p2 exp notes

8/2/2019 P2 Exp Notes

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ACCA Paper P2 (INT)Corporate Reporting

For exams in 2012

Notes

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ACCA P2 Corporate Reporting

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Contents

About ExPress Notes 3

1. Group Accounting 72. Foreign currency: IAS 21 153. Statements of cash flow: IAS 7 214. Provisions and contingencies: IAS 37 265. Taxation: IAS 12 286. Employment costs: IAS 19 327. Financial instruments: 368. Share based payment: IFRS 2 429. Tangible non-current assets 4910. Intangible non-current assets: IAS 38 5211. Impairment of assets: IAS 36 5612. Revenue: IAS 18 5913. Estimates, errors and accounting policies: IAS 8 6114. Equity reconstructions (insolvency) 63


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Chapter 1

Group Accounting

STARTThe Big Picture

Group accounting will form the backbone of the compulsory question 1 in the exam, and will

be worth approximately a third of the marks in the exam.

Most people do rather better in the groups part of the exam. Without doubt, groups are

important, but be careful not to over-estimate the importance of groups in your preparation.

Paper P2 is mostly not about group accounting!

Although question 1 will be a groups question at its core, there will be lots of other

adjustments in the individual accounts that require correction before the consolidation.

These notes focus on the areas of groups that are new to paper P2 from paper F7, though

we start with some core definitions and workings that should be familiar from paper F7.

Consolidation is the process of replacing the single figure for investment in subsidiary in

the individual financial statements of the parent with more useful information about what

assets, liabilities, income and expenditure the parent company controls via its investment,

ie:


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Net assets in the subsidiarys financialstatements (ie equity or capital plusreserves) at the acquisition date.

Consideration transferred to buysubsidiary (as shown in theparent companys individualaccounts)

Non-controlling interestsshare of thenet assets of the subsidiary.

Goodwill arising on acquisition(premium paid to acquire thesubsidiary).

Consolidation is basically a double entry to derecognise the carrying value of the investment

(Cr Investment in subsidiary) and recognise the individual assets (Dr PP&E, etc), the

liabilities (Cr Payables, etc), the non-controlling interest (CR NCI) and recognise goodwill as

a balancing, residual, item (normally DR Goodwill).

Key definitionsWhat group accounting is trying to do

Subsidiary Any entity that is controlled by another entity, normally by havingmore than 50% of the voting power, though there is no minimumshareholding.

Parent An entity that controls one or more entities.

Associate A company in which the parent has significant influence, but notcontrol nor joint control (as with a joint venture).

ControlAn investor controls an investee when it is exposed, or has rights,to variable returns from its involvement with the investee and hasthe ability to affect those returns through its power over theinvestee.

Significant influence The power to control the financial and operating policies ofanother entity, so as to obtain benefit from its activities.

Equity Equity is defined in the Framework document as assets lessliabilities. By definition, this is the same as capital and reserves ofany company at any date in time. In group accounting, we veryfrequently use the capital + reserves = net assets. For example,


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this is used to work out the net assets on the date of acquiringcontrol of a company (as part of the goodwill working) and towork out post-acquisition growth in a subsidiarys assets (ie post-

acquisition profit).

Group reserves The cumulative gains made under the control of the parent. Theparent companys reserves, plus the post-acquisition retainedgains of all subsidiaries, joint ventures and associates.

Non-controllinginterest

Formerly called minority interest. The share of the net assets andgains of a subsidiary that is not owned by the parent.

Goodwill The premium paid by the parent to acquire its interest in asubsidiary or associate.

Key workingsHopefully familiar from paper F7, but revise thoroughly

Group retained earnings

This working is a core means of earning good marks in the exam. Produce one column for

each company under the parent companys influence. Then work down the rows

methodically, perhaps using the mnemonic TOP TIP PET to make sure you havent

forgotten anything. If the question has different types of reserves (eg revaluation reserve

as well as retained earnings) you will need to do a separate working like the one below for

each reserve to be shown in the group SOFP.

Parent

$000

Sub 1

$000

Sub 2

$000

Assoc

$000

Today 10,000 4,000 3,000 4,500

Omissions/ errors to correct in the individualfinancial statements of each company

400 200 (50)

Provision (eg for unrealised profit) (20) (50) -

Time passage effects (eg write-off of fair valueadjustments)

(40) 20

Impairments of goodwill (cumulative) (30)

Sub-total 10,350 4,110 2,970 4,500

Pre-acquisition reserves (2,000) (1,800) (4,200)

Post-acquisition 10,350 2,110 1,170 300


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x Effective ownership x 100% x 60 % x 40%**

x 40%

10,350 1,266 468 120TOTAL 12,204

** This is not a typo! A subsidiary may still be a subsidiary if an effective ownership of less than

50% still gives the parent control. See multiple groups below.

Non-controlling interests

These show the net assets controlled by the parent and so part of the group, but not

actually owned by the parent. There is no need to consider pre- and post-acquisition profitswhen calculating non-controlling interests in the SOFP.

Sub 1

$000

Sub 2

$000

Capital and share premium at SOFP date 800 400

Reserves, as consolidated (see eg above) 4,110 2,970

Fair value adjustments at acquisition 250 (80)

Less: Any items in the individual companysSOFP not recognised in the group SOFP (seebelow)

(50) -

Net assets (ie equity) as consolidated in thegroup SOFP

5,110 3,290

x NCI % 40% 60%

Non-controlling interest 2,044 1,974

Total non-controlling interest 4,018

Goodwill on a business combination

Fair value of consideration transferred 2,240

Less: Fair value of identifiable net assets acquired, calculated as:

Capital and share premium of target 800

Reserves of target at acquisition date 2,000

Net assets (equity) of target at targets book value 2,800

Fair value adjustments to targets net assets 250


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Net assets (equity) of target at fair value 3,050

X % acquired (60%) (1,830)

Goodwill arising in books of parent for consolidation 410

Goodwill: gross (total) or net (partial)?

