Moorland Group's Financial Statements: Income & Capital Analysis, Lecture notes of Accounting

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Professional Level – Essentials Module, Paper P2 (UK) Corporate Reporting (United Kingdom) September/December 2017 Sample Answers 1 (a) Consolidated statement of profit or loss and other comprehensive income for the Moorland Group for the year ended 30 June 2017 Total $m Revenue 887 Cost of sales (531) –––––– Gross profit 356 Administrative costs (142) Other expenses (85·9) –––––– Operating profit 128· Net finance costs (23·8) –––––– Profit before tax 104· Income tax expense (50·2) –––––– Profit for the year 54· –––––– Other comprehensive income Items that will not be reclassified to profit or loss Gains on property revaluation 61· Pension remeasurement loss (4·2) –––––– 57· Items that may be reclassified to profit or loss Exchange losses (85·9) –––––– Other comprehensive income (28·3) –––––– Total comprehensive income for year 25· –––––– Non-controlling interest profits (W9) 13· Shareholders of Moorland profits (balance) 40· –––––– Profit for the year 54· –––––– Non-controlling interest total comprehensive income (W9) 20· Shareholders of Moorland total comprehensive interest (W10) 5· –––––– Total comprehensive income for the year 25· ––––––

Working 4: Tybull goodwill The goodwill impairment of Tybull will be calculated as follows: dinar million Cost 990 Less net assets at acquisition (888) –––––– Goodwill at acquisition 102 Impairment at 25% (25·5) –––––– Goodwill for consolidated SFP 76· –––––– An exchange difference will arise on goodwill in the current year by comparing goodwill at the opening rate of exchange with goodwill at the closing rate of exchange. $m Goodwill of dinar 102m at opening rate of $1:3·5 dinar 29· Impairment of dinar 25·5m at average rate of $1:4 dinar (6·4) Exchange loss on goodwill (balancing figure) (7·4) ––––– Goodwill of dinar 76·5m at closing rate of $1:5 dinar 15· ––––– Consequently $6·4 million will be expensed to other expenses (W1). A loss arises in other comprehensive income of $7·4 million (W6). Working 5: Tybull translation The intra-group transaction between Tybull and Moorland will need to be cancelled in the consolidated financial statements. Since the profits of Tybull will be translated at the average rate of exchange of $1:dinar 4, the adjustment will be $30m (120m dinar/4 (W1)). Unrealised profit of dinar 36m ((dinar 120m x 60/160) x 80%) will arise on the group transaction. Tybull’s profit for the year will be adjusted for the extra depreciation arising from the fair value adjustment. Additional depreciation of dinar 24m will be expensed (48m/2) as part of cost of sales. Tybull’s profits will then be translated at the average rate of exchange as follows: dinar (millions) $ (millions) Revenue 540 135 Cost of sales (296 ) (74 ) Depreciation adjustment (24 ) (6 ) PURP (36 ) (9 ) Administrative costs (52 ) (13 ) Other expenses (40 ) (10 ) Net finance costs (16 ) (4 ) Income tax expense (28 ) (7 ) –––– –––– Profit after tax 48 12 –––– –––– Note that cost of sales will be $89m ($74m + $6m +$9m) (W1). Working 6: Other exchange differences on Tybull Further exchange differences will be recorded in other comprehensive income on the opening net assets of Tybull and their profit for the year. The opening net assets are given as dinar 888 million. The exchange difference is calculated by translating this at the opening and closing exchange rates. dinar 888 million at opening rate of $1:dinar 3·5 = $253·7 million. dinar 888 million at closing rate of $1:dinar 5 = $177·6 million. An exchange loss of $76·1 million arises ($253·7m – $177·6m) The revised profit of Tybull for the year is dinar 48 million (W5). An exchange difference arises by comparing the profit at the average rate of exchange ($12 million (W5)) with the closing rate of $1:5 dinar. Profit of dinar 48 million at closing rate of 5 = $9·6 million. A further exchange loss arises of $2·4 million ($12m – $9·6m). (Tutorial note: This excludes the goodwill impairment of Tybull since this forms part of the exchange difference on goodwill (W6) ) Total exchange differences to total comprehensive income are therefore $85·9 million ($7·4 million (W4) + $76·1 million + $2·4 million). Working 7: Revaluation of property, plant and equipment A revaluation gain arises on the property of Moorland of $64 million ($450m – $386m). This will be included within other comprehensive income. A deferred tax liability will arise of $69 million (($450m – $220m) x 30%) at 30 June 2017. The movement on deferred tax should be posted each year and the opening deferred tax balance would have been $36·6 million

