ARP Study Guide Modules 4-9 PDF

Skills Advanced Reporting and Performance Study Guide (Modules 4-9) 2024 Contents Module 4 – Income & Expenses........................................................................................................... 2 Module 5 – Financial Instr...

Skills Advanced Reporting and Performance Study Guide (Modules 4-9) 2024 Contents Module 4 – Income & Expenses........................................................................................................... 2 Module 5 – Financial Instruments...................................................................................................... 18 Module 6 – Consolidation................................................................................................................... 32 Module 7 – Statement of Cash Flows................................................................................................ 52 Module 8 – Non-financial Reporting: Sustainability Disclosures................................................... 60 Module 9 – The Relationship between financial and non-financial reporting............................... 81 1 Module 4 – Income & Expenses Introduction Welcome to the study guide for Module 4 of the Advanced Reporting and Performance course. This study guide will help you prepare for the assessment. Syllabus Learning Outcomes SLO1 Advise on the requirements for financial Reporting and Performance in accordance with relevant standards Module Learning Outcomes By completing this module, you will have worked towards the following module learning outcomes: 1.1 Construct, with appropriate workings, the financial statements for an individual company 1.3 Advise on the effect of transactions and adjustments on the financial statements of an individual company and of a group This will be achieved by working towards the following performance indicators: 1.1.6 Advise on disclosure notes in accordance with IFRS Accounting Standards for: Revenue Share-based payments Employee benefits 1.3.1 Advise on the effect of the following transactions and adjustments on the financial statements of an individual company: Revenue Share-based payments Employee benefits You will be ‘assessment ready’ for questions in Module 4 when you can confidently complete each set of the learning outcomes above. 2 What is the IFRS 15 five-step approach to revenue recognition? Refer to RP2 Module 4 study guide for the IFRS 15 5 step approach to revenue recognition. When is a contract within the scope of IFRS 15? 5 Criteria to be in scope of IFRS 15: Approval: The parties to the contract have approved it and are committed to performing their respective obligations under the contract. Rights: The entity can identify each party’s rights regarding the goods or services to be transferred. Payment terms: The entity can identify the payment terms for goods or services to be transferred. Commercial Substance: The contract has commercial substance. This is the case if the risk, amount or timing of the company’s cash flows is expected to change as a result of the contract. Consideration: It is probable that the entity will collect the consideration that it will be contractually entitled to. In evaluating probability, the entity should consider only the customer’s ability and intention to pay the consideration when it falls due. The evaluation is not affected by the fact that variable consideration in the contract may reduce the amount of consideration to be received. Unperformed contracts (IFRS 15.12) IFRS 15 does not apply to a wholly unperformed contract that any party can terminate without paying compensation to the other party. A contract is wholly unperformed if no goods or services have been transferred to the customer and the customer has not paid any consideration. When is a promise in a contract a distinct performance obligation? Refer to RP2 Module 4 Study guide for definition of performance obligation. In the Advanced Reporting and Performance assessment, you may be required to analyse more complex scenarios to determine the number of performance obligations in a contract and therefore it is important that you understand this definition in full. For a good or service to be distinct, it must meet two criteria; 1. The customer must be able to benefit from the good or service either on its own or together with other readily available resources; and 2. The promise to transfer the good or service must be separately identifiable from other promises in the contract. How is the transaction price in a contract determined? Refer to RP2 Module 4 Study guide for transaction price. 1. Exclude amounts collected for other parties 2. Adjust contract price if there is a significant financing component 3. Only include variable elements if it is highly probable that they will be reflected in the consideration received 3 How is variable consideration reflected in the transaction price? Variable consideration is included in the transaction price (and so recognised as part of revenue) only if it is highly probable that a significant amount will not be reversed in the future when any uncertainty associated with the variable consideration is resolved. This assessment requires a degree of judgement. Both the likelihood that variable consideration will be reversed and the magnitude of any reversal should be considered. Reversal is more likely if: The amount of consideration is highly susceptible to factors outside the entity’s control, e.g. weather Uncertainty about consideration is not expected to be resolved for a long time The entity's experience with similar contracts has limited predictive value The entity has a practice of offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances The contract has a large number and a broad range of consideration amounts Variable consideration should be reassessed at each period end until it is settled, taking into account any changes to expectations. If the transaction price changes, this is accounted for as a change in accounting estimate. Therefore, previously recognised revenue is not restated. Refund liabilities (IFRS 15.55, B21, B24) The expected level of refunds should be reflected in the measurement of revenue. Any amount received from customers that is not recognised as revenue, because it is expected to be refunded, is instead recognised as a refund liability. A refund liability should be updated at the end of each reporting period for changes in circumstances. Where refunds relate to customer returns (rather than a price rebate), an adjustment for returns is made to cost of sales as well as revenue. How are revenue contracts that include non-cash consideration accounted for? ‘Exchange transaction’ is only within the scope of IFRS 15 if the goods or services exchanged have different risks and cash flows, i.e., has commercial substance. Where consideration is not in the form of cash, the transaction price is determined using the following hierarchy: Use the fair value of non-cash consideration provided by the customer, if it can be reasonably estimated. 1. If not, use the stand-alone selling price of goods or services provided by the seller, if it can be reasonably measured. 2. If not, no revenue or cost of sales is recognised. 4 How is the transaction price allocated to performance obligations? Stand-alone selling price (IFRS 15.79) In RP2, it was assumed that stand-alone selling prices for goods and services provided in a contract would be available. This is not always true, and you may be required to estimate the stand-alone selling price. Adjusted market assessment Estimate the amount that a Expected cost plus margin customer in that market would be Forecast the costs to satisfy a willing to pay, taking into account performance obligation and then the amounts charged by add an appropriate margin for competitors for similar that good/service. goods/services. When should revenue be recognised over time? How is revenue recognised over time? Recognition over time: input and output methods (IFRS 15.40-41, B17-B19) Output methods Input methods Outputs used to measure progress There may not be a direct may not be directly observable relationship between the seller’s and the information required to inputs to the satisfaction of a use an output method may not be performance obligation and the available without undue cost, for transfer of control to the customer example paying a surveyor to certify work completed. 