SM FE 2e Loftus - Chapter 13 [Solutions Manual - Financial Reporting (2e 2018 )] PDF

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Download SM FE 2e Loftus - Chapter 13 [Solutions Manual - Financial Reporting (2e 2018 )] PDF

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Solutions manual to accompany

Financial reporting 2nd edition by Loftus, Leo, Daniliuc, Boys, Luke, Ang and Byrnes Prepared by Karyn Byrnes

© John Wiley & Sons Australia, Ltd 2018

Chapter 13: Share capital and reserves

Chapter 13: Share capital and reserves Comprehension questions 1. Explain the nature of a reserve. How do reserves differ from the other main components of equity? Under Australian accounting standards there are 2 forms of equity:  Contributed capital: inflows from equity contributors.  Reserves: the generic term for all equity accounts other than contributed equity. Reserves arise as a result of increases in equity other than from contributions from equity participants. They may arise from various actions:  earnings of profits [retained earnings]  increases in the fair value of assets [asset revaluation surplus]. Unlike share capital, reserves are not created via cash flows into the entity. Dividends may be paid out of reserves, but not out of capital.

© John Wiley and Sons Australia Ltd, 2018

13.2

Solutions manual to accompany Financial reporting 2e by Loftus et al.

2. The telecommunications industry in a particular country has been a part of the public sector. As a part of its privatisation agenda, the government decided to establish a limited liability company called Telecom Plus, with the issue of 10 million $3 shares. These shares were to be offered to the citizens of the country. The terms of issue were such that investors had to pay $2 on application and the other $1 per share would be called at a later time. Discuss: (a) The nature of the limited liability company, and in particular the financial obligations of acquirers of shares in the company. (b) The journal entries that would be required if applications were received for 11 million shares. The nature of a limited liability company is such that shareholders’ liability is limited to the issue price of a share. If the shares are issued at par value, the liability is limited to payment of that par value per share. If shares are issued at a given price, the limitation is to that price. The journal entries are – assuming that applications were received for 10 million shares: Cash Trust Application (Receipt of application money)

Dr Cr

20 000 000

Application Share capital (Issue of shares)

Dr Cr

20 000 000

Dr Cr

20 000 000

Cash Cash trust (Transfer from cash trust on issue of shares)

20 000 000

20 000 000

20 000 000

3. Explain when an options reserve would be raised. When options are issued, the holder of the option has a choice on whether to exercise the option or not. If an option to acquire ordinary shares is exercised then any monies paid for the option are capitalised into share capital. If the option is not exercised then any monies paid for the option are transferred to an options reserve.

© John Wiley and Sons Australia Ltd, 2018

13.3

Chapter 13: Share capital and reserves

4. Explain the difference between a renounceable and a non-renounceable rights issue. A rights issue is an issue of shares with the terms of issue giving existing shareholders the right to an additional number of shares in proportion to their current shareholding, i.e. the shares are offered on a pro rata basis. For example, each shareholder may be entitled to one share for every two currently held. Renounceable rights issue:  Existing shareholders may: - accept the offer i.e. exercise the rights; or - sell all or part of their rights to the new shares to another party; or - do nothing i.e. reject the offer. Non-renounceable rights issue:  Existing shareholders may: - do nothing i.e. reject the offer; or - accept the offer.

5. A company has a share capital consisting of 100 000 shares issued at $2 per share, and 50 000 shares issued at $3 per share. Discuss the effects on the accounts if: (a) The company buys back 20 000 shares at $4 per share (b) The company buys back 20 000 shares at $2.50 per share. At date of buyback, the company has issued 150 000 shares and has a total share capital of $350 000. Having issued the shares, the issue price is irrelevant. (a) If the company buys back 20 000 shares at $4 per share, the company will record a cash receipt of $80 000. Which equity accounts it adjusts is the decision of management. There is no requirement that share capital be reduced. (b) The answer is the same if the shares are bought back at $2.50 per share.

