IAS 1 Presentation of Financial Statements
IAS 1 Presentation of Financial Statements
IAS 1 Presentation of Financial Statements
XYZ plc
Statement of Comprehensive Income for the year ended 31 December 20X9
IFRS do not specify whether revenue can be presented only as a single line item in the statement of
comprehensive income, or whether an entity also may include the individual components of
revenue (for example: various sub-totals for banks).
Finance income cannot be netted against finance costs; it is included in Other income or show
separately in the income statement.
Where finance income is an incidental income, it is acceptable to present finance income
immediately before finance costs and include a sub-total of Net finance costs in the income
statement.
Where earning interest income is one of the entitys main line of business, it is presented as
revenue.
XYZ plc Statement of Changes in Equity for the year ended 31 December 20X9
IAS 16 (PPE) permits and it is best practice to make a transfer between reserves of the excess
depreciation arising as a result of revaluation. [IAS 1: 41]
When an asset carrying using revaluation model is disposed, any remaining revaluation reserve
relating to that asset is transferred directly to retained earnings. [IAS 1: 41]
An entity can present components of changes in equity either in the Statement of Changes in
Equity or in the notes to the financial statements. [IAS 1: 106]
Reserves other than share capital and retained earnings may be grouped as other components
of equity.
Entities must present a set of previous years statements for comparison purposes.
d) It does not have unconditional right to defer settlement of the liability for at least twelve
months after the reporting period.
An asset is a resource controlled by the entity as a result of past events and from which future
economic benefits are expected flow to the entity.
Initial recognition:
PPE should initially be recognised in an entity's statement of financial position at cost.
Cost is the amount of cash and cash equivalents paid to acquire the asset at the time of its
acquisition or construction PLUS the fair value of any other consideration given.
The initial estimate of dismantling and removing the item and restoring the site where it is
located if the entity is obliged to do so (to the extent it is recognised as a provision per IAS 37).
Gains from the expected disposal of assets should not be taken into account in measuring a
provision.
In case of a land, if initial estimation of restoration cost is capitalised then this capitalised
restoration cost shall be depreciated.
Borrowing costs incurred in the construction of qualifying assets if in accordance with IAS 23
Borrowing costs.
Any abnormal costs incurred by the entity, for example those arising from design errors,
wastage or industrial disputes, should be expensed as they are incurred and do not form
part of the capitalised cost of the PPE asset.
Estimated economic life and residual value of asset should 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.
The residual value of an asset is the estimated amount that an entity would currently
obtain from disposal of the asset, after deducting the estimated costs of disposal, if the
asset were already of the age and in the condition expected at the end of its useful life. [IAS
16: 6]
Subsequent expenditure only to be capitalised if enhances the life of the asset, or improves
quality or quantity of output, or reduces the cost. If not capitalised then recognise as
expense in I/S.
Measurement after initial recognition: After initially recognising an item of property, plant and
equipment in its statement of financial position at cost, an entity has two choices about how it
accounts for that item going forwards.
Cost model:
Carrying asset at cost less accumulated
depreciation and impairment losses
Revaluation model:
Carrying asset at revalued amount less
subsequent accumulated depreciation and
impairment losses
Revaluation model:
An entity can, if it chooses, revalue assets to their fair value (only if the fair value of the item
can be measured reliably)
For land and buildings this is normally determined based on their market values as determined
by an appraisal undertaken by professionally qualified valuers.
If this model is applied to one asset, it must also be applied to all other assets in the same
class.
Note that when the revaluation model is used PPE must still be depreciated. The revalued
amount is depreciated over the asset's remaining useful life.
For a revalued asset, IAS 16 allows (and encourage) a reserve transfer in the statement of
changes in equity (from revaluation reserve to retained earnings) of the 'excess'
depreciation because of an upward revaluation.
Methods of depreciation:
Straight line method
Reducing balance method
Machine hour method
Sum-of-the-digits method
$15,000
$15,000
$15,000
$15,000
X
X
X
X
5
4
3
2
/15
/15
/15
/15
= $5,000
=$4,000
= $3,000
= $2,000
Derecognition: Property, plant and equipment shall be derecognised (i.e. removed from the
statement of financial position) either:
On disposal; or
When no future economic benefits are expected from its use or disposal.
If on disposal of a revalued asset there remains a balance on the revaluation surplus relating to the
asset, this balance should be transferred to retained earnings.
An entity shall capitalise (i.e. as part of the asset) borrowing costs that are directly attributable to
the acquisition, construction or production of a qualifying asset as part of the costs of that asset.
[IAS 23: 8]
A qualifying asset is an asset that necessarily takes a
substantial period of time to get ready for its intended use
or sale. [IAS 23: 5]
An entity shall cease capitalisation borrowing costs when substantially all the activities necessary
to prepare the qualifying asset for its intended use or sale are complete. [IAS 23: 22]
01.01.12 - $1m
loan @10% for
2 years
Borrowing cost of 9
months (i.e. $75,000) to
be capitalised as part of
asset in Statement of
Financial Position
Borrowing cost of
12 months (i.e.
$100,000) to be
recognised in I/S
31.12.12 - Asset is
delivered & ready
31.12.13 - Loan
is matured and
repaid
Amount of borrowing costs available for capitalisation is actual borrowing costs incurred less any
investment income from temporary investment of those borrowings. [IAS 23: 13]
On 1 January 20X6 Stremans Co borrowed $1.5m to finance the production of two assets, both of
which were expected to take a year to build. Work started during 20X6. The loan facility was drawn
down and incurred on 1 January 20X6, and was utilised as follows, with the remaining funds
invested temporarily. Asset A Asset B $'000 $'000 1 January 20X6 250 500 1 July 20X6 250 500
The loan rate was 9% and Stremans Co can invest surplus funds at 7%.
Required: Ignoring compound interest, calculate the borrowing costs which may be capitalised for
each of the assets and consequently the cost of each asset as at 31 December 20X6.
Asset A
Asset B
$
$
Borrowing costs: To 31 December 20X6
45,000
90,000
Less investment income: To 30 June 20X6
(8,750)
(17,500)
($500,000/$1,000,000 9%)
($250,000/$500,000 7% 6/12)
For borrowings obtained generally, apply the capitalisation rate to the expenditure on the asset
(weighted average borrowing cost). [IAS 23: 14]
Acruni Co had the following loans in place at the beginning and end of 20X6.
1 January
31
December
10% Bank loan repayable 20X8
9.5% Bank loan repayable 20X9
8.9% debenture repayable 20X7
20X6
$m
120
80
20X6
$m
120
80
150
The 8.9% debenture was issued to fund the construction of a qualifying asset (a piece of mining
equipment), construction of which began on 1 July 20X6.
On 1 January 20X6, Acruni Co began construction of a qualifying asset, a piece of machinery for a
hydroelectric plant, using existing borrowings. Expenditure drawn down for the construction was: $
30m on 1 January 20X6, $20m on 1 October 20X6.
Required: Calculate the borrowing costs that can be capitalised for the hydro-electric plant
machine.
Capitalisation rate = weighted average rate = (10% (120/ (80 + 120))) + (9.5% (80 / (120 +
80))) = 9.8%
Borrowing costs = ($30m 9.8%) + ($20m 9.8% 3/12) = $3.43m
Investment property is a property (land or a building or part of a building or both) held (by
the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or
both, rather than for:
Use in the production or supply of goods or services or for administrative purposes; or
Sale in the ordinary course of business. [IAS 40: 5]
Points to note:
If a portion of an asset meets investment property criteria and other portion is not, then an
entity accounts for the portions separately (e.g. one portion under IAS 40 and another under
IAS 16) if those portions could be sold separately or leased out separately under finance lease.
[IAS 40: 10]
Where an entity owns property that is leased to, and occupied by, its parent or another
subsidiary, the property is treated as an investment property in the entity's own accounts.
However, the property does not qualify as investment property in the consolidated financial
statements as it is owner-occupied from the group perspective. [IAS 40: 15]
Measurement after recognition: After initial measurement at cost, an entity can choose
between two models: [IAS 40: 30]
The IAS 16 cost model
The fair value model
If the fair value model is adopted, the accounting treatment of investment properties will be as
follows:
All investment properties should be measured at fair value at the end of each reporting
period provided fair value can be measured reliably.