5 When does control pass to the customer? Often control is transferred when goods are delivered to the customer, but in more complex scenarios judgement may be required to determine at which point in time control is passed. Some indicators of transfer of control: 1. The seller has a present right to payment for the asset 2. The customer has legal title to the asset 3. The seller has transferred physical possession of the asset to the customer 4. The entity has transferred the significant risks and rewards of ownership of the asset to the customer 5. The customer has accepted the asset In an assessment question, in which you are required to provide advice on a judgemental issue, make sure that you do not jump to the conclusion, even if you think it is obvious. Marks will be available for walking through your thought process by stating the requirements of the IFRS Accounting Standard and then applying them to the scenario before reaching a conclusion. How are non-refundable up-front fees accounted for? If the up-front fee relates to the transfer of a If the up-front fee does not relate to a distinct promised good or service, and that good or performance obligation, it is a prepayment for service is a distinct performance obligation, the goods or services provided throughout the revenue should be recognised when the contract period and should be recognised as performance obligation is satisfied. revenue over that period. When is revenue recognised in a bill and hold transaction? In a bill-and-hold arrangement, the selling company takes payment for goods from a customer but it holds the goods at its own premises until the customer requires them. Revenue is recognised when the customer obtains control of the goods. In a bill-and-hold arrangement, this is the case only if ALL of the following conditions are met: The reason for the bill-and-hold arrangement is substantive (ie there is a genuine business reason for the arrangement) The goods are labelled as belonging to the customer The goods are ready for immediate transfer to the customer The selling company cannot use the goods or sell them to another party When is revenue recognised on a consignment sale? A manufacturer of goods may transfer them to a retailer who displays them with the aim of selling them to the final customer. This is known as a consignment sale. The manufacturer can only recognise revenue when it transfers control of its goods to another party. If goods are held ‘on consignment’ by the retailer or dealer, the manufacturer has not transferred control of the goods to them as the goods may be returned. In this case, the manufacturer can only recognise revenue when the goods are sold to the final customer. 6 Consignment arrangements and agency There is a secondary issue in an arrangement in which a retailer or dealer sells goods on a manufacturer’s behalf. If the retailer is acting as an agent on behalf of the manufacturer and is paid a commission: Manufacturer Retailer Revenue Price charged to the final customer Commission from manufacturer Expense Manufacturing cost plus commission paid to - retailer If the retailer is the principal in the transaction with the final customer: Manufacturer Retailer Revenue Price charged to retailer Price charged to final customer Expense Manufacturing cost Price paid to manufacturer When does a warranty form a separate performance obligation? Whilst IAS 37 applies to a standard warranty, IFRS 15 applies to an extended warranty. Extended warranty A promise over and above the promise made under the standard warranty, for example, to correct problems for an additional 2 years after the standard warranty expires, or to correct problems not covered by the standard warranty. This type of warranty may be sold to the customer or provided free of charge. The extended warranty is a separate performance obligation in the contract and is allocated some of the transaction price in the contract. Revenue in relation to the extended warranty is recognised over the extended warranty period. Any costs of extended warranty repairs are costs to fulfil the contract with the customer and should be recognised as incurred. How is a sale and repurchase transaction accounted for? Here are three types of repurchase agreement: A forward option, in which the company that sold the asset is obliged to repurchase it at a later date A call option, in which the company that sold the asset can choose to repurchase it at a later date, however, is under no obligation to do so A put option, in which the party that bought the asset can require the selling company to repurchase it at a later date A sale is only recognised if control of the asset has passed from the selling company to the other party. IFRS 15 provides guidance on whether control passes where the repurchase agreement takes the form of a forward or a call option and a different set of requirements where the agreement takes the form of a put option. 7 Only forward and call options will be assessed in Advanced Reporting and Performance. You will not be expected to account for sale and repurchase transactions which involve a put option. The repurchase price is less than IFRS 16 Leases is applied to the sale and leaseback element of the selling price and the the transaction first (see the previous module on liabilities). As a transaction is a sale and result of the repurchase option, the transfer of the asset is not a leaseback with the repurchase at sale. Therefore, IFRS 16 requires that this is recognised as a the end of the lease term. financing arrangement and IFRS 9 applies. Example Broderick Creamery Ltd (Broderick) manufactures and sells cheese, including its award-winning 10- year old vintage Cheddar cheese. On 8 April 20X2, it sold 50,000kg of Cheddar to Northern Bank for £500,000. The sales contract stipulated that Broderick must repurchase all 50,000kg of Cheddar on 8 April 20X8 for £580,000. The sale contains a forward and Broderick is obligated to repurchase the Cheddar. How would this transaction be accounted for? Solution Since the repurchase price of £580,000 exceeds the selling price of £500,000, this is accounted for as a financing transaction. The cheese remains in Broderick's accounts as inventory and the following journal entry is made to record the sale contract: Account name £ £ Dr Bank 500,000 Cr Loan 500,000 Being the recognition of proceeds from Northern Bank. Over the 6-year period to 8 April 20X8, the finance cost is recognised by: Account name £ £ Dr Finance cost 80,000 Cr Loan 80,000 Being the recognition of finance cost. On the repurchase date, the payment is recognised by: Account name £ £ Dr Loan 580,000 Cr Bank 580,000 Being the repurchase / repayment of the amount due to Northern Bank. The IFRS 9 effective interest method is applied and the finance cost accrues to the loan at a constant rate over the 6-year period. If the contract had contained a call option rather than a forward, and Broderick had not exercised its option, the loan would have been derecognised and revenue recognised instead. 8 What accounting treatment is applied to costs to obtain a contract? What accounting treatment is applied to costs to fulfil a contract? Some costs to fulfil a contract are always recognised as expenses when incurred. They are: General and administrative costs (unless rechargeable to the customer) The cost of wasted materials and resources that were not reflected in the contract price What accounting treatment is applied to a loss-making contract? A onerous contract is A contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. In this case, IFRS 15 is applied to measure and recognise revenue and costs incurred, and then IAS 37 is applied to ensure that the overall expected loss is recognised. 9 Example Bolling Ltd (Bolling) has entered into a non-cancellable contract to construct a series of log cabins for a holiday park. The customer will control the log cabins as they are created. The transaction price is £5 million and future unavoidable costs of the contract are estimated to be £3.85 million due to unexpected increases in the price of timber. There is no contract clause to pass this increase back to the customer. The contract started in the year ended 31 December 20X6 and Bolling has applied IFRS 15 and recognised revenue of £2 million and costs of £1.2 million in the year. Required What further accounting entries are required to reflect the fact that the contract is expected to make a loss? Solution Overall the contract is expected to make a loss, calculated as follows: £’000 Transaction price 5,000 Costs incurred to date (1,200) Future expected costs (3,850) Loss (50) To date a profit of £800 has been recognised, calculated as: £’000 Revenue recognised 2,000 Costs recognised (1,200) 800 Therefore a provision for £850,000 should be recorded to reflect future expected losses, which can be calculated as: £’000 Transaction price 5,000 Revenue recognised to date (2,000) Future revenue 3,000 Future expected costs (3,850) Future expected losses 850 This reverses the previously recognised profit of £800,000 and recognises the overall expected loss of £50,000. It is recognised by: Account name £ £ Dr Cost of sales 850,000 Cr Provision for onerous contract 850,000 Being the recognition of a provision for the onerous contract In the ARP assessment, you will not necessarily be told that a contract is onerous. Instead, you must use the scenario to calculate the expected profit or loss, and if loss-making, account for an onerous contract. 10 How is revenue presented and disclosed in the financial statements? Refer to RP2 Module 4 study guide for presentation and disclosure of revenue in the financial statements. What are monetary items? Refer to RP2 Module 4 study guide for monetary items. How are a foreign currency transaction and its subsequent settlement recognised? Foreign currency transactions settled BEFORE the reporting date. When and how are foreign currency balances in the SOFP remeasured? Foreign currency transactions settled AFTER the reporting date. 11 How are foreign currency transactions disclosed? IAS 21 requires that the following are disclosed: 1. The amount of exchange differences recognised in profit or loss (except for those arising on financial instruments measured at fair value through profit or loss in accordance with IFRS 9). 2. Net exchange differences recognised in other comprehensive income and accumulated in a separate component of equity. 