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ACCA Paper P2 Corporate Reporting

Mock Exam

Commentary, Marking scheme and Suggested solutions

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Commentary Tutor guidance on improving performance on the exam paper.

General Your script is the only evidence you will provide to convince an ACCA marker that you should pass this paper and therefore progress through your qualification. Even very talented students can fall down at this paper because they do not consider the following points:

The first question you attempt should be the one you feel most comfortable with. Give the marker the impression that you are comfortable with the syllabus as early as possible. Make it clear which question you are answering too!

Make sure you answer ALL questions even if you have to guess. It is amazing how a stab in the dark can generate the 50th mark – the one you need to pass – again it shows the marker that you can think about the question (albeit in simple terms).

Q1 Milton Part (a) is a consolidated statement of profit or loss and other comprehensive income for a complex group with a piecemeal acquisition and an indirect associate being acquired part way through the year. This part includes a number of adjustments including intra-group trading and unrealised profit, fair value adjustments, and pension costs. A methodical step by step approach is key here. Note that question 1 often includes adjustments on pensions or other accounting issues.

Part (b) requires a discussion of the principles involved in accounting for this type of business combination achieved in stages. Part (c) requires consideration of the ethical factors involved making decisions on the level of segment information to disclose. These types of written requirements are likely to appear on a recurring basis in question 1 so make sure you are comfortable with answering discussion type questions.

Q2 McNiven This is an entire question on various issues relating to employee remuneration, covering IAS 19 Employee Benefits and IFRS 2 Share-based Payment. Favourite topics of the examiner in the past for single topic questions include:

Employee benefits Share-based payments Financial instruments Deferred tax

so make sure you are prepared for questions on these topics.

Q3 Saverfast This is a specialised industry question which is based on a supermarket company. The examiner has mentioned that he is likely to set questions in the context of a specialised industry. No specific knowledge of the industry is required, rather the industry is used as a vehicle to test application of accounting standards. This question covered discussion of the accounting treatment of loyalty points, revaluations, hedging, borrowing costs and an onerous contract.

The key to passing this type of question is to identify enough of the issues within the scenario. Clearly, a good knowledge of accounting standards is helpful, but so is the ability to read the scenario carefully and use basic principles.

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Q4 Equitus The examiner has stated that he will use Question 4 for discussion of current developments in corporate reporting. What is required is some knowledge of these developments coupled with the ability to identify issues within a practical scenario. It is also important to produce a structured answer; the requirements are a good place to start in terms of section headings.

Make sure you are up-to-date and watch out for relevant articles in Student Accountant magazine, online at http://www.accaglobal.com/uk/en/student/sa.html.

Parts (a) and (b) of the question covered discussion of the issues, while part (c) required application. This is quite typical of the discussion question.

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Section A

1 Milton (a) Consolidated SPLOCI 5

Newbolt 8 Owen 6 Pope 3 Inventory 2 Pension curtailment 2 Dividend 2 Eliminate FV of investment in associate 2 NCI 5

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(b) Treatment of additional investment 5 Contingent consideration 2 7

(c) Discussion of relevant requirements of IFRS 8 3 Moral/ethical considerations 5 8 50

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(a) MILTON GROUP STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEAR ENDED 30 SEPTEMBER 20X5 $m Revenue: 1,941 + (564 9/12) + (340 12

6 ) – 72 (W4) 2,462.00

Cost of sales: 1,650 + (328 9/12) + (202 12

6 ) – 72 (W4) + 6 (W4) (1,931.00) Gross profit 531.00 Other income: 75 + (44 9/12) + (29

126 ) – 12 (W6) 110.50

Distribution costs: 72 + (50 9/12) + (62 12

6 ) (140.50)

Administrative expenses: 132 + (70 9/12) + (28 12

6 ) + 1.5(W3)

– 40 (W5) + 9 (W7) (169.00) Finance costs: 21 + (20 9/12) + (19

126 ) (45.50)

Share of profit of associate: 16 12

6 25% 2.00 Profit before tax 288.00 Income tax expense: 50 + (56 9/12) + (24

126 ) (104.00)

