FOUNDATION EXAM

FINANCIAL ACCOUNTING
AND REPORTING
 STUDY GUIDE

Foundation exam

Financial Accounting
and Reporting
 FINANCIAL ACCOUNTING AND REPORTING | iii

Ninth edition 2019

First edition 2010
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iv | INTRODUCTION

CONTENTS

Page

INTRODUCTION
Foundation exams v
Module features vi
Preparing for your foundation exam viii
Module summary x
Learning objectives xii

MODULES
1 The financial reporting environment 1
2 The accounting theory 99
3 Financial statements 149
4 Application of specific accounting standards 195
5 Business combinations 279
6 Analysis of financial statements 363

Revision questions 407

Answers to revision questions 433

Before you begin questions: Answers and commentary 447

Glossary of terms 465

Formulae 475

Index 479
 FINANCIAL ACCOUNTING AND REPORTING | v

FOUNDATION EXAMS

International Education Standards

CPA Australia is a member of the International Federation of Accountants (IFAC). All foundation exam
education materials are developed in line with IFAC's International Education Standards. These
standards provide guidance in establishing the content of professional accounting education
programs together with the associated assessment. The standards also assist in developing the
required passing standard for accounting education and competence of a professional accountant.
The foundation exams provide you with the opportunity to demonstrate your competence in areas
required for Associate membership of CPA Australia. By demonstrating this entry level knowledge you
will be well positioned to succeed at the CPA Program and ultimately attaining the CPA designation.

YOU AND YOUR STUDY PLAN

This Study guide is designed to give you an understanding of what to expect in your exam as well as
covering the fundamentals that you need to know. Exams will be based on the contents of the current
Study guide. You will need to check My Online Learning to confirm which version you should use
based on your exam date.
There are no specifically recommended hours of study. Each candidate brings their own level of
experience and knowledge to the foundation exams. The number of study hours required is entirely
dependent on your prior knowledge of the subject. You will need to develop your own study plan.
Refer to Preparing for your foundation exam on page vii.

ADDITIONAL LEARNING SUPPORT

If you feel you have gaps in your knowledge after reviewing the Study guide, there is a range of
optional additional support to assist in your exam preparation. Additional learning support caters for
different learning styles and budgets.
Please check the CPA Australia website for more information www.cpaaustralia.com.au/cpa-
program/cpa-program-candidates/your-in-semester-support/learning-resources/foundation

STANDARDS AND LEGISLATION

The material in this Study guide has been prepared based upon selected standards from the IASB.
Candidates are advised that they should use this Study guide as the primary resource for their studies
as the standards are frequently updated. Exams are based on the learning objectives outlined within
this Study guide.
vi | INTRODUCTION

MODULE FEATURES

Each module contains a number of helpful features to guide you through each topic.

Learning Show the referenced CPA Australia learning objectives.

objectives

Topic list Tells you what you will be studying in this module.

Module outline Presents a general idea of what is covered in this module.

Module summary Summarises the content of the module, helping to set the scene so that you
diagram can understand the bigger picture.

Before you begin A small bank of questions to test any pre-existing knowledge that you may
have of the module content. If you get them all correct then you may be
able to reduce the time you need to spend on the particular module. There
is a commentary section at the end of the Study guide called Before you
begin questions: Answers and commentary.
Section overview Summarises the key content of the particular section that you are about to
start.

Learning objective Indicates the learning objective covered by the section or paragraph to
reference which it relates.
LO
1.2

Definition Definitions of important concepts. You really need to know and understand
these before the exam.

Exam comments Highlight points that are likely to be particularly important or relevant to the
exam. (Please note that this feature does not apply in every foundation
exam
exam Study guide.)

Worked Example An illustration of a particular technique or concept with a solution or

explanation provided.

Question A question that enables you to practise a technique or test your

understanding. You will find the solution at the end of the module.

Key module points Reviews the key areas covered in the module.
 FINANCIAL ACCOUNTING AND REPORTING | vii

Quick revision A quick test of your knowledge of the main topics in this module.
questions The quick revision questions are not a representation of the difficulty or
style of questions which will be in the exam. They provide you with an
opportunity to revise and assess your knowledge of the key concepts
covered in the materials so far. They are not a practice exam, but rather a
means to reflect on key concepts and not as the sole revision for the exam.

Revision questions The revision questions are not a representation of the difficulty or style of
questions which will be in the exam. They provide you with an opportunity
to revise and assess your knowledge of the key concepts covered in the
materials so far. They are not a practice exam, but rather a means to reflect
on key concepts and not as the sole revision for the exam.

Case study A practical example or illustration, usually involving a real world scenario.

Formula to learn Formulae or equations that you need to learn as you may need to apply
them in the exam.

Bold text Throughout the Study guide you will see that some of the text is in bold
type. This is to add emphasis and to help you to grasp the key elements
within a sentence and paragraph.
viii | INTRODUCTION

PREPARING FOR YOUR FOUNDATION EXAM

STUDY PLAN
 Review all the learning objectives thoroughly. Use the weightings provided in the learning
objectives table (see Learning Objectives section) to develop a study plan to ensure you provide
yourself with enough time to revise each learning objective.
 Don't leave your study to the last minute. You may need more time to explore learning objectives
in greater detail than initially expected.
 Be confident that you understand each learning objective. If you find that you are still unsure after
reading the Study guide, seek additional information from other resources such as text books,
supplementary learning materials or tuition providers.

STUDY TECHNIQUES
 In addition to being able to complete the revision and self-assessment questions in the Study
guide, ensure you can apply the concepts of the learning objectives rather than just memorising
responses.
 Some exams have formulae and discount tables available to candidates throughout the exams. My
Online Learning lists the tools available for each exam. Also see Computer-based exam navigation
section.
 Check My Online Learning on a weekly basis to keep track of announcements or updates to the
Study guide.

TIPS FOR EXAMS

 Plan to arrive at the exam centre at least 15 minutes before your exam. Allow for possible delays
with public transport or traffic.
 You have three hours and fifteen minutes to complete the exam. As soon as you commence the
exam your exam clock in the top right hand corner of the screen begins to count down. Watch your
time carefully.

ANSWERING MULTIPLE CHOICE QUESTIONS

Foundation exams are a series of 100 multiple choice questions. Each question will contain four
possible options.
Step 1 Attempt every question. Read the question thoroughly. You may prefer to work out the
answer before looking at the options, or you may prefer to look at the options at the
beginning. Adopt the method that works best for you.
Step 2 Read the four options and see if one matches your own answer. Be careful with numerical
questions, as some options are designed to match answers that incorporate common
errors. Check that your calculation is correct. Have you followed the requirement exactly?
Have you included every step of the calculation?
Step 3 You may find that none of the options matches your answer.
 Re-read the question to ensure that you understand it and are answering the
requirement.
 Eliminate any obviously wrong answers.
 Consider which of the remaining answers is the most likely to be correct and select the
option.
 FINANCIAL ACCOUNTING AND REPORTING | ix

Step 4 If you are still unsure, you can flag the question and continue to the next question. Some
questions will take you longer to answer than others. Try to reduce the average time per
question, to allow yourself to revisit problem questions at the end of the exam.
Revisit unanswered questions. A review tool is available at the end of the exam, which
allows you to Review Incomplete or Review Flagged questions. When you come back to
a question after a break you often find you are able to answer it correctly straight away.
You are not penalised for incorrect answers, so never leave a question unanswered!

COMPUTER-BASED EXAM NAVIGATION

Your computer-based exam has the following functions:
 Navigation
– You can select your answer by: clicking on the circle to the left of the option, or typing the letter
corresponding to the option.
– To move through the exam, you use the 'Next' or 'Previous' buttons on the bottom of the
screen. The function of each button is selected by your mouse, or with a combination of
keyboard keys. For example, you can select the 'Next' button by clicking it with the mouse, or
by typing ALT + N.
– The 'Next' button moves you from one screen to the next screen. If you wish to go back and
view the screen you just viewed, click the 'Previous' button or type ALT + P.
– There is also a 'Navigator' button on the bottom of the screen which allows you to click ahead to
any question in the exam. This button can be accessed using your mouse or ALT + V. 'Navigator'
allows you to see a list of all questions and their status including 'Incomplete'/'Complete' and
'Unseen'. Any questions you have flagged for review will also be shown in this view.
 Formulae
– A 'Formulae' button is included in the computer-based exam for this subject.
– The 'Formulae' button allows you to view the formulae provided in this Study guide (see
Formulae section).
– The 'Formulae' button is located at the bottom of the screen, to the left of the 'Navigator'
button.
 Select for review
– There is a flag in the upper right corner of your exam screen labelled 'Flag for Review'.
Alternatively you can use ALT + F to flag a question. You mark an exam question to review at a
later time by clicking on this flag. The flag will appear filled-in once it is selected. You may mark
any exam question for later review, whether you select an answer or not.
 Review screen
– After finishing the last exam question, you will see a review screen. This lists every exam
question. If you clicked the 'Flag for Review' flag on a question screen, that question appears on
the Review screen marked with the flag filled in.
– If you skipped any exam questions, these will be labelled as 'Incomplete' even if you did not
select them for review.
– From the Review screen you can choose to:
1. review all of the questions in the exam by clicking 'Review All';
2. individually select questions for review (click on the question number) or choose more
questions for review (click on the flags corresponding to the questions);
3. review all questions marked as incomplete by clicking 'Review Incomplete';
4. begin reviewing the selected review questions by clicking 'Review Flagged'; or
5. exit by clicking 'End Review' – this will also end your exam.
x | INTRODUCTION

MODULE SUMMARY

This summary provides a snapshot of each of the modules, to help you to put the syllabus as a whole
and the Study guide itself into perspective.
Modules 1 and 2 mainly focus on the accounting concepts and principles and theories that are
relevant to financial accounting and reporting. Modules 3, 4 and 5 then cover the actual preparation
and presentation of financial statements for limited liability companies, both single companies and
groups of companies, with Module 4 focusing particularly on the application of specific accounting
standards. Finally, Module 6 covers the analysis and interpretation of financial statements.

MODULE 1 – THE FINANCIAL REPORTING ENVIRONMENT

In this module we will begin by considering the purpose of financial reporting and in particular who
the financial statements are prepared for – the users of financial statements – and their information
needs. We will also consider the regulatory framework within which international accounting standards
are prepared and how this contributes to international GAAP.
The IASB's Conceptual Framework for Financial Reporting sets out and explains the concepts and
principles on which, in theory, IFRSs are based. We look at the advantages and disadvantages of using
a conceptual framework and also at the objectives of general purpose financial reports: financial
statements prepared for users external to a business.
We also consider accounting policies: the specific principles and conventions that an entity adopts in
preparing and presenting financial statements.
This module also explains the concepts that underlie the preparation of financial statements and the
qualities that financial information must have if it is to be useful to the users of financial statements.
This module ends with a consideration of the elements of financial statements as set out in the IASB's
Conceptual Framework – these are assets, liabilities, equity, income and expenses. You will learn the
recognition criteria for each of these elements.

MODULE 2 – THE ACCOUNTING THEORY

The most common measure of asset/liability valuation is historical cost. However, in this module you
will learn how to identify, explain and calculate other methods of measurement bases. You will also
consider alternative methods of measuring capital and how this ties in with asset/liability valuation.
In a company the shareholders are the owners, but the company is managed by the directors. The
directors are agents of the shareholders, therefore you will consider what is meant by agency theory.
You will also look at the various types of information within a company's annual report and financial
statements that are available to shareholders and other users. Some of this information helps the
shareholders to assess the performance of the company and of its directors.

MODULE 3 – FINANCIAL STATEMENTS

In this module we begin by looking at the overall format and content of company financial statements
as set out in IAS 1 (revised) Presentation of Financial Statements. The module covers the statement of
profit or loss and other comprehensive income, the statement of financial position and the statement
of cash flows (IAS 7 Statement of Cash Flows).

MODULE 4 – APPLICATION OF SPECIFIC ACCOUNTING

STANDARDS
In this module, we consider in detail the application of specific accounting standards, in particular the
accounting treatment of intangible non-current assets in general and research and development
costs, as well as the accounting treatment in situations where assets (tangible or intangible), fall in
value. The module moves on to the topical areas of revenue recognition and accounting for current
 FINANCIAL ACCOUNTING AND REPORTING | xi

tax and deferred tax. The module then covers foreign currency accounting. There are two main
aspects to dealing with foreign exchange – firstly, many companies will buy or sell goods from or to
another country and in a foreign currency. These transactions in the foreign currency must be
translated before they can be included in the financial records. The second aspect is that groups may
include a foreign subsidiary and before the subsidiary's results can be included in the group financial
statements the subsidiary's own financial statements must be translated. The module ends with the
accounting of leases under IFRS 16.

MODULE 5 – BUSINESS COMBINATIONS

This detailed module will be looking at the techniques for preparing group financial statements or
consolidated financial statements. It begins with a consideration of the major definitions and
principles of consolidation which are vital to your understanding of the subject. Next we will study the
basic procedures for producing a consolidated statement of financial position. Plenty of question
practice is required but if you understand the basic steps and workings at this stage then your further
studies of consolidated financial statements will become much easier. We move on to covering the
preparation of the consolidated statement of profit or loss. This module ends with an examination of
the accounting treatment of associated companies – the equity method of accounting.

MODULE 6 – ANALYSIS OF FINANCIAL STATEMENTS

In this module we consider the interpretation of financial statements by looking at the calculation of a
number of different ratios and more importantly how these ratios can be used to analyse and interpret
the financial statements. We shall also consider the limitations of financial analysis.
xii | INTRODUCTION

LEARNING OBJECTIVES

CPA Australia's learning objectives for this Study guide are set out below. They are cross-referenced
to the module in the Study guide where they are covered.

GENERAL OVERVIEW
This exam covers an understanding of the format and function of financial statements, including
analysis and interpretation of financial statements. It also includes the production of financial
statements for consolidated company groups, and foreign currency translation.
This exam covers a critical awareness of accounting issues in an international context. It requires an
understanding of the theoretical concepts within the regulatory and conceptual framework of
corporate reporting. This includes recognition criteria, methods of valuation, and reporting and
disclosure of the financial performance of companies.
These are the Learning Objectives that will be covered in the exam.
Module Learning Objectives (LO) Weighting
Module 1 The LO1.1 Describe the regulatory environment for financial 25%
financial reporting in Australia and the reasons for accounting and
reporting reporting requirements.
environment
LO1.2 Discuss the main types of business entity and explain the
reasons for selecting each structure.
LO1.3 Identify different types of accounting regulation, including
laws, Generally Accepted Accounting Principles and
International Financial Reporting Standards.
LO1.4 Explain how the requirements from users, together with
social and environmental developments, impact the
underlying principles and requirements of financial
reporting and the desire to establish a single set of
international accounting standards.
LO1.5 Describe the role of the International Accounting
Standards Board in developing a regulatory framework
and explain how new policies and standards are
established.
LO1.6 Identify the purpose of a conceptual framework and the
key characteristics in the Generally Accepted Accounting
Principles (GAAP) and apply this knowledge to define and
recognise the different elements of the financial
statements.
LO1.7 Describe and demonstrate the role of accounting
standards and accounting policies in fairly presenting the
financial performance and financial position of an entity.
 FINANCIAL ACCOUNTING AND REPORTING | xiii

Module Learning Objectives (LO) Weighting

Module 2 The LO2.1 Compare historical cost accounting with other methods of 15%
accounting valuation and explain the differences.
theory
LO2.2 Explain agency and contracting theories and how they
relate to accounting policy choice (positive accounting
theory).
LO2.3 Apply the recognition criteria for the elements of the
financial statements according to the conceptual
framework (normative theory).
Module 3 LO3.1 Prepare and present the statement of profit or loss and 15%
Financial other comprehensive income with appropriate disclosure
statements in accordance with relevant accounting standards and
policies.
LO3.2 Prepare and present the statement of financial position
with appropriate disclosure in accordance with relevant
accounting standards and policies.
LO3.3 Prepare and present the statement of cash flows in
accordance with relevant accounting standards and
policies.
LO3.4 Demonstrate the ability to detect, investigate and correct
discrepancies or particular items/events while matching
the financial statements to supporting documentation.
Module 4 LO4.1 Calculate the carrying amounts of different classes of 22%
Application intangible assets and prepare the relevant journal entries.
of specific
LO4.2 Interpret contracts to determine the amount and timing of
accounting
revenue to be recognised in the financial statements and
standards
reconcile the differences between ledgers if necessary.
LO4.3 Calculate current and deferred income tax and prepare
the relevant journal entries to record the tax effect in the
financial statements.
LO4.4 Calculate and account for foreign currency transactions at
transaction date and subsequent dates.
LO4.5 Translate financial statements from a functional currency to
a presentation currency.
xiv | INTRODUCTION

Module Learning Objectives (LO) Weighting

Module 5 LO5.1 Discuss the accounting issues for various forms of business 13%
Business combinations.
combinations
LO5.2 Explain how goodwill is measured and disclosed at the
date of acquisition and prepare the relevant journal
entries.
LO5.3 Explain how goodwill is measured and impaired
subsequent to acquisition and prepare the relevant
journal entries.
LO5.4 Discuss the concept of control and calculate the non-
controlling interest share of equity.
LO5.5 Prepare consolidated statements of financial position,
including the entries for goodwill and non-controlling
interests.
LO5.6 Prepare consolidated statements of profit or loss and
other comprehensive income, including the entries for
non-controlling interests and intra-group transactions.
Module 6 LO6.1 Calculate, analyse and interpret financial ratios and their 10%
Analysis of interrelationship in the financial statements.
financial
LO6.2 Explain the limitations of financial statement analysis.
statements
 1

MODULE 1
THE FINANCIAL
REPORTING
ENVIRONMENT
Learning objectives Reference

Describe the regulatory environment for financial reporting in Australia and the reasons LO1.1
for accounting and reporting requirements
Discuss the main types of business entity and explain the reasons for selecting each LO1.2
structure
Identify different types of accounting regulation, including laws, Generally Accepted LO1.3
Accounting Principles and International Financial Reporting Standards
Explain how the requirements from users, together with social and environmental LO1.4
developments, impact the underlying principles and requirements of financial reporting
and the desire to establish a single set of international accounting standards
Describe the role of the International Accounting Standards Board in developing a LO1.5
regulatory framework and explain how new policies and standards are established
Identify the purpose of a conceptual framework and the key characteristics in the LO1.6
Generally Accepted Accounting Principles (GAAP) and apply this knowledge to define
and recognise the different elements of the financial statements
Describe and demonstrate the role of accounting standards and accounting policies in LO1.7
fairly presenting the financial performance and financial position of an entity

Topic list

1 The purpose of accounting

2 Nature, principles and scope of financial reporting
3 Users' and shareholders' needs
4 The need for a regulatory framework
5 The IFRS Foundation and the IASB
6 Generally accepted accounting principles (GAAP)
7 Conceptual Framework
8 Accounting regulation
9 Accounting policies
10 IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
2 | THE FINANCIAL REPORTING ENVIRONMENT

Topic list

11 The role of accounting standards

12 Accounting standards and choice
13 Accounting concepts
14 Qualitative characteristics of financial information
15 Materiality in the context of financial reporting
16 International Financial Reporting Standards
17 Developments in international harmonisation
18 The elements of financial statements
19 Recognition and derecognition of the elements of financial statements
20 Applying the recognition criteria
21 The main financial statements
 FINANCIAL ACCOUNTING AND REPORTING | 3

MODULE OUTLINE

This module introduces some basic ideas about the need for financial information and the users of
financial information. It also covers the definition of financial reporting.

MODULE 1
We then move on to look at the different sources of accounting regulation. Accounting is regulated by
local statute (such as company law), by stock exchange requirements and by accounting standards.
We will focus in particular on the activities of the International Accounting Standards Board (IASB)
which is responsible for setting International Financial Reporting Standards (IFRS).
We will discuss the importance of IFRS in the global regulation of accounting and the process the
IASB undertakes in issuing a new accounting standard.
We move on to look at the IASB's Conceptual Framework for Financial Reporting (Conceptual
Framework) which represents the theoretical framework upon which all IFRS are based.
We also consider accounting policies: the specific principles and conventions that an entity adopts in
preparing and presenting financial statements. IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors explains how an entity should select and apply accounting policies.
We examine the role and purpose of accounting standards in the regulation of financial reporting. We
will look at this in the context of accounting policies and achieving the aim of preparing useful
financial information.
We will also review some of the key accounting concepts that have to be considered when preparing
financial statements and discuss the process of harmonisation of accounting standards on a global
basis.
We will examine the main elements of financial statements: assets, liabilities, equity, income and
expenses. Finally, we will look at the financial statements where these items are recognised and
examine the recognition criteria for each of the elements of the financial statements.
4 | THE FINANCIAL REPORTING ENVIRONMENT

The module content is summarised in the diagrams below.

The financial reporting environment

Financial reporting involves Need for regulation:

Accounting: process of producing financial statements
recording, analysing and for users GAAP is a combination of:
summarising transactions • company law
of a business and • accounting standards
communicating that • stock exchange rules
information to decision • IFRSs
makers Users have different needs:
• Management
• Shareholders
• Suppliers Regulation varies
• Customers amongst countries
Reporting entity: depending on local context
• Lenders
entity whose general and level of development
purpose financial • Authorities
of the nation
statements are relied • Employees
upon by users of • Financial analysts and
accounts advisers
• Public Benefits of regulation:
• Information prepared
consistently
• Companies disclose
A regulatory framework and more information than
accounting standards help make they would if there was
financial statements more useful no regulation
to users

IASB issues standards

IASB objectives:
• To develop high quality,
understandable and enforceable
global accounting standards
• To bring about convergence of
national standards and IFRS
 FINANCIAL ACCOUNTING AND REPORTING | 5

The Conceptual Framework and

accounting policies

The IASB’s Conceptual The IASB's Conceptual Framework The use of judgment in
Framework and GAAP are is the international conceptual accounting decisions:

MODULE 1
theoretical principles that form framework. Accounting standards provide
the frame of reference for Its purpose is to: guidance on dealing with
financial reporting
assist the IASB to develop IFRS that transactions
are based on consistent concepts; If no standard exists, the
assist preparers to develop accountant must use
consistent accounting policies when judgement
Benefits of framework: no IFRS applies to a particular Conceptual Framework is a
Used as a basis for transaction or event or when an useful reference point in
development of accounting IFRS allows a choice of accounting these situations
standards policy; and
Financial reporting based on assist all parties to understand and
standardised principles
interpret IFRS.
Preparers apply the spirit and
reasoning behind standards; Accounting policies:
therefore harder to avoid Principles, bases, rules,
compliance conventions and practices
used in preparing financial
Objective of general purpose statements
financial reporting:
Provide information that is
Provide useful information to relevant and faithfully
existing and potential investors, represents the underlying
lenders and other creditors
transactions

IAS 8 Accounting Policies, Changes

in Accounting Estimates and Errors

Accounting standards and concepts

Role of accounting standards: Accounting concepts: International harmonisation:

Set out accounting rules Going concern (underlying Aim to have one set of global
companies must follow assumption) accounting standards
Applying accounting standards Accruals Number of barriers, but many
should give a fair presentation Substance over form advantages
EU adopted IFRS from 2005
IASB and US FASB have
carried out important joint
Accounting standards and choice: projects to harmonise
Standards reduce variations in Fundamental qualitative accounting standards
methods of accounting characteristics of financial
information: relevance and
But may be faithful representation
inflexible/inappropriate in
some circumstances

Enhancing qualitative
characteristics of financial
information: comparability;
verifiability; timeliness; and
understandability
6 | THE FINANCIAL REPORTING ENVIRONMENT

Elements of financial
statements and their
recognition criteria

Elements of financial Recognition criteria The main elements of financial

statements • The Conceptual Framework states reports
The Conceptual Framework that an item of the financial • The statement of financial
defines: statements is recognised if it: position includes:
• assets – meets the definition of an – assets
• liabilities element; – liabilities
• equity – is relevant and will provide – equity
• income users of the financial • The statement of profit or
• expenses statements with a faithful loss and other
representation of the comprehensive income
transactions of the entity includes:
– income
– expenses

The financial reporting environment: Module summary diagrams

 FINANCIAL ACCOUNTING AND REPORTING | 7

BEFORE YOU BEGIN

If you have studied these topics before, you may wonder whether you need to study this module in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in
the area.

MODULE 1
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the module to ensure that you are familiar with
everything covered.
Please note, the Conceptual Framework was revised in March 2018, therefore if you studied this topic
previously it is likely that your knowledge may be based on the previous Conceptual Framework, if this
is the case please review this section of the module carefully.
There are references in brackets indicating where in the module you can find the information, and you
will also find a commentary at the back of the Study guide.
1 Identify three differences between financial and management accounts. (Sections 1.2 and 1.3)
2 What is the purpose of financial reporting? (Section 2.1)
3 Who are the main user groups of financial statements, and why are they
interested in financial information? (Section 3.2)
4 What is GAAP? (Section 4.2)
5 Which of the following is not an advantages of accounting regulation?
A Increased public confidence in financial statements
B Enhanced comparability between financial statements
C The development of rules which are applicable to all entities
D The disclosure of more useful information than if there were no regulations (Section 4.3)
6 What is the IASB and what are its objectives? (Sections 5.1 to 5.3)
7 What is the IFRS Advisory Council and what is its purpose? (Section 5.4)
8 What is the IFRS Interpretations Committee and what is its purpose? (Section 5.4)
9 What is a conceptual framework? (Section 7)
10 What are the problems associated with not having a conceptual framework? (Section 7.1.2)
11 Which of the following is not an objective of the IASB's Conceptual Framework?
A To assist in the understanding and interpretation of the Standards
B To assist in the development of new IFRS on a consistent basis
C To assist auditors in forming their opinion
D To assist preparers to develop consistent accounting policies when a standard allows a choice
of policy (Section 7.1.2)
12 What is the objective of general purpose financial reporting according to the
IASB's Conceptual Framework? (Section 7.3)
13 What is a reporting entity? (Section 7.4)
14 What are accounting policies? (Section 9)
15 How is a change in accounting policy accounted for? (Section 10.3)
16 How is a change in accounting estimate accounted for? (Section 10.4)
17 What is the underlying assumption in preparing financial statements according
to the Conceptual Framework? (Section 13.1)
18 Explain the concept of 'substance over form' and provide an example of
its application. (Section 13.3)
19 What are the two fundamental qualitative characteristics and the four
enhancing qualitative characteristics of financial statements identified by the
Conceptual Framework? (Section 14)
20 What makes financial information relevant? (Section 14.1)
8 | THE FINANCIAL REPORTING ENVIRONMENT

21 Identify three barriers to the global harmonisation of accounting standards. (Section 17.2)
22 Define an asset. (Section 18.3)
23 Define a liability. (Section 18.4)
24 Define equity. (Section 18.5)
25 What criteria must be met in order for an item to be recognised in the financial
statements? (Section 19)
26 Which of the following statements is correct?
A All assets and liabilities must always be presented in order of liquidity.
B A liability is always classified as non-current where the amount due is to be settled in more than
12 months.
C A liability only occurs if there is a probability of a future cash outflow.
D An asset occurs when an economic resource has the potential to produce economic benefits
even if those benefits are not likely. (Section 21.1) D
 FINANCIAL ACCOUNTING AND REPORTING | 9

1 THE PURPOSE OF ACCOUNTING

LO
1.2 Section overview
 Accounting is the process of recording, analysing and summarising transactions of an entity

MODULE 1
and communicating that information to decision makers.
 A business is an entity which exists to make a profit.
 There are three main types of business entity: sole traders, partnerships and limited liability
companies.
 Not-for-profit entities such as charities, clubs and government entities may also prepare
accounts.

1.1 WHAT IS ACCOUNTING?

You may have a wide understanding of what accounting and financial reporting is. Your job may be in
one area or type of accounting, but you must understand the breadth of work which an accountant
undertakes. In particular, you need to understand the distinction between financial accounting and
management accounting.

Definition

Accounting is the process of recording, analysing and summarising transactions of a business and
communicating that information to decision makers.

Renaissance scholar Luca Pacioli wrote the first printed explanation of double-entry bookkeeping in
1494. Double-entry bookkeeping involves entering every transaction as a debit in one account and a
corresponding credit in another account, and ensuring that they balance. Pacioli's description of the
method was widely influential.
The first English book on the subject was written in 1543 by John Gouge. The practice of double-entry
bookkeeping has barely changed since then and is standard across the world, based upon the
concept that every transaction has a dual effect expressed as debits equals credits.
The original role of the accounting function was to record financial information and this is still its main
focus.
Why do businesses need to produce accounts? If a business is being run efficiently, why should it have
to go through all the bother of accounting procedures in order to produce financial information?
A business needs to produce information about its activities because there are various groups of
people who want or need to know that information. Later in this module we will consider the different
groups of users and the type of information that is of interest to the members of each group.

1.2 FINANCIAL ACCOUNTING

Definition

Financial accounting is a method of reporting the results and financial position of a business.

It is not primarily concerned with providing information towards the more efficient running of the
business. Although financial accounts are of interest to management, their principal function is to
satisfy the information needs of persons not involved in running the business, in particular
shareholders. Financial accounts provide historical information.
 10 | THE FINANCIAL REPORTING ENVIRONMENT

1.3 MANAGEMENT ACCOUNTING

The information needs of management go far beyond those of other account users. Managers
have the responsibility of planning and controlling the resources of the business and for making
decisions about the direction of the business both in the longer term and on a day to day basis.
Therefore they need much more detailed information. They also need to plan for the future, for
example, budgets, which predict future revenue and expenditure.

Definition

Management accounting, sometimes known as cost accounting, is a management information

system which analyses data to provide information as a basis for managerial action. The concern of a
management accountant is to present accounting information in the form most helpful to
management.

1.4 WHAT IS A BUSINESS?

Definition

A business is an integrated set of activities and assets that is capable of being conducted and
managed for the purpose of providing a return in the form of dividends, lower costs or other
economic benefits directly to investors or other owners, members or participants.
Businesses of whatever size or nature exist to make a profit.

There are a number of different ways of looking at a business. Some ideas are listed below.
 A business is a commercial or industrial concern which exists to deal in the manufacture, re-sale
or supply of goods and services.
 A business is an organisation that uses economic resources to create goods or services which
customers will buy.
 A business is an organisation providing jobs for people.
 A business invests money in resources for example, buildings, machinery, employees, in order to
make even more money for its owners.
This last definition introduces the important idea of profit. Businesses vary from very small businesses
for example, the local shopkeeper or plumber, to very large ones for example, IKEA, Nestlé, Unilever.
However all of them want to earn profits.

Definition

Profit is the excess of revenue (income) over expenses. When expenses exceed revenue, the business
is running at a loss.

One of the jobs of an accountant is to measure revenue and expenditure, and so profit.

1.5 TYPES OF BUSINESS ENTITY

There are three main types of business entity:
 Sole traders;
 Partnerships; and
 Limited liability companies.
Sole traders are people who work for themselves. Examples may include the local shopkeeper, a
plumber and a hairdresser. The term sole trader refers to the ownership of the business – sole traders
can have employees.
 FINANCIAL ACCOUNTING AND REPORTING | 11

Partnerships occur when two or more people decide to run a business together. Examples may
include an accountancy practice, a medical practice and a legal practice.
Limited liability companies are incorporated to take advantage of 'limited liability' for their owners
(shareholders). This means that, unlike sole traders and partners, who are personally responsible for
the amounts owed by their business, the shareholders of a limited liability company are only
responsible for the amount unpaid on their shares. This means that if the shareholders have

MODULE 1
purchased shares costing $100 but have only paid $40 to date, they would have to contribute the
remaining $60 towards paying the company's debts.
Generally, in law sole traders and partnerships are not separate entities from their owners. This is true
in many jurisdictions, for example, Australia, the UK, India, New Zealand, China, Japan and Germany.
In the US, however, partnerships do have separate legal personality but the partners are wholly liable
for debts of the partnership. In all cases, however, a limited liability company is legally a separate
entity from its owners and it can issue contracts in the company's name.
For accounting purposes, all three entities are treated as separate from their owners. This is called
the business entity concept. The methods of accounting used in all three types of business entities
will be very similar, although will tend to become more complex the larger the entity.

1.5.1 NOT-FOR-PROFIT ENTITIES

It is not only businesses that need to prepare financial statements. Charities and clubs, for example,
may need to prepare financial statements every year. Financial statements also need to be prepared
for government organisations (public sector organisations such as hospitals and local councils).

2 NATURE, PRINCIPLES AND SCOPE OF FINANCIAL

REPORTING

LO
1.1 Section overview
 Financial reporting is the process of classifying, recording and presenting financial data in
accordance with generally established concepts and principles.

2.1 WHAT IS FINANCIAL REPORTING?

Financial data is the name given to the record of actual transactions carried out by a business for
example, sales of goods, purchases of goods, payment of expenses. These transactions are analysed
according to type, recorded in ledger accounts and summarised in the financial statements.
Financial reporting is the process of reporting the results and financial position of an entity. Although
financial accounts are of interest to management, their principal function is to provide historical
information in order to satisfy the information needs of external users such as shareholders. Financial
accounting is not primarily concerned with providing information towards the more efficient running
of the business – this is the function of a separate branch of accounting, known as 'management
accounting'.

2.2 GENERAL PURPOSE FINANCIAL REPORTING

The Conceptual Framework (and company law in some countries) prescribe that a company should
produce financial information about the reporting entity's assets, liabilities, equity, income and
expenses that is useful to users of financial statements in assessing the prospects for future net cash
inflows to the reporting entity and in assessing management's stewardship of the entity's economic
resources (Conceptual Framework para.3.2).
Accounts must normally be presented at least annually, and there are usually detailed regulations on
what they must contain and the form they must take. For example, in Australia, the form and content
of company financial statements is regulated by the Corporations Act 2001 and by Australian
 12 | THE FINANCIAL REPORTING ENVIRONMENT

Accounting Standards. The Australian Accounting Standards Board adopted the IFRSs for Australian
entities required to report under the Corporations Act 2001 (Cwlth) (Corporations Act) for annual
reporting periods beginning on or after 1 January 2005.
Large listed companies (sometimes known as public companies) are required to publish their annual
financial statements. A listed company is a company whose shares or debt instruments are publicly
traded on a stock exchange. Published financial statements may be printed or made available on the
company's website. In some countries, for example, the UK, all limited companies must 'publish' their
annual accounts by filing them with the Registrar of Companies. They are then available to members
of the public.
These 'published' annual financial statements are general purpose financial statements or general
purpose financial reports. In this module, the terms 'financial reports' and 'financial reporting' refer
to general purpose financial reports and general purpose financial reporting unless otherwise noted.
General purpose financial statements such as the statement of profit or loss and other comprehensive
income, statement of financial position, statement of changes in equity, and the statement of cash
flows and the notes make up the body of general purpose financial reports that are prepared for
external users.
They contain information which may be useful to a wide range of users external to the company.
They are distinct from non-general purpose financial statements, commonly known as special
purpose financial reports which are prepared for a particular group of users and for a particular
purpose. Financial report prepared for the use of tax computations, bank reporting and for fulfilment
of members reporting responsibilities are some examples of special purpose financial reports.
Some users of financial statements are able to obtain additional information. For example, owners or
lenders may be able to request forecasts and budgets and members of the public have access to
information in the financial press or on the internet. However, generally, most external users have to
rely on the annual financial statements as their major source of financial information.
Financial statements do not include directors' reports, statements by the chairman, management
commentaries or environmental and social reports, although these may be included in the published
annual report of a large listed company (see Module 2).

2.3 LIMITATIONS OF FINANCIAL REPORTING

General purpose financial statements cannot possibly provide all the information that external users
might need about a company or business. Users may also need to consider information from other
sources, such as general economic conditions, the political situation and conditions in the industry in
which the business operates.
There are other inherent limitations of the financial accounting and reporting process.
 Financial statements are based on estimates and judgments. For example, management must
estimate the useful lives of assets and the likelihood that amounts receivable will actually be
received. Preparing financial statements and reports involves classifying and aggregating (adding
together) information about transactions and other events. It also involves allocating the effects of
continuous business transactions over separate accounting periods.
 Financial statements are based on historical information. They do not reflect future events or
transactions that may affect the business and the way that it operates. Users of the financial
statements normally need to predict how well a business will perform in future and to understand
the factors which may affect its future performance.
 Financial statements largely record only the financial effects of transactions and events. For
example, intangible assets such as the technical expertise of the workforce may have a very
significant effect on a company's performance. However, these 'assets' are not recognised because
they cannot be reliably valued at a monetary amount. Financial statements do not include
non-financial information such as discussion of the risks and uncertainties that a business faces, or
a description of its effect on the natural environment.
 FINANCIAL ACCOUNTING AND REPORTING | 13

Question 1: Financial reporting

Financial reporting means the financial statements produced only by a large listed company.
Is this statement correct?
A Yes
B No

MODULE 1
(The answer is at the end of the module.)

3 USERS' AND SHAREHOLDERS' NEEDS

LO
1.4 Section overview
 There are various groups of people who need information about the activities of a business.

3.1 THE NEED FOR FINANCIAL STATEMENTS

The purpose of financial statements is to provide useful information about the financial position,
performance and changes in financial position of an entity to a wide range of users.
Users need this information for two reasons:
1. To make economic decisions; and
2. To assess the stewardship of management.

3.1.1 MAKING ECONOMIC DECISIONS

The types of economic decisions for which financial statements are likely to be used include the
following:
 Decisions to buy, hold or sell equity investments;
 Assessment of management stewardship and accountability;
 Assessment of the entity's ability to pay employees;
 Assessment of the security of amounts lent to the entity;
 Determination of taxation policies;
 Determination of distributable profits and dividends;
 Inclusion in national income statistics; and
 Regulation of the activities of entities.

3.1.2 STEWARDSHIP
Stewardship is relevant where an organisation is managed by people other than its owners. For
example, the owners of a listed company appoint directors to run the company on their behalf, who
are then accountable for the company's resources. They must use these resources efficiently and
effectively to produce profits or other benefits for the owners. Owners need to be able to assess the
performance of the directors so that they can decide whether to reappoint them or remove them and
how much they should be paid.

3.2 USERS OF FINANCIAL STATEMENTS AND ACCOUNTING

INFORMATION
A business should produce information about its activities because there are various groups of people
who want or need to know that information.
Large businesses are of interest to a greater variety of people and so we will consider the case of a
listed company, whose shares can be purchased and sold on a stock exchange.
 14 | THE FINANCIAL REPORTING ENVIRONMENT

The following people are likely to be interested in financial information about a company with listed
shares.
 Managers of the company appointed by the company's owners to supervise the day-to-day
activities of the company. They need information about the company's financial situation as it is
currently and as it is expected to be in the future. This is to enable them to manage the business
efficiently and to make effective decisions.
 Shareholders of the company, that is, the company's owners, want to assess how well the
management is performing. They want to know how profitable the company's operations are and
how much profit they can afford to withdraw from the business for their own use.
 Trade contacts include suppliers who provide goods to the company on credit and customers who
purchase the goods or services provided by the company. Suppliers want to know about the
company's ability to pay its debts; customers need to know that the company is a secure source of
supply and is in no danger of having to close down.
 Providers of finance to the company might include a bank which allows the company to operate
an overdraft, or provides longer-term finance by granting a loan. The bank wants to ensure that the
company is able to keep up interest payments, and eventually to repay the amounts advanced.
 The taxation authorities want to know about business profits in order to assess the tax payable by
the company, including sales taxes, for example, Goods and Services Tax or Value Added Tax.
 Employees of the company should have a right to information about the company's financial
situation, because their future careers and the size of their wages and salaries depend on it.
 Financial analysts and advisers need information for their clients or audience. As examples,
stockbrokers need information to advise investors; credit agencies want information to advise
potential suppliers of goods to the company; and journalists need information for their reading
public.
 Government and their agencies are interested in the allocation of resources and therefore in the
activities of business entities. They also require information in order to provide a basis for national
statistics.
 The public. Companies affect members of the public in a variety of ways. They may make a
substantial contribution to a local economy by providing employment and using local suppliers.
Another important factor is the effect of an entity on the environment as an example in relation to
pollution.
Accounting information is summarised in financial statements to satisfy the information needs of
these different groups. These information needs will differ between each user group and not all will be
equally satisfied.

3.3 NEEDS OF DIFFERENT USERS

Managers of a business need the most information, to help them make their planning and control
decisions. They clearly have 'special' access to information about the business, because they are able
to demand whatever internally produced statements they require. When managers want a large
amount of information about the costs and profitability of individual products, or different parts of
their business, they can obtain it through a system of cost and management accounting rather than
rely on the financial accounts.
Shareholders, providers of finance and financial analysts and advisers need information that helps
them to make decisions: whether to buy, hold or sell their investment in a business or whether to lend
money to it. Unlike managers, these users are external to the business. Therefore they normally have
to rely on the published financial statements to provide them with the information that they need.
For this reason, in most developed countries, including Australia, published financial statements are
primarily prepared to meet the information needs of existing and potential investors and lenders
and their advisors.
 FINANCIAL ACCOUNTING AND REPORTING | 15

Question 2: Information needs

Which of the following items in the financial statements of a company would be of particular interest
to a customer?
A Operating profit
B Retained earnings
C Dividend payments

MODULE 1
D Directors' remuneration
(The answer is at the end of the module.)

4 THE NEED FOR A REGULATORY FRAMEWORK

LOs
1.1, 1.3 Section overview
 The regulatory framework ensures that general purpose financial reporting produces
relevant and reliable information and therefore meets the needs of shareholders, lenders
and other users.
 Generally accepted accounting principles (GAAP) signifies all the rules, from whatever
source, that govern accounting. GAAP includes accounting standards (IFRS and national
standards), national company law, and local stock exchange requirements.
 Regulation of companies and their published financial information can vary significantly in
different countries throughout the world.

4.1 SUBJECT OUTLINE

The regulatory framework consists of accounting rules and company law. These ensure that general
purpose financial reporting provides useful information that meets the needs of shareholders, lenders
and other users.
The International Accounting Standards Board (IASB) develops and issues International Financial
Reporting Standards (IFRS). As IFRS have no jurisdiction, and the IASB has no authority to impose
accounting standards, individual countries draw up their own accounting regulations. In practice,
national governments often adopt IFRS and then adapt them to operate together with local laws and
regulations as necessary.

4.2 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

Generally accepted accounting principles (GAAP) signifies all the rules, from whatever source, which
govern accounting. The concept is applicable globally.
In individual countries GAAP is seen primarily as a combination of:
 national company law;
 national accounting standards; and
 local stock exchange requirements.
Although these sources are the basis for the GAAP of individual countries, the concept also includes
sources such as:
 IFRS; and
 accounting requirements of other countries.
In many countries, GAAP does not have any statutory or regulatory authority or definition. There are
different views of GAAP in different countries. The IASB convergence program seeks to reduce these
differences.
 16 | THE FINANCIAL REPORTING ENVIRONMENT

GAAP can be based on legislation and accounting standards that are either:
 prescriptive/rules-based; or
 principles-based.
The US operates a prescriptive system, where standards are very detailed, attempting to cover all
eventualities. Accounts which do not comply in all details are presumed to be misleading. This has the
advantage of clear requirements which can be generally understood and it removes any element of
judgment.
In general, international financial reporting standards (IFRS) are principles-based. They do not specify
all the details but seek to obtain adherence to the 'spirit' of the regulations. This leaves room for some
element of professional judgment. It also makes it harder for entities to avoid applying a standard as
the terms of reference are broader. (We will be discussing the differences between rules-based
standards and principles-based standards in more detail later in this module.)

4.2.1 INDIVIDUAL JUDGMENT

Financial statements are prepared on the basis of a number of fundamental accounting assumptions
and conventions. Many figures in financial statements are derived from the application of judgment
in putting these assumptions into practice.
It is clear that different people exercising their judgment on the same facts can arrive at very different
conclusions.

Question 3: Judgment

An accountancy training firm has an excellent reputation amongst students and employers. How
would you value this? The firm may have relatively little in the form of tangible assets that you can
touch, perhaps a building, desks and chairs. If you simply drew up a statement of financial position
showing the cost of the assets owned, then the business would not seem to be worth much, yet its
income earning potential might be high. This is true of many service organisations where the people
are among the most valuable assets. Here judgment must be used in order to reach a valuation for the
business, although one person's judgment may lead to a very different valuation from another
person's.
Required
Can you think of any other areas where judgment would have to be used in preparing financial
statements?
(The answer is at the end of the module.)

4.3 ADVANTAGES AND DISADVANTAGES OF REGULATION

The key benefit of accounting regulation is that it requires organisations to prepare financial
statements on a consistent basis. This is useful for the users of financial statements that were
identified earlier in this module. For example, an investor wishing to purchase shares in a company is
able to compare that company's performance with another, as their financial statements should
have been prepared on the same basis.
Other advantages of regulation include the following:
 The existence of accounting rules reduces variations in the way financial statements are prepared.
Without regulation it would be possible for preparers to adopt whatever accounting treatments
they choose and to vary these from year to year in order to present the company's profit figure and
net assets in as favourable a light as possible. In addition, transactions and businesses have
become increasingly complex. There are many legitimate ways to present, measure and disclose
items such as complex financial instruments, but the accounting treatment of these items needs to
be comparable between different entities and over time.
 FINANCIAL ACCOUNTING AND REPORTING | 17

 Regulation means there will be rules as to what should be disclosed which improves the quality of
information produced. For example, IAS 1 Presentation of Financial Statements requires
companies to disclose the accounting policies that they have followed, so that users can
understand the judgments that preparers have made in arriving at the amounts in the financial
statements. Financial statements must also include supporting notes which analyse and explain the
main line items in the financial statements. Specific information that must be disclosed is set out in

MODULE 1
accounting standards and (in some cases) companies legislation.
 The existence of regulation is likely to ensure that companies disclose more information about
their business activities and financial results than they may have done in the absence of such
regulation. There is an argument that companies resist disclosing information unless they are
required to do so. There are costs associated with providing financial information. Without
regulation, management is likely to be unwilling to deliver 'bad news' to investors, or to provide
information that could be used by competitors.
 Regulation of companies listed on stock exchanges means there are strict requirements in terms of
reporting and disclosure and this is likely to protect investors. In many countries, such as
Australia, the US and the UK, systems of accounting regulation were originally developed as a
response to high-profile company failures and frauds in which many investors lost their savings.
 A strong system of regulation will increase public confidence in the published financial
statements of companies. This is particularly important since there have recently been a number of
high profile corporate failures contributed to by inappropriate accounting.
 Some users of financial statements (for example, major corporate investors and lenders) have the
power to demand the information that they need. Other users (for example, small investors and
individual members of the public) have not. Regulation protects those less powerful individuals and
organisations and can therefore be seen as a social good.
Disadvantages of regulation include the following:
 Strict regulation could mean a lack of flexibility for some businesses. Sometimes companies have
differing business environments. These companies may have to adopt accounting treatments that
do not properly reflect their financial performance and position and actually lessen the quality of
the information that they provide. In this situation, it may be impossible for users to make
meaningful comparisons between companies.
 Companies may incur high costs in complying with the regulatory rules. The cost of providing the
information required may outweigh the benefits of that information. This is particularly relevant
where small companies have to comply with either US regulations or the full set of International
Accounting Standards (known as 'full IFRS'). Both the US and 'full IFRS' systems were designed
primarily to meet the accounting needs of multinational organisations and to protect large
institutional investors in those organisations. They therefore include standards on topics such as
financial instruments, earnings per share, operating segment disclosure and share-based payment
transactions, which are, in most cases, not relevant to smaller entities. The IASB has now
developed a special standard for small and medium entities (the IFRS for SMEs) as an alternative to
'full IFRS'. This standard omits certain topics and simplifies others in order to lessen the regulatory
burden on smaller entities.
 Detailed rules and regulations may mean that companies spend a great deal of time 'box-ticking'
without considering the spirit of the regulation they are complying with. Information is provided
because it is required, even though it is of little value. The problem can be particularly acute where
preparers are required to make specific narrative disclosures, for example, about corporate
governance or future prospects for the business. Users frequently complain about 'boiler plate'
disclosures: general statements that could apply to any company and tell the reader nothing.
 Regulation leads to financial statements that contain too much information and this can obscure
the overall picture that they present. The length and volume of company annual reports is steadily
growing as the result of new accounting requirements. Many commentators believe that published
financial statements have become too complex for anybody other than a financial reporting expert
to understand.
 18 | THE FINANCIAL REPORTING ENVIRONMENT

Question 4: Creative accounting

Creative accounting is the name given to accounting treatments which comply with all applicable
accounting regulations but which have been deliberately manipulated to give a biased impression of a
company's performance or financial position. From the 1990s onwards, new or improved accounting
standards were developed to prevent most of these practices.
Required
Briefly describe two possible methods of 'creative accounting'.
(The answer is at the end of the module.)

4.4 VARIATIONS IN REGULATORY REGIMES

Regulation of companies and their published financial information can vary significantly in different
countries throughout the world. There are many reasons for these differences. In some cases it is due
to differences in company structures, local culture and ownership patterns of companies.

4.4.1 COMPANY STRUCTURE AND OWNERSHIP

A country where the majority of companies are family owned with few, if any, external shareholders
outside the family will need far less regulation than a country which is dominated by large
multinational corporations with large numbers of shareholders, who have no connection to the
business. Much of the regulation in the latter case would be to ensure that companies are acting in
the best interests of shareholders. In many family companies, the shareholders and directors are the
same family members, so they will already be acting in the best interests of the shareholders and will
be concerned about the long-term future of the business.

4.4.2 LEVEL OF DEVELOPMENT

The level of development of a nation also has an impact on its level of regulation. Developing
countries are further behind in the process of setting standards and establishing regulatory regimes
than industrialised nations.
East Timor, a tiny nation in both territory and population, was officially accepted into the United
Nations as a sovereign state in 2002 after a long-running battle for independence from Indonesia. A
poor nation, it is establishing systems for long-term political and economic stability but is still
struggling with the problems facing many developing nations. It is party to international conventions
and standards (including IFRS), but lags behind in implementation. Cambodia is another example of a
Southeast Asian developing nation where conflict and resulting economic instability means it is still
'catching up' with more industrialised nations in terms of regulation adoption and implementation.
Fiji, one of the largest and economically strongest Pacific island nations, was suspended from both the
Pacific Island Forum and the Commonwealth of Nations during 2009, with both suspensions currently
remaining in force. Fiji's political upheaval means standard-setting and regulation is of low
importance.

4.4.3 DIFFERENT PURPOSES OF FINANCIAL REPORTING

In some countries the purpose of preparing financial statements is solely for tax assessment, and
therefore the accounting rules are often the same as the tax rules. In other countries, financial
statements exist to provide information for investor decision-making. This will have an impact on the
type of regulatory system in place.

4.4.4 DIFFERENT USER GROUPS

Countries have different ideas about who the relevant user groups are and their respective
importance. User groups may include financiers, management, investors, creditors, customers,
employees, the government and the general public. In some countries investor and creditor groups
are given prominence, while in others employees enjoy a higher profile.
 FINANCIAL ACCOUNTING AND REPORTING | 19

5 THE IFRS FOUNDATION AND THE IASB

LOs
1.1, 1.4, Section overview
1.5
 The International regulatory framework consists of the following:

MODULE 1
– The International Financial Reporting Standards Foundation (IFRS Foundation);
– The International Accounting Standards Board (IASB);
– The International Financial Reporting Standards Advisory Council; and
– The International Financial Reporting Standards Interpretations Committee.
 IFRS are developed through a formal system of due process and broad international
consultation involving accountants, financial analysts and other users and regulatory bodies
from around the world.

5.1 SUBJECT OUTLINE

The IFRS Foundation is an independent, not-for-profit private sector organisation working in the
public interest. It was founded in March 2001 as the International Accounting Standards Committee
(IASC) Foundation and is the parent entity of the IASB. The IFRS Foundation publishes and promotes
IFRS. Its mission statement is 'to develop IFRS Standards that bring transparency, accountability and
efficiency to financial markets around the world'.
The governance and oversight of the IFRS Foundation and its standard-setting bodies rests with the
Trustees. They are also responsible for promoting IFRS and securing the organisation's funding. The
Trustees are appointed for a renewable term of three years and must have an understanding of the
issues relevant to the setting and development of IFRS but are not involved in a technical capacity. Six
of the Trustees must be selected from the Asia/Oceania region, six from Europe, six from North
America, one from Africa, one from South America and two from the rest of the world.
A Monitoring Board (established in 2009) provides a formal link between the Trustees and public
capital market authorities. The Monitoring Board participates in the process for appointing Trustees
and approves their appointment. It also advises the Trustees, who are required to report to it annually,
and review their work. The Monitoring Board has six members drawn from the European Commission
(EC), the International Organization of Securities Commissions (IOSCO), the US Securities and
Exchange Commission (SEC) and other regulatory bodies.
The International Accounting Standards Board is the standard-setting body and is an independent,
privately-funded accounting standard setter based in London. It is a part of the International
regulatory framework, reporting to the IFRS Foundation.
From April 2001 the IASB assumed accounting standard setting responsibilities from its predecessor
body, the International Accounting Standards Committee (IASC).
The IASB has an important role to play in the regulation of financial information as it is responsible for
issuing IFRS, which are then adopted for use in many different jurisdictions. Since 2001, almost 120
countries have required or permitted the use of IFRS in preparing financial information which makes
the IASB the most important accounting body worldwide. Most of the remaining major economies,
other than the US, have timelines in place for the move from national accounting standards to
convergence with IFRS in the near future.

5.2 THE COMPOSITION OF THE IASB

The IASB is an independent group of experts with recent relevant practical experience. Its members
are selected so that there is a mix of auditors, preparers, users and academics.
The 12 members of the IASB come from many different countries and have a diverse range of
backgrounds. There are currently three members from the Asia/Oceania region; three members from
Europe; two members from North America; one member from Africa; one member from South America;
and two members appointed from any area, subject to maintaining overall geographical balance.
 20 | THE FINANCIAL REPORTING ENVIRONMENT

The IASB aims to be collaborative in its development of standards by engaging with the worldwide
standard setting community as well as investors, regulators, business leaders and the global
accountancy profession.

5.3 OBJECTIVES OF THE IFRS FOUNDATION AND THE IASB

The formal objectives of the IFRS Foundation and IASB are as follows:
 To develop, in the public interest, a single set of high quality, understandable, enforceable and
globally accepted financial reporting standards based upon clearly articulated principles. These
standards should require high quality, transparent and comparable information in financial
statements and other financial reporting to help investors, other participants in the world's capital
markets and other users of financial information to make economic decisions.
 To promote the use and rigorous application of those standards.
 To take account of the needs of a range of sizes and types of entities in diverse economic settings.
 To promote and facilitate adoption of International Financial Reporting Standards (IFRS), being
the standards and interpretations issued through the IASB, through the convergence of national
accounting standards and IFRSs.

5.4 STRUCTURE OF THE IFRS FOUNDATION

The structure of the IFRS Foundation has the following main features:
 The IFRS Foundation oversees two main areas – the standard-setting process and the IFRS
Advisory Council (previously known as the Standards Advisory Council).
 The standard-setting process consists of two bodies, the IASB (as discussed above) and the IFRS
Interpretations Committee. The IASB has the sole responsibility for setting international financial
reporting standards.
 The IFRS Interpretations Committee (previously known as the International Financial Reporting
Interpretations Committee or IFRIC) comprises 14 voting members drawn from a variety of
countries and professional backgrounds. The IFRS Interpretations Committee provides timely
guidance on the application and interpretation of IFRS. It deals with newly identified financial
reporting issues not specifically addressed in IFRS, or issues where unsatisfactory or conflicting
interpretations have developed, or seem likely to develop.
 The IFRS Advisory Council (previously the Standards Advisory Council) is the formal advisory body
to the IASB and Trustees of the IFRS Foundation. It is comprised of a wide range of representatives
from user groups, preparers, financial analysts, academics, auditors, regulators, professional
accounting bodies and investor groups that are affected by and interested in the IASB's work.
Members of the Advisory Council are appointed by the Trustees. It meets three times a year to
advise the IASB on a range of issues including the IASB's agenda and work program.
 FINANCIAL ACCOUNTING AND REPORTING | 21

The structure of the IFRS Foundation can be illustrated as follows:

Monitoring Board
of public capital market authorities

appoints, monitors reports to

MODULE 1
IFRS Foundation Trustees
(Governance)

oversee, review effectiveness,

appoint inform informs
appoint and finance

IFRS Advisory Council Standard setting

International Accounting Standards Board (IASB)

(IFRS/IFRS for SMEs)
provides
strategic
advice

IFRS Interpretations Committee

IFRS Foundation support operations

Education Initiative, IFRS Taxonomy (XBRL), Content Services

5.5 THE STANDARD SETTING PROCESS

IFRS are developed through a formal system of due process and broad international consultation
involving accountants, financial analysts and other users and regulatory bodies from around the world.
The process of developing an accounting standard has six stages as follows:
Step 1 Setting the agenda. The IASB evaluates the merits of adding a potential item to its
agenda mainly by reference to the needs of investors.
The IASB considers:
 the relevance to users of the information and the reliability of information that could
be provided;
 whether existing guidance is available;
 the possibility of increasing convergence;
 the quality of the standard to be developed; and
 resource constraints.
The IFRS Advisory Council and the IFRS Interpretations Committee, other
standard-setters and other interested parties may have made comments on accounting
issues that could become potential agenda items.
Step 2 Planning the project. When adding an item to its work agenda, the IASB considers
whether to conduct the project alone or jointly with another standard setter. A working
group is usually formed at this stage and the project plan is developed.
22 | THE FINANCIAL REPORTING ENVIRONMENT

Step 3 Developing and publishing the discussion paper. It is not mandatory for the IASB to
issue a discussion paper in the development of a standard, but it is usual practice where
there is a major new topic being developed and the IASB wish to set out their position and
invite comments at an early stage in the process. Typically, a discussion paper includes:
 a comprehensive overview of the issue;
 possible approaches in addressing the issue;
 the preliminary views of its authors or the IASB; and
 an invitation to comment.
Step 4 Developing and publishing the exposure draft. This is a mandatory step in the due
process. Regardless of whether a discussion paper has been published, the exposure
draft is the IASB's main means of consulting the public on the proposed standard. The
exposure draft sets out the proposed standard in detail. The development of the
exposure draft begins with the IASB considering the following:
 issues on the basis of staff research and recommendations;
 comments received on the discussion paper (if one was published); and
 suggestions made by the IFRS Advisory Council, working groups, other
standard-setters and public meetings where the proposed standard was discussed.
Once the exposure draft has been published the IASB again invites comments.
Step 5 Developing and publishing the standard. The development occurs at IASB meetings
when the IASB considers the comments received on the exposure draft. The IASB must
then consider whether a second exposure draft should be published. The IASB needs to:
 identify substantial issues that emerged during the comment period on the exposure
draft that it had not previously considered;
 assess the evidence that has been considered;
 evaluate whether it has sufficiently understood the issues and obtained the views of
constituents; and
 consider whether the various viewpoints were aired in the exposure draft and
adequately discussed and reviewed in the basis for conclusions.
If the IASB decides that the exposure draft should be republished then the same process
should be followed as for the first exposure draft. Once the IASB is satisfied that the
issues raised have been dealt with, the IFRS is drafted.
Step 6 After the standard is issued. After an IFRS is issued, IASB holds regular meetings with
interested parties, including other standard-setting bodies, to help understand
unanticipated issues related to the practical implementation and potential impact of its
proposals. If there are concerns about the quality of the standard from the IFRS Advisory
Council, the IFRS Interpretations Committee, standard-setters and constituents, then the
issue may be added to the IASB agenda and the process reverts back to Step 1.
Post-implementation reviews are carried out for each new standard, generally after the
requirements have been applied for two years internationally.
 FINANCIAL ACCOUNTING AND REPORTING | 23

The standard setting process can be illustrated in the diagram below:

Research

Discussion
paper (DP)
optional

MODULE 1
Public consultation

Proposal Extensive
outreach
activities
Exposure
draft
(ED)
Input
into standard
setting process Public
Consultation

Published Feedback
IFRS statement

IASB post-implementation review

5.6 CONSULTATION WITH NATIONAL STANDARD-SETTERS

The development of an IFRS involves an open, public process of debating technical issues and
evaluating input sought through several mechanisms. Opportunities for interested parties to
participate in the development of IFRS would include, depending on the nature of the project:
 participation in the development of views as a member of the IFRS Advisory Council;
 participation in advisory groups;
 submission of a comment letter in response to a discussion document;
 submission of a comment letter in response to an Exposure Draft;
 participation in public hearings; and/or
 participation in field visits and field tests.
The IASB publishes an annual report on its activities during the past year and priorities for next year.
This report provides a basis and opportunity for comment by interested parties. In addition, it also
undertakes a public consultation on its future technical agenda every three years. The first of these
public consultations took place in the second half of 2011 and the second public consultation was in
August 2015.
The IASB reports on its technical projects on its website. It also publishes a report on IASB decisions
immediately after each IASB meeting in its newsletter IASB Update.

5.7 THE NEED FOR INTERNATIONAL STANDARDS

Although the predecessor organisation of the IFRS Foundation was set up in the 1970s, the
development of International standards has grown in importance in the last 10 years. As business and
commerce became more global in nature, many interested parties began to understand the need for
a common set of accounting standards. Until that point, many multinational companies prepared
financial statements under a variety of GAAPs, which was costly. This also had an impact on the
auditors of those financial statements and current and future investors. Companies with stock
exchange listings in more than one jurisdiction had to prepare different sets of financial statements for
each jurisdiction which was viewed as inefficient.
 24 | THE FINANCIAL REPORTING ENVIRONMENT

The original International Accounting Standards were deliberately drafted to be flexible and to allow
choices. From the 1990s onwards it became increasingly clear that it was not enough to have a set of
international standards with which most countries could comply. These standards had to be
sufficiently rigorous to be acceptable to all stock exchanges, including those in the US.
The starting point for the rapid change of the last few years was the acceptance of international
accounting standards for cross border listings by the International Organisation of Securities
Commissions (IOSCO). International standards gained more prominence when the European Union
decided that from 2005, the consolidated financial statements of companies in the member states
would be prepared under international standards. IFRS became the global standards that were
needed and since then many countries, including Australia and South Africa, have adopted IFRS as
their national standards or have a program in place to adopt international standards in the near future.

5.7.1 BENEFITS OF HARMONISATION

There are several general benefits of harmonisation:
 Investors and lenders, both individual and corporate, need to be able to compare the financial
results of different companies internationally as well as nationally in making investment
decisions. Differences in accounting practice and reporting can prove to be a barrier to such
cross-border analysis. Harmonisation of financial reporting benefits investors, lenders and their
advisors, because it provides them with better quality information on which to base economic
decisions. Users no longer have to understand several different national GAAPs or to incur the
costs of adjusting financial statements in order to compare them with each other.
 Harmonisation benefits the global economy, because it makes it removes barriers to the flow of
capital between countries. It is easier for businesses to expand into and raise finance in
countries other than their own.
 Robust international financial reporting standards are also needed to protect investors and to
restore public confidence in financial reporting following the failure of several banks (notably
Lehman Brothers in 2008) and the resulting 'credit crunch' and global financial crisis. One of the
actions agreed upon by the G-20 leaders (finance ministers and central bank governors from the
world's largest economies), in their summit meetings after the crisis, was that the key global
accounting standards bodies should work intensively towards the objective of creating a single set
of high quality global standards.
A full list of countries adopting IFRS and their progress can be found on:
www.iasplus.com/en/resources/ifrs-topics
We look at the harmonisation process in more detail later in this module.

5.7.2 BARRIERS TO HARMONISATION

There are undoubtedly many barriers to full international harmonisation. Problems include the
following:
 Different purposes of financial reporting. In some countries the purpose is solely for tax
assessment, while in others it is for investor decision-making.
 Different legal systems. These may prevent the development of certain accounting practices and
restrict the options available.
 Different user groups. Countries have different ideas about who are the relevant user groups and
their respective importance. In the US investor and creditor groups are given prominence, while in
Europe employees enjoy a higher profile.
 Needs of developing countries. Developing countries are clearly behind in the standard-setting
process and they need to develop the basic standards and principles already in place in most
developed countries.
 Nationalism is demonstrated in an unwillingness to accept another country's standard.
 Cultural differences result in objectives for accounting systems differing from country to country.
 FINANCIAL ACCOUNTING AND REPORTING | 25

 Unique circumstances. Some countries may be experiencing unusual circumstances which affect
all aspects of everyday life and impinge on the ability of companies to produce proper reports, for
example, hyperinflation, civil war, currency restriction and so on.
 The lack of strong accountancy bodies. Many countries do not have strong independent
accountancy or business bodies which would press for better standards and greater harmonisation.
These are difficult problems to overcome, and yet attempts are being made continually to do so. We

MODULE 1
must therefore consider what the perceived advantages of harmonisation are, which justify so much
effort.

5.8 BENEFITS OF IFRS FOR NATIONAL JURISDICTIONS

The advantages of IFRS described above apply to individual nations. If it is possible to compare the
financial statements of an entity in one country with those of another entity located in a different
country it becomes easier to do business with overseas companies. This benefits national economies,
as well as the global economy.
In its 2002 policy statement International Convergence and Harmonisation Policy the Australian
Accounting Standards Board listed the following additional benefits of adopting IFRS:
 increasing the understanding by foreign investors of Australian financial reports;
 reducing financial reporting costs for Australian multinational companies and foreign companies
operating in Australia and reporting elsewhere;
 facilitating more meaningful comparisons of the financial performance and financial position of
Australian and foreign public sector reporting entities; and
 improving the quality of financial reporting in Australia to best international practice.
There are a number of further potential benefits for national jurisdictions:
 Many developing nations who do not have the resources to develop and implement their own
national standards can adopt IFRS as a full set of standards. This is perhaps more relevant since
the issue of the IFRS for SMEs as previously the level of detail in standards and the amount of
disclosure required was a barrier to adoption of IFRS in developing countries.
 It may be easier for national governments to control the activities of foreign multinational
companies that carry out operations within their territory. These companies would not be able to
'hide' behind foreign accounting practices which are difficult to understand.
 Tax authorities may find it easier to calculate the tax liability of investors.
Many national standard setting bodies are experiencing a change in their role as IFRS have become
more important. Many standard setters no longer develop and issue their own accounting standards
and instead comment on the work of the IASB, the impact of new IFRS and changes to existing IFRS
on their home jurisdiction. National standard setting bodies may also undertake research on behalf of
the IASB on particular projects.

5.9 OTHER INTERNATIONAL INFLUENCES

There are a number of other international bodies that have been involved in the recent trend of
moving to IFRS. They are discussed briefly below.

5.9.1 IASB AND THE EUROPEAN COMMISSION

The European Commission (EC) has acknowledged the role of the IASB in harmonising world-wide
accounting rules and EC representatives attend IASB Board meetings and have joined Steering
Committees involved in setting IFRS.
The EC has also set up a committee to investigate where there are conflicts between European Union
norms and International Standards so that compatibility can be achieved. In turn, the IASB has used
EC Directives in its work.
From 2005, all listed entities in member states have been required to use IFRS in their
consolidated financial statements.
 26 | THE FINANCIAL REPORTING ENVIRONMENT

5.9.2 UNITED NATIONS (UN)

The UN has a Commission and Centre on Transnational Reporting Corporations through which it
gathers information concerning the activities and reporting of multinational companies. The UN
processes are highly political and probably reflect the attitudes of the governments of developing
countries towards multinationals. For example, there is an inter-governmental working group of
'experts' on international standards of accounting and reporting which is dominated by the
non-developed countries.

5.9.3 INTERNATIONAL FEDERATION OF ACCOUNTANTS (IFAC)

The IFAC is a private sector body established in 1977 and which now consists of over 100 professional
accounting bodies, including CPA Australia, from around 80 different countries. The IFAC's main
objective is to coordinate the accounting profession on a global scale by issuing and establishing
International Standards on auditing, management accounting, public sector accounting, ethics,
education and training. The IFAC has separate committees working on these topics and also
organises the World Congress of Accountants, which is held every four years.

5.9.4 ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT (OECD)

The OECD was established in 1960 by the governments of 21 countries to 'achieve the highest
sustainable economic growth and employment and a rising standard of living in member countries
while maintaining financial stability and, thus, to contribute to the world economy'. It now has 35
member countries.
The OECD's aim is to bring together the governments of countries committed to democracy and the
market economy from around the world to:
 support sustainable economic growth;
 boost employment;
 raise living standards;
 maintain financial stability;
 assist other countries' economic development; and
 contribute to growth in world trade.
The Organisation provides a setting where governments compare policy experiences, seek answers to
common problems, identify good practice and coordinate domestic and international policies.
The OECD supports the work of the IASB but also undertakes its own research into accounting
standards via ad hoc working groups. The OECD also produces its own corporate governance
principles and other publications aimed at improving financial reporting, regulation and removing
corruption.

5.9.5 AUSTRALIAN ACCOUNTING STANDARDS BOARD (AASB)

The AASB is an independent accounting standard setting body based in Melbourne. The functions of
the AASB under the Australian Securities and Investments Commission (ASIC) 2001 Act are:
 to develop a conceptual framework, not having the force of an accounting standard, for the
purpose of evaluating proposed accounting standards and international standards;
 to make accounting standards under section 334 of the Corporations Act 2001 for the purposes of
the corporations legislation (other than the excluded provisions);
 to formulate accounting standards for other purposes;
 to participate in and contribute to the development of a single set of accounting standards for
worldwide use; and
 to advance and promote the main objects of Part 12 of the Australian Securities and Investments
Commission Act, with regard to the interests of Australian corporations which raise or propose to
raise capital in major international financial centres.
 FINANCIAL ACCOUNTING AND REPORTING | 27

The mission of the AASB is to:

 develop and maintain a high-quality conceptual framework for all sectors of the Australian
economy;
 develop and maintain high quality accounting (i.e. financial reporting) standards for reporting
entities in those sectors; and
 contribute, through thought leadership and participation, in the development of global financial

MODULE 1
reporting standards and standard-setting.
The Australian process of harmonisation with IFRS has been to issue IFRS-equivalent standards, that is,
adopt the content of IFRS with minor changes made to refer to the Australian legislative environment.
The audit report of a company's financial statements states that they have been prepared in
compliance with IFRS.
The AASB issues standards that apply to both for-profit and not-for-profit entities. Standards issued by
the International Accounting Standards Committee (IASC), the predecessor of the IASB, are
designated as IAS 1, IAS 2 etc. The Australian equivalents are AASB 101, AASB 102 etc. Standards
issued by the IASB are designated as IFRS 1, IFRS 2 etc, and the Australian equivalents are AASB 1,
AASB 2 etc.

5.10 TRUE AND FAIR VIEW/FAIR PRESENTATION

It is a requirement of national legislation in some countries that the financial statements should give a
true and fair view of (or 'present fairly, in all material respects') the financial performance and position
of the entity as at the end of the financial year. Despite this, the terms 'true and fair view' and 'present
fairly, in all material respects' are not defined in accounting or auditing standards.
In some jurisdictions a company's managers may depart from any of the provisions of accounting
standards if these are inconsistent with the requirement to give a true and fair view. This is commonly
referred to as the 'true and fair override'. It has been treated as an important loophole in the law in
different countries and has been the cause of much argument and dissatisfaction within the
accounting profession. For example, it is not recognised in Australia, where it was removed from
legislation in 1991. Australian regulators and bodies want the accounting standards (and the true and
fair view being established by them) given primacy. In Australia therefore, directors are required to
provide additional information in order to comply with the true and fair view, as they cannot depart
from any of the provisions of the accounting standards.

5.11 THE IASB AND CURRENT ACCOUNTING STANDARDS

The IASB's predecessor body, the IASC, had issued 41 International Accounting Standards (IASs) and
on 1 April 2001 the IASB adopted all of these standards and now issues its own International Financial
Reporting Standards (IFRS). So far 17 new IFRS have been issued as well as the IFRS for small and
medium-sized enterprises (SMEs). From now on in this Study guide we will use the phrase 'IFRS' for all
International Accounting Standards unless we are specifically discussing a particular IAS.

5.12 THE IASB AND FASB

The IASB and the US Financial Accounting Standards Board (FASB) have been working together
since 2002 to achieve convergence of IFRS and US GAAP. Both parties set out their agreement in a
Memorandum of Understanding known as the Norwalk Agreement. Their work plan was set out in a
roadmap for convergence which outlined their targets over the period up to 2008 (see also later in this
module).
In 2007, the US Securities and Exchange Commission (SEC) removed the necessity for a reconciliation
between IFRS and US GAAP for non-US companies that were listed in the US providing their financial
statements complied with IFRS. The SEC originally planned to phase in allowing all companies to use
IFRS by 2014. This has not happened and the SEC are currently considering whether a single set of
global accounting standards is achievable.
28 | THE FINANCIAL REPORTING ENVIRONMENT

In 2008, and again in 2010, the Memorandum of Understanding was updated, setting out the
objectives for the period to 2011 in the convergence of US GAAP and IFRS. The IASB and the FASB
set a June 2011 target date for those projects deemed to be most important, leaving those with a
lesser degree of importance to be dealt with later. The following projects were completed in June
2011:
 Business combinations;
 Consolidation;
 Derecognition of financial instruments;
 Fair value measurement;
 Financial statement presentation;
 Joint arrangements; and
 Post-employment benefits.
They published a joint progress report in 2012 on progress made on financial instruments, and in 2013
they issued a high level update on the status and timeline of the remaining projects. Since this, the
IASB and FASB have worked together on the following projects:
 Financial instruments;
 Revenue;
 Leases; and
 Insurance contracts.
These projects have now been completed although the pace of these projects has slowed down. The
IASB has also worked with the FASB to develop a common conceptual framework. This is intended to
provide a sound foundation for developing future accounting standards.
The IASB Conceptual Framework for Financial Reporting is discussed later in this module and you will
see that FASB have withdrawn from this project. This could begin to cast doubt over the future
relationship between IASB and FASB.
 FINANCIAL ACCOUNTING AND REPORTING | 29

KEY MODULE POINTS 1

 Accounting is the process of recording, analysing and summarising transactions of a business and
communicating that information to decision makers.
 A business is an entity which exists to make a profit.

MODULE 1
 There are three main types of business entity: sole traders, partnerships and limited liability
companies.
 Not-for-profit entities such as charities and clubs may also prepare accounts.
 Financial reporting is the process of classifying, recording and presenting financial data in
accordance with generally established concepts and principles.
 There are various groups of people who need information about the activities of a business.
 The regulatory framework is the most important element in ensuring that general purpose financial
reporting produces relevant and reliable information and therefore meets the needs of
shareholders, lenders and other users.
 As the IASB has no power to regulate the use of IFRS, regulation takes place at a national level.
 The organisational structure for International financial reporting consists of:
– the IFRS Foundation;
– the IASB;
– the IFRS Advisory Council; and
– the IFRS Interpretations Committee.
 IFRS are developed through a formal system of due process and broad international consultation
involving accountants, financial analysts and other users and regulatory bodies from around the
world.
 There are a number of benefits of harmonisation including the facilitation of cross-border
investment and financing.
 The move toward the use of IFRSs has been influenced by a number of international bodies.
 It is a requirement of national legislation in some countries that the financial statements should
give a true and fair view. However the term 'true and fair view' is not defined in accounting or
auditing standards.
30 | THE FINANCIAL REPORTING ENVIRONMENT

QUICK REVISION QUESTIONS 1

1 What is the main aim of accounting?

A To produce a trial balance
B To record every financial transaction individually
C To maintain ledger accounts for every asset and liability
D To provide financial information to users of such information

2 Which of the following groups of users would primarily be interested in a company's annual
published financial statements?
A Shareholders and suppliers
B Management and employees
C Shareholders and providers of finance
D General public, environmental pressure groups

3 Are the following statements correct or incorrect?

 The shareholder is only interested in a statement of financial prospects, that is, an indication of
future progress.
 The supplier of goods on credit is only interested in a statement of financial position, that is, an
indication of the current state of affairs.
Shareholder Supplier
A Correct Correct
B Correct Incorrect
C Incorrect Correct
D Incorrect Incorrect
4 Which of the following statements concerning the International Accounting Standards Board (IASB)
is correct?
I. It develops and ultimately issues International Financial Reporting Standards (IFRSs).
II. The IASB is accountable to the IFRS Foundation.

A I only
B II only
C Both I and II
D Neither I nor II

5 Which of the following statements is correct?

A The IASB appoints the Trustees of the IFRS Foundation.
B The IFRS Foundation develops and issues Interpretations.
C The IFRS Interpretations Committee oversees the work of the IFRS Foundation.
D The IFRS Advisory Council assists and advises the IASB in the process of developing IFRSs.

6 Which of these statements are correct?

I. The IASB has the objective of enforcing IFRS.
II. The IASB is responsible for developing and issuing IFRS.

A I only
B II only
C Both I and II
D Neither I nor II
 FINANCIAL ACCOUNTING AND REPORTING | 31

7 Which committee of the IASB provides guidance on the application of IFRS?

A IFRS Foundation
B IFRS Advisory Council
C IFRS Interpretations Committee
D International Accounting Standards Committee

8 What is the correct definition of GAAP?

MODULE 1
A National accounting standards and company law
B National accounting standards, stock exchange rules and company law
C International accounting standards, company law and stock exchange rules
D National accounting standards, international accounting standards, stock exchange rules and
company law

9 Which of the following is an advantage of a company that prepares a set of financial statements
under the regulatory framework?
A Lower costs of producing financial information
B Higher quality financial information is produced
C More financial information available for competitors
D Less disclosure of a company's activities in financial statements

10 What is the correct order for the process of issuing a new IFRS by the IASB?
A Discussion Paper, Standard
B Exposure Draft, Discussion Paper, Review
C Exposure Draft, Discussion Paper, Standard
D Discussion Paper, Exposure Draft, Standard
 32 | THE FINANCIAL REPORTING ENVIRONMENT

6 GENERALLY ACCEPTED ACCOUNTING

PRINCIPLES (GAAP)

LO
1.6 Section overview
 The rules, from whatever source, which govern accounting.

6.1 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

We defined GAAP earlier in this module as all of the rules, from whatever source, which govern
accounting.
There are different views of GAAP in different countries. The UK position can be explained in the
following extracts from UK GAAP (Davies, Paterson & Wilson, Ernst & Young, 5th edition).
Our view is that GAAP is a dynamic concept which requires constant review, adaptation and
reaction to changing circumstances. We believe that use of the term "principle" gives GAAP an
unjustified and inappropriate degree of permanence. GAAP changes in response to changing
business and economic needs and developments. As circumstances alter, accounting practices are
modified or developed accordingly … We believe that GAAP goes far beyond mere rules and
principles, and encompasses contemporary permissible accounting practice.
It is often argued that the term "generally accepted" implies that there must exist a high degree of
practical application of a particular accounting practice. However, this interpretation raises certain
practical difficulties. For example, what about new areas of accounting which have not, as yet, been
generally applied? What about different accounting treatments for similar items – are they all
generally accepted?
It is our view that "generally accepted" does not mean "generally adopted or used". We believe
that, in the UK context, GAAP refers to accounting practices which are regarded as permissible by
the accounting profession. The extent to which a particular practice has been adopted is, in our
opinion, not the overriding consideration. Any accounting practice which is legitimate in the
circumstances under which it has been applied should be regarded as GAAP. The decision as to
whether or not a particular practice is permissible or legitimate would depend on one or more of the
following factors:
 Is the practice addressed either in the accounting standards, statute or other official
pronouncements?
 If the practice is not addressed in UK accounting standards, is it dealt with in International
Accounting Standards, or the standards of other countries such as the US?
 Is the practice consistent with the needs of users and the objectives of financial reporting?
 Does the practice have authoritative support in the accounting literature?
 Is the practice being applied by other companies in similar situations?
 Is the practice consistent with the fundamental concept of 'true and fair'?
This view is not held in all countries. In the US particularly, the equivalent of a 'true and fair view' is
'fair presentation in accordance with GAAP'. Generally Accepted Accounting Principles are defined as
those principles which have 'substantial authoritative support'. Therefore, accounts prepared in
accordance with accounting principles for which there is not substantial authoritative support are
presumed to be misleading or inaccurate.
The effect here is that 'new' or 'different' accounting principles are not acceptable unless they have
been adopted by the mainstream accounting profession, usually the standard-setting bodies and/or
professional accountancy bodies. This is much more rigid than the UK view expressed above.
 FINANCIAL ACCOUNTING AND REPORTING | 33

In contrast, however, in Australia there does not seem to be any strong body of opinion on GAAP.
GAAP is only used by Australian companies if they need to prepare financial statements to US
standards in order to raise funds from, or obtain a listing, in the US. Otherwise, Australian companies
implement IFRS and the pronouncements of the IASB and AASB.

7 CONCEPTUAL FRAMEWORK

MODULE 1
Section overview
 The Conceptual Framework provides the theoretical framework for the development of
IFRS.

7.1 THE SEARCH FOR A CONCEPTUAL FRAMEWORK

A conceptual framework is a statement of generally accepted theoretical principles which form the
frame of reference for financial reporting.
The financial reporting process is concerned with providing information that is useful in the business
and economic decision-making process. Therefore, a conceptual framework forms the theoretical
basis for determining which events should be accounted for, how they should be measured and how
they should be communicated to the user.

7.1.1 THE NEED FOR A CONCEPTUAL FRAMEWORK

Definitions

Conceptual framework: A coherent system of interrelated objectives and fundamental concepts that
prescribes the nature, function and limits of financial accounting and reporting. (FASB)
Conceptual framework: A coherent system of concepts that flow from an objective. The objective of
financial reporting is the foundation of the framework. The other concepts provide guidance on
identifying the boundaries of financial reporting, selecting the transactions, other events and
circumstances to be represented; how they should be recognised and measured (or disclosed); and
how they should be summarised and communicated in financial reports. (IASB)

A conceptual framework is an important part of the financial reporting system as it underpins the
development of accounting standards and sets out the basis of recognition of items in the financial
statements such as assets, liabilities, income and expenses. It provides the basis for the development
of new accounting standards and the evaluation of those already in existence.
Where an agreed framework exists, the standard-setting body acts as an architect or designer,
building accounting rules on the foundation of sound, agreed basic principles.

7.1.2 ADVANTAGES AND DISADVANTAGES OF A CONCEPTUAL FRAMEWORK

Advantages
 The situation is avoided whereby standards are developed on a piecemeal basis as a reaction to
a particular accounting problem which has emerged. In this situation, resources may be channelled
into standardising accounting practice in that area, without regard to whether that particular issue
is necessarily the most important issue at that time. Standards developed in this way may be
inconsistent with basic concepts and with each other.
 The situation is also avoided where there are significant 'gaps' and certain topics are never
addressed. For example, before the development of the IASB's and the US FASB's conceptual
frameworks there were no formal definitions of terms such as 'asset', 'liability' or 'equity'.
 34 | THE FINANCIAL REPORTING ENVIRONMENT

 The development of certain standards (particularly national standards) has been subject to
considerable political interference from interested parties. Where there is a conflict of interest
between user groups on which policies to choose, policies deriving from a conceptual framework
will be less open to criticism that the standard-setter acceded to external pressure.
 The existence of a framework of principles means that it is much harder for preparers to avoid
complying with reporting requirements. Rules can be avoided, but preparers must apply the
'spirit' and reasoning behind standards based on principles.
 Standard setters may become more accountable to the users of financial statements, because the
reasoning behind specific standards should be clear. It should also be clear to users when standard
setters have departed from the principles set out in the framework.
 The process of developing standards should be easier and less costly because the basic
principles that underpin them have already been debated and established.
 Business is becoming increasingly complex. Accounting standards cannot cover all eventualities
and in practice the development of standards has lagged behind the growth in particular types of
complex transaction (for example, in 'off balance sheet' finance). A conceptual framework provides
principles that can be applied where there is no relevant accounting standard or other
guidance.
 The existence of a conceptual framework contributes to the general credibility of financial
reporting and increases public confidence in financial statements.
Disadvantages
 Financial statements are intended for a variety of users, and it is not certain that a single
conceptual framework can be devised which will suit all users.
 Given the diversity of user requirements, there may be a need for a variety of accounting
standards, each produced for a different purpose (and with different concepts as a basis).
 It is not clear that a conceptual framework makes the task of preparing and then implementing
standards any easier than without a framework.
 In practice, conceptual frameworks can lead to accounting standards which are very theoretical
and academic. They may increase the complexity of financial information and lead to solutions
that are conceptually pure but are difficult to understand and apply for many preparers and users.
 Conceptual frameworks tend to focus on the usefulness of financial information in making 'hold or
sell' decisions about an investment. However, many users of financial statements are also
interested in information that will help them assess the stewardship of management.
 In addition, accounting principles focus only on economic phenomena: transactions that can be
expressed in money terms. Many believe that other aspects of an entity's operations, such as its
effect on the natural environment or on the wider community, should be at least equally important
in assessing its performance and making investment decisions.
Before we look at the IASB's attempt to produce a conceptual framework, we need to consider
another element of importance to this debate: Generally Accepted Accounting Principles or GAAP.

7.2 THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING 2018

7.2.1 INTRODUCTION
The introduction to the Conceptual Framework points out the fundamental reason why financial
statements are produced worldwide, that is, to satisfy the requirements of external users, but that
practice varies due to the individual pressures in each country. These pressures may be social,
political, economic or legal, but they result in variations in practice from country to country, including
the form of statements, the definition of their component parts (assets, liabilities, equity, income,
expenses), the criteria for recognition of items and both the scope and disclosure of financial
statements.
The IASB wishes to narrow these differences by harmonising all aspects of financial statements, including
the regulations governing their accounting standards and their preparation and presentation.
 FINANCIAL ACCOUNTING AND REPORTING | 35

The introduction emphasises the way financial statements are used to make economic decisions.
The Conceptual Framework was revised in March 2018 and is effective for periods commencing on or
after 1 January 2020. It consists of several sections or chapters as follows:
 Chapter 1 – The objective of general purpose financial reporting (see below);
 Chapter 2 – Qualitative characteristics of useful financial information (see below);
 Chapter 3 – Financial statements and the reporting entity (see Module 3);

MODULE 1
 Chapter 4 – The elements of the financial statements (see below);
 Chapter 5 – Recognition and derecognition of the elements of the financial statements (see below);
 Chapter 6 – Measurement of the elements of the financial statements (see Module 2);
 Chapter 7 – Presentation and disclosure (see Module 3);
 Chapter 8 – Concepts of capital and capital maintenance (see Module 2).

Question 5: Economic decisions

Financial statements provide information that helps users to make economic decisions. What are the
main types of economic decision for which financial statements are likely to be used?
(The answer is at the end of the module.)

7.2.2 PURPOSE AND STATUS

The purposes of the Conceptual Framework are to:
 assist the International Accounting Standards Board (Board) to develop IFRS Standards (Standards)
that are based on consistent concepts;
 assist preparers to develop consistent accounting policies when no Standard applies to a particular
transaction or other event, or when a Standard allows a choice of accounting policy; and
 assist all parties to understand and interpret the Standards.

The IASB's Conceptual Framework for Financial Reporting (Conceptual Framework) is, in effect, the
theoretical framework upon which all IFRS are based and therefore determines how financial
statements are prepared and the information they contain.
The Conceptual Framework itself is not an International Financial Reporting Standard and so does not
overrule any individual IFRS. It acts to provide guidance in the absence of regulation and to provide a
consistent basis for developing and revising IFRSs. In the rare cases of conflict between an IFRS and
the Conceptual Framework, the IFRS will prevail. These cases will diminish over time to the extent
that the Conceptual Framework is used as a guide in the production of future IFRS. The Conceptual
Framework itself will be revised occasionally depending on the experience of the IASB in using it.

7.2.3 SCOPE
The Conceptual Framework is concerned with general purpose financial reporting. The term is not
defined or discussed in the Conceptual Framework, but generally means a normal set of annual
financial statements or published annual report available to users outside the reporting entity.
A reporting entity is an entity that is required, or chooses, to prepare financial statements. A reporting
entity can be a single entity or a portion of an entity or can comprise more than one entity. A
reporting entity is not necessarily a legal entity.
 36 | THE FINANCIAL REPORTING ENVIRONMENT

7.3 THE OBJECTIVE OF GENERAL PURPOSE FINANCIAL REPORTING

These decisions involve:
 buying, selling or holding equity and debt instruments (such as loan stock or debentures);
 providing or settling loans and other forms of credit: or
 exercising rights to vote on, or otherwise influence, management's actions that affect
the use of the entity's economic resources.
The Conceptual Framework explains that existing and potential investors, lenders and other creditors
must normally rely on general purpose financial reports for most of the financial information that they
need. Therefore they are the primary users to which general purpose financial reports are directed.
General purpose financial reports cannot provide all the information that existing and potential
investors, lenders and other creditors need. They may also need to consider relevant information
from other sources, for example, general economic conditions and expectations, political events and
information about the industry in which the company operates.
Financial statements do not provide a valuation of an entity, but should allow primary users sufficient
information to form their own opinions and estimations. Financial statements contain elements of
estimation and judgements made by the directors and management, and the Conceptual Framework
sets out the key concepts underlying these judgements.
The information provided by the financial statements should include detail about the entity's
economic resources, claims against the entity and changes in resources and claims. This will enable
users to assess how the management is running the business ('management's stewardship') users,
such as creditors and lenders, can use the information to assess the entity's potential to fund future
cash flows, for example a bank loan.
The Conceptual Framework makes it clear that this information should be prepared using
accrual accounting.
The Conceptual Framework explains that other users, such as regulators and members of the public
may also find general purpose financial reports useful. However, financial reports are not primarily
prepared for these groups of users.

Question 6: Users of financial information

Earlier in this module, we discussed the users of accounting information. List the nine groups of users
and describe the information needs of each group.
(The answer is at the end of the module.)

7.3.1 ECONOMIC RESOURCES, CLAIMS AND CHANGES IN RESOURCES AND CLAIMS

Financial reports provide information about the financial position of an entity:
 its economic resources; and
 the claims against it.
They also provide information about changes in an entity's economic resources and claims.
In other words, financial reports provide information about an entity's assets (which will generate
economic benefits in future) and liabilities (which will deplete economic benefits in future) in order to
determine the net position (assets minus liabilities) and how that net position changes. Information
about the entity's economic resources and the claims against it helps users to assess the entity's
liquidity and solvency, its needs for additional finance and how successful it is likely to be in
obtaining it.
 FINANCIAL ACCOUNTING AND REPORTING | 37

Definitions

Liquidity. The availability of sufficient funds to meet short-term financial commitments as they fall due.
Solvency. The availability of cash over the longer term to meet financial commitments as they fall due.

Changes in an entity's economic resources and claims result from its financial performance and also

MODULE 1
from other transactions and events such as the issue of shares or an increase in debt (borrowings).
Information about a reporting entity's financial performance helps users to understand the return
that the entity has produced on its economic resources. This is an indicator of how efficiently and
effectively management has used the resources of the entity and is helpful in predicting future
returns.
Information about an entity's financial performance helps users to assess the entity's past and future
ability to generate net cash inflows from its operations.
Information about a reporting entity's cash flows during a period also helps users assess the entity's
ability to generate future net cash inflows and provides information about factors that may affect its
liquidity or solvency. It also gives users a better understanding of the entity's operations and of its
financing and investing activities.

7.4 THE REPORTING ENTITY

The IASB acknowledges that it does not have authority to determine who must or should prepare
financial statements, but it provides general guidance in paragraph 3.10 of The Conceptual
Framework for Financial Reporting (Conceptual Framework):
A reporting entity is an entity that is required, or chooses, to prepare financial statements. A
reporting entity can be a single entity or a portion of an entity or can comprise more than one
entity. A reporting entity is not necessarily a legal entity.
General purpose financial reports are often needed as a result of regulatory requirements, especially
from entities who trade equities or have issued debt instruments in a public market. These reports will
typically be produced using IFRSs. The IASB makes it clear that general purpose financial reports are
not limited to legal entities, a reporting entity could take many forms including for example a
proportion of an entity or a not-for-profit entity. A reporting entity would exist if the entity has
existing and potential investors, lenders and other creditors who would rely on general purpose
financial reports for information they need to make decisions about providing resources to the entity.
For-profit private sector entities in Australia must prepare general purpose financial statements when
they have both public accountability and they are required by legislation to comply with Australian
Accounting Standards.
Public accountability arises when an entity has or is in the process of issuing debt or equity
instruments (i.e. securities) that are traded in a public market or it holds assets in a fiduciary capacity
for a broad group of outsiders as one of its primary businesses. This would include for example,
insurance companies, banks and mutual funds (AASB 1053, Appendix A).
Other Australian entities who do not meet the above criteria may issue non-general purpose
financial statements. These reports would be prepared and presented in accordance with the
specific information needs of the entity’s financial statement users as previously discussed.
 38 | THE FINANCIAL REPORTING ENVIRONMENT

8 ACCOUNTING REGULATION

LOs
1.6, 1.7 Section overview
 Accounting regulation is necessary to reduce subjectivity in producing financial reports and
to increase comparability.

8.1 ACCOUNTING STANDARDS

In an attempt to deal with some of the subjectivity that may occur in producing financial reports and to
achieve comparability between different organisations, accounting standards were developed. These
standards are developed at both a national level (in most countries) and an international level. In this
Study guide we are concerned with International Accounting Standards (IAS) and International
Financial Reporting Standards (IFRS).
The role of accounting standards is discussed in more detail later in this module.

8.2 ACCOUNTING FOR SITUATIONS WHERE ACCOUNTING

STANDARDS DO NOT EXIST
When there is no specific legal regulation or accounting standard which covers an item in the
accounts, the accountant must make a decision on how this item will be dealt with in the financial
statements. It may be possible to account for the item following the accounting treatment of a similar
item, hence applying the relevant accounting standard.
The accountant may need to make a judgment on the treatment of the item and account for it so that
the financial statements show a true and fair view or a fair presentation of the financial performance
and financial position of the entity.

8.3 USE OF CONCEPTUAL FRAMEWORK

A conceptual framework, such as the IASB Conceptual Framework can be beneficial in situations
where transactions are not covered by an accounting standard. The IASB's Conceptual Framework
includes definitions of the elements of financial statements, that is, assets, liabilities, equity, income
and expenses, and their recognition criteria. The Conceptual Framework also includes the qualitative
characteristics of financial information – these are the characteristics that financial information should
contain if it is to be useful to users. Therefore, the accountant will have sufficient information
contained within the Conceptual Framework to be able to exercise judgment and decide how to deal
with the transaction in a way that properly represents the underlying transaction where there is no
IFRSs that deal with similar and related issues.
For example, the accountant can refer to the definitions of assets and liabilities and consider whether
the transaction gives rise to new assets or new liabilities.
In this situation, the Conceptual Framework serves as a useful basis for accountants to refer to when
dealing with transactions not covered by an accounting standard. As the same recognition principles
are included in accounting standards, the outcome should be a consistent method of accounting
regardless of the detail in standards.
 FINANCIAL ACCOUNTING AND REPORTING | 39

9 ACCOUNTING POLICIES

Section overview
 Accounting policies are the specific principles, bases, conventions, rules and practices

MODULE 1
adopted by an entity in preparing and presenting financial statements.
 An entity should select accounting policies that provide users of the financial statements
with information that is relevant and reliable in order to ensure that the financial statements
are prepared in accordance with GAAP.

Accounting policies are defined in IAS 8 Accounting Policies, Changes in Accounting Estimates and
Errors.

Definition

Accounting policies are the specific principles, bases, conventions, rules and practices adopted by an
entity in preparing and presenting financial statements.

You will see from this definition that companies have some choice in the matter of accounting policies.
How to apply a particular accounting standard, where a choice exists, is a matter of accounting policy.
How items are presented in the financial statements (including the notes), where alternative
presentations are allowed, is a matter of accounting policy. Policies should be chosen to comply with
IFRS, but with the overriding need for fair presentation.
The first note to a company's financial statements is the disclosure of accounting policies. This may
include the depreciation policy and other issues, such as valuation of inventory or revaluation of non-
current assets.
Another term used is estimation techniques, sometimes called accounting estimates. These involve
the use of judgment when applying accounting policies. For instance, the accounting policy may state
that non-current assets are depreciated over their expected useful life. The decision regarding the
length of useful life is a matter of estimation. The decision regarding method of depreciation is also a
matter of estimation, rather than accounting policy.
There is the further matter of measurement bases. Is the value of the asset, upon which its
depreciation is based, stated at original cost or revalued amount or current replacement cost? This is
the measurement basis and will be stated in the accounting policy. The company must disclose in the
notes to the accounts any change of accounting policy. Any change in measurement basis is
regarded as a change of accounting policy and must be disclosed. Any change in estimation
technique is not a change of accounting policy; however the effects of such a change on the current
and future periods should be disclosed.

9.1 OBJECTIVES IN SELECTING ACCOUNTING POLICIES

In selecting accounting policies, businesses should seek to satisfy two primary criteria: relevance and
reliability. These criteria are characteristics of useful financial information.
The IASB's Conceptual Framework uses the terms relevance and faithful representation. We will look
at the characteristics of useful financial information in more detail in the next module.

9.1.1 RELEVANCE
Appropriate accounting policies will result in the presentation of relevant financial information.
Financial information is relevant if it is:
 capable of influencing the economic decisions of users; and
 provided in time to influence those decisions.
Relevant information possesses either predictive or confirmatory value or both.
 40 | THE FINANCIAL REPORTING ENVIRONMENT

9.1.2 FAITHFUL REPRESENTATION

Financial information meets the faithful representation criterion if:
 it reflects the substance of transactions that is, represents faithfully what has taken place;
 it is free from bias, or is neutral;
 it is free from material error;
 it is complete; and
 prudence (caution) has been applied where there is any uncertainty.

Question 7: Accounting policy

Decide whether or not these represent a change of accounting policy:

(a) The company has previously included certain overheads within cost of sales. It now proposes to
show those overheads within administrative expenses.
(b) A company has previously depreciated vehicles using the reducing balance method at 40 per cent
per year. It now proposes to depreciate vehicles using the straight-line method over five years.
(c) A company has previously measured inventory at weighted average cost. It now proposes to
measure it on a First In, First Out (FIFO) basis.
(The answer is at the end of the module.)

10 IAS 8 ACCOUNTING POLICIES, CHANGES IN

ACCOUNTING ESTIMATES AND ERRORS

Section overview
 IAS 8 deals with the treatment of changes in accounting estimates, changes in accounting
policies and errors.

10.1 DEFINITIONS
The following definitions are given in IAS 8:

Definitions

Accounting policies. The specific principles, bases, conventions, rules and practices adopted by an
entity in preparing and presenting financial statements.
A change in accounting estimate. An adjustment of the carrying amount of an asset or a liability or
the amount of the periodic consumption of an asset, that results from the assessment of the present
status of, and expected future benefits and obligations associated with, assets and liabilities. Changes
in accounting estimates result from new information or new developments and, accordingly, are not
corrections of errors.
Material. Omissions or misstatements of items are material if they could, individually or collectively,
influence the economic decisions that users make on the basis of the financial statements. (This is very
similar to the definition in the Conceptual Framework.)
Prior period errors. Are omissions from, and misstatements in, the entity's financial statements for
one or more prior periods arising from a failure to use, or misuse of, reliable information that:
 was available when financial statements for those periods were authorised for issue; and
 could reasonably be expected to have been obtained and taken into account in the preparation
and presentation of those financial statements.
Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies,
oversights or misinterpretations of facts, and fraud.
 FINANCIAL ACCOUNTING AND REPORTING | 41

Retrospective application. Is applying a new accounting policy to transactions, other events and
conditions as if that policy had always been applied.
Retrospective restatement. Is correcting the recognition, measurement and disclosure of amounts of
elements of financial statements as if a prior period error had never occurred.
Prospective application. Of a change in accounting policy and of recognising the effect of a change
in an accounting estimate, respectively, are:

MODULE 1
 applying the new accounting policy to transactions, other events and conditions occurring after the
date as at which the policy is changed; and
 recognising the effect of the change in the accounting estimate in the current and future periods
affected by the change.
Impracticable. Applying a requirement is impracticable when the entity cannot apply it after making
every reasonable effort to do so. It is impracticable to apply a change in an accounting policy
retrospectively or to make a retrospective restatement to correct an error if one of the following apply:
 The effects of the retrospective application or retrospective restatement cannot be determined.
 The retrospective application or retrospective restatement requires assumptions about what
management's intent would have been in that period.
 The retrospective application or retrospective restatement requires significant estimates of
amounts and it is impossible to distinguish objectively information about those estimates that:
– provides evidence of circumstances that existed on the date(s) at which those amounts are to
be recognised, measured or disclosed; and
– would have been available when the financial statements for that prior period were authorised
for issue, from other information.
(IAS 8)

10.2 DETERMINING ACCOUNTING POLICIES

Accounting policies are determined by applying the relevant IFRS and considering any relevant
Implementation Guidance issued by the IASB for that IFRS.
Where there is no applicable IFRS management should use its judgment in developing and applying
an accounting policy that results in information that is relevant and reliable.
Management should refer to (in the following priority order):
1 The requirements of IFRS dealing with similar and related issues; and
2 The definitions, recognition criteria and measurement concepts for assets, liabilities and expenses
in the Conceptual Framework.
Management may also consider the most recent pronouncements of other standard-setting bodies
that use a similar conceptual framework to develop Standards, other accounting literature and
accepted industry practices if these do not conflict with the sources above.
An entity must select and apply its accounting policies for a period consistently for similar
transactions, other events and conditions, unless an IFRS specifically requires or permits categorisation
of items for which different policies may be appropriate. If an IFRS requires or permits categorisation
of items, an appropriate accounting policy must be selected and applied consistently to each
category.
 42 | THE FINANCIAL REPORTING ENVIRONMENT

10.3 CHANGES IN ACCOUNTING POLICIES

Changes in accounting policy are normally applied retrospectively.
The same accounting policies are usually adopted from period to period, to allow users to analyse
trends over time in profit, cash flows and financial position. Changes in accounting policy will
therefore be unusual and should be made only if:
 the change is required by an IFRS; and
 the change will result in a more relevant and reliable presentation of events or transactions in the
financial statements of the entity.

10.3.1 ADOPTION OF AN IFRS

Where a new IFRS is adopted, IAS 8 requires any transitional provisions in the new IFRS itself to be
followed. If none are given in the IFRS which is being adopted, then the general principles of IAS 8
should be followed.

10.3.2 OTHER CHANGES IN ACCOUNTING POLICY

IAS 8 requires retrospective application, unless it is impracticable to determine the cumulative amount
of change. Any resulting adjustment should be reported as an adjustment to the opening balance of
retained earnings. Comparative information should be restated unless it is impracticable to do so.
This means that all comparative information must be restated as if the new policy had always been
in force, with amounts relating to earlier periods reflected in an adjustment to opening reserves of the
earliest period presented.
There is one important exception. Where an entity revalues assets for the first time this is treated as
a revaluation under IAS 16 Property, Plant and Equipment, not as a change of accounting policy under
IAS 8. Therefore it is not applied retrospectively.
If, at the beginning of the current period, it is impracticable to determine the cumulative effect of
applying a new accounting policy to prior periods, the entity should adjust the comparative
information to apply the new accounting policy prospectively only.

10.3.3 DISCLOSURES
Certain disclosures are required when a change in accounting policy has a material effect on the current
period or any prior period presented, or when it may have a material effect in subsequent periods:
 reasons for the change
 amount of the adjustment for the current period and for each period presented
 amount of the adjustment relating to periods prior to those included in the comparative information
 the fact that comparative information has been restated or that it is impracticable to do so
An entity should also disclose information relevant to assessing the impact of new IFRS on the
financial statements where these have not yet come into force.

Question 8: Change in accounting policy

During the year ended 31 December 20X7 MM Manufacturing decided to change its accounting
policy for inventory valuation from FIFO to weighted average.
Extracts from the financial statements for 20X6 (final) and 20X7 (draft) prior to this change were as
follows:
20X7 (draft) 20X6
$'000 $'000
Sales 54 000 50 000
Cost of goods sold (26 000) (24 000)
Profit before taxes 28 000 26 000
Income taxes ( 30%) (8 400) (7 800)
Profit for the period 19 600 18 200
 FINANCIAL ACCOUNTING AND REPORTING | 43

The estimated values of MM's inventory under the FIFO and weighted average methods were as
follows:
31.12.X7 31.12.X6 31.12.X5
$'000 $'000 $'000
FIFO 2 950 2 900 2 800
Weighted average 2 870 2 750 2 700
Required

MODULE 1
Show the impact of this change of policy on the statement of profit or loss for 20X7, with the 20X6
comparative.
(The answer is at the end of the module.)

10.4 CHANGES IN ACCOUNTING ESTIMATES

Changes in accounting estimate are not applied retrospectively.
Estimates arise in relation to business activities because of the uncertainties inherent within them.
Judgments are made based on the most up to date information and the use of such estimates is a
necessary part of the preparation of financial statements. It does not undermine their reliability. Here
are some examples of accounting estimates:
 a necessary irrecoverable debt allowance
 useful lives of depreciable assets
 provision for obsolescence of inventory
The rule here is that the effect of a change in an accounting estimate should be accounted for
prospectively that is, it should be included in profit before tax or loss in either:
 the period of the change, if the change affects that period only; or
 the period of the change and future periods, if the change affects both.
An example of a change in accounting estimate which affects only the current period is the
irrecoverable debt estimate. However, a revision in the life over which an asset is depreciated would
affect both the current and future periods, in the amount of the depreciation expense.
The effect of a change in an accounting estimate should be included in the same expense
classification as was used previously for the estimate. This rule helps to ensure consistency between
the financial statements of different periods.
The materiality of the change is also relevant. The nature and amount of a change in an accounting
estimate that has a material effect in the current period (or which is expected to have a material effect
in subsequent periods) should be disclosed. If it is not possible to quantify the amount, this
impracticability should be disclosed.

Question 9: Change in accounting estimate

On 1 January 20X3, an asset was purchased by MM Manufacturing for $100 000. It had an estimated
useful economic life of 10 years, and was depreciated on the straight line basis. On 31 December 20X7
a review of non-current assets indicated that the asset would continue to be useable until
31 December 20X9.
Required
Explain the accounting treatment for this asset.
(The answer is at the end of the module.)
 44 | THE FINANCIAL REPORTING ENVIRONMENT

10.5 ERRORS
Material prior period errors must be corrected retrospectively.
Errors discovered during a current period which relate to a prior period may arise through:
 mathematical mistakes;
 mistakes in the application of accounting policies;
 misinterpretation of facts;
 oversights; and/or
 fraud.
Most of the time these errors can be corrected through profit before tax or loss for the current
period. Where they are material prior period errors, however, this is not appropriate.

10.5.1 ACCOUNTING TREATMENT

Material prior period errors must be corrected retrospectively.
This involves:
(a) either restating the comparative amounts for the prior period(s) in which the error occurred; or
(b) when the error occurred before the earliest prior period presented, restating the opening balances
of assets, liabilities and equity for that period
so that the financial statements are presented as if the error had never occurred.
Only where it is impracticable to determine the cumulative effect of an error on prior periods can an
entity correct an error prospectively only.
Various disclosures are required:
(a) the nature of the prior period error;
(b) for each prior period, to the extent practicable, the amount of the correction:
(i) for each financial statement line item affected.
(ii) for basic and diluted earnings per share (if disclosed);
(c) the amount of the correction at the beginning of the earliest prior period presented; and
(d) if retrospective restatement is impracticable for a particular prior period, the circumstances that
led to the existence of that condition and a description of how and from when the error has been
corrected. Subsequent periods need not repeat these disclosures.

Question 10: Error

During 20X7 Global discovered that certain items had been included in inventory at 31 December
20X6, valued at $4.2m, which had in fact been sold before the year end. The following figures for 20X6
(as reported) and 20X7 (draft) are available.
20X7 (draft) 20X6
$'000 $'000
Sales 67 200 47 400
Cost of goods sold (55 800) (34 570)
Profit before taxation 11 400 12 830
Income taxes (3 420) (3 849)
Profit for the period 7 980 8 981

Retained earnings at 1 January 20X6 were $13m. The cost of goods sold for 20X7 includes the $4.2m
error in opening inventory. The income tax rate was 30 per cent for 20X6 and 20X7. No dividends have
been declared or paid.
Required
Show the statement of profit or loss and other comprehensive income for 20X7, with the 20X6
comparative, and retained earnings.
(The answer is at the end of the module.)
 FINANCIAL ACCOUNTING AND REPORTING | 45

KEY MODULE POINTS 2

 A conceptual framework is a statement of generally accepted theoretical principles which form the
frame of reference for financial reporting.
 There are advantages and disadvantages to having a conceptual framework.

MODULE 1
 The IASBs Conceptual Framework for Financial Reporting (Conceptual Framework) provides the
theoretical framework for the development of IFRS.
 The Conceptual Framework states that:
'The 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.'
 The IASB published a new Conceptual Framework in March 2018.
 Accounting policies are the specific principles, bases, conventions, rules and practices adopted by
an entity in preparing and presenting financial statements.
 Accounting policies are determined by applying the relevant IFRS and considering any relevant
Implementation Guidance issued by the IASB for that IFRS.
 An entity should select accounting policies that provide users of the financial statements with
information that is relevant and reliable.
 IAS 8 deals with the treatment of changes in accounting estimates, changes in accounting policies
and errors.
 A change in accounting policy is only allowed where it is required by legislation, by a new
accounting standard or when it will result in more appropriate presentation.
 A change in accounting policy is applied retrospectively.
 A change in accounting estimate is applied prospectively.
 A prior period error is corrected retrospectively.
46 | THE FINANCIAL REPORTING ENVIRONMENT

QUICK REVISION QUESTIONS 2

1 A conceptual framework is:

A the proforma financial statements.
B a list of key terms used by the IASB.
C a theoretical expression of accounting standards.
D a statement of theoretical principles which form the frame of reference for financial reporting.

2 Which of the following is an advantage of a conceptual framework?

A A framework encourages standardised accounting practice.
B The framework does not simplify the preparation and implementation of standards.
C There are a variety of users, so not all will be satisfied with the content of the framework.
D There are a variety of accounting situations which mean flexibility in the accounting approach is
needed.

3 What is the name of the IASB's conceptual framework?

A Statement of Principles for Financial Reporting
B The Conceptual Framework for Financial Reporting
C The Conceptual Framework for the Disclosure of Financial Statements
D The Conceptual Framework for the Presentation of Financial Statements to Users

4 What is the fundamental reason that financial statements are produced, according to the IASB's
Conceptual Framework?
A To provide information to tax authorities
B To satisfy the requirements of external users
C To provide information for internal management
D To report on a company's performance to its national government

5 Which of the following is not a use of financial statements prepared by a company?

A Reliable method of valuing the entity
B Decisions to buy, hold or sell equity investments
C Assessment of the security of amounts lent to the entity
D Assessment of management stewardship and accountability

6 According to the Conceptual Framework, who are the most important users of general purpose
financial reports?
A Investors and lenders
B Investors and employees
C Lenders and management
D Investors and the government

7 If an accountant comes across a transaction that is not covered by a specific IFRS accounting
standard, where should they initially look for guidance on accounting for that item?
A Listing authority regulations
B The requirements of IFRSs dealing with similar and related issues
C Company law
D Conceptual Framework
 FINANCIAL ACCOUNTING AND REPORTING | 47

8 Which of the following constitute a change of accounting policy according to IAS 8 Accounting
Policies, Changes in Accounting Estimates and Errors?
A A change in depreciation method
B A change in the basis of valuing inventory
C Adopting an accounting policy for a new type of transaction not previously dealt with
D A revision to the carrying amount of a building carried at its revalued amount

MODULE 1
9 Which of the following items would not qualify for treatment as a change in accounting estimate,
according to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors?
A Provision for obsolescence of inventory
B Correction necessitated by a material error
C A change in the useful life of a non-current asset
D A change in a previous provision for tax

10 Applying the rules of IAS 8, which of the following would qualify as a change in accounting policy?
A Revising the depreciation method for a class of asset from straight line to reducing balance.
B Revising the valuation of inventory to first in first out from average cost.
C Amending the cut-off point for recognising an allowance for doubtful debts from receivables
greater than 90 days old to receivables greater than 100 days old.
D Amending the provision for warranties so it is calculated on 5 per cent of sales rather than 10
per cent of sales.
11 Under some circumstances, IAS 8 requires companies to adjust the financial statements of prior
periods and re-state the balance on opening equity.
Which of the following cases would such treatment be in accordance with IAS 8?
A A material decrease in the valuation of the opening inventory resulting from a change in
legislation affecting the saleability of the company's products. This legislation was retrospective
and was suddenly announced after the financial statements for the previous year had been
agreed.
B The discovery of a significant fraud carried out during the year in an overseas subsidiary
resulting in a write-down in the valuation of its assets at the period end.
C The company has material under-provision for corporation tax arising from the use of incorrect
data by the tax advisors acting for the company.
D A deterioration in sales performance has led to the directors restating their general
irrecoverable debt provision.
 48 | THE FINANCIAL REPORTING ENVIRONMENT

11 THE ROLE OF ACCOUNTING STANDARDS

LO
1.7 Section overview
 There are two different approaches to developing accounting standards: principles-based,
and rules based. Principles-based standards are developed according to a set of laid down
principles. Rules-based standards regulate for issues as they arise. Both these approaches
have advantages and disadvantages.
 Accounting standards are authoritative statements of how particular types of transactions
and other events should be reflected in the financial statements.

11.1 SUBJECT OUTLINE

The next few sections of this module will examine the purpose of accounting standards as the means
of setting out the accounting rules to be followed. First, we will discuss the two different methods of
setting accounting rules, the principles-based and rules-based approaches and then look at the role of
accounting standards in more detail.

