13

14

GOODWILL & INTANGIBLES

E&E Ch.19
M Ch. 6

Financial Reporting Council (FRC) AP ‘Staff Research Report: Investor Views on Intangible

Assets and their Amortisation’, (FRC: London) March

2014.

IMPAIRMENT

E&E Ch.17 pp 440-445

M Ch. 7
LEASING

E&E Ch.18
M Ch. 9
ACCOUNTING FOR ASSOCIATES & JOINT VENTURES

E&E Ch.25

ABJ Ch. 28
M Ch. 20

FOREIGN EXCHANGE

E&E Ch.26

M Ch. 21

ADVANCED CONSOLIDATION ACCOUNTING

Handout

EARNINGS QUALITY

Dechow. P.M. and Schrand, C.M. “Earnings Quality”, The Research Foundation of CFA
Institute, (2004).

Healy, P. M., and Wahlen. J.M. “A Review of the Earnings Management Literature and
Its Implications for Standard Setting.” Accounting

Horizons, vol. 13, no. 4 December 1999,:365–383.

IASB IAS 33: Earnings per share (2009). On line available on :

http://www.iasplus.com/standard/ias33.htm
Jones, J., “Earnings management during import relief
investigations”, Journal of Accounting Research

(1991),29, 193-228.

Lin, J. W. and Hwang, M. I., “Audit Quality, Corporate Governance, and Earnings
Management: A Meta-Analysis”, International Journal of

Auditing, (2010), vol 14: 57–77, doi:10.1111/j.1099-

1123.2009.00403.x

Peasnell, K. V., Pope, P. F. & Young, S. “Detecting earnings management using cross-sectional
abnormal accruals models”, Accounting and Business

Research, (2000) Vol. 30, No. 4, pp. 313–26.

15

Schipper, K. “Earnings Management”, Accounting Horizons, (1989).

Vol.3, no. 4 (December):91–102.

SEGMENTAL REPORTING

E&E Ch. 4, pp. 73-80

M Ch. 24.

SHARE BASED PAYMENTS

E&E Ch. 15 pp. 385 -391

FINANCIAL INSTRUMENTS

E&E Ch. 14

M Ch. 11

REVENUE RECOGNITION

E&E Ch. 8
ACCOUNTING FOR RETIREMENT BENEFITS

E&E Ch. 15, pp. 369-385

M Ch. 4

FINALISATION OF ACCOUNTS

Beattie, V., Fearnley, S. and Hines, T. ‘Reaching Key Financial Reporting Decisions: How
Directors and Auditors Interact’. Chichester: John Wiley

(2011) – Ch. 1 & 5.

ACCOUNTING INFORMATION & FINANCIAL MARKETS

Handout
16

COURSEWORK – PART 2 (20% OF TOTAL UNIT MARK)
Required:

Critically evaluate the Corporate Sustainability Report published by Tata Motors Limited for 2013-2014 (available on Moodle) against the Global Reporting Initiative Guidelines and broader considerations of best practice, with particular emphasis on reporting to diverse stakeholder groups.

Further guidance:

-Briefly outline what sustainability accounting is and how it has evolved and what the Global Reporting Initiative is;

– As part of your analysis identify three stakeholder groups and briefly discuss how the company engages with them in the sustainability reporting process, how it identifies and reports on their particular concerns and what those concerns are perceived to be;

– Consider to what extent the Sustainability Report (2014) published by Tata Motors Ltd.:

a) deserves the A+ rating against GRI criteria that it claims, and

b) satisfies broader views of sustainability reporting which criticise initiatives like the GRI Guidelines.

Provide reasons for your conclusion.

Word Limit: 1700 words excluding bibliography. There is no 10% allowance, the real word limit is not 1,870 words! The word count should be stated on the university front sheet. A falsely stated word-count is an assessment offence which may result in a penalty, including the reduction of the mark to 0%.

Due Date: To be handed in to the Assessment Office no later than 11 December 2015. Remember to attach the appropriate front sheet – these can be obtained from the Assessment Office.

There are mark penalties for late hand in. (Corruption of computer disks is not an adequate excuse for late submission, as work should be adequately backed up.) As noted above, no work submitted after 20 workings days, which in this case is 19 January 2016, can be awarded a mark.

The work should be word processed. Font size should be between 11 and 14 and easy to read e.g. calibre, arial, times new roman. Line spacing should be between 1.5 and 2 with (approx.) 4 cm margins all round. Pages must be numbered.

17
Referencing: Students must reference sources using the Harvard APA. Guidance on this method of referencing can be found at www.referencing.port.ac.uk. Reference should be made to the primary source, except when the primary source can no longer be obtained. Poor citation of sources will result in a loss of marks.

Plagiarism: This is an individual assignment and students are reminded of the need to avoid plagiarism (see section above). Students should ensure that all sources are fully cited in footnotes and in the bibliography and that indentation or quotation marks (as appropriate) are used when quoting.

Turnitin: Students should retain an electronic copy of their coursework, so that it may be checked by a member of staff should a member of staff feel the need to do so. Tutors are entitled to request an electronic copy of coursework if they have any doubt about the accuracy of the stated word count and/or any suspicion of plagiarism. Failure to send an electronic copy of the coursework to a member of staff who has asked for a copy may result in a penalty.

If any student has a query about any of the above matters and wishes to obtain clarification or further information please contact your Unit Co-ordinator or personal tutor.

Learning outcomes: The intended learning outcomes of the assignment are to enable students to:

-Critically assess alternative conceptual and regulatory frameworks for financial reporting.

-Evaluate the interaction between accounting and society. -Improved written communication skills.

Marking will be undertaken in accordance with the marking criteria grid below and the University of Portsmouth grading criteria for UG level six.
18

Marking Failure < 40% Third 2.2 2.1 First
Criteria – 40-49% 50 – 59% 60– 69% >70%
Knowledge & Either no Work which Work that Very good Very good work
understanding evidence of attempts to attempts to work – contains
of relevant literature address the address the contains most accurate,
issues, use of being topic with topic with of the relevant
literature consulted or limited some information material,
(40%)
irrelevant to understandin understanding required, is demonstrates

the g. Literature and analysis, accurate and understanding
assignment is presented key aspect of relevant and of complex
set. uncritically in the subject demonstrates subject matter
a descriptive matter understanding and is able to
way. covered. Clear of the subject view it in a wider
evidence and matter and context and with
application of attempts to some originality.
readings view it in a Use of wide
relevant to the wider context. range of sources
subject. Able to which have been
critically analysed,
analyse the applied and
literature. discussed.
Weak Limited Some analysis, Shows some Shows excellent
Critical academic or analysis but evaluation & originality of analysis,
analysis intellectual developing problem thought with originality and /
skills. Mainly professional / solving. good critique or creativity of
(40%) descriptive. practical and analysis approach, clear
skills. assumptions, and well-
is aware of the articulated.
limits of
knowledge.
Conclusions Unsubstantiat Limited Evidence of Good Analytical and
(10%) ed / invalid evidence of findings and development clear
conclusions findings & conclusions shown in conclusions well
based on conclusions grounded in summary of grounded in
anecdote and supported by theory / arguments theory and
generalisatio theory / literature based in theory literature
n only, or no literature / literature. showing
conclusions development of
at all. new concepts.
Presentation: Poor: lack of Reasonably Good Demonstrates Excellent
clarity, use of clarity; clear communication very good communication
grammar, grammatical presentation; skills; mainly communication skills;
correct mistakes; referencing accurate skills; mainly consistently
spelling, referencing contains referencing; accurate accurate
referencing
either omitted some errors few/no referencing; referencing;
(10%)
or contains and grammatical or very few/no virtually no

serious omissions spelling errors grammatical or errors;
errors. but uses the spelling errors scholarly, well-
Harvard organised
format; some treatment of
grammatical/ material
spelling
mistakes

19

University of Portsmouth General Grading Criteria
Level 6
80+ As below plus:

• Outstanding work – contains accurate, relevant material, demonstrates understanding of complex subject matter and is able to view it in a wider context. Shows originality and confidence in analysing and criticising assumptions, is aware of the limits of knowledge. Likely to add new insights to the topic and approaches the quality of published material.

• Evidence of extensive research, uses and presents references effectively.

• Outstanding quality in terms of organisation, structure, use and flow of language, grammar, spelling, format, presentation, diagrams, tables etc.

70- As below plus:
79

• Outstanding work – contains accurate, relevant material, demonstrates understanding of complex subject matter and is able to view it in a wider context. Shows originality and confidence in analysing and criticising assumptions, is aware of the limits of knowledge.

• Evidence of extensive research, uses and presents references effectively.

• Excellent in terms of organisation, structure, use and flow of language, grammar, spelling, format, presentation, diagrams tables etc

60- As below plus:

69

• Very good work – contains most of the information required, is accurate and relevant and demonstrates understanding of the subject matter and attempts to view it in a wider context. Shows some originality of thought with good critique and analysis assumptions, is aware of the limits of knowledge.

• Well-researched, good use and presentation of references.

• Very good in terms of organisation, structure, use and flow of language.

20

Level 6

50-
59 As below plus:

• Work that attempts to address the topic with some understanding and analysis, key aspects of the subject matter covered.

• Research extends to primary sources. Appropriately cited and presented references.

• Satisfactory presentation with respect to presentation, organisation, language, grammar, spelling, format, diagrams, tables etc.

40- ?

49 • Adequate work which attempts to address the topic with limited understanding and analysis.

• Some research using texts, Internet and key reference sources with reference citation and presentation according to convention.

• An attempt to follow directions regarding organisation, structure, use and flow of language, grammar, spelling, format, diagrams, tables etc.

?

30-

39 FAIL – Anything which is inadequate in most or all of the following: length, content, structure, analysis, expression, argument, relevance, research and presentation. Work in this range attempts to address the question / problem but is substantially incomplete and deficient. Serious problems with a number of aspects of language use are often found in work in this range.

0-

29 FAIL – No serious attempt to address the question or problem, and / or manifests a serious misunderstanding of the requirements of the assignment. Acutely deficient in all aspects.
21

LECTURE NOTES & SEMINAR QUESTIONS FOR AUTUMN TERM
Week 1 Lecture
The Regulation of Financial Reporting

Learning outcomes

On completion of this lecture students should:

1. Understand some of the arguments for and against the regulation of financial reporting;

2. Understand various theoretical perspectives that describe who is likely to gain the greatest advantage from the implementation of accounting regulation;

3. Understand that accounting standard-setting is a very political process which seeks the views of a broad cross-section of account users;

4. Understand the relevance to the accounting standard-setting process of potential economic consequences arising from accounting regulations.

Introduction

In the UK the following regulators are relevant to financial reporting:

– International Accounting Standards Board (IASB) sets accounting standards (IFRSs) which are mandatory for group accounts of listed companies;

– Financial Reporting Council (FRC) sets standards for all entities who are not required / have chosen not to adopt IFRS on advice of the Accounting Council. It is responsible for enforcing both sets of accounting standards and pro-actively reviews a sample of company accounts for non-compliance. It also promotes high standards of corporate governance by publishing the UK Corporate Governance Code.

– Financial Conduct Authority has replaced the Financial Services Authority (FSA) and is now responsible for regulating the stock exchange.

Financial reporting is quite heavily regulated in most countries and tends to be more heavily regulated following an accounting failure (e.g. Enron, Parmalat).
Given that it is widely accepted that the markets for most goods and services should be free and competitive rather than regulated, we will examine the arguments for treating accounting information differently. First we will consider the arguments against regulation.

22
Free market view

This view treats accounting information like any other good. Forces of demand and supply should operate in a free market to determine the optimal supply of information about an entity. Shareholders would pay by accepting increased accounting costs thereby reducing their return.
There are a number of mechanisms in support of this view:

1. Private contracting perspective

Reduce agency costs (Jensen & Meckling, 1976; Watts & Zimmerman, 1978) – costs that arise as a result of delegation of decision making from principals (e.g. shareholders) to agents (e.g. managers).

Even in the absence of regulation there are private economics based incentives for the organisation to provide credible information about its operations and performance to certain external parties, or the costs of the organisation’s operations will rise.
Without such information external parties (e.g. shareholders) will assume that the managers might be operating the business for their own personal gain (e.g. shirking, consuming excessive perks) rather than with the aim of maximising the value of the organisation (and hence shareholder wealth). Potential external shareholders will therefore assume managers act in their own rational self interest and therefore reduce the amount they are prepared to pay for shares. Similarly lenders will charge a higher price for funds. The combined effect is to increase the cost of capital and therefore reduce the value of the entity.
To counter this (and managers who have large holdings of company shares will have an incentive to counter this) managers will voluntarily enter into contracts with shareholders and lenders which make a clear commitment to promote strategies favouring the interests of investors.

E.g. Debt covenants – Agreement with lenders to keep future debt levels below a certain % of assets or the terms of the loan can be renegotiated. This will lower the risk faced by lenders and should impact on the cost of debt finance.
23

Reward managers with a bonus based on reported profits reducing their propensity to ‘shirk’ so ensuring that interests of shareholders and mangers are aligned.

In such arrangements accounting numbers are the basis of the contract. So even if there were no regulation over financial reporting, companies would have incentives (i.e. reduce agency costs) to produce accounting information.
It is further argued that the organisation is best placed to decide what information should be disclosed to increase the confidence of shareholders, and that regulation may actually impede this process. The same incentives would encourage organisations to have their accounting information audited by an external party, thereby increasing the reliability of data and further reducing the cost of capital.
In practice while this argument suggests regulation is unnecessary, in reality the existence of many groups with different information requirements would make contracting difficult and expensive.
2. Market related incentives

Other arguments are based around the existence of market incentives which, it is suggested, remove the need for regulation.

1. Market for managers (Fama, 1980). Assumes that there is an efficient market for managers and that a manager’s past performance will impact on their future earnings.

Managers will have incentives to maximise the value of their organisations (favourable view of their own performance) including providing optimal amount of accounting information.

2. Market for corporate takeovers. Assumes that an underperforming company will be taken over and the existing management team will be replaced. To reduce this threat managers will be motivated to maximise the value of the firm and will produce accounting information to demonstrate this

Both these arguments assume managers know the optimal amount of information to be

disclosed.

24

3. Market for ‘lemons’ (Ackerlof, 1970). In the absence of any disclosure from a company, the markets in valuing its shares will assume it is a lemon (i.e. underperforming company). So no information is viewed as the same as disclosing bad news. Therefore there is an incentive for companies to release information as failure to do so may impact on manager’s wealth (e.g. lower market value). Taking the argument further Skinner

(1994) says that there is evidence that if managers fail to disclose bad news in good time the markets will penalise them (e.g. reduced share price). So when a company is doing well managers make ‘good news disclosures’ to distinguish them from less successful companies, but when a company is doing less well, managers make pre-emptive bad news disclosures to ensure their reputation is not damaged. Of course there is an information asymmetry in that the manager knows more than market investors so they won’t know that bad news is being withheld until it emerges later.
Arguments in favour of regulation

The arguments in favour of a free market rely on users paying for the goods or services that are being produced and consumed. Such arguments break down when we consider the consumption of free or public goods (e.g. lighthouses, defence). Accounting information is a public good because people can use it without paying for it and pass it on to others – they are

‘free-riders’. True demand is therefore understated because people know they can consume the product without paying for it, so it means few people have the incentive to pay for it, producers therefore lack an incentive to produce it, and this leads to underproduction of information. To address this underproduction, regulation is necessary.
Regulation may result in over-production because some groups (e.g. investment analysts) demand more accounting information safe in the knowledge that they will not have to pay for it. Accounting standards overload creates compliance costs for companies. It is difficult to get balance right as measuring costs and benefits is problematic.
25

Public interest theory

Public interest theory holds that regulation is supplied in response to demand from the public to correct inefficient or inequitable market practices. It provides a level playing field with everyone having access to the same information. The regulatory body is considered to benefit society as a whole rather than any vested group, and will need to balance social benefits with social costs of regulation. So in respect of financial accounting, in a capitalist economy society needs confidence that capital markets efficiently allocate resources to productive assets and regulation is considered an instrument to create such confidence.
Critics of this view argue that the cost of regulation is frequently underestimated and the benefits overestimated (Posner, 1974)
Capture theory

Admits the possibility that while regulation might initially be put in place for the public interest, subsequently regulation will become controlled by those parties who it was supposed to control. It is difficult for the regulator to remain independent of those it is regulating, as continuity over a period of time often depends on satisfying the expectations of the regulated. E.g. Accounting standard setters have often been captured by big accounting firms (Australia 1980s).
New regulators are often portrayed as objective and independent but the membership are often drawn heavily from the groups being regulated (e.g. members of professional accountancy bodies) – usually because they best understand the issues. Recently attempts have been made to try and ensure greater independence of accounting regulators e.g. IASB, but the membership is still professionally qualified accountants and conditioned by their experience. But who else could engage in accounting regulation?
A related view (private interest view of regulation, e.g. Posner, 1974) is that other groups other than that being regulated will also lobby regulators thus ensuring that no one group can effectively capture the regulator.

26

Economic consequences of regulation

Before considering theories which address the influence of private interests in the regulatory process, it is first necessary to consider why groups might care about accounting regulation.
One view is that accounting regulations just affect how economic transactions are reflected in accounts without any impact on underlying economic reality. However, there is considerable evidence that accounting regulations have real social and economic consequences for many organisations and people. E.g. in early 2000s a new accounting standard for pension liabilities was brought in which introduced new volatility into the measurement of pension fund assets and liabilities in defined benefit company pension funds (e.g. final salary pension schemes). This has been cited as a contributory factor in the closure of many such schemes and their replacement with less generous money purchase / defined contribution schemes.

Given that there might be winners and losers, groups are likely to employ lobbying in an effort to shape the regulations to maximise the benefit to the lobbying organisation.
Lobbying or economic interest group theory of regulation

This assumes that groups will form to protect their own self interests. Different groups with incompatible or mutually exclusive interests are viewed as being in conflict with one another and will lobby the regulator for different things. This view adopts no notion of public interest, but private interests are considered to dominate the regulatory process.
E.g Hope and Gray (1982) show how the aerospace industry successfully lobbied against a proposal to show all R&D expenditure as an expense in the income statement (thereby reducing reported profits) . The final standard permitted R&D to be capitalised in certain circumstances. At the time companies government defence projects were priced on the basis of % of net assets, so a higher net assets figure (i.e. capitalisation rather than expensing) the more the government could charge for contracts.

2005 – IAS 39 lobbied against by European banks (not a fair reflection of economic reality) resulted in a revised version being adopted within EU.

27

Even regulators can be an interest group employing strategies to maintain power and privilege (E.g. Broadbent and Laughlin, 2002). They will tend to look favourably on groups able to meet their needs.
Accounting regulation as an output of a political process

If accounting regulation affects the distribution of wealth in society it will be a political process. Therefore it is difficult to accept the view that financial reporting can be objective and neutral. All standard setters encourage various affected parties to make submissions on draft proposals as part of their ‘due process’. Proposed requirements must be acceptable to various groups and the benefits should exceed the costs, but this is difficult to measure. Consideration of possible economic consequences involves trade offs between different groups. Final answer is generally the result of a political process with compromise at the heart. It has been argued (e.g. Beaver, 1973) that without a knowledge of economic consequences policy makers would be unable to set optimal accounting standards, but the IASB would argue against taking economic consequences into account.
Conclusion

In this lecture we have considered how perceptions about potential economic and social consequences impact on the development of accounting standards and questioned whether accounts can be objective and neutral even when the standard setter claims that they are.

References

Ackerlof, G. A. (1970), ‘The market for lemons: quality uncertainty and the market mechanism’, Quarterly Journal of Economics, Vol. 84 pp. 488-500.

Beaver, W.H. (1973), ‘What should be the FASB’s objectives?’, The Journal of
Accountancy, Vol. 136, pp. 49-56.

Broadbent, J. & Laughlin, R. (2002), ‘Accounting choices: Technical and political tradeoffs and the UK’s private finance initiative’, Accounting, Auditing & Accountability, Vol. 15 (5), pp. 622-54.

Fama, E. (1980), ‘Agency problems and the theory of the firm’, Journal of Political Economy, Vol 88, pp. 288-307.
28

Hope, T. & Gray, R. (1982), ‘Power and policymaking: The development of an R&D standard’, Journal of Business Finance and Accounting, Vol. 9 (4), pp. 531-58.

Jensen, M.C. & Meckling, W. H. (1976), ‘Theory of the firm: Managerial behaviour, agency costs and ownership structure’, Journal of Financial Economics, Vol. 3 (October), pp. 305-60.

Posner, R. A. (1974), ‘Theories of economic regulation’, Bell Journal of Economics and Management Science, Vol. 5 (Autumn), pp. 335-58.

Skinner, D. J. (1994), ‘Why firms voluntarily disclose bad news’, Journal of Accounting Research, Vol. 32 (1), pp. 38-60.

Watts, R. L. & Zimmerman, J. L. (1983), ‘Towards a positive theory of the determination of accounting standards’, Accounting Review, Vol. 53 (1), pp. 112-34.

Seminar Questions

1. It has been argued that the extent of regulation in respect of financial reporting is excessive and should be reduced. What arguments do they use?

2. Is regulation more likely to be required in respect of public goods than other goods? Why?

3. What assumptions are made about the motivations of regulators in:

a. The public interest theory of regulation;

b. The capture theory of regulation;

c. The economic interest theory of regulation.

4. Review the structure, membership and financing of the IASB (www.ifrs.org). (Look under ‘about us’ both ‘about the organisation’ and ‘governance & accountability.) What characteristics make you believe that it is seeking to set standards in the public interest and which give you cause for doubt?

5. ‘Accounting standards merely regulate the reporting of economic transactions, they have

no impact upon the underlying economic performance or social impact of an entity.’ Evaluate this claim.

6. What do we mean when we say that financial accounting standards are the outcome of a political process? Why is the process political?
29

Week 2 Lecture
Global Harmonisation of Accounting

Learning Outcomes

As a result of this lecture students should:

1. Understand why international accounting differences evolved and why harmonisation is now considered an appropriate objective.

2. Be familiar with the current attempts to harmonise global financial reporting and evidence of its impact.

Causes of International Differences in Accounting

1. Legal systems

Common law – Some countries (e.g. UK, USA) have a legal system that relies on a small amount of statute law, which is then interpreted by the courts to produce case law. Each judgment sets a precedent.