The standard double entry working above produces a goodwill figures as it relates to the

parents share. Imagine that the fair value paid for the subsidiary was the fair value for a

60% stake. Then we deduct 60% of the net assets. This logically gives 60% or

thereabouts of the total implied goodwill (eg reputation, client list, motivated staff) of the

subsidiary.

IFRS 3 allows groups a choice with each acquisition whether to leave goodwill net as above,

or gross it up to show the implied total value of goodwill. In order to do the gross up, it is

necessary to be given the fair value of the non-controlling interests stake in the business at

the acquisition date. This would be given in the exam.

EXAMPLENon-controlling interest at fair value at acquisition date 1,350

Fair value of consideration transferred for 60% stake 2,240

Implied total value of company 3,590

Less: Fair value of identifiable net assets (3,050)

Implied total goodwill 540

Partial goodwill automatically recognised (see above) 410

Gross-up required for total goodwill recognition 130

This gross up, if chosen as the accounting policy, would be recognised as:

Dr Goodwill 130

Cr Non-controlling interests 130

Fair values

When buying a company, its previous owner will only accept the fair value of the company

as consideration, or they will not sell!


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In order to give a true and fair picture of the actual goodwill purchased, it is therefore

necessary to record all the assets and liabilities acquired in the subsidiary at their fair value.

Fair value is defined in IFRS 13 as the price that would be received to sell an asset or paidto transfer liability in an orderly transaction between market participants at measurement

date; i.e. it is an exit price or estimated using a valuation technique.A few notable fair value

adjustments are:

Consideration paid includes the market value of any shares paid. Any contingent

consideration is valued assuming that it will be paid, even if this is not certain.

Acquisition costs are written offimmediately.

Contingent liabilities of the subsidiary will be shown in the individual accounts at zero value

(see notes on IAS 37), but their existence would reduce the amount the acquirer is willing topay. They are therefore revalued as if they were provisions in the fair value exercise.

Changes in group structure

Disposals

The gain or loss on disposal of anything is the increase or decrease in net assets recognised

as a result of the transaction.

Proceeds (what is coming into the SOFP in the transaction) X

Less: Carrying value derecognised (what leaves the SOFP) (X)

Profit or loss on disposal (the increase or decrease in net assets) X

The carrying value of a subsidiary in a group SOFP comprises:

Individual assets and liabilities of the subsidiary at the SOFP date Goodwill remaining from the purchase by the parent Non-controlling interests at the SOFP date.

Therefore, the gain or loss on derecognition of a subsidiary is:


Less:

Individual assets and liabilities of the subsidiary at the SOFP date (X)


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Goodwill remaining from the purchase by the parent (X)

Non-controlling interests at the SOFP date (X)

Group gain or loss on disposal XX

The same working can be used to calculate gain or loss on partial disposal, where non-

controlling interest increases (eg where ownership goes from 80% to 60%).

Where a holding goes from 80% to 40%, the calculation is amended slightly, as in addition

to sales proceeds for the partial stake, there will also be a new associate recognised.


Value of new associate recognised X

Less:

Individual assets and liabilities of the subsidiary at the SOFP date (X)

Goodwill remaining from the purchase by the parent (X)

Non-controlling interests at the SOFP date (X)

Group gain or loss on disposal XX

Step acquisitions

Where an acquisition happens in stages (as it often does in reality), the treatment is to treat

the acquisition as a purchase on the date when control happens. Also derecognise any

previous holding, which might have been an available-for-sale financial asset or an

associate.

This results in an acquisition of a subsidiary and a gain or loss on disposal as part of the

same transaction.

In effect, step acquisitions use much the same logic as disposals, but in reverse.


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Multiple group structures

You should expect the structure of the group in question 1 in the exam to be a multiple

group structure, such as:

Parent

60%

Subsidiary 1

60%

Subsidiary 2

The main additional maters to consider here are:

What is the nature of the relationship between parent and subsidiary 2? Even if theeffective ownership is less than 50% (as it is here), it may still be a subsidiary, as

there is effectively a chain of command by which the parent can control subsidiary 2.

Parent has control of subsidiary 1, which has control of subsidiary 2.

In this example, the parent has an effective ownership of 36%, but has control.Subsidiary 2 is therefore consolidated as part of the Parent group, with non-

controlling interests of 64%.

The dates of acquisition determine whether there is one goodwill calculation, ormore. If Parent acquired Subsidiary 1 on 1.1.x1 and Subsidiary 1 acquired

Subsidiary 2 on 1.1.x2, then there would be two transactions under Parents control,

using resources controlled by Parent. This would require two goodwill calculations.

However, if Subsidiary 1 had acquired Subsidiary 2 on 1.1.x1 and Parent acquiredSubsidiary 1 on 1.1.x2, there would only be one transaction under Parents control,

using Parents resources. This would give one goodwill calculation

In the group SOFP, any historical costs of investments in subsidiaries are notincluded in the group SOFP, as the subsidiarys individual assets and liabilities are

consolidated instead. This means that any cost of investment in Subsidiary 2 in the

SOFP in Subsidiary 1 are excludedfrom the group SOFP and therefore NCI

calculation.


