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The aims of Paper F7, Financial Reporting are 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. The paper also forms the basis of the assumed knowledge required in Paper P2, Corporate Reporting.

On successful completion of Paper F7, candidates should be able to:

discuss and apply a conceptual framework for accounting

discuss a regulatory framework for financial reporting

prepare and present financial statements that conform with International Financial Reporting Standards (IFRS)

account for business combinations in accordance with IFRS

analyse and interpret financial statements.

Paper F7 builds on the knowledge and skills acquired from Paper F3, Financial Accounting. Paper F7 will provide the platform for progression to Paper P2, Corporate Reporting and (to a lesser extent) to Paper P3, Business Analysis. Knowledge obtained from studies of financial reporting will also be very relevant to many aspects of the Paper F8, Audit and Assurance syllabus.

As indicated, a substantial element of Paper F7, Financial Reporting is the requirement to understand and apply accounting standards. Not all accounting

financial reportingstandards are examinable; the examinable documents for each paper are regularly updated and published in student accountant.

Modern accounting standards can be very detailed and complex, and it would be inappropriate to expect candidates at this level to have a complete knowledge of such standards. Therefore, candidates will be expected to understand the main principles and objectives of accounting standards, and to be able to apply these when required to produce financial statements that are made available publicly (often referred to as published accounts questions) and in scenario questions.

A further important aspect of the syllabus is the theoretical and conceptual issues that underpin both accounting standards and generally accepted accounting principles, and the regulatory issues controlling the reporting of financial information to users. Much of the conceptual knowledge is to be found in the IASB’s Framework for the Preparation and Presentation of Financial Statements (Framework), whereas an understanding of the role of the IASB is an important element of the regulatory framework.

The concept of business combinations, and the preparation of consolidated financial statements (group accounts), is introduced to students in Paper F7. Accounting for business combinations can be seen as a progression from preparing the financial statements of a single entity. Consolidation questions will be limited to a parent company and one subsidiary, with the possible inclusion of an associate that will require equity accounting.

It should be noted that joint ventures are not examinable in Paper F7 (they were included in Paper 2.5).

Candidates may observe that some accounting standards appear in all three financial accounting papers. This illustrates the relationship between the papers, and reflects the continuity and progression of the syllabus. Where a topic that appears in Paper F3 is also included in Paper F7, any examination of that topic will be at a higher level, requiring greater understanding and appropriately higher skills.

The final element of the syllabus is the analysis and interpretation of financial statements. This section also includes the preparation and interpretation of cash flow statements, which should be seen as playing an important role in the assessment of an entity’s financial position. Along with basic group accounting, this is also an area that was previously included at a lower level, but is now examined for the first time in Paper F7. As a result, questions are expected to include more calculation of ratios, and a requirement to explain what particular ratios are intended to measure.

To summarise, candidates need to understand the theory and concepts underlying the preparation and regulation of an entity’s financial reports, to apply their knowledge of accounting standards to prepare financial statements of both single entities and groups, and finally, to demonstrate their analytical skills to assess the performance of entities based on the information provided by those financial statements.

examiner’s approach to Paper F7

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Format and structure of the examinationThe three-hour examination will comprise five compulsory questions, which differs from the format of the previous equivalent paper (Paper 2.5) where there was an element of choice. One of the reasons for this change is to counter what seemed to be a growing practice of only studying the ‘core’ topics (groups, published accounts, and interpretation). Such a strategy is very short term; it does not provide the breadth of knowledge required for progression to the Professional level nor does it provide the background knowledge required for workplace development. To further encourage broader study, candidates should be aware that an individual question may often involve elements that relate to different subject areas of the syllabus.

Question 1This will be a 25-mark question on aspects of business combinations. It will be largely computational (at least 20 marks), and may have a short written element. The computational element will test consolidated income statements and/or balance sheets. It will include no more than one subsidiary, but possibly also an associate. Candidates will need to master the concept of pre- and post-acquisition profits, calculation of goodwill and minority interests, and deal with fair value adjustments and elimination of intra-group transactions. The written element will test some of the principles of business combinations, such as the definition of a subsidiary, why an associate is equity accounted for, why it is necessary to use fair values for the subsidiary, and why intra-group transactions are eliminated. Past experience reveals that candidates are often very capable in the techniques of preparing group financial statements but, when asked, do not really know what these techniques achieve.

The question in the Pilot Paper suitably illustrates these points. It requires the consolidation of a subsidiary and equity accounting of an associate. This is preceded by a requirement to discuss how (and, implicitly, why) the three investments of the parent should be treated: there is control of one so it is a subsidiary, there is (presumed) influence

over another so it is an associate, and the final investment is a loan to the subsidiary – which is an intra-group cancelling item.

Question 2 This will be a 25-mark question requiring the preparation (or restatement) of a single entity’s financial statements. Information may be in the form of a trial balance accompanied by several notes that will need to be taken into account in preparing the financial statements. Alternatively, draft financial statements may be given that require adjustment and restatement for several items in accompanying notes. This question will be similar to the style and format of Question 2 in the previous Paper 2.5 exam. A common feature of this type of question is that it may include material from several topic areas and require the application of several accounting standards. For example, it may require accounting for a finance lease, the revaluation or impairment (and subsequent depreciation) of non-current assets, dealing with investment properties, issues of shares and loan notes, and calculating earnings per share figures. Occasionally, candidates may be asked to comment on the appropriateness or acceptability of management’s opinion or chosen accounting treatment. The Pilot Paper question is typical of what can be expected.

Question 3This will be a 25-mark question on aspects of the analysis and interpretation of financial statements. It will be similar to Question 4 in the Paper 2.5 examination. It may require the preparation of a cash flow statement and the calculation of certain ratios prior to their analysis. The scenario of the question may be quite varied, perhaps comparing two companies with a view to a prospective purchaser acquiring one of them. It may be to assist management in determining how corporate actions may have affected an entity’s performance (similar to the Pilot Paper question). Candidates will need an awareness of how certain transactions or events may have affected a valid comparison. For example, the revaluation of a property during a period will affect return on capital employed, compared to what it would have been had

it not been revalued. This is important when considering trend analysis. It is in this question that reference may be made to specialised, not-for-profit, and public sector entities as in the Pilot Paper. The Paper 2.5 syllabus (and examination notes) contained material on IFRS 8, Operating Segments, and IAS 24, Related Parties. These do not appear in the new syllabus. The main reason for this is that these standards contain many detailed definitions and disclosure requirements that can be learned by rote, and therefore do not merit detailed examination at this level. However, the effect that related parties can have on an entity’s financial statements is potentially very material, and candidates will be expected to be aware of this possibility when interpreting an entity’s financial statements (related party effects may also be important within business combinations). Occasionally, the interpretation question may be set in a segmental scenario. Note that neither of these possibilities will require specific knowledge of IFRS 8 or IAS 24.

Questions 4 and 5Questions 4 (15 marks) and 5 (10 marks) will cover the remainder of the syllabus. Within these questions, the Framework and accounting concepts will be a familiar theme, often related to practical examples of their application. For example, Question 4 of the Pilot Paper asks about the qualitative characteristics of information, and follows this up with three small examples of accounting treatment based on one or more of these characteristics. Question 5, on construction contracts, is preceded by a consideration of the (conceptual) issues of revenue recognition as applied to the particular circumstances of construction contracts (ie their durations normally span two or more accounting period-ends).

ConclusionI hope the above will be of assistance to candidates and tutors. This article should be read in conjunction with other related published material including the Syllabus, Study Guide, and Pilot Paper.

Steve Scott is examiner for Paper F7, Financial Reporting

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measurement and depreciation

This is the first of two articles which consider the main features of IAS 16, Property, Plant and Equipment (PPE). Both articles are relevant to students studying the International or UK stream. The series will primarily focus on the requirements of IAS 16, but will also compare IAS 16 with the equivalent UK standard, FRS 15, Tangible Fixed Assets. These standards deal with the four main aspects of financial reporting of PPE that are likely to be of major relevance in the exams, namely:

initial measurement and depreciation – covered in this article

revaluation and derecognition – covered in the second article.

property, plant and equipment, and tangible fixed assetsrelevant to CAT Papers 3 and 6, and new ACCA Qualification Papers F3 and F7

Note: There are no significant differences between IAS 16 and FRS 15 as far as either initial measurement or depreciation of PPE are concerned.

IAS 16 defines PPE as tangible items that are: held for use in the production or supply of

goods or services, for rental to others, or for administrative purposes

and expected to be used during more than one

accounting period.

THE INITIAL MEASUREMENT OF PPE IAS 16 requires that PPE should initially be measured at ‘cost’. The cost of an item of PPE comprises:

the cost of purchase, net of any trade discounts plus any import duties and non-refundable sales taxes

any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.

These are costs that would have been avoided if the asset had not been purchased or constructed. General overhead costs cannot be allocated to the cost of PPE. Directly attributable costs include:

employee benefits payable to staff installing, constructing, or initially testing the asset

site preparation professional fees directly associated with

the installation, construction, or initial testing of the asset

any other overhead costs directly associated with the installation, construction, or initial testing of the asset.

Where these costs are incurred over a period of time (such as employee benefits), the period for which the costs can be included in the cost of PPE ends when the asset is ready for use, even if the asset is not brought into use until a later date. As soon as an asset is capable of operating it is ready for use. The fact that it may not operate at normal levels immediately,

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Employment costs (Note 1) 1,800Production overheads directly related to the construction (Note 2) 1,200Allocated general administrative overheads 600 Architects’ and consultants’ fees directly related to the construction 400Costs of relocating staff who are to work at the new factory 300Costs relating to the formal opening of the factory 200Interest on loan to partly finance the construction of the factory (Note 3) 1,200

Note 1The factory was constructed in the eight months ended 31 May 20X7. It was brought into use on 30 June 20X7. The employment costs are for the nine months to 30 June 20X7.

Note 2The production overheads were incurred in the eight months ended 31 May 20X7. They included an abnormal cost of $200,000, caused by the need to rectify damage resulting from a gas leak.

Note 3Omega received the loan of $12m on 1 October 20X6. The loan carries a rate of interest of 10% per annum.

Note 4The factory has an expected useful economic life of 20 years. At that time the factory will be demolished and the site returned to its original condition. This is a legal obligation that arose on signing the contract to purchase the land. The expected costs of fulfilling this obligation are $2m. An appropriate annual discount rate is 8%.

RequirementCompute the initial carrying value of the factory (see Table 1 for solution).

DEPRECIATION OF PPEIAS 16 defines depreciation as ‘the systematic allocation of the depreciable amount of an asset over its useful life’. ‘Depreciable amount’ is the cost of an asset, cost less residual value,

because demand has not yet built up, does not justify further capitalisation of costs in this period. Any abnormal costs (for example, wasted material) cannot be included in the cost of PPE.

IAS 16 does not specifically address the issue of whether borrowing costs associated with the financing of a constructed asset can be regarded as a directly attributable cost of construction. This issue is addressed in IAS 23, Borrowing Costs. IAS 23 requires the inclusion of borrowing costs as part of the cost of constructing the asset. In order to be consistent with the treatment of ‘other costs’, only those finance costs that would have been avoided if the asset had not been constructed are eligible for inclusion. If the entity has borrowed funds specifically to finance the construction of an asset, then the amount to be capitalised is the actual finance costs incurred. Where the borrowings form part of the general borrowing of the entity, then a capitalisation rate that represents the weighted average borrowing rate of the entity should be used.

The cost of the asset will include the best available estimate of the costs of dismantling and removing the item and restoring the site on which it is located, where the entity has incurred an obligation to incur such costs by the date on which the cost is initially established. This is a component of cost to the extent that it is recognised as a provision under IAS 37, Provisions, Contingent Liabilities and Contingent Assets. In accordance with the principles of IAS 37, the amount to be capitalised in such circumstances would be the amount of foreseeable expenditure appropriately discounted where the effect is material.

EXAMPLE 1On 1 October 20X6, Omega began the construction of a new factory. Costs relating to the factory, incurred in the year ended 30 September 20X7, are as follows:

$000Purchase of the land 10,000Costs of dismantling existing structures on the site 500Purchase of materials to construct the factory 6,000

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or other amount (for more on the revaluation of the asset, see the second article in the August 2007 issue of student accountant). Depreciation is not providing for loss of value of an asset, but is an accrual technique that allocates the depreciable amount to the periods expected to benefit from the asset. Therefore assets that are increasing in value still need to be depreciated.

IAS 16 requires that depreciation should be recognised as an expense in the income statement, unless it is permitted to be included in the carrying amount of another asset. An example of this practice would be the possible inclusion of depreciation in the costs incurred on a construction contract that are carried forward and matched against future income from the contract, under the provisions of IAS 11.

A number of methods can be used to allocate depreciation to specific accounting periods. Two of the more common methods, specifically mentioned in IAS 16, are the straight line method, and the reducing (or diminishing) balance method.

The assessments of the useful life (UL) and residual value (RV) of an asset are extremely subjective. They will only be known for certain after the asset is sold or scrapped, and this is too late for the purpose of computing annual depreciation. Therefore, IAS 16 requires that the estimates should be reviewed at the end of each reporting period. If either changes significantly, then that change should be accounted for over the remaining estimated useful economic life.

EXAMPLE 2 An item of plant was acquired for $220,000 on 1 January 20X6. The estimated UL of the plant was five years and the estimated RV was $20,000. The asset is depreciated on a straight line basis. On 31 December 20X6 the future estimate of the UL of the plant was changed to three years, with an estimated RV of $12,000.

At the date of purchase, the plant’s depreciable amount would have been $200,000 ($220,000 - $20,000). Therefore, depreciation of $40,000 would have been charged in 20X6, and the carrying value would

have been $180,000 at the end of 20X6. Given the reassessment of the UL and RV, the depreciable amount at the end of 20X6 is $168,000 ($180,000 - $12,000) over three years. Therefore, the depreciation charges in 20X7, 20X8 and 20X9 will be $56,000 ($168,000/3) unless there are future changes in estimates. Where an asset comprises two or more major components with substantially different economic lives, each component should be accounted for separately for depreciation purposes, and each depreciated over its UL.

EXAMPLE 3On 1 January 20X2, an entity purchased a furnace for $200,000. The estimated UL of the furnace was 10 years, but its lining needed replacing after five years. On 1 January 20X2 the entity estimated that the cost of relining the furnace (at 1 January 20X2 prices) was $50,000. The lining was replaced on 1 January 20X7 at a cost of $70,000.

TABLE 1: SOLUTION TO EXAMPLE 1

SolutionComponent Amount Reason $000 Purchase of the site 10,000 Cost includes cost of purchaseDismantling costs 500 Site preparation costs represent a direct cost of getting the asset ready for useMaterials 6,000 All used in constructing the factoryEmployment costs 1,600 Allowed to include employment costs in the construction period, so 8/9 x 1,800 includedProduction overheads 1,000 Production overheads a direct cost of getting the asset ready for use but must exclude abnormal elementAdministrative overheads Nil Only direct costs allowed to be capitalisedArchitects’ fees 400 Architects’ fees a direct cost of getting the asset ready for useRelocation costs Nil Specifically disallowed by IAS 16 – not part of getting the asset ready for useCosts of opening the factory Nil Specifically disallowed by IAS 16 – not part of getting the asset ready for useCapitalised interest 800 As per IAS 23, can capitalise interest for the period of construction (ie 12,000 x 10% x 8/12)Restoration costs 429 The present value of $2m payable in 20 years at 8%Total cost of factory 20,729

RequirementCompute the annual depreciation charges on the furnace for each year of its life.

Solution20X2–20X6 inclusiveThe asset has two depreciable components: the lining element (allocated cost $50,000 – UL five years); and the balance of the cost (allocated cost $150,000 – UL 10 years). Therefore, the annual depreciation is $25,000 ($50,000 x 1/5 + $150,000 x 1/10). At 31 December 20X6, the ‘lining component’ has a written down value of zero.

20X7–20Y1 inclusiveThe $70,000 spent on the new lining is treated as the replacement of a separate component of an asset and added to PPE. The annual depreciation is now $29,000 ($70,000 x 1/5 + $150,000 x 1/10).

Paul Robins is a lecturer at FTC Kaplan

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revaluation and derecognition

This is the second of two articles, and considers revaluation of property, plant and equipment (PPE) and its derecognition. The first article, published in the June/July 2007 issue of student accountant, considered the initial measurement and depreciation of PPE.

There are rather more differences between IAS 16, Property, Plant and Equipment (the international standard) and FRS 15, Tangible Fixed Assets (the UK standard) in relation to revaluation and derecognition compared to initial measurement and depreciation. For both topics addressed in this article, the international position is outlined first, and then compared to the UK position.

REVALUATION OF PPE – IAS 16 POSITIONGeneral principlesIAS 16 allows entities the choice of two valuation models for PPE – the cost model or the revaluation model. Each model needs to be applied consistently to all PPE of the same ‘class’. A class of assets is a grouping of assets that have a similar nature or function within the business. For example, properties would

property, plant and equipment, and tangible fixed assets – part 2relevant to ACCA Qualification Papers F3 and F7

typically be one class of assets, and plant and equipment another. Additionally, if the revaluation model is chosen, the revaluations need to be kept up to date, although IAS 16 is not specific as to how often assets need to be revalued.

When the revaluation model is used, assets are carried at their fair value, defined as ‘the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction’.

Revaluation gains Revaluation gains are recognised in equity unless they reverse revaluation losses on the same asset that were previously recognised in the income statement. In these circumstances, the revaluation gain is recognised in the income statement. Revaluation changes the depreciable amount of an asset so subsequent depreciation charges are affected.

EXAMPLE 1 A property was purchased on 1 January 20X0 for $2m (estimated depreciable amount $1m

– useful economic life 50 years). Annual depreciation of $20,000 was charged from 20X0 to 20X4 inclusive and on 1 January 20X5 the carrying value of the property was $1.9m. The property was revalued to $2.8m on 1 January 20X5 (estimated depreciable amount $1.35m – the estimated useful economic life was unchanged). Show the treatment of the revaluation surplus and compute the revised annual depreciation charge.

Solution The revaluation surplus of $900,000 ($2.8m - $1.9m) is recognised in the statement of changes in equity by crediting a revaluation reserve. The depreciable amount of the property is now $1.35m and the remaining estimated useful economic life 45 years (50 years from 1 January 20X0). Therefore, the depreciation charge from 20X5 onwards would be $30,000 ($1.35m x 1/45).

A revaluation usually increases the annual depreciation charge in the income statement. In the above example, the annual increase

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Under FRS 15 the amount to which a fixed asset is revalued is different than under IAS 16. As far as properties are concerned (these probably being the class of fixed asset most likely to be carried at valuation) the basic valuation principle is value for existing use – not reflecting any development potential. Notional, directly attributable acquisition costs should also be included where material. However, specialised properties may need to be valued on the basis of depreciated replacement cost, since there may be no data on which to base an ‘existing use’ valuation. If properties are surplus to the entity’s requirements, then they should be valued at open market value net of expected directly attributable selling costs.

Revaluation losses that are caused by a clear consumption of economic benefits, for example physical damage to an asset, should be recognised in the profit and loss account. Such losses are recognised as an operating cost similar to depreciation.

Other revaluation losses, for example the effect of a general fall in market values on a portfolio of properties, should be partly recognised in the statement of total recognised gains and losses. However, if the loss is such that the carrying amount of the asset falls below depreciated historical cost, then any further losses need to be recognised in the profit and loss account.

EXAMPLE 3State how the answers to Examples 1 and 2 would change if FRS 15 were applied rather than IAS 16.

SolutionThe answer to Example 1 would not change at all. For Example 2, if the revaluation loss was caused by a consumption of economic benefits, then the whole loss would be recognised in the profit and loss account. If the revaluation loss was caused by general factors, then it would be necessary to compute the depreciated historical cost of the property. This is the carrying value of the property at 31 December 20X6 if the first revaluation on 1 January 20X5 had not been carried out and would be $1.86m ($2m - 7

x $20,000). The actual carrying value of the property at 31 December 20X6 was $2.74m (see Example 2). Therefore, of the revaluation loss of $1.24m (see Example 2), $880,000 ($2.74m - $1.86m) is charged to the statement of total recognised gains and losses, and the balance of $360,000 ($1.24m - $880,000) charged to the profit and loss account.

DERECOGNITION OF PPE – THE IAS 16 POSITION PPE should be derecognised (removed from PPE) either on disposal or when no future economic benefits are expected from the asset (in other words, it is effectively scrapped). A gain or loss on disposal is recognised as the difference between the disposal proceeds and the carrying value of the asset (using the cost or revaluation model) at the date of disposal. This net gain is included in the income statement – the sales proceeds should not be recognised as revenue.

Where assets are measured using the revaluation model, any remaining balance in the revaluation reserve relating to the asset disposed of is transferred directly to retained earnings. No recycling of this balance into the income statement is permitted.

DISPOSAL OF ASSETS – IFRS 5 POSITIONIFRS 5, Non-current assets held for sale and discontinued operations is another standard that deals with the disposal of non-current assets and discontinued operations. An item of PPE becomes subject to the provisions of IFRS 5 (rather than IAS 16) if it is classified as held for sale. This classification can either be made for a single asset (where the planned disposal of an individual and fairly substantial asset takes place) or for a group of assets (where the disposal of a business component takes place). This article considers the implications of disposing of a single asset.

IFRS 5 is only applied if the held for sale criteria are satisfied, and an asset is classified as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continued use. For this to be the case, the asset must be available for immediate sale in its present condition and its sale must be highly probable. Therefore,

is $10,000 ($30,000 - $20,000). IAS 16 allows (but does not require) entities to make a transfer of this ‘excess depreciation’ from the revaluation reserve directly to retained earnings.

Revaluation lossesRevaluation losses are recognised in the income statement. The only exception to this rule is where a revaluation surplus exists relating to a previous revaluation of that asset. To that extent, a revaluation loss can be recognised in equity.

EXAMPLE 2The property referred to in Example 1 was revalued on 31 December 20X6. Its fair value had fallen to $1.5m. Compute the revaluation loss and state how it should be treated in the financial statements.

SolutionThe carrying value of the property at 31 December 20X6 would have been $2.74m ($2.8m - 2 x $30,000). This means that the revaluation deficit is $1.24m ($2.74m - $1.5m).

If the transfer of excess depreciation (see above) is not made, then the balance in the revaluation reserve relating to this asset is $900,000 (see Example 1). Therefore $900,000 is deducted from equity and $340,000 ($1.24m - $900,000) is charged to the income statement.