Codified Roman law – Other countries (e.g. France, Italy) have a more elaborate system based on Roman law. Company law or commercial codes need to establish rules for accounting & financial reporting. Less flexibility so accountants are more like book-keepers in such countries.

2. Providers of finance

Some countries (e.g. Italy, Germany) have a strong tradition of bank finance, others (e.g. UK, USA) have larger numbers of companies reliant on private shareholders for finance. In the latter group of countries managers are accountable to shareholders via the annual report.

Germany has 7.9 domestic listed cos / million of population, UK has 44.4. (The Economist, 2005). Reporting to shareholders is not always considered the prime objective of financial reporting. Banks have alternative ways of getting the information they need (e.g. a seat on the board).

3. Taxation

Tax rules tend to be more prescriptive than accounting rules, which rely on judgement and greater disclosure. E.g. In UK depreciation is used for accounting purposes depends on estimates of future life and residual value. Capital allowances replace depreciation for tax purposes – for many assets charged at 20% flat rate.

In some countries (e.g. Germany) the tax rules are also the accounting rules. Traditionally less emphasis on the true and fair view, just follow the rules.

4. The profession

30

Strength & size of accountancy profession will vary enormously from country to country. E.g. UK CCAB professional bodies had 315,000 members in 2004 v. 11,000 in Germany v. 17,000 in France). Countries with strong capital markets had a demand for companies to produce annual audited financial statements which in turn creates a demand for accountants. Will impact on their

ability to influence / control accounting regulation.

So continental Europe typically has more bank finance, a smaller accountancy profession, accounts influenced by tax practices and code law. While UK / US financial reporting has traditionally been driven by capital markets, large profession, and common law approaches, but relatively separate from tax.

5. Culture

Hofstede (1980) argues that culture includes a set of societal values which drives institutional forms and practices. Suggested 4 basic dimensions:

Individualism v. Collectivism e.g. Italy has strong emphasis on individual and the family, Sweden emphasises interdependence and society

Large v. small power distance – degree of acceptance of uneven distribution of power Strong v. weak uncertainty avoidance – e.g. how tolerant of deviant beliefs.

Masculinity v. Femininity – To what extent does society value achievement, heroism, assertiveness & material success v. Relationships, quality of life, modesty.

These broad societal values have been applied to accounting by Gray (1988).

6. Other external influences

E.g. Colonial influences – British Companies Acts appear in many other countries. Strong similarities between UK and Canada, Australia and New Zealand.

Great Depression in US brought in extensive disclosure requirements & state control.

Rationale for Harmonisation

1. Investors (individual and corporate) make global investment decisions. Need high quality comparable information.

The expectation would be that global standards would generally be of higher quality than local GAAP, and the reduction in reporting discretion would improve transparency.

Even if the quality of financial reporting per se does not improve, IFRS makes it less costly for investors to compare firms across markets, thereby reducing information asymmetries and/or lower estimation risk. May lower cost of monitoring by analysts.

2. Companies providing such information should be able to raise finance more cheaply as perceived risk is linked to the return demanded by investors.
31

3. Companies seeking the cheapest finance may have be listed on more than one stock exchange. Would save costs of preparing two sets of accounts if reporting requirements are identical.E.g. Tomkins plc is listed on New York and London stock exchanges. They used to have to prepare accounts in UK GAAP and then reconcile those to US GAAP. Now accounts prepared under IFRS are accepted by the US.

4. Multinational groups of companies who prepare consolidated accounts may save cost converting accounts of foreign subsidiaries. Consolidations are easier if all the accounts of subsidiaries are prepared on the same basis. NB Even though IFRS is standard throughout the EU for listed companies unlisted companies (i.e. subsidiaries) are often permitted to use local GAAP at present.

5. International accountancy firms (i.e. KPMG, Ernst & Young, PriceWaterhouse Coopers, Deloittes) might benefit (staff mobility, training costs etc.)
How is Global Harmonisation being Achieved?

Some history:

1973 International Accounting Standards Committee (IASC) formed – developing international accounting standards (IAS) & promoting harmonisation; Slow progress – part time board, lack of resources. The standards were weak with lots of options.

IASC had no power to force national standard setters to adopt its standards. Most large developed countries chose to develop their own standards rather than use IAS.

1995 IOSCO (composed of international securities market regulators such as Financial Services Authority [FSA] in UK, Securities Exchange Commission [SEC] from US) agreed to work with IASC on programme of core standards that could be used by foreign companies listed on a stock exchange. For further progress the number of options needed to be reduced.

1990’s call for global standards from UN, IMF, World Bank etc. due to increased globalisation (increase in world trade, more foreign investment, growth of multinationals). Also economic crisis in Asian countries demonstrated need for high quality accounting.

1999 IOSCO approved core standards & Recommended its members allow use of IAS. This was a very important seal of approval.

1998 IASC began a constitutional review recognising that faster progress will be required in future and that a largely part time board would not be able to deliver. The review resulted in the International Accounting Standards Board (IASB) and a new standard setting structure.

32

International Standard Setting Structure

From 2001 IASC Foundation oversees the process. It is composed of 22 trustees and is responsible for funding (better funded than IASC).

It appoints 15 (rising to 16 by 2012) members of the International Accounting Standards Board (IASB) which issues IFRS. They are a mixture of auditors, preparers, users & academic. There is no no fixed geographical split of members – expertise is key requirement.

New international standard setting structure

Monitoring
IASC Foundation
Board
Trustees

International
Standards Advisory IASB Financial Reporting
Council Interpretations

Committee (IFRIC)

The IASC Foundation also appoints members to:

Standards Advisory Council (SAC) (45 members) gives the IASB advice on agenda decisions and priorities and informs them of views on major standard setting projects. A forum for wider participation in the standard setting process. Effectively a sounding board.

International Financial Reporting Interpretations Committee (IFRIC) reports to the IASB and has the role of interpreting the application of IFRS. It provides guidance on big application issues and may plug loopholes and issue interpretations. It is not a 24/7 helpline.

The whole structure is independent but with questionable accountability.
33

So…to deal with complaints of lack of accountability, since January 2009 the IASC Foundation has been monitored by the Monitoring Board composed of stock exchange regulators (i.e. institutions with some public accountability – usually key personnel appointed by governments).

They are responsible for appointing Trustees and ensuring that they discharge their duties in accordance with constitution.

The European Dimension

Another set of harmonisation initiatives affecting the UK have come via the EU.

Treaty of Rome (1957) set out to establish a common market. Specific provisions for the free movement of goods, services, people and capital. Harmonisation of

company law, including financial reporting, has been part of this process. Directives issued which must be incorporated into national law e.g.:

Fourth Directive – Company law

Seventh Directive – Consolidated accounts Eighth Directive – Auditing.

All became part of the Companies Act 2006.

Directives were a mixture from different traditions e.g. standard format of accounts from France etc., true & fair view from UK.

Provided very broad framework, many options still existed. The Directives mostly covered disclosure and presentation rather than measurement. National accounting standards had to fill in the detail.

The EU knew more was needed but the idea of European Accounting Standards Board considered and rejected.

EU Adoption of IFRS

Picking up on the IOSCO recommendation…

2000 European Commission proposed to Council and Parliament that all listed companies in EU be required to produce consolidated financial statements in accordance with international standards for year ends beginning after 1 January 2005.

June 2002 the EU Council of Ministers gave final approval to a Regulation implementing the 2000 proposal. A Regulation is directly incorporated into national law.

It is not legally possible for the EU to delegate accounting standard setting to a private organisation over which it has no influence so there is an endorsement mechanism. Any approved standard must be ‘ conducive to the European public good’.
34

The final decision on whether to endorse each IFRS is the remit of an Accounting Regulatory Committee (ARC). Composed of member state representatives chaired by the European Commission.

Technical expertise is provided by the European Financial Reporting Advisory Group (EFRAG) -private sector expert body. It acts as a link between IASB and EU.

They don’t always say ‘yes’, – EU adopted a ‘carved out’ version of IAS 39 on Financial Instruments. There is always the danger that a Euro version of IFRS will emerge.

The EU Regulation replaces all national standards and some company law, but domestic law implementing Accounting Directives will continue to apply to broader accounting issues (e.g. In UK the requirement to prepare and file audited accounts)

.

Accounting rules for other entities not covered by the Regulation (e.g unlisted companies) remain at the discretion of individual countries. In the UK they can adopt IFRS, use the UK Financial Reporting Standard or the FRSSE if they deemed ‘small’.

There is no international system of enforcing international accounting standards. That remains the responsibility of national regulators (e.g. FRC in the UK).

Australia adopted Australian equivalents of IFRS from 2005, NZ –2007, Canada – 2011, China and Brazil are also in the process of converging.

Nearly 100 countries permit use of IFRS
57 require use of IFRS for all listed companies….BUT not the US…yet.

This matters because the New York Stock Exchange is the largest in the world (4x bigger than Tokyo and London).

IFRS and US GAAP

2003 B & FASB (US) committed to convergence through ‘Norwalk Agreement’.

Joint conceptual framework project to agree fundamental principles underpinning financial reporting

2006 Joint ‘roadmap’ of convergence projects which could remove the requirement for foreign registrants filing IFRS based accounts to reconcile to US GAAP.

2007 SEC (body responsible for overseeing US standard setting) announced no need for reconciliation.

2008 SEC announced a detailed roadmap for adoption of IFRS. Not a commitment. Conditional on progress on certain issues notably accountability and funding.
35

US has had an enormous influence on IFRS recently.

People sue one another more frequently, lawyers are powerful. Consequently accounting standards tend to be based on detailed rules rather than broad principles. The results of that may run against common sense (e.g. use of ‘bright lines’ – rules that determine whether one accounting treatment or another completely different accounting treatment apply in a given situation). Lawyers are likely to be employed to uncover loopholes which can be exploited.

Post Enron many in the US expressed the view that they needed to rethink their approach to regulation

Principles based approach to setting standards

IASB says it adopts a principles based approach.

The focus is on established general principles derived from an underlying conceptual framework. Limited guidance on application encourages professional judgement to be exercised in applying standards. However many (particularly in the US) see this as dangerous in a litigious environment as it creates uncertainty.

Also many recent IFRSs are very similar to US equivalents (e.g. IFRS 8 on segmental reporting is a copy of the US equivalent)..

Emphasis on fair values adds further to complexity.

Recent developments

Following the 2008 US election a new chair of SEC was appointed and announced that they were

‘not bound by any roadmap’. Also in US CFOs lobbied the SEC arguing that the cost of conversion from US GAAP to IFRS was excessive.

October 2009 – IASB and FASB reaffirmed their commitment to convergence i.e. standards that are ‘increasingly similar if not the same’ (FASB website, 2011).

In Europe some influential people (FEE and chief executive of FRC) have argued that the IASB should be concentrating on improving standards and that the convergence project is a distraction. Also there is continuing resentment from some countries (notably France and Germany) that the

IASB’s approach ignores European needs and is ‘anglocentric’.

Problems in the world economy have increased tensions on a number of fronts.

July 2012 – SEC staff report is neutral on the incorporation of IFRS into the financial reporting system for US. There are no expectations that US will adopt IFRS in the foreseeable future.

36

December 2012 – IASB announced that it would continue to work on the conceptual framework without the involvement of FASB.

March 2014 – European Parliament criticises the IFRS Foundation for poor governance structures, a lack of transparency and close links with accountancy industry. Could threaten its future funding of the IASB.

Evidence on the effect of mandatory IFRS adoption

There have been numerous empirical studies investigating the economic consequences of mandatory IFRS adoption in Europe and elsewhere.

1. The first set of studies investigate compliance with, and accounting policy choices under, IFRS. Kvaal and Nobes, (2010 & 2012) find IFRS policy choices influenced by pre-IFRS reporting practices, suggesting that IFRS adoption is not sufficient to facilitate comparability of financial statements.

2. Other studies have examined the impact of IFRS on accounting practices e.g. Ahmed, Neel and Wang (2012) found an increase in income smoothing, aggressive reporting of accruals and a significant decrease in timeliness of loss recognition compared with a control group of non-adopting companies.

There is no evidence that mandatory IFRS adoption unanimously enhances transparency or quality of financial statements.

3. Other researchers have investigated the direct economic consequences of mandatory IFRS adoption in capital market.

Li (2010) identifies a reduction in the cost of equity capital, but only in countries with strong legal enforcement.

Florou and Pope (2012) examine the impact on institutional investors (arguably the group most likely to benefit from higher quality financial statements) demand for equities. They show that increased institutional holdings are concentrated in countries where enforcement and reporting incentives are relatively high and where the differences between local GAAP and IFRS are relatively high.

Overall there is fairly clear support for capital market benefits but these are dependent on appropriate institutional supporting arrangements.

While there is some evidence of positive capital market effects (depending on the quality of enforcement and other institutional arrangements), there is little evidence that transparency and comparability of financial statements have improved.

Conclusion

Massive change in the last 10 – 15 years due to increased globalisation.
37

IFRS has emerged as the global standards of choice.

US has the largest capital markets in the world so their involvement is necessary for true global standards. They were almost on board, were given a lot of influence over the future shape of standards, but it now appears as if progress has stalled. US GAAP may re-emerge as an alternative set of global accounting standards.

References

Ahmed, A.S., Neel, M. and Wang, D., (2013), ‘Does mandatory adoption of IFRS improve accounting quality?’, Contemporary Accounting Research, forthcoming.

Florou, A. and Pope, P. F. (2012), ‘Mandatory IFRS adoption and institutional investment decisions’, The Accounting Review, Vol. 87, No. 6, pp. 1993-2025.

Gray, S. J. (1988) ‘Towards a theory of cultural influences on the development of accounting systems internationally’, Abacus, March.

Hofstede, G. (1980) ‘Culture’s consequences: International differences in work-related values’
Beverly Hills, California: Sage.

Kvaal, E. and Nobes, C. (2010),’ International differences in IFRS policy choice: aresearch note’,
Accounting and Business Research, Vol. 40, No. 2, pp. 173-187.

Kvaal, E. and Nobes, C. (2012), ‘IFRS policy changes and the continuation on national patterns of IFRS practice’, The European Accounting Review, Vol. 21, No. 2, pp. 343-371.

Li, S. (2010), ‘Does mandatory adoption of International Financial Reporting Standards in the European Union reduce the cost of equity capital?’, The Accounting Review, Vol. 85, No. 2. Pp. 607-636.

38

Global harmonisation – Seminar questions

1. Distinguish between standardisation and harmonisation.

2. Explain how international differences in the ownership and financing of companies could lead to differences in financial reporting.

3. The IASB’s objective is to develop global accounting standards in the public interest. What does ‘in the public interest’ mean?

4. Which parties stand to gain from the international harmonisation of accounting?

5. What arguments are there against the process of international harmonisation of accounting?

6. Arguably the EU is the IASB’s biggest customer for its standards. Would it be appropriate for IASB to be made accountable to the EU Commission, or at least for Europeans to have a larger say in the process of developing standards?

7. What is meant by regulation based on ‘principles’ rather than ‘rules’?

8. Results of empirical research indicate that foreign equity investment increases when countries have mandatory adoption of IFRS and effective enforcement. Discuss why this might be the case.
39

Week 3 Lecture
Accounting theory and conceptual frameworks

Learning outcomes

On completion of this lecture students should:

1. Understand and evaluate the reasons for accounting standards;

2. Understand and evaluate how accounting policies and standards are set;

3. Understand the concept and development of accounting theory and its role in the standard setting process;

4. Understand and evaluate different approaches to the development of accounting theory;

5. Evaluate and analyse the development of conceptual frameworks

6. Understand the purposes and scope of the IASB conceptual framework
Reading

Elliott & Elliott Chapter 10 Concepts – A conceptual framework

Alexander , Britton & Jorissen, International Financial Reporting & Analysis (5th Edition)

Chapter 8

Why have Accounting standards?

Accounting can be judgmental in nature, with a wide variety of possible approaches to questions such as:

How do we value inventory? Cost? Net realisable value, replacement cost? How do we account for leases?

Even accepting the underlying principles of matching, accruals, prudence, historical cost and going concern a considerable amount of judgement and therefore range of approaches to answering these questions would exist.

For example:

Inventory valued at the lower of cost and net realisable value, But what basis FIFO, LIFO, Average cost, Standard cost?

What costs should be included? (production, overheads, based on actual or normal levels of production?)

How should the selling price be determined for net realisable value? (List, discounted, past prices achieved?)

40

What costs should be taken into account in calculating the net realisable value?
Requirement for standards

There is a general acceptance that standards are required to define the way in which accounting transactions are presented in financial statements so that their measurement and presentation are less subjective. Standards should improve the credibility and comparability of financial statements.

Credibility

The accounting profession and regulators would lose all credibility if they permitted companies experiencing similar events to produce financial reports that disclosed significantly different performance and net assets simply because they could select different accounting policies.

Comparability

In addition to financial statements allowing investors to evaluate management performance (i.e their stewardship of resources) they should provide a basis for investors to make valid inter-company comparisons of performance and trends. In order to do this investors need reliable standardised data
UK Accounting Standards – brief history

Prior to 1970 when the Accounting Standards Committee was set up there was no clear statement of accounting principles other than the accounts should be prudent, be consistent, follow accrual accounting and be based on the assumption that the business would remain a going concern.

Two major accounting scandals, GEC and Pergamon led to a lack of confidence in the accounting profession:

GEC

• 1967 GEC Ltd. made a hostile bid for AEI Ltd. AEI Ltd. forecast profit £10m for year in their pre-takeover accounts and recommended shareholders to reject the bid.
• The bid was successful and GEC acquired AEI.
• In AEI’s final accounts the actual result was a £4.5m loss.

• The difference of £14.5 million largely due to different judgements (e.g. stock valuations).

Pergamon

• 1968 Audited accounts produced showing a profit of £2m

• Independent review of the accounts carried out by PW that the profit should be reduced because of incorrect valuations and bases of valuation primarily

41

This lead to widespread criticism of accountancy profession, there was too much scope for different judgements. Calls were made for standards to narrow the areas of difference in

accounting practices and generally improve standards of reporting.

As a result the ASC was set up in 1970 and the first accounting standard issued in 1971. The ASC was initially regulated by the accounting profession. But eventually problems of creative accounting re-emerged in 1980s due to:

– Weak standards offering too many options;

– No means of enforcement.

In 1990 following a review a new structure was put in place and the Accounting Standards Board (ASB) became the UK standard setting body. In 2004, the regulation was further strengthened following various accounting scandals particularly in the US, with the ASB reporting to the regulator, the Financial Reporting Council.

Financial Accounting Standards Board

In 1973, the Foundation established the FASB to establish and improve standards of financial accounting and reporting for nongovernmental entities. Consistent with that mission, the FASB maintains the FASB Accounting Standards CodificationTM (Accounting Standards Codification) which represents the source of authoritative standards of accounting and reporting, other than those issued by the SEC, recognized by the FASB to be applied by nongovernmental entities.

Principles or Rules based approach

However, it has been a continuing view in the UK that standards should not be a comprehensive set of rigid rules and that they should not supersede the exercise of informed judgement in determining what constitutes true and fair in each circumstance. This is known as a “principles” based approach.

Other jurisdictions take a different view and have attempted to produce a comprehensive set of rigid rules to prescribe accounting in given circumstances. This is known as a “rules” based approach.

How are financial accounting policies and standards set?

There are three main inputs to accounting policy making function:

– Accounting Theory: developed and refined by the process of accounting research

– Political Factors: refers to the effect upon policy making of those who are subject to it (including different regulatory bodies and professional bodies)

42

– Economic Conditions: classic example is the acceleration of mergers and acquisitions causing the debate how to consolidate financial reporting for complex entities. Development of increasingly complex financial instruments and the financial crisis.

Once policy is made, Accounting Practice implements the policy which has to be audited by the independent external auditors, and users observe effects of implementation.

The Financial Accounting Environment
Financial accounting practices have not evolved in a vacuum. They are often responses to dynamic changes in financial, political, economic and commercial changes.

e.g How to deal with the effect of changing prices in periods of high inflation, increased pressure on regulation and standards following the global financial crisis,. Changing commercial practices e.g leasing, granting of share options

What should accounting standards be based on?

Accounting Theory

What is theory?

• A belief or priciple that guides actions or behaviours

• An idea or formal set of ideas that is intended to explain why something happens or exists.

• The set of principles on which a particular subject is based.

• More generally a conjecture or an opinion.

43

From an accounting perspective

Accounting theory will address;

• A description, explanation or a prediction[of accounting practice] based on observations and/or logical reasoning,

• Logical reasoning in the form of a broad set of principles that provide a general framework of reference by which accounting practice can be evaluated and guide the development of new practice and procedures.
Examples of theories
• How should leases be treated in the statement of financial position (balance sheet)?
• Should replacement values be used in the statement of financial position (balance sheet)?
• Changing price levels should be accounted for using Current Cost Accounting
• Changing accounting policies has no effect on a company’s share price.
• Profits are better predictors of share prices than cash flows.
• Why do firms change auditors?

Approaches to the development of accounting theory

Accounting has a long history, but we are going to consider two main theoretical approaches to the development of accounting theory:

• Empirical inductive approach
• Deductive approach
Empirical Inductive Approach

• The first approach, used for setting of early standards

• Theories are formed by generalising from experience (often ‘anecdotal’ rather than systematically researched). Looking at how transactions are accounted for (use of best practice) and standardising.

• Still much used in standard setting

• Acceptance from practitioners/auditors…..because they are effectively setting the standards

BUT

• Difficult to apply to new developments in a period of rapid economic, political and commercial change because there is little time for effective and uniform practices to evolve. e.g. Off balance sheet finance, intangibles, exotic financing

44

• Concern because existing practice can be perceived as having been tainted because it has been determined by finance directors and auditors

• Can result in inconsistent accounting standards and treatments
Deductive Approaches

• Perceived to be a purer theoretical approach involves developing a theory from basic propositions, premises and assumptions that result in accounting principles that a logical conclusion about the subject

• Based on reasoning from assumptions, i.e given a set of circumstances or type of transaction an answer can be derived

• But from who’s perspective?