(($422m – $300m) x 30%). Deferred tax must be reported in the financial statements to match the corresponding gains and losses. The movement in deferred tax is an increase of $32·4 million ($69m – $36·6m). Deferred tax on the revaluation gain must be reported in OCI of $19·2 million ($64m x 30%). This means that $13·2 million ($32·4m – $19·2m) must be added to the tax expense in the year. The necessary adjustment is summarised as follows: Dr PPE $64m Dr Income tax expense $13·2m Cr Deferred Tax $32·4m Cr Revaluation surplus/OCI ($64m – $19·2m) $44·8m Working 8: Pension scheme The benefits paid can be ignored as they will not alter the net pension deficit for the year. The service cost component and net interest component must be expensed against profit or loss. The cash contributions do not affect the statement of total comprehensive income as they will reduce Moorland’s cash balance but increase the pension scheme’s assets. A remeasurement component should be calculated and recorded in other comprehensive income for the year as follows: $ millions Net deficit at 30 June 2016 30 Net finance cost for the year (30 x 6%) 1· Service cost component 15 Cash contributions (9) Remeasurement loss (balancing figure) 4· ––––– Net deficit at 30 June 2017 42 ––––– The necessary adjustment is summarised as follows: Dr Finance cost $1·8m Dr Administrative expenses $15m Dr OCI $4·2m Cr Pension liability $12m Cr Cash $9m Working 9: Non-controlling interests Non-controlling interest share of profits: $m Lyndhurst: 40% x $33·5m (W1) 13· Non-controlling interest share of total comprehensive income: $m Lyndhurst: 40% x $50·5m (W1) 20· Working 10: Total comprehensive income Moorland $m Moorland profit for the year (W1) 15 Moorland property revaluation 44· Pension remeasurement loss (4·2) Lyndhurst (60% x $50·5m) (W1) 30· Tybull (100% x $5·6m) (W1) 5· Exchange loss (W6) (85·9) ––––– 5· ––––– (b) The plant should be initially recognised at cost of $2·72 million which is the present value of the future payment ($3 million x 1/(1·05)2). The unwinding of the discount would result in interest expense recognised in profit or loss for the three months until the revaluation of $34,000 ($2·72 million x 0·05/4). The interest would be unwound over the two-year period until the initial liability of $2·72 million is built up to the final liability of $3 million when, on the cash payment, it would be de-recognised. Under both IFRS for SMEs and FRS 102 The Financial Reporting Standard applicable in the UK and the Republic of Ireland , an entity should change an accounting policy only if the change: (a) is required by changes to the standard; or (b) results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity’s financial position, financial performance or cash flows. Under both standards, the following are not changes in accounting policies: (a) the application of an accounting policy for transactions, other events or conditions which differ in substance from those previously occurring;

Therefore, Formatt controls the specialised equipment before the equipment is transferred to the customer and is therefore the principal in this transaction. Formatt is also responsible for any defects. The supplier cannot decide to use the specialised equipment for another purpose as the equipment must be delivered to the customer to fulfil the promise in the contract. Formatt has the responsibility for fulfilling the contract, determines the price of the contract, is not paid on a commission basis and has the credit risk. (c) The Conceptual Framework defines an asset as a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. The existing Conceptual Framework does not define control. The Exposure Draft: Conceptual Framework for Financial Reporting defines an asset as a present economic resource controlled by the entity as a result of past events. It goes on to say that control links the economic resource to the entity and that assessing control helps to identify what economic resource the entity should account for. For example, if an entity has a proportionate share in a property without controlling the entire property, the entity’s asset is its share in the property, which it controls, not the property itself, which it does not. An entity controls an economic resource if it has the present ability to direct the use of the economic resource and obtain the economic benefits which flow from it. However, risks and rewards can be a helpful factor to consider when determining the transfer of control. The entity should consider whether the contractual rights to the cash flows from the asset have expired as, if so, the asset should be derecognised. Second, if the contractual rights to the cash flows have not expired, as is the case with Formatt, the entity should consider whether it has transferred the financial asset. When an entity transfers a financial asset, it should evaluate the extent to which it retains the risks and rewards. IFRS 9 Financial Instruments provides three examples of when an entity has transferred substantially all the risks and rewards of ownership. These are an unconditional sale of a financial asset, sale of a financial asset with an option to repurchase the financial asset at its fair value and sale of a financial asset which is deeply ‘out of the money’. Thus in this case, even though most of the cash flows which are derived from the loan are passed on to Window (up to a maximum of $7 million), Formatt is essentially still in ‘control’ of the asset as the risks and rewards have not been transferred because of the subordinated retained interest. Formatt’s residual interest also absorbs the potential credit losses. If Formatt has neither retained nor transferred substantially all of the risks and rewards of ownership, the assessment of control is important. If control has been retained, the entity would continue to recognise the asset to the extent of its continuing involvement. However, as Formatt has retained the risks and rewards, it should recognise the financial asset in the statement of financial position and the 12-month expected credit losses. 