Book 14th ed. — B. Elliott, J. Elliott (Pearson, 2011) BBS (1)


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Fourtyynth Edition
FINUNCIUL UCCciNhING
UND fEPcfhING
Barry Elliott
Jamiy Elliott
www.pearson-books.com
Nyw for this ydition:
Fully updatyd to aay 2010
ipdatyd covyragy of Intyrnational
Financial fyporting Standards
aory yxamplys of yxtracts from ryal
fi nancial ryports
Nyw, additional quystions and yxyrcisys
in sylyctyd chaptyrs
Financial Uccounting and fyporting
comys with
ayUccountingLav
, a staty of thy art onliny
lyarning rysourcy that givys studynts accyss to:
U pyrsonalisyd study plan that highlights whyry you yxcyl and whyry you nyyd to improvy so
you can study mory yffi ciyntly
Practicy provlyms with hundryds of diffyrynt variavlys which allow you to practisy ovyr and
ovyr again with no rypytition
Visit
www.myaccountinglav.com
to utilisy thysy onliny rysourcys.
For mory information on how to rygistyr syy insidy thy vook.
is thy most up to daty tyxt on thy markyt. Now fully updatyd in its fourtyynth
ydition, it includys yxtynsivy covyragy of Intyrnational Uccounting Standards (IUS) and Intyrnational Financial
hhis markyt-lyading tyxt offyrs studynts a clyar, wyll-structuryd and compryhynsivy tryatmynt of thy suvjyct.
Supportyd vy illustrations and yxyrcisys, thy vook providys a strong valancy of thyorytical and concyptual
covyragy. Studynts using this vook will gain thy knowlydgy and skills to hylp thym apply currynt standards,
, a staty of thy art onliny
U pyrsonalisyd study plan that highlights whyry you yxcyl and whyry you nyyd to improvy so
Practicy provlyms with hundryds of diffyrynt variavlys which allow you to practisy ovyr and
Barry Elliott
is a training consultant. Hy has yxtynsivy tyaching yxpyriyncy at undyrgraduaty, postgraduaty
and profyssional lyvyls in China, Hong Kong, Nyw nyaland and Singapory. Hy has widy yxpyriyncy as an yxtyrnal
yxaminyr voth in highyr yducation and at all lyvyls of profyssional yducation.
Jamiy Elliott
is a Diryctor with Dyloitty. Prior to this hy has lycturyd at univyrsity on undyrgraduaty dygryy
programmys and as an assistant profyssor on aBU and Exycutivy programmys at thy London Businyss School.
Suvstantial ryvisions to:
Puvlishyd fi nancial statymynts
fygulatory and concyptual
framyworks
Unalysis of accounts
Corporaty govyrnancy
Ethical vyhaviour and thy implication
for accountants
FINUNCIUL UCCciNhING
UND fEPcfhING
Elliott
Elliott
Fourtyynth
Edition
FINUNCIUL UCCciNhING
Elliott
Elliott
CODE INSIDE
unlock valuable
and Reporting
strongest educational materials in business and Þnance
FOURTEENTHEDITION

Our objective is to provide a balanced and comprehensive framework to enable students
to acquire the requisite knowledge and skills to appraise current practice critically and to
which had acquired Hooker Chemicals, was judged liable for the costs of clean-up of more
than $260 million.
13
Existing shareholders and the share price would also be affected by
these increased costs.
There is recognition that there is a wider interest than short-term prots.
31.10Background to companies reporting practices
Some companies have independently instituted comprehensive environmental management
The Framework emphasises the importance of adopting a strategic approach, so that
31.8Sustainability Ð environmental reporting
by switching electricity supply at both our Littlehampton sites and all UK company-
(known as a red top in the ABIs guidance) reduces a companys industry-adjusted
MeanStandard deviation
lenders are able to stipulate conditions and loan covenants, e.g. the maximum level of
gearing and action available to them if interest payments or capital repayments are missed.
However, institutional investors do not represent a majority in any company. Their role
6Institutional investors should have a clear policy on voting and disclosure of
REVIEW QUESTIONS
1
Explain in your own words what you understand corporate governance to mean.
2
Explain why governance procedures may vary from country to country.
3
What are the implications of governance for audit practices.
4
The Association of British Insurers held the view that options should be exercised only if the
Summary
Good governance is achieved when all parties feel that they have been fairly treated.
It is achieved when behaviour is prompted by the idea of fairness to all parties.
Independent behaviour is expected of the NEDs and auditors and they are expected to
have the strength of character to act professionally with proper regard for the interest
of the shareholders. The shareholders in turn should be exercising their rights and not
be inert. They have a role to play and it is not fair to sit on their hands and complain.
Good corporate governance cannot be achieved by rules alone. The principle-based
approach such as that of the FRC with the UK Corporate Governance Code recognises
ÔStronger corporate governance legislation is emerging globally but true success will only come
14
Egypt is a country in which many of the public companies have substantial shareholders in the
form of founding families or government shareholders. How do you think that would affect
corporate governance?
15
EXERCISES
Question 1: Scenario Fred Paris
Manufacturing Co has been negotiating with Fred Paris regarding the sale of some property that
represented an old manufacturing site which is now surplus to requirements. Because part of the site
was used for manufacturing, it has to be decontaminated before it can be subdivided as a new housing
development. This has complicated negotiations. Fred is a property developer and he has a private
company (Paris Property Development Pty Ltd) and is also a major (15%) shareholder of FP
Development of which he is chairman. The negotiators for Manufacturing Co note that the documents
Conglomerate plc was a family company which was so successful that the founding Alexander family
Alexander family holding ÔAÕ class shares and the public holding ÔBÕ class shares. ÔAÕ class shares held
the right to appoint six of the eleven directors. ÔBÕ class shares could appoint Þve directors and
had the same dividend rights as the ÔAÕ class shares. The company could not be wound up unless a
resolution was passed by 75% or more of ÔAÕ class shareholders. Is there any risk of a governance
failure? Discuss.
The board of White plc is discussing the Þlling of a vacant position arising from the death of Lord
(a)Lord Sperring who is a well known company director and who was the managing director of
Sperring Manufacturers before he switched to being a professional director.
(b)John Spate, B.Eng., PhD who is managing director of a successful, innovative high technology
Question 8
The nancial statements of Rolls-Royce plc (aero engine manufacturer) for the year ended 31 December
1999 disclose the following matters in relation to the directors:
(a)Remuneration committee
The remuneration committee, which operates within agreed terms of reference, has responsi-
bility for making recommendations to the board on the Groups general policy towards executive
7www.sec.gov/litigation/admin/3438494.txt
8A.R. Wyatt (2003)
31.2How nancial reporting has evolved to embrace
sustainability reporting
Primary stakeholders
When corporate bodies were rst created the primary stakeholders were the shareholders
who had invested the capital and it was seen as the directors responsibility to maximise
Objectives
By the end of the chapter, you should be able to:

discuss the evolution of sustainability reporting including:
triple bottom line reporting;
the connected framework;
IFAC Sustainability Framework;
of reporting social and environmental impacts provided an incentive for a company to
identify and establish performance indicators.
Environmental impacts were identied in relation, amongst other things, to waste, emissions
and energy. Social impacts were identied in relation, amongst other things, to employment
and human rights issues.
However, sustainability reporting is evolving and the author of TPL writes
4
that:
In sum, the TBL agenda as most people would currently understand it is only the
beginning. A much more comprehensive approach will be needed that involves a wide
range of stakeholders and coordinates across many areas of government policy, including
tax policy, technology policy, economic development policy, labour policy, security
policy, corporate reporting policy and so on. Developing this comprehensive approach
to sustainable development and environmental protection will be a central governance
The Connected Reporting Framework has the following ve key elements
1
An explanation of how sustainability is connected to the overall operational strategy of
customers and consumers.
840

Accountability
31.4.1The Connected Reporting Framework illustrated
CO
Other signiÞcant emissions
31.5IFAC Sustainability Framework
6
The Framework indicates that the successful management of a sustainable organisation
requires attention to four perspectives. These perspectives are: business strategy, internal
management, nancial investors and other stakeholders.
As far as accountants are concerned, in an organisation a business strategy perspective
would typically be taken by nance directors, an internal management perspective by manage-
ment accountants and nancial controllers, and a nancial investors/other stakeholders
perspective by accountants preparing and auditing the published nancial statements.
31.5.1The Frameworks four perspectives
Taking a perspective means being aware of needs and concerns in relation to sustainability.
For example, the importance attached to the control of carbon emissions by other stakeholders
inuences the priority given to it by management. This might also have to be reconciled with
the business strategy perspective which could be that funds are being diverted away from
productive capital investment. Taking a perspective means being aware, communicating
effectively and inuencing behaviour within an organisation.
Figure 31.1 is an extract from the Framework summarising the four perspectives.
842

Accountability
Greenhouse gas emissions
In 2007, our total CO
2
emissions increased, mainly due
to the inclusion of emissions
data from our new business in
Aviva USA, Aviva Global
Services, Sri Lanka and Russia.
From our existing businesses,
emissions have shown an 11%
decrease, by 13,555 tonnes
reecting signicant focus
on energy efciency and
resourcing renewable energy.
Waste
In 2007, the total volume of
waste decreased and the total
amount recycled increased.
Plastic wrap from the Auto
Windscreens operation is now
being recycled 70 tonnes per
year with a value of 135 per
tonne.
Resource usage
There is limited scope for
Industry
Benchmark Information
Greenhouse gas emissions

Carbon Disclosure Project
CDP 5. Best in class

Innovest ranking AAA.

BREEAM minimum ranking
Good for new build and
refurbishment.
Waste
200 kg of waste per employee
per year.
Recycling rate of 6070%
(BRE Ofce toolkit).
Resource usage
7.7 m
3
per employee per year.
(National Water Demand
Management Centre).
As mentioned above, the cost of collecting and reporting is frequently perceived to be
reports on nancial statements. The following is an extract relating to a UK experience
(www.sustainabilityreporting.eu/uk/index.htm):
The challenges facing companies are:

starting assurance engagements using the updated, 2008 version of the AA1000AS;

improving the standards of assurance statements (as in previous years), including:
UK Environmental Reporting Awards, the ACCA Social Reporting Awards and a new
Encouragement has been actively given to SME reporting. For example, in 2000, at the
Europe-wide level, the European Environmental Reporting Awards (EERA), in which
entries are selected from the winners of national schemes organised by EU member states,
selected four winners:

Overall winner: Shell International (UK),

Best rst-time reporter: Acquedotto Pugliese (Italy),

Best SME reporter: Obermurtaler Brauereigenossenschaft (Austria),

Best sustainability report: Novo Nordisk (Denmark).
The judges commented on strengths, and in respect of the best SME reporter listed:

its comprehensive reporting on corporate performance including ve-year trend data for
to do this in Austria).
SMEs continue to be encouraged to develop CSR reporting.
In the UK the ACCA awards again looked carefully at assurance and reported
(www.accaglobal.com/uk/publicinterest/sustainability/):

All the shortlisted companies for the 2008 ACCA UK Sustainability Reporting
Awards have some form of external assurance of their reports, including the small
and medium-sized enterprises (SMEs), but the scope and approach varies widely
The directors of Meela Ltd have indicated that the shareholders of Meela Ltd would prefer the form
of consideration for the purchase of their shares to be in cash and you are informed that this is accept-
able to the prospective purchasing company, Chekani plc.
The directors of Meela Ltd have now been asked to state the price at which the shareholders of Meela
Ltd would be prepared to sell their shares to Chekani plc. As a member of a rm of independent
accountants, you have been engaged as a consultant to advise the directors of Meela Ltd in this regard.
Meela Ltd accounts for year ended 30 June 20X4
Statement of nancial position extracts as at 30 June 20X4:
000
Purchased goodwill unamortised
15,000
Freehold property
30,000
Plant and machinery
60,000
Investments
15,000
Ordinary
(3,000)
(iv)The preference share capital can be sold independently, and a buyer has already been found.
The agreed purchase price is 90p per share.
(v)Chekani plc has agreed to purchase the debentures of Meela Ltd at a price of £110 for each
£100 debenture.
(vi)The current rental value of the freehold property is £4.5 million per annum and a buyer is avail-
The company decides to drop prices by 15% for the next two months and to change the terms of
sale so that property does not pass until the clothes are paid for. This is purely a reection of the
tough economic conditions and the need to protect the rm against customer insolvency. Further, it
is decided that if sales have not increased enough by the end of the two months, the company rep-
resentatives will be advised to ship goods to customers on the understanding that they will be invoiced
12E.I. Altman, ÔFinancial ratios, discriminant analysis and the prediction of corporate bankruptcyÕ,
, vol. 23(4), 1968, pp. 589Ð609.
13M.L. Inman, ÔZ-scores and the going concern reviewÕ,
29.1Introduction
The main objective of this chapter is to explain what XBRL is and how reports in XBRL
assist investors and analysts to access and analyse data in published nancial statements.
29.2The reason for the development of a business reporting language
We saw in the previous chapter that various online subscription databases such as Datastream,
FAME and OneSource are available, where selected nancial reports have been formatted
by each of the databases into a standardised format. This allows subscribers to select peer
Objectives
By the end of the chapter, you should be able to:

understand the reason for the development of a business reporting language;

explain the benets of tagging in XML and XBRL code data for nancial
reporting;

understand why companies should adopt XBRL;

list the processes a company needs to take to adopt XBRL.
29.2.2Data re-keyed for analysis
(C of A). Once the data has been captured in the GL, statements of comprehensive income,
nancial position and cash ows can be produced for shareholders and for statutory ling.
XBRL has taken XML one step further and designed ÔtagsÕ based upon the common Þnancial
29.6XBRL and the IASB
Tags have been developed as a business reporting language and individual countries are
date the XBRL based statements will have the same legal status as any other Þnancial report.
UK developments
UK companies Þling accounts at Companies House were notiÞed that from April 2011
online submissions must be prepared using Inline XBRL (iXBRL). iXBRL is a speciÞc
HM Revenue and Customs (HMRC) require similar Þling and have stated that companies
with a turnover of more than £100,000 must lodge online for companies with accounting
v
+
w
+
x
The taxonomy also contains linkbases which provide additional information. For example:

a means to cross-reference with the para in the relevant IFRS;

an indication of the language used in the nancial report e.g. English, French;

prompts when a note to the accounts is required for a particular element.
Calculation:
29.9What is needed when receiving XBRL output information?
$000$000
129
that tags have to be developed for many more items than before. The inclusion of the notes
to the accounts is not new but the new requirements from the SEC involve different levels
of disclosure within the notes and this will require further development of either a linkbase
12
Investors who go to the companys individual website to download the nancial information
will nd that most will be in Adobe Acrobat (PDF) format and not easily copied to Excel for
comparative analysis.
XBRL UK reports
13
that both HMRC and Companies House are implementing the
data and then view it on a PC. iXBRL may be able to ll this gap.
792

In Australia, the Australian Prudential Regulatory Authority (APRA), is the government
body that controls and regulates banking and superannuation funds in Australia. It collects
Participation is voluntary and the required Þles are distributed by the Treasury.
governments need to rationalise the formats and volume in which they require businesses to
lodge information.
We have discussed the use of XBRL and iXBRL for submitting reports to statutory
authorities. There have also been interesting developments in their use for internal
accounting.
29.10Progress of XBRL development for internal accounting
Development in the general ledger area is continuing and will probably be one of the most
important developments for companies with consolidation requirements when multiple
general ledgers are involved. The general ledger specication has the advantage that organ-
isational data is classied at source and the classication decision with respect to XBRL
names will have been made at the Chart of Accounts level.
This is quite a task as the nancial statements usually report aggregated data. For
example, the total for administration expenses in the Income Statement is usually made
up by aggregating a number of different account classications in the General Ledger.
A further consideration is the effect of IFRSs when aggregating expense accounts. For
example, the Chart of Account structure for the disclosure of segmentation by product class
or geographical areas, is distinctly different. The XBRL code also needs to reect this.
The XBRL for the General Ledger may also bring great cost savings as data collection at
source is automated and the extraction and processing of data into reports can be achieved
in a much shorter time. A company such as General Electric has more than 150 general
ledgers which are not compatible in use. XBRL has the potential to considerably streamline
consolidation processes considerably.
The XBRL Global General Ledger Working Group (XBRL GL WG) within XBRL has
released an updated GL module
25
to include the SRCD (Summary Reporting Contextual
Data):
SRCD is a module of the XBRL Global Ledger Framework (XBRL GL) designed
directions
for XBRL. The reader is encouraged to investigate further any of the resources
available on the XBRL and other websites. A number of the links provided will lead to
good discussions of the projects and demonstrate how XBRL is applied. Some of the links
will also bring the reader to websites in languages other than English (Google translation
toolbar may be helpful) and may be of particular interest to readers of this text living in these
countries.
794

Discuss how an investor might beneÞt from annual reports being made available in XBRL.
Explain how a body such as a tax authority might beneÞt from XBRL.
Explain what you understand by taxonomy and mapping.
this will continue and extend beyond the current focus on published Þnancial state-
Financial statements presented in XBRL format are capable of being downloaded
EXERCISES
Question 1
Visit www.us.kpmg.com/microsite/xbrl/kkb.asp to attempt the XBRL tutorial and write a brief note on
how you think it will affect the work of a nancial accountant.
Question 2
Find the nancial reports for a company of your own choice. List the company and in what format the
Annual report is. See if you can also nd information on the
companysown
website about its use
of XBRL.
Question 3
Visit www.microsoft.com/msft/faq/xbrl.mspx and write a summary of Microsofts involvement in
XBRL.
Question 4 for the adventurous!
(a)Go to the SAP website: https://www.sap.com/solutions/sapbusinessobjects/large/enterprise-
performance-management/xbrl-publishing/index.epx?kNtBzmUK9zU
(b)Watch the demo:SAP BUSINESSOBJECTS XBRL PUBLISHING DEMO (on the right side of
the screen). Take note of how the software facilitates the creation and validation of the XBRL
taxonomies.
(c)Now compare this with the application of iXBRL. A good starting point would be
http://blogs.coreling.com/category/inline-xbrl/
(d)Write a review on both approaches to XBRL and discuss the differences. What type of company
would be most suited to these two solutions?
Question 5
Find out more about any of the following topics and write a one page summary on:
(a)the XBRL general ledger work;
(b)use of XBRL by stock exchanges;
(c)the commitment by the IFRS to the XBRL project;
(d)accounting software companies involved in providing XBRL capabilities;
(e)public utilities who are using XBRL;
(f)government involvement in XBRL.
References
1www/w3/org/Consortium/
2www.xbrl/org/WhatIsXBRL
3www.sec.gov/rules/nal/2009/33-9002.pdf (accessed 27/2/2010); http://xbrl.us/Learn/Pages/
USGAAPandSEC.aspx
796

4www.companieshouse.gov.uk/about/pdf/hmrcCommonFiling1.pdf (accessed 1/3/2010).
5www.hmrc.gov.uk/carter/compulsory-deadlines.htm (accessed 1/3/2010).
6www.xbrl.org/eu/ and select ÔFEE Policy Statement on XBRLÕ (accessed 1/3/2010).
7www.coreÞling.com/products/seahorse.html
8www.tcsl.co.uk/ (accessed 28/2/2010).
9www.xbrlspy.org/to_render_or_not_to_render_xbrl (accessed 28/2/2010).
10www.claritysystems.com/ap/events/webcasts/Pages/XBRL4Tagging.aspx (accessed 3/3/2010).
11http://viewerprototype1.com/viewer
12www.companieshouse.gov.uk/
13www.xbrl.org/uk/Projects/ (accessed 6/3/2010).
14www.companieshouse.gov.uk/about/pdf/hmrcCommonFiling1.pdf
15www.acra.gov.sg/
16http://www.openanalyticsintl.com/
17www.sbr.gov.au/About_SBR.aspx (accessed 6/3/2010).
18www.sbr.gov.au/Learning.aspx (accessed 6/3/2010).
19www.med.govt.nz/templates/MultipageDocumentTOC____41220.aspx#B0
20www.xbrl.org.eu
21www.xbrl-ntp.nl/english
22see www.xbrl.org/eu/ and select ÔXBRL in Action in EuropeÕ and follow the links to ÔSome
23www.xbrl-ntp.nl/banken/ (accessed 7/3/2010). Tip: use Google translate this page.
The following websites were accessed:
www.adobe.com
www.xbrl.org/Example1/
www.xbrl.org/FRTaxonomies/
www.us.jkpmg.com/microsite/xbrl/train/86/start.htm
www.xbrl.org
www.oracle.com/applications/nancials/OracleGeneralLedgerDS-1.pdf
www.xbrl.org.au/training.NSWWorkshop.pdf
www.microsoft.com/ofce/solutions.xbrl/default.mspx
www.ubmatrix.com/home/
www.semansys.com
www.j3technology.com/
www.sec.gov/spotlight/xbrl/xbrl-vfp.shtml
798

30.1Introduction
30.2The concept
30.2.1Stakeholder perspectives
tional shareholders,short-term and long-term investors, domestic and foreign investors Ð
understand the concept of corporate governance;
environmentalist shareholders. Trade unions may be representing different groups of
employees within the same company and have different objectives, power and under-
standing of the economic position of the company.
As well as there being conicting interest, there are also differences in the inuence that
a stakeholder can exert. For example, dominant shareholders and institutional investors
have a greater ability to hold management to account and achieve good corporate governance
outcomes.
We have described the complexity of a stakeholder perspective which assumes that each
stakeholder will pursue their individual view of what constitutes good governance. There is
also a systems perspective.
30.2.2A systems perspective
relatively rm-specic human capital (employees) and suppliers of other tangible
place it is highlighted as quickly as possible so as to minimise the cost to the organisation
to recognise the potential conicts of interest. It is interesting to see the approach taken by
the professional accounting bodies which are concentrating on sensitising students and
30.6Different jurisdictions have different governance priorities
30.6.1Future developments
Corporate governance requirements are less developed in the European Union (EU) coun-
tries (except the UK) and Japan. What about the future? Developments in the EU, Japan,
China, Russia and other Eastern Bloc (former communist) countries are leading to a model
of much wider ownership of shares (i.e. like the US and the UK). For example, in 2006 the
ticipants and the terms will be less favourable. Another way of addressing this is to say
Also from a macro perspective, the more efÞcient and effective the individual Þrms, the
30.8.2Comprehensive nancial statements
There are two aspects, namely, the nancial data and the narrative.
Comprehensive nancial data
30.9External audits in corporate governance

30.9.3Lack of independence Ð Enron
n...the
30.9.4Failure to carry out audit in accordance with audit standards Ð TYCO
from an SEC Þnding 2003Ð95:
SEC Finds PricewaterhouseCoopersÕs Engagement Partner Recklessly Issued
end of the Tyco annual audit for its Þscal year ended Sept.30, 1998, if not before,
management has made full disclosure of all material activities and transactions in its nancial
records and statements.
However, the representations do not absolve the auditor from obtaining sufcient and
appropriate audit evidence. The following is an extract
7
from an SEC nding relating to two
CPAs who were auditing a company which had improperly recorded sales and then written
them off in the following accounting period:
Despite the fact that the language in FEC purchase orders clearly stated the orders
were conditional and subject to cancellation, the auditors accepted the controllers
explanation and did not take exception to the recognition of revenue on these orders.
This undue reliance on managements representations constitutes insufcient
professional skepticism by Present (the engagement partner).
Moreover, Present failed to corroborate managements representations regarding
conditional purchase orders with sufcient additional evidence that these sales were
properly recorde
d...
Overall, Present failed to exercise due professional care in the
performance of the audit.
In each of the above there is good reason for the expectation gap in that the audit had not
been conducted in accordance with generally accepted audit standards and there was a lack
of due professional care. If the auditors have been negligent then they are liable to be sued
in a civil action. In the UK the profession has sought to obtain a statutory limit on their
liability and, failing that, some have registered as limited liability partnerships the path
taken by Ernst & Young in 1996 and KPMG in 2002. In Australia some accountants operate
do not contain material misstatements. It is not a forensic investigation commissioned to
30.9.8Educating users
30.9.9Governance within audit Þrms
awareness of the individual auditors of the likelihood of being sued, what the costs will be
to them personally and how that compares to rewards of being a good revenue generator.
30.10Corporate governance in relation to the board of directors
A properly functioning board makes for good corporate governance. What do we mean by
properly functioning? It means that (a) there is no one person dominating the Board and
(b) there are independent board members and (c) the board committees have independent
members who are not unduly inuenced by the executive directors. We will now discuss
each of these points.
30.10.1Separation of chairperson of the board and the senior executive
One of the roles of a board is to evaluate the executive management team and where
necessary to remove non-performing executives. This is important in the sense that the
senior executive (variously titled CEO, Chief Executive Ofcer, MD, Managing Director,
Executive Director, Director General) and their team are being supervised. Where the senior
executive has a forceful personality there is a real need for someone who can constructively
challenge and make sure that major decisions are seriously reviewed. It is hard for subordin-
ates to tell their boss that a strategy is wrong or too risky an independent chairperson can.
30.10.2Independent board members
To ensure that the company can appoint independent directors, the company should have a
nominating committee for board and audit committee appointments so that board members
are not beholden to the CEO for their positions. Those committees should not include
management.
30.10.3Audit committees
To ensure that the audit committee of the board of directors is independent, it is normally
recommended that the chair of the audit committee be a person of high prestige who is
knowledgeable in accounting and independent of management. Some believe that all members
of the audit committee should be independent of management and of any substantial share-
holders. Independence also requires the ability to look at events and scrutinise them from
the perspectives of the relevant stakeholders. Independence is a state of mind which is much
more difcult to achieve when there are personal connections with the CEO.
30.11Executive remuneration
It is worth reinforcing the fact that the objective of corporate governance is to focus manage-
ment on achieving the objectives of the company whilst keeping risks to appropriate levels
and positioning the rm for a prosperous future. At the same time, sufcient safeguards
must be in place to reduce the risks of resources being inappropriately diverted to any group
at the expense of other groups involved.
gamble with company resources by taking excessive risks.
814

Accountability
30.11.1What is fair?
30.11.4Performance criteria
Directors are expected to produce increases in the share price and dividends. Traditional
measures have been largely based on growth in earnings per share (EPS), which has encour-
aged companies to seek to increase short-term earnings at the expense of long-term earnings,
e.g. by cutting back capital programmes. Even worse, concentrating on growth in earnings
per share can result in a reduction in shareholder value, e.g. by companies borrowing and
therefore, on the part of institutional investors to indicate a general preference for
documentation can help reduce the risks. In some companies the protection of intellectual
property should be of considerable relevance.
30.13.4Financial risks
rolled over were too optimistic and often items were looked at in isolation. By looking at it
in isolation, the risk associated with an item was assessed on the assumption that an adverse
event affected only that item whilst everything else was normal. However, when all parts of
risk the company spread its investments across all types of properties (residential units,
houses, industrial, ofce blocks, and shopping centres) and across several major cities. It did
its stress analysis assuming one segment at a time (say, shopping centres) fell 15% in value.
Under that analysis whichever segment fell, with the other segments remaining static,
great nancial crisis all segments fell 12% to 20% with an overall fall of 17%, causing the
30.14.1HK Code of Corporate Governance
there is a positive impact on performance is an Australian research project
17
looking at
companies in the S&P/ASX 200 index which found that companies which the researcher
classied as having poor corporate governance outperformed companies classied as having
30.15.2The UK Corporate Governance Code

The board should
The code is regularly updated to reßect changes in perception of best practice. For example,
a change was made which allowed the company chairman to sit on the remuneration com-
The code is periodically revised to adopt recommendations based on reports such as those
above. This is one of the strengths of the code that it continually attempts to review current
practice and improve the corporate governance regime.
30.15.4NEDs
The main function of non-executive directors is to ensure that the executive directors are
pursuing policies consistent with shareholders interests.
20
Review of their contribution
Considering the qualities that are required, the Cadbury Report recommended that the
board should include non-executive directors of sufcient calibre and number for their
views to carry signicant weight in the boards decisions. Research
21
indicated that they are
there may be constraints:
other board member.

Verication is seen as an important element and environmental audits, covering all activ-
ities at the organisation concerned, must be conducted within an audit cycle of no longer
31.14.1The International Chamber of Commerce (ICC)
In order to provide assurance to stakeholders over Nestl Creating Shared Value
reporting, an external auditor Bureau Veritas has been engaged. For more information,
read the full Bureau Veritas Assurance Statement.
Nestl is also among the rst food companies to join the Global Reporting Initiative
multi-stakeholder programme to develop global reporting standards and indicators on
sustainability in the food industry.
31.14.2The International Organization for Standardization (ISO)
The ISO is a non-governmental organisation established in 1947, and comprises a world-
wide federation of national standards with the aim of establishing international standards to
reduce barriers to international trade. Its standards, including environmental standards, are
voluntary and companies may elect to join in order to obtain ISO certication.
One group of standards, the ISO 14000 series, is intended to encourage organisations
to systematically assess the environmental impacts of their activities through a common
approach to environmental management systems. Within the group, the ISO 14001 standard
states the requirements for establishing an EMS and companies must satisfy its requirements
in order to qualify for ISO certication.
What benets arise from implementation of ISO 14001?
Those who support the ISO approach consider that there are a number of positive advantages,
such as:

Top-level management become involved
they are required to dene an overall
policy and, in addition, they recognise signicant nancial considerations from certica-
tion, e.g. customers might in the future prefer to deal with ISO compliant companies,
insurance premiums might be lower and there is the potential to reduce costs by greater
production efciency.

Environmental management
ISO 14001 establishes a framework for a systematic
approach to environmental management which can identify inefciencies that were not appar-
ent beforehand resulting in operational cost savings and reduced environmental liabilities.
We have seen above, for example, that Nestl reduced its energy consumption by 20%.

A framework for continual improvements is established
there is a requirement
for continual improvement of the management system.
What criticisms are there of a compliance approach?
31.15.2Investors
However, there is still a long way to go and the EUs Sixth Action Programme Environment
2010: Our Future, Our Choice
20
recognises that effective steps have not been taken by all
member states to implement EC environmental directives and there is weak ownership of
environmental objectives by stakeholders. The programme focuses on four major areas for
action climate change, health and the environment, nature and biodiversity, and natural
resource management and emphasises how important it is that all stakeholders should be
involved to achieve more environmentally friendly forms of production and consumption as
well as integration into all aspects of our life such as transport, energy and agriculture.
As with the other environmental reporting initiatives discussed above and the corporate
governance approach we have seen with the Hampel Report and the OFR, the programme
31.18The activities involved in an environmental audit
31.18.1Assessing the current position
31.18.2Assessing the future
crisismanagement
31.18.3The environmental audit report
We can see from the above that an environmental audit may be wide-ranging in its scope and
time-consuming, particularly when auditing a major organisation. A typical report could
include:

Current practice
a comprehensive review and comment on current operational practices.

List of action required
areas of
immediate concern
which the organisation needs to address as a matter of
urgency;
31.18.5Experience in the USA

internal stakeholders
managers and workers;

external stakeholders
shareholders, creditors, banks and debtors;

related stakeholders
29
The information needs of different categories, e.g. employees and the public, need not be
identical. The provision of information of particular interest to the public has been referred
to as
public interest accounting
,
30
but there is a danger that, whilst valid as an approach,
it could act as a constraint on matters that might be of legitimate interest to the employee
to the level of the employees. One study identiÞed that different levels of employee ranked
the information provided about the employer differently, e.g. lower-level employees rated
Statement of corporate objectives
Would this be the place for social accounting to start? Would this be the place for vested
interests to be represented so that agreed objectives take account of the views of all
stakeholders and not merely the management and, indirectly, the shareholders? At present,
social
accounting appears as a series of add-ons, e.g. a little on charity donations, a little on
disabled
recruitment policy. Corporate objectives or the mission statement are often seen as
Figure 31.2Barloworld Limited value added statement for year ended
31.20.1Why
The Corporate Report
was not implemented
The Corporate Report
s proposals for additional reports have not been implemented. There
are a number of views as to why this was so. There is a view that the business community,
despite the results of the chairmen survey, were concerned about the possibility of their report-
ing responsibility being extended through the reports concept of public accountability and
welcomed the release of the Sandilands Report on ination accounting which overshadowed
The Corporate Report
. There is a view that
The Corporate Report
fell short of making a
signicant contribution by virtue of its failure to select the accounting models appropriate
to the informational needs of the individual user groups which it had identied.
40
However, the most likely reason for it not being fully implemented was the change of
government. The Labour government produced a Green Paper in 1976,
Aims and Scope
of Company Reports
, which endorsed much of
The Corporate Report
concept. The reaction
from the business community and the Stock Exchange was hostile to any move away from
the traditional stewardship concept with its obligations only to shareholders. The CBI view
was that other users could ask for information, but that was no reason for companies to be
required to provide it.
41
In the event, there was a change of government and the Green Paper
sank without trace.
The new government supported the view of Milton Friedman, who wrote in 1962 that
few trends could s
o...
the Environment award for energy saving; and
We can see from this that community involvement can take many forms, e.g. charitable
within an overall compliance system that includes emergency planning, energy and
environment is as follows:
Human rights
Particularly applicable to countries with operations or suppliers in developing countries.
The issues measured under human rights largely apply to companies who operate
in, or buy from suppliers in, developing countries. What does or does not constitute
The human rights indicators are being developed further: in consultation with
non-governmental organisations and businesses engaged in human rights issues. While
Environment
Use of recycled material
¥
869
Recycled cardboard
200060%
199950%
199825%
Many types of packaging use recycled materials as a matter of course, e.g. glass bottles,
tin cans and transport boxes. Where we believe that the use of recycled materials is
or services or entering into any other commercial partnership arrangement will have
available to them a clear picture of the human and ecological impact of the business so that
they can make an informed decision.