3. A reconciliation of exchange differences accumulated in a separate component of equity at the beginning and end of the period. How are short-term benefits and defined contribution pension plans accounted for? Refer to RP2 Module 4 study guide for short-term benefits and defined contribution pension plans. How are defined benefit pension plans accounted for? Refer to RP2 Module 4 study guide for defined benefit pension plans. What are amendments, curtailments and settlements and how are they accounted for? Refer to RP2 Module 4 study guide for curtailments and settlements. How are employee benefits presented and disclosed? Presentation in financial statements Disclosure notes Short-term Presented as an operating expense in No specific requirements but consider employee SPL (within staff costs) requirements of other standards, e.g.: benefits IAS 1 Presentation of Financial Statements requires the disclosure of total employee expense IAS 24 Related Party Disclosures requires the disclosure of key management personnel remuneration. Defined Presented as an operating expense in Disclose the defined contribution contribution SPL (within staff costs) expense in the year and consider other pension plans standards, e.g. pension contributions made for key management personnel should be disclosed in accordance with IAS 24 Related Party Disclosures. Defined benefit Presented as an asset or liability in Explanation of characteristics of pension plans the SOFP plans and associated risks Current service cost and past service Explanation of amounts in financial cost are presented as operating statements (including separate expenses in SPL (within staff costs) reconciliations for pension assets Net interest presented as finance and pension obligations) cost/finance income in SPL Description of effect on amount, Remeasurements presented as OCI- timing and uncertainty of future cash Retained Earnings flows 12  Presentation in financial statements Disclosure notes Consider the requirements of other standards, e.g. IAS 24 Related Party Disclosures requires disclosure of: Related party transactions with pension plans and Pension benefits for key management personnel What are share-based payments? A share based payment is: A transaction in which an entity makes payment to a supplier or employee in the form of its own equity instruments (shares or share options) or a cash amount related to the value of those instruments. Share-based payments Cash-settled share-based Equity-settled share-based with a choice of settlement payments payments Payment is either equity- Payment is in the form of an Payment is in the form of settled or cash-settled at the amount of cash related to the shares or share options. option of either the entity or share price. the counterparty. How are equity and cash-settled share-based payments recognised? Equity-settled share-based payment Dr Expense / asset Cash settled share-based payment Cr Equity Being the recognition of an equity-settled Dr Expense/asset share-based payment. Cr Liability Being the recognition of a cash-settled The asset or expense account used share-based payment. depends on the nature of goods or services acquired, e.g. staff costs, purchases, The asset or expense account used inventory, property, plant and equipment. depends on the nature of goods or services acquired, e.g. staff costs, purchases, IFRS 2 does not stipulate the equity reserve inventory, property, plant and equipment. to be used. If shares are issued immediately, you The liability represents the obligation to pay should use share capital/share cash at a future date. You should use the premium. ‘other payables’ account. If share options are issued, you should use retained earnings. A share-based payment transaction is recognised when goods or services are received from the supplier or employee. This may be at a point in time or over a period of time. 13 The impact on distributable reserves Although a credit entry is made to retained earnings where payment is in the form of share options, this does not affect distributable reserves and no adjustment is required because the credit entry is legally considered to be distributable. How are equity and cash-settled share-based payments measured? What are grant dates, vesting periods and vesting dates? Grant date The date on which the entity and counterparty agree to a share-based payment arrangement. Vesting period The period between grant date and vesting date. Vesting date The date on which the counterparty is entitled to receive the equity instruments granted. In the ARP assessment, you could be asked to account for a share-based payment at its grant date, at any year-end date in the vesting period, or at the vesting date. Read the scenario carefully to establish the position and whether any accounting has/ has not taken place. How are equity-settled share-based payment transactions with suppliers recognised? Equity-settled share-based payments with suppliers are: Usually recognised immediately (because they vest immediately) Measured at the fair value of goods or services supplied, assuming these can be measured reliably 14 How are equity-settled share-based payment transactions with employees recognised? Equity-settled share-based payments with employees: Are measured at the fair value of instruments granted at the grant date Usually require a period of service to be completed (vesting condition) The equity instruments are provided as consideration for work performed during the required period of service and the transaction is therefore recognised over this period. What are vesting conditions and how do they affect accounting for share-based payment transactions? Vesting conditions are: The conditions that must be met during the vesting period in order for the counterparty to become entitled to equity instruments (or cash) in a share-based payment transaction. Service conditions Performance conditions related to share price A requirement for an employee to complete a specified An additional requirement for a performance target related period of service before they are entitled to the equity to the share price to be met while the employee delivers instruments granted to them. service to the company, e.g. share price must exceed £7.50. These are referred to as market performance The number of equity instruments expected to vest is conditions. updated at each reporting date for new information about leavers. No adjustment is made to the measurement of the share- based payment. Performance conditions unrelated to share price An additional requirement for a performance target not related to share price to be met while the employee delivers service to the company, e.g. revenue must increase by 10% or profits must reach a certain level. Performance targets can be related to the entity, part of the entity or the individual. These are referred to as non-market performance conditions. The number of equity instruments expected to vest is updated at each reporting date for new information about whether performance conditions are expected to be met. What accounting treatment applies to share options after the vesting date? After the vesting date, employees may exercise their share options (i.e. buy shares at the option price), or they may let them lapse (i.e. fail to exercise the options within the allowed timeframe). Options are exercised Options lapse Dr Bank No accounting entry is required. Cr Share capital Can transfer cumulative credit made to retained Cr Share premium earnings throughout the vesting period to another balance within equity. Can transfer cumulative credit made to retained earnings throughout the vesting period to another balance within equity. 15 How are cash-settled share-based payments recognised and measured? Cash-settled share-based payments are usually a form of reward provided to employees in exchange for their services. They may take the form of: Share appreciation rights (SARs), which grant employees a right to a future cash payment that is based on an increase in share price over a defined period A right to shares that are redeemable In Advanced Reporting and Performance, cash-settled share-based payments will take the form of share appreciation rights (SARs). Recognition Measurement Recognise as a liability: Measurement Dr Expense / asset Measure at the fair value of the liability Cr Other payables Remeasure at each reporting date and the Recognise when goods or services are settlement date provided. Any remeasurement gains or losses are recognised in profit or loss. This is the case even if the share-based payment qualifies for recognition as an asset. How do vesting conditions affect accounting for cash-settled share- based payments? Vesting conditions are reflected in the measurement of cash-settled share-based payments in the same way as equity-settled. How are share-based payments disclosed in the financial statements? General information Fair Values Effects on financial statements Information should be provided Information should be provided Information should be provided that allows users to understand that allows users to understand that allows users to understand the nature and extent of share- how the fair value of goods or the effect of share-based based payment arrangements services received or the fair payment transactions on profit in the period. value of instruments granted in or loss for the period and on its This includes: the period was determined. financial position. A description of each type Disclosed information should of arrangement, including include: vesting conditions. The total expense in the The number and weighted period, including separate average exercise price of disclosure of the expense share options that were: arising from equity-settled − outstanding at the start and share-based payments end of the period The carrying amount of − granted during the period share-based payment − lapsed during the period liabilities at the end of the − exercised during the period period − expired during the period − exercisable at the end of the period 16 How is deferred tax calculated in relation to cash-settled share- based payments? A cash-settled share-based payment results in the recognition of a liability at the reporting date and therefore deferred tax should be considered. Carrying amount Tax base The carrying amount should be calculated in The tax base of a liability is its carrying amount accordance