AAT Focus Notes (Tutor) - Financial Statements PDF

aat AQ2013 Level 4 FINANCIAL STATEMENTS FOCUS NOTES AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) © Kaplan Financial Limited, 2014 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any f...

aat AQ2013 Level 4 FINANCIAL STATEMENTS FOCUS NOTES AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) © Kaplan Financial Limited, 2014 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any firm or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of Kaplan Publishing. The text in this material and any others made available by any Kaplan Group company does not amount to advice on a particular matter and should not be taken as such. No reliance should be placed on the content as the basis for any investment or other decision or in connection with any advice given to third parties. Please consult your appropriate professional adviser as necessary. Kaplan Publishing Limited and all other Kaplan group companies expressly disclaim all liability to any person in respect of any losses or other claims, whether direct, indirect, incidental, consequential or otherwise arising in relation to the use of such materials. ii K A P LA N P UB L I S H I N G CONTENTS CHAPTER TITLE PAGE 1 Regulatory frameworks 1 2 The conceptual framework 5 3 Property, plant and equipment 13 4 Intangible assets 25 5 Impairments 33 6 Inventories 39 7 Taxation 45 8 Leases 51 9 Provisions and events after the reporting period 59 10 Revenue 69 11 Company finance 75 12 Company financial statements 81 13 Statement of cash flows 89 14 Interpreting financial statements 101 15 Consolidated statement of financial position 111 16 Consolidated statement of profit or loss 127 17 Consolidated accounts: Associates 137 18 Additional questions 143 Quality and accuracy are of the utmost importance to us so if you spot an error in any of our products, please send an email to [email protected] with full details, or follow the link to the feedback form in MyKaplan. Our Quality Co-ordinator will work with our technical team to verify the error and take action to ensure it is corrected in future editions. KAPLAN P UBLI S H I N G iii AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) iv K A P LA N P UB L I S H I N G Introduction Purpose of this unit: Follows on from ACPR and FSTP Purpose – to develop competence in drafting and interpreting financial statements of limited companies Relates to individual companies and corporate groups Requires knowledge and application of International Financial Reporting Standards Includes analysis and interpretation of financial statements to assist in the decision-making of external user groups Core topics within FSTM: The regulatory framework Key features of published financial statements Draft financial statements for a limited company Draft consolidated financial statements Interpretation of financial statements using ratio analysis Assessment of FSTM: Tasks 1 & 2 – Draft statutory financial statements for a limited company Task 3 – Conceptual and regulatory framework Tasks 4 & 5 – International financial reporting standards Task 6 – Consolidated financial statements Tasks 7 & 8 – Analysis and interpretation KAPLAN P UBLI S H I N G v AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) vi K A P LA N P UB L I S H I N G Regulatory frameworks Learning objectives: At the end of this chapter you will be able to: Demonstrate knowledge of the legislation and regulation that must be complied with when preparing financial statements. Contents: 1 The legal framework 2 The regulatory framework 3 Summary 4 Further reading and questions KAPLAN P UBLI S H I N G 1 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 1 The legal framework The legal framework in the UK Companies Act 2006 Additional law may apply to other companies – e.g. banks 2 The regulatory framework All UK companies may use International Financial Reporting Standards (IFRS) when preparing their financial statements. It is mandatory for listed UK companies to use IFRS. 2 K A P LA N P UB L I S H I N G  RE GULA TORY F RAMEWORK S : CHAPTER 1 3 Summary Legal regulation The Companies Act 2006 The regulatory framework The IFRS Foundation KAPLAN P UBLI S H I N G 3 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 4 Further reading and questions Further reading For more detailed explanation, analysis and illustration of this topic please read Chapter 1 of the Financial Statements text book. Less detailed summaries can be found in Chapter 1 of the Financial Statements pocket notes. If you are attending a revision course, please do not attempt the revision kit questions until your tutor instructs you to do so. Additional tutor resources Tutor’s supplementary question bank (for additional personalisation) Q1-2 are simpler questions for students who may be struggling Q36-37 are trickier questions to challenge more able students. These questions and answers may be printed off separately and distributed to students as necessary, to supplement the material listed above. Additional tutor guidance We recommend the following additional questions for the topics covered in this chapter: Study text (for teaching throughout the chapter) Regulatory frameworks – (Chapter 1): activity 1 4 K A P LA N P UB L I S H I N G The conceptual framework Learning objectives: At the end of this chapter you will be able to: Demonstrate a knowledge and understanding of the International Accounting Standards Board’s Conceptual Framework for Financial Reporting. Contents: 1 What is the framework? 2 The objective of financial statements 3 The qualitative characteristics of useful information 4 The underlying assumption 5 Elements of the financial statements 6 Measuring the elements 7 Summary 8 Further reading and questions KAPLAN P UBLI S H I N G 5 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 1 What is the framework? Conceptual Framework for Financial Reporting 2010 It provides a context, structure and principles for the development and application of IFRS 2 The objective of financial statements Objective of financial statements To provide information on the financial position and performance of a company that is useful to a range of users Principal users of financial statements Users Purpose Investors To assess risks and returns of relevant investments Lenders To decide whether to offer loans and what rates of interest to charge Suppliers To decide whether to supply goods on credit and the terms of the credit Principal users of financial statements Government To use figures to calculate the correct tax payable Employees To assess the position of the business with regard to job stability and opportunities Customers To ensure they have a stable supplier of goods and services Public To obtain information about companies of interest 6 K A P LA N P UB L I S H I N G  THE CONCEPTUAL FRAMEWOR K : C H A P T ER 2 3 The qualitative characteristics of useful information The Framework identifies two fundamental qualitative characteristics of useful financial information and four enhancing characteristics. Preparers of financial information should attempt to maximise these characteristics to benefit the users. Fundamental characteristics Relevance Capable of influencing decision-making Faithful representation Complete, neutral and free from error Enhancing qualitative characteristics Comparability Between entities and also for one entity between different time periods Verifiability This provides assurance regarding reliability of information Timeliness Information available within appropriate timescale for decision-making Understandability Information should be understandable to those who use it Principal users of financial statements Government To use figures to calculate the correct tax payable Employees To assess the position of the business with regard to job stability and opportunities Customers To ensure they have a stable supplier of goods and services Public To obtain information about companies of interest 4 The underlying assumption Going concern Definition: The business will continue in operational existence for the foreseeable future without the need or intention to cease trading KAPLAN P UBLI S H I N G 7 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 5 Elements of the financial statements Elements