6. When is a cash trust raised? A cash trust is raised whenever investors make an offer to a company to acquire equity instruments. This may occur when a company issues a prospectus outlining the details of a proposed share issue. It may also occur in relation to a proposed issue of options, if investors have to make an offer to the company to acquire the options. In such cases it is the investor who makes the offer to acquire the equity instrument and it is up to the company to accept/reject that offer. Until the company makes the decision to accept/reject the offer, any monies received by the company hare held in trust as no contract has as yet been formed between the offeror and the company. Where the company makes an offer inviting investors to invest, there is no need to raise a cash trust as on receipt of the cash the contract between the company and the investor is complete.

© John Wiley and Sons Australia Ltd, 2018

Solutions manual to accompany Financial reporting 2e by Loftus et al.

7. Discuss the nature of a rights issue, distinguishing between a renounceable and a non-renounceable issue. A rights issue is an issue of shares with the terms of issue giving existing shareholders the right to an additional number of shares in proportion to their current shareholding, i.e. the shares are offered on a pro rata basis. For example, each shareholder may be entitled to one share for every two currently held. Renounceable:  Existing shareholders may: - accept the offer i.e. exercise the rights. - sell all or part of their rights to the new shares to another party. - do nothing i.e. reject the offer. Non-renounceable:  Existing shareholders may:: - do nothing i.e. reject the offer. - accept the offer.

8. What is a private placement of shares? What are the advantages and disadvantages of such a placement? A private placement is where a company places the shares with specific investors rather than invite applications for the new issue of shares. Advantages [see text]:  speed  price  direction  prospectus. Disadvantages:  dilution of current shareholders’ interests  where shares are placed at a discount.

© John Wiley and Sons Australia Ltd, 2018

13.5

Chapter 13: Share capital and reserves

9. Discuss whether it is necessary to distinguish between the different components of equity rather than just having a single number for shareholders’ equity. The question is whether an investor would prefer to invest in Company A or Company B assuming the net assets of the company are the same: Company A

Company B

$100 000 30 000 40 000 170 000

$20 000 60 000 90 000 170 000

Share capital General reserve Retained earnings In general the composition of equity is irrelevant.

Composition may be relevant where local laws place restrictions on what can be done with particular equity accounts e.g. if dividends may be paid only out of profits.

10. For what reasons may a company make an appropriation of its retained earnings? Appropriations from retained earnings are made for:  dividends, cash or shares  transfer to other reserves. May also like to consider how increases in retained earnings occur:  earning of profit  transfers from reserves  recognition of actuarial gains and losses under IFRS 4 [note here that in all other cases amounts recognised directly in equity are taken to reserve accounts rather than to retained earnings].

© John Wiley and Sons Australia Ltd, 2018

Solutions manual to accompany Financial reporting 2e by Loftus et al.

Case studies Case study 13.1 Private placement Mining company Aeon Metals Ltd announced plans to raise $1 150 000 through a placement of 5 227 273 ordinary fully paid shares at $0.22 per share to institutional investors to fund new surveys and drilling campaigns for its copper project. Prior to this announcement the shares of Aeon Metals Ltd were trading at around $0.26. Required 1. Distinguish between a public share float and a private placement. 2. Assuming that the placement above proceeded, what journal entries would be required to account for it?

© John Wiley and Sons Australia Ltd, 2018

13.7

Chapter 13: Share capital and reserves

1. With a public share float the company asks investors – the general public – to apply for shares in the company. Investors will complete application forms, pay any requested application fees and wait for the company to accept or reject the offers. On acceptance of the offers the company will issue shares to the general public. With a private placement, the company places the shares with specific investors such as insurance companies and superannuation funds. Neither the general public nor current shareholders are invited to be a part of the share placement. As a result current shareholders suffer a dilution of their shareholdings. The advantages to the company of a placement are speed, price, direction and no need to issue a prospectus. Because of the effects on current shareholders the Companies Act places restrictions of the number of shares that may be placed by a company in a particular year. 2. Cash

Dr Share Capital

1 150 000.06

Cr

(Placement of 5 227 273 shares at $0.22 per share)

© John Wiley and Sons Australia Ltd, 2018

1 150 000.06

Solutions manual to accompany Financial reporting 2e by Loftus et al.