with IFRS 2, as described in Lesson 9. less any amount that will be deductible for tax purposes in future periods. In the UK, employee remuneration payable is only tax allowable if it is paid within nine months of the year end. Therefore no tax relief will have been given for a cash-settled share-based payment liability due in more than nine months. The tax base of the liability is therefore nil, because the full carrying amount will be deductible for tax purposes when paid. Temporary difference Deferred tax The amount of the temporary difference is the A deferred tax asset is calculated by applying carrying amount of the share-based payment the relevant tax rate to the temporary liability due in more than nine months. difference. It is a deductible temporary difference because tax relief will be given equal to the carrying amount in the future. In the Advanced Reporting and Performance assessment, you should treat any non-current share- based payment liability as a deductible temporary difference unless more specific information is provided (i.e. the liability is due in more than 9 months). As mentioned above, only consider the deferred tax consequences of share-based payments if the requirement asks you to do so. Study guide checklist Have you completed reading module 4? Have you completed the skills checkers and skills builders? Can you confidently complete the module learning outcomes listed on this module? Can you confidently answer the guiding questions? Have you completed the assessment practice questions? Have you used the discussion board to ask questions on areas you are unsure about? 17 Module 5 – Financial Instruments Introduction Welcome to the study guide for Module 5 of the Advanced Reporting and Performance course. This study guide will help you prepare for the assessment. Syllabus Learning Outcomes SLO1 Advise on the requirements for financial reporting and performance in accordance with relevant standards Module Learning Outcomes By completing this module, you will have worked towards the following module learning outcomes: 1.1 Construct, with appropriate workings, the financial statements for an individual company 1.3 Advise on the effect of transactions and adjustments on the financial statements of an individual company and of a group This will be achieved by working towards the following performance indicators: 1.1.6 Advise on disclosure notes in accordance with IFRS Accounting Standards for: Financial instruments Share capital Distributable profits 1.3.1 Advise on the effect of the following transactions and adjustments on the financial statements of an individual company Financial instruments Share capital Distributable profits You will be ‘assessment ready’ for questions in Module 5 when you can confidently complete each set of the learning outcomes above. 18 What are financial instruments, financial assets and financial liabilities? Refer to RP2 Module 5 study guide for definition of financial instruments, financial assets and financial liabilities. How are preference shares classified? Refer to RP2 Module 5 study guide for how preference shares are classified. In Advanced Reporting and Performance, you will not be required to account for redeemable preference shares with a discretionary dividend that is classified as a compound instrument. How does IAS 32 extend the definitions of financial asset and financial liability? IAS 32 extends the definitions of financial asset and financial liability beyond those that you encountered in RP2. Financial Asset Financial Liability A contract that will or may be settled in the A contract that will or may be settled in the entity’s own equity instruments and is one of the entity’s own equity instruments and is one of the following: following: A non-derivative for which the entity is or A non-derivative for which the entity may be may be obliged to receive a variable number obliged to deliver a variable number of its of its own equity instruments own equity instruments A derivative that will or may be settled other A derivative that will or may be settled other than by the exchange of a fixed amount of than by the exchange of a fixed amount of cash or another financial asset for a fixed cash or another financial asset for a fixed number of the entity’s own equity number of the entity’s own equity instruments. instruments. If a contract will or may be settled in a fixed number of a company’s own equity instruments, it is an equity instrument (a decrease to equity if shares will be received and an increase to equity if shares will be issued). In the Advanced Reporting and Performance assessment, you will not be required to account for a financial asset or a financial liability that is settled in a variable number of a company’s own equity instruments, but you may be expected to identify and explain whether such transactions are financial assets or financial liabilities. When are convertible instruments classified as compound instruments? Refer to RP2 Module 5 study guide for compound instruments. In Advanced Reporting and Performance, you will not be required to account for convertible instruments that are financial liabilities in their entirety. In Advanced Reporting and Performance, you can assume that any convertible instruments that you are required to account for are classified as compound instruments. 19 How are compound instruments presented in the financial statements? Refer to RP2 Module 5 study guide for how to determine the liability and equity elements of compound instruments. How are compound instruments accounted for at maturity? Refer to RP2 Module 5 study guide for how to accounting for compound instruments at maturity. How is an issue of equity shares, including bonus and rights issues, recognised? Issue of shares for non-cash consideration Issue of shares for cash A listed company must have the non-cash Dr Bank (issue price x number of shares consideration valued independently. issued) Dr Asset (fair value (FV) of non-cash Cr Share capital (nominal value x number consideration) of shares issued) Cr Share capital (nominal value x number Cr Share premium account (balance) of shares issued) Cr Share premium account (balance) Bonus issue Shares are issued for no consideration in proportion to existing shareholdings. Dr Share premium or retained earnings (nominal value x number of shares issued) Cr Share capital (nominal value x number of shares issued) Rights Issue A rights issue of shares is an issue of shares to existing shareholders in proportion to their existing shareholding in exchange for consideration. The issue price in a rights issue is usually below market price in order to incentivise shareholders to take up their rights and buy the offered shares. Since a rights issue is for consideration, the journal entry is the same as that for a cash issue of shares at market price: Account name £ £ Dr Bank Issue proceeds Cr Share capital Nominal value Cr Share premium Balance Being the issue of new shares 20 How are distributable profits calculated? In Advanced Reporting and Performance, you need to understand what distributions are and how distributable profits are calculated in accordance with the Companies Act. Distributions (CA06, s829) A distribution is any transfer of company assets to shareholders other than: An issue of bonus shares A distribution of assets on a winding up The redemption or purchase of a company’s own shares out of capital or unrealised profits A reduction of share capital to extinguish share capital not paid up or to repay paid-up share capital. Distributable profits (CA06, s830) Companies pay distributions out of retained earnings rather than current-year profits. The balance of retained earnings is not necessarily distributable in full. Private limited companies Listed companies 21 How do we distinguish between realised and unrealised profits and losses? Realised and unrealised profits and losses (CA06, s853(4)) Realised income/gains A gain from remeasuring an item to fair value if that item is readily convertible to cash, e.g. a gain on the remeasurement of a derivative which is measured at fair value through profit or loss (FVTPL) An exchange gain on the settlement of a monetary item or the retranslation of a monetary item, e.g. the settlement or remeasurement of a foreign currency receivable amount The reversal of an impairment loss previously regarded as realised, e.g. an impairment loss on property, plant and machinery measured using the cost model A gain previously considered to be unrealised that becomes realised due to sale, e.g. a revaluation surplus on property becomes realised when the property is sold For a revalued asset, the excess of depreciation based on revalued amount over depreciation based on historic cost. This is regardless of whether a reserves transfer is made from the revaluation surplus to retained earnings for the excess depreciation Unrealised income/gains Realised and unrealised losses Fair value gains on investment properties Almost all losses are realised. An exception is a revaluation decrease that cancels a previous revaluation increase. In the ARP assessment, you could be asked to calculate distributable profits and/ or explain whether a gain or loss is realised or unrealised. How do directors decide whether to pay dividends? Equity dividends are paid at the discretion of directors. In deciding whether to pay a dividend and how much to pay, directors should consider their fiduciary duty and the volatility of profits. Fiduciary Duty Volatility of Profits Directors have a fiduciary duty to protect the assets of a In a volatile market, losses may company and ensure that debts occur in the future, meaning can be paid when due. The that it is not prudent for payment of a dividend reduces directors