Management has the means to develop information systems to provide the basis for
monitoring performance, making inter-company comparisons and reporting to stakeholders.
870

Accountability
31.23.3What information should appear in an ideal GRI report?
31.23.5Will there be any impact on matters that are currently disclosed?
There may be an overlap with existing disclosures in the OFR and there is also a pressure
for additional information to permit a greater understanding of future risks, e.g. the GRI
acknowledges that in nancial reporting terms a going concern is one that is considered
to be nancially viable for at least the next nancial year but seeks additional information
such as:

The extent to which signicant internal and external operational, nancial, compliance,
and other risks are identied and assessed on an ongoing basis. Signicant risks may,

wages and benets: totals by country;

labour productivity: levels and changes by job category;

Discuss the relevance of corporate social reports to an existing and potential investor.
Obtain a copy of the environmental report of a company that has taken part in the ACCA
Awards for Sustainability Reporting and critically discuss from an investorÕs and public interest
ÔCharters and guidelines help make reports reliable but inhibit innovation and reduce their
relevance.Õ Discuss.
Discuss the implications of the Global Reporting Initiative for the accountancy profession.
The Corporate Report
Õs relevance to modern business; identify changes that would improve
current reporting practice and the conditions necessary for such changes to become mandatory.
(a)Explain the term ÔstakeholdersÕ in a corporate context.
(b)ÔSocial accounting recognises all
Corporate Report
users as stakeholders.Õ Discuss.
environmental and social. It is recognised that advances in environmental and social
As environmental and social reporting evolves, there are proposals being made to
harmonise the content and disclosure. This can be seen with the publication of the triple
In addition there are benchmark schemes which allow stakeholders to compare
corporate social reports and evaluate an individual companyÕs performance. The manage-
Corporate social reporting is coming of age. Initially there were fears that it would
add to costs and there are present concerns that it is diverting too much of a Þnance
7
Discuss the value added concept, giving examples, and ways to improve the statement.
8
Outline the arguments for and against a greater role for the audit function in corporate social reporting.
9
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
*Question 1
The following information relates to the Plus Factors Group plc for the years to 30 September 20X8
Notes20X920X8
£000£000
Associated company share of proÞt
10.910.7
AuditorsÕ remuneration
12.211.9
Payables for materials
1,109.1987.2
1,244.21,109.1
1,422.01,305.0
1,601.01,422.0
11% debentures
1500.0600.0
Depreciation
113.798.4
109.968.4
Hire of plant, machinery and vehicles
266.5367.3
Materials paid for in year
3,622.92,971.4
Minority interest in proÞt of the year
167.2144.1
Other overheads incurred
1,012.4738.3
Pensions and pension contributions paid
319.8222.2
ProÞt before taxation
1,437.41,156.4
Provision for corporation tax
464.7527.9
Salaries and wages
1,763.81,863.0
39,905.68,694.1
Shares at nominal value
Ordinary at 25p each fully paid
42,500.02,000.0
7% preference at £1 each fully paid
4500.0200.0
Inventories of materials
804.1689.7
837.8804.1
Ordinary dividends were declared as follows:
Interim1.12 pence per share (20X8, l.67p)
Final3.57 pence per share (20X8, 2.61p)
Average number of employees was 196 (20X8, 201)
Notes
:
1300,000 of debentures were redeemed at par on 31 March 20X9 and 200,000 new debentures
at the same rate of interest were issued at 98 for each 100 nominal value on the same date.
The new debentures are due to be redeemed in ve years time.
2This is the amount for inclusion in the statement of comprehensive income.
3All the groups sales are subject to value added tax at 15% and the gures given include such tax.
All other gures are exclusive of value added tax. This VAT rate has been increased to 17.5% and
may be subject to future changes, but for the purposes of this question the theory and workings
remain the same irrespective of the rate.
4All shares have been in issue throughout the year.
Workings000
Turnover
17,560.1
Less
: Bought-in materials and services
24,096.4
Value added by group
3,463.7
Share of prots of associated company
10.7
3,474.4
Applied in the following ways
To pay employees
32,153.662.0%
To pay providers of capital
4566.516.3%
To pay government
527.915.2%
3,474.4100.0%
Workings
1
Turnover
Sales inclusive of VAT
8,694.1
VAT at 15%
1,134.0
7,560.1
2
Bought-in materials and services
Cost of materials
Creditors at end of year
1,109.1
Add:
Payments in year
2,971.4
4,080.5
Less
: Payables at beginning of year
987.2
Materials purchased in year
3,093.3
Add
: Opening inventory
689.7
Less
: Closing inventory
(804.1)
Materials used
2,978.9
Add: Cost of bought-in services
Auditors remuneration
11.9
Hire of plant, machinery and vehicles
367.3
Other overheads
738.3
4,096.4
876

Accountability
Pensions and pension contributions
Salaries and wages
To pay providers of capital
Debenture interest
Preference 20X8 7% of £200,000
Ordinary 20X8 8 million shares at 4.28p
Minority interest
minority interest
(356.4)
Depreciation
(a)Prepare a statement of value added for the year to 30 September 20X9. Include a percentage
(b)Produce ratios related to employeesÕ interests based on the statement in (a) and explain how
(c)Explain brießy what the difÞculties are of measuring and reporting Þnancial information in the
Arton
Blendale
Clifearn

Sales
910,800
673,200
382,800
Cost of sales
633,100
504,900
287,100
Gross prot
277,700
168,300
95,700
Less
: Expenses:
David Marks salary
10,560
10,560
10,560
Other salaries and wages143,220
97,020
78,540
Rent
19,800
Rates
8,920
5,780
2,865
Advertising
2,640
2,640
2,640
Delivery van expenses
5,280
5,280
5,280
General expenses
11,220
3,300
1,188
Telephone
2,640
1,980
1,584
Wrapping materials
7,920
3,960
2,640
Depreciation:
Fixtures
8,220
4,260
2,940
Vehicle
3,000203,6203,000157,5803,000111,237
The gures for the year ended 31 May 20X4 follow the pattern of recent years. Because of this, David
20X620X5
£000£000
4042
(b)Although value added statements were recommended by
The Corporate Report
1Quantities of chemicals for disposals on site at the year-end included:
(A)Axylotl peroxide
40,000 gallons
(B)Pterodactyl chlorate35 tons
Chemical A is disposed of for a South Korean company, which was invoiced for 170 million won
on 30 January 20X5, for payment in 120 days. It is estimated that the costs of disposal will not
exceed 75,000. 60,000 of costs have been incurred at the year-end.
Chemical B is disposed of for a British company on a standard contract for cost of disposal
plus 35%, one month after processing. At the year-end the chemical has been broken down into
The following items have been extracted from the accounts:
m)2004 (
Cost of materials
25,69424,467
Depreciation/amortisation
4,2073,589
Providers of Þnance
1,3511,059
7,3067,125
(a)Prepare a Value Added Statement showing % for each year and % change
(b)Draft a note for inclusion in the Annual Report commenting on the Statement you have prepared.
1M. Friedman,
2www.wbcsd.org/templates/TemplateWBCSD5/layout.asp?type=p&MenuId=MTE0OQ
3J. Elkington,
Cannibals With Forks: TheTripleBottom Lineof 21st Century Business
4www.johnelkington.com/TBL-elkington-chapter.pdf.
5www.sustainabilityatwork.org.uk/strategy/report/0.
6web.ifac.org/sustainability-framework/ip-introduction.
7S.J. Gray and C.B. Roberts,
8AICPA,
9C. Lehman,
12KPMG Peat Marwick McLintock,
13M. Jones, ÔThe cost of cleaning upÕ,
14M. Campanale, ÔCost or opportunityÕ,
15See http://www.iasplus.com/resource/0105euroenv.pdf
16See www.unep.org
17See http://ec.europa.eu/environment/emas/index_en.htm
18See www.iccwbo.org
19See www.ceÞc.be/
20See http://ec.europa.eu/environment/newprg/
21See www.ceaa-acve.ca/aboutus.htm
24M.R. Matthews and M.H.B. Perera,
Accounting Theory and Development
, Chapman and Hall,
1991, p. 350.
25Accounting Standards Steering Committee,
The Corporate Report
, 1975.
26R. Gray, D. Owen and K. Maunders,
Corporate Social Reporting
, Prentice Hall, 1987, p. 75.
27ASB,
Statement of Principles: The Objective of Financial Statements
, 1991, para. 9.
28
Ibid
., para. 10.
29
Ibid
., para. 11.
Bibliography
The following references have been helpful for students carrying out assignments in the
developing areas of environmental and social reporting:
Association of British Insurers,
Investing in Social Responsibility Risks and Opportunities
, London:
Association of British Insurers, 2001.
C.A. Adams, W.-Y. Hill and C.B. Roberts, Corporate social reporting practices in Western Europe:
legitimating corporate behaviour?,
British Accounting Review
, vol. 30, no. 1, 1998, pp. 122.
C.C. Adams, A. Coutts and G. Harte, Corporate equal opportunities (non-) disclosure,
British
Accounting Review
, vol. 27, no. 2, 1995, pp. 87108.
P. Bartram, Go green, not into the red,
Accountancy Age
, 31 October 2002, p. 15.
J. Bebbington, Sustainable development: a review of the international development business and
accounting literature,
Accounting Forum
, vol. 25, no. 2, 2001, pp. 128157.
J. Bebbington and I. Thomson, Commentary on: Some thoughts on social and environmental
accounting education,
Accounting Education: An international journal
, vol. 10, no. 4, 2001,
pp. 353-355.
F. Birkin, P. Edwards and D. Woodward, Some Evidence on Executives Views of Corporate Social
Responsibility,
British Accounting Review
, vol. 33, 2001, pp. 357397.
J.H. Blokdijk and F. Drieenhuizen, The environment and the audit profession a Dutch research
study,
The European Accounting Review
, December 1992, pp. 437443.
K. Bondy, D. Matten and J. Moon, The adoption of voluntary codes of conduct in MNCs a three
countries comparative study,
MNCsÕ, in S. Benn and D. Dunphy (eds.)
Corporate Governance and Sustainability: Challenges
for Theory and Practice
W. Chapple and J. Moon, ÔCorporate social responsibility (CSR) in Asia: a seven country study of
CSR website reportingÕ,
A & J Muklow plc 426
A-scores 7534
abandonment 232, 233
abbreviated accounts 120
ACCA
see
Association of Chartered
Certied Accountants
Accor 117
accountability 143, 152, 179
SME test: public 122
stewardship
see separate entry
accountants 443, 815
environmental and social reporting
8445, 862, 872
failure prediction models 74955
H-scores 7523, 763
overview 73845
performance related remuneration
7569
risk reporting 738
sensitivity analysis 745
Index
for 736Ð8
shariah compliant companies 745Ð7
unquoted company shares 760Ð4
Z-scores 750Ð2, 763
696Ð7, 758
directorsÕ report 186, 207, 209Ð10,
discontinued operations 233Ð5
environmental reporting 845Ð6, 858
events after reporting period 235Ð7
environment 853Ð4, 858Ð60
cash ßow accounting 3Ð17, 32
characteristics of data 11Ð12, 15Ð16
cash ßow statement 186, 454, 668Ð70
accrual accounting 32Ð4
analysis of 679Ð84
consolidated 591Ð2, 677Ð9
free cash ßow (FCF) 682Ð3, 757
241, 681Ð2, 754
Chartered Institute of Public Finance
and Accountancy (CIPFA) 176
chief executive ofcer (CEO) 160,
1701, 807, 814, 827
chief nancial ofcer (CFO) 160, 807
China 805, 806
Hong Kong 821, 851
IFRSs 115
Chrysler Corporation 861
CIMA
see
Chartered Institute of
Management Accountants
CIPFA
see
Chartered Institute of Public
Finance and Accountancy
Citi 474
environmental 8456
contributions 205
control 141
denition of 5512
internal control systems 50910, 807
convertible loans 317, 653, 654
convertible preference shares 262,
31718, 6534
Cookson Group plc 2612
copyright 479, 480
corporate failure prediction models
74955
corporate governance 84950
accounting, role of 8078
auditors 804, 80914, 818, 831
behaviour, effect on corporate 8023
Board of Directors 814, 8234
norms in different 164
organisational 171
cumulative preference shares 262
segment reporting 226, 228Ð9
747Ð9, 765
deductive approach 131, 132Ð3
deferred tax 384Ð93, 844
critique of 393Ð6
accrual accounting 29Ð30
EBITDA (earnings before interest, tax,
depreciation and amortisation)
453, 454, 467, 707, 7201, 764,
822
Eco-Management and Audit Scheme
(EMAS) 8534
economic income 4953
economic value added (EVA) 7589,
763
economists
historical overview 130Ð3
177Ð8
publicÐprivate partnerships 536Ð7
recognition of 325Ð6, 336
history of 40Ð1
governments (
continued
)
related party disclosures 2401
social reporting 866
grants 205
Great Portland Estates plc 395
Greenbury Report 756
gross prot 2001
groups
accounts
see
consolidated accounts
denition 549
GUS 394
H-scores 7523, 763
Harris Queensway 510
Hart plc 348
hedge accounting 313, 32930, 382, 625
held-for-trading investments 321
held-to-maturity investments 322, 323,
3245, 327
Hicks, John 50, 132
Higgs report (2003) 825
historical cost accounting (HCA) 234,
32, 434, 54, 845, 131, 195
accounting base 201
ASB approach 81, 82, 83, 1456
CCA statements and 7980
example 615
IASB
Framework
137, 138, 503
intellectual property 482
modied 44, 46, 845, 130, 137, 145,
146, 152
problems of 5960, 429
historical overview
accounting scandals 1023, 11213
nancial accounting theory 1303
Holman AB 515
Hong Kong 821, 851
Hooker Chemical Corporation 8456
horizontal analysis 7412, 7434
hotels 410
HSBC 708
HTML (Hyper Text Mark-up
Language) 783, 784, 791
Hugo Boss 147, 476
human rights 840, 869
hyperination 834
IBM 474
ICAEW (Institute of Chartered
Accountants in England and
Wales) 103, 142, 267, 392, 395,
482, 669, 738
32Ð4, 669Ð79,
680, 683Ð5
235Ð7, 283, 375, 572
524Ð32, 538
382Ð92, 393, 395, 426
29Ð30, 146, 195, 385, 391, 405,
133, 284, 427, 441, 442Ð56
346, 347Ð58, 359
405, 425Ð7, 517
391, 623Ð33
118, 405, 406Ð7
237Ð41
leases 130, 427, 4414
denitions 441, 4423
depreciation 415, 446, 448, 455
information needs 138, 1512
leases 444
principlesbased approach 162
protection of 258, 2635, 26971, 273,
276
reconstruction: debenture holders
2713
see also
credit rating agencies
long-term contracts 44, 46
see also
construction contracts
SMEs 122
losses
unrealised 46
Þnancial reporting 22Ð3, 85Ð6, 134,
Þnancial statements 22Ð3, 86, 137,
138Ð40
income measurement 40Ð3
objectivity 11, 23Ð4, 43, 44, 46
262, 271, 274, 316Ð18
prepayments 189Ð90
present values (PV) 45, 47Ð9, 50, 53,
¥
893
ratios (
continued
)
comparison with previous year 715
consolidated accounts 720
cost classication and 2001
current 305, 498, 514, 698, 700, 7023,
705, 706, 719, 720, 740, 741, 745,
748, 749
EBITDA 7201
nancial instruments 31617
nancial leverage multiplier 698, 700,
701, 703, 705
free cash ow 683
gearing
see separate entry
inter-rm comparisons and industry
averages 71517, 71920
inventory valuation 498, 514
investment
see separate entry
key 698706
limitations of 71820
liquidity
see separate entry
non-nancial liabilities 304
earnings per share, use of 643Ð4
statement of nancial position (
continued
)
ination accounting 61, 623, 66,
6870, 726, 779
factoring 2889, 719
turnover ratio 71213, 718, 719, 742
trademarks 473, 479
transparency 314, 482, 737, 738, 765,
815, 825
non-nancial liabilities 304
principlesbased approach 149
special purpose entities (SPEs) 3045
Treadway Commission: COSO 510
treasury shares 257, 274, 275
trial balance 18890
triple bottom line (TBL) 83940, 8434
true and fair 16, 150, 162, 2034, 205,
498, 510, 813, 831
mandatory standards 101Ð3, 113
31.10Background to companiesÕ reporting practices
31.11European CommissionÕs recommendations for disclosures in
31.12Evolution of stand-alone environmental reports
31.13International charters and guidelines
31.14Self-regulation schemes
31.15Economic consequences of environmental reporting
31.16Summary on environmental reporting
31.17Environmental auditing: international initiatives
31.18The activities involved in an environmental audit
31.19Concept of social accounting
31.20Background to social accounting
31.21Corporate social responsibility
31.22Need for comparative data
31.23International initiatives towards triple bottom line reporting
Exercises
Bibliography
Chapter 4Accounting for price-level changesIAS 29
Chapter 8Preparation of statements of comprehensiveIAS 1, IFRS
Chapter 9Preparation of published accountsIAS 8, IAS 10, IAS 24, IFRS 5
¥
xxiii
worked solutions to all the exercises and is of a quality that allows them to be used as over-
We owe particular thanks to Ron Altshul, who has updated ÔTaxation in company
accountsÕ (Chapter 14); Charles Batchelor formerly of FTC Kaplan for ÔFinancial instru-
practice tools tied to the online e-book. At the core of
Practice tests for each section of the textbook enable students to test their understanding and identify
the areas in which they need to do further work. Lecturers can customise the practice tests or leave
We would also like to thank the authors of some of the end-of-chapter exercises. Some of
support in keeping us largely to schedule and the attractively produced and presented text.
Finally we thank our wives, Di and Jacklin, for their continued good humoured support
during the period of writing and revisions, and Giles Elliott for his critical comment from
the commencement of the project. We alone remain responsible for any errors and for the
thoughts and views that are expressed.
Barry and Jamie Elliott
xxiv

Preface and acknowlegements
xxvi

Guided tour of MyAccountingLab
Each student can work through the study plan at their own pace, with instruction provided in the
1.1Introduction
1.2Shareholders
of shareholders and managers;
The information to which shareholders are entitled is restricted to that specied by
statute, e.g. the Companies Acts, or by professional regulation, e.g. Financial Reporting
1.5What skills does an accountant require in respect of internal reports?

Openmirrors.com
Openmirrors.com
1.7Agency costs
3
The information in Figure 1.2 assumes that the directors have made their investment
decision based on the assumed preferences of the shareholders. However, in real life, the
directors might also be inuenced by how the decision impinges on their own position.
If, for example, their remuneration is a xed salary, they might select not the investment
with the highest IRR, but the one that maintains their security of employment. The result
might be suboptimal investment and nancing decisions based on risk aversion and over-
1.8.1Appraisal of the initial investment decision
Figure 1.5NPV calculation using discount tables
1.8.2Preparation of periodic nancial statements under the cash ow
concept
Having
predicted
the realised operating cash ows for the purpose of making the invest-
ment decision, we can assume that the owner of the business will wish to obtain
feedback
to evaluate the correctness of the investment decision. He does this by reviewing the actual
results on a regular
timely
basis and
comparing
these with the predicted forecast. Actual
results should be reported quarterly, half-yearly or annually in the same format as used
when making the decision in Figure 1.4. The actual results provide management with the
feedback information required to audit the initial decision; it is a technique for achieving
accountability. However, frequently, companies do not provide a report of actual cash ows
to compare with the forecast cash ows, and fail to carry out an audit review.
In some cases, the transactions relating to the investment cannot be readily separated from
other transactions, and the information necessary for the audit review of the investment
cannot be made available. In other cases, the routine accounting procedures fail to collect
such cash ow information because the reporting systems have not been designed to
provide nancial reports on a cash ow basis; rather, they have been designed to produce
reports prepared on an accrual basis.
What would nancial reports look like if they were prepared on a
cash ow basis?
To illustrate cash ow period accounts, we will prepare half-yearly accounts for Mr Norman.
To facilitate a comparison with the forecast that underpinned the investment decision, we
will redraft the forecast annual statement on a half-yearly basis. The data for the rst year
given in Figure 1.4 have therefore been redrafted to provide a forecast for the half-year to
30 June, as shown in Figure 1.6.
From this
These are, of course, only the cash ßows relating to the trading transactions.
The information in the ÔTotalÕ row of Figure 1.7 can be extracted to provide the Þnancial
statement for the six months ended 30 June 20X1, as shown in Figure 1.9.
The Þgure of £15,650 needs to be compared with the forecast cash ßows used in the
investment appraisal. This is a form of auditing. It allows the assumptions made on the initial
Figure 1.8Monthly realised operating cash ßows

The data are
consistent
. The statement incorporates the same cash ows within the
periodic nancial report of trading as the cash ows that were incorporated within the
initial capital investment report. This permits a logical comparison and conrmation that
the decision was realistic.

The results have a
conrmatory
value by helping users conrm or correct their past
assessments.

The results have a
predictive
value, in that they provide a basis for revising the initial
forecasts if necessary.
4

There is
norequirementforaccountingstandards
or disclosure of accounting policies
Figure 1.10Forecast/actual comparison
1.9.1Stewardship
Figure 1.12Statement of Þnancial position
If this is not acceptable, management will review its working capital by reconsidering the
credit given to customers, the credit taken from suppliers, stock-holding levels and the timing
of capital cash inows and outows.
If, in the example, it were possible to obtain 45 days credit from suppliers, then the
creditors at 30 June would rise from 37,000 to a new total of 53,500. This increase in
trade credit of 16,500 means that half of the May purchases (33,000/2) would not be
paid for until July, which would convert the overdraft of 14,350 into a positive balance of
2,150. As a new business it might not be possible to obtain credit from all of the suppliers.
In that case, other steps would be considered, such as phasing the payment for the lease of
the warehouse or introducing more capital.
An interesting research report
5
identied that for small rms survival and stability
were the main objectives rather than prot maximisation. This, in turn, meant that cash ow
indicators and managing cash ow were seen as crucial to survival. In addition, cash ow
information was perceived as important to external bodies such as banks in evaluating
performance.
is able clearly to identify the following:
of investing in the lease;
1.11.2Neutrality characteristic
1.11.5Substance over form
Cash ow accounting does not necessarily possess this characteristic which requires that
transactions should be accounted for and presented in accordance with their substance and
economic reality and not merely their legal form.
8
1.12Reports to external users
1.12.1Stewardship orientation
Cash ow accounting provides objective, consistent and prudent nancial information about
a businesss transactions. It is stewardship-orientated and offers a means of achieving
accountability over cash resources and investment decisions.
1.12.2Prediction orientation
External users are also interested in the ability of a company to pay dividends. It might be
thought that the past and current cash ows are the best indicators of future cash ows and
dividends. However, the cash ow might be misleading, in that a declining company might
Summary
To review our understanding of this chapter, we should ask ourselves the following
questions.
How useful is cash ow accounting for internal decision making?
Forecast cash ows are relevant for the appraisal of proposals for capital investment.
Actual cash ows are relevant for the conrmation of the decision for capital investment.
Cash ows are relevant for the management of working capital. Financial managers
accountable?
ment of Þnancial position, provides a stewardship report. Lee states that ÔCash ßow
By reducing judgements in this type of Þnancial report, management can report
factually on its stewardship function, whilst at the same time disclosing data of use
cash movements and to extend the statement of Þnancial position to include the
unrealised
cash ßows.
accountee, and the accountant ... the decision useful approach is heavily biased in favour of the
accountee ... with little concern for the accountor ... in the central position Ijiri would put fairness.
12
Discuss Ijiris view in the context of cash ow accounting.
3
Discuss the extent to which you consider that accounts for a small businessperson who is carrying
on business as a sole trader should be prepared on a cash ow basis.
4
Explain why your decision in question 3 might be different if the business entity were a medium-
sized limited company.
5
Realised operating cash ows are only of use for internal management purposes and are
irrelevant to investors. Discuss.
6
While accountants may be free from bias in the measurement of economic information, they
cannot be unbiased in identifying the economic information that they consider to be relevant.
Discuss.
7
EXERCISES
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
Question 1
(ix)She will introduce new capital of £82,500 on1April 20X1.
(x)Insurancecoveringthe12monthsof20X1of£2,100willbepaidforbychequeon30June20X1.
(xi)All receipts and payments will be by cheque.
(xii)Inventory on 30 June 20X1 will be £30,000.
Demand is seasonal and Fred and Sally nd that there is insufcient work during the winter months
to pay rent for the increased accommodation and also wages to the extra two members of staff. The
four of them could spend October to March in Lanzarote as windsurf instructors and close the UK
operation down in this period. If they did, however, they would lose the Dryline agency, as Dryline
3G. Whittred and I. Zimmer,
4IASC,
5R. Jarvis, J. Kitching, J. Curran and G. Lightfoot,
6IASC,
10T.A. Lee,
12D. Solomons,
2.1Introduction
The main purpose of this chapter is to extend cash ow accounting by adjusting for the
Objectives
By the end of this chapter, you should be able to:

explain the historical cost convention and accrual concept;

adjust cash receipts and payments in accordance with IAS 18
Revenue
;

The IASC considers that economic decisions also require an evaluation of an enterpriseÕs
ability to generate cash, and of the timing and certainty of its generation.
By this we mean that various parties who deal with the enterprise, such as lenders, will
know that the gures produced in any nancial statements are objective and not manipulated
by subjective judgements made by the directors. A typical example occurs when a lender
attaches a covenant to a loan that the enterprise shall not exceed a specied level of gearing.
At an operational level, revenue and expense in the statement of comprehensive income are
stated at the amount that appears on the invoices. This amount is objective and veriable.
Because of this, the historical cost convention has strengths for stewardship purposes, but
ination-adjusted gures may well be more appropriate for decision usefulness.
2.3Accrual basis of accounting
The accrual basis dictates when transactions with third parties should be recognised and, in
2.5Subjective judgements required in accrual accounting Ð adjusting cash
Revenue
Revenue represents the amounts, excluding VAT and similar sales-related taxes,
receivable by the Company for goods and services supplied to outside customers in
the ordinary course of business. Revenue is recognised when persuasive evidence of an
arrangement with a customer exists, products have been delivered or services have been
rendered and collectability is reasonably assured.
The revenue recognition policy for Wolseley plc in its 2008 Annual Report
14
is more
cooperative advertising programmes. The result of the guidance was that the fees must be
3.1Introduction
The main purpose of this chapter is to explain the need for income measurement, to
Objectives
By the end of this chapter, you should be able to:

explain the role and objective of income measurement;

explain the accountants view of income, capital and value;

critically comment on the accountants measure;

explain the economists view of income, capital and value;

critically comment on the economists measure;

dene various capital maintenance systems.
Question 4
The following is an extract from the Financial Reporting Review Panel website (www.frrp.org.uk)
relating to the Wiggins Group showing the restated nancial results.
Year
199519961997199819992000
TurnoverAs published6.46.919.917.826.749.8
(m)Adjustments(1.5)(2.6)(15.6)(6.7)(21.6)(42.5)
Restated4.94.34.311.15.17.3
Prot/(loss)As published0.71.04.95.112.125.1
before taxAdjustments(1.3)(1.9)(10.2)(8.5)(17.2)(35.0)
(m)Restated(0.6)(0.9)(5.3)(3.4)(5.1)(9.9)
Basic EPSAs published0.140.200.660.641.212.87
(pence)Adjustments(0.26)(0.38)(1.67)(1.14)(1.91)(4.06)
Restated(0.12)(0.18)(1.01)(0.50)(0.70)(1.19)
Restated8.98.25.517.718.410.4
Revenue recognition
The 1999 accounts contained an accounting policy for turnover in the following terms:
Commercial property sales are recognised at the date of exchange of contract, providing the
Group is reasonably assured of the receipt of the sale proceeds.
The FRRP accepted that this wording was similar to that used by many other companies and was not
on the face of it objectionable. In reviewing the companys 1999 accounts the FRRP noted that the
turnover and prots recognised under this policy were not reected in similar inows of cash; indeed,
operating cash ow was negative and the amount receivable within debtors of 46m represented
12IAS 18
13http://www.chloridepower.com/en-gb/Chloride-corporate/Investor-relations/Financial-reports/
14http://annualreport2008.wolseleyplc.com/wol_08/Þnancial_statements/accounting_policies/
17EITF 01-9,
19IAS 16
22FRS 15
the measures taken by Oftel and Ofwat to regulate the size of earnings by British Telecom
and the water companies.
3.2.2Income as a means of prediction
4
Instead, he considered the use of
2.7Mechanics of accrual accounting the statement of nancial position
be reframed into the customary statement of nancial position format, where items are
Figure 2.7Statement of comprehensive income for the six months ending 30 June
Figure 2.8Statement of Þnancial position as at 30 June
favourable cash ows; from the statement of nancial position prepared on an accrual basis
(as in Figure 2.8) an investor is able to obtain an indication of a businesss continuing ability
to generate favourable cash ows; from the cash ow statement (as in Figure 2.9) an investor
¥
33

REVIEW QUESTIONS
1
The Framework for the Preparation and Presentation of Financial Statements
identied seven user
groups: investors, employees, lenders, suppliers and other trade creditors, customers, government
and the public.
2
Discuss which of the nancial statements illustrated in Chapters 1 and 2 would be most useful to
each of these seven groups if they could only receive one statement.
34

Summary
Accrual accounting replaces cash receipts and payments with revenue and expenses
by adjusting the cash gures to take account of trading activity which has not been
converted into cash.
ÔAccrual accounting is preferable to cash ßow accounting because the information is more relevant
to all users of Þnancial statements.Õ Discuss.
ÔCash ßow accounting and accrual accounting information are both required by a potential share-
ÔInformation contained in a statement of comprehensive income and a statement of Þnancial
position prepared under accrual accounting concepts is factual and objective.Õ Discuss.
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
(x)Local taxes will be paid as follows: for the three months to 31 March 20X1 by cheque on
28 February 20X2, delay due to an oversight by Parker; for the 12 months ended 31 March
20X2 by cheque on 31 July 20X1. Local taxes are
A
8,000 per annum.
(xi)She will make drawings of
A
1,500 per month by cheque.
(xii)All receipts and payments are by cheque.
(xiii)Depreciate motor vehicles by 20% per annum and machinery by 10% per annum, using the
The Piano Warehouse Company Limited was established in the UK on 1 January 20X7 for the
purpose of making pianos. Jeremy Holmes, the managing director, had 20 yearsÕ experience in the
manufacture of pianos and was an acknowledged technical expert in the Þeld. He had invested his lifeÕs
savings of £15,000 in the company, and his decision to launch the company reßected his desire for
3.3AccountantÕs view of income, capital and value

Prot or income concept
. Prot as a concept is generally well understood in a capital
to each period.
Accounting income is presented in the form of the conventional prot and loss account
or statement of comprehensive income. This statement of comprehensive income, in being
based on actual transactions, is concerned with a past-dened period of time. Thus account-
ing prot is said to be historic income, i.e. an
ex post
measure because it is after the event.
Nature of accounting capital
matching costs with revenue for the current accounting period, they follow the prudence
In the long term, economic income and accountancy income are reconciled. The unrealised
proÞts of the economic measure are eventually realised and, at that point, they will be recognised
What if we cannot assume that a business will continue as a going concern?
less than 100. How much less is a matter of subjective evaluation, but compensation for
the time element may be found by reference to interest: a person forgoing the spending of
1 today and spending it one year later may earn interest of, say, 10% per annum in com-
pensation for the sacrice undergone by deferring consumption.
So 1 today invested at 10% p.a. will be worth 1.10 one year later, 1.21 two years
later, 1.331 three years later, and so on. This is the concept of compound interest. It may
be calculated by the formula (1
+
r
)
n
, where 1
=
the sum invested;
r
=
the rate of interest;
n
=
the number of periods of investment (in our case years). So for 1 invested at 10% p.a.
for four years:
(1
+
r
)
n
=
(1
+
0.10)
4
=
(1.1)
4
=
1.4641
and for ve years:
=
(1.1)
5
=
1.6105, and so on.
Notice how the
future value
increases because of the compound interest element it
varies
over time whereas the investment of 1 remains constant. So, conversely, the sum
of 1.10 received at the end of year one has a PV of 1, as does 1.21 received at the end
of year two and 1.331 at the end of year three.
It has been found convenient to construct tables to ease the task of calculating present
values. These show the cash ow, i.e. the future values, at a constant gure of 1 and allow
the investment to vary. So:
PV
=
where
CF
=
anticipated cash ow;
r
=
the discount (i.e. interest) rate. So the PV of a cash
ow of 1 receivable at the end of one year at 10% p.a. is:
=
0.9091
and 1 at the end of two years:
=
0.8264
and so on over successive years. The appropriate present values for years three, four and ve
would be 0.7513, 0.6830, 0.6209 respectively.
0.9091 invested today at 10% p.a. will produce 1 at the end of one year. The PV of 1
receivable at the end of two years is 0.8264 and so on.
1
(1
+
r
)
2
1
(1
+
r
)
1
CF
(1
+
r
)
n
48

3.5.2Nature of economic income
Thus, he reasoned, consumption (
C
) equals income (
Y
); so
Y
=
C
. He excluded savings
from income because savings were not consumed. There was no satisfaction derived from
savings; enjoyment necessitated consumption, he argued. Money was worthless until spent;
so growth of capital was ignored, but reductions in capital became part of income because
such reductions had to be spent.
In Fishers model, capital was a stock of wealth existing at a point in time, and as a stock
it generated income. Eventually, he reconciled the value of capital with the value of income
by employing the concept of present value. He assessed the PV of a future ow of income by
discounting
future ows using the discounted cash ow (DCF) technique. Fishers model
K
as saying the beginning of year two) is calculated in Figure 3.4. This shows that
K
£115,403 calculated as the present value of anticipated earnings of £131,000 spread over a
four-year term.
From this information we are able to calculate
Y
for the period
that
C
(consumption) is nil because, in this exercise, dividends representing consumption
have not been payable for
capital growth, i.e. savings.
By year-end
at
K
PV of £26,000. These earnings will no longer represent a
predicted
sum because they will
have been
and therefore will no longer be subjected to discounting.
Figure 3.4Economic value at
Figure 3.6Economic value at
K
2
Figure 3.7Calculation of
Y
for the period
Y
2
4.1Introduction
4.2Review of the problems of historical cost accounting (HCA)
3R.W. Scapens,
Accounting in an Inationary Environment
(2nd edition), Macmillan, 1981, p. 125.
4
Ibid
., p. 127.
5D. Solomons,
op. cit.
, p. 132.
6T.A. Lee,
op. cit
., pp. 5254.
7I. Fisher,
The Theory of Interest
, Macmillan, 1930, pp. 171181.
8J.R. Hicks,
Value and Capital
(2nd edition), Clarendon Press, 1946.
9R.W. Scapens,
op. cit
., p. 127.
Bibliography
American Institute of Certied Public Accountants,
Objectives of Financial Statements
, Report of the
Study Group, 1973.
The Corporate Report
, ASC, 1975, pp. 2831.
N. Kaldor, The concept of income in economic theory, in R.H. Parker and G.C. Harcourt (eds),
Readings in the Concept and Measurement of Income
, Cambridge University Press, 1969.
T.A. Lee, The accounting entity concept, accounting standards and ination accounting,
Accounting and Business Research
, Spring 1980, pp. 111.
J.R. Little, Income measurement: an introduction,

20X1CalculationIndex
31 Marchi.e.£76
30 Aprili.e.
100103.9
31 Mayi.e.
100106.6
30 Junei.e.
100110.5
76
¥
61
The following data are available for January 20X1:
3.6Critical comment on the economistÕs measure
costincome.
9
Thiswillbecomeclearerwhenthereplacementcostmodelisdealtwithinthe
nextchapter.

Financial capital
. Should capital be maintained in terms of a fund of general purchasing
entity and thus its ability to maintain real levels of income. If we do not maintain the capacity
of capital to generate the current level of prot, then the income measure, being the differ-
What is the purpose of measuring income?
Explain the nature of economic income.
The historical cost concept has withstood the test of time. Specify the reasons for this success,
economics, presents difÞculty in the accountancy world of annual reports. The accountantÕs
8
Examine and contrast the concepts of prot that you consider to be relevant to:
(a)an economist;
(b)a speculator;
(c)a business executive;
(d)the managing director of a company;
(e)a shareholder in a private company; (f)a shareholder in a large public company.
EXERCISES
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
*Question 1
(a)Measurement in nancial statements, Chapter 6 of the ASBs
Statement of Principles,
was published
The present value of £1 receivable at the end of a period discounted at 10% is as follows:
End of year one£0.909
End of year two£0.826
End of year three£0.751
Jason commenced with £135,000 cash. He acquired an established shop on 1 January 20X1. He agreed
the goodwill. He paid legal costs of £5,000. No liabilities were taken over. Jason could have resold the
business immediately for £135,000. Legal costs are to be expensed in 20X1.
Jason expected to draw £25,000 per year from the business for three years and to sell the shop at
Creditors
Based on his experience of the Þrst yearÕs trading, he revised his estimates and expected to draw
£35,000 per year for three years and sell the shop for £175,000 on 31 December 20X3.
JasonÕs opportunity cost of capital was 20%.
(a)Calculate the following income Þgures for 20X1:
(i)accounting income;
Figure 4.2Workings (W)
4.5.4The four models compared
HCACPPRCANRVA
Realised proÞt: 1,2001,1848701,200
Unrealised proÞtÑÑÑ1,200
ProÞt for month1,2001,1848702,400

It is a
measure of shareholders capital
and that capitals maintenance in terms of
purchasing power units. Prot is the residual value after maintaining the money value of
capital funds, taking account of changing price levels. Thus it is a measure readily under-
stood by the shareholder/user of the accounts. It can prevent payment of a dividend out
of real capital as measured by GPPA.

