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ACCA

Applied Skills

Financial
Reporting (FR)

For exams in September

2020, December 2020,
March 2021 and June 2021

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First edition 2020

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Contents
Introduction
Helping you to pass v
Chapter features  vi
Introduction to the Essential reading vii
Introduction to Financial Reporting (FR)  ix
The Exam xii
Essential skills areas to be successful in Financial Reporting xiii

1 The Conceptual Framework 1

2 The regulatory framework 29
3 Tangible non-current assets  45
4 Intangible assets  71
5 Impairment of assets 91
Skills checkpoint 1 107
6 Revenue and Government Grants 117
Skills checkpoint 2  143
7 Introduction to groups  153
8 The consolidated statement of financial position 177
9 The consolidated statement of profit or loss and other comprehensive income  219
10 Accounting for associates 243
Skills checkpoint 3 267
11 Financial instruments  277
12 Leases  299
Skills checkpoint 4  323
13 Provisions and events after the reporting period  329
14 Inventories and biological assets  355
15 Taxation 369
16 Presentation of published financial statements  393
17 Reporting financial performance 421
Skills checkpoint 5  443
18 Earnings per share  455
19 Interpretation of financial statements 477
20 Limitations of financial statements and interpretation techniques  511
21 Statement of cash flows 525
22 Specialised, not-for-profit and public sector entities  547

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Index 557
Bibliography  565

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Helping you to pass

BPP Learning Media – ACCA Approved Content Provider
As an ACCA Approved Content Provider, BPP Learning Media gives you the opportunity to use
study materials reviewed by the ACCA examining team. By incorporating the examining team’s
comments and suggestions regarding the depth and breadth of syllabus coverage, the BPP
Learning Media Workbook provides excellent, ACCA-approved support for your studies.
These materials are reviewed by the ACCA examining team. The objective of the review is to
ensure that the material properly covers the syllabus and study guide outcomes, used by the
examining team in setting the exams, in the appropriate breadth and depth. The review does not
ensure that every eventuality, combination or application of examinable topics is addressed by
the ACCA Approved Content. Nor does the review comprise a detailed technical check of the
content as the Approved Content Provider has its own quality assurance processes in place in this
respect.
BPP Learning Media do everything possible to ensure the material is accurate and up to date
when sending to print. In the event that any errors are found after the print date, they are
uploaded to the following website: www.bpp.com/learningmedia/Errata.

The PER Alert

Before you can qualify as an ACCA member, you not only have to pass all your exams but also
fulfil a three-year practical experience requirement (PER). To help you to recognise areas of the
syllabus that you might be able to apply in the workplace to achieve different performance
objectives, we have introduced the ‘PER alert’ feature (see the next section). You will find this
feature throughout the Workbook to remind you that what you are learning to pass your ACCA
exams is equally useful to the fulfilment of the PER requirement. Your achievement of the PER
should be recorded in your online My Experience record.

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Chapter features
Studying can be a daunting prospect, particularly when you have lots of other commitments. This
Workbook is full of useful features, explained in the key below, designed to help you to get the
most out of your studies and maximise your chances of exam success.
Key term
Central concepts are highlighted and clearly defined in the Key terms feature.
Key terms are also listed in bold in the Index, for quick and easy reference.

Formula to learn
This boxed feature will highlight important formula which you need to learn for
your exam.

PER alert
This feature identifies when something you are reading will also be useful for your
PER requirement (see ‘The PER alert’ section above for more details).

Real world examples

These will give real examples to help demonstrate the concepts you are reading
about.

Illustration
Illustrations walk through how to apply key knowledge and techniques step by step.

Activity
Activities give you essential practice of techniques covered in the chapter.

Essential reading
Links to the Essential reading are given throughout the chapter. The Essential
reading is included in the free eBook, accessed via the Exam Success Site (see inside
cover for details on how to access this).

At the end of each chapter you will find a Knowledge diagnostic, which is a summary of the main
learning points from the chapter to allow you to check you have understood the key concepts. You
will also find a Further study guidance contains suggestions for ways in which you can continue
your learning and enhance your understanding. This can include: recommendations for question
practice from the Further question practice and solutions, to test your understanding of the topics
in the Chapter; suggestions for further reading which can be done, such as technical articles and
ideas for your own research. The Chapter summary provides more detailed revision of the topics
covered and is intended to assist you as you prepare for your revision phase.

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Introduction to the Essential reading

The digital e-Book version of the Workbook contains additional content, selected to enhance your
studies. Consisting of revision materials, activities (including practice questions and solutions) and
background reading, it is designed to aid your understanding of key topics which are covered in
the main printed chapters of the Workbook. The Essential reading section of the e-Book also
includes further illustrations of complex areas.
To access the digital e-Book version of the BPP Workbook, follow the instructions which can be
found on the inside cover; you’ll be able to access your e-Book, plus download the BPP e-Book
mobile app on multiple devices, including smartphones and tablets.
A summary of the content of the Essential reading is given below:

Chapter Summary of essential reading content

3 Tangible non-current assets Further reading behind the cost and depreciation
criteria for non-current assets
Further reading on borrowing costs (IAS 23) and
investment property (IAS 40), together with
worked examples and activities

4 Intangible assets Revision of research and development costs

5 Impairment of assets Further reading on the definitions of fair value,

value in use, as well as examples of impairment of
an asset and impairment of a cost generating
unit

6 Revenue and government grants Further reading on long term contracts and
worked example. Additional activities on
government grants (income and capital)

7 Introduction to groups Exemptions from preparing consolidated

financial statements
Further reading on the definitions of goodwill,
including resulting from business combinations
Consistency of accounting policies requirement

8 The consolidated statement of • Forms of consideration (deferred, share

financial position exchange and contingent)
• IFRS 13 Fair value in the scope of IFRS 3
• Example of subsidiary acquired mid-year

9 The consolidated statement of • Example of subsidiary acquired mid-year

profit or loss • Fair value adjustments

10 Accounting for associates Further reading on the requirement to use the

equity method when accounting for associates
and activities with consolidation including an
associate

11 Financial instruments Further activities on financial instruments and

additional reading on the following:
• Compound instruments
• Business model test
• Contractual cash flow test

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Chapter Summary of essential reading content

12 Leasing Further reading on identifying and accounting
for a lease, including a detailed worked example.
Sale and leaseback not on market terms is also
covered.

13 Provisions and events after the Revision of IAS 37 covered in earlier studies,
reporting period including practice activities
Additional detailed worked example of the
discounting of a provision
Revision of contingent assets and liabilities, and
IAS 10 Events after the Reporting Period

14 Inventories and biological assets Revision of IAS 2 Inventories.

Further reading on IAS 41 Biological Assets

15 Taxation Further activities to consolidate your knowledge

of deferred tax

16 Presentation of published financial Further reading on IAS 1, including proforma

statements financial statements

17 Reporting financial performance Activities on the following:

• IAS 21
• IFRS 5
• Accounting errors
• Changes in accounting policies

18 Earnings per share Activities on the following:

• Basic calculation of EPS
• Rights issue
• Diluted EPS

19 Interpretation of financial Detailed further reading on ratios, including

statements examples and activities

20 Limitations of financial statements Further reading on the limitations of financial

and interpretation techniques statements regarding seasonable trading,
intragroup transactions and the impact of
accounting policy choices

21 Statements of cash flow Revision of the methodology of preparing

extracts from the statement of cash flows

22 Specialised, not-for-profit and Detail behind the primary aims and regulatory
public sector entities framework for these specialised entities.
Additional detail and activities behind their
performance measurement KPIs

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Introduction to Financial Reporting (FR)

Overall aim of the syllabus
To develop knowledge and skills in understanding and applying accounting standards and the
theoretical framework in the preparation of financial statements of entities, including groups and
how to analyse and interpret those financial statements.

Brought forward knowledge

Financial Reporting advances your Financial Accounting knowledge and skills. New Financial
Reporting topics include the analysis of consolidated financial statements, contracts where
performance obligations are satisfied over a period of time, biological assets, financial
instruments, leases and foreign currency. There is also coverage of creative accounting and the
limitations of financial statements and ratios.

The syllabus
The broad syllabus headings are:

A The conceptual and regulatory framework for financial reporting

B Accounting for transactions in financial statements

C Analysing and interpreting the financial statements of single entities and groups

D Preparation of financial statements

Main capabilities
On successful completion of this exam, candidates should be able to:

A Discuss and apply a conceptual and regulatory framework for financial reporting.

B Account for transactions in accordance with International accounting standards.

C Analyse and interpret financial statements.

D Prepare and present financial statements for single entities and business combinations
in accordance with International accounting standards.

Links with other exams

Strategic Business Strategic Business

Reporting (SBR) Leader (SBL)

Corporate and Financial Audit and

Business Law (LW) Reporting (FR) Assurance (AA)

Financial
Accounting (FA)

The financial reporting syllabus assumes knowledge acquired in Financial Accounting and
develops and applies this further and in greater depth. Strategic Business Reporting, assumes

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knowledge acquired at this level including core technical capabilities to prepare and analyse
financial reports for single and combined entities.

Achieving ACCA’s Study Guide Learning Outcomes

This BPP Workbook covers all the FR syllabus learning outcomes. The tables below show in which
chapter(s) each area of the syllabus is covered:

A The conceptual and regulatory framework for financial reporting

A1 The need for a conceptual framework and characteristics of useful Chapter 1

information

A2 Recognition and measurement Chapter 1

A3 Regulatory framework Chapter 2

A4 The concepts and principles of groups and consolidated financial Chapter 7–10
statements

B Accounting for transactions in financial statements

B1 Tangible non-current assets Chapter 3

B2 Intangible non-current assets Chapter 4

B3 Impairment of assets Chapter 5

B4 Inventory and biological assets Chapter 14

B5 Financial instruments Chapter 11

B6 Leasing Chapter 12

B7 Provisions and events after the reporting period Chapter 13

B8 Taxation Chapter 15

B9 Reporting financial performance Chapters 17 and 18

B10 Revenue Chapter 6

B11 Government grants Chapter 6

B12 Foreign currency transactions Chapter 17

C Analysing and interpreting the financial statements of single entities and groups

C1 Limitations of financial statements Chapter 20

C2 Calculation and interpretation of accounting ratios and trends to Chapter 19

address users’ and stakeholders’ needs

C3 Limitations of interpretation techniques Chapter 20

C4 Specialised, not-for-profit and public sector entities Chapter 22

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D Preparation of financial statements

D1 Preparation of single entity financial statements Chapters 16 and 21

D2 Preparation of consolidated financial statements including an Chapters 7–10

associate

The complete syllabus and study guide can be found by visiting the exam resource finder on the
ACCA website: www.accaglobal.com/gb/en.html

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The Exam
Computer-based exams
Applied Skills exams are all computer-based exams (CBE).

Approach to examining the syllabus

The examination lasts three hours and all questions are compulsory.
The exam format will comprise three exam sections.

Section Style of question type Description Proportion of

exam %
A Objective test (OT) 15 questions × 2 marks 30

B Objective test (OT) 3 questions × 10 marks 30

Each question will contain five
sub-parts each worth two marks

C Constructed response 2 questions × 20 marks 40

(long questions)

Total 100

Section A and B questions will be selected from the entire syllabus. These sections will contain a
variety of objective test questions. The responses to each question or subpart in the case of OT
cases are marked automatically as either correct or incorrect by computer.
Section C questions will mainly focus on the following syllabus areas but a minority of marks can
be drawn from any other area of the syllabus.
• Analysing and interpreting the financial statements of single entities and groups (syllabus area
C)
• Preparation of financial statements (syllabus area D)
The responses to these questions are human marked.

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Essential skills areas to be successful in Financial

Reporting
We think there are three areas you should develop in order to achieve exam success in Financial
Reporting (FR).
These are shown in the diagram below:
(1) Knowledge application
(2) Specific FR skills
(3) Exam success skills

cess skills
Exam suc

r planning
Answe

c FR skills C
n Specifi o
tio

rr req
a

ec ui
of
m

t i rem
or

nt
inf

erp ents
ng

Approach to Application

reta
agi

objective test of accounting

(OT) questions standards
Man

tion l y si s
Spreadsheet Interpretation
Go od

skills skills

ana
ti m

c al
Approach
em

to Case

e ri
OTQs
an

um
ag

tn
em

en

en
t ci
Effi
Effe cti
ve writing
a nd p r
esentation

Specific FR skills
These are the skills specific to FR that we think you need to develop in order to pass the exam.
In this Workbook, there are five Skills Checkpoints which define each skill and show how it is
applied in answering a question. A brief summary of each skill is given below.

Skill 1: Approach to OTQs

As 60% of your marks will be gained by correctly answering objective test questions (‘OTQ’), you
need to ensure that you are familiar with the different types of OTQs and the best approach to
tackling them in the exam.
A step-by-step technique for ensuring that you approach the OTQs in the most efficient and
effective way is outlined below:

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STEP 1: Answer the questions you know first.

If you’re having difficulty answering a question, move on and come back to tackle it
once you’ve answered all the questions you know.
It is often quicker to answer discursive style OT questions first, leaving more time
for calculations.

STEP 2: Answer all questions.

There is no penalty for an incorrect answer in ACCA exams; there is nothing to be
gained by leaving an OT question unanswered. If you are stuck on a question, as a
last resort, it is worth selecting the option you consider most likely to be correct
and moving on. Make a note of the question, so if you have time after you have
answered the rest of the questions, you can revisit it. 

STEP 3: Read the requirement first!

The requirement will be stated in bold text in the exam. Identify what you are
being asked to do, any technical knowledge required and what type of OT
question you are dealing with. Look for key words in the requirement such as
"Which TWO of the following," or "Which of the following is NOT".

STEP 4: Apply your technical knowledge to the data presented in the question.
Work through calculations taking your time and read through each answer option
with care. OT questions are designed so that each answer option is plausible. Work
through each response option and eliminate those you know are incorrect

Skills Checkpoint 1 covers this technique in detail through application to a series of exam-
standard question.

Skill 2: Approach to objective test (OT) case style questions

In the exam, you will have three OT Case style questions, each worth 10 marks each. They are
OTQ style questions, however, they will be linked along a common theme, such as recognising
revenue (including government grants) or accounting for non-current asset acquisitions and
resulting deferred tax adjustments. This allows the Examining Team to ask questions on specific
areas in greater detail than just one OTQ will permit.
Therefore, it is imperative that you are familiar with the OTQ style of question and recognise the
style of a case question.
A case question will be scenario based, so there will be a short description together with some
financial information, and five questions will be asked about the information. There will be a
combination of narrative and numerical questions.
Key steps in developing and applying this skill are outlined below:

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STEP 1: Read the scenario carefully

Read the introduction to the question carefully, ensuring you understand what the
questions are asking you to do. Skimming the questions requirement will help you
to identify whether the questions are narrative or numerical in style.

STEP 2: Start with narrative questions

Attempt the narrative questions first as this will allow you to use any remaining
time to focus on the numerical and calculation questions. The case is usually split
into three narrative questions with two further, calculation based questions.

STEP 3: Work through numerical questions methodically

Apply your technical knowledge to the data presented in the question.
Work through calculations taking your time and read through each answer option
with care. OT questions are designed so that each answer option is plausible. Work
through each response option and eliminate those you know are incorrect.

STEP 4: Be aware of time

Stick to your time carefully, as each question is worth two marks, so spending more
than the allocated time of 18 minutes on each case question is an inefficient use of
your time, as you will need to move onto the Section C questions. If you are
running out of time, or you cannot answer any of the questions, guess the answer
from the options provided. You do not lose marks for incorrect answers.

Skills Checkpoint 2 covers this technique in detail through application.

Skill 3: Using spreadsheets effectively

Section C will require the use of the spreadsheet functionality in the exam, so you need to be
familiar with the software and what the FR examining team is expecting to see in terms of
presentation.
Section C of the FR exam will have two longer questions worth a total of 40 marks. One question
will require you to prepare extracts from the financial statements (this may be for a single entity
or for a group, and it may be any of the primary financial statements). The second question will
ask you to interpret the financial position and performance of either a single entity or a group
and may require some calculations or ratios to be prepared.
A step-by-step technique for using spreadsheets in the exam is outlined below:

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STEP 1: Understanding the data in the question

Where a question includes a significant amount of data, read the requirements
carefully to make sure that you understand clearly what the question is asking
you to do. You can use the highlighting function to pull out important data from
the question. Use the data provided to think about what formula you will need to
use. For example, if the company calculates the allowance for receivables as a
percentage of the balance, use the percentage function.

STEP 2: Use a standard proforma working.

You are likely to be asked to prepare an extract or a set of financial statements. Set
out your statement of profit or loss or the statement of financial position before
you start to work through the question. This will give you the basic structure from
where you can enter the data in the question.
Format your cells to ensure the workings look consistent, for example, using the
comma function to mark the thousands in numerical answers.

STEP 3: Use spreadsheet formulae to perform basic calculations.

Ensure you are showing your workings by using the spreadsheet formula for simple
calculations, for example, the cost of sale figure will be made up of different
balances, so add them together using the formula. Cross refer any more detailed
workings, and link workings into your main answer.

Step 4: Use the spreadsheet functions to calculate ratios, with explanation set
out neatly below.
When answering questions on ratios, set out your ratio calculations separately from
your explanation. This allows you to use the formula function to perform the
calculations. The interpretation of the ratio is more important than the calculation,
so you must dedicate sufficient time and attention to interpreting the ratio in the
context of the information given in the scenario. Ensure the text is visible on one
page (not having one long sentence across the page, but broken down to enable
the Examining Team to read it easily).

Skills Checkpoint 3 covers this technique in detail through application to an exam-standard

question.

Skill 4: Application of accounting standards

Knowledge of the accounting standards will be required in all sections of the FR exam. You are
unlikely to be asked to explain the requirements of an accounting standard in a narrative
question, but may be asked questions about the application or impact of accounting standards in
an OTQ, or it may be relevant in the interpretation of an entity’s performance and position in
Section C.

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A step-by-step technique for applying your knowledge of accounting standards is outlined below:

STEP 1: Overview of key standards

Ensure you have a high-level overview of the key standards covered in the FR
exam. Use the summary diagrams at the end of the chapters in the Workbook to
act as your summaries. These are a useful way of remembering the key points.

STEP 2: Numerical question practice

Practice the numerical questions in the Workbook and in the Practice & Revision
Kit. These will test your knowledge of the mechanics of the accounting standards.
Often there can be a difference between understanding what the standard does
and how it applies to a specific scenario. Practice OTQs as well as longer, Section C
questions to consolidate your knowledge.

STEP 3: Narrative question practice

Practice the narrative questions which test your understanding of how the standard
can affect the financial statements. This will help you to revise your understanding
of why the accounting standard is important in a scenario. For example, what are
the key tests for impairment of assets and why would this be important for the
financial statements?

Skills Checkpoint 4 covers this technique in detail through application to an exam-standard

question.

Skill 5: Interpretation skills

Section C of the Financial Reporting (FR) exam will contain two questions. One of these will require
you to interpret a set of financial statements or extracts from a set of financial statements. The
interpretation is likely to contain computational elements in the form of ratios, but your focus
should be on the interpretation of those ratios to explain the performance and position of the
single entity or group you are presented with.
Given that the interpretation of financial statements will feature in Section C of every exam, it is
essential that you master the appropriate technique for analysing and interpreting information
and drawing relevant conclusions in order to maximise your chance of passing the FR exam.

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STEP 1: Read and analyse the requirement.

Read the requirement carefully to see what calculations are required and how many
marks are set for the calculation and how many for the commentary.
Work out how many minutes you have to answer each sub-requirement.

STEP 2: Read and analyse the scenario.

Identify the type of company you are dealing with and how the financial topics in
the requirement relate to that type of company. As you go through the scenario,
you should be highlighting key information which you think will play a key role in
answering the specific requirements.

STEP 3: Plan your answer.

Ensure your answer is balanced in terms of identifying the potential benefits and
limitations of topics that are being discussed or recommended.

STEP 4: Write your answer.

As you write your answer, try wherever possible to apply your analysis to the
scenario, instead of simply writing about the financial topic in generic, technical
terms.
As you write your answer, explain what you mean – in one (or two) sentence(s) –
and then explain why this matters in the given scenario. This should result in a
series of short paragraphs that address the specific context of the scenario. 

Skills Checkpoint 5 covers this technique in detail through application to an exam-standard

question.

Exam success skills

Passing the FR exam requires more than applying syllabus knowledge and demonstrating the
specific FR skills. It also requires the development of excellent exam technique through question
practice.
We consider the following six skills to be vital for exam success. The skills checkpoints show how
each of these skills can be applied in the exam.

Exam success skill 1

Managing information
Questions in the exam will present you with a lot of information. The skill is how you handle this
information to make the best use of your time. The key is determining how you will approach the
exam and then actively reading the questions.
Advice on developing Managing information
Approach
The exam is three hours long. There is no designated ‘reading’ time at the start of the exam.
Once you feel familiar with the exam paper consider the order in which you will attempt the
questions; always attempt them in your order of preference. For example, you may want to leave
to last the question you consider to be the most difficult.
If you do take this approach, remember to adjust the time available for each question
appropriately – see Exam success skill 6: Good time management.
If you find that this approach doesn’t work for you, don’t worry – you can develop your own
technique.

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Active reading
You must take an active approach to reading each question. Focus on the requirement first,
underlining key verbs such as ‘evaluate’, ‘analyse’, ‘explain’, ‘discuss’, to ensure you answer the
question properly. Then read the rest of the question, underlining and annotating important and
relevant information, and making notes of any relevant technical information you think you will
need.

Exam success skill 2

Correct interpretation of the requirements
The active verb used often dictates the approach that written answers should take (eg ‘explain’,
‘discuss’, ‘evaluate’). It is important you identify and use the verb to define your approach. The
correct interpretation of the requirements skill means correctly producing only what is being
asked for by a requirement. Anything not required will not earn marks.
Advice on developing the Correct interpretation of the requirements
This skill can be developed by analysing question requirements and applying this process:

Step 1 Read the requirement

Firstly, read the requirement a couple of times slowly and carefully and
highlight the active verbs. Use the active verbs to define what you plan to do.
Make sure you identify any sub-requirements.

Step 2 Read the rest of the question

By reading the requirement first, you will have an idea of what you are looking
out for as you read through the case overview and exhibits. This is a great time
saver and means you don’t end up having to read the whole question in full
twice. You should do this in an active way – see Exam success skill 1: Managing
Information.

Step 3 Read the requirement again

Read the requirement again to remind yourself of the exact wording before
starting your written answer. This will capture any misinterpretation of the
requirements or any missed requirements entirely. This should become a habit
in your approach and, with repeated practice, you will find the focus, relevance
and depth of your answer plan will improve.

Exam success skill 3

Answer planning: Priorities, structure and logic
This skill requires the planning of the key aspects of an answer which accurately and completely
responds to the requirement.
Advice on developing Answer planning: Priorities, structure and logic
Everyone will have a preferred style for an answer plan. For example, it may be a mind map,
bullet-pointed lists or simply annotating the question paper. Choose the approach that you feel
most comfortable with, or, if you are not sure, try out different approaches for different questions
until you have found your preferred style.
For a discussion question, annotating the question paper is likely to be insufficient. It would be
better to draw up a separate answer plan in the format of your choosing (eg a mind map or
bullet-pointed lists).

Exam success skill 4

Efficient numerical analysis
This skill aims to maximise the marks awarded by making clear to the marker the process of
arriving at your answer. This is achieved by laying out an answer such that, even if you make a
few errors, you can still score subsequent marks for follow-on calculations. It is vital that you do
not lose marks purely because the marker cannot follow what you have done.

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Advice on developing efficient numerical analysis

This skill can be developed by applying the following process:

Step 1 Use a standard proforma working where relevant

If answers can be laid out in a standard proforma then always plan to do so.
This will help the marker to understand your working and allocate the marks
easily. It will also help you to work through the figures in a methodical and
time-efficient way.

Step 2 Show your workings

Keep your workings as clear and simple as possible and ensure they are cross-
referenced to the main part of your answer. Where it helps, provide brief
narrative explanations to help the marker understand the steps in the
calculation. This means that if a mistake is made you do not lose any
subsequent marks for follow-on calculations.

Step 3 Keep moving!

It is important to remember that, in an exam situation, it can sometimes be
difficult to get every number 100% correct. The key is therefore ensuring you do
not spend too long on any single calculation. If you are struggling with a
solution then make a sensible assumption, state it and move on.

Exam success skill 5

Effective writing and presentation
Written answers should be presented so that the marker can clearly see the points you are
making, presented in the format specified in the question. The skill is to provide efficient written
answers with sufficient breadth of points that answer the question, in the right depth, in the time
available.
Advice on developing Effective writing and presentation

Step 1 Use headings

Using the headings and sub-headings from your answer plan will give your
answer structure, order and logic. This will ensure your answer links back to the
requirement and is clearly signposted, making it easier for the marker to
understand the different points you are making. Underlining your headings will
also help the marker.

Step 2 Write your answer in short, but full, sentences

Use short, punchy sentences with the aim that every sentence should say
something different and generate marks. Write in full sentences, ensuring your
style is professional.

Step 3 Do your calculations first and explanation, second

Questions often ask for an explanation with suitable calculations. The best
approach is to prepare the calculation first but present it on the bottom half of
the page of your answer, or on the next page. Then add the explanation before
the calculation. Performing the calculation first should enable you to explain
what you have done.

Exam success skill 6

Good time management
This skill means planning your time across all the requirements so that all tasks have been
attempted at the end of the three hours available and actively checking on time during your
exam. This is so that you can flex your approach and prioritise requirements which, in your
judgement, will generate the maximum marks in the available time remaining.

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Advice on developing Good time management

The exam is 3 hours long, which translates to 1.8 minutes per mark. Therefore a 10-mark
requirement should be allocated a maximum of 18 minutes to complete your answer before you
move on to the next task. At the beginning of a question, work out the amount of time you should
be spending on each requirement and write the finishing time next to each requirement on your
exam paper.
Keep an eye on the clock
Aim to attempt all requirements, but be ruthless and move on if your answer is not going as
planned. The challenge for many is sticking to planned timings. Be aware this is difficult to
achieve in the early stages of your studies and be ready to let this skill develop over time.
If you find yourself running short on time and know that a full answer is not possible in the time
you have, consider recreating your plan in overview form and then add key terms and details as
time allows. Remember, some marks may be available, for example, simply stating a conclusion
which you don’t have time to justify in full.

Question practice
Question practice is a core part of learning new topic areas. When you practice questions, you
should focus on improving the Exam success skills – personal to your needs – by obtaining
feedback or through a process of self-assessment.

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The Conceptual
1 Framework

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Describe what is meant by a conceptual A1(a)

framework for financial reporting.

Discuss whether a conceptual framework is A1(b)

necessary and what an alternative system
might be.

Discuss what is meant by relevance and A1(c)

faithful representation and describe the
qualities that enhance these characteristics.

Discuss whether faithful representation A1(d)

constitutes more than compliance with
accounting standards.

Discuss what is meant by understandability A1(e)

and verifiability in relation to the provision of
financial information.

Discuss the importance of comparability and A1(f)

timeliness to users of financial statements.

Discuss the principle of comparability in A1(g)

accounting for changes in accounting
policies.

Define what is meant by ‘recognition’ in A2(a)

financial statements and discuss the
recognition criteria.

Apply the recognition criteria to: A2(b)

(i) Assets and liabilities
(ii) Income and expenses

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Syllabus reference no.

Explain and compute amounts using the A2(c)

following measures:
(i) Historical cost
(ii) Current cost
(iii) Value in use
(iv) Fair value

Discuss the advantages and disadvantages of A2(d)

the use of historical cost accounting.

Discuss whether the use of current value A2(e)

accounting overcomes the problems of
historical cost accounting.

Describe the concept of financial and physical A2(f)

capital maintenance and how this affects the
determination of profits.

Discuss how the interpretation of current C2(e)

value-based financial statements would differ
from those using historical cost-based
accounts.
1

Exam context
The IASB’s Conceptual Framework for Financial Reporting underpins the methods used in financial
reporting. It is used as the basis to develop International Financial Reporting Standards (IFRS
Standards) and offers valuable guidance on how to account for an item where no IFRS Standard
exists and how to understand and interpret Standards. Knowledge of the Conceptual Framework
will be examined by objective test questions in Section A or Section B of the FR exam.
1

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Chapter overview
The Conceptual Framework

What is a The IASB’s The objective of

conceptual Conceptual general purpose
framework? Framework financial reporting

Advantages Purpose Accrual accounting

Disadvantages Status Going concern

Contents

Qualitative The elements Recognition

characteristics of useful of financial and
financial information statements derecognition

Fundamental qualitative Asset Recognition criteria

characteristics

Liability Derecognition
Enhancing qualitative
characteristics
Equity

The cost constraint

Income and expenses

Measurement Concepts of capital and

capital maintenance

Historical cost Capital

Current value Capital maintenance

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1 What is a conceptual framework?

A conceptual framework for financial reporting is a statement of generally accepted theoretical
principles, which form the frame of reference for financial reporting.
Its theoretical principles provide the basis for:
• The development of accounting standards; and
• The understanding and interpretation of accounting standards.
Therefore, a conceptual framework will form the theoretical basis for determining which events
should be accounted for, how they should be measured and how they should be communicated
to users of financial statements.

1.1 Advantages of a conceptual framework

(a) Accounting standards are developed on the same theoretical principles – which avoids a
haphazard approach to setting standards and should lead to standardised accounting
practices.
(b) The development of accounting standards is less subject to political pressure – pressure on
standard setters to adopt a certain approach would only prevail if it was acceptable under
the conceptual framework.
(c) Accounting standards use a consistent approach – eg without a conceptual framework, some
standards may concentrate on profit or loss whereas some may concentrate on the
valuation of net assets.
(d) A principles-based approach avoids the need for large volumes of ‘rules’ to address every
scenario. Instead, the same underlying principles can be applied to any scenario.

1.2 Disadvantages of a conceptual framework

(a) 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.
(b) 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).
(c) It is not clear that a conceptual framework makes the task of preparing and then
implementing standards any easier than without a framework.

2 The IASB’s Conceptual Framework

2.1 Purpose
IFRS Standards are based on the Conceptual Framework for Financial Reporting (the ‘Conceptual
Framework’) which addresses the concepts underlying the information presented in general
purpose financial statements.
The purpose of the Conceptual Framework is to:
• Assist the IASB to develop IFRS that are based on consistent concepts;
• Assist preparers of accounts to develop accounting policies in cases where there is no IFRS
applicable to a particular transaction, or where a choice of accounting policy exists; and
• Assist all parties to understand and interpret IFRSs.
(Conceptual Framework: para. SP1.1)

2.2 Status
The Conceptual Framework is not an IFRS Standard. It does not override any IFRS Standard, but
instead forms the conceptual basis for the development and application of IFRS Standards.

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2.3 Contents
The Conceptual Framework is divided into eight chapters. You do not need to know all of the
content of the Conceptual Framework for the Financial Reporting exam. In the rest of this chapter,
we will cover the key parts of the Conceptual Framework that are included in the Financial
Reporting syllabus.

2.4 The objective of general purpose financial reporting

The objective of general purpose financial reporting is ‘[t]o 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’ (Conceptual Framework: para. 1.2).
Existing and potential investors, lenders and other creditors are referred to as the ‘primary users’
of financial statements (Conceptual Framework: para. 1.5).
Primary users may make decisions about buying, selling or holding shares or debt instruments or
providing or settling loans (Conceptual Framework: para. 1.2).
To make decisions, primary users need information about:
• The economic resources of the entity, claims against the entity and changes in those
resources and claims
• Management’s stewardship: how efficiently and effectively the entity’s management and
governing board have discharged their responsibilities to use the entity’s economic resources

2.5 Accrual accounting

The Conceptual Framework requires financial statements to be prepared using accrual
accounting. That is, the effects of transactions and events are reported in the periods in which
those effects occur, even if the resulting cash receipts and payments occur in a different period.
This is also referred to as the ‘matching’ concept.

2.6 Underlying assumption: Going concern

Financial statements are normally prepared on the assumption that an entity is a going concern
and will continue in operation for the foreseeable future.
This means that it is assumed that the entity has neither the intention nor the need to liquidate or
curtail materially the scale of its operations.
However, if such an intention or need exists, the financial statements may have to be prepared on
a different basis such as the ‘break-up basis’.

3 Qualitative characteristics of useful financial

information
The Conceptual Framework identifies the characteristics of information that make that
information useful to users of financial statements.
There are fundamental qualitative characteristics and enhancing qualitative characteristics.

3.1 Fundamental qualitative characteristics

There are two fundamental qualitative characteristics: relevance and faithful representation.
Information is useful if it is relevant and faithfully represents what it purports to represent
(Conceptual Framework, para. 2.4).

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Fundamental qualitative characteristics

Relevance Faithful representation

Relevant information is capable of making a A faithful representation reflects economic
difference in the decisions made by users. substance rather than legal form, and is:
It has predictive and/or confirmatory value. • Complete – all information necessary for
Consideration should be given to materiality. understanding
• Neutral – without bias, supported by
Materiality exercise of prudence
Information is material if omitting, misstating • Free from error – processes and descriptions
or obscuring it could reasonably be expected without error, does not mean perfect
to influence decisions that the primary users
of general purpose financial statements make Prudence
on the basis of those financial statements Prudence is exercising caution, particularly
(IAS 1: para. 7) with areas where judgement or estimation is
required.
Supports the concept of neutrality

3.2 Enhancing qualitative characteristics

The enhancing qualitative characteristics are:
• Comparability
• Verifiability
• Timeliness
• Understandability
(Conceptual Framework: paras. 2.23–2.38)
The usefulness of information is enhanced if these characteristics are maximised.
Enhancing qualitative characteristics cannot make information useful if the information is
irrelevant or if it is not a faithful representation.
The benefits of reporting information should justify the costs incurred in reporting it. This is known
as the ‘cost constraint’.

3.2.1 Comparability

Comparability: The qualitative characteristic that enables users to identify and understand
KEY
TERM similarities in, and differences among, items (Conceptual Framework: para. 2.25).

For example:
• Consider the disclosure of accounting policies. Users must be able to distinguish between
different accounting policies in order to be able to compare similar items in the accounts of
different entities.
• When an entity changes an accounting policy, the change is applied retrospectively so that
the results from one period to the next can still be usefully compared.
• Comparability is not the same as uniformity. Accounting policies should be changed if the
change will result in information that is reliable and more relevant, or where the change is
required by an IFRS.

3.2.2 Verifiability

Verifiability: This helps assure users that information faithfully represents the economic
KEY
TERM phenomena it purports to represent. Verifiability means that different knowledgeable and
independent observers could reach consensus, although not necessarily complete agreement,
that a particular depiction is a faithful representation (Conceptual Framework: para. 2.30).

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Information can be verified to a model or formula or by direct observation, such as undertaking

an inventory count. Independent verification can be carried out, eg a valuation by a specialist.

3.2.3 Timeliness

Timeliness: This means having information available to decision-makers in time to be capable

KEY
TERM of influencing their decisions. Generally, the older information is the less useful it is
(Conceptual Framework: para. 2.33).

There is a balance between timeliness and the provision of reliable information.

If information is reported on a timely basis when not all aspects of the transaction are known, it
may not be complete or free from error. Conversely, if every detail of a transaction is known, it
may be too late to publish the information because it has become irrelevant. The overriding
consideration is how best to satisfy the economic decision-making needs of the users.

3.2.4 Understandability

Understandability: Classifying, characterising and presenting information clearly and

KEY
TERM concisely makes it understandable (Conceptual Framework: para. 2.34).

Financial reports are prepared for users who have a reasonable knowledge of business and
economic activities and who review and analyse the information diligently (Conceptual
Framework: para. 2.36).

Activity 1: Qualitative characteristics

Required
Which of the following statements describes comparability?
 The non-cash effects of transactions should be reflected in the financial statements for the
accounting period in which they occur and not in the period where any cash involved is
received or paid.
 Information should be provided to a decision maker in time to be capable of influencing
decisions.
 Information must have a predictive and/or confirmatory value.
 Similar items within a single set of financial statements should be given similar accounting
treatment.

Solution

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4 The elements of the financial statements

The Conceptual Framework defines the elements of the financial statements.
The five elements of financial statements are assets, liabilities, equity, income and expenses.

Asset: A present economic resource controlled by the entity as a result of past events
KEY
TERM (Conceptual Framework: para. 4.2).

An economic resource is a right that has the potential to produce economic benefits (Conceptual
Framework: para. 4.14).
Economic benefits include:
• Cash flows, such as returns on investment sources
• Exchange of goods, such as by trading, selling goods, provision of services
• Reduction or avoidance of liabilities, such as paying loans
(Conceptual Framework: para. 4.16)

Liability: A present obligation of the entity to transfer an economic resource as a result of past
KEY
TERM events (Conceptual Framework: para. 4.2).

An essential characteristic of a liability is that the entity has an obligation. An obligation is ‘a duty
or responsibility that the entity has no practical ability to avoid’ (Conceptual Framework: para.
4.29).

Equity: The residual interest in the assets of an entity after deducting all its liabilities
KEY
TERM (Conceptual Framework: para. 4.2).

Remember that EQUITY = NET ASSETS = SHARE CAPITAL + RESERVES.

Income: Increases in assets, or decreases in liabilities, that result in increases in equity, other
KEY
TERM than those relating to contributions from equity participants (Conceptual Framework: para.
4.2).
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: para.
4.2).

The Conceptual Framework describes financial reporting as providing information about financial
position and changes in financial position: assets and liabilities are defined first, and income and
expenses are defined as changes in assets and liabilities, rather than the other way around.

Activity 2: Asset or liability?

Required
Consider the following situations and in each case determine whether an asset, liability or neither
exists as defined by the Conceptual Framework.
(a) PAT Co purchased a licence for $20,000. The licence gives PAT Co sole use of a particular
manufacturing process which, in turn, will save them $3,000 a year for the next five years.
(b) BAW Co gifted an individual, Don Brennan, $10,000 to set up a car repair shop and have
requested that priority treatment is given to the fleet of cars used by BAW Co’s salesmen.

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(c) DOW Co operates a car dealership and provides a warranty with every car it sells.

Solution

5 Recognition of the elements of financial statements

5.1 Recognition process
The Conceptual Framework defines recognition as ‘the process of capturing for inclusion in the
statement of financial position or the statement(s) of financial performance an item that meets
the definition of one of the elements of financial statements’ (para. 5.1).
Put simply, recognition means including an item in the financial statements, with a description in
words and a number value.
Recognising one element requires the recognition or derecognition of one or more other elements:
Eg

Recognise at the same time Derecognise Recognise

or
an expense an asset a liability

Debit expenses Credit asset or Credit liability

5.2 Recognising an element

The Conceptual Framework requires an item to be recognised in the financial statements if (paras.
5.6-5.8):
(a) The item meets the definition of an element (asset, liability, income, expense or equity); and
(b) Recognition of that element provides users of the financial statements with information that is
useful, ie with:
- Relevant information about the element
- A faithful representation of the element
Recognition is subject to cost constraints: the benefits of the information provided by recognising
an element should justify the costs of recognising that element.

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5.3 Derecognition
Derecognition normally occurs when the item no longer meets the definition of an element:
• For an asset – when control is lost (derecognise part of a recognised asset if control of that
part is lost)
• For a liability – when there is no longer a present obligation
(Conceptual Framework: para. 5.26)

Activity 3: Recognition
Consider the following situations:
(a) Company A reports under IFRS Standards and provides a scheme of training for all of its
staff.
(b) The directors of Company B, a publicly listed company reporting under IFRS Standards,
propose a dividend at the board meeting on 28 December. The dividend is communicated to
the markets on 10 January once the financial statements for the year ended 31 December
have been prepared.
1 Required
Discuss what, if anything, should be recognised in the financial statements of Company A and
Company B relating to these situations.

Solution
1

6 Measurement
The Conceptual Framework specifically looks at the two measurement bases:
• Historical cost
• Current value
It outlines the information provided by both but stresses that the choice between them depends
on what information the users of the financial statements require.

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6.1 Historical cost

Historical cost: Historical cost for an asset is the cost that was incurred when the asset was
KEY
TERM acquired or created and, for a liability, is the value of the consideration received when the
liability was incurred.

Historical cost accounting (HCA) is the traditional form of Western accounting, modified in some
instances by revaluations of certain assets. It is objective, but it has its disadvantages.

6.1.1 Advantages of the historical cost basis for measurement

(a) Amounts used are objective, as it is more difficult to manipulate cost-based figures.
(b) Amounts are reliable, they can always be verified, they exist on invoices and documents.
(c) The statement of financial position and statement of cash flows figures are consistent with
each other.
(d) There is less possibility for manipulation by using ‘creative accounting’ in asset valuation.
(e) Cost is a measure that is readily understood.

6.1.2 Limitations of the historical cost basis for measurement

(a) Overstatement of profit – it shows current revenues less out of date costs. During periods
where price inflation is low, profit overstatement will be marginal. The disadvantages of
historical cost accounting become most apparent in periods of inflation.
(b) Out of date asset values – based on their historical values.
(c) Return on assets/capital employed is distorted by both (a) and (b).
(d) Holding gains/losses (ie the fact that something is worth more or costs more over time simply
due to price rises) are not measured separately from operating results.
(e) HCA does not measure any gain/loss on monetary items arising from the impact of inflation
(ie the fact that savers lose because the purchasing power of their savings is eroded, while
borrowers gain because they still owe the same nominal amount while earnings have risen
due to inflation).
(f) HCA gives a misleading trend of results since comparative figures are not restated for the
effects of inflation.

6.2 Current value

Current value accounting attempts to address some of the problems of HCA by using information
updated to reflect conditions at the measurement date. Current value measurement bases
include:
• Fair value
• Value in use for assets
• Current cost

6.2.1 Fair value

Fair value: The price that would be received to sell an asset, or paid to transfer a liability, in an
KEY
TERM orderly transaction between market participants at the measurement date (Conceptual
Framework: para. 6.12 and IFRS 13: Appendix A).

Fair value is measured in accordance with IFRS 13 Fair Value Measurement.

Fair value is most commonly calculated by taking the open market value. Where there is no active
market for the asset or liability, the following should be used as a basis:
• Estimates of future cash flows
• Time value of money (discounting the future cash flows)

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6.2.2 Value in use

Value in use: The present value of the cash flows, or other economic benefits, that an entity
KEY
TERM expects to derive from the use of an asset and from its ultimate disposal (Conceptual
Framework: para. 6.17).

Value in use looks at the likely future value to the entity of using the asset.
Value in use considers entity-specific factors, whereas fair value is market specific.

6.2.3 Current cost

Current cost of an asset: The current cost of an asset is the cost of an equivalent asset at the
KEY
TERM measurement date, comprising the consideration that would be paid at the measurement
date, plus the transaction costs that would be incurred at that date (Conceptual Framework:
para. 6.21).
Current cost of a liability: The current cost of a liability is 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: para. 6.21).

Current cost differs from historical cost as current cost assesses the price to purchase at the
reporting date, rather than the date the asset was acquired or liability assumed.
Where the current cost cannot be obtained from information in the market, then the entity can
adjust for condition and age to buy a similar model.

6.2.4 Advantages of using current value

(a) Assets are valued after management has considered the expected benefits from their future
use. Value in use is therefore a useful guide for management in deciding whether to hold or
sell assets.
(b) It is relevant to the needs of information users in:
(i) Assessing the stability of the business entity
(ii) Assessing the vulnerability of the business (eg to a takeover), or the liquidity of the
business
(iii) Evaluating the performance of management in maintaining and increasing the business
substance
(iv) Judging future prospects

6.2.5 Limitations of using current value

(a) The discount factor used to calculate the present value of future cash flows requires
subjective judgements by management. Also, the expected benefits from cash flows from the
asset will be upon management’s best estimates and judgements.
(b) There may be problems in deciding how to provide an estimate of current costs for non-
current assets which can only be purchased new, such as a bespoke or specialist piece of
machinery.
(c) As the Conceptual Framework allows different groups of assets and liabilities to be valued on
different bases (which are the most useful to users of the financial statements), this can mean
that some assets will be valued at current cost, but others will be valued at value in use or fair
value.

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Activity 4: Measurement
Ergo Co acquired an item of plant on 1 July 20X5 at a cost of $250,000. Ergo Co depreciates its
plant at a rate of 20% on a reducing balance basis. As at 30 June 20X6, the manufacturer of the
plant still makes the same item of plant and its current price is $300,000.
Required
What is the correct carrying amount to be shown in the statement of financial position of Drexler
as at 30 June 20X6 under historical cost and current cost?
 Historical cost: $200,000; Current cost: $300,000
 Historical cost: $200,000; Current cost: $240,000
 Historical cost: $250,000; Current cost: $300,000
 Historical cost: $250,000; Current cost $240,000

Solution

7 Concepts of capital and capital maintenance

7.1 Capital
There are two concepts relating to capital:
• Financial concept of capital where capital refers to the net assets or equity of an entity
• Physical concept of capital where capital is regarded as the productive capacity of the entity,
for example, units of output per day
A financial concept of capital is adopted by most entities (Conceptual Framework: para. 8.1).

7.2 Capital maintenance

A profit is made if the ‘capital’ at the end of the period exceeds the ‘capital’ at the beginning of
the period (excluding any distributions to/contributions from holders of equity claims during the
period).

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There are two concepts of capital maintenance:

Financial capital maintenance Physical capital maintenance

A profit is earned if the financial (money) A profit is made if the physical productive
amount of the net assets at the end of the capacity (or operating capability) of the
period exceeds the net assets at the beginning entity at the end of the period exceeds the
of the period, excluding distributions physical productive capacity at the beginning
to/contributions from holders of equity claims of the period (excluding any distributions
during the period). to/contributions from holders of equity claims
during the period) (Conceptual Framework:
para. 8.3).

Activity 5: Asset carrying amounts

You have been asked to show the effect of various asset measurement methods for the following
asset:
An item of equipment that was purchased on 1 January 20X3 for $140,000. The equipment is
depreciated as 25% per annum using the reducing balance method.
The equipment is still available and its list price at 31 December 20X4 is $180,000, although the
current model is 20% more efficient than the model the entity purchased in 20X3.
It is estimated that the equipment could be sold secondhand for $44,000, although the company
would have to spend about $500 in advertising costs to do so.
The asset is expected to generate net cash inflows of $20,000 for the next five years after which
time it will be scrapped. The company’s cost of borrowing is 6%.
The cumulative present value of $1 in five years’ time is $4.212.
1 Required
What is carrying amount of the equipment in the statement of financial position as at 31
December 20X4 using historical cost?
 $70,000
 $78,750
 $105,000
 $140,000
2 Required
What is the carrying amount of the equipment in the statement of financial position as at 31
December 20X4 using fair value?
 $32,868
 $43,500
 $44,000
 $44,500
3 Required
What is the carrying amount of the equipment in the statement of financial position as at 31
December 20X4 using current cost?
 $70,313
 $75,000
 $84,375
 $101,250

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4 Required
What is the carrying amount of the equipment in the statement of financial position as at 31
December 20X4 using the value in use method?
 $32,868
 $43,500
 $83,740
 $84,240
5 Required
What is the definition of the financial concept of capital?
 When profits increase the opening net assets of a company, allowing the company additional
purchasing ability.
 When company profits and additional injections of capital increase the opening net assets of
a company allowing the company additional purchasing ability.
 The increase in the physical ability of a company from one year to the next.
 The increase in the physical ability of a company from one year to the next, after deducting
any contributions from the owners.

Solution
1

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8 IAS 1 Presentation of Financial Statements

IAS 1 (para. 15) states that in order to achieve fair presentation, an entity must present
information in accordance with the principles in the Conceptual Framework and apply IFRS
Standards, which include all IFRSs, International Accounting Standards (IAS) and IFRIC
Interpretations originated by the IFRS Interpretations Committee.
Applying the requirements of IFRS Standards is presumed to result in a fair presentation.
IAS 1 (para. 17) clarifies that a fair presentation also requires an entity to:
(a) Select and apply appropriate accounting policies;
(b) Present information, including accounting policies, in a manner that provides relevant,
reliable, comparable and understandable information; and
(c) Provide additional disclosures when compliance with the specific requirements of IFRS
Standards is insufficient to enable users to understand the impact of particular transactions,
and other events and conditions on the entity’s financial position and financial performance.

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Chapter summary

The Conceptual Framework

What is a The IASB’s The objective of

conceptual Conceptual general purpose
framework? Framework financial reporting

A statement of generally Purpose To provide financial information

accepted theoretical principles, • To help develop IFRSs which about the reporting entity that is
which form the frame of are based on consistent useful to existing and potential
reference for financial reporting concepts investors, lenders and other
• To assist preparers where no creditors in making decisions
IFRS applies about providing resources to the
Advantages entity
• Accounting standards
developed on same principles, Status
using a consistent approach Accrual accounting
• Not an IFRS
• Development of accounting • Compliance required by IAS 1 The effects of transactions and
standards less subject to other events are recognised
political pressure when they occur, even if the
• Avoids need for large volume of Contents resultant cash receipts/payments
rules occur in a different period
• The objective of general
purpose financial reporting
• The qualitative characteristics
Disadvantages Going concern
of useful financial information
• Not clear that single • Financial statements and the The financial statements are
conceptual framework will suit reporting entity normally prepared on the
all users • The elements of financial assumption that the entity is a
• May be a need for a variety of statements going concern and will continue
accounting standards, each • Recognition and derecognition in operation for the foreseeable
produced for a different • Measurement future
purpose (and with different • Presentation and disclosure
concepts as a basis) • The concepts of capital and
• Not clear that a conceptual capital maintenance
framework makes the task of
preparing and then
implementing standards any
easier than without a
framework

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Qualitative The elements Recognition

characteristics of useful of financial and
financial information statements derecognition

Fundamental qualitative Asset Recognition criteria

characteristics Present economic resource • Meets the definition of an
• Relevance: controlled by the entity as a element
– Capable of making a result of past events • Provides information that is
difference in the decisions relevant and a faithful
made by users representation
– Predictive and/or Liability • At a cost that does not
confirmatory value A present obligation of an entity outweigh the benefit
– Materiality to transfer an economic resource
• Faithful representation: as a result of past events
– Represents economic Derecognition
phenomena in words and • When control of all/part of an
numbers Equity asset is lost
– Reflects substance The residual interest in the assets • When there is no longer a
– Complete of an entity after deducting all present obligation in respect of
– Neutral its liabilities all/part of a liability
– Free from error

Income and expenses

Enhancing qualitative
• Income: Increases in assets or
characteristics
decreases in liabilities that
• Comparability: About other result in increases in equity,
entities and other periods other than those relating to
• Verifiability: Information must contributions from holders of
be capable of being verified equity claims
• Timeliness: Information must • Expenses: Decreases in assets
be available in time to or increases in liabilities that
influence decision making result in decreases in equity,
• Understandability: Information other than those relating to
must be classified and distributions to holders of
presented in a clear and equity claims
concise manner

The cost constraint

The benefits of reporting
financial information must justify
the costs incurred to provide and
use it

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Measurement Concepts of capital and

capital maintenance
Historical cost
• Most common Capital
• Measured at the transaction • Financial concept of capital =
date and not subsequently net assets/equity
updated • Physical concept of capital =
• Asset: Cost of acquisition/ productive capacity
creation of asset plus
transaction costs
• Liability: Value to incur/take on Capital maintenance
the liability less transaction
• A 'profit' is made where
costs
'capital' has increased over the
period (excluding transactions
with holders of equity claims)
Current value
• Financial capital
• Information is updated to maintenance – profit is made if
reflect changes in value at the net assets/equity increase
measurement date • Physical capital maintenance –
• Fair value: Price that would be profit is made if the physical
received to sell an asset/paid productive capacity/operating
to transfer a liability in an capacity increases
orderly transaction between
market participants at the
measurement date
• Value in use (assets)/fulfilment
value (liabilities)
– Value in use – present value
of the cash flows expected to
be derived from the asset
– Fulfilment value – present
value of the cash flows
expected to be obliged to
transfer to fulfil the liability
• Current cost: Cost of an
equivalent asset/consideration
that would be received for an
equivalent liability at the
measurement date

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Knowledge diagnostic
1. What is a conceptual framework?
A conceptual framework for financial reporting 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.

2. The IASB’s Conceptual Framework

The Conceptual Framework establishes the objectives and principles underlying financial
statements and underlies the development of new standards.
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.

3. Qualitative characteristics of useful financial information

Useful information is information that is relevant and a faithful representation of what it purports
to represent.
The usefulness of information is enhanced if these characteristics are maximised:
• Comparability
• Verifiability
• Timeliness
• Understandability

4. The elements of the financial statements

The elements of financial statements are assets, liabilities, equity, income and expenses.

5. Recognition of the elements of financial statements

An element should be recognised in the financial statements when:
(a) It meets the definition of an element
(b) It provides relevant information that is a faithful representation at a cost that does not
outweigh benefits
A recognised element should be derecognised when:
• Control of an asset is lost
• There is no longer a present obligation for a liability

6. Measurement
Using the historical cost basis is an objective and readily understood method, but overstates
profits and return on capital employed in times of inflation.
Using the current value basis attempts to solve this problem. Current value includes:
• Fair value
• Value in use
• Fulfilment value
• Current cost

7. Concepts of capital and capital maintenance

Financial capital maintenance measures profit as the monetary growth in share capital and
reserves. Operating capital maintenance views capital as the physical assets of a business and

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measures profit after taking into account the cost of maintaining the assets’ current earnings
capacity.

8. IAS 1 Presentation of Financial Statements

In order to achieve fair presentation, an entity must comply with International Financial Reporting
Standards (IFRSs, IASs and IFRIC Interpretations).

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
1 Conceptual framework

Further reading
You should make time to read this article, which is available in the study support resources section
of the ACCA website:
Extreme makeover – IASB edition
www.accaglobal.com

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Activity answers

Activity 1: Qualitative characteristics

The correct answer is:
Similar items within a single set of financial statements should be given similar accounting
treatment.
Using accrual accounting, the effects of transactions should be reflected in the financial
statements for the accounting period in which they occur and not in the period where any cash
involved is received or paid. Information is relevant if it has a predictive and/or confirmatory value.
The second option describes the qualitative characteristics of timeliness.

Activity 2: Asset or liability?

The correct answer is:
(a) Asset. PAT Co has an intangible asset. Having purchased the licence (past event), PAT Co has
control over the manufacturing process (due to the licence) and this will bring PAT Co
economic resources (through future cost savings).
(b) Neither asset nor liability. The $10,000 gifted to Don Brennan cannot be classified as an
asset. The payment is a past event. However, BAW Co has no obvious control over the car
repair shop and it is difficult to determine whether this will bring economic resources to BAW
Co (other than the potential that repairs to their cars will be prioritised).
(c) Liability. The fact that DOW Co provides a warranty on every car sold constitutes a liability.
Upon sale of a car (past event) DOW Co is immediately responsible (present obligation) to
make good any deficiencies covered by the warranty. The liability is recognised when the
warranty is issued, rather than when a claim is made.

Activity 3: Recognition
1 The correct answer is:
(a) First, it is necessary to consider whether the amounts spent on training should be recognised
as an asset or an expense. To be an asset, there must be:
- Control
- A past event
- Present economic resource.
Whilst it is clear that there is a past event (the provision of training) and future economic benefits
(the staff that will be able to do a better job), the staff (human beings) are not personally
controlled by the company and thus the increased capability to do their jobs is not under the
control of the company.
(b) The issue here is whether the dividend should be recognised as a liability or not at the year
end. A liability exists only where three criteria are met at the year end:
- A present obligation
- (As a result of) a past event
- Expected to result in a transfer of economic resources.
A present obligation is one that exists at the year end. As the dividend payment has not been
communicated outside the company at the year end, there is no obligation for it to be paid: the
directors could change their mind as to how much or whether a dividend should be paid without
any consequences.
A present obligation does not therefore exist at the year end and no liability can be recognised for
proposed dividends. It is declaration of a dividend externally that creates an obligation for it to be
paid, and this has not happened at the year end. A liability would be recognised from 10 January,
even if the dividend has not been legally approved by shareholders, as a constructive obligation is
sufficient to generate a liability under IFRS; ie the creation of a valid expectation in those affected
that a payment will be made.

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When the dividend is recognised, it will be recognised as a reduction in equity, rather than as an
expense as it is a distribution to equity participants in the business.

Activity 4: Measurement
The correct answer is:
Historical cost: $200,000; Current cost: $240,000
Historical cost: $250,000 × 80% = $200,000 carrying amount
Current cost: $300,000 × 80% = $240,000 carrying amount

Activity 5: Asset carrying amounts

1 The correct answer is:
$78,750
Historical cost
$
1.1.X3 b/d 140,000
1.1.X3–31.12.X3 Dep’n @ 25% (35,000)
31.12.X3 Carrying amount 105,000
1.1.X4–31.12.X4 Dep’n @ 25% (26,250)
31.12.X4 Carrying amount 78,750

2 The correct answer is:

$44,000
The price that would be received to sell an asset in an orderly transaction between market
participants at the measurement date.
3 The correct answer is:
$84,375
Current cost
(restated)
$
1.1.X3 b/d (180,000 × 100%/120%) 150,000

1.1.X3-31.12.X3 Dep’n @ 25% (37,500)

31.12.X3 Carrying amount 112,500
1.1.X4-31.12.X4 Dep’n @ 25% (28,125)
31.12.X4 Carrying amount 84,375

4 The correct answer is:

$83,740
$84,240 - $500 = $83,740
Cash flow Discount factor Present value
31.12.X9 20,000 4.212 84,240
5 The correct answer is:
When profits increase the opening net assets of a company, allowing the company additional
purchasing ability.
When company profits and additional injections of capital increase the opening net assets of a
company, allowing the company additional purchasing ability. This statement is incorrect as it
must exclude any distributions or injections of capital made by the owners.

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The increase in the physical ability of a company from one year to the next. This statement is
incorrect, as it is referring to the physical concept of capital; however, it is not excluding injections
of capital from the owners, and is, therefore, an incomplete description of it.
The increase in the physical ability of a company from one year to the next, after deducting any
contributions from the owners. This statement is incorrect, as it is referring to the physical concept
of capital.

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The regulatory
2 framework

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Explain why a regulatory framework is needed A3(a)

including the advantages and disadvantages
of IFRS over a national regulatory framework.

Explain why accounting standards on their A3(b)

own are not a complete regulatory framework.

Distinguish between a principles-based and a A3(c)

rules-based framework and discuss whether
they can be complementary.

Describe the IASB’s standard-setting process A3(d)

including revisions to and interpretations of
Standards.

Explain the relationship of national standard A3(e)

setters to the IASB in respect of the standard
setting process.
2

Exam context
Building on your basic knowledge of some of the IFRS Standards introduced in your earlier
studies, the FR exam expands your knowledge of the standards and their application. It is
important to understand why there is a set of international accounting standards and recognising
the key aims of the IASB. This chapter also looks at the impact of IFRS Standards worldwide and
interactions with local accounting bodies.
This is an area that is most likely to be tested as part of a Section A objective test question (OTQ).
However, it is important to understand the basis of setting IFRS Standards for answering any
narrative explanation of why standards were required, for example, with the changes to the
leasing standard and the introduction of IFRS 16 Leases.
2

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Chapter overview
The Regulatory Framework

Need for regulatory framework Principles vs Rules

Advantages

Disadvantages

IASB IASB and national standard setters

Definition

Advantages

Disadvantages

Objectives of IFRS Standards

Due process of IASB Criticisms of the IASB

Standard setting Accounting standards and choice

Coordination with national standard setters Advantages

Interpretation of accounting standards Disadvantages

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1 The need for a regulatory framework

A regulatory framework for accounting is needed for two principal reasons:
(a) To act as a central source of reference of generally accepted accounting practice (GAAP) in
a given market; and
(b) To designate a system of enforcement of that GAAP to ensure consistency between
companies in practice.
The aim of a regulatory framework is to narrow the areas of difference and choice in financial
reporting and to improve comparability. This is even more important when we consider how
different financial reporting can be around the world.
Compliance with IFRS Standards cannot be required without their adoption in national or regional
law.

2 Principles-based versus rules-based approach

IFRS Standards are written using a ‘principles-based’ approach. This means that they are written,
based on the definitions of the elements of the financial statements, recognition and
measurement principles, as set out in the Conceptual Framework for Financial Reporting.
In IFRS, the underlying accounting treatments are these ‘principles’, which are designed to cover a
wider variety of scenarios without the need for very detailed scenario by scenario guidance as far
as possible.
Other GAAP, for example US GAAP, are ‘rules based’, which means that accounting standards
contain rules that apply to specific scenarios.

2.1 Advantages and disadvantages of a principles-based approach

Advantages
(a) A principles-based approach based on a single conceptual framework ensures standards are
consistent with each other.
(b) Rules can be broken and ‘loopholes’ found. Principles offer a ‘catch all’ scenario.
(c) Principles reduce the need for excessive detail in standards.
Disadvantages
(a) Principles can become out of date as practices (eg the current move towards greater use of
‘fair values’) change.
(b) Principles can be overly flexible and subject to manipulation.

3 The International Accounting Standards Board (IASB)

The IASB is an independent accounting standard setter established in April 2001. It is based in
London, UK. Its predecessor, the International Accounting Standards Committee (IASC), was
founded in 1973.
At the IASB’s first meeting, it adopted the International Accounting Standards (IAS) issued by the
IASC.

3.1 Advantages and disadvantages of IFRS over a national framework

Advantages
(a) Greater international consistency and comparability of financial statements
(b) Reduced cost of maintaining a national regulatory framework
(c) Reduced cost of finance and increased investment opportunities for companies
(d) Greater control over, and understanding of, foreign operations
(e) Consolidation of foreign operations using IFRS is easier

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Disadvantages
(a) IFRS may not meet local needs
(b) Loss of control and independence
(c) Interference and conflicts with national and regional law
(d) Language, translation and interpretation issues

Tutorial Note

You must keep up to date with the IASB’s progress and the problems it encounters in the financial
press. You should also be able to discuss:
• Use and application of IFRS Standards
• Due process of the IASB
• The IASB’s relationship with other standard setters which looks at current and future work of
the IASB
• Criticisms of the IASB

3.2 Objectives of the IASB

The three formal objectives of the IASB are:
(a) To develop, in the public interest, a single set of high quality, understandable and enforceable
global accounting standards that require high quality, transparent and comparable
information in the financial statements and other financial reporting to help participants in
the world’s capital markets and other users make economic decisions;
(b) To promote the use and rigorous application of those standards; and
(c) To bring about convergence of national accounting standards and IFRS to high quality
solutions.

4 The IASB’s relationship with other standard setters

As of September 2018, 144 countries required IFRS for all, or most, companies. A further 12
countries permitted companies to use IFRS Standards. However, only 15 of the G20 economies
currently require the use of IFRS Standards, with some of the largest global economies such as
China and the USA not currently permitting use of IFRS.

4.1 Working with other national standard setters

The IASB has worked with local country standard setters in a number of projects to harmonise
accounting standards worldwide.
The IASB concentrated on essentials when producing IFRSs. They tried not to make IFRSs too
complex, because otherwise they would be impossible to apply on a worldwide basis.
The IASB maintains a policy of dialogue with other key standard setters around the world, in the
interest of harmonising standards around the globe.
Partner standard setters are often involved in the development of Discussion Papers and Exposure
Drafts on new areas.
There are annual conferences for the world’s financial standard setters which discuss, amongst
specific issues, the increased convergence and adoption of IFRS Standards, as well as providing
feedback on current issues. In 2019, this included representatives from China, Germany, Canada,
Malaysia and Korea amongst other key stakeholders.
IFRS Foundation and the World Bank announced a cooperation agreement in 2017 to assist
emerging economies to adopt IFRS Standards.

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Activity 1: Barriers to international harmonisation

1 Required
Provide reasons why there may be barriers to increasing international harmonisation of
accounting standards.

Solution
1

4.2 US Financial Accounting Standards Board (FASB)

The IASB and the FASB have worked together significantly in the past, most notably with the
commencement in 2002, of the Norwalk Agreement, which brought the FASB and IASB together to
increase convergence with their differing accounting standards. This resulted in the publication of
several similar US GAAP and IFRS Standards.
However, in recent years, the work between these two bodies has slowed, with no significant
projects planned for the foreseeable future. Indeed, in 2017, the SEC issued a statement which
stated that the two sets of accounting standards were to ‘continue to co-exist…for the foreseeable
future’ (US Securities and Exchange Commission, 2017) implying that increasing convergence or a
move from the US to IFRS Standards was unlikely in the near future.

4.3 UK GAAP and Europe

The aim of the European Commission is to build a fully-integrated, globally competitive market.
Part of this involves harmonising company law across the member states and in order to establish
a level playing field for financial reporting.
The majority of the European region, including those countries outside of the EU (Switzerland,
Norway and Iceland), now permit or require IFRS Standards within their territories. In 2002, the
European Union adopted IFRS Standards as the required financial reporting standards for the
consolidated financial statements of all European companies whose debt or equity securities
trade in a regulated market in Europe, effective in 2005.

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In 2015, UK legislation, with amendments to the Companies Act 2006, saw increasing alignment
between the EU legal requirements for companies (which will affect all companies reporting under
IFRS Standards) now forming part of the legislation for domestic and non-listed companies in the
UK. Although this is not work undertaken by the IASB, it shows the impact of increasing alignment
across standard setters in Europe.
France requires IFRS Standards for listed companies, and is permitted for their subsidiary
companies. However, all individual financial accounts should follow the French Plan Comptable
Général (PCG), a specific set of reporting codes, which is more prescriptive in nature than IFRS.
The Russian Federation requires listed companies to use IFRS Standards.
Norway is currently considering whether to revise their national standards to converge with IFRS
for small and medium entities.

4.4 China, Japan and the Far East

China and Japan both are significant economies with differing levels of convergence. Japan
permits the use of IFRS Standards alongside its three other permitted reporting frameworks, with
increasing adoption by Japanese companies each year.
China’s national standards are substantially converged with IFRS Standards. However, the
implementation of IFRS Standards themselves has no current timetable. In 2015, the IASB and the
Chinese Ministry of Finance announced the formation of a joint working group for a possible
implementation of IFRS Standards within China.

4.5 Africa
In 2019, 17 African countries adopted IFRS Standards for listed companies and other public
companies. These included the Republic of Congo, Senegal and Cameroon to increase the
number of African jurisdictions/countries requiring some adoption of IFRS to 49.

4.6 South America

IFRS Standards are required in Brazil, Chile, Argentina (apart from banks) and across the
continent with the exception of Bolivia and French Guiana.

4.7 Other bodies

IFRS Foundation and the World Bank announced a cooperation agreement in 2017 to assist
emerging economies to adopt IFRS Standards.

Essential reading
The IASB has significant information on their website about the ongoing consideration and
adoption of IFRS Standards on a global basis on their website:
https://www.ifrs.org/use-around-the-world/
The Essential reading is available as an Appendix of the digital edition of the Workbook.

5 Due process of the IASB

IFRSs 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.

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5.1 Standard setting process

The following summarises the key steps in the standard-setting process:

IASB staff prepare an issues paper including studying

Issues paper
the approach of national standard setters.

The IFRS Advisory Council is consulted about the

advisability of adding the topic to the IASB's agenda.

Discussion Paper A Discussion Paper may be published for public comment.

Exposure Draft An Exposure Draft is published for public comment.

After considering all comments received, an IFRS is approved by

International Financial
a majority of the IASB. The final standard includes both a
Reporting Standard
basis for conclusions and any dissenting opinions.

The period of exposure for public comment is normally 120 days. However, in exceptional
circumstances, proposals may be issued with a comment period of no less than 30 days. Draft
IFRS Interpretations are exposed for a 60-day comment period (IFRS Foundation Due Process
Handbook: para. 6.7).

5.2 Coordination with national standard setters

Close coordination between IASB due process and due process of national standard setters is
important to the success of the IASB’s mandate.
The IASB continues to explore ways in which to integrate its due process more closely with
national due process, including:
• IASB and national standard setters aim to try and coordinate their work plans. There is an
annual IASB Conference, which enables discussion on key issues to facilitate this process. IASB
has liaison members who work with national standard setters. They help to promote
convergence or the full adoption of IFRS Standards.
• The IASB would continue to publish its own Exposure Drafts and other documents for public
comment. Local standard setters can issue their own Exposure Draft, including any
divergencies or amendments.
• National standards setters would not be required to vote for the IASB’s preferred solution in
their national standards. This gives the local territory the flexibility to adapt all, or make
amendments to, their local region if required.
• National standard setters would follow their own full due process, which they would ideally
choose to integrate with the IASB’s due process.

5.3 Interpretation of accounting standards

The IASB has developed a procedure for issuing interpretations of its standards using the IFRS
Interpretations Committee.
The duties of the IFRS Interpretations Committee are:
(a) To interpret the application of International Financial Reporting Standards and provide
timely guidance on financial reporting issues not specifically addressed in IFRSs or IASs.
(b) To have regard to the Board’s objective of working actively with national standard setters to
bring about convergence of national accounting standards and IFRSs to high quality
solutions.
(c) To review on a timely basis, any newly identified financial reporting issues not already
addressed in existing IFRSs.

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This is made up of 14 members with significant technical expertise who can offer guidance on the
application of IFRS Standards. This is often as a result of a question to the Committee who then
consider whether this requires further investigation based on the extent of the work required (is it
specific enough to be answered efficiently?).
An agenda decision will then decide whether further explanatory material is to be added to the
standard (such as in an appendix) or whether an actual amendment (‘Narrow Scope’ standard
setting).

Activity 2: Roles of the IASB

Required
Which of the following bodies is responsible for reviewing new financial reporting issues and
issuing guidance on the application of IFRS?
 The International Accounting Standards Board
 The IFRS Foundation
 The IFRS Interpretations Committee
 The IFRS Advisory Council

Solution

6 Criticisms of the IASB

6.1 Accounting standards and choice
It is sometimes argued that companies should be given a choice in matters of financial reporting.

6.2 Advantages
In favour of accounting standards (both national and international), the following points can be
made.
• They reduce, even eliminate, confusing variations in the methods used to prepare accounts.
• They provide a focal point for debate and discussions about accounting practice.
• They oblige companies to disclose the accounting policies used in the preparation of accounts.

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• They are a less rigid alternative to enforcing conformity by means of legislation.

• They have obliged companies to disclose more accounting information than they would
otherwise have done if accounting standards did not exist. For example, IAS 33 Earnings per
Share.

6.3 Disadvantages
Many companies are reluctant to disclose information that is not required by national legislation,
with some arguing against standardisation and in favour of choice.
• One method of preparing accounts might be inappropriate in some circumstances.
• Standards may be subject to lobbying or government pressure (in the case of national
standards).
• Many national standards are not based on a conceptual framework of accounting, although
this is the basis for IFRS Standards.
• There may be a trend towards rigidity.
• There are also political problems, as any international body, whatever its purpose or activity,
faces difficulties in attempting to gain international consensus and the IASB is no exception to
this. It is complex for the IASB to reconcile the financial reporting situation between economies
as diverse as developing countries and sophisticated first-world industrial powers.

Activity 3: Interpretation of IFRS Standards

Required
What development at the IASB aided users’ interpretation of IFRS Standards?
 IFRS Advisory Council
 IFRS Interpretations Committee
 Global Preparers Forum
 Accounting Standards Advisory Forum

Solution

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Activity 4: Objectives of the IASB

Required
Which TWO of the following are objectives of the IASB?
 To ensure the convergence of IFRS Standards within local national territories
 To develop a set of understandable global accounting standards
 To develop financial reporting standards which aim to provide comparable information in the
financial statements
 To provide a set of rules in the form of accounting standards which will be used by worldwide
preparers of financial statements

Solution

PER alert
One of the competences you require to fulfil Performance Objective 7 of the PER is the ability
to prepare drafts or review primary financial statements in accordance with relevant
accounting standards and policies and legislation. The information in this chapter will give you
knowledge to help you demonstrate this competence.

Essential reading
There are additional activities which are recommended in Chapter 2, Section 5 of the Essential
reading.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

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Chapter summary

The Regulatory Framework

Need for regulatory framework Principles vs Rules

• To act as a central source of reference • Principles = guidance

• Designate a system of enforcement to • Rules = specific
ensure consistency
Advantages
• Single framework ensuring consistency
across standards
• Principles avoid requirement of excessive detail
in standards
• Rules can be broken and loopholes found

Disadvantages
• Practices may change leading to outdated principles
• Principles may be overly flexible

IASB IASB and national standard setters

Definition • Working to harmonise accounting standards across

'Independent standard setter made up of the global economies
representatives from differing global economies' • Use of Discussion Papers and Exposure Drafts
• Annual IASB Conference to encourage debate and
discussion on key issues
Advantages • IASB works with both national standard setters
• Greater international consistency of financial and other global bodies, such as World Bank
statements • USA – FASB, some convergence and projects
• Reduced costs of running an international, (Norwalk, IFRS 15 and IFRS 16), however, no
centralised reporting framework than a national current plans
reporting framework
• Europe – EU Commission aiming to build fully
• Greater control over and understanding of foreign
integrated market, including recent harmonisation
operations, including their consolidation, as using
of company law (including non-EU entities)
one international recognised set of standards
• UK – FRS 100-105 based on IFRS. Company law
updates in 2017
Disadvantages
• Japan – increased convergence, with further local
• IFRS may not meet local needs adoption of IFRS Standards
• Loss of control at national level in respect of • China – national standards increasingly converged,
accounting standards but no plans to fully adopt IFRS Standards
• Language, translation and interpretation issues
• Africa – significant adoption of IFRS Standards
• May conflict with national law
across African continent
• South America – required across majority of the
Objectives of IFRS Standards continent
• To develop, in the public interest, a single set of high
quality, understandable and enforceable global
accounting standards
• To promote the use and rigorous application of those
standards
• To bring about convergence of national accounting
standards and IFRS

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Due process of IASB Criticisms of the IASB

Standard setting Accounting standards and choice

• Issues paper and consultation with IFRS Advisory Too much choice and variation in interpretation?
Council
• Discussion Paper
• Exposure Draft Advantages
• IFRS Standard • Reduce variations in accounting methods
• Focal point for debate and discussion on
accounting matters
Coordination with national standard setters • Companies must disclose their accounting policies
• Coordination of work plans • Increased conformity
• Power to local standard setters regarding issuance • Increased information available to the users of the
of Exposure Drafts financial statements
• National standard setters set the process regarding
integration and due process
Disadvantages
• 'One-size fits all' not always appropriate, especially
Interpretation of accounting standards across different industries and territories
• IFRS Interpretations Committee • May be subject to influence and pressure by
– Question resulting in discussion and consideration larger economies
by the Committee • Trend towards rigidity
• Resulting in either • Not all national standards have a conceptual
– Additional illustrative material added to existing framework of accounting
standard; or
– Amendment to the Standard (narrow scope
standard setting)

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Knowledge diagnostic
1. The need for a regulatory framework
• A regulatory framework is necessary to ensure a central source of reference and enforcement
procedures for generally accepted accounting practice.
• There are advantages and disadvantages of using IFRSs versus a national regulatory
framework.

2. Principles-based versus rules-based approach

• A principles-based approach results in shorter ‘catch-all’ standards consistent with a
conceptual framework.
• A rules-based approach can be more prescriptive, but loopholes can often be identified.

3. IASB
The IASB issues IFRSs and revised IASs, and is an independent standard setter made up of
representatives from different global economies.

4. The IASB’s relationship with other standard setters

• Working to harmonize accounting standards across global economies
• The IASB works with partner national standard setters on joint projects
• Increasing convergence and/or adoption of IFRS Standards on a global scale
• Annual IASB Conference to encourage debate and discussion on key issues

5. Due process of IASB

• Standard setting: A Discussion Paper is issued first to identify the issues, followed by a draft
standard, an Exposure Draft and finally an IFRS or revised IAS
• Coordination with national standard setters, including the coordination of work plans and
giving local standard setters a degree of autonomy in the final decisions to be made locally
• IFRS Interpretations Committee to clarify and where necessary make amendments to existing
standards

6. Advantages and criticisms of the IASB

• Advantages including better conformity and comparison across different regions and
industries.
• IASB is a focus point for accounting discussion and development.
• However, there may be issues regarding the adoption of standards on a local basis due to the
nature of the local economy, language as well as interpretation issues.

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
2 Regulators
3a Standard setters

Further reading
IASB publishes its workplan and future projects, including details of current and proposed
changes. The website also looks at the IFRS Standards adoption process on a global basis.
www.ifrs.org

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Activity answers

Activity 1: Barriers to international harmonisation

1 The correct answer is:
Barriers to harmonisation
(a) Different purposes of financial reporting. In some countries, the purpose is solely for tax
assessment, while in others, it is for investor decision making.
(b) Different legal systems. These prevent the development of certain accounting practices and
restrict the options available.
(c) Different user groups. Countries have different ideas about who the relevant user groups are
and their respective importance. In the USA, investor and creditor groups are given
prominence, while in Europe, employees enjoy a higher profile.
(d) Needs of developing countries. Many countries are developing their standard setting process
and they use IFRS Standards to develop their local standards and principles to ensure
comparability with other countries. They do not need to establish large bodies of committees
when the key principles are already in place and consistent with other, more established
economies.
(e) Nationalism is demonstrated in an unwillingness to accept another country’s standard.
(f) Cultural differences result in objectives for accounting systems differing from country to
country.
(g) 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.
(h) The lack of strong accountancy bodies. Many countries do not have strong independent
accountancy or business bodies that would press for better standards and greater
harmonisation.

Activity 2: Roles of the IASB

The correct answer is:
The IFRS Advisory Council

Activity 3: Interpretation of IFRS Standards

The correct answer is:
IFRS Interpretations Committee
IFRS Advisory Council is the formal advisory body to the IASB and the Trustees, but does not aid
user’s interpretation of IFRS Standards. Accounting Standards Advisory Forum consists of national
standard setters and contributes to the setting of new standards. The Global Preparers Forum is a
standing consultative group and is independent of the IASB.

Activity 4: Objectives of the IASB

The correct answers are:
• To develop a set of understandable global accounting standards
• To develop financial reporting standards which aim to provide comparable information in the
financial statements
The convergence of national accounting standards with IFRS Standards is promoted but not
insisted upon by the IASB. IFRS Standards are a principles-based, not a rules-based set of
accounting standards.

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Tangible non-current
3 assets

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Define and compute the initial measurement B1(a)

of a non-current (including a self-constructed
and borrowing costs) asset.

Identify subsequent expenditure that may be B1(b)

capitalised, distinguishing between capital
and revenue items.

Discuss the requirements of relevant B1(c)

accounting standards in relation to the
revaluation of non-current assets.

Account for revaluation and disposal gains B1(d)

and losses for non-current assets.

Compute depreciation based on the cost and B1(e)

revaluation models and on assets that have
two or more significant parts (complex assets).

Discuss why the treatment of investment B1(f)

properties should differ from other properties.

Apply the requirements of relevant accounting B1(g)

standards for investment property.
3

Exam context
Property, plant and equipment is an important area of the ACCA Financial Reporting syllabus.
You can almost guarantee that in every exam you will be required to account for property, plant
and equipment at least once and it can feature as an OTQ in Section A or B, or as an adjustment
when preparing primary financial statements in Section C. This chapter builds on the knowledge
of IAS 16 Property, Plant and Equipment that you have already seen in your earlier studies and
also introduces IAS 40 Investment Property and IAS 23 Borrowing Costs.
3

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Chapter overview
Tangible non-current assets

Property, plant and Investment property Borrowing costs

equipment (IAS 16) (IAS 40) (IAS 23)

Accounting for PPE Definitions Accounting treatment

Accounting for revaluations Recognition Borrowing costs eligible

for capitalisation

Revaluation of Initial measurement

depreciated assets Commencement, suspension
and cessation
Subsequent measurement
Complex assets

Transfers

Disposals

Disclosure

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1 Property, Plant and Equipment (IAS 16)

1.1 Accounting for property, plant and equipment (PPE)

Essential reading
You should recall IAS 16 Property, Plant and Equipment from your previous studies. This chapter
builds on the knowledge you already have and therefore it is important that you recap on the key
topics. Chapter 3, Section 1 of the Essential reading provides revision on the basic definitions,
recognition and measurement principles, basic revaluation, disposals and disclosure. Chapter 3,
Section 2 provides revision of depreciation. It is essential that you are comfortable with this
material before continuing with this chapter.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

1.2 Accounting for revaluations

Chapter 3, Section 1.7 of the Essential reading provides a brief introduction to accounting for PPE
using the revaluation model. We will build on this by considering the accounting requirements
where there has been an increase or decrease in valuation.

1.2.1 Revaluation surpluses

A revaluation exercise will normally result in an increase in the value of the asset. IAS 16 requires
the increase to be credited to other comprehensive income and accumulated in a revaluation
surplus (ie part of owners’ equity), unless there was previously a decrease on the revaluation of
the same asset.
DEBIT Carrying amount (statement of financial position) X
CREDIT Other comprehensive income (revaluation surplus) X

1.2.2 Reversing a previous decrease in value

If the asset has previously suffered a decrease in value that was charged to profit or loss, any
increase in value on a subsequent revaluation should be recognised in profit or loss to the extent
that it reverses the previous decrease (IAS 16: para. 39).
The amount of the reversal is not necessarily the same as the amount of the previous decrease –
the cumulative effect of any depreciation savings which arise as a result of the previous decrease
must also be considered. Any excess is then recognised in other comprehensive income and
accumulated in a revaluation surplus.

Illustration 1: Reversing a revaluation decrease

Binkie has a year end of 30 June 20X6. At 1 July 20X5, Binkie had land with a carrying amount of
$130,000 in its financial statements. On 1 July 20X3, a decline in land values led the company to
reduce the carrying amount of the land from $150,000. The decline was recorded as an expense
in profit or loss. There has been a surge in land prices in the current year and the land is worth
$200,000 at 30 June 20X6.
1 Required
Account for the revaluation in the current year.

Solution
1 The correct answer is:
The revaluation at 1 July 20X3 resulted in a decrease in value of $20,000, which was recorded in
profit or loss. As land is not depreciated, the decrease can be reversed in full in the year to 30
June 20X6. The excess value is recognised in other comprehensive income.

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The double entry is:

DEBIT Carrying amount of land (statement of financial position) $70,000
CREDIT Profit or loss $20,000
CREDIT Other comprehensive income (revaluation surplus) $50,000

1.2.3 Revaluation decreases

A decrease in value on revaluation is treated in a similar way. Any decrease should be recognised
as an expense, except where it offsets a previous increase taken as a revaluation surplus in
owners’ equity. Any decrease greater than the previous upwards increase in value must be taken
as an expense in the profit or loss.

Illustration 2: Revaluation decrease

Using the information in Illustration 1, but swapping round the figures. Let’s assume that the land
original cost was $150,000, it was revalued upwards to $200,000 on 1 July 20X5 and the
valuation at 30 June 20X6 has fallen to $130,000.
1 Required
Account for the decrease in value.

Solution
1 The correct answer is:
When the asset was revalued on 1 July 20X5, the revaluation surplus of $50,000 would have been
credited to other comprehensive income. The decrease of $70,000 in the current year will first be
debited to the revaluation surplus to reduce the balance to nil, with the remaining loss charged as
an expense to profit or loss.
The double entry is:
DEBIT Other comprehensive income (revaluation surplus) $50,000
DEBIT Profit or loss $20,000
CREDIT Carrying amount (statement of financial position) $70,000

1.3 Revaluation of depreciated assets

1.3.1 Timing of the revaluation
All depreciable assets must be depreciated for the entire period in which they are held. When a
revaluation has taken place in the year, we must be careful as to how to calculate depreciation

Revaluation at Revaluation at Revaluation mid-way

the start of the year the end of the year through the year

Depreciation for the year is Depreciation for the year is Two separate depreciation
based on the revalued amount. based on the cost or valuation calculations are required:
brought forward at the start of • Pro rata on the brought
the year. Depreciation for the forward cost or valuation to
year must be deducted in arrive at carrying amount at
arriving at the carrying the date of valuation
amount of the asset at the • Pro rata on the revalued
date of valuation. amount

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Exam focus point

The ACCA Financial Reporting examining team has also emphasised the importance of noting
the date that the revaluation takes place, requiring the approach described above to be
applied. Review the article on the ACCA website (www.accaglobal.com) Accounting for
property, plant and equipment, which has a section on the treatment of accounting for a
revaluation.

1.3.2 Depreciation and the revaluation surplus

There is a further complication when a revalued asset is being depreciated. A revaluation surplus
normally means that the depreciation charge will increase. Normally, a revaluation surplus is only
realised when the asset is sold. However, when it is being depreciated, part of that surplus is being
realised as the asset is used.
The amount of the surplus realised is the difference between depreciation charged on the
revalued amount and the (lower) depreciation, which would have been charged on the asset’s
original cost. This amount can be transferred to retained earnings but NOT through profit or loss.

Exam focus point

The ACCA Financial Reporting examining team has stated that in the exam, a reserves
transfer is only required if the examiner indicates that it is company policy to make a transfer
to realised profits in respect of excess depreciation on revalued assets. If this is not the case
then a reserves transfer is not necessary. For more information on this, refer to the Accounting
for property, plant and equipment article on the ACCA webpage (www.accaglobal.com).

Example: Transfer of revaluation surplus to retained earnings

If an asset is revalued from $100,000 to $140,000 and has a remaining useful life of 40 years at
that date, a revaluation surplus of $40,000 is recognised. The revaluation surplus can then be
transferred to retained earnings over the remaining useful life to represent the depreciation
difference as a result of the asset being revalued. It can be calculated as either:
Revaluation surplus $40,000 / 40 year remaining useful life = $1,000 per annum
OR
Depreciation per annum if value of asset is $100,000 / 40 years = $2,500 per annum
Depreciation per annum if value of asset is $140,000 / 40 years = $3,500 per annum
Therefore, additional depreciation of $1,000 can be transferred from the revaluation surplus to
retained earnings.
The following entry can be made annually over the remaining life of the asset:
DEBIT Revaluation surplus $1,000
CREDIT Retained earnings $1,000

If this entry is not made the full $40,000 is transferred to retained earnings when the asset is
disposed of/retired.

