ACCA P2 INT-UK Interim Assessment - Answers D14 PDF

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ACCA Paper P2 INT/UK Corporate Reporting December 2014

Interim Assessment – Answers

To gain maximum benefit, do not refer to these answers until you have completed the interim assessment questions and submitted them for marking.

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ACCA P2 (I NT & UK) : COR POR ATE R E P OR TIN G

© Kaplan Financial Limited, 2014 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. All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing.

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WATCH

Key answer tips Part (a) of this question involves correcting a draft statement of financial position. There are a number of errors and omissions relating to financial instruments, properties, revenue and share based payments. In the real P2 exam, question 1 will always involve the production of consolidated statements. However, included within the question will be a substantial number of errors in the individual statements that require correction. This question therefore provides you with good exposure to a range of accounting standards that you may see in the real exam and will help you develop your ability to correct errors and omissions. Part (b) of the question requires knowledge of IFRS 13. This has been a popular topic in recent P2 exams. Part (c) covers ethics. You are asked to discuss the issues raised, so try not to make your answer too one-sided or simplistic. However, there will always be some easy marks available for merely stating relevant ethical principles. (a)

Statement of Financial Position for Watch as at 31 December 20X5 $m

Marks

85.5 14.1 –––– 99.6

(W) (W)

13.1 17.0 3.0 –––– 132.7 ––––

1.5 0.5 0.5

Equity and liabilities Share capital Share premium Retained earnings (W3) Other components of equity (W4)

10.0 15.0 47.0 10.4

0.5 0.5 (W) (W)

Non-current liabilities Loans (W5)

17.7

(W)

Non-current assets Property, plant and equipment (W1) Financial assets (W2)

Current assets Inventories ($14 – $0.9 (W10)) Trade and other receivables Cash and cash equivalents Total assets

Current liabilities Trade and other payables (W6)

32.6 (W) –––– Total equity and liabilities 132.7 –––– Note: (W) indicates that the mark break-down is provided in the relevant working. Marks are also provided for correct calculations in (W7) – (W15).

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(W1) Property, plant and equipment Per draft F/S Revaluation gain (W7) Investment property reclassification (W8)

$m 76 4 5.5 –––– 85.5 ––––

Marks 0.5 1 1

$m 15 (3.7) 1.7 1.1 –––– 14.1 ––––

Marks 0.5 1 1 1

$m 50 0.5 (3.7) 1.7 0.2 (1.5) (0.1) (0.6) 0.5 –––– 47.0 ––––

Marks 0.5 1 1 1 1 1 1 1 1

(W2) Financial assets Per draft F/S Impairment (W9) Interest at effective rate (W9) Gain on hedging instrument (W10)

(W3) Retained earnings Per draft F/S Investment property gain (W8) Financial asset impairment (W9) Interest at effective rate (W9) Net gain on fair value hedge (W10) Revenue adjustment (W11) Pension accrual (W12) Share based payment expense (W13) Gain on loan retranslation (W14)

(W4) Other components of equity Per draft F/S Revaluation gain (W7) Share based payment (W13) Convertible bond (W15)

$m 5 4 0.6 0.8 –––– 10.4 ––––

Marks 0.5 1 1 1

$m 19 (0.5) (0.8) –––– 17.7 ––––

Marks 0.5 1 1

(W5) Loans Per draft F/S Retranslation gain (W14) Convertible bond (W15)

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(W6) Trade and other payables $m 31 1.5 0.1 –––– 32.6 ––––

Per draft F/S Revenue adjustment (W11) Pension accrual (W12)

Marks 0.5 1 1

(W7) Revaluation The difference between the carrying value of the asset at the revaluation date and its fair value is the revaluation gain. This gain is recorded in other comprehensive income. $m 10 (1) –––– 9 4 –––– 13 ––––

Cost Acc dep’n (($10/50 years) × 5 years) CV at revaluation date Revaluation gain (bal. fig) Fair value

