Paragraph 5 is outrageously complex. Given there are only 2 marks (!!!!) and therefore 3 minutes for this paragraph, it was probably best to ignore this paragraph altogether in the exam.
Joint control
Joint control is the power to direct activities divided between two or more investors with
unanimous vote. Joint control is visible in the scenario in the phrases “decisions must be agreed jointly” and “CP has the right of veto”. So the new publishing business is a joint arrangement (JA).
JO then JV
But there are two form of JA identified by incorporation. A joint venture (JV) is incorporated.
A joint operation (JO) is not. So the publishing business is a JO for six months and then a JV for six months. The problem is that Joey has completely ignored this and treated all the sales and all the costs and all the cash as if they were all Joey’s.
JO accounting
This simply aims to reflect the JO arrangement. Often proportional consolidation applies. But this JO is not even vaguely proportional. This JO is heavily weighted towards Joey with CP having only the right to the rather fiddly royalty based on percentages of sales and gp.
JO period journal
Hence, all Joey needs to do is recognise the royalty that Joey has ignored:-
Dr p/l 0.7
Cr liability to CP 0.7
Liability to CP = (10%)(6/12)($5m) + (30%)(6/12)($5m-$2m) JV accounting
JV accounting is equity accounting. This means that JVs are essentially associates and associates are outsiders. The JV called “JCP” has a life of its own outside the Joey group but Joey has taken all the cash as if that cash belonged to Joey. It does not. The cash belongs to JCP. That gives the credit entry below. And this starts the double entry with a liability to JCP.
But as mentioned the JV requires equity accounting. This means a share of profit going through the p/l and arriving at the b/s to land on top of the cost. But there are no set up costs. So
$0.75m should be in both p/l and b/s. The $0.75m is Joey’s 50% of the $1.5m profit for the second six months. So to repeat, $0.75m should be in both p/l and b/s. And if Joey had done nothing then this would be easy. But Joey has taken the whole of the $1.5m profit to its p/l instead of the 50% share that it has by rights. So a debit to the p/l is required to reduce the Joey profit recognition.
True JV period journal
Actually in real life this jv journal would be even more complicated as Joey has put $2.5m JCP sales into Joey sales and $1m JCP costs into Joey costs. Neither of these should be in Joey fs and both of which must be replaced by $0.75m for share of JV profit.
Dr Joint venture {b/s}($5m-$2m)(6/12)(50%) 0.75
Dr Sales {p/l} 2.5
Cr liability to JCP 1.5
Cr Joint venture {p/l} 0.75
Cr Costs {p/l} 1.0
(b) Marking guide
As ever there is 1 mark for each relevant point clearly expressed.
Share based payment
Share based payment (sbp) costs are measured by calculating a sbp obligation at each year end:- Sbp obligation = number of rights expected to vest x fair value x timing ratio
Number of rights expected to vest
This tricky estimate is based upon counting the number of employees still in the contract at each year end but then further deducting a guess for how many more employees are expected to leave before they get to the end of their sbp vesting period.
Fair value
The fair value depends upon the nature of the sbp:-
Options settled in equity grant fv
Share appreciation rights settled in cash current fv These are options and so we use grant fv.
Timing ratio
This is a simple ratio of the period to date over the vesting period. So if the employees are locked in for three years from 7 December 2014 just after our current year end then at next years end the ratio will be 1/3. But these options vest immediately. So the above equation collapses down as discussed below.
Vest immediately
Because the grant and vest day are the same day, the Joey group sbp obligation is as follows:- Sbp obligation = number of rights vesting x fair value at grant/vest date
Group accounting
The group accounting will be fairly simple. The group fs will have an sbp option reserve in other components of equity (OCE) with a fv balance on 7 December 2014 and the cost will go into the p/l as an operating cost:-
Dr operating costs {p/l} fv
Cr sbp option reserve [OCE] {b/s} fv
Sub employees
But a problem arises because these are sub employees being motivated by potential parent shares. You can understand why this might occur. The employees do not want sub shares as they would be near impossible to sell. The employees would much rather have parent shares as Joey is a plc and presumably quoted. And the parent does not want to give away sub shares as this then starts to mess with the nci.
Parent fs
So the parent must record a sbp obligation in OCE as discussed but also record a receivable from the sub. This receivable could be recognised on top of the investment in sub.
Sub fs
And the sub must record a payable to the parent with a corresponding operating cost. On consolidation the receivable and payable will contra down to zero.
Related party transactions
As a side point, both sub and parent would have to record a related party transaction because they are transacting with each other. Indeed if any of the employees are influential directors, which seems likely, then even the group would need rpd.
Corporate governance
But there is a corporate governance issue here. The options are simply given to the employees and vest immediately. This means employees can leave the day after they get their options on 7 December 2014. The idea is to motivate the employees to push for expansion. This might work with some of the employees. But others will leave before the expansion starts but will benefit from the expansion without being a part of the expansion. This is why sbp is not usually done like this. Usually sbp does have a vesting period.
