Sugar Co leased a machine from Spice Co. The terms of the lease are as follows:
Inception of lease 1 January 20X1
Lease term 4 years at $78,864 per annum payable in arrears
Present value of minimum lease payments $250,000
Useful life of asset 4 years
Required
(a) Calculate the interest rate implicit in the lease, using the table below.
This table shows the present value of $1 per annum, receivable or payable at the end of each year for n years.
Years
(n) Interest rates
6% 8% 10%
1 0.943 0.926 0.909 2 1.833 1.783 1.736 3 2.673 2.577 2.487 4 3.465 3.312 3.170 5 4.212 3.993 3.791 (b) Prepare the extracts from the financial statements of Sugar Co for the year ended 31 December 20X1. Notes
to the accounts are not required.
32 Holcombe 45 mins
6/10, amended (a) Leasing is important to Holcombe, a public limited company as a method of financing the business. The
Directors feel that it is important that they provide users of financial statements with a complete and understandable picture of the entity's leasing activities. They believe that the current accounting model is inadequate and does not meet the needs of users of financial statements.
Holcombe has leased plant for a fixed term of six years and the useful life of the plant is 12 years. The lease is non-cancellable, and there are no rights to extend the lease term or purchase the machine at the end of the term. There are no guarantees of its value at that point. The lessor does not have the right of access to the plant until the end of the contract or unless permission is granted by Holcombe.
Fixed lease payments are due annually over the lease term after delivery of the plant, which is maintained by Holcombe. Holcombe accounts for the lease as an operating lease but the directors are unsure as to whether the accounting treatment of an operating lease is conceptually correct.
Required
(i) Discuss the reasons why the current lease accounting standards may fail to meet the needs of users
and could be said to be conceptually flawed. (6 marks)
(ii) Discuss whether the plant operating lease in the financial statements of Holcombe meets the definition of an asset and liability as set out in Conceptual Framework for Financial Reporting.
(7 marks) (iii) Discuss the IASB's proposals to improve the reporting of leases. (4 marks) Professional marks will be awarded in part (a) (i) and (ii) for clarity and quality of discussion. (2 marks) (b) (i) On 1 May 20X4, Holcombe entered into a short operating lease agreement to lease another building.
The lease will last for three years and is currently $5 million per annum. However an inflation adjustment will be made at the conclusion of leasing years 1 and 2. Currently inflation is 4% per annum.
The following discount factors are relevant (8%).
Single cash flow Annuity
Year 1 0.926 0.926
Year 2 0.857 1.783
Year 3 0.794 2.577
Year 4 0.735 3.312
Year 5 0.681 3.993
Required
State how the inflation adjustment on this short term operating lease should be dealt with in the
financial statements of Holcombe. (3 marks)
(ii) Holcombe is considering entering a three-year lease of a machine from Brooke from 1 May 20X5. The machine has a total economic life of 20 years. The fair value of the machine at 1 May 20X5 is
$113,600.
The lease payments are $13,000 per year, and the present value of the lease payments is $21,700, calculated using the rate Brooke charges Holcombe.
The directors of Holcombe have heard about the proposals for revising the classification of leases, and wish to know whether the lease from Brooke would be classified as a 'Type A' lease or a 'Type B' lease under those proposals.
Required
Advise the directors on the appropriate classification. (3 marks) (Total = 25 marks)
33 William 45 mins
6/12 William is a public limited company and would like advice in relation to the following transactions.
(a) William owned a building on which it raised finance. William sold the building for $5 million to a finance company on 1 June 20X2 when the carrying amount was $3.5 million. The same building was leased back from the finance company for a period of twenty years, which was felt to be equivalent to the majority of the asset's economic life. The lease rentals for the period are $441,000 payable annually in arrears. The interest rate implicit in the lease is 7%. The present value of the minimum lease payments is the same as the sale
William wishes to know how to account for the above transaction for the year ended 31 May 20X3.
(7 marks) (b) William operates a defined benefit pension plan for its employees. Shortly before the year end of 31 May
20X3, William decided to relocate a division from one country to another, where labour and raw material costs are cheaper. The relocation is due to take place in December 20X3. On 13 May 20X3, a detailed formal plan was approved by the board of directors. Half of the affected division's employees will be made
redundant in July 20X3, and will accrue no further benefits under William's defined benefit pension plan.