to declare a large assets and may affect a dividend based on current company’s ability to settle profits. debts as they fall due. 22 How is a repurchase of ordinary shares recognised? Refer to RP2 Module 5 study guide for steps for repurchase of ordinary shares including maintenance of permanent capital. Remember: there are strict limits on what items can be charged (debited) to the share premium account. The following are allowed: A bonus issue of shares A write-off of expenses relating to the share issue that gave rise to the premium A write-off of the premium on certain purchases or redemptions of equity shares. When is a financial asset classified as measured at amortised cost, fair value through other comprehensive income (FVTOCI) or FVTPL? Refer to RP2 Module 5 study guide for financial asset classification. In Advanced Reporting and Performance, you must be able to analyse a given scenario and decide whether a financial asset should be classified as measured at amortised cost, FVTOCI or FVTPL, before applying the appropriate accounting treatment. What are the exceptions to the classification guidance? There are two exceptions to the general IFRS 9 classification guidance. In each case, the exception is: Available at initial recognition only Irrevocable, and Available on an asset-by-asset basis 23  Investments in equity instruments Investments in debt instruments By default, these are FVTPL as they fail If classified as amortised cost or FVTOCI, the SPPI test, but they can be classified these can instead be designated as as FVTOCI if not held for trading. FVTPL to avoid an accounting mismatch. Accounting mismatch (IFRS 9.4.1.5) An accounting mismatch occurs where a financial asset and a related liability are recognised or measured inconsistently. Traded debt Traded debt is debt instruments such as bonds that are bought and sold on organised markets. Financial liability A financial liability held for trading purposes/to be bought and sold frequently is classified as FVTPL. Financial asset A financial asset that will be held to maturity is classified as amortised cost. In this case, the company can choose to designate the financial asset as measured at FVTPL in order to avoid an accounting mismatch. As a result, the changes in fair value of both instruments would be matched in profit or loss: The loan’s fair value changes if market interest rates change; and The traded debt’s fair value changes as market prices change Recap of classification: 24 How are financial assets measured at initial recognition and subsequently? Refer to RP2 Module 5 study guide for how financial assets are measured at initial recognition and subsequently. How does accounting for equity instruments at FVTOCI and debt instruments at FVTOCI differ? Equity investments Debt investments Initial measurement At fair value (transaction price) plus transaction costs Measurement at reporting date At fair value Recognition of change in All recognised in OCI Finance income using the measurement in the year (Revaluation Reserve) effective interest method is recognised in SPL. Any further adjustment (to fair value) is recognised in OCI (Revaluation Reserve). Classification of OCI OCI will not be reclassified to OCI may be reclassified to profit profit or loss. or loss. When you are processing journal entries to OCI, you should be specific, stating OCI – Revaluation Reserve. [Revaluation Surplus or Remeasurement reserve will also be accepted]. What is the IFRS 9 approach to credit losses? Refer to RP2 Module 5 study guide for IFRS 9 approach to credit losses. What factors indicate a significant increase in credit risk? In your Advanced Reporting and Performance assessment, you may be required to analyse a given scenario in order to determine at what stage of the IFRS 9 ECL model a financial asset is, before going on to provide accounting advice. It is therefore important that you understand: When there is a significant increase in credit risk, meaning that a financial asset moves from stage 1 to stage 2 of the general approach, and When there is objective evidence of impairment, meaning that a financial asset has reached stage 3 of the general approach. 25  Significant increase in credit risk (IFRS Objective evidence of impairment (IFRS 9.B5.5.17, 5.5.11) 9.Appendix A) List of factors that may be relevant. These Evidence that a financial asset is credit-impaired include: includes observable data about events such as: An actual or expected significant decline in Significant financial difficulty of the borrower the operating results of the borrower A breach of contract, such as a default (non- Existing or forecast adverse changes in payment of contractual amount) business, financial or economic conditions It becoming probable that the borrower will An actual or expected downgrade in the enter bankruptcy or other financial borrower’s credit rating reorganisation. Actual or expected significant adverse changes in the regulatory, economic or technological environment of the borrower. How is a loss allowance calculated and recognised? Calculate the loss allowance 1. Calculate the separate ECL for each possible credit losses outcome: £ Present value of contractual cash flows from the financial asset X Present value of expected cash flows from the asset (X) ECL X 2. Loss allowance is calculated as the weighted average of possible credit loss outcomes. 3. Recognise the change in loss allowance in SPL 4. Present in Financial statements When calculating expected cash shortfalls for a debt instrument at FVTOCI, the present value of contractual cash flows is equal to the amortised cost of the asset rather than the fair value. What is the simplified approach to credit losses for trade receivables? Refer to RP2 Module 5 Study Guide. Apply provision matrix as you applied in RP1. When is a financial asset derecognised? In Advanced Reporting and Performance, you may be required to analyse a scenario and decide whether derecognition is appropriate. It is therefore important that you understand the detail of the IFRS 9 financial asset derecognition requirements. IFRS 9 states that a financial asset is derecognised when: the contractual rights to the cash flows from the financial asset expire, or the asset is transferred and the transfer qualifies for derecognition. 26  Contractual cash flows expire Asset is transferred (IFRS 9.3.2.4) The contractual cash flows from a financial An asset is transferred if substantially all risks asset expire due to: and rewards associated with the financial asset Settlement – for example, cash is received to are transferred and either: settle a trade receivable balance the contractual rights to receive cash flows Lapse – for example, options to purchase from the financial asset are transferred coffee beans may expire before they are or exercised the contractual rights to receive cash flows are Cancellation – for example, a lower court retained but there is a contractual arrangement awards damages to a company but a higher to pay these on to another entity. court subsequently cancels these. Risks and rewards (IFRS 9.3.2.7) Risks and rewards are related to the company’s exposure to variability in the amounts and timing of the present value of the net cash flows from the asset. They are: retained where the company’s exposure does not significantly change as a result of the transfer, and transferred where the company’s exposure is no longer significant in relation to the total variability. How is a transfer that does not qualify for derecognition recorded? If a financial asset is sold in exchange for consideration, but does not qualify for derecognition: The proceeds of the sale are recognised as a financial liability, and The retained asset and recognised liability are not offset. How is a financial asset derecognised? Derecognition of financial assets at Amortised Cost 1. Finance income up to the disposal date should be accrued to the carrying amount of the financial asset 2. The difference between the carrying amount and proceeds (net of transaction costs) is a gain or loss in profit or loss. Derecognition of financial assets at Fair Value 1. Remeasure the financial asset to fair value at the derecognition date 2. Recognise proceeds, derecognise the asset and recognise any gain or loss on disposal 3. For equity investments at FVTOCI, transfer the balance on the FVTOCI revaluation reserve to retained earnings Where a debt investment at FVTOCI is derecognised, the first two steps in the accounting treatment are similar to those already seen, but the third step is different. Step 1 Accrue interest to the disposal date using the effective interest method. Remeasure the asset to fair value, recognising the gain or loss in OCI. 27 Step 2 Recognise net proceeds and derecognise the asset. Recognise any difference as a gain or loss in profit or loss. Step 3 Reclassify the balance on the FVTOCI revaluation reserve related to the financial asset to profit or loss. Recognise the reclassification adjustment as part of the profit or loss on disposal. In the ARP assessment, you could be faced with a scenario in which, for example, the financial controller has determined that a financial asset should be derecognised, but analysis of the scenario indicates that the criteria have not been satisfied. You need to be able to explain any errors made by the financial controller with reference to the derecognition criteria and prepare any adjusting journal entries. How is a financial liability classified? Refer to RP2 Module 5 study guide for classification of financial liabilities. In Advanced Reporting and Performance, you may be required to analyse a given scenario in order to classify a financial liability before accounting for it. A financial liability is measured at amortised cost unless it is classified as FVTPL; therefore, it is important to understand when a financial liability is classified as FVTPL. Elimination of an accounting mismatch (IFRS 9.B4.1.29) For example, if a company funds the purchase of equity shares using a bank loan: The equity investment (financial asset) is classified as FVTPL The bank loan (financial liability) is ordinarily classified as amortised cost. The financial liability can be designated as FVTPL so that changes in the fair value of both instruments are matched in profit or loss. How is a financial liability measured at initial recognition and at subsequent reporting dates? Refer to RP2 Module 5 study guide for initial recognition and subsequent measurement of financial liabilities. When is a financial liability derecognised? Refer to RP2 Module 5 study guide for derecognition of financial liabilities. What is the objective of disclosures relating to financial instruments? The objective of financial instrument disclosures is to provide useful information to users about: The significance of financial instruments − Users need to be able to evaluate the significance of financial instruments for a company’s financial position and performance. Risks associated with financial instruments − Users need to be able to understand the nature and extent of risks associated with financial instruments and how they are managed. 