It
estimates or assessments. It does not possess the factual characteristics of HCA. It is open

It is less reliable and veriable than HC.

The statement of comprehensive income will report a more volatile prot if changes in
NRV are taken to the statement of comprehensive income each year.

The prot arising from the changes in NRV may not have been realised.
4.7Operating capital maintenance a comprehensive example
4.7.1Restating the opening statement of Þnancial position to current cost
IndexCCAIncrease
140,25055,250
42,07516,575
98,17538,675
100
125
120
HCAAdjustmentCCADifference
000
000000
Opening inventory17,000
)
=
19,479
)
=
2,479
Purchases


17,000
)
19,479
)
Closing inventory(25,500)
=
24,181
)
=
1,319
(8,500)
(4,702)3,798
137.5
145
137.5
120
a proÞt decrease of like amount and a current cost reserve increase of like amount.
HCAAdjustmentCCADifference
£000£000
Depreciation8,500
100
The prot before interest and tax will be reduced as follows:
000000
Prot before interest and tax
26,350
Less:
COSA
(3,798)
DA
(5,695)
MWCA
(1,345)
Current cost operating adjustments
(10,838)
Current cost operating prot
15,512
The adjustments will be credited to the current cost reserve.
Trade receivables34,00023,375
Trade payables25,50017,000
MWC
=
8,5006,375Overall change
=
2,125
The MWC is now adjusted by the average index for the year.
This adjustment will reveal the change in volume.
8,500

6,373

=
7,7927,012
=
Volume change
,
780
So price change
=
1,345
D
F
137.5
125
A
C
D
F
137.5
150
A
C
CCA value at 31 December 20X5
=
140,250
=
157,250
Revaluation holding gain for 20X5 to CC reserve in W8
17,000
This holding gain of 17,000,000 is transferred to CC reserves.
185
165
expensed (i.e. charged to revenue account) as an adjustment of HCA proÞt, but is charged
(as per W1 and statement of Þnancial position at 1 January 20X5)42,075
14,195
6,630
62,900
94,350
(iii)Inventory valuation at year-end
17,000
×
125/120
=
17,708
=
increase of
708
4.7.4Current cost statement of Þnancial position as at 31 December 20X5
74

Depreciation
62,900(W7(ii))
42,075(W1)
94,350 (W7(ii))
98,175
Cash
17,000
1,875
77,379
42,958
Current liabilities
Trade payables
25,500
17,000
Income tax
8,500
4,250
Dividend proposed5,000
4,000
39,000
25,250
Less:
8% debentures11,000
11,000
27,379
6,708
121,729
104,883
Financed by
Share capital: authorised
and issued 1 shares
50,000
50,000
Share premium
1,500
1,500
* CC reserve
55,067
39,383
Shareholders funds
121,729
104,883
*
CC reserve
000
000
Opening balance
39,383(W3)
Holding gains
Inventory
,
171(W7(iii))
17,171
COSA
3,798(W4)
MWCA
1,345(W6)
Less:
backlog depreciation(6,630)(W7(ii))(1,487)
55,067
)
4.7.5How to take the level of borrowings into account
(1,345)(W6)
15,162
+
D
F
Average shareholdersÕ funds
for year
A
D
(
+
S
Income tax
8,500
4,250
Cash
(17,000)(1,875)
proposed dividends)
126,729108,883
Add
129,229122,258
Or, alternatively:
000
000
Inventory
26,37917,708
MWC
8,500
6,375
129,229122,258
Average
L
+
S
=
=
125,743,500
So gearing
=
A
(COSA + MWCA + Extra depreciation)

(3,798,000
+
1,345,000
+
5,695,000)
=
6.31% of 10,838,000
=
683,877, say
684,000
7,937,500
125,743,500
L
L
+
S
129,229,000 + 122,258,000
2
2,500,000 + 13,375,000
2
Thus the CC adjustment of 10,838,000 charged against historical prot may be reduced by
4.7.6The closing current cost statement of Þnancial position
an attempt to achieve
5.1Introduction
5.2Why do we need Þnancial reporting standards?
This risk is specically addressed in the Johnson Matthey Annual Report as shown in the
following extract:
of disclosure by persuasion but, in reality, the profession found it difcult to resist
management pressures.
During the 1960s the nancial sector of the UK economy lost condence in the accoun-
tancy profession when internationally known UK-based companies were seen to have
published nancial data that were materially incorrect. Shareholders are normally unaware
that this occurs and it tends only to become public knowledge in restricted circumstances,
e.g. when a third party has a
vested interest
in revealing adverse facts following a takeover,
or when a company falls into the hands of an administrator, inspector or liquidator,
whose
duty it is to enquire and report
on shortcomings in the management of a company.
Two scandals which disturbed the public at the time, GEC/AEI and Pergamon Press,
2
were both made public in the restricted circumstances referred to above, when nancial
reports prepared from the same basic information disclosed a materially different picture.
5.3.1GEC takeover of AEI in 1967
The rst calamity for the profession involved GEC Ltd in its takeover bid for AEI Ltd when
the pre-takeover accounts prepared by the old AEI directors differed materially from the
post-takeover accounts prepared by the new AEI directors.
102

Regulatory framework an attempt to achieve uniformity
78

4.8Critique of CCA statements
Figure 4.7(
3
HCA prot might be adjusted to reect the moving price level syndrome:
(a)by use of the operating capital maintenance approach, which regards only the CCA
operating
prot as the authentic result for the period and which treats any holding
gain or loss as a movement on reserves;
(b)by adoption of the real terms
nancial
capital maintenance approach, which applies
a general ination measure via the RPI, combined with CCA information regarding
holding gains.
Thus the statement can reveal information to satisfy the demands of the management
¥
81
(a)it quantiÞes cost of sales and depreciation after allowing for changing price levels;
(b)resources are maintained, having eliminated the possibility of paying dividend out of
(c)yardsticks for management performance are more comparable as a time series within
4.9.1Remove the right to modify cost in the statement of nancial
position
This would mean pruning the system back to one rigorously based on the principles of
historical costs, with current values shown by way of note.
This option has strong support from the profession not only in the UK, e.g. in our view
...the most signicant advantage of historical cost over current value accountin
g...is
that
it is based on the actual transactions which the company has undertaken and the cash ows
that it has generate
d...
this is an advantage not just in terms of reliability, but also in terms
of relevance,
2
but also in the USA, e.g. a study showed that users were opposed to replacing
the current historic cost based accounting mode
l...
because it provides them with a stable
and consistent benchmark that they can rely on to establish historical trends.
3
Although this would have brought UK practice into line with that of the USA and some
of the EU countries, it has been rejected by the ASB. This is no doubt on the basis that the
ASB wishes to see current values established in the UK in the longer term.
4.9.2Introduce a coherent current value system immediately
This would mean developing the system into one more clearly founded on principles embrac-
ing current values. One such system, advocated by the ASB in Chapter 6 of its
Statement of
Accounting Principles
, is based on
value to the business
. The value to the business measure-
ment model is eclectic in that it draws on various current value systems. The approach to
Accumulated depreciation (6 years straight line)
120,000
Aggregate depreciation
180,000
Depreciated replacement cost
120,000
Value in use (discounted future income)
70,565
ad hoc
improvements to the present modiÞed historical cost system
The ASB favoured this option for removing anomalies, on the basis that practice should
be evolutionary and should follow various ASB pronouncements (e.g. on the revaluation of
ad hoc
basis. The
continues to envisage that a mixed measurement system will be used and it focuses on the
transactions that have occurred at different times, even within the same accounting period,
is misleading.
What rate indicates that hyperination exists?
IAS 29 does not specify an absolute rate this is a matter of qualitative judgement but it
It is interesting to note that in the US there is a view that Þnancial statements should be
primarily decision-useful. This is a move away from the position adopted by the IASB in its
How will Þnancial statements be affected if fair values are adopted?
The Þnancial statements will have the same virtues and defects as the NRVA model
(section 4.6.4 above). Some concerns have been raised that reported annual income will become
Stewardship
Summary
The traditional HCA system reveals disturbing inadequacies in times of changing price
levels, calling into question the value of nancial reports using this system. Consider-
able resources and energy have been expended in searching for a substitute model able

REVIEW QUESTIONS
1
(a)Explain the limitations of HCA when prices are rising.
(b)Why has the HCA model survived in spite of its shortcomings in times of ination?
2
Explain the features of the CPP model in contrast with those of the CCA model.
3
What factors should be taken into account when designing a system of accounting for ination?
4
To what extent are CCA statements useful to an investor?
5
Compare the operating and nancial capital maintenance concepts.
6
Historical cost accounting is the worst possible accounting convention, until one considers the
alternatives. Discuss this statement in relation to CPP, CCA and NRVA.
7
To be relevant to investors, the prot for the year should include both realised and unrealised
gains/losses. Discuss.
8
EXERCISES
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
*Question 1
Shower Ltd was incorporated towards the end of 20X2, but it did not start trading until 20X3. Its
historical cost statement of nancial position at 1 January 20X3 was as follows:
88


Share capital, 1 shares
2,000
Loan (interest free)
8,000
10,000
Inventory, at cost (4,000 units)
4,000
10,000

1 Jan 20X3Opening balance
nil
30 Jun 20X3Sales (8,000 units)
20,000
Less
29 Jun 20X3Purchase (6,000 units)9,000
Sundry expenses5,00014,000
31 Dec 20X3Closing balance
6,000
(i)historical cost;
(ii)current purchasing power (general price level);
(iii)replacement cost;
(iv)continuous contemporary accounting (NRVA).
The Þnance director of Toy plc has been asked by a shareholder to explain items that appear in the
current cost statement of comprehensive income for the year ended 31.8.20X9 and the statement of
(a)Explain what each of the items numbered 1Ð6 represents and the purpose of each.
(b)What do you consider to be the beneÞts to users of providing current cost information?
Historical cost proÞt
Additional depreciation
Current cost operating proÞt before tax
Gearing adjustment
CCA operating proÞt
Accumulated current cost depreciation(5)
12% debentures
Issued share capital
Current cost reserve
Question 3
Statement of nancial position
20X8
20X7
000000000000000000
Freehold land
60,00060,00060,00060,000
Buildings
40,0008,00032,00040,0007,20032,800
Plant and machinery
30,00016,00014,00030,00010,00020,000
Vehicles
40,00020,00020,00040,00012,00028,000
170,00044,000126,000170,00029,200140,800
Cash at bank and in hand
5,000
5,000
195,000
115,000
Current liabilities
Trade payables
90,000
60,000
Bank overdraft
50,000
45,000
Taxation
28,000
15,000
Dividends
15,000
10,000
183,000
130,000
138,000
125,800
Financed by
Ordinary share capital
80,000
80,000
Share premium
10,000
10,000
118,000
105,800
Long-term loans
20,000
20,000
138,000
125,800
Statement of comprehensive income of Parkway plc
for the year ended 30 June 20X8
000
Sales
738,000
Cost of sales
620,000
Gross prot
118,000
1The freehold land and buildings were purchased on 1 July 20X0. The company policy is to depreciate
buildings over 50 years and to provide no depreciation on land.
2Depreciation on plant and machinery and motor vehicles is provided at the rate of 20% per
annum on a straight-line basis.
3Depreciation on buildings and plant and equipment has been included in administration expenses,
while that on motor vehicles is included in distribution expenses.
4The directors of Parkway plc have provided you with the following information relating to price rises:
RPIInventoryLandBuildingsPlantVehicles
10060705090120
170140290145135180
190180310175165175
Average for year ending 30 June 20X8180160300163145177
(a)Making and stating any assumptions that are necessary, and giving reasons for those assump-
£000£000
(i)Cost of goods sold:
Inventory at 1 April 20X4
Purchases
Inventory at 31 March 20X511,30037,500
(ii)Depreciation of equipment
£000£000
(iii)Equipment at cost
: Accumulated depreciation16,44041,160
(iv)Inventory
2In the statement of Þnancial position:
The inventory held on 31 March 20X4 and 31 March 20X5 was in each case purchased evenly during
92

Smith plc Statement of comprehensive income for the year ended 31 December 20X8
000
000
Sales
2,000
Cost of sales:
Opening inventory 1 January 20X8
320
Purchases
1,680
2,000
Closing inventory at 31 December 20X8
280
1,720
Gross prot
,
280
Depreciation
20
Administration expenses
100
120
1Land and buildings were acquired in 20X0 with the buildings component costing £800,000 and
depreciated over 40 years.
2Share capital was issued in 20X0.
3Closing inventories were acquired in the last quarter of the year.
4RPI numbers were:
Average for 20X0
20X7 last quarter
At 31 December 20X7220
20X8 last quarter
Average for 20X8
At 31 December 20X8236
(i)Explain the basic concept of the CPP accounting system.
(ii)Prepare CPP accounts for Smith plc for the year ended 20X8.
(a)Restate the statement of comprehensive income for the current year in terms of £CPP at
(b)Restate the closing statement of Þnancial position in £CPP at year-end, but excluding
Less aggregate depreciation
1,180
Trade receivables
40
120
560
Trade payables
,
1,600
Ordinary share capital
1,600
94

Aspirations Ltd
Statement of comprehensive income for the year ended 31 December 20X1

Sales
868,425
Purchases
520,125
Less
: Inventory 31 December 20X1
24,250
Cost of sales
495,875
Gross prot
372,550
Expenses
95,750
Depreciation
25,250
121,000
Freehold property
650,000
6,500643,500
Ofce equipment
375,000
18,750356,250
1,025,000
25,250999,750
Cash
1,090,300
1,368,050
Current liabilities
116,250
1,251,800
Non-current liabilities
500,000751,800
1,751,550
Issued share capital
1,500,000 1 ordinary shares
1,500,000
1,751,550
The year 20X1 witnessed a surge of inßation and in consequence the directors became concerned
about the validity of the revenue account and statement of Þnancial position as income and capital
statements. Index numbers reßecting price changes were:
SpeciÞc index numbers reßecting replacement costs
1 January 20X131 December 20X1Average for 20X1
Inventory
Freehold property
General price index numbers
Regarding current exit costs
Inventory is anticipated to sell at a proÞt of 75% of cost.
Initial purchases of inventory were effected on 1 January 20X1 amounting to £34,375; the balance of
96

Current purchasing power accounting Prot and Loss Account for the year ended 31 October 2005
$
Sales
63,190
less
Cost of sales
48,972
14,218
Cash
61,600
82,588
Financed by:
Opening capital
69,960
Prot for the year
12,628
82,588
Current cost accounting Prot and Loss Account for the year ended 31 October 2005
Historical cost prot
15,400
less
Cost of sales adjustment
1,400
Current cost income
14,000
Cash
61,600
82,600
Financed by:
Opening capital
66,000
Current cost reserve
2,600
Prot for the year
14,000
82,600
Required:
(a)Prepare Antonios historical cost prot and loss account for the year ended 31 October 2005
2Ernst & Young,
, SSAP 7, ASC, 1974.
Accounting for Stewardship in a Period of Inßation
6.1Introduction
6.1.1Different countries meant different Þnancial statements
17Nobes and Parker,
op. cit
., pp. 7375.
18See S.P. Agrawal, P.H. Jensen, A.L. Meader and K. Sellers, An international comparison of
conceptual frameworks of accounting,
The International Journal of Accounting
, vol. 24, 1989,
pp. 237249.
19
Accountancy
, June 1989, p. 10.
20See, e.g., B. Chauveau, The Spanish
Plan General de Contabilidad
: Agent of development and
innovation?,
European Accounting Review
, vol. 4, no. 1, 1995, pp. 125138.
21See, e.g., P.E.M. Standish, Origins of the
Plan Comptable Gnral
: a study in cultural intrusion
and reaction,
Accounting and Business Research
, vol. 20, no. 80, 1990, pp. 337351.
National standards varied in their quality and in the level of enforcement. This is illustrated
by the following comment
1
by the International Forum on Accountancy Development (IFAD):
Lessons from the crisis
...the Asian crisis showed that under the forces of nancial globalisation it is essential
for countries to improv
e...
the supervision, regulation and transparency of nancial
system
s...
empirical inductive approach
was followed by the accounting profession prior to
1970.
This resulted in standards or reporting practices that were based on rationalising what
Disclosure of Accounting
Policies
Inventories
deductive approach
followed in the 1970s.
This resulted in standards or reporting practices that were based on rationalising what
we discussed in Chapter 2. The early standards were produced under this regime, e.g. the
standard on inventory valuation.
This approach has played an important role in the evolution of nancial reporting prac-
tices and will continue to do so. After all, it is the preparers of the nancial statements and
purposes, e.g. replacement cost accounting produces an income Þgure that indicates how
These income Þgures were regarded as a public good, i.e. cost-free to the user. Latterly,
it has been recognised that there is a cost implication to the production of information,
6.3FASB Concepts Statements
The FASB was the originator of attempts to create a conceptual framework with the
issue of a series of Concepts Statements as a basis for nancial accounting and reporting
standards. It is easy to overlook this fact, particularly as the present preference for principles
as a result of past transactions or events.

Liabilities
probable future sacrices of economic benets arising from present obliga-
Source
: Concept 2, Figure 1 from FASB, 1980, p. 13.

Revenues
6.4IASC

Concepts Ð evolution of a global conceptual framework
What information should be provided to satisfy the information needs?
The
Statement
proposes that information is required in four areas: nancial performance,
nancial position, generation and use of cash, and nancial adaptability.
Financial performance

Concepts Ð evolution of a global conceptual framework
142

Regulatory framework an attempt to achieve uniformity

tion require the information to be veriÞable?
Unresolved relative importance
The approach taken has to be to regard decision usefulness as paramount. It is not clear
where this leaves accountability and stewardship. There are unresolved questions such as,
revenue in the prot and loss account and carry the balance into the statement of nancial
position, i.e. the allocation is driven by the need to match costs to revenue. The
Statement
of Principles
approach is different in that it identies the amount of the expenditure to be
Concepts Ð evolution of a global conceptual framework
146

Regulatory framework an attempt to achieve uniformity
ASB gradualist approach
The underlying support of the ASB for a gradualist move towards the use of current values
is reected in Although the objective of nancial statements and the qualitative character-
istics of nancial information, in particular relevance and reliability may not chang
e...as
A value to the business approach (often referred to as deprival value) was presented as a
logical approach to selecting a value to be recognised in Þnancial statements. Standard
Statement of nancial position
Good presentation involves:

Concepts Ð evolution of a global conceptual framework
6.6Conceptual framework developments
6.6.1Piecemeal development
Qualitative characteristics and constraints of decision-useful nancial
reporting information
There are two fundamental qualitative characteristics if information is to be decision-useful
and not misleading. These are relevance and faithful representation.
There are other characteristics that may make the information more useful. These are
comparability, consistency, veriability, timeliness and understandability.
Some characteristics were considered but not included on the grounds that they were
covered by the above characteristics. For instance, true and fair was not included because it
was considered to be equivalent to faithful representation.
As with other frameworks, there are constraints on the information to be disclosed. These
are materiality, dened in the usual way as being information whose omission or misstate-
ment could inuence decisions, and cost, if this exceeds the benet of providing the
information.
We can see that the project by the IASB to develop an agreed Conceptual Framework is
progressing in a piecemeal fashion with only Chapters 1 and 2 nalised and the date for the
nalisation of some of the other chapters still to be announced. This might be seen as a
strength in that time and thought are being given to the project. However, there is also a
downside as seen in the ASB response to the IASB (see www.frc.org.uk/documents/
pagemanager/asb/Conceptual_framework/Conceptual%20Framework%20IASB%20ED_
ASB%20Response_Final.pdf) which expressed concern that:

The current Framework applies to nancial
statements
rather than nancial
reporting
.
If it is to be extended to nancial reporting, this could include other areas such as
prospectuses, news releases, managements forecasts but this has not been dened.

There is a risk that the piecemeal approach could lead to internal inconsistencies
Summary
Directors and accountants are constrained by a mass of rules and regulations which
govern the measurement, presentation and disclosure of nancial information. Regula-
tions are derived from three major sources: the legislature in the form of statutes, the
accountancy profession in the form of standards, and the Financial Services Authority
in the form of Listing Rules.
Concepts Ð evolution of a global conceptual framework
and presentation of Þnancial statements continue to evolve. Steps are being taken to
provide a conceptual framework and there is growing international agreement on the
152

Regulatory framework an attempt to achieve uniformity
REVIEW QUESTIONS
1
(a)Name the user groups and information needs of the user groups identied by the IASC
Framework for the Presentation and Preparation of Financial Statements
.
1
(b)Discuss the effect of theFramework on current nancial reporting practice.
2
The workload on the IASB in seeking to converge standards with the FASB has diverted resources
1
...measures of performanc
e...
are based on original or historical cost
s...
2
Much emphasis is placed on a single measure of earnings per shar
e...
3
...insufcient attention is paid to changes in an enterprises cash or liquidity
positio
n...
4
The present system is essentially backward lookin
g...
5
Emphasis is often placed on the legal form rather than on the economic
substance of transaction
s...
23
We have seen that some of these ve limitations are being addressed, but not all, e.g.
the provision of projected gures.
The second extract is from
Making Corporate Reports Valuable
:
7.1Introduction
Objectives
By the end of this chapter, you should be able to:

A Conceptual Framework for Financial Accounting and Reporting: The Possibilities for an
Agreed Structure
suggested that the search for a conceptual framework was a political process.
The following extract is from
Conceptual Framework for Financial Accounting and Reporting: Elements of
Financial Statements and Their Measurement
Concepts Ð evolution of a global conceptual framework
The benets of achieving agreement on a conceptual framework for nancial accounting and
reporting manifest themselves in several ways. Among other things, a conceptual framework
can (1) guide the body responsible for establishing accounting standards, (2) provide a frame of
reference for resolving accounting questions in the absence of a specic promulgated standard,
8Statement of Financial Accounting Concepts No. 5: Recognition and Measurement in Financial
11FRS 6
16IAS 16
17SFAS No 157
18Discussion Paper
19ICAS,
20A. Lennard, ÔThe peg on which standards hangÕ,
21S. Fearnley and M. Page, ÔWhy the ASB has lost its bearingsÕ,
22D. Solomons,
23J. Arnold
reviewed subsequently by an uninvolved outsider who is not an accountant. This is because
the community places its trust in professionals because they have expertise that others do


pose systemic risks.
The amendment that was passed acknowledged that the proposed systemic risk regulator
that would be created under the bill would have the ability to comment, like other interested
7.5.2How does the accounting profession attempt to ensure that nancial
reports reect the substance of a transaction?
for the discussion of rules versus principles.
7.6.2What are the implications of the above discussion?
criteria of fairness to all stakeholders (Þnanciers, workers, suppliers, customers and the com-
munity) was made by Leonard Spacek
view was not appreciated by the profession at that time. We now see current developments
7.8.1Acting in the public interest
The rst underlying statement that accountants should act in the public interest is probably
more difcult to achieve than is imagined. This requires accounting professionals to stand
rm against accounting standards which are not in the public interest, even when the poli-
ticians and company executives may be pressing for their acceptance. Due to the fact that,
in the conduct of an audit, the auditors have dealings mainly with the management, it is easy
to lose sight of who the clients actually are. For example, the expression audit clients is
commonly used in professional papers and academic books when they are referring to the
management of the companies being audited. It immediately suggests a relationship which
is biased towards management when, legally, the client may be either the shareholders as a
group or specic stakeholders. Whilst it is a small but subtle distinction, it could be the start
of a misplaced orientation towards seeing the management as the client.
7.8.2Fundamental principles
The ve fundamental principles are probably uncontentious guides to professional conduct.
It is the application of those guides in specic circumstances which provides the greatest
challenges. The IFAC paper provides guidance in relation to public accountants covering
Remuneration
Remuneration must be adequate to allow the work to be done in a professional manner.
166

Regulatory framework an attempt to achieve uniformity
objective when advising your client and in any event must at least be disclosed to clients.
Whilst not discussed in the document, the involvement of accountants in personal Þnancial
The Way We Work
among other things says:
How would you explain your decision to your colleagues in different countries?
How would you explain your decision to your family or in public?
7.10.2Hidden liabilities
authority could be the board of directors, or the auditors or regulatory authorities. She attri-
For accountants in industry, the message is that if your employer has a culture which is not
elsewhere. For auditors, the message is that the presence of symptoms suggested above is
grounds for employing greater levels of scepticism in the audit.
Waddell & Reed, Inc., in which the rm was ned $5 million and ordered to pay
$11 million in restitution to customers to resolve charges related to variable annuity
switching; and, FINRAs 2002 action against Credit Suisse First Boston to resolve
charges of siphoning tens of millions of dollars of customers prots in exchange for
hot IPO shares, which resulted in a $50 million ne imposed by FINRA and an
additional $50 million ne imposed by the Securities and Exchange Commission.
The Accounting and Actuarial Disciplinary Board
In the UK there is the Accounting and Actuarial Disciplinary Board which investigates and
hears complaints. It has on its web pages
25
7.12.2Legal requirement to report Ð national and international regulation
taken by nancial institutions and others such as casinos, real estate dealers, lawyers and
accountants. The Recommendations are recognised as the global anti-money laundering
(AML) and counter-terrorist nancing (CFT) standard.
The FATF issued a report
26
in 2009 titled
Money Laundering Through the Football Sector
.
This report identied the vulnerabilities of the sector arising from transactions relating
3
(c)You pay a sizeable account for freight on the internal shipping of product deliveries in an
underdeveloped country. At morning tea the gossip is that the company is paying bribes to a
general in the underdeveloped country as protection money.
(d)The credit card statement for the managing director includes payments to a casino. The
managing director says it is for the entertainment of important customers.
(e)You are processing a payment for materials which have been approved for repairs and main-
tenance when you realise the delivery is not to one of the business addresses of the company.
16
EXERCISES
Question 1
Joe Withers is the chief Þnancial ofÞcer for Withco plc responsible for negotiating bank loans. It has
and margins have fallen. The managing director has said that he doesnÕt want to report a loss for the
Þrst time in the companyÕs history as it might scare Þnanciers.
14www.ir.jameshardie.com.au/jh/asbestos_compensation.jsp
15M.M. Jennings,

8.1Introduction
The published accounts of a listed company are intended to provide a report to enable share-
holders to assess current year stewardship and management performance and to predict
future cash ows. In order to assess stewardship and management performance, there have
been mandatory requirements for standardised presentation, using formats prescribed by
International Financial Reporting Standards.
The main standard that will be considered in this chapter is IAS 1
Presentation of
Financial Statements
.
Each company sends an annual report and accounts to its shareholders. It is the means
Objectives
By the end of this chapter, you should be able to:

understand the structure and content of published nancial statements;

explain the nature of the items within published nancial statements;

prepare the main primary statements that are required in published nancial
statements;

comment critically on the information included in published nancial statements.
8.2The prescribed formats Ð the statement of comprehensive income

warehousing costs associated with the operation of the premises, e.g. rent, rates, insurance,
utilities, depreciation, repairs and maintenance and wage costs, e.g. gross wages and
pension contributions of warehouse staff;

promotion costs, e.g. advertising, trade shows;

selling costs, e.g. salaries, commissions and pension contributions of sales staff; costs
associated with the premises, e.g. rent, rates; cash discounts on sales; travelling and
entertainment;

transport costs, e.g. gross wages and pension contributions of transport staff, vehicle
costs, e.g. running costs, maintenance and depreciation.
8.2.4Administrative expenses
These are the costs of running the business that have not been classied as either cost of
sales or distribution costs. Expenditure classied under this heading will typically include:

administration, e.g. salaries, commissions, and pension contributions of administration staff;

costs associated with the premises, e.g. rent, rates;

amounts written off the receivables that appear in the statement of nancial position
8.2.8The trial balance
Preparation of statements of comprehensive income and Þnancial position
Figure 8.1The trial balance for Illustrious SpA as at 31 December 20X1
8.2.9Identify year end adjustments

Inventory at cost at 31 December 20X1 was
a
25,875,000.

Depreciation is to be provided as follows:
In this example, there is a revaluation surplus and this needs to be added to the prot on
ordinary activities for the year in order to arrive at the comprehensive income. This is shown
in Figure 8.4.
b
b
Revenue
345,000
Decrease in inventory
(17,250)
(258,750)
(276,000)
Employee beneÞts expense
Salaries
(23,230)
(1,150)
(24,380)
Other expenses
Motor expenses
(9,200)
Insurance
(3,450)
Stationery
(1,840)
Audit fees
(1,150)
Light and power
( 920)
Repairs
(460)
Hire charges
(300)
(275)
(17,595)
(5,175)
(5,175)
8.2.14What information would be disclosed by way of note to the

exceptional, such as unusually high impairment of trade receivables. These should be dis-
closed separately either by way of note or on the face of the statement of comprehensive
income if that degree of prominence is necessary in order to give a fair view.
For Illustrious SpA the note would read as follows:
Operating prot is stated after charging:
b
000
Depreciation
5,175
8.3The prescribed formats the statement of nancial position
of their liquidity. Not all headings will, of course, be applicable to all companies.
8.3.3What are the explanatory notes that accompany a statement of
nancial position?
Finished goods
13.150
25.875
Property, plant and equipment normally has a schedule as shown in Figure 8.6. From this
Preparation of statements of comprehensive income and Þnancial position
Figure 8.7Staff costs
ating segment or no categorisation at all. However, because there is no standard form of
Employees themselves might be interested when, for example, attempting to assess a
companyÕs view that redundancies, short-time working and pay restrictions are actually
8.5Has prescribing the formats meant that identical transactions are
reported identically?
That is the intention, but there are various reasons why there may still be differences. For
Figure 8.10Effect of physical inventory ßow assumptions on the percentage gross
While we can carry out academic exercises as in Figure 8.10 and we are aware of the effect
of different inventory valuation policies on the level of prots, it is not possible to carry out
such an exercise in real life.
Textile
Accounting policies
Accounting policies are chosen by a company as being the most appropriate to the
companys circumstances and
best able to produce a fair view
. They typically disclose
the accounting policies followed for the basis of accounting, i.e. historical or alternative
8.7.2What is meant by a fair view?
8.7.3IAS 1 requirements Ð fair presentation
Preparation of statements of comprehensive income and Þnancial position
It is however important to observe that the application of the concept involves
judgement in questions of degree
. The information contained in the accounts must
be accurate and comprehensive to within acceptable limits. What is acceptable and how
is this to be achieved?
Reasonable businessmen and accountants may differ over the degree of accuracy or
comprehensiveness which in particular cases the accounts should attain.
has to be taken into consideration by preparers and auditors of nancial statements.
It can occur for a number
8.8What does an investor need in addition to the nancial statements to
make decisions?
Investors attempt to estimate future cash ows when making an investment decision. As
regards future cash ows, these are normally perceived to be inuenced by past prots, the
8.8.2Additional qualitative information Ð ChairmanÕs Report
8.8.4OFR Reporting Standard RS 1
The ASB published RS 1 in 2005. This is not a statutory Standard and is intended to inform
best practice. The intention was that directors should focus on the information needs
specic to their company and its shareholders rather than follow a rigid list of items to be
ÐCash conversion rate: rate at which proÞt is converted into cash
and position of the business and KPIs would be required to be included in the Business
Review
where necessary
, i.e. in those circumstances where it were thought to be necessary in
order to provide a balanced and comprehensive analysis of the development, performance
and position of the business, or describe the principal risks and uncertainties facing the
business. It could well be that in practice companies will satisfy the requirements of the
Reporting Statement and include within the Business Review a cut-down version of that
information.
8.8.6ASB review of narrative reporting
In 2006 the ASB (www.accountancyfoundation.com/asb/press/pub1228.html) carried out
reviews of narrative reporting by FTSE 100 companies. It identied that there was good
Summary
In order to assess stewardship and management performance, there have been man-
datory requirements for standardised presentation, using formats prescribed by
International Financial Reporting Standards. There have also been mandatory require-
ments for the disclosure of accounting policies, which allow shareholders to make
Explain why two companies carrying out identical trading transactions could produce different
gross proÞt Þgures.
A statement of comprehensive income might contain the following proÞt Þgures:
Gross proÞt
ProÞt from operations
ProÞt before tax
(f)Provisions for warranty claims
(g)Interest on funds borrowed to Þnance an increase in working capital
(h)Interest on funds borrowed to Þnance an increase in property plant and equipment.
ÔWe analyze a sample of UK public companies that invoked a TFV override during 1998Ð2000
overrides that are more costly
...Þnancial statements are not less informative than control
Discuss the enquiries and action that you think an auditor should take to ensure that the Þnancial
statements give a more true and fair view than from applying standards.
When preparing accounts under Format 1, how would a bad debt that was materially larger than
normal be disclosed?
EXERCISES
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
Question 1
Basalt plc is a wholesaler. The following is its trial balance as at 31 December 20X0.
DrCr
000000
Ordinary share capital: 1 shares
300
Share premium
20
General reserve
16
Trade receivables
326
Cash at bank
62
Trade payables
66
1,5001,500
The following additional information is supplied:
(i)Depreciate plant and machinery 20% on straight-line basis.
(ii)Inventory at 31 December 20X0 is 90,000.
(iii)Accrue auditors remuneration 2,000.
(iv)Income tax for the year will be 58,000 payable October 20X1.
(v)It is estimated that 7/11 of the plant and machinery is used in connection with distribution, with
the remainder for administration. The motor vehicle costs should be allocated to distribution.
Required:
Prepare a statement of income and statement of nancial position in a form that complies with
IAS 1. No notes to the accounts are required.
212