Profit for the year 184.50 Other comprehensive income (not reclassified to profit or loss) Derecognition of investment in equity instrument (10 – 9 (W7)) 1.00 Gain on investments in equity instruments: 48 + (22 9/12) ((16 – 6 (W7))

126 ) 69.50

Gain/loss on property revaluation: 28 + (14 9/12) 38.50 Remeasurement loss on defined benefit plan: (34.00) Share of other comprehensive income of associate: 32

126 25% 4.00

Other comprehensive income for the year net of tax 79.00 Total comprehensive income for the year 263.50

Profit attributable to: Owners of the parent (bal. fig.) 161.15 Non-controlling interests (W2) 23.35

184.50 Total comprehensive income attributable to:

Owners of the parent 227.10 Non-controlling interests (W2) 36.40

263.50

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Workings

1 Group structure

Milton

Newbolt Owen

Pope

The Milton group controls Owen so the indirect associate, Pope, will be equity accounted using 25% but part of this is owned by the 25% non-controlling interest in Owen.

Timeline

Milton

Newbolt

Subsidiary with 40% NCI 129

Owen

Subsidiary with 25% NCI 126

Pope

25% associate (with 25% NCI by Owen)

1.10.X4 1.4.X5 30.9.X5 1.1.X5

1.10.X4 10% 1.1. X 5 50%

60%

75%

25%

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2 Non-controlling interests

Newbolt Owen Profit for year TCI Profit for year TCI $m $m $m $m Per question 84 12

9 63

120 129 90

34 126 17.0

50 126 25

Depreciation of fair value adjustment (W3)

(1.5)

(1.5)

Elimination of fair value gain recognised on investment in Pope (W8)

(3)

Impairment of 'full' goodwill (W7)

(9.0)

(9.0)

Unrealised profit (W4) (6.0) (6.0) Share of profit of associate

Per SPLOCI 2.0 Share of TCI of associate (2.0 + 4.0) 6 46.5 73.5 19.0 28 40% 40% 25% 25% 18.6 29.4 4.75 7.0

$23.35m $36.40

3 Fair value adjustments

Newbolt At acquisition Movement At year end 1 Jan 20X5 20X5

30 September

20X5 $m $m

$m

Plant (380 – (100 + 160 + 100)) 20 10

20 9/12 =

(1.5)

18.5

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4 Intragroup trading

(i) Cancel intra group sales/purchases:

DEBIT Revenue $72m CREDIT Cost of sales (purchases) $72m

(ii) Unrealised profit:

DEBIT Cost of sales (72 ½ 12020 ) $6m

CREDIT Inventories (SOFP) $6m

Note. As the intra-group sale was made by the subsidiary, the unrealised profit adjustment must be reflected in the non-controlling interest.

5 Defined benefit pension – changes to plan

The closure of the defined benefit plan represents a curtailment of the pension plan. The effect should be recognised at the point when the curtailment occurs, in this case, with the signing of the agreement. As this change falls outside normal actuarial assumptions the gain arising is recognised in profit or loss.

DEBIT Net pension liability (SOFP) $40m CREDIT Administrative expenses (P/L) $40m

6 Intra-group dividend

The dividend received from Newbolt by Milton must be cancelled out on consolidation of the statement of profit or loss and other comprehensive income.

DEBIT Other income (P/L)($20m 60%) $12m CREDIT Dividends paid (Newbolt) $12m

7 Goodwill

Newbolt $m Consideration transferred:

Cash 200.0 Contingent consideration (Note 2) 220.0 Fair value of previously held investment (Note 3)

10.0

Non-controlling interest (at FV) 40.0 Fair value of net assets (380.0) 90.0 Impairment loss 10% (9.0) 81.0

Notes:

1 No information was provided in respect of the goodwill on the acquisition of Owen, but as no impairment has arisen, it would have no effect in the statement of profit or loss and other comprehensive income.

