Comisión de Interior - BOLETÍN OFICIAL DE LAS CORTES GENERALES

Financial Reporting (International Stream) December 2003 Answers 1 (a) Consolidated Balance Sheet of Highmoor as at 30 September 2003:

$ million $ million Assets

Non-current assets

Tangible (585 + 172) 757 Intangible

Consolidated negative goodwill (40 – 19 (w (ii))) 1(21) Software (w (v)) 124 Investments (225 – 160 shares – 50 loan (w (iv)) + 13) 128 ––––

1788

Current assets

Inventory (85 + 42) 127 Accounts receivable (95 – 4 in transit (w (iv)) + 36) 127 Tax asset 180

Bank (20 + 9 in transit (w (iv))) 129 363 –––– ––––– Total assets 1,151 ––––– Equity and liabilities

Capital and reserves:

Ordinary shares $1 each 400 Accumulated profits (w (i)) 305 –––– 705 Non-current liabilities

12% loan notes 1 35 Minority interest (w (iii)) 1 43 Current liabilities

Accounts payable (210 + 71) 1281 Overdraft 1117

Taxation 1170 368 –––– ––––– Total equity and liabilities 1,151 ––––– Workings (Note: all figures in $ million)

(i) Accumulated profits

Highmoor Slowmoor Highmoor Slowmoor Unrealised profit (w (v)) 116 B/f 330 115 Minority interest (20% x 115) 123 Post acq loss 1(28)

Pre-acq profit (80% x 150) 120 Realisation of negative

goodwill (w (ii)) 119 Post acq loss (80% x 35) (28)

Balance c/f 305

–––– –––– –––– –––– 321 115 321 115 –––– –––– –––– –––– (ii) Cost of control

Investments at cost Ordinary shares

(100 x 80% x $2) 160 (80% x 100) 180 Pre acq profit (w (i)) 120 Negative goodwill 140

–––– ––––

200 200

–––– ––––

The contingent consideration has not been included in the above calculation. IAS 22 ‘Business Combinations’ only requires contingent consideration to be included in the cost of an acquisition if it is probable that the amount will be paid and it can be measured reliably. The additional $96 million (i.e. $1·20 per share) is only payable if Slowmoor makes a profit within two years of acquisition. In the year since acquisition the company made a loss of $35 million, much higher than the $15 million in its acquisition plan, and the directors of Highmoor are now less confident of the future prospects of Slowmoor. This seems to indicate that it is unlikely that any further consideration will be paid and the above treatment is justified.

The negative goodwill of $40 million will be realised as follows:

Attributable to: Proportion realised year to 30 September 2003 amount expected losses attributable to Highmoor 12 100% 12 non-monetary assets 28 25% (four year life) 17

––– –––

Total negative goodwill 40 19

––– –––

(iii) Minority interest

Ordinary shares (20% x 100) 20 Accumulated profits (w (i)) 23 Balance c/f 43

––– –––

43 43

––– –––

(iv) Elimination of loan and accrued interest:

The investments of Highmoor will show an unadjusted amount of $50 million as a loan to Slowmoor. The cash in transit of $9 million from Slowmoor should be applied $4 million to cancel the accrued interest receivable and the balance of $5 million to the investment (loan). When this adjustment is made the investment and the loan will cancel each other out.

(v) The net book value of the software in Slowmoor’s books is $40 million. If the software had been depreciated on its original cost of $30 million it would have a book value of $24 million ($30 less $6 million depreciation at 20% per annum). Thus there is an unrealised profit on the transfer of the software of $16 million ($40 million – $24 million).

(b) Negative goodwill arises in bookkeeping where the consideration given for a business is less than the fair value of the net assets acquired. Intuitively it does not make sense for a vendor to sell net assets for less than they are worth. This view is reflected by the IASB as they appear rather sceptical about the existence of negative goodwill. They say where an acquisition appears to create negative goodwill, a careful check of the value of the assets acquired and whether any liabilities have been omitted is required.

Negative goodwill may arise for several reasons; the most obvious is that there has been a bargain purchase. This may occur through the vendor being in a poor financial position and needing to realise assets quickly, or it may be due to good negotiating skills on the part of the acquirer, or the vendor may not realise how much the assets are really worth.

A more controversial occasion where negative goodwill arises is where a company, in determining the amount of consideration it is willing to pay for a business, will take into account the cost of anticipated future losses and post acquisition reorganisation expenditure that it believes will be required. The effect of this is that it would reduce the consideration offered/paid. As these costs cannot generally be recognised as a liability at the date of purchase, this can lead to the consideration being lower than the recognisable net assets.

