UNIT 1: INTRODUCTION TO GROUPS OF COMPANIES

A group of companies consists of a parent company together with one or more subsidiary
companies which are controlled by the parent company.

Definitions

Subsidiary- An entity controlled by another entity

Parent- An entity that controls one or more subsidiaries

A group- a parent and all its subsidiaries

Control-An Investor has control of 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 power over the investee.

Power- Existing rights that give the current ability to direct the relevant activities of the investee.
Power can be obtained directly from ownership of the majority of voting rights or can be derived
from other rights, such as

i. Right to appoint, reassign or remove key management personnel who can direct the
relevant activities

ii. Rights to appoint or remove another entity that directs the relevant activities

iii. Rights to direct the investee to enter into, or veto changes to, transactions for the benefit
of the investor

iv. Other rights, such as those specified in a management contract

CONTROL
An investor determines whether it is a parent by assessing whether it controls one or more
investees. In doing so, an investor considers all relevant facts and circumstances when assessing
whether it controls an investee.

Control is deemed to exist when one company owns (either directly or indirectly through other
subsidiaries) more the majority of the ordinary shares (i.e more than 50% of the voting power of
another company), unless it can be demonstrated that such ownership does not give control.

IFRS 10 provides a definition of control and identifies three separate elements of control:

1
An investor controls an investee if and only if it has all of the following

a) Power over the investee. Power arises from rights. Such rights can be straightforward
(e.g. through voting rights) or be complex (e.g. embedded in contractual arrangements).
An investor that holds only protective rights cannot have power over an investee and so
cannot control an investee. Protective rights are rights designed to protect the interest of
the party holding those rights without giving that party power over the entity to which
those rights relate

b) Exposure to, or rights to, variable returns from its involvement with the investee. An
investor must be exposed, or have rights, to variable returns from its involvement with an
investee to control the investee. Such returns must have the potential to vary as a result of
the investee's performance and can be positive, negative, or both; and

c) The ability to use its power over the investee to affect the amount of the investor’s
returns. A parent must not only have power over an investee and exposure or rights to
variable returns from its involvement with the investee, but a parent must also have the
ability to use its power over the investee to affect its returns from its involvement with
the investee

According to the standard, if there are changes to one or more of the above three mentioned three
elements of control, then an investor should reassess whether it controls an investee.

A Parent company loses control of a subsidiary company when it can no longer govern the
subsidiary’s financial and operation policies. This usually occurs when the parent ceases to own
more than 50% of the subsidiary’s voting power. But control could also be lost for other reasons
(e.g. if a subsidiary became subject to government or court control)

Exclusion of a subsidiary from consolidation

The rules on exclusion of subsidiaries from consolidation are necessarily strict, because this is a
common method used by entities to manipulate their results. For example, a subsidiary that
carries a large amount of debt can be excluded so as to have an improved gearing of the group as

2
a whole. IAS 27 did originally allow a subsidiary to be excluded from consolidation where
control is intended to be temporary but this exclusion was then removed by IFRS 5.

In the other words, control must actually be lost for exclusion to occur.

An Investment entity is an entity that:

1. Obtains funds from one or more investors for the purpose of providing those investor(s)
with investment management services
2. Commits to its investor(s) that its business purpose is to invest funds solely for returns
from capital appreciation, investment income, or both, and

3. Measures and evaluates the performance of substantially all of its investments on a fair
value basis.

Where an entity meets the definition of an 'investment entity, it does not consolidate its
subsidiaries, or apply IFRS 3 Business Combinations when it obtains control of another entity.

Consolidated Financial Statements

Consolidated Financial Statements are financial statements of a group in which the assets,
liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are
presented as those of a single economic entity. Group accounts and consolidated accounts are
terms often used synonymously. A group has no separate (legal) existence and this is done only
for accounting purposes.

Consolidated financial statements typically comprises the following

i. Parent company financial statements- this will include investments in subsidiary

undertakings as an asset in the statement of financial position, and income from
subsidiary (dividends) in the statement of profit or loss

ii. Consolidated statement of financial position

iii. Consolidated statement of profit or loss and other comprehensive income

iv. Consolidated statement of cash flows

3
A parent prepares consolidated financial statements using uniform accounting policies for like
transactions and other events in similar circumstances. Adjustments must be made where
members of a group use different accounting policies, so that their financial statements are
suitable for consolidation.

However, a parent need not present consolidated financial statements if it meets all of the
following conditions:

 it is a wholly-owned subsidiary or is a partially-owned subsidiary of another entity and its

other owners, including those not otherwise entitled to vote, have been informed about,
and do not object to, the parent not presenting consolidated financial statements
 its debt or equity instruments are not traded in a public market (a domestic or foreign
stock exchange or an over-the-counter market, including local and regional markets)

 it did not file, nor is it in the process of filing, its financial statements with a securities
commission or other regulatory organisation for the purpose of issuing any class of
instruments in a public market, and

 Its ultimate or any intermediate parent of the parent produces consolidated financial
statements available for public use that comply with IFRSs.

IFRS 10 requires the results of subsidiary undertakings to be included in the consolidated

financial statements from

a) The date of acquisition- date when control is obtained

b) The date of disposal- date when control is lost

The Mechanics of Consolidation

According to IFRS 10, consolidated financial statements:

 combine like items of assets, liabilities, equity, income, expenses and cash flows of the
parent with those of its subsidiaries
 offset (eliminate) the carrying amount of the parent's investment in each subsidiary and
the parent's portion of equity of each subsidiary (IFRS 3 Business Combinations explains
how to account for any related goodwill)
4
  eliminate in full intragroup assets and liabilities (see below) , equity, income, expenses
and cash flows relating to transactions between entities of the group (profits or losses
resulting from intragroup transactions that are recognised in assets, such as inventory and
fixed assets, are eliminated in full).

A reporting entity includes the income and expenses of a subsidiary in the consolidated financial
statements from the date it gains control until the date when the reporting entity ceases to control
the subsidiary.

The parent and subsidiaries are required to have the same reporting dates, or consolidation based
on additional financial information prepared by subsidiary, unless impracticable. Where
impracticable, the most recent financial statements of the subsidiary are used, adjusted for the
effects of significant transactions or events between the reporting dates of the subsidiary and
consolidated financial statements. The difference between the date of the subsidiary's financial
statements and that of the consolidated financial statements shall be no more than three months

Consolidation of the Statements of Financial Position

A standard group accounting question will provide the accounts of the parent and the accounts of
the subsidiary and will require the preparation of consolidated accounts

Its is help to perform 5 standard workings plus any other workings in the consolidation process
and these are listed below

Working 1- Group Structure

Working indicates how many shares of the subsidiary are owned by the parent. E.g.

P P P P

70% 65% 55% 40%

S S S S

P owns 70% of S, P owns 65% shares of S, P owns 55% shares of S, and P owns 40% shares of
S and since the shareholding is less that 50%, S is not a subsidiary of P. All these share holdings
are as at the date of acquisition.
5
Working 2- Net Assets of the Subsidiary

Net Assets are defined as total assets less total liabilities. In the statement of Financial Position,
this forms one part of the statement of financial position and the other balancing part is the one
that consists of share capital and reserves. The two should be in agreement for the statement of
financial position to balance.

Shareholders equity (share capital + reserves) = assets minus liabilities

It therefore follows that the total of Share Capital and Reserves represents Net Assets of an
entity. Working 2 for net assets is therefore done as follows

At Acquisition At the reporting date

Share Capital X X

Reserves:

Share Premium X X

Retained Earnings X X

X X

In most cases, the difference between the total of net assets at acquisition and the total of net
assets at the reporting date represents the post acquisition profit of the subsidiary (profits attained
after the acquisition date up to the reporting date in consideration)

Working 3- Goodwill

Goodwill is an accounting concept meaning the value of an entity over and above the value of
its assets. Goodwill in financial statements arises when a company is purchased for more
6
than the fair value of the identifiable net assets of the company. The difference between the
purchase price and the sum of the fair value of the net assets is by definition the value of the
goodwill of the purchased company. The parent company must recognize goodwill as an
intangible asset in its financial statements and present it as a separate line item on the
statement of Financial Position.

Please note that Goodwill can be negative, arising where the net assets at the date of acquisition,
fairly valued, exceed the cost of acquisition. According to IFRS 3 Negative goodwill is
recognized as Income in the Statement of profit or loss and increases the group’s reserves.
Working 3 is done as follows

Parent cost of Investment X

Less: Fair value of net assets acquired (W2) (X)

Goodwill on acquisition X

Goodwill may be impaired during the post acquisition period and this must be reflected in the
group financial statements

Working 4- Non Controlling Interest (NCI)

NCI used to be called Minority Interest and the term was derived from the fact that since the
parent owns 50% or more of the shares of the subsidiary, then the parent has the majority share
holding and the other shareholders only have a minority share holding. Minority interests are
now called Non Controlling Interest because their shareholding is less than 50% and hence
they do not control the financial and operating policies of the subsidiary. In other words, NCI is
an accounting concept that refers to the portion of a subsidiary corporation’s stock that is not
owned by the parent corporation.

NCI belongs to other investors other than the parent and is reported on the consolidated
statement of financial position of the parent company to reflect the claim on assets belonging to
other shareholders. IFRS 3 allows two alternative ways of calculating non-controlling interest in
the group statement of financial position;

i) its proportionate share of the fair value of the subsidiary’s net assets, or

ii) Full (or fair) value which is usually based on the market value of the shares held by
the NCI

7
Where the option is to value NCI at fair value, the goodwill attributable to the NCI will also be
added to the NCI at the year end. The most straight forward way to calculate this is to start with
the fair value of the NCI and add the NCI share of post-acquisition retained earnings

In the Statement of profit or loss, the share of profit belonging to NCI is reported in the
“attributable to” section. Working 3, can be calculated as follows

a) NCI share of net assets at the reporting date X

b) NCI value at acquisition (W2) X

NCI share of post-acquisition reserves (W2) X

NCI value to statement of Financial Position X

Working 5- Group Retained Earnings

The group retained earnings is made up of the retained earnings for the Parent plus the Parent’s
share of the post acquisition profit of the Subsidiary. Pre Acquisition profits of the Subsidiary are
deducted from the retained earnings shown in the Subsidiary’s statement of Financial Position so
as to come up with the post acquisition profits. Please note that only the Parent’s share is added
to the retained earnings of the parent. Working 5 is done as follows

Parent’s retained earnings (100%) X

Parent’s share of the post- Acq profits of the Subsidiary X
Retained earnings to the consolidated statement of FP X

Example,

The following statements of financial position were extracted from the books of two companies
at 31 December 2009
Derek Clive

8
 K K
Non Current Assets
Property, Plant and Equipment 75,000 11,000
Investment in Clive 27,000 _____
102,000
Current Assets 214,000 33,000
316,000 44,000
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

Derek acquired all of the share capital of Clive one year ago when the retained earnings of Clive
stood at K 2,000 on the day of acquisition. Goodwill is calculated using the proportion of net
assets method. There has been no impairment of goodwill since acquisition.

Prepare the consolidated statement of financial position of Derek Group as at 31 December 2009.

Solution

W1-Group Structure
D

100%

W2- Net Assets

On Acquisition Date On Reporting Date
K K
Share Capital 4,000 4,000
Share Premium 6,000 6,000
9
Retained Earnings 2,000 9,000
12,000 19,000

Note: The difference between the net assets on the acquisition date and on the reporting date
represents the post-acquisition profits of Clive and in this case, 7,000 is the post-acquisition
profits.

W3- Goodwill (proportionate method)

K
Purchase Consideration 27,000
Share of NA@DOA (100% of 12,000) (12,000)
Goodwill 15,000

W4-Non-Controlling Interest
Since Derek acquired all the share capital of Clive, there are no NCI in this case

W5- Group Reserves

K
Parent (Derek) 40,000
Share of subsidiaries post-acq profits
(100% of 7,000) 7,000
47,000

The Derek Group Consolidated Statement of Financial Position as at 31 December 2009

K
Non-Current Assets
Goodwill (W3) 15,000
Property, Plant and Equipment 86,000
101,000
Current Assets 247,000
348,000
Equity:
Share Capital 80,000
Share Premium 20,000
Retained Earnings (W5) 47,000
147,000
Current Liabilities 201,000
348,000

10
Note: Share Capital and Share Premium shown in the consolidated statement for financial
position is only for the Parent. Share Capital and Share Premium for the subsidiary has already
filtered through the consolidated financial statements by way of working 2 (Net Assets)

UNIT 2: REVISED IFRS 3- FULL GOODWILL METHOD

IFRS 3 (revised) gives entities the option of valuing NCI at fair value. The idea behind this is
that the NCI also owns some of the goodwill in the subsidiary and that the traditional
(proportionate) method of consolidation does not this goodwill. Therefore IFRS 3 (revised)
revised provides group companies a choice in valuing the NCI at acquisition.
1. The Proportionate Method
This is the old method that companies have been using before the issuance of the revised
version of IFRS 3 ( i.e as in the workings above). Where an exam question requires the
use of this method, it will state that “it is group policy to value the NCI at its
proportionate share of the fair value of the subsidiary’s identifiable net assets”.
11
 2. Fair Value Method ( Full Goodwill method)- This method requires that where shares are
publicly traded, the fair value of the NCI is measured according to market prices. If
market value can not be ascertained, other valuation techniques must be used. This
method is also referred to as the full goodwill method because the entire goodwill
( parent and NCI) is reflected in the group financial statements as an asset

Example 2
The draft statements of Financial Position of Piper and Swans on 31 December 2001 are as
follows
Piper Swans
K000 K000
Property, Plant and equipment 90 100
Investment in Swans 110
Current Assets 50 30
250 130

Ordinary shares 100 100

Retained Earnings 120 20
220 120
Current Liabilities 30 10
250 130

Piper had bought 80% of the ordinary shares of Swans on 1 January 2001 when the retained
profits of Swans were K15,000. No impairment of goodwill has occurred to date.

Prepare a consolidated statement of financial position as at 31 December 2001, assuming that the
Piper group values the NCI using the fair value method and that the Non-Controlling Interest on
the acquisition date were valued at K 40,000

Solution
W1-Group Structure

80%

12
S 20% NCI

W2- Net Assets of the Subsidiary

On Acquisition On Reporting
K’000 K’000
Share Capital 100 100
Retained Earnings 15 20
115 120 Post-Acq Profits = K5,000

W3-Goodwill (full goodwill method)

Group NCI
K’000 K’000
Purchase consideration/NCI Fair value 110 40
Share of NA @DOA
Group 80% of 115,000 (92)
NCI 20% of 115,000 (23)
18 17
Therefore total to the statement of CSOFP is K35,000 (18,000 + 17,000)

W4- Non Controlling Interest

K’000
Fair Value of NCI @DOA 40
Share of post-Acq profits (20% of 5,000) 1
41

Alternatively

Share of NA @DOR (20% OF 120) 24

NCI Goodwill 17
41

13
W5- Group Reserves
K’000
Parent’s Retained Earnings 120
Share of Subsidiary’s post-acq profits
80% of 5,000 4
124

The Piper Group Consolidated Statement of Financial Position as at 31 December 2001

K000
Goodwill (w3) 35
Property, Plant and equipment 190
Current Assets 80
305

Ordinary shares 100

Retained Earnings (w5) 124
NCI(w4) 41
265
Current Liabilities 40
305

UNIT 3: INTRA-GROUP TRADING

RELATED PARTIES- Intra Group items

Two parties are considered related if:

 One party has the ability to control the other party

 One party has the ability to exercise significant influence over the other party
14
  The parties are under common control

Types of transactions that may occur between parent and subsidiary (related parties) and their
impact on financial statements of the individual company and the group are:

Sales and purchases Favorable prices, affecting profits

Finance Favorable rates of interest, effecting profits

Provision for services at minimum or no cost, affecting profits

Such transactions may or may not be at arm’s length. Even when related party transactions
are at arm’s length, it is still important to realize that they are related party transactions.
This is because they could have only occurred because of the relationship.

These are called intra group transactions and for the consolidated financial statements to show a
true and fair view, they must be excluded.

These can be grouped into 5 categories

1. Current accounts between the Parent and the Subsidiary.

This arises when the parent company trades with one of its subsidiaries on credit and this
may lead to a
 A receivable (current) account in one company’s statement of Financial Position
 A payable (current) account in the other company’s statement of Financial
Position

The Parent and the Subsidiary are both companies in the same group and so these are
amounts owing within the group and they must there be cancelled when preparing the
consolidated statement of financial position.

A situation may arise at the year where by current accounts of the two companies in the
same group do not balance or agree. This may be due to the existence of in-transit items
such as goods or cash. For the purpose of consolidated the following rules must be
followed

If the goods or cash are in transit between the parent and the subsidiary, then

 In case of cash in transit ( Dr Cash in transit and Cr Receivables)

15
  In the case of goods in transit ( Dr Inventory and Cr Payables current account)

2. Loans held by one company in the other- These should be cancelled when consolidating
as the two are in the same group

3. Dividends and loan interest- These affect the Statement of profit or loss and if unpaid at
the year end, may also affect the statement of financial position. These should be
eliminated when preparing consolidated accounts.

4. Unrealized profits on sales of Inventory- One group company may goods (inventory or
fixed assets) to the other at a profit. This profit will be recognized in the accounts of the
individual company that sold but for consolidation purposes, such profits are unrealized
and must be eliminated from the consolidated accounts. They only become realized when
passed on to the companies outside the group
5. Unrealized profits on sales of non-current assets- One group company may sell a non-
current asset to another company in the group. Unlike inventory, the non-current asset
bought by one Group Company from the other will likely be included in the consolidated
Statement of Financial Position for a number of years (probably useful economic life of
the asset) and therefore the provision for unrealized profit will reduce as the non-current
asset is depreciated. Two key adjustments will have to be effected, one relating to
unrealized profit on the sale of the non-current asset and the other on additional
depreciation caused by the amount of the unrealized profit. The following adjustments
will have to be made.

I. Sale of NCA by the parent entity

Adjust for the unrealized profit by passing the following entries

Dr Group Reserves
Cr Non-Current Asset

Adjust for the additional depreciation on the NCA by passing the following
entries

Dr Non-Current Assets
Cr Group Reserves
Cr NCI

If it’s a sale of the NCA by subsidiary, adjust for the unrealized profit as follows

16
 Dr Group Reserves
Dr NCI
Cr Non Current Assets

And then adjust for the additional depreciation as follows

Dr NCA
Cr Group Reserves

Example

Draft statement of financial position of Plant and Shrub on 31 March 2007 are as follows

Plant Shrub

K000 K000

Property, Plant & Equipment 100 140

Investment in Shrub 180

Current assets

Inventory 30 35

Trade receivables 20 10

Cash 10 5_

340 190_

Equity and Liabilities

Share Capital: Ordinary K1 shares 200 100

Share Premium 10 30
17
Retained Earnings 40 20__

250 150

10 loan notes 65

Current Liabilities 25 40

340 190

Notes:

 Plant bought 80,000 shares in Shrub in 2001 when Shrub’s reserves included a share
premium of K 30,000 and retained profits of K5,000.
 Plant’s accounts show K6,000 owing to Shrub; Shrub’s accounts show K8,000 owed by
Plant. The difference is explained as cash in transit
 No Impairment of goodwill has occurred to date
 Plant uses the proportion of net assets method to value the NCI
Prepare a consolidated statement of financial position as at 31 March 2007

Solution

W1-Group Structure

P 80,000 = 80%

80% 100,000

S 20% NCI

W2- Net Assets of the subsidiary

On Acq Date On Rep Date

K’000 K’000

Share Capital 100 100

Share premium 30 30

Retained earnings 5 20

135 150 Post-Acq profits = 15,000

18
W3-Goodwill (proportionate method)

K’000

Purchase consideration 180

Share of NA@DOA

(80% of 135,000) (108)

Goodwill 72

W4- Non-controlling Interest

20% of 150 = 30

W5-Group Reserves

Parent 40

Share of post Acq profits 12

52

The Plant Group Consolidated Statement of Financial Position as at 31 March 2007

K000

Goodwill 72

Property, Plant & Equipment 240

Current assets

Inventory 65

Trade receivables (20 +10 – 2-6) 22

Cash (10+5+2) 17
19
 416

Equity and Liabilities

Share Capital: Ordinary K1 shares 200

Share Premium 10

Retained Earnings 52

NCI 30

292

10 loan notes 65

Current Liabilities (25+40-6) 59

416

Unrealized Profits

When one group member sells good to another member of the group, a number of adjustments
may be needed

 As from above, current accounts have to be cancelled

 If the goods are still held by the buying group member, any unrealized profits must be
cancelled
 The key point to note is that Inventory must always be included at original price to the
group ( remove the profit component added to the cost price)
 Margin and Mark up may be used to calculate the profit component that must be
eliminated (note that Margin is based on the selling price and Mark up is based on cost)
 Adjustments are made in the accounts of the selling company and not in the accounts of
the buying group company (if the seller is the parent, Dr Group Retained Earnings, Cr
Group Inventory, If the seller is the subsidiary, Dr Subsidiary retained earnings in W2, Cr
Group Inventory)
Example
The following are the statements of financial position of two companies at 31 October 2010, the
end of their most recent financial years;

Multa plc Tuli plc

Km Km

20
Assets

Non-current assets

Property, Plant and equipment 425 288

Investments, at cost 147 13

572 301

Current Assets

Inventories 88 73

Trade Receivables 147 106

Other current assets 37 22

Cash and cash equivalents 36 15

Total Assets 880 517

Equity

Ordinary share capital (K1 shares) 300 150

Retained earnings 157 135

457 285

Non-current liabilities 150 82

Current Liabilities

Trade payables 184 56

Current tax payable 89 69

Bank Overdraft ____ 25_

880 517

The following additional information is available

1. On 1 Nov 2008, Multa plc purchased 90,000,000 ordinary shares in Tuli plc paying a
total of 120,000,000. The reserves of Tuli plc on 1 November 2008 were 30,000,000. It
21
 was agreed that all the assets and liabilities of Tuli plc were reported in its financial
statements at fair values as at 1 November 2008. Since then the directors of Multa plc
feel that the amount paid for as goodwill upon the acquisition has been impaired by
3,000,000
2. During the year ended 31 October 2010 Multa plc sold inventory to Tuli plc for
25,000,000. Multa plc earned a uniform margin of 40% on these sales. During the year
ended 31 October 2010 Tuli plc resold 80% of this inventory. On 31 October 2010 Tuli
plc had unpaid invoices totaling 18,000,000 payable to Multa plc in respect of these
purchases
3. Each ordinary share in Tuli plc carries one vote and there are no other voting rights in the
company
NCI are valued using the proportionate basis

Prepare the consolidated statement of Financial Position for the Multa group as at 31 October
2010, showing all your workings

Solution

W1-Group Structure

M 90,000 = 60%

150,000
60%

T 40% NCI

W2- Net Assets of the Subsidiary

On Acq date On reporting date

K’m K’m

Share Capital 150 150

22
Retained Earnings 30 135

180 285 Post-Acq profits = 105

Note that the unrealized profit on the sale of inventory is not included in working 2 net assets
because the selling company is the parent and not the subsidiary and so this will be taken care in
working5 group retained earnings.

W3- Goodwill (proportionate method)

K’m

Purchase consideration 120

Share of NA@DOA

(60% of 180m) (108)

12

Goodwill Impairment (3)

Goodwill to CSOFP 9

Note that the purchase consideration used in the calculation of goodwill is actual consideration
paid for the acquisition of the subsidiary. The statement of Financial Position for Multa shows
K147m under investment at cost. Of this K147m, only K120 is for the purchase consideration of
Tuli Plc. This means that K27m is for other investments and should be shown in the consolidated
statement of financial position for the Multa Group.

W4- Non-Controlling Interest

40% of K285m = K114m

W5-Group Reserves

K’m

Parent (Multa plc) 157

Goodwill impaired (3)

PURP-Inventory(w6) (2)

Share of post-Acq profits of Tuli Plc

(60% of 105m) 63
23
 215

W6-Unrealised profits of the sale of Inventory

Since margin is on sales, this calculation is very straight forward.

40% x 25m= K10m, this is the total profit made on this sale but we are told that 80% of this
inventory has since been resold by Tuli plc. This leaves us with 20% of the inventory still
included in the closing inventory of Tuli plc, which is also of the inventory shown in the
statement of financial position of Tuli plc. The unrealized profit will then be 20% of the total
profit of 10m, giving us K2m

The Multa Group Consolidated Statement of Financial Position as at 31 October 2010

Km

Assets

Non-current assets

Goodwill 9

Property, Plant and equipment 713

Investments, at cost (147+13-120) 40

762

Current Assets

Inventories (88+73-2) 159

Trade Receivables (147+106-18) 235

Other current assets 59

24
Cash and cash equivalents 51

Total Assets 1,266

Equity

Ordinary share capital (K1 shares) 300

Retained earnings (w5) 215

NCI 114

Non-current liabilities 232

Current Liabilities

Trade payables (184+56-18) 222

Current tax payable (89+69) 158

Bank Overdraft 25

1,266

UNIT 4: PURCHASE CONSIDERATION

The Purchase consideration includes the acquisition date fair value of all consideration.
Acquisitions are a form of business combination in which one of the entities (the acquirer)
obtains control over the net assets and operations of another entity (the acquired) in exchange for
the transfer of assets, incurrence of liabilities or issue of equity.

The terms of the consideration for the subsidiary may involve more than simply a cash payment.
The purchase consideration may include contingent consideration, even though it is not deemed
to be probable of payment at the date of acquisition.

Contingent consideration is defined by IFRS 3 as “usually, an obligation of the acquirer to

transfer additional assets or equity interests to the former owners of an acquired as part of the
exchange for control of the acquired if specified future events or conditions are met

IFRS 3 revised requires the acquirer to recognize the acquisition date fair value of contingent
consideration and forms part of the total purchase consideration. The previous version of IFRS 3
only allowed entities to recognize contingent consideration only if it’s probable that it would
become payable. For contingent consideration to be included in the purchase consideration, it
must however, be capable of reliable measurement.

25
Contingent consideration may take the form of equity or a liability (issuing a debt instrument or
cash). It may also be an asset if the acquirer has the right to return of some of the consideration
transferred if certain conditions are met.

Deferred consideration is also taken as part of the purchase consideration and the present value
must be taken into consideration after taking into account any premium or discount likely to be
incurred on settlement.

Most times 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 and forms part of the purchase consideration

Please note that the purchase consideration does not include costs of acquisition (such as
professional fees i.e accounting and legal fees). These have to be expensed in the period in which
they are incurred but direct costs such as registration costs may be included in the purchase
consideration

Also note that IFRS 3 requires that the identifiable net assets of the subsidiary should be
measured at their fair values at the date of acquisition. If the fair values were not incorporated
into the measurement of net assets on acquisition date and this information is now available,
necessary adjustments have to be made and entries have to be passed to take into account the fair
values of components of net assets.

Example,

Malawi has made an acquisition of 100% of the shares in Blantyre when the net assets of
Blantyre were K 80,000. The consideration that Malawi gave for the investment in the subsidiary
Blantyre comprised

1. Cash paid K25,454

2. Shares- Malawi issued 10,000 shares to the shareholders of Blantyre , each with a
nominal value of K1 and a market value of K4

3. Deferred consideration- K20,000 is to be paid one year after the date of acquisition. The
relevant discount rate is 10%

4. Contingent consideration-K100,000 may be paid one year after the date of acquisition. It
is judged that there is only 40% chance that this will occur. The fair value of this
consideration can be measured at the present value of the expected value

5. Legal fees associated with the acquisition amounted to K15,000

26
Calculate goodwill arising on the acquisition of Blantyre

Solution

Purchase Consideration

Cash payment 25,454

Share issue (10,000 x 4) 40,000

Deferred Consideration (20,000/1.1) 18,182

Contingent consideration (100,000 x 40%)/1.1 36,364

120,000

Share of NA@DOA (100% of 80,000) (80,000)

Goodwill 40,000

Note: Legal fees do not form part of the purchase consideration following the revision of
IFRS3. These have to be expensed in the Statement of profit or loss in the period they are
incurred. We not take the nominal value of the share capital as we compute the purchase
consideration but the market value. This is because the purchase consideration includes that
fair value of the consideration paid for the acquisition of the net assets of the subsidiary.
There nominal value will not give us the fair value of the share capital but the market price
will.