If the transfer of excess depreciation is made, then the balance on the revaluation reserve at 31 December 20X6 is $880,000 ($900,000 - 2 x $10,000). Therefore $880,000 is deducted from equity and $360,000 ($1.24m - $880,000) charged to the income statement.

REVALUATION OF PPE – FRS 15 POSITIONAlthough the basic position in FRS 15 is similar to that of IAS 16, there are differences:

FRS 15 is more specific than IAS 16 regarding the frequency of valuations. FRS 15 states that, as a minimum, assets should be revalued every five years.

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an appropriate level of management must be committed to a plan to sell the asset, and an active programme to locate a buyer and complete the plan must have been initiated. The asset needs to be actively marketed at a reasonable price, and a successful sale should normally be expected within one year of the date of classification.

The types of asset that would typically satisfy the above criteria would be property, and very substantial items of plant and equipment. The normal disposal or scrapping of plant and equipment towards the end of its useful life would be subject to the provisions of IAS 16. When an asset is classified as held for sale, IFRS 5 requires that it be moved from its existing balance sheet presentation (non-current assets) to a new category of the balance sheet – ‘non-current assets held for sale’. No further depreciation is charged as its carrying value will be recovered principally through sale rather than continuing use.

The existing carrying value of the asset is compared with its ‘fair value less costs to sell’ (effectively the selling price less selling costs). If fair value less costs to sell is below the current carrying value, then the asset is written down to fair value less costs to sell and an impairment loss recognised. When the asset is sold, any difference between the new carrying value and the net selling price is shown as a profit or loss on sale.

EXAMPLE 4An asset has a carrying value of $600,000. It is classified as held for sale on 30 September 20X6. At that date its fair value less costs to sell is estimated at $550,000. The asset was sold for $555,000 on 30 November 20X6. The year end of the entity is 31 December 20X6.1 How would the classification as held for

sale, and subsequent disposal, be treated in the 20X6 financial statements?

2 How would the answer differ if the carrying value of the asset at 30 September 20X6 was $500,000, with all other figures remaining the same?

Solution1 On 30 September 20X6, the asset would

be written down to its fair value less costs

to sell of $550,000 and an impairment loss of $50,000 recognised. It would be removed from non-current assets and presented in ‘non-current assets held for sale’. On 30 November 20X6 a profit on sale of $5,000 would be recognised.

2 On 30 September 20X6 the asset would be transferred to non-current assets held for sale at its existing carrying value of $500,000. When the asset is sold on 30 November 20X6, a profit on sale of $55,000 would be recognised.

Where an asset is measured under the revaluation model then IFRS 5 requires that its revaluation must be updated immediately prior to being classified as held for sale. The effect of this treatment is that the selling costs will always be charged to the income statement at the date the asset is classified as held for sale.

EXAMPLE 5An asset being classified as held for sale is currently carried under the revaluation model at $600,000. Its latest fair value is $700,000 and the estimated costs of selling the asset are $10,000. Show how this transaction would be recorded in the financial statements.

SolutionImmediately prior to being classified as held for sale, the asset would be revalued to its latest fair value of $700,000, with a credit of $100,000 to equity. The fair value less costs to sell of the asset is $690,000 ($700,000 - $10,000). On reclassification, the asset would be written down to this value (being lower than the updated revalued amount) and $10,000 charged to the income statement.

DERECOGNITION OF PPE – FRS 15 POSITIONThe FRS 15 position is effectively identical to that of IAS 16 in as far as derecognition of PPE is covered by IAS 16. However, there is no UK standard equivalent to IFRS 5, although the UK Accounting Standards Board has issued an exposure draft that is very similar to IFRS 5.

Paul Robins is a lecturer at FTC Kaplan

This is the second of two articles, and considers revaluation of property, plant and equipment (PPE) and its derecognition. The first article, published in the June/July 2007 issue of student accountant, considered the initial measurement and depreciation of PPE.

42 student accountant September 2007

technical

This article explains the accounting treatment for research and development (R&D) costs under both UK and International Accounting Standards. Both UK and International Accounting Standards recognise the importance of accounting for R&D, but take a different viewpoint as to the method used.

WHY SPEND MONEY ON R&D?Many businesses in the commercial world spend vast amounts of money, on an annual basis, on the research and development of products and services. These entities do this with the intention of developing a product or service that will, in future periods, provide significant amounts of income for years to come.

THE ACCOUNTING PREDICAMENTIf, in the future, economic benefit is expected to flow to the entity as a result of incurring R&D costs, then it can be argued that these costs should be treated as an asset rather than an expense, as they meet the definition of an asset prescribed by both the Statement of Principles and the IASB Framework for the Preparation and Presentation of Financial Statements. Equally, the argument exists that it may be

research and developmentrelevant to CAT Paper 6 and ACCA Qualification Papers F3, F7, and P2

impossible to predict whether or not a project will give rise to future income. As a result, both the UK and International Accounting Standards provide accountants with more information in order to clarify the situation.

INTANGIBLE ASSETSIntangible assets are business assets that have no physical form. Unlike a tangible asset, such as a computer, you can’t see or touch an intangible asset.

There are two types of intangible assets: those that are purchased and those that are internally generated. The accounting treatment of purchased intangibles is relatively straightforward in that the purchase price is capitalised in the same way as for a tangible asset. Accounting for internally-generated assets, however, requires more thought.

R&D costs fall into the category of internally-generated intangible assets, and are therefore subject to specific recognition criteria under both the UK and international standards.

R&D – DEFINITIONSResearch is original and planned investigation, undertaken with the prospect of gaining

fresh

beginningsnew scientific or technical knowledge and understanding. An example of research could be a company in the pharmaceuticals industry undertaking activities or tests aimed at obtaining new knowledge to develop a new vaccine. The company is researching the unknown, and therefore, at this early stage, no future economic benefit can be expected to flow to the entity.

Development is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems, or services, before the start of commercial production or use. An example of development is a car manufacturer undertaking the design, construction, and testing of a pre-production model.

UK TREATMENT OF R&DSo far we have established that expenditure on R&D can fall into the category of intangible assets. Under UK accounting standards, intangible assets are accounted for using the rules from FRS 10, Goodwill and Intangibles.

Even though R&D can be an intangible asset in the UK, accounting for R&D is governed by its own accounting standard

– SSAP 13, Accounting for Research and Development.

RecognitionResearchSSAP 13 states that expenditure on research does not directly lead to future economic benefits, and capitalising such costs does not comply with the accruals concept. Therefore, the accounting treatment for all research expenditure is to write it off to the profit and loss account as incurred.

DevelopmentAs a basic rule, expenditure on development costs should be written off to the profit and loss account as incurred, as with the expenditure on research. However, under SSAP 13, there is an option to defer the development expenditure and carry it forward as an intangible asset if the following criteria are met:

there is a clearly defined project expenditure is separately identifiable the project is commercially viable the project is technically feasible project income is expected to outweigh cost resources are available to complete

the project.

If these criteria are met, the entity may choose to either capitalise the costs, bringing them ‘on balance sheet’, or maintain the policy to write the costs off to the profit and loss account. Note that if an accounting policy of capitalisation is adopted it should be applied consistently to all development projects that meet that criteria.

Treatment of capitalised development costsSSAP 13 requires that where development costs are recognised as an asset, they should be amortised over the periods expected to benefit from them. Amortisation should begin only once commercial production has started or when the developed product or service comes into use.

Every capitalised project should be reviewed at the end of every accounting period to ensure that the recognition criteria are still met. Where the conditions no longer exist or are doubtful, the capitalised costs

should be written off to the profit and loss account immediately.

Problems with SSAP 13SSAP 13 is not in line with the newer International Accounting Standard covering this area. As seen previously, the UK allows a choice over capitalisation; this can lead to inconsistencies between companies and, as some of the criteria are subjective, this ‘choice’ can be manipulated by companies wishing to capitalise development costs.

INTERNATIONAL TREATMENT OF R&DOne notable difference between the UK and international treatment is that the UK has a separate standard for the treatment of R&D (SSAP 13), whereas under International Accounting Standards the accounting for R&D is dealt with under IAS 38, Intangible Assets.

RecognitionIAS 38 states that an intangible asset is to be recognised if, and only if, the following criteria are met:

it is probable that future economic benefits from the asset will flow to the entity

the cost of the asset can be reliably measured.

The above recognition criteria look straightforward enough, but in reality it can prove to be very difficult to assess whether or not these have been met. In order to make the recognition of internally-generated intangibles more clear-cut, IAS 38 separates an R&D project into a research phase and a development phase.

Research phaseIt is impossible to demonstrate whether or not a product or service at the research stage will generate any probable future economic benefit. As a result, IAS 38 states that all expenditure incurred at the research stage should be written off to the income statement as an expense when incurred, and will never be capitalised as an intangible asset.

Development phaseUnder IAS 38, an intangible asset arising from

development must be capitalised if an entity can demonstrate all of the following criteria:

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

intention to complete and use or sell the asset

ability to use or sell the asset existence of a market or, if to be used

internally, the usefulness of the asset availability of adequate technical,

financial, and other resources to complete the asset

the cost of the asset can be measured reliably.

If any of the recognition criteria are not met then the expenditure must be charged to the income statement as incurred. Note that if the recognition criteria have been met, capitalisation must take place.

Treatment of capitalised development costsOnce development costs have been capitalised, the asset should be amortised in accordance with the accruals concept over its finite life. Amortisation must only begin when commercial production has commenced (hence matching the income and expenditure to the period in which it relates).

Each development project must be reviewed at the end of each accounting period to ensure that the recognition criteria are still met. If the criteria are no longer met, then the previously capitalised costs must be written off to the income statement immediately.

EXAMPLE A company incurs research costs, during one year, amounting to $125,000, and development costs of $490,000. The accountant informs you that the recognition criteria (as prescribed by both SSAP 13 and IAS 38) have been met. What effect will the above transactions have on the financial statements when following either the UK or International Accounting Standards? (See page 45 for the answer.)

Bobbie Retallack is a lecturer at Kaplan Financial in Birmingham, UK

44 student accountant September 2007

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September 2007 student accountant 45

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Example: Answer

UK Option 1: expense all costs

Profit and loss account extract Balance sheet extractExpenses:

R&D 615,000 Option 2: Expense research as required and capitalise development costs

Profit and loss account extract Balance sheet extractExpenses:

Research 125,000

Intangible asset:

Development costs 490,000

International Income statement extract Balance sheet extractExpenses:

Research 125,000 Intangible asset:

Development costs 490,000

Summary

UK International SSAP 13 IAS 38

Research costs Expense Expense

Development costs Choice policy. If the recognition criteria are met, Must capitalise if the recognition criteria are met the company can choose to capitalise (if there is a (must be able to demonstrate future benefit). reasonable expectation of future benefit) or expense. Amortise when commercial production begins. Amortise when commercial production begins.

Review annually to ensure criteria are still met – Review annually to ensure criteria are still met – if not, expense. if not, expense.

Expense if any of the recognition criteria are Expense if any of the recognition criteria are not met. not met.

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student accountantNOVeMBeR/DeCeMBeR 2008

CONSTRUCTION CONTRACTSRELEVANT TO ACCA QUALIFICATION PAPER F7

For many businesses, revenue and costs are easily divisible into a 12-month accounting period. For example, a retailer will recognise revenue when realised throughout the year, and match costs in accordance with the accruals concept. For some businesses, however, traditional revenue recognition methods (ie ‘show revenue when realised’) are not applicable. Many such organisations are in the construction industry and their business dealings involve contracts that are usually long-term in nature or span at least one accounting year end.

For example, a contractor has just won the bid to build a stadium in the new Olympic village in London for the 2012 Olympic Games. Work will commence on 1 January 2009 and it is anticipated that the stadium will be completed on 31 December 2011. If this type of contract were treated as a normal sale of goods, then revenue and profit would not be recognised until the stadium was completed at the end of the third year. This is known as the completed contracts basis and is an application of prudence, where profits should not be anticipated.

It can be argued that recognising the revenue at the end of the project would not faithfully present the situation under the construction contract, as in reality the revenue has been earned over the three-year period and not just when the stadium is completed. In addition, the fundamental accruals concept would not have been adhered to.

The problem with this type of industry, therefore, is to determine at what point revenue and costs should be recognised. For these businesses, the difficulties of accounting for both revenue and cost is remedied by the use of IAS 11, Construction Contracts, which prescribes the accounting treatment that should be followed.

IAS 11 – DEFINITIONWhen answering an exam question, it is necessary to know the definition of the relevant accounting standard. IAS 11 defines a construction contract as: a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology, and function for their ultimate purpose or use.

IAS 11 TREATMENTWhere possible, IAS 11 applies the accruals concept to the revenue earned on a construction contract. If the outcome of a project can be reasonably foreseen, then the accruals concept is applied by recognising profit on uncompleted contracts in proportion to the percentage of completion, applied to the estimated total contract profit. If, however, a loss is expected on the contract, then an application of prudence is necessary and the loss will be recognised immediately.

OUTCOME CAN BE RELIABLY MEASUREDIAS 11 only allows revenue and contract costs to be recognised when the outcome of the contract can be predicted with reasonable certainty. This means that it should be probable that the economic benefit attached to the contract will flow to the entity. If a loss is calculated, then the entire loss should be recognised immediately.

If a profit is estimated, then revenue and costs should be recognised according to the stage that the project has completed. There are two ways in which stage of completion can be calculated, and, in the exam, it is important to determine from the question scenario which method the examiner intends you to use, either the:

work certified method (sometimes referred to as the sales basis)

work certified to date contract price

cost method costs incurred to date total contract costs

EXAM FOCUSTo answer an exam question on construction contracts, a step approach is required, which can be practised by looking at the following examples.

EXAMPLE 1 Profit-making contractLily is a construction company that prepares its financial statements to 31 December each year. During the year ended 31 December 2008, the

company commenced a contract that is expected to take more than one year to complete. The contract summary at 31 December 2008 is as follows: $000Progress payments 1,400Contract price 2,736Work certified complete 1,824Contract costs incurred to 31 December 2008 2,160Estimated total cost at 31 December 2008* 2,520

* The examiner sometimes presents information in this manner – ‘estimated total cost’ means costs incurred plus costs to complete.

The agreed value of the work completed at 31 December 2008 is considered to be equal to the revenue earned in the year ended 31 December 2008. The percentage of completion is calculated as the value of the work invoiced to date compared to the contract price.

Required:Calculate the effect of the above contract on the financial statements at 31 December 2008.

Step approachStep 1: Set up extracts of the financial statements and a working paper.Step 2: Determine at W1 whether a profit or loss is expected on the contract.Step 3: In this example a profit will be calculated, so determine the accounting policy from the question and calculate the stage of completion. Step 4: Calculate how much profit should be shown this year from the stage of completion and include it in the income statement extract.Step 5: ‘Build’ up the income statement. If it is a work-certified accounting policy, then the work certified for the year should be taken to the revenue line. If it is a cost-basis accounting policy, then the costs incurred should be taken to the cost of sales line.

The correct timing of revenue (and profit) is crucial in order to faithfully represent the results shown in the income statement.

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Step 6: Depending on what approach was taken at step 5, you are now in a position to find the balancing figure to complete the income statement.Step 7: Calculate the asset or liability outstanding on the construction contract.

Income statement extract – 31 December 2008 $000Revenue (work certified) 1,824 COS (ß) 1,680Gross profit (W2) 144

Statement of financial position extract – 31 December 2008Current assetsAsset on a construction contract (W3) 904

WORKING PAPER(W1) Expected outcome $000Contract price 2,736Total costs 2,520Expected profit 216

(W2) Percentage of completionAccounting policy = Work certified completeWork certified to date Contract price1,824 = 66.67% 2,736(As a round percentage was not found, use the fraction to complete workings instead)

Profit to be recognised = $216 (W1) x $1,824 / $2,736 = $144

(W3) Asset on construction contractCosts incurred to date 2,160Profit recognised to date 144Less: Progress payments (1,400) 904

EXAMPLE 2 Loss-making contractGladioli is a construction company that prepares its financial statements to 31 March each year. During the year ended 31 March 2008, the company commenced a contract that is expected to take more than one year to complete. The contract summary at 31 March 2008 is as follows: $000Progress payments 3,780Contract price 4,500Contract costs incurred to 31 March 2008 3,600Estimated cost to complete at 31 March 2008 1,200

The percentage completion of this contract is to be based on the costs to date compared to the estimated total contract costs.

Required:Calculate the effect of the above contract in the financial statements at 31 March 2008.

SOLUTION 1Step 1: Set up extracts of the financial statements and a working paper.Step 2: Determine at W1 whether a profit or loss is expected on the contract.Step 3: A loss will be calculated in this example and should be recognised in the income statement immediately. Step 4: ‘Build’ up the income statement. If it is a work-certified accounting policy, then the work certified for the year should be taken to the revenue line. If it is a cost-basis accounting policy, then the costs incurred should be taken to the cost of sales line.Step 5: Depending on the approach taken at step 4, you are now in a position to find the balancing figure to complete the income statement.Step 6: Calculate the asset or liability outstanding on the construction contract.

Income statement extract – 31 March 2008 $000Revenue (ß) 3,300 COS (costs incurred) (3,600)Gross loss (W1) (300)

Statement of financial position extract – 31 March 2008Current liabilitiesLiability on a construction contract 480

WORKING PAPER(W1) Expected outcome $000Contract price 4,500Total cost (3,600 + 1,200) (4,800)Expected loss (300)(W2) Liability on construction contractCosts incurred to date 3,600Loss recognised to date (300)Less: Progress payments (3,780)Liability on construction (480) OUTCOME CANNOT BE RELIABLY MEASUREDIn following prudence, where an outcome cannot be reliably measured, any costs incurred during the financial year should be expensed immediately and revenue recognised as equivalent to the contract costs expected to be recoverable.

EXAMPLE 3 Take no profit on contractA welding company negotiated a two-year project that commenced in the latter half of the year. The project manager has been reviewing the contract and, at the year end, is unsure whether the contract will make a profit or a loss as there are uncertainties surrounding the project’s completion. The project manager’s records show that costs

during the year amount to $700,000 and no cash had yet been received. What should the accounting entries be regarding the contract at the year end?

SolutionDuring the year, as costs have been incurred, the natural double entries occurring would have been:Dr Purchases $700,000 Cr Bank/payables $700,000

As the outcome cannot be reliably measured, and assuming all costs are recoverable, revenue should be taken as equal to the costs incurred:Dr Receivables $700,000Cr Revenue $700,000

In processing the above journals, no profit will be taken on the contract during the financial year.

WHAT IS INCLUDED IN CONTRACT REVENUE AND COSTS?Contract revenue will be the amount agreed in the initial contract, plus revenue from variations in the original contract work, plus incentive payments and claims that can be reliably measured, such as contract revenue which can be valued at the fair value of received or receivable revenue.

Contract costs are to include costs relating directly to the initial contract plus costs attributable to general contract activity, plus costs that can be specifically charged to the customer under the terms of the contract.

EXAM ADVICEThere are two common ‘technical areas’ that may feature in any exam question on construction contracts, and which could cause difficulties. The first is when unplanned rectification costs are included within the question information. Rectification costs must be charged to the period in which they were incurred, and not spread over the remainder of the contract life. Therefore, such costs should not be added in when calculating the profit or loss to be shown on a contract.

The second difficulty is where a contract is already part way through, ie in its second year. If this is the second year of a contract, candidates must realise that some revenue and costs have previously been recognised. Candidates should take this into account in their calculations to make sure they show the current year revenue and costs.

CONCLUSION IAS 11 could feature in the Paper F7 exam as part of Question 2 (on published accounts), or in its own right in Questions 4 or 5, for 15 marks and 10 marks respectively. It is therefore an extremely important accounting standard at this level and candidates are strongly advised to practise past questions relating to this area of the syllabus.

Bobbie Retallack is Kaplan Publishing’s content specialist for Papers F3 and F7

linKed PeRFoRMance oBJectiVesstudying paper F7? did you know that perForManCe oBJeCtiVes 10 and 11 are linked?

Deferred tax is a topic that is consistently tested in Paper F7, Financial Reporting and is often tested in further detail in Paper P2, Corporate Reporting. This article will start by considering aspects of deferred tax that are relevant to Paper F7, before moving on to the more complicated situations that may be tested in Paper P2.

The basicsDeferred tax is accounted for in accordance with IAS 12, Income Taxes. In Paper F7, deferred tax normally results in a liability being recognised within the Statement of Financial Position. IAS 12 defines a deferred tax liability as being the amount of income tax payable in future periods in respect of taxable temporary differences. So, in simple terms, deferred tax is tax that is payable in the future. However, to understand this definition more fully, it is necessary to explain the term ‘taxable temporary differences’.

Temporary differences are defined as being differences between the carrying amount of an asset (or liability) within the Statement of Financial Position and its tax base ie the amount at which the asset (or liability) is valued for tax purposes by the relevant tax authority.

Taxable temporary differences are those on which tax will be charged in the future when the asset (or liability) is recovered (or settled).

IAS 12 requires that a deferred tax liability is recorded in respect of all taxable temporary differences that exist at the year-end – this is sometimes known as the full provision method.

All of this terminology can be rather overwhelming and difficult to understand, so consider it alongside an example. Depreciable non-current assets are the typical example behind deferred tax in Paper F7.

Within financial statements, non-current assets with a limited economic life are subject to depreciation. However, within tax computations, non-current assets are subject to capital allowances (also known as tax depreciation) at rates set within the relevant tax legislation. Where at the year-end the cumulative depreciation charged

and the cumulative capital allowances claimed are different, the carrying value of the asset (cost less accumulated depreciation) will then be different to its tax base (cost less accumulated capital allowances) and hence a taxable temporary difference arises.

Example 1A non-current asset costing $2,000 was acquired at the start of year 1. It is being depreciated straight line over four years, resulting in annual depreciation charges of $500. Thus a total of $2,000 of depreciation is being charged. The capital allowances granted on this asset are: $Year 1 800Year 2 600Year 3 360Year 4 240Total capital allowances 2,000

Table 1 shows the carrying value of the asset, the tax base of the asset and therefore the temporary difference at the end of each year.

As stated above, deferred tax liabilities arise on taxable temporary differences, ie those temporary differences that result in tax being payable in the future as the temporary difference reverses. So, how does the above example result in tax being payable in the future?

Entities pay income tax on their taxable profits. When determining taxable profits, the tax authorities start by taking the profit before tax (accounting profits) of an entity from their financial statements and then make various adjustments. For example, depreciation is considered a disallowable expense for taxation purposes but instead tax relief on capital expenditure is granted in the form of capital allowances. Therefore, taxable profits are arrived at by adding back depreciation and deducting capital allowances from the accounting profits. Entities are then charged tax at the appropriate tax rate on these taxable profits.