Activity 1: Revaluation and depreciation

Crinkle prepares its financial statements to 31 December each year. It bought an asset that had a
useful life of five years for $10,000 in January 20X6. On 1 January 20X8, the asset was revalued
to $12,000. The expected useful life has remained unchanged (ie three years remain). It is the
policy of Crinkle to make a reserve transfer for excess depreciation.
1 Required
Account for the revaluation and state the treatment for depreciation from 20X8 onwards.

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Solution
1

Activity 2: Property, plant and equipment

$
List price of machine 8,550
Trade discount (855)
Delivery costs 105
Set-up costs incurred internally 356
8,156

Notes
(a) The machine was expected to have a useful life of 12 years and a residual value of $2,000.
(b) Xavier’s accounting policy is to charge a full year’s depreciation in the year of purchase and
no depreciation is the year of retirement or sale.
(c) Xavier has a policy of keeping all equipment at revalued amounts. No revaluations had been
necessary until 30 September 20X8 when one of the major suppliers of such machines went
bankrupt, causing a rise in prices. A specific market value for Xavier’s machine was not
available, but an equivalent brand-new machine would now cost $15,200 (including relevant
disbursements). Xavier treats revaluation surpluses as being realised through use of the asset
and transfers them to retained earnings over the life of the asset. The remaining useful life
and residual value of the machine remained the same.
(d) Xavier’s year end is 30 September.

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1 Required
What is the carrying amount of plant and equipment at 30 September 20X5?
 $7,200
 $7,317
 $7,643
 $8,427
2 Required
What is the carrying amount of the plant and equipment at 30 September 20X8?
 $10,800
 $11,900
 $13,200
 $15,200
3 Required
Which TWO of the following statements are correct when revaluing property, plant and
equipment?
 All property, plant and equipment should be revalued
 The revaluation should take place every three to five years
 The revalued asset continues to be depreciated
 The asset should be revalued to fair value if available
4 Required
What is the balance on the revaluation surplus at 30 September 20X8?
 $2,052
 $4,696
 $5,439
 $6,104
5 Required
How much of the revaluation surplus is transferred to retained earnings in the year to 30
September 20X9?

Solution
1

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1.4 Complex assets

1.4.1 Depreciation of complex assets
Large and complex assets are often made up of a number of components of smaller assets, which
each have different useful lives and wear out at different rates. For example, a building may have
a useful life of 50 years but the lift within that building may be expected to last for 15 years. IAS 16
requires that the component parts of such assets are capitalised and depreciated separately.

Illustration 3: Depreciation of complex assets

An aircraft could be considered as having the following components.
Cost Useful life
$’000
Fuselage 20,000 20 years
Undercarriage 5,000 500 landings
Engines 8,000 1,600 flying hours

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1 Required
Calculate the depreciation for the year.

Solution
1 The correct answer is:
Depreciation at the end of the first year, in which 150 flights totalling 400 hours were made would
then be:
$’000
Fuselage (20,000 / 20 years) 1,000
Undercarriage (5,000 × 150/500 landings) 1,500
Engines (8,000 × 400/1,600 hours) 2,000
4,500

1.4.2 Replacements and Overhauls

Parts of some items of property, plant and equipment may require replacement at regular
intervals, often as a legal requirement. IAS 16 gives examples of a furnace that may require
relining after a specified number of hours or aircraft interiors which may require replacement
several times during the life of the aircraft.
The cost of the replacement parts should be recognised in full when it is incurred and added to
the carrying amount of the asset. It should be depreciated over its useful life, which may be
different from the useful life of the other components of the asset. The carrying amount of the
item being replaced, such as the old furnace lining, should be derecognised when the
replacement takes place (IAS 16: para. 13).

Illustration 4: Cost of overhaul

Following Illustration Depreciation of complex assets above, an overhaul of the aircraft was
required at the end of year 3 and every third year thereafter at a cost of $1.2 million.
1 Required
Explain how the overhaul would be accounted for.

Solution
1 The correct answer is:
The cost of the overhaul would be capitalised as a separate component. $1.2 million would be
added to the cost and the depreciation (assuming 150 flights again) would therefore be:
$’000
Total as above 4,500
Overhaul ($1,200,000/3) 400
4,900

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2 Investment property (IAS 40)

Investment property: Property (land or a building – or part of a building – or both) held (by
KEY
TERM the owner or by the lessee as a right-of-use asset) to earn rentals or for capital appreciation or
both, rather than for:
(a) Use in the production or supply of goods or services or for administrative purposes, or
(b) Sale in the ordinary course of business.
Owner-occupied property: Property held by the owner for use in the production or supply of
goods or services or for administrative purposes.
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.
Cost: The amount of cash or cash equivalents paid or the fair value of other consideration
given to acquire an asset at the time of its acquisition or construction.
Carrying amount: The amount at which an asset is recognised in the statement of financial
position.

2.1 Recognition
Consistent with the recognition criteria under IAS 16, IAS 40 requires that an investment property
is recognised when, and only when:

It is probable that future economic

The cost of the investment property to
benefits associated with the investment and
the entity can be measured reliably
property will flow to the entity

(IAS 40, para. 16)

2.2 Initial measurement

Investment property is measured initially at cost.
Cost includes purchase price and any directly attributable expenditure such as professional fees
for legal services, property transfer taxes and other transaction costs.
For self-constructed investment properties, cost is the cost at the date when the construction or
development is complete.

2.3 Subsequent measurement

An entity can choose whether to use:

Cost model (=IAS 16) Fair value model

Carry the asset at its historic cost less • Investment property is measured at fair value
• Depreciation and at the end of the reporting period
• Any accumulated impairment loss • Any resulting gain or loss is included in profit
or loss for the period
• The investment property is not depreciated

The model chosen should be applied to all investment property.

It is important to note from the above that if the fair value model is applied, the gain or loss is
reported in profit or loss. This is in contrast to the revaluation model in IAS 16 where the revaluation
surplus is utilised.

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Activity 3: Investment property

On 1 October 20X9 Propex has the following properties. It uses the fair value model to measure
investment property:
(a) Tennant House which cost $150,000 on 1 October 20X4. The property is freehold and is let out
to private individuals for six-monthly periods. The current market value of the property is
$175,000.
(b) Stowe Place which cost $75,000. This is used by Propex as its headquarters. The building was
acquired on 1 October 20W9. The current market value is $120,000.
Propex depreciates its buildings at 2% per annum on cost.
1 How should the property be shown in the statement of financial position at 1 October 20X9?
Required
Match the amount to the property.

Tennant House ▼

Stowe Place ▼

Picklist options
• $60,000
• $120,000
• $135,000
• $175,000

Solution
1

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Essential reading
Chapter 3, Section 3 of the Essential reading provides further detail on the fair value and cost
models for investment property.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

2.4 Transfers
Transfers to or from investment property should only be made when there is a change in use. For
example, owner occupation commences so the investment property will be treated under IAS 16 as
an owner-occupied property.

2.4.1 Investment property to PPE/Inventory

Transfer from investment property

to owner-occupied or inventories

• Cost for subsequent accounting is fair value

at date of change of use
• Apply IAS 16 or IAS 2 as appropriate after
date of change of use

Consider the situation in which an investment property becomes owner-occupied on 1 July 20X6:
1 Jan X6 1 Jul X6 31 Dec X6

Date of transfer
Determine FV

Account for as IP. No depreciation Account for as PPE. Fair value at

and gain/loss to profit or loss. transfer is initial measurement.
Depreciation commences.
Cost or valuation model per IAS 16.

2.4.2 PPE to Investment property

Transfer from owner-occupied

to investment property

• Apply IAS 16 up to date of change of use

• At date of change, property revalued to fair value
• At date of change, any difference between the
carrying amount under IAS 16 and its fair value is
treated as a revaluation under IAS 16

(IAS 40: paras. 57–65)

Activity 4: Transfer of PPE to investment property

Kapital owns a building which it has been using as a head office. In order to reduce costs, on 30
June 20X9 it moved its head office functions to one of its production centres and is now letting out
its head office. Company policy is to use the fair value model for investment property.
The building had an original cost on 1 January 20X0 of $250,000 and was being depreciated over
50 years. At 31 December 20X9, its fair value was judged to be $350,000.

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1 Required
Explain how the building will be accounted for in the financial statements of Kapital Co at 31
December 20X9

Solution
1

2.5 Disposals
Derecognise (eliminate from the statement of financial position) an investment property on
disposal or when it is permanently withdrawn from use and no future economic benefits are
expected from its disposal.
Any gain or loss on disposal is the difference between the net disposal proceeds and the carrying
amount of the asset. It should generally be recognised as income or expense in profit or loss.
Compensation from third parties for investment property that was impaired, lost or given up shall
be recognised in profit or loss when the compensation becomes receivable (IAS 40: paras. 66–69).

2.6 Disclosure requirements

These relate to:
• Choice of fair value model or cost model
• Criteria for classification as investment property
• Assumptions in determining fair value
• Use of independent professional valuer (encouraged but not required)
• Rental income and expenses
• Any restrictions or obligations (IAS 40: paras. 74–79)

2.6.1 Fair value model – additional disclosures

An entity that adopts this must also disclose a reconciliation of the carrying amount of the
investment property at the beginning and end of the period (IAS 40: paras. 77–78).

2.6.2 Cost model – additional disclosures

These relate mainly to the depreciation method. In addition, an entity which adopts the cost
model must disclose the fair value of the investment property (IAS 40: para. 79).

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3 Borrowing costs (IAS 23)

3.1 Accounting treatment
Borrowing costs that directly relate to the acquisition, construction or production of a qualifying
asset must be capitalised as a part of the cost of that asset (IAS 23: para. 26).
A qualifying asset is an asset that necessarily takes a substantial period of time to be ready for its
intended use or sale (IAS 23: para. 5).

3.2 Borrowing costs eligible for capitalisation

Funds borrowed Capitalise actual borrowing costs incurred less investment

specifically for a qualifying income on temporary investment of the funds (IAS 23: para.
asset 12)

Funds borrowed generally Weighted average of borrowing costs outstanding during the
period (excluding borrowings specifically for a qualifying
asset) multiplied by expenditure on qualifying asset. The
amount capitalised should not exceed total borrowing costs
incurred in the period (IAS 23: para. 14).

3.3 Commencement, suspension and cessation

3.3.1 Commencement
Commencement of capitalisation begins when:
(a) Expenditures for the asset are being incurred;
(b) Borrowing costs are being incurred; and
(c) Activities that are necessary to prepare the asset for its intended use or sale are in progress.
(IAS 23: para. 17)

3.3.2 Suspension
Capitalisation is suspended during extended periods when development is interrupted. (IAS 23:
para. 20)

3.3.3 Cessation
Capitalisation ceases when substantially all the activities necessary to prepare the qualifying
asset for its intended use or sale are complete (IAS 23: para. 22).
The capitalisation of borrowing costs should be calculated pro-rata if the commencement or
cessation occurs within the period, or there has been a suspension within the period.

Essential reading
Chapter 3, Section 4 of the Essential reading provides more detail on the commencement,
suspension and cessation of capitalisation.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

Illustration 5: Borrowing costs

On 1 January 20X6, Stremans Co borrowed $1.5 million to finance the production of two assets,
both of which were expected to take a year to build. Work started during 20X6. The loan facility
was drawn down and incurred on 1 January 20X6, and was utilised as follows, with the remaining
funds invested temporarily.

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Asset Alpha Asset Bravo

$’000 $’000
1 January 20X6 250 500
1 July 20X6 250 500

The loan rate was 9% and Stremans Co can invest surplus funds at 7%.
1 Required
Ignoring compound interest, calculate the borrowing costs that may be capitalised for each of the
assets and consequently, the cost of each asset as at 31 December 20X6.

Solution
1 The correct answer is:
Asset Alpha Asset Bravo
$ $
Borrowing costs
To 31 December 20X6 $500,000/$1,000,000 × 9% 45,000 90,000
Less investment income (8,750) (17,500)
To 30 June 20X6 $250,000/$500,000 × 7% × 6/12 36,250 72,500
Cost of assets
Expenditure incurred 500,00 1,000,000
Borrowing costs 36,250 72,500
1,072,500

Activity 5: Capitalisation of borrowing costs

Acruni Co had the following loans in place at the beginning and end of 20X6.
1 January 20X6 31 December 20X6
$m $m
10% Bank loan repayable 20X8 120 120
9.5% Bank loan repayable 80 80

On 1 January 20X6, Acruni Co began construction of a qualifying asset, a piece of machinery for
a hydro-electric plant, using existing borrowings. Expenditure drawn down for the construction
was: $30 million on 1 January 20X6, $20 million on 1 October 20X6.
1 Required
Calculate the borrowing costs that can be capitalised for the hydro-electric plant machinery.

Solution
1

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Chapter summary

Tangible non-current assets

Property, plant and Investment property (IAS 40)

equipment (IAS 16)

Accounting for PPE Definitions Subsequent measurement

Assumed knowledge – • Investment property – is • Cost model (IAS 16)
recognition, measurement, property held to earn rentals • Fair value model
depreciation, disposals, or for capital appreciation – Measure fair value at end of
disclosure • Owner-occupied – property each reporting period
held by the owner for use in – Gain or loss to p/l
the production or supply of – No depreciation
Accounting for revaluations goods or services or for
• Revaluation surpluses in OCI administrative purposes
and revaluation surplus (SFP) • Fair value – price that would Transfers
– Unless reverses previous be received to sell an asset in • Investment property to
decrease in which case P/L an orderly transaction at the PPE/Inventory
to cancel previous loss then measurement date – Per IAS 40 to the date of
OCI • Cost – cash or cash transfer, fair value becomes
equivalents paid or the fair cost of PPE/inventory
• Revaluation decreases to P/L
value of other consideration
– Unless reverses previous • PPE to Investment property
given to acquire an asset
surplus in which case loss to – Per IAS 16 to date of transfer,
• Carrying amount – amount at
OCI then P/L then IAS 40
which an asset is recognised
in the statement of financial
Revaluation of depreciated position. Disposals
assets Gain or loss recognised in p/l
• All assets depreciated for year Recognition
– If revaluation at the start of
• Probably economic benefits Disclosure
the year, revalue then
will flow to the entity
depreciate • Choice of fair value model or
• Cost can be reliably measured
– If revaluation at the end of cost model
the year, depreciate on • Criteria for classification as
b/fwd cost/valuation to find investment property
Initial measurement
CA then revalue • Assumptions in determining
– If revaluation mid-year, Cost per IAS 16
fair value
pro-rate calculations • Use of independent
• Revalution surplus may be professional valuer
released to retained earnings (encouraged but not required)
• Rental income and expenses
• Any restrictions or obligations
Complex assets
• Components of complex assets
depreciated separately
• Cost of replacement parts/
overhauls capitalised if
recognition criteria satisfied

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Borrowing costs (IAS 23)

Accounting treatment
• Borrowing costs relating to a qualifying
asset must be capitalised as part of the
cost of that asset
– A qualifying asset is one that
necessarily takes a long period of
time to be ready for its intended use
or sale

Borrowing costs eligible for

capitalisation
• Funds specifically borrowed – at actual
borrowing rate less any income
• General funds – weighted average of
borrowing costs in period
– Amount capitalised should not
exceed actual cost

Commencement, suspension and

cessation
• Commence capitalisation when:
– Expenditure incurred
– Borrowing costs incurred
– Activities to get the asset ready for
use/sale are in progress
• Suspend capitalisation when
development is interrupted
• Cease capitalisation when activities to
get the asset ready for use/sale are
complete

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Knowledge diagnostic
1. Property, plant and equipment (IAS 16)
Property, plant and equipment can be accounted for under the cost model (historic cost less
accumulated depreciation an impairment losses) or revaluation model (valuation less depreciation
and impairment losses). Revaluation surpluses are reported in other comprehensive income and
the revaluation surplus unless they reverse previous revaluation losses.
Separate components of complex assets require to be depreciated separately. The costs of
overhauls/replacement parts may be capitalised if recognition criteria are satisfied.

2. Investment property (IAS 40)

Investment property can be accounted for under the cost model or the fair value model (not
depreciated, gains and losses reported in profit or loss).
Transfers from investment property to PPE/inventories are accounted for under IAS 40 to the date
of transfer. The fair value at transfer becomes the cost of the asset which is then accounted for
under IAS 16/IAS 2.
Transfers from PPE to investment property are accounted for under IAS 16 to the date of transfer
then IAS 40 applies.

3. Borrowing costs (IAS 23)

Borrowing costs relating to qualifying assets (those which necessarily take a substantial period of
time to be ready for use/sale) must be capitalised. This includes both specific and general
borrowings of the company.

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Further study guidance

Question practice
You should attempt the following question from the Further question practice bank (available in
the digital edition of the Workbook):
5 Gains Co

Further reading
Accounting for property, plant and equipment (key areas of IAS 16)
Property, plant and equipment and tangible fixed assets – part 1 (focus on IAS 16)
Property, plant and equipment and tangible fixed assets – part 2 (revaluations)
www.accaglobal.com

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Activity answers

Activity 1: Revaluation and depreciation

1 The correct answer is:
On 1 January 20X8 the carrying amount of the asset is $10,000 – (2 × $10,000 / 5) = $6,000. For
the revaluation:
DEBIT Accumulated depreciation $4,000
DEBIT Carrying amount $2,000
CREDIT Other comprehensive income (revaluation surplus) $6,000

The depreciation for the next three years will be $12,000 / 3 = $4,000, compared to depreciation
on cost of $10,000 / 5 = $2,000. So each year, the extra $2,000 can be treated as part of the
surplus that has become realised (this can also be calculated by taking the revaluation surplus of
$6,000 over the remaining useful life of three years):
DEBIT Other comprehensive income (revaluation surplus) $2,000
CREDIT Retained earnings $2,000

This is a movement on owners’ equity only and it will be shown in the statement of changes in
equity. It is not an item in profit or loss.

Activity 2: Property, plant and equipment

1 The correct answer is:
$7,643
AT 30 SEPTEMBER 20X5
Plant and equipment
$
Cost (8,550 – 855 + 105 + 356) 8,156
Accumulated depreciation (8,156 – 2,000)/12 years (513)
7,643
2 The correct answer is:
$10,800
AT 30 SEPTEMBER 20X8
Plant and equipment
$
Revalued amount (Working) 10,800
Accumulated depreciation (0)
10,800

Working: Revalued amount (depreciated replacement cost)

$
Gross replacement cost 15,200
Depreciation (15,200 – 2,000) × 4/12 (4,400)
Depreciated replacement cost 10,800
3 The correct answer is:
• The revalued asset continues to be depreciated
• The asset should be revalued to fair value if available

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4 The correct answer is:

$4,696
Revaluation surplus ((W1)10,800 – (W2) 6,104)
Workings
1 Revalued amount (depreciated replacement cost)
$
Gross replacement cost 15,200
Depreciation (15,200 – 2,000) × 4/12 (4,400)
Depreciated replacement cost 10,800

2 Carrying amount before revaluation

$
Cost 8,156
Accumulated depreciation (8,156 – 2,000) × 4/12 (2,052)
6,104
5 The correct answer is:
$587
Workings
$
Depreciation on new revalued amount (10,800 – 2,000)/8-year remaining life 1,100
Depreciation on historic cost (6,014 – 2,000)/8 years (513)
Difference transferred to retained earnings each year 587

or
$
Balance on revaluation surplus at 30.9.X8 (4,696/8 years) 587

Activity 3: Investment property

1 The correct answer is:

Tennant House $175,000

Stowe Place $60,000

(a) Tennant House

- Held for its investment potential and not for use by Propex
- Treat as investment property in accordance with IAS 40
- Rental income to profit or loss
- Revalue to market value of $175,000, the difference of $25,000 credited to profit or loss
(b) Stowe Place
- Held for use by Propex
- Depreciate over useful life 75,000 × 2% = 1,500 per annum to profit or loss
- Carrying amount 75,000 – (1,500 × 10) = 60,000 to be shown in SOFP

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Activity 4: Transfer of PPE to investment property

1 The correct answer is:
The building will be depreciated up to 30 June 20X9.
$
Original cost 250,000
Depreciation 1.1.X0 – 1.1.X9 (250/50 × 9) (45,000)
Depreciation to 30.6.X9 (250/50 × 6/12) 2,500
Carrying amount at 30.6.X9 202,500
Revaluation surplus 147,500
Fair value at 30.6.X9 350,000

The difference between the carrying amount and fair value at the date of transfer is taken to the
revaluation surplus.
After the date of transfer, the building is accounted for as an investment property and will be
subjected to a fair value exercise at each year end and these gains or losses will go to profit or
loss. If at the end of the following year, the fair value of the building is found to be $380,000, then
$30,000 will be credited to profit or loss.

Activity 5: Capitalisation of borrowing costs

1 The correct answer is:
Capitalisation rate = weighted average rate = (10% × 120 / (120 + 80)) + (9.5% × 80 / (120 + 80))
= 9.8%
Borrowing costs = ($30m × 9.8%) + ($20m × 9.8% × 3/12)
= $3.43m

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Intangible assets
4
4

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Discuss the nature and accounting treatment B2(a)

of internally generated and purchased
intangibles.

Describe the criteria for the initial recognition B2(c)

and measurement of intangible assets.

Describe and apply the requirements of B2(f)

relevant accounting standards to research
and development expenditure.
4

Exam context
Intangible assets are increasingly important in modern business where the trend is away from
investment in property, plant and equipment and inventory and towards building businesses
around brands, data intelligence, software or workforce talent. IAS 38 considers how intangible
assets can be recognised and measured in an entity’s financial statements, although there is
some criticism as to whether the standard reflects the true value of modern businesses. In the
ACCA Financial Reporting exam, intangible assets could feature as an objective test question
(OTQ) in Section A or B, or as an adjustment in a preparation question in Section C.
4

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Chapter overview
Intangible assets

Definitions Recognition and categories of intangible asset

Intangible assets Recognition criteria

Identifiable

Monetary assets

Acquired intangible assets Internally generated intangible assets

Recognition criteria Definitions

Goodwill Recognition criteria

Initial measurement Subsequent measurement

Cost model or revaluation model

Revaluation model

Amortisation/Impairment Derecognition

Point of derecognition

Gain or loss on derecognition

Revaluation model

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1 Definitions
Intangible asset: ‘An identifiable non-monetary asset without physical substance.’ (IAS 38:
KEY
TERM para. 8)

1.1 Identifiable

An asset is identifiable if either:

It is separable – capable of being OR It arises from contractual or other legal

separated / divided from the entity and rights (regardless of whether those rights
sold / transferred / licensed / rented / exchanged are transferable or separable from the entity
• Individually; or or other rights / obligations)
• With a related contract or identifiable
asset or liability
regardless of whether the entity intends to
do so.

(IAS 38: para. 12)

1.2 Monetary vs non-monetary assets

Monetary assets are defined as:

Monetary assets: ‘Money held and assets to be received in fixed or determinable amounts of
KEY
TERM money.’ (IAS 38: para. 8)

• Cash and receivables are both examples of monetary assets and therefore do not meet the
definition of an intangible asset.
• Property, plant and equipment and inventories are examples of non-monetary assets.
However, they have physical substance and therefore also do not meet the definition of
intangible assets.
• Computer software, brands, licences and patents are all examples of intangible assets.

2 Recognition and categories of intangible asset

2.1 Recognition
An intangible asset may be recognised in the financial statements if it meets:
(a) The definition of an intangible asset; and
(b) The recognition criteria
(IAS 38: para. 18)
The recognition criteria set by IAS 38 are:

It is probable that future economic

The cost of the asset to the
benefits associated with the asset and
entity can be measured reliably
will flow to the entity

(IAS 38: para. 21)

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Essential reading
Chapter 4, Section 1 of the Essential reading discusses the recognition criteria in more detail. You
will find that it is generally consistent with that covered for tangible non-current assets in Chapter
3.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

Activity 1: Recognition criteria

Required
Which THREE of the following are likely to meet the recognition criteria of IAS 38 Intangible Assets?
(Tick the correct answers.)
 Expenditure of $300,000 on increasing the skills of staff
 $250,000 acquiring a licence to operate in a new geographical location
 $28,000 spend on advertising a new product which is expected to generate economic benefits
for the entity
 $100,000 on computer software acquired from a supplier
 A brand, valued at $500,000 acquired as part of the purchase of a new subsidiary
 An internally developed brand name, estimated to be worth $100,000

Solution

2.2 Categories of intangible assets

IAS 38 breaks down intangible assets into the following categories:
• Acquired intangible assets, which can be either:
- Separately acquired; or
- Acquired as part of a business combination;
• Internally generated intangible assets.

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3 Acquired intangible assets

3.1 Recognition criteria
The recognition criteria are always presumed to have been met for intangible assets that are
acquired separately or acquired as part of a business combination.

Acquired separately Acquired as part of a business combination

Recognise as an Recognise as intangible assets separately

intangible asset from goodwill in the group accounts
(irrespective of whether recognised by
acquiree before the business combination).
If only separable together with a related
contract, identifiable asset or liability,
group together with related item.

(IAS 38: paras. 25, 26, 33, 34, 35 & 36)

3.1.1 Business combination

A business combination is defined by IFRS 3 Business Combinations as:

Business combination: ‘A transaction or other event in which an acquirer obtains control of

KEY
TERM one or more businesses.’ (IFRS 3: Appendix A)

A business combination usually results in the need to prepare group accounts, as covered in
Chapters 7–10 of this Workbook.

3.2 Goodwill
Goodwill reflects an entity’s value over and above its recorded value in the financial statements.
It is often referred to as representing the reputation of a business.
There are two types of goodwill:

Internally generated goodwill Goodwill arising as the result of a

business combination

Do not recognise as an intangible Recognise positive goodwill as

asset as it is not identifiable an intangible asset in the
(not separable nor arising from group accounts
contractual / legal rights) and
cannot be measured reliably

(IAS 38: paras. 48 & 49; IFRS 3: para. 32)

Goodwill arising at the result of a business combination will be covered in more detail with group
accounting in Chapters 7–10 of this Workbook.

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4 Internally generated intangible assets

4.1 Definitions

Research: ‘Original and planned investigation undertaken with the prospect of gaining new
KEY
TERM scientific or technical knowledge and understanding.’ (IAS 38: para. 8)
Development: ‘Application of research findings to a plan or design for the production of new or
substantially improved materials, products, processes, systems or services before the start of
commercial production or use.’ (IAS 38: para. 8)

4.2 Recognition criteria

To assess whether an internally generated intangible asset meets the IAS 38 recognition criteria,
an entity classifies expenditure into:
(a) A research phase; and
(b) A development phase.

Essential reading
You should be familiar with the research and development phases and the PIRATE criteria from
your previous studies. A recap has been included in Chapter 4, Section 2 of the Essential reading.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

Internally generated
intangible assets

Research Development
'original and planned investigation 'application of research findings to a
undertaken with the prospect of plan or design for the production of
gaining new scientific or technical new or substantially improved
knowledge and understanding' materials, products, processes,
systems or services before the start of
commercial production or use'

Meets all of the 'PIRATE' criteria?

Probable future economic benefits will
be generated by the asset
Intention to complete and use / sell asset
Resources (technical, financial, other)
adequate to complete asset
Ability to use/sell asset
Technical feasibility of completing asset
Expenditure can be measured reliably

NO YES

Not recognised as an Recognise as an

intangible asset intangible asset
Recognise as an
expense in the statement
of profit or loss

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(IAS 8: para. 8)

4.2.1 Expenditure specifically excluded from recognition

The standard states that expenditure on internally generated brands, mastheads, publishing
titles, customer lists and items similar in substance are not recognised as intangible assets
(because they cannot be distinguished from the cost of developing the business as a whole).
Similarly, start-up, training, advertising, promotional, relocation and reorganisation costs are all
recognised as expenses.
(IAS 38: paras. 63 & 67)

5 Initial measurement
Intangible asset Intangible asset acquired Internally generated
acquired separately as part of a business intangible asset
combination

Measure at cost: Measure at fair value: Measure at cost:

• Purchase price • Defined by IFRS 13 • Sum of expenditure
(include import duties as 'the price that incurred from date
and non-refundable would be received to intangible asset first
purchase taxes; sell an asset or paid meets the recognition
deduct trade discounts to transfer a liability criteria ('PIRATE')
and rebates) in an orderly • Directly attributable
• Any directly transaction between costs necessary to
attributable costs in market participants at create, produce and
preparing asset for its the measurement date' prepare asset to be
intended use (eg cost (IFRS 13: Appendix A) capable of operating in
of employee benefits manner intended by
directly arising from management (eg costs
bringing the asset to of materials and
its working condition, services, costs of
professional fees and employee benefits, fee
costs of testing to register a legal right
whether asset is and amortisation of
functioning properly) patents / licences used to
generate the asset)

(IAS 38: paras. 27, 33, 65 & 66)

Activity 2: Initial measurement of a separately acquired intangible asset

Apricot Co purchases an operating licence from an overseas supplier for $180,000 plus non-
refundable purchase taxes of $18,000. The supplier’s normal list price is $200,000 but it has
awarded Apricot Co a 10% trade discount. Apricot Co has to pay import duties on the purchase of
this licence of $20,000.
As part of the purchase process, Apricot Co seeks advice from a lawyer and incurs legal fees of
$15,000.
Required
Calculate the initial cost of the intangible asset that Apricot Co should recognise in relation to this
licence.

Solution

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Activity 3: Initial measurement of an internally generated intangible asset

Dopper Co is developing a new production process. During 20X3, expenditure incurred was
$100,000, of which $90,000 was incurred before 1 December 20X3 and $10,000 between 1
December 20X3 and 31 December 20X3. Dopper Co can demonstrate that, at 1 December 20X3,
the production process met the criteria for recognition as an intangible asset. The recoverable
amount of the know-how embodied in the process is estimated to be $50,000.
Required
Explain how the expenditure should be treated in Dopper Co’s financial statements for the year
ended 31 December 20X3.

Solution

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6 Subsequent measurement
After initial recognition, an intangible asset can either be measured using the cost or the
revaluation model.

6.1 Cost model

The carrying amount of an intangible asset measured using the cost model is cost less
accumulated amortisation and impairment losses (IAS 38: para. 74).

6.2 Revaluation model

The carrying amount of an intangible asset measured using the revaluation model is its fair value
at the date of the revaluation less subsequent accumulated amortisation and impairment losses
(IAS 38: para. 75).

6.2.1 Active market

If the revaluation model is followed, fair value shall be measured by reference to an active market.
All other assets in the same class must also be accounted for using the revaluation model unless
there is no active market for them in which case the cost model is used for those assets.

Active market: ‘A market in which transactions for the asset or liability take place with
KEY
TERM sufficient frequency and volume to provide pricing information on an ongoing basis.’ (IFRS 13:
Appendix A)

It is uncommon for an active market to exist for intangible assets, although this may happen for
some intangibles, eg freely transferable taxi licences.

6.2.2 Frequency of revaluations

Revaluations must be made with such regularity that the carrying amount does not differ
materially from its fair value at the end of the reporting period.

6.2.3 Accounting for revaluations

Revaluation increases and decreases for intangible assets is accounted for in the same way as it
is for tangible non-current assets, as covered in Chapter 3.

Increase in value Decrease in value

Recognise in other comprehensive income * (a) Recognise in other comprehensive
(and accumulate in equity under the heading income to the extent of any credit
‘revaluation surplus’) balance in the revaluation surplus in
* or in profit or loss to the extent it reverses a respect of that asset (and reduce the
revaluation decrease of the same asset revaluation surplus in equity)
previously recognised in profit or loss (b) Recognise any excess in profit or loss

DEBIT Asset (carrying amount) DEBIT Other comprehensive income (and

CREDIT Other comprehensive income (and reduce revaluation surplus)
accumulate in ‘revaluation surplus’) DEBIT Profit or loss
CREDIT Asset (carrying amount)

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7 Amortisation/impairment tests
An entity shall assess whether the useful life of an intangible asset is finite or indefinite. (IAS 38:
para. 88)

Finite useful life Indefinite useful life

• Amortise asset on a systematic • Do not amortise asset

basis over its useful life • Conduct impairment reviews:
• Usually recognise amortisation in – Annually; and
profit or loss (unless part of the – Where indication of
cost of another asset) possible impairment
• Residual value is normally zero • Review useful life at least annually
• Amortisation begins when asset is to determine if events and
available for use circumstances still support an
• Review useful life and amortisation indefinite useful life assessment
method at least each year end and
adjust where necessary

(IAS 38: paras. 97, 99, 100, 104, 107–109)

Activity 4: Intangible assets

Stauffer plc has a year end of 30 September 20X6. The following transactions occurred during the
year:
(a) The Stauffer brand has become well known and has developed a lot of customer loyalty since
the company was set up eight years ago. Recently, valuation consultants valued the brand
for sale purposes at $14.6 million. Stauffer’s directors are delighted and plan to recognise the
brand as an intangible asset in the financial statements. They plan to report the gain in the
revaluation surplus as they feel that crediting it to profit or loss would be imprudent.
(b) The company undertook an expensive, but successful, advertising campaign during the year
to promote a new product. The campaign cost $1 million, but the directors believe that the
extra sales generated by the campaign will be $3.6 million over its four-year expected useful
life.
(c) Stauffer owns a 30-year patent that it acquired on 1 April 20X4 for $8 million, which is being
amortised over its remaining useful life of 16 years from acquisition. The product sold is
performing much better than expected. Stauffer’s valuation consultants have valued its
current market price at $14 million.
(d) Stauffer has been developing a new piece of technology over the past 18 months. Costs
incurred and expensed in the year ended 30 September 20X5 were $1.6 million; further costs
of $0.4 million were incurred up to 31 December 20X5 when the project met the criteria for
capitalisation. Costs incurred after 1 January 20X6 were $0.9 million.
1 Required
In accordance with IAS 38, which of the following is the correct treatment of the brand?
 Recognise an intangible asset of $14.6m with the gain to the profit or loss
 Recognise an intangible asset of $14.6m with the gain to other comprehensive income
 Recognise an intangible asset of $14.6m with the gain direct to the revaluation surplus
 Do not recognise the brand
2 Required
What is the carrying amount of the advertising campaign in the statement of financial position at
30 September 20X9?
 Nil
 $750,000
 $1,000,000

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 $3,600,000
3 Required
Which TWO of the following are TRUE regarding revaluing intangibles?
 Revaluations should be carried out with reference to an active market
 Revaluations should take place every three to five years
 All assets in the same class should be revalued
 Active markets are very common for intangible assets
4 Required
What is the carrying amount of the patent in the statement of financial position at 30 September
20X6?
 $6.5m
 $6.75m
 $8m
 $14m
5 Required
What amount should be capitalised as an intangible asset for the development project?

$ million

Solution
1

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8 Derecognition
8.1 Point of derecognition
An intangible asset is derecognised:
(a) On disposal; or
(b) When no future economic benefits are expected from its use or disposal.
(IAS 38: para. 112)

8.2 Gain or loss on derecognition

The gain or loss on derecognition is calculated as:
$
Net disposal proceeds (proceeds less selling costs) X
Less: Carrying amount of intangible asset (X)
Gain/loss on derecognition (recognise in profit or loss) X/(X)

The accounting entry required on derecognition is:

DEBIT (↑) Cash (if any)
CREDIT (↓) Intangible asset
CREDIT/DEBIT Profit or loss (balancing figure)

8.3 Revaluation model

On derecognition, if the intangible asset has been held under the revaluation model, any balance
on the revaluation surplus may be transferred to retained earnings (IAS 38: para. 87):
DEBIT (↓) Revaluation surplus
CREDIT (↑) Retained earnings

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Chapter summary

Intangible assets

Definitions Recognition and categories of intangible asset

Intangible assets Recognition criteria

• Identifiable Recognise intangible asset if it meets:
• Non-monetary asset • Definition of an intangible asset
• Without physical substance • Recognition criteria
– Probable future economic benefits
– Cost can be measured reliably
Identifiable
• Separable:
– Capable of being separated/divided from entity
and sold/transferred/licensed/exchanged; or
• Arises from contractual or other legal rights

Monetary assets
• Money held
• Assets to be received in fixed/determinable
amounts of money

Acquired intangible assets Internally generated intangible assets

Recognition criteria Definitions

• Assumed to be satisfied • Research – original and planned investigation to
• Separately acquired recognised at purchase gain new knowledge/understanding
• Acquired as part of a business combination • Development – application of research to
– Recognise separately from goodwill develop/enhance products

Goodwill Recognition criteria

• Internally generated – do not recognise • Research expenditure
• As a result of a business combination – recognise – Recognise as an expense in P/L
positive goodwill as an intangible asset in the • Development expenditure:
group accounts – Capitalise as an intangible asset if all of the
following are met:
◦ Probable future economic benefits
◦ Intention to complete and use/sell
◦ Resources available to complete asset
◦ Ability to use/sell asset
◦ Technical feasibility of completing asset
◦ Expenditure can be measured reliably
• Recognition as an intangible asset
prohibited for:
– Brands
– Mastheads
– Publishing titles
– Customer lists

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Initial measurement Subsequent measurement

• Acquired separately: Measure at cost Cost model or revaluation model

– Purchase price (include import duties and • Cost model:
non-refundable purchase taxes; deduct trade
Cost X
discounts and rebates)
Accumulated amortisation (X)
– Directly attributable costs
Accumulated impairment (X)
• Acquired as part of a business combination:
Measure at fair value Carrying amount X
• Internally generated: Measure at cost • Revaluation model:
– Sum of expenditure incurred from date Fair value (at revaluation date) X
intangible asset first meets recognition criteria Subsequent accumulated amortisation (X)
– Directly attributable costs
Subsequent accumulated impairment (X)
Carrying amount X

Revaluation model
• Revalue to fair value by reference to an
active market
• Revalue all assets of that class unless no
active market
• Revalue sufficiently often that carrying amount
does not differ materially from fair value
• Increase in value: to OCI (unless reverses
previous revaluation loss in P/L)
• Decrease in value: (1) to OCI (2) to P/L

Amortisation/Impairment Derecognition

• Finite useful life Point of derecognition

– Amortise on systematic basis over useful life Derecognise an intangible asset:
– Usually recognise in P/L • On disposal; or
– Residual value normally zero • When no future economic benefits are expected
– Begins when asset is available for use from its use or disposal
– Review useful life and amortisation method at
least every year end
• Indefinite useful life: Gain or loss on derecognition
– Do not amortise asset
Net disposal proceeds X
– Conduct impairment reviews:
Less: Carrying amount (X)
◦ Annually; and
◦ Where indication of possible impairment Gain/(loss) on derecognition X
• Review useful life at least annually • Recognise gain/loss in P/L
• Accounting entry:
DEBIT Cash (if any)
CREDIT Intangible asset
CREDIT/DEBIT Profit or loss (balancing figure)

Revaluation model
Balance on revaluation surplus transferred to
retained earnings

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Knowledge diagnostic
1. Definitions
‘An intangible asset is an identifiable non-monetary asset without physical substance.’ (IAS 38:
para. 8)

2. Recognition and categories of intangible asset

IAS 38 recognition criteria is:
• Probable that future economic benefits will flow to the entity; and
• Cost can be measured reliably.
Intangible assets can be acquired (separately or as part of a business combination) or internally
generated. (IAS 38, para. 21)

3. Acquired intangible assets

Separate acquired intangible assets meet the recognition criteria and can be capitalised at the
date of purchase.
Intangible assets acquired as part of a business combination should be recognised separately
from goodwill in the group accounts.

4. Internally generated intangible assets

Research expenditure should be written off as an expense to profit or loss.
Development expenditure must be capitalised if the PIRATE criteria are satisfied:
• Probable future economic benefits will be generated by the asset
• Intention to complete and use/sell asset
• Resources (technical, financial, other) adequate to complete asset
• Ability to use/sell asset
• Technical feasibility of completing asset
• Expenditure can be measured reliably

5. Initial measurement
(a) Intangible assets separately acquired – purchase price plus directly attributable costs
(b) Intangible assets acquired as part of a business combination – at fair value (IFRS 13)
(c) Internally generated – at expenditure incurred after criteria satisfied plus directly attributable
costs

6. Subsequent measurement
Cost model or revaluation model: Revaluation model only permitted if an active market exists for
the asset, eg licences, quota.

7. Amortisation/impairment
If the intangible asset has a finite useful life, it should be amortised on a systematic basis across
that useful life.

8. Derecognition
Intangible asset should be derecognised on disposal or when no further benefits are expected. A
gain or loss on disposal should be calculated by comparing proceeds on disposal with the
carrying amount of the asset. Any revaluation surplus should be released to retained earnings.

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Further study guidance

Question practice
You should attempt the following from the Further question practice (available in the digital
edition of the Workbook):
6 Biogenics Co

Further reading
For further reading on the problems on the treatment of intangible assets, there is a useful
technical article on the CPD area of the ACCA webpage from February 2018:
Reporting on intangibles is all a bit of a muddle
www.accaglobal.com

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Activity answers

Activity 1: Recognition criteria

The correct answers are:
• $250,000 acquiring a licence to operate in a new geographical location
• $100,000 on computer software acquired from a supplier
• A brand, valued at $500,000 acquired as part of the purchase of a new subsidiary
The licence is an acquired intangible asset. Therefore, according to IAS 38, the recognition criteria
are presumed to have been met.
Computer software is an acquired intangible asset. Therefore, according to IAS 38, the recognition
criteria are presumed to have been met.
A brand is an intangible asset acquired as part of a business combination. Therefore, according to
IAS 38, the recognition criteria are presumed to have been met and the brand should be
recognised as an intangible asset in the group accounts separately from goodwill.

Activity 2: Initial measurement of a separately acquired intangible asset

The correct answer is:
$233,000
$
Purchase price:
Purchase price (net of trade discount) 180,000
Non-refundable purchase taxes 18,000
Import duties 20,000

Directly attributable costs:

Legal fees 15,000
233,000

Activity 3: Initial measurement of an internally generated intangible asset

The correct answer is:
The recognition criteria were satisfied at 1 December 20X3. Any costs incurred after this date can
be capitalised, therefore for the year ended 31 December 20X3, the production process is
recognised as an intangible asset at a cost of $10,000. The $90,000 expenditure incurred before 1
December 20X3 is expensed in profit or loss, because the recognition criteria were not met. It will
never form part of the cost of the production process recognised in the statement of financial
position.

Activity 4: Intangible assets

1 The correct answer is:
Do not recognise the brand
The Stauffer brand is an ‘internally generated’ intangible asset rather than a purchased one. IAS
38 specifically prohibits the recognition of internally generated brands, on the grounds that they
cannot be reliably measured in the absence of a commercial transaction. Stauffer will not
therefore be able to recognise the brand in its statement of financial position.
2 The correct answer is:
Nil
The advertising campaign is treated as an expense. Advertising expenditure cannot be capitalised
under IAS 38, as the economic benefits it generates cannot be clearly identified so no intangible
asset is created.

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3 The correct answer is:

• Revaluations should be carried out with reference to an active market
• All assets in the same class should be revalued
Revaluations should take place with reference to an active market and all assets in the same class
should be revalued.
There is not often an active market for intangible assets as they are not frequently traded. IAS 38
does not specify a three- to five-year time frame for revaluations, but instead says that
‘revaluations should be carried out with sufficient regularity to ensure that the carrying amount
does not differ materiality from its fair value’. (IAS 38, para. 75)
4 The correct answer is:
$6.75m
The patent is amortised to a nil residual value at $500,000 per annum based on its acquisition
cost of $8m and remaining useful life of 16 years.
The patent cannot be revalued under the IAS 38 rules as there is no active market as a patent is
unique. IAS 38 does not permit revaluation without an active market, as the value cannot be
reliably measured in the absence of a commercial transaction.
5 The correct answer is:
$0.9 million
All costs prior to the project meeting the criteria for capitalisation should be expensed through the
profit or loss.

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Impairment of assets
5
5

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Define and calculate an impairment loss. B3(a)

Identify the circumstances that may indicate B3(b)

impairments to assets.

Describe what is meant by a cash-generating B3(c)

unit.

State the basis on which impairment losses B3(d)

should be allocated, and allocate an
impairment loss to the assets of a cash-
generating unit.

Exam context
It is important that assets are not carried in the financial statements at more than they are worth.
An impairment arises when the carrying amount of an asset exceeds its value to an entity. Entities
must consider whether there have been any internal events or external factors that would indicate
that the carrying amount of assets is too high. Impairment is an important concept and applies
mainly to non-current tangible and intangible assets. It is frequently examined as an objective
test question (OTQ) in Section A and B of the ACCA Financial Reporting exam, and could be an
adjustment you are required to make when preparing the primary financial statements in Section
C.
5

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Chapter overview
Impairment of assets

Principle of impairment Impairment

indicators

Basic principle Recoverable amount Examples of impairment indicators

Definitions Impairment loss

Cash generating Recognition of After the

units impairment losses impairment review

Assets within CGU Recognition of impairment losses Depreciation and amortisation

in the financial statements

Reversal of impairment loss

Allocation of impairment
losses for CGU
Maximum value

Minimum value

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1 Principle of impairment
1.1 Basic principle
There is an established principle that assets should not be carried above their recoverable
amount. IAS 36 Impairment of Assets states that an entity should write down the carrying amount
of an asset to its recoverable amount if the carrying amount of an asset is not recoverable in full.
(IAS 36: paras. 18–24)
Note that assets in this case include all tangible and intangible assets. It does not include assets
such as inventories, deferred tax assets, assets arising under IAS 19 Employee Benefits and
financial assets within the scope of IFRS 9 Financial Instruments as these standards already have
rules for recognising and measuring impairment. Note also that IAS 36 does not apply to non-
current assets held for sale, which are dealt with under IFRS 5 Non-current Assets held for Sale
and Discontinued Operations.

1.2 Definitions

Impairment loss: The amount by which the carrying amount of an asset or a cash-generating
KEY
TERM unit exceeds its recoverable amount.
Carrying amount: The amount at which the asset is recognised after deducting accumulated
depreciation and any impairment losses in the statement of financial position.
Recoverable amount: The higher of the fair value less costs of disposal of an asset (or cash-
generating unit) and its value in use.
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.
Fair value less costs of disposal: The price that would be received to sell the asset in an
orderly transaction between market participants at the measurement date (IFRS 13 Fair Value
Measurement), less the direct incremental costs attributable to the disposal of the asset.
Value in use of an asset: The present value of estimated future cash flows expected to be
derived from the use of an asset.
(IAS 36: para. 6)

1.3 Recoverable amount

It is important that you can apply the definition of recoverable amount to information you are
provided with in a question:

Recoverable amount =
Higher of

Fair value less costs of disposal Value in use

Illustration 1: Recoverable amount

Henry Co holds an item of machinery which it believes is impaired. The following information is
relevant:
• The fair value of the machinery is $10,000, the cost of selling is $500.
• The value in use of the machinery is estimated to be $9,000.
It is the company’s intention to continue to use the asset for the remainder of its useful life.
Required
Determine the recoverable amount of the machinery.

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Solution
The correct answer is:

Recoverable amount =
Higher of

Fair value less costs of disposal Value in use

$10,000 – $500 = $9,500 $9,000

Therefore, the recoverable amount is $9,500. Note that the company’s intention to continue to use
the asset is not a relevant factor.

Essential reading
Chapter 5, Section 1 of the Essential reading provides detail on measuring the recoverable amount
of an asset.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

1.4 Impairment loss

If there is any indication that an asset may be impaired, the entity should compare its carrying
amount with its recoverable amount.

greater than carrying amount No impairment

Recoverable amount

less than carrying amount Impairment loss

An impairment loss is the amount by which the carrying amount of an asset or cash-generating
unit exceeds its recoverable amount.

Illustration 2: Impairment loss

Following on from Illustration 1, further information has been provided about the carrying amount
of the asset:
• The machinery is held at historical cost
• The carrying amount of the machinery is $10,500
Required
Using the recoverable amount determined in Illustration 1, calculate the impairment loss.

Solution
The correct answer is:
The carrying amount of the machinery must be compared to its recoverable amount.
The recoverable amount was determined in Illustration 1 as $9,500.
The carrying amount of the machinery is therefore greater than its recoverable amount, so the
machinery is impaired.
The impairment loss charged is: $10,500 – $9,500 = $1,000.

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Section 4 of this chapter will consider how to account for the impairment.

2 Impairment indicators
An entity must assess at the end of each reporting period whether there is any indication that an
asset may be impaired.

2.1 Examples of events indicating impairment

2.1.1 External sources
• Observable indications that the value of the asset has declined during the period significantly
more than expected due to the passage of time or normal use
• Significant changes with an adverse effect on the entity in the technological, market,
economic or legal environment in which the entity operates
• Increased market interest rates or other market rates of return affecting discount rates and
thus reducing value in use
• Carrying amount of net assets of the entity exceeds market capitalisation

2.1.2 Internal sources

• Evidence of obsolescence or physical damage
• Significant changes with an adverse effect on the entity (including the asset becoming idle,
plans to discontinue or restructure an operation to which the asset belongs or to dispose of it
earlier than expected and reassessing the useful life of an asset as finite rather than indefinite)
• Internal evidence available that asset performance will be worse than expected

3 Cash-generating units (CGUs)

It may not be possible to estimate the recoverable amount of an individual asset. An entity must
therefore determine the recoverable amount of the CGU to which the asset belongs.

3.1 Assets within a CGU

If an active market exists for the output produced by the asset or a group of assets, this asset or
group should be identified as a cash-generating unit, even if some or all of the output is used
internally. (IAS 36: para. 70)
Cash-generating units should be identified consistently from period to period for the same type of
asset, unless a change is justified. (IAS 36: para. 72)
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. (IAS 36: para. 75)
Goodwill (and corporate assets eg head office assets – or a portion of them – that can be
allocated on a reasonable and consistent basis) are allocated to a CGU (or group of CGUs) when
determining carrying amount and recoverable amount.

Activity 1: Cash-generating units

Minimart Co belongs to a retail store chain, Magnus Co. Minimart Co makes all its retail
purchases through Magnus Co’s purchasing centre. Pricing, marketing, advertising and human
resources policies (except for hiring Minimart Co’s cashiers and salesmen) are decided by Magnus
Co. Magnus Co also owns five other stores in the same city as Minimart Co (although in different
neighbourhoods) and 20 other stores in other cities. All stores are managed in the same way as
Minimart Co. Minimart Co and four other stores were purchased five years ago and goodwill was
recognised.
Required
What is the cash-generating unit for Minimart Co?

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Solution

4 Recognition of impairment losses

4.1 Recognition of impairment losses in the financial statements
4.1.1 Impairment losses for individual assets
Impairment losses are treated in the following way:

Assets carried at historical cost Revalued assets

The impairment loss is recognised The impairment loss is accounted

as an expense in profit or loss. for under the appropriate rules of
the applicable IFRS Standards.

For example under IAS 16 the

impairment loss is charged:
1. First to other comprehensive
income (reducing any
revaluation surplus relating to
the particular asset); and
2. Any remainder as an expense in
profit or loss.

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Activity 2: Impairment of a revalued asset

Brix Co owns a building which it uses as its offices, warehouse and garage. The land is carried as
a separate non-current tangible asset in the statement of financial position.
Brix Co has a policy of regularly revaluing its non-current tangible assets. The original cost of the
building in October 20X2 was $1,000,000; it was assumed to have a remaining useful life of 20
years at that date, with no residual value. The building was revalued on 30 September 20X4 by a
professional valuer at $1,800,000. The economic climate had deteriorated during 20X5, causing
Brix Co to carry out an impairment review of its assets at 30 September 20X5. Brix Co’s building
was valued at a market value of $1,500,000 on 30 September 20X5 by an independent valuer.
Required
At 30 September 20X5, what is the impairment loss AND where should it be recognised?
Loss options

$200,000 $300,000

Area of the financial statements

Other comprehensive income Profit or loss

Solution

4.2 Allocation of impairment losses for a CGU

The impairment loss is allocated to reduce the carrying amount of the assets of the unit in the
following order:
(a) To any goodwill allocated to the CGU;
(b) To the other assets of the unit on a pro-rata basis based on the carrying amount of each
asset in the unit.

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Illustration 3: Allocation of impairment loss for CGU

A cash-generating unit comprises the following:
$m
Building 30
Plant and equipment 6
Goodwill 10
Current assets 20
66

Following a recession, an impairment review has estimated the recoverable amount of the cash-
generating unit to be $50 million.
Required
Allocate the impairment loss to the assets in the CGU.

Solution
The correct answer is:
There is an impairment of $16 million as the recoverable amount of $50 million is less than the
carrying amount of $66 million.
$10 million of the impairment is allocated to goodwill. The remaining $6 million will be allocated to
the other non-current assets on a pro-rata basis based on their carrying amounts.
• Impairment allocated to building is 30/36 × $6 million
• Impairment allocated to plant and equipment is 6/36 × $6 million
Plant and Current
Building equipment Goodwill assets Total
$m $m $m $m $m
Carrying amount 30 6 10 20 66
Impairment – goodwill — — (10) — (10)
30 6 — 20 56
Impairment – other assets (5) (1) — — (6)
Carrying amount after
impairment 25 5 — 20 50

4.3 Minimum value

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 the impairment loss should be recognised as a liability if required by
other standards. (IAS 36: paras. 104–108)

Activity 3: Calculation and allocation of impairment loss

On 31 December 20X1, Invest Co purchased all the shares of Mash Co for $2 million. The net fair
value of the identifiable assets acquired and liabilities assumed of Mash Co at that date was $1.8
million. Mash Co made a loss in the year ended 31 December 20X2 and at 31 December 20X2, the
net assets of Mash Co – based on fair values at 1 January 20X2 – were as follows:
$’000
Property, plant and equipment 1,300

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$’000
Development expenditure 200
Net current assets 250
1,750

An impairment review on 31 December 20X2 indicated that the recoverable amount of Mash Co at
that date was $1.5 million. The capitalised development expenditure has no ascertainable external
market value and the current fair value less costs of disposal of the property, plant and
equipment is $1,120,000. Value in use could not be determined separately for these two items.
Required
Calculate the impairment loss that would arise in the consolidated financial statements of Invest
as a result of the impairment review of Mash Co at 31 December 20X2 and show how the
impairment loss would be allocated.
Asset values at 31 Allocation of Carrying amount
December 20X2 impairment after impairment
before impairment loss loss
$’000 $’000 $’000
Goodwill
Property, plant and equipment
Development expenditure
Net current assets

Solution

5 After the impairment review

5.1 Depreciation and amortisation
After the recognition of an impairment loss, the depreciation or amortisation charge for the asset
in future periods should allocate the asset’s revised carrying amount less its residual value over its

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remaining useful life. It is often the case that the remaining useful life of an asset will be
reassessed at the date of the impairment review.

5.2 Reversal of an impairment loss

It may be possible that there is a change in the economic or operating conditions for an asset or
CGU that mean a previous impairment loss can now be reversed. An impairment loss recognised
for an asset in prior years should be recovered only if there has been a change in the estimates
used to determine the asset’s recoverable amount since the last impairment loss was recognised.
(IAS 36, para. 114)
If there is a change in estimates that requires an impairment loss to be reversed, the carrying
amount of the asset should be increased to its new recoverable amount:

Assets carried at historical cost Revalued assets

Reversal of the impairment loss Reversal of the impairment loss should be

should be recognised immediately recognised in other comprehensive
in profit or loss income and accumulated as a revaluation
surplus in equity

(IAS 36: para. 119)

5.2.1 Maximum value

The asset cannot be revalued to a carrying amount that is higher than what it would have been if
the asset had not been impaired originally, ie its depreciated carrying amount had the
impairment not taken place.

5.2.2 Subsequent depreciation and amortisation

Depreciation of the asset should now be based on its new revalued amount, its estimated residual
value (if any) and its estimated remaining useful life.

5.2.3 Goodwill
An exception to the rule above is for goodwill. An impairment loss for goodwill should not be
reversed in a subsequent period. (IAS 36, para. 124)

Activity 4: Reversal of impairment loss

A head office building with a carrying amount of $140 million is estimated to have a recoverable
amount of $90 million due to falling property values in the area. An impairment loss of $50 million
is recognised.
After three years, property prices in the area have risen, and the recoverable amount of the
building increases to $120 million. The carrying amount of the building, had the impairment not
occurred, would have been $110 million.
Required
Calculate the reversal of the impairment loss.

Solution

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Essential reading
Chapter 5, Section 2 of the Essential reading contains two further activities to allow you to
practise calculating impairment loss for an individual asset and a CGU.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

PER alert
One of the competences you require to fulfil Performance Objective 6 of the PER is the ability
to record and process transactions and events, using the right accounting treatments for
those transactions and events. The treatment of impairment losses for both assets and cash-
generating units is one that is non-routine, but increasingly important in the current economic
climate. The information in this chapter will give you knowledge to help you demonstrate this
competence.

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Chapter summary

Impairment of assets

Principle of impairment Impairment

indicators

Basic principle Recoverable amount Examples of impairment indicators

Assets should not be carried at Higher of: • External
more than their value to an entity • Fair value less costs of disposal – Asset's value declined more
• Value in use than expected due to the
Definitions passage of time or normal use
– Adverse changes in
• Impairment loss – amount by Impairment loss
technological, market,
which carrying amount exceeds • If carrying amount exceeds economic or legal environment
recoverable amount recoverable amount, impairment – Increased market interest rates
• Carrying amount – amount at loss arises – Carrying amount of net assets
which asset is presented in • If carrying amount is less than exceeds market capitalisation
financial statements recoverable amount, no
• Recoverable amount – higher of • Internal
impairment loss – Obsolescence or physical
fair value less costs of disposal
and value in use damage
• Cash generating unit – smallest – Significant changes with an
identifiable group of assets that adverse effect on the entity
generates cash flows – Evidence available that asset
• Fair value less costs of disposal performance will be worse
– price received to sell an asset than expected
less incremental costs to dispose
of the asset
• Value in use – present value of
the net future cash flows

Cash generating Recognition of After the

units impairment losses impairment review

Assets within CGU Recognition of impairment losses Depreciation and amortisation

• Smallest group of assets that in the financial statements Based on revised carrying amount
generates cash flows Losses for individual assets: over estimated remaining useful life
• Net of associated liabilities • If at historic cost – in profit/loss
• Goodwill and corporate assets • If revalued assets – rules per Reversal of impairment loss
should be allocated relevant IFRS Standard • Only if change in circumstances
• Asset at historic cost –
Allocation of impairment losses for immediately in profit/loss
CGU • Revalued asset – as a
Allocate first to goodwill, then to revaluation surplus
other assets pro-rata
Maximum value
Minimum value Asset not above carrying amount
No asset below: had no impairment occurred
• Its fair value less costs of
disposal
• Its value in use (if determinable)
• Zero

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Knowledge diagnostic
1. Principle of impairment
Assets should not be measured at more than their value to an entity. An asset’s recoverable
amount is the higher of value in use (net cash flows) and fair value less costs of disposal.
Impairment losses occur where the carrying amount of an asset is above its recoverable amount.

2. Impairment indicators
An entity must do an impairment test when there are impairment indicators. These can be
internal, such as physical damage to an asset or external, such as significant technological
advances.

3. Cash generating units

Where the cash flows of individual assets cannot be measured separately, the recoverable
amount is calculated by reference to the CGU.

4. Recognition of impairment losses

Impairment losses are charged first to other comprehensive income (re: any revaluation surplus
relating to the asset) and then to profit or loss.
In the case of a CGU, the credit is allocated first against any goodwill and then pro-rata over the
other assets of the CGU.

5. After the impairment review

After the impairment review, depreciation/amortisation is allocated over the asset’s revised
remaining useful life.
Impairment losses can be reversed in subsequent periods, provided there is a change in the
circumstances that gave rise to the impairment. Reversals are up to a maximum of what the asset
would have been carried at, had no impairment occurred.

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Activity answers

Activity 1: Cash-generating units

The correct answer is:
In identifying Minimart Co’s cash-generating unit, an entity considers whether, for example:
(a) Internal management reporting is organised to measure performance on a store-by-store
basis.
(b) The business is run on a store-by-store profit basis or on a region/city basis.
All Magnus Co’s stores are in different neighbourhoods and probably have different customer
bases. So, although Minimart Co is managed at a corporate level, Minimart Co generates cash
inflows that are largely independent from those of Magnus Co’s other stores. Therefore, it is likely
that Minimart Co is a cash-generating unit.

Activity 2: Impairment of a revalued asset

The correct answer is:
Loss options
$200,000
Area of the financial statements
Other comprehensive income

Activity 3: Calculation and allocation of impairment loss

The correct answer is:
Asset values at Allocation of Carrying amount
31.12.X2 before impairment loss after impairment
impairment (W1)/(W2) loss
$’000 $’000 $’000
Goodwill (2,000 – 1,800) 200 (200) –
Property, plant and 1,300 (180) 1,120
equipment
Development expenditure 200 (70) 130
Net current assets 250 – 250
1,950 (450) 1,500

Workings
1 Impairment loss
$’000
Carrying amount 1,950
Recoverable amount 1,500
Impairment loss 450

Amount to allocate against goodwill 200

Amount to allocate pro-rata against other assets 250

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2 Allocation of the impairment losses on pro-rata basis

Carrying
amount if Actual
Initial Impairment fully loss Impaired
value pro-rated allocated Reallocation allocated value
$’000 $’000 $’000 $’000 $’000 $’000
PPE (250 ×
1,300/1,500) 1,300 217 1,083 (37) 180 1,120
Dev exp (250 ×
200/1,500) 200 33 167 37 70 130

The amount not allocated to the PPE because the assets cannot be taken below their recoverable
amount is allocated to other remaining assets pro-rata, in this case all against the development
expenditure.
Hence the development expenditure is reduced by a further $37,000 (217,000 – 180,000), making
the total impairment $70,000 (33,000 + 37,000).
The net current assets are not included when pro-rating the impairment loss. As current assets are
not intended to be held as assets in future periods, they are more likely to be measured at their
recoverable amount and therefore are less likely to be impaired.

Activity 4: Reversal of impairment loss

The correct answer is:
The reversal of the impairment loss is recognised to the extent that it increases the carrying
amount of the building to what it would have been, had the impairment not taken place, ie a
reversal of impairment loss of $20 million is recognised and the building written back to $110
million.

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Skills checkpoint 1
Approach to objective test
(OT) questions

Chapter overview
cess skills
Exam suc

Answer planning

c FR skills C
n Specifi o
tio

rr req
a

ec ui
of
m

t i rem
or

nt
inf

erp ents
ng

Approach to Application

reta
agi

objective test of accounting

(OT) questions standards
Man

tion l y si s
Spreadsheet Interpretation
Go od

skills skills
ana
ti m

c al

Approach
em

to Case
e ri

OTQs
an

um
ag

tn
em

en

en
t ci
Effi
Effective writing
and presentation

Introduction
Sections A and B of the FR exam consist of OT questions (OTQs).
The OTQs in Section A are single, short questions that are auto-marked and worth two marks
each. You must answer the whole question correctly to earn the two marks. There are no partial
marks.
The OTQs in Section A aim for a broad coverage of the syllabus, and so all areas of the syllabus
need to be carefully studied. You need to work through as many practice OTQs as possible,
reviewing the answers carefully to understand how the correct answers are derived.
The OTQs in Section B are a series of short questions that relate to a common scenario, or case.
The types of OTQ and approach to answering the questions is the same as for the Section A
questions.

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The following types of OTQ commonly appear in the FR exam:

Question type Explanation

Multiple choice You need to choose one correct answer from four given response
(MCQ) options.

Multiple response These are a kind of multiple choice question, except you need to select
(MR) more than one answer from a number of given options. The question will
specify how many answers need to be selected, but the system won’t
stop you from selecting more answers than this. It is important to read
the requirement carefully.

Fill in the blank (FIB) This question type requires you to type a numerical answer into a box.
The unit of measurement (eg $) will sit outside the box, and if there are
specific rounding requirements these will be displayed.

Drag and drop Drag and drop questions involve you dragging an answer and dropping
it into the correct place. Some questions could involve matching more
than one answer to a response area and some questions may have
more answer choices than response areas, which means not all
available answer choices need to be used.

Drop down list This question type requires you to select one answer from a drop down
list. Some of these questions may contain more than one drop down list
and an answer has to be selected from each one.

Hot spot For hot spot questions, you are required to select one point on an image
as your answer. When the cursor is hovered over the image, it will
display as an ‘X’. To answer, place the X on the appropriate point on the
diagram.

Hot area These are like hot spot questions, but instead of selecting a specific
point you are required to select one or more areas in an image.

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Approach to OTQs
A step-by-step technique for approaching OTQs is outlined below. Each step will be explained in
more detail in the following sections as we work through a range of OTQs.

STEP 1: Answer the questions you know first.

If you’re having difficulty answering a question, move on and come back to tackle it
once you’ve answered all the questions you know.
It is often quicker to answer discursive style OT questions first, leaving more time
for calculations.

STEP 2: Answer all questions.

There is no penalty for an incorrect answer in ACCA exams; there is nothing to be
gained by leaving an OT question unanswered. If you are stuck on a question, as a
last resort, it is worth selecting the option you consider most likely to be correct
and moving on. Make a note of the question, so if you have time after you have
answered the rest of the questions, you can revisit it. 

STEP 3: Read the requirement first!

The requirement will be stated in bold text in the exam. Identify what you are
being asked to do, any technical knowledge required and what type of OT
question you are dealing with. Look for key words in the requirement such as
"Which TWO of the following," or "Which of the following is NOT".

STEP 4: Apply your technical knowledge to the data presented in the question.
Work through calculations taking your time and read through each answer option
with care. OT questions are designed so that each answer option is plausible. Work
through each response option and eliminate those you know are incorrect

Exam success skills

The following questions are examples of the types of OTQ you may come across in the exam. This
does not cover all of the styles, but focuses on the trickier ones which you may face on the day.
For this question, we will also focus on the following exam success skills:
• Managing information. It is easy for the amount of information contained in an OTQ in section
B to feel a little overwhelming due to the volume of information within the case scenario. Active
reading is a useful technique to help avoid this. This involves focusing on each of the five
requirements first, on the basis that until you have done this the detail in the question will have
little meaning and will seem more intimidating as a result.
Focus on the requirements, highlighting key verbs to ensure you understand the requirement
properly and correctly identify what type of OT question you are dealing with. Then read the
rest of the scenario, underlining and annotating important and relevant information, and
making notes of any relevant technical information you think you will need.
• Correct interpretation of requirements. Identify from the requirement the different types of
OTQ. This is especially important with multiple response questions to ensure you select the
correct number of response options.
• Good time management. Complete all OTQs in the time available. Each OTQ is worth 2 marks
and should be allocated 3.6 minutes (based on 1.8 minutes per mark).

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Skill activity
1. Which TWO of the following are acceptable methods of accounting for a government grant
relating to an asset in accordance with IAS 20 Accounting for Government Grants and
Disclosure of Government Assistance?
Note. This is an MCQ requiring you to select two valid statements. IAS 20 is being examined here.
• Set up the grant as deferred income
• Credit the full amount received to profit or loss
• Deduct the grant from the carrying amount of the asset
• Add the grant to the carrying amount of the asset
(2 marks)

2. Which ONE of the following would be recognised as an investment property under IAS 40
Investment Property in the consolidated financial statements of Build Co?
Note. This is an MCQ question requiring you to select one valid statement.
• A property intended for sale in the ordinary course of business
• A property being constructed for a customer
• A property held by Build Co as a right-of-use asset and leased out under a six-month lease
• A property owned by Build Co and leased out to a subsidiary
(2 marks)

3. Lichen Ltd owns a machine that has a carrying amount of $85,000 at the year end of 31
March 20X9. Its market value is $78,000 and costs of disposal are estimated at $2,500. A new
machine would cost $150,000. Lichen Ltd expects it to produce net cash flows of $30,000 per
annum for the next three years. The cost of capital of Lichen Ltd is 8%.
Note. This is a FIB question. This is testing your knowledge of impairment and a calculation of the
loss to be recognised on the machine.
What is the impairment loss on the machine to be recognised in the financial statements at 31
March 20X9?

$
(2 marks)

4. Springthorpe Co entered into a three-year contract on 1 January 20X2 to construct a factory

on a client’s land. The client gains control of the asset as the construction takes place.
Springthorpe Co does not have an alternative use for the factory and has an enforceable right to
payment for performance completed to date. Springthorpe Co has determined that performance
obligations are satisfied over time, with progress measured according to certificates issued by a
surveyor. At 31 December 20X2 details of the contract were as follows:
$m
Total contract price 12
Costs incurred to date 5
Amounts invoiced to date 4
Certified as complete by surveyor 40%

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Identify whether a contract asset or contract liability should be recognised and at what
carrying amount in the statement of financial position of Springthorpe Co as at 31 December
20X2?
Asset or liability Carrying amount
Contract asset $200,000
Contract liability $800,000
$1,000,000

(2 marks)

5. On 30 September 20X7 and impairment review of the assets of Jack Co was carried out.
The following amounts were established in respect of the Jillobucket machine:
$
Carrying amount 1,700,000
Value in use 1,240,000
Fair value 1,275,000
Costs of disposal 45,000

Using the picklist provided, what should be the carrying amount of the machine following the
impairment review?
Note. This is a picklist question, very similar to the MCQ except the selection is taken from a drop
down box.
Picklist
1,275,000
1,240,000
1,230,000
1,195,000
STEP 1 Answer the questions you know first.
If you’re having difficulty answering a question, move on and come back to tackle it once you’ve answered
all the questions you know. It is often quicker to answer discursive style OTQs first, leaving more time for
calculations.
Questions 1 and 2 are discursive style questions. It would make sense to answer these questions
first as it is likely that you will be able to complete them comfortably within the 3.6 minutes per
question allocated to them. Any time saved could then be spent on the more complex calculations
required to answer Questions 3, 4 and 5.
STEP 2 Answer all questions.
There is no penalty for an incorrect answer in ACCA exams, there is nothing to be gained by leaving an OTQ
unanswered. If you are stuck on a question, as a last resort, it is worth selecting the option you consider
most likely to be correct and moving on. Make a note of the question, so if you have time after you have
answered the rest of the questions, you can revisit it.
Of the questions here, four out of five of them could be guessed as there are suggested answers
given. With an MCQ or picklist question you have a 25% chance of getting the question correct so
don’t leave any unanswered. It is obviously more difficult to get a fill in the blank question (like
Question 3) correct by guessing.
STEP 3 Read the requirement first!
The requirement will be stated in bold text in the exam. Identify what you are being asked to do, any
technical knowledge required and what type of OT question you are dealing with. Look for key words in the
requirement such as “Which TWO of the following” and “ Which of the following is NOT” etc.
Question 3 is a FIB question, you need to follow the instructions carefully. Questions 1 and 2 ask
you to identify which statements are correct. Read through each statement carefully knowing
that you are looking to identify the statement that is correct. Question 4 is a hot area question,
which ask you to select the correct type of indicator for each statement.

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STEP 4 Apply your technical knowledge to the data presented in the question.
Work through calculations taking your time and read through each answer option with care. OT questions
are designed so that each answer option is plausible. Work through each response option and eliminate
those you know are incorrect.

Let’s look at the questions in turn:

Question 1

The question is testing your knowledge of IAS 20 and the

permissible ways of accounting for a grant.

As no application of the standard is required, it is a

relatively simple knowledge exercise requiring two
statements to be selected. It is important that you
remember to select two statements in order to gain the
marks (partial marks are not available, you must get
both statements correct).

The correct answer is:

• Set up the grant as deferred income; and

• Deduct the grant from the carrying amount of the

asset

Both of these are options available stated within the

standard. The second statement would not meet the
criteria of accruals accounting as the costs of the asset
(depreciation expense) would not be matched to the
income included wholly in year 1. The last statement
would be the correct treatment if a requirement to
repay the grant was necessary.

Question 2 works in a similar way, again testing the

knowledge rather than the application of the standard.

The correct answer is:

A property held by Build Co as a right-of-use asset and

leased out under a six-month lease.

The property intended for sale and the property being

constructed would be classified as inventory and WIP.
The property leased out to a subsidiary would be
regarded as an investment property in the single entity
financial statements of Build Co but is treated as owner
occupied in the consolidated financial statements (as it
is occupied by a subsidiary not a third party).

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Question 3 is a calculation question requiring

knowledge of the impairment of assets (IAS 36) and the
application of that knowledge.

This is quite a time-consuming question if you not

confident with the treatment of impairment of assets.

You should start by pulling out the key data from the
question:

Lichen Ltd owns a machine that has a carrying amount

of $85,0001 at the year end of 31 March 20X9. Its market 1
Carrying amount $85,000

value is $78,0002 and costs of disposal are estimated at 2

Fair value $78,000
3
$2,500. A new machine would cost $150,000. Lichen
3
This is a FIB question. This is testing
Ltd expects it to produce net cash flows of $30,000 per
your knowledge of impairment and a
annum for the next three years. The cost of capital of calculation of the loss to be recognised
on the machine.
Lichen Ltd is 8%.

What is the impairment loss on the machine to be

recognised in the financial statements at 31 March
20X9?

What information do we need?

The carrying amount must be compared to its

recoverable amount.

The recoverable amount of an asset should be

measured as the higher of:

1. The asset’s fair value less costs of disposal

2. The value in use

Step 1: Carrying amount is $85,000 (information in the

question)

Step 2: Asset’s fair value less costs of disposal is $75,500

– $78,000 market value(question)less $2,500 costs of
disposal (question).

Step 3: Value in use requires a calculation:

Value in use:
30,000 × 1 / 1.08 = 27,778
30,000 × 1 / 1.082 = 25,720
30,000 × 1 / 1.083 = 23,815
$77,313

Note. Cash flows of £30,000 per annum for three years. Interest rate of 8%

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Step 4: Compare the answers using the information

from the standard:

The recoverable amount is the higher of the fair value

less costs of disposal $75,500 and the value in use
£77,313. The recoverable amount is therefore $77,313.

The calculation of the impairment is $85,000 – $77,313 =

$7,687

Question 4 is another calculation question. In this case

however, there are three potential numerical answers,
and you have to select whether there is a contract asset
or a contract liability to be recognised. Once again, you
need to pull the relevant data out of the question and
apply it to your knowledge of IFRS 15 Revenue from
Contracts with Customers.

This style of question works better on software as you

will click on the correct answers.

The correct answer is:

Asset or liability Carrying amount
Contract asset $800,000

Working

A contract asset represents an entity’s right to receive

consideration in respect of goods or services transferred
to a customer.

A contract liability represents an entity’s obligation to

transfer goods or services to a customer for which it has
already received consideration.

This is determined by reference to the revenue that can

be recognised to date and the amount invoiced to date.
$
Revenue recognised ($12m × 40%) 4.8
Amounts invoiced (4.0)
Contract asset 0.8

A contract asset arises as the entity has transferred

goods or services to the customer with a value of $4.8
million but has only charged $4 million to date for those
goods or services.

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Question 5 is the other numerical question, requiring

knowledge of impairment recoverable amounts of asset.
A reminder from IAS 36 Impairment of Assets:

The question asks what the carrying amount of the

asset would be following the impairment review.
Therefore, you are required to compare the current
carrying amount to the recoverable amount to
determine whether an impairment is required.

The current carrying amount is given in the question as

$1,700,000.

The recoverable amount of an asset should be

measured as the higher of:

• The asset’s fair value less costs of disposal

($1,275,000 – $45,000 = $1,230,000)

• The value in use ($1,240,000)

Therefore, the recoverable amount is $1,240,000 which

is lower than the current carrying amount and therefore
the asset is impaired. It must be written down from its
carrying amount of $1,700,000 to the recoverable
amount of $1,240,000: therefore the impairment is
$460,000 and the carrying amount after the
impairment review would be $1,240,000.

Exam success skills diagnostic

Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table below allows you to
perform a check for the OTQs you undertake in timed conditions to give you an idea of how to
complete the diagnostic.

Exam success skills Your reflections/observations

Managing information Some questions are longer than others, so
prioritise the topics which you feel more
confident with. Ensure you are familiar with
the time period in the question, and what data
is required in order to answer the question, eg
calculation of the depreciation in order to give
the required answer of the carrying amount of
an asset.

Correct interpretation of requirements Ensure you read the question requirement

carefully so that you answer the question
being asked (not the one you think or hope is
being asked!)

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Exam success skills Your reflections/observations

Good time management Remember that each OTQ is worth two marks,
regardless of how hard it is or how long it
takes you to answer. You are aiming for to
spend 3.6 minutes on each question (180
minutes/100 marks × 2 marks).
Some questions will be quicker than others,
due to their nature (narrative) or how
confident you are on a certain topic.
Ensure you don’t overrun, but equally, don’t
rush your answers and make mistakes.

Most important action points to apply to your next question – Read the scenario and
requirement carefully.

Summary
60% of the FR exam consist of OTQs. Key skills to focus on throughout your studies will therefore
include:
• Always read the requirements first to identify what you are being asked to do and what type of
OTQ you are dealing with.
• Actively read the scenario highlighting key data needed to answer each requirement.
• Answer OTQs in a sensible order dealing with any easier discursive style questions first.

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Revenue and
6 Government Grants

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Explain and apply the principles of recognition of revenue: B10(a)

• Identification of contracts
- Identification of performance obligations
- Determination of transaction price
- Allocation of the price to performance obligations
- Recognition of revenue when/as performance obligations are
satisfied

Explain and apply the criteria for recognising revenue generated B10(b)
from contracts where performance obligations are satisfied over
time or at a point in time

Describe the acceptable methods for measuring progress towards B10(c)

complete satisfaction of a performance obligation

Explain and apply the criteria for the recognition of contract costs B10(d)

Apply the principles of recognition of revenue and specifically B10(e)

account for the following types of transaction:
• Principal versus agent
• Repurchase agreements
• Bill and hold arrangements
• Consignments

Prepare financial statement extracts for contracts where B10(f)

performance obligations are satisfied over time

Apply the provisions of relevant accounting standards in relation to B11(a)

accounting for government grants
6

Exam context
Understanding the rules of revenue recognition using IFRS 15, Revenue from Contracts with
Customers, is vital in your FR studies, as it will be examined across all parts of the syllabus. You
must become confident in accounting for revenue, as this will be tested as part of your work on
single and consolidated entities. Revenue is usually the single largest figure in a statement of
profit or loss, so it is important that it is measured correctly.

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This chapter also covers IAS 20, Government Grants and Disclosure of Government Assistance.
This is more likely to be asked as part of an OTQ, particularly in a Section B case OTQ question,
perhaps with the case question also covering related topics of revenue and the acquisition of
tangible assets.
6

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Chapter overview
Revenue and government grants

Revenue IFRS 15 Revenue from

recognition Contracts with Customers

IFRS 15 five steps to recognition of revenue Common types of transaction

1. Identify contract Principal vs agent

2. Identify performance obligations Sales with a right of return

3. Determine transaction price Consignment arrangements

4. Allocate transaction price Bill and hold arrangements

to performance obligations

Warranties
5. Recognise revenue when (or as)
performance obligation is satisfied

Performance IAS 20 Accounting for

obligations Government Grants and Disclosure
of Government Assistance

Performance obligations satisfied over time Grants relating to income

Methods of measuring performance Grants relating to assets

Repayment of grants

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1 Revenue recognition
Income

Revenue Interest and Other gains or

(profit or loss) dividend income losses on assets
(profit or loss)
Refer to
Chapter 11,
Definition Financial Revaluation of Revaluation of other
Income arising in the Instruments investments non-current assets
course of an entity's (Profit or loss) (Other comprehensive
ordinary activities Refer to income)
(IFRS 15, App A) Chapter 11, Refer to Chapter 3,
Financial Tangible non-current
Instruments assets, Chapter 5,
Examples Impairment of assets
• Sale of goods
• Rendering of services
• Contracts to
construct an asset

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.

2 IFRS 15 Revenue from Contracts with Customers

2.1 Definitions

Contract: An agreement between two or more parties that creates enforceable rights and
KEY
TERM obligations.
Performance obligation: A promise in a contract with a customer to transfer to the customer
either:
(a) A good or service (or a bundle of goods or services) that is distinct; or
(b) A series of distinct goods or services that are substantially the same ad that have the
same pattern of transfer to the 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.
(IFRS 15, Appendix A)

2.2 Principle of revenue recognition

The core principle of IFRS 15 is that an entity recognises revenue to depict the transfer of goods or
services to customers in an amount that reflects the consideration to which the entity expects to
be entitled in exchange for those goods or services.
Revenue is recognised when there is transfer of control to the customer from the entity supplying
the goods or services.

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Some indicators of the transfer of control are:

(a) The entity has a present right to payment for the asset.
(b) The customer has legal title to the asset.
(c) The entity has transferred physical possession of the asset.
(d) The significant risks and rewards of ownership have been transferred to the customer.
(IFRS 15: para. 38)

2.3 IFRS 15 – Five steps to recognise and measure revenue

IFRS 15 sets out a series of actions for recognising and measuring revenue. These can be broken
down into five steps.

(1) Identify contract A contract is only in scope when:

(a) Both parties are committed to carrying it out
(b) Each party’s rights to be transferred can be identified
(c) The payment terms can be identified
(d) The contract has commercial substance
(e) It is probable the entity will collect the consideration
A contract can be written, verbal or implied.

(2) Identify A performance obligation is a promise to transfer a good or service to

performance a customer. Performance obligations should be accounted for
obligations separately provided the good or service is distinct. Where a promised
good or service is not distinct, it is combined with others until a
distinct bundle of goods or services is identified.

(3) Determine The amount to which the entity expects to be ‘entitled’

transaction price Probability-weighted expected value or most likely amount used for
variable consideration
Discounting not required where less than one year

(4) Allocate Multiple deliverables: transaction price allocated to each separate

transaction price to performance obligation in proportion to the stand-alone selling price
performance at contract inception of each performance obligation
obligations
(5) Recognise Ie when entity transfers control of a promised good or service to a
revenue when (or customer
as) performance An entity must be able to reasonably measure the outcome of a
obligation is performance obligation before the revenue can be recognised.
satisfied

3 Identify the contract

A contract with a customer is within the scope of IFRS 15 only when:
(a) The parties have approved the contract and are committed to fulfilling the terms of the
contract
(b) Each party’s rights regarding the goods and services to be transferred can be identified.
(c) Clear identification of the payment terms for the goods and services
(d) The contract has commercial substance.
(e) It is probable that the entity will collect the consideration to which it will be entitled.
(f) The contract can be written, verbal or implied.
(IFRS 15: para. 9–10)

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4 Identify the performance obligations

4.1 Performance obligation
At the start of a contract, the goods or services promised to the customer should be assessed.
Each transfer of a distinct good/service is a performance obligation within the contract. There
may be more than one performance obligation within the same contract.
IFRS 15 states that a good or service that is promised to a customer is distinct if both of the
following criteria are met:
(a) The customer can benefit from the good or service either on its own or together with other
resources that are readily available to the customer (ie the good or service is capable of
being distinct); and
(b) The entity’s promise to transfer the good or service to the customer is separately identifiable
from other promises in the contract (ie the good or service is distinct within the context of the
contract). (IFRS 15, para. 27)

Activity 1: Identifying the separate performance obligation

Office Solutions Co, a limited company, has developed a communications software package
called CommSoft. Office Solutions Co has entered into a contract with Logisticity Co to supply
the following:
(a) Licence to use Commsoft
(b) Installation service; this may require an upgrade to the computer operating system, but the
software package does not need to be customised
(c) Technical support for three years
(d) Three years of updates for Commsoft
Office Solutions Co is not the only company able to install CommSoft, and the technical support
can also be provided by other companies. The software can function without the updates and
technical support.
1 Required
Explain whether the goods or services provided to Logisticity Co are distinct in accordance with
IFRS 15 Revenue from Contracts with Customers.

Solution
1

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5 Determine the transaction price

The transaction price is the amount of consideration a company expects to be entitled to from
the customer in exchange for transferring goods or services.
In determining the transaction price, consider the effects of:
• Variable consideration
• The existence of a significant financing component
• Non-cash consideration
• Consideration payable to a customer

5.1 Variable consideration

The transaction price should include variable consideration if it is highly probable that a
significant reverse of cumulative revenue will not occur (IFRS 15, para. 56). The variable
consideration should be included provided that it is highly probable that it will be received.
It should be estimated using one of the following methods. The choice of method will be
dependent on which best predicts the amount of consideration to be received:
• Probability weight expected value (eg reviewing past, similar contracts to assess the likelihood
of receiving the consideration); or
• Most likely amount (eg if there are only two possible outcomes).

5.2 The existence of a variable financing component

If the consideration is due from a customer which is dependent on a significant financing
component, then the credit risk should be taken into account when assessing the consideration
expected to be received from the customer.
The discount rate may be stated in the contract, but it should reflect the credit risk of the
transaction and represent market terms.
This may result in different consideration amounts being recognised for different customers, even
if the contracts are similar. This is because the customers may be more of a credit risk than others.

5.3 Non-cash consideration

This will be measured at fair value (where this cannot be easily determined, then it will be
compared to the selling price of the goods being sold by the entity)

5.4 Consideration payable to a customer

Examples of this type of consideration include discounts, rebates or refunds on goods or services
provided by the entity. Judgment may need to be applied by management to estimate the
transaction price if there is a degree of variability, such as the consideration being based on
timing or whether deadlines are met.

Activity 2: Determining the transaction price

Taplop Co supplies laptop computers to large businesses. On 1 July 20X5, Taplop Co entered into
a contract with TrillCo, under which TrillCo was to purchase laptops at $500 per unit. The
contract states that if TrillCo purchases more than 500 laptops in a year, the price per unit is
reduced retrospectively to $450 per unit. Taplop’s year end is 30 June.
(a) As at 30 September 20X5, TrillCo had bought 70 laptops from Taplop. Taplop Co therefore
estimated that TrillCo’s purchases would not exceed 500 in the year to 30 June 20X6, and
TrillCo would therefore not be entitled to the volume discount.