Example

Mesan Plc acquired 70% of Better Plc on 30th September 2017 with the purchase
consideration consisting of the following

K 4,000,000 payable on 30th September 2017

K 3,000,000 payable on 30 September 2018, and a final payment of 3 times the 2018 profits
payable on 30 September 2019.

Mesan Plc’s cost of capital is 10% and Better Plc anticipates the profits for 2018 to be
K2,000,000. Mesan Plc paid his accountants K80,000 in professional fees for the work
involved in the takeover

Calculate

27
 a) The carrying value of Mesan’s Investment in Better Plc

b) The interest charge in the statement of comprehensive income for 2018 and 2019

c) The Liability in Mesan’s Plc Statement of Financial Position as at 30 th September

2017, and 2018.

d) If Better’s profits in 2018, when calculated and agreed on 31 March 2019 where
in fact K2,200,000. What adjustments are to be made?

Solution

a) Carrying value of Mesan’s Investment in Better Plc

Cash Consideration 4,000,000

Deferred Consideration (3,000,000/1.1) 2,727,272

Contingent consideration (6,000,000/(1.1 x 1.1) 4,958,678

11,685,950

b) and c) can be solved in one schedule as shown below

Interest is at 10%

Interest Liability

Consideration 11,685,950

Amount paid 30.09.17 (4,000,000)

Outstanding 30.09.17 7,685,950

Interest for 30.09.18 768,595 768,595 7,685,950

8,454,545

Amount paid 30.09.18 (3,000,000)

Outstanding at 30.9.18 5,454,545

Interest for 30.09.19 545,455 545,455 5,454,545

28
 6,000,000

Amount paid 30.09.19 (6,000,000)

0_____

d. If the profits were in fact 2,200,000 and not 2,000,000. This will give a difference of 200,000
and hence a 600,000 difference in the contingent consideration. This is adjusted by passing the
following journal entry

Dr Statement of profit or loss 600,000

Cr Liability 600,000

In summary, assets and liabilities that existed on the date of acquisition are to be included in the
net assets but they have to be capable of reliable measurement. Provisions for future losses have
to be excluded because these fall in the post-acquisition period. Therefore any intentions and
plans of the acquiring company cannot be included in the net assets on the acquisition date.

Generally, the financial statements of a parent company and its subsidiaries should all be drawn
up to the same date. If the reporting period of a parent is different from that of subsidiary, the
subsidiary should prepare additional financial statements for consolidation purposes, using the
same reporting period as its parent. If this is impracticable, the financial statements of the
subsidiary should be adjusted before consolidation to reflect any significant transactions or
events that occur between the end of the subsidiary’s reporting period and the end of the parent’s
reporting period. In any case, IAS 27 requires that the difference between the end the end of the
reporting period of a subsidiary and that of its parent should not exceed three months. Further,
consolidated financial statements should be prepared using uniform accounting policies. If a
group company uses different accounting policies from those adopted in the consolidated
financial statements, its own financial statements should be adjusted in line with the group’s
accounting policies before consolidation takes place should be used in the valuation exercise and
in cases where there is a conflict between the policies of the parent and those of subsidiaries; it’s
commonly accepted to go by the parent company’s policies (eg depreciation policies)

29
 UNIT 5: MID-YEAR ACQUISITIONS-STATEMENT OF FINANCIAL
POSITION
If a subsidiary is acquired part of the way through the accounting period for which group
accounts are being prepared, it is necessary to apportion the subsidiary’s profit for that period
into pre-acquisition and post-acquisition components.

This will require

 Identification of the net assets of the subsidiary at the date of acquisition in order to
calculate goodwill
 Time apportionment of the results of S in the year of acquisition. This is done with the
assumption that revenue and expenses accrue evenly

Example,

On 1st May 2019, Karl bought 60% of Susan paying K76,000 cash. The summarized statements
of Financial Position for the two companies as at 30 November 2019 are:

Karl Susan
K K
Non-Current Assets
Property, Plant and 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

30
 272,000 152,000

The following information is relevant:

1. The Inventory of Susan includes K8,000 of goods purchased from Karl at cost plus 25%

2. On 1st June 2019 Susan transferred an item of plant to Karl forK15,000. Its carrying
amount at that date was K10,000. The asset had a remaining useful economic life of 5
years

3. The Karl Group values the NCI using the fair value method. At the date of acquisition the
fair value of the 40% NCI was K50,000

4. An impairment loss of K1,000 is to be charged against goodwill at the year-end.

5. Susan earned a profit of K9,000 in the year ended 30 November 2019.

6. The loan note in Susan’s books represents monies borrowed from Karl during the year.
All of the loan note interest has been accounted for.

7. Included in Karl’s receivables is K4,000 relating to Inventory sold to Susan during the
year. Susan raised a cheque for K2,500 and sent it to Karl on 29 th November 2019. Karl
did not receive this cheque until 4 December 2019.

Prepare the consolidated statement of financial position as at 30 November 2019

Solution

W1-Group Structure

1 Dec 2006 to 30 April 2019- Pre Acq period- 5 months

60% 1 May 2007 to 30 Nov 2019 is the post acq period- 7 months

S 40% NCI

We- Net Assets of the Subsidiary

31
 On Acq date on Rept date

Share Capital 40,000 40,000

Retained earnings (w6) 63,750 69,000

PURP on Plant transfer (w7) (4,500)

103,750 104,500 Post-Acq profits= 750

W3-Goodwill (full goodwill method)

Group NCI

Purchase Consideration 76,000 50,000

Share of NA@DOA

60% of 103,750 (62,250) (41,500)

13,750 8,500

Total Goodwill 22,250

Less: Impairment (1,000)

Goodwill to CSOFP 21, 250

W4- Non-Controlling Interest

NCI fair value of acquisition date 50,000

Add: share of post-Acq profits (40% of 750) 300

Less: Share of Goodwill impaired (40% of 1,000) (400)

49,900

Alternatively

Share of NA@DOR (40% of 104,500) 41,800

Add: NCI goodwill 8,500

Less: share of goodwill impaired (400)

32
 49,900

W5-Group Retained Earnings

Parent ( Karl) retained earnings 189,000

Less: PURP on inventory (w8) (1,600)

Share of post-Acq profits (60% of 750) 450

Share of goodwill impaired (600)

187,250

W6- Retained earnings on Acquisition

Retained earnings on reporting date 69,000

Less: Profit for the year (9,000)

Retained profits at 30 November 2018 60,000

The Subsidiary was acquired part through the accounting period and so the profit for the year of
9,000 should have be apportioned between the pre-acquisition period and the post-acquisition
period. The pre-acquisition period will have to be added to the 60,000 calculated above so as to
come up with the total pre-acquisition profits.

Pre-Acquisition is 5/12 of 9,000 = 3,750

Post-Acquisition portion is 7/12 of 9,000 = 5,250

So total pre-acquisition profit is 60,000 + 3,750 = 63,750

Alternatively, this can also be calculated by taking the total retained earnings on the reporting
date and subtracting the post-acquisition profit, and that will give us the pre-acquisition profit

69,000 – 5,250 = 63,750

W7- Unrealized profit on the transfer of Plant

33
The calculation of PURPs on Plant is different from the way PURPs are calculated on Inventory.
The difference is because profits on inventory only become realized once the inventory passes on
to the third part (resold to a company outside the group). For Property, Plant and Equipment, the
profit will only become realized by continued use of the asset and so profit is realized as the asset
is depreciated. So PURP on Plant will be calculated as the difference between what the carrying
amount would have been had the asset been transferred at the original price and the carrying
amount at the transfer price. The difference between these two represents unrealized profit on the
transfer or sale of Plant.

15,000 – (15,000/5 x 1/2) = 13,500

10,000 – (10,000/5 x 1/2) = (8,000)

4,500

W8- PURP on Inventory

The selling company in this case is the parent and so this wil be adjusted for in Group Retained
earnings (w5) and not in net assets (w2). Also note that the phrase “cost plus” means mark up
and so the 25% will have to be on cost and not the selling price

Y x 1.25 = 8,000 (Y being the cost price which after adding the 25% gives you the selling price
of 8,000). Y will then be equal to 6,400

And so PURP = 8,000 -6,400 = 1,600

The Karl Group Consolidated Statement of Financial Position as at 30 Nov 2019

Non-Current Assets

Goodwill 21,250

Property, Plant and Equipment (138,000 + 115,000 – 4,500) 248,500

Investments (98,000 – 76,000 – 20,000) 2,000

271,750

Inventory (15,000+17,000 – 1,600) 30,400

Receivables (19,000 + 20,000 – 2,500 -1,500) 35,000

34
Cash (2000 + 2,500) 4,500

341,650

Share Capital 50,000

Retained earnings (w5) 187,250

NCI (w4) 49,900

287,150

Current Liabilities (33,000 +23,000 – 1,500) 54,500

341,650

Practice Questions

Question 1

The Statement of Financial Position as 31 December 2019 for Theo and Care are as follows

Non-Current Assets Theo Care

Property, Plant and Equipment 800,000 200,000

Investment in Care 750,000

Land and Buildings 600,000 800,000

2,150,000 1,000,000

Current Assets

Inventories 200,000 50,000

Trade Receivables 100,000 25,000

Cash 50,000 70,000

Total Assets 2,500,000 1,145,000

Equity

K1 ordinary shares 1,500,000 450,000

35
Share Premium 200,000 50,000

Retained Earnings 400,000 300,000

2,100,000 800,000

Non-current liabilities

Deferred Tax 200,000 -

Current Liabilities

Current Tax 50,000 35,000

Trade payables 150,000 310,000

2,500,000 1,145,000

The following information is available:

 Theo bought 270,000 of the ordinary share capital of Care three years ago when Care’s
retained earnings stood at 200,000.

 The Inventory of Theo includes 20,000 of goods purchased from Care at a cost plus 25%

 At the year end, the current accounts of Theo and Care could not balance by 5,000 and
after further investigations; the difference was attributed to goods in transit. This has not
yet been taken care of.

 Goodwill is not impaired and its group policy to value the Non-Controlling Interest on a
proportionate basis

Required:

a) Prepare the consolidated statements of Financial Position as at 31st December 2010.

b) Distinguish between “control” and “significant Influence”

Question 2

36
The statement of Financial Position for Care and Crispen Plc at 31 December 2019 were as
follows

Care Crispen

K’ m K’ m

Non- Current Assets

Property, Plant and Equipment 30,000 20,000

Investment in Crispen 24,000 ______

54,000 20,000

Current Assets

Inventory 10,000 6,000

Trade Receivables 6,000 2,000

Cash 10,000 1,000

Total Assets 80,000 29,000

Equity

Ordinary Share Capital 40,000 10,000

Share Premium 10,000 1,000

Retained Earnings 20,000 12,000

70,000 23,000

Non- current Liabilities

Deferred tax 4,000 0

Current liabilities

Trade payables 6,000 6,000

80,000 29,000

37
The following information is also available.

1. Care Plc acquired 8,000 million of the ordinary share capital of Crispen Plc five years
ago when Crispen’s retained earnings stood at K 4,000 million.
2. During the year to 31 December 2019, Crispen sold goods to Care at K 3,000 million
which was at a margin of 20%. Care had three-quarters of these goods in inventory at 31
December 2019.
3. At the year end, the current accounts of Care and Crispen Plc could not balance by K
4,000 million. After further investigations, it was found that Care sent a cheque of K
4,000 million to Crispen Plc on 28th December 2019 and Crispen Plc only received the
cheque on 3rd January 2020.

Required:

a) Prepare the consolidated statement of Financial Position for the Care Group as at 31
December 2019, clearly showing all your workings.

Comprehensive Exam Question

Agnes acquired 72% of the equity shares of Dace on 30 June 2019 for K250,000. On 31 Aug
2019, the statements of Financial Position for the two companies were as follows:

Agne Dace

K’000 K’000

Non-Current Assets 223 270

Investment in Dace 250 -__

473 270

Current Assets

Inventory 50 63

Receivables 60 48

Cash 19 14

129 124

38
Total Assets 602 394

Equity

K1 Ordinary Shares 300 200

Share Premium 40 10

Retained Earnings 210 64

550 274

Non-current liabilities 40 100

Current Liabilities 12 20

602 394

The following information is also available

1. At the date of acquisition, some of Dace’s Inventory had a fair value of K16,000 in
excess of its carrying value. All had been sold before the year end.

2. On 31st July 2019, Dace had sold an item of Property, Plant and Equipment to Agnes
realizing a profit on the sale of K20,000. Agnes was depreciating this item over its
remaining useful life of 4 years. It is group policy to charge a full year’s depreciation in
the year of purchase and non in the year of sale

3. On 29th August, Agnes dispatched goods to Dace at a transfer value of K26,000. Agnes
sells goods at a markup of 30%. Dace had sold a quarter of these goods by the Statement
of Financial Position date

4. The current accounts did not reconcile at the year end because Dace had sent a payment
of K5,000 to Agnes but Agnes only received it on 3 September 2019. Before any
necessary adjustments, the intra group balance in Dace’s records showed an amount
owing to Agnes of K12,000

5. Goodwill is impaired by 25%

6. Both entities have declared but not yet accounted for a dividend of 5n per K1 share

7. The directors valued the NCI at K87,667 at the date of acquisition

Required

Prepare a consolidated statement of Financial Position for the Agnes Group as at 31 August 2019

39
 UNIT 6: CONSOLIDATED STATEMENT OF PROFIT OR LOSS
The consolidated Statement of profit or loss shows the profit generated by all resources disclosed
in the statement of financial position.

40
The main purpose of a group (consolidated) statement of profit or loss is to report the profit and
loss of a group as a whole.

IAS 27 requires that such a statement should be prepared and presented in recognition of the fact
that a parent company and its subsidiaries are in effect a single economic entity.

A group statement of profit or loss is prepared by adding together (line by line) the individual
statements of profit or loss of all of the companies in the group, cancelling out any intra-group
items.

The following should be taken care of

 Any intra-group sales are included in the sales of the selling company and in the cost of
sales of the buying company. Therefore, intra-group sales are deducted from group sales
revenue and from group cost of sales when preparing the group statement of profit or
loss. This ensures that the group financial statements show only the sales revenue from
external customers and the cost of goods sold to external customers
 Other intra-group items that may arise (and which must be cancelled out) include interest
payable by one group member to another and management expense charged by one group
member to another.
 Any unrealized profit on inventories is deducted from the inventories figure shown in the
group statement of financial position. A reduction in closing inventory causes an increase
in cost of sales, so the group’s cost of sales figure must be increased by the amount of
any unrealized profit.
 If any goodwill acquired by the parent company on acquisition has suffered an
impairment loss during the period, this loss is shown as an expense in the group statement
of comprehensive.
 If a group includes any partly owned subsidiaries, part of the group’s profit after tax is
attributable to non-controlling interest. This amount is deducted in the group statement of
profit or loss, leaving the profit attributable to the group
 Dividends paid by a subsidiary to its parent company (shown in the subsidiary’s
statement of changes in equity) are cancelled against the dividends received shown in the
parent’s statement of profit or loss. However, dividends paid by a subsidiary to its
minority shareholders are ignored when preparing the group financial statements. This is
because the full amount of profit attributable to non-controlling interest has already been
shown in the group statement of profit or loss. Also the payment of dividends by a
subsidiary reduces its retained earnings and so automatically reduces the non-controlling
interest which is shown in the group statement of financial position.
 If there is a loan outstanding between group companies, only the loan interest would be
shown in the individual entities statement of profit or loss and so any effect of loan
interest received and paid must be eliminated from the consolidated Statement of profit or
41
 loss. In case of Loan interest received, it must be deducted from group investment income
and any interest paid must be deducted from group finance costs.

Example

On 1 January 2019, Zebedee acquired 60% of the ordinary shares of Xavier.

The following Statements of profit or loss have been produced by Zebedee and Xavier for the
year ended 31 December 2019

Zebedee Xavier
K’000 K’000
Revenue 1,260 520
Cost of Sales (420) (210)
Gross Profit 840 310
Distribution Costs (180) (60)
Administrative expenses (120) (90)
Profit from Operations 540 160
Investment Income from Xavier 36 _____
Profit before Taxation 576 160
Taxation (130) (26)
Profit for the year 446 134

During the year ended 31 December 2019, Zebedee had sold K84,000 worth of goods to
Xavier. These goods had cost Zebedee K56,000. On 31 December 2019 Xavier still had
K36,000 worth of these goods in inventories (held at cost to Xavier)

Prepare the consolidated Statement of profit or loss to incorporate Zebedee and Xavier for
the year ended 31 December 2019

Solution

The Zebedee Group Consolidated Statement of profit or loss 31 Dec 2019

K’000
42
Revenue (1,260 + 520 – 84) 1,696
Cost of Sales (420+210-84+12) (558)

Gross Profit 1,138

Distribution Costs (180+60) (240)
Administrative expenses (120+90) (210)
Profit from Operations 688
Investment Income from Xavier 0
Profit before Taxation 688
Taxation (130+26) (156)
Profit for the year 532

Attributable to:
NCI ( 40% of 134) 53.6
Group (balancing figure) 478.4
532

W1- PURP on Inventory

This can be worked out in two ways: you can either through it by way of finding the mark-up
or margin.

Mark-up

56,000 x y = 84,000

Y= 1.5, meaning that the mark-up is 50%

Therefore 1.5 x y= 36,000

Y= 24,000 (original cost price of the goods which have a cost have a cost of 36,000 to Xavier
after the sale)

So the unreleased profit will be 12,000 (36,000 – 24,000)

Margin

Start by calculating the initial profit made from the sale

84,000 – 56,000 = 28,000

43
And so 84,000 x y = 28,000
Y = Margin = 0.33%

33.33333% x 36,000 = 12,000 which is the PURP

Practice Question

On 1 January 2019, Vivian Ltd paid K 92,000 to acquire 80% of the share capital of Wisely
Ltd. The financial statements of Vivian and Wisely Ltd for the year to 31 December 2019 are
as follows:
Statements of Profit or loss for the year to 31 December 2019

Vivian Wisely
K’000 K’000
Sales Revenue 870 340
Cost of sales (370) (160)
Gross Profit 500 180
Operating Expenses (285) (105)
Profit before tax 215 75
Taxation (73) (20)

Profit for the year 142 55

Statement of Changes in equity (retained earnings only) for the year to 31 December
2019

Vivien Wisely
K’000 K’000
Balance at 31 December 2018 180 30
Profit for the year 142 55
Balance at 31 December 2019 322 85

Statements of Financial Position as at 31 December 2019

Vivien Wisely
K’000 K’000
Assets
44
 Non-Current Assets
Property, Plant and Equipment 360 120
Investment in Wisely 92 ___
452 120
Current Assets 150 60
602 180
Equity
Ordinary Share Capital 200 50
Retained Earnings 322 85
522 135
Liabilities
Current Liabilities 80 45
602 180
The following information is also available

1. All of the assets and liabilities of Wisely were carried at their fair values on 1 January
2019 and the company’s share capital has not changed since that date
2. Other profit or loss for the year to 31 December 2019 was nil for both companies
3. Goodwill arising on consolidation has suffered no impairment losses

Prepare a consolidated statement of profit or loss for the year to 31 December 2019 and a
consolidated statement of financial position as at that date. Also prepare an extract from the
consolidated statement of changes in equity; showing the changes in the group’s retained
earnings. Assume that non-controlling interests at the date of acquisition are not measured at fair
value.

MID-YEAR ACQUISITIONS-CONSOLIDATED STATEMENT OF PROFIT OR LOSS

If a subsidiary is acquired part of the way through the accounting period for which group
accounts are being prepared, the treatment of a subsidiary’s profit in the year of acquisition is
simply a further application of the requirement to exclude pre-acquisition profits from the
consolidated statement of profit or loss. The apportionment of a subsidiary’s profits in the year of
acquisition is normally done on a time basis. However, a different approach may be necessary if
45
the subsidiary’s business is affected by seasonal or other factors so that a straightforward time
apportionment would not be appropriate

Example

Yande Ltd acquired 75% of the ordinary share capital of Mukupa Ltd on 1st April 2019. Both
companies prepare accounts to 30 September each year. Their statements of profit or loss for the
year to 30 September 2019 are as follows:

Yande Mukupa

Sales Revenue 317,500 96,000

Cost of sales (149,500) (31,200)

Gross Profit 168,000 64,800

Distribution Costs (36,300) (4,800)

Administrative expenses (59,400) (20,400)

Profit before tax 72,300 39,600

Taxation (21,000) (8,000)

Profit for the year 51,300 31,600

Movements in the retained earnings of Yande Ltd and Mukupa Ltd for the year to 30 September
2019 are as follows:

Yande Mukupa

Balance at 30 September 2018 112,600 77,700

Profit for the year 51,300 31,600

Balance at 30 September 2019 163,900 109,300

The following information is also available

a) Two-thirds of the sales, cost of sales and distribution costs of Mukupa Ltd occur in the
second half of the accounting year. Administrative expenses are spread evenly over the
year. 5,000 of Mukupa’s tax liability relates to the second half of the year.

b) Other profit or loss for the year to 30 September 2019 was nil for both companies

c) Goodwill arising on consolidation has suffered no impairment

46
Prepare a consolidated statement of profit or loss for the year to 30 September 2019 and calculate
the group’s retained earnings as at that date.

Solution

Mukupa was acquired on 1 April 2019 which is 6 months into the accounting period. Therefore
six months will be pre-acquisition and the other six months will form the post-acquisition period
for the consolidation of Mukupa’s results in the

The Yande Group consolidated Statement of profit or loss for the year ended 30 Sept 2019

Sales Revenue 317,500+ (96,000 x 2/3) 381,500

Cost of sales 149,500 + (31,200 x 2/3) (170,300)

Gross Profit 211,200

Distribution Costs 36,300+ ( 4,800 x 2/3) (39,500)

Administrative expenses 59,400 + (20,400 x 1/2) (69,600)

Profit before tax 102,100

Taxation (21,000+5,000) (26,000)

Profit for the year 76,100

Attributed to:

NCI

Group

Practice Question

On 1 July 2017, R Ltd acquired 70% of the ordinary share capital of S Ltd. There are no
preference shares. The retained earnings of S Ltd on 1 July 2017 were K 2,000. Statements of
profit or loss for the year for year to 30 June 2020 are as follows

47
 R Ltd S Ltd

Sales Revenue 624,000 109,000

Cost of sales (267,400) (65,300)

Gross Profit 356,600 43,700

Distribution Costs (71,370) (5,100)

Administrative Expenses (101,430) (10,500)

Operating Profit 183,800 28,100

Dividend from S Ltd 14,000 ________

Profit before tax 197,800 28,100

Taxation (51,200) (7,100)

Profit for the year 146,600 21,000

Other profit or loss for the year was nil in each case. The following figures are taken from
retained earnings column of the statement of changes in equity of R Ltd and S Ltd for the
year to 30 June 2020

R Ltd S Ltd

Balance at 30 June 2019 54,900 7,000

Profit for the year 146,600 21,000

Dividends paid (120,000) (20,000)

Balance at 30 June 2010 81,500 8,000

The following information is also available

a) During the year, R Ltd sold goods to S for K 8,000. These goods had cost R Ltd K
5,000. At the year end, one-half of these goods were still held by S Ltd

b) The goodwill arising on consolidation has suffered no impairment losses

48
Prepare a consolidated statement of profit or loss for the year to 30 June 2010. Also prepare an
extract from the consolidated statement of changes in equity for the year, showing the changes in
the group’s retained earnings.

IAS 28- INVESTMENTS IN ASSOCIATES.

IAS 28 was originally issued in 1989 and amended in 1994, 1998, 1999 and 2000. Since then it
has been further amended by changes made in other standards, particularly IFRS 3 business
combination.

IAS28 Investments in Associates includes the following important definitions

 An Associate is an entity, including an unincorporated entity such as partnership, 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 participant in the financial and operating policy
decisions of the investee but is not control or joint control over those policies

IAS 28 requires all investment in associates to be accounted for in the consolidated accounts
using the equity method, unless the investment is classified as `held for sale` in accordance with
IFRS 5 in which case it should be accounted for under IFRS 5.

The Equity method is defined as a method by which the investment is iniatially recognised at
cost and adjusted thereafter for the post-acquisition change in the investor’s share of the net
assets of the investee

The equity method in

When an investor company owns (directly or indirectly) at least 20% of the voting power of an
investee company, significant influence is presumed to exist unless it can be clearly
demonstrated that this is not the case.

IAS28 also states that significant influence is presumed not to exist if the investor owns less than
20% of the voting power of the investee, unless such influence can be clearly demonstrated. The
existence of significant influence is usually evidenced by

49
  Representation on the board of directors which governs the investee company

 Participation in policy-making processes of the investee, including participation in

decisions about dividends or other distributions, or

 Material transactions between the investor and the investee, or

 Interchange of managerial personnel, or

 Provision of essential technical information

An investor company loses significant influence over an investee company when it losses the
power to participate in the investee’s financial and operating policies. This generally occurs
when the investor no longer owns at least 20% of the investee’s voting power. Significant
influence could also be lost for other reasons such as if the investee became subject to
government or court control

Accounting for Associates

IAS28 requires that an investment in an associate should normally be accounted for using the
equity method. The Equity method is defined as a method of accounting whereby the
investment is initially recognized at cost and adjusted thereafter for the post-acquisition
change in the investor’s share of the net assets of the investee.

The effect of this is that the consolidated statement of financial position will only include
investments in associate’s line within the non-current assets which includes the group share of
assets and liabilities of the associate.

In the consolidated Statement of profit or loss, a one line item of share of associate’s profits will
be included and this represents the group’s share of the associate’s profit after tax.

For the Parent company to equity account, IAS28 states that the parent company must already be
producing consolidated financial statements (it must at least have one subsidiary)

The amount to be included in the consolidated statement of Financial Position is calculated as

follows

Cost of Investment in associate X

Share of the post acq profits X

Less: Impairment losses (X)

Less: Provision for unrealized profits (PURP) (X)

50
 X

 A further working (w6) will have to be introduced and this will be the working on the
Investment in associate given by the formula above

 Note that IFRS 3 revised does not apply to associates as they are not controlled.

 Intra-group transactions (sales and purchases; receivables and payables) are not
eliminated between the group because associates are considered to be outside the group

But any unrealized profit on transactions must be eliminated and it’s only the group’s share
that is eliminated and not the whole amount. Upstream and downstream transactions are
transactions between an investor and associate. An example of an upstream transaction is the
sale of goods by the associate to the investor while the sale of goods by the investor to the
associate is an example of a downstream transaction. IAS 28 requires that any unrealized
profits resulting from such transactions be eliminated to the extent of the investor’s interest in
the associate. This differs from the IAS 27 requirement that unrealized profits on intra-group
transactions should be eliminated in full, whether or not the subsidiary concerned is wholly-
owned. In terms of accounting treatment
 A sale by the associate to the investor (upstream) - in the investor’s financial
statements, the unrealized profit is subtracted from the investor’s share of profit
from associates. This automatically reduces the investment in associates figure
shown in the statement of financial position.
 A sale by the investor to the associate (downstream)- in the investor’s financial
statements, the unrealized profit is subtracted from gross profit (usually by
increasing cost of sales) and is also subtracted from the investment in associates
figure shown in the statement of financial position
Example

An Investor company has a 25% interest in an associate. During the year to 31 December 2009,
the investor bought goods from the associate on which the associate earned a profit of K10,000.
One half of these goods remained unsold by the investor at the year end.
a) Calculate the unrealized profit on this transaction and explain how this is eliminated from
the investor’s financial statements
b) Explain how the required accounting treatment would differ if the goods had been sold by
the investor to the associate rather the other way around.
Solution

The unrealized profit is 5,000 (half of 10,000) but only the investor’s interest in the associate will
be taken into consideration when eliminating the PURP which in this case is K1,250 (25% of
5,000) and so in the investor’s financial statements, share of profit from the associate will be
51
reduced by amount of the PURP (K1,250) and investment in associate is reduced by the same
amount.