2 Although the original estimate of the FV of the contingent consideration would have been used at the acquisition date, IFRS 3 allows the figure to be adjusted through goodwill if changes arise from additional information about facts and circumstances that existed at the acquisition date. (IFRS 3 para. 58)

3 The fair value of Milton's original 10% holding would be measured using the same share price as for the non-controlling interest at that date. The gain on the derecognition of the investment in equity instruments at the date control is obtained is therefore:

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$$m Fair value at date control obtained (10/40 40) 10 Carrying value brought down from previous year end (30.9.X4) (9) 1

8 Fair value of Owen's investment in Pope

Part of the fair value uplift on the investment in Pope that has been recognised in Owen's other comprehensive income must be eliminated on consolidation. Owen and Pope have been part of the Milton Group for only six months (since 1 April 20X5), so only 6/12 of this gain is eliminated: $6m 6/12 = $3m The carrying value of the 'investment in associate' in the consolidated statement of financial position would be based on the fair value paid at the acquisition date (including $3m of the fair value update at 1 April 20X5), plus the group share of the associate's retained earnings.

(b) Treatment of additional investment in Newbolt

This is a business combination achieved in stages, also known as a 'step acquisition' (or 'piecemeal acquisition'). The increase in Milton's investment from 10% to 60% means that control is obtained on 1 January 20X5. The basic treatment in the consolidated financial statements is:

Newbolt is fully consolidated (with a 40% non-controlling interest) in the consolidated statement of financial position

Newbolt's post acquisition results (for the nine months from 1 January 20X5) are consolidated in the statement of profit or loss and other comprehensive income.

The original investment of 10% that would have been treated as an investment in equity instruments under IFRS 9 is revalued at the date control is obtained and the gain (or loss if applicable) recorded. The gain or loss is recognised in profit or loss unless an irrevocable election was made to hold the investment at fair value through other comprehensive income.

In the case of Milton, this irrevocable election has been made in respect of all its investments in equity instruments, including Newbolt. Accordingly the gain on derecognition of the investment in Newbolt is recognised in other comprehensive income for the year.

Any gains or losses recognised on this investment in other comprehensive income in previous years are not reclassified.

Goodwill is measured on the date that control is obtained. The fair value of the previous investment is added to the consideration transferred and the non-controlling interest in the calculation of goodwill.

Contingent consideration

The basic principle is that contingent consideration must be measured at its acquisition date fair value. The treatment of changes in the value of contingent consideration depends on the reason for the change.

If (as in part (a)) new information becomes available about circumstances at the acquisition date and within the measurement period of a maximum of one year from the acquisition date, the changes are treated as adjustments to the original accounting for the acquisition and will change the measurement of goodwill.

If the change is a result of post-combination changes, for example, changes to a profit-based payment when post-acquisition results differ from those forecast at the acquisition date must be recognised in post-acquisition results. In this case, any further changes to the liability for the consideration will be recognised in profit or loss.

(c) Ethical behaviour in the preparation of financial statements, and in other areas, is of paramount importance. This applies equally to preparers of accounts, to auditors and to accountants giving advice to

to OCI

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directors. Accountants act unethically if they use 'creative' accounting in accounts preparation to make the figures look better, and they act unethically if, in the role of advisor, they fail to point this out.

One of the ACCA Code of Ethics fundamental principles is professional competence and due care. Professional competence in the case of a preparer of financial statements, is demonstrated by compliance with GAAP and accounting standards. Under the requirements of IFRS 8 Operating segments the two divisions each meet the criteria to be treated as operating segments. There is discrete financial information about each division and this is used by the chief operating decision maker. The size of each division is well above the 10% thresholds for reportable segments in IFRS 8. In certain circumstances, segments may be aggregated, but there are a number of criteria to be met, including that they must have similar economic characteristics, including having similar classes of customer. This is clearly not the case in Newbold's two main divisions.

Finally, the Code clearly states that members should not be associated with reports that are misleading, prepared with bias or omit or obscure information. To change the internal reporting structure with the intention of obscuring aspects of the entity's performance would clearly breach this requirement.

In conclusion, if the finance director carried out the proposal to rearrange internal reporting in order to obscure information that would have been made transparent under IFRS 8, he has contravened the ACCA Code of Ethics and Conduct.