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(b) During the quarter ended 31 December 20X5, TrillCo expanded rapidly as a result of a
substantial acquisition, and purchased an additional 250 laptops from Taplop Co. Taplop Co
then estimated that TrillCo’s purchases would exceed the threshold for the volume discount in
the year to 30 June 20X6.
1 Required
Calculate the revenue Taplop Co would recognise in:
(a) Quarter ended 30 September 20X5
(b) Quarter ended 31 December 20X5

Solution
1

6 Allocating transaction price to performance obligations

Where a contract contains more than one distinct performance obligation a company allocates
the transaction price to all separate performance obligations in proportion to the stand-alone
selling price of the good or service underlying each performance obligation

Activity 3: Allocating the transaction price to the performance obligations

A mobile phone company, Deltawave Co, gives customers a free handset when they sign a two-
year contract for the provision of network services. The handset has a stand-alone price of $100
and the contract is $20 per month.
1 Required
Allocate the transaction price between the handset and the network services contract.

Solution
1

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7 Recognising revenue as performance obligations met

Revenue is only recognised when a performance obligation is satisfied.
• A performance obligation is satisfied when the entity transfers a promised good or service (ie
an asset) to a customer.
• An asset is considered transferred when (or as) the customer obtains control of that asset.
• Control of an asset refers to the ability to direct the use of, and obtain substantially all of the
remaining benefits from, the asset. (IFRS 15, paras. 31–33)
A performance obligation can be satisfied at a point in time eg goods being delivered to a
customer, or over a period of time eg construction of an asset for a customer.

7.1 Performance obligations satisfied over time

A performance obligation is satisfied over time if one of the following criteria is met:
• The customer simultaneously receives and consumes the benefits provided as they occur;
• The entity’s performance creates or enhances an asset that the customer controls as the asset
is created or enhanced; or
• 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 the performance completed to date.
An entity must determine the amounts to include as revenue in each accounting period where
performance obligations are satisfied over time. This is done by measuring progress towards
completion of the performance obligation. There are various methods that can be used to do this:

Method to measure progress of performance obligations

Output methods Input methods

Proportion of the work completed based Proportion of work completed based
on assessing how much of the finished on the inputs (eg costs) incurred to date
product is completed • Resources consumed
• Surveys of performance completed to date • Labour hours expended
• Appraisals of results achieved • Costs incurred
• Time elapsed • Time elapsed
• Units produced or delivered • Machine hours used

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Examples include:
Constructing a:
• Bridge
• Building
• Dam
• Ship

8 Presentation and accounting entries

Where the entity undertakes a contract with performance obligations satisfied over time, such as
construction of a building, the entity must determine what to include as revenue and costs in
each accounting period. There may be either a contract asset or a contract liability in the
statement of financial position.
There are different ways that a contract with a customer may be presented in the statement of
financial position (IFRS 15, para. 105):

Statement of financial Description

position
Receivable If an entity’s right to consideration is unconditional (only the
passage of time is required before payment is due), it should
be recognised as a receivable (IFRS 15, para. 108).

Contract liability If a customer pays consideration or the entity has a right to

an amount of consideration that is unconditional (ie a
receivable) before the entity transfers the goods or services to
the customer, the entity should present the contract as a
‘contract liability’ when the payment is made or falls due
(whichever is earlier) (IFRS 15, para. 106).

Contract asset If the entity transfers goods or services before the customer
pays, it should present the contract as a ‘contract asset’ if the
entity’s right to consideration is conditional on something
other than the passage of time (eg the entity’s performance)
(IFRS 15, para. 107).

Contract asset: A contract asset is recognised when revenue has been earned but not yet
KEY
TERM invoiced (revenue that has been invoiced is a receivable).
Contract asset (presented separately under current assets)
$
Revenue recognised (based on % certified to date) X
Less amounts invoiced to the customer to date (X)
Contract asset/(liability) X/(X)

Contract liability: A customer has paid prior to the entity transferring control of the good or
service to the customer.

This is calculated as above. However, if the answer is a net amount due to the customer, then this
is included as a contract liability.
The amount of revenue the entity is entitled to corresponds to the amount of performance
complete to date.

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Activity 4: Contract completed over time

A contract to build an office building is started on 1 January 20X5, with an estimated completion
date of 31 December 20X6. Control of the asset is passed to the customer as construction takes
place.
In the first year, to 31 December 20X5:
(a) Certificates of work completed have been issued, to the value of $750,000.
(b) The final contract price is $1,500,000.
(c) Amounts invoiced to the customer as at 31 December 20X5 is $625,000.
(d) No payments had been received in respect of the receivable at year end.
1 Required
What is the revenue recognised in the financial statements at 31 December 20X5, and what
entries would be made for the contract on the statement of financial position at 31 December
20X5?

Solution
1

Activity 5: Recognition in the financial statements

A company entered into a four-year contract to build a sports stadium, the customer takes control
of the stadium as construction takes place. Details of the contract activity at 31 December 20X1,
20X2 and 20X3 are as follows:
20X1 20X2 20X3
$m $m $m
Total fixed contract price 380 380 380
Percentage of the contract completion as
certified at year end 20% 65% 100%
Invoices issued to the customer (cumulative) 70 160 200
Cash received from the customer to date
(cumulative) 62 124 170

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It is company policy to calculate satisfaction of performance obligations based on the work

certified.
1 Required
What should be the revenue recognised in the statement of profit or loss for the years ended 31
December 20X1, 20X2 and 20X3?
 20X1: $62m, 20X2: 62m, 20X3: $46m
 20X1: $70m, 20X2: $90m, 20X3: $110m
 20X1: $76m, 20X2: $171m, 20X3: $133m
 20X1: $62m, 20X2: $247m, 20X3: $380m
2 Required
What are the accounting entries to be recorded in the statement of financial position for the year
ended 31 December 20X3?
 Trade receivable $30m; Contract asset $93m
 Trade receivable $10m; Contract asset $93m
 Trade receivable $30m; Contract asset $180m
 Trade receivable $10m; Contract asset $180m

Solution
1

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9 Common types of transactions

IFRS 15 has specific guidance on different transactions, here we look at some of the most
common.
• Principal versus agent
• Sales with a right of return
• Consignment arrangements
• Bill and hold arrangements
• Warranties

9.1 Principal versus agent

When another party is involved in providing goods or services to a customer, the entity shall
determine whether the nature of its promise is a performance obligation to provide the specified
goods/services itself, or to arrange for those goods or services to be provided to the customer
(IFRS 15: para. B34).

Principal v agent

Entity arranges for goods or services

Entity controls the goods or services
to be provided by the other party

Principal Agent

Revenue = gross revenue Revenue = fee or commission

Indicators that an entity controls the goods or services before transfer and therefore is classified
as a principal include (IFRS 15, para. B37):
(a) The entity is primarily responsible for fulfilling the promise to provide the specified good or
service;
(b) The entity has inventory risk; and
(c) The entity has discretion in establishing the price for the specified good or service.

Activity 6: Principal versus agent

TicketsRUS Co, a ticket agency, sells tickets to a theatre show for $100. TicketsRUS Co is entitled
to a commission of 5% of the ticket price and passes the remainder to the theatre. The tickets are
non-refundable and there is no sales tax.
1 Required
Calculate the revenue to be recognised for the current financial period.

Solution
1

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9.2 Sales with a right of return

An entity sells an item to a customer with a right or option to repurchase. There are three forms of
these:

Right of return

Obligation to Right to repurchase Obligation to repurchase the asset

repurchase the asset the asset if requested by the customer
Forward contract Call option Put option

Consider whether or not the

customer is likely to exercise the option?

Repurchase price >/= Repurchase price<

or
original selling price original selling price

Outright sale with

Treat as financing arrangements
right of return
Customer does not obtain control of the asset = effectively a loan
Customer unlikely to exercise
Revenue recognised when period has expired
option as they will lose money

9.3 Consignment arrangements

The customer does not obtain control of the product at the delivery date. The inventory remains in
the books of the entity and revenue is not recognised until control passes.

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Activity 7: Consignment arrangements

A wholesaler sells goods to a retailer for $42,000 on credit on 31 December 20X1 and accounts for
them as a sale recognising the revenue immediately. The wholesaler sells at a mark-up of 20% on
cost.
The retailer will sell the goods to the final customer, but can return any unsold goods for a refund.
No goods were sold to the final customer on 31 December 20X1.
1 Required
What are the adjustments needed to correct the wholesaler’s financial statements for the year
ended 31 December 20X1?

Solution
1

9.4 Bill and hold arrangements

Goods are sold but remain in the possession of the seller for a specified period of time. An entity
will need to determine at what point the customer obtains control of the product.
For a customer to have obtained control of a product in a bill and hold arrangement the following
criteria must be met:
(a) The reason for the bill and hold must be substantive.
(b) The product must be separately identified as belonging to the customer.
(c) The product must be ready for physical transfer to the customer.
(d) The entity cannot have the ability to use the product or transfer it to another customer.

9.5 Warranties
If a customer has the option to purchase a warranty separately from the product to which it
relates, it constitutes a distinct service and is accounted for as a separate performance
obligation.
This would apply to a warranty which provides the customer with a service in addition to the
assurance that the product complies with agreed-upon specifications.
If the customer does not have the option to purchase the warranty separately, for instance if the
warranty is required by law, that does not give rise to a performance obligation and the warranty

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is accounted for in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent
Assets. (IFRS 15: paras. B28–43)

10 IAS 20 Accounting for Government Grants

10.1 Recognition
Grants are not recognised until there is reasonable assurance that the conditions will be complied
with and the grants will be received.

Government grants: Assistance by government in the form of transfers of resources to an

KEY
TERM entity in return for past or future compliance with certain conditions relating to the operating
activities of the entity. They exclude those forms of government assistance which cannot
reasonably have a value placed upon them and transactions with government which cannot
be distinguished from the normal trading transactions of the entity.
Forgivable loans: Loans for which the lender undertakes to waive repayment under certain
prescribed conditions (IAS 20: para. 3).

10.2 Accounting treatment

Grants relating to income
Grants relating to income are shown in profit or loss either separately or as part of ‘other income’
or alternatively deducted from the related expense.

Grants related to assets: Government grants whose primary condition is that an entity
KEY
TERM qualifying for them should purchase, construct or otherwise acquire non-current assets.
Subsidiary conditions may also be attached restricting the type or location of the assets or the
periods during which they are to be acquired or held (IFRS 15: para. 3).

Government grants relating to assets are presented in the statement of financial position either:
(a) As deferred income (Dr Cash, Cr Deferred income), this is then released to the profit or loss
account over the useful life of the asset (effectively over the same period as the asset is being
depreciated); or
(b) By deducting the grant in calculating the carrying amount of the asset.
Grant conditions
In the case of grants for non-depreciable assets, certain obligations may need to be fulfilled, in
which case the grant should be recognised as income over the periods in which the cost of
meeting the obligation is incurred. For example, if a piece of land is granted on condition that a
building is erected on it, then the grant should be recognised as income over the useful life of the
building.
There may be a series of conditions attached to a grant, in the nature of a package of financial
aid. An entity must take care to identify precisely those conditions which give rise to costs that in
turn determine the periods over which the grant will be earned. When appropriate, the grant may
be split and the parts allocated on different bases.

10.3 Repayment of grants

A government grant that becomes repayable is accounted for as a change in accounting estimate
in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.
Repayment of grants relating to income are applied first against any unamortised deferred credit
and then in profit or loss.
Repayments of grants relating to assets are recorded by increasing the carrying amount of the
asset or reducing the deferred income balance. Any resultant cumulative extra depreciation is
recognised in profit or loss immediately.

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Activity 8: Recognition of the grant

Maddoc purchased a new item of plant for $800,000 on 1 January 20X2, and expected to use it
for five years with a zero residual value. The Government awarded Maddoc a grant of $300,000
towards the cost of the plant on the same date.
Maddoc treated the grant as deferred income and has a 30 June year end.
Required
How much is recognised in non-current liabilities in respect of the grant as at 30 June 20X2?
 $60,000
 $30,000
 $210,000
 $270,000

Solution

Essential reading
There are a number of additional activities to apply your knowledge obtained in this chapter,
which are in addition to the Further question practice bank (available in the digital edition of the
Workbook) and the Practice and Revision Kit. Please see Chapter 6 of the Essential reading.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

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Chapter summary

Revenue and government grants

Revenue IFRS 15 Revenue from

recognition Contracts with Customers

Revenue is income arising in the course of an entity’s Revenue is recognised when there is transfer of
ordinary activities (IFRS 15: Appendix A)  control to the customer from the entity supplying the
goods or services

IFRS 15 five steps to recognition of revenue Common types of transaction

1. Identify contract Principal versus agent

• Contract: An agreement between two or more Indicators that an entity controls the goods or
parties that creates enforceable rights and services before transfer and therefore is a principal
obligations. include (para. B37):
• Contract costs are the incremental costs of (a) The entity is primarily responsible for fulfilling the
obtaining a contract (such as sale commission) are promise to provide the specified good or service;
recognised as an asset if the entity expects to (b) The entity has inventory risk; and
recover those costs (c) The entity has discretion in establishing the price
for the specified good or service.
2. Identify performance obligations
• Performance obligations should be accounted for Sales with a right of return
separately provided the good or service is distinct. (a) Obligation to repurchase (forward contract)
• Where a promised good or service is not distinct, it is ↓
combined with others until a distinct bundle of Treat as financing
goods or services is identified ↑
(b) Right to repurchase (call option)
3. Determine transaction price (c) Obligation to repurchase if requested by customer
(put option)
The amount to which the entity expects to be 'entitled' (i) If Repurchase price>/= SP → Treat as financing
(ii) If Repurchase price< SP → Outright sale with
4. Allocate transaction price to performance right of return
obligations
Based on standalone selling prices Consignment arrangements
• The customer does not obtain control of the product
5. Recognise revenue when (or as) performance at the delivery date
obligation is satisfied ↓
• The inventory remains in the books of the entity and
When entity transfers control of a promised good or
revenue is not recognised until control passes
service to a customer

Bill and hold arrangements

An entity will need to determine at what point the
customer obtains control of the product

Warranties
• IFRS 15: If separate performance obligation as a
part of the warranty IFRS 15
• IAS 37: If legal and constructive obligation

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Performance IAS 20 Accounting for

obligations Government Grants and Disclosure
of Government Assistance

• A contract includes a promise to transfer Grants are not recognised until there is
goods or services to a customer reasonable assurance that the conditions will
• This is the performance obligation within the be complied with and the grants will be received
contract
• An entity must be able to reasonably measure
the outcome of a performance obligation Grants relating to income
before the revenue can be recognised Grants relating to income are shown in profit or
loss either separately or as part of 'other
income' or alternatively deducted from the
Performance obligations satisfied over time related expense
• An entity may transfer a good or service over
time with the revenue being recognised over
time Grants relating to assets
• A performance obligation is satisfied when Government grants relating to assets are
the entity transfers a promised good or presented in the statement of financial position
service (ie an asset) to a customer either:
↓ • As deferred income; or
• An asset is considered transferred when (or • By deducting the grant in calculating the
as) the customer obtains control of that asset carrying amount of the asset
↓ • Any deferred credit is amortised to profit or
• Control of an asset refers to the ability to loss over the asset's useful life
direct the use of, and obtain substantially all
of the remaining benefits from, the asset
Repayment of grants
• A government grant that becomes repayable
Methods of measuring performance is accounted for as a change in accounting
• Output methods estimate in accordance with IAS 8 Accounting
– Units produced Policies, Changes in Accounting Estimates
– Survey of completion to date and Errors
• Input methods • Repayment of grants relating to income are
– Resources consumed applied first against any unamortised
– Costs incurred deferred credit and then in profit or loss
• A contract asset is recognised when revenue • Repayments of grants relating to assets are
has been earned but not yet invoiced (revenue recorded by increasing the carrying amount
that has been invoiced is a receivable) of the asset or reducing the deferred income
• A contract liability is recognised when a balance
customer has paid prior to the entity • Any resultant cumulative extra depreciation is
transferring control of the good or service to recognised in profit or loss immediately
the customer 

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Knowledge diagnostic
1. Revenue recognition
• Revenue is recognised when there is a transfer of control to the customer from the entity
supplying the goods or services.
• Five step model for recognition:
Step 1 Identify the contract with the customer
Step 2 Identify the separate performance obligations
Step 3 Determine the transaction price
Step 4 Allocate the transaction price to the performance obligations
Step 5 Recognise revenue when a performance obligation is satisfied.
• Where the outcome cannot be estimated reliably, revenue is only recognised to the extent of
expenses recognised that are recoverable, ie no profit is recognised until the outcome can be
estimated reliably.
• Where performance obligations are satisfied over time, for example with a construction
contract, revenue and costs are recognised by reference to the stage of completion of the
construction contract where its outcome can be estimated reliably. However, any expected
losses are recognised immediately on the grounds of prudence.
• Where the outcome cannot be estimated reliably, revenue is recognised only to the extent of
contract costs incurred that are recoverable, consistent with the treatment of service revenue.

2. Government Grants
• An entity should not recognise grant income unless:
(i) The conditions attached to the grant will be complied with; and
(ii) The entity will receive the money
• Grants relating to income are shown in profit or loss either separately or as part of ‘other
income’ or alternatively deducted from the related expense
• Government grants relating to assets are presented in the statement of financial position
either:
(i) As deferred income; or
(ii) By deducting the grant in calculating the carrying amount of the asset.

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
20 Jenson Co
21 Trontacc Co
22 Crayzee Co

Further reading
There are articles on the ACCA website, written by the FR examining team, which are relevant to
the topics studied in this chapter and which you should read:
Revenue revisited
www.accaglobal.com

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Activity answers

Activity 1: Identifying the separate performance obligation

1 The correct answer is:
CommSoft Co was delivered before the other goods or services and remains functional without
the updates and the technical support. It may be concluded that Logisticity Co can benefit from
each of the goods and services either on their own or together with the other goods and services
that are readily available.
The promises to transfer each good and service to the customer are separately identifiable. In
particular, the installation service does not significantly modify the software itself and, as such,
the software and the installation service are separate outputs promised by Office Solutions Co
rather than inputs used to produce a combined output.
In conclusion, the goods and services are distinct and amount to four performance obligations in
the contract under IFRS 15.

Activity 2: Determining the transaction price

1 The correct answer is:
(a) Applying the requirements of IFRS 15 to TrillCo’s purchasing pattern at 30 September 20X5,
Taplop should conclude that it was highly probable that a significant reversal in the
cumulative amount of revenue recognised ($500 per laptop) would not occur when the
uncertainty was resolved, that is when the total amount of purchases was known.
Consequently, Taplop Co should recognise revenue of 70 × $500 = $35,000 for the first
quarter ended 30 September 20X5.
(b) In the quarter ended 31 December 20X5, TrillCo’s purchasing pattern changed such that it
would be reasonable for Taplop Co to conclude that TrillCo’s purchases would exceed the
threshold for the volume discount in the year to 30 June 20X6, and therefore that it was
appropriate to retrospectively reduce the price to $450 per laptop.
Taplop Co should therefore recognise revenue of $109,000 for the quarter ended 31 December
20X5. The amount is calculated from $112,500 (250 laptops × $450) less the change in
transaction price of $3,500 (70 laptops × $50 price reduction) for the reduction of the price of
the laptops sold in the quarter ended 30 September 20X5.

Activity 3: Allocating the transaction price to the performance obligations

1 The correct answer is:
Under IFRS 15, revenue must be allocated to the handset because delivery of the handset
constitutes a performance obligation. This will be calculated as follows:
$ %
Handset 100 17
Contract – two years 480 83
Total value 580 100

As the total receipts are $480, this is the amount that must be allocated to the separate
performance obligations. Revenue will be recognised as follows (rounded to nearest $).
$
Year 1
Handset (480 × 17%) 82
Contract (480 – 82)/2 199
281
Year 2
Contract as above 199

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Activity 4: Contract completed over time

1 The correct answer is:
This is a contract in which the performance obligation is satisfied over time, as the control of the
office building is transferred to the customer throughout the contract period.
The entity is constructing an asset for resale, and there is a contract in place.
Certificates of work completed have been issued.
In this case the contract is certified as 50% (750,000/1,500,000 = 50%) complete, measuring
progress under the output method.
The (unconditional) receivable is shown separately as a trade receivable, and the (conditional, as
not yet invoiced to the customer) balance of the revenue recognised at year end is recorded as a
contract asset.
DR Trade receivable 625,000
DR Contract asset (750,000–625,000) 125,000
CR Revenue 750,000

Activity 5: Recognition in the financial statements

1 The correct answer is:
20X1: $70m, 20X2: $90m, 20X3: $110m
STATEMENT OF PROFIT OR LOSS (EXTRACTS)
20X1 20X2 20X3
$m $m $m
Revenue
20X1: $380m × 20% 76
20X2: $380m × (65%–20%) 171
20X3: $380m × (100%–65%) 133
2 The correct answer is:
Trade receivable $10m; Contract asset $180m
STATEMENT OF FINANCIAL POSITION (extracts
Trade receivables ($200m–$170m) $30m
Contract asset (working) $180m
Working 20X3
$m
Revenue recognised 380
Less: amounts billed to the customer (200)
Contract asset 180

Activity 6: Principal versus agent

1 The correct answer is:
TicketsRUS Co can only recognise $100 × 5% = $5 as revenue rather than recognising $100 as
revenue and $95 as costs, since the ticket price is collected as agent on behalf of the theatre.
The remaining $95 received is reported as a liability to the theatre.

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Activity 7: Consignment arrangements

1 The correct answer is:
Revenue cannot be recognised in the wholesaler’s financial statements as at 31 December 20X1 as
control has not transferred to the buyer (the retailer).
The sales transaction must be reversed in the wholesaler’s financial statements and the closing
inventory balance adjusted:
DR Revenue $42,000 and DR Inventories
(42,000 × 100%/120%) $35,000
CR Trade receivables $42,000 CR Cost of sales $35,000

Activity 8: Recognition of the grant

The correct answer is:
$210,000
The grant is treated as deferred income:

1 January 20X2 Cash received 300,000

20X1–20X2 year Credited to profit or loss (300,000/5 × 6/12) (30,000)

30 June 20X2 c/d 270,000

The $270,000 deferred income at 30 June 20X2 must be split into current and non-current
elements:

20X2–20X3 Credited to profit or loss (300,000/5) = current amount

year (60,000)

30 June 20X3 c/d = non-current amount at 30 June 20X2 210,000

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Skills checkpoint 2
Approach to objective test
(OT) case style questions

Chapter overview
cess skills
Exam suc

Answer planning

c FR skills C
n Specifi o
tio
rr req
a

ec ui
of
m

t i rem
or

nt
inf

erp ents
ng

Approach to Application
reta
agi

objective test of accounting

(OT) questions standards
Man

tion l y si s

Spreadsheet Interpretation
Go od

skills skills
ana
ti m

c al

Approach
em

to Case
e ri

OTQs
an

um
ag

tn
em

en

en
t ci
Effi
Effective writing
and presentation

Introduction
Section B of the FR exam consist of further OT style questions.
Each OT Case contains a group of five OT questions based around a single scenario (occasionally
two connected themes, such as government grants and revenue recognition). These can be any
combination of the single OT question types and they are auto-marked in the same way as the
single OT questions.
OT Cases are worth 10 marks (each of the five OTs within it are worth two marks, and as with the
OT questions described above, students will receive either two marks or zero marks for those
individual questions).
The OT questions in Section B aim for a more focused testing of specific areas of the syllabus.
There will only be one or two (connected) main themes in the question. Your skills from practising
the Section A questions will be relevant in this section.
OT cases are written so that there are no dependencies between the individual questions. So, if
you did get the first question wrong, this does not affect your ability to get the other four correct.
The OT Case scenario remains on screen so you can see it while answering the questions.
Each OT case normally consists of two numerical and three discursive style questions. It is often
quicker to tackle the discursive questions first leaving some additional time to tackle calculations.

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As we saw in Skills Checkpoint 1, the following types of OT question commonly appear in the FR
exam:

Question type Explanation

Multiple choice (MCQ) You need to choose one correct answer from
four given response options.

Multiple response (MR) These are a kind of multiple choice question,

except you need to select more than one
answer from a number of given options. The
question will specify how many answers need
to be selected, but the system won’t stop you
from selecting more answers than this. It is
important to read the requirement carefully.

Fill in the blank (FIB) This question type requires you to type a
numerical answer into a box. The unit of
measurement (eg $) will sit outside the box,
and if there are specific rounding
requirements these will be displayed.

Drag and drop Drag and drop questions involve you dragging
an answer and dropping it into place. Some
questions could involve matching more than
one answer to a response area and some
questions may have more answer choices
than response areas, which means not all
available answer choices need to be used.

Drop down list This question type requires you to select one
answer from a drop down list. Some of these
questions may contain more than one drop
down list and an answer has to be selected
from each one.

Hot spot For hot spot questions, you are required to

select one point on an image as your answer.
When the cursor is hovered over the image, it
will display as an ‘X’. To answer, place the X
on the appropriate point on the diagram.

Hot area These are like hot spot questions, but instead
of selecting a specific point you are required
to select one or more areas in an image.

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Approach to OT Case questions

A step-by-step technique for approaching OT questions is outlined below. Each step will be
explained in more detail in the following sections as the OT case question ‘Dearing Co’ is
answered in stages.

STEP 1: Read the scenario carefully

Read the introduction to the question carefully, ensuring you understand what the
questions are asking you to do. Skimming the questions requirement will help you
to identify whether the questions are narrative or numerical in style.

STEP 2: Start with narrative questions

Attempt the narrative questions first as this will allow you to use any remaining
time to focus on the numerical and calculation questions. The case is usually split
into three narrative questions with two further, calculation based questions.

STEP 3: Work through numerical questions methodically

Apply your technical knowledge to the data presented in the question.
Work through calculations taking your time and read through each answer option
with care. OT questions are designed so that each answer option is plausible. Work
through each response option and eliminate those you know are incorrect.

STEP 4: Be aware of time

Stick to your time carefully, as each question is worth two marks, so spending more
than the allocated time of 18 minutes on each case question is an inefficient use of
your time, as you will need to move onto the Section C questions. If you are
running out of time, or you cannot answer any of the questions, guess the answer
from the options provided. You do not lose marks for incorrect answers.

Exam success skills

The following question is a Section B OT case question from a past exam worth 10 marks.
For this question, we will also focus on the following exam success skills:
• Managing information. It is easy for the amount of information contained in an OT case
questions in Section B to feel a little overwhelming. Active reading is a useful technique to help
avoid this. This involves focusing on each of the five requirements first, on the basis that until
you have done this the detail in the question will have little meaning and will seem more
intimidating as a result.
Focus on the requirements, highlighting key verbs to ensure you understand the requirement
properly and correctly identify what type of OT question you are dealing with. Then read the
rest of the scenario, underlining and annotating important and relevant information, and
making notes of any relevant technical information you think you will need.
• Correct interpretation of requirements. Identify from the requirement the different types of OT
question. This is especially important with multiple response questions to ensure you select the
correct number of response options.
• Efficient numerical analysis. The key to success here is using the information from the
question and ensuring that you check the detail, such as which period the question is asking
you to conclude upon. Working through the numerical data in a logical manner will ensure
that you stay focused.

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• Good time management. Complete all OT’s in the time available. Each OT Case is worth 10
marks and should be allocated 18 minutes.

Skill activity
The following scenario relates to questions 1 to 5.
On 1 October 20X5 Dearing Co acquired a machine under the following terms.
$
Cost 1,050,000
Trade discount (applying to cost only) 20%
Freight charges 30,000
Electrical installation cost 28,000
Staff training in use of machine 40,000
Pre-production testing 22,000
Purchase of a three-year maintenance contract 60,000

On 1 October 20X7 Dearing Co decided to upgrade the machine by adding new components at a
cost of $200,000. This upgrade led to a reduction in the production time per unit of the goods
being manufactured using the machine.
1. What amount should be recognised under non-current assets as the cost of the machine?
Note. This is an MCQ requiring one correct answer to be selected. A calculation of the total cost
of the machine to be capitalised under IAS 16 is required.
• $840,000
• $920,000
• $898,000
• $958,000

2. How should the $200,000 worth of new components be accounted for?

Note. This is an MCQ question requiring you to select one valid statement.
• Added to the carrying amount of the machine
• Charged to profit or loss
• Capitalised as a separate asset
• Debited to accumulated depreciation

3. Every five years the machine will need a major overhaul in order to keep running. How should
this be accounted for?
Note. This is an MCQ question requiring you to select one valid statement.
• Set up a provision at year 1
• Build up the provision over years 1–5 capitalising the cost in year 1 and releasing it over five
years.
• Capitalise the cost when it arises in year 5 and amortising over five years
• Write the overhaul off to maintenance costs in the year they are incurred

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4. By 27 September 20X7 internal evidence had emerged suggesting that Dearing Co’s
machine was impaired. Select whether the following are internal or external indicators of
impairment.
Note. This is a hot area question, requiring you to select the correct responses by clicking on the
box (the software in the exam will colour the box in). You need to select whether the statement
represents an internal or an external indicator of impairment.

The performance of the machine had declined Internal indicator External indicator
leading to reduced economic benefits.

There were legal and regulatory changes Internal indicator External indicator
affecting the operating of the machine.

There was an unexpected fall in the market Internal indicator External indicator
value of the machine.

New technological innovations were producing Internal indicator External indicator

more efficient machines.

5. On 30 September 20X7 the impairment review was carried out. The following amounts were
established in respect of the machine:
$
Carrying amount 850,000
Value in use 760,000
Fair value 850,000
Costs of disposal 30,000

What should be the carrying amount of the machine following the impairment review?
Note. This is a FIB question. A calculation of the CA of Dearing Co’s machine following the
impairment is required. The recoverable amount must be compared to the existing carrying
amount to identify any impairment.

$
STEP 1 Read the introduction to the question carefully, ensuring you understand what the questions are asking you
to do. Skimming the questions requirement will help you to identify whether the questions are narrative or
numerical in style.
Question 5 is a FIB question, you need to follow the instructions carefully. Questions 2 and 3 ask
you to identify which statements are correct. Read through each statement carefully knowing
that you are looking to identify the statement that is correct. Question 4 is a hot area question,
which ask you to select the correct type of indicator for each statement.
STEP 2 Attempt the narrative questions first as this will allow you to use any remaining time to focus on the
numerical and calculation questions. The case is usually split into three narrative questions with two further,
calculation-based questions.
Questions 2, 3, and 4 are discursive style ‘narrative’ questions that do not require any
calculations. It would make sense to answer these three questions first as it is likely that you will be
able to complete them comfortably within the 10.8 minutes allocated to them. Any time saved
could then be spent on the more complex calculations required to answer Questions 1 and 5.
STEP 3 Apply your technical knowledge to the data presented in the question.
Work through calculations taking your time and read through each answer option with care. OT questions
are designed so that each answer option is plausible. Work through each response option and eliminate
those you know are incorrect.
To answer Questions 1 and 5 you need to analyse the data given in the question.

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Let’s look at Question 1 in detail. The question asks you to calculate the cost of Dearing Co’s asset
based on the information provided. You need to use your knowledge of IAS 16 Property, Plant and
Equipment, to identify which of the costs stated may be capitalised.
IAS 16 specifies the costs which must be included in the capitalised plant:
• Purchase price
• Import duties
• Directly attributable costs (including site preparation, professional fees and testing costs.
• Any estimates of costs to be incurred for dismantling the machine at the end of its life.
In summary, these are defined by IAS 16 as those costs which bring ‘the asset to the location and
working conditions necessary for it to be capable of operating in the manner intended by
management’ (IAS 16: para. 16). Even if you cannot remember the list above, then bear the
guidance in mind as to whether the asset would be able to operate without the cost being
incurred.
$ Note
Cost 1,050,000
Trade discount (applying to cost only) 20% 1
Freight charges 30,000 2
Electrical installation cost 28,000 3
Staff training in use of machine 40,000 4
Pre-production testing 22,000 5
Purchase of a three-year maintenance contract 60,000 6

Notes
1. You will need to calculate the discount value.
2. Freight charges (allowable as part of the initial delivery costs, and capitalised under IAS 16).
3. Electrical costs (allowable as part of the initial delivery costs, and capitalised under IAS 16).
4. These costs should be expensed.
5. Testing is specifically allowed, as without it, the asset would not be able to function. Therefore,
allowable capitalised cost.
6. Not allowable, as the asset would be able to function without the maintenance contract (it
would be classed as repairs and maintenance cost, therefore expensed).
The cost of staff training is more complex, as without staff the machine cannot be operated,
however, the company does not have control over them (they may leave the company) and
therefore there is no guarantee of future economic benefit coming as a result of the training.
These are incidental costs which should be expensed at the time of being incurred.
Therefore, the cost calculation should look like this:
$
Cost 1,050,000
Trade discount (1,050,000 × 20%) (210,000)
840,000
Freight charges 30,000
Electrical installation cost 28,000
Pre-production testing 22,000
920,000

The correct answer is therefore $920,000.

The $840,000 option only included the discounted purchase cost of the asset (the standard
requires all costs relating to bringing the asset to its working condition). Equally, the answer with
$898,000 is missing the cost of pre-production testing. Finally, the $958,000 includes the
discounted cost of the purchase, plus the freight and electrical costs, however, incorrectly
excludes the testing costs but include the maintenance contract.

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Question 5 is the other numerical question, requiring knowledge of impairment recoverable

amounts of an asset. A reminder from IAS 36 Impairment of Assets:
The recoverable amount of an asset should be measured as the higher of:
(a) The asset’s fair value less costs of disposal
(b) The value in use
Applying this guidance, the options will be:
(a) $850,000 less $30,000 = $820,000
(b) $760,000
Therefore, $820,000 (the fair value less costs of disposal) is the correct answer.
An asset is impaired if its recoverable amount is less than its carrying amount. In this question, the
carrying amount is $850,000, and so there is an impairment and the asset would be written down
to its recoverable amount of $820,000. This is the ‘carrying amount of the machine following an
impairment review’ required in the question.
Question 2 is answered by applying your knowledge of the accounting standards covered in this
question, namely IAS 16.
• Added to the carrying amount of the machine
• Charged to profit or loss
• Capitalised as a separate asset
• Debited to accumulated depreciation
You need to eliminate the responses that are incorrect by referring to the guidance in the
standard.
The correct answer is:
Added to the carrying amount of the machine.
They should be added to the carrying amount of the machine as they cannot be capitalised as a
separate asset (as per IAS 16 para. 8) they should be capitalised with the relevant PPE to which
they relate). Spare parts will normally be expensed. However, upgrades and major spare parts
that will be used over more than one period should be capitalised. They would not be debited to
accumulated depreciation as they increase the cost of the item, rather than reducing the
depreciation to date.
To answer Question 3 you can start by eliminating the response options that do not correctly
identify the treatment required by IAS 16.
3. Every five years the machine will need a major overhaul in order to keep running. How should
this be accounted for?
• Set up a provision at year 1
• Build up the provision over years 1–5, capitalising the cost in year 1 and releasing it over five
years
• Capitalise the cost when it arises in year 5 and amortising over five years
• Write the overhaul off to maintenance costs in the year they are incurred
In this case, there is no other alternative but to incur the cost otherwise the machine would not be
able to function.
Consider the requirement to apply the principle of accrual accounting. In this respect, writing the
overhaul off to expenditure would be wrong, as the company benefits from the revenues
generated by the asset for five years, and the costs are only incurred in year five. This would be
acceptable for minor repairs. However, a significant overhaul requires capitalisation of the cost.
The options remain of setting up a provision in year one or over five years, or capitalising the cost.
Again, the accruals concept would not be met if the provision was fully set up in year 1.
It is important to read the question information carefully. Although capitalising the cost in year 5
looks correct, it is actually taking the costs incurred in year 5 and then capitalising them (and
amortising them over the next five years). This is not matching the costs of the asset with the
same revenues (revenues are being generated years 1–5, and the costs incurred, capitalised and
amortized years 5–10).

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Therefore, building up the provision over the five years is correct. IAS 16 requires the provision to
be capitalised and then released to the profit or loss account over the next five years (in line with
the revenue being generated) as amortisation and finance costs.
Question 4 requires an understanding of the indicators of impairment. In each given scenario,
state whether these are internal or external indicators.

The performance of the machine (Note 1) had declined Internal indicator

leading to reduced economic benefits

There were legal and regulatory changes (Note 2) External

affecting the operating of the machine. indicator

There was an unexpected fall in the market value (Note External

3) of the machine. indicator

New technological innovations (Note 4) were producing External

more efficient machines. indicator

Notes
1. The machine is used and maintained by the company, it therefore has influence over its use and
state of repair. This is deemed to be an internal factor.
2. The laws are made external to the company.
3. The company cannot dictate market prices, so this is external.
4. There is no indication in the question that the company has R&D costs, so it is assumed that it is
‘general technological updates’ and therefore external to the company.
STEP 4 Stick to your time carefully, as each question is worth two marks, so spending more than the allocated time
of 3.6 minutes on each individual element of the case question is an inefficient use of your time, as you will
need to move onto the Section C questions. If you are running out of time, or you cannot answer any of the
questions, guess the answer from the options provided. You do not lose marks for incorrect answers.
Be strict with your time keeping, if you feel that you are getting stuck on one question, select an
answer and move onto to the next question. With the exception of the FIB (fill in the box) questions,
all OT questions can be attempted by guessing one of the given answers. If your revised carefully
and know the key knowledge areas of the standards, then the statement questions should be a
case of selecting the correct answer. The calculation questions require application of your
knowledge.
Remember each OT question gives you two marks regardless of the style of question. It is
important to practice OT questions as this question practice will develop your skills and improve
your timekeeping (as you will know, from experience, how long it will take you to complete a style
of question).

Exam success skills diagnostic

Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table below allows you to
perform a check for the OT activities you undertake in timed conditions to give you an idea of how
to complete the diagnostic.

Exam success skills Your reflection/observations

Managing information Some questions are longer than others.
Prioritise the topics which you feel more
confident with. Ensure you are familiar with
the time period in the question, and what data
is required in order to answer the question, eg
calculation of the depreciation in order to give
the required answer of the carrying amount of
an asset.

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Exam success skills Your reflection/observations

Correct interpretation of requirements Ensure you read the question requirement
carefully so that you answer the question
being asked (not the one you think is being
asked by the Examining team).

Good time management Remember that each OT question is worth two

marks, regardless of how hard it is. You are
aiming to spend 3.6 minutes on each question
(180 minutes/100 marks × 2 marks). Some
questions will be quicker than others, due to
their nature (narrative) or how confident you
are on a certain topic. Ensure you don’t
overrun, but equally, don’t rush your answers
and make mistakes.

Most important action points to apply to your next question

Summary
60% of the FR exam consist of OT questions. Key skills to focus on throughout your studies will
therefore include:
• Always read the requirements first to identify what you are being asked to do and what type of
OT question you are dealing with.
• Actively read the scenario highlighting key data needed to answer each requirement.
• Answer OT questions in a sensible order dealing with any easier discursive style questions first.

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Introduction to groups
7
7

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Describe the concept of a group as a single A4(a)

economic unit.

Explain and apply the definition of a A4(b)

subsidiary within relevant accounting
standards.

Using accounting standards and other A4(c)

regulation, identify and outline the
circumstances in which a group is required to
prepare consolidated financial statements.

Describe the circumstances when a group A4(d)

may claim exemption from the preparation of
consolidated financial statements.

Explain why directors may not wish to A4(e)

consolidate a subsidiary and when this is
permitted by accounting standards and other
applicable regulation.

Explain the need for using coterminous year A4(f)

ends and uniform accounting policies when
preparing consolidated financial statements.

Explain the objective of consolidated financial A4(h)

statements.

Prepare a consolidated statement of financial D2(a)

position for a simple group (parent and one
subsidiary and associate) dealing with pre
and post acquisition profits, non-controlling
interests and consolidated goodwill.

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Exam context
Companies often expand by acquiring a controlling interest in another entity. The two previously
separate entities then form a group and group accounting needs to be applied.
Group accounting is an important component of the ACCA FR exam. It may be examined as an
objective test question (OTQ) in Section A or B, but more importantly, the 20 mark Section C
questions often cover the preparation and interpretation of financial statements for either a single
entity or a group. This chapter is an introduction to the preparation of group accounts. The
concepts introduced in this chapter will be developed further in Chapters 8, 9 and 10.
Interpretation will be covered in Chapter 19.
7

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Chapter overview
Introduction to groups

Introduction and definitions Control

Types of investment Criteria for control

Definitions

Parent's separate financial statements Group financial statements

Parent's statement of financial position Requirement to prepare group financial statements

Important features Features of the consolidated

statement of financial position

Goodwill Non-controlling interest (NCI)

Recognition and initial measurement What is the NCI?

Calculation of goodwill Points to note

Subsequent measurement

Impairment of positive goodwill

Mid-year acquisitions

Net assets of subsidiary

Pre- and post-acquisition reserves

Rules for mid-year acquisition

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1 Introduction and definitions

1.1 Acquisition of another entity
A company may expand or diversify its operations by acquiring another entity. There are different
ways in which an entity might acquire another business:

Acquire sole trade Acquire partnership Acquire company

Acquire individual assets and liabilities Acquire shares

Add assets and liabilities Investment in parent’s accounts represents

to SOFP as now owned ownership of shares which in turn
represents ownership of the net assets of
the acquired company (the subsidiary)
Profits and losses which are generated
by sole trade/partnership assets are
reported in profit or loss After the transaction the subsidiary will
continue to exist as a separate legal entity

Group financial statements

are required if control exists

We will only consider the situation where the entity acquires a company by the acquisition of its
ordinary shares. We can summarise the different types of investment that result from the
acquisition of a company’s shares and the required accounting treatment in the group accounts
as follows:

Investment Criteria Required treatment in group accounts

Subsidiary Control Full consolidation

Associate Significant influence Equity accounting

Investment which is Asset held for As an investment under IFRS 9 Financial

none of the above accretion of wealth Instruments

This chapter, along with Chapter 8 and Chapter 9 of this Workbook, consider the accounting
requirements for a subsidiary. Chapter 10 looks at accounting for an associate and Chapter 11,
the accounting for an investment.

1.2 Definitions
The following definitions are important for group accounting:

Control: An investor controls an investee when the investor is exposed, or has rights, to variable
KEY
TERM returns from its involvement with the investee and has the ability to affect those returns
through power over the investee.
Power: Existing rights that give the current ability to direct the relevant activities of the
investee.
Subsidiary: An entity that is controlled by another entity.
Parent: An entity that controls one or more subsidiaries.
Group: A parent and all its subsidiaries.
Associate: An entity over which an investor has significant influence and which is neither a
subsidiary nor an interest in a joint venture.

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(IFRS 10: App. A)

Significant influence: The power to participate in the financial and operating policy decisions
of an investee but it is not control or joint control over those policies. (IAS 28: para. 3)

2 Control
We noted above that the acquired company is a subsidiary if control exists. It is important that
you do not simply consider the percentage ownership of the acquired company’s shares to
determine whether a subsidiary exists and instead focus on the criteria for control.

2.1 Criteria for control

A parent (investor) only has control of the potential subsidiary (investee) if it has all of the
following:

Control

Power to Exposure or Ability to use

direct relevant rights to variable power to affect the
activities returns amount of returns

Examples of power: Examples of variable An investor (the parent)

• Voting rights returns: can have the current
• Rights to appoint, reassign • Dividends ability to direct the
or remove key management • Interest from debt
activities of an investee
personnel (the potential subsidiary)
• Changes in value
even if it does not
• Rights to appoint or remove of investment
actively direct the
another entity that directs
activities of the investee
relevant activities
• Decision-making rights
stipulated in a management
contract
Examples of relevant activities:
• Selling and purchasing
goods/services
• Selecting, acquiring,
disposing of assets
• Researching and developing
new products/processes
• Determining funding
decisions

(IFRS 10: paras. 7, B9, B11, B15 & B57)

Activity 1: Control
Alpha acquired 4,000 of the 10,000 equity voting shares and 8,000 of the 10,000 non-voting
preference shares in Crofton.
Alpha acquired 4,000 of the 10,000 equity voting shares in Element and had a signed agreement
giving it the power to appoint or remove all of the directors of Element.

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Required
Which investment would be classified as a subsidiary of Alpha?
 Both Crofton and Element
 Crofton only
 Element only
 Neither Crofton nor Element

Solution

3 Parent’s separate financial statements

Before we consider the consolidated financial statements, we must first look at how the investment
in the subsidiary is presented in the parent’s individual financial statements.

3.1 Parent’s statement of financial position

Under IAS 27 Separate Financial Statements, the investment can be recorded in the parent’s
separate financial statements either:

At cost At fair value Using equity accounting method

Assumed in this As a financial asset under Only likely to be adopted for

course/ACCA FR exam IFRS 9 Financial Instruments investments in associates when
the parent does not prepare
consolidated financial statements

(IAS 27: para. 10)

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Example: Parent’s statement of financial position

The statements of financial position of Portus Co and Sanus Co at 31 December 20X4 are as
follows:
Portus Co Sanus Co
$’000 $’000
Non-current assets
Property, plant and equipment 56,600 16,200
Investment in Sanus Co (at cost) 13,800 –
70,400 16,200
Current assets
Inventories 2,900 1,200
Trade receivables 3,300 1,100
Cash 1,700 100
7,900 2,400
78,300 18,600
Equity
Share capital ($1 shares) 8,000 2,400
Reserves 54,100 10,600
62,100 13,000
Non-current liabilities
Long-term borrowings 13,200 4,800
Current liabilities
Trade and other payables 3,000 800
78,300 18,600

On 31 December 20X4, Portus Co purchased a 100% holding in Sanus Co for $13.8 million in cash.
It shows investment in Sanus Co at cost. This will remain unchanged from year to year, ie post-
acquisition increases in value are not evident from the parent’s separate statement of financial
position.
The assets and liabilities shown are only those held by the parent (Portus Co) directly.

4 Group financial statements

4.1 Requirement to prepared group financial statements
When a parent acquires a subsidiary, it is required to produce an additional set of financial
statements, known as group or consolidated financial statements, which aim to record the
substance of its relationship with its subsidiary rather than its strict legal form.

Essential reading
Chapter 7 Section 1 of the Essential reading considers the exemptions that are available from
preparing consolidated financial statements.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

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4.2 Features of the consolidated statement of financial position

The group, or consolidated, financial statements:

Present the results and financial position Are issued to the shareholders
of a group of companies as if it was of the parent
a single business entity

Provide information on all companies

Are issued in addition to and not instead controlled by the parent
of the parent's own financial statements

Show share capital of the parent only

Show no investment in subsidiary.
Instead the assets and liabilities of
the subsidiary are included. Show the assets and liabilities
that the group controls, ie
the resources available to the group
Shows the equity owners of the
parent company the consolidated
net assets of the group

5 Goodwill
5.1 Recognition and initial measurement

Essential reading
Chapter 7, Section 2 of the Essential reading discusses goodwill under IFRS 3 Business
Combinations in detail.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

Goodwill arises when the:

value of a business as a whole

fair value of
(cost of the investment + any exceeds
net assets acquired
non-controlling share not purchased)

Goodwill is shown as a separate asset in the consolidated statement of financial position,

measured at the acquisition date (under IFRS 3 Business Combinations) as:
$
Consideration transferred (cost of investment) X
Non-controlling interests (NCI) X
Less net acquisition-date fair value of identifiable assets (X)
acquired and liabilities assumed
X

5.2 Subsequent measurement

Goodwill arising on consolidation is subjected to an annual impairment review and impairment
may be expressed as an amount or as a percentage.
The initial and subsequent measurement of goodwill is considered further in Chapter 8 of this
Workbook.

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Activity 2: Goodwill
At 31 December 20X4, the statements of financial position of Portus Co and Sanus Co were as
follows:
Portus Co Sanus Co
$’000 $’000
Non-current assets
Property, plant and equipment 56,600 16,200
Investment in Sanus (at cost) 13,800 –
70,400 16,200
Current assets
Inventories 2,900 1,200
Trade receivables 3,300 1,100
Cash 1,700 100
7,900 2,400
78,300 18,600
Equity
Share capital ($1 shares) 8,000 2,400
Reserves 54,100 10,600
62,100 13,000
Non-current liabilities
Long-term borrowings 13,200 4,800
Current liabilities
Trade and other payables 3,000 800
78,300 18,600

Note. On 31 December 20X4, Portus Co purchased a 100% holding in Sanus Co for $13.8 million in
cash.
1 Required
Prepare the consolidated statement of financial position of the Portus Group as at 31 December
20X4.
Method
(a) Cancel the investment in Sanus Co in Portus’s books with the shares and reserves (at the date
of acquisition) in Sanus Co’s books. Any difference is goodwill.
(b) Aggregate the two statements of financial position.

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PORTUS GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4
$’000
Non-current assets
Property, plant and equipment
Goodwill (W(b))

Current assets
Inventories
Trade receivables
Cash

Equity attributable to owners of the parent

Share capital ($1 shares)
Reserves (W(c))

Non-current liabilities
Long-term borrowings
Current liabilities
Trade and other payables

Workings
1 Group structure

2 Goodwill
$’000 $’000
Consideration transferred

Less fair value of identifiable net assets at acquisition:

Share capital
Reserves

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3 Consolidated reserves (proof)

Portus Co Sanus Co
$’000 $’000
Per question
Pre-acquisition reserves

Group share of post-acq’n reserves:

Solution
1

6 Non-controlling interests
6.1 What are non-controlling interests?
Parent (P)

The parent does not

P holds 80% of the ordinary Non-controlling interests
own all of the
shares and has control over S own the remaining 20%
subsidiary – only 80%

Subsidiary (S)

Non-controlling interests are the 'equity in a subsidiary not attributable, directly or indirectly, to a
parent' (IFRS 3: App. A), ie the non-group shareholders' interest in the net assets of the subsidiary

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6.2 Points to note

(a) Remember you do not have to own 100% of a company to control it.
(b) The group accounts will need to show the extent to which the assets and liabilities are
controlled by the parent, but are owned by other parties, namely the non-controlling
interests.

7 Mid-year acquisitions
7.1 Net assets of subsidiary
So far, we have considered acquisitions only at the end of a reporting period. Since companies
produce statements of financial position at that date anyway, there has been no special need to
establish the net assets of the acquired company at that date.
With a mid-year acquisition, a statement of financial position will not exist at the date of
acquisition, as required. Accordingly, we have to estimate the net assets at the date of acquisition
using various assumptions. Any profits made after acquisition – post-acquisition reserves – must
be consolidated in the group financial statements.

7.2 Subsidiary profits pre- and post-acquisition

1 Jan 20X5 1 Jul 20X5 31 Dec 20X5

Date of acquisition,
becomes subsidiary of P

Pre-acquistion period. Any profits Post-acquisition period. Any

of S are included in retained profits of S are included in
earnings at date of acquisition. group financial statements.

7.3 Rule for mid-year acquisitions

Assume that profits accrue evenly throughout the year, unless specifically told otherwise.

Activity 3: Mid-year acquisitions

At 31 December 20X4, the statements of financial position of Portus Co and Sanus Co were as
follows:
Portus Co Sanus Co
$’000 $’000
Non-current assets
Property, plant and equipment 56,600 16,200
Investment in Sanus Co (at cost) 13,800 –
70,400 16,200
Current assets
Inventories 2,900 1,200
Trade receivables 3,300 1,100
Cash 1,700 100
7,900 2,400
78,300 18,600
Equity
Share capital ($1 shares) 8,000 2,400
Reserves 54,100 10,600
62,100 13,000

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Portus Co Sanus Co
$’000 $’000
Non-current liabilities
Long-term borrowings 13,200 4,800
Current liabilities
Trade and other payables 3,000 800
78,300 18,600

Notes
1. On 1 April 20X4, Portus Co purchased an 80% holding in Sanus Co for $13.8 million in cash.
Sanus Co’s total comprehensive income for the year ended 31 December 20X4 was $2.0 million,
accruing evenly over the year. Sanus Co did not pay any dividends in the year.
2. The non-controlling interest in Sanus Co is to be valued at its fair value of $3.2 million at the
date of acquisition.
1 Required
Prepare the consolidated statement of financial position of the Portus Group as at 31 December
20X4.
PORTUS GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4
$’000
Non-current assets
Property, plant and equipment
Goodwill (W2)

Current assets
Inventories
Trade receivables
Cash

Equity attributable to owners of the parent

Share capital ($1 shares)
Reserves (W3)

Non-controlling interests (W4)

Non-current liabilities
Long-term borrowings
Current liabilities
Trade and other payables

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Workings
1 Group structure

Portus Co

Sanus Co
Pre-acq'n reserves

2 Goodwill
$’000 $’000
Consideration transferred
Non-controlling interests (at fair value)

Less fair value of identifiable net assets at acquisition:

Share capital
Reserves

3 Consolidated reserves
Portus Co Sanus Co
$’000 $’000
Per question
Pre-acquisition reserves

Group share of post-acq’n reserves:

Sanus Co

4 Non-controlling interests

$’000
NCI at acquisition (W2)
NCI share of post-acquisition reserves

Solution
1

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Essential reading
Chapter 7 Section 3 of the Essential reading considers the accounting policies and year-end date
of the subsidiary.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

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Chapter summary

Introduction to groups

Introduction and definitions Control

Types of investment Criteria for control

• Subsidiary – control – full consolidation • Power to direct relevant activities
• Associate – significant influence – equity accounting • Exposure or rights to variable returns
• Investment – acretion of wealth – financial • Ability to use power to affect returns
instrument • Examples of power:
– Voting rights
– Rights to appoint/remove management
Definitions – Right to appoint/remove entity directing relevant
• Control – investor is exposed, or has rights, to activities
variable returns and has the ability to affect those – Decision-making rights in a management contract
returns • Examples of relevant activities:
• Power – right to direct activities – Selling and purchasing goods/services
• Subsidiary – entity that is controlled by another – Selecting/acquiring/disposing of assets
entity – Research and development
• Parent – entity that controls one or more other – Determining funding decisions
entities • Examples of variable returns:
• Group – parent and all its subsidiaries – Dividends
• Associate – an entity over which an investor has – Interest
significant influence – Changes in value of investment
• Significant influence – power to participate in the • Ability to use power to affect returns:
policy decisions of an investee – Current ability even if entity does not use the
ability

Parent's separate financial statements Group financial statements

Parent's statement of financial position Requirement to prepare group financial statements

Investment held at: cost, fair value, equity method Required to prepare group financial statements which
show substance of relationship

Important features
• Investment remains at cost, unchanged over time Features of the consolidated statement of financial
• Assets and liabilities are those of parent only position
• Present results as single economic entity
• No investment in subsidiary
• Subsidiary assets and liabilities included
• Share capital that of parent only
• Show the assets and liabilities controlled by
the group
• Shows the equity of the owners of the net assets

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Performance IAS 20 Accounting for

obligations Government Grants and Disclosure
of Government Assistance

• A contract includes a promise to transfer Grants are not recognised until there is
goods or services to a customer reasonable assurance that the conditions will
• This is the performance obligation within the be complied with and the grants will be received
contract
• An entity must be able to reasonably measure
the outcome of a performance obligation Grants relating to income
before the revenue can be recognised Grants relating to income are shown in profit or
loss either separately or as part of 'other
income' or alternatively deducted from the
Performance obligations satisfied over time related expense
• An entity may transfer a good or service over
time with the revenue being recognised over
time Grants relating to assets
• A performance obligation is satisfied when Government grants relating to assets are
the entity transfers a promised good or presented in the statement of financial position
service (ie an asset) to a customer either:
↓ • As deferred income; or
• An asset is considered transferred when (or • By deducting the grant in calculating the
as) the customer obtains control of that asset carrying amount of the asset
↓ • Any deferred credit is amortised to profit or
• Control of an asset refers to the ability to loss over the asset's useful life
direct the use of, and obtain substantially all
of the remaining benefits from, the asset
Repayment of grants
• A government grant that becomes repayable
Methods of measuring performance is accounted for as a change in accounting
• Output methods estimate in accordance with IAS 8 Accounting
– Units produced Policies, Changes in Accounting Estimates
– Survey of completion to date and Errors
• Input methods • Repayment of grants relating to income are
– Resources consumed applied first against any unamortised
– Costs incurred deferred credit and then in profit or loss
• A contract asset is recognised when revenue • Repayments of grants relating to assets are
has been earned but not yet invoiced (revenue recorded by increasing the carrying amount
that has been invoiced is a receivable) of the asset or reducing the deferred income
• A contract liability is recognised when a balance
customer has paid prior to the entity • Any resultant cumulative extra depreciation is
transferring control of the good or service to recognised in profit or loss immediately
the customer 

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Knowledge diagnostic
1. Introduction and definitions
A company can acquire another entity by purchasing its shares. If it gains control over the other
entity, it has a subsidiary and group, or consolidated, financial statements should be prepared.

2. Control
Control exists when the acquiring company:
• Has the power to direct relevant activities of the other entity
• Has exposure or the right to variable returns
• Ability to use power to direct the amount of those returns

3. Parent’s separate financial statements

Investment is shown in the statement of financial position, either:
• At cost
• At fair value
• Using the equity accounting method

4. Group financial statements

Required to prepare group financial statements which present the group as a single economic
entity. The group financial statements show:
• No investment in subsidiary
• The assets and liabilities of the parent and subsidiary
• Share capital of the parent only

5. Goodwill
Goodwill arises when the value of a business as a whole exceeds the fair value of the net asset
acquired. It is subsequently tested for impairment annually.

6. Non-controlling interests
Non-controlling interests own any interest in a subsidiary that the parent does not own.

7. Mid-year acquisitions
The net assets of a subsidiary need to be established at the date of acquisition. Any profits
earned by the subsidiary pre-acquisition are included in its retained earnings, and therefore its
net assets, at the date of acquisition. Any post-acquisition profits of the subsidiary are included
within the consolidated financial statements.

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Further study guidance

Question practice
As this is an introductory chapter, there are no recommended questions from the Further question
practice bank at this stage. Questions will be recommended in Chapters 8–10 which build on the
concepts covered in this chapter.

Further reading
ACCA have produced a number of technical articles which look at key areas of the FR syllabus.
IFRS 3, Business combinations
www.accaglobal.com

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Activity answers

Activity 1: Control
The correct answer is:
Element only
Alpha does not have power over Crofton as the non-voting preference shares do not give it power
and they only own 40% of the voting shares. The agreement regarding Element affords Alpha with
power, thus Element is a subsidiary.

Activity 2: Goodwill
1 The correct answer is:
PORTUS GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4
$’000
Non-current assets
Property, plant and equipment (56,600 + 16,200) 72,800
Goodwill (W(b)) 800
73,600
Current assets
Inventories (2,900 + 1,200) 4,100
Trade receivables (3,300 + 1,100) 4,400
Cash (1,700 + 100) 1,800
10,300
83,900
Equity attributable to owners of the parent
Share capital ($1 shares) 8,000
Reserves (W(c)) 54,100
62,100
Non-current liabilities
Long-term borrowings (13,200 + 4,800) 18,000
Current liabilities
Trade and other payables (3,000 + 800) 3,800
83,900

Workings
1 Group structure

Portus Co

31.12.X4
100%
Cost $13.8m

Sanus Co
Pre-acq'n reserves $10.6m

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2 Goodwill
$’000 $’000
Consideration transferred 13,800

Less fair value of identifiable net assets at acquisition:

Share capital 2,400
Reserves 10,600
(13,000)
800

3 Consolidated reserves (proof)

Portus Co Sanus Co
$’000 $’000
Per question 54,100 10,600
Pre-acquisition reserves (10,600)
0
Group share of post-acq’n reserves:
Sanus Co (0 × 100%) 0
54,100

Activity 3: Mid-year acquisitions

1 The correct answer is:
PORTUS GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4
$’000
Non-current assets
Property, plant and equipment (56,600 + 16,200) 72,800
Goodwill (W2) 5,500
78,300
Current assets
Inventories (2,900 + 1,200) 4,100
Trade receivables (3,300 + 1,100) 4,400
Cash (1,700 + 100) 1,800
10,300
88,600
Equity attributable to owners of the parent
Share capital ($1 shares) 8,000
Reserves (W3) 55,300
63,300
Non-controlling interests (W4) 3,500
66,800
Non-current liabilities
Long-term borrowings (13,200 + 4,800) 18,000
Current liabilities
Trade and other payables (3,000 + 800) 3,800
88,600

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Workings
1 Group structure

Portus Co

Sanus Co
Pre-acq'n reserves

2 Goodwill
$’000 $’000
Consideration transferred 13,800
Non-controlling interests (at fair value) 3,200

Less fair value of identifiable net assets at acquisition:

Share capital 2,400
Reserves (10,600 – (2,000 × 9/12)) 9,100
(11,500)
5,500

3 Consolidated reserves
Portus Co Sanus Co
$’000 $’000
Per question 54,100 10,600
Pre-acquisition reserves (10,600 – (2,000 × 9/12)) (9,100)
1,500
Group share of post-acq’n reserves:
Sanus Co (1,500 × 80%) 1,200
55,300

4 Non-controlling interests
$’000
NCI at acquisition (W2) 3,200
NCI share of post-acquisition reserves ((W3) 1,500 × 20%) 300
3,500

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The consolidated statement

8 of financial position

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Explain why it is necessary to eliminate A4(g)

intragroup transactions.

Explain why it is necessary to use fair values A4(i)

for the consideration for an investment in a
subsidiary together with the fair values of a
subsidiary’s identifiable assets and liabilities
when preparing consolidated financial
statements.

Distinguish between goodwill and other B2(b)

intangible assets.

Describe the subsequent accounting B2(d)

treatment, including the principle of
impairment tests in relation to goodwill.

Indicate why the value of purchase B2(e)

consideration for an investment may be less
than the value of the acquired identifiable net
assets and how the difference should be
accounted for.

Prepare a consolidated statement of financial D2(a)

position for a simple group (parent and one
subsidiary and associate) dealing with pre-
and post-acquisition profits, non-controlling
interests and consolidated goodwill.

Explain and account for other reserves (eg D2(c)

share premium and revaluation surplus).

Account for the effects in the financial D2(d)

statements of intragroup trading.

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Syllabus reference no.

Account for the effects of fair value D2(e)

adjustments (including their effect on
consolidated goodwill) to:
(a) Depreciating and non-depreciating non-
current assets
(b) Inventory
(c) Monetary liabilities
(d) Assets and liabilities not included in the
subsidiary’s own statement of financial
position, including contingent assets and
liabilities

Account for goodwill impairment. D2(f)

Describe and apply the required accounting D2(g)

treatment of consolidated goodwill.
8

Exam context
The consolidated statement of financial position is one of the key financial statements you need to
be able to prepare and/or interpret in Section C of the ACCA Financial Reporting exam. It is
important that you understand the approach to preparing the consolidated statement of financial
position and that you can apply that approach efficiently in an exam question.
8

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Chapter overview
The consolidated statement of financial position

Approach to the Goodwill

consolidated statement
of financial position

Basic procedure Calculation of goodwill Impairment of positive goodwill

Standard approach Accounting treatment Fair value of

consideration transferred

Fair Pre- and post-acquisition Dividends paid

values profits and other reserves by subsidiary

Definition of fair value Pre- and post-acquisition profits

Measuring NCI at acquisition Other reserves

Fair value of subsidiary’s net

assets at acquisition

Intragroup Unrealised profit on Transfer of

balances transfer of inventory non-current assets

IFRS 10 requirement Cost v NRV Carrying amount

and depreciation

Intragroup payables Method for eliminating

and receivables unrealised profit Method

Reconciliation of
intragroup balances

Method

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1 Approach to the consolidated statement of financial

position
In Chapter 7, we introduced group accounting, including some of the key features of the
consolidated statement of financial position. This chapter builds on that knowledge by looking in
more detail at the procedures and adjustments required on consolidation.

1.1 Basic procedure

The financial statements of a parent and its subsidiaries are combined on a line-by-line basis by
adding together like items of assets, liabilities, equity, income and expenses.
In respect of the consolidated statement of financial position, the following steps are then taken,
in order that the consolidated financial statements should show financial information about the
group as if it was a single entity.
Approach
• The carrying amount of the parent’s investment in each subsidiary and the equity of each
subsidiary are eliminated or cancelled.
• Goodwill arising on consolidation should be recognised in accordance with IFRS 3 Business
Combinations.
• Non-controlling interests in the net assets of consolidated subsidiaries should be presented
separately in the consolidated statement of financial position.
• Internal transactions such as dividends paid by a subsidiary, intragroup trading, inventories
and non-current assets transfers must be adjusted.

1.2 Standard procedures for the consolidated statement of financial

position
You must be able to work accurately and efficiently if you were required to prepare a statement of
financial position in Section C of the FR exam. A high level summary of the key procedures you will
undertake is provided below. Some of these procedures will not make sense to you at this stage;
we will work through the details of these steps as we progress through this chapter.

Step Procedure/exam technique

Step 1 Read the question and create a short note in your blank spreadsheet
workspace, or in the scratch pad, which shows:
• The group structure
• The percentage owned
• Acquisition date
• Pre-acquisition reserves

Step 2 Enter a proforma statement of financial position into the spreadsheet

workspace, which includes:
• A line for goodwill (in non-current assets)
• A line for non-controlling interests (in equity)

Step 3 Transfer figures from the parent and subsidiary financial statements to the
proforma:
• Include the parent plus 100% of the subsidiary’s assets/liabilities
controlled at the year end on a line by line basis
• Include only the parent’s share capital and share premium in the equity
section

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Step Procedure/exam technique

Step 4 Complete your workings for standard adjustments/line items:
• Goodwill
• Non-controlling interests
• Retained earnings and any other reserves of the subsidiary
• Dividends paid by the subsidiary
• Intragroup trading
• Inventories transferred within the group
• Non-current assets transferred within the group

Step 5 Transfer your workings to the proforma and complete your answer

Exam focus point

It is essential that you show all workings in the spreadsheet workspace. You should label your
workings clearly and cross reference on the face of the statement of financial position.

1.3 Goodwill calculation

We noted the basic goodwill calculation in Chapter 7. We will now consider the accounting
treatment for goodwill and the components of the calculation in more detail.
Goodwill
$
Consideration transferred (cost of investment) X
Non-controlling interests (NCI) X
Less the fair value of identifiable assets acquired and liabilities (X)
assumed at the acquisition date
Goodwill X

1.4 Accounting treatment

Goodwill

Purchased (IFRS 3) Internally generated

• Not capitalised (IAS 38: para. 48).
See Chapter 4.

Positive Gain on bargain purchase

• Capitalise as a non-current • Reassess information used
asset (IFRS 3: para. 32) in the calculation
• Test annually for impairment • Credit any gain to profit or
(IAS 36: para. 10(b)) loss attributable to the
parent (IFRS 3: para. 34)

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Activity 1: Basic goodwill calculation

Sing Co gained control of Wing Co on 31 March 20X5 when it acquired 80% of its ordinary shares.
The draft statements of financial position of each company were as follows:
SING CO
STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 20X5
$
Assets
Non-current assets
Investment in 40,000 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 20X5
$
Current assets 60,000
Equity
50,000 ordinary shares of $1 each 50,000
Retained earnings 10,000
60,000

The fair value of the non-controlling interest in Wing Co as at 31 March 20X5 has been determined
as $12,500.
1 Required
Prepare the consolidated statement of financial position as at 31 March 20X5.
$
Assets
Non-current assets
Goodwill arising on consolidation (W)
Current assets
Total assets
Equity and liabilities
Ordinary shares
Retained earnings
Non-controlling interests
Total equity and liabilities

Solution
1

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1.5 Fair value of consideration transferred

The first component of the goodwill calculation is the consideration transferred (which is the same
as the figure recorded as the cost of the investment in the parent’s separate financial statements).
Consideration may contain several components:

Consideration

Transferred at the Deferred Contingent

date of acquisition consideration consideration

Calculated as the Consideration that is to Contingent consideration

acquisition-date fair values of: be paid in the future (ie a payment dependent
• The assets transferred by should be discounted to on whether specified
the acquirer; present value to future events occur or
• The liabilities incurred by
determine its fair value. conditions are met, eg
a profit target) is
the acquirer (to former
measured at fair value
owners of the acquiree); and
at acquisition date
• Equity interests issued by
the parent.
Any costs involved in the
transaction are charged to
profit or loss.

Illustration 1: Deferred consideration

A liability of $100,000 is to be paid in two years’ time. The discount rate of 6%.
Required
At what amount should the liability be recorded?

Solution
The correct answer is:
The liability should be recorded at $100,000 × 1/1.062 = $89,000.

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Essential reading
Chapter 8, Section 1 of the Essential reading provides more detail on the types of consideration
that may be used to acquire a subsidiary.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

Activity 2: Consideration
ABC acquired 300,000 of DEF’s 400,000 ordinary shares during the year ending 28 February
20X5. DEF was purchased from its directors who will remain in their current roles in the business.
The purchase consideration comprised:
• $250,000 in cash payable at acquisition
• $88,200 payable two years after acquisition
• $100,000 payable in two years’ time if profits exceed $2 million
• New shares issued in ABC at acquisition on a 1 for 3 basis
The consideration payable in two years after acquisition is a tough target for the directors of DEF,
which means its fair value (taking into account the time value of money) has been measured at
only $30,750.
The market value of ABC’s shares on the acquisition date was $7.35.
An appropriate discount rate for use where relevant is 5%.
1 Required
How much is the consideration that has been/will be paid in cash to include in the calculation of
goodwill on acquisition?

$
2 Required
How much is the consideration payable in shares that will be included in the calculation of
goodwill on acquisition?

Solution
1

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1.6 Impairment testing

Any goodwill arising on a business combination should be tested annually for impairment,
irrespective of whether there are any specific indicators of impairment (IAS 36: para. 10(b)). Any
impairment may be expressed as an amount or as a percentage. The double entry to write off the
impairment is:
DEBIT Group retained earnings
CREDIT Goodwill

However, this is complicated when there is NCI at fair value at the date of acquisition.
When NCI is valued at fair value the goodwill in the statement of financial position includes
goodwill attributable to the NCI. In this case, the double entry will reflect the NCI proportion
based on their shareholding as follows:
DEBIT Group retained earnings
DEBIT Non-controlling interest
CREDIT Goodwill

Illustration 2: Goodwill impairment

Using the information in Activity 1 above, assume that in the year ending 31 March 20X6, the
goodwill of Wing is impaired by 20%.
1 Required
Prepare the journal entry to record goodwill impairment in the year ended 31 March 20X6.

Solution
1 The correct answer is:
The goodwill impairment is $32,500 × 20% = $6,500. $5,200 ($6,500 × 80%) of this will be
allocated to the group and the remaining $1,300 ($6,500 × 20%) will be allocated to the NCI.

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DEBIT Group retained earnings $5,200

DEBIT Non-controlling interest $1,300
CREDIT Goodwill $6,500

1.7 Gain on bargain purchase

Goodwill arising on consolidation is the difference between the cost of an acquisition and the
value of the subsidiary’s net assets acquired. This difference can be negative: the aggregate of
the fair values of the separable net assets acquired may exceed what the parent company paid
for them. This is often referred to as negative goodwill. IFRS 3 refers to it as a ‘gain on a bargain
purchase’ (para. 34). In this situation:
(a) An entity 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.
(b) Any excess remaining should be recognised immediately in profit or loss.

2 Fair values
In order to calculate goodwill, we need to establish
• The fair value of the non-controlling interest; and
• The fair value of the net assets acquired

2.1 Definition

Fair value: The price that would be received to sell an asset or paid to transfer a liability in an
KEY
TERM orderly transaction between market participants at the measurement date (IFRS 13: para. 9).

Essential reading
Chapter 8 Section 2 of the Essential reading provides more detail regarding the interaction of IFRS
3 and IFRS 13.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

2.2 Fair value of non-controlling interests

IFRS 3 allows the non-controlling interests in a subsidiary to be measured at the acquisition date
in one of two ways:

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NCI at acquisition

At their fair value (ie how much it At the non-controlling interest's

would cost for the acquirer to proportionate share of the fair value of
acquire the remaining shares). the acquiree's identifiable net assets.

Known as the ‘full goodwill’ This is sometimes called the 'partial

approach. goodwill' approach.

Measurement of the non-controlling

Means that some of the goodwill
interests at proportionate share of the fair
calculated is attributable to the NCI.
value of the acquiree's identifiable net
NCI therefore needs to be allocated
assets means that no non-controlling
any subsequent impairment losses.
interest in goodwill is recognised.

Note that a parent can choose which method to use on a transaction by transaction basis.

Illustration 3: Measuring NCI at fair value compared to measuring at

proportionate share of net assets
On 31 December 20X8, Penn acquired four million of the five million $1 ordinary shares of
Sylvania, paying $10 million in cash. On that date, the fair value of Sylvania’s net assets was $7.5
million.
1 Required
Calculate the goodwill arising on acquisition assuming:
(a) Penn has elected to value the non-controlling interest at acquisition at fair value. The market
price of the shares held by the non-controlling shareholders immediately before the
acquisition was $2.00.
(b) Penn has elected to value the non-controlling interest at acquisition at its proportionate share
of the fair value of the subsidiary’s identifiable net assets.

Solution
1 The correct answer is:
(a) NCI at fair value
$’000
Consideration transferred 10,000
Non-controlling interest: 1m × $2 2,000
12,000
Net assets acquired (7,500)
Goodwill 4,500

(b) NCI at proportion of net assets

$’000
Consideration transferred 10,000
Non-controlling interest: 20% × $7.5m 1,500
11,500
Net assets acquired (7,500)
Goodwill 4,000

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You can see from the above illustration that measuring NCI at fair value at acquisition results in an
increased amount of goodwill. The additional amount of goodwill represents goodwill attributable
to the shares held by non-controlling shareholders. It is not necessarily proportionate to the
goodwill attributed to the parent as the parent may have paid more to acquire a controlling
interest.

Exam focus point

The ACCA examining team has stated that they will only test partial goodwill as a comparison
to the ‘full goodwill’ approach we have used so far.

2.3 Fair value of identifiable assets acquired and liabilities assumed

2.3.1 IFRS 3 requirement
IFRS 3 Business Combinations requires the identifiable assets acquired and liabilities assumed of
subsidiaries to be brought into the consolidated financial statements at their FAIR VALUE rather
than their carrying amount.
Assets and liabilities in an entity’s own financial statements are often not stated at their fair value,
eg where the entity’s accounting policy is to use the cost model for assets. If the subsidiary’s
financial statements are not adjusted to their fair values, where, for example, an asset’s value has
risen since purchase, goodwill would be overstated (as it would include the increase in value of the
asset).
The difference between fair values and carrying amount is a consolidation adjustment made
only for the purposes of the consolidated financial statements.

2.3.2 Restructuring and future operating 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 at the date of acquisition.

2.3.3 Assets and liabilities only recognised on consolidation

Some assets and liabilities are not recognised in the subsidiary’s individual financial statements
but are recognised on consolidation.

Item Valuation basis

Internally generated intangible assets Recognised as non-current assets as acquiring
company is giving valuable consideration for these
assets

Contingent liabilities Recognised providing:

• It is a present obligation; and
• Its fair value can be measured reliably. (IAS 37
rules do not apply.)

2.3.4 Measurement period

If the initial accounting for a business combination is incomplete by the end of the reporting
period in which the combination occurs, provisional figures for the consideration transferred,
assets acquired and liabilities assumed are used.
Adjustments to the provisional figures may be made up to the point the acquirer receives all the
necessary information (or learns that it is not obtainable), with a corresponding adjustment to
goodwill, but the measurement period cannot exceed one year from the acquisition date.

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Thereafter, goodwill is only adjusted for the correction of errors.

Acquisition date Year end End of measurement period

1 May 20X7 31 Dec 20X7 30 April 20X8

Adjustments to provisional figures permitted Only correction

of error permitted

Activity 3: Fair values

At 31 December 20X4, the statements of financial position of Portus Co and Sanus Co were as
follows:
Portus Co Sanus Co
$’000 $’000
Non-current assets
Property, plant and equipment 56,600 16,200
Investment in Sanus Co (at cost) 13,800 –
70,400 16,200
Current assets
Inventories 2,900 1,200
Trade receivables 3,300 1,100
Cash 1,700 100
7,900 2,400
78,300 18,600
Equity
Share capital ($1 shares) 8,000 2,400
Reserves 54,100 10,600
62,100 13,000
Non-current liabilities
Long-term borrowings 13,200 4,800
Current liabilities
Trade and other payables 3,000 800
78,300 18,600

Notes
(a) On 1 April 20X4, Portus Co purchased an 80% holding in Sanus Co for $13.8 million in cash.
Sanus Co’s total comprehensive income for the year ending 31 December 20X4 was $2.0
million, accruing evenly over the year. Sanus Co did not pay any dividends in the year.
(b) At the date of acquisition, the fair value of Sanus Co’s assets was equal to their carrying
amounts with the exception of the items listed below which exceeded their carrying amounts
as follows:
$’000
Inventories 300
Plant and equipment (10-year remaining useful life) 1,200
1,500

Sanus Co has not adjusted the carrying amounts as a result of the fair value exercise. The
inventories were sold by Sanus Co before the year end.

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(c) The non-controlling interest in Sanus Co is to be valued at its fair value of $3.2 million at the
date of acquisition.
An impairment test conducted at the year-end revealed that the consolidated goodwill of
Sanus Co was impaired by $150,000.
1 Required
Prepare the consolidated statement of financial position of the Portus Group as at 31 December
20X4.
PORTUS GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4
$’000
Non-current assets
Property, plant and equipment
Goodwill (W2)

Current assets
Inventories
Trade receivables
Cash

Equity attributable to owners of the parent

Share capital ($1 shares)
Reserves (W3)

Non-controlling interests (W4)

Non-current liabilities
Long-term borrowings
Current liabilities
Trade and other payables

Workings
1 Group structure

2 Goodwill
$’000 $’000
Consideration transferred
Non-controlling interests (at fair value)

Less fair value of identifiable net assets at acquisition:

Share capital
Reserves
Fair value adjustments (W5)

Less impairment losses

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3 Consolidated reserves
Portus Co Sanus Co
$’000 $’000
Per question
Fair value movement (W5)
Pre-acquisition reserves

Group share of post-acq’n reserves:

Sanus
Less impairment losses

4 Non-controlling interests
$’000
NCI at acquisition (W2)
NCI share of post-acquisition reserves (W3)
NCI share of impairment losses

5 Fair value adjustments

At acquisition date Movement At year end
$’000 $’000 $’000
Inventories
Plant and equipment

Take to Goodwill Take to COS Take to SOFP

& reserves

2 Required
Show how the goodwill and non-controlling interests would change if the non-controlling interests
were measured at acquisition at the proportionate share of the fair value of the acquiree’s
identifiable net assets.
Workings
1 Goodwill
$’000 $’000
Consideration transferred
Non-controlling interests (at %FVNA)

Less fair value of identifiable net assets at acquisition:

Share capital
Reserves
Fair value adjustments (W5)

Less impairment losses

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2 Non-controlling interests
$’000
NCI at acquisition
NCI share of post-acquisition reserves
NCI share of impairment losses

3 Required
Explain how the goodwill would have been treated if the calculation had resulted in a negative
figure, and how such a negative figure may arise.

Solution
1

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3 Pre- and post-acquisition profits and other reserves

3.1 Pre- and post-acquisition profits
Pre- and post-acquisition profits were introduced in Chapter 7.
When a subsidiary is acquired mid-way through the year, for consolidation purposes, it is
necessary to distinguish between:
(a) Profits earned before acquisition (pre-acquisition profits)
(b) Profits earned after acquisition (post acquisition profits)
The assumption can be made that profits accrue evenly whenever it is impracticable to arrive at
an accurate split of pre- and post‑acquisition profits. You should make this assumption in the FR
exam unless you are told otherwise.

3.1.1 Pre-acquisition profits

Once the amount of pre‑acquisition profit has been established by pro-rating the profit for the
year, it should be included in retained earnings in order that the appropriate consolidation
workings can be produced.

3.1.2 Post-acquisition profits

Any profits earned by the subsidiary after the date of acquisition are included in the group profit
for the year.

Essential reading
Chapter 8, Section 3 of the Essential reading is an activity in which a subsidiary is acquired mid-
way through the year.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

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3.2 Other reserves

Exam questions will often give other reserves (such as a revaluation surplus) as well as retained
earnings. These reserves should be treated in exactly the same way as retained earnings, which
we have already seen.

3.2.1 Pre-acquisition other reserves

If the reserve is pre‑acquisition, it forms part of the calculation of net assets at the date of
acquisition and is therefore used in the goodwill calculation.

3.2.2 Post-acquisition other reserves

If the reserve is post‑acquisition or there has been some movement on a reserve existing at
acquisition, the consolidated statement of financial position will show the parent’s reserve plus its
share of the movement on the subsidiary’s reserve.

Activity 4: Other reserves

The total reserves of Portus Co and Sanus Co in Activity 3 can be broken down as follows:
Portus Co Sanus Co
$’000 $’000
Equity
Share capital ($1 shares) 8,000 2,400
Retained earnings 42,700 9,000
Revaluation surplus 11,400 1,600
62,100 13,000

At acquisition, the retained earnings of Sanus Co were $7.8 million and its revaluation surplus
stood at $1.3 million (coming to a total of $9.1 million as before).
1 Required
Calculate the consolidated retained earnings, consolidated revaluation surplus and non-
controlling interests for the Portus Group as at 31 December 20X4.

PORTUS GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4
(EXTRACT)
$’000
Equity attributable to owners of the parent
Share capital ($1 shares) 8,000
Retained earnings (W1)
Revaluation surplus (W2)

Non-controlling interests (W3) 3,392

66,260

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Workings
1 Consolidated retained earnings
Portus Co Sanus Co
$’000 $’000
Per question
Fair value movement (W5) (390)
Pre-acquisition retained earnings

Group share of post-acq’n retained earnings:

Sanus Co ( × 80%)
Less impairment losses: Sanus Co (150 × 80%) (120)

2 Consolidated revaluation surplus

Portus Co Sanus Co
$’000 $’000
Per question
Pre-acquisition revaluation surplus

Group share of post-acq’n revaluation surplus:

Sanus Co ( × 80%)

3 Non-controlling interests
$’000
NCI at acquisition (LE1(a) (W2)) 3,200
NCI share of post-acquisition retained earnings ((W1) ( × 20%))
NCI share of post-acquisition revaluation surplus ((W2) ( × 20%))
NCI share of impairment losses (Activity 1(a) (W2) 150 × 20%) (30)
3,392

Solution
1

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4 Dividends paid by a subsidiary

When a subsidiary pays a dividend during the year, the accounting treatment is not difficult.
Suppose Subsidiary Co, a 60% subsidiary of Parent Co, pays a dividend of $1,000 on the last day
of its accounting period. Its total reserves before paying the dividend stood at $5,000.
(a) $400 (40%) of the dividend is paid to non-controlling shareholders. The cash leaves the group
and will not appear anywhere in the consolidated statement of financial position.
(b) The parent company receives $600 of the dividend, debiting cash and crediting profit or loss.
This will be cancelled on consolidation.
(c) The remaining balance of retained earnings in Subsidiary Co’s statement of financial position
($4,000) will be consolidated in the normal way. The group’s share (60% × $4,000 = $2,400)
will be included in group retained earnings in the statement of financial position; the non-
controlling interest share (40% × $4,000 = $1,600) is credited to the non-controlling interest
account in the statement of financial position.

5 Intragroup trading
5.1 IFRS 10 requirement
IFRS 10 Consolidated Financial Statements states ‘Intragroup balances, transactions, income and
expenses shall be eliminated in full’ (IFRS 10: para. B86).
The purpose of consolidation is to present the parent and its subsidiaries as if they are trading as
one entity.
Therefore, only amounts owing to or from outside the group should be included in the statement
of financial position, and any assets should be stated at cost to the group.

5.2 Intragroup balances

Trading transactions will normally be recorded via a current account between the trading
companies, which would also keep a track of amounts received and/or paid.
The current account receivable in one company’s books should equal the current account
payable in the other. These two balances should be cancelled on consolidation as intragroup
receivables and payables should not be shown.

5.2.1 Reconciliation of intragroup balances

Where current accounts do not agree at the year-end, this will be due to in transit items such as
inventories and cash.
Prior to consolidation, adjustments will need to be made for the cash or goods in transit. This is
usually done by following through the transaction to its ultimate destination (IFRS 10 is not
specific).

5.3 Method
Make the adjustments for in transit items on your proforma answer after consolidating the assets
and liabilities.

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• Cash in transit
DEBIT Cash
CREDIT Receivables
• Goods in transit
DEBIT Inventories
CREDIT Payables
• Eliminate intragroup receivables and payables
DEBIT Intragroup payable
CREDIT Intragroup receivable

6 Inventories sold at a profit (within the group)

6.1 Cost and NRV
Inventories must be valued at the lower of cost and net realisable value (NRV) to the group.

Inventories transferred at a profit within group

Sold to a third party Remain in inventories

Profit realised Profit unrealised

6.2 Method
Calculate the unrealised profit included in inventories and mark the adjustment to inventories on
your proforma answer and to retained earnings in your workings.
To eliminate the unrealised profit from retained earnings and inventories a provision is usually
made in the books of the company making the sale (IFRS 10 is not specific). This only happens on
consolidation. Following this approach, the entries required are:

Sale by P to S Adjust in P’s accounts

DEBIT Cost of sales/Retained earnings of P
CREDIT Consolidated inventories

Sale by S to P Adjust in S’s accounts

DEBIT Cost of sales/Retained earnings of S
CREDIT Consolidated inventories

The non-controlling interests will be affected

by this adjustment (when allocating their
share of post-acquisition profits).

