––– ––––––
Profit from operations 20,750 16,150 13,680
Finance costs (325) − −
–––––– –––––– ––––––
Profit before tax 20,425 16,150 13,680
Tax (8,300) (5,390) (4,241)
–––––– –––––– ––––––
Profit for the period 12,125 10,760 9,439
–––––– –––––– ––––––
Notes
Excellence Melon Kiwi
Dividends paid in the year 9,500
Retained earnings brought forward 20,013 13,315 10,459

The draft statements of financial position as at 31 December 20X6 are as follows:

Excellence Melon Kiwi

Rs 000 Rs 000 Rs 000
Assets:
Non-current
assets (NBV) 35,483 24,273 13,063
Investments:
Shares in Melon 6,650 − −
Shares in Kiwi − 3,800 −
Current assets 1,568 9,025 8,883
–––––– –––––– ––––––
Total assets 43,701 37,098 21,946
–––––– –––––– –––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 314

 Equity and liabilities:
Equity shares (Rs 10) 8,000 3,000 2,000
Retained earnings 22,638 24,075 19,898
–––––– –––––– ––––––
Total equity 30,638 27,075 21,898
Sundry liabilities 13,063 10,023 48
–––––– –––––– ––––––
Total equity and liabilities 43,701 37,098 21,946
–––––– –––––– ––––––

The following information is available relating to Excellence, Melon and Kiwi:

(1) On 1 January 20X1 Excellence acquired 270,000 Rs 10 equity shares in

Melon for Rs 6,650,000 at which date there was a credit balance on the
retained earnings of Melon of Rs 1,425,000. No shares have been issued
by Melon since Excellence acquired its interest.

(2) On 1 January 20X3 Melon acquired 160,000 Rs 10 equity shares in Kiwi

for Rs 3,800,000 at which date there was a credit balance on the retained
earnings of Kiwi of Rs 950,000. No shares have been issued by Kiwi
since Melon acquired its interest.

(3) During 20X6, Kiwi had made intercompany sales to Melon of Rs 480,000
making a profit of 25% on cost and Rs 75,000 of these goods were in
inventory at 31 December 20X6.

(4) During 20X6, Melon had made intercompany sales to Excellence of Rs

260,000 making a profit of 33⅓% on cost and Rs 60,000 of these goods
were in inventory at 31 December 20X6.

(5) On 1 November 20X6 Excellence sold warehouse equipment to Melon for

Rs 240,000 from inventory. Melon has included this equipment in its Non-
current assets. The equipment had been purchased on credit by
Excellence for Rs 200,000 in October 20X6 and this amount is included
in its liabilities as at 31 December 20X6.

(6) Melon charges depreciation on its warehouse equipment at 20% on cost.

It is company policy to charge a full year’s depreciation in the year of
acquisition to be included in the cost of sales.

(7) It is group policy to account for non-controlling interest on a proportionate

basis. Since acquisition, the goodwill of Melon has been fully written off
as a result of an impairment review which took place two years ago. The
goodwill of Kiwi has been impaired 60% by 31 December 20X5 and a

Advanced Financial Accounting and Corporate Reporting (Study Text) 315

 further 50% of the remaining balance of goodwill was impaired in the year
ended 31 December 20X6.

Required:
(a) Prepare a consolidated statement of comprehensive income for the
Excellence Group for the year ended 31 December 20X6 including a
reconciliation of retained earnings for the year.

(b) Prepare a consolidated statement of financial position as at that date

Solution Excellence
(a) Consolidated statement of comprehensive income for the year ended 31
December 20X6
Excellence Melon Kiwi Adjusts SOCI
Rs 000 Rs 000 Rs 000 Rs 000 Rs 000
Revenue 45,600 24,700 22,800 (980) ) 92,120
Cost of sales (18,150) (5,463) (5,320) (740) )
Cost re-equipment sale 200 (27.915)
URPS made by Melon and Kiwi (W5) (15) (15)
Excess dep'n adj (W6) 8 ––––––
Gross profit 64,205
Distribution costs (3,325) (2,137) (1,900) (7,362)
Administration expenses (3,475) (950) (1,900) (6,325)
Goodwill impaired (W3) (259)
––––––
Profit from operations 50,259
Finance costs (325) (325)
––––––
Profit before tax 49,934
Tax (8,300) (5,390) (4,241) (17,931)
–––––– ––––– ––––––
Profit for the period 10,753 9,424 32,003
–––––– ––––– ––––––
Attributable to:
Equity holders of the parent (bal fig) 28,289
Non-controlling interests (W8) 3,714
––––––
32,003
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 316

 Reconciliation of retained earnings:

Retained earnings brought forward (W9) 34,115

Profit for the period 28,289
Dividends paid (9,500)
––––––
Retained earnings carried forward 52,904
––––––
(b) Consolidated statement of financial position as at 31 December 20X6
Rs 000
Assets:
Non-current
assets (35,483 + 24,273 + 13,063 – 32 (W6)) 72,787
Goodwill (W3) 259
Current assets (1,568 + 9,025 + 8,883 – 30) 19,446
––––––
Total assets 92,492
––––––
Equity and liabilities:
Rs 10 equity shares 8,000
Group retained earnings (W7) 52,904
––––––
60,904
Non-controlling interest (W4) 8,454
––––––
Total equity 69,358
Sundry liabilities:(13,063 + 10,023 + 48) 23,134
––––––
Total equity and liabilities 92,492
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 317

 Workings

(W1) Group structure

270
= 90% Excellence
300
90% Effective interest of Excellence in
Kiwi (90% x 80%) =72%

Melon
Effective NCI in Kiwi =28%
80%

160
= 80% Kiwi
200

At date of acquisition At reporting date

Rs 000 Rs 000 Rs 000 Rs 000
Melon
Equity capital 3,000 3,000
Retained earnings 1,425 24,075
Excess depreciation (W6) 8
Unrealised profit (W5) (15)
–––––– ––––––
1,425 24,068
–––––– ––––––
4,425 27,068
–––––– –––––
At date of acquisition At reporting date
Rs 000 Rs 000 Rs 000 Rs 000
Kiwi
Equity capital 2,000 2,000
Retained earnings 950 19,898
Unrealised profit (W5) (15)
–––––– ––––––
950 19,883
–––––– ––––––
2,950 21,883
–––––– ––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 318

 (W3 Goodwill)
In Melon In Kiwi
Rs 000 Rs 000
Cost of investment to the group 6,650
90% × 3,800 3,420
Melon: NCI% of CV of NA at acq'n (10% × 4425)(W2) 4442
Kiwi: NCI% of CV of NA at acq'n (28% × 950)(W2) 826
–––––– –––––
7,092 4,246
Fair value of all net assets at acquisition:
Melon: (W2) (4,425)
Kiwi: (W2) (2,950)
–––––– –––––
2,667 1,296
Impairment – in previous years (100%) / 60% (2,667) (778)
–––––– –––––
− 518
Impairment current year (50% × 518) (I/S) − (259)
–––––– –––––
Statement of financial position − 259
–––––– –––––
Charged against retained earnings 2,667 1,037

(W4) Non-controlling Interest – proportionate basis for both subsidiaries

Melon
CV of NCI at acquisition (10% × 4,425) (W2) 442.5
Share of postacq'n retained earnings
(10% × (27,068 – 4,425)) (W2) 2264.3
–––––
(rounded) 2,707
Kiwi (use effective interest %)
CV of NCI at acquisition (28% × 2,950) (W2) 826
Share of post-acq'n retained earnings
(28% × (21,883 – 2,950)) (W2) 5,301
Less: NCI share of cost of investment by melon in Kiwi
(10% × 3,800) (380)
–––––
8,454
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 319

 (W5) Unrealised profit in inventory

Kiwi – Melon 75,000 × 25 ÷ 125 = 15,000

Melon – Excellence 60,000 × 33 1/3 = 15,000
1331/3

(W6) Intercompany transfers of Non-current assets

Excellence – Melon 240,000

Therefore Excellence has made an unrealised profit.
Debit group statement of comprehensive income 40,000
Credit group Non-current assets 40,000

Total intra-group revenues (480 + 260 + 240) = Rs 980,000

Total intra-group adjustment to cost of sales (480 + 260)
= Rs 740,000

Total intra-group addition to NCA re equipt sold by Excellence to Melon = Rs

240,000 when original cost was Rs 200,000.

Depreciation is charged on Rs 240,000 at 20% on cost (i.e. Rs 48,000 each

year). This should be charged in the group accounts at 20% on Rs 200,000 (i.e.
Rs 40,000).

Therefore Rs 8,000 extra depreciation has been charged each year and must be
added back.

Debit depreciation group 8,000

Credit statement of comprehensive income group 8,000
Therefore net impact Rs 40,000 – Rs 8,000 = 32,000
Net Non-current assets credit 32,000
Statement of comprehensive income debit 32,000

(W7) Consolidated retained earnings carried forward

Rs 000
All of Excellence
Per the question 22,638
Unrealised profit (W6) (40)
––––––
22,598
Share of Melon
90% (24,068 – 1,425) (W2) 20,378

Advanced Financial Accounting and Corporate Reporting (Study Text) 320

 Share of Kiwi
72% (19,883 – 950) (W2) 13,632
Goodwill impairment (2,667 + 1,037) (W3) (3,704)
––––––
52,904
––––––
(W8) Non-controlling interest in profit

Melon (10,753 × 10%) 1075

Kiwi’s profit (9,424 × 28%) 2,639
–––––
3,714
–––––
(W9)
Rs 000
All of Excellence 20,013
Share of Melon
90% (13,315 – 1,425) (W2) 10,701
Share of Kiwi
72% (10,459 – 950) (W2) 6,846
Goodwill impairment (2,667 + 778) (W3) (3,445)
––––––
34,115
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 321

 Chapter Summary

Advanced Financial Accounting and Corporate Reporting (Study Text) 322

 Self-Test Questions

1. The following are the statements of financial position at 31 December 20X7 for H
group companies:
H S T
Rs Rs Rs
4,500 shares in S 65,000
3,000 shares in T 55,000
Sundry assets 280,000 133,000 100,000
––––––– ––––––– –––––––
345,000 188,000 100,000
––––––– –––––– –––––––

Equity share capital (Rs 10 shares) 100,000 60,000 50,000

Retained earnings 45,000 28,000 25,000
Liabilities 200,000 100,000 25,000
––––––– ––––––– –––––––
345,000 188,000 100,000
––––––– ––––––– –––––––
The intercompany shareholdings were acquired on 1 January 20X1 when the
retained earnings of S were Rs 10,000 and those of T were Rs 8,000. At that
date, the fair value of the non-controlling interest in S was Rs 20,000. The fair
value of the total non-controlling interest (direct and indirect) in T was Rs
50,000. It is group policy to value the non-controlling interest using the full
goodwill method. At the reporting date, goodwill is fully impaired and had been
written off in an earlier year.

Required:

Prepare the consolidated statement of financial position for the H group at 31

December 20X7.
2. Grape purchased 4,000 of the 5,000 Rs 10 shares in Vine on 1 July 20X5, when the
retained earnings of that entity were Rs 80,000. At that time, Vine held 750 of the
1,000 Rs 10 shares in Wipe. These had been purchased on 1 January 20X5 when
Wipe’s retained earnings were Rs 65,000. On 1 July 20X5, Wipe’s retained
earnings were Rs 67,000.

At 1 July 20X5, the fair value of the non-controlling interest in Vine was Rs 27,000,
and that of Wipe (both direct and indirect) was Rs 31,500.

Advanced Financial Accounting and Corporate Reporting (Study Text) 323

 Statements of financial position of the three entities at 30 June 20X6 were as
follows:

Grape Vine Wipe

Rs 000 Rs 000 Rs 000
Investment 110 60
Sundry assets 350 200 120
–––– –––– ––––
Net assets 460 260 120
–––– –––– ––––

Equity share capital 100 50 10

Retained earnings 210 110 70
Liabilities 150 100 40
–––– –––– ––––
460 260 120
–––– –––– ––––
Required:

Prepare the consolidated statement of financial position for Grape group at 30

June 20X6. It is group policy to value the non-controlling interest using the full
goodwill method.

3. T, S & R

The following are the summarised statements of financial position of T, S and R

as at 31 December 20X4.

T S R
Rs Rs Rs
Non-current assets 140,000 61,000 170,000
Investments 200,000 65,000 –
Current assets 20,000 20,000 15,000
––––––– ––––––– –––––––
360,000 146,000 185,000
––––––– ––––––– –––––––
Equity shares of Rs 10 each 200,000 80,000 100,000
Retained earnings 150,000 60,000 80,000
Liabilities 10,000 6,000 5,000
––––––– ––––––– –––––––
360,000 146,000 185,000
––––––– ––––––– –––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 324

 On 1 January 20X3 S acquired 3,500 ordinary shares in R at a cost of Rs 65,000
when the retained earnings of R amounted to Rs 40,000.

On 1 January 20X4 T acquired 6,400 shares in S at a cost of Rs 120,000 and 4,000

shares in R at a cost of Rs 80,000. The retained earnings of S and R amounted to
Rs 50,000 and Rs 60,000 respectively on 1 January 20X4. The fair value of the NCI
in S at that date was Rs 27,000. The fair value of the whole (direct and indirect) NCI
in R was Rs 56,000. The non-controlling interest is measured using the full goodwill
method. At the reporting date, goodwill has not been impaired.

Required:
Prepare the consolidated statement of financial position of the T group as at 31
December 20X4.

Advanced Financial Accounting and Corporate Reporting (Study Text) 325

 Answers

1 – H, S & T

Consolidated statement of financial position as at 31 December 20X7

Rs
Sundry net assets (280,000 + 133,000 + 100,000) 513,000
–––––––
Equity and liabilities
Equity share capital 100,000
Retained earnings (W5) 39,938
NCI (W4) 48,062
Liabilities (200,000 + 100,000 + 25,000) 325,000
–––––––
513,000
–––––––

(W1) Group structure

H
4.5/6 = 75%

S
3/5 = 60%

Consolidation %
S: Group share 75%
NCI 25%
T: Group share 75% of 60% 45%
NCI 55% (40% directly plus (25% × 60% =)
15% indirectly)

(W2) Net assets

S T
At At At At
acq'n rep date acq'n rep date
Rs Rs Rs Rs
Equity capital 60,000 60,000 50,000 50,000
Retained earnings 10,000 28,000 8,000 25,000
–––––– –––––– –––––– ––––––
70,000 88,000 58,000 75,000
–––––– –––––– –––––– ––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 326

 (W3) Goodwill
S T
Rs Rs
Consideration paid 65,000 55,000
FV of NCI 20,000 50,000
Indirect Holding Adjustment (25% × Rs 55,000) (13,750)
–––––– ––––––
85,000 91,250
FV of NA at acquisition (70,000) (58,000)
–––––– ––––––
Goodwill at acquisition 15,000 33,250
–––––– ––––––
Less: allocation of impairment based upon
shareholdings
Group share (75%:45%) (11,250) (14,962)
NCI share (25%:55%) (3,750) (18,288)
–––––– ––––––
Goodwill at reporting date Nil Nil
–––––– ––––––

(W4) Non-controlling interest

Rs
S – FV at date of acquisition 20,000
S – NCI share of postacq'n retained earnings (25% × 18,000) 4,500
T – FV at date of acquisition 50,000
T – NCI share of postacq'n retained earnings (55% × 17,000) 9,350
Indirect Holding Adjustment (25% × 55,000) (13,750)
––––––
70,100
Less NCI share of goodwill impairment re S & T (3,750 +
18,288) (W3) (22,038)
––––––
Total for CSFP 48,062
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 327

 (W5) Consolidated retained earnings

Rs
Retained earnings of H 45,000
Group share of post-acquisition
retained earnings or change in net assets
S (75% × 18,000) 13,500
T (45% × 17,000) 7,650
Goodwill impaired (11,250 + 14,962) (W3) (26,212)
––––––
39,938
––––––
2 Grape, Vine and Wipe

Consolidated statement of financial position as at 30 June 20X6

Rs
Goodwill (7,000 + 2,500 (W3)) 9,500
Sundry assets (350,000 + 200,000 + 120,000) 670,000
–––––––
679,500
–––––––
Equity and liabilities Rs

Equity share capital 100,000

Retained earnings (W5) 235,800
Non-controlling interest (W4) 53,700
Liabilities (150,000 + 100,000 + 40,000) 290,000
–––––––
679,500
–––––––

(W1) Group structure

Advanced Financial Accounting and Corporate Reporting (Study Text) 328

 Consolidation %
Vine Group share 80%
NCI 20%
Wipe Group share 80% of 75% 60%
NCI 40% (25% directly plus (20% × 75% =)
15% indirectly)
(W2)
Vine Wipe
At At At At
acq'n reporting acq'n reporting
date date
Rs Rs Rs Rs
Equity capital 50,000 50,000 10,000 10,000
Retained earnings 80,000 110,000 67,000 70,000
––––––– ––––––– –––––– ––––––
130,000 160,000 77,000 80,000
––––––– ––––––– –––––– ––––––
The acquisition date for both entities is the date they joined the Grape group, i.e.
1 July 20X5.

(W3) Goodwill – full basis

Vine Wipe
Rs Rs
Consideration paid 110,000 60,000
FV of NCI 27,000 31,500
Indirect holding adjustment (20% × Rs 60,000) (12,000)
––––––– ––––––
137,000 79,500
FV of net assets at acquisition (W2) (130,000) (77,000)
––––––– ––––––
Goodwill – full basis 7,000 2,500
––––––– ––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 329

 (W4) Non-controlling interest
Rs
V – FV of NCI at date of acquisition 27,000
V – NCI share of post acq'n retained earnings (20% × 30,000) 6,000
W – FV of NCI at date of acquisition 31,500
W – NCI share of post acq'n retained earnings (40% × 3,000) 1,200
Indirect Holding Adjustment (20% × 60,000) (12,000)
––––––
53,700
––––––
(W5) Consolidated retained earnings
Rs
Retained earnings of Grape 210,000
Group share of post-acquisition retained earnings
V (80% × Rs 30,000) 24,000
W (60% × Rs 3,000) 1,800
–––––––
235,800
–––––––
3 – T, S & R

T consolidated statement of financial position as at 31 December 20X4

Rs
Intangible fixed assets: goodwill (17,000 + 28,000(W3)) 45,000
Non-current assets (140,000 + 61,000 + 170,000) 371,000
Current assets (20,000 + 20,000 + 15,000) 55,000
–––––––
471,000
–––––––

Rs
Equity share capital 200,000
Group retained earnings (W5) 171,600
–––––––
371,600
Non-controlling (W4) 78,400
Liabilities (10,000 + 6,000 + 5,000) 21,000
–––––––
471,000
–––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 330

(W1) Group structure
T has a controlling interest in both S and R as follows:

Interest in S Interest in R
T 80% T – direct 40%
T – indirect (80% × 35%) 28% 68%
NCI 20% NCI 32%
_____ _____
100% 100%
_____ _____

(W2)
S R
At acq'n At rep At acq'n At rep
date date
Rs Rs Rs Rs
Equity share capital 80,000 80,000 100,000 100,000
Retained earnings 50,000 60,000 60,000 80,000
––––––– ––––––– ––––––– –––––––
130,000 140,000 160,000 180,000
––––––– ––––––– ––––––– –––––––
T's acquisition date for both entities is 1 January 20X4.

(W3) Goodwill – S Fair value (full goodwill) method

Rs
Consideration paid 120,000
FV of NCI 27,000
–––––––
147,000
FV of net assets at acquisition (W2) (130,000)
–––––––
Total Goodwill 17,000
–––––––
Goodwill – R
Rs
Direct purchase consideration 80,000
Indirect purchase consideration (80% × 65,000) 52,000
Fair value of NCI at acquisition 56,000
–––––––
188,000
FV of net assets at acquisition (W2) (160,000)
–––––––
Full goodwill 28,000
–––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 331

 (W4) Non-controlling interest
Rs
S – FV of NCI at acquisition 27,000
S – NCI share of post-acquisition retained earnings
(20% × 10,000) 2,000
Less NCI share of S cost of investment in R (20% × 65,000) (13,000)
R – FV of NCI at acquisition 56,000
R – NCI share of post-acquisition retained earnings (32% × 20,000) 6,400
––––––
Total NCI to SOFP 78,400
––––––

(W5) Group retained earnings

Rs
T 150,000
S (share of post-acquisition retained earnings)
80% × Rs 10,000 8,000
R (share of post-acquisition retained earnings)
68% × Rs 20,000 13,600
–––––––
171,600
–––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 332

Advanced Financial Accounting and Corporate Reporting (Study Text) 333
GROUP ACCOUNTING – FOREIGN CURRENCY
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

 Outline and apply the principles for translating foreign currency amounts,
including translations into the functional currency and presentation currency.
 Account for the consolidation of foreign operations and their disposal.
 Understand how to report operating results and financial position of
companies existing in hyperinflationary economy in accordance with IAS 29.

Advanced Financial Accounting and Corporate Reporting (Study Text) 334

1 IAS 21 The Effects of Changes in Foreign Exchange Rates:

1.1 IAS 21 deals with:

• the definition of functional and presentation currencies

• accounting for individual transactions in a foreign currency
• translating the financial statements of a foreign operation.

1.2 Functional and presentation currencies:

Functional Currency:

 The functional currency is the currency an entity will use in its day-to-day
transactions. IAS 21 also identifies that that an entity should consider the
following factors in determining its functional currency:

• The currency in which funding from issuing debt and equity is generated.
• The currency in which receipts from operating activities are usually
retained.
Let us consider an example to illustrate this point. Entity A operates in the
USA. It sells goods throughout the USA and Europe with all transactions
denominated in dollar. Cash is received from sales in dollar. It raises finance
locally from US banks with all loans denominated in dollar.

Looking at the factors listed above it is apparent that the functional currency
for Entity A is dollar. It trades in this currency and raises finance in this
currency.

Therefore Entity A would record its accounting transactions in dollar as its

functional currency.

One complication in determining functional currency arises if an entity is a

foreign operation. For example, if Entity A (from above) has a subsidiary
Entity B located in Europe, Entity B will also have to determine its functional
currency. The question arises as to whether this will be the same as the
parent or will be the local currency where Entity B is located.

The factors that must be considered are:

• whether the activities of the foreign operation are carried out as an
extension of the parent, rather than with a significant degree of
autonomy

• whether transactions with the parent are a high or low proportion of the
foreign operation’s activities

Advanced Financial Accounting and Corporate Reporting (Study Text) 335

 • whether cash flows from the foreign operation directly affect the cash
flows of the parent and are readily available for remittance to it

• whether cash flows from the activities of the foreign operation are
sufficient to service existing debt obligations without funds being made
available by the parent.

So, continuing with the example above, if Entity B operates as an independent

operation, generating income and expenses in its local currency and raising
finance in its local currency, then its functional currency would be its local
currency and not that of Entity A. However, if Entity B was merely an
extension of Entity A, only selling goods imported from Entity A and remitting
all profits back to Entity A, then the functional currency should be the same as
the parent. In this case Entity B would record its transactions in dollar and not
its local currency.

Once a functional currency is determined it is not changed unless there is a

change in the underlying circumstances that were relevant when determining
the original functional currency.

Presentation Currency:
The presentation currency is the currency in which the entity presents its
financial statements. This can be different from the functional currency,
particularly if the entity in question is a foreign- owned subsidiary. It may have
to present its financial statements in the currency of its parent, even though
that is different from its own functional currency.

IAS 21 states that whereas an entity is constrained by the factors listed above
in determining its functional currency, it has a completely free choice as to the
currency in which it presents its financial statements. If the presentation
currency is different from the functional currency, then the financial
statements must be translated into the presentation currency. For example, a
group may have subsidiaries whose functional currencies are different to that
of the parent. These must be translated into the presentation currency so that
the consolidation procedure can take place.

1.3 Accounting for individual transactions in a foreign currency:

Where an entity enters into a transaction denominated in a currency other
than its functional currency, that transaction must be translated into the
functional currency before it is recorded

Advanced Financial Accounting and Corporate Reporting (Study Text) 336

 Examples of foreign currency transactions:
Whenever a business enters into a contract where the consideration is
expressed in a foreign currency, it will be necessary to translate that foreign
currency amount at some stage into the functional currency for inclusion into
its own accounts. Examples include:
• imports of raw materials
• exports of finished goods
• importation of foreign-manufactured non-current assets
• investments in foreign securities
• raising an overseas loan.

The exchange rate used should be:

• the spot exchange rate on the date the transaction occurred

• an average rate over a period of time, providing the exchange rate has
not fluctuated significantly.

Cash settlement:
When cash settlement occurs, for example payment by a receivable, the
settled amount should be translated using the spot exchange rate on the
settlement date. If this amount differs from that used when the transaction
occurred, there will be an exchange difference.

Exchange differences on settlement:

These must be recognised in profit or loss in the period in which they arise.

Illustration:
On 7 May 20X6 an entity sells goods to a foreign entity for FC 48,000 when
the rate of exchange was Rs 1 = FC 3.2
To record the sale:
Rs

Dr Customer FC 48,000 @ 3.2 15,000

Cr Sales 15,000

On 20 July 20X6 the customer remitted a draft for FC 48,000 when the rate of
exchange was Rs 1 = FC 3.17.
Rs

Dr Bank FC 48,000 @ 3.17 15,142

Cr Customer 15,000
Cr Statement of Comprehensive Income (exchange gain) 142

Rs 142 exchange gain forms part of the profit for the year.

Advanced Financial Accounting and Corporate Reporting (Study Text) 337

2 Treatment of Year-End Balances:

2.1 The treatment of any ‘foreign’ items remaining in the statement of financial
position at the yearend will depend on whether they are classified as
monetary or non-monetary:

Advanced Financial Accounting and Corporate Reporting (Study Text) 338

 2.2 Exchange differences on retranslation of monetary items:
These must be recognised in profit or loss in the period in which they arise.

Illustration:

Non-Monetary Items
An entity purchases plant, for its own use, from a foreign supplier on 30 June
20X7 for cash of FC 90,000 when the rate of exchange was Rs 1 = FC 1.80.
The asset is recorded at Rs 50,000 (FC 90,000 @ 1.80)

Dr Non-current asset Rs 50,000

Cr Cash Rs 50,000
No further translation will occur. All depreciation charged on this asset will be
based on Rs 50,000

3 Translating the financial statements of a foreign operation:

3.1 Where a subsidiary entity’s functional currency is different from the

presentation currency of its parent, its financial statements must be translated
into the parent’s presentation currency prior to consolidation.

The following exchange rates should be used in the translation:

Statement of comprehensive income:

Income (At the rate for each transaction or, as an
Expenses approximation, the average rate for the year)

Statement of financial position:

Assets and liabilities At the closing rate
Share capital At the closing rate
Pre-acquisition reserves rate on reporting date
Post-acquisition reserves rate on reporting date

The balancing figure that makes up the post-acquisition reserves includes the
exchange difference for the year and prior post-acquisition years. This amount
should be disclosed as a component of other comprehensive income and,
following amendment of IAS 1 in June 2011, should be identified within other
comprehensive income as an item that may be reclassified to profit or loss in
a subsequent year. It should also be accumulated each year and disclosed as
a separate component within equity. The following section deals with its
calculation

Advanced Financial Accounting and Corporate Reporting (Study Text) 339

3.2 Exchange difference arising on translation of accounts:
Exchange differences arise because items are translated at different points in
time at different rates of exchange.

The exchange difference arising on translation of foreign currency accounts

arises as follows:

Opening net assets + Profit = Closing net assets

These were translated at Revenue and expenses
last year's closing rate are translated within the
(CR) for the purpose of Statement of
last year's accounts. For Comprehensive Income at
the purpose of this year's the average rate. The profit
accounts they are included is, however, included
within closing net assets at within this year's closing
this year's closing rate. net assets at the
closing rate

3.3 Consolidation of a foreign operation:

In principle, the same workings and adjustments required in any consolidation
question will be required. You should prepare a group structure, and workings
for net assets, goodwill, non-controlling interest and retained earnings will
typically be required. However, IAS 21 requires that goodwill is calculated
using the functional currency of the subsidiary and then subject to annual
retranslation at the closing rate at each reporting date. It follows that the cost
of investment and NCI should be calculated using the same closing exchange
rate.

Where goodwill is calculated on a "full" or "fair value" basis, it should be

calculated using a two-stage approach. This will determine the respective
group and NCI share of goodwill. This ratio will then be used to allocate
exchange gains or losses arising on retranslation of goodwill each year
between the group and NCI.

Advanced Financial Accounting and Corporate Reporting (Study Text) 340

3.4 Goodwill on consolidation:
Goodwill is calculated as follows:
Rs

Cost to group of gaining control X

Less: group share of net assets at acquisition (X)
––
Proportionate goodwill X
––
NCI at fair value X
Less: NCI share of net assets at acquisition (X)
NCI goodwill –– X
––
Goodwill at fair value X
––

IAS 21 states that the fair value of net assets acquired should be restated at
each year end using the closing exchange rate. This annual restatement will
result in an exchange difference, calculated as:

Goodwill (in foreign currency) at this year’s closing rate X

Goodwill (in foreign currency) at last year’s closing rate X
––
Exchange gain(loss) on retranslation X

In the consolidated accounts this exchange difference will form part of the
total exchange difference disclosed as other comprehensive income and
accumulated in other components of equity.

The exchange difference arising on goodwill will be allocated as follows:

• To the group only if goodwill is accounted for on a proportionate basis.

• Between group and NCI if goodwill is accounted for on a full (fair value)
basis. Note that the allocation is made based upon their respective share of
total goodwill. This will therefore require goodwill to be calculated in a two-
stage process as identified earlier within this section.

In order to calculate the foreign exchange differences arising on the net

investment in a foreign operation, calculate the following:

Advanced Financial Accounting and Corporate Reporting (Study Text) 341

 Illustration – Calculation of exchange differences:
The three elements of foreign exchange differences are as follows:

• opening net assets of subsidiary

• profit for the year of subsidiary
• goodwill – whether calculated on a fair value or proportionate basis

Parent NCI
Opening net assets of subsidiary
(= equity brought forward) @ closing rate X
@ opening rate (X)
–––
Gain/(loss) X/(X) x parent% X/(X)
x NCI% X/(X)

Profit of subsidiary for year @ closing rate X

@ average rate (X)
–––

Gain/(loss) X/(X) x parent% X/(X)

x NCI% X/(X)

Opening goodwill – P's share @ closing rate X

@ opening rate (X)
–––

Gain/(loss) X/(X) x 100% X/(X)

Opening goodwill – NCI's share
Note: full goodwill method only @ closing rate X
@ opening rate (X)
–––
Gain/(loss) X/(X) x 100% – X/(X)
––– –––
Gain/(loss) for year X/(X) X/(X)
––– –––

Advanced Financial Accounting and Corporate Reporting (Study Text) 342

 Example 1:

Translation of Goodwill:
S Ltd , whose currency is the Dracma (DR), acquired 75% of Flash on 1 June
20X5 for cash consideration of DEK(Kr) 250,000. The equity and liabilities of
Flash at 31 May 20X6 are as follows:

Kr

Equity capital 100,000

Retained earnings – at 1 June 20X5 125,000
– profit for the year 75,000
–––––––
300,000
–––––––

The S Group values the non-controlling interest using the proportion of net
assets method

Required:
At what value should the goodwill be shown in the consolidated financial
statements of S for the year ended 31 May 20X6?

Exchange rates were as follows:

Kr to DR

1 June 20X5 2.5

31 May 20X6 2.0

Solution:

Step 1:
The net assets of Flash must be translated into DR at the closing rate on 31
May 20X6:

Kr Rate DR

Equity capital 100,000 2.0 50,000

Retained earnings – at 1 June 20X5 125,000 2.0 62,500
– profit for the year 75,000 2.0 37,500
––––––– –––––––
300,000 150,000
––––––– –––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 343

 This also gives us the net assets at acquisition translated at this year’s closing
rate, being the total of the equity capital and the pre-acquisition retained
earnings, i.e. DR 50,000 + DR 62,500 = DR 112,500.

Step 2:
The cost of investment must be calculated. When S bought the shares in
Flash, Kr 250,000 cash was paid and the exchange rate at that date was Kr
2.5 : DR 1. The investment would have been recorded in the individual
accounts of S as follows

Dr Cost of investment (Kr 250,000/2.5) DR100,000

Cr Cash DR100,000

If we are to calculate goodwill at the year end, the cost of investment needs to
be retranslated to the closing rate. As seen in Step 1, the net assets at
acquisition have been translated at the closing rate, so the cost of investment
must be on the same basis.

Therefore, the cost of investment will become:

Kr 250,000/2.0 = DR 125,000

S has a gain on the cost of investment of DR 25,000. This must be credited to

group reserves. The other side of the entry is in goodwill, as the cost of
investment that has been retranslated is the one used to calculate goodwill at
the closing rate.

Step 3:
Now we have both components of goodwill and can calculate the goodwill at
31 May 20X6.

DR

Cost of investment (step 2) 125,000

Non-controlling interest
(25% x (50,000 + 62,500)) 28,125
–––––––
153,125
Net assets of Flash at acq'n (112,500)
–––––––
40,625
–––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 344

3.5 Cost of investment – parent's books:
Since IAS 21 requires the cost of investment within the goodwill calculation to
be based on the closing rate, an extra adjustment is required as part of the
consolidation process.

The cost of investment in the parent's accounts must be retranslated to the

closing rate. An exchange gain or loss is recorded as a component of other
comprehensive income in the group accounts, and so accumulated as a
component of equity.

3.6 Goodwill retranslation journals:

• As part of the consolidation process, the investment in the parent
entity’s accounts is replaced with the group share of the subsidiary’s
net assets and goodwill arising on acquisition.