11.2 PRINCIPLES-BASED VERSUS RULES-BASED SYSTEMS

A principles-based system works within a set of defined principles. A rules-based system regulates for
issues as they arise. Both of these have advantages and disadvantages.
The IASB's Conceptual Framework for Financial Reporting is intended to provide the underlying
principles within which standards can be developed. One of the main purposes of a conceptual
framework is to ensure that standards are not produced which are in conflict with each other. In
addition, any departure from a standard can be judged on the basis of whether or not it is in keeping
with the principles set out in the Conceptual Framework. A principles-based system of accounting is
a system which is based on a conceptual framework.
The opposite of a principles based system is a rules-based system, in which there are a number of
detailed regulations designed to cover every eventuality.
In practice, most standard setting bodies, including the IASB, have developed or adopted standards
that are a mixture of principles and rules. IFRSs are generally accepted as a principles based
approach, there is a conceptual framework and many standards are principles-based, however some
standards (mainly those influenced by US GAAP) are rules-based.

11.3 THE DIFFERENCES BETWEEN A PRINCIPLES-BASED SYSTEM AND A

RULES-BASED SYSTEM
A rules-based system requires preparers to understand and apply detailed rules to report specific
transactions.
A principles-based system requires preparers to use judgment in order to develop accounting
policies to report specific types of transactions and events.
Consider accounting for tangible non-current assets. An extreme rules-based approach would set out
precise requirements for each type of asset, for example:
'Plant and equipment should be depreciated on the straight line basis over a period not exceeding
four years.'
A principles-based approach would contain more general requirements, for example:
'The depreciable amount of an asset shall be allocated on a systematic basis over its useful
life … The depreciation method used shall reflect the pattern in which the asset's future economic
benefits are expected to be consumed by the entity.' (IAS 16 Property, Plant and Equipment)
 FINANCIAL ACCOUNTING AND REPORTING | 49

Rules-based accounting standards often need to contain complex definitions and scope exceptions.
For example, if plant and equipment must be depreciated over four years, while other classes of asset
are depreciable over a longer period, the standard must define what is meant by plant and
equipment. Standards often contain further material that explains and interprets the rules and this in
turn may be supplemented by guidance and regulations relating to particular industries or types of
transaction. As a result, accounting standards and guidance can be voluminous.

MODULE 1
A rules-based system has the following advantages:
 in theory, it results in financial statements being comparable between entities (or between entities
in the same industry);
 it may reduce the volume of explanation necessary in financial statements (as in theory there is
only one allowed accounting treatment for each type of transaction or event);
 it is suitable for large, complex economies (such as the US); and
 it provides the 'answers' in almost all situations; preparers do not have to make judgments and
risk the consequences (e.g. litigation or reputational damage if a user makes a wrong decision
based on information in the financial statements).
Principles-based accounting standards are likely to be less lengthy and complex than rules-based
standards, with fewer definitions and scope exceptions.
There may be an explicit requirement that the financial statements show a 'true and fair view' of the
entity's financial performance and financial position and that this requirement should override all
others. An entity may depart from a requirement if management is convinced that this is necessary
(normally in exceptional circumstances).
Standards normally require very full disclosure of information about the nature of transactions or
events and the accounting policies adopted. This is seen as necessary in order for users to understand
the information that is being presented in the financial statements and to make meaningful
comparisons between different entities.
In practice, principles based standards often need to be accompanied or supported by explanatory
material, illustrative examples, and interpretations. The IASB has a separate operating body that
issues interpretations of standards where interpretation difficulties arise, while the Australian
Accounting Standards Board appoints Interpretation Advisory Panels on an ad hoc basis.
A principles-based system has the following advantages:
 in theory, it is more likely than a rigid-rules based system to result in financial statements that show
a true and fair view/give a fair presentation;
 it encourages the use of professional judgment;
 it is less open to 'creative accounting' abuses as principles are harder to evade than rules; and
 arguably it is more flexible than a system of rules and can therefore cope better with a rapidly
changing business and economic environment.
See also the advantages of a conceptual framework we covered earlier in this module; many of these
also apply here.

Question 11: What type of standard?

Below are extracts from IAS 38 Intangible Assets:

Research is original and planned investigation undertaken with the prospect of gaining new scientific
or technical knowledge and understanding.
Development is 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.
No intangible asset arising from research shall be recognised. Expenditure on research shall be
recognised as an expense when it is incurred.
 50 | THE FINANCIAL REPORTING ENVIRONMENT

An intangible asset arising from development activities shall be recognised if and only if an entity can
demonstrate specific conditions.
Required
(a) What type of standard is this, rules-based or principles-based?
(b) Explain why the requirements above might reduce the usefulness of the information in the financial
statements.
(The answer is at the end of the module.)

11.4 THE PURPOSE OF ACCOUNTING STANDARDS

Definition

Accounting standards. Are authoritative statements of how particular types of transactions and other
events should be reflected in the financial statements.

Accounting standards form part of the Generally Accepted Accounting Principles (GAAP) that sets out
the accounting rules that companies must abide by. They are structured to provide detailed guidance
on accounting for a particular item. For example, there are a number of accounting standards that
deal with the accounting treatment of items recognised in the financial statements such as non-current
assets, provisions and liabilities.
Accounting standards are of key importance in the regulation process as they provide the detailed rules
on dealing with transactions and disclosures in the financial statements. Without this detailed guidance,
companies would be free to account for transactions as they wished, which would firstly reduce the
comparability of financial statements and secondly, could lead to misleading accounts if companies
report transactions in a more favourable light. Neither of these options would be beneficial to users of
the financial statements.
In many countries, including Australia, accounting standards have the force of law. Some or all limited
liability companies are required to comply with them in preparing financial statements. Listing
authorities also require compliance with standards as a condition of obtaining a stock exchange
listing. In some countries, including Australia and the UK, some not for profit entities and
governmental organisations may also be required to comply with accounting standards.
Even where compliance is not an actual legal requirement (for example, for a small or unincorporated
entity) the requirements of accounting standards are normally taken to represent 'best practice'.

11.4.1 ACCOUNTING STANDARDS AND THE CONCEPTUAL FRAMEWORK

We have already seen that a conceptual framework exists to provide a basis for the preparation of
financial statements. In theory, accounting standards should be consistent with the principles of the
conceptual framework. For example, any accounting standard dealing with the recognition of assets
should include the definition of an asset from the conceptual framework as well as the relevant
recognition criteria.
One of the stated purposes of the IASB's Conceptual Framework is to assist in applying IFRS. Where
there is no accounting standard covering a particular transaction, the Conceptual Framework can be
used to assist in developing an appropriate accounting treatment.

11.4.2 ACCOUNTING STANDARDS AND A FAIR PRESENTATION

The objective of financial statements is to provide information about the financial position and
performance of an entity. Financial information should show a fair presentation or true and fair view
of the activities of an entity.
 FINANCIAL ACCOUNTING AND REPORTING | 51

Like 'true and fair view', 'present fairly' is not defined in the Conceptual Framework or in any IFRS.
However, IAS 1 Presentation of Financial Statements explains that:
 Fair presentation requires the faithful representation of the effects of transactions, other events
and conditions in accordance with the definitions and recognition criteria for assets, liabilities,
income and expenses set out in the Conceptual Framework.
 Compliance with IFRS, with additional disclosure where necessary, is presumed to result in

MODULE 1
financial statements that achieve a fair presentation.
We will examine the meaning of faithful representation later in this module.
The following points made by IAS 1 expand on this principle:
 If an entity has complied with IFRS, it should disclose that fact in its financial statements.
 All relevant IFRS must be followed if compliance with IFRS is disclosed.
 Use of an inappropriate accounting treatment cannot be rectified either by disclosure of
accounting policies or notes/explanatory material.
Fair presentation involves more than mere compliance. Preparers should apply the 'spirit' (or general
intention) behind an accounting standard as well as the strict 'letter'. The requirement to 'present
fairly' also applies to transactions which are not covered by any specific accounting standard.
Fair presentation requires an entity to:
 select and apply appropriate accounting policies;
 present information in a manner that results in relevant, reliable, comparable and understandable
information; and
 provide additional disclosures where these are necessary to enable users to understand the
impact of particular transactions, other events and conditions on an entity's financial performance
and position.
IAS 1 states that disclosure (explanatory material or notes) does not rectify inappropriate
accounting policies.

12 ACCOUNTING STANDARDS AND CHOICE

Section overview
 There are arguments for and against having accounting standards.

It is sometimes argued that having accounting standards actually reduces the quality of financial
reporting, and that individual companies should be given more choice over how they report
transactions. There are arguments on both sides.
Many of the advantages and disadvantages of accounting standards are similar to the advantages and
disadvantages of accounting regulation in general which we covered earlier in this module.

12.1 ADVANTAGES OF ACCOUNTING STANDARDS

Standards have the following advantages:
 They reduce or eliminate confusing variations in the methods used to prepare accounts and so
increase the usefulness of financial information. Users of financial statements need to be able to
compare an entity's financial performance and position with those of other, similar entities. They
also need to be able to compare the performance and position of an entity over time, in order to
evaluate trends. (For example, have sales increased or decreased compared with those of the
previous period?)
 They make it more difficult for preparers to adopt accounting treatments that deliberately
mislead users. Without accounting standards management could adopt the accounting
treatments that produced the highest reported profit and the strongest financial position possible,
even if these did not give a fair presentation.
 52 | THE FINANCIAL REPORTING ENVIRONMENT

 They provide guidance to preparers of financial statements. The business environment is

becoming increasingly complex and some preparers may find it difficult to determine the
appropriate accounting treatment for many types of transaction or event (for example, those
involving derivative financial instruments or arrangements whose economic substance is not the
same as their legal form).
 Financial statements prepared in accordance with accounting standards are based on generally
accepted accounting practice and arguably this makes them more understandable than they
would otherwise be.
 They generally improve the quality of general purpose financial reporting. Standards require
entities to disclose more accounting information than they would otherwise have done if
standards did not exist. This information includes the accounting policies used in the preparation
of the financial statements. As well as increasing the amount of information that is available, in
theory, standards help to ensure that the financial statements actually do provide relevant
information that users need.
 They provide a focal point for debate and discussions about accounting practice and in that way
contribute to the development of best practice.
 They are a means of reaching a consensus about the way in which particular items should be
treated. The development of IFRS involves a full consultative process in which users and preparers
are able to be directly involved.
 They are a less rigid alternative to enforcing conformity by means of legislation.
 They improve the credibility of financial reporting generally. Users are more likely to trust financial
information if it has been prepared in accordance with accounting standards and other regulation
than if they would be if standards did not exist.

12.2 DISADVANTAGES OF ACCOUNTING STANDARDS

The disadvantages of accounting standards are as follows:
 Not all entities are the same size or operate in the same industry. An accounting treatment that is
appropriate for some entities may not be appropriate for others. The use of an inappropriate
accounting treatment may actually reduce the quality of the information provided.
 The development of accounting standards and other regulation is a political process and may be
affected by lobbying or government pressure. Although anyone can comment on a proposed
standard, most commentators tend to be large listed companies or large professional firms:
organisations with considerable power to influence standard setters in their own interests.
 Most recent standards have been developed to meet the needs of providers of capital to large
public companies. For many smaller entities, the cost of complying (both in time and money)
outweigh the benefits to users.
 Accounting standards do not always prevent preparers from manipulating the figures. Some
preparers view them as a set of rules that they can evade through 'creative accounting'. (This is
less likely if standards are based on principles and concepts rather than detailed rules.)
 Earlier standards were not based on a conceptual framework of accounting. This means that they
may be inconsistent with one another. The IASB is committed to rectifying this.
 There may be a trend towards rigidity, and away from flexibility in applying the rules. Some
commentators believe that preparers should be free to use their professional judgment on
technical matters.
 Accounting standards often require extensive disclosure. It can be argued that this makes
financial statements harder to understand and less useful.
 Accounting standards may have unforeseen economic consequences for the entities who have to
apply them and for others and may affect the commercial decisions taken by management. For
example, a company might avoid particular actions (such as investment in certain types of asset)
that might benefit it in the long term, if they were required to treat the transactions in a way that
dramatically reduced reported profit.
 FINANCIAL ACCOUNTING AND REPORTING | 53

Case study: Economic consequences

The UK standard FRS 17 Accounting for Retirement Benefits changed the financial reporting treatment
of some types of pension scheme (defined benefit schemes). This had the effect of significantly
increasing the non-current liabilities of the companies that operated those schemes. As a result, most
companies which operated defined benefit schemes closed them to new entrants and replaced them
with pension arrangements that were much less advantageous to their employees.

MODULE 1
It has been argued that accounting standards should reflect economic reality (e.g. companies that
operate defined benefit schemes have a liability for the cost of providing pensions in future periods)
and standard setters should not concern themselves with the possible consequences of requiring a
particular accounting treatment. Recently, however, following the global economic crisis, a few
commentators and politicians have begun to question this.

13 ACCOUNTING CONCEPTS

Section overview
 Going concern is an underlying assumption in preparing financial statements. It is the main
underlying assumption stated in the Conceptual Framework.
 Financial information (other than information about cash flows) should be prepared on an
accruals basis.

13.1 GOING CONCERN

Definition

Going concern. The entity is normally viewed as a going concern, that is, as continuing in operation
for the foreseeable future. It is assumed that the entity has neither the intention nor the need to
liquidate or curtail materially the scale of its operations.

This concept assumes that, when preparing a normal set of accounts, the business will continue to
operate in approximately the same manner for the foreseeable future (at least the next 12 months).
In particular, the entity will not go into liquidation or scale down its operations in a material way.
The main significance of a business being a going concern is that:
1. Assets should not be measured at their 'break-up' value that is the amount they would sell for if
they were sold off piecemeal and the business was broken up (unless the assets satisfy the
requirements of IFRS 5 Non-current Assets Held for Sale and Discontinued Operations). If assets
are classified as held for sale in accordance with IFRS 5, they should be measured at the lower of
carrying amount and fair value less costs to sell.
2. Liabilities are classified as current or non-current depending on when they are due to be settled.

13.1.1 EXAMPLE: GOING CONCERN

Emma acquires a T-shirt printing machine at a cost of $60 000. The asset has an estimated life of six
years with a scrap value of nil at the end of six years, and it is normal to write off the cost of the asset
to the statement of profit or loss over this time. In this case a depreciation cost of $10 000 per year is
charged.
Using the going concern assumption, it is presumed that the business will continue its operations and
so the asset will produce economic benefits throughout its full six years in use. A depreciation charge
of $10 000 is made each year, and the value of the asset in the statement of financial position is its cost
less the accumulated depreciation charged to date. After one year, the carrying amount of the asset
is $(60 000 – 10 000) = $50 000, after 2 years it is $40 000, after 3 years $30 000 and so on, until it is
written down to a value of 0 after 6 years.
 54 | THE FINANCIAL REPORTING ENVIRONMENT

This asset has no other operational use outside the business and, in a forced sale, it would only sell for
scrap. After one year of operation, its scrap value is $8000.
The carrying amount of the asset, applying the going concern assumption, is $50 000 after 1 year, but
its immediate sell-off value only $8000. It can be argued that the asset is over-valued at $50 000, that it
should be written down to its break-up value ($8000) and the balance of its cost should be treated as
an expense. However, provided that the going concern assumption is valid, it is appropriate
accounting practice to value the asset at its carrying amount.

Question 12: Going concern

A retailer commences business on 1 January and buys inventory of 20 washing machines, each costing
$100. During the year they sell 17 machines at $150 each. How should the remaining machines be
valued at 31 December in the following circumstances?
(a) They are forced to close down the business at the end of the year and the remaining machines will
realise only $60 each in a forced sale.
(b) They intend to continue the business into the next year.
(The answer is at the end of the module.)

If the going concern assumption is not followed, that fact must be disclosed, together with:
 the basis on which the financial statements have been prepared; and
 the reasons why the entity is not considered to be a going concern.

13.2 ACCRUALS BASIS OF ACCOUNTING

Definition
In the accruals basis of accounting, items are recognised as assets, liabilities, equity, income and
expenses (the elements of financial statements) when they satisfy the definitions and recognition
criteria for those elements in the Conceptual Framework. (IAS 1)

Entities should prepare their financial statements on the basis that transactions are recorded in them,
not as the cash is paid or received, but as the revenues or expenses are earned or incurred in the
accounting period to which they relate.
According to the accruals assumption, profit is computed as the surplus/(deficit) of revenue and
expenses. In computing profit, revenue earned must be matched against the expenditure incurred in
earning it. This is also known as the matching convention.

13.2.1 EXAMPLE: ACCRUALS

Emma prints 20 T-shirts in her first month of trading (May) at a cost of $5 each (purchased on credit
terms). She then sells all of them for $10 each. Emma has therefore made a profit of $100, the surplus
of revenue ($200) earned over the cost ($100) of acquiring them.
If, however, Emma only sells 18 T-shirts, it is incorrect to charge her statement of profit or loss (income
statement) with the cost of 20 T-shirts, as she still has 2 T-shirts in inventory. If she sells them in June,
she is likely to make a profit on the sale. Therefore, the profit is $90, the surplus of sales revenue ($180)
over the purchase cost of 18 T-shirts ($90).
 FINANCIAL ACCOUNTING AND REPORTING | 55

Her statement of financial position will look like this.

$
Assets
Inventory (at cost, i.e. 2 × $5) 10
Accounts receivable (18 × $10) 180
190
Capital and liabilities

MODULE 1
Proprietor's capital (profit for the period: 18 × $5) 90
Accounts payable (20 × $5) 100
190

However, if Emma had decided to give up selling T-shirts, then the going concern assumption no
longer applies and the value of the 2 T-shirts in the statement of financial position is break-up
valuation, not cost. Similarly, if the 2 unsold T-shirts are unlikely to be sold at more than their cost of
$5 each (say, because of damage or a fall in demand) then they should be recorded on the statement
of financial position at their net realisable value (i.e. the likely eventual sales price less any expenses
incurred to make them saleable, i.e. say, $4 each) rather than cost. This shows the application of the
prudence concept, which we will discuss shortly.
In this example, the concepts of going concern and accruals are linked. Since the business is assumed
to be a going concern, it is possible to carry forward the cost of the unsold T-shirts as a charge against
profits of the next period.

13.3 SUBSTANCE OVER FORM

Faithful representation of a transaction is only possible if it is accounted for according to its substance
and economic reality, not solely based on its legal form.

Definition

Substance over form. The principle that transactions and other events are accounted for and
presented in accordance with their substance and economic reality and not merely their legal form.

For instance, one party may sell an asset to another party and the sales documentation may record
that legal ownership has been transferred. However, if agreements exist whereby the party selling the
asset continues to enjoy the future economic benefits arising from the asset, then in substance no sale
has taken place.
An example of substance over form is found in accounting for leases. A lease is a contract that
conveys the right to use an asset for a period of time. In a lease the lessee never obtains legal title to
the asset so does not own that asset. However, they have all the risks and rewards of ownership, such
as the right to use the asset for most, if not all, of its useful life and they must bear the costs of
ownership such as insurance and maintenance. For this reason, the asset is capitalised in the lessee's
accounts and treated as an owned asset, following the substance of the transaction. This accounting
treatment will ensure that the financial statements show the true financial position of the entity, and
does not hide assets and liabilities from the statement of financial position.
In accounting for the lease above, if the legal form was followed, the asset and the lease liability would
not be recognised which would make the financial statements look better than they actually are. This
has the effect of improving the gearing ratio, as the liability is not recorded, it also improves the return
on capital employed, as the asset base is lower. Hence following substance over form is key in
showing a fair presentation of the financial statements of an entity.
 56 | THE FINANCIAL REPORTING ENVIRONMENT

Case study: Repo 105

After the investment bank, Lehman Brothers, collapsed in 2008 it was discovered that the bank had
used a transaction known as 'Repo 105' to raise short-term finance. Financial assets were swapped for
cash but with an agreement to buy them back at a future date. The substance of this transaction is that
the 'seller' continues to control the asset, so it remains in the statement of financial position. The
obligation to redeem for cash is recorded as a liability.
However, Lehman Brothers transferred assets worth 105 per cent of the cash it received in return.
Because of this, under the rules in US GAAP it was able to record the transaction as a sale on the
grounds that technically it had lost control of the assets and no longer owned them. Therefore the
cash received was recorded as an asset rather than a liability. The bank's liabilities were significantly
understated and it was able to mislead investors and lenders about its true financial position.

14 QUALITATIVE CHARACTERISTICS OF FINANCIAL

INFORMATION

LO
1.6 Section overview
 Qualitative characteristics are the attributes that make the information provided in financial
statements useful to users.
 The two fundamental qualitative characteristics are: relevance and faithful representation.
 The four enhancing qualitative characteristics are: comparability, verifiability, timeliness and
understandability.

The IASB's Conceptual Framework for Financial Reporting sets out and explains the qualitative
characteristics of useful financial information.
There are two fundamental qualitative characteristics: relevance and faithful representation.
Information must be possess these characteristics in order to be useful.
There are four enhancing qualitative characteristics: comparability, verifiability, timeliness and
understandability. These qualities enhance the usefulness of financial information.

14.1 RELEVANCE
Relevant financial information has predictive value, confirmatory value, or both.

Definition

Relevance. Relevant financial information is capable of making a difference in the decisions made by
users. (Conceptual Framework)

Information on financial position and performance is often used to predict future position and
performance and other things of interest to the user, for example, likely dividend, wage rises. Financial
information is also used to confirm (or change) users' past conclusions about an entity's financial
performance or financial position.
Information can have both predictive value and confirmatory value. For example, revenue for the
current year can be used to predict revenue for next year. Actual revenue for the current year can also
be compared with expected revenue that was predicted using last year's financial statements.
 FINANCIAL ACCOUNTING AND REPORTING | 57

14.1.1 MATERIALITY
The relevance of information is affected by its materiality.

Definition

Materiality. Information is material if omitting it or misstating it could influence decisions that users
make on the basis of financial information about a specific reporting entity. (Conceptual Framework)

MODULE 1
The Conceptual Framework explains that materiality is entity-specific. It depends on the nature or size
(or both) of items taken in the context of an individual entity's financial report.
Information may be judged relevant simply because of its nature, even though the amounts involved may
be small in relation to the financial statements as a whole (for example, remuneration of management). In
other cases, both the nature and materiality of the information are important. Materiality is not a primary
qualitative characteristic itself because it is merely a threshold or cut-off point.
The IASB issued IFRS Practice Statement 2 Making Materiality Judgements in September 2017, this is
discussed further below.

14.2 FAITHFUL REPRESENTATION

To be useful, financial information must faithfully represent the economic events that it purports to
represent. The user must be able to depend on it being a faithful representation.

Definition

Faithful representation. A faithful representation is complete, neutral and free from error.
A complete depiction includes all the information necessary for a user to understand the
phenomenon being depicted, including all necessary descriptions and explanations.
A neutral depiction is without bias in the selection or presentation of financial information. This means
that information must not be manipulated in any way in order to influence the decisions of users.
Free from error means there are no errors or omissions in the description of the phenomenon and no
errors made in the process by which the financial information was produced. It does not mean that no
inaccuracies can arise, particularly where estimates have to be made. (Conceptual Framework)

Neutrality is supported by the concept of prudence. Prudence is the exercise of caution particularly
when estimates and judgements are required.

14.3 COMPARABILITY
Comparability is the qualitative characteristic that enables users to identify and understand similarities
in, and differences among, items. Information about a reporting entity is more useful if it can be
compared with similar information about other entities and with similar information about the same
entity for another period or another date.
The consistency of treatment is therefore important across like items over time, within the entity and
across all entities.
The disclosure of accounting policies is particularly important here. Users must be able to
distinguish between different accounting policies in order to be able to make a valid comparison of
similar items in the accounts of different entities.
Comparability is not the same as uniformity that is, items need not be identical in order to be
comparable. For information to be comparable, like things must look alike and different things must
look different, Comparability is not enhanced by making unlike items look alike. Therefore entities
should change accounting policies if they become inappropriate.
Corresponding information for preceding periods should be shown to enable comparison over time.
 58 | THE FINANCIAL REPORTING ENVIRONMENT

14.4 VERIFIABILITY
Verifiability helps assure users that information faithfully represents the economic events it purports to
represent.
Verifiability means that different knowledgeable and independent observers could reach consensus
(not necessarily complete agreement) that a particular depiction is a faithful representation.

14.5 TIMELINESS
Timeliness means having information available to users in time to be capable of influencing their
decisions.
Generally, the older the information is, the less useful it is. However, older financial information may
still be useful for identifying and assessing trends (for example, growth in profits over a number of
years).

14.6 UNDERSTANDABILITY
Classifying, characterising and presenting information clearly and concisely makes it understandable.
Some information is inherently complex and difficult to understand. Excluding this information from
the financial statements would make them more understandable, but they would also be incomplete
and potentially misleading.
Financial reports are prepared for users who have a reasonable knowledge of business and economic
activities and who review and analyse the information diligently. Users may sometimes need to seek
help from an adviser in order to understand information about complex economic events.

14.7 APPLYING THE QUALITATIVE CHARACTERISTICS

Information must be both relevant and faithfully represented if it is to be useful. In practice, an entity
must often find a balance between the two, with the aim of presenting the most relevant information
that can be faithfully represented.
A faithful representation, by itself, does not necessarily result in useful information. Suppose that an
entity receives a government grant to purchase an asset. The asset has no cost to the entity and
therefore is not recognised in the statement of financial position. This is a faithful representation of the
transaction, but users of the financial statements are not aware that the entity has the asset. They have
been deprived of useful and relevant information.
The same principle applies to the enhancing qualitative characteristics. Sometimes, one characteristic
may have to be diminished in order to maximise another. For example, applying a new standard may
reduce comparability in the short term, but may improve relevance or faithful representation in the
longer term.

14.8 THE COST CONSTRAINT ON USEFUL FINANCIAL REPORTING

Cost is a pervasive constraint on the information that can be provided by financial reporting. The
Conceptual Framework explains that it is important that the costs of reporting financial information
are justified by the benefits.
The IASB takes this into account when developing standards. It considers costs and benefits in relation
to financial reporting generally, not just in relation to individual entities. Different reporting
requirements for different reporting entities may be appropriate in some circumstances. For example,
the IASB has recently developed a special standard for small and medium sized entities.
 FINANCIAL ACCOUNTING AND REPORTING | 59

15 MATERIALITY IN THE CONTEXT OF FINANCIAL

REPORTING
Section overview

MODULE 1
 IFRS Practice Statement 2 Making Materiality Judgements was issued in September 2017.
• The aim of the IASB in issuing Practice Statement 2 is to encourage greater application of
judgment in the preparation of financial statements. The guidance is not mandatory.

Practice Statement 2 was developed in response to concerns that some companies were unsure how
to make materiality judgements. This can result in excessive disclosure of immaterial information
while important information can be obscured or even missed out of the financial statements. This is
particularly true for information disclosed in the notes where it appears that some companies use IFRS
disclosure requirements as a 'checklist' and therefore provide all disclosures, whether material or not.
The key points of the guidance are summarised below.

15.1 General characteristics of materiality

The Conceptual Framework defines what is meant by 'material'.

Definition

Material. Information is material if omitting it or misstating it could influence decisions that the
primary users of general purpose financial reports make on the basis of those reports, which provide
financial information about a specific reporting entity. In other words, materiality is an entity-specific
aspect of relevance based on the nature or magnitude, or both, of the items to which the information
relates in the context of an individual entity’s financial report. (Conceptual Framework: para. 2.11)

(a) Preparers of financial statements make materiality judgements when applying IFRSs
Recognition and measurement:
 Recognition and measurement criteria: only need to be applied when the effect of applying
them is material.
 For example, an entity may choose to capitalise items of property, plant and equipment only
when the cost of an individual item exceeds, say $2,000, on the basis that capitalising items
below this amount will not have a material effect on the financial statements. The
Presentation and disclosure:
 Disclosure criteria: if the information provided by a certain disclosure requirement is not
material, the entity does not need to make that disclosure, even if that disclosure is part of a
list of minimum required disclosures in an IFRS Standard.
 However, the entity should consider whether it also needs to disclose information not
specifically required by an IFRS Standard if that information is needed to understand the
financial statements.
(b) Financial statements provide financial information to primary users that is useful to them when
making decisions about providing resources to the entity.
 Primary users are investors, lenders and other creditors, both existing and potential.
 General purpose financial statements cannot meet all of the information needs of primary users.
Instead the entity should aim to meet the information needs common to all investors, all lenders
and all other creditors.
 The entity is not required to meet the information needs of other stakeholders, or the individual
requirements of particular primary users.
 60 | THE FINANCIAL REPORTING ENVIRONMENT

15.2 Effect of local laws and regulations

In order to state compliance with IFRS Standards, the entity must provide all information required by
IFRS Standards, even if local laws and regulations permit otherwise.
Additionally, local laws and regulations sometimes require disclosure of information that is not
material. IFRS Standards permit this disclosure, but it should not obscure information that is material.

15.3 Making materiality judgments: a four-step process

One way of making materiality judgements when preparing the financial statements is to apply a
four-step process:
Step 1 Identify potentially material information
An entity should consider the International Financial reporting standard requirements
applicable to its transactions its primary users’ information needs to identify information
that has the potential to be material.
Step 2 Assess materiality of information
Consider quantitative and qualitative factors to assess whether an item of information
could reasonably be expected to influence primary users decisions
Step 3 Organise clearly and concisely in draft financial statements
This could include emphasising material matters, highlighting relationships between
different pieces of information, ensuring material information is not obscured by
immaterial information and tailoring information to the entity’s own circumstances.
Step 4 Review complete set of draft financial statements
Assess the information provided in the draft financial statements as a whole. Consider
whether the information is material both individually and in combination with other
information. This may lead to information being added, removed or reorganised.

15.4 Assessing materiality of information

There are common 'materiality factors' which can be used to help assess whether information is material.
These are:
(a) Quantitative factors
Consider the size of the effect of the transaction/event recognised in the financial statements
against measures of the entity's financial position, performance and cash flows to assess whether
the effect is of such a size that it could reasonably be expected to influence its primary users’
decisions about providing resources to the entity. Consider any unrecognised items (for example
contingent liabilities) that could affect primary users' perception.
(b) Qualitative factors
 these are characteristics that make information more likely to influence the decisions of primary
users (regardless of the size of the transaction/event), they can be internal or external
– internal include: involvement of related parties, uncommon features, unexpected changes in
trends
– external include: geographic location, industry section, state of the economy
Both quantitative factors and qualitative factors should be considered.
Quantitative factors can be assessed with the help of a threshold – such as 5% of profit.
It is usually more efficient to assess items from a quantitative perspective first: if an item exceeds
the quantitative threshold, it is material and no further assessment is required.
If an item is considered immaterial on the basis of the quantitative threshold, qualitative factors should
then be considered. The presence of a qualitative factor in a transaction/event, such as the
involvement of a related party, lowers the quantitative threshold.
 FINANCIAL ACCOUNTING AND REPORTING | 61

The presence of qualitative factors does not mean that information is always material. An entity may
decide that, despite the presence of qualitative factors, information is not material because its effect
on the financial statements is so small that it could not reasonably be expected to influence
primary users’ decisions.

Worked Example:

Runner Co. has set a quantitative materiality threshold of $15,000 based on 5% of profit. During the

MODULE 1
year a motor vehicle with a carrying amount of $12,000 was considered surplus to requirements and
sold to a director of Runner Co. for $2,000. The market value of the vehicle was considered to be the
same as its carrying amount.
Discuss whether the disposal of the vehicle should be considered a material transaction.

Solution

The vehicle has been disposed of for a loss of $10,000 ($12,000 – $2000). The loss is below the
quantitative materiality threshold, however the sale was to a director of the company and also at a
price that was considerably below market value. The presence of these qualitative factors lowers the
threshold for the quantitative assessment and it may well now be considered a material transaction.

16 INTERNATIONAL FINANCIAL REPORTING

STANDARDS

Section overview
 There are currently 17 IFRS in issue, as well as several International Accounting Standards
(IAS).
 IFRS are having a growing influence on national accounting requirements and practices.
 Where a company has to change from a national GAAP to IFRS, it has to deal with a
number of practical issues.

16.1 STANDARDS CURRENTLY IN ISSUE

The current list of International Accounting Standards and International Financial Reporting Standards
is as follows:
DATE OF
INTERNATIONAL ACCOUNTING STANDARDS
ISSUE
IAS 1 (revised) Presentation of Financial Statements Jun 2011
IAS 2 Inventories Dec 2003
IAS 7 Statement of Cash Flows Dec 1992
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors Dec 2003
IAS 10 Events after the Reporting Period Dec 2003
IAS 12 Income Taxes Nov 2000
IAS 16 Property, Plant and Equipment Dec 2003
IAS 17 Leases Dec 2003
IAS 19 Employee Benefits
(revised) Jun 2011
IAS 20 Accounting for Government Grants and Disclosure of Government Assistance Jan 1995
IAS 21 The Effects of Changes in Foreign Exchange Rates Dec 2003
 62 | THE FINANCIAL REPORTING ENVIRONMENT

DATE OF
INTERNATIONAL ACCOUNTING STANDARDS
ISSUE
IAS 23 Borrowing Costs
(revised) Jan 2008
IAS 24 Related Party Disclosures
(revised) Nov 2009
IAS 26 Accounting and Reporting by Retirement Benefit Plans Jan 1995
IAS 27 Consolidated and Separate Financial Statements
(revised) May 2011
IAS 28 Investments in Associates and Joint Ventures
(revised) May 2011
IAS 29 Financial Reporting in Hyperinflationary Economies Jan 1995
IAS 32 Financial Instruments: Presentation Dec 2003
IAS 33 Earnings per Share Dec 2003
IAS 34 Interim Financial Reporting Feb 1998
IAS 36 Impairment of Assets Mar 2004
IAS 37 Provisions, Contingent Liabilities and Contingent Assets Sep 1998
IAS 38 Intangible Assets Mar 2004
IAS 40 Investment Property Dec 2003
IAS 41 Agriculture Feb 2001

DATE OF EFFECTIVE
INTERNATIONAL FINANCIAL REPORTING STANDARDS
ISSUE DATE
IFRS 1 (revised) First time Adoption of International Financial Reporting Nov 2008 1 Jul 2009
Standards
IFRS 2 Share-based Payment Feb 2004 1 Jan 2005
IFRS 3 (revised) Business Combinations Jan 2008 1 Jul 2009
IFRS 4 Insurance Contracts Mar 2004 1 Jan 2005
IFRS 5 Non-current Assets Held for Sale and Discontinued Operations Mar 2004 1 Jan 2005
IFRS 6 Exploration for and Evaluation of Mineral Resources Dec 2004 1 Jan 2006
IFRS 7 Financial Instruments: Disclosures Aug 2005 1 Jan 2007
IFRS 8 Operating Segments Nov 2006 1 Jan 2009
IFRS 9 Financial Instruments Nov 2013 1 Jan 2018
IFRS 10 Consolidated Financial Statements May 2011 1 Jan 2013
IFRS 11 Joint Arrangements May 2011 1 Jan 2013
IFRS 12 Disclosure of Interests in Other Entities May 2011 1 Jan 2013
IFRS 13 Fair Value Measurement May 2011 1 Jan 2013
IFRS 14 Regulatory Deferral Accounts Jan 2014 1 Jan 2016
IFRS 15 Revenue from Contracts with Customers May 2014 1 Jan 2018
IFRS 16 Leases Jan 2016 1 Jan 2019
IFRS 17 Insurance Contracts May 2017 1 Jan 2021
IFRS for SMEs International Financial Reporting Standard for Small and Jul 2009
Medium sized Entities

16.2 SCOPE AND APPLICATION OF IFRS

16.2.1 SCOPE
Any limitation of the applicability of a specific IFRS is made clear within that standard. IFRS are not
intended to be applied to immaterial items. An item is immaterial if its omission or misstatement
would not influence decisions that users of financial statements make. Each individual IFRS lays out its
scope at the beginning of the standard.
 FINANCIAL ACCOUNTING AND REPORTING | 63

16.2.2 APPLICATION
Within each individual country local regulations govern, to varying degrees, the issue of financial
statements. These local regulations include accounting standards issued by the national regulatory
bodies and/or professional accountancy bodies in the country concerned.

16.3 ALTERNATIVE TREATMENTS

MODULE 1
Many of the old standards permitted two accounting treatments for like transactions or events. One
treatment was designated as the benchmark treatment (effectively the preferred treatment) and the
other was known as the alternative treatment. This is no longer the case. However, some standards do
still allow more than one policy – for instance, IAS 16 allows property, plant and equipment to be carried at
cost or revalued amount.

16.4 INTERPRETATION OF IFRS

The IFRS Interpretations Committee (as discussed earlier in this module) has the responsibility for
issuing additional guidance on the application of an accounting standard where unsatisfactory or
conflicting interpretations exist. The documents issued are called IFRICs. As at October 2016, there
are 23 IFRICs in issue (of which 13 are still in force), together with 32 SICs (of which 27 have been
superseded) which were issued by the IFRS Interpretations Committee's predecessor, the Standing
Interpretations Committee.
The IFRS Interpretations Committee may also suggest IASB agenda items if there are financial
reporting issues that are not specifically covered by an IFRS.

16.5 FAIR PRESENTATION OVERRIDE

There may be (very rare) circumstances when management decides that compliance with a
requirement of an IFRS would be misleading. Departure from the IFRS is therefore required to
achieve a fair presentation. IAS 1 Presentation of Financial Statements states that the following should
be disclosed in such an event:
 Management confirmation that the financial statements fairly present the entity's financial position,
performance and cash flows;
 A statement that all IFRS have been complied with except departure from one IFRS to achieve a
fair presentation;
 Details of the nature of the departure, why the IFRS treatment would be misleading, and the
treatment adopted; or
 Financial impact of the departure.
This is sometimes referred to as the 'true and fair override' or the 'fair presentation' override. Not
all jurisdictions allow the use of the 'true and fair' override. For example, in Australia, preparers of
financial statements are not permitted to depart from any of the requirements of accounting
standards (see section 6.10). Instead, the financial statements must disclose additional information.

16.6 EXTREME CASE DISCLOSURES

In very rare circumstances, management may conclude that compliance with a requirement in a
Standard or Interpretation may be so misleading that it would conflict with the objective of financial
statements set out in the Conceptual Framework, but the relevant regulatory framework prohibits
departure from the requirements. IAS 1 states that in such cases the entity needs to reduce the
perceived misleading aspects of compliance by disclosing:
 the title of the Standard, the nature of the requirement and the reason why management has
reached its conclusion; and
 for each period, the adjustment to each item in the financial statements that would be necessary to
achieve fair presentation.
 64 | THE FINANCIAL REPORTING ENVIRONMENT

16.7 WORLDWIDE EFFECT OF IFRS AND THE IASB

The IASB, and before it the IASC, has now been in existence for around 40 years, and it is worthwhile
considering the effect it has had in that time.
As far as Europe is concerned, the consolidated financial statements of many of Europe's top
multinationals are now prepared in conformity with national requirements, European Commission (EC)
directives and IFRS. Furthermore, IFRS are having a growing influence on national accounting
requirements and practices. Many of these developments have been given added impetus by the
internationalisation of capital markets.
Australia has wholly adopted IFRS and issues Australian Equivalent International Financial Reporting
Standards (AIFRS). The AASB adopted IFRS for annual reporting periods for companies from
1 January 2005. This means that all general financial purpose statements prepared by for-profit
entities prepared in accordance with AASB are also in accordance with IFRS.
In 2006, China officially released a new set of Chinese Accounting Standards (CASs) which are
substantially converged with IFRSs, and reaffirmed its commitment to international convergence.
In 2005, the IASB and the Accounting Standards Board of Japan (ASBJ) announced a joint project to
reduce differences between IFRSs and Japanese accounting standards. Since 2010, Japanese listed
companies meeting certain criteria have been permitted to use IFRSs as designated by The Financial
Services Agency of Japan. Consultation is also underway on the use of IFRSs in Japan.
Until recently, the US was one of the few countries in which IFRS financial statements were not
accepted. However, over the last 10 years the US authorities have moved significantly closer to
recognising IFRS, although it is unlikely that the US will adopt IFRSs in the near future. Convergence of
IFRS and US GAAP was discussed earlier when we introduced the Norwalk Agreement, and is
discussed in more detail in the following section.

16.8 EFFECT OF HARMONISATION ON COMPANIES

There are two main ways in which an individual country can harmonise its national GAAP with IFRS. It
can require some or all entities (usually listed companies) to comply with IFRS from a particular date.
Alternatively, it can converge its domestic standards with IFRS over a period of time, typically in
stages. Obviously, the effect on individual companies is less dramatic and easier to manage if
countries choose the second of these routes to harmonisation.
Where a company has to change from a national GAAP to IFRS on a particular date it has to deal with
a number of practical issues. Typically, the main issues are as follows:
 Management, internal accounts staff and auditors need to be fully trained in IFRS. While there may
be broad similarities between domestic standards and IFRS, there are frequently numerous
differences in the detail.
 Accounting systems and information systems may need to be upgraded to deal with more
complex or different reporting requirements.
 It is important to communicate with shareholders (particularly investors, lenders and their advisors)
to prepare them for the possible effect of the change on the entity's reported results and financial
position.
 The change to IFRS affects reported profits and net assets. Management remuneration may
depend on a certain level of profits or on increases in profits. Debt covenants (agreements with
lenders) may depend on a company maintaining a key level of assets to liabilities, or debt to
equity. Remuneration schemes and debt covenants may need to be re-negotiated.
 IFRS disclosure requirements may be far more onerous than those of national GAAP. Preparers
need to make sure that they have all the necessary information, bearing in mind that they will need
to present at least one set of comparative figures under IFRS, as well as the figures for the current
year.
 It may still be necessary to prepare accounts under national GAAP for the tax authorities.
 FINANCIAL ACCOUNTING AND REPORTING | 65

A 2009 AASB publication IFRS Adoption in Australia summarised the outcomes of the change to IFRS
from 2005. The benefits have been:
 Australian entities' financial reports are more readily understood world wide;
 there are synergies in the preparation, audit and analysis of Australian financial reports for entities
that are part of a multinational group; and
 improved reporting of financial instruments (an area in which IFRS was more comprehensive than

MODULE 1
Australian GAAP).
The disadvantages have been:
 the initial costs of adoption, particularly for banks and insurers in implementing the standards on
financial instruments;
 the pace of change: companies have had to deal with numerous amendments to IFRS that are
often driven by issues that are not a concern in Australia; and
 accounting and reporting issues that are important to Australian companies (for example, for
extractive industries) are not a priority for the IASB.

17 DEVELOPMENTS IN INTERNATIONAL
HARMONISATION

Section overview
 Although the IASB has faced criticism and political pressures, there is broad general
support for its overall objective of implementing a single set of high quality, global financial
reporting standards.

Arguably, the development of high quality International Financial Reporting Standards has been a
major factor in making international harmonisation possible. International standards have to be
perceived as at least as good as, or preferably better than, the national GAAP that they replace,
otherwise they will not be accepted by the world's major stock exchanges.
This section looks at the progress that has been made towards harmonisation and the obstacles that
still remain.

17.1 THE IASB AND IOSCO

The International Organisation of Securities Commissions (IOSCO) is the representative of the world's
securities markets' regulators. High quality information is vital for the operation of an efficient capital
market, and differences in the quality of the accounting policies and their enforcement between
countries leads to inefficiencies between markets. IOSCO has been active in encouraging and
promoting the improvement and quality of IFRS over the last 15 years. This commitment was
evidenced by the agreement between the International Accounting Standards Committee (IASC) (the
predecessor of the IASB) and IOSCO to work on a program of 'core standards' which could be used
by publicly listed entities when offering securities in foreign jurisdictions.
The 'core standards' project resulted in 15 new or revised IFRS and was completed in 1999. IOSCO
spent a year reviewing the results of the project and released a report in May 2000 which
recommended to all its members that they allow multinational issuers to use IFRS, as supplemented
by reconciliation, disclosure and interpretation where necessary to address outstanding substantive
issues at a national or regional level.
IASB staff and IOSCO continue to work together to resolve outstanding issues and to identify areas
where new IASB standards are needed. In June 2016 the IASB and IOSCO strengthened their
 66 | THE FINANCIAL REPORTING ENVIRONMENT

cooperation by publishing a joint Statement of Protocols, the aim being the development and
consistent application of international standards.

17.2 POLITICAL PROBLEMS

Any international body, whatever its purpose or activity, faces enormous political difficulties in
attempting to gain international consensus and the IASB is no exception to this. How can the IASB
reconcile the financial reporting situation between economies as diverse as third-world developing
countries and sophisticated first-world industrial powers?
Developing countries are suspicious of the IASB, believing it to be dominated by the US. This arises
because acceptance by the US listing authority, the Securities and Exchange Commission (SEC), of
IFRS has been seen as a major hurdle to be overcome. For all practical purposes it is the American
market which must be persuaded to accept IFRS and we discussed this earlier in this module when we
briefly looked at the Norwalk Agreement. Developing countries have been catered for to some extent
by the issue of a Standard on agriculture, which is generally of much more relevance to such
countries.
There are also tensions between the UK/US model of financial reporting and the European model.
The UK/US model is based around investor reporting, whereas the European model is mainly
concerned with tax rules, so shareholder reporting has a much lower priority.
Although the EU countries have now adopted IFRS for the consolidated financial statements of listed
entities, the Regulation actually requires listed companies to adopt the standards and Interpretations
that have been endorsed by the European Financial Reporting Advisory Group (EFRAG). Many
have feared that in practice this might lead to EFRAG effectively becoming a European standard
setting body and that eventually Europe might adopt its own variant of IFRS. This has not
happened.
The global financial crisis of 2008 intensified the above problems. Because IFRS requires most
financial assets to be measured at fair value, entities had to record huge losses on remeasurement
when share prices fell. Many argued that the IASB had contributed to the crisis by requiring the use
of fair values (sometimes called 'mark to market' accounting). Some politicians, particularly within
Europe, began to press the IASB to amend its financial instruments standards urgently so that
companies would not have to recognise changes in the fair value of financial instruments in profit or
loss. The IASB responded by accelerating its project to develop a new standard on financial
instruments and this led to the issuing of IFRS 9, which has an effective adoption date of 1 January 2018,
but has not retreated from its basic position, that is, that most financial assets should be measured at
fair value.
Many also voiced general criticisms of the IASB and the IFRS Foundation that:
 it was not publicly accountable;
 its operating procedures were not sufficiently transparent and did not allow enough consultation;
and
 it continued to be dominated by US interests and has prioritised convergence to US GAAP at the
expense of other projects.
The IASB has responded to these criticisms by making some changes in its constitution and operating
procedures. These include the following:
 A Monitoring Board has been set up to provide a formal link between the Trustees and public
capital market authorities. The role of the Monitoring Board was described earlier in this module.
 The composition of the IASB board has changed. Originally, the IASB board had 14 members, of
which 12 were full time and 2 were part time. Although most developed countries were
represented, in practice over half the members came from North America. The IASB now has 12
members. As before, the members are appointed on the basis of their experience and technical
expertise and are selected so that there is a mix of auditors, preparers of financial statements,
users of financial statements and academics. Currently, there are three members from the
Asia/Oceania region; three members from Europe; two members from North America; one
 FINANCIAL ACCOUNTING AND REPORTING | 67

member from Africa; one member from South America; and two members appointed from any
area, subject to maintaining overall geographical balance.
 Three-yearly public consultations on the IASB's technical agenda have been introduced. The most
recent of these consultations took place in 2015 and the results were announced on
2 November 2016. The IASB has taken account of these results in drawing up its current work
program.

MODULE 1
 A provision for accelerated due process has been introduced for use in exceptional circumstances.
Despite the criticisms, there is still broad general support for the IASB's overall objective of
implementing a single set of high quality, global financial reporting standards.

17.3 THE EUROPEAN COMMISSION (EC) REGULATION

As we have already seen, the EC regulations form one part of a broader program for the
harmonisation of company law in member states. The Commission is uniquely the only organisation to
produce international standards of accounting practice that are legally enforceable, in the form of
directives that must be included in the national legislation of member states. The directives have been
criticised as they might become constraints on the application of world-wide standards and bring
accounting standardisation and harmonisation into the political arena.
The EC adopted a regulation stating that from 2005 consolidated accounts of listed companies are
required to comply with IFRS. The implications of this are far reaching.
Many commentators believe that, in the light of the above, it is only a matter of time before national
standard-setting bodies are, in effect, replaced by the IASB and national standards fall into disuse.
However, national standards were designed for the national environment, which may include small
companies, the not-for-profit private sector and/or the public sector. Moreover, the IASB will need
input and expertise from valued national standard-setters.

17.4 CONVERGENCE WITH US GAAP

Since 2002 there have been a variety of attempts to increase convergence of International and US
accounting standards. Some standards have been issued jointly by the IASB and FASB, and since 2007
Companies listed on US stock exchanges but filing financial statements under IFRSs have not been
required to prepare a reconciliation to US GAAP. However pressure within the US accounting
community means that there is unlikely to be a move to IFRSs in the near future.
As discussed earlier in this module, in 2004 the IASB and FASB agreed to develop a common
conceptual framework which would be a significant step towards harmonisation of future standards.
Several chapters were released, but the remainder of the new Conceptual Framework has been
developed by the IASB alone.
 68 | THE FINANCIAL REPORTING ENVIRONMENT

17.5 DIALOGUE WITH OTHER KEY STANDARD-SETTERS

The IASB maintains a policy of dialogue with other key standard-setters around the world, in the
interest of harmonising standards across the globe.
National standard-setters are often involved in the development of Discussion Papers and Exposure
Drafts on new areas. To ensure international representation, both the members of the IASB and the
Trustees of the IFRS Foundation are to be taken from a broad geographical range which is specified:
six from Asia/Oceania; six from Europe; six from North America; one from Africa; one from South
America; and two from the rest of the world.
In addition, in 2013 the IFRS Foundation set up a new body, the Accounting Standards Advisory
Forum (ASAF). This consists of national accounting standard setters and regional bodies with an
interest in financial reporting. The purpose of the group is to provide technical advice and feedback to
the IASB. The 12 members of the ASAF are chosen to ensure a broad geographical representation
and balance of the major economic regions of the world and include the US FASB, the Australian
Accounting Standards Board (AASB) and the UK Financial Reporting Council, as well as the standard-
setting bodies from China and Japan and the Asian-Oceanian Standard Setters Group. The IFRS
Trustees review membership of ASAF every two years.

17.6 THE SITUATION TODAY AND IN THE FUTURE

Many organisations committed to global harmonisation have done a great deal of work towards this
goal. It is the case at present, however, that some disagreements still exist between countries and
organisations about the way forward. One of the major inconsistencies is between the reporting
requirements in developed countries and those in non-developed countries. It will be some time
before these difficulties can be overcome. The IASB is likely to be the lead body in attempting to do
so, as discussed above.
 FINANCIAL ACCOUNTING AND REPORTING | 69

KEY MODULE POINTS 3

 A principles-based system works within a set of laid down principles. A rules-based system
regulates for issues as they arise. Both of these have advantages and disadvantages.
 There are arguments for and against having accounting standards.

MODULE 1
 Going concern is a key assumption in preparing financial statements.
 Financial information (other than information about cash flows) should be prepared on the accruals
basis.
 Qualitative characteristics are the attributes that make the information provided in financial
statements useful to users.
 The two fundamental qualitative characteristics are: relevance and faithful representation.
 The four enhancing qualitative characteristics are: comparability, verifiability, timeliness and
understandability.
 Materiality should be considered when deciding on whether to include an item in the financial
statements. Both quantitative factors and qualitative factors should be considered in making
materiality judgments.
 Although the IASB has faced criticism and political pressures, there is broad general support for its
overall objective of implementing a single set of high quality, global financial reporting standards.
 A great deal of work has been done towards the goal of global harmonisation, however, some
disagreements still exist between countries and organisations about the way forward.
70 | THE FINANCIAL REPORTING ENVIRONMENT

QUICK REVISION QUESTIONS 3

1 Which of the following is an advantage of a principles based system of accounting standard

setting?
A It always provides the answers.
B It discourages creative accounting.
C It results in greater comparability of financial statements.
D It needs to be supported by illustrative examples and interpretations.

2 Which of the following statements is incorrect?

A Application of IFRS is presumed to result in financial statements that achieve a fair presentation.
B Under IFRS, all published financial statements are required to present fairly the financial
position and financial performance of an entity.
C Application of IFRS whilst preparing a set of financial statements should ensure that they are
completely accurate.
D Application of IFRS is presumed to result in financial statements that are more comparable.

3 Which of the following statements represents a disadvantage of the use of accounting standards?
A Standards are a less rigid alternative to legislation.
B Standards may tend towards rigidity in applying the rules.
C Standards oblige companies to disclose their accounting policies.
D Standards reduce variations in methods used to produce accounts.

4 Which of the following statements about going concern assumption is true?

A The going concern basis should only be used if an entity can prove that it has the resources
necessary to continue trading.
B If an entity has any doubts over its ability to continue to trade, a basis other than going concern
should be used.
C The going concern basis should be used if the entity is expected to continue in operation for
the foreseeable future.
D The going concern basis should be used if the entity is expected to continue in operation for
the next twelve months, but is looking to liquidate after that period.

5 There are four enhancing qualitative characteristics of useful financial information. What are those
characteristics?
A Going concern, accruals, completeness, verifiability
B Comparability, timeliness, verifiability, understandability
C Substance over form, neutrality, going concern, accruals
D Comparability, understandability, completeness, neutrality

6 Which of these comments is correct, according to the IASB's Conceptual Framework for Financial
Reporting?
A Materiality means that only items having a physical existence may be recognised as assets.
B A faithful representation of financial information can never include amounts based on estimates.
C Financial information prepared using accrual accounting provides a better basis for assessing an
entity's performance than information based only on cash flows.
D To show faithful representation items should be complete, up to date and free from error.
 FINANCIAL ACCOUNTING AND REPORTING | 71

7 What is the accounting concept called that requires income and expenses to be matched in the
period in which they occur, rather than when the cash is received or paid?
A Accruals
B Neutrality
C Materiality
D Faithful representation

MODULE 1
8 How many IFRS have been published by the IASB (excluding the IFRS for SMEs)?
A 17
B 29
C 41
D 43

9 Which of the following is a benefit of harmonisation?

A Ability of investors to compare cross border financial statements
B Increased training of staff to deal with new accounting standards
C Amendment of tax systems in different countries to align with accounting requirements
D Different countries have different legal systems for accounting which need to be amended

10 With which accounting body has the IASB carried out a joint project to develop several common
accounting standards?
A The OECD
B The Standards Advisory Council
C The Financial Accounting Standards Board
D The Australian Accounting Standards Board
 72 | THE FINANCIAL REPORTING ENVIRONMENT

18 THE ELEMENTS OF FINANCIAL STATEMENTS

LO
1.6 Section overview
 Transactions and other events are grouped together in broad classes and in this way their
financial effects are shown in the financial statements. These broad classes are the
elements of financial statements.

18.1 SUBJECT OUTLINE

Earlier in this module, we discussed the principles of the IASB's Conceptual Framework for Financial
Reporting. This section looks at some of the detail within the Conceptual Framework and examines
the definitions of the elements of financial statements.
The Conceptual Framework sets out these elements as follows:

Elements of financial
statements

Measurement of Measurement of
financial position in performance in the
the statement of statement of profit or
financial position loss and other
comprehensive income

• Assets • Income
• Liabilities • Expenses
• Equity

A process of sub-classification then takes place for presentation in the financial statements, for
example, assets are classified by their nature or function in the business to show information in the
best way for users to make economic decisions.

18.2 FINANCIAL POSITION

We need to define the three terms listed under this heading above.

Definitions

Asset. A present economic resource controlled by the entity as a result of past events.

Liability. A present obligation of the entity to transfer an economic resource as a result of past events.

Equity. The residual interest in the assets of the entity after deducting all its liabilities.
(Conceptual Framework)
 FINANCIAL ACCOUNTING AND REPORTING | 73

These definitions are important, but they do not cover the criteria for recognition of any of these
items, which are discussed in the next section of this module. This means that the definitions may
include items which would not actually be recognised in the statement of financial position because
they fail to satisfy recognition criteria.
Whether an item satisfies any of the definitions above will depend on the substance and economic
reality of the transaction, not merely its legal form as discussed earlier.

MODULE 1
18.3 ASSETS
Definition

Asset. A present economic resource controlled by the entity as a result of past events.
(Conceptual Framework)

Economic resource
An economic resource is a right that has the potential to produce economic benefits. For the
economic resource to have the 'potential to produce' economic benefits, it does not need to be
certain, or even likely, that the right will produce economic benefits. It is only necessary that the
economic resource already exists (present) and that there is at least one circumstance in which it
would produce economic benefits.
Rights may:
• correspond to the obligation of another party (e.g. a right to receive cash or goods/ services or a
right to exchange economic resources on favourable terms); or
• not correspond to the obligation of another party (e.g. rights to use or sell physical property or
rights to use intellectual property)
Not all rights are assets; in order to be so they must have the potential to produce economic benefits
and be controlled.
Further, a right that does not create rights for the entity beyond those that exist for other parties will
generate no economic benefits. For example, this applies to the right of use of roads.
Control
An entity controls an economic resource if:
• it can direct the use of the resource;
• it obtains economic benefits that flow from it; and
• it can prevent other entities from doing this.
Assets are usually employed to produce goods or services for customers; customers will then pay for
these, so resulting in economic benefit.
The existence of an asset, particularly in terms of control, is not reliant on:
(a) physical form (hence patents and copyrights are assets); nor
(b) legal rights (hence leases can give rise to assets).
Past events
Transactions or events in the past give rise to assets; those expected to occur in the future do not in
themselves give rise to assets. For example, an intention to purchase a non-current asset does not, in
itself, meet the definition of an asset.

18.4 LIABILITIES
Definition

Liability. A present obligation of the entity to transfer an economic resource as a result of past events.
(Conceptual Framework)
 74 | THE FINANCIAL REPORTING ENVIRONMENT

Again we can look more closely at some aspects of the definition. An essential characteristic of a
liability is that the entity has a present obligation.

Definition

Obligation. An obligation is a duty or responsibility that an entity has no practical ability to avoid.
(Conceptual Framework)

An obligation is always owed to another party (or parties). The other party (or parties) could be a
person or another entity, a group of people or other entities, or society at large. It is not necessary to
know the identity of the party (or parties) to whom the obligation is owed. Obligations may be legally
enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise,
however, from normal business practice, custom and a desire to maintain good business relations or
act in an equitable manner.
It is important to distinguish between a present obligation and a future commitment. A management
decision to purchase assets in the future does not, in itself, give rise to a present obligation. An
obligation is something that cannot be avoided.
Settlement of a present obligation will involve transfer of an economic resource in order to satisfy the
claim of the other party. This may be done in various ways, not just by payment of cash.
Liabilities must arise from past transactions or events. For example, in the recognition of future
rebates to customers based on annual purchases, the sale of goods in the past is the transaction that
gives rise to the liability.

Question 13: Asset or liability?

Consider the following situations. In each case, does the company have an asset or liability within the
definitions given by the Conceptual Framework? Give reasons for your answer.
(a) Pat Co. has purchased a patent for $20 000. The patent gives the company sole use of a particular
manufacturing process which will save $3000 a year for the next 5 years.
(b) Baldwin Co. paid a mechanic $10 000 to set up a car repair shop, on condition that priority
treatment is given to cars from the company's fleet.
(c) Deals on Wheels Co. announces that it will pay all of its staff a bonus.
(The answer is at the end of the module.)

18.5 EQUITY
Definition
Equity. The residual interest in the assets of the entity after deducting all its liabilities.
(Conceptual Framework)

Equity is defined above as a residual, but it may be sub-classified in the statement of financial position
into different equity reserves. This will indicate legal or other restrictions on the ability of the entity to
distribute or otherwise apply its equity. Some reserves are required by statute or other law, e.g. for the
future protection of creditors.
The amount shown for equity depends on the measurement of assets and liabilities. It has nothing
to do with the market value of the entity's shares. This is discussed in more detail later in this module.

18.6 FINANCIAL PERFORMANCE

Profit is used as a measure of performance, or as a basis for other measures (e.g. earnings per share).
It depends directly on the measurement of income and expenses, which in turn depend (in part) on
 FINANCIAL ACCOUNTING AND REPORTING | 75

the concepts of capital (the amount invested in a business by its owners) and capital maintenance
adopted (see Module 2).
The elements of income and expenses are therefore defined.

Definitions

Income. Increases in assets, or decreases in liabilities, that result in increases in equity, other

MODULE 1
than those relating to contributions from equity participants.
Expenses. Decreases in assets, or increases in liabilities, that result in decreases in equity, other than
those relating to distributions to equity participants. (Conceptual Framework)

Income and expenses can be presented in different ways in the financial statements to provide
information relevant for economic decision-making. For example, a distinction is made between
income and expenses which relate to continuing operations and those which do not.

18.7 INCOME
Both revenue and gains are included in the definition of income. Revenue arises in the course of
ordinary activities of an entity.

Gains include those arising on the disposal of non-current assets. The definition of income also
includes unrealised gains, for example, on revaluation of marketable securities. These are gains which
have not yet been realised because the securities have not yet been sold at the increased price.

18.8 EXPENSES
As with income, the definition of expenses includes losses as well as those expenses that arise in the
course of ordinary activities of an entity.

Losses will include those arising on the disposal of non-current assets. The definition of expenses will
also include unrealised losses, for example, downward revaluation of property, unrealised because
the property has not been sold at the reduced value.

18.9 CAPITAL MAINTENANCE ADJUSTMENTS

Definition

Capital maintenance adjustments. The revaluation or restatement of assets and liabilities gives rise
to increases or decreases in equity. (Conceptual Framework)

IFRSs allow or require certain assets to be measured at fair value in the financial statements. Such
assets are remeasured periodically in accordance with the requirements of relevant IFRS, to ensure
that an up to date fair value is reflected.
This periodic revaluation, or restatement, of an asset's carrying amount may be either upwards or
downwards, so resulting in either a gain (income) or a loss (expense).
The gain or loss is not included in an entity's profit or loss for the year under certain concepts of
capital maintenance. Instead it is shown as 'other comprehensive income'. Other comprehensive
income includes items of income or expense which are not permitted to be included in profit or loss
for the year, but which do meet the definition of income and expenses and result in an increase or
decrease in equity.
 76 | THE FINANCIAL REPORTING ENVIRONMENT

19 RECOGNITION AND DERECOGNITION OF THE

ELEMENTS OF FINANCIAL STATEMENTS

LO
1.6 Section overview
 Items which meet the definition of assets or liabilities may still not be recognised in financial
statements because they must also meet certain recognition criteria.

Definition

Recognition. The process of incorporating into the statement of financial position or statement of
profit or loss and other comprehensive income an item that meets the definition of an element of the
financial statements.
These elements should be recognised if it is relevant and will provide users of the financial statements
with a faithful representation of the transactions of the entity. (Conceptual Framework)

19.1 RELEVANCE
The recognition of a particular element of the financial statements may not always provide relevant
information. This could particularly be the case if it’s uncertain whether an asset or liability exists or the
probability of an inflow or outflow of economic benefits is low.
The uncertainty over the existence of an element could for example be caused by a dispute between
parties, where one party might dispute whether the entity has a right to receive an economic resource
from them. This uncertainty may only be resolved by a court ruling.
The probability of an inflow or outflow of economic benefit could for example relate to a warranty
provided on the sale of a product where the chance of a return or repair is very low. In this case it may
be more relevant to include information about the size and timing of possible inflows or outflows in
the notes.
19.2 FAITHFUL REPRESENTATION
The cost or value of an item, in many cases, must be estimated, which gives rise to measurement
uncertainty. The Conceptual Framework states, however, that the use of reasonable estimates is an
essential part of the preparation of financial statements and does not undermine their reliability.
Where no reasonable estimate can be made, the item should not be recognised, although its
existence should be disclosed in the notes, or other explanatory material.
Items may still qualify for recognition at a later date due to changes in circumstances or subsequent
events.
 FINANCIAL ACCOUNTING AND REPORTING | 77

20 APPLYING THE RECOGNITION CRITERIA

LO
1.6 Section overview
 The Conceptual Framework for Financial Reporting sets out criteria that should be applied

MODULE 1
in determining whether to recognise assets, liabilities, equity, income or expenses in the
financial statements.

20.1 ASSETS
An asset is not recognised in the statement of financial position just because expenditure has been
incurred. The expenditure must give rise to an economic resource controlled by the entity that will
have the potential to produce economic benefits. It should only be recognised if it is relevant and will
provide users of the financial statements with a faithful representation of the transactions of the
entity, if not an expense is recognised instead.
Consider the case of advertising expenditure. The company incurs the cost of having its products and
services advertised because management believes that increased sales revenue will result. It could be
argued that the advertising meets the definition of an asset, but let’s consider the criteria more carefully:
 Is it a right that has the potential to produce economic benefits?
Advertising certainly has the potential to produce economic benefits as a successful advertising
campaign should result in an increase in sales. Whether there is a right will require a little more
thought, the company paying for the advertisement certainly has the right for its advent to be
shown; however, this is where the obligation of the other party ends.
 Is the right controlled by the entity?
Once again we could argue that this is the case to a limited extent in that the entity will have
agreed a contract specifying things like timing of adverts and therefore can initially direct the use
of the resource. However, any alteration to the advertising schedule or format may not be possible
and is likely to incur an additional cost.
The company also does not control the output of the advertising, viewers may ignore the advert,
they may enjoy watching the adverts, but not buy the advertised product, or may buy a similar
product from another company.
 Does it provide information that is relevant and a faithful representation of the item?
The level of uncertainty involved in measuring the advertising asset is likely to be exceptionally
high this is because even if there is a pattern of increased sales following an advertising campaign,
it would be very difficult to prove that a certain number of customers bought a particular product
or a service just because they had seen an advert for it (although that may have been a factor,
possibly a subconscious one, in their decision), in the same way, it would be very difficult to prove
that X amount of advertising expenditure resulted in Y amount of additional sales revenue.
Therefore the 'asset' does not have a cost that can be measured reliably. Hence, advertising
expenditure is not recorded as asset and is expensed when incurred.

Question 14: Research and development expenditure

Below is an extract from the annual report of a retail group.
Significant Accounting Policies
Research and development
Expenditure on research activities, undertaken with the prospect of gaining new technical knowledge
and understanding, is recognised in the profit and loss as an expense as incurred.
Expenditure on development activities, whereby research findings are applied to a plan or design for
the production of new or substantially improved products and processes, is capitalised if the product
or process is technically and commercially feasible and the consolidated entity has sufficient resources
 78 | THE FINANCIAL REPORTING ENVIRONMENT

to complete development. The expenditure capitalised includes the cost of materials, direct labour
and an appropriate proportion of overheads.
Other development expenditure is recognised in the income statement as an expense as incurred.
Capitalised development expenditure is stated at cost less accumulated amortisation and impairment
losses.
Required
Explain the reasoning behind these accounting policies and any conflict there may be with the
Conceptual Framework for Financial Reporting.
(The answer is at the end of the module.)

20.2 LIABILITIES
A liability is recognised in the statement of financial position when:
 There is a present obligation to transfer an economic resource as a result of past events; and
 it is relevant and will provide users of the financial statements with a faithful representation of the
transactions of the entity.
Consider a possible liability arising from a claim against a company. One of its customers has been
seriously injured, allegedly as the result of buying and using the company's products. For there to be a
liability, there must be a present obligation which has the potential to require the entity to transfer
economic resource (the purchase and use of the products). At the year-end, lawyers advise that there
is approximately an 80 per cent chance that the company will be found liable. Here the probability of
transfer is high and it is likely that the company will have to pay compensation, which will amount to
between $50 000 and $100 000.
In this case, the definition of a liability has been met, recognition will lead to a the information being
relevant as it is clear that the liability exists and the probability of transfer of economic benefits is not
low. The lawyers have been able to determine a range of possible outcomes and expected level of
compensation therefore the amount of the liability can be measured reliably.
The company recognises a provision (a liability of uncertain timing or amount) for the best estimate
of the amount to settle the obligation.
Question 15: Refunds

Cloud 11 is a retailer with a policy of refunding purchases by dissatisfied customers, even though it is
under no legal obligation to do so. Its policy of making refunds is displayed on its website, in its
advertising and on signs throughout its stores

Required
Explain whether a provision for refunds should be recognised in the financial statements of Cloud 11.
(The answer is at the end of the module.)

20.3 EQUITY
The Conceptual Framework defines equity as the residual interest in the assets of the entity after
deducting all its liabilities. This is a restatement of the basic accounting equation:
ASSETS – LIABILITIES = EQUITY
Equity consists of funds contributed by shareholders (share capital), retained earnings and other
reserves. Other reserves are normally appropriations of retained earnings.
Equity can be viewed as a type of liability: the amount owed to the equity shareholders (its owners).
However, there is a crucial difference between equity and liabilities. For there to be a liability there
must be an obligation: an outflow of economic benefits that cannot realistically be avoided.
 FINANCIAL ACCOUNTING AND REPORTING | 79

Many companies are financed by a mixture of equity and debt (borrowings).

 Debt finance is a liability of the company. The company will eventually have an obligation to
repay the amount. In almost all cases, the company also has an obligation to pay interest on its
debt, regardless of the amount of the entity's profits or losses. There is normally reasonable
certainty about the amount that the lenders will receive and about when they will receive it.
 Share capital gives their holders the right to share in the company's profit and losses and (in

MODULE 1
theory) to influence the policies adopted by management by exercising voting rights. They are
exposed to the risks and uncertainties of the business. The return on their investment (in the form
of dividends) depends on the company's results; in a poor year they may receive nothing. If the
company is wound up, they may receive a share of its retained profits, but only after the lenders
and other creditors have been paid.
During the last thirty years there has been a growth in the number and complexity of types of financial
instrument. For legal reasons, some instruments are called shares although they have the
characteristics of debt. Preparers of financial statements should look at the economic substance of the
arrangement in order to decide whether a financial instrument is debt (a liability) or equity.
Question 16: Preference shares
A company has two classes of shares: ordinary shares and 6 per cent redeemable preference shares
which were issued at $1 each. Holders of the preference shares receive a dividend of 6 per cent of the
amount of their shareholding each year. For example, a shareholder who held 10 000 preference
shares would automatically receive a dividend of $600 each year, regardless of the company's
performance. The preference shares mature in five years' time: at that date the capital that the holders
have invested will be repaid to them.
Required
Are the preference shares part of equity, or a liability? Explain your answer.
(The answer is at the end of the module.)

20.4 INCOME
The Conceptual Framework explains that income is recognised when:
 there has been an increase in future economic benefits related to an increase in an asset or a
decrease of a liability; and
 this increase or decrease can be measured reliably.
For example, when an entity makes a sale it recognises revenue and it also recognises an asset: cash
or an amount receivable that will eventually be converted into cash. This asset meets the recognition
criteria:
 it is probable that there will be an inflow of economic benefit (cash has either already been
received or will be received in the near future); and
 the amount can be reliably measured (it is normally a matter of fact and can be verified).
Similarly, when an entity recognises a gain on disposal of an asset it also recognises a net increase in
assets: tangible assets decrease, but cash increases by a greater amount.
Determining when to recognise revenue can sometimes be a problem. Even a simple sales transaction
has several stages: the customer orders the goods; the goods are produced; the goods are delivered
to the customer; the customer is invoiced; and the cash is received. In theory, a company could argue
a case for recognising a sale at any of these stages, but generally accepted accounting practice is to
recognise the revenue when the goods are despatched to the customer. This is the critical event in
the earnings cycle. At this point the company has performed its side of the sales contract with the
customer and has earned the right to payment. Control of the asset has been transferred to the
customer.
When it is a service that is sold, revenue is recognised as or when the service is performed. For
example, revenue from a magazine subscription is recognised over the period of the subscription.
 80 | THE FINANCIAL REPORTING ENVIRONMENT

In recent years, there have been several occasions on which companies have adopted controversial
accounting policies for revenue recognition (sometimes called 'aggressive earnings management').
These controversial policies have all involved recognising revenue before it has actually been earned.
Question 17: Airline
Below is an extract from the annual report of an international airline group:
Statement of significant accounting policies: Revenue Recognition
Passenger, Freight and Tours and Travel Revenue
Passenger, freight and tours and travel revenue is recognised when passengers or freight are
uplifted or when tours and travel air tickets and land content are utilised. Unused tickets are
recognised as revenue using estimates based on the terms and conditions of the ticket.
Required
Explain the reasoning behind this accounting policy by applying the recognition criteria in the
Conceptual Framework.
(The answer is at the end of the module.)

20.5 EXPENSES
The Conceptual Framework explains that expenses are recognised when:
(a) there has been a decrease in future economic benefits related to a decrease in an asset or an
increase in a liability; and
(b) this increase or decrease can be measured reliably.
For example, when an entity incurs office expenses such as light and heat, it recognises the expense
and it also recognises a liability: the amount payable to the supplier. This liability meets the
recognition criteria:
 it is probable that there will be an outflow of economic benefits (the entity must eventually pay the
amount it owes to the supplier); and
 the amount can be reliably measured (the amount payable will either have been invoiced or can be
estimated based on past experience).
Expenses are recognised in profit or loss on the basis of a direct association between the costs
incurred and the earning of specific items of income (the matching of costs and revenues). Applying
the matching concept should not result in the recognition of items in the statement of financial
position that do not meet the definition of assets or liabilities.
Where economic benefits are expected to arise over several accounting periods, expenses are
allocated to accounting periods in a systematic and rational way. For example, property, plant and
equipment is depreciated in order to match the expense of acquiring it to the income which it
generates. The expense is recognised in the accounting periods in which the economic benefits
associated with it are consumed.
When expenditure produces no future economic benefits an expense should be recognised
immediately in profit or loss. An expense is also recognised when a liability is incurred without the
recognition of an asset.

Question 18: Restoration costs

A mining company is legally obliged to restore the site and to rectify environmental damage after
each mine is closed. Typically, a mine is expected to operate for at least 20 years. Approximately 40
per cent of the eventual expense relates to the removal of mineshafts and the rectification of damage
that occurs when the mine is originally sunk, the remainder of the cost relates to damage that is
caused progressively as the minerals are extracted.
 FINANCIAL ACCOUNTING AND REPORTING | 81

During the current reporting period the company has sunk a mineshaft but not yet commenced
extracting minerals.
According to the Conceptual Framework, how should this event be reported in the financial
statements for the current period and subsequent periods?
(The answer is at the end of the module.)

MODULE 1
20.6 DERECOGNITION
Derecognition is the removal of all or part of a recognised asset or liability from an entity’s statement
of financial position. The following normally occurs:
 Assets – when control is lost
 Liabilities – when there is no longer a present obligation
An asset or liability is not derecognised if, for example:
• an entity has apparently transferred an asset but retains exposure to the significant positive or
negative variations in the amount of economic benefits that may be produced by the asset
(indicating that it still controls it); or
• an entity has transferred an asset to another party that holds the asset as an agent for the entity
(meaning that the entity still controls the asset).

21 THE MAIN FINANCIAL STATEMENTS

Section overview
 The principal financial statements of a business are the statement of financial position
and the statement of profit or loss and other comprehensive income.

21.1 STATEMENT OF FINANCIAL POSITION

Definition

The statement of financial position is simply a list of all the assets owned and/or controlled and all
the liabilities owed by a business as at a particular date. It is a snapshot of the financial position of the
business at a particular moment. Monetary amounts are attributed to each of the assets and liabilities.

21.1.1 ASSETS
Examples of assets are factories, office buildings, warehouses, delivery vans, lorries, plant and
machinery, computer equipment, office furniture, amounts owing from customers (receivables), cash
and goods held in store awaiting sale to customers.
Some assets are held and used in operations for a long time. An office building is occupied by
administrative staff for years; similarly, a machine has a productive life of many years before it wears
out. These types of assets are called non-current assets.
Other assets are held for only a short time. The owner of a newspaper shop, for example, has to sell
their newspapers on the same day that they get them. The more quickly a business can sell the goods
it has in store, the more profit it is likely to make; provided, of course, that the goods are sold at a
higher price than what it cost the business to acquire them. These are current assets.
Current/non-current distinction
An entity must present current and non-current assets as separate classifications on the face of the
statement of financial position.
 82 | THE FINANCIAL REPORTING ENVIRONMENT

21.1.2 LIABILITIES
Examples of liabilities are amounts owed to a supplier for goods purchased on credit, amounts owed
to a bank (or other lender), a bank overdraft and amounts owed to tax authorities (e.g. in respect of
sales tax/GST).
Some liabilities are due to be paid fairly quickly for example, amounts payable to suppliers. Other
liabilities may take some years to repay (e.g. a bank loan).
Current/non-current distinction
The categorisation of current liabilities is very similar to that of current assets.

21.1.3 CAPITAL OR EQUITY

The amounts invested in a business by the owner, together with the retained profits of the business,
are amounts that the business owes to the owner. These are known as capital or equity. In a limited
liability company, capital introduced usually takes the form of shares. Equity may be thought of as the
owner's stake in the net assets of the business, but note that this would only be paid to the owner (less
liquidation costs) in the unlikely event of the business winding up.

21.1.4 FORM OF STATEMENT OF FINANCIAL POSITION

A statement of financial position may also be called a balance sheet. This name is appropriate
because assets will always be equal to liabilities plus equity. An example of a statement of financial
position for a company is shown below.
XYZ – STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER
20X7 20X6
Assets $'000 $'000
Non-current assets
Property, plant and equipment 450 850 470 790
Goodwill 80 800 91 200
Other intangible assets 227 470 227 470
Financial assets 142 500 156 000
901 620 945 460
Current assets
Inventories 135 230 132 500
Trade receivables 91 600 110 800
Other current assets 25 650 12 540
Cash and cash equivalents 312 400 322 900
564 880 578 740
Total assets 1 466 500 1 524 200
Equity and liabilities
Share capital 650 000 600 000
Retained earnings 313 550 210 300
Other components of equity 10 200 21 200
Total equity 973 750 831 500
Non-current liabilities
Long-term borrowings 120 000 160 000
Deferred tax 28 800 26 040
Long-term provisions 28 850 52 240
Total non-current liabilities 177 650 238 280
Current liabilities
Trade and other payables 115 100 187 620
Short-term borrowings 150 000 200 000
Current portion of long-term borrowings 10 000 20 000
Current tax payable 35 000 42 000
Short-term provisions 5 000 4 800
Total current liabilities 315 100 454 420
Total liabilities 492 750 692 700
Total equity and liabilities 1 466 500 1 524 200
 FINANCIAL ACCOUNTING AND REPORTING | 83

Case study: Statement of financial position

The consolidated statement of financial position of Wesfarmers Ltd Group at 30 June 2012 is shown
below. This is presented in a different order from the illustration above, but notice that it still clearly
shows the three elements defined in the Conceptual Framework and the relationship between them:
ASSETS less LIABILITIES equals EQUITY. Many Australian companies present their statements of
financial position in the order used by Wesfarmers.

MODULE 1
Notice also that it clearly analyses assets and liabilities between current items and non-current items.

Reproduced with permission from Wesfarmers Limited

 84 | THE FINANCIAL REPORTING ENVIRONMENT

21.2 STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE

INCOME
Definition

A statement of profit or loss and other comprehensive income is a record of income generated
and expenditure incurred over a given period. The statement shows whether the business has had
more income than expenditure (a profit) or more expenditure than income (loss).

The statement of profit or loss and other comprehensive income shows, as the name suggests:
 profit or loss for the period; and
 other comprehensive income.
Together profit or loss and other comprehensive income give total comprehensive income and this
statement may also be referred to as the statement of comprehensive income.

21.2.1 INCOME AND EXPENSES

Income within the statement of profit or loss and other comprehensive income is the income earned
within a period. The expenses are the costs of running the business for the same period.

21.2.2 OTHER COMPREHENSIVE INCOME

Certain items of income and expense do not form profit or loss for the year, and instead are
recognised as other comprehensive income. IAS 1 and other IFRSs specify the items which this applies
to, and requires that these are sub-classified according to whether they may be reclassified to profit or
loss at a future date.

21.2.3 FORM OF STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

The period chosen will depend on the purpose for which the statement is produced. The statement of
profit or loss and other comprehensive income which forms part of the published annual financial
statements of a limited liability company will usually be for the period of a year, commencing from
the date of the previous year's statements. On the other hand, management might want to keep a
closer eye on a company's profitability by making up quarterly or monthly statements from a
management accounting perspective.
The statement of profit or loss and other comprehensive income may be shown as a single statement
or in two statements. The example below shows the 'single statement approach', starting with
revenue and ending with total comprehensive income. The alternative approach includes:
1. a statement of profit or loss, showing line items from revenue to profit or loss for the year; and
2. a second statement, the statement of comprehensive income, showing profit for the year (i.e. the
total from 1 above) and items of other comprehensive income to give total comprehensive income.
XYZ – STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE
YEAR ENDED 31 DECEMBER 20X7
20X7 20X6
$'000 $'000
Revenue 415 000 375 000
Cost of sales (245 000) (230 000)
Gross profit 170 000 145 000
Other income 17 767 16 400
Distribution costs (9 000) (8 700)
Administrative expenses (20 000) (21 000)
Other expenses (2 100) (1 200)
Finance costs (8 000) (7 500)
Profit before tax 148 667 123 000
Income tax expense (30 417) (27 000)
Profit for the year from continuing operations 118 250 96 000
Loss for the year from discontinued operations – (30 500)
Profit for the year 118 250 65 500
 FINANCIAL ACCOUNTING AND REPORTING | 85

20X7 20X6
$'000 $'000

Other comprehensive income:

Remeasurement of financial assets (14 000) 20 000
Gains on property revaluation 3 000 8 000
Other comprehensive income for the year (11 000) 28 000

MODULE 1
Total comprehensive income for the year 107 250 93 500

Case study: Statement of profit or loss and other comprehensive income

The statement profit or loss of Wesfarmers Ltd Group for the year ended 30 June 2012 is shown
below. Wesfarmers presents two separate statements of financial performance: an income statement
and a statement of comprehensive income. Only the income statement is shown here.
Notice that Wesfarmers analyses items of income and expenses according to their nature. The
illustration above analyses expenses by their function. But the statement still clearly shows the two
elements: income and expenses.
INCOME STATEMENT FOR THE YEAR ENDED 30 JUNE 2012 – WESFARMERS LTD GROUP AND
ITS CONTROLLED ENTITIES

Reproduced with permission from Wesfarmers Limited

 86 | THE FINANCIAL REPORTING ENVIRONMENT

21.3 OTHER FINANCIAL STATEMENTS

The statement of financial position and the statement of profit or loss and other comprehensive
income form the basis of the financial statements of most businesses.
In Module 3, we will explain how to prepare a statement of financial position and a statement of profit
or loss and other comprehensive income for a limited liability company in accordance with IAS 1
Presentation of Financial Statements. Under IFRS, limited liability companies are also required to
prepare a statement of changes in equity and a statement of cash flows, as well as notes to the
financial statements.

21.3.1 STATEMENT OF CHANGES IN EQUITY

The statement of changes in equity shows the movements in the various components of equity (share
capital, retained earnings and other reserves) for a period. The purpose of the statement is to show
the transactions between the company and its owners. These consist of:
 total comprehensive income for the year, made up of the profit or loss for the year (changes in
retained earnings), plus other comprehensive income (items such as revaluation gains which are
not included in profit or loss, but recognised in a separate reserve within equity);
 contributions from owners: issues of shares; and
 distributions to owners: dividends paid.
An example of a simple statement of changes in equity is shown below.
XYZ – STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20X7

Other
Share Retained components
capital earnings of equity
Total
$'000 $'000 $'000 $'000
Balance at 1 Jan 20X7 600 000 210 300 21 200 831 500
Changes in equity for 20X7
Issue of share capital 50 000 – – 50 000
Dividends – (15 000) – (15 000)

Total comprehensive
income for the year – 118 250 (11 000) 107 250
Balance at 31 Dec 20X7 650 000 313 550 10 200 973 750

The preparation of a statement of changes in equity is covered in Module 3.

21.3.2 STATEMENT OF CASH FLOWS

The statement of cash flows shows all movements of cash and cash equivalents into and out of a
business during the accounting period. These cash flows are classified into operating, investing and
financing activities. The cash flows for each of these are totalled to give the net inflow or outflow of
cash for the period.
The statement of cash flows is covered in more detail in Module 3.

Question 19: Accounting information

The financial statements of a limited liability company will consist solely of the statement of financial
position and statement of profit or loss and other comprehensive income.
This statement is:
A correct.
B incorrect.
(The answer is at the end of the module.)
 FINANCIAL ACCOUNTING AND REPORTING | 87

KEY MODULE POINTS 4

 Transactions and other events are grouped together in broad classes and in this way their financial
effects are shown in the financial statements. These broad classes are the elements of financial
statements.

MODULE 1
 Financial position is shown by:
– assets
– liabilities
– equity.
 Financial performance is shown by:
– income
– expenses.
 Items which meet the definition of assets or liabilities should be recognised if they are relevant and
will provide users of the financial statements with a faithful representation of the transactions of
the entity.
 The principal financial statements of a business are the statement of financial position and the
statement of profit or loss and other comprehensive income. Other statements include the
statement of changes in equity and the statement of cash flows.
88 | THE FINANCIAL REPORTING ENVIRONMENT

QUICK REVISION QUESTIONS 4

1 What is the following statement a definition of?

'A present economic resource controlled by the entity as a result of past events.'
A Asset
B Equity
C Liability
D Expense

2 Which of the following is the correct definition of a liability?

A The residual interest in the assets of the entity after deducting all its liabilities
B A present obligation arising from past events from which future economic benefits are expected
to flow from the entity
C A resource controlled by an entity as a result of past events and from which future economic
benefits are expected to flow to the entity
D A present obligation of the entity to transfer an economic resource as a result of past events

3 What are the criteria for recognition of items in the financial statements according to the IASB's
Conceptual Framework?
I. Must meet the definition of an element of the financial statements
II. Must be measured reliably
III. Probable that there will be an inflow or outflow of future economic benefits and there is a past
transaction
IV Must provide relevant information and a faithful representation of the transactions of the entity.

A IV only
B I and IV only
C II and III only
D I, II, III, and IV

4 What items are recognised in the statement of profit or loss and other comprehensive income?
I. Equity
II. Assets
III. Income
IV. Liabilities
V. Expenses

A III only
B I and V only
C III and V only
D I, II, III, IV and V

5 Which of the following is an example of a current asset?

A Retained earnings
B Manufacturing licences
C Property, plant and equipment
D Motor vehicles held for sale as part of a trade
 FINANCIAL ACCOUNTING AND REPORTING | 89

6 Which of the following items are non-current assets?

I. Land
II. Inventory
III. Bank loan
IV. Machinery

A I only

MODULE 1
B I and IV only
C I, III and IV only
D II, III and IV only

7 How is a bank overdraft classified in the statement of financial position?

A Current asset
B Current liability
C Non-current asset
D Non-current liability

8 How should the balance of accounts payable be reported in the financial statements?
A As an expense
B As a current asset
C As a current liability
D As a non-current asset

9 Which of the following is an example of a liability?

A Loan payable
B Inventory
C Receivables
D Plant and machinery
90 | THE FINANCIAL REPORTING ENVIRONMENT

ANSWERS TO QUICK REVISION QUESTIONS 1

1 D The primary aim of accounting is to provide financial information for users.

2 C Lenders and shareholders in particular are identified as the primary users of financial
statements. Information produced with them in mind should also be useful for other user
groups, however these other groups are not considered to be the main audience of financial
accounts.
3 D Although shareholders need to know the future prospects, they also need to know that the
current position of the company is secure. Similarly, suppliers need to know the future
prospects to ensure that they will be paid.
4 C The IASB is overseen by and accountable to the IFRS Foundation. The IASB is responsible for
issuing IFRSs.
5 D A, B and C are not correct as the IFRS Foundation appoints the members of the IASB; the IFRS
Interpretations Committee issues Interpretations; and the IFRS Foundation oversees the work of
the IFRS Interpretations Committee. D is correct as the IFRS Advisory Council assists and
advises the IASB in the process of developing IFRSs.
6 B The IASB has no powers of enforcement.
7 C The IFRS Interpretations Committee interprets the application of IFRS and provides guidance
on topics not specifically covered by an IFRS.
8 D GAAP is all the rules and regulations a company must follow so can include national as well as
international standards.
9 B A, C and D – under the regulated framework, financial statements of the company will result in:
more disclosure being required; the extra work involved in adhering to regulations is costly and
competitors have access to more information which they may use to their advantage.
Regulation does, however, result in higher quality, more comparable, relevant and faithfully
represented information.
10 D Although the issue of a discussion paper is not a mandatory step in due process, this would be
issued before the (mandatory) exposure draft, and in due course a final standard.

ANSWERS TO QUICK REVISION QUESTIONS 2

1 D A conceptual framework is sometimes referred to as a 'guiding light' which underpins

accounting standards.
2 A The framework provides the principles which underpin IFRS; in addition its principles are
applied where no standard exists. Therefore all transactions are effectively accounted for in line
with the framework, so resulting in standardised accounting practice.
3 B The Conceptual Framework for Financial Reporting is the name of the IASB's conceptual
framework.
4 B All are valid reasons that financial statements are produced, but the key reason is B.
5 A Financial statements are not used to value a company, methods such as historic cost mean
valuations do not necessarily represent the current value of the entity.
6 A Existing and potential investors, lenders and other creditors (providers of capital).
7 B The requirements of IFRSs dealing with similar and related issues. Whilst guidance should also
be sought from the underlying principles of the Conceptual Framework, this is secondary to
consulting similar IFRSs.
8 B A is a change of accounting estimate, C is specifically mentioned in IAS 8 as not constituting a
change of accounting policy, D is a change in an estimate.
9 B Material errors are treated in the same way as changes of accounting policy. They are corrected
retrospectively, so that the financial statements are presented as if the error had never
occurred.
 FINANCIAL ACCOUNTING AND REPORTING | 91

10 B All of the other options are changes in accounting estimates. A change in accounting estimate
is defined by IAS 8 as ‘an adjustment of the carrying amount of an asset or a liability, or the
amount of the periodic consumption of an asset, that results from the assessment of the present
status of, and expected future benefits and obligations associated with, assets and liabilities’. If
company changes its inventory valuation method to FIFO from weighted average method then
it is basically changing the principle of valuation as FIFO follows a particular cost flow
assumption whereas weighted average method uses weighted average of the cost at which

MODULE 1
inventory was held at the beginning of the period and cost of the goods bought during the
period. So, both methods use different basis to value the closing inventory this is a change in
measurement basis. Therefore, it is a change in accounting policy.
Under IAS 8, accounting policies are defined as ‘the specific principles, bases, conventions,
rules and practices applied by an entity in preparing and presenting financial statements’.
Presenting incorporates which heading an item is reported under in a primary statement which
is why B is a change in accounting policy.
11 C Decrease in the opening value of inventory would be considered to be a change of accounting
estimate, so no prior period adjustment would be required.
Discovery of significant fraud would be classed as a material error, however the error only
relates to this period. Therefore, a prior period adjustment is not necessary. Similarly, the wrong
tax charge would also be a material error, if it was based on incorrect information, this would
require a prior period adjustment.
The change in method of calculating irrecoverable debt provision would be a change in
accounting estimate. Therefore no prior period adjustment would be required.
92 | THE FINANCIAL REPORTING ENVIRONMENT

ANSWERS TO QUICK REVISION QUESTIONS 3

1 B A principles based system discourages 'creative accounting' abuses. Principles are harder to
evade than rules. Many people believe that A and C are advantages of a rules based system. D
is often true of principles based standards, but many view this as a disadvantage.
2 C Application of IFRS will not result in completely accurate financial statement, due to the use of
estimates and judgements.
3 B The other arguments are all in favour of accounting standards.
4 C The going concern basis should be used unless an entity has the intention or need to enter
liquidation or cease trading. If an entity has concerns or doubts the going concern basis, but
made the assessment that the going concern basis is appropriate, then the going concern basis
applies and supported by additional disclosures.
5 B These are the four qualitative characteristics contained within the Conceptual Framework which
enhance the usefulness of information that is relevant and faithfully represented.
6 C Materiality concerns whether omitting or misstating an item of information in the financial
statements could influence decisions that the primary users of general purpose financial reports
make on the basis of those reports.
A faithful representation must be free from error, but this does not mean perfectly accurate in
all respects.
Faithful representation requires an item to be complete, neutral and free from error.
7 A The accruals concept requires that the effects of transactions are recognised when they occur,
so meaning that credit sales and purchases, for example, are included in profit or loss for a
period.
8 A 17 IFRS have been published by the IASB.
9 A Investors will benefit as financial statements will be more comparable.
10 C The FASB is the US standard setter. It has worked with the IASB on a number of projects,
including new standards on business combinations, fair value measurement, financial
instruments and revenue recognition.

ANSWERS TO QUICK REVISION QUESTIONS 4

1 A This is the definition of an asset contained within the Conceptual Framework and various IFRS.
2 D This is the definition of a liability contained within the Conceptual Framework. A is the definition
of equity; C is the definition of an asset; B for an obligation to meet the definition of a liability, it
does not need to be certain, or even likely, that the entity will be required to transfer an
economic resource, the obligation must just have the potential to require a transfer of
economic resource.
3 D For an item to recognised in the financial statements it must meet the definition of an element
recognition must provide relevant information and a faithful representation of the
transactions of the entity.
4 C Assets, liability and equity are included in the statement of financial position.
5 D Motor vehicles are generally a non-current asset, however motor vehicles held for sale as part of
a trade are current assets in accordance with IAS 2 Inventories. Property, plant and equipment
and licences are non-current assets of a business; retained earnings are part of the equity in a
business.
6 B A bank loan is a liability of a business and inventory is a current asset.
7 B An overdraft is classed as current, even where there is a rolling facility, as it is repayable on
demand.
 FINANCIAL ACCOUNTING AND REPORTING | 93

8 C Payable accounts are part of the normal operating cycle of a business, and as such are classified
as current liabilities, even where the credit period exceeds 12 months.
9 A B, C and D are all assets.

ANSWERS TO MODULE QUESTIONS

MODULE 1
1 B Financial reporting is carried out by all businesses, no matter what their size or structure.
2 A Customers need to know that the business is making sufficient profits to be a secure source of
supply.
3 Other examples of areas where the judgment of different people may vary are as follows:
(a) valuation of buildings in times of rising property prices
(b) research and development: is it right to treat this only as an expense? In a sense it is an
investment to generate future revenue.
(c) accounting for inflation
(d) brands such as 'Coca Cola' or 'Hoover' – are they assets in the same way that a fork lift truck is
an asset?
Working from the same data, different groups of people may produce very different financial
statements. If the exercise of judgment is completely unrestrained, there will be no comparability
between the accounts of different organisations. This will be all the more significant in cases where
deliberate manipulation occurs, in order to present accounts in the most favourable light.
4 Methods of 'creative accounting' include:
 'Off balance sheet financing': an entity enters into a financing transaction which is structured
so that it can avoid having to recognise all its assets and liabilities in the statement of financial
position. For example, a company might sell an asset but enter into an agreement to
repurchase it after a set period of time. The substance of the transaction is that the company
has a loan (a liability) secured on the asset that has been 'sold' but legally, the company has
made a sale and so recognises cash and income. The company's financial performance and
particularly its financial position appear to be much stronger than they are. Transactions such as
these enable a company to 'hide' material borrowings from shareholders and other lenders.
 'Window dressing': at the year-end an entity enters into transactions whose sole purpose is to
improve the appearance of the financial statements. For example, a company might make a
fictitious 'sale', which would be reversed by means of a credit note early in the new reporting
period. Revenue and profit would appear to be higher than they really were.
 'Profit smoothing': in a profitable year an entity deliberately recognises a liability for future
expenditure to which it is not committed (for example, for a 'restructuring' or for future losses).
This 'provision' is then available to be released to profit or loss to increase profits in a poor year
(the provision is sometimes called the 'big bath').
 'Aggressive earnings management': recognising sales revenue before it has been earned
(before the entity has actually delivered the goods or performed the services).
Most of the accounting scandals of the past 20 years have involved one or more of these. For
example, the management of Enron used a sophisticated form of off balance sheet financing to
mislead the users of its financial statements.
5 The types of economic decisions for which financial statements are likely to be used include the
following:
 decisions to buy, hold or sell equity investments;
 assessment of management stewardship and accountability;
 assessment of the entity's ability to pay employees;
 assessment of the security of amounts lent to the entity;
 determination of taxation policies;
94 | THE FINANCIAL REPORTING ENVIRONMENT

 determination of distributable profits and dividends;

 inclusion in national income statistics; and/or
 regulations of the activities of entities.
6 The nine user groups who are likely to be interested in financial information about a company are:
 Managers of the company will need information about the company's financial situation as it is
currently and as it is expected to be in the future. This is to enable them to manage the
business efficiently and to make effective decisions.
 Shareholders of the company will want to assess how well the management is performing.
They want to know how profitable the company's operations are and how much profit they can
afford to withdraw from the business for their own use.
 Trade contacts include suppliers who provide goods to the company on credit and customers who
purchase the goods or services provided by the company. Suppliers want to know about the
company's ability to pay its debts; customers need to know that the company is a secure source of
supply and is in no danger of having to close down.
 Providers of finance to the company will wants to ensure that the company is able to keep up
interest payments, and eventually to repay the amounts advanced.
 The taxation authorities want to know about business profits in order to assess the tax payable
by the company, including sales taxes, for example, Goods and Services Tax or Value Added
Tax.
 Employees of the company should have a right to information about the company's financial
situation, because their future careers and the size of their wages and salaries depend on it.
 Financial analysts and advisers need information for their clients or audience. As examples,
stockbrokers need information to advise investors; credit agencies want information to advise
potential suppliers of goods to the company; and journalists need information for their reading
public.
 Government and their agencies are interested in the allocation of resources and therefore in
the activities of business entities. They also require information in order to provide a basis for
national statistics.
 The public. Companies affect members of the public in a variety of ways. They may make a
substantial contribution to a local economy by providing employment and using local suppliers.
Another important factor is the effect of an entity on the environment as an example in relation
to pollution.
7 (a) This is a change in presentation, so it does represent a change of accounting policy.
(b) This is a change of accounting estimate, not a change of accounting policy.
(c) This is a change of measurement basis, so it does represent a change of accounting policy.
8 STATEMENT OF PROFIT OR LOSS
20X7 20X6
$'000 $'000
Sales 54 000 50 000
Cost of goods sold (25 930) (24 050)
Profit before tax 28 070 25 950
Income tax (8 421) (7 785)
Profit for the year 19 649 18 165

9 Change in accounting estimate

The change in accounting estimate affects the accounts for 20X7 and subsequent years. At
31 December 20X7 the NBV of the asset is $60 000 (assuming that 20X7 depreciation has not yet
been charged). This should be spread over the revised remaining useful life, that is, three years.
Depreciation on the asset for 20X7, 20X8 and 20X9 will be $20 000 per annum.
 FINANCIAL ACCOUNTING AND REPORTING | 95

10 STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

20X7 20X6
$'000 $'000
Sales 67 200 47 400
Cost of goods sold (W1) (51 600) (38 770)
Profit before tax 15 600 8 630

MODULE 1
Income tax (W2) (4 680) (2 589)
Profit for the year 10 920 6 041
RETAINED EARNINGS
20X7 20X6
Opening retained earnings $'000 $'000
As previously reported 21 981 13 000
Correction of prior period
error (4200 – 1260) (2 940) –
As restated 19 041 13 000
Profit for the year 10 920 6 041
Closing retained earnings 29 961 19 041

Workings
1 Cost of goods sold 20X7 20X6
$'000 $'000
As stated in question 55 800 34 570
Inventory adjustment (4 200) 4 200
51 600 38 770
2 Income tax 20X7 20X6
$'000 $'000
As stated in question 3 420 3 849
Inventory adjustment (4200 × 30%) 1 260 (1 260)
4 680 2 589

11 (a) IAS 38 is generally viewed as a principles-based standard. This is despite that there is a minor
component of rules involved, such as 'research must be expensed and development costs are
capitalised if all of the conditions are met'. However, this rule is being overruled by the principle
approach, that is, by requiring management to assess whether they meet the criteria.
(b) There is a danger that management might ignore the basic principle and simply apply the rules,
particularly if this improves the entity's financial position. They might decide to capitalise all
development costs rather than making the judgements required. However, given IAS 38 is a
principles-based standard, it is harder for management to ignore the principles as the standard
requires management to assess whether they meet the criteria for recognition, not just
capitalise on development costs that do not meet the criteria.
12 (a) If the business is to be closed down, the remaining three machines must be valued at the
amount they will realise in a forced sale, that is, 3 × $60 = $180.
(b) If the business is viewed as a going concern, the inventory unsold at 31 December will be
carried forward into the following year, when the cost of the three machines will be matched
against the eventual sale proceeds in computing that year's profits. The three machines will
therefore be valued at cost, 3 × $100 = $300.
13 (a) This is an intangible asset. There is a past event, control and future economic benefit as a result
of cost savings.
(b) This cannot be classified as an asset. Baldwin Co. has no control over the car repair shop and it
is difficult to argue that there are 'future economic benefits'.
(c) The bonus is a liability as the business has created an obligation.
14 The accounting policies apply the requirements of IAS 38 Intangible Assets, but in some aspects
conflict with the definitions and the recognition criteria in the Conceptual Framework for Financial
Reporting.
96 | THE FINANCIAL REPORTING ENVIRONMENT

An intangible asset is recognised under IAS 38 if:

• it is probable that the expected future economic benefits attributed to the asset will flow to the
entity; and
• the cost of the asset can be measured reliably
Although expenditure on research activities may eventually result in future economic benefits (and
therefore there may be an asset) it cannot be capitalised because it does not meet the recognition
criteria: it is too early to say whether there will actually be any economic benefits or to be able to
make any kind of reliable estimate of the amount.
In contrast, development expenditure is capitalised if it meets certain criteria. There is an asset: the
new product and the ideas behind it are controlled by the entity and there is expected to be an
inflow of economic benefits in the form of increased revenue or reduced costs. An intangible asset
is recognised if the product or process is technically and commercially feasible and there are
sufficient resources to complete development. If these criteria are met the inflow of economic
benefits is probable. The second criteria of reliable measurement is also met because the
amount to be capitalised is the cost of materials, labour and a proportion of overheads; these
amounts will be recorded in the company's accounting system.
If development expenditure does not meet the criteria it is not recognised as an asset, but as an
expense in the period in which it is incurred.
The definition of an asset under the Conceptual Framework does not require the probable inflow
of future economic benefit, only the potential to produce economic benefit, these benefits do not
need to be certain or even likely. In most cases it is likely that research and development would be
carried out with some type of economic benefit in mind. Therefore the definition of an asset
according to the Conceptual Framework conflicts with that of IAS 38.
The Conceptual Framework also does not specify a reliable measurement, instead it requires the
information to be relevant and a faithful representation. The unknown outcome of the research and
development could make it uncertain whether an asset exists, there seems to be much more
certainty around the development costs that are technically feasible, whereas the research and
other development costs are very uncertain, therefore treating these as an asset may not give
relevant information.
The Conceptual Framework itself is not an International Financial Reporting Standard and so does
not overrule any individual IFRS. In the rare cases of conflict between an IFRS and the Conceptual
Framework, the IFRS will prevail.
15 Refunds
Cloud 11 should recognise a liability for the best estimate of costs of refunds on goods sold to
customers prior to the year end based on the following analysis.
A liability is a present obligation to transfer an economic resource as a result of past events.
Considering the three aspects of this definition:
• Cloud 11 has a constructive obligation to give dissatisfied customers refunds for returned
goods. This is because through its published policy (on its website, in its advertising and on
signs in its store), Cloud 11 has created a valid expectation in its customers that it will refund all
returned goods.
• The obligation has the potential to require Cloud 11 to transfer economic resource in the form
of a refund to customers if they return unwanted goods.
• A past event has occurred because Cloud 11 has taken an action in the form of sales to its
customers and, as a consequence, it may have to transfer an economic resource in the form of a
refund that otherwise it would not have had to.
The information would be relevant as it is very likely that some customers will seek refunds,
therefore the probability that there would be a transfer of economic benefits is not low. As the
policy has been in place for several years it is likely that a reliable estimate can be made based on
previous refund levels.
 FINANCIAL ACCOUNTING AND REPORTING | 97

16 The preference shares are a non-current liability and should not be presented as part of equity in
the statement of financial position. They have the characteristics of a loan, rather than an owners'
interest. A liability exists because the company has an obligation to pay interest over the life of the
'shares' and eventually to repay the principal amount.
17 In order for an entity to recognise revenue, the conceptual framework states the entity must have
the right and potential to produce economic benefits and be able to exercise control. Customers

MODULE 1
pay for airline tickets before they actually receive the service that they have paid for. The terms of
airline tickets vary. In some cases the passenger can only fly on the date and to the destination
originally booked, but in other cases tickets may be exchangeable, transferable or refundable or
they may be valid for travel during a particular period, rather than on a specific flight. So whilst the
company does have an increase in assets (the cash it receives, which has the potential to produce
economic benefit) it also has an obligation, in that it has an obligation to deliver a service (the
flight), or even the possibility of a repayment to the customer, therefore the net assets have not
increased.
The airline group does not recognise revenue until passengers actually travel, that is, when it
actually delivers the service that has been paid for. Depending on the terms of the ticket, until that
time the company probably has a liability in the form of an obligation to make a refund to the
customer or to offer another flight. When the customer actually travels, the liability is discharged.
The recognition conditions are met: there is a decrease in a liability, and a certain inflow of
economic benefit which can be reliably measured.
Unused tickets can be recognised as revenue in certain conditions. For example, where a customer
books a ticket that only permits travel on a specific flight and then fails to travel, the company still
receives the cash paid for the ticket (an inflow of economic benefit that meets both recognition
conditions) but has no obligation to provide another flight.
18 In the current period
The company has sunk a mine in the current period but has not yet commenced the extraction of
minerals.
As a result of sinking the mine, at the year-end, the company has a legal obligation to restore the
site at the end of the mine's operating life. It therefore has a liability which meets both the
recognition criteria:
(a) A present obligation to transfer an economic resource as a result of past events; and
(b) It is relevant and will provide users of the financial statements with a faithful representation of
the transactions of the entity. The amount can be reliably estimated (on the basis of the amount
it would cost to restore the site at the year-end, adjusted as necessary for expected future
changes in technology etc).
The company should therefore recognise a liability in respect of 40 per cent of the total cost of
restoring the site at the end of the mine's operating life. The remaining 60 per cent of the eventual
cost of restoration is the result of extracting minerals. As this activity has not yet commenced, there
is no related liability.
The restoration costs recognised as a liability also meet the definition of an asset (the expenditure
will generate future economic benefits in the form of sales revenue) and also meet the recognition
criteria: an inflow of economic benefit is probable and the cost of restoration can be reliably
estimated. Therefore these costs form part of the cost of the mine within non-current assets.
In subsequent periods
The remaining 60 per cent of the eventual total cost of restoration relates to damage caused
progressively as minerals are extracted. Therefore as this damage occurs over the mine's operating
life, the liability for restoration costs is increased.
98 | THE FINANCIAL REPORTING ENVIRONMENT

19 B A complete set of financial statements for a limited company (reporting entity) normally
includes:
 a statement of the entity's financial position;
 a statement or statements showing the entity's financial performance;
 a statement showing changes in the entity's financial position (usually a statement of cash
flows);
 a statement showing changes in equity; and
 notes to the financial statements and other supplementary information.
 99

MODULE 2
THE ACCOUNTING
THEORY

Learning objectives Reference

Compare historical cost accounting with other methods of valuation and explain the LO2.1
differences
Explain agency and contracting theories and how they relate to accounting policy LO2.2
choice (positive accounting theory)
Apply the recognition criteria for the elements of the financial statements according to LO2.3
the Conceptual Framework (normative theory)

Topic list

1 Historical cost accounting

2 Measurement bases of the elements of financial statements
3 Positive and normative accounting theory
4 Alternatives to historical cost
5 Concepts of capital and capital maintenance
6 Current purchasing power (CPP)
7 Current cost accounting (CCA)
8 Agency theory
9 Information provided in annual reports
10 Information available to shareholders
11 Content of company reports
100 | THE ACCOUNTING THEORY

MODULE OUTLINE

In this module we look at the advantages and disadvantages of using historic cost to measure assets
and liabilities. Following on from that, we look at other measurement bases that can be used in
financial statements including fair value, deprival value, replacement cost and net realisable value.
We then consider the alternatives to historical cost accounting. These are different ways of measuring
profit that attempt to include the effect of price changes: current purchasing power accounting and
current cost accounting.
We also examine agency theory and the elements of the relationship between shareholders and
directors. We take this further by looking at the information disclosed in the annual report and
financial statements that enables shareholders to assess the performance of the company. Some of
this information is mandatory (it must be provided) and some is provided voluntarily.
The module content is summarised in the diagrams below.

The accounting theory

Measurement bases

Historical cost accounting Measurement of the elements of

• Assets are recorded at the amounts financial statements
paid/received at acquisition Measurement options other than
historical cost include the following:
Disadvantages:
• Inflation • Fair value
• Increases in asset values are not • Value in use/fulfilment value
reflected in financial statements • Current cost

Advantages:
• Objective method
• Costs can easily be verified
 FINANCIAL ACCOUNTING AND REPORTING | 101

Theories of
accounting

Positive and normative Alternative to historical cost: Concepts of capital and

theories: capital maintenance:
• Current value accounting
• Positive: accounting theory • Financial capital maintenance:
• Increased use of fair values in
explains actual accounting profits is the difference between
financial statements
practice income and expenses as in
• Normative: accounting theory historical cost accounting
explains what should occur, • Physical (operating) capital
not what actually does maintenance:
profit is the increase in physical
productive capital

MODULE 2
Current purchasing power (CPP):
• Profit is the difference between Current cost accounting (CCA):
capital at beginning and end of • Capital maintenance approach
period based on maintaining operating
• Capital must be maintained so capability
must take account of effect of • Assets consumed, owned os sold
inflation should be shown at the value to the
business, i,e deprival value

Reporting and disclosure

Agency theory: Information provided in annual

• Principal task the agent with report:
undertaking a tas on their behalf • Mandatory information includes financial
• Shareholders task directors and statements
management to run company on their • Voluntary information includes the following:
behalf — Sustainability reports
• Problems occur if agent doesn’t act in — Managable governance
best interest of principal — Risk information

• Agency costs incurred by principal • Aim of information to provide

monitoring activities of agent shareholders with understanding of the
company’s activities in the peroid

The accounting theory: Module summary diagrams

102 | THE ACCOUNTING THEORY

BEFORE YOU BEGIN

If you have studied these topics before, you may wonder whether you need to study this module in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the module to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the module you can find the information, and you
will also find a commentary at the back of the Study guide.
1 Explain the historical cost basis of measurement. (Section 1.1)
2 What are the advantages and disadvantages of historical cost basis of
measurement? (Sections 2.4 and 2.5)
3 Which of the following are examples of current value?
I. Fair value
II. Historical cost
III. Fulfilment value
IV. Replacement cost
V. Value in use
A III and IV only
B III and V only
C I, II and III only
D I, III, IV and V only (Section 2)
4 What is the definition of fair value? (Section 2.1)
5 What is a normative accounting theory? (Section 3.3)
6 What is operating (or physical) capital maintenance? (Section 5.1)
7 What is current purchasing power accounting? (Section 6)
8 What is current cost accounting (CCA)? (Section 7)
9 What is an agency relationship? (Section 8.1)
10 What principal-agent relationships may exist in the context of a company? (Sections 8.3)
11 What is the purpose of corporate governance disclosures? (Section 9.2.1)
12 What are the advantages of disclosing non-mandatory information such as
social reports? (Section 9.2.3)
13 What information does a corporate governance report contain? (Section 11.4)
14 What information does a corporate social responsibility report contain? (Section 11.5)
 FINANCIAL ACCOUNTING AND REPORTING | 103

1 HISTORICAL COST ACCOUNTING

LO
2.1 Section overview
 A basic principle of accounting is that transactions are normally stated at their historical
amount.
 Historical cost is one of the measurement bases as per Conceptual Framework.
 Historical cost is the most commonly adopted measurement basis, but this is often
combined with other bases, such as net realisable value or fair value.
 Although historical cost is objective, there are some problems associated with using it.

1.1 SUBJECT OUTLINE

Accounting concepts are part of the theoretical framework on which accounting practice is based. It is
worth looking at one further general point: the problem of attributing monetary values to the items

MODULE 2
which appear in financial statements.
A basic principle of accounting (some writers include it in the list of fundamental accounting concepts)
is that transactions are normally stated in accounts at their historical cost.
Measurement is defined below.