of the financial statements Asset A resource controlled by an entity as a result of past transactions or events, from which future economic benefits are expected to flow to the entity Liability A present obligation arising from past transactions or events, the settlement of which is expected to result in an outflow of economic benefits from the entity Equity The residual interest of the business when it ceases to trade (and all the assets are sold and liabilities paid) The statement of financial position presents the assets, equity and liabilities of the company as at the end of a reporting period. Statement of financial position as at 30 June 20X6 £ £ Non-current assets Property, plant and equipment X Intangible assets X ––– Current assets X Inventories X Trade and other receivables X Cash and cash equivalents X ––– X ––– Total assets X ––– Equity Share capital X Share premium account X Retained earnings X Revaluation reserve X ––– Total equity X ––– 8 K A P LA N P UB L I S H I N G  THE CONCEPTUAL FRAMEWOR K : C H A P T ER 2 Non-current liabilities Long-term loans or debentures X Current liabilities Trade and other payables X Bank overdrafts X Tax payable X ––– X ––– Total liabilities X ––– Total equity and liabilities X ––– Elements of the financial statements Income The increase in economic benefits during an accounting period Expense The decreases in economic benefits during an accounting period The statement of profit or loss and other comprehensive income shows the performance of the company over the period. It includes items of other comprehensive income, such as revaluation gains, which are not recognised in profit or loss. Statement of profit or loss and other comprehensive income for year ended 30 June 20X6 £ Revenue X Cost of sales (X) ––– Gross profit X Distribution costs (X) Administrative expenses (X) ––– Profit from operations X Finance costs (X) ––– Profit before tax X Income tax expense (X) ––– Profit for the period X ––– Other comprehensive income Revaluation gain X ––– Total comprehensive income for year X ––– KAPLAN P UBLI S H I N G 9 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) Note that there is more formalised terminology and only certain headings and amounts are required to be disclosed in the annual financial statements. Note also that the capital structure of a limited company is different to that of a sole trader or a partnership. 6 Measuring the elements Measuring the elements Historical cost: Assets would be recorded at the price paid to acquire them. Liabilities would be recognised at the proceeds received Current cost: Assets would be carried at the current purchase price. Liabilities would be carried at the amount required to settle them. Measuring the elements Realisable value: Assets would be carried at the amount that would be obtained from their sale. Liabilities would be carried at the amount required to settle them Present value: Assets would be carried at the discounted value of the future cash inflows that the item will generate. Liabilities would be carried at the discounted value of the cash flows required to settle them 10 K A P LA N P UB L I S H I N G  THE CONCEPTUAL FRAMEWOR K : C H A P T ER 2 7 Summary The objective of financial statements To provide information About position, performance and changes That is useful to a range of users Qualitative characteristics Relevance Faithful representation Comparability Verifiability Timeliness Understandability The elements: Assets Liabilities Equity Income Expenses Possible measure bases are: Historical cost Current cost Realisable value Present value KAPLAN P UBLI S H I N G 11 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 8 Further reading and questions Further reading For more detailed explanation, analysis and illustration of this topic please read Chapter 2 of the Financial Statements text book. Less detailed summaries can be found in Chapter 1 of the Financial Statements pocket notes. Real assessment standard question practice Revision kit: Question 10 (Recognition) Question 11 (Objectives) Additional, more challenging questions The following questions can be found at the rear of Chapter 2 of the Financial Statements text book Workbook Activities 5 – 9 If you are attending a revision course, please do not attempt the revision kit questions until your tutor instructs you to do so. Additional tutor resources Tutor’s supplementary question bank (for additional personalisation) Q3-4 are simpler questions for students who may be struggling Q38-39 are trickier questions to challenge more able students. These questions and answers may be printed off separately and distributed to students as necessary, to supplement the material listed above. Additional tutor guidance We recommend the following additional questions for the topics covered in this chapter: Study text (for teaching throughout the chapter) The conceptual framework – (Chapter 2): activities 1, 2 3 and 4 Revision kit (for recapping and revising the chapter) Questions 12 and 13 12 K A P LA N P UB L I S H I N G Property, plant and equipment Learning objectives: At the end of this chapter you will be able to: Account for the purchase, depreciation and disposal of property, plant and equipment Account for revaluation gains and losses Explain the disclosures required for property, plant and equipment Contents: 1 Recording property, plant and equipment 2 Depreciation of property, plant and equipment 3 Disposal 4 Example 1 – Disposal 5 Revaluation 6 Example 2 – Revaluation 7 Disclosures 8 Summary 9 Further reading and questions KAPLAN P UBLI S H I N G 13 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 1 Recording property, plant and equipment IAS 16 – Property, plant and equipment Contents: Definitions Accounting treatments Disclosure requirements Definitions Non-current assets – assets that are purchased with the intention of long term use within the business Tangible non-current assets – assets that have a tangible, physical form, such as land and, buildings, machinery and cars Intangible non-current assets – are assets for long-term use in the business that have no physical form, e.g. patents and licences Definitions Capital expenditure – expenditure on non-current assets or on the improvement of non-current assets. Capital purchases are recorded as assets on the statement of financial position Revenue expenditure – all other expenditure within the business that is not of a capital nature. This may include expenditure that maintains but does not improve non-current assets, such as money spent on repairs and renewals 14 K A P LA N P UB L I S H I N G  PRO PER TY, P L AN T AND E QUIPMENT : C HA P T ER 3 2 Depreciation of property, plant and equipment Definitions Depreciation: The consumption or usage of a non-current asset in the accounting period which is spread over its estimated useful life to the business Useful economic life – the period over which economic benefits are expected to be derived from the asset. Residual value – the amount that the asset is expected to be sold for at the end of its useful economic life. Methods of depreciation Straight-line – this assumes that the asset is used consistently throughout its life. The depreciation charge is the same each year Diminishing balance – this assumes that an asset is used less and less the older that it gets. The depreciation charge falls each year Straight-line depreciation – method EITHER: (Cost – residual value)/Useful life OR: (Cost – residual value) × % KAPLAN P UBLI S H I N G 15 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) Diminishing balance depreciation – method Carrying value of non-current asset × % Carrying value – the cost of the asset less the accumulated depreciation charged to date Accounting entries for the annual depreciation charge DR: Depreciation expense (P&L) CR: Accumulated depreciation (SOFP) 3 Disposal Accounting treatment upon disposal of a non-current asset 1 – Remove the cost of the asset and transfer to a disposal account DR: Disposal of NCA CR: Non-current asset Accounting treatment upon disposal of a non-current asset 2 – Remove the accumulated depreciation and transfer to disposal account DR: Accumulated depreciation CR: Disposal of NCA 16 K A P LA N P UB L I S H I N G  PRO PER TY, P L AN T AND E QUIPMENT : C HA P T ER 3 Accounting treatment upon disposal of a non-current asset 3 – Record disposal proceeds received in disposal account DR: Cash / Bank CR: Disposal of NCA Accounting treatment upon disposal of a non-current asset 4 – Transfer remaining balance on disposal account to P&L DR: Disposal of NCA CR: P&L (if a profit on disposal) OR: DR: P&L (if a loss on disposal) CR: Disposal of NCA Calculation of profit or loss upon disposal of a NCA £ Proceeds X Less carrying value: Cost X Accumulated dep’n (X) ––– (X) –––– Profit/(Loss) X/(X) KAPLAN P UBLI S H I N G 17 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 4 Example 1 – Disposal Vintage Ltd bought a machine on 1 January 2010 for £10,000. It depreciates machines on a straight line basis over 5 years with no estimated residual value. On 31 December 2012, Vintage Ltd sold the machine for £7,000 Task: Calculate the profit or loss on disposal? Solution: The profit or loss on disposal can be calculated as follows: £ Proceeds: 7,000 Carrying value: Cost: 10,000 Accumulated Depreciation ((£10,000/5 years) × 3 years) (6,000) –––––– (4,000) –––––– Profit on disposal 3,000 –––––– The answer to the above example can be found in Chapter 19. 