Regulatory framework an attempt to achieve uniformity
*Question 2
The following trial balance was extracted from the books of Old NV on 31 December 20X1.
B
Sales
12,050
Administrative expenses
DirectorsÕ remuneration
Trade receivables
19,53919,539
Note of information not taken into the trial balance data:
(a)Provide for:
(i)An audit fee of
(ii)Depreciation of plant at 20% straight-line.
(iii)Depreciation of vehicles at 25% reducing balance.
(iv)The goodwill suffered an impairment in the year of
(v)Income tax of
(vi)Debenture interest of
(b)Closing inventory was valued at
Question 3
HK Ltd has prepared its draft trial balance to 30 June 20X1, which is shown below.
Trial balance at 30 June 20X1
$000$000
Freehold land
2,100
Freehold buildings (cost $4,680)
4,126
Plant and machinery (cost $3,096)
1,858
Fixtures and ttings (cost $864)
691
Goodwill
480
Trade receivables
7,263
Trade payables
2,591
Inventory
11,794
Bank balance
11,561
Development grant received
85
Prot on sale of freehold land
536
Sales
381,600
Cost of sales
318,979
Administration expenses
9,000
Distribution costs
35,100
Directors emoluments
562
Bad debts
157
Auditors remuneration
112
Hire of plant and machinery
2,400
Loan interest
605
Dividends paid during the year preference
162
Dividends paid during the year ordinary
426
9% loan
7,200
Share capital preference shares (treated as equity)
3,600
Share capital ordinary shares
5,400
407,376407,376
The following information is available:
(a)The authorised share capital is 4,000,000 9% preference shares of $1 each and The authorised
share capital is 4,000,000 9% preference shares of $1 each and 18,000,000 ordinary shares of
50c each.
(b)Provide for depreciation at the following rates:
(i)Plant and machinery 20% on cost
(ii)Fixtures and ttings 10% on cost
(iii)Buildings 2% on cost
Charge all depreciation to cost of sales.
(c)Provide $5,348,000 for income tax.
(d)The loan was raised during the year and there is no outstanding interest accrued at the year-end.
214

Regulatory framework an attempt to achieve uniformity
(e)Government grants of $85,000 have been received in respect of plant purchased during the year
and are shown in the trial balance. One-Þfth is to be taken into proÞt in the current year.
(f)During the year a Þre took place at one of the companyÕs depots, involving losses of $200,000.
These losses have already been written off to cost of sales shown in the trial balance. Since the
£000£000
Freehold premises
Plant and machinery
1,800540
Furniture and Þttings
620360
Inventory at 30 June 20X7
Administrative expenses
Ordinary shares of £1 each
Trade investments
Revaluation reserve
Share premium
Personal ledger balances
947566
Distribution costs
Overprovision for tax
Dividend received
Interim dividend paid
Preparation of statements of comprehensive income and Þnancial position
The following information is available:
1Freehold premises acquired for 1.8 million were revalued in 20X4, recognising a gain of
600,000. These include a warehouse, which cost 120,000, was revalued at 150,000 and
was sold in June 20X7 for 225,000. Phoenix does not depreciate freehold premises.
$000$000
Property valuation
Factory at cost
Administration building at cost
Delivery vehicles at cost
Inventory at 1 November 2004
Purchases
Factory wages
Administration expenses
Distribution costs
Interest paid (6 months to 30 April 2005)
Accumulated proÞt at 1 November 2004
$1 Ordinary shares (incl. issue on 1 May 2005)
Share premium (after issue on 1 May 2005)
Revaluation reserve
Deferred tax
Other relevant information:
*Question 6
Olive A/S, incorporated with an authorised capital consisting of one million ordinary shares of
A
1 each, employs 646 persons, of whom 428 work at the factory and the rest at the head ofce.
The trial balance extracted from its books as at 30 September 20X4 is as follows:
B
000
B
000
Land and buildings (cost
A
600,000)
520

Plant and machinery (cost
A
840,000)
680

Proceeds on disposal of plant and machinery

180
Fixtures and equipment (cost
A
120,000)
94

Sales

3,460
Carriage inwards
162

Share premium account

150
Advertising
112

Inventory on 1 Oct 20X3
211

Heating and lighting
80

Prepayments
115

Salaries
820

Trade investments at cost
248

158

Cash and bank balance
38

Ordinary shares of
A
1 fully called

600
5,960
5,960
You are informed as follows:
(a)As at 1 October 20X3 land and buildings were revalued at
A
900,000. A third of the cost as well
as all the valuation is regarded as attributable to the land. Directors have decided to report this

Prepaid rent
15
A
115
(f)In March 20X3 a customer had led legal action claiming damages at
A
240,000. When accounts
for the year ended 30 September 20X3 were nalised, a provision of
A
90,000 was made in
Question 7
Rafes Ltd trades as a wine wholesaler with a large warehouse in Asia. The trainee accountant at
Rafes Ltd has produced the following draft accounts for the year ended 31 December 20X6.
Statement of comprehensive income
$
Sales
1,628,000
Less
: Cost of sales
1,100,000
Gross prot
528,000
Debenture interest paid
9,000
Distribution costs
32,800
Audit fees
7,000
Impairment of goodwill
2,500
Income tax liability on prots
165,000
Interim dividend
18,000
Dividend received from Diat Por plc
(6,000)
Bank interest
3,000
Over provision of income tax in prior years
(4,250)
Depreciation
Land and buildings
3,000
Plant and machinery
10,000
Fixtures and ttings
6,750
Administrative expenses
206,300
Draft statement of nancial position at 31 December 20X6
$$
Bank balance
12,700Inventory
156,350
10% debentures 20X9180,000Receivables
179,830
Ordinary share capital
Land and buildings
238,000
50c nominal value
250,000Plant and machinery
74,000
Trade payables
32,830Fixtures and ttings
20,250
Income tax
Creditor
165,000Goodwill
40,000
Revaluation reserve
25,000
838,430
838,430
The following information is relevant:
1The directors maintain that the investments in Diat Por plc will be held by the company on a
4The company incurred $150,000 in restructuring costs during the year. These have been debited
to the administrative expenses account. The trainee accountant subsequently informs you that tax
credit control in the company in recent months.
8Depreciation policy is as follows:
Land and buildings:No depreciation on land. Buildings are depreciated over 25 years on
a straight-line basis. This is to be charged to cost of sales.
Plant and machinery:10% on cost, charge to cost of sales.
Fixtures and Þttings:25% reducing balance, charge to administration.
9The directors have provided information on a potential lawsuit. A customer is suing them for
allegedly tampering with the imported wine by injecting an illegal substance to improve the colour
of the wine. The managing director informs you that this lawsuit is just Ôsour grapesÕ by a jealous
customer and provides evidence from the company solicitor which indicates that there is only a
10Purchased goodwill was acquired in 20X3 for $50,000. The annual impairment test revealed an
impairment of $2,500 in the current year.
11Plant and machinery of $80,000 was purchased during the year to add to the $20,000 plant
Question 8
Graydon Ross CFO of Diversied Industries PLC is discussing the publication of the annual report
with his managing director Phil Davison. Graydon says: The law requires us to comply with accounting
standards and at the same time to provide a true and fair view of the results and nancial position. As
half of the business consists of the crockery and brick making business which your great great grand-
mother started, and the other half is the insurance company which your father started, I am not sure
that the consolidated accounts are very meaningful. It is hard to make sense of any of the ratios as
you dont know what industry to compare them with. What say we also give them the comprehen-
9.1Introduction
discuss the major provisions of IFRS 8
Þnancial statements of an entity (and to consolidated Þnancial statements of a group with a
parent):
Not every part of the entity will necessarily be an operating segment. For example, a
corporate headquarters may not earn revenues.
Criteria for identifying the chief operating decision maker
The chief operating decision maker may be an individual or a group of directors or others.
The key identifying factors will be those of performance assessment and resource allocation.
Total Revenue
ProÞt
360
21
176
60
3
13
125
5
84
232
27
102
124
2
31
73
5
39
63
445
Segments?
Solution
Corporate Training
Print Media
Online Publishing
are clearly more than 10% of total revenues and so these segments
are reportable.
are under 10% of entity totals for
services, geographical areas, regulatory environments, or a combination of factors and
9.3.9Evaluation of the impact of IFRS 8
into EU law, which will require EU companies listed in the European Union to disclose
segmental information in accordance with the through-the-eyes-of-management approach.
9.3.10Sample disclosures under IFRS 8
(450)
3,550
ProÞt or loss
£m
Total proÞt or loss for reportable segments
397
Other proÞt or loss
10
Elimination of inter-segment proÞts
(50)
Unallocated amounts:
(25)
307
150
3Information about major customers
Sample disclosure might be:
Revenues from one customer of the software and hotels segments represent
approximately 400 million of the entitys total revenue.
(NB: disclosure is not required of the customers name or of the revenue for each operating
segment.)
9.4IFRS 5 meaning of held for sale
IFRS 5
7
7
1
15
22
9
14
36
9.6.2Signicance
The basic signicance is that the results of discontinued operations should be separately
disclosed from those of other, continuing, operations in the statement of comprehensive
income. As a minimum, on the face of the statement, entities should show, as a single
amount, the total of:

the post-tax prot or loss of discontinued operations; and

the post-tax gain or loss recognised on the measurement to fair value less cost to sell or
consideration with a fair value of approximately 0.23 trillion (1.1 billion), comprised of
preferred equity and a subordinated loan. SoftBank also assumed debt of approximately
0.13 trillion (0.6 billion). Vodafone K.K. represented a separate geographical area of
operation and, on this basis, Vodafone K.K. was treated as a discontinued operation in
Vodafone Group Plcs annual report for the year ended 31 March 2006.
234

Regulatory framework an attempt to achieve uniformity
20072006
£m£m
5207,268
Ñ(2)
Events in this period are referred to as Events after the Reporting Period. In certain
circumstances the nancial statements should be adjusted to reect the occurrence of such
events.
9.7.1Adjusting events
These are events after the reporting period that provide additional evidence of conditions
that exist at the year end date. Examples of such events include, but are not limited to:

9.7.4Going concern issues

E is the joint venture of a third entity and AE is an associate of the third entity, or
vice versa.

AE is a post-employment benet plan for the benet of either E or an entity related to E.
If E is such a plan, then the sponsoring employees are also related to E.

AE is controlled or jointly controlled by any person that is a related party of E (see
9.8.1 above).
9.8.3Parties deemed not to be related parties
IAS 24 emphasises that it is necessary to carefully consider the substance of each relation-
9.8.6Disclosure of related party transactions
related parties.
These disclosures should be given separately for each of the following categories:
The following are examples of transactions that are disclosed if they are with a related party:
b
million
b
million
Related party balances
2009
2008
Trading and other balances due from joint ventures
231
240
Trading and other balances due from/(to) associates
5
(33)
Joint ventures
related party relationship. Therefore, the basis of conclusions to IAS 24 (BC 43) states that,
needed in these circumstances:
The objective of IAS 24 is to provide disclosures necessary to draw attention to the
In order to assist shareholders to predict future cash ßows with an understanding of
the risks involved, more information has been required by the IASB. This has taken
1
more quantitative information in the accounts, e.g. segmental analysis, and the
impact of changes on the operation, e.g. a breakdown of turnover, costs and proÞts
2
more qualitative information, e.g. related party disclosures and events occurring
Explain the criteria that have to be satisÞed when identifying an operating segment.
Explain the criteria that have to be satisÞed to identify a reportable segment.
Explain why it is necessary to identify a chief operating decision maker and describe the key
identifying factors.
EXERCISES
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
*Question 1
Filios Products plc owns a chain of hotels through which it provides three basic services; restaurant
facilities, accommodation, and leisure facilities. The latest nancial statements contain the following
information:
Statement of nancial position of Filios Products
m
Bank balance
128
509
EQUITY AND LIABILITIES
Equity
Share capital
800
Current liabilities
193
Total Equity and liabilities
2,172
Statement of comprehensive income of Filios Products
mm
Revenue
1,028
Less
:Cost of sales
684
Administration expenses
110
Distribution costs
101
Interest charged
14(909)
The following breakdown is provided of the companyÕs results into three divisions and head ofÞce:
RestaurantsHotelsLeisureHead ofÞce
£m£m
152368
81287
Administration expenses
1438
Distribution costs
1225
Interest charged
ÑÑ
Long-term borrowings
ÑÑ
(a)Outline the nature of segmental reports and explain the reason for presenting such information
(b)Prepare a segmental statement for Filios Products plc for complying, so far as the information
(i)Revenue;
(ii)ProÞt;
*Question 3
Epsilon is a listed entity. You are the nancial controller of the entity and its consolidated nancial state-
ments for the year ended 31 March 2009 are being prepared. The board of directors is responsible
for all key nancial and operating decisions, including the allocation of resources.
Your assistant is preparing the rst draft of the statements. He has a reasonable general accounting
B
18,000
2,000
6,000
C
4,000
(3,000)
5,000
D
1,000
150
500
E
3,000
450
400
Sub-total
49,000
2,600
19,900
Head ofce
Nil
Nil
6,000
Entity total
49,000
2,600
25,900
I am unsure of the following matters regarding the reporting of operating segments:

How do we decide on what our operating segments should be?

Should we report segment information relating to head ofce?

Which of our operational areas should report separate information? Operational areas A, B and
C exhibit very distinct economic characteristics but the economic characteristics of operational
areas D and E are very similar.

Why has IFRS8 attracted such critical comment?
Issue 2
I note that on 31 January 2009 the board of directors decided to discontinue the activities of a number
of our subsidiaries. This decision was made, I believe, because these subsidiaries did not t into the
long-term plans of the group and the board did not consider it likely that the subsidiaries could be
sold. This decision was communicated to the employees on 28 February 2009 and the activities of the
alternative employment would be $10 million. Following 30 April 2009 these estimates were
revised to $22 million and $9 million respectively.
(b)Latest estimates are that the operating losses of the affected subsidiaries for the six months to
(c)A number of the subsidiaries are leasing properties under non-cancellable operating leases.
I believe that at 31 March 2009 the present value of the future lease payments relating to these
properties totalled $6 million. The cost of immediate termination of these lease obligations would
(d)The carrying values of the freehold properties owned by the affected subsidiaries at 31 March
Omega computes its depreciation charge on a monthly basis.
No impairment of the plant had occurred by 31 March 2007.
On 31 December 2006 the directors decided to dispose of a property that was surplus to require-
ments. They instructed selling agents to procure a suitable purchaser and advertised the property at
a commercially realistic price.
The property was being measured under the revaluation model and had been revalued at $15 million
on 31 March 2006. The depreciable element of the property was estimated as $8 million at 31 March
2006 and the useful economic life of the depreciable element was estimated as 25 years from that
Question 7
(a)In 20X3 Arthur is a large loan creditor of X Ltd and receives interest at 20% p.a. on this loan. He
also has a 24% shareholding in X Ltd. Until 20X1 he was a director of the company and left after
a disagreement. The remaining 76% of the shares are held by the remaining directors.
(b)Brenda joined Y Ltd, an insurance broking company, on 1 January 20X0 on a low salary but high
commission basis. She brought clients with her that generated 30% of the companys 20X0
revenue.
(c)Carrie is a director and major shareholder of Z Ltd. Her husband, Donald, is employed in the
company on administrative duties for which he is paid a salary of 25,000 p.a. Her daughter,
Emma, is a business consultant running her own business. In 20X0 Emma carried out various
consultancy exercises for the company for which she was paid 85,000.
(d)Fred is a director of V Ltd. V Ltd is a major customer of W Ltd. In 20X0 Fred also became a
director of W Ltd.
Required:
The following trial balance has been extracted from the books of Hoodurz as at 31 March 2006:
$000$000
Administration expenses
Ordinary share capital, $1 per share
Trade receivables
Bank overdraft
Provision for warranty claims
Distribution costs
2,010
65
2005/2006 interim dividend paid
3,6303,630
The following information is relevant:
(i)The trial balance Þgures include the following amounts for a disposal group that has been classi-
(vi)Staff bonuses totalling $20,000 for administration and $20,000 for distribution are to be accrued.
(vii)The property was acquired during February 2006, therefore, depreciation for the year ended
$m$m
Revenue
563
Cost of sales
310
253
Distribution costs
45
Administrative expenses
78
123
Prot on ordinary activities before tax
130
Tax on prot on ordinary activities
45
Prot brought forward at 1 January 2003
101
Prot carried forward at 31 December 2003
186
You are given the following additional information, which is reected in the above statement of
comprehensive income only to the extent stated:
1Distribution costs include a bad debt of $15 million which arose on the insolvency of a major
customer. There is no prospect of recovering any of this debt. Bad debts have never been material
in the past.
2The company has traditionally consisted of a manufacturing division and a distribution division.
On 31 December 2003, the entire distribution division was sold for $50 million; its book value at
the time of sale was $40 million. The prot on disposal was credited to administrative expenses.
(Ignore any related income tax.)
3During 2003, the distribution division made sales of $100 million and had a cost of sales of
$30 million. There will be no reduction in stated distribution costs or administration expenses as
a result of this disposal.
4The company owns ofces which it purchased on 1 January 2001 for $500 million, comprising
$200 million for land and $300 million for buildings. No depreciation was charged in 2001 or 2002,
but the company now considers that such a charge should be introduced. The buildings were
250

Regulatory framework an attempt to achieve uniformity

000
Auditors remuneration
30
Income tax based on the accounting prot:
For the year to 31 March 20X4
3,200
Overprovision for the year to 31 March 20X3
200
Delivery expenses (including 300,000 overseas)
1,200
Dividends:nal (proposed to be paid 1 August 20X4)
200
interim (paid on 1 October 20X3)
100
Storeroom staff
400
Annual Report: additional nancial statements

251
Openmirrors.com
Notes:
1Depreciation is provided at the following annual rates on a straight-line basis: delivery vans 20%;
ofce cars 25%; stores 1%.
2The following taxation rates may be assumed: corporate income tax 35%; personal income
tax 25%.
3The dividend income arises from investments held in non-current investments.
4It has been decided to transfer an amount of 150,000 to the deferred taxation account.
5The overseas operations consisted of exports. In 20X3/X4 these amounted to 5,000,000 (sales)
with purchases of 4,000,000. Related costs included 100,000 in storeroom staff and 15,000 for
ofce staff.
6Directors emoluments include:
Chairperson
100,000
Managing director125,000
Finance director75,000
Sales director
75,000
Export director25,000(resigned 31 December 20X3)
400,000
Required:
(a)Produce a statement of comprehensive income suitable for publication and complying as far as
possible with generally accepted accounting practice.
(b)Comment on how IFRS 5 has improved the quality of information available to users of
accounts.
Question 12
As the nancial controller of SEAS Ltd, you are responsible for preparing the companys nancial state-
ments and are at present nalising these for the year ended 31 March 20X8 for presentation to the
board of directors. The following items are material:
(i)Costs of 250,000 arose from the closure of the companys factory in Garratt, which manufac-
(vi)Dynatron Ltd, a customer, owed the company 50,000 on 31 March 20X8. However, on 15 May
20X8 it went into creditors voluntary liquidation. Of the 50,000, 40,000 is still outstanding and
the liquidator of Dynatron is expected to pay approximately 25p in the pound to unsecured
creditors.
(vii)On 30 April 20X8, the company made a 1 for 4 rights issue to the ordinary shareholders, which
involved the issue of 50,000 1 ordinary shares for a sum of 62,500.
252

Regulatory framework an attempt to achieve uniformity
1IFRS 8
position Ð equity, liability
10.1Introduction
10.2Common themes
Statutory rules have, therefore, evolved which attempt a balancing act by protecting the
creditors on the one hand, e.g. by restricting dividend distributions to realised proÞts, whilst,

conversion rights when there must be a split into their debt and equity elements, with
each element being accounted for separately.

Preference shares are not entitled (unless participating) to share in the residual income
but may be entitled to a xed or oating rate of interest on their investment.


share proportionately in the rewards, i.e.:
the residual prot remaining after paying any loan interest or xed dividends to
are issued. In Japan, for example, the Japanese Commercial Code was amended in 2002
to allow companies to issue shares with special rights, e.g. power to veto certain company
Reasons for issuing shares
and placed 540,000,000 ordinary shares and expected to raise cash proceeds of about
, e.g. Microsoft Corp. acquired Great Plains Software
structure for the current environment and enhance covenant and longer-term liquidity
headroom under current debt facilities.

To loan creditors in exchange for debt
, e.g. Sirius XM, a satellite radio station, with
about $1 billion debt due to mature in February 2009, in January 2009 exchanged shares
for 2
1
/
2
% convertible debt.

To obtain funds for future acquisitions
, e.g. SSL International, a successful company
that had outperformed the FTSE All-Share index 2008, raised 87 million to fund its

To reduce levels of debt
to avoid credit rating agencies downgrading the company
which would make it difcult or more expensive to borrow.

To overcome liquidity problems
, e.g. Brio experienced liquidity problems and
renanced with the isue of SK300 million shares to raise over 25 million.
10.4.4Types of preference shares
The following illustrate some of the ways in which specic rights can vary.
Cumulative preference shares
Dividends not paid in respect of any one year because of a lack of prots are accumulated
for payment in some future year when distributable prots are sufcient.
Non-cumulative preference shares
Dividends not paid in any one year because of a lack of distributable prots are permanently
forgone.
Participating preference shares
These shares carry the right to participate in a distribution of additional prots over and
above the xed rate of dividend after the ordinary shareholders have received an agreed
percentage. The participation rights are based on a precise formula.
Redeemable preference shares
These shares may be redeemed by the company at an agreed future date and at an agreed price.
Convertible preference shares
These shares may be converted into ordinary shares at a future date on agreed terms. The
10.5.2Shares issued at a premium
10.7Creditor protection: why capital maintenance rules are necessary
It is helpful at this point to review the position of unincorporated businesses in relation to
capital maintenance.
10.7.1Unincorporated businesses
An unincorporated business such as a sole trader or partnership is not required to maintain
any specied amount of capital within the business to safeguard the interests of its creditors.
direct
approach which requires the
10.10.1Distributable prots: general rule for private companies
The denition of distributable prots under the Companies Act 2006 is:
Accumulated, realised prots, so far as not previously utilised by distribution or
capitalisation, less its accumulated, realised losses, as far as not previously written
off in a reduction or reorganisation of capital.
This means the following:

Unrealised prots cannot be distributed.

pass the dividends they receive to their shareholders, irrespective of any changes in the values
order approving a reduction of capital. In line with the wish to reduce the regulatory burden
on private companies the government legislated
to reduce their capital by special resolution subject to the directors signing a solvency
and may be distributed, although it need not be and could be used for other purposes,
e.g. writing off accumulated trading losses.
10.13Writing off part of capital which has already been lost and is not
There might be statutory procedures such as the requirement for the directors to obtain
a special resolution and court approval to reduce the 1 ordinary shares to ordinary shares
of 10p each. Subject to satisfying such requirements, the accounting entries would be:
Dr
Cr

Capital reduction account
180,000
Statement of income:
180,000
Transfer of debit balance
Share capital
180,000
Capital reduction account:
180,000
Reduction of share capital
Accounting treatment for a capital reduction to eliminate accumulated
200,000 ordinary shares of £1 each
200,000
(180,000)
12,000
The plant and equipment is revalued at £5,000 and it is resolved to reduce the share capital
to ordinary shares of 5p each. The accounting entries would be:
Dr
Cr
££
Capital reduction account
190,000
Statement of income
180,000
Plant and machinery:
10,000
Transfer of accumulated losses and loss on revaluation
Share capital
190,000
Capital reduction account:
190,000
Reduction of share capital to 200,000 shares of 5p each
The statement of Þnancial position after the capital reduction shows that the share capital
10,000
12,0005,000
The pro forma statement of Þnancial position shown in Figure 10.1 is from the PilkingtonÕs
The proposal was the subject of a special resolution to be conÞrmed by the High Court Ð the
court would consider the proposal taking creditor protection into account. The company
¥
269
10.13.2Accounting treatment for a capital reduction to eliminate
accumulated trading losses and loss of value on non-current
of Hopeful Ltd would be inuenced by their prospects of receiving payment if Hopeful
were to cease trading immediately, the effect on their results without Hopeful as a continuing
270

the Company will need to demonstrate to the satisfaction of the High Court that no
creditor of the Company who has consented to the cancellations will be prejudiced by
them. At present, it is anticipated that the creditor protection will take the form of an
undertaking ... not to treat as distributable any sum realised ... which represents the
realisation of hidden value in the statement of nancial position.
following reconstruction.
Loan creditors
Loan creditors would take into account the expected value of any security they possess
Note 1(800)
600
The directors are faced with a decision to liquidate or reconstruct. Having satised
holdersshareholders

Less
: Prior claim
(600,000)600,000
Less
: Ordinary shareholders
(50,000)
50,000
600,00050,000
This shows that the ordinary shareholders would lose almost all of their capital, whereas
the debenture holders would be in a much stronger position. This is important because it
might inuence the amount of inducement that the debenture holders require to accept any
variation of their rights.
Company continues without reconstruction
Debenture Ordinary
holdersshareholders

Expected annual income:
Expected operating prot
150,000
Debenture interest
(60,000)60,000
Less: Ordinary dividend
(90,000)
90,000
Annual income
60,000
90,000
However, as far as the ordinary shareholders are concerned, no dividend will be allowed
to be paid until the debit balance of 800,000 has been eliminated, i.e. there will be no
dividend for more than nine years (for simplicity the illustration ignores tax effects).
272

holdersshareholders
£££
150,000
(50,000)50,000
(33,000)33,000
(67,000)
67,000
Ñ83,000
600
Ordinary share capital (25p)300
12.5% debentures (new issue)400
Ordinary share capital (25p)300,000
12.5% debentures of £1400,000
10.14Repayment of part of paid-in capital to shareholders or cancellation

buyback, leaving itself liable to service the debt. Where it uses free cash rather than loans
(15,000)
240,000
In some countries, e.g. Switzerland, the treasury shares have been reported in the statement
There are certain restrictions whilst shares are held in treasury, namely:

Their aggregate nominal value must not exceed 10% of the nominal value of issued share
capital (if it exceeds 10% then the excess must be disposed of or cancelled).

Rights attaching to the class of share e.g. receiving dividends, and the right to vote
cannot be exercised by the company.
Treasury shares cancellation

Where shares are held as treasury shares, the company may at any time cancel some or all
of the shares.

If shares held as treasury shares cease to be qualifying shares, then the company must
cancel the shares.

On cancellation the amount of the companys share capital is reduced by the nominal
amount of the shares cancelled.
The Singapore experience
It is interesting to note that until 1998 companies in Singapore were not permitted to
purchase their own shares and had to rely on obtaining a court order to reduce capital. It was
realised, however, that regimes such as those in the UK allowed a quicker and less expensive
What is the relevance of dividend cover if dividends are paid out of distributable proÞts?
How can distributable proÞts become non-distributable?
Why do companies reorganise their capital structure when they have accumulated losses?
What factors would a loan creditor take into account if asked to bear some of the accumulated loss?
Explain a debt/equity swap and the reasons for debt/equity swaps, and discuss the effect on
existing shareholders and loan creditors.
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-elliott)
for exercises marked with an asterisk (*).
The draft statement of Þnancial position of Telin plc at 30 September 20X5 was as follows:
Ordinary shares of £1 each, fully paid12,000Product development costs1,400
Share premium
4,000Cash and bank
10,420
39,020
Preference shares of the company were originally issued at a premium of 2p per share. The directors
of the company decided to redeem these shares at the end of October 20X5 at a premium of 5p per
share. They also decided to write off the balances on development costs and discount on debentures
All write-offs and other transactions are to be entered into the accounts according to the provisions of
the Companies Acts and in a manner Þnancially advantageous to the company and to its shareholders.
11.1Introduction
understand and explain why it is important that companies reßect as accurately
all interest expense is disclosed as such in the income statement when assessing risks and
To be useful, information must also be reliable. Information has the quality of reliability
when it is free from material error and bias and can be depended upon by users to
repre-
sent faithfully
that which it either purports to represent or could reasonably be expected
to represent.
Faithful representation
To be reliable, information must represent faithfully the transactions and other events it
either purports to represent or could reasonably be expected to represent. Thus, for example,
1Substance
The following transactions took place during October 20X5:
(a)On 4 October the company issued for cash 2,400,000 10% debentures of I each at a discount
of 2
1

2
%.
(b)On 6 October the balances on development costs and discount of debentures were written off.
(c)On 12 October the company issued for cash 6,000,000 ordinary shares at a premium of 10p per
share. This was a specic issue to help redeem preference shares.
(d)On 29 October the company redeemed the 12% preference shares at a premium of 5p per share
and included in the payments to shareholders one months dividend for October.
(e)On 30 October the company made a bonus issue, to all ordinary shareholders, of one fully paid
ordinary share for every 20 shares held.
000
000
000
CostAccumulated
depreciation
Freehold property
46
5
41
Plant
85
6
79
131
11
120
Investments
Shares in subsidiary company
90
Loans
40
130
Trade receivables
106
238
Current liabilities
Trade payables
282
Bank overdraft
58
340
Capital and reserves
250,000 8
1

2
% cumulative redeemable preference shares
of 1 each fully paid
250
100,000 ordinary shares of 1 each 75p paid
75
325
148
278

The following information is relevant:
IThere are contingent liabilities in respect of (i) a guarantee given to bankers to cover a loan of
£30,000 made to the subsidiary and (ii) uncalled capital of I0p per share on the holding of 100,000
shares of £I each in the subsidiary.
2The arrears of preference dividend amount to £106,250.
3The following capital reconstruction scheme, to take effect as from I July 20X8, has been duly
approved and authorised:
(i)the unpaid capital on the ordinary shares to be called up;
(ii)the ordinary shares thereupon to be reduced to shares of 25p each fully paid up by cancell-
ing 75p per share and then each fully paid share of 25p to be subdivided into Þve shares of
800,000 ordinary shares of
shares of £1 each
300,000Bank
General reserves
400,000
1,700,000
During 20XI, the company:
(i)Issued 200,000 ordinary shares of £I each at a premium of I0p per share (a speciÞc issue to
redeem preference shares).
Redeemed all preference shares at a premium of 5%. These were originally issued at 25% premium.
(iii)Issued 4,000 7% debentures of 100 each at 90.
(iv)Used share premium, if any, to issue fully paid bonus shares to members.
Statement of nancial position (000s)
Secured loan (secured on the land)
(1,200)
1,440
Financed by
Ordinary shares of 1 each
3,000
Statement of comprehensive income
(1,560)
1,440
280

Supporting information
warehouse to be converted into apartments. If planning permission were to be obtained, the
(b)planning permission was obtained.
Delta Ltd has been developing a lightweight automated wheelchair. The research costs written off
have been far greater than originally estimated and the equity and preference capital has been eroded
£000£000
Freehold property
6501,450
200
1,270
Current liabilities
Trade payables
Bank overdraft
(490)(550)
10% debentures (secured on freehold premises)
7% cumulative preference shares of £1 each
¥
281
The nance director has prepared the following information for consideration by the board:
1Estimated current and liquidation values were estimated as follows:
Current valuesLiquidation values
000
000
Capitalised development costs
300

Freehold property
1,200
1,200
Plant and equipment
600
100
Inventory
480
300
Trade receivables
590
590
Investments
200
200
2,390
2If the company were to be liquidated there would be disposal costs of 100,000.
3The preference dividend had not been paid for ve years.
4It is estimated that the company would make prots before interest over the next ve years of
150,000 rising to 400,000 by the fth year.
5The directors have indicated that they would consider introducing further equity capital.
6It was the nance directors opinion that for any scheme to succeed , it should satisfy the following
conditions:
Factoring is a means of accelerating the cash inow by selling trade receivables to a third
payment. If these risks have been transferred to a third party the substance of the factoring
without recourse
then the third party accepts the
risks and will have no recourse to the enterprise in the event of non-payment by the debtor.
If the agreement transfers the debts
with recourse
then the third party has not accepted
the risks and in the event of default by the debtor the third party will seek redress from the
The above examples of substance over form concentrate on the fair representation of
11.5.2What are the general principles that IAS 37 applies to the
recognition of a provision?
The general principles are that a provision should be recognised when:
6
(a)
an entity has a
present obligation
(legal or constructive)
as a result of past events
;
(b)
it is
probable
that a transfer of
and IAS 37 comments
the use of estimates is an essential part of the preparation
of Þnancial statements and does not undermine their reliability
.
The IAS addresses the uncertainties arising in respect of present obligation, past event,

A single obligation exists
where a single obligation is being measured, the individual most likely outcome may be
the best estimate;
however, there may be other outcomes that are signicantly higher or lower indicating
11.5.5Disclosures
Specic disclosures,
14
for each material class of provision, should be given as to the amount
recognised at the year-end and about any movements in the year, e.g.:

Increases in provisions
any new provisions; any increases to existing provisions; and,
where provisions are carried at present value, any change in value arising from the passage
of time or from any movement in the discount rate.