• True Income: first deductive approach based on Economic theories

– Price level accounting, led to development of individual standards in the early
80’s

• User needs
– Conceptual frameworks (practitioner based)
– Behavioural Research
– Market Reaction Studies

• Advantages,
– ability to develop “untainted accounting principles”,
– ability to deduce an answer in new or unusual transactions

• Problems

– From whose viewpoint should the principles be set? Economists, preparers of accounts, users of accounts?
What is a Conceptual Framework?

A conceptual framework is an example of a deductive approach to accounting. It has been defined as:

• ‘A statement of generally accepted theoretical principles which form the frame of reference for a particular field of enquiry’

International GAAP
45

• Important elements of this definition

– Generally accepted
– Theoretical principles
– Frame of reference

• The Conceptual Framework sets out the concepts that underlie the preparation and presentation of IFRS-compliant financial reports. The objective of the project is to develop a comprehensive Conceptual Framework that assists the IASB in developing Standards and reviewing existing ones.

What FASB thinks …

The Conceptual Framework is a coherent system of interrelated objectives and fundamental concepts that prescribes the nature, function, and limits of financial accounting and reporting and that is expected to lead to consistent guidance. It is intended to serve the public interest by providing structure and direction to financial accounting and reporting to facilitate the provision of unbiased financial and related information. That information helps capital and other markets to function efficiently in allocating scarce resources in the economy and society. (Emphasis added)

What do conceptual frameworks cover?

Conceptual frameworks generally cover the following areas:

• The objectives of financial statements

Attempts to address who the users of financial statements are and the type of information that they should be provided with

• The reporting entity

Addresses when an entity should report information and which activities to include in the report

• The qualitative characteristics of financial information

What characteristics does the financial information need to satisfy to be useful? Relevant / Reliable? Timely? Consistent?

• The elements of financial statements

An element is an item that could appear in financial statements and provides a definition of those elements e.g Asset, Liability, Equity, Income, Expenses

• Recognition and measurement of the elements in financial statements

When should the elements of financial statements be recognised and derecognised? How should the elements be measured? E.g historical cost, valuation, current cost
46

• Presentation of financial statements

What information should be presented, how should it be summarised, how should items of unusual incidence or amount be disclosed

Development of Conceptual Frameworks

A number of attempts have been made since the 1970s to create a coherent conceptual framework:

• Academic writing
• 1974 Trueblood Report issued in the USA
• 1975 The Corporate Report issued in the UK
• 1978-1982 The FASB Conceptual framework

• 1989 The IASC Conceptual Framework was issued (summary at http://www.iasplus.com/standard/framewk.htm)

• 1992 -1999 ASB’s Statement of Principles issued in the UK
• 2005 Joint IASB/FASB project to harmonise CF’s commenced
• September 2010 Chapters 1 and 3 of new CF published covering:
– The objectives of general purpose financial reporting; and
– Qualitative characteristics of financial information
• 2010 joint project stalls

• 28 September 2012 IASB announce that they will reinstate and complete the update of the Conceptual Framework, but that it will no longer be a joint project with FASB

• July 2013 IASB issue discussion paper regarding updating the conceptual framework

• May 2015 Two exposure drafts are issued covering areas within the Conceptual Framework where the IASB feel an amendment or further guidance are needed.
IASB Conceptual Framework

This is currently based on the IASC “Framework for the Preparation and Presentation of Financial Statements” issued in 1989 as amended by the joint IASB/FASB project in 2010 for the objectives of financial statements and the qualitative characteristics of financial reporting information. Because of the membership and standard setting process of the IASB the focus is on developing a conceptual framework through consensus, which should take account of the views of practitioners and users of accounting information. The IASB conceptual framework deals with the following matters:

a) the objectives of general purpose financial reporting
b) the qualitative characteristics of useful financial information
c) the going concern assumption (underlying assumptions of financial reporting)
d) the elements of financial statements
e) recognition of the elements of financial statements
f) measurement of the elements of financial statements

47

g) concepts of capital maintenance

Purposes and scope of the IASB Conceptual Framework

a) to assist in the development of future international standards and in the review of existing standards

b) to provide a basis for reducing the number of alternative accounting treatments permitted by international standards

c) to assist national standard-setters in developing new national standards
d) to assist preparers of financial statements in applying international financial statements

e) to assist preparers of financial statements in dealing with topics that are not yet covered by international standards

f) to assist users of financial statements in interpreting the information contained in financial statements prepared in accordance with international accounting standards

g) to assist auditors in forming an opinion as to whether financial statements conform with international standards

h) to provide those who are interested in the work of the IASB with information about its approach to the formulation of international accounting standards

Seminar questions:

1. Explain and evaluate the requirements for and development of accounting standards in the UK.
2. Discuss the advantages and disadvantages of the inductive approach and deductive approach in forming accounting theories.
3. Accounting standards and regulations should aim to state how to deal with all situations. Discuss
4) a)Provide a definition of a conceptual framework for financial reporting and discuss its role in the UK.

(8 marks)

b) Identify and evaluate the main issues likely to be addressed by a conceptual framework.

(7 marks)

48

Week 4 Lecture
Conceptual frameworks 2
Learning outcomes

On completion of this lecture students should:

1.Understand and evaluate the content of the IASB conceptual framework;

2.Understand the status of the development of the IASB conceptual framework;

3.Understand and evaluate the criticisms/objections to the conceptual framework

4.Critically appraise the content of the IASB conceptual framework
Reading

Elliott & Elliott Chapter 10 Concepts – A conceptual framework

Alexander , Britton & Jorissen, International Financial Reporting & Analysis (5th Edition)

Chapter 8

Alfredson et al, Chapter 1, Applying International Financial Reporting Standards

The IASB Conceptual Framework

Current status of the IASB Conceptual Framework

The IASB conceptual framework is in the process of being updated into a conceptual framework for financial reporting. This project was originally going to be a joint project with the FASB (USA) to develop a common conceptual framework as part of the harmonisation project with the FASB. This project was started in 2005 and has only produced 2 updates to the current conceptual framework. The project stalled in 2010 and recently the IASB announced that they intend to complete the project to update the conceptual framework without the FASB. After consultations following the discussion paper issued in 2013, the IASB issued two exposure drafts detailing the proposed changes to the conceptual framework. Changes include the reintroduction of the prudence concept together with clarification on how it will support neutrality throughout financial reporting. Comments on the exposure drafts are being taken until October 2015 with a view to finalise the revisions in 2016.

As a result the currently operable conceptual framework for IFRS is based on the IASC

“Framework for the Preparation and Presentation of Financial Statements” issued in 1989 as amended by the joint IASB/FASB project in 2010 for the objectives of financial statements and the qualitative characteristics of financial reporting information. The IASB conceptual framework deals with the following matters:
49

a) the objectives of general purpose financial reporting (updated in 2010)
b) the qualitative characteristics of useful financial information (updated in 2010)
c) the going concern assumption (underlying assumption of financial reporting)
d) the elements of financial statements
e) recognition of the elements of financial statements
f) measurement of the elements of financial statements
g) concepts of capital maintenance

Current content of the IASB Conceptual Framework

a) The objectives of general purpose financial reporting

As the conceptual framework is a user based framework the definition of users is critical in shaping the overall framework.

The conceptual framework attempts to establish the objectives of financial reporting and not just of financial statements.

Primary users
It states that the fundamental objective of general purpose financial reporting is to:

“provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity”.

“Those decisions involve buying, selling or holding equity and debt instruments and providing or settling loans and other forms of credit”.

Users expectations

The framework then states that users expectations about returns (e.g cash available for dividends, ability to make principal and interest payments, projected increase in market value) depend on their assessment, amount, timing and uncertainty of future cash inflows to the entity.

Other users

The framework notes that “other parties such as regulators, members of the public and other creditors may also find general purpose financial reports useful. However, those reports are not primarily directed to these other groups.”

Information to be reported

To make these assessments users need information about:
50

• The economic resources and claims against the entity (Statement of Financial Position)

• Changes in these resources and claims arising from operations (Financial performance) (income statement)

• Changes in these resources and claims arising from other events and transactions, e.g issuing new shares (Statement of changes in equity)

• The impact of operating, investing and financing activities on an entity’s cash flows
(Statement of Cash Flows)

Basis of preparation

General purpose financial reports are based on management’s best estimates, judgements and models rather than exact depictions and are “not designed to show the value of a reporting entity, but they provide information…to estimate the value of the reporting entity”.

Critical appraisal of the objectives of general purpose financial reporting

• Right users?

Current definition of users has a focus on capital markets, rather than the wider definition of users in the past which also included (Government, employees, customers, suppliers).

The IASB response was that information that meets the needs of the specified primary users is likely to meet the needs of users both in shareholder and stakeholder jurisdictions (Framework 2010) and that government and regulators don’t need to be stated as users because they have the right to request/demand information in any case.

It is clearly a questionable assumption that focus on capital market users will meet these broader requirements.

• Right objective?

All the conceptual frameworks are based on the idea of reporting information which is useful for making economic decisions. Is the information provided (Statement of Financial Position, Income Statement, Statement of Changes in Equity, Statement of Cash Flows) fit for this purpose?

To be useful for making economic decisions information reported would need additional characteristics:

• Forward looking e.g profit forecasts
• Current values (including unrealised profits)
• Include the impact of future events
• Including currently unrecognised assets and liabilities

51

• Would require increasing use of fair value measurement and increasing subjectivity/judgements.

Possible alternative objective

Stewardship – Reporting what management has done would be an alternative, making management accountable for its actions-arguably the satisfied initial purpose that financial reporting in certain jurisdictions.

Some authors consider that knowledge of what will be reported makes management well-behaved and so makes a whole range of economic relationships possible (e.g borrowing and equity shares). They also consider that it makes accounting more objective.

Stewardship was included in the 1989 framework but is missing from the objectives of the current framework.

b) Qualitative characteristics

Fundamental Qualitative Characteristics:

Fundamental qualitative characteristics distinguish useful financial reporting information from information that is not useful or misleading. For financial information to be useful it must be relevant and faithfully represent what it purports to represent.

• Relevant

Relevant information is capable of making a difference in decision making by virtue of its predictive or confirmatory value.

• Faithfully representation

Financial information is a faithful representation if it depicts the substance of an economic phenomenon completely, neutrally and without error. The framework states

“Of course perfection is seldom, if ever achievable, the objective is to maximise those qualities to the extent possible”.

Enhancing Qualitative Characteristics:

Enhancing qualitative characteristics distinguish more useful information from less useful information and should be maximised to the extent possible. The enhancing qualitative characteristics are:

• Comparable

Comparability enables users to identify similarities in and differences between two sets of financial reports. Making decisions about an entity will be enhanced if comparable information is available about similar entities.

52

• Verifiable

Verifiability helps assure users that information is faithfully represented. It is achieved if different observers could reach the same general conclusion that the information represents the economic phenomena or that a particular recognition or measurement model has been appropriately applied.

• Timely

Timeliness means having the information available to decision makers before it loses its capacity to influence decisions.

• Understandable

Understandability is the quality of information that enables users to comprehend its meaning.

Constraints

Providing useful financial reporting information is limited by two pervasive constraints:

• Materiality

Information is material if its omission or misstatement could influence the decisions that users make on the basis of an entity’s financial information.

• Costs

The benefits of providing financial information should justify the costs of providing that information

Concerns over the characteristics

Writers have expressed concerns over the apparent relegation of characteristics such as verifiability, comparability and understandability to supporting qualitative characteristics. Some see this as further evidence towards a move to fair value accounting where valuation is more subjective and, therefore, less easy to verify, compare and understand.

c) Assumptions
Two underlying assumptions underpin the conceptual framework:

Accruals

The accrual basis of accounting should be used in the preparation of general purpose financial reporting. The effects of accounting and other transactions should be recognised when they occur rather than when cash or its equivalent is paid or received.

Going concern

Financial statements are prepared under the assumption that the entity will continue to operate for the foreseeable future. If management intends to liquidate the entity’s operations

53

then the going concern assumption is put aside and the financial statements are prepared on a break-up basis.

d) Elements

The framework contains definitions of the elements underlying financial statements, namely assets, liabilities, equity, income and expenses:

Asset

An Asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

Key parts of the definition:

? Controlled by the entity – the entity must have control over the future economic benefits of the asset

? A result of past events – the event or events giving rise to the entity’s control of the asset must have occurred

? Future economic benefit – must have the potential to contribute directly or indirectly to the flow of cash and cash equivalents to the entity

? Probable- more likely than not to occur
Liability

A Liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

Key parts of the definition:
? Present obligation

? Past events

? Outflow of economic resources

? Probable

Equity

Equity is the residual interest in the assets of the entity after deducting all its liabilities.

Income

Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.

54

The definition of income therefore includes revenue which is described as arising in the ordinary course of business, e.g sales, fees, interest, rent and royalties; and gains. Gains can arise from the disposal of non-current assets and revaluations of securities and can be realised and unrealised. Gains are normally displayed separately because they are not part of the ordinary course of business. Certain gains are treated as part of comprehensive rather than net income. The treatment of gains and losses is dealt with by IAS1

Expenses

Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

Expenses therefore include expenses in the ordinary course of business and losses.

Criticisms
• Every time something is defined either:
– it is defined in new terms, leading to infinite regress, or
– it is defined in terms of existing definitions, leading to circularity

E.g. ‘assets’ defined in terms of ‘resource’, ‘control’, ‘economic benefits’ and ‘past events’, which are not themselves defined. This is the idea that income or profit should be a surplus declared only after we are sure that an entity, individual or group is as well off at the end of the year as it was at the start (i.e. we have maintained captal).

– International GAAP (2007 p 110) points out that the definition is circular: assets are ‘economic benefits’ so that an ‘asset’ is something that leads to a flow of ‘assets’.

• Income and Expense are not defined from its economic activities, but from their influences on assets / liabilities

• Users want to know about all future economic events – the CF restricts them to those which are controlled and have arisen because of past events

• Equity is defined as the residual ‘assets – liabilities’ but not otherwise explained, although later discussion mentions ‘ownership interest’. Shareholders rights fall a long way short of ownership.

e) Recognition

• Recognition is the process of incorporating in the balance sheet or income statement an item that meets the definition of an element and satisfies the following criteria for recognition:
• Recognise if
– Probable flow of economic benefits
– Cost or value can be measured reliably

55

Criticisms
• Further restricts the class of items users are allowed to know about
• Fails to deal with problem of probability

– How to include a large liability which is only 45% likely to occur, or an asset with a 55% probability of occurrence

f) Measurement

Measurement is the process of determining monetary amounts at which the elements of the financial statements are to be carried in the statement of financial position and income statement. Because the concepts of equity, income and expenses are highly dependent on the concepts of assets and liabilities measurement of equity, income and expenses are dependent upon the measurement of assets and liabilities.

The framework recognises that a number of different bases may be used for assets, liabilities, income and expenses in various degrees and combinations. The framework does not prescribe any measurement basis, but rather describes the following, the most common of which is historical cost:

• Historical cost
• Current cost
• Realisable or settlement value
• Present value
g) Concepts of capital maintenance

This is the idea that income or profit should be a surplus declared only after we are sure that an entity, individual or group is as well off at the end of the year as it was at the start (i.e. we have maintained capital).

The framework identifies two main concepts of capital, the financial concept and the physical concept:

Financial capital maintenance
The financial concept of capital may take two forms:

• Protection of invested money in historical terms (nominal financial capital) where profit is earned based on the change in net assets in a period after taking account of distributions to and contributions from an owner during a period.

• Protection of invested purchasing power, under this concept profit is earned after maintain the purchasing power of the business, involves restating the opening assets to take account of inflation

Physical capital maintenance

56

• Under this concept a profit is only earned if the operating capacity embodied in the net assets at the end of the period exceeds the operating capacity of the net assets at the start of the period

Most entities adopt a financial concept of capital, normally in the absence of severe inflation, nominal financial capital.

Objections to and criticisms of the Conceptual framework

Readers have criticised the conceptual framework for a number of reasons, whilst these criticisms have valid arguments it is inevitable that a framework of this type will attract criticism for a number of reasons as it is unlikely to satisfy everyone about the requirements for financial reporting. The criticisms include:

? Seeking to do the impossible

? CFs aim to achieve agreement on theoretical principles for accounting

? But accounting choices redistribute wealth so people made worse off by them cannot be expected to agree

? (In the new CF FASB seems to have abandoned the idea of general agreement and now only wants the CF to lead to ‘consistent guidance’)

? The framework attempts to be descriptive rather than prescriptive, i.e it decribes a range of different practices particularly with regard to measurement rather than prescribing a required approach

? Wrong objectives

All the CFs are based on the idea of reporting information which is useful for making economic decisions. But, information for this purpose would not look anything like what is currently reported; its characteristics would be:

? Forward looking eg profit forecasts

? Current values (including unrealised profits)

? Including effects of future events

? Including currently unrecognised assets and liabilities

? But, increasing use of fair value measurement, moves reporting in this direction

? Wrong choice of rules

? Decision-usefulness demands current values

? Current values are difficult to measure and subjective

? IASB avoids the issue of choosing measurement rules

? Recognition rules fails to deal with problem of probability
57

? How to include a large liability which is only 45% likely to occur, or an asset with a 55% probability of occurrence

? The conceptual framework can be ambiguous

The conceptual framework is intended to provide a common language for accounting. However, some argue that the principles and definitions in the conceptual framework are broad and individuals may interpret them differently.

? Internal inconsistencies

? Users want to know about all future economic events – the CF restricts them to those which are controlled and have arisen because of past events

? Equity is defined as the residual ‘assets – liabilities’ but not otherwise explained, although later discussion mentions ‘ownership interest’.

? Balance sheet (statement of financial position) focus

? Assets and liabilities are defined, with income, expenses and equity being recognised and defined as changes in assets/liabilities

? HC accounting defines income and expense through the realisation and matching principles

? Accordingly if the CF is rigorously applied it will produce radical changes in accounting

Future Development of the IASB Conceptual Framework

The IASB Conceptual Framework project was paused after the 2010 updates in part because of fairly fundamental differences between the IASB and FASB over certain key definitions e.g what constitutes an asset. At a meeting on September 27, 2012 it was agreed that The IASB will conduct this project as an IASB project, not as a joint project with any other standard-setter, in other words the project will continue as an IASB project and not be a joint project with the FASB, with a view to completing the update of the conceptual framework by September 2015.

The IASB Conceptual Framework has been redrafted and an exposure draft published in May 2015. Comments are being welcomed until October 2015 before the Conceptual Framework is expected to be updated in 2016. The exposure draft allows business owners and accounting practitioners an opportunity to highlight issues and loopholes prior to the finalisation of the new framework.

The exposure drafts cover all sections of the existing framework with a number of notable changes namely:

1) The reintroduction of the Prudence concept, being the exercise of caution in areas of accounting judgement, and highlighting it’s close relationship with neutrality.

58

2) An increased emphasis on faithful representation, specifically in areas where substance should prevail over legal form.

3) The Statement of Comprehensive Income has been amended to be the Statement of Financial Performance.

4) Recognition and derecognition is addressed in light of proposed changes to the definition of assets, liabilities and equity.

Issue of discussion paper in July 2013

In July 2013 the IASB issued a discussion paper designed to carry forward the conceptual framework debate. Comments are due on the discussion paper by January 2014 and during 2014 it is expected that draft proposals will be put forward to update the conceptual framework. When developing the Discussion Paper, the IASB focused on those areas that have caused it problems in practice or that needed updating to reflect concepts developed by the IASB in other projects.

These include:
(a) definitions of assets and liabilities;
(b) recognition and derecognition of assets and liabilities;
(c) measurement;
(d) equity;
(e) profit or loss and other comprehensive income (OCI); and
(f) presentation and disclosure.
On the face of it this will be a widespread change to the existing framework designed to update the framework and address some of its anomalies and inconsistencies, but the original project plan did not seek to address any changes to the objectives of financial reporting and the qualitative characteristic, nor did it seek to remove the range of measurement options.

The discussion paper invoked a large number of responses and these were summarised by the board in an overview: http://www.ifrs.org/Current-Projects/IASB-Projects/Conceptual-Framework/Documents/Feedback-on-Conceptual-Framework-Discussion-Paper.pdf

As a result of this the IASB issued a summary document incorporating some of the findings into revised project plan in July 2014. The full document can be found at: http://www.ifrs.org/Current-Projects/IASB-Projects/Conceptual-Framework/Documents/Effect-of-Board-decisions-DP-July-2014.pdf

The key elements of this document are as follows:

• Exposure draft to be issued by the end of 2014

• New Conceptual framework to be issued by end of 2015
• 18 month implementation period once new framework issued

• No fundamental revision to the objectives of financial reporting and qualitative characteristics, although stewardship and prudence are mentioned.

Summary

59

The framework describes the basic concepts that underlie financial reporting in accordance with International Financial Reporting Standards. It serves as a guide to the development of new accounting standards and in resolving accounting issues that are not addressed directly in an accounting standard. It attempts to apply a scientific approach, but the framework as it stands has many critics who claim that it is far from a theory in a scientific sense. It is in the process of being updated, but is unlikely to satisfy all its critics because of fundamental remaining differences over the purpose of financial reporting.
Seminar questions:

Q1. Is the labour force an asset?

Q2: Forecasted Losses

Fly-by-night is an airline that operates a single route. Because of a business recession that has reduced passenger loads, and led to ruinous price cutting by its competitors, Fly-by-night forecasts that it will incur operating losses for the next two years. Although management thinks those losses are inevitable, the company is solvent and expects to return to profitability after two years have elapsed. Should the company make a provision for losses from its operations?

Q3: There has been considerable debate for many years regarding the objective of financial reporting. The IASB’s conceptual framework states that its prime purpose is to enable users of accounts to make decisions. Critically appraise this view.

(10 marks)

A good answer will appraise
a) What the conceptual framework says that general purpose financial reporting is for
b) Appraise the users identified by the conceptual framework

c) Appraise the types of information that is likely to be required to make financial reporting decision useful

d) Consider alternative suggestions for the purpose of financial reporting.

Q4: Some readers have criticised the Conceptual framework, critically appraise their views.

Q5: What changes to the conceptual framework are being considered in the current exposure draft issued in May 2015?