Case study 13.2 Right issues The following is an extract from a letter sent on 22 February 2017 by Oz Outback Ltd to its shareholders in relation to a rights issue by the company.

Required A client who holds shares in Oz Outback Ltd has approached you in relation to this letter. She requires you to explain the nature of a renounceable rights issue and who will receive shares in Oz Outback Ltd under the proposed rights issue. Write a report to your client providing the requested advice.

© John Wiley and Sons Australia Ltd, 2018

13.9

Chapter 13: Share capital and reserves

A rights issue is an offer of shares to existing shareholders to acquire additional shares in a company in proportion to their current shareholdings – that is, the shares are offered on a pro rata basis. The shares are generally offered at a discount price. Current shareholders may accept the offer in whole or in part. Under a renounceable rights offer existing shareholders may sell their rights to the new shares to another party during the offer period. With the Oz Outback offer:  The share offer is for current shareholders to acquire 3 shares for every one held  It is underwritten by convertible noteholders who will acquire shares if current shareholders do not accept the rights offer or are unable to find other parties who are willing to buy the rights to the shares and who then accept the offer.  If the rights issue is not fully subscribed, the company can offer “eligible shareholders” the right to apply for the new shares. There is a limit on the number of shares that can be allocated to eligible shareholders. The offering of shares to an eligible shareholder is in effect a placement as the issue is to a selected group of shareholders.

© John Wiley and Sons Australia Ltd, 2018

Solutions manual to accompany Financial reporting 2e by Loftus et al.

Case study 13.3 Reserves In its consolidated balance sheet, Qantas Airways Ltd (2013, p. 100) provided the following information.

In Note 23 of its 2013 annual report, Qantas Airways Ltd (2013, p. 132) explained the composition of its reserves:

Required Explain the nature of a reserve, and evaluate whether a company should retain reserve accounts other than retained earnings — provide examples to illustrate your analysis.

© John Wiley and Sons Australia Ltd, 2018

13.11

Chapter 13: Share capital and reserves

“Reserves” is the generic term used for all equity accounts other than contributed equity. Contributed equity is equity directly contributed by owners. Hence with reserves they arise from events other than by contribution from owners such as:  earning profit and loss from trading  revaluation of assets  transfers from other equity accounts. For each reserve created there should be some reason for establishing the reserve. Shareholders should receive information about the operation of the company from viewing the reserves, for example:  asset revaluation reserve: some assets are measured at fair value and not at cost  foreign currency translation reserve: the company has a subsidiary whose accounts are kept in currency other than $A.

© John Wiley and Sons Australia Ltd, 2018

Solutions manual to accompany Financial reporting 2e by Loftus et al.

Application and analysis questions Exercise 13.1 Repurchase of shares The directors of Sand Ltd are considering spending $5 million in a repurchase of the company’s shares. Some directors argue that this outlay requires the company to use a large amount of its capital that could be better put to alternative uses. They also argue that current shareholders may prefer to reward a company that grows its own business rather than artificially inflate the share price by a repurchase of shares. There is a fear among some directors that the repurchase could be a sign that the company cannot find anything better to do with its cash. Required Analyse these arguments and set out the main arguments in favour of a share buyback for the company in the form of a report to management of Sand Ltd. (LO7)

© John Wiley and Sons Australia Ltd, 2018

13.13

Chapter 13: Share capital and reserves

Some of the reasons a company may consider buying back its own shares are:  to increase the worth per share of the remaining shares: this will depend on whether the funds used to buy back the shares were not being used effectively in the company;  to manage the capital structure by reducing equity;  to provide price support for issued shares: by acquiring its own shares a company demonstrates confidence in the future of the company;  to most efficiently manage surplus funds held by the company: rather than pay a dividend or reinvest in other ventures the company reduces the number of shares on issue and hopefully increases earnings per share. Should the money spent on buying back shares could be better spent on other uses? Perhaps if there are no suitable investments around then it is in the best interests of shareholders for the company to use excess cash to buy back shares. This allows the shareholders to choose where to invest their money. Are prices “artificially” raised by buybacks? If the market sees the buyback as a good deal for remaining shareholders then the prices will rise and shareholders will be better off. The price rise is not artificial.