Reductions in provisions
any amounts utilised during the period; management are
required to review provisions at each reporting date and
adjust to reect the current best estimates; and
11.5.7Contingent liabilities
IAS 37 deals with provisions and contingent liabilities within the same IAS because the
IASB regarded all provisions as contingent as they are uncertain in timing and amount. For
11.6ED IAS 37
11.6.2Approach taken by ED IAS 37
Non-nancial Liabilities
The new proposed standard uses the term non-nancial liabilities which it denes as a
liability other than a nancial liability as dened in IAS32
Financial Instruments: Presenta-
tion
. In considering ED IAS 37, we will look at the proposed treatment of contingent
ÔpossibleÕ (
p
50%) when it required no liability to be recognised.
What disclosure is required for maximum potential liability?
ED IAS 37 does not require disclosure of the maximum potential liability, e.g. the maximum
damages if the entity loses the legal case.
11.6.3Measured reliably
The
Framework
denition of a liability includes the condition and the amount at which the
11.6.10Restructurings
ED IAS 37 says:
An entity shall recognise a non-nancial liability for a cost associated with a
restructuring only when the denition of a liability has been satised.
There are situations where management has made a decision to restructure and the ED
provides that in these cases a decision by the management of an entity to undertake a
restructuring is not the requisite past event for recognition of a liability. A cost associated
with a restructuring is recognised as a liability on the same basis as if that cost arose
independently of the restructuring.
11.6.11Other items
These include the treatment of termination costs and future operating losses where the
11.6.13Conclusion on ED IAS 37 Non-Þnancial Liabilities
that the actual outcome might be higher, estimating the amount a third party would require
to take over this risk.
If the liability can be cancelled or transferred, there is a choice available to full the
obligation, to cancel the obligation or to transfer the liability. The logical choice is to choose
the lower of the present value of fullling the obligation and the amount that would have to
be paid to either cancel or transfer.
Potential impact on ratios and transparency
A new standard that applies this measurement approach will not have an identical impact on
all entities some will have to include higher non-liabilities on their statement of nancial
position, others will have to reduce the non-liabilities. This means that there will be
Given the process of establishing expected values and risk adjustments, it might be that
additional narrative explanation will be required in the annual report particularly if the
non-liabilities are material.
11.8Special purpose entities (SPEs) lack of transparency
Investors rely on the nancial statements presenting a true and fair view of material items.
11.9Impact of converting to IFRS
There might be difÞculties in differentiating real changes in performance from the impact
of the new IFRS requirements. It will be important for companies to highlight the economic
306

Summary
Traditional book-keeping resulted in the production of a statement of nancial position
that was simply a list of unused and unpaid balances on account at the close of the
nancial year. It was intrinsically a document conrming the double entry system but
it was used by investors and analysts to assess the risk inherent in the capital structure.
Unfortunately the transaction-based nature of book-keeping created a statement of
Some members of the board of directors of a company deliberating over a possible source of
new capital believe that irredeemable debentures carrying a Þxed annual coupon rate would
sufÞce. They also believe that the going concern concept of the Þnancial statements would obviate
the need to include the debt thereon: the entity is a going concern and there is no intention to
repay the debt; therefore disclosure is unwarranted. Discuss.
The Notes in the BG Group 2007 Annual Report included the following extract:
20072006
£m£m
As at 1 January
311260
Unwinding of discount16
The estimated cost of decommissioning at the end of the producing lives of Þelds is reviewed at
least annually and engineering estimates and reports are updated periodically. Provision is made
that current circumstances indicate BG Group will ultimately bear this cost.
Explain why the provision has been increased in 2006 and 2007 by the unwinding of discount and
why these increases are for different amounts.
As a sales incentive, a computer manufacturer, Burgot SA, offers to buy back its computers after
three years at 25% of the original selling price, so providing the customer with a guaranteed
residual value which would be exercised if he or she were unable to achieve a higher price in the
how the transaction would be dealt with in the books of D Ltd under each of the following inde-

at the close of the days transactions. The factor also has recourse to D Ltd for the rst
10,000 of any loss.
7
Mining, nuclear and oil companies have normally provided an amount each year over the life of an
enterprise to provide for decommissioning costs. Explain why the IASB considered this to be an
inappropriate treatment and how these companies would be affected by IAS 37
Provisions,
EXERCISES
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
Question 1
(a)Provisions are particular kinds of liabilities. It therefore follows that provisions should be recog-
which relates solely to the uneconomic supply of oil. Additionally the oil company is exposed
to environmental liabilities arising out of its past obligations, principally in respect of soil and
ground water restoration costs, although currently there is no legal obligation to carry out the
legal advice that the claim has little chance of success and the insurance advisers have indicated
that to insure against losing the case would cost $20 million as a premium.
or design of the product, the company repairs or replaces the product. However, the company does
not make this practice widely known.
Required:
Explain how repairs after the guarantee period should be treated in the nancial statements.
Question 5
In 20X6 Alpha AS made the decision to close a loss-making department in 20X7. The company pro-
posed to make a provision for the future costs of termination in the 20X6 prot or loss. Its argument
was that a liability existed in 20X6 which should be recognised in 20X6. The auditor objected to
recognising a liability, but agreed to recognition if it could be shown that the management decision
was irrevocable.
Required:
1K.V. Peasnell and R.A.Yaansah,
CHAPTER
12
Financial instruments
12.1Introduction
Accounting for nancial instruments has proven to be one of the most difcult areas for
the IASB to provide guidance on, and the current standards are far from perfect. In 2009
the IASB began a process to amend the existing nancial instrument accounting with the
issue of revised guidance on the recognition and measurement of nancial instruments. It is
Objectives
By the end of this chapter, you should be able to:

dene what nancial instruments are and be able to outline the main accounting
requirements under IFRS;

comment critically on the international accounting requirements for nancial
instruments and understand why they continue to prove both difcult and
controversial topics in accounting;

account for different types of common nancial instrument that companies may use.
12.2.1Rules versus principles
to the Þnancial crisis, not only for measurement of Þnancial instruments that was
addressed by IFRS 9 but also in areas such as consolidation, derecognition of Þnancial
An
equity instrument
that required the maintenance of certain ratios such as gearing or interest cover. Moving pre-
ference shares to debt and dividends to interest costs could mean the covenants are breached
and other loans become repayable.
expensive.
These very practical issues need to be managed by companies converting to IFRS from a
local accounting regime that treats preference shares as equity or non-equity funds. Good
Compound instruments
and equity. A convertible loan, which gives the holder the option to convert into equity shares
The split is made by measuring the debt part and making the equity the residual of the
proceeds. This approach is in line with the deÞnitions of liabilities and equity, where equity
ßows on the debt instrument.
The value of debt is therefore:
Present value of redemption payment (discounted @ 6%)
£
£21,062
£95,788
Value of the equity proceeds: (£100,000
Š
£95,788)
£4,212
spilt accounting was adopted in 2004:
¥
317
Extract from Balfour Beatty IFRS restatement of 2004 results
Preference shares:
The Groups 136m outstanding convertible redeemable preference shares included
within Shareholders funds at 31 December 2004 under UK GAAP are, under IAS 32,
regarded as a compound instrument consisting of a liability (112m, including 10m
deferred tax) and an equity component (19m). The preference dividend is shown in
the statement of comprehensive income as an interest expense.
UK GAAPIAS 32 Adjusted
Capital and reserves
Called-up share capital
213
212
Share premium account
150
15
Equity component of preference shares

19
Non-current liabilities
Liability component of preference shares

(102)
equity instrument as opposed to a debt instrument. IAS 32, however, takes the view that it
is a debt instrument because the interest must be paid (as compared to dividends which are
only paid if prots are available for distribution and if directors declare a dividend approved
by the shareholders), and the present value of all the future obligations to pay interest will
12.3.4Calculation of nance costs on liability instruments
The nance costs will be changed to prot or loss. The nance cost of debt is the total pay-
ments to be incurred over the life-span of that debt less the initial carrying value. Such costs
should be allocated to prot or loss over the life-time of the debt at a constant rate of interest
term. It received from the lender 890,000, being the face value of the debt less a discount
of 110,000. Interest was payable yearly in arrears at 8% per annum on the principal sum
of 1,000,000. The principal sum was to be repaid on 31 December 20X9.
¥
319
r
the companyÕs annual rate of discount and
I
=+++Š
=+++Š
16,926
+
11,493
G
(1.12)
(1.12)
(1.12)
(1.12)
(1.11)
(1.11)
(1.11)
(1.11)
(1
+
r
(1
+
r
(1
+
r
(1
+
r
=
n
=
1
1
+
r
=
n
320

11.59% enables 430,000 to be charged to prot or loss after allowing for payment of all
interest, costs and repayment of the face value of the instrument.
The nance charge per annum and the successive year-end carrying amounts
The charge to the statement of comprehensive income and the carrying values in the state-
ment of nancial position are shown in Figure 12.1.
12.4.1Scope of the standard

(b)Held-to-maturity investments
(c)Loans and receivables
324

or held-to-maturity.
InstrumentClassiÞcationStatementProÞt Other
of Þnancial or losscomprehensive
Forward contractFV-P&L
£100,000£100,000Ñ
Corporate bondHeld-to-maturity£1,000,000*(£60,000)Ñ
Equity investmentAvailable-for-sale£550,000Ñ£50,000
InstrumentClassiÞcationStatementProÞt Other
of Þnancial or losscomprehensive
Forward contractFV-P&L
£100,000£100,000Ñ
Corporate bondAvailable-for-sale£960,000(£60,000)(£40,000)
Equity investmentAvailable-for-sale£550,000Ñ£50,000
InstrumentClassiÞcationStatementProÞt Other
of Þnancial or losscomprehensive
Forward contractFV-P&L
£100,000£100,000Ñ
Corporate bondHeld-to-maturity£1,000,000(£60,000)Ñ
Equity investmentFV-P&L
£550,000£50,000Ñ
12.4.3Recognition of Þnancial instruments
326

An embedded instrument should be separated from the host contract and accounted for
¥
327
328

¥
329
330

8The carrying amounts of each of the following categories, as deÞned in IAS 39,
332

cash equivalents (12,767,000) and equity attributable to equity holders of the parent,
¥
333
334

Figure 12.5The classication approach of IFRS 9
¥
335
336

Summary
This chapter has given some insight into the difculties and complexities of accounting
for nancial instruments and the ongoing debate on this topic, highlighted by the
nancial crisis that began in 2008. The approach of the IASB is to adhere to the prin-
ciples contained in the
Framework
but to also issue guidance that is robust enough to
¥
337
Explain what is meant by the term split accounting when applied to convertible debt or con-
vertible preference shares and the rationale for splitting.
Discuss the implications for a business if a substance approach is used for the reporting of con-
vertible loans.
Explain how a gain or loss on a forward contract is dealt with in the accounts if the contract is
reported in the Þnancial statements.
The authors
contend that the use of current valuations can present an inaccurate view of a
EXERCISES
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
*Question 1
On 1 April year 1, a deep discount bond was issued by DDB AG. It had a face value of 2.5 million
covering a ve-year term. The lenders were granted a discount of 5%. The coupon rate was 10% on
the principal sum of 2.5 million, payable annually in arrears. The principal sum was repayable in cash
on 31 March year 5. Issuing costs amounted to 150,000.
Required:
Compute the nance charge per annum and the carrying value of the loan to be reported in each
years prot or loss and statement of nancial position respectively.
Question 2
On 1 October year 1, RPS plc issued one million 1 5% redeemable preference shares. The shares
were issued at a discount of 50,000 and are due to be redeemed on 30 September Year 5.
Dividends are paid on 30 September each year.
Required:
Show the accounting treatment of the preference shares throughout the life-span of the instrument
calculating the nance cost to be charged to prot or loss in each period.
Question 3
October 20X1, Little Raven plc issued 50,000 debentures, with a par value of 100 each, to investors
at 80 each. The debentures are redeemable at par on 30 September 20X6 and have a coupon rate
Y/e 30 Sept 20X5Y/e 30 Sept 20X4
Turnover
(3,025)
(2,900)
Gross proÞt
Overheads
Interest payableÐ debenture
Ð others
ProÞt for the Þnancial year
Extracts from the statement of Þnancial position are:
At 30 Sept 20X5At 30 Sept 20X4
Share capital
Share premium
7,100
6% debentures
11,100
(a)Outline the considerations involved in deciding how to account for the issue, the interest cost
Required:
*Question 5
George plc adopted IFRS for the rst time on 1 January 2008 and has three different instruments
whose accounting George is concerned will change as a result of the adoption of the standard. The
three instruments are:
1An investment in 15% of the ordinary shares of Joshua Ltd, a private company. This investment
cost
A
50,000, but had a fair value of
A
60,000 on 1 January 2008,
A
70,000 on 31 December 2008
and
A
65,000 on 31 December 2009.
2An investment of
A
40,000 in 6% debentures. The debentures were acquired at their face value
of
A
40,000 on 1 July 2007 and pay interest half yearly in arrears on 31 December and 30 June
each year. The bonds have a fair value of
A
41,000 at 1 January 2008,
A
43,000 at 31 December
2008 and
A
38,000 at 31 December 2009.
3An interest rate swap taken out to swap oating rate interest on an outstanding loan to xed rate
interest. Since taking out the swap the loan has been repaid, however, George plc decided to
(ii)Where possible, investments are treated as held to maturity.
(iii)Where equity investments are treated as fair value through prot and loss and debt invest-
ments are treated as loans and receivables.
Question 6
Isabelle Limited borrows 100,000 from a bank on the following terms:
(i)Arrangement fees of 2,000 are charged by the bank and deducted from the initial proceeds on
the loan;
(ii)Interest is payable at 5% for the rst 3 years of the loan and then increases to 7% for the
remaining 2 years of the loan;
(iii)The full balance of 100,000 is repaid at the end of year 5.
Required:
(a)What interest should be recognised in the statement of comprehensive income for each year
of the loan?
(b)If Isabelle Limited repaid the loan after 3 years for 100,000 what gain or loss would be recog-
nised in the statement of comprehensive income?
Question 7
A company borrows on a oating rate loan, but wishes to hedge against interest variations so swaps
the interest for xed rate. The swap should be perfectly effective and has zero fair value at inception.

000FinancialIAS CategoryMeasurement
investments
900
13,400
held for future sale1,200
3,250
Current liabilities
Trade creditors(3,500)
Lease creditor
(800)
Income tax
(1,000)
Forward contracts
(note 1)
(500)
(5,800)
Non-current liabilities
Bank loan
(5,000)
Convertible debt(1,800)
Deferred tax
(500)
Pension liability
(900)
(8,200)
Note
Required:
13.1Introduction
position and performance.
344

Actuarial gains and losses arise mainly from changes in actuarial assumptions
5%£135,000
13.6DeÞned beneÞt pension schemes
13.6.1Position before 1998
348

YearContributionStatement of comprehensive Statement of nancial
income charge
position liability

2008
Nil
7,000
7,000
2009
Nil
7,000
14,000
2010
Nil
7,000
21,000
201110,000
7,000
18,000
201210,000
7,000
15,000
201310,000
7,000
12,000
201410,000
7,000
9,000
201510,000
7,000
6,000
201610,000
7,000
3,000
201710,000
7,000

70,000
The statement of comprehensive income charge is the total contributions paid over the period
(70,000) divided by the average remaining service lives of ten years. The effect of this is to
spread the surplus over the remaining service lives in the statement of comprehensive income.
13.6.2Problems of the old standard
The old IAS 19 had a number of problems in its approach which needed to be addressed by
the revised standard.
A misleading statement of nancial position
Making the statement of nancial position accrual or prepayment a balancing gure based
on the comparison of the amount paid and charged to date could be very misleading. In the
above illustration it can be seen that the statement of nancial position shows a liability even
though there is a surplus on the fund. A user of the nancial statements who was unaware
¥
349
income recording the change in the statement of Þnancial position. Accounting for pension
The old IAS 19 was also inconsistent with the way that US GAAP would require pensions
to be accounted for, although in its defence it was consistent with the approach adopted by
Valuation basis
350

Year
12345
Benet attributed to prior years
0131262393524
Benet attributed to current year
(1% of nal salary)*
131131131131131
Benet attributed to current and
prior years
131262393524655
Opening obligation (present value
of benet attributed to prior years)89196324476
Interest at 10%
9203348
Current service cost (present value
of benet attributed to current year)8998108119131
Closing obligation (present value
of benet attributed to current and
prior years)**
89196324476655
* Final salary is 10,000

(1.07)
4
=
13,100.
**Discounting the benet attributable to current and prior years at 10%.
13.8.2Actuarial gains and losses
Actuarial gains or losses result from changes either in the present value of the dened bene-
and requires gains and losses to be recognised in other comprehensive income.
10% corridor approach
provision for pensions for the rst ve years of employment (and past service costs could
arise in this period), as these will be pensionable service years provided the employees work
for more than ve years.
IAS 12 Deferred taxation
(4)
13.10Comprehensive illustration
20X120X220X3
10%9%8%
20X120X220X3
1,0001,1001,380
10099110
160140150
Ñ50Ñ
(150)(180)(190)
(10)1715
1,1001,3801,455
354

20X120X220X3
Contributions
90100110
Benets paid
(150)(180)(190)
(balancing gure)
130131(241)
Step 3The 10% corridor calculation
20X120X220X3
Limit of 10% corridor at 1 January
100119138
Cumulative unrecognised gains (losses)
1 January
14098
Gains (losses) on the obligation
10(171)(5)
Cumulative gains (losses) before amortisation
140100(148)
Amortisation of excess over ten years
(see working)
(2)
Cumulative unrecognised gains (losses)
31 December
14098(148)
Working:
=
2

amortisation charge in 20X2.
(140

119)
10 yrs
Step 4Calculate the proÞt or loss entry
20X120X220X3
160140150
10099110
(2)
50
140156123
Step 5Calculate the statement of Þnancial position entry
20X120X220X3
1,1001,3801,455
14098(148)
50106119
An enterprise should account for a multi-employer dened benet plan as follows:

It is common practice for leave entitlement to be an accumulating absence (perhaps
restricted to a certain number of days) but for sick pay entitlement to be non-accumulating.
Prot-sharing and bonus plans
The expected cost of a prot-sharing or bonus plan should only be recognised when:
(a)
the enterprise has a present legal or constructive obligation to make such payments as a
result of past events; and
(b)
a reliable estimate of the obligation can be made.
13.16Termination benets
8
These benets are treated separately from other employee benets in IAS 19 (revised)
because the event that gives rise to the obligation to pay is the termination of employment
as opposed to the service of the employee.
The accounting treatment for termination benets is consistent with the requirements of
IAS 37 and the rules concern when the obligation should be provided for and the measure-
ment of the obligation.
Recognition
Termination benets can only be recognised as a liability when the enterprise is demon-
strably committed to either:
(a)
terminate the employment of an employee or group of employees before the normal
13.17IFRS 2
13.17.1Should an expense be recognised?
13.18Scope of IFRS 2
IFRS 2 proposes a comprehensive standard that would cover all aspects of share-based
payments. Specically IFRS 2 covers:

The IASB went for the grant date as it felt that the grant of options was the reward to
the employees and not the exercise of the options. This means that after the grant date any
362

Less: recognised to date
(427)
352
£000£000
(779)
467
Re-priced options
If an entity re-prices its options, for instance in the event of a falling share price, the incre-
mental fair value should be spread over the remaining vesting period. The incremental fair
The accounting treatment is dependent upon which counterparty has the choice of
¥
365
obligations it has to pay pensions. The standard mainly contains the presentation and
disclosure
Report format
IAS 26 proposes three different report formats that will full the content requirements
¥
367
368

REVIEW QUESTIONS
1
Provisions for pensions and similar obligations comprise both the provision obligations of the
trend of 3.5% (previous year: 2.5%) for the growth in pensions, and a discount rate of 6.0%
31 Mar 98 31 Mar 99
Provisions for pensions and similar obligations
395,365426,829
18,225 thousand (previous year:
Interest expense for claims already acquired
21,58322,855
14,84819,407
53,33359,346
* The expense for the pension plan included under personnel expenses totals 36,491 thousand
(previous year: 31,750 thousand).
We include interest expenses for already acquired pension claims under interest and similar
370

EXERCISES
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
Question 1
Kathryn
Discount rate at start of year
No directors were expected to leave the company but, surprisingly, on 30 November 20X9 a
director with 30,000 options did leave the company and therefore forfeited his options. At the
31 December 20X7 and 20X8 year-ends C plc estimated that they would achieve the prot
Present value of obligation at start of 2008 ($000)
20,000
(a)Calculate the present value of the deÞned beneÞt plan obligation as at the start and end of 2008
obtained it on a very tight proÞt margin. Liquidity was a problem and there was no prospect of
offering staff a cash bonus. Instead, the company granted its 80 production employees share options
for 1,000 shares each at £10 per share. There was a condition that they would only vest if they still
remained in employment at 31 December 20X2. The options were then exercisable during the year
ended 31 December 20X3. Each option had an estimated fair value of £6.5 at the grant date.
The share price had increased from £9 on 1 January 20X1 to £9.90.
References
1IAS 19
Employee Benets
, IASB, amended 2002.
2IAS 26
14.1Introduction
14.2Corporation tax
The reason for the need to adjust accounting prots for tax purposes is that although the
tax payable is based on the accounting prots as disclosed in the prot and loss account, the
tax rules may differ from the accounting rules which apply prudence to income recognition.
For example, the tax rules may not accept that all the expenses which are recognised by the
accountant under the IASBs
Framework for the Preparation and Presentation of Financial
Statements
and the IAS 1
Presentation of Financial Statements
accrual concept are deductible
when arriving at the taxable prot. An example of this might be a bonus, payable to an
employee (based on prots), which is payable in arrear but which is deducted from account-
ing prot as an accrual under IAS 1. This expense is only allowed in calculating taxable
prot on a cash basis when it is paid in order to ensure that one taxpayer does not reduce his
potential tax liability before another becomes liable to tax on the income received.
The accounting prot may therefore be lower or higher than the taxable prot. For
example, the Companies Acts require that the formation expenses of a company, which
are the costs of establishing it on incorporation, must be written off in its rst account-
ing period; the rules of corporation tax, however, state that these are a capital expense
and cannot be deducted from the prot for tax purposes. This means that more tax will be
assessed as payable than one would assume from an inspection of the published prot and
loss account.
Similarly, although most businesses would consider that entertaining customers and other
business associates was a normal commercial trading expense, it is not allowed as a deduc-
tion for tax purposes.
A more complicated situation arises in the case of depreciation. Because the directors
double taxation is inequitable when compared to the taxation system on unincorporated
that the more prosperous tend to pay a greater proportion of their income in order to fund
the needs of the poorer; this is called a progressive system. As Franklin Roosevelt, the
American politician, stated, taxes, after all, are the dues that we pay for the privileges
example might be increased tax depreciation (capital allowances) on capital investment, in
order to increase industrial investment and improve productivity within the UK economy.
The use of such provisions, as intended by the legislators, is not criticised by anyone,
reached with the Justice Department requires permanent restrictions on KPMG tax
¥
379
14.5Corporation tax the system from 6 April 1999
A company pays corporation tax on its income. When that company pays a dividend to

Dividend being the cash paid by the company and
disclosed in the companys prot and loss account
400.00
Imputed tax credit of 1/9 of dividend paid
(being the rate from 6 April 1999)
44.44
Gross dividend
444.44
The imputed tax credit calculation (as shown above) has been based on a basic tax rate of
10% for dividends paid, being the basic rate of income tax on dividend income from 6 April
1999. This means that an individual shareholder who only pays basic rate income tax has
no further liability in that the assumption is that the basic rate tax has been paid by the
company. A non-taxpayer cannot obtain a repayment of tax.
Although a company pays corporation tax on its income, when that company pays a
dividend to its shareholders it is still considered to be distributing some of its taxed income
14.5.1Advance corporation tax Ð the system until 5 April 1999
to do this. Consequently two different standards will be acceptable for some years. The

Health care benets
2,0001,000
17,02518,590
Deduct
Depreciation for tax purposes
(8,100)(11,850)
Taxable prot
8,9256,740
Current tax expense at 40%
3,570
Current tax expense at 35%
2,359
IAS 12 and FRS 16
IAS 12 is similar to FRS 16
Current Tax
, which UK non-quoted companies that choose not
to follow international standards can choose to adopt.
There are very few rules for calculating current tax in UK GAAP, although in practice
the calculation will be largely similar to that under IAS 12. FRS 16 does not go into the
until actually paid some considerable time later, thus giving tax relief in a later period.
Temporary differences
The original IAS 12 allowed an enterprise to account for deferred tax using the statement
calculating the tax effect ignores the effect of changing tax rates on the timing differences
that arose in earlier periods. This means that the total provision may consist of differences
calculated at the rate of tax in force in the year when the entry was made to the provision.
in 1999 to recalculate the tax effect of the timing difference that was provided for in earlier
The effect on the charge to the 2000 proÞt statement (Figures 14.2 and 14.3) is that
2,0002,0002,0002,0002,000
Depreciation for tax purposes2,5002,5002,5002,5000
(500)(500)(500)(500)2,000
Current tax expense (income) at 40%(200)(200)(200)(200)800
8,0006,0004,0002,0000
7,5005,0002,50000
5001,0001,5002,0000
0200400600800
200200200200(800)
2004006008000
Figure 14.5Deferred tax liability
Year
12345
Income ()
2,0002,0002,0002,0002,000
Depreciation
2,0002,0002,0002,0002,000
Prot before tax
00000
Current tax expense (income)
(200)(200)(200)(200)800
Deferred tax expense (income)
200200200200(800)
Total tax expense (income)
00000
Business
Combinations
average of possible outcomes of tax in dispute. Apart from the difculty in assessing
such probabilities, company directors may well prove averse to accounting for their opinions
proving to be incorrect.
The proposals proved contentious. At one extreme was the argument that at a time when
there are many other issues to deal with relating to the nancial crisis, it was not the right
time to pursue this project. Amongst the proponents of this point was the CIMA (the
Chartered Institute of Management Accountants). Although it might seem improper to take
such a pragmatic (and indeed political) approach, it must be remembered that in order for
changes in policy to be accepted generally the view of company management must accept
the logic and mechanism of proposed changes.
payment; indeed he expressed his exasperation with the topic in stating that Ôhe wished
receipts and payments, and the treatment of tax should be considered in the same way. This
view has received support from others,
28
who have held that tax attaches to taxable income
and not to the reported accounting income and that there is no legal requirement for the tax
to bear any relationship to the reported accounting income. Indeed it has been argued that
deferred tax means income smoothing.
29
Before discussing the arguments it is appropriate to consider the economic reality of
deferred taxation.
Those industries which are capital-intensive tend to have beneted from tax deferral by
way of accelerated tax depreciation on plant investment, and it could be suggested that their
accounts do not truly reect the economic reality without provision for deferred taxation.
Studies in the UK certainly support this view.
In the UK it has not been the practice to make full provision for deferred taxation.
Full provision refers to the fact that
the potential liability to deferred taxation has
not been reduced
to allow for the view of management that the entire liability will not
be paid in the future as a result of timing differences because the taxation benets of
future capital investments will result in a further deferral of taxation liability. In the UK,
the deferred taxation liability has been reduced to allow for the effects of these anticipated
future investments.
Terry Smith points out in Table 17.2 of his
Accounting for Growth
30
that according to
the companies own gures their estimated EPS would fall as follows if full provision for
deferred tax were made:
British Airways36.4%
Severn Trent25.3%
British Gas20.5% (based on CCA earnings of 15.1p per share adjusted to exclude
restructuring costs)
TI Group13.8%
In his Table 17.3 he lists companies which expected an EPS fall of over 10% and with
more than 10% of shareholders funds in unprovided deferred tax:
Estimated impact on historic gearing of full provision
From
To
%%
British Airways
148
214
BP
67
78
British Gas
56
68
He points out in his Table 17.4 that ve of the companies he lists without any exposure to
an increase in deferred tax charge are some of the UKs most successful and conservatively
nanced large companies.
Tax rate (%)
General Electric
32
Marks & Spencer
32
Reuters
32
GUS
33
Wolseley
33
394

oppose deferred tax accounting, for it would lower their company stock valuation, whereas
¥
397
Figure 14.6(
398

IAS 18 (para. 8) makes clear that the same principles are followed:
Revenue includes only the gross inows of economic benets received and receivable
by the enterprise on its own account. Amounts collected on behalf of third parties such
as sales taxes, goods and services taxes and value added taxes are not economic benets
which ow to the enterprise and do not result in increases in equity. Therefore, they
are excluded from revenue.
39
14.12.1The effects of the standard
The effects of the standard vary depending on the status of the accounting entity under the
VAT legislation. The term trader appears in the legislation and is the terminology for a
business entity. The traders or companies, as we would normally refer to them, are classied
under the following headings:
(a)Registered trader
Why does the charge to taxation in a companyÕs accounts not equal the proÞt multiplied by the
current rate of corporation tax?
Explain clearly how advance corporation tax arose and its effect on the proÞt and loss account
and the year-end statement of Þnancial position Þgures. (Use a simple example to illustrate.)
Explain how the corporation tax system changed as from April 1999.
Deferred tax accounting may be seen as an income-smoothing device which distorts the true and
fair view. Explain the impact of deferred tax on reported income and justify its continued use.
Explain how dividends received and paid are shown in the accounts.
remove the possibility for the discounting of deferred tax on the adoption of the full
6
EXERCISES
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
Question 1
In your capacity as chief assistant to the nancial controller, your managing director has asked you to
Discuss the arguments for and against discounting the deferred tax charge.
Austin Mitchell MP proposed an Early Day Motion in the House of Commons on 17 May 2005 as follows:
That this House urges the Government to clamp down on artiÞcial tax avoidance schemes and end
the ... tax avoidance loop-holes that enable millionaires and numerous companies trading in the
UK to avoid UK taxes; and further urges the Government to ... so that transactions lacking normal
commercial substance and solely entered into for the purpose of tax avoidance are ignored for tax
purposes, thereby providing certainty, fairness and clarity, which the UKÕs taxation system requires
to prevent abusive tax avoidance, to protect the interests of ordinary citizens who are committed
Question 7
The following information is given in respect of Unambitious plc:
Year ended 30 JuneDepreciation charge for yearCapital allowances for year

2011
12,000
53,000
2012
14,000
49,000
2013
20,000
36,000
2014
40,000
32,000
2015
44,000
32,000
2016
46,000
36,000
For the following years, capital allowances are likely to continue to be in excess of depreciation
for the foreseeable future.
(d)Corporation tax is to be taken at 21%.
Required:
Calculate the deferred tax charges or credits for the next six years, commencing with the year
ended 30 June 2011, in accordance with the provisions of IAS 12.
References
1OECD,
15.1Introduction
Objectives
By the end of this chapter, you should be able to:

14R. Altshul, ÔAct nowÕ,
15William Gale, ÔWhat can America Learn from the British Tax System?Õ,
16Section 836A
17Sections 50 to 54, under the heading of Accounting Practice, and Schedule 10 (Amendment of
18Schedule 23 to Finance Act 2003.
19IAS 12
20SFAS 109,
21IAS 12
22IAS 12
23P. RosenÞeld and W.C. Dent, ÔDeferred income taxesÕ in R. Bloom and P.T. Elgers (eds),
24Andrew C. Lennard during a guest lecture at Sunderland Business School.
406

15.5What is depreciation?
IAS 16 denes depreciation
6
as the systematic allocation of the depreciable amount of an
Reviews are made annually of the estimated remaining lives of individual productive
Mineral and surface rights
Mineral and surface rights are recorded at cost of acquisition. When there is little
likelihood of a mineral right being exploited, or the value of mineral rights have
diminished below cost, a write-down is effected against income in the period that
15.6What are the constituents in the depreciation formula?
Š
£200
2
Š
£200
4
Š
Estimated residual value
Estimated economic life
¥
411
(no signicant change anticipated over useful economic life)1,000
Depreciable amount
10,000
How should the depreciable amount be charged to the statement of comprehensive income
over the ve years? IAS 16 tells us that it should be allocated on a systematic basis and the
income, but with a dramatically different pattern of statement of comprehensive income
charges. The charge for straight-line depreciation in the Þrst year is less than half that for
414

assuming a rate of interest of 10% would show:
YearAnnuity
11.1000
20.5762
30.4021
40.3155
50.2638

It is the most straightforward to compute.

In the light of the three additional subjective factors [cost (or revalued amount); residual
value; useful life] that need to be estimated, any imperfections in the charge for depreci-
15.10.2The revaluation model
international accounting standards: Items of PPE are stated at historical cost modied by
smallest group is referred to as a cash generating unit (CGU).
15.11.3Indications of impairment

Internal indicators:

material changes in operations;

major reorganisation;

loss of key personnel;

These are discounted using an appropriate long-term pre-tax interest rate. When an
30,000
The unit is reviewed for impairment due to the existence of indicators and the recoverable
¥
421
422

Goodwill
70,000(70,000)
Nil
PPE
100,000(24,000)76,000
Inventory
40,000
Nil
40,000
Receivables
30,000
Nil
30,000
250,000(100,000)150,000
Notes to table:
1
The impairment loss is rst allocated against goodwill. After this has been done 30,000
(100,000

70,000) remains to be allocated.
2
No impairment loss can be allocated to the property, inventory or receivables because
Head ofce overheads apportioned
(0.25)
Cash inow per model
5.00
20X320X420X520X6
6,0008,00011,00014,000
Revised estimate at 31 December 20X3Ñ8,00011,0004,000
10%10%10%
20X41/1.1
20X51/(1.1)
20X61/(1.1)
15.11.7Illustrating calculation of value in use
8,00011,0004,000
£5£5£5
40,00055,00020,000
5,000
40,00055,00025,000
0.9090.8260.751
36,36045,43018,775
15.12IFRS 5

Transfers

25.8(25.8)
End of year38.386.5642.328.9796.0
Disposals
(10.6)(10.6)
End of year
8.347.3394.2

449.8
Beginning of year31.940.0241.229.9343.0
End of year30.039.2248.128.9346.2
Additionally the nancial statements should disclose:

the existence and amounts of restrictions on title, and PPE pledged as security for liabilities;

the accounting policy for the estimated costs of restoring the site of items of PPE;

the amount of expenditures on account of PPE in the course of construction;

the amount of commitments for the acquisition of PPE.
15.14Government grants towards the cost of PPE
The accounting treatment of government grants is covered by IAS 20. The basis of the
standard is the accruals concept, which requires the matching of cost and revenue so as to
recognise both in the statements of comprehensive income of the periods to which they
Property, plant and equipment (PPE)

425
Openmirrors.com
relate. This should, of course, be tempered with the prudence concept, which requires that
revenue is not anticipated. Therefore, in the light of the complex conditions usually attached
to grants, credit should not be taken until receipt is assured.
Similarly, there may be a right to recover the grant wholly or partially in the event of a
breach of conditions, and on that basis these conditions should be regularly reviewed and, if
necessary, provision made.
Should the tax treatment of a grant differ from the accounting treatment, then the effect
of this would be accounted for in accordance with IAS 12
Income Taxes
.
IAS 20
Government grants should be recognised in the statement of comprehensive income so as to
Among the reasons for the Board amending IAS 20 were the following:
Grant income
Capital grants are shown in other creditors within the statement of Þnancial position
Accounting models
Under IAS 40, an entity must choose either:

a fair value model: investment property should be measured at fair value and changes in
fair value should be recognised in the statement of comprehensive income; or

a cost model (the same as the benchmark treatment in IAS 16
Property, Plant and Equipment
):
investment property should be measured at depreciated cost (less any accumulated impair-
ment losses). An entity that chooses the cost model should disclose the fair value of its
investment property.
An entity should apply the model chosen to all its investment property. A change from one
model to the other model should be made only if the change will result in a more appropriate
presentation. The standard states that this is highly unlikely to be the case for a change from
the fair value model to the cost model.
In exceptional cases, there is clear evidence when an entity that has chosen the fair value
model rst acquires an investment property (or when an existing property rst becomes
reserves when comparing the gearing or leverage of companies.
The problem is compounded because the carrying value may be amended at random
430

REVIEW QUESTIONS
1
Dene PPE and explain how materiality affects the concept of PPE.
2
Summary
Before IAS 16 there were signicant problems in relation to the accounting treatment
¥
431
4
DeÞne ÔcostÕ in connection with PPE.
5
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-elliott)
for exercises marked with an asterisk (*).
(a)Discuss why IAS 40
Investment Property
was produced.
(b)Universal Entrepreneurs plc has the following items on its PPE list:
(i)£1,000,000 Ð the right to extract sandstone from a particular quarry. Geologists predict that
extraction at the present rate may be continued for ten years.
432

(B)Accumulated depreciation
(16,000)(28,800)(28,080)?
The only other information available is that disposals have taken place at the beginning of the nancial
years concerned:
Date of
OriginalSales
DisposalOriginal acquisitioncostproceeds
12 months ended 31 March

First disposal
20X8
20X6
15,0008,000
Second disposal
20X8
20X6
30,00021,000
Plant sold was replaced on the same day by new plant. The cost of the plant which replaced the rst
disposal is not known but the replacement for the second disposal is known to have cost 50,000.
Required:

Cost as per suppliers list
12,000
Less
: Agreed discount
1,00011,000
Delivery charge
100
Erection charge
200
Maintenance charge
300
Additional component to increase capacity
400
Replacement parts
250
Required:
(a)State and justify the cost gure which should be used as the basis for depreciation.
(b)What does depreciation do, and why is it necessary?
(c)Briey explain, without numerical illustration, how the straight-line and diminishing balance
(d)Explain the term ÔobjectivityÕ as used by accountants. To what extent is depreciation objective?
during its Þve-year life. He has produced the following table and suggested to the Þnance director that
the annual average cost should be used in the Þnancial accounts to represent the depreciation charge
in the proÞt and loss account.
Table prepared to calculate the annual average cost
Years of life
Purchase price
20,00020,00020,00020,00020,000
Maintenance/repairs
Year2
1,0001,0001,0001,000
1,5001,5001,500
1,8501,850
20,00021,00022,50024,35026,350
11,50010,0008,0105,350350
Annual average cost
8,5005,5004,8304,7505,200
434