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Chapter 2

IAS 21


An entity cannot mix currencies when producing financial statements!

Eg USD + EUR = Nothing useful.

There are two sets of rules to know, depending upon where in the flow of transactions

something is happening.

Foreign currency Functionalcurrency

Presentationcurrency

Translationrules

Presentationrules

Functional currency

Generally, the currency that the entitys trial balance is produced in. The currency of the primary economic environment in which the company operates. Effectively the currency that the companythinks in.


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May not be the currency of the country in which the company operates, especially ifthe company is more like a branch of a foreign parent and depends upon the foreign

parent for day-to-day support.

All other currencies other than the functional currency are a foreign currency.

Key workings/ methodsTranslation rules

1Record all transactions in the functional currency. Record all purchases, sales,

etc at the spot rate ruling on the date of the translation.

2At the period end:

Translate monetary assets and liabilities at the closing rate.

Dont retranslate non-monetary items.

3AExchange difference arising inthe year on retranslation offoreign currency loans isreported in profit in financeincome/ finance cost.

3B Exchange difference arising in theyear on retranslation of foreigncurrency trade payables andreceivables is reported in profit inother operating income/ otheroperating expenses.

Key workings/ methodsPresentation rules

This is normally examined in the context of group accounting, but it could be examined as a

single company only.

An entity may choose any currency it likes for the presentation of its financial statements.

Eg a company with a dual listing in the USA and in the European Union is likely to choose

the US dollar as its presentation currency and also the euro as its presentation currency.

The basic rules are simple: translate the financial statements using these rules:

All items in the SOFP: translate at the closing rate. All items in the SOCI: translate at the average rate for the period, or spot rate for

any large one-off items.


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Exchange differences will arise, eg imagine the position of Lear Co for the year ended 31

Dec 20x1:

Date Euro

Net assets (equity) at 1 Jan 20x1 10,000Profit for the year to 31 Dec 20x1 2,000Other comprehensive income for the yearto 31 Dec 20x1

1,000

Dividend declared for the year (1,500)Net assets (equity) at 31 Dec 20x1 11,500

Assume these exchange rates USD/ EUR

1 Jan 20x1 1.2

Average for 20x1 1.25

31 Dec 20x1 1.15

Date Euro Exchangerate

USD

Net assets (equity) at 1 Jan 20x1 10,000 1.2 12,000Profit for the year to 31 Dec 20x1 2,000 1.25 2,500Other comprehensive income for the yearto 31 Dec 20x1

1,000 1.25 1,250

Dividend declared for the year (1,500) 1.15 (1,725)Net assets (equity) at 31 Dec 20x1 11,500 1.15 13,225

The error is an exchange difference arising in the year.

This is not considered to be a realised gain or loss, so is reported directly in equity in the

statement of changes in equity. It is not reported as part of other comprehensive income.

This does

not add u !


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So Lear Cos statement of changes in equity for the year ended 31 Dec 20x1 will show:

Date USDThis exchange gain or loss

arising on translation inthe year is a gain in the

reserves of the subsidiaryfor consolidation. It istherefore split between

parent and non-controllinginterests.

Net assets (equity) at 1 Jan 20x1 12,000Profit for the year to 31 Dec 20x1 2,500Other comprehensive income for the yearto 31 Dec 20x1

1,250

Dividend declared for the year (1,725)Exchange gain on translation arising in theyear (balancing item)

800

Net assets (equity) at 31 Dec 20x1 13,225

Groups and foreign currency

It is common to have to translate the financial statements of a subsidiary into the reporting

currency of the parent prior to consolidation.

This is simply an additional stage to complete prior to the process of consolidation.

Approach to questions with foreign subsidiaries:

1Correct the individual accounts of each company for errors/ omissions in theindividual accounts.

2Translate the subsidiarys financial statements into the presentation currency ofthe parent using the presentation rules.

3Consolidate as normal.


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Further aspects of foreign currency groups

Goodwill

Goodwill on consolidation always arises in the books of the acquirer (ie parent) since it is the

property of the parent company. The cost of buying the subsidiary from its previous owners

can be broken down into:

Net assets in the subsidiarys financialstatements (ie equity or capital plusreserves) at the acquisition date.

Consideration transferred to buysubsidiary (as shown in the

parent companys individualaccounts)

Non-controlling interestsshare of the

net assets of the subsidiary.

Goodwill arising on acquisition(premium paid to acquire thesubsidiary).

The goodwills value will vary with the exchange rate as the value of the subsidiarys future

earnings in the parents currency will vary with the exchange rate. This means that goodwill

must be revalued each year with a consequent revaluation gain or loss.

This means that each year, goodwill must be calculated similarly to how the exchange gain

or loss is calculated for the translation of the net assets of the subsidiary:

Date Euro Exchangerate

USD

Goodwill at 1 Jan 20x1 1,000 1.2 1,200Impairment loss in the year to 31 Dec20x1

(200) 1.25 (250)

Exchange difference in the year - balance 50Goodwill at 31 Dec 20x1 800 1.25 1,000

Thisgainof50isagainmadebytheparent,sopartoftheparentsreserves


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Key workings/ methodsTranslation of subsidiarys financial statements for consolidation

Statement of financial position ofsubsidiary at the year-end

Foreigncurrency

()

Exchangerate

Presentationcurrency ($)

Assets (top half of SOFP) X Year endrate

$X

Capital of subsidiary X Rate atacquisition

$X

Reserves of subsidiary @ acquisition X Rate atacquisition

$X

Post acquisition gains (balancing item) X balance $XLiabilities X Year-end

rate$X

Total equity and liabilities X $X


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Chapter 3

IAS 7

START

The Big Picture

These notes focus on group statements of cash flow. If you are unsure of single company

statements of cash flow, you should revise the notes for paper F7 before studying these.