• Although the journal is embedded within the consolidation workings,

this is in part achieved by:

Dr Goodwill calculation cost of investment

Cr Investment in Parent’s account cost of investment

• In the parent’s own accounts, the cost of investment is treated as a

non-monetary asset and so held at the historic rate of exchange.

• The IAS 21 rules on the calculation of goodwill, as seen above, require

the cost of investment to be retranslated prior to calculating goodwill,
based on the closing rate.

• These rules mean that the above journal does not involve equal
amounts.

• Therefore, as part of the consolidation process, the investment held in

the parent’s accounts must be retranslated using the closing rate.

• The resulting exchange gain or loss is disclosed as an element of other

comprehensive income and recorded within other components of
equity

Advanced Financial Accounting and Corporate Reporting (Study Text) 345

4 Non-Controlling Interests:

4.1 Statement of Comprehensive Income:

The non-controlling interest is the share of the subsidiary's profit after tax for
the year as translated for consolidation purposes.

4.2 Statement of financial position:

The non-controlling interest is computed by reference to either fair value at
acquisition plus share of post-acquisition retained earnings or the net assets of
the subsidiary, in either case translated at the closing rate at the reporting date.

Example 2:
On 1 July 20X1 H acquired 80% of ABC Ltd, whose functional currency is FC.
The cost of gaining control was FC 7,500. Their financial statements at 30
June 20X2 were as follows.

Statement of financial position:

H ABC
Assets PKR FC
Investment in ABC 5,000 –
Non-current assets 10,000 3,000
Current assets 5,000 2,000
–––––– ––––––
20,000 5,000
–––––– ––––––
Equity and liabilities Rs KR
Equity capital 6,000 1,500
Retained earnings 4,000 2,500
Liabilities 10,000 1,000
–––––– ––––––
20,000 5,000
–––––– ––––––
Statement of Comprehensive Income:
H ABC
Rs FC

Revenue 25,000 35,000

Operating costs (15,000) (26,250)
–––––– ––––––
Profit before tax 10,000 8,750
Tax (8,000) (7,450)
–––––– ––––––
Profit for the year 2,000 1,300
–––––– ––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 346

 Neither entity recognised any components of other comprehensive income in
their individual accounts in the period.

The following information is applicable

(i) At the date of acquisition the fair value of the net assets of ABC were
FC 6,000. The increase in the fair value is attributable to land that
remains carried by ABC at its historical cost.

(ii) During the year H sold goods on cash terms for Rs 1,000 to ABC.

(iii) On 1 June 20X2 H made a short-term loan to ABC of Rs 400. The

liability is recorded by ABC at the historic rate. The loan is recorded
within current assets and liabilities as appropriate

(iv) The non-controlling interest is valued using the proportion of net assets
method.

Exchange rates to Rs

FC
1 July 20X1 1.50
Average rate 1.75
1 June 20X2 1.90
30 June 20X2 2

Required:
Prepare the group statement of financial position, Statement of
Comprehensive Income and statement of other comprehensive income

Solution;

H & ABC Group statement of financial position

Assets Rs
Non-current assets
Intangible – goodwill (W3) 1,350
Tangible (10,000 + (FC 3,000 + FC 3,300) /2.0 13,150
––––––
14,500
Current assets (5,000 + FC 2,000 /2.0 – inter-co 400) 5,600
––––––
20,100
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 347

 Equity and liabilities Rs
Share capital 6,000
Retained earnings (W5) 4,576
Group exchange differences (W8) (1,322)
––––––
9,254
Non-controlling interest (W4) 726
––––––
Equity 9,980
Liabilities (10,000 + (FC 1.000 + 40(W1)) /2.0 – inter-co 400) 10,120
––––––
20,100
––––––

H Group – Statement of comprehensive income for the year:

Rs

Revenue (25,000 + (35,000/1.75) – inter-co 1,000) 44,000

Operating costs (15,000 + (26,250 + 40(W1) /1.75) – inter-co 1,000) (29,023)
–––––––
Profit before tax 14,977
Tax (8,000 + (7,450 / 1.75)) (12,257)
–––––––
Profit after tax 2,720

Other comprehensive income – amounts which may be reclassified to profit or

loss in subsequent years:

Exchange differences on translation of foreign

operations (W8) (1,540)
––––––
Total comprehensive income 1,180
––––––
Profit for the year attributable to:

Owners of parent (β) 2,576

Non-controlling interest (20% × ((1,260 (W2)) /1.75)) 144
––––––

Total comprehensive income for the year attributable to:

Owners of parent (β) 1,254

Non-controlling interest (144 (as above) – 218)(W8)) 74
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 348

 (W1) Group structure:

H
NCI = 20% for full year
80%

ABC

Note (iii) error to correct before translation

H has made a loan to ABC. ABC therefore has a liability outstanding at the
reporting date of a monetary item denominated in foreign currency – this
needs to be restated at the closing rate prior to translation at the yearend. Any
gain or loss on translation is part of the operating results of ABC for the year.
1 June ABC received loan of Rs 400 @ 1.9 = FC 760

30 June restate loan at closing rate Rs 400 @ 2.0 = FC 800

i.e. increased liability and exchange loss of FC 40 for ABC

(W2) Net assets of subsidiary in own functional currency:

FC FC

Equity capital 1,500 1,500

Retained earnings 1,200 2,500
FVA – land 3,300 3,300 to SOFP

Exchange loss (W1) (40)

––––– –––––
Movement in post acq'n retained earnings 6,000 7,260 1,260
––––– ––––– –––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 349

 (W3) Goodwill in ABC functional currency – proportionate basis:

FC

Investment in ABC Rs 5,000 × 1.5 7,500

FV of NCI at acquisition (FC 6,000 × 20%) 1,200
–––––
8,700
Less: FV of NA at acquisition (W2) (6,000)
–––––
Prop goodwill to SOFP 2,700
– no impairment to date – / CR 2.0 = Rs 1,350 –––––

Exchange loss by parent company on retranslation of cost of investment

Rs

At acq'n FC 7,500 @ 1.5 5,000

At cl rate FC 7,500 @ 2.0 3,750
–––––
Exchange loss on retranslation of cost of investment (W6) 1,250
–––––

(W4) NCI – need to translate sub NA at closing rate:

FC Rs

NCI at date of acquisition (20%× 6,000) (W2) 1,200

NCI %age of post acq'n retained earnings
(20% × (7,260 – 6,000)) (W2) 252
–––– –––
Translate at closing rate @ 2.0 1,452 726
–––– –––

Advanced Financial Accounting and Corporate Reporting (Study Text) 350

 (W5) Retained earnings:

These group reserves comprise both realised profit and unrealised group
exchange differences; strictly, they should be separated out.
Rs
Parent 4,000
80%(W1) x (W2) FC 1,260/1.75 576
i.e. post-acquisition retained earnings of sub @ average rate
–––––
4,576
–––––

(W6) Group retained earnings including other equity components:

Rs

Parent 4,000
Less exchange loss on cost of investment by parent (W3) (1,250)
Less goodwill impaired Nil
Plus group % of post-acquisition (80% × (FC 1,260 (W2) / 2.0)) 504
––––––
3,254
––––––

(W7) Proof of group retained earnings including other equity

components:

Rs
Opening group retained earnings
(parent only (4,000 – 2,000)) 2,000
Group income for the year – per SOCI 2,576
Group exchange difference (W8) (1,322)
––––––
Closing group retained earnings 3,254
––––––

These group reserves comprise both realised profit and unrealised group
exchange differences; strictly, they should be separated out.

Advanced Financial Accounting and Corporate Reporting (Study Text) 351

 (W8) Exchange difference:

On opening net assets Rs Rs Group NCI

FC 6,000(W2) @ 2.0 cl rate 3,000 80% 20%
FC 6,000(W2) @ 1.5 acq'n rate (4,000)
––––– (1,000)
On income
FC 1,260 (W2) @ 2.0 cl rate 630
FC 1,260 (W2) @ 1.75 ave rate (720)
––––– (90)
–––––
(1,090) (872) (218)
On goodwill – prop basis
FC 2,700 @ 2.0 cl rate 1,350
FC 2,700 @ 1.5 acq'n rate 1,800
––––– (450) (450)
–––––– ––––– ––––
Summary of total exchange gains and
Losses (1,540) (1,322)
(218)
–––––– ––––– ––––

5 Disposal of a Foreign Entity:

On the disposal of a foreign subsidiary, the cumulative exchange difference
recognised as other comprehensive income and accumulated in a separate
component of equity (because it was unrealised) becomes realised. The
standard requires the exchange reserve to be reclassified on the disposal of
the subsidiary as part of the gain/loss on disposal.

6 Equity Accounting:
The principles to be used in translating a subsidiary’s financial statements
also apply to the translation of an associate’s.

Once the results are translated, the carrying amount of the associate (cost (at
the closing rate) plus the share of post-acquisition retained earnings) can be
calculated together with the group’s share of the profits for the period and
included in the group financial statements

7 Reporting in Hyperinflationary Economies IAS 29:

In a hyperinflationary economy, reporting of operating results and financial
position in the local currency without restatement is not useful. Money loses
purchasing power at such a rate that comparison of amounts from

Advanced Financial Accounting and Corporate Reporting (Study Text) 352

 transactions and other events that have occurred at different times, even
within the same accounting period, is misleading. The Standard does not
establish an absolute rate at which hyperinflation is deemed to arise. It is a
matter of judgement when restatement of financial statements in accordance
with the Standard becomes necessary.

Prices change over time as the result of various specific or general political,
economic and social forces.. In addition, general forces may result in changes
in the general level of prices and therefore in the general purchasing power of
money.

Entities that prepare financial statements on the historical cost basis of

accounting do so without regard either to changes in the general level of
prices or to increases in specific prices of recognised assets or liabilities. The
exceptions to this are those assets and liabilities that the entity is required, or
chooses, to measure at fair value. For example, property, plant and equipment
may be revalued to fair value and biological assets are generally required to
be measured at fair value. Some entities, however, present financial
statements that are based on a current cost approach that reflects the effects
of changes in the specific prices of assets held.

In a hyperinflationary economy, financial statements, whether they are based

on a historical cost approach or a current cost approach, are useful only if they
are expressed in terms of the measuring unit current at the end of the
reporting period. As a result, the Standard applies to the financial statements
of entities reporting in the currency of a hyperinflationary economy. The
financial statements of an entity whose functional currency is the currency of a
hyperinflationary economy, whether they are based on a historical cost
approach or a current cost approach, shall be stated in terms of the measuring
unit current at the end of the reporting period. The corresponding figures for
the previous period required by IAS 1 Presentation of Financial Statements
and any information in respect of earlier periods shall also be stated in terms
of the measuring unit current at the end of the reporting period.

The gain or loss on the net monetary position shall be included in profit or loss
and separately disclosed.

The restatement of financial statements in accordance with the Standard

requires the application of certain procedures as well as judgement. The
consistent application of these procedures and judgements from period to
period is more important than the precise accuracy of the resulting amounts
included in the restated financial statements.

Advanced Financial Accounting and Corporate Reporting (Study Text) 353

Chapter Summary:

Advanced Financial Accounting and Corporate Reporting (Study Text) 354

 Self-Test Questions:

1 (a) An entity, BB Ltd, has a reporting date of 31 December. On 27

November 20X6 BB Ltd buys goods from a foreign supplier for FC
324,000.

On 19 December 20X6 BB Ltd pays the foreign supplier in full.

Exchange rates were as follows:

27 November 20X6 Rs 1 = FC 11.15

19 December 20X6 Rs 1 = FC 10.93

Required:

Show how the expense and liability, together with the exchange
difference arising, should be accounted for in the financial
statements.

(b) An entity, Waiter, which has a reporting date of 31 December and the
Rs as its functional currency borrows in the foreign currency of the
Kram (K). The loan of K 120,000 was taken out on 1 January 20X7. A
repayment of K 40,000 was made on 1 March 20X7

K1 to Rs

1 January 20X7 K1:Rs 2

1 March 20X7 K1: Rs 3
31 December 20X7 K1: Rs 3.5

Required:
Show how the liability and the exchange difference will be represented
in the year-end financial statements.

(c) An entity, Attendant, which has a reporting date of 31 December, has

the Rs as its functional currency purchased a plot of land overseas on
1 March 20X0. The entity paid for the land in the currency of the
Rylands (R). The purchase cost of the land at was R 60,000. The value
of the land at the reporting date was R 80,000.

Rates of exchange were as follows:

1 March 20X0 R 8: Rs 1
31 December 20X0 R 10: Rs 1

Advanced Financial Accounting and Corporate Reporting (Study Text) 355

 Required:

Show how this transaction should be accounted for in the

financial statements for the year ended 31 December 20X0:

• if the land is carried at cost

• if the land is carried at valuation

2. (a) On 15 March an entity, Rays Ltd, purchased a non-current asset on

one month’s credit for KR 20,000, having its functional currency Ryland
(R)

Exchange rates

15 March KR 5 : R 1
31 March KR 4 : R 1

Required:

Explain and illustrate how the transaction is recorded and dealt

with if the reporting date is 31 March

(b) The following transactions were undertaken by Sunshine Ltd in the

accounting year ended 31 December 20X1, having functional currency
(FC)

Date Narrative Amount

KR

1 January 20X1 Purchase of a non-current 100,000

asset on credit
31 March 20X1 Payment for the non-current asset 100,000
Purchases on credit 50,000
30 June 20X1 Sales on credit 95,000
30 September 20X1 Payment for purchases 50,000
30 November 20X1 Longterm loan taken out 200,000

Advanced Financial Accounting and Corporate Reporting (Study Text) 356

 Exchange rates KR : FC

1 January 20X1 2.0 : 1

31 March 20X1 2.3 : 1
30 June 20X1 2.1 : 1
30 September 20X1 2.0 : 1
30 November 20X1 1.8 : 1
31 December 20X1 1.9 : 1

Required:

Prepare journal entries to record the above transactions.

3. Parent & Overseas:

Parent is an entity that owns 80% of the ordinary shares of its foreign
subsidiary that has the Shilling as its the functional currency. The subsidiary
was acquired at the start of the current accounting period on 1 January 20X7
when its reported reserves were 6,000 Shillings.

At that date the fair value of the net assets of the subsidiary was 20,000
Shillings. This included a fair value adjustment in respect of land of 4,000
Shillings that the subsidiary has not incorporated into its accounting records
and still owns.

Parent wishes the presentation currency of the group accounts to be Rs.

Goodwill is to be accounted for on a fair value basis, which is unimpaired at
the reporting date. At the date of acquisition, the non-controlling interest in
Overseas had a fair value of 5,000 Shillings.

Parent Overseas
Rs Shillings

Investment (21,000 shillings) 3,818

Assets 9,500 40,000
––––––– –––––––
13,318 40,000
––––––– –––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 357

 Equity and liabilities Rs Shillings
Equity capital 5,000 10,000
Retained earnings 6,000 8,200
Liabilities 2,318 21,800
––––––– –––––––
13,318 40,000
––––––– –––––––

Statement of comprehensive income

Parent Overseas
Rs Shillings

Revenue 8,000 5,200

Costs (2,500) (2,600)
–––––– –––––––
Profit before tax 5,500 2,600
Tax (2,000) (400)
–––––– –––––––
Profit for the year 3,500 2,200
–––––– –––––––
Neither entity recognised any other comprehensive income in their individual
accounts in the period.

Relevant exchange rates (Shillings to Rs 1) are:

Date Exchange rate (Shillings to Rs 1)

1 January 20X7 5.5

31 December 20X 75
Weighted average for year 5.2

Required:
Prepare the consolidated statement of financial position at 31 December
20X7, together with a consolidated Statement of Comprehensive Income for
the year ended 31 December 20X7, a statement showing other
comprehensive income and a schedule of the movement over the year on
retained earnings and other components of equity.

Advanced Financial Accounting and Corporate Reporting (Study Text) 358

4 S Ltd & A Ltd:

On the 1 July 20X1 S Ltd acquired 60% of A Ltd Inc, whose functional
currency is D’s. The financial statements of both entities as at 30 June 20X2
were as follows.

S Ltd A Ltd
Assets: Rs D
Investment in A Ltd 5,000 –
Loan to A 1,400 –
Tangible assets 10,000 15,400
Inventory 5,000 4,000
Receivables 4,000 500
Cash at bank 1,600 560
–––––– ––––––
27,000 20,460
–––––– ––––––

Equity and liabilities: Rs D

Equity capital (Rs 10 D 1) 10,000 1,000
Share Premium 3,000 500
Reserves 4,000 12,500
Non-Current Liabilities 5,000 5,460
Current Liabilities 5,000 1,000
––––––– –––––––
27,000 20,460
–––– –––––––

S Ltd A Ltd
Rs D

Revenue 50,000 60,000

Cost of sales (20,000) (30,000)
––––––– ––––––
Gross profit 30,000 30,000
Distribution and Administration expenses (20,000) (12,000)
––––––– –––––––
Profit before tax 10,000 18,000
Tax (8,000) (6,000)
––––––– –––––––
Income for Year 2,000 12,000
––––––– –––––––
The following information is applicable.

Advanced Financial Accounting and Corporate Reporting (Study Text) 359

 (i) S Ltd purchased the shares in A Ltd for D 10,000 on the first day of the
accounting period. At the date of acquisition the retained earnings of A
Ltd were D 500 and there was an upward fair value adjustment of D
1,000. The fair value adjustment is attributable to plant with a
remaining five year life as at the date of acquisition. This plant remains
held by A Ltd and has not been revalued. No shares have issued since
the date of acquisition.

(ii) Just before the year-end S Ltd acquired some goods from a third party
at a cost of Rs 800, which it sold to A Ltd for cash at a markup of 50%.
At the reporting date all the goods remain unsold.

(iii) On 1 June X2 S Ltd lent A Ltd Rs 1,400. The liability is recorded at the
historic rate within the non-current liabilities of A Ltd.

(iv) No dividends have been paid. Neither company has recognised any
gain or loss in reserves.

(v) Goodwill is to be accounted for on a "full" fair value basis. No goodwill

has been impaired. The fair value of the non-controlling interest at the
date of acquisition was D 5,000. The presentational currency of the
group is to be the Rs.

Exchange rates to Rs 1 D

1 July 20X1 2.00

Average rate 3.00
1 June 20X2 3.90
30 June 20X2 4.00

Required:
(1) Prepare the group statement of financial position at 30 June 20X2.
(2) Prepare the group Statement of Comprehensive Income for the year
ended 30 June 20X2.
(3) Prepare the group statement of other comprehensive income for the
period showing the group exchange difference arising in the year.

5 The LUMS group has sold its entire 100% holding in an overseas subsidiary
for proceeds of Rs 50,000. The net assets at the date of disposal were Rs
20,000 and the carrying value of goodwill at that date was Rs 10,000. The
cumulative balance on the group foreign currency reserve is a gain of Rs
5,000. Tax can be ignored.

Advanced Financial Accounting and Corporate Reporting (Study Text) 360

 Required:
Calculate the exceptional gain arising to the group on the disposal of the
foreign subsidiary.

6 Little was incorporated over 20 years ago, operating as an independent entity

for 15 years until 1 April 20X0 when it was taken over by Large. Large’s
directors decided that the local expertise of Little’s management should be
utilised as far as possible, and since the takeover they have allowed the
subsidiary to operate independently, maintaining its existing supplier and
customer bases. Large exercises ‘arms’ length’ strategic control, but takes no
part in day-to-day operational decisions.

The statements of financial position of Large and Little at 31 March 20X4 are
given below. The statement of financial position of Little is prepared in francos
(F), its functional currency.
Large Little
Rs. ‘000’ Rs. ‘000’ F 000 F000
Non-current assets:
Property, plant and equipment 63,000 80,000
Investments 12,000 -
———— ————
75,000 80,000
51,000 63,000
———— ————
126,000 143,000
———— ————
Equity:

Equity capital:

(Rs 10 /1 Franco shares) 30,000 40,000

Revaluation reserve – 6,000
Retained earnings 35,000 34,000
———— ————
65,000 80,000
Non-current liabilities:

Long-term borrowings 20,000 25,000

Deferred tax 6,000 10,000
———— ————
26,000 35,000

Advanced Financial Accounting and Corporate Reporting (Study Text) 361

 Current liabilities:

Trade payables 25,000 20,000

Tax 7,000 8,000
Bank overdraft 3,000 -
———— ————
35,000 28,000
———— ————
126,000 143,000
———— ————

Notes to the SFPs:

Note 1 – Investment by Large in Little:

On 1 April 20X0 Large purchased 36 million shares in Little for 72 million
francos. The retained earnings of Little at that date were 26 million francos. It
is group accounting policy to account for goodwill on a proportionate basis. At
1 April 20X3 goodwill had been fully written off as a result of impairment
losses.

Advanced Financial Accounting and Corporate Reporting (Study Text) 362

 Answers

1 BB Ltd, Waiter and Attendant:

(a) BB Ltd – Solution:

27 November 20X6 Translate transaction prior to 324,000 / = Rs 29,058
recording: 11.15

Dr Purchases Rs 29,058
Cr Payables Rs 29,058
19 December 20X6 FC 324,000 is paid.
At 19 December rate this is:324,000 / = Rs 29,643
10.93

Dr Payables Rs 29,058 (being the payable created on 27

November)
Dr Income Rs 585 i.e. exchange loss
statement
Cr Cash Rs 29,643

Rs 585 is an exchange loss arising because the functional currency

(Rs ) has weakened against the transaction currency (FC) since the
transaction occurred.

(b) Waiter – Solution:

K Exchange Rate
Rs

1 January 20X7 record liability 120,000 2.0 240,000

1 March 20X7 repay part of liability (40,000) 3.0 (120,000)
Exchange loss – balancing figure – taken to (160,000)
income
–––––– –––––––
31 December 20X7 80,000 3.5 280,000
–––––– –––––––

The Rs 160,000 is the loss that will be reported in income for the year.
The liability as a monetary item has been retranslated at the closing
rate will be reported on the statement of financial position as Rs
280,000.

(c) Attendant:

As the asset is a nonmonetary item, it will not be subject to

retranslation at the reporting date. If the land is carried at cost, the

Advanced Financial Accounting and Corporate Reporting (Study Text) 363

 asset remains stated at Rs cost translated at the rate ruling at the date
of purchase as follows:

R 60,000 divided by 8 = Rs 7,500

Assuming that the asset is revalued then the revalued amount will be
translated to create a gain or loss that is taken directly to equity /
reserves.

R Rate Rs

1 March 20X0 purchase land 60,000 8.0 7,500

Gain to equity 500
–––––– ––––––
31 December 20X0 80,000 10.0 8,000

2 Rays:
On 15 March the purchase is recorded using the exchange rate on that date.

Dr Non-current asset (KR 20,000/5) R 4,000

Cr Payable R 4,000

• At the year end the non-current asset, being a nonmonetary item, is not
retranslated but remains measured at R 4,000.

• The payable remains outstanding at the yearend. This is a monetary

item and must be retranslated using the closing rate: KR 20,000 / 4 = R
5,000

• The payable must be increased by R 1,000, giving rise to an unrealised

exchange loss:

Dr Statement of Comprehensive Income (exchange loss) R1,000

Cr Payable R1,000

Advanced Financial Accounting and Corporate Reporting (Study Text) 364

 Sunshine:
1 January KR100,000 / = Dr Non-current FC 50,000
20X1 2.0 FC 50,000 assets
Cr Payable FC 50,000
31 March KR100,000 / = Dr Payable FC 50,000
20X1 2.3 FC 43,478

Cr Cash FC 43,478
Cr Income FC 6,522
Statement
KR 50,000 / 2.3 = Dr Purchases FC 21,739
FC 21,739

Cr Payables FC 21,739
30 June 20X1 KR 95,000 / 2.1 = Dr Receivables FC 45,238
FC 45,238

Cr Sales revenue FC 45,238

30 September 20X1 = FC 25,000 Dr Payables FC 21,739
Dr Statement of
Comprehensive Income
FC 3,261
Cr Cash FC 25,000
30 November 20X1 = FC 111,111 Dr Cash FC 111,111
Cr Loan FC 111,111
31 December 20X1*
= FC 50,000 Dr Receivables FC 4,762
Cr Statement of
Comprehensive Income
FC 4,762

= FC 105,263 Dr Loan FC 5,848

Cr Statement of
Comprehensive Income
FC 5,848

*Note: at the reporting date of 31 December, any monetary items designated

in foreign currency which are still outstanding or unsettled are restated using
the closing rate of exchange at that date. This will provide the best estimate at
the reporting date of the FC of any future receipt or payment of cash when the
monetary item is subsequently settled. Consequently, the receivables
recorded in June and the foreign currency loan recorded in November must
be restated.

Advanced Financial Accounting and Corporate Reporting (Study Text) 365

3 Parent & Overseas:

Group statement of financial position:

Note: the assets and liabilities of Overseas have been translated at the
closing rate of 5 Shillings – Rs 1.
Rs

Goodwill (W3) 1,200

Assets 9,500 + ((40,000 + 4000) / 5.0) 18,300
––––––
19,500
––––––

Equity and liabilities Rs

Equity capital 5,000
Retained earnings and other components of equity (W5) 6,734
––––––
11,734
Non-controlling interest (W4) 1,088
––––––
Total equity of the group 12,822
Liabilities (2,318 + (21,800 / 5.0) 6,678
––––––
19,500
––––––

Group Statement of Comprehensive Income:

Note: the income and expenses for Overseas have been translated at the
average rate of 5.2 Shillings = Rs 1
Rs

Revenue (8,000 + (5,200 / 5.2) 9,000

Costs (2,500 + (2,600 / 5.2) (3,000)
–––––
Profit before tax 6,000
Tax (2,000 + (400 / 5.2) (2,077)
–––––
Profit for the year 3,923

Advanced Financial Accounting and Corporate Reporting (Study Text) 366

 Other comprehensive income which may be reclassified to profit
or loss in future years:

Exchange gains on net investment of foreign subsidiary (W7) 490

–––––
Total comprehensive income for the year 4,413
–––––
Profit for the year attributable to:
Owners of Parent ( β) 3,838
Non-controlling
interest (20% × (2,200 / 5.2)) 85
–––––
3,923
–––––
Total comprehensive income attributable to:
Owners of Parent ( β) 4,234
Non-controlling
interest 85 (per IS) + 94 (W6) 179
–––––
Total comprehensive income 4,413
–––––
Workings

(W1) Group structure:

80%

O NCI = 20% for complete year

(W2) Net assets of subsidiary in functional currency:

Acq'n date Rep date

Shillings Shillings Shillings

Share capital 10,000 10,000

Retained earnings 6,000 8,200
Fair value adjustment – land 4,000 4,000
––––– –––––
Post-acquisition
movement 20,000 22,200 2,200
––––– ––––– –––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 367

 (W3) Goodwill at fair value in subsidiary functional currency You need to
identify the respective share of goodwill between the parent and
subsidiary entities as this is used to allocate exchange gains and
losses arising on the retranslation of goodwill at the closing rate at
each reporting date. This can either be done by calculation of both
elements of goodwill for parent and NCI separately, or by identifying
the parent share of goodwill and deducting this from full goodwill. Both
approaches are shown below:

Either: Calculation of full goodwill in normal manner, then deduct

parent share of goodwill (i.e. proportionate goodwill), to arrive at NCI
share of goodwill:

Full goodwill: Shillings

Cost of investment Rs 3,818 @ 5.5 20,999
FV of NCI at acquisition (20% × 20,000) (W2) 5,000
25,999
FV of NA at acquisition 20,000
––––––
Full goodwill at acquisition 5,999
––––––
Translate at closing rate @ 5.0 Rs 1,200
––––––

Proportionate goodwill: Shillings

Cost of investment Rs 3,818 @ 5.5 20,999
CV of NCI at acquisition (20% × 20,000) (W2) 4,000
24,999
FV of NA at acquisition 20,000
––––––
Proportionate goodwill 4,999
––––––
Therefore NCI share of goodwill = Sh5,999 – Sh4,999 = Sh1,000
Or: Calculation of the separate elements of goodwill:

Advanced Financial Accounting and Corporate Reporting (Study Text) 368

 Parent share of goodwill Shillings
Cost of investment Rs 3,818 @ 5.5 20,999
80% x 20,000(W2) (16,000)
––––––
Proportionate goodwill 4,999
NCI at fair value 5,000
20% x 20,000(W2) 4,000 1.000
––––– ––––––
5,999
––––––
Translate at closing rate @ 5.0 Rs 1,200
––––––

Gain or loss to Parent on retranslation of cost of investment:

Cost of investment in Overseas 20,999 Shillings @ 5.5 acquisition rate
= Rs 3,818

Cost of investment in Overseas 20,000 Shillings @ 5.0 closing rate =

Rs 4,200

Exchange gain Rs 382 to group reserves (W5)

(W4) Non-controlling interest at fair value:

Shillings Rs

Fair value at acquisition 5,000

NCI share of post-acquisition profit
(20% x 2,200 (W2)) 440
––––––
Translated at closing rate @ 5.0 5,440 1,088
–––––– –––––

(W5) Group reserves:

Shillings Rs

Parent 6,000
Group share of post-acquisition profit
(80% x 2,200 (W2)) 1,760
Translated at closing rate @ 5.0 352
Gain on retranslation of cost of investment (W3) 382
–––––
6,734
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 369

 Comprising group retained earnings of Rs 6,338 and exchange gains
on net investment in foreign subsidiary Rs 396 – see below:

Group retained earnings Rs

Parent 6,000
Group share of post-acquisition profit
(80% x 2,200 (W2))
Translated at average rate @ 5.2 338
–––––
6,338
–––––
(W6) Group exchange difference:
The group exchange difference is dealt with as other comprehensive
income and it arises on the retranslation of three elements: the opening
net assets, the subsidiary profit for the year and goodwill as follows.

Opening net assets Rs Rs Group NCI

20,000 Shillings @ 5.5 opening (or acq'n) rate 3,636
20,000 Shillings @ 5.0 closing rate 4,000
––––
Exchange gain split (80:20) 364 291 73
Profit for the year
2,200 Shillings @ 5.2 average rate 423
2,200 Shillings @ 5.0 closing rate 440
––––
Exchange gain split (80:20) 17 14 3
Goodwill at fair value
5,999 Shillings @ 5.5 opening (or acq'n) rate 1,091
5,999 Shillings @ 5.0 closing rate 1,200
––––
Exchange gain split in proportion per W3 (5:1) 109 91 18
––– ––– ––
490 396 94
––– ––– ––

Advanced Financial Accounting and Corporate Reporting (Study Text) 370

4 S Ltd & A Ltd:
Note: Assets and liabilities of A Ltd translated at the closing rate of D 4 = Rs 1

Statement of financial position:

Rs

Goodwill (W3) 3,000

Loan to A 1,400 Interco Nil
(1,400)
Tangible assets 10,000 + 4,050 14,050
Inventory 5,000 + purp (W5) 5,600
1,000 (400)
Receivables 4,000 + 125 4,125
Cash at bank 1,600 + 140 1,740
–––––
28,515
–––––

Rs

Equity capital 10,000

Share premium 3,000
Group reserves (W5) 2,849
(profit 5,932(W6) + foreign currency
loss (3,083)(W7))
Non-controlling interest (W4) 2,416
Non-current liabilities 5,000 + Inter-co 5,000
1,400 (1,400)
Current liabilities 5,000 + 250 5,250
–––––
28,515
–––––

Note: income and expenses of A Ltd translated at the average rate for the
year of D3 = Rs 1.