28 How are financial instruments presented and disclosed in the statement of financial position and associated notes? Significance of financial instruments: statement of financial position (IFRS 7.8) Carrying amounts of financial assets and financial liabilities should be disclosed by classification: The following additional points are relevant to the disclosure of carrying amounts by classification: These disclosures can be made either on the face of the statement of financial position or in the notes to the financial statements. For financial assets and liabilities at FVTPL, the total carrying amount should be split between: − instruments designated as measured at FVTPL − instruments that are required to be measured at FVTPL. Additional disclosures related to the statement of financial position IFRS 7 also has the following additional requirements. If a company has elected to measure equity investments at FVTOCI, it should make additional disclosures, including: Which investments are measured at FVTOCI and why The fair value of each investment at the reporting date Dividends recognised in the reporting period The gain or loss on any equity investments at FVTOCI that are disposed of in the period and the fair value prior to disposal. Loss allowance for financial assets at FVTOCI (IFRS 7.16A) The loss allowance for financial assets at FVTOCI is recognised in OCI rather than as a separate credit balance that reduces the carrying amount of the related asset. Therefore, the loss allowance should be disclosed in the notes to the financial statements. 29 How are financial instruments presented and disclosed in the statement of profit or loss and OCI and associated notes? Following amounts recognised in the statement of profit or loss and OCI should be separately disclosed: Financial assets Net gains and losses on financial assets at amortised cost, FVTOCI, FVTPL Total finance income on financial assets at amortised cost Impairment losses on financial assets at amortised cost and FVTOCI Financial liabilities Net gains and losses on financial liabilities at amortised cost, FVTPL Total finance cost on financial liabilities at amortised cost The following additional points are relevant: These disclosures can be made either on the face of the statement of profit or loss and OCI or in the notes to the financial statements Net gains or losses on equity investments at FVTOCI should be disclosed separately from those relating to other financial assets Amounts reported in OCI in relation to debt investments measured at FVTOCI should be split between gains and losses in the period and reclassification adjustments on disposal For financial assets and liabilities at FVTPL total net gains and losses should be split between: − instruments designated as measured at FVTPL − instruments that are required to be measured at FVTPL. What information should be disclosed in respect of risks associated with financial instruments? The second type of financial instruments disclosure relates to risks associated with financial instruments. Credit risk Liquidity risk The risk that one party in a The risk that a company will not financial instrument will cause a be able to pay cash due to settle financial loss for the other party. financial liabilities. For example, For example, where a borrower where a company has no cash does not pay amounts due to to repay a loan that is due. the lender. Market risk The risk that the fair value of a financial instrument will fluctuate because of changes in market prices. For example, where a foreign currency loan obligation increases due to exchange rates. In Advanced Reporting and Performance, you will not be required to prepare disclosures related to risk; however, you should be prepared to advise an entity that disclosures should be prepared for inclusion in the financial statements. 30  Study guide checklist Have you completed reading module 5? Have you completed the skills checkers and skills builders? Can you confidently complete the module learning outcomes listed on this module? Can you confidently answer the guiding questions? Have you completed the assessment practice questions? Have you used the discussion board to ask questions on areas you are unsure about? 31 Module 6 – Consolidation Introduction Welcome to the study guide for Module 6 of the Advanced Reporting and Performance course. This study guide will help you prepare for the assessment. Syllabus Learning Outcomes By completing this module, you will have worked towards the following syllabus learning outcomes: SLO 1 Advise on the requirements for financial reporting and performance in accordance with relevant standards Module Learning Outcomes By completing this module, you will have worked towards the following module learning outcomes: 1.2 Construct, with appropriate workings, the consolidated financial statements for a group. 1.3 Advise on the effect of transactions and adjustments on the financial statements of an individual company and of a group. This will be achieved by working towards the following performance indicators: 1.2.1 Consider the appropriate accounting treatment of changes in group structure: A business combination achieved in stages. A complete disposal. A partial disposal (still with a controlling stake). 1.2.2 Advise on the disclosure requirements of IFRS 12 Disclosure of Interests in Other Entities for subsidiaries, associates and joint ventures. 1.2.3 Consider whether other entities require consolidation and explain the accounting treatment required. 1.2.4 Construct consolidated financial statements including adjustments for intercompany transactions and balances, fair values, goodwill and gain from bargain purchase. 1.2.5 Construct consolidated financial statements for the following situations: A business combination achieved in stages. A partial disposal. A complete disposal. A foreign subsidiary 1.2.6 Advise on disclosure notes in accordance with IFRS Accounting Standards for consolidated accounts. 1.2.7 Advise on the treatment required where a company has an associate or a joint venture but does not prepare consolidated financial statements. 1.3.2 Consider alternative methods of accounting for interests in other entities in the consolidated financial statements. 1.3.3 Advise on the effect of transactions and adjustments related to consolidation on the financial statements of a group. 1.3.4 Advise on the impact of fair value adjustments necessary on the acquisition of a subsidiary on consolidated and individual accounts. You will be ‘assessment ready’ for questions in Module 6 when you can confidently complete each set of the learning outcomes above. 32 How are the different types of investment recognised in the individual and consolidated financial statements? How is control defined under IFRS 10? In RP2, it was assumed that control exists where the parent company holds a majority of the ordinary shares in another company (i.e., >50%). However, under IFRS 10, an investor controls a subsidiary when it is exposed, or has rights, to variable returns from its involvement with the subsidiary and has the ability to affect those returns through its power over the subsidiary [IFRS 10, 6]. Thus, an investor controls an investee if and only if the investor has all the following [IFRS 10, 7] : Power over the investee (subsidiary); exposure, or rights, to variable returns from its involvement with the investee (subsidiary); the ability to use its power over the investee (subsidiary) to affect the amount of the investor’s returns. 33 Power is defined as [IFRS 10, 10]: Existing rights that give the current ability to direct relevant activities. Power may be obtained by holding the majority of voting rights (i.e. more than 50%). This is not always how power is determined [IFRS 10, B42]: IFRS 10 also requires that voting patterns at previous shareholder meetings are considered when determining whether voting rights indicate power. There is also the possibility of the potential voting rights. These arise from convertible instruments or options, which provide voting rights to the holder on conversion or on exercise. Non-controlling interests (NCI) are based on actual voting rights [IFRS 10, B47, B50]. Investor can be principal or agent as shown below: In the ARP assessment, subject to any additional information, you should assume that a shareholding of more than 50% represents control. In narrative questions you may be required to advise on the IFRS 10 definition of control. 