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In the above example, when the capital allowances are greater than the depreciation expense in years 1 and 2, the entity has received tax relief early. This is good for cash flow in that it delays (ie defers) the payment of tax. However, the difference is only a temporary difference and so the tax will have to be paid in the future. In years 3 and 4, when the capital allowances for the year are less than the depreciation charged, the entity is being charged additional tax and the temporary difference is reversing. Hence the temporary differences can be said to be taxable temporary differences.

Notice that overall, the accumulated depreciation and accumulated capital allowances both equal $2,000 – the cost of the asset – so over the four-year period, there is no difference between the taxable profits and the profits per the financial statements.

At the end of year 1, the entity has a temporary difference of $300, which will result in tax being payable in the future (in years 3 and 4). In accordance with the concept of prudence, a liability is therefore recorded equal to the expected tax payable.

Assuming that the tax rate applicable to the company is 25%, the deferred tax liability that will be recognised at the end of year 1 is 25% x $300 = $75. This will be recorded by crediting (increasing) a deferred tax liability in the Statement of Financial Position and debiting (increasing) the tax expense in the Income Statement.

By the end of year 2, the entity has a taxable temporary difference of $400, ie the $300 bought forward from year 1, plus the additional difference of $100 arising in year 2. A liability is therefore now recorded equal to 25% x $400 = $100. Since there was a liability of $75 recorded at the end of year 1, the double entry that is recorded in year 2 is to credit (increase) the liability and debit (increase) the tax expense by $25.

At the end of year 3, the entity’s taxable temporary differences have decreased to $260 (since the company has now been charged tax on the difference of $140). Therefore in the future, the tax payable will be 25% x $260 = $65. The deferred tax liability now needs reducing from $100 to $65 and so is debited (a decrease) by $35. Consequently, there is now a credit (a decrease) to the tax expense of $35.

At the end of year 4, there are no taxable temporary differences since now the carrying value of the asset is equal to its tax base. Therefore the opening liability of $65 needs to be removed by a debit entry (a decrease) and hence there is a credit entry (a decrease) of $65 to the tax expense. This can all be summarised in the following working.D

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TablE 1: ThE carrying ValuE, ThE Tax basE of ThE assET anD ThErEforE ThE TEmporary DiffErEncE aT ThE EnD of Each yEar (ExamplE 1)

year carrying value Tax base Temporary (cost - accumulated depreciation) (cost - accumulated capital allowances) difference $ $ $1 1,500 1,200 3002 1,000 600 4003 500 240 2604 Nil Nil Nil

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The movements in the liability are recorded in the Income Statement as part of the taxation charge

Year 1 2 3 4 $ $ $ $Opening deferredtax liability 0 75 100 65Increase/(decrease) in the year 75 25 (35) (65)Closing deferredtax liability 75 100 65 0 The closing figures are reported in the Statement of Financial Position as part of the deferred tax liability.

proformaExample 1 provides a proforma, which may be a useful format to deal with deferred tax within a published accounts question.

The movement in the deferred tax liability in the year is recorded in the Income Statement where:¤ an increase in the liability, increases the

tax expense¤ a decrease in the liability, decreases the

tax expense.

The closing figures are reported in the Statement of Financial Position as the deferred tax liability.

The income statementAs IAS 12 considers deferred tax from the perspective of temporary differences between the carrying value and tax base of assets and liabilities, the standard can be said to take a ‘balance sheet approach’. However, it will be helpful to consider the effect on the Income Statement.

Continuing with the previous example, suppose that the profit before tax of the entity for each of years 1 to 4 is $10,000 (after charging depreciation). Since the tax rate is 25%, it would then be logical to expect the tax expense for each year to be $2,500. However, income tax is based on taxable profits not on the accounting profits.

The taxable profits and so the actual tax liability for each year could be calculated as in Table 2.

The income tax liability is then recorded as a tax expense. As we have seen in the example, accounting for deferred tax then results in a further increase or decrease in the tax expense. Therefore, the final tax expense for each year reported in the Income Statement would be as in Table 3.

It can therefore be said that accounting for deferred tax is ensuring that the matching principle is applied. The tax expense reported in each period is the tax consequences (ie tax charges less tax relief) of the items reported within profit in that period.

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balance or draft financial statements will be the opening liability balance.

¤ In the notes to the question there will be information to enable you to calculate the closing liability for the SFP or the increase/decrease in the liability.

It is important that you read the information carefully. You will need to ascertain exactly what you are being told within the notes to the question and therefore how this relates to the working that you can use to calculate the figures for the answer.

Consider the following sets of information – all of which will achieve the same ultimate answer in the published accounts.

Example 2The trial balance shows a credit balance of $1,500 in respect of a deferred tax liability.

The notes to the question could contain one of the following sets of information:1 At the year-end, the required deferred tax liability

is $2,500.2 At the year-end, it was determined that an

increase in the deferred tax liability of $1,000 was required.

3 At the year-end, there are taxable temporary differences of $10,000. Tax is charged at a rate of 25%.

4 During the year, taxable temporary differences increased by $4,000. Tax is charged at a rate of 25%.

TablE 2: TaxablE profiT anD acTual Tax liabiliTy calculaTion (ExamplE 1)

Year 1 Year 2 Year 3 Year 4 $ $ $ $Profit before tax 10,000 10,000 10,000 10,000Depreciation 500 500 500 500Capital allowances (800) (600) (360) (240)Taxable profits 9,700 9,900 10,140 10,260 Tax liability @ 25% of taxable profits 2,425 2,475 2,535 2,565

TablE 3: final Tax ExpEnsE for Each rEporTED incomE sTaTEmEnT yEar (ExamplE 1)

Year 1 Year 2 Year 3 Year 4Income tax 2,425 2,475 2,535 2,565Increase/(decrease) due to deferred tax 75 25 (35) (65)Total tax expense 2,500 2,500 2,500 2,500

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the revaluation surplus is recorded in equity (in a revaluation reserve) and reported as other comprehensive income. While the carrying value of the asset has increased, the tax base of the asset remains the same and so a temporary difference arises.

Tax will become payable on the surplus when the asset is sold and so the temporary difference is taxable. Since the revaluation surplus has been recognised within equity, to comply with matching, the tax charge on the surplus is also charged to equity. Suppose that in Example 1, the asset is revalued to $2,500 at the end of year 2, as shown in Table 5. r

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Situations 1 and 2 are both giving a figure that can be slotted straight into the deferred tax working. In situations 3 and 4 however, the temporary differences are being given. These are then used to calculate a figure which can be slotted into the working. In all situations, the missing figure is calculated as a balancing figure. Table 4 shows the completed workings.

revaluations of non-current assets Revaluations of non-current assets (NCA) are a further example of a taxable temporary difference. When an NCA is revalued to its current value within the financial statements,

TablE 4: ExamplE 2 – publishED accounTs quEsTion situation 1 $ Opening deferred tax liability 1,500 Provided in trial balanceIncrease in the year to be taken to ISas an increase in tax expense 1,000 Balancing figureClosing deferred tax liability to be reported in SFP 2,500 Provided in information

situation 2 $ Opening deferred tax liability 1,500 Provided in trial balanceIncrease in the year to be taken to ISas an increase in tax expense 1,000 Provided in informationClosing deferred tax liability to be reported in SFP 2,500 Balancing figure

situation 3 $ Opening deferred tax liability 1,500 Provided in trial balanceIncrease in the year to be taken to ISas an increase in tax expense 1,000 Balancing figureClosing deferred tax liability to be reported in SFP 2,500 Calculated from information (25% x $10,000)

situation 4 $ Opening deferred tax liability 1,500 Provided in trial balanceIncrease in the year to be taken to IS Calculated from informationas an increase in tax expense 1,000 (25% x $4,000)Closing deferred tax liability to be reported in SFP 2,500 Balancing figure

TEchnical

The carrying value will now be $2,500 while the tax base remains at $600. There is, therefore, a temporary difference of $1,900, of which $1,500 relates to the revaluation surplus. This gives rise to a deferred tax liability of 25% x $1,900 = $475 at the year-end to report in the Statement of Financial Position. The liability was $75 at the start of the year (Example 1) and thus there is an increase of $400 to record.

However, the increase in relation to the revaluation surplus of 25% x $1,500 = $375 will be charged to the revaluation reserve and reported within other comprehensive income. The remaining increase of $25 will be charged to the Income Statement as before.

The overall double entry is:Dr Tax expense in Income Statement $25Dr Revaluation reserve in equity $375Cr Deferred tax liability in SFP $400

ThE papEr p2 ExamIn the pilot paper for the new syllabus, the theory of and accounting for deferred tax formed the basis of a 25-mark question in Section B. More recently in June 2009, it was tested within the group accounts in Question 1. It is important to appreciate that deferred tax can arise in respect of many different types of asset or liability and not just non-current assets as discussed above. Therefore, for Paper P2 it is more important that students understand the principles behind deferred tax so that they can be applied to any

given situation. Some of the situations that may be seen are discussed below. In all of the following situations, assume that the applicable tax rate is 25%.

Deferred tax assetsIt is important to be aware that temporary differences can result in needing to record a deferred tax asset instead of a liability. Temporary differences affect the timing of when tax is paid or when tax relief is received. While normally they result in the payment being deferred until the future or relief being received in advance (and hence a deferred tax liability) they can result in the payment being accelerated or relief being due in the future.

In these latter situations the temporary differences result in a deferred tax asset arising (or where the entity has other larger temporary differences that create deferred tax liabilities, a reduced deferred tax liability).

Whether an individual temporary difference gives rise to a deferred tax asset or liability can be ascertained by applying the following rule:

Carrying value Tax base Temporaryof asset / - of asset / = difference(Liability) (Liability) If the temporary difference is positive, a deferred tax liability will arise. If the temporary difference is negative, a deferred tax asset will arise.

TablE 5: rEValuED assET aT ThE EnD of yEar 2 (ExamplE 1)

year 2 carrying value Tax base Temporary (cost - accumulated (cost - accumulated difference depreciation) capital allowances) $ $ $Opening balance 1,500 1,200 300Depreciation charge/capital allowance (500) (600) 100Revaluation 1,500 - 1,500Closing Balance 2,500 600 1,900

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Example 3 Suppose that at the reporting date the carrying value of a non-current asset is $2,800 while its tax base is $3,500, as shown in Table 6 above.

In this scenario, the carrying value of the asset has been written down to below the tax base. This might be because an impairment loss has been recorded on the asset which is not allowable for tax purposes until the asset is sold. The entity will therefore receive tax relief on the impairment loss in the future when the asset is sold.

The deferred tax asset at the reporting date will be 25% x $700 = $175.

It is worth noting here that revaluation gains, which increase the carrying value of the asset and leave the tax base unchanged, result in a deferred tax liability. Conversely, impairment losses, which decrease the carrying value of the asset and leave the tax base unchanged, result in a deferred tax asset.

Example 4At the reporting date, inventory which cost $10,000 has been written down to its net realisable value of $9,000. The write down is ignored for tax purposes until the goods are sold.

The write off of inventory will generate tax relief, but only in the future when the goods are sold. Hence the tax base of the inventory is not reduced by the write off. Consequently, a deferred tax asset of 25% x $1,000 = $250 as shown in Table 8 should be recorded at the reporting date.

Example 5At the reporting date, an entity has recorded a liability of $25,000 in respect of pension contributions due. Tax relief is available on pension contributions only when they are paid.

TablE 6: impairmEnT of non-currEnT assET (ExamplE 3)

carrying value of the asset Tax base of the asset Temporary difference Deferred tax asset or liability? $ $ $ 2,800 3,500 (700) Asset

TablE 7: wriTE Down of inVEnTory (ExamplE 4)

carrying value of the asset Tax base of the asset Temporary difference Deferred tax asset or liability? $ $ $ 9,000 10,000 (1,000) Asset

TablE 8: accruED pEnsion conTribuTions (ExamplE 5)

carrying value of the asset Tax base of the asset Temporary difference Deferred tax asset or liability? $ $ $ (25,000) Nil (25,000) Asset

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The contributions will only be recognised for tax purposes when they are paid in the future. Hence the pension expense is currently ignored within the tax computations and so the liability has a nil tax base, as shown in Table 8. The entity will receive tax relief in the future and so a deferred tax asset of 25% x $25,000 = $6,250 should be recorded at the reporting date.

group financial statementsWhen dealing with deferred tax in group accounts, it is important to remember that a group does not legally exist and so is not subject to tax. Instead, tax is levied on the individual legal entities within the group and their individual tax assets and liabilities are cross-cast in the consolidation process. To calculate the deferred tax implications on consolidation adjustments when preparing the group accounts, the carrying value refers to the carrying value within the group accounts while the tax base will be the tax base in the entities’ individual accounts.

Fair value adjustmentsAt the date of acquisition, a subsidiary’s net assets are measured at fair value. The fair value adjustments may not alter the tax base of the net assets and hence a temporary difference may arise. Any deferred tax asset/liability arising as a result is included within the fair value of the subsidiary’s net assets at acquisition for the purposes of calculating goodwill.

GoodwillGoodwill only arises on consolidation – it is not recognised as an asset within the individual financial statements. Theoretically, goodwill gives rise to a temporary difference that would result in a deferred tax liability as it is an asset with a carrying value within the group accounts but will have a nil tax base. However, IAS 12 specifically excludes a deferred tax liability being recognised in respect of goodwill.

Provisions for unrealised profits (PUPs)When goods are sold between group companies and remain in the inventory of the buying company at the year-end, an adjustment is made to remove the unrealised profit from the consolidated accounts. This adjustment also reduces the inventory to the original cost when a group company first purchased it. However, the tax base of the inventory will be based on individual financial statements and so will be at the higher transfer price. Consequently, a deferred tax asset will arise. Recognition of the asset and the consequent decrease in the tax expense will ensure that the tax already charged to the individual selling company is not reflected in the current year’s consolidated income statement but will be matched against the future period when the profit is recognised by the group.

Example 6P owns 100% of the equity share capital of S. P sold goods to S for $1,000 recording a profit of $200. All of the goods remain in the inventory of S at the year-end. Table 9 shows that a deferred tax asset of 25% x $200 = $50 should be recorded within the group financial statements.

measurement of deferred taxIAS 12 states that deferred tax assets and liabilities should be measured based on the tax rates that are expected to apply when the asset/liability will be realised/settled. Normally, current tax rates are used to calculate deferred tax on the basis that they are a reasonable approximation of future tax rates and that it would be too unreliable to estimate future tax rates.

Deferred tax assets and liabilities represent future taxes that will be recovered or that will be payable. It may therefore be expected that they should be discounted to reflect the time value of money, which would be consistent with the way in which other liabilities are measured. IAS 12, however, does not permit or allow the discounting of deferred tax assets or liabilities on practical grounds.

sTuDEnT accounTanT 08/2009

The primary reason behind this is that it would be necessary for entities to determine when the future tax would be recovered or paid. In practice this is highly complex and subjective. Therefore, to require discounting of deferred tax liabilities would result in a high degree of unreliability. Furthermore, to allow but not require discounting would result in inconsistency and so a lack of comparability between entities.

Deferred tax and the frameworkAs we have seen, IAS 12 considers deferred tax by taking a balance sheet approach to the accounting problem by considering temporary differences in terms of the difference between the carrying values and the tax values of assets and liabilities – also known as the valuation approach. This can be said to be consistent with the IASB Framework’s approach to recognition within financial statements.

However, the valuation approach is applied regardless of whether the resulting deferred tax will meet the definition of an asset or liability in its own right.

TablE 9: proVision for unrEalisED profiTs (ExamplE 6)

carrying value Tax base Temporary Deferred tax of the asset within of the asset in difference asset or liability? group accounts individual entity accounts $ $ $ Cost to S 1,000 PUP (200) 800 1,000 (200) Asset

Thus, IAS 12 considers the overriding accounting issue behind deferred tax to be the application of matching – ensuring that the tax consequences of an item reported within the financial statements are reported in the same accounting period as the item itself.

For example, in the case of a revaluation surplus, since the gain has been recognised in the financial statements, the tax consequences of this gain should also be recognised – that is to say, a tax charge. In order to recognise a tax charge, it is necessary to complete the double entry by also recording a corresponding deferred tax liability.

However, part of the Framework’s definition of a liability is that there is a ‘present obligation’. Therefore, the deferred tax liability arising on the revaluation gain should represent the current obligation to pay tax in the future when the asset is sold. However, since there is no present obligation to sell the asset, there is no present obligation to pay the tax.

Therefore, it is also acknowledged that IAS 12 is inconsistent with the Framework to the extent that a deferred tax asset or liability does not necessarily meet the definition of an asset or liability.

Sally Baker and Tom Clendon are tutors at Kaplan Financial

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Following the revisions to IFRS 3, Business Combinations and IAS 27, Consolidated and Separate Financial Statements in January 2008, there are now two ways of measuring the goodwill that arises on the acquisition of a subsidiary and each has a slightly different impairment process.

This article discusses and shows both ways of measuring goodwill following the acquisition of a subsidiary, and how each measurement of goodwill is subject to an impairment review.

How to calculate goodwillThe traditional measurement of goodwill on the acquisition of a subsidiary is the excess of the fair value of the consideration given by the parent over the parent’s share of the fair value of the net assets acquired. This method can be referred to as the proportionate method. It determines only the goodwill that is attributable to the parent company.

The new method of measuring goodwill on the acquisition of the subsidiary is to compare the fair value of the whole of the subsidiary (as represented by the fair value of the consideration given by the parent and the fair value of the non controlling interest) with all of the fair value of the net assets of the subsidiary acquired. This method can be referred to as the gross or full goodwill method. It determines the goodwill that relates to the whole of the subsidiary, ie goodwill that is both attributable to the parent’s interest and the non-controlling interest (NCI).

Consider calculating goodwillBorough acquires an 80% interest in the equity shares of High for consideration of $500. The fair value of the net assets of Borough at that date is $400. The fair value of the NCI at that date (ie the fair value of High’s shares not acquired by Borough) is $100.

Required1 Calculate the goodwill arising on the acquisition

of High on a proportionate basis.2 Calculate the gross goodwill arising on the

acquisition of High, ie using the fair value of the NCI.

Solution1 The proportionate goodwill arising is calculated

by matching the consideration that the parent has given, with the interest that the parent acquires in the net assets of the subsidiary, to give the goodwill of the subsidiary that is attributable to the parent.

Parent’s cost of investmentat the fair value of consideration given $500Less the parent’s share of thefair value of the net assets of the subsidiary acquired (80% x $400) ($320)Goodwill attributable to the parent $180

2 The gross goodwill arising is calculated by matching the fair value of the whole business with the whole fair value of the net assets of the subsidiary to give the whole goodwill of the subsidiary, attributable to both the parent and to the NCI.

Parent’s cost of investmentat the fair value ofconsideration given $500Fair value of the NCI $100Less the fair value of the net assets of the subsidiaryacquired (100% x $400) ($400)Gross goodwill $200

Given a gross goodwill of $200 and a goodwill attributable to the parent of $180, the goodwill attributable to the NCI is the difference of $20.

In these examples, goodwill is said to be a premium arising on acquisition. Such goodwill is positive goodwill and accounted for as an intangible

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Studying Papers F7 or P2? performance objectives 10 and 11 are linked

asset in the group accounts, and as we shall see be subject to an annual impairment review.

In the event that there is a bargain purchase, ie negative goodwill arises, then this is regarded as a profit and immediately recognised in income.

basic principles of impairmentAn asset is impaired when its carrying value exceeds the recoverable amount. The recoverable amount is, in turn, defined as the higher of the fair value less cost to sell and the value in use; where the value in use is the present value of the future cash flows.

An impairment review calculation looks like this.

This is the net book value, ie the figure that the asset is currently recorded at in the accounts.

Impairment review

Carrying value of the asset X > Recoverable amount (X) This is the estimate of how much cash the company thinks it will get from the asset, either by selling it or using it.Impairment loss X

This loss must be recognised, and the asset written down to the recoverable amount.

Consider an impairment reviewA company has an asset that has a carrying value of $800. The asset has not been revalued. The asset is subject to an impairment review. If the asset was sold then it would sell for $610 and there would be associated selling costs of $10. (The fair value less costs to sell of the asset is therefore $600.) The estimate of the present value of the future cash flows to be generated by the asset if it were kept is $750. (This is the value in use of the asset.)

RequiredDetermine the outcome of the impairment review.

SolutionAn asset is impaired when its carrying value exceeds the recoverable amount, where the recoverable amount is the higher of the fair value less costs to sell and the value in use. In this case, with a fair value less cost to sell of only $600 and a value in use of $750 it both follows the rules, and makes common sense to minimise losses, that the recoverable amount will be the higher of the two, ie $750.

Impairment review

Carrying value of the asset $800Recoverable amount ($750)Impairment loss $50

The impairment loss must be recorded so that the asset is written down. There is no accounting policy or choice about this. In the event that the recoverable amount had exceeded the recoverable amount then there would be no impairment loss to recognise and as there is no such thing as an impairment gain, no accounting entry would arise.

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As the asset has never been revalued, the loss has to be charged to income. Impairment losses are non-cash expenses, like depreciation, so in the cash flow statement they will be added back when reconciling operating profit to cash generated from operating activities, just like depreciation again.

Assets are generally subject to an impairment review only if there are indicators of impairment. IAS 36, Impairment of Assets lists examples of circumstances that would trigger an impairment review.

External sources¤ market value declines ¤ negative changes in technology, markets,

economy, or laws ¤ increases in market interest rates ¤ company share price is below book value

Internal sources¤ obsolescence or physical damage ¤ asset is part of a restructuring or held

for disposal ¤ worse economic performance than expected

goodwill and impairment The asset of goodwill does not exist in a vacuum; rather, it arises in the group accounts because it is not separable from the net assets of the subsidiary that have just been acquired.

The impairment review of goodwill therefore takes place at the level of a cash-generating unit, that is to say a collection of assets that together create an independent stream of cash. The cash-generating unit will normally be assumed to be the subsidiary. In this way, when conducting the impairment review, the carrying value will be that of the net assets and the goodwill of the subsidiary compared with the recoverable amount of the subsidiary.

When looking to assign the impairment loss to particular assets within the cash generating unit, unless there is an asset that is specifically impaired, it is goodwill that is written off first, with any further balance being assigned on a pro rata basis.