Statements of cash flow for a group show cash and cash equivalents leaving the group of

companies and coming into the group of companies. Intra-group cash flows are not

reported.

Group statements of cash flow are generally somewhat more straightforward than groupstatements of comprehensive income in the exam, since most of the adjustments required

to group financial statements (eg intra-group balances, allowances for unrealised profit, fair

value adjustments) are non-cash adjustments.

Group statements of cash flow generally appear in question 1 of the exam, probably about

one sitting in every five. They may alternatively appear in section B of the exam, but this is

less common. They are one of the more popular subjects with students and the level of

performance in the exam itself is likely to be strong if a cash flow question comes up, so you

need to be well prepared for this topic.


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You should study group statements of cash flow after revising single company statements of

cash flow from paper F7 and studying groups for paper P2. If you are reasonably

comfortable with these two topics, group statements of cash flow are likely to give you few

difficulties.

These are the main techniques that you need to be familiar with when preparing a group

statement of cash flow over a single company statement of cash flow:

Reconciliation of profit to operating cash flow: impact of purchase/ sale of asubsidiary

Impact of purchase/ sale of subsidiary on T account workings (eg property, plant andequipment)

Cash paid to non-controlling interests

Cash received from associates Disclosures on acquisition and disposal of a subsidiary (these are simple).

Key workings/ methodsReconciliation of profit before tax to cash from operations

A reconciliation is a statement explaining why two numbers do not agree. IAS 7 (indirect

method) starts with profit before tax and reconciles this to cash flow from operations.The easiest way to do this is to reconcile EBIT (ie operating profit) to operating cash flow.An item will appear in the reconciliation if it does affect EBIT but does not affect operatingcash flow, or vice versa.

AffectsEBIT?

Affectsoperatingcash flow?

Inreconciliation?

Depreciation Yes No Yes

Impairment of goodwill in the year Yes No Yes

Credit sale made but not paid in cash (ie

increase in receivables)

Yes No Yes

Write-down of inventory to recoverablevalue

Yes No Yes

Increase in tax payable No No No

Goods purchased on credit (ie increase inpayables)

Yes No Yes

Increase in provision for warranty costs Yes No Yes


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The only addition so far compared with statements of cash flow in paper F7 is the mention

of goodwill impairment above.

Normally, an increase in receivables is deducted, since this is a credit sale (which has beencredited to revenue) but no cash received.

When a subsidiary is purchased, it is likely that the subsidiary will have receivables in its

SOFP at purchase. These will cause an increase in group receivables, but they will not have

affected group EBIT. Think about it if the receivable existed when the subsidiary was

purchased, that receivable must have been created by a pre-acquisition sale. Pre-

acquisition revenue and expenses are not consolidated.

AffectsEBIT?

Affectsoperatingcash flow?

Inreconciliation?

Increase in receivables due to purchase ofsubsidiary

No (pre-acquisition)

No No

Increase in payables/ accruals/ provisionsdue to purchase of subsidiary


No No

Increase in receivables/ prepayments dueto purchase of subsidiary


No No

This means that the usual working capital adjustments when you prepare the reconciliation

of profit to operating cash flow needs to be amended. Since the year-end figure will include

any receivables (etc) arising on a purchase of subsidiary, but these should be excluded from

the reconciliation, they must be deducted in the calculation.

EXAMPLEEdgar Co purchased a subsidiary Edmund Co on 30 September 20x1. On that date, Edmund

Co had receivables in its SOFP of $1,200.

Edgar Co and its subsidiaries at the start of 20x1 had receivables of $9,800 and on 31

December 20x1 had receivables of $11,450.


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The figure in the reconciliation of profit to operating cash flow in the year to 31 December

20x1 will be:

Increase in receivables (11,450 1,200 9,800) (450)

Key workings/ methodsAssociates, non-controlling interests

In a group statement of cash flows, cash can come into the group from an associate (an

associate is not part of the group, since its not controlled by the parent) and cash paid to

non-controlling interests. The cash paid to non-controlling interest will be their share of

dividend paid by the subsidiary.

Both of these can be calculated using a T-account (or similar presentation), using the figures

from the group SOFP.

EXAMPLEAssociate (SOFP)

1.1.x1 b/d 10,000 31.12.x1 Cash received(balancing item)

1,500

31.12.x1 Share of profit aftertax 2,000

31.12.x1 c/d 10,500

12,000 12,000

Non-controlling interests (SOFP)

1.1.x1 b/d 15,00031.12.x1 Cash paid

(balancing item)700 31.12.x1 Share of profit of

subsidiaries2,000

31.12.x1 16,800 31.12.x1 Share of othercomprehensiveincome ofsubsidiaries

500

17,500 17,500


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Effect of acquisition or disposal of subsidiary

The acquisition of a subsidiary in the year will increase the size of each item in the SOFP, as

a result of the parent having control of a greater number of (eg) non-current assets. Thisincrease will not represent a payment in cash directly for those non-current assets (any

payment of cash to acquire control of a subsidiary was a payment to acquire shares!)