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Activity 5: Sale of inventory at a profit

At 31 December 20X4, the statements of financial position of Portus Co and Sanus Co were as
follows:
Portus Co Sanus Co
$’000 $’000
Non-current assets
Property, plant and equipment 56,600 16,200
Investment in Sanus Co (at cost) 13,800 –
70,400 16,200
Current assets
Inventories 2,900 1,200
Trade receivables 3,300 1,100
Cash 1,700 100
7,900 2,400
78,300 18,600
Equity
Share capital ($1 shares) 8,000 2,400
Reserves 54,100 10,600
62,100 13,000
Non-current liabilities
Long-term borrowings 13,200 4,800
Current liabilities
Trade and other payables 3,000 800
78,300 18,600

Notes
(a) On 1 April 20X4, Portus Co purchased an 80% holding in Sanus Co for $13.8 million in cash.
Sanus’s total comprehensive income for the year ending 31 December 20X4 was $2 million,
accruing evenly over the year. Sanus Co did not pay any dividends in the year.
(b) At the date of acquisition, the fair value of Sanus Co’s assets was equal to their carrying
amounts with the exception of the items listed below which exceeded their carrying amounts
as follows:
$’000
Inventories 300
Plant and equipment (10-year remaining useful life) 1,200
1,500

Sanus Co has not adjusted the carrying amounts as a result of the fair value exercise. The
inventories were sold by Sanus Co before the year end.
(c) The non-controlling interest in Sanus Co is to be valued at its fair value of $3.2 million at the
date of acquisition.
An impairment test conducted at the year end revealed that the consolidated goodwill of
Sanus Co was impaired by $150,000.
(d) On 1 October 20X4, Sanus Co sold goods to Portus Co for $200,000 at a gross profit margin
of 40%. The goods were still in Portus Co’s inventories at the year end. No other sales were
made between Portus Co and Sanus Co in the year.
At 31 December 20X4, Portus Co’s current account with Sanus Co was $130,000 (credit). This
did not agree with the equivalent balance in Sanus’s books due to cash in transit of $70,000
which was not received by Sanus Co until after the year end.

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1 Required
Prepare the consolidated statement of financial position of the Portus Group as at 31 December
20X4 (incorporating the changes from the previous example identified in bold text).

PORTUS GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4
$’000
Non-current assets
Property, plant and equipment (56,600 + 16,200 + (W5) 1,110) 73,910
Goodwill (W2) 3,850
77,760
Current assets
Inventories (2,900 + 1,200)
Trade receivables (3,300 + 1,100)
Cash (1,700 + 100)

Equity attributable to owners of the parent

Share capital ($1 shares) 8,000
Reserves (W3)

Non-controlling interests (W4)

Non-current liabilities
Long-term borrowings (13,200 + 4,800) 18,000
Current liabilities
Trade and other payables (3,000 + 800)

Workings
1 Group structure

Portus Co

1.4.X4
80%
Cost $13.8m

Sanus
Pre-acq'n reserves $9.1m
($10.6m – ($2.0m × 9/12))
or ($10.6m – $2.0m + ($2.0 × 3/12))

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2 Goodwill
$’000 $’000
Consideration transferred 13,800
Non-controlling interests (at fair value) 3,200

Less fair value of identifiable net assets at acquisition:

Share capital 2,400
Reserves (10,600 – (2,000 × 9/12)) 9,100
Fair value adjustments (W5) 1,500
(13,000)
4,000
Less impairment losses (150)
3,850

3 Consolidated reserves

Portus Co Sanus
$’000 $’000
Per question 54,100 10,600
Fair value movement (W5) (390)
Provision for unrealised profit (W6)
Pre-acquisition reserves (10,600 – (2,000 × 9/12)) (9,100)

Group share of post-acq’n reserves:

Sanus Co ( × 80%)
Less impairment losses: Sanus Co (150 × 80%) (120)

4 Non-controlling interests
$’000
NCI at acquisition (W2) 3,200
NCI share of post-acquisition reserves ((W3) ( × 20%)
NCI share of impairment losses ((W2) 150 × 20%) (30)

5 Fair value adjustments

At acquisition date Movement At year end
$’000 $’000 $’000
Inventories 300 (300) ––
Plant and equipment 1,200 (90)* 1,110
1,500 (390) 1,110
*Extra depreciation $1,200,000 × 1/10 × 9/12
Take to Goodwill Take to COS Take to
& reserves SOFP

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6 Intragroup trading
(1) Cash in transit
$’000
DEBIT
CREDIT

(2) Cancel intragroup balances

$’000
DEBIT
CREDIT

(3) Eliminate unrealised profit

Sanus:
Profit element in inventories:
$’000
DEBIT
CREDIT

Solution
1

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7 Intra-group sale of property, plant and equipment

Group companies may sell items of property plant and equipment (PPE) from one group
company to another.

7.1 Accounting treatment

In their individual accounts, the companies will treat the sale of PPE just like a sale between
unconnected parties:
• The selling company will record a profit or loss on sale.
• 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.
However, the consolidated statement of financial position must show assets at their cost to the
group, and any depreciation charged must be based on that cost. Therefore, two consolidation
adjustments are required:
(a) An adjustment to alter retained earnings and non-current assets cost to remove unrealised
profit
(b) An adjustment to alter retained earnings and accumulated depreciation so that consolidated
depreciation is based on the asset’s cost to the group

7.2 Method
(a) Calculate the unrealised profit on the transfer of the item of property, plant and equipment
(PPE).
(b) Calculate the amount of this unrealised profit that has been depreciated by the year-end.
This is the ‘excess depreciation’ that must be added back to group PPE.
(c) Adjust for these amounts in your consolidation workings.

The double entry is as follows:

(a) Sale by parent to subsidiary
DEBIT Retained earnings (group’s column in retained earnings working)
CREDIT PPE
With the unrealised profit on disposal

DEBIT PPE
CREDIT Retained earnings (subsidiary’s column in retained earnings working)
With the excess depreciation
(b) Sale by subsidiary
DEBIT Retained earnings (subsidiary’s column in retained earnings working)
CREDIT PPE
With the unrealised profit on disposal

DEBIT PPE
CREDIT Retained earnings (group’s column in retained earnings working)
With the excess depreciation

Illustration 4: Intragroup sale of PPE

Percy Co owns 60% of the equity shares of Edmund Co, giving Percy Co control over Edmund Co.
On 1 January 20X1, Edmund Co sold a machine with a carrying amount of $10,000 to Percy Co
for $12,500.

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The reporting date of the group is 31 December 20X1 and the balances on the retained earnings of
Percy Co and Edmund Co at that date are:
$
Percy Co, after charging depreciation of 10% on the machine 27,000
Edmund Co, including profit on the sale of the machine to Percy Co 18,000

1 Required
Show the working for consolidated retained earnings.

Solution
1 The correct answer is:
Consolidated retained earnings
Percy Co Edmund Co
$ $
Per question 27,000 18,000
Disposal of plant
Profit (2,500)
Excess depreciation: 10% × $2,500 250
15,500
Share of Edmund Co: $15,500 × 60% 9,300
Retained earnings 36,550

Notes
1 The NCI in the retained earnings of Edmund Co is 40% × $15,500 = $6,200.
2 The profit on the transfer of $2,250 ($2,500 – $250) will be deducted from the carrying
amount of the machine to write it down to cost to the group.

Activity 6: Non-current asset transfer

Sanus Co sells plant with a remaining useful life of four years and a carrying amount of $120,000
to Portus Co for $200,000 on 1 October 20X4.
1 Required
Using the options below, select the correct entries for the journals to remove the unrealised profit
in the consolidated statement of financial position as at 31 December 20X4.

Debit Credit

Retained earnings

Property, plant and equipment

With the unrealised profit on disposal

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Debit Credit

Retained earnings

Property, plant and equipment

With the excess depreciation

Picklist options
• $5,000
• $20,000
• $60,000
• $75,000
• $80,000

Solution
1

Essential reading
Chapter 8 Section 4 of the Essential reading provides a further activity relating to the
consolidated statement of financial position.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

PER alert
One of the competences you require to fulfil Performance Objective 7 of the PER is the ability
to classify information in accordance with the requirements for external financial statements
or for inclusion in disclosure notes in the statements. You can apply the knowledge you obtain
from this chapter to help to demonstrate this competence.

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Chapter summary

The consolidated statement of financial position

Approach to the Goodwill

consolidated statement
of financial position

Basic procedure Calculation of goodwill Impairment of positive goodwill

• Combined on line by line basis $ For a wholly-owned subsidiary:
• Present as if group is single Consideration transferred X DEBIT Expenses (and reduce
entity Non-controlling interests X retained earnings)
Less fair value of net assets CREDIT Goodwill
at acquisition (X)
Standard approach
Goodwill X
• Establish group structure Fair value of consideration
• Enter proforma transferred
• Transfer figures from question • Measure at fair value:
Accounting treatment
to proforma – Assets transferred by
• Complete workings for • Positive purchased goodwill:
the parent
standard adjustments for – Intangible non-current asset
– Liabilities incurred by
– Goodwill – Test annually for impairment
the parent
– Non-controlling interests • Negative purchased goodwill: – Equity instruments issued
– Retained earnings and other – Reassess by the parent
reserves – Credit to profit or loss
• Deferred consideration:
– Other transactions per – Gain from a bargain
– Discount to present value
question purchase
• Contingent consideration:
• Transfer workings to proforma • Internally generated goodwill:
– Measure at fair value at
and complete – Do not recognise
acquisition
– Adjust goodwill if additional
info re facts at acquisition
date
– Any other change, do not
adjust equity and take
changes in liability to P/L

Fair values

Definition of fair value Fair value of subsidiary’s net assets at acquisition

Market-based measure (IFRS 13) • Identifiable
– Separable; or
– Arise from contractual or other legal rights
Measuring NCI at acquisition • Meet the Conceptual Framework's definitions of assets and liabilities
• At proportionate share of net • Detailed rules:
assets; or • Recognise identifiable net assets even if not in subsidiary's accounts eg
• At fair value – Intangible assets
– Contingent liabilities

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Pre- and post-acquisition Dividends paid

profits and other reserves by subsidiary

Pre- and post-acquisition profits • Dividends paid to NCI not

• Pre-acquisition reserves cancelled as not generated under parent's presented in consolidated
control statement of financial position
• Include group share of subsidiary's post-acquisition reserves • Dividends paid to parent
cancelled on consolidation

Other reserves
• Include in goodwill working
• Include parent + group share of subsidiary post-acquisition

Intragroup Unrealised profit on Transfer of

balances transfer of inventory non-current assets

IFRS 10 requirement Cost v NRV Carrying amount and

• Single entity concept • One group company sells depreciation
• Eliminate intragroup balances goods to another • If sale at a profit, profit is
• If goods still in inventory at the unrealised
year end: • Depreciation will be based on
Intragroup payables and – Internal profit: must be transfer value
receivables eliminated
• Arise from credit transactions – Inventory overstated: state at
between group companies lower of cost and NRV to the Method
• Eliminate them on group • Adjust profit in the selling
consolidation company
• Adjust depreciation in the
Method for eliminating receiving company
Reconciliation of intragroup unrealised profit • NCI takes share of any
balances • In the consolidated retained adjustment that impacts profit
• If balances do not agree, earnings working:
adjust for in transit items – Deduct the unrealised profit
• Push them forward to their from the sellers column
ultimate destination • When adding across inventory
of parent and subsidiary:
– Deduct the unrealised profit
Method • If the subsidiary is the seller,
(1) Account for items in transit adjustment is required in NCI
• Cash: DEBIT working
CREDIT
• Goods: DEBIT
CREDIT
(2) Eliminate intragroup payable
and receivable
DEBIT Intragroup payable
CREDIT Intragroup receivable

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Knowledge diagnostic
1. Approach to the consolidated statement of financial position
Consolidated financial statements should show the financial information of the group as if it was
a single entity. BPP recommends following a methodical step by step approach. You need to
practice preparing consolidated financial statements in the exam software. Remember to show all
workings.

2. Goodwill
Positive goodwill is capitalised and tested annually for impairment. ‘Negative’ goodwill (once
reassessed to ensure it is accurate) is recognised as a bargain purchase in profit or loss.
The consideration transferred comprises any assets or equity transferred at the date of
acquisition, less any liabilities incurred, deferred consideration and any contingent consideration.

3. Fair values
Non-controlling interests at acquisition can be measured either at their fair value (full goodwill
method) or at their proportionate share (partial goodwill method) of the fair value of the
acquiree’s identifiable net assets.
The fair value of the assets acquired and liabilities assumed must be recognised at fair value at
the date of acquisition. Internally generated intangible assets and contingent liabilities not
recognised in the individual financial statements of the subsidiary are recognised on acquisition,
provided criteria satisfied.

4. Pre- and post-acquisition profits and other reserves

Pre-acquisition profits of the subsidiary are included in the reserves (net assets) of the subsidiary
at the date of acquisition.
Post-acquisition profits of the subsidiary are included in the consolidated financial statements.
Reserves other than retained earnings (eg revaluation reserve) should be treated in the same way
as retained earnings.

5. Dividends paid by the subsidiary

Dividends paid to the NCI are not shown in the consolidated statement of financial position.
Dividends paid to the parent company are cancelled on consolidation.

6. Intragroup trading
In the consolidated accounts (only), items in transit must be accounted for and intragroup
balances cancelled.

7. Inventories sold at a profit

Where inventories that are sold intragroup have not been sold onto a third party, the unrealised
profit must be eliminated in the group financial statements.

8. Transfer of property, plant and equipment

A similar adjustment must be made to eliminate unrealised profit remaining on intragroup
transfers of property, plant and equipment.

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
9 Barcelona Co and Madrid Co
10 Reprise Group
14 Highveldt Co

Further reading
There is a useful article written by the examining team on the calculation of goodwill, which can
be found on the ACCA website.
The use of fair values in the goodwill calculation
www.accaglobal.com

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Activity answers

Activity 1: Basic goodwill calculation

1 The correct answer is:
$ $
Consideration transferred 80,000
Non-controlling interest 12,500
Net assets acquired as represented by:
Ordinary share capital 50,000
Retained earnings on acquisition 10,000
(60,000)
Goodwill 32,500

SING CO
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 20X5
$
Assets
Non-current assets
Goodwill arising on consolidation (W) 32,500
Current assets (40,000 + 60,000) 100,000
Total assets 132,500
Equity and liabilities
Ordinary shares 75,000
Retained earnings 45,000
Non-controlling interests 12,500
Total equity and liabilities 132,500

Activity 2: Consideration
1 The correct answer is:
$360,750
$
Cash 250,000
Deferred consideration (88,200 × (1/1.052)) 80,000
Contingent consideration 30,750
360,750

2 The correct answer is:

$735,000
Shares in ABC (300,000/3 × $7.35) $735,000

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Activity 3: Fair values

1 The correct answer is:
PORTUS GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4
$’000
Non-current assets
Property, plant and equipment (56,600 + 16,200 + 1,110 (W5)) 73,910
Goodwill (W2) 3,850
77,760
Current assets
Inventories (2,900 + 1,200) 4,100
Trade receivables (3,300 + 1,100) 4,400
Cash (1,700 + 100) 1,800
10,300
88,060
Equity attributable to owners of the parent
Share capital ($1 shares) 8,000
Reserves (W3) 54,868
62,868
Non-controlling interests (W4) 3,392
66,260
Non-current liabilities
Long-term borrowings (13,200 + 4,800) 18,000
Current liabilities
Trade and other payables (3,000 + 800) 3,800
88,060

Workings
1 Group structure
Portus Co

1.4.X4
80%
Cost $13.8m

Sanus
Pre-acq'n reserves $9.1m
($10.6m – ($2.0m × 9/12))
or ($10.6m – $2.0m + ($2.0 × 3/12))

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2 Goodwill
$’000 $’000
Consideration transferred 13,800
Non-controlling interests (at fair value) 3,200
Less fair value of identifiable net assets at
acquisition:
Share capital 2,400
Reserves (10,600 – (2,000 × 9/12)) 9,100
Fair value adjustments (W5) 1,500
(13,000)
4,000
Less impairment losses (150)
3,850

3 Consolidated reserves
Portus Co Sanus Co
$’000 $’000
Per question 54,100 10,600
Fair value movement (W5) (390)
Pre-acquisition reserves (10,600 – (2,000 × 9/12)) (9,100)
1,110
Group share of post-acq’n reserves:
Sanus Co (1,110 × 80%) 888
Less impairment losses: Sanus Co (150 × 80%) (120)
54,868

4 Non-controlling interests
$’000
NCI at acquisition (W2) 3,200
NCI share of post-acquisition reserves ((W3) 1,110 × 20%) 222
NCI share of impairment losses ((W2) 150 × 20%) (30)

5 Fair value adjustments

At acquisition Movement At year end
date
$’000 $’000 $’000
Inventories 300 (300) ––
Plant and equipment 1,200 (90)* 1,110
1,500 (390) 1,110
Take to Goodwill Take to Take to SOFP
CoS/reserves
*Extra depreciation $1,200,000 × 1/10 × 9/12

2 The correct answer is:

1 Goodwill
$’000 $’000
Consideration transferred 13,800
Non-controlling interests (at %FVNA) (13,000 × 20%) 2,600

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$’000 $’000
Less fair value of identifiable net assets at
acquisition:
Share capital 2,400
Reserves (10,600 – (2,000 × 9/12)) 9,100
Fair value adjustments (W5) 1,500
(13,000)
3,400
Less impairment losses (150 × 80%) (120)
3,280

2 Non-controlling interests
$’000
NCI at acquisition (W2) 2,600
NCI share of post-acquisition reserves ((W3) 1,110 × 20%) 222
NCI share of impairment losses (0)
2,822

3 The correct answer is:

Where the goodwill calculation results in a negative figure (ie where the fair value of net assets at
acquisition exceeds the consideration paid and value attributed to non-controlling interests), the
full amount is treated as a ‘bargain purchase’. It is credited directly to profit or loss (and retained
earnings) attributable to the parent. There is no non-controlling interest effect.
This situation could arise for several reasons:
(a) The seller needed to make a quick/forced sale (eg due to liquidity or regulatory reasons)
resulting in a bargain purchase of the net assets at less than their fair value.
(b) An expectation that losses will be made lowering the value of the net assets acquired before
the business can be turned around.
(c) An expectation that the business will need to be broken up and sold off with significant break-
up costs.
(d) The existence of liabilities that did not meet the recognition criteria for recognition in the fair
value of the net assets acquired (for this reason, IFRS 3 actually requires a review of the
calculations of net assets acquired to ensure no contingent liabilities that can be recognised
have been missed before a credit is allowed to be made to profit or loss).

Activity 4: Other reserves

1 The correct answer is:
PORTUS GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4
(EXTRACT)
$’000
Equity attributable to owners of the parent
Share capital ($1 shares) 8,000
Retained earnings (W1) 43,228
Revaluation surplus (W2) 11,640

Non-controlling interests (W3) 3,392

66,260

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Workings
1 Consolidated retained earnings
Portus Co Sanus Co
$’000 $’000
Per question 42,700 9,000
Fair value movement (W5) (390)
Pre-acquisition retained earnings (7,800)
810
Group share of post-acq’n retained earnings:
Sanus Co (810 × 80%) 648
Less impairment losses: Sanus Co (150 × 80%) (120)
43,228

2 Consolidated revaluation surplus

Portus Co Sanus Co
$’000 $’000
Per question 11,400 1,600
Pre-acquisition revaluation surplus (1,300)
300

Group share of post-acq’n revaluation surplus:

Sanus Co (300 × 80%) 240
11,640

3 Non-controlling interests
$’000
NCI at acquisition (LE1(a) (W2)) 3,200
NCI share of post-acquisition retained earnings ((W1) (810 × 20%)) 162
NCI share of post-acquisition revaluation surplus ((W2) (300 × 20%)) 60
NCI share of impairment losses (Activity 1(a) (W2) 150 × 20%) (30)
3,392

Activity 5: Sale of inventory at a profit

1 The correct answer is:
PORTUS GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4
$’000
Non-current assets
Property, plant and equipment (56,600 + 16,200 + (W5) 1,110) 73,910
Goodwill (W2) 3,850
77,760
Current assets
Inventories (2,900 + 1,200 – (W6) 80) 4,020
Trade receivables (3,300 + 1,100 – (W6) 70 – (W6) 130) 4,200
Cash (1,700 + 100 + (W6) 70) 1,870
10,090
87,850

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$’000
Equity attributable to owners of the parent
Share capital ($1 shares) 8,000
Reserves (W3) 54,804
62,804
Non-controlling interests (W4) 3,376
66,180
Non-current liabilities
Long-term borrowings (13,200 + 4,800) 18,000
Current liabilities
Trade and other payables (3,000 + 800 – (W6) 130) 3,670
87,850

Workings
1 Group structure
Portus Co

1.4.X4
80%
Cost $13.8m

Sanus
Pre-acq'n reserves $9.1m
($10.6m – ($2.0m × 9/12))
or ($10.6m – $2.0m + ($2.0 × 3/12))

2 Goodwill
$’000 $’000
Consideration transferred 13,800
Non-controlling interests (at fair value) 3,200

Less fair value of identifiable net assets at acquisition:

Share capital 2,400
Reserves (10,600 – (2,000 × 9/12)) 9,100
Fair value adjustments (W5) 1,500
(13,000)
4,000
Less impairment losses (150)
3,850

3 Consolidated reserves

Portus Co Sanus Co
$’000 $’000
Per question 54,100 10,600
Fair value movement (W5) (390)
Provision for unrealised profit (W6) (80)
Pre-acquisition reserves (10,600 – (2,000 × 9/12)) (9,100)
1,030

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Portus Co Sanus Co
$’000 $’000
Group share of post-acq’n reserves:
Sanus Co (1,030 × 80%) 824
Less impairment losses: Sanus Co (150 × 80%) (120)
54,804

4 Non-controlling interests
$’000
NCI at acquisition (W2) 3,200
NCI share of post-acquisition reserves ((W3) 1,030 × 20%) 206
NCI share of impairment losses ((W2) 150 × 20%) (30)
3,376

5 Fair value adjustments

At acquisition Movement At year end
date
$’000 $’000 $’000
Inventories 300 (300) ––
Plant and equipment 1,200 (90)* 1,110
1,500 (390) 1,110
*Extra depreciation $1,200,000 × 1/10 × 9/12
Take to Take to COS Take to SOFP
Goodwill & reserves

6 Intragroup trading
(1) Cash in transit
$’000 $’000
DEBIT Group cash 70
CREDIT Trade receivables 70

(2) Cancel intragroup balances

$’000 $’000
DEBIT Group payables 130
CREDIT Group receivables 130

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(3) Eliminate unrealised profit

Sanus Co:
Profit element in inventories: $200,000 × 40% = $80,000
$’000 $’000
DEBIT Cost of sales (& reserves) (of Sanus Co the seller) 80
CREDIT Group inventories 80

Activity 6: Non-current asset transfer

1 The correct answer is:
Working: Unrealised profit
$
Profit on transfer (200 – 120) 80,000
Excess depreciation (80 × 3/12 × ¼) 5,000

Therefore, adjustment required:

Debit Credit

Retained earnings $80,000

Property, plant and equipment $80,000

With the unrealised profit on disposal

Debit Credit

Retained earnings $5,000

Property, plant and equipment $5,000

With the excess depreciation

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The consolidated statement

9 of profit or loss and other
comprehensive income
9

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Prepare a consolidated statement of profit or D2(b)

loss and consolidated statement of profit or
loss and other comprehensive income for a
simple group dealing with an acquisition in the
period and non-controlling interest.

Account for the effects in the financial D2(d)

statements of intra-group trading.

Explain the need for using coterminous year- A4(f)

ends and uniform accounting polices when
preparing consolidated financial statements.

Explain and illustrate the effect of the disposal D2(h)

of a parent’s investment in a subsidiary in the
parent’s individual financial statements and/or
those of the group (restricted to disposals of
the parent’s entire investment in the
subsidiary).
9

Exam context
The group accounting question in Section C of the ACCA Financial Reporting (FR) exam may ask
you to prepare and/or interpret a consolidated statement of profit or loss and other
comprehensive income (SPLOCI). This chapter builds on the knowledge gained in Chapters 7 and
8, focusing on the inclusion of a subsidiary in the group financial statements. As with Chapter 8, it
is important that you develop an approach to preparing the SPLOCI and that you can apply that
approach efficiently in an exam question.
9

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Chapter overview
The consolidated statement of profit or loss and other comprehensive income (SPLOCI)

Approach to the consolidated statement of profit or loss Intragroup

and other comprehensive income (SPLOCI) trading

Aim of the consolidated SPLOCI Issue

Allocation of profit and other comprehensive income  Method

Basic procedure

Mid year acquisitions

Impairment

Dividends paid to subsidiary

Intragroup loans Disposal of

and interest subsidiary

Issue Control boundary

Method Approach to full disposal

Calculation of profit or loss on disposal

(in consolidated accounts)

Calculation of profit or loss on disposal in

parent's separate financial statements

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1 Approach to the consolidated statement of profit or loss

and other comprehensive income (SPLOCI)
1.1 Aim of the consolidated SPLOCI
The aim of the consolidated SPLOCI is to show the results of the group for an accounting period
as if it were a single economic entity. The same logic is used as for the statement of financial
position, ie all income and expenses controlled by the parent are reported in the consolidated
statement of profit or loss and other comprehensive income.

1.2 Allocation of profit and other comprehensive income

Non-controlling interest needs to be allocated its share of profit for the year and total
comprehensive income for the year as follows:
Revenue

Add all of P + 100% S as represents what is controlled

Profit for the year (PFY)
Other comprehensive income
Total comprehensive income (TCI)

Profit for the year attributable to:

Owners of parent β – balancing figure
NCI S's PFY × NCI%
Ownership reconciliation
Total comprehensive income for the year attributable to:
Owners of parent β – balancing figure
NCI S's TCI × NCI%

A working is required to calculate non-controlling interests in profit and total comprehensive

income for the year:
Total
comprehensive
Profit for the year income for the year
(PFY) (TCI)

$ $
S’s PFY/S’s TCI per the question X X
Consolidation adjustments affecting the subsidiary’s
profit:
• Impairment loss on goodwill for the year (Non- (X) (X)
controlling interest (NCI) is measured at fair value at
acquisition)
• Provision for unrealised profit (if the subsidiary is the (X) (X)
seller)
• Interest on intragroup loans (X)/X (X)/X
• Fair value adjustments – movement in the year (X)/X (X)/X
A B
NCI share NCI % × A NCI % × B

These materials are ofprovided

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1.3 Basic procedure

Step Procedure/exam technique

Step 1 Read the question and create a short note in your blank spreadsheet
workspace, or in the scratch pad, which shows:
• The group structure
- The percentage owned
- Acquisition date
- Pre- and post-acquisition profits
• Remember if the subsidiary was acquired during the year it may be
useful to create a quick timeline (Section 1.5)

Step 2 Enter a proforma SPLOCI in your spreadsheet workspace.

• Remember to add lines for the NCI in profit it in the year and NCI in total
comprehensive income reconciliations at the foot of the statement.

Step 3 Transfer figures from the parent and subsidiary financial statements to the
proforma:
• 100% of all income/expenses (or if acquired in the year, time apportioned
if appropriate)
• Exclude dividends from subsidiary (Section 1.7)

Step 4 Go through question, calculating the necessary adjustments to profit for the
year in respect of:
• Intragroup trading (Section 2)
• Intragroup loans and interest (Section 3)
• Fair value adjustments (Essential reading Chapter 9, available in the
digital edition of the Workbook)
• Remember to make the adjustments in the NCI working where the
subsidiary’s profit is affected

Step 5 Complete NCI in subsidiary’s PFY and TCI calculation (Section 1.2).

1.4 Mid‑year acquisitions

Simply include results in the normal way but only from date of acquisition ie time apportion them
as appropriate. Assume revenue and expenses accrue evenly unless told otherwise.

Essential reading
Chapter 9, Section 1 of the Essential reading provides further detail and an Activity on the pre-
and post-acquisition profits.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

1.5 Impairment losses

Only impairment losses arising in the current year are reported in the consolidated statement of
profit or loss and other comprehensive income (while cumulative impairment losses to date are
reported in the statement of financial position).

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1.6 Intragroup dividends

If the parent has some dividend income from the subsidiary in its SPLOCI, this must be cancelled
on consolidation for the following reasons:
• It is showing the legal form (the parent owns shares in the subsidiary and earns dividends from
the shares) rather than the substance (the parent controls the subsidiary’s income, expenses
and OCI) so dividend income is replaced by adding across the subsidiary’s results line by line.
This is similar to the cancellation of the investment in the subsidiary when preparing the
consolidated statement of financial position.
• The aim of the consolidated SPLOCI is to show the group as a single entity. Therefore,
intragroup transactions must be cancelled. Dividends paid are reported as a deduction to
retained earnings in the statement of changes in equity (SOCIE). Therefore, the dividend
income in the parent’s SPLOCI is cancelled with the deduction in retained earnings in the
subsidiary’s SOCIE.

Activity 1: Basic consolidated statement of profit or loss.

The statements of profit or loss and other comprehensive income of Portus Co and its subsidiary
Sanus Co for the year ended 31 December 20X4 are as follows:
Portus Co Sanus Co
$’000 $’000
Revenue 28,500 11,800
Cost of sales (17,100) (7,000)
Gross profit 11,400 4,800
Expenses (4,400) (2,200)
Finance costs (400) (200)
Profit before tax 6,600 2,400
Income tax expense (2,100) (800)
PROFIT FOR THE YEAR 4,500 1,600
Other comprehensive income:
Gains on property revaluation 900 400
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 5,400 2,000

Note. On 1 April 20X4, Portus Co purchased an 80% holding in Sanus Co for $13.8 million in cash.
Sanus’s total comprehensive income for the year ended 31 December 20X4 was $2.0 million,
accruing evenly over the year. Sanus Co did not pay any dividends in the year. Portus Co paid
dividends of $3 million in the year.
1 Required
Using the proformas provided, prepare the consolidated statement of profit or loss and other
comprehensive income for the Portus Group for the year ended 31 December 20X4 (excluding
consolidation adjustments).

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PORTUS GROUP
CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR
THE YEAR ENDED 31 DECEMBER 20X4
$’000
Revenue
Cost of sales
Gross profit
Expenses
Finance costs
Profit before tax
Income tax expense
PROFIT FOR THE YEAR
Other comprehensive income:
Gains on property revaluation
Other comprehensive income for the year
TOTAL COMPREHENSIVE INCOME FOR THE YEAR

Profit attributable to:

Owners of the parent
Non-controlling interests (W2)

Total comprehensive income attributable to:

Owners of the parent
Non-controlling interests (W2)

Workings
1 Group structure
2 Non-controlling interests (SPLOCI)
Profit for the Total comp
year income
$’000 $’000
PFY/TCI per question
× % × %

Solution
1

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2 Intragroup trading
2.1 Issue
There are two issues caused by intragroup trading to address in the consolidated SPLOCI.
Consider the following:

Example

3rd party
supplier

Supplier sells goods

to P for $1,600

P sells goods on to S
80% for $2,000, making a
profit of $400

S holds inventories of
S
$2,000 at the year end

After this transaction, the individual company and consolidated statements of profit or loss
(before cancellation of intragroup trading) look like this:
P S Consolidated
$ $ $ $ $ $
Revenue 2,000 – 2,000
Cost of sales:
Opening inventory – – –
Purchases 1,600 2,000 3,600
Closing inventory (–) (2,000) (2,000)

(1,600) (–) (1,600)

Gross profit 400 – 400

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The two issues are:

(a) Intragroup revenue and cost of sales
When considering the group as if it were a single entity, intragroup trading represents
transactions which the group undertakes with itself. These have to be eliminated in the
consolidated SPLOCI. In this Illustration, the intragroup revenue of $2,000 and intragroup
purchase of $2,000 (in cost of sales) must be eliminated.
(b) Unrealised profit
The value of inventories in consolidated cost of sales also needs to be adjusted to ensure that
it represents the cost to the group. As closing inventory is a deduction from cost of sales,
unrealised profit is eliminated from inventory by increasing cost of sales. In this Illustration,
closing inventory must be reduced from $2,000 to the $1,600 cost to the group by increasing
cost of sales by $400. Increasing cost of sales reduces the gross profit, thereby successfully
removing the unrealised profit.
After these adjustments, the consolidated statement of profit or loss is now as follows:

P S Adj Consolidated
$ $ $ $ $ $ $
Revenue 2,000 – (2,000) –
Cost of sales:
Opening inventory – – –
Purchases 1,600 2,000 (2,000) 1,600
Closing inventory (–) (2,000) 400 (1,600)

(1,600) (–) (–)

Gross profit 400 – –

Note. The intragroup revenue and purchase of $2,000 have been eliminated leaving the $1,600
purchase from the third-party supplier. Closing inventory has been reduced to the cost to the
group of $1,600 and the unrealised profit of $400 has been eliminated.

2.2 Method
There are two potential adjustments needed when group companies trade with each other:

2.2.1 Eliminate intragroup transactions

Intragroup transactions need to be eliminated from the revenue and cost of sales figures:
DEBIT Group revenue X
CREDIT Group cost of sales X

With the total amount of the intragroup sales between the companies. This adjustment is needed
regardless of whether any of the goods are still in inventories at the year end or not.

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2.2.2 Eliminate unrealised profit

An adjustment is required to cancel any unrealised profit in respect of any goods still in inventories
at the year end:
DEBIT Cost of sales (SOPL)/Retained earnings X (PUP)
CREDIT Inventories (SOFP) X (PUP)

An adjustment will also need to be made in the NCI calculation if it is the subsidiary that makes
the sale.

Activity 2: Unrealised profit

Continuing from the previous example, the statements of profit or loss and other comprehensive
income of Portus Co and its subsidiary, Sanus Co, for the year ended 31 December 20X4 are as
follows:
Portus Co Sanus Co
$’000 $’000
Revenue 28,500 11,800
Cost of sales (17,100) (7,000)
Gross profit 11,400 4,800
Expenses (4,400) (2,200)
Finance costs (400) (200)
Profit before tax 6,600 2,400
Income tax expense (2,100) (800)
PROFIT FOR THE YEAR 4,500 1,600
Other comprehensive income:
Gains on property revaluation 900 400
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 5,400 2,000

Notes
(a) On 1 April 20X4 Portus Co purchased an 80% holding in Sanus Co for $13.8 million in cash.
Sanus’s total comprehensive income for the year ended 31 December 20X4 was $2.0 million,
accruing evenly over the year. Sanus Co did not pay any dividends in the year. Portus Co
paid dividends of $3 million in the year.
(b) At the date of acquisition, the fair value of Sanus’s assets were equal to their carrying
amounts with the exception of the items listed below which exceeded their carrying amounts
as follows:
$’000
Inventories 300
Plant and equipment (10-year remaining useful life) 1,200
1,500

Sanus Co has not adjusted the carrying amounts as a result of the fair value exercise. The
inventories were sold by Sanus Co before the year end.
(c) The NCI in Sanus Co is to be valued at its fair value of $3.2 million at the date of acquisition.
An impairment test conducted at the year-end revealed that the consolidated goodwill of
Sanus Co was impaired by $150,000.
(d) On 1 October 20X4, Sanus Co sold goods to Portus Co for $200,000 at a gross profit margin
of 40%. The goods were still in Portus Co’s inventories at the year end. No other sales were
made between Portus Co and Sanus Co in the year.
At 31 December 20X4, Portus Co’s current account with Sanus Co was $130,000 (credit). This
did not agree with the equivalent balance in Sanus’s books due to cash in transit of $70,000
which was not received by Sanus Co until after the year end.

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1 Required
Prepare the consolidated statement of profit or loss and other comprehensive income for the
Portus Group for the year ended 31 December 20X4.

PORTUS GROUP
CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR
THE YEAR ENDED 31 DECEMBER 20X4
$’000
Revenue
Cost of sales
Gross profit
Expenses
Finance costs
Profit before tax
Income tax expense
PROFIT FOR THE YEAR
Other comprehensive income:
Gains on property revaluation
Other comprehensive income for the year
TOTAL COMPREHENSIVE INCOME FOR THE YEAR

Profit attributable to:

Owners of the parent
NCI (W2)

Total comprehensive income attributable to:

Owners of the parent
NCI (W2)

Workings
1 Group structure
1.1.X4 1.4.X4 1.7.X4 31.12.X4

Portus Co – all year

Sanus Co – Income & expenses & 20% NCI × 9/12

2 Non-controlling interests (SPLOCI)

Profit for the year Total comp income
$’000 $’000
PFY/TCI per question
Less impairment losses
Less fair value movement (W3)
Less unrealised profit (W4)

× 20% × 20%

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3 Fair value adjustments

At acquisition date Movement At year end
$’000 $’000 $’000
Inventories –
Plant and equipment

Goodwill COS & SOFP

reserves

4 Intragroup trading
(1) Cancel intragroup trading
$’000 $’000
DEBIT
CREDIT

(2) Eliminate unrealised profit

Sanus:
Profit element in inventories:
$’000 $’000
DEBIT
CREDIT

2 Required
Explain how the statement of profit or loss and other comprehensive income would differ if Portus
Co had sold the goods in Note (d) to Sanus.

Solution
1

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3 Intragroup loans and interest

3.1 Issue
It is common for a parent to advance a loan at a preferential interest rate to a subsidiary.
Similarly, a loan may be made by a cash-rich subsidiary to its parent.
These items are intragroup borrowings which do not represent additional finance or finance costs
from the group point of view, and must therefore be eliminated on consolidation.

3.2 Method
3.2.1 Cancel the loan in the consolidated statement of financial position
Adjustment is required to cancel the loans in the consolidated statement of financial position:
The loan balance will be a receivable in the statement of financial position of the provider of the
loan and a payable to the recipient of the loan. The balances need to be cancelled in the
consolidated statement of financial position:
DEBIT Loan payable
CREDIT Loan receivable

3.2.2 Cancel the finance cost and finance income in the consolidated statement of profit or
loss and other comprehensive income
The provider of the loan will present finance income in its statement of profit or loss and the
recipient of the loan will show a finance cost. This is an intragroup income and expense which
must be cancelled in the consolidated statement of profit or loss and other comprehensive
income:
DEBIT Group finance income
CREDIT Group finance costs

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Example
P acquired 100% of S on its incorporation. On the same date, P made a fixed rate 4% loan to S.
The loan has not been repaid at the year end:
STATEMENTS OF FINANCIAL POSITION
P S Consolidated
$’000 $’000 $’000
Non-current assets
Property, plant and equipment 6,200 3,050 9,250
Investment in S 1,000 – –
4% loan to S 400 – –
7,600 3,050 9,250
Current assets 1,350 850 2,200
8,950 3,900 11,450

Equity
Share capital 800 1,000 800
Retained earnings 6,900 1,800 8,700
7,700 2,800 9,500
Non-current liabilities
Bank loan 200 – 200
4% loan from P – 400 –
200 400 200
Current liabilities 1,050 700 1,750
8,950 3,900 11,450

STATEMENT OF PROFIT OR LOSS

$’000 $’000 $’000
Revenue 2,200 1,100 3,300
Cost of sales and expenses (1,540) (770) (2,310)
Profit before interest and tax 660 330 990
Finance income (from S) 16 – –
Finance costs (20) (16) (20)
Profit before tax 656 314 970
Income tax expense (196) (94) (290)
PROFIT FOR THE YEAR 460 220 680

4 Disposal of a subsidiary

Exam focus point

You will not be expected to prepare a consolidated statement of profit of loss containing the
disposal of a subsidiary in Section C of the ACCA Financial Reporting exam. It may however
be asked as an objective test question in Section A or B.

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4.1 Control boundary

When a parent sells its interest in a subsidiary, the control boundary is passed:
0% (20%) (50%) 100%

SIG INFLUENCE

CONTROL
0% 80%

4.2 Approach to full disposal

Statement of profit or loss and OCI Statement of financial position

• Consolidate results and NCI to • No consolidation (and no NCI) as
date of disposal no subsidiary at year end
• Show profit or loss on disposal

4.3 Calculation of profit or loss on disposal (in consolidated accounts)

$ $
Fair value of consideration received X
Less share of consolidated carrying amount at date control lost:
Net assets X
X
Goodwill

Less NCI (X)

(X)
Group profit/(loss) X/(X)

If the profit or loss is significant, the profit or loss should be disclosed separately (IAS 1
Presentation of Financial Statements).

4.4 Calculation of profit or loss on disposal in parent’s separate financial

statements
In the parent’s separate financial statements, investments in subsidiaries are held at cost or at fair
value under IFRS 9 Financial Instruments. Consequently, the profit or loss on disposal is different:
$
Fair value of consideration received X
Less carrying amount of investment disposed of (X)
Profit/(loss) X/(X)

Activity 3: Disposal of subsidiary

Pelmer Co acquired 80% of Symta Co’s 100,000 $1 shares on 1 January 20X2 for $600,000 when
the reserves of Symta Co were $410,000. Symta Co had a brand name valued at $50,000 which
was recognised on acquisition. It is group policy to measure non-controlling interests at fair value
at acquisition. The fair value of the non-controlling interests in Symta Co at acquisition was
$150,000. No impairment has been necessary.

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On 1 June 20X6, Pelmer Co disposed of its shareholding for $1,500,000. At that date, Symta Co’s
reserves were $710,000 and it had net assets with a carrying amount of $650,000. The value of
the brand name has not changed since acquisition.
Required
What is the group profit or loss on disposal of Symta Co to be shown in the consolidated accounts
for the year ended 31 December 20X6?
 $500,000
 $550,000
 $700,000
 $800,000

Solution

Essential reading
Chapter 9, Section 2 of the Essential reading contains a further activity relating to the disposal of
a subsidiary.
Chapter 9, Section 3 of the Essential reading considers the impact of fair value adjustments on the
consolidated statement of profit or loss.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

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Chapter summary

The consolidated statement of profit or loss and other comprehensive income (SPLOCI)

Approach to the consolidated statement of profit or loss Intragroup

and other comprehensive income (SPLOCI) trading

Aim of the consolidated SPLOCI Issue

Show group as a single entity • Treat group as if it were a
single entity
• Eliminate intragroup trading
Allocation of profit and other comprehensive income  and unrealised profit
Non-controlling interests (NCI)
Working:
Method
PFY TCI
$ $ • Eliminate intragroup revenue
Per question X X and cost of sales
DEBIT (↓) Group revenue
CREDIT (↓) Group cost for
profit:
sales
Impairment loss on goodwill for year (if NCI at fair
for all intragroup trading in
value at acq’n) (X) (X)
the year
Provision for unrealised profit (if sub is the seller) (X) (X)
• Eliminate unrealised profit on
Interest on intra group loans (X)/X (X)/X
goods still in inventory at the
Fair value adjustments – movement in the year (X)/X (X)/X year end
A B DEBIT (↑) Cost of sales
NCI share NCI % A NCI % B CREDIT (↓) Inventories

Basic procedure
• Draw up group structure, % ownership, date of acquisition
• Create proforma
• Transfer parent and 100% sub to proform (pro-rate mid year)
• Adjust for intragroup trading, loans, fair value adjustments
• Complete NCI calculations

Mid year acquisitions

Include results from date of acquisition

Impairment
Only current year impairment losses included

Dividends paid to subsidiary

• Dividends paid to the parent are eliminated on consolidation
• Remove dividend income and reinstate subsidiary retained earnings

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Intragroup loans Disposal of

and interest subsidiary

Issue Control boundary

• Intragroup borrowings do not Full disposal of subsidiary means parent no longer has control or
represent: significant influence
– Amounts owed/owing
– Additional finance
income/expense Approach to full disposal
– From a group perspective • SPLOCI – include results up to disposal and profit/loss on disposal
• SFP – no consolidation as no subsidiary at year end

Method
• Cancel the loan Calculation of profit or loss on disposal (in consolidated accounts)
DEBIT (↓) Loan payable Fair value of consideration received X
CREDIT (↓) Loan receivable Less share of consolidated carrying amount at date
• Eliminate the interest control lost:
DEBIT (↓) Finance income Net assets X
CREDIT (↓) Finance expense Goodwill X
Less NCI (X)
(X)
Group profit/(loss) X/(X)

Calculation of profit or loss on disposal in parent's separate financial

statements
Fair value of consideration received X
Less carrying amount of investment disposed of (X)
Profit/(loss) X/(X)

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Knowledge diagnostic
1. Approach to the consolidated statement of profit or loss and other comprehensive income
The purpose of the consolidated statement of profit or loss and other comprehensive income is to
show the results of the group as a single business entity.
Where an acquisition occurs part way through an accounting period, income and expenses are
only consolidated for the number of months that the subsidiary is controlled by the parent.

2. Intragroup trading
In order not to overstate group revenue and costs, intragroup trading is cancelled. Similarly,
unrealised profits on intragroup trading are eliminated.

3. Intragroup loans and interest

Intragroup loans and interest must be cancelled as the group is treated as a single business entity
and cannot lend money to itself.

4. Disposals
When a disposal occurs where control is lost, the subsidiary is derecognised in the group financial
statements and a gain/loss on disposal is calculated, being the difference between the fair value
of the consideration received plus the fair value of any remaining investment less the consolidated
share of the subsidiary disposed.
In the consolidated statement of profit or loss and other comprehensive income, the subsidiary is
consolidated for the period up to the disposal.

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Further study guidance

Question practice
You should attempt the following questions from the Further question practice (available in the
digital edition of the Workbook):
11 Fallowfield Co and Rusholme Co
12 Panther Group

Further reading
You should make time to read this article, which is available in the study support resources section
of the ACCA website:
The use of fair values in the goodwill calculation
www.accaglobal.com

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Activity answers

Activity 1: Basic consolidated statement of profit or loss.

1 The correct answer is:
PORTUS GROUP
CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR
THE YEAR ENDED 31 DECEMBER 20X4
$’000
Revenue (28,500 + (11,800 × 9/12)) 37,350
Cost of sales (17,100 + (7,000 × 9/12)) (22,350)
Gross profit 15,000
Expenses (4,400 + (2,200 × 9/12)) (6,050)
Finance costs (400 + (200 × 9/12)) (550)
Profit before tax 8,400
Income tax expense (2,100 + (800 × 9/12)) (2,700)
PROFIT FOR THE YEAR 5,700
Other comprehensive income:
Gains on property revaluation (900 + (400 × 9/12)) 1,200
Other comprehensive income for the year 1,200
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 6,900

Profit attributable to:

Owners of the parent 5,460
Non-controlling interests (W2) 240
5,700
Total comprehensive income attributable to:
Owners of the parent 6,600
Non-controlling interests (W2) 300
6,900

Workings
1 Group structure
1.1.X4 1.4.X4 1.7.X4 31.12.X4

Portus Co – all year

Sanus Co – Income & expenses & 20% NCI × 9/12

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2 Non-controlling interests (SPLOCI)

Profit for Total comp
the year income
$’000 $’000
PFY/TCI per question (1,600 × 9/12)/(2,000 × 9/12) 1,200 1,500
× 20% × 20%
240 300

Activity 2: Unrealised profit

1 The correct answer is:
PORTUS GROUP
CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR
THE YEAR ENDED 31 DECEMBER 20X4
$’000
Revenue (28,500 + (11,800 × 9/12) – (W4) 200) 37,150
Cost of sales (17,100 + (7,000 × 9/12) + (W3) 390 – (W4) 200 + (W4) 80) (22,620)
Gross profit 14,530
Expenses (4,400 + (2,200 × 9/12) + (150 per question) (6,200)
Finance costs (400 + (200 × 9/12)) (550)
Profit before tax 7,780
Income tax expense (2,100 + (800 × 9/12)) (2,700)
PROFIT FOR THE YEAR 5,080
Other comprehensive income:
Gains on property revaluation (900 + (400 × 9/12)) 1,200
Other comprehensive income for the year 1,200
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 6,280
Profit attributable to:
Owners of the parent (β) 4,964
NCI (W2) 116
5,080
Total comprehensive income attributable to:
Owners of the parent (β) 6,104
NCI (W2) 176
6,280

Workings
1 Group structure
1.1.X4 1.4.X4 1.7.X4 31.12.X4

Portus Co – all year

Sanus Co – Income & expenses & 20% NCI × 9/12

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2 Non-controlling interests (SPLOCI)

Profit for the Total comp

year income
$’000 $’000
PFY/TCI per question (1,600 × 9/12)/(2,000 × 9/12) 1,200 1,500
Less impairment losses (per question) (150) (150)
Less fair value movement (W3) (390) (390)
Less unrealised profit (W4) (80) (80)
580 880
× 20% × 20%
116 176

3 Fair value adjustments

At acquisition date Movement At year end
$’000 $’000 $’000
Inventories 300 (300) ––
Plant and equipment 1,200 (90)* 1,110
1,500 (390) 1,110
Take to Goodwill Take to COS Take to SOFP
& reserves
*Extra depreciation $1,200,000 × 1/10 × 9/12

4 Intragroup trading
(1) Cancel intragroup trading
$’000 $’000
DEBIT Group revenue 200
CREDIT Group purchases (COS) 200

(2) Eliminate unrealised profit

Sanus:
Profit element in inventories: $200,000 × 40% = $80,000
$’000 $’000
DEBIT Cost of sales (& reserves) (of Sanus Co – the seller) 80
CREDIT Group inventories 80

2 The correct answer is:

If Portus Co (the parent) sold the inventories rather than Sanus Co, there would be no change on
the top half of the statement of profit or loss and other comprehensive income. However, in the
reconciliation of profit and total comprehensive income attributable to owners of the parent and
to non-controlling interests, unrealised profit would no longer affect profit attributable to non-
controlling interests. Non-controlling interests would therefore be:

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Profit for the Total comp

year income
$’000 $’000
PFY/TCI per question (1,600 × 9/12)/(2,000 × 9/12) 1,200 1,500
Less impairment losses (per question) (150) (150)
Less fair value movement (W3) (390) (390)
660 960
× 20% × 20%
132 192

Profit and total comprehensive income attributable to owners of the parent would therefore
decrease by the amount of the increase in the respective non-controlling interest, as they are
calculated as residual figures.

Activity 3: Disposal of subsidiary

The correct answer is:
$700,000
$’000 $’000
Consideration transferred 1,500
Less share of consolidated
carrying amount at date
control lost:
Net assets (100 + 660 + 50) 810
Goodwill (W1) 190
Non-controlling interests (W2) (200)
(800)
Gain 700

Workings
1 Goodwill at acquisition
$’000
Consideration 600
NCI at fair value 150
Less: Reserves at acquisition 410
Fair value adjustment 50
190

2 Non-controlling interests
$’000
NCI at acquisition 150
Add NCI share of post-acquisition reserves
(20% × (660 + 50 – 410 – 50) 50
200

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Accounting for
10 associates

10

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Define an associate and explain the principles A4(j)

and reasoning for the use of equity
accounting.

Prepare a consolidated statement of financial D2(a)

position for a simple group (parent and one
subsidiary and associate) dealing with pre-
and post-acquisition profits, non-controlling
interests and consolidated goodwill.

Prepare a consolidated statement of profit or D2(b)

loss and consolidated statement of profit or
loss and other comprehensive income for a
simple group dealing with an acquisition in the
period and non-controlling interest.
10

Exam context
When investing in another company, a parent may not wish to buy a controlling stake. It may
instead buy a smaller stake but still obtain significant influence over another entity, resulting in
the group having an associate. Section C of the exam may require you to prepare and/or
interpret group financial statements that contain an associate. The approach to accounting for
an associate is very different to that for a subsidiary and you must be clear on the differences
between them.
10

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Chapter overview
Associates and joint arrangements

Associates – Associates – parent's Associates – consolidated

definitions separate financial statements financial statements

Associate Equity method

Significant influence

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1 Definitions
Associate: An associate is an entity over which the investor has significant influence. (IAS 28:
KEY
TERM para. 3)
Significant influence: ‘The power to participate in the financial and operating policy decisions
of the investee but is not control or joint control over those policies.’ (IAS 28: para. 3)

Significant influence could be shown by:

(a) Representation on the board of directors
(b) Participation in policy-making processes
(c) Material transactions between the entity and investee
(d) Interchange of managerial personnel
(e) Provision of essential technical information
(IAS 28: para. 6)

1.1 Presumptions
If an investor holds, directly or indirectly:

≥ 20% of voting power < 20% of voting power

Presumption of significant influence Presumption of no significant influence
unless demonstrated otherwise unless demonstrated otherwise

(IAS 28: para. 5)

Exam focus point

In the absence of other information, you should use the percentage ownership to determine
significant influence in the exam.

Activity 1: Identifying an associate

Athens has a number of investments.
Required
Which TWO of the following are associates of Athens? Tick the correct answers.
 Crete: Athens owns 30% of the ordinary shares of Crete and appoints 8 out of 10 directors to
Crete’s board.
 Rhodes: Athens owns 25% of the ordinary shares of Rhodes but does not have the power to
participate in policy-making processes.
 Lesbos: Athens owns 50% of the ordinary shares of Lesbos and provides essential technical
information to Lesbos
 Samos: Athens owns 40% of the preference shares of Samos.
 Thassos: Athens owns 45% of the ordinary shares of Thassos and regularly sends its directors
to Thassos to assist senior management with strategic decisions.

Solution

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2 Parent’s separate financial statements

As we covered in Chapter 7, under IAS 27 Separate Financial Statements, the investment can be
recorded in the parent’s separate financial statements either:

At cost At fair value Using equity accounting method

Assumed in this As a financial asset under Only likely to be adopted for

course/ACCA FR exam IFRS 9 Financial Instruments investments in associates when
the parent does not prepare
consolidated financial statements

(IAS 27: para. 10)

3 Accounting treatment
3.1 Consolidated financial statements
An investment in an associate is accounted for in consolidated financial statements using the
equity method.

3.1.1 Equity method

The equity method is defined by IAS 28 Investments in Associates and Joint Ventures.

Equity method: ‘A method of accounting whereby the investment is initially measured at cost
KEY
TERM and adjusted thereafter for the post-acquisition change in the investor’s share of the investee’s
net assets. The investor’s profit or loss includes its share of the investee’s profit or loss and the
investor’s other comprehensive income includes its share of the investee’s other comprehensive
income.’
(IAS 28: para. 3)

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Essential reading
Chapter 10, Section 1 of the Essential reading provides more detail on the requirement to apply
equity accounting.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

3.1.2 Consolidated statement of financial position

The consolidated statement of financial position presents a single ‘Investment in associate’ line to
reflect any associates of the group.
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
Non-current assets
Investment in associate (Working) X

Working
Cost of associate X
Share of post-acquisition retained reserves X/(X)
Less impairment losses on associate to date (Section 3.1.3) (X)
Less group share of unrealised profit (Section 3.1.5) (X)
X

3.1.3 Impairment losses

After application of the equity method, any impairment losses are considered re: the investor’s net
investment in the associate as a whole in the statement of financial position. (IAS 28: para. 40)

3.1.4 Consolidated statement of profit or loss and other comprehensive income

The consolidated statement of profit or loss and other comprehensive income presents a single
‘Share of profit of the associate’ line in the profit or loss and another ‘Share of other
comprehensive income of the associate’ line in other comprehensive income. The group presents
its share of the associate’s profit for the year (ie its profit after tax) but presents this in the profit
before tax of the group.

CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

Profit or loss $
Share of profit of associate:
A’s profit for the year × Group % X

Less Impairment losses (X)

Less Group share of unrealised profit (X)

Other comprehensive income

Share of other comprehensive income of the associate X
A’s other comprehensive income for the year × Group %

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Activity 2: Share of profit of associate

Holly Co owns 35% of Hock Co, its only associate. During the year to 31 December 20X4, Hock Co
made a profit for the year of $721,000. Holly Co considers its investment in Hock to have suffered
a $20,000 impairment during the year.
Required
At what amount should ‘share of profit of associate’ be stated in the consolidated statement of
profit or loss of Holly Co for the year ended 31 December 20X4?

Solution

3.1.5 Unrealised profit

An associate is not a group company (as the parent does not control its associates) so no
elimination of ‘intragroup’ transactions and balances is required.
However, IAS 28 states that the investor’s share of unrealised profits and losses on transactions
between investor and associate should be eliminated in the same way as for transactions between
a parent and its subsidiaries (para. 28). It is important to remember that only the group’s share is
eliminated.
This is done as follows:
DEBIT Group share of profit of associate Group % × unrealised
(SOPL) profit
CREDIT Investment in associate (SOFP) Group % × unrealised
profit

Note that this journal entry will be used regardless of whether this is a sale from a parent to the
associate, or from the associate to parent.

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Activity 3: Equity method

Beta purchased a 60% holding in Delta’s ordinary shares on 1 January 20X0 for $6.1 million when
the retained earnings of Delta were $3.6 million. The retained earnings of Delta at 31 December
20X4 were $10.6 million. Since acquisition, there has been no impairment of the goodwill in Delta.
Beta also has a 30% holding in Kappa’s ordinary shares, which it acquired on 1 July 20X1 for $4.1
million when the retained earnings of Kappa were $6.2 million. The retained earnings of Kappa at
31 December 20X4 were $9.2 million.
An impairment test conducted at the year end revealed that the investment in the associate
(Kappa) was impaired by $500,000.
During the year, Kappa sold goods to Beta for $3 million at a profit margin of 20%. One-third of
these goods remained in Beta’s inventories at the year end. The retained earnings of Beta at 31
December 20X4 were $41.6 million.
1 Required
State the accounting adjustment required in respect of the unrealised profit on the sale of goods
from Kappa to Beta.
2 Required
Calculate the following amounts for inclusion in the consolidated statement of financial position
of the Beta group as at 31 December 20X4:
(a) Investment in associate
(b) Consolidated retained earnings

Solution
1

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Activity 4: Consolidated statement of financial position

At 31 December 20X4, the statements of financial position of Portus Co, Sanus Co and Allus Co
were as follows:
Portus Co Sanus Co Allus Co
$’000 $’000 $’000
Non-current assets
Property, plant and equipment 56,600 16,200 16,100
Investment in Sanus Co (at cost) 13,800 – –
70,400 16,200 16,100
Current assets
Inventories 2,900 1,200 500
Trade receivables 3,300 1,100 1,100
Cash 1,700 100 300
7,900 2,400 1,900
78,300 18,600 18,000
Equity
Share capital ($1 shares) 8,000 2,400 2,800
Reserves 54,100 10,600 9,200
62,100 13,000 12,000
Non-current liabilities
Long-term borrowings 13,200 4,800 5,100
Current liabilities
Trade and other payables 3,000 800 900
78,300 18,600 18,000
(a) On 1 April 20X4, Portus Co purchased an 80% holding in Sanus Co for $13.8 million in cash.
Sanus Co’s total comprehensive income for the year ended 31 December 20X4 was $2.0
million, accruing evenly over the year. Sanus Co did not pay any dividends in the year.
Portus Co also acquired a 30% holding in Allus Co on 1 July 20X4 for 500,000 of its own
shares. The stock market value of Portus Co’s shares at the date of this share exchange was
$9.40 each. Portus Co has not yet recorded the investment in Allus Co. Allus Co ‘s reserves
were $8.6 million on 1 July 20X4.
(b) At the date of acquisition, the fair value of Sanus Co’s assets were equal to their carrying
amounts, with the exception of the items listed below which exceeded their carrying amounts
as follows:

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$’000
Inventories 300
Plant and equipment (10-year remaining useful life) 1,200
1,500

Sanus Co has not adjusted the carrying amounts as a result of the fair value exercise. The
inventories were sold by Sanus Co before the year end.
(c) The non-controlling interest in Sanus Co is to be valued at its fair value of $3.2 million at the
date of acquisition.
An impairment test conducted at the year end revealed that the consolidated goodwill of
Sanus Co was impaired by $150,000.
Additionally, an impairment loss of $40,000 is to be recognised in respect of Portus Co’s
investment in Allus Co in the group financial statements.
(d) On 1 October 20X4, Sanus Co sold goods to Portus Co for $200,000 at a gross profit margin
of 40%. The goods were still in Portus Co’s inventories at the year end. No other sales were
made between Portus Co and Sanus Co in the year.
At 31 December 20X4, Portus Co’s current account with Sanus Co was $130,000 (credit). This
did not agree with the equivalent balance in Sanus Co’s books due to cash in transit of
$70,000 which was not received by Sanus Co until after the year end.
After the acquisition, Allus Co sold goods to Portus Co for $400,000 at a mark-up on cost of
25%. A quarter of these goods remained in Portus Co’s inventories at the year end.
1 Required
Prepare the consolidated statement of financial position of the Portus Group as at 31 December
20X4.
PORTUS GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4
$’000
Non-current assets
Property, plant and equipment
Goodwill (W2)
Investment in associate (W3)

Current assets
Inventories
Trade receivables
Cash

Equity attributable to owners of the parent

Share capital ($1 shares)
Share premium
Reserves (W4)
Non-controlling interests (W5)

Non-current liabilities
Long-term borrowings
Current liabilities
Trade and other payables

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Workings
(W1) Group structure

(W2) Goodwill
$’000 $’000
Consideration transferred
Non-controlling interests (at fair value)

Less fair value of identifiable net assets at acquisition:

Share capital
Reserves
Fair value adjustments (W6)

Less impairment losses

(W3) Investment in associate

$’000

(W4) Consolidated reserves

Portus Co Sanus Co Allus Co
$’000 $’000 $’000
Per question
Fair value movement (W6)
Provision for unrealised profit (W7)
Pre-acquisition reserves

Group share of post-acq’n reserves:

Sanus Co
Allus Co
Less impairment losses: Sanus Co
Allus Co

(W5) Non-controlling interests (SOFP)

$’000
NCI at acquisition (W2)
NCI share of post-acquisition reserves (W4)
NCI share of impairment losses (W2)

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(W6) Fair value adjustments

At acquisition
date Movement At year end
$’000 $’000 $’000
Inventories
Plant and equipment

*Extra depreciation
Take to COS
Goodwill & reserves Take to SOFP

(W7) Intragroup trading

(a) Cash in transit
$’000 $’000
DEBIT Group cash
CREDIT Trade receivables

(b) Cancel intragroup trading and balances (only with subsidiary)

$’000 $’000
DEBIT Group revenue
CREDIT Group purchases (cost of sales)

$’000 $’000
DEBIT Group payables
CREDIT Group receivables

(c) Eliminate unrealised profit

Sanus Co:
Profit element in inventories:
$’000 $’000
DEBIT Cost of sales (& reserves) (of Sanus Co the seller)
CREDIT Group inventories

Allus Co:
Profit element in inventories:
Associate share:
$’000 $’000
DEBIT
CREDIT

Solution
1

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Activity 5: Consolidated statement of profit or loss

The statements of profit or loss and other comprehensive income of Portus Co, its subsidiary
Sanus Co and its associate Allus Co for the year ended 31 December 20X4 are as follows:
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
Portus Co Sanus Co Allus Co
$’000 $’000 $’000
Revenue 28,500 11,800 9,500
Cost of sales (17,100) (7,000) (5,800)
Gross profit 11,400 4,800 3,700
Expenses (4,400) (2,200) (1,600)
Finance costs (400) (200) (200)
Dividend income from Allus Co 60 – –
Profit before tax 6,660 2,400 1,900
Income tax expense (2,100) (800) (600)
PROFIT FOR THE YEAR 4,560 1,600 1,300
Other comprehensive income:
Gains on property revaluation 900 400 300
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 5,460 2,000 1,600
(a) On 1 April 20X4, Portus Co purchased an 80% holding in Sanus Co for $13.8 million in cash.
Sanus Co’s total comprehensive income for the year ended 31 December 20X4 was $2.0
million, accruing evenly over the year. Sanus Co did not pay any dividends in the year.
Portus Co also acquired a 30% holding in Allus Co on 1 July 20X4 for 500,000 of its own
shares. The stock market value of Portus Co’s shares at the date of this share exchange was
$9.40 each. Portus Co has not yet recorded the investment in Allus Co. Allus Co ‘s reserves
were $8.6 million on 1 July 20X4.
(b) At the date of acquisition, the fair value of Sanus Co’s assets were equal to their carrying
amounts, with the exception of the items listed below which exceeded their carrying amounts
as follows:
$’000
Inventories 300
Plant and equipment (10-year remaining useful life) 1,200
1,500

Sanus Co has not adjusted the carrying amounts as a result of the fair value exercise. The
inventories were sold by Sanus Co before the year end.
(c) The non-controlling interest in Sanus Co is to be valued at its fair value of $3.2m at the date
of acquisition.

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An impairment test conducted at the year end revealed that the consolidated goodwill of
Sanus Co was impaired by $150,000.
Additionally, an impairment loss of $40,000 is to be recognised in respect of Portus Co’s
investment in Allus Co in the group financial statements.
(d) On 1 October 20X4, Sanus Co sold goods to Portus Co for $200,000 at a gross profit margin
of 40%. The goods were still in Portus Co’s inventories at the year end. No other sales were
made between Portus Co and Sanus Co in the year.
At 31 December 20X4, Portus Co’s current account with Sanus Co was $130,000 (credit). This
did not agree with the equivalent balance in Sanus Co’s books due to cash in transit of
$70,000 which was not received by Sanus Co until after the year end.
After the acquisition, Allus Co sold goods to Portus Co for $400,000 at a mark-up on cost of
25%. A quarter of these goods remained in Portus Co’s inventories at the year end. After the
acquisition, Allus Co sold goods to Portus Co for $400,000 at a mark-up on cost of 25%. A
quarter of these goods remained in Portus Co’s inventories at the year end.
1 Required
Prepare the consolidated statement of profit or loss and other comprehensive income for the
Portus Group for the year ended 31 December 20X4.

PORTUS GROUP
CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR
THE YEAR ENDED 31 DECEMBER 20X4
$’000
Revenue
Cost of sales
Gross profit
Expenses
Finance costs
Share of profit of associate
Profit before tax
Income tax expense
PROFIT FOR THE YEAR
Other comprehensive income:
Gains on property revaluation
Share of gain on property revaluation of associate
Other comprehensive income for the year
TOTAL COMPREHENSIVE INCOME FOR THE YEAR

Profit attributable to:

Owners of the parent
Non-controlling interests (W2)

Total comprehensive income attributable to:

Owners of the parent
Non-controlling interests (W2)

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Workings
(W1) Timeline

(W2) Non-controlling interests (SPLOCI)

Profit for the year Total comp income
$’000 $’000
PFY/TCI per question
Less impairment losses (LE1 (W2))
Less fair value movement (LE1 (W6))
Less unrealised profit (LE1 (W7))

× 20% × 20%

Solution
1

Essential reading
Chapter 10, Section 2 of the Essential reading contains a further Activity to allow you to practise
preparing consolidated financial statements containing an Associate.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

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Chapter summary

Associates and joint arrangements

Associates – Associates – parent's Associates – consolidated

definitions separate financial statements financial statements

Associate Carry investment: Equity method

An entity over which the investor • At cost; or • Consolidated statement of
has significant influence • At fair value (financial financial position
instrument under IFRS 9); or – Investment in associate:
• Using equity method $
Significant influence Cost of associate X
• Usually 20% - 50% of voting Share of post-acquisition
power reserves X
• Other indicators: Impairment (X)
– Representation on board of Group share of
directors unrealised profit (X)
– Participation in
X
policy-making process
– Material transactions • Impairment of investment in
between entity and investee associate
– Interchange of management – Deduct from investment in
personnel associate
– Provision of essential • Consolidated statement of
technical information profit or loss and other
comprehensive income
– Group share of associate's
profit for the year
– Group share of associate's
other comprehensive income
for the year
• Unrealised profit
– Cancel group share:
DEBIT Share of profit of
associate
CREDIT Investment in
associate

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Knowledge diagnostic
1. Definition
An associate relationship exists where there is significant influence. Significant influence is ‘the
power to participate in the financial and operating policy decisions of the investee but is not
control or joint control over those policies’ (IAS 28: para. 3). This is presumed where a parent holds
20% or more of voting shares, but also can be demonstrated in other ways.

2. Parent’s separate financial statements

The investment may be accounted for:
• At cost
• At fair value
• Using the equity accounting method (if only have an associate)

3. Accounting treatment
In the group financial statements, an associate is equity accounted as a one-line entry
‘investment in associate’ in the statement of financial position and the share of the associate’s
profit and other comprehensive income are shown on two separate lines in the statement of profit
or loss and other comprehensive income.
The following adjustment is required for unrealised profits in inventory:
$’000 $’000
DEBIT Group share of profit in associate (SOPL) Group % × unrealised profit
CREDIT Investment in associate (SOFP) Group % × unrealised profit

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
13 Hever Co

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These materials are provided by BPP

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Activity answers

Activity 1: Identifying an associate

The correct answers are:
• Lesbos: Athens owns 50% of the ordinary shares of Lesbos and provides essential technical
information to Lesbos
• Thassos: Athens owns 45% of the ordinary shares of Thassos and regularly sends its directors
to Thassos to assist senior management with strategic decisions.

Tick Options
Crete: Athens owns 30% of the ordinary shares of Crete and appoints 8 out of 10
directors to Crete’s board.
As Athens appoints the majority of the directors to Crete’s board, Crete is likely
to be a subsidiary, rather than an associate.

Rhodes: Athens owns 25% of the ordinary shares of Rhodes but does not have
the power to participate in policy-making processes.
As Athens does not have the power to participate in policy-making processes,
Athens does not have significant influence over Rhodes, making Rhodes a
simple financial asset, rather than an associate.

 Lesbos: Athens owns 50% of the ordinary shares of Lesbos and provides essential
technical information to Lesbos.
50% does not give Athens control (> 50% indicates control) so Lesbos is not a
subsidiary. However, 50% is sufficient to give Athens significant influence over
Lesbos and this influence is further evidenced by the essential technical
information Athens provides to Lesbos.

Samos: Athens owns 40% of the preference shares of Samos.

Preference shares do not have voting rights, so do not give Athens significant
influence. This investment would make Samos a simple financial asset, rather
than an associate.

 Thassos: Athens owns 45% of the ordinary shares of Thassos and regularly sends
its directors to Thassos to assist senior management with strategic decisions.
45% indicates significant influence and this is supported by the interchange of
management personnel.

Activity 2: Share of profit of associate

The correct answer is:
$232,350
The share of profit of associate is calculated as ($721,000) × 35% = $252,350 – $20,000
impairment loss for the year.

Activity 3: Equity method

1 The correct answer is:
The accounting adjustment is:
DEBIT Group share of profit of associate 60,000
(SOPL)
CREDIT Investment in associate (SOFP) 60,000

Unrealised profit adjustment (Kappa → Beta)

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PUP = $3,000,000 (× 20%/100% margin × 1/3 in inventory × 30% group share = $60,000.
2 The correct answer is:
(a) Investment in associate
$’000
Cost of associate 4,100
Share of post-acquisition retained earnings (9,200 – 6,200) × 30% 900
5,000
Less impairment losses on associate to date (500)
Less: adjustment for unrealised profit (60)
4,440

(b) Consolidated retained earnings

Beta Delta Kappa
$’000 $’000 $’000
At the year end 41,600 10,600 9,200
Unrealised profit (part (a)) (60) – –
At acquisition (3,600) (6,200)
7,000 3,000
Delta – share of post-acquisition retained earnings
(7,000 × 60%) 4,200
Kappa – share of post-acquisition retained earnings
(3,000 × 30%) 900
Less impairment losses on associate to date (500)
46,140 – –

Note. Even though the associate was the seller for the intragroup trading, PUP is adjusted in the
parent’s column so as not to multiply it by the group share twice.
Working: Group structure
Beta

1.1.X0 60% 1.7.X1 30%

Delta Kappa

Pre-acquisition retained earnings = $3.6m Pre-acquisition retained earnings = $6.2m

Activity 4: Consolidated statement of financial position

1 The correct answer is:
PORTUS GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X4
$’000
Non-current assets
Property, plant and equipment (56,600 + 16,200 + (W6) 1,110) 73,910
Goodwill (W2) 3,850
Investment in associate (W3) 4,834
82,654

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$’000

Current assets
Inventories (2,900 + 1,200 – (W7) 80) 4,020
Trade receivables (3,300 + 1,100 – (W7) 70 – (W7) 130) 4,200
Cash (1,700 + 100 + (W7) 70) 1,870
10,090
92,684

Equity attributable to owners of the parent

Share capital ($1 shares) (8,000 + (W8) 500) 8,500
Share premium (W8) 4,200
Reserves (W4) 54,938
67,638
Non-controlling interests (W5) 3,376
71,014
Non-current liabilities
Long-term borrowings (13,200 + 4,800) 18,000
Current liabilities
Trade and other payables (3,000 + 800 – (W7) 130) 3,670
92,684

Workings
(W1) Group structure
Portus Co
1.4.X4 1.7.X4
80% 30%
Cost $13.8m (W8) $4.7m

Sanus Co Allus
Pre-acq'n reserves $9.1m $8.6m
($10.6m – ($2.0m × 9/12))
or ($10.6m – $2.0m + ($2.0 × 3/12))

(W2) Goodwill
$’000 $’000
Consideration transferred 13,800
Non-controlling interests (at fair value) 3,200

Less fair value of identifiable net assets at acquisition:

Share capital 2,400
Reserves (10,600 – (2,000 × 9/12)) 9,100
Fair value adjustments (W6) 1,500
(13,000)
4,000
Less impairment losses (150)
3,850

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(W3) Investment in associate

$’000
Cost of associate (W8) 4,700
Add post-acquisition reserves (W4) 180
Less impairment losses on associate to date (40)
Provision for unrealised profit (W7) (6)
4,834

(W4) Consolidated reserves

Portus Co Sanus Co Allus Co
$’000 $’000 $’000
Per question 54,100 10,600 9,200
Fair value movement (W6) (390)
Provision for unrealised profit (W7) (6) (80)
Pre-acquisition reserves (10,600 – (2,000 × 9/12)) (9,100) (8,600)
1,030 600
Group share of post-acq’n reserves:
Sanus Co (1,030 × 80%) 824
Allus Co (600 × 30%) 180
Less impairment losses: Sanus Co (150 × 80%) (120)
Allus Co (40)
54,938

Activity 5: Consolidated statement of profit or loss

1 The correct answer is:
PORTUS GROUP
CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR
THE YEAR ENDED 31 DECEMBER 20X4
$’000
Revenue (28,500 + (11,800 × 9/12) – LE1 (W7) 200) 37,150
Cost of sales (17,100 + (7,000 × 9/12) + (W6) 390 – (W7) 200 + (W7) 80) (22,620)
Gross profit 14,530
Expenses (4,400 + (2,200 × 9/12) + LE1 (W2) 150) (6,200)
Finance costs (400 + (200 × 9/12)) (550)
Share of profit of associate [(1,300 × 30% × 6/12) – LE1 (W7) 6 – 40 imp 149
losses)]
Profit before tax 7,929
Income tax expense (2,100 + (800 × 9/12)) (2,700)
PROFIT FOR THE YEAR 5,229
Other comprehensive income:
Gains on property revaluation (900 + (400 × 9/12)) 1,200
Share of gain on property revaluation of associate (300 × 30% × 6/12) 45
Other comprehensive income for the year 1,245
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 6,474
Profit attributable to:
Owners of the parent (β) 5,113
Non-controlling interests (W2) 116

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$’000
5,229
Total comprehensive income attributable to:
Owners of the parent (β) 6,298
Non-controlling interests (W2) 176
6,474

Workings
(W1) Timeline
1.1.X4 1.4.X4 1.7.X4 31.12.X4

Portus Co – all year

Sanus Co – Income & expenses & 20% NCI × 9/12

Allus Co – PFY & OCI × 30% × 6/12

PUP
adjustment

(W2) Non-controlling interests (SPLOCI)

Profit for the year Total comp income
$’000 $’000
PFY/TCI per question (1,600 × 9/12)/(2,000 × 9/12) 1,200 1,500
Less impairment losses (LE1 (W2)) (150) (150)
Less fair value movement (LE1 (W6)) (390) (390)
Less unrealised profit (LE1 (W7)) (80) (80)
580 880
× 20% × 20%
116 176

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Skills checkpoint 3
Using spreadsheets
effectively

Chapter overview
cess skills
Exam suc

Answer planning

c FR skills C
n Specifi o
tio
rr req
a

ec ui
of
m

t i rem
or

nt
inf

erp ents
ng

Approach to Application
reta
agi

objective test of accounting

(OT) questions standards
Man

tion
l y si s

Spreadsheet Interpretation
Go od

skills skills
ana
ti m

c al

Approach
em

to Case
e ri

OTQs
an

um
ag

tn
em

en

en
t ci
Effi
Effective writing
and presentation

Introduction
Section C of the FR exam will have two longer questions worth a total of 40 marks. One question
will require you to prepare extracts from the financial statements (this may be for a single entity
or for a group, and it may be any of the primary financial statements). The second question will
ask you to interpret the financial position and performance of either a single entity or a group,
and may require some calculations or ratios to be prepared.

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Skills Checkpoint 3: Using spreadsheets effectively

FR Skill: Using spreadsheets effectively
The key steps in applying this skill are outlined below and will be explained in more detail in the
following sections as the exam standard question Viagem Co is used as an example question.

STEP 1: Understanding the data in the question

Where a question includes a significant amount of data, read the requirements
carefully to make sure that you understand clearly what the question is asking
you to do. You can use the highlighting function to pull out important data from
the question. Use the data provided to think about what formula you will need to
use. For example, if the company calculates the allowance for receivables as a
percentage of the balance, use the percentage function.

STEP 2: Use a standard proforma working.

You are likely to be asked to prepare an extract or a set of financial statements. Set
out your statement of profit or loss or the statement of financial position before
you start to work through the question. This will give you the basic structure from
where you can enter the data in the question.
Format your cells to ensure the workings look consistent, for example, using the
comma function to mark the thousands in numerical answers.

STEP 3: Use spreadsheet formulae to perform basic calculations.

Ensure you are showing your workings by using the spreadsheet formula for simple
calculations, for example, the cost of sale figure will be made up of different
balances, so add them together using the formula. Cross refer any more detailed
workings, and link workings into your main answer.

Step 4: Use the spreadsheet functions to calculate ratios, with explanation set
out neatly below.
When answering questions on ratios, set out your ratio calculations separately from
your explanation. This allows you to use the formula function to perform the
calculations. The interpretation of the ratio is more important than the calculation,
so you must dedicate sufficient time and attention to interpreting the ratio in the
context of the information given in the scenario. Ensure the text is visible on one
page (not having one long sentence across the page, but broken down to enable
the Examining Team to read it easily).

Exam success skills

The following question, Viagem Co, is a past exam question worth 20 marks.
For this question, we will focus on the following exam success skills:
• Managing information. It is easy for the amount of information contained in a Section C
question to feel over-whelming. Active reading is a useful technique to help avoid this. This
involves focusing on the requirement first, on the basis that until you have done so the detail in
the question will have little meaning.
This is especially important in a question that may have lots of information, such as one which
requires you to prepare a set of financial statements based on a draft trial balance, and a
series of further elements of information.

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• Correct interpretation of requirements. The requirement clearly has two separate parts. The
calculation of goodwill and, separately, the preparation of a consolidated statement of profit
or loss.
• Efficient numerical analysis. The key to success here is applying a sensible proforma for the
calculation of goodwill and for key figures within the consolidated statement of profit or loss,
such as non-controlling interest. (You must show all workings and use the formula facility in the
spreadsheet tool to link your workings to the consolidated statement of profit or loss where
appropriate).
• Good time management. Complete all tasks in the time available, being careful not to overrun
the calculation of goodwill at the expense of the second part of the question.

Skill activity
STEP 1 Understanding the data in the question.
Where a question includes a significant amount of data, read the requirements carefully to make sure that
you understand clearly what the question is asking you to do. You can use the highlighting function to pull
out important data from the question. Use the data provided to think about what formula you will need to
use. For example, if the company calculates the allowance for receivables as a percentage of the balance,
use the percentage function.

When you initially open your online exam for Section C,

the screen will look something like this, with the question
scenario given on the left of the screen, and your
answer workspace on the right.
Symbol Calculator Scratch Pad

The question scenario will appear here. The question requirement will appear here.

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11

A1
A B C D E F G H I
1
2
3
4
5
6
7
8
9
10
11

The ACCA website (www.accaglobal.com) has a useful

tool which enables you to familiarise yourself with the
functionality of the workspace (both the spreadsheet
and the word processing space).

For FR, it is recommended that any questions which

require calculations are performed in the spreadsheet
tool as it allows you to show your workings (using
formula) and still write up your answers neatly.

In the ribbon across the top, there are tools you can use
to highlight and mark up the question.

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On 1 January 20X2, Viagem Co acquired 90% of the

equity share capital of Greca Co in a share exchange in
which Viagem Co issued two new shares for every three
shares it acquired in Greca Co.4 Additionally, on 31 4
Use the highlight function to highlight
key areas. Here there are details of a
December 20X2, Viagem Co will pay the shareholders of share issue in order to obtain a
subsidiary.
Greca Co $1.76 per share acquired. Viagem Co’s cost of
capital is 10% per annum.

At the date of acquisition, shares in Viagem Co and

Greca Co had a market value of $6.505 and $2.506 5
Highlighting the MV of Viagem shares at
$6.50
each respectively.

STATEMENTS OF PROFIT OR LOSS FOR THE YEAR 6

Highlighting the MV of Greca shares at
ENDED 30 SEPTEMBER 20X2 $2.50

Viagem Co Greca Co
$’000 $’000
Revenue 64,600 38,000
Cost of sales (51,200) (26,000)
Gross profit 13,400 12,000
Distribution costs (1,600) (1,800)
Administrative expenses (3,800) (2,400)
Investment income 500 –
Finance costs (420) –
Profit before tax 8,080 7,800
Income tax expense (2,800) (1,600)
Profit for the year 5,280 6,200
Equity as at 1 October 20X1
Equity shares of $1 each 30,000 10,000
Retained earnings 54,000 35,000

The following information is relevant:

(a) At the date of acquisition the fair values of Greca

Co’s assets were equal to their carrying amounts
with the exception of two items7: 7
Two issues here: Fair value adjustment
on PPE and the contingent liability which
(i) An item of plant had a fair value of $1.8 million will require adjusting the goodwill
calculation.
above its carrying amount. The remaining life
of the plant at the date of acquisition was
three years. Depreciation is charged to cost of
sales.

(ii) Greca Co had a contingent liability which

Viagem Co estimated to have a fair value of
$450,000. This has not changed as at 30
September 20X2.

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(iii) Greca Co has not incorporated these fair value

changes into its financial statements.

(b) Viagem Co’s policy is to value the non-controlling

interest at fair value at the date of acquisition.8 For 8
Method of valuing non-controlling
interest is fair value in this question (don’t
this purpose, the market value of Greca Co’s shares use the alternative method of
proportionate share!)
at that date can be deemed to be representative of
the fair value of the shares held by the non-
controlling interest.

(c) Sales from Viagem Co to Greca Co throughout the

year ended 30 September 20X2 had consistently
been $800,000 per month. Viagem Co made a
mark-up on cost of 25% on these sales. Greca Co
had $1.5 million of these goods in inventory as at 30
September 20X2.9 9
Another area to highlight: Intragroup
sales and Purp for calculation and
(d) Viagem Co’s investment income is a dividend adjustment in the consolidated financial
statements
received10 from its investment in a 40% owned
associate which it has held for several years. The 10
Adjustment: a dividend received from
associate’s profit for the year ended 30 September the associate. Requires calculation: 40%
x $2m and inclusion as share of profit of
20X2 was $2 million. associate in CSOPL.

(e) Although Greca Co has been profitable since its

acquisition by Viagem Co, the market for Greca
Co’s products has been badly hit in recent months
and Viagem Co has calculated that the goodwill
has been impaired by $2 million11 as at 30 11
Goodwill adjustment: an impairment of
$2m.
September 20X2.

Required

(a) Calculate the goodwill arising on the acquisition of

Greca Co. (6 marks)

(b) Prepare the consolidated statement of profit or loss

for Viagem Co for the year ended 30 September
20X2. (14 marks)
(Total = 20 marks)
STEP 2 Use a standard proforma working.
You are likely to be asked for prepare an extract or a set of financial statements. Set out your statement of
profit or loss or the statement of financial position before you start to work through the question. This will
give you the basic structure from where you can enter the data in the question.
Format your cells to ensure the workings look consistent, for example, using the comma function to mark
the thousands in numerical answers.
In this example, the question is calling for two parts to be answered. Firstly, the calculation of
goodwill and secondly, preparation of the consolidated statement of profit or loss.