5 Revaluation Revaluation rules IAS 16 permits revaluation of PPE – it is not compulsory The company must revalue all assets within the class or category – there cannot be selective revaluation of assets Revalued assets should be depreciated over their remaining estimated useful lives Revalue at regular intervals to keep valuation up to date 18 K A P LA N P UB L I S H I N G  PRO PER TY, P L AN T AND E QUIPMENT : C HA P T ER 3 Revaluation – accounting treatment An increase in the CV of PPE creates an unrealised gain – recognise in other comprehensive income and in revaluation reserve within equity Dr PPE – asset account (to increase the cost to valuation amount value) Dr Accumulated depreciation (to remove accumulated depreciation to date) Cr Revaluation reserve (to record the gain in the value of the asset) Revaluation – accounting treatment A decrease in the CV of PPE creates an unrealised loss – recognise first against revaluation reserve (if possible), and then in P&L Dr Revaluation reserve / profit or loss (to recognise fall in value) Dr Accumulated depreciation (to remove all accumulated depreciation) Cr PPE – asset account (to record the loss in the value of the asset) Revaluation – excess depreciation annual transfer within SOCIE Transfer is not compulsory, but if done, must be applied consistently every year Effect is to regard part of revaluation reserve as being realised Dr Revaluation reserve Cr Retained earnings Disposal of a revalued asset A gain or loss on disposal is included in profit or loss for the year Transfer balance on revaluation reserve to retained earnings within SOCIE Dr Revaluation reserve Dr Retained earnings KAPLAN P UBLI S H I N G 19 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 6 Example 2 – Revaluation On 31 December 20X2, Earlgrey plc revalued a building. The building originally cost £5,000,000 and had an estimated useful life of fifty years with no residual value. Accumulated depreciation at the date of revaluation was £1,000,000. The estimated market value of the building was £5,500,000. Several years ago, Lapsong Ltd re-valued a building to £3,000,000 recording a gain of £100,000 which is held within a revaluation reserve. On 31 December 20X2, the accumulated depreciation on the building was £400,000. At that date, a surveyor advises that the building was now worth only £2,000,000 with a remaining estimated useful life of twenty years. Required: State the double entry required to record each revaluation and calculate the new annual deprecation charge for each building. Solution: The double entry required to record each revaluation Earlgrey plc: The building has a carrying value of £4,000,000 (5,000,000 – £1,000,000). It needs to be re-valued to £5,500,000. This will create a gain of £1,500,000 (£5,500,000 – £4,000,000) that will be held within a revaluation reserve. Dr Building – asset account £500,000 (£5,500,000 – £5,000,000) Dr Accumulated depreciation £1,000,000 (to remove acc dep’n) Cr Revaluation reserve £1,500,000 Revised depreciation charge: £5,500,000 / 40 years = £137,500 Lapsong Ltd The asset currently has a carrying value of £2,600,000 (£3,000,000 – £400,000). It needs to be re- valued to £2,000,000. This is a revaluation loss of £600,000. This will first of all be allocated to the revaluation reserve, reducing it from £100,000 to nil. The remaining loss of £500,000 (£600,000 – £100,000) will be expensed to profit or loss. Dr Revaluation reserve £100,000 (reduced to nil by the revaluation loss) Dr Profit or loss £500,000 (balancing figure) Dr Accumulated depreciation £400,000 (to remove acc dep’n) Cr Building – asset account £1,000,000 (£3,000,000 – £2,000,000) Revised depreciation charge: £2,000,000 / 20 years = £100,000 The answer to the above example can be found in Chapter 19. 20 K A P LA N P UB L I S H I N G  PRO PER TY, P L AN T AND E QUIPMENT : C HA P T ER 3 7 Disclosures In the financial statements, a disclosure note is required that details the changes in the cost and accumulated depreciation account balances of each class of property, plant and equipment since the last reporting date. Land and Plant and Motor Total buildings machinery vehicles Cost or valuation At 1 January 20X2 X X X X Additions X X X X Disposals (X) (X) (X) (X) Revaluations X X X X –––– –––– –––– –––– At 31 December 20X2 X X X X –––– –––– –––– –––– Accumulated depreciation At 1 January 20X2 X X X X Revaluations (X) (X) (X) (X) Charge for year X X X X Disposals (X) (X) (X) (X) –––– –––– –––– –––– At 31 December 20X2 X X X X –––– –––– –––– –––– Carrying value At 31 December 20X2 X X X X –––– –––– –––– –––– At 1 January 20X2 X X X X –––– –––– –––– –––– Note that the PPE asset accounts may now include some items measured at cost whilst others are stated on a valuation basis. Strictly, the term ‘cost account’ should no longer be used – ‘assets at cost or valuation’ is a more accurate description. Accounting policies disclosures Depreciation methods and rate(s) used for each major class of asset Measurement basis (cost or valuation) for each major class of asset KAPLAN P UBLI S H I N G 21 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 8 Summary Recognition Record PPE at total of capital expenditure Depreciation Straight line Diminishing balance Revaluations Gains are recorded in reserves Losses are recorded in profit or loss 22 K A P LA N P UB L I S H I N G  PRO PER TY, P L AN T AND E QUIPMENT : C HA P T ER 3 9 Further reading and questions Further reading For more detailed explanation, analysis and illustration of this topic please read Chapter 3 of the Financial Statements text book. Less detailed summaries can be found in Chapter 6 of the Financial Statement pocket notes Real assessment standard question practice Revision kit: Question 32 (Larch plc) Question 33 (Revaluation) Additional, more challenging questions The following questions can be found at the rear of Chapter 3 of the Financial Statements text book Workbook activities 2, 3 and 4 If you are attending a revision course, please do not attempt the revision kit questions until your tutor instructs you to do so. Additional tutor resources Tutor’s supplementary question bank (for additional personalisation) Q5-7 are simpler questions for students who may be struggling Q40-41 are trickier questions to challenge more able students. These questions and answers may be printed off separately and distributed to students as necessary, to supplement the material listed above. Additional tutor guidance We recommend the following additional questions for the topics covered in this chapter: Study text (for teaching throughout the chapter) Valuation gains – (Chapter 3): activities 1 Revision kit (for recapping and revising the chapter) Questions 14 and 34 KAPLAN P UBLI S H I N G 23 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 24 K A P LA N P UB L I S H I N G Intangible assets Learning objectives: At the end of this chapter you will be able to: Distinguish between tangible and intangible assets Record entries for the acquisition of intangible assets Distinguish between research and development activities Explain the