This will need to be adjusted for in each item in the SOFP, eg:

Property, plant and equipment (SOFP)

1.1.x1 b/d X 31.12.x1 Depreciation expense X

31.12.x1 Finance leasesincepting in year

X

31.12.x1 Impairment losses X

31.12.x1 Acquired via controlof new subsidiary inyear

31.12.x1 Disposals @ NBV X

31.12.x1 Cash paid to acquirenew P,P&E in theyear (balancing item)

X

31.12.x1 Revaluation surplusin the year

X 31.12.x1 c/d X

XX XX

The actual acquisition itself will be shown as a single cash flow in the investing activities

section of the statement of cash flows. This will be the cash paid (if any) by the parent to

the previous owners of the subsidiary, less any cash balances of the subsidiary acquired.


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Chapter 4

IAS 37


Provisions are a form of liability, simply one of uncertain timing or amount.

If requires an obligation (something that is legally or constructively impossible to avoid by

any means). An intention is never an obligation, so an intention to incur an expense can

never generate a provision.

Initial valuation (provisions)

For a series of events (eg multiple goods sold under guarantee), use the expectedvalue of the outflow and discount if the time value of money is material.

For a one-off event (eg a single litigation), use the single most probable outcomeand discount if the time value of money is material.

Change in valuation: Update each period to the latest estimate. This is a change in

accounting estimates, so an increase of $10,000 would be recorded in profit in the year

when the estimate is changed, not as a prior period adjustment:


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Dr Expense $10,000 Cr Provision $10,000

Initial valuation (contingent liabilities)

Given a value of zero, unless on a fair value adjustment on acquisition by another company.

See groups notes.

Summary diagram

Provisions and contingent liabilities for individual companies

Probable: Greater than 50% estimated probability

Possible: Greater than 5% and up to 50% estimated probability

Remote: 5% of lower probability

Reliable: Any estimate which is more reliable than making no estimate

Provide: Provide expected value and discount at an appropriate rate.


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Chapter 5

IAS 12


Current tax: The amount demanded by the tax authority in respect of taxable gains/ losses

subject to tax in the current period. Generally an estimate at the year-end.

Deferred tax: Future tax due on gains recognised in the current period but not assessed

for tax until some future period. Generally a net liability, but can very

occasionally be a net asset.

Deferred tax is pervasive in financial statements, though it is generally examined as either a

part of a question or as a stand alone question on its own. Normally, questions instruct you

to ignore deferred tax.

In practice, you will need to consider the deferred tax position of every transaction where

the accounting policy and the tax base (tax accounting policy see below) are not the

same.


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Key definitionsThese are ExPs definitions, which are simplified for exam

preparation purposes

Tax base The carrying value of the asset as it would be in the statement

of financial position if the tax policy were used as the

accounting policy, eg using taxable capital allowances instead

of depreciation.

Temporary difference The difference between the IFRS carrying value of an asset/

liability and its tax base. Both tax base and IFRS value start

with purchase price and both will become zero when the asset

is scrapped.

Permanent difference This is not a phrase used in IAS 12, but its helpful in forming

an understanding. This is where the tax base and the IFRS

value of an asset or liability are always different, as a matter of

principle. Eg government grant income received may never be

taxable, though its income in profit.

Goodwill gives a permanent difference since impairment losses

on goodwill are never a tax deductible expense. The tax base

of an investment in a subsidiary is historical cost of purchase,so goodwill never appears at all in the tax computation. The

fact that it never appears makes it a permanent difference.

Key workings/ methods

Exchange differences will arise, eg imagine the position of Lear Co for the year ended 31

Dec 20x1:

Eg Property Software Provisions

IFRS value in SOFP 10,000 DR 4,000 DR 3,000 CRLess: Tax base 8,000 DR 500 DR 0 CRTemporary difference 2,000 DR 4,500DR 3,000 CRTax rate expected when the differencereverses

30% 30% 25%

Deferred tax 600 CR 1,350 CR 750 DR

Net deferred tax liability = 1,200 CR


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Exam approachCalculation of deferred tax liability and SOCI effect

1Go through the accounting policies of the entity and identify each one wherethe accounting policy (IFRS) is not the same as the tax base.

2Identify which of these differences are permanent differences, eg:

Business entertaining expenditure Government grants receivable Goodwill arising on consolidation.

State in your exam answer that this is a permanent difference, so has no futuretax effects.

3For each difference (other than permanent difference) calculate the temporarydifference at the period end using the working above.

4Multiply the temporary difference by the tax rate expected to be in force whenthe item becomes taxable (when it reverses).

Note: Cr temporary differences produce Dr deferred tax assets

Dr temporary differences produce Cr deferred tax liabilities

5Look at all the deferred tax assets for evidence of impairment. Offset deferredtax liabilities against deferred tax assets with the same tax authority.

6Calculate the movement on the deferred tax liability. This will be the totalcharge to the statement of comprehensive income for deferred tax.


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7Split the movement on deferred tax liability in the year into the elementreported in other comprehensive income and the rest that will be reported aspart of the profit and loss charge for taxation in the period.

This is done by matching the movement on deferred tax (eg caused by aproperty upward revaluation) with where the gain or loss causing thatmovement in deferred tax was reported.

7AWork out the movement indeferred tax due to itemsreported in equity, eg:

Property revaluationgains

Movements in value onavailable-for-salefinancial assets

Take the proportion ofdeferred tax movement onequity gains to equity.

7B Show the movement in deferredtax that isnt shown as gains takento equity (step 7A) and show thisas the deferred tax movement in

profit.