(c) Marking guide 1 mark per point.
Ethics
A good model to analyse ethics for a professional accountant is the ACCA principles in the ACCA ethical guidelines:-
Professionalism Integrity Competence Confidentiality Objectivity Directors
The directors are lying to the bank; to cut a long story short. It seems likely that the directors
Professional accountant
But the question asks us to discuss how “a professional accountant” should respond.
Presumably the relevant professional accountant is the new chief accountant and he is in a very difficult position.
Objectivity
The chief accountant has stated that “he cannot afford to lose his job”. So in a conflict of interest between ethical interests and financial interests the chief accountant would side with the financial interests. This is already a breach of objectivity even before the chief accountant does anything.
Practicalities
But being a little more practical and reasonable about this, of course the chief accountant needs his job or else he would be sunning on the beach. Saying to an accountant that you cannot put yourself in a position in which you cannot afford to lose your job is like saying to an accountant that you cannot have children.
Openly stated
For me the daft mistake that the chief accountant has made is openly stating that he needs his job. He should have kept his big mouth shut. Now he is playing into the hands of his directors.
Action
So now I must discuss what action the chief accountant should take when the directors come to him and ask him to manipulate the cff. First he should do his best to persuade his directors that honesty is the best course of action.
Alternative finance
Then the chief should help the directors look for alternative finance. Maybe the current bank is not the best deal. Maybe issuing debt or equity is the way.
In conclusion the chief accountant should try his best to retain his ethics throughout. But as a word of advice on evidence, the chief accountant should make sure he confirms every word said aloud in email as directors like this can be very slippery when the trouble hits the fan.
Q88 Coatmin Marking guide
There is 1 mark per relevant point throughout.
(a) Related party disclosure
Transactions between parties related by control or influence must be disclosed. Related parties include subs and parents and directors and pension schemes. But any entity connected to Coatmin by an unbroken chain of control or influence would qualify.
Common control
Coatmin is not in a group with the other banks, by the way. A group has a parent at the top and a government is not a parent. The rather lovely expression used to describe the situation is
“common control”. The same also applies to entities with a billionaire at the top like Richard Branson sitting on top of the Virgin common control portfolio.
Related parties
But the other banks are related parties. The government controls Coatmin and the government controls the other banks. But Coatmin should stop worrying as there are no transactions to disclose with these other entities under common control.
Underwritten loans
But the underwritten loans are quite a different thing. Of course Coatmin should disclose this relationship with the railway and the post. It is a related party transaction. But also it is a possible contingent liability. And disclosure may even be required under law as it is in the UK.
China
Actually IAS24 was recently watered down to exclude rpt through the government. This change was requested by China. In China many entities are related via the government. The USA often cite this change as proof that the IASB is swayed by national governments. The USA has a point. But they also have a damned cheek given that they have spent years and years manipulating the IASB themselves. It seems the USA government do not like it when the IASB listens to other governments.
Financial guarantee
Actually the underwriting obligation is in a class called “financial guarantees” and these are carried fvpl as discussed below. But even though the examiner examined two financial
guarantees right next to each other in (a) and (b) the examiner appears to have missed this point in his answer. This shows just how hard and specialist this question is. Maybe the examiner was focussing purely on disclosure.
(b) Group fs
The scenario describes a loan guarantee between a parent and a sub. For the purposes of the
Contingent liabilities
The second thing to note is that the guarantee is a contingent liability of $60m. It is a liability of
$60m that will only flow out if the sub cannot pay. Contingent liabilities are recorded roughly as follows (IAS37):-
Probable provide
Possible disclose
Remote ignore
Possible contingent liability
At last year’s end the chances of an outflow would probably be best described as possible. So this is further evidence that the guarantee must be disclosed.
Financial guarantee
And if this were simply a “product guarantee” then that would be the end of the story. But this is a “financial guarantee” and these are carried fvpl (IFRS9) and not as simple contingent liabilities. Frankly unless you work in a bank in the financial guarantees department there is no way you could know this specialist knowledge. Except one. The examiner tells you in the question.
Financial liability
IFRS9 looks at financial guarantees like this. The guarantee is a financial liability as soon as it is signed. The guarantee confers obligations onto Coatmin even if the guarantee is not expected to be called. The point is that the guarantee may be called even if it is not thought likely. The obligation is effectively in a class called “derivatives” and should be carried fvpl as described in the scenario. In fact the more specific name for this class is “credit derivatives”.
Derivatives
Derivatives derive their value from an underlying something. In this case the underlying
something is the health of the sub. If the health of the sub goes down then the chances of breach go up and the fv of the guarantee goes up too. The opposite is true if the health of the sub goes up.