accounting treatment of research and development activities Record entries for the amortisation of intangible assets Contents: 1 Recognition and measurement of intangible assets 2 Research and development 3 Example 1 – Research and development 4 Amortisation 5 Example 2 – Amortisation 6 Summary 7 Further reading and questions KAPLAN P UBLI S H I N G 25 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 1 Recognition and measurement of intangible assets IAS 38 – Intangible assets Contents: Definition Recognition requirement Accounting treatments Disclosure requirements IAS 38 – Intangible assets Definition – an identifiable, non-monetary asset without physical substance Recognition Identifiable – capable of being separated from other assets Controlled – able to use or determine who can use the assets Reliable measurement of cost – otherwise cannot recognise Future economic benefits – applied to every asset Internally generated assets – not normally recognised IAS 38 – Intangible assets Measurement Initially recognise at cost Amortise if reliable estimate of EUL If no EUL – permanent asset, subject to annual impairment review Future economic benefits Permitted to revalue intangible assets, but requires active market for identical assets – very rare 26 K A P LA N P UB L I S H I N G  I N TAN GIB LE A SSE TS : CHA PT ER 4 2 Research and development IAS 38 – Intangible assets Research – is original investigation which is undertaken in order to obtain new knowledge Write off to P&L as incurred IAS 38 – Intangible assets Development – is the application of research findings to produce new or improved materials, products or processes Capitalise and amortise if meeting specific criteria – otherwise write off to P&L Development costs criteria for compulsory capitalisation Remember SECTOR Sufficient resources to complete Entity will complete development of product Complete the project Technically feasible Overall profitable Reliably measured KAPLAN P UBLI S H I N G 27 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 3 Example 1 – Research and development Salmon Ltd, a manufacturer of food packaging, has undertaken a number of research and development activities in the year ended 31 December 2013. It can be assumed that expenditure occurred evenly over the course of the year. (i) £500,000 has been spent testing a new type of plastic to see if it is harmful to humans. (ii) In the prior year, Salmon Ltd performed tests on a new type of plastic and found that it decomposes much more quickly than traditional plastics. During the year ended 31 December 2013, £120,000 has been spent designing a milk bottle that incorporates the new plastic. On 1 August, the directors received the results of market research that demonstrated a massive demand for this new milk bottle. Salmon Ltd has sufficient resources to bring the product to market. Required: What is the correct accounting treatment for the research and development activities in the year ended 31 December 2013? Solution: (i) This project is still in the research phase. Therefore, all £500,000 must be recognised as an expense in the statement of profit or loss. (ii) This project is in the development stage. An intangible asset must be recognised when the IAS 38 criteria are met. The profitability of the project was confirmed on 1 August 2013 so expenditure from this date is capitalised. Therefore an intangible should be recognised at £50,000 (5/12 × £120,000). The remaining £70,000 (£120,000 – £50,000) must be charged to the statement of profit or loss. The answer to the above example can be found in Chapter 19. 4 Amortisation IAS 38 – Intangible assets Amortisation of intangible fixed assets Similar to accounting for depreciation on tangible fixed assets Dr: Amortisation expense (P&L) Cr: Accumulated amortisation (SOFP) 28 K A P LA N P UB L I S H I N G  I N TAN GIB LE A SSE TS : CHA PT ER 4 IAS 38 – Intangible assets Amortisation of intangible fixed assets If no reliable estimate of EUL, then cannot amortise, but must have annual impairment review 5 Example 2 – Amortisation Chardonnay Ltd purchased two brands on 30 June 2013. Details of these brands are given below: Brand Name Cost (£) Useful Life (years) A 100,000 10 B 500,000 Indefinite In addition, Chardonnay Ltd has internally generated a new brand (Brand C). It estimates that this cost £400,000 in staff costs. Required: What is the correct accounting treatment of the brands in the year ended 31 December 2013? Solution: Brand A: This brand will be recognised in the statement of financial position at its cost of £100,000. This will be amortised over the useful life of 10 years from the date the brand is available to use (30 June 2013). The amortisation expense in the statement of profit or loss is therefore £5,000 ((£100,000/10 years) × 6/12)). This will reduce the value of the brand in the statement of financial position to £95,000 (£100,000 – £5,000). Brand B: The brand will be recognised in the statement of financial position at its cost of £500,000. This brand has an indefinite useful life and is therefore not amortised. Instead, it will be subject to an annual impairment review. Brand C: This is an internally generated intangible asset. Internally generated intangible assets can only be recognised if they result from development activities and strict criteria are met. Therefore, Brand C will not be held on the statement of financial position. The answer to the above example can be found in Chapter 19. KAPLAN P UBLI S H I N G 29 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 6 Summary Intangible assets Recognise if purchased Do not recognise if internally generated (except R&D) Research and development Research costs are expensed Development costs are capitalised if all criteria are fulfilled. Intangible assets are amortised over their useful economic life If they have an indefinite life, they are subject to an annual impairment review. 30 K A P LA N P UB L I S H I N G  I N TAN GIB LE A SSE TS : CHA PT ER 4 7 Further reading and questions Further reading For more detailed explanation, analysis and illustration of this topic please read Chapter 4 of the Financial Statements text book. Less detailed summaries can be found in Chapter 6 of the Financial Statements pocket notes. Real assessment standard question practice Revision kit: Question 15 (Victoria plc) Question 48 (Research and Development) Additional, more challenging questions The following questions can be found at the rear of Chapter 4 of the Financial Statements text book. Workbook activities 2 and 3 If you are attending a revision course, please do not attempt the revision kit questions until your tutor instructs you to do so. Additional tutor resources Tutor’s supplementary question bank (for additional personalisation) Q8-9 are simpler questions for students who may be struggling Q42-43 are trickier questions to challenge more able students. These questions and answers may be printed off separately and distributed to students as necessary, to supplement the material listed above. Additional tutor guidance We recommend the following additional questions for the topics covered in this chapter: Study text (for teaching throughout the chapter) Capitalising research and development – (Chapter 4): activity 1 Revision kit (for recapping and revising the chapter) Questions 18 and 47 KAPLAN P UBLI S H I N G 31 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 32 K A P LA N P UB L I S H I N G Impairments Learning objectives: At the end of this chapter you will be able to: Assess when an impairment review is required Calculate if an asset is impaired Account for the impairment of an asset Contents: 1 Impairment of assets 2 Impairment reviews 3 Example 1 – Impairment review 4 Summary 5 Further reading and questions KAPLAN P UBLI S H I N G 33 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 1 Impairment of assets IAS 36 – Impairment of assets Contents: Definition Recognition requirement Accounting treatment IAS 36 – Impairment of assets – definitions Impairment – a reduction in the recoverable amount of an asset below its carrying amount Recoverable amount – the higher of either fair value less costs to sell or value in use Fair value less costs to sell – the amount an asset could be sold for, less direct selling