Changes in fair value, whether gains or losses, should be recognised in profit or
loss for the period in which they arise. [IAS 40: 35]
When determining fair value, do not deduct costs to sale from the fair value. [IAS 40: 37]
The policy chosen should be applied consistently to all of the entity's investment property
IAS 40 encourages the assessment of fair value by independent, appropriately qualified and
experienced professionals but does not require it.
An entity should not recognise government grants until it has reasonable assurance that: [IAS 20:
7]
The entity will comply with any conditions attached to the grant
The entity will actually receive the grant
Receiving the grant not necessarily prove that the conditions attached to it have been or will
be fulfilled.
The treatment will be same whether the grant is received in cash or given as a reduction in a
liability to government. [IAS 20: 10]
Grants relating to income: Such grants should be recognised in profit or loss as other income or
deducted from the related expense. [IAS 20: 29]
As with grants related to assets, the benefit of the grant should be recognised in profit or loss
over the periods in which the entity recognises as expenses the related costs for which the
grants are intended to compensate.
Government grants that cannot reasonably have a value placed on them (for example the
provision of free services by a government department) are excluded from the definition of
government grants.
Repayment of government grant: If a grant must be repaid it should be accounted for as a revision
of an accounting estimate (IAS 8). [IAS 20: 34]
Repayment of grant related to income: apply first against any unamortised deferred income
set up in respect of the grant, any excess should be recognised immediately as an expense.
[IAS 20: 32]
Repayment of a grant related to an asset: increase the carrying amount of the asset or reduce
the deferred income balance by the amount repayable. The cumulative additional depreciation
that would have been recognised to date in the absence of the grant should be immediately
recognised as an expense. [IAS 20: 32]
It is possible that the circumstances surrounding repayment may require a review of the asset
value and an impairment of the new carrying amount of the asset.
An intangible asset is an identifiable non-monetary asset without physical substance. [IAS 38: 8]
An asset is identifiable if it either: [IAS 38: 12]
(a) is separable, i.e. is capable of being
separated or divided from the entity
and sold, transferred, licensed, rented
or exchanged, either individually or
together with a related contract,
identifiable asset or liability, regardless
of whether the entity intends to do so;
or
(b) arises from contractual or other legal
rights, regardless of whether those
rights are transferable or separable
IAS
are
-
38 states that an intangible asset is to be recognised if, and only if, the following criteria
met: [IAS 38: 21]
it is probable that future economic benefits from the asset will flow to the entity
the cost of the asset can be reliably measured.
Purchased
phaseDevelopment
phaseResearch
Internally generated
Internally generated goodwill should not be recognised as an asset. [IAS 38: 48]
Internally generated brands, mastheads, publishing titles, customer lists and items similar in
substance shall not be recognised as intangible assets. [IAS 38: 63]
An intangible asset with a finite useful life should be amortised over its expected useful life [IAS 38:
89]
An intangible asset with an indefinite life should not be amortised [IAS 38: 89], but should be
reviewed for impairment on an annual basis [IAS 38: 108]
There must be an annual review of whether the indefinite life assessment is still appropriate. [IAS
38: 109]
Residual values should be assumed to be nil, except if an active market exists or there is a
commitment by a third party to purchase the asset at the end of its useful life [IAS 38: 100]
An active market is a market in which all the following
conditions exist:
(a) The items traded in the market are homogeneous (i.e.
similar)
(b) Willing buyers and sellers can normally be found at any
An asset is impaired when its carrying amount is higher than its recoverable amount. [IAS 36: 6]
Higher of
Value in use:
-
Where it is not possible to estimate the recoverable amount of an individual asset, the entity
estimates the recoverable amount of the cash-generating unit to which it belongs. [IAS 36: 66]
A cash-generating unit is the smallest identifiable group of assets that generates cash inflows
that are largely independent of the cash inflows from other assets or groups of assets. [IAS 36:
68]
If an active market exists for the output produced by an asset or a group of assets, this group
of assets should be identified as a CGU even if some or all of the output is used internally. [IAS
36: 70]
If the cash inflows are affected by internal transfer pricing, managements best estimate of
future price that could be achieved in arms length transactions are used in estimating the
CGUs value in use. [IAS 36: 70]
Impairment loss is allocated among the asset/CGU in the following order: [IAS 36: 104]
1. any individual asset that is specifically impaired
2. goodwill allocated to the CGU
3. other assets pro rata to their carrying amount in the CGU (subject of the carrying amount of an
asset not being reduced below its individual recoverable amount. [IAS 36: 105]
I/S:
An impairment loss reversal on property, plant and equipment first reverses the loss recorded in
profit or loss (and any remainder is credited to the revaluation surplus, subject to IAS 16
requirements) [IAS 36: 119]
SFP:
A reversal for a CGU is allocated to the assets of the CGU, except for goodwill, pro rata with the
carrying amounts of those assets [IAS 36: 122]
Once recognised, impairment losses on goodwill are not reversed [IAS 36: 124]
In case of a reversal, the carrying amount of an asset must not increase above the lower of:
Its recoverable amount; and
Its depreciated carrying amount had no impairment loss originally been recognised. [IAS
36: 123]
Impairment indicators:
The entity should look for evidence at the end of each period and conduct an impairment review
on any asset where there is evidence of impairment. [IAS 36: 9]
Evidence of obsolescence or
physical damage
Significant changes with an
adverse effect on the entity
Evidence available that asset
performance will be worse than
expected.
Intangible assets with an indefinite useful life or not yet available for use, and goodwill acquired in
business combination are subject to annual impairment test irrespective of whether there are
indications of impairment. [IAS 36: 10]
On future
transactions
Policy change
date
Two types of event which do not constitute changes in accounting policy:
(i)
Adopting an accounting policy for a new type of transaction or event not dealt with
previously by the entity.
(ii)
Adopting a new accounting policy for a transaction or event which has not occurred in
the past or which was not material.
Changes in accounting policy will be very rare and should be made only if:
The change is required by an IFRS, or
The change will result in a more appropriate presentation of events or transactions in the
financial statements of the entity, providing more reliable and relevant information.
Revaluation of non-current assets should not be treated as changes in accounting policy (i.e.
no retrospective effect for revaluation).
Changes in accounting
estimate
Errors:
Errors discovered during a current period which relate to a prior period may arise through:
Mathematical mistakes
Mistakes in the application of accounting policies
Misinterpretation of facts
Omissions
Fraud
when the error occurred before the earliest prior period presented, restating the opening
balances of assets, liabilities and equity for that period
Error/ fraud
discovered
IAS 17 Leases
Finance lease: A lease that transfers substantially all the risks and rewards incidental to
ownership of an asset to the lessee (who took the lease). Title may or may not eventually be
transferred.
IAS 17 identifies five situations which would normally lead to a lease being classified as
a finance lease:
i.
ii.
iii.
iv.
Transfer of ownership of the asset to the lessee at the end of the lease term
The lessee has the option to purchase the asset at a price sufficiently below fair value at
the option exercise date, that it is reasonably certain the option will be exercised
The lease term is for a major part of the assets economic life even if title is not transferred
at end of lease term
Present value of minimum lease payment amounts to substantially all of the assets fair
value at inception
Present value of minimum lease payments is the payments over the lease term that the lessee is required to
make discounted applying implicit interest rate.
v.
The leased asset is so specialised that it could only be used by the lessee without major
modifications being made
At commencement of a finance lease, leasee (i.e. user of the asset) recognises a Non-current asset
and a Liability in Statement of financial position.
use useful life if reasonable certainty exists that the lessee will obtain
ownership (IAS 17: 27)
On 1 October 20X3 Evans entered into a non-cancellable agreement whereby Evans would lease a new
rocket booster. The terms of the agreement were that Evans would pay 26 rentals of $3,000 quarterly
in advance commencing on 1 October 20X3, and that after this initial period Evans could continue, at
its option, to use the rocket booster for a nominal rental which is not material. The cash price of this
asset would have been $61,570 and the asset has a useful life of 10 years. Evans has a policy to
charge full years depreciation in the year of purchase of a non-current asset. The rate of interest
implicit in the lease is 2% per quarter.
Required:
Identify whether this is a finance lease and show how these transactions would be reflected in the
financial statements for the year ended 31 December 20X3.