The goodwill arising on the acquisition of a subsidiary is subject to an annual impairment review. This requirement ensures that the asset of goodwill is not being overstated in the group accounts. Goodwill is a peculiar asset in that it cannot be revalued so any impairment loss will automatically be charged against income. Goodwill is not deemed to be systematically consumed or worn out thus there is no requirement for a systematic amortisation.

proportionate goodwill and the impairment reviewWhen goodwill has been calculated on a proportionate basis then for the purposes of conducting the impairment review it is necessary to gross up goodwill so that in the impairment review goodwill will include an unrecognised notional goodwill attributable to the NCI.

Any impairment loss that arises is first allocated against the total of recognised and unrecognised goodwill in the normal proportions that the parent and NCI share profits and losses.

Any amounts written off against the notional goodwill will not affect the consolidated financial statements and NCI. Any amounts written off against the recognised goodwill will be attributable to the parent only, without affecting the NCI.

If the total amount of impairment loss exceeds the amount allocated against recognised and notional goodwill, the excess will be allocated against the other assets on a pro rata basis. This further loss will be shared between the parent and the NCI in the normal proportion that they share profits and losses.

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Consider an impairment review of proportionate goodwillAt the year-end, an impairment review is being conducted on a 60%-owned subsidiary. At the date of the impairment review the carrying value of the subsidiary’s net assets were $250 and the goodwill attributable to the parent $300 and the recoverable amount of the subsidiary $700.

RequiredDetermine the outcome of the impairment review.

SolutionIn conducting the impairment review of proportionate goodwill, it is first necessary to gross it up.

Proportionate Grossed up Goodwillgoodwill including the notional unrecognised NCI$300 x 100/60 = $500

Now, for the purposes of the impairment review, the goodwill of $500 together with the net assets of $250 form the carrying value of the cash-generating unit.

Impairment review

Carrying value Net assets $250Goodwill $500 $750Recoverable amount ($700)Impairment loss $50

The impairment loss does not exceed the total of the recognised and unrecognised goodwill so therefore it is only goodwill that has been impaired. The other assets are not impaired. As proportionate goodwill is only attributable to the parent, the impairment loss will not impact NCI.

Only the parent’s share of the goodwill impairment loss will actually be recorded, ie 60% x $50 = $30.

The impairment loss will be applied to write down the goodwill, so that the intangible asset of goodwill that will appear on the group statement of financial position will be $270 ($300 - $30).

In the group statement of financial position, the accumulated profits will be reduced $30. There is no impact on the NCI.

In the group income statement, the impairment loss of $30 will be charged as an extra operating expense. There is no impact on the NCI.

gross goodwill and the impairment reviewWhere goodwill has been calculated gross, then all the ingredients in the impairment review process are already consistently recorded in full. Any impairment loss (whether it relates to the gross goodwill or the other assets) will be allocated between the parent and the NCI in the normal proportion that they share profits and losses.

Consider an impairment review of gross goodwillAt the year-end, an impairment review is being conducted on an 80%-owned subsidiary. At the date of the impairment review the carrying value of the net assets were $400 and the gross goodwill $300 (of which $40 is attributable to the NCI) and the recoverable amount of the subsidiary $500.

RequiredDetermine the outcome of the impairment review.

SolutionThe impairment review of goodwill is really the impairment review of the net asset’s subsidiary and its goodwill, as together they form a cash generating unit for which it is possible to ascertain a recoverable amount.

STudenT aCCounTanT 08/2009

This explains the strange phenomena that while the NCI are attributed with only $40 out of the $300 of the gross goodwill, when the gross goodwill was impaired by $200 (ie two thirds of its value), the NCI are charged $40 of that loss, representing all of the goodwill attributable to the NCI.

Tom Clendon and Sally Baker are tutors at Kaplan Financial

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Impairment review

Carrying value Net assets $400Goodwill $300 $700Recoverable amount ($500)Impairment loss $200

The impairment loss will be applied to write down the goodwill, so that the intangible asset of goodwill that will appear on the group statement of financial position, will be $100 ($300 - $200).

In the equity of the group statement of financial position, the accumulated profits will be reduced by the parent’s share of the impairment loss on the gross goodwill, ie $160 (80% x $200) and the NCI reduced by the NCI’s share, ie $40 (20% x $200).

In the income statement, the impairment loss of $200 will be charged as an extra operating expense. As the impairment loss relates to the gross goodwill of the subsidiary, so it will reduce the NCI in the subsidiary’s profit for the year by $40 (20% x $200).

observationIn passing, you may wish to note an apparent anomaly with regards to the accounting treatment of gross goodwill and the impairment losses attributable to the NCI. The goodwill attributable to the NCI in this example is stated as $40. This means that goodwill is $40 greater than it would have been if it had been measured on a proportionate basis; likewise, the NCI is also $40 greater for having been measured at fair value at acquisition.

The split of the gross goodwill between what is attributable to the parent and what is attributable to the NCI is determined by the relative values of the NCI at acquisition to the parent’s cost of investment. However, when it comes to the allocation of impairment losses attributable to the write off of goodwill then these losses are shared in the normal proportions that the parent and the NCI share profits and losses, ie in this case 80%/20%.

TeCHniCal

The term ‘charity’ refers to the practice of benevolent giving. Charities are established for general or specific philanthropic purposes.

They are one type of not‑for‑profit organisation, but with several additional distinguishing features:¤ they exist entirely to benefit

defined groups in society¤ as their purposes are

philanthropic, they can usually avail themselves of favourable tax treatment, and for this reason have to be registered with a regulator

¤ their activities are restricted or limited by a regulator

¤ they rely on the financial support of the public or businesses (or both) in order to achieve their objectives

¤ in order to be financially viable, they rely heavily on voluntary (unpaid) managers and workers.

CHARITABLE ACTIVITIESIn the UK, charities are regulated by the Charities Act 2006, which sets out in very broad terms what may be considered to be charitable activities, many of which would be considered as such in other jurisdictions within most other countries. These include:¤ the prevention or relief

of poverty ¤ the advancement of education ¤ the advancement of religion ¤ the advancement of health or

the saving of lives¤ the advancement of citizenship

or community development

¤ the advancement of the arts, culture, heritage or science

¤ the advancement of amateur sport

¤ the advancement of human rights, conflict resolution or reconciliation or the promotion of religious or racial harmony or equality and diversity

¤ the advancement of environmental protection or improvement

¤ the relief of those in need, by reason of youth, age, ill‑health, disability, financial hardship or other disadvantage

¤ the advancement of animal welfare

¤ the promotion of the efficiency of the armed forces of the Crown or of the police, fire and rescue services or ambulance services

¤ other purposes currently recognised as charitable and any new charitable purposes which are similar to another charitable purpose.

The activities of charities in England and Wales are regulated by the Charity Commission, itself a not‑for‑profit organisation, located in Liverpool. The precise definition of what constitutes charitable activities differs, of course, from country to country. However, most of the activities listed above would be considered as charitable, as they would seldom be associated with commercial organisations.

CORPORATE FORMCharities differ widely in respect of their size, objectives and

activities. For example, Oxfam is a federal international organisation comprising 13 different bodies across all continents, while many thousands of charities are local organisations managed and staffed entirely by volunteers. Unsurprisingly, most of the constituent organisations within Oxfam operate as limited companies, while local charities would find this form inappropriate and prefer to be established as associations.

A charity is not forbidden from engaging in commercial activities provided that these activities fully serve the objectives of the charity. For example, charities such as the British Heart Foundation, the British Red Cross, and Age Concern all raise funds by operating chains of retail shops. These shops are profitable businesses, but if a company is formed to operate the shops, the company would be expected to formally covenant its entire annual profits to the charity.

Charities with high value non‑current assets, such as real estate, usually vest the ownership of such assets to independent guardian trustees, whose role is to ensure that the assets are deployed in a manner that reflects the objectives of the charity.

The guardian trustees are empowered to lease land, subject to the provisions of the lease satisfying requirements laid down by the Charity Commission.

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PART 2: CHARITIES RELEVAnT TO PAPERS F1, F5, F7, F8, P2, P3 And P5

01 TECHnICAL

FORMATIOn, COnSTITuTIOn And OBJECTIVESCharities are always formed with specific philanthropic purposes in mind. These purposes may be expanded or varied over time, provided the underlying purpose remains. For example, Oxfam was originally formed as the Oxford Committee for Famine Relief in 1942, and its original purpose was to relieve the famine in Greece brought about by the Allied blockade. Oxfam now provides famine relief on a worldwide basis.

The governing constitution of a charity is normally set down in its rules, which expand on the purposes of the business. Quite often, the constitution dictates what the organisation cannot do, as well as what it can do.

Charities plan and control their activities with reference to measures of effectiveness, economy and efficiency. They often publish their performance outcomes in order to convince the giving public that the good causes that they support ultimately benefit from charitable activities.

MAnAgEMEnTMost charities are managed by a Council, made up entirely of volunteers. These are broadly equivalent to non‑executive directors in limited companies. It is the responsibility of the Council to chart the medium to long‑term strategy of the charity and to ensure that objectives are met.

Objectives may change over time due to changes in the external environment in which the charity operates. Barnardos is a childrens’ charity that was originally founded as Doctor Barnado’s Homes, to provide for orphans who could not rely on family support.

The development of welfare services after World War II and the increasing willingness of families to adopt and foster children resulted in less reliance on the provision of residential homes for children but greater reliance on other support services. As a result, the Barnardos charity had to change the way in which it looked at maximising the welfare of orphaned children.

Local charities are dependent on the support of a more limited population and therefore have to consider whether their supporters will continue to provide the finance necessary to operate continuously. For example, a local charity supporting disabled sports could be profoundly affected by the development of facilities funded by central or local government.

Every charity is confronted by distinctive strategic and operational risks, of which the Council must take account in developing and implementing its plans. International aid charities are vulnerable to country risk and currency risk, so plans have to take account of local conditions in countries whose populations they serve. Many such countries C

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organisationsmay, of course, be inherently unstable politically.

Operational risk for charities arises from the high dependence on volunteer workers, including the extent to which they can rely on continued support, as well as problems of internal control. For example, many charities staff their shops with the help of unpaid retired people, but there is some debate as to whether future generations of retired people will be as willing to do this for nothing.

As many charities have to contain operating expenses in order to ensure that their objectives can be met, it is often difficult or impossible for them to employ full‑time or part‑time paid staff to replace volunteer workers.

Risks also arise from the social environment, particularly in times of recession, when members of the public may be less disposed to give to benefit others as their discretionary household income is reduced.

There is some evidence of ‘charity fatigue’ in the UK. This arises when the public feel pressurised by so many different competing charities that they feel ill disposed to give anything to anyone at all.

Robert Souster is examiner for Paper F1

Test how much of this article, and Part 1 of the article published in the September 2009 issue of Student Accountant, you have understood on the next page

STudEnT ACCOunTAnT 10/2009 02

Question 1What performance measures might be used by a famine relief charity?

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Question 2Why do individuals give to charities?

Question 3XYZ Charity provides local community facilities for disabled persons participating in sports. Its management committee wishes to outsource the operation of its club premises and land to a specialist organisation. What conditions might be imposed by the governing council of XYZ Charity?

Answer 1The measures that might be used include:¤ income in donations and

changes in income over time¤ income by source – personal

donations, corporate donations etc

¤ responses to campaign initiatives such as television adverts, newspaper coupon advertising, appeals relating to specific crises, and collection envelopes

¤ cost containment measures, such as management costs and other operating expenses (this is a particularly important factor, as some charities are criticised if administration costs absorb a high proportion of income)

¤ income from commercial activities

¤ numbers of volunteers attracted

¤ changes in mortality and sickness in areas where relief has been provided.

Answer 2There are many motives for giving to charities. In relation to charities that finance research into illnesses and diseases, such as cancer research, many people give because they or their families have been affected personally by the illnesses and diseases. They may give to similar charities such as Marie Curie nurses (who provide help for those affected by cancer) in order to give something back to those who have supported them.

Some give to charities because they have a deep‑seated belief in what the charity does. A good example of this is Amnesty International.

A purely financial motive for giving is to avail oneself of tax breaks, as most charitable donations can be set against tax liabilities.

Some give because they regard it as an expectation of society, or because they follow the example of family and friends.

Another motive for giving is simply that it makes some people feel good, or raises their profile with others.

Answer 3The council would wish to ensure that:¤ the commercial value of

the premises/business has been assessed by a suitably qualified valuer

¤ an appropriate rent would be included in the lease to ensure that income would be at least that received under existing arrangements, and that appropriate steps would have been taken to secure the highest possible rent

¤ the lessee would sign a covenant to be bound by the rules of the charity, as well as any covenants applicable to the title to the land

¤ the property belonging to the charity could not be used in any manner inconsistent with the aims and objectives of the charity

¤ any conditions applicable to the lease would be applicable to any subsequent sub‑lease, or that sub‑letting would be prohibited/restricted

¤ the tenant would be a fit and proper person.

CHECK yOuR undERSTAndIngTest your knowledge by answering these self-test questions – the questions are based on both this article and Part 1, published in the September 2009 issue.

03 TECHnICAL

IFRS 3, buSIneSS combInatIonS, RequIReS the acquIReR to RecognISe any contIngent conSIdeRatIon aS paRt oF the conSIdeRatIon FoR the acquIRee.

IFRS 3, Business Combinations was issued in January 2008 as the second phase of a joint project with the Financial Accounting Standards Board (FASB), the US standards setter, and is designed to improve financial reporting and international convergence in this area. The standard has also led to minor changes in IAS 27, Consolidated and Separate Financial Statements. The requirements of the revised IFRS 3 have been examinable since December 2008. This article relates to the relevance of IFRS 3 to Paper F7, Financial Reporting.

This article is also of interest to candidates studying UK-based papers, as under UK regulation consolidated goodwill is calculated using the non-controlling interest’s (NCI) proportionate share of the subsidiary’s identifiable net assets (referred to as method (ii) below).

The revised IFRS 3 introduces:¤ Restrictions on the expenses that can form part of the

acquisition costs ¤ New principles for the treatment of

contingent consideration¤ A choice in the measurement of non-controlling

interests (which have a knock-on effect to consolidated goodwill), considerable guidance on recognising and measuring the identifiable assets and liabilities of the acquired subsidiary, in particular the illustrative examples discuss several intangibles, such as market-related, customer-related, artistic-related and technology-related assets.

acquISItIon coStSAll acquisition costs, even those directly related to the acquisition such as professional fees (legal, accounting, valuation, etc), must be expensed. The costs of issuing debt or equity are to be accounted for under the rules of IAS 39, Financial Instruments: Recognition and Measurement.

contIngent conSIdeRatIonIFRS 3 defines contingent consideration as: ‘Usually, an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met’ (this would be an asset).

IFRS 3 requires the acquirer to recognise any contingent consideration as part of the consideration for the acquiree. It must be recognised at its fair value which is ‘the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction’. This ‘fair value’ approach is consistent with the way in which other forms of consideration are valued. Applying this definition to contingent consideration may not be easy as the definition is largely hypothetical; it is highly unlikely that the acquisition date liability for contingent consideration could be or would be settled by ‘willing parties in an arm’s length transaction’. An exam question would give the fair value of any contingent consideration or would specify how it is to be calculated. The payment of contingent consideration may be in the form of equity, a liability (issuing a debt instrument) or cash.

ifrs 3, business

Relevant to acca qualIFIcatIon papeR F7

01technIcal

If there is a change to the fair value of contingent consideration due to additional information obtained after the acquisition date that affects the facts or circumstances as they existed at the acquisition date, it is treated as a ‘measurement period adjustment’ and the contingent liability (and goodwill) are remeasured. This is effectively a retrospective adjustment and is rather similar to an adjusting event under IAS 10, Events After the Reporting Period. Changes in the fair value of contingent consideration due to events after the acquisition date (for example, meeting an earnings target which triggers a higher payment than was provided for at acquisition) are treated as follows: ¤ Contingent consideration classified as equity shall not

be remeasured, and its subsequent settlement shall be accounted for within equity (eg Cr share capital/share premium Dr retained earnings).

¤ Contingent consideration classified as an asset or a liability that:– is a financial instrument and is within the scope of

IAS 39 shall be measured at fair value, with any resulting gain or loss recognised either in profit or loss, or in other comprehensive income in accordance with that IFRS

– is not within the scope of IAS 39 shall be accounted for in accordance with IAS 37, Provisions, Contingent Liabilities and Contingent Assets, or other IFRSs as appropriate.

Note that although contingent consideration is usually a liability, it may be an asset if the acquirer has the right to a return of some of the consideration transferred if certain conditions are met.

goodwIll and non-contRollIng InteReStSThe acquirer (parent) measures any non-controlling interest either:(i) at fair value as determined by the directors of the

acquiring company (often called the ‘full goodwill’ method); or

(ii) at the non-controlling interest’s proportionate share of the acquiree’s (subsidiary’s) identifiable net assets (this is the UK method).

The differential effect of the two methods is that (i) recognises the whole of the goodwill attributable to an acquired subsidiary, whereas (ii) only recognises the parent’s share of the goodwill.

eXample 1Parent pays $100m for 80% of Subsidiary which has net assets with a fair value of $75m. The directors of Parent have determined the fair value of the NCI at the date of acquisition was $25m.

Method (i) Consideration $ Parent 100 NCI 25 125 Fair value of net assets (75) Consolidated goodwill on acquisition 50

In the consolidated statement of financial position the non-controlling interests would be shown as $25m.

In the above example the value of the non-controlling interests of $25m as determined by the directors of Parent is proportionate to that of Parent’s consideration ($100m x 20%/80%). This is not always (in fact rarely) the case.

Method (ii) Consideration $ Parent 100 Share of fair value of net assets acquired ($75m x 80%) (60) Consolidated goodwill 40

In the consolidated statement of financial position the non-controlling interest would be shown at its proportionate share of the subsidiary’s net assets of $15m ($75m x 20%).

Studying Paper F7? performance objectives 10 and 11 are relevant to this exam

combinations

Student accountant issue14/2010 02

The two methods are an extension of the methodology used in IAS 36, Impairment of Assets when calculating the impairment of goodwill of a cash generating unit (CGU) where there is a non-controlling interest.

eXample 2Parent owns 80% of Subsidiary (a CGU). Its identifiable net assets at 31 March 2010 are $500.

Scenario 1 $Net assets included in the consolidated statement of financial position 500Consolidated goodwill (calculated under method (i)) 200 700

NCI 140

Scenario 2 $Net assets included In the consolidated statement of financial position 500Consolidated goodwill (calculated under method (ii)) 160 660

NCI 100

An impairment review of Subsidiary was carried out at 31 March 2010.

Required:For scenarios 1 and 2, calculate the impairment losses and show how they would be allocated if the recoverable amount of Subsidiary at 31 March 2010 if the impairment review concluded that the recoverable of Subsidiary was:(i) $450(ii) $550

answerScenario 1 (i) The impairment loss is $250 (700 - 450). This loss will

be first applied to goodwill (eliminating it) and then to the other net assets reducing them to $450, ie equal to the recoverable amount of the CGU. The statement of financial position would now be:

$Net assets (to be consolidated) 450Consolidated goodwill nil 450

NCI (140 - (250 x 20%)) (see below)) 90

Note: IFRS 3 requires that any impairment loss should be written of to the controlling and non-controlling interests on the same basis as that in which profits loss are allocated.

(ii) With a recoverable amount of $550, the impairment loss will be $150 and applied to the goodwill reducing it to $50. The statement of financial position would now be:

$Net assets (to be consolidated) 500Consolidated goodwill (under method (i)) 50 550

NCI (140 - (150 x 20%)) 110

Scenario 2Where method (ii) has been used to calculate goodwill and the non-controlling interests, IAS 36 requires a notional adjustment to the goodwill of Subsidiary, before being compared to the recoverable amount. This is because the recoverable amount relates to the value of Subsidiary as a whole (ie including all of its goodwill). The notional adjustment is always based on the non-controlling interest in goodwill being proportional to that of the parent.

Goodwill Net assets Total $ $ $Carrying amount – re Parent 160 500 660

Notional adjustment re NCI(see below) 40 40 200 500 700

If the goodwill of Parent is $160 and this represents 80%, then the goodwill attributable to the NCI is deemed to be $40 ($160 x 20%/80%).

03technIcal

In this case, because the fair value of the non-controlling interests in scenario 1 is proportional to the consideration paid by Parent, the notional adjustment leads to the same impairment losses of $450 for (i) and $550 for (ii) as under scenario 1 (see *). Applying these:(i) the impairment loss of $250 is again applied to eliminate

goodwill and the remaining $50 is applied to reduce the other net assets. The non-controlling interest will be reduced by $10 being its share (20%) of the reduction of other net assets. This gives exactly the same statement of financial position as under scenario 1.

$ Net assets (to be consolidated) 450Consolidated goodwill nil 450

NCI (100 - 10 (50 x 20%)) 90

(ii) the impairment loss of $150 would be applied to goodwill leaving the other net assets unaffected. As only Parent’s share of goodwill is recognised, only 80% of the loss is applied, giving:

$Net assets 500Goodwill (160 - (150 x 80%)) 40 540

NCI (unaffected) 100

From this it can be seen that the carrying amount of the CGU is now $540, which is less than the recoverable amount ($550) of the CGU. This is because the recoverable amount takes into account the unrecognised goodwill of the NCI which would be $10 (goodwill of $200 - $150 impairment) x 20%).

The problem with this methodology is that goodwill (or what is subsumed within it) is a very complex item. If asked to describe goodwill, traditional aspects such as product reputation, skilled workforce, site location, market share, and so on, all spring to mind. These are perfectly valid, but in an acquisition, goodwill may contain other factors such as a premium to acquire control, and the value of synergies (cost savings or higher profits) when the subsidiary is integrated within the rest of the group. While non-controlling interests may legitimately lay claim to their share of the more traditional aspects of goodwill, they are unlikely to benefit from the other aspects, as they relate to the ability to control the subsidiary.

*Thus, it may not be appropriate to value non-controlling interests on the same basis (proportional to) as the controlling interests (see method (i) below).

IFRS 3 illustrates the calculation of consolidated goodwill at the date of acquisition as:

Consideration paid by parent + non-controlling interest - fair value of the subsidiary’s net identifiable assets = consolidated goodwill.

The non-controlling interest in the above formula may be valued at its fair value (method (i)) or its proportionate share of the subsidiary’s net identifiable assets (method (ii)).

Subsequent to acquisition the carrying amount of the non-controlling interest (under either method) will change in proportion it is share of the post acquisition profits or losses of the subsidiary. Consolidated goodwill (under either method) will remain the same unless impaired.