Movement
So the movement in the guarantee liability measured at fv would be approximately as follows:-
$m
The $0.8m above at the current year start is a guess. The scenario tells us that the loan is being paid in three equal instalments (of $20m each) and that the first has been paid (at last years end).
So it makes sense that the fv of the guarantee liability has dropped by a third given that the principal owed by the sub has dropped by a third. The $0.4m at the current year end is another guess using the same logic.
Difficulties
Now we must decide how to deal with the “difficulties”. This is very tricky because at the year end the sub looks like it is in real trouble and it looks like the remaining $40m owed by the sub will be paid by Coatmin. Then a few days later a donor comes to the rescue and the sub is back on the tracks.
Decision
What we must decide is whether the donor rescue after the year end was hovering in the background at the year end or alternatively that the donor was unaware of the subs troubles at the year end and the sub was on its own at that time.
Events after the reporting period
The ifrs on EARP (IAS10) is not much help. All that says is that an adjusting event is an event that reveals after the year end a condition that was already in existence at the year end. The problem is that we have no idea if the donor was hovering over the sub like a guardian angel at the year end.
Conclusion
My guess is that the donor is unlikely to have made the donation without being ready to step in earlier. So the guarantee that looked likely to be called at the year end never was likely to be called because the donor was in the background ready to pick up the pieces. So the closing liability of $0.4m above would be recognised as such on the Coatmin b/s.
Adjusting EARP
The technical name of the above logic is “adjusting EARP”. In the draft fs the accountants would have pushed the guarantee liability up to $40m at the year end based on what they knew then. But later the accountants would have adjusted the guarantee liability back down to $0.4m when they realised that the donor would step in.
(c) Issue
The word “issue” tells us that the debt is the financial liability of Coatmin. And financial liabilities default into amortised cost. So the debt liability is carried at amortised cost.
Hedging
This is the process of betting against yourself. When an entity faces a risk that it cannot easily avoid then the entity can cancel out this risk by setting up an equal and opposite risk. This is called hedging and it uses derivatives.
Example
For example if an entity must buy coffee but fears that the price of coffee will rise before the coffee ripens then the entity can bet on the price of coffee rising. If the price does go up as feared then the entity will lose on the coffee purchase but win on the derivative bet and so end up net neutral.
Fixed rate bond
But there is no risk in the fixed rate bond. Coatmin has contracted to pay $40k next year (2% of
$2m) and another $40k plus the $2m principal the following year. There is no chance that Coatmin might pay more in interest because it is fixed and there is no chance that Coatmin will pay more in principal because it is fixed. This is not a variable rate loan. This is not a foreign loan. There is no risk.
Conclusion
So that is the end of that. Coatmin cannot do hedge accounting because there is no hedging because there is no risk.
Effect
But the swap still exists and must be accounted for. The swap is simply recognised as a regular speculative derivative using fvpl:-
The technical name for looking at a hedge to see if it makes sense is “prospective and retrospective testing”. All this means is that you have to check that there is a hedging
relationship between the risk item and the derivative at the start and then test again at each year end looking backwards to see that the hedging worked out roughly as expected.
IAS39
By the way, under old IAS39 there was a test of hedge effectiveness that required the ratio of loss/gain to be within a range of 80% to 125%. This test no longer applies under IFRS9.
Comment
Hedging is an odd subject. Not only is it conceptually challenging, it is also common that two people looking at the same problem will view the issues differently. Even though one person may see no risk and feel no need for hedging; another person might see a risk and feel the need to hedge. In real life real companies do hedge fixed cash outflow obligations. And then they apply hedge accounting. And then the auditors accept that. Even in those real companies some of the treasury guys will think their own hedging is odd and disagree with the treasury guy doing the hedges. So it is possible to do hedging in the strangest situations and in the oddest ways. So all that you can do in an exam is look at the problem in your own way and say what you think and avoid being dogmatic.
Further comment
Hedging is also very complex. To illustrate the point, it can be noted that it appears the examiner has an internal conflict within his question. The question says that Coatmin’s credit worthiness has been worsening. The question also says that the movement in the fv of the bond is less than the movement in the swap. But this is the wrong way around. If Coatmin’s credit worthiness is worsening then the bond fv movement should be greater than the swap fv movement. That would certainly be more normal anyhow. If this is baffling then use it as further proof that hedging is very complex. You may not even know what a swap is and may never have heard of LIBOR. So the best solution is to learn what little you can and apply it as best as you can if hedging comes up in your exam.
(d) Financial liabilities
Fl are generally carried at amortised cost. It is very rare for fl to be carried at fv. But we are told that this is the case in this case and so there can be no debate.
Fl are generally carried at amortised cost. It is very rare for fl to be carried at fv. But we are told that this is the case in this case and so there can be no debate.