Advanced Financial Accounting and Corporate Reporting (Study Text) 371

Statement of comprehensive income:
Rs

Revenue 50,000 + 20,000 Less Interco (Rs 1,200) 68,800

Cost of sales 20,000 + 10,000 Less Interco (Rs1,200) (29,314)
purp Rs 400
depr on FV D200 @ 3 = Rs 67
correction D140 @ 3 = Rs 47
––––––

Gross profit 39,486

Admin exps 20,000 + 4,000
––––––
Profit before tax 15,486
Tax 8,000 + 2,000
––––––
Profit for Year 5,486

Statement of other Comprehensive Income:

Profit for the Year 5,486

Item that may be classified to profit or loss in subsequent periods:
Total exchange differences arising on foreign operations (W7) (4,722)
–––––
Total Comprehensive income for the year 764

Profit for the year

Attributable to Group Bal fig 3,931

Attributable to NCI (D11,660 (W2) @ 3 x 40%) 1,555
–––––
5,486
Total comprehensive income
Attributable to Group Bal fig 848
Attributable to NCI (1,555 – 1,639) (W7) (W8) (84)
–––––
764

Advanced Financial Accounting and Corporate Reporting (Study Text) 372

(W1) Group Structure:

S Ltd

60 % acquired one year ago – NCI = 40%

A Ltd

(W2) Net assets of subsidiary in own functional currency:

At acquisition Rep date

D D D

Equity capital 1,000 1,000

Share premium 500 500
Retained earnings 500 12,500
Fair value adjustment – plant 1,000 1,000
FVA – dep'n on plant (1/5) (200)
Exchange loss on loan (140)
Post-acquisition movement
––––– –––––
3,000 14,660 11,660
––––– –––––
Exchange loss on loan received by A Ltd

Received 1 June X2 Rs 1,400 @ 3.9 = D5,460

Non-current liability 30 June X2 Rs 1,400 @ 4.0 = D5,600

Exchange loss A Ltd = D140 and increased non-current liability

(W3) Goodwill at fair value in functional currency of subsidiary:

In order to correctly calculate exchange differences on the net
investment in a foreign subsidiary, goodwill needs to be calculated
separately for the group and non-controlling interests elements as
follows:

Advanced Financial Accounting and Corporate Reporting (Study Text) 373

 Full goodwill:
D

Cost to parent Rs 5,000 @ 2 10,000

FV of NCI at acquisition 5,000
–––––

FV of NA at acquisition 15,000
NCI share of NA at acquisition (3,000)
–––––
Fair value goodwill – not impaired 12,000
––––––
Translate at closing rate @ 4 for SOFP Rs 3,000
––––––
Proportionate goodwill:

Cost to parent Rs 5,000 @ 2 10,000

CV of NCI at acquisition (40% × 3,000) 1,200
–––––
FV of NA at acquisition 11,200
NCI share of NA at acquisition (3,000)
–––––
Fair value goodwill – not impaired 8,200
–––––

NCI share of full goodwill: (D12,000 – D8,200) = D3,800

There is also an exchange gain or loss to the parent entity due to the
annual retranslation of the cost of investment calculated as follows:

Cost of investment to parent D10,000 at acq'n rate @ 2 = Rs 5,000

Cost of investment to parent D10,000 at closing rate @ 4 = Rs 2,500

Exchange loss to parent on retranslation of cost of investment = Rs

2,500

Advanced Financial Accounting and Corporate Reporting (Study Text) 374

 (W4) Non-controlling interest at fair value:
D Rs
FV at acquisition per question 5,000
NCI share of post-acquisition profit (40% x D11,660) 4,664
–––––
Translate at closing rate @ 4 to SOFP 9,664
–––––
2,416 2,416
––––– –––––
(W5) Group reserves:
Rs
Parent retained earnings 4,000
Exchange loss to parent on cost of investment (W3) (2,500)
Group share of post-acq'n profit 60% x (D11,660 / 4) cl rate 1,749
URPS on inventory (800 x 1.5 = 1,200 800 = 400) (400)
–––––
2,849
–––––
Alternatively:

Group b'fwd: (only S Ltd) 2,000

Group income after tax per IS 3,932
Group exchange gains and losses on net investment in foreign
subsidiary (W7) (3,083)
–––––
2,849
–––––
Comprising:

Group retained earnings (W6) 5,932

Group exchange gains and losses on net
investment in foreign subsidiary (W7) (3,083)
–––––
2,849
–––––
(W6) Group retained earnings:
Rs

Parent retained earnings 4,000

Group share of post-acq'n profit 60% x (D11,660 / 3) avg rate 2,332
URPS on inventory (800 x 1.5 = 1,200 800 = 400) (400)
–––––
5,932
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 375

 (W7) Exchange differences on net investment in foreign subsidiary:

On full goodwill D Rate Rs Group NCI

at acq'n rate 12,000 2.0 6,000

at rep date 12,000 4.0 3,000
–––––
Exchange loss (split per respective (3,000) (2,050) (950)
share of total goodwill per W3
(8,200:3,800)
–––––
On opening net assets
at opening date 3,000 2.0 1,500
at rep date 3,000 4.0 750
–––––
Exchange loss split per respective (750) (450) (300)
shareholdings (60:40)
–––––
On subsidiary profit for the year
ave rate of year 11,660 3.0 3,887
at rep date 11,660 4.0 2,915
–––––
Exchange loss split per respective (972) (583) (389)
shareholdings (60:40)
––––– ––––– –––––
Summary of total exchange (4,722) (3083) (1,639)
gains and losses on net investment ––––– ––––– –––––

5 LUMS Group:
Rs

Proceeds 50,000
Net assets recorded prior to disposal:
Net assets 20,000
Goodwill 10,000
______ (30,000)
Realisation of the group exchange 5,000
difference, reclassified to profit as part of the gain ______
25,000

Advanced Financial Accounting and Corporate Reporting (Study Text) 376

6 Large & Little:
Group accounting – foreign currency Large and Little

(a) It is clear from the information contained in the question that, on a day to day
basis, Little operates as a relatively independent entity, with its own supplier
and customer bases. Therefore, the cash flows of Little do not have a day-to-
day impact on the cash flows of Large. The functional currency of Little is the
Franco, rather than the Rupees. For consolidation purposes, the financial
statements of Little must be translated into a presentation currency: the
Rupees (the functional currency of Large, in which the consolidated financial
statements of Large are presented). In these circumstances, IAS 21 The
effects of changes in foreign exchange rates requires that the financial
statements be translated using the closing rate (or net investment) method
(the presentation currency method). This involves translating the net assets in
the statement of financial position at the spot rate of exchange at the reporting
date and income and expenses in the Statement of Comprehensive Income
and statement of other comprehensive income at the rate on the date of the
transactions, or as an approximation, a weighted average rate for the year.

Exchange differences are reported as other comprehensive income as they

do not impact on the cash flows of the group until the relevant investment is
disposed of.

(b) Group statement of financial position – Large Group

Rs. ‘000’

Non-current assets 63,000 + ((80,000 – 6,000) / 5) 77,800

Current assets
Inventories 25,000 + ((30,000 – 1,250 30,750
(URP)) / 5)
Trade receivables 20,000 + (28,000 / 5) – 1,000 (CIT) 24,600

Cash 6,000 + (5,000 / 5) + 1,000 (CIT) 8,000

———
141,150
———
Equity share capital 30,000
Revaluation reserve (6,000 – 6,000) –
Retained earnings: (W5) 36,095
Non-controlling interest (W4) 1,455
———
Total equity 67,550
Non-current liabilities 20,000 + (25,000 / 5) 25,000

Advanced Financial Accounting and Corporate Reporting (Study Text) 377

 Deferred tax 6,000 + (10,000 / 5) 8,000

Current liabilities
Payables 25,000 + (20,000 / 5) 29,000
Tax 7,000 + (8,000 / 5) 8,600
Overdraft 3,000 + 0 3,000
———
141,150
———
Workings:

(W1) Group structure:

(W2) Net assets of subsidiary in functional currency:

Acquisition Date Reporting

Date
F000 F000

Equity capital 40,000 40,000

Retained earnings 26,000 34,000
Revaluation reserve 6,000
Accounting policy adjustment (**see below) (6,000)
URPS (*see below) (1,250)
–––––– ––––––
66,000 72,750
–––––– ––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 378

 *Calculation of unrealised profit on closing inventory sold by subsidiary:

URPS on inventory sold by subsidiary %age F000

Cost 100.0 3,750

Profit element 33.3 1,250
–––––– ––––––
Selling price 133.3 5,000
–––––– ––––––

**Accounting policy adjustment:

This arises due to the parent and subsidiary having different

accounting policies relating to property. At the reporting date, the
property has been owned by the subsidiary, and depreciated, for one
year (F25m / 25 year = F1m per annum), giving a carrying value of
F24m before the revaluation is accounted for at the reporting date. The
revaluation reserve created is therefore (F30m – F24m) F6m. This
needs to be removed from both non-current assets and revaluation
reserve of the subsidiary.

(W3) Goodwill on proportionate basis in subsidiary functional

currency:

F000

Cost 72,000
90% x 66,000(W2) 59,400
––––––
12,600
––––––

Translated at closing rate @ 5 – fully impaired (W5) Rs 2,520

––––––
Gain or loss on retranslation of cost of investment:
Cost at acquisition F72,000 @ 6 Rs 12,000
Cost retranslated at closing rate F72,000 @ 5 Rs 14,400
––––––
Gain to parent (W5) 2,400
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 379

 (W4) Non-controlling interest on proportionate basis:

Rs. ‘000’

F72,750 (W2) @ 5 x 10% 1,455

–––––

(W5) Group retained earnings:

Rs. ‘000’

Large 35,000
Little F6,750 @ 5 x 90% 1,215
Goodwill impaired (W3) (2,520)
Gain on retranslation of cost of investment 2,400
––––––
36,095
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 380

Advanced Financial Accounting and Corporate Reporting (Study Text) 381
GROUP STATEMENT OF CASH FLOWS
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

• Prepare and discuss the group statement of cash flows according to IAS 7.

Advanced Financial Accounting and Corporate Reporting (Study Text) 382

1. Objective of Statement of Cash Flows

1.1 • IAS 7 Statement of cash flows provides guidance on the preparation

of a statement of cash flow.

• The objective of a statement of cash flows is to provide information on

an entity’s changes in cash and cash equivalents during the period.

• The statement of financial position and statement of comprehensive

income (SCI) are prepared on an accruals basis and do not show how
the business has generated and used cash in the accounting period.

• The statement of comprehensive income (SCI) may show profits on an

accruals basis even if the company is suffering severe cash flow
problems.

• Statements of cash flows enable users of the financial statements to

assess the liquidity, solvency and financial adaptability of a
business.

1.2 Definitions:
• Cash consists of cash in hand and deposits repayable upon demand,
less overdrafts. This includes cash held in a foreign currency.

• Cash equivalents are short-term, highly liquid investments that are

readily convertible to known amounts of cash and are subject to an
insignificant risk of changes in value.

• Cash flows are inflows and outflows of cash and cash equivalents.

2. Classification of Cash Flows

2.1 IAS 7 does not prescribe a specific format for the statement of cash flows,
although it requires that cash flows are classified under three headings:

• cash flows from operating activities, defined as the entity’s principal

revenue earning activities and other activities that do not fall under the
next two headings

• cash flows from investing activities, defined as the acquisition and

disposal of long-term assets and other investments (excluding cash
equivalents)

Advanced Financial Accounting and Corporate Reporting (Study Text) 383

 • cash flows from financing activities, defined as activities that change
the size and composition of the entity’s equity and borrowings

Proforma statement of cash flow per IAS 7

Rs Rs
Operating activities
Profit before tax X
Add: interest expense X
Less: Income from associate X
Adjust for non-cash items dealt with in arriving at operating profit:

Add: depreciation X
Add: loss on impairment X
Add: loss on disposal of non-current assets X
Add: increase in provisions X
––––
X
Changes in working capital:
Increase in inventory (X)
Increase in receivables (X)
Decrease in payables (X)
––––
Cash generated X
Interest paid (X)
Taxation paid (X)
––––

Investing activities

Payments to purchase NCA (X)

Receipts from NCA disposals X
Cash paid to acquire subsidiary (net of cash balances acquired) (X)
Cash proceeds from subsidiary disposal
(net of cash balances disposed) X
Dividend received from associate X
Interest received X
–––– X(X)

Advanced Financial Accounting and Corporate Reporting (Study Text) 384

 Financing activities

Proceeds from share issue X

Proceeds from loan or debenture issue X
Cash repayment of loans or debentures (X)
Finance lease repayments (X)
Equity dividend paid (X)
Dividend paid to NCI (X)
–––– X(X)
––––
Change in cash and equivalents X(X)
Cash and equivalents brought forward X(X)
––––
Cash and equivalents carried forward X(X)

2.2 Cash flows from operating activities

There are two methods of calculating the cash from operations.

• The direct method shows operating cash receipts and payments. This
includes cash receipts from customers, cash payments to suppliers
and cash payments to and on behalf of employees.

• The indirect method starts with profit before tax and adjusts it for non-
cash charges and credits, to reconcile it to the net cash flow from
operating activities.

IAS 7 permits either method; note that the standard encourages, but does not
require, use of the direct method. The methods differ only in respect of
derivation of the item 'net cash inflow from operating activities'. Subsequent
inflows and outflows for investing and financing activities are the same. A
comparison between the direct and indirect method to arrive at net cash inflow
from operating activities is shown below.

Direct method: Rs m Indirect method: Rs m

Cash receipts from Customers 15,424 Profit before tax 6,022

Cash payments to suppliers (5,824) Depreciation charges 899
Cash payments to and on
behalf of employees (2,200) Increase in inventory (194)
Other cash payments (511) Increase in receivables (72)
Increase in payables 234
–––– ––––
Net cash inflow from Net cash inflow from
operating activities 6,889 operating activities 6,889

Advanced Financial Accounting and Corporate Reporting (Study Text) 385

 The principal advantage of the direct method is that it discloses operating
cash receipts and payments. Knowledge of the specific sources of cash
receipts and the purposes for which cash payments have been made in past
periods may be useful in assessing and predicting future cash flows.

Under the indirect method, typically begin with profit before tax and then
make adjustments for a number of items, the most frequently occurring of
which are:

• depreciation or amortisation charges in the year

• impairment charged to profit or loss in the year
• profit or loss on disposal of non current assets
• change in inventory
• change in receivables
• change in payables

2.3 Cash flows from investing activities

Cash flows to appear under this heading include:
• cash paid for property, plant and equipment and other non-current
assets

• cash received on the sale of property, plant and equipment and other
non-current Assets

• cash paid for investments in or loans to other entities (excluding

movements on loans from financial institutions, which are shown under
financing)
•
• cash received for the sale of investments or the repayment of loans to
other entities (again excluding loans from financial institutions).

2.4 Cash flows from financing activities

Financing cash flows mainly comprise receipts or repayments of principal
from or to external providers of finance.

Financing cash inflows include:

• receipts from issuing shares or other equity instruments

• receipts from issuing debentures, loans, notes and bonds and from
other long-term and short-term borrowings (other than overdrafts,
which are normally included in cash and cash equivalents).

• repayments of amounts borrowed (other than overdrafts)

Advanced Financial Accounting and Corporate Reporting (Study Text) 386

 • the capital element of finance lease rental payments

• payments to reacquire or redeem the entity’s shares.

2.5 Interest and dividends

There are divergent and strongly held views about how interest and dividends
cash flows should be classified. Some regard them as part of operating
activities, because they are as much part of the day to day activities as
receipts from customers, payments to suppliers and payments to staff. Others
regard them as part of financing activities, the heading under which the
instruments giving rise to the payments and receipts are classified. Still others
believe they are part of investing activities, because this is what the long-term
finance raised in this way is used for.

IAS 7 allows interest and dividends, whether received or paid, to be classified

under any of the three headings, provided the classification is consistent from
period to period.

The practice adopted in this workbook is to classify:

• interest received as a cash flow from investing activities
• interest paid as a cash flow from operating activities
• dividends received as a cash flow from investing activities
• dividends paid as a cash flow from financing activities.

3. Calculation of Net Cash Flow from Operating Activities

3.1 Profit before tax is computed on the accruals basis, whereas net cash flow
from operating activities only records the cash inflows and outflows arising out
of trading. The main categories of items in the statement of comprehensive
income /statement of comprehensive income and on the statement of financial
position that form part of the reconciliation between profit before tax and net
cash flow from operating activities using the indirect method are:

• Depreciation.
Depreciation is a non-cash cost, being a book write-off of capital
expenditure. Capital expenditure will be recorded under ‘investing
activities’ at the time of the cash outflow. Depreciation therefore
represents an addition to reported profit in deriving cash inflow.

• Profit/loss on disposal of non-current assets

The cash inflow from such a disposal needs to be recorded under
‘investing activities’. If the profit or loss on the sale has been included
in profit before tax, an adjustment is necessary in computing operating

Advanced Financial Accounting and Corporate Reporting (Study Text) 387

 cash flow. A loss on disposal is added to reported profit, while a profit
on disposal is deducted from reported profit.

• Statement of financial position change in inventories

Inventory at the reporting date represents a purchase that has not
actually been charged against current profits. However, as cash was
spent on its purchase or a payable incurred, it does represent an actual
or potential cash outflow. The effect on the statement of cash flows of a
change in inventories is:

– an increase in inventory is a deduction from reported profit,

because it requires financing

– a decrease in inventory is an addition to reported profit, because

the amount of financing required has fallen.

• Statement of financial position change in receivables

A sale once made creates income irrespective of the date of cash
receipt. If the cash has not been received by the reporting date, there is
no cash inflow from operating activities for the current accounting
period. Similarly, opening receivables represent sales of a previous
accounting period, most of which will be cash receipts in the current
period.

The change between opening and closing receivables will thus

represent the adjustment required to move from profit to net cash
inflow. The reasoning is the same as for inventories.

– An increase in receivables is a deduction from reported profit.

– A decrease in receivables is an addition to reported profit.

• Statement of financial position change in payables

A purchase represents the incurring of expenditure and a charge or
potential charge to the statement of comprehensive income (SCI). It
does not represent a cash outflow until paid. To the extent that a
purchase results in a charge to the statement of comprehensive income
(SCI):

– an increase in payables between two reporting dates is an

addition to reported profit
– a decrease in payables is a deduction from reported profit.

If the purchase does not result in a charge to the statement of

comprehensive income in the current year, the corresponding payable

Advanced Financial Accounting and Corporate Reporting (Study Text) 388

 is not included in the reconciliation of profit to net cash inflow. For
example, a payable in respect of a non-current asset is not included.

3.2 Tax Expense

Cash flows arising from taxes on income should be separately disclosed as
part of operating activities unless they can be specifically identified with
financing or investing activities. It is reasonable to include income taxes as
part of operating activities unless a question gives a clear indication to the
contrary.

If income tax payments are allocated over more than one class of activity, the
total should be disclosed by note.

The computation of income taxes paid may present a practical problem.

It is often convenient to arrive at the figure by means of a single tax working

account into which all tax balances, whether current or deferred, are entered.

Sales tax
The existence of sales tax raises the question of whether the relevant cash
flows should be reported gross or net of the tax element and how the balance
of tax paid to, or repaid by, the taxing authorities should be reported.

The cash flows of an entity include sales tax where appropriate and thus
strictly the various elements of the statement of cash flows should include
sales tax. However, this treatment does not take into account the fact that
normally sales tax is a short-term timing difference as far as the entity’s
overall cash flows are concerned and the inclusion of sales tax in the cash
flows may distort the allocation of cash flows to standard headings.

In order to avoid this distortion and to show cash flows attributable to the
reporting entity’s activities, it is usual for amounts to be shown net of sales
taxes and the net movement on the amount payable to, or receivable from,
the taxing authority should be allocated to cash flows from operating activities
unless a different treatment is more appropriate in the particular
circumstances concerned.

Advanced Financial Accounting and Corporate Reporting (Study Text) 389

3.3 Unusual items and non-cash Transactions

Unusual cash flows

Where cash flows are unusual because of their size or incidence, sufficient
disclosure should be given to explain their cause and nature.

For a cash flow to be unusual on the grounds of its size alone, it must be
unusual in relation to cash flows of a similar nature.

Discontinued activities
Cash flows relating to discontinued activities are required by IFRS 5 to be
shown separately, either on the face of the statement of cash flows or by note.

Major non-cash transactions

Material transactions not resulting in movements of cash should be disclosed
in the notes to the statement of cash flows if disclosure is necessary for an
understanding of the underlying transactions.

Consideration for transactions may be in a form other than cash. The purpose
of a statement of cash flows is to report cash flows, and non-cash
transactions should therefore not be reported in a statement of cash flows.
However, to obtain a full picture of the alterations in financial position caused
by the transactions for the period, separate disclosure of material non-cash
transactions is also necessary.

Examples of non-cash transactions are:

• the acquisition of assets by finance leases

Finance leases are accounted for by the lessee capitalising the present
value of the minimum lease payments. A liability and a corresponding
asset are produced, which do not reflect cash flows in the accounting
period. The statement of cash flows records the cash flow, i.e. the
rentals paid, with the reduction in liability shown under financing. The
interest element of the payment may be included in operating activities
with only the portion of the payment which reduces the lease liability
shown under financing activities.

• the conversion of debt to equity

If debt is issued with conversion rights attached it will be cancelled
using an issue of shares and no cash flow will arise. The statement of
cash flows is not affected.

Advanced Financial Accounting and Corporate Reporting (Study Text) 390

 • the acquisition of a subsidiary by issue of shares
If the purchase consideration on acquisition of a subsidiary is settled
using a share for share exchange no cash flow will arise and the
statement of cash flows is not affected.

4. Preparation of Group Statement of Cash Flows

So far in this chapter, we have revised the basics on statements of cash flows.
You should be familiar with this from previous studies.

Group statements of cash flows add three extra elements:

• cash paid to non-controlling interests

• cash received from associates
• acquisition and disposal of subsidiaries.

4.1 Cash paid to Non-controlling Interest

• When a subsidiary that is not wholly owned pays a dividend, some of
that dividend is paid outside of the group to the non-controlling interest.

• Such dividends paid to non-controlling interests should be disclosed

separately in the statement of cash flows.

• To calculate the amount paid, reconcile the non-controlling interest in

the statement of financial position from the opening to the closing
balance. You can use a T-account to do this. This working remains the
same whichever method is used to value the non-controlling interest.

Example 1
The following information has been extracted from the consolidated financial
statements of WG for the years ended 31 December:

20X7 20X6
Rs 000 Rs 000
NCI in consolidated net assets 780 690
NCI in consolidated profit after tax 120 230

What is the dividend paid to non-controlling interests in the year 20X6?

Advanced Financial Accounting and Corporate Reporting (Study Text) 391

 Solution

Steps:
(1) Set up a T account for the NCI interest balance.
(2) Insert the opening and closing balances for net assets and the NCI
share of profit after tax.
(3) Balance the account.
(4) The balancing figure is the cash paid to the NCI.

Rs 000 Rs 000
Dividends paid Balance b/d
(bal. fig) 30 NCI 690
Balance c/d NCI 780 Share of profits in year 120
–––– ––––
810 810

Watch out for an acquisition or disposal of a subsidiary in the year. This will
affect the NCI and will need to be taken account of in the T-account, showing
the NCI that has been acquired or disposed of in the period.

4.2 Cash Received from Associates

Associates generate cash flows into or out of the group to the extent that:

• dividends are received out of the profits of the associate

• trading occurs between the group and associate
• further investment is made in the associate.

Associates are usually dealt with under the equity method of accounting and
this terminology is used below. (This also applies to jointly controlled entities
as defined in IAS 31 Interests in joint ventures).

Standard accounting practice

• The cash flows of any equity accounted entity should be included in the
group statement of cash flows only to the extent of the actual cash
flows between the group and the entity concerned, for example
dividends received in cash and loans made or repaid.

Dividends
• Only dividends received represent a cash inflow. Dividends declared
but unpaid represent an increase in group receivables.

Advanced Financial Accounting and Corporate Reporting (Study Text) 392

 • When reconciling group net cash inflow to group reported profit, the
movement between opening and closing receivables must exclude
dividends receivable from the associate so that dividends received can
be shown in the statement of cash flows.

• Dividends received from associates should be included as a separate

item in the group statement of cash flows.

Trading between group and associate

• Trading between the group and an associate will give rise to inter-entity
balances in the group statement of financial position at the year end.

• The balances will be treated in the same way as any other trading
receivables and payables, i.e. the movement between opening and
closing balances forms part of the reconciliation between group profit
and group net cash inflow from operating activities.

Change in investment in associate

A change in investment in the associate can arise when:
• an additional shareholding is purchased or part of the shareholding is
sold

• loans are made to/from the associate or amounts previously loaned are
repaid.

Example 2

Associates
The following information has been extracted from the consolidated financial
statements of H for the year ended 31 December 20X1:

Advanced Financial Accounting and Corporate Reporting (Study Text) 393

Group statement of comprehensive income
Rs 000
Operating profit 734
Income from associate 68
–––––
Profit before tax 802
Tax on profit (including 20 in respect of associate) (324)
––––
Profit after tax 478

Group statement of financial position

20X1 20X0
Rs 000 Rs 000
Investments in associates

Share of net assets 466 456

Loan to associate 380 300

Current assets

Receivables 260 190

Included within group receivables is the following amount:
Current account with associate 40 70

Show the relevant figures to be included in the group statement of cash flows
for the year ended 31 December 20X1

Solution
When dealing with the dividend from the associate, the process is the same
as we have already seen with the non-controlling interest.

Set up a T account and bring in all the balances that relate to the associate.
When you balance the account, the balancing figure will be the cash received
from the associate.

Advanced Financial Accounting and Corporate Reporting (Study Text) 394

 (W1) Dividend received from associate

Associate
Rs 000 Rs 000

Balance b/d Dividend received

Share of net assets 456 (bal fig) 38
Share of net assets 466
Share of profit after tax 48
(68–20) –––– ––––
504 504
–––– ––––

Note that the current account with the associate remains within receivables.

Extracts from statement of cash flows

Rs 000
Cash flows from operating activities

Profit before tax 802

Share of profit of associate (68)

Investing activities

Dividend received from associate (W1) 38

Loan to associate (380 – 300) (80)

4.3 Acquisition and Disposal of Subsidiaries

Standard accounting practice

• If a subsidiary joins or leaves a group during a financial year, the cash
flows of the group should include the cash flows of that subsidiary for
the same period that the results of the subsidiary are included in the
statement of comprehensive income / SCI.

• Cash payments to acquire subsidiaries and receipts from disposals of

subsidiaries must be reported separately in the statement of cash flows
under investing activities. The cash and cash equivalents acquired or
disposed of should be shown separately.

• A note to the statement of cash flows should show a summary of the

effects of acquisitions and disposals of subsidiaries, indicating how

Advanced Financial Accounting and Corporate Reporting (Study Text) 395

 much of the consideration comprised cash and cash equivalents, and
the assets and liabilities acquired or disposed of.

Acquisitions
• In the statement of cash flows we must record the actual cash flow for
the purchase, not the net assets acquired.

• The assets and liabilities purchased will not be shown with the cash
outflow in the statement of cash flows.

• All assets and liabilities acquired must be included in any workings to

calculate the cash movement for an item during the year. If they are not
included in deriving the balancing figure, the incorrect cash flow figure
will be calculated. This applies to all assets and liabilities acquired
including the non-controlling interest.

Disposals
• The statement of cash flows will show the cash received from the sale
of the subsidiary, net of any cash balances that were transferred out
with the sale.

• The assets and liabilities disposed of are not shown in the cash flow.
When calculating the movement between the opening and closing
balance of an item, the assets and liabilities that have been disposed of
must be taken into account in order to calculate the correct cash figure.
As with acquisitions, this applies to all assets and liabilities and the
non-controlling interest.

Example 3

Acquisition of Subsidiary
The extracts of a company’s statement of financial position is shown below:

20X8 20X7
Rs Rs
Inventory 74,666 53,019

During the year, a subsidiary was acquired. At the date of acquisition, the
subsidiary had an inventory balance of Rs 9,384.

Calculate the movement on inventory for the statement of cash flows.

Advanced Financial Accounting and Corporate Reporting (Study Text) 396

 Solution
At the beginning of the year, the inventory balance of Rs 53,019 does not
include the inventory of the subsidiary.

At the end of the year, the inventory balance of Rs 74,666 does include the
inventory of the newly acquired subsidiary.

In order to calculate the correct cash movement, the acquired inventory must
be excluded as it is dealt with in the cash paid to acquire the subsidiary. The
comparison of the opening and closing inventory figures is then calculated on
the same basis.

The movement on inventory is: (74,666 – 9,384) – 53,019 = Rs 12,263

increase. This is shown as a negative cash flow.

Example 4

Disposal of Subsidiary
The same principle applies if there is a disposal in the period.

For example, the year end receivables balance was as follows:

20X8 20X7
Rs Rs
Receivables 52,335 48,991

During the year, a subsidiary was disposed of. At the date of disposal the
subsidiary had a receivables balance of Rs 6,543.

Calculate the movement on receivables for the statement of cash flows.

Solution
At the beginning of the year, the receivables balance of Rs 48,911 does
include the receivables of the subsidiary.

At the end of the year, the receivables balance of Rs 52,335 does not include
the receivables of the disposed subsidiary.

In order to calculate the correct cash movement, the receivables of the

disposed subsidiary must be excluded.

The movement on receivables is:

52,335 – (48,911 – 6,543) = Rs 9,967 increase, which is shown as a negative
cash flow.

Advanced Financial Accounting and Corporate Reporting (Study Text) 397

5. Foreign Currency Transactions

5.1 It is likely that any statement of cash flows question will require you to deal
with exchange gains and losses.

Individual entity stage

• Exchange differences arising at the individual entity stage are in most
instances reported as part of operating profit. If the foreign currency
transaction has been settled in the year, the cash flows will reflect the
reporting currency cash receipt or payment and thus no problem
arises.

• An unsettled foreign currency transaction will, however, give rise to an

exchange difference for which there is no cash flow effect in the current
year. Such exchange differences therefore need to be eliminated in
computing net cash flows from operating activities.

• Fortunately this will not require much work if the unsettled foreign
currency transaction is in working capital. Adjusting profit by
movements in working capital will automatically adjust correctly for the
non-cash flow exchange gains and losses.

Example 5
The financial statements of A are as follows:

Statements of financial position at 31 December 20X3 20X4

Rs Rs
Non-current assets – –
Current assets
Inventory 300,000 300,000
Cash 335,000 595,000
––––––– –––––––
635,000 895,000
––––––– –––––––

Equity and liabilities 100,000 190,000

Foreign currency loan 235,000 245,000
Trade payables 300,000 460,000
––––––– –––––––
635,000 895,000
––––––– –––––––
Capital and reserves 100,000 190,000
Foreign currency loan 235,000 245,000

Advanced Financial Accounting and Corporate Reporting (Study Text) 398

 Trade payables 300,000 460,000
––––––– –––––––
635,000 895,000
––––––– –––––––

Statement of comprehensive income for the year ended 31 December 20X4

Revenue – all cash sales 1,003,000
Cost of sales (910,000)
–-––––––
Operating profit before exchange differences 93,000
–-––––––
Exchange differences
Trading (2 + 5) 7,000
Loan (245 – 235) (10,000)
––––––
(3,000)
–––––––
Profit before tax 90,000
Tax –
–––––––
Profit for the period 90,000

Statement of comprehensive income for the year ended 31 December

20X4
Rs Rs
Revenue – all cash sales 1,003,000
Cost of sales (910,000)
–-––––––
Operating profit before exchange differences 93,000
–-––––––
Exchange differences
Trading (2 + 5) 7,000
Loan (245 – 235) (10,000)
–-–––––
(3,000)
–––––––
Profit before tax 90,000
Tax –
–––––––
Profit for the period 90,000

Advanced Financial Accounting and Corporate Reporting (Study Text) 399

 During the year, A purchased raw materials for Z 200,000, recorded in its
books as Rs 100,000. By the year end A had settled half the debt for Rs
48,000 and the remaining payable is retranslated at closing rate at Rs 45,000.

These transactions are included in the purchase ledger control account, which
is as follows:

Purchase ledger control

Rs Rs
Cash 743,000 Balance b/d 300,000
Exchange gains Purchases 910,000
On settled transaction
(50,000 – 48,000) 2,000
On unsettled transaction
(50,000 – 45,000) 5,000
Balance c/d
Foreign currency payable 45,000
Other 415,000
–-–––––– –-––––––
1,210,000 1,210,00

Show the gross cash flows (i.e. cash flows under the direct method) from
operating activities, together with a reconciliation of profit before tax to net
cash flow from operating activities.

Solution
Statement of cash flows for the year
Rs Rs
Cash received from customers 1,003,000
Cash payments to suppliers 743,000
––––––––
Net cash inflow from operations 260,000
–––––––
Increase in cash 260,000
–––––––
Note that because there is no change in inventory, cost of sales is the same
as purchases reconciliation of profit before tax to net cash inflow from
operating activities
Rs
Profit before tax 90,000
Exchange loss on foreign currency loan 10,000
Increase in payables 160,000
–––––––
Net cash inflow from operations 260,000

Advanced Financial Accounting and Corporate Reporting (Study Text) 400

5.2 Consolidated statement of cash flows
The key to the preparation of a group statement of cash flows involving
a foreign subsidiary is an understanding of the makeup of the foreign
exchange differences themselves.

• None of the differences reflects a cash inflow/outflow to the group. The

main concern, therefore, is to determine the real cash flows,
particularly if they have to be derived as balancing figures from the
opening and closing statements of financial position.

• If cash balances are partly denominated in a foreign currency, the

effect of exchange rate movements on cash is reported in the
statement of cash flows in order to reconcile the cash balances at the
beginning and end of the period. This amount is presented separately
from cash flows from operating, investing and financing activities.

5.3 Closing rate/net investment method

• Using the closing rate/net investment method, the exchange difference
on translating the statements of the foreign entity will relate to the
opening net assets of that entity (i.e. non-current assets, inventories,
receivables, cash, payables and loans) and also to the difference
between the average and the closing rates of exchange on translation
of the result for the period.

• Under the closing rate/net investment method, translation exchange

differences are disclosed as other comprehensive income and taken to
other components of equity in the statement of financial position.

Care needs to be taken in two areas:

• Analysis of non-current assets

Non-current assets may require analysis in order to determine cash
expenditure. Part of the movement in non-current assets may reflect an
exchange gain/loss.

• Analysis of non-controlling interests

If non-controlling interests require analysis to determine the dividend
paid to them, it must be remembered that they have a share in the
exchange gain/loss arising from the translation of the subsidiary’s
accounts.

Advanced Financial Accounting and Corporate Reporting (Study Text) 401

 Example 6: Foreign currency transactions
B Group recognised a gain of Rs 160,000 on the translation of the financial
statements of a 75% owned foreign subsidiary for the year ended 31
December 20X7. This gain is found to be made up as follows

Rs
Gain on opening net assets:
Non-current assets 90,000
Inventories 30,000
Receivables 50,000
Payables (40,000)
Cash 30,000
–––––––
160,000

B Group recognised a loss of Rs 70,000 on retranslating the parent entity’s

foreign currency loan. This loss has been disclosed as other comprehensive
income and charged to reserves in the draft financial statements.

Consolidated statements of financial position as at 31 December 20X7 20X6

Rs 000 Rs 000
Non-current assets 2,100 1,700
Inventories 650 480
Receivables 990 800
Cash 500 160
–––––– ––––––
4,240 3,140
–––––– ––––––
Share capital 1,000 1,000
Consolidated reserves 1,600 770
–––––– ––––––
2,600 1,770
Non controlling interest 520 370
–––––– ––––––
Equity 3,120 2,140
Long term loan 250 180
Payables 870 820
–––––– ––––––
4,240 3,140
–––––– ––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 402

 There were no non-current asset disposals during the year.

