Answer 1 OSCAR INC
(a) Income statement for the year ended 31 March 2008
$000 Notes
Sales 2,010
Operating costs $(140 + 960 – 150 + 420 + 210 + 16) (1,596) ———
Operating profit before interest 414
Income from investments (75 + 20) 95 (2) Extract from SOCIE (not required by question)
Opening retained earnings 180
Profit for year 460
Dividends $(120 + 300) (420)
———
Closing retained earnings 220
——— Statement of financial position as at 31 March 2008
$000 $000 Notes
Current liabilities 714 (6)
Non-current liabilities
Provisions for liabilities and charges 196 (7)
The following notes form part of these accounts. Notes to the accounts for the year to 31 March 2008
(1) Included in operating profit are the following items
$000
Depreciation $(27 + 5) 32
Directors’ emoluments 45
(2) Income from fixed asset investments
$000
Listed fixed asset investments 75
Gain in value of investment 20
—— (3) Income tax
$000 Income tax based on the profits for the year at a rate of 33% 74
Over provision for tax in the previous year (25)
—— 49 —— (4) Tangible assets – plant and machinery
$000 their fair value at 31 March 2008 was $580,000. The gain in value of $20,000 has been credited to profit or loss.
(6) Current liabilities
$000
Trade payables 260
Mainstream corporation tax 74
Proposed dividend 300
Bank overdraft 80
(7) Provisions for liabilities and charges
$000 Pension costs
At 1 April 2007 180
Provided in the year 16
——
At 31 March 2008 196
—— (8) Called up share capital
Authorised Issued
$000 $000
Ordinary shares of $1 each 1,000 600
——— ——–
Answer 2 MERCURY CO
(a) Statement of comprehensive income for the year ended 30 June 2008
$000 $000 $000
Revenue 3,000
Opening inventory 450
Purchases 2,030
_____ 2,480
Less closing inventory (500)
_____
Cost of sales 1,980
_____
Gross profit 1,020
Distribution costs
(240 + (20% × (1,020 – 370)) + 30) 400 Administrative expenses (205 + (5% × 900)) 250
Other expenses (50+ 5 (W1)) 55
___
Profit before interest and tax 315
Finance costs
Loan note interest (10% × 500) 50 Preference dividend (7% × 500) 35
(85) ___
Profit before tax 230
Income tax 55
___
Profit after tax 175
(b) Statement of changes in equity for the year ended 30 June 2008 Share Share Accumulated
capital premium profit Total
$000 $000 $000 $000
Balance at 1 July 2007 250 180 70 500
Bonus issue 100 (100)
Profit for the period 175 175
Dividends (W2) ______ _____ _____ (25) _____ (25)
Balance at 30 June 2008 350 80 220 650
–––––– ––––– ––––– –––––
WORKINGS
(1) Allowance for doubtful debts
$000 5% trade receivables (5% × 600) 30
Brought forward (25)
__
Expense ___ 5
(2) Dividends
$000
Preferred (7% × 500) 35
Ordinary (250 × 2 × 0.05) 25
(c) Statement of financial position as at 30 June 2008
Cost Accumulated Net book depreciation value Tangible non-current assets $000 $000 $000
Land 300 300
Buildings 900 180 720
Plant _____ 1,020 500 ___ _____ 520
2,220 680 1,540
_____ ___
Current assets
Inventory 500
Trade receivables (600 – 30) 570
Bank 135
_____ 1,205
_____
Total assets 2,745
_____ Capital and reserves
50 cent ordinary shares (250 + (2/
3 × 250)) 350
Share premium account (180 – 100) 80
Retained earnings 220
_____ 650 Non-current liabilities
10% Loan notes 500
7% Preferred shares of $1 500
Current liabilities
Trade payables 900
Income tax 55
Accrued expenses (50 + 30) 80
Dividends (W2) 60
_____ 1,095
_____
Total equity and liabilities 2,745
Answer 3 SULPHUR
(i) Statement of comprehensive income for the year ended 30 June 2008
$
Revenue (530,650 – 1,880) 528,770
Cost of sales (W1) (363,960) _______
* Gross profit 164,810
Other operating income (1,500 + 12,000) _______ 13,500 178,310
Distribution costs (W1) (48,126)
Administrative expenses (W1) _______ (18,710)
* Profit before tax 111,474
Income tax expense (38,100) ______
* Profit for year 73,374
Other Comprehensive income
Revaluation surplus ______ 40,000
Total comprehensive income for year 113,374
–––––– (ii) Statement of changes in equity
Share Revaluation Retained
capital surplus earnings Total
$ $ $ $
Balance at 1 July 2007 150,000 – 160,030 310,030
Comprehensive income 40,000 73,374 113,374
(iii) Statement of financial position as at 30 June 2008
$ $
* ASSETS
* Non current assets
Land and buildings (at valuation) 390,000
Delivery vehicles (NBV)
($19,230 – $3,846) 15,384
Factory plant and equipment (NBV)
($24,000 – $2,400) _______ 21,600
426,984
Investments 30,000
* Current assets
Inventories 29,170
Trade receivables ($15,690 – $460) 15,230
Cash ______ 410
44,810 _______
* Total assets 501,794
––––––– * EQUITY AND LIABILITIES
* Capital and reserves
Issued ordinary capital 225,000
Revaluation surplus 40,000
Retained earnings _______ 158,404
423,404 * Current liabilities
Trade payables ($34,700 – $700) 34,000
Accrued expenses 1,240
Bank overdraft ($4,820 + $690 – $460) 5,050
Income tax ______ 38,100
78,390
_______
* Total equity and liabilities 501,794
WORKINGS
(1) Cost analysis
Cost of sales Distribution Administrative
$ $ $
Opening inventory 24,680
Purchases 298,400
Discount received (10)
Closing inventory (29,170)
Factory overheads
(66,420 + 1,240) 67,660
Per TB 44,280 18,710
Depreciation (as calculated in (a)) _______ 2,400 ______ 3,846 ______
363,960 48,126 18,710
_______ ______ ______
Answer 4 CAYMAN Co
Statement of comprehensive income for the year ended 30 September 2008 $000
* Revenue (7,400 – 12) 7,388
* Cost of sales (W1) (5,140) _____
* Gross profit 2,248
* Distribution costs (W2) (711)
* Administrative expenses (W2) ____ (871)
* Profit from operations 666
* Finance cost (12% × $1m) (120) ___
* Profit for the year 546
Other comprehensive income
Revaluation deficit (250) ___
Total comprehensive income 296
Statement of financial position at 30 September 2008
$000 $000
*ASSETS
*Non-current assets
Property, plant and equipment (W3) 11,735
*Current assets
Inventory (W1) 783
Trade receivables (2,060 – 12) 2,048
Prepayments (60 + 30) ___ 90
2,921 ______
*Total assets 14,656
––––––
*EQUITY AND LIABILITIES *Capital and reserves
Issued capital 7,000
Share premium account 2,000
Revaluation surplus 1,250
Retained earnings ______ 1,836
12,086 *Non-current liabilities
Interest bearing borrowings/12% Loan (2015) 1,000 *Current liabilities
Trade payables 1,120
Operating overdraft 40
Accrued expenses (95 + 35) 130
Statement of changes in equity for the year ended 30 September 2008
Share Share Revaluation Retained
capital premium surplus earnings Total
$000 $000 $000 $000 $000