3 (a) (i) IFRS 15 Revenue from Contracts with Customers sets out the core principle that an entity will recognise revenue to depict the transfer of promised goods or services to customers in an amount which reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This principle is delivered through a five-step model. Once the contract with the customer has been identified, step 2 of the model identifies those elements of the contract which should be accounted for separately. The performance obligations should be identified at the beginning of the contract by identifying distinct goods or services in the contract. To do so, the entity should identify all the goods and services which have been promised. The distinct performance obligations are the units of account which determine when and how revenue is recognised. A good or service is distinct only if the customer can benefit from the good or service either on its own or together with other resources available to the customer and the good or service is separately identifiable from other promises in the contract. A customer can benefit from a good or service on its own if it can be used, consumed, or sold to generate economic benefits. Determining whether a good or service is distinct within the context of the contract requires assessment of the contract terms and the intent of the parties. Thus in the case of Darlatt, the entity is required to assess whether the deliverables it has promised to the customer give rise to separate performance obligations. The purchase of the wind turbine and the maintenance contract are obviously separate performance obligations. However, the two warranties require further consideration. The nature of the warranty will determine the accounting impact. IFRS 15 states that an entity accounts for a warranty as a separate performance obligation if the customer has the option to purchase the warranty separately. An entity accounts for a warranty as a cost accrual if it is not sold separately, unless the warranty is to provide the customer with a service in addition to assurance that the product complies with agreed specifications. The free warranty simply provides the customer with the assurance that the wind turbine meets the agreed specification and thus is not a separate performance obligation. Where the warranty provides an additional service as is the case with the ten-year warranty, then the income will be treated as deferred revenue. Once the separate performance obligations have been identified, then the transaction price is allocated to them based on the relative stand-alone selling prices of the goods or services promised. This allocation is made at contract inception and not adjusted to reflect subsequent changes in the stand-alone selling prices of those goods or services. The best evidence of stand-alone selling price is the observable price of a good or service when the entity sells that good or service separately. Therefore, the wind turbine will be allocated with ($3·2m/$4·1m x $3·6m), i.e. $2·8 million and the maintenance contract with ($0·9m/$4·1m x $3·6m), i.e. $0·8 million of the total revenue. Thus the maintenance contract and additional warranty will be recognised over time and the sale of the wind turbine and free warranty will be recognised at a

point in time. Where revenue is recognised over time, a method should be used which best reflects the pattern of transfer of goods or services to the customer. In this case, it would appear that both of the above elements would be recognised over 10 years. (ii) The contract is not accounted for under IFRS 9 Financial Instruments. The contract is simply a right and an obligation to exchange economic resources (or to pay or receive the difference in values between two economic resources if the contract will be settled net). The entity should therefore apply the general measurement concepts in the Conceptual Framework and the relevant IFRS. The result in this case would be that the contract would be measured at zero and hence is not recognised unless the contract is onerous. If an entity enters into a forward contract to purchase a resource at a future date, the entity’s asset is normally its right to buy the underlying resource, not the underlying resource itself. However, there may be circumstances in which the terms of a forward contract to purchase a resource give the purchaser control of that resource. In such circumstances, the purchaser should identify both an