In relation to the acquisition of Slowmoor the following are questionable issues:

– Highmoor may be trying to deliberately create losses at Slowmoor to avoid paying the further consideration. An example of this may be the transfer price of the software. The additional consideration of $96 million, if payable, would change the negative goodwill into positive goodwill of $56 million.

– The tax asset of Slowmoor may be questionable. Accounting standards are quite restrictive over the recognition of tax assets.

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2 (a) The sale of the plant has been incorrectly treated on two counts. Firstly even if it were a genuine sale it should not have been included in sales and cost of sales, rather it should have been treated as the disposal of a non-current asset. Only the profit or loss on the disposal would be included in the income statement (requiring separate disclosure if material). However even this treatment would be incorrect. As Tourmalet will continue to use the plant for the remainder of its useful life, the substance of this transaction is a secured loan. Thus the receipt of $50 million for the ‘sale’ of the plant should be treated as a loan. The rentals, when they are eventually paid, will be applied partly as interest (at 12% per annum) and the remainder will be a capital repayment of the loan. In the income statement an accrual for loan interest of 12% per annum on $50 million for four months ($2 million) is required.

(b) Tourmalet Income Statement – Year to 30 September 2003

continuing discontinuing Total operations operations

$000 $000 $000 Sales revenues (313,000 – 50,000 (see above)) 247,800 15,200 263,000 Cost of sales (w (i)) (128,800) (16,000) (144,800)

––––––––– –––––––– ––––––––– Gross profit (loss) 119,000 (800) 118,200 Distribution expenses (26,400) nil (26,400) Administration expenses (w (iii)) (20,000) (4,700) (24,700) ––––––––– –––––––– ––––––––– Profit (loss) on the ordinary activities before interest 72,600 (5,500) 67,100

––––––––– ––––––––

Financing cost (w (iv)) (3,800) Loss on investment properties ($10 million – $9·8 million) (200) Investment income 1,200

––––––––– Profit before tax 64,300 Income tax (9,200 – 2,100) (7,100)

––––––––– Profit for the period 57,200 ––––––––– Note: IAS 35 ‘Discontinuing Operations’ does not require a specific presentation of the results of a discontinued operation. The above is only one of several acceptable presentations.

(c) Tourmalet Statement of Changes in Equity – Year to 30 September 2003

Accumulated Revaluation Ordinary Total Profits reserve shares

$000 $000 $000 $000 At 1 October 2002 47,800 18,500 50,000 116,300 Profit for period 57,200 57,200 Transfer to realised profit 500 (500)

Ordinary dividends paid (2,500) (2,500) –––––––– –––––– ––––––– –––––––– At 30 September 2003 103,000 18,000 50,000 171,000 –––––––– –––––– ––––––– –––––––– Note: IAS 32 ‘Financial Instruments: Disclosure and Presentation’ says redeemable preference shares have the substance of debt and should be treated as non-current liabilities and not as equity. This also means that preference dividends are treated as a finance cost in the income statement.

Workings

(i) Cost of sales: $000 Opening inventory 26,550 Purchases 158,450 Transfer to plant (see (a)) (40,000) Depreciation (w (ii)) 25,800 Closing inventory (28·5 million – 2·5 million see below) (26,000)

–––––––– 144,800 ––––––––

The slow moving inventory should be written down to its estimated realisable value. Despite the optimism of the Directors, it would seem prudent to base the realisable value on the best offer so far received (i.e. $2 million).

(ii) Non-current asset depreciation: $000 Buildings $120/40 years 3,000 Plant – per trial balance ((98,600 – 24,600) x 20%) 14,800

Plant– plant treated as sold (40,000/5 years) 8,000

––––––– 25,800 –––––––

Note: investment properties do not require depreciating under the fair value model in IAS 40. Instead they are revalued each year with the surplus or deficit being taken to income.

For information only:

in the balance sheet cost/valuation accumulated net book depreciation value $000 $000 $000 Land and buildings 150,000 12,000 138,000 Plant – per trial balance 98,600 39,400 59,200 Plant incorrectly treated as sold 40,000 8,000 32,000 –––––––– 229,200 –––––––– (iii) It would seem prudent to accrue for the penalty on the lease as it is uncertain that the permission for a change of use

will be granted. In these circumstances, the payment of the penalty will be the lowest liability. This gives total administration expenses of $24,700 (23,200 + 1,500), of which $4,700 (3,200 + 1,500) is classed as discontinuing.