Consolidated statement of comprehensive income for the year ended 31

December 20X7
Rs 000
Profit before tax (after depreciation of Rs 220,000) 2,170
Tax (650)
––––––
Group profit for the year 1,520
––––––
Profit attributable to:
Owners of the parent 1,260
Non-controlling interest 260
––––––
Net profit for the period 1,520
––––––
Note: The dividend paid during the year was Rs 480,000.

Prepare a consolidated statement of cash flows for the year ended 31

December 20X7.

Solution
The first stage is to produce a statement of reserves so as to analyse the
movements during the year.

Statement of reserves
Rs 000
Reserves brought forward 770
Retained profit (1,260 – 480) 780

Exchange gain
(160,000 × 75%) – 70,000 50
–––––
Reserves carried forward 1,600
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 403

 Statement of cash flows for the year ended 31 December 20X7
Cash flows from operating activities
Rs 000
Profit before tax 2,170
Depreciation charges 220
Increase in inventory (650 – 480 – 30) (140)
Increase in receivables (990 – 800 – 50) (140)
Increase in payables (870 – 820 – 40) 10
–––––
Cash generated from operations 2,120
Income taxes paid (650)
–––––
Net cash from operating activities 1,470
Cash flows from investing activities
Purchase of non-current assets (W2) (530)
–––––
–––––
(530)

Cash flows from financing activities

Dividends paid to non-controlling interests (W1) (150)
Dividends paid (480)
–––––
(630)
Exchange gain on cash 30
–––––
Increase in cash 340
Cash at 1 Jan 20X7 160
–––––
Cash at 31 Dec 20X7 500

Workings:

(W-1) Non-controlling interest

Rs 000 Rs 000
Dividend paid (bal fig) 150 Balance b/d 370
Balance c/d 520 Total comprehensive income 300
(Note)
––––– –––––
670 670
––––– –––––

Note: i.e. NCI share of tax 260 + (25% x Rs 160,000 exchange gain) = 300

Advanced Financial Accounting and Corporate Reporting (Study Text) 404

(W-2) Non-current assets

Rs 000 Rs 000

Balance b/d 1,700 Depreciation 220

Exchange gain 90 Balance c/d 2,100
Additions (bal fig) 530 Exchange gain
–––––– –––––
2,320 2,320

Example 7
Opening Closing
Balance Balance
Rs 000 Rs 000
Group statement of financial position extracts

Non-current assets 400 500

Loans 600 300
Tax 300 200

Statement of comprehensive income extracts

Depreciation 50
Loss on disposal of non-current asset
(sold for Rs 30,000) 10
Tax charge 200

During the accounting period, one subsidiary was sold, and another acquired.
Extracts from the statements of financial position are as follows:

Sold Acquired
Rs 000 Rs 000
Non-current assets 60 70
Loans 110 80
Tax 45 65

During the accounting period, the following net exchange gain arose in
respect of overseas net assets:
Rs 000
Non-current assets 40
Loans (5)
Tax (5)

Advanced Financial Accounting and Corporate Reporting (Study Text) 405

 Required:
Calculate the group cash flows for non-current assets, loans and tax.

SOLUTION

Non-current assets
Rs 000
Opening balance 400
Depreciation (50)
Disposal (30 + 10) (40)
Disposal of subsidiary (60)
Acquisition of subsidiary 70
Exchange gain 40
––––
360
Cash acquisitions (bal figure) 140
––––
Closing balance 500
––––
Loans
Opening balance 600
Disposal of subsidiary (110)
Acquisition of subsidiary 80
Exchange loss 5
––––
575
Therefore redemption (275)
––––
Closing balance 300
––––

Tax
Opening balance 300
Charge for the year 200
Disposal of subsidiary (45)
Acquisition of subsidiary 65
Exchange loss 5
––––
525
Therefore cash paid (325)
––––
Closing balance 200
––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 406

6. Evaluation of Statement of Cash Flows

6.1 Usefulness of statement of cash flows

A statement of cash flows can provide information that is not available from
statements of financial position and statements of comprehensive income.

(a) It may assist users of financial statements in making judgements on the

amount, timing and degree of certainty of future cash flows.

(b) It gives an indication of the relationship between profitability and cash

generating ability, and thus of the quality of the profit earned.

(c) Analysts and other users of financial information often, formally or

informally, develop models to assess and compare the present value of
the future cash flow of entities. Historical cash flow information could be
useful to check the accuracy of past assessments.

(d) A statement of cash flow in conjunction with a statement of financial

position provides information on liquidity, solvency and adaptability.
The statement of financial position is often used to obtain information
on liquidity, but the information is incomplete for this purpose as the
statement of financial position is drawn up at a particular point in time.

(e) Cash flow cannot easily be manipulated and is not affected by

judgement or by accounting policies.

6.2 Limitations of statement of cash flows

Statements of cash flows should normally be used in conjunction with
statement of comprehensive incomes/statements of comprehensive income
and statements of financial position when making an assessment of future
cash flows.

(a) Statements of cash flows are based on historical information and

therefore do not provide complete information for assessing future cash
flows.

(b) There is some scope for manipulation of cash flows. For example, a
business may delay paying suppliers until after the yearend, or it may
structure transactions so that the cash balance is favourably affected. It
can be argued that cash management is an important aspect of
stewardship and therefore desirable. However, more deliberate
manipulation is possible (e.g. assets may be sold and then immediately
repurchased). Application of the substance over form principle should

Advanced Financial Accounting and Corporate Reporting (Study Text) 407

 alert users of the financial statements to the true nature of such
arrangements

(c) Cash flow is necessary for survival in the short term, but in order to
survive in the long term a business must be profitable. It is often
necessary to sacrifice cash flow in the short term in order to generate
profits in the long term (e.g. by investment in non-current assets). A
substantial cash balance is not a sign of good management if the cash
could be invested elsewhere to generate profit.

Neither cash flow nor profit provides a complete picture of an entity’s

performance when looked at in isolation.

Advanced Financial Accounting and Corporate Reporting (Study Text) 408

 Chapter Summary

Advanced Financial Accounting and Corporate Reporting (Study Text) 409

 Self-Test Questions

1. Cash Flow Exercises

Calculate the cash flows given the following extracts from statements of
financial position drawn up at the year ended 31 December 20X0 and 20X1.

(1) 20X0 20X1

Rs Rs
Non-current assets (CV) 100 250

During the year depreciation charged was Rs 20, a revaluation surplus of Rs

60 was recorded, non-current assets with a CV of Rs 15 were disposed of and
non-current assets acquired subject to finance leases had a CV of Rs 30.

Required:
How much cash was spent on non-current assets in the period?

(2) 20X0 20X1

Rs Rs
Deferred tax 50 100
Income tax liability 100 120

The income tax charge was Rs 180.

Required:
How much tax was paid in the period?

(3) 20X0 20X1

Rs Rs
Non-controlling interest 440 840

The group statement of comprehensive income reported a non controlling

interest of Rs 500.

Required:
How much was the cash dividend paid to the non-controlling interest?

(4) 20X0 20X1

Rs Rs
Non-controlling interest 500 850

Advanced Financial Accounting and Corporate Reporting (Study Text) 410

 The group statement of comprehensive income reporting a non-controlling
interest of Rs 600.

Required:
How much was the cash dividend paid to the non-controlling interest?

(5) 20X0 20X1

Rs Rs
Investment in associate undertaking 200 500

The group statement of comprehensive income reported ‘Income from

Associate Undertakings’ of Rs 750.

Required:
How much was the cash dividend received by the group?

(6) 20X0 20X1

Rs Rs
Investment in associate undertaking 600 3200

The group statement of comprehensive income reported ‘Income from

Associate Undertakings’ of Rs 4,000

In addition, during the period the associate revalued its non-current assets,
the group share of which is Rs 500.

Required:
How much was the cash dividend received by the group?

(7)
20X0 20X1
Rs Rs
Non-current asset (CV) 150 500

During the year depreciation charged was Rs 50, and the group acquired a
subsidiary with non-current assets of Rs 200.

Required:
How much cash was spent on non-current assets in the period?

(8) 20X0 20X1

Rs Rs
Loan 2,500 1,000

Advanced Financial Accounting and Corporate Reporting (Study Text) 411

 The loan is denominated in an overseas currency, and a loss of Rs 200 has
been recorded on the retranslation.

Required:
How much cash was paid?

The group had the following working capital:

(9) 20X0 2.0X1

Rs Rs
Inventory 200 100
Receivables 200 300
Trade payables 200 500

During the period the group acquired a subsidiary with the following working
capital.

Inventory 50
Receivables 200
Trade Payables 40

During the period the group disposed of a subsidiary with the following
working capital.

Inventory 25
Receivables 45
Trade Payables 20

During the period the group experienced the following exchange rate
differences.

Inventory 11
Gain
Receivables 21
Gain
Trade payables 31
Loss

Required:
Calculate the extract from the statement of cash flows for working capital.

Advanced Financial Accounting and Corporate Reporting (Study Text) 412

2. AH Group
Extracts from the consolidated financial statements of the AH Group for the
year ended 30 June 20X5 are given below:

AH Group: Consolidated statement of comprehensive income for the

year ended 30 June 20X5

20X5
Rs 000
Revenue 85,000
Cost of sales (60,750)
–––––––
Gross profit 24,250
Operating expenses (5,650)
–––––––
Operating Profit 18,600
Finance cost (1,400)
During the period the group acquired a subsidiary with the following working
capital.

Inventory 50
Receivables 200
Trade Payables 40

During the period the group disposed of a subsidiary with the following
working capital.

Inventory 25
Receivables 45
Trade Payables 20

During the period the group experienced the following exchange rate
differences.

Inventory 11 Gain
Receivables 21 Gain
Trade payables 31 Loss

Required:
Calculate the extract from the statement of cash flows for working capital.

Advanced Financial Accounting and Corporate Reporting (Study Text) 413

 AH Group: Consolidated statement of comprehensive income for the year
ended 30 June 20X5

20X5 20X4
ASSETS Rs 000 Rs 000 Rs 000 Rs 000
Non-current assets
Property, plant and equipment 50,600 44,050
Goodwill (note 3) 5,910 4,160
–––––– ––––––
56,510 48,210
Current assets
Inventories 33,500 28,750
Trade receivables 27,130 26,300
Cash 1,870 3,900
–––––– ––––––
62,500 58,950
––––––– –––––––
119,010 107,160
––––––– –––––––
Equity and liabilities
Equity shares @ Rs 10 each 20,000 18,000
Share premium 12,000 10,000
Retained earnings 24,135 18,340
–––––– ––––––
56,135 46,340
Non-controlling interest 3,875 1,920
––––––– ––––––
Total equity 60,010 48,260
Non-current liabilities
Interest bearing borrowings 18,200 19,200

Current liabilities
Trade payables 33,340 32,810
Interest payables 1,360 1,440
Tax 6,100 5,450
–––––– ––––––
40,800 39,700
––––––– –––––––
119,010 107,160

Advanced Financial Accounting and Corporate Reporting (Study Text) 414

 Notes:
(1) Several years ago, AH acquired 80% of the issued equity shares of its
subsidiary, BI. On 1 January 20X5, AH acquired 75% of the issued
equity shares of CJ in exchange for a fresh issue of 0.2 million of its
own Rs 10 equity shares (issued at a premium of Rs 10 each) and Rs
2 million in cash. The net assets of CJ at the date of acquisition were
assessed as having the following fair values:

Rs 000
Property, plant and equipment 4,200
Inventories 1,650
Receivables 1,300
Cash 50
Trade payables (1,950)
Tax (250)
–––––
5,000

(2) During the year, AH disposed of a non-current asset of property for

proceeds of Rs 2,250,000. The carrying value of the asset at the date
of disposal was Rs 1,000,000. There were no other disposals of non-
current assets. Depreciation of Rs 7,950,000 was charged against
consolidated profits for the year.

(3) Goodwill on acquisition relates to the acquisition of two subsidiaries.

Entity BI was acquired many years ago, and goodwill relating to this
acquisition was calculated on a proportion of net assets basis. Goodwill
relating to the acquisition of entity CJ during the year was calculated on
the full goodwill basis. On 1 January 20X5 when CJ was acquired, the
fair value of the non-controlling interest was Rs 1,750,000. Any
impairment of goodwill during the year was accounted for within cost of
sales.

Required:
Prepare the consolidated statement of cash flows of the AH Group for the
financial year ended 30 June 20X5 in the form required by IAS 7 Statements
of Cash Flows, and using the indirect method. Notes to the statement of cash
flows are NOT required, but full workings should be shown.

Advanced Financial Accounting and Corporate Reporting (Study Text) 415

3. Cash Ltd

Extract from the consolidated financial statements of Cash Ltd are given
below:

20X5 20X4
Rs 000 Rs 000 Rs 000 Rs 000
Non-current assets
Property, plant and equipment 5,900 4,400
Goodwill 85 130
Investment in associate 170 140
–––––– ––––––
6,155 4,670
Current assets
Inventories 1,000 930
Receivables 1,340 1,140
Short term deposits 35 20
Cash at bank 180 120
–––––– ––––––
2,555 2,210
–––––– ––––––
8,710 6,880
–––––– ––––––
Equity and liabilities
Equity capital 2,000 1,500
Share premium 300 –
Other components of equity 50 –
Retained earnings 3,400 3,320
–––––– ––––––
5,750 4,820
Non-controlling interests 75 175
–––––– ––––––
Total equity 5,825 4,995
Non-current liabilities
Interest bearing borrowings 1,400 1,000
Obligations under finance leases 210 45
Deferred tax 340 305
–––––– ––––––
1,950 1,350

Advanced Financial Accounting and Corporate Reporting (Study Text) 416

 Current liabilities
Trade payables 885 495
Accrued interest 7 9
Income tax 28 21
Obligations under finance leases 15 10
–––––– ––––––
935 535
–––––– ––––––
8,710 6,880

Consolidated statement of comprehensive income for the year ended 31

March 20X5
Rs 000
Revenue 875
Cost of sales (440)
–––––
Gross profit 435
Other operating expenses (210)
–––––
Profit from operations 225
Finance cost (100)
Gain on sale of subsidiary 30
Share of associate’s profit 38
–––––
Profit before tax 193
Tax (48)
–––––
Profit for the year 145

Other comprehensive income

Gains on land revaluation 50
–––––
Total comprehensive income for the year 195

Profit attributable to:

Equity holders of the parent 120
Non-controlling interests 25
–––––
145
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 417

 Total comprehensive income attributable to:
Equity holders of the parent 170
Non-controlling interests 25
–––––
195

Notes:

Dividends
Cash Ltd paid a dividend of Rs 40,000 during the year.

Property, plant and equipment

The following transactions took place during the year:

• Land was revalued upwards by Rs 50,000 on 1st April 20X4.

• During the year, depreciation of Rs 80,000 was charged in the

statement of comprehensive income.

• Additions include Rs 300,000 acquired under finance leases.

• A property was disposed of during the year for Rs 250,000 cash. Its
carrying amount was Rs 295,000 at the date of disposal. The loss on
disposal has been included within cost of sales.

Gain on sale of subsidiary

On 1 January 20X5, Cash Ltd disposed of a 80% owned subsidiary for Rs
390,000 in cash. The subsidiary had the following net assets at the date of
disposal:

Rs 000
Property, plant and equipment 635
Inventory 20
Receivables 45
Cash 35
Payables (130)
Income tax (5)
Interest-bearing borrowings (200)
––––
400

Advanced Financial Accounting and Corporate Reporting (Study Text) 418

 This subsidiary had been acquired on 1 January 20X1 for a cash payment of
Rs 220,000 when its net assets had a fair value of Rs 225,000 and the non-
controlling interest had a fair value of Rs 50,000.

Goodwill
The Cash Ltd Group uses the full goodwill method to calculate goodwill. No
impairments have arisen during the year.

Required:
Prepare the consolidated statement of cash flows of the Cash Ltd group for
the year ended 31 March 20X5 in the form required by IAS 7 Statement of
cash flows. Show your workings clearly.

4. Border Ltd
Set out below is a summary of the accounts of Border Ltd, a public limited
company, for the year ended 31 December 20X7.

Consolidated statement of comprehensive income for the year ended 31

December 20X7
Rs 000
Revenue 44,754
Cost of sales and other expenses (39,613)
Income from associates 30
Finance cost (305)
––––––
Profit before tax 4,866
Tax: (2,038)
––––––
Net profit for the period 2,828
––––––
Attributable to:
Owners of the parent 2,805
Non-controlling interests 23
––––––
2,828
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 419

 Statement of other comprehensive income
Profit for the year 2,828
Exchange difference on translation of foreign operations (note 5) 302
––––––
Total comprehensive income 3,130
––––––
Summary of changes in equity for the year
Equity b/f 14,164

Profit for year 2,805

Dividends paid (445)
Exchange differences 302
–––––
Equity c/f 16,826

Consolidated statements of financial position at 31 December

20X7 20X6
Note Rs 000 Rs 000 Rs 000 Rs 000
Non-current assets
Intangible assets – goodwill 500 –
Tangible assets (1) 11,157 8,985
Investment in associate 300 280
–––––– –––––
11,957 9,265
Current assets
Inventories 9,749 7,624
Receivables 5,354 4,420
Short term investments 1,543 741
Cash at bank and in hand 1,013 17,659 394 13,179
––––– –––––– ––––– –––––
29,616 22,444
–––––– –––––
Equity and liabilities Rs 000 Rs 000
Equity share capital @ Rs 10 1,997 1,997
Share premium 5,808 5,808
Retained earnings 9,021 6,359
–––––– ––––––
16,826 14,164
Non-controlling interest 170 17
–––––– ––––––
Total equity 16,996 14,181

Advanced Financial Accounting and Corporate Reporting (Study Text) 420

 Non-current liabilities:
Loans 2,102 1,682
Provisions (3) 1,290 935
Current liabilities: (2) 9,228 5,646
–––––– ––––––
29,616 22,444
Notes to the accounts

(1) Tangible assets

Non-current asset movements included the following:

Disposals at carrying amount 305

Proceeds from asset sales 854
Depreciation provided for the year 907

(2) Current liabilities

20X7 20X6
Rs 000 ‘000’
Bank overdrafts 1,228 91
Trade payables 4,278 2,989
Tax 3,722 2,566
–––––– ––––––
9,228 5,646

(3) Provisions
Pensions Deferred Total
taxation
Rs 000 Rs 000 Rs 000
At 31 December 20X6 246 689 935
Exchange rate adjustment 29 – 29
Increase in provision 460 – 460
Decrease in provision – (134) (134)
––––– ––––– –––––
At 31 December 20X7 735 555 1,290

Advanced Financial Accounting and Corporate Reporting (Study Text) 421

 (4) LAS Ltd
During the year, the company acquired 82% of the issued equity capital
of LAS Ltd for a cash consideration of Rs 1,268,000. The fair values of
the assets of LAS Ltd were as follows:

Rs 000
Non-current assets 208
Inventories 612
Trade receivables 500
Cash in hand 232
Trade payables (407)
Debenture loans (312)
–––––
833

(5) Exchange gains on translating the financial statements of a wholly-

owned subsidiary have been taken to equity and comprise differences
on the retranslation of the following:

Rs 000
Non-current assets 138
Pensions (29)
Inventories 116
Trade receivables 286
Trade payables (209)
_____
302

(6) Non-controlling interest

The non-controlling interest is valued using the proportion of net assets

method.

Required:
Prepare a statement of cash flows for the year ended 31 December 20X7.

Advanced Financial Accounting and Corporate Reporting (Study Text) 422

Answers

1.

(1) Non-current assets (CV)

Rs Rs
Balance b/f 100 Depreciation 20
Revaluation 60 Disposals 15
Additions (bal fig) 125 Balance c/f 250
–––– ––––
285 285

Cash additions = 125 – finance lease additions of 30 = 95

(2) Tax

Rs Rs
Tax paid (bal fig) 110 Balances b/fwd
DT 50
Balances c/fwd CT 100
DT 100
CT 120 Statement of comprehensive 180
income
–––– ––––
330 330

(3) Non-controlling interest

Rs Rs
Balance b/f 440
Cash dividend paid (bal. fig) 100 Statement of comprehensive 500
Balance c/f 840 income
–––– ––––
940 940

(4) Non-controlling interest

Rs Rs
Balance b/f 500
Cash dividend paid (bal. fig) 250 Statement of comprehensive 600
Balance c/f 850 income
––––– –––––
1,100 1,100

Advanced Financial Accounting and Corporate Reporting (Study Text) 423

(5) Associate
Rs Rs
Balance b/f 200 Cash received (bal fig) 450
Statement of comprehensive income 750 Balance c/f 500
–––– ––––
950 950

(6) Associate
Rs Rs
Balance b/f 600
Statement of comprehensive income 4,000 Cash received (bal fig) 1,900
Revaluation 500 Balance c/f 3,200
––––– –––––
5,100 5,100

(7) Non-current assets (CV)

Rs Rs
Balance b/f 150 Depreciation 50
New subsidiary 200
Cash additions (bal fig) 200 Balance c/f 500
–––– ––––
550 550

(8) Loan
Rs Rs
Balance b/f 2,500
Cash paid (bal fig) 1,700 Exchange loss 200
Balance c/f 1,000
––––– –––––
2,700 2,700

(9) Rs
Movement in inventory (W1) 136
Movement in receivables (W2) 76
Movement in payables (W3) 249

Advanced Financial Accounting and Corporate Reporting (Study Text) 424

(W1) Movement in inventory

Rs Rs
B/f balance 200 C/f balance 100
Disposal (25) Acquisition (50)
Exchange gain (11)
–––– ––––
Revised b/f 175 Revised c/f 39

Movement therefore a decrease of 136

(W2) Movement of receivables

Rs Rs
B/f balance 200 C/f balance 300
Disposal (45) Acquisition (200)
Exchange gain (21)
–––– ––––
Revised b/f 155 Revised c/f 79

Movement therefore a decrease of 76.

(W3) Movement of payables

Rs Rs
B/f balance 200 C/f balance 500
Disposal (20) Acquisition (40)
Exchange loss (31)
–––– ––––
Revised b/f 180 Revised c/f 429

Movement therefore an increase of 249

Advanced Financial Accounting and Corporate Reporting (Study Text) 425

2. AH Group

Consolidated statement of cash flows for the year ended 30 June 20X5
Rs 000 Rs 000
Operating activities
Profit before tax 18,450
Adjustment
Less: gain on disposal of property (1,250)
Add: finance cost 1,400
Adjustment for non-cash items dealt with in arriving at operating profit:
Depreciation 7,950
Decrease in trade and other receivables (27,130 – 26,300 – 1,300) 470
Increase in inventories (33,500 – 28,750 – 1,650) (3,100)
Decrease in trade payables (33,340 – 32,810 – 1,950) (1,420)

Goodwill impaired (W4) 1,000

––––––
-
Cash generated from operations 23,500
Interest paid (W1) (1,480)
Income taxes paid (W2) (5,850)
––––––
Net cash from operating activities 16,170

nvesting activities
Acquisition of subsidiary net of cash acquired (2,000 – 50)(1,950)
Purchase of property, plant, and equipment (W3) (11,300)
Proceeds from sale of property 2,250
––––––
Net cash used in investing activities (11,000)

Financing activities
Repayment of long term borrowings (18,200 – 19,200) (1,000)
Dividend paid by parent (W7) (6,000)
Dividends paid to NCI (W6) (200)
–––––
Net cash used in financing activities (7,200)
––––––
Net decrease in cash and cash equivalents (2,030)
Cash and cash equivalents at 1 July 20X4 3,900
––––––
Cash and cash equivalents at 30 June 20X5 1,870

Advanced Financial Accounting and Corporate Reporting (Study Text) 426

Workings:

(W1)
Interest paid
Rs 000 Rs 000
Cash paid (balancing figure) 1,480 Balance b/d 1,440
Balance c/d 1,360 Statement of
comprehensive income 1,400
––––– –––––
2,840 2,840

(W2)
Income taxes paid
Rs 000 Rs 000
Cash paid (balancing figure) 5,850 Balance b/d 5,450
Statement of comprehensive
income 6250
Balance c/d 6,100 New subsidiary 250
––––– –––––
11,950 11,950

(W3)
Property, plant and equipment
Rs 000 Rs 000
Balance b/d 44,050 Depreciation 7,950
New subsidiary 4,200 Disposals 1,000
Additions (balancing figure) 11,300 Balance c/d 50,600
––––– –––––
59,550 59,550

(W4) Goodwill re acquisition during year

Rs 000
Fair value of shares issued Equity capital – nominal value 2,000
Share premium 2,000
Cash paid 2,000
–––––
6,000
Fair value of NCI per question 1,750
–––––
7,750
Fair value of net assets at acquisition per question 5,000
–––––
Full goodwill at acquisition 2,750

Advanced Financial Accounting and Corporate Reporting (Study Text) 427

(W5)

Goodwill
Rs 000 Rs 000
Balance b/d 4,160 Impaired in year (bal fig) 1,000
Full goodwill on subsidiary acquired (W4) 2,750 Balance c/d 5,910
––––– –––––
6,910 6,910

(W6)
Non-controlling interest
Rs 000 Rs 000
Dividend paid (balancing figure) 200 Balance b/d 1,920
NCI at fair value re CJ
acquired 1,750
Balance c/d 3,875 Statement of comprehensive
income 405
––––– –––––
4,075 4,075

(W7)
Retained earnings
Rs 000 Rs 000
Dividend paid (balancing figure) 6,000 Balance b/d 18,340
Balance c/d 24,135 Statement of comprehensive
income 11,795
––––– –––––
30,135 30,135

3. Cash Ltd
Consolidated statement of cash flows for the year ended 31 March 20X5

Rs 000 Rs 000
Cash flows from operating activities
Profit before tax 193
Gain on sale of subsidiary (30)
Share of associate’s profit (38)
Finance costs 100
Adjust for non-cash items dealt with in arriving at operating profit:
Depreciation 80
Loss on disposal of property (250 – 295) 45
–––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 428

Operating profit before working capital changes 350
Increase in inventory (1,000 – (930 – 20)) (90)
Increase in receivables (1,340 – (1,140 – 45)) (245)
Increase in payables (885 – (495 – 130)) 520
–––––
535
Finance costs paid (W2) (102)
Tax paid (W3) (1)
–––––
432
Cash flows from investing activities
Sale of property 250
Purchases of property, plant and equipment (W4) (2,160)
Dividends received from associate (W5) 8
Proceeds from sale of subsidiary, net of cash balances (390 – 35) 355
–––––
(1,547)
Cash flows from financing activities
Repayments of finance leases (W6) (130)
Cash raised from interest bearing borrowings (W7) 600
Issue of shares (500 + 300) 800
Dividends paid to equity shareholders of parent (40)
Dividends paid to non-controlling interests (W8) (40)
–––––

1,190
–––––
Increase in cash and cash equivalents 75
Opening cash and cash equivalents (120 + 20) 140
–––––
Closing cash and cash equivalents (180 + 35) 215
–––––

(1) Goodwill
Goodwill on acquisition of subsidiary disposed of during the year
Rs 000
Fair value of consideration paid 220
Fair value of NCI 50
––––
270
Less: Fair value of net assets at acquisition (225)
––––
Full goodwill at acquisition 45
––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 429

 Goodwill
Rs 000 Rs 000
Bal b/d 130 Disposal of sub (as above) 45
Bal c/d 85
–––– ––––
130 130

(2) Finance
Finance

Rs 000 Rs 000
Cash (bal fig) 102 Bal b/d 9
Bal b/d 7 SCI 100
–––– ––––
109 109

(3) Tax paid

Tax
Bal b/d – IT 21
Bal b/d – DT 305
Disposal of sub 5 SCI - group 48
Tax paid (bal fig) 1
Bal c/d – IT 28
Bal c/d – DT 340
–––– ––––
374 374

(4) Purchase of non-current assets

Property, plant and equipment

Rs Rs
Bal b/d 4,400
Revaluation 50 Depreciation 80
Finance leases (W6) 300 Disposal –property 295
Cash (bal fig) 2,160 Disposal – sub 635
Bal c/d 5,900
––––– –––––
6,910 6,910

Advanced Financial Accounting and Corporate Reporting (Study Text) 430

(5) Dividend from associate

Associates

Rs Rs
Bal b/d 140
Share of profit for the year 38 Dividend received (bal: fig) 8
Bal c/d 170
–––– ––––
178 178

(6) Repayment of finance leases

Finance leases
Rs Rs
Bal b/d (10 + 45) 55
New leases (W4) 300
Repayments (bal fig) 130
Bal c/d (15 + 210) 225
–––– ––––
355 355

(7) Cash raised from borrowings

Interest bearing borrowings

Rs Rs
Bal b/d 1,000
Disposal of sub 200 Cash (bal fig) 600
Bal b/d 1,400
––––– –––––
1,600 1,600

(8) Dividend paid to non-controlling interests

Non-controlling interests
Rs Rs
Bal b/d 175
NCI in sub at disposal date (W9) 85 Share of profits 25
Dividends paid (bal fig) 40
Bal c/d 75
–––– ––––
200 200

Advanced Financial Accounting and Corporate Reporting (Study Text) 431

(W9) NCI in sub at disposal date

FV of NCI at acquisition 50
NCI share of increase in post-acquisition retained earnings (20% x (400 –225)) 35
–––
85

4. Border Ltd

Statement of cash flows for the year ended 31 December 20X7

Rs 000 Rs 000
Operating activities
Profit before tax 4,866
Interest payable 305
Income from associate (30)
–––––
Operating profit 5,141
Non-cash items
Depreciation 907
Goodwill (W7) 85
Gain on disposal of assets (W1) (549)
Increase in pension provision 460
–––––
6,044
Change in working capital
Increase in inventory
(9,749 – 7,624 – 612 acq – 116 ex diff) (1,397)
Increase in receivables
(5,354 – 4,420 – 500 acq – 286 ex diff) (148)

Increase in payables
(4,278 – 2,989 – 407 acq – 209 ex diff) 673
–––––
5,172
Interest paid (305)
Tax paid (W2) (1,016)
––––– –––––
3,851

Advanced Financial Accounting and Corporate Reporting (Study Text) 432

Investing activities
Purchase of non-current assets (W3) (3,038)
Proceeds on disposal 854
Cash consideration paid on acquisition of subsidiary,
net of cash acquired (1,268 – 232) (1,036)
Dividend received from associate (W4) 10
––––– –––––
(3,210)
Financing activities
Dividends paid (445)
Dividends paid to NCI (W6) (20)
Proceeds from debt issue (W5) 108
––––– –––––
(357)
–––––
Change in cash and cash equivalents 284
Opening cash and cash equivalents (394 + 741 – 91) 1,044
–––––
Closing cash and cash equivalents (1,013 + 1,543 – 1,228) 1,328

Workings

W-1 Proceeds of disposal of NCA

Rs
Sales proceeds 854
CV (305)
––––
Profit on disposal 549

(W2)
Tax
Rs Rs
Cash 1,016 Balance b/f–CT 2,566
Balance c/f–CT 3,722 Balance b/f–DT 689
Balance c/f–DT 555 I/S 2,038
––––– –––––
5,293 5,293

Advanced Financial Accounting and Corporate Reporting (Study Text) 433

(W3)
Non-current assets
Rs Rs
Balance b/f 8,985 Depreciation 907
Exchange gain 138 Disposal 305
Acquisition 208 Balance c/f 11,157
Cash 3,038
––––– –––––
12,369 12,369

(W4)
Dividends from associates
Rs Rs
Balance b/f 280 Cash 10
Profit 30 Balance c/f 300
–––– ––––
310 310

(W5)
Debentures
Rs Rs
Balance c/f 2,102 Balance b/f 1,682
Acquisition 312
Cash 108
––––– –––––
2,102 2,102

(W6)
Non-controlling interest
Rs Rs
Cash 20 Balance b/f 17
Balance c/f 170 I/S 23
Acquisition (18% × 833) 150
–––– ––––
190 190

Advanced Financial Accounting and Corporate Reporting (Study Text) 434

(W7) Goodwill – proportionate basis
Rs
Cost of investment 1,268
CV of NCI at acquisition (18% × 833) 150
–––––
1,418
FV of net assets at acquisition (833)
–––––
Goodwill at acquisition 585
Balance b/fwd nil
–––––
585
Amount written off (Bal fig) (85)
–––––
Bal c/fwd per closing group SOFP 500

Advanced Financial Accounting and Corporate Reporting (Study Text) 435

Advanced Financial Accounting and Corporate Reporting (Study Text) 436
RATIO AND TREND ANALYSIS
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

• Define and compute relevant financial ratios.

• Explain what aspects of performance specific ratios are intended to assess,

analyse and interpret ratios to give an assessment of an entity’s performance and
financial position in comparison with an entity’s previous period financial
statements.

• Analyse and interpret ratios to give an assessment of an entity’s performance and

financial position in comparison with another similar entity for the same period.

• Analyse and interpret ratios to give an assessment of an entity’s performance and

financial position in comparison with industry average ratios.

• Interpret an entity’s financial statements to give advice from the perspective of

different stakeholders.

• Explain the limitations in the use of ratio analysis for assessing corporate
performance.

Advanced Financial Accounting and Corporate Reporting (Study Text) 437

1 Interpreting Financial Information

1.1 Introduction
Financial statements on their own are of limited use. In this chapter we will
consider how to interpret them and gain additional useful information from
them.

Users of financial statements

When interpreting financial statements it is important to ascertain who are the
users of accounts and what information they need:

• shareholders and potential investors – primarily concerned with

receiving an adequate return on their investment, but it must at least
provide security and liquidity
• suppliers and lenders – concerned with the security of their debt or
loan
• management – concerned with the trend and level of profits, since this
is the main measure of their success.