Balance at 1 October 2007 5,000 (β) 1,000 (β) 1,500 1,570 9,070
Comprehensive income (250) 546 296
Dividends (14m × 2c) (280) (280)
Issue of share capital 2,000 1,000 3,000
(4m × 50c and 25c) _____ _____ _____ _____ ______
Balance at 30 September 2008 7,000 2,000 1,250 1,836 12,086
WORKINGS
(1) Cost of sales
$000
Opening inventory 695
Production costs 4,140
Depreciation 80% × ([2% × $4m] + [20% × $6.4m]) 1,088 Less: Closing inventory (780k – 5k + 8k) _____ (783)
5,140 –––––
(2) Cost classification
Distribution Admin
$000 $000
Per list of balances 540 730
Prepayments (60) (30)
Accrued expenses 95 35
Depreciation
– buildings (10% × 2% × $4m) 8 8
– plant and equipment (10% × 20% × $6.4m) 128 ___ 128 ___
711 871
––– –––
(3) Property, plant and equipment
$000
Land 5,000
Buildings (4,000 – 1,065 – 80) 2,855
Plant and equipment (6,400 – 1,240 – 1,280) ______ 3,880 11,735 ––––––
Answer 5 FIVE CONCEPTS (a) Entity concept
In accounting, it is necessary to define the boundaries of the entity concerned. In the case of a limited liability company, only transactions of that company must be included. There must be no confusion between the transactions of the company and the transactions of its owners and managers.
If the entity concept is not followed, the profit, financial position and cash flow may all be distorted to the point where they become meaningless.
(b) Going concern concept
The going concern is that financial statements are prepared on the basis that the entity will continue for the foreseeable future – that there is no intention or necessity to liquidate or curtail the scale of operations.
If the going concern concept is followed when it is not appropriate, assets may be overstated, liabilities may continue to be shown as non-current when the collapse of the going concern status of the entity renders them current liabilities, and the profit is likely to be overstated. (c) Materiality
Information is material if its omission from, or misstatement in, the financial statements could influence the economic decisions of users. Materiality cannot always be measured in monetary or percentage terms, but a commonly used measure is 5% of normal pre-tax profit. Above that level, for example, the transaction would need to be disclosed in the financial statements.
Materiality is not solely related to the size of a transaction, it would also be necessary to consider the nature of the transaction and the fact that the nature would give rise to an item being treated as material and require disclosure.
If the materiality concept is not followed, financial statements could become confused by the inclusion of unnecessary detail of trivial matters, or could be rendered misleading by the exclusion of reference to important matters.
(d) Fair presentation (true and fair view)
Fair presentation really means that all figures in financial statements have been arrived at accurately when accuracy is possible (true) and that when judgement or estimation is needed it has been exercised without bias (fair). Compliance with generally accepted concepts and principles will normally result in fair presentation.
Failure to present information fairly will obviously mean that users may be misled by the financial statements.
Answer 6 IASB (a) Objectives
To formulate and publish in the public interest accounting standards to be observed
in the presentation of financial statements and to promote their world-wide acceptance and observance.
To work generally for the improvement and harmonisation of regulations,
accounting standards and procedures relating to the presentation of financial statements.
(b) Producing an IFRS
A Steering Committee is set up, chaired by a Board representative, and usually
including representatives of at least three other countries.
The Steering Committee identifies and reviews all the accounting issues associated
with the topic. These will include:
The application of the IASB “Framework for Preparation and Presentation
Review of existing national and regional accounting requirements and
practice.
The Steering Committee then submits a Point Outline to the Board.
After receiving comments from the Board, the Steering Committee prepares and
publishes a Draft Statement of Principles. Comments are invited from all interested parties during an exposure period, usually between four and six months.
The next stage is the preparation of a final Statement of Principles, which is
submitted to the Board by the Steering Committee. This final Statement is used as a basis for preparing an Exposure Draft of a proposed IFRS. The final Statement of Principles is available to the public on request, but is not formally published.
The Steering Committee prepares a draft Exposure Draft for approval by the Board.
After revision, and with the approval of at least 9 of the 14 members of the board, the Exposure Draft is published. Comments are invited from all interested parties during an exposure period, usually six months.
The Steering Committee reviews the comments and prepares a draft IFRS for
review by the Board. After revision, and with the approval of at least 9 of the 14 members of the board, the IFRS is published.
During the process, the Board may decide to issue a Discussion Paper for comment, or to issue more than one Exposure Draft
(c) The Framework for the Preparation and Presentation of Financial Statements The purposes of the Framework are:
To assist the IASB in developing IFRSs and reviewing existing ones. To assist the IASB in harmonising regulations and accounting standards by
providing a basis for reducing alternative treatments.
To assist national standard setting bodies in developing national standards. To assist prepares of financial statements in applying IFRSs and in dealing with
topics not yet covered by IFRSs.
To assist auditors in forming an opinion as to whether financial statements comply
with IFRSs.
To assist users of financial statements in interpreting financial statements.
To give those interested in the work of the IASB information about its approach to
Answer 7 OBJECTIVES (a) Users
Information needs
(1) Investors and their advisers performance of management in achieving
profit growth while ensuring the continued solvency of the company;
the risk inherent in the company’s operations.
(2) Employees stability and survival of the company; ability of the company to provide
remuneration, employment opportunities and retirement benefits.