If the goods had been sold by the investor, in the investor’s financial statements, the cost of sales
figure would been increased by the amount of the PURP (K1,250) so that gross profit is reduced
and then investment in associate would also been reduced by K1,250.

Losses of an associate

The investor’s share of an associate’s loss is recognized as an expense in the investor’s financial
statements and is subtracted from the carrying amount of the investment. However, if the
investor’s share of an associate’s loss is greater than the carrying amount of the investment, that
amount is reduced to zero and the investor should normally recognize no further loss. But further
losses are recognized if the investor has incurred legal or constructive obligations on behalf of
the associate. This situation might occur if the investor has guaranteed the associates’ debts.

If the carrying amount of the investment is reduced to zero but the associate then eventually
returns to profit, the investor should not resume recognition of its share of the associate’s profits
until after those profits have cancelled out the losses which were not being recognized whilst the
carrying amount of the investment was zero

Impairment Losses
Any goodwill which is included in the carrying amount of the investment in an associate is not
separately recognized and is not separately tested for impairment. However, the entire carrying
amount of the investment should be tested for impairment whenever there is an indication that
impairment may have occurred and IAS 39 Financial Instruments: Recognition and
Measurement sets out a list of such indications

Reporting Periods and Accounting Policies

IAS 28 (Investment in Associates) sets out the rules with regard to reporting periods and
accounting policies that are similar to their IAS 27 (Consolidated and separate financial
statement) counterparts

The standard states that if the reporting period of an investor and an associate are different, the
associate should prepare additional financial statements for use for the investor, using the same
reporting period as the investor. If this is impracticable, the financial statements of the associate
should be adjusted to take account of any significant transactions or events which occur between
the end of the associate’s reporting period and the end of the investor’s reporting period. In any

52
case, the difference between the end of the associate’s reporting period and that of the investor
should not exceed three months

The investor’s financial statements should be prepared using uniform accounting policies. If an
associate uses different accounting policies from those adopted by the investor, its financial
statements should be adjusted to conform with the investor’s accounting policies before the
equity method is applied.

It is important to grasp the difference between the equity method which is used in relation to
associates and the acquisition method which is used in relation to subsidiaries. With the equity
method, only the investor’s share of the associate’s profit or loss is shown in the investor’s
financial statements (consolidated statement of profit or loss) and this is shown as a single figure.
With the acquisition method, all of subsidiary’s revenue and expenses are incorporated line by
line into the consolidated statement of profit or loss and then the profit attributable to the non-
controlling interest (if any) is subtracted.

Similarly, under the equity method, an investment in an associate is shown in the investor’s
financial statements (or consolidated financial statements) as a single non-current asset. With the
acquisition method, all of the subsidiary’s assets and liabilities are incorporated line by line into
the consolidated statement of financial position.

Example
Gamma plc is the parent of several wholly-owned subsidiaries. On 1 July 2009, Gamma plc
acquired 30% of the ordinary shares of Delta Ltd at a cost of K70,000. Delta Ltd had retained
earnings of K50,000 on that date and all of its assets and liabilities were carried at fair value.
Delta Ltd has issued no shares since Gamma plc acquired its 30% holding.

The draft consolidated financial statements (before applying the equity method) of Gamma plc
for the year to 30 June 2010 and the financial statements of Delta Ltd for that year are as follows:

Statement of Profit or loss for the year to 30 June 2010

Gamma Plc and Delta Ltd

Subsidiaries
K’000 K’000
Sales Revenue 930 320
Cost of Sales 340 170
Gross Profit 590 150
53
Operating Expenses 215 105
Operating Profit 375 45
Dividends received from Delta Ltd 6 ___
Profit before tax 381 45
Taxation 75 15
Profit for the year 306 30

Statement of Financial Position as at 30 June 2010

Gamma Plc and Delta Ltd

Subsidiaries
K’000 K’000
Assets
Non-current assets
Property, Plant and Equipment 510 155
Investment in Delta 70 ___
580 155
Current assets 225 40
Total assets 805 195
Equity
Ordinary Share capital 300 100
Retained earnings 390 60
690 160
Liabilities
Current liabilities 115 35
805 195
Statement of changes in equity (retained earnings only) for the year to 30 June 2010

Gamma Plc and Delta Ltd

Subsidiaries
K’000 K’000
Balance at 30 June 2009 204 50
Profit for the year 306 30
510 80
Dividends paid 120 20
Balance at 30 June 2010 390 60

Prepare a consolidated statement of profit or loss for the year to 30 June 2010 and a
consolidated statement of financial position as at that date. Also prepare an extract from the

54
 consolidated statement of changes in equity; showing the changes in the group’s retained
earnings in the year.

Solution

Gamma Plc Group Consolidated Statement of Profit or loss for the yr to 30 June 2010

K’000

Sales Revenue 930

Cost of Sales 340
Gross Profit 590
Operating Expenses 215
Operating Profit 375
Share of Associates Profit (w1) 9
Profit before tax 384
Taxation 75
Profit for the year 309

Gamma Plc Group Consolidated Statement of Financial Position as at 30 June 2010

K’000
Assets
Non-current assets
Property, Plant and Equipment 510
Investment in Delta (w2) 73
583
Current assets 225
Total assets 808
Equity
Ordinary Share capital 300
Retained earnings (w3) 393
693
Liabilities
55
Current liabilities 115
808

W1- Associates share of profit

30% of K30,000 = K6,000. Please note that dividends from associate is taken out and
replaced by the share of profit

W2- Investment in Associate

Carrying value of Investment 70

Share of Associate’s profit 9
Less: Dividend received (6)
73

W3- Group Retained Earnings

Gamma Retained Earnings 390

Add: share of associate’s profit 9
Less: dividend received (6)
393

Gamma Group Statement of changes in equity (retained earnings only) for the year to
30 June 2010

K’000
Balance at 30 June 2009 204
Profit for the year 309
513
Dividends paid 120
Balance at 30 June 2010 393

UNIT 9: IAS 31 Interest Joint Ventures

56
A joint venture is defined as a contractual arrangement whereby two or more parties undertake
an economic activity which is subject to joint control. Therefore none of the parties can control
the activity alone. All important decisions on financial and operating policies must be taken with
the consent of each of the parties to the venture.

The standard defines joint control as the contractually agreed sharing of control over an
economic activity, and exists only when the strategic, financial and operating decisions relating
to the activity require the unanimous consent of the parties sharing control (the venturers).

A venturer is defined as a party to a joint venture and has joint control over that joint venture

The important characteristic of a joint venture that distinguishes it from a subsidiary or associate
is that there is a contractual arrangement to share control. Without such an arrangement, joint
control cannot exist and the activity concerned is not a joint venture.

IAS 31 identifies three basic types of joint venture

1. Jointly controlled operations: This type of venture involves the use of the assets and
other resources of the separate venturers other than establishing a separate entity. It is
not very common for a jointly controlled operation to have its own set of financial
statements. The individual financial statements of each individual venturer will
recognize
 The assets that it controls and the liability that it incurs
 The expenses that it incurs and its share of the revenue that it earns from the
sale of goods or services by the joint venture
The agreement between the venturers specifies the way in which the revenue from the
operation should be allocated between them. An example of a jointly controlled operation
occurs when two or more venturers jointly agree to manufacture an aircraft, where one
venturer builds the engine, another builds the fuselage and so forth. The venturers beat
their own costs and each venturer takes a share of the revenue derived from selling the
aircraft. In this case, there is no need to prepare financial statements for the joint venture
itself as each individual venturer will recognize the assets, liabilities, expenses and
revenues associated with the operation in the individual financial statements.

2. Jointly controlled assets: This is where the venturers have joint control (and often
joint ownership) of the assets that contribute to the venture, or were acquired to be
used in the venture. Similarly, for this type of venture, it is very rare to find a set of
financial statements but most likely each individual venturer will open a joint venture
account in their own records for income and expenses incurred in respect of the joint
venture. As with a jointly controlled operation, this form of joint venture does not
involve the establishment of a new business entity. Each venturer takes a share of the
57
 revenue or other output derived from these assets and bears an agreed share of any
expenses. An example of this occurs when two or more venturers jointly own a
property which is leased to tenants, with each venturer taking a share if the rents and
bearing a share if the related expenses

IAS 31 requires that each venturer should recognized the following items in respect to
an interest in jointly controlled assets
 Its share of the jointly controlled assets
 Any liabilities which it has incurred individually in relation to the joint
venture
 Its share of any liabilities jointly incurred with other venturers
 Any income derived from its share of the output of the joint venture and its
share of any expenses incurred by the joint venture
 Any expenses which it has incurred individually in relation to the joint venture

3. Jointly Controlled entities: This is where a separate legal entity is created in which
each venturer has an interest. A jointly controlled entity keeps its own accounting
records and each individual venturer will enter the investment in the joint venture in
the financial statements and the investment is entered at cost. The venturers have a
contractual agreement to jointly control the entity’s activities. Since a legal entity is
formed which operates in the same way as any other entity, the jointly controlled
entity has its own assets, incurs its own expenses and liabilities and earns its own
income. Each venturer usually contributes cash or other resources to the jointly
controlled entity (perhaps by subscribing to a share issue) and is entitled to a share of
the entity’s profits.

ACCOUNTING FOR JOINTLY CONTROLLED ENTITIES

58
 IAS 31 provides two choices of accounting for jointly controlled entities.
a) The Equity Method- This is the same method as is used when accounting for an
investment in an associate.
b) Proportionate Consolidation- This is an accounting method whereby a venturer’s
share of each of the assets, liabilities, income and expenses of a jointly controlled
entity is combined line by line with similar items in the venturer’s financial
statements or reported as separated line items in the venturer’s financial
statements. Proportional consolidation involves consolidating the parent’s
proportion of the joint venture’s financial statements on a line by line basis. This
is the bench mark method and under this, there are two ways of presenting
proportional consolidation figures

Either
100% of parents + 25% of joint venture Intangible Non-Current Assets X
100% of parents + 25% of joint venture Tangible Non-Current Assets X

Or
100% of parent intangible non-current assets X
25% of joint venture intangible non-current assets X
X
100% of parent tangible non-current assets X
25% of venture tangible non-current assets X
X
If the first method is used, a disclosure note is required showing how the proportional
consolidation has affected the figures disclosed in the financial statements

From the above methods, one can see that the consolidation procedure is similar to that which is
used when the preparing group accounts but differs in that only the venturer’s share of net assets
etc of the jointly controlled entity are brought into account. This means that the venturer’s
financial statements do not account for non-controlling interest

In general, an interest in a jointly controlled entity should be accounted for by one of these two
methods (equity method and proportional consolidation), regardless of whether the venturer also
has subsidiaries and so present consolidated financial statements. However:

1) Under certain conditions, a venturer which is itself a subsidiary company may elect to
account for an interest in a jointly controlled entity either at cost on in accordance with
IAS 39

59
 2) An interest that is classified as held for sale in accordance with IFRS 5 Non-current
Assets Held for Sale and Discontinued Operations should be dealt with as required by
that standard
Please note that the proportionate consolidation method is the preferred method and the Equity
method is an allowed alternative.

Transactions between a Venturer and a Joint Venture

If a venturer contributes or sells an asset to a jointly controlled entity, while the assets are
retained by the joint venture, provided that the venturer has transferred the risks and rewards of
ownership, it should recognize only the proportion of the gain attributable to the other venturers.
The venturer should recognize the full amount of any loss incurred when the contribution or sale
provides evidence of a reduction in the net realizable value of current assets or an impairment
loss. [IAS 31.48]

When a venturer purchases assets from a jointly controlled entity, it should not recognize its
share of the gain until it resells the asset to an independent party. Losses should be recognized
when they represent a reduction in the net realizable value of current assets or an impairment
loss. [IAS 31.49]

Financial Statements of an Investor

An investor in a joint venture who does not have joint control should report its interest in a joint
venture in its consolidated financial statements either: [IAS 31.51]

 in accordance with IAS 28 Investments in Associates – only if the investor has significant
influence in the joint venture; or
 in accordance with IAS 39 Financial Instruments: Recognition and Measurement.

Partial Disposals of Joint Ventures

If an investor loses joint control of a jointly controlled entity, it derecognizes that investment and
recognizes in profit or loss the difference between the sum of the proceeds received and any
retained interest, and the carrying amount of the investment in the jointly controlled entity at the
date when joint control is lost. [IAS 31.45]

Disclosure

60
A venturer is required to disclose:

 Information about contingent liabilities relating to its interest in a joint venture. [IAS
31.54]
 Information about commitments relating to its interests in joint ventures. [IAS 31.55]
 A listing and description of interests in significant joint ventures and the proportion of
ownership interest held in jointly controlled entities. A venturer that recognizes its
interests in jointly controlled entities using the line-by-line reporting format for
proportionate consolidation or the equity method shall disclose the aggregate amounts of
each of current assets, long-term assets, current liabilities, long-term liabilities, income,
and expenses related to its interests in joint ventures. [IAS 31.56]
 The method it uses to recognize its interests in jointly controlled entities. [IAS 31.57]

Example

Danuta acquired 40% of the equity of Alex on 1 st January 2009 and on that date entered into
a joint venture with 3 friends, sharing equally activities of a separate entity which they
established in the same of Saulius. The Statement of profit or loss for Danuta Ltd, Alex and
Saulius Ltd for the year ending 31 December 2009 were as follows

Danuta Alex Saulius

Revenue 50,000 30,000 20,000

Cost of Sales (30,000) (19,000) (11,000)
Gross Profit 20,000 11,000 9,000
Expenses ( 5,000) ( 4,000) ( 3,000)
Dividend from Saulius 1,000
Finance Costs ( 3,000) ( 1,600) ________
Profit before tax 13,000 5,400 6,000
Taxation ( 5,000) ( 2,000) ( 1,500)
Profit for the year 8,000 3,400 4,500

The three entities have proposed dividends of K3,600, K2,000 and K4,000 respectively

Prepare the consolidated statement of profit or loss for Danuta incorporating the results of
Alex as an Associate and Saulius using the benchmark treatment.

Solution
61
 Revenue 50,000 + (20,000/4) 55,000
Cost of Sales 30,000 + (11,000/4) (32,750)
Gross Profit 22,250
Expenses 5,000 + (3,000/4) (5,750)
Finance Costs (3,000)
Profit before tax 13,500
Share of Alex’s profit 1,360
14,860
Taxation 5,000 + (1,500/4) (5,375)
Profit for the year 9,485

Retained profit for the year is therefore 9,486 – 3,600 = 5,886

Example

On 1 January 2009, Jonas Ltd and 5 friends acquired the whole of Antonas Ltd for a
consideration of K120,000 when the net assets of Anotonos were K100,000
The statements of financial position of Jonas and Antonos as at 31 Dec 2009 were:

Jonas Antonas
TNCA 80,000 70,000
Investment in Antonas 20,000 _____
100,000 70,000
Current Assets 90,000 60,000
190,000 130,000

Equity shares of K1 110,000 80,000

Retained Earnings 50,000 32,000
160,000 112,000
Current liabilities 30,000 18,000
190,000 130,000

Prepare the Consolidated Statement of Financial Position for Jonas incorporating Antonas’
results under
a) The Equity method
b) The Benchmark method
NB: Jonas’ share of goodwill have been valued at K3,000 at the year end
Workings
62
W1-Net assets
On Acq On Rept
Share Capital 80,000 80,000
Retained Earnings (bal fig) 20,000 32,000
Net Assets 100,000 112,000
W2-Goodwill
Purchase consideration 20,000
Share of NA@DOA (100,000/6) 16,667
3,333
Impairment (balancing figure) (333)
Goodwill to statement of FP 3,000

W3- Group Retained earnings

Parent 50,000
Share of post Acq profits of
Antonas (12,000/6) 2,000
Less Impairment loss (333)
51,667

W4- Investment in joint venture

Purchase consideration 20,000
Share of post Acq profits of Antonas 2,000
Less: Goodwill impaired (333)
21,667

The Jonas Group consolidated statement of financial position as at 31 Dec 2009

Equity Method Proportional Consolidation

Goodwill (w2) - 3,000
TNCA 80,000 91,667
Investment in Antonas 21,667 -
Current Assets 90,000 100,000
191,667 194,667
Share Capital 110,000 110,000
Retained earnings(w3) 51,667 51,667
Current liabilities 30,000 33,000
191,667 194,667
Practice Question
63
Question 1
Theta Ltd is a parent company with several wholly-owned subsidiaries. Iota Ltd is jointly
controlled by Theta and three other companies. The draft consolidated statement of financial
position of Theta Ltd as at 32 March 2010 is presented below, together with the statement of
financial position of Iota Ltd at that date.

Theta Ltd and Iota Ltd

Subsidiaries
K K
Assets
Non-Current Assets
Property, plant and equipment 644,000 244,000
Investment in Iota, at cost 70,000 _______
714,000 244,000
Current Assets 238,000 88,000
952,000 332,000
Equity
Ordinary Share Capital 500,000 120,000
Retained earnings 317,000 164,000
817,000 284,000
Liabilities
Current Liabilities 135,000 48,000
952,000 332,000
The following information is available:
a) On 1 April 2007, Theta Ltd paid K70,000 to acquire 25% of the shares in Iota Ltd. On
that date, the retained earnings of Iota Ltd were K72,000 and the fair value of the
company’s non-current assets was K40,000 more than their book value. This revaluation
has not been reflected in the books of Iota Ltd.
b) Iota Ltd has issued no shares since Theta Ltd acquired its holding and there have been no
impairment losses in relation to goodwill
c) The interest of Theta Ltd in Iota Ltd is to be accounted for by means of proportionate
consolidation.

Prepare the consolidated statement of financial position of Theta Ltd as at 31 March 2010

64
 UNIT 11: COMPLEX GROUP STRUCTURES
The Complex group structures exist where a subsidiary of an entity owns shares in another entity
which make that other entity the subsidiary of the parent company as well. Complex structures
can be classified as vertical groups or mixed groups

VERTICAL GROUPS
The term sub- subsidiary refers to a situation where the ultimate parent P has a subsidiary H and
H itself has a subsidiary S. A vertical group structure arises where a parent company has a
subsidiary and a sub-subsidiary as well

H H H

60% 55% 90%

S1 40% S1 45% S1 10%

55% 70% 80%

S2 45% S2 30% S2 20%

The Parent company controls both the subsidiaries because it has a controlling interest in S
which in turn controls another subsidiary. Control is the key and since the parent company
ultimately controls the 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. In this case, we can say that the parent company has a direct interest in S
(Subsidiary) and an indirect interest in S1 (Sub-Subsidiary).

 The consolidation principles used in simple groups will be applied in the consolidation of
vertical groups however certain matters do need to be treated with particular care and
these include

1. The Computation of Non- Controlling Interests in the Subsidiary

2. The effective date of acquisition of the sub-subsidiary

3. The Computation of goodwill on consolidation of the sub-subsidiary

When consolidating, the effective date of acquisition is when the parent company acquired
control of the subsidiary and not when the subsidiary acquired control of the sub-subsidiary.

Goodwill for the subsidiary company is calculated in the same way as in the simple group
structure (paying attention to the method of valuation of the NCI) but for the sub-subsidiary, the
65
goodwill is calculated from the perspective of the ultimate parent company rather than the
immediate parent. In this case, the effective cost of acquisition of the sub-subsidiary by the
ultimate parent is only the ultimate parent’s share of the amount that the subsidiary paid for the
acquisition of the sub-subsidiary.

When computing the Non-Controlling Interest (in working 4), the NCI share of the Subsidiary
net assets must be adjusted to take out the cost of investment in the sub-subsidiary that is
included in the net assets of the subsidiary.

The non-controlling in the subsidiary are entitled to the indirect share of the net assets of the sub-
subsidiary, but they receive these by virtue of the effective interest that will be used to calculate
the non-controlling interest in the sub-subsidiary.

When computing the group reserves, only the effective interest of the ultimate parent’s share of
the sub-subsidiary is taken of the post-acquisition profits of the sub-sub subsidiary.

Example

Pong made a 75% investment of ZMK 80,000 million in Sung Company on 31st December 2006
when the net assets of S were ZMK 96,000 million ( issued share capital ZMK 48,000 million
plus retained earnings of ZMK 48,000 million).

On 31st December 2007, Sung made a 60% investment of ZMK 40,000 million in Tung when the
net assets of Tung were ZMK 60,000 million (issued share capital ZMK 40,000 million plus
retained earnings of ZMK 20,000 million)

None of the entities has issued new shares since 31 st December 2006 and there has been no
impairment of goodwill since the acquisitions. It is the group policy to value NCI at the
proportionate share of net assets of the subsidiary. The summarized statement of financial
position of the three entities at 31st December 2010 were as shown below

Pong Sung Tung

66
 K million K million K million

Investments in Subsidiary 80,000 40,000 -

Non-Current assets 120,000 80,000 80,000

Net current assets 40,000 24,000 20,000

240,000 144,000 100,000

Issued Share Capital 120,000 48,000 40,000

Retained Earnings 120,000 96,000 60,000

240,000 144,000 100,000

Required:

Prepare the consolidated statement of financial position of Pong group at 31st December 2010,
showing appropriate workings

Answer

(w1) Group Structure (w1b) Group and Non-Controlling Interest

P S T

75% Group Interest 75% 45%

NCI 25% 55%

S 25% NCI 100% 100%

60%

T 40% NCI

(w2a) Net Assets of Subsidiaries

Sung Tung
67
 At Acq At Rptg At Acq At Rptg

Share Capital 48,000 48,000 40,000 40,000

Retained Earnings 48,000 96,000 20,000 60,000

96,000 144,000 60,000 100,000

(w2b) Goodwill

Sung Tung

Purchase Consideration 80,000 40,000

Share of Net Assets (72,000) (36,000)

8,000 4,000

Parent Share 8,000 3,000

Total Goodwill is 11,000

(w3) Non-Controlling Interest

Sung NCI 36,000

Less Share of Investment (10,000)

26,000

Tung NCI 55,000

81,000

(w4) Group Retained Earnings

Parent (Pong) 120,000

Share of Sung Post Acq 36,000

Share of Tung Post Acq 18,000

174,000
68
Consolidated statement of financial Position for Pong Group as at 31 Dec 2010

Goodwill 11,000

Non-Current Assets 280,000

Net Current Assets 84,000

375,000

Share Capital 120,000

Retained earnings 174,000

NCI 81,000

375,000

MIXED ( D-Shaped) GROUPS

A mixed group arises where the parent entity has a direct controlling interest in at least one
subsidiary and in addition, the parent entity and the subsidiary together hold a controlling interest
in a further entity

a) H b) H

70% 30% 55%

S 30% T S1 8%

65%

S2

 In A, H Controls 70% of S and this means that S is subsidiary of H

69
H controls 30% of T and also controls 30% indirectly through its
investment in S
 Is T a sub subsidiary of the H group?

 As for B, H

 Is S2 a sub subsidiary of the H group?

 As with the vertical group, the date of acquisition of each subsidiary is the date on which
H gains control.

Note that the definition of a mixed group does not include the situation where the parent and an
associate together hold a controlling interest in a further entity. For example H owns 35% of S
and S owns 40% of W and H owns 40% of W. This is not a mixed group situation and neither S
nor W is a member of the H group although S and W may both be associates of H.

All consolidation workings are the same as those used in vertical group situations, with the
exception of goodwill which in this case has two elements that have to be considered

 The cost of the parent’s direct holding

 The percentage of the cost of the parent’s indirect holding

Example

Post Tel bought 55% of Zam Cel on 1st January 2009 for K 90,000 when Zam Cel’s retained
earnings on that date were K115,000 and share capital of K 35,000. On 1st January 2010, Tele
Zain bought 140,000 of Post Tel’s 200,000 K1 equity shares for K 300,000. On 1st January 2010,
Post Tel’s retained earnings were K 100,000.00 and Zam Cel’s retained earnings were K
125,000.

The value of Post Tel shares immediately before the Tele Zain takeover was K1.80 per share

Required:

Calculate the goodwill figure which will appear in the Tele Zain Consolidated Statements of
Financial Position as at 1st January 2010.

Solution

W1. Group Structure

70
Example

The following are the summarized statements of financial position of T, P and A as at 31

December 2004

T P A

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 K1 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

On 1 January 2003 P acquired 35,000 ordinary shares in A at a cost of 65,000 when the retained
earnings of A amounted to 40,000.

On 1 January 2004 T acquired 64,000 shares in P at a cost of 120,000 and 40,000 shares in A at a
cost of 80,000. The retained earnings of P and A amounted to 50,000 and 60,000 respectively on
1 January 2004. The fair value of the NCI in P at that date was 27,000. The fair value of the
whole (direct and indirect) NCI in A was 56,000. Goodwill has not been impaired.

Prepare the consolidated statements of financial position of the T group as at 31 December 2004
using the full goodwill method to value the non-controlling interest

Answer

(w1) Group Structure (w1a) Group and Non Controlling Interest

T P A

80% Group Interest 80% 68%

40% NCI 20% 32%

71
P 100 100

35%

(w2) Net Assets

P A

At Acq At Rptg At Acq At Rptg

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

(w2a) Goodwill

Goodwill arising on acquisition of P

P NCI

Purchase consideration 120,000 27,000

Share of Net Assets (104,000) (26,000)

16,000 1,000

Total for P is 17,000

Goodwill arising on the acquisition of A A NCI

Direct Purchase Consideration 80,000 56,000

72
Indirect Purchase Consideration 52,000 0

132,000 56,000

Share of Net Assets (108,000) (51,200)

23,200 4,800 Total 28,000

(w4) NCI

NCI in P 28,000

Less share of cost of Inv (13,000)

NCI in A 57,600

NCI Goodwill in P 1,000

NCI Goodwill in A 4,800

78,400

(w5) Group Retained Earnings

Retained earnings (Parent) 150,000

Share of Past Acq Profit in P 8,000

Share of Post Acq Profit in A 13,600

171,600

T Consolidated Statement of Financial Position as at 31 Dec 2004

Goodwill 45,000

Non-Current Asset 371,000

73
Current assets 55,000

471,000

Equity Share Capital 200,000

Group Retained Earnings 171,600

371,600

NCI 78,400

Liabilities 21,000

471,000

Example 4

The Statement of profit or loss of Pong, Sung and Tung for the year ended 31st December 2010
are as follows

Pong Sung Tung

K million K million K million

Revenue 400,000 320,000 240,000

Cost of Sales (200,000) (160,000) (120,000)

Gross Profit 200,000 160,000 120,000

Other Operating Exp (100,000) (80,000) (60,000)

Invest Income (Intra Group) 24,000 12,000 ________

74
Profit before tax 124,000 92,000 60,000

Income tax Exp (36,000) (24,000) (20,000)

Profit for the year 88,000 68,000 40,000

Pong made a 75% investment of ZMK 80,000 million in Sung Company on 31st December 2006
when the net assets of S were ZMK 96,000 million ( issued share capital ZMK 48,000 million
plus retained earnings of ZMK 48,000 million).

On 31st December 2007, Sung made a 60% investment of ZMK 40,000 million in Tung when the
net assets of Tung were ZMK 60,000 million (issued share capital ZMK 40,000 million plus
retained earnings of ZMK 20,000 million)

None of the entities has issued new shares since 31 st December 2006 and there has been no
impairment of goodwill since the acquisitions. It is the group policy to value NCI at the
proportionate share of net assets of the subsidiary. The summarized statements of profit or loss of
the three entities for the year to 31 st December 2010 are as shown above. Prepare the
consolidated Statement of profit or loss for the year ended 31st December 2010.