¥
435
Trade payables
436

The Blissopia Leisure Group consists of three divisions: Blissopia 1, which operates mainstream bars;
Blissopia 2, which operates large restaurants; and Blissopia 3, which operates one hotel Ð the Eden.
Divisions 1 and 2 have been trading very successfully and there are no indications of any potential
impairment. It is a different matter with the Eden however. The Eden is a ÔboutiqueÕ hotel and was
0.10
0.09
Trade receivables
Trade payables
The following facts were discovered following an impairment review as at 31 October 2007:
(i)During August 2007, a rival hotel commenced trading in the same location as the Eden. The
Blissopia Leisure Group expects hotel revenues to be signiÞcantly affected and has calculated the
Question 9
Cryptic plc extracted its trial balance on 30 June 20X5 as follows:
000000
Land and buildings at cost
750

Plant and machinery at cost
480

Accumulated depreciation on plant and machinery at 30 Jun 20X5
400
Depreciation on plant and machinery
80

Furniture, tools and equipment at cost
380

Ordinary shares of 50p each
1,000
12% Preference shares of 1 each (IAS 32 liability)
200
Cash and bank balance
29

5,6005,600
The following information is relevant:
(i)The company discontinued a major activity during the year and replaced it with another. All non-
(ii)On 1 January 20X5 the company acquired new land and buildings for £150,000. The remainder
of land and buildings, acquired nine years earlier, have NOT been depreciated until this year.
References
1IAS 16
Property, Plant and Equipment
, IASB, revised 2004, para. 6.
2
Ibid
., para. 16.
3
Ibid
., para. 22.
4IAS 23
Borrowing Costs
, IASB, revised 2007, para. 8.
5IAS 16
Property, Plant and Equipment
, IASB, revised 2004, para. 18.
6
Ibid
., para. 6.
7
Ibid
., para. 6.
8IAS 36
16.1Introduction
16.2Background to leasing
16.2.1What is a lease?
442

16.5Accounting requirements for operating leases
446

(1.1)
1.1
¥
447
448

(Right toDepreciation5,5005,5005,500
(Right toDepreciation5,00011,00016,500
1,500
Finance charge
Allocated using sum of digits:
Year 1
=
2/(1
+
2)

1,500
=
(1,000)
Year 2
=
1/(1
+
2)

1,500
=
(500)
Note that the allocation is only over two periods because the instalments are being made
in advance. If the instalments were being made in arrears, the liability would continue over
three years and the allocation would be over three years.
Step 6
Reduce the obligation in the statement of nancial position:
Statement of nancial
position (extract) as at31 Dec 20X131 Dec 20X231 Dec 20X3
LiabilityOpening value16,50011,5006,000
(ObligationLease payment6,0006,0006,000
under nance
10,5005,500

lease)Finance charge1,000
500

Closing value11,5006,000

31 Dec 20X131 Dec 20X231 Dec 20X3
5,500
5,500
5,500
1,000
500
Ñ
6,500
6,000
5,500
450

Lease commitments
The following charges arise from these commitments:
Operating leases
Lease commitments refer mainly to buildings, industrial equipment, vehicles and IT
2008
2007
Within one year
609
559
In the second year
487
425
In the third to Þfth year inclusive
918
859
524
571
2,414
Finance leases
PresentFuturePresentFuture
valuevaluevaluevalue
6567
7888
5464
100120
101139
146208
74181
122264
294451
446680
Classifying the building segment of the lease
The building segment of the lease is different. The residual value has fallen to $50,000
which has a present value of $19,275 (50,000

0.3855). This means that 96% of the
benet has been transferred (500,000

19,275) and the building segment is, therefore, a
nance lease.
How to apportion the lease payment in the statement of comprehensive
income
The payment should be split at the commencement of the lease according to the fair value
of the components covered by the lease. In the case of the land, the present value of the land
is $500,000 of which $258,285 (670,000

0.3855) represents the present value of the land
at the end of the contract so the balance of $241,715 represents the present value of the
operating lease. Similarly the amount covered by the nance lease is $480,725. Splitting
the lease payment of $106,886 in those proportions (241,715:480,725) gives $35,763 for the
land component and $71,123 for the nance lease representing the buildings leased.
How to report in the statement of nancial position
RATIOANALYSISOFBUYVERSUSLEASEDECISION
40,00044,00044,000
200,000200,000200,000
100,000200,000100,000
300,000400,000300,000
0.5:11:10.5:1
13.33%11%14.66%
16.10Accounting for leases Ð a new approach
454

16.11Accounting for leases by lessors
110,727
58,000
5,273
58,000
174,00015,339
16.11.2Operating leases
Summary
The initial upturn in leasing activity in the 1970s was attributable to the economy and
tax requirements rather than the popularity of lease transactions
per se
. High interest
rates, a high ination rate, 100% rst year tax allowances and a sequence of annual
losses in the manufacturing industry made leasing transactions extremely attractive to
both the lessors and the lessees.
REVIEW QUESTIONS
1
Can the legal position on leases be ignored now that substance over form is used for nancial
reporting? Discuss.
2
(a)Consider the importance of the categorisation of lease transactions into operating lease or
nance lease decisions when carrying out nancial ratio analysis. What ratios might be affected
if a nance lease is structured to t the operating lease classication?
(b)Discuss the effects of renegotiating/reclassifying all operating leases into nance leases. For
which industries might this classication have a signicant impact on the nancial ratios?
3
State the factors that indicate that a lease is a nance lease under IAS 17.
4

EXERCISES
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-elliott)
for exercises marked with an asterisk (*).
*Question 1
458

(a)Calculate and state the charges to the statement of comprehensive income for 20X6 and 20X7
if the leases were treated as operating leases.
(b)Calculate and state the charges to the statement of comprehensive income for 20X6 and 20X7
Question 7
Construction First provides nance and nancial solutions to companies in the construction industry.
On 1 January 2007 the company agreed to nance the lease of equipment costing $145,080 to Bodge
Brothers over its useful life of ve years at an annual rental of $39,000 payable annually in arrears. The
interest rate associated with this transaction is 10% and Construction First incurred direct costs of
17.1Introduction
deÞne and explain how to account for research and development (R&D),
17.3.1Research dened
IAS 38 states
2
expenditure on research shall be recognised as an expense when it is
2
the search for, evaluation and nal selection of, applications of research ndings or other
knowledge;
3
the search for alternatives for materials, devices, products, processes, systems and services;
4
the formulation, design, evaluation and nal selection of possible alternatives for new or
improved materials, devices, products, processes, systems or services.
Normally, research expenditure is not related directly to any of the companys products or
processes. For instance, development of a high temperature material, which can be used in
any aero engine, would be research, but development of a honeycomb for a particular
engine would be development. Whilst it is in the research phase, the IAS position
4
is that
reasonable certainty that the intended economic beneÞts will be achieved. Because of this
uncertainty, the accounting profession has traditionally considered it more prudent to write
(e)
17.6.3ProÞt measurement Ð estimating future sales
Accounting for Goodwill
was issued in 1984. This
allowed entities two alternative treatments:
1
write off the goodwill directly to reserves in the year of acquisition (option b); or
2
amortise the goodwill to the statement of comprehensive income over its expected life
(option c).
Almost all UK companies used treatment 1 above, as it had no effect on reported proÞt in
MmmM
Ñ121.4
(85.8)Ñ
(1.2)(87.0)
(1.2)34.4
Ñ0.3
(9.8)Ñ
(0.2)(10.0)
Administrative expenses(18.7)Ñ
(0.3)(19.0)
Other operating expenses(1.2)(6.7)(0.5)(8.4)
6.2(6.7)(2.2)(2.7)
and bad debt provisions.
(d) An annual impairment check
IFRS 3
has introduced a new treatment for purchased goodwill when
it arises from a business combination (i.e. the purchase of a company which becomes a sub-
sidiary). It assumes that goodwill has an indeÞnite economic life which means that it is not
This is called a Ôstatement of Þnancial position approachÕ to accounting, as the charge is
only made when the value (in the statement of Þnancial position) falls below its original cost.
The IFRS 3 treatment is consistent with the Framework,
recognised in the statement of comprehensive income when a decrease in future economic
Convergence pressure
In issuing recent International Standards, the IASB has not only aimed to produce world-
17.12.2Meaning of cost
Computer software
109
assess managementÕs stewardship of brands. If this cannot be reported on the face of the
statement of Þnancial position then there is an argument for having an additional statement
17.14.6Effect on management decisions
It is claimed that including brands on the statement of nancial position leads to more
informed and improved management decision making. The quality of internal decisions is
related to the quality of information available to management.
25
As brands represent one of
The three possible situations are:
1If the company receives the certicates free from the government, their value in the
nancial statements should be zero. It would be unreasonable to put a value on them in
the companys nancial statement (e.g. number of tonnes of CO
2

CO
2
emissions value
per tonne). This would be boosting the statement of nancial position.
2
If the company is trading in the certicates, they are nancial instruments under IAS 39
Financial Instruments: Recognition and Measurement
. They can be valued at cost, with
impairment if their value becomes less than cost. However, it is probably more appro-
prepayment. The company buys the certiÞcates (like buying insurance for the future) and
like a prepayment than the other items considered.
This discussion is Ôa viewÕ based on various arguments. It is not a deÞnitive answer. You
could consider these and other arguments and come to a different conclusion. It will be
Although the scheme has been in operation for over three years, there is no standard
treatment. An example of one companyÕs accounting policy is seen in the following extract
Accounting policy
of science and technology and enriching the world of arts. Through its work, WIPO plays
an important part in enhancing the quality and enjoyment of life as well as creating real
wealth for nations. With headquarters in Geneva, Switzerland, WIPO is one of the sixteen
specialised agencies of the United Nations system of organisations. It administers twenty-
one international treaties dealing with different aspects of intellectual property protection.
The organisation counts 175 nations as member states. Its importance is recognised in the
knowledge workers, often from different disciplines, can collaborate to create new know-
Traditionally, accounting reports have been prepared on the basis of historical cost. This
does not provide for the identication and measurement of intangibles in organisations
especially knowledge-based organisations. The limitations of the existing nancial reporting
systems have resulted in a move towards nding new ways to measure and report on a
companys intellectual capital.
Guthrie, while arguing
37
that accountants must nd a way to incorporate accurate measures
and values of intellectual capital in formal company reports or they will become irrelevant,
suggests that the importance of intellectual capital is specically emphasised in:

100 companies on acquisitions, and over half of this (53%) was allocated to goodwill. This
3Aviva:
In March 2005, Aviva bought the RAC for 1.1 billion. The RAC has 7 million
customers and is one of the most trusted brands in the UK. The brand and customer
relationships should most likely have accounted for the majority of the acquisition
price whereas they were reported as being worth only 260 million and 132 million
respectively, 35% of the total cost. Goodwill dominates and is unexplained.
4Kingsher:
In June 2005 Kingsher bought OBI, a chain of 13 DIY superstores in
China, for its B&Q brand for 144 million, placing no value whatsoever on its brand or
customer relationships.
17.18.3Elements within goodwill but still difcult to value separately
Some of the reasons for this inadequate reporting have already been discussed. But how
Summary
As business has become more complex and industrial processes more sophisticated,
Brands
479
425
4,846
2,385
1,866
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-elliott)
for exercises marked with an asterisk (*).
Environmental Engineering plc is engaged in the development of an environmentally friendly personal
transport vehicle. This will run on an electric motor powered by solar cells, supplemented by
passenger effort in the form of pedal assistance.
At the end of the current accounting period, the following costs have been attributed to the project:
(a)A grant of £500,000 to the Polytechnic of the South Coast Faculty of Solar Engineering to
encourage research.
(b)Costs of £1,200,000 expended on the development of the necessary solar cells prior to the
decision to incorporate them in a vehicle.
(c)Costs of £5,000,000 expended on designing the vehicle and its motors, and the planned
Costs to date (pure research 25%, applied research 75%)
Costs to develop product (to be incurred in the year to 30 September 20X1)
Expected future sales per annum for 20X2Ð20X7
Required:
Prepare a report for the board outlining the principles involved in accounting for research and
development and showing what accounting entries will be made in the companys accounts for each
of the years ending 30 September 20X120X7 inclusive.
Indicate what factors need to be taken into account when assessing each research and develop-
ment project for accounting purposes, and what disclosure is needed for research and development
in the companys published accounts.
*Question 3
Oxlag plc, a manufacturer of pharmaceutical products, has the following research and development
projects on hand at 31 January 20X2:
(A)A general survey into the long-term effects of its sleeping pill Chalcedon upon human resistance
to infections. At the year-end the research is still at a basic stage and no worthwhile results with
any particular applications have been obtained.
The following costs have been brought forward at 1 February 20X1:
ProjectABCD
000
Specialised laboratory
Cost
500
Depreciation
25
Specialised equipment
Cost
7550
Depreciation
1510
Capitalised development costs
200
8,800
Current liabilities
Provision for liabilities and charges
Capital reserves
Called-up share capital
(ordinary shares of £1)
Share premium account
Additional information relating to the above statement of nancial position
In short, the conclusion was that Ôthe present ßexible position, far from being neutral, is potentially
economic life that is expected to be indeÞnite. The value of the brand name is not included in
the statement of nancial position of Kappa as the directors of Kappa do not consider that it
Accumulated depreciation
118,000
122,000
The accumulated depreciation gure is made up as follows:
$
Impairment recognised during the year ended 31 October 2006
18,000
118,000
430
Current liabilities
Non-current liabilities
Issued share capital
6,955
Grimsel has been a very successful company in its time. However, a series of losses due to a
included in current and non-current liabilities have left its shareholders keen to sell.
Brenner, another limited liability company, operates in the same line of business as Grimsel.
Brenner has been very successful and sees an opportunity to acquire Grimsel at a bargain price.
Brenner has successfully concluded negotiations with Grimsel and has agreed a price of $2,000,000
for all the issued share capital of Grimsel.
The following additional information is available:
Required:
Applying the rules in IFRS 3 calculate the amount of goodwill arising on the acquisition of Grimsel
by Brenner.
(e)Summarise the guidance in IFRS 3 when goodwill turns out to be a negative.
(
The Association of International Accountants
)
Question 9
Ross Neale is the divisional accountant for the Research and Development division of Critical
Pharmaceuticals PLC. He is discussing the third-quarter results with Tina Snedden who is the manager
of the division. The conversation focuses on the fact that whilst they have already fully committed the
1IAS 38
37J. Guthrie, Measuring up to change,
Financial Management
, December 2000, CIMA, London,
p. 11.
38J. Unerman, J. Guthrie and M. Striukova,
UK Reporting of Intellectual Capital
, ICAEW, 2007,
www.icaew.co.uk
18.1Introduction
498


Openmirrors.com
500

¥
501
Inventories
ßuctuations in the price of Arab Light which moved from $8.74 per barrel on 31 December
1998 to $24.55 per barrel on 31 December 1999 and down to $17.10 on 31 December 2001
Silver
Appropriate overhead
It is here that the major difculties arise in calculating the true cost of the product for
inventory valuation purposes. Normal practice is to classify overheads into ve types and
We will look at each of these in turn, to demonstrate the difculties that the accountant
experiences.
Direct overheads
. These should normally be included as part of cost. But imagine
a situation where some subcontract work has been carried out on
some
of a companys
products because of a capacity problem (i.e. the factory could normally do the work, but due
to a short-term problem some of the work has been subcontracted at a higher price/cost).
In theory, those items subject to the subcontract work should have a higher inventory value
than normal items. However, in practice, the difculty of identifying such subcontracted
items is so great that many companies do not include such non-routine subcontract work in
the inventory value as a direct overhead. For example, if a factory produces 1,000,000 drills
per month and 1,000 of them have to be sent out because of a machine breakdown, since all
the drills are identical it would be very costly and time-consuming to treat the 1,000 drills
differently from the other 999,000. Hence the subcontract work would
not
form part of
the overhead for inventory valuation purposes (in such an organisation, the standard cost
approach would be used when valuing inventory). On the other hand, in a customised car
rm producing twenty vehicles per month, special subcontract work would form part of the
inventory value because it is readily identiable to individual units of inventory.
To summarise, any regular, routine direct overhead will be included in the inventory
valuation, but a non-routine cost could present difculties, especially in a high-volume/
high-turnover organisation.
Indirect overheads
. These always form part of the inventory valuation, as such expenses
are incurred in support of production. They include factory rent and rates, factory power
and depreciation of plant and machinery; in fact, any indirect factory-related cost, including
An additional difÞculty concerns the modern inventory technique of Ôjust-in-timeÕ (JIT).
Here, the customer does not keep large inventories, but simply Ôcalls offÕ inventory from the
3,000

£200,000
£100,000
£106,000
¥
505
Inventory value based on planned or normal activity
Direct cost
3,000

2
6,000
Overhead
3,000

200,000
60,000
10,000
Closing inventory value
66,000
Comparing the value of inventory based upon actual activity with the value based upon
planned or normal activity, we have a 40,000 difference. This could be regarded as increas-
1No. 876
2No. 997
3No. 1822
4No. 2076
5No. 4732
(a)68,000(b)66,500
(c)58,000
18.6Work-in-progress

Where the item of WIP is complex or materially signicant, the actual time booked or
recorded will form part of the WIP valuation.

In a mass production situation, such precision may not be possible and an accounting
Overhead 22/DLH

120 hours2,640
WIP value of 821/C
5,220
This is an accurate WIP value provided
all
the costs have been accurately recorded and
charged. The amount of accounting work involved is not great as the information is required
by a normal job cost system. An added advantage is that the gure can be formally audited
and proven.

Appropriate overhead10.00
Total cost
18.00(for nished goods inventory value purposes)
The company accountant takes the view that for WIP purposes the following applies:
¥
509
Direct material
£2.00
100%
=
£2.00
Direct labour
£6.00
80%
=
£4.80
Appropriate overhead£10.00
£9.80
If the company has 100,000 drills in WIP, the value is:
100,000
×
£9.80
=
£980,000
This is a very simplistic view, but the principle can be adapted to cover more complex issues.
For instance, there could be 200 different types of drill, but the same calculation can be done
on each. Of course, sophisticated software makes the accountantÕs job mechanically easier.
arrangements are satisfactory. For example, in September 1987 Harris Queensway announced
an inventory reduction of some 15 million in projected prot caused by write-downs in
its furniture division. It blamed this on the inadequacy of control systems to identify ranges
that were selling and ensure their replacement. Interestingly, at the preceding AGM, no
hint of the overvaluation was given and the auditors insisted that the company had no
problem from the accounting point of view.
5
In many cases the auditor will be present at the inventory count. Even with this apparent
¥
511
Where inventory records are poorly maintained it has been possible for senior manage-
ment to fail to record material shrinkage due to loss and theft as in the matter of Rite Aid
In addition to suppressing purchase invoices, making Þctitious transfers, failing to write off
512

18.9.3Physical condition of inventory items
514

The following extracts are from the Precious Woods Groups 2005 Annual Report:
General Valuation Principles according to IAS 41
Other general costs incurred during the year
387,416
Carrying amount end of year
38,224,201
18.11.3An illustrative example
A farmer owned a dairy herd. At the start of the period the herd contained 100 animals that
were two years old and fty newly born calves. At the end of the period a further thirty
Due to birth of new calves: 30

$55
1,650
Total change
3,400
The costs incurred in maintaining the herd would all be charged in the statement of
comprehensive income in the relevant period.
516

18.11.4Agricultural produce
18.11.5Land
Fidelity, the electronic equipment manufacturer, was purchased for £13.4 million.
REVIEW QUESTIONS
1
¥
519
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
*Question 2
Purchases of a certain product during July were:
July1100 units @ £10.00
12100 units @ £9.80
1550 units @ £9.60
20100 units @ £9.40
Units sold during the month were:
July1080 units
14100 units
3090 units
520

The statement of comprehensive income of Bottom, a manufacturing company, for the year ending
31 January 20X2 is as follows:
Gross proÞt
Other operating expenses(9,000)
ProÞt from operations
ProÞt before tax
(7,000)
Information regarding fair values is as follows:
Item
Fair value less point of sale costs
1 October 20031 April 200430 September 2004
$$$
Land
20 m
22 m
24 m
New born calves (per calf)
20
21
22
Six-month-old calves (per calf)
23
24
25
Two-year-old cows (per cow)
90
92
94
Three-year-old cows (per cow)
93
95
97
Milk (per litre)
0.6
0.55
0.55
Required:
(a)Discuss how the IAS 41 requirements regarding the recognition and measurement of biological
19.1Introduction
19.2The accounting issue for construction contracts
19.2.1The future of revenue recognition
identify when IAS11
prepare the Þnancial statements to reßect construction contracts appropriately;
this type of arrangement is reßected in the Þnancial statements.
524

Construction contracts
526

period.
Care needs to be taken to ensure that non-contract costs are not attributed to a contract
causing the prot for the year to be inated. For example, the following is an extract from
the Cray Inc 2005 Annual Report:
Construction contracts
This policy is IAS 11 compliant in all respects other than the treatment of advances.
IAS 11 requires that these be shown as liabilities until the related work is performed.

Preface and acknowledgements
xx
Guided tour of MyAccountingLab
xxv
Part 1
Construction contracts
544

Year to 31 October 2007
6.500.503.00
To date
6.500.509.00
Payments received:
To 31 October 2006
5.75
Year to 31 October 2007
3.761.75
To date
3.767.50
Invoices sent to client:
To 31 October 2006
6.00
Year to 31 October 2007
5.000.502.76
To date
5.000.508.76
Costs incurred:
To 31 October 2006
6.56
Year to 31 October 2007
11.501.503.94
To date
11.501.5010.50
(c)During 2007, Jack Matelot had two major worries: (i) the operating performance of JTM had
not been as good as expected; and (ii) the planned disposal of surplus property (to Þnance the
528

Expected future costs
(14,500)
Overall anticipated result
5,000
Step 2Statement of comprehensive income: revenue entry
The next step is to compute the revenue that will be included in the statement of compre-
hensive income for the year ended 30 June 20X0:
Contract A
000
Cumulative revenue (28% of total)
7,000
So revenue for the year
7,000
Step 3Statement of comprehensive income: expense entry
We now move on to compute the expense that will be recognised:
Contract A
000
28% of total anticipated costs (use actual)5,500
Allowance for future losses
Nil
So expense for the year
5,500
Expense
(5,500)
Construction contracts
Step 4Statement of Þnancial position entries
: recognised proÞts less recognised losses1,500
Ñ
7,000
Note: As no problems had been experienced or were anticipated the company decided that
(6,000)
Step 2Statement of comprehensive income: revenue entry
(7,000)
8,000
530

Less
: recognised in previous years
(5,500)
So expense for the year
6,500
Contract A
Year 1This yearCumulative
000000000
Revenue
7,0008,00015,000
Expense
(5,500)(6,500)(12,000)
Less
: progress billings
(12,000)
Gross amounts due from customers
5,000
19.5.3Example: Loss making contract step approach
ABC has two construction contracts outstanding at the end of its nancial year, 30 June
Step 1Overall anticipated result
(9,000)
Step 2Statement of comprehensive income: revenue entry
(2,000)
Step 3Statement of comprehensive income: expense entry
(2,000)
12,000
As far as contract B is concerned, recognising 50% of the total contract price and revenue
Year 1This yearCumulative
£000£000£000
2,0008,00010,000
2,000(12,000)(14,000)
Step 4Statement of nancial position entries
As far as this statement is concerned, the gures presented will be based on the cumulative
amounts. The gross amounts due from customers will be as follows:
Contract B
000
Costs incurred to date
15,000
Add
: recognised prots less recognised losses(4,000)
Less
: progress billings
(10,000)
Gross amounts due from customers
1,000
19.6Publicprivate partnerships (PPPs)
PPPs have become a common government policy for public bodies to enter into contracts
with private companies which have included contracts for the building and management of
transport infrastructure, prisons, schools and hospitals. There are inherent risks in any pro-
ject and the intention is that the government, through a PPP arrangement, should transfer
some or all of such risks to private contractors. For this to work equitably there needs to
be an incentive for the private contractors to be able to make a reasonable prot provided
they are efcient whilst ensuring that the providers, users of the service, tax payers and
employees also receive a fair share of the benets of the PPP.
Improved public services
It has been recognised that where such contracts satisfy a value for money test it makes
economic sense to transfer some or all of the risks to a private contractor. In this way it has
been possible to deliver signicantly improved public services with:

increases in the quality and quantity of investment, e.g. by the private contractor
534

tion company and the maintenance company; and
long-term debt.
NOTE: The long-term debt may be up to 90% of the nance required on the basis that it is
cheaper to use debt rather than equity. The loan would typically be obtained from banks and
would be without recourse to the shareholders of the project company. As there is no recourse to
the shareholders, lenders need to be satised that there is a reliable income stream coming to the
project company from the public sector, i.e. the lender needs to be condent that the project
company can satisfy the contractual terms agreed with the public sector.
The subordinated debt made available to the project company by the promoters will be subordinated
to the claims of the long-term lenders in that they will only be repaid after the long-term lenders.

receives regular payments, usually over a twenty-ve to thirty-year period, from the public
Construction contracts
19.6.2ProÞt and cash ßow proÞle for the shareholders
Figure 19.1The operation of PFI
536

that relating to the assumed road. Revenue on the constructed road is recognised as
turnover as it is received. Revenue on the assumed road is recognised as turnover as
IFRIC 12
Service Concession Agreements
For enterprises preparing Þnancial statements in accordance with IFRS, IFRIC 12 was
issued in November 2006 and became effective for periods beginning on or after 31 January

REVIEW QUESTIONS
1
Discuss the point in a contracts life when it becomes appropriate to recognise prot and the
Summary
Construction contracts
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-elliott)
for exercises marked with an asterisk (*).
MACTAR have a series of contracts to resurface sections of motorways. The scale of the contract
means several yearsÕ work and each motorway section is regarded as a separate contract.
From the following information, calculate for each contract the amount of proÞt (or loss) you
would show for the year and show how these contracts would appear in the statement of Þnancial
Contract
Payments received to date
The M62 contract has had
difÞculties due to difÞcult terrain, and the contract only allows for
a 10% increase in contract sum for such events.
540

12345
000000000000000
Contract price
1,1009501,4001,3001,200
At 31 October
Cumulative costs incurred
6645358106401,070
Estimated further costs to
12345
000000000000000
Cumulative revenue
560340517400610
Cumulative costs incurred
transferred to cost of sales
460245517400610
Foreseeable loss transferred to
cost of sales
70
It is the accounting policy of Lytax Ltd to arrive at contract revenue by adjusting contract cost of sales
(including foreseeable losses) by the amount of contract prot or loss to be regarded as recognised,
separately for each contract.
Required:
Show how these items will appear in the statement of nancial position of Lytax Ltd with all appro-
priate notes. Show all workings in tabular form.
Construction contracts
*Question 3
During its Þnancial year ended 30 June 20X7 Beavers, an engineering company, has worked on several
contracts. Information relating to one of them is given below:
542

A
Materials issued from stores
13,407
Materials delivered direct to site73,078
Wages
39,498
Administration expenses
3,742
Site expenses
4,693
On 31 March 20X1 there were outstanding amounts for wages 396 and site expenses 122, and the
stock of materials on site amounted to 5,467.
The following information is also relevant:
1On 1 July 20X0 plant was purchased for exclusive use on site at a cost of 15,320. It was estimated
that it would be used for two years after which it would have a residual value of 5,000.
2By 31 March 20X1 Newbild SA had received 114,580, being the amount of work certied by the
20.1Introduction
20.2The deÞnition of a group
20.3Consolidated accounts and some reasons for their preparation
for a wholly-owned subsidiary;
(ii)
To provide a more meaningful EPS gure. Consolidated accounts show the full
earnings on a parent companys investment while parents individual accounts only
show the dividend received from the subsidiaries.
(iii)
. . .Subsidiaries are entities over which, either directly or indirectly, the Company
Control is
when one party to the combination owns more than half of the voting
rights of the other either directly or through a subsidiary. This is illustrated with the follow-
¥
551
Principles of consolidation
The consolidated nancial statements include the parent company Wartsila
Corporation and all subsidiaries in which the parent directly or indirectly holds
more than 50 per cent of the voting rights or in which Wartsila is otherwise in
contro
l...
What if the voting rights acquired are less than half?
Even in this situation, it may still be possible
6
to identify an acquirer when one of the
combining enterprises, as a result of the business combination, acquires:
(a)
power over more than one-half of the voting rights of the other enterprise by virtue of
an agreement with other investors;
(b)
power to govern the nancial and operating policies of the other enterprise under a
statute or an agreement;
(c)
power to appoint or remove the majority of the members of the board of directors or
equivalent governing body of the other enterprise; or
(d)
activities.
Rose plcTulip plcGroup
£££
16,00010,00016,000Note 3
43,00014,00043,000
££
The parent companyÕs investment
15,000
Less
a i the subsidiaryÕs share capital(100%
10,000)10,000
1,000*
Note 3.Calculate the consolidated share capital and reserves for the group

Rose plcTulip plcAdjustmentsGroup


Share capital
16,00010,000(10,000) a16,000
43,00014,000
43,000
Supported by the same notes ( Notes 13) shown above.
An extract from the 2008 annual report of EnBW Energie Baden-Wrttemberg AG
(EnBW) states:
there have been errors measuring the fair value of either the cost of the combination or

BirdFlowerGroup

Share capital
16,00010,00016,000Note 4
Non-controlling interest
2,800Note 2
43,00014,00045,800
Note 1.Calculate goodwill

The parent companys investment in Flower
12,000
Less
: The parents share of the subsidiarys share capital (80%

10,000) 8,000
The difference is goodwill
800
Note 2. Calculate the non-controlling interest
The non-controlling interest in the share capital
of Flower
(20%

10,000)
=
2,000
earnings of Flower
(20%

4,000)
=
800
556

Consolidated accounts
the equity of the group as follows:
Share capital
16,000
2,800
Non-controllinginterest is, therefore, now shown as part of the ownership of the group
Note 4.Calculate the consolidated share capital and reserves for the group
BirdFlowerAdjustmentGroup
16,00010,000(8,000) a i16,000
(800) b ii27,000
43,00014,000
800 b ii2,800
43,00014,000
¥
557
at the date of acquisition (14,000)
(2,800)
Attributable goodwill
100
The consolidated statement of nancial position would now be as follows:

45,900
Share capital
16,000
Non-controlling interest (2,800
+
100)
2,900
45,900
Note that we assumed that the fair value of the non-controlling interest at the date of acqui-
sition was 2,900. This gure may well be given in a question. However, if it were necessary
to calculate it, one approach would be to calculate the value of the subsidiary at the date of
acquisition and take 20% of that gure. The non-controlling interest would be:
20% of the fair value of the subsidiary at the date of acquisition
(using share price if available)

x
Less
BirdFlowerGroup
16,00010,00016,000
ÑÑ2,920Note 2
43,00014,00045,920
: The parentÕs share of the subsidiaryÕs share capital(80%
10,000)8,000
(80%
600) 480
320
£
The non-controlling interest in the share capital
of Flower
(20%
10,000)
=
2,000
As from the date of acquisition, an acquirer should:
(a)
incorporate into the statement of comprehensive income the results of operations of
the acquiree; and
(b)
Summary
When one company acquires a controlling interest in another and the combination is
treated as an acquisition, the investment in the subsidiary is recorded in the acquirers
consolidated statement of nancial position at the fair value of the investment.
On consolidation, if the acquirer has acquired less than 100% of the common shares,
Explain how negative goodwill may arise and its accounting treatment.
(d)Bean plc acquired 30% of the shares of Pea plc several years ago with the intention of
acquiring inuence over the operating and nancial policies of that company. Pea sells 80% of
EXERCISES
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-elliott)
for exercises marked with an asterisk (*).
Questions 15
Required:
Prepare the statements of nancial position of Parent Ltd and the consolidated statement of nan-
cial position as at 1 January 20X7 after each transaction, using for each question the statements of
nancial position of Parent Ltd and Daughter Ltd as at 1 January 20X7 which were as follows:
Parent LtdDaughter Ltd

Ordinary shares of 1 each
40,5009,000
45,00010,800
Cash
20,0002,000
45,00010,800
Question 1
(a)Assume that on 1 January 20X7 Parent Ltd acquired all the ordinary shares in Daughter Ltd for
(b)The purchase consideration was satisÞed by the issue of 5,400 new ordinary shares in Parent Ltd.
Capital reserve
Non-controlling interest
267,680
Inventory
Trade receivables
24,360
Ñ
122,920
Trade payables
27,160
20,720
Bank overdraft
140,840
Working capital
267,680
¥
563
Notes:
Rouge
Noir

million

million
Property, plant and equipment
100
60
Investment in Noir
132
EQUITY AND LIABILITIES
Ordinary 1 shares
200
60
252
100
Current liabilities
60
30
Total equity and liabilities
312
130
Note:
The fair values are the same as the book values.
Required: Prepare a consolidated statement of nancial position for Rouge plc as at 1 January 20X0.
*Question 8
Ham plc acquired 100% of the common shares of Burg plc on 1 January 20X0 and gained control.
At that date the statements of nancial position of the two companies were as follows:
564

Consolidated accounts
Burg
Property, plant and equipment
Investment in Burg
Capital and reserves
£1 shares
110
Current liabilities
440
170
1The fair value is the same as the book value.
Capital and reserves
Share capital (£5 shares)
Current liabilities
400
On 1/1/20X0 Berlin acquired 100% of the shares of Hanover for £100,000 and gained control.
(a)Berlin acquired the shares for cash.
Question 10
Bleu plc acquired 80% of the common shares of Verte plc on 1 January 20X0 and gained control.
At that date the statements of nancial position of the two companies were as follows:
Bleu
Verte
m
m
Property, plant and equipment
150
120
Investment in Verte
210
Bleu
Verte
m
m
EQUITY AND LIABILITIES
Capital and reserves
Share capital
300
120
378
180
Current liabilities
90
45
Total equity and liabilities
468
225
Note:
The fair values are the same as the book values.
Required: Prepare a consolidated statement of nancial position for Bleu plc as at 1 January 20X0.
Base
Ball
000
000
Property, plant and equipment
250
100
Investment in Ball
90
EQUITY AND LIABILITIES
Capital and reserves
Share capital
200
80
Share premium
20
360
110
Current liabilities
80
60
Total equity and liabilities
440
170
566

Consolidated accounts
The fair value of the property, plant and equipment in Ball at 1/1/20X0 was £120,000. The fair value
Share capital
1,200
Because of ValleyÕs loss in 20X0, the directors of Hill decided to write down the value of goodwill by
21.1Introduction
The main purpose of this chapter is to prepare consolidated nancial statements after a
period of trading.
21.2Pre- and post-acquisition prots/losses
Pre-acquisition prots
Any prots or losses of a subsidiary made
before
the date of acquisition are referred
to as
pre-acquisition prots/losses
in the consolidated nancial statements. These are
Objectives
By the end of this chapter, you should be able to:

account for the post-acquisition prots of a subsidiary;

eliminate inter-company balances and deal with reconciling items;

account for unrealised prots on inter-company transactions.
16,00010,00016,000Note 4
ÑÑ3,350Note 2
51,00016,00055,950
££
(c)
Fair value adjustment
the parents share of any change in the book values:
80%

11,680
Goodwill attributable to the parent company shareholders
320

Fair value of non-controlling interest at date of acquisition
2,950
Goodwill attributable to the non-controlling interest
30
Total goodwill (320
+
30)
350
Non-controlling interest in any revaluation reserve(20%

600)
=
120
Non-controlling interest in goodwill
30
3,350
Total
55,950
Note 4. Calculate the consolidated share capital and reserves for the group accounts

Share capital
(parent company only)
16,000
Reserves:
prot at 1.1.20X1)
1,600
36,600
Total shareholders interest
52,600
Notes:
21.3Inter-company balances
21.3.3Inter-company balances arising from sales or other transactions
IAS 27 requires inter-company balances to be eliminated in full.
2
Eliminating inter-company balances
If entries in the parents records and the subsidiarys records are up to date, the same gure

At 31 December 20X1

Half of the goods sold by Prose were still in the inventory of Verse, i.e. there is unrealised
prot, and both the consolidated gross prot and inventories in the consolidated state-
ment of nancial position will need to be reduced by the amount unrealised.