Answer:
Though the lease term is only 6.5 years ((26 quarter X 3)/ 12 months), the lease assumed to be a
finance lease because the present value of the minimum lease payment is similar to the fair value of
the leased asset.
Present value of the minimum lease payment:
58,570
61,570
: $1,150 (non-refundable)
: $4,000 per annum for seven years payable in arrears
: $20,000 (Fair value of the lease asset at commencement of the
lease)
The asset has useful life of four years and the interest rate implicit in the lease is 11%.
Required: Prepare extracts from the income statement and statement of the financial position of
Branch for the year ending 31 December 20X1.
Answer:
It is assumed that fair value of the leased asset and present value of minimum lease payments are
same at the commencement of the lease.
IAS 18 Revenue
Income
Revenue
Amounts collected on behalf of third parties such as sales taxes, goods and services taxes and
value added taxes are not part of revenue. [IAS 18: 8]
In an agency relationship, for an agent, revenue is only the amount of his commission. [IAS 18: 8]
In some cases two or more transactions are considered together. For example, an entity may sell
goods and, at the same time, enter into a separate agreement to repurchase the goods at a later
date. This sale and repurchase agreement may constitute a secured loan and recognised as loan
liability instead of sales revenue. [IAS 18: 13]
IAS 2 Inventories
Cost of purchase
Cost of
+ conversion
Costs directly related
to the units of
production (e.g. direct
materials, direct
labours)
+
Fixed and variable
production overheads
incurred in converting
materials to finished
goods, allocated on a
systematic basis
+
Borrowing costs (if met
IAS 23 criteria)
+
Estimated selling price in the ordinary
course of business, when completed
Estimated costs to completion and the
estimated costs necessary to make the sale.
Write-down to NRV:
If inventories are write-down to their NRV, this will result closing inventory with lower carrying
value, which will have automatic effect on cost of sales (i.e. cost of sales will be increased).
IAS 2 does not apply to inventories covered by other standards, such as:
Work in progress under construction contracts (IAS 11 Construction contracts)
Provision: is a liability where there is uncertainty over its timing or the amount at which it will be
settled. A provision should be recognised where:
-
i.e. established
past
An entity has a present obligation (legal or constructive)
as a result
of a past event;
It is probable (i.e. more likely than not) that there will be an outflow of resources in the form of
cash or other assets;
A reliable estimate can be made of the amount [IAS 37: 10]
A provision should not be recognised in respect of future operating losses since there is no present
obligation arising from a past event. [IAS 37: 63]
An entity can be required to recognise a provision and capitalise (DR Non-current asset: Property,
plant & equipment; CR Liability: Provision) initial estimation of future dismantling and restoration
cost if above provision recognition criteria and IAS 16 capitalisation criteria are met. [IAS 16: 16, 18]
Gains from the expected disposal of assets shall not be taken into account in measuring a
provision. [IAS 37: 51]
If an entity sells goods with a warranty, a provision recognition (DR I/S: Expense; CR Liability:
Provision) can be required based on the best estimate of the expenditure required to settle the
present obligation at the end of the reporting period. [IAS 37: 36]
-
When the selling price includes an identifiable (i.e. distinguishable) amount for subsequent
servicing, that amount is deferred (DR Asset: Cash/ Receivable; CR Liability: Deferred income)
and recognised as revenue over the period during which the service is performed (DR Liability:
Deferred income; CR I/S: Revenue). [IAS 18: 13]
Where the provision being measured involves a large population of items, the obligation is
estimated by expected value calculation. [IAS 37: 39]
A detailed formal plan has been made, identifying the areas of the business and number of
employees affected with an estimate of likely costs an timescales; and
An announcement has been made to those who will e affected by the restructuring.
A restructuring provision does not include costs of retraining or relocating continuing staff,
marketing, or investment in new systems [IAS 37: 81]
Discounting to present value: When there is a significant period of time between the end of
reporting period and settlement of the obligation, the amount of provision should be discounted to
present value. [IAS 37: 45]
Discount factor: (1+r)
The discount rate shall be a pre-tax rate that reflects current market assessment of the time value
of money and the risks specific to the liability.
Example: If a provision of $1,000 is required to settle a liability after 2 years; at 10% discount rate
the provision will be recognised at Year-0 is $827 ($1,000 X 0.827).
At end of Year-1: $83 ($827X10%); DR I/S: Finance cost; CR Liability: Provision (that makes closing
provision liability = $910 ($827+$83))
At end of Year-2: $91 ($910X10%); DR I/S: Finance cost; CR Liability: Provision (that makes closing
Reimbursement: An entity may be entitled to reimbursement from a third party for all or part of the
expenditure required to settle a provision. Such a reimbursement:
Should only be recognised (DR Assets: Receivable; CR I/S: Other income) where receipt is virtually
certain, and
Should be treated as a separate asset in the statement of financial position (i.e. not netted off
against the provision) at an amount no greater than that provision.
The provision and the amount recognised for reimbursement may be netted off in the I/S. [IAS 37:
Contingent liability: is a possible obligation that arises from past events and whose existence will
be confirmed only by occurrence or non-occurrence of one or more uncertain future events not
wholly within the control of the entity.
-
Contingent liability is not recognised in the financial statements because either it is not
probable, or the amount cannot be measured with sufficient reliability.
Contingent liability is only disclosed in the notes of financial statements. [IAS 37: 10, 13]
Contingent asset: is a possible asset that arises from past events and whose existence will be
confirmed only by occurrence or non-occurrence of one or more uncertain future events not wholly
within the control of the entity.
-
When the realisation of income is virtually certain, then the related receivable is recognised in the
financial statements (DR Asset: Receivable; CR I/S: Other income) [IAS 37: 33]
Disclosure let out: IAS 37 permits reporting entities to avoid disclosure requirements relating to
provisions, contingent liabilities and contingent assets if they would be expected to be seriously prejudicial
(i.e. will cause serious disadvantage) to the position of the entity in dispute with other parties.
An entity shall classify a non-current asset (or disposal group) as held for sale if its carrying
amount will be recovered principally through a sale transaction rather than through continuing use.
[IFRS 5: 6]
The sale should be expected to take place within one year from the date of classification [IFRS
5: 8].
Once an asset or group of assets and related liabilities is classified as held for sale, the following
rules should be followed:
Fair value less cost to sell is equivalent to net
realisable value
Carry at lower of its carrying amount and fair value less cost to sell, which may give rise to an
impairment loss [IFRS 5: 15].
Presentation of a non-current asset or a disposal group classified as held for sale: [IFRS
5: 38]
Non-current assets and disposal groups classified as held for sale should be presented separately
from other assets in the statements of financial position. The liabilities of a disposal group should
be presented separately from other liabilities in the statement of financial position.
Assets and liabilities held for sale should not be offset.
The major classes of assets and liabilities held for sale should be separately disclosed either
on the face of the statement of financial position or in the notes.
On ultimate disposal of an asset classified as held for sale, any difference between its carrying
amount and the disposal proceeds is treated as a loss or gain recognised in income statement.
A non-current asset or disposal group that is no longer classified as held for sale (for
example, because the sale has not taken place within one year) is measured at the lower of: [IFRS
5: 27]
Its carrying amount before it was classified as held for sale, adjusted for any depreciation
that would have been charged had the asset not been held for sale.
Its recoverable amount at the date of the decision not to sell.
An asset that is to be abandoned should not be classified as held for sale. [IFRS 5: 13]
Discounted operation:
Discontinued operation is a component of an entity that has either been disposed of, or is
classified as held for sale, and:
represents a separate major line of business or geographical area of operations
is part of a single co-ordinated plan to dispose of a separate major line of business or
geographical area of operations, or
is a subsidiary acquired exclusively with a view to resale. [IFRS 5: 32]
For discontinued operations, an entity should disclose a single amount in the statement of
comprehensive income comprising the total of: [IFRS 5: 33]
-
An entity shall disclose the amount of income from continuing operations and from
discontinuing operations attributable to owners of the parent.
An entity should also disclose the net cash flows attributable to the operating, investing and
financing activities of discontinued operations. These disclosures may be presented either on
the face of the statement of cash flows or in the notes.