Practice questions

Question 1

Matis bought 40,000 of the shares in Dimitrys on 1 September, 2005 for K95,000. On that date,
the retained earnings in Dimitrys were K60,000. One year earlier Dimitrys had bought 60% of
the share capital of Vitalis for K80,000 when Vitalis’ retained earnings were K40,000. Vitalis’
profits for the year ended 31 August 2005 were K8,000.

The directors of Matis felt that goodwill in the year to 31 August, 2009 should be impaired by
10%. This was the first impairment of goodwill since the acquisitions.

75
The directors of Matis estimated the fair value of the non-controlling interest investment in
Dimitrys at K23,000 and in Vitalis, the fair value of the 52% non-controlling interest was
estimated at K 61,360 inclusive of their share of investment in Vitalis by Dimirtys

The three statement of Financial Position as at 31 August, 2009 are set out below

Matis Dimitrys Vitalis

Investment 95,000 80,000

Tangible Non-Current Assets 100,000 70,000 120,000

Current assets 45,000 30,000 30,000

240,000 180,000 150,000

Equity Shares of K1 each 150,000 50,000 70,000

Retained earnings 80,000 110,000 64,000

230,000 160,000 134,000

Current Liabilities 10,000 20,000 16,000

240,000 180,000 150,000

Prepare the consolidated statement of financial position as at 31 August, 2009.

Question 2

Below are the statements of Financial Position of Andra, Kristina and Liena as at 30 June, 2009.

Anda Kristina Liena

‘000 ‘000 ‘000

Investments 743 400 160

76
Tangible Non-Current Assets 1,079 833 362

Current Assets 218 357 318

2,040 1,590 840

Equity Shares of K1 800 500 300

Retained Earnings 1,050 850 450

1,850 1,350 750

Current Liabilities 190 240 90

2,040 1,590 840

Many years ago, Anda bought 350,000 shares in Kristina at K1.70 per share when the retained
earnings in Kristina were K250,000.

Anda and Kristina bought shares in liena on the same day, two years ago, at K2 per share. Anda
also invested K68,000 on an original painting by a local artist. Liena owned shares in the
country’s national telephone company. There was no other investments held by any of the three
companies. Liena’s retained earnings two years ago were K270,000.

Goodwill arising from the Liena acquisition had declined by 10% this year, for the first time
since acquisition, and arising from the acquisition of Kristina, goodwill has been impaired this
year by 20%. The directors of Anda had valued goodwill attributable to the Non-Controlling
Interest in Kristina at K15,000 and a proportional basis for the non-controlling interest in Liena.

Prepare the consolidated Statement of Financial Position for the Anda Group as at 30
June, 2009.

UNIT 13: CHANGES IN THE COMPOSITION OF A GROUP

77
A Parent entity’s interest can change in two ways

1. Either by increasing an existing investment

2. Or by reducing an existing investment

Step Acquisitions
A step acquisition occurs when the parent company acquires control over the subsidiary in stages
by way of buying blocks of shares at different times. It is probable that an investment will be
acquired over a period of time. This is also referred to as piecemeal acquisition.

There are three possible situations that can arise

 Where an investment of say, 16% with no significant influence is increased to, say, 70%
where control is achieved

 Where an Investment of say, 25% with significant is increased to say, 70%

 Where an Investment of say, 55% with control already achieved, is increased to say, 80%

In the first two situations, control is achieved from a mare investment and from an associate level
to being a subsidiary. In the final situation, control is already achieved and is merely increased
from 55% to 80%. The accounting treatment for two situations is fundamentally different.

In the first two situations, the accounting treatment is to treat the original investment as being
disposed of at fair value and re-acquired at fair value and at the same time, the deemed disposal
at fair value gives rise to a profit (or loss) on disposal which is reflected in the year’s Statement
of profit or loss.

Acquisition accounting is only applied at the date when control is achieved and on this date

 You have to re-measure the previously held equity interest to fair value

 Recognize any resulting gain or loss in the profit or loss

 Calculate goodwill and NCI on either a partial (proportionate) or full (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 the acquisition date

78
 In a situation of a further purchase of shares in a subsidiary after control has been
acquired (e.g. taking group interest from 60% to 75%), goodwill should NOT be
recalculated and is regarded as a transaction between equity holders.

 Using acquisition accounting, which should apply from the date on which the parent
company achieves control of it. This method results in the line-by-line consolidation of
the subsidiary’s net assets and the recognition of a goodwill asset and non-controlling
interests
 Where an entity purchases shares in another entity and later buys additional shares in it,
the second purchase is referred to as a step acquisition.

In the first two situations where a subsidiary is now acquired, the working for goodwill
changes so as to reflect the fair value of the deemed disposal as part of the cost of acquisition
of the new investment

Goodwill working (using the full goodwill method)

Parent NCI
Cost of additional investment X X
Add: Fair value of original Investment X X
X X

Net Assets @ date of obtaining control:

Shares X
Retained Earnings X
X
Parent’s new combined share (X) (X)
Goodwill X X

A further working will be required to determine the profit or loss on the deemed disposal

Parent’s profit on deemed disposal

Fair value of existing holding at date of acquisition of control X

Less carrying value of existing holding (X)

Profit on deemed disposal X

Example,

79
On January 1, 2007 Company X acquired a 20 per cent shareholding in company Y at a cost of
£40,000. On January 1, 2009 X acquired a further 40 per cent shareholding in Y at a cost of
£150,000. At this time it was determined that the fair value of X’s 20 per cent shareholding in Y
was £50,000. Between January 1, 2007 and January 1, 2009 Y made a profit of £30,000. You are
required to:
A. Calculate the cost of investment for the purposes of calculating goodwill.
B. Calculate the gain arising that will be recognized within profit, assuming:
(i) that X’s initial 20 per cent holding didn’t enable it to exercise significant
influence Over Y; and then
(ii) that X’s initial holding did enable it to exercise significant influence over
Y.
Solution

Cost of Investment
Cost of additional Investment 150,000
Fair value of original investment 50,000
200,000

Gain on the deemed disposal assuming that 20% did not enable significant influence will be
10,000 ( fair value of 50,000 less 40,000 initial cost of investment). This is because the
transaction is being accounted for in effect, as if X disposed of its 20% holding, which cost
40,000 for deemed proceeds of 50,000 and then acquires a 60% holding at a cost of 200,000.

In the second scenario where the initial 20% did enable the exercise of significant influence, then
Y would have been treated as an associate, therefore, and equity accounting would be used in the
consolidated accounts. Consequently, on 1 January, 2009, the investment in the associate would
have a carrying value in the consolidated statement of financial position of the cost of investment
plus its share of post-acquisition profits and would have been 46,000 ( 40,000 + (20% x
30,000)). This would have meant that the gain arising on the deemed disposal would be 4,000
(50,000 – 46,000) which is the fair value of the previous holding minus the carrying value of that
holding.

Please note that if step acquisition occurs part-way through the financial year, it will be
necessary when preparing the consolidated Statement of profit or loss to time-apportion the
results of the investee and equity account for the proportion of the year in which it’s an associate
and use acquisition accounting for the proportion in which it’s a subsidiary.

Practice question

When Mesan Plc acquired 15% of Better’s Plc K 400,000 share capital in 2007 for K100,000,
Better’s retained earnings were K200,000. Two years later Mesan Plc acquired a further 60% of
Better’s shares for K520,000 when the retained earnings had risen to K360,000. Share capital
was unchanged. The fair value of the non-controlling interest’s investment was estimated as
K200,000

80
Calculate goodwill and profit on the deemed disposal.
Example

Major acquired 40% of Tom on 31 December 2001 for K90,000. At this time the retained
earnings of Tom stood at K76,000. A further 20% of shares in Tom was acquired by Major three
years later for K70,000. On this date, the fair value of the existing holding in Tom was K
105,000. Tom’s retained earnings were K100,000 on the second acquisition date at which date
the fair value of the NCI interest in goodwill was K 10,000.

The statements of financial position of two companies, Major and Tom as at 31 Dec 2006 are as
follows

Major Tom

K’000 K’000

Investment 160

Sundry assets 350 250

510 250

Equity Share Capital 200 100

Retained earnings 250 122

Liabilities 60 28

510 250

Prepare the consolidated statement of financial position for the Major group as at 31 December
2006, assuming that it is group policy to value the NCI on a fair value basis.

Answer
(w1)- Group Structure

Major

60% (40% + 20%)

Tom

81
Therefore, Tom becomes a subsidiary of Major from Dec 2004

In the books of Major, the investment will be revalued

Dr Investment 15,000

Cr Profit 15,000

(w2) Net assets

At Acquisition At Reporting date

2004

Share Capital 100,000 100,000

Retained Earnings 100,000 122,000

200,000 222,000

(w3) Goodwill

Purchase Consideration 175,000

Parent share of Net Assets (60% of 200,000) (120,000)

55,000

NCI (given in question) 10,000

Good will 65,000

(w4) NCI

40% of K 222,000 88,800

NCI goodwill (given in question) 10,000

98,800

(W4) Group Retained Earnings

82
Major 250,000

Gain on remeasurement 15,000

Share of post Acq profit of Tom (60% of 222-200) 13,200

278,200

Consolidated statement of financial position for Major as at 31 December 2006

Goodwill (w3) 65,000

Sundry assets ( 350,000 + 250,000) 600,000

665,000

Equity Share Capital 200,000

Retained Earnings (w5) 278,000

NCI (w4) 98,800

Liabilities (60,000 + 28,000) 88,000

665,000

83
INCREASE IN GROUP STRUCTURE WHERE CONTROL IS ALREADY
OBTAINED
A step acquisition will reduce the NCIs’ holding in cases where the initial investment gave the
parent a controlling shareholding, so the investee has already been consolidated as a subsidiary.
As a result, there is no change in the subsidiary status of the investee when the subsequent share
purchase occurs. There is simply a change in the proportions of ownership between the parent
and the NCIs at the step acquisition. In effect, the parent is buying shares from the NCIs. Since
this is a transaction between shareholders, no gain or loss arises and so there is no effect on
profit. But a difference may need recording within equity. This adjustment to equity requires an
additional working as shown below

Fair value of consideration for additional (say 25%) holding X

Net Assets on date of additional acquisition:
Shares X
Retained Earnings X
X

Proportion acquired (say 25% of net assets on date of add acq) (X)

Share of NCI goodwill acquired * (X)

Adjustment to parent’s equity X

 * Please note that share of NCI goodwill acquired is only subtracted where NCI is valued
on a fair value basis (as distinct from a proportional basis)

Example

When Sergijus acquired 55% of Indra’s 800,000 K1 equity shares, the retained earnings in Indra
were K480,000. Two years later on 1 December, 2009, Sergijus acquired at a cost of K500,000 a
further 25%. The Non-Controlling interest in good on original acquisition had been valued at
K100,000.

Goodwill has not been impaired

The financial statements of Sergijus and Indra at 30 November, 2010 were:

84
 Sergijus Indra

Investment in Indra 1,400,000

Other net assets 580,000 1,620,000

1,980,000 1,620,000

Shares 700,000 800,000

Retained earnings 1,280,000 820,000

1,980,000 1,620,000

Operating profit 100,000 120,000

Tax 30,000 36,000

Retained earnings for the year 70,000 84,000

Prepare the consolidated financial statements for Sergijus Group for the year ended 30
November, 2010.

85
DISPOSAL OF INVESTMENT
So far we have seen the situation where a parent increases its holding in an investment. During
the year, the parent may sell one or all of its shares in another entity

Possible situations include

 The disposal of all the shares held in the subsidiary, where an investment of say, 80% is
disposed of completely
 The disposal of part of the shareholding, leaving a residual holding which is regarded as a
trade investment, where an investment of say, 80% is sold down to 15%
 The disposal of part of the shareholding, leaving a residual holding which allows the
company to have significant influence, where an Investment of say, 80% is sold down to say,
40%
 The disposal of part of the shareholding, leaving a controlling interest after the sale where an
investment of say, 80% is sold down to say, 60%

It can be seen from the situations above that in the first 3, control is lost but in the last
situation, control is retained and is merely reduced.

Where control is lost (as in the first three situations) the accounting treatment is
fundamentally different from the situation where control is merely reduced.

1. Sale of entire holding

Where a parent sells its entire holding in a subsidiary, we will need to work out two
workings to calculate the gain (loss) on disposal in both the parent’s own financial
statements and the group’s financial statements. Additionally, there will be derecognition
of assets and liabilities for the subsidiary disposed of together with elimination of
goodwill and NCI from the group accounts.

a. Gain in Parent

Proceeds of disposal X

Less: Carrying amount (usually cost) of shares sold (X)

Gain in parent X

Tax at say 25% (X)

Net gain in parent X

86
 b. Gain in group

Proceeds of disposal X

Net Assets on date of disposal:

Shares X

Retained Earnings X

Proportion sold, say 80% (X)

Less Goodwill Sold (X)

Gain in group X

Tax (same figure as in above) (X)

Net gain in Group X

Please note that 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

Example 1

Diana had acquired 75% of Liga’s 300,000 K1 equity shares four years ago when Liga’s
retained earnings were K150,000. On 30 June, 2009 Diana sold the entire holding for
K400,000. NCI investment on acquisition was valued on a proportional basis. There has
been no impairment of goodwill up to 30 June, 2009. The disposal has not yet been
reflected in Diana’s financial statements. Taxation rate for the entities if 30%

87
The summarized financial statements for Diana and Liga for 30 June 2009 are as follows

Diana Liga

Investment in Liga 350,000

Other net assets 750,000 700,000

1,100,000 700,000

Shares 500,000 300,000

Retained Earnings 600,000 400,000

1,100,000 700,000

Profit before tax 100,000 70,000

Tax 30,000 21,000

Retained earnings for the year 70,000 49,000

Prepare the consolidated financial statements for the Diana Group for 30 June, 2009

Diana and Liga was an example of a complete disposal and control was therefore lost

We still have two situations were control is lost

 80% to 15%

 80% to 40%

As in the example above, we need to calculate the gain (or loss) on disposal in the
parent’s own financial statements and the gain or loss in the group. For the calculation
of the gain or loss in the group, we need to add the fair value of the investment
retained to the consideration received.

 So in these two scenarios, control is lost and the subsidiary becomes an associate
or Investment.

The Parent should recognize

 The Consideration received

88
  Any investment retained in the former subsidiary at fair value on the date of the
disposal

The Parent should Derecognise

 The assets and liabilities of the subsidiary at the date of disposal

 Unimpaired goodwill in the subsidiary

 NCI at the date of disposal

Note

Any difference between these amounts is recognized as a gain or loss on disposal in the
group accounts

In the group Statement of profit or loss, 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 mere investment as appropriate

In the case where the disposal leads to a trade investment, only include dividend income
after the date of disposal in the Statement of profit or loss and recognize the holding
retained as an investment, measured at fair value in the statement of financial
position. The gain/loss is calculated as follows

Consideration received X

Plus fair value of investment retained X

Less net assets of sub at disp (X)

Less our share of goodwill at date control is lost (X)

Pre-tax gain or loss to the group X

Example

Accounting for a disposal where control is not lost

Where there is a sale of shares but control is not lost, in essence, this is an increase in the NCI.

In this case

89
 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 NCI is accounted for in
shareholders ‘equity as follows

Cash proceeds received X

NCI in sub post disposal X

NCI in Sub pre disposal (X)

Difference to equity X

In terms of consolidation

In the Statement of profit or loss

 Consolidate the subsidiary’s result for the whole year

 Calculate the NCI relating to the periods before and after the disposal separately and then
add together ( Y/12 X PROFIT X 10%) + ( X/12 X PRFIT X 40%)

In the statement of financial position

 Consolidate as normal, with the NCI valued by reference to the year-end holding

Example

The draft accounts of two companies at 31 March 2001 were as follows

Statement of Financial Position

Cagney Gr Lacey

K K

Investment in Lacey at cost 3,440

Sundry assets 41,950 9,500

45,390 9,500

90
Equity Capital (K1 shares) 20,000 3,000

Retained earnings 11,000 3,500

Sundry Liabilities 5,500 3,000

Sales proceeds of dis (Susp a/c) 8,890

45,390 9,500

Statement of Profit or loss

Revenue 31,590 11,870

Cost of sales (15,290) (5,820)

Gross Profit 16,300 6,050

Distribution Costs (3,000) (2,000)

Admin Expenses (350) (250)

Profit before tax 12,950 3,800

Tax (5,400) (2,150)

Profit after tax for the year 7,550 1,650

The companies retained earnings on 1 April 2000 were as follows

Cagney 3,450 and Lacey 1,850

Cagney had acquired 90% of Lacey when the reserves of Lacey were K700. Goodwill of
K110, calculated on a proportionate basis, has been fully impaired. The Cagney group
includes other 100% owned subsidiaries.

On 31 Dec 2000, Cagney sold shares in Lacey.

Required

Prepare extracts from the Cagney Group Statement of financial position and statement of
profit or loss on the basis that Cagney sold a 15% holding in Lacey. Include a statement
of changes in equity within your answer.

91
Practice question

Question

Changes in group structure can take the form of where by one entity sells some or all of its
shares in another entity.

The following statements of financial position relate to the results of Care and Ashley Plc as at
31 March 2011.

Statements of Financial Position at 31 March 2011

Care Ashley

K’000 K’000

Property, Plant and Equipment 109,750 37,500

Investment in Ashley at Cost 17,200 ______

126,950 37,500

Inventory 30,000 5,000

Trade Payables 40,000 3,000

Cash 30,000 2,000

226,950 47,500

Equity Capital (K1 shares) 100,000 15,000

Retained Earnings 55,000 17,500

Payables 27,500 15,000

Sales proceeds of disposal (suspense account) 44,450 ______

92
 226,950 47,500

Statement of Profit or loss Extracts for the year to 31st March 2011

Care Ashley

K’000 K’000

Operating Profit 64,750 19,000

Taxation (27,000) (10,750)

Profit after tax 37,750 8,250

The companies retained earnings on 1st April 2010 were as follows

Care K 17,250,000

Ashley K 9,250,000

The following information is available

1. Care Plc is a listed Company on the Lusaka Stock Exchange. Care acquired 90% of
Ashley Plc many years ago when the reserves of Ashley were K 3,500,000. Goodwill of
K 550,000, calculated on a proportionate basis, has been fully impaired. The Care group
includes other 100% owned subsidiaries.

2. On 31 December 2010, Care sold shares in Ashley

Required:

a) Prepare the consolidated statement of financial position for the Care group on the
basis that a 10% holding in Ashley was sold by Care ( 20 Marks)

93
 b) Prepare the consolidated statement of financial position for the Care group on the
basis that a 50% holding in Ashley was sold by Care ( 10 Marks)

IAS 7 CASH FLOW

It’s always said that cash is the “life blood” of a business. Without cash, a business cannot pay its
suppliers and will soon fail. Therefore a financial statement which focuses on the flows of cash
in and out of a business serves a useful purpose.

Users of financial statements need information on the liquidity, viability and financial
adaptability of entities.
One reason of the cash flow is that profit figures are relatively very easy to manipulate. The
are many items in the in the Statement of profit or loss that involve a lot of Judgment
 Inventory valuation
 Depreciation
 Allowance for receivables

This may make it difficult to interpret a company’s results with confidence.

A statement of cash flow showing merely inflows and outflows is easier to understand and more
difficult to manipulate.
It might be thought that a profitable business would never run out of cash, but this is not always
the case. A business might report a healthy profit in its financial statements and yet suffer severe
cash problems. Some of the reasons for this could be:
i. As stated earlier, profits are computed on the accruals basis. Therefore, revenue shown in
the statement of profit or loss might not be actually received for a considerable period of
time, especially if the business offers lengthy credit to its customers
ii. The purchase of non-current assets has an immediate cash impact but filters through to
the statement of profit or loss only gradually, in the form of depreciation
iii. A business which builds up large inventories usually has to pay for those inventories
fairly quickly, but their cost has no impact on reported profit until they are sold at some
time in the future
iv. The repayment of a loan takes cash out of the business but has no direct effect on profit.
The same applies to the payment of a dividend

94
For such reasons, the size of an entity’s profit is an unreliable indicator of its cash situation and
that’s why a statement of cash flows in needed.
Cash flows are inflows and outflows of cash and cash equivalents
A statement of cash flows is needed to show the actual cash position of an entity at a given
period.

The main objective of IAS 7 is “to require the provision of information about the historical
changes in cash and cash equivalents of an entity by means of a statement of cash flows which
classifies cash flows during the period from operating, investing and financing activities

Definitions

 Cash- Comprises cash on hand and demand deposits

 Cash Equivalents are short term, highly liquid investments that are readily convertible
to known amounts of cash and which are subject to insignificant risk of changes in value.
An investment will usually not qualify as a cash equivalent unless it has a maturity date
which is no more than three months after the date of acquisition. Equity Investments are
generally excluded from the definition but redeemable preference shares with a specified
redemption date in the near future might qualify.

In some countries, Bank Overdrafts are generally repayable on demand and are an integral part
of an entity’s cash management. In these circumstances, bank overdrafts are regarded as a
component of an entity’s cash and cash equivalents. This means that the total of cash and cash
equivalents can be negative.

Such loans are treated as part of the entity’s financing activities

Classification of cash flows by activity

Although IAS7 does not prescribe a format for statements of cash flows, it does require the cash
flows to be classified by Operating, Investing, and Financing activities

Operating activities

Operating activities are defined by IAS7 as “the principal revenue-producing activities of the
entity….”. Cash inflows and outflows arising from operating activities include:

 Cash receipts from the sale of goods and services

 Cash payments from royalties, fess, commissions and other revenue
 Cash payments to Suppliers for goods and services
 Cash payments to and on behalf of employees

95
  Cash payments or cash refunds of income taxes

Investing activities

The standard defines Investing activities as the acquisition and disposal of long-term assets and
other investments not included in cash equivalents.

Cash inflows and outflows arising from investing activities include

 Cash payments to acquire property, plant and equipment, intangibles assets and other
long term assets
 Cash receipts from the sale of property, plant and equipment, intangible assets and other
long-term assets
 Cash payments to acquire equity or debt instruments (e.g. debentures) of other entities
 Cash receipts from the sale of equity or debt instruments of other entities
 Cash advances and loans made to other parties
 Cash receipts from the repayment of advances and loans to other parties

Financing Activities

Financing activities are defined by the standard as activities that result in changes in the size and
composition of the contributed equity and borrowings of the entity. These include

 Cash proceeds from issuing shares

 Cash proceeds from issuing debentures, loans and other borrowings
 Cash payments to owners to acquire or redeem the entity’s own shares
 Cash repayments of amounts borrowed
 Cash payments by a lessee for the reduction of the outstanding liability relating to a
finance lease.
Note: Interest paid on a loan obtained for operating purposes might be classified under
operating activities while the loan is classified under financing activities. It can be argued
that it should also be a classified under financing activities

Dividends paid might be classified under operating activities so that users may determine an
entity’s ability to pay dividends out of operating cash flows. It may be argued that dividends
are a cost of obtaining finance resources and so should be classified under financing
activities

REPORTING CASH FLOWS

96
 A statement of cash flows begin by reporting cash flows arising from the entity’s operating
activities. These cash flows may be reported using either the direct method or the indirect
method.

The direct method shows major classes of receipts and payments arising from operating
activities and these are disclosed individually on the face of the cash flow statement and then
aggregated to give the total amount of cash generated from operations. A statement of cash
flows prepared using the direct method might typically disclose:

a) Cash receipts from customers

b) Cash paid to suppliers of goods and services

c) Cash paid to employees

These figures could be obtained by conducting an analysis of the entity’s cashbook for the
period. Alternatively, if the information provided in the financial statements is sufficiently
detailed, it might be possible to derive figures without conducting such an analysis.

The indirect method takes as its starting point the profit or loss for the period (before tax) and
then makes a number of adjustments to this profit or loss so as to calculate the total amount of
cash generated from operations

Each of these methods will give the same bottom line figure for the total amount of cash
generated from operations during an accounting period.

IAS7 encourages use of the direct method as this method provides more detailed information
than the indirect method. However, the indirect method is permitted by IAS7 and is used
extensively in practice. Each of the two methods gives the same bottom line figure

Revision of cash statements covered in earlier studies

A company’s statement of profit or loss for the year to 31 March 2010 is shown below. The
company’s statement of financial position as at that date (with comparative figures for 2009)
is also shown.

Statement of profit or loss for the year to 31 March 2010

K’000
97
Sales 752

Cost of sales (387)

Gross profit 365

Admin and selling costs (225)

Interest payable (18)

Dividends received 22

Profit before tax 144

Taxation (33)

Profit after tax 111

Statement of Financial Position at 31 March 2010

2010 2009

K’000 K’000

Assets

Property, Plant and Equipment 488 470

Investments 250 250

Inventories 231 212

Trade receivables 140 157

Cash at Bank 15 0

1,124 1,089

Equity

Share Capital 220 200

Share Premium 70 60
98
 Retained earnings 526 445

816 705

Liabilities

Long term loan 90 130

Trade payables 182 176

Accrued Interest payable 3 0

Taxation 33 55

Bank Overdraft 0 23

1,124 1,089

The following information is also available

a) Administrative and selling expenses include employee salaries of K 148,000 and

equipment depreciation of K70,000

b) There were no non-current asset disposals during the year to 31 March 2010.

c) A dividend of K30,000 was paid in June 2009

Required:

Prepare a statement of cash flows for the year to 31 March using the direct method. Also
demonstrate that use of the indirect method would give the same figure for cash generated from
operations as is given by the direct method

Solution

Statement of cash flows for the year to 31 March 2010

K’000 K’000

Cash flows from operating activities

Cash Receipts (157 + 752 – 140) 769

Cash paid to suppliers of goods and services (387-212+231) (407)

Cash paid to employees (148)

99
Cash generated from operations 214

Interest paid (18-3) (15)

Tax Paid (55+33-33) (55)

(70)

Net Cash Inflow from operating activities 144

Cash Generated from investing activities

Acquisition of property, Plant and Equipment (488-470+70) (88)

Dividends received 22

Net Cash out flow from investing activities (66)

Cash flows from financing activities

Proceeds from issue of shares (220+70-200-60) 30

Repayment of long-term loan borrowings (130-90) (40)

Dividend Paid (30)

Net Cash out flow from financing activities (40)

Net increase in cash and cash equivalents 38

Cash and cash equivalents at 1 April 2009 (0-23) (23)

Cash and cash equivalents at 31 March 2010 15

Indirect Method

The indirect method would also have given K 214,000 as the figure for cash generated from
operations, as follows:

K’000

Cash generated from operating activities

Profit before taxation 144

100
 Depreciation 70

Interest payable 18

Dividends received (22)

Increase in Inventories (231-212) (19)

Decrease in trade receivables (140-157) 17

Increase in Payables (182-176) 6

Cash generated from operations 214

From this point onwards, the statement of cash flows would then have continued exactly as
shown above.