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Start with part (a) first, setting out the key elements of the goodwill calculation. Give your work a
title ((a) Goodwill calculation) and reference it to the question so that the Examining Team can see
clearly what part of the question you are answering:
Edit Format

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11

C1
A B C D E F
1
2 (a) Goodwill calculaon $΄000 $΄000
3
4 Consideraon transferred:
5 Shares
6 Deferred consideraon
7
8
9
10
11

Columns C and D have been highlighted. At this point, it is a sensible idea to format the cells so
that they show thousand dividers. This makes the numbers easier to read and means you are less
likely to start answering in, for example thousands and later change to millions or full numbers,
which can be confusing.
Edit Format

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C4 45200 General
A B C
Custom D E F
1 0.00
2 (a) Goodwill calculaon $΄000 $΄000
#,##0
3
#,##0.00
4 Consideraon transferred:
5 Shares
6 Deferred consideraon

By highlighting the whole two columns, this speeds up the formatting process. This is where you
will insert the figures.
If you feel you will need more columns highlighting and formatting, then select more columns.
Once you have completed part (a) of the question, the second part calls for a proforma of a
consolidated statement of profit or loss. You may also want to consider setting up proforma some
of the sub-calculations you may require such as non-controlling interests.
It is important to make your work clear to the Examining team using headings, referencing and
formatting the cells. Set out your proforma under a suitable heading, you may wish to use bold
text or underline to make your headings clearer.
STEP 3 Use spreadsheet formulae to perform basic calculations.
Ensure you are showing your workings by using the spreadsheet formula for simple calculations, for
example, the cost of sales figure will be made up of different balances, so add them together using the
formula. Cross refer any more detailed workings, and link workings into your main answer.
One issue that repeatedly comes up in the Examiner’s Report, is that students do not show where
their figures have come from. This makes it difficult for marks to be awarded, as the workings are
often key to ensuring that students understand the process. Also, if a mistake is made in the
calculations, then marks cannot be awarded for the method or the parts which were correct.
There are some useful tools that will assist in both your calculation and presentation of your
answer:

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Use the formula in the spreadsheet tool. This may be simple addition or subtraction formula, such
as adding numbers together to get the administrative costs figure or to calculate the subtotals:
11

C13 =C11-C12
A B C D
9 (b) Consolidated statement of profit or loss
10 $΄000 $΄000
11 Revenue 85,900
12 Cost of sales 64,250
13 Gross profit =C11-C12
14 Distribu"on costs
15 Administra"on costs
16

Here, the gross profit is calculated by subtracting the cost of sales figure from the revenue figure.
This does three things:
• It ensures that the arithmetic is correct
• It shows the Examining team where the numbers have come from
• Future proofs the answer. If you later change the revenue figure, the subtotals will
automatically update.
If the working is more complex, then set up a new working below the proforma and cross reference
it. It is also recommended (in order to ensure updates if you make changes later) that you link the
cells together:
B25 =(14400*.1)*(9/12)
A B C
20 Profit for the year
21
22 Workings
23 (W1) Finance costs $΄000
24 Viagem Co per statement of profit or loss 420
25 Unwinding of discount on deferred considera"on 1080
26 1500
27

Then link the answer back to the consolidated statement of profit or loss:
5 Administraon costs -7,600
6 Finance costs (W1) =-B26
7 Share of profit of associate
8 Profit before tax
9 Income tax expense
10 Profit for the year
11
12 Workings $΄000
13 (W1) Finance costs 420
14 Viagem Co per statement of profit or loss 1080
15 Unwinding of discount on deferred consideraon 1500
16
17

STEP 4 Use the spreadsheet functions to calculate ratios, with explanation set out neatly below.
When answering questions on ratios, set out your ratio calculations separately from your explanation. This
allows you to use the formula function to perform the calculations. The interpretation of the ratio is more
important than the calculation, so you must dedicate sufficient time and attention to interpreting the ratio
in the context of the information given in the scenario. Ensure the text is visible on one page (not having one
long sentence across the page, but broken down to enable the Examining team to read it easily).
Your FR exam will have an interpretation of financial statements question in Section C. This is likely
to involve the calculation of ratios. It is recommended that you use formula to calculate your
ratios:
• This will ensure arithmetical accuracy of your calculation; and
• Show the Examining team how you have calculated your figures.

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You will then have to interpret the performance and position of the single entity or group using the
ratios you have calculated. In this case, you will continue to write your answer in the spreadsheet
tool. Just ensure that your layout of the question is neat and can be easily read by the Examining
team by using headings.
Our example of Viagem Co does not have an interpretation element, but here is an example of
what a ratio answer may look like.
29
30 Part C: Interpretaon of financial performance
31
32 ROCE 12%
33 Opera ng profit margin 7.50%
34 Gross profit margin 25%
35
36 Bizarre Co has a ROCE significantly lower at 12% than the sector averages of 16.8%. This is mainly due to
37 the lower than average gross profit margin and consequent low opera ng profit margin of 7.5%
38

Note that you should not simply state what the ratio represents but instead focus on interpreting
it using the information in the question. In the above, you may have been told for example that
the company had suffered an increase in the price of raw materials which it had not passed on to
customers, which would explain why the gross profit margin was lower than average.

Exam success skills diagnostic

Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been completed
below for the Viagem activity to give you an idea of how to complete the diagnostic.

Exam success skills Your reflections/observations

Managing information There is a lot of information in this question, and there are two
separate workings to be set out using proformas.
Highlighting the relevant data within the question will help you
to ensure you have picked up all the information.
This question had separate elements which affected the
calculation of goodwill. These included two forms of
consideration (shares and deferred consideration), plus there
were adjustments to be made in respect of the impairment of
the fair value of the asset, the contingent liability and, in a
separate bullet point, the impairment of goodwill.
Due to the presentation of the points separately, it is easy to
miss information. Provided you show your workings, you will
gain some marks, but clearly it is better to ensure that all the
information is incorporated in the answer.

Correct interpretation of The question is asking for a calculation of goodwill and then
requirements preparation of the consolidated statement of profit or loss. It is
important to make sure that all parts of the question are
answered, and the relevant information taken from the
information given in the question.

Efficient numerical analysis The answer needs to be presented neatly, and all information
easily readable by the Examining team.
Ensure that formula is used to show where the numbers have
come from, and to ensure accuracy in the calculation
(provided the formula has been correctly inserted).

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Exam success skills Your reflections/observations

Good time management The question is worth 20 marks but split into two sections. The
calculation of goodwill is worth six marks, so you should allow
no more than 10–11 minutes for this section, and then move
onto the consolidated statement of profit or loss. It is
important not to linger too long on one section as you may
miss easy marks in the next question at the expense of
spending longer than allowed to gain an additional mark or
two.

Most important action points to apply to your next question: show all workings.

Summary
Section C of the FR exam will contain questions that require proformas and calculations to be
carried out using the spreadsheet facility in the exam.
Make sure you are familiar with the tool (the ACCA website allows access both in completing an
online example paper, and also just to practice using the spreadsheet functionality).
It is also important to be aware that in the exam you are dealing with detailed calculations under
timed exam conditions and time management is absolutely crucial. You therefore need to ensure
that you:
• Interpret the date given in the question correctly.
• Use clear proformas (where appropriate) for your workings and your financial statement
extracts.
• Use spreadsheet formula to perform basic calculations.
• Show clear workings using a combination of formula and linking separate workings (such as
goodwill calculation that can be linked into your statement of financial position).

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Financial instruments
11
11

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Explain the need for an accounting standard on financial B5(a)

instruments.

Define financial instruments in terms of financial assets B5(b)

and financial liabilities.

Explain and account for the factoring of receivables. B5(c)

Indicate for the following categories of financial B5(d)

instruments how they should be measured and how any
gains and losses from subsequent measurement should be
treated in the financial statements:
(a) Amortised cost
(b) Fair value through other comprehensive income
(including when an irrevocable election has been
made for equity instruments that are not held for
trading)
(c) fair value through profit or loss

Distinguish between debt and equity capital. B5(e)

Apply the requirements of relevant accounting standards B5(f)

to the issue and finance costs of:
(a) Equity
(b) Redeemable preference shares and debt instruments
with no conversion rights (principle of amortised cost)
(c) Convertible debt
11

Exam context
Financial instruments are frequently examined in all sections of the Financial Reporting exam. It is
a technical area which students sometimes find challenging. The December 2018 examining
team’s report stated that students need to avoid a superficial understanding of this subject area
and the June 2019 examiner’s report identified that financial instruments is one of the more
technical areas of the course that students struggle with.
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Chapter overview
Financial instruments

The need for Classification

a standard

Categories Compound financial instruments

Liabilities v equity Interest, dividends,

gains and losses

Recognition Derecognition Factoring of trade receivables

Measurement

Measurement of financial assets Measurement of financial liabilities

Initial and subsequent measurement Initial and subsequent measurement

Fair value Fair value

Amortised cost Amortised cost

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1 The need for a standard

The dynamic nature of international financial markets and the increasing number and variety of
financial instruments that have been introduced in recent years have meant the standard setters
struggled to keep pace with the rate of change in the market. As a result, there was a lack of
guidance as to how financial instruments should be accounted for. This caused problems such as:
• Inconsistencies in the way in which financial instruments were recognised and measured,
leading to comparability problems for international companies who reported under different
accounting regimes
• Criticism about the accounting and disclosure requirements following high-profile scandals
relating to financial instruments
• A lack of understanding from the users of financial statements, for example, one of the key
user ratios is the gearing ratio, ie the measure of the proportion of debt to equity. In order for
this measure to be meaningful, there must be consistency in the allocation of financial
instruments between these two categories.
In response to the issues with the accounting for financial instruments, the IASB has developed
and implemented the following standards relating to financial instruments:

IAS 32 Financial Instruments: IFRS 9 Financial IFRS 7 Financial Instruments:

Presentation Instruments Disclosures

2 Classification
2.1 Definitions
In order to understand how to account for financial instruments, we must first understand what we
mean by financial instruments.

Financial instruments

Financial assets Financial liabilities Equity

Eg cash, trade receivables Eg bonds issued, trade Eg ordinary shares,
investments in shares, payables, redeemable irredeemable
investments in debt preference shares preference shares

Financial instrument: Any contract that gives rise to both a financial asset of one entity and a
KEY
TERM financial liability or equity instrument of another entity.
Financial asset: Any asset that is:
(a) Cash
(b) An equity instrument of another entity
(c) A contractual right to receive cash or another financial asset from another entity; or to
exchange financial instruments with another entity under conditions that are potentially
favourable to the entity.
Financial liability: Any liability that is:
(a) A contractual obligation:
(i) To deliver cash or another financial asset to another entity, or
(ii) To exchange financial instruments with another entity under conditions that are
potentially unfavourable.

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Equity instrument: Any contract that evidences a residual interest in the assets of an entity
after deducting all of its liabilities.
(IAS 32: para. 11)

2.2 Liability v equity

The classification of a financial instrument as a liability or as equity depends on:
• The substance of the contractual arrangement on initial recognition
• The definitions of a financial liability and an equity instrument
(IAS 32: para. 15)
The critical feature of a liability is an obligation to transfer economic benefit.

Illustration 1: Liability v equity

Jess Co issues $100,000 6% preference shares, redeemable on 1 January 20X6.
Required
Explain whether the preference shares are debt or equity.

Solution
The correct answer is:
Although we may first think of shares as equity, in substance, redeemable preference shares meet
the definition of a financial liability as they contain an obligation to pay a fixed amount of interest
and are redeemable at a fixed future date. Accordingly, the redeemable shares will be reported
under non-current liabilities in the statement of financial position (unless they are repayable
within one year, in which case they are considered to be current liabilities).

2.3 Compound financial instruments

Compound instrument
Eg convertible debt

Liability element and Equity element

IAS 32 requires the component parts of the compound instrument, ie the liability element and the
equity element, to be classified separately. (IAS 32: para. 28)
The following method should be used to initially measure the liability and equity elements:

Step 1 Determine the value of the whole instrument

(the proceeds received on the issue of the instrument)

Step 2 Calculate the value of the liability element

(the present value of the principal and the present value of the interest)

Step 3 Calculate the residual value of the equity component

(the difference between the value of the whole instrument and the value of the
liability element)

(IAS 32: para. 32)

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Activity 1: Compound instruments

Rathbone Co issues 2,000 convertible bonds at the start of 20X2. The bonds have a three-year
term, and are issued at par with a face value of $1,000 per bond, giving total proceeds of
$2,000,000. Interest is payable annually in arrears at a nominal annual interest rate of 6%. Each
bond is convertible into 250 ordinary shares.
The carrying amount of the liability element of the compound instrument can be measured based
on an interest rate of 9%, which is the prevailing market interest rate for similar debt without
conversion options.
Relevant discount rates:
• Present value of 9% interest rate after 3 years is 0.772
• Cumulative present value of 9% interest rate after 3 years is 2.531
Required
Calculate the value of the liability and equity components of the bond.

Solution

Essential reading
Chapter 11, Section 1 of the Essential reading provides more detail and a further activity relating
to compound financial instruments.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

2.4 Interest, dividends, gains and losses

IAS 32 also considers how the treatment of the interest, dividends, losses or gains associated with
financial instruments varies, depending on whether they relate to a financial liability or an equity
instrument.

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(a) Interest, dividends, losses and gains relating to a financial liability should be recognised as
income or expense in profit or loss. (IAS 32: para. 35)
(b) Distributions to holders of equity instruments (dividends to ordinary shareholders) should be
debited directly to equity by the issuer. (IAS 32: para. 35)
(c) Transaction costs of an equity transaction should be accounted for as a deduction from
equity, usually debited to share premium. (IAS 32: para. 39)

3 Recognition and derecognition

3.1 Recognition
A financial asset or financial liability should be initially recognised in the statement of financial
position when the reporting entity becomes a party to the contractual provisions of the
instrument. (IFRS 9: para. 3.1.1)
In practical terms, this usually means:

Type of financial instrument Recognition

Trade receivable/payable On delivery of goods or performance of
service

Loans, bonds, debentures On issue

Shares On issue

3.2 Derecognition
Derecognition happens:

Type of financial instrument Derecognition

Financial assets When the contractual rights to the cash flows
expire (eg because a customer has paid their
debt or an option has expired worthless); or
When the financial asset is transferred (eg
sold), based on whether the entity has
transferred substantially all the risks and
rewards of ownership of the financial asset.
(IFRS 9: paras. 3.2.3 & 3.2.6)

Financial liabilities When the obligation is discharged (eg paid

off), cancelled or expires. (IFRS 9: para. 3.3.1)

You need to apply the principles of derecognition only in respect of the factoring of trade
receivables.

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3.3 Factoring of receivables

An entity might sell, or factor, its trade receivables to another debt factoring company in return
for a cash amount that is less than the carrying amount of the trade receivables. The debt factor
then owns and collects the debts. However, we must consider the substance of the debt factoring
agreement to determine the appropriate accounting treatment. Debt factoring can lead to two
possible outcomes:

The transaction is in substance a

genuine sale of the debts for less than Trade receivable
market price, with the entity retaining no is derecognised
continuing interest in the debts

The transaction is in substance a secured Trade receivable is not

loan if the risk of non-payment remains derecognised and a corresponding
with the entity that sold the debts. liability is also recognised

Factors that tend to indicate a secured loan:

• The debt factoring company can claim
back unpaid amounts.
• Interest is charged on monies advanced
by the debt factoring company.

Activity 2: Debt factoring

Freddo Co sold $300,000 of receivables to a debt factor for $270,000 on 1 July 20X1.
The factor charges interest of 5% per annum on amounts advanced.
The factor collected $150,000 of the amounts due on 31 December 20X1. No other amounts were
collected in 20X1, but the amounts due are still considered recoverable.
Under the terms of the agreement, any unpaid debts will be returned to Freddo Co for a cash
repayment on 1 July 20X2.
Required
Explain how Freddo should account for the debt factoring arrangement as at 31 December 20X2.

Solution

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4 Measurement
The following definitions are important for measurement:

Amortised cost: The amount at which the financial asset (financial liability) is measured at
KEY
TERM initial recognition, minus the principal repayments, plus (minus) the cumulative amortisation
using the effective interest.
Effective interest rate: The rate that exactly discounts estimated future cash receipts
(payments) through the expected life of the financial asset (financial liability) to the gross
carrying amount of a financial asset (amortised cost of a financial liability).
(IFRS 9: Appendix A)

Exam focus point

The effective interest rate will always be provided in the ACCA Financial Reporting exam.

4.1 Measurement of financial assets

The classification (type) of financial asset determines how it is initially and subsequently
measured. It is important that you learn the rules in the below table.

Type of financial asset Initial Subsequent

measurement measurement
1 Investments in debt instruments
Business model test
(a) Held to collect contractual Fair value + Amortised cost
cash flows; and cash flows are transaction costs
solely principal and interest

(b) Held to collect contractual Fair value + Fair value through other
cash flows and to sell; and cash transaction costs comprehensive income (with
flows are solely principal and reclassification to P/L on
interest derecognition)
NB: interest revenue
calculated on amortised cost
basis recognised in P/L

2 Investments in equity instruments Fair value + Fair value through other

not ‘held for trading’ transaction costs comprehensive income (no
(optional irrevocable election on reclassification to P/L on
initial recognition) derecognition)
NB: dividend income
recognised in P/L

3 All other financial assets Fair value (transaction Fair value through profit or
(eg derivate financial assets not costs expensed in P/L) loss
covered further in ACCA Financial
Reporting)

(IFRS 9: paras. 4.1.1 – 4.1.4)

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Exam focus point

Applying the business model test, the entity’s intention to hold the financial instrument to
collect the contractual cash flows is most common in exam scenarios, as it allows the examiner
to test the principles of amortised cost accounting.

Essential reading
In the Essential reading, Chapter 11, Section 2 provides more detail on the business model test and
Chapter 11, Section 3 provides more detail on the contractual cash flow test.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

4.1.1 Financial assets at fair value

Investments in equity instruments can either be held at fair value through profit or loss (FVTPL) or
fair value through other comprehensive income (FVTOCI).
If equity instruments are held at FVTPL, no transaction costs are included in the carrying amount.
Equity instruments can be held at FVTOCI if:
(a) They are not held for trading (ie the intention is to hold them for the long term to collect
dividend income)
(b) An irrevocable election is made at initial recognition to measure the investment at FVTOCI
If the investment is held at FVTOCI, all changes in fair value go through other comprehensive
income. Only dividend income will appear in profit or loss. (IFRS 9: para. 4.1.4)

Illustration 2: Financial assets at fair value

An entity holds an investment in shares in another company, which cost $45,000. At the date of
purchase the election was made to record changes in value in other comprehensive income for
this asset. At the year end, their value has risen to $49,000.
Required
How should the increase in value be accounted for?

Solution
The correct answer is:
The following adjustment would need to be made in an accounts preparation question:
DEBIT Investment in shares ($49,000 – $45,000) $4,000
CREDIT Other comprehensive income (and other
components of equity in SOFP) $4,000

If the shares were held at fair value through profit or loss, the gain would be reported in profit or
loss.
In either case, dividends received on the share are reported as income.

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Activity 3: Financial assets at fair value

Grafton Co’s draft statement of financial position as at 31 March 20X8 shows financial assets at
fair value through profit or loss with a carrying amount of $9.5 million as at 1 April 20X7.
These financial assets are held in a fund whose value changes directly in proportion to a specified
market index. At 1 April 20X7, the relevant index was 1,100 and at 31 March 20X8, it was 1,187.
Required
What amount of gain or loss should be recognised at 31 March 20X8 in respect of these assets?
 $827,000 gain
 $751,000 gain
 $1,000,000 loss
 $827,000 loss

Solution

4.1.2 Financial assets at amortised cost

This is the amount at which the item was initially recorded, less any principal repayments, plus
the cumulative amortisation of the difference between the initial and maturity values.
This difference is amortised using the effective interest rate of the instrument, ie its internal rate of
return (as seen in Chapter 2). It includes:
• Transaction costs
• Interest payments
• Any discount on the debt on inception
• Any premium payable on redemption
(IFRS 9: Appendix A)

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The proforma and double entries for the amortised cost table is as follows:
Financial asset:
$ Accounting entries:
Balance b/d X DEBIT (↑) Financial asset
CREDIT (↓) Cash
(if initial recognition at start of year)
Finance income (effective interest × b/d) X SPL DEBIT (↑) Financial asset
CREDIT (↑) Finance income
Interest received (coupon × par value) (X) DEBIT (↑) Cash
CREDIT (↓) Financial asset
Balance c/d X SOFP

Activity 4: Financial asset held at amortised cost

Zebidee Co purchases a deep discount bond with a par value of $500,000 on 1 January 20X1 for
proceeds of $440,000 with the intention of holding it until the redemption value is received.
Annual coupon payments of 5% are payable on 31 December. Zebidee Co incurred transaction
costs of $5,867. The bond will be redeemed on 31 December 20X3 at par.
The effective interest rate on the bond has been calculated at 9.3%.
Required
What is the interest income in the profit or loss for the year ended 31 December 20X2?
20X1 20X2 20X3
$ $ $
b/d at 1 January
Interest income
Cash received
c/d at 31 December
 $40,914
 $41,466
 $42,997
 $44,670

Solution

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Essential reading
Chapter 11, Section 4 of the Essential reading provides further activities relating to the
measurement of amortised cost financial assets.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

4.2 Measurement of financial liabilities

Similar to financial assets, the category (type) of financial liability determines how it is initially
and subsequently measured.

Initial Subsequent
Type of financial liability
measurement measurement
1 Most financial liabilities (eg Fair value less Amortised cost
trade payables, loans, transaction costs
preference shares classified as a
liability)

2 Financial liabilities at fair value Fair value (transaction Fair value through profit or
through profit or loss costs expensed in P/L) loss
• ‘Held for trading’ (short-term
profit making)
• Derivatives that are liabilities

(IFRS 9: para. 4.2.1)

4.2.1 Financial liabilities at amortised cost

The amortised cost approach for a financial liability is consistent with that for a financial asset:
Financial liability $ Accounting entries:
Balance b/d X DEBIT (↑) Cash
CREDIT (↑) Financial liability
(if initial recognition at start of year)
Finance cost (effective interest × b/d) X SPL DEBIT (↑) Finance cost
CREDIT (↑) Financial liability
Interest paid (coupon × par value) (X) DEBIT (↓) Financial liability
CREDIT (↓) Cash
Balance c/d X SOFP

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Activity 5: Financial liability at amortised cost

Dire Co issued 3,000 convertible bonds at par on 1 January 20X1. The bonds are redeemable on
31 December 20X4 at their par value of $100 per bond.
The bonds pay interest annually in arrears at an interest rate (based on nominal value) of 5%.
Each bond can be converted at the maturity date into five $1 shares.
The prevailing market interest rate for four-year bonds that have no right of conversion is 8%.
The present value at 8% of $1 receivable at end of:
Year 1 0.926
Year 2 0.857
Year 3 0.794
Year 4 0.735

1 Required
Show the accounting treatment of the:
(a) Bond at inception
(b) Financial liability component at 31 December 20X1 using amortised cost
Note. The examining team has stated that they will not test the treatment of the equity
component after inception.
(a)
At 1 January 20X1 $
Non-current liabilities
Financial liability component of convertible bond
Equity
Equity component of convertible bond
Working: Fair value of equivalent non-convertible debt
Present value of principal
Present value of interest

(b)
At 31 December 20X1 $
Finance costs (profit or loss)
Effective interest on financial liability component of convertible bond
Non-current liabilities
Financial liability component of convertible bond
Working

Solution
1

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Essential reading
Chapter 11, Section 5 of the Essential reading includes detail on the disclosure requirements of
IFRS 7.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

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Chapter summary

Financial instruments

The need for Classification

a standard

• Increase in number and variety Categories Liabilities v equity

of financial instruments • Financial asset: • Substance over form important
• Standard setters did not keep – Cash • Liabilities contain a
pace – Equity instrument of another contractual obligation
• Inconsistencies in recognition entity
and measurement – Contractual right to:
• Criticism about recognition ◦ Receive cash (or another Compound financial instruments
and disclosure financial asset) • Split into financial liability and
• Lack of understanding from ◦ Exchange financial equity components
users instruments under • Financial liability:
favourable conditions Present value of principal X
• Financial liability: Present value of interest X
– Contractual obligation to X
◦ Deliver cash (or another • Equity:
financial asset) – Proceeds – financial liability
◦ Exchange financial
instruments under
unfavourable conditions Interest, dividends, gains and
• Equity: losses
– Evidences a residual interest • Presented in p/l if associated
in the assets after deducting with liabilities
all of its liabilities • Presented in equity if
associated with equity

Recognition Derecognition Factoring of trade receivables

• When entity becomes party to • Financial assets – rights to • In substance a genuine sale
contractual provisions of the cashflows expire or – Derecognise trade receivable
instrument • Substantially all risks and • In substance a secured loan
• Usually: rewards transferred – Continue to recognise a
– Trade receivable/payable • Financial liabilities – trade receivable and
◦ On transfer of promised discharged, cancelled, expires recognise a financial liability
goods/services
– Loans
◦ On issue
– Shares
◦ On issue

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Measurement

Measurement of financial assets Measurement of financial liabilities

Business model test Two categories

Initial and subsequent measurement Initial and subsequent measurement

• Investments in debt instruments held to collect • Most financial liabilities:
contractual cash flows (solely principal and – Initial: Fair value - transaction costs
interest) – Subsequent: Amortised cost
– Initial: FV + transaction costs • Financial liabilities at fair value through P/L
– Subsequent: Amortised cost ('held for trading' and derivative liabilities)
• Investments in debt instruments held to collect – Initial: Fair value
contractual cash flows (solely principal and – Subsequent: Fair value through P/L
interest) and to sell
– Initial: FV + transaction costs
– Subsequent: FV through OCI Fair value
• Investments in equity instruments not 'held for Price to sell an asset or transfer a liability in
trading' (optional irrevocable election on orderly transaction between market
initial recognition) participants at the measurement date
– Initial: FV + transaction costs
– Subsequent: FV through OCI
• All other financial assets Amortised cost
– Initial: FV + transaction costs • Amount at which item was initially recorded
– Subsequent: FV through OCI less any principal repayments, plus the
cumulative amortisation of the difference
between the initial and maturity values
Fair value • Calculation:
Price to sell an asset or transfer a liability in Balance b/d X
orderly transaction between market X
participants at the measurement date Interest received (coupon × par value) (X)
Balance c/d X
Amortised cost
• Amount at which item was initially recorded
less any principal repayments, plus the
cumulative amortisation of the difference
between the initial and maturity values
• Calculation:
Balance b/d X
X
Interest received (coupon × par value) (X)
Balance c/d X

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Knowledge diagnostic
1. The need for an accounting standard
The market for financial instruments developed faster than the standard setters could keep pace
with. There was a lack of guidance around accounting for financial instruments, leading to
inconsistencies and a lack of understanding.

2. Classifications
Financial assets are cash, the right to receive cash under a contract or derivative assets. Similarly,
financial liabilities are an obligation to deliver cash under a contract or derivative liabilities.
Financial instruments are classified in accordance with their substance. Redeemable preference
shares are, in substance, debt and are shown as a non-current liability in the statement of
financial position.
Compound instruments must be split into its financial liability and equity components. This is
done by measuring the financial liability (debt) component, first by discounting the debt’s cash
flows, and then assigning the residual cash received to the equity component.

3. Recognition and derecognition

Recognition – A financial asset or financial liability should be initially recognised in the statement
of financial position when the reporting entity becomes a party to the contractual provisions of
the instrument.
Derecognition of financial assets – When the contractual rights to the cash flows expire; or when
the financial asset is transferred, based on whether the entity has transferred substantially all
the risks and rewards of ownership of the financial asset.
Derecognition of financial liabilities – When the obligation is discharged (eg paid off), cancelled
or expires.
Factoring of trade receivables – If factoring is, in substance, a genuine sale, derecognise the
trade receivables. If factoring is, in substance, a secured loan, continue to recognise the trade
receivable and recognise a financial liability.

4. Measurement
Financial assets are measured depending upon their classification.
Financial assets that are investments in debt instruments held for the purpose of collecting cash
flows that are solely interest and principal cash flows are held at amortised cost.
Investments in debt instruments held to collect cash flows that are solely payments of principals
and interest and the intention is to sell the instrument are accounted for at fair value through
other comprehensive income (FVTOCI) with no reclassification to profit or loss.
All other financial instruments (including all derivatives) are held at fair value through profit or loss
(FVTPL). An exception is permitted for investments in equity instruments of another entity (eg an
investment in shares) that are not held for trading which can be accounted for as FVTOCI with
reclassification to profit or loss if an election is made to use that treatment at the original date of
purchase.
Most financial liabilities are accounted for as amortised cost.
Financial liabilities held for trading are accounted for as FVTPL.

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
18 Financial assets and liabilities

Further reading
There is a useful article regarding this subject on the ACCA website:
Financial Instruments
www.accaglobal.com

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Activity answers

Activity 1: Compound instruments

The correct answer is:
£
Step 1: Calculate the value of the whole instrument 2,000,000
Step 2: Calculate the value of the liability element (using the 9% interest
rate for equivalent bonds without conversion rights)

PV of the principal ($2m × 0.772) 1,544,000

PV of the interest ($120,000* × 2.531) 303,720
1,847,720
Step 3: 152,280
Calculate the residual value of the equity component
(balancing figure)

*The annual interest is 6% × $2m = $120,000

Activity 2: Debt factoring

The correct answer is:
This arrangement is a secured loan as the risk of non-payment is borne by Freddo Co, and a
lender’s return is charged on balances outstanding.
The receivables should remain in Freddo Co’s books. Interest is accrued on the monies advanced
by the factor and added to the loan payable. Amounts collected by the factor reduce receivables
and reduce the loan payable.

Activity 3: Financial assets at fair value

The correct answer is:
$751,000 gain
$’000
$9,500 × 1,187/1,100 10,251
Carrying amount (9,500)
Gain 751

Activity 4: Financial asset held at amortised cost

The correct answer is:
$42,997
At inception the bond is classed as a financial asset:
DEBIT Financial asset 445,867
CREDIT Cash 445,867

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IFRS 9 requires financial assets held to collect the cash flows to be held at amortised cost based
on their effective rate of interest (internal rate of return, IRR) as follows:
20X1 20X2 20X3
$ $ $
1 January – cash paid (440,000 + 5,867)/b/d 445,867 462,333 480,330
Interest income (445,867 × 9.3%)/(462,333 × 9.3%)/
(480,330 × 9.3%) 41,466 42,997 44,670
Coupon received (5% × 500,000)/20X3: coupon and
capital of 500,000 (25,000) (25,000) (525,000)
Financial asset c/d at 31 December 462,333 480,330 –

Activity 5: Financial liability at amortised cost

1 The correct answer is:
(a)
At 1 January 20X1 $
Non-current liabilities
Financial liability component of convertible bond (W1) 270,180
Equity component of convertible bond (300,000 – (W1) 270,180) 29,820

W1: Fair value of equivalent non-convertible debt $

Present value of principal payable at end of four years
(3,000 × $100 = $300,000 × 0.735) 220,500
Present value of interest payable annually in arrears for four years

Year 1 (5% × 300,000) = 15,000 × 0.926 13,890

Year 2 15,000 × 0.857 12,855
Year 3 15,000 × 0.794 11,910
Year 4 15,000 × 0.735 11,025
49,680
270,180
(b)
At 31 December 20X1 $
Finance costs (profit or loss)
Effective interest on financial liability component of convertible bond 21,614
Non-current liabilities
Financial liability component of convertible bond (W2) 276,794

W2
$
1.1.X1 Liability b/d 270,180
1.1.X1–31.12.X1 Interest at 8% 21,614
31.12.X1 Coupon interest paid (15,000)
31.12.X1 Liability c/d 276,794

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Leases
12
12

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference
no.

Account for right-of-use assets and lease liabilities in the records of the B6(a)
lessee.

Explain the exemption from the recognition criteria for leases in the B6(b)
records of the lessee.

Account for sale and leaseback agreements. B6(c)

12

Exam context
Leasing is an important area at the Applied Skills level, although you will be only looking at it from
the perspective of the lessee for your FR exam. It is vital that you understand the key steps and
question practice is key in order to consolidate your knowledge and application in this important
topic.
It is likely that this will come up as part of a longer, Section C question, and you may be asked to
comment on leasing and the accounting treatment as part of an interpretation of financial
statements question. This is also an area that works well as part of a Section B case style objective
testing question.
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Chapter overview
Leases (IFRS 16)

Issue Identifying a lease Lease liability

Definitions

Right-of-use asset Presentation Recognition exemptions

Right-of-use asset

Sale and leaseback

transactions

Transfer is in substance a sale

Transfer is NOT in
substance a sale

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1 Issue
1.1 Objective
Under IFRS 16 Leases, lessees must recognise assets and liabilities for all leases with a term of
more than 12 months, unless the underlying asset is of low value.
This is to prevent the previous practice of ‘off balance sheet financing’ whereby certain leases
(‘operating leases’) would not be shown on the statement of financial position, failing to recognise
the liability of that lease, nor the benefit of the asset they were leasing.

Exam focus point

You are only concerned with the accounting treatment of a lease from the perspective of the
lessee for your FR exam. However, it is important that you have a good understanding as the
concept will be developed further, including understanding the lessor accounting, at the SBR
level.

2 Identifying a lease
2.1 Definitions

Lease: A contract is, or contains, a lease if there is an identifiable asset and the contract
KEY
TERM conveys the right to control the use of the identified asset for a period of time in exchange for
consideration (IFRS 16: para. 9).
Underlying asset: An asset that is the subject of a lease, for which the right to use that asset
has been provided by a lessor to a lessee (IFRS 16: Appendix A).

The contract has to meet the definition of a lease contract to be within the scope of IFRS 16. A
lessee does not control the use of an identified asset if the lessor can substitute the underlying
asset for another asset during the lease term and would benefit economically from doing so.
Some contracts may contain elements that are not leases, such as service contracts. These must
be separated out from the lease and accounted for separately (IFRS 16: para. 13).

2.2 Elements of a lease

Right to control Identified asset Period of use

Entity must have the • Stated in the contract • Period of use in time or
right to: • May be part of a larger in units produced
• Obtain substantially all asset • Lease may only be for
economic benefits from • The lessor has no a portion of the term
the use of the asset; and substitution rights (a of the contract (if the
• Direct the use of the similar asset cannot be right to control the
asset used instead of the asset exists for part of
original leased asset) the term)

Illustration 1: Identifiable asset

Coketown Council has entered into a five-year contract with Carefleet Co, under which Carefleet
Co supplies the council with ten vehicles for the purposes of community transport. Carefleet Co
owns the relevant vehicle, all ten of which are specified in the contract. Coketown Council
determines the routes taken for community transport and the charges and eligibility for discounts.

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The council can choose to use the vehicles for purposes other than community transport. When
the vehicles are not being used, they are kept at the council’s offices and cannot be retrieved by
Carefleet Co, unless Coketown Council defaults on payment. If a vehicle needs to be serviced or
repaired, Carefleet Co is obliged to provide a temporary replacement vehicle of the same type.
1 Required
Does this contract contain a lease under the definition of IFRS 16?

Solution
1 The correct answer is:
This is a lease. There is an identifiable asset, the ten vehicles specified in the contract. The council
has a right to use the vehicles for the period of the contract. Carefleet Co does not have the right
to substitute any of the vehicles unless they are being serviced or repaired. Therefore, Coketown
Council would need to recognise a right-of-use asset and a lease liability in its statement of
financial position.

Activity 1: Is it a lease?
Outandabout Co provides tours around places of interest in the tourist city of Sightsee. While
these tours are mainly within the city, it does the occasional day trip to visit tourist sites further
away. Outandabout Co has entered into a three-year contract with Fastcoach Co for the use of
one of its coaches for this purpose. The coach must seat 50 people, but Fastcoach Co can use
any of its 50-seater coaches when required.
1 Required
Is this a lease?

Solution
1

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3 Lease liability
3.1 Initial measurement of the lease liability
At the start of the lease, the lease liability is measured at the present value of future lease
payments, including any expected payments at the end of the lease, discounted at the interest
rate implicit in the lease.
If that rate cannot be readily determined, use the lessee’s incremental borrowing rate.
The rate will be given to you in your exam.

Exam focus point

In the examination, the question will specify a value for the cumulative present value of $1
payable in X years’ time, so that candidates can calculate the present value quickly. So, for
example, you will be given the cumulative value of $1 in four years’ time at 5% as $3.546, and
a lease with an annual charge of $50,000 would have a present value of $50,000 × $3.546 =
$177,300.

3.2 Lease payments

As the company benefits from paying the lease over a period of time, the total amount paid will
therefore include capital and interest payments. The interest is referred to as an interest charge or
finance charge.

3.3 Allocating the finance charge

IFRS 16 requires the finance charge to be allocated to periods during the lease term, ie applying
the interest rate implicit in the lease (the lease’s internal rate of return) to the amount of capital
outstanding to calculate the finance charge for the period.
Consequently, at the start of the lease, the finance charges will be a higher proportion of the
lease payments. Towards the end of the lease’s life, the finance charge will be smaller as the
outstanding lease liability is smaller.

3.4 Calculation of lease liability

Payments in arrears
$
1.1.X1 Least liability (PVFLP) X
1.1.X1-31.12.X1 Interest at X% X
31.12.X1 Instalment in arrears (X)
31.12.X1 Liability c/d X
1.1.X2–31.12.X2 Interest at x% X
31.12.X2 Instalment in arrears (X)
31.12.X2 Liability > 1 year X

Payments in advance
$
1.1.X1 Lease liability (PVFLP) X
1.1.X1–31.12.X1 Interest at x% X*
31.12.X1 Liability c/d X
1.1.X2 Instalment in advance (X)
Liability > 1 year X

*Note. Can be analysed separately as interest payable as not paid at y/e, but no IFRS 16
requirement to do so.

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Activity 2: Leasing Case QTD

Bento Co leases an asset on 1 January 20X1. The terms of the lease are to pay a non-refundable
deposit of $575 followed by seven annual instalments of $2,000 payable in arrears. The present
value of the future lease payments, excluding the deposit, on 1 January 20X1 is $10,000.
The interest rate implicit in the lease is 9.2%.
1 Required
What is the interest charge in the statement of profit or loss for the year ended 31 December
20X1?

$
2 Required
What is the current and non-current liability balances included in the statement of financial
position as at 31 December 20X1?

Balance options
1,179 7,055

1,122 7,113

1,232 7,741

1,237 8,426

Balance to be shown as
Current liability

Non-current liability

Solution
1

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3.5 Subsequent measurement of the lease liability

• It will increase due to interest accrued on the outstanding liability
• It will decrease due to lease payments made
• Revised lease payments will be discounted based on the original discount interest rate.
• Any adjustment to the lease liability will be recognised as an adjustment to the right-of-use
asset measurement (through the statement of profit or loss).

4 Right-of-use asset
Right-of-use asset: An asset that represents a lessee’s right-to-use an underlying asset for the
KEY
TERM lease term.

The key is the right to control the use of the asset. The right to control the use of an identified
asset depends on the lessee having:
(a) The right to obtain substantially all of the economic benefits from use of the identified asset;
and
(b) The right to direct the use of the identified asset. This arises if either:
(i) The customer has the right to direct how and for what purpose the asset is used during
the whole of its period of use; or
(ii) The relevant decisions about use are predetermined and the customer can operate the
asset without the supplier having the right to change those operating instructions, or the
customer designed the asset in a way that predetermines how and for what purpose the
asset will be used throughout the period of use.

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4.1 Initial measurement of the right-of-use asset

The right-of-use asset is measured at cost, consisting of:
$m $m
Initial measurement of lease liability X
Payments made before or at commencement of lease X
Less incentives received (X)
X
Initial direct costs X
PV of costs of dismantling, removing and restoring the site X
Right-of-use asset X

At the commencement date, recognise a right-of-use asset, representing the right to use the
underlying asset and a lease liability representing the company’s obligation to make lease
payments
DEBIT Right-of-use asset X
CREDIT Lease liability X

4.2 Subsequent measurement of the right-of-use asset

After the commencement date, the right-of-use asset should be measured using the cost model in
IAS 16, unless it is an investment property or belongs to a class of assets to which the revaluation
model applies (IAS 16: para. 29).
IAS 16 cost model
Depreciation must be provided on the right-of-use asset:
DEBIT Depreciation X
CREDIT Right-of-use asset (accumulated depreciation) (SOFP) X

The right-of-use asset must be depreciated over:

(a) The useful life of the asset, if ownership transfers at the end of the lease term, or if the lessee
has a purchase option and is likely to exercise it; or
(b) If there is no transfer of ownership or purchase option, the shorter of the lease term and the
useful life of the asset.
The depreciation rate should be consistent with other non-current assets in the same class, to
ensure a consistent accounting policy.
Revaluation model
If a lessee applies the IAS 16 Property, Plant and Equipment revaluation model to a certain class of
property, plant and equipment, then the lessee can choose to also apply the revaluation model to
right-of-use assets that relate to that same class of property, plant and equipment (IFRS 16: para.
35).
If the revaluation model has been adopted for the same type of class of non-current asset, and
the entity must therefore apply the same accounting policy to the right-of-use asset. Impairment
reviews will be required in accordance with IAS 36 Impairment of Assets.

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Investment property
If the type of asset meets the criteria of an investment property, then the fair value model under
IAS 40 Investment Property must be adopted.

Exam focus point

The Examiner’s Report from June 2018 stated that candidates struggled with leases where the
payments were made in advance. Ensure that careful question practice on the topic of leases
is completed.

5 Presentation
5.1 Statement of financial position
Right-of-use assets
Right-of-use assets should be disclosed separately from other assets, either as a separate line on
the statement of financial position or separately within the notes.
Right-of-use assets which qualify as investment property are an exception; they should be
presented within investment property in the statement of financial position.
Lease liabilities
Lease liabilities should be disclosed separately from other liabilities, either in the statement of
financial position or in the notes.
The balance remaining at the year-end needs to be split between current liabilities and non-
current liabilities. (IFRS 16 does not require this but this should be in accordance with IAS 1
Presentation of Financial Statements.)
Non-current liabilities
Lease liabilities X
Current liabilities
Lease liabilities X

5.2 Statement of profit or loss and other comprehensive income

Interest expense on the lease liability and depreciation on the right-to-use asset should be
presented separately.
Interest expense should be presented as part of finance costs.

5.3 Disclosures
IFRS 16 requires information about a company’s leases to be disclosed in a separate note and
include:
$
Interest expense on lease liabilities X

Depreciation on right-of-use assets (by class of underlying asset) X

Expenses relating to short-term and low-value leases X
Carrying amount of right-of-use assets (by class of underlying asset) X

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Activity 3: Alpha Co
Alpha Co makes up its accounts to 31 December each year. It enters into a lease (as lessee) to
lease an item of equipment with the following terms:

Inception of lease: 1 January 20X1

Term: Five years: $2,000 paid at commencement of

lease, followed by 4 payments of $2,000
payable in advance

Fair value: $8000

Present value of future lease payments: $6,075

Useful life: 8 years

Interest implicit in the lease: 12%

1 Required
What is the value of the right-of-use asset in the statement of financial position as at 31
December 20X1?
 $8,000
 $6,460
 $6,000
 $8,075
2 Required
What is the non-current liability balance in the statement of financial position as at 31 December
20X1?
 $4,075
 $4,804
 $6,804
 $6,075

Solution
1

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6 Recognition exemptions
6.1 Which leases are exempt?
IFRS 16 provides optional exemptions from applying the full requirements of IFRS 16 on the
following types of lease:
(a) Short-term leases. These are leases with a lease term of 12 months or less. This election is
made by class of underlying asset. A lease that contains a purchase option cannot be a
short-term lease.
(b) Low-value leases. These are leases where the underlying asset has a low value when new
(such as tablet and personal computers or small items of office furniture and telephones).
This election can be made on a lease-by-lease basis. An underlying asset qualifies as low
value only if two conditions apply:
(i) The lessee can benefit from using the underlying asset.
(ii) The underlying asset is not highly dependent on, or highly interrelated with, other assets.
An entity must elect to utilise the exemption. The election for low value leases can be made on a
lease-be-lease basis, but the election for short-term leases is made by class of underlying assets.

6.2 Accounting treatment

Lease payments are recognised as an expense in profit or loss on a straight-line basis over the
lease term, unless some other systematic basis is representative of the time pattern of the user’s
benefit.

Activity 4: Oscar Co
Oscar Co is preparing its financial statements for the year ended 30 June 20X6. On 1 May 20X6,
Oscar made a payment of $32,000 for an eight-month lease of a milling machine. Oscar has
elected to utilise any lease exemptions available.
1 Required
What amount would be charged to Oscar Co’s statement of profit or loss for the year ended 30
June 20X6 in respect of this transaction?

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Solution
1

7 Sale and leaseback transactions

7.1 Issue
A sale and leaseback transaction involves the sale of an asset and the leasing back of the same
asset. The key question in determining the accounting treatment is: does the transaction
constitute a sale? This is determined by considering when the performance obligation is satisfied
in accordance with IFRS 15 Revenue from Contracts with Customers.

7.2 Accounting treatment

Transaction is a sale, per IFRS 15
Measure the right-of-use asset arising from the leaseback at the proportion of the previous
carrying amount of the asset that relates to the right of use retained by the seller/lessee. This is
calculated as:
Present value of future lease payments (PVFLP)
Carrying amount × Fair value

The discounted future lease payments are calculated as for any other lease.
Recognise only the amount of any gain or loss on the sale that relates to the rights transferred to
the buyer/lessor. Calculate in three stages:

Stage 1: Calculate gain = fair value (usually = proceeds) less carrying amount

Stage 2: Calculate gain that relates to rights retained:

Gain × present value of future lease payments/fair value = Gain relating to rights
retained

Stage 3: Gain relating to rights transferred is the balancing figure:

Gain on rights transferred = total gain (Stage 1) less gain on rights retained (Stage
2)

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The right-of-use asset continues to be depreciated as normal, although a revision of its remaining
useful life may be necessary to restrict it to the lease term.

Activity 5: Wigton Co
On 1 April 20X2, Wigton Co bought an injection moulding machine for $600,000. The carrying
amount of the machine as at 31 March 20X3 was $500,000. On 1 April 20X3, Wigton Co sold it to
Whitehaven Co for $740,000, its fair value. Wigton Co immediately leased the machine back for
five years, the remainder of its useful life, at $160,000 per annum payable in arrears. The present
value of the future lease payments is $700,000 and the transaction satisfies the IFRS 15 criteria to
be recognised as a sale.
Required
What gain should Wigton Co recognise for the year ended 31 March 20X4 as a result of the sale
and leaseback?
 $227,027
 $240,000
 $12,973
 $40,000

Solution

Activity 6: Capital Co
Capital Co entered into a sale and leaseback on 1 April 20X7. It sold a lathe with a carrying
amount of $300,000 for $400,000 (equivalent to fair value) and leased it back over a five-year
period, equivalent to its remaining useful life. The transaction constitutes a sale in accordance
with IFRS 15.
The lease provided for five annual payments in arrears of $90,000. The rate of interest implicit in
the lease is 5%. The cumulative value of $1 in five years’ time is $4.329.
1 Required
What are the amounts to be recognised in the financial statements at 31 March 20X8 in respect of
this transaction?

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Solution
1

7.3 Transaction is not a sale per IFRS 15

If the transfer does not satisfy the IFRS 15 requirements to be accounted for as a sale:
• The seller must continue to recognise the transferred asset
• The transfer proceeds are treated as a financial liability, accounted for in accordance with
IFRS 9
The transaction is more in the nature of a secured loan.

Essential reading
In Chapter 12 of the Essential reading there is additional information about how to account for
sale and leaseback transaction that is not on market terms. There is also a detailed illustration
which explains the various steps in accounting for a lease, as this can be a tricky area for
students.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

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Chapter summary

Leases (IFRS 16)

Issue Identifying a lease Lease liability

To prevent off-balance Definitions PVLP not paid at

sheet financing • A contract, or part of a contract, that conveys the commence. date X
right to use an asset (the underlying asset) for a Interest at implicit % X
period of time in exchange for consideration Payment in arrears (X)
• Contract contains a lease if the contract conveys Liability c/d
the right to control an asset for a period of time for (split NCL & CL) X
consideration, where, throughout the period of use,
the customer has:
(a) Right to obtain
substantially all of the economic benefits from
use, and
(b) Right to direct use of identified asset

Right-of-use asset Presentation Recognition exemptions

Right-of-use asset • Right-of-use assets disclosed • Optional exemptions (expense

PVLP not paid at separately from other assets, in P/L):
commence. date X EITHER as a separate line on – Short-term leases (lease term
Payments on/before the face of the SOFP or as a < 12 months)
comm. date X separate category within the – Underlying asset is low value
Notes. (eg tablet PCs, small office
Initial direct costs X
• Right-of-use investment assets furniture, telephones)
Dismantling/restoration costs X to be presented within
X investment property
• Lease liabilities should be split
between current and
Depreciate to earlier of end of non-current (IAS 1)
useful life (UL) and lease term • Interest expense presented in
(UL if ownership expected to finance costs
transfer)

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Sale and leaseback transactions

Transfer is in substance a sale

• Seller/lessee:
– Derecognises asset transferred
– Recognises a right-of-use asset at proportion of
previous CA for right of use retained
– Recognises gain/loss in relation to rights
transferred
• If consideration received is not equal to asset's FV (or
lease payments not at market rates):
– Below-market terms: prepayment of lease
payments (add to right-of-use asset)
– Above-market terms: additional financing (split PV
lease liability between loan and lease payments at
market rates)
• Buyer-lessor accounts for:
– The purchase as normal purchase
– The lease per IFRS 16

Transfer is NOT in substance a sale

• Seller-lessee:
– Continues to recognise transferred asset
– Recognises financial liability equal to transfer
proceeds (and accounts for it per IFRS 9)

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Knowledge diagnostic
1. Issue
• Lessee accounting is an example of the application of the substance over form concept.
• The asset is recognised in the books of the entity that controls it, even though that asset may
never be owned by the entity.

2. Leases
• A contract, or part of a contract, that conveys the right to use an asset, the underlying asset,
for a period of time in exchange for consideration.
• Lessees must recognise assets and liabilities for all leases with a term of more than 12 months,
unless the underlying asset is of low value.

3. Recognition exemptions
• For short-term leases or leases of low value assets, the lease payments are simply charged to
profit or loss as an expense.

4. Sale and leaseback transactions

• Accounting for sale and leaseback transactions depends on whether the transaction meets the
IFRS 15 criteria for a sale.
• Sale: Recognise a right-of-use asset at the proportion of the previous carrying amount of the
asset that relates to the right-of-use retained. Recognises only the amount of any gain/loss
that relates to the rights transferred.
• Not a sale: Continue to recognise the transferred asset and treat the transfer as a financial
liability, as per IFRS 9.

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
24 Bulwell Aggregates Co
25 Lis Co

Further reading
There are articles in the Exam Resources section of the ACCA website which are relevant to the
topics covered in this chapter and would be useful to read:
IFRS 16 Leases
www.accaglobal.com

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Activity answers

Activity 1: Is it a lease?
1 The correct answer is:
This is not a lease. There is no identifiable asset. Fastcoach Co can substitute one coach for
another, and would derive economic benefits from doing so in terms of convenience. Therefore,
Outandabout Co should account for the rental payments as an expense in the statement of profit
or loss.

Activity 2: Leasing Case QTD

1 The correct answer is:
$920
2 The correct answer is:

Balance options
1,179 Current liability 7,055

1,122 7,113

1,232 7,741 Non-current liability

1,237 8,426

Working
$
1.1.X1 Liability b/d 10,000
1.1.X1–31.12.X1 Interest at 9.2% 920
31.12.X1 Instalment 1 (in arrears) (2,000)
31.12.X1 Liability c/d 8,920
1.1.X2–31.12.X2 Interest at 9.2% 821
31.12.X1 Instalment 2 (in arrears) (2,000)
31.12.X1 Liability c/d 7,741

Activity 3: Alpha Co
1 The correct answer is:
$6,460
RIGHT-OF-USE ASSET
$
Initial measurement of lease liability 6,075
Payments made before or at commencement of lease 2,000
Right-of-use asset 8,075

Depreciation charge = $8,075/5 = $1,615 (depreciate over shorter of useful life or lease term)
Carrying amount = $8,075 – $1,615 = $6,460

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2 The correct answer is:

$4,804
STATEMENT OF FINANCIAL POSITION (EXTRACT)
$
Non-current assets
Right-of-use asset (8,075 – 1,615) 6,460

Non-current liabilities
Lease liability (Working) 4,804

Working
$
1.1.X1 Liability b/d 6,075
1.1.X1-31.12.X1 Interest at 12% 729
31.12.X1 Liability c/d 6,804
1.1.X2 Instalment 2 (in advance) – current liability (2000)
1.1.X2 Non-current liability 4,804

Activity 4: Oscar Co
1 The correct answer is:
The lease is for eight months, which counts as a short-term lease, and so it does not need to be
recognised in the statement of financial position. The amount charged to profit or loss for the year
ended 30 June 20X6 is therefore $32,000 × 2/8 = $8,000.

Activity 5: Wigton Co
The correct answer is:
$12,973
Stage 1: Gain on sale: $700,000 – $540,000 = $240,000
Stage 2: Gain relating to rights retained = $(240,000 × 700,000/740,000) = $227,027
Stage 3: Gain relating to rights transferred = $240,000 – $227,027 = $12,973

Activity 6: Capital Co
1 The correct answer is:
(a) Calculate the lease liability at the commencement date.
$90,000 × $4.329 = $389,610
(b) Measure the right-of-use asset = carrying amount × discounted lease payments/fair value.
= 300,000 × 389,610/400,000
= $292,208
(c) Calculate the gain on the sale and leaseback.
Stage 1: Total gain on the sale = Fair value – carrying amount
= $400,000 – $300,000
= $100,000
Stage 2: Gain relating to the rights retained Discounted lease payments
Gain × Fair value
= $(100,000 × 389,610/400,000)
= $97,402

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Stage 3: Gain relating to the rights = Total gain (Stage 1) – gain on rights
transferred retained (Stage 2)
= $100,000 – $97,402
= $2,598

(d) Record the transaction in the accounts:

(i) Record the initial lease transaction:
Debit Credit
$ $
Cash 400,000
Right-of-use asset 292,208
Underlying asset 300,000
Liability 389,610
Gain on transfer – 2,598
692,208 692,208

(ii) Reflect the payments made during the year:

Debit Credit
$ $
Cash 90,000
Lease liability 90,000 –
90,000 90,000

(iii) Depreciation charged on the right of use asset:

Debit Credit
$ $
Depreciation expense (SOPL) (292,208/5) 58,442
Accumulated depreciation (SOFP) – 58,442
58,442 58,442

(iv) Record the finance charge on the lease liability:

Debit Credit
$ $
Interest expense (W) 19,480
Lease liability – 19,480
19,480 19,480

The transaction will be shown in the financial statements as follows:

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$
Statement of profit or loss
Gain on transfer 2,598
Depreciation (292,208/5) (58,442)
Interest (W) (19,480)

Statement of financial position

Non-current asset
Right-of-use asset (292,208 – 58,442) 233,766

Non-current liabilities
Lease liability (W) 245,044

Current liabilities
Lease liability (319,090 – 245,044) (W) 74,046

Working – lease liability

$
1.4.X7 Lease liability (present value of future lease payments) 389,610
1.4.X7 – 31.3.X8 Interest at 5% 19,480
31.3.X8 Instalment paid in arrears (90,000)
31.3.X8 Liability carried down 319,090
1.4.X8 – 31.3.X9 Interest at 5% 15,954
31.3.X9 Instalment paid in arrears (90,000)
31.3.X9 Liability due in more than 1 year 245,044

Current liabilities reflect the amount of the lease liability that will become due within 12 months.

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Skills checkpoint 4
Application of accounting
standards

Chapter overview
cess skills
Exam suc

Answer planning

c FR skills C
n Specifi o
tio

rr req
a

ec ui
of
m

t i rem
or

nt
inf

erp ents
ng

Approach to Application

reta
agi

objective test of accounting

(OT) questions standards
Man

tion l y si s
Spreadsheet Interpretation
Go od

skills skills
ana
ti m

c al

Approach
em

to Case
e ri

OTQs
an

um
ag

tn
em

en

en
t ci
Effi
Effe cti
ve writing
a nd p r
esentation

Introduction
FR introduces more accounting standards and tests a further understanding of the ones already
covered in your earlier studies (for example, IAS 2 Inventories and IAS 16 Property, Plant and
Equipment).
It is important that you understand how the standards that are covered in the FR exam apply to
financial statements, not just gaining the knowledge of what they are and how they work, but
also developing your application skills. These application skills will be further developed in SBR, so
it is vitally important that you gain a confident knowledge of the main accounting standards in
your FR studies.
Knowledge of the accounting standards will be required in all sections of the FR exam. You are
unlikely to be asked to explain the requirements of an accounting standard in a narrative
question, but may be asked questions about the application or impact of accounting standards in
an OTQ, or it may be relevant in the interpretation of an entity’s performance and position in
Section C.
The key to success in the FR exam is:
• Understanding the key elements of the accounting standards; and
• Applying your knowledge of these accounting standards.

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Skills Checkpoint 4: Application of accounting

standards
FR Skill: Application of accounting standards
We would suggest the following approach for tackling your FR exam in respect of demonstrating
your application of accounting standards.

STEP 1: Overview of key standards

Ensure you have a high-level overview of the key standards covered in the FR
exam. Use the summary diagrams at the end of the chapters in the Workbook to
act as your summaries. These are a useful way of remembering the key points.

STEP 2: Numerical question practice

Practice the numerical questions in the Workbook and in the Practice & Revision
Kit. These will test your knowledge of the mechanics of the accounting standards.
Often there can be a difference between understanding what the standard does
and how it applies to a specific scenario. Practice OTQs as well as longer, Section C
questions to consolidate your knowledge.

STEP 3: Narrative question practice

Practice the narrative questions which test your understanding of how the standard
can affect the financial statements. This will help you to revise your understanding
of why the accounting standard is important in a scenario. For example, what are
the key tests for impairment of assets and why would this be important for the
financial statements?

Exam success skills

The following question is an example of the way in which you may be asked to demonstrate your
knowledge and application of an accounting standard. Here, the question is asking about IAS 8
Accounting Policies, Changes in Accounting Estimates and Errors.
For these questions, we will also focus on the following exam success skills:
• Managing information. It is easy for the amount of information contained in a question,
particularly the cases in Section B and the Section C question to feel overwhelming. Active
reading is a useful technique to help you avoid this. This involves focusing on the requirement
first, on the basis that until you have done this the detail in the question will have little
meaning.
• Correct interpretation of requirements. Make sure you understand why you are being asked
about a particular standard. Is it so can you apply the rules in a calculation question, or is it so
you understand for example a difference in accounting treatment that is relevant to
interpretation?
• Efficient numerical analysis. Ensure you understand what the standard requires you to do
with the financial information you are provided with in the question. This is testing your
application of the standards.
• Effective writing and presentation. Section C questions require application of an accounting
standard both in the accounts preparation question as knowledge of the accounting standard
is essential in preparing calculations and adjustments and also in the interpretation question
where the standard applied may be relevant to your understanding of the entity. Set out your
points clearly and methodically, to enable the Examining team to read your answer easily.

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Skill activity
STEP 1 Ensure you have a high-level overview of the key standards covered in the FR exam. Use the summary
diagrams at the end of the chapters in the Workbook to act as your summaries. These are a useful way of
remembering the key points.
It is important that you have the knowledge of the mechanics of the standard. One way of doing
this is by using the chapter summaries in the Workbook which summarise the key points about the
standards discussed. IAS 8 is discussed in Chapter 17 of the Workbook, and here is an extract of
the summary diagram.

Events after the reporting period (IAS 10)

Definition
Events which occur between the end of the reporting
period and the date when the financial statements are
authorised for issue

Accounting treatment
• Conditions which existed at end of reporting period –
adjusting
• Conditions which arose after the end of the reporting
period – non-adjusting

Nature of disclosure
Material events to disclose the nature and estimate of the
financial impact (or why it cannot be reliably estimated)

Need for disclosure

Users can understand the reason behind unusual
movements or provisions in the financial statements, and
their financial impact

Ensure that you are familiar with the standard, and understand the key points made in the
summary. This will act, initially, as your main reference for applying the accounting treatment.
Once you have gained additional question practice, you will be familiar with different question
styles and different scenarios.
STEP 2 Practice the numerical questions in the workbook and in the BPP Practice and Revision Kit. These will test
your knowledge of the mechanics of the accounting standards. Often there can be a difference between
understanding what the standard does and how it applies to a specific scenario. Practice OTQs as well as
longer, Section C questions to consolidate your knowledge.
Question practice is key to success in your FR exam. Practising the OTQ style questions are a
relatively quick way of testing your knowledge, both of narrative and numerical questions.
However, having knowledge of the theory of the standard and applying that knowledge can often
cause problems for students, especially in the more complex standards such as IFRS 16 Leases.
STEP 3 Practice the narrative questions which test your understanding of how the standard can affect the financial
statements. This will help you to revise your understanding of why the accounting standard is important in a
scenario, for example, what are the key tests for impairment of assets and why would this be important for
the financial statements?

Success in answering narrative OTQs requires you to

explain what the accounting treatment in a given
scenario is. These questions require you to read the
answer options very carefully. Although there is only

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one correct answer, all will be viable alternatives so it

can be difficult to discount any options immediately or
arrive at the correct answer easily without giving the
question due attention.

Here is an example of the type of narrative style

question you may get asked in a Section A OTQ:

Which of the following would be treated under IAS 812 12

This is the key accounting standard in
the question, but the answer options
Accounting Policies, Changes in Accounting Estimates require knowledge of other standards.
and Errors as a change of accounting policy13? 13
IAS 8 covers 3 areas - here we are
14 focused on change in accounting policy.
(a) A change in valuation of inventory from a
weighted average to a FIFO basis
14
Here you need to think of the
15
(b) A change of depreciation method from straight interaction between IAS 2 and IAS 8. Is
there an accounting policy choice
line to reducing balance relating to the valuation of inventory?

(c) The correction of the opening balance for accruals

15
Here you need to think of the
as a result of a recording inaccuracy in the prior interaction between IAS 16 and IAS 8.
Depreciation is an accounting policy
year16 choice, but the method of depreciation is
an accounting estimate.
(d) Capitalisation of borrowing costs which have arisen
for the first time17 16
There is no mention of a policy here.
(2 marks)
17
The fact that this policy is being
The correct answer is: applied for the first time tells us that it
cannot be a change in policy.
A change in valuation of inventory from a weighted
average to a FIFO basis.

Answering this question required you to understand IAS

8, but also the underlying accounting standards
relating to IAS 2, IAS 16 and to a lesser extent IAS 23.

IAS 2 Inventories permits an entity to value its inventory

using either the weighted average or FIFO basis and
therefore permits an accounting policy choice. As such,
the change in valuation is an example of a change in
accounting policy.

The change of depreciation method is treated as a

change of accounting estimate. The difference between
these is subtle and is a good example of you needing to
understand not just IAS 8 – you need to know the
difference between a change in accounting policy and
a change in accounting estimate, but also IAS 16 as you

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need to know that the policy is to depreciate, which has

not changed.

The correction of opening balances is clearly

accounting for an error and therefore not related to an
accounting policy.

Application of a new accounting policy (such as

capitalisation of borrowing costs) for transactions that
did not previously occur is not a change in accounting
policy according to IAS 8.

Exam success skills diagnostic

Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been completed
below for the above question to give you an idea of how to complete the diagnostic.

Exam success skills Your reflections/observations

Managing information Ensure that you read the question carefully, highlighting any
areas which you may need to refer back to. In a short OTQ
such as this one, the key was the standard which was IAS 8
and the fact that we were focusing on accounting policies.

Correct interpretation of Make sure you have answered the question by referring to the
requirements given information. As mentioned above, this question hinged
on you understanding that you should focus on accounting
policies and not the whole of IAS 8.

Efficient numerical analysis There was not any numerical analysis in this narrative
question. Remember that FR is not all about getting the
numbers right. Expect a range of numerical and narrative
questions in the exam.

Effective writing and In an OTQ, you don’t need to worry about writing and
presentation presentation. However, consider how you might discuss the
impact of the change in accounting policy in an interpretation
question in Section C.

Most important action points to apply to your next question – work through each of the
alternative answers carefully as the differences between the options are often subtle.

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Provisions and events

13 after the reporting period

13

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference
no.

Explain why an accounting standard on provisions is necessary. B7(a)

Distinguish between legal and constructive obligations. B7(b)

State when provisions may and may not be made and demonstrate how B7(c)
they should be accounted for.

Explain how provisions should be measured. B7(d)

Define contingent assets and liabilities and describe their accounting B7(e)
treatment and required disclosures.

Identify and account for: B7(f)

(a) Warranties/guarantees
(b) Onerous contracts
(c) Environmental and similar provisions
(d) Provisions for future repairs or refurbishments

Events after the reporting period: B7(g)

(a) Distinguish between and account for adjusting and non-adjusting
events after the reporting period.
(b) Identify items requiring separate disclosure, including their
accounting treatment and required disclosures.
13

Exam context
You will already have covered the basic aspects of IAS 37 Provisions, Contingent Liabilities and
Contingent Assets, in your earlier studies. The FR exam builds on this knowledge by looking at the
criteria for provisions for restructuring. IAS 10 Events After the Reporting Period is also revisited,
and you need to be able to review financial statements and correct for errors and omissions which
occur after the reporting date. The exam will test your application of these skills within both
objective test and as part of longer (Section C) questions. If you require revision from your earlier
studies, review the activities and information in the Essential reading section.
13

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Chapter overview
Provisions and events after the reporting period

Provisions Types of provision

(IAS 37)

Definition Warranties Future operating losses

Recognition Decommissioning costs Onerous contracts

Measurement Restructuring

Contingent Contingent Events after the

liabilities assets reporting period (IAS 10)

Definition Definition Definition

Accounting treatment Accounting treatment Accounting treatment

Nature of disclosure Nature of disclosure Nature of disclosure

Need for disclosure Need for disclosure Need for disclosure

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1 Provisions (IAS 37 Provisions, Contingent Liabilities and

Contingent Assets)
You were introduced to IAS 37 Provisions, Contingent Liabilities and Contingent Assets in your
earlier studies, so some of this section will be revision. In FR, provisions become more complex,
such as the accounting treatment for onerous contracts as well as other types of provisions (such
as warranties and restructuring provisions). The complexity of provisions is greater at FR as
discounting is also introduced to reflect the time value of money for future losses or provisions

Essential reading
For revision on IAS 37, refer to your Essential reading.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

Provision: A provision is a liability of uncertain timing or amount. (IAS 37: para. 10)
KEY
TERM

Recognition
(a) ‘A provision shall be recognised when:
(i) An entity has a present obligation (legal or constructive) as a result of a past event;
(ii) It is probable that an outflow of resources embodying economic benefits will be required
to settle obligation; and
(iii) A reliable estimate can be made of the amount of the obligation.’
(IAS 37: para. 14)
Unless these conditions are met, no provision can be recognised.
(b) Provisions are reviewed each year and adjusted to reflect current best estimate. If it is no
longer probable that an outflow of resources embodying economic benefits will be required,
the provision is reversed.
Present obligations and obligating events
(c) A past event which leads to a present obligation is called an obligating event. For an event to
be an obligating event, it is necessary that the entity has ‘no realistic alternative to settling
that obligation’ created by the event (IAS 37: para. 17).
(d) In rare cases, it is not clear whether there is a present obligation. In these cases, a past event
is deemed to give rise to a present obligation if, taking into account all available evidence, it is
more likely than not that a present obligation exists at the end of the reporting period.
Legal and constructive obligations
(e) An obligation can either be legal or constructive.
(f) A legal obligation is one that derives from a contract, legislation or any other operation of
law.
(g) A constructive obligation is an obligation that derives from the actions of an entity where:
(i) From an established pattern of past practice, published policies or a specific statement,
the entity has indicated to other parties that it will accept certain responsibilities; and
(ii) As a result, the entity has created a valid expectation in other parties that it will
discharge those responsibilities.
(IAS 37: para. 10)
Measurement
(h) The amount recognised as a provision is the best estimate of the expenditure required to
settle the obligation at the end of the reporting period.
Provisions are discounted where the effect of the time value of money is material.

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Activity 1: Discounting the provision

Cambridge Co is preparing the financial statements for the year ended 31 December 20X5.
Cambridge Co knows that when it ceases a certain operation in five years’ time it will have to pay
environmental clean-up costs of $5 million.
The relevant discount rate in this case is 10%.
The discounted values of $1 are as follows:
$1 in five years = $0.621
$1 in four years = $0.683
Required
Answer the following questions:
(a) Calculate the provision required for the year end 31 December 20X5.
(b) Calculate the provision required for the year end 31 December 20X6.

Solution

Essential reading
The Essential reading has an example showing the double entry and full explanation of unwinding
of a discount, looking in depth at the impact on the financial statements.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

Exam focus point

You will be given the relevant discount factor in your exam question, such as the value of $1 in
four years’ time will be 0.683. Ensure you are familiar with the discounting and the subsequent
unwinding of the discount with sufficient question practice.

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Uncertainties
Where the provision involves a large population of items:
• Use expected values, taking into account the probability of all expected outcomes.
Where a single obligation is being measured:
• The individual most likely outcome may be the best evidence of the liability.

2 Types of provision
Applied Skills level develops your application of knowledge gained in your earlier studies as well as
introducing more complex ideas.

2.1 Warranties
Warranties are argued to be genuine provisions based on past experience that it is probable, ie
more likely than not, that some claims will emerge.
Due to the developments in IFRS 15, Revenue from Contracts with Customers, the nature of how
the liability has arisen should be taken into account regarding its accounting treatment. You
should consider whether:
• There is a legal obligation, such as all goods being purchased online may be returned within
14 days for a full refund under the Consumer Contracts Regulations; or
• There is a constructive obligation, such as the store has historically allowed a 12 month, ‘no
quibble’ return guarantee.
Then the entity should make the provision under IAS 37.
Warranties that the customer pays for separately (extended warranties, such as for white goods)
are covered by IFRS 15 Revenue from Contracts with Customers (see Chapter 6). This is due there
being a contract between the customer and the supplier in exchange for a separable component
(a performance obligation).
The nature of the warranty granted will determine whether the warranty should be accounted for
under IAS 37 or IFRS 15.

Activity 2: Warranties
Warren Co gives warranties, at no additional cost, to its customers. There is no legal requirement
to repair or replace these items after 28 days, but Warren Co promises, on its website, to make
good, by repair or replacement, manufacturing defects that become apparent within a period of
one year from the date of the sale. Warren Co has replaced between 4% and 6% of total sales of
the product in the past five years.
Required
Which of the following statements about the above scenario is correct?
 Warren Co is not required to make a provision because there is no legal obligation to
undertake the repair work.
 Warren Co has an obligation to repair or replace all items of product that show
manufacturing defects, therefore a provision for the cost of this should be made.
 Warren Co has an obligation to repair or replace all items that show manufacturing defects,
however, as the amount cannot be reliably estimated, no provision is required.
 Warren Co must make a provision under IAS 37 because this is a potential future operating
loss.

Solution

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2.2 Decommissioning or other environmental costs

These costs usually arise at the end of the useful life of an asset. A provision should only be
recognised if there is a present obligation as a result of a past event, eg if the future
decommissioning costs are legally required. If the provision relates to an asset, then it can be
capitalised as part of the cost of the asset. The decommissioning or other environmental costs
often occur many years in the future, and so the future cost should be discounted to present
value.
For example, when an oil company initially purchases an oilfield it is put under a legal obligation
to decommission the site at the end of its life.
IAS 37 considers that a legal obligation exists on the initial expenditure on the field and therefore
the provision should be recognised immediately. The view is taken that the cost of purchasing the
field in the first place is not only the cost of the field itself but also the costs of putting it right
again. Thus, all the costs of decommissioning may be capitalised.

2.2.1 Capitalised provision costs

Costs which are capitalised will be depreciated over the useful life of the machine (or if it relates to
a specific overhaul or major refurbishment, the useful life prior to that date). So, if a machine
requires a major refurbishment every five years in order to remain functional, then the capitalised
provision will be depreciated over the five years.
This is demonstrating the accruals concept of accounting as the costs relating to the asset (both
its use and its required refurbishment) are spread across the period when the revenue is being
generated.
The double entry would be:
DEBIT Non-current assets
CREDIT Provision
The costs have not yet been expensed in the statement of profit or loss. Instead, the costs are
released to the profit or loss account by depreciating the asset (and the capitalised provision).
Subsequent double entries would be:
DEBIT Depreciation expense (SOPL)
CREDIT Accumulated depreciation (SOFP)
This will expense the cost of the provision over the period, such as a refurbishment required in five
years’ time, depreciation expensed over five years.
Once the provision is required in the final year, the accounting entries will be:
DEBIT Provision
CREDIT Cash

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Exam focus point

Questions in Part B of your exam may ask multiple questions about a topic, and as we have
already seen in earlier examples, the questions may cover more than one area. In the following
activity, it tests both your understanding of provisions (IAS 37) and also the effect on the non-
current assets (IAS 16).

Activity 3: Decommissioning costs

Petrolleo Co built an oil rig at a cost of $80 million. The oil rig came into operation on 1 January
20X2. The operating licence is for 20 years from 1 January 20X2, after which time Petrolleo Co is
obliged to dismantle the oil rig and dispose of the parts in an environmentally friendly way. At 1
January 20X2, the cost of dismantling was estimated at $10 million.
An appropriate discount rate is 6%, when the present value of $1 is $0.312 in 20 years’ time.
1 Required
Which of the following statements are TRUE?
 A legal obligation to dismantle the rig exists from 1 January 20X2, therefore a provision should
be recognised at that date and expensed through the profit or loss immediately.
 A legal obligation to dismantle the rig exists from 1 January 20X2, therefore a provision should
be recognised at that date and added to the cost of the asset.
 A legal obligation accrues over the 20-year operating life of the asset, therefore the provision
should be accrued over the period.
 No obligation exists until the rig is dismantled and thus no provision is required.
2 Required
What is the value of the provision in the statement of financial position at 31 December 20X2?
 Nil
 $500,000
 $3,118,000
 $3,307,000
3 Required
What is the carrying amount of the oil rig asset at 31 December 20X2?
 $76 million
 $78.964 million
 $83.118 million
 $85.5 million

Solution
1

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2.3 Future operating losses

Provisions are not recognised for future operating losses.
Future operating losses do not meet the definition of a liability or the Conceptual Framework
recognition criteria. However, it is important that you can distinguish this from an onerous
contract.

2.4 Onerous contracts

Onerous contracts: An onerous contract is a contract entered into with another party under
KEY
TERM which the unavoidable costs of fulfilling the terms of the contract exceed any revenues
expected to be received from the goods or services supplied or purchased directly or indirectly
under the contract and where the entity would have to compensate the other party if it did not
fulfil the terms of the contract.
(IAS 37: para. 68)

If an entity has a contract that is onerous, the present obligation under the contract should be
recognised and measured as a provision (IAS 37: para. 66). An example might be a three-year
contract to make and supply a service to a third party. The seller can no longer provide the
service, so it becomes ‘onerous’, and the costs to the seller would be the costs of outsourcing the
provision of the service or any penalties for non-provision.

Unavoidable costs of meeting

an obligation are the lower of:

Cost of fulfilling Penalties from failure

the contract to fulfil the contract

Activity 4: Onerous contract

You have a contract to buy 300 metres of silk from China Co each month for $9 per metre. From
each metre of silk, you make one silk shirt. You also incur labour and other direct variable costs of
$8 per shirt.
Usually you can sell each shirt for $22 but in late July 20X8 the market price falls to $14. You are
considering ceasing production since you think that the market may not improve.
If you decide to cancel the silk purchase contract without two months’ notice you must pay a
cancellation penalty of $1,200 for each of the next two months.
Required
What will appear in respect of the contract in your financial statements for the period ending 31
July 20X8?
 $1,800
 $2,400
 $8,400
 $10,200

Solution

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2.5 Provisions for restructuring

Restructuring: A programme that is planned and is controlled by management and materially

KEY
TERM changes one of two things.
• The scope of a business undertaken by an entity
• The manner in which that business is conducted
(IAS 37: para. 10)

The IAS gives the following examples of events that may fall under the definition of restructuring.
• The sale or termination of a line of business
• The closure of business locations in a country or region or the relocation of business activities
from one country region to another
• Changes in management structure, for example, the elimination of a layer of management
• Fundamental reorganisations that have a material effect on the nature and focus of the
entity’s operations (IAS 37: para. 70)

2.5.1 Constructive obligation

A provision for restructuring costs is recognised only when the entity has a constructive obligation
to restructure. Such an obligation only arises where an entity:
(a) Has a detailed formal plan for the restructuring; and
(b) Has raised a valid expectation in those affected that it will carry out the restructuring by
starting to implement the plan or announcing it main features to those affected by it (IAS 37:
para. 72).

Activity 5: Constructive obligation for business closure

On 12 December 20X1, the board of Shutdown Co decided to close down a division. The detailed
plan was agreed by the board on 20 December 20X1, and letters sent to notify customers. By the
year end of 31 December 20X1, the staff had received redundancy notices.
Required
Explain the appropriate accounting treatment for the closure for the year ended 31 December
20X1.

Solution

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2.5.2 Provision recognition criteria

A mere management decision is not normally sufficient to recognise a provision. Management
decisions may sometimes trigger recognition, but only if earlier events such as negotiations with
employee representatives and other interested parties have been concluded subject only to
management approval. (IAS 37: para. 75)
Where the restructuring involves the sale of an operation then IAS 37 states that no obligation
arises until the entity has entered into a binding sale agreement. This is because until this has
occurred the entity will be able to change its mind and withdraw from the sale even if its intentions
have been announced publicly. (IAS 37: para. 78)

2.5.3 Restructuring expenses

A restructuring provision includes only direct expenditures arising from the restructuring and
which are:
(a) Necessarily entailed by the restructuring; and
(b) Not associated with the ongoing activities of the entity
(IAS 37: para. 80)
A restructuring provision does not include such costs as:
• Retraining or relocating continuing staff
• Marketing
• Investment in new systems and distribution networks
(IAS 37: para. 81)

Activity 6: Provision or not?

1 Required
In which of the following circumstances might a provision be recognised?
(a) On 13 December 20X9, the board of an entity decided to close down a division. The
accounting date of the company is 31 December. Before 31 December 20X9 the decision was
not communicated to any of those affected and no other steps were taken to implement the
decision.
(b) The board agreed a detailed closure plan on 20 December 20X9 and details were given to
customers and employees.
(c) A company is obliged to incur clean-up costs for environmental damage (that has already
been caused).
(d) A company intends to carry out future expenditure to operate in a particular way in the
future.

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Solution
1

3 Contingent liabilities
3.1 Definition

Contingent liability:
KEY
TERM • A possible obligation that arises from past events and whose existence will be confirmed
only by the occurrence or non-occurrence of one or more uncertain future events not
wholly within the control of the entity; or
• A present obligation that arises from past events but is not recognised because:
- It is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; or
- The amount of the obligation cannot be measured with sufficient reliability
(IAS 37: para. 10)

3.2 Recognition
An entity should not recognise a contingent asset or liability, but they should be disclosed
(IAS 37: paras. 27 & 31).
Contingent liabilities should not be recognised in financial statements but they should be
disclosed.

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Essential reading
See Chapter 13 Section 1.5 of the Essential reading for a decision tree summarising the recognition
criteria of IAS 37 for provisions and contingent liabilities.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

3.3 Disclosure
For each class of contingent liability, an entity must disclose at the end of the reporting period all
of the following:
(a) The nature of the contingent liability
(b) An estimate of its financial effect
(c) An indication of the uncertainties relating to the amount or timing of any outflow
(d) The possibility of any reimbursement (see illustration ‘Product recall’ later in the chapter for
an example of this).
(IAS 37: para. 86)
The users of the financial statements need to be made aware of any potential impact on cash
flows of the company and any impacts on future profits, hence the reason for explaining the
nature, possible timing and amount of the financial impact.

4 Contingent assets
4.1 Definition

Contingent asset: A possible asset that arises from past events and whose existence will be
KEY
TERM confirmed by the occurrence or non-occurrence of one or more uncertain future events not
wholly within control of the entity. (IAS 37: para. 10)
• A contingent asset must not be recognised.
• Only when the realisation of the related economic benefits is virtually certain should
recognition take place. At that point, the asset is no longer a contingent asset!

Example – Legal dispute

A company is engaged in a legal dispute. The outcome is not yet known. A number of possibilities
arise:
• It expects to have to pay about $100,000. A provision is recognised.
• Possible damages are $100,000 but it is not expected to have to pay them. A contingent
liability is disclosed.
• The company expects to have to pay damages but is unable to estimate the amount. A
contingent liability is disclosed.
• The company expects to receive damages of $100,000 and this is virtually certain. An asset is
recognised.
• The company expects to probably receive damages of $100,000. A contingent asset is
disclosed.
• The company thinks it may receive damages, but it is not probable. No disclosure.

4.2 Timing of the obligating event

There may be instances when there is cause for a provision but with the added complication of
identifying the issue in one year and the actual problem occurring in another.

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Illustration 1: Product recall

Jackaboo Co has an accounting year-end of 31 December 20X5. On 14 February 20X6, Jackaboo
Co released a product recall for its Bimblebat. It was discovered in February, that a batch of the
resin used to manufacture the Bimblebat was faulty, with the effect of all products manufactured
between 10 November 20X5 and 2 December 20X5 were fundamentally flawed.
The supplier of the resin has taken full responsibility and will reimburse Jackaboo Co for any costs
relating to the recall.
1 Required
Advise whether a provision is required in respect of this transaction at the 31 December 20X5 year
end.

Solution
1 The correct answer is:
• There is a requirement for a provision at 31 December 20X5 as the obligating event was the
faulty Bimblebats which were manufactured prior to the year-end.
• The supplier has taken responsibility and agree to reimburse Jackaboo Co. However, there is
doubt as to the exact amount that will be recovered, however probable that recovery may be.
Therefore, it will be recognised as a contingent asset.

4.3 Let out clause

• IAS 37 permits reporting entities to avoid disclosure requirements relating to provisions,
contingent liabilities and contingent assets if they would be expected to seriously prejudice the
position of the entity in dispute with other parties.
• This should only be employed in extremely rare cases. Details of the general nature of the
provision/contingencies must still be provided, together with an explanation of why it has not
been disclosed (IAS 37: para. 92).

Activity 7: Provision or contingency?

During 20X0 Smack Co gives a guarantee of certain borrowings of Pony Co, whose financial
condition at that time is sound. During 20X1, the financial condition of Pony Co deteriorates and
at 30 June 20X1 Pony Co files for protection from its creditors.
1 Required
What accounting treatment is required?
(a) At 31 December 20X0
(b) At 31 December 20X1

Solution
1

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4.4 Disclosure
The following must be disclosed in a note to the accounts:
(a) A brief description of the nature of the contingent asset at the end of the reporting period
(b) Where possible, an estimate of the financial effect
Although the contingent asset will not be included within the figures of the financial statements,
the user should be made aware of any potential impact on cash flows of the company and any
impacts on future profits.

5 IAS 10 Events after the Reporting Period

This topic was covered in your earlier studies, so if you require a revision on the detail, please refer
to Chapter 13 of the Essential reading. In your FR exam, you are likely to come across IAS 10
questions either as an objective test question, or as part of an explanatory written question in
Section C. Making adjustments to existing draft financial statements or revising notes to the
financial statements should be expected in Section C longer questions, so ensure that you are
familiar with the difference between provisions and contingent liabilities or assets.

5.1 Definition

Events after the reporting period: Those events, both favourable and unfavourable, that occur
KEY
TERM between the end of the reporting period and the date when the financial statements are
authorised for issue.

5.2 Recognition
• Those that provide evidence of conditions that existed at the end of the reporting period –
adjusting
• Those that are indicative of conditions that arose after the reporting period – non-adjusting
(IAS 10: para. 3)

Essential reading
See Chapter 13, Section 4 of the Essential reading for revision on the main elements of IAS 10,
including a table which gives examples of adjusting and non-adjusting events.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

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Activity 8: IAS 10
Required
Which ONE of the following events taking place after the year-end but before the financial
statements were authorised for issue would require adjustment in accordance with IAS 10 Events
After the Reporting Period?
 Three lines of inventory held at the year-end were destroyed by flooding in the warehouse.
 The directors announced a major restructuring.
 Two lines of inventory held at the year-end were discovered to have faults rendering them
unsaleable.
 The value of the company’s investments fell sharply.

Solution

Activity 9: Provisions
Extraction Co prepares its financial statements to 31 December each year. During the years
ended 31 December 20X0 and 31 December 20X1, the following event occurred:
Extraction Co is involved in extracting minerals in a number of different countries. The process
typically involves some contamination of the site from which the minerals are extracted.
Extraction Co makes good this contamination only where legally required to do so by legislation
passed in the relevant country.
The company has been extracting minerals in Copperland since January 20W8 and expects its
site to produce output until 31 December 20X5. On 23 December 20X0, it came to the attention of
the directors of Extraction Co that the government of Copperland was virtually certain to pass
legislation requiring the making good of mineral extraction sites. The legislation was duly passed
on 15 March 20X1. The directors of Extraction Co estimate that the cost of making good the site in
Copperland will be $2 million. This estimate is of the actual cash expenditure that will be incurred
on 31 December 20X5.
1 Required
Compute the effect of the estimated cost of making good the site on the financial statements of
Extraction Co for BOTH of the years ended 31 December 20X0 and 20X1. Give full explanations of
the figures you compute.

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Notes
The annual discount rate to be used in any relevant calculations is 10%.
The relevant discount factors at 10% are:
Year 4 at 10% – 0.683
Year 5 at 10% – 0.621

Solution
1

5.3 Disclosure
• An entity discloses the date when the financial statements were authorised for issue and who
gave the authorisation (IAS 10: para. 17).
• If non-adjusting events after the reporting period are material, non-disclosure could influence
the decisions of users taken on the basis of the financial statements. Accordingly, the following
is disclosed for each material category of non-adjusting event after the reporting period:
- The nature of the event; and
- An estimate of its financial effect, or statement that such an estimate cannot be made (IAS
10: para. 21).

PER alert
One of the competences you require to fulfil Performance Objective 7 of the PER is the ability
to review financial statements and correct for errors and make any required disclosures
regarding events after the reporting date. The information in this chapter will give you
knowledge to help you demonstrate this competence.