(HINT a summary of the ED can be accessed at http://www.ifrs.org/Current-Projects/IASB-Projects/Conceptual-Framework/Documents/May%202015/Snapshot_Conceptual%20Framework_May2015.pdf ) This document can also be found on Moodle.

60

Week 5 Lecture
Social, Environmental & Sustainability Reporting

Learning outcomes

After this lecture students should:
a) Understand the nature of social, environmental and sustainability reporting;
b) Appreciate the arguments for and against it;
c) Be familiar with the various forms it might take and evaluate each;
d) Understand the way in which it has developed in the UK in the recent past.

Introduction

“Corporations dominate all aspects of our lives. Their power affects the quality of life, food, water, gas, electricity, seas, rivers, environment, schools, hospitals, medicine, news, entertainment, transport, communications and even the lives of unborn babies……Unaccountable corporate power is damaging the fabric of society, the structure of families, the quality of life and even the very future of the planet” (Mitchell & Sikka 2005).

It has therefore been argued that companies should be accountable to groups other than shareholders and for issues other than their financial performance. The proposed form of this broader reporting has been evolving since the 1970s and been given various names – corporate social reporting, social and environmental reporting and more recently corporate responsibility reporting and sustainability reporting.

What is Corporate social responsibility (CSR)?

Social responsibility as practised by business is controversial. A socially responsible business engages in activities and incurs costs which may benefit society or groups within it.

The stakeholder view of company objectives is that many groups of people have an interest in what the company does. Management must balance the profit objective with the pressures from the non-shareholder groups.

Conceptualized by (Carroll 1979) as “the social responsibility of business encompasses the economic, legal, ethical and discretionary expectations that a society has of organizations at a given point of time”.

Academics regularly identify four main aspects to corporate social responsibility:

? Legal responsibility: It is expected that an organisation should be able to fulfil its fiduciary duty while following the legal and regulatory requirements that have been established by society.

? Economic responsibility or fiduciary duty: the organisation needs to fulfil its economic objectives and fiduciary duties to for example shareholders

61

? Legitimacy: the organisation needs to operate ethically and meet its ethical responsibilities

? Charitable activities and discretionary activities involve being a good corporate citizen through for example charitable donations, family friendly work policies.

? Corporate social responsibility changes over time in line with the extent of legislation and the expectations of society.

If a company has social responsibility then it has responsibility to undertake particular actions (or refrain from doing so) and to provide an account of such actions.

Gray et al. (1996) defines corporate social reporting as ‘the process of communicating the social and environmental effects of organisations’ economic actions to particular interest groups within society and to society at large’ (p.3).

Corporate social reporting (CSR) tends to cover the following issues: – Environmental issues

Air pollution, water pollution, waste disposal, recycling, energy conservation, potential environmental liabilities

– Racial & sexual equality
– Overseas policies

Trade with regimes with poor human rights records, conditions of employment of overseas workers.

– Product safety & quality
% returns.
– Health & safety at work
Accident statistics.
– Employee involvement
Measures taken to improve it
– Donations
Charitable & political.
– Community involvement
Donations / sponsorship to art, sport, recreation, education.

-Stakeholder involvement

What is environmental reporting?

Environmental issues are likely to have a growing impact on business in the future due to legislation and pressure from stakeholders. Originally considered part of corporate social responsibility but increasingly considered sufficiently important to be considered separately.

Likely to consist of the following:

-Separately identifying environmentally related costs and costs within he conventional accounting systems;
62

– Devising new forms of financial and non-financial accounting systems, information systems

– Developing new forms of performance measurement, reporting and appraisal for both internal and external purposes;

– Identifying, examining and seeking to rectify areas on which conventional (i.e. financial) and environmental criteria are in conflict;

Theoretical justifications against / for corporate social responsibility

It must be recognised that extending the scope of business responsibility and disclosing CSR activities will impose a cost on the company which needs to be justified by some benefit.

1. Market related justifications

Friedman (1962):

‘Few trends could so thoroughly undermine the very foundations of our free society as the acceptance by corporate officials of a social responsibility other than to make as much money for their shareholders as possible’ (p. 133).

Implies narrow view of accountability: -to shareholders;
-in financial terms;
– based on legal contracts.

Business is owned by the shareholders, so the assets of the company are the shareholders’ property. Managers have no moral right to dispose of business assets on non-business objectives, as this has the effect of reducing the return available to shareholders.

It is for governments to make laws on social issues (e.g. health & safety, minimum wages) and to raise taxes.

Within that framework it is management’s job to maximise wealth as this is the best way society can benefit from a business activities:

– maximising wealth has effect of increasing tax revenues available to the state to spend on socially desirable objectives.

– maximising wealth for the few is sometimes held to have a ‘trickle down’ effect on the disadvantaged members of society.

– Many company shares are held by pension funds, whose ultimate beneficiaries may not be the wealthy.

While this view seems to rule out CSR, what if there is a positive link between corporate social responsibility?
63

If a company management acts in a socially responsible way they are more likely to possess the skills to run a company well, improving its financial performance and making it an attractive investment (Alexander and Bucholz, 1978).

Many research studies using a variety of methods have come to conflicting conclusions. On balance evidence appears to support the view that social and financial performance are linked (e.g Johnson and Greening, 1994, Margolis, Elfenbein and Walsh, 2007).

There is a growing perception in the corporate and shareholder communities that companies that perform well in the social, ethical and environmental arenas also perform well financially. Institutional investors consider that CSR has a significant positive effect on long term corporate performance.

2. Socially related justifications

Stakeholder theory

Stakeholder view of company objectives is that many groups of people have a stake in what the company does (i.e. they are affected by it). While shareholders own the business there are also suppliers, managers, workers, customers and the public

? Carroll & Buchholtz (2006) states “it appears that the Corporate Social Responsibility concept has a bright future because at its core, it addresses and captures most of the important concerns of the public regarding business and society relationships”

? Cadbury (2002) “ the broadest way of defining social responsibility is to say that the continued existence of companies is based upon an implied agreement between business and society” and that “the essence of the contract between business and society is that companies shall not pursue immediate profit objectives at the expense of the longer term interest of society”

For example responsible consumers may be concerned about the environmental impact of their choices or social issues such as the use of child labour in production. The public pays for roads, infrastructure, education and health all of which benefits business. Ethical groups of investors are becoming increasingly important e.g. European Sustainable Investment Forum, a pan-European network aiming to promote sustainability through financial markets.

A business depends on appropriate relationships with these groups, otherwise it will find it hard to function. Each of these groups has its own objectives, so that a balance is required. Companies may need to prioritise a manageable sub set of stakeholders. This implies that some stakeholders who affected by the organisation may be marginalized. Who decides the priority groups?
Management must balance the profit objective with the pressures from non-shareholder groups in deciding the specific targets of the business.
64

Implies broader form of accountability:
– to all stakeholders;
– in non-financial and financial terms;
– based on social contracts (i.e. discretionary activities)

If it is accepted that businesses do not bear the total social cost of their activities, then exercise of social responsibility is a way of compensating for this.

Legitimacy theory

Variation on the above but still assumes a social contract between company and society (Mathews, 1993). Companies need to demonstrate that they have a ‘licence to operate’ and voluntary CSR is a means by which they can legitimise their existence to society. It also explains why they may choose to only disclose positive aspects of performance.

Different motivation – it’s about managers maintaining control of their organisations.

Motivations for CSR at company level

From the company’s perspective, the following benefits linked to improved performance may be identified:

1. Acting in the public interest
No selfish motive, just doing the right thing.

Furthermore public disclosure acts as an internal driver for continuing performance improvement.

2. An increase in customers who share the same values.
E.g. green consumers, organic consumers, thereby gaining a competitive advantage.

3. Strengthens the relationships with stakeholders by involving them in the reporting process.

A consequence of corporate transparency is improved trust and confidence.

4. General public approval, thus lowering reputational risk.

Increasingly a large proportion of a company’s value is determined by reputation e.g. value of a brand.

5. Effective self regulation minimises the risk of regulatory intervention.

By adopting high social and environmental standard, an organisation is prepared for any future legislation, but may delay its introduction.

6. Accessing ‘preferred suppliers’ lists’ of companies which consider social / environmental issues upstream to their own.

65

For a company at the end of a supply chain to be able to promote itself as an ethical, socially responsible business it will be dependent on it’s suppliers to have the same values.

Increasingly suppliers can only win new business contracts by agreeing to uphold the CSR initiatives and policies of their customers

7. Reduce corporate risk and may therefore reduce the cost of finance.

Where environmental risks, in particular, are identified and addressed, an organisation can enhance its investment potential.

8. Enhances employee morale
A by-product of an open and transparent style of business

9. Access to capital

Increasing number of ethical and green investment funds demanding relevant information. E.g. Association of British Insurers (ABI) Guidelines on Responsible Investment Disclorure, FTSE4Good Index.

Methods of discharging requirement to be socially accountable by reporting CSR activities

CSR is increasingly being reported under the banner of Corporate Responsibility reporting which increasingly focuses on all aspects of Corporate responsibility.

Voluntary approach

There is no IFRS on social and environmental reporting and no disclosure requirements, although

IAS 37 ‘Provisions, contingent liabilities and contingent assets’ addresses environmental liabilities such as site restoration costs.

Most disclosure in the area of CSR is voluntary although there are some limited statutory disclosures. E.g. In directors’ report details are required of amount of political & charity donations; policy on employing disabled persons; policy on consulting employees.

The Companies Act 2006 introduced the requirement that quoted companies should include an enhanced business review in the directors’ report. Its aim is to equip shareholders to make an informed assessment of the performance and prospects of the company. It includes forward looking key performance indicators and information on environmental, employment, social and community issues.

The voluntary approach is perceived to have certain advantages and disadvantages:

Advantages

• Encourages best practice by avoiding a tick box approach;
• Avoids placing further burdens on business i.e. costs of disclosure;
• Allows individual companies to creatively explore various options within CSR; and

66

• Allows best practice to develop on an industry by industry basis rather than having a generic “one size fits all list of disclosures that will not be applicable to all industries

Disadvantages:

• Wide gulf between best examples and worst, loss of comparability between companies;
• Tendency for CSR to be used as a form of PR with bad news being buried;
• Broader accountability not discharged properly;

• If no mandatory requirement to report, there can be no mandatory requirement for the information to be audited thereby undermining its value

Where is it reported?

There are two main alternatives:

1. In the annual report – widely distributed but already a large document without CSR content. Statutory issues will need to be covered here;

2. A separate report covering social and environmental issues – typically available from the company website and allows more extensive reporting.

Types of disclosure:

1. Statements of policy

A form of disclosure which is not really reporting. The best will set out objectives which are sufficiently specific to permit subsequent measures of actual performance to be compared with them.

2. Narrative information

Describes particular actions taken by the company in pursuit of environmental objectives. Danger that content will be selective and self criticism rare.

3. Quantitative performance data (non-financial)

The inclusion of ‘hard data’ would enhance reporting (particularly on environmental issues) enabling a better assessment of corporate social and environmental performance. May be difficult for many to understand.

4. Financial data

May take a number of forms. Most simply disclosure of relevant costs, revenues, assets and liabilities. More ambitious would be an attempt to value externalities in financial terms (e.g. damage caused by pollution).

Independent review/audit

A related issue is whether the disclosures should be audited or not. Given that they are generally voluntary, they are not covered by the statutory requirement, although companies have the option to obtain an assurance opinion. Clearly audited information has greater credibility. There is
67

now an assurance standard governing CSR reports AA 1000 Assurance Standard. It is designed to complement the GRI standards.

What is sustainability reporting?

Definition of sustainability: ‘Meeting the needs of the present without compromising the ability of future generations to meet their own needs’ (World Commission on Environment and Development, 1987).

Sustainability reporting is wider in scope than social and environmental reporting. It includes the economic element of sustainability (e.g. wages, taxes and core financial statistics) and involves integrating environmental, social and economic performance data and measures.

Global Reporting Initiative

GRI is ‘a long term, multi-stakeholder, international undertaking whose mission is to develop and disseminate globally applicable Sustainability Reporting Guidelines for voluntary use by organisations reporting on the economic, environmental and social dimensions of their activites, products and services’.

In 2000 the Global Reporting Initiative Steering Committee issued ‘Sustainability Reporting Guidelines’. The GRI published revised Sustainability Reporting Guidelines (G3) in 2006 and a further update (G4) in May 2013. The Guidelines set out the framework of a sustainability report. The following issues would be covered:

1. Profile – providing an overview of the organisation and the scope of the report;

2. Vision and strategy – – a statement of the vision for the future and how that integrates economic, environmental and social performance;

3. Governance structure and management systems – an overview of the governance and management systems to implement this vision and a discussion of how stakeholders have been engaged, because they have a key role in identifying impacts.
4. Performance indicators
a. Economic
b. Environmental
c. Social

Examples of performance indicators that might be disclosed under each heading:

• Economic dimension: including financial and non-financial information e.g profit, segmental information, EBIT, EBITDA, ROCE, intangible assets, investment in human capital, R&D, debt/equity ratio, wages and benefits information by country, labour productivity, suppliers value of goods and services outsourced performance in meeting credit terms
68

• Environmental dimension: disclosures may include, major issues with products and services e.g waste disposal, packaging, percentage of product reclaimed after use; supplier issues eg sourcing of natural resources, travel information eg product mileage, fleet operations, travel costs

• Social dimensions may include disclosures regarding: quantity of management, employee retention rates, ratio of jobs offered to jobs accepted, employer ranking in surveys, health and safety cases, lost days, absentee rates, investment per worker in injury prevention, training of workers information, annual training spend, grievance procedures, freedom of association

GRI reports provide assurance as they are verified by independent, competent and impartial external assurance providers.
KPMG 2013 Survey of current CSR reporting practice

Results of an international survey of Corporate Responsibility Reporting by 4,100 companies in 41 countries including the 250 largest companies in the world can be summarised as follows:

• Corporate responsibility (CR) reporting has become the de facto law for business 71% of the 4,100 companies surveyed report CR

• CR reporting has increased significantly in emerging economies
• In all industry sectors more than 50% of Companies report on CR

• Over 51% (2011 20%, 2003 9%) of Companies now include CR information in their annual financial reports

• Use of GRI as the reporting basis is almost universal with 78% of companies reporting CR using the approach

• Increasing numbers of companies (59%) of the Global 250 are obtaining external assurance reports on their CR reporting.

• Reasons for adopting CSR : –
1. Reputation or brand

2. Ethical considerations
3. Employee motivation
4. Innovation and learning
5. Risk management and risk reduction
6. Access to capital
7. Economic considerations
8. Strengthened supplier relationships
9. Market position
10. Improved relationship with governmental authorities

See extracts below:

69

So everything is going in the right direction?

Deegan (2013) argues that any form of social and environmental reporting that uses financial reporting as a platform is unlikely to succeed as it is based on too many assumptions that make it inappropriate for social and environmental reporting. For example, the entity principle whereby any activity of the entity tat does not impact on its own financial position or performance is ignored. Also conventional recognition criteria requires that items can be measured with

‘reliability’ and should be ‘verifiable’.

He accepts that GRI’s Sustainability Reporting Guidelines has helped in promoting greater corporate accountability, but argues that because it has adopted many financial reporting conventions these have limited the scope of disclosures that could be made and its overall effectiveness.

Gray (2013) argues that environmental reports being produced are ‘with very few exceptions, …are woefully poor accounts if judged by standards of information characteristics and communication quality’ (p.465). He suggests that ‘the corporate world expends enormous efforts to produce extremely poor environmental reports whilst working hard to ensure that such reports are neither legislated for nor analysed in legitimate fora and exposed as the trivia they are’

(p.465). In other words the effort is about avoiding accountability but promoting PR. He argues that the contribution of accounting will be limited until it can be imagined that it has a role beyond serving ‘the managers of large corporations and their fickle investors’ (p.467).

Conclusion

This is an issue which has grown in importance over the last 30 years and which is likely to continue to be a focus of attention. The debate has shifted away from whether sustainability reporting is necessary towards the form that it should take, and particularly how it can become tool for discharging accountability rather than a PR opportunity.

70

References

Alexander, G. J. and Bucholz, R. A. (1978), ‘Corporate social responsibility and stock market performance’,

Academy of Management Journal, Vol. 21, No. 3, pp. 479-486.

Cadbury, A. (2002), ‘Corporate Governance and Chairmanship: A Personal View’, Oxford University Press: Oxford.

Carroll, A. B. (1979), ‘A three dimensional conceptual model of corporate social performance’, Academy of

Management Review, Vol. 4, pp. 497-505.

Carroll, A. B. and Buchholtz, A. K. (2006), ‘Ethics and Shareholder Management’, Sixth Edition, Thomson South-Western: Mason, Ohio.

Deegan, C. (2013), ‘The accountant will have a central role in saving the planet…really? A reflection on ‘green accounting and green eyeshades twenty years later’, Critical Perspectives on Accounting, Vol. 24, pp. 448-458.

Friedman, M. (1962), ‘Capitalism and Freedom’, University of Chicago Press: Chicago.

Global Reporting Initiative (2006), ‘Sustainability Reporting Guidelines’. Available at www.globalreporting.org.

Gray, R. (2013), ‘Back to basics: What do we mean by environment (and social) accounting and what is it for? – A reaction to Thornton’, Critical Perspectives on Accounting, Vol. 24, pp. 459-468.

Gray, R., Owen, D. and Adams, C. (1996), ‘Accounting and Accountability: Changes and Challenges in Corporate Social and Environmental Reports’, Prentice Hall, Europe: Hemel Hempstead.

Johnson, R. D. and Greening D. W. (1999), ‘The effects of corporate governance and institutional ownership types on corporate social performance.’, ‘Academy of Management Journal, Vol. 42, pp. 564-578.

KPMG (2013), ‘The KPMG Survey of Corporate Responsibility Reporting 2013’. Available at http://www.kpmg.com/global/en/issuesandinsights/articlespublications/corporate-responsibility/pages/corporate-responsibility-reporting-survey-2013.aspx

Margolis, J. D., Elfenbein, H. A.,Walsh J. P., (2007), ‘Does it pay to be good? A meta-analysis and redirection of research on the relationship between corporate social and financial performance.’ Working paper, Harvard Business

School, Cambridge MA.

Mathews, M. R. (1993), “Socially Responsible Accounting’, Chapman & Hall: London.

Mitchell & Sikka (2005), ‘Taming the Corporation’, Association for Accounting and Business Affairs: Basildon.

World Commission on Environment and Development (1987), ‘Report of the World Commission on Environment and Development’, United Nations: New York.

75

Seminar Questions

1.

a) Define what is meant by Corporate Social responsibility and evaluate why it changes over time.

b) To what extent do companies have a responsibility to anyone other than shareholders?
c) Contrast the market view of CSR with one based on stakeholder theory.

2. You have recently been appointed Finance Director of Affluent Chemicals PLC. The Chief Executive of the business, Mr Aroma, has recently attended a presentation by the company’s auditors regarding Corporate Social Responsibility. Following the meeting he is enthused about the prospect of incorporating Corporate Social Responsibility within the business, but is unclear about the reporting requirements for Corporate Social Responsibility and in particular the concept of “Triple Bottom Line” reporting.

He has asked you to prepare a report for the next board meeting to:

a) Critically appraise the potential benefits to Affluent Chemicals PLC of integrating Corporate Social Responsibility within the business.

(11 marks)

b) Evaluate and explain the concept of “Triple Bottom Line Reporting” giving examples of the types of disclosures that the company would make.

(8 marks)

c) Critically appraise the methods available to the company of reporting its Corporate Social Responsibility activities

(6 marks) Total (25 marks)

3. The UK government and the EU Commission both appear to favour a voluntary approach to CSR. What are the advantages and disadvantages of this?

4.Review the sustainability report for BP for 2014, a copy can be found on Moodle or at

http://www.bp.com/content/dam/bp/pdf/sustainability/group-reports/Sustainability_Report_2014.pdf

a) Summarise the content of the report and critically evaluate its relevance as a means of discharging accountability.

b) What assurance report did Ernst & Young give on the report?

5. Discuss the implications of the Global Reporting Initiative for the accountancy profession.

76

Week 6 Lecture
Intangible Assets & Goodwill

Learning outcomes

After this session students should:

1. Appreciate the significance of intangible assets goodwill and the difficulty in accounting for them;

2. Understand the requirements of IAS 38 and IFRS 3 in this area.

Why intangibles matter

We live in an age in which companies gain a competitive advantage through innovation, achieved as a consequence of creativity. The innovations impact not only on products and services, but also processes and structures.

It is estimated that in the 1980’s 30% of the value of business assets took the form of intangibles, by 2000 some estimates claim that this has risen to 95%.

Intangible assets

Covered by IAS 38 ‘Intangible assets’ published in September 1998. Does not apply to goodwill
– covered by IFRS 3 ‘Business Combinations’.

Deals with:
a) When intangible assets should be / may be recognised;
b) How intangible assets should be measured;
c) Relevant disclosure requirements.

Recognition

To deal with when intangibles should be recognised in the accounts, we need a definition (per IAS 38):

‘An identifiable non-monetary asset without physical substance held for use in the production or supply of goods or services, for rental to others, or for administrative purposes. The asset must be:
a) controlled by the entity as a result of events in the past, and
b) be something from which the entity expects future economic benefits to flow.’

Examples – computer software, patents, copyrights, motion picture films, franchises, fishing rights, taxi cab licenses.

An intangible asset must be identifiable to distinguish it from goodwill which may be difficult for non-physical items.

77

An asset may be identifiable because it is separable (i.e. it can be sold separately from the rest of the business, but assets that only generate future economic benefits in combination with other assets can still be identifiable.

If it has been purchased with other assets, there may be separate legal rights which would help to make an asset identifiable.

An intangible asset must be controllable by the business to enjoy the future economic benefits from the asset and prevent others from doing so. A legally enforceable right is evidence of such control.

E.g. Control over technical knowledge only exists if it is protected by legal rights.

Customer loyalty or market share would not be recognisable as the entity does not control the future actions of its customers.

An item can only be recognised if economic benefits are expected to flow from the ownership of the asset. These can take the form of income or cost savings.

Internally generated intangible resources can satisfy the criteria for asset recognition.