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Chapter 6

IAS 19


Promises of pensions payable to staff are an expense of the sponsoring company. The act

of making a promise to pay pensions creates an obligation (ie liability). This may be a

liability to pay pension funds into a private pension plan, or a liability to pay a pension

between retirement and death, depending on the pension type.

There are two types of pension plan: defined contribution and defined benefit.

Pension costs are fairly frequently examined. Although they seem difficult at first, they are

surprisingly easy to deal with after working a few examples. To master the subject, you

need to have:

A good working understanding of double entry bookkeeping To understand the transaction itself (ie how a promise is made and assets set aside

to cover the cost of honouring that promise)

A methodical step-by-step approach to dealing with the numbers in a logical,chronological, sequence.


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Defined contribution

These are easy. The employer makes contributions into a savings scheme for the employee.

All risks of the fund being inadequate to support the employee between retirement and

death rest with the employee, not with the employer. They are therefore much more risky

for the employee than for the employer.

The accounting is simple:

Impact on SOFP: None.

Impact on SOCI: Contributions payable into the pension plan are an expense.

Defined benefit plans

These are considerably more complicated for the accountant and considerably more risky for

the employer.

Here, the employer promises to make future pension payments (an obligation, therefore a

liability).

Impact on SOFP: Pension plan assets (ringfenced assets from which future pensions will

be paid).

Pension plan liability (NPV of pensions promised by the year-end)

Deferred costs and income (see below)

Impact on SOCI: Service component: the cost of pensions promised in the year (current

service cost and past service cost) that is charged to P/L.

Net interest component: computed by applying the discount rate to

measure the plan obligation to the net defined benefit liability or asset.

This is charged/credited to P/L.

Remeasurement component: includes actuarial gains and losses

during the reporting period, including the returns on plan assets less

any amount taken to P/L as part of net interest component. This is

charged to OCI and will never be recycled to P/L in future periods.

Actuarial gains/ losses

If a pension plan is perfectly in balance, then the assets will precisely equal the liabilities.

This is unlikely ever to happen, as the valuation of investments will be volatile. Also,


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assumptions about the actuarial liability (ie expected cost of paying an uncertain amount to

pensioners until they die) will vary year by year. It is normal for a pension plan therefore to

be slightly out of balance.

Assets LiabilitiesThese unexpected movements give an actuarial gain or loss each period and are always a

balancing item in the calculations, since (by definition) they are unexpected!

Key definitionsThese are ExPs definitions, which are simplified for exampreparation purposes

Current service cost The NPV of the extra pensions promised to staff in return for

work they did this period. Defined benefit plans are

characterised by offering greater pensions to people who have

worked for the company longer, so one extra period of service

increases pensions liability.(part of the service cost

component).

Past service cost The NPV of the extra pensions promised to staff in return for

work they did in the past. This is much less common than

current service cost and might happen only if a company needsto eliminate an actuarial surplus on the pension plan (part of

service cost component)..

Net interest component Relates to change in measurement in both the plan obligation

and the plan assets arising from passage of time ans is reported as a separate component to

P/L.

Deficit


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EXAMPLECordeliaCo

Below are given the fictional numbers of Cordelia Co, relating to Cordelia Cos defined

benefit pension plan in the year to 31 December 20x1.

Plan assets Pensionsliability

Profit andloss effect

B/f @ start of period 10,000 DR 9,500 CR -

Current service costs - 500 CR 500 DR

Past service costs - 200 CR 200DR

Interest charge - 450 CR 450 DR

Contributions paid into the plan

(Dr Plan assets, Cr company cash)

180 DR - -

Pensions paid to pensioners 210 CR 210 DR -

Interest return 600 DR - 600 CR

Expected figure c/f 10,570 DR 10,440 CR

Actual figure c/f 8,650 DR 10,200 CR

=> Remeasurement component (gain) 240 DR See below

=> Remeasurement component (loss) 1,920 CR See below

Net actuarial loss in year 1,680 CR See below

Recognition of actuarial gains and losses

Actuarial gains and losses arise each year. Often they are self-correcting over time (eg a

short-term stock market crash is likely to recover by it comes time to pay out the pensions

promised).

Actuarial gains and losses arising during the accounting period (comprised in the

remeasurement component) are recognised in OCI for the year and will not be recycled to

P/L in future periods.


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Chapter 7

IAS 39


Although financial instruments appear frequently in the P2 exam, they are only at level 2

knowledge within the syllabus. This means that the scenarios in which they are tested are

likely to be relatively straightforward.

Its easy to spend too much time preparing for these accounting standards, since they cover

a huge array of different possible transactions, from regular trade receivables to exotic

currency and interest rate swaps.

The best way to approach study is to know:

The classifications of all financial instruments The difference in fair value and amortised cost accounting The possible ways in which any gain or loss (whether on a financial instrument or

not) may be reported in financial statements.

If you are keen to take this as far as you can, then move on to study hedging, though this

has generally only been worth a couple of marks in the exam.


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Financial liabilities Financial assets

When used...Example.... Trade payables, debenture

loans, redeemablepreference shares

Trade receivables, options,investments in equity shares

-Initial recognition Fair value Fair value and will exclude

transactions costs for allassets kept at FVPL

Subsequent measurement Fair value (derivatives andliabilities held for trading) oramortised cost..

Fair value (either to P/L orOCI) or amortised cost lessimpairements.

Gains or losses reported in... Profit or loss Profit or loss/OCI

When used...Example....Example that cant becategorised this way

Initial recognised valueYear-end valuation methodGains or losses reported in...