asset (the underlying resource which it already controls) and a liability (its obligation to pay for the resource). In practice, obligations under contracts which are not performed would not be accrued in the financial statements. For example, the liability for the steel ordered but not yet received would not generally be recognised as a liability in the financial statements. If historical cost measurement is applied to the contract, the contract would be measured at zero which has the same practical effect as not recognising the contract unless it is onerous. However, in order to achieve consistency with the existing requirements in IAS 2 Inventories , a contract would be regarded as onerous if the contractual price payable for the inventory exceeded its net realisable value. At 31 August 2017, the price which Dalatt would have to pay for the steel would be (2,000 tonnes x €400/1·75), i.e. $457,142. At the time of the contract, the contract price would have been (2,000 tonnes x €400/2), i.e. $400,000. Therefore it can be argued that a provision of $57, should be made as the fall in the dollar/euro exchange is unlikely to be reversed. The deposit paid of €100,000 is a non-monetary item as it is non-refundable. IAS 21 The Effects of Changes in Foreign Exchange Rates states that the essential feature of a non-monetary item is the absence of a right to receive or an obligation to deliver a fixed or determinable number of units of currency. The standard further gives an example of non-monetary items as amounts prepaid for goods and services. Non-monetary items which are measured in terms of historical cost or fair value are translated using the exchange rate at the date of the transaction or at the date when the fair value was measured. Thus the deposit will be stated at $50,000 in the financial statements under current assets. (b) FRS 102 The Financial Reporting Standard applicable in the UK and the Republic of Ireland gives examples of the development phase of a project as the design, construction and testing of pre-production or pre-use prototypes and models and the design of tools, jigs, moulds and dies involving new technology and the design, construction and operation of a pilot plant which is not of a scale economically feasible for commercial production. Commercial production is not defined in FRS 102 but it would suggest that it includes an approved technology or any output from its use being available for sale to customers. The wind farm is essentially a test site to create knowledge about the design of future wind turbines to create a more efficient and cost effective product. There has not been commercial production of the wind turbine because of doubts over its durability and therefore the designation of the farm as a development project should remain until the technology has been proven. Once commercial production commences, then the development phase is complete. During the development phase, these costs should be treated as intangible assets if they meet the capitalisation requirements in FRS 102. These requirements include its technical feasibility for use or sale, the entity’s intention to complete the intangible asset and use or sell it, the generation of probable future economic benefits, the availability of adequate resources to complete the development and the entity’s ability to measure reliably the expenditure on the development. However, judgement will have to be used to determine whether these assets should be recorded as property, plant and equipment as they are actually producing energy. Under FRS 102, an entity measures intangible assets after initial recognition using the cost model or the revaluation model. Where the revaluation model is selected, this is applied to all intangible assets in the same class. If an intangible asset in a class of revalued intangible assets cannot be revalued because there is no active market for this asset, the asset is carried at its cost less any accumulated amortisation and impairment losses. However, under IFRS for SMEs, an entity measures intangible assets at cost less any accumulated amortisation and any accumulated impairment losses. 4 (a) (i) Importance of information concerning an entity’s capital Essentially there are two classes of capital reported in financial statements, namely debt and equity. However, debt and equity instruments can have different levels of right, benefit and risks. Hence, the details underlying a company’s capital structure are absolutely essential to assessing the prospects for changes in a company’s financial flexibility, and ultimately, its value. For investors who are assessing the risk profile of an entity, the management and level of an entity’s capital is an important consideration. Disclosures about capital are normally in addition to disclosures required by regulators as their reasons for disclosure may differ from those of the International Accounting Standards Board (IASB). The details underlying a company’s capital structure are essential to the assessment of any potential change in an entity’s financial standing.