CONSOLIDATED CASH FLOW STATEMEMTS

We have covered cash flow statements in our earlier studies in third year. At this level we will
concentrate on an additional aspect of cash flow statements which is the consolidated statement
of cash flows and bring in the aspect of cash received from associates, cash paid to non-
controlling interests, acquisition of subsidiaries and disposal of subsidiaries.
Dividends paid to Non-Controlling Interest
From earlier units, you will recall that a subsidiary that is not wholly owned must pay a dividend
to the non-controlling interests that are outside the group. These dividends must be disclosed
separately in the statement of cash flows since they represent dividends paid to shareholders
outside the group.
To calculate dividends paid to minority interest, it may be useful to use a T account and reconcile
the non-controlling interest in the statement of financial position from the opening and closing
balances.
Example
The following information has been extracted from the consolidated financial statements of WG
for the years ended 31 December:

101
 2007 2006
K’000 K’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 2006?
Solution

Dividends paid (bal figure) 30 Bal b/d

NCI 690
Bal c/d NCI 780 Share of profit 120
810 810

The principle used in the T-Account above is similar to that used for retained earnings. For
retained earnings, it makes sense that the retained earnings brought forward from the last
accounting period, plus profit for the current accounting period, less dividend paid out in the
current period will be equal to retained earnings figure shown in the statement of financial
position for current accounting period.
Therefore in the example above, the balance brought forward from 2006 is K690,000 and then
the NCI for the current accounting period of 2010 in the Statement of profit or loss is K120,000
and so if there was no dividend paid out to NCI, the closing balance for NCI to be shown in the
statement of financial position for 2010, would have been K810,000. But the figure shown in the
2010 statement of financial position is K780,000 and so where is the difference of K30,000 gone
to? Without any other information given, it can be assumed reasonably that NCI in the 2010
statement of financial position is not K810,000 but K 780,000 because a K30,000 dividend has
been paid out to the NCI. This dividend will fall within investing activities in the statement of
cash flows
Associates and Jointly controlled entities
The standard accounting for associates and jointly controlled entities is that all 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 instance,
dividends received from associates will be shown within Investing Activities.
Points to remember on consolidated cash flows are as follows:
102
  Non-Controlling Interest. Dividends paid to any minority interests are reported under
“cash flow from operating activities”
 Associate undertakings. The only cash flow that is relevant for the equity accounted
investment is the dividends received. Dividends received from Associates are reported
under “cash flow from investing activities”.
 Acquisition or disposal of a subsidiary during the year. Cash paid or received as
consideration should be shown net of any cash transferred as part of the purchase or sale.
The net cash flow is reported under “ cash flows from investing activities”
 Foreign Subsidiaries. The exchange differences on translating a foreign subsidiary have
to be adjusted for when preparing the consolidated statement of cash flows, as exchange
differences are not cash flows. The net assets have the exchange differences removed
from the carry forward balances.

Example
Extracts from Ryan’s consolidated financial statements for the year ended 31 December, 2009
are as follows
Group profit from operations 53,000
Share of Ezelis Associate profits 13,000
66,000
Tax 15,900
50,100
2009 2008
Investment in Ezelis 190,000 180,000
Calculate the dividend received from Ezelis
Solution
According to equity accounting, the investment shown in the statement of financial position from
the last accounting period to the current one should be increased by the share of profit for the
current period. Therefore the investment for 2009 should have been shown as 193,000

103
(180,000 + 13,000) but the total we have is 190,000 and so the 3,000 should have been received
by the group in terms of dividends.
Please note that when reconciling group net cash flow 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.
On acquisition of subsidiaries, only the net cash paid in the acquisition of a subsidiary should be
shown within investing activities. The purchase consideration might involve cash paid, share or
equity exchange and loan notes but in the statement of cash flows, only the actual cash paid will
be considered. The other items that form part of the purchase consideration will be shown in the
disclosure notes
Example
When Sintija acquired 80% of the shares of Armine, on 1 January, 2009, the agreed
consideration of K72,000 was settled by the issue of 15,000 Sintija shares, valued at K4 each,
and the balance payable in cash. On the date of acquisition, Armine had prepared a statement of
Financial Positions as follows
Tangible non-current assets 40,000
Inventory 8,000
Receivables 16,000
Cash 18,000
Payables (6,000)
76,000
Sintija consolidated financial statements for 2008 and 2009 as at 31 December, were
2009 2008
Intangible non-current Assets 10,000
Tangible non-current assets 115,000 30,000
Inventory 53,000 17,000
Receivables 59,000 20,000
Cash 23,400 12,000
260,400 79,000
Shares 65,000 50,000
Premium 48,000 3,000
104
Retained Earnings 32,400 22,000
Revaluation Reserve 60,000
Non-controlling interest 18,200 ______
223,600 75,000
Current Liabilities
Payables 28,800 3,000
Tax 8,000 1,000
260,400 79,000

Consolidated Statement of Profit or loss for the year ended 31 December, 2009

Revenue 100,000
Cost of sales 42,000
58,000
Administrative expenses 19,000
Distribution costs 7,000
Profit before tax 26,000
32,000
Tax 8,000
Profit after tax 24,000

Statement of changes in equity

Retained Revaluation Non-Controlling Share Share
Earnings Reserve Interest Capital Premium
Brought forward 22,000 50,000 3,000
105
Issued 15,000 45,000
Profit for the Year 24,000
On Acquisition 15,200
Revaluation 60,000
NCI (3,600) 3,600
Dividend (10,000) (600)
Carried forward 32,400 60,000 18,200 65,000 48,000
You are also given the following information:
i. All Sintija’s other subsidiaries are wholly owned
ii. There were no purchases nor disposals of tangible non-current assets in the year
Prepare a consolidated statement of cash flows for the Sintija Group for the year ended 31
December, 2009.

Solution
K K
Operating Activities
Profit before tax 32,000
Add:
Depreciation (40,000 + 30,000 + 60,000- 115,000) 15,000
Goodwill Impairment (11,200 – 10,000) 1,200 16,200
48,200

Changes in working capital

Increase in Inventories (53,000-17,000-8,000) (28,000)
Increase in receivables (59,000-20,000-16,000) (23,000)
Increase in Payables (28,800-3,000-6,000) 19,800 (31,200)
17,000
106
Tax paid (1,000+8000-8,000) (1,000)
Dividends paid
-Sontija (10,000)
-NCI (600) (11,600)
Net cash flow from operating activities 5,400
Investing Activities
Acquisition of Subsidiary (12,000-18,000) 6,000
Net Cash flow from investing activities 6,000
Financing Activities -
Net cash flow for the year 11,400
Cash and cash equivalents brought forward 12,000
Cash and cash equivalents carried forward 23,400

Workings
W1-Group Structure W2- Goodwill
S Cost of Acquisition 72,000
80% Share of net assets on DOA:
As per question=76,000 x 80% (60,800)
11,200
A 20% NCI Impairment (1,200)
Goodwill to SFP 10,000

Disposal transactions
The statement of cash flows will show the cash received from the sale of the subsidiary. The
same principles will apply here as with acquisitions. Part of the changes in the statement of
financial position figures are accounted for by the disposal of the subsidiary’s assets and
liabilities.

107
Example
Austis sold his entire shareholding of Lokys on 28 February, 2009 for K800,000. He had held the
shares for 10 years, since the incorporation of Lokys.

At the date of disposal, the Lokys statement of Financial Position was:

Tangible on-current assets 500,000

Inventory 150,000
Receivables 100,000
Cash 50,000
Payables (75,000)
Tax (15,000)
Net Assets 710,000

The consolidated financial statements of the Austis Group as at 30 June, 2009 and 2008 were:
2009 2008
K’000 K’000 K’000 K’000
Tangible non-current assets 1,300 900
Inventory 750 800
Receivables 600 510
Cash 150 100
1,500 1,410

2,800 2,310
Equity Shares K1 each 1,000
817
Share Premium 100
Retained earnings 900 800
108
Non-controlling interest 400 583
2,400 2,200
Current Liabilities
Payables 300 60
Tax 100 50
2,800 2,310
Consolidated Statement of Profit or loss for the year ended 30 June, 2009
Operating Profit 47,000
Profit on disposal of subsidiaries 303,000
Profit before tax 350,000
Tax 120,000
230,000

Consolidated statement of changes in equity

Retained Non-Controlling Share Share Total

Earnings Interest Capital Premium
B/F 800,000 583,000 817,000 - 2,200,000
Share Issue 183,000 100,000 283,000
Profit for the year 230,000 230,000
NCI (30,000) 30,000 -
Disposals (213,000) (213,000)
Dividend (100,000) (100,000)
900,000 400,000 1,000,000 100,000 2,400,000

109
You are also told that depreciation charge for the year was K200,000 and, other than the disposal
of Lokys, there were no other asset disposals.

Prepare the consolidated statement of cash flows for the Austis Group for the year ended
30 June 2009 using the indirect method.

Solution
K K
Operating Activities
Profit before tax 350,000
Add: Depreciation 200,000
Less: Profit on disposal of subsidiary (800-710+213) (303,000) (103,000)
247,000
Changes in working capital
Increase in Inventories (750-(800-150)) (100,000)
Increase in receivables (600-(510-100)) (190,000)
Increase in payables (300-(50-65)) 315,000 25,000
272,000
Dividends Paid (100,000)
Tax Paid (100-(50-15)-120) (55,000) (155,000)
Net Cash flow from operating activities 117,000
Investing Activities
Purchase of Tangible Non-Current Assets (1,300-900-500-200) (1,100,000)
Net Proceeds on disposal of subsidiary (800-50) 750,000
Net cash out flow from investing activities (350,000)
Financing Activities
Proceeds from share issue

110
 Shares 183,000
Premium 100,000
Net cash flow from Investing activities 283,000
Net cash flow for the year 50,000
Cash and cash equivalents brought forward 100,000
Cash and cash equivalents carried forward 150,000

Exchange Differences
Exchange differences arising at the individual entity stage are in most instances reported as part
of the operating profit.

ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS-IAS 21

Businesses are becoming increasingly international. It is not unusual for firms to import or
export goods and services to firms in other countries. These transactions may involve the
purchase of, for example, raw materials from a foreign supplier. In order to pay for such
materials, the purchaser will have to acquire some foreign currency. A similar situation would
arise if a company sold to overseas buyer and received payment in a foreign currency.

111
IAS 21 The effects of changes in Foreign Exchange Rates was issued by the International
Accounting Standards Committee in December 1993 and replaced IAS 21 Accounting for the
effects of change in Foreign Exchange Rates which was issued in 1983

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

Why Foreign currency transactions

Entities may carry out foreign activities in two ways

 An entity may have transactions that are denominated in a foreign currency

 An entity may have a foreign operation

Definitions

IAS 21 defines a foreign currency transaction as a transaction that is denominated or requires

settlement in a foreign currency.

Functional Currency- is the currency of the primary economic environment in which the entity
operates. In general terms, the primary economic environment in which an entity operates is
normally the one in which it mainly generates and spends cash. Although the functional currency
is not necessarily the “local” currency of the country in which the entity operates, in most cases it
will be. When a reporting entity prepares financial statements, the standard requires that each
individual entity included in the reporting entity must determine its functional currency and
measure its results and financial position in that currency. The following should be considered
when determining an entity’s functional currency

 The currency that mainly influences sales prices for goods and services (Which is
often the currency in which these prices are denominated and settled)

 The currency of the country whose competitive forces and regulations mainly
determine the sales price of goods and services

 The currency that mainly influences labour, material and other costs of providing
goods and services (Which is often the currency in which such costs are
denominated)
112
  The currency in which funds from financing activities are generated (e.g. The
currency in which funding from issuing debt and equity is generated)

 The currency in which receipts from operating activities are retained

 Please note that if the evidence provided by all of these various factors is mixed,
then the management of the entity should use its judgment to determine the
entity’s functional currency

The entity maintains its day-to-day financial records in its functional currency. Once decided on,
the functional currency does not change unless there is a change in the underlying nature of the
transactions and relevant conditions and events. Therefore it can be said a foreign currency is a
currency other than the functional currency of the entity but of course IAS 21 defines a
foreign currency transaction as a transaction that is denominated or requires settlement in
a foreign currency.

Presentation Currency is the currency in which the entity presents its financial statements. The
standard permits an entity to present its financial statements in any currency (or currencies). This
can be different from the functional currency, particularly if the entity in question is a foreign-
owned subsidiary. An entity is required to translate its results and financial position from its
functional currency into a presentation currency using the method required for translating a
foreign operation for inclusion in the reporting entity’s financial statements.

Conversion is the exchange of one currency for another, while translation is the expression of
another currency in terms of the currency if the reporting entity.

If the presentation currency is different from the functional currency, then the financial
statements must be translated into the presentation currency.

For individual entities transaction denominated in a currency other than the functional
currency, that transaction must be translated into the functional currency before it is recorded.
The rate used to translate must be the exchange rate ruling on the date of the transactions (Spot
Rate).

ACCOUNTING TREATMENT

Individual Transactions

On initial recognition, a foreign currency transaction should be recorded in the entity’s functional
currency by applying the spot exchange rate between the functional currency and the foreign
currency as at the date of the transaction. The entity can also use the average rate over a period of
time, providing the exchange rate has not fluctuated significantly.

113
Most exchange rates are not fixed but vary from day to day. This fluctuation can pose problems
for a company dealing with overseas suppliers or customers. Exchange differences (gains and
losses) arise when there is a delay between entering into a transaction and receiving payment
because during this period of “delay” the exchange rate moves.

Monetary and non-monetary items

The distinction between monetary and non-monetary items is important, since the rate used in
the translation of these items differs.

Monetary items are defined as units of currency held and assets and liabilities to be received or
paid in a fixed or determinable number of units of currency (Cash, receivables, payables, loans).

Non-Monetary items are other items in the statement of financial position (Non-current Assets,
Inventory and Investments)

During the financial year:

 Each transaction should be translated at the exchange rate on the date of the
transaction

 An average rate may be used as an approximation, where rates do not vary

significantly

 If the transaction is entered into at a contracted rate, then that is the rate to use

At the year end

 Monetary assets and liabilities should be restated at the closing rate (unless at
contracted rate in which case, leave at contracted rate)..

 Non-monetary assets carried at historic cost are left at historic rate (at the
exchange rate at the day of the transaction which gave rise to the item)

 Non- monetary assets carried at fair value should be translated at the rate when
fair value was established

 If the carrying amount of an asset is determined by comparing two or more

amounts-for example, lower of cost or net realizable value in the case of
inventory, then

114
  Cost (or carrying amount) will be translated at the spot rate

 Net realizable value will be translated at the closing rate

 Sales and purchases of goods will be translated at the rate ruling when the
sale or purchases was made

Translation of monetary items often brings about exchange differences. This may also arise on
the settlement of monetary items. Exchange differences are part of the profits (or loss) for the
year. So if there are monetary assets and liabilities in existence at the end of the reporting period,
then these should be re-translated at the rate of exchange ruling at that date. This is referred to as
the “closing rate”. By using the closing rate, this means that those monetary items are shown in
the statement of financial position at an up-to-date (As though they were recoverable or payable
at the end of the reporting period). If there are any exchange gains or losses arising on
transactions and outstanding monetary items, then these gains or losses should be recognised in
profit or loss for the year.

Non-monetary items should be recorded at the rate ruling at the date of the transaction. These
items are not re-translated at any time in the future unless there is a fair value adjustment.

There is no guidance given as to exactly where, within the statement of profit or loss, the
exchange differences should be accounted for but generally accepted practice is

 If it’s from trading transactions, include within operating

 If it’s from financing transactions, include within financing

 But if a gain or loss is on a non-monetary item, then it has to be recognized in other profit
or loss (e.g. on revaluation)

 But if a gain or loss on a non-monetary item is recognized in the calculation of the

entity’s profit or loss (e.g. on disposal) then any exchange component of that gain or loss
is also recognized in the calculation of the profit or loss.

Example 1

(a) The following transactions were undertaken by Jeyes plc in the accounting year ended
31st December 2001

115
 Date Narrative Amount

KR

1st Jan 2001 Purchase of NCA on credit 100,000

31st March 2001 Payment for the NCA 100,000

31st March 2001 Purchases on credit 50,000

30th June 2001 Sales on credit 95,000

30th September 2001 Payment for purchases 50,000

30th November 2001 Long term loan taken out 200,000

Exchange rates KR: K

1 January 2001 2.0 : 1

31st March 2001 2.3 : 1

30th June 2001 2.1 : 1

30th September 2001 2.0 : 1

30th November 2001 1.8 : 1

31st December 2001 1.9 : 1

Prepare Journal entries to record the above transactions

Solution

1st Jan 2001 Dr NCA K 50,000

Cr Payable K 50,000

31 st March Dr Payable K 50,000

116
 Cr Cash K 43,478

Cr Statement of profit or loss 6,522

31st March Credit Purchase

Dr Purchase 21,739

Cr Payables 21,739

30th June Credit Sales

Dr Receivables 45,238

Cr Sales Revenue 45,238

30th September- Payment for Purchases

Dr Payables 21,739

Dr Income State 3,261

Cr Cash 25,000

30th Nov- Loan

Dr Cash/Bank 111,111

Cr Loan 111,111

30th Dec –Closing date (Sales on Credit)

Dr Receivables 4,762

Cr Income State 4,762

Loan Dr Loan 5,848

Cr Income State 5,848

117
Example 2

A company acquired non-depreciable land in Sweden for SKr 70m cash on 1 January 2010. On
31 December 2013 the land was estimated to have a value of SKr 90m and the directors have
decided to incorporate this value into the financial statements as at that date.

Exchange rates are: SKr: K1

1 January 2010 14

31 December 2013 15

Prepare the relevant journal entries to account for the land in 2010 and 2013

Solution

2010

The purchase of the land (a non-monetary item) will be translated at the exchange rate ruling on
the date of the transaction ( SKr 70m/14= K5m)

Dr Land K5m

Cr Bank K5m

2013

The land is to be carried at its revalued amount. The exchange rate to be used is that prevailing at
the date fair value was determined i.e SKr 90m/15=K6m

Therefore the journal entry to reflect the revaluation gain would be

Dr Land K1m

Cr Rev Reserve K1m

118
CONSOLIDATION OF FOREIGN OPERATIONS
If an entity has a foreign operation (e.g. a foreign subsidiary, associate or joint venture), it will be
necessary to translate the financial statements of that operation into the same currency as is used
by the entity’s own financial statements. Only then will it be possible for the results of the
foreign operation to be consolidated with those of the parent. The translated amounts, now in the
functional currency, should now be translated into the reporting (or presentational) currency.

Any goodwill and fair value adjustments are treated as assets and liabilities of the foreign entity,
and therefore retranslated at each balance sheet date at the closing spot rate.

Exchange differences on intra-group items are recognized in profit or loss, unless they are a
result of the retranslation of an entity’s net investment in a foreign operation when it is classified
as equity.

Dividends paid in a foreign currency by a subsidiary to its parent firm may lead to exchange
differences in the parent’s financial statements. These should not be eliminated on consolidation
but should be recognized in profit or loss for the period. When a foreign operation is disposed of,
the cumulative amount of the exchange difference in equity relating to that foreign operation is
recognized in profit or loss when the gain or loss on disposal is recognized.

IAS 21 RULES FOR CONVERSION

Before consolidating, the financial statements of the foreign subsidiary have to be translated into
the presentation currency of the parent company.

In the Statement of Financial Position

 Translate everything at the closing rate

 The assets and liabilities shown in the foreign operation’s statement of financial
position are translated at the closing rate at the year end, regardless of the date
on which those items originated.

Statement of Profit or loss

 Everything at the actual rate ( or average as an approximation)

 Except dividends- at actual rate

119
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.

The cost of investment and NCI should be calculated using the closing exchange rate

Exchange differences on Net Investment in a foreign operation.

Net Investment in a foreign operation is defined by IAS 21 as the amount of the reporting
entity’s interest in the net assets of that operation. This contains three elements namely

 Opening net assets of subsidiary

 Profit for the year of subsidiary

 Goodwill-Whether calculated on a fair value or proportionate basis.

The calculations are as explained below.

1. IAS 21 states that goodwill should be restated at the end of each using the closing
exchange rate. This annual restatement will result in an exchange difference
which should 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 there require goodwill to be calculated in two
stage process so as to determine the respective group and NCI share of
goodwill. Please see example of Saints Plc below

2. 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.

3. The profit for year for the subsidiary should be restated at each year using the
closing rate from the average rate. This annual restated will result in an exchange
difference

4. The total exchange difference will form part of the total exchange difference
disclosed as other profit or loss and accumulated in other components of equity.

120
Example

On 1 July 2001, Saint acquired 60% of Albans Inc, whose functional currency is D’s. The
financial statements of both companies as at 30 June 2002 are as follows

Saint Albans

K D

Investment in Albans 5,000

Loan to Alban 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

Share Capital (K1/D1) 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

Revenue 50,000 60,000

Cost of sales (20,000) (30,000)

Gross Profit 30,000 30,000

Distribution Expenses (20,000) (12,000)

10,000 18,000

Tax (8,000) (6,000)

Income for the year 2,000 12,000

121
The following information is applicable

I. Saint purchased the shares in Albans for D10, 000 on the first day of the accounting
period. At the date of acquisition the retained earnings of Albans were D500 and there
was an upward fair value adjustment of D1, 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 Albans and has not been revalued. No shares have been issued since the date of
acquisition.

II. Just before the year-end Saint acquired some goods from a third party at a cost of K800,
which it sold to Albans for cash at a markup of 50%. At the reporting date all the goods
remain unsold

III. On 1 June 2002, Saint lent Albans K1,400. The liability is recorded at the historic rate
within the non-current liabilities of Albans

IV. No dividends have been paid. Neither company has recognized any gain or loss in
reserves

V. Goodwill is to be accounted for on a fair value basis. No goodwill has been impaired. The
fair value of the NCI at the date of acquisition was D5, 000. The presentational currency
of the group is to be the dollar

Exchange rates to K1

1 July 2001 2.00

Average rate 3.00

1 June 2002 3.90

30 June 2002 4.00

a) Prepare the group statement of Financial Position at 30 June 2002

b) Prepare the group Statement of profit or loss for the year ended 30 June 2002

c) Prepare the group statement of other profit or loss for the period showing the group
exchange difference arising in the year

122
Solution

W1-Group Structure

Saint

60%

Albans 40% NCI

W2- Net Assets of Albans

Acquisition Reporting

D D

Share Capital 1,000 1,000

Share Premium 500 500

Retained earnings 500 12,500

Fair value adjustment 1,000 1,000

Additional Depn-Fair value adj (200)

Exchange loss on Loan (w6) (140)

3,000 14,660 Post Acq Profits = 11,660

Note: The intra-group transaction does not appear in working 2 (net assets) because the selling
company is the Parent (Saint) and not the subsidiary (Albans) and so it will be taken care in w5
(Group retained earnings)

W3- Goodwill (full goodwill method)

Goodwill has to be calculated in the functional currency and in this case, D and so any amount
that is in dollar has to be converted D

123
 Group NCI

D D

Cost of Investment 10,000 5,000

Share of NA@DOA (1,800) (1,200)

Goodwill 8,200 3,800

Total Goodwill to CSOFP D12, 000 translated at the closing rate of D4 to a K = K3,000

W4- Non-Controlling Interest

Fair value of NCI on acquisition date 5,000

Share of post acq profits (40% of 11,660) 4,664

9,664

Translated using the closing rate of D4 to a K= K2,416

W5- Group Reserves

Saint’s retained earnings 4,000

Exchange loss to parent on cost of investment (w7) (2,500)

URPS on Inventory (800 x 50%) (400)

Group share of post acq profit (60% of 11,660) /4 1,749

Total to CSOFP 2,849

124
W6- Exchange loss on loan

A loan is a monetary item and so it has to be recorded at the closing rate and this will give rise to
exchange differences that have to be accounted for in the net assets of Albans and in the
Statement of profit or loss of Albans

Albans got the loan on 1 June 2002 when the rate was 3.9 D to a dollar and so this loan of
K1,400 was entered into Albans records at D5,460 (3.9 x 1,400) but it has to translated using the
closing rate on the date of the statement of financial position which is 30 June 2002 @ D4 to a
dollar. This will give us D5,600, and thereby giving us an exchange difference of D140. This is
an exchange loss because on the date of the loan, Albans only owed Saint D5,460 but because of
retranslating the loan using the closing rate, Albans now owes Saint D5,600 which is more by
D140. Therefore this D140 increase the loan amount (non-current liability) from D5,460 to D
5,600

W7- Exchange gain or loss to the parent on the annual retranslation of the cost of investment

The investment in the Subsidiary is a monetary asset of the Parent and therefore it must be
retranslated on an annual basis and this retranslation brings about exchange gains or losses. The
comparison is between the current period (closing rate) and the closing rate of the previous
accounting period. In the case of Albans, since it was acquired on the first day of the accounting
period, then we will use the rate on the acquisition date.

Cost of Acquisition to parent at closing rate (D10,000 @ 4) K2,500

Cost of Acquisition to parent at acq rate (D10,000 @ 2) (K5,000)

Exchange loss to parent (K2,500)

Note: Since this is a loss to the parent, it will be deducted in the group reserves working (w5)

125
W8- Exchange difference on net investment in foreign subsidiary

K K Group NCI

Goodwill*

At Closing rate 12,000@ 4 3,000

At Acqui rate 12,000@ 2 (6,000) (3,000) (2,050) (950)

On opening net assets

At closing rate 3,000@4 750

At opening date 3,000@2 (1,500) (750) (450) (300)

On Subsidiary’s profit for the year**

At closing rate 11,660@4 2,915

At average rate 11,660@2 (3,887) (972) (583) (389)

(4,722) (3,083) (1,639)

Note

Goodwill*- Notice that the sharing of the exchange gain or loss on goodwill is not according to
the 60%:40% proportions. If this was the case, the Group’s share would have been K1,800 and
NCI would have had K1,200. The exchange gain or loss has been shared in proportion to the
respective share of total goodwill. From working 2, the Group contributes 68.3% to goodwill
(8,200/12,000) and NCI contributes 31.7% (3,800/12,000). Therefore these are the same
percentages that will be used to split the exchange gain or loss arising on the retranslation of
goodwill. Also note that this is only done when goodwill is valued using the fair value method. If
it was valued using the proportional method, the whole gain or loss would have been attributed
to the group only and none would be attributed to NCI

Profit for the year**- When computing the exchange gain or loss on the subsidiary profit for
the year, note that the rate used to compare with the closing rate is the average rate and not the
opening rate. This is because, the figure for profit for the period is coming from the Statement of
profit or loss and all figures in the Statement of profit or loss used to calculate profit or loss for
the period are translated using the average rate.

126
The Saint Group Consolidated Statement of Financial Position as at 30 June 2002

Goodwill 3,000

Tangible assets 10,000 + (15,400 + 1,000 – 200)/4 14,050

Inventory (5,000 – 400) + (4,000/4) 5,600

Receivables 4,000 + (500/4) 4,125

Cash at Bank 1,600 + (560/4) 1,740

28,515

Share Capital 10,000

Share Premium 3,000

Reserves (w5) 2,849

Non-Controlling interest 2,416

18,265

Non-current Liabilities 5,000 + (5,460+ 140)/4) – 1,400 5,000

Current Liabilities 5,000 + (1,000/4) 5,250

28,515

Saint Group statement of Profit or loss for the year ended 30 June 2002

Revenue 50,000 + (60,000/3) – 1,200 68,800

Cost of sales 20,000 + (30,000/3) – 1,200 + 400 + (200/3) + (140/3) (29,314)

Gross Profit 39,486

Admin expenses 20,000+ (12,000/3) (24,000)

Profit before tax 15,486

Tax 8,000 + (6,000/3) (10,000)

127
Prof for the year 5,486

Statement of other profit or loss

Profit for the year 5,486

Total Exchange differences (w8) (4,722)

Total Profit or loss for the year 764

Profit for the year

Attributable to:

Group (bal figure) 3,931

NCI (11,660/3 X 40%) 1,555

5,486

Total Profit or loss

Attributable to:

Group (bal figure) 848

NCI (1,555 – 1,639) (84)

764

Please note that the working for exchange differences on net investment in foreign subsidiary
(w8) is very useful and easy to calculate if the subsidiary was acquired at the beginning of the
accounting period like in the example of Saint and Albans. This is because all the post-
acquisition profits relate to the current accounting period. If the Subsidiary was acquired more
than one accounting periods ago, the simplest way to consolidate is to make a revision to
working 5 (group reserves) and then skip working 8(exchange differences on net investment in
subsidiary).