Gains and losses on the re-measurement of a non-current asset or disposal group that is not a
discontinued operation but is held for sale should be included in profit or loss from continuing
operations. [IFRS 5: 37]
XYZ plc - Consolidated statement of comprehensive income for the year ended 31 December
20X9
$000
Revenue
X
Cost of sales
(X)
Gross profit
X
Other income
X
Distribution costs
(X)
Administrative expenses
(X)
Other expenses
(X) 11 Construction
IAS
contracts
Revenue and cost: should be recognised according to the stage of completion of the contract at
the end of the reporting period, but only when the outcome of the activity can be estimated
reliably.
Contract costs which cannot be recovered should be recognised as an expense straight away.
If a loss is predicted (i.e. the contract value < total contract cost) on a contract then it should be
recognised immediately in I/S.
Penalty charged by client (may be for delay) will reduce the revenue; will not increase the cost.
Finance costs should be included in contract costs under IAS 23 Borrowing Costs.
Accounting treatments:
Income Statement:
Revenue
X
((Total contract value X % completed) Revenue recognised in previous periods )
Cost of sales
(X)
((Total contract costs X % completed) Costs and losses charged in previous periods)
Foreseeable loss not previously recognised (ALWAYS test for foreseeable loss)
(X)
(((Total contract value Total contract cost) X % yet to complete)
Any of this loss previously recognised)
Profit/(loss) (before non-reimbursable abnormal cost)
X/(X)
Abnormal cost (e.g. rectification cost which is not reimbursed by client)
(X)
DR SFP: Cash
115
CR I/S: Revenue
100
CR SFP: Current liability: Sales
Sales tax
tax payable
TAX
15
DR Purchase
80
DR SFP: Current asset: Sales tax recoverable
12
(or, DR SFP: Current liability: Sales tax payable,
if there is already a sales tax payable balance)
30
30
Income
Under-provision
or
over-provision
of tax: The
tax
Deferred
tax
actual tax liability for the year and the tax
charge in the income statement are not
necessarily the same amount. The actual tax
liability for the year is agreed with tax
authorities, may be, in a later year.
-
Deferred tax: This is an accounting measure rather than a tax levied by government; it
represents tax payable or recoverable in future accounting periods in relation to transactions which
have already taken place.
Temporary differences are differences between the carrying amount of an asset or liability in the
statement of financial position and its tax base. Temporary differences may be either taxable or
deductible.
-
Taxable temporary differences will result in taxable amounts in determining taxable profit
(loss) of future periods when the carrying amount of the asset or liability is recovered or
settled.
Deferred tax liabilities: are the amounts of income taxes payable in future periods in
respect of taxable temporary differences.
DR Tax charge
CR SFP: Non-current liabilities: Deferred tax liability
Deductible temporary differences will result in amounts that are deductible in determining
taxable profit (tax loss) of future periods when the carrying amount of the asset is recovered or
settled.
Deferred tax assets: are the amounts of income taxes recoverable in future periods in
respect of deductible temporary differences (and in respect of the carry forward of unused
tax losses or tax credits).
DR SFP: Non-current assets: Deferred tax asset
CR Tax charge
Recognise deferred tax (that is the difference between the opening and closing deferred tax
balances in the SFP) normally in profit or loss. But, exceptions are:
-
Deferred tax relating to items dealt with as other comprehensive income (such as revaluation)
should be recognised as tax relating to other comprehensive income within the statement of
comprehensive income
Deferred tax relating to items dealt with directly in equity (such as the correction of an error
or retrospective application of a change in accounting policy) should also be recognised
directly in equity
Step 2: Calculate the temporary difference (i.e. difference between carrying value and tax
base value) at year beginning and at year end.
Temporary difference will be either taxable temporary difference or deductible temporary
difference. Check the decision tree below.
In the question sometime the temporary differences are given. In that case you dont need
to apply Step 1.
Step 3: Apply tax rate on temporary differences to identify deferred tax asset or liability at
year beginning and at year end.
The deferred tax asset or liability identified from year end balances is the amount to be
shown in Statement of Financial Position.
The movement from year beginning deferred tax asset or liability to year end deferred tax
asset or liability to be shown in I/S (in other comprehensive income if the portion related to
revaluation).
Expense:
Asset
Income:
Asset
- The tax rate to be used in the calculation for determining a deferred tax asset or liability is
the rate that is expected to apply when the asset is realised, or the liability is settled.
The most important temporary difference is that between depreciation charged in the
financial statements and capital allowances in the tax computation. In practice capital
allowances tend to be higher than depreciation charges, resulting in accounting profits being
higher than taxable profits. This means that the actual tax charge (current tax) is too low in
comparison with accounting profits. However, these differences even out over the life of an
asset, and so at some point in the future the accounting profits will be lower than the taxable
profits, resulting in a relatively high current tax charge.
These differences are misleading for investors who value companies on the basis of their
post-tax profits (by using EPS for example). Deferred tax adjusts the reported tax expense for
these differences. As a result the reported tax expense (the current tax plus the deferred tax)
will be comparable to the reported profits, and in the statement of financial position a
provision is built up for the expected increase in the tax charge in the future.
There are different ways that deferred tax could be calculated. IAS 12 states that the balance
sheet liability method should be used. [IAS 12: IN2]
Question:
Company 'T' buys equipment for $50,000 and depreciates it on a straight line basis over its expected
useful life of five years (i.e. @20%). For tax purposes, the equipment is depreciated at 25% per annum
on a straight line basis (i.e. will be fully depreciated at end of Year-4). Accounting profit before tax is
$5,000 for each of Year 1 to 5. The tax rate is 40%. Show current and deferred tax impacts from Year 1
to 5.
Answer:
Note:
1.
-
Future taxable amount considered as equivalent to the Carrying amount since the economic
benefit (e.g. operations of the business which will generate income) from using the P&E yet to be
taxable.
Future deductible amount is $3,500 since $6,500 already claimed as tax depreciation in taxable
profit calculation. $3,500 will be deductible in the future periods taxable profit calculation.
2.
-
The amount will be taxable on cash basis; i.e. when the cash will be received in the future. So,
the whole $1,000 amount is Future taxable amount.
The amount will never be deductible in taxable profit calculation. So, Nil Future deductible
amount.
3.
-
The amount already been taxed; so will not be taxed further. That is why Future taxable amount
is Nil. - The amount will never be deductible in taxable profit calculation. So, Nil Future
deductible amount.
4.
-
The amount not taxable and not deductible in the future. So, Future taxable amount and Future
deductible amount both are Nil.
5.
-
The amount will not be taxed or deductible in the future. So, both of the values are Nil.
Putting this into a formula: Tax base = Carrying amount + Future taxable amount* Future
deductible amount
*Exception applies for unearned revenue (i.e. revenue received in advance) (see following Note-2)
Note:
1.
-
The related expense will be deducted for tax purposes on a cash basis. Since the amount yet to
be paid, the $1,000 will be Future deductible amount.
The amount is an expense, so will not the taxable in the future.
2.
-
The amount is charged for tax on cash basis. Since the cash is already received, the amount is
already taxed and will not be taxed again. That is why Future taxable amount is taken as a
negative figure, instead of positive (as given in the formula). This is exception to the general
formula, but in compliance with IAS 12 requirements.
Alternative way of calculating Tax base of Unearned revenue is: Carrying amount Amount
that will not be taxable in the future. Thus the calculation will be: 10,000 - 10,000 = Nil
3.
4.
Financial instruments
A compound or hybrid financial instrument is one that contains both a liability component and an
equity component. As an example, an issuer of a convertible bond has:
-
The obligation to pay annual interest and eventually repay the capital the liability component
The possibility of issuing equity, should bondholders choose the conversion option the equity
component.
In substance the issue of such a bond is the same as issuing separately a non-convertible bond and an
option to purchase shares. At the date of issue the components of such instruments should be
classified separately according to their substance. This is often called split accounting.
The amount received on the issue (net of any issue expense) should be allocated between the
separate components as follows:
-
The fair value of the liability component should be measured at the present value of the
periodic interest payments and the eventual capital repayment assuming the bond is
redeemed.
The present value should be discounted at the market rate for an instrument of comparable credit
status and the same cash flows but without the conversion option.
-
The fair value of the equity component should be measured as the remainder of the net
proceeds.