© John Wiley and Sons Australia Ltd, 2018

Solutions manual to accompany Financial reporting 2e by Loftus et al.

Exercise 13.2 Placement of shares Sun Ltd is in need of an injection of capital. The directors are considering whether to raise capital via a public issue or by placing new shares with a selected group of new investors. Required Examine the factors that would motivate the directors to choose a placement of shares over an issue of shares to existing shareholders. (LO6)

© John Wiley and Sons Australia Ltd, 2018

13.15

Chapter 13: Share capital and reserves

The advantages to the company of a placement of shares are:  Speed: - A placement can be effected in a short period of time, 1-2 days; this lowers risks relating to movements in the market.  Price: - Because a placement is made to other than existing shareholders, and to a market that is potentially more informed and better funded, the issue price of the new shares may be closer to the market price at the date of issue. There are also lower underwriting costs.  Direction: - The shares may be placed with investors who approve of the directions of the company, or who will not interfere in the formation of company policies  Prospectus: - In some cases, a placement can occur without the need for a detailed prospectus to be prepared. There are potential disadvantages to the existing shareholders from private placements in that the current shareholders will have their interest in the company diluted as a result of the placement. As a result, there are limits placed on the amounts of placements of shares without the approval of existing shareholders, namely a 15% of issued capital limit in a 12-month period. Further disadvantages to current shareholders can occur if the company places the shares at a large discount. Again, securities laws are enacted to ensure that management cannot abuse the placement process and that current shareholders are protected.

© John Wiley and Sons Australia Ltd, 2018

Solutions manual to accompany Financial reporting 2e by Loftus et al.

Exercise 13.3 Crab Ltd in its statement of financial position at 30 June 2019 reported the existence of two reserves:  an asset replacement reserve created to inform shareholders of the potential amounts of funds needed to replace critical manufacturing assets in the next few years  an assets revaluation surplus created because of the application of the revaluation model to property held by the company. Required Write an information release to shareholders informing them how movements in these accounts will be accounted for and the potential effects on profit or loss and other comprehensive income. (LO8)

© John Wiley and Sons Australia Ltd, 2018

13.17

Chapter 13: Share capital and reserves

Reserves Asset replacement reserve This reserve is created by a transfer from other reserve accounts e.g. a transfer from the retained earnings account. The general form of the entry to create or recognise increments in the account is: Transfer to asset replacement reserve (RE) Asset replacement reserve

Dr Cr

x x

The account will never have an effect on profit or loss or other comprehensive income. Asset revaluation surplus This account is created when there is an upward revaluation of an item of property, plant and equipment or an intangible asset under the revaluation model. Under this model such assets are measured at fair value. Increments are recognised in other comprehensive income and accumulated in equity. Hence comprehensive income increases when a revaluation increment occurs (assuming no prior revaluation decrement). The general form of the entries, using land as the asset being revalued upwards, is: Dr Cr

20 000

Income Tax Expense (OCI) Deferred Tax Liability (Tax effect of revaluation of land)

Dr Cr

6 000

Gain on Revaluation of Land (OCI) Income Tax Expense (OCI) Asset Revaluation Surplus (Accumulation of net revaluation gain in equity)

Dr Cr Cr

20 000

Land Gain on Revaluation of Land (OCI) (Recognition of revaluation increment)

20 000

6 000

© John Wiley and Sons Australia Ltd, 2018

6 000 14 000

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