Marks

1

The entry to adjust for the revaluation is: Dr PPE (W1) $4m Cr Other components of equity (W4) $4m (W8) Investment properties The property was an investment property. Now that it is owner occupied, it must be reclassified to property, plant and equipment. Before reclassification, the property must be revalued by $0.5m ($5.5 – $5.0) under IAS 40. This means that the gain is recorded in the statement of profit or loss. The following adjustment is required: Dr Investment properties Cr Retained earnings (W3)

$0.5m $0.5m

The property should then be re-classified to PPE. Dr PPE (W1) Cr Investment properties

$5.5m $5.5m

(W9) Financial asset This is an interest free loan, so Watch is effectively making a loss on the asset over its life. The fair value of the asset should be calculated at inception by taking the repayment in 2 years time and discounting using the prevailing market interest rate for a similar instrument. The financial asset should have been initially be recognised at $11.3m ($15m × (1/1.152)). (1 mark)

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To correct this, Watch needs to post the following: Dr Retained earnings (W3) Cr Financial asset ($15m – $11.3m) (W2)

$3.7m $3.7m

The financial asset is measured at amortised cost. Therefore, investment income should be recognised at $1.7m ($11.3m × 15%). Dr Financial asset (W2) Cr Retained earnings (W3)

$1.7m $1.7m

(W10)Fair value hedge Hedge accounting is permitted if the hedge is highly effective. This means that the movement in the fair value of the instrument (future) and the item (inventory) are within 80 – 125% of each other. Hedge effectiveness is 122% ($1.1m/$0.9m). (1 mark) Hedge effectiveness could also be calculated as 82% ($0.9m/$1.1m). The hedge is highly effective and hedge accounting is permitted. Under a fair value hedge, the movement in the fair value of the item and the instrument are accounted for through profit or loss. The following adjustment is therefore required: Dr Financial assets (W2) Cr Inventory Cr Retained earnings (W3)

$1.1m $0.9m $0.2m

(W11) Revenue Revenue from the sale of a good should not be recognised until the risks and rewards of ownership have transferred. This is unlikely to occur before delivery. Therefore, the revenue must be removed from the statement of profit or loss. The following adjustment is required: Dr Retained earnings (W3) Cr Trade and other payables (W6)

$1.5m $1.5m

(W12) Pension Under a defined contribution pension scheme, an entity should charge agreed annual contributions to profit or loss. A prepayment or accrual will arise if the cash paid does not equal the value of agreed contributions. $m Marks Agreed contributions ($8m × 5%) 0.4 Cash paid into scheme (0.3) –––– Accrual required 0.1 1 –––– The following adjustment is required: Dr Retained earnings (W3) Cr Trade and other payables (W6)

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$0.1m $0.1m

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(W13) Share based payments The number of employees expected to remain at the vesting date is 820 (970 – (5 × 30 months)). (1 mark) The share based payment expense to be charged through the statement of profit or loss is $0.6m (820 employees × 1,000 options × $4.20 × 6/36). (1 mark) The adjusting entry is: Dr Retained earnings (W3) Cr Other components of equity (W4)

$0.6m $0.6m

(W14) Loan translation The loan is a monetary liability so should be re-translated at the year-end date. The gain or loss is charged to the statement of profit or loss. $m Loan at 1 March 20X5 (MK13m/3.2)

4.1

Forex gain (bal. fig)

(0.5)

Marks

1

–––– Loan at 31 December 20X5 (MK13m/3.6)

3.6 ––––

The correcting entry is: Dr Loans (W5) Cr Retained earnings (W3)

$0.5m $0.5m

(W15) Convertible bond Convertible bonds should be split into a liability component and an equity component. The liability is calculated as the present value of the repayments when discounted at the rate of a similar debt instrument without a conversion option. The equity component is calculated as the balance of the proceeds from the bond issue. Cash flow $m 31/12/X6 31/12/X7 31/12/X8

Equity element Cash proceeds

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0.5 0.5 10.5

Discount rate

Present value $m

1/1.08 1/1.082 1/1.083

0.46 0.43 8.34 –––– 9.2 0.8 –––– 10.0 ––––

Bal. fig

Marks

1 1

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The correcting entry is: Dr Loans (W5) Cr Other components of equity (W4) (b)

