Relevant to ACCA Qualification Paper P2
The Paper P2 examiner often features one question per exam that focuses on a single International Financial Reporting Standard (IFRS). But be warned – while these questions take their lead from a single IFRS, the examiner also brings in other issues from other IFRS.
The December 2010 exam included a share-based payment question called Margie. Before that, in the December 2009 exam, there was a question on impairment and, in June 2009, another on financial instruments.
In the last exam, the Margie question was not just about share-based payment. It also included financial instruments, fair value and simple share issues. Also, the question was highly analytical. There were few marks f or regurgitation of knowledge. The bulk of the marks were reserved for analysis.
So to give you an idea of how these questions work, and to revisit a subject that has not been the subject of focus for a while, I am going to resurrect an old Paper P2 question called Satellite. It is a focus question that looks at provisions, but also has plenty of other accounting issues to consider. Of course, I have had to change the question slightly to bring it up to date. (Please note that this article was written in 2010. You need to check the relevant examinable documents to check how each standard is examined in the exam session that you're attempting.)
The purpose of this article is to give you a feel as to how to tackle such questions.
Satellite, a public limited company, has produced draft consolidated financial statements as at 30 November. The group accountant has asked your advice on several matters. These issues are set out below and have not been dealt with in the draft group financial statements:
(a) Discuss the recognition criteria for the recognition of a provision (IAS 37). (5 marks)
(b) Discuss how the above five issues should be dealt with in the group financial statements of Satellite. (20 marks)
(Total: 25 marks)
The marking guide was based on the usual one mark per idea well expressed. So the following would look good on a marker’s screen.
There are three recognition criteria.
Reasonably reliable estimate
It must be possible to make a reasonably reliable estimate of the outflow that will result from the obligation before a provision is permitted.
There must be a present legal or constructive obligation at the year-end before a provision is permitted.
There must be an expectation that economic benefit will flow out in the future as a result of the obligation.
Frankly, the IAS argues it is always possible to estimate the outflow and it is very rare for a transfer out to be avoidable. So, in practice, the accountant can focus purely on the obligation criteria.
Perhaps it should be noted how the above closely follows the focus of the framework on assets and liabilities. The framework also defines a liability in terms of pre sent obligations.
1 Operating lease
Actually, it is irrelevant whether the above is operating or finance lease in the context of analysing related provisions. Either type of lease creates an obligation.
But the trick here is to spot the present obligation. Satellite does have a present obligation for the damage done during the tenure ($1.2m) but not for the damage that might be done in the future (maybe $4.8m).
So Satellite should provide $1.2m and should probably recognise the charge to the p/l as super-exceptional on the face of the income statement given its unusual nature.
First we must eye this problem form the perspective of the subsidiary. It is the subsidiary that will be put ting through the double entry. Then we can look at the effect on the group.
The key term in this paragraph is ‘modify’. We can see that Universe already has made the modifications and therefore has a present obligation as a result of this past obliging event.
So a provision is require d for the cost of restoration. The provision is required at the point of modification. The modification occurred at the year start.
However, the restoration will not take place until the end of the lease; so the time value of money must be considered. But we need to be careful here, as the $2m is already discounted.
So the year start double entry is:
Dr Non-current asset $2m
Cr Provision $2m
In fact, the above non-current asset entry goes on top of the initial premium:
Initial cost $10m
Then, of course, the above is depreciated over its life, which is 10 years.
Depreciation double entry
This is the same every year:
Dr i/s $1m
Cr NCA $1m
And, of course, quite separately the liability unwinds. The scenario does not tell us the discount rate, so I have assumed 10%.
Unwinding double entry
This snowballs every year (grows exponentially), but the first year journal would be as follows:
Dr i/s $0.2m
Cr Prov ($2m)(10%) $0.2m
There is even data for an impairment test. However, there is no impairment as the carrying value of the asset at the year-end ($9m) is less than the recoverable value ($9.5m).
The above double entry will be accommodated by the sub. However, because this is a partially owned sub, the group/non-controlling interest effect will be 80%/20%.
There appears to be no obligation for the repairs. Just an intent to repair sometime in the future.
So I suggest there can be no provision for the repairs.
Buildings should be depreciated over their useful lives regardless of being owned or otherwise.
An intangible is recognised if it is purchased. Also, development is recognised if it is recoverable. It sounds like the external costs are the former and the internal costs are the latter.
So it appears to be reasonable to capitalise and depreciate the asset. However, I would advise Satellite to adjust the life down to four years, as that appears to be more realistic. Also, the re is no obligation to revise. So no provision is possible.
Clearly, if Satellite had predicted the extra $8m, it would have put it in t he consideration and the acquisition goodwill would have been higher.
Prior period adjustment (PPA)
But the only way to adjust last year’s goodwill is via a PPA (restatement). This is only permissible i f the $8m is a material error. But to me it sounds like a change in an estimate. So the $8m will simply have to be costed to the i/s.
IFRS 3 supports this view, by giving a 12 months ’ limit on playing with goodwill after acquisition.
I hope the above gave you a feel for how you can think about addressing a focus question and how to address wider issues so that you can broaden your analysis.
Martin Jones is a lecturer at the London School of Business and Finance