Recognition and derecognition

The recognition criteria for financial instruments are slightly different to the recognition

criteria in many other IASs/ IFRSs. The intention is to ensure that as many as recognised as

possible, for as long as possible. They are recognised when the entity becomes party to the

contract rather than when control is obtained. They are derecognised only when its virtuallycertain that all the risks of a financial instrument have expired or have been transferred to

another party.

Fair value accounting

Fair value essentially means market value. So if the market is acting irrationally, then fair

value may lead to dysfunctional financial reporting. This is a recent criticism of fair value

accounting techniques.


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Fair values are determined as:

Best achievable market value (but not deducting expected transaction costs), or Valuation using discounted cash flows that consider all matters relevant (eg expectedcash flows, timing of cash flows, credit risk, market interest rates, or Exceptionally if no reliable DCF valuation is possible, historical cost.

Amortised cost

Can apply to debt instruments only if the following two tests are passed:

the business model test, and the contractual cash flow characteristics test.

The business model test establishes whether the entity holds the financial asset to collectthe contractual cash flows or whether the objective is to sell the financial asset prior tomaturity to realise changes in fair value. If it is the former, it implies that there will be no orfew sales of such financial assets from a portfolio prior to their maturity date. If this is thecase, the test ispassed. Where this is not the case, it would suggest that the assets are not being held withthe objective to collect contractual cashflows, but perhaps may be disposed of to respond tochanges in fair value. In this situation, the test is failed and the financial asset cannot bemeasured at amortised cost.

The contractual cash flow characteristics test determines whether the contractualterms of the financial asset give rise to cash flows on specified dates that are solely ofprincipal and interest based upon the principal amount outstanding. If this is not thecase, the test is failed and the financial asset cannot be measured at amortised cost.

For example, convertible bonds contain rights in addition to the repayment of interest andprincipal (the right to convert the bond to equity) and therefore would fail the test andmust be accounted for as fair value through profit or loss.

In summary, for a debt instrument to be measured at amortised cost, it will thereforerequire that:

the asset is held within a business model whose objective is to hold the assets to collectthe contractual cashflows, and the contractual terms of the financial asset give rise, on specified dates, to cash flows thatare solely payments of principal and interest on the principal outstanding.

EXAMPLE


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On 1 January 20x1, Cordelia Co issued a bond with a nominal value of $200,000, a coupon

rate (ie cash paid) of 4% of nominal value. The bond is due for redemption on 31

December 20x5 for $200,000 (plus the coupon payable on that date).

In reality, its likely that the effective rate would be worked out using a spreadsheet and the

IRR function, which is illustrated below.

This means that by the end of the five year life of the bond, it has been transformed

(amortised) from its initially recognised value to its redemption value of $200,000.

So the charge or credit to profit for finance costs/ finance income is determined using the

effective rate. The difference between interest calculated using the effective rate and the

coupon paid/ received is the rolled up interest, which is added to the value of the bond

each year.

Reclassication

Where an entity changes its business model, it may be required to reclassify its financialassets as a consequence, but this is expected to be infrequent occurrence. If reclassificationdoes occur, it is accounted for from the first day of the accounting period in whichreclassification takes place.

Impairments


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All financial assets held at fair value are automatically revalued for impairments. If a

financial asset measured at amortised cost appears to be impaired (eg if the credit risk

increases a great deal), then the new impaired value must be calculated using:

The revised expected cash flows and expected timing At the original discount rate.

Note that discounting the revised cash flows at the new rate (which would be higher, as the

risk has increased) would double count the risk factor and result in undervaluation of the

asset.

Hedging

The Big Picture

Hedging has only occasionally been tested in paper P2 and then normally as a relatively

minor adjustment in question 1. It is common in practice and useful knowledge. Becoming

expert in hedging should not be a top priority for most students studying for paper P2, since

it can take a lot of time to master for a relatively low profile in the exam itself.


Hedged item: The thing the enterprise is worried about changing in value, eg:

Foreign currency investment Foreign currency payable Variable interest rate loan resulting in higher than expected cash outflows Forecast future major purchase in a foreign currency becoming unaffordable due to

changes in the exchange rate.

To remove or reduce this risk, the entity may buy something that is expected to move in

value in the opposite direction to the hedged item. This counterweight is the hedging

instrument and may be an almost infinite number of different financial instruments,

though derivatives are common. Understanding the intricacies of how hedging relationships

may be set up is not important for paper P2. Its useful to know how to account for

movements in the hedged item and the hedging instrument.


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Though three types of hedge are mentioned in IAS 39, there are only two accounting

treatments for hedges, so there are basically two types of hedge:

Fair value hedge. The hedging instrument was taken out in order to protect against value

changes of an item recognised in the SOFP. Eg a foreign currency loan to protect against a

foreign exchange chage in value ofa foreign currency receivable that is being shown in the

SOFP.

Cash flow hedge. A hedge that is not a fair value hedge, broadly! This might be to

protect against adverse movements in an item not in the SOFP yet. Eg an entity may

structure its business plan around buying a ship from a foreign ship builder, but it has notyet placed a binding order. As there is no binding order, there is no obligation, so there is

no liability. The forecast/ intended transaction is not yet a liability, though the company will

want to ensure that they can afford the expected future cash outflow.

To protect against adverse exchange movements making the ship unaffordable, the entity

may hedge the foreign currency exposure, eg buy buying a foreign currency forward

contract.

Accounting for hedges

A fair value hedge is simple. Both the hedged item and hedging instrument will be in the

SOFP and will record a gain and a loss. The accounting rules simply offset the gain on the

hedged item with the loss on the hedging instrument, or vice versa.