$0.8m $0.8m

Fair value is defined by IFRS 13 as ‘the price that would be received to sell an asset (or paid to transfer a liability) in an orderly transaction between market participants at the measurement date’. (1 mark) This means that it is the exit price in an orderly market and not a distress or an emergency sale. (1 mark) It assumes that the price is measured in the entity's principal (or most advantageous) market. (1 mark) The principal market is normally regarded as that which has the greatest volume or level of activity for that asset or liability. (1 mark) If there is no principal market, the most advantageous market should be used and this is determined by choosing the market that maximises the amount that would be received upon sale of an asset. (1 mark) The measure of fair value considers only the characteristics of the asset (or liability) e.g. the condition and location of the asset. (1 mark) Therefore the measure of fair value should not be adjusted for transaction costs as these are not characteristics of the asset (or liability). (1 mark) Measurement of non-financial assets should be based on the highest and best use. Thus in determining the fair value of land currently being used as a car park, it should be taken into account that alternative uses for the land may exist, for example its development potential. (1 mark) The objective of using a valuation technique is to determine the price at which an orderly transaction would take place between market participants at the measurement date. (1 mark) The fair value hierarchy gives highest priority to level 1 inputs and the lowest priority to level 3 inputs in order to increase reliability. (1 mark) Level 1 inputs are quoted prices, unadjusted in active markets for identical assets. (1 mark) Level 2 inputs are relevant observable inputs, such as quoted prices of similar assets. (1 mark) Level 3 inputs are not observable, which means that they are not based on market data. Instead, they comprise the outcome of application of management judgments and estimates. (1 mark) (IFRS 13 knowledge: 1 mark per point) (Part b: 9 marks max)

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(c)

Financial statements are important to a range of user groups, such as shareholders, banks, employees and suppliers. These users rely on the directors to faithfully represent the performance and position of the company. (1 mark) A faithful representation is often presumed to have been provided if accounting standards have been complied with. Therefore, it is essential that the directors adhere to the requirements of IFRS 13 Fair Value Measurement. (1 mark) It will be unlikely that prices exist for identical buildings in an active market, since interiors, condition and location are all likely to vary. Therefore, level 1 inputs are unlikely. This means that adjustments must be made to the prices obtained by similar buildings, which would be a level 2 input. (1 mark) Some degree of judgement and subjectivity must be used when obtaining a fair value for a building. Therefore, there is scope for manipulation. (1 mark) The Directors of a business may be driven by a desire to show a higher asset value in the statement of financial position, as this may make finance and investment easier to obtain. (1 mark) This contradicts the ACCA Code of Ethics and Conduct, which stresses the importance of confidentiality, objectivity, professional behaviour, integrity, and professional competence and due care. (1 mark) Using a particular valuation simply because it is higher specifically contradicts the principle of objectivity. (1 mark) This decision may mislead the users of the financial statements. For instance, banks or investors might make economic decisions based on the inflated asset value in the statement of financial position. (1 mark) (Ethics knowledge and application: 1 mark per point) (Part c: 6 marks max) Marking scheme

(a) (b) (c)

SFP Fair value Ethical issues

Total

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Marks 35 9 6 ––– 50 –––

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SHINE

Key answer tips This is a scenario-based question based upon an entity in the process of completing its financial statements, subject to some matters outstanding. Use the mark allocation to help with time–management to ensure that you attempt all parts of the question. Breadth and depth of knowledge across the syllabus are needed to score well in these questions. Section B answers are mainly discursive and explanatory, although supporting computations may be necessary.

(a)

A person is a related party of an entity if they have control over it. (1 mark) An entity is related to the reporting entity if a member of key management personnel of the entity also controls the reporting entity. (1 mark) If an entity has entered into transactions with related party, then all transactions between the two parties must be disclosed. (1 mark) Mrs Jones is a related party of Shine.