(3) Lenders the solvency of the company;
profitability, to ensure payment of interest
when due;
asset values.
(4) Suppliers and other creditors information as to the solvency of the company
and its ability to pay, probably over a shorter period than lenders.
(5) Customers information about the continuance of the
company, especially if they have a long term involvement with it.
(b) Achieving objectives
Users of financial statements are interested in three main areas in their use of company financial statements:
profitability solvency/liquidity the risk of the operation
The statement of comprehensive income provides a measure of profitability. However, the use of historical cost accounting means that the profit is often overstated as depreciation is often based on historical cost of the assets and inventory tends to be valued at an historic cost which does not match itself to the current revenue figure.
The statement of financial position details of current assets and liabilities enable users to form a reasonable assessment of a company’s solvency, because they are reasonably reliably valued. Lack of information about the dates of payments to sundry accounts payable or receipts from sundry accounts receivable could affect the position. Users would be very interested in seeing the age analysis of the accounts receivable balances in order that they may make a more informed judgement on the solvency of the business.
Two ways in which the quality of information disclosed in financial statements could be improved:
requiring regular revaluation of non-current assets;
reducing the number of alternative accounting treatments allowed by accounting
standards. Answer 8 COMPARABILITY (a) Meaning and types
Comparability means that users are able to draw conclusions about the performance or financial position of a business by relating figures for a particular period to other relevant figures.
Possible types of comparison are with:
figures for the same business for earlier periods; figures for other businesses for the same period; budgets or forecasts.
Tutorial note: Two types only required for full marks. (b) Aid to comparability
The IASB’s Framework and the requirements of accounting standards aid comparability by:
requiring the disclosure of accounting policies (IAS 1 Presentation of Financial
Statements) and the effect of changes in them (IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors);
reducing or eliminating the number of possible alternative treatments for similar
items available to businesses;
requiring businesses to treat similar items in the same way within each period and
from one period to the next (unless a change is required to comply with accounting standards or to ensure that a more appropriate presentation of events or transactions is provided).
Answer 9 ADJUSTMENTS INC
Internal memorandum To Members of the Board
From S Beancounter, Financial Accountant Date 5 February 2008
Re Adjustments to depreciation
(a) Lathe
The lathe was purchased in 2001 and was originally being written off over an estimated useful life of twelve years. As at 1 January 2007 six of the years have elapsed with a further six years remaining. It was decided that the machine will now only be usable for a further four years.
IAS 16 Property, plant and equipment requires that where the original estimate of useful life is revised, adjustments should be made in current and future periods (not in prior periods). I therefore propose that the unamortised cost of the asset should be charged to revenue over the remaining useful life of the asset. The net book value of $75,000 should therefore be charged over the remaining four years of useful life, giving an annual depreciation charge of $18,750.
The revision is not a change in accounting policy, or an error. It is merely a refinement of an existing policy to reflect changed circumstances. It is therefore not appropriate to deal with any excess depreciation by adjusting opening retained earnings.
(b) Grinder
The grinder was purchased in 2004 and was originally being depreciated on a straight line basis. It has now been decided to depreciate this on the sum of digits basis.
IAS 16 requires that depreciation methods be reviewed annually and if there is a significant change in the expected pattern of economic benefits, the method should be changed. Depreciation adjustments should be made in current and future periods. This change might be appropriate if, for instance, usage of the machine is greater in the early years of an asset’s life when it is still new and consequently it is appropriate to have a higher depreciation charge.
If the change is implemented, I propose that the unamortised cost (the net book value) of the asset should be written off over the remaining useful life commencing with the period in which the change is made. The depreciation charge for the remaining life of the asset will therefore be as follows.
Year No of digits Depreciation
$
2007 7 7/28 × $70,000 17,500
2008 6 6/28 × $70,000 15,000
2009 5 12,500
2010 4 10,000
2011 3 7,500
2012 2 5,000
2013 1 2,500
—— ———–
1/2 × 7 (7 + 1) 28 70,000
—— ———–
(c) Leasehold land
IAS 16’s revaluation model allows groups of assets to be subsequently valued at a revalued amount, which will normally be its fair value.
Where any item of property plant or equipment is revalued, the entire class to which the asset belongs should be revalued. Revaluations must be kept up to date. Where there are volatile movements in fair value, the revaluation should be performed annually. Where there are no such movements, revaluations every three to five years may be appropriate. Accumulated depreciation at the date of revaluation is either
(i) restated proportionately with the change in the gross carrying amount so that the carrying amount after the revaluation equals the revalued amount (e.g. where revaluations are made to depreciated replacement cost using indices) (ii) eliminated against the gross carrying amount of the assets and the net amount
restated to the revalued amount of the asset (e.g. where buildings are revalued to their market value).
IAS 16 requires that the subsequent charge for depreciation should be based on the revalued amount. The annual depreciation will therefore be $62,500, i.e. $1,500,000 divided by the 24 years of remaining life.
There will then be a difference between the revalued depreciation charge and the historical depreciation charge.
The resulting excess depreciation may be dealt with by a movement in reserves, i.e. by transferring from the revaluation surplus to retained earnings a figure equal to the depreciation charged on the revaluation surplus each year.
Additional disclosures required under IAS 16 include the following:
(i) the basis used to revalue the assets (e.g. market value based on existing use) (ii) the date of the revaluation
(iii) whether an independent valuer was involved (iv) the nature of any indices used
(v) the carrying amount of each class of property plant and equipment that would have been included at historical cost
Answer 10 SPONGER INC
MEMORANDUM To Philip Tislid, Sponger Inc
From Bill Smith, Accountant Date 27 January 2008
Subject Accounting for government assistance received by Sponger Inc
IAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires that no grant should be recognised until there is reasonable assurance that the entity will comply with the conditions attaching to them and that the grants will actually be received. The IAS covers forgivable loans and non-monetary grants.
(a) Research and development grants
The general principle of IAS 20 is that grants should be matched in the statement of comprehensive income with the expenditure to which they are intended to contribute. They should not be credited directly to shareholders interests.
Cuckoo project
The expenditure on the Cuckoo project is research and therefore is written off as incurred under IAS 38 Intangible Assets. Accordingly the grant of $10,000 should be credited to profit or loss in the years in which the expenditure to which it relates is incurred.