A cash flow hedge is a bigger challenge for the writers of the IAS! The hedging instrument

will be a contract, so will be in the SOFP, but the hedged item will be an intention, so is not

in the SOFP. Since the hedging instrument exists only because of the expected existence of

the hedged item, the gain or loss on the hedging instrument is hidden in equity until the

hedged transaction takes place.


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Chapter 8

IFRS 2


Prior to IFRS 2, listed companies often paid senior staff in shares that were issued below

market value. These shares were then sold at a profit by the holders, with two effects:

The holder made a profit on sale, which in substance was part of their totalremuneration, and

The other shareholders lost wealth (ie suffered an expense) as the share price fell bynew shares being issued below market price.

Prior to IFRS 2, this was simply recorded as:

Dr Cash (with actual cash received, below market value)

Cr Capital/ share premium account.

IFRS 2 remedies this by making an estimate of the loss to other shareholders by granting

cheap shares and spreading that cost over the period the company gains benefit from the

share scheme.

IFRS 2 is an unpopular accounting standard with many preparers of accounts, who say that

it generates artificial expenses, brings in highly subjective valuations as expenses and

repeats the same information as IAS 33 diluted earnings per share.


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KEY KNOWLEDGESuggested approach to questions

1Decide whether the scheme is entirely payment in shares, is a payment in cashthat is linked to the share price or some mix of the two. This decides how theshare based payment is valued, as the rules are different for pure equity schemesand schemes in cash.Equity settled: The holder is paid only in shares. He/ she has no right to a cashalternative.

1AFor an equity settled transaction,estimate the total benefit of theshare plan to the holders bymultiplying the total number ofcheap shares to be issued by theoption of the share at its grantdate. This option value will begiven in the exam. It is thenfrozen at the value per share atthe grant date it is never

updated.

1B For a cash based payment, estimatethe total liability that the plangenerates. As this is a liability, itmust be revalued at the end ofeach period to its latest value.

2Work out the vesting period. That is the period that staff must stay in thecompanys employment to be able to exercise their options over cheap shares.This is the period over which the cost/ benefit of the share option plan will bespread.

3Work out the cost of the share based payment each period, as:

Latest estimate of total cost of the plan X (Expected total cost)Divided by years between grant and vesting date X (Total cost to date)Less: Costs cumulatively already recognised (X)Current period expense X


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REVIEW AND TEST 1The Crossmen

On 1 January 20x1, Crossmen Coropration granted 5,000 options on shares to each of its

200 most senior staff. Each option is conditional upon each member of staff staying in the

companys employment until 31 December 20x3. On 31 December 20x3, participating staff

can continue to hold the share options and may choose to exercise them on 31 December

20x4 or 31 December 20x5. Each option allows the holder to buy Crossmen Co shares at a

price of $1 each.

You are given this data and are required to calculate the expense for each of the years in

question.

Date Fair value ofoption ($)

Number ofparticipantsexpected tostay until 31

Dec 20x3

Share price($)

1 Jan 20x1 3.30 180 4.0031 Dec 20x1 3.40 175 4.20

31 Dec 20x2 3.45 180 4.2531 Dec 20x3 2.95 165 3.8031 Dec 20x4 3.10 165 3.9531 Dec 20x5 3.30 165 4.30

Step 1: This is a pure equity settled transaction. Its value per share option is therefore

frozen at the grant date.

Total expected cost to the companys other shareholders: 5,000 x 180 x 3.30 = $2.97

million.

Step 2: The vesting period is three years. Although people may stay longer than that, the

company cannot presume that they will voluntarily stay longer than the minimum required.

Step 3: The cumulative cost in each year is now worked out.


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Date Cumulative

expense ($)

Expense

previouslyrecognised

Expense

recognisedin year

31 Dec 20x1 (5,000 x $3.30 x 175 x 1/3) 962,500 0 962,50031 Dec 20x2 (5,000 x $3.30 x 180 x 2/3) 1,980,000 962,500 1,017,50031 Dec 20x3 (5,000 x $3.30 x 165 x 3/3) 2,722,500 1,017,500 742,50031 Dec 20x4 (5,000 x $3.30 x 165 x 3/3) 2,722,500 2,722,500 031 Dec 20x5 (5,000 x $3.30 x 165 x 3/3) 2,722,500 2,722,500 0

The expense each year is recognised as:

Dr Expense

Cr Equity.

REVIEW AND TEST 2Wright

On 1 January 20x1, Wright Co granted 15,000 cash appreciation rights to 150 of its staff.

These rights gave a bonus in cash based on the price of Wright Cos shares. The cash

appreciation rights offered a cash payment equal to the companys share price at the

exercise date, less the share price at the grant date. Participants have to stay in Wright Cos

employment until 31 December 20x3 in order for the rights to vest, though they may

exercise on either 31 December 20x3, 31 December 20x4 or 31 December 20x5.

Date Number ofoptions

exercised inthe period(000s)

Number ofparticipants

expected tostay until 31Dec 20x3

Share price($)

1 Jan 20x1 0 140 1.2031 Dec 20x1 0 140 1.4531 Dec 20x2 0 142 1.5031 Dec 20x3 1,100 144 1.5231 Dec 20x4 800 144 1.6031 Dec 20x5 260 144 1.48


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Step 1: This is a cash settled transaction, which therefore gives rise to a liability. As a

liability, the expected value must be revalued each year.

Step 2: The vestin

p2 exp notes

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