Definition

Measurement basis. Elements recognised in financial statements are quantified in monetary terms.
This requires the selection of a measurement basis. A measurement basis is an identified feature – for
example, historical cost, fair value or fulfilment value – of an item being measured.
Applying a measurement basis to an asset or liability creates a measure for that asset or liability and
for related income and expenses. (Conceptual Framework)

There are two categories of measurement basis, historical cost measurement basis and current value
measurement basis. The Conceptual Framework provides the following definitions:

Definitions

Historical cost. Historical cost measures provide information about elements that is derived from the
historical price of the transaction or event that gave rise to the item being considered for
measurement; so, for an asset, this would be the cost incurred in acquiring/creating the asset. For a
liability, this would be the value of the consideration received to incur/take on the liability. The
historical cost of both an asset and a liability will be updated over time to depict, for example, any
consumption of the asset or fulfilment of the liability, or the impact of any events that cause the asset
to become impaired or the liability onerous.
Current value. Current value measures provide monetary information about assets, liabilities and
related income and expenses, using information updated to reflect conditions at the measurement
date.
Current value measures includes the following:
 Fair value. Fair value is the price that would be received to sell an asset, or paid to transfer a
liability, in an orderly transaction between market participants at the measurement date.
 Value in use for assets and fulfilment value for liabilities. Value in use is the present value of the
cash flows, or other economic benefits, that an entity expects to derive from the use of an asset
and from its ultimate disposal. Fulfilment value is the present value of the cash, or other economic
resources, that an entity expects to be obliged to transfer as it fulfils a liability.
 Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be
paid if the same or an equivalent asset was acquired currently.
 104 | THE ACCOUNTING THEORY

Liabilities are carried at the amount of the consideration that would be received for an equivalent
liability at the measurement date. (Conceptual Framework)

Historical cost is the most commonly adopted measurement basis, but this is usually combined with
other bases, for example, inventory is carried at the lower of cost and net realisable value, marketable
securities and non-current assets may be carried at market value (or fair value) and pension liabilities
are carried at their present value.
During the 1970s and 1980s some entities used current cost as a way of dealing with the effects of
high rates of inflation. However, at the present time current cost is used very rarely.

1.2 HISTORICAL COST

The historical cost convention has a number of implications:
 Transactions are recorded at original cost. This means, for example, that the cost of goods sold is
not suddenly increased at the end of the year.
 Assets and liabilities are stated at their historical cost.
The historical cost of an asset when it is acquired or created is the value of the costs incurred in
acquiring or creating the asset, comprising the consideration paid to acquire or create the asset plus
transaction costs.
The historical cost of a liability when it is incurred or taken on is the value of the consideration
received to incur or take on the liability minus transaction costs. (Conceptual Framework)

An important advantage of this convention is that there is usually objective, documentary evidence to
prove the purchase price of an asset, or amounts paid as expenses.
In general, accountants prefer to deal with objective costs, rather than with estimated values. This is
because valuations tend to be subjective and to vary according to the purpose of the valuation. There
are some disadvantages with the principle of historical cost which include:
 the wearing out of assets over time;
 the increase in market value of property; and
 inflation.
You may be able to think of other problems. Advantages and disadvantages of historical costs
accounting will be discussed further in this module.

Worked Example: Problems with historical cost

Suppose that a partnership buys a machine to use in its business. The machine has an expected useful
life of four years. At the end of two years the partnership is preparing a statement of financial position
and has to decide what monetary amount to attribute to the asset. Numerous possibilities might be
considered:
 The original cost (historical cost) of the machine;
 Half of the historical cost, on the basis that half of its useful life has expired;
 The amount the machine might fetch on the second-hand market;
 The amount it would cost to replace the machine with an identical machine;
 The amount it would cost to replace the machine with a more modern machine incorporating the
technological advances of the previous two years; and/or
 The machine's economic value, that is, the amount of the profits it is expected to generate for the
partnership during its remaining life.
All of these valuations have something to recommend them, but the great advantage of the first two is
that they are based on a figure (the machine's historical cost) which is objectively verifiable.
 FINANCIAL ACCOUNTING AND REPORTING | 105

2 MEASUREMENT BASES OF THE ELEMENTS OF

FINANCIAL STATEMENTS

LO
2.1 Section overview
 Besides historical cost, there are a variety of other possible methods of measurement:
– Fair value
– Value in use and fulfilment value
– Current cost
 The main advantage of historical cost accounting is that the cost of an item is known and
can be proved. There are also a number of disadvantages and these usually arise in times
of rising prices (inflation). Other disadvantages have arisen as business practice and
transactions have become more complex.

MODULE 2
2.1 FAIR VALUE
Definition
Fair value. Is 'the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date'.
(Conceptual Framework)

Fair value is the amount an asset could be sold or a liability discharged in an arm's length transaction.
Fair value is the market value of an item in a hypothetical transaction. In IFRS it is normally taken to be
open market value, or 'exit value', from the seller's perspective.
Fair value can be more reliably estimated where there is an active market for the asset being valued.
But where there is no active market, substitutes or estimates have to be used which, in some cases,
may result in a valuation that does not fairly represent the resource available.

2.2 CURRENT COST

Definition

Current cost.
Asset: The cost of an equivalent asset at the measurement date, comprising the consideration that
would be paid at the measurement date plus the transaction costs that would be incurred at that date.
Liability: The consideration that would be received for an equivalent liability at the measurement date
minus the transaction costs that would be incurred at that date.
(Conceptual Framework)

Worked Example: Current cost

XY Co. purchased a machine five years ago for $15 000. It is now worn out and needs replacing.
An identical machine can be purchased for $20 000.
Historical cost is $15 000
Current cost is $20 000
 106 | THE ACCOUNTING THEORY

In some cases, current cost cannot be determined directly by observing prices in an active market and
must be determined indirectly by other means. For example, if prices are available only for new assets,
the current cost of a used asset might need to be estimated by adjusting the current price of a new
asset to reflect the current age and condition of the asset held by the entity.

Question 1: Current cost

AB Co. purchased a machine three years ago for $75 000. Its useful life is expected to be 15 years. An
identical new machine can now be purchased for $80 000.
Required
Calculate the historic and current cost of the machine.
(The answer is at the end of the module.)

2.3 VALUE IN USE/FULFILMENT VALUE

Definition

Value in use. The present value of the estimated cash flows from the use of an asset and from its
ultimate disposal.
Fulfilment value. The present value of the estimated cash flows needed to fulfil a liability.
(Conceptual Framework)

Worked Example: Value in use

Suppose XY Co. purchases a new machine for $20 000. It is estimated that the new machine will
generate profits of $4 000 per year for its useful life of 8 years and then will be sold for $5 000. What is
its value in use?
Value in use = $(4 000 × 8) + 5 000
= $37 000

Note that these cash flows should be discounted, but discounting is beyond the coverage of this unit.

2.4 ADVANTAGES OF HISTORICAL COST ACCOUNTING

Historical cost accounting has several important advantages.
 It is objective. Cost is known and can be proved (e.g. by the invoice). If fair values or other forms of
current value are used, these are necessarily subjective.
 It is easily understood by users. Profit is the amount by which selling price exceeds the
(depreciated) original cost of the item sold or service provided.
 It is easy to apply. In contrast, most of the alternatives (deprival value, current cost and even fair
value) can be difficult and time consuming to estimate or calculate. For example, arriving at
deprival value may involve estimating future cash flows for a number of years and then discounting
them to present value.
 It provides useful information to users. Users need reliable and faithfully represented information
about past transactions in order to predict an entity's future performance. Information about the
current or fair value of assets may be useful to large institutional investors in listed companies, but
is largely irrelevant for others.
 It is prudent. Until fairly recently, prudence (conservatism) was recognised as a fundamental
accounting concept. Revenue and profits are not anticipated, but included in profit or loss only
when it is reasonably certain that they will be realised in the form of cash or other assets. Where
there is uncertainty, measuring non-current assets at historical cost is a cautious approach.
 FINANCIAL ACCOUNTING AND REPORTING | 107

 It has stood the test of time. Some theorists argue that historical cost is worth retaining because it
has been developed by trial and error by business owners and managers over several years. In
contrast, systems of current cost accounting and fair value accounting are based on academic
theories and have never really been proved to work in practice.
 If (for example) the current market prices of property or investments are very different from their
historical cost, this information can be disclosed in the notes to the financial statements. There is
no need to adjust the amounts in the statement of financial position or the other primary
statements.
Defenders of historical cost accounting argue that, although historical cost has shortcomings, there is
no real evidence that current costs or fair values provide more useful information. Some advantages of
historical cost accounting follow from the disadvantages of current value or fair value accounting:
 Use of fair values and current values can encourage management to manipulate the amounts in
the financial statements, because current value can only be an estimate. Accounting standards and
other forms of regulation can provide some protection against this, by, for example, requiring
regular revaluations by qualified external valuers, but there will always be some scope for 'creative
accounting'.

MODULE 2
 Current value accounting anticipates profits that may never be realised. Market prices may fall or
the asset may be damaged before it can be sold. Alternatively, the entity may have no intention of
selling the asset in the foreseeable future (for example, because it uses it in its operations).
 Because market values can fluctuate, using fair value can cause volatility in the financial
statements. IFRS require gains and losses on revaluation of investment property and some financial
instruments to be recognised directly in profit or loss. When reported results fluctuate
unexpectedly it can be difficult for users to make a fair assessment of an entity's performance and
to understand underlying trends. Some believe this volatility is acceptable because it reflects
economic reality. However, unexpected losses can also have serious economic consequences;
many believe that the use of fair values contributed to the global economic crisis in 2008.

Question 2: Objectivity

The main arguments in favour of historical cost accounting are that it is objective and that users
generally find it easier to understand than the alternatives, such as fair value.
Required
Briefly explain why this may not always be the case.
(The answer is at the end of the module.)

2.5 DISADVANTAGES OF HISTORICAL COST ACCOUNTING

There are a number of disadvantages of historical cost accounting. Many of these arise in particular in
times of rising prices (inflation). When inflation is low, historical cost accounting is usually satisfactory.
However, when inflation is high the following problems can occur. Other disadvantages have arisen as
business practice and transactions have become more complex.

2.5.1 NON-CURRENT ASSET VALUES ARE UNREALISTIC

The most striking example is property. Although some entities have periodically updated the amounts
shown in the statement of financial position, in general there has been a lack of consistency in the
approach adopted and a lack of clarity in the way in which the effects of these changes in value have
been expressed.
If non-current assets are measured at their historical cost, unrealised holding gains are not
recognised. This means that the total holding gain, if any, will be recognised during the year in which
the asset is realised, rather than spread over the period during which it was owned. In contrast
unrealised holding losses are recognised in the form of impairment of assets.
 108 | THE ACCOUNTING THEORY

There are, in essence, two contradictory points to be considered:

1. Although it has long been accepted that a statement of financial position prepared under the
historical cost concept is an historical record and not a statement of current worth, many people
now argue that the statement of financial position should at least give an indication of the current
value of the company's tangible net assets.
2. Traditionally, generally accepted accounting practice has required that profits should only be
recognised when realised in the form of either cash or other assets, the ultimate cash realisation of
which can be assessed with reasonable certainty (prudence or conservatism). It may be argued
that recognising unrealised holding gains on non-current assets is contrary to this convention.
On balance, the weight of opinion held generally by the IASB and specifically by Australia and the UK
is now in favour of restating asset values. It is felt that the criticism based on prudence can be met by
ensuring that valuations are made as objectively as possible (e.g. in the case of property, by having
independent expert valuations), by not taking unrealised gains through profit or loss, but instead
through reserves and by disclosing assumptions on which fair value estimate is based.

2.5.2 DEPRECIATION IS INADEQUATE TO FINANCE THE REPLACEMENT OF NON-CURRENT

ASSETS
Depreciation is not provided for in order to enforce retention of profits and therefore ensure that
funds are available for asset replacement. It is intended as a measure of the contribution of non-
current assets to an entity's activities in the period. However, an incidental effect of providing for
depreciation is that not all liquid funds can be paid out to investors thus enabling funds for asset
replacement to remain on hand. What is important is not the replacement of one asset by an identical
new one (something that rarely happens) but the replacement of the operating capability
represented by the old asset.

2.5.3 HOLDING GAINS ON INVENTORIES ARE INCLUDED IN PROFIT

Another criticism of historical cost accounting is that it does not fully reflect the value of the asset
consumed during the accounting year.
During a period of high inflation the monetary value of inventories held may increase significantly
while they are being processed. The conventions of historical cost accounting lead to the unrealised
part of this holding gain (known as inventory appreciation) being included in profit for the year.
The following simple example is given to help your understanding of this difficult concept.

Worked Example: Holding gain

At the beginning of the year a company has 100 units of inventory and no other assets. Its trading
account for the year is shown below.
TRADING ACCOUNT
Units $ Units $
Opening inventory 100 200 Sales (made 31 December) 100 500
Purchases (made 31 December) 100 400
200 600
Closing inventory (FIFO basis) 100 400
100 200 (COGS)
Gross profit – 300
100 500 (Sales) 100 500

Apparently the company has made a gross profit of $300. But, at the beginning of the year the
company owned 100 units of inventory and at the end of the year it owned 100 units of inventory and
$100 cash (sales $500 less purchases $400). From this it would seem that a profit of $100 is more
reasonable. The remaining $200 is inventory appreciation arising because the purchase price
increased from $2 to $4.
The criticism can be overcome by using a capital maintenance concept based on physical units
rather than money values (explained in more detail later in this module).
 FINANCIAL ACCOUNTING AND REPORTING | 109

2.5.4 PROFITS (OR LOSSES) ON HOLDINGS OF NET MONETARY ITEMS ARE NOT SHOWN
In periods of inflation the purchasing power, and therefore the value, of money falls. It follows that an
investment in money will have a lower real value at the end of a period of time than it did at the
beginning. A loss has been incurred. Similarly, the real value of a monetary liability will reduce over a
period of time and a gain will be made.

2.5.5 THE TRUE EFFECT OF INFLATION ON CAPITAL MAINTENANCE IS NOT SHOWN

To a large extent this follows from the points already mentioned. It is a widely held principle that
distributable profits should only be recognised after full allowance has been made for any erosion in
the capital value of a business. In historical cost accounts, although capital is maintained in nominal
money terms, it may not be in real terms. So, profits may be distributed to the detriment of the
long-term viability of the business. This criticism may be made by those who advocate capital
maintenance in physical terms.

2.5.6 COMPARISONS OVER TIME ARE UNREALISTIC

This will tend to an exaggeration of growth. For example, if a company's profit in 1982 was $100 000
and in 2012 $500 000, a shareholder's initial reaction might be that the company had done rather well.

MODULE 2
If, however, it was then revealed that with $100 000 in 1982 they could buy exactly the same goods as
with $500 000 in 2012, the apparent growth would seem less impressive.

2.5.7 HISTORICAL COST NO LONGER REFLECTS ECONOMIC REALITY

The arguments against historical cost accounting set out above mainly relate to its conceptual
shortcomings. More recently criticisms of historical cost have focused on its failure to capture
important information about particular types of transaction or event. There are two main issues:
1. Historical cost does not record any transaction that does not have a monetary impact. This is
particularly important where an entity holds certain types of financial instruments, such as
derivatives. A derivative is a financial instrument whose value changes in response to the change
in a specified interest rate, commodity price, foreign exchange rate or other variable. Derivatives
can be acquired for very little or no upfront cost, but can expose an entity to very significant
uncertainty and risk (potential for gain or loss) and this can have a very material effect on its
financial performance, financial position and cash flows. During the 1990s there were a number of
high profile accounting scandals and company failures involving derivatives. Because a derivative
contract normally has little or no initial cost, under traditional accounting it may not be
recognised in the financial statements at all. Alternatively it may be recognised at an amount
which bears no relation to its current value. This is clearly misleading and leaves users of the
financial statements unaware of the level of risk that the company faces. Current standards
require derivatives to be measured at fair value.
2. Historical cost provided relevant information when the main purpose of financial statements was to
enable owners to assess the stewardship of management. The emphasis is now on the financial
statements as a means of providing information to investors, lenders and other creditors and their
advisors to help them to make buy, hold or sell decisions. Many believe that fair value provides
these users with more relevant information than historical cost because:
 fair values have more predictive value;
 some assets are traded on an active market or held for their investment potential (rather than
being held to be used in the business);
 fair value often reflects the way risks are managed (for financial instruments); and
 for assets such as property, fair value provides information on the resources actually available
to an entity.
The Conceptual Framework explains that users need information to help them assess the
prospects for future net cash inflows to an entity; this is unlikely to be provided by historical cost
information alone.
 110 | THE ACCOUNTING THEORY

The points mentioned above have demonstrated some of the accounting problems associated with
historical cost accounting, particularly in times of severe and prolonged inflation. So far, we have
considered possible alternative measurement bases, such as fair value, but there are also alternative
systems of accounting.
Of the various possible systems of accounting for price changes, most fall into one of three categories
as follows:
1. general price change bases and in particular, current purchasing power (CPP)
2. current value bases. The basic principles of all these are:
(a) to show statement of financial position items at some form of current value rather than historical
cost; and
(b) to compute profits by matching the current value of costs at the date of consumption against
revenue.
The current value of an item will normally be based on replacement cost, net realisable value or
economic value.
3. a combination of these two systems: suggestions of this type have been put forward by many
writers
in practice, however, these methods are rarely applied.

2.6 WHY MODIFIED HISTORICAL COST ACCOUNTING IS STILL USED

Modified historical cost accounting refers to the method of accounting whereby assets and liabilities
are measured at historical cost with the exception of certain assets which may be revalued to current
values (fair value). This is the type of accounting prescribed by IFRS. Despite criticism, modified
historical cost accounting is still widely used. There are various reasons for this, not the least of which
is resistance to change in the conservative accounting profession.
Many entities prepare modified historical cost accounts: some assets (normally non-current tangible
assets and financial instruments) are measured at fair value or current value/deprival value while the
remainder continue to be measured at historical cost. Modified historical cost accounts are easy to
prepare, and easier to read and understand than the alternatives. While such accounts do not reflect
current values, the revaluation of non-current assets greatly improves the usefulness of them. IFRS
encourages the use of fair value, although entities can choose to measure non-financial assets,
including investment property, at depreciated historical cost.
In addition, as we have seen, alternatives such as fair value and deprival value also have
disadvantages. Some argue that no single alternative measurement base can fairly represent the
economic substance of all transactions.

3 POSITIVE AND NORMATIVE ACCOUNTING

THEORY

LOs
2.2, 2.3 Section overview
 Positive accounting theory explains and attempts to predict actual accounting practice.
 Normative accounting theory describes what should occur rather than predicting what
actually does occur.

3.1 ACCOUNTING THEORY

An accounting theory refers to having a body of knowledge which sets out the rules and regulations to
be followed in accounting for transactions. Accounting theories should provide guidance to
accounting practice and a basis for the future development of accounting standards.
 FINANCIAL ACCOUNTING AND REPORTING | 111

There is no single theory of accounting, several have developed over the years. Theory usually
underpins the development of standards. It can be argued that the IASB's Conceptual Framework is
an attempt at creating a body of accounting theory as it sets out the principles and process of
accounting for items in the financial statements.
In this section there are two theories we will briefly look at, positive accounting theory and normative
accounting theory.

3.2 POSITIVE ACCOUNTING THEORY

A positive approach to accounting is one where accounting theory is thought of as a body of
knowledge that explains and attempts to predict actual accounting practice. Positive theory does not
attempt to prescribe what businesses should or ought do, it merely predicts behaviour. It originated
as a theory from the work of two academics, Watts and Zimmerman in the 1970s and 1980s. Therefore,
information that provides guidance on accounting for particular events would be based on what has
been observed as actual accounting practice rather than what should occur. It is an explanation of
what actually happens rather than what should happen. Supporters of positive accounting theory can
attempt to predict accounting behaviour by observing what actually happens and applying this to

MODULE 2
particular situations.
One example of a positive accounting theory is the Efficient Market Hypothesis (or EMH). This is a
theory which attempts to explain the way in which share prices move in response to new information,
and it is in this theory that positive accounting theory found its roots.

3.3 NORMATIVE ACCOUNTING THEORY

Normative accounting theory differs from positive theory in that it describes what should occur rather
than predicting what actually does occur. This theory suggests that accounting should specify how
items should be defined and recognised. Normative theory may not be based on actual accounting
practice as its basis is not what actually happens but what should happen. For example, the use of a
conceptual framework and accounting standards based on that framework would be an example of
normative theory.
In this module we will be looking at the two main systems that have been developed as possible
alternatives to historical cost accounting: current cost accounting (CCA) and current purchasing power
(CPP). These are also normative theories of accounting.

4 ALTERNATIVES TO HISTORICAL COST

Section overview
 A number of alternatives to historical cost accounting have been developed and discussed.
It is unlikely that the IASB will propose a full system of current cost accounting in the near
future, but standards are requiring increasing use of fair values.

4.1 CURRENT VALUE ACCOUNTING

The move towards current value accounting has already taken a number of steps. Entities are now
permitted to revalue non-current assets such as land and buildings in line with fair value, and certain
financial assets and liabilities such as securities and investments can be carried at fair value, defined in
several IFRS as: 'the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date'.
These developments, and the use of fair values in acquisition accounting (to measure the assets of the
subsidiary and therefore arrive at a realistic goodwill valuation) are relatively uncontroversial. However,
there are those who would like fair value to be used more widely as a system of current value. Under
Current Value Accounting (CVA) the original cost of an asset would be replaced with its discounted
 112 | THE ACCOUNTING THEORY

present value, that is, the present value of its future cash flows. This is obviously suitable for monetary
items such as receivables and payables. The expected inflows and outflows would be discounted to
present value using an interest rate which reflects the current time value of money. For assets such as
vehicles, which do not yield a pre-determined future cash flow, current cost would be a more
applicable measure – based either on the current cost of the original asset or on its replacement by a
more up to date version. For inventories, current replacement cost or net realisable value would be
indicated.

4.2 HISTORICAL COST ACCOUNTING – DOES IT HAVE A FUTURE?

Investment analysts have argued that historical cost information is out of date and not relevant and
that fair value information, based on active market prices, is the best available measure of future cash
flows which an asset can be expected to generate.
This argument is heard increasingly in the US, where investors are the most highly-regarded user
group for financial information.
We will now go on to discuss two alternative systems which have sought in the past to address the
shortcomings of historical cost accounting – current purchasing power (CPP) and current cost
accounting (CCA). We begin by looking at the fundamental difference between these two systems
being a different concept of capital maintenance and therefore of profit.

5 CONCEPTS OF CAPITAL AND CAPITAL

MAINTENANCE

LO
2.1 Section overview
 An entity should select the concept of capital that is appropriate to the needs of the users
of its financial statements.

Most entities use a financial concept of capital when preparing their financial statements.

5.1 CONCEPTS OF CAPITAL MAINTENANCE AND THE

DETERMINATION OF PROFIT
First of all, we need to define the different concepts of capital.

Definitions

Financial capital maintenance. Under this concept a profit is earned only if the financial (or money)
amount of the net assets at the end of the period exceeds the financial (or money) amount of net
assets at the beginning of the period, after excluding any distributions to, and contributions from,
owners during the period.
Financial capital maintenance can be measured in either nominal monetary units or units of constant
purchasing power.
Physical capital maintenance (operating concept of capital). Under this concept a profit is earned
only if the physical productive capacity (or operating capability) of the entity (or the resources or funds
needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at
the beginning of the period, after excluding any distributions to, and contributions from, owners
during the period.
(Conceptual Framework)
 FINANCIAL ACCOUNTING AND REPORTING | 113

The main difference between the two concepts of capital maintenance is the treatment of the effects
of changes in the prices of assets and liabilities of the entity. In general terms, an entity has
maintained its capital if it has as much capital at the end of the period as it had at the beginning of the
period. Any amount over and above that required to maintain the capital at the beginning of the
period is profit.
(a) Financial capital maintenance: profit is the increase in nominal money capital over the period.
This is the concept used under historical cost accounting.
(b) Physical (or Operating) capital maintenance: profit is the increase in the physical productive
capacity over the period. This is the concept used in CCA.

6 CURRENT PURCHASING POWER (CPP)

LO
2.1 Section overview
 Current purchasing power accounting (CPP) measures profits as the increase in the current

MODULE 2
purchasing power of equity. Profits are therefore stated after allowing for the declining
purchasing power of money due to price inflation.

6.1 CAPITAL MAINTENANCE

Profit can be measured as the difference between how wealthy a company is at the beginning and
at the end of an accounting period.
 This wealth can be expressed in terms of the capital of a company as shown in its opening and
closing statements of financial position.
 A business which maintains its capital unchanged during an accounting period can be said to have
broken even.
 Once capital has been maintained, anything achieved in excess represents profit.
For this analysis to be of any use, we must be able to draw up a company's statement of financial
position at the beginning and at the end of a period, so as to place a value on the opening and
closing capital. There are particular difficulties in doing this during a period of rising prices.
In conventional historical cost accounts, assets are stated in the statement of financial position at the
amount it cost to acquire them (less any amounts written off in respect of depreciation or impairment
in value). Capital is simply the difference between assets and liabilities.
For example, consider the following opening and closing statements of financial position of a
company.
Opening Closing
$ $
Inventory (100 items at cost) 500 600
Other net assets 1 000 1 000
Capital 1 500 1 600
Assuming that no new capital has been introduced during the year, and no capital has been
distributed as dividends, the profit shown in historical cost accounts would be $100, being the excess
of closing capital over opening capital. And yet in physical terms the company is no better off: it still
has 100 units of inventory (which cost $5 each at the beginning of the period, but $6 each at the end)
and its other net assets are identical. The 'profit' earned has merely enabled the company to keep
pace with inflation.
An alternative to the concept of capital maintenance based on historical costs is to express capital in
physical terms. On this basis, no profit would be recognised in the example above because the
physical substance of the company is unchanged over the accounting period. Capital is maintained if
at the end of the period the company is in a position to achieve the same physical output as it was at
 114 | THE ACCOUNTING THEORY

the beginning of the period. You should bear in mind that financial definitions of capital maintenance
are not the only ones possible; in theory at least, there is no reason why profit should not be measured
as the increase in a company's physical capital over an accounting period.

6.2 THE UNIT OF MEASUREMENT

Another way to tackle the problems of capital maintenance in times of rising prices is to look at the
unit of measurement in which accounting values are expressed.
It is a basis of conventional accounting, as it has developed over the years, that value should be
measured in terms of money. It is also implicitly assumed that money values are stable, so that $1 at
the start of the financial year has the same value as $1 at the end of that year. But when prices are
rising, this assumption is invalid: $1 at the end of the year has less value (less purchasing power)
than it had one year previously.
This leads to problems when aggregating amounts which have arisen at different times. For example,
a company's non-current assets may include items bought at different times over a period of many
years. They will each have been recorded in $, but the value of $1 will have varied over the period. In
effect, the non-current asset figure in a historical cost statement of financial position is an
aggregate of a number of items expressed in different units. It could be argued that such a figure
is meaningless.
One possibility would be to re-state all accounts items in terms of a stable monetary unit. There would
be difficulties in practice, but in theory there is no reason why a stable unit ($ CPP = $ of current
purchasing power) should not be devised. In this section we will look at a system of accounting
(current purchasing power accounting, or CPP) based on this idea.

6.3 SPECIFIC AND GENERAL PRICE CHANGES

We can identify two different types of price inflation.
When prices are rising, it is likely that the current value of assets will also rise, but not necessarily by
the general rate of inflation. For example, if the replacement cost of a machine on 1 January 20X2 was
$5000, and the general rate of inflation in 20X2 was 8 per cent, we would not necessarily expect the
replacement cost of the machine at 31 December 20X2 to be $5000 plus 8% = $5400. The rate of price
increase on the machinery might have been less than 8 per cent or more than 8 per cent.
(Conceivably, in spite of general inflation, the replacement cost of the machinery might have gone
down.)
 Specific price inflation, which measures price changes over time for a specific asset or group of
assets.
 General price inflation, which is the average rate of inflation, which reduces the general
purchasing power of money.
To counter the problems of specific price inflation some system of current value accounting may be
used (such as current cost accounting). The capital maintenance concepts underlying current value
systems do not attempt to allow for the maintenance of real value in money terms.
Current purchasing power (CPP) accounting is based on a different concept of capital maintenance.

Definition

Current purchasing power (CPP). Measures profits as the increase in the current purchasing power of
equity. Profits are therefore stated after allowing for the declining purchasing power of money due to
price inflation.

When applied to historical cost accounting, CPP is a system of accounting which makes adjustments
to income and capital values to allow for the general rate of price inflation.
 FINANCIAL ACCOUNTING AND REPORTING | 115

6.4 MONETARY AND NON-MONETARY ITEMS

It is obvious that during a period of inflation borrowers benefit at the expense of lenders. A sum
borrowed at the beginning of the year will cost less to repay at the end of the year (although lenders
will seek to allow for this in higher interest charges). Similarly, customers with balances owing benefit
at the expense of suppliers. CPP accounting seeks to remove this gain arising through changes in the
value of money, or 'holding gain'.
Monetary items (cash, receivables, payables) cannot be restated as their amount is fixed.
Non-monetary items (non-current assets and inventories) are restated in line with the general price
index (at $c) and the balancing figure is equity.

Question 3: CPP profits

Rice and Price Co. set up in business on 1 January 20X5 with no non-current assets, and cash of $5000.
On 1 January they acquired inventories for the full $5000, which they sold on 30 June 20X5 for $6000.
On 30 November they obtained a further $2100 of inventory on credit. The index of the general price
level gives the following index figures:
Date Index

MODULE 2
1 January 20X5 300
30 June 20X5 330
30 November 20X5 350
31 December 20X5 360
Required
Calculate the CPP profits (or losses) of Rice and Price for the year to 31 December 20X5.
(The answer is at the end of the module.)

6.5 THE ADVANTAGES AND DISADVANTAGES OF CPP ACCOUNTING

6.5.1 ADVANTAGES
 The restatement of asset values in terms of a stable money value provides a more meaningful
basis of comparison with other companies. Similarly, provided that previous years' profits are
re-valued into CPP terms, it is also possible to compare the current year's results with past
performance.
 Profit is measured in 'real' terms and excludes 'inflationary value increments'. This enables better
forecasts of future prospects to be made.
 CPP avoids the subjective valuations of current value accounting, because a single price index is
applied to all non-monetary assets.
 CPP provides a stable monetary unit with which to value profit and capital.
 Since it is based on historical cost accounting, raw data is easily verified, and measurements of
value can be readily audited.

6.5.2 DISADVANTAGES
 'Generalised purchasing power' as measured by a retail price index, or indeed any other general
price index, has no obvious practical significance.
'Generalised purchasing power has no relevance to any person or entity because no such thing
exists in reality, except as a statistician's computation.' (T A Lee)
 The use of indices inevitably involves approximations in the measurements of value.
 The value of assets in a CPP statement of financial position has less meaning than a current
value statement of financial position. It cannot be supposed that the CPP value of net assets
reflects:
– the general goods and services that could be bought if the assets were released; and
 116 | THE ACCOUNTING THEORY

– the consumption of general goods and services that would have to be forgone to replace those
assets.
In this respect, a CPP statement of financial position has similar drawbacks to an historical cost
statement of financial position (i.e. it is fairly meaningless).

7 CURRENT COST ACCOUNTING (CCA)

LO
2.1 Section overview
 Current cost accounting (CCA) reflects an approach to capital maintenance based on
maintaining the operating capability of a business. Assets consumed or sold, and assets in
the statement of financial position, are measured at their value to the business.

7.1 VALUE TO THE BUSINESS (DEPRIVAL VALUE)

Current cost accounting (CCA) reflects an approach to capital maintenance based on maintaining the
operating capability of a business. The conceptual basis of CCA is that the value of assets consumed
or sold, and the value of assets in the statement of financial position, should be stated at their value
to the business (also known as 'deprival value').
(a) A basic assumption in CCA is that 'capital maintenance' should mean maintenance of the 'business
substance' or 'operating capability' of the business entity. As we have seen already, it is generally
accepted that profit is earned only after a sufficient amount has been charged against sales to
ensure that the capital of the business is maintained. In CCA, a physical rather than financial
definition of capital is used: capital maintenance is measured by the ability of the business entity to
keep up the same level of operating capability.
(b) 'Value to the business' is the required method of valuation in CCA, because it reflects the extra
funds which would be required to maintain the operating capability of the business entity if it
suddenly lost the use of an asset.
The deprival value is the lower of replacement cost and recoverable amount. In turn the recoverable
amount is the higher of net realisable value and economic value.
If the asset is worth replacing, its deprival value will always be net replacement cost. If the asset is
not worth replacing, it might have been disposed of straight away, or else it might have been kept in
operation until the end of its useful life.
We have already seen that if an asset is not worth replacing, the deprival value will be NRV or EV.
However, there are many assets which will not be replaced either:
 because the asset is technologically obsolete, and has been (or will be) superseded by more
modern equipment; or
 because the business is changing the nature of its operations and will not want to continue in the
same line of business once the asset has been used up.
Such assets, even though there are reasons not to replace them, would still be valued (usually) at net
replacement cost, because this 'deprival value' still provides an estimate of the operating capability
of the business.

7.2 CCA PROFITS AND DEPRIVAL VALUE

The deprival value of assets is reflected in the CCA statement of profit or loss by the following means:
 Depreciation is charged on non-current assets on the basis of gross replacement cost of the
asset (where NRC is the deprival value).
 FINANCIAL ACCOUNTING AND REPORTING | 117

 Where NRV or EV is the deprival value, the charge against CCA profits will be the loss in value of
the asset during the accounting period; that is, from its previous carrying value to its current NRV
or EV.
 Goods sold are charged at their replacement cost. Therefore if an item of inventory cost $15 to
produce, and sells for $20, by which time its replacement cost has risen to $17, the CCA profit
would be $3.
$
Sales 20
Less: replacement cost of goods sold 17
Current cost profit 3

7.3 CCA VERSUS ACCOUNTING FOR INFLATION

Worked Example: CCA v accounting for inflation

Suppose that Arthur Smith Co. buys a non current asset on 1 January for $10 000. The estimated life of
the asset is five years, and straight line depreciation is charged. At 31 December the gross
replacement cost of the asset is $10 500 (5 per cent higher than on 1 January) but general inflation

MODULE 2
during the year, as measured by the retail price index, has risen 20 per cent.
(a) To maintain the value of the business against inflation, the asset should be revalued as follows:
$
Gross replacement cost ($10 000  120%) 12 000
Depreciation charge for the year ( 20%) 2 400
Net value in the statement of financial position 9 600

(b) In CCA, the business maintains its operating capability if we revalue the asset as follows:
$
Gross replacement cost 10 500
Depreciation charge for the year (note) 2 100
NRC value in the statement of financial position 8 400

Note: $
Historical cost depreciation 2 000
CCA depreciation adjustment (5%) 100
Total CCA depreciation cost 2 100
CCA preserves the operating capability of the company but does not necessarily preserve it against
the declining value in the purchasing power of money (against inflation). As mentioned previously,
CCA is a system which takes account of specific price inflation (changes in the prices of specific assets
or groups of assets) but not of general price inflation.
A strict view of current cost accounting might suggest that a set of CCA accounts should be prepared
from the outset on the basis of deprival values. In practice, current cost accounts are usually prepared
by starting from historical cost accounts and making appropriate adjustments.

7.4 CCA ACCOUNTS

CCA accounts will include the following adjustments:
1. Depreciation adjustment – to amend depreciation in line with the gross replacement cost of the
asset.
2. Cost of sales adjustment – to take account of increases in inventory prices and remove any element
of profit based on this.
3. Working capital adjustment – to remove any element of profit or loss based on holding payables or
receivables in a period of inflation.
You do not need to know how to do these adjustments, but you can see that they attempt to deal with
the areas where inflation can lead to 'holding gains'.
 118 | THE ACCOUNTING THEORY

7.5 THE ADVANTAGES AND DISADVANTAGES OF CURRENT COST

ACCOUNTING
7.5.1 ADVANTAGES
 By excluding holding gains from profit, CCA can be used to indicate whether the dividends paid to
shareholders will reduce the operating capability of the business.
 Assets are valued after management has considered the opportunity cost of holding them, and the
expected benefits from their future use. CCA is therefore a useful guide for management in
deciding whether to hold or sell assets.
 It is relevant to the needs of information users in:
– assessing the stability of the business entity;
– assessing the vulnerability of the business (e.g. to a takeover), or the liquidity of the business;
– evaluating the performance of management in maintaining and increasing the business
substance; and
– judging future prospects.
 It can be implemented fairly easily in practice, by making simple adjustments to the historical cost
accounting profits. A current cost statement of financial position can also be prepared with
reasonable simplicity.

7.5.2 DISADVANTAGES
 It is impossible to make valuations of EV or NRV without subjective judgments. The measurements
used are therefore not objective.
 There are several problems to be overcome in deciding how to provide an estimate of
replacement costs for non-current assets.
 The mixed value approach to valuation means that some assets will be valued at replacement cost,
but others will be valued at NRV or EV. It is arguable that the total assets will, therefore, have an
aggregate value which is not particularly meaningful because of this mixture of different concepts.
 It can be argued that 'deprival value' is an unrealistic concept, because the business entity has not
been deprived of the use of the asset. This argument is one which would seem to reject the
fundamental approach to 'capital maintenance' on which CCA is based.
 FINANCIAL ACCOUNTING AND REPORTING | 119

KEY MODULE POINTS 1

 A basic principle of accounting is that transactions are normally stated in accounts at their historical
amount.
 There are a variety of other possible methods of measurement:
– Fair value
– Value in use/fulfilment value
– Current cost
 The main advantage of historical cost accounting is that the cost is known and can be proved.
There are also a number of disadvantages and these usually arise in times of rising prices (inflation).
Other disadvantages have arisen as business practice and transactions have become more
complex.
 An accounting theory refers to having a body of knowledge which sets out the rules and
regulations to be followed in accounting for transactions. Accounting theories should guide

MODULE 2
accounting practice and form a basis for the future development of accounting standards. Two
possible accounting theories are positive accounting theory and normative accounting theory.
 A number of alternatives to historical cost accounting have been developed and discussed. It is
unlikely that the IASB will propose a full system of current cost accounting in the near future, but
standards are requiring increasing use of fair values.
 An entity should select the concept of capital that is appropriate to the needs of the users of its
financial statements.
 Two alternative systems which have sought in the past to address the shortcomings of historical
cost accounting are current purchasing power (CPP) and current cost accounting (CCA).
 CPP measures profits as the increase in the current purchasing power of equity. Profits are
therefore stated after allowing for the declining purchasing power of money due to price inflation.
 CCA reflects an approach to capital maintenance based on maintaining the operating capability of
a business.
120 | THE ACCOUNTING THEORY

QUICK REVISION QUESTIONS 1

1 Which statement is correct of the historical cost convention?

A It records only past transactions.
B It fails to take account of changing price levels over time.
C It has been replaced in accounting records by a system of current cost accounting.
D It values all assets at their cost to the business, without any adjustment for depreciation.

2 Under what basis are assets usually valued?

A Historical cost
B Fair value
C Current cost
D Fulfilment value

3 In times of rising prices, what effect does the use of the historical cost concept have on a
company's asset values and profit?
A Asset values and profit both overstated
B Asset values and profit both understated
C Asset values understated and profit overstated
D Asset values overstated and profit understated

4 Korbin Co. buys a machine for $50 000, paying $2 000 delivery charge. It will generate income of
$8 000 per annum for seven years. At the end of seven years it will be scrapped, Korbin will pay a
scrapping fee of $1 000 but will receive $4 000 for the scrap metal. What is its value in use?
A $50 000
B $52 000
C $59 000
D $60 000

5 Ladybird Co. purchased machine four years ago for $12 000, two years ago they paid for an
upgraded component which cost $2 000, the machine is expected to have a useful life of six years.
The machine can be purchased today for $14 000 and the upgrade component for $2 500. What is
the current cost of the machine?
A $4667
B $5000
C $5500
D $5917

6 Which of the following statements is correct?

A Positive accounting theory is not based on actual accounting practice.
B Normative accounting theory attempts to predict actual accounting practice.
C The use of a conceptual framework is an example of positive accounting theory.
D The development of alternatives to historic cost is an example of normative accounting theory.

7 What does the following statement describe?

'The point of reference by which profit is measured; it is a prerequisite for distinguishing between
an entity's return on capital and its return of capital.'
A Fair value
B Historical cost
C Capital maintenance
D Current cost accounting
 FINANCIAL ACCOUNTING AND REPORTING | 121

8 Consider the following statements:

I. Specific price inflation is based on the average rate of inflation.
II. General price inflation measures price changes for a particular group of assets.
Which statements are correct?
A I only
B II only
C Both I and II
D Neither I nor II
9 Which of the following statements about current purchasing power accounting (CPP) are correct?
I. It measures profit as the increase in nominal money capital over the period.
II. It measures profit as the difference between income and expenses after allowing for the effect
of inflation.
III. It measures profit as the difference between income and expenses after ensuring that physical
capital has been maintained.
A II only

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B III only
C I and II only
D I and III only
10 Which of the following is not used as a measure of deprival value?
A Fair value
B Economic value
C Replacement cost
D Net realisable value
11 Historical cost accounting remains in use because of its practical advantages.
Which of the following is not an advantage of historical cost accounting?
A Amounts of transactions are reliable and can be verified
B Amounts in the statement of financial position can be matched to amounts in the statement of
cash flows
C It avoids the overstatement of profit which can arise during periods of inflation
D It provides fewer opportunities for creative accounting than systems of current value accounting
12 Overstatement of profits can arise during periods of inflation. This then leads to a number of other
consequences. Which of the following is not a likely consequence of overstatement of profits?
A Higher wage demands from employees
B Higher tax bills
C Reduced dividends to shareholders
D Overstated EPS
13 Suter Co. acquired an item of plant on 1 January 20X2 at a cost of $500 000. It has a useful life of
five years (straight-line depreciation) and an estimated residual value of 10 per cent of its historical
cost or current cost as appropriate. As at 31 December 20X4, the manufacturer of the plant still
makes the same item of plant and its current price is $600 000.
What is the correct carrying amount to be shown in the statement of financial position of Suter Co.
as at 31 December 20X4 under historical cost and current cost?
Historical cost Current cost
$ $
A 320 000 600 000
B 320 000 384 000
C 300 000 600 000
D 300 000 384 000
122 | THE ACCOUNTING THEORY

14 The 'physical capital maintenance' concept states that profit is the increase in the physical
productive capacity of the business over the period.
What type of accounting is this concept is applied in?
A Current cost accounting
B Historical cost accounting
C Current value accounting
D Current purchasing power accounting
 FINANCIAL ACCOUNTING AND REPORTING | 123

8 AGENCY THEORY

LO
2.2 Section overview
 Agency is extremely important in corporate governance as often the directors/managers
are acting as agents for the owners of the entity. Corporate governance frameworks aim to
ensure directors/managers fulfil their responsibilities as agents by requiring disclosure
and suggesting they be rewarded on the basis of performance.

8.1 NATURE OF AGENCY

Definition

Agency relationship. Is a contract under which one or more persons (the principals) engage another
person (the agent) to perform some service on their behalf that involves delegating some
decision-making authority to the agent. (Jensen and Meckling)

MODULE 2
There are a number of specific types of agent. These have either evolved in particular trades or
developed in response to specific commercial needs. The most common in accounting is the
relationship between directors and shareholders as the shareholders task the directors and
management with running the company on their behalf.

8.2 ACCOUNTABILITY AND FIDUCIARY RESPONSIBILITIES

8.2.1 ACCOUNTABILITY
Definition

In the context of agency, accountability means that the agent is answerable under the contract to
the principal and must account for the resources of the principal and the money gained working on
the principal's behalf.

Potentially two problems arise with this:

1. How does the principal enforce this accountability? – this is the agency problem – see below; as
we shall see, the corporate governance systems developed to monitor the behaviour of directors
have been designed to address this issue.
2. What if the agent is accountable to parties other than their principal? – how does the agent
reconcile possibly conflicting duties?

8.2.2 FIDUCIARY DUTY

Under common law it is usually the case that company directors owe a fiduciary duty to the company
to exercise their powers in what they honestly consider to be the interests of the company. This duty
is owed to the company and not generally to individual shareholders.
Clearly the concepts of fiduciary duty and accountability are very similar though not identical. Where
certain wider responsibilities are laid down in law, do directors have a duty to go beyond the law, or
can they regard the law as defining what society as a whole requires of them?

8.2.3 OTHER DUTIES

 The agent who agrees to act as an agent for a reward has a contractual obligation to perform
their agreed task. An unpaid agent is not bound to carry out their agreed duties. Any agent may
refuse to perform an illegal act.
 124 | THE ACCOUNTING THEORY

 The agent must act strictly in accordance with their principal's instructions provided these are
lawful and reasonable. Even if they believe disobedience to be in their principal's best interests,
they may not disobey instructions. Only if they are asked to commit an illegal act may they do so.
 A paid agent undertakes to maintain the standard of skill and care to be expected of a person in
their profession.
 The agent is typically selected because of their personal qualities and owes a duty to perform their
task themself and not to delegate it to another. But they may delegate in a few special
circumstances, if delegation is necessary, such as a solicitor acting for a client would be obliged to
instruct a stockbroker to buy or sell listed securities on a stock exchange.
 The agent owes to their principal a duty not to put themself in a situation where their own
interests conflict with those of the principal; for example, they must not sell their own property to
the principal even if the sale is at a fair price.
 The agent must keep in confidence what they know of their principal's affairs even after the
agency relationship has ceased.
 Any benefit must be handed over to the principal unless they agree that the agent may retain it.
Although an agent is entitled to their agreed remuneration, they must account to the principal for
any other benefits. If they accept from the other party any commission or reward as an
inducement to make the contract with them, it is considered to be a bribe and the contract is
fraudulent.

8.3 AGENCY IN THE CONTEXT OF THE DIRECTOR-SHAREHOLDER

RELATIONSHIP
Agency is a significant issue in corporate governance because of the dominance of the limited
liability company. For larger companies this has led to the separation of ownership of the company
from its management. The owners (the shareholders) can be seen as the principal, the management
of the company as the agents.
Although ordinary shareholders (equity shareholders) are the owners of the company to whom the
board of directors are accountable as agents, the actual powers of shareholders tend to be restricted.
They normally have no right to inspect the financial records, and their forecasts of future prospects are
gleaned from the annual report and accounts, stockbrokers, journals and daily newspapers.
The day to day running of a company is the responsibility of the directors and other managers to
whom the directors delegate, not the shareholders. For these reasons, therefore, there is the potential
for conflicts of interest between management and shareholders.

8.4 THE AGENCY PROBLEM

The agency problem in limited liability companies derives from the principals (owners) not being able
to run the business themselves and therefore having to rely on agents (directors) to do so for them.
This separation of ownership from management can cause issues if there is a breach of trust by
directors through intentional action, omission, neglect or incompetence. This breach may arise
because the directors are pursuing their own interests rather than those of the shareholders or
because they have different attitudes to risk-taking than the shareholders.
For example, if managers hold none or very little of the share capital of the company they work for,
what is to stop them from working inefficiently, concentrating too much on achieving short-term
profits and hence maximising their own bonuses, not bothering to look for profitable new investment
opportunities, or giving themselves high salaries and benefits (e.g. bonuses and other benefits or
advantages)?
One power that shareholders possess is the right to remove the directors from office. But
shareholders have to take the initiative to do this, and in many companies, the shareholders lack the
energy and organisation to take such a step. Ultimately they can vote in favour of a takeover or
removal of individual directors or entire boards, but this may be undesirable for other reasons.
 FINANCIAL ACCOUNTING AND REPORTING | 125

8.5 AGENCY COSTS

To alleviate the agency problem, shareholders have to take steps to exercise control, such as
attending annual general meetings or ultimately becoming directors themselves. However, agency
theory assumes that it will be expensive and difficult to:
 verify what the agent is doing, partly because the agent has more available information about their
activities than the principal does; and
 introduce mechanisms to control the activities of the agent.
Agency costs arise therefore, from attempts by principals to monitor the activities of agents, and may
be viewed in monetary terms, resources consumed or time taken in monitoring. There will also be
costs involved in establishing methods of control such as contracts. These costs may not just be
incurred by the shareholders. To fulfil the requirements imposed on them and to obtain the rewards of
fulfilment, managers will spend time and resources proving that they are maximising shareholder
value by, for example, providing increased disclosure.
Types of agency costs include salaries paid to directors in their role as agents running the company
on shareholders' behalf. Additionally, the principal incurs monitoring costs to ensure that the agent is
doing what they should be. This can include costs of preparing financial information including

MODULE 2
corporate governance reports, the cost of an external auditor who reports independently on the
financial statements, and the internal audit function (if there is one). An agency cost can also include
the shareholders' personal cost of accepting higher risks than they would perhaps wish to, as they are
tasking the agent with running the business on their behalf.

8.6 RESOLVING THE AGENCY PROBLEM: ALIGNMENT OF INTERESTS

Agency theory sees employees of businesses, including managers, as individuals, each with their own
objectives. Within a department of a business, there are departmental objectives. If achieving these
various objectives leads also to the achievement of the objectives of the organisation as a whole,
there is said to be alignment of interests.

Definition

Alignment of interests. Is agreement between the objectives of agents acting within an organisation
and the objectives of the organisation as a whole. Alignment of interests is sometimes referred to as
goal congruence, although goal congruence may also be used in other ways.

Alignment of interests may be better achieved and the 'agency problem' better dealt with by giving
managers some profit-related pay, or by providing incentives that are related to profits or share price.
Examples of such remuneration incentives are:
 Profit-related/economic value-added pay
Pay or bonuses related to the size of profits.
 Rewarding managers with shares
This might be done when a private company 'goes public' and managers are invited to subscribe
for shares in the company at an attractive offer price. In a management buy-out or buy-in (the
latter involving purchase of the business by new managers; the former by existing managers),
managers become joint owner-managers.
 Executive share option plans (ESOPs)
In a share option scheme, selected employees are given a number of share options, each of which
gives the holder the right after a certain date to subscribe for shares in the company at a fixed
price. The value of an option will increase if the company is successful and its share price goes up,
therefore giving managers an incentive to make decisions to increase the value of the company,
actions congruent with wider shareholder interests.
 126 | THE ACCOUNTING THEORY

Such measures might merely encourage management to adopt 'creative accounting' methods which
will distort the reported performance of the company in the service of the managers' own ends. The
global financial crisis has highlighted issues with the use of such remuneration incentives.
An alternative approach is to attempt to monitor managers' behaviour, for example by establishing
'management audit' procedures, to introduce additional reporting requirements, or to seek
assurances from managers that shareholders' interests will be foremost in their priorities. The most
significant problem with monitoring is likely to be the agency costs involved, as they may imply
significant shareholder engagement with the company.

Definition

Transparency. Means open and clear disclosure of relevant information to shareholders and other
shareholders and also not concealing information when it may affect decisions. It means open
discussions and a default position of information provision rather than concealment.

Disclosure in this context clearly includes information in the financial statements, not just the numbers
and notes to the accounts but also narrative statements such as the directors' report and the
operating and financial review. It also includes all voluntary disclosure, that is disclosure above the
minimum required by law or regulation. Voluntary corporate communications include management
forecasts, analysts' presentations, press releases, information placed on websites and other reports
such as stand-alone environmental or social reports.
The main reason why transparency is so important relates to the agency problem discussed above,
that of the potential conflict between owners and managers. Without effective disclosure the position
could be unfairly weighted towards managers, since they have far more knowledge of the company's
activities and financial situation than owners/investors. Avoidance of this information asymmetry
requires not only effective disclosure rules, but strong internal controls that ensure that the
information that is disclosed is reliable.
Linked with the agency issue, publication of relevant and reliable information underpins stock market
confidence in how companies are being governed and therefore significantly influences market
prices. International accounting standards and stock market regulations based on corporate
governance codes, require information published to be true and fair. Information can only fulfil this
requirement if adequate disclosure is made of uncertainties and adverse events.
Circumstances where concealment may be justified include discussions about future strategy
(knowledge of which would benefit competitors), confidential issues relating to individuals and
discussions leading to an agreed position that is then to be made public.

8.7 OTHER AGENCY RELATIONSHIPS

8.7.1 SHAREHOLDER-AUDITOR RELATIONSHIP
The shareholder-auditor relationship is another agency relationship on which corporate governance
guidance has focused. The shareholders are the principals, the auditors are the agents and the
auditor's report the key method of communication. The agency problem with auditors is that auditors
may not be independent of management; they may become too close or are afraid that management
will not give them more lucrative non-audit work. The Code of Ethics that applies to professional
accounting bodies, such as CPA Australia, guards against such outcomes.

8.7.2 OTHER RELATIONSHIPS

Other significant agency relationships include directors themselves acting as principals to
managers/employees as agents. It is, of course, a significant responsibility of directors to make sure
that this agency relationship works by establishing appropriate systems of performance
measurement and monitoring.
 FINANCIAL ACCOUNTING AND REPORTING | 127

9 INFORMATION PROVIDED IN ANNUAL REPORTS

Section overview
 Reporting performance to shareholders is of key importance as a result of the agency issues
discussed above. Because in many companies the shareholders are not involved in the day
to day running of the company, shareholders and other shareholders rely on the annual
report to provide them with essential information on which to base their investment and
other decisions.

9.1 IMPORTANCE OF REPORTING

One key principle of good corporate governance is for companies to regularly engage in effective and
fair communication with shareholders. Companies should aim to be as descriptive, detailed and
forthcoming as possible.
Good disclosure helps reduce the gap between the information available to directors and the

MODULE 2
information available to shareholders, and therefore addresses one of the key difficulties of the
agency relationship between directors and shareholders.

9.2 REPORTING REQUIREMENTS

Annual reports contain some information which is required by accounting standards or by legislation.
Other information is included voluntarily.

9.2.1 MANDATORY INFORMATION

According to IAS 1 Presentation of Financial Statements, a complete set of financial statements
includes the following components:
 Statement of financial position;
 Statement of profit or loss and other comprehensive income;
 Statement of changes in equity;
 Statement of cash flows;
 Accounting policies and explanatory notes; and
 Comparative information in respect of the preceding period.
The preparation of these statements is the responsibility of the board of directors. IAS 1 also
encourages a financial review by management and the production of any other reports and
statements which may aid users.
The auditor's report must also be disclosed with the financial statements as it provides an
independent opinion as to whether the financial statements show a fair presentation/true and fair view
of the performance and position of the entity and comply with relevant accounting standards.
Reporting requirements are also found in the listing requirements of stock exchanges, for example,
in Australia the Australian Securities Exchange (ASX) Listing Rules. While these rules are not part of
regulatory company supervision, companies who are listed on the ASX must comply with the Listing
Rules. This is the same situation as the UK where the UK Corporate Governance Code is not a
mandatory standard, but companies listed on the London Stock Exchange must prepare corporate
governance disclosure, so for listed companies it becomes a mandatory requirement.
Corporate governance disclosure helps the shareholders understand the way the company is being
run and ensures that the directors have proper procedures in place to deal with accountability, audits,
directors' roles and responsibilities, internal control and relations with shareholders. The disclosures
should explain how the company achieves good corporate governance and should clearly state
instances where the company fails to meet the recommendations of the relevant corporate
governance code, for example, if there is no audit committee.
 128 | THE ACCOUNTING THEORY

9.2.2 NON-MANDATORY INFORMATION

There has been an increasing trend for companies to provide a great deal of additional information in
their annual report. This information is largely voluntary and is disclosed in order to improve
transparency and accountability to shareholders. A company may also take into account the
information wishes of other shareholders such as the local community, environmental pressure groups,
local government and employees. All this means that a company may be reporting to more than just
shareholders and therefore the amount of information disclosed can be very large indeed.
There are a number of different areas of non-mandatory disclosure:
 Social and environmental reporting or sustainability reporting, which includes the nature and
extent of social, transformation, ethical, safety, health and environmental management policies and
practices.
 A business review such as the management commentary which should set out the directors' analysis of
the current and proposed future performance of the business. It should include discussion and
interpretation of the performance of the business and the future risks and prospects of the company.
Note that although this is not required by legislation or accounting standards, and so not mandatory in
that sense, a management commentary is required for listed companies in many jurisdictions, including
Australia, in order to comply with relevant Stock Exchange requirements.
 Risk information – this may detail the work of the risk committee whose role is to identify, assess
and minimise risks facing the organisation.

9.2.3 ADVANTAGES AND DISADVANTAGES OF DISCLOSING NON-MANDATORY

INFORMATION
Disclosing information voluntarily, going beyond what is required by law or listing rules, can be
advantageous for the following reasons:
 Wider information provision
Disclosures covering wider areas than those required by law or regulations should give
shareholders a better idea of the environment within which the company is operating and how it is
responding to that environment. This should enable investors to carry out a more informed analysis
of the strategies the company is pursuing, reducing information asymmetry between directors and
shareholders. (Information asymmetry exists where some shareholders of an entity have access to
more or better information than others.)
 Different focus of information
Voluntary information can be focused on future strategies and objectives, giving readers a different
perspective from compulsory information that tends to be focused on historical accounting data.
 Assurance about management
Voluntary information provides investors with further yardsticks to judge the performance of
management. Its disclosure demonstrates to shareholders that managers are actively concerned
with all aspects of the company's performance.
While the provision of detailed information can be very useful and goes a long way towards achieving
the corporate governance principles of transparency and accountability, the downside is that there is
such a large amount of information that some shareholders may experience 'information overload'. In
response to this, many companies ask shareholders if they want to receive a summarised annual report
and accounts, and then publish the full report and accounts plus the other voluntary information on
their website. This allows users to choose how much they want to read.
For example, Tesco plc, a UK supermarket group, has a vast amount of information on its corporate
website, but users can create their own report by only selecting the information they wish to read and
therefore avoid the information they are not interested in.
Many of the top 20 Australian publicly listed companies allow shareholders to view annual reports
interactively online. This means they can access any annual report or financial statement and launch
interactive features allowing them to navigate through the report or statement as they wish.
 FINANCIAL ACCOUNTING AND REPORTING | 129

Companies providing this feature include BHP Billiton Ltd, Telstra Corporation Ltd., Wesfarmers Ltd.,
the Westfield Group and Woolworths Ltd.
Other disadvantages of the disclosure of non-mandatory information include the following:
 Costs of preparation
The costs of assimilating information in respect of environmental and similar issues may far
outweigh any benefit which the company receives as a result of disclosure.
 Loss of competitive advantage
Particularly where disclosure includes detail of future strategies and objectives, competitors may
gain useful knowledge about a company which they use to improve their own position in the
market.
 Usefulness of information
There is an argument that non-financial non-mandatory information is irrelevant to investors who
are more interested in financial factors in order to asses the return on their investment. Equally,
such information can generally not be compared with like information for other entities due to the
varied performance measures and presentation used.

MODULE 2
10 INFORMATION AVAILABLE TO SHAREHOLDERS

Section overview
 Information available to shareholders comes from a wide variety of sources, including
financial statements, the financial press and the internet.
 Companies have many incentives to provide information. Management needs to
communicate with shareholders, their advisers and the wider public.

10.1 AVAILABILITY OF INFORMATION

Information comes from financial statements, financial databases, the financial press and the internet.
Information provided directly by the company may include:
 Annual financial report;
 Chairman's statement;
 Directors' report;
 Corporate governance statement;
 Corporate social responsibility report;
 Auditors' report; and/or
 Management commentary.

10.2 BENEFITS OF PROVIDING COMPANY INFORMATION TO

SHAREHOLDERS
Earlier in this module, we looked at some of the benefits of disclosing more information than is
actually required by law, accounting standards or other regulations. Later in this module we will look in
more detail at some of the additional information that large listed companies provide to the public as
part of, or alongside, their annual report. Some of this information, such as corporate governance
disclosures, may be required by listing authorities. However, other information, such as a corporate
social responsibility reports, is largely provided voluntarily.
There is an argument that companies provide such information partly through 'peer pressure'. Once a
certain number of organisations are providing a certain type of disclosure, this becomes accepted
'best practice'. 20 years ago, a relatively small number of organisations published an environmental
report, now, most large listed companies do so.
130 | THE ACCOUNTING THEORY

There are other powerful incentives in place to provide information and these are connected with the
need for a company's management to communicate with shareholders, their advisers and the wider
public:
 Conventional financial statements have limitations
They provide historical information, whereas managers and investors need to predict future
performance. Financial statements only recognise monetary transactions and assets and liabilities
that can be measured reliably at a monetary amount. Many organisations are successful as a result
of their intangible assets: technical expertise; patents; software design; human and intellectual
capital. Additional narrative reports enable management to explain a company's future prospects
and the significance of items that do not appear in the main financial statements.
 Complexity and uncertainty
Business operations are complex and affected by changes in the wider economic and political
environment. Management needs to explain the risks and uncertainties that could affect a
company's future performance and position and the actions that it is taking to manage them.
 Openness and transparency
Full disclosure implies that management has nothing to hide and can be trusted. There is an
argument that it is better to disclose 'bad news' than no information at all, particularly as disclosure
provides an opportunity to explain the reasons for a poor performance and to describe the action
that is being taken to ensure that future results will be better.
Information about a company affects share prices. Voluntary disclosure gives management an
opportunity to control the supply of information and to manage its impact on investors, analysts and
the wider public. A company's reputation may be damaged if it fails to disclose bad news in a timely
manner. Silence may lead the market to assume that a company's situation is very much worse than it
actually is.

Question 4: Bad news

Hemlock is a listed entity involved in the business of oil exploration, drilling and refining. The business
has been consistently profitable, creating high returns for its international shareholders. Two years
ago, an environmental group based in Overland started lobbying the government to take action
against Hemlock for alleged destruction of valuable wildlife habitats in Overland's protected wetlands
and the displacement of the local population. Hemlock's legal advisers assessed the risk of liability at
less than 50 per cent. A contingent liability of $250 million was noted in the financial statements to
cover possible fines, legal costs, compensation to displaced persons and reinstatement of the
habitats.
Hemlock is currently preparing its financial statements for the year ended 31 December 20X9. Recent
advice from the entity's legal advisers has assessed that the risk of a successful action against Hemlock
has increased, and must now be regarded as more likely than not to occur. The directors accept that a
provision of $250 million is required. The draft financial statements show that without the provision,
operating profit margin and earnings per share both show a substantial increase on the previous year.
However, recognising the provision will have an adverse effect on the financial statements for 20X9.
Although the reported result for the year will still be a profit, both operating profit and earnings per
share will be significantly lower than the comparative amounts for 20X8.
The directors are concerned about the potentially adverse effect on the share price. In addition, they
feel that the reputation of the company will probably be damaged. The chief executive makes the
following suggestion:
We should publish an environmental and social report. Most of our competitors do this now. This
would give us the opportunity to publicise the many good things that we do to care for the
environment and it might help to deflect some of the public attention from us over the problems in
Overland. It would be a good public relations opportunity as well; we can use it to tell people
about our work with charities and our equal opportunities program. We could probably pull
something together to go out with this year's annual report.
 FINANCIAL ACCOUNTING AND REPORTING | 131

Required
(a) Briefly discuss the directors' view that the company's share price and its reputation will be
adversely affected as a result of recognising the provision in the financial statements for 20X9.
(b) Identify the advantages and disadvantages to Hemlock of adopting the Chief Executive's proposal
to publish an environmental and social report.
(The answer is at the end of the module.)

11 CONTENT OF COMPANY REPORTS

Section overview
 The annual financial report consists of the main financial statements together with notes
and other explanatory material.
 Other information provided with the annual financial report may include the following:

MODULE 2
– Chairman's statement
– Directors' report
– Corporate governance statement
– Corporate social responsibility report
– Auditor's report
– Management commentary.

11.1 ANNUAL FINANCIAL REPORT

The annual financial report consists of the main financial statements together with notes and other
explanatory material. The primary statements are cross-referenced to the notes.
IAS 1 explains that the notes are normally presented in the following order:
1. A statement of compliance with IFRSs
2. A summary of significant accounting policies adopted
3. Supporting information for items presented in the primary statements in the order in which each
statement and each line item is presented
4. Other disclosures, including details of the company's contingent liabilities and contractual
commitments not recognised in the financial statements; and non-financial disclosures, such as the
company's policies for managing risk connected with its financial instruments
The disclosures relating to accounting policies should include details of any significant judgments
that management has made in applying the policies chosen, assumptions that it has made about the
future and of other major sources of estimation uncertainty at the end of the reporting period.

11.2 CHAIRMAN'S STATEMENT

This is usually a fairly brief overview of the key achievements of the company in the period. The
statement is voluntary and in theory it can contain whatever information the Chairman or the
management wish. It may be used to provide users with important information about the future
strategy of the company, but it normally emphasises the positive aspects of the company's
performance in the past year. It may include some summary financial information or non-financial
measures (often presented as graphs or charts) or it may consist entirely of narrative content. The
Chairman's statement can be incorporated as part of the Directors' report as is commonly the case
with the annual reports of Australian companies.
 132 | THE ACCOUNTING THEORY

11.3 DIRECTORS' REPORT

In many countries, including Australia and the UK, the content of the Directors' report is prescribed by
companies legislation. In Australia, the Corporations Act 2001 requires that the report must include
general information about the company and its activities, including:
 a review of its operations during the year and the results of those operations;
 details of any significant changes in the entity's state of affairs during the year;
 the entity's principal activities during the year and any significant changes in the nature of those
activities during the year;
 details of any matter or circumstance that has arisen since the end of the year that has
significantly affected, or may significantly affect the entity's operations in future financial years; and
 details of likely developments in the entity's operations in future financial years and the
expected results of those operations.
The directors' report must also include:
 dividends paid during the year; and
 the name of each person who has been a director of the company during the year.
Public and/or listed companies may be required to disclose additional information about each
director's qualifications, experience or special responsibilities; their attendance at board and
committee meetings during the year; and their interests in the company's shares, debentures, or share
options.
In many jurisdictions, including Australia, the directors' report must also include detailed disclosures
about directors' remuneration, including performance related remuneration (for example, bonus
payments dependent on the company's results or movements in its share price). In some jurisdictions,
this information may be provided in a separate report, or as part of corporate governance disclosures
(see below).

Question 5: Purpose of the directors' report

The only objective of general purpose financial reporting is to provide existing and potential
investors, lenders and other creditors with information that is useful in making economic decisions.
Required
In relation to the directors' report, is this statement correct or incorrect?
(The answer is at the end of the module.)

11.4 CORPORATE GOVERNANCE STATEMENT

Corporate governance is the system by which companies are directed and controlled.

Definition

Corporate governance. Is the framework of rules, relationships, systems and processes within and by
which authority is exercised and controlled in corporations. It encompasses the mechanisms by which
companies, and those in control, are held to account. (Australian Securities Exchange)

The directors are responsible for the governance of their companies. Most listing authorities require
companies to comply with codes of corporate governance as a condition of listing. A code of
corporate governance requires the directors to set up a system of controls and procedures to
ensure that the company is being run effectively for the benefit of the shareholders.
 FINANCIAL ACCOUNTING AND REPORTING | 133

Listed companies must include a corporate governance statement in their annual report. Many listing
authorities, including the ASX and the London Stock Exchange, have adopted the 'if not, why not?'
approach, whereby companies are required to disclose the extent to which they have followed the
recommendations or principles set out in the code in the reporting period. Where companies have
not followed all the recommendations, they must identify those that have not been followed and give
reasons for not following them. Other listing authorities may require a different approach.
The ASX sets out eight fundamental principles of corporate governance in its Corporate Governance
Principles and Recommendations document which is to:
1. lay solid foundations for management and oversight
2. structure the board to add value
3. act ethically and responsibly
4. safeguard integrity in corporate reporting
5. make timely and balanced disclosure
6. respect the rights of security holders
7. recognise and manage risk
8. remunerate fairly and responsibly.

MODULE 2
In practice the corporate governance guidance includes descriptions of the roles and responsibilities
of the directors, procedures put in place to maintain the independence of non-executive directors,
relationships with external auditors, investors and other key shareholders. It shows the members of the
board who sit on the various committees, such as audit, remuneration and nomination committees. It
also describes and explains the systems that the directors have put in place to manage risk, including
the company's internal control systems.

11.5 CORPORATE SOCIAL RESPONSIBILITY REPORT

Most large listed entities present a corporate social responsibility report of some kind, either as part of
their annual report, or as a stand-alone document. The corporate social responsibility report provides
information about the way in which a company's activities have affected the natural environment
and the community in which it operates. It describes and explains the actions it has taken to
safeguard the environment and to act in an ethical and socially responsible manner towards its
employees and other people affected by its activities.
Corporate social responsibility reports may be called environmental, social or sustainability reports.
Information about corporate social responsibility may also be included in the directors' report (see
above) or in the management commentary (see below).
Most jurisdictions now encourage companies to provide information and companies legislation may
contain limited reporting requirements. In the UK, quoted companies must include information about
the impact of the company's business on the environment; the company's employees; and information
about social and community issues in the directors' report. However, most corporate social
responsibility reporting is voluntary. Although there are a number of published guidelines and codes
of practice (of which the most important are the Sustainability Reporting Guidelines published by the
Global Reporting Initiative (GRI)), there are no disclosure or reporting requirements within IFRS.
Therefore companies can disclose whatever information they wish or as much or as little as they
wish.
While some reports are mainly public relations exercises, many now provide useful information,
including key performance measures, with comparatives for previous periods. Many companies now
present reports that have been audited or accredited under the GRI or similar guidelines.
134 | THE ACCOUNTING THEORY

Case study: Sustainability report

Below is an extract from the 2012 Sustainability Report of Origin Energy, a company included in the
Dow Jones Sustainability Asia Pacific Index and the FTSE 4 Good Index. This report is a separate
stand-alone report, intended for a wide range of shareholders including shareholders, customers,
communities and employees. It includes photographs, diagrams, charts and a glossary. It reports the
company's progress against a series of five year objectives that were set in 2007.
FINANCIAL ACCOUNTING AND REPORTING | 135

MODULE 2
136 | THE ACCOUNTING THEORY

Reproduced with permission from Origin Energy Limited

You may like to compare this report with that of Newcrest Mining Limited www.newcrest.com.au.
Newcrest Mining reports under the GRI Sustainability Reporting Guidelines, which are extremely
detailed and cover three areas: Economic Performance, Environmental Performance and Social
Performance. The full report is very lengthy and probably intended to be read mainly by corporate
investors and industry experts.
 FINANCIAL ACCOUNTING AND REPORTING | 137

11.6 AUDITOR'S REPORT

The auditor's report sets out the auditor's opinion of the financial statements. It states whether, in the
auditor's opinion, the financial statements show a true and fair view/fair presentation of the financial
performance and financial position of the entity. The exact wording of the report is normally set out in
auditing standards and guidelines.
The following is an example of an auditor's report per International Standards on Auditing (ISA),
specifically ISA 700 (Revised) Forming an Opinion and Reporting on Financial Statements (ISAs are
outside the scope of the FAR syllabus):
INDEPENDENT AUDITOR'S REPORT
To the Shareholders of ABC Company [or Other Appropriate Addressee]
Report on the Audit of the Financial Statements
Opinion
We have audited the financial statements of ABC Company (the Company), which comprise the
statement of financial position as at 31 December 20X1, and the statement of comprehensive income,
statement of changes in equity and statement of cash flows for the year then ended, and notes to the

MODULE 2
financial statements, including a summary of significant accounting policies.
In our opinion, the accompanying financial statements present fairly, in all material respects, (or give a
true and fair view of) the financial position of the Company as at 31 December 20X1, and (of) its
financial performance and its cash flows for the year then ended in accordance with International
Financial Reporting Standards (IFRSs).

Basis for Opinion

We conducted our audit in accordance with International Standards on Auditing (ISAs). Our
responsibilities under those standards are further described in the Auditor's Responsibilities for the
Audit of the Financial Statements section of our report. We are independent of the Company in
accordance with the International Ethics Standards Board for Accountants' Code of Ethics for
Professional Accountants (IESBA Code) together with the ethical requirements that are relevant to our
audit of the financial statements in [jurisdiction], and we have fulfilled our other ethical responsibilities
in accordance with these requirements and the IESBA Code. We believe that the audit evidence we
have obtained is sufficient and appropriate to provide a basis for our opinion.
Key Audit Matters
Key audit matters are those matters that, in our professional judgment, were of most significance in
our audit of the financial statements of the current period. These matters were addressed in the
context of our audit of the financial statements as a whole, and in forming our opinion thereon, and
we do not provide a separate opinion on these matters.
Responsibilities of Management and Those Charged with Governance for the Financial
Statements
Management is responsible for the preparation and fair presentation of the financial statements in
accordance with IFRSs, and for such internal control as management determines is necessary to
enable the preparation of financial statements that are free from material misstatement, whether due
to fraud or error.
In preparing the financial statements, management is responsible for assessing the Company's ability
to continue as a going concern, disclosing, as applicable, matters related to going concern and using
the going concern basis of accounting unless management either intends to liquidate the Company or
to cease operations, or has no realistic alternative but to do so.
Those charged with governance are responsible for overseeing the Company's financial reporting
process.
Auditor's Responsibilities for the Audit of the Financial Statements
Our objectives are to obtain reasonable assurance about whether the financial statements as a whole
are free from material misstatement, whether due to fraud or error, and to issue an auditor's report
that includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee
138 | THE ACCOUNTING THEORY

that an audit conducted in accordance with ISAs will always detect a material misstatement when it
exists. Misstatements can arise from fraud or error and are considered material if, individually or in the
aggregate, they could reasonably be expected to influence the economic decisions of users taken on
the basis of these financial statements.
As part of an audit in accordance with ISAs, we exercise professional judgment and maintain
professional scepticism throughout the audit. We also:
 Identify and assess the risks of material misstatement of the financial statements, whether due to
fraud or error, design and perform audit procedures responsive to those risks, and obtain audit
evidence that is sufficient and appropriate to provide a basis for our opinion. The risk of not
detecting a material misstatement resulting from fraud is higher than for one resulting from error,
as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override
of internal control.
 Obtain an understanding of internal control relevant to the audit in order to design audit
procedures that are appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control.
 Evaluate the appropriateness of accounting policies used and the reasonableness of accounting
estimates and related disclosures made by management.
 Conclude on the appropriateness of management's use of the going concern basis of accounting
and, based on the audit evidence obtained, whether a material uncertainty exists related to events
or conditions that may cast significant doubt on the Company's ability to continue as a going
concern. If we conclude that a material uncertainty exists, we are required to draw attention in our
auditor's report to the related disclosures in the financial statements or, if such disclosures are
inadequate, to modify our opinion. Our conclusions are based on the audit evidence obtained up
to the date of our auditor's report. However, future events or conditions may cause the Company
to cease to continue as a going concern.
 Evaluate the overall presentation, structure and content of the financial statements, including the
disclosures, and whether the financial statements represent the underlying transactions and events
in a manner that achieves fair presentation.
We communicate with those charged with governance regarding, among other matters, the planned
scope and timing of the audit and significant audit findings, including any significant deficiencies in
internal control that we identify during our audit. We also provide those charged with governance with
a statement that we have complied with relevant ethical requirements regarding independence, and
to communicate with them all relationships and other matters that may reasonably be thought to bear
on our independence, and where applicable, related safeguards. From the matters communicated
with those charged with governance, we determine those matters that were of most significance in the
audit of the financial statements of the current period and are therefore the key audit matters. We
describe these matters in our auditor's report unless law or regulation precludes public disclosure
about the matter or when, in extremely rare circumstances, we determine that a matter should not be
communicated in our report because the adverse consequences of doing so would reasonably be
expected to outweigh the public interest benefits of such communication.
Report on Other Legal and Regulatory Requirements
The form and content of this section of the auditor's report would vary depending on the nature of the
auditor's other reporting responsibilities prescribed by local law, regulation, or national auditing
standards. The matters addressed by other law, regulation or national auditing standards (referred to
as 'other reporting responsibilities') shall be addressed within this section unless the other reporting
responsibilities address the same topics as those presented under the reporting responsibilities
required by the ISAs as part of the Report on the Audit of the Financial Statements section. The
reporting of other reporting responsibilities that address the same topics as those required by the
ISAs may be combined (i.e. included in the Report on the Audit of the Financial Statements section
under the appropriate subheadings) provided that the wording in the auditor's report clearly
differentiates the other reporting responsibilities from the reporting that is required by the ISAs where
such a difference exists. The engagement partner on the audit resulting in this independent auditor's
 FINANCIAL ACCOUNTING AND REPORTING | 139

report is [name]. [Signature in the name of the audit firm, the personal name of the auditor, or both, as
appropriate for the particular jurisdiction]
[Auditor Address]
[Date]
This is an unmodified (unqualified), or 'clean' audit report. The financial statements give a true and fair
view.
Modified audit opinions are rare, and may arise due to material misstatements or a lack of sufficient
appropriate audit evidence. Because of the potential damage to a company's reputation,
management and auditors normally resolve any disagreements. The financial statements are adjusted
if this is necessary. A modified audit opinion states that the financial statements give a true and fair
view or a fair presentation except for a particular matter or matters. Where problems are pervasive
(fundamental), the auditor can either disclaim an opinion (due to a lack of sufficient appropriate audit
evidence that is both material and pervasive) or give an adverse opinion (due to a misstatement that is
both material and pervasive).

11.7 MANAGEMENT COMMENTARY

MODULE 2
Definition

Management commentary. Is a narrative report that relates to financial statements that have been
prepared in accordance with IFRSs. Management commentary provides users with historical
explanations of the amounts presented in the financial statements, specifically the entity's financial
position, financial performance and cash flows. It also provides commentary on an entity's prospects
and other information not presented in the financial statements. Management commentary also
serves as a basis for understanding management's objectives and its strategies for achieving those
objectives. (IFRS Practice Statement: Management Commentary)

Most listed companies present a management commentary of some kind. Although this is not
required by IFRS or normally by companies legislation, it may be required by listing authorities and is
generally regarded as best practice. A management commentary is sometimes called an Operating
and Financial Review or a Management Discussion and Analysis.
The purpose of a management commentary is to provide users with information that helps them
place the related financial statements in context. It explains management's view on not only what
has happened, but also why management believes it has happened and what management believes
the implications are for the entity's future.
The IASB has issued a Practice Statement Management Commentary that sets out general principles
that should be followed when preparing management commentary and elements that should be
included in it, but compliance is not mandatory. The Practice Statement does not prescribe the form
and content of the report in detail because this will depend on the nature of the entity's business and
its circumstances.
The principles are that management commentary should:
 provide management's view of the entity's performance, position and progress;
 supplement and complement the information in the financial statements; and
 include forward-looking information.
A management commentary should include information that is essential to an understanding of:
 the nature of the business;
 management's objectives and strategies for meeting those objectives;
 the entity's most significant resources, risks and relationships;
 the results of operations and prospects; and
 the critical performance measures and indicators that management uses to evaluate the entity's
performance against stated objectives (sometimes called Key Performance Indicators or KPIs).
140 | THE ACCOUNTING THEORY

Case study: Bunnings (a Wesfarmers' business)

Below is an extract from the 2012 Annual Report of Wesfarmers Limited. The Annual Report includes a
Finance Director's Review, a commentary on the group's results, cash flow, statement of financial
position, debt management, equity management, dividend policy, risk management and internal
control and assurance. The Annual Report then considers each of the company's main operations in
turn using the same headings for each: the business (a brief description); strategy; results; year in brief;
business sustainability; and outlook.

Reproduced with permission from Wesfarmers Limited

 FINANCIAL ACCOUNTING AND REPORTING | 141

KEY MODULE POINTS 2

 Agency is extremely important in corporate governance as often the directors/managers are acting
as agents for the owners. Corporate governance frameworks aim to ensure directors/managers
fulfil their responsibilities as agents by requiring disclosure and suggesting they be rewarded on
the basis of performance.
 Annual reports must convey a fair and balanced view of the organisation. They should state
whether the organisation has complied with governance regulations and codes. It is considered
best practice to give specific disclosures about the board, internal control reviews, going concern
status and relations with shareholders.
 Information provided by a company to its shareholders may come from the following sources,
although this may vary in different jurisdictions:
– Annual financial report
– Chairman's statement

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– Directors' report
– Corporate governance statement
– Corporate social responsibility report
– Auditor's report
– Management commentary
 Information may also be obtained from press reports, financial databases, the internet etc.
142 | THE ACCOUNTING THEORY

QUICK REVISION QUESTIONS 2

1 What does the following statement define?

'A contract under which one or more persons engage another person to perform some service on
their behalf.'
A Accountability
B Agency theory
C Principal theory
D Substance over form

2 Fiduciary duty is:

A the directors running a company on behalf of the shareholders.
B the need for directors to prepare financial statements that show a true and fair view.
C the need for directors to disclose their personal shareholding in a company they manage.
D the need for directors to act in the best interests of the company and not out of self-interest.

3 Which of the following are examples of agency costs?

I. Directors' salaries
II. External audit fees
III. Finance department salaries

A I only
B II only
C I and II only
D I, II and III

4 According to IAS 1 Presentation of Financial Statements, which of the following are mandatory
disclosures in the annual financial report?
I. Risk review
II. Accounting policies
III. Environmental report
IV. Statement of profit or loss

A IV only
B II and IV only
C I, II and IV only
D I, II, III and IV

5 ABC Co. is a large company, listed on the ASX. Which of the following items is it required to
prepare as part of its annual financial report?
I. A Chairman's Statement
II. A corporate governance report

A I only
B II only
C Both I and II
D Neither I nor II
 FINANCIAL ACCOUNTING AND REPORTING | 143

6 Which of the following must be disclosed in a non-listed company's annual report?

A Accounting policies
B Environmental report
C Management commentary
D Corporate governance statement
7 Who is responsible for the preparation of the financial statements?
A The external auditors.
B The finance director.
C The board of directors.
D The internal audit department.
8 Which of the following statements is/are correct?
I. Paying management fixed levels of pay, helps to alleviate the agency problem
II. Incentive schemes for managers such as profit related pay can lead to creative accounting

A I only
B II only

MODULE 2
C Both I and II
D Neither I nor II
9 If an auditor is unable to gather the evidence needed on their audit due to a fire destroying most
of a company’s accounting records, what type of audit opinion should they give?
A Unqualified
B Modified
C Disclaimer
D Adverse
10 Which of the following statements is/are correct?
I. A management commentary should provide management's view of the entity's performance,
position and progress
II. A management commentary should focus on the comparison of the current year’s results with
previous periods

A I only
B II only
C Both I and II
D Neither I nor II
11 Which of the following does not form part of a company’s main financial statements?
A Statement of cash flows
B Directors' report
C Notes to the accounts
D Statement of financial position
144 | THE ACCOUNTING THEORY

ANSWERS TO QUICK REVISION QUESTIONS 1

1 B Under the historical cost convention, assets are recorded at the amount of cash or cash
equivalents paid or the fair value of the consideration given to acquire them at the time of their
acquisition.
2 A Historical cost is the measurement basis most widely applied in financial statements.
3 C Assets will tend to be understated and profits overstated due to low depreciation charges.
4 C (($8 000  7) + ($4 000 – $1 000)) = $59 000.
5 C Cost of new machine and upgrade part ($14 000 + $2 500)  2/6 = $5 500
6 D Positive accounting theory is based on actual accounting practice. Normative accounting theory
explains what should occur rather than predicting what actually does occur.
7 C Capital maintenance. An entity has maintained its capital if the net assets total at the end of the
period is the same as that at the beginning of the period. If capital (assets less liabilities) is
greater at the end of the period than at the beginning, the entity has made a profit.
8 D Specific price inflation measures price changes over time for a specific group of assets. General
price inflation is the average rate of inflation that reduces the general purchasing power of
money.
9 A Statement III refers to current cost accounting. Statement I refers to historical cost accounting.
10 A Deprival value is the lower of replacement cost and recoverable value. Recoverable value is the
higher of sales value (net realisable value) and value in use (economic value).
11 C It avoids the overstatement of profit which can arise during periods of inflation. Historical cost
accounting does not avoid the overstatement of profit which arises during periods of inflation,
which is why alternative models have been proposed.
12 C In the case of C, what tends to happen when profits are overstated is that too much cash is paid
out in dividends to shareholders, depleting funds needed for investment. It is a widely held
principle that distributable profits should only be recognised after full allowance has been made
for any erosion in the capital value of a business. In historical cost accounts, although capital is
maintained in nominal money terms, it may not be in real terms. So, inflated profits may be
distributed to the detriment of the long-term viability of the business.
13 B $320 000 Historical cost; $384 000 current cost
Historical cost Current cost
$'000 $'000
Cost/valuation 500 600
Depreciation ((500 000 × 90%) / 5) × 2 (180)
Depreciation ((600 000 × 90%) / 5) × 2 (216)
Carrying amount 320 384

14 A Current cost accounting

 FINANCIAL ACCOUNTING AND REPORTING | 145

ANSWERS TO QUICK REVISION QUESTIONS 2

1 B An agency relationship involves a contract under which the principals engage the agent to
perform some service on their behalf and delegate some decision-making authority to the
agent.
2 D Company directors owe a fiduciary duty to a company to exercise their powers in what they
honestly consider to be the interests of the company. This duty is owed to the company and not
generally to individual shareholders.
3 C Agency costs include:
 salaries paid to directors in their role as agents
 monitoring costs to ensure that the agent is doing what they should be (such as the costs of
preparing financial information, the cost of an external auditor and the internal audit
function).
4 B Other mandatory items include the statement of financial position, statement of cash flows and

MODULE 2
statement of changes in equity. Narrative reports such as a risk review and environmental report
are not mandatory, however these may be included in the annual report.
5 B The corporate governance report is required as part of the listing rules. The Chairman's
Statement is voluntary.
6 A Per IAS 1, accounting policies must be disclosed. Provision of a corporate governance
statement would be good practice but as the company is unlisted it is not mandatory.
7 C The board of directors. They may delegate their responsibility to the finance department but
they will still retain the overall responsibility.
8 B Paying management element of profit related pay can help alleviate the agency problem as it
incentivises management to work on behalf of the company, therefore item I is incorrect.
However incentive schemes can also lead to creative accounting and manipulation of financial
statements if mangers are reliant on results to earn salary/bonus.
9 C Disclaimer.
10 A A management commentary should include the management’s view of the business, it should
also have some elements that are forward looking, therefore statement 2 is incorrect.
11 B The directors' report is part of the other information included in a financial report, it is not part
of the main financial statements themselves.
146 | THE ACCOUNTING THEORY

ANSWERS TO MODULE QUESTIONS

1 Historic cost – $75 000  12/15 = $60,000

Current cost – $80 000  12/15 = $64 000
2 Historical cost accounting makes extensive use of subjective estimates, for example, useful lives of
assets, allowances for doubtful receivables and inventory valuation.
It can be argued that some users are confused by historical cost accounts. Non-accountants may
believe that the statement of financial position shows the actual value of an entity's assets and
liabilities, rather than their cost.
3 The approach is to prepare a CPP statement of profit or loss.
$c $c
Sales (6000  360/330) 6 545
Less: cost of goods sold (5000  360/300) 6 000
545
Loss on holding cash for 6 months* (545)
Gain by owing payables for 1 month** 60
485
CPP profit 60

* ($6000  360/330) – $6000 = $c 545

**($2100  360/350) – $2100 = $c 60
Note that under historic cost accounting the gross profit would be $1000 ($6000 – $5000).
4 (a) The directors are probably justified in fearing that the fall in operating profit will have an
adverse effect on the share price in the short term, particularly as investors often look at
earnings per share in isolation.
However, the company is still profitable. A contingent liability for the same amount was
disclosed two years ago, so analysts will have had some warning that this situation might arise.
It should also be clear that this is a 'one off' expense and that otherwise the company has
performed strongly during the year. In the medium term the company's share price will
probably recover. There may be advantages in getting the bad news over quickly; analysts may
feel that it is better to be aware of the worst case scenario.
(b) Advantages of publishing an environmental and social report:
 It would probably enhance the company's reputation. Hemlock would appear to be
responding to the information needs of all its shareholders, not just providers of capital.
 Ethical and 'green' issues are becoming increasingly important to customers, suppliers,
employees and the general public. If Hemlock is genuinely able to demonstrate that it is
aware of its corporate social responsibilities this may improve its performance and share
price in the longer term.
Disadvantages of publishing an environmental and social report:
 If the report is to be taken seriously and to reflect well upon the company it must not be
perceived as a public relations exercise but a genuine attempt to provide useful information.
It must be at least as good as those of the company's competitors, otherwise it may damage
Hemlock's reputation, rather than enhance it.
 The report will be time consuming and costly to prepare. It will not be possible to 'pull
something together'. To be credible, the report should include performance indicators and
these should remain the same from year to year, even if performance declines in those areas.
 FINANCIAL ACCOUNTING AND REPORTING | 147

5 The statement is incorrect. The directors' report does provide useful information for making
economic decisions, but that is not its only purpose. The information disclosed helps shareholders
to assess the stewardship of management. Investors need to know how efficiently and effectively
the directors have discharged their responsibility to use the entity's resources to generate returns.
In particular, the information about directors' remuneration is largely provided so that shareholders
will be aware of any attempts by the directors to reward themselves excessively.

MODULE 2
148 | THE ACCOUNTING THEORY
 149

MODULE 3
FINANCIAL STATEMENTS
Learning objectives Reference

Prepare and present the statement of profit or loss and other comprehensive income LO3.1
with appropriate disclosure in accordance with relevant accounting standards and
policies

Prepare and present the statement of financial position with appropriate disclosure in LO3.2
accordance with relevant accounting standards and policies

Prepare and present the statement of cash flows in accordance with relevant accounting LO3.3
standards and policies

Demonstrate the ability to detect, investigate and correct discrepancies or particular LO3.4
items/events while matching the financial statements to supporting documentation

Topic list

1 IAS 1 Presentation of Financial Statements

2 Statement of financial position
3 Statement of profit or loss and other comprehensive income
4 Statement of changes in equity
5 Notes to the financial statements
6 IAS 7 Statement of Cash Flows
7 Preparing a statement of cash flows
8 Internal control, and the role of internal and external auditors
150 | FINANCIAL STATEMENTS

MODULE OUTLINE

The bulk of this Study guide looks at the financial statements of limited liability companies, either
single companies or groups.
We begin this module by looking at the overall content and format of company financial statements.
These are governed by IAS 1 Presentation of Financial Statements.
In the long run, a profit will result in an increase in the company's cash balance but, in the short run,
this will not necessarily be the case. There is an important distinction between cash and profit. The
statement of financial position and statement of profit or loss and other comprehensive income do
not tell us whether the company has, or will be able to generate, sufficient cash to finance its
operations. The importance of the distinction between cash and profit and the scant attention paid
to this by the statement of profit or loss and other comprehensive income has resulted in the
development of statements of cash flows.
This module adopts a systematic approach to the preparation of all the components of statements of
cash flows in examinations; you should learn this method and you will then be equipped for all
questions in the exam.
At the end of this module, we briefly look at internal control, and the role of internal and external
auditors in the audit of an entity's financial statements.
The module content is summarised in the diagrams below.

Financial statements

IAS 1 Presentation of
Financial Statements

Statement of Statement of profit or loss

Statement of
financial position and other comprehensive
changes in equity
(SFP) income (SPLOCI)

• Assets and liabilities • Reconciles opening share • Shows total comprehensive

split between current capital and reserves to\ income made up of profit
and non-current closing showing transactions or loss and other
• Certain items with shareholders in capacity comprehensive income
presented on face of as shareholders • One or two statements
SFP • Total comprehensive • Certain items presented
• Certain items income shown in aggregate on face of SPLOCI
disclosed in notes • Certain items disclosed in
notes

Notes to the financial statements

 FINANCIAL ACCOUNTING AND REPORTING | 151

Advantages of cash flow information

Profit vs cash • Not affected by accounting
conventions
• Profit is desirable in the
long term but in the • Better for comparisons
short term, cash is needed • Cash flow forecasts more useful than
to meet commitments profit forecasts

Statement of
cash flows

Cash flows from Cash flows from Cash flows from

operating activities investing activities financing activities

Direct or indirect
method

Cash from operations Sales and purchases of Issues of shares

MODULE 3
non-current assets
Income taxes Issues and redemption
of debt

Change in cash and

cash equivalents

Financial statements: Module summary diagrams

152 | FINANCIAL STATEMENTS

BEFORE YOU BEGIN

If you have studied these topics before, you may wonder whether you need to study this module in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the module to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the module you can find the information, and you
will also find a commentary at the back of the Study guide.
1 What is the format of the statement of financial position required by IAS 1? (Section 3.2.1)
2 What is the format of the statement of profit or loss required by IAS 1? (Section 3.1)
3 When should an asset be classified as a current asset according to IAS 1? (Section 2.3.1)
4 When should a liability be classified as a current liability according to IAS 1? (Section 2.3.2)
5 What is other comprehensive income? (Section 3)
6 Which items must be reported in the profit or loss section of the statement of
profit or loss as a minimum according to IAS 1? (Section 3.2.2)
7 What is the purpose of a statement of changes in equity? (Section 4)
8 Why are notes to the financial statements required? (Section 5.1)
9 Why is a statement of cash flows useful to users of the financial statements? (Section 6)
10 What are cash equivalents? (Section 6.3 and 6.4)
11 What three classifications of cash flows are required by IAS 7? (Section 6.5)
12 How is cash generated by operations calculated using the direct method? (Section 6.6.1)
13 How is cash generated by operations calculated using the indirect method? (Section 6.6.2)
14 What are the advantages of cash flow accounting rather than accounting on an
accruals basis? (Section 7.4)
15 What is the role of the internal and external auditors in the audit of an entity's
financial statements? (Section 8)
 FINANCIAL ACCOUNTING AND REPORTING | 153

1 IAS 1 PRESENTATION OF FINANCIAL

STATEMENTS

LO
3.1 Section overview
 IAS 1 covers the form and content of financial statements. The main components are:
– statement of financial position
– statement of profit or loss and other comprehensive income
– statement of changes in equity
– statement of cash flows
– notes to the financial statements

IAS 1 Presentation of Financial Statements gives substantial guidance on the form and content of
published financial statements. The Standard looks at the statement of financial position and
statement of profit or loss and other comprehensive income (the statement of cash flows is covered by
IAS 7 Statement of Cash Flows, which we cover in detail in sections 6 and 7 of this module).

1.1 PROFIT OR LOSS FOR THE PERIOD

The statement of profit or loss and other comprehensive income shows a company's financial
performance. So it is important to ensure that it is not misleading.
IAS 1 stipulates that all items of income and expense recognised in a period should be included in
profit or loss unless a Standard or an Interpretation requires otherwise.
Circumstances where items may be excluded from profit or loss for the current year include the
correction of errors and the effect of changes in accounting policies. These were covered in Module 1

MODULE 3
when we looked at IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.

1.2 HOW ITEMS ARE DISCLOSED

IAS 1 specifies disclosures of certain items in certain ways.
 Some items must appear in the statement of financial position or statement of profit or loss and
other comprehensive income.
 Other items can appear in a note to the financial statements instead.
 Recommended formats are given.
Disclosures are specified by other Standards and we will mention the necessary disclosures when we
cover each statement in turn. Disclosures required by IAS 1 and other Standards must be made either
in the statement or in the notes unless otherwise stated, that is, disclosures cannot be made in an
accompanying commentary or report. We will not give all the detailed disclosures as some are outside
the scope of your syllabus.

1.3 IDENTIFICATION OF FINANCIAL STATEMENTS

It is most important that entities distinguish the financial statements very clearly from any other
information published with them. This is because all IASs/IFRSs apply only to the financial statements
(i.e. the main statements and related notes), so readers of the annual report must be able to
differentiate between the parts of the report which are prepared under IFRSs, and other parts which
are not.
The entity should identify each financial statement and the notes very clearly. IAS 1 also requires
disclosure of the following information in a prominent position. If necessary, it should be repeated
wherever it is felt to be of use to the reader in their understanding of the information presented.
 154 | FINANCIAL STATEMENTS

 name of the reporting entity (or other means of identification)

 whether the accounts cover the single entity only or a group of entities
 the date of the end of the reporting period or the period covered by the financial statements (as
appropriate)
 the presentation currency (i.e. the currency in which amounts are presented)
 the level of rounding used in presenting amounts in the financial statements.
Judgment must be used to determine the best method of presenting this information. In particular,
the Standard suggests that the approach to this will be very different when the financial statements
are communicated electronically.
The level of rounding is important, as presenting figures in thousands or millions of units makes the
figures more understandable. The level of rounding must be disclosed, and it should not obscure
necessary details or make the information less relevant.

1.4 REPORTING PERIOD

It is normal for entities to present financial statements annually and IAS 1 states that they should be
prepared at least as often as this. If (unusually) the end of an entity's reporting period is changed, for
whatever reason, the period for which the statements are presented will be less or more than one
year. In such cases the entity should also disclose:
 the reason(s) why a period other than one year is used; and
 the fact that amounts presented in the financial statements are not entirely comparable.
For practical purposes, some entities prefer to use a period which approximates to a year, for
example, 52 weeks, and IAS 1 allows this approach as it produces statements not materially different
from those produced on an annual basis.

2 STATEMENT OF FINANCIAL POSITION

LO
3.2 Section overview
 IAS 1 specifies the line items to be presented in the statement of financial position.

2.1 STATEMENT OF FINANCIAL POSITION EXAMPLE

The example given by IAS 1 is as follows.
XYZ GROUP – STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER
20X7 20X6
$'000 $'000
Assets
Non-current assets
Property, plant and equipment 350 700 360 020
Goodwill 80 800 91 200
Other intangible assets 227 470 227 470
Investments in associates 100 150 110 770
Available-for-sale financial assets 142 500 156 000
901 620 945 460
Current assets
Inventories 135 230 132 500
Trade receivables 91 600 110 800
Other current assets 25 650 12 540
Cash and cash equivalents 312 400 322 900
564 880 578 740
Total assets 1 466 500 1 524 200
 FINANCIAL ACCOUNTING AND REPORTING | 155

20X7 20X6
$'000 $'000
Equity and liabilities
Equity attributable to owners of the parent
Share capital 650 000 600 000
Retained earnings 243 500 161 700
Other components of equity 10 200 21 200
903 700 782 900
Non-controlling interest 70 050 48 600
Total equity 973 750 831 500
Non-current liabilities
Long-term borrowings 120 000 160 000
Deferred tax 28 800 26 040
Long-term provisions 28 850 52 240
Total non-current liabilities 177 650 238 280
Current liabilities
Trade and other payables 115 100 187 620
Short-term borrowings 150 000 200 000
Current portion of long-term borrowings 10 000 20 000
Current tax payable 35 000 42 000
Short-term provisions 5 000 4 800
Total current liabilities 315 100 454 420
Total liabilities 492 750 692 700
Total equity and liabilities 1 466 500 1 524 200

IAS 1 specifies various items which must appear in the statement of financial position as a minimum
disclosure, where applicable:
(a) property, plant and equipment (covered in the Foundations of Accounting Study guide);
(b) investment property (outside the scope of the syllabus);
(c) intangible assets (Module 4);

MODULE 3
(d) financial assets (excluding amounts shown under (e), (h) and (i)) (outside the scope of the syllabus);
(e) investments accounted for using the equity method (Module 5);
(f) biological assets (outside the scope of the syllabus);
(g) inventories (covered in the Foundations of Accounting Study guide);
(h) trade and other receivables (assumed knowledge);
(i) cash and cash equivalents (sections 6 and 7);
(j) assets classified as held for sale under IFRS 5 (outside the scope of the syllabus);
(k) trade and other payables (assumed knowledge);
(l) provisions (outside the scope of the syllabus);
(m) financial liabilities (other than (k) and (l)) (outside the scope of the syllabus);
(n) current tax liabilities and assets as defined in IAS 12 (Module 4);
(o) deferred tax liabilities and assets (Module 4);
(p) liabilities included in disposal groups under IFRS 5 (outside the scope of the syllabus);
(q) non-controlling interests (Module 5); and
(r) issued capital and reserves (assumed knowledge).
Any other line items, headings or sub-totals should be shown in the statement of financial position
when it is necessary for an understanding of the entity's financial position.
The example shown above is for illustration only (although we will follow the format in this Study
guide). The IAS does not prescribe the order or format in which the items listed should be presented.
It simply states that they must be presented separately because they are so different in nature or
function from each other.
 156 | FINANCIAL STATEMENTS

2.2 INFORMATION PRESENTED EITHER IN THE STATEMENT OF

FINANCIAL POSITION OR BY NOTE
Further sub-classification of the line items listed above should be disclosed either in the statement of
financial position or in the notes. The classification will depend upon the nature of the entity's
operations. As well as each item being sub-classified by its nature, any amounts payable to or
receivable from any group company should also be disclosed separately.
Disclosures will vary from item to item and IAS 1 gives the following examples.
 Property, plant and equipment are classified by class as described in IAS 16 Property, Plant and
Equipment.
 Receivables are analysed between amounts receivable from trade customers, other members of
the group, receivables from related parties, prepayments and other amounts.
 Inventories are sub-classified, in accordance with IAS 2 Inventories, into classifications such as
merchandise, production supplies, materials, work in progress and finished goods.
 Provisions are analysed showing separately provisions for employee benefits and any other items
classified in a manner appropriate to the entity's operations.
 Equity capital and reserves are analysed showing separately the various classes of paid-in capital,
and reserves.
The Standard then lists some specific disclosures which must be made, either in the statement of
financial position or in the related notes.
 Share capital disclosures (for each class of share capital):
– number of shares authorised;
– number of shares issued and fully paid, and issued but not fully paid;
– par value per share, or that the shares have no par value;
– reconciliation of the number of shares outstanding at the beginning and at the end of the
period;
– rights, preferences and restrictions attaching to that class including restrictions on the
distribution of dividends and the repayment of capital;
– shares in the entity held by the entity itself or by related group companies; and
– shares reserved for issue under options and sales contracts, including the terms and amounts.
 Description of the nature and purpose of each reserve within owners' equity.
Some types of entity have no share capital, for example, partnerships. Such entities should disclose
information which is equivalent to that listed above. This means disclosing the movement during the
period in each category of equity interest and any rights, preferences or restrictions attached to each
category of equity interest.

2.3 THE CURRENT/NON-CURRENT DISTINCTION

An entity shall present current and non-current assets, and current and non-current liabilities, as
separate classifications in its statement of financial position except when a presentation based on
liquidity provides information that is reliable and more relevant. When that exception applies, an
entity shall present all assets and liabilities in order of liquidity.
Whichever method of presentation is adopted, an entity shall disclose the amount expected to be
recovered or settled after more than twelve months for each asset and liability line item that combines
amounts expected to be recovered or settled:
(a) no more than twelve months after the reporting period, and
(b) more than twelve months after the reporting period.
(IAS 1, para 60 and 61)
 FINANCIAL ACCOUNTING AND REPORTING | 157

2.3.1 CURRENT ASSETS

Definition

An asset should be classified as a current asset when it:

 is expected to be realised in, or is held for sale or consumption in, the normal course of the entity's
operating cycle;
 is held primarily for trading purposes or for the short term and expected to be realised within
12 months of the reporting period; or
 is cash or a cash equivalent asset which is not restricted in its use.
All other assets should be classified as non-current assets. (IAS 1, para 67)

Non-current assets include tangible, intangible, operating and financial assets of a long-term nature.
Other terms with the same meaning can be used (e.g. 'fixed', 'long-term').
The term 'operating cycle' has been used several times above and the Standard defines it as follows.

Definition

The operating cycle of an entity is the time between the acquisition of assets for processing and their
realisation in cash or cash equivalents. (IAS 1)

Current assets therefore include inventories and trade receivables that are sold, consumed and
realised as part of the normal operating cycle. This is the case even where they are not expected to
be realised within 12 months.

2.3.2 CURRENT LIABILITIES

Definition

MODULE 3
A liability should be classified as a current liability when it either:
 is expected to be settled in the normal course of the entity's operating cycle;
 is held primarily for the purpose of trading;
 is due to be settled within 12 months after the reporting period; or
 the entity does not have an unconditional right to defer settlement of the liability for at least
12 months after the reporting period.
All other liabilities should be classified as non-current liabilities. (IAS 1)

The categorisation of current liabilities is very similar to that of current assets. Some current liabilities
are part of the working capital used in the normal operating cycle of the business (i.e. trade payables
and accruals for employee and other operating costs). Such items are classified as current liabilities
even where they are due to be settled more than 12 months after the end of the reporting
period.
There are also current liabilities which are not settled as part of the normal operating cycle, but which
are due to be settled within 12 months of the end of the reporting period. These include bank
overdrafts, income taxes, other non-trade payables and the current portion of interest-bearing
liabilities. Any interest-bearing liabilities that are used to finance working capital on a long-term basis,
and that are not due for settlement within 12 months, are classified as non-current liabilities.
 158 | FINANCIAL STATEMENTS

3 STATEMENT OF PROFIT OR LOSS AND OTHER

COMPREHENSIVE INCOME
LO
3.1 Section overview
 IAS 1 requires all items of income and expense in a period to be shown in a statement of
profit or loss and other comprehensive income.

The statement of profit or loss and other comprehensive income shows the entity's total
comprehensive income.
'Profit or loss' is the total of income less expenses shown in the top half of the statement of profit or
loss and other comprehensive income. This is sometimes called the statement of profit or loss.
'Other comprehensive income' comprises items of income and expense which other Standards do not
allow or permit to be recognised in profit or loss.
IAS 1 provides a list of items which are classified as other comprehensive income. The following two
are within the Financial Accounting and Reporting syllabus:
 revaluations of non-current assets (covered in the Foundations of Accounting Study guide); and
 foreign exchange differences (covered in Module 4 of this Study guide).
Other comprehensive income is grouped into items that will not be reclassified to profit or loss in the
future and items that may be reclassified to profit or loss when specific conditions are met. Although
the reclassification of other comprehensive income is not within your syllabus and should not concern
you, you should be aware of the related presentation requirements of IAS 1.

3.1 STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE

INCOME – FORMAT
IAS 1 allows total comprehensive income to be presented either:
(a) in a single statement of profit or loss and other comprehensive income; or
(b) in two statements: a statement of profit or loss and a statement of comprehensive income.
The format for a single statement of profit or loss and other comprehensive income provided in the
Standard is shown below. The section down to 'profit for the year' can be shown as a separate
'statement of profit or loss' with an additional 'statement of comprehensive income'. Note that for
completeness, this illustration includes some items that are not covered in this syllabus.
XYZ GROUP – STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR
THE YEAR ENDED 31 DECEMBER 20X7
20X7 20X6
$'000 $'000
Revenue 390 000 355 000
Cost of sales (245 000) (230 000)
Gross profit 145 000 125 000
Other income 20 667 11 300
Distribution costs (9 000) (8 700)
Administrative expenses (20 000) (21 000)
Other expenses (2 100) (1 200)
Finance costs (8 000) (7 500)
Share of profit of associates 35 100 30 100
Profit before tax 161 667 128 000
Income tax expense (40 417) (32 000)
Profit for the year from continuing operations 121 250 96 000
* Loss for the year from discontinued operations – (30 500)
Profit for the year 121 250 65 500
Other comprehensive income:
 FINANCIAL ACCOUNTING AND REPORTING | 159

20X7 20X6
$'000 $'000
Items that will not be reclassified to profit or loss
Gains on property revaluation 933 3 367
*Remeasurements of defined benefit pension plans (667) 1 333
Share of gain/(loss) on property revaluation of associates 400 (700)
Income tax relating to items that will not be reclassified (166) (1 000)
500 3 000
Items that may be reclassified to profit or loss
Exchange differences on translating foreign operations 5 334 10 667
*Available-for-sale financial assets (24 000) 26 667
*Cash flow hedges (667) (4 000)

Income tax relating to items that may be reclassified 4 833 (8 334)

(14 500) 25 000
Other comprehensive income for the year, net of tax (14 000) 28 000
Total comprehensive income for the year 107 250 93 500
Profit attributable to:
Owners of the parent 97 000 52 400
Non-controlling interest 24 250 13 100
121 250 65 500
Total comprehensive income attributable to
Owners of the parent 85 800 74 800
Non-controlling interest 21 450 18 700
107 250 93 500
Earnings per share (in currency units) 0.46 0.30

*Not in the Financial Accounting and Reporting syllabus

Companies are given the option of presenting this information in two statements as follows:

MODULE 3
XYZ GROUP – STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X7
20X7 20X6
$'000 $'000
Revenue 390 000 355 000
Cost of sales (245 000) (230 000)
Gross profit 145 000 125 000
Other income 20 667 11 300
Distribution costs (9 000) (8 700)
Administrative expenses (20 000) (21 000)
Other expenses (2 100) (1 200)
Finance costs (8 000) (7 500)
Share of profit of associates 35 100 30 100
Profit before tax 161 667 128 000
Income tax expense (40 417) (32 000)
Profit for the year from continuing operations 121 250 96 000
* Loss for the year from discontinued operations – (30 500)
Profit for the year 121 250 65 500
Profit attributable to:
Owners of the parent 97 000 52 400
Non-controlling interest 24 250 13 100
121 250 65 500
 160 | FINANCIAL STATEMENTS

XYZ GROUP – STATEMENT OF OTHER COMPREHENSIVE INCOME FOR THE YEAR ENDED
31 DECEMBER 20X7
20X7 20X6
$'000 $'000
Profit for the year 121 250 65 500
Other comprehensive income:
Items that will not be reclassified to profit or loss
Gains on property revaluation 933 3 367
*Remeasurements of defined benefit pension plans (667) 1 333
Share of gain on property revaluation of associates 400 (700)
Income tax relating to items that will not be reclassified (166) (1 000)
500 3 000
Items that may be reclassified to profit or loss
Exchange differences on translating foreign operations 5 334 10 667
*Available-for-sale financial assets (24 000) 26 667
*Cash flow hedges (667) (4 000)

Income tax relating to items that may be reclassified 4 833 (8 334)

(14 500) 25 000

Other comprehensive income for the year, net of tax (14 000) 28 000
Total comprehensive income for the year 107 250 93 500
Total comprehensive income attributable to
Owners of the parent 85 800 74 800
Non-controlling interest 21 450 18 700
107 250 93 500
Earnings per share (in currency units) 0.46 0.30

*Not in the Financial Accounting and Reporting syllabus

3.2 STATEMENT OF PROFIT OR LOSS

IAS 1 offers two possible formats for the statement of profit or loss section or separate statement of
profit or loss – by function or by nature. Classification by function is more common. 'Function' refers to
the business function to which the expense relates, whereas 'nature' considers the type of expense.

3.2.1 EXAMPLE OF SEPARATE STATEMENTS OF PROFIT OR LOSS

Worked Example: XYZ Group

STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X8

Illustrating the classification of expenses by function:
20X8 20X7
$'000 $'000
Revenue X X
Cost of sales (X) (X)
Gross profit X X
Other income X X
Distribution costs (X) (X)
Administrative expenses (X) (X)
Other expenses (X) (X)
Finance costs (X) (X)
Share of profit of associates X X
Profit before tax X X
Income tax expense (X) (X)
Profit for the year X X
Attributable to:
Owners of the parent X X
Non-controlling interest X X
X X
 FINANCIAL ACCOUNTING AND REPORTING | 161

Illustrating the classification of expenses by nature:

20X8 20X7
$'000 $'000
Revenue X X
Other operating income X X
Changes in inventories of finished goods and work in progress (X) X
Work performed by the entity and capitalised X X
Raw material and consumables used (X) (X)
Employee benefits expense (X) (X)
Depreciation and amortisation expense (X) (X)
Impairment of property, plant and equipment (X) (X)
Other expenses (X) (X)
Finance costs (X) (X)
Share of profit of associates X X
Profit before tax X X
Income tax expense (X) (X)
Profit for the year X X
Attributable to:
Owners of the parent X X
Non-controlling interest X X
X X

Note: The usual method of presentation is expenses by function.

3.2.2 INFORMATION PRESENTED IN THE STATEMENT OF PROFIT OR LOSS

In addition to items required by other IFRSs, IAS 1 requires that the statement of profit or loss includes
the following line items:
 Revenue
 Finance costs
 Share of profits and losses of associates and joint ventures accounted for using the equity method

MODULE 3
 Tax expense
 A single amount for the total of discontinued operations.
The following items must be disclosed as allocations of profit or loss for the period:
 Profit or loss attributable to non-controlling interests; and
 Profit or loss attributable to owners of the parent.
The allocated amounts must not be presented as items of income or expense. These relate to group
accounts, covered later in this Study guide.
Income and expense items can be offset when, and only when:
 it is permitted or required by an IFRS; or
 gains, losses and related expenses arising from the same or similar transactions and events are
immaterial, in which case they can be aggregated.

3.2.3 EXCEPTIONAL ITEMS

IAS 1 requires that additional line items are disclosed in the statement of profit or loss and other
comprehensive income where they are relevant to an understanding of an entity's financial performance.
IAS 1 does not allow the presentation of any items as extraordinary.

3.2.4 INFORMATION PRESENTED EITHER IN THE STATEMENT OR IN THE NOTES

An analysis of expenses must be shown either in the statement of profit or loss (as above, which is
encouraged by the Standard) or by note, using a classification based on either the nature of the
expenses or their function.
Nature of expense method
Expenses are not reallocated amongst various functions within the entity, but are aggregated in the
statement of profit or loss according to their nature (e.g. purchase of materials, depreciation, wages
and salaries, transport costs).
 162 | FINANCIAL STATEMENTS

Function of expense/cost of sales method

You are likely to be more familiar with this method. Expenses are classified according to their function
as part of cost of sales, distribution or administrative activities. This method often gives more relevant
information for users, but the allocation of expenses by function requires the use of judgment and
can be arbitrary. Consequently, perhaps, when this method is used, entities should disclose
additional information on the nature of expenses, including employee benefits expense and
depreciation and amortisation expense.
Which of the above methods is chosen by an entity will depend on historical and industry factors,
and also the nature of the organisation. The choice of method should fairly reflect the main elements
of the entity's performance.
Under both methods an indication should be given of costs which are likely to vary (directly or
indirectly) with the level of sales or production.