Hairspray project
The Hairspray project appears to satisfy the criteria of IAS 38 for deferral of development expenditure, and thus may be carried forward as an intangible fixed asset until commercial production commences (2009). It will then be amortised to profit or loss over the period of successful production. Technological and economic obsolescence create uncertainties that restrict the time period over which development costs should be amortised.
The grant of $10,000 relating to it will therefore also be carried forward as deferred income, and will be released to profit or loss in line with the amortisation of the development expenditure. The balance of $10,000 will appear in the statement of financial position at 31 December 2007 under current and non-current liabilities as appropriate. Grants relating to assets can either be:
– set up as deferred income and recognised in profit or loss over the useful life of the asset (to match the depreciation charge), or
(b) Compensation grant
IAS 20 states that grants receivable as compensation for expenses or losses already incurred should be recognised as income when they become receivable. They cannot be taken back to prior periods, as their receipt does not constitute correction of a prior period error or a change in accounting policy. Disclosure may be appropriate.
However, in order to apply the prudence concept, the standard requires grants not to be recognised until conditions for receipt have been satisfied and receipt is reasonably assured.
In this situation the conditions for receipt, namely filling out the triplicate form, have not been fully satisfied and therefore the grant should not be recognised in the accounts at 31 December 2007.
(c) “Vocational experience” grant (i) General accounting
This grant relates not to specific expenditure but to a non-financial objective. The terms of the grant suggest that it is effectively earned at a rate of $1,000 per visit, and therefore it should be credited to income at that rate. In the year to 31 December 2007 the credit will be $7,000. Amounts to be recognised in future periods will be carried forward as deferred income.
The grant is not spread over the life of the bus as it does not specifically contribute to its cost.
(ii) Repayments
A repayment of $5,000 is due relating to unfulfilled visits in the current year and should be provided for. However, as this is expected to recur in each of the next four years, provision also needs to be made in total for repayments relating to twenty further unfulfilled visits.
A contingent liability should be disclosed relating to the potential repayment of the grant relevant to the visits in future periods which are expected to take place.
(iii) Amounts for the financial statements
Statement of comprehensive income
$
Grants received (7 × $1,000) 7,000
Statement of financial position
$ Current liabilities (1 × 7 × $1,000) 7,000 Non current liabilities (3 × 7 × $1,000) 21,000 Provision for grant repayment (5 × 5 × $1,000) 25,000 Note to the financial statements
Answer 11 FAM Accounting policies
(a) Property, plant and equipment is stated at historical cost less depreciation, or at valuation. (b) Depreciation is provided on all assets, except land, and is calculated to write down the cost
or valuation over the estimated useful life of the asset. The principal rates are as follows.
Buildings 2% pa straight line Plant and machinery 20% pa straight line Fixtures and fittings 25% pa reducing balance
Non-current asset movements Land Plant Fixtures, Payments on and and fittings, account and
buildings machinery tools and assets in the Total equipment course of
construction
Cost/valuation $000 $000 $000 $000 $000
Cost at 1 January 2007 900 1,613 390 91 2,994
Revaluation adjustment 600 – – –
600
Additions – 154 40 73 (W1) 267
Reclassifications 100 – – (100) –
Disposals – (277) (41) – (318)
——— ——— —— —— ———
Cost at 31 December 2007 100 1,490 389 64 2,043
2007 valuation 1,500 1,500
——— ——— —— —— ———
Depreciation
At 1 January 2007 80 458 140 – 678
Revaluation adjustment (80) – – –
(80)
Provisions for year (W2) 17 298 70 – 385
Disposals – (195) (31) – (226)
—— —— —— —— ——
At 31 December 2007 17 561 179 – 757
—— —— —— —— ——
Net book value
At 31 December 2007 1,583 929 210 64 2,786
——— ——— —— —— ———
At 31 December 2006 820 1,155 250 91 2,316
——— ——— —— —— ———
The corresponding historical cost information is as follows.
Land and buildings $000 Cost
Brought forward 900
Reclassification 100
———
Carried forward 1,000
——— Depreciation
Brought forward 80
Provided in year 10
———
Carried forward 90
———
Net book value 910
——— WORKINGS
$000
(1) Additions to assets under construction 53
Deposit on computer 20
—— 73 —— $000 (2) Depreciation on buildings
40
600 + (100 × 2%) 17
2% straight line depreciation is equivalent to a 50 year life. The buildings are ten years old at valuation and therefore have 40 years remaining.
Depreciation on plant (1,613 + 154 – 277) × 20% 298 Depreciation on fixtures (390 + 40 – 41 – 140 + 31) × 25% 70
Answer 12 STOAT To: Directors of Stoat From: Financial adviser
Depreciation and non-current asset valuation
You asked me to explain certain aspects of the accounting regulations governing depreciation and non-current asset valuations, and I have set out the information you need below.
(a) Purpose of depreciation and factors affecting its assessment
The factors affecting the assessment of the useful life of an asset are:
expected usage;
expected physical wear and tear; technological obsolescence;
legal or similar limits on the use of the asset, such as the expiry dates of related
leases.
(b) Evidence that depreciation rates might be too low [Three from]
substantial losses on sale of non-current assets;
frequent scrapping of assets before end of useful lives assessed; advice from auditors;
information from other companies’ financial statements; information from trade associations.
(c) Disclosures if depreciation methods are changed
the effect, if material, in the year of change; the reason for the change.
(d) Revaluation of non-current assets
IAS 16 “Property, Plant and Equipment” allows the revaluation of non-current assets other than goodwill if a policy of revaluation is adopted.
IAS 16 requires that if any asset of a class is revalued, all assets of that class must be revalued. Once revaluation is adopted, values must be kept up to date.
Any change in value will be recognised within equity as a revaluation surplus, after being included within other comprehensive income. Any surplus, or loss, cannot be reclassified when the asset is disposed, although a reserve transfer can be made from the revaluation surplus to retained earnings.
There are extensive disclosure requirements, including the basis of valuation, whether an independent valuer was involved and the date and amounts of valuations.
Answer 13 SUBSTANCE OVER FORM
Preparing accounts on a substance over form basis means that they should reflect the commercial effect of transactions rather than their legal form.
The IASB’s Framework for the Preparation and Presentation of Financial Statements notes that financial statements are frequently described as showing a “true and fair view” (as in the UK), or as “presenting fairly” the financial position (as in the US).