Examples of items that do not satisfy the criteria: internally generated brands, advertising or promotion, customer lists, publishing titles.

Measurement

When initially recognised an intangible asset should be valued at cost.

If acquired separately, cost can be measured reliably at purchase price (less any costs of purchase).

If acquired as part of a business combination the cost is its fair value on the date of the acquisition. Easy where market values exist, less so where none exists.

If we are unable to measure fair value with sufficient reliability we should not recognise it.

All expenditure which relates to intangibles which does not meet the criteria for recognition should be written off as an expense. IAS 38 expresses the view that subsequent expenditure incurred after the initial recognition of an intangible asset should not normally result in an increase in the capitalized cost due to difficulties in linking the expenditure with additional economic benefits.

After the intangible asset has been initially recognised at cost, it can be either:
78

a) Carried at cost less any accumulated amortisation and/or less any accumulated impairment losses, or

b) Carried at a revalued amount (based on fair value) less any subsequent accumulated amortisation and or accumulated impairment losses.

The second option requires a reasonably active market in that type of asset to allow fair value to be measured reliably otherwise it should not be used. For most intangibles these do not exist, but there are some exceptions (e.g. taxi licences, fishing quotas).

IAS 38 states that some intangibles (e.g. publishing rights, film rights) each have a unique value, so revaluation to fair value would not be appropriate.

All intangible assets of similar class would have to be treated the same way and revaluations would need to be kept current.

The treatment of revaluations is the same as for other non-current assets. When an intangible asset is revalued upwards, the amount of revaluation is credited to revaluation reserve.

If it is revalued downwards, the amount of revaluation is debited to the income statement unless there was a previous upward revaluation in which case the revaluation decrease can first be charged against any previous revaluation surplus.

EXAMPLE 1

An intangible asset which cost £200k is revalued to £600k in 20×3. At the end of 20×4, the asset is valued again at £100k. What is the accounting treatment of the downward valuation?

SOLUTION

In 20×3 a revaluation reserve of £400k was created, therefore for the downward valuation of £500k, £400k can be set against the revaluation reserve with £100k against profit in the income statement.

An intangible asset with a finite useful life should be amortised over its expected useful life.

Finite useful life may be determined by many factors –e.g. expected actions by competitors, the stability of the industry, product life cycles, legal limits on the use of the asset.

Period and method of amortisation is to be reviewed annually.

Intangible assets with an indefinite (i.e. no foreseeable limit) useful life should not be amortised, but should be subject to an annual impairment review (or whenever there are indications that the asset may be impaired).
79

Research and development costs

Traditionally dealt with under a separate standard under UK GAAP (SSAP 13) but included in IAS 38. This part of the standard essentially sets out the approach for assessing whether internally generated resources satisfy the criteria for recognition as an asset.

It defines research as ‘activities aiming at obtaining new knowledge; the search for, evaluation and final selection of, applications of research findings or other knowledge; the search for alternatives for materials, devices, products, processes, systems or services; and the formulation, design, evaluation and final selection of possible alternatives for new or improved materials, devices, products, processes, systems or services.’

There is too much uncertainty about the likely success of the project, so research costs should be written off as an expense as they are incurred.

Development is defined as ‘the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services prior to the commencement of commercial production or use.’

E.g. design, construction and testing of pre-production models.

Development costs may qualify as recognition as an intangible fixed asset if all the following are met:

a) The technical feasibility of completing the intangible asset so that it will be available for use or sale;

b) Its intention to complete the intangible asset and use or sell it;
c) Its ability to use or sell the intangible asset;

d) A market exists for the output of the intangible asset or the intangible asset itself, or if it is to be used internally, the usefulness of the intangible asset;

e) Possible to measure the expenditure attributable to the intangible asset during its development reliably.

If these criteria are met, development expenditure should be capitalised and treated as an intangible asset, then amortised over the expected life of the project. Previously in the UK under SSAP 13 directors had the choice of writing it off as an expense or capitalising it (subject to similar strict criteria being met). Many preferred the certainty and prudence of an immediate write off. In practice directors will still have the choice as they can use pessimistic projections to ensure they fail the criteria for capitalisation.

The costs that can be included in development expenditure follow the same rules as those used in determining the cost of inventories – all expenditure directly related to generating the asset (e.g. labour, materials) and a reasonable proportion of the overheads necessary to generate the asset.
80
Goodwill

Most businesses have an enhanced value due to a good reputation, good customer service, helpful staff, high quality management etc.

In service industries this may form a high % of total value. However it is not normally recognised in the accounts. Inherent goodwill has not been purchased and has no objective value. Furthermore, it may be quite volatile changing regularly e.g. nice staff replaced by grumpy staff.
IAS 38 specifically states that internally generated goodwill should not be recognised as its cost cannot be reliably measured, nor is it controllable or identifiable.

Purchased goodwill (i.e. arising out of the acquisition of a business) is different because it can be calculated on the basis of an objective market price.

Covered by IFRS 3. Defined as:

‘Future economic benefits arising from assets that are not capable of being individually identified and separately recognised.’

Goodwill is not an identifiable asset or liability but a residual amount. However, it is shown as an asset in the balance sheet measured at cost.

Cost = Cost of investment – acquirer’s interest in fair value of acquiree’s identifiable assets and liabilities and contingent liabilities (i.e. share of share capital and pre-acquisition reserves).

Essentially it represents a payment made by the acquirer in a business combination in anticipation of future economic benefits from assets that are not capable of being individually identified and separately recognized.

IFRS 3 requires an acquirer to recognize intangible assets separately if they meet the definition of an intangible asset in IAS 38 and their fair value can be measured reliably.

Potential accounting treatments

Purchased goodwill has had a long history in standards with many different treatments being proposed at various times:

a) Treat goodwill as an asset at original cost and amortise through income statement over estimated useful life.

This one of the options in the UK during the 1980’s (SSAP 22) and 1990’s (FRS 10 except where there was an indefinite life). Also basis of IAS 22.

Arguments used to support this view:

81

– The asset is a measure of the extent to which the earnings of the purchased business will exceed those which could be expected from its identifiable net assets. Therefore it should be amortised to match costs against income.
– Has tended to ensure consistency with treatment of other intangible assets.

– Purchased goodwill will have a finite life, although it may subsequently be replaced by inherent goodwill which is not recognised.

The main argument against is that it is very difficult to know precisely what the composition of goodwill is, so even harder to estimate its useful life.

b) Treat goodwill as an asset, but retain in the balance sheet indefinitely unless a permanent reduction of value becomes evident (impairment review).

Required in UK where indefinite life under FRS 10, mandatory in all cases under IFRS 3.

– Avoids the need to come up with a potentially arbitrary estimated useful life.
– Some would argue that the impairment review is complex and / or subjective.

c) Write off the entire amount against reserves at the time of acquisition. The other option in the UK under SSAP 22.

Arguments in favour:
– Ensures consistency of treatment with inherent goodwill.
– As uncertainty exists over the useful life of purchased goodwill, it is prudent to write it off.
– Some would argue goodwill is not an asset (e.g. it cant be sold off separately).
Arguments against:
-Some debate as to which reserves should be available for write off.

– Acquisitions of real value had the effect of reducing shareholders funds in the balance sheet, arguably making it look like a mistake. However a number of key ratios would be distorted favourably (e.g. ROCE).

This was a popular option with companies who could avoid an amortisation charge going through the income statement adversely affecting reported profits.

IFRS 3 Treatment of goodwill

IFRS 3 requires a treatment which is none of the above. Subsequent to recognition the goodwill is tested annually for impairment which may result in write downs of the carrying value. Amortisation is not permitted. This means that costs will hit the income statement at irregular intervals, usually at a time when other things have gone wrong in the business, and will result in greater earnings volatility.

82

Negative goodwill can arise out of a bargain purchase. After checking that it has not arisen as a consequence of errors in determining fair value, it should be immediately recognised in the income statement.

In the past there was considerable scope to manipulate the size of purchased goodwill by changing the value of net assets being acquired. The most common way was to set up provisons for future losses and provisions for reorganization following acquisition. IFRS 3 bases its approach on the conceptual framework definition of a liability (i.e. a present obligation arising from a past event). This would rule out such practices.

Evaluation of current standards

There is a difference in treatment between intangibles (amortization) and goodwill (annual impairment review). It appears that the convergence project between IASB and FASB may have had an impact. The US standard on goodwill requires an annual impairment review not amortization so the IASB may have felt under pressure to follow suit.

Also companies might prefer the possibility of an impairment charge to the certainty of an amortization charge against their reported profits.

When IFRS was first implemented company directors were reluctant to fully identify all intangibles assets acquired as part of an acquisition, preferring to include them as goodwill. E.g. In June 2005 Kingfisher bought OBI (a DIY chain) for £144million placing no value on its brand or customer relationships.

Company directors have variously argued that the additional information is not useful and analysts ignore published information about intangibles even when produced; also that it is a expensive to value intangibles, especially if external consultants are hired.

The FRRP made it clear that they were monitoring the application of IFRS 3.
Conclusion

Intangible assets have become an increasingly important source of value in recent years and therefore there have been attempts to recognize more of them on the balance sheet given certain criteria, an approach resisted by some directors. Many internally generated intangible resources do not satisfy the criteria, but this does not mean they are not important. The balance sheet continues to provide a partial view of intangibles.
83

Seminar Questions

1. What are the main characteristics of goodwill which distinguish it from other intangible non-current assets? To what extent do you consider that these characteristics should affect the accounting treatment of goodwill? State your reasons.

2. Why is it considered necessary to distinguish between research and development expenditure, and how does this distinction affect the accounting treatment?

3. Forkbender Ltd. Develops and manufactures exotic cutlery and has the following projects in hand:

Project
1 2 3 4
£000 £000 £000 £000
Deferred development
expenditure b/f 1.1.×2 280 450 – –
Development expenditure incurred
during the year:
Salaries 35 – 60 20
Overhead costs 2 – – 3
Materials and services 3 – 11 4
Patents and licences 1 – – –
Market research – – 2 –

Project 1 was originally expected to be highly profitable but this is now in doubt since the scientist in charge of the project is now behind schedule, with the result that his competitors are gaining ground.

Project 2: commercial production started during the year. Sales were 20,000 units in 20×2 and future sales are expected to be: 20×3 30,000 units; 20×4 60,000 units; 20×5 40,000 units; 20×6 30,000 units. There are no sales expected after 20×6.

Project 3: these costs relate to a new project which meets the criteria for deferral of expenditure and which is expected to last for three years.

Project 4 is another new project involving the development of a ‘loss leader’, expected to raise the level of future sales.

The company policy is that expenditure carried forward is written off evenly over the expected sales life of projects, starting in the first year of sales.

Required:
84

Show how the above projects should be treated in the financial statements of Forkbender Ltd. Assuming compliance with IAS 38. Justify your treatment of each project.

4. Do you think the following could possibly be categorised as intangible assets under IAS 38? For each item (a) to (e) consider:

Is there an identifiable asset? Would the company have control?
Will it bring future economic benefits?
Can the cost of the intangible be measured reliably?
(a) Customer list purchased from a competitor in financial difficulties;
(b) Company’s own customer list;
(c) Computer software – internally developed;
(d) A trained and highly motivated workforce;
(e) A purchased trademark (i.e. recognised name or symbol).

5. Read chapter 1 of FRC ARP Staff Research Report ‘Investor Views on Intangible Assets and their Amortisation’ published in March 2014 (available on Moodle) and evaluate whether the treatment of intangibles under IAS 38 is appropriate.

85

Week 7 Lecture

Impairment of Assets
Learning Outcomes
After this session students should:

1. Understand the nature of an impairment review;

2. Be able to apply and appraise the requirements of IAS 36 ‘Impairment of Assets’.

Introduction

It is important that users of financial statements can rely on the information. In particular, they need to be assured that the assets in the balance sheet are not stated at amounts greater than the entity can expect to recover from those assets. It has always been necessary to write down non-current assets if they had been subject to a ‘permanent diminution of value’. However, there was never any clear guidance as to what this meant. Impairment testing has recently become a more familiar aspect of financial reporting. The relevant accounting standard is IAS 36 ‘Impairment of Assets’, effective from 31 March 2004.

Overview of an impairment review

1. Review the smallest group of assets that produces a ‘largely independent’ stream of cash flows. That is a ‘cash generating unit’ (CGU).

2. Compare the net book value of the asset(s) (also known as the carrying value) with the recoverable amount. This will be cost – accumulated depreciation- any previous accumulated impairment loss, unless the asset has been subject to revaluation. Liabilities are usually ignored.

3. Recoverable amount is the higher of ‘net selling price’ (amount at which an asset could be disposed less any direct selling costs) and ‘value in use’ (i.e. net present value).

4. If the carrying value is higher than the recoverable amount, the asset(s) need to be written down by the excess so that the carrying value equals the recoverable amount.

If the selling price of assets can be shown to be above their carrying value then a full impairment review can be avoided.

Identification of CGUs is a highly judgemental exercise. E.g. If a company is a retailer with a number of retail site, should each one be a CGU? If the CGUs are identified at too high a level, poorly performing parts of the business may be obscured (i.e. some sites may be performing particularly poorly). If at too low a level the cost of preparing cash flow forecasts for each site may be excessive.
86

EXAMPLE 1

A company has a factory making shoes. The depreciated historical cost of non-current assets is £10 million. Foreign competition means the operation is loss making

The non-current assets could be sold £5 million (net of disposal costs).

The NPV of future cash flows discounted at the company’s weighted average cost of capital (WACC) is £6 million.

What would be the result of an impairment review?

SOLUTION

The recoverable amount is £6 million (value in use is higher than net selling price). The company will therefore need to write down the factory (i.e. the CGU) to £6 million, resulting in an impairment charge of £4 million for the year.

What are the problems inherent in impairment reviews?

The basic principles are fairly easy to understand but there are a number of practical problems:

1. When is a review triggered?

2. Estimating cash flows;

3. Choosing a discount rate;

4. Determining net selling price;

5. Allocating write downs to assets;

6. Allocating head office assets and costs;

When do we undertake an impairment review?

IFRS 3 requires goodwill to be subject to an annual impairment test. IAS 38 requires that intangible assets with an indefinite useful life should also be subject to an annual impairment test.

Other non-current assets, both tangible and intangible, should also be reviewed for impairment if there is some indication that impairment has occurred. Investments in subsidiaries, associates and joint ventures are included within the scope of IAS 36, but current assets are not.

External indicators of impairment might include:

– Fall in market value of asset (e.g. due to delays in introducing new technologies);

87

– Adverse changes in the regulatory environment;

– Adverse changes in markets (e.g. a competitor has introduced a new product which will have a major impact on market share);

– Long term increase in market rate of return used for discounting.

Internal indicators might include:

– Changes in operations;

– Major reorganisation (e.g. might change the way in which the asset is used);

– Loss of key personnel;

– Continuing losses or cash outflows – worse than expected.

Calculating value in use

Estimating cash flows

The basic approach is to estimate future pre-tax cash inflows and outflows to be derived from the continuing use of the asset(s) and from its ultimate disposal. Use cash flows consistent with

CGU’s budgets and plans. Assume a ‘steady or declining growth rate’ beyond the planning horizon. Adjust for the effect of price changes.

The cash flow forecasts should be based on the asset(s) in its current state or condition and should exclude the impact of any future capital expenditure or any restructuring to which the company is not yet committed.

Choosing a discount rate

Apply the appropriate risk adjusted discount rate to the identified cash flows. The company’s weighted average cost of capital (e.g. determined by the capital asset pricing model) might provide a starting point in identifying a discount rate but it should be adjusted to reflect the way in which the market would assess the particular risks (e.g. currency risk, price risk) associated with the projected cash flows. Likely to be very subjective.

EXAMPLE 2

A CGU has a total carrying value of £30,000 million and has a pre-tax WACC of 12%. Sales are predicted to grow at 10% for the next 5 years with fixed costs increasing at 3%.

Sales in year 1 are £5,000 million and fixed costs are £1,000 million. Variable costs are 40% of sales. After five years it is assumed that net cash flows will grow at 2.25%.

The net selling price is £25,000 million.

What impairment write off is necessary?

88

SOLUTION

We need to calculate the value in use to complete the impairment review. Forecast cash flows

t= 1 2 3 4 5
£m £m £m £m £m
Sales 5,000 5,500 6,050 6,655 7,321
Cost of sales (2,000) (2,200) (2,420) (2,662) (2,928)
Fixed costs (1,000) (1,030) (1,061) (1,093) (1,126)
Net cash flow 2,000 2,270 2,569 2,900 3,267
Value of future flows 34,262
(year 6 onwards)
Discount factors @ 12% 0.8929 0.7972 0.7118 0.6355 0.5674
Discounted cash flows 1,785.8 1,809.6 1,828.6 1,842.9 21,294

NPV = £28,560.9m, say £28,561m.
Recoverable amount is therefore £28,561m (i.e. value in use exceeds net selling costs).
The amount of impairment is therefore £30,000m – £28,561m = £1,439m, and the company
would need to write off this amount against profit.
Dr. Impairment loss (IS) £1,439m
Cr. Accumulated depreciation & impairment losses (BS) £1,439m.

Note 1. Value of future flows assumes that the future cash flows will continue to grow indefinitely at 2.25% pa and is calculated using the growth model formula

V= D(1+g)/ (r-g) = 3,267x 1.0225/ (0.120-0.0225)= £34,262m.

An alternative assumption might have been zero growth, treat as a perpetuity. V= D/r = 3,267/0.12 = £27,225m.

By definition goodwill does not generate cash flows independently from other assets, so the recoverable amount of goodwill as an individual asset cannot be determined. If there are indications that goodwill may be impaired, the recoverable amount must be determined for the CGU to which it belongs. When a new business is acquired, the purchased goodwill should be allocated to each of the newly acquired cash generating units that are expected to benefit from the synergies of the acquisition on a reasonable basis (e.g. net assets).

Determining net selling costs

Should be much more straightforward being fair value less any incremental costs directly attributable to the disposal of the asset. Fair value can be ascertained by reference to comparable transactions. Costs of disposal might include legal costs, stamp duty and costs of removing the asset.

Allocating write downs

Where an impairment loss arises, the loss should ideally be set against the specific asset to which it relates.

89

When the loss cannot be identified as relating to a specific asset (i.e. because our analysis is at the level of the CGU), it should be apportioned within the CGU to reduce the most subjective values first:

1. Write off goodwill allocated to the CGU first.

2. Then write down other assets in the CGU on a pro-rata basis on the basis of their carrying value.

3. However, do not write any individual asset down below the higher of its net selling price, value in use, or zero. Current assets are valued at the lower of cost and NRV so are usually excluded from the apportionment.

EXAMPLE 3
A cash generating unit contains the following assets:
£
Goodwill 60,000
Intangible assets 10,000
Plant, property & equipment 110,000
Inventory 50,000
Receivables 40,000
270,000

The unit is reviewed for impairment and the recoverable amount is estimated at £180,000. The plant, property and equipment includes a property with a carrying amount of £80,000 and a market value of £150,000. The net realisable value of the inventory is greater than its carrying value. None of the receivables is considered doubtful.

Show the allocation of the impairment.

SOLUTION

The impairment is £90,000 and this has first been allocated to goodwill.

No impairment loss can be allocated to the property, inventories or receivables.

The remaining impairment loss is allocated pro-rata to intangible assets (carrying value £10,000) and the remaining PPE (Carrying amount £30,000(i.e.110,000-80,000).

£30,000x (30,000/40,000) =£22,500 PPE £30,000 x (10,000/40,000) = £7,500 Intangibles
90

Pre –impairment Impairment Post-impairment
£ £ £
Goodwill 60,000 (60,000) 0
Intangible assets 10,000 (7,500) 2,500
Plant, property & equipment 110,000 (22,500) 87,500
Inventory 50,000 0 50,000
Receivables 40,000 0 40,000
270,000 (90,000) 180,000

If a CGU is a non-wholly owned subsidiary, the recoverable amount is calculated for the entity as a whole. For example, if there is allocated goodwill of £100,000 for a 75% owned subsidiary, this should be grossed up to £133,333 (£100,000 x 100/75) to calculate the carrying amount and therefore the impairment loss. If an impairment loss of £50,000 was identified to be written off against goodwill, the minority interest’s share of that loss is not recognised in the accounts, so the write off becomes

Dr Impairment loss (£50,000×75%) £37,500
Cr. Goodwill £37,500

Corporate assets

If an entity is divided into CGUs it raises the question as to how corporate assets (e.g. headquarters, IT support centre) should be treated in determining impairment losses. They may well be integral to all the CGUs but do not themselves generate cash.

IAS 36 suggests a two stage process:

1. If corporate assets can be allocated on a reasonable and consistent basis to CGUs, this should be done and included in the impairment test. If a loss is identified in a CGU, the loss is allocated pro-rata across the assets including the portion of corporate assets allocated to that unit.

2. For corporate assets where this is not appropriate, the entity should identify the smallest cash generating unit that includes the unallocated corporate assets and this unit is then tested for impairment. For example, if a research centre serves all the CGUs in an entity, then an impairment test should be carried out on the entity as a whole.

Treatment of impairment losses

If an asset has not been previously revalued all losses go through the income statement.

If an asset has been revalued any impairment loss is first charged against the revaluation surplus of the same asset.

91

When as asset has been subject to an impairment write down, the depreciation charge for the asset should be adjusted to allocate the revised carrying amount, net of any residual value, over its remaining useful life.

Past impairment losses in respect of assets other than goodwill may be restored where the recoverable amount increases due to improving economic conditions.

Criticisms of IAS 36

1. The impairment test does not measure whether goodwill has been impaired. Any impairment loss identified in a CGU is arbitrarily first allocated to goodwill, although it might have been attributable to other identifiable assets.

2. The standard requires many subjective judgements to be made with respect to when an impairment test is necessary, in identifying CGUs and the data used in the impairment tests. Some would question whether this process produces useful information, particularly as directors may be reluctant to write down an investment they previously championed.
Conclusion

This is a detailed and complex standard which establish reasonably clear principles for the impairment review process. The real problems come when those principles are applied in practical situations.