128
Working 5 can do as follows

Group Reserves

Parent retained earnings 4,000

Group Share of post-acq profit 60 %( 11,660/3)* 2,332

URPS on Inventory (800 x 50%) (400)

5,932

Notice that if you take 5,932 calculated above and subtract the group exchange difference in w8
of (3,083), you will arrive at 2,849 which is the figure we worked out in working5 Group
reserves. Therefore if you use this formula of calculating the group reserves, then you do not
need to include the exchange difference (from w8). In the exam or test, be careful to read and
understand what you are required to do. You may be used to show the working for exchange
differences and factor the amount in the statement of financial position. In this case, you then
need to proceed as we did

Example

Little was incorporated over 20 years ago, operating as an independent entity for 15 years until 1
April 2004 when it was taken over by Large. Large’s directors decided that the local expertise of
Little’s management should be utilized 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 “arm’s 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 2004 are given below. The
statement of financial of Little is prepared in francos (F), its reporting currency.

Large Little

K’000 K’000 F’000 F’000

Non-current assets:

Property, plant and equipment 63,000 80,000

Investments 12,000 75,000 ______ 80,000

129
Current assets:

Inventories 25,000 30,000

Trade receivables 20,000 28,000

Cash 6,000 51,000 5,000 63,000

Total Assets 126,000 143,000

Equity:

Share Capital (50 cents/1 Franco) 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 26,000 10,000 35,000

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 Statement of Financial Positions

1. On 1 April 2004 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 policy to
account for goodwill on a proportionate basis. At 1 April 2003 goodwill had been fully
written off as a result of impairment losses.

2. Little sells goods to Large, charging a mark-up of one-third on production cost. At 31

March 2004, Large held K1 million (at cost to Large) of goods purchased from Little in

130
 its inventories. The goods were purchased during March 2004 and were recorded by
Large using an exchange rate of K1 = 5 francos. (There were minimal fluctuations
between the two currencies during March 2004). At 31 March 2004, Large’s inventories
included no goods purchased from Little. On 29 March 2004, Large sent Little a cheque
for K1 million to clear the intra-group payable. Little received and recorded this cash on
3 April 2004.

3. The accounting policies of the two companies are the same, except that the directors of
Little have decided to adopt a policy of revaluation of property, whereas Large includes
all property in its statement of financial position at depreciated historical cost. Until 1
April 2003, Little operated from a rented warehouse premises. On that date, the entity
purchased a leasehold building for 25 million francos, taking out a long-term loan to
finance the purchase. The building’s estimated useful life at 1 April 2003 was 25 years,
with an estimated residual value of nil, and the directors decided to adopt a policy of
straight line depreciation. The building was professionally revalued at 30 million francos
on 31 March 2004, and the directors have included the revalued amount in the statement
of financial position. No other property was owned by Little during the year

4. The exchange rates were as follows

Date Exchange rate (francos to K1)

1 April 2000 6.0

31 March 2003 5.5

31 March 2004 5.0

Weighted average for the year to 31 March 2004 5.2

Weighted average for the dates of acquisition of closing Inventory 5.1

Required

a) Explain (with reference to relevant accounting standards to support your argument) how
the financial statements (statement of financial position, Statement of profit or loss, and
statement of profit or loss) of Little should be translated into Ks for the consolidation of
Large and Little.

b) Translate the statement of financial position of Little at 31 March 2004 into Ks and
prepare the consolidated statement of financial position of the Large group at 31 March
2004.

131
 Note: Large Group uses the proportional of net assets method to value the non-controlling
interest.

Practice question

The following draft statements of financial position relate to Billience, Boyd and Charles, all
public limited companies, as at 31 May 2011:

Billience Boyd Charles

K’000 K’000 Z’000

Assets

Non-Current Assets:

Property, Plant and Equipment 1,300 625 2,540

Investment in Boyd 490

Investment in Charles 150

Current Assets 110 85 600

Total Assets 2,050 710 3,140

Ordinary Shares 300 200 1,045

Other Reserves 150 50

Retained Earnings 600 400 1,495

Total Equity 1,050 650 2,540

Non-Current Liabilities 450 25 240

Current Liabilities 550 35 360

2,050 710 3,140

The following information needs to be taken account of in the preparation of the group financial
statements of Billience.

132
1. Billience acquired 70% of the ordinary shares of Boyd on 1 June 2009 when Boyd’s
other reserves were K50,000 and retained earnings were K 300,000. The fair value of the
net assets of Boyd was K600,000 at the date of acquisition. Billience acquired 60% of the
ordinary shares of Charles for 1,650,000 Zians ON 1 June 2009 when Charles’ retained
earnings were 1,100,000 Zians. The fair value of the net assets of Charles on 1 June 2009
was 2,475,000 Zians. The excess of the fair value over the nets assets of Boyd and
Charles is due to an increase in the value of non-depreciable land. There have been no
issues of ordinary shares since acquisition and goodwill on acquisition is not impaired for
either Boyd or Charles

2. Charles is located in a foreign country called Zianonos somewhere in the very centre of
the Indian Ocean. Charles Imports its raw materials at a price which is normally
denominated in dollars but sells its products in Zianonos at selling prices denominated in
Zians and the selling prices are usually determined by local competition. Charles incurs
and settles all selling and operating expenses in Zians but the distribution of profits is
determined by Billience, after all, they are the parent company. Charles’s management
have a considerable degree of authority and autonomy in carrying out the operations of
Charles and other than the loan from Boyd, are not dependent upon group companies for
finance.

3. Billience has a building which it purchased on 1 June 2010 for 200,000 Zians and which
is located overseas. The building is carried at cost and has been depreciated on the
straight line basis over its useful life of 20 years. At 31 May 2011, as a result of an
impairment review, the recoverable amount of the building was estimated to be 180,000
Zians.

4. At 31 May 2011, the Inventories of Billience includes K 20,000 of goods purchased from
Boyd at cost plus 25%.

5. On 1st December 2010, Boyd transferred an item of plant to Billience for £ 150,000. Its
carrying amount at that date was K 100,000. The asset had a remaining useful economic
life of 5 years

6. Included in Billience’s receivables is K 20,000 relating to inventory sold to Boyd during

the year. Boyd raised a cheque for K 12,500 and sent it to Billience on 28 th May 2011.
Billience did not receive this cheque until 4th June 2011.

7. The following exchange rates are relevant to the preparation of the group financial
statements

Zian to K
133
 1 June 2009 11

1 June 2010 10

31 May 2011 12

Average for the year to 31 May 2011 10.5

Required:

a) Discuss and apply the principles set out in IAS 21 “The effects of changes in foreign
exchange rates” in order to determine the functional currency of Charles ( 5 Marks)

b) Prepare a consolidated statement of financial position of the Billience Group at 31 May

2011 in accordance with the International Financial Reporting Standards

(30 Marks)

c) Explain how you would treat any foreign currency transactions (Monetary items and
Non-Monetary items) remaining in the statement of financial position at the year end

(5 Marks)

134
 UNIT 20: SUBSTANCE OVER FORM
IAS1 requires that financial statements:

 Must represent fairly the transactions that have been carried out
 Must reflect the economic substance of events and transactions and not merely their legal
form
Examples of transaction that are accounted for in a manner that brings out the economic
substance are Finance leases and consolidated financial statements.

It is generally accepted in accounting that where the legal nature of a transaction is different from
its commercial or economic substance, the transaction must be accounted for according to its
commercial substance.

The commercial substance portrays how the transacting parties will behave in practice as
opposed to what is contained in the legal agreement.

It’s key to note that in most cases, the legal form will be the same as commercial substance.

The subject of substance over form is addressed within the IASC’s framework and not by any
accounting standard.

To determine the commercial substance of a transaction, the first step is to determine whether
assets or liabilities of an entity arise from a transactions or whether assets and liabilities no
longer exist.

This means that we have to consider the sufficiency of the evidence showing that the entity has
access to benefits associated with the asset, or evidence showing that the entity is exposed to
unavoidable outflow of economic benefits. If there is evidence that the entity has access to the
economic benefits, then the item should be treated as an asset. If the entity is exposed to an
unavoidable outflow of economic benefits, then a liability should be recognized.

According to the framework, an asset is defined as a resource controlled by an enterprise as a

result of past events and from which future economic benefits are expected to flow to the
enterprises

A liability is defined as a present obligation of the enterprise arising from past events, the
settlement of which is expected to result in an outflow from the enterprise of resources
embodying economic benefits

The condition which would prevent recognition is if the item cannot be measured with reliable
certainty.
135
The framework identifies three types of transaction where legal form may differ from
commercial substance

1. Consignment Inventory
2. Factoring receivables
3. Sale and Repurchase Agreements

Consignment Inventory
This is a situation whereby for instance, a manufacturer supplies goods to a retailer a on sale or
return basis. In other words, the consignor delivers goods to the consignee with the intention that
over time, the consignee will sell the goods or to return the goods back to the manufacturer
(consignor) after a period of time. In determining the economic substance of this kind of
transaction, one has to consider whether the risks and benefits have been transferred to the
consignee or not.

Risks may include

a) Loss of Inventory ( who bears the risk)

b) Unfavorable changes in market prices
Benefits may include

a) Favorable changes in market prices

b) Freedom to deal with the inventory
It’s also important to consider past experience. If in the past, the consignee has never returned
the inventory, the sale and purchase must be recognized at the time of delivery

Conclusion: whoever bears the risk of the inventory should recognize it in their statement of
financial position.

If risk is born by manufacturer, as a retailer, you should only recognize the income which is
recorded as commission receivable.

Example 1

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

Describe how Carmart should account for the above transactions

136
Solution

The dealer faxes the risk of slow movement as it is obliged to purchase the car and has no right
of return. The dealer insures and maintains the cars and faces the risk of theft. The dealer can
also sell the cars to the public. Therefore the cars should be recognized on the dealer’s statement
of financial position at delivery

Sale and Leaseback

This is a kind of a situation where an entity sells an asset and simultaneously enters into an
agreement to buy back the same asset at a later date. The legal form is that a sale has taken
place but when it comes to determining the economic substance of the transaction, we have to
consider whether substantially all risks and benefits have been transferred.

Usually sales and leaseback transactions are usually entered into when with a view of
overcoming cash flow difficulties. A good example is in the whisky distillery business.

Where the seller must buy back the assets at a fixed price and the buyer does not receive benefits
from the asset during the ownership period, it is likely that all benefits and risks relating to the
asset have been retained by the sellers. In this case, the seller must not derecognize the asset but
instead treat disposal proceeds as loan repayable with interest by way of the buyback price

Example

X sold a building to Z an investment company, for K1 million when the current market value
was K2 million. X can repurchase the property at any time within the next three years for the
original selling price of K1 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 recognized; the K1 million is a loan received from Z.

Factoring Receivables
Factoring of receivables is where a company transfers its receivables balances to another
organization (a factor) for management and collection and receives an advance on the value of

137
those receivables in return. The amount received from the factor is usually less than the amount
of the receivables on the due date and the difference is the factors profit.

The legal form is that the assignor has transferred ownership of the receivables but the
commercial substance will depend on whether substantially all risks and benefits have been
transferred to the assignee.

The question can be asked- 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?

Another factor to consider is who bears the risk of the slow payment and irrecoverable debts

If the transfer is with recourse to the assignor and the assignor is entitled to further sums
depending on payment by the party owing, not all risks and benefits have been transferred. In
this case, the benefits of recovering further and the bad debts risks are still in the hands of the
assignor. Therefore, the receivables must not be derecognized and the transaction can be taken as
a financing arrangement (a loan payable on the due date of the receivables) Excess to be treated
as finance cost.

Example

An entity has an outstanding receivable balance with a major customer amounting to K12 million
and this was factored to FinanceCo on 1 September 2007. The terms of the factoring were:

Financeo will pay 80% of the gross receivables 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

 FinanceCo will charge 1% per month of the net amount owing from the entity at the
beginning of each month. FinaneCo had not collected any of the factored receivable
amount by the year-end

 The entity debited the cash from FinanceCo 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 2007?

138
Solution

As the entity 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 derecognized 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 summarized as follows:

Dr Cr

K’000 K’000

Receivables 12,000

Loan from factor 9,600

Administration (12,000-9,600) 2,400

Finance cost: accrued interest (9.6m x 1%) 96

Accruals 96

12,096 12,096

Practice question

It is generally accepted in accounting that where the legal nature of a transaction is different from
its commercial substance, the transaction must be accounted for according to its commercial
substance.

a) Discuss the principle of substance over form and how it relates to the fair
presentation of financial information ( 2 Marks)

b) Theo Plc sold inventory to Mayaba on 1 January 2011 for K 240 million when the
fair value was K 280 million. The inventory had cost Theo Plc K 200 million
during the year ended 31 January 2010. The agreement with Mayaba Plc states
that Theo Plc must buy back the inventory from Mayaba Plc on 31 December
2013 at a price of K 360 million. During the period of its ownership of the
inventory, Mayaba Plc is not allowed to use it or sell it to any other person.
During the period of Mayaba’s ownership, the inventory’s insurance premiums
are reimbursable by Theo Plc to Mayaba Plc

Required:

139
 Explain how Theo Plc must account for the transactions in its Financial
statements for the to 31 December 2011 ( 6 Marks)

c) On 1 January 2011 Theo Plc, sold their block of offices located at 2 Jambo way.
This sell was motivated by the fact that Theo wanted to invest more funds in the
business so as expand. They block of offices had a cost of K 50 billion. Theo sold
the offices to Standard Chartered Bank Plc for at the cost price to Theo. Under the
agreement, Theo has the option to repurchase the offices on 31 December, five
years later at K 60 billion. Meanwhile, Theo will continue to use the property as
normal throughout the period and will be responsible for the maintenance and
insurance during the period. The office block was valued at transfer on 1 January
2011 at K 90 billion and expected to rise in value throughout the five year period.

Required:

Explain and show how Theo should record the above transaction during the
first year following the transfer of the property to Standard Chartered Bank
Plc (6 Marks)

d) On 1 December 2011, Theo Plc discovered that it had a huge balance of

outstanding receivables balance with a Mayaba Plc amounting to K 60 billion.
Theo then entered into agreement with COBUSU Financial Services, a company
run by former CBU BAcc graduates who put their funds together to start up a
Financial Services Company. Theo factored these receivables to COBUSU Fin
Services on 1 December 2011. The terms of the agreement were that COBUSU
pays 90% of the gross receivables outstanding to Theo Plc immediately. A
Finance charge of 5% per month will be charged by COBUSU Fin Services of the
net amount owing at the beginning of each month. COBUSU had not collected
any of the factored receivable amounts by the year end. Theo will have to pay the
balance, less of the finance charges when the debt is collected in full and any
amount of debt outstanding after four months will be transferred back to Theo at
its full book value.

Required:

Explain and show how this transaction should be treated by Theo in their
books at 31 December 2011 (6 Marks)

140
 UNIT 21: INTRODUCTION TO FINANCIAL INSTRUMENTS
Financial Instruments are one area in accounting that has attracted a lot of interest and attention
in the past few years. There are three international Accounting Standards which deal with
Financial Instruments and these are

IAS32 Financial Instruments: Presentation

IAS39 Financial Instruments: Recognition and Measurement

IFRS7 Financial Instruments: Disclosures

Broadly speaking, a financial instrument can be defined as a means of raising finance and simple
examples include loans of various types and share issues. In practice, financial instruments cover
a wide range of highly complex arrangements

The three standards define the term “financial Instrument” as any contract that gives rise to a
financial asset of one entity and a financial liability or equity instrument of another entity. The
standards identify several different types of financial instruments and prescribe how each one of
them should be accounted for.

Definitions

IAS32 Financial Instrument: Presentation provides four key definitions which apply to all the
other standards that deal with financial instruments and these are as follows

1. 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.

2. A financial Asset is any asset that is:

i. Cash;

ii. An equity instrument of another entity;

iii. A contractual right to receive cash or another financial asset from another entity

iv. 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

v. 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.

141
 3. A financial liability is any liability that is a contractual obligation

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

ii. to exchange financial instruments with another entity under conditions that are
potentially unfavorable

iii. 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

iv. 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

4. An equity instrument is any contract that evidences a residual interest in the assets of an
entity after deducting all of its liabilities

IAS32 deals with classification of financial instruments and their presentation in financial
statements. The main object of the standard is to provide a distinction between liabilities and
equity and to ensure that financial liabilities and equity instruments are correctly identified in an
entity’s financial statements.

IAS32 takes a “substance over form” approach to distinguish between liabilities and equity. This
means that even though the legal form of a financial instrument might be a share issue, the
instrument could still be regarded as giving rise to a financial liability if the underlying substance
of the transaction indicates that this is the case.

IAS32 states that a financial instrument should be classified as an equity instrument if and only if
the instrument includes no contractual obligation to deliver cash or another financial asset to
another entity. Therefore ordinary shares are an example of an equity instrument, since the
company which issues the shares is under no contractual obligation to pay dividends and cannot
legally repay the share capital. Ordinary shareholders may in fact receive dividends from time to
time but the company cannot be required to deliver cash or any other financial asset to these
shareholders but if we look at a loan, the borrower is obliged to make interest payments
throughout the loan period and the repay the loan at the end of the period and so a loan is not an
equity instrument

A redeemable preference share is a share which either:

 Provide for mandatory repayment of the share capital at a future date, or

142
  Gives the shareholder the right to require repayment of the share capital on or after a
particular date, for a fixed or determinable amount.

In the case, the issuing company has a contractual obligation to deliver cash making redeemable
preference shares to be classified as financial liabilities rather than as equity. This is in line with
the substance over form approach.

Furthermore, IAS32 states that accounting treatment of interest, dividends, losses and gains
relating to a financial instrument should follow the treatment of the instrument itself. Interest and
dividends relating to financial liabilities (redeemable preference shares) should be recognized as
a finance expense when calculating the issuing company’s profit or loss. Dividends paid on
shares classified as equity will be reported in the statement of changes in equity.

Compound financial Instruments

Compound instrument contain characteristics of both equity and liability. The standards states
that compound instruments should be separated into their two components and that each on these
components should then be recognized separately, one as a financial liability and the other as
equity. An example of compound instrument is loan stock that is convertible to ordinary shares at
the option of the lender. Therefore, according to IAS32, this instrument will have to be split into
the two components of

i. Financial liability ( the debt or loan)

ii. Equity instrument ( the option to convert into shares)

The fair value of the liability component is determined first. This is equal to the fair value of a
similar instrument without an associated equity component. The measurement rules of IAS39
indicate that this amount should be calculated by discounting the cash flows that the financial
instrument generates, using a market rate of interest

The fair value of the equity component is then determined by deducting the fair value of the
liability component from the fair value of the whole instrument. IAS39 states that the fair value
of the whole instrument is normally equal to the amount of the consideration which was given or
received when the instrument was issued.

Example

On 1 January 2001, Daniels issued a K50m three-year convertible bond at par

 There were no issue costs

 The coupon rate is 10%, payable annually in arrears on 31 December

143
  The bond is redeemable at par on 1 January 2004

 Bondholders may opt for conversion. The terms are two 25 cent shares for every K1
owed to each bondholder on 1 January 2004

 Bonds issued by similar companies 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 Daniels?

Solution

The cash payments on the bond should be discounted to their present value using the interest rate
for a bond without the conversion rights (15%)

Date payment cash flow Discount factor (15%) Present value

31/12/01 interest 5,000 0.869565 4,347.8

31/12/02 interest 5,000 0.75613667 3,780.7

31/12/03 Interest 5,000 0.65751632 3,287.6

1/01/04 Principal 50,000 0.65751632 32,875.8

Present value of liability component 44,291.9

Therefore the equity component is 50,000 – 44,291.9 = 5,708.1

Then calculate the annual finance costs and year end carrying amounts

Year Opening balance Effective payments Payments Closing balance

Interest (15%)

2001 44,291.9 6,643.8 (5,000) 45,935.7

2002 45,935.7 6,890.4 (5,000) 47,826.1

2003 47,826.1 7,173.9 (5,000) 50,000

The conversion of the bond

144
As at 1 January 2004, the carrying amounts are as follows

Equity 5,708.1

Liability-Bond 50,000

55,708.1

The conversion terms are two 25 cents shares for every K1, so 50m x 2 shares= 100m shares
with a nominal values of (100 x K0.25) = K 25m

The remaining (55,708,100 – 25,000,000) K 30,708,100 should be classified as share premium

and therefore there is no remaining liability because very thing has been converted into shares.

Test your understanding

On 1 January 2009, a company issues K 200,000 of 7% loan stock at par. Interest on this loan
stock is payable on 31 December each year. The stock is due for redemption at par on 31
December 2012 but may be converted into ordinary shares on that date instead.

Assuming that the stock of interest to be used in the cash flow calculations is 9% per annum;
calculate the liability component and the equity component of this loan.

UNIT 22: IAS39 FINANCIAL INSTRUMENTS: Recognition and Measurement

145
IFRS 9 Financial Instruments, issued in November 2009 and updated in October 2010 replaced
parts of IAS 39, with respect to the recognition, derecognition, classification and measurement of
financial assets and liabilities. The standard is a work in progress and will fully replace IAS 39.

IFRS 9 applies to all entities and to all types of financial Instruments except those specifically
excluded, for example

i. Investment in Subsidiaries, Associates, and Joint Ventures that are accounted for under
IFRS 10, 11 and 12

ii. Leases covered in IAS 17

iii. Employee benefit plan covered in IAS 19

Initial Recognition

The standard states that a financial asset or financial liability should be recognized in the
statement of financial position when and only when the entity becomes a party to the contractual
provisions of the instrument.

Classification of Financial Assets

On recognition, IFRS 9 requires that financial assets are classified as measured at either

a) Amortised Costs, or

b) Fair value

A financial asset is classified as measured at amortised cost where;

a) The objective of the business model within which the asset is held is to hold assets in
order to collect contractual cash flows and

b) 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.

An application of these rules means that equity investments may not be classified as measured at
amortised cost and must be measured at fair value. They are held at fair value with changes
going through profit or loss unless the entity makes an irrevocable election at initial recognition
to recognize all changes through other profit or loss. All derivatives are measured at fair value.

A debt instrument may be classified as measured at either amortised cost or fair value depending
on whether it meets the criteria above. Even where the criteria are met at initial recognition, a
debt instrument may in certain circumstances be classified as measured at fair value through
profit or loss.
146
IFRS 9 simplifies the IAS 39 definitions and the table below shows how IAS 39 requirements
were in terms of initial recognition

Old IAS 39 Category Measured at Gains and Losses

Financial asset at fair value Fair Value Profit or Loss

through profit or loss

Available for sale financial Fair value Other profit or loss

asset

Financial asset held to Amortised cost Profit or loss

maturity

Loans and receivables Amortised cost Profit or loss

IFRS 9 introduces a business model test that requires an entity to assess whether its business
objective for a debt instrument is to collect the contractual cash flows of the instruments as
opposed to realizing its fair value change from sale prior to its contractual maturity.

Although on initial recognition financial assets must be classified in accordance with the
requirements of IFRS 9, in some cases they may be subsequently reclassified. IFRS 9 requires
that when an entity changes its business model for managing financial assets, it should reclassify
all affected financial assets. This reclassification applies only to debt instruments, as equity
instruments must be classified as measured at fair value

Classification of Financial Liabilities

On recognition, IFRS 9 requires that financial liabilities are classified as measured at either

147
 a) At fair value through profit or loss, or

b) Financial liabilities at amortised cost

A financial liability is classified at fair value through profit or loss if:

a) It is held for trading, or

b) Upon initial recognition it is designated at fair value through profit or loss

These measurement rules are the same as under IAS 39 which

Financial Liabilities at fair value through profit or loss are financial liabilities that are held for
trading (expected to sold in the near future)

Other financial liabilities are not specifically defined but are all such liabilities except those at
fair value through profit or loss. An entity’s borrowings would normally be classified under this
heading.

Measurement of financial instruments

Financial instruments are initially be measured at fair value of the consideration given or
received (i.e cost) plus (or minus in the case of financial liabilities) transaction costs that are
directly attributable to the acquisition or issue of the financial instrument. The addition (or
subtraction in case of financial liabilities) only applies to financial assets and financial liabilities
classified as measured at amortised cost.

This means that transaction costs on financial instruments designated at fair value through profit
or loss are not added (subtracted) to the fair value at initial recognition.

The fair value of the consideration is normally the transaction price or market prices.

Subsequent Measurement

After initial recognition, IFRS 9 requires an entity to measure financial assets at either amortised
cost or fair values, based on

a) The entity’s business model for managing the financial assets; and

b) The contractual cash flow characteristics of the financial asset

A financial asset is measured at amortised cost if both of the following conditions are met

a) The objective of the business model within which the asset is held is to hold assets in
order to collect contractual cash flows and

148
 b) 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.

After initial recognition all financial liabilities should be measured at amortised cost, with the
exception of financial liabilities at fair value through profit or loss.

A financial asset or liability at fair value through profit or loss meets either of the following
conditions

a) It is classified as held for trading

b) Upon initial recognition it is designated by the entity as at fair value through profit or loss

Amortised cost of a financial asset or financial liability is the amount at which the financial asset
or financial liability is measured at initial recognition minus principal repayments, plus or minus
the cumulative amortization of any difference between that initial amount and the maturity
amount, and minus any write-down for impairment or collectability.

The effective interest method is a method of calculating the amortised cost of a financial
instrument and of allocating the interest income or interest expense over the relevant period.

Effective interest method

 The amortized cost of a financial asset is equal to the amount at which the asset was
initially recognized, plus the amount of interest earned to date, minus any repayments
received to date

 The effective interest method is a way of calculating the amount of interest earned to
date. This method uses an interest rate that exactly discounts estimated future cash
receipts to the initial carrying amount of the asset. This calculation takes into account
not only interest receivable, but also items such as premiums and discounts. This is
the internal rate of return of the instrument.

A usual example of a loan that uses an effective rate of interest is a deep discount bond which
has many unique features and key ones being

 It has a coupon rate much lower than market rates of interest

 Initial carrying amount of the bond equal to 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

149
  Full cost include issue costs, deep discount on issue, annual interest payments and
premium on redemption.

Example

On 1 January 2001 James issued a deep discount bond with a K50,000 nominal value. The
discount was 16% of nominal value, and the cost of issue was K2,000. Interest of 5% of nominal
value is payable annually in arrears

The bond must be redeemed on 1 January 2006 (after 5 years) at a premium of K4, 611 and the
effective rate of interest is 12% per annum

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

Solution

We first need to establish at what amount the bond will initially be recognized in the statement of
financial position. This will be calculated as follows

Fair value 50,000

Less: 16 discount (16% 0f 50,000) (8,000)

Less: issue costs (2,000)

40,000

Initial recognition of liability

Repayments

Capital 50,000

Premium on redemption 4,611

54,611

Interest paid: 50,000 x 5% x 5 years 12,500 67,111

Total Finance cost 27,111

Now we can proceed and work out the balance of the loan at the end of each period

150
Yr Opening Bal Effective interest Payments Closing balance

Rate 12% 5%

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

The finance charge taken to the Statement of profit or loss is greater than the actual interest paid,
and so he 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 1-4 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

Test your understanding

On 1 January 2009, a company buys K100,000 of 6% loan stock for K93,930. Interest will be
received on 31 December each year and the stock will be redeemed at par on 31 December 2013.
The company intends to hold the stock until maturity and calculates the effective interest rate to
be 7.5% per annum. Financial statements are prepared to 31 December each year.

a) State the amount at which this stock should be measured on 1 January 2009

b) Calculate the amount at which the loan stock should be measured on 31 December 2009,
2010, 2011, 2012, and 2013

c) Show that the effective rate of 7.5% exactly discounts estimated future cash receipts to
the initial carrying amount of the asset as required by IAS39

Derecognition

Derecognition of financial instruments is done in the following circumstances

 A financial asset is derecognized (removed from the statement of financial position)

when the entity’s contractual rights to receive cash flows from the asset expire; or

151
  It transfers substantially all the risks and rewards of ownership of the financial to another
party

 A financial liability is derecognized when the entity’s contractual obligations expire or

discharged or cancelled

Impairment of financial assets

IAS39 provides that if there is objective evidence that an impairment loss has been incurred on a
financial asset carried at amortized costs, this loss should be measured as the difference between:

1) The current carrying amount of the asset, and

2) The present value of the estimated future cash flows relating to the asset, discounted at
the effective rate of interest which was calculated at initial recognition

In other words, except for those financial assets that are measured at fair value through profit or
loss, all financial assets are subject to an impairment review and this assessment as to be done
annually ( on every reporting date). An event that would cause a negative impact on expected
future cash flows of the financial asset also provides objective evidence that an impairment loss
can been incurred and this would also be in line with the prudence concept. The event causing
the negative impact must have already happened before an impairment loss can be recognized.