costs Value in use – the present value of future cash flows arising from continued use of the asset 34 K A P LA N P UB L I S H I N G  IMPAIR MENTS : C HA P T ER 5 2 Impairment reviews IAS 36 – Impairment of assets Annual impairment reviews required: Intangible assets which have been assessed as having an indefinite useful life Goodwill arising from a business combination Otherwise – only need impairment review when there is an indication of possible impairment IAS 36 – Impairment of assets Indicators of impairment (not exhaustive): Decreases in the market value of an asset A reduction in the usage of an asset Evidence that an asset has performed worse than expected IAS 36 – Impairment of assets Impairment review calculation £ Carrying value of asset X Less recoverable amount – the higher of (a) FV less costs to sell X (b) Value in use X (X) ––– (X) –––– KAPLAN P UBLI S H I N G 35 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) IAS 36 – Impairment of assets Outcome of impairment review: If recoverable amount exceeds CV of asset, then no impairment If recoverable amounts is less than CV of asset – impairment loss is written off against revaluation reserve if a revalued asset, otherwise to P&L Disclose impairment losses in notes to P&L Depreciate reduced asset CV over remaining EUL 3 Example 1 – Impairment review The following information relates to three assets held by a company. A B C Carrying value (£) 200 200 200 Net selling price (£) 250 175 160 Value in use (£) 180 150 180 Required: Calculate the impairment losses, if any, in respect of the three assets. Solution: Recoverable amount is the higher of the net selling price (fair value less costs to sell) and value in use. A B C Recoverable amount (£) 250 175 180 Carrying value (£) 200 200 200 Impairment (£) No (25) (20) The answer to the above example can be found in Chapter 19. 36 K A P LA N P UB L I S H I N G  IMPAIR MENTS : C HA P T ER 5 4 Summary Perform an impairment review on: Intangibles with indefinite lives Goodwill Assets with indicators of impairment An asset is impaired if: Carrying value > Recoverable amount Recoverable amount is the higher of: Fair value less costs to sell Value in use Impairment losses Dr Profit or loss X Cr Asset (SOFP) X KAPLAN P UBLI S H I N G 37 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 5 Further reading and questions Further reading For more detailed explanation, analysis and illustration of this topic please read Chapter 5 of the Financial Statements text book. Less detailed summaries can be found in Chapter 6 of the Financial Statements pocket notes. Real assessment standard question practice Revision kit: Question 38 (Frank Ltd) Question 39 (Bovey Ltd) Additional, more challenging questions The following question can be found at the rear of Chapter 5 of the Financial Statements text book. Workbook Activity 2 If you are attending a revision course, please do not attempt the revision kit questions until your tutor instructs you to do so. Additional tutor resources Tutor’s supplementary question bank (for additional personalisation) Q10-11 are simpler questions for students who may be struggling Q44-45 are trickier questions to challenge more able students. These questions and answers may be printed off separately and distributed to students as necessary, to supplement the material listed above. Additional tutor guidance We recommend the following additional questions for the topics covered in this chapter: Study text (for teaching throughout the chapter) Impairment review – (Chapter 5): activity 1 Revision kit (for recapping and revising the chapter) Questions 40, 41 and 42 38 K A P LA N P UB L I S H I N G Inventories Learning objectives: At the end of this chapter you will be able to: Account for closing inventory at the lower of its cost and net realisable value Contents: 1 Recording inventories 2 Example 1 – Recording inventories 3 Example 2 – Net realisable value 4 Summary 5 Further reading and questions KAPLAN P UBLI S H I N G 39 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 1 Recording inventories IAS 2 – Inventories Contents: Definitions Accounting treatment IAS 2 – Inventories – Definitions: Cost – comprises all costs of purchase, conversion and finishing to bring items to their current location and condition: e.g. purchase cost of raw materials Net realisable value – the estimated selling price in the ordinary course of business, less the estimated costs required to complete and sell the item IAS 2 – Inventories Methods of identifying cost per unit for identical items: Unit cost – purchase cost Weighted average cost – average cost for items purchased First-in-first-out (FIFO) – inventory held consists of the most recent purchases IAS 2 – Inventories Accounting requirement: Inventory is measured (i.e. valued) at the lower of cost or net realisable value for each separate item or product 40 K A P LA N P UB L I S H I N G  I N V E N TO R IES : CHAPTER 6 IAS 2 Inventories – Accounting entries for closing inventories: Dr: Closing inventory (SOFP) Cr: Closing inventory (Cost of sales – P&L) 2 Example 1 – Recording inventories A company starts trading in January. It makes the following inventory purchases: Units £/unit 1 January 5 10 15 January 10 12 29 January 8 15 On 31 January, the company sells 10 units of inventory. Task: Calculate the cost of closing inventory on 31 January using: (i) First-in, first-out (FIFO) (ii) Average cost Solution: Total unit purchases were 23 (5 + 10 + 8). Therefore, there are 13 units (23 – 10) of closing inventory (i) Under FIFO, these will be valued at the latest purchase prices: 8 units × £15 = £120 5 units × £12 = £60 –––––– –––––– 13 units £180 –––––– –––––– (ii) (The total purchase cost is £290 ((5 units × £10) + (10 units × £12) + (8 units × £15)) The average purchase cost is therefore £12.61 (£290/23 units) Closing inventory will be valued at £163.93 (13 units × £12.61) The answer to the above example can be found in Chapter 19. KAPLAN P UBLI S H I N G 41 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 3 Example 2 – Net realisable value Tracey Ltd sells three products – A, B and C. The following information was available at the year-end: A B C £ per unit £ per unit £ per unit Original cost 7 10 19 Estimated selling price 15 13 20 Selling and distribution costs 2 5 6 Units of inventory 20 25 15 Task: What is the correct value of closing inventories? Solution: All items should be valued at the lower of cost and NRV. Unit A: Cost = £7 NRV = £13 (£15 – £2) Therefore each of the 20 units should be valued at £7 Unit B: Cost = £10 NRV = £8 (£13 – £5) Therefore each of the 25 units should be valued at £8 Unit C: Cost = £19 NRV = £14 (£20 – £6) Therefore each of the 15 units should be valued at £14 Closing inventory is therefore £550 ((20 × £7) + (25 × £8) + (15 × £14)) The answer to the above example can be found in Chapter 19. 42 K A P LA N P UB L I S H I N G  I N V E N TO R IES : CHAPTER 6 4 Summary Closing inventory Dr Inventory (SOFP) X Cr Cost of sales (P/L) X The cost of inventory Unit cost FIFO Average cost Inventory is measured at the lower of: Cost NRV KAPLAN P UBLI S H I N G 43 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 5 Further reading and questions Further reading For more detailed explanation, analysis and illustration of this topic please read Chapter 6 of the Financial Statements text book. Less detailed summaries can be found in Chapter 7 of the Financial Statements pocket notes. Real assessment standard question practice Revision kit: Question 20 (Chestnut plc) Question 21 (FIFO) Additional, more challenging questions The following question can be found at the rear of Chapter 6 of the Financial Statements text book Workbook Activity 4 If you are attending a revision course, please do not attempt the revision kit questions until your tutor instructs you to do so. Additional tutor resources Tutor’s supplementary question bank (for additional personalisation) Q12-13 are simpler questions for students who may be struggling Q46-47 are trickier questions to challenge more able students. These questions and answers may be printed off separately and distributed to students as necessary, to supplement the material listed above. Additional tutor guidance We recommend the following additional questions for