Note that the rate of interest on the convertible will be lower than the rate of interest on the
comparable instrument without the convertibility option, because of the value of the option to
acquire equity.
CRITERIA
Subsidiary
Associate
Contractual agreement
REQUIRED TREATMENT IN
GROUP ACCOUNTS
Full consolidation, i.e. single
entity IAS 27 Consolidated and
Separate Financial Statements
IFRS 3 Business Combinations
IFRS 10 Consolidated Financial
Statements
Equity accounting
IAS 28 Investment in Associates
and Joint Ventures
Proportionate consolidation or
equity accounting IAS 28
Investment in Associates and
Joint Ventures IFRS 11 Joint
Arrangements
As for single company accounts
(IFRS 9: Financial instruments)
Present assets or group of
assets separately in Statement
of Financial Position and results
of discontinued operations to
be presented separately in the
Statement of Comprehensive
Income.
Investments in Subsidiary:
Control achieved by owning more than 50% voting power. But, control can still exist with less
than 50% voting power.
Control may be lost even without changing the ownership levels; when subsidiary becomes
subject to control of a government, court administration or regulator.
Exemptions from preparing group accounts: A parent need not present consolidated financial
statements if ALL of the following conditions are satisfied:
It is a wholly-owned subsidiary or a partially-owned subsidiary of another entity and its other
owners have not objected to the parent not presenting consolidated financial statements
Its securities are not publicly traded
It is not in the process of issuing securities in public securities markets
The ultimate or intermediate parent publishes consolidated financial statements that comply
with IFRS
Different reporting dates: If a subsidiarys reporting date is different then parent and bulk of
other subsidiaries in the group:
the subsidiary may prepare another set of financial statements
OR, if it is not possible, the subsidiarys accounts may still be used provided that the gap is
not more than three months and adjustments are made to reflect significant transactions or
other events.
Differing accounting policies: Uniform accounting policies should be used. Adjustments should
be made where accounting policies of subsidiary differ from parent.
1.
GROUP STRUCTURE:
Parent
2.
3.
50% + (control)
Subsidiary
Associate
COST OF INVESTMENT:
Do not include costs like professional fees, legal fees in the cost of investment; these must be
recognised in the Profit or Loss account as expense as incurred. Also, in cost of investment do not
include loan issued to subsidiary.
Any contingent consideration payable must be included even at the date of acquisition if it is not
deemed probable that it will be paid
It is possible that the FV of the contingent consideration may change after the acquisition date. If
it is due to additional information obtained that affects the position at acquisition date, goodwill
should be remeasured (one year qualifying period applies). If the change is due to events after the
acquisition date (such as earnings target met) then the goodwill will not be remeasured (gain/loss
from remeasurement will be recognised in I/S)
4.
5.
GOODWILL:
i.
New method: When examiner will require to use the new method, he will mention full,
gross, new, or calculate NCI at fair value. In this case FV of NCI (value of shares not
acquired) at acquisition date will be given.
ii.
Old method: Where an exam question requires use of the old method, it will state that it is
group policy to value the non-controlling interest at its proportionate share of the fair value of
the subsidiarys identifiable net assets.
6.
CONSOLIDATED RESERVE:
7.
INVESTMENT IN ASSOCIATE:
* If subsidiary is acquired part way through the year then all income and expenses of subsidiary shall
be time apportioned
X1: Transaction value of inter-company trading (i.e. the total selling price in inter-company trading)
X2: Who is the seller? (only deduct the unrealised profit)
****The formats are not comprehensive. All information in the formats may not be required in every
situation. It is very important to understand the underlying concept than mere memorising the format.
Ratio analysis
Liquidity Ratios: Liquidity ratio measures a company's ability to pay short-term obligations
1. Current ratio =
= X:1
Current ratio is mainly used to give an idea of the company's ability to pay back its short-term
liabilities (debt and payables) with its short-term assets (cash, inventory, receivables).
The higher the current ratio, the more capable the company is of paying its obligations.
A current ratio of 1.5:1 to 2:1 can mean sufficient current asset to cover its current liabilities.
A current ratio of above 2:1 may mean over investment in working capital (i.e. in current
assets). Surplus assets can be used to
to expand the business operation or to increase capacity which will earn additional profit,
to repay debt which will save interest expenses,
distribute to shareholders as dividend.
Current Asset
Current Liabilities
A current ratio below 1 suggests that the company would be unable to pay off all of its current
liabilities if they came due at that point.
Current ratio can be improved by
A weak current ratio shows that the company is not in good financial health, but it does not
necessarily mean that it will go bankrupt as there are many ways to access financing; but it is
definitely not a good sign.
Companies that have trouble getting paid by its receivables or have long inventory turnover
can run into liquidity problems
=X:1
The quick ratio measures a company's ability to meet its short-term obligations with its most
liquid assets (as it excludes inventory).
Inventory is excluded because some companies (specially manufacturing companies with high
inventory holding period) have difficulty turning their inventory into cash.
The higher the quick ratio, the better the position of the company.
A quick ratio of 1:1 is normally most appropriate. For companies with a high inventory turnover
ratio (i.e. short inventory holding period) can have a less than 1 quick ratio without suggesting
that the company could be cash flow trouble.
If quick ratio is too low than the current ratio; this could mean that high amount of working
capital is tied up in inventory. High amount of inventory means high inventory holding costs.
Profitibality Ratios:
1.
100% = X%
Current Liability portion of Long-term liabilities; and a constant amount of Overdraft normally
also considered as Non-current liability for Capital employed calculation
If you are required to compare ratios between two different years and cannot calculate
average for both of the years, then take only the SFP value of the year (i.e. do not
average). This is for comparability purpose.
There is a lot other contexts to define capital employed. This is basically the capital required
for a business to function.
ROCE is the prime measure of operating performance. This ratio indicates how efficiently a
business (i.e. managers) is using the funds invested (equity and long-term debt).
ROCE increase from previous year or above industry average means a good sign and reflects
the fact that the company (by managers) has managed to increase the sales without a
proportionate increase in costs.
ROCE decrease from previous year or below industry average shows problem with controlling
of costs. Level of dividend may also fall as a consequence.
The value of capital employed is lower where company mainly uses rented assets (i.e.
thorough operating lease) rather owning or finance lease. This is also possible where assets
carrying value is lot less than the cost (remember in that case assets will need replacement).
These may result a higher ROCE.
2.
Asset revaluation (especially land) will result a higher amount of Capital employed, which will
give a lower ROCE without indicating company performance became poorer.
ROCE should always be higher than the rate at which the company borrows; otherwise any
increase in borrowing will reduce shareholders' earnings.
X 100% = X%
Profit after tax and preference dividend is the Profit attributable to ordinary shareholders
It is common to use book values rather market value of shares (if market value used then
remember to exclude Reserves)
Better to use average of Shareholders Capital (Opening + Closing Ordinary Share Capital and
Reserves / 2 ) where possible; specially, when closing balance significantly differs from
opening balance.
- If you are required to compare ratios between two different years and cannot calculate
average for both of the years, then take only the SFP value of the year (i.e. do not average).
This is for comparability purpose.
Return on equity (ROE) indicates to ordinary shareholders how well their investments have
performed measuring how much profit the company has generated for them with their money.
A good figure results in a high share price and makes it easy to attract new funds.
With a similar level of ROCE, a fall in ROE may mean increased finance cost because of new
loans.
An improved ROE with a similar ROCE may mean some of the loans are repaid which resulted a
lower finance cost and, so, improved profit attributable to ordinary shareholders.
If new share issued sometime at period end, this may result a declined ROE without indicating
poor performance of the company because company really did not get time to utilise the new
capital.
Gross Profit
Sales
X 100% = X%
High gross profit margin may indicate effective purchasing strategy which results a lower
material &/ production cost (i.e. lower cost of sales). A high gross profit margin may also
indicate concentration on low volume-high margin sales.
Low gross profit margin may be an indication of selling products cheaply (i.e. at discount) in
order to generate high volume of sales. This may also indicate increased production cost
(including material and labour cost) without a proportionate increase in selling price.
X 100% = X%
Operating profit margin gives analysts an idea of how much profit (before interest and tax) the
company is making from each dollar of sales.