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Section B

2 McNiven (a) (i) Entity has choice/cash-settled due to past practice 1 Measure at FV at y/e, spread over vesting period, remove

leavers 1

Change in share price after y/e = non adjusting event after reporting period

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Calculation of expense/liability 2 Explain deferred tax 1 Calculate deferred tax 1 Available/Maximum 7 (ii) Basic principles 1 Specific rules for replacement scheme 2 Available/Maximum 3 (b) Accumulating/non-accumulating 2 Explanation of McNiven liability 2 Calculation 2 Available/Maximum 6 (c) CSC 1 Benefits 1 Interest on liability (9/12) 1 Expected return on assets (9/12) 1 Financial statement extracts 3 Available/Maximum 7 Professional skills – clarity and quality of presentation and discussion 2 25

(a) (i) Accounting treatment for share-based payment

This is a share-based payment transaction where the entity (McNiven) has a choice of settlement.

IFRS 2 Share-based payment requires the transaction to be treated as cash-settled if there is a present obligation to settle in cash. If there is no obligation, the transaction should be treated as equity settled.

Here, McNiven's past practice of always settling in cash has created a valid expectation in employees that they will receive cash. Therefore, there is a constructive present obligation for McNiven to settle in cash and McNiven should account for the scheme as a cash settled transaction.

Cash-settled share-based payments are accounted for as follows:

(1) An expense should be recognised over the vesting period (two years).

(2) A corresponding liability should be recorded in the statement of financial position.

(3) The liability should be measured at fair value and this fair value updated each year end to give the best estimate of amount to be paid.

(4) Any expected leavers over the vesting period should be removed from the number of employees as they will not receive the share-based payment (the best estimate at each year end should be used).

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Calculation

The fair value of the liability at the year end is valued using the year end share price as this represents the cash value at that date.

The liability as at 30 September 20X5 and the corresponding expense to be recognised in profit or loss for the year ended 30 September 20X5 is calculated as follows:

[(30 managers – 2 leavers) 6,000 shares $9 year end fair value ½ vested] = $756,000

Event after the reporting period

The post year end increase in the share price to $9.25 on 20 October 20X5 is a non-adjusting event after the reporting period. This is because it relates to conditions that arose after the 30 September 20X5 year end. The liability at 30 September 20X5 is not adjusted for this but the difference of $20,250 [27 managers 6,000 shares ($9.25 – $9) ½] would be disclosed as a non-adjusting event after the reporting period if considered material.

Deferred tax

IAS 12 Income taxes requires deferred tax to be recognised on temporary differences. With this cash-settled scheme, a temporary difference arises because an expense is recognised in profit or loss over the vesting period whereas a tax deduction is given at one point in time ie on exercise. The carrying amount of the share-based payment expense is zero as it has already been deducted in determining accounting profit. The tax base is calculated as the expected tax deduction on exercise (estimated by using the year end share price in this case) based on employees' services to date. $ Carrying amount of share-based payment expense 0 Tax base (same as expense as calculated above as based on y/e price) (756,000) Temporary difference (756,000) Deferred tax asset ($756,000 30%) 226,800

This deferred tax asset (representing future tax relief on exercise of the instruments) should only be recognised if McNiven has sufficient future taxable profits against which it can be offset.

A corresponding credit is recognised in profit or loss.

(ii) Modification to share-based payment

The general principle is that the value of the services received up to the date of the modification must be recognised under the normal IFRS 2 approach. If the modification increases the total fair value of the share-based payment, it must be recognised over the remaining vesting period (as a change in accounting estimate).

If, as in this case, instruments are granted as a replacement for cancelled instruments, this is treated as a modification of the original grant. The additional fair value is measured as the fair value of the replacement instruments less the net fair value of the cancelled instruments. (The fair value as at the cancellation date less any payment made to the holders at that date, such as the cash payment suggested in this scenario.)

(b) Unused leave accrual

Annual leave is mentioned in IAS 19 Employee benefits as an example of a compensated absence. IAS 19 distinguishes between accumulating absences, like the leave in McNiven, that may be carried forward to another accounting period and non-accumulating absences, such as sick pay, that cannot normally be carried forward.

Where annual leave is accumulating, the entity should provide for the cost of providing the benefit. The liability should be calculated at the level of individual employees and should be based on the additional amount that the entity expects to pay in respect of the unused entitlement.