the topics covered in this chapter: Study text (for teaching throughout the chapter) Application of IAS 2 – (Chapter 6): activities 1, 2 and 3 Revision kit (for recapping and revising the chapter) Questions 22 and 23 44 K A P LA N P UB L I S H I N G Taxation Learning objectives: At the end of this chapter you will be able to: Identify the amount of tax to be recognised in the statement of financial position and the statement of profit or loss Account for adjustments in respect of over or under-estimated tax in prior periods Contents: 1 Tax in the financial statements 2 Example 1 – Tax 3 Summary 4 Further reading and questions KAPLAN P UBLI S H I N G 45 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 1 Tax in the financial statements IAS 12 – Income taxes Contents: Definitions – note that IAS 12 refers to Income taxes – this is tax charged on the income of a company which would normally be referred to as corporation tax in the UK. Reference to income taxes in this context should not be confused with tax paid by individuals. When the provision for a company’s income tax is made in the accounts, it is an estimate. The final amount will be agreed with the tax authorities at a later date. The basic accounting treatment is very similar to accounting for an expense on an accruals basis. Any difference between the original estimate and the actual amount paid at a later date will be adjusted in the following year. IAS 12 – Income taxes Accounting treatment: Dr: Tax expense (P&L) Cr: Tax payable (SOFP) IAS 12 – Income taxes Tax in the financial statements £ Tax charge estimated for the year (To SOFP) X Less: overprovision in earlier year (X) Add: underprovision in earlier year X ––– Tax charge in P&L (X) –––– 46 K A P LA N P UB L I S H I N G  TAXATION : C H A P T ER 7 IAS 12 Income taxes Definitions: Underprovision – is an under-estimate of the tax expense in the previous year. This must be added to the current year tax charge. Overprovision – is an overestimate of the tax expense in the previous year. This must be deducted from the current year tax charge. 2 Example 1 – Tax CalcsRus Ltd estimated that the tax due on its profits for the year ended 31 December 2012 was £90,000. On 1 October 2013, it settled its prior year tax bill for £88,000. CalcsRus Ltd estimate that the tax due on its profits for the year-ended 31 December 2013 is £110,000. Task: What is the accounting treatment of the above for the year-ended 31 December 2013? Solution: The 2012 tax bill has been paid. CalcsRus Ltd’s liability for the year-ended 31 December 2013 is the current year tax bill only. Therefore the liability on the statement of financial position is £110,000. The statement of profit or loss and other comprehensive income will include the current year tax expense but also an adjustment for the prior year. CalcsRus estimated that their tax on the 2012 profits would be £90,000 but they only paid £88,000. They therefore over-estimated the prior year expense by £2,000. The expense in 2013 can be calculated as follows: £ Current year tax expense 110,000 Prior year over-estimate (2,000) Prior year under-estimate – ––––––– 108,000 ––––––– Alternatively, this can be presented in a T account: Tax payable Cash 88,000 Bfd 90,000 Cfd (c/y estimate) 110,000 Profit or loss (bal. fig) 108,000 ––––––– ––––––– 198,000 198,000 The answer to the above example can be found in Chapter 19. KAPLAN P UBLI S H I N G 47 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 3 Summary Tax in the statement of financial position: The liability is always the estimate of the current year’s tax bill Tax in the statement of profit or loss and other comprehensive income: The expense is calculated as: Current year estimate – prior year over-estimate + prior year under- estimate 48 K A P LA N P UB L I S H I N G  TAXATION : C H A P T ER 7 4 Further reading and questions Further reading For more detailed explanation, analysis and illustration of this topic please read Chapter 7 of the Financial Statements text book. Less detailed summaries can be found in Chapter 7 of the Financial Statements pocket notes. If you are attending a revision course, please do not attempt the revision kit questions until your tutor instructs you to do so. Additional tutor resources Tutor’s supplementary question bank (for additional personalisation) Q14-15 are simpler questions for students who may be struggling Q48-49 are trickier questions to challenge more able students. These questions and answers may be printed off separately and distributed to students as necessary, to supplement the material listed above. Additional tutor guidance We recommend the following additional questions for the topics covered in this chapter: Study text (for teaching throughout the chapter) Tax in the financial statements – (Chapter 7): activity 1 Revision kit (for recapping and revising the chapter) Questions 19 (part e) KAPLAN P UBLI S H I N G 49 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 50 K A P LA N P UB L I S H I N G Leases Learning objectives: At the end of this chapter you will be able to: Classify a lease as either a finance lease or an operating lease Understand the accounting treatment of finance leases and operating leases Contents: 1 What is a lease? 2 Accounting treatment – operating leases 3 Accounting treatment – finance leases 4 Illustration 1 5 Summary 6 Further reading and questions KAPLAN P UBLI S H I N G 51 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 1 What is a lease? IAS 17 – Leases Contents: Definitions Accounting treatment IAS 17 – Leases – definitions Lease – a lease is a contract to hire out an asset between the lessor (owner of the asset) and the lessee (who uses the asset). In effect, a lease agreement is a form of rental agreement. IAS 17 – Leases – definitions Finance lease – a lease that transfers substantially all of the risks and rewards of ownership of the asset to the lessee. Operating lease – any lease that does not meet the definition of a finance lease is regarded as an operating lease. IAS 17 – Leases – definitions Lessee – the lessee is the company or business that uses the leased asset in its business Lessor – the lessor is the owner of the asset who allows the lessee to use the asset for an agreed period of time in exchange for payment 52 K A P LA N P UB L I S H I N G  LEASES : CHAPTER 8 IAS 17 – Leases Indicators of a finance lease: Transfer of legal ownership at end of lease term The lessee has the option to purchase the asset at the end of the lease term at less than fair value The lease term is for substantially most of the economic useful life of the asset At the start of the lease, the present value of the minimum lease payments amounts to substantially all of the fair value of the asset The lessee will compensate the lessor if the lease is cancelled 2 Accounting treatment – operating leases If a lessee enters into an operating lease, it does not recognise an asset. Instead, the lessee simply recognises an annual leasing expense in the statement of profit or loss. IAS 17 – Leases Operating leases: Annual lease rental charge is calculated as: Total lease payments / Total lease term Dr: Operating lease expense (to P&L) Cr: Bank KAPLAN P UBLI S H I N G 53 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 3 Accounting treatment – finance leases The lessee controls the asset and, in accordance with the Framework, the substance of the transaction should be recorded in the financial statements. IAS 17 – Leases Finance leases: Recognise or record a finance lease asset and finance lease liability: Dr: Finance lease asset (NCA in SOFP) Cr: Finance lease liability (in SOFP) IAS 17 – Leases Finance leases: Depreciate the asset over the shorter of either the lease term or the useful economic life of the asset: Dr: Depreciation expense (P&L) Cr: Accumulated depreciation (SOFP) IAS 17 – Leases Finance leases: The liability or obligation is a form of loan finance – a finance cost is incurred: Dr: Finance costs (P&L) Cr: Finance lease liability (SOFP) 54 K A P LA N P UB L I S H I N G  LEASES : CHAPTER 8 IAS 17 – Leases Finance leases: Lease (or loan) repayments are made to reduce the total liability: Dr: Finance lease liability (SOFP) Cr: Bank (SOFP) 4 Illustration 1 Two companies entered into lease agreements on 1 January 