A good example of impairment loss arises if a trade receivable becomes wholly or partly
uncollectible, in which case the loss is either written off as a bad debt or dealt with through an
allowance for doubtful receivables. If a short term receivable is measured at the original invoice
amount rather than amortized cost, the amount of any impairment loss is simply the difference
between the carrying amount of the receivable and the undiscounted cash flows expected to be
received in relation to it.

Reversal of impairment losses

A reversal of an impairment loss would only be allowed if there is an event that occurs to reverse
the event that led to the recognition of the impairment loss. An example of such would be the
credit rating of customer being revised upwards by the rating agency

Since impairment losses are only done on financial instruments that are carried at amortized cost,
an impairment loss in respect of a financial asset that is carried at cost or available-for-sale
equity instrument may not be reversed

UNIT 23: IFRS7 FINANCIAL INSTRUMENTS: Disclosures

152
Under this standard, entities are required to provide a number of disclosures relating to financial
instruments. The objective of these disclosures is to enable users to evaluate two things and these
are:

1) The significance of financial instruments for the financial position and financial
performance of the entity concerned

2) The nature and extent of any risks to which the entity is exposed in relation to financial
instruments, and the way in which those risks are being managed

Significance of financial instruments

An entity must disclose the significance of financial instruments for their financial position and
performance and the disclosures have to be for each class of financial instruments. The main
disclosures required by IFRS7 to enable users to evaluate the significance of financial
instruments for an entity’s financial position and performance are as follows

a) Carrying amounts. The carrying amount of each of the following categories of financial
assets and financial liabilities should be disclosed either in the statement of financial
position or in the notes

i. Financial assets at fair value through profit or loss, distinguishing between those
designated as such by the entity and those which are held for trading

ii. Held-to-maturity investments

iii. Loans and receivables

iv. Available-for-sale financial assets

v. Financial liabilities at fair value through profit or loss, distinguishing between

those designated as such by the entity and those which are held for trading

vi. Financial liabilities measured at amortized cost

b) Allowance for credit losses. If financial assets are impaired by credit losses and the
amount of the impairment is recorded in an allowance account ( e.g. an allowance for
doubtful receivables) then the entity should disclose a reconciliation of changes in this
allowance account during the accounting period for each class of financial assets

c) Fair value. The fair value of each class of financial asset or liability should be disclosed
in a way that facilitates comparison with carrying amounts. This disclosure is not
required if fair value cannot be measured reliably (e.g in the case of unquoted ordinary
shares)

153
d) Items of income, expense, gains and losses. The entity should disclose the following
items , either in the statement of profit or loss or in the notes:

i. Net gains or losses on each class of financial asset or liabilities (e.g. gains or
losses arising from fair value fluctuations)

ii. Total interest income and total interest expense for financial assets and liabilities
measured at amortized cost

iii. The amount of any impairment loss for each of financial asset

e) Accounting policies. The entity should disclose the measurement bases and other
accounting policies used in relation to financial instruments, where these are relevant to
an understanding of the financial statements

Nature and extent of risks

IFRS7 defines three main types of risks associated with financial instruments. These are

a) Credit risk. Credit risk is the risk that one party to a financial instrument will cause a
financial loss for the other party by failing to discharge an obligation

b) Liquidity risk. Liquidity risk is the risk that an entity will encounter difficulty in meeting
obligations associated with financial liabilities

c) Market risk. Market risk is the risk that the fair value or future cash flows of a financial
instrument will fluctuate because of changes in market prices. Such changes may occur
may occur because of changes in exchange rates (currency risk), changes in market
interest rates ( interest rate risk) or for other reasons (other price risk)

IFRS7 requires entities to disclose information which enables the users of the financial
statements to evaluate the nature and extent of the risks arising from financial instruments.
This information should include

a) A description of the risks concerned

b) A description of the methods used to measure risk

c) A description of the entity’s policies for managing risk

d) Quantitative data about the exposure to risk at the end of the reporting period

154
Specific detailed disclosures are also required in relation to credit risk, liquidity risk, and market
risk. The main disclosures are as follows

a) Credit risk. For each class of financial asset, the entity should disclose :

i. The amount of the maximum exposure to credit risk

ii. An age analysis of financial assets that are overdue but not impaired

iii. An analysis of financial assets that are impaired

iv. A description of collateral held in respect of the amounts disclosed in i., ii., and iii
above

b) Liquidity risk. The entity should disclose a maturity analysis for financial liabilities and a
description of how any inherent liquidity risk is managed

c) Market risk. The entity should disclose a sensitivity analysis for each type of market risk
to which the entity is exposed. This analysis should show how profit or loss and equity
would be affected by changes in the relevant risk variable (e.g. exchange rates or market
interest rates)

UNIT 24: SEGMENTAL ANALYSIS

155
Relevant standards- IFRS8 AND IAS14

Many entities (especially large companies) engage in a wide range of business activities and
operate in a number of economic environments. Each of these business activities or economic
environment may be subject to differing

 Rates of profitability,
 Opportunities for growth
 Future prospects
 Risks
But all the above listed points might not apparent from the aggregated information given in the
main financial statements. IFRS8 Operating Segments requires an entity which falls within its
scope to disclose information that will enable the users of 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.

It is important to note that IFRS8 is effective only for accounting periods beginning on or after 1
January 2009 though earlier application is permitted. For periods prior to this, the applicable
standard is IAS14 Segment Reporting

Also note that the requirements of both IFRS8 and IAS14 apply only to entities whose shares
or securities are publicly traded.

IFRS8 OPERATING SEGMENTS

An operating segment is defined under IFRS8 as a component of an entity:

a) 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)
b) 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, and
c) For which discrete financial information is available
The term “chief operating decision maker” identifies a function rather than a manager with a
specific title. In many cases this function will be performed by the chief executive or chief
operating officer but the function might be performed by a group of executive directors or other
managers.

In general, each segment will be managed by a segment manager who reports to the chief
operating decision maker.

156
IFRS8 points out that not every component of an entity is necessarily an operating segment or
even part of an operating segment. For example, a corporate headquarters may not earn revenue
and therefore would not be an operating segment.

It is critical to note that segmental reports are designed to reveal significant information that
might otherwise be hidden by the process of presenting a single statement of profit or
loss/Statement of profit or loss and statement of financial position

Consider an entity with three segments as follows

Segment A B C Total

Operating profits 100,000 200,000 (250,000) 50,000

If only the overall profit is disclosed, then only 50,000 would be shown on the face of the
statement of financial position and this would give decision makers incomplete information that
might be worthwhile for proper decision making. But if the segment information is disclosed, the
decision maker will be able to see that actually segment A and B are doing much better and that
segment C is making losses and thereby suppressing the results of the other two segments. The
right decision then might be to restructure segment C or even abandon it and channel the
resources to A and B.

REPORTABLE SEGMENTS

IFRS8 requires an entity to provide separate information about each of its “reportable
segments”. This information is disclosed in the notes to the financial statements.

Rules for identification of an entity’s reportable segments

a) A reportable segment is a single or combined operating segment which meets any of he

following “quantitative thresholds”
i. Its reported total revenue from sales to external customers and sales to other
operating segments is at least 10% of the total revenue (external and internal) of
all operating segments
ii. Its reported profit or loss is at least 10% of the combined profit of all operating
segments that reported a profit or the combined loss of all operating segments that
reported a loss, whoever is the greater
iii. Its assets are at least 10% of the total assets of all operating segments

b) An operating segment that does not meet any of the 10% threshold may nonetheless be
treated as a reportable segment if management believes that information about the
segment would be useful to the users of the financial statements
157
c) Two or more operating segments may be combined into one operating segment if the
segments have similar economic characteristics and are similar in each of the following
respects
 The nature of the products and services involved
 The nature of the production process
 The type or class of customer for the products and services
 The distribution methods used
 The nature of the applicable regulatory environment (if any)
d) If the total external revenue attributable to reportable segments is less than 75% of the
entity’s total external revenue, additional operating segments must be identified as
reportable (even though they are beneath the 10% thresholds) until at least 75% of the
total external revenue is included in reportable segments
Example 2

A listed company has identified seven operating segments (labeled A to G). The following
information is available in relation to each segment’s revenue, profit or loss and assets for the
year to 31 December 2009:

External Sales to other Profit Assets

Revenue Segments (loss)

K000 K000 K000 K000

Segment A 3,040 2,440 720 3,170

Segment B 1,460 0 (160) 1,590

Segment C 1,580 60 (60) 1,480

Segment D 1,720 0 120 2,150

Segment E 760 520 150 1,620

Segment F 2,360 1,740 560 3,780

Segment G 1,520 0 (50) 1,460

12,440 4,760 1,280 15,250

Identify the company’s reportable segments for this accounting period

Solution

158
  The company’s total revenue (external and internal) is K17.2m. So a segment must
have revenue of at least 1,720,000 to satisfy the first 10% test
 The combined profits of profitable segments are K1.55m and combined losses of loss
making segments are K0.27m. The larger of these is K1.55m. So a segment must
have a profit or loss of at least 155,000 to satisfy the second 10% test.
 Total assets are 15.25m. So a segment must have assets of at least 1,525,000 to
satisfy the third 10%
 The results of the three 10% tests for each operating segment are as follows:

TT Rev (atleat 1.72m) P or L(0.155M) Assets(1.525) Reportable S

Seg A Y Y Y Y

Seg B N Y Y Y

Seg C N N N N

Seg D Y N Y Y

Seg E N N Y Y

Seg F Y Y Y Y

Seg G N N N N

Segments C and G fail all the three of the 10% tests, so these will not be reportable as long as the
remaining segments satisfy the 75% test.

75% of the company’s total external revenue is 9.33 (75% x 12.44). The total external revenue of
reportable segments A, B, C, D, E and F is 9.34m, so the 75% test is satisfied.

Reportable segments can be identified by using two main approaches

 Risk and return approach

 Managerial approach
Risk and return approach identifies segments on the basis of different risks and returns arising
from different lines of business and geographical areas. The risk and returns approach was the
one adopted by IAS14 Segment reporting

The managerial approach identifies segmental corresponding to the internal organization

structure of the entity. This is the approach adopted by IFRS 8.

159
Practice Question

Mesan, a public limited company, has three business segments which are currently reported in its
financial statements. Mesan is an international golf resort group which reports to management on
the basis of the regions. It does not currently report segmental information under IFRS8
“Operating Segments”. The results of the regional segments for the year ended 31 May 2010 are
as follows:

Region Revenue Segment results Segment Segment

External Internal Profit (loss) assets liabilities

K’000 K’000 K’000 K’000 K’000

South Asia 1,000 15 (50) 1,500 1,000

Africa 1,500 10 300 4,000 1,500

Other regions 2,500 25 525 10,000 7,000

There were no significant intercompany balances in the segment assets and liabilities. The Golf
Resorts are located in capital cities in the various regions, and the company sets individual
performance indicators for each Golf Resort based on its city location

Required:

a) Discuss the principles in IFRS8 “ Operating Segments” for the determination of a

company’s reportable operating segments and how these principles would be applied to
Mesan Plc using the information given above (15 Marks)

b) Explain why the users of financial statements may find a segment report useful

(2 Marks)

c) Explain the two main approaches used to identify reportable segments (3 Marks)

UNIT 25: IAS33-EARNINGS PER SHARE

160
  There are many ratios which may be used to analyze a company’s financial performance
and provide a basis for performance comparisons between companies and between
accounting periods
 EPS is very widely used as a means of assessing a company’s performance
 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

BASIC EPS

 IAS 33 requires companies to calculate and present their basic earnings per share
 EPS for an accounting period is calculated by dividing the profit (loss) for that period
which is attributable to the ordinary shareholders by the weighted average number of
ordinary shares outstanding during the period
 The profit attributable to the ordinary shareholders is the profit for the period after
deduction of tax and any preference dividends. In the case of consolidated
accounts, the profit attributable to NCI is also deducted
 In general, shares are outstanding as from the date on which they are issued.
 It is necessary to present basic EPS for the previous accounting period as well as
for the current accounting period

BASIC EPS

The basic EPS calculation is given by the formula

Earnings
Shares
Earnings should be apportioned over the weighted average equity share capital

Example 1

161
A company’s summarized statement of Income for the year to 31 May 2010 is as follows
£’000
Profit before tax 650
Taxation 200
Profit for the period 450

The following information is also available

a. The company’s issued share capital consists of 500,000 10% preference shares of £1 each
and 1,000,000 £1 ordinary shares. There were no changes to the issued share capital
during the year.
b. The preference dividend of £50,000 was paid in full during the year
Calculate the company’s basic EPS for the year to 31 May 2010
Solution

450,000 – 50,000 = 40p per share

1,000,000
Your answer should be expressed as cents, pence or ngwee per share to 1 decimal place

Example 2
A company issued 200,000 shares at full market price (K3.00) on 1 July 2008
2008 2007
Profit attributable to the Ordinary s/holders for the yr ending 31 Dec 550,000 460,000
Number of ordinary shares in issue at 31 Dec 1,000,000 800,000

Required: Calculate the EPS for each of the years

Solution

162
2007 460,000/800,000= 57.5c
2008
Date Actual No of shares Fraction of the yr Total
1 Jan 2008 800,000 6/12 400,000
1July 2008 1,000,000 6/12 500,000
Number of shares in EPS Calculation 900,000
EPS =550,000/900,000=61.1c

BONUS ISSUES (or capitalization issue or script issue)

A bonus issue consists of an issue of free extra shares to existing shareholders in proportion to
their existing holdings. A company may decide to distribute further shares as an alternative
to increasing the dividend payout. For example, the company may give one bonus share for
every five shares held.
From the point of view of calculating EPS, the most important feature of a bonus issue is that a
company’s resources do not increase when such an issue is made. Therefore a bonus issue
increases the number of shares outstanding without increasing the company’s ability to earn
profits.
If the bonus issue made in accounting period were treated in the same way as an issue of shares
at full price, the effect would be to depress the EPS figure and distort the comparison with EPS
in previous periods.
To resolve this problem, IAS 33 states that a bonus issue should be treated as if it had
occurred at the beginning of the earliest period presented. The bonus shares are deemed to
have been issued at the start of the year. Since most companies’ present information for the
previous period only, this means that bonus issues are usually treated as if they had
occurred at the beginning of the previous accounting period.
It is necessary in these circumstances to recalculate and restate the EPS figure for the previous
period as well as to calculate the EPS figure for the current period.
Example 3
A company’s profit after tax for the year to 30 June 2010 was £2.2 million. The comparative
figure for the year to 30 June 2009 was £2 million. The company’s issued share capital at 1 July
2008 consisted of 800,000 ordinary shares. No shares were issued during the year to 30 June
2009 but a 1 to 4 bonus issue was made on 1 March 2010.
Calculate the company’s basic EPS for the year to 30 June 2010 and the restated comparative
figure for the year to 30 June 2009
163
Solution
The bonus issue of 200,000 ordinary shares is treated as if made on 1 July 2008. So that the
number of ordinary shares outstanding is 1 million through out both years
EPS for year to 30 June 2010 is 2.2m/1m=£2.2per share
Restated basic EPS for the year to 30 June 2009 is 2m/1m= £2.00 per share
RIGHTS ISSUE
Like a bonus issue, a rights issue consists of an issue of extra shares to existing shareholders in
proportion to their existing shareholding. However, rights shares are not issued free of charge.
With the issued rights, existing shareholders have the privilege to buy a specified number of new
shares from the firm at a specified price within a specified time.
 If a rights issue is issued at full market price, it is treated in exactly the same way as any
other full-price issue when calculating basic EPS.
 But rights shares are often issued at a price which is lower than the market price and so
contain a “bonus element”
 IAS33 requires that the rights issue should be separated into two components
 The bonus element
 An issue of shares at full market price
 Each of the components is then treated as earlier stated.
1. Calculate the Theoretical ex rights price (The market price that a stock
will theoretically have following a new rights issue)
For Example, A company issued 1 new share for every 2 existing shares by way
of rights at K1.50 per share on 1 July 2008. Pre- issue market price was K3.00 per
share. Calculate the theoretical ex rights price.
2 shares @ K3.00 per share 6
1 share @ K1.50 per share 1.5
Total for 3 shares 7.5
Theoretical price per share 7.5/3= K 2.5

2. Calculate the weighted average number of shares

164
 From the example above, we have the following additional information
2008 2007
Profits attributable to Ord S/Holders -yr ending 31 Dec 550,000 460,000
No of Ord shares in issue at 31 Dec 1,200,000 800,000

6/12 x 800,000 x Actual cum(market) price 3 480,000

Theoreticalex rights price 2.5
6/12 x 1,200,000 600,000
1,080,000

3. Calculate EPS for 2008

550,000 = 50.9cents
1,080,000
4. Restate the comparative EPS
Profit X Theoretical ex price = 460,000 X 2.5 = 47.9 cents
No of share Actual cum price 800,000 3.0

Example 4
A company’s profit after tax for the year 31 March 2010 was £351,000. The comparative
figure for the year to 31 March 2009 was £288,000. Issued share capital at 1 April 2008
consisted of 100,000 ordinary shares. No shares were issued during the year to 31 March
2009 but a 1 to 2 rights issue was made on 1 October 2009 at 60p per share and this issue
was fully subscribed. The market value of the company’s shares just before this rights issue
was £1.20 per share.
Calculate the Company’s basic EPS for the year to 31 March 2010 and the restated
comparative figure for the year to 31 March 2009

Solution
165
 2010 2009
Profit after tax 351,000 288,000
Number of shares 31 March 150,000 100,000

Step 1- Theoretical ex price

2 @ 1.2 2.4
1 @ 0.6 0.6
3
Theoretical ex price per share = 3/3= £1
Step 2- Weighted Number of shares
6/12 x 100,000 x 1.2/1 60,000
6/12 x 150,000 75,000
Weighted Average 135,000

Step 3 Calculate EPS FOR 2010

351,000/135,000= £2.6
Step 4 Restate 2009
EPS for 2009 x 1/1.2= £2.4

166
 UNIT 26: IAS33-DILUTED EARNINGS PER SHARE
Diluted EPS is the EPS figure which would arise if all dilutive potential ordinary shares
were issued.
The calculation of basic EPS only takes into consideration those ordinary shares which are
already outstanding (The shares of a corporation's stock that have been issued and are in the
hands of the public)
However, a company may have issued financial instruments which give the holder the right to
acquire ordinary shares at some time in the future.
When these “potential ordinary shares” are eventually issued, the company’s earnings will be
spread over a greater number of shares than before, so that EPS will be reduced or “diluted”
Common examples of potential ordinary shares are
a. Liabilities that are convertible into ordinary shares (e.g. convertible loan stock)
b. Options to purchase ordinary shares
To ensure that existing shareholders are made aware of the extent to which earnings per share
would be reduced if potential ordinary shares were issued, IAS33 requires companies to calculate
a figure for diluted EPS as well as EPS. The provision of a diluted EPS figure attempts to
alert shareholders to the potential impact on EPS.
DEPS is calculated as follows
Earnings + notional extra earnings
Number of shares + notional extra shares
Potential ordinary shares are regarded as dilutive if the effect of their issue would be to reduce
decrease the company’s EPS. If the issue of potential ordinary shares would increase EPS, the
shares are said to be “antidilutive” and are entirely ignored when calculating diluted EPS.
The calculation of diluted EPS generally requires the following adjustments to the figures which
were used when calculating basic EPS:
Earnings- The Company’s earnings must be adjusted for the after- tax effect of any change in
income or expenses that would result from the issue of dilutive potential ordinary shares. E.g.
Earnings would be increased by the amount of extra after-tax profit that would arise as the result
of no longer paying interest on convertible loan stock.
Weighted average number of shares- The weighted average number of ordinary shares must be
increased to reflect the maximum number of additional ordinary shares that would become
outstanding if all dilutive potential ordinary shares were issued
Please note that these shares are treated as if issued at the beginning of the accounting period.

167
Example
A Company has issued share capital consisting of 8 million ordinary shares. The Company’s
after-tax profit for the year to 30 September 2009 is £2 million
In 2006, the company issued £10 million of 8% convertible loan stock. This stock is convertible
into ordinary shares during year 2012 at the rate of 1 ordinary share per £ 5 of loan stock.
A tax rate of 30% may be assumed
a) Calculate the company’s basic EPS for the year to 30 September 2009
b) Determine whether the potential ordinary shares derived from the loan stock are dilutive
or antidilutive and calculate the company’s dilutive EPS for the year
c) Explain how the situation would differ if the loan stock attracted interest at 6% rather
than 8%.
Solution
a) Basic EPS is £2 million divided by 8 million shares, giving 25p per share
b) If all of the loan stock were converted into shares, the company would save interest of
£ 800,000 per annum, giving an increase in after tax profits of £ 560,000 (800,000
less 30% tax). There would be 2 million extra ordinary shares, so the incremental EPS
would be 28p per share (560,000 divided by 2 million shares). This exceeds the
company’s basic EPS and the effect it will have on the basic EPS is an incremental
one and not to reduce it. Therefore the potential ordinary shares are antidilutive and
can be ignored. Diluted EPS is the same as the basic EPS
c) If the loan stock attracted interest at only 6%, the increase in after-tax profits on
conversion would be £420,000 (600,000 less 30% tax). Incremental EPS would be
21p per share, which is less than basic EPS. Therefore the potential ordinary shares
would be dilutive. Dilutive EPS would be £2,420,000 divided by 10 million shares,
giving 24.2p per share

The above example covers convertible loan stock. Other convertibles include convertible
bonds and preference shares. The interest/dividend paid would be saved therefore
earnings would be higher and the number of shares would increase.
Options and warrants to subscribe for shares
A share option or warranty generally gives the holder of that option the right to acquire
shares at less than full market price. When such an option is exercised, the resulting
increase in the number of shares outstanding will have a dilutive effect on EPS but this
effect will be mitigated because of the extra resources that will enter the company when

168
 the option holder pays for the shares. When calculating diluted EPS, share options are
dealt with as follows
a) The total consideration that will be payable by the option-holder when the option
is exercised is divided by the market price per share ( or the average price of the
shares during the period) so as to give the number of shares that could be acquired
for that consideration
b) Based upon this calculation, the potential share issue is now split into a potential
issue of shares at full market price and a potential issue of shares for no
consideration. The potential issue of shares for no consideration are treated like a
bonus issue
c) Shares issued at full price are not dilutive, so the weighted average number of
shares used in the diluted EPS calculation is adjusted to reflect only the potential
issue of shares for no consideration
Example
On 1 January 2007, a company has 4 million ordinary shares in issue and issues
options over another million shares. The net profit for the year is K500,000.
During the year to 31 Dec 2007, the average fair value on one ordinary share was K 3
and the exercise price for the shares under the option was K2.
Calculate the basic EPS and diluted EPS for the year ended 31 Dec 2007

Solution
Basic EPS= 500,000/4million =12.5c
Options = 1million X K2 = 2,000,000
At fair value= 2,000,000/3 = 666,667
Number issued free = 1,000,000 – 666,667 = 333,333
Therefore diluted EPS = 500,000/ (4MILLION + 333,333) = 11.5C

The Importance of EPS and Diluted EPS

 The EPS figure is used to computer the major stock market indicator of performance
which is the Price Earnings Ratio (P/E ratio).

169
 P/E ratio = Market value of share
EPS

The P/E ratio (price-to-earnings ratio) of a stock is a measure of the price paid for a share
relative to the annual net income or profit earned by the firm per share. The price-to-earnings
ratio is a financial ratio used for valuation: a higher P/E ratio means that investors are paying
more for each unit of net income, so the stock is more expensive compared to one with a lower
P/E ratio.

 EPS measures performance for the perspective of investors and potential investors
 EPS shows the amount of earnings available to each ordinary shareholder, so that it
indicates the potential return on individual investments
 Diluted EPS shows what the current year’s EPS would be if all the dilutive potential
ordinary shares in issue had been converted.
 In theory, it serves as a warning to equity shareholders that the return on their investment
may fall in future periods

LIMITATIONS OF EPS
 It does not take account of inflation so there could be a sudden growth in earnings
which is due to a rise in inflation
 It is based on historic information and as such, it can not be used to predict any future
prospects for the entity
 It may not always be appropriate to compare the EPS of different companies as
entity’s earnings are affected by the choice of the accounting policies
 Diluted EPS is only an additional measure of past performance despite looking at
future potential shares
Practice Question
Crispin Plc is a publicly listed company. The issued share capital of Crispin consists of 800,000
ordinary shares. There are no preference shares. Some years ago, Crispin Plc issued K1 million
of 10% convertible loan stock, convertible in 2015 at the rate of 2 ordinary shares for every K10
of loan stock. Crispin’s profit after tax for the year to 31 March 2011 is K 640,000.00

170
 a) Calculate basic EPS for the year to 31 March 2011.

b) Calculate diluted EPS for the year to 31 March 2011, assuming that the company pays tax
at 30%.

c) Assuming that the loan stock was not issued “some years ago” but was in fact issued on 1
October 2010

I. Calculate basic EPS for the year to 31 March 2010

II. Calculate Diluted EPS for the year to March 2010, assuming that the company
pays tax at 30%

What do you understand by the term “theoretical ex rights price”

171
 UNIT 27: TAXATION IN FINANCIAL STATEMENTS
IAS12 Income Taxes sets out rules for the accounting treatment of current tax and deferred tax

CURRENT INCOME TAX

Current income tax can simply be defined as the income tax on the entity’s taxable profits for the
period. Taxable profit (tax loss) is the profit (loss) for a period, determined in accordance with
the rules established by the taxation authorities, upon which income taxes are payable.

IAS12 defines Current tax as the amount of income taxes payable (recoverable) in respect of the
taxable profit (tax loss) for a period. The term “income taxes” refers to any tax which is payable
on an entity’s profits, regardless of the name given to that tax in the country concerned. In the
UK, it’s called Corporation Tax and in Zambia, it’s called Company Income Tax.

Current tax is the expense and liability to be recognised based on the tax assessment of a
company’s result. This means that;

 The amount of current tax for an accounting period is recognised as an expense (or an
income in the case of tax recoverable) and should be included in the calculation of profit
or loss
 Any current tax that remains unpaid at the end of the period should be recognised as a
liability. If the amount already paid exceeds the amount due, the excess should be
recognised as an asset.
 Please note that current tax assets and liabilities should not be offset in the statement of
financial position unless there is a legally enforceable right to do so.

Current tax should be measured using tax rates and tax laws that have been enacted or
substantially enacted by the end of the reporting period. Tax rates and tax laws which have been
announced but not enacted by the end of the period can be treated as substantially enacted if their
enactment (which may occur several months after the announcement) is regarded as more or less
a formality.

Tax rates and laws which are announced after the end of the accounting period are dealt with as
non-adjusting events in accordance with IAS10 Events after the reporting date.