Other potential users include:

• bank managers
• financial institutions
• employees
• professional advisors to investors
• financial journalists and commentators.

1.2 Ratio analysis

A number of ratios can be calculated to help interpret the financial statements.

In an examination question you will not have time to calculate all of the ratios
presented in this chapter so you must make a choice:

• choose those relevant to the situation

• choose those relevant to the party you are analysing for
• make use of any additional information given in question to help your
choice.

Further information needs

Analysts will, in practice, be limited in the analysis that can be performed by
the amount of information available. They are unlikely to have access to all
the facts which are available to a company’s management.

Advanced Financial Accounting and Corporate Reporting (Study Text) 438

 In the examination the information which can be provided about a company in
any one question will be limited.

1.3 Commenting on ratios

Ratios are of limited use on their own, thus most of the marks in an
examination question will be available for sensible, well-explained and
accurate comments on the key ratios.
If you doubt that you have anything to say, the following points should serve
as a useful checklist:

• What does the ratio literally mean?

• What does a change in the ratio mean?
• What is the norm?
• What are the limitations of the ratio?

2 Profitability Ratios

2.1 Gross profit margin

Gross profit margin or percentage is:

Gross profit
–––––––––––– x 100%
Sales revenue

This is the margin that the company makes on its sales, and would be
expected to remain reasonably constant.

Since the ratio is affected by only a small number of variables, a change may
be traced to a change in:

• selling prices – normally deliberate though sometimes unavoidable,

e.g. because of increased competition
• sales mix – often deliberate
• purchase cost – including carriage or discounts
• production cost – materials, labour or production overheads
• inventory – errors in counting, valuing or cutoff, inventory shortages.

Comparing gross profit margin over time

If gross profit has not increased in line with sales revenue, you need to
establish why not. Is the discrepancy due to:

• increased ‘purchase’ costs: if so, are the costs under the company’s
control (i.e. does the company manufacture the goods sold)?

Advanced Financial Accounting and Corporate Reporting (Study Text) 439

 • inventory write-offs (likely where the company operates in a volatile
marketplace, such as fashion retail)? Or

• other costs being allocated to cost of sales – for example, research and
development (R&D) expenditure?

Inter-company comparison of gross profit margin

Intercompany comparison of margins can be very useful but it is
especially important to look at businesses within the same sector. For
example, food retailing is able to support low margins because of the
high volume of sales. A manufacturing industry would usually need
higher margins to offset lower sales volumes

Low margins usually suggest poor performance but may be due to

expansion costs (launching a new product) or trying to increase market
share. Lower margins than usual suggest scope for improvement.

Above-average margins are usually a sign of good management

although unusually high margins may make the competition keen to
join in and enjoy the ‘rich pickings’

2.2 Operating profit margin (net profit)

The operating profit margin or net profit margin is calculated as:

PBIT
–––––––––––– x 100%
Sales revenue

Any changes in operating profit margin should be considered further:

• Are they in line with changes in gross profit margin?

• Are they in line with changes in sales revenue?
• As many costs are fixed they need not necessarily increase/decrease
with a change in revenue.
• Look for individual cost categories that have increased/decreased
significantly.

This is affected by more factors than the gross profit margin but it is equally
useful and if the company does not disclose a cost of sales it may be used on
its own in lieu of the gross profit percentage.

One of the many factors affecting the trading profit margin is depreciation,
which is open to considerable subjective judgment. Intercompany

Advanced Financial Accounting and Corporate Reporting (Study Text) 440

 comparisons should be made after suitable adjustments to align accounting
policies.

By the time you have reached operating (net) profit, there are many more
factors to consider. If you are provided with a breakdown of expenses you can
use this for further line-by-line comparisons. Bear in mind that:

• some costs are fixed or semi-fixed (e.g. property costs) and therefore
not expected to change in line with revenue

• other costs are variable (e.g. packing and distribution, and commission).

3 ROCE

Profit
ROCE = –––––––––––– x 100%
Capital employed

Profit is measured as:

• operating (trading) profit, or
• the PBIT, i.e. the profit before taking account of any returns paid to the
providers of long-term finance.

Capital employed is measured as:

• equity, plus interest-bearing finance, i.e. the long-term finance
supporting the business.

ROCE for the current year should be compared to:

1. the prior year ROCE
2. a target ROCE
3. the cost of borrowing
4. other companies’ ROCE in the same industry.

Once calculated, ROCE should be compared with:

1. previous years’ figures – provided there have been no changes in

accounting policies, or suitable adjustments have been made to
facilitate comparison (note, however that the effect of not replacing
noncurrent assets is that their value will decrease and ROCE will
increase)

2. the company’s target ROCE – where the company’s management has

determined a target return as part of its budget procedure, consistent

Advanced Financial Accounting and Corporate Reporting (Study Text) 441

 failure by a part of the business to meet the target may make it a target
for disposal

1. the cost of borrowings – if the cost of borrowing is say 10% and ROCE
7%, then further borrowings will reduce EPS unless the extra money
can be used in areas where the ROCE is higher than the cost of
borrowings

2. other companies in same industry – care is required in interpretation,

because of the possibility, noted above, of different accounting policies,
ages of plant, etc.

The ratio also shows how efficiently a business is using its resources. If
the return is very low, the business may be better off realising its
assets and investing the proceeds in a high interest bank account!
(This may sound extreme, but should be considered particularly for a
small, unprofitable business with valuable assets such as property.)

Furthermore, a low return can easily become a loss if the business

suffers a downturn.

Further points

• Treatment of associates and investments: where the profit excludes

investment income, the statement of financial position carrying
amounts for associates and investments should be excluded from the
capital employed.

• This gives an accurate measure of trading performance. If associates

and investments are not excluded, the overall profit figure should
include income from investments and associates.

• Large cash balances are not contributing to profits and some analysts
therefore deduct them from capital employed (to compare operating
profits with operating assets). However, it is usually acceptable not to
make this adjustment as ROCE is a performance measure and
management have decided to operate with that large balance.

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4 Net Asset Turnover

4.1 The net asset turnover is:

Sales revenue
–––––––––––––––––––––– = times pa
Capital employed (net assets)

It measures management’s efficiency in generating revenue from the net

assets at its disposal:

• the higher, the more efficient

Note that this can be further subdivided into:

• noncurrent asset turnover (by making noncurrent assets the
denominator) and
• working capital turnover (by making net current assets the denominator).

4.2 Relationship between ratios

ROCE can be subdivided into profit margin and asset turnover.

Profit margin × Asset turnover = ROCE

PBIT Sales revenue PBIT

–––––––––––– × –––––––––––– = ––––––––––––
Sales revenue Capital employed Capital employed

Profit margin is often seen as an indication of the quality of products or

services supplied (top-of-range products usually have higher margins).

Asset turnover is often seen as a measure of how intensively the assets are
worked.

A tradeoff may exist between margin and asset turnover.

• Low-margin businesses (e.g. food retailers) usually have a high asset
turnover.

• Capital-intensive manufacturing industries usually have relatively low

asset turnover but higher margins (e.g. electrical equipment
manufacturers).

Advanced Financial Accounting and Corporate Reporting (Study Text) 443

 Two completely different strategies can achieve the same ROCE.
• Sell goods at a high profit margin with sales volume remaining low (e.g.
designer dress shop).

• Sell goods at a low profit margin with very high sales volume (e.g.
discount clothes store).

5 Liquidity and working capital ratios

5.1 Working capital ratios

There are two ratios used to measure overall working capital:

• the current ratio

• the quick or acid test ratio.

5.2 Current ratio

Current or working capital ratio:

Current assets
–––––––––––– : 1
Current liabilities

The current ratio measures the adequacy of current assets to meet the
liabilities as they fall due.

A high or increasing figure may appear safe but should be regarded with
suspicion as it may be due to:

• high levels of inventory and receivables (check working capital

management ratios)

• high cash levels which could be put to better use (e.g. by investing in
non-current assets).

The current ratio measures the adequacy of current assets to meet the
company’s short-term liabilities. It reflects whether the company is in a
position to meet its liabilities as they fall due.

Traditionally, a current ratio of 2:1 or higher was regarded as appropriate for

most businesses to maintain creditworthiness. However, more recently a
figure of 1.5:1 is regarded as the norm.

Advanced Financial Accounting and Corporate Reporting (Study Text) 444

 The current ratio should be looked at in the light of what is normal for the
business. For example, supermarkets tend to have low current ratios
because:

• there are few trade receivables

• there is a high level of trade payables
• there is usually very tight cash control, to fund investment in developing
new sites and improving sites.

It is also worth considering:

• availability of further finance, e.g. is the overdraft at the limit? – very
often this information is highly relevant but is not disclosed in the
accounts

• seasonal nature of the business – one way of doing this is to compare

the interest charges in the income statement with the overdraft and
other loans in the statement of financial position; if the interest rate
appears abnormally high, this is probably because the company has
had higher levels of borrowings during the year

• long-term liabilities, when they fall due and how will they be financed

• nature of the inventory – where inventories are slow moving, the quick
ratio probably provides a better indicator of short-term liquidity.

5.3 Quick ratio

Quick ratio (also known as the liquidity and acid test) ratio:

Current assets – Inventory

Quick ratio = –––––––––––––––––––– : 1
Current liabilities

The quick ratio is also known as the acid test ratio because by eliminating
inventory from current assets it provides the acid test of whether the company
has sufficient liquid resources (receivables and cash) to settle its liabilities.

Normal levels for the quick ratio range from 1:1 to 0.7:1.
Like the current ratio it is relevant to consider the nature of the business
(again supermarkets have very low quick ratios).

Sometimes the quick ratio is calculated on the basis of a six-week timeframe

(i.e. the quick assets are those which will turn into cash in six weeks; quick

Advanced Financial Accounting and Corporate Reporting (Study Text) 445

 liabilities are those which fall due for payment within six weeks). This basis
would usually include the following in quick assets:
• bank, cash and short-term investments
• trade receivables.

thus excluding prepayments and inventory

Quick liabilities would usually include:

• bank overdraft which is repayable on demand
• trade payables, tax and social security
• dividends.

Income tax liabilities may be excluded.

When interpreting the quick ratio, care should be taken over the status of the
bank overdraft. A company with a low quick ratio may actually have no
problem in paying its amounts due if sufficient overall overdraft facilities are
available

5.4 Inventory turnover period

Inventory turnover period is defined as:

Inventory
–––––––– × 365 days
COS
An alternative is to express the inventory turnover period as a number of times:

Cost of sales
––––––––––– = times pa
Inventory

An increasing number of days (or a diminishing multiple) implies that inventory

is turning over less quickly which is regarded as a bad sign as it may indicate:

• lack of demand for the goods

• poor inventory control
• an increase in costs (storage, obsolescence, insurance, damage).

However, it may not necessarily be bad where management are:

• buying inventory in larger quantities to take advantage of trade

discounts, or
• increasing inventory levels to avoid stock-outs

Advanced Financial Accounting and Corporate Reporting (Study Text) 446

 Inventory Days
Year-end inventory is normally used in the calculation of inventory turnover.
An average (based on the average of year-start and yearend inventories) may
be used to have a smoothing effect, although this may dampen the effect of a
major change in the period.

Inventory turnover ratios vary enormously with the nature of the business. For
example, a fishmonger selling fresh fish would have an inventory turnover
period of 12 days, whereas a building contractor may have an inventory
turnover period of 200 days. Manufacturing companies may have an inventory
turnover ratio of 60100 days; this period is likely to increase as the goods
made become larger and more complex.

For large and complex items (e.g. rolling stock or aircraft) there may be sharp
fluctuations in inventory turnover according to whether delivery took place just
before or just after the year end.

A manufacturer should take into consideration:

• reliability of suppliers: if the supplier is unreliable it is prudent to hold

more raw materials
• demand: if demand is erratic it is prudent to hold more finished goods.

5.5 Receivables collection period

This is normally expressed as a number of days:

Trade receivables
–––––––––––– × 365 days
Credit sales

The collection period should be compared with:

• the stated credit policy
• previous period figures

Increasing accounts receivables collection period is usually a bad sign

suggesting lack of proper credit control which may lead to irrecoverable debts.

It may, however, be due to:

• a deliberate policy to attract more trade, or
• a major new customer being allowed different terms.

Falling receivables days is usually a good sign, though it could indicate that
the company is suffering a cash shortage.

Advanced Financial Accounting and Corporate Reporting (Study Text) 447

 Receivable Days
The trade receivables used may be a year-end figure or the average for the
year. Where an average is used to calculate the number of days, the ratio is
the average number of days’ credit taken by customers.

For many businesses total sales revenue can safely be used, because cash
sales will be insignificant. But cash-based businesses like supermarkets make
the substantial majority of their sales for cash, so the receivables period
should be calculated by reference to credit sales only.

The result should be compared with the stated credit policy. A period of 30
days or ‘at the end of the month following delivery’ are common credit terms.

The receivables days ratio can be distorted by:

• using yearend figures which do not represent average receivables
• factoring of accounts receivables which results in very low trade
receivables
• sales on unusually long credit terms to some customers.

5.6 Payables payment period

This is usually expressed as:

Trade payables
–––––––––––– × 365 days
Credit purchases

This represents the credit period taken by the company from its suppliers.

The ratio is always compared to previous years:

• A long credit period may be good as it represents a source of free
finance.

• A long credit period may indicate that the company is unable to pay
more quickly because of liquidity problems.

If the credit period is long:

• the company may develop a poor reputation as a slow payer and may
not be able to find new suppliers

• existing suppliers may decide to discontinue supplies

• the company may be losing out on worthwhile cash discount

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 In most sets of financial statements (in practice and in examinations) the
figure for purchases will not be available therefore cost of sales is normally
used as an approximation in the calculation of the accounts payable payment
period.

5.7 Overtrading
Overtrading arises where a company expands its sales revenue fairly rapidly
without securing additional long-term capital adequate for its needs. The
symptoms of overtrading are:

• inventory increasing, possibly more than proportionately to revenue

• receivables increasing, possibly more than proportionately to revenue
• cash and liquid assets declining at a fairly alarming rate
• trade payables increasing rapidly.

The symptoms of overtrading simply imply that the company has expanded
without giving proper thought to the necessity to expand its capital base. It
has consequently continued to rely on its trade payables and probably its
bank overdraft to provide the additional finance required. It will reach a stage
where suppliers will withhold further supplies and bankers will refuse to
honour further cheques until borrowings are reduced. The problem is that
borrowings cannot be reduced until sales revenue is earned, which in turn
cannot be achieved until production is completed, which in turn is dependent
upon materials being available and wages paid. Overall result – deadlock and
rapid financial collapse!

This is a particularly difficult stage for small-to-medium sized companies. They

have reached a stage in their life when conventional payables and overdraft
facilities are being stretched to the maximum, but they are probably too small
to manage a flotation. In many cases, by proper planning, the company can
arrange fixed-term loan funding from the bank rather than relying exclusively
on overdraft finance

Advanced Financial Accounting and Corporate Reporting (Study Text) 449

6 Long-Term Financial Stability

6.1 Introduction
The main points to consider when assessing the longer-term financial position
are:

• gearing
• overtrading
6.2 Gearing
Gearing ratios indicate:

• the degree of risk attached to the company and

• the sensitivity of earnings and dividends to changes in profitability and
activity level.

Preference share capital is usually counted as part of debt rather than equity
since it carries the right to a fixed rate of dividend which is payable before the
ordinary shareholders have any right to a dividend.

High and low gearing

In highly geared businesses:

• a large proportion of fixed-return capital is used

• there is a greater risk of insolvency
• returns to shareholders will grow proportionately more if profits are
growing.

Low-geared businesses:
• provide scope to increase borrowings when potentially profitable
projects are available
• can usually borrow more easily

Not all companies are suitable for a highly-geared structure. A company must
have two fundamental characteristics if it is to use gearing successfully.

Relatively stable profits

Loan stock interest must be paid whether or not profits are earned. A
company with erratic profits may have insufficient funds in a bad year with
which to pay the interest. This would result in the appointment of a receiver
and possibly the liquidation of the company.

Advanced Financial Accounting and Corporate Reporting (Study Text) 450

 Suitable assets for security
Most issues of loan capital are secured on some or all of the company’s
assets which must be suitable for the purpose. A company with most of its
capital invested in fast depreciating assets or inventory subject to rapid
changes in demand and price would not be suitable for high gearing.

The classic examples of companies that are suited to high gearing are those
in property investment and the hotel/leisure services industry. These
companies generally enjoy relatively stable profits and have assets which are
highly suitable for charging. Nonetheless, these are industries that could be
described as cyclical.

Companies not suited to high gearing would include those in the extractive,
and high-tech, industries where constant changes occur. These companies
could experience erratic profits and would generally have inadequate assets
to pledge as security.

6.3 Measuring gearing

There are two methods commonly used to express gearing as follows.
Debt/equity ratio:

Loans + Preference share capital

–––––––––––––––––––––––––––––––––––––––––––––
Ordinary share capital + Reserves + Non-controlling interest

Percentage of capital employed represented by borrowings:

Loans + Preference share capital

––––––––––––––––––––––––––––––––––––––––––––––
Ordinary share capital + Reserves + Non-controlling interest
+ Loans + Preference share capital

6.4 Interest Cover

PBIT
Interest cover = ––––––––––––
Interest payable

Interest cover indicates the ability of a company to pay interest out of profits
generated:

• low interest cover indicates to shareholders that their dividends are at

risk (because most profits are eaten up by interest payments) and

Advanced Financial Accounting and Corporate Reporting (Study Text) 451

 • the company may have difficulty financing its debts if its profits fall
• interest cover of less than two is usually considered unsatisfactory

A business must have a sufficient level of long-term capital to finance its long-
term investment in noncurrent assets.

Part of the investment in current assets would usually be financed by

relatively permanent capital with the balance being provided by credit from
suppliers and other short-term borrowings. Any expansion in activity will
normally require a broadening of the long-term capital base, without which
‘overtrading’ may develop (see below).

Suitability of finance is also a key factor. A permanent expansion of a

company’s activities should not be financed by temporary, short-term
borrowings. On the other hand, a short-term increase in activity such as the
‘January sales’ in a retail trading company could ideally be financed by
overdraft.

A major addition to noncurrent assets such as the construction of a new

factory would not normally be financed on a long-term basis by overdraft. It
might be found, however, that the expenditure was temporarily financed by
short-term loans until construction was completed, when the overdraft would
be ‘funded’ by a long-term borrowing secured on the completed building.

Example 1
Statements of financial position and income statements for Ocean Motors are
set out below.
Statement of financial position for Ocean Motors
20X2 20X1
Rs 000 Rs 000 Rs 000 Rs 000
Noncurrent assets:
Land and buildings
Cost 1,600 1,450
Depreciation (200) (150)
–––– ––––
1,400 1,300
Plant and machinery:
Cost 600 400
Depreciation (120) (100)
–––– –––
480 300
–––– ––––
1,880 1,600
Current assets:

Advanced Financial Accounting and Corporate Reporting (Study Text) 452

 Inventory 300 100
Receivables 400 100
–––– ––––
700 200
–––– ––––
Total assets 2,580 1,800
Equity:
Share capital – Rs 1 ordinary shares 1,200 1,200
Retained earnings 310 220
–––– ––––
1,510 1,420
–––– ––––
Current liabilities:
Bank overdraft 590 210
Payables and accruals 370 70
Taxation liability 110 100
–––– ––––
1,070 380
–––– ––––
2,580 1,800
–––– ––––

Income statements for Ocean Motors

20X2 20X1
Rs 000 Rs 000
Sales revenue 1,500 1,000
Cost of sales (700) (300)
–––– ––––
Gross profit 800 700
Administration and distribution expenses (400) (360)
–––– ––––
Net profit before tax 400 340
Income tax expense (200) (170)
–––– ––––
Net profit after tax 200 170

The dividend for 20X1 was Rs 100,000 and for 20X2 was Rs 110,000.
Calculate the following ratios for Ocean Motors and briefly comment upon
what they indicate:

Advanced Financial Accounting and Corporate Reporting (Study Text) 453

 Profitability ratios:
• gross profit margin
• operating profit margin
• ROCE
• net asset turnover.

Liquidity and working capital ratios:

• current ratio
• quick ratio
• inventory collection period
• accounts receivable collection period
• accounts payable payment period

Solution
Profitability ratios
20X2 20X1
ROCE 400/1,510 = 26.4% 340/1,420 = 23.9%
Gross profit margin 800/1,500 = 53.3% 700/1,000 = 70.0%
Operating profit margin 400/1,500 = 26.7% 340/1,000 = 34.0%
Asset turnover 1,500/1,510 = 0.99 1,000/1,420 = 0.70
Check: .99 × 26.7 = 26.4% 0.70 × 34.0% = 23.8%

Comment
Key factors:
• revenue has increased by 50%
• gross profit margin significantly decreased maybe due to lowering of
selling prices in order to increase market share and sales revenue
• operating profit margin has decreased in line with gross profit margin
• ROCE has increased due to the improvement in asset turnover.

Advanced Financial Accounting and Corporate Reporting (Study Text) 454

 Liquidity and working capital ratios
20X2 20X1
Current ratio 700/1,070 200/380
= 0.65 : 1 = 0.53 : 1
Quick ratio 400/1,070 100/380
= 0.37 : 1 = 0.26 : 1
Inventory collection period 300/700 × 365 100/300 × 365
156 days 122 days
2.3 times 3.0 times
Accounts receivable
collection period 400/1,500 × 365 100/1,000 × 365
97 days 36.5 days
Accounts payable
payment period 370/700 × 365 70/300 × 365
193 days 85 days

Comment
Overall the liquidity of the company would appear to be in some doubt:

• Both the current ratio and quick ratio appear very low although
they have improved since the previous year.

• We do not know anything about the type of business therefore it

is difficult to comment on these absolute levels of liquidity.

• Inventory turnover indicates that inventory is held for a

considerable time and that this time is increasing.

• Accounts receivable collection period has deteriorated rapidly

although given the increase in revenue this may be due to a
conscious policy of offering extended credit terms in order to
attract new custom.

• Accounts payable payment period has also more than doubled

and is even longer than the period of credit taken by customers.

• Clearly the business is heavily dependent upon its overdraft

finance

Advanced Financial Accounting and Corporate Reporting (Study Text) 455

7 Investor Ratios

7.1 EPS
The calculation of EPS was covered in an earlier chapter.

Limitations of EPS
EPS is used primarily as a measure of profitability, so an increasing EPS is
seen as a good sign. EPS is also used to calculate the price earnings ratio
which is dealt with below.

The limitations of EPS may be listed as follows.

• In times of rising prices EPS will increase as profits increase. Thus any
improvement in EPS should be viewed in the context of the effect of
price level changes on the company’s profits.

• Where there is a new share issue for cash, the shares are included for,
say, half the year on the grounds that earnings will also increase for
half of the year. However, in practice a new project funded by that cash
does not begin generating normal returns immediately, so a new share
issue is often accompanied by a decrease in EPS.

• EPS is dependent on an earnings figure which is subject to many

judgments. Some elements of that earnings figure, such as movements
on provisions, are particularly sensitive to different judgments.

• A single earnings figure should not be used as a key performance

measure. This is to take a far too simplistic approach to the analysis of
performance.

• EPS cannot be used as a basis of comparison between companies, as

the number of shares in issue in any particular company is not related
to the amount of capital employed. For example, two companies may
have the same amount of capital employed but one company has
100,000 Rs 1 shares in issue and reserves of Rs 4,900,000. Another
company may have 5 million Rs 0.5 shares in issue and reserves of Rs
2,500,000. If earnings are the same, EPS is different.

• EPS is an historical figure based on historical accounts. This is a

disadvantage where it is used for a forward-looking figure such as the
price earnings ratio.

• The diluted EPS (DEPS) is a theoretical measure of the effect of

dilution on the basic EPS. DEPS should serve as a warning to equity

Advanced Financial Accounting and Corporate Reporting (Study Text) 456

 shareholders that their future earnings will be affected by diluting
factors. Thus, notes in the accounts relating to convertible loan stock,
convertible preference shares and share options should all be analysed
carefully.

7.2 P/E ratio

Current share price
P/E ratio = ––––––––––––––
Latest EPS

• Represents the market’s view of the future prospects of the share.

• High P/E suggests that high growth is expected

This is the most widely referred to stock market ratio, also commonly
described as an earnings multiple. It is calculated as the ‘purchase of a
number of years’ earnings’, but it represents the market’s consensus of the
future prospects of that share. The higher the P/E ratio, the faster the growth
the market is expecting in the company’s future EPS. Correspondingly, the
lower the P/E ratio, the lower the expected future growth.

Another aspect of interpreting it, is that a published EPS exists for a year and
therefore the P/E ratio given in a newspaper is generally based on an
increasingly out-of-date EPS. To give an extreme but simple example:

Company X
• For the year ended 31 December 20X6, EPS = Rs 0.1

• Overall market P/E ratio = 10.

• P/E ratio for X = 20 (because market expects above average growth).

• Market price at 30 April 20X7 (date of publication of previous year’s

accounts) = Rs 2.

• During the year, X does even better than expected and by 29 April
20X8, the share price is up to Rs 3, therefore giving a P/E ratio of 30
(based on EPS for year ended 31 December 20X6).

• Year ended 31 December 20X7, EPS = Rs 0.15, announced on 30

April 20X8. This is in line with expectations so share price is
unchanged and P/E ratio drops again to 20 (Rs 3/Rs 0.15).

Advanced Financial Accounting and Corporate Reporting (Study Text) 457

 The earnings yield is the reciprocal of the P/E ratio, calculated as earnings as
a percentage of market price. For Company X at 30 April 20X8 it is 5% (Rs
0.5 as a % of Rs 3).

7.3 Dividend yield

Dividend per share
Dividend yield = –––––––––––––––
Current share price

• can be compared to the yields available on other investment possibilities

• the lower the dividend yield, the more the market is expecting future
growth in the dividend, and vice versa.

Dividend cover
Profit after tax
Dividend cover = –––––––––––
Dividends

• This is the relationship between available profits and the dividends

payable out of the profits.

• The higher the dividend cover, the more likely it is that the current
dividend level can be sustained in the future.

Example 2
Given below are the income statements for Pacific Motors for the last two
years.

Income statements

20X2 20X1
Rs 000 Rs 000
Sales revenue 1,500 1,000
Cost of sales (700) (300)
–––– ––––
Gross profit 800 700
Administration and distribution expenses (400) (360)
–––– ––––
Net profit before tax 400 340
Income tax expense (200) (170)
–––– ––––
Net profit after tax 200 170

In 20X1 dividends were Rs 100,000 and in 20X2 they were Rs 110,000.

Advanced Financial Accounting and Corporate Reporting (Study Text) 458

 The company is financed by 120,000 Rs 10 ordinary shares and let us
suppose that the market price of each share was Rs 16.4 at 31 December
20X2 and Rs 15.3 at 31 December 20X1.

For each year calculate the following ratios and comment on them briefly:
• EPS
• P/E ratio
• dividend yield
• dividend cover.

Solution
20X2 20X1
EPS 200/120 170/120
= Rs 1.67 Rs 1.42
P/E ratio 164/16.7 153/14.2
= 9.8 = 10.77
Dividend yield (110/120)/16.4 (100/120)/15.3
= 5.6% = 5.5%
Dividend cover 200/110 170/100
= 1.8 times 1.7 times

Comment
There has not been a significant amount of change in the investor ratios over
the two years but the following specific comments could be made:

• both EPS and dividend per share have increased by a small amount
over the two years which is a policy often designed to satisfy
shareholders

• the P/E ratio has declined which indicates that the market does not
think as highly of the shares this year as last year

• dividend cover is slightly higher which means that a slightly higher

proportion of the profits for the year have been retained within the
business.

Advanced Financial Accounting and Corporate Reporting (Study Text) 459

8 Limitations of Financial Statements and Ratio Analysis

8.1 Historical cost accounts

Ratios are a tool to assist analysis.

• They help to focus attention systematically on important areas and summarise

information in an understandable form.

• They assist in identifying trends and relationships.

However ratios are not predictive if they are based on historical information.

• They ignore future action by management.

• They can be manipulated by window dressing or creative accounting.
• They may be distorted by differences in accounting policies

Asset values shown in the statement of financial position at historic cost may
bear no resemblance to their current value or what it may cost to replace
them. This may result in a low depreciation charge and overstatement of profit
in real terms. As a result of historical costs the financial statements do not
show the real cost of using the noncurrent assets

Advanced Financial Accounting and Corporate Reporting (Study Text) 460

8.2 Creative accounting
Creative accounting refers to the accounting practices that are designed to
mislead the view that the user of financial statements has on a company’s
underlying economic performance. Typically creative accounting is used to
increase profits, inflate asset values or understate liabilities.

In the past companies could smooth profits to maintain a steady upward trend
by making use of general provisions (no longer allowed per IAS 37). An
upward profit trend is reassuring to both existing and potential investors or of
benefit to bonus-seeking directors. As the restrictions on provisions have
tightened, companies have found other ways to manipulate profit, such as,
unsuitable revenue recognition or inappropriate accruals.

Creative accounting techniques can also be used to manipulate the gearing

level of a company. A company that is highly geared has high interest
payments that reduce the amount of distributable profit available to
shareholders and increases the risk associated with the company, making it
more difficult to obtain future lending.

Other reasons for creative accounting could include the desire to influence
share price, to keep the company’s financial results within agreed limits set by
creditors, personal incentives or to pay less tax.

8.3 Window dressing

Window dressing is a method of carrying out transactions in order to distort
the position shown by the financial statements and generally improve the
position shown by them.

Examples of window dressing include:

• a company might chase receivables more quickly at the year end to improve
their bank balance;

• a company may change its depreciation estimate i.e. by increasing the

expected useful economic life of an asset, the depreciation charge will be
smaller resulting in increased profits; and

• an existing loan may be repaid immediately before the year end and then
taken out again in the next financial year.

8.4 Change in accounting policies

It is necessary to be able to assess the impact of accounting policies on the
calculation of ratios. Comparison between businesses that follow different

Advanced Financial Accounting and Corporate Reporting (Study Text) 461

 policies becomes a major issue if accounting standards give either choice or
judgement to companies i.e. IAS 40 or IAS 16.

8.5 Limitations of Ratio Analysis

Although there are general guidelines (for example, the quick ratio
should not normally be less than 1:1), there is no such thing as an
‘ideal’ ratio. A quick ratio of less than 1:1 would be acceptable in some
businesses, but dangerously low for many others.

• Unless ratios are calculated on a uniform basis, from uniform data,

comparisons can be very misleading.

• The statement of financial position shown in the financial statements

may not be representative of the financial position at other times in the
year. Many businesses set the end of their accounting period to a date
on which there is a relatively low amount of trading activity. As a result,
the items on a statement of financial position are not representative of
the items throughout the accounting period.

Consider inventory levels in a retail organisation. They may vary

throughout the year with lows at the end of a season and highs at the
start of the season.

Adding opening and closing inventory and dividing by two will not
produce a fair average.

• Ratios based on historical cost accounts do not give a true

picture of trends from year to year. An apparent increase in
profit may not be a ‘true’ increase, because of the effects of
inflation.

• Financial statements only reflect those activities which can be

expressed in money terms. They do not give a complete picture
of the activities of a business.

• The application of accounting policies in the preparation of

financial statements must be understood when attempting to
interpret financial ratios.

• The earning power of a business may well be affected by factors

which are not reflected in the financial statements. Thus, these
do not necessarily represent a complete picture of a business,
but only a collection of those parts which can be translated into
money terms.

Advanced Financial Accounting and Corporate Reporting (Study Text) 462

 For example, the size of the order book is normally ignored in financial
statements.

• Ratios must not be used as the sole test of efficiency.

Concentration on ratios by managers may inhibit the incentive to
grow and expand, to the detriment of the long-term interests of
the company.

• A few simple ratios do not provide an automatic means of

running a company. Business problems usually involve complex
patterns which cannot be solved solely by the use of ratios.

8.6 Inter-firm comparisons

It can be useful to compare ratios for an individual company with those of
other firms in the same industry. However, comparing the financial statements
of similar businesses can be misleading because:

• the businesses may use different accounting policies

• ratios may not be calculated according to the same formula (for

example, there are several possible definitions of gearing and ROCE)

• large organisations can achieve economies of scale (e.g. by

negotiating extended credit periods, or discounts for bulk buying with
suppliers) while these measures may not be available to smaller
businesses

• companies within the same industry can serve completely different

markets and there may be differences in sales mix and product range.
These can affect profitability and activity ratios such as profit margin
and expenses to sales.

Advanced Financial Accounting and Corporate Reporting (Study Text) 463

 Chapter Summary

Advanced Financial Accounting and Corporate Reporting (Study Text) 464

 Self-Test Questions

1. Navy Ltd is a company that manufactures and retails office products. Their
summarised financial statements for the years ended 30 June 20X4 and 20X5
are given below:

Income Statements for the year ended 30 June

20X4 20X5
Rs 000's Rs 000's
Revenue 1,159,850 1,391,820
Cost of Sales (753,450) (1,050,825)
–––––––– ––––––––
Gross profit 406,400 340,995
Operating expenses (170,950) (161,450)
–––––––– ––––––––

Profit from operations 235,450 179,545

Finance costs (14,000) (10,000)
–––––––– ––––––––
Profits before tax 221,450 169,545
Tax (66,300) (50,800)
–––––––– ––––––––
Net profit 155,150 118,745

Statements of Financial Position as at 30 June

20X4 20X5
Rs 000's Rs 000's
Noncurrent
assets 341,400 509,590
Current Assets Inventory 88,760 109,400
Receivables 206,550 419,455
Bank 95,400 -
–––––––– ––––––––
732,110 1,038,445
–––––––– ––––––––
Share capital 100,000 100,000
Share premium 20,000 20,000
Revaluation reserve 50,000
Retained earnings 287,420 376,165
–––––––– ––––––––
407,420 546,165
Noncurrent liabilities 83,100 61,600

Advanced Financial Accounting and Corporate Reporting (Study Text) 465

 Current liabilities
Payables 179,590 345,480
Overdraft - 30,200
Tax 62,000 55,000
–––––––– ––––––––
732,110 1,038,445
–––––––– ––––––––

The directors concluded that their revenue for the year ended 30 June 20X4
fell below budget and introduced measures in the year end 30 June 20X5 to
improve the situation. These included:

• Cutting prices;
• Extending credit facilities to customers;
• Leasing additional machinery in order to be able to manufacture more
products.