The affected employees were informed of this decision on 14 May 20X3. The resulting reduction in the net pension liability due the relocation is estimated to have a present value of $15 million as at 31 May 20X3.
Total relocation costs (excluding the impact on the pension plan) are estimated at $50 million.
William requires advice on how to account for the relocation costs and the reduction in the net pension
liability for the year ended 31 May 20X3. (7 marks)
(c) On 1 June 20X0, William granted 500 share appreciation rights to each of its twenty managers. All of the rights vest after two years' service and they can be exercised during the following two years up to 31 May 20X4. The fair value of the right at the grant date was $20. It was thought that three managers would leave over the initial two-year period and they did so. The fair value of each right was as follows.
Year Fair value at the year-end ($)
31 May 20X1 23
31 May 20X2 14
31 May 20X3 24
On 31 May 20X3, seven managers exercised their rights when the intrinsic value of the right was $21.
William wishes to know what the liability and expense will be at 31 May 20X3. (5 marks) (d) William acquired another entity, Chrissy, on 1 May 20X3. At the time of the acquisition, Chrissy was being
sued as there is an alleged mis-selling case potentially implicating the entity. The claimants are suing for damages of $10 million. William estimates that the fair value of any contingent liability is $4 million and feels that it is more likely than not that no outflow of funds will occur.
William wishes to know how to account for this potential liability in Chrissy's entity financial statements and whether the treatment would be the same in the consolidated financial statements. (4 marks) Required
Discuss, with suitable computations, the advice that should be given to William in accounting for the above events.
Note. The mark allocation is shown against each of the four events above.
Professional marks will be awarded for the quality of the discussion. (2 marks) (Total = 25 marks)
GROUP FINANCIAL STATEMENTS
Questions 34 to 54 cover Group Financial Statements, the subject of Part C of the BPP Study Text for Paper P2.
34 Marrgrett 45 mins
12/08 Marrgrett, a public limited company, is currently planning to acquire and sell interests in other entities and has asked for advice on the impact of IFRS 3 (Revised) Business combinations. The company is particularly concerned about the impact on earnings, net assets and goodwill at the acquisition date and any ongoing earnings impact that the revised standards may have.
The company is considering purchasing additional shares in an associate, Josey, a public limited company. The holding will increase from 30% stake to 70% stake by offering the shareholders of Josey cash and shares in Marrgrett. Marrgrett anticipates that it will pay $5 million in transaction costs to lawyers and bankers. Josey had previously been the subject of a management buyout. In order that the current management shareholders may remain in the business, Marrgrett is going to offer them share options in Josey subject to them remaining in employment for two years after the acquisition. Additionally, Marrgrett will offer the same shareholders, shares in the holding company which are contingent upon a certain level of profitability being achieved by Josey. Each shareholder will receive shares of the holding company up to a value of $50,000, if Josey achieves a pre-determined rate of return on capital employed for the next two years.
Josey has several marketing-related intangible assets that are used primarily in marketing or promotion of its products. These include trade names, internet domain names and non-competition agreements. These are not currently recognised in Josey's financial statements.
Marrgrett does not wish to measure the non-controlling interest in subsidiaries on the basis of the proportionate interest in the identifiable net assets, but wishes to use the 'full goodwill' method on the transaction. Marrgrett is unsure as to whether this method is mandatory, or what the effects are of recognising 'full goodwill'. Additionally the company is unsure as to whether the nature of the consideration would affect the calculation of goodwill.
To finance the acquisition of Josey, Marrgrett intends to dispose of a partial interest in two subsidiaries. Marrgrett will retain control of the first subsidiary but will sell the controlling interest in the second subsidiary which will become an associate. Because of its plans to change the overall structure of the business, Marrgrett wishes to recognise a re-organisation provision at the date of the business combination.
Required
Discuss the principles and the nature of the accounting treatment of the above plans under International Financial Reporting Standards setting out any impact that IFRS 3 (Revised) Business combinations might have on the earnings and net assets of the group.
Note: this requirement includes 2 professional marks for the quality of the discussion. (25 marks)