(IAS 24: knowledge: 2 marks max) (1 mark)

Shine is therefore a related party of Star because Mrs Jones controls Shine and is a director of Shine. (1 mark) There have been sales transactions between Shine and Star during the year. Therefore, Shine must disclose that Star is a related party. (1 mark) Shine must also disclose the $500,000 of sales that have occurred, as well as the fact that $500,000 remained outstanding at the year end. (1 mark) Disclosures that related party transactions were made on terms equivalent to those that prevail in arm’s length transactions are only made if such terms can be substantiated. (1 mark) The sales between Shine and Star were not on terms equivalent to arm’s length transactions so therefore this disclosure cannot be made. (1 mark) (IAS 24: application: 3 marks max) (b)

(Part (a): 5 marks max) Per IAS 38, no intangible asset arising from research should be recognised. (1 mark) An intangible asset should be recognised from development activities if the entity can demonstrate: • • • •

The technical feasibility of completing the intangible asset The intention to complete the asset The fact that the entity will generate future economic benefits The availability of financial resources to complete the asset. (2 marks) (IAS 38 knowledge: 2 marks max)

The research costs of $1.2 million must be expensed to the statement of profit or loss. (1 mark) On 1 May 20X1, it appears that Shine believes that there is a market for the asset and that, once completed, it will generate profits. However, it is only on 30 June 20X1 that the entity has the financial resources to complete the development. (1 mark) 10

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Therefore, the costs incurred in May and June 20X1 of $0.45m (2/8 × $1.8m) should be expensed to the statement of profit or loss. The remaining development expenditure of $1.35m ($1.8m – $0.45m) will be recognised as an intangible asset. (1 mark) (IAS 38 application: 2 marks max) Per IAS 12, a deferred tax liability should be recognised for taxable temporary differences. (1 mark) As noted above, the intangible asset has a carrying value of $1.35m. However, the tax base is nil because all of the tax relief has already been obtained. (1 mark) This means that there is a taxable temporary difference of $1.35m ($1.35m – $0) that will give rise to a deferred tax liability of $0.34m ($1.35m × 25%). (1 mark) (IAS 12 knowledge and application: 2 marks max) (Part (b): 6 marks max) (c)

A finance lease is a lease where the risks and rewards of ownership have transferred from the lessor to the lessee. (1 mark) According to IAS 17, key indications of a finance lease are: • •

If the lease term is for the majority of the asset’s useful economic life If the present value of the minimum lease payments amounts to substantially all of the fair value of the leased asset. (1 mark) (IAS 17 knowledge: 2 marks)

The lease term is only for 17% (5 years/30 years) of the asset’s remaining life, which is not the majority. (1 mark) The total lease payments (ignoring the time value of money) amount to $4,000,000 ($800,000 × 5 years), which is substantially below the asset’s fair value. (1 mark) This is therefore a sale and operating leaseback. (1 mark) The office building must be derecognised because Shine no longer has the risks and rewards of ownership. The total gain on the disposal is $6.8m ($10m – $3.2m). (1 mark) The sales price of $10m is above the fair value of $7m. The excess profit (the excess of sales price over fair value) on the disposal must be deferred. (1 mark) Therefore, a profit of $3.8m ($7m – $3.2m) is recognised immediately and the remaining $3m ($10m – $7m) is deferred and will be released to profit or loss over the lease term. (1 mark) In the current year, $0.3m (($3m/5 years) × 6/12) of deferred profit will be released to the statement of profit or loss. The remaining $2.7m ($3m – $0.3m) of deferred profit will be held within liabilities on the statement of financial position. (1 mark) Operating lease rentals will be expensed through profit or loss on a straight line basis. In the current financial year, rentals of $400,000 ($800,000 × 6/12) will be expensed. (1 mark) (IAS 17 application: 4 marks max) (Part (c): 6 marks max)

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(d)

IAS 16 says that property plant and equipment should initially be recognised at cost. (1 mark) Cost includes purchase price, as well as obligations to dismantle the asset at the end of its life that meet the recognition criteria of IAS ...