The standard recognises that there may be many ways of calculating the fair value of the non-controlling interest (method (i)), one of which may be to use the market price of the subsidiary’s shares prior to the acquisition (where this exists). In the Paper F7 exam this is the most common method; an alternative would be to simply give the fair value of the non-controlling interests in the question.

eXample 3 This comprehensive example is an adaptation of Question 1 from the December 2007 Paper F7 (INT) paper, and calculates goodwill based on the fair value of the non-controlling interests (method (i) above) by valuing the non-controlling interests using the subsidiary’s share price at the date of acquisition (see note (iv) of the question).

Student accountant issue14/2010 04

On 1 October 2006, Plateau acquired the following non-current investments:

Three million equity shares in Savannah by an exchange of one share in Plateau for every two shares in Savannah, plus $1.25 per acquired Savannah share in cash. The market price of each Plateau share at the date of acquisition was $6, and the market price of each Savannah share at the date of acquisition was $3.25.

Thirty per cent of the equity shares of Axle at a cost of $7.50 per share in cash.

Only the cash consideration of the above investments has been recorded by Plateau. In addition, $500,000 of professional costs relating to the acquisition of Savannah are included in the cost of the investment.

The summarised draft statements of financial position of the three companies at 30 September 2007 are:

Plateau Savannah Axle $’000 $’000 $’000AssetsNon-current assets: Property, plantand equipment 18,400 10,400 18,000Investments in Savannahand Axle 13,250 nil nilFinancial asset investments 6,500 nil nil 38,150 10,400 18,000Current assets:Inventory 6,900 6,200 3,600Trade receivables 3,200 1,500 2,400Total assets 48,250 18,100 24,000

Equity and liabilitiesEquity shares of $1 each 10,000 4,000 4,000Retained earnings – at 30 September 2006 16,000 6,000 11,000– for year ended30 September 2007 9,250 2,900 5,000 35,250 12,900 20,000Non-current liabilities7% Loan notes 5,000 1,000 1,000

Current liabilities 8,000 4,200 3,000Total equity and liabilities 48,250 18,100 24,000

The following information is relevant: (i) At the date of acquisition, Savannah had five years

remaining of an agreement to supply goods to one of its major customers. Savannah believes it is highly likely that the agreement will be renewed when it expires. The directors of Plateau estimate that the value of this customer based contract has a fair value of $1m, an indefinite life, and has not suffered any impairment.

(ii) On 1 October 2006, Plateau sold an item of plant to Savannah at its agreed fair value of $2.5m. Its carrying amount prior to the sale was $2m. The estimated remaining life of the plant at the date of sale was five years (straight-line depreciation).

(iii) During the year ended 30 September 2007, Savannah sold goods to Plateau for $2.7m. Savannah had marked up these goods by 50% on cost. Plateau had a third of the goods still in its inventory at 30 September 2007. There were no intra-group payables/receivables at 30 September 2007.

(iv) At the date of acquisition the non-controlling interest in Savannah is to be valued at its fair value. For this purpose Savannah’s share price at that date can be taken to be indicative of the fair value of the shareholding of the non-controlling interest. Impairment tests on 30 September 2007 concluded that neither consolidated goodwill nor the value of the investment in Axle had been impaired.

(v) The financial asset investments are included in Plateau’s statement of financial position (above) at their fair value on 1 October 2006, but they have a fair value of $9m at 30 September 2007.

(vi) No dividends were paid during the year by any of the companies.

RequiredPrepare the consolidated statement of financial position for Plateau as at 30 September 2007. (20 marks)

05technIcal

the conSIdeRatIon gIven by plateau FoR the ShaReS oF Savannah woRkS out at $4.25 peR ShaRe, Ie conSIdeRatIon oF $12.75m FoR3 mIllIon ShaReS.

tutorial noteNote (iv) may instead have said that the fair value of the NCI at the date of acquisition was $3,250,000. Alternatively, it may have said that the goodwill attributable to the NCI was $500,000. All these are different ways of giving the same information.

answerConsolidated statement of financial position of Plateau as at 30 September 2007: $’000 $’000AssetsNon-current assets:Property, plant and equipment (18,400 + 10,400 - 400 (w (i))) 28,400 Goodwill (w (ii)) 5,000Customer-based intangible 1,000Investments – associate (w (iii)) 10,500– financial asset 9,000 53,900 Current assets:Inventory (6,900 + 6,200 - 300 URP (w (iv))) 12,800Trade receivables (3,200 + 1,500) 4,700 17,500Total assets 71,400

Equity and liabilitiesEquity attributable to equity holders of the parentEquity shares of $1 each (w (v)) 11,500 ReservesShare premium (w (v)) 7,500Retained earnings (w (vi)) 30,300 37,800 49,300Non-controlling interest (w (vii)) 3,900Total equity 53,200

Non-current liabilities7% Loan notes (5,000 + 1,000) 6,000

Current liabilities (8,000 + 4,200) 12,200Total equity and liabilities 71,400

Workings (figures in brackets are in $’000).

(i) Property, plant and equipment The transfer of the plant creates an initial unrealised

profit (URP) of $500,000. This is reduced by $100,000 for each year (straight-line depreciation over five years) of depreciation in the post-acquisition period. Thus at 30 September 2007, the net unrealised profit is $400,000. This should be eliminated from Plateau’s retained profits and from the carrying amount of the plant.

(ii) Goodwill in Savannah $’000 $’000

Controlling interest:Shares issued (3,000/2 x $6) 9,000Cash (3,000 x $1.25) 3,750 12,750Non-controlling interests(1 million shares at $3.25) 3,250Total consideration 16,000

Equity shares of Savannah 4,000Pre-acquisition reserves 6,000Customer-based contract 1,000 (11,000) Consolidated goodwill 5,000

tutorial noteThe consideration given by Plateau for the shares of Savannah works out at $4.25 per share, ie consideration of $12.75m for 3 million shares. This is higher than the market price of Savannah’s shares ($3.25) before the acquisition and could be argued to be the premium paid to gain control of Savannah. This is also why it is (often) appropriate to value the NCI in Savannah shares at $3.25 each, because (by definition) the NCI does not have control.

Student accountant issue14/2010 06

(iii) Carrying amount of Axle at 30 September 2007 $’000 Cost (4,000 x 30% x $7.50) 9,000 Share post-acquisition profit (5,000 x 30%) 1,500 10,500

(iv) The unrealised profit (URP) in inventory Intra-group sales are $2.7m on which Savannah made

a profit of $900,000 (2,700 x 50/150). One third of these are still in the inventory of Plateau, thus there is an unrealised profit of $300,000.

(v) The 1.5 million shares issued by Plateau in the share exchange, at a value of $6 each, would be recorded as $1 per share as capital and $5 per share as premium, giving an increase in share capital of $1.5m and a share premium of $7.5m.

(vi) Consolidated retained earnings $’000Plateau’s retained earnings 25,250Professional costs of acquisitionmust be expensed (500)Savannah’s post-acquisition (2,900 - 300 URP) x 75% 1,950Axle’s post-acquisition profits (5,000 x 30%) 1,500URP in plant (see (i)) (400)Gain on financial asset investments (9,000 - 6,500) 2,500 30,300

(vii) NCI

Fair value at acquisition 3,250Post-acquisition profit (2,900 - 300 URP) x 25% 650 3,900

Note that subsequent to the date of acquisition, the non-controlling interest is valued at its fair value at acquisition plus its proportionate share of Savannah’s (adjusted) post acquisition profits.

FuRtheR ISSueSThe original question contained an impairment of goodwill; let’s say that this is $1m. IAS 36 (as amended by IFRS 3) requires a goodwill impairment of a subsidiary (if a cash generating unit) to be allocated between the parent and the non-controlling interests in on the same basis as the subsidiary’s profits and losses are allocated. Thus, of the impairment of $1m, $750,000 would be allocated to the parent (and debited to group retained earnings reducing them to $29.55m ($30,300,000 - $750,000)) and $250,000 would be allocated to the non-controlling interests, writing it down to $3.65m ($3,900,000 - $250,000).

It could be argued that this requirement represents an anomaly. It can be calculated (though not done in this example) that of Savannah’s recognised goodwill (before the impairment) of $5m only $500,000 (ie 10%) relates to the non-controlling interests, but the NCI suffers 25% (its proportionate shareholding in Savannah) of the goodwill impairment.

Steve Scott is examiner for Paper F7

the oRIgInal queStIon contaIned an ImpaIRment oF goodwIll; let’S Say that thIS IS $1m. IaS 36 (aS amended by IFRS 3) RequIReS a goodwIll ImpaIRment oF a SubSIdIaRy (IF a caSh geneRatIng unIt) to be allocated between the paRent and the non-contRollIng InteReStS In on the Same baSIS aS the SubSIdIaRy’S pRoFItS and loSSeS aRe allocated.

07technIcal

This article outlines amendments to the Paper F7 (UK) and Paper P2 (UK) syllabuses. The amendments are effective from the June 2011 exam session. The article is particularly relevant to anyone wishing to obtain the UK or Irish audit qualification (to practise as an auditor within the UK or Ireland) or qualify under the UK or Irish papers. However, by reading this article, all candidates will obtain insight into how Papers F7 and P2 are constructed and therefore examined.

In this article, any reference to: ¤ ‘UK’ means ‘UK and Irish papers’¤ ‘International’ means ‘International,

Singapore, Malaysia and Hong Kong papers’.

WHY IS ACCA MAKING AMENDMENTS TO THE UK VERSIONS OF PAPERS F7 AND P2?All UK and Irish professional accountancy bodies are governed by the requirements of the Statutory Audit Directive (SAD). In order to comply with the requirements of SAD – and to practise as an auditor – certain elements of UK legislation and regulation should be examined. The revised Papers F7 (UK) and P2 (UK) fully meet regulatory and business environment requirements for those wishing to obtain the UK audit qualification, or qualify by studying UK papers.

SO WHAT ARE THE AMENDMENTS?From June 2011 onwards, the UK versions for both Papers F7 and P2 will: ¤ be based on international accounting

standards in the same way as the international versions of these papers

¤ include relevant elements of UK legislation

¤ include relevant elements of differences between international GAAP and UK GAAP

¤ be written using $ (dollars) as the currency

¤ be based on international terminology.

The Study Guides provide details on UK legislation and GAAP differences, and the examinable documents available after the cut off date (30 September 2010) for 2011 exams has passed will list which differences are examinable for Papers F7 (UK) and P2 (UK). This detail will be outlined on a syllabus section-by-section basis.

RELEVANT TO ACCA QUALIFICATION PAPERS F7 AND P2

REPORTING chaNGEsThis article outlines amendments to the Paper F7 (UK) and Paper P2 (UK) syllabuses. The amendments are effective from the June 2011 exam session. The article is particularly relevant to anyone wishing to obtain the UK or Irish audit qualification (to practise as an auditor within the UK or Ireland) or qualify under the UK or Irish papers. However, by reading this article, all candidates will obtain insight into how Papers F7 and P2 are constructed and therefore examined.

In this article, any reference to: ¤ ‘UK’ means ‘UK and Irish papers’¤ ‘International’ means ‘International,

Singapore, Malaysia and Hong Kong papers’.

WHY IS ACCA MAKING AMENDMENTS TO THE UK VERSIONS OF PAPERS F7 AND P2?All UK and Irish professional accountancy bodies are governed by the requirements of the Statutory Audit Directive (SAD). In order to comply with the requirements of SAD – and to practise as an auditor – certain elements of UK legislation and regulation should be examined. The revised Papers F7 (UK) and P2 (UK) fully meet regulatory and business environment requirements for those wishing to obtain the UK audit qualification, or qualify by studying UK papers.

SO WHAT ARE THE AMENDMENTS?From June 2011 onwards, the UK versions for both Papers F7 and P2 will: ¤ be based on international accounting

standards in the same way as the international versions of these papers

¤ include relevant elements of UK legislation

¤ include relevant elements of differences between international GAAP and UK GAAP

¤ be written using $ (dollars) as the currency

¤ be based on international terminology.

The Study Guides provide details on UK legislation and GAAP differences, and the examinable documents available after the cut off date (30 September 2010) for 2011 exams has passed will list which differences are examinable for Papers F7 (UK) and P2 (UK). This detail will be outlined on a syllabus section-by-section basis.

WILL THERE BE ANY IMPACT ON THE INTERNATIONAL PAPERS?There should be little impact on the international papers except that the examinable documents will be revised in the regular annual update. Please note that the international syllabuses now include more detail on IFRS for SMEs and reconstructions. The international paper is the primary paper to be produced and the UK paper will be based on this paper.

SO HOW WILL THE UK PAPER EXAMINE UK LEGISLATION AND UK GAAP DIFFERENCES?The majority of the UK paper will be the same as the international paper, which is based on IFRS. There will be some key UK differences examined in the UK paper, but it is anticipated that the differences will account for no more than 10% of the marks available in Paper F7 and 20% in Paper P2. It is expected that UK GAAP differences and/or UK legislation will appear in all exam sessions from June 2011.

There will be little overall change to the question style, although some of the written elements will focus on the legal requirements rather than accounting standard requirements. Candidates may have to discuss and show the impact of differences between UK and international GAAP.

The UK GAAP differences and UK legislation will be examined as parts or sections of questions rather than as separate questions. In Paper P2, the differences and legislation may be examined across Sections A or B, and it is possible that there may be a whole question in the UK paper which is different to the international paper. In both Papers P2 and F7 there may also be slight amendments to the scenario in the UK paper adapted from the international paper in order to place the UK paper in a UK context and therefore make the different UK elements and requirements more apparent.

Here is an example of how a UK GAAP difference scenario may work within Paper F7 (UK). Question 2, for example, may require the preparation of an income statement and a statement of financial position including the revaluation of a property that will create a temporary difference on which deferred tax should be calculated. The UK paper might then ask the candidate to outline the method under which the property should be valued and the effect of the revaluation on deferred tax under UK GAAP rules.

In Paper F7 this could appear as:

RequiredDescribe how the provision for deferred tax relating to the revaluation of the property would differ from IFRS under FRS 19, Deferred tax (UK GAAP rules) where:i the directors intended to sell the property

shortly after the year end, but had not entered into a binding agreement to sell

ii there was a binding agreement to sell the property (at the revalued amount) one month after the year end.

Answeri Consistent with the principle of other

provisions, FRS 19 does not require a provision for deferred tax to be made based solely on management’s ‘intentions’. Thus the revaluation of the property would not affect the deferred tax provision at the year end.

ii The binding agreement to sell the property shortly after the year end means that a tax liability is almost certain to arise and, in these circumstances FRS 19 requires deferred tax to be provided for at an amount equal to the revaluation gain multiplied by the applicable rate of tax. This would then mean the provision under UK GAAP was the same as under IFRS rules.

In Paper P2, this requirement may be developed further by requiring the candidate to calculate or show the impact of following UK GAAP instead of international GAAP with respect to this difference.

RELEVANT TO ACCA QUALIFICATION PAPERS F7 AND P2

REPORTING chaNGEs

01TECHNICAL01TECHNICAL

As there are more UK GAAP differences examinable in Paper P2, candidates may be required to reconcile from international GAAP to UK GAAP and vice versa. This is essentially expanding the current syllabus requirement to discuss the impact of moving from one GAAP to another, for example, advising a company on the implications of moving from UK GAAP to IFRS with reference to a selected number of accounting topics outlined in the Study Guide.

A further Paper P2 example would be:Previously, under UK GAAP, it was

possible to view sale and lease back as a single transaction. The asset was seen as being retained rather than sold and re-acquired. The proceeds of the sale were simply credited to a liability account.

This is not acceptable under IAS 17, Leases. Thus, if an entity A sells a building to another entity B and leases it back over the major part of the buildings life, IAS 17 would treat the lease as a finance lease. The profit on the sale would be released to profit or loss over the lease term as entity A never disposes of the risks and rewards of ownership of the asset. The leased asset and liability would be recorded in the statement of financial position at the present value of the minimum lease payments and depreciation would be charged over the lease term. The rentals would be credited to cash and debited to the lease creditor and interest.

Students would be expected to discuss the impact of the move to IFRS and possibly show the accounting entries and implications.

As mentioned above, reconstruction has been brought into the Paper P2 syllabus (both UK and international papers). The illustrative answers to the UK paper could include the legal elements relating to schemes of arrangement and reconstructions.

WHAT ELEMENTS OF UK LEGISLATION AND UK GAAP DIFFERENCES ARE POTENTIALLY EXAMINABLE?A full schedule of differences can found in the UK examinable documents. However, the following may provide a useful guide of some of the examinable areas.

RegulationThe Paper F7 (UK) syllabus requires a certain amount of knowledge of the regulation relating to UK legislation. Of particular relevance is the requirement to produce financial statements (for single entity and groups) and the circumstances where a parent may be exempted from producing group accounts.

For Paper P2 (UK), in addition to the above requirements for Paper F7 (UK), basic knowledge of legislation surrounding schemes of arrangement and reconstruction has been included. Note that reconstructions are also examinable in the international paper, but without the specific legal requirements.

Accounting standardsGroup accountsPaper F7 (UK) candidates need to know how the computation of consolidated goodwill (including negative goodwill) and the requirements for its amortisation recognition differ to IFRS rules. This also impacts on the calculation/valuation of non-controlling interests/minority interests.

Other group accounting differences are in the recognition of separable intangibles only, treatment of acquisitions costs, and changes in the value of contingent consideration.

The Paper P2 syllabus develops the concept of group accounting and therefore additional differences result in the accounting for disposals and joint ventures. Candidates will need to have a good working knowledge of these differences.

Non-current assetsDifferences in the rules covering the frequency of revaluations of tangible non-current assets and different valuation methods dependent on the nature of the asset are examinable in Paper F7 (UK). There are also examinable differences in the treatment of the gains or losses on non-current assets including those relating to a clear consumption of benefits.

The UK GAAP rules allow a choice of recognising or expensing certain development costs. Whereas Paper F7 (UK) requires candidates to explain these differences in principle, Paper P2 (UK) may incorporate numerical calculations.

TaxationThe use of timing differences (rather than temporary differences) in UK GAAP and that discounting of the deferred tax liability is permitted under UK GAAP are examinable in Paper F7 (UK). Deferred tax on a revaluation of non-monetary assets (normally a property) is only accounted for where a binding agreement has been entered into to sell the property. Paper P2 (UK) may incorporate calculations whereas Paper F7 (UK) will only require discussion in principle of the issues.

Other differences examinable in Paper F7 (UK) include:¤ statement of cash flows: main UK GAAP

differences are in the format of the statement and in the definitions of cash and liquid resources

¤ construction contracts: main UK GAAP difference is simply the presentation of the contract balances in the statement of financial position

¤ borrowing costs: main UK GAAP difference is the choice over capitalisation during the construction of non-current assets

¤ discontinued operations: differences relate to the recognition criteria and the presentation and analysis in the income statement of a discontinuing operation

¤ the use and treatment of ‘exceptional’ items under UK GAAP.

¤ UK GAAP has the use of a ‘90% rebuttable presumption’ to determine the classification of a leased asset.

THE STUDY GUIDES PROVIDE DETAIL ON UK LEGISLATION AND GAAP DIFFERENCES, AND THE EXAMINABLE DOCUMENTS AVAILABLE AFTER THE CUT OFF DATE(30 SEPTEMBER 2010) FOR 2011 EXAMS HAS PASSED WILL LIST WHICH DIFFERENCES ARE EXAMINABLE FOR PAPERS F7 (UK) AND P2 (UK).

Studying Papers F7 and P2? Performance objectives 10 and 11 are relevant to these exams

02STUDENT ACCOUNTANT issue18/2010

The Paper P2 syllabus develops (with the exception of construction contracts – this is not examinable at Paper P2) many topics covered at Paper F7, but also introduces some new areas. Of these developed topics and new areas, the following is an outline of some of the key Paper P2 (UK) examinable differences not previously covered in this article.¤ Leasing developed to cover differences in

treatment of land and buildings, sale and leaseback, and operating leases.

¤ Employee benefits in that UK GAAP only addresses retirement benefits and does not allow the 10% corridor.

¤ Related party differences with reference to the materiality being considered under UK GAAP, disclosure and exemption from disclosures.

¤ Segmental reporting approach, accounting and key disclosure differences.

¤ IFRS for SMEs is a recent addition to the syllabus. The key areas to focus on will be:

i definition of an SMEii key principles and rationale for IFRSiiitopics omitted from IFRS for SMEs iv types of simplifications v accounting treatments disallowed under

IFRS for SMEs vi specific recognition and

measurement simplifications vii summary of the IFRS for SMEs focusing

on differences with full IFRS.

Candidates will only need to be aware of the UK differences in principle for the above.

Full details of examinable differences are given in the examinable documents, which should be read in conjunction with the Study Guide.

HOW SHOULD CANDIDATES PREPARE FOR THE UK PAPER?It is important for candidates to be fully versed in examinable international GAAP as this is the main focus of the UK papers. Candidates are expected to have a reasonable working knowledge of the key differences and areas of examinable legislation as they are deemed relevant for those continuing to use UK GAAP or wanting to obtain the audit qualification. If intending to become a registered auditor in the UK – hence obtain the audit qualification in order to do this – any student taking Papers P2 and P7 from June 2011 onwards must take the new UK version. As such it would be beneficial that candidates commencing study attempt Paper F3 (INT) rather than Paper F3 (UK) (from December 2011, Paper F3 (UK) will not be offered) and then move on to Paper F7 (UK) and Paper P2 (UK) as these will be in the new form outlined above. For those who have already completed Paper F3 (UK) and plan to attempt F7:¤ at the December 2010 session

should consider attempting Paper F7 (INT) as this is marginally a better underpinning paper for P2 (UK) from June 2011 onwards

¤ after December 2010 should continue with the Paper F7 (UK) as it will be in the new form outlined above.

IT IS IMPORTANT FOR CANDIDATES TO BE FULLY VERSED IN EXAMINABLE INTERNATIONAL GAAP AS THIS IS THE MAIN FOCUS OF THE UK PAPERS. CANDIDATES ARE EXPECTED TO HAVE A REASONABLE WORKING KNOWLEDGE OF THE KEY DIFFERENCES AND AREASOF EXAMINABLE LEGISLATION AS THEY ARE DEEMED RELEVANT FOR THOSE CONTINUING TO USE UK GAAP OR WANTING TO OBTAIN THE AUDIT QUALIFICATION.

Those who have completed Paper F3 (UK) and Paper F7 (UK) and plan to sit Paper P2 (UK): ¤ at December 2010 are not impacted by

the amendments outlined above¤ after December 2010 should not be

too concerned as the differences in UK and international GAAP are not so technically different at F7 and hence not insurmountable.