The directors’ are now reviewing the results for the year ended 30 June 20X5
and have asked for your advice as an external business consultant, as to
whether or not the above strategies have been successful.

Required:
Prepare a report to the directors of Navy Ltd assessing the performance
and position of the company in the year ended 30 June 20X5 compared
to the previous year and advise them on whether or not you believe that
their strategies have been successful.

Advanced Financial Accounting and Corporate Reporting (Study Text) 466

Answers

1 Navy Ltd
Report

To: Directors of Navy Ltd

From: Business Consultant
Date: XX.XX.XX
Subject: Performance of Navy Ltd

Introduction
As requested I have analysed the financial statements of Navy Ltd for the
year ended 30 June 20X5 compared to the previous year to assess the
performance and position of the entity and to determine whether the
strategies that you have implemented have been successful. The ratios that I
have calculated are in an appendix to this report.

Performance

Profitability
The revenue of the entity has increased by 20% on last year. It would
therefore appear that the strategy of cutting prices and extending credit
facilities has attracted customers and generated an increase in revenue.
Whether or not the revenue is now above budget, as was the directors’ aim, is
unknown.

Despite this increase however, the profitability of the company has worsened
with both gross profit and operating profit being lower than the previous year.
Similarly the operating profit margin has declined from 20.3% to 12.9%. There
are likely to be several reasons behind this deterioration.

The reduction in prices of goods will have contributed to the worsening gross
profit. To rectify this, Navy Ltd may consider approaching their suppliers for
some bulk-buying discounts on the basis that since they are selling more
items they will be purchasing more material from suppliers

The move of leasing additional machinery may also have contributed to the
lower profitability. Assuming that the leases are being treated as operating
leases the lease payments will be being expensed to the income statement.
Given that noncurrent liabilities have decreased this year it would appear that
the leases are being treated as operating leases and not finance leases.

The return on capital employed has dropped significantly from 48% to 29.5%.
This is mainly due to the lower operating profit margins and reasons

Advanced Financial Accounting and Corporate Reporting (Study Text) 467

 discussed above, as opposed to a decline in the efficient use of assets since
the asset utilisation has suffered only a slight fall.

The revaluation of noncurrent assets will also have contributed to the fall in
the return on capital employed and would explain why the asset utilisation has
fallen slightly.

The revaluation will have caused additional depreciation charges in the

income statement and thus is another factor in the worsening profits.

The increase in noncurrent assets is not fully explained by the revaluation.

Hence it can be concluded that Navy Ltd have probably purchased additional
machinery (as well as leasing) to meet the increased production needs. These
new machines may not have been fully operational in the current year and so
would also explain the lower returns. The higher depreciation charges will also
have contributed to lower profits.

Position

Liquidity
Again, the company’s results are showing a worsening position in this area
with the current ratio declining from 1.62 to 1.23.

The cause for this would seem to be the extension of credit facilities to
customers.

Receivables days have increased from an appropriate level of 65 days to 110

days. Although the benefits of this strategy have been shown by the increase
in revenue, it would seem that Navy Ltd have now allowed customers too
much credit. It would be recommended that receivables days should be
reduced to closer to 90 days.

As a result of the increase in the receivables collection period, Navy Ltd have
been taking longer to pay their suppliers. Their payables days are now at an
unacceptably high level of 120 days. This is likely to be causing dissatisfaction
with suppliers and would reduce the ability of Navy Ltd being able to negotiate
discounts as discussed above.

Inventory holding days have increased slightly from 38 days to 43 days. This
does not give any immediate cause for concern and is probably due to
increased production levels.

As a consequence of these factors, by the end of the year Navy Ltd are
operating a significant overdraft.

Advanced Financial Accounting and Corporate Reporting (Study Text) 468

 Gearing
The gearing ratio has fallen from 16.9% to 10.1% as a result of the reduction
in noncurrent liabilities. Assuming that these are loans, it would appear that
Navy Ltd have further utilised their cash resources to repay these loans. This
does not seem to have been a sensible move given their poor liquidity
position.

The revaluation of noncurrent assets would also have contributed to the

lowering of this ratio.

Further, the gearing ratio last year does not seem particularly high –
comparison with an industry average would confirm this – and the company
had a significant level of profits covering their finance costs.

Hence it would have seemed appropriate to have increased the longer term
debt of the company to finance the growth rather than increasing their current
liabilities.

If Navy Ltd had leased their additional machinery under finance leases, it is
likely that less would be charged to their income statement and so would
improve their profitability while the subsequent increase in the gearing ratio
would not have caused significant concern.

Also, it was identified above that Navy Ltd may have purchased additional
noncurrent assets. Given the gearing and liquidity positions, it would seem
that these have been financed from short-term sources rather than more
appropriate long-term sources.

Summary
Although the directors’ initial aim of improving revenue has been achieved
with the measures taken, the strategies do not appear to have been
successful overall. The cutting of prices has caused lowering profit margins
and combined with additional lease expenses and depreciation charges has
resulted in a worsening profit situation overall.

The extension of credit periods has again been successful to the extent that it
has helped increase revenue but has caused a poor liquidity position.

It would seem that Navy Ltd are showing signs of overtrading

To rectify the situation it would seem appropriate to increase the long term
debt of the company as a matter of priority.

Advanced Financial Accounting and Corporate Reporting (Study Text) 469

 Appendix

20X4 20X5
Revenue 1,159,850 1,391,820 +20%
Gross profit 406,400 340,995 – 16.1%
Operating profit 235,450 179,545 – 23.7%

235,450 179,545
OP% 20.3% 12.9%
1,159,850 1,391,765
235,450 179,545
ROCE 48.0% 29.5%
490,520 607,765
159,850 1,391,820
Asset turnover 2.36 2.29
490,520 607,765

88,760x365 109,400x365
Inventory days 43 days 38 days
753,480 1,050,825

206,550x36 5 419,455x36 5
Receivables days 65 days 110 days
1,159,850 1,391,820

179,590x365 345,480x36 5
Payables days 87 days 120 days
753,450 1,050,825

Advanced Financial Accounting and Corporate Reporting (Study Text) 470

Advanced Financial Accounting and Corporate Reporting (Study Text) 471
EARNINGS PER SHARE
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

• Define and calculate basic earnings per share (EPS).

• Explain the relevance of diluted EPS (DEPS).
• Calculate DEPS involving convertible debt.
• Calculate DEPS involving share options (warrants).
• Explain the importance of EPS as a stock market indicator.
• Explain why the trend in EPS may be a more accurate indicator of performance
than a company’s profit trend.
• Explain the limitations of EPS as a performance measure.

Advanced Financial Accounting and Corporate Reporting (Study Text) 472

1 Introduction

1.1 Earnings per share (EPS) is widely regarded as the most important indicator
of a company’s performance. It is important that users of the financial
statements:
• are able to compare the EPS of different entities and
• are able to compare the EPS of the same entity in different accounting
periods.

IAS 33 achieves comparability by:

• defining earnings
• prescribing methods for determining the number of shares to be
included in the calculation of EPS
• requiring standard presentation and disclosures.

1.2 The Scope of IAS 33

IAS 33 applies to entities whose ordinary shares are publicly traded.

Publicly traded entities which present both parent and consolidated financial
statements are only required to present EPS based on the consolidated
figures.

2 Basic EPS

2.1 The basic EPS calculation is simply

Earnings
–––––––––
Shares

• Earnings: group profit after tax, less non-controlling interests and

irredeemable preference share dividends.
• Shares: weighted average number of ordinary shares outstanding
during the period.

2.2 Issue of shares at full market price

Earnings should be apportioned over the weighted average equity share
capital (i.e. taking account of the date any new shares are issued during the
year).

Advanced Financial Accounting and Corporate Reporting (Study Text) 473

 Example 1

Full Market Share Issue

A company issued 200,000 shares at full market price (Rs 3.00) on 1 July
20X8.

Relevant information
20X8 20X7
Profit attributable to the ordinary shareholders for
the year ending 31 December Rs 550,000 Rs 460,000
Number of ordinary shares in issue at 31 December 1,000,000 800,000

Requirement
Calculate the EPS for each of the years.

Solution

Calculation of EPS

Rs 460,000
20X7 EPS = –––––––– = Rs 0.575
800,000

Issue at full market price:

Date Actual number of shares Fraction of year Total

1 Jan 20X8 800,000 6/12 400,000

1 July 20X8 1,000,000 6/12 500,000
–––––––
Number of shares in EPS calculation 900,000
–––––––
Rs 550,000
20X8 EPS = –––––––– = Rs 0.611
900,000

Since the 200,000 shares have only generated additional resources towards
the earning of profits for half a year, the number of new shares is adjusted
proportionately. Note that the approach is to use the earnings figure for the
period without adjustment, but divide by the average number of shares
weighted on a time basis.

Advanced Financial Accounting and Corporate Reporting (Study Text) 474

2.3 Bonus issue
A bonus issue (or capitalization issue or scrip issue):

• does not provide additional resources to the issuer

• means that the shareholder owns the same proportion of the business
before and after the issue.

In the calculation of EPS:

• the bonus shares are deemed to have been issued at the start of the
year
• comparative figures are restated to allow for the proportional increase
in share capital caused by the bonus issue.

Illustration

Consider:
• Mr A owns 5,000 shares in Company B which has an issued capital of
100,000 shares. Mr A therefore owns 5% of Company B.

• Company B makes a 1 for 1 bonus issue.

• Mr A now owns 10,000 shares and Company B has 200,000 shares in

issue. Mr A still owns 5% of Company B.

The shares issued as a result of the bonus issue are deemed to have been
issued at the start of the year, regardless of the actual date when the bonus
issue took place. To ensure that the EPS for the year of the bonus issue
remains comparable with the EPS of previous years, comparative figures for
earlier years are restated using the same increased figure.

Example 2
A company makes a bonus issue of one new share for every five existing
shares held on 1 July 20X8.

20X8 20X7
Profit attributable to the ordinary shareholders for
the year ending 31 December Rs 550,000 Rs 460,000
Number of ordinary shares in issue at 31
December 1,200,000 1,000,000

Calculate the EPS in 20X8 accounts.

Advanced Financial Accounting and Corporate Reporting (Study Text) 475

 Solution
Calculation of EPS in 20X8 accounts.

Rs 460,000
20X7 –––––––– = Rs 0.383
1,200,000
Rs 550,000
20X8 –––––––– = Rs 0.458
1,200,000

In the 20X7 accounts, the EPS for the year would have appeared as Rs 0.46
(Rs 460,000 ÷ 1,000,000). In the example above, the computation has been
reworked in full. However, to make the changes required it would be simpler
to adjust directly the EPS figures themselves.

Since the old calculation was based on dividing by 1,000,000 while the new is
determined by using 1,200,000, it would be necessary to multiply the EPS by
the first and divide by the second. The fraction to apply is, therefore:

1,000,000 5
–––––––– or ––
1,200,000 6
5
Consequently: 0.46 × –– = Rs 0.383
6

2.4 Rights issue

Rights issues present special problems:

Therefore they combine the characteristics of issues at full market price and
bonus issues.

• they contribute additional resources

• they are normally priced below full market price.

Determining the weighted average capital, therefore, involves two steps as

follows:

(1) adjust for bonus element in rights issue, by multiplying capital in issue
before the rights issue by the following fraction:

Actual cum rights price

––––––––––––––––––––
Theoretical ex rights price

Advanced Financial Accounting and Corporate Reporting (Study Text) 476

 (2) calculate the weighted average capital in the issue as above.

Example 3

Right Issue
A company issued one new share for every two existing shares held by way
of rights at Rs 1.50 per share on 1 July 20X8. Pre-issue market price was Rs
3.00 per share.

Relevant information:
20X8 20X7
Profit attributable to the ordinary shareholders for
the year ending 31 December Rs 550,000 Rs 460,000
Number of ordinary shares in issue at 31
December 1,200,000 800,000

Solution

20X8: Earnings Rs 550,000

––––––––––––––––––––––––––––– = ––––––– = Rs 0.509
Weighted average number of shares (W1) 1,080,000

20X7:
The prior year EPS must be adjusted to reflect the bonus element in the rights
issue.

Rs 2.50 (W2)
EPS = 57.5 paisas (W3) × ––––––––– = Rs 0.479
Rs 3.00
NB: To restate the EPS for the previous year simply multiply EPS by the
inverse of the rights issue bonus fraction.

(W1) 20X8 Weighted average number of shares

The number of shares before the rights issue must be adjusted for the bonus
element in the rights issue using the theoretical ex rights price.

6/12 × 800,000 × 3.00/2.50 (W2) 480,000

6/12 × 1,200,000 600,000
––––––––
1,080,000
––––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 477

 (W2) Theoretical ex rights price

2 shares @ Rs 3.00 Rs 6.00

1 share @ Rs 1.50 Rs 1.50
–––––
3 shares Rs 7.50
–––––
Theoretical ex rights price = Rs 7.50/3 Rs 2.50

(W3)

20X7 comparative EPS = Rs 460,000

––––––––
800,000
= Rs 0.575

3 Diluted Earnings per Share (DEPS)

3.1 Introduction
Equity share capital may change in the future owing to circumstances which
exist now – known as dilution. The provision of a diluted EPS figure attempts
to alert shareholders to the potential impact on EPS.

Examples of dilutive factors are:

• the conversion terms for convertible bonds

• the conversion terms for convertible preference shares
• the exercise price for options and the subscription price for warrants.

3.2 Basic principles of calculation

To deal with potential ordinary shares, adjust basic earnings and number of
shares assuming convertibles, options, etc. had converted to equity shares on
the first day of the accounting period, or on the date of issue, if later.

DEPS is calculated as follows:

Earnings + notional extra earnings

–––––––––––––––––––––––––––––––
Number of shares + notional extra shares

3.3 Why DEPS is calculated?

The basic EPS figure calculated as above could be misleading to users if at
some future time the number of shares in issue will increase without a
proportionate increase in resources. For example, if an entity has issued

Advanced Financial Accounting and Corporate Reporting (Study Text) 478

 bonds convertible at a later date into ordinary shares, on conversion the
number of ordinary shares will rise, no fresh capital will enter the entity and
earnings will rise by the savings in no longer having to pay the post-tax
amount of the interest on the bonds. Often the earnings increase is less,
proportionately, than the increase in the shares in issue. This effect is referred
to as ‘dilution’ and the shares to be issued are called ‘dilutive potential
ordinary shares’.

IAS 33 therefore requires an entity to disclose the DEPS, as well as the basic
EPS, calculated using current earnings but assuming that the worst possible
future dilution has already happened. Existing shareholders can look at the
DEPS to see the effect on current profitability of commitments already entered
into to issue ordinary shares in the future.

For the purpose of calculating DEPS, the number of ordinary shares should
be the weighted average number of ordinary shares calculated as for basic
EPS, plus the weighted average number of ordinary shares which would be
issued on the conversion of all the dilutive potential ordinary shares into
ordinary shares. Dilutive potential ordinary shares are deemed to have been
converted into ordinary shares at the beginning of the period or, if later, the
date of the issue of the potential ordinary shares.

3.4 Convertibles
The principles of convertible bonds and convertible preference shares are
similar and will be dealt with together.

If the convertible bonds/preference shares had been converted:

• the interest/dividend would be saved therefore earnings would be higher

• the number of shares would increase.

Example 4
On 1 April 20X1, a company issued Rs 1,250,000 8% convertible unsecured
bonds for cash at par. Each Rs 100 nominal of the loan stock will be
convertible in 20X6/20X9 into the number of ordinary shares set out below:

• On 31 December 20X6 124 shares.

• On 31 December 20X7 120 shares.
• On 31 December 20X8 115 shares.
• On 31 December 20X9 110 shares.

Up to 20X5, the maximum number of shares issuable after the end of the
financial year will be at the rate of 124 shares per Rs 100 on Rs 1,250,000
debt, which is 1,550,000 shares. With 4,000,000 already in issue, the total

Advanced Financial Accounting and Corporate Reporting (Study Text) 479

 becomes 5,550,000. It is the maximum possible number of shares that can be
converted into which is always used.

Relevant information
Issued share capital:

• Rs 500,000 in 10% cumulative irredeemable preference shares of Rs 1.

• Rs 1,000,000 in ordinary shares of Rs 0.25 = 4,000,000 shares.
• Income taxes are 30%.

Trading results for the years ended 31 December were as follows:

20X2 20X1
Rs Rs

Profit before interest and tax 1,100,000 991,818

Interest on 8% convertible unsecured bonds 100,000 75,000
–––––––– ––––––––
Profit before tax 1,000,000 916,818
Income tax (300,000) (275,045)
–––––––– ––––––––
Profit after tax 700,000 641,773
–––––––– ––––––––
Solution
Calculation of EPS

Basic EPS Rs Rs
Profit after tax 700,000 641,773
Less: Preference dividend (50,000) (50,000)
–––––––– ––––––––
Earnings 650,000 591,773
–––––––– ––––––––
EPS based on 4,000,000 shares Rs 0.1625 Rs 0.148
–––––––– ––––––––
DEPS
Earnings as above 650,000 591,773
––––––– –––––––
Add: Interest on the convertible
Unsecured bonds 100,000 75,000
Less: Income tax (30,000) (22,500)
––––––– –––––––
70,000 52,500
––––––– –––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 480

 Adjusted earnings 720,000 644,273
––––––– –––––––
EPS based on
5,550,000 shares (20X1 – 5,162,500) Rs 0.13 Rs 0.125
––––––– –––––––

The weighted average number of shares issued and issuable for 20X1 would
have been one-quarter of 4,000,000 plus three-quarters of 5,550,000, i.e.
5,162,500.

Convertible preference shares are dealt with on the same basis, except that
often they do not qualify for tax relief so there is no tax saving foregone to be
adjusted for.

3.5 Options and warrants to subscribe for shares

An option or warrant gives the holder the right to buy shares at some time in
the future at a predetermined price.

Cash does enter the entity at the time the option is exercised, and the DEPS
calculation must allow for this.

The total number of shares issued on the exercise of the option or warrant is
split into two:

• the number of shares that would have been issued if the cash received
had been used to buy shares at fair value (using the average price of
the shares during the period)

• the remainder, which are treated like a bonus issue (i.e. as having
been issued for no consideration).

The number of shares issued for no consideration is added to the number of

shares when calculating the DEPS.

Example 5

Options
On 1 January 20X7, a company has 4 million ordinary shares in issue and
issues options over another million shares. The net profit for the year is Rs
500,000.

During the year to 31 December 20X7 the average fair value of one ordinary
share was Rs 3 and the exercise price for the shares under option was Rs 2.

Advanced Financial Accounting and Corporate Reporting (Study Text) 481

 Calculate basic EPS and DEPS for the year ended 31 December 20X7.

Solution

Rs 500,000
Basic EPS = –––––––– = Rs 0.125
4,000,000

Options or warrants
Rs

Earnings 500,000
––––––––
Number of shares
Basic 4,000,000
Options (W1) 333,333
––––––––
4,333,333
––––––––
Rs 500,000
The DEPS is therefore –––––––– = Rs 0.115
4,333,333

(W1) Number of shares at option price

Options = 1,000,000 × Rs 2.00

= Rs 2,000,000

Rs 2,000,000
At fair value –––––––– = 666,667
Rs 3.00

Number issued free = 1,000,000 – 666,667 = 333,333

3.6 Anti-dilutive Instruments

The objective of DEPS’ inclusion in financial statements is to present lowest
possible earning per share, in order to arrive at this minimum ratio we must
exclude any anti-dilutive instruments. Anti dilutive instruments are those
instruments whose effect on numerator is greater than the denominator i.e an
increased ratio of earning per share.

To do so, we calculate effect of each dilutive instrument on EPS separately

and rank those with lowest EPS ranked 1st and ignore the anti-dilutive

Advanced Financial Accounting and Corporate Reporting (Study Text) 482

 instrument which is bringing an increase in the lowest possible EPS, consider
the following example.

Example 6
The profit after tax earned by AAZ Limited during the year ended
December 31,20x7 amounted to Rs. 127.83 million. The weighted average
number of shares outstanding during the year was 85.22 million.

Details of potential ordinary shares as at December 31, 20x7 are as

follows:

• The company had issued debentures which are convertible into 3 million
ordinary shares. The debenture holders can exercise the option on
December 31, 20x9. If the debentures are not converted into ordinary
shares they shall be redeemed on December 31, 20X9. The interest on
debentures for the year 20X7 amounted to Rs. 7.5 million.

• Preference shares issued in 20X4 are convertible into 4 million ordinary

shares at the option of the preference shareholders. The conversion
option is exercisable on December 31, 20X0. The dividend paid on
preference shares during the year 20X7 amounted to Rs. 2.45 million.

• The company has issued options carrying the right to acquire 1.5 million
ordinary shares of the company on or after December 31, 20X7 at a
strike price of Rs. 9.90 per share.

During the year 20X7, the average market price of the shares was Rs. 11
per share.

The company is subject to income tax at the rate of 30%.

Required
Compute diluted earnings per share.

Advanced Financial Accounting and Corporate Reporting (Study Text) 483

 Solution

Increase Increase in Earnings Rank

in no. of per
earnings ordinary incremental
shares shares
Rs. Rs.
Convertible 5,250,000 3,000,000 1.75 3
Debentures
Increase in
earnings
(Rs. 7.5m x
70%)
Increase in
shares
Convertible 2,450,000 4,000,000 0.61 2
Preference
Shares
Increase in
earnings
Increase in
shares
Options - 150,000 - 1
Increase in
earnings
Increase in
shares
(1.5m x 1.1 /
11)

Advanced Financial Accounting and Corporate Reporting (Study Text) 484

Step 2: Testing for dilutive effect

Profit from Ordinary EPS Effect

operations Shares
attributable
to
ordinary
shareholder
s
Rs. Rs.
Basic Earnings *125,380,000 85,220,000 1.471 -
per share - 150,000
Options (Rank 1)
125,380,000 85,370,000 1.469 Dilutive

Convertible 2,450,000 4,000,000

preference
shares (Rank 2)
127,830,000 89,370,000 1.430 Dilutive

Convertible 5,250,000 3,000,000

debentures
(Rank 3)
133,080,000 92,370,000 1.44 Anti-
Dilutive

*Rs. 127,830,000 – Rs. 2,450,000 = Rs. 125,380,000

Example 7
Following data related to AC Company and its subsidiary DC Company for
the year ended June 30, 20x2:

AC Company: (in .000. )

Rs.
Profit attributable to ordinary share holders of AC Company 25,000
Ordinary shares outstanding 10,000
Instruments of DC Company owned by AC Company:
Ordinary shares outstanding 900
Warrants exercisable to purchase ordinary share of DC
Company 300
Convertible preference shares 375

Advanced Financial Accounting and Corporate Reporting (Study Text) 485

DC Company

Profit for the year (after tax) Rs.8,000

Ordinary shares outstanding 1,200
Warrants exercisable to purchase ordinary shares of
DC Company 600
Convertible preference shares (convertible into
1 equity share) 500
Exercise price is Rs.10
Average market price is Rs. 20
Dividend on preference shares is Re.1 per share

Required

Calculate basic earnings per share and diluted earnings per share for
a) the subsidiary and
b) The group.

Ignore income tax and assume that no inter-company elimination or

adjustment is necessary except for dividends.

Solution
a)

Basic EPS of subsidiary

(Rs.000)
Profit (W1) 7500.00
No of shares 1,200.00
Basic EPS (7,500 /1,200) Rs.6.25

Diluted Earning per share

Profit Rs.8,000
No of shares (W2) 2,000
Diluted Earning per share (8,000 / 2,000) Rs.4.00

Working 1
Profit Rs.8,000
Less : Dividend paid to preference share holder Rs. (500)
Rs.7,500

Advanced Financial Accounting and Corporate Reporting (Study Text) 486

 Working 2
Ordinary shares 1,200
Incremental shares from warrants
[600 (600 x 10) + 20] 300
Convertible preference shares 500
2,000
b)
For Group
Basic EPS
Profit (W1) Rs.31,000
No of shares 10,000
Basic EPS (31,000 = 10,000) Rs.3.10

Diluted Earning per share

Profit (W2) Rs30,7000
No of shares 10,000
Diluted Earning per share (30,700 + 10,000) Rs.3.07

Working 1

Profit Rs.25,000
Add Portion of DC profit (375x1)+(900x6.25) Rs.6,000
Rs.31,000

Working 2
Profit Rs.25,000
Add DC's earning attributable to ordinary shareholder
(1200 x 4.00 x 75%) Rs.3,600
Add DC's earning attributable to Warrant (300 x 4) x
50% Rs.600
Add DC's earning attributable to Preference share
(500x4)x75% Rs.1.500
30,700

Advanced Financial Accounting and Corporate Reporting (Study Text) 487

4 The Importance of EPS

4.1 Price earnings ratio

The EPS figure is used to compute the major stock market indicator of
performance, the price earnings ratio (P/E ratio). The calculation is as follows:
Market value of share
P/E ratio = –––––––––––––––
EPS

Trend in EPS
Although EPS is based on profit on ordinary activities after taxation, the trend
in EPS may be a more accurate performance indicator than the trend in profit,

EPS
• measures performance from the perspective of investors and potential
investors

• shows the amount of earnings available to each ordinary shareholder,

so that it indicates the potential return on individual investments.

4.2 Importance of DEPS

DEPS is important for the following reasons:

• it shows what the current year’s EPS would be if all the dilutive
potential ordinary shares in issue had been converted

• it can be used to assess trends in past performance

• in theory, it serves as a warning to equity shareholders that the return

on their investment may fall in future periods.

4.3 Limitations of EPS

Although EPS is believed to have a real influence on the market price of
shares, it has several important limitations as a performance measure:

• It does not take account of inflation. Apparent growth in earnings may

not be real.

• It is based on historic information and therefore it does not necessarily

have predictive value.

Advanced Financial Accounting and Corporate Reporting (Study Text) 488

 • An entity’s earnings are affected by the choice of its accounting
policies. Therefore it may not always be appropriate to compare the
EPS of different companies.

• DEPS is only an additional measure of past performance despite

looking at future potential shares.

Advanced Financial Accounting and Corporate Reporting (Study Text) 489

 Chapter Summary

Advanced Financial Accounting and Corporate Reporting (Study Text) 490

 Self-Test Questions

1. G Ltd 's earnings for the year ended 31 December 20X4 are Rs 2,208,000.
On 1 January 20X4, the issued share capital of G Ltd was 8,280,000 ordinary
shares of Rs 10 each. The company issued 331,200 shares at full market
value on 30 June 20X4.

Calculate the EPS for G Ltd for 20X4.

2. Bell Ltd had the following capital and reserves on 1 April 20X1:

Rs. ‘000’

Share capital (Rs 10 ordinary shares) 7,000

Share premium 900
Revaluation reserve 500
Retained earnings 9,000
––––––
Shareholders’ funds 17,400

Bell Ltd makes a bonus issue, of one share for every seven held, on 31
August 20X2.
Bell Ltd ’s results are as follows:

20X3 20X2

Rs 000 Rs 000
Profit after tax and NCI 1,150 750
–––––– ––––––

Calculate EPS for the year ending 31 March 20X3, together with the
comparative EPS for 20X2 that would be presented in the 20X3
accounts.

3. On 31 December 20X1, the issued share capital consisted of 100,000

ordinary shares of Rs 10 each, and the shares were quoted at Rs 40. On 1
July 20X2 the company made a rights issue in the proportion of 1 for 4 at Rs
20 per share. Its trading results for the last two years were as follows:

Advanced Financial Accounting and Corporate Reporting (Study Text) 491

 20X1 20X2
Rs Rs

Profit after tax 320,000 425,000

Show the calculation of basic EPS to be presented in the financial

statements for the year ended 31 December 20X2 (including the
comparative figure).

4. A company had 8.28 million shares in issue at the start of the year and made
no new issue of shares during the year ended 31 December 20X4, but on that
date it had in issue Rs 2,300,000 10% convertible loan stock 20X6-20X9.
Assume a corporation tax rate of 30%.The earnings for the year were Rs
2,208,000.

This loan stock will be convertible into ordinary Rs 1 shares as follows.

20X6 90 Rs 1 shares for Rs 100 nominal value loan stock

20X7 85 Rs 1 shares for Rs 100 nominal value loan stock
20X8 80 Rs 1 shares for Rs 100 nominal value loan stock
20X9 75 Rs 1 shares for Rs 100 nominal value loan stock

Calculate the fully DEPS for the year ended 31 December 20X4.
5. A company had 0.828 million shares in issue at the start of the year and made
no issue of shares during the year ended 31 December 20X4, but on that date
there were outstanding options to purchase 92,000 ordinary Rs 10 shares at
Rs 17 per share. The average fair value of ordinary shares was Rs 18.
Earnings for the year ended 31 December 20X4 were Rs 2,208,000.

Calculate the fully DEPS for the year ended 31 December 20X4.
6. On 1 January the issued share capital of Box Ltd was 12 million preference
shares of Rs 1 each and 10 million ordinary shares of Rs 1 each. Assume
where appropriate that the income tax rate is 30%. The earnings for the year
ended 31 December were Rs 5,950,000.

Calculate the EPS separately in respect of the year ended 31 December for
each of the following circumstances (a)(f), on the basis that:

(a) there was no change in the issued share capital of the company during
the year ended 31 December

Advanced Financial Accounting and Corporate Reporting (Study Text) 492

 (b) the company made a bonus issue on 1 October of one ordinary share
for every four shares in issue at 30 September

(c) the company issued 1 share for every 10 on 1 August at full market
value of Rs. 4

(d) the company made a rights issue of Rs 1 ordinary shares on 1 October

in the proportion of 1 of every 3 shares held, at a price of Rs 3. The
middle market price for the shares on the last day of quotation cum
rights was Rs 4 per share

(e) the company made no new issue of shares during the year ended 31
December, but on that date it had in issue Rs 2,600,000 10%
convertible bonds. These bonds will be convertible into ordinary Rs 1
shares as follows:

20X6 90 Rs 1 shares for Rs 100 nominal value bonds

20X7 85 Rs 1 shares for Rs 100 nominal value bonds
20X8 80 Rs 1 shares for Rs 100 nominal value bonds
20X9 75 Rs 1 shares for Rs 100 nominal value bonds

(f) the company made no issue of shares during the year ended 31
December, but on that date there were outstanding options to purchase
74,000 ordinary Rs 1 shares at Rs 2.50 per share. Share price during
the year was Rs 4.

Advanced Financial Accounting and Corporate Reporting (Study Text) 493

 Answers

1.
Issue at full market price

Date Actual number of shares Fraction of year Total

1 January 20X4 828,000 6/12 414,000

30 June 20X4 1,159,200 (W1) 6/12 579,600
–––––––
Number of shares in EPS
calculation 993,600
–––––––
(W1) New number of shares
Original number 828,000
New issue 331,200
–––––––––
New number 1,159,200

The earnings per share for 20X4 would now be calculated as:

Rs 2,208,000
–––––––––– = Rs 2.22
993,600

2. The number of shares to be used in the EPS calculation for both years is
700,000 + 100,000 = 800,000.
The EPS for 20X2 is 750,000 / 800,000 × 1 = Rs 0.94
The EPS for 20X3 is 1,150,000 / 800,000 × 1 = Rs 1.44
Alternatively adjust last year’s EPS
20X2 750,000/700,000 × 7/8 = Rs 0.94

Rs425,000
3. EPS = = Rs 3.6 per share
118,055
20x1 EPS
Applying correction factor to calculate adjusted comparative figure of EPS:
Theoreticalexrightsprice 36
0.08 x = Rs 0.08 x = Rs 2.88 per shares
Actualcum rights price 1

Advanced Financial Accounting and Corporate Reporting (Study Text) 494

 (W-1) Current year weighted average number of shares
Number of shares 1 January 20x2 to 30 June 20x 2 (as adjusted):

Actualcumrightprice 6 montsh
100,000 x x
Theoretifcal cum rights price 12 months

100 6
100,000 x x = 55,555 shares
90 12
Number of shares 1 July 20X2 to 31 December 20X2 (actual):

6
x 125,000 = 62,500 shares
12
Total adjusted shares for year 118,055

(W-2) Theoretical ex rights price

Because the rights issue contains a bonus element, the past EPS
figures should be adjusted by the factor:

Theoretical ex rights price

––––––––––––––––––––
Actual cum rights price
Rs

Prior to rights issue 4 shares worth 4 × Rs 40 = 160

Taking up rights 1 share cost Rs 20 = 20
–– ––––
5 180
–– ––––

i.e. theoretical ex rights price of each share is Rs 180 ÷ 5 = Rs 36

(W3) Prior year EPS

Last year, reported EPS were Rs 320,000 ÷ 100,000 = Rs 3.2

4. If this loan stock was converted to shares the impact on earnings would be as
follows.
Rs Rs

Basic earnings 2,208,000

Add notional interest saved
(Rs 2,300,000 × 10%) 230,000
Less tax relief Rs 230,000 × 30% (69,000)
––––––
Advanced Financial Accounting and Corporate Reporting (Study Text) 495
 161,000
–––––––––
Revised earnings 2,369,000
–––––––––
Number of shares if loan converted

Basic number of shares 8,280,000

Notional extra shares under the most dilution possible

90
2,300,000 × 2,070,000
100
–––––––––
Revised number of shares 10,350,000
–––––––––

Rs2,369,000
DEPS = = Rs 0.229
10,350,000

Rs

Earnings 2,208,000
–––––––––
Number of shares
Basic 828,000
Options (W1) 5,111
–––––––––
833,111
–––––––––

Rs2,208,000
The DEPS is therefore = Rs 2.65
833,111

(W1) Number of shares at option price

Options = 92,000 × Rs 17
= Rs 1,564,000
Rs 1,564,000
Rs1,564,000
At fair value: = 86,889
Rs18
Number issued free = 920,000 – 868,889 = 5,111

Advanced Financial Accounting and Corporate Reporting (Study Text) 496

6. (a) EPS (basic) = Rs 0.595
Earnings Rs 5,950
Shares 10,000
––––––
EPS 0.595
––––––

(b) EPS (basic) = 0.476

Earnings Rs 5,950
Shares (10m × 5/4) 12,500
––––––
EPS 0.476
––––––
(c) EPS (basic) = Rs 0.571
Earnings Rs 5,950
Shares 10,416
––––––
EPS 0.571
––––––
Pre (7/12 ×10m) Rs 5,833
Post (5/12 ×10m ×11/10) Rs 4,583

(d) EPS (basic) = Rs 0.525

Earnings Rs 5,950
Shares 11,333
––––––
EPS 0.525
––––––
Pre (9/12 × 10m × 4.00/3.75) 8,000
Post (3/12 × 10m × 4/3) 3,333
Actual cum rights price Rs 4.00
TERP (1@300 +3@400)/4 Rs 3.75

(e) EPS (basic) = Rs 0.595

EPS (fully diluted) = Rs 0.497
Earnings (5.95m + (10% × 2.6m × 70%)) Rs 6,132
Shares (10m + (90/100 × 2.6m)) 12,340
––––––
EPS 0.497
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 497

 (f) EPS (basic) = Rs 0.595
EPS (fully diluted) = Rs 0.593
Earnings Rs 5,950
Shares (10m + (150/400× 74) 10,028
––––––
EPS 0.593
––––––

Advanced Financial Accounting and Corporate Reporting (Study Text) 498

Advanced Financial Accounting and Corporate Reporting (Study Text) 499
SEGMENT REPORTING

Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

• Determine the nature and extent of reportable segments.