Many other countries adopt similar requirements for financial statements, particularly in Europe where the requirements of directives state that all member states’ financial statements should give a true and fair view. This is, for example, translated as “donner une image fidele” in France. Some countries interpret this as meaning in accordance with their own legislation, particularly in Germany, but generally speaking, legislatures and accounting standard setters increasingly recognise an overriding notion of truth and fairness.
One of the key qualitative characteristics required by the Framework in order to give a true and fair view, is that financial statements show the substance and economic reality of transactions, not merely their legal form. It gives the example of an entity disposing of an asset in such a way that the documentation purports to pass legal ownership to a third party, but where agreements exist to ensure that the entity continues to enjoy the future economic benefits embodied in the assets. In such circumstances the reporting of a sale would not represent faithfully the transaction entered into. Application of the principle
IAS 17 Leases requires that finance leases be capitalised in the statement of financial position where certain conditions are met. In such cases the legal form of the transaction is that the lessor retains the legal title to the assets. The economic substance of the transaction however is that the lessee is the true “owner” of the asset as the lease transfers substantially all the risks and rewards incident to the ownership of the asset. The lessee therefore includes it in its financial statements. Not to do so would distort gearing ratios.
IAS 27 Consolidated and Separate Financial Statements requires that group accounts be prepared to show information about the group as that of a single entity, without regard for the legal boundaries of the separate legal entities.
IAS 32 Financial Instruments recognises that some financial instruments take the legal form of equity, but are liabilities in substances and requires that classification of an instrument is made on the basis of an assessment of its substance when it is first recognised.
IAS 1 Presentation of Financial Statements states the importance of prudence, substance over form and materiality in the selection and application of accounting policies and the preparation of financial statements.
Other areas where the principle applies include the factoring of receivables and the sale and repurchase of inventories. Factored debts are “sold” to a third party in exchange for a proportion of the book value of the debt. Such agreements vary considerably in their nature and some leave the entity with most of the risks associated with the collection of the receivables. In such circumstances it may be appropriate to keep the receivables on the face of the statement of financial position and recognise the cash received from the factor as a liability, rather than accounting for the transaction as a sale of the receivable.
Consistency, comparability and subjectivity
It may be true that the certainty of legal form would increase, but this does not mean the comparability. In fact most accountants would say that it is the substance over form principle which is designed to increase comparability by making transactions of a similar nature treated in similar ways.
It may introduce another element of subjectivity, but accounts preparation inevitably does involve many judgmental decisions. It is these judgments that make accounts fair as well as true, and hence duly comparable.
Accounting or extra disclosure
A further argument against the proposal is that it may not be essential to account on the basis of substance over form, but merely to provide additional disclosure.
The argument here rests on whether any amount of disclosure can compensate for a transaction which is fundamentally misleadingly treated in the accounts. If additional disclosure is not so much addition as contradictory to the accounting treatment, then surely the result is confusing the user and hence still misleading and not true and fair.
Conclusion
Broadly speaking, the Anglo-Saxon world regards economic substance as being more important than legal form. This is at least in part due to the historical separation of fiscal and financial accounting. Countries with civil, as opposed to common law legal traditions place more emphasis on the fiscal correctness of financial statements. With increasing globalisation of capital markets the trend, at the moment seems to be away from legal form, and towards economic substance. However, the inherent uncertainties in the notion of economic substance mean that there is an ever increasing volume of accounting standards on what exactly is meant by “substance” as it is very easily abused.
Answer 14 HUGHES AND CUSTOM CARS (a) Hughes
The Framework for the Preparation and Presentation of Financial Statements states that financial statements should show the economic substance of transactions over their legal form.
Hughes has entered into a sale and repurchase agreement with the Wodwo Bank. Hughes has received $36 million now. If Hughes exercises its call option after one month, it will repurchase the inventory at a premium of $1.8 million which represents a finance charge of 5% for the month. If the Wodwo Bank exercises its put option after two months, Hughes will repurchase the inventory at a premium of $3.7 million which represents a finance charge of 5% for each of the two months.
(b) Custom Cars
Unless Sigma’s cash contribution is very substantial (say 80% as opposed to 20% of the expenditure incurred by Custom Cars), there should be no doubt that Custom Cars owns the extension (and has the risks and rewards of ownership).
The fittings supplied free of charge by Sigma could be excluded from the statement of financial position on the grounds that they are not owned by Custom Cars. Also their economic benefit is primarily to Sigma Inc in promoting Sigma’s product.
Answer 15 PERSEUS
(a) Adjustments to be made (i) For inventory
The opening balance of retained earnings should be adjusted in the statement of
changes in equity.
Comparative information should be restated, unless it is impracticable to do so
(ii) IAS 8 required disclosure
The nature of the error.
The amount of the correction for the current period and for each prior period
presented.
The fact that comparative information has been restated or that it is impracticable to
do so. (b) Current assets
$
Inventory (W1) 4,249,800
Trade receivables (W2) 2,674,300
Prepayments 773,400
Cash at bank 940,000
WORKINGS (1) Inventory
$ $
As originally taken 4,190,000
(i) Reduction to net realisable value
Original cost 16,000
Net realisable value (10,400 – 600) 9,800 (6,200) (ii) Goods on sale or return at cost _________ 66,000
(2) Trade receivables As originally stated
Accounts receivable ledger 2,980,000
Less: Goods on sale or return _________ 88,000 2,892,000 Less: Debts written off _________ 92,000 2,800,000 Less: Allowance for doubtful debts
5% × $2,800,000 _________ 140,000
2,660,000
Accounts payable ledger balances _________ 14,300
2,674,300 _________ (3) Prepayments
$ $
As originally stated 770,000
Payments on account 25,000
Less: Commission due
2/102 × $1,101,600 21,600
Problems of revenue recognition in accounting arise from the requirement to produce financial statements for specific periods of reporting. Consequently accounting principles and practices have evolved which focus on when and at what value transactions should be recognised in financial statements. Annual reporting creates artificial periods that are not related to the natural operating cycle of an entity. A typical operating cycle (for a manufacturing company) would comprise of acquiring goods or raw materials from which a saleable product is manufactured, at some stage orders would be obtained for these goods and they would then be delivered to and accepted by customers. The collection of cash for these sales is often considered to be the end of this process, but it should be borne in mind that in some cases further risks can exist in relation to product warranties or other after-sale commitments. The critical event theory argues that there comes a stage in the operating cycle, beyond which there is either no further significant risks or uncertainties or that they can be estimated with sufficient accuracy to enable revenue to be recognised. The point at which there remain no further risks is referred to as the critical event. For most transactions the critical event is synonymous with full performance, but in theory, the critical event could occur at almost any point in the operating cycle.