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Chapter summary

Provisions and events after the reporting period

Provisions Types of provision

(IAS 37)

Definition Warranties Future operating losses

Liability of uncertain timing or • Legal obligation or a Do not recognise provisions for
amount constructive obligation future operating losses
• Provision required under IAS 37
• Separate contract for
Recognition performance (such as Onerous contracts
Recognise provision if meet all extended warranty) requires • Definition: Unavoidable costs
three of: treatment under IFRS 15 exceed benefits
• Present obligation as result of • Provide for the least net cost of
past event exiting the contract ie lower of:
• Probable outflow Decommissioning costs – Net cost of fulfilling the
• Reliable estimate • Provision for contract
dismantling/removal of plant – Compensation or penalties
and restoring construction arising from failure to fulfil
Measurement damage: contract
• Best estimate – Recognise at time of
• Discount if time value of money construction and include as
is material part of asset cost Restructuring
• Expected values if large DEBIT Property, plant & • Constructive obligation exists if
population of items equipment entity has:
• Most likely outcome for single CREDIT Provision – A detailed formal plan
obligation • Provision for restoring damage – Raised a valid expectation in
– To create/increase a from plant's operation eg those affected
provision: extraction: • Provision should only include
DEBIT Expense/PPE – Recognise over the period of direct expenditure:
CREDIT Provision operation – Necessarily entailed by the
– To decrease a provision: DEBIT Expense restructuring
DEBIT Provision CREDIT Provision – Not associated with the
CREDIT Expense/PPE entity's ongoing activities
– To use a provision:
DEBIT Provision
CREDIT Cash

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Contingent Contingent Events after the

liabilities assets reporting period (IAS 10)

Definition Definition Definition

• Possible obligation • Possible asset from past events Events which occur between
• Present obligation: outflow not • Existence will be confirmed by the end of the reporting period
probable/ cannot measure future uncertain event(s) and the date when the
reliably financial statements are
authorised for issue
Accounting treatment
Accounting treatment Inflow:
Disclose in note to the financial • Virtually certain – recognise Accounting treatment
statements unless possibility of asset • Conditions which existed at
outflow is remote • Probable – disclose end of reporting period –
• Possible – do nothing adjusting
• Remote – do nothing • Conditions which arose after
Nature of disclosure the end of the reporting
• Nature of contingent liability period – non-adjusting
• Estimate of financial effect Nature of disclosure
• Uncertainties relating to • Brief description
amount or timing • Estimate of financial effect Nature of disclosure
• Possibility of reimbursement Material events to disclose the
nature and estimate of the
Need for disclosure financial impact (or why it
Need for disclosure Make users aware of potential cannot be reliably estimated)
Make users aware of potential positive impact on cash
adverse impact on cash flows/profit
flows/profit Need for disclosure
Users can understand the
reason behind unusual
movements or provisions in the
financial statements, and their
financial impact

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Knowledge diagnostic
1. Provisions
Provisions are recognised when there is a present obligation as a result of a past event, with a
probable outflow of economics resources that can be measured reliably.

2. Specific types of provision

• Provisions are not made for future operating losses as there is no obligation to incur them
• Where a contract is onerous a provision is made for the unavoidable cost.
• Restructuring provisions are only recognised when certain criteria are met.
• A provision is recognised for decommissioning costs where there is a legal or constructive
obligation. Where it relates to an asset it is capitalised and depreciated.

3. Contingent liabilities
• Contingent liabilities are not recognised because they are possible rather than present
obligations, the outflow is not probable or the liability cannot be reliably measured.
• Contingent liabilities are disclosed.

4. Contingent assets
Contingent assets are disclosed, but only where an inflow of economic benefits is probable.

5. Events after the reporting period

• Events that occur after the end of the reporting period but before the financial statements are
authorised for issue can be adjusting or non-adjusting events
• Adjusting events are those which provide information about conditions that existed at the
year-end and are adjusted for in the financial statements
• Non-adjusting events do not provide information about conditions that existed at the year-end
and so are not adjusted, but are disclosed if material.

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
17 Provisions

Further reading
The FR examining team has provided a useful technical article on IAS 37 Provisions, Contingent
Liabilities and Contingent Assets. This should help you in understanding the key criteria of the
standard.
IAS 37, Provisions, contingent liabilities and contingent assets
www.accaglobal.com

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Activity answers

Activity 1: Discounting the provision

The correct answer is:
Cambridge Co knows that when it ceases a certain operation in five years’ time it will have to pay
environmental clean-up costs of $5 million.
The provision to be made now will be the present value of $5 million in five years’ time.
The relevant discount rate in this case is 10%.
(a) Therefore, a provision will be made for:
$
$5m × 0.621* 3,105,000

*The discount rate for five years at 10%.

(b) The following year the provision will be:
$5m × 0.683** 3,415,000
Increase in the provision (Note) 310,500

**The discount rate for four years at 10%.

Note. The increase in the second year of $310,500 will be charged to profit or loss. It is referred to
as the unwinding of the discount. This is accounted for as a finance cost. The original provision of
$3.105 million will be added to the cost of the assets involved in the operation and depreciated
over five years.

Activity 2: Warranties
The correct answer is:
Warren Co has an obligation to repair or replace all items of product that show manufacturing
defects, therefore a provision for the cost of this should be made.
Warren Co has an obligation to repair or replace all items of product that manifest
manufacturing defects in respect of which warranties are given before the end of the reporting
period, and a provision for the cost of this should therefore be made. The cost cannot be avoided.
Warren Co is obliged to repair or replace items that fail within the entire warranty period.
Therefore, in respect of this year’s sales, the obligation provided for at the end of the reporting
period should be the cost of making good items for which defects have been notified but not yet
processed, plus an estimate of costs in respect of the other items sold for which there is sufficient
evidence that manufacturing defects will manifest themselves during their remaining periods of
warranty cover.

Activity 3: Decommissioning costs

1 The correct answer is:
A legal obligation to dismantle the rig exists from 1 January 20X2, therefore a provision should be
recognised at that date and added to the cost of the asset.
2 The correct answer is:
$3,307,000
Provision for dismantling costs
$’000
At 1 January 20X2 3,120
Interest (3,120 × 6%) 187
c/d at 31 December 20X2 3,307
3 The correct answer is:
$78.964 million

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Carrying amount of oil rig

$’000
Cost 80,000
Provision (10,000 × 0.312) 3,120
83,120
Depreciation (83,120/20 years) (4,156)
78,964

The provision has been capitalised, by crediting the provision and debiting the non-current asset.
This is applying the accruals method as it is matching the costs of the provision and the asset with
the revenue generated by the provision.

Activity 4: Onerous contract

The correct answer is:
$1,800

Unavoidable costs of meeting

an obligation are the lower of:

Cost of fulfilling Penalties from failure

the contract to fulfil the contract

Honour contract Cancel contract

Revenue (300m × $14 × 2 months) $8,400 Penalties ($1,200 × 2 months = $2,400)
Costs (300m × ($9 + $8) × 2 months) ($10,200)
Loss ($1,800)

Therefore, the unavoidable cost is $1,800.

This will be shown as a provision in the statement of financial position and as an expense in profit
or loss.

Activity 5: Constructive obligation for business closure

The correct answer is:
The communication of the decision to the customers and employees gives rise to a constructive
obligation because it creates a valid expectation that the division will be closed.
The outflow of resources embodying economic benefits is probable so, at 31 December 20X1, a
provision should be recognised for the best estimate of the direct costs of closing the division.

Activity 6: Provision or not?

1 The correct answer is:
(a) No provision would be recognised as the decision has not been communicated.
(b) A provision would be made in the 20X9 financial statements.
(c) A provision for such costs is appropriate.
(d) No present obligation exists and under IAS 37 no provision would be appropriate. This is
because the entity could avoid the future expenditure by its future actions, maybe by
changing its method of operation.

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Activity 7: Provision or contingency?

1 The correct answer is:
(a) At 31 December 20X0
There is a present obligation as a result of a past obligating event. The obligating event is the
giving of the guarantee, which gives rise to a legal obligation. However, at 31 December 20X0
no transfer of resources is probable in settlement of the obligation.
No provision is recognised. The guarantee is disclosed as a contingent liability unless the
probability of any transfer is regarded as remote.
(b) At 31 December 20X1
As above, there is a present obligation as a result of a past obligating event, namely the
giving of the guarantee.
At 31 December 20X1, it is probable that a transfer of resources will be required to settle the
obligation. A provision is therefore recognised for the best estimate of the obligation.

Activity 8: IAS 10
The correct answer is:
Two lines of inventory held at the year-end were discovered to have faults rendering them
unsaleable.
We can assume that these faults also existed at the year-end, so this is the only option which
would require adjustment. The others have all taken place after the year-end.

Activity 9: Provisions
1 The correct answer is:
For the year ended 31 December 20X0:
• A provision of $1,242,000 (2,000,000 × 0.621) is reported as a liability.
• A non-current asset of $1,242,000 is also recognised. The provision results in a corresponding
asset because the expenditure gives the company access to an inflow of resources embodying
future economic benefits; there is no effect on profit or loss for the year.
For the year ended 31 December 20X1:
• Depreciation of $248,400 (1,242,000 × 20%) is charged to profit or loss. The non-current asset
is depreciated over its remaining useful life of five years from 31 December 20X0 (the site will
cease to produce output on 31 December 20X5).
• Therefore, at 31 December 20X1 the carrying amount of the non-current asset will be $993,600
(1,242,000 – 248,400).
• At 31 December 20X1, the provision will be $1,366,000 (2,000,000 × 0.683).
• The increase in the provision of $124,000 (1,366,000 – 1,242,000) is recognised in profit or loss
as a finance cost. This arises due to the unwinding of the discount.

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Inventories and
14 biological assets

14

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Describe and apply the principles of inventory B4(a)

valuation.

Apply the requirements of relevant accounting B4(b)

standards for biological assets.
14

Exam context
Inventory is an important balance as it is often a key figure in the statement of financial position,
particularly for retail companies, and impacts on cost of sales in the statement of profit or loss.
Questions on inventory or biological assets could appear as OTQs in Section A or B and may also
feature in the accounts preparation or when analysing the gross profit margin or the inventory
holding period in interpretation questions in Section C.
14

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Chapter overview

Inventories and biological assets

IAS 2 Inventories IAS 41 Agriculture

IAS 2 definition IAS 41 definition

Measurement Recognition

Disclosure Measurement

Presentation

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1 IAS 2 Inventories
1.1 Introduction
IAS 2 Inventories lays out the required accounting treatment for inventories. Inventories are
recorded as an asset of the entity until they are sold, at which point the asset (inventories) is
derecognised and an expense (cost of sales) is recognised.

1.2 IAS 2 definition

Inventories: Assets that are:

KEY
TERM • Held for sale in the ordinary course of business;
• In the process of production for such sale; or
• In the form of materials or supplies to be consumed in the production process or in the
rendering of services. (IAS 2: para. 6)

Examples of inventories include:

• Raw materials (awaiting use in the production process)
• Work in progress (WIP)
• Finished goods
• Goods purchased and held for resale

1.3 Measurement
Inventories shall be measured at the lower of cost and net realisable value (NRV) (IAS 2: para. 9).

1.4 Components of cost

The cost of inventories comprises all of the costs of purchase, costs of conversion and other
costs incurred in bringing the inventories to their present location and condition.

Costs of purchase Costs of conversion Other costs

• Purchase price, less any • Costs directly related to Costs related to bringing the
trade discounts or rebates units of production, for inventories to their present
• Import duties and any example: location and condition which
other taxes, for example - Direct materials are not already included in
non-refundable sales tax costs of purchase. For
- Direct labour
example, non-production
• Directly attributable costs - Sub‑contracted work overheads such as designing
of acquiring the inventory
• Systematic allocation of a product for a specific
including delivery and
fixed and variable customer.
handling costs
production overheads*
incurred in converting
materials into finished
goods

*Fixed production overheads relate to indirect costs such as the cost of factory management and
administration which remain relatively constant regardless of the volume of production. These
should be allocated to units of production based on a normal level of activity.
Variable production overheads include indirect materials and labour and vary with the volume of
production.

1.5 Determining cost

The cost of inventory should be the actual unit cost of the item, this can prove difficult to
determine and so estimation methods may be used for convenience if the results approximate to
actual costs.

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Examples include:

Standard cost Retail method

Cost is based on normal levels of materials Cost is determined by reducing sales value of
and supplies, labour efficiency and capacity the inventory by the appropriate percentage
utilisation. gross margin. The percentage used takes into
Standards must be regularly reviewed and consideration inventory which has been
revised where necessary. marked down to below its original selling price.
This is often used in the retail industry for
measuring inventories of rapidly changing
items that have similar margins.

1.6 Interchangeable items

If there are a large number of identical or very similar items of inventory that have been
purchased at different times during the year and at different prices, it may be impossible to
determine precisely which items are still held at the year-end and therefore the actual purchase
cost.
In such circumstances, IAS 2 Inventories allows the following estimation techniques to be used to
approximate cost:

First in, first out (FIFO) Weighted average cost

The calculation of the cost of inventories on The cost of inventories is calculated by using a
the basis that the quantities in hand represent weighted average price computed by dividing
the most recent purchases or production. the total cost of items by the total number of
such items.
The price is recalculated on a periodic basis
or as each additional shipment is received and
items taken out of inventory are removed at
the prevailing weighted average cost.

An entity must use the same cost formula for all inventories having a similar nature and use to
the entity.

You should be aware of these methods from your previous studies and also know that the last in,
first out (LIFO) formula is not permitted by IAS 2 on the basis that it does not bear a good
approximation to actual costs.

Essential reading
Chapter 14, Section 1 of the Essential reading provides more detail on the consistency of cost
formula used.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

1.7 Net realisable value (NRV)

Net realisable value: The estimated selling price in the ordinary course of business, less:
KEY
TERM • The estimated cost of completion; and
• The estimated costs necessary to make the sale, eg marketing, selling and distribution costs
(IAS 2: para. 6).

As noted above, where the net realisable value of inventories is less than cost the inventories in the
financial statements should be measured at the lower of cost and net realisable value.

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1.8 NRV less than cost

The net realisable value of inventories may be less than cost due to:

Errors in An increase in A physical

production or costs or a fall in deterioration
purchasing selling price of inventories

A decision being Obsolescence

made as part of a of products
company's marketing
strategy to manufacture
and sell products at a loss

Essential reading
Chapter 14, Section 1 of the Essential reading provides more detail on the NRV of inventory.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

Illustration 1: Value of inventory

The following figures relate to inventory held at the year-end:
A B C
$ $ $
Cost 20 9 12
Selling price 30 12 22
Modification cost to enable sale – 2 8
Marketing costs 7 2 2

Units held 200 150 300

1 Required
Calculate the value of inventory held at the year-end in accordance with IAS 2 Inventories.

Solution
1 The correct answer is:
The value of inventory is $8,800.
Product Cost NRV Valuation Quantity Total value
$ $ $ Units $
A 20 30 – 7 = 23 20 200 4,000
B 9 12 – 2 – 2 = 8 8 150 1,200
C 12 22 – 8 – 2 = 10 12 300 3,600
8,800

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Activity 1: Write down of inventory

Teddy Co has 500 items of product HGJ in inventory at 31 October 20X8. These items are no
longer saleable in their current condition. However, they can be adjusted for a cost of $2.50 per
item. Once adjusted, the items can be sold at their normal price of $5.30 each.
The original cost of the items was $2.25 each. The replacement cost of item HGJ at 31 October
20X8 is $2.45 each.
Required
What should Teddy Co recognise in relation to its inventory at 31 October 20X8?
 $nil
 $275
 $1,125
 $1,400

Solution

1.9 Disclosure
The financial statements should disclose the following:
• The accounting policies adopted in measuring inventories, including the cost formula used;
• The total carrying amount of inventories and the carrying amount in classifications
appropriate to the entity;
• The carrying amount of inventories carried at fair value less costs to sell;
• The amount of inventories recognised as an expense during the period;
• The amount of any write‑down of inventories recognised as an expense in the period;
• The amount of any reversal of any write‑down that is recognised as a reduction in the amount
of inventories recognised as expense in the period;
• The circumstances or events that led to the reversal of a write‑down of inventories; and
• The carrying amount of inventories pledged as security for liabilities.

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2 IAS 41 Agriculture
2.1 Introduction
IAS 41 Agriculture covers the accounting treatment of biological assets (except bearer plants) and
agricultural produce at the point of harvest. After harvest, IAS 2 Inventories applies to the
agricultural produce, as illustrated in the timeline below.
IAS 41 IAS 2

Time

Biological transformation
Planting/ Harvest/ Sale
birth slaughter

Bearer plants, which are plants that are used to grow crops but are not themselves consumed (eg
grapevines), are excluded from the scope of IAS 41. Instead they are accounted for under IAS 16
using either the cost or revaluation model.

2.2 Definitions

Biological assets: Living animals or plants.

KEY
TERM
Biological transformation: The processes of growth, degeneration, production and procreation
that cause qualitative and quantitative changes in a biological asset.
Agricultural produce: The harvested product of an entity’s biological assets.
(IAS 41: para. 5)

Essential reading
Chapter 14, Section 3 of the Essential reading provides further explanation as to what a biological
asset is.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

2.3 Recognition
As with other non-financial assets under the Conceptual Framework, a biological asset or
agricultural produce is recognised when:
(a) The entity controls the asset as a result of past events;
(b) It is probable that future economic benefits associated with the asset will flow to the entity;
and
(c) The fair value or cost of the asset can be measured reliably.
(IAS 41: para. 10)

2.4 Measurement
Biological assets are measured both on initial recognition and at the end of each reporting period
at fair value less costs to sell.
Agricultural produce at the point of harvest is also measured at fair value less costs to sell.
The fair value less costs to sell of agricultural produce harvested becomes its cost under IAS 2.
After harvest, the agricultural produce is measured at the lower of cost and net realisable value in
accordance with IAS 2.
Fair value is the price that would be received to sell the asset (IFRS 13 Fair Value Measurement).

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Costs to sell are incremental costs directly attributable to disposal of the asset, eg commissions to
brokers and transfer taxes.
Changes in fair value less costs to sell are recognised in profit or loss.
Where fair value of biological assets cannot be measured reliably, they are measured at cost
less accumulated depreciation and impairment losses.

2.5 Presentation
Biological assets are presented as non-current assets.

Activity 2: Biological assets

Required
Which of the following are examples of biological assets?
(i) Sheep
(ii) Fruit trees
(iii) Wool
(iv) Fruit juice
 (i) only
 (i) and (ii) only
 (i) and (iii) only
 (ii) and (iv) only

Solution

PER alert
Performance objective 7 of the PER requires you to demonstrate that you can contribute to the
drafting or reviewing of primary financial statements according to accounting standards and
legislation. The Standards covered in this chapter will help you to do this for a business’s
inventory and biological assets.

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Chapter summary

Inventories and biological assets

IAS 2 Inventories IAS 41 Agriculture

IAS 2 definition IAS 41 definition

Assets that are: • Biological assets – living animals or plants
• Held for sale in the ordinary course of • Biological transformation – processes that
business cause qualitative and quantitative changes in
• In the process of production for sale a biological asset
• In the form of materials/supplies to be • Agricultural produce – the harvested product
consumed in the production process/ of an entity's biological assets
rendering of services

Recognition
Measurement • Entity controls the asset as a result of past
• At the lower of cost and net realisable value events
• Cost: • Probable that future economic benefits will
– Costs of purchase flow to the entity
– Costs of conversion • Fair value or cost of the asset can be
– Other costs measured reliably
• Estimation techniques to determine cost:
– Standard cost
– Retail method Measurement
– FIFO • Biological assets
– Weighted average – Initial measurement at fair value less costs
• NRV: to sell
– Estimated selling price less estimated costs – Subsequent measurement also at fair value
of completion and estimated costs less costs to sell
necessary to make the sale (marketing, • Agricultural produce
selling, distribution) – Initial measurement (at harvest) at fair value
less costs to sell
– Subsequent measurement per IAS 2
Disclosure
• Accounting policies including cost formula
• Total carrying amount of inventories Presentation
(RM, WIP, FG) Biological assets are non-current assets

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Knowledge diagnostic
1. IAS 2 Inventories
Inventories are held at the lower of cost and net realisable value. The cost of interchangeable
inventories is measured using the FIFO or weighted average methods only.

2. Agriculture (IAS 41)

Biological assets and agricultural produce at the point of harvest are measured at fair value less
costs to sell, with changes reported in profit or loss.

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
15 Villandry Co
16 Biological assets

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Activity answers

Activity 1: Write down of inventory

The correct answer is:
$1,125
Cost per question = $2.25
Net realisable value:
$
Selling price 5.30
Adjustment costs (2.50)
Net realisable value 2.80

Use lower of cost and net realisable value. This is the cost amount: $2.25 × 500 units = $1,125.
The replacement value is irrelevant.

Activity 2: Biological assets

The correct answer is:
(i) and (ii) only
Wool is agricultural produce.
Fruit juice is a product that is a result of processing the agricultural produce (fruit) after harvest.

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Taxation
15
15

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Account for current taxation in accordance with B8(a)

relevant accounting standards.

Explain the effect of taxable temporary differences B8(b)

on accounting and taxable profits.

Compute and record deferred tax amounts in the B8(c)

financial statements.
15

Exam context
Taxation is an important area of the syllabus and expected to feature in exam questions. Current
tax will be included in a Section C financial statements preparation question. Deferred tax could
be tested in Section A or Section B of the exam as an objective test (OT) question. Also, deferred
tax may feature as an adjustment in a financial statements preparation question.
15

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Chapter overview
Taxation

IAS 12 Income Taxes Current tax

What is deferred tax?

Temporary differences

Measurement

Calculating deferred tax Other aspects of deferred tax

Presentation

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1 IAS 12 Income Taxes

1.1 Introduction
IAS 12 Income Taxes covers both current and deferred tax. Current tax is relatively straightforward.
Complexities arise when we consider the future tax consequences of items which are currently
recorded in the accounts. This can result in deferred tax, which we will look at later in this chapter.
Having calculated the amount of tax due to be paid on the company’s taxable profits using the
current rates set by legislation, the accounting entry is as follows:
DEBIT Tax charge (statement of profit or loss)
CREDIT Tax liability (statement of financial position)

1.2 Definitions
IAS 12 provides the following definitions:

Accounting profit: Net profit or loss for a period before deducting tax expense is referred to as
KEY
TERM the accounting profit.
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 net profit
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.
Deferred tax liabilities: The amounts of income taxes payable in future periods in respect of
taxable temporary differences.
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
Temporary differences: 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
Tax base: The tax base of an asset or liability is the amount attributed to that asset or liability
for tax purposes.
(IAS 12: para. 5)

The main differences between current and deferred tax are:

(a) Current tax is the amount actually payable to the tax authorities in relation to the trading
activities of the entity during the period.
(b) Deferred tax is an accounting measure, used to match the tax effects of transactions with
their accounting impact and thereby produce less distorted results.

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2 Current tax
2.1 Recognition of current tax liabilities and assets
IAS 12 requires any unpaid tax in respect of the current or prior periods to be recognised as a
liability.
Any excess tax paid in respect of current or prior periods over what is due should be recognised as
an asset. (IAS 12: para. 12)

Current tax is recognised as income or expense in current period

except when

Tax arising from business combination Tax arising from transaction which
Treat as part of goodwill (IAS 12: para. 19) affects equity only
• Include within equity (IAS 12: Obj)
• Eg IAS 8 adjustment made to the opening
balances due to change in accounting policy
or fundamental error

Illustration 1: Darton Co
In 20X8, Darton Co had taxable profits of $120,000. In the previous year, (20X7) income tax on
profits had been estimated as $30,000. The income tax rate is 30%.
1 Required
Calculate tax payable and the charge for 20X8 if the tax due on 20X7 profits was subsequently
agreed with the tax authorities as:
(a) $35,000; or
(b) $25,000.
Any under- or over-payments are not settled until the following year’s tax payment is due.

Solution
1 The correct answer is:
(a)
$
Tax due on 20X8 profits ($120,000 × 30%) 36,000
Underpayment for 20X7 5,000
Tax charge and liability 41,000

(b)
$
Tax due on 20X8 profits (as above) 36,000
Overpayment for 20X7 (5,000)
Tax charge and liability 31,000

Alternatively, the rebate due could be shown separately as income in the statement of
comprehensive income and as an asset in the statement of financial position. An offset approach
like this is, however, most likely.

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Activity 1: Current tax

A provision of $60,000 is required for income tax on the profits for the year ended 31 December
20X8. The balance on current tax in the trial balance is an under/over provision for tax in the
previous year and is shown below.
Debit Credit
$ $
Current tax 850

Required
What is the tax expense to be shown in the statement of profit or loss and the tax liability to be
included in the statement of financial position for the year ended 31 December 20X8?
 Expense $60,000; Liability $60,850
 Expense $60,850; Liability $60,850
 Expense $60,850; Liability $60,000
 Expense $59,150; Liability $60,000

Solution

3 Deferred tax
Deferred tax is an accounting measure used to match the tax effects of transactions with their
accounting impact.
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 (EPS).
Where a difference arises, IAS 12 requires companies to recognise a deferred tax liability (or
deferred tax asset).

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3.1 How deferred tax may arise

Deferred tax
• Not a tax payable to the authorities
• Accounting adjustment only

Arises due to difference between

Carrying amount of asset/liability and Tax base of the asset/liability

Property, plant and equipment

Accounting treatment Difference arises Tax treatment

Accounting depreciation A temporary difference arises when the Tax depreciation (eg capital
accounting depreciation and the tax depreciation allowances in the UK)
occur at different rates

Accrued income/accrued expense

Accounting treatment Difference arises Tax treatment

Accrued income/accrued Accrued income – deferred tax liability as tax Income and expenses are
expenses are included in will be paid in the future when the income is taxed on a cash basis ie
the financial statements in actually received. they are chargeable to tax
accordance with the Accrued expenses, deferred tax asset, as the when they are actually paid
accruals concept entity will get tax relief in the future when the or received.
expense is actually paid.

Provisions and allowances for doubtful debts

Accounting treatment Difference arises Tax treatment

Provisions meeting criteria Deferred tax asset occurs as the entity benefits Tax relief when the debt
of IAS 37 from tax relief in the future when debt written off becomes irrecoverable and
written off

Revaluation of non-current assets

Accounting treatment Difference arises Tax treatment

Accounting depreciation Temporary difference arises when asset is Tax depreciation (eg capital
revalued (accounting difference). This will only allowances in the UK)
impact tax upon the sale or use of the asset.
A deferred tax liability as the gain has been
recognised.

As the gain on the revaluation is charged to SPLOCI (other comprehensive income),

so the deferred tax is also only recognised in the SPLOCI

3.2 Tax base

Tax payable by an entity is calculated by the tax authorities using a tax computation. A tax
computation is similar to a statement of profit or loss, except that it is constructed using tax rules
instead of IFRS.
Different tax jurisdictions may have different tax rules. The tax rules determine the tax base.

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Exam focus point

It is important for you to understand how to calculate and account for deferred tax. The
March 2018 examination required students to compare the carrying amount of property, plant
and equipment to the tax base provided and calculate a temporary difference to include in
the deferred tax calculation. In June 2018, deferred tax was tested as part of Section A
questions.

3.3 Measurement
Deferred tax assets and liabilities are measured at the tax rates expected to apply to the period
when the asset is realised or liability settled, based on tax rates (and tax laws) that have been
enacted (or substantively enacted) by the end of the reporting period (IAS 12: para. 47).
Changes in tax rates after the year-end are therefore non-adjusting events after the reporting
period.

4 Calculating deferred tax

4.1 Calculation of deferred tax
$
Carrying amount of asset/(liability) [in accounting statement of financial position] X/(X)
Less tax base [value for tax purposes] (X)/X
Temporary difference X/(X)
Deferred tax (liability)/asset [always opposite sign to temporary difference] (X)/X

Deferred tax is the tax attributable to temporary differences. There are two types of temporary
difference (IAS 12: paras. 15 & 24).

Taxable temporary difference

For example, the entity has recognised
accrued income, but the accrued income is Tax to pay in the future Deferred tax liability
not chargeable for tax until the entity
receives the cash.

Deductible temporary difference

For example, the entity has recorded a
provision, but the provision does not Tax saving in the future Deferred tax asset
attract tax relief until the entity actually
spends the cash.

If an item is never taxable or tax deductible, its tax base is deemed to be its carrying amount so
there is no temporary difference and no related deferred tax. This is a permanent difference and
does not give rise to deferred tax.

4.2 Non-current assets

The main reason for deferred tax occurring is due to the difference in the tax depreciation and the
accounting depreciation.

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Illustration 2: Taxable temporary differences

Custard Co purchased an asset costing $1,500. At the end of 20X8 the carrying amount is $1,000.
The cumulative depreciation for tax purposes is $900 and the current tax rate is 25%.
1 Required
Calculate the deferred tax liability for the asset.

Solution
1 The correct answer is:
First, what is the tax base of the asset? It is $1,500 – $900 = $600.
In order to recover the carrying amount of $1,000, Custard Co must earn taxable income of
$1,000, but it will only be able to deduct $600 as a taxable expense. Custard Co must therefore
pay income tax of $400 × 25% = $100 when the carrying amount of the asset is recovered.
Custard Co must therefore recognise a deferred tax liability of $400 × 25% = $100, recognising
the difference between the carrying amount of $1,000 and the tax base of $600 as a taxable
temporary difference.

Activity 2: Tax base

1 Required
State the tax base of each of the following assets and any temporary difference arising.
(a) A machine costs $10,000 and has a carrying amount of $8,000. For tax purposes,
depreciation of $3,000 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 $1,000. 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 $1 million. The repayment of the loan will have no
tax consequences.

Solution
1

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4.3 Development costs

Development costs which have been capitalised, are treated in a similar way. Under IAS 38
Intangible Assets, development costs are capitalised when the criteria are met and are then
amortised over their useful life. Under tax rules, these costs are tax deductible once they are paid
(in the period incurred).
Therefore, a temporary tax difference occurs.

Activity 3: Epsilon Co
During the year ended 31 March 20X4, Epsilon Co correctly capitalised development costs of $1.6
million in accordance with IAS 38. The development project began to generate economic benefits
for Epsilon from 1 January 20X4. The directors of Epsilon Co estimated that the project would
generate economic benefits for five years from that date. Amortisation is charged on a monthly
pro-rata basis. The development expenditure was fully deductible against taxable profits for the
year ended 31 March 20X4 and the rate of tax applicable is 25%.
1 Required
Discuss the deferred tax implications of the above in the financial statements of Epsilon for the
year ended 31 March 20X4.

Solution
1

4.4 Revaluation of non-current assets

Under IAS 16, assets may be revalued. If the revaluation does not affect current taxable profits,
the tax base of the asset is not adjusted.

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The gain (or loss) between the carrying amount of a revalued asset and its tax base is a
temporary difference and gives rise to a deferred tax liability (or deferred tax asset) which is
recognised as a component of equity (as the revaluation is recorded in equity and shown on the
SOCIE).

Activity 4: Lecehus Co
Lecehus Co purchased some land on 1 January 20X7 for $400,000. On 31 December 20X8, the
land was revalued to $500,000. In the tax regime in which the company operates, revaluations do
not affect either the tax base of the asset or taxable profits.
The income tax rate is 30%. Profit for the year was $850,000.
Required
How much should be included with other comprehensive income and as a liability at 31 December
20X8?
 Other comprehensive income $100,000; Liability $30,000
 Other comprehensive income $70,000; Liability $30,000
 Other comprehensive income $30,000; Liability $30,000
 Other comprehensive income $100,000; Liability $100,000

Solution

4.5 Impairment losses and inventory losses

If an item of property, plant or equipment suffers an impairment loss, the carrying amount of that
asset is reduced.
If tax relief on the loss is only granted when the asset is sold, the reduction in value of the asset is
ignored for tax purposes until the sale. The tax base of the asset does not change, resulting in a
deductible temporary difference and a deferred tax asset.
Similarly, losses on inventory that are not tax deductible until the inventory is sold generate a
deferred tax asset.

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4.6 Provisions
As for non-current assets, there is a potential timing difference between the accounting and the
tax treatment of provisions. In this next question, the provision is in respect of warranty costs, but
this could also apply to an allowance for doubtful debts.

Activity 5: Pargatha Co
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
the warranty claims. The tax rate is 25%.
1 Required
State the deferred tax implications of this situation.

Solution
1

Exam focus point

Deferred tax can be tested on specific aspects of the Standard. In June 2018, there was a
question asking candidates to calculate deferred tax in relation to a revaluation surplus.

5 Other aspects of deferred tax

5.1 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 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 (para. 47).

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Essential reading
In Chapter 15 of the Essential reading, there is an additional activity (Activity 2: Ginger Co) which
looks at the effect of changing tax rates on deferred tax. Do attempt further question practice on
this topic as it is generally an area that students struggle with in the exam.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

5.2 Losses that can be carried forward

Losses that can be carried forward to reduce current tax on future profits represent a future tax
saving.
Therefore, a deferred tax asset is recognised in respect of tax losses to the extent that it is
probable that the losses can be used before they expire. If an entity has a history of recent losses,
then this is evidence that future taxable profit may not be available.

Activity 6: Deorf Co
Deorf Co incurs $80,000 of tax losses in the year ended 31 December 20X1 which it can carry
forward for two accounting periods before they expire. Deorf Co expects to make a loss in 20X2
and to return to profitability in 20X3, expecting to make a profit of $50,000 in that year. The
company pays tax at 20%. What is the deferred tax balance in the statement of financial position
at 31 December 20X1?
Required
What is the deferred tax balance in the statement of financial position at 31 December 20X1?
 Deferred tax asset $10,000
 Deferred tax liability $10,000
 Deferred tax asset $50,000
 Deferred tax liability $50,000

Solution

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5.3 Carrying amount of deferred tax assets

The carrying amount of deferred tax assets should be 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 (IAS 12: para. 56).
Examples of IASs which allow certain items to be credited/charged directly to equity include:
(a) Revaluations of property, plant and equipment (IAS 16)
(b) The effect of a change in accounting policy (applied retrospectively) or correction of a
material error (IAS 8)
Revaluations will appear under ‘other comprehensive income’ in the statement of profit or loss and
other comprehensive income and the tax element will be shown separately as ‘income tax relating
to components of other comprehensive income’ (IAS 12: para. 61).

5.4 Key disclosures

Taxation in the statement of financial position
In the statement of financial position, tax assets and liabilities should be shown separately from
other assets and liabilities.
Current tax assets and liabilities can be offset, but this should happen only when:
(a) There is a legally enforceable right to set off the recognised amounts.
(b) The amounts will be settled on a net basis, or the asset and liability settled at the same time.
The tax expense or income for the year should be presented in the statement of profit or loss.
In relation to tax, the statement of financial position will include several items:
(a) Amounts underprovided/overprovided in the prior year which appear as debits/credits to the
tax payable account.
(b) If no tax is payable (or very little), then there might be an income tax recoverable asset
disclosed in current assets (income tax is normally recovered by offset against the tax liability
for the year).
(c) There will usually be a liability for tax assessed as due for the current year.
(d) There may also be a liability on the deferred taxation account. Deferred taxation is shown
under ‘non-current liabilities’ in the statement of financial position.
Taxation in the statement of profit or loss
The tax on profit on ordinary activities is calculated by aggregating:
(a) Income tax on taxable profits
(b) Transfers to or from deferred taxation
(c) Any under provision or overprovision of income tax on profits of previous years

Activity 7: Awkward Co
Awkward Co buys an item of equipment on 1 January 20X1 for $1,000,000. It has a useful life of
10 years and an estimated residual value of $100,000. The equipment is depreciated on a
straight-line basis. For tax purposes, a tax expense can be claimed on a 20% reducing balance
basis.
The rate of income tax can be taken as 30%.
1 Required
In respect of the above item of equipment, calculate the deferred tax charge/credit in the profit or
loss of Awkward Co for the year to 31 December 20X2 and the deferred tax balance in the
statement of financial position at that date.

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MOVEMENT IN THE DEFERRED TAX LIABILITY FOR THE YEAR ENDED 31 DECEMBER 20X2
$’000
Deferred tax liability b/d
Profit or loss charge/(credit) Profit or loss charge/(credit)
Deferred tax liability c/d

Workings
1. Deferred tax liability
Accounting Temporary Deferred tax
carrying amount Tax base differences liability @ 30%
$’000 $’000 $’000 $’000
20X1
Cost
Depreciation

c/d
20X2
b/d
Depreciation
(W2) and (W3)
c/d

2. Depreciation

3. Tax depreciation/capital allowances

20X1:
20X2:

Solution
1

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Essential reading
In Chapter 15 of the Essential reading, there is an additional activity (Activity 3: Norman Kronkest
Co) which looks at the effect of deferred tax on a number of different adjustments to the financial
statements. Do attempt further question practice on this topic as it is generally an area that
students struggle with in the exam.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

Activity 8: Neil Down Co

In the accounting year to 31 December 20X3, Neil Down Co generated a profit before tax of
$110,000.
Income tax on the profit before tax has been estimated as $45,000. In the previous year (20X2),
income tax on profits had been estimated as $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.
1 Required
Calculate the tax on profits for 20X3 for disclosure in the accounts.
2 Required
Calculate the amount of tax payable

Solution
1

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Chapter summary

Taxation

IAS 12 Income Taxes Current tax

IAS 12 covers current and deferred tax • Tax actually payable to the tax authorities
• Tax charged by tax authority
• Unpaid tax due is recognised as a liability
• Excess tax paid over what is due is recognised as
an asset
• Having calculated the tax due:
– DEBIT Tax charge (SOPL)
– CREDIT Tax liability (SOFP)

What is deferred tax?

• Deferred tax is an accounting measure only Temporary differences continued

• Deferred tax is recognised for all temporary • Provision and allowances for doubtful debts
differences except – Accounting provisions under IAS 37
– Tax arising on business combination – Tax treatment allows relief when debt written off
(incl in goodwill) • Revaluation of non-current assets
– Taxes on adjustments which go to equity – As the gain on the revaluation is charged to
(IAS 8 accounting policy change) SPLOCI (other comprehensive income), so the
deferred tax is also only recognised in the SPLOCI
Temporary differences • Tax base: tax rules set out by each jurisdiction
• Property, plant & machinery
– Temporary differences arises due to different Measurement
rates of depreciation between the accounting
• Tax rates used that have been enacted by end of
and the tax rates
the reporting period
• Accrued income/accrued expense • Changes in tax rates after the year end are
– Accounting uses accruals principle to recognise non-adjusting events after the reporting period
income and expense
– Tax treatment takes the date of payment
or receipt

Calculating deferred tax Other aspects of deferred tax

Deferred tax is calculated as follows: Losses can be carried forward to reduce the future
$ tax liability – future tax saving – deferred tax asset
Carrying amount of asset/(liability) [in recognised
accounting statement of financial position] X/(X)
Less tax base [value for tax purposes] (X)/X Presentation
X/(X) • Deferred tax assets/liabilities should be shown
Deferred tax (liability)/asset [always opposite separately from other assets/liabilities.
• Current tax – can be offset ONLY WHEN
(X)/X – Legally enforceable right to do so
– Amounts will be settled on a net basis, or the
asset and liability settled at the same time

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Knowledge diagnostic
1. IAS 12 Income Taxes
IAS 12 Income Taxes explains the accounting treatment for current tax and deferred tax.
The accounting entry to record tax in the financial statements is:
DEBIT Tax charge (statement of profit or loss)
CREDIT Tax liability (statement of financial position)

2. Current tax
Current tax is the amount actually payable to the tax authorities in relation to the trading
activities of the entity during the period.
IAS 12 requires any unpaid tax in respect of the current or prior periods to be recognised as a
liability.
Conversely, any excess tax paid in respect of current or prior periods over what is due should be
recognised as an asset.

3. What is deferred tax?

Deferred tax is an accounting adjustment. It is not a tax which is payable to the tax authorities.
Essentially, it is the difference between:
• The carrying amount of the asset (or liability) on the statement of financial position, eg non-
current asset, warranty provision; and
• The tax value of the asset (or liability). This is called the ‘tax base’.

4. Calculating deferred tax

Deferred tax is the tax attributable to temporary differences.
There are two types of temporary difference:
• Taxable temporary difference – tax to pay in the future – giving rise to a deferred tax liability
• Deductible temporary difference – tax saving in the future – giving rise to a deferred tax asset
If an item is never taxable or tax deductible, its tax base is deemed to be its carrying amount so
there is no temporary difference and no related deferred tax. This is a permanent difference and
does not give rise to deferred tax.
Depreciation on non-current assets is an example of a circumstance which gives rise to taxable
temporary differences.
Revaluations of non-current assets are generally not recognised for tax until the asset is sold. As
the revaluation is recognised in other comprehensive income, the associated deferred tax is also
recognised in other comprehensive income.

5. Other aspects of deferred tax

A deferred tax asset is recognised for tax losses that can be carried forward that it is probable will
be used.
Deferred tax assets and liabilities are measured at the tax rates expected to apply to the period
when the asset is realised or liability settled, based on tax rates that have been enacted by the
end of the reporting period.

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
23 Telenorth Co
26 Carpati Co

Further reading
ACCA has prepared a useful technical article on deferred tax, which is available on its website
under Exam Support Resources.
Deferred Tax
www.accaglobal.com

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Activity answers

Activity 1: Current tax

The correct answer is:
Expense $59,150; Liability $60,000
The tax expense will be reduced by the prior year over-provision, however the liability will
represent the amount due for the coming year.

Activity 2: Tax base

1 The correct answer is:
(a) The tax base of the machine is $7,000. The carrying amount of the machine is $8,000,
therefore the temporary difference is $1,000.
(b) The interest has not yet been received in cash. The tax base of the interest receivable is nil.
The temporary difference is $1,000.
(c) The tax base of the trade receivables is $10,000. There is no temporary difference as the
carrying amount and tax base are equal.
(d) The loan is not taxable and so the tax base is deemed to be the carrying amount of the loan
which is $1 million. There is no temporary difference.

Activity 3: Epsilon Co
1 The correct answer is:
Amortisation of the development costs over their useful life of five years should commence on 1
January 20X4. Therefore, at 31 March 20X4, the development costs have a carrying amount of
$1.52 million ($1.6m – ($1.6m × 1/5 × 3/12)) in the financial statements.
The tax base of the development costs is nil since the relevant tax deduction has already been
claimed.
The deferred tax liability will be $380,000 ($1.52m × 25%).

Activity 4: Lecehus Co
The correct answer is:
Other comprehensive income $70,000; Liability $30,000
$’000
Other comprehensive income:
Gain on property revaluation 100
Deferred tax relating to other comprehensive income (Working) (30)
Other comprehensive income for the year, net of tax 70

Working
$’000
Accounting carrying amount 500
Tax base (400)
Temporary difference 100

Deferred tax liability @ 30% (30)

Activity 5: Pargatha Co
1 The correct answer is:
What is the tax base of the liability? It is nil (as the amount in respect of warranty claims will not

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be deductible for tax purposes until future periods when the claims are paid).
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 by $10,000 × 25% = $2,500.
The difference of $10,000 between the carrying amount ($10,000) and the tax base (nil) is a
deductible temporary difference. Pargatha Co should therefore recognise a deferred tax asset of
$10,000 × 25% = $2,500 provided that it is probable that the entity will earn sufficient taxable
profits in future periods to benefit from a reduction in tax payments.

Activity 6: Deorf Co
The correct answer is:
Deferred tax asset $10,000
A deferred tax asset is recognised in 20X1 for $50,000 × 20% = $10,000:
DEBIT Deferred tax asset (SOFP) $10,000
CREDIT Deferred tax (P/L) $10,000

In 20X3 the deferred tax asset is charged to profit or loss when profits are earned that the tax
losses are used against.

Activity 7: Awkward Co
1 The correct answer is:
The deferred tax liability in the statement of financial position at 31 December 20X2 will be the
potential tax on the difference between the accounting carrying amount of $820,000 and the tax
base of $640,000. The temporary difference is $180,000 and the deferred tax on the difference is
a $54,000 charge/liability.
The charge (or credit) for deferred tax in profit or loss for the year is the increase (or decrease) in
the deferred tax liability during the year. The closing deferred tax liability of $54,000 is greater
than the opening deferred tax liability of $33,000, so there is a deferred tax charge of $21,000 to
profit or loss in respect of this year.

MOVEMENT IN THE DEFERRED TAX LIABILITY FOR THE YEAR ENDED 31 DECEMBER 20X2
$’000
Deferred tax liability b/d 33
 Profit or loss charge 21
Deferred tax liability c/d 54

Workings
1 Deferred tax liability
Accounting
carrying Temporary Deferred tax
amount Tax base differences liability @ 30%
$’000 $’000 $’000 $’000
20X1
Cost 1,000 1,000 – –
Depreciation
(W2) and (W3) (90) (200)
c/d 910 800 110 (33)
20X2
b/d 910 800
Depreciation
(W2) and (W3) (90) (160)
c/d 820 640 180 (54)

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2 Depreciation
$1,000,000 cost – $100,000 residual value/10 years = $90,000 per annum.
3 Tax depreciation/capital allowances
20X1: $1,000,000 × 20% = $200,000
20X2: $800,000 carrying amount b/d × 20% = $160,000

Activity 8: Neil Down Co

1 The correct answer is:
$
Income tax on profit before tax (liability in the statement of financial position) 45,000
Deferred taxation 16,000
Underprovision of tax in previous year ($40,500 – $38,000) 2,500
Tax on profits for 20X3 (profit or loss charge) 63,500

2 The correct answer is:

$
Tax payable on 20X3 profits (liability) 45,000

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Presentation of published
16 financial statements

16

Learning objectives
On completion of this chapter, you should be able to

Syllabus reference
no.

Prepare an entity’s statement of financial position and statement of D1(a)

profit or loss and other comprehensive income in accordance with the
structure and content prescribed within IFRS and with accounting
treatments as identified within syllabus areas A, B and C.

Prepare and explain the contents and purpose of the statement of D1(b)
changes in equity.

Indicate the circumstances where separate disclosure of material items B9(c)

of income and expense is required.
16

Exam context
The presentation of published financial statements is a key area of the Financial Reporting
syllabus and will be tested in a constructed response question in Section C of the exam. In Section
C, you will be required to prepare the statement of financial position, statement of profit or loss
and other comprehensive income and/or the statement of cash flows.
16

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Chapter overview
Presentation of published financial statements

IFRS Statement of Statement of profit

Financial financial or loss and other
statements position comprehensive income

Key sections of the statement of Key sections of the statement of

financial position profit or loss

Key section of the statement of

other comprehensive income

Revision of basic Statement of Financial statement

accounts preparation changes in equity preparation questions

Recap Key sections of the statement of

changes in equity

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1 IFRS financial statements

1.1 IAS 1 Presentation of Financial Statements
1.1.1 Scope
IAS 1 Presentation of Financial Statements applies to the preparation and presentation of general-
purpose financial statements in accordance with IFRS.

1.1.2 Financial statements

A complete set of financial statements comprises:
(a) A statement of financial position at the end of the period
(b) A statement of profit or loss and other comprehensive income for the period
(c) A statement of changes in equity for the period
(d) A statement of cash flows for the period
(e) Notes, comprising a summary of significant accounting policies and other explanatory
information
(f) Comparative information in respect of the preceding period
(g) A statement of financial position at the beginning of the earliest comparative period where
an entity applies an accounting policy retrospectively or makes a retrospective restatement
of items in its financial statements, or when it reclassifies items in its financial statements.
IAS 1 also permits the use of other terms than those used in the standard, such as:
• ‘Balance sheet’ for the ‘statement of financial position’
• ‘Statement of comprehensive income’ for the ‘statement of profit or loss and other
comprehensive income’
• Income statement’ for the ‘statement of profit or loss’

Essential reading
Chapter 16, Section 1 Presentation of Financial Statements of the Essential reading provides useful
information on how information is reported in the financial statements. This includes detail on
reporting profit or loss for the year, disclosure, identification of financial statements, the reporting
period and timeliness. Review this section carefully.
Further, you must understand the type of information that is included in the notes to the financial
statements. Read Chapter 16, Section 3 Notes to the financial statements in the Essential reading
and make sure you can explain the type of information shown by way of a note.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

2 Statement of financial position

2.1 Format of the statement of financial position
An example of a statement of financial position given by IAS 1 (Illustrative Guidance) is as follows:

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GENERIC 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
Investments in equity instruments 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
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: para. 80)

2.2 The current/non-current distinction

Exam focus point

You should appreciate the distinction between current and non-current assets and liabilities
and the affect this has on the way they are recorded in the financial statements.

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An entity must present current and non-current assets as separate classifications on the face of
the statement of financial position. A presentation based on liquidity should only be used where it
provides more relevant and reliable information, in which case all assets and liabilities must be
presented broadly in order of liquidity. (IAS 1: para. 60)
In either case, the entity should disclose any portion of an asset or liability that is expected to be
recovered or settled after more than 12 months. For example, for an amount receivable that is due
in instalments over 18 months, the portion due after more than 12 months must be disclosed. (IAS
1: para. 61)
The IAS emphasises how helpful information on the operating cycle is to users of financial
statements. Where there is a clearly defined operating cycle within which the entity supplies
goods or services, then information disclosing those net assets that are continuously circulating
as working capital is useful. (IAS 1: para. 62)
This distinguishes them from those net assets used in the long-term operations of the entity.
Assets that are expected to be realised and liabilities that are due for settlement within the
operating cycle are therefore highlighted. (IAS 1: para. 62)
The liquidity and solvency of an entity is also indicated by information about the maturity dates
of assets and liabilities. As we will see later, IFRS 7 Financial Instruments: Disclosures requires
disclosure of maturity dates of both financial assets and financial liabilities. (Financial assets
include trade and other receivables; financial liabilities include trade and other payables.) (IAS 1:
para. 63)

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

KEY
TERM • Is expected to be realised in, or is held for sale or consumption in, the normal course of the
entity’s operating cycle; or
• 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.
All other assets should be classified as non-current assets.
(IAS 1: para. 66)

Non-current assets include tangible, intangible, operating and financial assets of a long-term
nature. Other terms with the same meaning can be used (eg ‘fixed’, ‘long-term’). (IAS 1: para. 67)
The term ‘operating cycle’ has been used several times above. The standard defines it as follows.

Operating cycle: The time between the acquisition of assets for processing and their
KEY
TERM realisation in cash or cash equivalents. (IAS 1: para. 68)

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. (IAS 1: para. 68)
Current assets will also include marketable securities if they are expected to be realised within 12
months after the reporting period. If expected to be realised later, they should be included in non-
current assets. (IAS 1: para. 68)

Current liabilities: A liability should be classified as a current liability when it:

KEY
TERM • Is expected to be settled in the normal course of the entity’s operating cycle; or
• Is held primarily for the purpose of trading; or
• Is due to be settled within 12 months after the end of the reporting period; or when
• 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.
All other liabilities should be classified as non-current liabilities.
(IAS 1: para. 69)

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The categorisation of current liabilities is very similar to that of current assets. Thus, some current
liabilities are part of the working capital used in the normal operating cycle of the business (ie
trade payables and accruals for employee and other operating costs). Such items will be classed
as current liabilities, even where they are due to be settled more than 12 months after the end of
the reporting period. (IAS 1: para. 70)
There are also current liabilities that 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, should be classed as non-
current liabilities. (IAS 1: para. 71)
A non-current financial liability due to be settled within 12 months of the end of the reporting
period should be classified as a current liability, even if an agreement to refinance, or to
reschedule payments, on a long-term basis is completed after the end of the reporting period and
before the financial statements are authorised for issue. (IAS 1: para. 72)

End of the Agreement to refinance Date financial Settlement date <12

reporting period on long-term basis statements authorised months after end of
for issue the reporting period
therefore current liability

A non-current financial liability that is payable on demand because the entity breached a
condition of its loan agreement should be classified as current at the end of the reporting period,
even if the lender has agreed after the end of the reporting period, and before the financial
statements are authorised for issue, not to demand payment as a consequence of the breach.

Condition of loan End of the Lender agrees not to Date financial

agreement breached. reporting period enforce payment resulting statements are
Non-current liability from breach authorised for issue.
becomes payable Loan shown as
on demand current liability

However, if the lender has agreed by the end of the reporting period to provide a period of grace
ending at least 12 months after the end of the reporting period within which the entity can rectify
the breach, and during that time the lender cannot demand immediate repayment, the liability is
classified as non-current.

3 Statement of profit or loss and other comprehensive

income
3.1 Format
IAS 1 allows income and expense items to be presented either:
(a) In a single statement of profit or loss and other comprehensive income; or
(b) In two statements: a separate statement of profit or loss and statement of other
comprehensive income.
(para. 81)
The format for a single statement of profit or loss and other comprehensive income is shown as
follows in the standard. The section down to ‘profit for the year’ can be shown as a separate
‘statement of profit or loss’ with an additional ‘statement of other comprehensive income’. Note
that not all of the items that would appear under ‘other comprehensive income’ are included in
your syllabus.

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Exam focus point

In the exam, if a ‘statement of profit or loss and other comprehensive income’ is referred to,
this will always relate to the single statement format. If ‘statements of profit or loss’ are
referred to, this relates to the statement from ‘revenue’ to ‘profit for the year’.
Exams may refer to ‘other comprehensive income’ that relates to the ‘other comprehensive
income’ section of the statement. In practice, the item of ‘other comprehensive income’ you
are most likely to meet is a revaluation surplus.
Where the phrase ‘statement of profit or loss’ is used in this Workbook, this can be taken to
refer to the profit or loss section of the full statement or separate statement of profit or loss.

3.2 Format of the statement of profit or loss and other comprehensive

income
An example of a statement of profit or loss and other comprehensive income given by IAS 1 is as
follows:
GENERIC 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:
Items that will not be reclassified to profit or loss:
Gains on property revaluation 933 3,367
Investments in equity instruments (24,000) 26,667
Remeasurement gains (losses) on 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 5,834 (7,667)
(17,500) 23,000
Items that may be reclassified subsequently to profit or loss
*Exchange differences on translating foreign operations 5,334 10,667
*Cash flow hedges (667) (4,000)
Income tax relating to items that may be reclassified (1,167) (1,667)
3,500 5,000
Other comprehensive income for the year, net of tax (14,000) 28,000
Total comprehensive income for the year 107,250 93,500

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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 Reporting syllabus

This is the full statement as issued by the IASB. (IAS 1: IG)
Note that the amendment to IAS 1 splits items of other comprehensive income into those which can
be reclassified to profit or loss and those which cannot be reclassified. In practice, none of the
items that can be reclassified are examinable at Financial Reporting, so this is not an issue that
you will encounter in your exam.

PER alert
One of the competences required to fulfil performance objective 7 of the PER is the ability to
prepare and review financial statements in accordance with legal and regulatory
requirements. You can apply the knowledge you obtain from this section of the Workbook to
help you demonstrate this competence.

4 Revision of basic accounts preparation

In this section we move on to the mechanics of preparing financial statements. It would be useful
at this point to refresh your memory of the basic accounting you have already studied and these
questions will help you. Make sure that you understand everything before you go on.

Illustration 1: Recap of financial accounts

A friend has bought some shares in a company quoted on a local stock exchange and has
received the latest accounts. There is one page he is having difficulty in understanding.
Briefly, but clearly, answer his questions.
1 Required
What is a statement of financial position?
2 Required
What is an asset?
3 Required
What is a liability?
4 Required
What is share capital?
5 Required
What are reserves?
6 Required
Why does the statement of financial position balance?
7 Required
To what extent does the statement of financial position value my investment?

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Solution
1 The correct answer is:
A statement of financial position is a statement of the assets, liabilities and capital of a business
as at a stated date. It is laid out to show either total assets as equivalent to total liabilities and
capital, or net assets as equivalent to capital. Other formats are also possible but the top half (or
left hand) total will always equal the bottom half (or right hand) total.
2 The correct answer is:
An asset is a resource controlled by a business and is expected to be of some future benefit. Its
value is determined as the historical cost of producing or obtaining it (unless an attempt is being
made to reflect rising prices in the accounts, in which case a replacement cost might be used).
Examples of assets are:
(a) Plant, machinery, land and other non-current assets
(b) Current assets such as inventories, cash and debts owed to the business with reasonable
assurance of recovery; these are assets which are not intended to be held on a continuing
basis in the business
3 The correct answer is:
A liability is an amount owed by a business, other than the amount owed to its proprietors
(capital). Examples of liabilities are:
(a) Amounts owed to the government (sales or other taxes)
(b) Amounts owed to suppliers
(c) Bank overdraft
(d) Long-term loans from banks or investors
It is usual to differentiate between ‘current’ and ‘long-term’ liabilities. The former fall due within a
year of the end of the reporting period.
4 The correct answer is:
Share capital is the permanent investment in a business by its owners. In the case of a limited
company, this takes the form of shares for which investors subscribe on formation of the
company. Each share has a nominal or par (ie face) value (say $1). In the statement of financial
position, total issued share capital is shown at its par value.
5 The correct answer is:
If a company issues shares for more than their nominal value (at a premium) then (usually) by
law, this premium must be recorded separately from the par value as ‘share premium’. This is an
example of a reserve. It belongs to the shareholders but cannot be distributed to them, because it
is a capital reserve. Other capital reserves include the revaluation surplus, which shows the
surpluses arising on revaluation of assets that are still owned by the company.
Share capital and capital reserves are not distributable except on the winding up of the company,
as a guarantee to the company’s creditors that the company has enough assets to meet its debts.
This is necessary because shareholders in limited liability companies have ‘limited liability’; once
they have paid the company for their shares, they have no further liability to it if it becomes
insolvent. The proprietors of other businesses are, by contrast, personally liable for business
debts.
Retained earnings constitute accumulated profits (less losses) made by the company and can be
distributed to shareholders as dividends. They too belong to the shareholders, and so are a claim
on the resources of the company.
6 The correct answer is:
Statements of financial position do not always balance on the first attempt, as all accountants
know! However, once errors are corrected, all statements of financial position balance. This is
because in double entry bookkeeping every transaction recorded has a dual effect. Assets are
always equal to liabilities plus capital and so capital is always equal to assets less liabilities. This
makes sense as the owners of the business are entitled to the net assets of the business as
representing their capital plus accumulated surpluses (or less accumulated deficit).

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7 The correct answer is:

The statement of financial position is not intended as a statement of a business’s worth at a given
point in time. This is because, except where some attempt is made to adjust for the effects of
rising prices, assets and liabilities are recorded at historical cost and on a prudent basis. For
example, if there is any doubt about the recoverability of a debt, then the value in the accounts
must be reduced to the likely recoverable amount. In addition, where non-current assets have a
finite useful life, their cost is gradually written off to reflect the use being made of them.
Sometimes non-current assets are revalued to their market value but this revaluation then goes
out of date as few assets are revalued every year.
The figure in the statement of financial position for capital and reserves therefore bears no
relationship to the market value of shares. Market values are the product of a large number of
factors, including general economic conditions, alternative investment returns (eg interest rates),
likely future profits and dividends and, last but not least, market sentiment.

Essential reading
Chapter 16, Section 2 Proforma Financial Statements shows the structure of the financial
statements. Make sure you are familiar with these proformas and can produce them quickly in the
exam.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

5 Statement of changes in equity

A statement of changes in equity shows the movement in the equity section of the statement of
financial position. IAS 1 requires a statement of changes in equity and therefore a full set of
financial statements includes this statement.

5.1 Format
This is the format of the statement of changes in equity as per IAS 1. For clarity, columns relating
to items not in the Financial Reporting syllabus, as highlighted in Section 3 are omitted, and the
totals are amended accordingly. (IAS 1: IG)
GENERIC GROUP – STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER
20X7
Share
capital

Retained
earnings

Investments
In equity
instruments

Revaluation
surplus

Total

Non-controlling
interest

Total equity

$’000 $’000 $’000 $’000 $’000 $’000 $’000

Balance at 1
January 20X6 600,000 118,100 1,600 – 719,700 29,800 749,500
Changes in
accounting
policy – 400 – – 400 100 500
Restated balance 600,000 118,500 1,600 – 720,100 29,900 750,000
Changes in equity
Dividends – (10,000) – – (10,000) – (10,000)

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Share
capital

Retained
earnings

Investments
In equity
instruments

Revaluation
surplus

Total

Non-controlling
interest

Total equity
$’000 $’000 $’000 $’000 $’000 $’000 $’000

Total
comprehensive
income for the
year – 53,200 16,000 1,600 70,800 18,700 89,500
Balance at 31
December
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
income for the
year – 96,600 (14,400) 800 83,000 21,450 104,450
Transfer to
retained
earnings – 200 – (200) – – –
Balance at 31
December
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, the adjustment is disclosed for each period. So, rather than just showing an
adjustment to the balance brought forward on 1.1.X7, the balances for 20X6 are restated.

5.2 Illustration
Having explored the proformas for the statement of financial position, the statement of profit and
loss and the statement of changes in equity, this next Illustration will demonstrate how a set of
IFRS financial statements are prepared.

Illustration 2: Wislon Co
The accountant of Wislon Co has prepared the following list of account balances as at 31
December 20X7.
$’000
50c ordinary shares (fully paid) 450
10% loan notes (secured) 200
Retained earnings 1.1.X7 242
Other components of equity 1.1.X7 171
Land and buildings 1.1.X7 (cost) 430
Plant and machinery 1.1.X7 (cost) 830
Accumulated depreciation
Buildings 1.1.X7 20

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$’000
Plant and machinery 1.1.X7 222
Inventory 1.1.X7 190
Sales 2,695
Purchases 2,152
Ordinary dividend 15
Loan note interest 10
Wages and salaries 254
Light and heat 31
Sundry expenses 113
Suspense account 135
Trade accounts receivable 179
Trade accounts payable 195
Cash 126

Additional information
(a) Sundry expenses include $9,000 paid in respect of insurance for the year ending 1 September
20X8. Light and heat does not include an invoice of $3,000 for electricity for the three
months ending 2 January 20X8, which was paid in February 20X8. Light and heat also
includes $20,000 relating to sales commission.
(b) The suspense account is in respect of the following items.
$’000
Proceeds from the issue of 100,000 ordinary shares 120
Proceeds from the sale of plant 300
420
Less consideration for the acquisition of Mary & Co 285
135

(c) The net assets of Mary & Co were purchased on 3 March 20X7. Assets were valued as follows.
$’000
Equity investments 231
Inventory 34
265

All the inventory acquired was sold during 20X7. The equity investments were still held by Wislon
at 31.12.X7. Goodwill has not been impaired in value.
(d) The property was acquired some years ago. The buildings element of the cost was estimated
at $100,000 and the estimated useful life of the assets was 50 years at the time of purchase.
As at 31 December 20X7, the property is to be revalued at $800,000.
(e) The plant, which was sold, had cost $350,000 and had a carrying amount of $274,000 as on
1.1.X7. $36,000 depreciation is to be charged on plant and machinery for 20X7.
(f) The management wish to provide for:
(i) Loan note interest due
(ii) A transfer to other components of equity of $16,000
(iii) Audit fees of $4,000
(g) Inventory as at 31 December 20X7 was valued at $220,000 (cost).
(h) Taxation is to be ignored.
Required
Prepare the financial statements of Wislon Co as at 31 December 20X7. You do not need to
produce notes to the statements.

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Solution
The correct answer is:
For ease of reference, we will first address the adjustments and then prepare the financial
statements proformas. Both the adjustments and figures per the trial balance that do not require
adjustment are posted to the proformas.
(a) Normal adjustments are needed for accruals and prepayments (insurance, light and heat,
loan note interest and audit fees). The loan note interest accrued is calculated as follows.
$’000
Charge needed in profit or loss (10% × $200,000) 20
Amount paid so far, as shown in list of account balances 10
Accrual: presumably six months’ interest now payable 10

The accrued expenses shown in the statement of financial position comprise:

$’000
Loan note interest 10
Light and heat 3
Audit fee 4
17

(b) The misposting of $20,000 to light and heat is also adjusted, by reducing the light and heat
expense, but charging $20,000 to sales commission.
(c) Depreciation on the building is calculated as $100,000/50 = $2,000.
The carrying amount of the building is then $430,000 – $20,000 – $2,000 = $408,000 at the end
of the year. When the property is revalued, a reserve of $800,000 – $408,000 = $392,000 is then
created.
(d) The profit on disposal of plant is calculated as proceeds $300,000 (per suspense account)
less carrying amount $274,000, ie $26,000. The cost of the remaining plant is calculated at
$830,000 – $350,000 = $480,000. The depreciation provision at the year end is:
$’000
Balance 1.1.X7 222
Charge for 20X7 36
Less depreciation on disposals (350 – 274) (76)
182

(e) Goodwill arising on the purchase of Mary & Co is:

$’000
Consideration (per suspense account) 285
Assets at valuation 265
Goodwill 20

This is shown as an asset in the statement of financial position. The equity investments, being
owned by Wislon Co at the year end, are also shown on the statement of financial position,
whereas Mary & Co’s inventory, acquired and then sold, is added to the purchases figure for the
year.
(f) The other item in the suspense account is dealt with as follows:
$’000
Proceeds of issue of 100,000 ordinary shares 120
Less nominal value 100,000 × 50c 50

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$’000
Excess of consideration over par value (= share premium) 70

(g) The transfer to other components of equity increases it to $171,000 + $16,000 = $187,000.
We can now prepare the financial statements.
WISLON CO
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEAR ENDED
31 DECEMBER 20X7
$’000
Revenue 2,695
Cost of sales (W(a)) (2,156)
Gross profit 539
Other income (profit on disposal of plant) 26
Administrative expenses (W(b)) (437)
Finance costs (20)
Profit for the year 108
Other comprehensive income:
Gain on property revaluation 392
Total comprehensive income for the year 500

Note. The only item of ‘other comprehensive income’ for the year was the revaluation gain. If there
had been no revaluation gain, only a statement of profit or loss would have been required.
Workings
(a) Cost of sales
$’000
Opening inventory 190
Purchases (2,152 + 34) 2,186
Closing inventory (220)
2,156

(b) Administrative expenses

$’000
Wages, salaries and commission (254 + 20) 274
Sundry expenses (113 – 6) 107
Light and heat (31 – 20 + 3) 14
Depreciation: buildings 2
plant 36
Audit fees 4
437

WISLON CO
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X7
$’000 $’000
Assets
Non-current assets
Property, plant and equipment
Property at valuation 800
Plant: cost 480

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$’000 $’000
accumulated depreciation (182)
298
Goodwill 20
Equity investments 231

Current assets
Inventories 220
Trade accounts receivable 179
Prepayments 6
Cash and cash equivalents 126
531
Total assets 1,880
Equity and liabilities
Equity
50c ordinary shares 500
Share premium 70
Revaluation surplus 392
Other components of equity 187
Retained earnings 319
1,468
Non-current liabilities
10% loan stock (secured) 200
Current liabilities
Trade and other payables 195
Accrued expenses 17
212
Total equity and liabilities 1,880

WISLON CO
STATEMENT OF CHANGES IN EQUITY
FOR THE YEAR ENDED 31 DECEMBER 20X7
Other
Share Share Retained components Revaluation
capital premium earnings of equity Surplus Total
$’000 $’000 $’000 $’000 $’000 $’000
Balance at 1.1.X7 450 – 242 171 – 863
Issue of share capital 50 70 120
Dividends (15) (15)
Total comprehensive
income for the year 108 392 500
Transfer to reserve – – (16) 16 – –
Balance at 31.12.X7 500 70 319 187 392 1,468

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6 Financial statement preparation questions

Having considered the components and presentation of financial statements, in this section we
will look at an exam-standard question on this topic.
Approach to questions

Step Procedure / exam technique

Step 1 Read the requirements carefully. Then read the scenario. Make brief notes of
any key details on the electronic Scratch Pad or on the scrap paper
provided.

Step 2 Enter proformas into the constructed response spreadsheet workspace, as

specified in the requirements. For example, you may be asked to prepare a
statement of profit or loss and other comprehensive income and/or a
statement of financial position, or extracts of these statements.
Also, set up space for workings. Remember to label your workings.

Step 3 Read the additional information given thoroughly and note any items in the
trial balance that are going to change.

Step 4 Transfer the figures from the trial balance:

• Unaffected figures may be entered directly on your proformas.
• Figures requiring adjustment can either be put into a working or brackets
opened up on the face of your proforma solution.

Step 5 Finally, work through the adjustments in the additional notes. Deal with both
sides of the double entry, balance off workings and transfer the figures to
your proforma.

As the Financial Reporting exam will be taken online as a CBE, the recommended approach to
questions given above is for online exams. However, a similar approach can be adopted for paper-
based questions, albeit using paper instead of a spreadsheet.

Activity 1: Mandolin Co
Mandolin Co is a quoted manufacturing company. Its finished products are stored in a nearby
warehouse until ordered by customers. Mandolin Co has performed very well in the past, but has
been in financial difficulties in recent months and has been organising the business to improve
performance.
The trial balance for Mandolin Co at 31 March 20X3 was as follows:
$’000 $’000
Sales 124,900
Cost of goods manufactured in the year to
31 March 20X3 (excluding depreciation) 94,000
Distribution costs 9,060
Administrative expenses 16,020
Restructuring costs 121
Interest received 1,200
Loan note interest paid 639
Land and buildings (including land $20,000,000) 50,300
Plant and equipment 3,720
Accumulated depreciation at 31 March 20X2:
Buildings 6,060
Plant and equipment 1,670

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$’000 $’000
Investment properties (at market value) 24,000
Inventories at 31 March 20X2 4,852
Trade receivables 9,330
Bank and cash 1,190
Ordinary shares of $1 each, fully paid 20,000
Share premium 430
Revaluation surplus 3,125
Retained earnings at 31 March 20X2 28,077
Ordinary dividends paid 1,000
7% loan notes 20X7 18,250
Trade payables 8,120
Proceeds of share issue – 2,400
214,232 214,232

Additional information provided:

(a) The property, plant and equipment are being depreciated as follows:
- Buildings 5% per annum straight-line
- Plant and equipment 25% per annum reducing balance
- Depreciation of buildings is considered an administrative cost while depreciation of plant
and equipment should be treated as a cost of sale.
(b) On 31 March 20X3, the land was revalued to $24,000,000.
(c) Income tax for the year to 31 March 20X3 is estimated at $976,000. Ignore deferred tax.
(d) The closing inventories at 31 March 20X3 were $5,180,000. An inspection of finished goods
found that a production machine had been set up incorrectly and that several production
batches, which had cost $50,000 to manufacture, had the wrong packaging. The goods
cannot be sold in this condition but could be repacked at an additional cost of $20,000. They
could then be sold for $55,000. The wrongly packaged goods were included in closing
inventories at their cost of $50,000.
(e) The 7% loan notes are ten-year loans due for repayment by 31 March 20X7. Interest on these
loan notes needs to be accrued for the six months to 31 March 20X3.
(f) The restructuring costs in the trial balance represent the cost of a major restructuring of the
company to improve competitiveness and future profitability.
(g) No fair value adjustments were necessary to the investment properties during the period.
(h) During the year, the company issued 2 million new ordinary shares for cash at $1.20 per
share. The proceeds have been recorded as ‘Proceeds of share issue’.
Required
Prepare the statement of profit or loss and other comprehensive income and statement of
changes in equity for Mandolin Co for the year to 31 March 20X3 and a statement of financial
position at that date.
Notes to the financial statements are not required, but all workings must be clearly shown.

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MANDOLIN CO
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEAR ENDED
31 MARCH 20X3
$’000
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Other expenses
Finance income
Finance costs
Profit before tax
Income tax expense
PROFIT FOR THE YEAR
Other comprehensive income:
Gain on land revaluation
TOTAL COMPREHENSIVE INCOME FOR THE YEAR

MANDOLIN CO
STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 20X3
$’000
Non-current assets
Property, plant and equipment
Investment properties

Current assets
Inventories
Trade receivables
Cash and cash equivalents

Equity
Share capital
Share premium
Retained earnings
Revaluation surplus

Non-current liabilities
7% loan notes 20X7

Current liabilities
Trade payables
Income tax payable
Interest payable

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MANDOLIN CO
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 MARCH 20X3
Share Share Retained Revaluation
capital premium earnings surplus Total
$’000 $’000 $’000 $’000 $’000
Balance at 1 April 20X2
Issue of share capital
Dividends
Total comprehensive income for the
year
Balance at 31 March 20X3

Workings
(a) Expenses
Cost of sales Distribution Administrative Other
$’000 $’000 $’000 $’000

(b) Property, plant and equipment

Plant &
Land Buildings equipment Total
$’000 $’000 $’000 $’000
Cost
Accumulated depreciation –
b/d
Carrying amount b/d
Charge for year
–

Revaluation (balancing figure)

Carrying amount c/d

Solution

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Chapter summary

Presentation of published financial statements

IFRS Statement of Statement of profit

Financial financial or loss and other
statements position comprehensive income

IAS 1 Presentation of Financial Key sections of the statement of Key sections of the statement of
Statements applies to the financial position profit or loss
preparation and presentation of • Non-current assets • Revenue
general purpose financial • Current assets • Cost of sales
statements in accordance with • Equity • Gross profit
IFRS • Non-current liabilities • Other income
• Current liabilities • Distribution costs
• Administrative expenses
• Other expenses
• Finance costs
• Income tax expense

Key section of the statement of

other comprehensive income
Gains/(losses) on property
revaluation

Revision of basic Statement of Financial statement

accounts preparation changes in equity preparation questions

Recap Key sections of the statement of A methodical approach is

• An asset is a resource control changes in equity important in the exam
by the business • Equity section of the SOFP
• An asset is expected to be of • Shows movement arising from:
future benefit – Dividends
• A liability is an amount owed – Share issues
by the business – Profit or loss
• Share capital is a permanent – Revaluation gains or losses
investment in the business by
its owners
• Retained earnings are
accumulated profits (less
losses)

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Knowledge diagnostic
1. IFRS financial statements
A set of IFRS financial statements includes a statement of profit or loss and other comprehensive
income, statement of financial position, statement of changes in equity, statement of cash flows,
accounting policies and notes to the financial statements.

2. Statement financial position

In the exam, you may be asked to prepare a statement of financial position. Therefore, learning
the formats is vital in achieving a pass on this type of question. Make sure that you understand
the difference between current assets and liabilities, and non-current assets and liabilities.

3. Statement of profit or loss and other comprehensive income

Similarly, you could be asked to prepare a statement of profit or loss and other comprehensive
income in Section C of the exam. Again, check that you can draw up this proforma easily and
understand which items are classified in ‘other comprehensive income’.

4. Revision of basic accounts preparation

You will be familiar with the terms statement of financial position, assets, liabilities, share capital
and reserves from your Financial Accounting studies. Briefly review this section to remind yourself
of the key concepts.

5. Statement of changes in equity

This statement shows the movement in the equity section in the statement of financial position.
Ensure you are familiar with this proforma.

6. Financial statement preparation questions

In the exam, you are likely to be asked to prepare a set of IFRS financial statements (which could
include a statement of changes in equity) from a trial balance.
BPP recommends a methodical approach of familiarising yourself with the information in the
question and setting up on-screen proformas/workings, then working down the draft trial
balance, transferring figures to the face of the financial statements (directly or in brackets if
adjustments will be required) or to a working.
Having made the more straightforward entries, you can then turn your attention to adjustments.
This is consistent with our approach to preparing statement of cash flows and group financial
statements.

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
4 Polymer Co
23(a) Telenorth Co

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Activity answers

Activity 1: Mandolin Co
The correct answer is:
Mandolin Co
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 MARCH 20X3
$’000
Revenue 124,900
Cost of sales (W(a)) (94,200)
Gross profit 30,700
Distribution costs (W(a)) (9,060)
Administrative expenses (W(a)) (17,535)
Other expenses (W(a)) (121)
Finance income 1,200
Finance costs (18,250 × 7%) (1,278)
Profit before tax 3,906
Income tax expense (976)
PROFIT FOR THE YEAR 2,930
Other comprehensive income:
Gain on land revaluation 4,000
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 6,930

Other expenses represent the cost of a major restructuring undertaken during the period.

MANDOLIN CO
STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 20X3
$’000
Non-current assets
Property, plant and equipment (W(b)) 48,262
Investment properties 24,000
72,262
Current assets
Inventories (5,180 – (W(c)) 15) 5,165
Trade receivables 9,330
Cash and cash equivalents 1,190
15,685
87,947
Equity
Share capital (20,000 + (W(d)) 2,000) 22,000
Share premium (430 + (W(d)) 400) 830
Retained earnings (28,077 – 1,000 + 2,930) 30,007
Revaluation surplus (3,125 + 4,000) 7,125
59,962
Non-current liabilities
7% loan notes 20X7 18,250
18,250

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Current liabilities
Trade payables 8,120
Income tax payable 976
Interest payable (1,278 – 639) 639
9,735
87,947

Mandolin Co
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 MARCH 20X3
Share Share Retained Revaluation
capital premium earnings surplus Total
$’000 $’000 $’000 $’000 $’000
Balance at 1 April 20X2 20,000 430 28,077 3,125 51,632
Issue of share capital 2,000 400 2,400
Dividends (1,000) (1,000)
Total comprehensive income
for the year – – 2,930 4,000 6,930
Balance at 31 March 20X3 22,000 830 30,007 7,125 59,962

Workings
(a) Expenses
Cost of sales Distribution Admin Other
$’000 $’000 $’000 $’000
Per TB 94,000 9,060 16,020 121
Opening inventories 4,852
Depreciation on buildings (W2) 1,515
Depreciation on P&E (W2) 513
Closing inventories (5,180 – (W3) 15) (5,165) – – –
94,200 9,060 17,535 121

(b) Property, plant and equipment

Land Buildings P&E Total
$’000 $’000 $’000 $’000
Cost b/d 20,000 30,300 3,720 54,020
Acc’d depreciation b/d – (6,060) (1,670) (7,730)
20,000 24,240 2,050 46,290
Depreciation charge for year:
• $30,300 × 5% – (1,515) (1,515)
• ($3,720 – $1,670) × 25% – – (513) (513)
20,000 22,725 1,537 44,262
Revaluation (balancing figure) 4,000 – – 4,000
Carrying amount c/d 24,000 22,725 1,537 48,262

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(c) Inventories
$’000
Defective batch:
Selling price 55
Cost to complete: repackaging required (20)
 NRV 35
Cost (50)
 Write-off required (15)

(d) Share issue

The proceeds have been recorded separately in the trial balance. This requires a transfer to the
appropriate accounts:
$’000 $’000
DEBIT Proceeds of share issue 2,400
CREDIT Share capital (2,000 × $1) 2,000
CREDIT Share premium (2,000 × $0.20) 400

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Reporting financial
17 performance

17

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference
no.

Discuss the importance of identifying and reporting the results of B9(a)

discontinued operations.

Define and account for non-current assets held for sale and B9(b)
discontinued operations.

Account for changes in accounting estimates, changes in accounting B9(d)

policies and correction of prior period errors.

Discuss the principle of comparability in accounting for changes in A1(g)

accounting policies.

Explain the difference between functional and presentation currency B12(a)

and explain why adjustments for foreign currency transactions are
necessary.

Account for the translation of foreign currency transactions and B12(b)

monetary/non-monetary foreign currency items at the reporting date.
17

Exam context
This chapter looks at the IFRS Standards which consider how to deal with presentation issues,
such as a change in an accounting policy or correction of a fundamental error (IAS 8 Accounting
Policies, Changes in Accounting Estimates and Errors). The presentation of transactions in foreign
currencies, and therefore which exchange rates to use, are covered in IAS 21 The Effects of
Changes in Foreign Exchange Rates. You are likely to be asked about IAS 21 in Sections A or B as
part of an OTQ, although you may be asked to translate some foreign currency transactions as
part of a longer Section C question.
Finally, IFRS 5 Non-current Assets Held for Sale and Discontinued Operations looks at how to deal
with business operations which have ceased in the year. Although you have already seen how to
account for non-current assets, entities may also acquire them with the aim of reselling them in
the near future.
Ensure you are familiar with the key points and practice your OTQs in order to consolidate your
knowledge and application skills in this chapter.
17

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Chapter overview
Reporting financial performance

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors

Accounting policies Accounting estimates Prior period errors

Changes in accounting policies Changes in accounting Correction of the error

estimates

Disclosure Disclosure
Disclosure

IFRS 5 Non-current Assets Held for Sale IAS 21 Foreign

and Discontinued Operations currency

Non-current assets held for sale Discontinued operations

Accounting treatment Disclosure

Disclosure

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1 IAS 8 Accounting Policies, Changes in Accounting

Estimates and Errors
This standard deals with:
• Selection and application of accounting policies
• Changes in accounting policies
• Changes in accounting estimates
• Accounting for errors

1.1 Accounting policies

1.1.1 Definition

Accounting policies: The specific principles, bases, conventions, rules and practices applied by
KEY
TERM an entity in preparing and presenting the financial statements (IAS 8: para. 5).

An entity determines its accounting policies by applying the appropriate IFRS.

In the absence of an IFRS applying to the area, management uses its judgement to develop and
apply a policy that results in information that is relevant and that faithfully represents what it
purports to represent as outlined in the Conceptual Framework.
In making the judgement management also considers (in order of importance):
(a) IFRSs dealing with similar and related issues;
(b) The definitions, recognition criteria and measurement concepts outlined in the Conceptual
Framework; and
(c) The most recent pronouncements of other standard-setting bodies that use a similar
conceptual framework or accepted industry practices.
Accounting policies must be consistently applied for similar transactions, categories, other events
and conditions. The exception being if a standard requires or permits categorisation of items for
which different policies may be appropriate.

1.1.2 Changes in accounting policies

A change in accounting policy is rare and is made only if:
(a) It is required by an IFRS; or
(b) It results in the financial statements providing reliable and more relevant information about
the effects of transactions, other events or conditions on the entity’s financial position,
financial performance or cash flows.
The standard highlights two types of event which do not constitute changes in accounting policy:
(a) Adopting an accounting policy for a new type of transaction or event not dealt with
previously by the entity
(b) Adopting a new accounting policy for a transaction or event which has not occurred in the
past or which was not material (this includes adopting a policy of revaluation for the first time
for tangible non-current assets, which would be treated under IAS 16 (See chapter on tangible
non-current assets)
Where a new accounting standard is adopted, resulting in a change of accounting policy, IAS 8
requires any transitional provisions in the new standard to be followed. If none are given in the
standard then the general principles of IAS 8 should be followed.

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1.1.3 Accounting treatment

Where the initial application of an IFRS does not prescribe specific transitional provisions, an
entity applies the change retrospectively by:
(a) Restating comparative amounts for each prior period presented as if the accounting policy
had always been applied;
(b) Adjusting the opening balance of each affected component of equity for the earliest prior
period presented; and
(c) Including the adjustment to opening equity as the second line of the statement of changes in
equity.
Where it is impracticable to determine the period-specific effects, the entity applies the new
accounting policy from the earliest period for which retrospective application is practicable (and
discloses that fact).

1.1.4 Key disclosures

(a) The nature of the change in accounting policy
(b) The reasons for the change
(c) The amount of the adjustment for the current and each prior period presented for each line
item affected
(d) The amount of the adjustment to periods before those presented
Disclosure is important to maintain the principle of comparability. Users should be able to
compare the financial statements of an entity over time and to compare the financial statements
of entities in the same line of business.

1.2 Changes in accounting estimates

1.2.1 Definition

Changes in accounting estimates: An adjustment of the carrying amount of an asset or

KEY
TERM 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 (IAS 8: para. 5).

Changes in accounting estimates result from new information or new developments and,
accordingly, are not correction of errors.
Examples of estimates that may change include:
• Allowances for doubtful debts
• Inventory obsolescence
• Useful lives/expected pattern of consumption of depreciable assets
• Warranty obligations

1.2.2 Accounting treatment

Changes in accounting estimates relating to assets, liabilities or equity items are adjusted in the
period of the change. All others are applied prospectively in profit or loss, ie in the current period
(and future periods if the change affects both current and future periods).
Changes in accounting estimates are not accounted for retrospectively.
The rule here is that the effect of a change in an accounting estimate should be included in the
determination of net profit or loss in one of:
(a) The period of the change, if the change affects that period only
(b) The period of the change and future periods, if the change affects both (IAS 8: para. 36)
Changes may occur in the circumstances which were in force at the time the estimate was
calculated, or perhaps additional information or subsequent developments have come to light.

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An example of a change in accounting estimate which affects only the current period is the
irrecoverable debt allowance. 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.
Reasonably enough, 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.

1.2.3 Key disclosures

The nature and amount of changes in accounting estimates that affect current and/or future
periods must be disclosed.
The materiality of the change is also relevant. The nature and the amount have a material effect,
and this should be disclosed.

1.3 Prior period errors

1.3.1 Definition

Prior period errors: Omissions from, and misstatements in, the entity’s financial statements for
KEY
TERM one or more prior periods arising from a failure to use, or misuse of, reliable information that:
(a) Was available when the financial statements for those periods were authorised for issue;
and
(b) Could reasonably be expected to have been obtained and taken into account in the
preparation and presentation of those financial statements.
(IAS 8: para. 5)

Errors may arise from:

(a) Mathematical mistakes
(b) Mistakes in applying accounting policies
(c) Oversights
(d) Misinterpretation of facts
(e) Fraud

1.3.2 Accounting treatment

An entity corrects material prior period errors retrospectively in the first set of financial statements
authorised for issue after their discovery by:
(a) Restating comparative amounts for each prior period presented in which the error occurred;
(b) (If the error occurred before the earliest prior period presented) Restating the opening
balances of assets, liabilities and equity for the earliest prior period presented; and
(c) Including any adjustment to opening equity as the second line of the statement of changes in
equity.
Where it is impracticable to determine the period-specific effects or the cumulative effect of the
error, the entity corrects the error from the earliest period/date practicable (and discloses that
fact).

1.3.3 Key disclosures

(a) The nature of the prior period error
(b) The amount of the correction for each prior period presented for each line item affected
(c) The amount of the correction at the beginning of the earliest prior period presented

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Activity 1: IAS 8
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors provides guidance as to
how to account for prior period errors.
Required
Which of the following options describe a prior period error?
 A material decrease in the valuation of the closing inventory resulting from a change in
legislation affecting the saleability of the company’s products.
 The discovery of a significant fraud in a foreign subsidiary resulting in a write-down in the
valuation of its assets. The perpetrators have confessed to the fraud which goes back at least
five years.
 The company has a material under provision for income tax arising from the use of incorrect
data by the tax advisers acting for the company.
 A deterioration in sales performance has led to the directors restating their methods for the
calculation of the general irrecoverable debt provision.

Solution

Essential reading
Chapter 17 Section 1 Reporting Financial Performance of the Essential reading covers additional
examples and activities on changes in accounting policies, estimates and errors. Do familiarise
yourself with them and practice the activities.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

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2 IFRS 5 Non-current Assets Held for Sale and

Discontinued Operations
The objective of IFRS 5 is to require entities to disclose information about discontinued operations
and measurement criteria for assets where a decision had been taken to sell them. This enhances
the ability of readers of financial statements to make projections about the future of the company
(profitability, cash flow, financial position, etc).