The closing statements of nancial position of Prose and Verse at 31 December 20X1
ProseVerseGroup

EQUITY and LIABILITIES
Equity share capital
24,00011,00024,000 Note 5
Preferred shares
4,0008,0004,000Note 5
Other current liabilities
6,5207,90014,420Note 4
69,52050,75097,835
Note 1. Calculation of goodwill (note that this calculation will be the same as
when calculated at the date of acquisition)

The cost of the parent companys investment for common shares,
additional paid in capital, preferred shares and bonds
24,000
Less:
(a i)
parents share of the
subsidiarys equity share capital:
80%

common shares of Verse
(80%

11,000)
=
8,800
(a ii)
parentÕs share of any change in
subsidiaryÕs book values
80%
×
revaluation of land at
(80%
×
1,000)
=
800
(a iv)
parentÕs share of preferred shares:
20%
×
preferred shares
of Verse
(20%
8,000)
=
1,600
(a v)
parentÕs share of
×
bonds of Verse
(10%
7,000)
=
700
(a vi)Goodwill in statement of Þnancial position
(b i)
The
current accounts
of Verse(80%
10,500
25,920
+
(43,400
+
revaluation 1,000)
=
70,320
Inventories 9,600
+
(4,000 Ð provision for unrealised
=
13,300
Other current liabilities6,520
Preparation of consolidated statements of Þnancial position after the date of acquisition
Note 5.Calculate the consolidated share capital and reserves for the group accounts
Share capital:

Equity share capital
(parent companys only)
24,000
Preferred shares
(parent companys only)
4,000
Less:
Provision for unrealised prot
(300)
29,700
Parents share of the
post-acquisition prot
of the subsidiary
80%

8,500 6,800
Less:
80% of pre-acquisition prots(80%

4,000)
(3,200)
3,600
Note 6. Bonds
Parent Subsidiary

Bonds 5,000
+
(7,000 inter-company 700)
=
11,300
The following is presented in schedule format:
ProseVerse
Adjustments
Group
DRCR
576

Consolidated accounts
Equity share capital24,00011,000(8,800)ai
(2,200)ci
4,0008,000(1,600)aiv
(6,400)civ
(300)biii
58,00027,500
Non-controlling interestÑÑ
2,200ci10,500
1,700cii
200ciii
6,400civ
5,0007,000(700)av
8,000(8,000)2,200
Other current liabilities6,5207,900(35)6,40014,420
69,52050,75042,83542,83597,835
21.5Provision for unrealised proÞt affecting a non-controlling interest
21.6Uniform accounting policies and reporting dates
21.7How is the investment in subsidiaries reported in the parents own
statement of nancial position?
IAS 27 gives the parent a choice as to how to report the investment.
5
It can either report
the investment at cost, or report it in accordance with the provisions of IAS 39
Financial
Instruments: Recognition and Measurement
. Cost in this context means the fair value of the
consideration at the date of acquisition.
578

Consolidated accounts
Summary
When consolidated accounts are prepared after the subsidiary has traded whilst under
the control of the parent, the goodwill calculation remains as at the date of the acquisi-
tion but all inter-company transactions have to be eliminated.
REVIEW QUESTIONS
1
The 2006 accounts of Eybl International state:
Elimination of intra-group balances
EXERCISES
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-elliott)
for exercises marked with an asterisk (*).
Question 1
Sweden acquired 100% of the equity shares of Oslo on 1 March 20X1 and gained control. At that
date the balances on the reserves of Oslo were as follows:
The Revaluation reserve Kr10 million
The statements of Þnancial position of the two companies at 31/12/20X1 were as follows:
Krm
Krm
Property, plant and equipment
200
Kr10 shares
Revaluation reserve
200
Current liabilities
624
260
1The fair values were the same as the book values on 1/3/20X1.
2There have been no movements on share capital since 1/3/20X1.
320% of the goodwill is to be written off as an impairment loss.
SummerWinter
Property, plant and equipment
141
Equity shares
220
Current liabilities
441
340
Preparation of consolidated statements of Þnancial position after the date of acquisition
Notes:
1The fair value of the non-controlling interest at the date of acquisition was 92,000. The non-
Gold
Silver

Silver current account
20,000
Bond interest receivable
175
EQUITY AND LIABILITIES
Equity share capital
60,000
27,600
Preferred shares
10,000
20,000
145,000
68,800
Non-current liabilities bonds
12,500
17,500
Current liabilities
Gold current account
20,000
Bond interest payable
625
875
Other current liabilities
18,550
18,875
Total equity and liabilities
176,675
126,050
Notes:
120% of the goodwill is to be written off as an impairment loss.
2During the year Gold sold some of its inventory to Silver for 3,000, which represented cost plus
a mark-up of 25%. Half of these goods are still in the inventory of Silver at 31/12/20X1.
3There is no depreciation of land.
4There has been no movement on share capital since the acquisition.
Prop and Flap have produced the following statements of Þnancial position as at 31 October 2008:
Prop
$m$m$m$m
800
Inventories
580
280
400
8
708
Equity share capital
Non-current liabilities
Long-term borrowing
Current liabilities
1,100
228
Bank overdraft
308
4,760
1,188
The following information is relevant to the preparation of the Þnancial statements of the Prop Group:
References
1IAS 16
Property, Plant and Equipment
, IASB, revised 2003, para. 31.
2IAS 27
Consolidated and Separate Financial Statements
, IASB, revised 2008, para. 20.
3
Ibid
., para. 24.
4
Ibid
., paras 22 and 23.
5
Ibid
., para. 38.
582

Consolidated accounts
22.1Introduction
22.2Preparation of a consolidated statement of comprehensive income Ð
eliminate inter-company transactions from a consolidated statement of
20% is to be written-off goodwill as an impairment loss.
Dividends paid in the year by group companies were as follows:
AntePost
On ordinary shares
40,0005,000
On preferred shares
3,000
Statements of comprehensive income for the year ended 31 December 20X2
AntePostConsolidated

Sales
200,000120,000308,000Notes 1/3
Cost of sales
60,00060,000109,500Notes 1/2/3
Gross prot
140,00060,000198,500
Expenses
59,08240,00099,082 Note 4
Impairment of goodwill

2,000 Note 5
Prot from operations
80,91820,00097,418
Dividends received common shares3,750 Note 6
Dividends received preferred shares600Note 6
Prot before tax
85,26820,00097,418
Income tax expense
14,0046,00020,004Note 7
Prot for the period
71,26414,00077,414
Attributable to:
Ordinary shareholders of Ante (balance)
72,264
Non-controlling shareholders in Post (Note 8)
5,150
77,414
Prot realised from operations 97,418 see Notes 15
Adjustments are required to establish the prot
realised
from operations. This entails
eliminating the effects of inter-company sales and inventory transferred within the group
with a prot loading but not sold at the statementoff
nancialposition
date and charging any
goodwill impairment.
Notes:
1Eliminate inter-company sales on consolidation.
Cancel the inter-company sales of 12,000 (9,000
+
1
/
3
) by.
(i)reducing the sales of Ante from 200,000 to 188,000; and
(ii)reducing the cost of sales of Post by the same amount from 60,000 to 48,000.
2Eliminate unrealised prot on inter-company goods still in closing inventory.
(i)Ante had sold the goods to Post at a mark up 3,000.
(ii)Half of the goods remain in the inventory of Post at the year-end.
(iii)
From the groups view there is an unrealised prot of half of the mark-up, i.e. 1,500.
Therefore:

deduct 1,500 from the gross prot of Ante by adding this amount to the cost of sales;

add this amount to a provision for unrealised prot;
584

Consolidated accounts
3Aggregate the adjusted sales and cost of sales Þgures for items in Notes 1 and 2.
(i)Add the adjusted sales Þgures
(ii)Add the adjusted cost of sales Þgures;
4Aggregate expenses
5Deduct the impairment loss.
6Accounting for inter-company dividends
(ii)Cancel the inter-company dividend received by Ante with £3,750 dividend paid by
(iv)Cancel the £600 preferred dividend received by Ante with £600 of the preferred
(v)the balance of £2,400 remaining was paid to the non-controlling interest.
7Aggregate the taxation Þgures.
8Calculate the share of post-taxation proÞts belonging to the non-controlling
×
(14,000
Š
3,000)
=
2,750
5,150
Preparation of consolidated statements of comprehensive income
22.3The statement of changes in equity (SOCE)
3
We will prepare extracts from the consolidated statement of changes in equity for the Ante

Opening balance (Notes 1 & 2)
87,33613,500100,836
Comprehensive income for the period 72,2645,15077,414
(from the consolidated statement of
comprehensive income)
Dividends paid (Note 3)
(40,000)(3,650)(43,650)
Closing balance
119,60015,000134,600
Note 1 Opening balance for the Ante group

since acquisition (75%

(54,000

30,000))
87,336
Note 2 Opening balance for the non-controlling shareholders
54,000

25%
=
13,500. The relevant percentage to use is 25% because only
ordinary
shareholders will have any interest in the
years. The depreciation charge in the subsidairy would have been £20,000 (£100,000/5).
588

Consolidated accounts
be reported as such in the parents statement of nancial position. This is illustrated in the
Bow plc example below:
Illustration of a dividend paid out of pre-acquisition prots
Bow plc acquired 75% of the shares in Tie plc on 1 January 20X1 for 80,000 when the balance
BowTieConsolidated

Gross prot
130,00070,000200,000
Expenses
50,00040,00090,000
Prot from operations
80,00030,000110,000
Dividends received from Tie (see note)
3,000

Prot before tax
83,00030,000110,000
Income tax expense
24,0006,00030,000
Prot for the period
59,00024,00080,000
Note:
The 3,000 dividend received from Tie is not income and must not therefore appear in
Bow statement of comprehensive income. The correct treatment is to deduct it from the
investment in Tie, which will then become 77,000 (80,000

3,000). The consolidation
would then proceed as usual.
22.6A subsidiary acquired part of the way through the year
It would be attractive for a company whose results had not been as good as expected to
acquire a protable subsidiary at the end of the year and take its annual prot into the group
accounts. However, this type of window dressing is not permitted and the group can only
bring in a subsidiarys prots from the date of the acquisition. The Tight plc example below
illustrates the approach.
22.6.1Illustration of a subsidiary acquired part of the way through the
year Tight plc
The following information is available:
At date of acquisition 30 September 20X1
Tight acquired 75% of the shares and 20% of the 5% bonds in Loose.
The purchase consideration (amount paid) was 10,000 more than book value.
The book value and fair value were the same amount.
Preparation of consolidated statements of comprehensive income
TightLooseConsolidated
£££
200,000120,000
60,00060,000
140,00060,000155,000
59,08230,000
10,000
2,000
Note 4
2,000
Ñ
82,91820,00086,418
3,600 NILNILNote 5
86,51820,00086,418
14,0046,000
72,51414,00070,914
875
1Inter-company sales
2Time-apportion and aggregate the revenue and cost of sales Þgures.
(120,000
×
=
£
(60,000
×
=
£
3Aggregate the expense.
(30,000
×
=
£
4Accounting for inter-company interest
Prot before tax
Inter-company expense items need to be eliminated. These include items such as management
charges, consulting fees and interest payments. In this example we illustrate the treatment
of interest. Interest is an expense which is normally deemed to accrue evenly over the year
and to be apportioned on a time basis.
5Accounting for inter-company dividends
Amount received by Tight
=
3,600
The dividend received by Tight is apportioned on a time basis,
and the pre-acquisition element is credited to the cost of investment
in Tights statement of nancial position, i.e.
9
/
12

3,600
=
(2,700)
The post-acquisition element is cancelled with part of the
dividend paid in Loose statement of comprehensive income prior
to consolidation.
=
(900)
Amount credited to consolidated statement of comprehensive income
NIL
6Aggregate the tax gures.
This includes the whole of the parents tax and the time-apportioned
part of the subsidiarys tax, i.e. 14,004
+
(6,000

3
/
12
)
=

15,504
The group taxation is that of Tight plus
3
/
12
of Loose.
7Calculate the share of post-acquisition consolidated prots belonging to the
non-controlling interest.
As only the post-acquisition proportion of the subsidiarys prot after
tax has been included in the consolidated statement of comprehensive
income, the amount deducted as the non-controlling interest in the
prot after tax is also time-apportioned, i.e.
25%

(14,000

3
/
12
)
=
875
22.7Published format statement of comprehensive income
The statement of comprehensive income follows the classication of expenses by function
as illustrated in IAS 1:

Revenue
230,000
Cost of sales
75,000
Gross prot
155,000
Distribution costs
xxxxxx
Administrative expense
xxxxxx
66,582
88,418
Finance cost
2,000
86,418
Income tax expense
15,504
Prot for the period
70,914
Attributable to:
Equity holders of the parent
70,039
Non-controlling interest
875
590

Consolidated accounts
22.8Consolidated statements of cash ßows
5Reduce amount paid to acquire subsidiary in
10Reduce share cash inßow
Share premium10Reduce share cash inßow
3Payment to acquire subsidiary in investing section
Cash ows from operating activities
000000
Depreciation
102
Operating prot before working capital changes
602
Increase in trade and other receivables
(260)
Increase in inventories
(400)
Less
:
inventory brought in on acquisition
10(390)
Decrease in trade payables
(40)
Add
:
trade payables brought in on acquisition
(12)(52)
Cash generated from operations
160
Income taxes paid (200
+
190

170)
(220)
Less
:
vehicles brought in on acquisition
20(543)
Payment to acquire subsidiary
(3)
Cash acquired with subsidiary
5
Less
:
shares issued on acquisition not for cash
(20)280
Dividends paid (
from statement of comprehensive income)
(120)
Cash and cash equivalents at the end of the period
(369)
Supplemental disclosure of acquisition

Total purchase consideration
23,000
Portion of purchase consideration discharged by means of cash or cash equivalents3,000
Amount of cash and cash equivalents in the subsidiary acquired
5,000
592

Consolidated accounts
Summary
Preparation of consolidated statements of comprehensive income
Explain why the dividends deducted from the group in the statement of changes in equity are only
those of the parent company.
An extract from the solution is provided on the Companion website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
*Question 1
Bill plc acquired 80% of the common shares and 10% of the preferred shares in Ben plc on
and dividends.
The non-controlling interest in the proÞt after tax of the subsidiary is deducted to
arrive at the proÞt for the year attributable to the equity holders of the parent.
The amounts paid as dividends to the parent companyÕs shareholders are shown as
deductions in the consolidated statement of changes in equity.
If a subsidiary is acquired during a Þnancial year, the items in its statement of com-
prehensive income require apportioning. In the illustration in the text we assumed that
trading was evenly spread throughout the year Ð in practice you would need to consider
594

Consolidated accounts
The statements of comprehensive income of the two companies for the year ended 31 December
20X1 were as follows:
Bill
Ben

Revenue
300,000180,000
Cost of sales
90,00090,000
Gross prot
210,00090,000
Expenses
88,62360,000
121,37730,000
Dividends received common shares
6,000

Dividends received preferred shares
450

Prot before tax
127,82730,000
Income tax expense
21,0069,000
Prot for the period
106,82121,000
Required:
Prepare a consolidated statement of comprehensive income for the year ended 31 December 20X1.
Question 2
Morn Ltd acquired 90% of the shares in Eve Ltd on 1 January 20X1 for 90,000 when Eve Ltds
accumulated prots were 50,000. On 10 January 20X1 Morn Ltd received a dividend of 10,800
from Eve Ltd out of the prots for the year ended 31/12/20X0. On 31/12/20X1 Morn increased its
Morn
Eve

Gross prot
360,000180,000
Expenses
120,000110,000
240,00070,000
Dividends received from Eve Ltd
10,800

Prot before tax
250,80070,000
Income tax expense
69,00018,000
Prot for the period
181,80052,000
There were no inter-company transactions, other than the dividend. There was no goodwill.
Required:
Prepare a consolidated statement of comprehensive income for the year ended 31 December 20X1.
Question 3
River plc acquired 90% of the common shares and 10% of the 5% bonds in Pool Ltd on 31 March
20X1. All income and expenses are deemed to accrue evenly through the year. On 31 January 20X1
River sold Pool goods for 6,000 plus a mark up of one-third. 75% of these goods were still in stock
at the end of the year. There was a goodwill impairment loss of 4,000. On 31/12/20X1 River increased
Preparation of consolidated statements of comprehensive income
Pool
££
30,00030,000
Gross proÞt
70,00030,000
20,54115,000
Interest payable on 5% bonds
Interest receivable on Pool Ltd bonds
49,95910,000
Dividends received
ProÞt before tax
52,11910,000
7,0023,000
ProÞt for the period
45,1177,000
The statements of Þnancial position of Mars plc and Jupiter plc at 31 December 20X2 are as follows:
Mars Jupiter
Depreciation
220,00067,500
330,000157,500
Trade receivables
180,00090,000
Current account Ð Jupiter
36,00018,000
463,500175,500
Capital and reserves
£1 common shares
196,00090,000
General reserve
245,00031,500
666,000256,500
Current liabilities
Trade payables
283,50040,500
31,50013,500
Current account Ð Mars
315,00076,500
981,000333,000
596

Consolidated accounts
Statements of comprehensive income for the year ended 31 December 20X2

Sales
1,440,000 270,000
Cost of sales
1,045,000135,000
Gross prot
395,000135,000
Expenses
123,50090,000
Dividends received from Jupiter
9,000
NIL
Prot before tax
280,50045,000
Income tax expense
31,50013,500
Prot for the period
249,00031,500
Dividends paid
180,00011,250
69,00020,250
225,000135,000
Red
Pink
$$
Depreciation
80,00030,000
145,00070,000
Investment in Pink Ltd
110,000
Trade receivables
80,00040,000
Current account Pink Ltd
10,000
Bank
16,000 8,000
206,00078,000
Preparation of consolidated statements of comprehensive income
Capital and reserves
$1 common shares
176,00040,000
General reserve
20,00014,000
Revaluation reserve
321,000114,000
Current liabilities
Trade payables
125,99618,000
14,0046,000
Current account Ð Red Ltd
140,00034,000
461,000148,000
Sales
200,000 120,000
60,00060,000
Gross proÞt
140,00060,000
59,08240,000
Dividends received
ProÞt before tax
84,66820,000
14,0046,000
70,66414,000
Surplus on revaluation
95,66414,000
598

Consolidated accounts
Statement of comprehensive income
Cost of sales
(90,000)(60,000)(54,000)
Gross prot
90,00060,00052,000
Distribution costs
(9,000)(8,000)(8,000)
Administrative expenses
(10,000)(9,000)(8,000)
Investment income (Note 2)
26,450
Nil
Nil
Finance cost
(10,000)(8,000)(5,000)
Prot before tax
87,45035,00031,000
Income tax expense
(21,800)(8,800)(7,800)
Summarised statements of changes in equity
Balance at 1 April 20X6
152,000111,000102,000
Dividends paid on 31 January 20X7
(30,000)(13,000)(15,000)
Balance at 31 March 20X7
187,650144,200110,200
Notes to the nancial statements
Note 1 Inter-company sales
Preparation of consolidated statements of comprehensive income
Statements of comprehensive income for the year ended 30 September 20X4
H LtdS LtdH Group
£000£000£000
Turnover
4,0002,2005,700
(1,100)(960)(1,605)
2,9001,2404,095
Administration
(420)(130)(550)
Distribution
(170)(95)(265)
Dividends received
180ÑÑ
ProÞt before tax
2,4901,0153,280
(620)(335)(955)
ProÞt after tax
1,8706802,325
Attributable to:
Equity shareholders of H Ltd
Non-controlling shareholders in S Ltd
600

Consolidated accounts
Statements of nancial position at 30 September 20X4
H Ltd
S Ltd
H Group
000000000000000000
Investment in S Ltd1,7008,7532,1969,249
Bank
2797219659461,426
Current liabilities:
Payables
(300)
(260)
(355)
Dividend to non-controlling
interest


(45)
Taxation
(605)(905)(375)(635)(980)(1,380)
8,820
2,220
9,295
H Ltd
S Ltd
H Group
000
000
000
Share capital
4,500
760
4,500
Non-controlling interest


555
8,820
2,220
9,295
Goodwill of 410,000 was written off at the date of acquisition following an impairment review.
Required:
(a)Calculate the percentage of S Ltd which is owned by H Ltd.
The following are the Þnancial statements of White and its subsidiary Brown as at 30 September 20X9
Preparation of consolidated statements of comprehensive income
WhiteBrown
£000£000
Sales revenue
245,00095,000
(140,000)(52,000)
Gross proÞt
105,00043,000
Distribution costs(12,000)(10,000)
Admin expenses(55,000)(13,000)
ProÞt from operations38,00020,000
Dividend from Brown7,000Ñ
ProÞt before tax45,00020,000
(13,250)(5,000)
30 September 20X9
WhiteBrown
£000£000
165,50052,740
Equity & reserves:
Ordinary shares of £1 each100,00030,000
Reserves
9,2001,000
136,50040,280
Current liabilities:
Trade Payables
9,0002,460
Dividend declared
20,00010,000
165,50052,740
The following information is also available:
(i)White purchased its ordinary shares in Brown on 1 September 20X4 when Brown had credit
Question 9
Hyson plc acquired 75% of the shares in Green plc on 1 January 20X0 for 6 million when Green
Revenue
23,5006,400
Cost of sales
16,4004,700
Gross prot
7,1001,700
Expenses
4,6501,240
Prot before tax
2,450460
Income tax expense
740140
Prot for the period
1,710320
Revenue
21,3008,600
Cost of sales
14,9006,020
Gross prot
6,4002,580
Other operating expenses
3,7001,750
Prot before tax
2,700830
Taxation
820250
Prot after tax
1,880580
Required:
Prepare an income statement for the Forest plc group for the year ended 31 December 20X3.
References
1IAS 27
Consolidated and Separate Financial Statements
, IASB, revised 2008, para. 20.
2
Ibid
., para. 28.
3IAS 1
Presentation of Financial Statements
, IASB, revised 2007, Implementation Guidance.
602

Consolidated accounts
23.2DeÞnitions of associates and of signiÞcant inßuence
23.1Introduction
incorporate an associate into the consolidated Þnancial statements using the
(c)
Brill
and SubsidsCodGroup

Inventories
132,44027,000132,440
Trade receivables
151,05027,000151,050
Current account Cod
2,250
2,250Note 2
Bank
36,200 4,50036,200
527,840117,750531,440
604

Consolidated accounts
and SubsidsCodGroup
£££
110,25025,500110,250
27,7506,00027,750
2,250
138,00033,750138,000
187,50037,500187,500
24,9009,00025,500 Note 3
31,500Ñ31,500Note 5
389,84084,000393,440
1Investment in associate
20% (9,000 Ð 6,000)(general reserves)
6003,600
600
25,500
22,500)
=
3,000
5Non-controlling interest
23.4.2Consolidated statement of comprehensive income
Statements of comprehensive income for the year ended 31 December 20X2
Brill
and SubsidsCodGroup

Sales
329,00075,000329,000
Cost of sales
114,06030,000114,060
Gross prot
214,94045,000214,940
Expenses
107,70022,500107,700
Prot from operations
107,24022,500107,240
Dividends received
1,200NILNote 1
Share of associates prot

3,300
Note 2
Prot before tax
108,44022,500110,540
Income tax expense
27,7506,000
27,750
Prot for the period
80,69016,50082,790
Notes:
Prot before tax
1Dividend received from Cod
is not shown because the share of Cods prots (before
dividend) has been included in the group account (see note 2). To include the dividend
as well would be double counting.
2Share of Cods prot after tax
=
20%

16,500
=

3,300
3
As in the statement of nancial position, there is no need to account for a non-controlling
interest in Cod. This is because the consolidated statement of comprehensive income only
ever included the group share of Cods prots.
4
There are no additional complications in the statement of changes in equity. The group
and SubsidsBlowaccounts
£££
225,000112,500225,000Note 1
75,00056,25075,000Note 2
150,00056,250150,000
89,85030,00089,850
60,15026,25060,150
Dividends received from associate1,350NILNILNote 3
Ñ3,713Note 4
61,50026,25063,863
15,0006,75015,000
46,50019,50048,863
1
The revenue, cost of sales and all other income and expenses of the associated company
are not added on a line by line basis with the those of the parent company and its sub-
2
The group accounts Ôcost of salesÕ Þgure does not include the provision for unrealised
3
The dividend received of £1,350 is eliminated, being replaced by the group share of its
¥
607
4
Share of prots after tax of the associate

Prot after tax
19,500
Apportion for 9 months (
9
/
12

19,500)
14,625
Less: unrealised prot (
25
/
125

15,000)

75%
2,250
12,375
Group share (30%

12,375)
3,713
5
according to the amount of throughput is an example
Financial reports
The following are reported in the Þnancial statements of each venturer:
(a)
REVIEW QUESTIONS
1
The following is an extract from the notes to the 1999 consolidated nancial statements of the
Chugoku Electric Power Company, Incorporated.
Summary
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
*Question 1
The following are the Þnancial statements of the parent company Swish plc, a subsidiary company
Broom and an associate company Handle.

SwishBroomHandle
Depreciation
200,00070,00021,000
120,000110,00079,000
Investment in Broom
140,000
Investment in Handle
40,000
Bank
24,000 7,0006,000
EQUITY AND LIABILITIES
1 ordinary shares
250,00060,00050,000
General reserve
30,00020,00012,000
Current account Swish
15,0003,000
Total equity and liabilities
592,000247,000157,000
Statement of comprehensive income for the year ended 31 December 20X3

Sales
300,000 160,000100,000
Cost of sales
90,00080,00040,000
Gross prot
210,00080,00060,000
Expenses
95,00050,00040,000
Dividends paid (shown in equity)
40,00010,0008,000
Dividends received from Broom and Handle
11,000 NIL10,000
Prot before tax
126,00030,00030,000
Income tax expense
30,0007,0008,000
Prot for the period
96,00023,00022,000
Dividend paid (shown in equity)
40,00010,0008,000
Openmirrors.com
Openmirrors.com
During the year Swish sold Broom goods for £16,000, which included a mark-up of one-third. 80% of
these goods were still in inventory at the end of the year.
AntBugNit
Depreciation
150,00052,50015,750
90,00082,50059,250
17,250 5,2504,500
$1 ordinary shares
187,50045,00037,500
General reserve
22,50015,0009,000
Current account Ð Ant
11,2502,250
444,000185,250117,750
¥
613
Statements of comprehensive income for the year ended 31 December 20X9
$$$
Sales
225,000120,00075,000
Cost of sales
67,50060,00030,000
Gross prot
157,50060,00045,000
Expenses
70,50037,50030,000
Dividends received
7,500 NIL7,500
Prot before tax
94,50022,50022,500
Taxation
22,5005,2506,000
Prot for the year
72,00017,25016,500
Dividends paid in year
30,0007,5006,000
(110,000)(78,000)(66,000)
Gross proÞt
40,00022,00030,000
Distribution costs
(7,000)(6,000)(6,000)
Administrative expenses
(8,000)(7,000)(7,200)
ProÞt from operations
25,0009,00016,800
6,450NilNil
(5,000)(3,000)(4,200)
ProÞt before tax
26,4506,00012,600
(7,000)(1,800)(3,600)
122,00091,00082,000
(6,500)(3,000)(5,000)
134,95092,20086,000
Purchased in Included in Included in closing
yearopening inventoryinventory
Entity
Date of Fair value adjustment
acquisitionat date of acquisition
$000
*Question 4
The following are the statements of comprehensive income of four companies for the year ended
31 October 2006, the end of their most recent Þnancial year.
AfjarJikkiHupinSofrin
$000$000$000$000
8,8904,5804,4702,760
(3,000)(2,200)(1,800)(1,700)
5,8902,3802,6701,060
Distribution costs
(900)(540)(1,010)(230)
Administrative expenses
(1,060)(990)(1,100)(250)
3,930850560580
Dividends receivable
410130
Interest receivable
230321150
Interest payable
(1,188)(455)(380)
(1,000)(200)(80)(100)
Earnings per share (in cents)
11.94.02.52.4
The following additional information is available:
(a)All shares issued by the companies have a face value of $1.
(b)The companies made the following dividend payments to shareholders during the year ended
31October 2006:
AfjarJikkiHupinSofrin
Preference dividend
$000$000$000$000
ÐÞnal for 2005, paid March 2006
400120
Ðinterim for 2006, paid September 2006
400120
Ordinary dividend
ÐÞnal for 2005, paid March 2006
8001805476
Ðinterim for 2006, paid September 2006
8001805476
Financial Instruments: Disclosure and Presentation
dividends on preference shares have
been included in interest payable.
(c)Afjar owns 60% of the ordinary shares in Jikki, 40% of the shares in Hupin and 25% of the shares
in Sofrin. Jikki is a subsidiary of Afjar, Hupin is an associate of Afjar, and Sofrin is a joint venture.
(d)During the year ended 31 October 2006 Afjar sold inventory which had cost $640,000 to Jikki at
a mark up of 25%. Jikki had resold 65% of these items by 31 October 2006.
(e)On 1 July 2006 Jikki made a long term loan of $500,000 to Afjar. The loan bears interest at 12%
a year payable every six months in arrears.
Required:
Prepare, in so far as the information given permits, the consolidated statement of comprehensive
income of Afjar for the year ended 31 October 2006. Your statement of comprehensive income
should include a gure for earnings per share with a supportive disclosure note.
(
The Association of International Accountants
)
Question 5
The statements of comprehensive income for Continent plc, Island Ltd and River Ltd for the year ended
31 December 20X9 were as follows:
Continent plcIsland LtdRiver Ltd
BBB
Revenue
825,000220,00082,500
Cost of sales
(616,000)(55,000)(8,250)
Gross prot
209,000165,00074,250
Administration costs
(33,495)(18,700)(3,850)
Distribution costs
(11,000)(14,300)(2,750)
Dividends receivable from Island and River
4,620
Prot before tax
169,125132,00067,650
Income tax
(55,000)(33,000)(11,000)
Prot after tax
114,12599,00056,650
Continent plc acquired 80% of Island Ltd for
A
The statements of comprehensive income for Highway plc, Road Ltd and Lane Ltd for the year ended
31 December 20X9 were as follows:
Highway plcRoad LtdLane Ltd
$$$
184,000152,00080,000
(48,000)(24,000)(16,000)
Gross proÞt
136,000128,00064,000
Administration costs
(13,680)(11,200)(20,800)
Distribution costs
(11,200)(17,600)(8,000)
Dividends receivable from Road
ProÞt before tax
113,60099,20035,200
(32,000)(8,000)(4,800)
ProÞt for the period
81,60091,20030,400
Highway plc acquired 80% of Road Ltd for $160,000 on 1.1.20X6 when Road LtdÕs share capital was
$64,000 and reserves were $16,000.
Highway plc acquired 30% of Lane Ltd for $40,000 on 1.1.20X7 when Lane LtdÕs share capital was
$8,000 and reserves were $8,000.
Goodwill of Road Ltd had suffered impairment charges of $14,400 in previous years and $4,800 was
to be charged in the current year. Goodwill of Lane Ltd had suffered impairment charges of $3,520
in previous years and $1,760 was to be charged in the current year.
During the year Road Ltd sold goods to Highway plc for $8,000. These goods had cost Road Ltd
$1,600. 50% were still in HighwayÕs inventory at the year end.
During the year Lane Ltd sold goods to Highway plc for $6,400. These goods had cost Lane Ltd
$3,200. 50% were still in HighwayÕs inventory at the year end.
HighwayÕs revenue included management fees of 5% of Road and LaneÕs turnover. Both of those
companies have treated the charge as an administration cost.
Question 7
Cash
237,60062,10067,500
EQUITY AND LIABILITIES
1 shares
540,00067,50027,000
Current account Alpha
10,80013,500
Total equity and liabilities
1,456,920445,500496,800
The following are the statements of Þnancial position of Garden plc, its subsidiary Rose Ltd and its
6,60067,200300
£1 shares
300,000120,00030,000
Revaluation reserve
Current account Ð Garden
Ñ15,0002,400
705,000444,60090,900
On 1 January 20X3 Garden plc acquired 75% of Rose Ltdfor £300,000 when RoseÕs share capital and
References
1IAS 28
Investments in Associates
, IASB, revised 2003, para. 2.
2
Ibid
., para. 2.
3
Ibid
., para. 6.
4
Ibid
., para. 7.
5
Ibid
., para. 38.
6
Ibid
., para. 2.
7IAS 1
Presentation of Financial Statements
, IASB, revised 2003, Implementation Guidance.
8IAS 28, para. 2.
9
Ibid
., para. 31.
10
Ibid
., para. 22.
11IAS 31
Interests in Joint Ventures
, IASB, revised 2003, para. 3.
12
Ibid
., para. 10.
13
Ibid
., para. 20.
14
Ibid
., para. 28.
15
Ibid
., para. 3.
16
Ibid
., paras 3841.
622

Consolidated accounts
24.1Introduction
24.3The functional currency
The
functional currency
is the currency of the primary economic environment in which
the entity operates.
the reporting entity.
24.4The presentation currency
5
The
presentation currency
is the currency a reporting entity uses for its nancial state-
ments. The reporting entity is entitled to present its nancial statement in any currency, so
that in some cases the presentation currency may differ from the functional currency.
24.6The rules on the recording of foreign currency transactions carried
1/11Buys goods for $30,000 on credit from Nevada Inc
15/11Sells goods for $40,000 on credit to Union Inc
15/11Pays Nevada Inc $20,000 for on account for the goods purchased
10/12Receives $25,000 on account from Union Inc in payment for the goods sold
10/12Buys machinery for $80,000 from Florida Inc on credit
10/12Borrowed $60,000 from an American bank; this is held in a dollar bank account
22/12Pays Florida Inc $80,000 for the machinery
The exchange rates at the relevant dates were:
1/111
=
$2.00
15/111
=
$2.20
10/121
=
$2.40
22/121
=
$2.50
31/121
=
$2.60
Required:
Calculate the prot or loss on foreign currency to be reported in the nancial
statements of Boil plc at 31/12/20X0.
on foreign exchange ()2,063(1,996)1,3331,923
626

Consolidated accounts
All other balances, i.e. purchases and sales in the statement of comprehensive income and
Granby LtdBerlin Gmbh
000
b
000
Sales
430,000140,000
Opening inventories
70,00021,200
Purchases
250,00080,000
Closing inventories
25,00017,200
Cost of sales
295,00084,000
Gross prot
135,00056,000
Dividend received
2,400NIL
Depreciation
40,00012,000
Other expenses
10,600
4,000
Interest paid
7,000
2,000
Total expenses
57,60018,000
Prot before taxation
79,80038,000
Taxation
20,00012,000
Prot after taxation
59,80026,000
Dividend paid 30.6.20X3
25,000
8,000
628