Note that this article is based on UK GAAP and international GAAP as at September 2010.

Steve Scott is examiner for Paper F7 and Graham Holt is examiner for Paper P2

03TECHNICAL

The accounting for IAS 16, Property, Plant and Equipment is a particularly important area of the Paper F7 syllabus. You can almost guarantee that in every exam you will be required to account for property, plant and equipment at least once.

This article is designed to outline the key areas of IAS 16, Property, Plant and Equipment that you may be required to attempt in the F7 exam.

IAS 16, ProPerty, PlAnt And equIPment overvIewThere are essentially four key areas when accounting for property, plant and equipment that you must ensure that you are familiar with:¤ initial recognition¤ depreciation¤ revaluation¤ derecognition (disposals).

InItIAl recognItIonThe basic principle of IAS 16 is that items of property, plant and equipment that qualify for recognition should initially be measured at cost.

One of the easiest ways to remember this is that you should capitalise all costs to bring an asset to its present location and condition for its intended use.

Commonly used examples of cost include:¤ purchase price of an asset (less any trade discount)¤ directly attributable costs such as:

– cost of site preparation– initial delivery and handling costs– installation and testing costs– professional fees

¤ the initial estimate of dismantling and removing the asset and restoring the site on which it is located, to its original condition (ie to the extent that it is recognised as a provision per IAS 37, Provisions, Contingent Assets and Liabilities)

¤ borrowing costs in accordance with IAS 23, Borrowing Costs.

exAmPle 1On 1 March 2008 Yucca acquired a machine from Plant under the following terms: $List price of machine 82,000Import duty 1,500Delivery fees 2,050Electrical installation costs 9,500Pre-production testing 4,900Purchase of a five-year maintenance contract with Plant 7,000

In addition to the above information Yucca was granted a trade discount of 10% on the initial list price of the asset and a settlement discount of 5% if payment for the machine was received within one month of purchase. Yucca paid for the plant on 25 March 2008.

How should the above information be accounted for in the financial statements? (See page 5 for the solution to Example 1.)

exAmPle 2Construction of Deb and Ham’s new store began on 1 April 2009. The following costs were incurred on the construction:

$000Freehold land 4,500Architect fees 620Site preparation 1,650Materials 7,800Direct labour costs 11,200Legal fees 2,400General overheads 940

The store was completed on 1 January 2010 and brought into use following its grand opening on the 1 April 2010. Deb and Ham issued a $25m unsecured loan on 1 April 2009 to aid construction of the new store (which meets the definition of a qualifying asset per IAS 23). The loan carried an interest rate of 8% per annum and is repayable on 1 April 2012.

RequiredCalculate the amount to be included as property, plant and equipment in respect of the new store and state what impact the above information would have on the income statement (if any) for the year ended 31 March 2010.

(See page 5 for the solution to Example 2.)

Subsequent costsOnce an item of PPE has been recognised and capitalised in the financial statements, a company may incur further costs on that asset in the future. IAS 16 requires that subsequent costs should be capitalised if:¤ it is probable that future economic benefits associated with the

extra costs will flow to the entity¤ the cost of the item can be reliably measured.

All other subsequent costs should be recognised as an expense in the income statement in the period that they are incurred.

exAmPle 3On 1 March 2010 Yucca purchased an upgrade package from Plant at a cost of $18,000 for the machine it originally purchased in 2008 (Example 1). The upgrade took a total of two days where new components were added to the machine. Yucca agreed to purchase the package as the new components would lead to a reduction in production time per unit of 15%. This will enable Yucca to increase production without the need to purchase a new machine.

Should the additional expenditure be capitalised or expensed? (See page 5 for the solution to Example 3.)

relevAnt to AccA quAlIFIcAtIon PAPer F7

accounting for property, plant and equipment

01technIcAl01technIcAl

exAmPle 6 A company purchased a property with an overall cost of $100m on 1 April 2009. The property elements are made up as follows:

$000 Estimated lifeLand and buildings (Land element $20,000) 65,000 50 yearsFixtures and fittings 24,000 10 yearsLifts 11,000 20 years 100,000

Calculate the annual depreciation charge for the property for the year ended 31 March 2010. (See page 6 for the solution to Example 6.)

revAluAtIonSThis is an important topic in the exam and features regularly in Question 2, so you should ensure that you are familiar with all aspects of revaluations.

IAS 16 rulesIAS 16 permits the choice of two possible treatments in respect of property, plant and equipment:¤ The cost model (carry an asset at cost less accumulated

depreciation/impairments).¤ The revaluation model (carry an asset at its fair value

at the revaluation date less subsequent accumulated depreciation impairment).

If the revaluation policy is adopted this should be applied to all assets in the entire category, ie if you revalue a building, you must revalue all land and buildings in that class of asset. Revaluations must also be carried out with sufficient regularity so that the carrying amount does not differ materially from that which would be determined using fair value at the reporting date.

AccountIng For A revAluAtIonThere are a series of accounting adjustments that must be undertaken when revaluing a non-current asset. These adjustments are indicated below.

the initial revaluationYou may find it useful in the exam to first determine if there is a gain or loss on the revaluation with a simple calculation to compare:

Carrying value of non-current asset at revaluation date XValuation of non-current asset XDifference = gain or loss on revaluation X

depreciationDepreciation is defined in IAS 16 as being the systematic allocation of the depreciable amount of an asset over its useful economic life.

In other words, depreciation applies the accruals concept to the capitalised cost of a non-current asset and matches this cost to the period that it relates to.

depreciation methodsThere are many methods of depreciating a non-current asset with the most common being:¤ Straight line

¤ % on cost or¤ Cost – residual value Useful economic life

¤ Reducing balance¤ % on carrying value

exAmPle 4An item of plant was purchased on 1 April 2008 for $200,000 and is being depreciated at 25% on a reducing balance basis.

Prepare the extracts of the financial statements for the year ended 31 March 2010. (See page 5 for the solution to Example 4.)

useful economic lives and residual valuesIAS 16 requires that these estimates be reviewed at the end of each reporting period. If either changes significantly, the change should be accounted for over the useful economic life remaining.

exAmPle 5A machine was purchased on 1 April 2007 for $120,000. It was estimated that the asset had a residual value of $20,000 and a useful economic life of 10 years at this date. On 1 April 2009 (two years later) the residual value was reassessed as being only $15,000 and the useful economic life remaining was considered to be only five years.

How should the asset be accounted for in the years ending 31 March 2008/2009/2010? (See page 5 for the solution to Example 5.)

component depreciationIf an asset comprises two or more major components with different economic lives, then each component should be accounted for separately for depreciation purposes and depreciated over its own useful economic life.

A gAIn on revAluAtIon IS AlwAyS recognISed In equIty, under A revAluAtIon reServe (unleSS the gAIn reverSe’S revAluAtIon loSSeS on the SAme ASSet thAt were PrevIouSly recognISed In the Income StAtement – In thIS InStAnce the gAIn IS to be Shown In the Income StAtement). the revAluAtIon gAIn IS known AS An unreAlISed gAIn whIch lAter becomeS reAlISed when the ASSet IS dISPoSed oF (derecognISed).

020202Student AccountAnt issue19/2010 02Studying Paper F7?

Performance objectives 10 and 11 are relevant to this exam

Double entry:Dr Revaluation reserve Cr Retained earnings

Be careful, 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.

This movement in reserves should also be disclosed in the statement of changes in equity.

exAmPle 9 A company revalued its property on 1 April 2009 to $20m ($8m for the land). The property originally cost $10m ($2m for the land) 10 years ago. The original useful economic life of 40 years is unchanged. The company’s policy is to make a transfer to realised profits in respect of excess depreciation.

How will the property be accounted for in the year ended 31 March 2010? (See page 6 for the solution to Example 9.)

exAm FocuSIn the exam make sure you pay attention to the date that the revaluation takes place. If the revaluation takes place at the start of the year then the revaluation should be accounted for immediately and depreciation should be charged in accordance with the rule above.

If however the revaluation takes place at the year-end then the asset would be depreciated for a full 12 months first based on the original depreciation of that asset. This will enable the carrying amount of the asset to be known at the revaluation date, at which point the revaluation can be accounted for.

A further situation may arise if the examiner states that the revaluation takes place mid-way through the year. If this were to happen the carrying amount would need to be found at the date of revaluation, and therefore the asset would be depreciated based on the original depreciation for the period up until revaluation, then the revaluation will take place and be accounted for. Once the asset has been revalued you will need to consider the last period of depreciation. This will be found based upon the revaluation rules (depreciate the revalued amount over remaining useful economic life). This will be the most complicated situation and you must ensure that your working is clearly structured for this; ie depreciate for first period based on old depreciation, revalue, then depreciate last period based on new depreciation rule for revalued assets.

exAmPle 10A company purchased a building on 1 April 2005 for $100,000 at which point it was considered to have a useful economic life of 40 years. At the year end 31 March 2010 the company decided to revalue the building to its current value of $98,000.

How will the building be accounted for in the year ended 31 March 2010? (See page 7 for the solution to Example 10.)

revaluation gainsA gain on revaluation is always recognised in equity, under a revaluation reserve (unless the gain reverse’s revaluation losses on the same asset that were previously recognised in the income statement – in this instance the gain is to be shown in the income statement).

The revaluation gain is known as an unrealised gain which later becomes realised when the asset is disposed of (derecognised).

Double entry:Dr Non-current asset cost (difference between valuation and original cost/valuation)Dr Accumulated depreciation (with any historical cost accumulated depreciation)Cr Revaluation reserve (gain on revaluation)

exAmPle 7 A company purchased a building on 1 April 2007 for $100,000. The asset had a useful economic life at that date of 40 years. On 1 April 2009 the company revalued the building to its current fair value of $120,000.

What is the double entry to record the revaluation? (See page 6 for the solution to Example 7.)

revaluation lossesA revaluation loss should be charged against any related revaluation surplus to the extent that the decrease does not exceed the amount held in the revaluation reserve in respect of the same asset. Any additional loss must be charged as an expense in the income statement.

Double entry:Dr Revaluation reserve (to maximum of original gain)Dr Income statement (any residual loss)Cr Non-current asset (loss on revaluation)

exAmPle 8The carrying value of Zen’s property at the end of the year amounted to $108,000. On this date the property was revalued and was deemed to have a fair value of $95,000. The balance on the revaluation reserve relating to the original gain of the property was $10,000.

What is the double entry to record the revaluation? (See page 6 for the solution to Example 8.)

depreciationThe asset must continue to be depreciated following the revaluation. However, now that the asset has been revalued the depreciable amount has changed. In simple terms the revalued amount should be depreciated over the assets remaining useful economic life.

reserves transferThe depreciation charge on the revalued asset will be different to the depreciation that would have been charged based on the historical cost of the asset. As a result of this, IAS 16 permits a transfer to be made of an amount equal to the excess depreciation from the revaluation reserve to retained earnings.

03technIcAl

be cAreFul, In the exAm A reServeS trAnSFer IS only requIred IF the exAmIner IndIcAteS thAt It IS comPAny PolIcy to mAke A trAnSFer toreAlISed ProFItS In reSPect oF exceSS dePrecIAtIon on revAlued ASSetS. IF thIS IS not the cASe then A reServeS trAnSFer IS not neceSSAry. thIS movement In reServeS Should AlSobe dIScloSed In the StAtement oF chAngeS In equIty.

exAmPle 11At 1 April 2009 HD Ltd carried its office block in its financial statements at its original cost of $2 million less depreciation of $400,000 (based on its original life of 50 years). HD Ltd decided to revalue the office block on 1 October 2009 to its current value of $2.2m. The useful economic life remaining was reassessed at the time of valuation and is considered to be 40 years at this date. It is the company’s policy to charge depreciation proportionally.

How will the office block be accounted for in the year ended 31 March 2010? (See page 7 for the solution to Example 11.)

derecognition Property, plant and equipment should be derecognised when it is no longer expected to generate future economic benefit or when it is disposed of.

When property, plant and equipment is to be derecognised, a gain or loss on disposal is to be calculated. This can be found by comparing the difference between:

Carrying value XDisposal proceeds XProfit or loss on disposal X

Tip: When the disposal proceeds are greater than the carrying value there is a profit on disposal and when the disposal proceeds are less than the carrying value there is a loss on disposal.

exAmPle 12An asset that originally cost $16,000 and had accumulated depreciation on it of $8,000 was disposed of during the year for $5,000 cash.

How should the disposal be accounted for in the financial statements?(See page 7 for the solution to Example 12.)

disposal of previously revalued assetsWhen an asset is disposed of that has previously been revalued, a profit or loss on disposal is to be calculated (as above). Any remaining surplus on the revaluation reserve is now considered to be a ‘realised’ gain and therefore should be transferred to retained earnings as:

Dr Revaluation reserveCr Retained earnings

In summary, it can be seen that accounting for property, plant and equipment is an important topic that features regularly in the Paper F7 exam. With most of what is examinable feeding though from Paper F3 this should be a comfortable topic that you can tackle well in the exam.

Bobbie-Anne Retallack is a content specialist at Kaplan Publishing

See pages 5, 6 and 7 for solutions to all the examples illustrated in this technical article.

04Student AccountAnt issue19/2010

¤ Depreciation of the store. Even though the asset has not yet been brought into use, IAS 16 states depreciation of an asset begins when it is available for use, ie when it is in the location and condition necessary for it to be capable of operating in the manner intended by management.

Note: depreciation cannot be calculated in this question as information surrounding useful economic life has not been provided – this is for illustrative purposes only. Depreciation is covered later in this article.

SolutIon 3The $18,000 should be capitalised as part of the cost of the asset as the revenue earning capacity of the machine has significantly increased, which could in turn lead to the inflow of additional economic benefit and the cost of the upgrade can be reliably measured.

SolutIon 4Income statement extractDepreciation expense $37,500Statement of financial position extractPlant(200,000 – 50,000 – 37,500) $112,500

Working for depreciation:31/03/09 Cost 200,000 Depreciation – 25% (50,000) Carrying value 150,000

31/03/10 Carrying value 150,000 Depreciation – 25% (37,500) Carrying value 112,500

SolutIon 531 March 2008At the date of acquisition the cost of the asset of $120,000 would be capitalised. The asset should then be depreciated for the years to 31 March 2008/2009 as:

Cost – residual value = 120,000 – 20,000 = $10,000 per annumUseful economic life 10 years

Income statement extract 2008Depreciation $10,000Statement of financial position extract 2008Machine(120,000 – 10,000) $110,000

31 March 2009Income statement extract 2009Depreciation $10,000Statement of financial position extract 2009Machine(120,000 – 20,000) $100,000

SolutIon 1In accordance with IAS 16, all costs required to bring an asset to its present location and condition for its intended use should be capitalised. Therefore, the initial purchase price of the asset should be: $List price 82,000Less: trade discount (10%) (8,200) 73,800Import duty 1,500Delivery fees 2,050Electrical installation costs 9,500Pre-production testing 4,900Total amount to be capitalised at 1 March 91,750

The maintenance contract of $7,000 is an expense and therefore should be spread over a five-year period in accordance with the accruals concept and taken to the income statement. If the $7,000 has been paid in full, then some of this cost will represent a prepayment.

In addition the settlement discount received of $3,690 ($73,800 x 5%) is to be shown as other income in the income statement.

SolutIon 2This is an example of a self-constructed asset. All costs to get the store to its present location and condition for its intended use should be capitalised. All of the expenditure listed in the question, with the exception of general overheads would qualify for capitalisation.

The interest on the loan should also be capitalised from 1 April 2009 as in accordance with IAS 23 it meets the definition of a qualifying asset. The recognition criteria for capitalisation appears to be met ie activities to prepare the asset for its intended use are in progress, expenditure for the asset is being incurred and borrowing costs are being incurred. Capitalisation of the interest on the loan must cease when the asset is ready for use, ie 1 January 2010. At this point any remaining interest for the period should be charged as a finance cost in the income statement.

Property, plant and equipmentStore: $000Freehold land 4,500Architect fees 620Site preparation 1,650Materials 7,800Direct labour costs 11,200Legal fees 2,400Borrowing costs(25,000 x 8%) x 9 /12 1,500Total to be capitalised 29,670

Income statement impactWith regards to the income statement this should be charged with: ¤ General overheads of $940,000¤ Remaining interest for Jan–Mar which is now an expense

$500,000 (25,000 x 8% x 3/12) and;

ias 16 solutions

05technIcAl

31 March 2010As the residual value and useful economic life estimates have changed during the year ended 2010, the depreciation charge will need to be recalculated. The carrying value will now be spread according to the revised estimates.

Depreciation charge:100,000 – 15,000 = $17,000 per annum 5 years

Income statement extract 2010Depreciation $17,000Statement of financial position extract 2010Machine(100,000 – 17,000) $83,000

SolutIon 6 $000Land and buildings(65,000 – 20,000)/50 years)) 900Fixtures and fittings (24,000/10 years) 2,400Lifts (11,000/20 years) 550Total property depreciation 3,850

SolutIon 7 Gain on revaluation:Carrying value of non-current asset at revaluation date(100,000 – (100,000/40 years x 2 years)) 95,000Valuation 120,000Gain on revaluation 25,000

Double entry:Dr Building cost(120,000 – 100,000) 20,000Dr Accumulated depreciation(100,000/40 years x 2 years) 5,000Cr Revaluation reserve 25,000

SolutIon 8Loss on revaluation:Carrying value of non-current asset at revaluation date 108,000Valuation 95,000Loss on revaluation 13,000

Double entry:Dr Revaluation reserve(to maximum of original gain) 10,000Dr Income statement 3,000Cr Non-current asset 13,000

The revaluation gain or loss must be disclosed in both the statement of changes in equity and in other comprehensive income.

SolutIon 9 Statement of comprehensive income extract for the year ended 31 March 2010 $000 Depreciation expense 400

Other comprehensive income: Revaluation gain 12,000

Statement of financial position extract as at 31 March 2010

$000 Non-current assets Property(20,000 – 400) 19,600 Equity Revaluation reserve(12,000 – 200) 11,800

Statement of changes in equity extracts Revaluation reserve Retained earnings $000 $000Revaluation gain 12,000 Reserves transfer (200) 200

Workings:Gain on revaluation: $000Carrying value of non-current asset at revaluation date(10,000 – ((10,000 – 2,000)/40 years x 10 years)) 8,000Valuation 20,000Gain on revaluation 12,000

Double entry:Dr Property(20,000 – 10,000) 10,000Dr Accumulated depreciation((10,000 – 2,000)/40 years x 10 years) 2,000Cr Revaluation reserve 12,000

Depreciation charge for year to 31 March 2010:Dr depreciation expense((20,000 – 8,000)/30 years) 400Cr Accumulated depreciation 400

Reserves transfer:Historical cost depreciation charge((10,000 – 2,000)/40 years) 200Revaluation depreciation charge 400Excess depreciation to be transferred 200

Dr Revaluation reserve 200Cr Retained earnings 200

06Student AccountAnt issue19/2010

Working paper:Note: Revaluation takes place part way through the year and therefore depreciation must first be charged for the period 1 April 09 – 30 September 09, then the revaluation can be recorded and then depreciation needs to be charged for the period 1 October 2009 – 31 March 2010.

(W1) Depreciation 1 April–30 September 20092,000,000 x 6/12 = $20,000 50 years

(W2) RevaluationThe carrying value of the asset at 1 October 2009 can now be found and revalued.

Carrying value of non-current asset at revaluation date(2,000,000 – (400,000 – 20,000)) 1,580,000Valuation of non-current asset 2,200,000Gain on revaluation 620,000

Double entry:Dr NCA cost (2,200,000 – 2,000,000) 200,000Dr Accumulated depreciation 420,000Cr Revaluation reserve 620,000

(W3) Depreciation 1 October – 31 March 20102,200,000 x 6/12 = $27,500 40 years

SolutIon 12The asset and its associated depreciation should be removed from the statement of financial position and a profit or loss on disposal should be recorded in the income statement.

The loss on disposal is:

Carrying value at disposal date(16,000 – 8,000) 8,000Disposal proceeds 5,000Loss on disposal 3,000

SolutIon 10Statement of comprehensive income extract 31 March 2010

Depreciation charge 2,500

Other comprehensive income: Revaluation gain 10,500

Statement of financial position extract 31 March 2010Building at valuation 98,000

Statement of changes in equity extract Revaluation reserveRevaluation gain 10,500

Working paper:Note: revaluation takes place at year end, therefore a full year of depreciation must first be charged.

(W1) Depreciation year ended 31 March 2010100,0000 = $2,500 40 years

(W2) RevaluationThe carrying value of the asset at 31 March 2010 can now be found and revalued.

Carrying value of non-current asset at revaluation date(100,000 – (100,000/40 years x 5 years)) 87,500Valuation of non-current asset 98,000Gain or loss on revaluation 10,500

Double entry:Dr Accumulated depreciation 12,500Cr NCA cost 2,500Cr Revaluation reserve 10,500

SolutIon 11Statement of comprehensive income extract 31 March 2010

Depreciation charge(20,000 (W1) + 27,500 (W2) 47,500

Other comprehensive income: Revaluation gain 620,000

Statement of financial position extract 31 March 2010Office block (carrying value at 31 March): Valuation 2,200,000Depreciation (27,500)Carrying value 2,172,500

Statement of changes in equity extract Revaluation reserveRevaluation gain 620,000

07technIcAl

RELEVANT TO ACCA QUALIFICATION PAPER F7

Studying Paper F7? Performance objectives 10 and 11 are relevant to this exam

© 2010 ACCA

ACCOUNTING FOR LEASES

The accounting topic of leases is a popular Paper F7 exam area that could feature to varying degrees in Questions 2, 3, 4 or 5 of the exam. This topic area is currently covered by IAS 17, Leases. IAS 17, Leases takes the concept of substance over form and applies it to the specific accounting area of leases. When applying this concept, it is often deemed necessary to account for the substance of a transaction, ie its commercial reality, rather than its strict legal form. In other words, the legal basis of a transaction can be used to hide the true nature of a transaction. It is argued that by applying substance, the financial statements become more reliable and ensure that the lease is faithfully represented.