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In McNiven, the liability should be based on only the 75% of employees who are expected to use the two days brought forward in the year before they lapse. The liability will be based on 1,500 days (two days for each of 750 employees) and the estimated cost will be 75% 253

2 $840,000 = $4,980.

(c) Pension costs

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEAR ENDED 30 SEPTEMBER 20X5 (EXTRACTS)

Profit or loss $ Service cost 15,500 Net interest on net defined benefit obligation: 5,243 – 3.267 1,976 Charge to profit or loss 17,476

Other comprehensive income $ Actuarial gain on defined benefit obligation (W1) 7,143 Return on plan assets (excluding amounts in net interest) (W2) (11,367) (4,224)

STATEMENT OF FINANCIAL POSITION FOR THE YEAR ENDED 30 SEPTEMBER 20X5 (EXTRACTS)

$ Present value of defined benefit pension plan obligation 119,500 Fair value of defined benefit pension plan assets (102,100) 17,400

Workings 1 Changes in the present value of the defined benefit obligation

$'000 Opening defined benefit obligation 116,500 Interest on obligation (116,500 6% 9/12 ) 5,243 Current service cost 15,500 Benefits paid (10,600) Gain on remeasurement through OCI (balancing figure) (7,143) Closing defined benefit obligation 119,500

2 Changes in the fair value of plan assets $'000 Opening fair value of plan assets 72,600 Interest on plan assets (72,600 6% 9/12) 3,267 Contributions by MK 48,200 Benefits paid (10,600) Loss on remeasurement through OCI (balancing figure) (11,367) Closing fair value of plan assets 102,100

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3 Saverfast

Marking scheme Marks Loyalty points IFRS 15 1

Adjust for expected redemption rate 1 Split between revenue and deferred revenue 2

Store valuation Calculations 2

Explanation of treatment 3 Identification of other issues 2

Forward contract Cash flow hedge 1

At inception 1 Year end fair value 1 Gain to OCI 1 Calculations 2

Borrowing costs Qualifying asset 1

Explanation of interest rate 1 Amount to capitalise 1 Cessation of capitalisation 1

Sub-lease Recognise onerous contract 1

Provision 1 Professional marks – clarity and quality of presentation and discussion 2 25

Suggested solution REPORT

To: The Directors of Saverfast From: Accountant Date: Today Subject: Preparation of financial statements for year ending 30 September 20X5

Terms of reference:

This report considers the accounting treatment of a number issues and in particular:

Loyalty points Revaluation losses Cash flow hedging Borrowing costs Sub-lease costs.

Loyalty points

The treatment of the reward points is governed by IFRS 15 Revenue with contracts from customers. The principles of the standard require that:

(i) The points should be accounted for as a separate component of the sale.

(ii) The promise to provide the discount is a performance obligation.

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(ii) The entity must estimate the stand-alone selling price of the points in accordance with IFRS 15. That estimate must reflect the discount that the customer would obtain when redeeming the points, adjusted for both of the following:

(1) Any discount that the customer could receive without redeeming the points (2) The likelihood that the points will be redeemed.

In substance, customers are implicitly paying for the reward points they receive when they buy goods and services and hence some of that revenue should be allocated to the points.

Here, total reward points have a face value of $1,000m at the year end but only three in five customers are expected to redeem their points, giving a value of $600m (ie $1000m 3/5). Effectively Saverfast has sold goods worth $12,600m (ie $12,000m + $600m) for a consideration of $12,000m. To allocate the transaction price, step (iv) of IFRS 15's five-step process for revenue recognition, the proceeds need to be split proportionally pro-rata the stand-alone prices of the two elements. Thus allocating the $12,000m between the two elements would mean that $11,429m ($12,000m/$12,600m $12,000m) would be allocated to food revenue and the balance of $571m ($600m/$12,600m $12,000m) to the reward points. $11,429m would be recognised as revenue in year ended 30 September 20X5. The $571m attributable to the reward points is only recognised when the performance obligations are fulfilled, that is when the points are redeemed.

Property revaluation

As Saverfast has a policy of carrying its supermarket properties at fair value, the values must be restated regularly (and in the case of an apparently volatile asset such as this overseas store, annually).