2.1 Definition

Disposal group: A group of assets to be disposed of, by sale or otherwise, together as a group
KEY
TERM in a single transaction, and liabilities directly associated with those assets that will be
transferred in the transaction. (In practice a disposal group could be a subsidiary, a cash-
generating unit or a single operation within an entity.)
Cash-generating unit: The smallest identifiable group of assets for which independent cash
flows can be identified and measured (IFRS 5: App A).
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.
Costs of disposal: The incremental costs directly attributable to the disposal of an asset (or
disposal group), excluding finance costs and income tax expense.
Recoverable amount: The higher of an asset’s fair value less costs of disposal and its value in
use.
Value in use: The present value of estimated future cash flows expected to arise from the
continuing use of an asset and from its disposal at the end of its useful life (IFRS 5: App A).

2.2 Classification as held for sale

Non-current assets are classified as held for sale if their carrying amount will be recovered
principally through a sales transaction rather than through continuing use.
To be classified as ‘held for sale’, the following criteria must be met:
(a) The asset must be available for immediate sale in its present condition, subject only to usual
and customary sales terms; and
(b) The sale must be highly probable.
For the sale to be highly probable, the following must apply:
(a) Management must be committed to a plan to sell the asset.
(b) There must be an active programme to locate a buyer.
(c) The asset must be marketed for sale at a price that is reasonable in relation to its current fair
value.
(d) The sale should be expected to take place within one year from the date of classification.
(e) It is unlikely that significant changes to the plan will be made or that the plan will be
withdrawn.
(IFRS 5: para. 8).

Exam focus point

Note that under IFRS 5, the carrying amount is compared to the fair value less costs of
disposal. However, the carrying amount of the asset is compared to the recoverable amount
(which is the higher of fair value less costs of disposal and value in use), under IAS 36.

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2.3 Accounting treatment

A non-current asset (or disposal group) that is held for sale should be measured at the lower of its
carrying amount and fair value less costs of disposal. (IFRS 5: para. 15)

FV (less disposal costs)

Higher than Lower than

Carrying amount Carrying amount

No change Impairment loss to be recognised

If the fair value of an asset less costs of disposal is lower than the carrying amount, an
impairment loss is recorded.
• Immediately before initial classification as held for sale, the asset is measured in accordance
with the applicable IFRS (eg property, plant and equipment held under the IAS 16 revaluation
model is revalued).
• On classification of the non-current asset as held for sale, it is written down to fair value less
costs to sell (if less than carrying amount). Any impairment loss arising under IFRS 5 is
charged to profit or loss.
• Non-current assets classified as held for sale are not depreciated/amortised.
• Disclosure:
- As a single amount separately from other assets;
- On the face of the statement of financial position; and
- Normally as current assets

Activity 2: Starlight Co
Starlight Co has an asset with a carrying amount of $150,000 at 1 January 20X3 held under the
cost model (cost $200,000) and being depreciated straight line over an eight-year life to a nil
residual value. At 1 July 20X3, Starlight Co classifies the asset as held for sale (and all necessary
criteria is met). At that date, it is estimated that the asset could be sold for $135,000 and that it
would cost $1,000 to secure the sale.
Required
What is the impairment loss to be charged to the profit or loss on 1 July 20X3?
 $2,500
 $3,500
 $7,000
 $9,000

Solution

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2.4 Discontinued operations

An entity should present and disclose information that enables users of the financial statements
to evaluate the financial effects of discontinued operations and disposals of non-current assets
or disposal groups. (IFRS 5: para. 30)

2.4.1 Definition

Discontinued operation: A component of an entity that either has been disposed of or is

KEY
TERM classified as held for sale and:
(a) Represents a separate major line of business or geographical area of operations; or
(b) Is part of a single co-ordinated plan to dispose of a separate major line of business or
geographical area of operations; or
(c) Is a subsidiary acquired exclusively with a view to resale.

IFRS 5 requires specific disclosures for components meeting the definition during the accounting
period. This allows users to distinguish between operations which will continue in the future and
those which will not, and makes it more possible to predict future results.

2.4.2 Key disclosures

The following disclosures apply:
Discontinued Operations
On the face of the statement of profit or loss and other comprehensive income:
Single amount comprising the total of:
• The post-tax profit or loss of discontinued operations; and
• The post-tax gain or loss recognised on the remeasurement to fair value less costs to sell or on
the disposal of assets comprising the discontinued operation.
On the face of the statement of profit or loss and other comprehensive income or in the notes:
• Revenue
• Expenses
• Profit before tax
• Income tax expense
• Post-tax gain or loss on disposal of assets or on remeasurement to fair value less costs to sell

Essential reading
Chapter 17 Section 3 of the Essential reading has examples of proforma disclosure for
discontinued operations.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

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Activity 3: Milligan Co
MILLIGAN CO STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE
YEAR ENDED 31 DECEMBER 20X1
20X1
$’000
Revenue 3,000
Cost of sales (1,000)
Gross profit 2,000
Distribution costs (400)
Administrative expenses (900)
Profit before tax 700
Income tax expense (210)
PROFIT FOR THE YEAR 490
Other comprehensive income for the year, net of tax 40
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 530

During the year, Milligan Co ran down a material business operation with all activities ceasing on
26 December 20X1. The results of the operation for 20X1 were as follows:
20X1
$’000
Revenue 320
Cost of sales (150)
Gross profit 170
Distribution costs (120)
Administrative expenses (100)
Loss before tax (50)
Income tax expense 15
LOSS FOR THE YEAR (35)
Other comprehensive income for the year, net of tax 5
TOTAL COMPREHENSIVE INCOME FOR THE YEAR (30)

Milligan Co recognised a loss of $30,000 on initial classification of the assets of the discontinued
operation as held for sale, followed by a subsequent gain of $120,000 on their disposal in 20X1.
These have been netted against administrative expenses. The income tax rate applicable to profits
on continuing operations and tax savings on the discontinued operation’s losses is 30%.
1 Required
Prepare the statement of profit or loss and other comprehensive income for the year ended 31
December 20X1 for Milligan Co complying with the provisions of IFRS 5.
MILLIGAN CO STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE
YEAR ENDED 31 DECEMBER 20X1
$’000
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Profit before tax
Income tax expense
Profit for the year from continuing operations

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$’000
Loss for the year from discontinued operations
PROFIT FOR THE YEAR
Other comprehensive income for the year, net of tax
TOTAL COMPREHENSIVE INCOME FOR THE YEAR

Note. Discontinued operations

During the year, Milligan Co ran down a material business operation with all activities ceasing on
26 December 20X1. The results of the operation were as follows:
20X1
$’000
Revenue
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Loss before tax
Income tax expense
Loss after tax
Post-tax gain on remeasurement and subsequent disposal of assets classified as held
for sale
LOSS FOR THE YEAR
Other comprehensive income for the year, net of tax
TOTAL COMPREHENSIVE INCOME FOR THE YEAR

Solution
1

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3 Foreign currency
3.1 Definition

Foreign currency: The currency of the primary economic environment in which the entity
KEY
TERM operates (IAS 21 The Effects of Changes in Foreign Interest Rates).

It is the currency in which the financial statement transactions are measured.

3.2 Determining an entity’s functional currency

An entity considers the following factors in determining its functional currency:
(a) The currency:
(i) Mainly influences sales prices for goods and services (often the currency in which sales
prices for its goods and services are denominated and settled); and
(ii) Of the country whose competitive forces and regulations mainly determine the sales
prices of its goods and services.
(b) The currency that mainly influences labour, material and other costs of providing goods or
services (will often be the currency in which such costs are denominated and settled).
The following factors may also provide evidence of an entity’s functional currency:
(a) The currency in which funds from financing activities are generated
(b) The currency in which receipts from operating activities are usually retained

3.3 Reporting foreign currency transactions in the functional currency

Where an entity undertakes a transaction which is not in its functional currency this is known as a
foreign currency transaction.
The foreign currency transaction must be converted into the entity’s functional currency before it
can be recognised in the financial statements.

3.4 Initial recognition

Translate each transaction by applying the spot exchange rate between the functional currency
and the foreign currency at the date of the transaction.
Note that an average rate for a period may be used as an approximation if exchange rates do not
fluctuate significantly.

3.5 At the end of the reporting period

Some values may need to be translated at the end of the reporting period depending on the
nature of the item in the financial statements:

Item Accounting treatment

Monetary assets and liabilities Restate at closing rate

Non-monetary assets measured at historical Do not restate – these items remain at

cost (eg non-current assets, inventories) historical rate

Non-monetary assets measured at fair value Restate at exchange rate when the fair value
was determined

3.6 Recognition of exchange differences

Exchange differences are recognised as part of profit or loss for the period in which they arise.
Any differences that relate to items charged to other comprehensive income (OCI), such as
revaluations, should also be charged to OCI.

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Activity 4: Foreign exchange

San Francisco Co, a company whose functional currency is the dollar, entered into the following
foreign currency transaction:
31.10.X8 Purchased goods from Mexico SA for 129,000 Mexican pesos
31.12.X8 Payables have not yet been paid
31.1.X9 San Francisco Co paid its payables
The exchange rates are as follows:
Pesos to $1
31.10.X8 9.5
31.12.X8 10.0
31.1.X9 9.7

Required
How would this transaction be recorded in the books of San Francisco Co as at 31 December
20X8?
Drag the options to complete the double entry.

DR

CR

Payables $679

Purchases $1,358

Profit or loss $12,900

Solution

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3.7 Presentation currency

An entity can present its financial statements in any currency (or currencies) it chooses.
Its presentation currency will normally be the same as its functional currency (the currency of the
country in which it operates).

PER alert
One of the competences you require to fulfil Performance Objective 8 of the PER is the ability
to evaluate the effect of chosen accounting policies on the reported performance and position
of the company. Also, to demonstrate the ability to evaluate any underlying estimates on the
position of the entity.
It can also be used to support your competency in Performance Objective 7 which requires the
ability to correct errors and to disclose them. This chapter deals with important disclosures
and you can apply the knowledge you obtain from this chapter to help to demonstrate this
competence.

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Chapter summary

Reporting financial performance

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors

Accounting policies Accounting estimates Prior period errors

• Accounting policies are the • Changes in accounting • Prior period errors are
specific principles, bases, estimates result from new omissions from, and
conventions, rules and information or new misstatements in, the entity's
practices applied by an entity developments and, financial statements for one or
in preparing and presenting accordingly, are not correction more prior periods arising from
the financial statements of errors a failure to use reliable
• Area of judgment • Examples: information that:
• Information relevant and – Allowances for doubtful (a) Was available when the
reliable debts financial statements for
– Inventory provisions those periods were
– Useful lives of non-current authorised for issue; and
Changes in accounting policies assets (b) Could reasonably be
• A change in accounting policy expected to have been
is made only if: obtained and taken into
(a) It is required by an IFRS; or Changes in accounting account in the preparation
(b) It results in the financial estimates and presentation of those
statements providing • Changes in SOFP (assets, financial statements
reliable and more relevant liabilities, equity) – adjust in • Examples
information the period of the change – Arithmetical errors
• Change applied • Changes in SOPL (income, – Mistakes in applying
retrospectively expense) – adjust in current accounting policies
– Restate comparatives (as if and future period if the change – Deliberate errors
new policy had always affects both
applied)
– Adjust opening balance for Correction of the error
each component of equity Disclosure • An entity corrects material
for the earlier period • Nature of the change prior period errors
presented; and • Quantify the change retrospectively in the first set of
– Show adjustment in SOCIE financial statements
as separate (second) line authorised for issue after their
discovery
– Restate comparative
Disclosure amounts for each prior
• Nature of the change period in which the error
• Reason for the change occurred
• Quantify the effect of the – Show adjustment in SOCIE
change as separate (second) line

Disclosure
• Nature of the change
• Quantify the effect of the
change

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IFRS 5 Non-current Assets Held for Sale IAS 21

and Discontinued Operations Foreign
currency

Aids the users of the statements Discontinued operations • Functional currency: currency
to under the future of the • A major line of of the primary economic
company's operations business/geographical region environment in which the entity
of business; or operates
• Part of a single co-ordinated • Translated at spot rate at date
Non-current assets held for sale plan to dispose of a major of transaction.
To be classified as 'held for sale': line/geographical region of • Restatement at year end
business; or (closing rate) if: Monetary
(a) The asset must be available
• Subsidiary acquired for resale assets and liabilities
for immediate sale in its
• Exchange differences
present condition, subject
recognised in SOPL
only to usual and customary
Disclosure • Differences arising on items in
sales terms; and
OCI are also charged to OCI
(b) The sale must be highly • On the face of the SOPL: single
(eg revaluations)
probable amount of post-tax profit or
loss of discontinued operations
and post-tax gain/loss on any
Accounting treatment FV adjustments
• Write down NCA to FV less • On the face of the statement of
costs to sell (if less than CA) profit or loss and other
• Impairment loss charged to comprehensive income or in
SOPL the notes:
• NCA classified as 'Held for sale' – Revenue
and not depreciated/amortised – Expenses
– Profit before tax
– Income tax expense
Disclosure – Post-tax gain or loss on
• As a single amount separately disposal of assets or on
from other assets remeasurement to fair value
• On the face of the SOFP less costs to sell
• Normally as current assets

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Knowledge diagnostic
1. Accounting Policies, Changes in Accounting Estimates and Errors
• An entity uses judgement in selecting accounting policies most relevant to its users, in
accordance with IFRSs.
• Changes in accounting policies can only be made where required by a standard or when they
provide relevant, more reliable information. They are accounted for retrospectively by
adjusting opening reserves.
• Changes in accounting estimates, such as a change in depreciation method, are accounted
for prospectively.
• Material prior period errors are corrected by restating the comparative figures or, if they
occurred in an earlier period, by adjusting opening reserves.

2. Non-current Assets Held for Sale and Discontinued Operations

• Non-current assets are classified as held for sale when available for immediate sale in their
current condition and the sale is highly probable. Such assets are written down to fair value
less costs to sell if lower than carrying amount, not depreciated and disclosed separately in
the statement of financial position.
• Discontinued operations are also disclosed separately. The minimum disclosure on the face of
the statement of profit or loss and other comprehensive income is the profit/loss on the
discontinued operations and any gains or losses on sale or remeasurement if classified as
held for sale.

3. Foreign currency transactions

• The functional currency is the currency of the primary economic environment. Any transaction
not in the functional currency is a foreign currency transaction.
• Transactions should be initially converted at the spot rate. Monetary balances should then be
translated at the end of the year. Non-monetary balances are not translated at the year-end.

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
8 Hewlett Co

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Activity answers

Activity 1: IAS 8
The correct answer is:
The discovery of a significant fraud in a foreign subsidiary resulting in a write-down in the
valuation of its assets. The perpetrators have confessed to the fraud which goes back at least five
years.
In general, errors which arose as a result of imperfectly available information will be treated as a
change in accounting estimates. Errors that arise as a result of carelessness or negligence will be
treated as correction of an error.

Activity 2: Starlight Co
The correct answer is:
$3,500
At 1 July 20X3, the carrying amount of the asset is $137,500 ($150,000 – $200,000/8 × 6/12). Its
fair value less costs to sell is $134,000.
Therefore, a loss of $3,500 is recognised in profit or loss.

Activity 3: Milligan Co
1 The correct answer is:
MILLIGAN CO STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE
YEAR ENDED 31 DECEMBER 20X1
20X1
$’000
Revenue (3,000 – 320)/(2,200 – 400) 2,680
Cost of sales (1,000 – 150)/(700 – 190) (850)
Gross profit 1,830
Distribution costs (400 – 120)/(300 – 130) (280)
Administrative expenses (900 – 100)/(800 – 90) (800)
Profit before tax 750
Income tax expense (210 + 15)/(120 + 3) (225)
Profit for the year from continuing operations 525
Loss for the year from discontinued operations (35)
PROFIT FOR THE YEAR 490
Other comprehensive income for the year, net of tax 40
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 530

Note. Discontinued operations

During the year, Milligan Co ran down a material business operation with all activities ceasing on
26 December 20X1. The results of the operation were as follows:
20X1
$’000
Revenue 320
Cost of sales (150)
Gross profit 170
Distribution costs (120)
Administrative expenses (100 + 90) (190)
Loss before tax (140)
Income tax expense (15 + (90 × 30%)) 42
Loss after tax (98)

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20X1
$’000
Post-tax gain on remeasurement and subsequent disposal of assets classified
as held for sale (90 × 70%) 63
LOSS FOR THE YEAR (35)
Other comprehensive income for the year, net of tax 5
TOTAL COMPREHENSIVE INCOME FOR THE YEAR (30)

Activity 4: Foreign exchange

The correct answer is:

DR Payables $679

CR Profit or loss $679

$ $
31.10.X8 Purchases (129,000 × 9.50) 13,579
Payables 13,579

31.12.X8 Payables (Working) 679

Profit or loss – exchange gains 679

31.1.X9 Payables 12,900

Profit or loss – exchange losses 399
Cash (129,000 × 9.7) 13,299

Working
$
Payables as at 31.12.X8 (129,000 × 10) 12,900
Payables as previously recorded 13,579
Exchange gain 679

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Skills checkpoint 5
Interpretation skills

Chapter overview
cess skills
Exam suc

r planning
Answe

c FR skills C
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Approach to Application
reta
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objective test of accounting

(OT) questions standards
Man

tion l y si s

Spreadsheet Interpretation
Go od

skills skills
ana
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Approach
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OTQs
an

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a nd p r
esentation

Introduction
Section C of the Financial Reporting (FR) exam will contain two questions. One of these will
require you to interpret a set of financial statements, or extracts from a set of financial
statements. The interpretation is likely to contain computational elements in the form of ratios, but
your focus should be on the interpretation of those ratios to explain the performance and position
of the single entity or group you are presented with.
Given that the interpretation of financial statements will feature in Section C of every exam, it is
essential that you master the appropriate technique for analysing and interpreting information
and drawing relevant conclusions in order to maximise your chance of passing the FR exam.

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Skills Checkpoint 5: Interpreting financial statements

FR Skill: Interpretation skills
Interpreting financial statements is likely to begin with a requirement to calculate financial ratios.
You will then be asked to comment on the results in the light of the scenario. The FR exam will
expect you to go beyond calculations and require you to explain your findings offering reasons
for the movements and the results of any financial calculations with reference to the information
in the scenario. Interpreting financial statements may include, for example:
• Ratio analysis where the focus is on selecting appropriate ratios, calculating them and
commenting on reasons for the movements or the results of the ratios
• Trend analysis, where you consider the movement of financial statement figures over time
• Consideration of the impact of any changes in accounting policies or changes in estimates on
the financial statements and how they may affect those ratios

STEP 1: Read and analyse the requirement.

Read the requirement carefully to see what calculations are required and how many
marks are set for the calculation and how many for the commentary.
Work out how many minutes you have to answer each sub-requirement.

STEP 2: Read and analyse the scenario.

Identify the type of company you are dealing with and how the financial topics in
the requirement relate to that type of company. As you go through the scenario,
you should be highlighting key information which you think will play a key role in
answering the specific requirements.

STEP 3: Plan your answer.

Ensure your answer is balanced in terms of identifying the potential benefits and
limitations of topics that are being discussed or recommended.

STEP 4: Write your answer.

As you write your answer, try wherever possible to apply your analysis to the
scenario, instead of simply writing about the financial topic in generic, technical
terms.
As you write your answer, explain what you mean – in one (or two) sentence(s) –
and then explain why this matters in the given scenario. This should result in a
series of short paragraphs that address the specific context of the scenario. 

Exam success skills

In the analysis of the Bengal Co question, we will focus on the following exam success skills and in
particular:
• Good time management. The exam will be time pressured and you will need to manage it
carefully to ensure that you can make a good attempt at every part of every question. You will
have 3 hours in the exam, which works out at 1.8 minutes per mark, or 36 minutes for a 20-
mark question.
• Managing information. There is a lot of information to absorb in this question and the best
approach is active reading. Firstly, you should identify any specific ratios required. The
majority of marks will be for the interpretation of the ratios and it is important that you
understand how the information in the scenario helps to explain the ratios calculated.

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• Correct interpretation of the requirements. There are two parts to the Bengal question and the
first part has two sub-requirements (the calculation of ratios and their interpretation). Make
sure you analyse the requirement carefully so you understand how to approach your answer.
• Answer planning. Everyone will have a preferred style for an answer plan. For example, it may
be a mind map, bullet-pointed lists or simply annotating the question paper. Choose the
approach that you feel most comfortable with or, if you are not sure, try out different
approaches for different questions until you have found your preferred style. You will typically
be awarded 1 mark per relevant, well explained point so you should aim to generate sufficient
points to score a comfortable pass.
• Efficient numerical analysis. The most effective way to approach this part of the question is to
calculate your ratios and put them in a separate appendix, so all your numbers are in one
place. Make sure you show your workings, so that if you make a mistake, the Examining team
can award marks for method or following the number through in your explanation.
• Effective writing and presentation. Use headings and sub-headings in your answer and write
in full sentences, ensuring your style is professional. Ensuring that all sub-requirements are
answered and that all issues in the scenario are addressed will help you obtain maximum
marks.

Skill Activity
STEP 1 Read the requirement carefully to see what calculations are required and how many marks are set for the
calculation and how many for the commentary.
Work out how many minutes you have available to answer each sub requirement.

Required
(a) Comment on the performance (including addressing the shareholder’s observation) and
financial position of Bengal Co for the year ended 31 March 20X1. Up to five marks are
available for the calculation of appropriate ratios. (15 marks)
(b) Explain the limitations of ratio analysis. (5 marks)
(Total = 20 marks)
There are two parts to this question. The first part is asking for you to analyse the performance of
Bengal Co, together with the calculation of appropriate ratios.
When you read the scenario, consider which ratios would be appropriate. As only five marks are
available for the calculation of the ratios, you should not spend any longer than nine minutes on
this element of the question.
This will leave the remaining ten marks from Part (a) requiring interpretation of the ratios which
you have calculated and any remaining conclusions that you reached from reading the scenario.
This is demonstrating your application and interpretation skills.
Part B of the question is worth five marks and should be based upon your knowledge of ratio
analysis, tying your answer, where possible, to the scenario. Again, be strict on your timekeeping
here as you should only spend nine minutes on this part.
The question is worth 20 marks, so you should spend no longer than 36 minutes on this question.
STEP 2 Read and analyse the scenario.
Identify the type of company you are dealing with and how the financial topics in the requirement relate to
that type of company. As you go through the scenario you should be highlighting key information which
you think will play a key role in answering the specific requirements.

Chapter 19 of this Workbook gives the six different types

of scenario that you may come across in the exam.
Briefly, these are:

(a) Comparison of one entity over two periods

(b) Comparison of two entities over one period

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(c) Comparison of an entity with sector averages

(d) Analysis of consolidated financial statements

(acquisition of a subsidiary)

(e) Analysis of consolidated financial statements

(disposal of a subsidiary)

(f) Analysis of cash flow information

Ensure you are familiar with these different types of

question and think about them when reading the
requirement in the exam.

The question, Bengal Co, is adapted from a previous

exam question. Read through the scenario carefully,
highlighting any areas which may suggest a problem or
a benefit. This is a question worth 20 marks, so you
have 36 minutes to attempt it.

This is a comparison of one entity over two periods type

of question.

Bengal Co is a public company. Its most recent financial

statements are shown below:

STATEMENTS OF PROFIT OR LOSS FOR THE YEAR

ENDED 31 MARCH
20X1 20X0
$’000 $’000
Revenue (Note 1) 25,500 17,250
Cost of sales (14,800) (10,350)
Gross profit (Note 2) 10,700 6,900
Distribution costs (2,700) (1,850)
Administrative expenses (2,100) (1,450)
Finance costs (Note 3) (650) (100)
Profit before taxation 5,250 3,500
Income tax expense (Note 4) (2,250) (1,000)
Profit for the year 3,000 2,500

Notes

1. Increase in revenue 48%.

2. Increase in gross profit is 55%, compared to revenue,

this is suggesting efficiency during production.

3. Rise in finance costs (there is a significant rise in loans

on the SOFP too). Consider interest cover and reasons
why the loan may have been obtained.

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4. Income tax increased by 125% in 20X1. Profit before

tax increased by 50%. What could be the cause?

STATEMENTS OF FINANCIAL POSITION AS AT 31 MARCH

20X1 20X0
$’000 $’000 $’000 $’000
Non-current assets
Property, plant and equipment 9,500 5,400
Intangible assets (Note 1) 6,200 -
15,700 5,400
Current assets
Inventories (Note 2) 3,600 1,800
Trade receivables 2,400 1,400
Cash and cash equivalents - 4,000
Non-current assets held for sale 2,000 8,000 - 7,200
Total assets 23,700 12,600
Equity and liabilities
Equity
Equity shares of $1 each 5,000 5,000
Retained earnings (Note 3) 4,500 2,250
9,500 7,250
Non-current liabilities
5% loan notes 2,000 2,000
8% loan notes (Note 4) 7,000 -
Current liabilities
Bank overdraft (Note 5) 200 -
Trade payables 2,800 2,150
Current tax payable 2,200 5,200 1,200 3,350
Total equity and liabilities 23,700 12,600

Notes

1. What are the intangible assets? Why the significant

rise year on year? Consider potential problems here
such as incorrect capitalisation of R&D costs.

2. Increase in inventories and trade receivables,

suggesting possible liquidity issues. Compare increase
in receivables with increase in revenue.

3. Increase in shares, has this been from a bonus issue

(no cash flow) or rights issue (cash flow)? Increase in
shares used to fund capital growth.

4. Increase in loans, again suggesting cash for capital

growth.

5. Bank overdraft, possible liquidity issues?

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Additional information:

(a) Bengal Co acquired the assets of another business

during the year. It has identified that some of the
assets are surplus to requirements and have been
classified as ‘held for sale’18 at 31 March 20X1. It 18
IFRS 5, Non-Current Assets Held for
Sale and Discontinued Operations
expects that it will take some time for the remaining
assets to be fully integrated into its current
business. There were no disposals of assets.

(b) Depreciation of property, plant and equipment for

the year ended 31 March 20X1 was $640,000.

A disappointed shareholder has observed that although

revenue during the year has increased by 48% (8,250 /
17,250 × 100), profit for the year has only increased by
20% (500 / 2,500 × 100).

Required

(a) Comment on the performance (including

addressing the shareholder’s observation) and
financial position of Bengal Co for the year ended
31 March 20X1. Up to five marks are available for
the calculation of appropriate ratios. (15 marks)19 19
Ensure you stick to your time here: 27
minutes (with 9 marks for the ratio
(b) Explain the limitations of ratio analysis. (5 marks)20 calculation only)
(Total = 20 marks) 20
Ensure you spend no more than 9
STEP 3 Plan your answer minutes on this part.
Ensure your answer is balanced in terms of identifying the potential
benefits and limitations of topics that are being discussed or
recommended.
You only have 36 minutes to answer this 20-mark question, however, taking a couple of minutes to
plan your answer will ensure you have a structure.
Consider the main elements of the scenario in the light of the requirements which you must
complete. Here a plan has been sketched using a mind map (or spidergram). Ideas can be pulled
from the structure of the requirement which are added to by comments from the review of the
scenario.

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Performance = SOPL
• Revenue increase/profit for
year increase Calculation of
• Finance cost increase suitable ratios
• Income tax charge increase 5 marks = 9 minutes

Financial position = SOFP Comment on the performance (including Compare revenue

addressing the shareholder's observation) and profit
• Increase in debt and equity,
result in increase in and financial position of Bengal Co for the • Revenue increase
non-current assets year ended 31 March 20X1. Up to five year on year
• Working capital position marks are available for the calculation of • Compare profit
(working capital cycle) appropriate ratios. (15 marks) year on year
• Put ratios in
appendix

Gearing & liquidity ratios Shareholders asking the question –

shareholders interest?
• Increase in loan – interest
cover ratio? • ROCE ratio?
• Gearing ratio? • Dividends?

Explain the limitations of ratio analysis. (5 marks)

• Difference in calculation
• Comparison between companies – different accounting policies
• Valuation of assets – different policies
• Seasonality of trading

Required
(a) The requirement for Part (a) has been looked at in great detail, and following the review of the
scenario, already some ideas about potential issues have been noted (liquidity, gearing,
increase in non-production and selling costs, such as finance and income tax).
(b) The requirement for Part (b) is simpler but again, already some notes have been made to get
at least four out of five marks here:

Explain the limitations of ratio analysis. (5 marks)

Difference in calculation

Comparison between companies – different accounting policies

Valuation of assets – different policies

Seasonality of trading

Besides the plan which generates ideas, you will need to ensure that you have a brief introduction
(because it is the shareholder who needs the question answering) and a conclusion to summarise
your findings.
STEP 4 Write your answer
As you write your answer, try wherever possible to apply your analysis to the scenario, instead of simply
writing about the financial topic in generic, technical terms. As you write your answer, explain what you
mean – in one (or two) sentence(s) – and then explain why this matters in the given scenario. This should
result in a series of short paragraphs that address the specific context of the scenario.

One recurring complaint which the Examining team

make during their exam reports is that the students do
not refer their interpretation answers back to the
scenario. As a result of this, the answers are often

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generic and can lack focus on the main points to be

answered in the question.

Make your point and then give a suitable and plausible

reason (taking your inspiration from the scenario) that
may explain the increase or decrease.

It is worth putting your ratios and calculations in a

separate appendix at the end of your answer. This will
keep the layout less chaotic and allow the narrative to
look clearer and neater without workings in the middle
of the text.

Let’s have a look at the sample answer given for this

question:

Required

(a) Overview

(Give your parts of the answer subheadings and titles to

show you have structure to your answer.)

It is correct that revenue has increased by 48% while

profit for the year has only increased by 20%.

However, on closer inspection, we can see that this is to

a large degree attributable to the tax charge for the
year. The tax charge was 28.6% of the profit before tax
in the year ended 31.3.20X0 and 42.8% of the profit
before tax in the year ended 31.3.20X1.

We do not have a breakdown21 of the tax charge but it 21

State any limitations in your analysis,
but highlight the problems this can give.
could include underpayments in previous years, which
distorts the trading results.

Performance

A better comparison between the two years is the profit

before tax % and the gross profit %. Both of these are
higher in 20X1 than in 20X0.

The shareholders will also be interested in the ROCE.

There has been a significant increase in capital
employed during the year ended 31.3. 20X1.

Bengal Co has acquired nearly $13 million in tangible

and intangible assets, financed from cash reserves and
a new issue of 8% loan notes.

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An additional $2 million22 of non-current assets have 22

State figures to show you are referring
to the scenario.
been reclassified as held for sale. This is consistent with
the fact that Bengal Co has taken over the assets of
another business and is disposing of the surplus assets.
Bengal Co23 has identified that it may take some time 23
Referencing the scenario to make the
answer relevant to the question.
for the assets to be fully integrated into its current
business, hence it may take time to show a return and
the ROCE does show a significant drop in 20X1.

However, if we disregard the loan capital and look at the

ROE we can see a considerable increase in 20X1.

Position/Gearing

The increase in loan capital24 does have significance for 24

Don’t just state that there is an
increase in loan capital, explain how it
shareholders. The interest charge has increased from affects their returns (or company profits,
such as increase in finance costs).
$100,000 to $650,000, which reduces the amount
available for dividend.

Gearing has increased significantly. The rate that

Bengal Co has to offer to loan note holders has already
increased from 5% to 8%. If it required further
borrowing, with this high gearing, it would have to pay
substantially more.

Shares in Bengal Co have become a riskier investment.

One indicator of this is the interest cover, which has
fallen from 36 times to 9 times.

The acquisition could presumably have been financed

from a share issue or share exchange, rather than loan
capital. However, this would have diluted the return
available to shareholders.

Liquidity

The area in which there is most cause for concern is

liquidity.

As we can see from the statement of financial position,

cash and cash equivalents have fallen by $4.2 million
and the company is now running an overdraft.

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It has tax to pay of $2.2 million and this will incur

penalties if it is not paid on time.

The current ratio25 has declined from 2.1:1 to 1.5:1 and 25

When quoting ratios, give plausible,
reasonable explanations for reasons why
this is including the non-current assets held for sale as the change may have occurred.
part of non-current assets.

The quick ratio, excluding inventory and non-current

assets held for sale, indicates the immediate cash
situation and this shows a fall from 1.6:1 to 0.46:1.

Bengal Co needs to remedy this by disposing of the

non-current assets held for sale as soon as possible and
selling off surplus inventory, which may have been
acquired as part of the acquisition.

Conclusion

(Ensure you have a conclusion to your analysis.)

Overall, the shareholder should be reassured that

Bengal Co is profitable and expanding. The company
has perhaps overstretched itself and significantly raised
its gearing, but it is to be hoped that the investment will
bring in future returns.

This is no doubt the picture the company wants to give

to shareholders, which is why it has paid a dividend in
spite of having very little cash with which to do so.

(b) While ratio analysis is a useful tool, it has a number

of limitations, particularly when comparing ratios
for different companies.

Some ratios can be calculated in different ways. For

instance, gearing can be expressed using debt as a
proportion of debt and equity or simply debt as a
proportion of equity. Ratios can be distorted by
inflation, especially where non-current assets are
carried at original cost.

Ratios are based upon financial statements which may

not be comparable due to the adoption of different
accounting policies and different estimation techniques.
For instance, whether non-current assets are carried at
original cost or current value will affect ROCE, as will
the use of different depreciation rates. In addition,

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financial statements are often prepared with the key

ratios in mind, so may have been subject to creative
accounting. The year-end values also may not be
representative of values during the year, due to
seasonal trading.

Appendix: Ratios26 26
Ratios are kept in a separate appendix.

20X1 20X0
Net profit % (note) (3,000/25,500) / (2,500/17,250) 11.8% 14.5%
Net profit % (pre-tax) (5,250/25,500) / (3,500/17,250) 20.6% 20.3%
Gross profit % (10,700/25,500) / (6,900/17,250) 42% 40%
ROCE (5,900/18,500) / (3,600/9,250) 31.9% 38.9%
ROE (3,000/9,500) / (2,500/7,250) 31.6% 34.5%
Gearing (9,000/9,500) / (2,000/7,250) 94.7% 27.6%
Interest cover (5,900/650) / (3,600/100) 9 times 36 times
Current ratio (8,000/5,200) / (7,200/3,350) 1.5:1 2.1:1
Quick ratio (2,400/5,200) / (5,400/3,350) 0.5:1 1.6:1

Note. There are 9 ratios calculated here. You would only need 5 of these at most, as only 5 marks
are available. It is important to ensure that they are relevant to the scenario and the requirement.

Exam success skills diagnostic

Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been completed
below for the Bengal Co activity to give you an idea of how to complete the diagnostic.

Exam success skills Your reflections/observations

Good time management Did you spend time reading and planning?
Ensure you allocate your writing time on Part (a)spending
around nine minutes on the calculation of ratios, with 18
minutes discussing them and five minutes on Part (b)?

Managing information Ensure you highlight or underline useful information and make
notes in the margins where appropriate.
Think about the impact of each issue or ratio on the
performance or position of the company.
Ensure you answer the query posed by the shareholder.

Answer planning Check that your plan covered all parts of the question.
Make sure you generate enough points to score a pass.

Correct interpretation of the Ensure you analyse the requirements and address all aspects
requirements in your answer.

Efficient numerical analysis Use separate workings for your ratios and used an appendix or
separate area to show the ratio and the workings.

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Exam success skills Your reflections/observations

Effective writing and Use underlined headings and sub-headings.
presentation Write in full sentences and use professional language.
Answer all the requirements.
Structure your answer with the assistance of a draft plan.

Most important action points to apply to your next question – Remember that you are asked
to interpret the ratios using the information in the scenario, not to explain what the ratio
means in generic terms.

Summary
For a question requiring you to explain the impact on a specified ratio, the key to success is to
think of the formula of the ratio. Then you need to think about the double entry and the impact it
has on the numerator and/or denominator and therefore the overall ratio.
However, this is a very broad syllabus area that could generate many different types of questions
so the approach in this Skills Checkpoint will have to be adapted to suit the specific requirements
and scenario in the exam. The basic five steps for answering any FR question will always be a
good starting point:
(1) Time (1.8 minutes per mark)
(2) Read and analyse the requirement(s)
(3) Read and analyse the scenario
(4) Prepare an answer plan
(5) Write up your answer

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Earnings per share

18
18

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Earnings per share (eps) B9(e)

• Calculate the eps in accordance with relevant accounting
standards (dealing with bonus issues, full market value
issues and rights issues).
• Explain the relevance of the diluted eps and calculate the
diluted eps involving convertible debt and share options
(warrants).

• Explain why the trend of eps may be a more accurate C3(f)

indicator of performance than a company’s profit trend and
the importance of eps as a stock market indicator.
• Discuss the limitations of using eps as a performance
measure.
18

Exam context
Earnings per share (eps) is a commonly reported performance measure. It is widely used by
investors as a measure of a company’s performance and is of particular importance for
comparing the results of an entity over time and for comparing the performance of one entity
against another. It also allows investors to compare against the returns obtainable from loan stock
and other forms of investment. It is important in the Financial Reporting (FR) exam that you can
calculate basic and diluted eps, and that you can interpret why changes or differences in eps
may have occurred.
18

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Chapter overview
Earnings per share

Basic eps

Objective Calculation

Definitions Weighted average number of shares outstanding

Presentation

Diluted eps Eps as a performance measure

Issue Importance of the eps measure

Calculation of diluted eps =

Limitations of eps

Convertible debt

Share options and warrants

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1 Basic earnings per share (eps)

1.1 Objective
The objective of IAS 33 Earnings per Share is to provide a basis for the comparison of the
performance of different entities in the same period and of the same entity in different accounting
periods. The standard prescribes methods for determining the number of shares to be included in
the calculation of earnings per share and other amounts per share and specifies their
presentation. Disclosure of eps is only required for entities with shares which are publicly traded.

Ordinary shares: ‘An equity instrument that is subordinate to all other classes of equity
KEY
TERM instruments’. (IAS 33: para. 5)
Potential ordinary share: ‘A financial instrument or other contract that may entitle its holder to
ordinary shares’. (IAS 33: para. 5)
Options, warrants and their equivalents: ‘Financial instruments that give the holder the right
to purchase ordinary shares’. (IAS 33: para. 5)
Financial instrument: ‘Any contract that gives rise to both a financial asset of one entity and a
financial liability or equity instrument of another entity’. (IAS 32: para. 11)
Equity instrument: ‘Any contract that evidences a residual interest in the assets of an entity
after deducting all of its liabilities’. (IAS 32: para. 11)
Dilution: ‘A reduction in earnings per share or an increase in loss per share resulting from the
assumption that convertible instruments are converted, that options or warrants are exercised,
or that ordinary shares are issued upon the satisfaction of specified conditions’. (IAS 33: para.
5)

1.2 Presentation
Both basic and diluted eps are shown on the face of the statement of profit or loss and other
comprehensive income with equal prominence whether the result is positive or negative for each
class of ordinary shares and period presented.

1.3 Calculation
The basic eps calculation is:
Earnings
eps = Weighted average no. of equity shares utstanding during the period cents

1.3.1 Earnings
Earnings is profit or loss for the period attributable to ordinary equity holders of the parent,
which is the consolidated profit after deducting:
• Income taxes
• Non-controlling interests
• Preference dividends (on preference shares classified as equity)*
*As you may recall from Chapter 11, redeemable preference shares are treated as financial
liabilities and their dividends as a finance cost, which will already have been deducted in arriving
at the consolidated profit. (IAS 33: paras. 12–14)

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Activity 1: Calculation of earnings

An extract from Apricot’s consolidated statement of profit or loss for the year ended 31 December
20X9 is as follows:
$’000
Profit for the year attributable to:
Owners of the parent 7,000
Non-controlling interests 1,000
8,000

On 1 January 20X9, Apricot issued 500,000 $1 6% irredeemable preference shares. Apricot also
had in issue for the full year 900,000 $1 5% redeemable preference shares. All preference
dividends were paid in full on 31 December 20X9.
Required
Calculate the earnings figure that should be used in the basic eps calculation for the year ended
31 December 20X9.
 $6,925,000
 $6,955,000
 $6,970,000
 $7,000,000

Solution

1.4 Weighted average number of equity shares outstanding during the

period
Where there are share issues in the year, a calculation is required to determine the weighted
average number of shares outstanding in the period. The nature of the calculation depends on the
way in which the new shares were issued.

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1.4.1 Changes in the number of equity shares

Share issues

Issue at full market price Bonus issue Rights issue

Increase in earnings No effect on earnings Some effect on earnings

therefore use weighted therefore apply effect therefore treat as issue at
average number of shares retrospectively including full market price followed
(no retrospective effect) restatement of comparatives by bonus issue

1.4.2 Issue at full market price

Where an issue of shares is made at full market price, the company ought to generate additional
profits, as it has extra funds to generate profits from. However, if the issue was not at the
beginning of the year, this will need to be time apportioned to reflect the fact that the company
will have only been able to generate extra profits from the extra funds for part of the year.

Illustration 1: Time apportionment

Murray has a year end of 31 December 20X2. On 1 October 20X2, it issued 300,000 shares at full
market price. The share capital before the share issue was 600,000 shares.
Required
Calculate the weighted average number of shares that should be used in the basic earnings per
share calculation for the year ended 31 December 20X2.

Solution
The correct answer is:
Weighted number of shares:
Date Narrative No. shares Time period Weighted average
1.1.X2 b/d 600,000 × 9/12 450,000
1.10.X2 Issue at full market 300,000
price
900,000 × 3/12 225,000
675,000

(IAS 33: para. 20, Illustrative Example 2)

1.4.3 Bonus issue

Bonus issues (sometimes known as scrip issues) involve ordinary shares being issued to existing
shareholders for no additional consideration. The number of ordinary shares has increased
without an increase in resources. (IAS 33: para. 27)
The company cannot therefore be expected to generate the same eps, which causes problems
with comparability between periods. This problem is solved by adjusting the number of ordinary
shares outstanding before the event for the proportionate change in the number of shares
outstanding as if the event had occurred at the beginning of the earliest period reported. (IAS 33:
para. 28)
A bonus fraction is calculated to make this adjustment. The numerator in the bonus fraction is the
new number of shares after the bonus issue has taken place. The denominator is the number of
shares before the bonus issue.

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Example – Bonus issues

Fabio undertook a 1:1 bonus issue on 1 January 20X2. The numerator in the bonus fraction is
therefore 2 (the 1 original share, plus the 1 from bonus issue). The denominator is the original 1
share. The bonus fraction is therefore:
20X2 20X1
Assets (eg cash) $100,000 $100,000
Earnings $20,000 $20,000
Shares 200,000 100,000
eps 10c 20c

To make eps comparable, we need to restate the 20X1 figure as if it had the same share capital as
20X2, ie $20,000 / 100,000 × 2/1.
This is algebraically the same as restating the previous eps by the reciprocal of the bonus
fraction, ie 20c × 1/2 = 10c.

Activity 2: Bonus issue

Greymatter Co has a year end of 31 December 20X2. It had 400,000 shares in issue until
30 September 20X2 when it made a bonus issue of 100,000 shares. Its earnings for 20X2 were
$80,000 and its eps 20X1 was $0.1875.
Required
Calculate the eps for 20X2 and the restated figure for 20X1.

Solution

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1.4.4 Rights issue

A rights issue involves the issue of ordinary shares to existing shareholders at a discount to their
market price. The rights issue therefore includes both an issue of some shares at full market price
and a bonus element which must be adjusted for. (IAS 33: para. 27(b))

Rights issue (at below

current market price)

Some full market price Some bonus

shares issue shares

Include for the number of Treat as though they had

months they were in issue always been in issue for
(weighted average) all of current year and
prior year (restate
number of shares using
the bonus faction)

A bonus fraction which must be applied in respect of the bonus shares is calculated as:
Fair value per share immediately before exercise of rights
Theoretical ex rights price (TERP)

It is applied to all periods (eg months) prior to the issue.

Theoretical ex-rights price (TERP) is calculated as:
Fair value of all outstanding shares + total received from exercise of rights
No. shares outstanding prior to exercise + no. shares issued in exercise

Illustration 2: Theoretical ex rights price

Assume a rights issue on a 1 for 4 basis.
Share price immediately before exercise of rights is $10.
Rights price is $6.50.
Required
Calculate the bonus fraction.

Solution
The correct answer is:
$
4 @ 10 = 40.00
1 @ 6.50 6.50
5 46.50

TERP = $46.50 /5 = $9.30

Bonus fraction = 10 / 9.3
To restate comparatives, use reciprocal 9.3 / 10

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Essential reading
Chapter 18, Section 2 of the Essential reading provides the procedure that you should apply when
a rights issue has been made in the year. It also includes an activity which gives another
opportunity to practise the rights issue calculations.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

Activity 3: Basic eps

On 1 January 20X1, Saunders Co had 2,000,000 ordinary shares in issue.
On 30 April 20X1, Saunders Co issued, at full market price, 270,000 ordinary shares.
On 31 July 20X1, a rights issue of 1 for 10 @ $2.00 was made. The fair value of the shares on the
last day before the issue of shares from the rights issue was $3.10.
Finally, on 30 September 20X1, Saunders Co made a 1 for 20 bonus issue.
Profit for the year was $400,000.
The reported eps for the year ended 31 December 20X0 was 18.6c.
1 Required
What is the weighted average number of shares for 31 December 20X1?
 2,455,921
 2,266,388
 2,431,508
 2,346,509
2 Required
What is the earnings per share for the year ended 31 December 20X1?
 17.6c
 17.0c
 16.5c
 16.3c
3 Required
What is the restated earnings per share for the year ended 31 December 20X0?
 20.2c
 18.3c
 17.1c
 18.9c

Solution
1

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2 Diluted eps
2.1 The issue
Basic eps is calculated by comparing earnings with the number of shares currently in issue. If an
entity has a commitment to issue shares in the future, for example on the exercise of options or
the conversion of loan stock, this may result in a change to the basic eps. IAS 33 refers to such
commitments as ‘potential ordinary shares’, defined as ‘a financial instrument or other contract
that may entitle its holder to ordinary shares’ (IAS 33: para. 5).
Diluted eps shows how basic eps would change if potential ordinary shares (such as convertible
debt) become ordinary shares. It is therefore a ‘warning’ measure of what may happen in the
future for current ordinary shareholders.
When the potential shares are actually issued, the impact on basic eps will be twofold:

Impact on basic eps

The number of shares will increase There may be a change in earnings

eg lower interest charges

2.2 Calculation of diluted eps

To calculate diluted eps, we assume that all of the potential ordinary shares were converted into
ordinary shares at the beginning of the period (or the actual date of issue, if later), and at the
most advantageous rate for the holder of the potential ordinary shares (ie the rate that gives the
maximum dilution). (IAS 33: para. 36)

2.3 Convertible debt

Convertible debt gives rise to potential ordinary shares as the debt instruments may be converted
to equity at some point in the future.

2.3.1 Earnings
Earnings is adjusted for the interest or preference dividends which would be ‘saved‘ if conversion
into ordinary shares took place. Interest on convertible debt attracts tax relief. This tax relief will
be lost on conversion of the debt into ordinary shares, therefore, the net increase in earnings
(which is an after-tax figure) is the interest less the tax relief.
Earnings $
Basic earnings X
Add back saving on interest on debt, net of income tax ‘saved’ X
X

2.3.2 Number of shares

The number of ordinary shares is the weighted average number of ordinary shares calculated for
basic eps, plus the maximum number of ordinary shares that would be issued on conversion into
ordinary shares.
No. of shares Number
Basic weighted average X
Add additional shares on conversion (using terms giving maximum dilution X
available after the year-end)
Diluted number X

(IAS 33: paras. 33, 36 & 39)

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Activity 4: Diluted eps – convertible debt

Acorn Co had the same 10 million ordinary shares in issue on both 1 April 20X1 and 31 March
20X2. On 1 April 20X1, the company issued 1.2 million $1 units of 5% convertible loan stock. Each
unit of loan stock is convertible into four ordinary shares on 1 April 20X9 at the option of the
holder. The following is an extract from Acorn Co’s statement of profit or loss and other
comprehensive income for the year ended 31 March 20X2:
$’000
Profit before interest and tax 980
Finance cost on 5% convertible loan stock (60)
Profit before tax 920
Income tax at 30% (276)
Profit for the year 644

Required
What is the diluted earnings per share for the year ended 31 March 20X2?
 4.76c
 4.64c
 4.35c
 6.86c

Solution

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2.4 Share options or warrants

Options and warrants are potential ordinary shares as the holders may convert the option or
warrant to shares at some point in the future, provided the exercise price is less than the market
value of the shares. In order to calculate diluted eps, the number of potential ordinary shares is
split into two parts (IAS 33: paras. 45 & 46):

Potential ordinary shares

(options or warrants)

Shares that would have been issued Shares that are treated as having
+
if the cash received on exercise of been issued for no consideration
the option / warrant had been used to
buy shares at average market price
for the period

Ignore as they have Add to the number of shares in

no dilutive effect issue to calculate diluted eps

2.4.1 Calculation
No of shares under option X
No that would have been issued at average market price (AMP) [(no of options × exercise (X)
price)/AMP]
 No of shares treated as issued for nil consideration X

It is only the shares deemed to have been issued for no consideration which are added to the
number of shares in issue when calculating diluted eps (shares issued at full market price have no
dilutive effect). There is no impact on earnings.

Activity 5: Diluted eps – options

Galaxy Co has a profit for the year of $3 million for the year. 1.4 million ordinary shares were in
issue during the year.
Galaxy Co also had 250,000 options outstanding for the whole year with an exercise price of
$15. The AMP of one ordinary share during the period was $20.
Required
What is the diluted eps?
 $2.05
 $1.89
 $2.14
 $1.88

Solution

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Essential reading
Chapter 18, Section 3 of the Essential reading contains a further activity which will allow you to
practise calculating diluted eps.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

3 Eps as a performance indicator

3.1 Importance of the eps measure
• Eps may be a better indication than profit of the financial performance of an entity as it
considers changes in capital during the period, ie new capital can only generate a return from
the date it is paid into the company.
• Eps is considered a key stock market indicator and is quoted in the financial press.
• Eps is important because of its role in the price/earnings (p/e) ratio. This is probably the most
important ratio for analysis work due to the ability to compare different companies and its use
as a ‘value for money’ measure.

3.2 Limitations of eps

• Eps is based on historical, not prospective, data, and so is an indication of past rather than
future performance.
• The diluted eps figure is a theoretical calculation. Markets do not necessarily react in the same
way.
• The official eps definition includes one-off income/expense which distorts the eps figure.
Additional eps measures are permitted, however they must be disclosed in the notes to the
financial statements, not on the face of the statement of profit or loss and other
comprehensive income.

Essential reading
Chapter 18, Section 4 of the Essential reading provides further information relating to the
disclosure of eps and Section 5 on alternative ways of presenting the eps figure.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

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Exam focus point

You should know how to deal with the effect of bonus and rights issues on eps and be able to
calculate diluted eps. Basic eps calculations and diluted eps calculations may come up as an
objective test question (OTQ) in Section A or B of the exam, or be included as part of the
interpretations question in Section C.

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Chapter summary

Earnings per share

Basic eps

Objective Calculation
• Improve comparison between entities and over Earnings
• Basic EPS =
periods Weighted average no. of equity shares
• Applies to listed companies only outstanding during the period
• Earnings is profit attributable to ordinary
shareholders of the parent ie consolidated profit
Definitions after:
• Ordinary shares – equity instrument subordinate to – Income taxes
all other classes of equity instruments – Non-controlling interests
• Potential ordinary shares – financial instrument – Preference dividends on preference shares
that may entitle its holder to ordinary shares. classified as equity
• Financial instrument – contract that gives a
financial asset of one entity and a financial liability
or equity instrument of another entity. Weighted average number of shares outstanding
• Equity instrument – any contract that evidences a • Full market price:
residual interest in the assets of an entity after – Time apportion share issues in the year
deducting all of its liabilities. • Bonus issue:
• Dilution – A reduction in earnings per share or an Number of shares after bonus issue
increase in loss per share – Bonus fraction =
Number of shares before bonus issue
– Use bonus fraction retrospectively in current year
– Fraction = no shares after/no shares before
Presentation
– Use reciprocal to restate comparative
Basic and diluted EPS shown on face of SPLOCI with
• Rights issue:
equal prominence Fair value per share immediately
– Bonus fraction = before exercise of rights
for rights issue Theoretical ex-rights price (TERP)
– Use bonus fraction retrospectively in current year
– Fraction = FV before rights/TERP
– Use reciprocal to restate comparative

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Diluted eps Eps as a performance measure

Issue Importance of the eps measure

A 'warning' measure of what may happen in the • May be a better indication than profit as it
future if potential ordinary shares are converted considers changes in capital
to shares • Considered a key stock market indicator and is
quoted in the financial press
• It has a role in the price/earnings (P/E) ratio
Calculation of diluted eps
Assume that all of the pos are converted into ordinary
shares at the beginning of the period and at the most Limitations of eps
advantageous rate • Based on historical data and so is an indication of
past performance
• Diluted EPS figure is theoretical
Convertible debt • Includes one-off income/expense which distorts the
Earnings EPS figure
Basic earnings X
Add back: interest net of tax (or preference
dividend) X
Diluted earnings X

No. of shares
Basic weighted average number of shares X
Add additional (max) shares on conversion X
Diluted number of shares X

Share options and warrants

No. of shares
Basic weighted average number of shares X
Add shares deemed issued for nil consideration (W1) X
Diluted number of shares X

Working 1
No. shares under option X
Less no. that would have been issued at average
market price X
No. of shares deemed issued for nil consideration X

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Knowledge diagnostic
1. Basic eps
Basic eps is calculated as earnings/weighted average number of equity shares outstanding during
the period.
Earnings is consolidated profit after tax, non-controlling interest and preference dividends (on
redeemable preference shares).
The weighted average number of shares is adjusted for issues in the period. Share issues may be:
• Issued at full market value – include pro-rata
• Bonus issues – calculate bonus fraction and apply it retrospectively
• Rights issue – separate into shares paid for at full value and bonus issue; calculate the bonus
fraction and apply it retrospectively

2. Diluted eps
Diluted eps represents a ‘warning’ measure of how eps would change if ‘potential ordinary shares’
were converted into shares. Both earnings and the number of shares are adjusted for the effects
of the conversion of debt into shares. The number of shares is adjusted for the effects of share
options/warrants into shares.

3. Eps as performance measure

Eps is an important financial indicator and is used in the price/earnings (p/e) ratio which is used to
assess the health of and to value companies.
It also has limitations because it is based on historical data and includes one-off items of income
and expense.

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
23(b) Telenorth Co
27 Pilum Co

Further reading
ACCA provides a useful article relating to performance appraisal in the FR exam:
Performance appraisal
www.accaglobal.com

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Activity answers

Activity 1: Calculation of earnings

The correct answer is:
$6,970,000
This is the profit attributable to the owners of the parent less dividends on the non-cumulative
irredeemable preference shares as they are classified as equity.
The irredeemable preference shares are classified as equity as there is no obligation to pay the
dividends or repay the principal. Therefore, the dividends on the preference shares need to be
deducted from the profit for the year attributable to the owners to the parent to arrive at earnings
relating to ordinary shareholders.
However, the redeemable preference shares are classified as a financial liability as there is an
obligation to pay the dividends and to repay the principal. Therefore, the dividends on these
shares are treated as a finance cost so have already been deducted in arriving at the profit for the
year figure. As such, there is no need to deduct them when calculating earnings.
The earnings figure should be profit attributable to the ordinary shareholders of the parent.
Therefore, earnings is calculated as follows:
$’000
Profit for the year attributable to the owners of the parent 7,000
Less: Preference dividends on preference shares classified as equity (500,000 ×
6%) (30)
6,970

Activity 2: Bonus issue

The correct answer is:
20X2
Earnings $80,000
Shares at 1 January 400,000
Bonus issue 100,000
500,000 shares
Eps ($80,000 / 500,000) $0.16 per share

The number of shares for 20X1 must also be adjusted if the figures for eps are to remain
comparable.
The eps for 20X1 is therefore restated as:
$0.1875 × 400,000/500,000 = $0.15

Activity 3: Basic eps

1 The correct answer is:
2,431,508

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W1 Weighted average number of shares

Weighted
Date Narrative Shares Time Bonus fraction average
1.1.20X1 2,000,000 × (4/12) × (3.10/3.00 (W2)) 723,333
× (21/20)
30.4.20X1 Full market 270,000/2,270,000 × (3/12) × (3.10/3.00 (W2))
price × (21/20) 615,738
31.7.20X1 Rights issue 227,000/2,497,000 × (2/12) × (21/20) 436,975
(1/10)
30.9.20X1 Bonus issue 124,850/2,621,850 × (3/12) 655,462
(1/20)
2,431,508

W2 TERP
$
z10 @ $3.10 31.00
1 @ $2.00 2.00
11 33.00

33/11 = $3.00
2 The correct answer is:
16.5c
Eps for year ended 31.12.X1 = $400,000 / 2,431,508 (W1) = 16.5c
3 The correct answer is:
17.1c
Restated eps for year ended 31.12.20X0
18.6c × 3.00/3.10 × 20/21 = 17.1c

Activity 4: Diluted eps – convertible debt

The correct answer is:
4.64c
Earnings
$
Basic 644,000
Interest saving, net of tax 1,200,000 @ 5% × 70% 42,000
686,000
Number of shares
Basic 10,000,000
On conversion (1,200,000 × 4) 4,800,000
14,800,000

Diluted eps = $686,000 / 14,800,000 = 4.64c

Activity 5: Diluted eps – options

The correct answer is:
$2.05
Diluted EPS
Number of shares under option 250,000
No that would have been issued at average market price [(250,000 × (187,500)
$15)/$20]

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Number of shares under option 250,000

 No of shares treated as issued for nil consideration 62,500

Diluted EPS = $3,000,000 / (1,400,000 + 62,500) = $2.05

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Interpretation of
19 financial statements

19

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Define and compute relevant financial ratios. C2(a)

Explain what aspects of performance specific ratios are C2(b)

intended to assess.

Analyse and interpret ratios to give an assessment of an C2(c)

entity’s/group’s performance and financial position in
comparison with:
(i) Previous period’s financial statements
(ii) Another similar entity/group for the same reporting period
(iii) Industry average ratios

Interpret financial statements to give advice from the C2(d)

perspectives of different stakeholders.

Discuss how the interpretation of current value based financial C2(e)

statements would differ from those using historical cost based
accounts.
19

Exam context
One of the 20-mark questions in Section C of the ACCA Financial Reporting (FR) exam will require
you to interpret the financial statements of either a single entity or a group. The ACCA FR
Examining team has stated that ‘although candidates will be expected to calculate various
accounting ratios, FR places emphasis on the interpretation of what particular ratios are intended
to measure and the impact that consolidation adjustments may have on any comparisons of
group financial statements. The financial statements that require interpretation will include the
Statement of Profit or Loss, the Statement of Financial Position and the Statement of Cash Flows’.
Therefore, the focus of this chapter and your study should be on interpretation rather than
calculation of ratios.
19

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Chapter overview
Interpretation of financial statements

Analysis and interpretation Financial ratios Interpretation

Ratio analysis vs interpretation Categories Approach to analysing

financial statements

Profitability ratios
Interpretation questions
in the exam
Short term liquidity
and efficiency
Stakeholder perspectives

Long-term liquidity/gearing

Investors' ratios

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1 Analysis and interpretation

1.1 Ratio analysis v interpretation
1.1.1 Ratio analysis
Calculating ratios may highlight unusual results or clarify trends, but they are simply a starting
point to understand how an entity has changed over time or how it compares to another entity or
to industry averages.
It is important that you can:
• Identify which ratios should be calculated in different circumstances, depending on what area
of the business you want to understand more about; and
• Accurately calculate ratios using the primary financial statements
However, the identification and calculation of ratios is unlikely to be worth many marks in the
ACCA Financial Reporting exam, the focus must be on interpretation.

1.1.2 Interpretation
Interpretation involves using the ratios calculated, the financial statements provided and
information within a scenario to explain your understanding of the performance and position of
an entity in the period.
For ratios to be useful, comparisons must be made – on a year-to-year basis, or between
companies. On their own, they are useless for any sensible decision-making. It is important that
you use information you are provided with about an entity to draw conclusions as to why a ratio
has changed or is different to another entity.
It is important that you understand what the ratio is intended to show in order to explain it
correctly.

Exam focus point

The ACCA FR Examining team has stated that the following scenarios may be asked in the
interpretation question:
• Comparison of one entity over two periods
• Comparison of two entities over the same period
• Comparison of an entity with industry averages
• Analysis of consolidated financial statements – acquisition of a subsidiary
• Analysis of consolidated financial statements – disposal of a subsidiary
• Analysis of cash flow information
Further detail on each of these scenarios is covered later in this chapter.

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2 Financial ratios
2.1 Categories of ratios

Profitability Short term liquidity and efficiency

• Return on capital employed • Current ratio
• Net profit margin • Acid-test ratio
• Asset turnover • Inventory holding period
• Return on equity • Receivables collection period
• Gross profit margin • Payables payment period

Long term liquidity/Gearing Investors' ratios

• Gearing • Dividend yield
• Interest cover • Dividend cover
• p/e ratio

2.2 Profitability ratios

2.2.1 Return on capital employed

Formula to learn
PBIT
ROCE = Capital Employed × 100

PBIT = profit before interest and tax. It is often referred to internationally as IBIT (income before
interest and tax) and may also be called operating profit.
Capital employed = debt + equity = TALCL (total assets less current liabilities). It represents the
debt and equity capital that is used by the company to generate profit.
Return on capital employed (ROCE) measures how efficiently a company uses its capital to
generate profits. A potential investor or lender should compare the return to a target return or a
return on other investments/loans. It is impossible to assess profits or profit growth properly
without relating them to the amount of funds (capital) that were employed in making the profits.
Therefore, ROCE is a very important profitability ratio as it allows the profitability of different
companies or time periods to be compared.
When considering changes in ROCE year to year or differences between entities, consider looking
PBIT and capital employed separately to understand if transactions or events that you are made
aware of in the scenario impact on both the numerator and denominator in the same way. If a
transaction only impacts profit, or only impacts capital employed, that would affect the ROCE for
that company/period.
The following are reasons why ROCE might differ between years or companies.
(a) Type of industry (a manufacturing company will typically have higher assets and therefore
lower ROCE than a services or knowledge-based company)
(b) Age of assets (old assets have a lower carrying amount resulting in low capital employed and
high ROCE)
(c) Leased assets versus asset purchased outright for cash (a leased asset results in recognition
of a lease liability, a proportion of which will appear as a non-current liability, increasing
capital employed and reducing ROCE; whereas an asset purchased with surplus cash will
have no impact on capital employed)
(d) Timing of the purchase of assets (eg if assets are purchased at the year-end, capital
employed will increase but there will have been no time to increase profits yet, so ROCE is
likely to fall).

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(e) Assets held under the revaluation model versus assets held under the cost model (an upwards
revaluation results in recognition of a revaluation surplus which increases capital employed
whilst higher depreciation will result in a lower PBIT; a decrease in the numerator and an
increase in the denominator will cause ROCE to fall)

2.2.2 Example: ROCE

Maroon Co has PBIT of $1.64 million and capital employed of $32.85 million at 31 December 20X5.
Its ROCE for 20X5 has, therefore, been calculated as 5.0%, a significant decrease on the ROCE
for 20X4 of 6.8%.
Further information has revealed that Maroon Co purchased $10 million of non-current assets on
20 December 20X5. Maroon Co fully financed the purchase using a bank loan taken out on the
same date. The timing of the purchase, just before the year-end means that the machine will not
have been able to impact profit/returns.
We have the situation where the denominator (capital employed) has increased by $10 million
without any corresponding increase in the numerator (return). Without the $10 million loan, the
ROCE would have been 7.2% ($1.64m / ($32.65m – $10m)), which is actually a slight improvement
on the 20X4 ROCE. It is important that you read the information given on the question carefully
and consider the interactions between increases and decreases to profit/return and capital
employed in the light of the business’ performance for the year. Taking ROCE as a standalone
figure does not give the user of the financial statements the whole picture.
We often sub‑analyse ROCE, to find out more about why the ROCE is high or low, or better or
worse than last year. There are two factors that contribute towards a return on capital employed:

Net profit margin

ROCE = Asset turnover

PBIT Revenue PBIT

∴ Revenue × Capitalemployed = Capital employed

2.2.3 Net profit margin

Formula to learn
PBIT
Net profit margin = Revenue × 100

Net profit margin considers how much of an entity’s sales are converted to profit. There is no right
or wrong net profit margin that an entity should achieve and what is ‘normal’ will vary by industry
and by company based on the target market of that company. It is important that you consider
volume of sales as well as the net profit margin. For example, a company that makes a profit of
25c per $1 of sales is making a bigger return on its revenue than another company making a profit
of only 10c per $1 of sale. However, if the high margin is because sales prices are high, there is a
strong possibility that the volume of sales will be low and, therefore, revenue may be depressed,
and so the asset turnover will be lower.

2.2.4 Asset turnover

Formula to learn
Revenue
Asset turnover = Capital employed

Asset turnover is a measure of how well the assets (total assets less current liabilities) of a business
are being used to generate sales. For example, if two companies each have capital employed 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

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assets (twice as much asset turnover as Company B) and this will help A to make a higher return
on capital employed 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.

Activity 1: Return on Capital Employed

Extracts from the financial statements of Burke for the year ended 31 December 20X1 are shown
below:
EXTRACT FROM THE STATEMENT OF PROFIT OR LOSS
$’000
Gross profit 300
Finance cost (10)
Profit before tax 230
Tax (70)
Profit for the year 160

EXTRACT FROM THE STATEMENT OF FINANCIAL POSITION

$’000
Non-current assets 550

Equity
Share capital 200
Share premium 40
Retained earnings 500
Revaluation surplus (60)

Required
Calculate Burke’s return on capital employed for the year ended 31 December 20X1. Give your
answer as a percentage to one decimal place.

Solution

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2.2.5 Return on equity

Formula to learn
PAT + Preference dividends
Return on equity = Equity × 100

Whilst the return on capital employed looks at the overall return on the long-term sources of
finance, return on equity focuses on the return for the ordinary shareholders.
Return on equity gives a more restricted view of capital than ROCE, but it is based on the same
principles. ROE is not a widely used ratio, however, because there are more useful ratios that give
an indication of the return to shareholders, such as earnings per share, dividend per share,
dividend yield and earnings yield, which are described later.

2.2.6 Gross profit margin

Formula to learn
Gross profit
Gross profit margin = Revenue × 100

The gross profit margin measures how well a company is running its core operations.
Depending on the format of the statement of profit or loss, you may be able to calculate the gross
profit margin as well as the net profit margin. Gross profit margin is a measure of the profit
generated from an entity’s sales. Looking at the two profit margins together can be quite
informative. If two entities have a similar net profit margin but a different gross profit margin, it
may be that they classify expenses differently which causes the inconsistency. For example, one
company might present the depreciation on its machinery in cost of sales, which will reduce the
gross profit margin. Another company might present the depreciation on its machinery as an
administrative expense and therefore report a higher gross profit margin. When it comes to
calculating the net profit margin, where the depreciation is presented does not make a difference.
There may be various reasons for a change in gross profit margin, but it is important to note that
a change in sales volume alone will not necessarily affect gross margin as the same proportionate
change would be expected in cost of sales. However, if an increase in sales volume is achieved by
offering customers a bulk buy discount, this will cause the gross margin to fall.
The following factors could explain the movement in gross margin between years or companies:
(a) Change in sales price
(b) Change in sales mix
(c) Change in purchase price and/or production costs (eg due to discounts/efficiencies)
(d) Inventory obsolescence (written off through cost of sales)

Activity 2: Profitability ratios

The following information is available for two potential acquisition targets. The entities have
similar capital structures and both operate in the manufacturing sector.

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Required
Which THREE of the following statements give realistic conclusions that could be drawn from the
above information? Tick the correct answers.
Fulton Hutton
Revenue $460m $420m
Gross profit margin 25% 14%
Net profit margin 10% 9%
 Hutton has sourced cheaper raw materials than Fulton.
 Fulton operates its production process more efficiently than Hutton with less wastage and
more goods produced per machine hour.
 Hutton operates in the low price end of the market but incurs similar manufacturing costs to
Fulton.
 Fulton’s management exercises better cost control of the entity’s non-production overheads
than Hutton’s management.
 Hutton has access to cheaper interest rates on its borrowings than Fulton.

Solution

2.3 Short term liquidity and efficiency

2.3.1 Current ratio

Formula to learn
Current assets
Current ratio = Current liabilities

Current ratio is a measure of a company’s ability to meet its short-term obligations using its
current assets. 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 one 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

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excess of one should be expected, but what is ‘comfortable’ varies between different types of
businesses.
Companies are not able to convert all their current assets into cash very 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 terms. Some companies produce or manufacture products that
necessarily have to be stored for a long period of time, such as certain chemical and
pharmaceutical products. In such businesses, where inventory turnover is slow, most inventories
are not very ‘liquid’ assets, because the cash cycle is so long. For these reasons, we calculate an
additional liquidity ratio, known as the quick ratio or acid test ratio.

2.3.2 Quick (acid-test) ratio

Formula to learn
Current assets - inventories
Quick ratio (acid test) = Current liabilities

This ratio should ideally be at least one for companies with a slow inventory turnover. For
companies with a fast inventory turnover, a quick ratio can be comfortably less than one without
suggesting that the company could be in cash flow trouble.
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 current ratio of 0.52 and a quick ratio of 0.17. Supermarkets have low receivables
(people do not buy groceries on credit), low cash (good cash management), medium inventories
(high levels of inventories but quick turnover, particularly in view of perishability) and very high
payables. Contrast this with, for example, a luxury sofa manufacturer is likely to have a higher
current ratio (to cover the time to make the sofas as well as holding sufficient materials on hand).
What is important is the trend of these ratios. From this, one can easily ascertain whether liquidity
is improving or deteriorating. If a supermarket has traded for the last ten 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
were to fall 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.
Do not forget the other side of the coin either: A current ratio and a quick ratio can get bigger
than they need to be. A company that has large volumes of inventories and receivables might be
over‑investing in working capital, and so tying up more funds in the business than it needs to. This
would suggest poor management of receivables (credit) or inventories by the company.

Activity 3: Liquidity
Required
Which of the following independent options is the most likely cause of the movement in Robbo’s
current ratio?
Tick the correct answer.
20X3 20X2
Current ratio 2.1 2.4
 Replacement of an overdraft with a long-term loan
 A decrease in the length of credit terms offered by suppliers
 As issue of five-year bonds
 A significant write down of obsolete inventory

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Solution

Essential reading
Chapter 19 Section 1 of the Essential reading provides more information on liquidity and the cash
cycle.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

2.3.3 Inventory holding period

Formula to learn
Inventories
Inventory holding period = Cost of sales × 365 days

This indicates the average number of days that items of inventory are held for. This is a measure
of how vigorously a business is trading. A lengthening inventory holding period from one year to
the next indicates:
(a) A slowdown in demand/trading; or
(b) A build-up in inventory levels, perhaps suggesting that the investment in inventories is
becoming excessive
Generally, the lower the inventory holding period (ie the fewer days that an entity holds its
inventory) the better, assuming the inventory is being sold at a profit, however several aspects of
inventory holding policy have to be balanced. An entity must hold enough inventory to satisfy
demand, and therefore must consider:
(a) Lead times
(b) Seasonal fluctuations in orders
(c) Alternative uses of warehouse space
(d) Bulk buying discounts
(e) Likelihood of inventory perishing or becoming obsolete

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2.3.4 Receivables collection period

Formula to learn
Trade receivables
Receivables collection period = Credit revenue × 365 days

The receivables collection period tells us how long, on average, it takes a company to collect
payment from credit customers. Note that any cash sales should be excluded from the revenue
denominator. This ratio only uses credit sales as they generate trade receivables. 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 accounts.
The estimate of the accounts receivable collection period is only approximate.
(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 made to other companies are usually made on ‘normal credit terms’ of payment within, say,
30 days. A collection period significantly in excess of this might be representative of poor
management of funds of a business. However, some companies must allow generous credit terms
to win customers.
The type of company is also important: A retail company will have the majority of its sales made
with immediate payment (such as shops, online sales where the customer pays prior the goods
being despatched). A wholesaler or distribution company is more likely to offer credit terms; for
example, a wholesaler will sell its range of toys to a retail store offering 30–60 day credit terms.
Exporting companies in particular may have to carry large amounts of receivables, and so their
average collection period might be well in excess of 30 days.
It is important to give reasons specific to the example in the exam, as noting a company with few
trade receivables may be implicit of the type of company rather than them being particularly
good at credit collection.
The trend of the collection period over time is probably the best guide. If the collection period is
increasing year on year, this is indicative of a poorly managed credit control function (and
potentially, therefore, a poorly managed company). Also, this may affect credit being offered to it
in the longer-term, which would mean paying for its supplies up front (or ‘proforma’) which would
put an increased pressure on the cash flow.

2.3.5 Payables payment period

Formula to learn
Trade payables
Payables payment period = Credit purchases × 365 days

The payables payment period tells us how long, on average, it takes a company to pay its credit
suppliers. The payables payment period It is rare to find purchases disclosed in published
accounts and so cost of sales serves as an approximation. The payment period often 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.

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2.4 Working capital cycle

The working capital cycle includes cash, receivables, inventories and payables. It effectively
represents the time taken to purchase inventories, then sell them and collect the cash. The length
of the cycle is determined using the above ratios:

Buy Inventory Sell Receivables Receive cash

inventories holding period inventories collection period from receivables

Payables Working
payment period capital cycle

Pay payables

Activity 4: Working capital ratios

Tungsten Co has the following working capital ratios:
Required
Which TWO of the following statements are correct?
20X9 20X8
Current ratio 1.2 1.5
Receivables collection period 75 days 50 days
Payables payment period 30 days 45 days
Inventory holding period 42 days 35 days
 Tungsten Co’s liquidity and working capital has improved in 20X9.
 Tungsten Co is receiving cash more quickly from customers in 20X9 than in 20X8.
 Tungsten Co is suffering from a worsening liquidity situation in 20X9.
 Tungsten Co is paying its suppliers more quickly in 20X9 than in 20X8.

Solution

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2.5 Gearing and long-term liquidity

2.5.1 Gearing

Formulas to learn
Debt
Gearing = Debt + Equity × 100
Interest bearing debt
Gearing = Interest bearing debt + Equity × 100

Gearing or leverage is concerned with a company’s long‑term capital structure. We can think of
a company as consisting of non-current assets and net current assets (ie working capital, which is
current assets minus current liabilities). These assets must be financed by long‑term capital of the
company, which is one of two things:
(a) Issued share capital which can be divided into:
(i) Ordinary shares plus other equity (eg reserves)
(ii) Non-redeemable preference shares (unusual)
(b) Long-term debt including redeemable preference shares
Preference share capital is normally classified as a non-current liability in accordance with IAS 32
(AG35), and preference dividends (paid or accrued) are included in finance costs in profit or loss.
There is no absolute limit to what a gearing ratio ought to be. A company with a gearing ratio of
more than 50% is said to be high‑geared (whereas low gearing means a gearing ratio of less than
50%). Many companies are high geared, but if a high geared company is becoming increasingly
high geared, it is likely to have difficulty in the future when it wants to borrow even more, unless it
can also boost its shareholders’ capital, either with retained profits or by a new share issue.
Gearing is, amongst other things, an attempt to quantify the degree of risk involved in holding
equity shares 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. The more highly geared the company, the greater the risk
that little (if anything) will be available to distribute by way of dividend to the ordinary
shareholders.

Activity 5: Gearing
The following is an extract from the statement of financial position of Fleck Co:
$’000
Equity
Share capital 200
Share premium 50
Retained earnings 400
Revaluation surplus 70
Total equity 720

Non-current liabilities
Long-term borrowings 300
Redeemable preference shares 100
Deferred tax 20

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$’000
Warranty provision (not discounted) 60
Total non-current liabilities 480

Required
What is the gearing ratio for Fleck (calculated as debt/(debt + equity))? Give your answer as a
percentage to one decimal place.

Solution

Essential reading
Chapter 19 Section 2 of the Essential reading provides discussion of the impact of a high or low
gearing ratio.
The debt ratio is another ratio that considers capital structure, though is less commonly used than
gearing. The debt ratio is discussed in Chapter 19 Section 3 of the Essential reading.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

2.5.2 Interest cover

Formula to learn
PBIT
Interest cover = Finance cost

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 PBIT would then have a significant effect on profits available for
ordinary shareholders.

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An interest cover of two times or less would be low, and should really exceed three times before the
company’s interest costs are to be considered within acceptable limits.

2.6 Investors’ ratios

2.6.1 Dividend yield

Formula to learn
Dividend per share
Dividend yield = Share price × 100

Dividend yield is the return a shareholder is currently expecting on the shares of a company.
(a) The dividend per share is taken as the dividend for the previous year.
(b) If the share price is quoted ‘ex-div’, that means that the share price does not include the right
to the most recent dividend.
Shareholders look for both dividend yield and capital growth.

2.6.2 Dividend cover

Formula to learn
Earnings per share (EPS)
Dividend cover = Dividend per share

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. A dividend cover of two times would indicate that the
company had paid 50% of its distributable profits as dividends, and retained 50% in the business
to help to finance future operations. Retained profits are an important source of funds for most
companies, and so the dividend cover can in some cases 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, so as to keep shareholder expectations satisfied.

2.6.3 Price/earnings (P/E) ratio

Formula to learn
Share price
Price/Earnings (P/E) ratio = Earnings per share

A high P/E ratio indicates strong shareholder confidence in the company and its future, eg 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:
• Other companies in the same business sector
• Other companies generally
It is often used in stock exchange reporting where prices are readily available.

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3 Interpretation
3.1 Approach to interpretation
• Identify user and format required for solution
• Read question and analyse data
- Look for obvious changes/differences in the figures (no ratio calculations yet, but can
consider % movements year on year)
• Calculate key ratios as required by the question
• Write up your answer summarising performance and position:
- Structured using your categories
- Comment on main features first
- Then bring in relevant ratios to support your arguments
- Suggest reasons for key changes
- Use any information given in the question!
• Reach a conclusion

Exam focus point

The ACCA Financial Reporting Examiner’s Reports – for example, the June 2018 Examiner
Report – repeatedly comment on the answers given by candidates. Remember these key
points:
• Depth of answer – explain the ratio and the underlying reasons for the movement
• Use the scenario – apply relevant ratios applicable to the question being asked
• Calculations – marks are awarded for showing where the numbers have come from.

3.2 Interpretation scenarios in the exam

The ACCA Financial Reporting examining team has produced a helpful Technical Article titled ‘Tell
me a story’ which can be found on the ACCA website (www.accaglobal.com) which indicates that
there are six different types of interpretation question you may be faced with in Section C of the
exam. Key points relating to each type of question are provided in the sections below.

3.2.1 Comparison of one entity over two periods

You may be asked to compare the same entity over two accounting periods. Rather than saying
that ratio has increased or decreased, you should state whether it has improved or deteriorated
and you must offer possible reasons for the movements based on information within the scenario.
You should consider one-off events that could skew the comparison (eg an impairment loss that
has increased expenses and therefore reduced the operating profit margin). If these exist, it may
be valuable to strip these out of the accounting numbers and recalculate the ratios to show the
underlying position for comparison.

3.2.2 Comparison of two entities in the same period

You may be presented with, or asked to calculate, the ratios for two competitor firms and asked to
compare their performance or decide which is more suitable to target for acquisition. You should
consider whether there are any differences in accounting policies which might skew the
comparison (accounting for non-current assets at cost vs fair value is often a key reason for
return on assets or return on equity differences). There may also be useful information about
which areas of the market the company targets (for example, a company that sells luxury goods
is likely to have a higher gross profit margin than a discount retailer within the same industry) or
information about significant customers.

3.2.3 Comparison of an entity with the sector averages

Similar to the comparison of two entities discussed above, candidates should give consideration to
the fact that different entities in the sector will have different margins as they target different

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ends of the market. Also firms may have different year-ends which could skew the comparison,
particularly if there is, for example, seasonal trade which impacts on eg, receivables and
inventories balances at year-end. Finally, consider if the entity in question has different
accounting policies to the rest of the sector.

3.2.4 Analysis of consolidated financial statements – acquisition of a subsidiary

Consolidated financial statements will have group-related issues and therefore the interpretation
must focus on different issues to that of a single entity. In the situation where there is an
acquisition of a subsidiary, the results will not be comparable year on year and discussion must
focus on the impact of the acquisition. This may include:
• The acquired subsidiary might have different margins or operate at a different sector.
• Some transactions such as intra-group sales or unrealised profits will need to be eliminated. If
the parent previously transacted with the entity that it has now acquired, this means that
revenue and profits reported in the single entity financial statements are now cancelled as
they are intragroup.
• There may be one-off fees associated with the acquisition that impact on the operating profit
margin.
• The subsidiary acquired may have different payment terms for its receivables and payables
which impact on the collection and payment periods.
• Shares or other capital issued to acquire the subsidiary may impact the gearing ratio.
• The accounting policies of the parent and subsidiary may be different. Again, be alert to one
company accounting for its non-current assets at cost and the other at fair value.

Date of acquisition

Start of the year Mid year End of the year

Consolidated statement of CSPLOCI will include results CSPLOCI will not include the
profit or loss will include of subsidiary post acquisition results of subsidiary whereas
results of subsidiary for the whereas the CSFP will include the CSFP will include all
whole year and the all assets and liabilities of the assets and liabilities of the
consolidated statement of subsidiary. This means that subsidiary. As such, students
financial position will ratios that use elements of must reflect that the increase
include all assets and both performance (CSPLOCI) in assets and liabilities of the
liabilities of the subsidiary. and position (CSFP) will be group will not have
There is therefore complex to interpret. generated additional results
consistency between the Students should reflect on in the period, which will skew
CSPLOCI and CSFP and this within their interpretation. the ratios.
discussion can focus on For example, if a subsidiary is
the impact of the acquired six months into the
acquisition as above. year, then only six months
revenue will be included, but
the entire receivables balance
will be included within the
statement of financial
position. This would give a
false impression of the
receivables collection period.

3.2.5 Analysis of consolidated financial statements – disposal of a subsidiary

Similar to some of the comments noted for the acquisition of a subsidiary above, there may be
one off items relating to the disposal which impact mainly on the profitability ratios such as
professional fees or redundancy costs. Students should also consider whether there has been any
gain or loss on the disposal.

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Students should also discuss that if a subsidiary has been disposed during the year (regardless of
whether mid-way through the year or at year-end), then the CSPLOCI will contain the results of
the subsidiary up until the date of disposal whereas the CSFP will not contain any assets or
liabilities of the subsidiary since it has been disposed. Therefore, similar to as noted above, this
creates a mismatch which should be discussed when interpreting changes or movements.

3.2.6 Analysis of cash flow information

Interpreting the statement of cash flows requires a different approach from students as they will
not be able to base their answer on any ratios calculated. You should analyse the three sections
of the statement of cash flows separately:
Cash generated from operations
This shows how much cash the business can generate from its core activities. The cash generated
from operations figure is effectively the cash profit from operations. Students need to use the
SPLOCI and SFP to interpret and explain the movements, but also information in the scenario If,
for example, you were told in the scenario that the company had changed its credit terms offered
to customers, now offering 60 days instead of 30 days, it would be expected that the cash
generated from operations might decrease as the entity will have collected less cash from its
sales.
Cash generated / used in investing activities
These cash in/outflows are one-off items and it is likely that information about these will be
provided in the scenario. Students should be careful about saying whether cash generated from
investing activities is good or bad. Consider the situation where a company is forced to sell assets
and rent them back in order to generate cash flow to allow it to continue to trade. This is likely to
mean that the cash generated from investing activities increases in the period, but is clearly not a
sign that the entity has performed well.
Cash generated / used in financing activities
Similar to investing activities, cash flows are likely to be one-off in nature. Where there has been,
for example, a new loan which increases cash generated from financing activities, this may be
positive for the company if the proceeds from the loan are used to invest in new assets (which you
should be able to link to cash used in investing activities), but negative for the company if the
proceeds are needed to allow the company to continue trading.
(Amended from ‘Tell me a story’, from www.accaglobal.com)

3.3 Stakeholder perspectives

Activity 6: Stakeholder
This question has been adapted from the June 2015 exam.
Yogi Co is a public company and extracts from its most recent financial statements are provided
below:
STATEMENTS OF PROFIT OR LOSS FOR THE YEAR ENDED 31 MARCH
20X5 20X4
$’000 $’000
Revenue 36,000 50,000
Cost of sales (24,000) (30,000)
Gross profit 12,000 20,000
Profit from sale of division (Note (a)) 1,000 -
Distribution costs (3,500) (5,300)
Administrative expenses (4,800) (2,900)
Finance costs (400) (800)
Profit before tax 4,300 11,000
Income tax expense (1,300) (3,300)
Profit for the year 3,000 7,700

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STATEMENTS OF FINANCIAL POSITION AS AT 31 MARCH

20X5 20X4
$’000 $’000 $’000 $’000

ASSETS
Non-current assets
Property, plant and equipment 16,300 19,000
- 2,000
16,300 21,000
Current assets
Inventories 3,400 5,800
Trade receivables 1,300 2,400
Cash and cash equivalents 1,500 -
6,200 8,200
Total assets 22,500 29,200

EQUITY AND LIABILITIES

Equity
Equity shares of $1 each 10,000 10,000
Retained earnings 3,000 4,000
13,000 14,000
Non-current liabilities
10% loan notes 4,000 8,000
Current liabilities
Bank overdraft - 1,400
Trade and other payables 4,300 3,100
Current tax payable 1,200 2,700
5,500 7,200
Total equity and liabilities 22,500 29,200

Notes
(a) On 1 April 20X4, Yogi Co sold the net assets (including goodwill) of a separately operated
division of its business for $8 million cash on which it made a profit of $1 million. This
transaction required shareholder approval and, in order to secure this, the management of
Yogi Co offered shareholders a dividend of 40 cents for each share in issue out of the
proceeds of the sale. The trading results of the division which are included in the statement of
profit or loss for the year ending 31 March 20X4 above are:
$’000
Revenue 18,000
Cost of sales (10,000)
Gross profit 8,000
Distribution costs (1,000)
Administrative expenses (1,200)
Profit before interest and tax 5,800

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(b) Key ratios for Yogi Co for 20X4 (as originally reported) are as follows:
Gross profit margin 40.0%
Operating profit margin 23.6%
Return on capital employed 53.6%
(profit before interest and tax / (total assets – current liabilities)
Asset turnover 2.27 times

1 Required
Calculate the equivalent ratios for Yogi Co:
(a) For the year ended 31 March 20X4, after excluding the contribution made by the division that
has been sold; and
(b) For the year ended 31 March 20X5, excluding the profit on the sale of the division.
2 Required
Comment on the comparative financial performance and position of Yogi Co for the year ended
31 March 20X5.