Why do we need to apply substance to a lease? A lease agreement is a contract between two parties, the lessor and the lessee. The lessor is the legal owner of the asset, the lessee obtains the right to use the asset in return for rental payments. Historically, assets that were used but not owned were not shown on the statement of financial position and therefore any associated liability was also left out of the statement – this was known as ‘off balance sheet’ finance and was a way that companies were able to keep their liabilities low, thus distorting gearing and other key financial ratios. This form of accounting did not faithfully represent the transaction. In reality a company often effectively ‘owned’ these assets and ‘owed a liability’. Under modern day accounting the IASB framework states that an asset is ‘a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity’ and a liability is ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’. These substance-based definitions form the platform for IAS 17, Leases. So how does IAS 17 work? IAS 17 states that there are two types of lease, a finance lease and an operating lease. The definitions of these leases are vital and could be required when preparing an answer in the exam.

2 ACCOUNTING FOR LEASES OCTOBER 2010

© 2010 ACCA

Finance lease

A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset to the lessee. Operating lease An operating lease is defined as being any lease other than a finance

lease.

Classification of a lease In order to gain classification of the type of lease you are dealing with, you must first look at the information provided within the scenario and determine if the risks and rewards associated with owning the asset are with the lessee or the lessor. If the risks and rewards lie with the lessee then it is said to be a finance lease, if the lessee does not take on the risks and rewards, then the lease is said to be an operating lease. Finance lease indicators

There are many risks and rewards outlined within the standard, but for the purpose of the Paper F7 exam there are several important areas. The main reward is where the lessee has the right to use the asset for most of, or all of, its useful economic life. The primary risks are where the lessee pays to insure, maintain and repair the asset. When the risks and rewards remain with the lessee, the substance is such that even though the lessee is not the legal owner of the asset, the commercial reality is that they have acquired an asset with finance from the leasing company and, therefore, an asset and liability should be recognised. Other indicators that a lease is a finance lease include: • At the inception of the lease the present value of the minimum

lease payments* amounts to substantially all of the fair value of the asset

• The lease agreement transfers ownership of the asset to the lessee by the end of the lease

• The leased asset is of a specialised nature • The lessee has the option to purchase the asset at a price expected

to be substantially lower than the fair value at the date the option becomes exercisable

Finance lease accounting

Initial accounting The initial accounting is that the lessee should capitalise the finance leased asset and set up a lease liability for the value of the asset recognised. The accounting for this will be:

3 ACCOUNTING FOR LEASES OCTOBER 2010

© 2010 ACCA

Dr Non-current assets Cr Finance lease liability (This should be done by using the lower of the fair value of the asset or the present value of the minimum lease payments*.) *Note The present value of the minimum lease payments is essentially the lease payments over the life of the lease discounted to present value – you

will either be given this figure in the Paper F7 exam or, if not, use the fair value of the asset. You will not be expected to calculate the minimum lease

payments.. Subsequent accounting Depreciation

Following the initial capitalisation of the leased asset, depreciation should be charged on the asset over the shorter of the lease term or the useful economic life of the asset. The accounting for this will be: Dr Depreciation expense Cr Accumulated depreciation Lease rental/interest

When you look at a lease agreement it should be relatively easy to see that there is a finance cost tied up within the transaction. For example, a company could buy an asset with a useful economic life of four years for $10,000 or lease it for four years paying a rental of $3,000 per annum. If the leasing option is chosen, over a four-year period the company will have paid $12,000 in total for use of the asset ($3,000 pa x 4 years), ie the finance charge in this example totals $2,000 (the difference between the total lease cost ($12,000) and the purchase price of the asset ($10,000)). When a company pays a rental, in effect it is making a capital repayment (ie against the lease obligation) and an interest payment. The impact of this will need to be shown within the financial statements in the form of a finance cost in the income statement and a reduction of the outstanding liability in the statement of financial position. In reality there are several ways that this can be done, but the Paper F7 examiner has stated that he will examine the actuarial method only. The actuarial method of accounting for a finance lease allocates the interest to the period it actually relates to, ie the finance cost is higher when the capital outstanding is greatest, but as the capital gets repaid, interest payments become lower (similar to a repayment mortgage that you may have on your property). To allocate the interest to a specific period you will require the interest rate implicit within the lease

4 ACCOUNTING FOR LEASES OCTOBER 2010

© 2010 ACCA

agreement – again this will be provided in the exam and you are not required to calculate it. One of the easiest ways to apply the actuarial method in the exam is to use a leasing table. Please take note of when the rental payment is actually due, is it in advance (ie rental made at beginning of the lease year) or is it in arrears (ie rental made at the end of the lease year)? This will affect the completion of the lease table as highlighted below: Rental payments in advance

Year B/fwd Rental Capital o/s

Interest (rate

given)

C/fwd

X X (X) X X X

To income statement

(finance costs)

To statement

of financial position

(liability) Rental payments in arrears

Year B/fwd Interest (rate given)

Rental C/fwd

X X X (X) X To income

statement (finance

costs)

To statement

of financial position

(liability) Tip: to be technically accurate the lease liability should be split between a non-current liability and a current liability. Example 1 – Rentals in arrears treatment On 1 April 2009 Bush Co entered into an agreement to lease a machine that had an estimated life of four years. The lease period is also four years, at which point the asset will be returned to the leasing company. Annual rentals of $5,000 are payable in arrears from 31 March 2010. The machine is expected to have a nil residual value at the end of its life. The machine had a fair value of $14,275 at the inception of the lease. The lessor includes a finance cost of 15% per annum when calculating annual rentals. How should the lease be accounted for in the financial statements of Bush for the year end 31 March 2010?

5 ACCOUNTING FOR LEASES OCTOBER 2010

© 2010 ACCA

Solution

The lease should be classified as a finance lease as the estimated life of the asset is four years and Bush retains the right to use this asset for four years in accordance with the lease agreement therefore enjoying the rewards of the asset.

Initial accounting: recognise the asset and the lease liability Dr Property, plant and equipment 14,275 Cr Finance lease obligations 14,275

Subsequent accounting: depreciation Dr Depreciation expense 3,568 ($14,275 / 4 years) Cr Accumulated depreciation 3,568

Subsequent accounting: lease rental/interest Tip: use the lease table and complete next year as well to help you complete the split between non-current and current liabilities.

Year B/fwd Interest (15%)

Rental C/fwd

1 14,275 2,141 (5,000) 11,416 2 11,416 1,712 (5,000) 8,128

Income statement extract Depreciation 3,568 Finance costs 2,141 Statement of financial position extract

Non-current assets Carrying value machine (14,275 – 3,568)

10,707

Non-current liabilities

Lease obligation 8,128

Current liabilities Lease obligation Capital ((11,416 – 8,128)

3,288

Example 2 – Rentals in advance treatment On 1 April 2009 Shrub Co entered into an agreement to lease a machine that had an estimated life of four years. The lease period is also four years at which point the asset will be returned to the leasing company. Shrub is required to pay for all maintenance and insurance costs

NCL

6 ACCOUNTING FOR LEASES OCTOBER 2010

© 2010 ACCA

relating to the asset. Annual rentals of $8,000 are payable in advance from 1 April 2009. The machine is expected to have a nil residual value at the end of its life. The machine had a fair value of $28,000 at the inception of the lease. The lessor includes a finance cost of 10% per annum when calculating annual rentals. How should the lease be accounted for in the financial statements of Shrub for the year end 31 March 2010? Solution

The lease should be classified as a finance lease as the estimated life of the asset is four years and Shrub retains the right to use this asset for four years in accordance with the lease agreement therefore enjoying the rewards of the asset. In addition to this Shrub is required to maintain and insure the asset, therefore retaining the risks of asset ownership. Initial accounting: recognise the asset and the lease liability Dr Property, plant and equipment 28,000 Cr Finance lease obligations 28,000 Subsequent accounting: depreciation Dr Depreciation expense 7,000 ($28,000 / 4 years) Cr Accumulated depreciation 7,000 Subsequent accounting: lease rental/interest Year B/fwd Rental Capital

o/s Interest (10%)

C/fwd

1 28,000 (8,000) 20,000 2,000 22,000

2 22,000 (8,000) 14,000 Income statement extract

Depreciation 7,000 Finance costs 2,000

NCL

7 ACCOUNTING FOR LEASES OCTOBER 2010

© 2010 ACCA

Statement of financial position extract

Non-current assets Carrying value machine (28,000 – 7,000)

21,000

Non-current liabilities

Lease obligation 14,000

Current liabilities Lease obligation Accrued interest Capital ((22,000 – 14,000) –2,000)

2,000 6,000

Example 3 – Split lease year treatment

On 1 October 2008 Number Co entered into an agreement to lease a machine that had an estimated life of four years. The lease period is also four years with annual rentals of $10,000 payable in advance from 1 October 2008. The machine is expected to have a nil residual value at the end of its life. The machine had a fair value of $35,000 at the inception of the lease. The lessor includes a finance cost of 10% per annum when calculating annual rentals. How should the lease be accounted for in the financial statements of Number for the year end 31 March 2010?

Solution The lease should be classified as a finance lease as the estimated life of the asset is four years and Number retains the right to use this asset for four years in accordance with the lease agreement therefore enjoying the rewards of the asset.

Initial accounting: recognise the asset and the lease liability Dr Property, plant and equipment 35,000 Cr Finance lease obligations 35,000 Subsequent accounting: depreciation Tip: the depreciation for the year ended 31 March 2010 is a straightforward annual charge, but you will also have to take into account the depreciation for the first six months of the lease that was attributable to the year ended 31 March 2009 as this will be required to find the closing carrying value in the statement of financial position.

8 ACCOUNTING FOR LEASES OCTOBER 2010

© 2010 ACCA

1 October 2008 – 31 March 2009

Dr Depreciation expense 4,375 ($35,000 / 4 years x 6/12) Cr Accumulated depreciation 4,375 1 April 2009 – 31 March 2010 Dr Depreciation expense 8,750 ($35,000 / 4 years) Cr Accumulated depreciation 8,750 Subsequent accounting: lease rental/interest Tip: you are looking for the outstanding value of the lease 18 months after the lease agreement began. It is advisable that you extend your lease table so that you have two separate ‘c/fwd’ balances – the balance at the end of the accounting year (31 March) and the balance at the end of the lease year (30 September). Year B/fwd Rental Capital

o/s Interest (10%) (6

months)

C/fwd (31 Mar)

Interest (10%) (6

months)

C/fwd (30 Sep)

1 35,000 (10,000) 25,000 1,250 26,250 1,250 27,500

2 27,500 (10,000) 17,500 875 18,375 875 19,250 3 19,250 (10,000) 9,250

Income statement extract 31 March 2010 Depreciation 8,750 Finance costs 2,125 (1,250 + 875)

Statement of financial position extract 31 March 2010 Non-current assets Carrying value machine (35,000 – 4,375 (first 6 months depreciation) – 8,750 (current year charge))

21,875

Non-current liabilities

Lease obligation 9,250

Current liabilities Lease obligation Interest Capital ((18375 - 9,250) - 875)

875 8,250

NCL

9 ACCOUNTING FOR LEASES OCTOBER 2010

© 2010 ACCA

Operating lease accounting

As the risks and rewards of ownership of an asset are not transferred in the case of an operating lease, an asset is not recognised in the statement of financial position. Instead rentals under operating leases are charged to the income statement on a straight-line basis over the term of the lease, any difference between amounts charged and amounts paid will be prepayments or accruals. Example 4 – Operating lease treatment On 1 October 2009 Alpine Ltd entered into an agreement to lease a machine that had an estimated life of 10 years. The lease period is for four years with annual rentals of $5,000 payable in advance from 1 October 2009. The machine is expected to have a nil residual value at the end of its life. The machine had a fair value of $50,000 at the inception of the lease. How should the lease be accounted for in the financial statements of Alpine for the year end 31 March 2010? Solution In the absence of any further information, this transaction would be classified as an operating lease as Alpine does not get to use the asset for most of/all of the assets useful economic life and therefore it can be argued that they do not enjoy all the rewards from this asset. In addition to this, the present value of the minimum lease payments, if calculated (you are not required to do this in the exam, only use if the examiner gives to you) would be substantially less than the fair value of the asset. The accounting for this lease should therefore be relatively straightforward and is shown below: Rental of $5,000 paid on 1 October: Dr Lease expense (income statement) 5,000 Cr Bank 5,000 This rental however spans the lease period 1 October 2009 to 30 September 2010 and therefore $2,500 (the last six-months’ rental) has been prepaid at the year end 31 March 2010. Dr Prepayments 2,500 Cr Lease expense 2,500

10 ACCOUNTING FOR LEASES OCTOBER 2010

© 2010 ACCA

Income statement extract

Lease expense 2,500 Statement of financial position extract

Current assets: Prepayments 2,500 Example 5 – Initial rent free incentive A Co entered into an agreement to lease office space on 1 April 2009 for a fixed period of five years. As an incentive to encourage the office space to be occupied, a first year rent-free period was included in the agreement after which A Co is required to pay an annual rental of $36,000. How should the lease be accounted for in the year ended 31 March 2010? Solution

The total cost of leasing the office space is $144,000 ($36,000 4 years). Despite there being a ‘rent-free’ period the total cost of the lease should be matched to the period in which it relates. Therefore, in year 1: Income statement extract

Rental $28,800 ($144,000 / 5 years) Statement of financial position extract

Current liabilities Accruals $28,800 In summary, the accounting topic of leases is a really important accounting area and is highly examinable. To master this topic, ensure that you know the definitions of both types of lease, the recognition criteria for a finance lease and practise plenty of examples of accounting for finance leases. Bobbie-Anne Retallack is a content specialist at Kaplan Publishing

RELEVANT TO ACCA QUALIFICATION PAPERS F7 and P2

Studying Paper F7 or P2? Performance objectives 10 and 11 are relevant to these exams

© 2011 ACCA

How to account for property in Hong Kong This article is applicable to any candidate studying for F7, P2 or DipIFR

With very few exceptions, all land in Hong Kong is owned by the Government

and leased out for a limited period. It does not matter if the properties are

high-rise buildings, residential, offices or factories, they are built on land under

a government lease.

Developers of these properties lease lots of land from the Government and

develop the land according to the lease conditions, such as to construct

buildings on the land according to the specifications within a specified period.

Individual units of these lots of land and buildings are usually sold as

undivided shares in the lots. Interests of all parties, including future buyers of

the units, are governed by the deeds of mutual covenant.

In substance and in form, ‘owners‘ of these units are a lessee of a lease of land

and buildings. According to IFRS, the land and buildings elements of these

leases should be considered separately for the purposes of lease classification

under IAS 17.

Allocation of the interests in leases of land and building

IAS 17

When a lease includes both land and buildings elements, we should assess the

classification of each element as a finance or an operating lease separately.

(Except, if the amount that would initially be recognised for the land element is

immaterial, the land and buildings may be treated as a single unit for the

purpose of lease classification. In such a case, the economic life of the

buildings is regarded as the economic life of the entire leased asset.)

In determining whether the land element is an operating or a finance lease, an

important consideration is that land normally has an indefinite economic life,

which makes most of the land elements operating leases.

However, this is not always the case. Land elements can be classified as a

finance lease if significant risks and rewards associated with the land during

the lease period would have been transferred from the lessor to the lessee

despite there being no transfer of title. For example, consider a 999-year lease

of land and buildings. In this situation, significant risks and rewards associated

with the land during the lease term would have been transferred to the lessee

despite there being no transfer of title.

Separate measurement of the land and buildings elements is not required

when the lessee’s interest in both land and buildings is classified as an

investment property in accordance with IAS 40 and the fair value model is

adopted.

2 ACCOUNTING FOR PROPERTY JANUARY 2011

© 2011 ACCA

Classification as property, plant and equipment or as an investment property

The issue is complicated when the separate elements of the land and buildings

are further classified in accordance with IAS 16, Property, Plant and Equipment

and IAS 40, Investment Properties.

IAS 16

According to IAS 16, land and buildings are separable assets and are

accounted for separately, even when they are acquired together. Land has an

unlimited useful life and, therefore, is not depreciated. Buildings have a limited

useful life and, therefore, are depreciable assets. An increase in the value of

the land on which a building stands does not affect the determination of the

depreciable amount of the building.

IAS 40

A property interest that is held by a lessee under an operating lease may be

classified and accounted for as investment property provided that:

• the rest of the definition of investment property is met

• the operating lease is accounted for as if it were a finance lease in

accordance with IAS 17, Leases, and

• the lessee uses the fair value model for investment property

The choice between the cost and fair value models is not available to a lessee

accounting for a property interest held under an operating lease that it has

elected to classify and account for as investment property. The standard

requires such investment property to be measured using the fair value model.

IAS 40 depends on IAS 17 for requirements for the classification of leases, the

accounting for finance and operating leases and for some of the disclosures

relevant to leased investment properties. When a property interest held under

an operating lease is classified and accounted for as an investment property,

IAS 40 overrides IAS 17 by requiring that the lease is accounted for as if it

were a finance lease.

Scenario summaries

Scenario 1: Long-term lease of land

Element Option 1 Option 2 Option 3 Option 4

Land IAS 16

(Cost

model)

IAS 16

(Revaluation)

model)

IAS 40 (Cost

model)

IAS 40

(Fair model)

Buildings IAS 16

(Cost

model)

IAS 16

(Revaluation

model)

IAS 40

(Cost

model)

IAS 40

(Fair model)

Land element is classified as a finance lease under IAS 17 as significant risks

and rewards associated with the land during the lease period would have been

transferred to the lease despite there being no transfer of title.

The land should be recognised under IAS 16 (option 1 and 2) if it is

owner-occupied or under IAS 40 (option 3 and 4) if it is used for rental earned.

Option 1: Both land and buildings elements are measured at cost and

presented under Property, Plant and Equipment in the statement of financial

3 ACCOUNTING FOR PROPERTY JANUARY 2011

© 2011 ACCA

position. No depreciation is required for the land element but it is required for

the buildings element.

Option 2: Both land and buildings elements are measured at fair value with

changes being posted to equity and presented under Property, Plant and

Equipment in the statement of financial position. No depreciation is required

for the land element but it is required for the buildings element.

Option 3: Both land and buildings elements are measured at cost and

presented under investment property in the statement of financial position. No

depreciation is required for the land element but is required for the buildings

element.

Option 4: Both land and buildings elements are measured at fair value and

presented under investment property in the statement of financial position. No

depreciation is required for either the land element or buildings element.

Scenario 2: Short-term lease of land

Element Option 1 Option 2 Option 3 Option 4

Land IAS 17 IAS 17 IAS 17

Buildings IAS 16

(Cost

model)

IAS 16

(Revaluation

model)

IAS 40

(Cost

model)

IAS 40 (Fair Value

model) - for both

land and building

Land element is classified as an operating lease under IAS 17 because it has

indefinite economic life.

The land element should be recognised under IAS 17, as prepaid lease

payments that are amortised over the lease term. Except for, it can be

classified as investment property and the fair value model is used (option 4)

The buildings element should be recognised under IAS 16 (option 1 and 2) if it

is owner occupied or under IAS 40 (option 3 and 4) if it is used for rental

earned.

Option 1: Land element is measured as prepaid lease payments that are

amortised over the lease term. While the buildings element is measured at cost

and presented under Property, Plant and Equipment in the statement of

financial position. Depreciation is required for the building element.

Option 2: Land element is measured as prepaid lease payments that are

amortised over the lease term. While the buildings element is measured at fair

value with changes being posted to equity and presented under Property, Plant

and Equipment in the statement of financial position. Depreciation is required

for the building element.

Option 3: Land element is measured as prepaid lease payments that are

amortised over the lease term. While the buildings element is measured at cost

and presented under Investment property in the statement of financial

position. Depreciation is required for buildings element.

4 ACCOUNTING FOR PROPERTY JANUARY 2011

© 2011 ACCA

Option 4: Both land and buildings elements are measured at fair value and

presented under Investment property in the statement of financial position. No

depreciation is required for the land element and buildings element.

Scenario 3: Land element is immaterial

Element Option 1 Option 2 Option 3 Option 4

Land All the purchase price will be treated as buildings

element

Buildings IAS 16

(Cost

model)

IAS 16

(Revaluation

model)

IAS 40

(Cost

model)

IAS 40

(Fair model)

As the land element is immaterial, the land and buildings elements are treated

as a single unit for the purpose of lease classification. The economic life of the

buildings is regarded as the economic life of the entire leased property.

Option 1: Property is measured at cost and presented under Property, Plant

and Equipment in the statement of financial position. Depreciation is required.

Option 2: Property is measured at fair value with change being posted to

equity and presented under Property, Plant and Equipment in the statement of

financial position. Depreciation is required.

Option 3: Property is measured at cost and presented under Investment

property in the statement of financial position. Depreciation is required.

Option 4: Property is measured at fair value and presented under Investment

property in the statement of financial position. No depreciation is required.

Impairment review under IAS 36 is required to all assets at the reporting date

except for those where the fair value model is adopted.

Linda Ng, HKCA Learning Media

RELEVANT TO ACCA QUALIFICATION PAPER F7 AND P2

Studying Paper F7 or P2? Performance objectives 10 and 11 are relevant to this exam

© 2011 ACCA

The IASB’s Conceptual Framework for Financial Reporting I am from England, and here in the UK, unlike most countries, our system of government has no comprehensive written constitution. Many countries do have such constitutions and in these circumstances the laws of the land are

shaped and influenced by the constitution. Now while the International Accounting Standards Board (IASB) is not a country it does have a sort of

constitution, in the form of the Conceptual Framework for Financial Reporting (the Framework), that proves the definitive reference document for the

development of accounting standards. The Framework can also be described as a theoretical base, a statement of principles, a philosophy and a map. By

setting out the very basic theory of accounting the Framework points the way for the development of new accounting standards. It should be noted that the Framework is not an accounting standard, and where there is perceived to be a

conflict between the Framework and the specific provisions of an accounting standard then the accounting standard prevails.

Before we look at the contents of the Framework, let us continue to put the

Framework into context. It is true to say that the Framework: • seeks to ensure that accounting standards have a consistent approach to

problem solving and do not represent a series of ad hoc responses that address accounting problems on a piece meal basis

• assists the IASB in the development of coherent and consistent

accounting standards • is not a standard, but rather acts as a guide to the preparers of financial

statements to enable them to resolve accounting issues that are not addressed directly in a standard

• is an incredibly important and influential document that helps users understand the purpose of, and limitations of, financial reporting

• used to be called the Framework for the Preparation and Presentation of Financial Statements

• is a current issue as it is being revised as a joint project with the IASB's American counterparts the Financial Accounting Standards Board .

Overview of the contents of the Framework The starting point of the Framework is to address the fundamental question of

why financial statements are actually prepared. The basic answer to that is they are prepared 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.