34 Which are the deficiencies of individual financial statements in accounting for subsidiaries? If stakeholders only received accounts of the parent company, they would not have full information about the assets and liabilities controlled and operated by their company and its directors. They would also have limited information about the financial performance for the period of the subsidiary – the main income they would see would be dividends. The revenue, operating expenses and operating profit of the group would not be apparent. To rectify this situation, there is a requirement for companies which have subsidiaries to prepare, in addition to their own individual financial statements, a set of consolidated financial statements which effectively combine the accounts of the parent and its subsidiaries as if it were one company. How do you calculate goodwill or gain from bargain purchase? Refer to the RP2 Module 6 study guide for the steps in the approach to consolidation. Goodwill is dealt with in step 2. 35 Refer to RP2 Module 6 study guide for Journal entries to record Goodwill and Gain from Bargain Purchase. Refer to RP2 Study Guide for impairment of Goodwill (Step 3). In RP2, it was suggested that the NCI at acquisition will always be measured as a proportion of the net assets of the acquired company. However, at ARP The fair value method can be used for NCI measurement. The consideration transferred in a business combination shall be measured at fair value [IFRS 3, 37]. These are: 36 What are the criteria to recognise intangible assets and contingent liabilities arising from acquisition? To qualify for recognition as part of applying the acquisition method, the identifiable assets acquired and liabilities assumed must meet the definitions of assets and liabilities [IFRS 3, 11]. An asset is identifiable if it either is separable or arises from contractual or other legal rights. IAS 38 Intangible Assets requires an intangible asset to be recognised if two criteria are met: probable future economic benefits flow to the entity and the asset can be measured reliably. These criteria apply in the subsidiary’s individual financial statements as well as the consolidated financial statements. An exception to the recognition principle exists in respect of some contingent liabilities and IAS 37 Provisions, Contingent Liabilities and Contingent Assets does not apply. The definition of a contingent liability is relevant [IFRS 3, 22]: 37 Recognition of reorganisation costs and future operating losses Costs that are not acquisition-date obligations of the acquiree are not recognised as a liability: What are the issues affecting goodwill estimation? Measurement and Exceptions to recognition and measurement principles The acquirer shall measure the identifiable assets acquired and liabilities assumed at their acquisition- date fair value. This is determined in accordance with IFRS 13 Fair Value Measurement. Similar with contingent liabilities, IFRS 3 includes certain other exceptions to its recognition and measurement principles. These include[24,26,31]: In addition we also have Fair Value adjustments at step 2. IFRS 3 requirements, take precedence over the requirements of other standards; for example, inventories are measured at fair value rather than at the lower of cost and net realisable value, as required by IAS 2 Inventories. In an exception to this rule, where a subsidiary measure an asset or liability using an IFRS fair value model (e.g. the revaluation model from IAS 16 Property, Plant and Equipment) and carrying amount is not equal to fair value, the adjustment must be recognised in the subsidiary’s individual financial statements prior to consolidation in the normal way. Fair value adjustments made to net assets will also lead to subsequent measurement issues within the consolidated financial statements only. There will be a knock on impact in Step 6 of consolidation. Refer back to RP2 module 6 study guide for these fair value adjustments. Refer back to RP2 Module 6 study guide for a summary of the 6 steps for consolidation. 38 How do we define a joint arrangement? Joint arrangements An arrangement of which two or more parties have joint control. The contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. In assessing whether an entity has joint control of an arrangement, an entity shall assess first whether all the parties, or a group of the parties, control the arrangement [B5]. Joint arrangements are classified as joint operations or joint ventures. Only the accounting joint ventures is covered at ARP. Joint ventures A joint venture must be set up as a separate legal entity that keeps its own accounting records and produces financial statements[B21]. How do we account for a joint arrangement? How do we construct consolidated financial statements including a joint venture? You are already familiar with the equity method through its application in accounting for associates in RP2. The equity method for joint ventures is identical to that for associates. Refer to RP2 Module 6 study guide for steps involved in the equity method. 39 When is an entity exempted from using the equity method? An investor need not apply the IAS 28 equity method if[17,20]: Separate financial statements Where an investor does not prepare consolidated financial statements, it should incorporate its Uniform accounting policies investment in an associate or joint venture in its separate financial statements in line with IAS 27. Uniform accounting policies should be applied by The investment should be measured : associates/ joint ventures and investors. At cost; or In accordance with IFRS 9; or Using the IAS 28 equity method Coterminous year-end dates Unless impractical, all companies included in consolidated financial statements should have the same reporting date. Where an associate or joint venture does not have the same reporting date as the group, its accounts may be used for equity accounting purposes provided that the gap between reporting dates is three months or less and adjustments are made for the effects of significant transactions or events during this time. How do we treat a company that has a joint venture but does not prepare consolidated financial statements? Disclosure of joint arrangements Under IFRS 12, companies shall disclose information that enables users of its financial statements to evaluate the nature, extent and financial effects of its interests in joint arrangements and the nature of risks associated with their interests [IFRS 12, 20]. Specifically, an entity shall disclose [IFRS 12, 21, 22]: a) A list of joint arrangements that are material for the entity, including the names of joint arrangements, the nature of the entity’s relationship with them, the principal place of business, and the proportion of ownership interest. 40 b) Accounting method used and summarised financial information for the joint ventures that are material to the firm. c) the nature and extent of any significant restrictions (e.g. resulting from borrowing arrangements, regulatory requirements or contractual arrangements between investors with joint control of or significant influence over a joint venture or an associate) on the ability of joint ventures or associates to transfer funds to the entity in the form of cash dividends, or to repay loans or advances made by the entity. d) Risks associated with an entity’s interests in joint ventures, namely commitments that it has relating to its joint ventures and contingent liabilities incurred relating to its interests in joint ventures. How do you account for business combination? Sometimes business combination is achieved in stages, sometimes also referred to as a step acquisition. Changes in proportion held by non-controlling interests: When the proportion of the entity held by non-controlling interests changes, an entity shall adjust the carrying amounts of the controlling and non-controlling interests [IFRS 10, B96]. The entity shall recognise directly in equity any difference between the amount by which the non- controlling interests are adjusted and the fair value of the consideration paid. Goodwill is not recalculated – it is calculated only at the point where control is obtained. If the additional shares had been acquired during the year, we would have needed to apportion profits and apply the relevant non-controlling interests (NCI) percentages at different points during the year. You should assume that profits arise evenly throughout the year, unless otherwise stated. 41 Worked Example: Mist Ltd (Mist) has share capital consisting of 100,000 ordinary shares of £1.00 each. There has been no change in share capital since the company was incorporated. Fog Ltd (Fog) prepares its financial statements to 30 June each year. Fog purchased shares in Mist as follows: Retained earnings Shares Cost of Mist ’000 £’000 £’000 1 January 20X2 15 60 150 30 June 20X6 40 320 400 The fair value of the original 15,000 shares purchased was determined to be £78,000 at 30 June 20X5 and £85,000 at 30 June 20X6. All changes in fair value have been correctly recorded in Fog’s individual financial statements. Control was achieved on 30 June 20X6, when holding was 55%. Step 2 £’000 £’000 Investment in Mist (£85k + £320k) 405 Non-controlling interests’ share of net assets (45%* (400K+100K) 225 630 Share capital 100 Retained earnings 400 500 Goodwill 130 (Normal Goodwill Journal would be processed) Then… Fog purchased a further 20,000 shares in Mist on 30 June 20X9 for £270,000 when Mist had retained earnings of £900,000. Mist’s profit for the year ended 30 June 20X9 was £150,000. Mist did not declare or pay a dividend during the year ended 30 June 20X9. Goodwill is recognised at the acquisition date, at which control is achieved. The calculation above for Goodwill remains UNCHANGED. 