92

Seminar Questions

1. A company has an CGU with a carrying value of £80m. The company estimates its pre-tax weighted average cost of capital to be 18%. Recently interest rates have increased significantly and the auditors have asked the company to conduct an impairment test on the CGU. The company estimates that the net realisable value of the assets employed in the CGU is £60m. The

CGU’s projected sales for the next year are £20m. Variable costs are 60% of sales. It is expected that Sales and Variable costs will grow by 10% a year in money terms for the following four years but that fixed costs, £1m next year, will rise at 3% a year. After five years it is assumed that net cash flows will grow at the long run growth rate of the economy of 2.25%.

Work out the recoverable amount of the business and decide whether an impairment write down is required, and if so, how much?

How would any write down be dealt with in the accounts a) if the assets of the business had never been revalued? b) if the assets had previously been revalued by £10m and the surplus taken to a reserve?

2. Bergerac Ltd. is the parent of two subsidiaries. It owns all the issued shares of Rouen Ltd. and 80% of the issued shares of Amiens Ltd.

At 31 July 20×6, the carrying amounts of the assets of these entities ( including the goodwill allocated to these entities as a result of the consolidation process) within the group were as follows:
Rouen Ltd. Amiens Ltd.
£ £
Land 400,000 150,000
Plant 300,000 520,000
Less Accumulated depreciation (120,000) (280,000)
Inventory 70,000 60,000
Cash 30,000 20,000
Goodwill 20,000 16,000

As part of the impairment testing procedures undertaken by Bergerac Ltd., the recoverable amounts of the two cash generating units were:

Recoverable amount 650,000 482,000

The net realisable value of the inventory was greater than its carrying value for both entities. In relation to land:

Fair value less costs to sell 390,000 155,000
93

Required:

Determine the accounting adjustments required as a result of the impairment tests for each of the cash generating units.

3.Twerton plc has provided the following cash flow forecasts as at 31 December 20×0 in respect of two of its cash generating units, Lansdown and Bathwick:

Lansdown Bathwick
£000 £000
20×1 4,000 8,000
20×2 3,600 8,600
20×3 3,900 8,000
20×4 4,200 8,200
20×5 4,800 8,500
20×6 5,000 9,000

The growth in net cash flows after 20×6 is assumed to be 2.25% for both divisions. (N.B. The formula for the growth model is V= D0(1+g)/(r-g)).

The appropriate discount rate for activities undertaken by Lansdown is 8% while for Bathwick it is 6%.

While reviewing valuations of assets at the year end they have identified a net selling price of £76,000k for Lansdown and £180,000k for Bathwick.

The carrying value of the assets comprising these CGUs is outlined below:

Lansdown Bathwick
£000 £000
Property 24,000 100,000
Plant and Equipment 37,000 80,000
Goodwill 4,000 8,000
Inventories 20,000 38,500
Total Assets 85,000 226,500
The net realisable value of the inventory is greater than its carrying value for both divisions. The market value of the property held by Lansdown is £28,000k.

Required:

a) Apply IAS 36 to determine whether the company needs to recognise an impairment loss for either of the divisions for the year ended 31 December 20×0. Show how any impairment would be allocated against the assets of the cash generating units concerned using journal entries and provide a revised post-impairment summary statement of

94

financial position.

(20 Marks)

b) Discuss the view that impairment would not be necessary if appropriate depreciation methods are used by companies.

(5 marks) (Total 25 Marks)

95

Week 8 Lecture
Accounting for Leases

Learning outcomes

After this lecture students should:
1. Appreciate why a standard on leasing was necessary;

2. Be able to understand the rationale behind IAS 17 and why further changes are being considered for the future;

3. Be able to account for an operating or finance lease from the perspective of a lessee in accordance with IAS 17.

Reasons for popularity of leases

Reasons:

1. Leases can ease cash flow problems. Lease payments can be varied to match income from the related asset.

2. Given rapid technological change, flexibility is desirable.

3. A leasing agreement is a source of credit which cannot easily be withdrawn.

4. Before the existence of an accounting standard on the subject, the use of leases could enhance the appearance of a company’s financial statements…and if the lease is carefully written, may still be possible.

Why an accounting standard was needed

Traditionally accounting looked at legal ownership in determining the accounting treatment (i.e. if an asset was not owned it was not included on the statement of financial position / balance sheet).

EXAMPLE 1

There are two identical companies (A and B). Both earn profits of £1million per annum generated from identical net assets valued at £10 million. However company A owns all its assets, while company B has obtained £ 2 million of its assets via long term leases. What is the return on capital employed for the two companies?

Company A: £1m/£10m = 10%;
Company B: £1m/£8m = 12.5%

1. Loss of comparability as ratios distorted.
96

2. Ignores economic reality. It is a form of off balance sheet financing.
Principle of “substance over form” is now enshrined in conceptual frameworks.

3. Court Line collapse acted as a catalyst for action.

IFRS: IAS 17 (issued 1982, revised 2003);
UK GAAP: SSAP 21 (issued 1984).
Virtually identical.

IAS 17 General approach

Definition of a lease:

“A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments, the right to use an asset for a given period of time.” (IAS 17).

Where title passes at the end of the lease term the arrangement is called hire purchase.

Lessor – person who owns the asset.
Lessee – person who uses the asset.

Leases are divided into two types:

1.Finance lease (Long term lease – like ownership)

“A lease that transfers substantially all the risks and rewards incident to ownership of an asset. Title may or may not eventually be transferred.” (IAS 17).

Consists of two transactions:
– Borrowing funds to be repaid over a period of time;
– Paying a supplier for use of an asset.

Indicators that a lease is a finance lease:
a) The lease transfers ownership of the asset to the lessee by the end of the lease term;

b) The lessee has the option to purchase the asset at a price sufficiently lower than the fair value at the date the option becomes exercisable such that, at the inception of the lease, it is reasonably certain that the option will be exercised (i.e. a bargain purchase option).
c) The lease term is for a major part of the asset’s economic life;

d) At the inception of the lease, the present value of the minimum lease payments amount to substantially all of the fair value of the leased asset (SSAP 21 specified 90%);

e) The leased assets are of specialised nature such that only the lessee can use them without major modifications being made.

2. Operating lease (Short term lease like renting).
“A lease other than a finance lease.” (IAS 17).
97

A lease should be classified at the start of its term.

Accounting treatment of leases

Focus on lessees for numerical examples, just broad overview for lessors.

1. Operating Lease

Lessee – Rental payments charged as an expense in the income statement.

Lessor- Leased assets are recorded in statement of financial position or balance sheet, usually as non-current assets and depreciated.

Income from leases recognised in the income statement.

Lessees should also disclose by way of note the total of future minimum lease payments under non-cancellable operating leases for each of the following periods:

– Not later than one year;
– Later than one year an not later than five years;
– Later than five years.

EXAMPLE 2

Shell plc is a company which negotiates a lease for a machine to begin on 1 January 20×4 on the following terms:

Term of lease 4 years
Estimated useful life of machine 9 years
Age of machine at start of lease 4 years
Purchase price of machine £750,000
Annual rental payments £140,000

How should the lease be treated in the accounts for the year ended 31 December 20×4?

SOLUTION

Annual rental payment of £140,000 charged to income statement and separately disclosed as
“operating lease rentals” by way of note.

Note of future commitments:
Future minimum lease payments:
within one year £140,000
within 2-5 years £ 280,000.
98

2. Finance lease

Lessee- In the statement of financial position or balance sheet, leased assets recognised – usually as a non-current asset and depreciated. The carrying value of leased assets needs to be separately identified by way of note.

In the statement of financial position or balance sheet, the finance lease obligation should be recognised as a liability. Will be the same value as the asset at the start of the lease.

Repayments divided into:

– Capital, which reduces the liability in the statement of financial position or balance sheet

– Interest, which gives rise to a finance charge in the income statement.

Lessor – In the balance sheet, net investment in lease as a receivable.

Repayments received divided into:

– Capital, which reduces the receivable in the statement of financial position or balance sheet;

– Interest , shown as revenue in the income statement.

Problem: How to split lease repayments between capital and interest?

Lease payments should be apportioned between the finance charge and the reduction of the outstanding liability. The finance charge should be allocated to periods during the lease term so as to produce a constant rate of interest on the remaining balance of the liability for each period. Some form of approximation, however, is acceptable.

– Actuarial method;
– Sum of the digits method;

EXAMPLE 3

A company has two alternatives. It can buy an asset for cash at a cost of £571,000 or it can lease it by way of finance lease. The terms of the lease are as follows:

1. Primary period is for four years from 1 January 20×2 with a rental of £200,000 per annum payable on 31 December each year (i.e. in arrears).

2. The lessee has the right to continue to lease the asset after end of the primary period for an indefinite period, subject to a nominal rent.

3. The lessee is required to pay all repair, maintenance and insurance costs as they arise. The lessee estimates the useful life of the asset to be 8 years. Depreciation is provided on a straight line basis. Accounting year end is 31 December.
99

Required:

a) Show the effects of the above transaction on the financial statements of the lessee over the full life of the asset. You should apply IAS 17 and use:

i) Actuarial method;
ii) Sum of the digits
method to allocate capital and interest over different accounting periods.

b) Assume that the lease rentals are made on the 1 January each year (i.e in advance) and repeat part (a).

SOLUTION

a) i- By actuarial method

Discount factor
Need to find interest rate implicit in the lease.

Discount factor = £ 571,000 £200,000 = 2.855

From inspection of annuity tables for a four year period, relevant discount rate is 15%.

The figures for the various years may be built up as follows:

Period Capital sum Finance Sub total Rental paid Capital sum
(y.e 31.12) at start of charge@ at end of
year 15% year
£ £ £ £ £
20×2 571,000 85,650 656,650 (200,000) 456,650
20×3 456,650 68,498 525,148 (200,000) 325,148
20×4 325,148 48,772 373,920 (200,000) 173,920
20×5 173,920 26,080 200,000 (200,000) 0
Total 229,000 (800,000)

NB Total finance charge is £229,000 which is the difference between the total rentals and the fair value of the assets.

Depreciation

The asset will be depreciated over the lower of the estimated useful life (8 years) and lease term – both primary and secondary (indefinite).

Annual depreciation charge = £ 571,000 / 8 years = £71,375.

100

Effect on financial statements of lessee

Year end Income Income BS – BS – Total BS – Non BS –
31/12 statement- statement- Non- obligations Current Current
Interest Depreciation current under obligations obligations
on assets finance under under
finance (finance leases finance finance
leases leases) leases leases
£ £ £ £ £ £
20×2 85,650 71,375 499,625 456,650 325,148 131,502
20×3 68,498 71,375 428,250 325,148 173,920 151,228
20×4 48,772 71,375 356,875 173,920 0 173,920
20×5 26,080 71,375 285,500 0
20×6 71,375 214,125
20×7 71,375 142,750
20×8 71,375 71,375
20×9 71,375 0
ii By sum of the digits method

Interest will be spread over 4 payments.

Sum of the digits = N(N+1)=4(4+1) =10 (i.e. 1+2+3+4) 2 2

Year ended 31 December

20×2 4/10 x £229,000 = £91,600
20×3 3/10 x £229,000 = £68,700

20×4 2/10x £229,000 = £45,800
20×5 1/10x £229,000 = £22,900

These figures represent the finance charges each year. The liability can be calculated by slotting the above figures into the table used in (i) in place of calculated interest.

Treatment of non-current assets and depreciation remains unchanged.

b)Assuming payments in advance

When lease repayments are made in advance: 1. The first repayment is 100% capital;
101

2. There will be some interest incurred since the last repayment which will be included in the creditor.

– By actuarial method

Discount factor

First payment is capital only, and then obligation is outstanding for a three year period. Discount factor = £571,000 – £200,000

£200,000 = 1.855

From inspection of annuity tables for a three year period, relevant discount rate is approximately 28%. The figures for the various year may be built up as follows:

Period Capital sum Rental paid Sub total Finance Capital sum
(y.e 31.12) at start of charge @ at end of
year 28% year
£ £ £ £ £
20×2 571,000 (200,000) 371,000 103,880 474,880
20×3 474,880 (200,000) 274,880 76,996 351,846
20×4 351,846 (200,000) 151,846 42,516 194,362
20×5 194,362 (200,000) 0 0 0

Depreciation
As for example 3 a.
Effect on financial statements of lessee

Year end Income Income BS – BS – Total BS – Non- BS –
31/12 statement- statement- Non- obligations Current Current
Interest Depreciation current under obligations obligations
on assets finance under under
finance (finance leases finance finance
leases leases) leases leases
£ £ £ £ £ £
20×2 103,880 71,375 499,625 474,880 274,880 200,000
20×3 76,996 71,375 428,250 351,846 151,846 200,000
20×4 42,516 71,375 356,875 194,362 0 194,362
20×5 71,375 285,500 0
20×6 71,375 214,125
20×7 71,375 142,750
20×8 71,375 71,375
20×9 71,375 0
102

ii By sum of the digits method

Interest will be spread over 3 payments.

Sum of the digits = N(N+1)=3(3+1) = 6

2 2 Year ended 31 December

20×2 3/6 x £229,000 = £114,500
20×3 2/6 x £229,000 = £ 76,333

20×4 1/6x £229,000 = £ 38,167.

These figures represent the finance charges each year. The liability can be calculated by slotting the above figures into the table used in (i) in place of calculated interest.

Treatment of non-current assets and depreciation remains unchanged.

Leases – the future

Economically similar transactions treated very differently for accounting purposes make comparisons between companies difficult. Creative accounting still exists in this area. Contracts which are essentially finance leases are often carefully drafted to ensure that they meet the criteria of an operating lease.

Because operating leases are not shown on the statement of financial position or balance sheet of a company, investors have to estimate their impact on gearing and earnings, and the adjustments they make could be wrong. Ideally they would have information in the financial statements about expected future cash flows for all leases.

The IASB have proposed that non-cancellable operating leases should be treated the same way as finance leases. So a lessee has acquired the right to use an asset and it pays for that right with lease payments. A lessee would record in the accounts:

– An asset for its right to use the underlying asset (initially recorded at PV of lease payments and then amortised over the life of the lease and tested for impairment. It would be shown under property, plant and equipment but separately from assets that the lessee owns);

– A liability to pay rentals.
– Amortisation and interest in P&L account.

The US standard setter (FASB) prefers the current dual model approach and a joint meeting with the IASB in March 2014 did not produce a consensus. European standard setters (including the FRC) are currently performing further public consultation on the two different approaches being proposed for lessees.
103

SEMINAR QUESTIONS
1. Todorov plc enters into three leasing agreements on 1 July 2003 as a lessee.

i) Equipment costing £45,000 was leased on an annual rental of £8,000 payable in
arrears. The lease is for two years. It is expected that the equipment will last for
8 years and will have no scrap value at the end of that period.

ii) A lease for machinery costing £56,300 the primary period is for five years with a
rental of £14,100 per year payable in arrears. The lessee has the right to continue

to lease the asset after the primary period for an indefinite time subject to a
nominal rent. It is estimated that the machinery has a useful economic life of 5
years.

iii) A lease for equipment costing £55,792. The lease requires the payment of an
annual rental of £16,000 payable in advance. The primary period of the lease is
for four years. The interest rate implicit in the lease is 10%. After the primary
period, the lessee has the right to extend the lease indefinitely on payment of a
nominal annual rental. The lessee believes that the equipment will last for eight
years and will have no scrap value at the end of that period.

Further information:

-Depreciation is charged on a straight line basis.

-Todorov plc uses the actuarial method to allocate capital and interest on a finance lease.

-The accounting year end for Todorov plc is 30 June.

Required:

a) Prepare the relevant balance sheet and profit and loss extracts for the years ended 30 June 2004 and 30 June 2005. Compliance with IAS 17 is required.

(18 marks)

b) Discuss whether the distinction between finance and operating leases made by standard setters is justified.

(7 marks)
(Total 25 marks).

Question 2

Charlton plc is a company in the engineering sector with a 31 March year end. On the 1 April 20×6 it entered into three leasing arrangements:
104

i) A lease with a primary period of 5 years to obtain the use of a machine costing £122,665. An annual rental, payable in advance, of £ 30,385 is required under the terms of the lease throughout the primary period. After the end of the initial 5 years, the company has the option to extend the lease for an indefinite period on the payment of a nominal annual rental, and it is expected that this will be exercised. It is estimated that the machine concerned will last for 6 years, after which it will have a nil scrap value.

ii) Equipment costing £15,000 was leased at a monthly rental of £140 payable in arrears. The lease is for two years, and although it may be possible to renew the agreement for subsequent years, this option does not feature in current plans. It is expected that the equipment will last for ten years and will have no scrap value at the end of that period.

iii) Use of a machine costing £25,678 was obtained through a 5 year lease, with an annual rental of £7,400 payable in arrears. It is estimated that the machine concerned will last for 5 years after which it will have a nil scrap value.

Further information:
– Depreciation is charged on a straight line basis.

– Charlton plc uses the ‘sum of the digits’ method to allocate capital and interest on finance leases.

Required:

Prepare the relevant statement of financial position and income statement extracts for the years ended 31 March 20×7 and 31 March 20×8, assuming the requirements of IAS 17 are satisfied.
105

Week 9 Lecture
ASSOCIATED COMPANIES AND JOINT VENTURES

Learning objectives

After this session you should:
a) Understand the need for an accounting standard covering associates;
b) Be able to recognise different investor / investee relationships;
c) Know how to account for these different relationships.
d) Be able to evaluate the solution proposed by IAS 28.
e) Be aware of the accounting for joint arrangements under IFRS 11.

Revision of Investment Relationships

Simple investment

The investor has limited influence (e.g. 5% shareholding) or its interest is not long term. Accounting treatment:

Income statement – Dividends received;

Statement of Financial Position (Balance Sheet) – Investment in shares shown as part of non-current assets at either cost or valuation.

Subsidiary governed by IFRS10

The investor controls the investee (e.g. 60% shareholding). An investor controls an investee when it is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. [IFRS 10:5-6; IFRS 10:8]

Accounting treatment:

Income statement – Consolidate all income and expenses of subsidiary, show the % of profits due to minority interests after tax.

Statement of Financial Position (Balance Sheet) – Consolidate all assets and liabilities of subsidiary, showing the claim that minority interests have on the net assets of the subsidiary.

Background to IAS 28

1960’s – common for companies to trade through other companies in which they held a substantial but not controlling interest.

How to account for the arrangement? Not subsidiaries.

Traditional approach of treating them like a trade investment was also criticised for not reflecting the reality of the investment.
106

E.g. in the income statement the only income from such companies was dividend income received, although the investing company could influence dividend policy and use it to smooth earnings. If the investing company had poor results for the year its overall position could be improved by ensuring that a higher dividend was paid by the investee. Also the value of the investment in the Statement of Financial Position (Balance Sheet) would be increasingly out of date, not reflecting retained profits.

It became increasingly apparent that an interim form of accounting was desirable for such circumstances, reflecting the close involvement of the investing company, taking into account the investor’s share of profits and net assets in the investee.

1964 Royal Dutch Shell pioneered use of equity accounting as a means of accounting for associated companies.

1971 Unified approach adopted via SSAP 1 Accounting for Associated Companies@.

1997 FRS 9 Associates and Joint Ventures issued as a replacement with increased emphasis on the commercial substance of a relationship between 2 companies rather than legal form. Also provided guidance on joint ventures for the first time.

IAS 28 was revised in 2003 and is virtually a replica of FRS 9 – although it does not cover joint ventures.

IAS 28 revised again in 2011, with all disclosure requirements now contained in IFRS12

(“Disclosure of interests in other entities”) and a new standard IFRS 11 issued “Joint Arrangements” dealing with joint ventures. Standards are compulsory from 1 January 2013.

Definition of Associate

It is important to have a reasonably tight definition otherwise companies will be considered as associates when making profits but not when incurring losses.

Associate:

“An entity in which the investor has significant influence and which is neither a subsidiary nor a joint arrangement of the investor.” (IAS 28).

Significant influence:

“The power to participate in the financial and operating policy decisions of the investee but is not control over these policies”. (IAS 28).

The existence of significant influence by an entity is usually evidenced in one or more of the following ways: [IAS 28(2011).6]

• representation on the board of directors or equivalent governing body of the investee;
107

• participation in the policy-making process, including participation in decisions about dividends or other distributions;

• material transactions between the entity and the investee;
• interchange of managerial personnel; or
• provision of essential technical information.

If an investor holds, directly or indirectly, 20% or more of the voting power of the investee, it is presumed that it has significant influence, unless it can be demonstrated that this is not the case. Conversely, if less than 20% the presumption is that the investor does not have significant influence. The presumption is rebuttable:

E.g. Royal Bank of Scotland holds just 12.8% of the shares of one of its associates, while RMC holds 25.7 % of shares in another company not regarded as an associate.

Sometimes tenuous e.g. Bradford Wool Mills had a 27% holding in another company with a director on the board and it was accounted for as an associate. The director became ill, it was not possible to find a replacement director acceptable to the associate, so it is no longer treated as an associate.

Accounting for Associates

IAS 28 requires that a reporting entity that prepares consolidated financial statements should include its associates in those statements using the equity method.

Uniform accounting policies should be adopted and appropriate adjustments should be made to the associate’s accounts where necessary.

In the investor’s own financial statements, its interest in associates should be treated as non-current asset investments shown at cost less any amounts written off or at valuation. Dividends received should be shown in the income statement.

Consolidated Statement of Financial Position (Balance Sheet)

IAS 28 requires the following:

The investor’s consolidated Statement of Financial Position (Balance Sheet) should include as a non-current asset investment “Investment in associates” comprising:

a) the investor’s share of the net assets of its associates shown as a separate item.

b) Goodwill arising on the investor’s acquisition of its associates, should be included in the carrying amount for the associates but should be disclosed separately.

c) Less any write-down for impairment in the investment

108

Example 1 – Statement of Financial Position (Balance Sheet) only

On 1 January 20×6 the net tangible assets of A Ltd. amount to £220,000, financed by 100,000 £1 ordinary shares and revenue reserves of £120,000. H Ltd., a company with subsidiaries, acquires

30,000 of the shares in A Ltd. for £75,000. During the year ended 31 December 20×6 A Ltd.’s profit after tax is £30,000, from which dividends of £12,000 are paid.

Show how H Ltd.’s investment in A Ltd. would appear in the consolidated Statement of Financial Position (Balance Sheet) as at 31 December 20×6.