In its Framework, the IASB advocates a different approach, it takes a balance sheet approach to the process of revenue recognition. It chooses to define the elements of financial statements, principally assets and liabilities, and uses these to determine income (gains) and expenses (losses). Recognition of gains and losses takes place when there is an increase or decrease in equity other than from contributions to, or withdrawals of, equity. Thus increases in economic benefits in the form of enhancements of assets or decreases in liabilities result in income, and decreases in economic benefits in the form of outflows or depletions of assets or incurrences of liabilities results in losses (expenses). Recognition is the incorporation of an item in the financial statements. It involves the depiction of the item in words and at a monetary amount. For a transaction to be recognised as giving rise to a new asset or liability, or to add to an existing one it must meet the following recognition criteria:
(i) it is probable that any future economic benefit associated with the item will flow to the entity; and
(ii) the item has a cost or value that can be measured with reliability. (b) Acquisition of goods or raw materials:
For most industries this event is a routine occurrence that could not be considered as critical. However where this is a very difficult task, perhaps due the rarity or scarcity of materials, then it may be critical. A rare practical example of this is in the extraction of precious metals e.g. gold mining. Because gold is a valuable and readily marketable commodity the real difficulty in deriving income from it is obtaining it, so this is the critical event. A logical progression of this point would be to say that any industry whose products are normally sold on a commodities market could consider the obtaining of the product to be the critical event. Such industries may include, for example, growing coffee beans.
During the manufacture or production of goods:
Again for most industries this is not the critical event. Normally there would be far too many uncertainties remaining in the operating cycle. For example the manufacturing process could be flawed and therefore not produce saleable goods. Even if the goods are manufactured properly, it does not necessarily mean someone will buy them. It could be argued that where there is a firm order for the goods this would overcome some of the uncertainties, but it would still be imprudent to recognise firm orders as sales. There are however some industries where, due to a long production period, revenues are recognised during the production or manufacturing period. The most common example of this is the percentage of completion method of profit recognition for construction contracts under IAS 11 “Construction Contracts”. Where companies adopt this approach to revenue (and profit) recognition it is generally referred to as the “accretion approach”.
Delivery/acceptance of the goods:
When a condition has been satisfied after the goods have been delivered:
The most common occurrence of this type of sale is where the customer has the right to return goods and not incur a liability for them. In most cases the condition is the passage of time (e.g. goods may be returned within three months of delivery), but it may also occur in relation to some other event such as their subsequent resale to another party. Traditionally with this type of sale, its recognition is delayed until the condition has been met, however one could argue that the substance of these transactions should be considered. Although a customer may have the right to return goods, if it can be demonstrated that in practice this never actually occurs, then recognising the sale before the expiry of the return period could be justified. Another example of this type of condition is where the terms of a sale of say an item of equipment required the seller to install and test the equipment. If this involves significant expense or risk then recognition of this type of sale would be deferred until completion of the installation.
Collection of cash:
For most (credit) sales the risk of non-payment is relatively low. Revenue recognition would only be delayed to the point of receipt of cash if its collection was perceived to be particularly difficult or risky. Revenues (and profits) from high risk credit sale agreements may be examples of this. Another possibility is sales made to risky overseas countries/customers, particularly if they are in non-convertible currencies or the country has strict exchange controls.
Expiry of guarantees/warranties:
This serves as a reminder that not all the risks and associated costs are resolved when cash is received. For some products such costs can be significant (e.g. with the supply of new motor vehicles or rectification work on construction contracts); however it is normally possible to reliably estimate these costs and provide for them at the time of the sale. It would be unrealistic, and may cause distortions, if revenues were not recognised until such obligations had elapsed.
(c)
(i) Although this agreement may be worded as a sale, and even if the title to the goods passes to Wholesaler, it seems clear that this is not a sale – it is a secured loan. Therefore Jenson should not treat the income from Wholesaler as revenue, but instead as a loan in its statement of financial position. The goods should continue to be recognised as inventory, and accrued interest of $3,150 ($35,000 × 12% × 9/12) should be provide for against profit or loss.
(iii) An accruals/matching approach to this problem would be to say that the profit on each publication would be $2,000 (($240000 – $192,000)/24). In the year to 31 March 2008, as six of the 24 publications have been produced and delivered, the profit or loss would include:
$
Sales (6 × 240,00/24) 60,000
Cost of sales (6 × 192,000/24) (48,000)
––––––
Profit 12,000
––––––
Deferred income on the statement of financial position would be $180,000 ($240,000 – $60,000).
The problem with the above approach is that the deferred income does not seem to fit the definition of liability in the Framework and IAS 37 “Provisions, Contingent Liabilities and Contingent Assets”. A liability is defined as “an obligation of an entity to transfer economic benefits as a result of past transactions or events”. The Framework effectively says that a statement of financial position comprises only of assets, liabilities and equity. Deferred income does not satisfy the definition of any of the elements. The liability of Jenson is to produce and deliver the next 18 publications. The cost of this liability is $144,000 ($192,000 × 18/24). Thus adopting the balance sheet approach to revenue recognition advocated in the Framework would mean recognising only $144,000 as a liability on the statement of financial position instead of $180,000 as deferred income under the accruals approach. The balance sheet approach would mean that Jenson would recognise all of the profit on the publications on receipt of the subscriptions. Many commentators have criticised the Framework for its lack of prudence in reporting profit and being contrary to existing accounting practice and, in some cases IFRS.