(iv) Finance costs: income statement

$000 Accrued interest on in-substance loan (see (a)) 2,000 Preference dividends (30,000 x 6%) 1,800 –––––– 3,800 ––––––

Note this balance sheet is provided for information only. It does not form part of the answer or marking scheme. Tourmalet – Balance Sheet as at 30 September 2003

$000 $000 Non-current assets (w (ii)) 229,200 Investment properties 9,800 –––––––– 239,000 Current Assets

Inventory (w (i)) 26,000 Trade accounts receivable 31,200

Bank 3,700 60,900 ––––––– –––––––– Total assets 299,900 –––––––– Equity and liabilities

Capital and Reserves:

Ordinary shares of 20c each 50,000 Accumulated profits 103,000

Revaluation reserve (see (c)) 18,000 121,000 –––––––– –––––––– 171,000 Non-current liabilities

6% Redeemable preference shares $1 each 30,000

In-substance loan (see (a)) 50,000 80,000 ––––––––

Current liabilities

Trade accounts payable 35,300 Accrued penalty cost (w (iii)) 1,500 Accrued finance costs (2,000 + 900) 2,900

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3 (a) IAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’ only deals with those provisions that are regarded as liabilities. The term provision is also generally used to describe those amounts set aside to write down the value of assets such as depreciation charges and provisions for diminution in value (e.g. provision to write down the value of damaged or slow moving inventory). The definition of a provision in the Standard is quite simple; provisions are liabilities of uncertain timing or amount. If there is reasonable certainty over these two aspects the liability is a creditor. There is clearly an overlap between provisions and contingencies. Because of the ‘uncertainty’ aspects of the definition, it can be argued that to some extent all provisions have an element of contingency. The IASB distinguishes between the two by stating that a contingency is not recognised as a liability if it is either only possible and therefore yet to be confirmed as a liability, or where there is a liability but it cannot be measured with sufficient reliability. The IASB notes the latter should be rare.

The IASB intends that only those liabilities that meet the characteristics of a liability in its Framework for the Preparation and Presentation of Financial Statements should be reported in the balance sheet.

IAS 37 summarises the above by requiring provisions to satisfy all of the following three recognition criteria: – there is a present obligation (legal or constructive) as a result of a past event;

– it is probable that a transfer of economic benefits will be required to settle the obligation; – the obligation can be estimated reliably.

A provision is triggered by an obligating event. This must have already occurred, future events cannot create current liabilities. The first of the criteria refers to legal or constructive obligations. A legal obligation is straightforward and uncontroversial, but constructive obligations are a relatively new concept. These arise where a company creates an expectation that it will meet certain obligations that it is not legally bound to meet. These may arise due to a published statement or even by a pattern of past practice. In reality constructive obligations are usually accepted because the alternative action is unattractive or may damage the reputation of the company. The most commonly quoted example of such is a commitment to pay for environmental damage caused by the company, even where there is no legal obligation to do so.

To summarise: a company must provide for a liability where the three defining criteria of a provision are met, but conversely a company cannot provide for a liability where they are not met. The latter part of the above may seem obvious, but it is an area where there has been some past abuse of provisioning as is referred to in (b).

(b) The main need for an accounting standard in this area is to clarify and regulate when provisions should and should not be made. Many controversial areas including the possible abuse of provisioning are based on contravening aspects of the above definitions. One of the most controversial examples of provisioning is in relation to future restructuring or reorganisation costs (often as part of an acquisition). This is sometimes extended to providing for future operating losses. The attraction of providing for this type of expense/loss is that once the provision has been made, the future costs are then charged to the provision such that they bypass the income statement (of the period when they occur). Such provisions can be glossed over by management as ‘exceptional items’, which analysts are expected to disregard when assessing the company’s future prospects. If this type of provision were to be incorporated as a liability as part of a subsidiary’s net assets at the date of acquisition, the provision itself would not be charged to the income statement. IAS 37 now prevents this practice as future costs and operating losses (unless they are for an onerous contract) do not constitute past events.

Another important change initiated by IAS 37 is the way in which environmental provisions must be treated. Practice in this area has differed considerably. Some companies did not provide for such costs and those that did often accrued for them on an annual basis. If say a company expected environmental site restoration cost of $10 million in 10 years time, it might argue that this is not a liability until the restoration is needed or it may accrue $1 million per annum for 10 years (ignoring discounting). Somewhat controversially this practice is no longer possible. IAS 37 requires that if the environmental costs are a liability (legal or constructive), then the whole of the costs must be provided for immediately. That has led to large liabilities appearing in some companies’ balance sheets.

A third example of bad practice is the use of ‘big bath’ provisions and over provisioning. In its simplest form this occurs where a company makes a large provision, often for non-specific future expenses, or as part of an overall restructuring package. If the provision is deliberately overprovided, then its later release will improve future profits. Alternatively the company could charge to the provision a different cost than the one it was originally created for. IAS 37 addresses this practice in two ways: by not allowing provisions to be created if they do not meet the definition of an obligation; and specifically preventing a provision made for one expense to be used for a different expense. Under IAS 37 the original provision would have to be reversed and a new one would be created with appropriate disclosures. Whilst this treatment does not affect overall profits, it does enhance transparency.