SOLUTION

Calculate goodwill
£
Price paid for shares 75,000
Net assets acquired by group (30% x £220,000) 66,000
Goodwill 9,000
Share of Net assets
A Ltd.’s net assets at 31 December 20×6
Net assets at 1 January 20×6 220,000
Retained profit for year (£30,000-£12,000) 18,000
238,000
Group share (30%) 71,400
Investment in associate 80,400

Consolidated income statement

IAS 28 requires the following treatment:

a) The investor’s share of its associates post-tax results should be included immediately after the group profit from operations together with Finance income and charges.

b) Any write down for impairment in the Investment in associate should be charged at this point and disclosed. As should the investor’s share of any exceptional items.

c) The investor’s share of changes recognised in other comprehensive income by the associate shall be recognised by the investor in other comprehensive income.

Segmental analysis of turnover and profit should distinguish between group and associates.

See example bearing in mind that most of the information could appear by way of note to the accounts.
109

Additional disclosures

IAS 28 requires disclosure of significant associates, including proportion of shares held and the method used to account for them.

Example 2 – Comprehensive

Aroma plc purchased 30% of Therapy Ltd. on 1 July 20×4. At all times Aroma participates fully in Therapy’s financial and operating policy decisions. Goodwill is to be capitalised and reviewed annually for impairment.
Extract from Therapy Ltd.’s Statement of Financial Position (Balance Sheet) at acquisition

£000
Share capital 1,000
Revaluation reserve 100
Profit & loss reserve 450
1,550
Statement of Financial Position (Balance Sheet)s as at 30 June 20×8
Aroma plc group Therapy Ltd.
£000 £000 £000 £000
Non-current assets
Plant, property & equipment 4,000 3,500
Investment in Therapy 1,000 –
5,000 3,500
Current assets
Inventories 670 430
Trade receivables 500 395
Cash 130 215
1,300 1,040
6,300 4,540
Capital and reserves
Share capital 2,000 1,000
110

Revaluation reserve 1,000 500
Profit & loss reserve 2,550 2,470
5,550 3,970
Current liabilities
Trade payables 750 570
6,300 4,540
Income statements for the year ending 30 June 20×8
Revenue 5,000 3,000
Cost of sales (3,000) (1,500)
Gross profit 2,000 1,500
Expenses (750) (440)
Operating profit 1,250 1,060
Finance Charges (50) (10)

Profit before tax 1,200 1,050
Tax (400) (350)
Profit after tax 800 700

Required:

Prepare the consolidated Statement of Financial Position (Balance Sheet) and income statement for the year ended 30 June 20×8.

EXAMPLE 2 –SOLUTION

1. Calculate the goodwill in the investment in Therapy Ltd.

£000 £000
Cost of investment 1,000
Less Aroma’s % of net assets (= share capital and pre-acquisition reserves)
Share capital 1,000
Revaluation reserve 100
Profit & loss reserve 450
1,550
x30% 465
Goodwill 535

111

2. Complete the top half of the Statement of Financial Position (Balance Sheet) by calculating the
‘Investments in Associates line’
£000
Share of Associates net assets
(30% x £3,970,000) 1,191
Goodwill 535
1,726
3. Calculate the Statement of Financial Position (Balance Sheet) reserves
£000 £000
Bring in Aroma’s share of post acquisition reserves
a) Revaluation reserve Aroma plc 1,000
Therapy Ltd. – at 30 June 20×8 (Balance Sheet) date 500
– at acquisition (100)
400
x30% 120
1,120
b) Profit & loss reserve
Aroma plc 2,550
Therapy Ltd. at 30 June 20×8 (Balance Sheet) date 2,470
– at acquisition (450)
2,020
x30% 606
3,156

N.B. In the event of a write down following an impairment review, the relevant amount would be deducted from both ‘Investment in Associates’ and ‘Profit & loss reserve’.

4. Calculate ‘Share of Profit after tax in Associate’ for inclusion in consolidated income statement.

£000
Profit after tax x 30%
(£700,000 x 30%) 210

N.B. Any goodwill written off during the year following impairment review would be deducted from this figure.

112

Aroma plc Consolidated Statement of Financial Position (Balance Sheet) as at 30 June
20×8 £000 £000
Non-current assets
Plant, property & equipment 4,000
Investments in associates (see working 2) 1,726
5,726
Current assets
Inventories 670
Trade receivables 500
Cash 130
1,300
7,026
Capital and reserves
Share capital 2,000
Revaluation reserve (see working 3) 1,120
Profit & loss reserve (see working 3) 3,156
6,276
Current liabilities
Trade payables 750
7,026
Aroma plc Consolidated Income statement for the year ending 30 June 20×8
£000
Revenue 5,000
Cost of sales (3,000)
Gross profit 2,000
Expenses (750)
Group operating profit 1,250
Finance Charges (50)
Share of profits of associate (see working 4) 210
113

Profit before tax 1,410
Tax: Group (400)
Profit after tax 1,010

Further points:
1. Inter-company debts

Debts between a group company and an associate do not need to be eliminated as the associate is not part of the group.

2. Unrealised profit on inventories

If a group company sells inventories to an associate company and some of the inventories remain unsold at the year end, only the appropriate % of unrealised profit is deducted from group share of associates profit in the income statement and from investment in associates in the Statement of Financial Position (Balance Sheet).

3. Dividends paid from an associate to a group company. This has to be eliminated from the group income statement as it will also be included in share of operating profit of associate and double counting would occur.

Joint Arrangements

Accounting for joint arrangements is covered by a separate international standard IFRS 11 ‘Joint Arrangements’ which replaced IAS 31 ‘Interests in Joint Ventures’, with effect from 1st January 2013.

Joint arrangements

A joint arrangement is an arrangement of which two or more parties have joint control. [IFRS 11:4]. A joint arrangement has the following characteristics: [IFRS 11:5]

• the parties are bound by a contractual arrangement, and

• the contractual arrangement gives two or more of those parties joint control of the arrangement.

Types of joint arrangements

Joint arrangements are either joint operations or joint ventures:

• A joint operation is a joint arrangement whereby the parties that have joint control of the arrangement have rights to the assets, and obligations for the liabilities, relating to the arrangement. Those parties are called joint operators. [IFRS 11:15]. Joint operations are not structured through a separate vehicle (company, partnership etc)
114

• A joint venture is a joint arrangement whereby the parties that have joint control of the arrangement have rights to the net assets of the arrangement. Those parties are called joint venturers. [IFRS 11:16]

Joint control

Joint control is the contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. [IFRS 11:7]. It means that decisions on financial and operating policy require each parties consent (i.e. each has a veto).

Accounting Treatment for joint arrangements

Accounting treatment joint ventures:

IFRS 11 requires joint ventures to be accounted for using the equity method and hence to be accounted for in an identical manner to associated undertakings.

IAS 31 had previously allowed two treatments, either the Equity method as per IAS 28 for Associates or proportional consolidation. The preferred option of IAS 31 was proportional consolidation.

The 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 separate line items in the venturer’s financial statements.

Accounting treatment joint operations:.

Each joint operator records its individual assets a, liabilities and income in accordance with the agreement for the joint operation.

.

Conclusion

The accounting treatment for associates and joint ventures are now identical and fairly straightforward with the introduction of IFRS 11. However, despite the introduction of IFRS 11

“Joint Arrangements” there is still some ongoing debate as to whether the equity method is the best method for recording arrangements where there is joint control.

115

SEMINAR QUESTIONS

1. How is the situation of the minority interest shareholder in a company different from the position of an investor in a:

a) Joint venture;
b) Associated company.

2. Ajaccio plc, a company with subsidiaries, acquired a 40 % investment in Bonifacio Ltd (sufficient to enable it to exercise significant influence over policy) on 1 April 2007 when the reserves of Bonifacio Ltd. consisted of retained profits of £130,000. The accounts of the Ajaccio group and of Bonifacio Ltd. for the year to 31 March 2011, before consolidating the results of the associate were as follows:

Summarised Statement of Financial Position (Balance Sheet)
Ajaccio plc Bonifacio
Ltd.
£000 £000
Non current assets
Plant, property and equipment 582 580
Goodwill 100 0
Investment in associate (at cost) 254 0
Current assets 428 550
1,364 1,130
Capital and reserves
Called up share capital (£1 shares) 280 180
Retained profits 560 510
840 690
Minority interest 70 0
910 690
Non-current creditors
Long term loans 200 230
Provision for deferred taxation 54 60
1,164 980
Current creditors 200 150
1,364 1,130
Income statements
Ajaccio plc Bonifacio
Ltd.
£000 £000
Revenue 1,860 980
Cost of sales 1,020 360
Gross profit 840 620
Administration expenses 328 220
Operating profit 512 400
Interest payable 38 40
Profit from ordinary activities before tax 474 360
Taxation 180 110
Profit after taxation 294 250
116

REQUIRED:

a) Prepare the consolidated income statement of the Ajaccio Group for the year ended 31 March 2011 and a Consolidated Statement of Financial Position (Balance Sheet) as at that date.

(18 marks)

b) Discuss the difference between the following categories of investment, making reference to their accounting treatment:

– Associated company;
– Joint venture;
– Subsidiary.

(7 marks) (Total 25 marks)

3. Carr plc acquired shares in another company Saunders plc on 1 January 20×5. The directors are uncertain concerning the appropriate accounting treatment that should be adopted for this transaction. The following information is made available as at 31 December 20×6:

Carr group Saunders
(excluding Saunders)
£000 £000
Assets
4 million shares in Saunders Ltd. 23,500 –
Sundry net assets 126,500 20,000
150,000 20,000
Financed by:
Share capital (ordinary shares of £1 each) 40,000 5,000
Retained profit at 1 January 20×5 100,000 11,000
Profit for 20×5 6,400 2,000
Profit for 20×6 3,600 2,000
150,000 20,000
Required:

a) Prepare three separate Statement of Financial Position (Balance Sheet)s of the Carr Group at 31 December 20×6, incorporating the results of Saunders Ltd., on the assumption that Saunders Ltd. is accounted for:

(i) As a pure investment;
(ii) As an associated company, using equity accounting;
(iii) As a subsidiary, using acquisition basis.

b) State the circumstances in which each of the three methods should be used. Advise the directors which of the above methods appears to be appropriate, based on the information provided, to comply with the relevant IFRS.
117

Week 10 Lecture
Accounting for the Effects of Changes in Foreign Exchange Rates

Learning Outcomes

After this lecture students should:
1. Understand the problems associated with accounting for foreign currencies;
2. Be able to record foreign exchange transactions into a companies own books;

3. Be able to incorporate the accounts of foreign subsidiaries into the parent company’s accounts by translating them in accordance with IAS 21. This approach requires the nature of the relationship between parent and subsidiary to be considered.

Problems of Accounting for Foreign Currencies Transactions

Obviously the key problem is that the value of one currency measured against another currency will tend to fluctuate over time. Foreign exchange rates are continually changing. IAS 21 ‘The effects of changes in foreign exchange rates’ provides guidance on the treatment of these issues and provides some key definitions.

Conversion
Conversion is the process of exchanging amounts of one foreign currency for another.

If a company trades overseas it will buy or sell assets in foreign currencies. E.g. A UK company may buy materials from Spain, paying for them in euros, selling the finished goods to the US, receiving payment in US dollars.

If the relevant rate of foreign exchange has changed between the date of the transaction and ultimate payment, a profit or loss on conversion will arise which will be included in the income statement.

Translation

Does not involve the act of exchanging one currency for another. Translation is required at the end of an accounting period when a company still holds assets or liabilities in a foreign currency.

For an individual company, any amounts receivable or payable at the end of an accounting period must be converted into the local currency to be included in the accounts.

If a parent has a subsidiary whose accounts are presented in a foreign currency, those accounts must be translated into the local currency before they can be included in the consolidated financial statements.

Exchange differences may arise as a consequence of translating units of one currency into another at different exchange rates (e.g. this year v. last year).

Further terms:
Functional currency
The currency of the primary economic environment in which the entity operates.
118

Need to consider which currency influences sales prices for goods and services, the currency of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services and which currency influences costs (e.g. labour & materials) of providing those goods and services.

Presentation currency
The currency in which the financial statements are presented.

IAS 21 – Individual Company Stage

Each entity will need to determine its functional currency which for an individual company is unlikely to be different from its presentation currency.

IAS 21 states that a foreign currency transaction should be recorded by applying the exchange rate between the presentation currency and the foreign currency at the date of transaction to the foreign currency amount.

For each subsequent Statement of Financial Position (Balance Sheet):

-Report foreign currency monetary items (e.g. cash held or receivables / payables due) using the closing rate (i.e. rate at Statement of Financial Position (Balance Sheet) date).

– Report non-monetary items (e.g. non-current assets, inventories) carried at historic cost in a foreign exchange currency using the exchange rate at the date of the transaction (i.e. historic rate)

– Report non-monetary items which are carried at fair value in a foreign currency using the exchange rates that existed when the values were determined.

IAS 21 requires disclosure of the amount of exchange differences recognised in the income statement.

EXAMPLE 1

A UK company buys plant from a Swiss company on 1 January 20×1 for 2,000,000 Swiss francs (SF). At that date £1 = 2.5 SF.

The year end is 31 March 20×1 and payment has not been made at that stage. At that date the exchange rate is £1= 2.3 SF.

The UK company makes a payment on 15 April when the exchange rate is £1 = 2.4 SF.

How should the above be recorded in the books of the UK company?

SOLUTION

1. On acquisition use exchange rate ruling on 1 January.
Dr. Plant (SF2,000,000 / 2.5) £800,000
Cr. Trade payables (Swiss co.) £800,000

2. At the Statement of Financial Position (Balance Sheet) date calculate value of unsettled liability and determine any exchange gain applicable to the year ended 31 March 20×1.

119

SF 2,000,000/2.3 = £869,565 – an increase in the sterling amount of the liability of
£69,565, which is the foreign exchange loss.
Dr. Exchange loss – income statement £69,565
Cr. Trade payables £69,565.

3. On settlement of the debt the UK company must pay (SF2,000,000/2.4) £833,333. in sterling terms. Since the Statement of Financial Position (Balance Sheet) date sterling has strengthened against the Swiss franc which will result in an exchange gain which will be included in the income statement for the year ended 31 March 20×2.

Dr. Trade payables £869,565
Cr. Cash £833,333
Cr. Exchange gain – income statement £ 36,232.

IAS 21 Consolidated Financial Statements Stage

There are two methods of translation available under IAS 21, the method used depends on whether the subsidiary has the same functional currency as the parent.

If the foreign subsidiary is semi –autonomous (e.g. activities financed from its own cash flows, transactions with the parent company form a relatively low proportion of the foreign subsidiaries activities) it almost certainly has a different functional currency from the parent.

If the foreign subsidiary carries out its business as though it were an extension of the parent company (e.g. it only sells goods imported from the parent, any sale proceeds are remitted back to the parent company) it almost certainly has the same functional currency as the parent.

Accounting treatments reflect different economic realities.

a) Different functional currency from parent –‘presentation currency method’.

A change in exchange rate will have little or no direct effect on the present or future cash flows from operations of either subsidiary or parent company. The change in investment will affect only the parent company’s net investment in the foreign subsidiary, not the individual monetary and non-monetary items held by the subsidiary.

E.g. if the £ strengthens against the euro, the £ value of assets in a French subsidiary will rise, but so will the £ value of liabilities, so little change in net investment.

– Income statement: translate using actual rate, but average is an acceptable practical alternative. For depreciation, which is an allocation for a period, average rate may be used.

– All assets and liabilities are translated at closing rate at the Statement of Financial Position (Balance Sheet) date, while share capital and pre-acquisition reserves are translated at historic rate. The balancing figure on the translated Statement of Financial Position (Balance Sheet) represents the parent company’s net investment in the foreign subsidiary.

120

– Exchange differences are taken direct to equity not through the income statement.

b) Same functional currency as parent – ‘functional currency method’.

Any movement in the exchange rate between the reporting currency and the foreign subsidiary’s currency will have an immediate impact on the parent company’s cash flows from operations. As far as possible the transactions of the subsidiary should be portrayed as if they had been undertaken by the parent. The same procedures used for individual company accounts should be used.

– Income statement: translate using actual rates, although an average for a period may be used where there is no significant fluctuation. Expenses such as depreciation which relate to non-monetary assets should be translated at the same historic rate as the asset.

– Non-monetary Statement of Financial Position (Balance Sheet) items and share capital and pre-acquisition reserves: translate using historical rate at date of purchase.

– Monetary Statement of Financial Position (Balance Sheet) items: translate at closing rate.

– Exchange differences report as part of profit for year.

EXAMPLE 2

On 1 January 20×1 Mendip plc acquired 100% of the shares of Texas Inc.- a company based in the United States. The most recent Statement of Financial Position (Balance Sheet) and income statement of both companies appear below:

Statement of Financial Position (Balance Sheet) as at 31 December 20×9
Mendip Texas
£000 £000 $000 $000
Assets
Non-current assets
Plant at cost 600 500
Less depreciation (250) (200)
350 300
Investment in Texas Inc. 125 –
475 300
Current assets
Inventories 125 200
Trade receivables 150 100
275 300
750 600
Equity and liabilities
Capital and reserves
Ordinary £1/$1 shares 300 100
Retained profit 300 280
600 380
Non-current liabilities
121

Long term loans 50 110
Current liabilities
Trade payables 100 110
750 600
Income Statement for the year ended 31 December 20×9
Mendip Texas
£000 £000 $000 $000
Revenue 3,700 1,200
Opening inventories 300 300
Purchases 2,725 740
Closing inventories (225) (200)
Cost of sales 2,800 (840)
Gross profit 900 360
Depreciation (100) (40)
Other expenses (600) (160)
Profit before tax 200 160
Tax (100) (80)
Profit after tax 100 80

Further information:

– Mendip plc acquired its interest in Texas Inc. when the balance of retained profits in Texas was $100,000.

– The net assets of Texas Inc at 31 December 20×8 were $300,000. These were translated to £150,000 using the Presentation currency method and £96,000 using the functional currency method

– Exchange rates:

$4 to £1 when Texas Inc. was acquired by Mendip plc $2.5 to £1 when Texas Inc. acquired its non-current assets $2.3 to £ 1 when opening inventory acquired
$2 to £1 on 31 December 20×8

$1.6 to £1 average rate of exchange year ending 31 December 20×9 $1.2 to £1 when closing inventory acquired

$1 to £1 on 31 December 20×9.

Required:
Prepare the consolidated financial statements of Mendip plc using:

a) the presentation currency method
b) the functional currency method.
SOLUTION – PRESENTATION CURRENCY METHOD

STEP 1 – The Statement of Financial Position (Balance Sheet) of Texas Inc. at 31 December 20×9 should be translated at closing rate ($1 =£1) except for share capital and pre-acquisition reserves which should be translated at historical rate ($4= £1).
122

Statement of Financial Position (Balance Sheet) as at 31 December 20×9
$000 $000 Rate £000 £000
Assets
Non-current assets
Plant at cost 500 500
Less depreciation (200) (200)
300 1 300
Current assets
Inventories 200 1 200
Trade receivables 100 1 100
300 300
600 600
Equity and liabilities
Capital and reserves
Ordinary $1 shares 100 4 25
Retained profit –pre-acq’n 100 4 25
Retained profit – post acq’n 180 Bal fig 330
380 380
Non-current liabilities
Long term loans 110 1 110
Current liabilities
Trade payables 110 1 110
600 600

STEP 2 – The income statement of Texas Inc. for the year ended 31December 20×9 should be translated at actual rate at the date of transaction. For most items in the income statement, the average rate for the year is a reasonable approximation (i.e. $1.6 = £1). Here opening / closing inventory are separately identifiable so more accurate actual rates can be used:

Income Statement for the year ended 31 December 20×9
$000 $000 Rate £000 £000
Revenue 1,200 1.6 750
Opening inventories 300 2.3 130
Purchases 740 1.6 463
Closing inventories (200) 1.2 (167)
Cost of sales (840) (426)
Gross profit 360 324
Depreciation (40) 1.6 (25)
Other expenses (160) 1.6 (100)
Profit before tax 160 199
Tax (80) 1.6 (50)
Profit after tax 80 149

123

STEP 3 – Calculate the post acquisition retained profits at the start of the year. This may involve translating the whole opening balance sheet or a summary as in this question: Net assets are translated in the question, for share capital and pre-acquisition reserves use the rate applicable when Texas was acquired[$4=£1).

Statement of Financial Position (Balance Sheet) as at 31 December 20×8
$000 Rate £000
Net assets (from question) 300 150
Equity and liabilities
Capital and reserves
Ordinary $1 shares 100 4 25
Retained profit –pre-acq’n 100 4 25
Retained profit – post acq’n 100 Bal fig 100
300 150
STEP 4 – Identify the exchange difference
£000
Post acquisition reserves at 31 December 20×9 (see stage 1) 330
Less: post acquisition reserves at 31 December 20×8 (see stage 3) 100
230
Less: Retained profit for the year (see stage 2) 149
Exchange gain 81
STEP 5 – Prepare consolidated financial statements.
Calculate goodwill on consolidation:
£000
Cost of investment in Texas Inc. 125
Less: Group share (100%)of Texas share capital (stage 1) 25
Group share (100%) of pre-acquisition reserves of Texas (stage 1) 25
Goodwill on consolidation 75

Mendip plc Consolidated Statement of Financial Position (Balance Sheet) as at 31 December 20×9
£000 £000
Assets
Non-current assets
Plant ( 350+300) 650
Goodwill 75
725
Current assets
Inventories (125+200) 325
Trade receivables (150+100) 250
575
1,300
124

Equity and liabilities
Capital and reserves
Ordinary £1 shares 300
Retained profits (300+330) 630
930
Non-current liabilities
Long term loans (50+110) 160
Current liabilities
Trade payables (100+110) 210
1,300

Mendip plc Consolidated Income Statement for the year ended 31December 20×9
£000
Revenue (3,700+750) 4,450
Cost of sales (2,800+426) (3,226)
Gross profit 1,224
Depreciation (100+25) (125)
Other expenses (600+100) (700)
Profit before tax 399
Tax (100+50) (150)
Profit after tax 249

Mendip plc Consolidated Statement of Movement on Reserves for the year ended 31 December 20×9
£000
Consolidated reserves at 31 December 20×8 (200+100) 300
Exchange gain arising on consolidation (step 4) 81
Retained profit for the year 249
Consolidated reserves at 31 December 20×9 630

Remember exchange differences in presentation method are as a reserve
movement.