In turn this means the Framework has to consider what is meant by useful information. In essence for information to be useful it must be considered both

relevant, ie capable of making a difference in the decisions made by users and

2 THE IASB’S CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING MARCH 2011

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be faithful in its presentation, ie be complete, neutral and free from error. The

usefulness of information is enhanced if it is also comparable, verifiable, timely, and understandable.

The Framework also considers the nature of the reporting entity and, in what reminds me of my school chemistry lessons, the basic elements from which

financial statements are constructed. The Framework identifies three elements relating to the statement of financial position, being assets, liabilities and

equity, and two relating to the income statement, being income and expenses. The definitions and recognition criteria of these elements are very important

and these are considered in detail below.

The five elements An asset is defined as a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the

entity.

Assets are presented on the statement of financial position as being noncurrent or current. They can be intangible, ie without physical presence, eg

goodwill. Examples of assets include property plant and equipment, financial assets and inventory.

While most assets will be both controlled and legally owned by the entity it should be noted that legal ownership is not a prerequisite for recognition,

rather it is control that is the key issue. For example IAS 17, Leases, with regard to a lessee with a finance lease, is consistent with the Framework's

definition of an asset. IAS 17 requires that where substantially all the risks and rewards of ownership have passed to the lessee it is regarded as a finance

lease and the lessee should recognise an asset on the statement of financial position in respect of the benefits that it controls, even though the asset

subject to the lease is not the legally owned by the lessee. So this reflects that the economic reality of a finance lease is a loan to buy an asset, and so the

accounting is a faithful presentation. A liability is defined as a present obligation of the entity arising from past

events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

Liabilities are also presented on the statement of financial position as being

noncurrent or current. Examples of liabilities include trade payables, tax creditors and loans.

It should be noted that in order to recognise a liability there does not have to be an obligation that is due on demand but rather there has to be a present

obligation. Thus for example IAS 37, Provisions, Contingent Liabilities and

3 THE IASB’S CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING MARCH 2011

© 2011 ACCA

Contingent Assets is consistent with the Framework's approach when

considering whether there is a liability for the future costs to decommission oil rigs. As soon as a company has erected an oil rig that it is required to

dismantle at the end of the oil rig's life, it will have a present obligation in respect of the decommissioning costs. This liability will be recognised in full, as a non-current liability and measured at present value to reflect the time

value of money. The past event that creates the present obligation is the original erection of the oil rig as once it is erected the company is responsible

to incur the costs of decommissioning.

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

The effect of this definition is to acknowledge the supreme conceptual importance of indentifying, recognising and measuring assets and liabilities, as

equity is conceptually regarded as a function of assets and liabilities, ie a balancing figure.

Equity includes the original capital introduced by the owners, ie share capital

and share premium, the accumulated retained profits of the entity, ie retained earnings, unrealised asset gains in the form of revaluation reserves and, in

group accounts, the equity interest in the subsidiaries not enjoyed by the parent company, ie the non-controlling interest (NCI). Slightly more exotically, equity can also include the equity element of convertible loan stock, equity

settled share based payments, differences arising when there are increases or decreases in the NCI, group foreign exchange differences and contingently

issuable shares. These would probably all be included in equity under the umbrella term of Other Components of Equity.

Income is defined as the increases in economic benefits during the accounting

period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to

contributions from equity participants. Most income is revenue generated from the normal activities of the business in

selling goods and services, and as such is recognised in the Income section of the Statement of Comprehensive Income, however certain types of income are

required by specific standards to be recognised directly to equity, ie reserves, for example certain revaluation gains on assets. In these circumstances the

income (gain) is then also reported in the Other Comprehensive Income section of the Statement of Comprehensive Income.

The reference to ‘other than those relating to contributions from equity participants’ means that when the entity issues shares to equity shareholders,

4 THE IASB’S CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING MARCH 2011

© 2011 ACCA

while this clearly increases the asset of cash, it is a transaction with equity

participants and so does not represent income for the entity.

Again note how the definition of income is linked into assets and liabilities. This is often referred to as ‘the balance sheet approach’ (the former name for the statement of financial position).

Expenses are defined as decreases in economic benefits during the accounting

period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to

distributions to equity participants.

The reference to ‘other than those relating to distributions to equity participants’ refers to the payment of dividends to equity shareholders. Such dividends are not an expense and so are not recognised anywhere in the

Statement of Comprehensive Income. Rather they represent an appropriation of profit that is as reported as a deduction from Retained Earnings in the

Statement of Changes in Equity.

Examples of expenses include depreciation, impairment of assets and purchases. As with income most expenses are recognised in the Income

Statement section of the Statement of Comprehensive Income, but in certain circumstances expenses (losses) are required by specific standards to be recognised directly in equity and reported in the Other Comprehensive Income

Section of the Statement of Comprehensive Income. An example of this is an impairment loss, on a previously revalued asset, that does not exceed the

balance of its Revaluation Reserve.

The recognition criteria for elements The Framework also lays out the formal recognition criteria that have to be met

to enable elements to be recognised in the financial statements. The recognition criteria that have to be met are that

• that an item that meets the definition of an element and • it is probable that any future economic benefit associated with the item

will flow to or from the entity and

• the item’s cost or value can be measured with reliability.

Measurement issues for elements Finally the issue of whether assets and liabilities should be measured at cost or

value is considered by the Framework. To use cost should be reliable as the cost is generally known, though cost is not necessary very relevant for the

users as it is past orientated. To use a valuation method is generally regarded as relevant to the users as it up to date, but value does have the drawback of not always being reliable. This conflict creates a dilemma that is not

satisfactorily resolved as the Framework is indecisive and acknowledges that

5 THE IASB’S CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING MARCH 2011

© 2011 ACCA

there are various measurement methods that can be used. The failure to be

prescriptive at this basic level results in many accounting standards sitting on the fence how they wish to measure assets. For example IAS 40, Investment

Properties and IAS 16, Property, Plant and Equipment both allow the preparer the choice to formulate their own accounting policy on measurement.

Applying the Framework A company is about to enter into a three-year lease to rent a building. The

lease cannot be cancelled and there is no certainty of renewal. The landlord retains responsibility for maintaining the premises in good repair. The

directors are aware that in accordance with IAS 17 that technically the lease is classified as an operating lease, and that accordingly the correct accounting

treatment is to simply expense the income statement with the rentals payable. Required

Explain how such a lease can be regarded as creating an asset and liability per the Framework.

Solution – lease

Given that it is reasonable to assume that the expected life of the premises will vastly exceed three years and that the landlord (lessor) is responsible for the

maintenance, on the basis of the information given, the risks and rewards of ownership have not passed. As such IAS 17 prescribes that the lessee charges the rentals payable to the income statement. No asset or liability is recognised,

although the notes to the financial statements will disclose the existence of the future rental payments.

However, instead of considering IAS 17 let us consider how the Framework

could approach the issue. To recognise a liability per the Framework requires that there is a past event that gives rise to a present obligation. It can be

argued that the signing of the lease is a sufficient past event as to create a present obligation to pay the rentals for the whole period of the lease. On the

same basis, while substantially all the risks and rewards of ownership have not passed, the lessee does control the use of the building for three years and has the benefits that brings. Accordingly, when considering the Framework, a

radically different potential treatment arises for this lease. On entering the lease a liability is recognised, measured at the present value of the future cash

flow obligations to reflect the time value of money. In turn an asset would also be accounted for. After the initial recognition of the liability, a finance cost is

charged against profit in respect of unwinding the discount on the liability. The annual cash rental payments are accounted for as a reduction in the liability.

The asset is systematically written off against profit over the three years of the agreement (depreciation).

6 THE IASB’S CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING MARCH 2011

© 2011 ACCA

There is, at present, a conflict between IAS 17 and the Framework. The IASB is

currently reviewing IAS 17 because the current accounting treatment of lessees not recognising the future operating lease rentals as liabilities arguably

amounts to off balance sheet financing. The Framework’s definition of a liability is at the heart of proposals to revise IAS 17 to ensure that the statement of financial position faithfully and completely represents all an

entity’s liabilities. Accordingly this conflict should soon be resolved.

Tom Clendon FCCA is a subject expert at Kaplan

RELEVANT TO ACCA QUALIFICATION PAPER F7 AND

PERFORMANCE OBJECTIVES 10 AND 11

© 2011 ACCA

The need for and an understanding of a conceptual framework This topic forms most of Section A (and has an influence on Section B) of the syllabus for Paper F7, Financial Reporting. A conceptual framework is important to the understanding of the many principles and concepts that underpin International Financial Reporting Standards (IFRS) and is an often-neglected part of candidates’ studies. Questions from these areas regularly appear in Paper F7 exams – usually as Question 4 – and I often comment in my examiner’s report that they are the least well-answered question in the exam paper; the questions also have a high incidence of candidates not attempting them at all. This article is intended to illustrate the relevance and importance of this topic. What is a conceptual framework? In a broad sense a conceptual framework can be seen as an attempt to define the nature and purpose of accounting. A conceptual framework must consider the theoretical and conceptual issues surrounding financial reporting and form a coherent and consistent foundation that will underpin the development of accounting standards. It is not surprising that early writings on this subject were mainly from academics. Conceptual frameworks can apply to many disciplines, but when specifically related to financial reporting, a conceptual framework can be seen as a statement of generally accepted accounting principles (GAAP) that form a frame of reference for the evaluation of existing practices and the development of new ones. As the purpose of financial reporting is to provide useful information as a basis for economic decision making, a conceptual framework will form a theoretical basis for determining how transactions should be measured (historical value or current value) and reported – ie how they are presented or communicated to users. Some accountants have questioned whether a conceptual framework is necessary in order to produce reliable financial statements. Past history of standard setting bodies throughout the world tells us it is. In the absence of a conceptual framework, accounting standards were often produced that had serious defects – that is:

• they were not consistent with each other particularly in the role of prudence versus accruals/matching

• they were also internally inconsistent and often the effect of the transaction on the statement of financial position was considered more important than its effect on income the statement

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• standards were produced on a ‘fire fighting’ approach, often reacting to a corporate scandal or failure, rather than being proactive in determining best policy.

• Some standard setting bodies were biased in their composition (ie not fairly representative of all user groups) and this influenced the quality and direction of standards

• the same theoretical issues were revisited many times in successive standards – for example, does a transaction give rise to an asset (research and development expenditure) or liability (environmental provisions)?

It could be argued that the lack of a conceptual framework led to a proliferation of ‘rules-based’ accounting systems whose main objective is that the treatment of all accounting transactions should be dealt with by detailed specific rules or requirements. Such a system is very prescriptive and inflexible, but has the attraction of financial statements being more comparable and consistent. By contrast, the availability of a conceptual framework could lead to ‘principles-based’ system whereby accounting standards are developed from an agreed conceptual basis with specific objectives. This brings us to the International Accounting Standards Board’s (IASB) The Conceptual Framework for Financial Reporting (the Framework), which is in essence the IASB’s interpretation of a conceptual framework and in the process of being updated. The main purpose of the Framework is to:

• assist in the development of future IFRS and the review of existing standards by setting out the underlying concepts

• promote harmonisation of accounting regulation and standards by reducing the number of permitted alternative accounting treatments

• assist the preparers of financial statements in the application of IFRS, which would include dealing with accounting transactions for which there is not (yet) an accounting standard.

The Framework is also of value to auditors, and the users of financial statements, and more generally help interested parties to understand the IASB’s approach to the formulation of an accounting standard. The content of the Framework can be summarised as follows:

• Identifying the objective of financial statements • The reporting entity (to be issued) • Identifying the parties that use financial statements • The qualitative characteristics that make financial statements useful • The remaining text of the old Framework dealing with elements of

financial statements: assets, liabilities equity income and expenses and

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© 2011 ACCA

when they should be recognised and a discussion of measurement issues (for example, historic cost, current cost) and the related concept of capital maintenance.

The development of the Framework over the years has led to the IASB producing a body of world-class standards that have the following advantages for those companies that adopt them:

• IFRS are widely accepted as a set of high-quality and transparent global standards that are intended to achieve consistency and comparability across the world.

• They have been produced in cooperation with other internationally renowned standard setters, with the aspiration of achieving consensus and global convergence.

• Companies that use IFRS and have their financial statements audited in accordance with International Standards on Auditing (ISA) will have an enhanced status and reputation.

• The International Organisation of Securities Commissions (IOSCO) recognise IFRS for listing purposes – thus companies that use IFRS need produce only one set of financial statements for any securities listing for countries that are members of IOSCO. This makes it easier and cheaper to raise finance in international markets.

• Companies that own foreign subsidiaries will find the process of consolidation simplified if all their subsidiaries use IFRS.

• Companies that use IFRS will find their results are more easily compared with those of other companies that use IFRS. This should obviate the need for any reconciliation from local GAAP to IFRS when analysts assess comparative performance.

It is not the purpose of this article to go through the detailed content of the Framework; this is well documented in many textbooks. At this point I would stress that it is important to think about what the content of the Framework really means; it is not enough merely to rote learn the principles/definitions. This is because an understanding and application of these topics will be tested in exam questions and it is on these aspects that candidates perform rather poorly. As previously mentioned, this topic is generally examined as Question 4 (worth 15 marks). Typically, the question will identify two or three areas of the Framework and ask for a definition or explanation of them – for example, the definition of assets and liabilities, an explanation of accounting concepts such as substance over form or materiality, or qualitative characteristics such as relevance and reliability. This section will usually be followed by short scenarios intended to test candidates’ understanding and their ability to apply the above knowledge.

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Here are a few examples of past questions. June 2008 exam (a) The IASB’s Framework for the Preparation and Presentation of Financial Statements requires financial statements to be prepared on the basis that they comply with certain accounting concepts, underlying assumptions and (qualitative) characteristics. Five of these are:

• Matching/accruals • Substance over form • Prudence • Comparability • Materiality

Required Briefly explain the meaning of each of the above concepts/assumptions. (5 marks) (b) For most entities, applying the appropriate concepts/assumptions in for inventories is an important element in preparing their financial statements. Required Illustrate with an example how each of the concepts/assumptions in (a) may be applied to accounting for inventory. (10 marks) (15 marks) Observations This question illustrates the progression of the topic from Paper F3 to F7. Part (a) is not much more than expected knowledge from F3, however Part (b) progresses this knowledge. It requires the application of each of the concepts, not to just any situation, but specifically to inventory thus illustrating how a single transaction (inventory in this case) can be subject to many different accounting concepts. June 2010 exam (a) An important aspect of the International Accounting Standards Board’s (IASB) Framework for the Preparation and Presentation of Financial Statements is that transactions should be recorded on the basis of their substance over their form. Required Explain why it is important that financial statements should reflect the substance of the underlying transactions and describe the features that may

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indicate that the substance of a transaction may be different from its legal form. Observations Part (a) is based on the important topic of substance over form. Note the question does not ask for a definition of the concept (this would be more for Paper F3); instead it asks why the concept is important and what features may indicate that the substance of a transaction may be different to its legal form. In other words, how do we identify such transactions? Most answers to this question merely gave a definition of substance and an example (inevitably leasing) of its use in financial statements. Part (b) consisted of a numerical example related to a sale and re-purchase agreement to illustrate the difference that the application of substance has on financial statements (compared to the legal form). June 2011 exam (a) Your assistant has been reading the IASB’s Framework for the Preparation and Presentation of Financial Statements (the Framework) and, as part of the qualitative characteristics of financial statements under the heading of ‘relevance’, he notes that the predictive value of information is considered important. He is aware that financial statements are prepared historically (ie after transactions have occurred) and offers the view that the predictive value of financial statements would be enhanced if forward-looking information (for example, forecasts) were published rather than backward-looking historical statements. Required By the use of specific examples, provide an explanation to your assistant of how IFRS presentation and disclosure requirements can assist the predictive role of historically prepared financial statements. (6 marks) Observations Again Part (a) is themed on the Framework: the important characteristic of relevance. This is such an import characteristic that the Framework says (implicitly) that if information is not relevant, it is of no use. This question focuses on a particular aspect of relevance; that of predictability. Predictability recognises that users of financial statements are very interested the future performance of an entity. The core of this question was about how historical information can be presented, such that it enhances the predictive value of financial statements.

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From memory I would say that this (section) question had the highest number of candidates that did not give any answer; and of those that did, very few scored more than half of the available marks. Part (a) was followed by a section on continuing and discontinued operations, and a calculation of diluted earnings per share. If these topics had been mentioned in Part (a) alone, it would have gained two of the six marks available. Conclusion Simply look out for more of this type of question – it is an important area and should not be neglected. Steve Scott is examiner for Paper F7

Several papers in the ACCA Qualification may feature questions on not-for-profit organisations. At the Fundamentals level, these include Papers F1, F5, F7 and F8. At the Professional level they include Papers P2, P3 and P5. Although many of the principles of management and organisation apply to most business models, not-for-profit organisations have numerous features that distinguish them from the profit maximising organisations often assumed in conventional economic theory.

This article explains some of these features. The first part of the article broadly describes the generic characteristics of not-for-profit organisations. The second part of the article, to be published in the October 2009 digital issue of Student Accountant, takes a specific and deeper look at charities, which are one of the more important types of not-for-profit organisations.

What is a not-for-profit organisation?It would be simplistic to assume that any organisation that does not pursue profit as an objective is a not-for-profit organisation. This is an incorrect assumption, as many such organisations do make a profit every year and overtly include this in their formal plans. Quite often, they will describe their profit as a ‘surplus’ rather than a profit, but as either term can be defined as an excess of income over expenditure, the difference may be considered rather semantic.

Not-for-profit organisations are distinguished from profit maximising organisations by three characteristics. First, most not-for-profit organisations do not have external shareholders providing risk capital for the business. Second, and building on the first point, they do not distribute dividends, so any profit (or surplus) that is generated is retained by the business as a further source of capital. Third, their objectives usually include some social, cultural, philanthropic, welfare or environmental dimension, which in their absence, would not be readily provided efficiently through the workings of the market system.

Types of not-for-profit organisationNot-for-profit organisations exist in both the public sector and the private sector. Most, but not all, public sector organisations do not have profit as their primary objective and were established in order to provide what economists refer to as public goods. These are mainly services that would not be available at the right price to those who need to use them (such as medical care, museums, art galleries and some forms of transportation), or could not be provided at all through the market (such as defence and regulation of markets and businesses). Private sector examples include most forms of charity and self-help organisations, such as housing associations that provide housing for low income and minority groups, sports associations (many football supporters’ trusts are set up as industrial and provident societies), scientific research foundations and environmental groups.

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Corporate formNot-for-profit organisations can be established as incorporated or unincorporated bodies. The common business forms include the following:¤ in the public sector, they may

be departments or agents of government

¤ some public sector bodies are established as private companies limited by guarantee, including the Financial Services Authority (the UK financial services regulator)

¤ in the private sector they may be established as cooperatives, industrial or provident societies (a specific type of mutual organisation, owned by its members), by trust, as limited companies or simply as clubs or associations.

A cooperative is a body owned by its members, and usually governed on the basis of ‘one member, one vote’.

A trust is an entity specifically constituted to achieve certain objectives. The trustees are appointed by the founders to manage the funds and ensure compliance with the objectives of the trust. Many private foundations (charities that do not solicit funds from the general public) are set up as trusts.

formation, constitution, and objectivesNot-for-profit organisations are invariably set up with a purpose or set of purposes in mind, and the organisation will be expected to pursue such objectives beyond the lifetime of the founders. On establishment, the founders will decide on the type of organisation and put in place a constitution that will reflect their goals. The constitutional base of the organisation will be dictated by its legal form.

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organisationsIf it is a company, it will have a Memorandum and Articles of Association, with the contents of the latter entrenched to ensure that the objectives cannot be altered easily in the future. Not-for-profit organisations that are not companies most commonly have a set of Rules, which are broadly equivalent to Articles of Association.

As with any type of organisation, the objectives of not-for-profit organisations are laid down by the founders and their successors in management. Unlike profit maximisers, however, the broad strategic objectives of not-for-profit organisations will tend not to change over time.

The purposes of the latter are most often dictated by the underlying founding principles. Within these broad objectives, however, the focus of activity may change quite markedly. For example, during the 1990s the British Know-How Fund, which was established by the UK government to provide development aid, switched its focus away from the emerging central European nations in favour of African nations.

noT-for-profiT organiSaTionS are invariably SeT up WiTh a purpoSe in mind, and The organiSaTion Will be expeCTed To purSue SuCh objeCTiveS beyond The lifeTime of The founderS. on eSTabliShmenT, The founderS Will deCide on The Type of organiSaTion and puT in plaCe a ConSTiTuTionThaT Will refleCT Their goalS.

STudenT aCCounTanT 09/2009 02

It is important to recognise that although not-for-profit organisations do not maximise profit as a primary objective, many are expected to be self-financing and, therefore, generate profit in order to survive and grow. Even if their activities rely to some extent on external grants or subventions, the providers of this finance invariably expect the organisation to be as financially self-reliant as possible.

As the performance of not-for-profit organisations cannot be properly assessed by conventional accounting ratios, such as ROCE, ROI, etc, it often has to be assessed with reference to other measures. Most not-for-profit organisations rely on measures that estimate the performance of the organisation in relation to:¤ effectiveness – the extent to

which the organisation achieves its objectives

¤ economy – the ability of the organisation to optimise the use of its productive resources (often assessed in relation to cost containment)

¤ efficiency – the ‘output’ of the organisation per unit of resource consumed.

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Many service-orientated organisations use ‘value for money’ indicators that can be used to assess performance against objectives. Where the organisation has public accountability, performance measures can also be published to demonstrate that funds have been used in the most cost-effective manner.

It is important within an exam question to read the clues given by the examiner regarding what is important to the organisation and what are its guiding principles, and to use these when assessing the performance of the organisation.

managementThe management structure of not-for-profit organisations resembles that of profit maximisers, though the terms used to describe certain bodies and officers may differ somewhat.

While limited companies have a board of directors comprising executive and non-executive directors, many not-for-profit organisations are managed by a Council or Board of Management whose role is to ensure adherence to the founding objectives. In recent times there has been some convergence between how companies and not-for-profit organisations are managed, including increasing reliance on non-executive officers (notably in respect of the scrutiny or oversight role) and the employment of ‘career’ executives to run the business on a daily basis.

Robert Souster is examiner for Paper F1

Read the second part of this article on charities in the October 2009 digital issue of Student Accountant

alThough many of The prinCipleSof managemenT and organiSaTion apply To moST buSineSS modelS, noT-for-profiT organiSaTionShave feaTureS ThaT diSTinguiSh Them from The profiT maximiSing organiSaTionS ofTen aSSumed in ConvenTionaleConomiC Theory.

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