In the year ended 30 September 20X4 a valuation gain of $3.6 million would have been recognised in other comprehensive income. (See calculations in point 1 of Appendix 1.) In the current year the depreciation charge of $0.7 million will have been charged to profit or loss, with the excess over the depreciation that would have been charged on the building at its historical cost transferred to retained earnings.

The valuation at 30 September 20X5 reveals a loss of $7.3 million. IAS 16 restricts the amount of revaluation loss that can be charged against the revaluation surplus (through other comprehensive income) to the amount held in the revaluation surplus relating to that asset. The calculations in point 1 of Appendix 1 show that only $3.5 million may be charged to other comprehensive income and the excess $3.8 million must be charged to profit or loss.

The other issue relating to the circumstances of this store is the possibility that it may be closed. As no decision has yet been made, there is no need to consider any implications of IFRS 5 Non-current assets held for sale and discontinued operations as no reclassification of assets is done until a sale or closure is highly probable. If a decision is made before the financial statements are approved, it may be appropriate to disclose this as a non-adjusting event after the reporting period under IAS 10 if this store is material to the group.

Forward contract

Given that Saverfast is hedging the volatility of the future cash outflow to purchase fuel, the forward contract is accounted for as a cash flow hedge, assuming all the criteria for hedge accounting are met (ie the hedging relationship consists of eligible items, designation and documentation at inception as a cash flow hedge, and the hedge effectiveness criteria are met).

At inception, no entries are required as the fair value of a forward contract at inception is zero. However, the existence of the hedge is disclosed under IFRS 7 Financial instruments: disclosures.

At the year end the forward contract must be valued at its fair value of $0.12 million as follows. The gain is recognised in other comprehensive income (items that may subsequently be reclassified to profit or loss) in the current year as the hedged cash flow has not yet occurred. This will be reclassified to profit or loss in the next accounting period when the cost of the diesel purchase is recognised.

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Borrowing costs

It is correct to assume that borrowing costs can be capitalised here as the new supermarkets under construction meet the definition of qualifying assets under IAS 23 Borrowing costs. A qualifying asset is one that necessarily takes a substantial period of time to get ready for its intended use or sale.

In this case, there is no specific loan funding the construction of the asset, so it is not permitted to choose one individual interest rate. Instead, a rate should be calculated as the weighted average of borrowing costs outstanding during the period (excluding borrowings specifically for a qualifying asset) multiplied by expenditure on qualifying asset. The amount capitalised should not exceed total borrowing costs incurred in the period.

Once this weighted average has been calculated, it should be applied to the costs to date for the period from the start of the building project to the year end.

Capitalisation of interest must cease when substantially all the activities necessary to prepare the asset for its intended use or sale are complete

Sub-lease costs

The problem with the lease costs and the sub-letting of the buildings is an example from IAS 37 Provisions, contingent liabilities and contingent assets, of an onerous contract. The IAS states that a provision should be made for the amounts of the shortfall in the financial statements at 31 December 20X8.

Appendix 1

1 Property revaluation

Carrying value

Revaluation

surplus $m $m 1.10. 20X3 Cost 20.0 Depreciation (20 – 8) 20

(0.6)

Revaluation (bal. fig) 3.6 3.6 30.9. 20X4 Revalued c/d 23.0 Depreciation for year 23 – 10 19

(0.7)

Transfer to retained earnings: 0.700 – 0.600 (0.1) 3.5 Revaluation loss (bal. fig.) (7.3) (3.5) 30.9. 20X5 Revalued c/d 15.0 0.0

Original entries:

DEBIT Other comprehensive income $7.3m CREDIT Property, plant and equipment $7.3m

Correct entries:

DEBIT Other comprehensive income $3.5m DEBIT Profit or loss (bal. fig.) $3.8m CREDIT Property, plant and equipment $7.3m

To correct:

DEBIT Profit or loss $3.8m CREDIT Other comprehensive income $3.8m

To OCI (not re-classified on disposal)

and 3.8 to P/L

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2 Forward contract $m Market price of forward contract for delivery on 31 December (1m $2.16) 2.16 Saverfast's forward price (1m $2.04) (2.04) Cumulative gain 0.12