2013. (i) Borrow Ltd has signed an agreement to lease a photocopier for 2 years. This will cost £10,000 per annum as well as an upfront, non-refundable deposit of £5,000. The photocopier has an estimated total useful life of 10 years. Borrow Ltd is not responsible for insuring and maintaining the photocopier. (ii) Buy Ltd has signed an agreement to lease a machine for four years. This will cost £2,000 per annum, with payments being made at the end of each year. The asset, which has an expected useful life of four years, could have been bought outright for £5,800 and the present value of the minimum lease payments is £5,710. The interest rate implicit in the lease is 15%. Required: What is the accounting treatment of the above for each company for the year ended 31 December 2013? Solution: (i) The risks and rewards of ownership have not passed to Borrow Ltd: Borrow Ltd will not be using the asset for most of its life (the lease term is 2 years while the asset has a useful life of 10 years). Borrow Ltd is not responsible for fixing the asset if it breaks down. This lease is therefore an operating lease: The photocopier is not recognised as an asset. The total cost of the lease is spread straight line over the lease term in the statement of profit or loss. Total payments = £5,000 deposit + (2 × £10,000) = £25,000 Spread over 2 years = £12,500 per year. An expense of £12,500 will therefore be recognised in the year ending 31 December 2013. £15,000 has been paid this year, so a prepayment of £2,500 will be presented on the statement of financial position. KAPLAN P UBLI S H I N G 55 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) Financial statement extracts £ Extract from statement of profit or loss Operating lease rentals 12,500 Extract from statement of financial position Prepayment 2,500 (ii) The risks and rewards of ownership have passed to Buy Ltd: Buy Ltd will be using the asset throughout its useful life (the lease term is 4 years, which is the same as the asset’s useful life). The present value of the minimum lease payments (£5,710) is almost the same as the asset’s fair value (£5,800). This lease is therefore a finance lease. Recognise the asset The machine will be recognised as an asset in the statement of financial position at £5,710 (the lower of the present value of the minimum lease payments and the fair value). A corresponding finance lease liability will be recognised at £5,710. Depreciate the asset The asset will be depreciated over the lower of the lease term and the useful life of the asset. These are both 4 years. Therefore, depreciation will be £1,428 (£5,710/4 years). Record interest on the liability Interest will be charged on the liability at 15%: £5,710 × 15% = £857 Record the cash payments Buy Ltd pays £2,000 to the lessor and this will reduce the liability. Extracts from statement of profit or loss £ Depreciation 1,428 Finance costs 857 Extract from statement of financial position Non-current assets (£5,710 – 1,428) 4,282 Total finance lease liability 4,567 (£5,710 + £857 interest – £2,000 payment) Liability due after more than one year (£4,567 + £456 interest – £2,000 payment) 3,023 Liability due within one year 1,544 56 K A P LA N P UB L I S H I N G  LEASES : CHAPTER 8 5 Summary Finance lease A lease where the risks and rewards of ownership transfer from the lessor to the lessee. Accounting for a finance lease Recognise the leased asset and a finance lease liability on the statement of financial position. Operating lease A lease which is not a finance lease. Accounting for an operating lease The total lease payments are expensed to the statement of profit or loss over the lease term. KAPLAN P UBLI S H I N G 57 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 6 Further reading and questions Further reading For more detailed explanation, analysis and illustration of this topic please read Chapter 8 of the Financial Statements text book. Less detailed summaries can be found in Chapter 7 of the Financial Statements pocket notes. Real assessment question practice Revision kit: Question 16 (Poppy plc) Question 35 (Ash plc) Additional, more challenging questions The following question can be found at the rear of Chapter 8 of the Financial Statements text book. Workbook Activity 3 If you are attending a revision course, please do not attempt the revision kit questions until your tutor instructs you to do so. Additional tutor resources Tutor’s supplementary question bank (for additional personalisation) Q16-17 are simpler questions for students who may be struggling Q50-51 are trickier questions to challenge more able students These questions and answers may be printed off separately and distributed to students as necessary, to supplement the material listed above. Additional tutor guidance We recommend the following additional questions for the topics covered in this chapter: Study text (for teaching throughout the chapter) Finance lease – (Chapter 8): activity 1 Operating lease – (Chapter 8): activity 2 Revision kit (for recapping and revising the chapter) Questions 36 and 37 58 K A P LA N P UB L I S H I N G Provisions and events after the reporting period Learning objectives: At the end of this chapter you will be able to: Explain what is meant by a provision, contingent liability and contingent asset Identify the correct accounting treatment for provisions and contingencies Prepare the accounting entries to recognise and adjust for provisions Distinguish between adjusting and non-adjusting events Contents: 1 What is a provision? 2 Recognising a provision 3 Illustration 1 4 Accounting for a provision 5 Example 1 – Provisions 6 Provisions – summary of accounting treatment 7 Contingent liabilities and contingent assets 8 What are events after the reporting period? 9 Summary 10 Further reading and questions K A P LA N P UB L I S H I N G 59 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 1 What is a provision? IAS 37 – Provisions, contingent liabilities and contingent assets Contents: Definitions Accounting treatment IAS 37 –Provisions, contingent liabilities and contingent assets Definition – a provision is a form of liability Liability – an obligation that arises from a past transaction or event that will lead to an outflow of economic resources Provision – a liability where there is uncertainty regarding either the exact amount and/or the timing of any payment Provisions involve uncertainty and therefore need to be estimated. IAS 37 says that they should be measured at a best estimate. This might be based on past experience or on expert advice. 2 Recognising a provision IAS 37 – Provisions, contingent liabilities and contingent assets: A provision should be recognised in the financial statements only if: there is an obligation (legal or constructive) , and it is probable that there will be an outflow of economic benefits, and the outflow of economic benefits can be reliably measured. Note: A provision cannot be made for future operating losses – they are avoidable. 60 K A P LA N P UB L I S H I N G  PROV IS IONS A ND E VEN TS AF TER THE REPO RTING PER IOD : C H A P T ER 9 3 Illustration 1 During the year ended 31 December 20X3, a company made an employee redundant. The employee started legal proceedings against the company for wrongful dismissal as they believed that the redundancy selection process was unfair. Legal advisers believe that the company will lose the case and, based on similar legal cases the past, will have to pay £300,000 in compensation to lease agreements on 1 January 2013. Task: Determine whether or not a provision needs to be recognised in the financial statements or the year ended 31 December 20X3. Solution: Is there an obliging event at the year end? Yes – the employee has been made redundant Is it probable that there will be an outflow of economic benefits as a result? Yes – the company will probably lose the case as it has not complied with relevant law or regulation when selecting employees for redundancy. Can the probable outflow of economic benefits be reliably measured? Yes – legal advisors have estimated that a payment of approximately £300,000 may be required if the case is lost. Conclusion: A provision should be recognised in the financial statements for the year ended 31 December 20X3 for £300,000. 