3.3 OTHER COMPREHENSIVE INCOME

IAS 1 requires the following line items for the amounts for the period in the other comprehensive
income section:
 items of comprehensive income grouped into those that:
– Will not be reclassified subsequently to profit or loss
– Will be reclassified subsequently to profit or loss when certain conditions are met
 share of other comprehensive income of associates and joint ventures accounted for using the
equity method.
Items of other comprehensive income may be presented either:
 net of related tax effects; or
 before related tax effects with an aggregate amount of tax disclosed separately for items which will
not be reclassified to profit or loss and items which may be reclassified to profit or loss.
An entity shall present the following items, in addition to the profit or loss and other comprehensive
income sections, as allocation of profit or loss and other comprehensive income for the period:
 profit or loss for the period attributable to:
– non-controlling interests, and
– owners of the parent.
 comprehensive income for the period attributable to:
– non-controlling interests, and
– owners of the parent

4 STATEMENT OF CHANGES IN EQUITY

LOs
3.1, Section overview
3.2
 IAS 1 requires a statement of changes in equity. This shows the movement in the equity
section of the statement of financial position. A full set of financial statements includes a
statement of changes in equity.

4.1 FORMAT
This is the format of the statement of changes in equity according to IAS 1. Total comprehensive
income is reported in aggregate, and profit or loss and the individual elements of other
comprehensive income are not identified. This reflects the aim of the statement to provide
information about transactions between a company and its shareholders in their capacity as
shareholders for example, dividends and share issues. IAS 1 requires an analysis of other
 FINANCIAL ACCOUNTING AND REPORTING | 163

comprehensive income by item to be shown either in the statement of changes in equity or in the
notes to the accounts.
The below example illustrated that XYZ Group have selected to show items such as ‘available-for-sale
financial assets’ and ‘revaluation surplus’ in the face of the statement of changes in equity, not in the
notes to the accounts. However, as discussed above, these items are not required to be shown in the
face of the statement of changes in equity.
XYZ GROUP – STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER
20X7
Available
for-sale Non-
Share Retained financial Revaluation controlling Total
capital earnings assets surplus Total interests equity
$'000 $'000 $'000 $'000 $'000 $'000 $'000
Balance at 1 Jan 20X6 600 000 118 100 1 600 – 719 700 29 800 749 500
Changes in accounting – 400 – – 400 100 500
policy
Restated balance 600 000 118 500 1 600 – 720 100 29 900 750 000

Changes in equity
Dividends – (10 000) – – (10 000) – (10 000)

Total comprehensive
income for the year – 53 200 16 000 1 600 70 800 18 700 89 500
Balance at 31 Dec 20X6 600 000 161 700 17 600 1 600 780 900 48 600 829 500
Changes in equity for 20X7
Issue of share capital 50 000 – – – 50 000 – 50 000
Dividends – (15 000) – – (15 000) – (15 000)

Total comprehensive

MODULE 3
income for the year – 96 600 (14 400) 800 83 000 21 450 104 450
Transfer to retained – 200 – (200) – – –
earnings
Balance at 31 Dec 20X7 650 000 243 500 3 200 2 200 898 900 70 050 968 950

Note that where there has been a change of accounting policy necessitating a retrospective
restatement, (see IAS 8 in Module 1), the adjustment is disclosed for each period. So, rather than just
showing an adjustment to the balance brought forward on 1 January 20X7, the balances for 20X6 are
restated.

5 NOTES TO THE FINANCIAL STATEMENTS

LOs
3.1, Section overview
3.2
 Some items need to be disclosed by way of note.

5.1 CONTENTS OF NOTES

The notes to the financial statements amplify the information given in the statement of financial
position, statement of profit or loss and other comprehensive income and statement of changes in
equity. We have already noted above the information which the Standard allows to be shown by note
rather than in the statements. To some extent, then, the contents of the notes will be determined by
the level of detail shown in the statements.
 164 | FINANCIAL STATEMENTS

5.2 STRUCTURE
The notes to the financial statements perform the following functions:
 Provide information about the basis on which the financial statements were prepared and which
specific accounting policies were chosen and applied to significant transactions/events
 Disclose any information, not shown elsewhere in the financial statements, which is required by
IFRSs
 Show any additional information that is relevant to understanding which is not shown elsewhere in
the financial statements.
The way the notes are presented is important. They should be given in a systematic manner and
cross-referenced to the related figure(s) in the statement of financial position, statement of profit or
loss and other comprehensive income or statement of cash flows.
Notes to the financial statements will amplify the information shown therein by giving the following:
 More detailed analysis or breakdowns of figures in the statements;
 Narrative information explaining figures in the statements; and
 Additional information.
For example, contingent liabilities and commitments.
IAS 1 suggests a certain order for notes to the financial statements. This will assist users when
comparing the statements of different entities:
 Statement of compliance with IFRSs;
 Statement of the measurement bases and other accounting policies applied;
 Supporting information for items presented in each financial statement in the same order as each
line item and each financial statement is presented; and
 Other disclosures, for example:
– Contingent liabilities, commitments and other financial disclosures; and
– Non-financial disclosures.
The order of specific items may have to be varied occasionally, but a systematic structure is still
required.

5.3 DISCLOSURE OF ACCOUNTING POLICIES

The accounting policies section should describe the following:
 The measurement basis (or bases) used in preparing the financial statements; and
 The other accounting policies used, as required for a proper understanding of the financial
statements.
The information on measurement bases used is clearly fundamental to an understanding of the
financial statements. Where more than one basis is used, it should be stated to which assets or
liabilities each basis has been applied.
Accounting policies were covered in Module 1.

5.4 OTHER DISCLOSURES

An entity must disclose in the notes:
 The amount of dividends proposed or declared before the financial statements were authorised for
issue but not recognised as a distribution to owners during the period, and the amount per share;
and
 The amount of any cumulative preference dividends not recognised.
IAS 1 ends by listing some specific disclosures which will always be required if they are not shown
elsewhere in the financial statements:
 The domicile and legal form of the entity, its country of incorporation and the address of the
registered office (or, if different, principal place of business);
 FINANCIAL ACCOUNTING AND REPORTING | 165

 A description of the nature of the entity's operations and its principal activities; and
 The name of the parent entity and the ultimate parent entity of the group.

6 IAS 7 STATEMENT OF CASH FLOWS

LO
3.3 Section overview
 Statements of cash flows are a useful addition to the financial statements of an entity
because accounting profit is not the only indicator of performance. Statements of cash
flows show the sources and uses of cash and are a useful indicator of an entity's liquidity
and solvency.
Profit does not always give a useful or meaningful picture of a company's performance. Readers of a
company's financial statements might even be misled by a reported profit figure, as shown below:
 Shareholders might believe that if a company makes a profit after tax, of say, $100 000 that this is
the amount it can afford to pay as a dividend. Unless the company has sufficient cash available to
both stay in business and pay such a dividend, the shareholders' expectations would be wrong.
 Employees might believe that if a company makes profits, it can afford to pay higher wages in the
following year. This opinion may not be correct: the ability to pay wages depends on the
availability of cash.
 Survival of a company depends on its ability to pay its debts when they fall due. Such payments
include 'profit or loss' items such as material purchases, wages, interest and taxation, but also
capital payments for new non-current assets and the repayment of loans when they fall due.
From these examples, it is apparent that a company's performance and prospects depend not so
much on the 'profits' earned in a period, but more realistically on liquidity or cash flows.
It is very important that the management of a company understand the need to control cash flows and

MODULE 3
actively monitor the company's cash position.

6.1 OBJECTIVE OF IAS 7

The aim of IAS 7 is to provide information to users of financial statements about an entity's ability to
generate cash and cash equivalents. The statement of cash flows provides historical information
about cash and cash equivalents, classifying cash flows between operating, investing and financing
activities which readers can use to make predictions of future cash flows.
A statement of cash flows is presented as an integral part of an entity's financial statements. All types
of entity can provide useful information about cash flows as the need for cash is universal, whatever
the nature of their revenue-producing activities. All entities are required by the Standard to
produce a statement of cash flows.

6.2 BENEFITS OF CASH FLOW INFORMATION

Statements of cash flows should be used in conjunction with the rest of the financial statements.
Information about cash flows helps users gain further understanding of the change in net assets, of the
entity's financial position (liquidity and solvency) and of the entity's ability to adapt to changing
circumstances by adjusting the amount and timing of cash flows. Statements of cash flows enhance
comparability as they are not affected by differing accounting policies used for the same type of
transactions or events.
Cash flow information of a historical nature can be used as an indicator of the amount, timing and
certainty of future cash flows. The relationship between profit and cash flows can be analysed as can
changes in cash flows over time. All this information helps users of accounts make decisions.
 166 | FINANCIAL STATEMENTS

6.3 DEFINITIONS
The standard gives the following definitions.

Definitions

Cash. Comprises cash on hand and demand deposits.

Cash equivalents. Are short-term, highly liquid investments that are readily convertible to known
amounts of cash and which are subject to an insignificant risk of changes in value.
Cash flows. Are inflows and outflows of cash and cash equivalents.
Operating activities. Are the principal revenue-producing activities of the entity and other activities
that are not investing or financing activities.
Investing activities. Are the acquisition and disposal of non-current assets and other investments not
included in cash equivalents.
Financing activities. Are activities that result in changes in the size and composition of the equity
capital and borrowings of the entity. (IAS 7)

6.4 CASH AND CASH EQUIVALENTS

The Standard expands on the definition of cash equivalents: they are not held for investment or other
long-term purposes, but rather to meet short-term cash commitments. An investment maturing within
three months of acquisition is a cash equivalent. Other investments such as equity investments (i.e.
shares in other companies) are not cash equivalents (unless they are redeemable preference shares
acquired with a very close redemption date!).
Loans and other borrowings are classified as financing activities. In some countries bank overdrafts
are repayable on demand. In these circumstances an overdrawn balance will be included as a
reduction in cash and cash equivalents. Such banking arrangements are characterised by a balance
which fluctuates between overdrawn (debit) and cash at bank (credit).
Movements between different types of cash and cash equivalents are not included in cash flows.
The investment of surplus cash in cash equivalents is part of cash management, not part of operating,
investing or financing activities.

6.5 PRESENTATION OF A STATEMENT OF CASH FLOWS

Statements of cash flows show cash flows during the period classified as operating, investing or
financing activities.
Classifying cash flows between different activities in this way helps users see the impact on cash and
cash equivalents of each one, and their relationships with each other.

6.5.1 OPERATING ACTIVITIES

This is perhaps the key part of the statement of cash flows because it shows whether, and to what
extent, companies can generate cash from their operations. It is these operating cash flows which
must, in the end, pay for all cash outflows relating to other activities, such as the acquisition of non-
current assets.
Most of the components of cash flows from operating activities will be those items which determine
the net profit or loss of the entity, that is they relate to its main revenue-producing activities. The
Standard gives the following as examples of cash flows from operating activities:
 cash receipts from the sale of goods and the rendering of services;
 cash receipts from royalties, fees, commissions and other revenue;
 cash payments to suppliers for goods and services; and
 cash payments to and on behalf of employees.
 FINANCIAL ACCOUNTING AND REPORTING | 167

Certain items are included in the net profit or loss which are not operational cash flows, for example,
the profit or loss on the sale of a piece of plant will be included in net profit or loss, but the cash flows
will be classed as investing.

6.5.2 INVESTING ACTIVITIES

The cash flows classified under this heading show the extent of new investment in assets which will
generate future profit and cash flows. The Standard gives the following examples of cash flows
arising from investing activities:
 cash payments to acquire property, plant and equipment, intangibles and other non-current assets,
including those relating to capitalised development costs and self-constructed property, plant and
equipment;
 cash receipts from sales of property, plant and equipment, intangibles and other non-current
assets;
 cash payments to acquire shares or loan capital of other entities;
 cash receipts from sales of shares or loan capital of other entities;
 cash advances and loans made to other parties; and
 cash receipts from the repayment of advances and loans made to other parties.

6.5.3 FINANCING ACTIVITIES

This section of the statement of cash flows shows the amount of cash which the entity's capital
providers have claimed during the period. This is an indicator of likely future interest and dividend
payments. The Standard gives the following examples of cash flows which might arise under these
headings:
 cash proceeds from issuing shares;
 cash payments to owners to acquire or redeem the entity's shares;
 cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short or long-

MODULE 3
term borrowings; and
 cash repayments of amounts borrowed.

6.6 REPORTING CASH FLOWS FROM OPERATING ACTIVITIES

The Standard offers a choice of method for calculating operating cash flows:
 direct method: disclose major classes of gross cash receipts and gross cash payments.
 indirect method: net profit or loss is adjusted for the effects of transactions of a non-cash nature,
any prepayments or accruals of past or future operating cash receipts or payments, and items of
income or expense classified as investing or financing cash flows.
The direct method discloses information that is not available elsewhere in the financial statements,
which could be of use in estimating future cash flows. The indirect method is more widely used in
some countries, but in Australia the direct method is used by a large majority of listed companies.

6.6.1 USING THE DIRECT METHOD

There are different ways in which the information about gross cash receipts and payments can be
obtained. The most obvious way is simply to extract the information from the accounting records.
A proforma for the direct method is given below.
$'000 $'000
Cash flows from operating activities
Cash receipts from customers X
Cash paid to suppliers and employees (X)
Cash generated from operations X
Interest paid (X)
Income taxes paid (X)
Net cash from operating activities X
 168 | FINANCIAL STATEMENTS

Worked Example: The direct method

Boggis Co. had the following transactions during the year:

(a) Purchases from suppliers were $19 500, of which $2550 was unpaid at the year end. Brought
forward payables were $1000.
(b) Wages and salaries amounted to $10 500, of which $750 was unpaid at the year end. The accounts
for the previous year showed an accrual for wages and salaries of $1500.
(c) Interest of $2100 on a long-term loan was paid in the year.
(d) Sales revenue was $33 400, including $900 receivables at the year end. Brought forward receivables
were $400.
(e) Interest on cash deposits at the bank amounted to $75.
Calculate the cash flow from operating activities using the direct method.

Solution

$ $
Cash flows from operating activities
Cash received from customers ($400 + $33 400 – $900) 32 900
Cash paid to suppliers ($1000 + $19 500 – $2550) (17 950)
Cash paid to employees ($1500 + $10 500 – $750) (11 250)
Interest paid (2 100)
Interest received 75
Net cash flow from operating activities 1 675

6.6.2 USING THE INDIRECT METHOD

The profit or loss from operations for the period is adjusted for the following:
(a) non-cash items, for example, depreciation, provisions, profits/losses on the sales of assets
(b) changes during the period in inventories, operating receivables and payables.
A proforma of such a calculation is as follows:
$
Profit before tax (statement of profit or loss) X
Add: depreciation X
Finance expense X
Loss/(profit) on sale of non-current assets X/(X)
(Increase)/decrease in inventories (X)/X
(Increase)/decrease in receivables (X)/X
Increase/(decrease) in payables X/(X)
Cash generated from operations X
Interest paid (X)
Dividends paid (X)
Income taxes paid (X)
Net cash flow from operating activities X

It is important to understand why certain items are added and others subtracted.
Note the following points:
 Depreciation is not a cash expense, but is deducted in arriving at the profit figure in the statement
of profit or loss and other comprehensive income. It makes sense, therefore, to eliminate it by
adding it back.
 By the same logic, a loss on a disposal of a non-current asset (arising through under provision of
depreciation) needs to be added back and a profit deducted.
 An increase in inventories means less cash – you have spent cash on buying inventory.
 An increase in receivables means the company's customers have not paid as much, and therefore
there is less cash.
 If we pay off payables, causing the figure to decrease, again, we have less cash.
 FINANCIAL ACCOUNTING AND REPORTING | 169

6.6.3 DIRECT VERSUS INDIRECT

The direct method is encouraged where the necessary information is not too costly to obtain, but
IAS 7 does not demand it. It could be argued that companies ought to monitor their cash flows
carefully enough on an ongoing basis to be able to use the direct method at minimal extra cost.

6.7 INTEREST AND DIVIDENDS

Interest and dividends are disclosed separately, and classified consistently as either operating,
investing or financing activities. In other words there is a choice of classification.
Generally a financial institution will classify interest paid and interest and dividends received as
operating cash flows. There is, however, no consensus of opinion on the classification of such cash
flows for other entities.
 Interest paid and interest and dividends received may be classified as operating cash flows on the
basis that these amounts enter into the determination of profit or loss.
 Interest paid may be classified as a financing cash flow on the basis that this is the cost of obtaining
finance.
 Interest and dividends received may be classified as investing cash flows on the basis that these
amounts are returns on investments.
Dividends paid may be classified as:
 financing cash flows on the basis that they represent the cost of obtaining finance; or
 cash flows from operating activities in order to assist users to determine the ability of an entity to
pay dividends from operating cash flows.
In this module we do not deal with the statements of cash flows of financial institutions and therefore
the following approach is taken unless stated otherwise: interest paid is included as an operating cash
flow, dividends paid as a financing cash flow and interest and dividends received as investing cash
flows.

MODULE 3
6.8 TAXES ON INCOME
Cash flows arising from taxes on income are separately disclosed and classified as cash flows from
operating activities unless they can be specifically identified with financing and investing activities.
Taxation cash flows are often difficult to match to the originating underlying transaction, so usually
tax cash flows are classified as arising from operating activities.

6.9 EXAMPLE OF A STATEMENT OF CASH FLOWS

In the next section we will prepare a statement of cash flows. First, look at these examples, adapted
from the example given in the standard.

Worked Example: Direct method

STATEMENT OF CASH FLOWS (DIRECT METHOD) FOR THE YEAR ENDED 31 DECEMBER 20X7
$m $m
Cash flows from operating activities
Cash receipts from customers 30 330
Cash paid to suppliers and employees (27 600)
Cash generated from operations 2 730
Interest paid (270)
Income taxes paid (900)
Net cash from operating activities 1 560
Cash flows from investing activities
Purchase of property, plant and equipment (900)
Proceeds from sale of equipment 20
Interest received 200
Dividends received 200
170 | FINANCIAL STATEMENTS

$m $m
Net cash used in investing activities (480)
Cash flows from financing activities
Proceeds from issuance of share capital 250
Proceeds from long-term borrowings 250
Dividends paid (1 290)
(790)
Net cash used in financing activities
Net increase in cash and cash equivalents 290
Cash and cash equivalents at beginning of period (note) 120
Cash and cash equivalents at end of period (note) 410

Worked Example: Indirect method

STATEMENT OF CASH FLOWS (INDIRECT METHOD) FOR THE YEAR ENDED 31 DECEMBER
20X7
$m $m
Cash flows from operating activities
Profit before taxation 3 570
Adjustments for:
Depreciation 450
Investment income (500)
Finance expense 400
Operating profit before working capital changes 3 920
Increase in trade and other receivables (500)
Decrease in inventories 1 050
Decrease in trade payables (1 740)
Cash generated from operations 2 730
Interest paid (270)
Income taxes paid (900)
Net cash from operating activities 1 560
Cash flows from investing activities
Purchase of property, plant and equipment (900)
Proceeds from sale of equipment 20
Interest received 200
Dividends received 200
Net cash used in investing activities (480)
Cash flows from financing activities
Proceeds from issuance of share capital 250
Proceeds from long-term borrowings 250
Dividends paid (1 290)
Net cash used in financing activities (790)
Net increase in cash and cash equivalents 290
Cash and cash equivalents at beginning of period (note) 120
Cash and cash equivalents at end of period (note) 410

Note that in the indirect method version of the statement, the following items are treated in a way that
might seem confusing, but the treatment is logical if you think in terms of cash:
 Increase in inventory is treated as negative (in brackets). This is because it represents a cash
outflow; cash is being spent on inventory.
 An increase in receivables would be treated as negative for the same reasons; more receivables
means less cash.
 By contrast an increase in payables is positive because cash is being retained and not used to
settle accounts payable. Consequently, more cash remains in the business.
 FINANCIAL ACCOUNTING AND REPORTING | 171

6.10 COMPONENTS OF CASH AND CASH EQUIVALENTS

The components of cash and cash equivalents are disclosed and a reconciliation presented, showing
the amounts in the statement of cash flows reconciled with the equivalent items reported in the
statement of financial position.
We also disclose the accounting policy used to decide the items included in cash and cash
equivalents, in accordance with IAS 1 Presentation of Financial Statements.

6.10.1 CASH AND CASH EQUIVALENTS NOTE: ILLUSTRATION

Note: Cash and cash equivalents.
Cash and cash equivalents consist of cash on hand and balances with banks, and investments in
money market instruments. Cash and cash equivalents included in the statement of cash flows
comprise the following statement of financial position amounts:
20X7 20X6
$m $m
Cash on hand and balances with banks 40 25
Short-term investments 370 95
Cash and cash equivalents 410 120

6.11 NON-CASH TRANSACTIONS

Many investing and financing transactions do not have a direct effect on cash flows, even though they
change the capital (equity) and assets of an entity. An example of a non-cash transaction would be
making a bonus issue of shares.
Investing and financing transactions that do not generate or use cash or cash equivalents are
excluded from the statement of cash flows. These transactions are disclosed in the notes to the
financial statements.

6.12 OTHER DISCLOSURES

MODULE 3
All entities should disclose, together with a commentary by management, any other information
likely to be of importance, for example:
 restrictions on the use of or access to any part of cash and cash equivalents;
 the amount of undrawn borrowing facilities which are available; and
 cash flows which increased operating capacity compared to cash flows which merely maintained
operating capacity.

7 PREPARING A STATEMENT OF CASH FLOWS

LO
3.3 Section overview
 You need to be aware of the format of the statement as laid out in IAS 7. Setting out the
format is the first step. Then follow the step-by-step preparation procedure.

Although the nature of the Financial Accounting and Reporting exam means that you will not be
required to produce a full statement of cash flows, you can be asked to calculate particular
amounts within it so you need to understand the underlying principles.
 172 | FINANCIAL STATEMENTS

7.1 EXAMPLE: PREPARATION OF A STATEMENT OF CASH FLOWS

(DIRECT METHOD)
Worked Example: Colby Co. (1)
Colby Co.'s statement of profit or loss for the year ended 31 December 20X2 and statements of
financial position at 31 December 20X1 and 31 December 20X2 were as follows:
COLBY CO.
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X2
$'000 $'000
Revenue 720
Raw materials consumed 70
Employee costs 94
Depreciation 118
Loss on disposal of non-current asset 18
(300)
420
Finance expense (28)
Profit before tax 392
Taxation (124)
Profit for the period 268

COLBY CO.
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER
20X2 20X1
$'000 $'000 $'000 $'000
Assets
Property, plant and equipment
Cost 1 596 1 560
Depreciation 318 224
1 278 1 336
Current assets
Inventory 24 20
Trade receivables 76 58
Cash and cash equivalents 48 56
48 134
Total assets 1 426 1 470

Equity and liabilities

Capital and reserves
Share capital 396 364
Retained earnings 716 514
1 112 878
Non-current liabilities
Non-current loans 200 500
Current liabilities
Trade payables 12 6
Taxation 102 86
114 92
Total equity and liabilities 1 426 1 470

During the year, the company paid $90 000 for a new piece of machinery.
Dividends paid during 20X2 totalled $66 000.
Required
Prepare a statement of cash flows for Colby Co. for the year ended 31 December 20X2 in accordance
with the requirements of IAS 7, using the direct method.
 FINANCIAL ACCOUNTING AND REPORTING | 173

Solution

Step 1 Set out the proforma statement of cash flows with the headings required by IAS 7.
Step 2 Calculate the figure for cash receipts from customers. Cash received from customers is
sales for the year (from the statement of profit or loss), plus opening trade receivables,
less closing trade receivables (from the statement of financial position).
Step 3 Calculate the figure for cash paid to suppliers and employees. First calculate the figure
for purchases: raw materials consumed (from the statement of profit or loss), less opening
inventories, plus closing inventories (from the statement of financial position). Then use
the purchases figure to calculate the cash outflow: purchases, plus opening trade
payables, less closing trade payables (from the statement of financial position). Cash paid
to employees can be taken directly from the statement of profit or loss.
Where the statement of profit or loss is presented by function (the more usual method)
the calculations can be slightly more complicated. Purchases include cost of sales, plus
distribution costs and administrative expenses. If cost of sales and other expenses
include depreciation, this must be excluded, as depreciation is not a cash flow. As before,
to calculate these amounts, you may find it useful to use T accounts or reconciliation
workings: the opening balance in the statement of financial position will reconcile to the
closing balance in the statement of financial position by way of the profit or loss items
and cash flows.
Step 4 You can now complete the statement by correctly inserting the figures given or
calculated above. Notice that the figures for cash generated from operations, interest
paid and tax paid are exactly the same as under the indirect method.
COLBY CO.
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 20X2
$'000 $'000
Cash flows from operating activities

MODULE 3
Cash receipts from customers 702
Cash paid to suppliers and employees (68 + 94) `(162)
Cash generated from operations 540
Interest paid (28)
Tax paid (86 + 124 – 102) (108)
Net cash from operating activities 404

Working
CASH RECEIPTS FROM CUSTOMERS
$'000 $'000
At 1.1.X2 58 At 31.12.X2 76
Sales 720 Cash received (balance) 702
778 778

CASH PAID TO SUPPLIERS

$'000 $'000
At 31.12.X2 12 At 1.1.X2 6
Cash paid (balance) 68 Purchases (70 – 20 + 24) 74
80 80

7.2 EXAMPLE: PREPARATION OF A STATEMENT OF CASH FLOWS

(INDIRECT METHOD)
Worked Example: Colby Co. (2)

Use the financial statements of Colby Co. for the year ended 31 December 20X2 to prepare a
statement of cash flows for Colby Co. for the year ended 31 December 20X2 in accordance with the
requirements of IAS 7, using the indirect method.
174 | FINANCIAL STATEMENTS

If the indirect method is used, the cash flows from operating activities are presented differently,
showing a reconciliation of profit before tax to the net cash flow from operating activities rather than
cash received from customers and cash paid to suppliers and employees. Cash flows from investing
activities and cash flows from financing activities are calculated and presented in exactly the same way
as before.

Solution

Step 1 Set out the proforma statement of cash flows with the headings required by IAS 7. It is
obviously essential to know the formats very well.
Step 2 Begin with the reconciliation of profit before tax to net cash from operating activities as
far as possible. When preparing the statement from statements of financial position, you
will usually have to calculate such items as depreciation, profit or loss on sale of non-
current assets, profit for the year and tax paid (see Step 4). Note that you may not be
given the tax charge in the statement of profit or loss. You will then have to assume that
the tax paid in the year is last year's year-end liability and calculate the charge as the
balancing figure.
Step 3 Calculate the cash flow figures for dividends paid, purchase or sale of non-current assets,
issue of shares and repayment of loans if these are not already given to you (as they may
be). In order to calculate these amounts, you may find it useful to use T accounts or
reconciliation workings: the opening balance in the statement of financial position will
reconcile to the closing balance in the statement of financial position by way of profit or
loss items and cash flows.
Step 4 If you are not given the profit figure, you will need to calculate this amount. Using
opening and closing retained earnings, the taxation charge and dividends paid, you will
be able to calculate profit for the year as the balancing figure to put in the profit before
tax to net cash flow from operating activities section.
Step 5 You will now be able to complete the statement by correctly inserting the figures given or
calculated above.
COLBY CO.
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 20X2
$'000 $'000
Cash flows from operating activities
Profit before tax 392
Depreciation charges 118
Loss on sale of property, plant and equipment 18
Finance expense 28
Increase in inventories (4)
Increase in receivables (18)
Increase in payables 6
Cash generated from operations 540
Interest paid (28)
Tax paid (86 + 124 – 102) (108)
Net cash from operating activities 404
Cash flows from investing activities
Payments to acquire property, plant and equipment (90)
Proceeds from sales of property, plant and equipment (W) 12
Net cash used in investing activities (78)
Cash flows from financing activities
Issue of share capital (396  364) 32
Long-term loans repaid (500  200) (300)
Dividends paid (66)
Net cash used in financing activities (334)
Decrease in cash and cash equivalents (8)
Cash and cash equivalents at 1.1.X2 56
Cash and cash equivalents at 31.12.X2 48
 FINANCIAL ACCOUNTING AND REPORTING | 175

Working: Property, plant and equipment

COST
$'000 $'000
At 1.1.X2 1 560 At 31.12.X2 1 596
Purchases 90 Disposals (balance) 54
1 650 1 650

ACCUMULATED DEPRECIATION
$'000 $'000
At 31.12.X2 318 At 1.1.X2 224
Depreciation on disposals Charge for year 118
(balance) 24
342 342
Carrying amount of disposals (54 – 24) 30
Net loss reported (18)
Proceeds from disposals 12

Question 1: Statement of cash flows

Set out below are the financial statements of Shabnum Co. You are the financial controller, faced with
the task of implementing IAS 7 Statement of Cash Flows.
SHABNUM CO.
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEAR
ENDED 31 DECEMBER 20X2
$'000
Revenue 2 553
Cost of sales (1 814)
Gross profit 739

MODULE 3
Distribution costs (125)
Administrative expenses (264)
350
Interest received 25
Finance costs (75)
Profit before taxation 300
Taxation (140)
Profit for the period 160
Other comprehensive income:
Surplus on revaluation of property 9
Total comprehensive income for the period 169

SHABNUM CO.
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER
20X2 20X1
$'000 $'000
Assets
Non-current assets
Property, plant and equipment 380 305
Intangible assets 250 200
Investments – 25
Current assets
Inventories 150 102
Receivables 390 315
Short-term investments 50 –
Cash balances 2 1
Total assets 1 222 948
 176 | FINANCIAL STATEMENTS

20X2 20X1
$'000 $'000
Equity and liabilities
Equity
Share capital 360 300
Revaluation reserve 100 91
Retained earnings 260 180
Non-current liabilities
Loan 170 50
Current liabilities
Trade payables 127 119
Bank overdraft 85 98
Taxation 120 110
Total equity and liabilities 1 222 948

The following information is available:

(a) Proceeds from the sale of non-current asset investments amounted to $30 000.
(b) Fixtures and fittings, with an original cost of $85 000 and a carrying amount of $45 000, were sold
for $32 000 during the year.
(c) The following information relates to property, plant and equipment:
31.12.20X2 31.12.20X1
$'000 $'000
Cost 720 595
Accumulated depreciation 340 290
Carrying amount 380 305

(d) 50 000 ordinary shares were issued during the year.

(e) Dividends totalling $80 000 were paid during the year.
(f) Shabnum Co. classifies interest paid as an operating cash flow, dividends paid as a financing cash
flow and interest and dividends received as investing cash flows.
Required
Prepare a statement of cash flows for the year to 31 December 20X2 in accordance with the
requirements of IAS 7, using the indirect method.
(The answer is at the end of the module.)

7.3 CALCULATING CASH FLOWS: THE BASIC PRINCIPLE

In the examples above, we used the opening and closing statements of financial position and the
statement of profit or loss and other comprehensive income for the year to arrive at a balancing
figure: the cash flow for the year. We can use the same technique to find any cash flow amount.
We can also use this relationship to calculate figures in the statement of profit or loss and other
comprehensive income or statement of financial position using the statement of cash flows and other
information.
Worked Example: Retained earnings and dividends paid
In the example above, Colby Co., you were given the amount of dividends paid during the year. It
would also have been possible to calculate dividends paid from the information in the financial
statements.
The statement of financial position shows opening retained earnings and closing retained earnings.
The statement of profit or loss shows the profit before tax for the year. We can use these figures to
reconstruct the movements in retained earnings. Closing retained earnings are less than opening
retained earnings plus profit for the year. The difference is dividends paid:
 FINANCIAL ACCOUNTING AND REPORTING | 177

$'000
Opening retained earnings (statement of financial position) 514
Add: Profit after tax for the year (statement of profit or loss) 268
Less: dividends paid (balancing figure) (66)
Closing retained earnings (statement of financial position) 716

Question 2: Opening balance

During the year ended 31 December 20X6, Tin Ltd had cash receipts from customers of $220 000 and
sales revenue of $250 000. Irrecoverable debts for the year were $ 10 000. At 31 December 20X6, trade
receivables were $70 000.
Required
What amount was shown in the statement of financial position for trade receivables at 1 January 20X6?
A $30 000
B $40 000
C $50 000
D $90 000
(The answer is at the end of the module.)

Question 3: Cash paid to suppliers

The following information has been extracted from the statement of financial position of Iron Ltd.
20X4 20X3
$'000 $'000
Inventories 450 390
Trade payables and accruals 220 130

MODULE 3
Cost of sales for the year ended 31 December 20X4 was $575 000. Operating expenses for the year
were $120 000. Depreciation for the year (included in cost of sales) was $40 000.
Required
What was cash paid to suppliers in respect of purchases and expenses for the year ended
31 December 20X4?
(The answer is at the end of the module.)

Question 4: Cash flow accounting

Can you think of some possible disadvantages of cash flow accounting?

(The answer is at the end of the module.)

7.4 THE ADVANTAGES OF CASH FLOW ACCOUNTING

The advantages of cash flow accounting are as follows:
 Survival in business depends on the ability to generate cash. Cash flow accounting directs
attention towards this critical issue.
 Cash flow is less subjective than 'profit' which is dependent on accounting conventions and
concepts.
 Creditors (long- and short-term) are more interested in an entity's ability to repay them than in its
profitability. Whereas 'profits' might indicate that cash is likely to be available, cash flow
accounting is more direct with its message.
 178 | FINANCIAL STATEMENTS

 Cash flow reporting provides a better means of comparing the results of different companies than
traditional profit reporting.
 Cash flow reporting satisfies the needs of all users better.
– For management, it provides the sort of information on which decisions should be taken: (in
management accounting, 'relevant costs' to a decision are future cash flows); traditional profit
accounting does not help with decision-making.
– For shareholders and auditors, cash flow accounting can provide a satisfactory basis for
stewardship accounting.
– As described previously, the information needs of creditors and employees will be better
served by cash flow accounting.
 Cash flow forecasts are easier to prepare, as well as more useful, than profit forecasts.
 Cash flow reporting can in some respects be audited more easily than accounts based on the
accruals concept.
 The accruals concept is confusing, and cash flows are more easily understood.

7.5 CRITICISMS OF IAS 7

The inclusion of cash equivalents has been criticised because it does not reflect the way in which
businesses are managed: in particular, the requirement that to be a cash equivalent an investment has
to be within three months of maturity is considered unrealistic.

8 INTERNAL CONTROL, AND THE ROLE OF THE

INTERNAL AND EXTERNAL AUDITORS

Section overview
 An entity will implement controls to ensure that financial statements and underlying
accounting records are complete and accurate. Internal auditors will have a role in this. The
external audit is a type of assurance engagement carried out by an external auditor to
provide an independent opinion on the truth and fairness of an entity's financial
statements.

8.1 INTERNAL CONTROL

Internal control. Is the process designed, implemented and maintained by those charged with
governance, management, and other personnel to provide reasonable assurance about the
achievement of an entity's objectives with regard to reliability of financial reporting, effectiveness
and efficiency of operations and compliance with applicable laws and regulations.

In other words, a system of internal control helps management:

 report reliably
 operate efficiently
 comply with legal requirements
 keep its assets secure from theft or damage.
Internal control has five elements:
1. the control environment
2. the entity's risk assessment process
3. the information system relevant to financial reporting
4. control activities
 FINANCIAL ACCOUNTING AND REPORTING | 179

5. monitoring of controls.
Let's look at two of these in more detail – the information system relevant to financial reporting and
control activities as these relate directly to the financial statements.

Definition

The information system relevant to financial reporting is a component of internal control that
includes the financial reporting system, and consists of the procedures and records established to
initiate, record, process and report entity transactions and to maintain accountability for the related
assets, liabilities and equity.

The information system relevant to financial reporting includes the following:

 the classes of transactions in the entity's operations that are significant to the financial statements
 the procedures, within both IT and manual systems, by which those transactions are initiated,
recorded, processed, corrected, transferred to the nominal ledger and reported in the financial
statements
 the related accounting records, supporting information, and specific accounts in the financial
statements, in respect of initiating, recording, processing and reporting transactions
 how the information system captures events and conditions, other than transactions, that are
significant to the financial statements
 the financial reporting process used to prepare the entity's financial statements, including
significant accounting estimates and disclosures
 controls surrounding journal entries, including non-standard journal entries used to record non-
recurring, unusual transactions or adjustments.

Definition

Control activities. Are those policies and procedures that help ensure that management directives

MODULE 3
are carried out.

Control activities include those activities designed to prevent or to detect and correct errors.
Examples include activities relating to authorisation, performance reviews, information processing,
physical controls and segregation of duties.

In terms of the financial statements, these control activities are particularly relevant:
EXAMPLES OF CONTROL ACTIVITIES
Approval and control of Transactions should be approved by an appropriate person. For example,
documents overtime should be approved by departmental managers.
Controls over computerised Examples include batch and hash totals.
applications
Checking the arithmetical For example, checking to see if individual invoices have been added up
accuracy of records correctly.
Maintaining and reviewing Control accounts bring together transactions in individual ledgers. Trial
control accounts and trial balances bring together unusual transactions for the organisation as a
balances whole. Preparing these can highlight unusual transactions or accounts.
Reconciliations Reconciliations involve comparison of a specific balance in the accounting
records with what another source says the balance should be, for
example, a bank reconciliation. Differences between the two figures
should only be reconciling items.
Comparing the results of cash, For example, in a physical count of petty cash, the balance shown in the
security and inventory counts cash book should be the same as the amount held.
with accounting records
 180 | FINANCIAL STATEMENTS

Comparing internal data with For example, comparing records of goods despatched to customers with
external sources of information customers' acknowledgement of goods that have been received.
Limiting physical access to assets Only authorised personnel should have access to certain assets
and records (particularly valuable or portable ones). For example, ensuring that the
inventory store is only open when store personnel are there and is
otherwise locked.

At a more senior level, management can also make use of analytical procedures to carry out a sense
check on the completeness and accuracy of the financial statements.

Definition

Analytical procedures. Are evaluations of financial information through analysis of plausible

relationships among both financial and nonfinancial data.

Analytical procedures will include comparison of financial statements with prior year financial
statements and with budgets to allow for a high level check on the reasonableness and consistency of
the financial statements.

8.2 THE ROLE OF THE INTERNAL AUDITOR

A key part of the internal control system discussed above will be the internal audit function. The
internal audit function is generally a feature of large companies. It is a function, provided either by
employees of the entity or sourced from an external organisation to assist management in achieving
corporate objectives.

Definition

Internal audit function. Is a function of an entity that performs assurance and consulting activities
designed to evaluate and improve the effectiveness of the entity's governance, risk management and
internal control processes.
(ISA 610)

The internal audit function can assist the board in other ways as well:
 by, in effect, acting as auditors for board reports not audited by the external auditors
 by being the experts in fields such as auditing and accounting standards in the company and
assisting in implementation of new standards
 by liaising with external auditors, particularly where external auditors can use internal audit work
and reduce the time and therefore cost of the external audit. In addition, internal audit can check
that external auditors are reporting back to the board everything they are required to under
auditing standards.
Internal auditors may carry out a range of activities, from fraud investigations to value for money
audits. In terms of the financial statements, their role may include financial audit which involves
reviewing all the available evidence (usually the company's records) to substantiate information in
management and financial reporting.
We mentioned external auditors here and this will be discussed in more detail below.
 FINANCIAL ACCOUNTING AND REPORTING | 181

8.3 WHY ARE EXTERNAL AUDITS REQUIRED?

Directors of all companies are usually required to produce financial statements annually which give
a true and fair view of the affairs of the company and its profit or loss for the period. They are also
encouraged to communicate with shareholders on matters relating to directors' pay and benefits
(this is required by law in the case of public limited companies), going concern and management of
risks.

But how will the shareholders know whether the directors' communications are accurate, or present a
fair picture? This is where the external auditor comes in. External auditors provide an impartial,
independent opinion on a set of financial statements and make an assessment on the truth and
fairness of that set of financial statements.

The purpose of an external audit is to enable auditors to give an opinion on the financial statements.
While an audit might produce by-products, such as advice to the directors on how to run the business,
its objective is solely to report to the shareholders.

8.4 STATUTORY AND NON-STATUTORY EXTERNAL AUDITS

In many countries, external audits are required under national statute for many undertakings,
including limited liability companies. Other organisations and entities requiring a statutory audit may
include charities, investment businesses and trade unions. In the UK for example, under registered
companies' legislation (currently the Companies Act 2006), most companies are required to have an
audit.
The statutory audit can bring various advantages to the company and shareholders. The key benefit to
shareholders is the impartial view provided by the auditors. However, the company also benefits from
professional accountants reviewing the accounts and system as part of the audit. Advantages might
include recommendations being made in relation to accounting and control systems and the
possibility that auditors might detect fraud and error.

MODULE 3
Non-statutory audits are performed by independent auditors because the company's owners,
proprietors, members, trustees, professional and governing bodies or other interested parties want
them, rather than because the law requires them. In consequence, auditing may extend to every type
of undertaking which produces accounts, including clubs, charities (some of these may require
statutory audits as well), sole traders and partnerships. Some of these organisations do not operate for
profit, and this has a specific impact on the nature of their audit.

8.5 THE NATURE AND DEVELOPMENT OF AUDIT AND OTHER

ASSURANCE ENGAGEMENTS
The accounting and auditing professions have been under the public spotlight for many years now
and, as a result of certain events, many changes have occurred in relation to audit and assurance
engagements.

As a result of the stock market bubble of the late 1990s and speculation over the future of 'dotcom'
companies, many countries experienced huge corporate financial scandals and frauds. The bubble
burst in 2000, followed by a revelation that senior management at Enron, a US energy company, had
been deceiving investors by fraudulently overstating profitability. Its auditor, Arthur Andersen, was
shown to have lacked objectivity in evaluating Enron's accounting methods. This led to the demise of
Arthur Andersen in 2002.
Other companies that were also involved in corporate frauds included WorldCom, Parmalat, Cable &
Wireless and Xerox, to name but a few. The subsequent fallout of these frauds was a lack of
confidence in the way companies were run and audited. In the US, this resulted in the Sarbanes-Oxley
Act 2002 which has not only radically changed the regulation of the accounting profession in the US
but also influenced such issues worldwide.
 182 | FINANCIAL STATEMENTS

In September 2008 Lehman Brothers, a global financial services firm, filed for bankruptcy in the US
triggering a severe worldwide financial crisis. Lehman had expanded aggressively into
property-related investments, including so-called sub-prime mortgages (loans to people on low
incomes or with poor credit histories). In subsequent reports it was claimed that Lehman Brothers
covered up the extent of its irrecoverable debts using an accounting manoeuvre known as 'Repo 105',
which involves loaning 'bad' assets to other firms in exchange for short-term financing. Lehman's
auditors had issued a clean audit report on the accounts to 30 November 2007 and the Accountancy
and Actuarial Discipline Board (AADB), an independent investigative and disciplinary body in the UK,
commenced an investigation in 2010 into the conduct of the auditors of Lehman Brothers International
Europe.
Following the collapse of Lehman Brothers, other banks failed worldwide and many needed
government support to continue. There was a knock-on effect in the wider economy in many countries
in 2008 and 2009, with many businesses struggling or failing altogether.
In light of this global financial crisis, regulators have again been considering the effectiveness of the
audit and the auditor's role in helping to prevent, or at least provide warning of, corporate and
financial institution collapses in the future.
The above events illustrate how important it is to companies and their shareholders that auditing and
other assurance engagements are carried out effectively.

8.6 THE AUDITOR'S REPORT

The end-product of the external audit is the auditor's report. This sets out the auditor's opinion on
the truth and fairness of the entity's financial statements.
The audit opinion on whether the financial statements are true and fair is not an opinion of absolute
correctness. 'True' and 'fair' are not defined in law or audit guidance, but the following definitions are
generally accepted.
True. Information is factual and conforms with reality. In addition, the information conforms with
required standards and law. The financial statements have been correctly extracted from the books
and records.
Fair. Information is free from discrimination and bias and in compliance with expected standards and
rules. The financial statements should reflect the commercial substance of the company's underlying
transactions.

We looked at an example of an unmodified (i.e. the financial statements are true and fair) auditor's
report in Module 2. You do not need to know the detail of this – it is simply included in this Study
guide for illustration.
Auditors' reports with modified opinions may arise because of a number of different reasons but
these are outside the scope of this syllabus.
The auditor's report refers to the fact that the auditor's objective is to obtain 'reasonable assurance' as
to whether the financial statements are free from material misstatement. This is because the auditor
cannot check everything and therefore can only provide 'reasonable', not 'absolute', assurance.
Definition
An audit gives the reader reasonable assurance on the truth and fairness of the financial statements,
which is a high, but not absolute, level of assurance. The auditor's report does not guarantee that the
financial statements are correct, but that they are true and fair within a reasonable margin of error.
 FINANCIAL ACCOUNTING AND REPORTING | 183

KEY MODULE POINTS

 IAS 1 covers the form and content of financial statements. The main components are:
– statement of financial position;
– statement of profit or loss and other comprehensive income;
– statement of changes in equity;
– statement of cash flows; and
– notes to the financial statements.
 IAS 1 suggests a format for the statement of financial position. Certain items are specified for
disclosure in the financial statements and notes to the accounts.
 Assets and liabilities should be analysed between current and non-current, and there are rules
determining the appropriate category.
 IAS 1 requires total comprehensive income in a period to be shown either in a statement of profit
or loss and other comprehensive income or in a separate statement reporting other
comprehensive income and total comprehensive income.
 Total comprehensive income is the change in equity during a period resulting from transactions
and other events, other than those changes resulting from transactions with owners in their
capacity as owners. It comprises all components of profit or loss and of other comprehensive
income.
 Other comprehensive income refers to items which other standards do not allow or permit to be
recognised in profit or loss.
 IAS 1 offers two possible formats for the profit or loss section of the statement of profit or loss and
other comprehensive income or separate statement of profit or loss – by function or by nature.
Classification by function is more common.

MODULE 3
 IAS 1 requires a statement of changes in equity. This shows the movement in the equity section of
the statement of financial position as a result of transactions with shareholders in their capacity as
shareholders. It also shows profit or loss and other comprehensive income.
 Some items need to be disclosed by way of note, for example, accounting policies.
 A statement of cash flows concentrates on the sources and uses of cash and is a useful indicator of
a company's liquidity and solvency.
 A company cannot survive without cash and therefore cash flow is at least as important as profits. It
is also factual and not affected by accounting policies or estimates.
 The statement of cash flows provides historical information about cash and cash equivalents,
classifying cash flows between operating, investing and financing activities.
 Cash comprises cash in hand and cash equivalents, such as demand deposits. Cash equivalents are
short-term, highly liquid investments that are readily convertible to known amounts of cash and
which are subject to an insignificant risk of changes in value.
 Cash flows from operating activities include:
– cash receipts from the sale of goods and the rendering of services
– cash receipts from royalties, fees, commissions and other revenue
– cash payments to suppliers for goods and services
– cash payments to and on behalf of employees.
 The direct or indirect method may be used to report cash flows from operating activities.
 Cash flows arising from investing activities include:
– cash payments to acquire property, plant and equipment, intangibles and other non-current
assets, including those relating to capitalised development costs and self-constructed property,
plant and equipment
184 | FINANCIAL STATEMENTS

– cash receipts from sales of property, plant and equipment, intangibles and other non-current
assets
– cash payments to acquire shares or loan capital of other entities
– cash receipts from sales of shares or loan capital of other entities
– cash advances and loans made to other parties
– cash receipts from the repayment of advances and loans made to other parties.
 Cash flows from financing activities include:
– cash proceeds from issuing shares
– cash payments to owners to acquire or redeem the entity's shares
– cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short- or
long-term borrowings
– cash repayments of amounts borrowed.
 Interest and dividend cash flows may be classified as either operating, investing or financing cash
flows, however a consistent approach must be taken.
 The role of the external auditor is to provide an independent opinion on whether an entity's
financial statements are true and fair.
 FINANCIAL ACCOUNTING AND REPORTING | 185

QUICK REVISION QUESTIONS

1 Which of the following are examples of current assets?

I. Prepayments
II. Cash equivalents
III. Manufacturing licences
IV. Income received in advance
V. Property, plant and equipment

A IV only
B I and II only
C I, II and III only
D I, II, III, IV and V

2 Which of the following must be disclosed in the statement of profit or loss and other
comprehensive income?
I. Tax expense
II. Analysis of expenses
III. Net profit or loss for the period

A I and II only
B I and III only
C II and III only
D I, II and III

3 Which of the following must be disclosed separately on the face of the statement of financial

MODULE 3
position??
A Accruals and prepayments
B Revaluation surplus
C Deferred tax liabilities and deferred tax assets
D Bank overdraft

4 In the current financial year, Natamo has raised a loan for $3 million. The loan is repayable in 10
equal half yearly instalments. The first instalment is due six months after the loan was raised.
The loan will be reported in Natamo's next financial statements:
A As capital.
B As a current liability.
C As a non-current liability.
D As both a current and a non-current liability.

5 When reporting profit for a period, companies are required to ensure that income and expenses
are correctly classified.
Which of the following expenses will not be included in the calculation of profit before tax?
A Interest payable
B Reorganisation costs
C Depreciation expense
D Profits attributable to non-controlling interests

6 The draft statement of profit or loss and other comprehensive income of Thermin for the year
ended 30 November 20X4 shows a profit before tax of $325 800. This includes:
1. A restructuring charge of $85 000; and
186 | FINANCIAL STATEMENTS

2. An adjustment of $42 000 to reduce the value of opening inventory. An error at the previous
year end had led to the inventory being over-valued.
What is the correct profit before tax for the year ended 30 November 20X4?
A $283 800
B $325 800
C $367 800
D $452 800
7 In the last financial year Cuchabee issued an invoice for $28 900 for the sale of inventory which had
cost $27 600.
What was the effect of this transaction on the company's assets, liabilities and capital and reserves?
Assets Liabilities Capital and reserves
A Increased Reduced Increased
B Increased Unchanged Increased
C Reduced Unchanged Reduced
D Unchanged Reduced Increased
8 Which of the following is reported as other comprehensive income?
A A dividend
B The proceeds of a share issue
C The profit on sale of a property
D A surplus on revaluation of a property
9 Which of the following is true concerning the statement of changes in equity?
A It reports all realised profits and losses only
B It does not include revaluation surpluses
C It includes other comprehensive income
D All of the above
10 D Co's transactions and results for the period to 31 December 20X9 are shown below:
$m

Profit for the period 29

Surplus on property 1 revaluation 14
Deficit on property 2 revaluation (7)
Issue of share capital 1
Property 2 had previously been revalued upwards by $10m.
What amount would appear in the statement of changes in equity as total comprehensive
income for the period?
A $30m
B $36m
C $37m
D $43m
11 Which of the following items could appear in a company's statement of cash flows?
I. Dividends received
II. Proposed dividend
III. Proceeds from issue of shares
IV. Irrecoverable debts written-off
V. Surplus on revaluation of non-current assets
A I and III only
B II and IV only
C I, II and IV only
D I, III and V only
 FINANCIAL ACCOUNTING AND REPORTING | 187

12 Part of the process of preparing a company's statement of cash flows is the calculation of cash flow
from operating activities.
Which of the following statements about that calculation (using the indirect method) are correct?
I. Increase in payables should be added to operating profits.
II. Increase in inventory should be deducted from operating profits.
III. Depreciation charges should be added to profit before tax.
IV. Loss on sale of operating non-current assets should be deducted from profit before tax.
A I, II and III only
B I, II and IV only
C I, III and IV only
D II, III and IV only

13 In the course of preparing a company's statement of cash flows, the following figures are to be
included in the calculation of net cash from operating activities.
$
Depreciation charges 980 000
Profit on sale of non-current assets 40 000
Increase in inventories 130 000
Decrease in receivables 100 000
Increase in payables 80 000

What will the net effect of these items be in the statement of cash flows?
$
A Addition to operating profit 890 000
B Subtraction from operating profit 890 000
C Addition to operating profit 990 000
D Addition to operating profit 1 070 000

14 Part of a company's draft statement of operating cash flows is shown below:

MODULE 3
$'000
Operating profit 8 640
Depreciation charges (2 160)
Proceeds from sale of non-current assets 360
Increase in inventory (330)
Increase in accounts payable 440

The following criticisms of the above extract have been made:

I. Increase in inventory should have been added, not deducted.
II. Depreciation charges should have been added, not deducted.
III. Increase in accounts payable should have been deducted, not added.
IV. Proceeds from sale of non-current assets should not appear in this part of the statement of cash
flows.
Which of these criticisms are valid?
A I and III only
B I and IV only
C II and III only
D II and IV only

15 A company has the following information about property, plant and equipment:
20X7 20X6
$'000 $'000
Cost 750 600
Accumulated depreciation 250 150
Carrying amount 500 450

Plant with a carrying amount of $75 000 (original cost $90 000) was sold for $30 000 during the year.
188 | FINANCIAL STATEMENTS

What is the cash flow from investing activities for the year?
A $95 000 inflow
B $210 000 inflow
C $95 000 outflow
D $210 000 outflow

16 A company provides the following extract from its statement of financial position:
20X7 20X6
$'000 $'000
Share capital 2 500 1 000
Loans 750 1 000
What is the cash flow from financing activities for the year?
A $1 250 000 inflow
B $1 750 000 inflow
C $1 250 000 outflow
D $1 750 000 outflow

17 In the year ended 31 December 20X4 a company sold some plant which had cost $100 000 for
$20 000. At the time of sale the carrying amount of the plant was $18 000.
Which of the following correctly states the treatment of the transaction in the company's statement
of cash flows?
Proceeds of sale Profit on sale
A Cash inflow under Added to profit in calculating cash
financing activities flow from operating activities
B Cash inflow under Added to profit in calculating cash
investing activities flow from operating activities
C Cash inflow under Deducted from profit in calculating
financing activities cash flow from operating activities
D Cash inflow under Deducted from profit in calculating
investing activities cash flow from operating activities
18 A company's statements of financial position at 31 December 20X4 and 20X5 included the
following items:
Statements of financial
position at
31.12.X5 31.12.X4
$'000 $'000
Taxation payable 840 760
Retained earnings 1 660 1 470
The company paid no interest or interim dividends during these years, and the tax liability of
$760 000 in the 20X4 statement of financial position was the amount paid in 20X5. Using this
information, what is the company's operating profit for 20X5 for inclusion in its statement of cash
flows?
A $190 000
B $950 000
C $1 030 000
D $1 660 000
 FINANCIAL ACCOUNTING AND REPORTING | 189

19 The statements of financial position of R, a limited liability company, at 31 December 20X3 and
20X4 included these figures:
31 December
20X3 20X4
Property, plant and equipment: $m $m
Cost 40 50
Accumulated depreciation (10) (14)
30 36
The statement of profit or loss and other comprehensive income for the year ended 31 December
20X4 showed the following figures:
Depreciation charge for year $6m
Loss on sale of property, plant and equipment $1m
The company purchased new property, plant and equipment costing $16m during the year.
What figure should appear in the company's statement of cash flows for 20X4 for receipts from the
sale of property, plant and equipment?
A $3m
B $4m
C $5m
D The figure cannot be calculated from the information provided.

20 At 1 October 20X4, BK had the following balance:

Accrued interest payable $12 000 credit
During the year ended 30 September 20X5, BK charged interest payable of $41 000 to its
statement of profit or loss and other comprehensive income. The closing balance on accrued
interest payable account at 30 September 20X5 was $15 000 credit.
How much interest paid should BK show in its statement of cash flows for the year ended
30 September 20X5?

MODULE 3
A $38 000
B $41 000
C $44 000
D $53 000

21 What is the role of the external auditor in the audit of a set of financial statements?
A To provide management with a set of financial statements
B To provide absolute assurance that the financial statements are correct
C To provide recommendations to the entity's management on improving controls
D To provide reasonable assurance on the truth and fairness of the financial statements

22 Which of the following might appear as a separate item in the 'other comprehensive income'
section of the statement of profit or loss and other comprehensive income?
A A gain on revaluation of a property.
B A large write-off of inventory in the period.
C A profit on disposal of the company's head office building.
D Disclosure of a large contingent liability resulting from a legal suit.

23 Which of the following is not a function of an internal audit team?

A Review and monitor internal control systems.
B Express an opinion on the financial statements.
C Review operational economy, efficiency and effectiveness.
D Review compliance with laws and regulations.
190 | FINANCIAL STATEMENTS

ANSWERS TO QUICK REVISION QUESTIONS

1 B I and II only. III and V are non-current assets. Income received in advance is termed deferred
income and recognised as a current (and/or non-current) liability.
2 B I and III only. II may be shown in the notes.
3 C Deferred tax liabilities and deferred tax assets, although the other items relate to the statement
of financial position, they do not need to be disclosed separately.
4 D The amount due within 12 months of the reporting date should be disclosed as a current
liability and the remainder as non-current.
5 D Non-controlling interests are apportioned their share of profits after tax; they do not feature
within the calculation of profit before tax.
6 B Both items have been dealt with correctly. The restructuring charge, although exceptional in
nature, should be charged against this year's profits. Although the adjustment to opening
inventory is a prior period adjustment (it corrects an error) it also affects the profit for the current
year because it affects cost of sales for both years. Cost of sales for the prior period is increased
and profit reduced; cost of sales for the current year is reduced and profit increased.
7 B Assets will increase as the receivable value is higher than the carrying amount of the inventory.
There is no effect on liabilities. Capital and reserves will increase as the inventory was sold for a
profit.
8 D A and B are transactions with shareholders and so reported in the statement of changes in
equity; C is realised income and so reported within profit or loss in the statement of profit or
loss and other comprehensive income.
9 C It includes other comprehensive income.
Other comprehensive income is included within the aggregated amount for total
comprehensive income. Changes in equity is a primary statement and includes gains taken
directly to reserves.
It is presented with the same prominence as the statement of profit or loss and statement of
financial position. All gains are included whether they are reported in the statement of profit or
loss or in reserves.
10 B $36m
$m
Profit for the year 29
Revaluations (14 – 7) 7
36

11 A Only the proceeds of a share issue and dividends received involve the movement of cash.
12 A Loss on sale of non-current assets should be added back to profit before tax.
13 C
$
Add: depreciation charge 980 000
Less: profit on sale of assets (40 000)
Less: increase in inventories (130 000)
Add: decrease in receivables 100 000
Add: increase in payables 80 000
Addition to operating profit 990 000

14 D Depreciation should be added back as it not a cash flow and proceeds from sale of non-current
assets appears under 'investing' cash flows.
 FINANCIAL ACCOUNTING AND REPORTING | 191

15 D PROPERTY, PLANT AND EQUIPMENT

$'000 $'000
Opening balance 600 Disposals 90
Purchases (balancing figure) 240 Closing balance 750
840 840
Purchase of property, plant and equipment 240 000
Proceeds from sale of property, plant and equipment (30 000)
Net cash outflow 210 000

16 A
$'000
Issue of share capital (2500 – 1000) 1 500
Repayment of loans (1000 – 750) (250)
Net cash inflow 1 250

17 D Profit on disposal will be included in profit, so should be deducted.

18 C
$'000
Retained earnings 31.12.X5 1 660
Retained earnings 31.12.X4 1 470
 Post tax profit for 20X5 190
Add back tax charge* 840
1 030

* Note: This is the current liability at 31.12.X5, just as the 20X4 charge is the current liability at
31.12.X4.
19 A PROPERTY, PLANT AND EQUIPMENT: COST
$m $m
Opening balance 40 Transfer disposal (balancing figure) 6
Cash – additions 16 Closing balance 50

MODULE 3
56 56

PROPERTY, PLANT AND EQUIPMENT: ACCUMULATED DEPRECIATION

$m $m
Opening balance 10
Transfer disposal (balancing figure) 2 Profit or loss 6
Closing balance 14
16 16

PROPERTY, PLANT AND EQUIPMENT: DISPOSAL

$m $m
Transfer cost 6 Transfer depreciation 2
Loss on sale 1
Proceeds of sale (balancing figure) 3
6 6

20 A Interest paid = $38 000

INTEREST PAYABLE
$ $
Cash paid (bal fig) 38 000 Opening balance 12 000
Closing balance 15 000 Profit or loss 41 000
53 000 53 000
21 D
22 A It is the only one of the four options that is a gain or loss accounted for in 'other comprehensive
income' rather than in profit or loss for the year.
23 B Expressing an opinion on the financial statements is the responsibility of the external auditor.
192 | FINANCIAL STATEMENTS

ANSWERS TO MODULE QUESTIONS

1 SHABNUM CO.
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 20X2
$'000 $'000
Cash flows from operating activities
Profit before tax 300
Depreciation charge (W1) 90
Interest expense 50
Loss on sale of property, plant and equipment (45 – 32) 13
Profit on sale of non-current asset investments (5)
(Increase)/decrease in inventories (48)
(Increase)/decrease in receivables (75)
Increase/(decrease) in payables 8
Cash generated from operating activities 333
Interest paid (75)
Tax paid (110 + 140 – 120) (130)
Net cash from operating activities 128
Cash flows from investing activities
Payments to acquire property, plant and equipment (W2) (201)
Payments to acquire intangible non-current assets (50)
Receipts from sales of property, plant and equipment 32
Receipts from sale of non-current asset investments 30
Interest received 25
Net cash used in investing activities (164)

Cash flows from financing activities

Proceeds from issue of share capital 60
Proceeds from long-term borrowings 120
Dividends paid (80)
Net cash from financing activities 100
Increase in cash and cash equivalents 64
Cash and cash equivalents at 1.1.X2 (note) (97)
Cash and cash equivalents at 31.12.X2 (note) (33)

NOTES TO THE STATEMENT OF CASH FLOWS

Note: Analysis of the balances of cash and cash equivalents as shown in the statement of financial
position.
20X2 20X1
$'000 $'000
Cash in hand 2 1
Short-term investments 50 –
Bank overdraft (85) (98)
(33) (97)
Workings
1 Depreciation charge
$'000 $'000
Accumulated depreciation at 31 December 20X2 340
Accumulated depreciation at 31 December 20X1 290
Depreciation on assets sold (85  45) (40)
(250)
Charge for the year 90
 FINANCIAL ACCOUNTING AND REPORTING | 193

2 Purchase of property, plant and equipment

PROPERTY, PLANT AND EQUIPMENT
$'000 $'000
1.1.X2 Balance b/d 595 Disposals 85
Revaluation (OCI) 9
Purchases (bal fig) 201 31.12.X2 Balance c/d 720
805 805

Note: In this answer, dividends paid have been presented under financing activities, but it
would also be acceptable to include them under operating activities and/or investing activities.
2 The answer is C.
TRADE RECEIVABLES
$'000 $'000
At 1.1.X6 (balance) 50 Cash received 220
Irrecoverable debts 10
Sales 250 At 31.12.X6 70
300 300

3 The answer is $625 000.

TRADE PAYABLES AND ACCRUALS
$'000 $'000
At 31.12.X4 220 At 1.1.X4 130
Cash paid (balance) 625 Purchases and expenses (W) 715
845 845

Purchases:
$'000
Cost of sales: 575
Less: depreciation (40)

MODULE 3
535
Less: opening inventories (390)
Add: closing inventories 450
Purchases 595
Operating expenses 120
Purchases and expenses 715

4 The main disadvantages of cash flow accounting are essentially the advantages of accruals
accounting (proper matching of related items). There is also the practical problem that few
businesses keep historical cash flow information in the form needed to prepare a historical
statement of cash flows and so extra record-keeping is likely to be necessary.
A problem common to all financial statements is that cash flow information is historic, however
users are more interested in forward looking information. A further drawback is the possibility of
manipulation of cash flows. For example, a business may delay making large payments to suppliers
until after the end of the accounting period.
194 | FINANCIAL STATEMENTS
 195

MODULE 4
APPLICATION OF
SPECIFIC ACCOUNTING
STANDARDS
Learning objectives Reference

Calculate the carrying amounts of different classes of intangible assets and prepare the LO4.1
relevant journal entries

Interpret contracts to determine the amount and timing of revenue to be recognised in LO4.2
the financial statements and reconcile the differences between ledgers if necessary

Calculate current and deferred income tax and prepare the relevant journal entries to LO4.3
record the tax effect in the financial statements

Calculate and account for foreign currency transactions at transaction date and LO4.4
subsequent dates

Translate financial statements from a functional currency to a presentation currency LO4.5

Topic list

1 IAS 16 Property, Plant and Equipment

2 IAS 38 Intangible Assets
3 Research and development costs
4 Impairment of individual assets
5 Cash-generating units (CGUs)
6 Accounting treatment of an impairment loss
7 Revenue recognition
8 Current tax
9 Deferred tax
10 Taxable temporary differences
11 Deductible temporary differences
12 Measurement and recognition of deferred tax
13 Taxation in company accounts
14 Foreign currency
15 Foreign currency transactions
16 Foreign currency financial statements
17 IFRS 16 Leases
196 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

MODULE OUTLINE

In this module, we examine a number of specific issues, including tangible and intangible assets,
impairment of assets, revenue recognition, tax, foreign currency and leases.
IAS 16 Property Plant and Equipment is a topic that you will have covered before, it is included in the
workbook as a brief overview of assumed knowledge rather than to bring in any new technical detail.
Intangible non-current assets are long-term assets which have a value to the business but no physical
substance. In many companies, especially those which produce food or 'scientific' products such as
medicines or 'high technology' products, the expenditure on research and development (R & D) is
considerable. When R & D is a large item of cost its accounting treatment will have a significant
influence on the profits of a business and its statement of financial position. As a result of this,
attempts have been made to standardise the accounting treatment, and these are discussed in this
module.
Revenue recognition is a key area when preparing financial statements. IFRS 15 deals with when
revenue can be recognised in the financial statements, and hinges on the key principle within IFRS 15,
which is that revenue is recognised when there is a transfer of control to the customer from the entity
supplying the goods or services, rather than accounting for the revenue when money is received.
IAS 36 Impairment of Assets is an important Standard. It deals with falls in value, or impairments, of
both tangible and intangible non-current assets and cash-generating units.
Entities are taxed on the basis of their trading profits. In some countries this may be called corporation
or corporate tax, but we will follow the terminology of IAS 12 Income Taxes and call it income tax.
There are two aspects of income tax which must be accounted for: current tax and deferred tax.
Many companies buy from overseas suppliers or sell to overseas customers. These transactions are
often denominated in a foreign currency and the amount must be converted into local currency before
it is recorded in the financial statements.
Similarly, some companies are members of a group but operate in a different country from other
group companies and prepare their accounts in a different currency. Their financial statements must
be translated into the currency used by the group before they can be consolidated.
Almost all companies need non-current assets to carry out their trade. These can be financed in a
number of ways. IFRS 16 covers the treatment of account for assets acquired by entering into a leasing
arrangement and how to deal with the fact that the assets are not usually legally owned by the
company. The treatment of when to recognise an asset and its related liability will be covered in this
section.
The module content is summarised in the diagrams below.

IAS 16 Property,
plant and equipment

Recognition Initial measurement Subsequent measurement

• Probable economic benefits • Purchase price • Cost
• Cost reliably measured • Directly attributable costs • Fair value
• Present value of cost of • Depreciation over useful life
dismantling/removing
• Subsequent costs capitalised if
meet recognition criteria
 FINANCIAL ACCOUNTING AND REPORTING | 197

Application of specific
accounting standards

includes
Intangible assets R & D costs

Brands
Goodwill

Impairment of assets

Impairment of individual Impairment of cash Accounting treatment of

assets generating units an impairment loss

Impaired if recoverable Cash generating unit (CGU) = Individual asset:

amount (higher of fair value smallert identifyable group of Recognise in profit or loss
less costs to sell and value assets for which independent unless asset previously
in use) less than carrying cash inflows can be identified revalued
amount and measured

MODULE 4

Allocate goodwill and CGU: Impairment loss

corporate assets to CGUs allocated; firstly, reduce
carrying amount of goodwill
allocated to CGU, then other
assets on a pro-rata basis
198 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

IFRS 15 Revenue
from contracts with customers

5-step model Contracts satisfied over time Variable consideration

• Step 1 = Identify contract with • Customer simultaneously receives • Customer expected to take
customer and consumes benefits as the settlement discount –
• Step 2 = Identify separate performance takes place recognise revenue net
performance obligations • Creates or enhances an asset that • Customer not expected to take
• Step 3 = Determine transaction the customer controls settlement discount – recognise
price • Does not create an asset with an revenue gross
• Step 4 = Allocate transaction alternative use to the entity • Subsequent adjustment if
price to performance o • Entity has an enforceable right to
bligations different to expectations
payment for performance
• Step 5 = Recognise revenue completed to date
when/as performance
obligations satisfied
 FINANCIAL ACCOUNTING AND REPORTING | 199

Taxation

Deferred tax
Current tax
• An accounting measure
Tax on profits of year
used to match the tax
• Adjust in profit or loss for
effects of transactions with
over/under provision of
previous year their accounting impact

Taxable temporary Deductible temporary

differences differences
• Arise where carrying amount • Arise where carrying amount
of an asset > tax base or of a liability > tax base or
carrying amount of a liability carrying amount of an asset
< tax base < tax base
Result in deferred tax liability Result in deferred tax asset
E.g. accelerated capital E.g. tax losses
allowances

Measurement and recognition of deferred

tax
• Use tax rate expected to apply at
settlement
• Do not discount
• Recognise deffered tax in OCI or equity
if underlying item is recognised in OCI
and equity

Tax in company accounts

• Tax charge in profit or loss is tax on profits
MODULE 4
+/– under/overprovision +/– movement on
deffered tax
• Statement of financial position is current
tax asset/liability + separate deferred tax
200 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

Accounting for
foreign currency

Foreign currency Foreign currency transactions Foreign currency financial

Functional currency = operating 1. Translate transaction amounts statements
currency of the entity into local currency before 1. Translate assets and liabilities at
Presentation currency = currency recording in the accounts closing rate
in which financial statements are 2. Retranslate monetary items at 2. Translate share capital and pre-
presented the year end and record acquisition reserves at historical
exchange difference in profit or acquisition date rate
loss 3. Post-acquisition reserves are
3. Record cash settlement using balancing figure
spot rate and recognise exchange
differences in profit or loss 4. Translate statement of profit or
loss at average rate

Exchange differences on translation of accounts:

Opening net assets at opening rate X
Opening net assets at closing rate X
X
Profit for year at average rate X
Profit for year at closing rate X
X
Exchange gain/loss X

IFRS 16 Lease

Accounting for lessee Accounting for lessor

• Initial measurement liability = Variable consideration • Finance lease

PV of future lease payments. • Short term leases • Operating lease
• Initial measurement asset = initial • Low value assets • Net investment in the lease =
measurement of liability + present value of lease payments
payments made before lease receivable + present value of
any unguaranteed residual value
commencement + direct costs +
estimated costs of dismantling,
removing or restoring where
applicable.
• Subsequent measurement liability
= increase the carrying amount
to reflect interest on the lease
liability – payments made.
• Subsequent measurement asset =
cost model and depreciated.
 FINANCIAL ACCOUNTING AND REPORTING | 201

BEFORE YOU BEGIN

If you have studied these topics before, you may wonder whether you need to study this module in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the module to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the module you can find the information, and you
will also find a commentary at the back of the Study guide.
1 What is the definition of property, plant and equipment? (Section 1.1)
2 At what value are property, plant and equipment recognised? (Section 1.3)
3 Property, plant and equipment can be revalued. What is the revalued amount? (Section 1.5)
4 Over what period is the depreciable value of an asset allocated? (Section 1.6)
5 What is an intangible asset? (Section 2.2)
6 How is an intangible asset initially measured? (Section 2.3)
7 Under what circumstances can an intangible asset be revalued? (Section 2.4)
8 Fill in the blank: Internally generated goodwill, brands, mastheads, publishing
titles and customer lists ........................................ be capitalised as intangible
assets. (Section 2.7)
9 What is research in the context of IAS 38? (Section 3.2)
10 What is development in the context of IAS 38? (Section 3.2)
11 How are research costs accounted for? (Section 3.4.1)
12 What are the IAS 38 recognition criteria for development costs? (Section 3.4.2)
13 Identify indicators of an impairment. (Section 4.2)
14 Which assets must be tested for impairment annually? (Section 4.2)
15 What is the recoverable amount of an asset? (Section 4.3)
16 What is the rule to determine if an impairment loss must be recognised? (Section 4.4)
17 Where is an impairment loss recognised? (Section 4.4)
18 What is a CGU? (Section 5)
19 How are impairment losses allocated to a CGU? (Section 6)
20 Which accounting standard governs revenue recognition? (Section 7.2)
21 What are the five steps in the approach to revenue recognition? (Section 7.5)
22 What is current tax? (Section 8)
MODULE 4

23 How is current tax recorded in the financial statements? (Section 8.3)

24 What is an overprovision and how is it accounted for? (Section 8.3)
25 What is deferred tax? (Section 9.1)
26 How is a temporary difference calculated? (Section 9.2)
27 What is the tax base of an asset? (Section 9.3)
28 What is a taxable temporary difference? (Section 10.1)
29 Give examples of situations in which a taxable temporary difference may arise. (Section 10.2)
30 What is a deductible temporary difference? (Section 11.1)
31 Give examples of situations in which a deductible temporary difference may arise. (Section 11.2)
32 Where is the movement in deferred tax recognised? (Section 12.4)
33 Why is deferred tax recognised in the financial statements? (Section 12.5)
34 What elements make up the tax charged to profit or loss? (Section 13.1)
35 What is the functional currency of an entity? (Section 14.1)
36 What is the presentation currency of an entity? (Section 14.1)
202 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

37 At what rate should a foreign currency transaction be initially translated before

it is recorded in the accounts? (Section 15.1)
38 How does an exchange difference relating to a foreign currency transaction
arise and where should it be recorded? (Section 15)
39 What is a monetary item? (Section 15.3.1)
40 Where a foreign operation has a different functional currency from the
reporting entity, at what rate are items in the foreign operation's statement of
financial position translated from its functional currency to the reporting entity's
presentation currency? (Section 16.2)
41 At what rate are items in the foreign operation's statement of profit or loss
translated from functional to presentation currency? (Section 16.2)
42 What makes up the exchange difference arising on the translation of the foreign
operation's financial statements into presentation currency? (Section 16.3)
43 How is a lease liability initially accounted for? (Section 17)
44 In what situations can an entity elect to not apply IFRS 16 leases? (Section 17.2)
 FINANCIAL ACCOUNTING AND REPORTING | 203

1 IAS 16 PROPERTY, PLANT AND EQUIPMENT

LO
4.1 Section overview
 The section below on Property, Plant and Equipment (IAS 16) revises some of the key areas
of IAS 16. Knowledge of these areas is needed in order to help with the application of other
topics coming up in this module.

Definition
Property, plant and equipment are tangible items that:
(a) are held by an entity for use in the production or supply of goods or services, for rental to others,
or for administrative purposes; and
(b) are expected to be used during more than one period.
(IAS 16)

1.1 RECOGNITION
The cost of an item of property, plant and equipment shall be recognised as an asset if, and only if:
 it is probable that future economic benefits associated with the item will flow to the entity; and
 the cost of the item can be measured reliably.

1.2 MEASUREMENT AT RECOGNITION

All items of property, plant and equipment are recognised at cost. Cost includes the following:
 Purchase price, including import duties and non-refundable purchase taxes, after deducting trade
discounts and rebates
 Directly attributable costs of bringing the asset to the location and condition necessary for it to
be capable of operating in the manner intended by management. Examples of directly attributable
costs include delivery, installation costs and relevant professional fees. Examples of costs that are
not costs of an item of property, plant and equipment are costs of opening a new facility and
administration, and other general overhead costs.
 Estimated cost of dismantling and removing the item and restoring the site on which it is
located due to obligation (IAS 37 Provisions, Contingent Liabilities and Contingent Assets) incurred
when the item is acquired or through use (other than to produce inventories).

1.3 SUBSEQUENT COSTS

MODULE 4

Subsequent costs on property, plant and equipment are capitalised when the cost of
replacement is incurred providing the recognition criteria are met. For example, the cost of replacing
part of the machine due to wear and tear is recognised and the part it replaces is derecognised.

1.4 MEASUREMENT AFTER RECOGNITION

Cost model
Property, plant and equipment is carried at cost less accumulated depreciation and accumulated
impairment losses.
Revaluation model
Property, plant and equipment is carried at a revalued amount whose fair value can be measured
reliably.
Revalued amount = fair value at date of revaluation less subsequent accumulated depreciation and
subsequent accumulated impairment losses.
Where an item of property, plant and equipment is revalued, all other assets in the same class must
also be revalued.
 204 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

Fair value
Fair value is defined by IFRS 13 Fair Value Measurement as 'the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market participants at the
measurement date.' (IFRS 13: para. 9)
This is the market price in the principal market for the asset. Where a market price is unavailable,
current replacement cost (adjusted for obsolescence) or present value techniques are used.
Frequency
Revaluations must be made with sufficient regularity to ensure that the carrying amount does not
differ materially from that which would be determined using fair value at the end of the reporting
period.
Revaluation gains are reported in other comprehensive income (and the revaluation surplus in the
statement of financial position) except where reversing a previous revaluation loss charged to profit or
loss.
Revaluation losses are charged directly in profit or loss unless, the asset has a credit
balance existing in the revaluation surplus. In that case, revaluation losses will first be charged to
other comprehensive income (in respect any revaluation surplus relating to the particular asset) any
remainder as an expense in profit or loss.
The revaluation surplus may be transferred directly to retained earnings when the asset is
derecognised. This may be when the asset is retired or disposed of. However, some of the surplus
may be transferred as the asset is used, calculated as the difference between depreciation based on
the revalued amount and depreciation based on original cost.

1.5 DEPRECIATION
The depreciable amount of an asset (cost/revalued amount less residual value) is allocated on a
systematic basis over its useful life.
Each part of an item of property, plant and equipment with a cost that is significant in relation to the
item's total cost is depreciated separately.
The useful life, residual value and depreciation method must be reviewed at least at each financial
year end and adjusted where necessary.

1.6 DERECOGNITION OF TANGIBLE ASSETS

Derecognition happens when a tangible asset is sold, exchanged or abandoned. The tangible asset
and associated cumulative depreciation is removed from the statement of financial position. A
resulting gain or loss may arise which is recognised at the same time.

2 IAS 38 INTANGIBLE ASSETS

LO
4.1 Section overview
 Intangible assets are defined by IAS 38 as non-monetary assets without physical substance.

'Intangible assets' are assets that have no physical substance or existence, as opposed to tangible
assets (such as plant and machinery) which have a physical existence. Intangible assets include
goodwill, intellectual rights (e.g. patents, performing rights and authorship rights), computer software
and development costs.

2.1 THE OBJECTIVES OF IAS 38

 To establish the criteria for when an intangible asset is recognised
 To specify how intangible assets are measured
 To specify the disclosure requirements for intangible assets
 FINANCIAL ACCOUNTING AND REPORTING | 205

2.2 DEFINITION OF AN INTANGIBLE ASSET

Definition
An intangible asset is an identifiable non-monetary asset without physical substance.
An asset as defined in the Conceptual Framework is a present economic resource controlled by the
entity as a result of past events.
(Conceptual Framework)

We shall consider the elements of this definition in turn in Sections 1.2.1–1.2.3.

2.2.1 INTANGIBLE ASSET: MUST BE IDENTIFIABLE

An intangible asset is identifiable:
 if it is separable, that is if it could be rented or sold separately; or
 it is a legal or contractual right.

2.2.2 INTANGIBLE ASSET: CONTROL BY THE ENTITY

Another element of the definition of an intangible asset is that it must be under the control of the
entity as a result of a past event. The entity must be able to enjoy the future economic benefits from
the asset, and prevent the access of others to those benefits.
 Control over technical knowledge or know-how only exists, and is recognisable as an intangible
asset, if it is protected by a legal right.
 The skill of employees, and the costs of training are most unlikely to be recognisable as an
intangible asset, because an entity does not control the future actions of its staff.
 Similarly, market share and customer loyalty cannot be intangible assets, because an entity
cannot control the actions of its customers.
2.2.3 INTANGIBLE ASSET: EXPECTED FUTURE ECONOMIC BENEFITS
An item can only be recognised as an intangible asset if economic benefits are expected to flow in the
future from ownership of the asset. Economic benefits may come from the sale of products or
services, or from a reduction in expenditure (cost savings).
Worked Example: Intangible assets (1)

The accountant of a company is considering whether the following meet the definition of an
intangible asset.
Bus licence
The licence gives the company the right to operate a bus route in the certain states of South Australia.
The licence was granted by the government and lasts for five years. It is not transferable.
MODULE 4

Recruitment and training of the workforce

The company spends considerable amounts each year on recruitment and training.
Brand ‘Super X’
This was acquired from a competitor and is expected to yield considerable future benefits.
Advertising
CQ invests substantially in advertising to promote its services.
Required
Advise, providing explanations, on whether the above items meet the definition of an intangible asset.
Solution

Bus licence
As the license arises from legal rights, it meets the definition of an intangible asset, providing it will
generate economic benefits. It may or may not be separable but that is not relevant due to the
existence of legal rights.
 206 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

Recruitment and training of workforce

It is unlikely that CQ has sufficient control over the workforce to give access to future economic
benefits. This does not meet the definition of an intangible asset.
Training costs are specifically identified by IAS 38 as being recognised as an expense when they are
incurred.
Brand ‘Super X’
The brand is controlled by the company (through ownership) and is expected to yield economic
benefits. Therefore, it meets the definition of an asset. Also, as the brand was acquired, it is separable
and can be regarded as an intangible asset.
Advertising
Although it would be expected that advertising would yield future economic benefits (increased
sales), there is insufficient control to give rise to an asset.
Even if there was, advertising would fail the identifiability test as it is not separable nor does it arise
from contractual or other legal rights.

2.3 INITIAL MEASUREMENT OF AN INTANGIBLE ASSET

When it is acquired an intangible asset is measured at cost. It should be recognised if, and only if
both the following occur:
 it is probable that the future economic benefits that are attributable to the asset will flow to the
entity; and
 the cost can be measured reliably.
If an intangible asset is acquired separately, its cost can usually be measured reliably as its purchase
price (including incidental costs of purchase such as legal fees, and any costs incurred in getting the
asset ready for use).
When an intangible asset is acquired with other assets and liabilities as part of a business
combination (i.e. an acquisition or takeover), the cost of the intangible asset is its fair value at the date
of the acquisition.

2.4 SUBSEQUENT MEASUREMENT OF AN INTANGIBLE ASSET

The revaluation model may be applied to intangible assets only where a fair value can be established
by reference to an active market. An active market is one in which items traded are homogenous,
willing buyers and sellers are available and prices are made public.
In practice, there are very few examples of intangible assets that are part of an active market; possibly
produce quotas and taxi licences. By definition, most intangible assets are unique and therefore do
not qualify as belonging to an active market and so cannot be revalued.
Where revaluations are allowed, they should be made sufficiently regularly that the carrying amount of
the asset is not materially different from its fair value.

2.5 AMORTISATION OF INTANGIBLE ASSETS

Intangible assets with a finite useful life are amortised over their useful life, beginning when the asset
is available for use. Amortisation should be on a straight-line basis unless some other basis better
reflects the way in which the asset's future economic benefits are expected to be consumed by the
entity. The residual value of an intangible asset is nil unless there is a commitment by a third party to
purchase the asset at the end of its life or there is an active market for the asset that is likely to exist at
the end of its useful life.
Intangible assets with an indefinite useful life are not amortised but tested each year for impairment.
 FINANCIAL ACCOUNTING AND REPORTING | 207

2.6 INTERNALLY GENERATED GOODWILL

Goodwill is the value to a business of its reputation, brand names, position in the market and so on.
When one company buys another, purchased goodwill arises. This is discussed in more detail in
Module 5. Internally generated goodwill is developed by a company over time as it builds up its
reputation.
Principle to learn
Internally generated goodwill is not recognised as an asset.

The standard deliberately precludes recognition of internally generated goodwill because its cost
cannot be measured reliably and it is not identifiable.

2.7 OTHER INTERNALLY GENERATED INTANGIBLE ASSETS

The Standard prohibits the recognition of internally generated brands, mastheads, publishing titles
and customer lists and similar items as intangible assets. These all fail to meet one or more of (in some
cases all) the definition and recognition criteria and in some cases are probably indistinguishable from
internally generated goodwill.

2.8 DERECOGNITION OF INTANGIBLE ASSETS

Derecognition happens when an intangible asset is sold, exchanged or abandoned. The intangible
asset and associated cumulative amortisation is removed from the statement of financial position. A
resulting gain or loss may arise which is recognised at the same time.

3 RESEARCH AND DEVELOPMENT COSTS

LO
4.1 Section overview
 Expenditure on research must always be written off in the period in which it is incurred.
 If the criteria laid down by IAS 38 are satisfied, development expenditure must be
capitalised as an intangible asset. If it has a finite useful life, it is amortised over that life.

3.1 INTRODUCTION TO R & D

Large companies may spend significant amounts of money on research and development (R & D)
activities. Obviously, any amounts so expended must be credited to cash and debited to an account
for research and development expenditure. The accounting problem is how to treat the debit
MODULE 4

balance on R & D account at the reporting date.

The two possible treatments are:
 The debit balance is classified as an expense and transferred to profit or loss. This is referred to as
'writing off' the expenditure. The argument here is that it is an expense just like rent or wages and
its accounting treatment should be the same.
 The debit balance is classified as an asset and included in the statement of financial position. This
is referred to as 'capitalising', 'carrying forward' or 'deferring' the expenditure. This argument is
based on the accrual assumption. If R & D activity eventually leads to new or improved products
which generate revenue, the costs should be carried forward to be matched against that revenue in
future accounting periods.
So the main question surrounding R & D costs is should they be treated as an expense or capitalised
as an asset.
 208 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

3.2 DEFINITIONS
The following definitions are given by IAS 38.
Definitions
Research. Is original and planned investigation undertaken with the prospect of gaining new scientific
or technical knowledge and understanding.
Development. Is 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 before the start of commercial production or use.
(IAS 38)

Although these definitions are usually well-understood, in practice it may not be so easy to identify
the activities encompassed by R & D and the dividing line between the categories may be indistinct.
Identification often depends on the type of business involved, the projects it undertakes and how it is
organised.
The Standard gives examples of activities which might be included in either research or development,
or which are neither but may be closely associated with both.
 Research
– Activities aimed at obtaining new knowledge;
– The search for applications of research findings or other knowledge;
– The search for product or process alternatives; and
– The formulation and design of possible new or improved product or process alternatives.
 Development
– The design, construction and testing of pre-production prototypes and models;
– The design of tools, jigs, moulds and dies involving new technology;
– The design, construction and operation of a pilot plant that is not of a scale economically
feasible for commercial production; and
– The design, construction and testing of a chosen alternative for new/improved materials.

3.3 COMPONENTS OF RESEARCH AND DEVELOPMENT COSTS

Research and development costs will include all costs that are directly attributable to research and
development activities, or that can be allocated on a reasonable basis.
The Standard lists the costs which may be included in R & D, where applicable (note that selling costs
are excluded):
 Salaries, wages and other employment related costs of personnel engaged in R & D activities;
 Costs of materials and services consumed in R & D activities;
 Depreciation of property, plant and equipment to the extent that these assets are used for
R & D activities;
 Overhead costs, other than general administrative costs, related to R & D activities; these cost are
allocated on bases similar to those used in allocating overhead costs to inventories (see IAS 2
Inventories); and
 Other costs, such as the amortisation of patents and licences, to the extent that these assets are
used for R & D activities.
 FINANCIAL ACCOUNTING AND REPORTING | 209

3.4 RECOGNITION OF R & D COSTS

The relationship between the R & D costs and the economic benefit expected to be derived from
them determines the allocation of those costs to different periods. Recognition of the costs as an
asset will only occur where it is probable that the cost will produce future economic benefits for the
entity and the costs can be measured reliably.

3.4.1 RESEARCH COSTS

Research costs are recognised as an expense in the period in which they are incurred. They cannot
be subsequently recognised as an asset in a later period.

3.4.2 DEVELOPMENT COSTS

Development costs are recognised as an expense in the period in which they are incurred unless
the criteria for asset recognition identified below are met. Development costs initially recognised as
an expense cannot be subsequently recognised as an asset in a later period.
Development expenditure is recognised as an asset when the business can demonstrate all of the
following (where these criteria are met, development expenditure must be capitalised):
 the technical feasibility of completing the intangible asset so that it will be available for use or sale;
 its intention to complete the intangible asset and use or sell it;
 its ability to use or sell the intangible asset;
 how the intangible asset will generate probable future economic benefits. Among other things,
the entity should demonstrate the existence of a market for the output of the intangible asset itself
or, if it is to be used internally, the usefulness of the intangible asset;
 the availability of adequate technical, financial and other resources to complete the development
and to use or sell the intangible asset; and
 its ability to measure reliably the expenditure attributable to the intangible asset during its
development.

3.5 AMORTISATION OF DEVELOPMENT COSTS

Definition
Amortisation. Is the systematic allocation of the depreciable amount of an intangible asset over its
useful life.
Once capitalised as an asset, development costs are amortised and recognised as an expense to
match the costs with the related revenue or cost savings. This must be done on a systematic basis, to
reflect the pattern in which the related economic benefits are recognised. If no other pattern can be
identified then the straight-line method should be used. MODULE 4

The amortisation will begin when the asset is available for use. Until the asset is available for use it
should be subject to an annual impairment review.
If the intangible asset is considered to have an indefinite useful life, it is not amortised but subjected
to an annual impairment review.

3.6 IMPAIRMENT OF DEVELOPMENT COSTS

As with all assets, impairment (fall in value of an asset) is a possibility. The development costs should be
written down to the extent that the unamortised balance (taken together with further development
costs, related production costs, and selling and administrative costs directly incurred in marketing the
product) exceeds the expected future economic benefits. This is covered later in the module.
 210 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

3.7 DISCLOSURE
The Standard has fairly extensive disclosure requirements for intangible assets. The financial statements
should disclose the accounting policies that have been adopted for intangible assets.
For each class of intangible assets (including development costs), disclosure is required of the following:
 the method of amortisation used;
 the useful life of the assets or the amortisation rate used;
 the gross carrying amount, the accumulated amortisation and the accumulated impairment
losses as at the beginning and the end of the period;
 a reconciliation of the carrying amount as at the beginning and at the end of the period
(additions, retirements/disposals, revaluations, impairment losses, impairment losses reversed,
amortisation charge for the period, net exchange differences, other movements);
 the line item to which amortisation has been charged in the SPLOCI; and
 the carrying amount of internally-generated intangible assets (development).
An entity should also disclose the amount of research and development expenditure charged as an
expense.
Question 1: Y Co. (1)
Y Co. is a research company which specialises in developing new materials and manufacturing
processes for the furniture industry. The company receives payments from a variety of manufacturers,
which pay for the right to use the company's patented fabrics and processes.
Research and development costs for the year ended 30 September 20X5 can be analysed as follows:
$
Expenditure on continuing research projects 1 420 000
Amortisation of development expenditure capitalised in earlier years 240 000
New projects started during the year:
Project A 280 000
New flame-proof padding. Expected to cost a total of $800 000 to develop. Expected total
revenue $2 000 000 once work completed – probably late 20X6.
Project B 150 000
New colour-fast dye. Expected to cost a total of $3 000 000 to complete. Future revenues are
likely to exceed $5 000 000. The completion date is uncertain because external funding will
have to be obtained before research work can be completed.
Project C 110 000
Investigation of new adhesive recently developed in aerospace industry. If this proves effective
then Y Co. may well generate significant income because it will be used in place of existing
adhesives.
2 200 000

Required
Explain how the three research projects A, B and C will be dealt with in Y Co.'s statement of profit or
loss and other comprehensive income and statement of financial position.
In each case, explain your proposed treatment in terms of IAS 38 Intangible Assets.
(The answer is at the end of the module.)
 FINANCIAL ACCOUNTING AND REPORTING | 211

Question 2: Y Co. (2)

Show how the research and development costs in the previous question will be disclosed in the
financial statements of Y Co. listed below.
(a) Statement of profit or loss and other comprehensive income
(b) Statement of financial position
(c) Notes to the financial statements.
Assume the cost of capitalised development expenditure brought forward is $1 480 000, and that
accumulated amortisation of $240 000 was brought forward at the beginning of the year.
(The answer is at the end of the module.)

4 IMPAIRMENT OF INDIVIDUAL ASSETS

LO
4.1 Section overview
 Impairment is determined by comparing the carrying amount of the asset with its
recoverable amount. This is the higher of its fair value less costs of disposal and its value
in use.

There is an established principle that assets are not carried at above their recoverable amount. An
entity should write down the carrying amount of an asset to its recoverable amount. IAS 36
Impairment of Assets covers impairment reviews and related accounting treatments and disclosures.

4.1 SCOPE
IAS 36 applies to most tangible and intangible assets, but certain asset types are excluded because
they are covered specifically by another Standard. These include inventories (covered by IAS 2), assets
arising from construction contracts, deferred tax assets (IAS 12), financial assets that are within the
scope of IFRS 9, investment property that is measured at fair value (IAS 40) and a small number of
other asset types. This is because these standards already have rules for recognising and measuring
impairment,
Definitions

Impairment. A fall in the value of an asset, so that its 'recoverable amount' is less than its carrying
amount.
Carrying amount. Is the amount at which an asset is recognised after deducting accumulated
depreciation and impairments. (IAS 36)
MODULE 4

The basic principle underlying IAS 36 is relatively straightforward. If an asset's value in the accounts is
higher than its 'recoverable amount', the asset has suffered an impairment loss. It should therefore be
reduced in value, by the amount of the impairment loss. The general rule is that the amount of the
impairment loss should be written off against profit or loss immediately (exceptions will be covered
later).
The main accounting issues to consider are:
 How to identify when an impairment loss may have occurred?
 How should the recoverable amount of the asset be measured?
 How should an 'impairment loss' be reported in the accounts?
 212 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

4.2 IDENTIFYING A POTENTIALLY IMPAIRED ASSET

An entity should assess at the end of each reporting period whether there are any indications of
impairment. The concept of materiality applies, and only material impairment needs to be identified.
If there are indications of possible impairment, the entity must estimate the recoverable amount of
the assets concerned.
IAS 36 suggests indications of a possible impairment. The suggestions are based largely on
common sense.
 External sources of information
– A fall in the asset's market value that is more significant than would normally be expected from
passage of time or normal use.
– A significant change in the technological, market, legal or economic environment of the
business in which the assets are employed.
– An increase in market interest rates or market rates of return on investments likely to affect the
discount rate used in calculating value in use.
– The carrying amount of the entity's net assets being more than its market capitalisation.
 Internal sources of information: evidence of obsolescence or physical damage, adverse changes
in the use to which the asset is put, or the asset's economic performance.
Even if there are no indications of impairment, the following assets must always be tested for
impairment annually:
 an intangible asset with an indefinite useful life;
 an intangible asset which is not yet available for use; and
 goodwill acquired in a business combination.

4.3 MEASURING THE RECOVERABLE AMOUNT OF THE ASSET

What is an asset's recoverable amount?
Definition
The recoverable amount of an asset is the higher value of:
 the asset's fair value less costs of disposal; and
 its value in use. (IAS 36)

An asset's fair value less costs of disposal is the amount net of selling costs that could be obtained
from the sale of the asset. Selling costs include sales transaction costs, such as legal expenses. Selling
costs do not include restructuring or reorganisation expenses, or any costs that have already been
recognised in the financial statements.
The concept of 'value in use' is very important.
Definition

The value in use of an asset is measured as the present value of estimated future cash flows (inflows
minus outflows) generated by the asset, including its estimated net disposal value (if any) at the end of
its expected useful life.
(IAS 36)
 FINANCIAL ACCOUNTING AND REPORTING | 213

4.4 RECOGNITION AND MEASUREMENT OF AN IMPAIRMENT LOSS

The rule for assets at historical cost is:

Rule to learn
If the recoverable amount of an asset is lower than the carrying amount, the carrying amount should
be reduced by the difference (i.e. the impairment loss) which should be charged as an expense in
profit or loss.

The rule for assets held at a revalued amount (such as property revalued under IAS 16) is:
Rule to learn

The impairment loss is to be treated as a revaluation decrease under the relevant IAS.

In practice this means:

 To the extent that there is a revaluation surplus held in respect of the asset, the impairment loss
should be charged to the revaluation surplus.
 Any excess should be charged to profit or loss.
Once reduced to recoverable amount, the depreciation charge on the asset is based on recoverable
amount, estimated residual value (if any) and estimated remaining useful life.
Worked Example: Impairment and depreciation charge

Two years ago a company bought a machine for $500 000. Depreciation has been charged straight
line over five years assuming no residual value. Now the machine has a value in use of $270 000 and
the fair value less costs of disposal is $120 000. Its useful life is still estimated as five years from
acquisition and residual value is still expected to be zero. Calculate and record the impairment and
the future depreciation charge.
Solution
The carrying amount now will be $300 000 (being the cost of $500 000 less two years depreciation at
$100 000 each year).
The recoverable amount is the higher of $270 000 and $120 000 which is $270 000.
The carrying amount is written down by the impairment of $30 000.
Dr. Impairment expense $30 000
Cr. Accumulated impairment losses $30 000
The future depreciation charge will be $270 000 / 3 years = $90 000 each year
MODULE 4

5 CASH-GENERATING UNITS (CGUs)

Section overview
 When it is not possible to calculate the recoverable amount of a single asset, that of its
cash-generating unit should be measured instead.

The IAS goes into quite a large amount of detail about the important concept of cash-generating
units. As a basic rule, the recoverable amount of an asset should be calculated for the asset
individually. However, there will be occasions when it is not possible to estimate such a value for an
individual asset, particularly in the calculation of value in use. This is because cash inflows and outflows
cannot be attributed to the individual asset.
 214 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

If it is not possible to calculate the recoverable amount for an individual asset, the recoverable amount
of the asset's cash-generating unit should be measured instead.
Definition

A cash-generating unit is the smallest identifiable group of assets for which independent cash inflows
can be identified and measured.
(IAS 36)

Question 3: Cash-generating unit

Can you think of some examples of how a cash-generating unit would be identified?
(The answer is at the end of the module.)

Question 4: Cash-generating unit

Minimart belongs to a retail store chain Maximart. Minimart makes all its retail purchases through
Maximart's purchasing centre. Pricing, marketing, advertising and human resources policies (except
for hiring Minimart's cashiers and sales staff) are decided by Maximart. Maximart also owns five other
stores in the same city as Minimart (although in different neighbourhoods) and 20 stores in other
cities. All stores are managed in the same way as Minimart. Minimart and four other stores were
purchased five years ago and goodwill was recognised.
Required
What is the cash-generating unit for Minimart?
(The answer is at the end of the module.)

Cash-generating units should be identified consistently from period to period for the same type of
asset unless a change is justified.
The group of net assets less liabilities that are considered for impairment should be the same as those
considered in the calculation of the recoverable amount. (For the treatment of goodwill and corporate
assets see below.)

5.1 ALLOCATING GOODWILL TO CASH-GENERATING UNITS

Goodwill acquired in a business combination does not generate cash flows independently of other
assets. It must be allocated to the acquirer's cash-generating units (or groups of cash-generating
units) that are expected to benefit from the synergies of the combination.

5.2 TESTING CASH-GENERATING UNITS WITH GOODWILL FOR

IMPAIRMENT
There are two situations to consider:
 Where goodwill has been allocated to a cash-generating unit.
 Where it has not been possible to allocate goodwill to a specific cash-generating unit, but only to a
group of units.
A cash-generating unit to which goodwill has been allocated is tested for impairment annually.
The carrying amount of the unit, including goodwill, is compared with the recoverable amount.
If the carrying amount of the unit exceeds the recoverable amount, the entity must recognise an
impairment loss.
Where goodwill relates to a cash-generating unit but has not been allocated to that unit, the unit is tested
for impairment by comparing its carrying amount (excluding goodwill) with its recoverable amount.
The entity must recognise an impairment loss if the carrying amount exceeds the recoverable amount.
The annual impairment test may be performed at any time during an accounting period, but must be
performed at the same time every year.
 FINANCIAL ACCOUNTING AND REPORTING | 215

5.3 CORPORATE ASSETS

Corporate assets are assets such as a head office building, computer equipment or a research centre.
Essentially, corporate assets are assets that do not generate cash inflows independently from other
assets. Therefore, their carrying amount cannot be fully attributed to a single cash-generating unit
under review.
In testing a cash-generating unit for impairment, an entity should identify all the corporate assets that
relate to the cash-generating unit:
 If a portion of the carrying amount of a corporate asset can be allocated to the unit on a
reasonable and consistent basis, the entity compares the carrying amount of the unit (including the
portion of the asset) with its recoverable amount.
 If a portion of the carrying amount of a corporate asset cannot be allocated to the unit on a
reasonable and consistent basis, the entity:
– compares the carrying amount of the unit (excluding the asset) with its recoverable amount and
recognises any impairment loss
– identifies the smallest group of cash-generating units that includes the cash-generating unit to
which the asset belongs and to which a portion of the carrying amount of the asset can be
allocated on a reasonable and consistent basis
– compares the carrying amount of that group of cash-generating units (including the portion of
the asset allocated to the group of units) with the recoverable amount of the group of units and
recognises any impairment loss.

6 ACCOUNTING TREATMENT OF AN IMPAIRMENT

LOSS

LO
4.1 Section overview
 An impairment loss is recognised immediately in profit or loss unless the asset has been
revalued, in which case the loss is treated as a revaluation decrease.

If, and only if, the recoverable amount of an asset is less than its carrying amount in the statement of
financial position, an impairment loss has occurred. This loss should be recognised immediately.
As we saw earlier:
(a) the asset's carrying amount should be reduced to its recoverable amount in the statement of
financial position. MODULE 4
(b) the impairment loss should be recognised immediately in profit or loss (unless the asset has been
revalued in which case the loss is treated as a revaluation decrease).
After reducing an asset to its recoverable amount, the depreciation charge on the asset should then
be based on its new carrying amount, its estimated residual value (if any) and its estimated remaining
useful life.
An impairment loss is recognised for a cash-generating unit if the recoverable amount for the cash-
generating unit is less than the carrying amount of all the assets in the unit. When an impairment loss
is recognised for a cash-generating unit, the loss is allocated between the assets in the unit in the
following order:
 First, to any assets that are obviously damaged or destroyed
 Next, to the goodwill allocated to the cash-generating unit
 Then to all other assets in the cash-generating unit, on a pro rata basis.
Note that point (c) refers to 'all other assets in the cash-generating unit', however remember that
some assets such as inventory are outside the scope of IAS 36 (see Section 1.1) and are therefore not
included within 'all other assets'.
216 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

In allocating an impairment loss, the carrying amount of an asset should not be reduced below the
highest of:
 its fair value less costs of disposal
 its value in use (if determinable)
 zero.
Any remaining amount of an impairment loss should be recognised as a liability if required by other
IFRSs.
Worked Example: Impairment loss (1)

A company that extracts natural gas and oil has a drilling platform in the Caspian Sea. It is required by
legislation of the country concerned to remove and dismantle the platform at the end of its useful life.
Accordingly, the company has included an amount in its financial statements for removal and
dismantling costs, and is depreciating this amount over the platform's expected life.
The company is carrying out an exercise to establish whether there has been an impairment of the
platform.
(a) Its carrying amount in the statement of financial position is $3m.
(b) The company has received an offer of $2.8m for the platform from another oil company. The
bidder would take over the responsibility (and costs) for dismantling and removing the platform at
the end of its life.
(c) The present value of the estimated cash flows from the platform's continued use is $3.3m (before
adjusting for dismantling costs).
(d) The carrying amount in the statement of financial position for the provision (a liability) for
dismantling and removal is currently $0.6m.
What should be the value of the drilling platform in the statement of financial position, and what, if
anything, is the impairment loss?
Solution

Fair value less costs of disposal = $2.8m

Value in use = PV of cash flows from use less the carrying amount of the provision / liability
= $3.3m – $0.6m = $2.7m
Recoverable amount = Higher of these two amounts, i.e. $2.8m
Carrying amount = $3m
Impairment loss = $0.2m
The carrying amount should be reduced to $2.8m.

Worked Example: Impairment loss (2)

A company has acquired another business for $4.5m: tangible assets are valued at $4.0m and goodwill
at $0.5m.
An asset with a carrying amount of $1m is destroyed in a terrorist attack. The asset was not insured.
The loss of the asset, without insurance, has prompted the company to assess whether there has been
an impairment of assets in the acquired business and what the amount of any such loss is.
The recoverable amount of the business (a single cash-generating unit) is measured as $3.1m.
Solution
There has been an impairment loss of $1.4m ($4.5m – $3.1m).
The impairment loss will be recognised in profit or loss. The loss will be allocated between the assets
in the cash-generating unit as follows:
(a) A loss of $1m can be attributed directly to the uninsured asset that has been destroyed.
(b) The remaining loss of $0.4m should be allocated to goodwill.
The carrying amount of the assets will now be $3m for tangible assets and $0.1m for goodwill.
 FINANCIAL ACCOUNTING AND REPORTING | 217

6.1 REVERSAL OF AN IMPAIRMENT LOSS

The annual assessment to determine whether there may have been some impairment should be
applied to all assets, including assets that have already been impaired in the past.
In some cases, the recoverable amount of an asset that has previously been impaired might turn out
to be higher than the asset's current carrying amount. In other words, there might have been a
reversal of some of the previous impairment loss.
In this case, the carrying amount of the asset is increased to its new recoverable amount, which
should not exceed the asset's carrying amount at that date had the original impairment loss not
occurred.
 A reversal of an impairment loss on an asset held at historic cost is recognised immediately in profit
or loss.
 A reversal of an impairment loss on a revalued asset is recognised in profit or loss to the extent that
the original impairment loss was recognised in profit or loss. The balance of the reversal is
recognised as other comprehensive income and increases the revaluation surplus for that asset.
An exception to this rule is for goodwill. An impairment loss for goodwill is not reversed.
Question 5: Reversal of impairment loss
A cash-generating unit comprising a factory, plant and equipment etc. and associated purchased
goodwill becomes impaired because the product it makes is overtaken by a technologically more
advanced model produced by a competitor. The recoverable amount of the cash-generating unit falls
to $60m, resulting in an impairment loss of $80m, allocated as follows:
Carrying amounts Carrying amounts
before impairment after impairment
$m $m
Goodwill 40 –
Patent (with no market value) 20 –
Tangible non-current assets (market value $60m) 80 60
Total 140 60

After three years, the entity makes a technological breakthrough of its own, and the recoverable
amount of the cash-generating unit increases to $90m. The carrying amount of the tangible non-
current assets had the impairment not occurred would have been $70m.
Required
Calculate the reversal of the impairment loss and explains how it should be accounted for.
(The answer is at the end of the module.)
MODULE 4
218 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

KEY MODULE POINTS 1

 Property, plant and equipment are tangible items for use in the production or supply of goods,
rental to other or administrative purposes, which are expected to be used during more than one
accounting period.
 Property, plant and equipment which meets the recognition criteria is initially measured at cost.
 The revaluation model may subsequently be applied to property, plant and equipment.
 An intangible asset is defined by IAS 38 as an identifiable non-monetary asset without physical
substance which is:
– controlled by an entity as a result of a past event; and
– expected to generate future economic benefits to the entity.
 An intangible asset which meets the recognition criteria of the Conceptual Framework is initially
measured at cost.
 The revaluation model may subsequently be applied to intangible assets only where a fair value
can be established by reference to an active market.
 Intangible assets with a finite useful life are amortised over that useful life, beginning when the
asset is available for use.
 Intangible assets with an indefinite useful life are not amortised but tested each year for
impairment and in addition whenever there are indications of impairment.
 Internally generated goodwill may not be recognised as an asset.
 Research is original and planned investigation undertaken with the prospect of gaining new
scientific or technical knowledge and understanding.
 Expenditure on research must always be written off in the period in which it is incurred.
 Development is 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.
 Expenditure on development is written off unless it meets the IAS 38 capitalisation criteria. In this
case it is capitalised at cost and amortised.
 Impairment is determined by comparing the carrying amount of the asset with its recoverable
amount. This is the higher of its fair value less costs of disposal and its value in use.
 If the recoverable amount of an asset is lower than the carrying amount, the carrying amount is
reduced by the difference.
 For an asset held at historical cost, the impairment is charged as an expense in profit or loss.
 For a revalued asset, the impairment loss is treated as a revaluation decrease under the relevant
IFRS.
 When it is not possible to calculate the recoverable amount of a single asset, then that of its cash-
generating unit is measured instead.
 A cash-generating unit is the smallest identifiable group of assets that generates cash inflows that
are largely independent of the cash inflows from other assets or groups of assets.
 Goodwill and corporate assets must be allocated to each of the acquirer's cash-generating units
(or groups of cash-generating units) that are expected to benefit from the synergies of the
combination.
 When an impairment loss is recognised for a cash-generating unit, the loss is allocated between
the assets in the unit in the following order:
 first, to any assets that are obviously damaged or destroyed
 next, to the goodwill allocated to the cash-generating unit
 then to all other assets in the cash-generating unit (and within the scope of IAS 36) on a pro rata
basis.
 FINANCIAL ACCOUNTING AND REPORTING | 219

QUICK REVISION QUESTIONS 1

1 XY Co. has development expenditure of $500 000. Its policy is to amortise development
expenditure at 2 per cent per annum. Accumulated amortisation brought forward is $20 000.
What is the amount shown in the statement of financial position at the year end for development
expenditure?
A $470 000
B $480 000
C $490 000
D $500 000
2 Which of the following statements about research and development expenditure are correct
according to IAS 38 Intangible Assets?
I. If certain conditions are met, an entity may decide to capitalise development expenditure.
II. Capitalised development expenditure must be amortised over a period not exceeding five years.
III. Research expenditure, other than capital expenditure on research facilities, must be written off
as incurred.
IV. Capitalised development expenditure must be classified in the statement of financial position
under intangible non-current assets.
A I and II only
B II and IV only
C III and IV only
D I, III and IV only
3 Which of the following should be capitalised as development expenditure?
A A Co. has incurred $140 000 investigating whether a newly identified plant has medicinal
properties, and found that it does.
B B Co. has found that a particular chemical compound may be useful in combating flu. A number
of large pharmaceutical companies are providing financial backing for B Co.
C C Co. has produced a prototype of a new product however trials in its use have revealed a
number of flaws. C Co. is currently working on overcoming these flaws with little success.
D D Co. has spent $90 000 making a new fabric resistant to the sun's rays for use in children's
clothing. Several large manufacturers are interested in the fabric which will be ready for
production in the coming year.
4 In the current year High Co. has developed a new heat retaining fabric from which clothing suitable
MODULE 4

for high altitudes will be made. The project meets the IAS 38 criteria for capitalisation and by
30 June 20X8, $210 000 had been capitalised.
The fabric is expected to generate revenue for 10 years from the date on which commercial
production commenced on 1 November 20X7, although in the first year only half of the revenue of
subsequent years is anticipated. What amount is charged to profit or loss in respect of the fabric in
the year ended 30 June 20X8?
A $7368
B $11 053
C $14 000
D $21 000
220 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

5 Cranford Co. has incurred $40 000 researching chemical compounds in the year ended 30 June
20X8. It has also spent $90 000 developing a new product. The product's development was
completed on 28 February but management has decided to delay commercial production until
July 20X8. The product is expected to have a useful life of five years. The development project
meets the IAS 38 capitalisation criteria. How should these costs be treated in the year ended
30 June 20X8?
A $130 000 should be written off to profit or loss
B $46 000 should be written off to profit or loss and $84 000 recognised as an intangible asset
C $40 000 should be written off to profit or loss and $90 000 recognised as an intangible asset
D $100 000 should be written off to profit or loss and $30 000 recognised as an intangible asset
6 Which of the following four statements is correct?
A Capitalised development expenditure must be amortised over a period not exceeding five
years.
B Capitalised development costs are classified in the statement of financial position as non-
current assets.
C Amortisation of capitalised development expenditure will appear as an item in a company's
statement of changes in equity.
D If all the conditions specified in IAS 38 Intangible Assets are met, the directors can choose
whether to capitalise the development expenditure or not.
7 Which of the following are IAS 38 criteria which must be met in order to capitalise an intangible
non-current asset?
I. The asset must be capable of separate disposal.
II. The asset must be within the control of the entity.
III. It is probable that future economic benefits will flow to the entity as a result of the asset.
A I and II only
B I and III only
C II and III only
D I, II and III
8 Which of the following is correct?
A An intangible asset must be amortised.
B Market share may be recognised as an intangible asset.
C Intangible assets with an indefinite useful life must be reviewed for impairment annually.
D Internally generated goodwill can be recognised in the financial statements by reference to the
amount of purchased goodwill of a similar company.
9 Choc Co. acquires a chocolate bar brand from a competitor for $900 000 on 1 August 20X9. The
brand is considered by Choc Co. to have a useful life of 25 years, and in order to maintain its
market position, Choc Co. have, since acquisition, spent $100 000 on a marketing campaign. What
intangible asset is recognised in Choc Co.'s statement of financial position at 31 December 20X9?
A $864 000
B $885 000
C $964 000
D $985 000
 FINANCIAL ACCOUNTING AND REPORTING | 221

10 Clever Co. has incurred the following costs in the course of the year ended 30 June 20X9:
 $400 000 training selected staff members to be 'World Class Knowledge Holders' (an internal
qualification which is believed to result in increased sales).
 $100 000 acquiring patents.
 $200 000 advertising new products. The advertising is expected to result in a doubling of sales
in the coming year.
What amount should Clever Co. capitalise as an intangible asset in respect of these items in the
year ended 30 June 20X9?
A $100 000
B $300 000
C $500 000
D $600 000
11 Which of the following represents the correct treatment of a revaluation surplus arising on a
property and an impairment loss on an asset which has not previously been revalued?
Revaluation surplus Impairment loss
A Profit or loss Profit or loss
B Other comprehensive income Profit or loss
C Profit or loss Other comprehensive income
D Other comprehensive income Other comprehensive income
12 At 1 May 20X4 the revaluation surplus of Bloxden was $1 257 000. This was in respect of the
company's head office.
During the year to 30 April 20X5 the value of the head office increased by a further $82 000. In the
same period, the company's factory suffered an impairment of $90 000.
What is the value of the revaluation surplus at 30 April 20X5?
A $1 167 000
B $1 249 000
C $1 257 000
D $1 339 000
13 Which of the following statements about IAS 36 Impairment of Assets are correct?
I. Non-current assets must undergo an annual impairment test.
II. If individual assets cannot be tested for impairment, it may be necessary to test a group of
assets as a unit.
III. An impairment loss must be recognised immediately in profit or loss, except that all or part of a
loss on a revalued asset should be charged against any related revaluation surplus.
A I and II only
MODULE 4

B I and III only

C II and III only
D I, II and III
222 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

14 A cash-generating unit comprises the following:

$m
Building 20
Plant and equipment 10
Goodwill 5
Current assets 10
45

Following a downturn in the market, an impairment review has been undertaken and the
recoverable amount of the cash-generating unit is estimated to be $25m.
What is the carrying amount of the building after adjusting for the impairment loss?
A $10m
B $11m
C $12.5m
D $20m
15 On 1 January 20X5 Plane Co. acquired 60 per cent of the equity share capital of Sycamore Co.
Goodwill of $100 000 arose on the acquisition.
Sycamore Co.'s performance for the years ended 31 December 20X5 and 31 December 20X6
slightly exceeded budget. However, in the year ended 31 December 20X7 it made substantial
losses that had not been forecast.
The goodwill arising on the acquisition of Sycamore Co. should be reviewed for impairment:
A in 20X5
B in 20X7
C annually
D in 20X5 and in 20X7
16 Man Co. bought a property on 1 April 20X5 costing $700 000 and commenced depreciation over a
50-year period. On 1 April 20X7, the property was revalued to $960 000 and depreciation
continued over the remaining useful life. Man Co. makes an annual reserve transfer in respect of
excess depreciation. On 31 March 20X8, as the result of fire damage, the property was found to be
impaired with a recoverable amount of $600 000.
Which of the following is correct for the year ended 31 March 20X8?
A An impairment loss of $340 000 arises, $288 000 is debited to the revaluation surplus and
$64 000 to profit or loss
B An impairment loss of $340 000 arises, $282 000 is debited to the revaluation surplus and
$58 000 to profit or loss
C An impairment loss of $340 800 arises, $282 800 is debited to the revaluation surplus and
$58 000 to profit or loss
D An impairment loss of $340 800 arises, $288 000 is debited to the revaluation surplus and
$52 800 to profit or loss
17 Skipton Co. bought land 11 years ago in 20W8 at a cost of $300 000. In 20X3 the land was revalued
to $350 000 and in 20X6 it was revalued again to $400 000. At the end of 20X9 the land had a value
in use of $270 000 and the fair value less costs of disposal was $285 000.
How is the resulting impairment loss recorded?
A $50 000 as other comprehensive income and $65 000 in profit or loss
B $50 000 as other comprehensive income and $80 000 in profit or loss
C $100 000 as other comprehensive income and $15 000 in profit or loss
D $100 000 as other comprehensive income and $30 000 in profit or loss
 FINANCIAL ACCOUNTING AND REPORTING | 223

18 Pannal Co. recorded an impairment of its goodwill five years ago, reducing the carrying amount by
half. The management of Pannal now believes that the value of goodwill has increased again to
75 per cent of its original value. Which of the following is correct?
A The reversal of the impairment loss cannot be recognised.
B The reversal of the impairment loss should be recognised in profit or loss.
C The reversal of the impairment loss should be recognised in other comprehensive income.
D The reversal of the impairment loss is recognised in either other comprehensive income or
profit or loss depending on how the initial impairment was recognised.
19 Denton Co. acquired a piece of machinery on 1 July 20X7 for $80 000 and commenced
depreciation on a straight-line basis over 10 years. At 31 December 20X8, the machine was tested
for impairment as a result of a downturn in the market. It was found to have a value in use of
$66 000 and the fair value less costs of disposal was $60 000.
What was the depreciation charge on the machine in the year ended 31 December 20X9 assuming
that there was no change in useful life?
A $7059
B $7529
C $7765
D $8000
20 Which of the following statements is correct?
I. An intangible asset with an indefinite useful life must be tested for impairment at the end of
each reporting period.
II. A head office building which is shared by a number of cash-generating units is always tested for
impairment on an individual basis.
A I only
B II only
C Both statements
D Neither statement

MODULE 4
 224 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

7 REVENUE RECOGNITION

LO
4.2 Section overview
 Revenue recognition is straightforward for most business transactions, but some situations
are more complicated and some give opportunities for manipulation.