Solution
1

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3.4 Stakeholder perspectives

There are a number of stakeholders in an entity. To provide a useful analysis, an assessment of
the stakeholder’s needs is necessary when tackling any interpretation question. Each stakeholder
has differing needs.

Stakeholder Potential interest

(a) Shareholders • Performance of management during the year
• Decision to buy, hold or sell shares

(b) Potential investors • Future growth and profit potential

• Investment decision

(c) Banks and capital providers • Ability to pay existing interest and loan capital
• Decision whether to grant further loans

(d) Employees • Company stability as an employer

• Wage negotiation

(e) Management • Weak performing areas that need attention

• Whether targets met

(f) Suppliers • Creditworthiness as a customer

(g) Government • Statistics

• Decision whether to award a grant

Activity 7: Single entity interpretation

1 Below are the summarised financial statements for the year to 31 March 20X5 and 20X6 of
Heywood Bottles Co, a company which manufactures bottles for many different drinks
companies.
Note. The statements for the year to 31 March 20X6 have not been audited.
HEYWOOD BOTTLES CO – STATEMENTS OF PROFIT OR LOSS OR THE YEARS ENDED 31 MARCH
20X6 20X5
$m $m $m $m
Revenue 300 120
Manufacturing costs 261 83
Depreciation 9 7
Costs of sales (270) (90)
Gross profit 30 30
Other expenses (28) (10)
Profit before interest and tax 2 20
Finance costs (10) (2)
Profit/(loss) before tax (8) 18
Income tax expense (4) (6)

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20X6 20X5
$m $m $m $m
PROFIT/(LOSS) FOR THE YEAR (12) 12
Dividends paid 8 8

HEYWOOD BOTTLES CO – STATEMENTS OF FINANCIAL POSITION AS AT 31 MARCH

20X6 20X5
$m $m
Non-current assets
Land and buildings 5 5
Plant and equipment 18 10
Right-of-use asset 40 28
63 43
Current assets
Inventories 18 12
Receivables 94 25
Prepayment 6 –
Bank – 8
118 45
181 88
Equity
$1 ordinary shares 25 25
Other reserves 10 11
Retained earnings (12) 8
23 44
Non-current liabilities
Lease liabilities 32 19
Current liabilities
Trade payables 80 15
Other payables 12 10
Other payables 34 –
126 25
181 88

The directors were disappointed in the profit for the year to 31 March 20X5 and held a board
meeting in April 20X5 to discuss future strategy. The Managing Director was insistent that the way
to improve the company’s results was to increase sales and market share. As a result, the
following actions were implemented.
(a) An aggressive marketing campaign costing $12 million was undertaken. Due to expected
long-term benefits $6 million of this has been included as a current asset in the statement of
financial position at 31 March 20X6.
(b) A ‘price promise’ to undercut any other supplier’s price was announced in the advertising
campaign.
(c) A major contract with Koola Drinks Co was signed that accounted for a substantial
proportion of the company’s output. This contract was obtained through very competitive
tendering.
(d) The credit period for receivables was extended from two to three months.
A preliminary review by the board of the accounts to 31 March 20X6 concluded that the
company’s performance had deteriorated rather than improved. There was particular concern
over the prospect of renewing the bank facility because the maximum agreed level of $30 million
had been exceeded. The board decided that it was time to seek independent professional advice
on the company’s situation.

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Required
In the capacity of a business consultant, prepare a report for the board of Heywood Bottles Co
based on a review of the company’s performance for the year to 31 March 20X6 in comparison
with the previous year. Particular emphasis should be given to the effects of the implementation
of the actions referred to in points (a) to (d) above.

Solution
1

PER alert
Technical performance objective P08 requires you to Analyse and Interpret Financial Reports.
Completion of this chapter will allow you to achieve the following four elements from this
objective:
(a) Assess the financial performance and position of an entity based on financial statements
and disclosure notes.
(b) Evaluate the effect of chosen accounting policies on the reported performance and
position of an entity.
(c) Evaluate the effects of fair value measurements and any underlying estimates on the
reported performance and position of an entity.
(d) Conclude on the performance and position of an entity identifying relevant factors and
make recommendations to management.

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Chapter summary

Interpretation of financial statements

Analysis and Financial ratios

interpretation

Ratio analysis vs Categories Short term liquidity and efficiency

interpretation • Profitability • Current ratio =
• Ratio analysis starting • Short-term liquidity and efficiency Current assets
point to understanding • Long-term liquidity/gearing Current liabilities
changes in entity or • Investors' ratios
between entities Measures a company's ability to pay
• Interpretation involves its current liabilities out of its current
using ratios and Profitability ratios assets
information about • Return on capital employed = • Quick ratio (or acid test) =
entity to explain Current assets − Inventories
Profit before interest and taxation
changes/differences × 100% Current liabilities
Capital employed
Measure of how efficiently a Removes inventory (the least liquid
company uses capital to generate asset) from current assets
profits • Inventory holding period (or
• Net profit margin = inventory days) =
Inventories
Profit for year × 365 days
× 100% Cost of sales
Revenue
Measure of how an entity converts The average number of days
revenue to profit inventories are held by a company
before being sold to customers
• Asset turnover =
• Receivables collection period (or
Revenue
receivables days) =
Capital employed
Trade receivables
Measure of how efficiently the × 365 days
Revenue
company is using its capital to
generate revenue The average number of days it takes
to receive payment from credit
• Return on equity =
customers
Profit after tax and preference dividends
Ordinary share capital + reserves
× 100% • Payables payment period (or
payables days) =
Return for ordinary shareholders
Trade payables
• Gross profit margin = × 365 days
Cost of sales
Gross profit
× 100% The average number of days it takes
Revenue
the company to pay its suppliers for
goods purchased on credit

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Financial ratios continued Interpretation

Long-term liquidity/gearing Approach to analysing financial statements

• Gearing
1. Identify the user
Long-term debt
Debt/(Debt + Equity) = × 100% 2. Read question and analyse data
Long-term debt + Equity
3. Calculate key ratios
Measure of the long-term financial stability of 4. Write up your answer, discussing performance
the company and position
• Interest cover = 5. Consider the limitations of analysis and identify
any areas where further information is needed
PBIT
6. Reach a conclusion
Interest expense
The number of times a company could pay its
interest out of its profit from operations Interpretation questions in the exam
• Comparison of a single entity over time
• Comparison of two entities in the same period
Investors' ratios • Comparison of the entity with the sector
• Dividend yield = • Analysis of groups – acquisition of subsidiary
Dividend per share • Analysis of groups – disposal of subsidiary
% • Interpretation of the statement of cash flows
Share price
A measure of the return an investor expects on a
company's shares Stakeholder perspectives
• Dividend cover = Assessment of stakeholder's needs is necessary when
Profit for the year tackling an interpretation question
Dividends
How easily a company can afford to pay its
dividend out of its current profit
• Price/earnings (P/E) ratio =
Share price
EPS
Indicates shareholder confidence in the company
and its future

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Knowledge diagnostic
1. Analysis and interpretation
Ratios are a starting point to performing financial analysis, but performing ratio analysis and
simply explaining what each ratio means is not interpretation. Interpretation requires you to use
what you know about the company/companies to explain the movements in ratios year on year or
between different entities.

2. Financial ratios
It is important that you learn the categories of ratio (profitability, short-term liquidity and
efficiency, long-term liquidity/gearing, investors’ ratios), understand the ratio definitions and what
the ratio is trying to tell you, learn the formulae and know how to apply them in questions.

3. Interpretation
You must use the information in the scenario to suggest possible reasons why a ratio has moved in
the period or is different to another entity. You should not simply describe the ratio, nor simply
state that a ratio is good or bad. Try to find relevant points that help you explain the performance
and position.
Interpretation of group financial statements requires you to consider the impact of an acquisition
or disposal on the ratios. Consider that there may be inconsistency between the information in
the consolidated statement of profit or loss and the consolidated statement of financial position
depending on the timing of the acquisition or sale.
Each section of the statement of cash flows should be interpreted separately. You should avoid
saying a cash inflow is good and a cash outflow is bad without understanding the reason for the
cash flow.

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
13 Hever Co

Further reading
There are articles in the Exam Resources section of the ACCA website which are relevant to the
topics covered in his chapter and would be useful to read:
Tell me a story
Performance appraisal
www.accaglobal.com

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Activity answers

Activity 1: Return on Capital Employed

The correct answer is:
23.4 %
Profit before interest and tax
Return on capital employed = capital employed × 100
230 + 10
= 800 + 225 × 100 = 23.4%

Activity 2: Profitability ratios

The correct answers are:
• Fulton operates its production process more efficiently than Hutton with less wastage and
more goods produced per machine hour.
• Hutton operates in the low price end of the market but incurs similar manufacturing costs to
Fulton.
• Hutton has access to cheaper interest rates on its borrowings than Fulton.
The first option listed above is correct because Fulton has a higher gross margin than Hutton and
a more efficient production process would cause this.
The second is correct as it would cause Hutton to have a lower gross margin than Fulton.
Finally, one of the differences between gross and net margin is interest and, as Hutton has a
smaller difference between gross and net margins, this could be explained by Hutton having lower
finance costs than Fulton.

Activity 3: Liquidity
The correct answer is:
A significant write down of obsolete inventory
This would cause inventory and, therefore, current assets to decrease, which would cause the
current ratio to decrease. The other answers result in the current ratio being unchanged or
increasing.
Replacement of an overdraft with a long-term loan would increase current assets (more cash) and
decrease current liabilities (no overdraft) which would increase the current ratio.
A decrease in the length of credit offered would result in a decrease in trade payables and a
corresponding decrease in cash, so no overall impact on the current ratio.
Issuing bonds would result in a cash inflow (increase of current assets) which would also increase
the current ratio.

Activity 4: Working capital ratios

The correct answers are:
• Tungsten Co is suffering from a worsening liquidity situation in 20X9.
• Tungsten Co is paying its suppliers more quickly in 20X9 than in 20X8.
This is true because the current ratio has fallen, customers are taking longer to pay, inventory is
taking longer to sell and Tungsten Co is paying its suppliers more quickly.

Activity 5: Gearing
The correct answer is:
35.7 %
Working
Long - term debt
Gearing = Debt/(Debt + Equity) = Long - term debt + Equity × 100%

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300 + 100
= 300 + 100 + 720 × 100%
Note. Long-term borrowings and redeemable preference shares are included in debt as they are
both interest-bearing. However, no interest is payable on deferred tax or the warranty provision, so
these are excluded from debt.

Activity 6: Stakeholder
1 The correct answer is:
Calculation of equivalent ratios (figures in $’000):
20X4 20X5 20X4
excl. division as reported per question
Gross profit margin
((20,000 – 8,000)/(50,000 – 18,000) × 100) 37.5% 33.3% 40.0%
Operating profit margin
((11,800 – 5,800)/32,000) × 100) 18.8% 10.3% 23.6%
Return on capital employed (ROCE)
((11,800 – 5,800)/(29,200 – 7,200 – 7,000) × 100 40.0% 21.8% 53.6%
Asset turnover (32,000/15,000) 2.13 times 2.12 times 2.27 times

Note. The capital employed in the division sold at 31 March 20X4 was $7 million ($8 million sale
proceeds less $1 million profit on sale).
The figures for the calculations of 20X4’s adjusted ratios (ie excluding the effects of the sale of the
division) are given in brackets; the figures for 20X5 are derived from the equivalent figures in the
question, however, the operating profit margin and ROCE calculations exclude the profit from the
sale of the division (as stated in the requirement) as it is a ‘one off’ item.
2 The correct answer is:
The most relevant comparison is the 20X5 results (excluding the profit on disposal of the division)
with the results of 20X4 (excluding the results of the division), otherwise like is not being compared
with like.
Profitability
Although comparative sales have increased (excluding the effect of the sale of the division) by $4
million (36,000 – 32,000), equivalent to 12.5%, the gross profit margin has fallen considerably
(from 37.5% in 20X4 down to 33.3% in 20X5) and this deterioration has been compounded by the
sale of the division, which was the most profitable part of the business (which earned a gross
profit margin of 44.4% (8/18)). The deterioration of the operating profit margin (from 18.8% in 20X4
down to 10.3% in 20X5) is largely due to poor gross profit margins, but operating expenses are
proportionately higher (as a percentage of sales) in 20X5 (23.0% compared to 18.8%) which has
further reduced profitability. This is due to higher administrative expenses (as distribution costs
have fallen), perhaps relating to the sale of the division.
Yogi Co’s performance as measured by ROCE has deteriorated dramatically from 40.0% in 20X4
(as adjusted) to only 21.8% in 20X5. As the net asset turnover has remained broadly the same at
2.1 times (rounded), it is the fall in the operating profit which is responsible for the overall
deterioration in performance. Whilst it is true that Yogi Co has sold the most profitable part of its
business, this does not explain why the 20X5 results have deteriorated so much (by definition the
adjusted 20X4 figures exclude the favourable results of the division). Consequently, Yogi Co’s
management need to investigate why profit margins have fallen in 20X5; it may be that customers
of the sold division also bought (more profitable) goods from Yogi Co’s remaining business and
they have taken their custom to the new owners of the division; or it may be related to external
issues which are also being experienced by other companies such as an economic recession. A
study of industry sector average ratios could reveal this.
Other issues
It is very questionable to have offered shareholders such a high dividend (half of the disposal

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proceeds) to persuade them to vote for the disposal. At $4 million ($4,000 + $3,000 – $3,000, ie
the movement on retained earnings or 10 million shares at 40 cents) the dividend represents
double the profit for the year of $2 million ($3,000 – $1,000) if the gain on the disposal is
excluded. Another effect of the disposal is that Yogi Co appears to have used the other $4 million
(after paying the dividend) from the disposal proceeds to pay down half of the 10% loan notes.
This has reduced finance costs and interest cover; interestingly, however, as the finance cost at
10% is much lower than the 20X5 ROCE of 21.8%, it will have had a detrimental effect on overall
profit available to shareholders.
Summary
In retrospect, it may have been unwise for Yogi Co to sell the most profitable part of its business at
what appears to be a very low price. It has coincided with a remarkable deterioration in
profitability (not solely due to the sale) and the proceeds of the disposal have not been used to
replace capacity or improve long-term prospects. By returning a substantial proportion of the sale
proceeds to shareholders, it represents a downsizing of the business.

Activity 7: Single entity interpretation

1 The correct answer is:
REPORT
To: The directors of Heywood Bottles Co
From: Business Consultant
Date: May 20X6
Subject: Company performance year to 31 March 20X6

Introduction
This report was commissioned in order to assess the financial performance of Heywood Bottles Co
for the year to 31 March 20X6 in the light of the strategic actions taken in April 20X5.
Specific areas addressed include profitability, liquidity and solvency. An appendix sets out the
calculations of selected ratios used.
Financial performance
Growth
Heywood Bottles Co revenue has grown by approximately 150% in the year. This appears to be
due to increased sales volume as a result of:
• The marketing campaign undertaken during the year successfully attracting new customers
• The ‘price promise’ to undercut other suppliers winning customers from competitors
• The new contract won with Koola Drinks
• Extending the credit period from two to three months, so attracting new customers
Profitability
Return on capital employed has deteriorated from 31.7% to 3.6% implying a decline in efficiency in
the use of assets to generate profit. This is as a result of the decline in margins (explained below)
and also because Heywood Bottles has purchased and leased new assets during the current year.
Depending on the date on which the new assets were acquired, Heywood Bottles Co may not have
been able to take advantage of these assets to generate additional profit this year.
The improvement in asset turnover implies that Heywood Bottles is successfully using its assets to
generate revenue but has been unable to convert that into improved profitability.

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The gross margin has deteriorated from 25% in 20X5 to 10% in 20X6. This is because increased
sales volume has been achieved at the cost of profit margins. The two main causes of this appear
to be:
• Lowering the sales price as a result of the ‘price promise’
• Competitive tendering for the new large contract with Koola Drinks, which implies a lower than
usual sales price
The net profit margin has also deteriorated (from 16.7% to 0.7%). This is partly due to the fall in
gross margin (as explained above) but also due to the one-off marketing expenses of $12 million,
half of which ($6m) have been recognised in operating expenses. Half of the marketing expenses
($6m) were recorded as a current asset but this accounting treatment is not correct as marketing
expenses do not meet the definition of an asset. Therefore the $6 million asset should be written
off as additional operating expenses. Once this has been adjusted for, the decline in operating
margins is even more severe, resulting in an operating loss of $4 million.
Profitability has been further eroded by a fivefold increase in interest payable, due to Heywood
Bottles’ large overdraft and the new leases entered into during the year.
Financial position
Liquidity
Both the current and quick (acid test) ratios have deteriorated (from 1.8/1.3 to 0.9/0.8). The
expansion during the year has come at a cost of declining profitability and liquidity problems. The
liquidity problems are due to:
• Poor working capital management
• Reliance on the overdraft as a source of long-term finance
An overdraft is not a good source of long-term finance as it is both expensive and risky ie it could
be withdrawn by the bank at any time. Heywood Bottles Co is particularly at risk of having its
overdraft facility withdrawn because the current balance of $34 million is in excess of the $30
million agreed limit.
Working capital management
Working capital management has worsened in the year:
• The receivables collection period has increased from 76 days to 114 days. This is largely
because Heywood Bottles increased its credit terms from two to three months.
• The new contract with Koola Drinks Co was obtained through competitive tendering, which
may imply longer than usual credit terms for this new customer.
• As a result of customers taking longer to pay, a need for extra finance arose. This resulted in
Heywood Bottles Co taking longer to pay its suppliers (61 days in 20X5 and 108 days in 20X6)
and heavy reliance on the overdraft facility. If this continues, there is a risk that Heywood
Bottles Co’s suppliers might stop their credit or even stop supply.
• Even though Heywood Bottles Co appears to be struggling to pay suppliers, the suppliers are
being paid more quickly than debts are being collected from customers. This has exacerbated
the liquidity problems.
• The inventory holding period has gone down from 49 days to 24 days – this is probably due to
increased sales demand as a result of the marketing, price promise, new customer and
increased credit terms. It could also be due to suppliers restricting supplies due to slow
payment.
Solvency
Gearing has increased from 30% to 58%. This increase would have been even higher if the
overdraft were to be included as long-term debt in the 20X6 calculation.
This is due to the fact that new assets were leased during the year (increasing long-term debt)
and because the loss for the year has created negative retained earnings (decreasing equity). This
means that Heywood Bottles is unable to pay a dividend in the current year which will make
investors unhappy. This, combined with the risk associated with increased non-discretionary
interest payments each year, means that it might well be difficult to raise further finance from
investors in the future.

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The decline in interest cover from 10 times to 0.2 times shows that whilst Heywood Bottles Co could
easily afford to pay its interest in 20X5, it is now struggling to do so. This could cause serious
problems in the future as interest is non-discretionary so non-payment could result in withdrawal
of the overdraft facility and/or seizure of non-current assets by the lessor.
Conclusion
The company is overtrading and will fail without an immediate injection of new capital and a
change in strategy.
The board actions in April 20X5 were, with hindsight, disastrous as, although they resulted in
expansion, it was at the cost of both profitability and liquidity. Increased turnover and market
share are only worthwhile while the company is trading profitably.
It will be very difficult to retain the loyalty of customers if prices are increased and relationships
with suppliers and other payables are severely strained.
APPENDIX
Selected ratios
Calculation 20X6 Calculation 20X5
ROCE 2/(23 + 32) × 100 3.6% 20/(44 + 19) × 100 31.7%
Asset turnover 300/(181 – 126) 5.5 120/(88 – 25) 1.9
Gross profit margin 30/300 × 100 10% 30/120 × 100 25%
Net profit margin 2/300 × 100 0.7% 20/120 × 100 16.7%
Current ratio 118/126 0.9 45/25 1.8
Acid-test ratio (118 – 18)/126 0.8 (45 – 12)/25 1.3
Inventory holding period 18/270 × 365 24 days 12/90 × 365 49 days
Receivables collection 94/300 × 365 114 days 25/120 × 365 76 days
period
Payables payment period 80/270 ×365 108 days 15/90 × 365 61 days
Gearing (long-term debt/ 32/(32 + 23) × 100 58% 19/(19 + 44) × 100 30%
long-term debt + equity)
Interest cover 2/10 0.2 times 20/2 10 times

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Limitations of financial
20 statements and
interpretation techniques
20

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference
no.

Indicate the problems of using historic information to predict future C1(a)

performance and trends.

Discuss how financial statements may be manipulated to produce a C1(b)

desired effect (creative accounting, window dressing).

Explain why figures in a statement of financial position may not be C1(c)

representative of average values throughout the period for example,
due to:
(i) Seasonal trading
(ii) Major asset acquisitions near the end of the accounting period

Explain how the use of consolidated financial statements might limit C1(d)
interpretation techniques.

Discuss the limitations in the use of ratio analysis for assessing C3(a)
corporate performance.

Discuss the effect that changes in accounting policies or the use of C3(b)
different accounting polices between entities can have on the ability to
interpret performance.

Indicate other information, including non-financial information, that C3(c)

may be of relevance to the assessment of an entity’s performance.
20

Exam context
In Chapter 19, we looked at the interpretation of financial statements as a useful basis for
understanding the position and performance of an entity. In this chapter, we will consider the
reasons why relying on the financial statements in this way can be problematic. 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 Conceptual Framework and the
IFRS Standards are there to ensure, as far as possible, that they do. However, there are a number
of reasons why the information in financial statements should not just be taken at face value. This
chapter is likely to be a component of a Section C question that requires the interpretation of a
single entity or a group.
20

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Chapter overview
Limitations of financial statements and interpretation techniques

Limitations of IAS 24 Related Limitations of

financial statements Party Disclosures interpretation techniques

Problems with Definitions Limitations of ratio analysis

historical information

Disclosure requirements Other factors

Creative accounting

Possible effect of related

party transactions on
financial statements

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1 Limitations of financial statements

1.1 Problems of historical financial information
The information within the financial statements is historical, as it reflects the performance and
position of the entity for a prior period. Using historical financial information can be problematic
for decision making:
• Financial data quickly becomes out of date and does not necessarily reflect the current
operating conditions of an entity.
• There is no guarantee that trends in historical data will continue and they cannot be reliably
used to predict future performance.
• A change in company strategy may have occurred since the financial data was published.
Similarly, a change in management since the results were published can lead to different
market expectations about the future.

1.1.1 Historical cost basis

As was covered in Chapter 1, historical cost is a permitted measurement basis under the
Conceptual Framework. The impact on the accounting ratios of, for example, a cost vs valuation
accounting policy for non-current assets was discussed in Chapter 19. The use of historical cost
can be particularly misleading when attempting to predict future performance.

Illustration 1: Problems with historic cost

Consider the situation where an entity holds its property, which was purchased 20 years ago, at
its historic cost of £100,000. The company has decided that the property will need to be replaced
in two years’ time, at a cost of £1,000,000.
Required
Discuss the impact of the replacement of the asset on the entity’s financial statements.

Solution
The correct answer is:
The impact on the statement of financial position is likely to be relatively easy to arrive at. The
purchase of the new property will result in a significant increase in the carrying amount of the
entities assets and will require appropriate financing, hence a large loan or lease obligation is
likely.
The impact on the statement of profit or loss and other comprehensive income can be more
difficult to determine. The purchase of the new property will 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 could have led to too much profit having been 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.

1.2 Creative accounting

We have seen throughout this Workbook that there is flexibility over the accounting policy that an
entity chooses to apply (for example, cost v revaluation of property, plant and equipment) and
that judgement and estimates have to be applied (for example, in determining the amount of a
warranty provision). As a result, there is some flexibility in how certain balances and transactions
are accounted for, which can give rise to creative accounting. Creative accounting is where
management use accounting methods to work in their favour to achieve a desired effect.

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1.2.1 Pressure from investors

Listed companies produce their financial statements with one eye on the stock market and, where
possible, they like to produce financial statements which show analysts what they are expecting
to see, for example:
• Steady growth in profits
• Stable dividends
• No key ratio changes for improvement in ratios
This is often supported by the directors who may have bonus targets based on achieving certain
sales or profit targets that are aligned to investor expectations.

1.2.2 Examples of creative accounting techniques

• Removing peaks and troughs or achieving a desired profit target
- Provisions subsequently reversed
- Cut off manipulation, eg invoicing in advance to boost revenue
- Selling an asset pre-year end to realise a profit and repurchasing it post-year to end
• Reducing apparent gearing
- Window dressing, eg paying back a loan just before the year end, but taking it out again at
the beginning of the next year
The opportunities for creative accounting have decreased over recent years.

Essential reading
In Chapter 19, we discussed the importance of taking account of issues such as intragroup
trading, seasonal trading and the timing of asset acquisitions when interpreting changes or
differences in ratios. Chapter 20, Section 1 of the Essential reading covers these issues in more
detail.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

2 IAS 24 Related Party Disclosures

Related party relationships and transactions are a normal feature of business. However, it is
important that the users of financial statements are made aware of their impact on the financial
statements. There is a presumption that transactions and balances reflected in the financial
statements have been entered into on an arm’s length basis, unless it is disclosed otherwise. ‘Arm’s
length’ means on the same terms as could have been negotiated with an external party, in which
each side bargained knowledgeably and freely, unaffected by any relationship between them.

2.1 Definitions

Related party (IAS 24): A person or entity that is related to the entity that is preparing its
KEY
TERM financial statements (the ’reporting entity’).
(a) A person or a close member of that person’s family is related to a reporting entity if that
person:
(i) Has control or joint control over the reporting entity;
(ii) Has significant influence over the reporting entity; or
(iii) Is a member of the key management personnel of the reporting entity or of a parent
of the reporting entity

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(b) An entity is related to a reporting entity if any of the following conditions apply:
(i) The entity and the reporting entity are members of the same group (which means
that each parent, subsidiary and fellow subsidiary is related to the others).
(ii) One entity is an associate* or joint venture* of the other entity (or an associate or
joint venture of a member of a group of which the other entity is a member).
(iii) Both entities are joint ventures* of the same third party.
(iv) One entity is a joint venture* of a third entity and the other entity is an associate of
the third entity.
(v) The entity is a post-employment benefit plan for the benefit of employees of either
the reporting entity or an entity related to the reporting entity.
(vi) The entity is controlled or jointly controlled by a person identified in (a).
(vii) A person identified in (a)(i) has significant influence over the entity or is a member of
the key management personnel of the entity (or of a parent of the entity).
(viii) The entity, or any member of a group of which it is a part, provides key
management personnel services to the reporting entity or the parent of the reporting
entity.
*including subsidiaries of the associate or joint venture
(IAS 24: para. 9)

2.1.1 Close members of family

Close members of the family of a person are defined as ‘those family members who may be
expected to influence, or be influenced by, that person in their dealings with the entity,’ (IAS 24:
para. 9) and include:
• That person’s children and spouse or domestic partner;
• Children of that person’s spouse or domestic partner; and
• Dependants of that person or that person’s spouse or domestic partner.
In considering each possible related party relationship, attention is directed to the substance of
the relationship, and not merely the legal form.

2.1.2 Entities that are not related parties

The following are not necessarily related parties:
(a) Two entities simply because they have a director or other member of key management
personnel in common, or because a member of key management personnel of one entity has
significant influence over the other entity;
(b) Two venturers simply because they share point joint control over a joint venture
(c) Entities such as providers of finance, trade unions, public utilities, and departments and
agencies of a government, simply by virtue of their normal dealings with an entity (even
though they may affect the freedom of action of an entity or participate in its decision-
making process); and
(d) A customer, supplier, franchisor, distributor, or general agent with whom an entity transacts a
significant volume of business, simply by virtue of the resulting economic dependence.
(IAS 24: para. 11)

2.2 Disclosure requirements

IAS 24 requires transactions with related parties to be disclosed. An entity must disclose the
following:
(a) The name of its parent and, if different, the ultimate controlling party, irrespective of whether
there have been any transactions.
(b) Total key management personnel compensation (broken down by category)
(c) If the entity has had related party transactions:
(i) Nature of the related party relationship

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(ii) Information about the transactions and outstanding balances, including commitments
and bad and doubtful debts necessary for users to understand the potential effect of the
relationship on the financial statements
No disclosure is required of intragroup related party transactions in the consolidated financial
statements.
Items of a similar nature may be disclosed in aggregate, except where separate disclosure is
necessary for understanding purposes.

2.3 Possible effect of related party transactions on the financial statements

When interpreting financial statements and you are aware that there have been related party
transactions, you must consider what the effect of that transaction is on the financial statements,
particularly:
(a) Higher or lower revenue and profit due to artificial prices on transactions with related parties
(b) Costs or savings due to different terms and conditions other than prices (eg lost interest due
to longer credit periods given to related parties)
(c) Revenue that would not occur without the influence of the related party
(d) Loans to or from related parties at preferential interest rates which would impact on finance
costs/finance income

3 Limitations of interpretation techniques

3.1 Limitations of ratio analysis
In Chapter 19, we saw that ratio analysis was the starting point to understanding the performance
and position of an entity. We have to be aware that the usefulness of ratio analysis is limited by
distorting factors. For example:
• Inflation when comparing to previous years that will increase sales prices and costs in the
current year. If, for example, there has been an inflationary increase in the cost of purchasing
goods for resale but the entity has decided not to increase its sales price in the year, the gross
profit margin and net profit margin would be lower in the current year than in prior years.
• Different accounting policies/classifications when comparing to different companies. This was
discussed in Chapter 19 when we considered the impact on ROCE and asset turnover of
adopting the revaluation, rather than cost model, for non-current assets.
• The financial statements are highly aggregated and the lack of information/breakdown of
information means that ratio analysis can be of limited value for decision making.
• Year-end figures are not necessarily representative of the position of the entity over the
period. Consider, for example, an entity that is holding a large quantity of inventory at its
year-end date in preparation for an increase in seasonal trade.
• Related party transactions, as discussed in Section 2 above, make the ratios incomparable
with other companies. Remember that IAS 24 requires disclosure of related party transactions
but the effect of the transactions will remain in the financial statements.
• Different companies in the same business may have different risk profiles or specific factors
affecting them, making industry comparisons less meaningful.
• Where financial statements are manipulated through creative accounting, as discussed in
Section 1 above, this is often done to improve key ratios, which can distort comparisons.

3.2 Other factors

When analysing the performance and position of an entity, it is usually beneficial to look beyond
the financial statements and consider other relevant factors about the business:
• 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’?

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• 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 takeover?

Activity 1: Limitations of ratio analysis

Required
Which THREE of the following are valid limitations of ratio analysis of published financial
statements?
 Published financial statements are frequently unreliable as a result either of fraud or of error
on the part of management.
 Published financial statements contain estimates such as depreciation.
 There are no prior year figures to compare to current year figures.
 Accounting policies may vary between companies, making comparisons difficult.
 The nature and character of a business may change over time, making strictly numerical
comparisons misleading.
 The nature of the industry may be volatile, making intercompany comparison within the
industry misleading.

Solution

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Activity 2: Interpreting asset turnover ratio

An analyst is comparing the non-current asset turnover ratios of two listed businesses engaged in
similar activities. The non-current asset turnover ratio of one entity is almost 50% higher than that
of the other entity, and she concludes that the entity with the higher non-current asset turnover
ratio is utilising its assets far more effectively.
Required
Which THREE of the following suggest this conclusion might not be valid?
 One entity revalues its properties and the other entity holds its assets under the historical cost
model.
 One entity buys its assets for cash and the other entity leases its assets under long-term
leases for all, or substantially all, the asset’s useful life.
 One entity has assets nearing the end of their useful life, whilst the other entity has recently
acquired new assets.
 One entity depreciates its assets over a much shorter useful life than the other entity.
 One entity pays a higher rate of interest on its borrowings than the other.
 One entity has significantly higher gearing than the other.

Solution

PER alert
One of the competences you require to fulfil Performance Objective 8 of the PER is the ability
to identify inconsistencies between information in the financial statements of an entity and
accompanying narrative reports. You can apply the knowledge you obtain from this chapter
to help to demonstrate this competence.

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Chapter summary

Limitations of financial statements and interpretation techniques

Limitations of IAS 24 Related Limitations of

financial statements Party Disclosures interpretation techniques

Problems with historical Definitions Limitations of ratio analysis

information Related party is a person or Consider the impact of:
• Reflects performance and entity that is related to the entity • Inflation
position in the past by being • Different accounting policies
– Not necessarily predictive of (a) A person or a close member • Lack of detailed information
future performance of that person's family • Year end figures not being
– No guarantee that trends (b) An entity that is related to representation of balances
continue another entity throughout the year
– Entities may change strategy • Related party transactions
• Historical cost accounting • The impact of different risk
widely used Disclosure requirements profiles
– Can be misleading when (a) The name of its parent and • Manipulation of financial
trying to predict future the ultimate controlling party statements
irrespective of whether there
have been any transactions
Creative accounting (b) Total key management Other factors
• Options in accounting policies, personnel compensation Factors other than the financial
judgements and estimates (c) If the entity has had related statements may be relevant:
allows flexibility party transactions: • How technologically advanced
• Entities under pressure from (i) Nature of the related is the company?
investors to report certain party relationship • What are its environmental
results (ii) Information about the policies?
– Profit smooth over time transactions and • What is the reputation of
– Sales/profit growth as outstanding balances management and as an
expected employer?
– No large changes in ratios • What is its mission statement?
Possible effect of related party
transactions on financial
statements
• Higher or lower revenue and
profit due to artificial prices
• Costs or savings due to
different terms and conditions
• Revenue that would not occur
without the influence of the
related party
• Loans to or from related
parties at preferential interest
rates

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Knowledge diagnostic
1. Limitations of financial statements
Financial statements are limited in their usefulness due to the fact that the information is historic
and does not necessarily help to predict future performance. There is also the possibility that
careful selection of accounting policies, estimates and judgements means that the entity has
applied creative accounting techniques, which may present the performance and position of the
entity in the best light or to meet market expectations.

2. Related party transactions

Related party transactions are a normal part of business, but the users of financial statements
assume that an entity carries out transactions at an arm’s length unless information is disclosed
to the contrary. IAS 24 requires related party relationships, transactions and balances to be
disclosed.

3. Limitations of interpretation techniques

The techniques we use to interpret financial data may also be limited due to, for example, the
impact of inflation, different accounting policies for accounting for similar transactions, year-end
figures not being representative of averages for the year or related party transactions distorting
the reported information.

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
29 Webster Co

Further reading
Performance appraisal
www.accaglobal.com

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Activity answers

Activity 1: Limitations of ratio analysis

The correct answers are:
• Published financial statements contain estimates such as depreciation.
• Accounting policies may vary between companies, making comparisons difficult.
• The nature and character of a business may change over time, making strictly numerical
comparisons misleading.
‘Published financial statements are frequently unreliable as a result either of fraud or of error on
the part of management’ may be the case, but this is offset by the statutory requirement for them
to represent a true and fair view, and by the fact that most investment decisions (for example)
would involve an element of due diligence work to ensure that the accounts could, in fact, be relied
upon.
‘There are no prior year figures to compare to current year figures’ is incorrect because in
published financial statements, comparatives must be shown.
The following are problems associated with inter-temporal analysis (ie analysis of the same
company, over time):
• Changes in the nature of the business
• Unrealistic depreciation rates under historical cost accounting
• The changing value of the currency unit being reported
• Changes in accounting policies
The following are problems associated with cross-sectional analysis (ie analysis of different
companies, at the same time):
• Different degrees of diversification
• Different production and purchasing policies
• Different financing policies
• Different accounting policies
• Different effects of government incentives
Although the nature of the business being volatile will impact the accounts, the volatility will affect
all companies within the industry and thus ratio analysis will still be useful/meaningful to assess
relative performance.

Activity 2: Interpreting asset turnover ratio

The correct answers are:
• One entity revalues its properties and the other entity holds its assets under the historical cost
model.
• One entity has assets nearing the end of their useful life, whilst the other entity has recently
acquired new assets.
• One entity depreciates its assets over a much shorter useful life than the other entity.
All of these would cause the value of non-current assets to be comparatively higher in one of the
entities, thus causing a difference to the asset turnover ratio. Whether an entity buys assets for
cash or leases assets under a long-term lease, has no impact on the non-current asset turnover
ratio because in both instances, the entity will record an asset in its statement of financial
position.
If one entity had purchased its assets for cash and the other under short-term leases (less than 12
months), that would impact asset turnover as, under a short-term lease (less than 12 months), no
asset is recorded in the statement of financial position.
Neither interest nor borrowings feature in the asset turnover ratio, so the rate of interest an entity
pays is not relevant this year.

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To help with questions like this, think of the formula and what impacts the items on the top and
bottom half:
Non - current assets
Revenue

The ratio of debt to equity does not feature in the asset turnover ratio, so has no impact.

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Statement of cash flows

21
21

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Prepare a statement of cash flows for a single entity (not a D1(c)

group) in accordance with relevant accounting standards
using the indirect method.

Compare the usefulness of cash flow information with that of C3(d)

a statement of profit or loss or statement of profit or loss and
other comprehensive income.

Interpret a statement of cash flows (together with other C3(e)

financial information) to assess the performance and financial
position of an entity.
21

Exam context
The preparation of statement of cash flows is examined in the Financial Accounting unit.
Therefore, in this exam it is unlikely that you will be asked to prepare a statement of cash flows in
a long Section C question. Instead the preparation of a statement of cash flows may be tested in
the Objective Test Questions in Section A or B of the exam.
However, in a long-form Section C question, you may well be asked to interpret a statement of
cash flows. Therefore, detailed knowledge of how to perform this type of analysis is required.
21

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Chapter overview
Statement of cash flows

IAS 7 Formats Interpretation of Cash flow

Statement statement of ratio
of cash flows cash flows

Key terms Key sections of the Analysis points Provides a useful

statement of cash flows indicator of a company's
cash position

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1 IAS 7 Statement of Cash Flows

Statement of cash flows: A useful component of the financial statements because it
KEY
TERM recognises that accounting profit is not the only indicator of a company’s performance.

2 Introduction
The purpose of the statement of cash flows is to show the effect of a company’s commercial
transactions on its cash balance.
It is thought that users of accounts can readily understand cash flows, as opposed to statements
of profit or loss and other comprehensive income and statements of financial position which are
subject to the effects of accounting policy choices and accounting estimates.
It has been argued that ‘profit’ does not always give a useful or meaningful picture of a
company’s operations. Readers of a company’s financial statements might even be misled by a
reported profit figure.
Shareholders might believe that if a company makes a profit after tax, of say, $100,000 then this
is the amount which it could afford to pay as a dividend. Unless the company has sufficient cash
in the business which is available to make a dividend payment, the shareholders’ expectations
would be wrong.
Cash flows are used in investment appraisal methods such as net present value and hence a
statement of cash flows gives potential investors the chance to evaluate a business.

2.1 Objective of IAS 7

The aim of IAS 7 is to provide information to users of financial statements about the entity’s ability
to generate cash and cash equivalents, as well as indicating the cash needs of the entity. The
statement of cash flows provides historical information about cash and cash equivalents,
classifying cash flows between operating, investing and financing activities.

2.2 Scope
A statement of cash flows should be 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. Therefore, all entities
are required by the standard to produce a statement of cash flows.

2.3 Benefits of cash flow information

The use of statements of cash flows is very much in conjunction with the other elements of the
financial statements. Users can gain further appreciation of the change in net assets, of the
entity’s financial position (liquidity and solvency) and the entity’s ability to adapt to changing
circumstances by affecting the amount and timing of cash flows. A statement 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. Past forecast cash flow information can be checked for
accuracy as actual figures emerge. The relationship between profit and cash flows can be
analysed as can changes in prices over time.

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2.4 Definitions
The standard provides the following definitions.

Cash: Comprises cash on hand and demand deposits.

KEY
TERM
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.
Operating activities: The principal revenue-producing activities of the entity and other
activities that are not investing or financing activities.
Investing activities: The acquisition and disposal of long-term assets and other investments
not included in cash equivalents.
Financing activities: Activities that result in changes in the size and composition of the
contributed equity and borrowings of the entity.
(IAS 7: para. 6).

2.5 Cash and cash equivalents

The standard expands on the definition of cash equivalents (IAS 7: para. 7): they are not held for
investment or other long-term purposes, but rather to meet short-term cash commitments. To fulfil
the above definition, an investment’s maturity date should normally be within three months from
its acquisition date. It would usually be the case then that equity investments (ie shares in other
companies) are not cash equivalents. An exception would be where preferred shares were
acquired with a very close maturity date.
Loans and other borrowings from banks are classified as financing activities (IAS 7: para. 8). In
some countries, however, bank overdrafts are repayable on demand and are treated as part of an
entity’s total cash management system. In these circumstances an overdrawn balance will be
included in cash and cash equivalents. Such banking arrangements are characterised by a
balance which fluctuates between overdrawn and credit.
Movements between different types of cash and cash equivalent 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 (IAS 7: para. 9).

3 Formats
As you have seen in Financial Accounting unit, IAS 7 Statement of Cash Flows allows two possible
layouts for the statement of cash flows in respect of operating activities:
(a) The indirect method, where profit before tax is reconciled to operating cash flow
(b) The direct method, where the cash flows themselves are shown
You will only be examined on the indirect method in your Financial Reporting exam.

Exam focus point

The preparation of statement of cash flows is brought forward knowledge from the Financial
Accounting unit. Therefore, in the exam you are unlikely to be asked to prepare a full
statement of cash flows in Section C. Instead, the preparation of components in the statement
of cash flows is expected to be examined in the OTQ Sections A or B of the exam.

Essential reading
Chapter 21 Sections 1 and 2 of the Essential reading recap your knowledge of the preparing a
statement of cash flows with an Activity on this topic using the indirect method.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

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3.1 Sections of the statement of cash flows

As is shown in the ‘Proforma – indirect method’ statement of cash flows below, IAS 7 splits cash
flows into three sections:
• Cash flows from operating activities
• Cash flows from investing activities
• Cash flows from financing activities

3.2 Operating activities

Cash flows from operating activities are primarily derived from the principal revenue producing
activities of the entity. Therefore, they generally result from the transactions or other events that
enter into the determination of profit or loss.
The amount of cash flows arising from operating activities is a key indicator of the extent to which
the operations of the entity have generated sufficient cash flows to repay loans, maintain the
operating capability of the entity, pay dividends and make new investments without recourse to
external sources of finance.

3.3 Investing activities

The cash flows included in this section are those related to the acquisition or disposal of any non-
current assets or trade investments together with returns received in cash from investments, ie
dividends and interest.
This section shows the extent of new investment in assets which will generate future income and
cash flows.

3.4 Financing activities

Financing cash flows comprise receipts from or repayments to external providers of finance in
respect of principal amounts of finance. Examples of financing cash flows are:
• Cash proceeds from issuing shares
• Cash proceeds from issuing loan notes, loans, notes, bonds, mortgages and other short- or
long-term borrowings
• Cash repayments of amounts borrowed
• Dividends paid to shareholders
• Lease liability payments (repayment of principal portion only)
In order to calculate such figures, the closing statement of financial position figure for long-term
debt or share capital and share premium is compared with the opening position for the same
items. The effects of any non-cash flow changes to share capital (eg bonus issues) must also be
taken into account.

3.5 Indirect method – proforma

This is an example of a completed statement of cash flows which has been prepared using the
indirect method.

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XYZ CO
STATEMENT OF CASH FLOWS (INDIRECT METHOD) FOR YEAR ENDED 20X7
$m $m
Cash flows from operating activities
Profit before taxation 3,390
Adjustments for:
Depreciation 380
Amortisation 75
Profit on sale of property, plant and equipment (5)
Investment income (500)
Interest expense 400
3,740
Decrease in inventories 1,050
Increase in trade and other receivables (500)
Decrease in trade payables (1,740)
Cash generated from operations 2,550
Interest paid (270)
Income taxes paid (900)
Net cash from operating activities 1,380

Cash flows from investing activities

Purchase of property, plant and equipment (800)
Purchase of intangible assets (100)
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 issue of share capital 250
Proceeds from long-term borrowings 250
Payment of lease liabilities (90)
Dividends paid (1,200)
Net cash used in financing activities (790)
Net increase in cash and cash equivalents 110
Cash and cash equivalents at beginning of year 120
Cash and cash equivalents at end of year 230

3.6 Direct method

The direct method is the preferred approach of IAS 7 as it shows information not available
elsewhere in the financial statements. This is outside of scope in your syllabus, but you need to be
aware of its existence.

4 Interpretation of statement of cash flows

4.1 Introduction
IAS 7 was introduced to enable users to evaluate an entity’s ability to generate cash and cash
equivalents and of its needs to utilise those cash flows.

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While the statement of cash flows clearly shows the overall cash inflow or outflow for the period,
and the closing position of cash and cash equivalents, the individuals lines of the statement of
cash flow can be analysed to give users detailed information on how the entity has performed
during the period, and the areas which have generated significant cash inflows and outflows.

Exam focus point

In an exam question on cash flows, read the requirements carefully and then explain the
movement in the cash flows that you are required to analyse in detail.

As has been seen, the statement of cash flows consists of three main areas. It is important to
understand what the cash flows from operating activities, investing activities and financing
activities tell us about the business’ activities.

Operating In order to continue long-term, the cash from operations figure should be
activities positive. If it is positive then the business will be generating funds from its core
activities, which suggests that it is a viable entity.
A healthy business would also expect to pay the interest and tax charge from
the cash generated from operations.
When you are analysing the cash flows relating to operating activities, consider
the movement in working capital. Does this suggest strong credit control (over
trade receivables), an inventories management system which is appropriate for
the level of sales the business is generating, and that trade payables are being
paid in a reasonable time frame? If not, then there may be issues with the
business’s day-to-day operations.

Investing If the business is seeking growth, there may well be a cash outflow in respect of
activities non-current assets. If the business is struggling then large items of property,
plant and equipment may be sold in order to generate short-term cash inflows.
Investment income will also be recorded in this section and therefore, interest
received or dividend income may feature here.

Financing In respect of financing, essentially the business will receive finance from two
activities main sources – share issues or loans.

4.2 Relationship between profit and cash

It is important to appreciate that it is wrong to try to assess the health of a reporting entity solely
on the basis of a single indicator. When analysing cash flow data, the comparison should not just
be between cash flows and profit, but also between cash flows over a period of time (say three to
five years).
Cash is not synonymous with profit on an annual basis, but you should also remember that the
‘behaviour’ of profit and cash flows will be very different. Profit is smoothed out through accruals,
prepayments, provisions and other accounting conventions. This does not apply to cash, so the
cash flow figures are likely to be ‘lumpy’ in comparison. You must distinguish between this
‘lumpiness’ and the trends which will appear over time.
The relationship between profit and cash flows will vary constantly. Note that healthy companies
do not always have reported profits exceeding operating cash flows. Similarly, unhealthy
companies can have operating cash flows well in excess of reported profit. The value of
comparing them is in determining the extent to which earned profits are being converted into the
necessary cash flows.
Profit is not as important as the extent to which a company can convert its profits into cash on a
continuing basis. This process should be judged over a period longer than one year. The cash
flows should be compared with profits over the same periods to decide how successfully the
reporting entity has converted earnings into cash.

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Activity 1: Tabba Co
Here is an example of how the position and performance of a company can be analysed using the
statement of financial position, profit or loss extracts and the statement of cash flows.
The following draft financial statements relate to Tabba Co, a private company:
STATEMENTS OF FINANCIAL POSITION AS AT:
30 September 20X5 30 September 20X4
$’000 $’000 $’000 $’000
Non-current assets
Property, plant and equipment 10,600 15,800
Current assets
Inventories 2,550 1,850
Trade receivables 3,100 2,600
Insurance claim 1,500 1,200
Cash and cash equivalents 850 nil
8,000 5,650
Total assets 18,600 21,450
Equity
Share capital ($1 each) 6,000 6,000
Reserves:
Revaluation nil 1,600
Retained earnings 2,550 850
2,550 2,450
8,550 8,450
Non–current liabilities
Lease obligations 2,000 1,700
6% loan notes 800 nil
10% loan notes nil 4,000
Deferred tax 200 500
Government grants 1,400 900
4,400 7,100
Current liabilities
Bank overdraft nil 550
Trade and other payables 4,050 2,950
Government grants 600 400
Lease obligations 900 800
Current tax payable 100 1,200
5,650 5,900
Total equity and liabilities 18,600 21,450

STATEMENT OF PROFIT OR LOSS EXTRACT FOR THE YEAR ENDED 30 SEPTEMBER 20X5
$’000
Operating profit before interest and tax 270
Interest expense (260)
Interest receivable 40
Profit before tax 50
Income tax credit 50
Profit for the year 100

Note. The interest expense includes interest payable in respect of lease liabilities.

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STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 30 SEPTEMBER 20X5

$’000 $’000
Cash flows from operating activities
Profit before taxation 50
Adjustments for:
Depreciation 2,200
Profit on disposal of PPE (Note (a)) (4,600)
Release of grant (250)
Increase in insurance claim receivable (300)
Interest expense 260
Investment income (40)
(2,680)
(Increase) decrease in inventories (700)
(Increase) decrease in trade & other receivables (500)
Increase (decrease) in trade payables 1,100
Cash used in operations (2,780)
Interest paid (260)
Income taxes paid (1,350)
Net cash outflow from operating activities (4,390)
Cash flows from investing activities
Interest received 40
Proceeds of grants 950
Proceeds of disposal of property 12,000
Purchase of property, plant and equipment (2,900)
Net cash from investing activities 10,090
Cash flows from financing activities
Proceeds of loan (6% loan received) 800
Repayment of loan (10% loan repaid) (4,000)
Payments under leases (1,100)
Net cash used in financing activities (4,300)
Net increase in cash and cash equivalents 1,400
Opening cash and cash equivalents (550)
Closing cash and cash equivalents 850

Additional information
(a) During the year Tabba Co sold its factory for its fair value $12 million.
(b) Plant acquired under leases during the year gave rise to right-of-use assets of $1.5 million.

Required
Using the information above, comment on the change in the financial position of Tabba Co during
the year ended 30 September 20X5.
Note that you are not required to calculate any ratios.

Solution

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4.3 Question practice

Having seen the analysis of changes in a company’s financial position in an illustration, you
should attempt the activity which follows.

Activity 2: Interpretation of a cash flow for Emma Co

Set out below are the financial statements of Emma Co.
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X2
$’000
Revenue 2,553
Cost of sales (1,814)
Gross profit 739
Other income: interest received 25
Distribution costs (125)
Administrative expenses (264)
Finance costs (75)
Profit before tax 300
Income tax expense (140)
Profit for the year 160

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STATEMENTS 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
Trade receivables 390 315
Short-term investments 50 –
Cash and cash equivalents 2 1
Total assets 1,222 948

20X2 20X1
Equity and liabilities $’000 $’000
Equity
Share capital ($1 ordinary shares) 200 150
Share premium account 160 150
Revaluation surplus 100 91
Retained earnings 260 180
Non-current liabilities
Long-term loan 130 50

Environmental provision 40 -
Current liabilities
Trade and other payables 127 119
Bank overdraft 85 98
Taxation 120 110
Total equity and liabilities 1,222 948

STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 20X2

$’000 $’000

Cash flows from operating activities

Profit before tax 300
Depreciation charge 90
Loss on sale of property, plant and equipment 13
Profit on sale of non-current asset investments (5)
Interest expense (net) 50
(Increase)/decrease in inventories (48)
(Increase)/decrease in trade receivables (75)
Increase/(decrease) in trade payables 8
333

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Interest paid (75)

Dividends paid (80)
Tax paid (130)
Net cash from operating activities 48

Cash flows from investing activities

Payments to acquire property, plant and equipment (161)
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 flows from investing activities (124)
Cash flows from financing activities
Issue of share capital 60
Long-term loan 80
Net cash flows from financing 140
Increase in cash and cash equivalents 64
Cash and cash equivalents at 1.1.X2 (97)
Cash and cash equivalents at 31.12.X2 (33)

The following information is available.

Working capital movement
Inventory Receivables Payables
$’000 $’000 $’000
B/d 102 315 119
Increase (decrease) 48 75 8
C/d 150 390 127

Required
Refer to the financial statements and additional information relating to Emma Co.
Using the information referenced above, comment on the change in the financial position of
Emma Co during the year ended 30 September 20X5.

Solution

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Activity 3: Financial adaptability

The following is an extract from the statement of cash flows of Quebec Co for the year ended 31
December 20X1:
$m
Cash flows from operating activities 600
Cash flows from investing activities (800)
Cash flows from financing activities (200)
Net decrease in cash and cash equivalents (400)
Cash and cash equivalents at the beginning of the period 100
Cash and cash equivalents at the end of the period (300)

Required
Based on the information provided, which of the following independent statements would be a
realistic conclusion about the financial adaptability of Quebec Co for the year ended 31
December 20X1?
 The failure of Quebec Co to raise long-term finance to fund its investing activities has resulted
in a deterioration of Quebec Co’s financial adaptability and liquidity.
 Quebec Co must be in decline as there is a negative cash flow relating to investing activities.
 The management of Quebec Co has shown competent stewardship of the entity’s resources
by relying on an overdraft to fund the excess outflow on investing activities not covered by the
inflow from operating activities.
 The working capital management of Quebec Co has deteriorated year on year.

Solution

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5 Cash flow ratio

As we have seen earlier in the course, accounting ratios can be used to appraise and
communicate the position and prospects of a business by assessing whether the ratios that have
been calculated indicate a strength or weakness in the company’s affairs.
The cash flow ratio can be used to evaluate a company’s net cash inflow to its total debts.
Net cash inflow
Total debt × 100
(a) Net cash inflow from operating activities is the amount of cash which the company has
coming into the business from its operations. A suitable figure for net cash inflow can be
obtained from the statement of cash flows.
(b) Total debts are short‑term and long‑term payables, including provisions. A distinction can be
made between debts payable within one year and other debts and provisions.
This ratio is expressed as a percentage.
A company needs to be earning enough cash from operations to be able to meet its foreseeable
debts and future commitments, and the cash flow ratio, and changes in the cash flow ratio from
one year to the next, provide a useful indicator of a company’s cash position.

Illustration 1: Cash flow ratio

For the year ended 31 December 20X2, Emma Co’s net cash inflow is $48,000 and its total debt is
$502,000.
Required
Calculate Emma Co’s cash flow ratio as at 31 December 20X2. State your answer to 1 decimal
place.

Solution
The correct answer is:
Net cash inflow from operating activities 48,000
Total debt = 502,000 × 100 = 9.6%

Note that to provide useful information in respect of the company, this ratio would need to be
compared to the cash flow ratio calculated using prior year financial information, budget and/or
industry benchmarks.

6 Advantages and disadvantages of cash flow accounting

6.1 The advantages of cash flow accounting
The advantages of cash flow accounting are:
(a) Survival in business depends on the ability to generate cash. Cash flow accounting directs
attention towards this critical issue.
(b) Cash flow is more comprehensive than ‘profit’ which is dependent on accounting policy
choices and accounting estimates.
(c) 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.
(d) Cash flow reporting provides a better means of comparing the results of different companies
than traditional profit reporting.
(e) Cash flow reporting satisfies the needs of all users better:

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(i) 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.
(ii) For shareholders and auditors, cash flow accounting can provide a satisfactory basis for
stewardship accounting.
(iii) As described previously, the information needs of creditors and employees will be better
served by cash flow accounting.
(f) Cash flow forecasts are easier to prepare, as well as more useful, than profit forecasts.
(g) They can in some respects be audited more easily than accounts based on accrual
accounting.
(h) Cash flows are more easily understood than performance measures based on profit.
(i) Cash flow accounting should be both retrospective, and also include a forecast for the future.
This is of great information value to all users of accounting information.
(j) Forecasts can subsequently be monitored by the publication of variance statements which
compare actual cash flows against the forecast.

6.2 The disadvantages of cash flow accounting

The main disadvantages of cash accounting are essentially the advantages of accrual
accounting.
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.

Exam focus point

A statement of cash flows is very likely to come up in your exam, in one of the long questions,
or at least in a couple of OTQs.
In this chapter, we give you the key information, but you should also do as many statement of
cash flows questions in the Practice and Revision Kit as possible. These will give you practice
at the various items that you may have to deal with in a cash flow question in the exam.

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Chapter summary

Statement of cash flows

IAS 7 Formats Interpretation of Cash flow

Statement statement of ratio
of cash flows cash flows

Key terms • Indirect method Analysis points Provides a useful

• Cash (examinable) • Overall increase/ indicator of a company's
• Cash equivalents • Direct method decrease in cash cash position
• Operating activities (awareness only – not • What are the Calculated as:
• Investing activities examinable in FR) significant Net operating
• Financing activities components in the cash inflow
× 100
cash flows? Total debt
Key sections of the • Cash flows from
statement of cash flows operating activities
• Cash flows from • Cash flows from
operating activities investing activities
• Cash flows from • Cash flows from
investing activities financing activities
• Cash flows from
financing activities

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Knowledge diagnostic
1. IAS 7 Statement of Cash Flows
The purpose of the statement of cash flows is to show the effect of a company’s commercial
transactions on its cash balance.
Cash flows are used in investment appraisal methods such as net present value and hence a
statement of cash flows gives potential investors the chance to evaluate a business.

2. Formats
There are two methods of presenting statements of cash flows, the indirect method (which
reconciles profit to operating cash flows) and the direct method (which shows actual operating
cash flows). Only the indirect method is examined in your Financial Reporting studies.

3. Interpretation of statement of cash flows

The statement of cash flows provides users with useful information about the business’s ability to
generate cash and the source/use of cash.
It is important to analyse the reasons behind the cash flows in detail. Generally, you should seek
to explain each main component of the statement of cash flows:
• Cash flows from operating activities
• Cash flows from investing activities
• Cash flows from financing activities
Identify and explain the significant cash flows within each category and the information they give
users of this information regarding the financial stability and expected future prospects of the
business.

4. Cash flow ratio

Net cash inflow
Total debt × 100

5. Advantages and disadvantages of the statement of cash flows

A key advantage of preparing a statement of cash flow is that for users, cash flow is more
comprehensive than ‘profit’ which is dependent on accounting conventions and concepts.

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
32 Elmgrove Co

Further reading
ACCA has prepared a useful technical article on analysing a statement of cash flows, which is
available on its website:
Analysing cash flows
www.accaglobal.com

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Activity answers

Activity 1: Tabba Co
The correct answer is:
Changes in Tabba Co’s financial position
The last section of the statement of cash flows reveals a healthy increase in cash of $1.4 million.
However, Tabba Co is losing cash on its operating activities and therefore its going concern status
must be in doubt.
To survive and thrive businesses must generate cash from their operations but Tabba Co has
absorbed a net cash outflow from operating activities of $2.68 million. Whereas most companies
report higher operating cash inflows than profits, Tabba Co has reported the reverse. The main
reason Tabba Co was able to report a profit was because of the one-off $4.6 million surplus on
disposal of property, plant and equipment. There were two other items that inflated profits without
generating cash; a $300,000 increase in the insurance claim receivable and a $250,000 release
of a government grant. Without these three items Tabba Co would have reported a $5.1 million
loss before tax.
Furthermore, were it not for the disposal proceeds of $12 million from the sale of its factory, Tabba
Co would be reporting a $10.6 million net decrease in cash. Tabba Co will not be able to sell the
factory for cash in the coming year, therefore, it seems likely that the forthcoming period will see a
large outflow of cash unless Tabba Co’s trading position improves.
Despite this downturn in trade Tabba Co’s working capital balances (inventories, trade receivables
and trade payables) have all increased in the year. (In respect of current assets inventories have
increased from $1.85 million and $2.55 million and trade receivables have increased from $2.6
million to $3.1 million.) This suggests poor financial management which in turn damages cash flow.
This is indicated by the increase in the level of payables (which have increased from $2.95 million
to $4.05 million). The increase in trade payables is an indication that the directors are managing a
lack of short-term cash inflows by delaying their payments to suppliers. This policy is not
sustainable.
The income tax paid of $1.35 million in relation to the previous period is high. This suggests that
Tabba Co’s fall from profitability has been swift and steep.
There are some good signs though. Investment in non-current assets has continued, although $1.5
million of this was on right-of-use assets which are often a sign of cash shortages.
Some of the disposal proceeds have been used to redeem the expensive $4 million 10% loan and
replace it with a smaller and cheaper $800,000 6% loan. This will save $352,000 per annum.
Tabba Co’s recovery may depend on whether the circumstances causing the slump in profits can
be addressed and the company is able to generate an operating cash inflow in the near future.
The statement of cash flows has, however, highlighted some serious issues for the shareholders to
discuss with the directors at the annual general meeting.

Activity 2: Interpretation of a cash flow for Emma Co

The correct answer is:
Overall, the cash position has improved during the year as Emma Co has seen a cash inflow of
$64,000. However, the company is still in a cumulative overall negative cash position of $33,000.
The company is making a positive cash flow from operations yet the working capital cycle (cash
from receivables, cash paid to payables and cash held in inventory) has decreased the cash inflow
by $115,000 ($48,000 + $75,000 – $8,000). Management should investigate why inventories and
receivables have increased so significantly, and therefore the reasons for so much cash being held
in the working capital of the company. It may be that sales have increased proportionately to the
increase in receivables, however, if this is not the case, there may be an issue with credit control
procedures. Equally, if too much cash is held in inventories, this could highlight slow moving or
obsolete inventory, so there may need to be a review of the inventory level being held by the
company.

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There were significant cash outflows to purchase new property, plant and equipment ($161,000)
which shows that management appear to be investing in the future prospects of Emma Co. These
purchases of property, plant and equipment appear to have been partly financed by the long-
term loan that has been taken out ($80,000) and also by an issue of share capital (raising
$60,000).
Interestingly, dividends equal to the long-term loan were paid during the year. It could be
questioned why the directors decided to announce this dividend when the funds would have been
better utilised within the business. Had the directors chosen to use the money allocated to the
dividend payment to repay the long-term loan, this would have the additional bonus of reducing
Emma Co’s interest payments.

Activity 3: Financial adaptability

The correct answer is:
The failure of Quebec Co to raise long-term finance to fund its investing activities has resulted in a
deterioration of Quebec Co’s financial adaptability and liquidity.
It is good financial management to finance long-term assets (investing activities) with long-term
finance (financing activities). However, whilst Quebec Co has managed to finance some of its
investing activities from its operating activities, it has failed to raise long-term finance to cover the
remainder. Instead, it has relied on an overdraft which is both expensive and risky.
The other statements are incorrect for the following reasons:
A negative cash flow in investing activities is indicative of expansion rather than decline. Quebec
Co has not shown competent stewardship by financing long-term assets with an overdraft. As no
prior year figures are given, it is not possible to conclude on whether Quebec Co’s working capital
management has improved or deteriorated.

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Specialised, not-for-profit
22 and public sector entities

22

Learning objectives
On completion of this chapter, you should be able to:

Syllabus reference no.

Explain how the interpretation of the financial C4(a)

statement of a specialised, not-for-profit or public
sector organisations might differ from that of a profit
making entity by reference to the different aims,
objectives and reporting requirements.
22

Exam context
In the exam, you are likely to get an OTQ on the types of performance indicator used by not-for-
profit companies. You may also get asked to analyse a set of not-for-profit company financial
statements, commenting on any differences between the profit and not-for-profit ratios and
performance indicators used in each case.
22

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Chapter overview
Specialised, not-for-profit and public sector entities

Primary aims of Regulatory Performance

not-for profit and framework measurement
public sector entities

Non-profit focused IFRS Standards form the basis Three Es: Economy, efficiency,
for accounting standards effectiveness

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1 Primary aims of not-for-profit and public sector entities

Not-for-profit or public sector organisations are focussed on meeting the needs of various,
specialised groups, such as hospital users and local communities. You have already seen how
many profit-making companies use ratios to analyse performance, such as return on capital. In
this chapter, the focus is on analysing the performance of companies where the main driver is not
meeting shareholder expectations for dividends, instead the question is how the company
resources have been used or whether performance targets have been met (such as bed
occupancy in hospitals or staff training).
Examples:
• Government departments and agencies, both at national and regional levels
• Local councils
• Public-funded bodies providing health/social services (eg NHS in the UK)
• Education institutions (schools, universities, colleges)
• Charities
• Sporting bodies such as national teams or associations
Aims:
• Quality of service provision is often more important than profit
• Efficiency of use of resources is key
• Focus is often on breakeven rather than profit-making
• Need to satisfy a wide group of stakeholders

2 Regulatory framework
IFRS Standards are designed ‘to help participants in the various capital markets of the world and
other users of the information to make economic decisions’ (IASB, IASB Objectives).
The world’s capital markets tend to focus on profit and fair value (buy; hold; sell decisions) which
are concepts that are not so relevant to not-for-profit and public sector entities.
However, accountability is still very important for these entities as they often handle public funds.
The use of IFRS Standards, which are designed for ‘general purpose financial statements’, would
make the performance of not-for-profit and public sector entities more accountable and
comparable.
Accounting regimes that apply IFRS do not normally require the use of IFRS Standards for these
entities.
Other international or national bodies publish specific standards for these entities which are
applicable in some national regimes, eg:
(a) The International Federation of Accountants (IFAC) publishes International Public Sector
Accounting Standards (IPSAS), based on IFRS Standards, but adapted to the public sector.
National governments can choose to apply them.
(b) The UK publishes a Statement of Recommended Practice (SORP) for charities which, while not
compulsory, is seen as best practice.

3 Performance measurement
Profit is clearly not the key objective of a ‘not-for-profit’ organisation.
However, such organisations produce budgets, which their performance can be assessed against
and many of the performance indicators relating to efficiency (eg inventory management) will be
relevant to a not-for-profit organisation.

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3.1 The Three Es

The ‘Three Es’ (or value for money) are often a useful way of assessing performance for not-for-
profit and public sector entities:

Economy Efficiency Effectiveness

Cost of resources used How is the work What is

and the output obtained completed? achieved?

Inputs Outputs Results

Cost of used trainee Proportion of donations Percentage of rubbish

teachers instead of spent on administration collections made on time
qualified teachers: Is the and overheads
quality of grades
obtained by students
achieved by using a less
expensive resource?

3.2 Key Performance Indicators (KPIs)

Examples of Key Performance Indicators (KPIs) relevant to not-for-profit organisations. These will
depend on the type of entity and the sector in which they operate.
Public sector (hospital):
• Length of waiting lists
• Percentage of patients treated successfully
• Level of skilled staff in the departments
Public sector (local council):
• Potholes reported and corrected
• Children using school transport
• Percentage of domestic waste recycled
Private sector (charity):
• Proportion of donations spent on administration
• Humanitarian aid provided
• Cancer patients homed in the hospice
• Animals rehomed from the shelter

Exam focus point

In the exam, it is important to read the requirement carefully to ensure that you understand
what are the main objectives for the not-for-profit entity. You may be asked to select the most
appropriate KPIs for that entity.

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Activity 1: Council KPIs

Public sector entities have performance measures laid down by government, based on KPIs.
Required
Which FOUR of the following statements are likely to be financial KPIs for a local council?
 Rent receipts outstanding
 Interest paid
 P/E ratio
 Interest cover
 Dividend cover
 Financial actuals against budget
 Return on capital employed

Solution

3.3 Financial reporting issues

Problems of reporting for specialised, not-for-profit and public sector entities include:
• Multiple objectives within the entity, eg a local council will be required to report in the most
efficient way on KPIs relating to education, social, environmental, political (because of local
elections) and administrative support.
• Difficulty of measurement of non-financial indicators, eg it may not be easy to decide whether
all children in the region are attending school as not all children may be registered with the
local authority (travelling families, new families moving into the area, children educated
privately, home-schooled children).
• Problems with comparison with similar entities, eg smaller charities may lack the skill and
resources to produce multiple results for KPIs, so they may focus purely on their one objective.
Charities of a similar size are likely to have differing objectives, so comparing a medical
research charity with an educational one is difficult due to their different aims.

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• Financial constraints, how best to prioritise if resources are limited? Most charities rely on
donations or legacies, and are wholly reliant on those revenue streams. Poor publicity may
affect the flow of these donations, or a significant disaster may increase both the donations
and change the priorities of the charity. Governments will be dependent on income from
taxation affecting how they can use their resources.
• Pressures of external factors, which may be social, political or legal. Charities, especially those
operating on an international basis, may be affected by political changes including the
outbreak of conflict affecting their ability to carry out their activities.

Essential reading
There are additional activities and information available in Chapter 23 of the Essential reading.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

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Chapter summary

Specialised, not-for-profit and public sector entities

Primary aims of Regulatory Performance

not-for profit and framework measurement
public sector entities

Non-profit focused IFRS Standards form the basis Three Es: Economy, efficiency,
• Government departments for accounting standards effectiveness
• Local councils • IPSAS 42 standards in issue • KPIs will be dependent on the
• Public funded bodies • SORP in the UK (non type of entity and the sector in
• Educational institutions compulsory) which they operate
• Charities • Problems with reporting can be
• Sporting bodies caused by:
– Multiple objectives
– Difficult of non-financial
indicators
– Comparison may be difficult
– Financial constraints
– Social, political and legal
barriers

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Knowledge diagnostic
1. Primary aims of not-for-profit and public sector entities
Entities will have different KPIs dependent on their main objectives rather than a reliance on profit
as a measure of performance.
There are different types of entities, including public sector (national and local government, local
councils) and charities (such as health, raising awareness of environmental measures or animal or
human welfare).

2. Regulatory framework
IFAC produces a framework, based upon IFRS Standards, but which has additional guidance on
topics which are covered only in the not-for-profit and public sector (such as guidance on
governmental reporting).

3. Performance measurement
• The Three Es (economy, efficiency and effectiveness)
• Wide range of KPIs available which will be reported on dependent on the main objectives of the
entity
• Problems in reporting the performance include external issues such as political and legal
barriers, problems with comparison between different charities and the often limited resources
of the entity restricting the achievement of the objectives

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Further study guidance

Question practice
Now try the following from the Further question practice bank (available in the digital edition of
the Workbook):
3(b) Standard setters
33 Measurement

Further reading
ACCA has useful articles online, including two which are Performance Management articles, but
relevant to the FR qualification:
Not for profit organisations (part 1)
Not for profit organisations (part 2)
Performance appraisal (Financial Reporting article)
www.accaglobal.com

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Activity answers

Activity 1: Council KPIs

The correct answers are:
• Rent receipts outstanding
• Interest paid
• Interest cover
• Financial actuals against budget
The council will need to ensure that they can service any debts or loans, therefore the interest KPIs
are useful. The local council will need to compare actuals against budget, as they will need to
explain where the resources have been used and explain any overruns. Councils often have social
housing and will need to ensure that the rents are paid and any in arrears are managed.

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Index

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A Capitalised provision costs, 334

Accounting for revaluations, 79 Carrying amount, 55, , 93
Accounting policies, 423 Carrying amount of deferred tax assets, 381
Accounting profit, 371 Cash, 528
Accrual accounting, 5 Cash and cash equivalents, 528
Acquired intangible assets, 74, 75 Cash equivalents, 528
Acquisition of another entity, 156 Cash flows, 528
Active market, 79 Cash-generating unit, 93, 95, 427
Adopting a new accounting policy, 423 Changes in accounting estimates, 424
Advantages of the historical cost basis for Changes in accounting policies, 423
measurement, 11 Changes in tax rates, 379
Advantages of using current value, 12 Chile, 34
Africa, 34 China, 32
Agricultural produce, 361 Classification as held for sale, 427
Allocating transaction price to performance Companies Act 2006, 34
obligations, 124
Comparability, 6, 424
Amortisation/impairment tests, 80
Complex assets, 53
Amortised cost, 284
Conceptual Framework, 4
Analysis of cash flow, 494
Consignment arrangements, 130
Analysis of consolidated financial statements,
Constructive obligation, 333, 338
493
Contingent asset, 341,
Applies the change retrospectively, 424
Contingent liability, 340,
Argentina, 34
Contract, 120, 301
Asset, 8
Contract asset, 126
Asset turnover, 481
Contract liability, 126
Associate, 156, 245
Control, 156
B Cost, 55,
Bearer plants, 361 Cost constraint, 6, 9
Bill and hold arrangements, 131 Cost model, 79
Biological assets, 361, Costs of conversion, 357
Biological transformation, 361 Costs of disposal, 427
Bolivia, 34 Costs of purchase, 357
Bonus fraction, 459, 461 Creative accounting, 513
Bonus issue, 459 Creative accounting techniques, 514
Borrowing costs, 59, Criteria for control, 157
Borrowing costs eligible for capitalisation, 59 Current asset, 397
Brazil, 34 Current cost of a liability, 12
Break-up basis, 5 Current cost of an asset, 12
Business combination, 75 Current liabilities, 397
Current ratio, 484
C
Current tax, 371, 372
Calculation of lease liability, 303
Current value, 10, 11
Canada, 32
Capital, 13 D
Capital maintenance, 13 Decommissioning costs, 334

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Deductible temporary differences, 371 Faithful representation, 5

Deferred tax, 373 Financial Accounting Standards Board (FASB),
Deferred tax assets, 371 33
Deferred tax liabilities, 371 Financial asset, 279
Depreciation and amortisation, 99 Financial assets at amortised cost, 286
Depreciation of complex assets, 53 Financial assets at fair value, 285
Derecognition, 10, Financial capital maintenance, 14
Development, 76 Financial instrument, 279, 457
Development costs, 377 Financial liability, 279
Diluted eps, 464 Financing activities, 528
Dilution, 457 First in, first out (FIFO), 358
Direct method, 528 Foreign currency, 432
Discontinued operation, 429 Forgivable loans, 132
Discounting the provision, 332 France, 34
Discussion Papers, 32 French Guiana, 34
Disposal group, 427 Frequency of revaluations, 79
Dividend cover, 491 Functional currency, 432
Dividend income from the subsidiary, 223 Fundamental qualitative characteristics, 5
Dividend yield, 491 Future operating losses, 337

E G
Earnings, 457 G20 economies, 32
Economic resources, 5 Gain on bargain purchase, 186
Effective interest rate, 284 Gearing, 489
Elements of the financial statements, 8 General purpose financial statements, 4
Enhancing qualitative characteristics, 5, 6 Germany, 32
Environmental costs, 334 Going concern, 5
Environmental policies, 516 Goodwill, 75, 160,
Eps as a performance indicator, 467 Goodwill calculation, 181
Equity, 8 Government grants, 132
Equity instrument, 280, 457 Grants for non-depreciable assets, 132
Equity method, 246 Grants related to assets, 132
European Commission, 33 Grants relating to income, 132
Events after the reporting period, 343, Gross profit margin, 483
Expenses, 8 Group, 156
Exposure Drafts, 32, 35 Group financial statements, 159
Extended warranties, 333 H
F Historical cost, 10, 11

Factoring of receivables, 283 I

Fair value, 11, 55, 186, 427 IAS 1 Presentation of Financial Statements, 17,
Fair value less costs of disposal, 93, 307, 395
Fair value through other comprehensive income IAS 10 Events After the Reporting Period, 329,
(FVTOCI), 285 343
Fair value through profit or loss (FVTPL), 285 IAS 12 Income Taxes, 371

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IAS 16 Property, Plant and Equipment, 47, 306, Interpreting asset turnover ratio, 518
IAS 2 Inventories, 357 Intragroup dividends, 223
IAS 20 Accounting for Government Grants, 132 Inventories, 357
IAS 21 The Effects of Changes in Foreign Inventory holding period, 486
Interest Rates, 432 Investing activities, 528
IAS 24 Related Party Disclosures, 514 Investment property, 55
IAS 27 Separate Financial Statements, 158, 246 Investment property (IAS 40), 55,
IAS 28 Investments in Associates and Joint
Ventures, 246 J
IAS 36 Impairment of Assets, 93, 306 Japan, 34
IAS 37 Provisions, Contingent Liabilities and Judgement, 423
Contingent Assets, 329
IAS 38 Intangible Assets, 377
K
IAS 40 Investment Property, 307 Key Performance Indicators (KPIs), 550

IAS 41 Agriculture, 361 L

IAS 7 Statement of Cash Flows, 527 Lease, 301
IAS 8 Accounting Policies, Changes in Legal and constructive obligations, 331
Accounting Estimates and Errors, 132, 423
Legal obligation, 333
IASB Conference, 35
Let out clause, 342
Identifiable non-monetary asset, 73
Liability, 8
Identify the performance obligations, 122
Limitations of eps, 467
IFRS 13 Fair Value Measurement, 11, 361
Limitations of ratio analysis, 516
IFRS 15 Revenue from Contracts with
Customers, 310 Limitations of the historical cost basis for
measurement, 11
IFRS 15 – Five steps to recognise and measure
revenue, 121 Limitations of using current value, 12

IFRS 15, Revenue from Contracts with Low-value leases, 309

Customers, 333
M
IFRS 3 Business Combinations, 160, , 180
Management’s stewardship, 5
IFRS 9 Financial Instruments, 156,
Matching, 5
IFRS Interpretations, 35
Measurement, 10
IFRS Interpretations Committee, 35
Measurement of financial assets, 284
Impairment indicators, 95
Measurement of financial liabilities, 288
Impairment losses and inventory losses, 378
Mid‑year acquisitions, 222
Impairment loss, 93
Mission statement, 517
Income, 8
Monetary assets, 73
Indirect method, 528
Inflation, 516 N
Intangible asset, 73 Negative goodwill, 186
Interest cover, 490 Net profit margin, 481
Internally generated intangible assets, 74, 76 Net realisable value, 358,
International Accounting Standards (IAS), 31 Non-cash consideration, 123
International Accounting Standards Committee Non-current assets, 397
(IASC), 31 Not-for-profit, 549
International Public Sector Accounting
Standards (IPSAS), 549

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O Recognition of impairment losses, 96

Objective of general purpose financial Recoverable amount, 93, 427
reporting, 5 Regulatory framework, 31
Objectives of the IASB, 32 Related party (IAS 24), 514
Obligating event, 331 Relevance, 5
Onerous contracts, 337 Reliable estimate, 331
Operating activities, 528 Repayment of grants, 132
Operating cycle, 397 Replacements and Overhauls, 54
Options, warrants and their equivalents, 457 Research, 76
Ordinary shares, 457 Restructuring, 338
Owner-occupied property, 55 Restructuring and future operating losses, 188,
Return on capital employed, 480
P
Return on equity, 483
Parent, 156
Revaluation model, 79
Payables payment period, 487
Revaluation of depreciated assets, 48
Performance obligation, 120
Revaluation of non-current assets, 377
Performance obligation is satisfied, 121
Revaluation surplus, 47
Performance obligations satisfied over time,
125 Reversal of an impairment loss, 100
Physical capital maintenance, 14 Reversing a previous decrease in value, 47
Potential ordinary share, 457, 464 Right-of-use asset, 305
Power, 156 Rights issue, 461
Present obligation, 331 ROCE, 481
Present obligations and obligating events, 331 Russian Federation, 34
Presentation currency, 434 S
Price/earnings (P/E) ratio, 491
Sale and leaseback transactions, 310
Primary users, 5
Short term liquidity and efficiency, 484
Principle of revenue recognition, 120
Short-term leases, 309
Principles-based versus rules-based, 31
Significant influence, 157, 245
Prior period errors, 425
Statement of cash flows, 527
Probable that an outflow of resources, 331
Statement of financial position, 395
Problems of historical financial information, 513
Statement of profit or loss and other
Profitability ratios, 480 comprehensive income, 398
Provision, 331, 379 Statement of Recommended Practice (SORP),
Provisions for restructuring, 338 549
Public sector, 549 Subsequent measurement of the right-of-use
asset, 306
Q Subsidiary, 156
Qualitative characteristics, 5
T
Quick (acid-test) ratio, 485
Tax base, 371
R Tax expense (tax income), 371
Ratio analysis, 479 Taxable profit (tax loss), 371
Receivables collection period, 487 Taxable temporary difference, 375
Recognition, 9 Taxable temporary differences, 371
Recognition criteria, 75 Temporary difference, 371

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The existence of a variable financing

component, 123
The International Accounting Standards Board
(IASB), 31
The International Federation of Accountants
(IFAC), 549
The Three Es, 550
Theoretical ex-rights price (TERP), 461
Timeliness, 7
Transaction is not a sale per IFRS 15, 312
Transaction price, 120
Transfer of control, 120
Transfers to or from investment property, 57

U
UK, 34
Underlying asset, 301
Understandability, 7
US GAAP, 31
USA, 32

V
Value in use, 12, , 427
Value in use of an asset, 93
Variable consideration, 123
Verifiability, 6

W
Warranties, 131, 333
Weighted average cost, 358
Working capital cycle, 488
World Bank, 32

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Index 563
 t.me/accaleaks

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564 Financial Reporting (FR)
 t.me/accaleaks

Bibliography

These materials are provided by BPP

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566 These materials are provided by BPP

Financial Reporting (FR)
 t.me/accaleaks

ACCA (2019) Examiner’s report Financial Reporting (FR) September 2017 [Online] from:
www.accaglobal.com [Accessed October 2019]
ACCA (2019) Examiner’s report Financial Reporting (FR) December 2017 [Online] from:
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ACCA (2019) Examiner’s report Financial Reporting (FR) March 2018 [Online] from:
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ACCA (2019) Examiner’s report Financial Reporting (FR) June 2018 [Online] from:
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ACCA (2019) Examiner’s report Financial Reporting (FR) September 2018 [Online] from:
www.accaglobal.com [Accessed October 2019]
ACCA (2019) Examiner’s report Financial Reporting (FR) December 2018 [Online] from:
www.accaglobal.com [Accessed October 2019]
ACCA (2019) Examiner’s report Financial Reporting (FR) March 2019 [Online] from:
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ACCA (2019) Examiner’s report Financial Reporting (FR) June 2019 [Online] from:
www.accaglobal.com [Accessed October 2019]
ACCA (2018) Tell me a story [Online] from: www.accaglobal.com/uk/en/student/exam-support-
resources/fundamentals-exams-study-resources/f7/technical-articles/analysis.html [Accessed
October 2019]
ACCA (2018) Deferred tax [Online] from: www.accaglobal.com/uk/en/student/exam-support-
resources/professional-exams-study-resources/strategic-business-reporting/technical-articles/de
ferred-tax.html [Accessed October 2019]
ACCA (2018) Analysing a statement of cash flows [Online] from:
www.accaglobal.com/uk/en/student/exam-support-resources/fundamentals-exams-study-
resources/f7/technical-articles/analysing-cashflows.html [Accessed October 2019]
IFRS Foundation (2018) IFRS [Online] Available at: http://eifrs.ifrs.org [Accessed October 2019]
International Accounting Standards Board (1989) Framework for the Preparation and Presentation
of Financial Statements. [Online] Available from: http://eifrs.ifrs.org [Accessed October 2019]
International Accounting Standards Board (2001) Statement of Cash Flows IAS 7 [Online] Available
from http://eifrs.ifrs.org [Accessed October 2019]
International Accounting Standards Board (2001) Income Taxes IAS 12 [Online] Available from
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International Accounting Standards Board (2001) Provisions, Contingent Liabilities and
Contingent Assets IAS 37 [Online] Available from http://eifrs.ifrs.org [Accessed October 2019]
International Accounting Standards Board (2003) Property, Plant and Equipment IAS 16 [Online]
Available from http://eifrs.ifrs.org [Accessed October 2019]
International Accounting Standards Board (2003) The Effects of Changes in Foreign Exchange
Rates IAS 21 [Online] Available from http://eifrs.ifrs.org [Accessed October 2019]
International Accounting Standards Board (2003) Earnings per Share IAS 33 [Online] Available
from http://eifrs.ifrs.org [Accessed October 2019]
International Accounting Standards Board (2003) Financial Instruments: Presentation IAS 32
[Online] Available from http://eifrs.ifrs.org [Accessed October 2019]
International Accounting Standards Board (2003) Inventories IAS 2 [Online] Available from
http://eifrs.ifrs.org [Accessed October 2019]
International Accounting Standards Board (2003) Accounting policies, Changes in Accounting
Estimates and Errors IAS 8 [Online] Available from http://eifrs.ifrs.org [Accessed October 2019]
International Accounting Standards Board (2003) Events after the Reporting Period IAS 10 [Online]
Available from http://eifrs.ifrs.org [Accessed October 2019]

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International Accounting Standards Board (2004) Impairment of Assets IAS 36 [Online] Available
from http://eifrs.ifrs.org [Accessed October 2019]
International Accounting Standards Board (2004) Intangible Assets IAS 38 [Online] Available from
http://eifrs.ifrs.org [Accessed October 2019]
International Accounting Standards Board (2004) Business Combinations IFRS 3 [Online] Available
from http://eifrs.ifrs.org [Accessed October 2019]
International Accounting Standards Board (2004) Non-current Assets Held for Sale and
Discontinued Operations IFRS 5 [Online] Available from http://eifrs.ifrs.org [Accessed October
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[Online] Available from http://eifrs.ifrs.org [Accessed October 2019]
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[Online] Available from http://eifrs.ifrs.org [Accessed October 2019]
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from http://eifrs.ifrs.org [Accessed October 2019]
International Accounting Standards Board (2016) Due Process Handbook [Online] Available from:
http://eifrs.ifrs.org [Accessed October 2019]
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05.html [Accessed February 2020]

568 These materials are provided by BPP

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