Answer 17 XYZ INC
(a) Extracts from the financial statements of XYZ Inc at 31 December 2007 Statement of financial position
(i) Tangible fixed assets held under finance leases
Plant and machinery $
Cost
At 1 January 2007 x
Additions 4,400
———
At 31 December 2007 4,400
——— Accumulated depreciation
At 1 January 2007 x
Charge for the year 629
———
At 31 December 2007 629
——— Net book value
At 31 December 2007 3,771
———
At 1 January 2007 x
——— (ii) Finance lease payables
Amounts payable:
$ Within one to five years ($600 × 8 – $284) 4,516
Less future finance charges 996
——— 3,520 ——— Accruals
$
Finance leases ($667 + $284) 951
Statement of comprehensive income Profit is stated after charging
$
Finance charges 604 (W2)
(b) Table
Period ended Amount Repaid Capital due 7.68% Amount due borrowed for period interest at period end
$ $ $ $ $
30 June 2007 4,400 (600) 3,800 292 4,092
31 December 2007 4,092 (600) 3,492 268 3,760
30 June 2008 3,760 (600) 3,160 243 3,403
31 December 2008 3,403 (600) 2,803 215 3,018
30 June 2009 3,018 (600) 2,418 186 2,604
31 December 2009 2,604 (600) 2,004 154 2,158
30 June 2010 2,158 (600) 1,558 119 1,677
31 December 2010 1,677 (600) 1,077 83 1,160
30 June 2011 1,160 (600) 560 40 600
31 December 2011 600 (600) – – –
Comparison
Period Sum of digits (W2) Actuarial (as above)
$ $
1 320 292
2 284 268
3 249 243
4 213 215
5 178 186
6 142 154
7 107 119
8 71 83
9 36 40
10 – –
——— ———
1,600 1,600
——— ———
WORKINGS
(1) Calculation of finance charge
$
Minimum lease payments 5 × $600 × 2 6,000
Fair value of asset (4,400)
———
Finance charge 1,600
(2) Allocation of finance charge
Period ended Digits Finance charge $
(3) Lease obligation
Period ended Amount Repaid Capital due Interest Amount borrowed for period due at
$3,520 Interest $284
During 2007
Answer 18 SNOW INC
Extracts from the financial statements of Snow Inc for year ended 31 December 2007 Statement of comprehensive income
Profit is stated after charging
$ Finance charges $(1,714 + 1,429 + 9,614) (W1 and 2) 12,757
Depreciation 41,667
Statement of financial position
Tangible fixed assets held under finance leases
WORKINGS
(1) Snowplough
(a) Calculation of finance charge
$
Deposit 2,000
MLP (6 × $6,500) 39,000
Fair value of asset (35,000)
———
Finance charge 6,000
——— (b) Allocation of finance charge
Period Digits Finance
ended charge
$23,143
Capital
$23,143 Interest –
During 2007
$11,000β End 2007 $12,143
(2) Snow machine
Period Amount Repayment Capital Interest Amount Ended O/s at start O/S at start at 8.36% O/S at end
$ $ $ $ $
31 Dec 2007 150,000 (35,000) 115,000 9,614 124,614
31 Dec 2008 124,614 (35,000) 89,614 7,492 97,106
$124,614
Capital
$115,000 Interest $9,614
During 2007
$25,386β End 2007 $89,614
Answer 19 INTELLECTUAL INDIVIDUALS INC (a) Memorandum
To Bobby Bobov, Chairman, Intellectual Individuals Inc From Amelia Bobouka
Date 22 February 2008
Subject Accounting treatment of research projects
(i) Project Rico
This research falls within the IAS 38 Intangible Assets definition of research as being original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge. The work being performed is experimental in nature, and to date there are not indications that it will be successful. It would thus be imprudent to capitalise such expenditure, and accordingly it should be written off in the year incurred.
(ii) Project Mounsey
The expenditure since 2003 has been classified as development expenditure which should be capitalised. IAS 38 requires that development costs be capitalised and amortised when all of the following criteria are met:
– the costs can be separately identified and measured reliably – the product or process is technically feasible
– the entity intends to produce, market or use the product/process – the market or usefulness to the entity of the product or process can
be demonstrated
– the entity can demonstrate how it can generate future economic benefits from the sale or use of the asset
– adequate resources are available to complete the project.
The amount capitalised should not exceed recoverable amounts net of production, selling and administrative costs directly incurred in marketing the product.
Prior to 2003 there was insufficient certainty as to the recoverability of costs to warrant capitalisation.
IAS 38 requires that development costs initially recognised as an expense should not be recognised as an asset in subsequent periods.
Accordingly, the expenditure of $200,000 between 2003 and 2005 has been correctly classified as an intangible non-current asset.
(iii) Project Wellington
The costs incurred refining Project Wellington have been capitalised since Department S discovered its extra properties. These costs should have been prudently amortised over a period of five years. IAS 38 requires that capitalised development costs be reviewed for impairment if any factors occur that may lead to the asset being impaired.
The recent legislation changes mean that the carrying value of the development costs capitalised should be written off immediately as they are no longer recoverable.
(b) Notes to the financial statements (6) Intangible assets
Deferred (10) Statement of comprehensive income disclosures
$ $
(a) Research and development
The company’s policy as regards research and development is contrary to the requirements of IAS 38. All research expenditure should be written off to profit or loss as it is incurred. The only exception is capital expenditure on research facilities.
All development expenditure should also be written off immediately unless the criteria in IAS 38 can be demonstrated:
technical feasibility;
intention to complete the product; ability to use or sell the product;
confidence that the product will make a profit if it is sold, or will be useful if for
availability of technical, financial and other resources needed to complete the
product;
measurable expenditure.
If all of these conditions are met the company must capitalise the development costs, to be written off systematically in the periods during which the product is used or sold. As the “substantial program” has only been begun this year all these conditions may have still to be met. Even if the conditions for capitalisation are met it is too soon to amortise the costs (before there is a product to use of sell).
In order to capitalise any costs as development Rover must have a costing system that distinguishes development expenditure from research.
(b) Provision/Contingent liability
IAS 37 defines a provision as a liability of uncertain timing or amount and a contingent liability as either a possible obligation which will be confirmed only by the occurrence or non-occurrence of a future event or a present obligation that is not recognised because it is unlikely that there will be an outflow of future economic benefits or the amount of the obligation cannot be measured reliably.
As it is felt that the claim is unlikely to succeed this would seem to fall into the definition of a contingent liability and IAS 37 requires the estimated amount of damages to be disclosed by note. However, as the legal costs are to be incurred whatever the outcome of the case, IAS 37 requires that a provision should be made for them in the company’s financial statements. Answer 21 LAMOND
(a) Conditions to be met
An entity must be able to demonstrate all of the following:
The technical feasibility of completing the project so that it will be available for use
or sale.
The intention to complete the project and use or sell the result. Its ability to use or sell the product.
The ability of the product to generate future economic benefits.
The availability of adequate technical, financial and other resources to use or sell
the product.