7.1 INTRODUCTION
Frequently the largest single number in the statement of profit or loss and other comprehensive
income is revenue. Of particular concern is when revenue should be recognised. Accruals accounting
is based on the matching of costs with the revenue they generate. It is therefore crucially important
that we establish the point at which revenue is recognised so that the correct treatment is applied to
related costs. For example, the costs of producing an item of finished goods should be carried as an
asset in the statement of financial position until such time as it is sold; then they are written off as a
charge to profit or loss. Which of these two treatments should be applied cannot be decided until it is
clear at what moment the sale of the item takes place.

7.2 IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS

The key principle within IFRS 15 is that revenue is recognised when there is a transfer of control to the
customer from the entity supplying the goods or services.
IFRS 15 Revenue from Contracts with Customers was issued in May 2014, replacing both IAS 18
Revenue and IAS 11 Construction Contracts. It is effective for reporting periods beginning on or after
1 January 2018.
Under IFRS 15 the transfer of goods and services is based upon the transfer of control, rather than the
transfer of risks and rewards as in IAS 18. Control of an asset is described in the standard as the
ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset.

7.3 SCOPE
IFRS 15 applies to all contracts with customers except:
 leases within the scope of IFRS 16;
 insurance contracts within the scope of IFRS 4;
 financial instruments and other contractual rights and obligations within the scope of IFRS 9,
IFRS 10, IFRS 11, IAS 27 or IAS 28; and
 non-monetary exchanges between entities in the same line of business.

7.4 DEFINITIONS
The following definitions are given in the Standard.
Definitions
Income. Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in an increase in equity, other than those
relating to contributions from equity participants.
Revenue. Income arising in the course of an entity’s ordinary activities.
Contract. An agreement between two or more parties that creates enforceable rights and obligations.
 FINANCIAL ACCOUNTING AND REPORTING | 225

Performance obligation: a promise in a contract with a customer to transfer to the customer either:
 a good or service (or a bundle of goods or services) that is distinct; or
 a series of distinct goods or services that are substantially the same and that have the same pattern
of transfer to the customer.
Stand-alone selling price: the price at which an entity would sell a promised good or service
separately to a customer.
Transaction price: the amount of consideration to which an entity expects to be entitled in exchange
for transferring promised goods or services to a customer, excluding amounts collected on behalf of
third parties.

Revenue does not include sales taxes, value added taxes or goods and service taxes which are only
collected for third parties, because these do not represent an economic benefit flowing to the entity.
The same is true for revenues collected by an agent on behalf of a principal. Revenue for the agent is
only the commission received for acting as agent.
(IFRS 15)

7.5 RECOGNITION AND MEASUREMENT OF REVENUE

IFRS 15 sets out a five-step model to be applied for the recognition of revenue:
Step 1 Identify the contract with the customer.
A contract is only within the scope of IFRS 15 when:
 the parties are committed to carrying it out;
 each party's rights to be transferred can be identified;
 the payment terms can be identified;
 the contract has commercial substance; and
 it is probable that the entity will collect the consideration.
A contract can be written, verbal or implied.

Step 2 Identify the separate performance obligations. A performance obligation is a promise

to transfer a good or a service to a customer. Performance obligations should be
accounted for separately provided the good or service is distinct. When a promised good
or service is not distinct it is combined.
A good or service is considered to be distinct if it could be sold separately.

Step 3 Determine the transaction price. The amount to which the entity expects to be entitled. MODULE 4
For variable consideration probability-weighted expected value or most likely amount is
used. An example of variable consideration is settlement discounts.
Discounting is not required where less than a year.
Step 4 Allocate the transaction price to the performance obligations. Where a contract
contains more than one distinct performance obligation a company allocates the
transaction price to the separate performance obligations in proportion to the relative
stand-alone selling price of each performance obligation.
Step 5 Recognise revenue when or as a performance obligation is satisfied. The entity
satisfies a performance obligation by transferring control of a promised good or service
to the customer. This could be at a point in time when goods are delivered to a
customer, or over a period of time.
An obligation satisfied over time is recognised when one of the following criteria is met:
 The customer simultaneously receives and consumes the benefits as the performance
takes place.
 226 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

 The entity's performance creates or enhances an asset that the customer controls as
the asset is created or enhanced.
 The entity's performance does not create an asset with an alternative use to the entity
and the entity has an enforceable right to payment for performance completed to
date.
The amount of revenue recognised is the amount allocated to that performance
obligation in Step 4.
An entity must be able to reasonably measure the outcome of a performance
obligation before the related revenue can be recognised.

7.6 WORKED EXAMPLES TO ILLUSTRATE THE FIVE-STEP MODEL

Worked Example: Identifying performance obligations

A company sells 200 washing machines for $500 each and includes a one-year warranty. The warranty
cannot be purchased separately. How does the business account for this sale?
Solution

The customer does not have the option to purchase the warranty separately which means there is only
one performance obligation in the contract, the supply of a washing machine.
The business will recognise revenue of $100 000 ($500  200). The business would then apply IAS 37 to
determine the level of provision required in respect of the obligations under the warranties.

Worked Example: Identifying separate performance obligations

A computerised accountancy package is sold with one year's after-sales technical support. The
technical support can be purchased from other suppliers. How many performance obligations are
there in this contract?
Solution

As the customer could purchase the technical support separately this would be a distinct performance
obligation. There are two performance obligations in this contract:
The sale of the accountancy package and the sale of the one year’s technical support.

Worked Example: Determining the transaction price

Alex made sales of goods on credit to Emily. The cost of the goods was $4000 but he offered her a
5 per cent trade discount and an additional 5 per cent discount if she paid within 14 days. What is the
transaction price for this sale?
Solution

Alex should calculate the transaction price after any trade discounts offered to customers and after
any settlements discounts he expects the customer to take. Assuming he expects Emily to pay within
the 14 days the transaction price would be $3610 ($4000  95% = $3800) and then the additional
5 per cent is applied as Alex expects Emily to take up the discount ($3800  95% =$3610)
The settlement discount is variable consideration and per IFRS 15 it should be determined by
reference to the amount of revenue that is expected to be received.
If Alex did not expect Emily to pay within the 14 days then the settlement discount would be ignored
as the expected consideration would be $3800 ($4000  95%).
IFRS 15 has changed the accounting for settlement discounts allowed to customers and you may have
learnt different treatment in your previous studies. In section 7.8 there are more detailed examples
of how to account for discounts allowed.
 FINANCIAL ACCOUNTING AND REPORTING | 227

Worked Example: Allocating the transaction price to the performance obligations

A mobile phone company gives a free handset to customers when they sign up for a three-year
mobile phone service for $15 a month. The handset would cost $200 if bought separately. How should
they allocate the transaction price to the performance obligations?
Solution

There are two performance obligations within the contract – the provision of the handset and the
provision of the mobile phone service for three years. The total revenue of $540 ($15  36 months)
must be allocated as follows:
$ %
Handset 200 27
Mobile phones services 540 73
Total 740 100
The customer is receiving a discount of $200 and they are only paying $540 in total and this needs to
be allocated to the two performance obligations.
Year 1 $
Handset (540  27%) 146
Mobile phone services (540  73% = 394 / 3 years) 131

In Year 1 revenue on the handset can be recognised as the performance obligation is satisfied when
the customer receives the handset. The revenue on the mobile phone services will be recognised over
the three years as the performance obligation is satisfied over a period of time.

7.7 CONTRACTS WHERE PERFORMANCE OBLIGATIONS ARE SATISFIED

OVER TIME
A construction company is building a new hotel for a client and they expect it to take three years to
complete. Over the three years they receive payments from the client and they will incur costs to build
the hotel such as building materials and labour costs.
Applying the five step model under IFRS 15 to this contract it would be a contract in which the
performance obligation is satisfied over a period of time. The contract meets the criteria in IFRS 15 as
the entity is carrying out the work for the benefit of the customer rather than creating an asset for its
own use and in this case it has an enforceable right to payment for work completed to date.
Worked Example: Construction contract

A building company is contracted to build a new factory for a client on 1 January 20X4 for an agreed
price of $4 000 000. On 31 December 20X4 the company has incurred costs to date of $1 000 000 and
they are reasonably certain that the additional costs to complete the factory will be $2 000 000. The
MODULE 4

building company have invoiced the company $1 250 000 and the client has paid this.
A surveyor has reviewed the work completed and confirmed that the value of work completed is worth
$1 500 000.
Discuss how the building company should account for this contract for the year ended
31 December 20X4.
Solution

This is a contract in which the performance obligation is satisfied over time. The entity is carrying out
the work for the benefit of the customer rather than creating an asset for its own use and in this case it
has an enforceable right to payment for work completed to date. This can be seen by the issuing of an
invoice which the client has paid.
Applying IFRS 15, the building company will need to measure the amount of performance obligations
completed to date using an appropriate method. One method would be to measure the revenue by
comparing the value of work performed to the total contract value. In this example this would mean
that the contract is 37.5 per cent complete at 31 December 20X4 (1.5m/4m).
 228 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

The same percentage will be used to calculate the costs that should be reflected in profit or loss. This
would give costs of $1 125 000 calculated as 37.5 per cent of costs incurred to date plus the expected
costs to complete.

7.8 SETTLEMENT DISCOUNTS ALLOWED

When a business allows settlement discounts they need to apply IFRS 15 Revenue from Contracts with
Customers to determine the amount they record the sale at. When a business offers this type of
discount they have variable consideration and they need to decide whether they expect their
customer to take up the settlement discount.

7.8.1 ACCOUNTING FOR A SETTLEMENT DISCOUNT WHEN YOU EXPECT THE CUSTOMER
TO TAKE UP THE OFFER
The sale will initially be recorded net of the settlement discount as this is the amount they expect to
receive as revenue. For example, Company S sells goods on credit to Company T for $100 and they
offer a 5 per cent discount for paying early. Company S expect Company T to pay early. Company S
will record the sale at $95, as they only expect to receive 95 per cent of the amount invoiced. This will
be recorded as follows:
$ $
Dr. Trade receivables control account 95
Cr. Sales 95
Company S then receives $95 as Company T pays early and this will be recorded as follows:
$ $
Dr. Cash 95
Cr. Trade receivables control account 95
If the customer pays late they will not be entitled to the settlement discount and Company S will
receive $100. The $5 will be recorded as additional revenue as follows:
$ $
Dr. Cash 100
Cr. Trade receivables control account 95
Cr. Sales 5

Worked Example: Settlement discounts when the customer is expected to take up the settlement
discount
Mumble Company sells some goods on credit to a customer for $4000. Their credit terms are 30 days
but Mumble Company offers the customer a 10 per cent discount if they pay within 10 days. Mumble
Company expects the customer to pay within the 10 days.
Mumble Company has variable consideration, they have made a sale for $4000 but they could just
receive $3600 ($4000  90%). Mumble Company should record revenue at $3600 as the question tells
you this is the amount they expect to receive.
$ $
Dr. Trade receivables control account 3 600
Cr. Sales 3 600
The customer pays within 10 days so Mumble Company will receive the $3600 and this will fully pay off
the trade receivable.
$ $
Dr. Cash 3 600
Cr. Trade receivables control account 3 600
 FINANCIAL ACCOUNTING AND REPORTING | 229

Question 6. Settlement discounts

On 1 May 20X7 Freddie sells some football merchandise to a customer on credit for $6000, and he
offers the customer a settlement discount of 10 per cent if they pay within 10 days. In the past the
customer has always taken up the settlement discount and Freddie expects this to continue. The
customer pays the full amount on the 16 May 20X7.
Required
(a) Prepare the initial entry to record the sale on 1 May 20X7.
(b) Prepare the entry to record the cash receipt on 16 May 20X7.
(The answer is at the end of the module.)

7.8.2 ACCOUNTING FOR A SETTLEMENT DISCOUNT WHEN YOU DO NOT EXPECT THE
CUSTOMER TO TAKE UP THE OFFER
The settlement discount will be ignored and the sale will initially be recorded at the full amount as this
is the amount they expect to receive as revenue. For example, Company X sells goods on credit to
Company Y for $500 and they offer a 5 per cent discount for paying early. Company X do not expect
Company Y to pay early so they will record the sale at $500. This will be recorded as follows:
$ $
Dr. Trade receivables control account 500
Cr. Sales 500
If Company X receives $500 as the customer does not pay early, this will be recorded as follows:
$ $
Dr. Cash 500
Cr. Trade receivables control account 500
If the customer pays early they could still take up the settlement discount and Company X will receive
$475 ($500  95%). The cash received is recorded as follows:
$ $
Dr. Cash 475
Cr. Trade receivables control account 475
Then Company X will need to account for the settlement discount as they had not expected the
customer to take this up. This is done by adjusting the sale as follows:
$ $
Dr. Sales 25
Cr. Trade receivables control account 25

Worked Example: Settlement discount when the customer is not expected to take up the discount.
MODULE 4

Company M sells goods to Company T at a price of $5000 and they offer a 10 per cent discount for
paying within 10 days. Company M does not expect Company T to take up the discount.
Company M should record the initial sale at $5000 as that is the amount they expect to receive. This
will be recorded as follows:
$ $
Dr. Trade receivables control account 5000
Cr. Sales 5000
Company T pays after the 10 days so Company Twill receive $5000 which will recorded as follows:
$ $
Dr. Cash 5000
Cr. Trade receivables control account 5000
 230 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

7.9 DISCLOSURE
The objective is for an entity to disclose sufficient information to enable users of financial statements
to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from
contracts with customers. The following amounts should be disclosed unless they have been
presented separately in the financial statements in accordance with other standards.
 Revenue recognised from contracts with customers, disclosed separately from other sources of
revenue.
 Any impairment losses recognised (in accordance with IFRS 9) on any receivables or contract assets
arising from an entity's contracts with customers, disclosed separately from other impairment
losses.
 The opening and closing balances of receivables, contract assets and contract liabilities from
contracts with customers.
 Revenue recognised in the reporting period that was included in the contract liability balance at
the beginning of the period.
 Revenue recognised in the reporting period from performance obligations satisfied in previous
periods (such as changes in transaction price).
Other information that should be provided:
 An explanation of significant changes in the contract asset and liability balances during the
reporting period.
 Information regarding the entity's performance obligations, including when they are typically
satisfied (upon delivery, upon shipment, as services are rendered etc.), significant payment terms
(such as when payment is typically due) and details of any agency transactions, obligations for
returns or refunds and warranties granted.
 The aggregate amount of the transaction price allocated to the performance obligations that are
not fully satisfied at the end of the reporting period and an explanation of when the entity expects
to recognise these amounts as revenue.
 Judgements, and changes in judgements, made in applying the standard that significantly affect
the determination of the amount and timing of revenue from contracts with customers.
 Assets recognised from the costs to obtain or fulfil a contract with a customer. This would include
pre-contract costs and set-up costs. The method of amortisation should also be disclosed.
Question 7: Recognition of revenue for a cleaning company

On 1 January 20X1 a cleaning company agrees to provide cleaning services for a customer over a
period of two years for a total price of $15 000. The customer agrees to make an upfront payment of
$10 000 and the remaining $5000 is payable at the start of the second year.
Required
Explain, with calculations the amount of revenue the business should recognise for the year ended
31 December 20X1.
(The answer is at the end of the module.)

Question 8: Recognition of revenue for an airline

An airline books a flight in September 20X6. The passenger will pay in October 20X6, depart in
January 20X7 and return in March 20X7.
Required
Discuss when the airline should recognise revenue.
(The answer is at the end of the module.)
 FINANCIAL ACCOUNTING AND REPORTING | 231

8 CURRENT TAX

LO
4.3 Section overview
 Current tax is the amount payable to the tax authorities in relation to the trading activities
of the period.

8.1 IAS 12 INCOME TAXES

IAS 12 covers both current and deferred tax. The objective of IAS 12 is to apply a 'balance sheet
liability method' of accounting for income taxes which recognises both the current tax consequences
and future tax consequences of its transactions, as a deferred tax charge, which is explained further in
Section 9. The parts relating to current tax are fairly brief, because this is the simple and
uncontroversial area of tax.

8.2 DEFINITIONS
These are some of the definitions given in IAS 12. We will look at the rest later.
Definitions

Accounting profit. Net profit or loss for a period before deducting tax expense.
Taxable profit (tax loss). The profit (loss) for a period, determined in accordance with the rules
established by the taxation authorities, upon which income taxes are payable (recoverable).
Tax expense (tax income). The aggregate amount included in the determination of profit before tax
or loss for the period in respect of current tax and deferred tax.
Current tax. The amount of income taxes payable (recoverable) in respect of the taxable profit (tax
loss) for a period. (IAS 12)

Before we go any further, let us be clear about the difference between current and deferred tax.
(a) Current tax is the estimated amount payable to the tax authorities in relation to the trading
activities of the entity during the period.
(b) Deferred tax is an accounting measure, representing the future tax consequences of past
transactions and events.
You will understand this after working through Sections 7 and 8.

8.3 RECOGNITION OF CURRENT TAX LIABILITIES AND ASSETS

IAS 12 requires any unpaid tax in respect of the current period to be charged (expensed) to profit or
MODULE 4

loss and recognised as a liability:

Dr. Tax expense (profit or loss)
Cr. Tax liability (statement of financial position)
This liability is normally estimated at the year end, and settled a number of months later, in the next
accounting period. Often the tax actually paid differs from the liability recorded.
Where the liability estimated at a period end is greater than the tax later paid, the balance remaining
on the tax liability account is termed an overprovision. This is deducted from the following year's tax
charge (expense).
Where the liability estimated at a period end is less than the tax later paid, the balance remaining on
the tax liability account is termed an under-provision. The following year's tax charge (expense) is
increased by this amount.
 232 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

Therefore, the charge (expense) to profit or loss shown in the statement of profit or loss and other
comprehensive income in relation to current tax is calculated as:
Estimated tax charge for the current year X
Under/(over) provision relating to the previous year X/(X)
Current tax payable X
IAS 12 refers to overprovisions and under-provisions as adjustments for current tax of prior periods.
Question 9: Current tax

In 20X8 Darton Co. had taxable profits of $120 000. In the previous year (20X7) income tax on 20X7
profits had been estimated as $30 000.
Required
Calculate tax payable and the charge for 20X8 (at a rate of 30 per cent) if the tax due on 20X7 profits
was subsequently paid to the tax authorities as:
(a) $35 000; or
(b) $25 000.
(The answer is at the end of the module.)

Taking this a stage further, IAS 12 also requires recognition (as an asset) of the benefit relating to any
tax loss that can be carried back to recover current tax of a previous period. This is acceptable
because it is probable that the benefit will flow to the entity and it can be reliably measured.
Worked Example: Tax losses carried back

In 20X7 Eramu Co. paid $50 000 in tax on its profits. In 20X8 the company made tax losses of $24 000.
The local tax authority rules allow losses to be carried back to offset against current tax of prior years.
Required
Show the tax expense and tax liability for 20X8.
Solution

Tax repayment due on tax losses = 30%  $24 000 = $7200.

The double entry will be: $ $
Dr. Tax receivable (statement of financial position) 7 200
Cr. Tax repayment (profit or loss) 7 200
The tax receivable will be shown as an asset until the repayment is received from the tax authorities.

8.4 MEASUREMENT
Measurement of current tax liabilities (assets) for the current and prior periods is very simple. They are
measured at the amount expected to be paid to (recovered from) the tax authorities. The tax rates
(and tax laws) used should be those enacted (or substantively enacted) by the end of the reporting
period.

8.5 RECOGNITION OF CURRENT TAX

Normally, current tax is recognised as income or expense and included in the net profit or loss for the
period, except in two cases:
(a) Tax arising from a business combination is treated differently. (Tax assets or liabilities of the
acquired subsidiary will form part of the goodwill calculation. See Module 5.)
(b) Tax arising from a transaction or event which is recognised directly in equity or as other
comprehensive income (in the same or a different period).
The rule in (b) is logical. If a transaction or event is charged or credited directly to equity, or as other
comprehensive income rather than to profit or loss, then the related tax should be also. An example of
 FINANCIAL ACCOUNTING AND REPORTING | 233

such a situation is where, under IAS 8, an adjustment is made to the opening balance of retained
earnings due to either a change in accounting policy that is applied retrospectively, or to the
correction of a material prior period error (see Module 1).
8.6 PRESENTATION
In the statement of financial position, tax assets and liabilities are shown separately from other assets
and liabilities.
Current tax assets and liabilities can be offset, but only when certain conditions apply:
 the entity has a legally enforceable right to set off the recognised amounts; and
 the entity intends to settle the amounts on a net basis, or to realise the asset and settle the liability
at the same time.
The tax expense (income) related to the profit or loss from ordinary activities is shown in the
statement of profit or loss and other comprehensive income.

9 DEFERRED TAX

LO
4.3 Section overview
 Deferred tax is an accounting measure used to match the tax effects of transactions with
their accounting impact.

9.1 WHAT IS DEFERRED TAX?

When a company recognises an asset or liability, it expects to recover or settle the carrying amount
of that asset or liability. In other words, it expects to sell or use up assets, and to pay off liabilities.
What happens if that recovery or settlement is likely to make future tax payments larger (or smaller)
than they would otherwise have been if the recovery or settlement had no tax consequences? In these
circumstances, IAS 12 requires companies to recognise a deferred tax liability (or deferred tax
asset).

9.2 DEFINITIONS
Don't worry too much if you don't understand the concept of deferred tax yet; things should become
clearer as you work through this section. First of all, here are the definitions relating to deferred tax
given in IAS 12.
Definitions
Deferred tax liabilities are the amounts of income taxes payable in future periods in respect of
MODULE 4

taxable temporary differences.

Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:
 deductible temporary differences;
 the carry forward of unused tax losses; and
 the carry forward of unused tax credits.
Temporary differences are differences between the carrying amount of an asset or liability in the
statement of financial position and its tax base.
Temporary differences may be either:
 Taxable temporary differences, which are temporary differences that will result in taxable
amounts in determining taxable profit (tax loss) of future periods when the carrying amount of the
asset or liability is recovered or settled.
 Deductible temporary differences, which are temporary differences that will result in amounts
that are deductible in determining taxable profit (tax loss) of future periods when the carrying
amount of the asset or liability is recovered or settled.
 234 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

A taxable temporary difference gives rise to a deferred tax liability. A deductible temporary
difference may give rise to a deferred tax asset.
The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.
(IAS 12)

We need to discuss some of these definitions in more detail.

9.3 TAX BASE

We can expand on the definition given above by stating that the tax base of an asset is the amount
that will be deductible for tax purposes against any taxable economic benefits that will flow to the
entity when it recovers the carrying amount of the asset. Where those economic benefits are not
taxable, the tax base of the asset is the same as its carrying amount. The tax base can also be
described as the written-down value, or carrying amount, of the asset or liability for tax purposes.
Essentially this is the valuation of the asset or liability under tax rules rather than accounting rules. For
example, the tax base of a non-current asset would be its tax written down value (cost less tax/capital
allowances) as opposed to its carrying value (cost less accumulated depreciation).
Question 10: Tax base assets
State the tax base of each of the following assets:
(a) A machine cost $10 000. For tax purposes, depreciation of $3000 has already been deducted in the
current and prior periods and the remaining cost will be deductible in future periods, either as
depreciation or through a deduction on disposal. Revenue generated by using the machine is
taxable, any gain on disposal of the machine will be taxable and any loss on disposal will be
deductible for tax purposes.
(b) Interest receivable has a carrying amount of $1000. The related interest revenue will be taxed on a
cash basis.
(c) Trade receivables have a carrying amount of $10 000. The related revenue has already been
included in taxable profit (tax loss).
(d) A loan receivable has a carrying amount of $1m. The repayment of the loan will have no tax
consequences.
(The answer is at the end of the module.)

In the case of a liability, the tax base will be its carrying amount, less any amount that will be
deducted for tax purposes in relation to the liability in future periods. For revenue received in
advance, the tax base of the resulting liability is its carrying amount, less any amount of the revenue
that will not be taxable in future periods.
Question 11: Tax base liabilities

State the tax base of each of the following liabilities.

(a) Current liabilities include accrued expenses with a carrying amount of $1000. The related expense
will be deducted for tax purposes on a cash basis.
(b) Current liabilities include interest revenue received in advance, with a carrying amount of $10 000.
The related interest revenue was taxed on a cash basis.
(c) Current liabilities include accrued expenses with a carrying amount of $2000. The related expense
has already been deducted for tax purposes.
(d) Current liabilities include accrued fines and penalties with a carrying amount of $100. Fines and
penalties are not deductible for tax purposes.
(e) A loan payable has a carrying amount of $1m. The repayment of the loan will have no tax
consequences.
(The answer is at the end of the module.)
 FINANCIAL ACCOUNTING AND REPORTING | 235

IAS 12 gives the following examples of circumstances in which the carrying amount of an asset or
liability will be equal to its tax base.
 Accrued expenses which have already been deducted in determining an entity's current tax
liability for the current or earlier periods.
 A loan payable is measured at the amount originally received and this amount is the same as the
amount repayable on final maturity of the loan.
 Accrued expenses which will never be deductible for tax purposes.
 Accrued income which will never be taxable.

9.4 TEMPORARY DIFFERENCES

You may have found the definition of temporary differences somewhat confusing. Remember that
accounting profits, form the basis for computing taxable profits, on which the tax liability for the year
is calculated. However, accounting profits and taxable profits are different due to differences between
the carrying amount of an asset or liability in the statement of financial position and its tax base, which
are referred to as temporary differences, and are determined as follows.
Temporary differences are identified by:
 Comparing the carrying amount (in the statement of financial position) of each asset and liability
with its tax base.
Temporary difference can be simplified as below:
Temporary difference = Carrying amount – Tax base amount
 Identifying all items that have a carrying amount of $nil (in the statement of financial position) but
have a tax base.
For example, research costs are expensed in the accounts in period when incurred (i.e. no asset is
recorded) but are deductible for tax purposes in a subsequent reporting period.
The table below further illustrates the concept of temporary differences.
Temporary Deductible
taxable temporary
Assets and liabilities Carrying amount Tax base difference difference
Plant and equipment $2 500 000 $2 000 000 $500 000 –
Provisions $10 000 $nil – $10 000
Deferred income $25 000 $nil – $25 000
Cash $15 000 $15 000 – –

The term temporary refers to the fact that such differences originate in a reporting period and reverse
in one or more later reporting periods. All temporary differences reverse over time.
For example, using the data included in the table above, the deductible temporary difference of
MODULE 4

$10 000 that arises in relation to the provision (i.e. as the carrying amount is greater than the tax base)
will reverse when the provision is settled. Once temporary differences have been determined, the
related deferred tax assets and deferred tax liabilities can be calculated using the appropriate tax
rate.
Temporary differences may be taxable or deductible. Taxable temporary differences are considered in
Section 9 of this module and deductible temporary differences in Section 10.

9.5 SECTION SUMMARY

 Deferred tax is an accounting device. It does not represent tax payable to the tax authorities.
 The tax base of an asset or liability is the value of that asset or liability for tax purposes.
 Deferred tax is the tax attributable to temporary differences.
 236 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

10 TAXABLE TEMPORARY DIFFERENCES

LO
4.3 Section overview
 A taxable temporary difference results in a deferred tax liability.

10.1 CALCULATION OF A TAXABLE TEMPORARY DIFFERENCE AND

ASSOCIATED LIABILITY
A taxable temporary difference arises where the carrying amount of an asset exceeds its tax base,
or the carrying amount of a liability is less than its tax base and is calculated as the difference
between the carrying amount and the tax base.
The resultant deferred tax liability is calculated by applying the relevant tax rate to the taxable
temporary difference.

10.2 EXAMPLES OF TAXABLE TEMPORARY DIFFERENCES

Common transactions which result in taxable temporary differences include the following:
 Interest revenue received in arrears and included in accounting profit on the basis of time
apportionment. It is included in taxable profit, however, on a cash basis i.e. when it is received.
 Depreciation of an asset is accelerated for tax purposes. When new assets are purchased,
allowances may be available against taxable profits which exceed the amount of depreciation
chargeable on the assets in the financial accounts for the year of purchase.
 Development costs which have been capitalised will be amortised through profit or loss, but they
were deducted in full from taxable profit in the period in which they were incurred.
 Prepaid expenses have already been deducted on a cash basis in determining the taxable profit
of the current or previous periods.
Exam comments
exam
For the purposes of the exam, ensure you understand taxable temporary differences relating to non-
current assets, sometimes referred to as accelerated capital allowances.

Worked Example: Taxable temporary differences

A company purchased an asset costing $1500. At the end of 20X8 the carrying amount is $1000. The
cumulative depreciation for tax purposes (capital allowances) is $900 and the current tax rate is 25 per
cent.
Required
Calculate the deferred tax liability for the asset.
Solution

First, what is the tax base of the asset? It is $1500 – $900 = $600.
The carrying amount is given as $1000.
Therefore, the taxable temporary difference is $400 and a deferred tax liability is calculated as $400 
25% = $100.
The rationale behind this is: to recover the carrying amount of $1000, the entity must earn taxable
income of $1000, but it will only be able to deduct $600 as a taxable expense. The entity must
therefore pay income tax of $400  25% = $100 when the carrying amount of the asset is recovered.
 FINANCIAL ACCOUNTING AND REPORTING | 237

10.3 REVALUED ASSETS

Under IAS 16 assets can be revalued. The revaluation is recognised in other comprehensive income
rather than profit. Therefore, the tax base of the asset remains unchanged.
The carrying amount will, however, increase to reflect the revalued amount. Therefore, on revaluation
the taxable temporary difference relating to the asset increases and there is a deferred tax effect.
The additional deferred tax liability at the date of the revaluation is calculated as:
Revaluation surplus  tax rate
Question 12: Current and deferred tax

Jonquil Co. buys equipment in 20X1 for $50 000 and depreciates it on a straight-line basis over its
expected useful life of five years. The equipment has no residual value. For tax purposes, the
equipment is depreciated at 25 per cent per annum on a straight-line basis. Tax losses may be carried
back against taxable profit of the previous five years. In year 20X0, the entity's taxable profit was
$25 000. The tax rate is 40 per cent.
Required
Assuming nil profits/losses after depreciation in years 20X1 to 20X5 show the current and deferred tax
impact in years 20X1 to 20X5 of the acquisition of the equipment.
(The answer is at the end of the module.)

11 DEDUCTIBLE TEMPORARY DIFFERENCES

LO
4.3 Section overview
 A deductible temporary difference results in a deferred tax asset.

11.1 CALCULATION OF A DEDUCTIBLE TEMPORARY DIFFERENCE AND

ASSOCIATED ASSET
A deductible temporary difference arises where the tax base of an asset exceeds its carrying
amount or the tax base of a liability is less than its carrying amount, and is calculated as the
difference between the tax base and the carrying amount.
The resultant deferred tax asset is calculated by applying the relevant tax rate to the deductible
temporary difference.
The deferred tax asset must also satisfy the recognition criteria given in IAS 12. This is that a deferred
MODULE 4
tax asset should be recognised for all deductible temporary differences to the extent that it is
probable that taxable profit will be available against which it can be utilised.

11.2 EXAMPLES OF DEDUCTIBLE TEMPORARY DIFFERENCES

Common transactions which result in deductible temporary differences include, but are not limited to,
the following:
 Retirement benefit costs (pension costs) are deducted from accounting profit as service is
provided by the employee. They are not deducted in determining taxable profit until the entity
pays either retirement benefits or contributions to a fund. (This may also apply to similar expenses.)
 The NRV of inventory, or the recoverable amount of an item of property, plant and equipment
falls and the carrying amount is therefore reduced, but that reduction is ignored for tax purposes
until the asset is sold.
 Research costs (or organisation/other start-up costs) are recognised as an expense for accounting
purposes, but are not deductible against taxable profits until a later period.
 238 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

 Income is deferred in the statement of financial position, but has already been included in taxable
profit in current/prior periods.
 Tax losses arise which are carried forward against future taxable profits.
Exam comments
exam
For the purposes of the exam, ensure you understand deductible temporary differences relating to tax
losses and expenses recognised in profit or loss before they are paid.

Worked Example: Deductible temporary differences

Pargatha Co. recognises a liability of $10 000 for accrued product warranty costs on 31 December
20X7. These product warranty costs will not be deductible for tax purposes until the entity pays claims.
The tax rate is 25 per cent.
Required
State the deferred tax implications of this situation.
Solution

The tax base of the liability is nil (carrying amount of $10 000 less the amount that will be deductible
for tax purposes in respect of the liability in future periods).
The carrying amount of the liability is $10 000.
Therefore, there is a deductible temporary difference of $10 000 and a deferred tax asset of $2500
arises ($10 000  25%) provided that it is probable that the entity will earn sufficient taxable profits in
future periods to benefit from a reduction in tax payments.
The rationale behind this is: when the liability is settled for its carrying amount, the entity's future
taxable profit will be reduced by $10 000 and so its future tax payments fall by $10 000  25% = $2500.

11.3 TAXABLE PROFITS IN FUTURE PERIODS

When can we be sure that sufficient taxable profit will be available against which a deductible
temporary difference can be utilised? IAS 12 states that this will be assumed when sufficient taxable
temporary differences exist which relate to the same taxation authority and the same taxable entity.
These should be expected to reverse:
 in the same period as the expected reversal of the deductible temporary difference; or
 in periods into which a tax loss arising from the deferred tax asset can be carried back or forward.
In these circumstances the deferred tax asset is recognised in the period in which the deductible
temporary differences arise.

11.4 UNUSED TAX LOSSES AND UNUSED TAX CREDITS

An entity may have unused tax losses (i.e. which it can offset against taxable profits) at the end of a
period. These losses are not recognised in the statement of financial position and so have nil carrying
amount. Their tax base is the amount that can be deducted from taxable profits in the future i.e. the
amount of the loss. Therefore, a deferred tax asset potentially arises, although IAS 12 states that it
may only be recognised to the extent that it is probable that future taxable profit will be available
against which the unused tax losses/credits can be utilised.
The amount of the deferred tax asset is calculated as: Recoverable tax losses c/f  tax rate
 FINANCIAL ACCOUNTING AND REPORTING | 239

12 MEASUREMENT AND RECOGNITION OF

DEFERRED TAX

LO
4.3 Section overview
 IAS 12 requires deferred tax assets and liabilities to be measured at the tax rates expected
to apply when the asset is realised or the liability settled.

12.1 CHANGES IN TAX RATES

Where the corporate rate of income tax fluctuates from one year to another, a problem arises in
respect of the amount of deferred tax to be credited (debited) to the statement of profit or loss and
other comprehensive income in later years.
IAS 12 requires deferred tax assets and liabilities to be measured at the tax rates expected to apply in
the period when the asset is realised or liability settled, based on tax rates and laws enacted (or
substantively enacted) at the end of the reporting period.

12.2 DEFERRED TAX ASSETS AND LIABILITIES ARE NOT DISCOUNTED

Discounting is used to allow for the effect of the time value of money.
IAS 12 states that deferred tax assets and liabilities are not discounted because of the complexities
and difficulties involved. Discounting is applied to other non-current liabilities such as provisions and
deferred payments.

12.3 CARRYING AMOUNT OF DEFERRED TAX ASSETS

The carrying amounts of deferred tax assets are reviewed at the end of each reporting period and
reduced where appropriate (insufficient future taxable profits). Such a reduction may be reversed in
future years.

12.4 RECOGNITION
Deferred tax (and current tax) is recognised as income or expense and included in the net profit or
loss for the period, unless the tax arises from a transaction or event which is recognised as other
comprehensive income or directly in equity in which case the tax is charged or credited to other
comprehensive income or directly to equity.
Examples of IFRSs which allow items to be credited or charged to other comprehensive income or
directly to equity include:
MODULE 4

 revaluations of property, plant and equipment (IAS 16) – credited to other comprehensive income;
and
 the effect of a change in accounting policy (applied retrospectively) or correction of a material
error (IAS 8) – credited or charged directly to equity.
Worked Example: Recognition

Z Co. owns a property which has a carrying amount at the beginning of 20X9 of $1 500 000. At the year
end it has revalued the property to $1 800 000. The tax rate is 30 per cent. How will this be shown in
the financial statements?
 240 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

Solution

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME (EXTRACT)

$'000
Profit for the year X
Other comprehensive income:
Gains on property revaluation 300
Income tax relating to components of other comprehensive income (300  30%) (90)
Other comprehensive income for the year net of tax 210

The amounts will be posted as follows:

Dr. Cr.
$'000 $'000
Property, plant and equipment 300
Deferred tax 90
Revaluation surplus 210

12.5 WHY DO WE RECOGNISE DEFERRED TAX?

 Adjustments for deferred tax are made in accordance with the accruals concept and in accordance
with the definition of a liability in the Conceptual Framework, i.e. a past event has given rise to an
obligation in the form of increased taxation which will be payable in the future and the amount can
be reliably estimated. A deferred tax asset similarly meets the definition of an asset.
 If the future tax consequences of transactions are not recognised, profit can be overstated, leading
to overpayment of dividends and distortion of share price and earnings per share.

13 TAXATION IN COMPANY ACCOUNTS

LO
4.3 Section overview
 In the statement of financial position the liability for tax payable is the tax owing for the
year. The deferred tax balance will also be included as a liability or (more unusually) asset.
In the statement of profit or loss and other comprehensive income the tax charge for the
year is adjusted for transfers to or from deferred tax and for prior year under or over-
provisions.

Tax affects three figures in company accounts.

 Taxation on profits in the statement of profit or loss and other comprehensive income.
 Taxation payments due, shown respectively as a current liability for current tax and a non-current
liability for deferred tax, in the statement of financial position.

13.1 TAXATION IN THE STATEMENT OF PROFIT OR LOSS AND OTHER

COMPREHENSIVE INCOME
The tax charge (expense) for the year is calculated by aggregating:
 income tax on taxable profits;
 transfers to or from deferred taxation; and
 any adjustments (under-provision or over-provision) for current tax on profits of previous years.
 FINANCIAL ACCOUNTING AND REPORTING | 241

Question 13: Tax payable

In the accounting year to 31 December 20X3, Neil Down Co. made an operating profit before taxation
of $110 000.
Income tax on the operating profit has been estimated at $45 000. In the previous year (20X2) income
tax on 20X2 profits had been estimated at $38 000 but it was subsequently agreed at $40 500.
A transfer to the credit of the deferred taxation account of $16 000 will be made in 20X3.
Required
(a) Calculate the tax on profits for 20X3 for in the statement of profit or loss and other comprehensive
income.
(b) Calculate the amount of tax payable in the statement of financial position.
(The answer is at the end of the module.)

13.2 TAXATION IN THE STATEMENT OF FINANCIAL POSITION

The statement of financial position will include a current liability for the income tax owing at year end.
This may not necessarily be the same amount as the income tax relating to the current year's profit, as
there may have been over or under-provision in previous years.
There will usually also be a deferred tax liability, shown as a non-current liability. Sometimes, but
rarely, there will be a deferred tax asset.
Question 14: Tax charge

For the year ended 31 July 20X4 Norman Kronkest Co. made taxable trading profits of $1 200 000 on
which income tax is payable at 30 per cent.
 An amount of $20 000 will be credited to the deferred taxation account. The deferred tax liability
brought forward at 1 August 20X3 was $100 000.
 The estimated tax on profits for the year ended 31 July 20X3 was $80 000, but tax has now been
agreed at $84 000 and fully paid.
 Tax on profits for the year to 31 July 20X4 is payable on 1 May 20X5.
 In the year to 31 July 20X4 the company made a capital gain of $60 000 on the sale of some
property. This gain is taxable at a rate of 30 per cent.
Required
(a) Calculate the tax charge for the year to 31 July 20X4.
(b) Calculate the tax liabilities in the statement of financial position of Norman Kronkest as at
31 July 20X4.
(The answer is at the end of the module.) MODULE 4

13.3 PRESENTATION OF TAX EXPENSE

The tax expense or income related to the profit or loss for the period should be disclosed as a line
item in the statement of profit or loss and other comprehensive income.
242 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

KEY MODULE POINTS 2

 IFRS 15 provides the rules for the recognition of revenue based on transfer of control to the
customer from the entity supplying the goods or services.
 IFRS 15 sets out a five-step model for the recognition of revenue.
 Revenue will be recognised at a point in time or over a period of time.
 Current tax is the amount payable to the tax authorities in relation to the trading activities of the
period.
 Unpaid tax in respect of the current period is charged to profit or loss and recognised as a liability.
 Where the liability is less than the tax later paid, the balance remaining on the tax liability account
is termed an under-provision. The following year's tax charge is increased by this amount.
 Where the liability is more than the tax later paid, the balance remaining on the tax liability account
is an over-provision and the following year's tax charge is decreased by this amount.
 Deferred tax is an accounting measure, used to match the tax effects of transactions with their
accounting impact and thereby produce less distorted results.
 Deferred tax adjusts for the effects of temporary differences arising because the tax treatment of
an item differs from its accounting treatment.
 A temporary difference is calculated by comparing the carrying amount of an asset or liability with
its tax base.
 The tax base of an asset or liability is the amount attributed to that asset or liability for tax
purposes.
 If the carrying amount of an asset is greater than its tax base, this is a taxable temporary difference
and results in a deferred tax liability.
 If the tax base of an asset is greater than its carrying amount, this is a deductible temporary
difference and results in a deferred tax asset.
 If the carrying amount of a liability is greater than its tax base, this is a deductible temporary
difference and results in a deferred tax asset.
 If the tax base of a liability is greater than its carrying amount, this is a taxable temporary difference
and results in a deferred tax liability.
 Deferred tax assets and liabilities are measured at the tax rates expected to apply in the period
when the asset is realised or liability settled, based on tax rates and laws enacted (or substantively
enacted) at the end of the reporting period.
 Deferred tax should normally be recognised as income or an expense and included in the net
profit or loss for the period.
 Deferred tax (and current tax) should be charged or credited to other comprehensive income or
directly to equity if the tax relates to items also charged or credited to other comprehensive
income or directly to equity (in the same or a different period).
 The tax charge for the year is calculated by aggregating:
– income tax on taxable profits;
– transfers to or from deferred taxation;
– any adjustments (under-provision or over-provision) of current tax on profits of previous years.
 FINANCIAL ACCOUNTING AND REPORTING | 243

QUICK REVISION QUESTIONS 2

1 On 31 March 20X7, DT received an order from a new customer, XX, for products with a sales value
of $900 000. XX enclosed a deposit with the order of $90 000.
On 31 March 20X7, DT had not completed credit referencing of XX and had not despatched any
goods. DT is considering the following possible entries for this transaction in its financial
statements for the year ended 31 March 20X7.
I. Recognise a liability for $90 000
II. Include $90 000 in revenue for the year
III. Include $900 000 in revenue for the year
IV. Recognise a trade receivable for $810 000
V. Do not include anything in revenue for the year
According to IFRS 15 Revenue from Contracts with Customers, how should DT record this
transaction in its financial statements for the year ended 31 March 20X7?
A I and II only
B I and V only
C III and IV only
D IV and V only
2 London Co. sells air conditioning systems, providing one year's free servicing with every system
sold. The servicing could be purchased separately for $500. How should London Co. account for
the $4000 sales price of each system?
A $4000 should be recognised as revenue spread over the first year after sale.
B $4000 should be recognised as revenue when each system is delivered to the customer.
C $3560 should be recognised as revenue when each system is delivered to the customer and
$440 should be spread over the first year of sale.
D $4000 should be recognised as revenue when each system is delivered to the customer and
$500 recognised as revenue over the first year after sale.
3 Which of the following statements regarding revenue recognition are correct?
I. Revenue should ignore any settlement discounts.
II. Tuition fees received by a college are recognised as income on the day the tuition commences.
III. Revenue from the sale of goods on a sale or return basis is recognised when the goods are sold
to a third party.
A I only
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B III only
C II and III only
D I, II and III
244 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

4 Leo Co. is liable to corporate income tax at a rate of 30 per cent. The following information is
relevant:
Y/e 30 November 20X7
Profit before tax $490 000
Taxable profits $502 000
Tax paid in 20X8 in respect of year $149 000
Y/e 30 November 20X8
Profit before tax $523 000
Taxable profits $582 000
Tax paid in 20X9 in respect of year $170 000
What is the tax charge in the statement of profit or loss and other comprehensive income for the
year ended 30 November 20X8?
A $158 900
B $170 000
C $173 000
D $174 600
5 At 30 September 20X2 the statement of financial position of CBN Co. included a liability for
deferred tax of $128 500. At 30 September 20X3 the non-current assets had a carrying amount of
$2 650 000 and a tax written down value of $1 872 000. The tax rate is 20 per cent.
What is the balance on the deferred tax account at 30 September 20X3?
A $27 100
B $128 500
C $155 600
D $778 000
6 A company in its first year of trading has significantly higher capital allowances (tax depreciation)
than the accounting depreciation charged to profit or loss on the same assets. What would be the
effect of recognising a liability for deferred taxation in respect of these assets?
Profit after tax Net assets
A Increase Increase
B Decrease Increase
C Increase Decrease
D Decrease Decrease
7 At 30 November 20X4 the carrying amount of the non-current assets of Reynard Co. was
$3 570 000 and the tax written down value was $2 450 000. The liability for deferred tax brought
forward was $250 000.
The tax rate is 22 per cent.
What should be reported in the statement of profit or loss and other comprehensive income in
respect of deferred tax?
A A credit of $3600
B A charge of $3600
C A credit of $246 400
D A charge of $246 400
 FINANCIAL ACCOUNTING AND REPORTING | 245

8 At 30 April 20X6, the carrying amount of the non-current assets of Bahno Co. was $80 000 greater
than the tax written down value, and the balance brought forward on the deferred tax account was
$24 800. The company accountant calculated that the income tax charge on the reported profit for
the year to 30 April 20X6 would be $53 960, based on the tax rate of 24 per cent.
What is the total charge for taxation in the statement of profit or loss and other comprehensive
income for the year to 30 April 20X6?
A $48 360
B $59 560
C $73 160
D $78 760
9 Which of the following statements about deferred taxation is correct?
A Deferred tax is an amount of tax certain to be payable at a future date.
B Deferred taxation is an accounting item used to apply the accruals concept to taxation charges
in the accounts.
C Deferred taxation is an accounting item used to apply the consistency concept to taxation
charges in the accounts.
D Deferred tax liabilities are shown in the statement of financial position of a company as part of
the taxation current liability.
10 Kelt Co. makes a tax-adjusted loss in its 20X8 financial year of $320 000. $120 000 of these losses
are carried back to relieve against the profits of 20X7 and $15 000 are used in the current year to
relieve other income. The remainder are carried forward. In 20X9 Kelt Co. is expected to make
significant profits as a result of the launch of a new product. Kelt Co.'s tax rate is 25 per cent.
What is the deferred tax implication, if any, in 20X8 of the loss made?
A A deferred tax asset of $46 250
B A deferred tax asset of $50 000
C A deferred tax liability of $46 250
D A deferred tax liability of $50 000
11 Which of the following statements are correct?
I. A deferred tax liability is the result of a deductible temporary difference.
II. The tax base of an asset is the future amount which is deductible from profits.
III. A revaluation will result in the recognition of a deferred tax movement in profit or loss.
IV. Where the carrying amount of an asset exceeds its tax base there will be a taxable temporary
difference.
A I and IV only
B II and III only
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C II and IV only
D I, II, III and IV
12 Parker Co. has non-current assets with an original cost of $580 000. As at 31 January 20X9,
accumulated depreciation provided on these assets amounts to $80 000 and tax allowances given
amount to $130 000. On this date, Parker recognised a $100 000 revaluation surplus in respect of a
factory included within the above. The original cost of the factory was $190 000, accumulated
depreciation to date was $20 000 and tax allowances $30 000. Parker's tax rate is 20 per cent and
the deferred tax liability brought forward in respect of accelerated capital allowances was $9000.
How are movements in deferred tax recognised in the statement of profit or loss and other
comprehensive income?
In profit or loss As other comprehensive income
A $1000 charge $20 000 charge
B $1000 credit $22 000 charge
C $8000 credit $22 000 charge
D $10 000 charge $20 000 charge
246 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

13 Extracts from the financial statements of Rasputin Co. are as follows:

Tax charge to profits $47 500
Company income tax liability for the year $56 000
Deferred tax liability at start of year $34 000
Deferred tax liability at end of year $28 000
Rasputin has always paid its tax due on time. What is the under or over-provision relating to the
previous year?
A $2500 over-provision
B $2500 under-provision
C $14 500 over-provision
D $14 500 under-provision
 FINANCIAL ACCOUNTING AND REPORTING | 247

14 FOREIGN CURRENCY

LO
4.4 Section overview
 IAS 21 deals with converting individual transactions into local currency before recording
them. It also deals with translating a foreign subsidiary's financial statements before
consolidating them.

IAS 21 The Effects of Changes in Foreign Exchange Rates recognises that there are two main
instances in which foreign currency amounts must be translated into another currency:
1. If a company trades overseas, it will buy or sell assets in foreign currencies. For example, an Indian
company might buy materials from Canada, and pay for them in US dollars, and then sell its
finished goods in Germany, receiving payment in Euro, or perhaps in some other currency. These
transactions must be translated into the functional currency of the Indian company before they can
be recorded in its financial statements.
2. A company might have a subsidiary abroad (i.e. a foreign entity that it owns), and the subsidiary will
trade in its own local currency. The subsidiary will keep the financial records and prepare its annual
accounts in its own currency. At the year end, the parent company must 'consolidate' the results of
the overseas subsidiary into its group financial statements. Before this can happen, the financial
statements of the subsidiary must be translated into the currency in which the group accounts are
prepared.

14.1 DEFINITIONS
These are some of the definitions given by IAS 21.
Definitions

Foreign currency. A currency other than the functional currency of the entity.
Functional currency. The currency of the primary economic environment in which the entity operates.
Presentation currency. The currency in which the financial statements are presented.
Exchange rate. The ratio of exchange for two currencies.
Exchange difference. The difference resulting from translating a given number of units of one
currency into another currency at different exchange rates.
Closing rate. The spot exchange rate at the end of the reporting period.
Spot exchange rate. The exchange rate for immediate delivery. (IAS 21)
MODULE 4

Each entity – whether an individual company, a parent of a group, or an operation within a group
(such as a subsidiary, associate or branch) – should determine its functional currency and measure its
results and financial position in that currency.
For most individual companies the functional currency is the currency of the country in which they are
located and in which they carry out most of their transactions. Determining the functional currency is
much more likely to be an issue where an entity operates as part of a group. IAS 21 contains detailed
guidance on how to determine an entity's functional currency and we will look at this in more detail in
section 15.
An entity can present its financial statements in any currency (or currencies) it chooses. IAS 21 deals
with the situation in which financial statements are presented in a currency other than the functional
currency. Again, this is unlikely to be an issue for most individual companies. Their presentation
currency is normally the same as their functional currency (the currency of the country in which they
operate).
 248 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

15 FOREIGN CURRENCY TRANSACTIONS

LO
4.4 Section overview
 Foreign currency transactions must be translated into the presentation currency of an entity
before they are recorded in the financial statements; monetary items remaining in the
statement of financial position at the year end are re-translated using the closing rate.

15.1 FOREIGN CURRENCY TRANSACTIONS: INITIAL RECOGNITION

IAS 21 requires that foreign currency transactions are translated using the exchange rate at the date of
the transaction (the spot rate) before they are recorded in the financial statements.
An average rate for a period may be used if exchange rates do not fluctuate significantly.
Worked Example: Initial recognition (1)

An Australian company with a 31 December year end buys a large consignment of goods from a
supplier in Germany. The order is placed on 1 May and the agreed price is €124 250. At the time of
delivery the rate of foreign exchange was €3.50 to $1. The Australian company would record the
amount owed in its books as follows:
Dr. Inventory (124 250 / 3.5) $35 500
Cr. Payables $35 500

15.2 SETTLEMENT BEFORE THE PERIOD END

Where a foreign currency amount payable or receivable is settled in the same period as that in which
the transaction took place, an exchange difference will arise (assuming that the exchange rate has
moved since the date of the transaction).
This is best explained by continuing the example above.
Worked Example: Initial recognition (2)

When the Australian company pays the supplier it needs to obtain some foreign currency. By this time,
however, the rate of exchange has altered to €3.55 to $1, and the cost of raising €124 250 would be
(/ 3.55) $35 000. The company needs to spend only $35 000 to settle a debt recorded at $35 500. As
inventory is a non-monetary asset the value of the inventories is not amended in the company's
financial records, instead we record a profit on conversion of $500.
Dr. Payables $35 500
Cr. Cash $35 000
Cr. Profit on conversion (exchange difference) $500
The profit on conversion is recognised as part of the profit or loss for the year.

15.3 SETTLEMENT AFTER THE PERIOD END

15.3.1 AT THE PERIOD END
Where there is a foreign currency asset or liability in the statement of financial position at the year
end, such as an unpaid supplier, the balance is re-translated using the closing (year end) exchange
rate.
This is done for monetary assets and liabilities. Non-monetary assets and liabilities are not
re-translated.
 FINANCIAL ACCOUNTING AND REPORTING | 249

Definition

Monetary items are units of currency held and assets and liabilities to be received or paid in a fixed or
determinable number of units of currency.
(IAS 21)

Therefore, the following rules apply at each subsequent year end:

(a) Report foreign currency monetary items (such as receivables and payables) using the closing rate.
(b) Report non-monetary items (for example, non-current assets, inventories) that are carried at
historical cost in a foreign currency using the exchange rate that was used at the date of the
transaction (historical rate).
(c) Report non-monetary items that are carried at fair value in a foreign currency using the exchange
rate that existed when the values were determined.
Exchange differences arising on the re-translation of monetary items are recognised as part of the
profit or loss for the year.
Worked Example: Revaluation
An Australian company purchased a property in Spain for €600 000 in cash on 1 January. The company
follows a policy of revaluation for all of its properties, therefore a revaluation was carried out for the
year-end financial statements giving a value of €670 000 on 31 December.
The exchange rate moved as follows:
€= $1
1 January 1.75
31 December 1.95
On acquisition the property will be recorded at the spot rate on the date of purchase (1.75).
Dr. Property (€600 000 / 1.75) $342 857
Cr. Cash $342 857
The property is a non-monetary item, therefore if it was being recorded at historic cost it would not be
retranslated at the year end. However as the company follows a policy of revaluation of property, the
revalued Euro amount must be translated at the date of the valuation.
The property will be included in the year-end financial statements at (670 000 / 1.95) = $343 590 by
making the following adjustments:
Dr. Property ($343 590 – $342 857) $733
Cr. Revaluation surplus $733
The change in the property’s value is due to the increased Euro valuation and the change in the
exchange rate. These two movements do not need to be calculated separately, both go through other
MODULE 4

comprehensive income (revaluation surplus).

15.3.2 SUBSEQUENT SETTLEMENT

When the monetary item is subsequently settled in the following period, any exchange difference
resulting from a movement in the exchange rate between the previous period end and the date of
settlement is recognised as part of the profit or loss for the year in which settlement takes place.
Question 15: Entries

White Cliffs Co., whose year end is 31 December, buys some goods from Rinka SA of France on
30 September. The invoice value is €40 000 and is due for settlement in equal instalments on
30 November and 31 January. The exchange rate moved as follows:
€= $1
30 September 1.60
30 November 1.80
 250 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

€= $1
31 December 1.90
31 January 1.85
Required
State the accounting entries in the books of White Cliffs Co.
(The answer is at the end of the module.)

16 FOREIGN CURRENCY FINANCIAL STATEMENTS

LO
4.5 Section overview
 An entity will operate its business and record transactions in its functional currency. Where
the entity is part of a group, the parent must translate its financial statements into the
group presentation currency prior to consolidation.

A holding or parent company with foreign operations must translate the financial statements of
those operations into its own reporting currency before they can be consolidated into the group
accounts. There are two methods; the method used depends upon whether the foreign operation
has the same functional currency as the parent.

16.1 DETERMINING FUNCTIONAL CURRENCY

IAS 21 states that an entity should consider the following factors in determining the functional
currency of an entity:
 The currency that mainly influences sales prices for goods and services (often the currency in
which prices are denominated and settled).
 The currency of the country whose competitive forces and regulations mainly determine the
sales prices of its goods and services.
 The currency that mainly influences labour, material and other costs of providing goods or
services (often the currency in which prices are denominated and settled).
Sometimes the functional currency of an entity is not immediately obvious. Management must then
exercise judgment and may also need to consider:
 The currency in which funds from financing activities (raising loans and issuing equity) are
generated.
 The currency in which receipts from operating activities are usually retained.
Where a parent has a foreign operation a number of factors are considered:
 Whether the activities of the foreign operation are carried out as an extension of the parent,
rather than being carried out with a significant degree of autonomy.
 Whether transactions with the parent are a high or a low proportion of the foreign operation's
activities.
 Whether cash flows from the activities of the foreign operation directly affect the cash flows of
the parent and are readily available for remittance to it.
 Whether the activities of the foreign operation are financed from its own cash flows or by
borrowing from the parent.
To sum up: to determine the functional currency of a foreign operation it is necessary to consider the
relationship between the foreign operation and its parent:
 If the foreign operation carries out its business as though it were an extension of the parent's
operations, it is likely to have the same functional currency as the parent.
 If the foreign operation is semi-autonomous it is likely to have a different functional currency
from the parent.
 FINANCIAL ACCOUNTING AND REPORTING | 251

The translation method used has to reflect the economic reality of the relationship between the
reporting entity (the parent) and the foreign operation.

16.1.1 SAME FUNCTIONAL CURRENCY AS THE REPORTING ENTITY

In this situation, the foreign operation normally carries on its business as though it were an extension
of the reporting entity's operations. For example, it may only sell goods imported from, and remit
the proceeds directly to, the reporting entity.
Any movement in the exchange rate between the reporting currency and the foreign operation's
currency will have an immediate impact on the reporting entity's cash flows from the foreign
operations. In other words, changes in the exchange rate affect the individual monetary items held
by the foreign operation, not the reporting entity's net investment in that operation.
Where a foreign operation has the same functional currency as its parent, it will almost certainly keep
its accounting records in its functional currency, even if this is not the same as the local currency. This
means that the financial statements of the foreign operation do not need to be translated.
In theory, the foreign operation could keep its accounting records and prepare individual financial
statements in the local currency. In this situation, the foreign operation's transactions should be
translated as if they had been those of the parent.

16.1.2 DIFFERENT FUNCTIONAL CURRENCY FROM THE REPORTING ENTITY

In this situation, although the reporting entity may be able to exercise control, the foreign operation
normally operates in a semi-autonomous way. It accumulates cash and other monetary items,
generates income and incurs expenses, and may also arrange borrowings, all in its own local
currency.
A change in the exchange rate will produce little or no direct effect on the present and future cash
flows from operations of either the foreign operation or the reporting entity. Rather, the change in
exchange rate affects the reporting entity's net investment in the foreign operation, not the individual
monetary and non-monetary items held by the foreign operation.

16.2 ACCOUNTING TREATMENT: DIFFERENT FUNCTIONAL CURRENCY

FROM THE REPORTING ENTITY
The financial statements of the foreign operation must be translated to the functional currency of the
parent. The functional currency of the parent is the presentation currency of the foreign operation.
 The assets and liabilities shown in the foreign operation's statement of financial position are
translated at the closing rate at the reporting date, regardless of the date on which those items
originated. Share capital and pre-acquisition reserves are translated at the historic rate being the
exchange rate on the date of acquisition. Post-acquisition reserves are a balancing figure and
include the exchange difference on translation. This is discussed in more detail in Section 15.3
MODULE 4
below
 Amounts in the statement of profit or loss are translated at the rate ruling at the date of the
transaction (an average rate will usually be used for practical purposes).
Worked Example: Different functional currency from the reporting entity

A dollar-based company, Stone Co., set up a foreign subsidiary on 30 June 20X7. Stone subscribed
€24 000 for share capital when the exchange rate was €2 = $1. The subsidiary, Brick Inc., borrowed
€72 000 and bought a non-monetary asset for €96 000. Stone Co. prepared its financial statements on
31 December 20X7 and by that time the exchange rate had moved to €3 = $1.
Required
Prepare Brick Inc's statement of financial position at 31 December 20X7 in both euros and dollars, and
calculate the exchange gain or loss arising since 30 June 20X7.
252 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

Solution

Stone Co. will record its initial investment at $12 000 which is the cost of the shares. The statement of
financial position of Brick Inc. at 31 December 20X7 is:
€'000
Non-monetary asset 96

Share capital 24
Loan 72
96
This is translated as:
$'000
Non-monetary asset
(€3 = $1) 32

Share capital and reserves* (retained earnings) (balancing figure) 8

Loan (€3 = $1) 24
32

Exchange gain/(loss) for 20X7 (4)

 Shown as a single figure in this example for simplicity.

The exchange loss is the difference between the value of the original investment ($12 000) and the
net assets stated in the statement of financial position ($32 – $24).

Question 16: Translation of financial statements

The abridged statement of financial position and statement of profit or loss of Xerxes Inc., appear
below:
DRAFT STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X9
Xerxes Inc.
€ €
Assets
Non-current assets
Plant at cost 500
Less: depreciation (200)
300
300
Current assets
Inventories 200
Receivables 100
300
600
Equity and liabilities
Equity
Ordinary shares 100
Reserves 280
380
Long-term loans 110
Current liabilities 110
600
 FINANCIAL ACCOUNTING AND REPORTING | 253

STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X9

Xerxes Inc.
€
Profit before tax 300
Tax (140)
Profit after tax, retained 160

The following further information is given:

(a) Darius Co. has owned shares in Xerxes Inc. since 1 January 20X9. On that date the company had
reserves of €120.
(b) Exchange rates: €1.8 to $1 on 1 January 20X9
€1.6 to $1 average rate of exchange year ending 31 December 20X9
€1 to $1 on 31 December 20X9.
Required
Translate the statement of financial position and statement of profit or loss of Xerxes Inc. into dollars.
(The answer is at the end of the module.)

16.3 ANALYSIS OF EXCHANGE DIFFERENCES

In question 15 above, the exchange difference arising on translation of Xerxes' financial statements
was included within post-acquisition reserves in the statement of financial position – although you
would not necessarily have considered this as you completed the question.
The correct presentation of the exchange difference is as an item of other comprehensive income in
the year which is then transferred to post-acquisition reserves. If you are asked to prepare a statement
of profit or loss and other comprehensive income, you may need to calculate the amount of the
exchange difference. It consists of exchange gains or losses arising from:
(a) translating income or expense items at the average rate, whereas assets or liabilities are
translated at the closing rate
(b) translating the opening net investment (opening net assets) in the foreign entity at a closing rate
different from the closing rate at which it was previously reported.
This can be demonstrated using Xerxes:
Using the opening statement of financial position and translating at €1.8 = $1 and €1 = $1 gives the
following:
€1.8 = $1 €1 = $1 Difference
€ $ $ $
Opening net assets
MODULE 4
Share capital 100
Reserves (pre-acquisition since
acquisition was at start of year) 120
220 122 220 98 gain

This is a gain because net assets worth $122 based on the opening exchange rate are now worth $220
based on the closing exchange rate.
Translating the statement of profit or loss using €1.60 = $1 and €1 = $1 gives the following results:
€1.60 = $1 €1 = $1 Difference
$ $ $
Profit of $100 100 160 60 gain

This is a gain because the reported profit of $100 based on the average exchange rate is worth $160
based on the closing exchange rate.
In the statement of profit or loss and other comprehensive income of Xerxes for the year ended
31 December 20X9, an exchange gain of $158 ($98 + $60) is recognised as other comprehensive
income.
 254 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

As we have said, the gain forms part of post-acquisition reserves and we can therefore analyse the
post-acquisition reserves figure as:
$
Profit since acquisition as reported in the translated statement of profit or loss
(note that in this case the profit since acquisition is the profit for the year) 100
Exchange gain in total (98 + 60) 158
258

16.4 DISCLOSURE REQUIREMENTS

IAS 21 requires the following disclosures in respect of foreign currency transactions:
 The amount of exchange differences recognised in profit or loss in the period
 The amount of exchange differences recognised as other comprehensive income
 If relevant, the fact that the presentation currency is different from the functional currency and the
reason why.
 FINANCIAL ACCOUNTING AND REPORTING | 255

KEY MODULE POINTS 3

 IAS 21 deals with converting individual transactions into local currency before recording them. It
also deals with translating a foreign subsidiary's financial statements before consolidating them.
 Individual foreign currency transactions are translated into the reporting currency of an entity
before they are recorded in the financial statements.
 Foreign monetary items remaining in the statement of financial position at the reporting date are
re-translated using the closing rate.
 Any exchange differences arising on re-translation or settlement are recognised in profit or loss.
 A foreign subsidiary will operate its business and record transactions in its functional currency.
Where the entity is part of a group, the parent must translate its financial statements into the group
presentation currency prior to consolidation.
 The assets and liabilities shown in the foreign operation's statement of financial position are
translated at the closing rate at the reporting date, regardless of the date on which those items
originated.
 Share capital and pre-acquisition reserves are translated at the historic rate being the exchange
rate on the date of acquisition.
 Post-acquisition reserves are a balancing figure and include the exchange difference on translation.
 Amounts in the statement of profit or loss are translated at the spot rate at the date of the
transaction (an average rate for the year will usually be applied to all amounts for practical
purposes).
 The exchange difference arising on translation is calculated as the difference between:
– opening net assets at the opening rate and opening net assets at the closing rate; plus
– retained profits at the average rate and retained profits at the closing rate.
It is recognised as other comprehensive income and forms part of post-acquisition reserves in the
statement of financial position.

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256 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

QUICK REVISION QUESTIONS 3

1 Which of the following statements, in respect of foreign currency translation, are correct according
to IAS 21 The Effects of Changes in Foreign Exchange Rates?
I. The functional currency of an entity is selected by management
II. The presentation currency of an entity is selected by management
III. The functional currency of an entity is identified by reference to the circumstances of the
business
IV. The presentation currency of an entity is identified by reference to the circumstances of the
business
A I and II only
B I and IV only
C II and III only
D III and IV only
2 BLX Co. holds several investments in subsidiaries. One of these, CMY Co., is located abroad.
CMY Co. prepares its financial statements in its local currency, the crown.
Several years ago, when the exchange rate was 5 crowns = $1, CMY Co. purchased land at a cost
of 170 000 crowns. On 1 June 20X5, when the exchange rate was 6.5 crowns = $1 the land was
revalued at a fair value of 600 000 crowns. The exchange rate at the group's year end,
31 December 20X5, was 7 crowns = $1.
In accordance with the requirements of IAS 21 The Effects of Changes in Foreign Exchange Rates,
at what value in $ should the land be recognised in BLX Co.'s group financial statements at
31 December 20X5?
A $85 714
B $90 440
C $100 154
D $120 000
3 Street Co. purchased goods for €450 000 from an overseas supplier on 30 November 20X6.
Street Co. paid for the goods on 31 January 20X7. They were not sold to third parties until
February 20X7.
Exchange rates were:
€=$1
30 November 20X6 1.5
31 December 20X6 1.45
31 January 20X7 1.55

What is the exchange difference that should be reported in profit or loss for the year ended
31 December 20X6 and at what amount should the goods be included in inventory in the
statement of financial position at that date?
Exchange difference Inventory
A $22 500 loss $652 500
B $22 500 loss $675 500
C $22 500 gain $675 500
D $22 500 gain $697 500
 FINANCIAL ACCOUNTING AND REPORTING | 257

4 Parent Co. has three overseas subsidiaries:

1. A Co. is 80 per cent owned. A Co. does not normally enter into transactions with Parent Co.,
other than to pay dividends. It operates as a fairly autonomous entity on a day to day basis
although Parent Co. controls its long-term strategy.
2. B Co. is 100 per cent owned and has been set up in order to assemble machines from materials
provided by Parent Co. These are then transferred to Parent Co., which sells them to third
parties.
3. C Co. is 75 per cent owned and is located in France. It manufactures and sells its own range of
products locally. It negotiates its own day to day financing needs with French banks.
Which of the subsidiaries are likely to have a different functional currency from Parent Co.?
A A Co. and B Co.
B A Co. and C Co.
C B Co. and C Co.
D All three subsidiaries
5 Archway Co. has an overseas subsidiary in Sweden. This subsidiary is 75 per cent owned and
operates semi-independently of its parent. The exchange gain arising from the translation of the
subsidiary's financial statements for the year ended 30 June 20X4 was $20 000.
On 1 June 20X4 Archway Co. purchased raw materials from a European supplier for €250 000. It
paid for the materials on 31 July 20X4. Relevant exchange rates were:
€=$1
1 June 20X4 1.6
30 June 20X4 1.61
31 July 20X4 1.63
In respect of these items, what is the exchange gain that should be included in the consolidated
statement of profit or loss for the year ended 30 June 20X4?
A $2500 loss
B $7500 loss
C $12 500 gain
D $17 500 gain
6 When a parent has a subsidiary that is a foreign operation, which rates of exchange should be used
to translate the items below into the parent's local currency?
Non-current assets Receivables Non-current liabilities
A Closing rate Closing rate Closing rate
B Historic rate Closing rate Closing rate
C Historic rate Historic rate Closing rate MODULE 4
D Historic rate Historic rate Historic rate
258 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

7 Bay Co. has a foreign subsidiary Sea Co., acquired on 1 January 20X7, which uses the Yoyo as its
functional currency. Details of Sea Co. are given below:
Net assets of Sea Co. at 1 Jan 20X7 Yoyo 340 000
Net assets of Sea Co. at 1 Jan 20X8 Yoyo 410 000
Net assets of Sea Co. at 31 Dec 20X8 Yoyo 500 000
Sea Co. has paid no dividends since acquisition. It translates all income and expense items using
the average rate for the period.
Relevant exchange rates are:
1 January 20X7 2.1 Yoyo: $1
1 January 20X8 2.0 Yoyo: $1
31 December 20X8 1.8 Yoyo: $1
Average rate 1 Jan X7–31 Dec X8 1.95 Yoyo: $1
Average rate 1 Jan X8–31 Dec X8 1.9 Yoyo: $1
What exchange difference is included in Bay Co.'s consolidated reserves for the year ended
31 December 20X8?
A $25 410 loss
B $25 410 gain
C $36 386 loss
D $36 386 gain
8 Rain Org is a subsidiary of the Weather Group. Its functional currency is the Zyco, and the
presentation currency of the group is the $. The abbreviated statement of financial position of
Rain Org at 31 December 20X9 is as follows:
Zyco
Non-current assets 420 000
Current assets 210 000

Total assets 630 000

Share capital 100 000

Reserves 350 000

Current liabilities 180 000

Equity and liabilities 630 000

Relevant exchange rates are as follows:

3 Zyco: $1 on 31 December 20X9
2.1 Zyco: $1 on date of acquisition of non-current assets
2 Zyco: $1 on date Rain Org acquired by Weather Group
What are the translated reserves of Rain Org at 31 December 20X9?
A $100 000
B $116 667
C $160 000
D $175 000
 FINANCIAL ACCOUNTING AND REPORTING | 259

9 Aardvark Co. bought goods from Hippo Co. for Milanian Pounds (MP) 230 000 on 31 October 20X8.
At that date the exchange rate was MP 2.3: $1. Aardvark paid MP 130 000 of the balance on
30 November in accordance with Hippo's terms. On that date the exchange rate was MP 2.1: $1.
Aardvark's year end is 31 December 20X8 and on that date the exchange rate was MP 1.8: $1.
The balance was settled by Aardvark at the end of January 20X9 when the exchange rate was
MP 2: $1.
What exchange difference is recorded in Aardvark's profit or loss for the year ended 31 December
20X8?
A $5383 loss
B $12 078 gain
C $17 461 loss
D $17 461 gain
10 Which of the following is correct?
A Monetary items include all types of current assets.
B Non-monetary items denominated in a foreign currency are never retranslated in an entity's
statement of financial position.
C Unrealised exchange differences on the retranslation of monetary items in an entity's individual
accounts are recognised in profit or loss.
D An exchange difference arising on the retranslation of a foreign currency loan is recognised in
other comprehensive income in an individual entity's financial statements.

MODULE 4
 260 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

17 IFRS 16 LEASES

Section overview
 IFRS 16 sets out the accounting treatment of leases and requires the lessee to recognise an
asset and liability for most leases.
This section has been included to highlight changes to lease accounting as IFRS 16 has
superseded IAS 17 and specifically, this section focuses on lessee accounting.

17.1 THE AIM OF IFRS 16 LEASES

A lease is a contract that allows the lessee the right to use an asset for a period of time. The aim of
IFRS 16 is to create a single accounting treatment for lessee accounting and this standard replaces
IAS 17 on leases. IAS 17 required lessees to classify leases as either a finance lease or an operating
lease. This meant that the liability for operating leases was not included on the statement of financial
position.
IFRS 16 remedies this by ensuring all leases are included on the lessee's statement of financial
position as an asset and with a corresponding liability even though the business does not actually own
the asset.

17.2 ACCOUNTING FOR LESSEE

17.2.1 EXEMPTIONS
The standard allows the lessee to elect to not apply IFRS 16 in the following situations:
 Short-term leases – this is a lease for a period of time that is for less than 12 months
 Low value leases – when the underlying asset has a low value when new (the order of magnitude of
US$5,000 or less.)

17.2.2 INITIAL MEASUREMENT OF THE LEASE

At the inception of the lease the lessee will record an asset and a liability:
Dr. Right to use asset
Cr. Lease liability
The amount will be measured at cost to include:
 the present value of the future lease payments including any expected cash flows at the end of the
lease, discounted at the interest rate implicit in the lease
 any lease payments made before the lease commences
 any initial direct costs incurred by the lessee.

17.2.3 SUBSEQUENT MEASUREMENT OF THE ASSET AND LIABILITY -

The right to use asset shall be recognised at the cost model under IAS 16 and should be depreciated
over the lower of:
 useful life of the asset; or
 lease term.
This rule is overridden when the lease transfers ownership to the lessee at the end of the lease in
which case the right of use asset should be depreciated over the useful life of the asset.
The lease liability is increased by any interest charges and reduced by any payment made under the
lease.
 FINANCIAL ACCOUNTING AND REPORTING | 261

Worked Example: Accounting for a lease by the lessee – payments in arrears

A business leases an item of machinery on 1 January 20X4 and pays an initial deposit of $1725
followed by seven instalments of $6000 at the end of each year. The interest rate implicit in the lease is
11 per cent and the present value of the lease instalment payments is $30 000.
Calculate the figures that will be shown in the financial statements for the year ended 31 December
20X4 in respect of the lease.
Solution
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X4
$
Depreciation expense 4 532
Finance cost 3 300
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4
$
Non-current asset
Right of use asset (31 725 – 4532) 27 193
Non-current liability
Lease liability 24 303
Current liability
Lease liability (27 300 – 24 303) 2 997
Working
The right of use asset will initially be recorded as follows:
Dr. Right of use asset $31 725
Cr. Lease liability $30 000
Cr. Cash $1 725
The present value of the future cash flows ignores the deposit as this is paid as the lease is taken out.
Lease liability calculation
Date Narrative $
1.1.20X4 Initial recording 30 000
31.12.20X4 Interest (30 000  11%) 3 300
31.12.20X4 Instalment (6 000)
27 300
31.12.20X4 Interest (27 300  11%) 3 003
31.12.20X4 Instalment (6 000)
24 303
Depreciation
31 725 / 7 years = 4532
MODULE 4

Question 17: Accounting for a lease by the lessee – payments in advance

A business leases an item of equipment on 1 January 20X7 and pays an initial deposit of $6000
followed by four instalments of $6000 at the beginning of each year. The interest rate implicit in the
lease is 12 per cent and the present value of the future lease payments is $18 225. The useful life of the
asset is eight years.
Required
Calculate the figures that will be shown in the financial statements for the year ended 31 December
20X7 in respect of the lease.
(The answer is at the end of the module.)
 262 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

17.3 ACCOUNTING FOR SHORT-TERM OR LOW VALUE LEASE

The accounting requirements when an entity elects for this option are to recognise a rental expense in
profit or loss on a straight line basis or other systematic basis.
Worked Example: Low value lease

On 1 January 20X6 AH Company (AH Co.) entered into a three year lease and paid $400 upfront and
three annual payments of $600. AH Co. elected to treat the lease as a low value lease.
What is the expense that AH Co. will recognise in profit or loss for the year ended 31 December 20X6?
Solution

The expense will be $733.

AH Co. is paying a total amount of $2200 (600  3 years plus the 400) and that should be spread over
the three years to give an annual expense of $733. AH Co. will have a prepayment on their statement
of financial position of $267, this being the cash paid of $1000 less the expense of $733.

17.4 ACCOUNTING FOR LESSOR

A lessor is required to classify each of its leases as either a finance lease or operating lease (IFRS 16,
para. 61).
Definitions
Operating lease. An operating lease is a lease that does not transfer substantially all the risks and
rewards incidental to ownership of an underlying asset. (IFRS 16: Appendix A). Here, the lessor
continues to recognise the asset and accounts for rental income received.
Finance lease. A finance lease is a lease that transfers substantially all the risks and rewards incidental
to ownership of an underlying asset. (IFRS 16: Appendix A). In this case, IFRS 16 requires the following
recognition and measurement criteria to be followed below.

17.4.1 FINANCE LEASE RECOGNITION AND MEASUREMENT

At the commencement date where the lessor makes the underlying asset available for use to the
lessee, the lessor derecognises the underlying asset and recognises a receivable at an amount equal
to the net investment in the lease (IFRS 16: para. 67). The net investment in the lease (IFRS 16:
Appendix A) is the sum of:
Present value of lease payments receivable by the lessor X
Present value of any unguaranteed residual value accruing to the lessor X
X
The unguaranteed residual value is that portion of the residual value of the underlying asset which is
not assured.
Finance income received from the lessee is recognised over the lease term based on a pattern
reflecting a constant periodic rate of return on the lessor's net investment in the lease (IFRS 16: para.
75).
 FINANCIAL ACCOUNTING AND REPORTING | 263

KEY MODULE POINTS 4

 IFRS 16 Leases requires lessees to recognise an asset and a liability for all leases that are for a
period of more than 12 months.
 An exception to this is for assets that are of a low value when the initial lease is taken out.
 This means that assets will be recognised as non-current assets by lessees even though the
business does not own the asset, this reflects the concept of substance over form. They are known
as a right of use asset.
 The right of use asset is initially measured at the present value of the future cash flows of the lease.
 The right of use asset is depreciated over the lower of the lease term and the useful life of the
asset.
 A finance cost will be shown in profit or loss based on the interest rate implicit in the lease.
 The lease liability will be calculated by adding on the finance cost and deducting any lease
payments.

MODULE 4
264 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

QUICK REVISION QUESTIONS 4

1. Murray leased a car on 1 January 20X4 with two payments due on 31 December 20X4 and
31 December 20X5 of $14 160 each. The present value of the lease payments is $24 000 and the
interest rate implicit in the lease is 12 per cent.
What is the lease liability that will be shown as a current liability as at 31 December 20X4?
A $11 021
B $12 000
C $12 720
D $14 160
2. Which of the following situations would require a right-of-use asset to be recognised under
IFRS 16?
I. A lease for a term of 10 years
II. A lease for a term of six months
III. A lease for an asset that has a low value when new
A I only
B II only
C II and III only
D All of the situations
3. Mutley leased an item of equipment on 1 January 20X4 under a lease for a term of five years with
an initial deposit of $200 000 and five annual rentals of $600 000 due at the end of the year. The
present value of the future cash flows is $2 500 000 and the interest rate implicit in the lease is
10 per cent.
What is the finance charge that will be recognised in profit or loss for the year ended 31 December
20X4?
A $190 000
B $250 000
C $270 000
D $300 000
4. Using the information from question 3:
What is the lease liability that will be shown as a current liability as at 31 December 20X4?
A $215 000
B $385 000
C $451 000
D $600 000
5. Sammy enters into a five year lease for an asset with a useful life of six years. Sammy pays an initial
deposit of $10 000 and the present value of the future cash flows is $65 000. The ownership of the
asset will transfer over to Sammy at the end of the lease.
What is the carrying value of the asset at the end of the first year?
A $52 000
B $54 167
C $60 000
D $62 500
 FINANCIAL ACCOUNTING AND REPORTING | 265

ANSWERS TO QUICK REVISION QUESTIONS 1

1 A Deferred development expenditure b/f is $480 000 (cost $500 000 – accumulated amortisation
$20 000), then deduct annual amortisation of $10 000 to give figure c/f of $470 000.
2 C I Development expenditure must be capitalised if the criteria are met.
II There is no time scale given by IAS 38 for amortisation.
3 D A and B are still in the research phase; C is in the development phase however problems mean
that it is still sufficiently distant from commercial production to write off expenses as incurred.
4 A Amortisation commences when production commences and therefore the amortisation charge
relates to an eight-month period. Amortisation should reflect the pattern of benefits; in this
case the first year's benefit is half that of later years, therefore:
0.5/9.5  $210 000  8/12m = $7368
* There are 10 years of amortisation, although the first year attracts only half the charge of the
subsequent nine years. Therefore the denominator is 9.5, being (1 year  ½ ) + (9 years  1)
5 C Amortisation does not start until commercial production commences.
6 B Intangible assets such as capitalised development costs that meet the capitalisation criteria of
IAS 38 must be capitalised and depreciated where they have a finite life. Any intangible assets
which are deemed to have an indefinite life are instead tested annually for impairment. Any
amortisation is charged to profit or loss.
7 C The asset must be identifiable. An asset which is capable of separate disposal is identifiable
however separability is not an essential feature of an intangible asset. For example, production
rights may not be capable of separate sale without a particular machine, however they still
qualify as an intangible asset.
8 C Only intangible assets which have an indefinite useful life or are not yet available for use must
be reviewed for impairment annually. All others undergo an impairment review if there are
indications of an impairment.
9 B $900 000/25  5/12 months = $15 000 amortisation to the end of the year.
Therefore carrying amount is $900 000 – $15 000 = $885 000.
Marketing costs must be expensed as incurred.
10 A Patents are purchased intangible assets and as such should be capitalised. The costs of staff
training and advertising, even where these are expected to result in future economic benefits,
cannot be capitalised according to IAS 38.
11 B A revaluation surplus is recognised as other comprehensive income in the period in which it
arises. An impairment loss suffered on a previously revalued asset may be recognised as other
comprehensive income to the extent that a revaluation surplus exists in respect of that asset. An
MODULE 4

impairment loss suffered on an asset held at depreciated cost must be recognised in profit or
loss.
12 D The impairment would have been written off to profit or loss as there is no credit in the
revaluation surplus for this asset. So only the increase in head office value appears in the
revaluation surplus.
13 C Most non-current assets only require testing for impairment if there are indicators of
impairment, rather than annually.
14 A The impairment loss is applied first against the goodwill and then against the other non-current
assets on a pro-rata basis. It will be allocated as follows:
$m
Building 10
Plant and equipment 5
Goodwill 5
20

The carrying amount of the building will then become $10m (20 – 10).
266 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

15 C Goodwill acquired in a business combination should be reviewed for impairment annually.

16 B
Revaluation
Property reserve
$ $
Cost 1 April 20X5 700 000
Depreciation (700 000  2 / 50) (28 000)
CV at 1 April 20X7 672 000
Revaluation surplus 288 000 288 000
960 000
Depreciation y/e 31 March 20X8
(960 000 / 48) (20 000)
Excess depreciation (20 – 14) 000 000 (6 000)
CV at 31 March 20X8 940 000 282 000
Impairment loss (340 000) (282 000)
Impaired value 600 000

17 C
Revaluation
reserve
$ $
Cost 300 000
Revaluation 50 000 50 000
X3 350 000
Revaluation 50 000 50 000
X4 400 000 100 000
Impairment (115 000) (100 000)
FV less costs of disposal 285 000 –

The balance of the impairment loss ($15 000) is charged to profit or loss.
18 A A reversal of an impairment loss in relation to goodwill cannot be recognised.
19 C The carrying amount of the machine on the date of the impairment test is $68 000 ($80 000 
8.5 / 10). The recoverable amount is $66 000 (the higher of the value in use and the fair value
less costs of disposal). Therefore the asset is impaired and its carrying amount is reduced to
$66 000. The depreciation charge for the following year is therefore $66 000 / 8.5 years = $7,765
20 D An intangible asset with an indefinite useful life is tested for impairment annually; however the
test may take place at any time during the reporting period providing that it is the same time
each year.
A head office building which is shared by a number of CGUs (a corporate asset) is only tested
for impairment on an individual basis if it cannot be allocated to CGUs on a reasonable and
consistent basis.
 FINANCIAL ACCOUNTING AND REPORTING | 267

ANSWERS TO QUICK REVISION QUESTIONS 2

1 B No sale has taken place, so DT must show that it is holding $90 000 which belongs to XX.
2 C The revenue on the system can be recognised immediately of $3560 (4000  89%) and the
revenue on the servicing of $440 (4000 x 11%) should be spread over the year.
$ %
System 4000 89
Servicing 500 11
3 B Settlement discounts count as variable consideration and any expected discounts should be
deducted from revenue.
Tuition fees are revenue from the provision of a service and should be recognised over the
period that the tuition is provided.
$
4 C Tax charge (30%  $582 000) 174 600
Over-provision from X7 ($502 000  30%) – 149 000 (1 600)
173 000

5 C The deferred tax liability will be the tax on temporary differences at the year end, i.e.
((2 650 000 – 1 872 000)  20%) = $155 600. Answer A is the deferred tax part of the year's tax
charge (the amount by which the liability is increased) i.e. $155 600 – $128 500. Answer B is the
opening balance rather than the year end balance. Answer D is the difference between the
carrying amount and the tax WDV, i.e. the temporary difference itself rather than the tax on the
difference.
6 D The creation of a deferred tax liability will increase the tax charge, so reducing profit after tax
for the year that is, the entry will be Dr. tax charge, Cr. deferred tax liability. The net assets will
also decrease due to increase in deferred tax liability.
7 A A carrying amount of $3 570 000 less tax WDV of $2 450 000 = $1 120 000 and at 22 per cent a
liability of $246 400 is required. There is already a liability of $250 000 so a credit of $3600 will be
reported.
8 A $
Current tax 53 960
Deferred tax (see below) (5 600)
48 360
Deferred tax – liability required = $80 000  24%
= 19 200
Opening balance on deferred tax = 24 800
MODULE 4

Decrease 5 600

9 B Deferred tax is recorded as a non-current liability; it does not represent an amount currently
payable, but is an accounting adjustment made in order to 'smooth' the tax charge so that the
tax charged in a period is in line with the profits made in that period.
10 A A deferred tax asset arises in respect of the losses carried forward which are expected to be
utilised against future profits that is, $185 000 ($320 000 – $120 000 – $15 000). The asset is
calculated by applying the tax rate of 25 per cent.
11 C A deferred tax liability is the result of a taxable temporary difference. Deferred tax arising on a
revaluation is recognised in other comprehensive income.
268 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

12 A Deferred tax on the accelerated capital allowances (recognised in profit or loss)

$
Carrying amount (580 000 – 80 000) 500 000
Tax base (580 000 – 130 000) 450 000
Temp difference 50 000
Deferred tax liability c/f (20%  $50 000) 10 000
Deferred tax liability b/f 9 000
Increase in liability/charge to profits 1 000
Deferred tax on revaluation (recognised as OCI)
$100 000  20% 20 000

13 A $
Tax charge for current year = liability 56 000
Decrease in deferred tax liability (6 000)
Over-provision (balancing figure) (2 500)
Tax charge to profits 47 500
 FINANCIAL ACCOUNTING AND REPORTING | 269

ANSWERS TO QUICK REVISION QUESTIONS 3

1 C The functional currency of an entity is the currency in which its day to day transactions are
denominated; the presentation currency is chosen by the management and is the currency in
which the financial statements are prepared.
2 A 600 000 crowns / 7 = $85 714
The closing rate must be used.
3 C $
Inventory value at 1 November 20X6 (450 000  $1.5) 675 000
Inventory value at 31 December 20X6 (450 000  $1.45) (652 500)
Gain / (Loss) 22 500
The inventory is a non-monetary asset. It is translated at the date of the original transaction and
remains in the statement of financial position at that amount being $300 000.
4 B Subsidiary B Co. is clearly an extension of Parent's Co.'s own activities and therefore it almost
certainly has the same functional currency as the parent.
5 D Exchange gain:
$
Purchase from European supplier:
1 June 20X4 (250 000  1.6) 400 000
30 June 20X4 (250 000  1.61) (402 500)
Gain / (Loss) (2 500)
Plus translation gain of 20 000
Total consolidated exchange gain 17 500

The overseas subsidiary has a different functional currency from its parent (i.e. it is a
semi-autonomous operation) and therefore the translation gain of $20 000 is recognised in
consolidated reserves rather than reported in profit or loss.
6 A The assets and liabilities of a foreign subsidiary are always translated at closing rate, not historic
rate, where the subsidiary has a different functional currency from its parent. For the translation
of a foreign subsidiary there is no consideration of monetary or non-monetary assets and
liabilities, all are translated at the closing rate.
7 B $ $
Opening net assets at opening rate (410 000 / 2) 205 000
Opening net assets at closing rate (410 000 / 1.8) 227 778
Gain 22 778
Profit for year at average rate (500 000 – 410 000) / 1.9 47 368
MODULE 4

Profit for year at closing rate (90 000 / 1.8) 50 000

Gain 2 632
Overall exchange gain 25 410

8 A $
Total assets (630 000 / 3) 210 000
Share capital (100 000 / 2) 50 000
Reserves (bal) 100 000
Current liabilities (180 000 / 3) 60 000
Equity and liabilities 210 000
270 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

9 C Exchange difference on settled amount:

$
MP 130 000 / 2.3 56 522
MP 130 000 / 2.1 61 905
Loss 5 383
Exchange difference on retranslation of outstanding amount at year end:
$
MP 100 000 / 2.3 43 478
MP 100 000 / 1.8 55 556
Loss 12 078
Overall loss 17 461

10 C Unrealised exchange differences on the retranslation of monetary items in individual entity

financial statements are recognised in profit or loss, not other comprehensive income.
Monetary items do not include current assets such as inventories and prepayments, which are
classified as non-monetary items.
Non-monetary items denominated in a foreign currency have to be retranslated before they can
be included in the statement of financial position.
 FINANCIAL ACCOUNTING AND REPORTING | 271

ANSWERS TO QUICK REVISION QUESTIONS 4

1 C
Dates Narrative $
1.1.20X4 Initial recognition 24 000
31.12.20X4 Interest 2 880
(24 000  12%)
31.12.20X4 Instalment (14 160)
Liability 12 720
2 A For leases that are less than 12 months or that have a low value at inception the business can
elect to use the simplified accounting under IFRS 16.
3 B $2 500 000  10% = $250 000
4 B 2 150 000 – 1 765 000 = $385 000
Dates Narrative $
1.1.20X4 Initial recognition 2 500 000
31.12.20X4 Interest 250 000
31.12.20X4 Instalment (600 000)
Liability 2 150 000
Interest (2 150 000  10%) 215 000
Instalment (600 000)
31.12.20X5 Liability 1 765 000
5 D The right of use asset is initially recognised at $75 000 (10 000 + 65 000) and this is depreciated
over six years to give a depreciation charge of $12 500 ($75 000 / 6), giving a carrying value of
$62 500 ($75 000 – $12 500). The asset is depreciated over six years rather than five years as the
lessee takes ownership at the end of the lease term.

MODULE 4
272 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

ANSWERS TO MODULE QUESTIONS

1 Project A
This project meets the criteria in IAS 38 for development expenditure to be recognised as an asset.
The project is technically feasible and the company intends to complete it so that the resulting
product will be available for sale. There is a market for the product and its sale will result in future
economic benefits. In the absence of other information it is assumed that the company has
adequate technical, financial and other resources to complete the development and to use or sell
the intangible asset. The company is clearly able to measure reliably the expenditure attributable
to the intangible asset during its development, because it has been able to estimate total costs
and expected revenue.
Hence the costs of $280 000 incurred to date should be transferred from research and
development costs to capitalised development expenditure and carried forward until revenues are
generated; they should then be matched with those revenues.
Project B
While this project meets most of the criteria discussed above which would enable the costs to be
carried forward it fails on the requirements that 'adequate resources exist, or their availability can
be demonstrated, to complete the project'.
Therefore, these costs should be written off as an expense in profit or loss. Once funding is
obtained the situation can then be reassessed and future costs may be capitalised.
Project C
This is a research project according to IAS 38, i.e. original and planned investigation undertaken
with the prospect of gaining new scientific or technical knowledge or understanding.
There is no certainty as to its ultimate success or commercial viability and therefore it cannot be
considered to be a development project. IAS 38 therefore requires that costs be written off as
incurred.
2 (a) STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME (EXTRACT)
$
Research expenditure (Project C + 1 420 000) 1 530 000
Development costs (Project B) 150 000
Amortisation of capitalised development costs 240 000
(b) STATEMENT OF FINANCIAL POSITION (EXTRACT)
$
Non-current assets
Intangible assets
Deferred development costs 1 280 000
(c) NOTE TO FINANCIAL STATEMENTS
Deferred development costs
$
Cost
Balance b/f 1 480 000
Additions during year (Project A) 280 000
Balance c/f 1 760 000
Amortisation
Balance b/f 240 000
Charge during year 240 000
Balance c/f 480 000
Net carrying amount at 30 September 20X5 1 280 000
Net carrying amount at 30 September 20X4 1 240 000
 FINANCIAL ACCOUNTING AND REPORTING | 273

3 Here are two possibilities:

(a) A mining company owns a private railway that it uses to transport output from one of its mines.
The railway now has no market value other than as scrap, and it is impossible to identify any
separate cash inflows with the use of the railway itself. Consequently, if the mining company
suspects an impairment in the value of the railway, it should treat the mine as a whole as a cash
generating unit, and measure the recoverable amount of the mine as a whole.
(b) A bus company has an arrangement with a town's authorities to run a bus service on four routes
in the town. Separately identifiable assets are allocated to each of the bus routes, and cash
inflows and outflows can be attributed to each individual route. Three routes are running at a
profit and one is running at a loss. The bus company suspects that there is an impairment of
assets on the loss-making route. However, the company will be unable to close the loss-making
route, because it is under an obligation to operate all four routes, as part of its contract with the
local authority. Consequently, the company should treat all four bus routes together as a cash
generating unit, and calculate the recoverable amount for the unit as a whole.
4 In identifying Minimart's cash-generating unit, an entity considers whether, for example:
 Internal management reporting is organised to measure performance on a store-by-store basis.
 The business is run on a store-by-store profit basis or on a region or city basis.
All Maximart's stores are in different neighbourhoods and probably have different customer bases.
So, although Minimart is managed at a corporate level, Minimart generates cash inflows that are
largely independent from those of Maximart's other stores. Therefore, it is likely that Minimart is a
cash-generating unit.
5 The reversal of the impairment loss is recognised to the extent that it increases the carrying
amount of the tangible non-current assets to what it would have been had the impairment not
taken place, i.e. a reversal of the impairment loss of $10m is recognised and the tangible non-
current assets written back to $70m. Reversal of the impairment is not recognised in relation to the
goodwill and patent because the effect of the external event that caused the original impairment
has not reversed – the original product is still overtaken by a more advanced model.
6 A. Dr. Trade receivables control account $5 400
Cr. Sales $5 400
As Freddie expects the customer to take up the settlement discount the sale is recorded at 90%
of the $6 000.
B. Dr. Cash $6 000
Cr. Trade receivables control account $5 400
Cr. Sales $600
As the customer pays on 16 May 20X7 they will not be entitled to the settlement discount so
Freddie will receive an additional $600 of sales revenue.
7 The cleaning company should recognise the revenue as they satisfy the performance obligations,
MODULE 4

this will mean they should recognise them over a period of time. The contract requires them to
clean over a two year period so the total amount should be spread over the two years. For the year
ended 31 December 20X1 they will recognise revenue of $7500 ($15 000 / 2 years) and they will
have deferred income (shown under current liabilities) of $2500 ($10 000 – $7500).
8 The airline satisfies the performance obligation in January when they provide the flight to the
customer so revenue should be recognised in January.
9 (a) $
Estimated tax charge for the 20X8 year ($120 000  30%) 36 000
Under provision relating to the previous year 5 000
Tax expense 41 000

(b) $
Estimated tax charge for the 20X8 year ($120 000  30%) 36 000
Over provision relating to the previous year (5 000)
Tax expense 31 000
274 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

10 (a) The tax base of the machine is $7000. As $3000 has already been deducted, $7000 will be
deducted in the future.
(b) The tax base of the interest receivable is nil. It will be fully taxable in the future, so that zero is
deductible in the future.
(c) The tax base of the trade receivables is $10 000. Since it has already been taxed in full, it is not
taxable in the future (and so it is deductible).
(d) The tax base of the loan is $1m. Since economic benefits are not taxable, the tax base is the
same as the carrying amount.
11 (a) The tax base of the accrued expenses is nil. Since whole amount will be deducted in the future,
tax base is $1000 – $1000 = $0.
(b) The tax base of the interest received in advance is nil. This is carrying amount of $10 000 less
$10 000 (the amount is not taxable in the future, since it's already taxed).
(c) The tax base of the accrued expenses is $2000. This is the carrying amount of $2000 less $0.
Since it was already deducted for tax purposes, it will not be deducted in the future.
(d) The tax base of the accrued fines and penalties is $100. Since it cannot be deducted in the
future, this is $100 – $0 = $100.
(e) The tax base of the loan is $1m. Since no tax consequences, the tax base is equal to the
carrying value.
12 Jonquil Co. will recover the carrying amount of the equipment by using it to manufacture goods for
resale. Therefore, the entity's current tax computation is as follows:
Year
20X1 20X2 20X3 20X4 20X5
$ $ $ $ $
Taxable income* 10 000 10 000 10 000 10 000 10 000
Depreciation for tax purposes 12 500 12 500 12 500 12 500 0
Taxable profit (tax loss) (2 500) (2 500) (2 500) (2 500) 10 000

Current tax expense (income) at 40% (1 000) (1 000) (1 000) (1 000) 4 000

* That is, nil profit plus $50 000 / 5 depreciation add-back.

The entity recognises a current tax asset at the end of years 20X1 to 20X4 because it recovers the
benefit of the tax loss against the taxable profit of year 20X5.
The temporary differences associated with the equipment and the resulting deferred tax asset and
liability and deferred tax expense and income are as follows:
Year
20X1 20X2 20X3 20X4 20X5
$ $ $ $ $
Carrying amount 40 000 30 000 20 000 10 000 0
Tax base 37 500 25 000 12 500 0 0
Taxable temporary difference 2 500 5 000 7 500 10 000 0

Opening deferred tax liability 0 1 000 2 000 3 000 4 000

Deferred tax exp (income): bal fig. 1 000 1 000 1 000 1 000 (4 000)
Closing deferred tax liability  40% 1 000 2 000 3 000 4 000 0

The entity recognises the deferred tax liability in years 20X1 to 20X4 because the reversal of the
taxable temporary difference will create taxable income in subsequent years.
 FINANCIAL ACCOUNTING AND REPORTING | 275

The entity's statement of profit or loss is as follows:

Year
20X1 20X2 20X3 20X4 20X5
$ $ $ $ $
Income 10 000 10 000 10 000 10 000 10 000
Depreciation (10 000) (10 000) (10 000) (10 000) (10 000)
Profit before tax 0 0 0 0 0
Current tax expense (income) (1 000) (1 000) (1 000) (1 000) 4 000
Deferred tax expense (income) 1 000 1 000 1 000 1 000 (4 000)
Total tax expense (income) 0 0 0 0 0
Profit before tax for the period 0 0 0 0 0

13
(a) $
Income tax on profits (liability in the statement of FP) 45 000
Deferred taxation 16 000
Under-provision of tax in previous year $(40 500 – 38 000) 2 500
Tax on profits for 20X3 (profit or loss) 63 500

(b) Tax payable on 20X3 profits (liability) 45 000

14 (a) Tax expense for the year

$
(i) Tax on trading profits (30% of $1 200 000) 360 000
Tax on capital gain 18 000
Deferred taxation 20 000
398 000
Under-provision of taxation in previous years $(84 000 – 80 000) 4 000
Tax expense on profit for the period 402 000

(ii) Note: The statement of profit or loss and other comprehensive income will show the
following:
$
Profit before tax (1 200 000 + 60 000) 1 260 000
Income tax expense (402 000)
Profit for the year 858 000
(b)
Deferred taxation
Balance brought forward 100 000
Transferred from profit or loss 20 000
MODULE 4

Deferred taxation in the statement of financial position 120 000

The tax liability is as follows:

Payable on 1 May 20X5 $
Tax on profits (30% of $1 200 000) 360 000
Tax on capital gain (30% of $60 000) 18 000
Due on 1 May 20X5 378 000
276 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS

Summary
Current liabilities
Tax payable on 1 May 20X5 378 000
Non-current liabilities
Deferred taxation 120 000
Note: It may be helpful to show the journal entries for these items.
$ $
Dr. Tax expense (profit or loss) 402 000
Cr. Tax payable *382 000
Deferred tax 20 000
* This account will show a debit balance of $4000 until the under-provision is recorded,
since payment has already been made: (360 000 + 18 000 + 4000).
The closing balance will therefore be $378 000.
15 The purchase will be recorded in the books of White Cliffs Co. using the rate of exchange ruling on
30 September.
Dr. Purchases $25 000
Cr. Trade payables $25 000
Being the $ cost of goods purchased for €40 000 (€40 000 / €1.60/$1)
On 30 November, White Cliffs must pay €20 000. This will cost €20 000 / €1.80/$1 = $11 111 and the
company has therefore made an exchange gain of $12 500 – $11 111 = $1389.
Dr. Trade payables $12 500
Cr. Exchange gains: (profit or loss) $1 389
Cr. Cash $11 111
On 31 December, the year end, the outstanding liability will be recalculated using the rate
applicable to that date: €20 000 / €1.90/$1 = $10 526. A further exchange gain of $1974 has been
made and will be recorded as follows:
Dr. Trade payables $1 974
Cr. Exchange gains: (profit or loss) $1 974
The total exchange gain of $3363 will be included in the operating profit for the year ending
31 December.
On 31 January, White Cliffs must pay the second instalment of €20 000. This will cost it $10 811
(€20 000 / €1.85/$1).
Dr. Trade payables $10 526
Exchange losses: (profit or loss) $285
Cr. Cash $10 811
 FINANCIAL ACCOUNTING AND REPORTING | 277

16 SUMMARISED STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER 20X9

$ $
Non-current assets (carrying amount) ($1: €1) 300
Current assets
Inventories ($1: €1) 200
Receivables ($1: €1) 100
300
600
Equity and liabilities
Equity
Ordinary shares (€100/1.8) 55

Pre-acquisition reserves (€120/1.8) 67

Post-acquisition reserves (balancing figure) 258
380
Non-current liabilities ($1: €1) 110
Current liabilities ($1: €1) 110
600

SUMMARISED STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X9
$
Profit before tax (€300/1.6) 187.5
Tax (€140/1.6) (87.5)
Profit after tax, retained 100

17 STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X7

$
Depreciation expense 4 845
Finance cost 2 187
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X7
$
Non-current asset
Right of use asset (24 225 – 4845) 19 380
Non-current liability
Lease liability (20 412 – 6000) 14 412
Current liability
Lease liability 6 000
Working
The right of use asset will initially be recorded as follows:
Dr. Right of use asset $24 225
MODULE 4

Cr. Lease liability $18 225

Cr. Cash $6 000
The present value of the future cash flows ignores the first payment as this is paid as the lease is
taken out.
Lease liability calculation
Date Narrative $
1.1.20X7 Initial recording 18 225
31.12.20X7 Interest (18 225  12%) 2 187
20 412
Depreciation
24 225 / 5 years = $4845
278 | APPLICATION OF SPECIFIC ACCOUNTING STANDARDS
 279

MODULE 5
BUSINESS COMBINATIONS
Learning objectives Reference

Discuss the accounting issues for various forms of business combinations LO5.1

Explain how goodwill is measured and disclosed at the date of acquisition and prepare LO5.2
the relevant journal entries

Explain how goodwill is measured and impaired subsequent to acquisition and prepare LO5.3
the relevant journal entries

Discuss the concept of control and calculate the non-controlling interest share of equity LO5.4

Prepare consolidated statements of financial position, including the entries for goodwill LO5.5
and non-controlling interests

Prepare consolidated statements of profit or loss and other comprehensive income, LO5.6
including the entries for non-controlling interests and intra-group transactions

Topic list

1 Group accounts – a subject outline

2 Group companies
3 Consolidated and separate financial statements
4 Intra-group transactions
5 Non-controlling interests
6 Goodwill arising on consolidation
7 Basic principles of the consolidated statement of financial position
8 Comprehensive example
9 Intra-group trading
10 Intra-group sales of non-current assets
11 Summary: consolidated statement of financial position
12 Acquisition of a subsidiary during its accounting period
13 Fair values in acquisition accounting
14 Basic principles of the consolidated statement of profit or loss
15 Intra-group transactions
16 Pre-acquisition profits and mid-year acquisitions
17 Other adjustments
18 Summary: consolidated statement of profit or loss
19 Accounting for associates
20 The equity method
21 Consolidated statement of profit or loss
22 Consolidated statement of financial position
23 Adjustments
280 | BUSINESS COMBINATIONS

MODULE OUTLINE

Consolidation is an extremely important area of your studies. In this module we begin by looking at
the major definitions used in consolidation. These matters are fundamental to your comprehension of
consolidated financial statements, so make sure you understand them and then learn them.
We then move onto the treatment of associates in consolidated financial statements, before ending
with a detailed examination of the consolidated statement of financial position and consolidated
statement of profit or loss and other comprehensive income.
The module content is summarised in the diagrams below.

Business combinations

Principles of
consolidation

Group accounts Interests in other Consolidated Intra-group

entities and separate financial transactions
statements

Consolidated or group Subsidiary (i.e. Exemption: Examples:

accounts report the controlled entity) • Parent is from having • Trading
position and to prepare consolidated • Loans
E.g. > 50% votes
performance of group accounts itself a • Dividends
as a single entity Consolidate per subsidiary;
IFRS 10
• Securities not
publicly traded;
• Not issuing
securities; and
• Ultimate parent
Associate
publishes
consolidated financial Eliminate in group
20%–50%
statements accounts
Equity account per
IAS 28

Investment < 20%

Treat as for single
company accounts per
IFRS 9
 FINANCIAL ACCOUNTING AND REPORTING | 281

The consolidated
statement of
financial position

Basic procedures:
• Add assets and liabilities
• Share capital of P only
• Eliminate investment in subsidiary
• Group reserves = P’s reserves + group
share of post-acquisition movement
in S’s reserves – goodwill impairment

Non-controlling Goodwill Intra-group trading and

interest of the transfers of non-current
acquirer (if any) assets

Measure at fair value Measure as FV of Eliminate on

or proportionate share consideration consolidation
of net assets at + NCI – FV of Adjust for unrealised
acquisition; increase by identifiable net assets profit in inventory and
NCI share of of acquiree non-current assets
post-acquisition Review for impairment
changes in equity (profit)

Fair values

Uplift subsidiary's SFP

to FV prior to
consolidation
MODULE 5
282 | BUSINESS COMBINATIONS

The consolidated
statement of
profit or loss

Basic principles:
• Add together income and expenses on a line by
line basis
• Eliminate dividend income from S in P’s income
statement
• Allocate the NCI their share of the profit of the
subsidiary

Intra-group Mid-year acquisitions Other adjustments

transactions

Eliminate the effect of Include subsidiary’s Adjustment for extra

intra-group trading result from date of depreciation on fair
acquisition value uplifts

Reduce profits by the Adjustment for impairment

amount of any of goodwill in year
unrealised profits on
trading or transfer of Where full goodwill NCI
non-current asset in year share of impairment is
allocated against their
profits

Adjust depreciation
charge on transferred
assets to ensure based
on historical cost to
group

Business combinations: Module summary diagrams

 FINANCIAL ACCOUNTING AND REPORTING | 283

Associates and Significant influence

equity accounting

Presumed where
The equity method 20%-50% ownership
Other indicators

Consolidated statement Consolidated Adjustments

of profit or loss statement of financial
position

Include group share of Include investment in Eliminate group share of

associate’s profit after associate as non-current unrealised profit
tax in one line asset measured at cost If associate loss making,
plus group share of post- recognise losses to extent
acquisition profits investment equals nil
Deduct loss from carrying
amount of investment in
associate

MODULE 5
284 | BUSINESS COMBINATIONS

BEFORE YOU BEGIN

If you have studied these topics before, you may wonder whether you need to study this module in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in
the area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the module to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the module you can find the information, and you
will also find a commentary at the back of the Study guide.
1 What is a subsidiary? (Section 2.1)
2 What is an associate? (Section 2.1)
3 How is control established? (Section 2.2)
4 How is significant influence established? (Section 2.3)
5 How are a subsidiary and an associate accounted for in the group accounts? (Section 2)
6 Which subsidiaries may be excluded from a consolidation? (Section 3.3)
7 What is the non-controlling interest and how is it measured at acquisition? (Section 5.1)
8 What are the basic consolidation procedures for assets, liabilities and share
capital? (Section 5.2)
9 When does goodwill arise in a consolidated statement of financial position? (Section 6)
10 How is goodwill accounted for? (Section 6.1)
11 How is goodwill calculated? (Sections 6.2 to 6.4)
12 How is a bargain purchase accounted for? (Section 6.8)
13 How is contingent consideration accounted for in calculating goodwill? (Section 6.9.1)
14 What is an unrealised profit in a group context? (Section 9.1)
15 How is an unrealised profit accounted for? (Sections 9.1 and 9.2)
16 What consolidation adjustments are required where the fair value of the
subsidiary's net assets differ from book value? (Section 13.3)
17 What are the basic consolidation procedures for income and expenses and
dividends received by the parent from subsidiary entities? (Section 14)
18 How is the non-controlling interest in profit calculated? (Section 14)
19 How are sales made by a subsidiary to a parent dealt with in the consolidated
statement of profit or loss? (Section 15.1)
20 What adjustment is required for an unrealised profit on inventory? (Section 15.1)
21 Where a non-current asset has been transferred between group entities in the
accounting period, how is the unrealised profit calculated? (Section 15.2)
22 How is the mid-year acquisition of a subsidiary dealt with in the consolidated
statement of profit or loss? (Section 16)
23 Where is an impairment of goodwill usually charged in the consolidated
statement of profit or loss? (Section 17.2)
24 What method is applied to account for an associate in the consolidated
financial statements? (Section 19.1)
25 How is an associate represented in the consolidated statement of profit or loss? (Section 21)
26 How is an investment in an associate calculated for inclusion in the consolidated
statement of financial position? (Section 22)
27 What adjustment is required where an unrealised profit arises on a sale of
goods from the associate to the parent company? (Section 23.1)
28 How is any impairment of an investment in an associate accounted for? (Section 23.3)
 FINANCIAL ACCOUNTING AND REPORTING | 285

1 GROUP ACCOUNTS – A SUBJECT OUTLINE

Section overview
 Many large businesses consist of several companies controlled by one central or
administrative company. Together these companies are called a group. The controlling
company, called the parent or holding company, will own some or all of the shares in the
other companies, referred to as subsidiaries.