Typically operational management has full control over operating costs (the amount of loan
capital and, so, interest expense normally depends on more higher level of management and
the amount of tax payable depends on government policy). So, operating profit margin
effectively measures performance of operational management.
A poor or declining Operating profit margin may indicate business is struggling in controlling
the costs. This may also happen because of decrease in selling price.
A healthy operating profit margin is required for a company to be able to pay interest on loans.
X 100% =
X%
Net profit margin sometimes calculated based on Profit before tax (after interest). Check
question for indication.
A higher percentage than last year or industry average indicates costs are being controlled
better. This may also indicate products are sold at higher price.
A weaken Net profit margin may indicate management is struggling in controlling the costs.
Company can sell at a discount to retain market share during economic downturn (and/or
because of intense competition). If costs remain at similar level this will result a lower Net
Profit Margin. Companies trading cheaper products can gain during economic downturn when
customers generally stop buying luxury products and turn to cheaper ones.
In large companies, where higher level of economies of scale can be achieved (i.e. lower level
of per unit cost) the net profit margin can be higher as a result.
Multinational companies can gain or loss from favourable or adverse exchange rate
movements.
Sales
Capital Employed
= X:1
Use of Non-current assets instead of Capital employed is also correct. Check question for
indication. If question says nothing, then use Capital employed.
This shows the sales that is generated from each $1 worth of Capital (or asset) employed. The
higher the sales per $1 invested the more efficient use of the capital was.
If business is selling luxury products or products with higher profit margin that may result a
lower Asset turnover ratio without a weaken ROCE or Net profit margin ratio.
Efficiency Ratios:
1.
X 365 = X days
Use only CREDIT SALES. If question gives us only a Sales figure (i.e. does not split between
credit and cash sales) then use the given Sales figure.
We need only TRADE RECEIVABLES (i.e. receivables derived from credit sales). Nontrade
receivables (e.g. advance, damage claim, receivables of government grant) shall not be
included. If question gives us only a Receivables figure, and does not give any other indication
about its components then assume that is the Trade receivables figure.
Better to use average trade receivables (Opening + Closing /2 ) where possible; specially,
when closing balance significantly differs from opening balance.
An alternative of using Average Receivables is using year-end receivables figure where amount
of receivables did not change significantly from year-beginning to year-end.
- If you are required to compare ratios between two different years and cannot calculate
average for both of the years, then take only the SFP value of the year (i.e. do not average).
This is for comparability purpose.
Receivables collection period is an approximate measure of the length of time customers take
to pay what they owe.
Collection Period of less than 30 days may seem normal. Significantly in excess of 30 days
might be representative of poor management of funds of the business. However, some
businesses such as export oriented businesses normally needs to allow generous credit terms
(may be 60 days) to win customers; whereas retailer may sell only or mainly on cash (may be
collection period of not more than 10 days).
A high or increasing collection period may mean poorly managed credit control function, and
increased risk of bad debts. This also may mean over investment in receivables.
Decreasing or low collection period may mean tighten credit control policy; which may cause
declining customer numbers (i.e. reduction of sales).
Receivables collection days can be improved by offering discount to customers for early
payment.
X 365 = X days
If Credit purchase or purchase amount cannot be identified from the question, use Cost of sales
as it serves as an approximation.
Use only Trade payables; i.e. payables generated from credit purchase.
Increasing or long payment period may indicate liquidity problem; and also may indicate
loosing opportunity of prompt payment discounts.
A longer payment period may also mean company has succeeded in obtaining very favourable
credit terms from its suppliers; contradictorily, this may also mean unethical business practice.
3.
Long credit term from suppliers is a source of interest free financing. But, some suppliers may
charge interest if payment period exceeds a certain duration.
Declining or short payment period may indicate business has sufficient cash to meet payables.
A short payment period may put companys credit ratings in higher position.
If receivables collection period is longer than the payables payment period then it can cause
cash flow difficulties.
Average Inventory
Cost of Sales
or,
Cost of Sales
Average Inventory
= X Times
Better to use Average Inventory figure to take into account the variation between Opening
inventory and Closing inventory. But, instead of Average Inventory the closing inventory figure
can be used where opening inventory level cannot be determined; in that case comparable
figure has to derive from same approach.
This ratio is an estimate of the average time that inventory is held before it is used or sold. If
average inventory holding period is 30 days, this means that the inventory is turned over (i.e.
sold) on average 12.16 times (= 365/30) in a year
A low turnover (i.e. high holding period) implies slow sales and, therefore, excess inventory
and/ or high level of inventory holding costs.
High inventory levels are unhealthy because they represent an investment with a zero rate of
return. It may also put company at a great loss if prices start to decline (think about
technological products).
In F9:
1. Finished goods inventory turnover period =
Average FG Inventory
Cost of Sales
Average RM Inventory
Annul Purchases
Average WIP
Cost of Sales
Days
X
X
X
X
(X)
X/(X)
This cycle is the length of time between cash payment to suppliers and cash received form
customers. This measured how long a firm will be deprived of cash.
A company could even achieve a negative cycle by collecting from customers before paying
suppliers. This policy of strict collections and delay payments is not always sustainable or
appreciable by customers (because they have to pay early) and suppliers (because they are
being paid late).
Investment Ratios:
1.
= $X
or,
Market Price per Share
Price Earnings Ratio
2.
= $X
EPS is generally considered to be the single most important variable in determining a shares
price. This is a key measure of company performance from ordinary shareholders point of
view.
EPS shows the amount of profit attributable to each ordinary share. But, it does not represent
actual income of the ordinary shareholders.
A constant growth in EPS may result in favourable movements (i.e. increase) in share price.
Both right issue and bonus issue of shares result in a fall of EPS. So, care must be taken while
interpreting.
EPS often ignores the amount of capital employed to generate the earnings. Two companies
could generate the same EPS, but one could do so with less investment; this could mean that
this company was more efficient at using its capital.
= X$
DPS is the actual portion of income received by the ordinary shareholders from EPS.
DPS is important for shareholders who are seeking income from shares rather capital gain.
Growth in dividend per share used in share price valuation. So, companies may have a policy
of achieving steady growth in dividend pay-out per share. A steady growth normally creates
positive market reaction (i.e. increase in share price).
X 100% = X%
or,
Ordinary Dividend Declared and Paid for The Year
Earnings (i e Profit) Attributable to Ordinary Shareholders
X 100% =
X%
Dividend pay-out ratio is the percentage of earnings paid to shareholders as dividends. This
shows how well earnings support the dividend payments.
4.
High dividend pay-out ratio may mean company confidence on future earnings. But, where
majority of shares are held by a small number of shareholders, it may also mean that
shareholders are taking out as much profit as they can; and this does not necessarily serve
companys long-term interest.
Low dividend pay-out ratio may mean company is expecting difficulties in the future; so now
interested in retaining earnings. But, it can also mean expansion (by reinvesting the retained
earnings) of business in the future.
Dividend cover =
= X Times
or,
Earnings (i.e. Profit) Attributable to Ordinary Shareholders
Ordinary Dividend for the Year
= X Times
Dividend cover represents how many times dividend could have paid from the profit
attributable to ordinary shareholders.
Dividend cover is a measure of the ability of a company to maintain the level of dividend paid
out. The higher the cover, the better the ability to maintain dividend pay-out if profits drop.
Typically, a ratio of 2 or higher is considered safe in the sense that the company can well afford
the dividend; but dividend cover below 1.5 may seem risky.
If the dividend cover is below 1 then the company is using its retained earnings from previous
years to pay current years dividend
A low level of dividend cover might be acceptable in a company with very stable profits, but
the same level of cover for a company with volatile profits would indicate that company may
not able to maintain the current level of dividend pay-out.
= X Times
or,
Companys Market Capitalisation
Earnings (i.e.Profit) Attributable to Ordinary Shareholders
= X Times
Market capitalisation is the total market value of all the issued ordinary shares of the company.
P/E ratio is a measure of company performance from the markets point of view.
P/E ratio shows how much money investors are currently willing to pay for each dollar of
earnings. It gives an indication of the confidence that the investors have in the future success
(i.e. earnings) of the business.
In a very basic term, a P/E ratio of 20 means investors are paying equivalent of 20 years
earnings (at current EPS level) to own a share in the company.
A P/E ratio of 1 means market is currently willing to pay $1 for each dollar of earnings currently
made by the company; this shows very little confidence on the companys future prosperity.