Mendip’s opening reserves calculated Opening reserves of
SOLUTION by subtracting Mendips profit after Texas Inc,
tax for the year £100K from Mendips calculated at step 3
STEP 1 – closing retained profits of £300K in (Balance Sheet) of Texas Inc. at 31
December its balance sheet at 31/12/X9 rate ($1 =£1) for monetary items
and actual rates for non-monetary assets and share capital and pre-acquisition reserves.
125

Statement of Financial Position (Balance Sheet) as at 31 December 20×9
$000 $000 Rate £000 £000
Assets
Non-current assets
Plant at cost 500 500
Less depreciation (200) (200)
300 2.5 120
Current assets
Inventories 200 1.2 167
Trade receivables 100 1 100
300 267
600 387
Equity and liabilities
Capital and reserves
Ordinary $1 shares 100 4 25
Retained profit –pre-acq’n 100 4 25
Retained profit – post acq’n 180 Bal fig 117
380 167
Non-current liabilities
Long term loans 110 1 110
Current liabilities
Trade payables 110 1 110
600 387

STEP 2 – The income statement of Texas Inc. for the year ended 31December 20×9 should be translated at actual rate at the date of transaction.

Income Statement for the year ended 31 December 20×9
$000 $000 Rate £000 £000
Revenue 1,200 1.6 750
Opening inventories 300 2.3 130
Purchases 740 1.6 463
Closing inventories (200) 1.2 (167)
Cost of sales (840) (426)
Gross profit 360 324
Depreciation (40) 2.5 (16)
Other expenses (160) 1.6 (100)
Profit before tax 160 208
Tax (80) 1.6 (50)
Profit after tax 80 158

STEP 3 – Calculate the post acquisition retained profits at the start of the year. This may involve translating the whole opening balance sheet or a summary as in this question: Net assets are translated in the question, for share capital and pre-acquisition reserves use the rate applicable when Texas was acquired[$4=£1).

126

Statement of Financial Position (Balance Sheet) as at 31 December 20×8
$000 Rate £000
Net assets (from question) 300 96
Equity and liabilities
Capital and reserves
Ordinary $1 shares 100 4 25
Retained profit –pre-acq’n 100 4 25
Retained profit – post acq’n 100 Bal fig 46
300 96
STEP 4 – Identify the exchange difference
£000
Post acquisition reserves at 31 December 20×9 (see stage 1) 117
Less: post acquisition reserves at 31 December 20×8 (see stage 3) 46
71
Less: Retained profit for the year (see stage 2) 158
Exchange loss (87)

STEP 5 – Prepare consolidated financial statements. Goodwill as calculated for presentation method.

Mendip plc Consolidated Statement of Financial Position (Balance Sheet) as at 31 December 20×9
£000 £000
Assets
Non-current assets
Plant ( 350+120) 470
Goodwill 75
545
Current assets
Inventories (125+167) 292
Trade receivables (150+100) 250
542
1,087
Equity and liabilities
Capital and reserves
Ordinary £1 shares 300
Retained profits (300+117) 417
717
Non-current liabilities
Long term loans (50+110) 160
Current liabilities
Trade payables (100+110) 210
1,087

127

Mendip plc Consolidated Income Statement for the year ended 31December 20×9
£000
Revenue (3,700+750) 4,450
Cost of sales (2,800+426) (3,226)
Gross profit 1,224
Depreciation (100+16) (116)
Other expenses (600+100) (700)
Loss on foreign exchange differences (Step 4) (87)
Profit before tax 321
Tax (100+50) (150)
Profit after tax 171

NB This is the same as under the presentation method except that the loss on foreign exchange differences has been incorporated into the income statement.

Mendip plc Consolidated Statement of Movement on Reserves for the year ended 31 December 20×9
£000
Consolidated reserves at 31 December 20×8 (200+46) 246
Retained profit for the year 171
Consolidated reserves at 31 December 20×9 417
Summary of Translation methods-consolidation
Financial statement item Presentation currency Functional currency
Income statement:
Expense/revenue items Use actual rates where Use actual rates where
other than depreciation available (average rate available (average rate
acceptable) acceptable)
Depreciation/impairment Use average rate Use same historical rate
expense used to translate the
related asset
Statement of Financial
position:
Non-monetary assets e.g Closing rate Historical rate at date of
(Fixed assets, inventories) purchase
Monetary assets and Closing rate Closing rate
liabilities e.g (cash,
receivables, payables).
Share capital and pre-acqn Historical rate at date of Historical rate at date of
reserves purchase purchase

Exchange gain or loss Movement on reserves Report as part of profit for
the year
128

Conclusion

Technically complex- just a few criticisms.

Some companies will use average rate for entire income statement – slight lack of comparability.

Element of judgement in deciding which method to use.

Under presentation method exchange differences on net investments do not pass through the income statement until they are sold, when they are recycled from equity to the income statement and effectively recognised twice.
129

SEMINAR QUESTIONS

1. Why does IAS 21 allow two methods of translating the accounts of a subsidiary for consolidation purpose?

2. A UK company, Pink Spots plc, purchases a major piece of plant from a Singaporean company on 1 March 20×2 for S$ 30,000,000. Pink Spots plc has a 31 March year end, but payment is not made until 15 May 20×2.

Using journal entries show how the above should be recorded in the books of Pink Spots plc, and indicate the effect on reported profits (if any) for 20×1/2 and 20×2/3.

Ignore depreciation.
S$ to £
1 March 20×2 2.00
31 March 20×2 1.70
15 May 20×2 1.60

3.On 1 January 20×2 Quantock plc acquired 100% of the shares of Boston Inc.- a company based in the United States. The most recent Statement of Financial Position (Balance Sheet) and income statement of both companies appear below:

Statement of Financial Position (Balance Sheet) as at 31 December 20×5
Quantock Boston
£000 £000 $000 $000
Assets
Non-current assets
Plant at cost 1,820 900
Less depreciation (1,180) (300)
640 600
Investment in Boston Inc. 425 –
1,065 600
Current assets
Inventories 625 400
Trade receivables 340 150
Cash 180 60
1,145 610
2,210 1,210
Equity and liabilities
Capital and reserves
Ordinary £1/$1 shares 500 100
Retained profit 760 620
1,260 720
Non-current liabilities
Long term loans 550 400
Current liabilities
Trade payables 400 90
2,210 1,210
130

Income Statement for the year ended 31 December 20×5
Quantock Boston
£000 £000 $000 $000
Revenue 8,600 3,200
Opening inventories 500 500
Purchases 5,725 2,340
Closing inventories (625) (400)
Cost of sales 5,600 (2,440)
Gross profit 3,000 760
Depreciation (150) (50)
Other expenses (1,600) (260)
Profit before tax 1,250 450
Tax (500) (80)
Profit after tax 750 370

Further information:

– Quantock plc acquired its interest in Boston Inc. when the balance of retained profits in Boston was $100,000.

– The net assets of Boston Inc at 31 December 20×4 were $350,000. These were translated to £159,000 using the Presentation currency method and £162,000 using the functional currency method

– Exchange rates:

$2.6 to £1 when Boston Inc. was acquired by Quantock plc $2.4 to £1 when Boston Inc. acquired its non-current assets $2.0 to £ 1 when opening inventory acquired
$2.2 to £1 on 31 December 20×4

$2.0 to £1 average rate of exchange year ending 31 December 20×5 $1.9 to £1 when closing inventory acquired

$1.8 to £1 on 31 December 20×5.

Required:
Prepare the consolidated financial statements of Quantock plc using:

a) the presentation currency method
b) the functional currency method.

131

Week 11 Lecture
Advanced Consolidation Accounting

Learning Outcomes

After this lecture students should:
1. Be able to prepare consolidated accounts for a mid-year acquisition;

2. Be able to incorporate a disposal of a subsidiary within consolidated accounts;

3. Be able to account for a step by step acquisition of a subsidiary.

Reading

Notes

Mid-year acquisition of a subsidiary

Previously we have considered how to account for a subsidiary acquired at the year-end date. What happens if the acquisition is made mid way through a year?

Preparation of accounts

When a parent company acquires control of a subsidiary during an accounting period it is not necessary to prepare consolidated financial statements immediately, although in most acquisition situations it is normal for financial statements to be prepared for the acquired subsidiary at the date of acquisition. These statements can be prepared at the normal year end.

However, it will be necessary to calculate goodwill at the date of acquisition, to apportion reserves between pre and post acquisition and to include the results of the acquired subsidiary in the consolidated income statement from the date of acquisition only

If separate accounts are not prepared at the acquisition date

If a separate set of accounts for the subsidiary is not prepared at the acquisition date it will be necessary to estimate the balance on reserves at the acquisition date. Time apportionment of the profit of the subsidiary for the relevant accounting period will generally be acceptable, unless the circumstances suggest that another method would be more accurate, e.g if the business was seasonal.

Example 1

On 30 September 2011 Carrot plc acquired a 75% interest in Swede Ltd for £800,000.

Notes:
1) The profits of Swede Ltd accrue evenly throughout the year
2) The book values of Swede Ltd represent the fair values of its net assets

132

The summarised income statements of the company’s for the year ended 31 December
2011 were as follows:
Carrot Swede
Plc Ltd
£’000 £’000
Revenue 6,000 2,000
Cost of sales 4,200 1,000
Gross profit 1,800 1,000
Expenses 1,100 700
Profit before taxation 700 300
Taxation 150 60
Profit after taxation 550 240

The summarised statements of financial position for the company’s at 31 December 2011 were as follows:

Carrot Swede
Plc Ltd
£’000 £’000
Property, Plant & Equipment 4,500 425
Investment in Swede Ltd 800
Non-current Assets 5,300 425
Other net assets 2,400 375
Net assets 7,700 800
Equity and Reserves
Ordinary Shares 2,500 100
Retained profits 5,200 700
7,700 800

Prepare the consolidate financial statements of Carrot plc for the year ended 31 December 2011

Step 1 Time apportion the profits of Swede Ltd

Pre acquisition 1 January – 30 September =9/12, post acquisition =3/12

Swede Pre-acq Post acq
Ltd 9/12 3/12
£’000 £’000 £’000
Revenue 2,000 1,500 500
Cost of sales 1,000 750 250
Gross profit 1,000 750 250
Expenses 700 525 175
Profit before taxation 300 225 75
Taxation 60 45 15
Profit after taxation 240 180 60

Step 2 Calculate the goodwill on acquisition 133

Equity and Reserves Ordinary Shares Retained profits (step 4)
Attributable to equity shareholders Minority (Non-controlling) interests (step 3)
£’000 £’000
Consideration 800
Fair value of net assets of Swede Ltd at 31/12/2011 800
Less post acquisition profits (step 1) (60)
Fair value of net assets of Swede Ltd at 30/9/2011 740
Group share of fair value of net assets of Swede Ltd 75% (555)
Goodwill on acquisition 245
Step 3 Calculate the minority interest
Minority interest = 25% x net assets of Swede Ltd
= 25% x £800,000 = £200,000
Step 4 Calculate the consolidated retained profits of Carrot plc
£’000
Retained profits of Carrot plc 5,200
Group share of post acquisition retained profits of Swede Ltd 75% x (60) 45
Group retained profits 5,245
Step 5 Prepare the consolidated financial statements of Carrot plc
Consolidated statement of financial position
at 31 December 2011 of Carrot plc
£’000
Property, Plant & Equipment (4,500+425) 4,925
Goodwill (step 2) 245
Non-current Assets 5,170
Other net assets (2,400+375) 2,775
Net assets 7,945
2,500
5,245

7,745
200

7,945

Consolidated income statement of Carrot plc for the year ended 31 December 2011

£’000
Revenue (6,000+500) 6,500
Cost of sales(4,200+250) 4,450
Gross profit 2,050
Expenses(1,100+175) 1,275
Profit before taxation 775
Taxation(150+15) 165
Profit after taxation 610

Disposal of a subsidiary

134

If a parent company loses control of a subsidiary, in other words reduces its holding so that it no longer controls the subsidiary or fully disposes of its entire shareholding, the parent:

• Fully derecognises the assets and liabilities of the former subsidiary from its statement of financial position;

• Recognises any retained investment in the former subsidiary at its fair value when control is lost and accounts for the revised interest in accordance with relevant IFRSs (as a financial asset or associate dependent on the remaining holding);

• and recognises the gain or loss associated with the loss of control in the consolidated income statement

Calculation of profit/loss on disposal
The profit loss on disposal is calculated as follows:
£M £M
Disposal proceeds X
Add back fair value of investment retained X
X
Less net assets eliminated:
Goodwill on acquisition Y
Group share of net assets eliminated Y
Total consolidated net assets eliminated (Y)
Profit on disposal Z
Example 2: full disposal

Jack plc disposed of its entire 60% holding in Jill Ltd on 31 December 2011 for £30M when the fair value of the net assets of Jill Ltd was £20M. Jack plc had bought its interest in Jill Ltd on 31 December 2004 for £15M when the fair value of the net assets of Jill Ltd was £10M. There have been no impairment provisions in relation to the goodwill on the acquisition of Jill Ltd.

Calculate the profit on disposal to be recorded in the consolidated accounts of Jack plc

Step 1 Calculate the goodwill recorded in the group’s accounts on acquisition of Jill
Ltd on 31 December 2004

£M
Purchase price 15
Less group share of fair value of net assets of Jill Ltd at
31 /12/2004 = 60%x £10M 6
Goodwill on acquisition 9
Step 2 Calculate the Group’s share of the net assets of the subsidiary on the date of disposal
135

Groups share of the fair value of Jill Ltd’s net assets at 31 December 2011 = 60% x £20M=£12M

Step 3 Calculate the profit on disposal
£M £M
Disposal proceeds 30
Less net assets eliminated
Goodwill on acquisition of Jill Ltd (Step 1) 9
Group share of net assets eliminated (Step 2) 12
Total consolidated net assets eliminated 21
Profit on disposal 9

Note no investment is retained in this example.

Example 3: retention of a small shareholding

Bill plc disposed of a 65% holding in Ben Ltd on 31 December 2011 for £39M when the fair value of the net assets of Ben Ltd was £30M, Bill plc retained a small investment of 5% in Ben Ltd, the fair value of the retained investment was £3M. Bill plc had bought its 70% interest in Ben Ltd on 31 December 2006 for £25M when the fair value of the net assets of Ben Ltd was £10M. There have been no impairment provisions in relation to the goodwill on the acquisition of Ben Ltd.

Calculate the profit on disposal to be recorded in the consolidated accounts of Bill plc

Step 1 Calculate the goodwill recorded in the group’s accounts on acquisition of Ben
Ltd on 31 December 2006

£M
Purchase price 25
Less group share of fair value of net assets of Ben Ltd
at 31 /12/2006 = 70%x £10M 7
Goodwill on acquisition 18
Step 2 Calculate the Group’s share of the net assets of the subsidiary on the date of disposal

Groups share of the fair value of Ben Ltd’s net assets at 31 December 2011

= 70% x £30M=£21M

Step 3 Calculate the profit on disposal

Note calculate the full elimination of assets, but bring back in the retained investment at fair value

£M £M
Disposal proceeds 39
Add back fair value of investment retained 3
42
Less net assets eliminated:
136

Goodwill on acquisition of Ben Ltd (Step 1) 18
Group share of net assets eliminated (Step 2) 21
Total consolidated net assets eliminated (39)
Profit on disposal 3
Treatment of profit on disposal in the consolidated accounts

If material the profit on disposal should be separately disclosed in the income statement or in the notes in accordance with IAS1. If the disposal constitutes the discontinuance of a component of an entity (business operation) then it should be accounted for as a discontinued operation in accordance with IFRS5.

Step by step acquisition

Many business combinations occur over a period of time and control of a subsidiary is often only obtained after more than one transaction. There are specific rules for accounting for such transactions.

Transactions where control is achieved through two transactions
IAS 39 IAS28/ IFRS 10
IFRS 11

75%
15% 75%
35%

50%
0% 20%
Significant
Passive Control
influence /
investment
Combinationsjoint controlguidance on how to account for such

situations

The principles to be applied are as follows:

• A business combination occurs only in respect of the transaction that gives one entity control over another entity

• The identifiable net assets of the acquired company are remeasured to their fair value on the date that control passes
137

• An equity interest previously held in the acquired company which qualified as a financial asset is treated as if it were disposed of and reacquired at fair value on the acquisition date. Any resulting gain or loss is recognised in profit or loss

• An equity interest previously held in the acquired company which qualified as an associate under IAS28 or a joint venture under IFRS11 is treated as if it were disposed of and reacquired at fair value on the acquisition date. Any resulting gain or loss is recognised in profit or loss.

Example 4

On 31 December 2010 Fuschia plc acquired a 15% investment in Rose Ltd for a consideration of £10M. On 31 December 2011 Fuschia plc acquired a further 60% in Rose Ltd for £60M.

The summarised statements of financial position for the company’s at 31 December 2011 were as follows:

Fuchsia Rose
Plc Ltd
£M £M
Property, Plant & Equipment 210 35
Investment in Rose Ltd 70
Non-current Assets 280 35
Other net assets 400 45
Net assets 680 80
Equity and Reserves
Ordinary Shares 280 10
Retained profits 400 70
680 80

Prepare the consolidated statement of financial position of Fuchsia plc at 31 Dec 2011

Step 1 Remeasure the initial investment in Rose Ltd

Consideration paid to acquire 60% of Rose Ltd on 31 December 2011 £60M Fair value of 100% of Rose Ltd at 31 December 2011 = 60M x 100/60 = £100M

Fair value of initial 15% investment in Rose Ltd at 31 December 2011 = 15% x £100M = £15M

Step 2 Calculate the profit on derecognition of the investment
£M
Fair value of initial 15% investment on attaining control (step 1) 15
Less cost of investment (10)
Profit on disposal of investment 5

138

Step 3 Calculate the goodwill on acquisition
£M
Fair value paid to acquire 60% of Rose Ltd 60
Fair value of previously held 15% investment in Rose Ltd (step 2) 15
75
Group share of fair value of net assets of Rose Ltd (75% x £80M) (60)
Goodwill on acquisition 15
Step 4 Calculate the minority interest
Minority interest = 25% x net assets of Rose Ltd
= 25% x £80M = £20M
Step 5 Calculate the consolidated retained profits of Fuchsia plc
£M
Retained profits of Fuchsia plc 400
Profit on derecognition of investment (step 2) 5
Group share of post acquisition retained profits of Rose Ltd 75% x(70-70) 0
Group retained profits 405

Step 6 Prepare the consolidated statement of financial position of Fuchsia plc

Consolidated statement of financial position
at 31 December 2011 of Fuchsia plc
£M
Property, Plant & Equipment (210+35) 245
Goodwill (step 3) 15
Non-current Assets 260
Other net assets (400+45) 445
Net assets 705
Equity and Reserves
Ordinary Shares 280
Retained profits (step 5) 405
Attributable to equity shareholders 685
Minority (Non-controlling) interests 20
705

139
Transactions that involve remeasurement of an existing interest
IAS 39 IAS28/ IFRS10
IFRS11

Acquisition of a
controlling interest
in a financial
investment

Acquisition of a
controlling interest
10%
In an associate or

40% jointly controlled
entity

0% 20% 50%
Passive Significant Control
influence /
investment
joint control

Note that IFRS only requires remeasurement of fair value if control is obtained. It does not explicitly deal with the situation where a simple investment moves to a situation of an associate. In such situations it remains acceptable to measure the cost of the associate by summing the cost of the investments in the entity.

140

SEMINAR QUESTIONS

1. On 30 June 2011 Radish plc acquired an 80% interest in Turnip Ltd for £1,200,000.

Notes:
1) The profits of Turnip Ltd accrue evenly throughout the year
2) The book values of Turnip Ltd represent the fair values of its net assets

The summarised income statements of the company’s for the year ended 31 December 2011 were as follows:
Radish Turnip
Plc Ltd
£’000 £’000
Revenue 9,000 3,800
Cost of sales 6,300 2,600
Gross profit 2,700 1,200
Expenses 1,400 650
Profit before taxation 1,300 550
Taxation 350 150
Profit after taxation 950 400

The summarised statements of financial position for the company’s at 31 December
2011 were as follows:

Radish Turnip
Plc Ltd
£’000 £’000
Property, Plant & Equipment 5,100 750
Investment in Turnip Ltd 1,200
Non-current Assets 6,300 750
Other net assets 1,100 370
Net assets 7,400 1,120
Equity and Reserves
Ordinary Shares 3,000 200
Retained profits 4,400 920
7,400 1,120

Prepare the consolidate financial statements of Radish plc for the year ended 31 December 2011

2. Smith plc disposed of a 70% holding in Jones Ltd on 31 December 2011 for £77M when the fair value of the net assets of Jones Ltd was £40M, Smith plc retained a small investment of 10% in Jones Ltd, the fair value of the retained investment was £11M. Smith plc had bought its 80% interest in Jones Ltd on 31 December 2003 for £40M when the fair value of the net assets of Jones Ltd was £12.5M. There have

141

been no impairment provisions in relation to the goodwill on the acquisition of Jones Ltd.

Required

a) Calculate the profit on disposal to be recorded in the consolidated accounts of Smith plc

b) Explain how the profit would be recorded in the consolidated accounts of Smith plc

3. On 31 December 2006 Arsenic plc acquired a 10% investment in Lace Ltd for a consideration of £3M. On 31 December 2011 Arsenic plc acquired a further 50% in Lace Ltd for £75M.

The summarised statements of financial position for the company’s at 31 December
2011 were as follows:
Arsenic Lace
Plc Ltd
£M £M
Property, Plant & Equipment 172 27
Investment in Lace Ltd 78
Non-current Assets 250 27
Other net assets 575 43
Net assets 825 70
Equity and Reserves
Ordinary Shares 200 20
Retained profits 625 50
825 70

Required

Prepare the consolidated statement of financial position of Arsenic plc at 31 Dec 2011.

find the cost of your paper