1.1 SUBJECT OUTLINE

There are many reasons for one company to buy all or part of another: for the goodwill associated
with the names of the subsidiaries, for tax or legal purposes and so forth. In many cases, one company
will grow by buying other companies.
A group of companies consists of a parent company and one or more subsidiary companies that
are controlled by the parent company.

1.2 THE NEED FOR GROUP FINANCIAL STATEMENTS

The information contained in the individual financial statements of a parent company and each of its
subsidiaries does not always give a picture of the group's total activities. Users of the accounts will be
unable to obtain an understanding of the overall position and performance of the group by looking at
the numerous financial statements of the individual companies that make up the group.
Therefore, consolidated financial statements are prepared.
Consolidated financial statements combine the information contained in the separate accounts of a
holding company and its subsidiaries as if they were the accounts of a single entity. 'Group accounts'
and 'consolidated accounts' are terms used synonymously in practice.
Most parent companies present their own individual accounts and their group accounts in a single
package. The package typically comprises the:
 parent company financial statements, which will include 'investments in subsidiaries' as an asset
in the statement of financial position, and income from subsidiaries (dividends) in the statement of
profit or loss and other comprehensive income;
 consolidated statement of financial position;
 consolidated statement of profit or loss and other comprehensive income;
 consolidated statement of changes in equity; and
 consolidated statement of cash flows.
It may not be necessary to publish all of the parent company's financial statements, depending on
local or national regulations.

1.3 ACCOUNTING STANDARDS

We will discuss four accounting Standards in this module:
 IAS 27 Separate Financial Statements
 IFRS 3 Business Combinations
 IFRS 10 Consolidated Financial Statements
 IAS 28 Investments in Associates and Joint Ventures
These standards are all concerned with different aspects of group financial statements, but there is
MODULE 5

some overlap between them.

In the first part of this module we will concentrate on IAS 27 and IFRS 10, which cover the basic group
definitions and consolidation procedures of a parent-subsidiary relationship. First, we consider all the
important definitions which determine how to treat each particular type of investment in group
financial statements.
 286 | BUSINESS COMBINATIONS

2 GROUP COMPANIES

LO
5.1 Section overview
 A subsidiary is an entity controlled by another entity, its parent. IFRS 10 provides a
definition of control.

2.1 DEFINITIONS
Exam comments
exam
All the definitions relating to group accounts are extremely important. You must learn them and
understand their meaning and application.

Definitions

Control. An investor controls an investee when the investor is exposed, or has rights, to variable
returns from its involvement with the investee and has the ability to affect those returns through power
over the investee. (IFRS 10)
Power. Existing rights that give the current ability to direct the relevant activities i.e. the activities that
significantly affect the investee’s returns.. (IFRS 10)
Returns. The investor’s returns can be only positive, only negative or both positive and negative. (IFRS 10)
Subsidiary. An entity that is controlled by another entity. (IFRS 10)
Parent. An entity that controls one or more subsidiaries. (IFRS 10)
Group. A parent and all its subsidiaries. (IFRS 10)
Associate. An entity over which the investor has significant influence. (IAS 28)
Significant influence is the power to participate in the financial and operating policy decisions of an
investee but is not control or joint control over those policies. (IAS 28)

Note that the definitions above refer to 'entities' rather than 'companies'. There is no requirement for
members of accounting groups to be companies and groups may include partnerships or other non-
corporate entities. Throughout this module we shall, however, concentrate on groups made up solely
of companies.
We can summarise the different types of investment and the required accounting for them as follows:
INVESTMENT CRITERIA REQUIRED TREATMENT IN GROUP
ACCOUNTS
Subsidiary Control Full consolidation
Associate Significant influence Equity accounting
Investment which is neither of No significant influence As in single company accounts
the above

2.2 INVESTMENTS IN SUBSIDIARIES

The important point here is control.
IFRS 10 provides a definition of control and identifies three separate elements of control:
An investor controls an investee if, and only if, it has all of the following:
1. power over the investee;
2. exposure to, or rights to, variable returns from its involvement with the investee; and
3. the ability to use its power over the investee to affect the amount of the investor's returns.
 FINANCIAL ACCOUNTING AND REPORTING | 287

If there are changes to one or more of these three elements of control, then an investor should
reassess whether it controls an investee.
In most cases, the parent has control because they own a majority of the ordinary shares in the
subsidiary (to which normal voting rights are attached). There are circumstances, however, when the
parent owns only a minority of the voting power in the subsidiary, but still has control because it has:
 rights to appoint, reassign or remove key management personnel who can direct the relevant
activities;
 rights to appoint or remove another entity that directs the relevant activities;
 rights to direct the investee to enter into, or veto changes to, transactions for the benefit of the
investor; and
 other rights, such as those specified in a management contract.
An entity's relevant activities are those which significantly affect its profits or losses (an investor's
returns), normally its trading, operating and financial activities.
If a parent has invested in a subsidiary it normally expects to obtain some kind of return on its
investment. The key point here is that the return must have the potential to vary as a result of the
investee's performance. If an investor has control over an investee, the amount of the return that it
receives depends on the investee's results.

2.2.1 ACCOUNTING TREATMENT IN GROUP FINANCIAL STATEMENTS

IFRS 10 requires a parent to present consolidated financial statements, in which the accounts of the
parent and subsidiary (or subsidiaries) are combined and presented as a single entity.

2.3 INVESTMENTS IN ASSOCIATES

This type of investment is something less than a subsidiary, but more than a simple investment. The
key criterion here is significant influence. This is defined as the 'power to participate', but not to
'control' (which would make the investment a subsidiary).
Significant influence can be determined by the holding of voting rights (usually attached to ordinary
shares) in the entity. IAS 28 states that if an investor holds 20 per cent or more of the voting power of
the investee, it is presumed that the investor has significant influence over the investee, unless it can
be clearly shown that this is not the case.
Significant influence can be presumed not to exist if the investor holds less than 20 per cent of the
voting power of the investee, unless it can be demonstrated otherwise.
The existence of significant influence is evidenced in one or more of the following ways:
 representation on the board of directors (or equivalent) of the investee;
 participation in the policy making process;
 material transactions between investor and investee;
 interchange of management personnel; and/or
 provision of essential technical information.

2.3.1 ACCOUNTING TREATMENT IN GROUP FINANCIAL STATEMENTS

IAS 28 requires use of the equity method of accounting for investments in associates. This method
will be explained in detail later on in this module.

Question 1: Treatments

The section summary after this question gives an augmented version of the table given in section 2
MODULE 5

above. Before you look at it, see if you can write out the table yourself.
(The answer is at the end of the module.)
 288 | BUSINESS COMBINATIONS

2.4 SECTION SUMMARY

INVESTMENT CRITERIA REQUIRED TREATMENT IN GROUP
ACCOUNTS
Subsidiary Control (> 50 per cent rule) Full consolidation (IFRS 10)
Associate Significant influence (20 per cent Equity accounting (IAS 28)
+ rule)
Investment which is No significant influence As for single company accounts
neither of the above (< 20 per cent rule)

3 CONSOLIDATED AND SEPARATE FINANCIAL

STATEMENTS

Section overview
 IFRS 10 requires a parent to present consolidated financial statements.

3.1 SUBJECT OUTLINE

Definition

Consolidated financial statements. The financial statements of a group in which the assets, liabilities,
equity, income, expenses and cash flows of the parent and its subsidiaries are presented as those of a
single economic entity. (IFRS 10)

When a parent issues consolidated financial statements, it consolidates all subsidiaries, both foreign
and domestic. IFRS 10 provides guidance on the mechanics of consolidation including exemptions
from consolidation, the use of uniform accounting policies, matching reporting dates and the
elimination of intra-group transactions.

3.2 EXEMPTION FROM PREPARING GROUP ACCOUNTS

A parent need not present consolidated financial statements if and only if all of the following hold:
 the parent is itself a wholly-owned subsidiary or it is a partially owned subsidiary of another
entity and its other owners, including those not otherwise entitled to vote, have been informed
about, and do not object to, the parent not presenting consolidated financial statements;
 its securities are not publicly traded;
 it is not in the process of issuing securities in public securities markets; and
 the ultimate or intermediate parent publishes consolidated financial statements that comply with
International Financial Reporting Standards.
A parent that does not present consolidated financial statements must comply with the IAS 27 rules on
separate financial statements.

3.3 EXCLUSION OF A SUBSIDIARY FROM CONSOLIDATION

A parent must include all entities that it controls in its consolidated financial statements.
The rules on exclusion of subsidiaries from consolidation are necessarily strict, because in the past this
was a common method used by entities to manipulate their results. If a subsidiary which carries a large
amount of debt can be excluded, then the gearing of the group as a whole will be improved. In other
words, this is a way of taking debt out of the statement of financial position.
 FINANCIAL ACCOUNTING AND REPORTING | 289

3.4 UNIFORM ACCOUNTING POLICIES

Consolidated financial statements are prepared using the same accounting policies for like
transactions and other events in similar circumstances.
Adjustments must be made where members of a group use different accounting policies, so that their
financial statements are suitable for consolidation.

3.5 DIFFERENT REPORTING DATES

In most cases, all group companies will prepare accounts to the same reporting date. One or more
subsidiaries may, however, prepare accounts to a different reporting date from the parent and the
bulk of other subsidiaries in the group.
In such cases the subsidiary may prepare additional statements to the reporting date of the rest of the
group, for consolidation purposes. If this is not possible, the subsidiary's accounts may still be used for
the consolidation, provided that the gap between the reporting dates is three months or less.
Where a subsidiary's accounts are drawn up to a different accounting date, adjustments should be
made for the effects of significant transactions or other events that occur between that date and the
parent's reporting date.

3.6 DATE OF INCLUSION OR EXCLUSION

The results of subsidiaries are included in the consolidated financial statements from:
 the date the parent obtains control, to
 the date the investor loses control.
Once an investment is no longer a subsidiary, it should be treated as an associate under IAS 28 (if
applicable) or as an investment under IFRS 9 (outside the scope of the Financial Accounting and
Reporting syllabus) as appropriate.

3.7 ACCOUNTING FOR SUBSIDIARIES AND ASSOCIATES IN THE

PARENT'S SEPARATE FINANCIAL STATEMENTS
Parent company financial statements are no longer required in Australia. Where a parent company
does not prepare separate financial statements, the Corporations Law requires various disclosures in
the notes to the consolidated financial statements about the parent company.
Where a parent company chooses to produce its own separate financial statements (single company
financial statements) these are prepared in accordance with IAS 27 Separate Financial Statements.
In a parent's separate financial statements, investments in subsidiaries and associates included in the
consolidated financial statements are either:
 accounted for at cost; or
 in accordance with IFRS 9 (outside the scope of the Financial Accounting and Reporting syllabus).
An entity should apply the same accounting treatment for each category of investments.
The parent recognises dividends from a subsidiary or an associate in profit or loss when its right to
receive the dividend is established.
MODULE 5
 290 | BUSINESS COMBINATIONS

4 INTRA-GROUP TRANSACTIONS

LO
5.6 Section overview
 It is common for parent companies to transact with their subsidiaries. These transactions
should not be reflected in the consolidated accounts.

One of the reasons why groups grow and companies acquire other companies is vertical integration
where a company acquires its suppliers or customers. Therefore, it follows that intra-group or
intercompany transactions are commonplace within groups. One group company may sell goods to
another, or one company provides funding for others. Equally, where a subsidiary pays a dividend to
its shareholders, some, or all of this amount is due to the parent company.
These transactions between group companies are (quite rightly) represented in the companies'
individual accounts. When preparing the group accounts, however, it must be remembered that they
present the group as a single economic entity. One entity is unable to trade with itself or lend to itself,
and therefore the effects of intra-group transactions must be eliminated on consolidation. The
mechanics of this are covered later in this module.
The net result is that the group accounts only include the effects of transactions between the group
companies and third parties outside the group.
 FINANCIAL ACCOUNTING AND REPORTING | 291

KEY MODULE POINTS 1

 The parent or holding company of a group owns some (over 50 per cent) or all of the shares in the
other companies.
 A subsidiary is an entity that is controlled by the parent company. Control can usually be assumed
to exist when the parent owns over 50 per cent of the voting power of an entity.
 Subsidiaries are consolidated in the group financial statements.
 The information contained in the individual financial statements of a parent company and each of
its investee companies does not give a picture of the group's total activities. Therefore, group
financial statements must be prepared from the aggregated individual ones with eliminations.
 Consolidated financial statements are prepared from parent and subsidiary accounts which use the
same accounting policies for like transactions and other events in similar circumstances.
 Consolidated financial statements are prepared from parent and subsidiary accounts prepared to
the same reporting date. If this is not possible, the subsidiary's accounts may still be used for the
consolidation, provided that the gap between the reporting dates is three months or less.
 It is common for parent companies to transact with their subsidiaries. These transactions should
not be reflected in the consolidated financial statements.
 A parent company has significant influence over an associate. Significant influence is normally
assumed to exist where the parent owns at least 20 per cent of the voting power of an entity.
 Associates are equity accounted within the group financial statements.
 Where a parent company has neither control nor significant influence over an investee, the
investment is recognised in group financial statements in the same way as in the parent's individual
accounts.

MODULE 5
292 | BUSINESS COMBINATIONS

QUICK REVISION QUESTIONS 1

1 During the last three years Harvert Co. has held 400 000 ordinary shares in Jamee Co. The issued
share capital of Jamee Co. is one million shares totalling $500 000. The finance director of Harvert
Co. is a director of Jamee Co.
How should the investment in Jamee Co. be treated in the consolidated financial statements of
Harvert Co.?
A As a subsidiary
B As an associate
C As a current asset investment
D As a non-current asset investment

2 A owns 51 per cent of the voting shares in B and 100 per cent of the voting shares in D. B owns
25 per cent of the voting shares in C and has board representation in that company.
All holdings have been held for a number of years.
Which of the following statements is correct?
A B, C and D are subsidiaries of A
B B and D are subsidiaries of A while C is a subsidiary of B
C B and D are subsidiaries of A while C is an associate of B
D D is a subsidiary of A while B and C are investments of A

3 Which of the following is a valid reason for excluding a 75 per cent owned company from
consolidation under current International Financial Reporting Standards?
A The company operates in a hyperinflationary environment.
B A formally documented decision has been made by the directors to wind down the activities of
the company.
C The activities of the company are dissimilar from those of the rest of the group so that it would
be confusing to include it in the consolidation.
D The company operates in a country where the government has recently passed a law to obtain
the power to govern the financial and operating policies of all entities.

4 Which of the following provide evidence of a parent-subsidiary relationship?

I. The parent has representation on the board of directors.
II. The parent has power to direct the operating activities of the entity by statute.
III. The parent has the power to remove a majority of members of the board of directors.
IV. The parent has power over more than 50 per cent of the voting rights through agreement with
other investors.
A IV only
B I and IV only
C II, III and IV only
D I, II, III and IV
5 During the last financial year, Orius Co. acquired 44 per cent of the issued share capital of
Eerus Co. Under the terms of the acquisition, the finance director of Orius was appointed to the
board of directors of Eerus.
Which of the following correctly describes how Orius should account for its interest in Eerus in the
consolidated financial statements?
A As a subsidiary, using equity accounting
B As an associate, using equity accounting
C As a subsidiary, using consolidation accounting
D As an associate, using consolidation accounting
 FINANCIAL ACCOUNTING AND REPORTING | 293

6 Which of the following provides evidence of a situation where the investee should be accounted
for using the equity method?
A A shareholding of 18 per cent in the investee
B Provision of operational personnel by the parent to the investee
C Provision of essential technical information by the parent to the investee
D The parent has the power to govern the financial policies of the investee by agreement

7 Where a subsidiary does not prepare accounts to the same date as the parent company, which of
the following is correct?
A Additional financial statements must be prepared to the group reporting date by the subsidiary.
B The subsidiary's accounts may be used for the consolidation provided that the gap between the
reporting dates is three months or less.
C The subsidiary's accounts may be used for the consolidation provided that they are prepared to
a date within three months after the end of the group reporting period.
D The subsidiary's accounts may be used for the consolidation provided that they are prepared to
a date within three months before the end of the group reporting period.

8 Which of the following statements are correct?

I. Intra-group transactions must be eliminated on consolidation.
II. Where a group comprises a parent company and an investee over which the parent has
significant influence, consolidated accounts must be prepared.
III. A holding of 10 per cent of ordinary voting shares in another company must be accounted for in
accordance with IAS 28 Investments in Associates and Joint Ventures.
IV. Where a subsidiary does not adopt the same accounting policies as its parent company,
adjustments must be made to bring its accounting policies into line prior to consolidation.
A I and II only
B I and IV only
C III and IV only
D I, II, III and IV

MODULE 5
 294 | BUSINESS COMBINATIONS

5 NON-CONTROLLING INTERESTS

LO
5.4 Section overview
 The consolidated statement of financial position shows non-controlling interest as a
separate item in equity.

5.1 SUBJECT OUTLINE

It was mentioned earlier that the total assets and liabilities of subsidiary companies are included in the
consolidated statement of financial position, even if the subsidiaries are not wholly owned by the
parent. A proportion of the net assets of such subsidiaries in fact belongs to investors from outside the
group (non-controlling interests).
IFRS 3 allows two alternative ways of measuring the non-controlling interest at acquisition:
1. ‘Partial goodwill’ method – As a proportionate share of the fair value of the subsidiary's net assets;
or
2. ‘Full goodwill’ method – At fair value (based on the market value of the shares held by the non-
controlling interest).
Regardless of the measurement method used, the non-controlling interest in the net assets of
consolidated subsidiaries at subsequent reporting dates is increased/decreased by the
non-controlling interest's share of changes in equity since the date of the combination
(i.e. post-acquisition changes in equity) (IAS 1, para. 81B).

Exam comments
exam
For the purposes of the exam, you are required to be able to apply both measurement methods.

The following examples shows non-controlling interest calculated using both the proportionate share
of the fair value of the subsidiary's net assets (‘partial goodwill’ method) and at fair value (‘full
goodwill’ method).

Worked Examples: Non-controlling interests

P Co. has owned 75 per cent of the share capital of S Co. since the date of S Co.'s incorporation. Their
latest statements of financial position are given below.
P CO.
STATEMENT OF FINANCIAL POSITION
$ $
Assets
Non-current assets
Property, plant and equipment 50 000
30 000 ordinary shares in S Co. at cost 30 000
80 000
Current assets 45 000
Total assets 125 000
Equity and liabilities
Equity
80 000 ordinary shares 80 000
Retained earnings 25 000
105 000
Current liabilities 20 000
Total equity and liabilities 125 000
 FINANCIAL ACCOUNTING AND REPORTING | 295

S CO.
STATEMENT OF FINANCIAL POSITION
$ $
Assets
Property, plant and equipment 35 000
Current assets 35 000
Total assets 70 000
Equity and liabilities
Equity
40 000 ordinary shares 40 000
Retained earnings 10 000
50 000
Current liabilities 20 000
Total equity and liabilities 70 000

Required
Part A
Prepare the consolidated statement of financial position. P Co.'s accounting policy is to measure
non-controlling interest at acquisition as a proportional share of the subsidiary's net assets (‘partial
goodwill’ method).

Solution

All of S Co.'s net assets are consolidated despite the fact that the company is only 75 per cent owned.
The amount of net assets attributable to non-controlling interests is calculated as follows:
$
Non-controlling interest at acquisition:
Non-controlling share of identifiable net assets (25%  $50 000) 12 500

Or, the calculation can be further analyse as follows:

$
Non-controlling interest at acquisition:
Non-controlling share of share capital (25%  $40 000) 10 000
Non-controlling share of S Co.'s profits since acquisition:
Non-controlling share of retained earnings (25%  $10 000) 2 500
12 500

Of S Co.'s share capital of $40 000, $10 000 is included in the figure for non-controlling interest, while
$30 000 is eliminated with P Co.'s asset 'investment in S Co.'.
Of S Co.'s retained earnings of $10 000, $2500 is included in the figure for non-controlling interest,
while $7500 'belongs' to the group and so is included in group retained earnings in the consolidated
statement of financial position.
Post-acquisition, the value of NCI will be increased or decreased in accordance to the share of
changes in equity since the date of the combination (i.e. post-acquisition changes in equity) (IAS 1,
para. 81B).
The consolidated statement of financial position just after acquisition can now be prepared.
P GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
$ $
Assets
85 000
MODULE 5

Property, plant and equipment

Current assets 80 000
Total assets 165 000
 296 | BUSINESS COMBINATIONS

$ $
Equity and liabilities
Equity attributable to owners of the parent
Share capital 80 000
Retained earnings $(25 000 + (75%  $10 000)) 32 500
112 500
Non-controlling interest 12 500
125 000
Current liabilities 40 000
Total equity and liabilities 165 000

Part B
Calculate the non-controlling interest using the fair value of the acquired company’s shares at the date
of acquisition (‘full goodwill’ method). Here, the share price of Company S at the date of acquisition
was $1.50 per share.
$
Non-controlling interest at acquisition:
Non-controlling interest shares at FV at date of acquisition (25%  40 000 shares @ $1.50 per share) 15 000
Non-controlling share of S Co.'s profits since acquisition:
Non-controlling share of retained earnings (25%  $10 000) 2 500
17 500

5.2 PROCEDURE IN SUMMARY

1. Aggregate the assets and liabilities in the statement of financial position i.e. 100 per cent P +
100 per cent S irrespective of how much P actually owns.
This shows the amount of net assets controlled by the group.
2. Share capital is that of the parent only.
3. Calculate the non-controlling interest share of the fair value of the subsidiary's net assets (share
capital plus retained earnings plus any other reserves).
4. The balance of the subsidiary's retained earnings and other reserves are consolidated (after
eliminating any intra-group items).

Question 2: Eliminations
Set out below are the draft statements of financial position of P Co. and its subsidiary S Co. You are
required to prepare the consolidated statement of financial position. The non-controlling interest is
valued at its proportional share of the fair value of the subsidiary's net assets.
P CO.
$ $
Assets
Non-current assets
Property, plant and equipment 31 000
Investment in S Co.
12 000 ordinary shares at cost 12 000
10% loan receivable from S Co. 8 000
20 000
51 000
Current assets 21 000
Total assets 72 000
Equity and liabilities
Equity
40 000 ordinary shares 40 000
Retained earnings 22 000
62 000
Current liabilities 10 000
Total equity and liabilities 72 000
 FINANCIAL ACCOUNTING AND REPORTING | 297

S CO.
$ $
Assets
Property, plant and equipment 34 000
Current assets 32 000
Total assets 66 000
Equity and liabilities
Equity
20 000 ordinary shares 20 000
Revaluation surplus 6 000
Retained earnings 4 000
30 000
Non-current liabilities
10% loan payable to P Co. 8 000
Other loan payable 18 000
Current liabilities 10 000
Total equity and liabilities 66 000

(The answer is at the end of the module.)

Question 3: Non-controlling interest

Pam Co. acquired 90 per cent of the ordinary voting shares in Sam Co. on 1 March 20X7 for
$5.6 million. At that date the fair value of a 10 per cent holding in Sam Co. was $460 000. Sam Co. has
made the following profits since acquisition:
– $275 400 in the year ended 28 February 20X8
– $286 000 in the year ended 28 February 20X9
The net assets of Sam Co. at 28 February 20X9 are $5.56 million and the fair value of a 10 per cent
shareholding at that date based on market values is $520 000. What is the non-controlling interest in
the Pam Co. Consolidated Statement of Financial Position at 28 February 20X9 assuming that it is
group policy to apply the fair value method (full goodwill method) of measurement of non-controlling
interest?
A $516 140
B $520 000
C $556 000
D $1 016 000
(The answer is at the end of the module.)

6 GOODWILL ARISING ON CONSOLIDATION

LOs
5.2, 5.3, Section overview
5.4
 Goodwill arises where the consideration transferred by the parent company is not equal to
the group share of the net assets of the subsidiary at acquisition.

6.1 ACCOUNTING FOR THE PURCHASE OF SHARES IN A SUBSIDIARY

MODULE 5

When a company P Co. purchases shares in a company S Co. it pays money or gives other purchase
consideration to the previous owners of those shares. Suppose P Co. purchases all 40 000 shares in
S Co. and pays $60 000 cash to the previous shareholders. The entries in P Co.'s books would be:
Dr. Investment in S Co. at cost $60 000
Cr. Bank $60 000
 298 | BUSINESS COMBINATIONS

However, the previous shareholders might be prepared to accept some other form of consideration.
For example, they might accept an agreed number of shares in P Co. P Co. issues new shares and
gives them to the former shareholders of S Co. This might be attractive to P Co. because it avoids a
heavy cash outlay. The former shareholders of S Co. retain an indirect interest in S Co.'s profitability
via their new holding in its parent company.
Continuing the example, suppose that instead of $60 000 cash for all 40 000 shares the
shareholders of S Co. agreed to accept one ordinary share in P Co. for every two ordinary shares
in S Co., because the market value of P Co.'s shares is $3 per share. P Co. issues 20 000 new
shares. How would this transaction be recorded in the books of P Co.?
Dr. Investment in S Co. (20 000  $3) $60 000
Cr. Share capital $60 000
The amount which P Co. pays and records in its books as the cost of its investment in S Co. may be
more or less than the book value of the assets it acquires. Suppose that S Co. in the previous example
has nil reserves and nil liabilities, so that its share capital of $40 000 is balanced by tangible
non-current assets with a book value of $40 000. For simplicity, assume that the book value of S Co.'s
assets is the same as their fair value.
Now, if the directors of P Co. agree to pay $60 000 for a 100 per cent investment in S Co. they must
believe that, in addition to its tangible non-current assets of $40 000, S Co. must also have intangible
assets worth $20 000. This amount of $20 000 paid over and above the value of the tangible net assets
acquired is called goodwill arising on consolidation (sometimes called premium on acquisition).
Following the normal elimination procedure the $40 000 share capital in S Co.'s statement of financial
position is eliminated against $40 000 of the 'investment in S Co.' in the statement of financial position
of P Co. This leaves a $20 000 debit remaining in the parent company's accounts and this $20 000
appears in the consolidated statement of financial position as 'Intangible non-current assets: goodwill
arising on consolidation'.
Goodwill arising on consolidation is not amortised; it is subject to an annual impairment review.

6.2 GOODWILL AND PRE-ACQUISITION PROFITS

Up to now we have assumed that S Co. had nil retained earnings when its shares were purchased by
P Co. Assuming instead that S Co. had earned profits of $8000 in the period before acquisition, its
statement of financial position just before the purchase would look as follows:
$
Total assets 48 000

Share capital 40 000

Retained earnings 8 000
48 000
If P Co. pays $60 000 to purchases all the shares in S Co. it has acquired total assets worth $48 000 and
clearly, S Co.'s intangible assets (goodwill) are being valued at $12 000. It should be apparent that any
earnings retained by the subsidiary prior to its acquisition by the parent company are incorporated
in the elimination process to arrive at a figure for goodwill. In other words, not only S Co.'s share
capital, but also its pre-acquisition retained earnings, are eliminated against the asset 'investment in
S Co.' in the accounts of the parent company. The remaining balance of $12 000 is goodwill in the
consolidated statement of financial position.
The consequence of this is that any pre-acquisition retained earnings of a subsidiary are not
aggregated with the parent's retained earnings in the consolidated statement of financial position.
The figure of consolidated retained earnings comprises the retained earnings of the parent plus the
post-acquisition retained earnings only of subsidiaries. The post-acquisition retained earnings are
simply retained earnings now less retained earnings at acquisition.
 FINANCIAL ACCOUNTING AND REPORTING | 299

Worked Example: Goodwill and pre-acquisition profits

Sing Co. acquired all of the ordinary shares of Wing Co. on 31 March, immediately after which the
draft statements of financial position of each company were as follows:
SING CO.
STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH
$
Assets
Non-current assets
Investment in 50 000 shares of Wing Co. at cost 80 000
Current assets 40 000
Total assets 120 000

Equity and liabilities

Equity
Ordinary shares 75 000
Retained earnings 45 000
Total equity and liabilities 120 000

WING CO.
STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH
$
Current assets 60 000

Equity
50 000 ordinary shares 50 000
Retained earnings 10 000
60 000

Prepare the consolidated statement of financial position as at 31 March.

Solution

The technique to adopt here is to produce a new working: 'Goodwill'. A proforma working is set out
below:
Goodwill
$ $
Consideration transferred X
Net assets acquired as represented by:
Ordinary share capital X
Retained earnings on acquisition X
(X)
Goodwill X

Applying this to our example the working will look like this:
$ $
Consideration transferred 80 000
Net assets acquired as represented by:
Ordinary share capital 50 000
Retained earnings on acquisition 10 000

(60 000)
Goodwill 20 000

SING CO.
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH
MODULE 5
 300 | BUSINESS COMBINATIONS

$
Assets
Non-current assets
Goodwill arising on consolidation (W) 20 000
Current assets (40 000 + 60 000) 100 000
120 000
Equity
Ordinary shares 75 000
Retained earnings 45 000
120 000

Worked Example: Goodwill and pre-acquisition losses

Suppose P Co. acquired all the $50 000 issued ordinary shares in S Co. for $20 000 on 1 January 20X1
when there was a debit balance of $35 000 on S Co.'s retained earnings. In the years 20X1 to 20X4
S Co. makes profits of $40 000 in total, leaving a credit balance of $5000 on retained earnings at
31 December 20X4. P Co.'s retained earnings at the same date are $70 000.
Calculate the values of goodwill and retained earnings in the consolidated statement of financial
position at 31 December 20X4.
Solution

The consolidation workings are:

1 Goodwill
$ $
Consideration transferred 20 000
Net assets acquired
as represented by
Ordinary share capital 50 000
Retained earnings (35 000)
(15 000)
Goodwill 5 000

2 Retained earnings
P Co. S Co.
$ $
At the end of the reporting period 70 000 5 000
Pre-acquisition loss 35 000
40 000
S Co. – share of post-acquisition retained earnings
(40 000  100%) 40 000
110 000

6.3 GOODWILL AND NON-CONTROLLING INTEREST AT A

PROPORTION OF FAIR VALUE OF NET ASSETS
Now let us look at what would happen if Sing Co. had obtained less than 100 per cent of the shares of
Wing Co.
If Sing Co. had paid $70 000 for 40 000 shares in Wing Co. (80 per cent), the goodwill calculation
includes the non-controlling interest. We'll assume that it is group policy to measure the NCI as a
proportion of net assets in the subsidiary (partial goodwill method).
 FINANCIAL ACCOUNTING AND REPORTING | 301

Therefore:
$
Consideration transferred 70 000
Non-controlling interest at acquisition (20%  $60 000) 12 000
82 000
Fair value of net assets acquired (60 000)
Goodwill 22 000

6.4 GOODWILL AND NON-CONTROLLING INTEREST AT FAIR VALUE

As we have seen, IFRS 3 gives companies the option of valuing the non-controlling interest (NCI) at
acquisition at fair value (full goodwill method). The thinking behind this is that the non-controlling
interest also owns some of the goodwill in the subsidiary, and that the traditional method of
consolidation does not show this goodwill.
IFRS 3 suggests that the closest approximation to fair value is the market price of the shares held by
non-controlling shareholders just before acquisition by the parent.
Continuing our example above, we will assume that the market price of the shares was $1.25. The
goodwill calculation will then be as follows:
$
Consideration transferred 70 000
Non-controlling interest at acquisition (20%  50 000 shares @ $1.25) 12 500
82 500
Fair value of net assets acquired (60 000)
Goodwill 22 500

Goodwill (total $22 500) is $500 higher than the goodwill calculated by measuring the non-controlling
interest at its share of the net assets of the subsidiary. This $500 represents the goodwill attributable
to the non-controlling interest. Which is the difference between the fair value of the equity interests
that the non-controlling interest has in the acquiree (i.e. $12 500) and the non-controlling interest‘s
proportionate share of the fair value of the acquiree’s identifiable net assets (i.e. $12 000). This can be
seen to better effect if the calculation is laid out slightly differently, as follows:
Group NCI
$ $
Consideration transferred/fair value of NCI (10 000 shares @ $1.25) 70 000 12 500
Net assets at acquisition – Group/NCI share (48 000) (12 000)
Goodwill 22 000 500

6.5 NON-CONTROLLING INTEREST AT YEAR END – POST ACQUISITION

As we have seen, the non-controlling interest at the year end is measured as:
NCI at acquisition X
NCI share of post-acquisition changes in equity X
X

Where the non-controlling interest is measured as a proportion of the fair value of the net assets of
the subsidiary, a simpler way to calculate the NCI at a given date is by taking the NCI's share of the
fair value of the net assets of the subsidiary at that date.
Where the non-controlling interest is measured at fair value at acquisition, an alternative calculation of
the NCI at a given reporting date is:
NCI share of fair value of net assets of S at reporting date X
NCI goodwill on acquisition X
X
MODULE 5

Worked Example: Consolidated statement of financial position

P acquired 75 per cent of the 50 000 shares in S on 1 January 20X7 when S had retained earnings of
$15 000. The shares were issued at $1.00 each. Therefore, at acquisition, the net assets of S is $65 000
[(50 000 shares @ $1.00) + $15 000). The market price of S's shares just before the date of acquisition
was $1.60. P values the non-controlling interest at fair value. Goodwill is not impaired.
302 | BUSINESS COMBINATIONS

The statements of financial position of P and S at 31 December 20X7 were as follows:

P S
$ $
Property, plant and equipment 60 000 50 000
Shares in S 68 000 –
128 000 50 000
Current assets 52 000 35 000
180 000 85 000

Share capital 100 000 50 000

Retained earnings 70 000 25 000
170 000 75 000
Current liabilities 10 000 10 000
180 000 85 000

Prepare the consolidated statement of financial position of the P Group as at 31 December 20X7.
Solution

CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X7

$
Assets
Property, plant and equipment (60 000 + 50 000) 110 000
Goodwill (W1) 23 000
Current assets (52 000 + 35 000) 87 000
Total assets 220 000
Equity and liabilities
Equity attributable to the owners of P
Share capital 100 000
Retained earnings (W2) 77 500
177 500
Non-controlling interest (W3) 22 500
Total equity 200 000
Current liabilities (10 000 + 10 000) 20 000
Total equity and liabilities 220 000

Workings
1 Goodwill
Group NCI
$ $
Consideration transferred/fair value of NCI (12 500 × $1.60) 68 000 20 000
Net assets of S at acquisition ($50 000 + $15 000) Group / NCI share (25% (48 750) (16 250)
 $65 000)
Goodwill (parent and non-controlling interest) 19 250 3 750

2 Retained earnings
P S
$ $
Per statement of financial position 70 000 25 000
Less: pre-acquisition (15 000)
10 000
Group share of S ($10 000 × 75%) 7 500
Group retained earnings 77 500

3 Non-controlling interest at year end

$
Share of net assets of S ($75 000 × 25%) 18 750
Goodwill (W1) 3 750
22 500
 FINANCIAL ACCOUNTING AND REPORTING | 303

6.6 EFFECT OF NON-CONTROLLING INTEREST AT FAIR VALUE

You can see from the above example that the use of the fair value option increases goodwill and
non-controlling interest by the same amount. That amount represents goodwill attributable to the
shares held by non-controlling shareholders. It is not necessarily proportionate to the goodwill
attributed to the parent. The parent may have paid proportionately more to acquire a controlling
interest. If non-controlling interest was valued under the usual method (share of net assets) goodwill
and non-controlling interest in the example above would be as follows:
W1 Goodwill
$
Consideration transferred 68 000
Non-controlling interest ((50 000 + 15 000) × 25%) 16 250
Fair value of net assets of S at acquisition (50 000 + 15 000) (65 000)
19 250
W3 Non-controlling interest at year end
$
Share of net assets of S (75 000 × 25%) 18 750

Compare these with goodwill and non-controlling interest in the solution above and you will see that
both have been reduced by $3750 – the goodwill attributable to the non-controlling interest. So
whether non-controlling interest is valued at share of fair value of net assets or at fair value, the
statement of financial position will still balance.

6.7 IMPAIRMENT OF GOODWILL

Goodwill arising on consolidation is subject to an annual impairment review, and impairment may be
expressed as an amount or as a percentage. The double entry to write off the impairment is:
Dr. Group retained earnings Cr. Goodwill

However, when non-controlling interest is valued at fair value the goodwill in the statement of
financial position includes goodwill attributable to the non-controlling interest. In this case the double
entry will reflect the non-controlling interest proportion based on their shareholding as follows:

Dr. Group retained earnings Cr. Goodwill

Dr. Non-controlling interest

In our solution above in 6.5 the non-controlling interest holds 25 per cent. If the total goodwill of
$23 000 was impaired by 20 per cent or $4600, the double entry for this would be:
$ $
Dr. Retained earnings 3 450 Cr. Goodwill 4 600
Dr. Non-controlling interest 1 150

The non-controlling interest at the year end would then be $21 350.

6.8 GAIN ON A BARGAIN PURCHASE

Goodwill arising on consolidation is the difference between the cost of an acquisition plus the
non-controlling interest and the value of the subsidiary's net assets. This difference can be negative.
IFRS 3 refers to this as a 'bargain purchase'. In this situation:
1. The acquirer should first re-assess the amounts at which it has measured both the cost of the
combination and the acquiree's identifiable net assets. This exercise should identify any errors.
2. Any excess remaining is recognised immediately in profit or loss.
MODULE 5

6.9 DEFERRED OR CONTINGENT CONSIDERATION

An acquirer measures the cost of an investment in a subsidiary as the total of the fair values, at the
date of acquisition, of assets transferred by the acquirer, liabilities incurred or assumed, and equity
instruments issued by the acquirer, in exchange for control of the acquiree.
 304 | BUSINESS COMBINATIONS

Where equity instruments (e.g. ordinary shares) of a quoted company form part of the consideration,
the published price at the date of exchange provides the best evidence of the instrument's fair value.
Sometimes all or part of the cost of an acquisition is deferred (i.e. does not become payable
immediately). Sometimes the deferred payment is also contingent (i.e. will only be paid if certain
conditions are fulfilled).

6.9.1 CONTINGENT CONSIDERATION

The parent company could agree that some of the consideration is withheld and paid only if future
stated conditions are fulfilled. For example, P Co. acquires 60 per cent of S Co.'s $100m share capital
on 1 January 20X6 for a cash payment of $150m and a further payment of $50m on 31 March 20X7 if
the subsidiary's post-acquisition profits have exceeded $50m by that date.
IFRS 3 requires the acquisition-date fair value of contingent consideration to be recognised as part of
the consideration. In an examination question candidates will be told the acquisition-date fair value or
told how to calculate it.

6.9.2 DEFERRED CONSIDERATION

An agreement may be made that part of the consideration for the combination will be paid at a future
date. This consideration is discounted to its present value using the acquiring company's cost of
capital.
For example, P Co. acquires 75 per cent of S Co.'s 80m shares on 1 January 20X6. It paid $3.50 per
share and agreed to pay a further $108m on 1 January 20X7.
P Co.'s cost of capital is 8 per cent.
In the financial statements for the year to 31 December 20X6 the cost of the combination will be:
$m
80m shares  75%  $3.50 210
Deferred consideration:
$108m  1 / 1.08 100
Total consideration 310

In P Co.'s books the transaction is recorded as:

Dr. Investment in subsidiary $310m
Cr. Cash $210m
Cr. Liability $100m
At 31 December 20X6, the cost of the investment will be unchanged but $8m will be charged as
finance costs and added to the carrying amount of the liability to unwind the discount on the deferred
consideration.

6.9.3 EXPENSES AND ISSUE COSTS

Expenses of the acquisition, such as lawyers' and accountants' fees are written off to profit or loss as
incurred. However, IFRS 3 requires that the costs of issuing equity are debited to the share capital
account.

Worked Example: Cost of a business combination

Tyzo Co. has just acquired 100 per cent of Kono Co., a company with net assets of $9.9m valued at fair
value.
Rather than pay cash for Kono Co.'s shares, Tyzo has funded the acquisition by issuing 4.5m of its own
shares to Kono Co.'s shareholders.
Tyzo's shares have a market value of $3. The costs of the share issue amounted to $500 000 and Tyzo
paid a total of $750 000 to lawyers and accountants to carry out the combination.
Calculate the goodwill.
 FINANCIAL ACCOUNTING AND REPORTING | 305

Solution
$m
Consideration:
Share issue (4.5m  $3) 13.5
Net assets acquired (9.9)
Goodwill 3.6

Note: The share issue costs are debited to share capital and the $750 000 expenses are thereby
written off.

6.10 GOODWILL DISCLOSURE

IFRS 3 requires that the following are disclosed in respect of acquired goodwill arising in the period:
 A qualitative description of the factors that make up the goodwill recognised;
 The acquisition-date fair value of the total consideration transferred split into each major class of
consideration;
 The amounts recognised at the acquisition date for each major class of assets acquired and
liabilities assumed;
 The amount of any gain recognised on a bargain purchase; and
 The amount of the non-controlling interest and the measurement basis used.
In subsequent years, a reconciliation of the carrying amount of goodwill at the beginning and end of
the reporting period is required showing separately:
 Impairment losses brought forward;
 Additional goodwill recognised in the period;
 Impairment losses recognised in the period;
 Impairment losses carried forward; and
 Any other changes in the carrying amount during the reporting period.

7 BASIC PRINCIPLES OF THE CONSOLIDATED

STATEMENT OF FINANCIAL POSITION

LO
5.5 Section overview
 How are consolidated financial statements prepared? IFRS 10 lays out the basic procedures
which we will follow in this module.

7.1 BASIC PROCEDURES

The preparation of a consolidated statement of financial position consists of two procedures:
 Take the individual accounts of the parent company and each subsidiary and eliminate items that
appear as an asset in one company and a liability or equity in another.
 Add together all the remaining assets and liabilities throughout the group.
MODULE 5
 306 | BUSINESS COMBINATIONS

7.2 ELIMINATION
Items requiring elimination include the following:
 The asset 'investment in subsidiary companies' which appears in the parent company's accounts
is matched with the liability (or equity) 'share capital and reserves' in the subsidiaries' accounts.
 There may be intra-group trading within the group. For example, S Co. may sell goods on credit
to P Co. P Co. would then be a receivable in the accounts of S Co., while S Co. would be a payable
in the accounts of P Co.

Worked Example: Elimination

P Co. regularly sells goods to its one subsidiary company, S Co., which it has owned since S Co.'s
incorporation. The statements of financial position of the two companies on 31 December 20X6 are
given below.
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X6
P Co. S Co.
Assets $ $
Non-current assets
Property, plant and equipment 35 000 45 000
Investment in 40 000 shares in S Co. at cost 40 000
75 000
Current assets
Inventories 16 000 12 000
Receivables: S Co. 2 000
Other 6 000 9 000
Cash at bank 1 000
Total assets 100 000 66 000
Equity and liabilities
Equity
40 000 ordinary shares 40 000
70 000 ordinary shares 70 000
Retained earnings 16 000 19 000
86 000 59 000
Current liabilities
Bank overdraft 3 000
Payables: P Co. 2 000
Other 14 000 2 000
Total equity and liabilities 100 000 66 000

Required
Prepare the consolidated statement of financial position of P Co. at 31 December 20X6.

Solution

The items for elimination are:

(a) P Co.'s asset 'investment in shares of S Co.' ($40 000) eliminates with S Co.'s liability (equity) 'share
capital' ($40 000);
(b) P Co.'s asset 'receivables: S Co.' ($2000) eliminates with S Co.'s liability 'payables: P Co.' ($2000).
The remaining assets and liabilities are added together to produce the following consolidated
statement of financial position.
 FINANCIAL ACCOUNTING AND REPORTING | 307

P CO.
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X6
Assets $ $
Non-current assets
Property, plant and equipment 80 000

Current assets
Inventories 28 000
Receivables 15 000
Cash at bank 1 000
44 000
Total assets 124 000
Equity and liabilities
Equity
70 000 ordinary shares 70 000
Retained earnings 35 000
105 000
Current liabilities
Bank overdraft 3 000
Payables 16 000
19 000
Total equity and liabilities 124 000

Note the following:

 P Co.'s bank balance is not netted off with S Co.'s bank overdraft. To offset one against the other
would be less informative and would conflict with the principle that assets and liabilities should not
be netted off.
 The share capital in the consolidated statement of financial position is the share capital of the
parent company alone. This must always be the case, no matter how complex the consolidation,
because the share capital of subsidiary companies must always be a wholly eliminating item.

7.3 PART ELIMINATION

An item may appear in the statements of financial position of a parent and its subsidiary, but not at
the same amounts:
 The parent company may have acquired shares in the subsidiary at a price greater or less than the
amount at which they are recorded in the accounts of the subsidiary. The asset (investment) will
appear in the parent's accounts at cost or fair value, while the liability (equity) will appear in the
subsidiary's accounts at book value. This is goodwill, which is dealt with later in this module.
 The parent company may not have acquired all the shares of the subsidiary (so the subsidiary
may be only partly owned). This is the non-controlling interest, which is dealt with later in this
module.
 The inter-company trading balances may not be equal and opposite because of goods or cash in
transit.
 One company may have purchased some, but not all, of the issued loan capital of the other
company. This means that one company has given a loan to another, resulting in a receivable in
one set of accounts and a payable in the other. Note that loan capital/loan stock is sometimes so
called because it is 'sold' (i.e. loans raised) in units (of, say, $100) but it does not give rise to voting
rights and so is not capital in the true sense.
The following question illustrates the techniques needed to deal with unequal inter-company trading
MODULE 5

balances. The procedure is to eliminate as far as possible. The remaining uneliminated amounts
appear in the consolidated statement of financial position:
 Uneliminated loan stock will appear as a liability of the group.
 Uneliminated balances on intra-group accounts represent goods or cash in transit, which will
appear in the consolidated statement of financial position.
308 | BUSINESS COMBINATIONS

Question 4: Elimination

The statements of financial position of P Co. and of its subsidiary S Co. have been made up to
30 June. P Co. has owned all the ordinary shares and 40 per cent of the loan stock of S Co. since its
incorporation.
P CO.
STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE
$ $
Assets
Non-current assets
Property, plant and equipment 120 000
Investment in S Co., at cost
80 000 ordinary shares 80 000
$20 000 of 12% loan stock in S Co. 20 000
220 000
Current assets
Inventories 50 000
Receivables 40 000
Current account with S Co. 18 000
Cash 4 000
112 000
Total assets 332 000
Equity and liabilities
Equity
Ordinary shares, fully paid 100 000
Retained earnings 95 000
195 000
Non-current liabilities
10% loan stock 75 000
Current liabilities
Payables 47 000
Taxation 15 000
62 000
Total equity and liabilities 332 000

S CO.
STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE
$ $
Non-current assets
Property, plant and equipment 100 000

Current assets
Inventories 60 000
Receivables 30 000
Cash 6 000
96 000
Total assets 196 000
Equity and liabilities
Equity
80 000 ordinary shares, fully paid 80 000
Retained earnings 28 000
108 000
Non-current liabilities
12% loan stock 50 000
Current liabilities
Payables 16 000
Taxation 10 000
Current account with P Co. 12 000
38 000
Total equity and liabilities 196 000
 FINANCIAL ACCOUNTING AND REPORTING | 309

The difference on current account arises because of goods in transit.

Required
Prepare the consolidated statement of financial position of P Co. as at 30 June.
(The answer is at the end of the module.)

8 COMPREHENSIVE EXAMPLE

Now we will look at a full consolidation question with the adjustments covered so far. Non-controlling
interest is measured at the acquisition date at fair value.

Question 5: Consolidated statement of financial position

The draft statements of financial position of Ping Co. and Pong Co. on 30 June 20X8 were as follows:
PING CO.
STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE 20X8
$ $
Assets
Non-current assets
Property, plant and equipment 50 000
20 000 ordinary shares in Pong Co. at cost 30 000
80 000
Current assets
Inventory 3 000
Receivables 16 000
Cash 2 000
21 000
Total assets 101 000
Equity and liabilities
Equity
45 000 Ordinary shares 45 000
Revaluation surplus 12 000
Retained earnings 26 000
83 000
Current liabilities
Owed to Pong Co. 8 000
Trade payables 10 000
18 000
Total equity and liabilities 101 000

PONG CO.
STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE 20X8
$ $
Assets
Property, plant and equipment 40 000
Current assets
Inventory 8 000
Owed by Ping Co. 10 000
Receivables 7 000
25 000
Total assets 65 000
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 310 | BUSINESS COMBINATIONS

$ $
Equity and liabilities
Equity
25 000 Ordinary shares 25 000
Revaluation surplus 5 000
Retained earnings 28 000
58 000
Current liabilities
Trade payables 7 000
Total equity and liabilities 65 000
Ping Co. acquired its investment in Pong Co. on 1 July 20X7 when the retained earnings of Pong Co.
stood at $6000. The agreed consideration was $30 000 cash and a further $10 000 on 1 July 20X9 if
Pong Co. attained certain anticipated profit targets. Ping Co.'s cost of capital is 7 per cent. Pong Co.
has an internally-developed brand name – 'Pongo' – which was valued at $5000 at the date of
acquisition. There have been no changes in the share capital or revaluation surplus of Pong Co. since
that date. At 30 June 20X8 Pong Co. had invoiced Ping Co. for goods to the value of $2000 which had
not been received by Ping Co.
There is no impairment of goodwill. It is group policy to value non-controlling interest at full fair value.
At the acquisition date the non-controlling interest was valued at $9000.
Prepare the consolidated statement of financial position of Ping Co. as at 30 June 20X8.
(The answer is at the end of the module.)

9 INTRA-GROUP TRADING

LO
5.6 Section overview
 Where one company in a group engages in trading with another group company any profit
made is eliminated on consolidation.

9.1 UNREALISED PROFIT

Any receivable/payable balances outstanding between parent and subsidiary are eliminated on
consolidation. No further problem arises if all such intra-group transactions are undertaken at cost,
without any mark-up for profit.
However, each company in a group is a separate trading entity and may wish to treat other group
companies in the same way as any other customer. In this case, a company (say A Co.) may buy goods
at one price and sell them at a higher price to another group company (B Co.). The accounts of A Co.
will quite properly include the profit earned on sales to B Co.; and similarly B Co.'s statement of
financial position will include inventories at their cost to B Co., that is, at the amount at which they
were purchased from A Co.
This gives rise to two problems:
 Although A Co. makes a profit as soon as it sells goods to B Co., the group does not make a sale
or achieve a profit until an outside customer buys the goods from B Co.
 Any purchases from A Co. which remain unsold by B Co. at the year end will be included in B Co.'s
inventory. Their value in the statement of financial position will be their cost to B Co., which is
bigger than their cost to the group.
The objective of consolidated accounts is to present the financial position of several connected
companies as that of a single entity, the group. This means that in a consolidated statement of
profit or loss the only profits recognised should be those earned by the group in providing goods
or services to outsiders. These are referred to as realised profits. Similarly, inventory in the
consolidated statement of financial position should be valued at cost to the group.
 FINANCIAL ACCOUNTING AND REPORTING | 311

Suppose that a holding company P Co. buys goods for $1600 and sells them to a wholly owned
subsidiary S Co. for $2000. The goods are in S Co.'s inventory at the year end and appear in S Co.'s
statement of financial position at $2000. P Co. will record a profit of $400 in its individual accounts, but
from the group's point of view the figures are:
Cost $1600
External sales nil
Closing inventory at cost $1600
Profit/loss nil
If we add together the figures for retained earnings and inventory in the individual statements of
financial position of P Co. and S Co. the resulting figures for consolidated retained earnings and
consolidated inventory will each be overstated by $400. A consolidation adjustment is therefore
necessary as follows:
Dr. Group retained earnings
Cr. Group inventory (statement of financial position)
with the amount of profit unrealised by the group.

Question 6: Unrealised profit

P Co. acquired all the 30 000 shares in S Co. one year ago when the reserves of S Co. stood at $10 000.
Draft statements of financial position for each company are now as follows:
P Co. S Co.
$ $ $ $
Assets
Non-current assets
Property, plant and equipment 80 000 40 000
Investment in S Co. at cost 46 000
126 000
Current assets 40 000 30 000
Total assets 166 000 70 000
Equity and liabilities
Equity
Ordinary shares 100 000 30 000
Retained earnings 45 000 22 000
145 000 52 000
Current liabilities 21 000 18 000
Total equity and liabilities 166 000 70 000

During the year S Co. sold goods to P Co. for $50 000, the profit to S Co. being 20 per cent of selling
price. At the end of the reporting period, $15 000 of these goods remained unsold in the inventories
of P Co. At the same date, P Co. owed S Co. $12 000 for goods bought and this debt is included in
the trade payables of P Co. and the receivables of S Co. The goodwill arising on consolidation has
been impaired. The amount of the impairment is $1500.
Required
Prepare a draft consolidated statement of financial position for P Co.
(The answer is at the end of the module.)

9.2 NON-CONTROLLING INTERESTS IN UNREALISED INTRA-GROUP

PROFITS
MODULE 5

What if a subsidiary which is not wholly owned is involved in intra-group trading within the group?
Suppose S Co. is 75 per cent owned and sells goods to its parent for $20 000 for which it paid $16 000,
and these items are unsold by P Co. at the end of the reporting period. The 'unrealised' profit of
$4000 earned by S Co. is partly owned by the non-controlling interest of S Co.
312 | BUSINESS COMBINATIONS

The correct treatment of these intra-group profits is to remove the whole profit, charging the non-
controlling interest with their proportion.

Formula to learn

Dr. Group retained earnings with P's share of the unrealised profit
Dr. Non-controlling interest with NCI share of the unrealised profit
Cr. Inventory (statement of financial position) with the unrealised profit

Worked Example: Non-controlling interests and intra-group profits

P Co. has owned 75 per cent of the 100 000 shares of S Co. since the incorporation of S Co. During the
year to 31 December 20X2, S Co. sold goods costing $16 000 to P Co. at a price of $20 000 and these
goods were still unsold by P Co. at the end of the year. Draft statements of financial position of each
company at 31 December 20X2 were as follows:
P Co. S Co.
Assets $ $ $ $
Non-current assets
Property, plant and equipment 125 000 120 000
Investment: 75 000 shares in S Co. at cost 75 000 –
200 000 120 000
Current assets
Inventories 50 000 48 000
Trade receivables 20 000 16 000
70 000 64 000
Total assets 270 000 184 000
Equity and liabilities
Equity
Ordinary shares 80 000 100 000
Retained earnings 150 000 60 000
230 000 160 000
Current liabilities 40 000 24 000
Total equity and liabilities 270 000 184 000

Required
Prepare the consolidated statement of financial position of P Co. at 31 December 20X2. It is the group
policy to measure the non-controlling interest at its proportionate share of the subsidiary's net assets.

Solution

The profit earned by S Co. but unrealised by the group is $4000 of which $3000 (75 per cent) is
attributable to the group and $1000 (25 per cent) to the non-controlling interest. Remove the whole of
the profit loading, charging the non-controlling interest with their proportion.
P Co. S Co.
$ $
Retained earnings
Per question 150 000 60 000
Less: unrealised profit (4 000)
56 000
Share of S Co: $56 000  75% 42 000
192 000
Non-controlling interest
S Co.'s net assets (184 000 – 24 000) 160 000
Unrealised profit (4 000)
156 000
Non-controlling share (25%) 39 000
 FINANCIAL ACCOUNTING AND REPORTING | 313

P CO.
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X2
$ $
Assets
Property, plant and equipment 245 000
Current assets
Inventories $(50 000 + 48 000 – 4000) 94 000
Trade receivables 36 000
130 000
Total assets 375 000
Equity and liabilities
Equity
Ordinary shares 80 000
Retained earnings 192 000
272 000
Non-controlling interest 39 000
311 000
Current liabilities 64 000
Total equity and liabilities 375 000

10 INTRA-GROUP SALES OF NON-CURRENT ASSETS

LO
5.5 Section overview
 As well as engaging in trading activities with each other, group companies may on occasion
transfer non-current assets.

10.1 ACCOUNTING TREATMENT

In their individual accounts the entities concerned will treat the transfer just like a sale between
unconnected parties: the selling company will record a profit or loss on sale, while the purchasing
company will record the asset at the amount paid to acquire it, and will use that amount as the basis
for calculating depreciation.
On consolidation, the usual 'group entity' principle applies. The consolidated statement of financial
position must show assets at their net carrying amount (written down value) to the group, and any
depreciation charged must be based on cost to the group. Two consolidation adjustments will usually
be needed to achieve this.
(a) An adjustment to alter retained earnings and non-current assets net carrying amount to remove
any element of unrealised profit or loss. This is similar to the adjustment required in respect of
unrealised profit in inventory.
(b) An adjustment to alter retained earnings and accumulated depreciation so that consolidated
depreciation is based on the asset's original cost to the group.
In practice, these steps are combined and the retained earnings of the company making the
unrealised profit are debited with the unrealised profit less the additional depreciation.
The double entry is as follows.
(a) Sale by parent
Dr. Group retained earnings
MODULE 5

Cr. Non-current assets

with the profit on disposal, less the additional depreciation.
 314 | BUSINESS COMBINATIONS

(b) Sale by subsidiary

Dr. Group retained earnings (P's share)
Dr. Non-controlling interest (NCI's share)
Cr. Non-current assets
with the profit on disposal, less additional depreciation.

Worked Example: Intra-group sale of non-current assets

P Co. owns 60 per cent of S Co. and on 1 January 20X1 S Co. sells plant with a net carrying amount of
$10 000 to P Co. for $12 500. The companies prepare accounts to 31 December 20X1 and the balances
on their retained earnings at that date are:
P Co. after charging depreciation of 10 per cent on plant $27 000
S Co. including profit on sale of plant $18 000
Required
Show the working for consolidated retained earnings.

Solution

Retained earnings
P Co. S Co.
$ $
Per question 27 000 18 000
Disposal of plant
Profit (2 500)
Depreciation: 10%  $2 500 250
15 750
Share of S Co.: $15 750  60% 9 450
36 450

Notes
1. The non-controlling interest in the retained earnings of S Co. is 40%  $15 750 = $6300.
2. The asset is written down to its net carrying amount at the date of transfer and depreciation on the
'profit' element is removed. The group profit for the year is thus reduced by a net (($2500 – $250) 
60%) = $1350.

11 SUMMARY: CONSOLIDATED STATEMENT OF

FINANCIAL POSITION

PURPOSE TO SHOW THE NET ASSETS WHICH P CONTROLS AND THE OWNERSHIP
OF THOSE ASSETS.
Net assets Always 100 per cent P plus 100 per cent S providing P holds a majority of voting
rights.
Share capital P only.
Reason Simply reporting to the parent company's shareholders in another form.
Retained earnings 100 per cent P plus group share of post-acquisition retained earnings of S less
consolidation adjustments.
Reason To show the extent to which the group actually owns total assets less liabilities.
Non-controlling interest NCI share of fair value of S's consolidated net assets, or fair value at acquisition
plus share of subsequent profits.
Reason To show the equity in a subsidiary not attributable to the parent.
 FINANCIAL ACCOUNTING AND REPORTING | 315

12 ACQUISITION OF A SUBSIDIARY DURING ITS

ACCOUNTING PERIOD

Section overview
 When a parent company acquires a subsidiary during its accounting period the only
accounting entries made at the time will be those recording the cost of acquisition in the
parent company's books.

12.1 ACCOUNTING PROBLEM

As we have seen, consolidated accounts are prepared at the end of the accounting year.
The subsidiary company's accounts show the subsidiary's profit or loss for the whole year. For
consolidation, it will be necessary to distinguish between:
 profits earned before acquisition
 profits earned after acquisition
In practice, a subsidiary's profit may not accrue evenly over the year; for example, the subsidiary might
be engaged in a trade, such as toy sales, with marked seasonal fluctuations. Nevertheless, the
assumption can be made in the exam that profits accrue evenly to split pre- and post-acquisition
profits.
Once the amount of pre-acquisition profit and thus the value of equity at acquisition has been
established the appropriate consolidation workings (goodwill, retained earnings) can be produced.
Suppose the accounts of S Co., a 60 per cent subsidiary of P Co., show retained earnings of $20 000 at
the end of the reporting period, of which $14 000 were earned prior to acquisition. The figure of
$20 000 will appear in the consolidated statement of financial position as follows.
$
Non-controlling interests: their share of total retained earnings
at the end of the reporting period (40%  $20 000) 8 000
Goodwill: group share of pre-acquisition retained earnings (60%  $14 000) 8 400
Consolidated retained earnings: group share of post-acquisition retained earnings
(60%  $6000) 3 600
20 000

Question 7: Acquisition during the accounting period

Hinge Co. acquired 80 per cent of the 20 000 ordinary shares of Singe Co. on 1 April 20X5. On
31 December 20X4 Singe Co.'s accounts showed retained earnings of $19 000. The statements of
financial position of the two companies at 31 December 20X5 are set out below. Neither company has
paid any dividends during the year. Non-controlling interest should be valued at full fair value. The
goodwill attributable to the non-controlling interest is valued at $3000.
You are required to prepare the consolidated statement of financial position of Hinge Co. at
31 December 20X5. There has been no impairment of goodwill.
MODULE 5
 316 | BUSINESS COMBINATIONS

HINGE CO
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X5
$ $
Assets
Non-current assets
Property, plant and equipment 32 000
16 000 ordinary shares in Singe Co 50 000
82 000
Current assets 85 000
Total assets 167 000
Equity and liabilities
Equity
Share capital 100 000
Retained earnings 47 000
147 000
Current liabilities 20 000
Total equity and liabilities 167 000

SINGE CO
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X5
$ $
Assets
Property, plant and equipment 30 000
Current assets 43 000
Total assets 73 000
Equity and liabilities
Equity
Share capital 10 000
Retained earnings 43 000
53 000
Current liabilities 20 000
Total equity and liabilities 73 000

(The answer is at the end of the module.)

13 FAIR VALUES IN ACQUISITION ACCOUNTING

Section overview
 An entity should adjust the subsidiary's accounts before consolidation to reflect the fair
values of the assets and liabilities acquired.

13.1 GOODWILL
To understand the importance of fair values in the acquisition of a subsidiary consider what we mean
by goodwill.

Definition

Goodwill. Any excess of the consideration transferred plus the non-controlling interest over the fair
value of the identifiable assets and liabilities of the investee as at the date of the acquisition.

The statement of financial position of a subsidiary at the date it is acquired may not be a guide to
the fair value of its net assets. For example, the market value of a freehold building may have risen
greatly since it was acquired, but it is shown in the statement of financial position at historical cost less
accumulated depreciation.
 FINANCIAL ACCOUNTING AND REPORTING | 317

13.2 WHAT IS FAIR VALUE?

Fair value is defined as follows by IFRS 3 and various other standards – it is an important definition.

Definition

Fair value. The price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date.

13.3 FAIR VALUE ADJUSTMENT CALCULATIONS

So far in this module we have calculated goodwill based on the book value of net assets of the
subsidiary. To comply with the definition above we must adjust the book value of the subsidiary's net
assets to their fair value.
There are two possible ways of achieving this:
 The subsidiary incorporates necessary revaluations in its own financial records. In this case, we
can proceed directly to the consolidation, taking asset values and reserves figures straight from the
subsidiary's statement of financial position.
 The revaluations are not incorporated in the subsidiary's books. In this case, we must make the
necessary adjustments to the subsidiary's statement of financial position as a working. Only then
can we proceed to the consolidation.
Note: Remember that when depreciable assets are revalued there will be a corresponding alteration
in the amount of depreciation charged and accumulated.

Worked Example: Fair value adjustments

P Co. acquired 75 per cent of the ordinary shares of S Co. on 1 September 20X5. At that date the fair
value of S Co.'s non-current assets was $23 000 greater than their carrying amount, and the balance of
retained earnings was $21 000. The statements of financial position of both companies at
31 August 20X6 are given below. S Co. has not incorporated any revaluation in its financial records.
Non-controlling interest is valued at full fair value which was deemed to be $18 000 at the acquisition
date.
P CO.
STATEMENT OF FINANCIAL POSITION AS AT 31 AUGUST 20X6
$ $
Assets
Non-current assets
Property, plant and equipment 63 000
Investment in S Co. at cost 51 000
114 000
Current assets 82 000
Total assets 196 000
Equity and liabilities
Equity
80 000 ordinary shares 80 000
Retained earnings 96 000
176 000
Current liabilities 20 000
Total equity and liabilities 196 000
MODULE 5
318 | BUSINESS COMBINATIONS

S CO.
STATEMENT OF FINANCIAL POSITION AS AT 31 AUGUST 20X6
$ $
Assets
Property, plant and equipment 28 000
Current assets 43 000
Total assets 71 000
Equity and liabilities
Equity
Ordinary shares 20 000
Retained earnings 41 000
61 000
Current liabilities 10 000
Total equity and liabilities 71 000

If S Co. had revalued its non-current assets at 1 September 20X5, an addition of $3000 would have
been made to the depreciation charged for 20X5/X6.
Required
Prepare P Co.'s consolidated statement of financial position as at 31 August 20X6.

Solution

P CO.
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 AUGUST 20X6
$ $
Non-current assets
Property, plant and equipment $(63 000 + 48 000)* 111 000
Goodwill (W1) 5 000
116 000
Current assets 125 000
241 000
Equity and liabilities
Equity
Ordinary shares 80 000
Retained earnings (W2) 108 750
188 750
Non-controlling interest (W3) 22 250
211 000
Current liabilities 30 000
241 000

* (28 000 + 23 000 – 3000)

1 Goodwill
Group NCI
$ $
Consideration transferred/fair value of NCI 51 000 18 000
Net assets acquired as represented by
Ordinary share capital 20 000
Retained earnings 21 000
Fair value adjustment 23 000
64 000
Group/NCI share (48 000) (16 000)
Goodwill 3 000 2 000
 FINANCIAL ACCOUNTING AND REPORTING | 319

2 Retained earnings
P Co. S Co.
$ $
Per question 96 000 41 000
Pre-acquisition profits (21 000)
Depreciation adjustment (3 000)
Post-acquisition S Co. 17 000
Group share in S Co.
($17 000 × 75%) 12 750
Group retained earnings 108 750

3 Non-controlling interest at reporting date

$
S Co.'s net assets (71 000 – 10 000) 61 000
Fair value adjustment (23 000 – 3 000) 20 000
81 000
 25% 20 250
Goodwill 2 000
22 250

Question 8: Fair value

An asset is recorded in S Co.'s books at its historical cost of $4000. On 1 January 20X5 P Co. bought
80 per cent of S Co.'s equity. Its directors attributed a fair value of $3000 to the asset as at that date. It
had been depreciated for two years out of an expected life of four years on the straight line basis.
There was no expected residual value. On 30 June 20X5 the asset was sold for $2600. What is the
profit or loss on disposal of this asset to be recorded in S Co.'s accounts and in P Co.'s consolidated
accounts for the year ended 31 December 20X5?
(The answer is at the end of the module.)

13.4 FAIR VALUES OF IDENTIFIABLE ASSETS AND LIABILITIES NOT

RECOGNISED BY THE ACQUIREE
IFRS 3 states that the acquirer should recognise the acquiree's identifiable assets acquired and
liabilities assumed at the acquisition date, if they meet the definitions of assets and liabilities in the
Conceptual Framework for Financial Reporting. This means:
 in the case of an asset it is probable that any associated future economic benefits will flow to the
acquirer, and its fair value can be measured reliably
 in the case of a liability it is probable that an outflow of resources embodying economic benefits
will be required to settle the obligation, and its fair value can be measured reliably.
The acquiree's identifiable assets and liabilities might include assets and liabilities not previously
recognised in the acquiree's financial statements. For example, a tax benefit arising from the
acquiree's tax losses that was not recognised by the acquiree may be recognised by the group if the
acquirer has future taxable profits against which the unrecognised tax benefit can be applied. Also,
IFRS 3 explains that an acquirer can recognise acquired identifiable intangible assets (such as
internally generated brand names, patents or customer relationships), that the acquiree did not
recognise. As the acquiring company is giving valuable consideration for these assets, they are now
recognised as assets in the consolidated financial statements.
MODULE 5
 320 | BUSINESS COMBINATIONS

13.4.1 RESTRUCTURING AND FUTURE LOSSES

An acquirer should not recognise liabilities for future losses or other costs expected to be incurred
as a result of the business combination.
IFRS 3 explains that a plan to restructure a subsidiary following an acquisition is not a present
obligation of the acquiree at the acquisition date. Neither does it meet the definition of a contingent
liability. Therefore, an acquirer should not recognise a liability for such a restructuring plan as part
of allocating the cost of the combination unless the subsidiary was already committed to the plan
before the acquisition.
This prevents creative accounting. An acquirer cannot set up a provision for restructuring or future
losses of a subsidiary and then release this to profit or loss in subsequent periods in order to reduce
losses or smooth profits.

Question 9: Goodwill on consolidation with fair value adjustments

On 1 September 20X7 Tyzo Co. acquired 6 million of the 8 million shares in Kono Co. at $2.00 per
share. At that date Kono Co. produced the following interim financial statements.
$m $m
Property, plant and equipment Trade payables 3.2
(note 1) 16.0 Taxation 0.6
Inventories (note 2) 4.0 Bank overdraft 3.9
Receivables 2.9 Long-term loans 4.0
Cash in hand 1.2 Share capital 8.0
Retained earnings 4.4
24.1 24.1

Notes
1. The property, plant and equipment of Kono Co. had a combined market value of $16.6 million at
1 September 20X7.
2. The inventories of Kono Co. which were shown in the interim financial statements are raw materials.
They would have cost $4.2 million to replace at 1 September 20X7.
3. On 1 September 20X7 Tyzo Co. took a decision to rationalise the group so as to integrate Kono Co.
The costs of the rationalisation were estimated to total $3.0 million and the process was due to start
on 1 March 20X8. No provision for these costs has been made in the financial statements given
above.
4. Tyzo Group values the non-controlling interest using the proportion of net assets method.
Required
Compute the goodwill on consolidation of Kono Co. that will be included in the consolidated financial
statements of the Tyzo Co. group for the year ended 31 December 20X7, explaining your treatment of
the items mentioned above. You should refer to the provisions of relevant accounting standards.
(The answer is at the end of the module.)
 FINANCIAL ACCOUNTING AND REPORTING | 321

KEY MODULE POINTS 2

 Where the parent does not hold 100 per cent of the shares in the subsidiary, the non-controlling
interest must be represented.
 IFRS 3 allows two alternative ways of measuring the non-controlling interest at acquisition:
– As a proportionate share of the fair value of the subsidiary's net assets; or
– At full (or fair) value (usually based on the market value of the shares held by the non-controlling
interest).
 The non-controlling interest reported in the consolidated statement of financial position at
subsequent reporting dates is increased by the non-controlling interest's share of profits made by
the subsidiary since acquisition.
 Goodwill arises where the consideration transferred by the parent is not equal to the group share
of net assets at acquisition.
 Goodwill is calculated as consideration plus NCI less the fair value of the net assets of the
subsidiary at acquisition.
 Fair value adjustments may therefore be required to the subsidiary's accounts before
consolidation.
 Goodwill arising on consolidation is not amortised but is subjected to an annual impairment review
and any loss is debited to group reserves.
 A bargain purchase is reassessed and then credited to profit or loss immediately.
 IFRS 10 sets out the procedures to prepare a consolidated statement of financial position.
 The basic procedure involves:
– adding the assets and liabilities of the parent and subsidiary on a line by line basis
– eliminating any intercompany amounts
– eliminating the parent's investment in the subsidiary and replacing it with the subsidiary's net
assets
– including the share capital of the parent only
– calculating group reserves as the parent's reserves plus the group share of post-acquisition
reserves of the subsidiary
 Unrealised profits made on the sale of goods or non-current assets to group companies must be
eliminated on consolidation.

MODULE 5
322 | BUSINESS COMBINATIONS

QUICK REVISION QUESTIONS 2

1 Major Co, which makes up its accounts to 31 December, has an 80 per cent owned subsidiary
Minor Co. Minor Co. sells goods to Major Co. at a mark-up on cost of 33.3 per cent. At
31 December 20X8, Major had $12 000 of such goods in its inventory and at 31 December 20X9
had $15 000 of such goods in its inventory.
What is the amount by which the consolidated profit attributable to Major Co.'s shareholders
should be adjusted in respect of the above?
Ignore taxation.
A $600 debit
B $750 credit
C $800 credit
D $1000 debit

The following information is relevant for questions 2 to 4

On 1 January 20X0 Alpha purchased 80 000 of the 100 000 ordinary shares in Beta for $180 000. At that
date Beta's retained earnings amounted to $90 000 and the fair values of Beta's assets at acquisition
were equal to their book values.
Three years later, on 31 December 20X2, the statements of financial position of the two companies
were:
Alpha Beta
$ $
Sundry net assets 230 000 260 000
Shares in Beta 180 000 –
410 000 260 000
Share capital
Ordinary shares 200 000 100 000
Retained earnings 210 000 160 000
410 000 260 000

The share capital of Beta has remained unchanged since 1 January 20X0. The non-controlling interest
is measured at full fair value and goodwill attributable to the non-controlling interest at acquisition
was $4000. There was no impairment of goodwill.

2 What amount should appear in the group's consolidated statement of financial position at
31 December 20X2 for goodwill?
A $14 000
B $25 000
C $28 000
D $32 000

3 What amount should appear in the group's consolidated statement of financial position at
31 December 20X2 for non-controlling interest?
A $32 000
B $48 000
C $52 000
D $56 000
 FINANCIAL ACCOUNTING AND REPORTING | 323

4 What amount should appear in the group's consolidated statement of financial position at
31 December 20X2 for retained earnings?
A $245 000
B $266 000
C $338 000
D $370 000

5 Strachey owns 75 per cent of the share capital in Bell. At 31 July 20X2, the inventory of Strachey
was valued at $420 000 and included goods costing $60 000 that it had purchased from Bell at cost
plus 20 per cent.
At 31 July 20X2, inventories were valued at $445 000 in the consolidated statement of financial
position of the Strachey group.
At 31 July 20X2, what is the inventory figure in the statement of financial position of Bell?
A $13 000
B $15 000
C $35 000
D $37 000

6 The summarised statements of financial position of Falcon and Kestrel at 31 December 20X8 were
as follows:
Falcon Kestrel
$m $m
Net assets (at fair values) 68 25
Share capital 10 10
Reserves 58 15
68 25

On 1 January 20X8 Falcon purchased 80 per cent of the equity share capital of Kestrel for
$24 million. The fair value of the net assets of Kestrel was $20 million at that date. The goodwill
arising on consolidation was impaired by 100 per cent. Non controlling interests are measured at
the proportion of fair value of net assets acquired.
Calculate the amount of consolidated reserves to be included in the statement of financial position
at 31 December 20X8.
A $54m
B $62m
C $65m
D $70m

7 Harrow acquired 270 000 ordinary shares in Slough on 1 January 20X9 at a cost of $400 000. At that
date, Slough had 300 000 ordinary $1 shares in issue and its reserves were $50 000. Non-controlling
interests are measured at the proportionate share of the net assets acquired.
The amount of goodwill arising on consolidation is:
A $50 000
B $80 000
C $85 000
D $130 000
MODULE 5
324 | BUSINESS COMBINATIONS

8 STV owns 75 per cent of the ordinary share capital of its subsidiary TUW. At the group's year end,
28 February 20X7, STV's payables include $3600 in respect of inventories sold to it by TUW.
TUW's receivables include $6700 in respect of inventories sold to STV. Two days before the year
end STV sent a payment of $3100 to TUW that was not recorded by the latter until two days after
the year end.
The in-transit item should be dealt with as follows in the consolidated statement of financial
position at 28 February 20X7:
A $2325 to be included as cash in transit
B $3100 to be included as cash in transit
C $3100 to be included as inventories in transit
D $3100 to be added to consolidated payables

9 Ploughshare acquired 80 per cent of the equity share capital of Sword on 30 September 20X1. On
31 December 20X1, the share capital and reserves of Sword were:
$'000
Ordinary shares 300
Retained earnings at 1 January 20X1 80
Retained profit for the year ended 31 December 20X1 40
420

The profits of Sword have accrued evenly throughout 20X1. Goodwill arising on the acquisition was
$20 000. Non-controlling interests are measured at the proportionate share of the net assets
acquired.
What was the cost of the investment in Sword?
A $324 000
B $332 000
C $348 000
D $356 000

10 XY owns 75 per cent of the issued equity share capital of PQ. At the year end, XY held inventories
valued at $160 000 and PQ held inventories valued at $90 000. The inventories held by XY included
$20 000 of goods purchased from PQ at a profit margin of 30 per cent. There was also inventories
in transit between the two companies; this amounted to a further $10 000 at selling price.
At what value should inventories appear in the consolidated statement of financial position?
A $228 500
B $251 000
C $254 000
D $266 000
 FINANCIAL ACCOUNTING AND REPORTING | 325

14 BASIC PRINCIPLES OF THE CONSOLIDATED

STATEMENT OF PROFIT OR LOSS

LO
5.5 Section overview
 The consolidated statement of profit or loss is produced by aggregating amounts from the
individual accounts of the parent and subsidiary. The non-controlling interest (NCI) is
recognised as a one-line adjustment at the end of the statement.

The consolidated statement of profit or loss is based on the following principles:

 Income and expenses of the parent and subsidiary are added together on a line by line basis.
 Dividend income in the parent's statement of profit or loss from the subsidiary is eliminated.
 The profit shown in the statement of profit or loss must be attributed to the non-controlling
interest and the parent in proportion to their ownership share.
 The non-controlling interest in profit is calculated as the NCI's share of the profit of the subsidiary
for the year after any consolidation adjustments attributable to the subsidiary.

Worked Example: Consolidated statement of profit or loss

P Co. acquired 75 per cent of the ordinary shares of S Co. on that company's incorporation in 20X3.
The summarised statements of profit or loss and movement on retained earnings of the two
companies for the year ending 31 December 20X6 are set out below:
P Co. S Co.
$ $
Revenue 75 000 38 000
Cost of sales 30 000 20 000
Gross profit 45 000 18 000
Administrative expenses 14 000 8 000
Profit before tax 31 000 10 000
Income tax expense 10 000 2 000
Profit for the year 21 000 8 000

Note: Movement in retained earnings.

Retained earnings brought forward 87 000 17 000
Profit for the year 21 000 8 000
Retained earnings carried forward 108 000 25 000

Required
Prepare the consolidated statement of profit or loss and extract from the statement of changes in
equity showing retained earnings and non-controlling interest for the year.

Solution

P CO.
CONSOLIDATED STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X6
$
Revenue (75 + 38) 113 000
Cost of sales (30 + 20) 50 000
Gross profit 63 000
Administrative expenses (14 + 8) 22 000
MODULE 5

Profit before tax 41 000

Income tax expense (10 + 2) 12 000
Profit for the year 29 000
 326 | BUSINESS COMBINATIONS

$
Profit attributable to:
Parent 27 000
Non-controlling interest ($8000  25%) 2 000
29 000
STATEMENT OF CHANGES IN EQUITY (EXTRACT)
Retained Non-controlling
earnings interest
$ $
Balance at 1 January 20X6
(RE)((87 000 + (17 000  75%))(NCI) (17 000  25%) 99 750 4 250
Total comprehensive income for the year 27 000 2 000
Balance at 31 December 20X6 126 750 6 250

Notice how the non-controlling interest is dealt with:

 Down to the line 'profit for the year' the whole of S Co.'s results is included without reference to
group share or non-controlling share. The profit is then allocated between the NCI and the parent.
 Retained earnings at 1 January 20X6 is calculated on the same basis as that used in the statement
of financial position detailed earlier in this module: the group share of S Co.'s retained earnings
brought forward of $12 750 (75%  $17 000) are added to P Co.'s retained earnings brought
forward of $87 000.
 The non-controlling interest brought forward of $4250 is calculated as the NCI share of S Co.'s
retained earnings brought forward (17 000  25%).
 The group retained earnings figure of $126 750 should be the same as the amount reported in the
consolidated statement of financial position.

We now consider the complications introduced by inter-company trading, inter-company dividends

and pre-acquisition profits in the subsidiary.

15 INTRA-GROUP TRANSACTIONS

LO
5.5 Section overview
 Intra-group sales and purchases are eliminated from the consolidated statement of profit or
loss.

15.1 INTRA-GROUP TRADING

Like the consolidated statement of financial position, the consolidated statement of profit or loss
deals with the results of the group as those of a single entity. When one company in a group sells
goods to another an identical amount is added to the sales revenue of the first company and to the
cost of sales of the second. Yet as far as the group's dealings with outsiders are concerned no sale has
taken place.
The consolidated figures for sales revenue and cost of sales should represent sales to, and purchases
from, outsiders. So, reduce sales revenue and cost of sales by the sales value of intra-group sales
during the year.
Also, we need to remove unrealised profits on intra-group trading. So, calculate the unrealised profit
on unsold inventories at the year end and increase the cost of sales of the seller by this amount.
 FINANCIAL ACCOUNTING AND REPORTING | 327

Worked Example: Intra-group trading

Suppose in our earlier example that S Co. had recorded sales of $5000 to P Co. during 20X6. S Co.
had purchased these goods from outside suppliers at a cost of $3000. One half of the goods remained
in P Co.'s inventory at 31 December 20X6. Prepare the revised consolidated statement of profit or
loss.

Solution

The consolidated statement of profit or loss for the year ended 31 December 20X6 would now be as
follows:
$
Revenue (75 + 38 – 5) 108 000
Cost of sales (30 + 20 – 5 + 1*) (46 000)
Gross profit 62 000
Administrative expenses (22 000)
Profit before taxation 40 000
Income tax expense (12 000)
Profit for the year 28 000
Profit attributable to:
Parent 26 250
Non-controlling interest (8000 – 1000) × 25% 1 750
28 000

Note:
Retained earnings brought forward 99 750
Profit for the year 26 250
Retained earnings carried forward 126 000

*Unrealised profit: ½ × ($5000 – $3000)

An adjustment will be made for the unrealised profit against the inventory figure in the consolidated
statement of financial position.

15.2 INTRA-GROUP TRANSFERS OF NON-CURRENT ASSETS

Earlier we saw that intra-group transfers of non-current assets are also likely to result in an unrealised
profit. The consolidated financial statements must show non-current assets at their depreciated cost
to the group and therefore such unrealised profits are eliminated on consolidation.
With depreciable the depreciation is supposed to reflect the use of the depreciable assets to produce
goods or services that will be sold to external parties, it is said that the unrealised profit of intra-group
transfers of depreciable assets is realised through depreciation. In essence, as the depreciated part of
the asset cannot be used in the business any more, it is equivalent to having been sold to external
parties and therefore the part of the intra-group profit proportional to how much of the asset was
depreciated since it was sold intra-group is now considered to be realised.
For example, if a depreciable non-current asset purchased from an external entity for $80 000 is sold
immediately intra-group for $100 000, the intra-group profit of $20 000 is considered unrealised from
the group’s perspective. However, assuming that the useful life of the asset is five years, with
economic benefits from the asset to be consumed evenly, at the end of one full year after the intra-
group sale, one-fifth of the asset’s economic benefits have been consumed. As such, profit of $4000
($20 000 / 5 years) each year can be considered realised and recognised in the group’s accounts. Note
that the group does not recognise this as directly affecting profit; rather, the depreciation expense
MODULE 5

recognised by the intra-group buyer of $20 000 ($100 000 / 5 years), being overstated from the point
of view of the group (which will only recognise $16 000, based on the original cost of $80 000 / 5
years), will be adjusted on consolidation, resulting in a decrease in depreciation expense by $4000 that
will indirectly affect the profit, increasing it by $4000 ($20 000 – $16 000) each year.
 328 | BUSINESS COMBINATIONS

Question 10: Transfer of non-current assets

Way Co. transferred a machine to Sly Co. on 1 May 20X8 for $26 000. The original cost of the machine
on 1 May 20X4 was $40 000, with an estimated useful life of 10 years. After the transfer, Sly Co.
continues to depreciate the machine over its remaining useful life on a straight line basis.
What adjustments must be made to consolidated profit or loss in the year ended 31 December 20X8?
(The answer is at the end of the module.)

15.3 INTRA-GROUP DIVIDENDS

A subsidiary may distribute some of its profits as dividends. The dividend received by the parent is
recorded in the parent's own accounts as income. On consolidation this must be removed as it is not
income from outside the group.

16 PRE-ACQUISITION PROFITS AND MID-YEAR

ACQUISITIONS

Section overview
 Only the post-acquisition profits of the subsidiary are included in consolidated profit or
loss.

Retained earnings in the consolidated statement of financial position comprise:

 the whole of the parent's retained earnings; and
 the group's share of post-acquisition retained earnings in the subsidiary.
So, the results of a subsidiary are consolidated only from the date of acquisition.
If a subsidiary is acquired during the accounting year, the entire statement of profit or loss of the
subsidiary is split into pre-acquisition and post-acquisition proportions. Only the post-acquisition
figures are included in the consolidated statement of profit or loss.

Question 11: Acquisition

P Co. acquired 60 per cent of the $100 000 equity of S Co. on 1 April 20X5. The statements of profit or
loss of the two companies for the year ended 31 December 20X5 are set out below::
P Co. S Co. S Co. (9/12)
$ $ $
Revenue 170 000 80 000 60 000
Cost of sales 65 000 36 000 27 000
Gross profit 105 000 44 000 33 000
Other income – dividend received S Co 3 600
Administrative expenses 43 000 12 000 9 000
Profit before tax 65 600 32 000 24 000
Income tax expense 23 000 8 000 6 000
Profit for the year 42 600 24 000 18 000

Note:
P Co. S Co.
$ $
Dividends (paid 31 December) 12 000 6 000
Profit retained 30 600 18 000
Retained earnings brought forward 81 000 40 000
Retained earnings carried forward 111 600 58 000
 FINANCIAL ACCOUNTING AND REPORTING | 329

Prepare the consolidated statement of profit or loss and the retained earnings and non-controlling
interest extracts from the statement of changes in equity.
(The answer is at the end of the module.)

Question 12: Non-controlling interest

The following information relates to Brodick Co. and its subsidiary Lamlash Co. for the year to
30 April 20X7.
Brodick Co. Lamlash Co.
$'000 $'000
Revenue 1 100 500
Cost of sales (630) (300)
Gross profit 470 200
Administrative expenses (105) (150)
Dividend from Lamlash Co. 24 –
Profit before tax 389 50
Income tax expense ( 65) (10)
Profit for the year 324 40

Note:
Dividends paid 200 30
Profit retained 124 10
Retained earnings brought forward 460 106
Retained earnings carried forward 584 116

Additional information
(a) The issued share capital of the group is as follows.
Brodick Co.: 5 000 000 ordinary shares totalling $5m
Lamlash Co.: 1 000 000 ordinary shares totalling $1m
(b) Brodick Co. purchased 80 per cent of the issued share capital of Lamlash Co. in 20X0. At that time,
the retained earnings of Lamlash stood at $56 000.
Required
To the extent that the information permits, prepare the Brodick group consolidated statement of
profit or loss for the year to 30 April 20X7, and extracts from the consolidated statement of changes in
equity showing retained earnings and non-controlling interest.
(The answer is at the end of the module.)

17 OTHER ADJUSTMENTS

LOs
5.2, 5.5 Section overview
 Adjustments must be made where a depreciable asset in the subsidiary's accounts has
been the subject of a fair value uplift or where goodwill has been impaired.

17.1 FAIR VALUE ADJUSTMENTS

When dealing with the consolidated statement of financial position, we discussed the adjusting of
assets (and liabilities) in the subsidiary's accounts to reflect fair value at the date of acquisition.
MODULE 5

If a non-current asset is the subject of a fair value uplift for consolidation purposes we need to charge
extra depreciation. Depreciation based on the book value of the asset will be included in the
subsidiary's own statement of profit or loss, the depreciation charge on the revalued amount will be
bigger and the difference is a consolidation adjustment.
 330 | BUSINESS COMBINATIONS

17.2 GOODWILL IMPAIRMENT

If goodwill has been impaired in the period, the impairment loss must be charged to consolidated
profits. Usually this amount is included in administrative expenses in the consolidated statement of
profit or loss.
Where the non-controlling interest is measured at fair value, part of the impairment is allocated to
non-controlling interest goodwill. The proportion relating to the non-controlling interest is deducted
from the profits allocated to the NCI.
Where the non-controlling interest is measured as a proportion of the net assets of the subsidiary,
goodwill relates only to the parent and therefore no adjustment to the non-controlling interest in
profit is required.

18 SUMMARY: CONSOLIDATED STATEMENT OF

PROFIT OR LOSS

The table below summarises the main points about the consolidated statement of profit or loss.
PURPOSE To show the results of the group for an accounting period as if it were a single entity.
REVENUE TO PROFIT 100 per cent P + 100 per cent S (excluding adjustments for inter-company transactions).
FOR YEAR
REASON To show the results of the group which were controlled by the parent.
INTRA-GROUP SALES Remove selling price from both revenue and cost of sales.
UNREALISED PROFIT (a) Goods sold by P. Increase cost of sales by unrealised profit.
ON INTRA-GROUP (b) Goods sold by S. Increase cost of sales by unrealised profit and decrease non-
SALES controlling interest by their share of unrealised profit.
DEPRECIATION If the value of S's non-current assets has been subjected to a fair value uplift, additional
depreciation must be charged in the consolidated statement of profit or loss. The non-
controlling interest will need to be adjusted for their share.
TRANSFER OF Expenses must be adjusted for any profit on the transfer and for any additional
NON-CURRENT depreciation arising from the increased carrying amount of the asset.
ASSETS
NON-CONTROLLING S's profit after tax (PAT) X
INTERESTS Less: * unrealised profit (X)
* profit on disposal of non-current assets (X)
additional depreciation following FV uplift (X)
Add: ** additional depreciation following disposal of
non-current assets X
X
NCI% X
* Only applicable if sales of goods and non-current assets made by subsidiary.
** Only applicable if sale of non-current assets made by subsidiary.
REASON To show the extent to which profits generated through P's control are in fact owned by
other parties.
 FINANCIAL ACCOUNTING AND REPORTING | 331

KEY MODULE POINTS 3

 The consolidated statement of profit or loss is produced by adding amounts in the individual
accounts of the parent and subsidiary on a line by line basis.
 The non-controlling interest is a one-line adjustment at the end of the statement. It is calculated as
the NCI share of the profits of the subsidiary for the year, after any consolidation adjustments
attributable to the subsidiary.
 Intra-group sales and purchases are eliminated from the consolidated statement of profit or loss.
 Any unrealised profits are eliminated.
 Intra-group dividends are eliminated.
 Only the post-acquisition profits of the subsidiary are included in the consolidated statement of
profit or loss. The profits of the subsidiary must be pro-rated if acquired mid-year.
 Where a non-current asset is the subject of a fair value uplift for consolidation purposes extra
depreciation is added as a consolidation adjustment.
 Where goodwill has been impaired in the period, the impairment loss is charged to the
consolidated statement of profit or loss.

MODULE 5
332 | BUSINESS COMBINATIONS

QUICK REVISION QUESTIONS 3

1 At the beginning of the year a subsidiary transfers a non-current asset to the parent for $500 000.
At that date, its carrying amount was $400 000 and it had four years of useful life left. What
adjustment is made to total consolidated profit before tax for the year in respect of the transfer?
A $25 000 credit
B $75 000 debit
C $100 000 credit
D $100 000 debit

2 AB acquired a 60 per cent holding in CD many years ago. At 31 December 20X3 AB held inventory
with a book value of $30 000 purchased from CD at cost plus 20 per cent.
The effect on the consolidated statement of profit or loss for the year is:
Profit attributable to parent Profit attributable to non-controlling interest
A Reduced by $5000 No effect
B Reduced by $6000 No effect
C Reduced by $3000 Reduced by $2000
D Reduced by $3600 Reduced by $2400

The following information is relevant for questions 3 and 4

Hardy has a 90 per cent subsidiary, Lawrence. During the year ended 31 December 20X2 Lawrence
sold goods to Hardy for $25 000, which was cost plus 25 per cent. At 31 December 20X2 $10 000 of
these goods remained unsold.
3 In the consolidated statement of profit or loss for the year ended 31 December 20X2, revenue will
be reduced by:
A $18 750
B $20 000
C $22 500
D $25 000

4 In the consolidated statement of profit or loss for the year ended 31 December 20X2, gross profit
will be reduced by:
A $1800
B $2000
C $2250
D $2500

5 Parent owned 80 per cent of the issued equity share capital of Subsidiary. For the year ended
31 December 20X6 Subsidiary reported a profit before tax of $55 million. During 20X6 Subsidiary
sold goods to Parent for $15 million at cost plus 20 per cent. At the year end half these goods are
still held by Parent.
In the consolidated statement of profit or loss for the year ended 31 December 20X6 the
non-controlling interest is:
A $8 million
B $10.7 million
C $10.75 million
D $11 million
 FINANCIAL ACCOUNTING AND REPORTING | 333

6 Where the purchase price of an acquisition is less than the aggregate fair value of the net assets
acquired, which of the following accounting treatments of the difference is required by IFRS 3
Business Combinations?
A Immediate recognition as a gain in profit or loss
B Recognition in profit over its estimated useful life
C Immediate recognition as a gain in the statement of changes in equity
D Deduction from goodwill in the consolidated statement of financial position

7 GPT regularly sells goods to its subsidiary in which it owns 60 per cent of the ordinary share capital.
During the group's financial year ended 31 August 20X7, GPT sold goods to its subsidiary valued at
$100 000 (selling price) upon which it makes a margin of 20 per cent. By the group's year end all of
the goods had been sold to parties outside the group.
What is the correct consolidation adjustment in respect of these sales for the year ended 31 August
20X7?
A No adjustment required
B Dr. Revenue $60 000; Cr. Cost of sales $60 000
C Dr. Revenue $80 000; Cr. Cost of sales $80 000
D Dr. Revenue $100 000; Cr. Cost of sales $100 000

8 Lay Co. acquired 90 per cent of the ordinary shares in Hay Co. on 1 August 20X8 at a cost of
$450 000. On that date the net assets of Hay Co. amounted to $460 000. In the year ended
30 June 20X9, Lay Co. reported a profit of $189 000 and Hay Co. of $60 000. Trading conditions
indicated that the goodwill in Hay Co. may be impaired and a review found that it was indeed
impaired by 50 per cent. It is Lay Co. group policy to measure the non-controlling interest as a
percentage of net assets. What is the profit for the year ended 30 June 20X9 before allocation to
the group owners and the non-controlling interest?
A $208 000
B $213 000
C $226 000
D $231 000

9 Radio Co. acquired 85 per cent of the ordinary shares in Stereo Co. a number of years ago giving
rise to $14 000 of goodwill calculated using the full fair value method. The following is relevant to
the year ended 31 December 20X8:
– Radio Co. has reported a profit of $90 000.
– Stereo Co. has reported a profit of $40 000.
– Intercompany sales were made by Radio to Stereo amounting to $20 000 at cost plus 10 per
cent. Half of the goods remain in inventory at the year end.
– Goodwill is impaired by $6000.
What is the non-controlling interest in profit for the year?
A $4191
B $5091
C $5100
D $6000
MODULE 5
 334 | BUSINESS COMBINATIONS

19 ACCOUNTING FOR ASSOCIATES

Section overview
 Accounting for associates is covered by IAS 28 Investments in Associates and Joint
Ventures. The investing company does not have control, as it does with a subsidiary, but it
does have significant influence.

Definitions

Associate. An entity over which the investor has significant influence.

Significant influence. The power to participate in the financial and operating policy decisions of the
investee but is not control or joint control of those policies.
Equity method. A method of accounting where the investment is initially recognised at cost and then
adjusted for the post-acquisition change in the investor's share of the investee's net assets and the
investor's share of the investee's profit or loss is recognised in group profit.

19.1 IAS 28
IAS 28 requires all investments in associates to be accounted for in the consolidated accounts using
the equity method, unless the investment is classified as 'held for sale' in accordance with IFRS 5 (not
within the FAR syllabus), or the exemption in the paragraph below applies.
An investor is exempt from applying the equity method if:
 It is a parent exempt from preparing consolidated financial statements under IFRS 10; or
 All of the following apply:
– The investor is a wholly-owned subsidiary or it is a partially-owned subsidiary of another
entity and its other owners, including those not otherwise entitled to vote, have been informed
about, and do not object to, the investor not applying the equity method;
– The investor's securities are not publicly traded;
– It is not in the process of issuing securities in public securities markets; and
– The ultimate or intermediate parent publishes consolidated financial statements that comply
with IFRS.
The use of the equity method is discontinued from the date that the investor ceases to be an
associate. From that date:
 if the investment becomes a subsidiary, it should be consolidated in accordance with IFRS 3 and
IFRS 10.
 if the retained interest is a financial asset (simple investment) the investor should account for the
investment in accordance with IFRS 9. The carrying amount of the investment at the date that it
ceases to be an associate should be regarded as its fair value on initial measurement as a financial
asset under IFRS 9. Note that IFRS 9 is not within the scope of the FAR syllabus.

19.2 SEPARATE FINANCIAL STATEMENTS OF THE INVESTOR

An investment in an associate is recorded in the investor's separate financial statements either:
 at cost; or
 at fair value (in accordance with IFRS 9).
This applies regardless of whether consolidated financial statements are produced or not.
 FINANCIAL ACCOUNTING AND REPORTING | 335

20 THE EQUITY METHOD

Section overview
 The group share of the associate's profit after tax forms part of group profits in the
consolidated statement of profit or loss; the associate is recognised in the consolidated
statement of financial position at cost plus the group share of the associate's post-
acquisition retained profits.

20.1 APPLICATION OF THE EQUITY METHOD: CONSOLIDATED

FINANCIAL STATEMENTS
Associates are not consolidated on a line by line basis because unlike subsidiaries, they and their
assets and liabilities are not controlled by the parent. The existence of significant influence means that
the parent's share of an associate's net assets and profits should be recognised in the consolidated
accounts. This is achieved by equity accounting.
Many of the adjustments required by the equity method are the same as are required for full
consolidation. In particular, intra-group unrealised profits must be excluded.

20.1.1 CONSOLIDATED STATEMENT OF PROFIT OR LOSS

The basic principle is that the investing company (P Co.) should take account of its share of the
earnings of the associate, A Co., whether or not A Co. distributes the earnings as dividends. P Co.
achieves this by adding the group's share of A Co.'s profit after tax to consolidated profit.
Notice the difference between this treatment and the consolidation of a subsidiary's results. If A Co.
was a subsidiary P Co. would take credit for the whole of its sales revenue, cost of sales and would
then make a one-line adjustment to remove any non-controlling share. Under equity accounting, the
associate's sales revenue, cost of sales and so on are not amalgamated with those of the group just
the group share of the associate's profit after tax for the year is added to the group profit.

20.1.2 CONSOLIDATED STATEMENT OF FINANCIAL POSITION

A figure for investment in associates is shown in non current assets. At acquisition it is stated at cost,
and is recorded by:
Dr. Investment in associate
Cr. Cash/consideration
This amount will increase (decrease) each year by the amount of the group's share of the associate's
profit (loss) for the year.

Worked Example: Associate

P Co., a company with subsidiaries, acquires 25 000 of the 100 000 ordinary shares in A Co. for $60 000
on 1 January 20X8. In the year to 31 December 20X8, A Co. earns profits after tax of $24 000, from
which it pays a dividend of $6000.
How will A Co.'s results be accounted for in the individual and consolidated accounts of P Co. for the
year ended 31 December 20X8?

Solution

In the individual accounts of P Co., the investment will be recorded on 1 January 20X8 at cost. Unless
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there is an impairment in the value of the investment (see below), this amount will remain in the
individual statement of financial position of P Co. permanently. The only entry in P Co.'s individual
statement of profit or loss will be to record dividends received. For the year ended 31 December
20X8, P Co. will:
 336 | BUSINESS COMBINATIONS

Dr. Cash $1 500

Cr. Income from shares in associates $1 500
In the consolidated accounts of P Co. equity accounting principles will be used to account for the
investment in A Co. Consolidated profit after tax will include the group's share of A Co.'s profit after
tax (25%  $24 000 = $6000). To the extent that this has been distributed as dividend, it is already
included in P Co.'s individual accounts and will automatically be brought into the consolidated results.
That part of the group's share of profit in the associate which has not been distributed as dividend
($4500) will be brought into consolidation by the following adjustment.

Dr. Income from shares in associates $1 500

Dr. Investment in associates $4 500
Cr. Share of profit of associates $6 000
The asset 'Investment in associates' is then stated at $64 500, being cost plus the group share of
post-acquisition retained profits.

21 CONSOLIDATED STATEMENT OF PROFIT OR

LOSS

LO
5.5 Section overview
 In the consolidated statement of profit or loss the investing group includes its share of
the after-tax profits of associates whether or not they are distributed as dividends.

A consolidation schedule may be used to prepare the consolidated statement of profit or loss of a
group with associates. The treatment of associates' profits in the following example should be studied
carefully.

21.1 EXAMPLE: CONSOLIDATION SCHEDULE

The following consolidation schedule relates to the P Co. group, consisting of the parent, an 80 per
cent owned subsidiary (S Co.) and an associate (A Co.) in which the group has a 30 per cent interest.
CONSOLIDATION SCHEDULE
Group P Co. S Co. A Co.
$'000 $'000 $'000 $'000
Revenue 1 400 600 800 300
Cost of sales 770 370 400 120
Gross profit 630 230 400 180
Administrative expenses 290 110 180 80
340 120 220 100
Interest receivable 30 30 – –
370 150 220 100
Interest payable (20) – (20) –
Share of profit of associate (57  30%) 17 – –
367 150 200 100
Income tax expense
Group (145) (55) (90)
Associate – – (43)
Profit for the year 222 95 110 57
Non-controlling interest (110  20%) (22)
200
 FINANCIAL ACCOUNTING AND REPORTING | 337

Notes
1. Group sales revenue, group gross profit and costs such as depreciation and so on exclude the
sales revenue, gross profit and costs of associated companies.
2. The group share of the associate's profits is credited to the group statement of profit or loss. If the
associate has been acquired during the year, deduct the pre-acquisition profits.
3. The non-controlling interest only applies to subsidiary companies.

21.2 PRO-FORMA STATEMENT OF PROFIT OR LOSS

The following is a suggested layout (using the figures given in the example above) for the
consolidated statement of profit or loss for a company having subsidiaries as well as associates.
$'000
Revenue 1 400
Cost of sales (770)
Gross profit 630
Other income: interest receivable 30
Administrative expenses (290)
Finance costs (20)
Share of profit of associate 17
Profit before tax 367
Income tax expense (145)
Profit for the year 222
Profit attributable to:
Parent 200
Non-controlling interest 22
222

22 CONSOLIDATED STATEMENT OF FINANCIAL

POSITION

Section overview
 In the consolidated statement of financial position the investment in associates is
recognised at an amount of:
– cost of the investment in the associate; plus
– group share of post acquisition profits; less
– amounts paid as dividends by the associate to the parent; less
– impairments.

As explained earlier, the consolidated statement of financial position will contain a non-current asset
'Investment in associates' which is the original cost plus the group's share of any profits earned
since acquisition which have not been distributed as dividends less any impairment loss (see section
22.3).

Worked Example: Consolidated statement of financial position

On 1 January 20X6 the net assets of A Co. were $220 000, financed by $100 000 ordinary shares and
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retained earnings of $120 000. P Co., a company with subsidiaries, acquires on 1 January 20X6 30 per
cent of the shares in A Co. for $75 000. During the year ended 31 December 20X6 A Co.'s profit after
tax is $30 000, from which dividends of $12 000 are paid.
Show how P Co.'s investment in A Co. would appear in the consolidated statement of financial
position at 31 December 20X6.
338 | BUSINESS COMBINATIONS

Solution

CONSOLIDATED STATEMENT OF FINANCIAL POSITION

AS AT 31 DECEMBER 20X6 (extract)
$
Non-current assets
Investment in associate
Cost 75 000
Group share of post-acquisition retained profits
(30%  $18 000) 5 400
80 400

Question 13: Associate

Set out below are the draft accounts of Parent Co. and its subsidiaries and of Associate Co. Parent Co.
acquired 40 per cent of the equity capital of Associate Co. three years ago when the latter's reserves
stood at $40 000.
SUMMARISED STATEMENTS OF FINANCIAL POSITION
Parent Co.
and subsidiaries Associate Co.
$'000 $'000
Tangible non-current assets 220 170
Investment in Associate Co. at cost 60 –
Loan to Associate Co. 20 –
Current assets 100 50
Loan from Parent Co. – (20)
400 200
Share capital 250 100
Retained earnings 150 100
400 200

SUMMARISED STATEMENTS OF PROFIT OR LOSS

Parent Co.
and subsidiaries Associate Co.
$'000 $'000
Profit before tax 95 80
Income tax expense 35 30
Profit before tax for the year 60 50

You are required to prepare the summarised consolidated financial statements of Parent Co.
Notes
1. Assume that the associate's assets/liabilities are stated at fair value.
2. Assume that there are no non-controlling interests in the subsidiary companies.
3. Assume that the loan from Parent Co. to Associate Co. is long-term so is part of Parent's
investment in Associate
(The answer is at the end of the module.)
 FINANCIAL ACCOUNTING AND REPORTING | 339

Question 14: Associate

Alfred Co. bought a 25 per cent shareholding on 31 December 20X8 in Grimbald Co. at a cost of
$38 000.
During the year to 31 December 20X9 Grimbald Co. made a profit before tax of $82 000 and the
taxation charge on the year's profits was $32 000. A dividend of $20 000 was paid on 31 December out
of these profits.
Calculate the entries for the associate which would appear in the consolidated accounts of the Alfred
group, in accordance with the requirements of IAS 28.
(The answer is at the end of the module.)

The following points are also relevant and are similar to a parent-subsidiary consolidation situation:
 Use financial statements drawn up to the same reporting date.
 If this is impracticable, adjust the financial statements for significant transactions/events in the
intervening period. The difference between the reporting date of the associate and that of the
investor must be no more than three months.
 Use uniform accounting policies for like transactions and events in similar circumstances,
adjusting the associate's statements to reflect group policies if necessary.

23 ADJUSTMENTS

23.1 TRANSACTIONS BETWEEN AN INVESTOR AND AN ASSOCIATE

Profits and losses resulting from transactions between an investor (including consolidated subsidiaries)
and an associate are eliminated to the extent of the investor's interest in the associate. This is very
similar to the procedure for eliminating intra-group transactions between a parent and a subsidiary.
The important thing to remember is that only the group's share is eliminated. The principle is the
same, whether the parent is selling to the associate, or the associate is selling to the parent.

Worked Example: P sells to A

P Co., a parent with subsidiaries, holds 25 per cent of the share capital in A Co. During the year, P Co.
makes sales of $1 000 000 to A Co. at cost plus a 25 per cent mark-up. At the year-end, A Co. has all
these goods still in inventories.

Solution

P Co. has recorded a profit of $200 000 (1 000 000  25 / 125) on its sales to the associate. The group's
share (25 per cent) of this must be eliminated:
Dr. Share of profit of associates
(consolidated statement of profit or loss) $50 000
Cr. Investment in associate (consolidated statement of financial position) $50 000
(The same consolidation adjustment would be made if it had been A Co. which had sold the goods to
P Co. during the year.)
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23.2 ASSOCIATE'S LOSSES

When the equity method is used and the investor's share of losses of the associate equals or exceeds
its investment in the associate, the investor should stop including its share of further losses. The
investment is recognised at nil value. Once the value is reduced to nil, additional losses are only
recognised if the investor has incurred obligations or made payments on behalf of the associate (for
example, if it has guaranteed amounts owed to third parties by the associate).

23.3 IMPAIRMENT LOSSES

An investment in an associate may become impaired. An impairment loss is recognised in accordance
with IAS 36 Impairment of Assets for each associate individually.
The accumulated impairment loss is deducted from the carrying amount of the investment in the
associate in the consolidated statement of financial position.
The working would be as follows:
$
Cost of investment X
Share of post-acquisition retained earnings X
X
Impairment loss (X)
Investment in associate X

The impairment loss arising in the year is charged against the group share of the associate's profits
recognised in the consolidated statement of profit or loss.

Question 15: Consolidated statement of financial position

The statements of financial position of J Co. and its investee companies, P Co. and S Co., at
31 December 20X5 are shown below:
STATEMENTS OF FINANCIAL POSITION AS AT 31 DECEMBER 20X5
J Co. P Co. S Co.
$'000 $'000 $'000
Non-current assets
Freehold property 1 950 1 250 500
Plant and machinery 795 375 285
Investments 1 500 – –
4 245 1 625 785
Current assets
Inventory 575 300 265
Trade receivables 330 290 370
Cash 50 120 20
955 710 655
Total assets 5 200 2 335 1 440
Equity and liabilities
Equity
Share capital 2 000 1 000 750
Retained earnings 1 460 885 390
3 460 1 885 1 140
Non-current liabilities
12% loan stock 500 100 –
Current liabilities
Trade payables 680 350 300
Bank overdraft 560 – –
1 240 350 300
Total equity and liabilities 5 200 2 335 1 440
 FINANCIAL ACCOUNTING AND REPORTING | 341

Additional information
(a) J Co. acquired 600 000 of the 1 000 000 ordinary shares in P Co. on 1 January 20X0 for $1 000 000
when the retained earnings of P Co. were $200 000.
(b) At the date of acquisition of P Co., the fair value of its freehold property was considered to be
$400 000 greater than its value in P Co.'s statement of financial position. P Co. had acquired the
property in January 20W0 and the buildings element (comprising 50 per cent of the total value) is
depreciated on cost over 50 years.
(c) J Co. acquired 225 000 of the 750 000 ordinary shares in S Co. on 1 January 20X4 for $500 000 when
the retained earnings of S Co. were $150 000.
(d) P Co. manufactures a component used by both J Co. and S Co. Transfers are made by P Co. at
cost plus 25 per cent. J Co. held $100 000 inventory of these components at 31 December 20X5
and S Co. held $80 000 at the same date.
(e) The goodwill in P Co. is impaired and should be fully written off. An impairment loss of $92 000 is
to be recognised on the investment in S Co.
(f) The non-controlling interest is valued at the proportionate share of net assets.
Required
Prepare, in a format suitable for inclusion in the annual report of the J Group, the consolidated
statement of financial position at 31 December 20X5.
(The answer is at the end of the module.)