(c) Guarantees or warranties appear to have the attributes of contingent liabilities. If the goods are sold faulty or develop a fault within the guarantee period there will be a liability, if not there will be no liability. The IASB view this problem as two separate situations. Where there is a single item warranty, it is considered in isolation and often leads to a discloseable contingent liability unless the chances of a claim are thought to be negligible. Where there are a number of similar items, they should be considered as a whole. This may mean that whilst the chances of a claim arising on an individual item may be small, when taken as a whole, it should be possible to estimate the number of claims from past experience. Where this is the case, the estimated liability is not considered contingent and it must be provided for.

(i) Bodyline’s 28-day refund policy is a constructive obligation. The company probably has notices in its shops informing customers of this policy. This would create an expectation that the company will honour its policy. The liability that this creates is rather tricky. The company will expect to give customers refunds of $175,000 ($1,750,000 x 10%). This is not the liability. 70% of these will be resold at the normal selling price, so the effect of the refund policy for these goods is that the profit on their sale must be deferred. The easiest way to account for this is to make a provision for the unrealised profit. This has to be calculated for two different profit margins:

Goods manufactured by Header (at a mark up of 40% on cost): $24,500 ($175,000 x 70% x 20%) x 40/140 = $7,000 Goods from other manufacturers (at a mark up of 25% on cost) $98,000 ($175,000 x 70% x 80%) x 25/125 = $19,600

The sale of the remaining 30% at half the normal selling price will create a loss. Again this must be calculated for both group of sales:

Goods manufactured by Header were originally sold for $10,500 (175,000 x 30% x 20%). These will be resold (at a loss) for half this amount i.e. $5,250. Thus a provision of $5,250 is required.

Goods manufactured by other manufacturers were originally sold for $42,000 (175,000 x 30% x 80%). These will be resold (at a loss) for half this amount i.e. $21,000. Thus a provision of $21,000 is required.

The total provision in respect of the 28 day return facility will be $52,850 (7,000 + 19,600 + 5,250 + 21,000).

(ii) Goods likely to be returned because they are faulty require a different treatment. These are effectively sales returns. Normally the manufacturer will reimburse the cost of the faulty goods. The effect of this is that Bodyline will not have made the profit originally recorded on their sale. This applies to all goods other than those supplied by Header. Thus these sales returns would be $128,000 (160,000 x 80%) and the credit due from the manufacturer would be $102,400 (128,000 x 100/125 removal of profit margin). The overall effect is that Bodyline would have to remove profits of $25,600 from its financial statements.

For those goods supplied by Header, Bodyline must suffer the whole loss as this is reflected in the negotiated discount. Thus the provision required for these goods is $32,000 (160,000 x 20%), giving a total provision of $57,600 (25,600 + 32,000).

(d) The Directors’ proposed treatment is incorrect. The replacement of the engine is an example of what has been described as cyclic repairs or replacement. Whilst it may seem logical and prudent to accrue for the cost of a replacement engine as the old one is being worn out, such practice leads to double counting. Under the Directors’ proposals the cost of the engine is being depreciated as part of the cost of the asset, albeit over an incorrect time period. The solution to this problem lies in IAS 16 ‘Property, Plant and Equipment’. The plant constitutes a ‘complex’ asset i.e. one that may be thought of as having separate components within a single asset. Thus part of the plant $16·5 million (total cost of $24 million less $7·5 assumed cost of the engine) should be depreciated at $1·65 million per annum over a 10-year life and the engine should be depreciated at $1,500 per hour of use (assuming machine hour depreciation is the most appropriate method). If a further provision of $1,500 per machine hour is made, there would be a double charge against profit for the cost of the engine. IAS 37 also refers to this type of provision and says that the future replacement of the engine is not a liability. The reasoning is that the replacement could be avoided if, for example, the company chose to sell the asset before replacement was due. If an item does not meet the definition of a liability it cannot be provided for.

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4 (a) Ratios are used to assess the financial performance of a company by comparing the calculated figures to various other sources. This may be to previous years’ ratios of the same company, it may be to the ratios of a similar rival company, to accepted norms (say of liquidity ratios) or, as in this example, to industry averages. The problems inherent in these processes are several. Probably the most important aspect of using ratios is to realise that they do not give the answers to the assessment of how well a company has performed, they merely raise the questions and direct the analyst into trying to determine what has caused favourable or unfavourable indicators. In many ways it can be said that ratios are only as useful as the skills of the person using them. It is also true that any assessment should also consider other information that may be available including non-financial information.