• Specify and discuss the nature of segment information to be disclosed .

Advanced Financial Accounting and Corporate Reporting (Study Text) 500

1 Defining Reportable Segments

1.1 Introduction
IFRS 8 Operating segments requires an entity to disclose information about
each of its operating segments.

• the purpose is to enable users of the financial statements to evaluate

the nature and financial effects of the business activities in which it
engages and the economic environments in which it operates.

IFRS 8 defines an operating segment as a component of an entity:

• that engages in business activities from which it may earn revenues

and incur expenses

• whose operating results are regularly reviewed by the entity’s chief

operating decision maker to make decisions about resources to be
allocated to the segment and assess its performance

• for which discrete financial information is available. Segmental reports

are designed to reveal significant information that might otherwise be
hidden by the process of presenting a single statement of
comprehensive income / income statement and statement of financial
position for an entity.

1.2 How to define reportable segments

Under IFRS 8 segment information reflects the way that the entity is actually
managed. An entity’s reportable segments (its operating segments) are those
that are used in its internal management reports. Therefore management
identifies the operating segments.

• Startup operations may be operating segments even before they begin

to earn revenue.

• A part of an entity that only sells goods to other parts of the entity is a
reportable segment if management treats it as one.

• Corporate headquarters and other similar departments do not earn

revenue and are therefore not operating segments. An entity’s pension
plan is not an operating segment.

Advanced Financial Accounting and Corporate Reporting (Study Text) 501

 • Management may use more than one set of segment information. For
example, an entity can analyse information by classes of business
(different products or services) and by geographical areas.

• If management uses more than one set of segment information, it

should identify a single set of components on which to base the
segmental disclosures. The basis of reporting information should be
the one that best enables users to understand the business and the
environment in which it operates.

• Operating segments can be combined into one reportable segment

provided that they have similar characteristics.

1.3 Quantitative thresholds

An entity must separately report information about an operating segment that
meets any of the following quantitative thresholds:

• its reported revenue, including both sales to external customers and

inter-segment sales, is ten per cent or more of the combined revenue
of all operating segments

• its reported profit or loss is ten per cent or more of the greater, in
absolute amount, of:

– the combined reported profit of all operating segments that did not
report a loss and

– the combined reported loss of all operating segments that reported a

loss.

• its assets are ten per cent or more of the combined assets of all
operating segments.

At least 75% of the entity’s external revenue should be included in reportable

segments. So if the quantitative test results in segmental disclosure of less
than this 75%, other segments should be identified as reportable segments
until this 75% is reached.

Information about other business activities and operating segments that are
not reportable are combined into an ‘all other segments’ category.

There is no precise limit to the number of segments that can be disclosed, but
if there are more than ten, the resulting information may become too detailed.

Advanced Financial Accounting and Corporate Reporting (Study Text) 502

 Although IFRS 8 defines a reportable segment in terms of size, size is not the
only criterion to be taken into account. There is some scope for subjectivity

Example 1

Defining Reportable Segments

Khurram Ltd carries out a number of different business activities.

Summarised information is given below.

Revenue Profit Total before tax assets

Rs m Rs m Rs m
Manufacture and sale of computer hardware 83 23 34
Development and supply of bespoke software:
to users of the company’s
hardware products 22 12 6
to other users 5 3 1
Technical support and training 10 2 4
Contract work on information
technology products 30 10 10
–––– –––– ––––
150 50 55
–––– –––– ––––

Which of the company’s activities should be identified as separate operating

segments?

Solution
Manufacture and sale of computer hardware and contract work on information
technology products are clearly reportable segments by virtue of size. Each of
these two operations exceeds all three ‘ten per cent thresholds’.

On the face of it, it appears that development of bespoke software is a third

segment. It would make logical sense for both parts of this operation to be
reported together, as supply to users of other hardware forms only three per
cent of total revenue and six per cent of total profit before tax.

Although technical support and training falls below all three ‘ten per cent
thresholds’, it should be disclosed as a fourth reportable segment if (as seems
likely) management treat it as a separate segment because it has different
characteristics from the rest of the business.

Advanced Financial Accounting and Corporate Reporting (Study Text) 503

1.4 Approaches to Identify Reportable Segment
There are two main approaches to identifying reportable segments:
• the ‘risks and returns’ approach
• the ‘managerial’ approach.

The ‘risks and returns’ approach identifies segments on the basis of different
risks and returns arising from different lines of business and geographical
areas. Broadly speaking, this was the approach adopted by IAS 14 Segment
reporting, which has been replaced by IFRS 8.

The ‘managerial’ approach identifies segments corresponding to the internal

organisation structure of the entity. This is the approach adopted by IFRS 8.

The ‘risks and returns’ approach

The ‘risks and returns’ approach is believed to have the following advantages:
• it produces information that is more comparable between companies
and consistent over time than the ‘managerial’ approach

• it assists in the assessment of profitability and the risks and returns of

the component parts of the entity

• it reflects the approach taken in the financial statements for external

reporting.

The main disadvantage of the approach is that defining segments can be

difficult in practice and also subjective. This affects comparability.

The ‘managerial’ approach

The ‘managerial’ approach bases both the segments reported and the
information reported about them on the information used internally for
decision making. This means that management defines the reportable
segments.

Arguments for the ‘managerial approach’ include the following

• Segments based on an entity’s internal structure are less subjective
than those identified by the ‘risks and returns’ approach.

• It highlights the risks and opportunities that management believes are

important.

• It provides information with predictive value because it enables users of

the financial statements to see the entity through the eyes of
management.

Advanced Financial Accounting and Corporate Reporting (Study Text) 504

 • The cost of providing the information is low (because it should already
have been provided for management’s use).

• It will produce segment information that is consistent with the way in

which management discuss their business in other parts of the annual
report (e.g. in the Chairman’s Statement and the Operating and
Financial Review).

Arguments against the ‘managerial approach’ include the following.

• Segments based on internal reporting structures are unlikely to be

comparable between entities and may not be comparable from year to
year for an individual entity. (For example, organisation structures, or
the way in which they are perceived, may change as a result of new
managers being appointed.)

• The information is likely to be commercially sensitive (because entities

are organised strategically).

• In theory, segmental information could be given other than by products

or services or geographically. This might be more difficult to analyse.

• Using the managerial approach could lead to segments with different

risks and returns being combined.

• Analysts define their area of expertise by industry segment, usually

based on product or service. The IAS 14 version of segmental
reporting is more likely to reflect these.

However, it should be remembered that for many entities, the risks and
returns approach and the managerial approach will probably identify exactly
the same reportable segments.

2. Disclosing Reportable Segments

2.1 General information

IFRS 8 requires disclosure of the following.

• Factors used to identify the entity’s reportable segments, including the

basis of organisation (for example, whether segments are based on
products and services, geographical areas or a combination of these).

Advanced Financial Accounting and Corporate Reporting (Study Text) 505

 • The types of products and services from which each reportable
segment derives its revenues.

2.2 Information about profit or loss and other segment items

For each reportable segment an entity should report:

• a measure of profit or loss

• a measure of total assets
• a measure of total liabilities (if such an amount is regularly used in
decision making).

IFRS 8 does not define segment revenue, segment result (profit or loss) or
segment assets.
• Therefore, the following amounts must be disclosed if they are included
in segment profit or loss:

– revenues from external customers

– revenues from intersegment transactions
– interest revenue
– interest expense
– depreciation and amortisation
– material items of income and expense (exceptional items)
– interests in the profit or loss of associates and joint ventures
accounted for by the equity method
– income tax expense
– material noncash items other than depreciation or amortisation.

• Interest revenue can be disclosed net of interest expense only if a

majority of the segment’s revenues are from interest and net interest
revenue is used in decision making.

• The following amounts must be disclosed if they are included in

segment assets:
– investments in associates and joint ventures accounted for by
the equity method
– amounts of additions to noncurrent assets other than financial
instruments.

Advanced Financial Accounting and Corporate Reporting (Study Text) 506

 • An entity must provide reconciliations of the totals disclosed in the
segment report to the amounts reported in the financial statements as
follows:

– segment revenue
– segment profit or loss (before tax and discontinued operations
unless these items are allocated to segments)
– segment assets
– segment liabilities (if reported)
– any other material item of segment information disclosed.

2.3 Entity wide disclosures

IFRS 8 also requires the following disclosures about the entity as a whole,
even if it only has one reportable segment.

• The revenues from external customers for each product and service or
each group of similar products and services.

• Revenues from external customers split between the entity’s country of

domicile and all foreign countries in total.

• Noncurrent assets split between those located in the entity’s country of

domicile and all foreign countries in total.

• Revenue from a single external customer which amounts to ten per

cent or more of an entity’s revenue. The identity of the customer does
not need to be disclosed.

2.4 Measurement
IFRS 8 requires segmental reports to be based on the information reported to
and used by management, even where this is prepared on a different basis
from the rest of the financial statements.

Therefore, an entity must provide explanations of the measurement of

segment profit or loss, segment assets and segment liabilities, including:

• the basis of accounting for any transactions between reportable

segments

• the nature of differences between the measurement of segment profit

or loss, assets and liabilities and the amounts reported in the financial
statements. Differences could result from accounting policies and/or

Advanced Financial Accounting and Corporate Reporting (Study Text) 507

 policies for the allocation of common costs and jointly used assets to
segments

• the nature of any changes from prior periods in measurement methods

• the nature and effect of any asymmetrical allocations to segments (for

example, where an entity allocates depreciation expense but not the
related noncurrent assets).

2.5 Preparing segmental reports

The illustration provides a useful format to follow when preparing a segmental
report.

Illustration 1
Segment Segment Segment Segment All other Total
A B C D
Rs ‘000’ Rs ‘000’ Rs ‘000’ Rs ‘000’ Rs ‘000’ Rs ‘000’

Revenues from external 5,000 9,500 12,000 5,000 1,000 32,500

customers
Revenues from inter-segment - 3,000 1,500 - - 4,500
transaction
Interest revenue 800 1,000 1,500 1,000 - 4,300
Interest expense 600 700 1,100 - - 2,400
Depreciation and amortization 100 50 1,500 900 - 2,550
Exceptional costs - - - 200 - 200
Segment assets 5,000 3,000 12,000 57,000 2,000 79,000
Additions to non-current assets 700 500 800 600 - 2,600
Segment liabilities 3,000 1,800 8,000 30,000 - 42,000

Notes
(1) The ‘all other’ column shows amounts relating to segments that fall
below the quantitative thresholds.

(2) Impairment of assets is disclosed as a material non-cash item.

(3) Comparatives should be provided. These should be restated if an entity

changes the structure of its internal organization so that its reportable
segments change, unless the information is not available and the cost
of preparing it would be excessive.

Advanced Financial Accounting and Corporate Reporting (Study Text) 508

3. Problem Areas in Segmental Reporting

3.1 Segmental reports can provide useful information, but they also have
important limitations.

• IFRS 8 states that segments should reflect the way in which the entity
is managed. This means that segments are defined by the directors.
Arguably, this provides too much flexibility. It also means that
segmental information is only useful for comparing the performance of
the same entity over time, not for comparing the performance of
different entities.

• Common costs may be allocated to different segments on whatever

basis the directors believe is reasonable. This can lead to arbitrary
allocation of these costs.

• A segment’s operating results can be distorted by trading with other

segments on noncommercial terms.

• These limitations have applied to most systems of segmental reporting,

regardless of the accounting standard being applied. IFRS 8 requires
disclosure of some information about the way in which common costs
are allocated and the basis of accounting for intersegment
transactions.

3.2 Further Problem Areas

IFRS 8 was issued relatively recently (November 2006) and will only be fully
effective from 2009. Presently, at January 2010, it is too early to say whether
it will be more successful than its predecessor, IAS 14. There are some
potential problem areas, which are briefly discussed below.

Determining reportable segments

IAS 14 required an entity to prepare two segmental reports: one based on
business segments and one based on geographical segments. IFRS 8 only
requires one segmental report. If management uses more than one set of
segment information, it should identify a single set of components on which to
base the segmental disclosures. In practice, this may be both difficult to do,
and subjective. For example, some entities adopt a ‘matrix’ form of
organisation in which some managers are responsible for different products
worldwide, while others are responsible for particular geographical areas.

Advanced Financial Accounting and Corporate Reporting (Study Text) 509

 Disclosure of segment information
Some information (for example, segment liabilities) is only required if it is
regularly provided to the chief operating decision maker. In theory, it would be
possible to avoid disclosing ‘bad news’ or other sensitive information on the
grounds that the information was not used in decision making.

Measurement of segment results and segment assets

IFRS 8 does not define segment results and segment assets. Although the
standard requires disclosure of certain figures if these are included in the
totals, the amounts will not necessarily be measured on the same basis as the
amounts in the main financial statements.

IAS 14 required segmental information to conform with the accounting policies

used in the main financial statements.

Changes to the way in which an entity is organised

One of the disadvantages of the IFRS 8 approach is that if a company
changes the way in which it is organised, its reportable segments may also
change. IFRS 8 requires an entity to restate its comparative information for
earlier periods unless the information is not available and the cost of
developing it would be excessive. If an entity does not restate its comparative
figures, segment information for the current period must be disclosed both on
the old basis and on the new basis. The disclosures should help users to
understand the effect of the change, but some users may find it difficult to
analyse the information, particularly where an entity undergoes frequent
restructurings.

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 Chapter Summary

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Self-Test Questions

1. An entity has prepared the following segmental report;

Operating segments

Fruit Growing Canning Other Group

20X2 20X1 20X2 20X1 20X2 20X1 20X2 20X1

Rs ’000’Rs ’000’ Rs ’000’ Rs ’000’ Rs ’000’ Rs ’000’ Rs ’000’ Rs ’000’

Total revenue 13,635 15,188 20,520 16,2005,400 4,050 39,555 35,438

Less Inter-segment
revenue 3,485 1,688 2,970 3,105 - - 6,455 4,793
_____ _____ _____ _____ _____ _____ _____ _____
External revenue 10,150 13,500 17,550 13,095 5,400 4,050 33,100 30,645
_____ _____ _____ _____ _____ _____ _____ _____
Segment profit 3,565 3,375 4,725 3,600 412 540 8,702 7,515
_____ _____ _____ _____ _____ _____ _____ _____
Segments 33,750 32,400 40,500 33,750 18,765 17,563 93,015 83,713
_____ _____ _____ _____ _____ _____ _____ _____
Unallocated (common) assets 13,500 11,003
______ ______
Total assets 106,515 94,716

Required:
Identify areas in which the segmental report provided below does not
necessarily result in the disclosure of useful information.

2. Tayyab Ltd has recently acquired four large overseas subsidiaries. These
subsidiaries manufacture products which are total different from those of the
holding company. The holding company manufactures paper and related
products whereas the subsidiaries manufacture the following:

Product Location
Subsidiary 1 Car product Spain
Subsidiary 2 Textiles Korea
Subsidiary 3 Kitchen utensils France
Subsidiary 4 Fashion garments Thailand

The directors have purchased these subsidiaries in order to diversify their

product base but do not have any knowledge on the information which is
required in the financial statements, regarding these subsidiaries, other than
the statutory requirements. These directors of the company realize that there

Advanced Financial Accounting and Corporate Reporting (Study Text) 512

 is a need to disclose segment information but do not understand what the
implication are for the published accounts.

Required:
(a) Explain to the directors the purpose of segmental reporting of financial
information. (4 Marks)

(b) Explain to the directors the criteria which should be used to identify the
separate reportable segments (you should illustrate your answer by
reference to the above information. (6 marks)

(c) Advise the directors on the information which should be disclosed in

financial statements for each segment. (7 marks)

(d) Critically evaluate IFRS 8 Operating segments, setting out the major
problems with the standard.

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Answers

1. Your answer may have included some of the following.

(i) Definition of segments: It would be helpful to know whether there are

any other classes of business included within the three operating
segments supplied by the company which are material. This is
particularly important when one looks at the Canning segment and
notices that it comprises 50% of the total sales to customers outside
the group.

(ii) Inter-segment sales: The intersegment sales for fruit growing are a
relatively high percentage (at around 25% (Rs 3,485/13,635)) of its
total revenue. In assessing the risk and economic trends it might well
be that those of the receiving segment are more useful in predicting
future prospects than those of the segment from which the sale
originated.

(iii) Analysis of assets: Users often need to calculate a return on capital

employed for each segment. Therefore, it is important to ensure that
the segment profit and assets are appropriately defined, so that
segment profit can be usefully related to the assets figure to produce a
meaningful ratio. This means that both the operating profit and assets
figure need to be precisely defined. If, for example, the assets are the
gross assets, then the operating profits should be before deduction of
interest. This means that the preparer of the segmental report needs to
be aware of the reader’s information needs.

(iv) Unallocated items: The information provided includes unallocated

assets that represent around 12% of the total assets. It is not clear
what these assets represent.

(v) Treatment of interest: It would be useful to know if there has been

any interest charge incurred and to ascertain whether it is material and
whether it can be reasonably identified as relating to any particular
segment. As mentioned in (iii) above, it is not clear how segment profit
is defined or how it has been derived.

2. (a) The purpose of segmental information is to provide users of financial

statements with sufficient details for them to be able to appreciate the
different rates of profitability, different opportunities for growth and
different degrees of risk that apply to an entity’s classes of business
and various geographical locations.

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 The segmental information should enable users to:

(i) appreciate more thoroughly the results and financial position of

the entity by permitting a better understanding of the entity’s
past performance and thus a better assessment of its future
prospects

(ii) be aware of the impact that changes in significant components

of a business may have on the business as a whole.

(b) IFRS 8 defines an operating segment as a component of an entity:

– that engages in business activities from which it may earn

revenues and incur expenses (including revenues and expenses
relating to transactions with other components of the same
entity)

– whose operating results are regularly reviewed by the entity’s

chief operating decision maker to make decisions about
resources to be allocated to the segment and assess its
performance

– for which discrete financial information is available.

– reported revenue, including both sales to external customers

These qualitative criteria are supplemented by quantitative:

– reported revenue, including both sales to external customers

and intersegment sales or transfers, is 10% or more of the
combined revenue, internal and external, of all operating
segments

– the absolute amount of its reported profit or loss is 10% or more

of the greater, in absolute amount, of (i) the combined reported
profit of all operating segments that did not report a loss and (ii)
the combined reported loss of all operating segments that
reported a loss

– assets are 10% or more of the combined assets of all operating

segments.

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 (c) An entity shall disclose the factors used to identify the entity’s
reportable segments and types of products and services from which
each reportable segment derives its revenues.

The following information will be reported about profit or loss, assets

and liabilities for each segment:

An entity shall report a measure of profit or loss and total assets for
each reportable segment:

• a measure of liabilities for each reportable segment if such an

amount is regularly provided to the chief operating decision
maker.

• An entity shall also disclose the following about each reportable

segment if the specified amounts are included in the measure of
segment profit or loss reviewed by the chief operating decision
maker, or are otherwise regularly provided to the chief operating
decision maker, even if not included in that measure of segment
profit or loss:

– revenues from external customers;

– revenues from transactions with other operating
segments of the same entity;
– interest revenue;
– interest expense;
– depreciation and amortisation;
– material items of income and expense disclosed in
accordance with IAS 1

Presentation of financial statements;

– the entity’s interest in the profit or loss of associates and
joint ventures accounted for by the equity method;
– income tax expense or income and
– material non-cash items other than depreciation and
amortisation.

TAYYAB Ltd has five types of products and more information is really
required on the commonality of any of these five. A product split could
thus be for five segments.

Likely candidates for grouping together are textiles and fashion

garments, perhaps under the heading ‘textiles’ or ‘textiles and clothing’.

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 In addition it may be reasonable to group car products and kitchen
utensils under the heading ‘domestic products’.

(d) IFRS 8 lays down some very broad and inclusive criteria for reporting
segments. Unlike earlier attempts to define segments in more
quantitative terms, segments are defined largely in terms of the
breakdown and analysis used by management. This is, potentially, a
very powerful method of ensuring that preparers provide useful
segmental information.

There will still be problems in deciding which segments to report, if only

because management may still attempt to reduce the amount of
commercially sensitive information that they produce.

The growing use of executive information systems and data

management within businesses makes it easier to generate reports on
an ad hoc basis. It would be relatively easy to provide management
with a very basic set of internal reports and analyses and leave
individual managers to prepare their own more detailed information
using the interrogation software provided by the system. If such
analyses became routine then they would be reportable under IFRS 8,
but that would be very difficult to check and audit.

There are problems in the measurement of segmental performance if

the segments trade with each other. Disclosure of details of
intersegment pricing policy is often considered to be detrimental to the
good of a company. There is little guidance on the policy for transfer
pricing.

Differing internal reporting structures could lead to inconsistent and

incompatible segmental reports, even from companies in the same
industry.

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Advanced Financial Accounting and Corporate Reporting (Study Text) 518
NON-FINANCIAL REPORTING
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

 Discuss the increased demand for transparency in corporate reports, and the
emergence of non-financial reporting standards.
 Understand the purpose, presentation and elements of Management
Commentary Reports.
 Discuss the progress towards a framework for environmental and
sustainability reporting.
 Appraise the impact of environmental, social and ethical factors on
performance measurement.
 Discuss human resource reporting.
 Discuss why entities might include disclosures relating to the environment and
society.

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1 Non-Financial Reporting

Non-financial information, in the form of additional information provided

alongside the financial information in the annual report, has become more
important in recent years.

While financial information remains important, stakeholders are interested in

other aspects of an entity’s performance.

For example:
• how the business is managed
• its future prospects
• the entity’s policy on the environment
• its attitude towards social responsibility, and so on.

Many of these issues, whilst included within the financial statements to some
extent, have not always been fully reported to meet the needs of users of
financial statements. In recent years, there has been a growing demand for
transparency of reported information covering both financial and non-financial
information. This could include information relating to a number of issues such
as:

• selection, application and appropriate disclosure of accounting policies

adopted by an entity, so that users of financial statements fully
understand the basis upon which financial statements have been
prepared.

• the impact of the entity's activities on the environment – this could include
waste management and recycling policies, use of renewable energy
sources and pollution management policies.

• the interaction of the entity with society generally or particular

communities within which it operates – this could include labour
recruitment and development policies, charitable donations and
activities and other contributions to the local community. Many
organisations now actively participate within the communities within
which they operate, perhaps by supporting or donating to local
charities, with the intention of 'putting something back' into those
communities. This may happen, for example, if an entity permits staff to
take time away from their employment to provide work or service to a
local charity or similar organisation for benevolent reasons.

Although these activities do have an impact upon financial position and

performance, some users of financial statements may have a particular

Advanced Financial Accounting and Corporate Reporting (Study Text) 520

 interest in these activities. For example, potential shareholders may be
attracted to invest in a particular entity (or not), based upon their
environmental or social policies, in addition to their financial performance.
Regulators or consumer pressure groups may also have a particular interest
in such policies and disclosures to manage their activities or monitor the
effectiveness of their activities.

All of this information is reported in a number of ways.

 An operating and financial review (OFR) will assess the results of the
period and discuss the future prospects of the business. Many entities
have embraced the spirit of the regulation, rather than merely complied
with the legal requirements, as a means to improve

 stakeholder understanding and awareness, which could lead to

competitive advantage.

 A report on corporate governance will report on how the entity is managed

and directed. For example, entities which are listed on the Stock
Exchange, are required to comply with a code of best practice and to
make disclosures regarding the extent of compliance or noncompliance
with the code as appropriate.

 An environmental and social report will report upon entity policies and
responsibilities towards the environment and society, or both of these
issues could be combined in a report on sustainability. This may include
policy statements, supported by narrative explanation

 together with both qualitative and quantitative disclosures to enable its

evaluation by users of that information.

 Information may be provided in the form of a management commentary.

The IASB has acknowledged that there is a growing demand for this form
of reporting, and a willingness on the part of entities to provide it, with the
publication of Practice Statement 1 (PS) Management Commentary in
December 2010 (see later within chapter).

The additional reports and disclosures go some way towards providing

transparency for evaluation of entity financial performance, position and
strategy. Transparency fosters confidence in the information which is made
available to investors and other stakeholders who may be interested in both
financial and non-financial information

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2 Management Commentary

2.1 Purpose of the Management Commentary (MC)

The IFRS Practice Statement (PS) Management Commentary provides a
broad, nonbinding framework for the presentation of management
commentary that relates to financial statements that have been prepared in
accordance with International Financial Reporting Standards (IFRSs)

It is a narrative report that provides a context within which to interpret the

financial position, financial performance and cash flows of an entity.
Management are able to explain its objectives and its strategies for achieving
those objectives. Users routinely use the type of information provided in
management commentary to help them evaluate an entity’s prospects and its
general risks, as well as the success of management’s strategies for
achieving its stated objectives. For many entities, management commentary
is already an important element of their communication with the capital
markets, supplementing as well as complementing the financial statements.

This PS helps management to provide useful commentary to financial

statements prepared in accordance with IFRS information. The users are
identified as existing and potential members, together with lenders and
creditors.

2.2 Framework for presentation of management commentary

The following principles should be applied when a management commentary
is prepared:

• to provide management’s view of the entity’s performance, position and

progress; and
•
• to supplement and complement information presented in the financial
statements

Consequently, the MC should include information which is both forward-

looking and adheres to the qualitative characteristics of information as
described in the 2010 Conceptual Framework for Financial Reporting

The management commentary should provide information to help users of the

financial reports to assess the performance of the entity and the actions of its
management relative to stated strategies and plans for progress. That type of
commentary will help users of the financial reports to understand, risk
exposures and strategies of the entity, relevant non-financial factors and other
issues not otherwise included within the financial statements.

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 Management commentary should provide management’s perspective of the
entity’s performance, position and progress. Management commentary should
derive from the information that is important to management in managing the
business.

2.3 Elements of management commentary

Although the particular focus of management commentary will depend on the
facts and circumstances of the entity, management commentary should
include information that is essential to an understanding of:

• the nature of the business;

• management’s objectives and its strategies for meeting those
objectives;
• the entity’s most significant resources, risks and relationships;
• the results of operations and prospects; and
• the critical performance measures and indicators that management
uses to evaluate the entity’s performance against stated objectives

3 Sustainability

3.1 Definition
Sustainability is the process of conducting business in such a way that it
enables an entity to meet its present needs without compromising the ability
of future generations to meet their needs.

Introduction
In a corporate context, sustainability means that a business entity must
attempt to reduce its environmental impact through more efficient use of
natural resources and improving environmental practices.

More and more business entities are reporting their approach to sustainability
in addition to the financial information reported in the annual report. There are
increased public expectations for business entities and industries to take
responsibility for the impact their activities have on the environment and
society.

3.2 Reporting sustainability

• Currently, sustainability reporting is voluntary, although its use is
increasing.

• Reports include highlights of non-financial performance such as

environmental, social and economic reports during the accounting
period.

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 • The report may be included in the annual report or published as a
stand alone document, possibly on the entity’s website.

• The increase in popularity of such reports highlights the growing trend

that business entities are taking sustainability seriously and are
attempting to be open about the impact of their activities.

• Reporting sustainability is sometimes called reporting the ‘triple bottom

line’ covering environment, social and economic reporting

3.3 Framework for sustainability reporting

• There is no framework for sustainability reporting in IFRS, so this
reporting is voluntary.
• This lack of regulation leads to several potential problems:

a. Because disclosure is largely voluntary, not all businesses disclose

information. Those that do tend to do so either because they are under
particular pressure to prove their ‘green’ credentials (for example, large
public utility companies whose operations directly affect the
environment) or because they have deliberately built their reputation on
environmental

b. friendliness or social responsibility.

c. The information disclosed may not be complete or reliable. Many

businesses see environmental reporting largely as a public relations
exercise and therefore only provide information that shows them in a
positive light.

d. The information may not be disclosed consistently from year to year.

e. Some businesses, particularly small and medium sized entities, may

believe that the costs of preparing and circulating additional information
outweigh the benefits of doing so.

The most accepted framework for reporting sustainability is the Global

Reporting Initiative’s Sustainability Reporting Guidelines, the latest of
which 'G3' – the third version of the guidelines – was issued in October
2006. As at August 2010, this is still the most recent version of the
guidelines.

• The most accepted framework for reporting sustainability is the Global

Reporting Initiative’s Sustainability Reporting Guidelines, the latest of
which 'G3' – the third version of the guidelines – was issued in October
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 2006. As at August 2010, this is still the most recent version of the
guidelines.

• The G3 Guidelines provide universal guidance for reporting on

sustainability performance. They are applicable to all entities including
SMEs and not-for-profit entities worldwide. The G3 consist of principles
and disclosure items .The principles help to define report content,
quality of the report, and give guidance on how to set the report
boundary. Disclosure items include disclosures on management of
issues, as well as performance indicators themselves.

The best way to understand sustainability is to look at some examples of

sustainability reports in financial statements.

Global Reporting Initiative

• You can also look at the Global Reporting Initiative website
(www.globalreporting.org)
• The financial statements of companies that have applied the GRI
guidelines are listed with a link to their reports

4 International Integrated Reporting Committee (IIRC)

4.1 What is the purpose of the IIRC?

The IIRC is being created to respond to this need for a concise, clear,
comprehensive and comparable integrated reporting framework structured
around the organization’s strategic objectives, its governance and business
model and integrating both material financial and non-financial information.
The objectives for an integrated reporting framework are to:

• support the information needs of longterm investors, by showing the

broader and longerterm consequences of decisionmaking;

• reflect the interconnections between environmental, social, governance

and financial factors in decisions that affect longterm performance and
condition, making clear the link between sustainability and economic
value;

• provide the necessary framework for environmental and social factors

to be taken into account systematically in reporting and
decisionmaking;

• rebalance performance metrics away from an undue emphasis on

short-term financial performance; and

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 • bring reporting closer to the information used by management to run
the business on a day-to-day basis.

4.2 What is the role of the IIRC?

At present a range of standard-setters and regulatory bodies are responsible
for individual elements of reporting. No single body has the oversight or
authority to bring together these different elements that are essential to the
presentation of an integrated picture of an organization and the impact of
environmental and social factors on its performance. In addition, globalisation
means that an accounting and reporting framework needs to be developed on
an international basis. At present, there is a risk that, as individual regulators
respond to the risks faced, multiple standards will emerge.

The role of the IIRC is to:

• raise awareness of this issue and develop a consensus among

governments, listing authorities, business, investors, accounting bodies
and standard setters for the best way to address it;

• develop an overarching integrated reporting framework setting out the

scope of integrated reporting and its key components;

• identify priority areas where additional work is needed and provide a

plan for development;

• consider whether standards in this area should be voluntary or

mandatory and facilitate collaboration between standard-setters and
convergence in the standards needed to underpin integrated reporting;
and

• promote the adoption of integrated reporting by relevant regulators and

report preparers

5 Environmental Reporting

5.1 Definition
Environmental reporting is the disclosure of information in the published
annual report or elsewhere, of the effect that the operations of the business
have on the natural environment.

This section details the contents of an environment report together with any
accounting issues.

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 Environmental reporting in practice
There are two main vehicles that companies use to publish information about
the ways in which they interact with the natural environment:

(a) The published annual report (which includes the financial statements)
(b) A separate environment report (either as a paper document or simply
posted on the company website).

The IASB encourages the presentation of environmental reports if

management believe that they will assist users in making economic decisions,
but they are not mandatory.