The gain is recognised in other comprehensive income as the cash flow has not yet occurred:

DEBIT Forward contract (Financial asset in SOFP) $0.12m CREDIT Other comprehensive income $0.12m

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4 Equitus

Marking scheme Marks (a) 1 mark per valid point from the following, maximum 6 Classification as a liability increases gearing Distributions on liabilities reduce profits Classification as equity reduces gearing Classification as equity can be viewed negatively Distributions on equity don't affect profit (charged to equity) Analysts look at underlying transactions Effect on loan covenants High gearing may result in higher new finance costs Example (b) 1 mark per explained point from the following: 6 Financial liability definition Equity instrument definition 'Fixed-fixed' is equity Equity is last resort if definition of liability not met Substance is applied Grey areas + example(s) Transactions set up to achieve an effect difficult to classify Need to revise Conceptual Framework elements (c) (i) Definition: contractual obligation to deliver cash 1 No obligation re principal (non-redeemable) 1 No obligation re dividends (at discretion of Equitus) 1 Treat as equity & dividends deducted from retained earnings 1 4 (ii) Definition: non-derivative settled in variable number of

entity's own shares 1

Financial liability 1 Recognised at present value 1 Interest applied 1 4 (iii) Liability exists as obligation to repay capital on fixed date 1 Treat as financial liability at amortised cost 1 Record dividends as finance cost 1 3 Clarity and quality of presentation and discussion 2 25 Other valid points accepted in parts (a) and (b) of the question

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Suggested solution (a) The classification of financial instruments as debt versus equity is particularly important with items

that are financial liabilities or equity as the presentation of the two items and associated financial effects are very different.

If a financial instrument is classified as a financial liability (debt) it will be reported within current or non-current liabilities. Non-current liabilities are relevant in determining an entity's leverage, or gearing, ie the proportion of debt finance versus equity finance of a business, and therefore risk to ordinary equity holders.

Distributions relating to instruments classified as financial liabilities are classified as finance cost, having an impact on reported profitability.

If a financial instrument is classified as equity, reported gearing will be lower than if it were classified as a financial liability. However, classification as equity is sometimes viewed negatively as it can be viewed as a dilution of existing equity interests.

Distributions on instruments classified as equity are charged to equity and therefore do not affect reported profit.

It is important to note that it is not just the presentation of an arrangement that determines the underlying gearing of a business that an analyst will use to assess the business' risk, but the substance of the arrangement. Analysts often make their own adjustments to financial statements where they believe that the information reported under IFRSs does not show the underlying economic reality. IAS 32 Financial Instruments: presentation strives to follow a substance-based approach to give the most realistic presentation of items that are in substance debt or equity, avoiding the need for analysts to make adjustments.

Classification of instruments can also have financial implications for businesses. For example, debt covenants on loans from financial institutions often contain clauses that reported gearing cannot exceed a stated figure, with penalties or call-in clauses if it does.

Companies with high gearing may also find it harder to get financing or financing may be at a higher interest rate.

High gearing is particularly unpopular in the current economic climate and there have been high profile cases of companies that have been pressed to sell of parts of their business to reduce their 'debt mountains', eg Telefónica SA, the Spanish telecoms provider, selling O2 Ireland to Hutchison Whampoa (the owner of the '3' telephone network).

(b) IAS 32 covers the classification of financial instruments as debt or equity through their definitions.

A financial liability is defined as:

'(i) a contractual obligation:

(1) to deliver cash or another financial asset to another entity; or

(2) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or

(ii) a contract that will or may be settled in the entity's own equity instruments and is:

(1) a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity's own equity instruments; or

(2) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity's own equity instruments.'

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Equity instruments are defined as 'any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities'.

A contract that will be settled by the entity delivering (or receiving) a fixed number of its own equity instruments in exchange for a fixed amount of cash or other financial asset is an equity instrument.

A key element of classification as debt is the contractual obligation to deliver cash or another financial asset to the holder.

However, IAS 32 makes it clear that an instrument is only classified as an equity instrument if neither (a) nor (b) in the definition above are met. This is consistent with the definition of equity as being a 'residual interest'.