Whereas, a P/E ratio of 20 expresses a great deal of optimism about the future of the company
since investors are currently willing to pay $20 for each dollar of companys earnings. Investors
paying 20 times of current earnings believe that company will do significantly better in coming
years, and this will not take long to get the $20 earnings.
6. Dividend yield =
X 100% = X%
Dividend Yield is a financial ratio that shows how much a company pays out in dividends
relative to its share price.
In the absence of any capital gains, the Dividend Yield is the return on investment for a share.
Investors can secure a minimum stream of cash flow from their investment portfolio by
investing in shares which is paying relatively high and stable dividend yields.
Mature and well-established companies tend to have higher dividend yields; while young and
growth oriented companies tend to have lower yield. Many fast growing companies do not
have a dividend yield at all because they do not pay-out any dividend.
2.
a.
Debt ratio =
Total Debt
Total Assets
Debts consist of all current and non-current liabilities (Deferred tax liabilities can be ignored).
This ratio represents how much money company owes compared to its Total assets.
If Debt ratio is greater than 50%, the business can be considered as a risky company. But, a
high Debt ratio may also mean companys ability to raise debt finance which shows confidence
of debt holders on the company.
Gearing ratios:
Debt to Equity ratio =
Debt Capital
Liabilities
Equity Capital X 100% =
Capital + Reserves X 100% = X%
b.
X 100% = X%
Debt Capital
Equity Capital + Debt Capital
X 100% = X%
3.
Leverage ratio :
Equity Capital
Equity Capital + Debt Capital X 100%
Take current liability portion as well of long-term liabilities in Debt capital calculation.
Normally do not include Deferred tax liability within Debt capital.
In F9 Preference share considered as Debt capital not Equity capital.
Also in F9, values for Gearing ratio can be either book values or market values. If using market
values remember market value of ordinary shares take account of reserves (i.e. do not add
reserve amount with total market value of ordinary shares)
A gearing level of more than 50% (where Debt Capital to Total Capital used) or more than
100% (where Debt Capital to Equity Capital used) or Leverage ratio of less than 50% means
company is highly geared (i.e. risky).
Risk is high for investors in a high geared company because of obligation to pay the interest
and repaying capital on time.
A relatively higher gearing may mean company adopted an aggressive strategy to expand its
operation. This has to be justified with sales and profit growth. A higher gearing may also
mean company is having financial difficulties; so may be a going concern issue.
A low or declining gearing may mean company is getting stronger financially and confident on
future earnings.
Where gearing is high, shareholders required rate of return will increase because of high level
of risk involve in the investment.
To lend money in a highly geared company, lenders may impose some covenants on the
company (example: a maximum limit of gearing, a minimum level of interest cover, pledge on
some assets)
4. Interest cover =
= X Times
Interest cover is a measure of the adequacy of a company's profit relative to interest payment
on its debt.
A high interest cover ratio means that the business is easily able to meet its interest
obligations from profits. Similarly, a low level of interest cover ratio means that the business is
potentially in danger of not being able to meet its interest obligations.
Interest cover of more than 2 is normally considered reasonably safe. But, companies with very
volatile earnings may require an even higher level of Interest cover.
Interest cover of less than 1 means the company did not earn sufficient earning (i.e. profit) to
meet its interest charge. This means company will have to pay some of its interest from
retained profit from previous years. This may also raise question about companys going
concern.
An entity is required to calculate and present a basic EPS and a diluted EPS amount based on
the profit/ (loss) attributable to the ordinary shareholders (of the parent entity).
Basic and diluted EPS figures should be presented on the face of the statement of
comprehensive income with equal prominence.
Basic EPS with bonus issue (scrip issue, capitalisation issue) and share split:
increases number of shares without any consideration. As a result, this distorts the comparison
of EPS in the current year with the EPS in the previous year. So, to ensure that the distortion
does not occur:
The EPS of the current year is calculated as if the bonus issue was in existence of the
beginning took place at the start of the year; and,
The corresponding previous years EPS also restated as that bonus issue was in existence
throughout that previous year.
The cum right price: This is the market price of a share just before the right issue
The ex-right price: This is the price of a share after the right issue. In theory the ex-right
price should be the weighted average of the cum right price of the shares and issue price of
corresponding number of share. This price is called the theoretical ex-right price.
In a right issue, shares are sold at a reduced price; so, we need to divide the total number
of shares issued into bonus shares and fully paid shares and treat as such.
Cum right
To verify the formula in Step 2: (Original shares + Bonus shares) X TERP = Original shares X Cum right
price (10,000,000 + 357,143) X $3.4 = 10,000,000 X $3.5 $35,214,286 = $35,000,000
So, there is a mismatch of ($35,214,286 - $35,000,000) = $214,286 (0.6%) if we use above formula!
But, we still need to use formula in Step-2 to identify bonus fraction in a rights issue, as it is required by
PROBLEM!!
when there will be multiple
Step 3: Calculate current years EPS issues
- check the example below
Step 4: Calculate corresponding previous years EPS taking the bonus share effect. We can
use following formula:
Diluted EPS:
Diluted EPS warns existing shareholders that the EPS may fall in future years because of
potential new ordinary shares that have been issued.
Convertible bonds (bonds and debentures that can be converted into ordinary shares)
Convertible preference shares (Preference shares that can be converted into ordinary shares)
Options and warrants (Option holders has right, but not obligation, to buy ordinary shares in a future
date at a predetermined price)
Contingently issuable shares (these are ordinary shares will be issued if certain conditions are met)
The diluted EPS is calculated by revising the original earnings (e.g. cancelling interest and
its tax effect in case of convertible bond) and weighted average number of shares as
though the potential ordinary shares had already been issued.
When calculating the revised weighted average number of shares, the convertible instrument (e.g.
convertible bond) is deemed to have been converted into ordinary shares at the beginning of the period
or, if later, the date of the convertible instrument issued.
Example: Diluted EPS with convertible bond
In 2010 Farrah Co had a basic EPS of 105c based on earnings of $105,000 and 100,000 ordinary $1
shares. It also had in issue $40,000 15% convertible bond which is convertible in two years time at the
rate of 4 ordinary shares for every $5 of bond. Tax is 30% of profit before tax. In 2010 gross profit of
$200,000 and expenses of $50,000 were recorded, including interest payable of $6,000. Calculate the
diluted EPS.
Solution:
$
Gross profit
200,000
Expenses
(50,000)
Add-back: Interest (40,000X15%)
6,000
Profit before tax
156,000
Tax expense (30%)
(46,800)
Earnings attributable to ordinary shareholders
109,200
Number of shares issued
100,000
Additional shares from conversation ($40,000X4/$5)
32,000
132,000
Diluted EPS = ($109,000/132,000) = $0.82.6, i.e. 82.6c
Dilution (i.e. decrease) in earnings would be (105c 82.6c) = 22.4c per share
Dilutive or antidilutive:
Example:
Ardent Co has 5,000,000 ordinary shares of 25 cents each in issue. The total earnings in 2010 were
$1,750,000. The rate of income tax is 35%. Decide which one of the following will dilute the EPS and
will be included in diluted EPS calculation:
(a) $1,000,000 of 14% convertible loan stock, convertible in three years time at the rate of 2 shares
per $10of stock
(b) $2,000,000 of 10% convertible loan stock, convertible in one years time at the rate of 3 shares per
$5 of stock
Solution:
Basic EPS = $1,750,000/5,000,000 = 35 cents
(a) Earnings increased (i.e. interest expense saves): i X(1 t) = $1,000,000 X 0.14 (1 0.35) =
$91,000
Potential ordinary shares: ($1,000,000 X 2)/ $10 = 200,000 shares
So, incremental EPS = $91,000/200,000 = 45.5c
Incremental EPS is higher than basic EPS; so NOT diluted and do not include in the diluted EPS
calculation.
(b) Earnings increased (i.e. interest expense saves): i X(1 t) = $2,000,000 X 0.10 (1 0.35) =
$130,000
Potential ordinary shares: ($2,000,000 X 3)/ $5 = 1,200,000 shares
So, incremental EPS = $130,000/1,200,000 = 10.8c
Incremental EPS is lower than basic EPS; so diluted (i.e. weakened) and need to include in the
diluted EPS calculation.