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342 | BUSINESS COMBINATIONS

KEY MODULE POINTS 4

 Accounting for associates is covered by IAS 28 Investments in Associates and Joint Ventures.
 The parent company does not have control, as it does with a subsidiary, but it does have significant
influence.
 In the consolidated statement of profit or loss the group includes its share of the after-tax profits of
associates.
 In the consolidated statement of financial position the investment in associates is:
– cost of the investment in the associate; plus
– group share of post acquisition profits; less
– amounts paid as dividends by the associate to the parent; less
– impairments.
 The group share of unrealised profit made on transactions between group companies and the
associate is eliminated.
 FINANCIAL ACCOUNTING AND REPORTING | 343

QUICK REVISION QUESTIONS 4

1 Which of the following statements regarding group accounting is/are correct?

I. Only the group's share of the assets of a subsidiary is reflected in the consolidated statement of
financial position.
II. An investment in an associate is initially reflected in the consolidated statement of financial
position at its cost.
III. The value of share capital in a consolidated statement of financial position will include the share
capital of both the investor and the investee.
A I only
B II only
C III only
D None of the statements

2 Consul owns the following equity shareholdings in other entities:

Admiral 25 per cent
Sultan 20 per cent
Warrior 30 per cent
Consul has a seat on the board of each entity.
Consul is the largest shareholding in Admiral (no other shareholdings are larger than 10 per cent).
Another entity owns 25 per cent of the share capital in Sultan and also has a seat on its board. No
other individual or entity owns more than 5 per cent of the equity share capital of Sultan.
Another entity holds 70 per cent of Warrior's equity and has a seat on its board. This entity ignores
Consul's opinions most of the time.
Which entities are associates of Consul?
A Admiral only
B Admiral and Sultan only
C Admiral and Warrior only
D Admiral, Sultan and Warrior

3 Outlook has one subsidiary. On 1 January 20X7 Outlook purchased 30 per cent of the share capital
of View for $12 million. The summarised statement of financial position of View at 31 December
20X7 was as follows:
$m
Net assets (at book value) 30
Share capital 10
Retained earnings at 1 January 20X7 15
Profit for the year ended 31 December 20X7 5
30

At 1 January 20X7 the fair value of the net assets of View was $5 million greater than their book
value. The difference relates to land which is still owned by View at 31 December 20X7.
Using the equity method, at what value is the investment in View shown in the consolidated
statement of financial position of the Outlook group at 31 December 20X7?
A $9.0m
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B $10.5m
C $12.0m
D $13.5m
344 | BUSINESS COMBINATIONS

4 Savoy owns 80 per cent of Spring and 30 per cent of White. Spring also owns 15 per cent of White.
Extracts from the statements of comprehensive income for the year ended 31 December 20X7:
Savoy Spring White
$'000 $'000 $'000
Gross profit 700 550 500
What is group gross profit for the year ended 31 December 20X7?
A $1 250 000
B $1 365 000
C $1 460 000
D $1 475 000

5 The following statements refer to a situation where an investing company (K) seeks to exert control
or influence over another company (L). Assume that K is required to prepare consolidated accounts
because of other investments.
I. If K controls the operating and financial policies of L, then L cannot be an associate of K.
II. If K owns more than 20 per cent, but less than 50 per cent of the share capital in L, then L is
bound to be an associate of K.
III. If L is an associate of K, then any amounts payable by L to K are not eliminated when preparing
the consolidated statement of financial position of K.
Which of the statements are correct?
A I only
B I and II only
C I and III only
D II and III only

6 As well as a 90 per cent investment in T, S held 25 per cent of the shares of U, and exerts a
significant influence over it. U sells goods to S. During the year ending 31 March 20X4, U sells
goods to S for $100 000. The cost of the goods to U is $80 000. At the year end, S's inventories
include $16 000 of goods purchased from U.
What adjustment is required in respect of unrealised profit in the consolidated statement of
financial position?
A $Nil
B $800
C $1000
D $3200

7 GPX's financial statements included an investment in associate at $6 600 000 in its consolidated
statement of financial position at 30 September 20X5. At 30 September 20X6, the investment in
associate had increased to $6 750 000. GPX's pre-tax share of profit in the associate was $420 000,
with a related tax charge of $180 000. The net amount of $240 000 was included in the consolidated
statement of profit or loss for the year ended 30 September 20X6.
There were no impairments to the investment in associate, or acquisitions or disposals of shares
during the financial year.
What dividend is paid to GPX by the associate in the year ended 30 September 20X6?
A $90 000
B $240 000
C $390 000
D $420 000
 FINANCIAL ACCOUNTING AND REPORTING | 345

8 Tami Co. has investments in a number of subsidiary companies and on 1 August 20X8 acquired a
30 per cent interest in Tiny Co. The investment cost $400 000. In the year ended 31 March 20X9,
Tiny Co. reported a profit after tax of $66 000. What amounts are reported in the group financial
statements in respect of Tiny Co.?
Statement of financial position Statement of profit or loss
A $400 000 $13 200
B $400 000 $19 800
C $413 200 $13 200
D $419 800 $19 800

9 Dune Group bought a 20 per cent investment in Sand Co. a number of years ago for $420 000.
Since acquisition Sand Co. has made $530 000 retained profits, $180 000 of which are made in the
year ended 31 December 20X8. At this date, an impairment review was carried out on Sand Co.
and Dune's investment was found to be impaired by 5 per cent.
What amount is reported as income from the associate in the consolidated statement of profit or
loss?
A $9700
B $15 000
C $30 740
D $36 000

10 AB owns a controlling interest in another entity, CD, and exerts significant influence over EF, an
entity in which it holds 30 per cent of the ordinary share capital.
During the financial year ended 30 April 20X5, EF sold goods to AB valued at $80 000. The cost of
the goods to EF was $60 000. 25 per cent of the goods remained in AB's inventory at 30 April 20X5.
At the period end, AB held $90 000 inventory, CD held $38 000 and EF held $65 000.
What inventory figure is reported in the consolidated statement of financial position?
A $126 500
B $128 000
C $191 500
D $193 000

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346 | BUSINESS COMBINATIONS

ANSWERS TO QUICK REVISION QUESTIONS 1

400 000 shares

1 B Shareholding in Jamee = = 40%
1000 000 shares
With such a shareholding and with one director on the board of Jamee it is likely that Harvert
has significant influence over the operating and financial policies of Jamee (although not
control).
Therefore, this investment would be treated as an associate in the consolidated financial
statements of Harvert.
2 C A controls B and D as a result of holding the majority of the shares in each company, therefore
they are subsidiaries. B has significant influence over C and therefore C is an associate of B. C is
not controlled by A or B and is therefore not a subsidiary of either of these companies.
3 D The company is no longer controlled; the laws passed by the government transfer control to the
state from the majority shareholder.
4 C Representation of the parent on the board of directors of the investee is evidence of significant
influence rather than dominant influence or control.
5 B With a shareholding of 44 per cent it would not appear that Orius has control of Eerus but
particularly with representation on the board of directors it does seem to exert significant
influence. Therefore, Eerus would be treated as an associate using equity accounting.
6 C Provision of essential technical information is usually evidence of the existence of significant
influence by an entity. An associate is accounted for using the equity method. An associate
relationship is presumed where the holding of ordinary voting shares is at least 20 per cent, so
the answer is not A. A further indicator of an associate relationship is the provision of
management personnel – not simply operational personnel, hence not B. Where the parent has
the power to govern the financial policies of the investee by agreement as noted in D, this is
evidence of a parent-subsidiary relationship. Hence, consolidation is required.
7 B A subsidiary need not prepare accounts to the same date as the parent company in order for
them to be consolidated, however the subsidiary's reporting date should be within three
months either side of the group reporting date.
8 B II is untrue because consolidated accounts are only required where there is at least one
subsidiary, not where there is an associate only.
III is untrue, as equity accounting is only required where there is significant influence over the
investee, presumed to be the case when 20 per cent of the voting shares are held.
 FINANCIAL ACCOUNTING AND REPORTING | 347

ANSWERS TO QUICK REVISION QUESTIONS 2

33.3
1 A (15 000 – 12 000)   80% = $599.54, rounded to $600
133.3
2 D $ $
Consideration transferred 180 000
Net assets acquired
Share capital 100 000
Retained earnings 90 000
190 000
Group share (190 000 × 80%) (152 000)
Goodwill attributable to parent 28 000
Goodwill attributable to non-controlling interest 4 000
Goodwill in statement of financial position 32 000

3 D Non-controlling interest = 20% × $260 000 = $52 000 + goodwill of $4 000 = $56 000
4 B $
Alpha retained earnings 210 000
Beta – group share post-acquisition (160 000 – 90 000) × 80% 56 000
266 000
5 C
$'000
Consolidated statement of financial position 445
Strachey (420)
25
Add: provision for unrealised profit (60  20/120) 10
35
6 A
$m
Falcon’s reserves 58
Kestrel’s reserves [80%  ($25m – $20m)] 4
Less: impairment of goodwill (8)
Consolidated reserves at 31 December 20X8 54

$'m
Goodwill workings:
Consideration transferred 24
Non-controlling interest at acquisition (20% x $20m) 4
28
Fair value of net assets acquired (20)
Goodwill at acquisition 8

7 C
$'000
Consideration transferred 400
Non-controlling interest at acquisition (10% x $350 000) 35
435

Net assets acquired [(300 000 shares @ $1 per share) + $50,000] (350)
Goodwill 85
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8 B $3100 to be included as cash in transit. The payment sent by STV the parent company to its
subsidiary TUW should be included as cash in transit on consolidation.
348 | BUSINESS COMBINATIONS

9 C
$'000 $'000
Net assets acquired:
Ordinary shares 300
Retained earnings at 1 January 20X1 80
Retained profit for the 9 months ended 30 September 20X1
(9/12  40) 30
Net assets at acquisition 410

Group share (80%) 328

Add: goodwill 20
348
10 B
$'000
XY 160
PQ 90
Inventory in transit 10
Provision for unrealised profit (20 + 10)  30% (9)
251
 FINANCIAL ACCOUNTING AND REPORTING | 349

ANSWERS TO QUICK REVISION QUESTIONS 3

1 B $
Unrealised profit ($500 000 – $400 000) (100 000)
Add back: Additional depreciation (100 / 4) 25 000
Increase / (decrease) adjustment to consolidated profit or loss ( (75 000)

Pro forma consolidation worksheet entries:

Dr. Cr.
$ $
Unrealised profit 100 000
Non-current asset 100 000

Accumulated depreciation 25 000

Depreciation expense 25 000
75 000 75 000
2 C The amount of unrealised profit is $5000 (30 000  20/120).
The subsidiary has sold to the parent, therefore the unrealised profit has arisen in the accounts
of the subsidiary and must be allocated between the parent and the non-controlling interest.
3 D Revenue is reduced by the full amount of intra-group sales.
4 B Gross profit is reduced by the element of unrealised profit, which is 10 000  25 / 125.
5 C $'000
Profit before tax of subsidiary 55 000
Less: provision for unrealised profit (15 000  20/120  ½) (1 250)
53 750
NCI share (20%) 10 750

6 A 'Negative goodwill' (referred to as a bargain purchase in IFRS 3) is re-assessed and then

recognised immediately in profit or loss.
7 D $ $
Dr. Revenue 100 000
Cr. Cost of sales 100 000
Intra-group revenue must be eliminated in full from revenue as income and costs are wholly
intra-group. As there is no unsold inventory at the year end and, therefore, no unrealised profit,
the adjustment to costs is the same as the adjustment to revenue.

8 C $ $
Profit of Lay Co. 189 000
Profit of Hay Co. since acquisition 11 / 12  $60 000 55 000
Goodwill impairment
Consideration transferred 450 000
NCI (10%  460 000) 46 000
Net assets of Hay Co. (460 000)
(18 000)
Profit for the year 50% × 36 000 226 000

9 C $
NCI in Stereo's profit ($40 000  15%) 6 000
NCI share of impairment loss ($6 000  15%) (900)
MODULE 5

5 100

The unrealised profit is dealt with in the selling company's books. In this case that is Radio.
350 | BUSINESS COMBINATIONS

ANSWERS TO QUICK REVISION QUESTIONS 4

1 B All of a subsidiary's assets and liabilities are included in the consolidated statement of financial
position and then an amount to reflect those not owned is shown in the form of the non-
controlling interest.
Share capital in the consolidated statement of financial position is only ever the investor's share
capital.
2 B Consul cannot exercise significant influence over Warrior because it is controlled by another
entity which ignores Consul's views. However, it has the largest shareholding and a board seat,
so exercising significant influence over Admiral. Sultan is not so clear. As another entity also has
significant influence over Sultan, it is likely that Consul does too.
3 D
$m
Cost of investment 12.0
Group share of post-acquisition reserves (30%  5) 1.5
13.5
4 A Group gross profit will only include the gross profit of the parent and the subsidiary. The
group's share of the profit of the associate is reported on a separate line below gross profit in
the consolidated statement of profit or loss.
$'000
Savoy 700
Spring 550
1 250
5 C Statement (I) True – if K controls L then L will be a subsidiary, not an associate.
Statement (II) Untrue – there is a presumption that L would be an associate of K but this is
rebuttable for example, if another party held say 70 per cent of the shares
while K only held 30 per cent.
Statement (III) True – there is no elimination of balances for an associate as the associate is
not part of the group.
6 B Mark up on cost = 20 000 / 80 000  100%
= 25%
Unrealised profit = $16 000  25 / 125  25%
= $800
7 A
$
Investment brought forward 6 600 000
Profit after tax (420 000 – 180 000) 240 000
Dividends paid (bal fig) (90 000)
Investment carried forward 6 750 000

8 C Share of profit of associate: 30%  8 / 12  $66 000 = $13 200

Carrying amount of associate: $400 000 + $13 200 = $413 200
9 A
$
Income from associate (20%  $180 000) 36 000
Impairment in associate (see below) (26 300)
9 700

Cost of investment 420 000

Share of post acquisition profits (20%  530 000) 106 000
526 000
Impairment (5%  526 000) 26 300
 FINANCIAL ACCOUNTING AND REPORTING | 351

10 B
$
AB's inventory 90 000
CD's inventory 38 000
128 000

Remember that the associate's inventory is not added across on a line by line basis; therefore
EF's $65 000 is not included in group inventory.
The unrealised profit to be eliminated is 30% × 25% × $20 000 = $1500, so a consolidation
adjustment to debit the share of profit of associates and credit the investment in associates by
$1500 is required. However this has no input on group inventory figures.

MODULE 5
352 | BUSINESS COMBINATIONS

ANSWERS TO MODULE QUESTIONS

1
INVESTMENT CRITERIA REQUIRED TREATMENT IN
GROUP ACCOUNTS
Subsidiary Control (> 50 per cent rule) Full consolidation (IFRS 10)
Associate Significant influence (20 per cent + rule) Equity accounting (IAS 28)
Investment which is neither of the No significant influence (< 20 per cent As for single company
above rule) accounts

2 The group structure is:

P Co.
60 per cent
S Co.
Partly eliminating items are the components of P Co.'s investment in S Co., that is, ordinary shares
and loan stock. Non-controlling shareholders have an interest in 40 per cent (8000/20 000) of
S Co.'s ordinary shares, including reserves.
You should now total the assets and liabilities and produce workings for non-controlling interest,
revaluation surplus and retained earnings as follows:
Workings
i Revaluation surplus
$
P Co. –
Share of S Co.'s revaluation surplus (60%  6 000) 3 600
3 600

ii Retained earnings
$
P Co. 22 000
Share of S Co.'s retained earnings (60%  4 000) 2 400
24 400

iii Non-controlling interest

$
S Co.'s net assets (66 000 – 36 000) 30 000
 40% 12 000
The results of the workings are now used to construct the consolidated statement of financial
position.
P GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
$ $
Assets
Property, plant and equipment 65 000
Current assets 53 000
Total assets 118 000
Equity and liabilities
Equity attributable to parent
Ordinary shares 40 000
Revaluation surplus (W1) 3 600
Retained earnings (W2) 24 400
68 000
Non-controlling interest (W3) 12 000
80 000
 FINANCIAL ACCOUNTING AND REPORTING | 353

$ $
Non-current liabilities
10% loan stock (26 000 – 8 000) 18 000
Current liabilities 20 000
Total equity and liabilities 118 000

Notes
a. S Co. is a subsidiary of P Co. because P Co. owns 60 per cent of its ordinary capital.
b. As always, the share capital in the consolidated statement of financial position is that of the
parent alone. The share capital in S Co.'s statement of financial position was partly eliminated
against the investment shown in P Co.'s statement of financial position, while the uneliminated
portion was credited to the non-controlling interest.
c. The figure for the non-controlling interest comprises the interest of outside investors in the
share capital and reserves of the subsidiary. The remaining portion of S Co.'s loan stock is not
shown as part of the non-controlling interest but is disclosed separately as a liability of the
group.
3 A The non-controlling interest at any given reporting date is measured as:
$
NCI as measured at acquisition X
NCI share of profits made by the subsidiary since acquisition X
X
Therefore:
NCI as measured at acquisition 460 000
NCI share of post-acquisition profits (10%  (275 400 + 286 000)) 56 140
516 140

4 P CO.
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE
$ $
Assets
Non-current assets
Property, plant and equipment (120 000 + 100 000) 220 000
Current assets
Inventories (50 000 + 60 000) 110 000
Goods in transit (18 000 – 12 000) 6 000
Receivables (40 000 + 30 000) 70 000
Cash (4 000 + 6 000) 10 000
196 000
Total assets 416 000
Equity and liabilities
Equity
Ordinary shares, fully paid (parent) 100 000
Retained earnings (95 000 + 28 000) 123 000
223 000
Non-current liabilities
10% loan stock 75 000
12% loan stock (50 000  60%) 30 000
105 000
Current liabilities
Payables (47 000 + 16 000) 63 000
Taxation (15 000 + 10 000) 25 000
88 000
Total equity and liabilities 416 000
MODULE 5

Note especially how:

a. The remaining loan stock in S Co. becomes a liability of the group
b. The goods in transit is the difference between the current accounts ($18 000 – $12 000)
c. The investment in S Co.'s shares is eliminated against S Co.'s share capital.
354 | BUSINESS COMBINATIONS

5 To prepare the consolidated statement of financial position, follow the steps below:
1. Agree current accounts
Ping Co. has goods in transit of $2000 making its total inventory $3000 + $2000 = $5000 and its
liability to Pong Co. $8000 + $2000 = $10 000.
Eliminate common items: these are the current accounts between the two companies of
$10 000 each.
2. Calculate goodwill
Goodwill
Group NCI
$ $
Consideration transferred (W3)/fair value of NCI 38 734 9 000
Net assets acquired as represented by:
Ordinary share capital 25 000
Revaluation surplus on acquisition 5 000
Retained earnings on acquisition 6 000
Intangible asset – brand name 5 000
41 000
Group/NCI % (32 800) (8 200)
Goodwill 5 934 800

This goodwill (total $6734) must be capitalised in the consolidated statement of financial
position.
3. Consideration transferred
$
Cash paid 30 000
Contingent consideration: 10 000 × 1/(1.072)* 8 734
38 734

* Note that the contingent consideration has been discounted at 7 per cent for 2 years (1 July
20X7 to 1 July 20X9).
However, at the date of the current financial statements, 30 June 20X8, the discount for one
year has unwound. The amount of the discount unwound is:
$
(10 000 × 1 / 1.07) – 8734 612
So this amount will be charged to finance costs in the consolidated financial statements and the
contingent consideration under liabilities will be shown as $9346 (8734 + 612).
4. Calculate consolidated reserves
Consolidated revaluation surplus
$
Ping Co | 12 000
Share of Pong Co.'s post acquisition revaluation surplus –
12 000
Consolidated retained earnings
Ping Pong
$ $
Retained earnings per question 26 000 28 000
Less: pre-acquisition (6 000)
Discount unwound – finance costs (612) 22 000
Share of Pong: 80% × $22 000 17 600
42 988
 FINANCIAL ACCOUNTING AND REPORTING | 355

5. Calculate non-controlling interest at year end

$
Pong Co.'s net assets per question (65 000 – 7000) 58 000
Intangible asset (brand name) 5 000
63 000

NCI share 20% 12 600

Goodwill (W2) 800
13 400

6. Prepare the consolidated statement of financial position

PING CO.
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE 20X8
$ $
Assets
Non-current assets
Property, plant and equipment ($50 000 + $40 000) 90 000
Intangible assets: goodwill (W2) 6 734
Brand name 5 000
Current assets
Inventories ($5000 + $8000) 13 000
Receivables ($16 000 + $7000) 23 000
Cash 2 000
38 000
Total assets 139 734
Equity and liabilities
Equity
Ordinary shares 45 000
Revaluation surplus (W4) 12 000
Retained earnings (W4) 42 988
99 988
Non-controlling interest (W5) 13 400
113 388
Current liabilities
Trade payables ($10 000 + $7000) 17 000
Contingent consideration (W3) 9 346
Total equity and liabilities 139 734

6 To prepare the consolidated statement of financial position, follow the steps below:
1 Goodwill
$ $
Consideration transferred 46 000
Net assets acquired as represented by
Share capital 30 000
Retained earnings 10 000
(40 000)
Goodwill 6 000

2 Retained earnings
P Co. S Co.
$ $
Retained earnings per question 45 000 22 000
Unrealised profit: 20%  $15 000 (3 000)
Pre-acquisition (10 000)
9 000
Share of S Co. 9 000
MODULE 5

Goodwill impairment loss (1 500)

52 500
356 | BUSINESS COMBINATIONS

P CO.
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
$ $
Assets
Non-current assets
Property, plant and equipment 120 000
Goodwill (6000 – 1500) 4 500
124 500
Current assets (W1) 55 000
Total assets 179 500
Equity and liabilities
Equity
Ordinary shares 100 000
Retained earnings 52 500
152 500
Current liabilities (W2) 27 000
Total equity and liabilities 179 500

Workings
1 Current assets
$ $
In P Co.'s statement of financial position 40 000
In S Co.'s statement of financial position 30 000
Less: S Co.'s current account with P Co. eliminated (12 000)
18 000
58 000
Less: unrealised profit excluded from inventory valuation (3 000)
55 000
2 Current liabilities
$
In P Co.'s statement of financial position 21 000
Less: P Co.'s current account with S Co. eliminated (12 000)
9 000
In S Co.'s statement of financial position 18 000
27 000

7 Singe Co. has made a profit of $24 000 ($43 000 – $19 000) for the year. In the absence of any
direction to the contrary, this should be assumed to have arisen evenly over the year; $6000 in the
three months to 31 March and $18 000 in the nine months after acquisition. The company's
pre-acquisition retained earnings are therefore as follows:
$
Balance at 31 December 20X4 19 000
Profit for three months to 31 March 20X5 6 000
Pre-acquisition retained earnings 25 000

The consolidation workings can now be drawn up.

1 Goodwill
$ $
Consideration transferred 50 000
Net assets acquired
represented by
Ordinary share capital 10 000
Retained earnings (pre-acquisition) 25 000
35 000
Group share 80% (28 000)
Goodwill attributable to group 22 000
Goodwill attributable to NCI 3 000
25 000
 FINANCIAL ACCOUNTING AND REPORTING | 357

2 Retained earnings
Hinge Co. Singe Co.
$ $
Per question 47 000 43 000
Pre-acquisition (see above) (25 000)
18 000
Share of Singe: $18 000  80% 14 400
61 400
3 Non-controlling interest at reporting date
$
Singe Co. net assets (73 000 – 20 000) 53 000
 20% 10 600
Goodwill 3 000
13 600

HINGE CO.
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X5
$ $
Assets
Property, plant and equipment 62 000
Goodwill (W1) 25 000
Current assets 128 000
Total assets 215 000
Equity and liabilities
Equity
Ordinary shares 100 000
Retained earnings (W2) 61 400
161 400
Non-controlling interest (W3) 13 600
175 000
Current liabilities 40 000
Total equity and liabilities 215 000

8 S Co.: carrying amount at disposal (at historical cost) = $4000  1½ / 4 = $1500

 Profit on disposal = $1100 (depreciation charge for the year = $500)
P Co.: carrying amount at disposal (at fair value) = $3000  1½ / 2 = $2250
 Profit on disposal for consolidation = $350 (depreciation for the year = $750)
The non-controlling interest would be credited with 20 per cent of both the profit on disposal and
the depreciation charge as part of the one line entry in the consolidated statement of profit or loss
and other comprehensive income.
9 Goodwill on consolidation of Kono Co.
$m $m
Consideration ($2.00  6m) 12.0
Fair value of net assets acquired
Share capital 8.0
Pre-acquisition reserves 4.4
Fair value adjustments
Property, plant and equipment (16.6 – 16.0) 0.6
Inventories (4.2 – 4.0) 0.2
13.2
Group share 75% (9.9)
Goodwill 2.1

Notes on treatment:
MODULE 5

1. Share capital and pre-acquisition profits represent the book value (carrying amount) of the net
assets of Kono Co. at the date of acquisition. Adjustments are then required to this book value
in order to give the fair value of the net assets at the date of acquisition. For short-term
monetary items, fair value is their carrying amount on acquisition.
358 | BUSINESS COMBINATIONS

2. IFRS 3 states that the fair value of property, plant and equipment should be determined by
market value.
3. Raw materials should be valued at their replacement cost of $4.2m.
4. The rationalisation costs cannot be reported in pre-acquisition results under IFRS 3 as they are
not a liability of Kono Co. at the acquisition date.
10 The unrealised profit on disposal which must be eliminated from the consolidated profit or loss:
$
Proceeds 26 000
Carrying amount at date of disposal 6/10  $40 000 (24 000)
2 000
The increase in depreciation charge which must be eliminated from the consolidated profit or loss:
8 months depreciation on historic cost to the group 8/12  $40 000 / 10 2 667
8 months depreciation on transfer price 8/12  $26 000 / 6 2 889
222
Therefore, the overall adjustment to the consolidated profit or loss is an decrease of $1778 ($2000 –
$222) to the consolidated profit.
11 The shares in S Co. were acquired three months into the year. Only the post-acquisition proportion
(9/12) of S Co.'s statement of profit or loss is included in the consolidated statement of profit or
loss.
P CO. CONSOLIDATED STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED
31 DECEMBER 20X5
$
Revenue (170 + 60) 230 000
Cost of sales (65 + 27) (92 000)
Gross profit 138 000
Administrative expenses (43 + 9) (52 000)
Profit before tax 86 000
Income tax expense (23 + 6) (29 000)
Profit for the year 57 000

Profit attributable to:

Parent 49 800
Non-controlling interest (18  40%) 7 200
57 000
STATEMENT OF CHANGES IN EQUITY
Retained Non-controlling
earnings interest
$ $
Balance at 1 January 20X5 81 000 –*
Dividends paid (6000  40%) (12 000) (2 400)
Total comprehensive income for the year 49 800 7 200
Added on acquisition of subsidiary (W) – 58 400
Balance at 31 December 20X5 118 800 63 200

* All of S Co.'s profits brought forward are pre-acquisition.

Working
$
Added on acquisition of subsidiary:
Share capital 100 000
Retained earnings brought forward 40 000
Profits Jan-Mar 20X5 (24 000 – 18 000) 6 000
146 000
Non-controlling share 40% 58 400
 FINANCIAL ACCOUNTING AND REPORTING | 359

12 BRODICK GROUP
CONSOLIDATED STATEMENT OF PROFIT OR LOSS FOR THE YEAR TO 30 APRIL 20X7
$'000
Revenue (1100 + 500) 1600
Cost of sales (630 + 300) (930)
Gross profit 670
Administrative expenses (105 + 150) (255)
Profit before tax 415
Income tax expense (65 + 10) (75)
Profit for the year 340

Profit attributable to:

Parent 332
Non-controlling interest (W1) 8
340
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY (extracts)
Retained Non-controlling
earnings interest
$'000 $'000
Balance brought forward (W2, W3) 500 221.2
Dividends paid (30 000 – 24 000) (200) (6)
Total comprehensive income for the year 332 8
Balance carried forward 632 223.2

Workings
1 Non-controlling interests
$'000
In Lamlash (20%  40) 8

2 Retained earnings brought forward

Brodick Co. Lamlash Co.
$'000 $'000
Per question 460 106
Less: pre-aqn (56)
50
Share of Lamlash: 80%  50 40
500
3 Non-controlling interest brought forward
$'000
Share capital 1 000
Retained earnings 106
1 106
Non-controlling share 20% 221.2

Note: The carried forward figures can be proved as follows:

Retained earnings 584 + 80% (116 – 56) = 632
Non-controlling interest 20%  (1 000 + 116) = 223.2
13 PARENT CO.
CONSOLIDATED STATEMENT OF PROFIT OR LOSS
$'000
Profit before tax of Parent and Subsidiaries 95
Share of profits of associate (50 × 40%) 20
Profit before tax 115
MODULE 5

Income tax expense (35)

Profit attributable to the members of Parent Co. 80
360 | BUSINESS COMBINATIONS

PARENT CO.
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
$'000
Assets
Tangible non-current assets 220
Investment in associate (note) 104
Current assets 100
Total assets 424
Equity and liabilities
Share capital 250
Retained earnings (W) 174
Total equity and liabilities 424

Note:
$'000
Investment in associate
Cost of investment 60
Share of post-acquisition retained earnings (W) 24
Loan to associate 20
104
Working
Parent and
Retained earnings Subsidiaries Associate
$'000 $'000
Per question 150 100
Pre-acquisition 40
Post-acquisition 60

Group share in associate

($60  40%) 24
Group retained earnings 174

14 CONSOLIDATED STATEMENT OF PROFIT OR LOSS

$
Share of profit of associate ((82 000 – 32 000) × 25%) 12 500

CONSOLIDATED STATEMENT OF FINANCIAL POSITION

$
Investment in associate 45 500

Working
$
Cost of investment 38 000
Share of post-acquisition retained earnings ((82 000 – 32 000 – 20 000)  25%) 7 500
45 500

15 J GROUP CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X5

$'000
Non-current assets
Freehold property (W2) 3 570.0
Plant and machinery (795 + 375) 1 170.0
Investment in associate (W9) 475.2
5 215.2
Current assets
Inventory (W3) 855.0
Receivables (W4) 620.0
Cash (50 + 120) 170.0
1 645.0
Total assets 6 860.2
 FINANCIAL ACCOUNTING AND REPORTING | 361

$'000
Equity and liabilities
Equity
Share capital 2 000.0
Retained earnings (W10) 1 776.2
3 776.2
Non-controlling interest (W11) 894.0
4 670.2
Non-current liabilities
12% loan stock (500 + 100) 600.0
Current liabilities (W5) 1 590.0
Total equity and liabilities 6 860.2

Workings
1 Group structure

2 Freehold property
$'000
J Co. 1 950
P Co. 1 250
Fair value adjustment 400
Additional depreciation (400  50% / 40)  6 years (20X0-20X5) (30)
3 570
3 Inventory
$'000
J Co. 575
P Co. 300
Provision for unrealised profit (100  25/125) (20)
855
4 Receivables
$'000
J Co. 330
P Co. 290
620
5 Current liabilities
$'000
J Co.: bank overdraft 560
trade payables 680
P Co.: trade payables 350
1 590
6 Provision for Unrealised Profit (PURP)
$'000
On sales to J (Parent Co.) 100  25/125 20.0

On sales to S (associate) 80  25/125  30% 4.8

7 Fair value adjustments
Difference at acquisition Difference now
$'000 $'000
Property 400 400
Additional depreciation: 200  6/40 – (30)
MODULE 5

400 370
 Charge $30 000 to retained earnings
362 | BUSINESS COMBINATIONS

8 Goodwill
$'000 $'000
P Co.
Consideration transferred 1 000
Net assets acquired
Share capital 1 000
Retained earnings 200
Fair value adjustment 400
1 600
Group share 60% (960)
Goodwill at acquisition 40
Impairment loss (40)
0
9 Investment in associate
$'000
Cost of investment 500.00
Share of post-acquisition profit (390 – 150)  30% 72.00
Less: PUP (W6) (4.80)
impairment loss (92.00)
475.20
10 Retained earnings
J P S
$'000 $'000 $'000
Retained earnings per question 1 460.0 885.0 390.0
Adjustments
Unrealised profit (W6) (20.0)
Fair value adjustments (W7) (30.0)
835.0 390.0
Less: pre-acquisition reserves (200.0) (150.0)
1 460.0 635.0 240.0
P: 60%  635 381.0
S: 30%  240 72.0
Less: PUP on sales to associate (W6) (4.8)
impairment losses: P (40.0)
S (92.0)
1 776.2
11 Non-controlling interest at reporting date
$'000
Net assets of P Co. 1 885.0
Fair value adjustment (W7) 370.0
Less PUP: sales to J Co. (20.0)
2 235.0
Non-controlling interest (40%) 894.0
 363

MODULE 6
ANALYSIS OF FINANCIAL
STATEMENTS
Learning objectives Reference

Calculate, analyse and interpret financial ratios and their interrelationship in the financial LO6.1
statements

Explain the limitations of financial statement analysis LO6.2

Topic list

1 Financial analysis: subject outline

2 Profitability
3 Solvency
4 Liquidity and efficiency
5 Investor ratios
6 Comprehensive question
7 Limitations of financial analysis
364 | ANALYSIS OF FINANCIAL STATEMENTS

MODULE OUTLINE

This module looks at interpretation of financial statements. We deal with the calculation of ratios
and how they are analysed and interpreted. We shall also consider the limitations of financial analysis.
The module content is summarised in the diagram below.

Analysis of financial Limitations of

financial analysis:
statements
• Limitations of
financial statements
• Accounting policies
• Limitations of ratio
analysis
Analysis of financial
statements:
• Comparable company analysis
• Trend analysis
• Ratio analysis

Profitability Liquidity Solvency Investor ratios

• Gross margin • Current ratio • Gearing • EPS

• Net margin • Quick ratio • Interest cover • Dividend cover
• ROI • Inventory days • Dividend yield
• ROA • Receivables’ days • P/E ratio
• ROE • Payables’ days
• Asset turnover

Analysis of financial statements: Module summary diagram

 FINANCIAL ACCOUNTING AND REPORTING | 365

BEFORE YOU BEGIN

If you have studied these topics before, you may wonder whether you need to study this module in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the

MODULE 6
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the module to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the module you can find the information, and you
will also find a commentary at the back of the Study guide.
1 What is comparable company analysis of financial statements? (Section 1)
2 What is trend analysis? (Section 1)
3 What are the broad groups of ratios that are relevant in any financial analysis? (Section 1.1)
4 How is return on investment (ROI) calculated? (Section 2.2)
5 What does ROI indicate? (Section 2.2)
6 How is asset turnover calculated? (Section 2.3.1)
7 What does asset turnover indicate? (Section 2.3.1)
8 What ratios indicate solvency? (Section 3)
9 What are the risks associated with a high level of gearing (or leverage)? (Section 3.2)
10 How is the current ratio calculated? (Section 4.2)
11 What is the difference between the current and quick ratio? (Section 4.2)
12 How is receivables' days calculated? (Section 4.3)
13 What does inventory turnover period (days) indicate? (Section 4.5)
14 What may an increase in payables' days indicate? (Section 4.6)
15 How is earnings per share calculated? (Section 5.1)
16 What does dividend cover indicate? (Sections 5.2)
17 What is the significance of a high P/E ratio? (Section 5.3)
18 What does dividend yield indicate? (Sections 5.4)
19 What are the limitations of financial statements? (Sections 7.1 to 7.3)
20 What are the limitations of ratio analysis? (Section 7.4)
 366 | ANALYSIS OF FINANCIAL STATEMENTS

1 FINANCIAL ANALYSIS: SUBJECT OUTLINE

LO
6.1 Section overview
 Financial analysis compares the financial statements and ratios of a company with for
example, prior years or industry averages.

When you look at a statement of financial position or statement of profit or loss and other
comprehensive income, how do you decide whether the company is doing well or badly? Or whether
it is financially strong or financially vulnerable?
Financial analysis is the practice of reviewing financial statements to answer these questions. It can be
broken down into different types:
1. Comparable company analysis compares one company's financial statements directly with those
of another similar company and considers why differences exist. For example, one company may
have a higher profit than another with a similar revenue. A review of expenses may reveal that one
company has lower interest costs which explains the difference. In the statements of financial
position the more profitable company will likely have lower debt than the other company.
2. Trend analysis is a similar exercise which compares the financial statements of one company with
those of the previous years. This form of analysis is useful in assessing the ongoing performance of
a company, particularly when analysis relates to a number of years.
3. Ratio analysis calculates further values which add to the findings of basic analysis. A ratio which
should already be familiar to you is the gross profit margin. The majority of this module relates to
common ratios and what they mean. As with other forms of analysis, there must be some form of
comparative or benchmark for ratios. This may be ratios calculated for a competitor, for the same
company in previous years, or industry averages.

1.1 RATIO ANALYSIS

Basic ratios can be grouped into four categories:
 Profitability;
 Solvency;
 Liquidity/efficiency; and
 Investor ratios.
Within each heading we will identify a number of ratios that are normally calculated and generally
accepted as meaningful indicators. Each individual business must be considered separately however,
so a ratio that is meaningful for a manufacturing company may be completely meaningless for a
financial institution.
It must be stressed that ratio analysis on its own is not sufficient for interpreting company financial
statements, and that there are other items of information which should be looked at, for example:
 the content of any accompanying commentary on the financial statements and other statements;
 the age and nature of the company's assets;
 current and future developments in the company's markets, at home and overseas, recent
acquisitions or disposals of a subsidiary by the company;
 unusual items separately disclosed in the statement of profit or loss and other comprehensive
income; and
 any other noticeable features of the report and financial statements, such as events after the end
of the reporting period, contingent liabilities, a qualified auditors' report, the company's taxation
position, and so on.
You will see that some ratios use average figures and some use year-end figures, make sure you are
guided by your formula sheet or as specified in the exam questions. In some cases the use of averages
 FINANCIAL ACCOUNTING AND REPORTING | 367

gives a more meaningful figure, for example if you were looking at how well an entity has used it’s
resources (plant and machinery etc) it would be more meaningful to look at the average amount of
machinery throughout the year rather than take a year-end figure, where purchases or sales of
machinery late in the year would cause a distortion in the results.

Worked Example: Calculating ratios

MODULE 6
To illustrate the calculation of ratios throughout this module, the following draft statement of financial
position and statement of profit or loss figures are used. Note that there are no items of other
comprehensive income.
FURLONG CO. STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X8
Notes 20X8 20X7
$ $
Revenue 1 3 095 576 1 909 051
Operating profit before interest and tax 1 360 245 247 011
Interest 18 115 21 909
Profit before taxation 342 130 225 102
Income tax expense 74 200 31 272
Profit for the year 267 930 193 830
Earnings per share 12.8c 9.3c

FURLONG CO. STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X8

Notes 20X8 20X7
$ $
Assets
Non-current assets
Property, plant and equipment 802 180 656 071
Current assets
Inventory 64 422 86 550
Receivables 2 1 002 701 853 441
Cash at bank and in hand 1 327 68 363
1 068 450 1 008 354
Total assets 1 870 630 1 664 425
Equity and liabilities
Equity
Ordinary shares (2.1million) 4 210 000 210 000
Retained earnings 699 899 458 769
909 899 668 769
Non-current liabilities
10% loan stock 20X4/20Y0 100 000 100 000
Current liabilities 3 860 731 895 656
Total equity and liabilities 1 870 630 1 664 425

Notes to the accounts:

20X8 20X7
$ $
1. Sales revenue and profit
Sales revenue 3 095 576 1 909 051
Cost of sales 2 402 609 1 441 950
Gross profit 692 967 467 101
Administration expenses 332 722 220 090
Operating profit 360 245 247 011
Depreciation charged 15 107 120 147
2. Receivables
Amounts falling due within one year
Trade receivables 905 679 807 712
Prepayments and accrued income 97 022 45 729
1 002 701 853 441
 368 | ANALYSIS OF FINANCIAL STATEMENTS

20X8 20X7
$ $
3. Current liabilities
Trade payables 627 018 545 340
Accruals and deferred income 81 279 280 464
Income taxes 108 000 37 200
Other taxes 44 434 32 652
860 731 895 656
4. Share capital
Issued and fully paid ordinary shares 210 000 210 000
5. Dividends paid 20 000 –

2 PROFITABILITY

LO
6.1 Section overview
 Return on investment (ROI), and return on equity (ROE) are used by shareholders or the
Board to assess the profitability of an entity and the performance of its management.

In our example, the company made a profit in both 20X8 and 20X7, and there was an increase in profit
between one year and the next:
(a) of 52 per cent before taxation [(342,130 – 225,102)/225,102]; and
(b) of 39 per cent after taxation [(267,930 – 193,830)/193,830]
Profit before taxation is generally thought to be a better figure to use than profit after taxation,
because there might be unusual variations in the tax charge from year to year which would not affect
the underlying profitability of the company's operations.
Another profit figure that should be calculated is EBIT, earnings before interest and tax. This is the
amount of profit which the company earned before paying interest to the providers of loan capital.
Loan capital is long-term loans, such as loan notes and bank loans, which are shown in the statement
of financial position as non-current liabilities.

Formula to learn

Earnings before interest and tax is:

(a) profit after tax; plus
(b) interest; plus
(c) tax.

Published financial statements do not always give sufficient detail to determine how much of the
interest payable is for long-term finance. We will assume in our example that all of the interest
expense ($18 115) relates to long-term finance.
EBIT in our example is therefore:
20X8 20X7
$ $
Profit before tax 342 130 225 102
Interest expense 18 115 21 909
EBIT 360 245 247 011

This shows a 46 per cent growth between 20X7 and 20X8.

 FINANCIAL ACCOUNTING AND REPORTING | 369

2.1 GROSS PROFIT MARGIN, OPERATING PROFIT MARGIN, NET PROFIT

MARGIN AND PROFIT ANALYSIS
Formula to learn

Gross profit

MODULE 6
Gross profit margin = × 100%
Sales
EBIT
Operating profit margin = × 100%
Sales
Net profit margin = Profit after tax (profit for the year)/Sales  100

If there is sufficient detail in the statement of profit or loss and other comprehensive income, you will
be able to calculate the gross profit margin and the operating profit margin (based on earnings before
interest and tax). Looking at the two together can be quite informative.
For example, suppose that a company has the following summarised statement of profit or loss for
two consecutive years:
Year 1 Year 2
$ $
Revenue 70 000 100 000
Cost of sales 42 000 55 000
Gross profit 28 000 45 000
Expenses 21 000 35 000
Profit before tax 7 000 10 000
Although the operating profit margin is the same for both years at 10 per cent, the gross profit margin
is not.
In Year 1 it is: $28 000 = 40%
$70 000
and in Year 2 it is: $45 000 = 45%
$100 000
The improved gross profit margin has not led to an improvement in the operating profit margin. This
is because expenses as a percentage of sales have risen from 30 per cent in Year 1 to 35 per cent in
Year 2.

2.2 RETURN ON INVESTMENT (ROI)

Return on investment is sometimes called return on capital employed (ROCE).
It is impossible to assess profits or profit growth properly without relating them to the amount that
has been invested in the company in order to earn the profits. The most important profitability
ratio is ROI which states the profit as a percentage of the amount of capital invested.
Investment (sometimes called capital = Shareholders' equity plus non-current
employed) liabilities
(or total assets less current liabilities)

Formula to learn

Earnings before interest and taxation

ROI =  100%
Total assets less current liabilities

We must compare like with like so if investment (capital) means share capital and reserves plus non-
current liabilities, profit must mean the profit earned by this capital. This is EBIT, since interest is the
return for loan capital.
 370 | ANALYSIS OF FINANCIAL STATEMENTS

In our example, investment = 20X8 $1 870 630 – $860 731 = $1 009 899
20X7 $1 664 425 – $895 656 = $768 769
These total figures are the total assets less current liabilities (TALCL) figures for 20X8 and 20X7 in the
statement of financial position.
20X8 20X7
$360 245 $247 011
ROI = 35.7% = 32.1%
$1 009 899 $768 769
What does a company's ROI tell us? What should we be looking for? There are three comparisons that
can be made:
 The change in ROI from one year to the next can be examined. In this example, there has been
an increase in ROI by about 4 percentage points from its 20X7 level.
 The ROI being earned by other companies, if this information is available, can be compared with
the ROI of this company. Here the information is not available.
 A comparison of the ROI with current market borrowing rates may be made:
– What would be the cost of extra borrowing to the company if it needed more loans, and is it
earning a ROI that suggests it makes sufficient profits for more borrowing to be worthwhile?
– Is the company making a ROI which suggests that it is getting value for money from its current
borrowing?
– Companies are a risky investment and commercial borrowing rates are a good independent
yardstick against which company performance can be judged.
In this example, if we suppose that current market interest rates, say, for medium-term borrowing from
banks, are around 10 per cent, then the company's actual ROI of 36 per cent in 20X8 would not seem
low. On the contrary, it might seem high.
However, it is easier to spot a low ROI than a high one, because there is always a chance that the
company's non-current assets, especially property, are undervalued in its statement of financial
position, and so the investment figure might be unrealistically low. If the company had earned a ROI,
not of 36 per cent, but of, say only 6 per cent, then its return would have been below current
borrowing rates and so disappointingly low.

2.3 RETURN ON EQUITY (ROE)

Return on equity (ROE) is another variation on return on investment (ROI). It looks at profit from the
perspective of equity investors. It measures the return that equity investors get on the funds they
have invested. (This contrasts with ROI, which measures return on investment for the company as a
whole i.e. including investment from both debt and equity.)

Formula to learn

Profit after tax and preference dividend

ROE =  100%
Shareholders' equity

As before, we must compare like with like. The return on equity shareholders' funds is the profit that
'belongs' to them: profit after interest, tax and preference dividends.
In our example, ROE is calculated as follows:
20X8 20X7
$267 930 = 29.4% $193 830 = 29.0%
ROE
$909 899 $668 769
 FINANCIAL ACCOUNTING AND REPORTING | 371

ROE is regarded as an important overall measure of the way in which management use the company's
assets to generate profits for shareholders. It is used in a similar way to ROI and ROA:
(a) It is compared with the ROE of previous periods; the ROE of other companies; and with current
market rates of borrowing.
(b) It is analysed into its secondary components.

MODULE 6
2.3.1 ANALYSING ROE
ROE can be broken down into three separate components:
1. Equity shareholder profit margin;
2. Asset turnover; and
3. Asset to equity ratio.

Formula to learn

Equity shareholder profit margin  Asset turnover  Assets to equity = ROE

Profit after tax and preference dividend Revenue TALCL
  = ROE
Revenue TALCL Shareholders' equity

In our example:
Equity
shareholder Asset Assets
profit margin turnover to equity ROE

(a) 20X8 $267 930 $3 095 576 $1009 899 $267 930
$3 095 576 $1 009 899 $909 899 $909 899
8.7%  3.06 times  1.11 times = 29.4%
(b) 20X7 $193 830 $1 909 051 $768 769 $193 830
$1 909 051 $768 769 $668 769 $668 769
10.2%  2.48 times  1.15 times = 29.0%

We can see that ROE has stayed more or less the same over the two years. This is deceptive. Equity
shareholder profit margin has fallen by 1.5 percentage points but (as we saw earlier) asset turnover has
risen. The company is less profitable but the assets are being used more efficiently than before. The
assets to equity ratio (also known as the equity multiplier) has fallen slightly. Shareholders' equity has
increased, while the amount of debt has remained the same. This indicates that the company's
gearing, or leverage, has fallen slightly.
Gearing will be discussed in more detail later in this module, but the fact that gearing has fallen
means that there is now slightly less risk attached to the shareholders' investment.
Suppose that a company has the following ratios:
Equity
shareholder Asset Assets
profit margin turnover to equity ROE

(a) 20X9 7.5%  2 times  2 times = 30%

(b) 20X8 10%  2.5 times  1.1 times = 27.5%

This company is showing an increase in ROE despite the fact that both its equity shareholder profit
margin and asset turnover have fallen. The increase in ROE has been caused by the sharp increase in
the assets to equity ratio, but this is a worrying sign. The company is less profitable and fewer sales are
being generated from the company's assets than before. In addition, gearing has risen because the
company has taken on more long-term debt. The shareholders appear to be receiving a slightly better
return on their investment, but they are also bearing much more risk.
 372 | ANALYSIS OF FINANCIAL STATEMENTS

2.4 ANALYSING PROFITABILITY AND RETURN IN MORE DETAIL: THE

SECONDARY RATIOS
We often sub-analyse ROI, to find out more about why the ROI is high or low, or better or worse than
last year. There are two factors that contribute towards a return on investment, both related to sales
revenue:

Formula to learn

Operating profit margin = Earnings before interest and tax/Sales × 100%

(a) Profit margin. A company might make a high or low profit margin on its sales. For example, a
company that makes a profit of 25c per $1 of sales is making a bigger return on its sales than
another company making a profit of only 10c per $1 of sales. There are various types of profit
margin calculations, these will be discussed further later in the module.

Formula to learn

Asset turnover = Sales/Total assets less current liabilities (TALCL)

(b) Asset turnover. Asset turnover is a measure of how much revenue is produced per unit of capital
invested. For example, if two companies each have assets of total investment of $100 000 and
Company A makes sales of $400 000 per annum whereas Company B makes sales of only $200 000
per annum, Company A is making a higher revenue from the same amount of investment (twice as
much asset turnover as Company B) and this will help A to make a higher return on investment than
B. Asset turnover is expressed as 'x times' so that assets generate x times their value in annual
sales. Here, Company A's asset turnover is four times and B's is two times.
Operating profit margin and asset turnover together explain the ROI and if the ROI is the primary
profitability ratio, then the other two are the secondary ratios. The relationship between the three
ratios can be shown mathematically.

Formula to learn

Operating profit margin  Asset turnover = ROI

EBIT Revenue EBIT
 × =
Revenue TALCL TALCL

In our example:
Operating
profit Asset
margin turnover ROI

(a) 20X8 $360 245 $3 095 576 $360 245

$3 095 576 $1 009 899 $1 009 899
11.6%  3.07 times = 35.7%
(b) 20X7 $247 011 $1 909 051 $247 011
$1 909 051 $768 769 $768 769
12.9%  2.48 times = 32.1%

In this example, the company's improvement in ROI between 20X7 and 20X8 is attributable to a higher
asset turnover. Indeed, the operating profit margin has fallen a little. The higher asset turnover has
more than compensated for this.
It is also worth commenting on the change in sales revenue from one year to the next. You may
already have noticed that Furlong achieved sales growth of over 60 per cent from $1.9 million to
 FINANCIAL ACCOUNTING AND REPORTING | 373

$3.1 million between 20X7 and 20X8. This is very strong growth, and one of the most significant items
in the statement of profit or loss and statement of financial position.

2.4.1 A WARNING ABOUT COMMENTS ON PROFIT MARGIN AND ASSET TURNOVER

It might be tempting to think that a high profit margin is good, and a low asset turnover means
sluggish trading. In broad terms, this is so. There is a trade-off between profit margin and asset

MODULE 6
turnover, and you cannot consider one without allowing for the other:
 A high profit margin means a high profit per $1 of sales, but if this also means that sales prices are
high, there is a strong possibility that sales revenue will be depressed because the high price is
likely to reduce demand for the product, and so asset turnover is lower.
 A high asset turnover means that the company is generating a lot of sales, but to do this it might
have to keep its prices down and so accept a low profit margin per $1 of sales.
Consider the following:
Company A Company B
Sales revenue $1 000 000 Sales revenue $4 000 000
Investment (TALCL) $1 000 000 Investment (TALCL) $1 000 000
EBIT $200 000 EBIT $200 000
These figures would give the following ratios.
$200 000 $200 000
ROI = = 20% ROI = = 20%
$1 000 000 $1 000 000
$200 000 $200 000
Operating profit margin = = 20% Operating profit margin = = 5%
$1 000 000 $4 000 000
$1 000 000 $4 000 000
Asset turnover = =1 Asset turnover = =4
$1 000 000 $1 000 000
The companies have the same ROI, but it is arrived at in very different ways. Company A operates with
a low asset turnover and a comparatively high operating profit margin whereas company B carries out
much more business, but on a lower operating profit margin. Company A could be operating at the
luxury end of the market, while company B may be operating at the popular end of the market.
Alternatively, company A and company B could be operating in different industry sectors.

2.4.2 RETURN ON ASSETS (ROA)

Return on assets (ROA) is another version of ROI. This ratio specifically examines the productivity of
non-current assets in generating sales, rather than the whole capital investment in the company (as
with ROI). It is calculated using average total assets, rather than total assets less current liabilities. The
statement of financial position of Furlong Co. shows total assets for 20X8 as $1 870 630 and total
assets for 20X7 as $1 664 425.

Formula to learn

Earnings before interest and tax

Return on assets (ROA) =  100%
Average total assets

In our example:
20X8 20X7
$360 245 $247 011
ROA = 20.3% = 14.8%
$1 767 527 $1 664 425
The average assets for 20X8 are calculated as: ((1 870 630 + 1 664 425)/2) = 1 767 527. In order to
calculate the average assets for 20X7 we would need to be given the 20X6 figures, for simplicity we
use the figure of $1,664,425 as the average for 20X7. In the exam make sure to look out for the
opening and closing figures to enable calculation of the average.
 374 | ANALYSIS OF FINANCIAL STATEMENTS

As before, the ratio can be analysed further:

Asset
Operating turnover
profit (average
margin total assets) ROA
(a) 20X8 $360 245 $3 095 576 $360 245
$3 095 576 $1 767 527 $1 767 527
11.6%  1.75 times = 20.3%
(b) 20X7 $247 011 $1 909 051 $247 011
$1 909 051 $1 664 425 $1 664 425
12.9%  1.14 times = 14.8%

Return on assets and asset turnover based on total assets are often used to assess the performance of
management as management are responsible for using the entity's assets to generate profit.
What is considered an acceptable return on assets depends upon the type of business and therefore
how many assets are recognised in the financial statements. For example, a manufacturer will have
(and will depend on) a high level of tangible assets (plant, machinery and factory buildings) to
generate revenue and profits. Other types of business, such as a service provider, will not. A service
provider relies on the expertise of its staff to generate profit. Human resources and intellectual capital
are intangible assets, but because they cannot be measured reliably they are not recognised as assets
in the statement of financial position. For this reason, ROA and asset turnover can be relatively
meaningless for some types of business such as information technology companies.
ROA can also be calculated for separate categories of assets. For example, many companies might
calculate a return on operating assets (normally property, plant and equipment).
Earnings before interest and tax
 100%
Tangible non - current assets
This measures the profit generated by the assets that are actually used to manufacture and/or sell
goods.

3 SOLVENCY

LO
6.1 Section overview
 Solvency is the availability of cash to meet longer term financial commitments as they fall
due.
Debt ratios are concerned with how much the company owes in relation to its size, whether it is
getting into more debt or repaying debt, and whether its debt burden seems heavy or light.
 When a company is heavily in debt, banks and other potential lenders may be unwilling to advance
further funds.
 When a company is earning only a modest profit before interest and tax, and has a heavy debt
burden, there will be very little profit left over for shareholders after the interest charges have been
paid. And so, if interest rates were to rise (on bank overdrafts and so on) or the company were to
borrow even more, it might soon be incurring interest charges in excess of EBIT. This might
eventually lead to the liquidation of the company.
These are two big reasons why companies should keep their debt burden under control. There are
two ratios that are particularly worth looking at, the gearing ratio and interest cover.

3.1 GEARING/LEVERAGE
Gearing or leverage is concerned with a company's long-term capital structure. Gearing represents
the proportion of the company's financing on which a return must be paid regardless of profitability.
 FINANCIAL ACCOUNTING AND REPORTING | 375

We can think of a company as consisting of non-current assets and net current assets (i.e. working
capital, which is current assets minus current liabilities). These assets must be financed by the
long-term capital of the company, which is one of two things:
 Issued share capital which can be divided into:
– Ordinary shares plus other equity (e.g. reserves)

MODULE 6
– Non-redeemable preference shares (unusual)
 Long-term debt including redeemable preference shares.
Redeemable preference share capital is normally classified as a non-current liability in accordance with
IAS 32 Financial Instruments: Presentation, and preference dividends (paid or accrued) are included in
finance costs in the statement of profit or loss and other comprehensive income.
The capital gearing ratio is a measure of the proportion of a company's capital that is debt. It is
measured as follows:

Formula to learn

Interest bearing debt

Gearing =  100%
Shareholders'equity+ interest bearing debt
Interest bearing debts refers to the sum of interest-bearing long-term and short-term debt such as
bonds, bank loans, bank overdraft, etc

There is no absolute limit to what a gearing ratio ought to be. A company with a gearing ratio of
more than 50 per cent is said to be highly geared (whereas low gearing means a gearing ratio of less
than 50 per cent). Many companies are highly geared, but if a highly geared company is becoming
increasingly highly geared, it is likely to have difficulty in the future when it wants to borrow even
more, unless it can also boost its shareholders' equity, either with retained profits or by a new share
issue.
Capital gearing measures gearing for the company as a whole. There are several variations in the way
that the gearing ratio can be calculated.

Formula to learn

Non-current assets + net current assets

Assets to equity ratio =  100%
Shareholders' equity

Interest bearing debt

Debt to total assets ratio =  100%
Total assets

The assets to equity ratio (also known as the equity multiplier) measures gearing from the viewpoint of
the equity investors. Gearing is one of the factors that influence the return they receive on their
investment.
The debt to total assets ratio is used to measure the extent to which a company's assets are financed
by debt, rather than by equity. When companies make major asset purchases, for example to build or
equip a new retail outlet, or to replace plant, they may need to raise finance specifically for this
purpose. Capital expenditure may be financed by a share issue, or by taking out a long-term loan, or
by a mixture of the two. Like return on assets (ROA), this ratio is most useful for a traditional type of
business which uses non-current assets to generate revenue. Where a company has financed its
operations with short-term borrowings, including bank overdrafts, the ratio is sometimes calculated as:
Total liabilities
Total assets
Note that gearing can also be looked at conversely, by calculating the proportion of total assets
financed by equity, and which may be called the equity to assets ratio. It is calculated as follows:
 376 | ANALYSIS OF FINANCIAL STATEMENTS

Formula to learn

Shareholders' equity
Equity to assets ratio =  100%
Non-current assets + net current assets
Shareholders' equity
or  100%
Total assets less current liabilities

In the example of Furlong, the company has a low gearing ratio. It has no preference share capital and
its only long-term debt is the 10 per cent loan stock. The assets to equity ratios are therefore high,
while the debt to total assets ratio is very low.
20X8 20X7

$100 000 $100 000

Gearing ratio =
$1 009 899 $768 769
= 9.9% = 13.0%
$1009 899 $768 769
Assets to equity =
$909 899 $668 769
= 1.11 times = 1.15 times
$100 000 $100 000
Debt to total assets =
$1870 630 $1664 425
= 5.3% = 6.0%
$909 899 $668 769
Equity to assets ratio =
$1 009 899 $768 769
= 90.1% = 87.0%

3.2 THE IMPLICATIONS OF HIGH OR LOW GEARING

Gearing or leverage is, among other things, an attempt to quantify the degree of risk involved in
holding share capital in a company, risk both in terms of the company's ability to remain in business
and in terms of expected ordinary dividends from the company. The problem with a highly geared
company is that, by definition, there is a lot of debt. Debt generally carries a fixed rate of interest (or
fixed rate of dividend if in the form of preference shares), hence there is a given (and large) amount to
be paid out from profits to holders of debt before arriving at a residue available for distribution to the
holders of equity. Consider this example:
Company A Company B Company C
$'000 $'000 $'000
Ordinary shares 600 400 300
Retained earnings 200 200 200
Revaluation reserve 100 100 100
900 700 600
6% preference shares (redeemable) – – 100
10% loan stock 100 300 300
Investment (capital employed) 1 000 1 000 1 000
Gearing ratio 10% 30% 40%
Equity to assets ratio 90% 70% 60%

Now suppose that each company makes a profit before interest and tax of $50 000, and the rate of tax
on company profits is 30 per cent. Amounts available for distribution to equity shareholders will be as
follows:
 FINANCIAL ACCOUNTING AND REPORTING | 377

Company A Company B Company C

$'000 $'000 $'000
Earnings before interest and tax 50 50 50
Interest/preference dividend 10 30 36
Taxable profit 40 20 14
Taxation at 30% 12 6 4
Profit for the period 28 14 10

MODULE 6
If in the subsequent year earnings before interest and tax falls to $40 000, the amounts available to
ordinary shareholders will become as follows:
Company A Company B Company C
$'000 $'000 $'000
Earnings before interest and tax 40 40 40
Interest/preference dividend 10 30 36
Taxable profit 30 10 4
Taxation at 30% 9 3 1
Profit for the period 21 7 3

Note the following:

Gearing ratio 10% 30% 40%
Equity to assets ratio 90% 70% 60%
Change in EBIT (20%) (20%) (20%)
Change in profit available for ordinary shareholders (25%) (50%) (70%)

The more highly geared the company, the greater the risk that little (if any) profit/funds will be
available to distribute by way of dividends to the ordinary shareholders. The example clearly
illustrates this fact. The more highly geared the company, the greater the percentage change in profit
available for ordinary shareholders for any given percentage change in profit before interest and tax.
The relationship similarly holds when profits increase, and if EBIT had risen by 20 per cent rather than
fallen, the largest percentage change in profit available for ordinary shareholders (this time an
increase) will be for the highly geared company. This means that there will be greater volatility of
amounts available for ordinary shareholders, and presumably therefore greater volatility in dividends
paid to those shareholders when a company is highly geared. That is the risk: shareholders in a
company that has high gearing may do extremely well or extremely badly without a particularly large
movement in the EBIT of the company.
The risk of a company's inability to remain in business was referred to earlier. Gearing or leverage is
relevant to this. A highly geared company has a large amount of interest to pay annually. If those
borrowings are 'secured' in any way then the holders of the debt are entitled to force the company
to sell secured assets to pay overdue interest. Clearly, the more highly geared a company the more
likely this is to occur when and if profits fall.

3.3 INTEREST COVER

The interest cover ratio shows whether a company is earning enough profits before interest and tax to
pay its interest costs comfortably, or whether its interest costs are high in relation to the size of its
profits, so that a fall in EBIT could have a significant effect on profits available for ordinary
shareholders.

Formula to learn

Earnings before interest and tax

Interest cover =
Interest charges

An interest cover of 2 times or less would be low, and should probably exceed 3 times before the
company's interest costs are considered within acceptable limits.
Returning to the example of Companies A, B and C we looked at in Section 3.2, the interest cover is as
follows:
 378 | ANALYSIS OF FINANCIAL STATEMENTS

Company A Company B Company C

(a) When EBIT was $50 000 = $50 000 $50 000 $50 000
$10 000 $30 000 $36 000
5 times 1.67 times 1.39 times
(b) When EBIT was $40 000 = $40 000 $40 000 $40 000
$10 000 $30 000 $36 000
4 times 1.33 times 1.11 times
Both B and C have a low interest cover, which is a warning to ordinary shareholders that their profits
and dividends are highly vulnerable to even small changes in EBIT.

Question 1: Interest cover

Returning to the example of Furlong, what is the company's interest cover, and what does this reveal?
(The answer is at the end of the module.)

4 LIQUIDITY AND EFFICIENCY

LO
6.1 Section overview
 The current and quick ratios reveal a company's ability to pay its debts as they fall due (its
liquidity). Efficient management of working capital revealed by efficiency ratios will
contribute to a healthy liquidity position.

Profitability is of course an important aspect of a company's performance and gearing or leverage is

another. Neither, however, addresses directly the key issue of liquidity.

Definition

Liquidity is the availability of sufficient funds to meet short-term financial commitments as they fall
due. Liquidity involves the management of liquid assets and short-term debt.

Liquid assets are:

 cash;
 short-term financial investments for which there is a ready market;
 trade receivables (because they will pay what they owe within a reasonably short period of time);
 inventories (if they are expected to be sold in a reasonably short period of time); and
 bills of exchange receivable (because like ordinary trade receivables, these represent amounts of
cash due to be received within a relatively short period of time).
In summary, liquid assets are current asset items that will or could soon be converted into cash,
and cash itself.
A company obtains liquid assets when it sells goods and services or non-current assets and when it
issues shares for cash or takes out a new loan. Clearly, a company cannot repeatedly sell non current
assets or keep on issuing shares and raising loans. To maintain liquid assets a company must make
sales revenue and profits. But profits do not always lead to increases in liquidity because funds
generated from trading may be immediately invested in non-current assets or paid out as dividends.
A company needs liquid assets to meet its debts when they fall due. Payments are continually made
for operating expenses and other costs, and there is a cash cycle from trading activities of cash
coming in from sales and cash going out for expenses.
 FINANCIAL ACCOUNTING AND REPORTING | 379

4.1 THE CASH CYCLE

To help you to understand liquidity ratios, it is useful to begin with a brief explanation of the cash
cycle. The cash cycle describes the flow of cash out of a business and back into it again as a result
of normal trading operations.
Cash goes out to pay suppliers, wages and salaries and other expenses. A business might hold

MODULE 6
inventory for a while and then sell it. Cash will come back into the business from sales. The main points
about the cash cycle are as follows:
 The timing of cash flows in and out of a business does not always coincide with the time when sales
and costs of sales occur. Cash outflows can be postponed by taking credit from suppliers. Cash
inflows can be delayed by giving credit to customers.
 The time between making a purchase and making a sale affects cash flows. If inventories are
held for a long time, the delay between the cash payment for inventory and cash receipts from
selling it will also be a long one.
 Holding inventories and having receivables can therefore be seen as two reasons why cash
receipts are delayed. Another way of saying this is that if a company invests in working capital, its
cash position will show a corresponding decrease.
 Similarly, taking credit from suppliers can be seen as a reason why cash payments are delayed.
The company's liquidity position will worsen when it has to pay the suppliers, unless it can get
more cash in from sales and receivables in the meantime.
The liquidity ratios and working capital turnover ratios are used to test a company's liquidity, length of
cash cycle, and investment in working capital.

4.2 LIQUIDITY RATIOS: CURRENT RATIO AND QUICK RATIO

The 'standard' test of liquidity is the current ratio.

Formula to learn

Current assets
Current ratio =
Current liabilities

The idea behind this is that a company should have enough current assets that give a promise of 'cash
to come' to meet its future commitments to pay off its current liabilities. Obviously, a ratio in excess
of 1 should be expected. Otherwise, there would be the prospect that the company might be unable
to pay its debts on time. In practice, a ratio comfortably in excess of 1 should be expected, but what is
'comfortable' varies between different types of businesses.
Companies are not always able to convert all current assets into cash quickly. In particular, some
manufacturing companies might hold large quantities of raw material inventories, which must be used
in production to create finished goods inventory. These might be warehoused for a long time, or sold
on lengthy credit. In such companies, inventories are not very 'liquid' assets, because the cash cycle is
so long. For these companies, we calculate an additional liquidity ratio, known as the quick ratio or
acid test ratio which ignores inventories.
The quick ratio, or acid test ratio, is calculated as follows:

Formula to learn

Current assets less inventory

Quick ratio (acid test ratio) =
Current liabilities

Both the current ratio and the quick ratio offer an indication of the company's liquidity position, but
the absolute figures should not be interpreted too literally. It is often theorised that an acceptable
current ratio is 1.5 and an acceptable quick ratio is 0.8, but these should only be used as a guide.
Different businesses operate in very different ways. A supermarket group for example, might have a
 380 | ANALYSIS OF FINANCIAL STATEMENTS

current ratio of 0.52 and a quick ratio of 0.17. Supermarkets have low receivables (supermarkets do not
give credit to customers), low cash (good cash management), medium inventories (high inventories
but quick turnover, particularly in view of perishability) and very high payables.
Compare this with a manufacturing and retail organisation, with a current ratio of 1.44 and a quick
ratio of 1.03. Such businesses operate with liquidity ratios closer to the standard.
What is important is the trend of these ratios. From this, it is easy to ascertain whether liquidity is
improving or deteriorating. If a supermarket has traded for the last 10 years (very successfully) with
current ratios of 0.52 and quick ratios of 0.17 then it should be supposed that the company can
continue in business with those levels of liquidity. If in the following year the current ratio fell to 0.38
and the quick ratio to 0.09, then further investigation into the liquidity situation would be appropriate.
It is the relative position that is far more important than the absolute figures.
Don't forget the opposing problem of having too much liquidity. A current ratio and a quick ratio can
get bigger than they need to be. A company that has large volumes of inventories or receivables or
idle cash might be over-investing in working capital, and tying up more funds in the business than it
needs to. This would suggest poor management of receivables (credit), inventories or cash by the
company.
Using our example (Furlong) above these ratios would be as follows:
20X8 20X7
Current ratio = 1 068 450/860 731 = 1 008 354/895 656
= 1.24 = 1.13
Acid test ratio = (1 068 450 – 64 422)/860 731 = (1 008 354 – 86 550)/895 656
= 1.17 = 1.03

4.3 EFFICIENCY RATIOS: CONTROL OF RECEIVABLES AND

INVENTORIES
A useful measure of the average length of time it takes for a company's customers to pay what they
owe is the accounts receivable collection period (receivables' days).

Formula to learn

The estimated average accounts receivable collection period is calculated as:

Trade receivables
Receivables' days =  365 days
Sales

The figure for sales should be taken as the sales revenue figure in the statement of profit or loss.
Ideally any cash sales should be excluded – this ratio should use credit sales – although in practice
this may be impossible. The trade receivables are not the total figure for receivables in the statement
of financial position, which includes prepayments and non-trade receivables. The trade receivables
figure will be itemised in an analysis of the receivable total, in a note to the financial statements.
The estimate of the accounts receivable collection period is only approximate because:
(a) The value of receivables in the statement of financial position might be abnormally high or low
compared with the 'normal' level the company usually has.
(b) Sales revenue in the statement of profit or loss is exclusive of sales taxes, but receivables in the
statement of financial position are inclusive of sales tax. We are not strictly comparing like with like.
Sales are usually made on 'normal credit terms' of payment within a stated number of days. A
collection period significantly in excess of this might be representative of poor management.
However, some companies must allow generous credit terms to win customers. Exporting companies
in particular may have to carry large amounts of receivables, and so their average collection period
might be long.
 FINANCIAL ACCOUNTING AND REPORTING | 381

The trend of the collection period over time is useful. If the collection period is increasing year on
year, this is probably indicative of a poorly managed credit control function (and potentially therefore
a poorly managed company).

4.4 ACCOUNTS RECEIVABLE COLLECTION PERIOD: EXAMPLES

MODULE 6
Using various types of company as examples, the collection period for each of the companies is as
follows.
Trade receivables Collection period Collection period
Company ( 365) Previous year ( 365)
Sales
$5 016 6 days $3 977 5 days
Supermarket = =
$284 986 $290 668
$458.3m 81 days $272.4m 78 days
Manufacturer = =
$2 059.5m $1 274.2m
Sugar refiner and
$304.4m 29 days $287.0m 31 days
seller = =
$3 817.3m $3 366.3m

The differences in collection period reflect the differences between the types of business.
Supermarkets have hardly any trade receivables at all, whereas manufacturing companies have far
more. The collection periods are fairly constant from the previous year for all three companies.

4.5 INVENTORY TURNOVER

Another useful ratio is the inventory turnover period (inventory days). This figure indicates the average
number of days that items of inventory are held. As with the average receivable collection period, it is
only an approximate figure, but one which is useful for comparing changes year on year.

Formula to learn

Inventory
Inventory turnover period =  365 days
Cost of sales

Inventory turnover can be calculated in terms of the number of times in a year that inventory is
replaced in the business (or 'turned over'). In this case the ratio is calculated as:

Formula to learn

Cost of sales
Inventory turnover =
Inventory

An inventory turnover period of five days would correspond to inventory turnover of 73 times. In other
words, inventory is sold and replaced every five days, or 73 times each year.
However inventory turnover is calculated, it is another measure of how vigorously a business is trading.
A lengthening inventory turnover period (or reducing inventory turnover) from one year to the next
indicates:
 a slowdown in trading; or
 a build-up in inventory levels, perhaps suggesting that the investment in inventories is becoming
excessive.
Generally the higher the inventory turnover the better, i.e. the lower the turnover period the better,
but several aspects of inventory holding policy have to be balanced:
 Lead times (the time between ordering and receiving goods);
 Seasonal fluctuations in sales;
 382 | ANALYSIS OF FINANCIAL STATEMENTS

 Alternative uses of warehouse space;

 Bulk buying discounts; and
 Likelihood of inventory perishing or becoming obsolete.

Worked Example: Inventory turnover period

The estimated inventory turnover periods for a supermarket are as follows:

Inventory turnover
period
Inventory
Company ( 365 days) Previous year
Cost of sales
$15 554K $14 094K
Supermarket  365 = 22 days  365 = 20 days
$254 571K $261 368K
Adding together the inventory turnover period and receivables collection period gives an indication of
how soon inventory is converted into cash. Both receivables collection period and inventory turnover
period therefore give us a further indication of the company's liquidity.
Using example of Furlong above:
20X8 20X7
Receivables days = 1 002 701 / 3 095 576  365 = 853 441 / 1 909 051  365
= 118 days = 163 days

Inventory days = 64 422 / 2 402 609  365 = 86 550 / 1 441 950  365
= 10 days = 22 days
Total = 128 days = 185 days

4.6 ACCOUNTS PAYABLE PAYMENT PERIOD

Another useful ratio is payables days. This figure indicates the average number of days credit taken
from suppliers. As with the average receivable collection period, it is only an approximate figure, but
one which is useful for comparing changes year on year.

Formula to learn

Accounts payable payment period (payables' days) is ideally calculated by the formula:
Trade accounts payable
× 365 days
Purchases

It is rare to find purchases disclosed in published financial statements but they can be approximated
as cost of sales plus increase (or minus decrease) in inventory.
For instance, we can calculate the 20X8 purchases of Furlong as (2 402 609 – (86 550 – 64 422))
= $2 380 481
This would give an accounts payable payment period of (627 018 / 2 380 481)  365 = 96 days.
The payables payment period helps to assess a company's liquidity; an increase is often a sign of lack
of long-term finance or poor management of current assets, resulting in the use of extended credit
from suppliers, increased bank overdraft and so on.
 FINANCIAL ACCOUNTING AND REPORTING | 383

Question 2: Liquidity and working capital

Calculate liquidity and working capital ratios from the financial statements of TEB Co., a business
which provides service support (cleaning) to customers worldwide. Comment on the results of your
calculations.
20X7 20X6

MODULE 6
$m $m
Sales revenue 2 176.2 2 344.8
Cost of sales 1 659.0 1 731.5
Gross profit 517.2 613.3

Current assets
Inventories 42.7 78.0
Receivables (note 1) 378.9 431.4
Short-term deposits and cash 205.2 145.0
626.8 654.4

Current liabilities
Loans and overdrafts 32.4 81.1
Tax on profits 67.8 76.7
Accruals 11.7 17.2
Payables (note 2) 487.2 467.2
599.1 642.2
Net current assets 27.7 12.2
Notes
1. Trade receivables 295.2 335.5
2. Trade payables 190.8 188.1
3. Inventories at the end of 20X5 were $83.5m

(The answer is at the end of the module.)

Question 3: Cash cycle

(a) Calculate the cash cycle for Moribund plc for 20X2 on the basis of the following information:
$
Inventory: raw materials 150 000
work in progress 60 000
finished goods 200 000
Purchases 500 000
Trade accounts receivable 230 000
Trade accounts payable 120 000
Sales 900 000
Cost of goods sold 750 000
Tutorial note: The cash cycle is calculated as inventory days plus receivables days minus payables
days.
(b) List the steps which might be taken in order to improve the cash cycle.
(The answer is at the end of the module.)
 384 | ANALYSIS OF FINANCIAL STATEMENTS

5 INVESTOR RATIOS

Section overview
 These are ratios which help equity shareholders and other investors assess the value and
quality of an investment in the ordinary shares of a company.

Relevant ratios are:

 earnings per share;
 dividend cover;
 price/earnings; and
 dividend yield.
The value of an investment in ordinary shares in a company listed on a stock exchange is its market
value, and investment ratios are based on information in the company's published financial statements
and knowledge of share prices.

5.1 EARNINGS PER SHARE

Earnings per share is the amount of profit before tax for the period that is attributable to each
ordinary share. The calculation can become rather complex, but these more complicated aspects are
outside the scope of the FAR syllabus. In its simplest form the calculation is:

Formula to learn

Profit attributable to ordinary shareholders

Earnings per share =
Number of ordinary shares on issue

where the profit attributable to ordinary shareholders is profit for the year. Earnings per share will rise
if profits increase or if there is a reduction in the number of ordinary shares.

5.2 DIVIDEND COVER

Formula to learn

Earnings per share

Dividend cover =
Dividend per (ordinary) share

This shows the proportion of profit for the year that is available for distribution to shareholders
that has been paid (or proposed) and the proportion retained in the business to finance future
growth. A dividend cover of 2 times would indicate that the company had paid 50 per cent of its
distributable profits as dividends, and retained 50 per cent in the business to finance future
operations. Retained profits are an important source of funds for most companies, therefore dividends
may only be a small proportion of available profits and so the dividend cover may be quite high.
A significant change in the dividend cover from one year to the next would be worth looking at
closely. For example, if a company's dividend cover were to fall sharply between one year and the
next, it could be that its profits had fallen, but the directors wished to pay at least the same amount of
dividends as in the previous year, to keep shareholder expectations satisfied.
Example: For Furlong, dividends in 20X8 were $20 000. Since there were 2.1m shares, dividends per
share would be 0.95c per share. No dividends were paid in 20X7.
20X8 20X7
Dividend cover = 12.8 / 0.95 N/A
= 13.5 times
 FINANCIAL ACCOUNTING AND REPORTING | 385

5.3 PRICE/EARNINGS (P/E) RATIO

Formula to learn

Current share price

The Price/Earnings (P/E) =
EPS

MODULE 6
A high P/E ratio indicates strong shareholder confidence in the company and its future, for example,
in profit growth, and a lower P/E ratio indicates lower confidence.
The P/E ratio of one company can be compared with the P/E ratios of:
 the same company but in previous accounting periods
 other companies in the same business sector
 other companies generally.

5.4 DIVIDEND YIELD

Dividend yield is the return a shareholder is currently expecting on the shares of a company.

Formula to learn

Dividend per share for the year

Dividend yield =  100%
Current market value of the share (ex-div)

 The dividend per share is taken as the dividend for the previous year.
 Ex-div means that the share price does not include the right to the most recent dividend.
Shareholders look for both dividend yield and capital growth. Dividend yield is therefore an
important aspect of a share's performance.

Question 4: Dividend yield

In the year to 30 September 20X8, an advertising agency declares an interim ordinary dividend of
7.4c per share and a final ordinary dividend of 8.6c per share. Assuming an ex-div share price of
315 cents, what is the dividend yield?
(The answer is at the end of the module.)

6 COMPREHENSIVE QUESTION

LO
6.1
Section overview
 The following question is not of the style that you will see in the Financial Accounting and
Reporting exam. It does, however, provide excellent practice in calculating relevant ratios
and thinking about what they mean.

Question 5: Ratios

The following information has been extracted from the recently published financial statements of DG.
EXTRACTS FROM THE STATEMENTS OF PROFIT OR LOSS TO 30 APRIL
20X9 20X8
$'000 $'000
Revenue 11 200 9 750
Cost of sales 8 460 6 825
Profit before tax 465 320
386 | ANALYSIS OF FINANCIAL STATEMENTS

20X9 20X8
$'000 $'000
This is after charging:
Depreciation 360 280
Loan note interest 80 60
Interest on bank overdraft 15 9
Audit fees 12 10

STATEMENTS OF FINANCIAL POSITION AS AT 30 APRIL

20X9 20X8
$'000 $'000 $'000 $'000
Assets
Non-current assets 1 850 1 430
Current assets
Inventory 640 490
Receivables 1 230 1 080
Cash 80 120
1 950 1 690
Total assets 3 800 3 120
Equity and liabilities
Equity
Ordinary share capital 800 800
Retained earnings 1 310 930
2 110 1 730
Non-current liabilities
10% loan stock 800 600
Current liabilities
Bank overdraft 110 80
Payables 750 690
Taxation 30 20
890 790
Total equity and liabilities 3 800 3 120

The following ratios are those calculated for DG, based on its published financial statements for the
previous year, and also the latest industry average ratios:
DG Industry
30 April 20X8 average
ROI (investment = equity and debentures) 16.70% 18.50%
Profit margin (EBIT/Sales) 4.00% 4.73%
Asset turnover 4.18 3.91
Current ratio 2.14 1.90
Quick ratio 1.52 1.27
Gross profit margin 30.00% 35.23%
Accounts receivable collection period 40 days 52 days
Accounts payable payment period 37 days 49 days
Inventory turnover (times) 13.93 18.30
Gearing 28.22% 32.71%
Required
(a) Calculate comparable ratios (to two decimal places where appropriate) for DG for the year ended
30 April 20X9. All calculations must be clearly shown.
(b) Write a report to the board of directors analysing the performance of DG, comparing the results
against the previous year and against the industry average.
(The answer is at the end of the module.)
 FINANCIAL ACCOUNTING AND REPORTING | 387

7 LIMITATIONS OF FINANCIAL ANALYSIS

LO
6.2 Section overview

MODULE 6
 Financial analysis, be it comparable company analysis with another company, trend analysis
over time or ratio analysis has a number of limitations. Many of these stem from the
limitations of the financial statements themselves.

7.1 LIMITATIONS OF FINANCIAL STATEMENTS

Financial statements are intended to give a fair presentation of the financial performance of an entity
over a period and its financial position at the end of that period. The IASB Conceptual Framework and
the IFRSs are there to ensure this. However, there are a number of reasons why the information in
financial statements should not just be taken at its face value.

7.1.1 PROBLEMS OF HISTORICAL COST INFORMATION

Historical cost information is reliable and can be verified, but it becomes less relevant as time goes by.
The value shown for assets in the statement of financial position at historical cost may bear no relation
whatever to their current value and what it may cost to replace them. The corresponding depreciation
charge will also be low, leading to the overstatement of profits in real terms.
This is particularly misleading when attempting to predict future performance or compare results with
those of a company with newer or revalued assets. In terms of predicting future performance, it could
be that a major asset will need to be replaced in two years time, at vastly more than the carrying
amount of the asset currently shown in the statement of financial position. This will then entail much
higher depreciation and interest payments (if a loan or lease is used). In addition, overstatement of
profit due to the low depreciation charge can lead to too much profit being distributed, increasing the
likelihood of new asset purchases having to be financed by loans. This information could not have
been obtained just from looking at the financial statements.
In a period of inflation, financial statements based on historic cost are subject to an additional
distortion. Sales revenue will be keeping pace with inflation and so will the cost of purchases.
However, using the FIFO method of valuing (and to some degree the weighted average method)
inventory being used will be valued at the earliest (and therefore cheapest) purchases. This leads to
understatement of cost of sales and overstatement of profits.

7.1.2 CREATIVE ACCOUNTING

Listed companies produce their financial statements while watching the stock market closely and,
where possible, they like to produce financial statements which show analysts what they are expecting
to see. For instance, a steady rise in profits, with no peaks or troughs is reassuring to potential
investors. Companies sometimes achieve this by delaying or advancing invoicing or manipulating cut-
offs or accruals. Directors who are paid performance bonuses will favour the steady rise (enough to
secure the bonus each year, rather than up one year, down the next) while those who hold share
options may be aiming for one spectacular set of results just before they sell.
An important aspect of improving the appearance of the statement of financial position is keeping
gearing as low as possible. Investors know that interest payments reduce the amount available for
distribution and potential lenders will be less willing to lend to a company which is already highly
geared.
 388 | ANALYSIS OF FINANCIAL STATEMENTS

A number of creative accounting measures are used to try to reduce gearing. Assets can be 'sold'
under a sale and leaseback agreement, which is in effect a disguised loan. And if all else fails, a last
minute piece of 'window dressing' can be undertaken. For instance, a loan can be repaid just before
the year end and taken out again at the beginning of the next year.

7.1.3 THE EFFECT OF RELATED PARTIES

Relationships and transactions with related parties are a normal feature of business. It is common for
entities to carry on activities with or through subsidiaries and associates, or occasionally to engage in
transactions with directors or their families. The point is that such transactions cannot be assumed to
have always been 'at arm's length' or in the best interests of the entity. Transfer pricing can be used to
transfer profit from one company to another and inter-company loans and transfers of non-current
assets can also be used in the same way.
IAS 24 Related Party Disclosures requires companies to disclose details of such transactions, but those
which wish to disguise a related party relationship can probably still find complex ways to do it (the
Enron scandal revealed the existence of numerous unfavourable related party transactions) and
financial statements do not show the unseen effects of such a relationship. For instance, a subsidiary
may not have been allowed to tender for a contract in competition with another group company. Its
shareholders will never know about such missed opportunities.

7.1.4 SEASONAL TRADING

This is another issue that can distort reported results. Many companies whose trade is seasonal
position their year end after their busy period, to minimise time spent on the inventory count. At this
point in time, the statement of financial position will show a healthy level of cash and/or receivables
and a low level of trade payables, assuming most of them have been paid. Thus the position is
reported at the moment when the company is at its most solvent. A statement of financial position
drawn up a few months earlier or later, when trade is slack but fixed costs still have to be paid, may
give a very different picture.

7.1.5 ASSET ACQUISITIONS

Major asset acquisitions just before the end of an accounting period can also distort results. The
statement of financial position will show an increased level of assets and corresponding liabilities
(probably a loan or lease payable), but the income which will be earned from utilisation of the asset
will not yet have materialised. This will adversely affect the company's return on investment.

7.2 ACCOUNTING POLICIES

Section overview
 The choice of an accounting policy and the effect of its implementation are almost as
important as its disclosure. The accounting policies adopted can have a significant impact
on the reported results of a company.

7.2.1 THE EFFECT OF CHOICE OF ACCOUNTING POLICIES

A choice is found in a number of areas of accounting, for example, the option to carry non-current
assets at historic cost or revalued amount. The choice made may distort the results of ratio analysis.
For example, a company which revalues its assets will have higher net assets and therefore lower ROI
than a company which does not. Such factors must be taken into account when performing
comparative analysis of two companies.
Where accounting standards allow alternative treatment of items in the financial statements, the
accounting policy note should declare which policy has been chosen. Being aware of this disclosure
helps to ensure that the results of any ratio analysis are meaningful.
 FINANCIAL ACCOUNTING AND REPORTING | 389

7.3 CHANGES IN ACCOUNTING POLICY

The effect of a change of accounting policy is treated as a prior year adjustment according to IAS 8
Accounting Policies, Changes in Accounting Estimates and Errors. This means that the comparative
figures are adjusted for the change in accounting policy for comparative purposes and an adjustment
is put through retained earnings.

MODULE 6
Under consistency of presentation in IAS 1 Presentation of Financial Statements, any change in
policy may only be made if it can be justified on the grounds that the new policy is preferable to the
one it replaces because it will give a fairer presentation of the result and of the financial position of a
reporting entity.
The problem with this situation is that the directors may be able to manipulate the results through
change(s) of accounting policies. This would be done to avoid the effect of an old accounting policy or
gain the effect of a new one. It is likely to be done in a sensitive period, perhaps when the company's
profits are low or the company is about to announce a rights issue. The management will have to
convince the auditors that the new policy was much better, but it is not difficult to produce reasons in
such cases.
The effect of such a change is very short term. Most analysts and sophisticated users will discount its
effect immediately, except to the extent that it will affect any dividend (because of the potential effect
on distributable property). It may also help to avoid breaches of banking covenants because of the effect
on certain ratios.
Obviously, the accounting policy for any item in the financial statements could only be changed once
in quite a long period of time. Auditors would not allow another change, even back to the old policy,
unless there was a wholly exceptional reason.
The managers of a company can choose accounting policies initially to suit the company or the type
of results they want to get. Any changes in accounting policy must be justified, but some managers
might try to change accounting policies just to manipulate the results.

7.4 LIMITATIONS OF RATIO ANALYSIS

The consideration of how accounting policies may be used to manipulate company results leads us to
some of the limitations of ratio analysis.
The most important ones are the following:
 In a company's first year of trading there will be no comparative figures. So there will be no
indication of whether or not a ratio is improving.
 Comparison against industry averages may not be very revealing. A business may be subject to
factors which are not common in the industry.
 Ratios based on historic cost accounts are subject to the distortions inherent in historic cost
accounting. In particular, undervalued assets will distort ROI and exaggerate gearing.
 Ratios are influenced by the choice of accounting policy. For instance, a company seeking to
maintain or increase its ROI may choose not to revalue its assets.
 Financial statements are subject to manipulation and so are the ratios based on them. Creative
accounting is undertaken with key ratios in mind.
 Inflation over a period will distort results and ratios. Profit before tax, and therefore ROI, can be
inflated where FIFO is applied during an inflationary period.
 No two companies, even operating in the same industry, will have the same financial and business
risk profile. For instance, one may have better access to cheap borrowing than the other and so
may be able to sustain a higher level of gearing.
 390 | ANALYSIS OF FINANCIAL STATEMENTS

7.5 OTHER ISSUES

Are there other issues which should be looked at when assessing an entity's performance? Factors to
consider are the following:
 How technologically advanced is it? If it is not using the latest equipment and processes it risks
being pushed out of the market at some point or having to undertake a high level of capital
expenditure.
 What are its environmental policies? Is it in danger of having to pay for cleanup if the law is
tightened? Does it appeal to those seeking 'ethical investment'?
 What is the reputation of its management? If it has attracted good people and kept them, that is a
positive indicator.
 What is its mission statement? To what degree does it appear to be fulfilling it?
 What is its reputation as an employer? Do people want to work for this company? What are its
labour relations like?
 What is the size of its market? Does it trade in just one or two countries or worldwide?
 How strong is its competition? Is it in danger of a takeover?
You can probably think of other factors that are important. In some cases you can also look at the
quality of the product that a company produces.
 FINANCIAL ACCOUNTING AND REPORTING | 391

KEY MODULE POINTS

 Financial analysis requires the financial statements and ratios of a company to be compared, for
example, with industry averages.

MODULE 6
 Comparable company analysis is a comparison of one company's financial statements with those of
another similar company and consideration of the differences.
 Trend analysis is a comparison of the financial statements of one company with those of the
previous year or years.
 Ratio analysis is the practice of analysing amounts reported within the financial statements to
calculate further values which add to the findings of comparable company analysis or trend
analysis.
 Ratios can be grouped into four categories: profitability, solvency, liquidity/efficiency, and investor
ratios.
 Profitability ratios include return on investment (ROI), return on assets (ROA), return on equity
(ROE), profit margins and asset turnover.
 ROI, ROA and ROE show how well investment (capital employed) is used to generate profits and
may be used by the shareholders or the Board to assess the performance of management.
 Solvency is the ability of a company to manage its debt burden in the long run.
 Solvency ratios include gearing, assets to equity, debt to total assets and interest cover.
 Liquidity ratios include the quick and current ratios (and represent short-term management of
debt).
 Efficiency ratios include receivables' days, inventory days and payables' days.
 The current and quick ratios reveal a company's ability to pay its debts as they fall due (its liquidity).
Efficient management of working capital revealed by efficiency ratios will contribute to a healthy
liquidity position.
 Investor ratios include earnings per share, dividend cover, price/earnings ratio and dividend yield.
 Financial statements and any analysis of them are affected by the obvious shortcomings of historic
cost information and are also subject to manipulation.
 The accounting policies adopted can have a significant impact on the reported results and ratios of
a company.
392 | ANALYSIS OF FINANCIAL STATEMENTS

QUICK REVISION QUESTIONS

1 An entity wishes to increase its return on investment (ROI). Which of the following courses of action
will help to achieve this in the short term?
A Increase sales
B Issue ordinary shares
C Revalue land and buildings
D Increase the level of dividends paid to equity shareholders

2 The following information relates to M at 31 December 20X3:

$'000
Trade receivables 80
Current asset investments (cash on deposit) 10
Trade payables 75
Bank overdraft 100
The entity has decided to take the following steps to reduce the overdraft.
1. Inventory with a book value of $8000 will be sold at a loss of $2000.
2. Customers will be offered a cash discount of 10 per cent for immediate payment. Customers
owing amounts with a total book value of $20 000 are expected to take advantage of this offer.
In return, the entity's bankers have agreed to make a loan of $40 000, which will be used
immediately to purchase new machinery. The loan will be repayable in five equal instalments, the
first of which falls due on 31 December 20X4.
Assuming that all the above transactions take place on 31 December 20X3, what is the revised
quick (acid test) ratio on that date?
A 0.39:1
B 0.44:1
C 0.46:1
D 0.51:1

3 Z has a current ratio of 1.5, a quick ratio of 0.4 and a positive cash balance. If it purchases inventory
on credit, what is the effect on these ratios?
Current ratio Quick ratio
A Increase Increase
B Decrease Increase
C Increase Decrease
D Decrease Decrease

4 KL has the following capital and reserves at 31 December 20X9:

$'000
Ordinary shares 300
8% irredeemable preference shares 100
Retained earnings 150
550

KL also had $200 000 10 per cent loan notes on issue throughout the year. Retained profit for the
year was $20 000 after paying the preferred dividend and an ordinary dividend of $7500.
What was the return on equity for the year ended 31 December 20X9?
A 5.0 per cent
B 6.1 per cent
C 6.7 per cent
D 9.2 per cent
 FINANCIAL ACCOUNTING AND REPORTING | 393

5 The accounting ratios of ABC are very similar to the average ratios for the industry in which it
operates. ABC has an average operating profit margin of 24 per cent and an average asset
turnover of 0.9.
This entity is likely to be:
A an architect.

MODULE 6
B a food retailer.
C a manufacturer.
D an insurance broker.

6 An entity has the following capital structure.

$'000
Ordinary shares 100 000
10% Redeemable preference shares 50 000
Retained earnings 80 000
230 000
12% loan notes 100 000
330 000

What is the gearing ratio?

A 30.3 per cent
B 43.5 per cent
C 45.5 per cent
D 83.3 per cent

7 X's asset turnover is very low compared with that of its main competitor.
What could be the reason for this?
A X has a smaller proportion of productive assets than its competitor.
B X has recruited a number of additional production staff during the year.
C X embarked on a major program of capital investment towards the end of the previous year.
D X carries its non-current assets at historic cost, while its competitor carries them at current value.

8 The following information relates to an entity.

$'000
Credit sales for the year ended 31 December 20X6 5600
Credit purchases for the year ended 31 December 20X6 4500
Trade receivables at 31 December 20X6 690
Trade payables at 31 December 20X6 250
The entity's cash cycle has been calculated at 105 days.
How much inventory did the entity hold at 31 December 20X6 (to the nearest thousand dollars)?
A $493 000
B $614 000
C $986 000
D $1 227 000
394 | ANALYSIS OF FINANCIAL STATEMENTS

9 Information from the statement of financial position of MNO has been expressed as percentages
of total assets less current liabilities:
%
Land and property 78
Other non-current assets 19
Inventories and work in progress –
Trade receivables 459
Cash/short-term investments 89
645
Bank overdraft (5)
Trade payables (540)
Total assets less current liabilities 100
In which of the following industries could MNO be operating?
A Retailing
B House building
C Manufacturing
D Insurance broking
10 ST, UV and WX are listed entities operating in the same business sector. At 31 October 20X6, their
P/E ratios were reported as follows:
ST 16.2
UV 12.7
WX 8.4
Which of the following statements about these P/E ratios is correct?
The P/E ratios suggest that
A ST has the highest earnings per share of the three entities.
B ST is regarded by the market as the riskiest of the three entities.
C UV represents the safest investment because its P/E lies approximately midway between the
other two.
D WX's share price may be relatively lower than that of ST and UV because of an adverse effect
such as a profit warning.

11 GG Co has the following balances in its financial statements:

$
Receivables 158 000
Inventories 20 000
Short-term investments 18 000
Trade payables 61 000
Bank overdraft 64 000
Income tax payable 10 000
Deposits received in advance 5 000
What is the quick ratio of GG Co given the information in the table?
A 1.13:1
B 1.26:1
C 1.35:1
D 1.40:1

12 A reduction in which of the following items will result in an increase in the length of a company’s
cash cycle?
A Receivables collection period
B Inventory holding period
C Payables payment period
D Time taken to produce goods
 FINANCIAL ACCOUNTING AND REPORTING | 395

13 In the year to 31 December 20X9 BK Co pays an interim equity dividend of 3.4c per share and
declares a final equity dividend of 11.1c. It has 5 million $1 shares in issue and the ex div share price
is $3.50.
What is the dividend yield?
A 4%

MODULE 6
B 24%
C 3.2%
D 4.1%
14 SS Co has an asset turnover of 2.0 and an operating profit margin of 10%. It is launching a new
product which is expected to generate additional sales of $1.6 million and additional profit of
$120,000. It will require additional assets of $500,000.
Assuming there are no other changes to current operations, how will the new product affect
operating profit margin and return on investment (ROI)?
Operating profit margin Return on investment (ROI)
A Increase Increase
B Decrease Increase
C Increase Decrease
D Decrease Decrease
15 TH Co carries its property at revalued amount. Property values have fallen during the current
period and an impairment loss has been recognised on the property, however its carrying amount
is still higher than its depreciated historical cost.
Assuming there are no other changes to current operations, how will the impairment affect the
return on investment (ROI) and gearing ratios of TH?
Return on investment (ROI) Gearing
A Increase Increase
B Decrease Increase
C Increase Decrease
D Decrease Decrease
16 Which of the following is a possible reason why a company's inventory holding period increases
from one year to the next?
A An increase in demand for its products
B A reduction in selling prices
C Obsolete inventory lines
D Seasonal fluctuations in orders
17 Which of the following measures will not reduce the level of a company’s gearing?
A Renegotiating a loan to secure a lower interest rate
B Treating a lease as a short-term rental agreement
C Repaying a loan just before the year end and taking it out again at the beginning of the next
year
D 'Selling' an asset under a sale and leaseback agreement
18 JF Co's return on capital employed has deteriorated as compared to the previous year.
Which of the following choices is not a possible reason for this decline?
A The company revalued its properties which resulted in a significant increase in the carrying
value as compared to three years ago.
B Towards the end of the current year JF made major investments in plant and machinery
financed by interest-bearing borrowing.
C JF issued $1 million 10% loan notes to redeem $1 million redeemable preference shares at par.
D Asset turnover has reduced as compared to the previous year.
396 | ANALYSIS OF FINANCIAL STATEMENTS

19 Analysis of the statement of financial position of DC Co. reveals the following ratios:
Current ratio 2:1
Revenue: current assets 5:1
Acid-test ratio 1.5:1
If revenue for the year was $30 million, what is the value of inventory that will appear in the
statement of financial position?
A $1.5m
B $3.0m
C $4.5m
D $10.5m
20 What would be the immediate effect on an entity's P/E ratio and dividend yield of an
announcement which caused a substantial rise in the share price?
P/E ratio Dividend yield
A Increase Increase
B Decrease Increase
C Increase Decrease
D Decrease Decrease
21 Which of the following ratios would be the least appropriate to calculate for a supermarket?
A Gross margin
B Receivable days
C Payable days
D Return on investment
22 RT Co. has an operating profit margin of 8% in 20X9 compared with 5% in 20X8.
Which of the following might explain this increase?
A RT Co. increased its sales during the year, by offering better discounts to its customers.
B RT Co. moved to an out-of-town office location where rent and employment costs were lower
than they were in 20X8.
C Year end market research focused on public awareness of the company's product range
indicates that the brands contained in closing inventory are more likely to sell this year than last.
D RT Co. restructured its long-term finance during 20X9, managing to reduce its finance cost.
23 Which of the following ratios would best assess the efficiency of a manufacturing company?
A P/E ratio
B Gearing
C Non-current asset turnover
D Current ratio
24 Which ratio does the following statement relate to?
'This ratio is a measure of the market's confidence in the future of an entity.'
A Dividend yield
B Earnings per share
C Return on capital employed
D P/E ratio
25 Which of the following is not a valid limitation of ratio analysis of published financial statements?
A Published financial statements contain estimates such as depreciation.
B There are no prior year figures to compare to current year figures.
C Accounting policies may vary between companies, making comparisons difficult.
D The nature and character of a business may change over time, making strictly numerical
comparisons misleading.
 FINANCIAL ACCOUNTING AND REPORTING | 397

ANSWERS TO QUICK REVISION QUESTIONS

1 A An increase in sales will probably lead to an increase in earnings before interest and tax
(sometimes called operating profit). There will be no increase in investment (net assets or

MODULE 6
capital employed).
Issuing ordinary shares (option B) increases net assets and decreases ROI in the short term,
although the issue proceeds can be used to generate additional profit and this may help to
increase ROI in the longer term. Revaluing land and buildings upwards (option C) decreases
ROI, because it increases net assets and reduces profits. Increasing the level of dividends
(option D) has no effect on ROI.
70 000
2 B Quick ratio: = 0.44: 1
159 000
$'000
Assets as stated (80 + 10) 90
Less customers taking advantage of discount (20)
70
Liabilities as stated (75 + 100) 175
Cash received from sale of inventory (8 – 2) (6)
Cash received from trade receivables (20  90%) (18)
Current portion of new loan (40 / 5) 8
159
3 D Example: suppose the entity purchases inventory worth $300 000:
Current ratio Quick ratio
Before 1 500 400
=1.5 = 0.4
1 000 1 000
After 1800 400
=1.4 = 0.3
1300 1300

Profit available to equity shareholders

4 B
Shareholders' equity
20 + 7.5
= 6.1%
300 + 150
5 C ABC has a relatively high operating profit and a relatively low asset turnover. This suggests that
it is capital intensive. A and D would not normally have high levels of non-current assets. B is
more likely to have significant non-current assets, but this type of business normally has low
operating profit share margins. Therefore, option C is the most likely option.
Interest bearing debt 100 + 50
6 C = = 45.5%
Shareholders'equity + interest bearing debt 330
7 C D and A are both likely to result in increased sales revenue relative to investment (capital
employed) and therefore in increased asset turnover. B is irrelevant.
Trade receivables 690
8 C Receivables collection period =  365 = 45 days
Sales 5600
Trade payables 250
Payables payment period =  365 = 20 days
Cost of sales 4500
If the cash cycle is 105 days, inventories turnover must be 80 days (105 + 20 – 45).
Inventories 80
Inventories turnover is so inventories are  4500 = $986 000
Cost of sales 365
398 | ANALYSIS OF FINANCIAL STATEMENTS

9 D MNO has no inventories, moderate levels of land and property, low levels of other non-current
assets and very high trade receivables and trade payables. This suggests that MNO operates in
a service industry. An insurance broker is the only one of the four that fits this profile.
10 D The P/E ratio provides indication of market confidence in an entity, not risk therefore both A
and C are incorrect. The ratio is calculated as price per share/earnings per share and therefore
without the share price of each entity it is impossible to decide whether B is correct. D is correct
as a low P/E may be due to a low share price.
11 B 1.26:1
(Receivables + short-term investments) are divided by (trade payables, overdraft, taxes payable
+ deposits in advance):(158,000 + 18,000)/(61,000 + 64,000 + 10,000 + 5,000) = 1.26
12 C Reducing the payables payment period will increase the length of a company's cash cycle, as
cash is being paid out more quickly. The other options will all speed up the cash cycle.
13 D 4.1%
(Dividends (3.4c + 11.1c) / Share price) × 100% = (14.5c / 350c) × 100% = 4.1%
14 B The new product will have an operating profit margin of 120 / 1,600 = 7.5%, so will reduce the
current margin of 10%. It will have an ROI of 120 / 500 = 24%, higher than the current 20%.
15 A The effect of this impairment will increase the ROI ratio of TH Co, and increase its gearing ratio.
Capital employed (assets) would decrease, increasing ROI. The impairment loss will reduce
equity(revaluation surplus) and so increase gearing.
16 C Obsolete inventory lines. Obsolete goods can lead to a build-up of unsold inventory, thereby
increasing the holding period. A reduction in selling price or an increase in demand could
increase sales leading to a fall in the holding period. Seasonal fluctuations will change the
holding period throughout the year, but should not affect the year on year picture.
17 A Renegotiating a loan to secure a lower interest rate will have no effect on gearing as the debt
amount will still be the same.
18 C Where loan notes are issued to replace shares and vice versa will have no impact on operating
profits or total capital employed and will therefore have no impact.
Revaluations decrease profits and increase capital employed and will therefore decrease return
on capital employed.
A year end investment in plant and machinery financed through additional capital will increase
the capital employed without increasing profits in the current year, and will therefore reduce
ROI.
ROI can be expressed as: asset turnover x operating margin. Therefore, when asset turnover
falls, this causes ROI to decrease.
19 A $1.5m
Revenue: current assets = 5:1
Therefore current assets = $30m/5 = $6m
Current ratio (current assets: current liabilities) = 2:1
Therefore current liabilities = $6m/2 = $3m
Acid test ratio (current assets – inventory: current liabilities) = 1.5:1
Therefore current assets – inventory = $3m × 1.5 = $4.5m
Hence, inventory = $6m – $4.5m = $1.5m
20 C P/E ratio = current market price per share/EPS so an increase in share price will cause the P/E
ratio to increase
Dividend yield = dividend per share/market price per share  100 so an increase in share price
will cause the dividend to fall.
21 B Receivable days – supermarkets do not offer customers a credit period. Immediate payment is
required on checkout. Therefore, there will be few trade receivables making receivable days a
pointless ratio to calculate.
 FINANCIAL ACCOUNTING AND REPORTING | 399

22 B RT Co. moved to an out-of-town office location where rent and employment costs were lower
than they were in 20X8.
Rent and employment are both operating costs, so reducing them would improve the operating
margin.
Interest is a finance cost, and would not be included within operating profit.

MODULE 6
Increasing the trade discounts offered would actually reduce the operating margin because it
would increase the cost of discounts allowed.
Increased public awareness of the company might help to explain e.g. a higher level of sales
activity, but this would not have any impact on the operating profit margin.
23 C Non-current asset turnover
A manufacturing company will have high assets (factory, plant and machinery, inventories etc.).
Therefore non-current asset turnover (sales/non-current assets) will be a measure of how
efficiently an entity is using its non-current assets to generate revenue.
24 D P/E ratio
The P/E ratio is a measure of the market confidence in the future of an entity. Gearing relates to
long-term solvency and the current ratio relates to liquidity.
25 B There are no prior year figures to compare to current year figures is incorrect because in
published financial statements comparatives must be shown.
400 | ANALYSIS OF FINANCIAL STATEMENTS

ANSWERS TO MODULE QUESTIONS

1 20X8 20X7
EBIT 360 245 247 011
Interest payable 18 115 21 909
= 20 times = 11 times
Furlong has more than sufficient interest cover. In view of the company's low gearing, this is not
too surprising and so we finally obtain a picture of Furlong as a company that does not seem to
have a debt problem.
2
20X7 20X6
Current ratio 626.8 654.4
= 1.05 = 1.02
599.1 642.2
Quick ratio 584.1 576.4
= 0.97 = 0.90
599.1 642.2
Accounts receivable 295.2 335.5
collection period  365 = 50 days  365 = 52 days
2 176.2 2 344.8
Inventory turnover period 42.7 78.0
 365 = 9 days  365 = 16 days
1 659.0 1 731.5
Accounts payable 190.8 188.1
payment period  365 = 43 days  365 = 40 days
1 623.7 1 726

Since cost of sales = opening inventories plus purchases less closing inventories, purchases = cost
of sales less opening inventories plus closing inventories. For 20X7 purchases = 1659 – 78 + 42.7 =
1623.7. For 20X6 purchases = 1731.5 – 83.5 + 78 = 1726.
The company's current ratio is a little lower than average but its quick ratio is better than average
and slightly less than the current ratio. This suggests that inventory levels are strictly controlled,
which is reinforced by the low inventory turnover period. It would seem that working capital is
tightly managed, to avoid the poor liquidity which could be caused by a long receivables collection
period and comparatively high payables.
The company in the exercise is a service company and hence it would be expected to have low
inventory and a short inventory turnover period. The similarity of receivables collection period and
payables payment period means that the company is passing on most of the delay in receiving
payment to its suppliers.
3 (a) The cash cycle can be found as follows:
Inventory
Inventory turnover period = × 365 days
Cost of sales
plus
Trade receivables
Receivables' days = × 365 days
Sales
less
Trade accounts payables
Accounts payable payment period (payables' days) = × 365 days
Purchases
 FINANCIAL ACCOUNTING AND REPORTING | 401

20X2
Total closing inventory ($) 410 000
Cost of goods sold ($) 750 000
Inventory turnover period 199.5 days
Closing receivables ($) 230 000
Sales ($) 900 000

MODULE 6
Receivables collection period 93.3 days
Closing payables ($) 120 000
Purchases ($) 500 000
Payables payment period (87.6 days)
Length of cash cycle (199.5 + 93.3  87.6) 205.2 days

(b) The steps that could be taken to reduce the cash cycle include the following:
(i) Reducing the raw material inventory turnover period.
(ii) Reducing the time taken to produce goods. However, the company must ensure that quality
is not sacrificed as a result of speeding up the production process.
(iii) Increasing the period of credit taken from suppliers. The credit period already seems very
long – the company is allowed three months' credit by its suppliers, and probably could not
be increased. If the credit period is extended then the company may lose discounts for
prompt payment.
(iv) Reducing the finished goods inventory turnover period.
(v) Reducing the receivables collection period. The administrative costs of speeding up debt
collection and the effect on sales of reducing the credit period allowed must be evaluated.
However, the credit period does already seem very long by the standards of most industries.
It may be that generous terms have been allowed to secure large contracts and little will be
able to be done about this in the short term.
4 The total dividend per share is (7.4 + 8.6) = 16 cents
16
× 100 = 5.1%
315
5 (a)
Industry
20X9 20X8 average
ROI 465 + 80 + 15 320 + 60 + 9
= 19.24% = 16.7% 18.5%
3 800 – 890 3 120 – 790
Profit margin 465 + 80 + 15 320 + 60 + 9
(EBIT/Sales) = 5.0% = 4.0% 4.7%
11 200 9 750
Asset turnover 11 200 9 750
= 3.85 × = 4.18 × 3.91 ×
3 800 – 890 3 120 – 790
Current ratio 1 950 1 690
= 2.19  = 2.14  1.90
890 790
Quick ratio 1 230 + 80 1 080 +120
= 1.47  = 1.52  1.27
890 790
Gross profit 11 200 – 8 460 9 750 – 6 825
margin = 24.46% = 30.0% 35.2%
11 200 9 750
Accounts 1 230 1 080
× 365 = 40 days × 365 = 40 days 52 days
receivable
11 200 9 750
collection period
402 | ANALYSIS OF FINANCIAL STATEMENTS

Industry
20X9 20X8 average
Accounts payable 750 690
payment period * × 365 = 32 days × 365 = 37 days 49 days
8 610 6 825
Inventory turnover 8 460 6 825
(times) = 13.22 × = 13.93 18.30 ×
640 490
Gearing 800 + 110 600 + 80
= 30.13% = 22.59% 32.7%
2 110 + 800 + 110 1730 + 600 + 80

* For 20X9 purchases are calculated as (8460 + (640 – 490)). The 20X8 ratio uses cost of sales as
we are unable to calculate the movement in inventory between 20X7 and 20X8.
(b) (i) REPORT
To: Board of directors
From: Accountant Date: XX/XX/XX
Subject: Analysis of performance of DG
This report should be read in conjunction with the appendix attached which shows the
relevant ratios (from part (a)).
Trading and profitability
Return on investment (return on capital employed) has improved considerably between 20X8
and 20X9 and is now higher than the industry average.
Profit after tax as a proportion of sales has also improved noticeably between the years and
is also now marginally ahead of the industry average. Gross margin, however, is considerably
lower than in the previous year and is only some 70 per cent of the industry average. This
suggests either that there has been a change in the cost structure of DG or that there has
been a change in the method of cost allocation between the periods. Either way, this is a
marked change that requires investigation. The company may be in a period of transition as
sales have increased by nearly 15 per cent over the year and it would appear that new non-
current assets have been purchased.
Asset turnover has declined between the periods although the 20X9 figure is in line with the
industry average. This reduction might indicate that the efficiency with which assets are used
has deteriorated or it might indicate that the assets acquired in 20X9 have not yet fully
contributed to the business. A longer term trend would clarify the picture.
(ii) Liquidity and working capital management
The current ratio has improved slightly over the year and is marginally higher than the
industry average. It is also in line with what is generally regarded as satisfactory (2:1).
The quick ratio has declined marginally but is still better than the industry average. This
suggests that DG has no short-term liquidity problems and should have no difficulty in
paying its debts as they become due.
Receivables as a proportion of sales is unchanged from 20X8 and are considerably lower
than the industry average. Consequently, there is probably little opportunity to reduce this
further and there may be pressure in the future from customers to increase the period of
credit given. The period of credit taken from suppliers has fallen from 37 days' purchases to
32 days' and is much lower than the industry average; thus, it may be possible to finance any
additional receivables by negotiating better credit terms from suppliers.
Inventory turnover has fallen slightly and is much slower than the industry average and this
may partly reflect stocking up ahead of a significant increase in sales. Alternatively, there is
some danger that the inventory could contain certain obsolete items that may require
writing off. The relative increase in the level of inventory has been financed by an increased
overdraft which may reduce if the inventory levels can be brought down.
 FINANCIAL ACCOUNTING AND REPORTING | 403

The high levels of inventory, overdraft and receivables compared to that of payables
suggests a labour intensive company or one where considerable value is added to bought-in
products.
(iii) Gearing
The level of gearing has increased over the year and is below the industry average. Since the

MODULE 6
return on investment is nearly twice the rate of interest on the loan stock, profitability is likely
to be increased by a modest increase in the level of gearing.
Signed: Accountant
404 | ANALYSIS OF FINANCIAL STATEMENTS
 405

REVISION QUESTIONS
406 | REVISION QUESTIONS
 FINANCIAL ACCOUNTING AND REPORTING | 407

MODULE 1

1 Which of the following are correct?

I. The term 'reporting entity' may be used to describe a group of companies.
II. The principal function of financial statements is to provide information to parties external to a
business.
III. The main purpose of financial reporting is to provide information aimed at running a business
more efficiently.