Substance is therefore applied, so, for example preference shares that are subject to mandatory redemption for fixed/determinable amount on a fixed/determinable date are classified as debt, and the distributions are classified as finance costs.

Nevertheless, there are some grey areas that could be addressed by improving the definitions. Some financial instruments have features of debt and equity which can lead to inconsistent reporting.

Some financial instruments, such as convertible loans need to be split into debt and equity components, however determining an interest rate to apply to the cash flows to determine the debt component can be problematic, and make a difference to the measurement of the two differently presented components.

Financial instruments are often set up and structured specifically to achieve particular accounting, regulatory or tax effects within existing financial reporting presentation rules, and their substance is consequently sometimes hard to assess.

In July 2013, the IASB published a Discussion Paper Review of the Conceptual Framework, which addresses areas found to be deficient in the existing Conceptual Framework, and the distinction between equity and liabilities was one of the areas considered. The distinction is clarified in the Paper through focus on the definition of a liability. The paper identifies two types of approach: narrow equity and strict obligation.

(i) Narrow equity approach. Equity is treated as being only the residual class issued, with changes in the measurement of other equity claims recognised in profit or loss.

(ii) Strict obligation approach. All equity claims are classified as equity with obligations to deliver cash or assets being classified as liabilities. Any changes in the measurement of equity claims would be shown in the statement of changes in equity.

Under the strict obligation approach, certain transactions now classified as liabilities would now be classified as equity because they do not involve an obligation to transfer cash or assets. An example of this is an issue of shares for a fixed monetary amount.

Clarification of the definitions of liabilities and equity may help resolve a number of accounting issues under the current framework.

(c) (i) IAS 32 requires a financial instrument to be classified as a liability if there is a contractual obligation to deliver cash or another financial asset to another entity.

In the case of the preference shares, as they are non-redeemable, there is no obligation to repay the principal.

In the case of the dividends, because of the condition that preference dividends will only be paid if ordinary dividends are paid in relation to the same period, the preference shareholder has no contractual right to a dividend. Instead, the distributions to holders of the preference shares are at the discretion of the issuer as Equitus can choose whether or not to pay an ordinary dividend and therefore a preference dividend. Therefore, there is no contractual obligation in relation to the dividend.

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As there is no contractual obligation in relation to either the dividends or principal, the definition of a financial liability has not been met and the preference shares should be treated as equity and initially recorded at fair value ie their par value of $40 million.

The treatment of dividends should be consistent with the classification of the shares and should therefore be charged directly to retained earnings.

(ii) The price of the equipment is fixed at $5 million one year after delivery. In terms of recognition and measurement of the equipment, the $5 million price would be discounted back one year to its present value.

The company is paying for the equipment by issuing shares. However, this is outside the scope of IFRS 2 Share-based payment because the payment is not dependent on the value of the shares, it is fixed at $5 million.

This is an example of a contract that 'will or may be settled in an entity's own equity instruments and is a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity's own equity instruments', ie a financial liability.

It is the number of shares rather than the amount paid that will vary, depending on share price. Therefore it should be classed as a financial liability and initially measured at the present value of the $5 million.

Subsequently, as it is not measured at fair value through profit or loss (as it is not held for short term profit-taking or a derivative), it should be measured at amortised cost.

As a result, interest will be applied to the discounted amount over the period until payment and recognised in profit or loss with a corresponding increase in the financial liability.

(iii) Most ordinary shares are treated as equity as they do not contain a contractual obligation to deliver cash.

However, in the case of the directors' shares, a contractual obligation to deliver cash exists on a specific date as the shares are redeemable at the end of the service contract.

The redemption is not discretionary, and Equitus has no right to avoid it. The mandatory nature of the repayment makes this capital a financial liability. The financial liability will initially be recognised at its fair value, ie the present value of the payment at the end of the service contract. It will be subsequently measured at amortised cost and effective interest will be applied over the period of the service contract.

Dividend payments on the shares are discretionary as they must be ratified at the Annual General Meeting. Therefore, no liability should be recognised for any dividend until it is ratified. When recognised, the classification of the dividend should be consistent with the classification of the shares and therefore any dividends are classified as a finance cost rather than as a deduction from retained earnings.

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