The ability to measure the expenditure attributable to the project reliability during
its development.
(b) Amounts to appear
Statement of Statement of comprehensive financial
income position
$ $
Project A
Amortisation 40,000
Statement of financial position 80,000
Project B
Expenditure written off 230,000 –
Project C
Development expenditure to date 255,000
Project D
Research expenditure _______ 80,000 _______ – 350,000 335,000 _______ _______ (c) Disclosure requirements
(i) Total research and development expenditure recognised as an expense was $350,000 analysed as follows:
$
Expenditure during the year 135,000
Amortised or written off from deferred expenditure _______ 215,000 350,000 _______ (ii) Movements on unamortised development costs
$
Balance at 1 July 2007 380,000
Expenditure recognised as an asset in current year _______ 225,000 605,000
Amortised during year (40,000)
Expenditure on abandoned project written off (230,000) _______
Balance at 30 June 2008 _______ 335,000
Answer 22 ALLRIGHTS INC
Directors’ views on inventory valuation
Striver. A prudent approach is necessary, but the concept of accruals is also important. It is not acceptable to undervalue inventories. Valuing inventories at low figures will not of itself help cash flow although, as profit will be reduced, the outgoings for bonuses, taxation and dividends may also be reduced.
Gloome. Budgeted cost is not acceptable. Opinion
Inventories should be valued at the lower of cost and net realisable value under IAS 2 Inventories. “Cost” means all costs of purchase, of conversions and other costs incurred in bringing inventories to their present location and condition. They include a systematic allocation of fixed and variable production overheads including depreciation and maintenence of factory buildings and the cost of factory management and administration. The allocation of these overheads must however be based on the normal capacity of production facilities such that the value of inventories is not increased as a result of inefficiencies.
In this case, Gloom indicates that there may have been some inefficiencies and these should be noted carefully before any final decision is made.
Costs to be included are therefore as follows:
$ Direct labour and materials 38
Bought-in components 5
Factory overheads 8
Production planning ($4,000 ÷ 1,000) 4 —— 55 ——
“Net realisable value” means the selling price to be obtained on sale in the normal course of business less any costs inevitably incurred on sale, i.e. $60 less royalty $2 and commission $4 = $54. Inventories therefore should be valued at $54.
Answer 23 SAMPI (IAS 2) (a) IAS 2 treatment
(i) Three acceptable methods
(1) Unit cost
Inventory is priced at the actual amount paid for each individual item of inventory held
(2) First in first out (FIFO)
Inventory is assumed to be composed of the items most recently purchased, regardless of whether this is actually the case. Inventory is therefore valued according to the price paid for the most recent purchase. If this purchase is insufficient to cover the quantity in inventory, the price of the next most recent purchase is taken as necessary.
(3) Average cost (AVCO)
All three of these methods are acceptable under IAS 2 because they are either the actual cost of the inventory (method 1) or a reasonably close approximation to that actual cost (methods 2 and 3).
(ii) Finished goods valuation
The cost of the inventory of finished goods would normally be arrived at by taking the labour and materials consumed in manufacturing the items plus an allocation of overheads. The overhead allocation should be based on the normal level of production and should exclude selling expenses and general management expenses.
(b) Computation of value of inventory Value using weighted average basis
Number Weighted Total value of units average of closing
cost inventory
$ $
Opening inventory 4,000 13.00
8 March _____ 3,800 15.00
Balance 7,800 13.97
12 March (5,000) _____
2,800 13.97
18 March (2,000) _____
800 13.97
22 March _____ 6,000 18.00
6,800 17.53
24 March (3,000) _____
3,800 17.53
28 March (2,000) _____
1,800 17.53 31,554
_____ _____
Tutorial note: Or 31,558 without rounding differences. Answer 24 WILLIAM INC
(a) Statement of comprehensive income (extracts)
for the year ended 31 December
2004 2005 2006 2007
$000 $000 $000 $000
Revenue(W3) 3,143 1,968 5,272 2,117
Cost of sales (2,750) (3,861) (3,339) (1,150)
——– ——– ——– ——–
Gross profit /(loss) (W1) 393 (1,893) 1,933 967
(b) Statement of financial position (extracts)
as at 31 December
2004 2005 2006 2007
$000 $000 $000 $000
Contract revenue recognised as revenue in the period:
3,143 1,968 5,272 2,117
—— —— —— ——
Contract costs incurred and recognised profits ( less recognised losses ) to date
3,143 4,250 10,383 12,500
—— —— —– ——
Gross amounts due from customers for contract work (W2)
143 Nil Nil Nil
—— —— —— ——
Gross amounts due to customers for contract work (W2)
Nil 750 617 Nil
—— —— —– ——
WORKINGS
(1) Expected profit
2004 2005 2006 2007
(2) Disclosure workings
2004 2005 2006 2007 Contract costs incurred 2,750 5,750 9,950 11,100 Profits /losses 393 (1500) 433 1,400
(3) Revenue Allocate on a costs basis
2004 2005 2006 2007
$000 $000 $000 $000
Costs to date 2,750 5,750 9,950 11,000
Total costs (2,750+7,750) (5,750+7,750) (9,950+1,550) 11,000
% complete 26% 43% 86% 100%
× tender value × 12,000 × 12,000 × 12,000 × Actual (12,500)
Revenue to date 3,143 5,111 10,383 12,500
Less taken
in prior periods – (3,143) (5,111) (10,383)
——– ——– ——– ——–
= Revenue
in year 3,143 1,968 5,272 2,117
——– ——– ——– ——–
Answer 25 EARLEY INC
(a) IAS 10 Events After the Reporting Period states that assets and liabilities should be adjusted for events occurring after the end of the reporting period that provide additional evidence relating to conditions existing at the end of the reporting period. It specifically includes the example of bad debts, where evidence of bankruptcy of a debtor occurs after the year end.
In this case, Nedengy appears to have recovered part of the debt and as such only $200,000 needs to be provided. It may be argued that the receivership has occurred as a result of events occurring after the end of the reporting period, as a result of a change in legislation for example, but this is unlikely.
IAS 18 Revenue states that when uncertainty arises about the collectability of an amount already included in revenue, the amount should be recognised as an expense.
(b) It is likely that the fall in the value of the property will fit the IAS 10 definition of adjusting events noted in (a) above, unless, again, it can be argued that the decline in the property market occurred after the year-end.