4 Accounting for a provision IAS 37 – Provisions, contingent liabilities and contingent assets Double entry for accounting for a provision: Dr: Expense (P&L) Cr: Provisions (SOFP) When the provision is fully or partly settled: Dr: Provision (SOFP) Cr: Bank (SOFP) KAPLAN P UBLI S H I N G 61 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) IAS 37 – Provisions, contingent liabilities and contingent assets At the year-end, re-estimate provision and adjust if required. Increase the provision: Dr: Expense (P&L) Cr: Provisions (SOFP) Decrease the provision: Dr: Provision (SOFP) Cr: Expense (P&L) As a provision is an estimate, the original estimate may not match the amount that is actually paid. Any under-provision or over-provision is cleared to P&L when it is established that no obligation remains outstanding. 5 Example 1 – Provisions Gaga Ltd started business on 1 January 20X2 and has a year end of 31 December. They sell computer equipment with a one year warranty. If the item breaks within one year of the sale, then Gaga Ltd will fix it at no extra cost to the customer. At 31 December 20X2, Gaga Ltd estimates that they will have to spend £500,000 fixing items which are still under warranty. During the year ended 31 December 20X3, Gaga Ltd spends £450,000 on repairing products returned under warranty. At 31 December 20X3, Gaga Ltd estimates they will have to spend £600,000 fixing items which have been sold and are still covered by a warranty. Task: What is the accounting treatment of the above for the year-ended 31 December 20X3? 62 K A P LA N P UB L I S H I N G  PROV IS IONS A ND E VEN TS AF TER THE REPO RTING PER IOD : C H A P T ER 9 Solution: Gaga Ltd should recognise a provision for the cost of repairing goods sold under warranty because: There is an obligation – The sale of goods under warranty has occurred An outflow of resources is probable – It is likely that some products will break and therefore that Gaga Ltd will spend money on repairing these The outflow can be measured reliably – Gaga Ltd will be able to estimate the cost of repairs through its knowledge of the percentage of products that typically develop faults and the actual cost of fixing these There would have been a provision on 31 December 20X2 for £500,000. Some of this has been utilised in 20X3, because Gaga Ltd has repaired computers and therefore fulfilled its obligation. The entry for this is: Dr Provisions £450,000 Cr Cash £450,000 The provision has therefore been reduced to £50,000 (£500,000 – £50,000). At 31 December 20X3, Gaga Ltd estimates that it needs a provision of £600,000. Therefore the provision needs to be increased by £550,000 (£600,000 – £50,000): Dr Profit or loss £550,000 Cr Provisions £550,000 This can be summarised in a T account as follows: Provisions Cash 450,000 Bfd 500,000 Cfd 600,000 Profit or loss 550,000 –––––––– –––––––– 1,050,000 1,050,000 –––––––– –––––––– Therefore, there will be a provision in the statement of financial position for £600,000 and a charge to the statement of profit or loss for £550,000. The answer to the above example can be found in Chapter 19. KAPLAN P UBLI S H I N G 63 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 6 Provisions – summary of accounting treatment IAS 37 – Provisions, contingent liabilities and contingent assets Summary of accounting requirements Probability of Inflow / outflow Liabilities Assets Virtually certain Provide Recognise Probable Provide Disclose Possible Disclose Ignore Remote Ignore Ignore 7 Contingent liabilities and contingent assets IAS 37 – Provisions, contingent liabilities and contingent assets Definition – contingent liability This is a possible obligation, the outcome of which will only be determined by one or more future events outside of the control of the entity. An obligation which cannot be measured reliably will also be treated as a contingent liability. IAS 37 – Provisions, contingent liabilities and contingent assets Definition – contingent asset This is a possible asset, the outcome of which will only be determined by one or more future events outside the control of the company. This can be related to the earlier illustration of the employee bringing legal proceedings for wrongful dismissal. It may be that the legal advisors cannot reliably predict the outcome of the case and/or the amount of compensation that would be payable if the company lost the case. It cannot therefore be regarded as a probable obligation – only a possible obligation. This could happen, for example, if the case is based upon new law which has not yet been tested in courts and there are no previous cases to refer to for guidance. In this situation, it would be regarded as a contingent liability and would be disclosed only in the financial statements. 64 K A P LA N P UB L I S H I N G  PROV IS IONS A ND E VEN TS AF TER THE REPO RTING PER IOD : C H A P T ER 9 8 What are events after the reporting period? IAS 10 –Events after the reporting period Definition: Those events, both favourable and unfavourable, which occur between the statement of financial position date and the date on which the financial statements are authorised for issue. IAS 10 –Events after the reporting period Definitions: Adjusting events – provide further evidence of conditions existing at the reporting date. The financial statements must be adjusted to reflect these events. Non-adjusting events – provide no additional evidence about the conditions that existed at the reporting date. If material, these events are merely disclosed by a note in the financial statements. K A P LA N P UB L I S H I N G 65 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) IAS 10 – Events after the reporting period Examples of adjusting events: Settlement post year-end of court case Bankruptcy post year-end of a credit customer Sale of inventory post year-end at less than cost Discovery of fraud/error that confirm the financial statements were incorrect IAS 10 – Events after the reporting period Examples of non-adjusting events: Mergers and acquisitions Reconstructions The issue of shares or debentures Purchase or sale of non-current assets or investments Loss of assets as a result of a catastrophe after the year end Dividends proposed after the reporting date 66 K A P LA N P UB L I S H I N G  PROV IS IONS A ND E VEN TS AF TER THE REPO RTING PER IOD : C H A P T ER 9 9 Summary Provisions Recognise at best estimate if: An obligation exists Payment is probable It can be measured reliably Recognising a provision Dr Profit or loss x Cr Provisions x The level of provision is then reviewed at the year end Contingent liabilities and assets Possible liabilities and assets Existence is confirmed by a future event Events after the reporting period Adjusting events Non-adjusting events KAPLAN P UBLI S H I N G 67 AA T FOCUS NO TES ( TUTOR) : FI NANCI AL STAT EM ENTS (FS TM) 10 Further reading and questions Further reading For more detailed explanation, analysis and illustration of this topic please read Chapter 9 of the Financial Statements text book. Less detailed summaries can be found in Chapter 7 of the Financial Statements pocket notes. Real assessment standard question practice Revision kit: Question 17 (Toddy plc) Question 31 (Events) Additional, more challenging questions The following questions can be found at the rear of Chapter 9 of the Financial Statements text book. Workbook Activities 4 and 5 If you are attending a revision course, please do not attempt the revision kit questions until your tutor instructs you to do so. Additional tutor resources Tutor’s supplementary question bank (for additional personalisation) Q18-19 are simpler questions for students who may be struggling Q52-53 are trickier questions to challenge more able students These questions and answers may be printed off separately and distributed to students as necessary, to supplement the material listed above. Additional tutor guidance We recommend the following additional questions for the topics covered in this chapter: Study text (for teaching throughout the chapter) Events after the reporting period – (Chapter 9): activities 1, and 3 Provisions (Chapter 9): activities 2 and 3 Revision kit (for recapping and revising the chapter) Questions 45 and 46 68 K A P LA N P UB L I S H I N G Revenue Learning objectives: At the end of thi