42 But we have to account for the additional investment… Additional investment in Mist 270 Net assets acquired from non-controlling interests (20% x [£100k + £900k]) 200 Loss to retained earnings 70 Dr SFP – non-controlling interests 200 Dr Retained earnings 70 Cr Investment in Mist 270 being elimination of additional investment and reduction in non-controlling interests Step 3 – Recognise any impairment of goodwill N/A – goodwill is not impaired Step 4 – Allocate share of subsidiary’s historical profit/ loss and other gains/ losses to non- controlling interests Retained earnings at 30 June 20X9 900 Profit for the year ended 30 June 20X9 (150) Retained earnings at 30 June 20X8 750 Retained earnings at 30 June 20X6 400 Increase 350 Non-controlling interests’ share of historical profit (45%) 158 Dr Retained earnings 158 Cr SFP – non-controlling interests 158 being non-controlling interests’ share of historical profit Step 5 – Allocate share of subsidiary’s current year profit/ loss and other gains/ losses to non- controlling interests Non-controlling interests’ share of current year profit = 45% x £150k = £68k Note. The additional 20% was not acquired until 30 June 20X9. Dr SPL – non-controlling interests 68 Cr SFP – non-controlling interests 68 being non-controlling interests’ share of current year profit Step 6 – Eliminate intercompany transactions and balances and allocate share of adjustments to subsidiary’s profit/ loss to non-controlling interests N/A – there are no intercompany transactions or balances. Final step – Transfer adjustments in the consolidated statement of profit or loss to the consolidated statement of financial position Dr Retained earnings 68 Cr SPL 68 being transfer to retained earnings 43 How do you calculate the gain or loss on a complete or partial disposal? This takes place AFTER step 6. Full consolidation steps take place, then we account for the disposal in a new step, STEP 7. Full disposal If a parent loses control of a subsidiary, it shall derecognise the assets (including any goodwill) and liabilities of the subsidiary at their carrying amounts and also the carrying amount of any NCI. The gain or loss on disposal is calculated as the fair value of the consideration received compared to the net assets disposed of. If the gain or loss is material it is normally presented as a separate item in the consolidated statement of profit or loss. The process is summarised as follows: 1. Consolidate results of subsidiary to disposal date 2. Calculate and recognise profit or loss on disposal: £'000 £'000 Proceeds on disposal X Net assets of sub at disposal date X NCI at disposal date (X) Goodwill at disposal date X (X) Gain/loss X/(X) Journal entry: Dr Bank Dr SOFP – NCI (if applicable) Cr Goodwill Cr Net assets disposed Cr SPL – gain on disposal (Dr if a loss) 3. Consider: a) Whether consolidated financial statements are still required b) Whether disposed of subsidiary is discontinued operation In the assessment, the credit to net assets entry is likely to be split into a number of debit entries to eliminate the subsidiary’s liabilities and credit entries to eliminate the subsidiary’s assets. Note that the debit entry to ‘Bank’ assume that the parent company has not recorded the proceeds correctly in its individual financial statements and, therefore, still has the investment in the subsidiary on its individual statement of financial position. Read the question carefully in the assessment to ascertain whether proceeds have been posted. 44 Partial disposal of an interest but control is retained. Parent company disposes of a partial interest in a subsidiary but retains control over the subsidiary, the transaction is accounted for as an equity transaction between the parent and its shareholders. This means that the difference between the carrying amount of the subsidiary interest disposed of and the consideration received (including any related transaction costs) is recognised directly in parent’s equity. No gain or loss is recognised in profit or loss as a result of such transactions. Worked Example: partial disposal but control is retained Alfred Ltd (Alfred) acquired 100% of Rodes Ltd (Rodes) for £900,000 at the end of 20X0 when the fair value of Rodes’ net assets were £800,000. Alfred sold 10% of its investment on Rodes on 31 December 20X2 for £300,000, retaining 80% controlling interest. The carrying amount of Rodes’ net assets, including goodwill of £100,000, is equal to £1,4 million. This takes place in new Step 7, after step 6 and all other consolidation procedures are performed. Parent company accounts Sale proceeds £300,000 Less cost of investment in Rodes (10%*£900,000) £90,000 Gain on sale recognised in Alfred £210,000 Consolidated accounts The change in ownership does not result in loss of control. This means: 1. The identifiable net assets and goodwill remains unchanged. 2. The difference between the sale proceeds and increase in NCI is directly recognised in equity (NOT in SPLOCI), together with the increase in NCI. Sale proceeds £300,000 Recognition of increase in NCI (10%*£1.4 m) (£140,000) Credit to equity £160,000 The difference between the gain recognised in the individual parent accounts and the consolidated accounts is the share of post-acquisition profit ((£1.4m - £900,000)*10%) retained in the subsidiary and have been reported in the group SPLOCI. Dr Bank 300,000 Cr SOFP – NCI 140,000 Cr SOFP - Equity 160,000 45 What are the requirements of IAS 21 to translate the individual financial statements of a foreign subsidiary? The results of a foreign subsidiary must be included in consolidated financial statements in the same way as the results of all other subsidiaries. If the foreign subsidiary’s functional currency differs from the group’s functional currency, it translates its results and financial position into the group’s presentation currency. All questions in the ARP exam will be based on a UK group with sterling as its presentation currency. How do you translate gains and losses arising on consolidation of a foreign subsidiary? Exchange differences are a result of : 46 Exchange differences are not recognised in profit or loss. The cumulative amount of the exchange differences is presented in a separate component of equity. We will use a translation reserve. This is reported in other comprehensive income (OCI) in the subsidiary’s individual financial statements. An exchange difference arises each year on translation and the amount reported in the translation reserve is cumulative. For the purposes of the ARP exam, all foreign subsidiaries will be acquired in the current accounting period. The translation reserve is a post-acquisition reserve and therefore part of it must be allocated to the non-controlling interests (NCI). How do you construct consolidated financial statements that include a foreign subsidiary We now have an additional PRE-CONSOLIDATIONS step to be performed. Pre-consolidation: Step 1 – Translate the financial statements to presentation currency Pre-consolidation: Step 2 – Calculate and recognise exchange differences on translation (see worked example below for calculation and journal entry) Goodwill and Fair Value Adjustments Any goodwill arising on the acquisition of a foreign operation and any fair value adjustments to the carrying amounts of assets and liabilities arising on the acquisition of that foreign operation shall be treated as assets and liabilities of the foreign operation. Thus, they shall be expressed in the functional currency of the foreign operation and shall be translated at the closing rate. The relevant process for the goodwill adjustment is presented below: 47 Consolidation of a foreign subsidiary: Worked Example Worldwide plc (Worldwide) purchased 75,000 $1.00 shares in a Canadian company, Maple Ltd (Maple), for £360,000 on 1 January 20X3. Extracts from the statement of financial position of Maple at that date are shown below: Maple Ltd Statement of financial position (extracts) As at 1 January 20X3 $’000 Equity Share capital 100 Retained earnings 560 Total equity 660 The abbreviated statements of financial position and extracts from the statements of profit or loss of the two companies at 31 December 20X3 were as follows: Statements of financial position (abbreviated) As at 31 December 20X3 Worldwide Maple £’000 $’000 Non-current assets 180 170 Investment in Maple 360 - Other net assets 250 530 790 700 Share capital 150 100 Retained earnings 640 600 790 700 Statements of profit or loss (extracts) For the year ended 31 December 20X3 Worldwide Maple £’000 $’000 Profit before tax 81 86 Taxation (20) (21) PROFIT FOR THE YEAR 61 65 Maple paid a dividend of $25,000 during the year, when the exchange rate was $1.63. Dividends received from Maple are included in finance income. Following an impairment review in the current year, 20% of the goodwill must be written off. NCI is based on share of net assets. The relevant exchange rates are as follows: 1 January 20X3 – $1.60:£1 Average for 20X3 – $1.63:£1 31 December 20X3 – $1.65:£1 Pre-consolidation: Step 1 – Translate the financial statements to presentation currency 48 Pre-consolidation: Step 2 – Calculate and recognise exchange differences on translation Retained profit for the year = $65k - $25k = $40k Exchange Opening net assets Closing rate Opening rate difference £’000 £’000 £’000 Share capital $100k/1.65 $100k/1.60 61 63 (2) Retained earnings $560k/1.65 $560k/1.60 339 350 (11) Profits Closing rate Average rate Retained profit for the year $40k/1.65 $40k/1.63 24 25 (1) Exchange losses on translation (14) JE 1 Dr Translation reserve 14 Cr Share capital 2