A I and II only
B I and III only
C II and III only
D I, II and III
2 Which of the following groups of users of accounts is interested primarily in the liquidity of a
company?
A Suppliers
B The government
C The management
D The tax authorities
3 Consider the following two statements:
I. The IASB operates a rules-based system of setting accounting standards.
II. The US FASB operates a principles-based system of setting accounting standards.
Which of these statements are correct?
A I only
B II only
C Both I and II
D Neither I nor II
4 Which bodies does the IFRS Foundation oversee?
A IASB and the Monitoring Board
B IASB and IFRS Interpretations Committee only
C IFRS Interpretations Committee and IFRS Advisory Council
D IFRS Advisory Council, IASB and IFRS Interpretations Committee
5 Which of the following is not a role of the IFRS Advisory Council?
A To consult on all major IASB projects
B To issue International Financial Reporting Standards
C To advise on the prioritisation of the work of the IASB
D To comment on the implications of the work of the IASB on users of financial statements
6 Consider the following two statements:
I. The Australian Accounting Standards Board (AASB) has adopted the content of IFRS with some
minor changes.
II. Both Australian companies' legislation and IFRS allow an entity to depart from the requirements
of an IFRS in exceptional circumstances.
Which of these statements are correct?
A I only
B II only
C Both I and II
D Neither I nor II
408 | REVISION QUESTIONS

7 According to the Conceptual Framework for Financial Reporting, information about an entity's
financial performance helps users to understand:
I. the entity's needs for additional finance.
II. the entity's financing and investing activities.
III. the efficiency and effectiveness of management.
IV. the return that the entity has produced on its economic resources.
A IV only
B III and IV only
C I and III only
D I and II only
8 Which of the following is not a chapter in the IASB's Conceptual Framework?
A Financial statements and the reporting entity
B Concepts and conventions
C The elements of financial statements
D Recognition and derecognition
9 Consider the following statements:
I. The IASB's Conceptual Framework underpins the preparation of financial statements; when an
IFRS conflicts with the framework, the framework guidance should be followed.
II. One of the purposes of the IASB's Conceptual Framework is to assist the IASB to develop IFRS
that are based on consistent concepts.
Which of the statements is correct?
A I only
B II only
C Both I and II
D Neither I nor II
10 What is shown by an entity's economic resources and the claims against it?
A Its operations
B Its financial position
C Its ownership interest
D Its financial performance
11 Why is information about a reporting entity's net cash flows helpful to users?
A It helps them to predict future cash flows.
B It helps them to assess the stewardship of management.
C It helps them to understand the claims against the entity.
D It helps them to understand the entity's financial performance.
12 Which of the following statements is/are correct?
I. An entity can only change an accounting policy if this is required by an accounting standard.
II. A change in accounting policy is always applied prospectively, so that the effect of the change
is recognised in the current period.

A I only
B II only
C I and II
D Neither I nor II
13 The underlying assumption in preparing and using general purpose financial reports is:
A accruals.
B materiality.
C going concern.
D substance over form.
 FINANCIAL ACCOUNTING AND REPORTING | 409

14 Consider the following statements:

I. Accounting standards are not retrospective.
II. Accounting standards are applied to all items in the financial statements.
Which statements are correct?
A I only
B II only
C Both I and II
D Neither I nor II
15 The two fundamental qualitative characteristics of useful financial information are:
A relevance and verifiability.
B verifiability and timeliness.
C faithful representation and relevance.
D faithful representation and timeliness.
16 Which of the following qualities are required to achieve a faithful representation of economic
phenomena?
I. Error free
II. Neutrality
III. Verifiability
IV. Comparability
V. Completeness
A I, II and III only
B I, II and V only
C I, III and V only
D II, IV and V only
17 Which of the following statements is/are correct?
I. Departure from an IFRS is allowed only where approved by the IASB.
II. In the case of a true and fair override the financial impact of the departure from IFRS should be
disclosed.
A I only
B II only
C I and II
D Neither I nor II
18 Which of the following is the correct definition of equity?
A The residual interest in the assets of the entity after deducting all its liabilities
B A present obligation arising from past events from which future economic benefits are expected
to flow to the entity
C A resource controlled by an entity as a result of past events and from which future economic
benefits are expected to flow to the entity
D A present obligation arising from past events, the settlement of which is expected to result in an
outflow of resources embodying economic benefits
19 Consider the following statements:
I. A provision is a liability for which the amount is an estimate.
II. A provision should not be recognised in the financial statements.
Which of the statements are correct?
A I only
B II only
C Both I and II
D Neither I nor II
410 | REVISION QUESTIONS

20 Consider the following statements:

I. Gains from revaluation of non-current assets are recognised in profit or loss.
II. Gains from the sale of non-current assets are not recognised in profit or loss.
Which of the statements are correct?
A I only
B II only
C Both statements
D Neither statement
21 Which of the following, taken together, would make up the working capital of a business?
A inventory, equity, cash at bank, receivables
B receivables, bank loan, payables, inventory
C payables, receivables, inventory, cash at bank
D inventory, bank loan, cash at bank, prepayments
22 Which of the following would appear in the statement of financial position as a current liability?
A Sales tax owing
B Employee wages paid
C Prepayments of expenses
D Revaluation surplus on a non-current asset
23 Which of the following should be recognised as an asset in the statement of financial position
according to the definition of an asset and recognition criteria provided in the Conceptual
Framework?
A A football player acquired on a contract for a transfer fee
B An amount spent on investigating the healing powers of an Amazonian plant
C An amount spent on training staff which is expected to result in increased productivity
D An amount spent on advertising that is expected to result in increased sales for the next three
years
 FINANCIAL ACCOUNTING AND REPORTING | 411

MODULE 2

1 What type of cost does the following definition describe?

'Assets are carried at the present value of cash flows from the continuing use and from its disposal
at the end of its useful life of the asset.'
A Current cost
B Fair value
C Historical cost
D Value in use
2 What is one of the main advantages of using historical cost as a measurement basis?
A It is objective.
B It is subjective.
C It is a reasonable estimate.
D It can use a formula for calculation.
3 Which of the following does this definition describe?
'The price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date'.
A Fair value
B Current value
C Residual value
D Economic value
4 Consider the following statements:
I. The use of a conceptual framework and accounting standards based on that framework would
be an example of positive accounting theory.
II. An attempt to predict accounting behaviour by observing what actually happens and applying
this to particular situations is an example of normative accounting theory.
Which statements are correct?
A I only
B II only
C Both I and II
D Neither I nor II
5 Which type of capital maintenance concept is described by the following statement?
'Capital is looked at as the capacity to maintain a level of assets'.
A Equity capital maintenance
B Financial capital maintenance
C Operating capital maintenance
D Proprietary capital maintenance
6 Consider the following statements:
I. In a time of rising prices, borrowers benefit.
II. Under current purchasing power (CPP) accounting, monetary items are restated to take into
account the effect of general price inflation.
Are these statements correct or incorrect?
Statement I Statement II
A Correct Correct
B Incorrect Correct
C Correct Incorrect
D Incorrect Incorrect
412 | REVISION QUESTIONS

7 Consider the following statements:

I. A management buy-in occurs when existing managers purchase the business.
II. In a share option scheme, employees are given a number of share options, each of which gives
the holder the right after a certain date to subscribe for shares in the company at a fixed price.
Which of the statements are correct?
A I only
B II only
C Both I and II
D Neither I nor II
8 The preparation of the financial statements is the responsibility of:
A the finance director.
B the external auditors.
C the board of directors.
D the internal audit department.
9 Consider the following statements:
I. The auditor's report must be disclosed in a set of financial statements.
II. The auditors' report confirms that the financial statements are correct.
A I only
B II only
C Both I and II
D Neither I nor II
10 Which of the following is a non-mandatory disclosure in a listed company's annual report?
A Statement of cash flows
B Statement of financial position
C Social and environment report
D Corporate governance disclosures
11 Which of the following is not an advantage of voluntary disclosures by companies?
A It can be focused on future strategies and objectives
B Provision of additional information to other companies in the same business
C Provides investors with further yardsticks to judge the performance of management
D Gives shareholders a better idea of the environment within which the company is operating and
how it is responding to that environment
12 Which of the following statements about the directors' report are correct?
I. It includes details of the individual directors on the board.
II. It includes a review of the entity's operations during the period.
III. It shows the members of the board who sit on the various committees, such as audit,
remuneration and nomination committees.
A I and II only
B I and III only
C II and III only
D I, II and III
 FINANCIAL ACCOUNTING AND REPORTING | 413

MODULE 3

1 Where in a company's financial statements are dividends paid found?

A The statement of financial position
B The statement of changes in equity
C The statement of profit or loss and other comprehensive income
D The statement of profit or loss and the statement of changes in equity
2 Classify the following amounts as current or non-current:
I. A bank overdraft expected to be in place for two years
II. Shares bought in another company for the purpose of resale in the near future
III. A receivable arising from a credit sale made to a customer with payment terms of 24 months
Current Non-current
A I II and III
B II I and III
C I and III II
D I, II and III None
3 Which of the following must be shown in the main financial statements of a typical manufacturing
company rather than in the notes to the financial statements?
A A classification of expenses
B The number of shares in issue
C The classes of property, plant and equipment
D The classification of assets as current and non-current
4 Which of the following items is not required to be shown in a separate line in the statement of
changes in equity?
A Revaluation of a property.
B A prior period adjustment resulting from a change in accounting policy.
C A share issue in the year.
D Dividends paid to ordinary shareholders.
5 A statement of cash flows prepared in accordance with the indirect method reconciles profit before
tax to cash generated from operations. Which of the following includes only items which should be
added to profit before tax in the reconciliation?
A Depreciation charge, investment income and increase in inventories
B Increase in payables, loss on disposal of non-current assets and depreciation
C Decrease in receivables, finance cost and profit on disposal of non-current assets
D Decrease in payables, depreciation charge and loss on disposal of non-current assets
6 A company made a profit for the year of $12 990 after accounting for depreciation of $1300. During
the year, non-current assets were purchased for $6500, receivables increased by $560, inventories
decreased by $1100 and payables increased by $230.
The increase in cash and bank balances during the year was
A $530
B $4420
C $7020
D $8560
414 | REVISION QUESTIONS

7 A business had non-current assets with a carrying amount of $90 000 at the start of the financial
year. During the year the business sold machinery that had cost $12 000 and been depreciated to a
carrying amount of $3400. The carrying amount of non-current assets at the end of the year was
$91 500. How much cash has been used to purchase non-current assets?
A $1900
B $4900
C $10 500
D $13 500
8 A business' bank balance increased by $960 000 during its last financial year. In this period, it:
 issued shares raising $1 400 000
 repaid a loan of $230 000
 purchased current asset investments of $800 000
 charged depreciation of $190 000
Working capital increased by $120 000 during the year.
The business' profit for the year was:
A $280 000
B $520 000
C $660 000
D $1 400 000
9 Extracts from a company's statement of financial position showed balances as follows:
20X9 20X8
$ $
Share capital 94 000 77 000
During 20X9 debentures of $70 000 were issued, a dividend of $12 000 was received and interest of
$4000 was paid.
What is the net cash flow from financing activities?
A $17 000 inflow
B $87 000 inflow
C $95 000 inflow
D $99 000 inflow
10 What type of assurance is provided by the external auditor's report on an entity's financial
statements?
A Limited
B Absolute
C Negative
D Reasonable
 FINANCIAL ACCOUNTING AND REPORTING | 415

MODULE 4

1 Which of the following conditions must be met, in order to capitalise development costs according
to IAS 38?
I. completion of the asset is technically feasible
II. resources are available to complete the project
III. there is a contract to sell or written commitment to use the item under development

A I only
B I and II only
C II and III only
D I, II and III
2 Which of the following statements about intangible assets is correct?
A Goodwill can never be revalued.
B An intangible asset must be separable.
C Development costs may be capitalised if the criteria laid down in IAS 38 are met.
D An intangible asset may be revalued where a fair value can be established through use of an
expert valuer.
3 An entity purchases a specialised machine on 1 January 20X8 for $400 000 together with
production rights to manufacture a patented component, for $20 000. These production rights are
worthless without the specialised machine, and the machine may not be used without the
production rights.
Which of the following statements is correct?
A $420 000 is capitalised as an intangible asset.
B $420 000 is capitalised as a tangible non-current asset.
C $400 000 is capitalised as a tangible non-current asset and $20 000 as an intangible asset.
D $400 000 is capitalised as a tangible non-current asset and $20 000 is expensed in the period.
4 An entity purchases the brand name of a product on 1 November 20X8 for $375 000. The
management feel that the brand has an indefinite useful life and have therefore not charged any
amortisation in the year ended 31 October 20X9.
Which of the following is correct?
A Amortisation should be charged based on an assumed maximum useful life of 20 years.
B Amortisation should be charged based on an assumed maximum useful life of 50 years.
C There is no requirement to charge amortisation, however the brand must be tested for
impairment when indications of an impairment arise.
D There is no requirement to charge amortisation, however the brand must be tested for
impairment each year and in addition, whenever there are indications of an impairment.
416 | REVISION QUESTIONS

5 The following is relevant to ABC Co. in the year ended 31 December 20X9:
 $28 000 was spent investigating the properties of a new type of plastic.
 $340 000 was capitalised relating to the development of a new product which went into
commercial production on 1 October 20X9. Sales of the product are expected to remain
constant for the first four years of its production and then halve for a further two years.
What amounts should be recognised in the financial statements of ABC Co. in the year ended
31 December 20X9?
Statement of profit or loss and
other comprehensive income Statement of financial position
A $17 000 $351 000
B $28 000 $340 000
C $36 500 $331 500
D $45 000 $323 000
6 At the current year end, Claxon Co. has undertaken impairment tests on two machines. The
following information is relevant:
Machine 1 Machine 2
Cost $450 000 $250 000
Useful life 10 years 15 years
Age 4 years 3 years
Fair value $300 000 $230 000
Costs of disposal $15 000 $35 000
Value in use $260 000 $198 000
At what carrying amount should machinery be recognised in the accounts of Claxon Co?
A $455 000
B $468 000
C $470 000
D $498 000
7 Taunton Co. owns a property which was revalued to $900 000 at the start of the current accounting
year. At that time the property had a remaining useful life of 25 years. As a result of market
conditions, an impairment test is carried out at the end of the year and the property is found to
have a value in use of $860 000 and a fair value of $870 000. Costs of disposal would amount to
5 per cent of fair value.
What impairment loss, if any, must be recorded in the year?
A $nil
B $4000
C $37 500
D $40 000
8 Which of the following statements is/are correct?
I. An impairment loss relating to goodwill cannot be reversed.
II. Corporate assets must always be allocated to individual CGUs.
III. An impairment loss relating to a CGU is allocated to goodwill in the first instance.
A I only
B II and III only
C I, II and III
D none of them
 FINANCIAL ACCOUNTING AND REPORTING | 417

9 Anton Co. has identified a cash generating unit made up of the following assets:
Carrying
amount
$
Property 200 000
Machinery 50 000
Goodwill 25 000
Receivables 15 000
Inventory 10 000
An impairment loss of $55 000 has been identified. What is the carrying amount of the machinery
after this loss has been accounted for?
A $39 000
B $42 727
C $43 333
D $44 000
10 Rawlin Co. purchased a depreciable asset a number of years ago at a cost of $200 000. On
1 January 20X8, when it had 20 years of its useful life remaining, the asset was revalued to $600 000,
with a revaluation surplus of $480 000 recognised as other comprehensive income. At 31 December
20X9, the value in use of the asset is $535 000 and its fair value less costs of disposal is $532 000.
What impairment loss must be recognised and where?
Loss Recognised in
A $5 000 Profit or loss
B $5 000 Other comprehensive income
C $35 000 Other comprehensive income
D $65 000 Other comprehensive income
11 Which of the following are conditions that permit revenue to be recognised over a period of time?
I. The customer has paid in advance.
II. The customer simultaneously receives and consumes the benefits as the performance takes
place.
III. The entity's performance creates or enhances an asset that the customer controls as the asset is
created or enhanced.

A I only
B I and II only
C II and III only
D I, II and III
12 Details of two of Lord Company's transactions in the month of May are as follows:
I. It has sold goods to another customer on credit. The goods have not yet been delivered.
II. It has sold an item of machinery to a customer; the machinery has been delivered and Lord
Company will undertake specialist installation in two months' time.
For which transactions should revenue be recognised in May?
A I only
B II only
C Both I and II
D Neither I nor II
418 | REVISION QUESTIONS

13 Bubble Co. made sales on credit during May 20X7 of $450 000 for goods that were all delivered
during May. Sales tax is charged at 5 per cent. They offer all customers a settlement discount of
5 per cent and on average 40 per cent of customers will take up the discount.
What is Bubble Co. revenue for May 20X7?
A $441 000
B $450 000
C $463 050
D $472 500
14 Ray Co. reported the following amounts in its statement of financial position at 31 December 20X8:
Liability for company taxes $43 800
Liability for deferred tax $79 320
The 20X8 tax liability was eventually settled at $42 120.
At the 20X9 year end, there is a liability for current tax of $52 300 and the total liability for deferred
tax is to decrease to $69 780. The decrease in deferred tax liability relates to items recognised
within profit or loss.
What is Ray Co.'s tax charge for 20X9?
A $41 080
B $44 440
C $60 160
D $63 520
15 The following information is relevant to Drive Co.'s non-current assets at 31 October 20X8 and
20X9:
20X9 20X8
Cost $765 400 $697 600
Accumulated depreciation $239 140 $202 300
Accumulated capital allowances $347 800 $278 000
Drive Co. pays corporate income tax at a rate of 20 per cent.
What is Drive Co.'s deferred tax liability at 31 October 20X9, and deferred tax charge for the year
ended 31 October 20X9?
Tax liability Tax charge
$ $
A 15 140 15 140
B 21 732 6 592
C 21 732 21 732
D 108 660 32 960
16 Which of the following statements about IAS 12 is/are correct?
I. Deferred tax liabilities may be classified as current liabilities.
II. Tax losses are an example of a taxable temporary difference.
III. Deferred tax relating to the revaluation of a property is reported as other comprehensive
income.
A II only
B I and II only
C I and III only
D II and III only
 FINANCIAL ACCOUNTING AND REPORTING | 419

17 Wiley Co. has made tax trading losses for two years, totalling $87 600. $23 000 of these were used
to relieve other taxable income in accordance with tax law. At the 31 December 20X9 year end,
Wiley Co. signs a large contract with a new customer which indicates that it will return to
profitability. Wiley Co.'s tax rate is 20 per cent. What is the deferred tax implication of the losses?
A A deductible temporary difference of $64 600 arises and a deferred tax asset of $12 920 is
recognised at 31 December 20X9
B A taxable temporary difference of $64 600 arises and a deferred tax liability of $12 920 is
recognised at 31 December 20X9
C A taxable temporary difference of $87 600 arises and a deferred tax liability of $17 520 is
recognised at 31 December 20X9
D A deductible temporary difference of $87 600 arises and a deferred tax asset of $17 520 is
recognised at 31 December 20X9
18 The trial balance of Vine Co. at 31 December 20X8 shows a credit balance on the tax payable
account of $450. The estimated current tax liability of $28 760 has not yet been accrued.
What amounts are reported in the financial statements in respect of current tax for the year?
Tax liability Tax charge
$ $
A 28 310 28 310
B 28 760 28 310
C 28 760 29 210
D 29 210 29 210
19 Radley Co. purchased raw materials on credit from a foreign supplier for 375 000 Goldings, halfway
through the year ended 31 December 20X9. Half of the goods were paid for on 30 November 20X9
and the remaining half on 31 January 20Y0.
Relevant exchange rates are as follows:
30 June 20X9 4.3 G: $1
30 November 20X9 4.6 G: $1
31 December 20X9 4.5 G: $1
31 January 20Y0 5 G: $1
What exchange difference is recognised in Radley Co.'s profit or loss in the year ended
31 December 20X9?
A $2844 loss
B $2844 gain
C $4782 loss
D $4782 gain
20 The abbreviated functional currency statement of financial position at 30 November 20X9 of Pedro
Co., a subsidiary of Aus Co., bought at the start of the year is as follows:
Euro
Assets 560 000
Share capital 100 000
Retained earnings b/f 220 000
Profit for the year 70 000
Liabilities 170 000
560 000
Pedro Co. was incorporated on 1 January 20X5.
Relevant exchange rates are as follows:
30 November 20X9 $1: euro 0.8
1 December 20X8 $1: euro 0.75
1 January 20X5 $1: euro 0.95
Average for y/e 30 November 20X9 $1: euro 0.77
420 | REVISION QUESTIONS

To the nearest $000 what are the translated retained earnings (including exchange differences) of
Pedro Co. at 30 November 20X9?
A $354 000
B $362 000
C $366 000
D $382 000
21 Flurry Co. prepares its financial statements in its functional currency, the Durham, translating to
dollars in order to report to its parent company.
The following information is relevant:
Net assets (D) Exchange rate
1 January 20X9 650 000 4.3D/$
31 December 20X9 780 000 4D/$
The retained profits for the year were D115 000 and the average exchange rate was 4.2D/$.
What exchange difference arises on translation of the financial statements?
A $11 337 loss
B $11 337 gain
C $12 706 loss
D $12 706 gain
22 Drayton Co. purchased a new non-current asset on 1 January 20X9 costing HK$ 1 450 000, agreeing
18 months' extended credit with the supplier.
The exchange rate on 1 January 20X9 was 6.75HK$:$1. At 31 December 20X9, the exchange rate
had moved to 7.2HK$:$1.
How are the asset and payable presented in the statement of financial position at 31 December
20X9?
Asset Payable
A $201 389 $201 389
B $201 389 $214 815
C $214 815 $201 389
D $214 815 $214 815
23 Which of the following statements is or are correct?
I. Exchange differences are always reported in profit or loss.
II. The currency that mainly influences sales prices set by an entity is likely to be the functional
currency.
III. A revalued 'foreign' asset is translated at the exchange rate in force on the date of the
revaluation.
A I and II only
B I and III only
C II and III only
D I, II and III
24 On 1 January 20X5 Cornwall Company entered into a three-year lease for new computer
equipment. A non-refundable set-up costs of $2000 was paid on this date. The first lease payment
of $8000 will be made on 1 January 20X6, in arrears with two further payments of $8000 being paid
on 1 January 20X7 and 20X8 also in arrears.
Cornwall Company elected to treat the lease as a low value lease.
What expense will be shown in the profit or loss for the year ended 31 December 20X5?
A $2000
B $6000
C $6500
D $8000
 FINANCIAL ACCOUNTING AND REPORTING | 421

25 On 1 January 20X5 Kent Company enters into a three year lease for an asset, paying an initial
deposit of $18 000. The present value of the future cash flows is $150 000. The asset they are
leasing has a useful life of five years and Kent Company will not obtain ownership at the end of the
lease.
What is the depreciation expense for the right of use asset for the year ended 31 December 20X5?
A $33 600
B $44 000
C $50 000
D $56 000
422 | REVISION QUESTIONS

MODULE 5

1 Raleigh Co. holds the following investments:

 30 per cent of the voting shares in Well Co. The remaining 70 per cent are held by a third,
unrelated, company, Slim Co., which refuses to communicate with Raleigh Co.
 18 per cent of the voting shares in Vic Co. One of Raleigh's Directors also sits on the Board of
Vic Co. and takes an active part in formulating strategy.
How should the investments be accounted for?
Well Co. Vic Co.
A Associate Associate
B Investment Associate
C Associate Investment
D Investment Investment
2 Dry Co. holds 20 per cent of the voting shares in Wet Co. and has agreed with the other
shareholders that it will direct the operating activities of that company. Dry Co. also holds 40 per
cent of the voting shares in Cloud Co., participating in the policy making process of that company,
and 25 per cent of the voting shares in Drizzle Co.
How should these investments be treated in the Dry Co. group accounts?
Wet Co. Cloud Co. Drizzle Co.
A Consolidated Consolidated Held at cost
B Equity accounted Equity accounted Held at cost
C Consolidated Equity accounted Equity accounted
D Equity accounted Consolidated Equity accounted
3 Which of the following conditions must be met in order for a parent to avoid presenting
consolidated financial statements?
I. All subsidiaries operate under severe long-term restrictions.
II. Its securities are not publicly traded and it is not in the process of issuing securities in public
securities markets.
III. The ultimate or intermediate parent publishes consolidated financial statements that comply
with International Financial Reporting Standards.
IV. The parent is itself a wholly-owned subsidiary or it is a partially-owned subsidiary of another
entity and its other owners do not object to the parent not presenting consolidated financial
statements.

A I, II and III only

B I, III and IV only
C II, III and IV only
D I, II, III and IV
4 Which of the following statements about consolidated financial statements is correct?
A IAS 28 states that investments should be held in the investor's individual accounts using the
equity method.
B IFRS 10 allows subsidiaries to be excluded from consolidation if their activities are dissimilar
from those of the parent.
C Where a subsidiary uses different accounting policies from its parent company, this must be
disclosed in the group accounts.
D An investor cannot control another company if it does not have the ability to use its power over
the investee to affect the amount of the investor's returns.
 FINANCIAL ACCOUNTING AND REPORTING | 423

5 Which of the following provides evidence of the existence of significant influence?

A Material transactions between investor and investee
B Power to govern the financial and operating policies of the entity
C Agreement with other shareholders of the entity to vote on their behalf
D Power to appoint or remove a majority of members of the board of directors

6 Train Co. owns 80 per cent of Car Co. Extracts from the companies' statements of financial position
are as follows:
Train Co. Car Co.
$'000 $'000
Receivables 91 67
Cash 23 –
Payables 87 53
Overdraft – 9

Included within the receivables of Car Co. is $7000 due from Train Co. Included within the payables
of Train Co. is $5600 due to Car Co. The difference is due to cash in transit.
What are the consolidated receivables and cash balances?
Receivables Cash
A $151 000 $23 000
B $151 000 $24 400
C $152 400 $23 000
D $152 400 $24 400
7 West Co. acquired 90 per cent of the 100 000 shares in East Co. on 1 January 20X7 for $480 000
when the reserves of that company amounted to $320 000. On that date the fair value of the
non-controlling interest was valued at $45 000. Included in East Co.'s statement of financial
position was land with a book value of $60 000. The fair value was $30 000 higher than this.
West Co. group measures the non-controlling interest at fair value.
What goodwill arose on the acquisition of East Co.?
A $75 000
B $102 000
C $105 000
D $135 000
8 North Co. acquired 80 per cent of South Co. on 1 February 20X8 for consideration totalling
$560 000. At this date the fair value of a 20 per cent holding in South Co. was $130 000, and the net
assets of South Co. were $620 000. In the year ended 31 January 20X9, South Co. reported profits
of $75 000. North Co. group measures the non-controlling interest using the proportion of net
assets method. What is the non-controlling interest to be reported in the consolidated statement
of financial position at 31 January 20X9?
A $137 750
B $139 000
C $143 750
D $145 000
424 | REVISION QUESTIONS

9 Axis Co. transferred an asset to its 75 per cent subsidiary Yves Co. on 31 October 20X9 for $25 000.
The asset cost $32 000 on 1 November 20X7 and was depreciated monthly by Axis Co. at 20 per
cent per annum on cost. Yves Co. did not amend the original useful life on the transfer and
continued to depreciate the asset over its remaining life. At 31 December 20X9, extracts from the
two companies' accounts were as follows:
Axis Co. $ Yves Co. $
Non-current assets 165 000 180 000
What is the consolidated figure for non-current assets?
A $339 200
B $339 522
C $343 522
D $345 000
10 Try Co. bought 80 per cent of the ordinary shares in Ply Co. when the retained earnings of that
company were $400 000. Goodwill arising on acquisition amounted to $68 000, and 25 per cent of
this amount was written off in the year ended 31 October 20X7.
During the year ended 31 October 20X9, Try Co. sold $50 000 goods to Ply Co., achieving a 20 per
cent mark up. At the year end, Ply Co. retained half of these in inventory.
The two companies' retained earnings at 31 October 20X9 were as follows:
Try Co. $680 900
Ply Co. $532 000
What are group retained earnings at 31 October 20X9?
A $553 300
B $765 333
C $782 333
D $1 085 333

11 P Co. acquired 80 per cent of the ordinary share capital in S Co. on 31 August 20X9. Extracts from
the two companies' statements of profit or loss for the year ended 31 October 20X9 were as
follows:
P Co. S Co.
$'000 $'000
Revenue 2 900 1 800
Cost of sales 1 500 900
During the year, P Co. made sales of $10 000 to S Co. each month, realising a mark up of 25 per
cent. At the end of the year S Co. had none of these goods in inventory.
What is the group gross profit for the year ended 31 October 20X9?
A $1 546 000
B $1 550 000
C $1 625 000
D $2 300 000
 FINANCIAL ACCOUNTING AND REPORTING | 425

12 Ed Co. has owned 100 per cent of the shares in Clem Co. for five years. These were bought for
$450 000 when the net assets of Clem Co. were $415 000. In the year of acquisition, Clem Co. was
impaired by $5000 due to a drop in profitability. Clem Co. has again suffered a loss of profits in the
year ended 31 December 20X9, and accordingly goodwill is to be impaired by 20 per cent of book
value. Extracts from the two companies' statements of profit or loss are as follows:
Ed Co. Clem Co.
$ $
Cost of sales 320 000 126 000
Administrative expenses 100 000 36 000
What are the amounts to be reported for group cost of sales and administrative expenses?
Cost of sales Administrative
expenses
$ $
A 439 000 136 000
B 440 000 136 000
C 446 000 129 000
D 446 000 142 000
13 Black Co. sold an item of machinery to Red Co., its subsidiary on 31 December 20X8 for $340 000.
The machine had cost Black Co. $400 000 and had a carrying amount of $320 000 on the date of
the transfer, based on annual depreciation at 10 per cent on the straight line basis. The remaining
useful life of the asset remains unchanged. Companies in the Black Co. Group depreciate any asset
held on the last day of the accounting period for a full year. Depreciation is charged to cost of
sales.
What adjustment is required to the Black Co. cost of sales in respect of this transfer in the year
ended 31 December 20X9?
A A decrease of $22 500
B A decrease of $2500
C An increase of $2500
D An increase of $17 500
14 Green Co. sold an item of plant to Brown Co., its subsidiary on 31 October 20X9 for $200 000. The
machine had cost Green Co. $300 000 and had a carrying amount of $220 000 on the date of the
transfer, based on a useful life of 15 years on the straight line basis. The remaining useful life of the
asset remains unchanged. Green Co. depreciates assets on a monthly basis.
What adjustment is required to Green Co.'s profit in respect of this transfer in the year ended
31 December 20X9?
A $18 182 to add back to profit
B $19 697 to add back to profit
C $20 303 to add back to profit
D $20 303 to deduct from profit
15 Which of the following statements about the consolidated statement of profit or loss are correct?
I. Dividend income in the parent company's statement of profit or loss is never carried across to
the consolidated statement of profit or loss.
II. The non-controlling interest in profit is presented separately from group profits in the
consolidated statement of profit or loss to leave profit allocated to the owners of the parent
company.
A I only
B II only
C Both I and II
D Neither I nor II
426 | REVISION QUESTIONS

16 Roulston Co. holds a 75 per cent investment in Hudson Co. and a 35 per cent investment in
White Co. During the year ended 30 November 20X9, Roulston Co. sold goods to Hudson Co. for
$400 000 and White Co. sold goods to Roulston Co. for $210 000. The companies' revenue as
reported in their individual financial statements was as follows:
$'000
Roulston Co. 1490
Hudson Co. 430
White Co. 1200
What is the consolidated revenue figure?
A $1 383 500
B $1 520 000
C $2 510 000
D $2 583 000
17 Dray Co. holds a 90 per cent investment in Ray Co. and a 25 per cent investment in Lay Co. Extracts
from their statements of profit or loss are as follows:
Dray Co. Ray Co. Lay Co.
$ $ $
Revenue 136 500 127 800 67 000
Cost of sales 86 500 73 400 24 000
During the year Dray Co. sold $40 000 goods to Ray Co. and $10 000 to Lay Co. at a 25 per cent
mark up. In each case all of these goods remained in inventory at the year end.
What is the consolidated cost of sales figure?
A $109 900
B $111 900
C $127 900
D $128 400
18 Blue Co. has a number of subsidiaries as well as a 45 per cent investment in Pink Co. bought for
$190 000 some years ago. Since acquisition, Pink Co. has made $450 000 profits and suffered no
impairment. During the year ended 31 October 20X9, Pink Co. sold $30 000 goods to Blue Co. at a
20 per cent margin. Half of these goods remained in Blue Co.'s warehouse at the year end.
What is the investment in associate shown in the Blue Co. Group statement of financial position at
31 October 20X9?
A $386 500
B $389 500
C $391 150
D $392 500
19 Which of the following statements about equity accounting and associates is correct?
A The tax charge relating to an associate must be separately disclosed in the consolidated
statement of profit or loss.
B Any impairment of an associate is charged to administrative expenses in the consolidated
statement of profit or loss.
C There is no requirement for an associate to be consolidated or equity accounted using the
same accounting policies as those adopted by the group.
D Where an associate is loss making, the investor should discontinue including its share of losses
when the investor's share of losses of the associate equals or exceeds its interest in the
associate.
 FINANCIAL ACCOUNTING AND REPORTING | 427

20 Arm Co. Group bought 16 per cent of the voting shares in Leg Co. on 1 January 20X9 for $160 000,
and on the same date started trading with Leg Co. such that 80 per cent of Leg Co.'s sales were
made to Arm Co. In the year ended 31 December 20X9, Leg Co. made $98 000 profits, 80 per cent
of these relating to sales to Arm Co. None of the goods purchased from Leg Co. remained in the
inventory of Arm Co. at the year end.
How is the investment in Leg Co. shown in Arm Co.'s group statement of financial position at
31 December 20X9?
A A trade investment of $160 000
B An investment in associate of $156 080
C An investment in associate of $175 680
D An investment in associate of $179 600
428 | REVISION QUESTIONS

MODULE 6

1 Which of the following ratios provide a measure of profitability?

I. Interest cover
II. Dividend cover
III. Return on equity
IV. Gross profit margin

A I and IV only
B III and IV only
C I, II and IV only
D I, II, III and IV
2 Booth Co. has increased its return on investment (ROI) since last year. Assuming all other factors
remain the same, which of the following is the best explanation for this?
A Lower interest cover than last year
B A lower profit margin than last year
C A higher current ratio than last year
D A higher asset turnover than last year
3 Which of the following will cause a company's gearing ratio to increase?
A The payment of a dividend
B A decrease in rental expenses
C A decrease in the allowance for receivables
D The upward revaluation of a non-current asset
4 Allister Co. reports the following amounts in its statement of financial position:
20X9 20X8
$ $
Inventory 13 500 14 200
Receivables ? 12 840
Prepayments 1 280 1 880
Cash 348 –
Payables 10 760 17 200
Overdraft – 1 200
Deferred tax 3 700 4 200
Assuming that Allister Co. maintained its quick ratio at the same level in 20X9, what was the
receivables figure in that year?
A $1770
B $6980
C $7771
D $11 822
 FINANCIAL ACCOUNTING AND REPORTING | 429

5 Extracts from Hunt Co.'s financial statements in the year ended 31 December 20X9 were as follows:
STATEMENT OF PROFIT OR LOSS $
Gross profit 3 216 400
Earnings before interest and tax 2 468 400
Profit before tax 2 094 400
Profit after tax 1 870 000
Earnings per share 7.48c
Hunt Co. made no issues of shares during the year.
What was the number of Hunt Co. shares in issue throughout the year to the nearest million?
A 25 million
B 28 million
C 33 million
D 43 million
6 Which of the following statements is correct?
A The interpretation of an entity's financial statements using ratios is only useful for potential
investors.
B Ratios based on historical data always predict the future performance of an entity.
C The analysis of financial statements using ratios provides useful information when compared
with previous performance or industry averages.
D An entity's management will not assess an entity's performance using financial ratios.
7 The following are extracts from BL's financial statements:
$'000
Profit before interest and tax 10,200
Finance costs (1,600)
Income tax expense (3,300)
Profit for the year 5,300

Share capital 20,000

Reserves 15,600
Net assets 35,600
Non-current loan payable 6,900
42,500
What is BL's return on investment (to the nearest %)?
A 24%
B 12%
C 29%
D 15%
8 What effect on ratios would an upwards revaluation of property, plant and equipment be likely to
lead to?
A Gearing ratio will increase.
B The current ratio will decrease.
C Net profit margin will decrease.
D Interest cover will increase.
9 A Bank has provided a long-term loan to NV Co.
Which of the following pairs of ratios is most likely to provide the bank with relevant information?
A Asset turnover and expenses to sales
B Gearing and interest cover
C Return on capital employed and gross profit margin
D Return on shareholders' equity and earnings per share
430 | REVISION QUESTIONS

10 GF Co is a global mobile phone manufacturer. Recent result for its trade in The Middle East are as
follows:
20X7 20X6
Revenue $8 736 000 $5 582 000
Operating profit margin 10.5% 11.5%
Which of the following is the most likely explanation for the movement in the operating profit
margin in the Middle East?
A GF won a new contract with the largest network provider and retailer in the Middle East on the
basis of a bulk buy discount.
B There has been an increase in demand for mobile phones in the Middle East.
C GF has only just begun selling phones in the Middle East.
D There has been an increase in popularity in high-end smartphones in the Middle East.
 431

ANSWERS TO REVISION
QUESTIONS
432 | ANSWERS TO REVISION QUESTIONS
 FINANCIAL ACCOUNTING AND REPORTING | 433

MODULE 1

1 A The provision of information aimed at running a business more efficiently is an objective of

management accounting rather than financial accounting. The aim of financial reporting is the
provision of information to meet the needs of external users.
2 A Suppliers' interest in their customers' accounts lies in the fact that they wish to be repaid in a
timely fashion. They are therefore interested primarily in the liquidity of a company.
3 D In each case the reverse is correct: US accounting standards are rules-based and IFRS are
principles-based.
4 D The IFRS Foundation is the overseeing body for the IASB, IFRS Interpretations Committee and
IFRS Advisory Council. The Monitoring Board serves as a mechanism for communication
between capital markets authorities and the IFRS Foundation.
5 B The IASB is responsible for issuing IFRS.
6 A The AASB has adopted IFRS equivalent standards (with changes made to reflect the Australian
legislative environment). Although IFRS allows the use of the 'true and fair/fair presentation
override', Australian companies' legislation does not.
7 D The entity's need for additional finance would be shown by its statement of financial position
and information about its investing and financing activities would be shown by its statement of
cash flows (and, to some extent, by its statement of financial position).
8 B Concepts and conventions are contained within the Conceptual Framework, however this is not
the title of a chapter.
9 B If the Conceptual Framework conflicts with an IFRS, the IFRS should be followed. Therefore I is
incorrect.
10 B Its financial position (i.e. its assets and liabilities).
11 A Information about a reporting entity's cash flows during a period helps users assess the entity's
ability to generate future net cash inflows.
12 D A change in accounting policy is applied retrospectively (as required by IAS 8), unless (a) it is
impracticable to do so or (b) the change is required by a new IFRS and the transitional
provisions require/allow prospective application.
A change in accounting policy may be made voluntarily, if the change will result in a more
relevant or reliable presentation in the financial statements.
13 C Users of financial statements are entitled to assume that they have been prepared on the basis
that the entity in question is a going concern, unless there is a clear statement to the contrary.
14 A Accounting standards do not apply to immaterial items.
15 C Verifiability and timeliness are not fundamental characteristics but are two of the four enhancing
qualitative characteristics (the others are comparability and understandability).
16 B A faithful representation is complete, neutral and free from error.
17 B Departure from an IFRS is allowed where compliance would be misleading. Prior agreement
with a regulatory body is not required.
18 A D is the definition of a liability; C is the definition of an asset; B is a mixture of the definitions of
an asset and a liability.
19 D A provision is a liability of uncertain timing and/or amount – the amount is not necessarily an
estimate; it may be known and the uncertainty surrounds timing of the payment. Provisions are
recognised in the financial statements when certain criteria are met.
20 D A gain from the sale of a non-current asset is recognised as part of the profit or loss for the
period but the revaluation of a non-current asset is not recognised in profit or loss (it is
recognised in equity as part of other comprehensive income).
21 C The working capital of a business is its current assets and current liabilities.
434 | ANSWERS TO REVISION QUESTIONS

22 A Prepayments are current assets; employee wages are an expense; a revaluation surplus forms
part of equity.
23 A The amount spent on investigating the healing powers of the plant is research rather than
development. At this stage it does not meet the recognition criteria as commercial
development and economic benefit is too distant.
The training costs do not meet the definition of an asset as the resultant benefit is not
controlled by the company (i.e. the trained staff could leave the organisation).
The advertising costs do not meet the definition of an asset as the resultant benefit is not
controlled by the company and there is no certainty of a future economic benefit .
 FINANCIAL ACCOUNTING AND REPORTING | 435

MODULE 2

1 D Value in use.
2 A Historical cost is objective in that it is equivalent to the amount paid to obtain an asset. No
estimation nor cost formulae are required.
3 A This is the definition of fair value contained within a number of IFRS.
4 D The first statement relates to normative theory and the second to positive theory.
5 C Operating capital maintenance is based on the productive capacity of an entity, and therefore
requires a maintained level of assets.
6 C Under CPP accounting it is non-monetary items which are restated for the effects of general
price inflation.
7 B A management buy-in is where external managers purchase the company.
8 C The board of directors are responsible for preparing the financial statements (even though the
actual preparation is probably carried out by staff within the finance department with the
assistance of the external auditors).
9 A The auditors' report must be disclosed in the financial statements. It gives an opinion as to
whether the financial statements show a true and fair view and/or are fairly presented.
10 C A statement of financial position and statement of cash flows are required by IAS 1 and IAS 7;
corporate governance disclosures are required as part of compliance with listing rules.
11 B B is not an advantage; competitors may use the information contained within such disclosures in
order to gain advantages in the market.
12 A The details of the members of the various committees are detailed in the corporate governance
report.
436 | ANSWERS TO REVISION QUESTIONS

MODULE 3

1 B Dividends must not be reported in the statement of profit or loss and other comprehensive
income as they are not an expense and therefore do not relate to the performance of an entity
in a reporting period. Dividend payments are reported in the statement of changes in equity
because they represent a transaction between the business and the equity owners in their
capacity as owners.
2 D The credit sale is part of the company's normal operating cycle and so the receivable arising is
classified as current.
The bank overdraft is repayable on demand and so classified as current.
The shares are a current asset investment.
3 D IAS 1 specifies what should be disclosed in the main financial statements.
4 A The revaluation of a property would not be required to be disclosed separately as they would
be automatically included in the ‘total comprehensive income for the year’ figure.
5 B A loss on disposal and depreciation are non cash expenses and so must be added back in the
reconciliation (a profit on disposal is non-cash income which must be deducted).
An increase in payables (or decrease in receivables or inventory) is added back in the
reconciliation (a decrease in payables or increase in receivables or inventory is deducted).
Finance cost is added back to profit before tax in the reconciliation (investment income is
deducted).
6 D $
Profit for the year 12 990
Depreciation 1 300
Purchase of NCAs (6 500)
Increase in receivables (560)
Decrease in inventories 1 100
Increase in payables 230
8 560

7 B $
Carrying amount b/f 90 000
Disposals at carrying amount (3 400)
Purchase of non-current assets (balancing figure) 4 900
Carrying amount c/f 91 500

8 B $
Profit (β) 520 000
Increase in working capital (120 000)
Depreciation 190 000
Current asset investment (800 000)
Loan (230 000)
Share issue 1 400 000
Increase in cash 960 000

9 B $
Issue of shares 17 000
Issue of debentures 70 000
87 000

Dividends received is a cash flow from investing activities.

Interest paid is a cash flow from operating activities.
10 D An external audit can only provide reasonable, not absolute, assurance.
 FINANCIAL ACCOUNTING AND REPORTING | 437

MODULE 4

1 B The entity developing the item must be able to sell or use the asset but no formal written
commitment to do so is required.
2 A An intangible asset need not be separable; it must be identifiable.
Development costs must be capitalised if the criteria laid down in IAS 38 are met.
An intangible asset can only be revalued where a fair value is established by reference to an
active market.
3 C Although the production rights are not separable (i.e. capable of separate disposal), they are
contractual and therefore meet the IAS 38 definition of identifiable. The rights must therefore
be recognised as an intangible asset in their own right.
4 D IAS 38 does not require an intangible asset to be amortised where it is assessed to have an
indefinite life. In this case the asset must be tested for impairment annually and whenever there
are indications of impairment.
5 D The research costs should be written off to profit or loss.
Amortisation on the capitalised development costs commences on 1 October, and mirrors the
expected sales pattern:
$
Year 1 68 000
Year 2 68 000
Year 3 68 000
Year 4 68 000
Year 5 34 000
Year 6 34 000
Therefore the total charge to profit or loss is:
$
Research costs 28 000
Amortisation (3/12  68 000) 17 000
45 000

The development costs reported as an asset are therefore $340 000 – $17 000 = $323 000.
6 B
Machine 1 Machine 2
$ $
Cost 450 000 250 000
Depreciation (4/10 and 3/15) (180 000) (50 000)
Carrying amount 270 000 200 000
FV less costs of disposal 285 000 195 000
Value in use 260 000 198 000
Therefore recoverable amount 285 000 198 000
Revised carrying amount 270 000 198 000
Total 270 000 + 198 000 = $468 000
7 B
Carrying amount (900 000  24/25) $864 000
Value in use $860 000
Fair value less costs of disposal ($870 000  95%) $826 500
Recoverable amount $860 000
Impairment loss $4 000

8 A An impairment loss relating to a CGU is initially allocated to any obviously impaired assets.
Corporate assets may be allocated to groups of CGUs where allocation to a single CGU cannot
be achieved on a reasonable and consistent basis. An impairment loss recognised for goodwill
shall not be reversed in a subsequent period.
438 | ANSWERS TO REVISION QUESTIONS

9 D The impairment is allocated first to the goodwill. The remaining $30 000 is split between the
property and machinery on a pro rata basis. Therefore, the machinery is measured at $50 000 –
($30 000  50/250) = $44 000. Note that IAS 36 does not apply to inventories or to financial
assets within the scope of IAS 39; these would include receivables.
10 B Carrying amount of property at 31 December 20X9
$
$600 000  18 / 20 years 540 000
Recoverable amount 535 000
Impairment loss 5 000

As the property has previously been revalued the impairment is charged against the revaluation
surplus and reported as other comprehensive income.
11 C IFRS 15 says any of three criteria must be met for revenue to be recognised over a period of
time. II and III are two of these and the third one is the entity's performance does not create an
asset with an alternative use to the entity and the entity has an enforceable right to payment for
performance completed to date.
12 D Revenue is not recognised on either transaction as Lord has not satisfied the performance
obligations under both contracts.
13 A
$
Customers expected to take up discount (450 000  40%  95%) 171 000
Customers not expected to take up discount (450 000  60%) 270 000
Total 441 000
The sales tax is ignored as this is being collected on behalf of the tax authorities. For the
customers who are expected to take up the discount revenue is recorded net of the settlement
discount as it counts as variable consideration.
14 A
$
Current tax (20X9) 52 300
Over-provision (43 800 – 42 120) (1 680)
Deferred tax (79 320 – 69 780) (9 540)
41 080

15 B
20X9 20X8
Carrying amount 526 260 495 300
Tax written down value 417 600 419 600
Temporary difference 108 660 75 700
 20% 21 732 15 140

Increase in liability = charge to tax $21 732 – $15 140 = $6592

16 A Deferred tax amounts may not be classified as current.
Tax losses are an example of a deductible temporary difference.
17 A A deferred tax asset arises in respect of losses carried forward which can be utilised against
future profits. Losses to be carried forward are ($87 600 – 23 000) = $64 600 giving rise to a
deferred tax asset of ($64 600 x 20%) = $12 920.
18 B The credit balance on the tax account represents the previous year's overprovision. This is
deducted from the current year tax charge ($28 760 – 450) = $28 310.
The current year liability is not adjusted for the over-provision.
 FINANCIAL ACCOUNTING AND REPORTING | 439

19 D
Settled Outstanding
payable payable
$ $
Recorded in June (375 000 / 2) / 4.3 43 605 43 605
Settled (375 000 / 2) / 4.6 40 761
Unsettled (375 000 / 2) / 4.5 41 667
Exchange gain 2 844 1 938
Total gain 4 782
20 A
$'000
Assets (560 / 0.8) 700
Share capital (100 / 0.75) 133
Retained earnings (β) 354
Liabilities (170 / 0.8) 213
700

21 D
$ $
Opening net assets at 4.3D / $ 151 163
Opening net assets at 4D / $ 162 500
Gain 11 337
Retained profits at 4.2D / $ 27 381
Retained profits at 4D / $ 28 750
Gain 1 369
Total gain 12 706

22 C The asset is a non-monetary asset and should not be re-translated at the year end (1 450 000 /
6.75) = $214 815; the payable is a monetary amount and must be re-translated (1 450 000 / 7.2) =
$201 388.
23 C Exchange differences arising on settlement of currency items or the retranslation of monetary
items are reported in profit or loss. Exchange differences arising on the translation of financial
statements into the presentation currency are reported as other comprehensive income.
24 C The total amount of lease payment of $26 000 calculated as $2000 + (3 payments  $8000) will be
spread over three years to give an annual expense of $6500.
25 D
$
Deposit 18 000
Present value of future lease payments 150 000
168 000
Depreciation 56 000
168 000 / 3 years
440 | ANSWERS TO REVISION QUESTIONS

MODULE 5

1 B Raleigh Co. cannot have significant influence over Well Co., since Slim Co. already has control
and refuses to listen to Raleigh Co. Therefore, only constitute and investment.
Vic Co. is an associate by virtue of the fact that Raleigh Co. has active representation on
Vic Co.'s board of directors.
2 C Dry Co. controls Wet Co. by virtue of the fact that it directs the relevant activities (operating
activities) of that company.
Dry Co. has significant influence over Cloud Co., evidenced by the 40 per cent shareholding
and participation in the policy-making process.
Dry Co. has significant influence over Drizzle Co., evidenced by the 25 per cent shareholding.
3 C IFRS 10 requires that II, III and IV are all met in order to avoid presenting consolidated financial
statements. I is irrelevant as where subsidiaries operate under long-term restrictions, control
may have been lost. In this case, they are no longer subsidiaries and so consolidated accounts
are not required, as there is no group.
4 D IFRS 10 states that all material subsidiaries should be consolidated; investments in group
companies in individual entity accounts are held at cost or in accordance with IFRS 9; the
accounting policies of the subsidiary must be brought in line with those of the group for the
purposes of consolidation.
5 A Both B and D refer to control.
6 A Car Co.'s accounts should be adjusted as though the cash has been received. Therefore, the
revised balances are:
Receivables $60 000
Overdraft $7 600
7 A
$'000
Consideration 480
Fair value of NCI 45
525
Fair value of net assets (100 + 320 + 30) (450)
75

8 B 20%  (620 000 + 75 000)

9 B
$
Axis Co. 165 000
Yves Co. 180 000
NCA PURP adjustment (see below) (5 478)
Consolidated figure for non-current assets 339 522

Unrealised profit on sale

$25 000 – ($32 000 – ($32 000  20%  2)) 5 800
Reduction in depreciation
($32 000  20%  2 / 12) – ($25 000 / 3yrs  2 / 12) (322)
5 478

Alternatively, the adjustment can be calculated by comparing the carrying amount of the asset at the
reporting date with the carrying amount had no transfer occurred:
Non-current asset post-transfer
$25 000 – ($25 000  2 / 36 months) 23 611
Non-current asset if no transfer had occurred
$32 000 – ($32 000  20%  2 2 / 12yrs) 18 133
NCA PURP 5 478
 FINANCIAL ACCOUNTING AND REPORTING | 441

10 B
$
Try Co. 680 900
Ply Co. 80% (532 000 – 400 000) 105 600
Goodwill impairment 25%  68 000 (17 000)
URP 20 / 120  $50 000  ½ (4 167)
Group retained earnings at 31 October 20X9 765 333
11 B
P Co. S Co.  2/12 Adj Group
$'000 $'000 $'000 $'000
Revenue 2 900 300 (20) 3 180
Cost of sales 1 500 150 (20) 1 630
Group gross profit for the year 1 550
ended 31 October 20X9

12 D
An impairment is charged to admin expenses: $'000
Ed Co. 100
Clem Co. 36
Impairment (450 000 – 415 000 – 5000)  20% 6
142

Cost of sales (320 000 + 126 000) 446

13 B 20X9 is not the year of transfer and therefore the URP is made up only of the difference in
depreciation charge:
'Old' depreciation $400 000  10% $40 000
'New' depreciation $340 000 / 8 yrs $42 500
Therefore, an extra $2500 has been charged and must be adjusted for to reduce cost of sales.
14 B 20X9 is the year of transfer and therefore the URP is made up of the loss on transfer and the
difference in depreciation charge:
$
Proceeds 200 000
Carrying amount at transfer (220 000)
Loss on transfer 20 000 to add back to profit

Depreciation:
'old' $300 000 / 15  2 / 12 3 333
'new' $200 000 / 11  2 / 12 3 030
303 extra to charge to profit

Therefore, the overall adjustment is $19 697 to add back to profit.

15 B Dividend income relating to investments other than subsidiaries (and associates) is carried
across to the consolidated statement of profit or loss.
Statement II is correct.
16 B
The associate's revenue is irrelevant to the calculation: $'000
Roulston Co. 1 490
Hudson Co. 430
Roulston sales to Hudson (400)
1 520
17 C
$
Dray Co. 86 500
Ray Co. 73 400
Sales from D to R (40 000)
URP on sales from D to R (40 000  25/125) 8 000
127 900

The URP on the sale to Lay Co. is adjusted against the share of profit of associate.
442 | ANSWERS TO REVISION QUESTIONS

18 C The group share of the URP is adjusted against the investment in the associate:
$
Cost 190 000
Share of post-acquisition profits
$450 000  45% 202 500
URP ($15 000  20%  45%) (1 350)
391 150

19 D Any impairment of an associate is charged against the profits of the associate.

20 C This is a parent associate relationship; significant influence is evidenced by the material
transactions between the two companies.
$
Cost of investment 160 000
Group share of post-acquisition profits
16% × $98 000 15 680
175 680

There is no unrealised profit, because all the goods have been sold on outside the group.
 FINANCIAL ACCOUNTING AND REPORTING | 443

MODULE 6

1 B Interest cover is an indicator of solvency; dividend cover is an investor ratio.

2 D ROI is the product of profit margin and asset turnover. An increase in either of these will
increase ROI. Interest cover and the current ratio are irrelevant to ROI.
3 A A decrease in expenses increases profits and so equity and decreases the gearing ratio.
A decrease in the allowance for receivables also increases equity.
An upward revaluation increases equity and so decreases the gearing ratio.
The payment of a dividend decreases equity and so increases the gearing ratio.
4 B The quick ratio of 20X8 was:
12 840 + 1 880
= 0.8
17 200 + 1 200
Therefore in 20X9:
? + 1 280 + 348
= 0.8
10 760
? + 1 628 = 0.8  10 760
? + 1 628 = 8 608
Receivables = 6 980
5 A Earnings per share is calculated as the profits attributable to the ordinary shareholders divided
by the number of shares. The profits attributable to ordinary shareholders is profit after tax and
therefore:
1 870 000
= 0.0748
No. of shares
1 870 000
No. of shares = = 25m
0.0748
6 C This is correct because ratios are only useful if they can be compared to other relevant and
comparable information so relative performance and position can be considered.
The other statements are incorrect for the following reasons:
Ratios are a useful tool to all stakeholders (including management) not just investors. Ratios
based on past performance are not necessarily indicative of what will happen in the future - for
example, the general economy might change, a new competitor might enter the market, an
entity might introduce a new product.
7 A The correct answer is: 24%
Earnings before interest and tax
Return on investment = × 100%
Total assets less current liabilities
= (10,200/42,500) × 100%
= 24%
8 C Net profit margin will decrease because as the assets are revalued upwards, the depreciation
will increase making profit lower and the profit margin decrease accordingly assuming all else
stays the same.
A revaluation will have no effect on the current ratio.
An upwards revaluation of property, plant and equipment and will make gearing ratio
(debt/equity) decrease as equity has increased.
Interest cover is likely to decrease because profit before interest and tax will fall due to the
higher depreciation.
Non-current asset turnover is calculated as revenue/non-current assets, therefore, it too will
decrease.
444 | ANSWERS TO REVISION QUESTIONS

9 B Gearing and interest cover ratios.

Although all these ratios could be of interest to the bank, as a long-term loan creditor the bank
will be particularly interested in factors that affect the company's ability to pay interest. These
include: whether it is getting into further debt or improving its situation (improving gearing ratio
by lowering the gearing ratio); and the level of profit in relation to interest expense.
10 A GF won a new contract with the largest network provider and retailer in the Middle East on the
basis of a bulk buy discount.
The operating margin in the Middle East has fallen in 20X7 (10.5%) from 20X6 (11.5%). However,
revenue has increased by 56.5%. A new contract could explain the reason for the increase in
revenue. The fact that the customer has negotiated a bulk buy discount could explain the
reason for the decline in operating margin as it implies a lower selling price that normal which
would cause the operating margin to decrease.
The other answers are incorrect because:
An increase in demand for mobile phones would cause revenue to increase but on its own
would not cause a change in operating margin unless there is also a change in sales price, a
change in production costs or a change in administrative and distribution expenses.
If GF had only just begun selling phones in the Middle East, you would expect the margin to be
lower in the early years due to start-up costs and then increasing year on year. However, here,
the operating margin has decreased in 20X7.
High-end smartphones would be likely to attract a higher margin than other devices which
would result in an increase rather than a decrease in operating margin.
 445

BEFORE YOU BEGIN

QUESTIONS:
ANSWERS AND
COMMENTARY
446 | BEFORE YOU BEGIN QUESTIONS: ANSWERS AND COMMENTARY
 FINANCIAL ACCOUNTING AND REPORTING | 447

MODULE 1

1 Differences include:
FINANCIAL ACCOUNTS MANAGEMENT ACCOUNTS
Prepared annually (although quarterly in some Normally prepared monthly or quarterly, often on a
jurisdictions) rolling basis
Provide historic information Provide historic information and future budgets/
forecasts
Are prepared in accordance with accounting Are not governed by any regulations
regulations
Contain summarised information Contain detailed information
Prepared for external use Prepared for internal use

2 Financial reporting is the process of recording, analysing and summarising financial data which is
made available to a variety of user groups.
3 Knowledge of the main user groups of financial statements is important for any accountant:
 Shareholders and investors want to know how profitable their investment is.
 Management need financial information in order to run the company and make decisions.
 Suppliers want to know whether they will be paid and whether the business will continue into
the future.
 Customers want to know whether they will have a continued supply.
 Lenders wish to know whether they will be repaid.
 Employees are interested in job security and whether they will be paid.
 The tax authorities are interested in profits for the purpose of calculating tax.
 The government is interested in companies' financial position from the perspective of the
economy and national statistics.
 The public is interested in how companies affect the environment in which they operate.
4 GAAP is Generally Accepted Accounting Principles. It refers to all of the rules, from whatever
source, that govern accounting in a particular jurisdiction. It may therefore include:
 national legislation
 accounting standards
 stock exchange requirements
5 The correct answer is C. Regulations are not necessarily relevant to all organisations. It is therefore
a disadvantage of a regulatory system that some companies are bound by regulations which are
not relevant to them.
6 The IASB is the International Accounting Standards Board. Its objectives include:
 to develop a single set of high quality, understandable, enforceable and globally acceptable
financial reporting standards;
 to promote the use and rigorous application of those standards; and
 to promote and facilitate adoption of International Financial Reporting Standards (IFRSs),
through the convergence of national accounting standards and IFRSs.
7 The IFRS Advisory Council was previously known as the Standards Advisory Council. The Council is
made up of a wide range of representatives from user groups, preparers, financial analysts,
academics, auditors, regulators, professional accounting bodies and investor groups who have an
interest in international financial reporting. As such, the Council advises the IASB on agenda
decisions, priorities in its work and the impact of standards in practice.
448 | BEFORE YOU BEGIN QUESTIONS: ANSWERS AND COMMENTARY

8 The IFRS Interpretations Committee assists the IASB in establishing and improving International
Financial Reporting Standards, dealing with newly identified financial reporting issues not
specifically addressed in IFRS, or issues where unsatisfactory or conflicting interpretations have
developed, or seem likely to develop.
Knowledge of the regulatory bodies which contribute to the development of International Financial
Reporting Standards is important.
9 A conceptual framework is a statement of generally accepted theoretical principles which form the
frame of reference for financial reporting.
10 Where there is no conceptual framework, the following problems may arise:
 Standards are produced in a haphazard manner and 'firefight' problems which have developed.
In other words they are reactive rather than proactive.
 Contradictions and inconsistencies arise between standards.
 Standards develop which are 'rules-based' rather than 'principles-based'. These offer no
flexibility and may result in incorrect reporting of the substance of transactions.
11 The correct answer is C. Whilst auditors use IFRSs and the Conceptual Framework to help form
their opinion the Conceptual Framework has not been developed specifically for this purpose.
12 'The 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'.
13 A reporting entity is defined in Australia as 'an entity in respect of which it is reasonable to expect
the existence of users who rely on the entity's general purpose financial statements for information
that will be useful to them for making and evaluating decisions about the allocation of resources.
A reporting entity can be a single entity or a group comprising a parent and all of its subsidiaries.'
The 'reporting entity' concept is not, however, one that is currently adopted outside of Australia
and at present international standard-setters have no official equivalent definition. Internationally
therefore, a reporting entity is taken quite simply to be an entity, or group of entities which prepare
accounts.
14 Accounting policies are the specific principles, bases, conventions, rules and practices adopted by
an entity in preparing and presenting financial statements.
15 A change in accounting policy is accounted for retrospectively i.e. the accounts are adjusted to
reflect the situation as if the new accounting policy had always been in force.
16 A change in accounting estimate is accounted for prospectively i.e. the accounts are amended
from the date of change.
17 Going concern is the assumption, when preparing a set of accounts, that an organisation will
continue to operate for the foreseeable future (at least 12 months).
18 Substance over form is the principle that transactions are accounted for in accordance with their
commercial substance rather than their legal form. Examples of its application include:
 recognising an asset acquired under a finance lease as a non-current asset
 producing consolidated accounts for groups of companies.
19 The qualitative characteristics of financial information are important; make sure that you know what
they are and understand what they mean:
 The fundamental qualitative characteristics are: relevance and faithful representation.
 The enhancing qualitative characteristics are: comparability, verifiability, timeliness and
understandability.
20 Financial information is relevant if it is capable of making a difference in the decisions made by
users. Relevant financial information has predictive value, confirmatory value, or both.
21 Barriers to the global harmonisation of accounting standards include:
 the different purpose of financial reporting in different countries;
 different legal systems;
 an unwillingness of some countries to give up their own national standards;
 FINANCIAL ACCOUNTING AND REPORTING | 449

 cultural differences;
 the need for more basic standards for developing countries and more sophisticated standards
for developed countries; and
 unique circumstances such as hyperinflation in certain countries.
22 An asset is a present economic resource controlled by the entity as a result of past events. An
economic resource is a right that has the potential to produce economic benefits.
23 A liability is a present obligation of the entity to transfer an economic resource as a result of past
events. An obligation is a duty of responsibility that the entity has no practical ability to avoid.
24 Equity is the residual interest in the assets of the entity after deducting all its liabilities.
These definitions of elements of the financial statements are applied throughout numerous IFRS. It
is therefore important that you are familiar with them.
25 The item must meet the definition of an element of the financial statements; and should be
recognised if it is relevant and will provide users of the financial statements with a faithful
representation of the transactions of the entity.
26 The correct answer is D.
Assets and liabilities are presented broadly in order of liquidity only where this provides more
relevant and reliable information.
An asset or liability settled in more than 12 months is classified as current if it is part of the normal
operating cycle of the entity.
Under the 2018 framework an asset no longer needs to have probable future outflows.
Under the 2018 framework the probability of inflow for an asset has been removed, it just has to
have the potential to produce economic benefits.
450 | BEFORE YOU BEGIN QUESTIONS: ANSWERS AND COMMENTARY
 FINANCIAL ACCOUNTING AND REPORTING | 451

MODULE 2

1 Where the historical cost basis of measurement is applied:

 assets are recorded at the amount of cash paid or the fair value of consideration given to
acquire them
 liabilities are recorded at the amount of proceeds received in exchange for the obligation.
2 Although the historical cost basis of measurement has a notable advantage in that it is objective,
there are also a number of disadvantages, including the following:
 The historical cost of an asset does not reflect its replacement cost where there is inflation or
prices have increased due to market conditions.
 Historical cost gives no indication of the realisable value of an asset.
 Comparisons over time are unrealistic.
 The cost of new non-current assets is aggregated together with the cost of some which may be
very old, meaning that additions are not on a like for like basis.
 Historic cost does not capture the effect of some important transactions and events, for
example, changes in the value of derivative financial instruments.
3 The correct answer is D. Current value can consist of fair value, current cost, value in use, fulfilment
value.
4 Fair value is 'the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date'.
5 A normative accounting theory is one which explains what should occur rather than what does.
6 Physical capital maintenance defines profit in terms of the increase in physical productive capacity
over a period rather than in terms of the increase in monetary capital. Where physical capital is
maintained, an entity is able to continue to operate at current levels of activity (having taken into
account price inflation of raw materials and other costs).
7 Current purchasing power accounting measures profits as the increase in the current purchasing
power of equity. Profits are therefore stated after allowing for the declining purchasing power of
money due to price inflation.
8 Current cost accounting requires that assets should be stated at their deprival value to the
business. By taking account of changing prices, it therefore results in accounts which reflect the
maintenance of the operating capability of a business.
9 An agency relationship is a contract under which one or more persons (the principals) engage
another person (the agent) to perform some service on their behalf that involves delegating some
decision-making authority to the agent.
10
PRINCIPAL AGENT
Shareholders Directors
Directors Auditors
Directors Employees

11 Corporate governance disclosures are important as they explain to the shareholders of an entity
what steps the directors are taking to ensure that the company is run properly.
12 The advantages of disclosing non-mandatory information include:
 enabling shareholders to better understand the company and its environment;
 providing shareholders with more information on which to base an assessment of the
stewardship of the directors; and
 allowing shareholders to access the information which interests them.
452 | BEFORE YOU BEGIN QUESTIONS: ANSWERS AND COMMENTARY

13 A corporate governance report details how the directors of an entity have complied with corporate
governance regulations during the financial year. In particular, it may include information on the
independence of non-executive directors, internal control systems, relationships with key
shareholders and the members of audit and remuneration committees.
14 A corporate social responsibility report explains how an entity has addressed social issues such as
the employment of disabled people or support of charities and environmental concerns such as
levels of emissions.
Ensure that you know the contents of the supplementary information found in a set of financial
statements.
 FINANCIAL ACCOUNTING AND REPORTING | 453

MODULE 3

1 The format of the IAS 1 statement of financial position is:

Assets
 Non-current assets
 Current assets
Equity and liabilities
Equity
Liabilities
 Non-current liabilities
 Current liabilities
2 The format of the IAS statement of profit or loss is:
 Revenue
 Cost of sales
 Gross profit
 Other income
 Distribution costs
 Administrative expenses
 Finance costs
 Profit before tax
 Taxation
 Profit for the year
3 An asset should be classified as a current asset when it:
 is expected to be realised in, or is held for sale or consumption in, the normal course of the
entity's operating cycle;
 is held primarily for trading purposes or for the short term and expected to be realised within
12 months of the end of the reporting period; or
 is cash or a cash equivalent asset which is not restricted in its use.
4 A liability should be classified as a current liability when it:
 is expected to be settled in the normal course of the entity's operating cycle;
 is held primarily for the purpose of trading;
 is due to be settled within 12 months after the end of the reporting period; or
 the entity does not have an unconditional right to defer settlement of the liability for at least 12
months after the end of the reporting period.
5 Other comprehensive income refers to items of income and expense which are not recognised in
profit or loss, as they are not realised for example, a revaluation gain on a non-current asset.
6 IAS 1 requires the following items to be disclosed in the profit or loss section of the statement of
profit or loss and other comprehensive income:
(a) Revenue
(b) Finance costs
(c) Share of profits and losses of associates and joint ventures accounted for using the equity
method
(d) A single amount for the total of discontinued operations
(e) Tax expense
7 To report transactions between a company and its shareholders in their capacity as shareholders.
8 The notes to the financial statements give additional information about the transactions and
balances recognised in the primary financial statements.
454 | BEFORE YOU BEGIN QUESTIONS: ANSWERS AND COMMENTARY

9 A statement of cash flows shows a company's ability to pay its debts as they fall due, and the
availability of cash to pay dividends, wages and so on. It is a useful indicator of liquidity and
solvency.
10 Cash equivalents are short term, highly liquid investments that are readily convertible to known
amounts of cash and which are subject to an insignificant risk of changes in value.
11 Cash flows from operating, investing and financing activities.
12 Cash generated by operations:
Cash received from customers X
Cash paid to employees and suppliers (X)
X

13 Cash generated by operations:

Profit before tax X

Add: depreciation X
Interest expense X
Loss (profit) on sale of non-current assets X
(Increase)/decrease in inventories (X)/X
(Increase)/decrease in receivables (X)/X
Increase/(decrease) in payables X/(X)
Cash generated from operations X

14 The advantages of cash flow accounting are as follows:

 Survival in business depends on the ability to generate cash. Cash flow accounting directs
attention towards this critical issue.
 Cash flow is less subjective than 'profit' which is dependent on accounting conventions and
concepts.
 Creditors (long- and short-term) are more interested in an entity's ability to repay them than in
its profitability. Whereas 'profits' might indicate that cash is likely to be available, cash flow
accounting is more direct with its message.
 Cash flow reporting provides a better means of comparing the results of different companies
than traditional profit reporting.
 Cash flow reporting better satisfies the needs of all users:
– For management, it provides the sort of information on which decisions should be taken (in
management accounting, 'relevant costs' to a decision are future cash flows); traditional
profit accounting does not help with decision-making.
– For shareholders and auditors, cash flow accounting can provide a satisfactory basis for
stewardship accounting.
– As described previously, the information needs of creditors and employees will be better
served by cash flow accounting.
 Cash flow forecasts are easier to prepare, as well as more useful, than profit forecasts.
 They can in some respects be audited more easily than accounts based on the accruals
concept.
 The accruals concept is confusing, and cash flows are more easily understood.
15 The external auditor's primary role is to form an independent opinion on a set of financial
statements and assess whether they are true and fair.
 FINANCIAL ACCOUNTING AND REPORTING | 455

MODULE 4

1 Property, plant and equipment are tangible assets that are held for the production or supply of
goods or services, for rental to others, or for administrative purposes and are expected to be used
during more than one period.
2 Property, plant and equipment is initially recognised at cost. Cost includes the initial purchase
price plus any directly attributable costs of bringing the asset to its location and condition and any
estimated dismantling or restoration costs. Subsequent costs can also be capitalised if they meet
certain criteria.
3 The revalued amount is the fair value at date of revaluation less subsequent accumulated
depreciation and subsequent accumulated impairment losses.
4 The depreciable value of an asset is allocated across the asset's useful life.
5 An intangible asset is a non-monetary asset without physical substance.
6 At cost, providing that the recognition criteria are met, that is:
(a) it is probable that the future economic benefits that are attributable to the asset will flow to the
entity
(b) the cost can be measured reliably
7 An intangible asset may only be revalued if it is part of an active market. An active market is one in
which items traded are homogenous, willing buyers and sellers are available and prices are
available to the public.
8 Internally generated goodwill, brands, mastheads, publishing titles and customer lists may not be
capitalised as intangible assets.
9 Research is original and planned investigation undertaken with the prospect of gaining new
scientific or technical knowledge and understanding.
10 Development is 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.
11 Research costs are expensed to profit or loss as incurred.
12 If all of the following six criteria are met, development costs must be capitalised:
 The completion of the intangible asset so that it will be available for use or sale is technically
feasible.
 There is an intention to complete the intangible asset and use or sell it.
 The intangible asset can be used or sold.
 The intangible asset will generate probable future economic benefits. Among other things, the
entity should demonstrate the existence of a market for the output of the intangible asset itself
or, if it is to be used internally, the usefulness of the intangible asset.
 Adequate technical, financial and other resources to complete the development and to use or
sell the intangible asset are available.
 The expenditure attributable to the intangible asset during its development can be measured
reliably.
These criteria are important and worth learning. Note how they mirror (in more detail) the
recognition criteria of the Conceptual Framework.
13 Indicators of impairment may be external or internal. They are largely based on common sense:
 External sources of information
– A fall in the asset's market value that is more significant than would normally be expected
from passage of time or normal use.
– A significant change in the technological, market, legal or economic environment of the
business in which the assets are employed.
456 | BEFORE YOU BEGIN QUESTIONS: ANSWERS AND COMMENTARY

– An increase in market interest rates or market rates of return on investments likely to affect
the discount rate used in calculating value in use.
– The carrying amount of the entity's net assets being more than its market capitalisation.
 Internal sources of information: evidence of obsolescence or physical damage, adverse
changes in the use to which the asset is put, or the asset's economic performance.
14 Even if there are no indications of impairment, the following assets must always be tested for
impairment annually:
 an intangible asset with an indefinite useful life
 an intangible asset which is not yet available for use
 goodwill acquired in a business combination
15 The recoverable amount of an asset should be measured as the higher value of:
 the asset's fair value less costs of disposal; and
 its value in use.
Learn this definition as it will be the key to correctly answering many questions.
16 An impairment loss must be recognised when the recoverable amount of an asset is less than its
carrying amount.
17 An impairment loss relating to an asset held at historical cost is recognised in profit or loss; an
impairment loss relating to a revalued asset is recognised as a revaluation decrease in accordance
with the relevant standard.
18 A cash-generating unit is the smallest identifiable group of assets for which independent cash
inflows can be identified and measured.
19 Impairment losses are allocated to a CGU in the following order:
1. first, to any assets that are obviously damaged or destroyed;
2. next, to the goodwill allocated to the cash generating unit; and
3. then to other assets in the cash-generating unit, on a pro rata basis.
20 IFRS 15 Revenue from Contracts with Customers
21 The model is as follows:
1. Identify the contract with a customer
2. Identify the separate performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations
5. Recognise revenue when (or as) the entity satisfies a performance obligation
22 Current tax is the estimated amount payable to the tax authorities in relation to the trading
activities of the entity during the period. It is calculated by applying the tax rate to taxable profits.
23 The correct double entry is:
Dr. Tax expense (profit or loss)
Cr. Tax liability (statement of financial position)
24 An over-provision of current tax arises where the liability recorded at one year end exceeds the
amount of tax actually paid in the next period. An over-provision reduces the following year's tax
charged to profits.
An under-provision is the opposite and increases the following year's tax charged to profits.
25 Deferred tax is an accounting measure used to match the tax effects of transactions with their
accounting impact.
26 A temporary difference is the difference between the carrying amount of an asset or liability and its
tax base.
27 The tax base of an asset is the amount that will be deductible for tax purposes against any taxable
economic benefits that will flow to the entity when it recovers the carrying amount of the asset.
Where those economic benefits are not taxable, the tax base of the asset is the same as its carrying
amount.
 FINANCIAL ACCOUNTING AND REPORTING | 457

28 A taxable temporary difference arises where the carrying amount of an asset exceeds its tax base
or the carrying amount of a liability is less than its tax base. It results in a deferred tax liability.
29 Common transactions which result in taxable temporary differences include the following:
 Interest revenue received in arrears and included in accounting profit on the basis of time
apportionment. It is included in taxable profit, however, on a cash basis.
 Depreciation of an asset is accelerated for tax purposes. When new assets are purchased,
allowances may be available against taxable profits which exceed the amount of depreciation
chargeable on the assets in the financial statements for the year of purchase.
 Development costs which have been capitalised will be amortised through profit or loss, but
they were deducted in full from taxable profit in the period in which they were incurred.
 Prepaid expenses have already been deducted on a cash basis in determining the taxable profit
of the current or previous periods.
It is worth learning this list (and that below relating to deductible temporary differences) so that
you can deal with exam questions on deferred tax quickly and without confusion.
30 A deductible temporary difference arises where the tax base of an asset exceeds its carrying
amount or the tax base of a liability is less than its carrying amount. It results in a deferred tax
asset.
31 Common transactions which result in deductible temporary differences include the following:
 Retirement benefit costs (pension costs) are deducted from accounting profit as service is
provided by the employee. They are not deducted in determining taxable profit until the entity
pays either retirement benefits or contributions to a fund. (This may also apply to similar
expenses.)
 The NRV of inventory, or the recoverable amount of an item of property, plant and equipment
falls and the carrying amount is therefore reduced, but that reduction is ignored for tax
purposes until the asset is sold.
 Research costs (or organisation/other start-up costs) are recognised as an expense for
accounting purposes but are not deductible against taxable profits until a later period.
 Income is deferred in the statement of financial position, but has already been included in
taxable profit in current/prior periods.
 Tax losses arise which are carried forward against future taxable profits.
32 IAS 12 requires deferred tax assets and liabilities to be measured at the tax rates expected to apply
in the period when the asset is realised or liability settled, based on tax rates and laws enacted (or
substantively enacted) at the end of the reporting period.
33 As with current tax, deferred tax should normally be recognised as income or an expense and
included in the net profit or loss for the period in the statement of profit or loss and other
comprehensive income. Deferred tax (and current tax) should be charged or credited to other
comprehensive income or directly to equity if the tax relates to items also charged or credited to
other comprehensive income or directly to equity (in the same or a different period).
34 The tax on profit on ordinary activities is calculated by aggregating:
 income tax on taxable profits
 transfers to or from deferred taxation
 any under-provision or over-provision of income tax on profits of previous years
35 The currency of the primary economic environment in which the entity operates.
36 The currency in which the financial statements are presented.
37 At the spot rate in force on the date of the transaction.
38 An exchange difference arises either:
 on the settlement of the item; or
 where a monetary item is retranslated at the period end.
Such exchange differences are recognised in profit or loss.
458 | BEFORE YOU BEGIN QUESTIONS: ANSWERS AND COMMENTARY

39 Monetary items are units of currency held and assets and liabilities to be received or paid in a
fixed or determinable number of units of currency.
40 Assets and liabilities are translated at the closing rate.
Share capital and pre-acquisition reserves are translated at the acquisition-date rate
Post-acquisition reserves are a balancing figure.
41 The exchange rate in force on the date of each transaction should be applied, however for
practical purposes, all items in the statement of profit or loss are usually translated at the average
rate.
Learn the rules in the answers to 40 and 41.
42 The exchange difference is made up of two elements:
1. the difference between opening net assets translated at the opening and closing rates
2. the difference between retained earnings for the year translated at the average and closing
rates
43 Leases are accounted for by recognising a right of use asset and a corresponding liability.
44 The standard allows the lessee to elect to not apply IFRS 16 for short-term leases – this is a lease for
a period of time that is for less than 12 months. Low value leases – this is when the underlying asset
has a low value when new.
 FINANCIAL ACCOUNTING AND REPORTING | 459

MODULE 5

1 A subsidiary is an entity that is controlled by another entity.

2 An associate is an entity over which an investor has significant influence.
3 IFRS 10 states that an investor controls an investee if, and only if, it has all of the following:
1. Power over the investee;
2. Exposure to, or rights to, variable returns from its involvement with the investee; and
3. The ability to use its power over the investee to affect the amount of the investor's returns.
Power over an investee is normally obtained directly from ownership of the majority of voting
rights, but it can be derived from other rights, such as:
 rights to appoint, reassign or remove key management personnel who can direct the relevant
activities
 rights to appoint or remove another entity that directs the relevant activities
 rights to direct the investee to enter into, or veto changes to, transactions for the benefit of the
investor
 other rights, such as those specified in a management contract.
4 IAS 28 states that if an investor holds 20 per cent or more of the voting power of the investee, it
can be presumed that the investor has significant influence over the investee, unless it can be
clearly shown that this is not the case. The existence of significant influence is evidenced in one or
more of the following ways:
 Representation on the board of directors (or equivalent) of the investee
 Participation in the policy-making process
 Material transactions between investor and investee
 Interchange of management personnel
 Provision of essential technical information
5 A subsidiary is consolidated and an associate is equity accounted.
6 All entities meeting the definition of a subsidiary must be consolidated. Note: There is one
exception to this rule required by IFRS 5, but this is not on the FAR syllabus.
7 The non-controlling interest is the share of the subsidiary not owned by the parent company. It is
measured at acquisition as either:
 the relevant proportion of the fair value of the net assets of the subsidiary; or
 fair value.
8 The assets and liabilities of the parent and subsidiary are added together on a line by line basis.
Share capital in the consolidated statement of financial position is that of the parent company only.
9 Goodwill arises when the consideration transferred by the parent plus the non-controlling interest
of the subsidiary at acquisition exceeds the fair value of the net assets of the subsidiary at
acquisition.
10 Positive goodwill is recognised as a non-current asset in the consolidated statement of financial
position. It is not amortised but is tested for impairment annually.
11 Goodwill is calculated as:
Consideration transferred X
Non-controlling interest X
X
Net assets of acquiree (X)
Goodwill X
12 A bargain purchase (or negative goodwill) is re-assessed and any remaining amount is recognised
immediately in profit or loss.
460 | BEFORE YOU BEGIN QUESTIONS: ANSWERS AND COMMENTARY

13 IFRS 3 requires the acquisition-date fair value of contingent consideration to be recognised as part
of the consideration for the acquiree.
14 An unrealised profit arises where one group company has sold goods (or a non-current asset) at a
profit to another group company during an accounting period, but these goods have not been
sold on to a third party outside the group.
15 An unrealised profit (URP) must be adjusted for on consolidation by
Dr. Group retained earnings
Cr. Inventory/non-current assets
Where the subsidiary is the selling company and there is a non controlling interest, the entry is:
Dr. Group retained earnings (with group share of URP)
Dr. NCI (with NCI share of URP)
Cr. Inventory/non-current assets
16 The subsidiary's statement of financial position must be adjusted to show fair values. These fair
values are incorporated into the consolidation and also into the calculation of goodwill.
17 The income and expenses of the parent and subsidiaries are added across on a line by line basis.
Dividend income received by the parent from subsidiaries is eliminated.
18 The non-controlling interest in profit is calculated as:
NCI %  profit of subsidiary (after consolidation adjustments attributable to the subsidiary)
19 The amount of the sales made in the period is eliminated from group sales and the same amount is
eliminated from group cost of sales.
20 The cost of sales of the selling company is increased by the amount of the URP in the consolidation
schedule.
21 Where the transfer has taken place in the year, the URP includes two elements:
 The profit or loss recorded by the selling company on the transfer
 The extra depreciation charged as a result of the transfer
22 The results of the subsidiary must be pro-rated prior to consolidation so that only the post-
acquisition results are included in the group statement of profit or loss.
23 An impairment of goodwill in the year is normally charged to administrative expenses.
24 An associate is accounted for using the equity method.
25 The group share of the associate's profit after tax for the year is included in the consolidated
statement of profit or loss in one line immediately before group profit before tax.
26 In the consolidated statement of financial position an investment in associate is included as a
non-current asset calculated as:
Cost of the investment in the associate X
Group share of post-acquisition profits X
Any amounts paid out as dividends (X)
Any amount written off the investment (X)
X

27 The group share of the unrealised profit is adjusted by:

Dr. Share of profit or loss of associates
Cr. Investment in associate
28 Any impairment loss arising in the year is charged against the group share of the associate's profits
recognised in the consolidated statement of profit or loss.
The investment in associate in the consolidated statement of financial position is shown net of
accumulated impairment losses.
 FINANCIAL ACCOUNTING AND REPORTING | 461

MODULE 6

1 Comparable company analysis involves comparing one company's financial statements directly
with those of another similar company and considering why differences may be evident.
2 Trend analysis involves comparing the results of one company over time.
3 Ratios may be classified into the following groups:
 Profitability
 Liquidity/efficiency
 Solvency
 Investor ratios
Earnings before interest and tax
4 ROI = × 100%
Total assets – Current liabilities
ROI is sometimes called return on capital employed (ROCE).
5 ROI indicates how well management are utilising the resources available to them to make profits.
Sales
6 Asset turnover =
Total assets  Current liabilities
7 Asset turnover is a measure of how well the assets of a business are being used to generate sales.
8 Gearing and interest cover provide an indication of solvency.
9 Leverage is an alternative name for gearing. A high level of gearing is risky as the high level of fixed
interest makes the shareholders' dividend return more susceptible to volatile profits. In turn, this
risk makes both equity and loan finance investors less willing to invest in the company.
Current assets
10 Current ratio =
Current liabilities
11 The quick ratio excludes inventory from current assets in the calculation above.
Receivables
12 Receivables' days = × 365 days
Credit sales
13 Inventory days indicates the time for which an entity holds goods before they are sold.
14 An increase in payables' days is often a sign of lack of long-term finance or poor management of
current assets, resulting in the use of extended credit from suppliers. Where payment exceeds
credit terms, supply may be halted, which may impact a business significantly.
Profit after tax and preference dividend
15 Earnings per share =
Number of ordinary shares
16 Dividend cover shows the proportion of profit for the year that is available for distribution to
shareholders that has been paid (or proposed) and what proportion will be retained in the business
to finance future growth.
17 A high P/E ratio indicates strong shareholder confidence in the company and its future.
The formulae to calculate the various ratios within this module must be learned.
18 Dividend yield is the return a shareholder is currently expecting on the shares of a company.
19 The limitations of financial statements include the following:
 They are usually based on historical cost information which can be out of date.
 They may be subject to manipulation or creative accounting.
 Significant transactions near the year end, seasonal trading and related parties may all distort
results.
 The effects of different accounting policies reduce comparability.
462 | BEFORE YOU BEGIN QUESTIONS: ANSWERS AND COMMENTARY

20 Limitations of ratio analysis include the following:

 In a company's first year of trading there will be no comparative figures. So there will be no
indication of whether or not a ratio is improving.
 Comparison against industry averages may not be that revealing. A business may be subject to
factors which are not common in the industry.
 Ratios based on historic cost accounts may be out of date. In particular, undervalued assets will
distort ROI and exaggerate gearing.
 Ratios are influenced by the choice of accounting policy. For instance, a company seeking to
maintain or increase its ROI may choose not to revalue its assets.
 Financial statements are subject to manipulation and so are the ratios based on them. Creative
accounting is undertaken with key ratios in mind.
 Inflation over a period will distort results and ratios. Profit before tax, and therefore ROI, can be
inflated where FIFO is applied during an inflationary period.
 No two companies, even operating in the same industry, will have the same financial and
business risk profile. For instance, one may have better access to cheap borrowing than the
other and so may be able to sustain a higher level of gearing.
 463

GLOSSARY OF TERMS
464 | GLOSSARY OF TERMS
 FINANCIAL ACCOUNTING AND REPORTING | 465

GLOSSARY OF TERMS

Accounting. The process of identifying, measuring, recording and communicating economic

information to others so that they may make resource allocation decisions on the basis of that
information.
Accounting policies. The specific principles, bases, conventions, rules and practices adopted by an
entity in preparing and presenting financial statements.
Accounting standards. Authoritative statements of how particular types of transactions and other
events should be reflected in the financial statements.
Accrual accounting. Depicts the effects of transactions and other events and circumstances on a
reporting entity's economic resources and claims in the periods in which those effects occur, even if
the resulting cash receipts and payments occur in a different period.
Accruals concept. Items are recognised as assets, liabilities, equity, income and expenses (the
elements of financial statements) when they satisfy the definitions and recognition criteria for those
elements in the Conceptual Framework. Therefore items of income and expenditure are matched and
accounted for in the period in which they were earned/incurred rather than when the cash was
received or paid.
Agency relationship. A contract under which one or more persons (the principals) engage another
person (the agent) to perform some service on their behalf that involves delegating some decision-
making authority to the agent.
Asset. A present economic resource controlled by the entity as a result of past events. An economic
resource is a right that has the potential to produce economic benefits.
Asset turnover. Sales compared to investment (capital employed). Can be calculated as sales
compared to total assets or sales compared to total assets less current liabilities.
Assets to equity ratio. Assets (non-current assets plus net current assets) compared to shareholders'
funds. A measure of gearing (leverage).
Associate. An entity over which the investor has significant influence.
Assurance engagement. An engagement in which a practitioner aims to obtain sufficient appropriate
evidence to express a conclusion designed to enhance the degree of confidence of the intended
users about the subject matter.
Audit. A type of assurance engagement carried out by an external auditor to provide an independent
opinion on an entity's financial statements.
Auditor's report. Sets out the auditors' opinion of the financial statements and states whether they
show a true and fair view/fair presentation of the financial performance and financial position of the
entity.
Business entity concept. The concept that financial accounting information relates only to the
activities of the business entity and not to the activities of its owner(s).
Capital gearing ratio. A measure of the proportion of a company's capital that is debt.
Carrying amount. The amount at which an asset is recognised after deducting accumulated
depreciation and any impairment losses.
Cash. Cash on hand and demand deposits.
Cash equivalents. Short-term, highly liquid investments that are readily convertible to known amounts
of cash and which are subject to an insignificant risk of changes in value.
Cash flows. Inflows and outflows of cash and cash equivalents.
Cash-generating unit. The smallest identifiable group of assets that generates cash inflows that are
largely independent of the cash inflows from other assets or groups of assets.
466 | GLOSSARY OF TERMS

Change in accounting estimate. An adjustment of the carrying amount of an asset or a liability or the
amount of the periodic consumption of an asset, that results from the assessment of the present
status of, and expected future benefits and obligations associated with, assets and liabilities.
Closing rate. The spot exchange rate at the year end date.
Comparability. Accounting policies used should be disclosed, to make it possible for users to
compare the company's results with its own prior years and with the results of other companies.
Conceptual framework. A statement of generally accepted theoretical principles which form the
frame of reference for financial reporting.
Conceptual Framework for Financial Reporting ('Conceptual Framework'). The IASB's Conceptual
Framework upon which all IFRSs are based. It determines how financial statements are prepared and
the information they contain.
Consolidated financial statements. The financial statements of a group in which the assets, liabilities,
equity, income, expenses and cash flows of the parent and its subsidiaries are presented as those of a
single economic entity.
Control. An investor (a parent) controls an investee (a subsidiary) 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.
Corporate governance. The framework of rules, relationships, systems and processes within and by
which authority is exercised and controlled in corporations. It encompasses the mechanisms by which
companies, and those in control, are held to account.
Cost model. Assets are measured at amounts based on their historical cost. For example, a
non-current asset is carried at its cost less depreciation and any accumulated impairment loss.
Current assets. Assets used in the trading activities of the business such as inventory, trade
receivables and cash at bank.
Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid
if the same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted
amount of cash or cash equivalents that would be required to settle the obligation currently.
Current Cost Accounting (CCA). Reflects an approach to capital maintenance based on maintaining
the operating capability of a business and so measures assets at their value to the business (deprival
value).
Current liabilities. Amounts due in the shorter term such as trade payables and sales tax.
Current purchasing power (CPP). Measures profits as the increase in the current purchasing power of
equity. Profits are therefore stated after allowing for the declining purchasing power of money due to
price inflation.
Current ratio. Ratio of current assets to current liabilities
Current tax. The amount payable to the tax authorities in relation to the trading activities of the
period.
Debt to total assets. Interest bearing debt compared with total assets. A measure of gearing
(leverage).
Deductible temporary differences. Temporary differences that will result in amounts that are
deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the
asset or liability is recovered or settled.
Deferred tax. An accounting measure, used to match the tax effects of transactions with their
accounting impact and thereby produce less distorted results.
Deferred tax assets. The amounts of income taxes recoverable in future periods in respect of:
 deductible temporary differences
 the carry forward of unused tax losses
 the carry forward of unused tax credits.
 FINANCIAL ACCOUNTING AND REPORTING | 467

Deferred tax liabilities. The amounts of income taxes payable in future periods in respect of taxable
temporary differences.
Depreciation. A method of spreading the cost of non-current assets over their useful lives with an
annual charge to profit or loss.
Deprival value. The lower of replacement cost and recoverable amount. In turn the recoverable
amount is the higher of net realisable value and economic value.
Development. 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.
Directors' report. A report contained in the annual report which gives a fair review of the
development of the business during the year and of its position at the end of it.
Dividend cover. Ratio of earnings per share to dividend per share.
Dividend yield. The return a shareholder is currently expecting on the shares of a company.
Earnings per share (EPS). The amount of profit before tax for the period that is attributable to each
ordinary share which is outstanding during all or part of the period.
Economic value (EV), or value in use. What the existing asset will be worth to the company over the
rest of its useful life, that is, the present value of future cash flows associated with the asset.
Equity. The residual interest in the assets of the entity after deducting all its liabilities.
Equity method. A method of accounting whereby the investment is initially recorded at cost and
adjusted thereafter for the post-acquisition change in the investor's share of net assets of the investee.
The profit or loss of the investor includes the investor's share of the profit or loss of the investee.
Exchange difference. The difference resulting from translating a given number of units of one
currency into another currency at different exchange rates.
Exchange rate. The ratio of exchange for two currencies.
Expenses. Decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurring of liabilities that result in decreases in equity, other than those
relating to distributions to equity participants.
External auditor. Undertakes an external audit of an entity's financial statement, makes an
independent opinion as to whether those financial statements are true and fair, and is independent of
that entity.
Fair. Information is free from discrimination and bias and in compliance with expected standards and
rules. The accounts should reflect the commercial substance of the company's underlying transactions.
Fair value. The price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date.
Faithful representation. Information that is faithfully represented is complete, neutral and free from
error.
Financial accounting. The accounting processes required for reporting the results and financial
position of a business and other economic information about a business to others so that they may
make decisions on the basis of that information.
Financial capital maintenance. Profit is the increase in money capital over the period. It can be
measured in either nominal monetary units or units of constant purchasing power.
Financial reporting. The process of classifying, recording and presenting financial data in accordance
with generally established concepts and principles.
Foreign currency. A currency other than the functional currency of the entity.
Functional currency. The currency of the primary economic environment in which the entity operates.
468 | GLOSSARY OF TERMS

Future economic benefit. The potential to contribute, directly or indirectly, to the flow of cash and
cash equivalents to the entity. The potential may be a productive one that is part of the operating
activities of the entity. It may also take the form of convertibility into cash or cash equivalents or a
capability to reduce cash outflows, such as when an alternative manufacturing process lowers the cost
of production.
Gains. Increases in economic benefits. As such they are no different in nature from revenue.
Gearing. Gearing represents the proportion of the company's financing on which a return must be
paid regardless of profitability. Also known as leverage.
Generally accepted accounting principles (GAAP). Signifies all the rules, from whatever source,
which govern accounting.
Going concern concept. The entity is normally viewed as a going concern, that is, as continuing in
operation for the foreseeable future. It is assumed that the entity has neither the intention nor the
necessity of liquidation or of curtailing materially the scale of its operations.
Goodwill. Any excess of the consideration transferred in order to obtain control of another entity plus
the non-controlling interest in that entity over the fair value of the identifiable assets and liabilities of
the entity as at the date of the exchange transaction.
Group. A parent and its subsidiaries.
Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of
the consideration given to acquire them at the time of their acquisition.
Impairment. A fall in the value of an asset, so that its 'recoverable amount' is now less than its carrying
amount in the statement of financial position.
Impairment loss. The amount by which the carrying amount of an asset exceeds its recoverable
amount.
Income. 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.
Intangible assets. Non-monetary assets without physical substance.
Interest cover. A ratio that shows whether a company is earning enough profits before interest and tax
to pay its interest costs comfortably, or whether its interest costs are high in relation to the size of its
profits.
Intra-group trading. Trading/transactions between companies in a group.
International Accounting Standards Board (IASB). An independent, privately-funded accounting
standard-setter. It is responsible for the setting of International Financial Reporting Standards (IFRSs).
International Auditing and Assurance Standards Board (IAASB). An independent standard setting
body, responsible for setting standards on auditing, assurance and other related areas and for
facilitating their adoption and implementation.
International Financial Reporting Standards (IFRSs). The accounting standards issued by the IASB.
Earlier accounting standards were known as International Accounting Standards (IASs) and many of
these are still in issue.
International Financial Reporting Standards Advisory Council. Provides a formal vehicle to give
advice to the IASB.
International Financial Reporting Standards Foundation (IFRS Foundation). An independent body
that oversees the IASB.
International Financial Reporting Standards Interpretations Committee. Provides timely guidance
on the application and interpretation of International Financial Reporting Standards.
International Standards on Auditing (ISAs). Global auditing standards issued by the IAASB and used
by auditors in the external audit of financial statements.
 FINANCIAL ACCOUNTING AND REPORTING | 469

Inventory turnover. Number of times in a year that inventory is 'turned over' or replaced in the
warehouse.
Inventory turnover period. Number of days inventories (or stocks of goods) are held for.
Leverage. Leverage represents the proportion of the company's financing on which a return must be
paid regardless of profitability. Also known as gearing.
Liability. A present obligation of the entity to transfer an economic resource as a result of past events.
An obligation is a duty of responsibility that the entity has no practical ability to avoid.
Liquidity. The availability of sufficient funds to meet short-term financial commitments as they fall due.
Losses. Decreases in economic benefits. As such they are no different in nature from other expenses.
Management accounting. The process of identifying, measuring and communicating the information
used by management to plan and control within an entity.
Management commentary. A narrative report that provides users with explanations of the amounts
presented in the financial statements. It also provides commentary on an entity's prospects and other
information not presented in the financial statements.
Materiality. Information is material if omitting it or misstating it could influence the economic
decisions that users make on the basis of financial information about a specific reporting entity.
Measurement. The process of determining the monetary amounts at which the elements of the
financial statements are to be recognised and carried in the statement of financial position and
statement of profit or loss and other comprehensive income.
Monetary items. Units of currency held, and assets and liabilities to be received or paid in a fixed or
determinable number of units of currency.
Net realisable value. The estimated selling price in the ordinary course of business less the estimated
costs of completion and the estimated costs necessary to make the sale.
Non-controlling interest. The shares in a subsidiary that are not owned by the parent company.
Non-current assets. Assets for long-term use within the business.
Non-current liabilities. Long-term liabilities usually due after more than one year.
Normative accounting theory. Explains what should occur rather than what actually does occur.
Obligation. A duty or responsibility to act or perform in a certain way. Obligations may be legally
enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise,
however, from normal business practice, custom and a desire to maintain good business relations or
act in an equitable manner.
Operating cycle of an entity. The time between the acquisition of assets for processing and their
realisation in cash or cash equivalents.
Operating or Physical capital maintenance. Profit is the increase in the physical productive capacity
over the period.
Other comprehensive income. Items of income and expense (including reclassification adjustments)
that are not recognised in profit or loss as required or permitted by other IFRSs.
Parent. An entity that controls one or more entities (known as subsidiaries).
Payables payment period. Number of days of credit taken from suppliers.
Performance obligation. A promise in a contract to transfer to a customer goods or services that are
distinct.
Positive accounting theory. One where accounting theory is thought of as a body of knowledge that
explains/predicts actual accounting practice.
Post-acquisition profits. Profits earned by a subsidiary since the date of acquisition.
Power. Existing rights that give an investor the current ability to direct the relevant activities of its
investee.
Present obligation. Obligation existing at the present time.
470 | GLOSSARY OF TERMS

Presentation currency. The currency in which the financial statements are presented.
Price/Earnings (P/E) ratio. The ratio of a company's current share price to the earnings per share.
Prior period errors. Omissions from, and misstatements in, the entity's financial statements for one or
more prior periods arising from a failure to use, or misuse of, reliable information that:
 was available when financial statements for those periods were authorised for issue; and
 could reasonably be expected to have been obtained and taken into account in the preparation.
Profit. The excess of revenue (income) over expenditure. When expenditure exceeds revenue, the
business is running at a loss.
Profit margin. Profit as a percentage of sales. Can be based on gross profit, earnings before interest
and tax or profit after interest, tax and preference dividends.
Prospective application. Relates to a change in accounting policy and of recognising the effect of a
change in an accounting estimate, respectively, by:
 applying the new accounting policy to transactions, other events and conditions occurring after the
date as at which the policy is changed; and
 recognising the effect of the change in the accounting estimate in the current and future periods
affected by the change.
Provision. A present obligation which satisfies the rest of the definition of a liability, even if the
amount or timing of the obligation has to be estimated.
Quick ratio. Ratio of current assets minus inventory to current liabilities – also known as the acid test
ratio.
Reasonable assurance. A high, but not absolute, level of assurance.
Receivables collection period. Number of days taken to collect receivables outstanding.
Recognition. The process of incorporating an item that meets the definition of an element in the
statement of financial position or statement of profit or loss and other comprehensive income.
Relevance. Relevant financial information is capable of making a difference in the decisions made by
users.
Reliable financial information. This has the following attributes:
 It reflects the substance of transactions i.e. represents faithfully what has taken place.
 It is free from bias, or neutral.
 It is free from material error.
 It is complete.
 Prudence (or caution) has been applied where there is any uncertainty.
Replacement cost. The amount needed to replace an item with an identical item. This is the same as
current cost.
Reporting entity. An entity for which there are users who rely on the financial statements as their
major source of financial information about the entity.
Research. Original and planned investigation undertaken with the prospect of gaining new scientific
or technical knowledge and understanding.
Residual value. The net amount which the entity expects to obtain for an asset at the end of its useful
life after deducting the expected costs of disposal.
Retrospective application. Applying a new accounting policy to transactions, other events and
conditions as if that policy had always been applied.
Return on assets (ROA). States the earnings before interest and tax as a percentage of total assets.
Return on equity (ROE). States profit after interest, tax and preference dividends as a percentage of
shareholders' funds.
 FINANCIAL ACCOUNTING AND REPORTING | 471

Return on investment (ROI). States the earnings before interest and tax as a percentage of the
amount of investment (total assets less current liabilities). Sometimes called return on capital
employed (ROCE).
Revaluation. Restatement of assets and liabilities, giving rise to increases or decreases in equity.
Revaluation model. Non-current assets are carried at a revalued amount, being their fair value at the
date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated
impairment losses.
Revenue. The gross inflow of economic benefits during the period arising in the course of the
ordinary activities of an entity when those inflows result in increases in equity, other than increases
relating to contributions from equity participants.
Revenue expenditure. Expenditure incurred for the purpose of the trade of the business or to
maintain the existing earning capacity of non-current assets.
Sales tax. A tax paid over to governments on each transaction but borne by the eventual consumer –
also known as GST in some countries, including Australia.
Settlement value. The undiscounted amounts of cash or cash equivalents expected to be paid to
satisfy a liability in the normal course of business.
Significant influence. The power to participate in the financial and operating policy decisions of an
investee but is not control or joint control over those policies.
Solvency. The availability of cash over the longer term to meet financial commitments as they fall due.
Spot exchange rate. The exchange rate for immediate delivery.
Statement of cash flows. A statement showing all movements of cash and cash equivalents into and
out of a business during the accounting period.
Statement of changes in equity. A statement showing the movement in the various components of
equity (share capital, retained earnings and other reserves) for a period.
Statement of financial position. Primary financial statement which lists the assets, liabilities and
owners' equity of a business. Sometimes referred to as a balance sheet.
Statement of profit or loss. Statement showing the income of the business less expenses giving a
final figure for profit. Sometimes referred to as an income statement, or a profit or loss account.
Statement of profit or loss and other comprehensive income. Primary financial statement showing
profit or loss for the period (see above) plus items of other comprehensive income (gains or losses
which are not recognised in profit or loss such as gains or losses on revaluation of non-current assets).
Sometimes referred to as a statement of comprehensive income.
Subsidiary. An entity that is controlled by another entity (known as the parent).
Substance over form. The principle that transactions and other events are accounted for and
presented in accordance with their substance and economic reality and not merely their legal form.
Tax base of an asset or liability. The amount attributed to that asset or liability for tax purposes.
Taxable temporary differences. Temporary differences that will result in taxable amounts in
determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability
is recovered or settled.
Timeliness. Financial information should be available in time to be capable of influencing users'
decisions.
Trade payables. The amounts due to credit suppliers.
Trade receivables. The amounts owed by credit customers.
True. Information is factual and conforms with reality and required standards and law. The financial
statements have been correctly extracted from the books and records.
Understandability. Financial information needs to be capable of being understood by users 'having a
reasonable knowledge of business and economic activities and accounting'.
472 | GLOSSARY OF TERMS

Unmodified opinion. The opinion expressed by an external auditor when they conclude that the
financial statements are prepared, in all material respects, in accordance with the applicable financial
reporting framework.
Useful life. One of two things:
 The period over which an asset is expected to be available for use by an entity; or
 The number of production or similar units expected to be obtained from the asset by an entity.
Value in use. The present value of estimated future cash flows (inflows minus outflows) generated by
an asset, including its estimated net disposal value (if any) at the end of its expected useful life.
Verifiability. Information is verifiable if different observers can broadly agree that a particular way of
presenting an item is a faithful representation.
 473

FORMULAE
474 | FORMULAE
 FINANCIAL ACCOUNTING AND REPORTING | 475

FORMULAE

These formulae are used in Module 6, Analysis of financial statements.

Earnings before interest and (a) The profit after tax;
tax (operating profit) (b) Interest; plus
(c) Tax

(a) The profit after taxation; plus (b) Interest; plus (c) Tax

Return on Investment (ROI) Earnings before interest and taxation

 100%
Total assets less current liabilities
Profit margin x Asset EBIT Sales EBIT
turnover = Return on   = ROI
Sales Investment Investment
investment (ROI)
Return on assets (ROA) Earnings before interest and tax
 100%
Average total assets
Return on equity (ROE) Profit after tax and preference dividend
 100%
Shareholders' equity
Profit margin  Asset Profit after tax and preference dividend Sales Assets
  = ROE
turnover  assets to equity = Sales Assets Equity
Return on equity
Gearing Interest bearing debt
 100%
Shareholders'equity + interest bearing debt
Assets to equity ratio Non-current assets + Net current assets
 100%
Shareholders' equity
Debt to total assets ratio Interest bearing debt
 100%
Total assets
Equity to assets ratio Shareholders' equity
 100%
Non-current assets + Net current assets
Shareholders' equity
or  100%
Total assets less current liabilities

Interest cover Earnings before interest and tax

Interest charges
Current ratio Current assets
Current liabilities

Quick ratio Current assets less inventory

Current liabilities

Accounts receivable Trade receivables

 365 days
collection period Sales
(Receivables' days)
476 | FORMULAE

Inventory turnover period Inventory

 365 days
(Inventory days) Cost of sales
Inventory turnover Cost of sales
Inventory

Accounts payables payment Trade accounts payable

 365 days
period (Payables days) Purchases
Earnings per share (EPS) Profit attributable to ordinary shareholders'
Number of ordinary shares on issue

Dividend cover Earnings per share

Dividend per (ordinary) share

Price earnings (P/E) ratio Current share price

EPS
Dividend yield Dividend per share for the year
 100%
Current market value of the share (ex-div)
 477

INDEX
478 | INDEX
 FINANCIAL ACCOUNTING AND REPORTING | 479

Closing rate, 247

A Conceptual framework, 33
Accountability, 123 Conflict of interest, 124
Accounting, 9, 39 Consolidated financial statements, 288
Accounting concepts, 53 Control, 286
Accounting device, 235 Control activities, 179
Accounting estimates, 39 Core standards, 65
Accounting policies, 39, 40 Corporate governance, 132
Accounting profit, 231 Corporate objectives, 180
Accounting standards, 50 Creative accounting, 126
Accounting standards and choice, 51 Current asset, 157
Accruals basis of accounting, 54 Current cost, 103
Accrued expenses, 235 Current cost accounting (CCA), 116
Accrued income, 235 Current liability, 157
Acid test ratio, 379 Current purchasing power (CPP), 114
Advantages and disadvantages of a Current ratio, 379
conceptual framework, 33 Current tax, 231
Advantages and disadvantages of current
cost accounting, 118
Advantages of accounting standards, 51 D
Agency, 123
Debt to total assets ratio, 375
Agency costs, 125
Deductible temporary differences, 233
Agency problem, 124
Deferred tax assets, 233
Agency relationship, 123
Deferred tax liabilities, 233
Agency theory, 123
Deprival value, 116
Alignment of interests, 125
Development, 208
Amortisation, 209
Development costs, 236
Amortisation of development costs, 209
Direct method, 167
Analytical procedures, 180
Directors, 124
Asset, 72, 73
Director-shareholder relationship, 124
Asset turnover, 371, 372
Disadvantages of accounting standards,
Assets to equity ratio, 375
52
Associate, 286, 334
Disadvantages of regulation, 17
Auditor's report, 182
Dividend cover, 384
Dividend yield, 385
Double-entry bookkeeping, 9
B
Barriers to harmonisation, 24
Benefit of accounting regulation, 16 E
Benefits of cash flow information, 165
Earnings before interest and tax (EBIT),
Business, 10
368
Earnings per share, 384
Economic value-added pay, 125
C Efficiency ratios, 380
Capital gearing ratio, 375 Equity, 72, 74
Capital maintenance, 113, 116 Equity method, 334
Capital maintenance adjustments, 75 Estimation techniques, 39
Carrying amount, 211 European Commission (EC), 25
Cash, 166 Exchange rate, 247
Cash and cash equivalents, 166 Exchange difference, 247
Cash cycle, 379 Executive Share Option Plans (ESOPs), 125
Cash equivalents, 166 Exemption from preparing group
Cash flows, 166 accounts, 288
Cash-generating unit, 214 Expenses, 75
CCA profits, 116 External audit, 178, 181
Change in accounting estimate, 40
Change in accounting policy, 239, 389
480 | INDEX

Information system relevant to financial

F reporting, 179
Fair, 182 Intangible asset, 205
Fair presentation, 27, 39 Interest cover, 377
Fair presentation override, 63 Interest revenue, 236
Fair value, 105, 317 Internal audit function, 180
Faithful representation, 57 Internal control, 178
Fiduciary responsibilities, 123 Internally generated goodwill, 207
Finance lease, 262 International Accounting Standards Board
Financial accounting, 9 (IASB), 20
Financial audit, 180 International Federation of Accountants
Financial capital maintenance, 112 (IFAC), 26
Financing activities, 166, 167 International Financial Reporting
Foreign currency, 247 Interpretations Committee (IFRIC), 20
Fulfilment value, 106 International Financial Reporting
Functional currency, 247 Standards (IFRS), 21, 61
International harmonisation, 65
International Organisation of Securities
G Commissions (IOSCO), 65
Interpretation of IFRS, 63
Gearing ratio, 374 Intra-group trading, 326
General price inflation, 114 Inventory (stock) turnover period, 381
Generally Accepted Accounting Principles Investing activities, 166, 167
(GAAP), 15, 32
Going concern, 53
Goodwill, 316 L
Goodwill and pre-acquisition profits, 298
Gross profit margin, 369 Leverage, 374
Group, 286 Leverage or gearing, 371
Liability, 72, 105, 234
Limitations of ratio analysis, 389
H Liquidity, 37, 378
Loan payable, 235
Historical cost, 103, 104
Historical cost convention, 104
M
I Management (or cost) accounting, 10
Management accounting, 10
IAS 7 Statement of Cash Flows, 165 Management audit, 126
IAS 12 Income Taxes, 231 Management buy-in, 125
IAS 27 Separate Financial Statements, 285, Management buy-out, 125
289 Management commentary, 139
IAS 28 Investments in Associates and Joint Managers, 124
Ventures, 334 Material, 40, 59
IAS 38 Intangible Assets, 203, 204 Materiality, 57
IASC Foundation, 19 Materiality judgements, 59
IFRS Foundation, 19 Measurement basis, 103
IFRS 3 Business Combinations, 285 Measurement of revenue, 225
IFRS 3: Fair Values, 319 Modified historical cost accounting, 110
IFRS 15 Revenue from contracts with Monetary items, 249
customers, 224
Impairment, 211
Impairment of development costs, 209 N
Implications of high or low gearing, 376
Need for financial statements, 13
Impracticable, 41
Net profit margin, 369
Income, 75
Net realisable value (NRV), 237
Indirect versus direct, 169
Neutral, 40
 FINANCIAL ACCOUNTING AND REPORTING | 481

Non-current assets, 157 Return on assets (ROA), 373

Non-statutory audits, 181 Return on equity (ROE), 370
Not-for-profit entities, 11 Return on investment (ROI), 369
Returns, 286
Revaluations, 239
O Revalued assets, 237
Revenue, 224
Obligation, 74 Rules-based system, 48
Operating activities, 166
Operating cycle, 157
Opinion, 181 S
Organisation for Economic Co-operation
and Development, 26 Secondary ratios, 372
Pacioli, 9 Share option scheme, 125
Parent, 286 Shareholders, 124
Performance, 123 Significant influence, 286, 334
Physical capital maintenance (operating Solvency, 37
concept of capital), 112 Specific price inflation, 114
Power, 286 Spot exchange rate, 247
Prepaid expenses, 236 Standard setting process, 21
Present value, 103 Statement of financial position, 81
Presentation currency, 247 Statement of profit or loss and other
Presentation of financial statements, 171 comprehensive income, 84
Primary profitability ratio, 372 Statutory audit, 181
Principles-based system, 48 Stewardship, 181
Prior period errors, 40 Structure of the IASB, 20
Profit, 10 Subsidiary, 286
Profit analysis, 369 Substance over form, 55
Profit margin, 371, 372
Profitability, 368
Profit-related pay, 125 T
Prospective application, 41 Tax base, 234, 235
Purpose of accounting standards, 50 Tax expense, 231, 241
Taxable profit, 231, 235
Taxable temporary differences, 233, 238
Q Taxation, 240
Qualitative factors, 60 Temporary differences, 233, 235
Quantitative factors, 60 Transactions are not covered by an
Quick ratio, 379 accounting standard, 38
Transparency, 126
True, 182
R True and fair view, 27
Truth and fairness, 181
Realisable (settlement) value, 103 Types of agency costs, 125
Reasonable assurance, 182
Recognition, 76
Recognition criteria, 237 U
Recoverable amount, 237
Users of accounting information, 13
Recoverable amount of an asset, 212
Relevance, 56
Reporting period, 154 V
Reporting requirements, 127
Research, 208 Value in use, 106, 212
Research and development (R & D), 207 Value to the business (deprival value), 116
Research costs, 237
Retirement benefit costs, 237
Retrospective application, 41 W
Retrospective restatement, 41
Working capital, 157
482