-
value of one ordinary share during the year was $20. Brand Co issued share option of 100,000
shares with exercise price applicable of $15. Calculate both basic and diluted EPS.
Solution:
If the options are exercised, the company will raise cash of (100,000 shares X $15) =
$1,500,000. That is ($1,500,000 / $20) = 75,000 shares if issued full price. So, the company is
giving away (100,000 75,000) = 25,000 shares for free. These 25,000 shares will dilute the
basic EPS.
Basic
Dilutive effect
Number of shares
500,000
25,000
525,000
Performance related
When performance criteria are
If shares are partly paid (i.e. less than shares market value is paid):
The equivalent number of fully paid shares must be established to the extent that partly
paid shares are entitled to participate in dividends during the period; and the equivalent
full number is included in the basic EPS calculation.
To the extent that partly paid shares are not entitled to participate in dividends during the
period they are treated as the equivalent of warrants or options in the calculation of diluted
EPS.
Diluted losses: when loss per share would be higher if potential shares were in issue.
Receivables factoring
(Relevant accounting standard: IFRS 9 Financial instruments, para 3.2.3-3.2.9)
Receivables factoring: Companies sometimes need cash before customers pay their account
balances. In such situations, the company may choose to sell accounts receivable to another
company that specializes in collections. This process is called factoring, and the company that
purchases accounts receivable is often called a factor.
The seller retains the risk of any under-collection of receivables by the factor. If the factor
fails to collect any amount of receivables then the seller reimburses that uncollected amount
to the factor.
Accounting:
i.
When the seller receives money from factor, the double entry is: DR SFP: Bank, CR SFP:
Liability
ii.
Interest charged by factor to the seller: DR I/S: Finance cost, CR SFP: Bank
iii.
Amount received by factor from Receivables: DR SFP: Liability, CR: SFP: Receivables
iv.
Any remaining receivables amount reimbursed by the seller: DR SFP: Liability, CR: SFP:
Bank
The seller transfers risk associated with collection of receivables to the factor. If the factor
fails to collect any amount of receivables, the seller does NOT reimburse that amount.
Accounting:
i.
Amount received by the seller from factor: DR SFP: Bank, CR: Receivables
ii.
Any cash commission charged by the factor: DR I/S: Finance cost, CR SFP: Bank
iii.
If factor charge commission by paying a lower amount of Receivables the seller: DR
SFP: Bank, DR I/S: Finance cost: amount under-received by seller, CR SFP: Receivables
Exercise question:
On 1 October 20X0, Jedders signed a receivables factoring agreement with a company Fab Factors.
Jedders trade receivables are to be split into three groups, as follows.
Group A receivables will not be factored or administered by Fab Factors under the agreement, but
instead will be collected as usual by Jedders.
Group B receivables are to be factored and collected by Fab Factors on a with recourse basis.
Fab Factors will charge a 1% per month finance charge on the balance outstanding at the beginning of
the month. Jedders will reimburse in full any individual balance outstanding after three months.
Group C receivables will be factored and collected by Fab Factors without recourse; Fab Factors will
pay Jedders 95% of the book value of the debtors.
Jedders has a policy of making a receivables allowance of 20% of a trade receivables balance when it
becomes three months old.
The receivables groups have been analysed as follows:
Required:
For the accounts of Jedders, calculate the finance costs and receivables allowance for each group of
trade receivables for the period 1 October 31 December 20X0 and show the financial position values
for those trade receivables as at 31 December 20X0.
Solution:
Group A: No factoring
By 31 December 20X0, 80% (30%+30%+20%) of the receivables collected by Jedders. So, Receivables
allowance of 20% to be recognised on remaining 20% receivables balance.
@ 31 October 20X0:
DR SFP: Bank
($1,250,000 X 30%)
CR SFP: Receivables
(30% of receivables collected by Jedders. So, decrease in receivables)
$375,000
$375,000
@ 30 November 20X0:
DR SFP: Bank
($1,250,000 X 30%)
CR SFP: Receivables
(Further 30% of receivables collected by Jedders. So, decrease in receivables)
$375,000
$375,000
@ 31 December 20X0:
DR SFP: Bank
($1,250,000 X 20%)
CR SFP: Receivables
(Further 20% of receivables collected by Jedders. So, decrease in receivables)
DR I/S: Expense: Increase in receivables allowance
(($1,250,000 X 20%) X 20%)
CR SFP: Receivables: Allowance for receivables
(Receivables allowance of 20% recognised on remaining 20% receivables balance.
This is provision for doubtful debts and presented as decrease in receivables in SFP.)
$250,000
$250,000
$50,000
$50,000
So, Group A receivables balance to be presented in SFP as at 31 December 20X0: (($1,250,000 $375,000 - $375,000 - $250,000) - $50,000) = $200,000.
($1,500,000-$600,000-$450,000) X 1%)
$4,500
CR SFP: Bank
$4,500
(Interest charged by Fab Factors on outstanding balance at month beginning)
DR SFP: Liability
($1,500,000 X 20%)
$300,000
CR SFP: Receivables
$300,000
(Further 20% of receivables collected by Fab Factors. So, decrease in receivables and liability)
DR SFP: Liability
$150,000
DR SFP: Bank
$150,000
($1,500,000-$600,000-$450,000-$300,000)
($2,000,000 X 95%)
($2,000,000 X 5%)
$1,900,000
$100,000
$2,000,000
There is no need for recognising any allowance for receivables on 31 December 20X0, since all the
receivables balance derecognised on 1 October 20X0. Jedders transferred the risk of any undercollection to Fab Factors; that is, Jedders has no more right on receivables balance.
(Shortcut answer is in the book! Check Q-55-Jedders of BPP question bank.)
Normally the financial statements are authorised by the directors before being issued to the
shareholders for approval.
board for its approval. The relevant cut-off date is the date on which the financial statements
are authorised for issue to the supervisory board.
-
The date on which the financial statements were authorised for issue should be disclosed.
If a significant event occurs after the authorisation of the financial statements but before the
annual report is published, then the entity is not required to apply the requirements of IAS 10.
However, if the event was so material that it affects the entitys business and operations in
the future, the entity may wish to discuss the event in the narrative section at the front of the
Annual Review but outside of the financial statements themselves.
Equity dividend (i.e. dividend to ordinary and irredeemable non-cumulative preference shares)
should only be recognised as a liability where they have been declared before the reporting date,
as this is the date on which the entity has an obligation.
Where equity dividends are declared after the reporting date, this fact should be disclosed but
no liability recognised at the reporting date.
Where the going-concern basis is clearly not appropriate, break-up basis should be
adopted.
The break-up measures the assets at their recoverable amount in a non trading environment,
and a provision is recognised for future costs that will be incurred to break-up the business.
Important definitions
Asset:
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. [Conceptual Framework: 4.4a]
Liability:
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. [Conceptual
Framework: 4.4b]
Equity:
The residual interest in the assets of the entity after deducting all its liabilities. [Conceptual
Framework: 4.4c]
Income:
Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decrease of liabilities that result in increases in equity, other than those
relating to contributions from equity participants. [Conceptual Framework: 4.25a]
Expenses:
Decrease in economic benefits during the accounting period in the form of outflow or depletions of
assets or incurrences of liabilities that result in decrease in equity, other than those relating to
distributions to equity participants. [Conceptual Framework: 4.25b]
Liquidity:
The availability of sufficient funds to meet deposit withdrawals and other short-term financial
commitments as they fall due.
Solvency:
The availability of cash over the longer term to meet financial commitments as they fall due.
records and reported in the financial statements of the periods to which they relate.
[Conceptual Framework: OB17]
-
Going concern: The entity is normally viewed as a going concern, that is, as continuing in
operation for the foreseeable future. It is assumed that the entity has neither the intention nor
the necessity of liquidation or of curtailing materially the scale of its operations. [Conceptual
Framework: 4.1]
Materiality:
Information is material if its omissions or misstatements could influence the economic decisions of
users taken on the basis of the financial statements. [Conceptual Framework: QC11]
Qualitative characteristics:
The attributes which make the information provided in financial statements useful to the users.
[Conceptual Framework: QC19]
Comparability
- Timeliness (Relevance)
Verifiability (Reliability)
Understandability