An entity will usually estimate the liability on its taxable profits before agreeing it with the tax
authorities. In any one period, it is usually the estimate which is accrued. It may occur that the
estimated amount which has already been accrued differs with the actual liability and this is
only known after the financial statements have been authorised for issue. The difference
172
between the estimate and the actual amount must be adjusted for in the following period when
the actual is known.
 Any adjustments necessary so as to reflect underestimates or overestimates of current tax
in previous periods should be included in the tax expense for the current period and then
disclosed separately in the notes.

The current income tax expense will therefore have two components as follows

Estimate of liability on taxable profits for the period X

Under /(over) provision for the liability for the previous period X (X)
Current tax expense for the year X___

Example 1

The following information relates to a company which prepares accounts to 30 June each year
and is now completing its financial statements for the year to 30 June 2010.

a) The company estimates that current tax for the year to 30 June 2010 is
£750,000.00. This figure takes into account new tax rates which were announced
in March 2010 and which are confidently expected to be enacted in August 2010.
If the new tax rates were disregarded, the amount due would be £810,000.
b) Payments on account totaling £390,000 have been made during the year to 30
June 2010 in relation to the current tax for the year.
c) Current tax for the year to 30 June 2009 was overstated by £30,000

Calculate the amount of the current tax expense which should be shown in the statement of profit
or loss for the year to 30 June 2010 and the amount of the current tax liability which should be
shown in the statement of financial position at that date

Solution

The new tax rates can be regarded as substantially enacted, so that current tax for the year is £
750,000. But the statement of profit or loss should show a current tax expense of only 720,000,
so as to adjust for the previous year’s overestimate.
Payments on account of £390,000 reduce the current tax liability shown in the statement of
financial position to £ 360,000 (750,000 – 390,000)

Example 2
173
 K
Income tax provision at 31 May 2005 316,000
Income Tax paid on 28 Feb 2006 263,000
Income tax charge at 30% for the year ended 31 May 2006 383,500

Show the entries in the income tax account and the Statement of profit or loss for the year 31
May 2006

Solution

Income Tax

28 Feb 2006 Bank 263,000 1 June 2005 Bal b/f 316,000

31 May 2006 Bal c/f 53,000

______ ______

316,000 316,000

31 May 2006, Bal b/d 53,000

At 31 May 2006, before accounting for the current year tax provision, there is already a credit
balance on the income tax account due to an over- provision of 53,000 in the previous year.

This is adjusted for by crediting the Statement of profit or loss for the year ending 31 May 2006
with the over-provision from last year of 53,000 and debiting the Statement of profit or loss with
the year provision of 383,500

174
 Income Tax

31 May 2006 Statement of profit or loss 53,000 31 May 2006 Bal b/f 53,000

31 May 2006 Bal c/f 383,500 31 May 2006 Statement of profit or loss
383,500

______ ______

436,500 436,500

1 June 2006 Bal b/f 383,500

175
 UNIT 28: DEFERRED TAX
Deferred Tax is defined as the estimated future tax consequences of transactions and events
recognized in the financial statements of the current and previous periods.

The amount of current tax payable by an entity for an accounting period depends upon the
entity’s taxable profit for that period. However, this taxable profit will often be different
from the profit shown in the financial statements (the accounting profit). Profits per the
financial statements and profits on which tax is payable are often different from each other.
The main reasons for this are as follows:

1. Permanent Difference. Some of the income shown in the financial statements may not be
chargeable to tax and similarly, some of the expenses shown in the financial statements
may not be deductible for tax purposes. In such cases, there will be a permanent
difference between the accounting profit and taxable profit (i.e. a difference that will not
reverse itself in a future accounting period). E.g. Political donations, fines for illegal acts
and in some countries, expenses for entertaining customers. Permanent differences are
one-off differences between accounting and taxable profits caused by certain items not
being taxable or allowable, and therefore only impact the tax computation of one period
(The period when the event or transaction takes place). Permanent differences therefore
do not have a deferred tax consequence

2. Temporary differences. These are differences between the carrying amount of an asset or
liability in the statement of financial position and its tax base. For example, the figure of
depreciation shown in the Statement of profit or loss may be far different from the tax
authority’s figure for capital allowances’ which is the tax authority’s way of calculating
allowances for depreciation.

In other words, the depreciation charges shown in the financial statements are
disregarded for tax purposes and are replaced by standardized depreciation charges
known as capital allowances. Total depreciation charges will equal total capital
allowances over the entire lifespan of an asset concerned but there may be significant
differences between depreciation and capital allowances in any one accounting period.
This is known as a temporary difference because it’s a kind of a difference that will
reverse itself in a future accounting period

 Temporary differences may be either

a) Taxable temporary differences, which are temporary differences that will result in
taxable amounts in determining taxable profit (tax loss) of future periods when the
carrying amount of the asset or liability is recovered or settled; or

176
 b) Deductible temporary differences, which are temporary differences that will result
in amounts that are deductible in determining taxable profit (tax loss) of future
periods when the carrying amount of the asset or liability is recovered or settled.
c) The Tax base of an asset or liability is an amount attributed to that asset or
liability for tax purposes

Accounting for Deferred Tax

An entity should recognise a deferred tax liability or asset: whenever the recovery or settlement
of the carrying amount of an asset or liability would make future tax payments larger or smaller
than they would be if such recovery or settlement were to have no tax consequences

IAS 12 requires entities to provide for deferred Tax on a full provision basis and uses the liability
method to calculate deferred tax by making reference to the tax base of an asset or liability
compared to its carrying value.

To determine the deferred tax expense/amount to be taken to the Statement of profit or

loss/statement of financial position, we first start by determining the deferred tax asset or liability
to report in the statement of financial position. The movement (increase or decrease) in the
deferred tax asset or liability for the period is the deferred tax expense for the period.

Example

A Company’s financial statements show profit before tax of K 1,000 in each of the years 1,2 and
3. This profit is stated after charging depreciation of K200 per annum. This is due to the
purchase of an asset costing K600 in year 1 which is being depreciated over its 3 year useful
economic life on a straight line basis.

The tax allowances granted for the related asset are:

Year 1 K240

Year 2 K210

Year 3 K150

Income tax is calculated as 30% of taxable profits

Apart from the above depreciation and tax allowances there are no other differences between the
accounting and taxable profits

177
Required:

1. Ignoring deferred tax, prepare the Statement of profit or loss extracts for each of the years
1,2 and 3

2. Accounting for deferred tax, prepare the Statement of profit or loss and statement of
Financial Position for each of the years 1, 2 and 3.

Solution

a) Statement of profit or loss Extracts

1 2 3

Profit before tax 1,000 1,000 1,000

Tax(w1) (288) (297) (315)

Profit after tax 712 703 685

b) (W1)

1 2 3

Accounting profits 1,000 1,000 1,000

Depreciation 200 200 200

Capital Allowances (240) (210) (150)

960 990 1,050

Income Tax @ 30% 288 297 315

178
W2- Temporary differences

Year end

1 2 3

Accounting base 400 200 0

Tax base 360 150 0

Tem differences 40 50 0

Deferred tax provision @30% 12 15 0

Increase (decrease) 12 3 (15)

W3 Tax Expense

1 2 3

Income Tax 288 297 315

Deferred Tax 12 3_ (15)

300 300 300

Statement of profit or loss

1 2 3

Profit after tax 1,000 1,000 1,000

Tax (300) (300) (300)

Profit after tax 700 700 700

179
Statement of Financial Position

1 2 3

Non-Current Liabilities:

Deferred Tax 12 15 0

Current Liabilities

Income Tax 288 297 315

From the above example, it can be seen that deferred tax is a means of allocating tax charges
fairly to particular accounting periods.

Example
A Plc acquired plant on 1 Jan 2005 costing ZMK 100m. The Plant has a useful life of 5 years. A
Plc depreciates plant on straight line basis with nil residual value.

For tax purposed, A Plc will claim an initial allowance of 25% in year ended 31 December 2005
and the balance of the cost as wear and tear allowances over the next four years on straight line
basis.

Required:
Determine the deferred tax expenses and liabilities to report in A Plc’s statement of Financial
Position for the year 2005 and 2006 assuming that A Plc is subject to tax on its profits at 30%

Solution
 A Plc will charge depreciation of ZMK 20m each year in the accounts

 Wear and tear allowances will be as follows for tax purposes;

 In year ending 31 Dec 2005, initial allowance of ZMK 25m

 In each of the next 4 years- wear and tear allowanced of ZMK 18.75m (75/4)

The accounting base, tax base and temporary differences will therefore be as follows over the
useful life of the plant
180
 31 Dec

2005 2006 2007 2008 2009

Acc base 80 60 40 20 0

Tax base 75 56.25 37.5 18.75 0

Tem diff 5 3.75 2.5 1.25 0

Def tax 1.5 1.125 0.75 0.375 0

Expenses- 2005 is 1.5 and for 2006 is (0.375)

Statement of Financial Position 2005 is 1.5 and for 2006 is 1.125

The accounting base represents the future economic benefits from the plant. These will be taxed
unless covered by the tax base amounts.

Where the accounting base of the asset is more than its tax base, the future tax effect is that the
excess (the temporary difference) is taxable to give a liability. Had the accounting base been less
than the tax base, the difference would be tax deductible. A deferred tax asset would be
recognized in that case if the asset is recoverable.

Unused tax losses

The tax law of the country in which an entity resides may allow trading and other losses to be
carried forward and deducted from future taxable profits, so reducing the tax due on those
profits. In these circumstances, IAS12 states that a deferred tax asset should be recognised to the
extent that it is probable that future taxable profits will be available against which the losses can
be utilised.

Disclosures

 Tax expense (income) should be presented on the face of the Statement of profit or loss

 The major components of tax expense(income)

 Current and deferred tax charges/credited directly to equity

 The amount of income tax relating to each component of other profit or loss

 An explanation of the relationship between tax expense (income) and accounting profit
181
Practice question

Taxation in company accounts is of paramount importance. IAS 12 “Income Taxes” sets out
rules on the accounting of current and deferred tax.

a) The draft statement of profit or loss for Crispin, a public company, for the year to 31
March 2010 shows an income tax expense of £ 55,000. The draft statement of financial
position shows a non-current liability of £ 28,000 for deferred tax but does not show a
current tax liability.

Tax on the profit for the year to 31 March 2010 is estimated at £ 260,000. The figure in
the draft statement of profit or loss is the underestimate for the year to 31 March 2009.
The carrying amount of Crispin’s net assets at 31 March 2010 is £1.4m more than their
tax base on that date. The tax rate is 25%

Required:

Restate the figures which should appear in relation to taxation in the company’s financial
statements for the year to 31 March 2010 (8 Marks)

b) Distinguish between Permanent differences and temporary differences (4 Marks)

c) Crispin Plc has the following assets and liabilities which appeared in the company’s
statement of financial position at 31 March 2010

i. A motor vehicle which cost £100,000 is shown at is written down value of

£20,000. For tax purposes, its written down value is £30,000

ii. A loan payable is shown at £60,000. The repayment of the loan will have no tax
consequences

iii. An amount receivable is shown at £45,000. Of this amount, £25,000 has already
been taxed but the remaining £20,000 will be taxed in the accounting period in
which it is received. The whole £45,000 has already been included in accounting
profit.

iv. An amount payable is shown at £3,000. This relates to an expense which has
already been deducted when computing accounting profit but which will not be
deducted for tax purposes until it is paid.
182
Compute the tax base of each of these assets and liabilities and identify any taxable or deducted
temporary differences

UNIT 29: IAS 19-EMPLOYEE BENEFITS

IAS19 Employee benefits, is one area in accounting that has attracted a lot of interest in the
recent past. The principle is that of matching; the entity receives a benefit in form of the
183
employee’s services in exchange for which the entity promises to pay the employee on the
occasion of the employee’s retirement

IAS19 explains the accounting treatment and disclosure requirements in relation to all forms of
benefits provided by employers to their employees. The main areas that the standard looks at are:

1) Short term employee benefits

2) Post-employment benefits (e.g. pensions)

3) Other long-term benefits

4) Termination benefits

This unit concentrates more on post-employment benefits for which the required accounting
treatment can be quite complex. Accounting for short term employee benefits is fairly straight
forward as they are generally an expense in the employer’s financial statements of the current
period. Accounting for the cost of deferral employee benefits is much more difficult and this is
because of the large amounts involved, as well as the long time scale, complicated estimates and
uncertainties.

Post-employment benefits

Post-employment benefits consist mainly of retirement benefits, such as pensions.

A pension plan (sometimes called a post-employment benefit scheme) consists of a pool of

assets and a liability for pensions owed to employees. In some cases, the pension plan is
administered by the employer (some parastals in Zambia used to administer pension plans for
their employees) but in most cases, a separate entity (a pension fund) is set up to receive
contributions and pay employee benefits. In Zambia, we have the National Pension Scheme
Authority (NAPSA). In either case, the requirements of IAS19 should be applied.

Pension plan assets normally consist of investments, cash and property.

A pension scheme could either be:

 A defined contribution plan

 Or a defined benefit plan

Defined contribution plan

Defined contribution schemes involve the employer paying an agreed percentage of the
employee’s salary into a fund administered by trustees. The employer is not obliged to make any
further contributions, even if the pension fund’s assets are insufficient to pay the expected level
184
of employee’s benefits. Therefore the annual cost to the employer is reasonably predictable. The
risk that benefits will be less than expected falls upon the employees and not the employer. The
trustees or pension fund will invest the fund with the hope that it will grow (probably make an
investment in shares of other entities). On retirement, the trustees will calculate how much is
attributable to that retiring employee and that amount is then used to pay a monthly pension to
the retired employee over the remaining useful life. Since it’s easy to predict the annual cost to
the employer, defined contribution plans present few accounting problems

Defined benefit plans

A defined benefit scheme involves the employer undertaking to pay a monthly pension based on
a percentage of the employee’s final salary. This means that the employer is obliged (either
legally or constructively) to provide an agreed level of post-employment benefits. The
employer’s contributions are not limited to any fixed amount and these contributions may need
to be increased if the pension fund has insufficient assets to pay the agreed level of benefits. The
risk of having to make further contributions is borne by the employer, not the employee.

The question is how much will the final salary be and for how many years will the retired
employee live after retirement? An actuary is required to calculate the amount that must be paid
into the plan each year in order to provide the promised pension. This will involve estimations of
post-retirement life, wage inflations and the actuary has to advise the entity of the values of the
plan assets, the future obligations and the amount to contribute into the fund.

Terminology used in IAS19

Post-employment benefits-These are employee which are payable after the completion of
employment

The present value of the defined benefit obligation- This is the present value, without deducting
any plan assets, of expected future payments required to settle the obligation resulting from
employee service in the current and prior periods

Current Service Cost- This is the increase in the present value of the defined obligation resulting
from employee service in the current period. In effect, the current service cost is the increase in
total pension’s payable as a result of continuing to employ your staff for another year

Interest Cost- This is the increase during a period in the present value of a defined benefit
obligation which arises because the benefits are one period closer to settlement

Plan Assets- are assets held in a legally separate trust in order to be able to pay the pensions in
future.

185
The Return on Plan Assets- is interest, dividends and other revenues derived from plan assets
together with realized and unrealized gains or losses on the plan assets, less any costs of
administering the plan and less any tax payable by the plan it self

Accounting for defined contribution plans

Accounting for defined contribution plans does not provide difficulties. In general, if an
employee has rendered services to an employer during an accounting period, the employer’s
financial statements for that period should recognise

a. An expense equal to the amount of the contributions payable by the employer into the
defined contribution in exchange of those services, and

b. A liability (accrue expense) equal to any part of this expense that has not yet been paid by
the end of the period. If the contributions already paid exceed the amount due to date, the
excess should be recognised as an asset (prepaid expense) to the extent that this
prepayment will lead to either reduction in future payments or a cash refund

Example,

A company makes contributions to the pension fund of employees at a rate of 5% of gross salary.
The contributions made are K100,000 per month for convenience with the balance being
contributed in the first month of the following accounting year. The wages and salaries for 2006
are K2.7 million

Calculate the pension expense for 2006 and the accrual/prepayment at the end of the year

Solution

It appears that the company does not have any further obligation beyond the 5% of gross salary
for its employees and therefore, this appears to be a defined contribution plan.

The charge to the profit or loss account will be 135,000 (5% of K2.7m)

Since the company has already paid K120,000 (K100,000 x 12 months), there is a shortfall of
15,000 (135,000 – 120,000) and so this amount will be shown in the statement of financial
position as an accrual (liability).

Accounting for defined benefit plans

The basic principle is that the entity recognizes both the liability for future pension payments and
the scheme assets.

 If the liability exceeds the assets, there is a deficit and a liability is reported in the
statement of financial position
186
  If the scheme assets exceed the liability, there is a surplus and an asset is reported in the
statement of financial position

 The pension expense for the period is the difference between the deficit/surplus at the
beginning of the period and the deficit/surplus at the end of the period

The complexity associated with accounting treatment of defined benefit plans arises because the
expense recognised in each accounting period should be the cost to the employer of the
retirement benefits that will eventually be paid to employees as a result of the services that they
have provided during the period. The problem is that these benefits may be payable in many
years’ time and their cost will depend upon a number of factors which are difficult to
determine in advance, such as employee mortality rates and future returns on investments.

The employer is exposed to both the actuarial risk that employees will live longer than
expected (which increases the cost or providing benefits) and the investment risk that assets
invested in the plan will be insufficient to pay the required benefits. The main steps to take in
the defined benefit calculations are as follows

a. At the end of each period accounting period, reliable estimates must be made of:

i. The amount of the accumulated benefits which past and present employees have
earned in return for their services to date and which will be payable to them in
future (the defined benefit contribution)

ii. The extra amount of such benefits that employees have earned in return for their
services during the current period (the current service cost).

These estimates involve the making of assumptions with regard to such matters as
employee mortality rates and future salary increases. Employers are encouraged
to engage a qualified actuary to make the necessary estimates

b. These estimates are discounted so as to determine the present value of the defined benefit
obligation and the present value of the current service cost

c. The interest cost for the period is calculated. This is equal to the increase during the
current accounting period of the present value of the defined benefit obligation which
was calculated at the end of the previous period. This increase arises because that
accumulated benefits which employees had earned at the end of the previous period are
now one period closer to be being paid

d. Actuarial gains and losses with regard to the defined benefit obligation may now be
calculated. These comprise

187
  Adjustments arising from differences between actuarial assumptions which were
made at the end of the previous period and actual events which occurred during
the current period

 The effect of changes in actuarial assumptions between the start and end of the
current period

The overall actuarial gain or loss with regard to the defined benefit obligation for an accounting
period is calculated by summarizing the changes in that obligation during the period and
inserting a balancing figure, as shown below

Present value of defined benefit obligation at start of period XXX

Add: Interest Cost XXX

Add: Present value of current service cost XXX

Less: Benefits paid during the period (XXX)

XXX

Actuarial losses/(gains) XXX (balancing figure)

Present value of defined benefit obligation at end of period XXX

e. The final step is the process is to determine the fair value of the plan assets at the end of
the accounting period and to calculate the actuarial gains and losses which have occurred
during the period with regard those assets. These actuarial gains and losses may arise
because the actual returns achieved on plan assets during the period did not equal the
expected returns. Once again, the overall actuarial gain or loss for an accounting period
may be calculated as a balancing figure, as follows:

Fair value of plans assets at start of period XXX

Add: Expected return on plan assets XXX

Contributions received from employer XXX

Contributions received from employees XXX

Less: Benefits paid during the period (XXX)

XXX

Actuarial gains (losses) XXX (balancing figure)

188
 Fair value of plan assets at end of period XXX

These calculations provide all of the figures required in order to compute the amount of the
defined benefit expense which should be shown in the statement of profit or loss for the period
and the amount of the defined benefit liability (or asset) which should be shown in the statement
of financial position at the end of the period. These amounts are arrived at as follows

Defined benefit expense and the defined benefit liability

The amount of the defined benefit expense which should be recognised in the employer’s
statement of profit or loss for an accounting period is arrived at by totaling:

 The present value of the current service cost for the period

 The interest cost for the period

 Any actuarial losses for that period

And then subtracting

 The expected return on plan assets for the period

 The amount of any employee contributions made during the period

 Any actuarial gains for that period

The amount of the defined liability which should be shown in the employer’s statement of
financial position at the end of the period is equal to the present value of the defined benefit
obligation at the end of the period, less the fair value of the plan assets at that date. If the result
of this calculation is negative, it’s an asset that is recognised and not a liability.

Example,

A company which prepares annual accounts to 31 December has operated a defined benefit
pension scheme for many years. The scheme is non-contributory (i.e. employees are not required
to make contributions). At 31 December 2008, the company’s statement of financial position
showed a defined benefit liability of K575,000, made up as follows

K’000

Present value of defined benefit obligation 2,430

189
Fair value of plan assets 1,855

575

The following figures relate to the year to 31 December 2009:

K’000

Expected returns on pension plan assets 170

Actual return on pension plan assets 155

Employer contributions 450

Benefits paid 375

Interest cost 220

Present value of current service cost for the year 415

Present value of defined benefit obligation at end of year 2,810

Fair value of plan assets at end of year 2,190

Calculate the defined benefit expense which should be shown in the company’s statement of
profit or loss for the year to 31 December 2009. Also calculate the defined benefit liability (or
asset) which should be shown in the company’s statement of financial position as at that date.

Solution

The only figures not supplied in the above example are the actuarial losses or gains with regard
to the defined benefit obligation and with regard to the plan assets. These can be computed as
follows:

K’000

Present value of DB obligation at start of year 2,430

Interest cost 220

190
Present value of current service cost for the year 415

Benefits paid during the year (375)

2,690

Actuarial losses (balancing figure) 120

Present value of defined benefit obligation at end of year 2,810

K’000

Fair value of plan assets at start of year 1,855

Expected return on plan assets 170

Employer contributions 450

Benefits paid during the year (375)

2,100

Actuarial gains (balancing figure) 90

Fair value of plan assets at end of year 2,190

Note that the difference between the expected and actual return on plan assets forms part of the
actuarial gain or loss for the year and is not shown separately. The amounts which should be
shown in the company’s financial statements for the year to 31 December 2009 can now be
calculated as follows

Define benefit expense

K’000

Present value of current service cost for the year 415

Interest cost 220

Actuarial losses (120-90) 30

Expected return on plan assets (170)

Defined benefit expense in statement of comp income 495

191
Defined benefit liability

K’000

Present value of defined benefit obligation at end of year 2,810

Fair value of plan assets at end of year 2,190

DB Liability in statement of financial position 620

The defined benefit expense for the year is K495,000 but the employer’s contributions were only
K450,000. This explains why the DB liability has increased by K45,000 during the year, from
K575,000 to K620,000.

Accounting for actuarial gains and losses

IAS19 offers a choice of accounting treatment for actuarial gains and losses. The simplest is the
one adopted in the above example, which is to recognise actuarial gains and losses in the period
in which they occur, by including them in the calculation of the defined benefit expense for that
period. However, the following alternatives are available

i. Actuarial gains and losses may be excluded when calculating the employer’s defined
expense for the period but may instead be recognised in other profit or loss. This
accounting treatment is permitted only if the employer adopts it for all actuarial gains and
losses and for all defined benefit plans

ii. A portion of actuarial gains and losses may be excluded when calculating the defined
benefit expense for the period but may instead be carried forward as part of the defined
benefit liability. IAS19 accepts that, in the long term, actuarial gains and losses may
offset one another and therefore the standard allows comparatively modest gains and
losses to be carried forward in that way

Generally, actuarial gains and losses which do not exceed 10% of the present value of the
defined benefit obligation and also do not exceed 10% of the fair value of the plan assets may be
carried forward. Gains and losses outside this 10% corridor must be recognised in the statement
of profit or loss but may be spread over the average remaining working lives of current

192
employees. The actuarial gains and losses which are recognised in the statement of profit or loss
may be included in the defined benefit expense or in other profit or loss

UNIT 30: SHORT-TERM EMPLOYEE BENEFITS

Short-term employee benefits are defined by IAS19 as employee benefits (other than termination
benefits) which fall due wholly within twelve months after the end of the period in which the
employees render the related service. This means that short-term employee benefits are those
which fall due either during the period in which the employee provides the services to the
employer or within twelve months of the end of that period. The definition of short-term
employee benefits covers items such as:

I. Wages and salaries

193
 II. Short-term holiday pay

III. Profit-sharing payments and bonuses payable within twelve months of the end of the
period in which the related employee’s services are performed

IV. Non-monetary benefits ( medical care, company cars) for current employees

In general, accounting for short-term employee benefits presents no great difficulties. If an

employee has rendered services to an employer during an accounting period, the employer’s
financial statements for that period should recognize:

a) An expense equal to the amount of the short-term employee benefits due in exchange for
those services, and

b) A liability (accrued expense) equal to any part of this expense that has not been paid by
the end of the period

An exception to the requirement to recognize an expense arises if another standard requires or

permits the cost of the benefits to be recognized as an asset. For instance, IAS16 requires
employee benefits to be capitalized if they arise directly from the construction acquisition of an
item or property, plant and equipment.

Note that short-term employee benefits are measured on an undiscounted basis, since the
required payments are made either during the relevant accounting period or within twelve
months of its end, so that the effect of discounting would be minimal.

Short-term compensated absences

IAS19 uses the expression short-term compensated absences” to refer to paid employee absences
(e.g. paid holiday and paid sick leave) which occur during the period in which the related
employee services are performed or which are expected to occur within twelve months of the end
of that period. Entitlement to paid absences falls into two categories
1. “accumulating” compensated absences, which can be carried forward and used in future
periods if the current period’s entitlement is not used in full
2. “non cumulating” compensated absences, which cannot be carried forward if not used
during the current period.
In the case of accumulating short-term compensated absences, the employer’s statement of
financial position should show a liability equal to the expected amount payable in future periods
as a result of unused entitlement carried forward.
Example

194
A company gives an annual entitlement to paid holiday leave. If there is any unused leave at the
end of the year, employees are entitled to carry forward the unused leave for up to 12 months. At
the end 2009, the company’s employees carried forward in total 50 days of unused holiday leave.
Employees are paid K100 per day

State the required accounting for the unused holiday carried forward.
Solution
The short-term accumulating compensated absences should be recognized as a cost in the year
when the entitlement arises, in this case, 2009.

Profit sharing or bonus plans

Profit shares or bonuses payable within 12 months after the end of the accounting period should
be recognized as an expected cost when the entity has a present obligation to pay it (when the
employer has no real option but to pay it. This will usually be when the employer recognizes the
profit or other performance achievement to which the profit share or bonus relates

Example
Moore Co runs a profit sharing plan under which it pays 3% of its profit for the year to those
employees who have not left during the year. Moore Co estimates that this will be reduced by
staff turnover to 2.5% in 2009.
Which costs should be recognized by Moore Co for the profit share?
Solution
Moore Co should recognize a liability and an expense of 2.5% of net profit

Practice question
A company has 1,000 employees, each of whom is entitled to ten days of sick leave in each
calendar year. Unused sick leave at the end of each year may be carried forward for up to one
further calendar year. Sick leave is taken first out of the current year’s ten-day entitlement and
then out of an unused entitlement brought forward.
At 31 December 2009, the average unused entitlement is six days per employee. Based on past
experience, the company expects that 85% of employees will take no more than ten days sick
leave in the forthcoming year but that the remaining 15% of employees will each take an average
of twelve days.
195
Assuming an average cost to the company of K120 per day of paid sick leave, calculate the
liability which should appear in the company’s statement of financial position at 31 December
2009 in relation to paid sick leave.

Disclosure Requirements
IAS 19 makes no specific disclosure requirement with regard to termination benefits, but certain
disclosures may be required by other standards. For instance
a) IAS 1 Presentation of financial statements requires separate disclosures of the nature and
amount of any material expense. This may apply to apply in the case of termination
payments
b) IAS24 Related Party Disclosures requires disclosures relating to benefits provided for
key management personnel. This requirement includes the disclosure of termination
benefits
There are no specific disclosure requirements for short term employee benefits in the standard.

196
197