(b) In the case of the first class of preference shares, even though there are negative consequences of not paying dividends on the preferred shares as agreed contractually, the company can avoid the obligation to deliver cash. The preferred shares do have redemption provisions but these are not mandatory and are at the sole discretion of the management committee and therefore the shares should be classified as equity. In the case of the second class, the contractual term requires no dividend to be paid to ordinary shareholders if a payment is not made on the preferred shares. In this case, as Amster can avoid the obligation to settle the annual dividend, the shares are classified as equity. Thus $75 million should be transferred from liabilities to equity. IFRS 2 Share-based Payment states that cash settled share-based payment transactions occur where goods or services are paid for at amounts which are based on the price of the company’s equity instruments. The expense for cash settled transactions is the cash paid by the company and any amounts accrued should be shown as liabilities and not equity. Therefore Amster should remove the following amount from equity and show it as a liability. Expense for year to 30 November 2017 is: ((1,500 – 180 employees x 250 awards x $35) x 1/3 = $3·85 million As a result of the adjustments to the financial statements, Amster’s gearing ratio will be lowered significantly as the liabilities will drop from 53·8% of total capitalisation to 33·2% of total capitalisation. However, the ROCE may stay the same even though there is an increase in shareholders equity as total capitalisation has not changed. However, this will depend upon the definition used by the entity for capital employed. Amster Group – capitalisation table 30 November 2017 Adjustment 30 November 2017 ($ million) ($m) ($ million) Long-term liabilities 81 3·85 84· Pension plan deficit 30 30 Cumulative preference shares 75 (75) – –––– ––––––– Liabilities 186 114· –––– ––––––– Non-controlling interest 10 10 Shareholders equity 150 (75 – 3·85) 221· –––– ––––––– Group equity 160 231· –––– ––––––– Total capitalisation 346 346 –––– –––––––

Professional Level – Essentials Module, Paper P2 (UK) Corporate Reporting (United Kingdom) September/December 2017 Sample Marking Scheme Marks 1 (a) Lyndhurst – legal fee 1 Lyndhurst – step acquisition 2 Lyndhurst – goodwill and impairment 3 Tybull – intra group and PURP 4 Tybull – fair value adjustment 2 Translation at average rate 1 Tybull goodwill and impairment 4 Exchange differences 4 Revaluation and deferred tax 4 Pension 4 NCI calculations 2 Other comprehensive income parent 3 SOPL presentation 1 ––– 35 (b) 1 mark per sensible point 8 (c) 1 mark per sensible point. Maximum of 4 marks per rationale intra group transactions and max of 4 marks per ethics Maximum 7 ––– 50 ––– 2 (a) 1 mark per point up to maximum 8 (b) 1 mark per point up to maximum 7 (c) 1 mark per point up to maximum 8 Professional marks 2 ––– 25 ––– 3 (a) (i) 1 mark per point up to maximum 8 (ii) 1 mark per point up to maximum 7 (b) 1 mark per point up to maximum 8 Professional marks 2 ––– 25 ––– 4 (a) (i) 1 mark per point up to maximum 8 (ii) 1 mark per point up to maximum 6 (b) 1 mark per point up to maximum 9 Professional marks 2 ––– 25 –––