IAS 1 points out that any statement or report presented outside financial
statements is outside the scope of IFRSs, so there are no mandatory IFRS
requirements on separate environmental reports.

5.2 Separate Environment Reports

Many large public companies publish environmental reports that are
completely separate from the annual report and financial statements. The
environmental report is often combined in a sustainability report.

Most environmental reports take the form of a combined statement of policy

and review of activity. They cover issues such as:

• waste management
• pollution
• intrusion into the landscape
• the effect of an entity’s activities upon wildlife
• use of energy
• the benefits to the environment of the entity’s products and services.

Generally, the reports disclose the entity’s targets and/or achievements, with
direct comparison between the two in some cases. They may also disclose
financial information, such as the amount invested in preserving the
environment.

Public and media interest has tended to focus on the environmental report
rather than on the disclosures in the published annual report and financial
statements. This separation reflects the fact that the two reports are aimed at
different audiences.

Shareholders are the main users of the annual report, while the environmental
report is designed to be read by the general public. Many companies publish

Advanced Financial Accounting and Corporate Reporting (Study Text) 527

 their environmental and social reports on their websites, which encourages
access to a wide audience.

5.3 The content of environment reports

The content of an environment report may cover the following areas.

(a) Environmental issues pertinent to the entity and industry

– The entity’s policy towards the environment and any improvements

made since first adopting the policy.

– Whether the entity has a formal system for managing environmental

risks.

– The identity of the director(s) responsible for environmental issues.

– The entity’s perception of the risks to the environment from its

operations.

– The extent to which the entity would be capable of responding to a

major environmental disaster and an estimate of the full economic
consequences of such a future major disaster.

– The effects of, and the entity’s response to, any government legislation
on environmental matters.

– Details of any significant infringement of environmental legislation or

regulations.

– Material environmental legal issues in which the entity is involved.

– Details of any significant initiatives taken, if possible linked to amounts

in financial statements.

– Details of key indicators (if any) used by the entity to measure

environmental performance. Actual performance should be compared
with targets and with performance in prior periods.

(b) Financial information

– The entity’s accounting policies relating to environmental costs,
provisions and contingencies.

– The amount charged to the income statement or statement of

comprehensive income during the accounting period in respect of
expenditure to prevent or rectify damage to the environment caused
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 by the entity’s operations. This could be analysed between
expenditure that the entity was legally obliged to incur and other
expenditure.

– The amount charged to the income statement or statement of

comprehensive income during the accounting period in respect of
expenditure to protect employees and society in general from the
consequences of damage to the environment caused by the entity’s
operations. Again, this could be analysed between compulsory and
voluntary expenditure.

– Details (including amounts) of any provisions or contingent liabilities

relating to environmental matters.

– The amount of environmental expenditure capitalised during the

year.

– Details of fines, penalties and compensation paid during the

accounting period in respect of noncompliance with environmental
regulations

5.4 Accounting for environment costs

Definitions
Environmental costs:
include environmental measures and environmental losses.

Environmental measures
are the costs of preventing, reducing or repairing damage to the environment
and the costs of conserving resources.

Environmental losses
are costs that bring no benefit to the business.

Environmental measures can include:

• capital expenditure
• closure or decommissioning costs
• clean-up costs
• development expenditure
• costs of recycling or conserving energy.
• Environmental losses can include:
• fines, penalties and compensation

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 • impairment or disposal losses relating to assets that have to be
scrapped or abandoned because they damage the environment.

Accounting Treatment
• Environmental costs are treated in accordance with the requirements of
current accounting standards.

• Most expenditure is charged in the income statement or statement of

comprehensive income in the period in which it is incurred. Material items
may need to be disclosed separately in the notes to the accounts or on the
face of the income statement/statement of comprehensive income as
required by IAS 1.

• Entities may have to undertake fundamental reorganisations or

restructuring or to discontinue particular activities in order to protect the
environment. If a sale or termination meets the definition of a discontinued
operation, its results must be separately disclosed in accordance with the
requirements of IFRS 5. Material restructuring costs may need to be
separately disclosed on the face of the income statement/statement of
comprehensive income.

• Fines and penalties for noncompliance with regulations are charged to the
income statement or statement of comprehensive income in the period in
which they are incurred. This applies even if the activities that resulted in
the penalties took place in an earlier accounting period, as they cannot be
treated retrospectively as prior period adjustments.

• Expenditure on noncurrent assets is capitalised and depreciated in the

usual way as per IAS 16 Property, plant and equipment. Any
government grants received for expenditure that protects the environment
are treated in accordance with IAS 20 Accounting for government
grants and disclosure of government assistance.

• (e) Noncurrent assets (including goodwill) may become impaired as a

result of environmental legislation or new regulations. IAS 36 Impairment
of assets lists events that could trigger an impairment review, one of
which is a significant adverse change in the legal environment in which the
business operates.

• (f) Research and development expenditure in respect of environmentally

friendly products, processes or services is covered by IAS

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6 Social Reporting

6.1 Definition

• Corporate social reporting is the process of communicating the social

and environmental effects of organisations’ economic actions to particular
interest groups within society and to society at large.

• It involves extending the accountability of organisations (particularly

companies) beyond the traditional role of providing a financial account to
the owners of capital. Social and ethical reporting would seem to be at
variance with the prevailing business. However, there are a number of
reasons why entities publish social reports.

(a) They may have deliberately built their reputation on social responsibility
in order to attract a particular customer base.

(b) They may perceive themselves as being under particular pressure to

prove that their activities do not exploit society as a whole or certain
sections of it (e.g. Shell International and large utility companies).

(c) They may be genuinely convinced that it is in their long-term interests

to balance the needs of the various stakeholder groups.

(d) They may fear that the government will eventually require them to
publish socially oriented information if they do not do so voluntarily

6.2 Social responsibility

A business interacts with society in several different ways as follows.

• It employs human resources in the form of management and other

employees.

• Its activities affect society as a whole, for example, it may:

– be the reason for a particular community’s existence

– produce goods that are helpful or harmful to particular members
of society
– damage the environment in ways that harm society as a whole
– undertake charitable works in the community or promote
particular values

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 If a business interacts with society in a responsible manner, the needs of
other stakeholders should be taken into account and performance may
encompass:

• providing fair remuneration and an acceptable working environment

• paying suppliers promptly

• minimising the damage to the environment caused by the entity’s

activities

• contributing to the community by providing employment or by other

means.

6.3 Social reporting in practice

Social reporting in the financial statements

• Disclosures of social reporting matters in financial statements tend to
be required by national legislation and by the stock exchange on which
an entity is quoted. There is little mention of social matters in
international accounting standards.

• IAS 1 requires disclosure of the total cost of employee benefits for the
period. If the ‘nature of expense’ method is chosen for the income
statement/statement of comprehensive income, then the total charge
for employee costs will be shown on the face of the income
statement/statement of comprehensive income. If the ‘function of
expense’ method is chosen, then IAS 1 requires disclosure of the total
employee costs in a note to the financial statements.

• IAS 24 Related party disclosures requires the benefits paid to key

management personnel to be disclosed in total and analysed into the
categories of benefits.

• Other possible disclosures (e.g. details of directors and corporate

governance matters, employee policies, supplier payment policies,
charitable contributions, etc.) are normally dealt with by local legislation
and would only be required by IFRSs when such disclosure is
necessary to present fairly the entity’s financial performance.

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 6.4 Special Social Reports
• Stand alone social and ethical reports do not have to be audited
and there are no international regulations prescribing their content.

• There are some sets of nonmandatory guidelines and codes of best

practice, for example, the standard AA1000, which has been issued
by the Institute of Social and Ethical Accountability (ISEA).

• Some organisations have the data in their reports independently

verified and include the auditor’s report in their published document.

The social report may or may not be combined with the environmental
report. It has been suggested that there should be three main types of
information in the social report.

(a) Information about relationships with stakeholders, e.g.

employee numbers, wages and salaries, provision of facilities for
customers and information about involvement with local charities.

(b) Information about the accountability of the entity, e.g. sickness

leave, accident rates, noise levels, numbers of disabled employees,
compliance with current legal, ethical and industry standards.

(c) Information about dialogue with stakeholders, e.g. the way in

which the entity consults with all stakeholders and provides public
feedback on the stakeholders’ perceptions of the entity’s
responsibilities to the community and its performance in meeting
stakeholder needs.

7 Human Capital Management (HCM)

7.1 Definition:
Human capital management relates to the management of the recruitment,
retention, training and development of employees. It views employees as a
business asset, rather than just a cost.

HCM is a key resource of competitive advantage and, ultimately,

profitability. Any business needs to ensure that its workforce has the right
mix of people, with appropriate skills and experiences, allowing the
business to compete effectively.

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7.2 Accounting for People Task Force
the Accounting for People Task Force is set up by to look at ways in which
organisations can measure the quality and effectiveness of their human
capital management. Its brief was to:

• look at the performance measures currently used to assess investment

in HCM
• consider best practice in human capital reporting, and the performance
measures that are most valuable to stakeholders
• establish and champion the business case for producing such reports
• produce a final advisory report

The Task Force believes that effective people policies and practices will
benefit organisations and their stakeholders. Managers, investors, workers,
consumers and clients all have an interest in knowing that an organisation is
aiming for high performance by investing in their people.

The Task Force recommends that reports on HCM should have a strategic
focus. They should communicate clearly, fairly and unambiguously the
board’s current understanding of the links between the HCM policies and
practices, its business strategy and its performance.

They should include information on:

• the size and composition of the workforce

• retention and motivation of employees
• the skills and competences necessary for success, and training to
achieve these
• remuneration and fair employment practices
• leadership and succession planning
• being balanced and objective, following a process that is susceptible to
review by auditors
• providing information in a form that enables comparisons over time.

In summary, this will become another area of corporate reporting alongside

environmental and social reports that companies will be expected to produce.
Already there is some guidance from the findings of the Task Force as to what
should be included in such a report. It remains to be seen whether this
requirement will become mandatory in the future. There is no doubt that by
requiring companies to consider this area, the link between investment in
employees and improved business performance will be made.

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8 Impact on Performance Measures

The developments outlined above in the reporting of the environmental and

social consequences of an entity’s activities have identified a wide array of
areas, over and above financial performance, in which management
performance should be evaluated, such as:
• Environmental
• Social
• Management of customers
• Management of employees
• Ethics

(a) environmental:
– use of energy, including proportion from renewable sources
– efficiency of energy creation (for power generators)
– CO2 emissions
– waste management
– accidents affecting environment
– transport.

(b) social:
– investment in local community initiatives
– time off for employees involved in charitable work
– matching money raised by employees for charitable work
– employment opportunities for the disadvantaged
– ethnic balance in workforce
– equality, e.g. women in senior management positions
– accidents affecting the community.

To these can be added other headings, such as:

(c) customers:
– failures to supply on time and in good condition
– customer complaints, e.g. about direct selling techniques
– fair pricing
– help for the disadvantaged through special pricing schemes.

(d) employees:
– absenteeism rates
– sickness leave
– diversity
– equal opportunities
– investment in training

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 – number of industrial relations tribunals in respect of the entity.

(e) ethics:
– number and cost of incidents leading to fines and/or penalties
– number and cost of incidents leading to compensation:
– to customers
– to employees
– to others
– non penalisation of whistle blowers.

But for performance measurement in these areas to be useful, the result must
be information which is helpful in the making of economic decisions, whether
they relate to the choice of investment, employment or suppliers. The IASB
Framework’s characteristics for useful financial information are that it should
be relevant, reliable and comparable. These characteristics can be applied to
environmental, social and ethical areas as follows.

• Relevance: how much weight do/will investors, employees and

consumers give to these factors, compared with that given to financial
factors (so return on investment, employee benefits and price,
respectively)?

• Reliability: how much can the performance measured in these areas

be relied on? How sure can users of this information be that it is a
faithful representation of what has occurred, as opposed to a selective
view, focusing on the successes? Are there external assurance
processes that can validate the information, perhaps using the GRI
guidelines?

• Comparability: is the information produced by different entities pulled

together on a comparable basis, using similar measurement policies,
so that the users can make informed choices between entities? If not,
all that can be measured is an entity’s performance compared with its
own performance in previous periods.

Even if the information is reliable and comparable, is it useful, i.e. will it

change the behaviour of investors, employees and consumers?

The answers to these questions will determine whether entities take such
reporting seriously or merely treat it as part of their promotional activities. And
the answers in ten years’ time will almost certainly be different from those of
today.

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 Chapter Summary

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 SELF-TEST QUESTIONS

1. You are the chief accountant of Crescent and you are currently finalising the
financial statements for the year ended 31 December 20X1. Your assistant
(who has prepared the draft accounts) is unsure about the treatment of two
transactions that have taken place during the year. She has written you a
memorandum that explains the key principles of each transaction and also the
treatment adopted in the draft accounts.

Transaction one
One of the corporate objectives of the enterprise is to ensure that its activities
are conducted in such a way as to minimise any damage to the natural
environment. It is committed in principle to spending extra money in pursuit of
this objective but has not yet made any firm proposals. The directors believe
that this objective will prove very popular with customers and are anxious to
emphasise their environmentally friendly policies in the annual report.

Your assistant suggests that a sum should be set aside from profits each year
to create a provision in the financial statements against the possible future
costs of environmental protection. Accordingly, she has charged the income
statement for the year ended 31 December 20X1 with a sum of Rs 100,000
and proposes to disclose this fact in a note to the accounts.

Transaction two
A new law has recently been enacted that will require Crescent to change one
of its production processes in order to reduce the amount of carbon dioxide
that is emitted. This will involve purchasing and installing some new plant that
is more efficient than the equipment currently in use. To comply with the law,
the new plant must be operational by 31 December 20X2. The new plant has
not yet been purchased.

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 Required:
Draft a reply to your assistant that:

(a) reviews the treatment suggested by your assistant and recommends

changes where relevant. In each case your reply should refer to relevant
International Accounting Standards

(b) replies to her suggestion that the financial statements for the year
ended 31 December 20X0 were wrong because they made no reference
to environmental matters.

2. (a) Explain why companies may wish to make social and

environmental disclosures in their annual report. Discuss how
this content should be determined.

(b) Company B owns a chemical plant, producing paint. The plant

uses a great deal of energy and releases emissions into the
environment. Its by-product is harmful and is treated before
being safely disposed of. The company has been fined for
damaging the environment following a spillage of the toxic waste
product. Due to stricter monitoring routines set up by the
company, the fines have reduced and in the current year they
have not been in breach of any local environment laws.

The company, is aware that emissions are high and has been steadily
reducing them. They purchase electricity from renewable sources and in the
current year have employed a temporary consultant to calculate their carbon
footprint so they can take steps to reduce it.

Discuss the information that could be included in Company B’s

environmental report.

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 Answers

1. MEMORANDUM

To: Assistant Accountant

From: Chief Accountant
Subject: Accounting treatment of two transactions and disclosure of
environmental matters in the financial statements

Date: 25 March 20X2

(a) Accounting treatment of two transactions

Transaction one
IAS 37 Provisions, contingent liabilities and contingent assets states that
provisions should only be recognised in the financial statements if:

– there is a present obligation as a result of a past event

– it is probable that a transfer of economic benefits will be required
to settle the obligation
– a reliable estimate can be made of the amount of the obligation.

In this case, there is no obligation to incur expenditure. There may be a

constructive obligation to do so in future, if the board creates a valid
expectation that it will protect the environment, but a board decision alone
does not create an obligation.

There is also some doubt as to whether the expenditure can be reliably

quantified. The sum of Rs 100,000 could be appropriated from retained
earnings and transferred to an environmental protection reserve within other
components of equity, subject to formal approval by the board. A note to the
financial statements should explain the transfer.

Transaction two
Again, IAS 37 states that a provision cannot be recognised if there is no
obligation to incur expenditure. At first sight it appears that there is an
obligation to purchase the new equipment, because the new law has been
enacted. However, the obligation must arise as the result of a past event. At
31 December 20X1, no such event had occurred as the new plant had not yet
been purchased and the new law had not yet come into effect. In theory, the
company does not have to purchase the new plant. It could completely
discontinue the activities that cause pollution or it could continue to operate
the old equipment and risk prosecution under the new law. Therefore no
provision can be recognised for the cost of new equipment.

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 It is likely that another effect of the new law is that the company will have to
dispose of the old plant before it would normally have expected to do so. IAS
36 Impairment of assets requires that the old plant must be reviewed for
impairment. If its carrying value is greater than its recoverable amount, it must
be written down and an impairment loss must be

charged against profits. This should be disclosed separately in the notes to

the income statement/statement of comprehensive income if it is material

b) Reference to environmental matters in the financial statements

At present, companies are not obliged to make any reference to
environmental matters within their financial statements. Current international
financial reporting practice is more designed to meet the needs of investors
and potential investors, rather than the general public. Some companies
choose to disclose information about the ways in which they attempt to
safeguard the environment, something that is often carried out as a public
relations exercise. Disclosures are often framed in very general terms and
appear outside the financial statements proper. This means that they do not
have to be audited.

Several companies publish fairly detailed ‘environmental reports’. It could be

argued that as Crescent’s operations affect the wider community, it has a
moral responsibility to disclose details of its activities and its environmental
policies. However, at present it is not required to do so by IFRSs.

If a company has, or may have, an obligation to make good any

environmental damage that it has caused, it is obliged to disclose information
about this commitment in its financial statements (unless the likelihood of this
is remote).

If it is probable (more likely than not) that the company will have to incur
expenditure to meet its obligation, then it is also required to set up a provision
in the financial statements.
In practice, these requirements are unlikely to apply unless a company is
actually obliged by law to rectify environmental damage or unless it has made
a firm commitment to the public to do so (for example, by promoting itself as
an organisation that cares for the environment, as the directors propose that
Redstart should do in future).

2. (a) The way in which companies manage their social and environmental
responsibilities is a high level strategic issue for management. Companies
that actively manage these responsibilities can help create long-term

Advanced Financial Accounting and Corporate Reporting (Study Text) 541

 sustainable performance in an increasingly competitive business
environment.

Reports that disclose transparent information will benefit organisations and

their stakeholders. These stakeholders will have an interest in knowing that
the company is attempting to adopt best practice in the area. Institutional
investors will see value in the ‘responsible ownership’ principle adopted by the
company.

Although there is no universal ‘best practice’, there seems to be growing

consensus that high performance is linked with high quality practice in such
areas as recruitment, organisational culture, training and reduction of
environmental risks and impact. Companies that actively reduce
environmental risks and promote social disclosures could be considered to be
potentially more sustainable, profitable, valuable and competitive. Many
companies build their reputation on the basis of social and environmental
responsibility and go to substantial lengths to prove that their activities do not
exploit their workforce or any other section of society

Governments are encouraging disclosure by passing legislation, for example

in the area of anti-discrimination and by their own example in terms of the
depth and breadth of reporting (also by requiring companies who provide
services to the government to disclose such information). External awards
and endorsements, such as environmental league tables and employer
awards, encourage companies to adopt a more strategic approach to these
issues. Finally, local cultural and social pressures are causing greater
demands for transparency of reporting.

There is no IFRS that determines the content of an environmental and social

report. While companies are allowed to include the information they wish to
disclose, there is a lack of comparability and the potential that only the
positive actions will be shown.

A common framework that provided guidelines on sustainability reporting

would be useful for both companies and stakeholders.

The Global Reporting Initiative (GRI) provides guidelines on the content of a

sustainability report, but these are not mandatory. However, a number of
companies prepare their reports in accordance with the guidelines and the
GRI is becoming the unofficial best practice guide in this area.

Advanced Financial Accounting and Corporate Reporting (Study Text) 542

 (b) Company B’s environmental report should include the following
information.

i. A statement of the environmental policy covering all aspects of

business activity. This can include their aim of using renewable
electricity and reducing their carbon footprint – the amount of carbon
dioxide released into the environment as a result of their activities.

ii. The management systems that reduce and minimise environmental

risks.

iii. Details of environmental training and expertise.

iv. A report on their environmental performance including verified

emissions to air/land and water, and how they are seeking to reduce
these and other environmental impacts. Operating site reports for local
communities for businesses with high environmental impacts.
Company B’s activities have a significant impact so it is important to
show how this is dealt with. The emissions data could be graphed to
show it is reducing. If they have the data, they could compare their
carbon dioxide emissions or their electricity usage over previous
periods. Presenting this information graphically helps stakeholders see
how the business is performing in the areas it is targeting.

v. Details of any environmental offence that resulted in enforcement

action, fine, etc. and any serious pollution incident. They can disclose
how fines have been reducing and state that there have not been any
pollution incidents in the current period.

vi. A report on historical trends for key indicators and a comparison with
the corporate targets.

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Advanced Financial Accounting and Corporate Reporting (Study Text) 544
INTERNATIONAL HARMONIZATION
Chapter Learning Objectives

Upon completion of this chapter, you will be able to:

 Prepare a consolidated income statement for a simple group and a non-

controlling interest.
 Account for the effects of intra-group trading in the income statement.
 Prepare a consolidated income statement for a simple group with an acquisition
in the period and non-controlling interest.
 Account for impairment of goodwill.
 Prepare a consolidated statement of comprehensive income.

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1 IFRS 1 First Time Adoption of IFRS

1.1 Due to the drive towards convergence of reporting standards between

IAS/IFRS and US GAAP, and also national moves to harmonise national
standards with IAS/IFRS, many of the historical differences between the
different GAAPs have been reduced or eliminated. Where differences remain
between IAS/ IFRS and a particular set of national reporting standards, they
are not as significant as they may have been, say, 20 years ago.
Consequently, the importance of first-time adoption of IFRS, and the
application of IFRS 1, may be perceived to be less important than it has been
in the past. However, it is still of importance for several reasons:

• Entities who expect to seek a listing for the first time still need guidance
on how the adoption process should be managed, accounted for, and
disclosed in the financial statements.

• Entities who have no expectation of seeking a listing may choose to

adopt IFRS if they perceive that IFRS is more relevant to their situation.

• Unlisted multinational corporate groups may choose to adopt IAS/IFRS

as the basis for financial reporting throughout the group. This may save
time and resources in the preparation of management information
throughout the group, and streamline group annual financial reporting
requirements.

• Entities may believe that adoption of IFRS could assist in their efforts to
raise capital; if potential capital providers are familiar with IFRS, it may
ease their evaluation of any capital investment opportunity.

• Entities may believe that they are ‘doing the right thing’ by adopting
IFRS as it is already used by other, usually listed and often larger
entities.

The above commentary demonstrates the significant progress to date made

by the IASB and FASB towards achieve their desired outcome of producing
high quality, compatible accounting standards that are suitable for both
domestic and cross border financial reporting. While there is still some way to
go, and numerous obstacles to be negotiated, there appears to be a
momentum which will ensure that progress continues in the coming

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 1.2 Introduction
• IFRS 1 First-time adoption of international financial reporting standards
sets out the procedures to follow when an entity adopts IFRS in its
published financial statements for the first time.

• Before adopting IFRS it will have applied its own national standards.

Definition
A first-time adopter is an entity that, for the first time, makes an explicit and
unreserved statement that its annual financial statements comply with IFRS.
There are five issues that need to be addressed when adopting IFRS

(1) The date of transition to IFRSs.

(2) Which IFRSs should be adopted.
(3) How gains or losses arising on adopting IFRS should be accounted for.
(4) The explanations and disclosures to be made in the year of transition.
(5) What exemptions are available

2 Benefits of Harmonisation

2.1 There are a number of reasons why the harmonisation of accounting

standards would be beneficial. Businesses operate on a global scale and
investors make investment decisions on a worldwide basis. There is thus a
need for financial information to be presented on a consistent basis. The
advantages are as follows.

(1) Multinational Entities

Multinational entities would benefit from closer harmonisation for the
following reasons

(a) Access to international finance would be easier as financial

information is more understandable if it is prepared on a
consistent basis.

(b) In a business that operates in several countries, the preparation

of financial information would be easier as it would all be
prepared on the same basis.

(c) There would be greater efficiency in accounting departments.

(d) Consolidation of financial statements would be easier.

Advanced Financial Accounting and Corporate Reporting (Study Text) 547

 (2) Investors
If investors wish to make decisions based on the worldwide availability
of investments, then better comparisons between entities are required.
Harmonisation assists this process, as financial information would be
consistent between different entities from different regions.

(3) International economic groupings

International economic groupings, e.g. the EU, could work more
effectively if there were international harmonisation of accounting
practices. Part of the function of international economic groupings is to
make cross-border trade easier. Similar accounting regulations would
improve access to capital markets and therefore help this process.

2.2 The reasons for differences in accounting practice

The reasons why, failing the introduction of a common set of international
reporting standards, accounting practices may differ from one country to
another, include the following

• Legal systems. In some countries, financial statements are prepared

according to a strict code imposed by the government. This is often
because the accounts are being prepared primarily for tax purposes
rather than for investment.

• Professional traditions. In contrast to countries where accounting

standards are embedded in legislation, other countries have a strong
and influential accounting profession and can rely on the profession to
draft relevant standards.

• User groups. As mentioned above, in some countries the tax

authorities are the main users of accounts, and so a standardised, rule-
based approach to accounting emerges. Quite often, depreciation rates
will be set by law rather than being based upon useful lives. In
countries where businesses are generally financed by loans (rather
than by equity) then financial statements will focus on a business’
ability to service and pay back its debts. In the UK and the US,
businesses are generally financed through equity. In these countries,
the shareholders share the risks of profits and losses, and so they
demand full disclosure of a business’ financial affairs.

• Nationalism. Individual countries believe that their own standards are

the best.

• Culture. Differences in culture can lead to differences in the objective

and method of accounting.

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 2.3 Culture and local custom
Financial reporting practice may be influenced by cultural factors in a number
of ways.

• Some nationalities are naturally conservative and this may affect their
attitude to accounting estimates, particularly when it comes to providing
for liabilities.

• Religion may affect accounting practices; for example, Islamic law

forbids the charging or accepting of interest.

• Different nationalities have different attitudes to risk. For example, in

Japan high gearing is usual and is a sign of confidence in an entity.

• Attitudes to disclosure also vary. Some cultures value openness while

others have a strong tradition of confidentiality.

• In the UK and the USA, the main objective of management and

shareholders is generally to maximise profit in the short term. However,
in other countries, investors and management may have different or
wider objectives, such as long-term growth, stability, benefiting the
community and safeguarding the interests of employees.

3 Convergence with US GAAP

In October 2002, the IASB and the US standard setter the Financial
Accounting Standards Board (FASB) announced the issuance of a
memorandum of understanding (‘Norwalk Agreement’), marking a step
towards formalising their commitment to the convergence of international
accounting standards. This agreement was updated in February 2006 and is
often referred to as the Roadmap.

Currently, the IASB and FASB have completed work on the short-term
convergence project. The scope of the short-term convergence project was
limited to those differences between US GAAP and IFRS in which
convergence around a high-quality solution appears achievable in the short
term (by 2008).

Because of the nature of the differences, it was expected that a solution could
be achieved by choosing between existing US GAAP and IFRS. Topics
covered by the short-term convergence project included:

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 • IAS 23 permitted borrowing costs on the construction of an asset to be
either capitalised or written off, whereas US GAAP required such costs
to be capitalised. IAS 23 was amended in March 2007 and is now in
line with US GAAP; from 1 January 2009, entities have been required
to capitalise borrowing costs where specified criteria are met.

• IAS 14 has been superseded by IFRS 8, which deals with segmental

reporting. IFRS 8 identifies reportable segments based on a
‘managerial approach’, which is consistent with the approach adopted
under US GAAP, rather than the ‘risk and returns’ approach adopted
by IAS 14.

• IAS 1 was revised in September 2007, with the balance sheet renamed
as the ‘statement of financial position’. The income statement was
renamed as the ‘statement of comprehensive income’, and now
includes items of income and expense that are not recognised in profit
or loss but were directly recognised in equity, such as revaluation
gains.

• IAS 27 and IFRS 3 were amended in January 2008. The new

standards change the calculation of goodwill and also the treatment of
piecemeal acquisitions. Along with changes to US GAAP, these
amendments bring the accounting treatment for goodwill into line,
although some differences still exist, such as the definition of control
and fair value. A review is scheduled for 2012, by which date the
revised standards would have been applied for two years.

Additionally, the IASB and FASB are also undertaking joint projects. Joint
projects are those that the standard setters have agreed to conduct
simultaneously in a coordinated manner. Joint projects involve the sharing of
staff resources, and every effort is made to keep joint projects on a similar
time schedule at each board.

There are also a number of longer-term projects to continue the

harmonisation process between IFRS/US GAAP, including the following:

• Fair value measurement – the objective is to clarify the definition of

fair value and to establish a single source of guidance for fair value
measurement. IFRS 13 was issued in June 2011

• Postemployment benefits – IASB and FASB intend to move to a

common standard on this topic, but there are currently significant
differences between their respective positions. IAS 19 was revised in
2011.

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 • Consolidation – the issue of IFRS 10 in 2011 dealing with
identification of when control is acquired and exercised, and therefore
when consolidation is required, achieves a substantial degree of
convergence between IFRS and US GAAP. In particular, the definitions
contained within IFRS 10 now make it more difficult for entities to
structure their activities in such a way to exclude liabilities from the
statement of financial position. Work continues to develop a converged
definition of what constitutes an investment entity and how they should
be accounted for.

• Joint arrangements – the issue of IFRS 11 in 2011 dealing with the

definition and accounting treatment for joint arrangements substantially
reduces the differences between IFRS and US GAAP. Joint
arrangements, including those arrangements which also meet the
definition of a joint venture.

• Revenue recognition – the objective is to develop a single model for

the recognition of revenue which can be applied across industries and
geographical regions. This would improve comparability and
understanding of financial reporting information.

• Leases – a new standard may result in operating leases being

regarded as an asset for the right to use an item, while also
recognising the liability to make rental payments. A standard on this
topic is not expected until late 2011 or thereafter.

• Earnings per share – this has involved both IASB and FASB
reviewing proposed amendments to the calculation of diluted earnings
per share.

• Conceptual framework – to date, this has focused on the objectives

of financial reporting and the qualitative characteristics of financial
reporting information.

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4 Differences in Accounting Treatment

4.1 Major differences between financial accounting practices in different

countries

Introduction
In recent years, more and more countries are harmonising their accounting
standards with IFRS. At the present time, the US standard setter, the
Financial Accounting Standards Board (FASB), and the IASB are involved in a
joint project to harmonise their accounting standards.

The ASB in the UK has also adopted a number of international standards.

However, some differences remain

Goodwill IAS US GAAP UK GAAP

Preferred Capitalise but do Capitalise but Capitalise and
treatment not amortise, do not amortise, amortise over
subject to annual subject to annual economic useful
impairment review impairment review life
Allowed No need to
Alternative - - amortise if life is
Treatment indefinite and` impairment is tested
annually

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Deferred Tax IAS/IFRS US GAAP UK GAAP
Preferred treatment Liability method, Liability method, full Liability method,
full provision provision based on full provision
based on temporary based on timing
temporary Differences differences
differences
Valuation of IAS/IFRS UK GAAP UK GAAP
property
Preferred treatment No preferred Cost No preferred
treatment treatment
Allowed alternative Cost or valuation - Cost or valuation
Not allowed - Valuation -
Capitalisation of IAS/IFRS US GAAP UK GAAP
development costs
Preferred treatment Recognise such Write off as incurred May recognize as
costs as assets assets when
when specified specific criteria
criteria are met are met; choice of
and write off as immediate write
expense when off also permitted
the criteria are
not met
Profits on IAS/IFRS US GAAP UK GAAP
longterm contracts
Preferred treatment Percentage of Percentage of Percentage of
completion completion or completion
method completed contract method
method

Not allowed Completed - Completed

contract method contract method

Borrowing costs IAS/IFRS US GAAP UK GAAP

Preferred treatment Capitalisation Capitalisation No preferred
compulsory for compulsory for treatment
certain assets certain assets

Allowed alternative - - Capitalise or write

treatment off immediately
Not allowed Immediate write Immediate write off -
off for certain assets

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 Reconciliation Statements
In some cases, an entity with a listing on more than one stock exchange may
still be required to produce financial information that is expressed in terms of
its domestic accounting policies.

A reconciliation statement reconciles the accounts prepared under domestic

accounting policies with another GAAP, such as US GAAP or IFRS.

4.2 The role of national standard setters

• The harmonisation process has gathered pace in the last few years.
From 2005 all European listed entities were required to adopt IFRS in
their group financial statements. Many other countries including Australia,
Canada and New Zealand decided to follow a similar process. National
standard setters are committed to a framework of accounting standards
based on IFRS.

• Additionally, the US are committed to harmonise with IFRS and the FASB
and the IASB are aiming for convergence over the next few years.

• In Europe, the EU has adopted IFRS for use in member countries, with
the exception of part of IAS 39 Financial Instruments: recognition and
measurement.

• In Japan, until the 1990s, financial reporting was not transparent and
while the economy prospered, there was little pressure for change.

However, the Asian economic crisis changed the situation, and Japan has committed
itself to developing new accounting standards more in line with the IASC model.

• In Russia, large-scale adoption of IFRS has been planned since 1998. It

is expected that this will be achieved by 2010.

• India announced in 2007 that it has decided to fully converge with IFRS
for accounting periods commencing on or after April 1 2011. In line with
other countries, this decision will initially be applied to listed companies
and public service entities.

• The overall impact of the above is that the trend towards closer
international harmonisation of accounting practices is now set.

Currently, 102 countries require or permit use of IFRS in the preparation of

financial statements in their countries. By 2011, this figure is expected to
reach 150. It will become increasingly difficult for domestic standard setters to
justify domestic standards at odds with IFRSs.

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 Chapter Summary

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