Consolidated accounts
b
4,500
4,000
11,000800
100,50038,000
60,00018,000
8,000
20,00012,000
80,00038,000
50,00016,000
52,0006,000
115,00074,000
1
Exchange rates were as follows:
At 30 June 20X0
£
=
a
Average for the year ending 30 June 20X3, an approximation of the rate
on the date of trading transactions and expenses
£
=
a
At 30 June/1 July 20X2
£
=
a
At 30 June 20X3
£
=
a
2
It is assumed that the functional currency of Berlin is the euro.
3
An amount of
4
b
000000
Owing to Granby
(8,000)(4,000)
Taxation
(12,000)(6,000)
Bonds
(16,000)(8,000)
Stage 2 compute goodwill on acquisition
000
Goodwill (see stage 2 above)
1,380
Bonds (50,000
+
8,000)
(58,000)
148,880
Share capital
52,000
Non-controlling interest(40%

37,000)
14,800
148,880
000
Granby
63,000
Berlin [60% (68,000

20,000)

1
/
2
]
14,400
Impairment of goodwill (4,140

1
/
2
)
(2,070)
Notional exchange difference on investment in Berlin
6,750
(See note below)
82,080
Note:
The notional exchange difference on the investment in Berlin of
a
22,500 that would have
Sales (430,000
+
(140,000
×
465,000
Cost of sales (295,000
Impairment of goodwill(1,380
Depreciation(40,000
Other expenses(10,600
(7,000
+
(2,000
×
(7,500)
ProÞt before taxation
86,210
(20,000
+
(12,000
×
(23,000)
Shareholders of Granby60,610
26,000
×
2,600
These arise in two ways:
EurosRate£Õ000
(balancing Þgure in euros)56,0003.516,000
26,00046,500
(8,000)2(4,000)
Exchange translation difference (balancing Þgure in £)Nil
74,000237,000
EurosRate£Õ000
2,760)4,1403.51,183
(1,380)2(690)
Exchange translation difference(balancing Þgure in £)Nil
2,76021,380
Accounting for the effects of changes in foreign exchange rates under IAS 21
Step 6 prepare the statement of total comprehensive income
000
Consolidated prot for the period
63,210
Other comprehensive income (18,500
+
887)
19,387
Total comprehensive income
82,597
Attributed to:
Shareholders of Granby
72,597
Non-controlling interest (2,600
+
(40%

18,500))
10,000
82,597
Note that none of the exchange difference on goodwill is allocated to the non-controlling
Discuss the desirability or otherwise of isolating proÞts or losses caused by exchange differences
from other proÞt or losses in Þnancial statements.
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
Fry Ltd has the following foreign currency transactions in the year to 31/12/20X0:
15/11Buys goods for $40,000 on credit from Texas Inc
15/11Sells goods for $60,000 on credit to Alamos Inc
20/11Pays Texas Inc $40,000 for the goods purchased
20/11Receives $30,000 on account from Alamos Inc in payment for the goods sold
20/11Buys machinery for $100,000 from Chicago Inc on credit
20/11Borrows $90,000 from an American bank
21/12Pays Chicago Inc $80,000 for the machinery
Accounting for the effects of changes in foreign exchange rates under IAS 21
statements has always been a difÞcult area of accounting with different views on
The exchange rates at the relevant dates were:
15/111
=
$2.60
20/111
=
$2.40
21/121
=
$2.30
31/121
=
$2.10
Required:
Calculate the prot or loss to be reported in the nancial statements of Fry Ltd at 31/12/20X0.
*Question 2
On 1 January 20X0 Walpole Ltd acquired 90% of the ordinary shares of a French subsidiary Paris SA.
Walpole LtdParis SA
000
B
000
Sales 317,200200,000
Opening inventories
50,00022,000
Purchases
180,00090,000
Closing inventories
60,00012,000
Cost of sales
170,000100,000
Gross prot
147,200100,000
Dividend received from Paris SA
1,800 NIL
Depreciation 30,00030,000
Other expenses
15,0007,000
Interest paid
6,0003,000
Total expenses
51,00040,000
Prot before taxation
98,00060,000
Taxation
21,00015,000
Prot after taxation
77,00045,000
Dividend paid
20,00010,000
634

Consolidated accounts
B
Investment in Paris SA
Paris SA
11,00011,000
21,00015,000
Total current liabilities
66,00045,000
Debentures
40,00010,000
Share capital
80,00060,000
Share premium
6,00020,000
Revaluation reserve
10,00012,000
163,000158,000
The following information is also available:
Question 3
(a)According to IAS 21
The Effects of Changes in Foreign Exchange Rates
, how should a company
decide what its functional currency is?
(b)Until recently Eufonion, a UK limited liability company, reported using the euro (
A
) as its func-
tional currency. However, on 1 November 2007 the company decided that its functional currency
should now be the dollar ($).
Cash and cash equivalents
8
76
Current taxation
41
104
Total liabilities
189
Total equity and liabilities
496
Non-current liabilities includes a loan of $70 million which was raised in dollars ($) and translated at
the closing rate of $1
=
A
0.72425.
Trade receivables include an amount of $20 million invoiced in dollars ($) to an American
customer which has been translated at the closing rate of $1
=
A
0.72425.
All items of property, plant and equipment were purchased in euros (
A
) except for plant which
was purchased in British pounds () in 2007 and which cost 150 million. This was translated at the
exchange rate of 1
=
A
1.46015 as at the date of purchase. The carrying value of the equipment was
90 million as at 31 October 2008.
Required:
1IAS 21
Accounting for the effects of changes in foreign exchange rates under IAS 21
25.1Introduction
25.2Why is the earnings per share Þgure important?
deÞne earnings per share and the PE ratio;
comment critically on the PE ratio of an enterprise in comparison with the
industry average;
the earnings per share, where the multiple represents the number of years earnings required
to recoup the price paid for the share. For example, it would take a shareholder in Company
B just under forty years to recoup her outlay if all earnings were to be distributed, whereas
it would take a shareholder in Company A just over twelve years to recoup his outlay, and
one in Company C just under twenty years.
25.2.1What factors affect the PE ratio?
The PE ratio for a company will reect investors condence and hopes about the inter-
national scene, the national economy and the industry sector, as well as about the current
years performance of the company as disclosed in its nancial report. It is difcult to
Earnings
Weighted number of ordinary shares
642

Companies are required to make this easy for the shareholder by disclosing separately,
Less preference dividend
(100)
Prot for the period attributable to ordinary shareholders 1,150
BEPS
=
1,150,000/1,000,000 shares
=
1.15
Note that it is the
number
of issued shares that is used in the calculation and
not the nominal
value
25.6Adjusting the number of shares used in the basic EPS calculation
comparative gures. However, a problem arises in the year in which the issue took place.
Unless the issue occurred on the rst day of the nancial year, the new funds would have
been
available to generate prots
for only a part of the year. It would therefore be misleading
to calculate the EPS gure by dividing the earnings generated during the year by the
(1,500,000)

(3/12 months)375,000
Time-weighted shares for use in BEPS calculation
1,125,000
BEPS for 20X1 will be 1,150,000/1,125,000 shares
=
1.02

The shares are undervalued.

follows:
Earnings per share
In the UK, examples are found amongst the FTSE 100 companies: e.g. in 1998 NatWest
apportioned from the beginning of the year to the date of buyback.
5/12416,667
31.5.20X1Number of shares bought back by company(240,000)
31.12.20X1 Opening capital less shares bought back760,000
25.7Rights issues
Step 1:Calculate the average price of shares before and after a rights issue
to identify the amount of the bonus the company has granted
Total cost of 3 shares as at 2 January
12.00
Average cost per share unchanged at
4.00
However, this did not happen. Mr Radmand only paid 3.25 for the new share. This
meant that the total cost of 3 shares to him was:

1 share at discounted price of 3.25 on 2 January 20X1
=
3.25
Total cost of 3 shares
=
11.25
Average cost per share (11.25/3 shares)
=
3.75
The rights issue has had the effect of reducing the cost per share of each of the three
shares held by Mr Radmand on 2 January 20X1 by (4.00

3.75)
0.25 per share
.
The accounting terms applied are:

Average cost per share after the rights issue (3.75) is
1 share at discounted rights issue price of 3.25 each
=
3.25
3 shares at fair value after issue (i.e. ex-rights)
=
11.25
Step2:Theweightedaveragenumberofsharesiscalculatedforcurrentyear
=
500,000
1,500,000
However, if a rights issue is made part way through the year, a time-apportionment is
No. of shares
Shares to date of rights issue:
1,000,000 shares held for a full year
=
1,000,000
Shares from date of issue:
3/12)
=
125,000
1,125,000
Note, however, that the 1,125,000 has not taken account of the fact that the new shares
=
1,000,000
Bonus shares deemed to be issued to existing shareholders
=
66,667
Bonus share for period of 9 months to date of issue
(66,667/12
×
9)
=
50,000
The bonus shares for the nine months are added to the existing shares and the time
No. of shares
Shares to date of rights issue:
1,000,000 shares held for a full year
=
1,000,000
Shares from date of issue:
3/12)
=
125,000
1,125,000
Bonus share:
9)
=
50,000
¥
649
The same gure of 1,175,000 can be derived from the following approach using the
BEPS as follows by multiplying it by the reciprocal of the bonus fraction:
=
As restated in the 20X1 accounts as at 31.12.20X1
=
1.15

(3.75/4.00)
=
1.08
3.75
4.00
Actual cum-rights share price
25.7.1Would BEPS for current and previous year be the same if the
93,750
Step 2:Allocate the total bonus shares to the 1,000,000 original shares
3/12 months
=
16,667
Step 3:Time-weight the rights issue and allocate bonus shares to
3/12 months 6,770
Weighted average ordinary shares (includes shares from Steps 2 and 3)1,175,000
Step 4:BEPS calculation for 20X1
£1,175,000
¥
651
Step 5:BEPS restated for 20X0
There were 93,750 bonus shares issued in 20X1. The 20X0 BEPS needs to be reduced,
therefore, by the same proportion as applied to the 1,000,000 ordinary shares in 20X1,
i.e. 1,000,000:1,066,667
20X0 BEPS

bonus adjustment
=
restated 20X0 BEPS
i.e. 20X0
=
1.15

(1,000,000/1,066,667)
=
1.08
This approach illustrates the rationale for the time-weighted average and the restatement
26.1Introduction
The main purpose of this chapter is to explain the reasons for preparing a statement of cash
ows and how to prepare a statement applying IAS 7.
26.2Development of statements of cash ows
At the end of an accounting period, an income statement is prepared which explains
Objectives
By the end of this chapter, you should be able to:

prepare a statement of cash ows in accordance with IAS 7;

analyse a statement of cash ows;

critically discuss their strengths and weaknesses.
was issued, requiring companies to
publish a funds ßow statement with the annual accounts.
Source and Application Statement for the year ended 31.12.20X9
Sources of funds
Funds from operations
1,000
600
2,300
Application of funds
Tax paid
250
Dividends paid
100
80
26.2.2Statement of cash ßows
widespread support for the belief thatstatements of cash ßow
The overwhelming reason for replacing a funds ow statement with a statement of
cash ows was that the latter provides more relevant and useful information to users of
nancial statements. When used in conjunction with the accrual-adjusted data included
in the statement of comprehensive income and the statement of nancial position, cash
ow information helps to assess liquidity, viability and nancial exibility. This view is held
by Henderson and Maness, who stress the need to integrate different types of analysis to
achieve an overall assessment of an organisations nancial health: cash ow analysis should
and reward the investors with an acceptable dividend policy. The end-result is that, inde-
pendent of reported prots, if an organisation is unable to generate sufcient cash, it will
eventually fail.
Statements of cash ows can also be used to evaluate any economic decisions related to
the nancial performance of an organisation. Decisions made on the basis of expected cash
ows can be monitored and reviewed whenever additional cash ow information becomes
available.
that provides insight into the amounts, timings and certainty of a companys future cash
receipts and payments is useful in evaluating solvency. Statements of past cash receipts
and payments are useful for the same basic reason that statements of comprehensive
income are useful in evaluating protability: both provide a basis for predicting future
performance.
9
26.3Applying IAS 7 (revised)
Statements of Cash Flows
26.3.1IAS 7 issued
IAS 7 was revised and renamed again in 2008 by the IASB to require companies to issue
a statement of cash ows. Its objective was to require companies to provide standardised
reports on their cash generation and cash absorption for a period. Its principal feature was
the analysis of cash ows under
three
standard headings of operating activities, investing
activities and nancing activities. Accounting commentators said that information on cash
is an essential part of a companys nancial statements.
direct

Number of shares under option
500,000
)
Number that would have been issued
At fair value (500,000

3.25)/4
(406,250)
Diluted EPS
1.05 1,150,000 1,093,750
)
25.8.5Procedure where there are convertible bonds or convertible
preference shares
The post-tax prot should be adjusted
12
for:

any dividends on dilutive potential ordinary shares that have been deducted in arriving at
25.8.6Convertible preference shares calculation illustrated for Watts plc
Assume that Watts plc had at 31 December 20X1:

an issued capital of 1,000,000 ordinary shares of 50p each nominal value;

post-tax earnings for the year of 1,150,000;

convertible 8% preference shares of 1 each totalling 1,000,000, convertible at one
ordinary share for every ve convertible preference shares.
The computation of basic and diluted EPS for convertible bonds is as follows:
Per shareEarningsShares
Number of shares resulting from conversion
200,000
Add back the preference dividend paid in 20X1
80,000
Adjusted earnings and number of shares
1,230,000 1,200,000
Diluted EPS (1,230,000/1,200,000)
1.025
25.8.7Convertible bonds calculation illustrated for Watts plc
Assume that Watts plc had at 31 December 20X1:

an issued capital of 1,000,000 ordinary shares of 50p each nominal value;

post-tax earnings after interest for the year of 1,150,000;

convertible 10% loan of 1,000,000;

Interest expense on convertible loan
100,000
Tax liability relating to interest expense
Assuming the rms marginal tax rate is 40%
(40,000)
Adjusted earnings and number of shares
1,210,000 1,250,000
Diluted EPS (1,210,000/1,250,000)
0.97
25.9Procedure where there are several potential dilutions
Where there are several potential dilutions the calculation must be done in progressive
stages starting with the most dilutive and ending with the least.
13
Any potential antidilutive
(i.e. potential issues that would increase earnings per share) are ignored.
654

Ñ93,750
1,150,000 1,093,7501.05 dilutive
60,000 250,000
1,210,000 1,343,750 0.90 dilutive
80,000 25,000
1,290,0001,368,750 0.94 antidilutive
Since the diluted earnings per share is increased when taking the convertible preference
shares into account (from 90p to 94p), the convertible preference shares are antidilutive and
are ignored in the calculation of diluted earnings per share. The lowest gure is selected and
the diluted EPS will, therefore, be disclosed as 90p.
25.10Exercise of conversion rights during nancial year
Shares actually issued will be in accordance with the terms of conversion and will be
included in the BEPS calculation on a time-apportioned basis from the date of conversion
to the end of the nancial year.
25.10.1Calculation of BEPS assuming that convertible loan has been
converted and options exercised during the nancial year
This is illustrated for the calculation for the year 20X2 accounts of Watts plc as follows.
Assume that Watts plc had at 31 December 20X2:

an issued capital of 1,000,000 ordinary shares of 50p each as at 1 January 20X2;

convertible 10% loan of 1,000,000
converted
on 1 April 20X2 into 250,000 ordinary
shares of 50p each;

share options for 500,000 ordinary shares of 50p each
exercised
on 1 August 20X2.
The weighted average number of shares for BEPS is calculated as follows:
Options
93,750
1,150,000 1,093,750 1.05 dilutive
10% convertible bonds
60,000 250,000
1,210,000 1,343,750 0.90 dilutive
Convertible preference shares
80,000 25,000
1,290,0001,368,750 0.94 antidilutive
25.11Disclosure requirements of IAS 33
The standard
14
requires the following disclosures:
For the current year:

Companies should disclose the basic and diluted EPS gures for prot or loss from

, February 2005, pp. 77Ð78) supports the Þnding that the
REVIEW QUESTIONS
1
Explain: (i) basic earnings per share; (ii) diluted earnings per share; (iii) potential ordinary shares;
and (iv) limitation of EPS as a performance measure.
2
Dividends
(39.4)(39.4)(37.2)
Attributable tax
0.3
Prot for year attributable to shareholders for calculating
the underlying earnings per share
86.3
84.0
The directors state that the underlying basis is a more appropriate basis for comparing perform-
outstanding basic
16,774,51516,874,89916,778,962
Effect of dilutive securities:
Options

365,528
Weighted average number of shares
outstanding diluted
16,774,51516,874,89917,144,490
For 2002 and 2001 options and warrants were not included in the computation of diluted earnings
per share because they were antidilutive. Warrants were not dilutive in 2000.
660

(a)why the BEPS shares were weighted; and
(b)what is meant by antidilutive.
Would the following items justify the calculation of a separate EPS Þgure under IAS 33?
(a)A charge of £1,500 million that appeared in the accounts, described as additional provisions
relating to exposure to countries experiencing payment difÞculties.
(b)Costs of £14 million that appeared in the accounts, described as redundancy and other non-
recurring costs.
(c)Costs of £62.1 million that appeared in the accounts, described as cost of rationalisation and
withdrawal from business activities.
(d)The following items that appeared in the accounts:
(i)ProÞt on sale of property
(ii)Reorganisation costs
(iii)Disposal and discontinuance of hotels£659m
Income smoothing describes the management practice of maintaining a steady proÞt Þgure.
(a)Explain why managers might wish to smooth the earnings Þgure. Give three examples of how
(b)It has been suggested that debt creditors are most at risk from income smoothing by the
managers. Discuss why this should be so.
Earnings per Share
(a)DeÞne the proÞt used to calculate basic and diluted EPS.
ProÞt for adjusted basic EPS calculation
£112.0mEPS: £27.3p
Depreciation
£103.0mEPS: £25.1p
ProÞt for adjusted cash EPS calculation
£215.0mEPS: £52.4p
Discuss the relevance of an adjusted cash EPS.
An extract from the outline solution is provided on the Companion Website (www.pearsoned.co.uk/
elliott-elliott) for exercises marked with an asterisk (*).
Alpha plc had an issued share capital of 2,000,000 ordinary shares at 1 January 20X1. The nominal
Question 2
Nottingham Industries plc
Statement of comprehensive income for the year ended 31 March 20X6
(extract from draft unaudited accounts)
000
Prot on ordinary activities before taxation(Note 2)
(1,000)
Tax on prot on ordinary activities
(Note 3)
(420)
Prot on ordinary activities after taxation
580
Notes:
1Called-up share capital of Nottingham Industries plc:
In issue at 1 April 20X5:
16,000,000 ordinary shares of 25p each
1,000,000 10% cumulative preference shares of 1 each
1 July 20X5: Bonus issue of ordinary shares, 1 for 5.
have been written off or provided for in the ordinary way.
(ii)Provision for loss through expropriation of the business of an overseas subsidiary by a foreign
government, 400,000.
662

5In the published accounts for the year ended 31 March 20X5, basic EPS was shown as 2.2p; fully
diluted EPS was the same Þgure.
6Dividends paid totalled £479,000.
(a)On the basis of the facts given, compute the basic EPS Þgures for 20X6 and restate the basic
(b)Compute the diluted earnings per share for 20X6 assuming that on 1 January 20X6 executives
of Nottingham plc were granted options to take up a total of 200,000 unissued ordinary shares
at a price of £1.00 per share: no options had been exercised at 31 March 20X6. The average
(c)Give your opinion as to the usefulness (to the user of Þnancial statements) of the EPS Þgures
*Question 4
The following information relates to Simrin plc for the year ended 31 December 20X0:
Turnover
Operating costs
Trading proÞt
Exceptional charges
Tax on ordinary activities
ProÞt after tax
Simrin plc had 100,000 ordinary shares of £1 each in issue throughout the year. Simrin plc has in issue
warrants entitling the holders to subscribe for a total of 50,000 shares in the company. The warrants
may be exercised after 31 December 20X5 at a price of £1.10 per share. The average fair value of
shares was £1.28. The company had paid an ordinary dividend of £15,000 and a preference dividend
(a)Calculate the basic EPS for Simrin plc for the year ended 31 December 20X0, in accordance
with best accounting practice.
(b)Calculate the diluted EPS Þgure, to be disclosed in the statutory accounts of Simrin plc in
(c)Brießy comment on the need to disclose a diluted EPS Þgure and on the relevance of this Þgure
(d)In the past, the single most important indicator of Þnancial performance has been earnings per
*Question 5
Gamma plc had an issued share capital at 1 April 20X0 of:

200,000 made up of 20p shares.

50,000 1 convertible preference shares receiving a dividend of 2.50 per share:
these shares were convertible in 20X6 on the basis of 1 ordinary share for 1 preference
share.
There was also loan capital of:

250,000 10% convertible loans:
the loan was convertible in 20X9 on the basis of 500 shares for each 1,000 of loan;
the tax rate was 40%.
Earnings for the year ended 31 March 20X1 were 5,000,000 after tax.
Required:
(a)Calculate the diluted EPS for 20X1.
(b)Calculate the diluted EPS assuming that the convertible preference shares were receiving a
dividend of 6 per share instead of 2.50.
Question 6
Delta NV has share capital of
A
lm in shares of
A
Average fair value for year of ordinary shares
1.50
1Share options have been granted to directors giving them the right to subscribe for ordinary
2The company has £20 million of 6% convertible loan stock in issue. The terms of conversion of
the loan stock per £200 nominal value of loan stock at the date of issue were:
Conversion date
No. of shares
Question 9
The capital structure of Chavboro, a quoted company, during the years ended 31 October 2005 and
2006 was as follows:
$
6,000,000 ordinary shares of 50 cents
3,000,000
10% preferred shares of $1
200,000
300,000 deferred ordinary shares of $1
300,000
12% convertible loan stock
250,000
The company has an executive share option scheme which gives the companys directors the option
to purchase a total of 100,000 ordinary shares for $2.10 each. During the year ended 31 October 2006
no shares were issued in accordance with the share incentive scheme and the companys obligations
under the scheme remained unchanged.
On 31 August 2006 Chavboro plc made a 1 for 6 rights issue at $2.50 per share. The cum-rights price
on the last day of quotation cum rights was $2.85 per share. The shares issued in the rights issue are
not included in the gure for ordinary shares given above.
The deferred ordinary shares will not rank for dividends until 1 November 2010 when they will each
be divided into two 50 cents ordinary shares ranking
pari passu
with the other ordinary shares then
in issue.
The 12% loan stock is convertible into 50 cents ordinary shares on the following terms:
(i)if the option is exercised on 1 November 2007 each $100 of loan stock can be converted into
40 ordinary shares;
(ii)if the option is exercised on 1 November 2008 each $100 of loan stock can be converted into
35 ordinary shares.
The following information comes from the statement of comprehensive income of the company for
the year ended 31 October 2006:
$
Prot before interest and tax
1,253,000
less Interest
30,000
1,223,000
less Income tax, at 30%
366,900
Prot attributable to shareholders
856,100
You may assume that the yield on 2.5% government consolidated stock was 7.5% on 1 November
2005 and 6% on 1 November 2006, and that the rate of income tax is 30% throughout. Chavboro
plcs reported earnings per share for the year ended 31 October 2005 were 10 cents.
666

(a)Calculate Chavboro plcÕs basic earnings per share in cents for the year ended 31 October 2006.
(b)Calculate Chavboro plcÕs restated earnings per share in cents for the year ended 31 October
(c)Calculate Chavboro plcÕs fully diluted earnings per share in cents for the year ended 31 October
(d)Calculate Chavboro plcÕs fully diluted earnings per share in cents for the year ended 31 October
(e)How can an investor evaluate the quality of the earnings per share Þgure published in a companyÕs
The Association of International Accountants
1J. Day, ÔThe use of annual reports by UK investment analystsÕ,
Autumn 1986, pp. 295Ð307.
2London Business School,
3IAS 33
10IAS 33, para. 31.
15Statement of Investment Practice No. 1,
16Coopers and Lybrand,
26.4.1The IAS 7 format is as follows
ProÞt before tax
x
Adjustments for:
Depreciation
x
Foreign exchange loss
x
Investment income
(x)
x
Operating proÞt before working capital changes
x
Increase in trade and other receivables
(x)
Decrease in inventories
x
(x)
Cash generated from operations
x
(x)
Income taxes paid
(x)
Cash ßow before extraordinary item
x
x
(x)
x
x
26.4.2Step approach to preparation of a statement of cash ßows Ð indirect
Step 1
Trade receivables
640
900
260PBT adjustment/decrease
Government securities
20
20Cash equivalent
Cash
80
10
70Cash equivalent
1,520
2,130
Current liabilities
Trade payables
540
500
40PBT adjustment/decrease
Taxation
190
170
20C
ash ow from operations
Dividends



Overdraft
8
478
470Cash equivalent
738
1,148
2,850
3,280
Share capital
1,300
1,400100Financing/increase
Share premium a/c
200
400200Financing/increase
Prot for year

180
10% loan 20

4
200
15050Financing/decrease
2,850
3,280
Step 2
: Identify any items in the Income statement for the year ended 31.3.20X9 after
Prot before Interest and tax (PBIT) to be entered under operating activities, investing or
nancing.
000000
Sales
3,000
Cost of sales
2,000
Gross prot
1,000
Distribution costs300
Administrative expenses180480
PBIT
520
Interest expense
(20)Add back interest expense to PBT
Prot before tax
500PBT as the rst Operating activities entry
Income tax expense
(200)Operating activities/decrease
Prot after tax
300
Dividend paid
120Financing/decrease
From Step 3 (ii)102
From Step 3 (iv)(13)
No accrual or prepayment(20)
170)(220)
80
Š
87
2
At 31.3.20X8Cost2,520Accum. depreciation
Additions560Charge for year
Disposal*320Disposal
From this we can see that there are four impacts:
(i)
Additions: The cash of 560,000 paid out on additions will appear under Investing.
(ii)
The depreciation charge: This is a non-cash item and the 102,000 will be added back
as a non-cash item to the Prot before tax in the Operating activities section.
(iii)
Disposal proceeds: The cash received from the disposal will appear under Investing. It
is calculated as NBV of 228,000 (320,000

92,000)
+
the prot gure of 13,000
=
241,000.
(iv)
Prot on disposal: As the full proceeds of 241,000 are included under Investing,
there would be double counting to leave the prot of 13,000 within the Prot before
tax gure. It is therefore deducted as a non-cash item from PBT in the Operating
activities section.
Cash paid to suppliers and employees (b)
(2,831)
Cash generated from operations
(91)
(a)
Cash received from customers
000
Sales
3,000
Receivables increase
260
2,740
(b)
Cash paid to suppliers and employees
000
Cost of sales
2,000
Payables decreased
40
Inventory increase
400
Depreciation
(102)
Prot on sale
13
Distribution costs
300
Administration expenses
180
2,831
26.4.4Additional notes required by IAS 7
As well as the presentation on the face of the cash ow statement, IAS 7 requires notes to
the cash ow statement to help the user understand the information. The notes that are
required are as follows:
676

If the entity has entered into major non-cash transactions that are therefore not represented
on the face of the cash ßow statement sufÞcient further information to understand the trans-
20X920X8
1080
20
(478)(8)
(448)(72)
26.5Consolidated statements of cash ßows
26.5.1Additional items
1Operating activities
ÐShare of proÞt of associate.
2Investing activities
ÐDividends received from associates.

Purchase of a subsidiary, interest in an associated/joint venture undertaking or of a
business.

Receipt from the disposal of a subsidiary, interest in an associated/joint venture
undertaking or of a business.
3Financing activities

Dividends paid to non-controlling interests (this is calculated as non-controlling interests
in the opening consolidated statement of nancial position plus non-controlling interests
in the statement of comprehensive income less non-controlling interests in the closing
statement of nancial position).
26.5.2Adjustments to amounts
Adjustments are required if the closing statement of nancial position items have been
increased or reduced as a result of
non-cash movements
. Such movements occur if there
Cash
5Show as cash acquired in the investing section
Cash
3Show as payment to acquire subsidiary in the investing
section
23
The Tyro Bruce consolidated statement of cash ows prepared using the indirect
10(390)
(40)
trade payables brought in on acquisition(12)(52)
(93)
Interest paid (
from statement of comprehensive income
(20)
190
Š
170)
(220)
241
Payment to acquire subsidiary
(3)
5
(50)
from statement of comprehensive income
(120)
72
26.6Analysing statements of cash ßows
In addition to interest cover, lenders want to be satised that their loan will be repaid. Failure
to do so could lead to a going concern problem for the company. One measure used is to
calculate the ratio of cash ow from operations less dividend payments to total debt and, of
more immediate interest, to loans that are about to mature. The ratio can be adjusted to
reect the companys current position. For example, if there is a signicant cash balance, it
The ratio of cash ßow from operating activities less interest paid to dividends paid indicates
This seems to indicate a possible increase in productive capacity. However, the cash ow
there is a view that such an analysis provides additional information, provided the break-
Free cash ßow per share is a measure of the cash which is freely available, after
2007200620052004
9799501,5111,374
(i)Free cash ßow margin %
8.0%12.5%11.5%9.6%
indicate that in each of the years there was a positive operating cash margin with almost 4%
In the UK FRS 1 requires companies to reconcile the movement in cash ows to the movement
provide information that assists in the assessment
of liquidity and solvency
IAS 7, however, does not require such a disclosure.
By way of illustration, the notes prepared under FRS 1 for Tyro Bruce (see section 26.4.2
above) would appear as follows:
20X9
20X8
1
Borrowings
(150)
(200)
Overdraft
(478)
(8)
Government securities
20
Cash
10
80
(448)
72
(598)
(128)
2
Decrease in cash
(520)
50
(470)
(128)
(598)
3
20X8Cash ow20X9
Cash at bank
80(520)10
Government securities
20
Overdraft
(8)
(478)
Debt outstanding
(200)50(150)
(128)(470)(598)
26.7Critique of cash ow accounting
IAS 7 (revised) applies stricter requirements to the format and presentation of cash ow
The management of any enterprise may put considerable emphasis on the cash ßow effects of its
decisions and actions, monitoring these with the internal reporting system. Cash ßow information
is also relevant to those with external interests in the enterprise. Discuss the importance of cash
ßow information for both internal and external decisions. What internal and external user needs
does cash ßow reporting satisfy? Is the current cash ßow information adequate for these purposes?
from the current or comparative statements of Þnancial position.
Company X has both a large cash balance and high borrowings. Explain why cash might not have
been used to reduce debt.
Explain how a payment under a Þnance lease would be treated.
Discuss the limitations of a cash ßow statement when evaluating a companyÕs control over its
working capital.
potential Þnancial problems and for allowing too much choice to companies in how
686

EXERCISES
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
Question 1
Direct plc provided the following information from its records for the year ended 30 September
20X9:
B
000
Sales
316,000
Cost of goods sold
110,400
Other expenses
72,000
Rent expense
14,400
Dividends
10,000
Amortisation expense
PPE
8,000
Advertising expense
4,800
Gain on sale of equipment
2,520
Interest expense
320
20X920X8
Accounts receivable
13,20015,200
Unearned revenue
8,0009,600
Inventory
18,40019,200
Prepaid advertising
0400
Accounts payable
11,2008,800
Rent payable
01,200
Interest payable
400
Required:
Almost Ready Ltd had extracted the following information from the statement of comprehensive
Proceeds from issue of ordinary shares 405, Dividends paid 1,923, Cash and cash equivalents at
beginning of the period 6,539, Dividends from joint ventures 228, Purchase of investments 29,
Interest received 43, Tax paid 1,389, Purchase of property 115, Cash and cash equivalents at
$000$000$000$000
Property, plant and equipment, at cost
Less accumulated depreciation
Inventory
Trade receivables
4877551907
Share premium
Trade payables
3917845211
1,285
1,577
Statements of cash ßows
¥
687
Statement of comprehensive income for the year ended 31 March 20X9
$000$000
Revenue
2,460
Cost of sales
1,780
Gross prot
680
Distribution costs
(124)
Administration expenses
(300)(424)
Operating prot
256
Interest on debentures
(24)
Prot before tax
232
Tax
(48)
Prot after tax
184
Note: The statement of changes in equity disclosed a dividend of $90,000.
Required:
(a)Prepare the statement of cash ows for Riddle plc for the year ended 31 March 20X9 and show
PPE at cost
1,743,750
1,983,750
Accumulated depreciation
551,2501,192,500619,1251,364,625
Inventory
101,250
85,500
Trade receivables
252,000
274,500
1,545,750
1,724,625
Capital and reserves
Common shares of
A
1 each
900,000
1,350,000
Share premium
30,000
Current liabilities
Trade payables
183,750
159,750
Bank overdraft
75,000
8,250
1,545,750
1,724,625
Note that during the year ended 31 December 20X6:
3A bonus issue was made at the beginning of the year of 1 bonus share for every 3 shares.
4A new issue of 150,000 shares was made on 1 July 20X6 at a price of 1.20 for each 1 share.
5A dividend of 60,000 was declared but no entries had been made in the books of the company.
*Question 5
The statements of Þnancial position of Radar plc at 30 September were as follows:
$000$000$000$000
Less accumulated depreciation
602
Investments
186
214
Inventory
Trade receivables
5933Ñ789
Share premium
Overdraft
586
The following information is available:
(i)An impairment review of the investments disclosed that there had been an impairment of
(ii)The depreciation charge made in the statement of comprehensive income was £64,000.
(iii)Equipment costing £72,000 was sold for £54,000 which gave a proÞt of £16,000.
(iv)The debentures redeemed in the year were redeemed at a premium of 25%.
(v)The premium paid on the debentures was written off to the share premium account.
(vi)The income tax expense was £92,000.
(vii)A dividend of £25,000 had been paid and dividends of £17,000 had been received.

20X1
20X0
000000000000
Plant and machinery
520
194
Motor vehicles
140
62
2,124
1,354
Government securities
40

Bank

22
,
808
484
Current liabilities
Trade payables
266
220
Taxation
120
50
Proposed dividend
72
40
Bank overdraft
184

642
310
Non-current liabilities
9% debentures
(432)
(350)
1,858
1,178
20X1
20X0
000000000000
Capital and reserves
Ordinary shares of 50p each fully paid
900
,
800
Share premium account
120
70
Revaluation reserve
360

General reserve
100
50
,
958
378
1,858
1,178
690

20X120X0
£000£000
Operating proÞt
479215
Interest paid
5230
ProÞt before taxation
427185
14965
ProÞt after taxation
278120
Additional information:
Motor
Ñ(60)Ñ
3,750880394
Depreciation at 1 January 20X1
2,211276169
Ñ(48)Ñ
7513285
Depreciation at 31 December 20X1
2,286360254
The plant and machinery disposed of during the year was sold for £20,000.
2During 20X1, a rights issue was made of one new ordinary share for every eight held at a price
3A dividend of £36,000 (20X0 £30,000) was paid in 20X1. A dividend of £72,000 (20X0 £40,000)
was proposed for 20X1. A transfer of £50,000 was made to the general reserve.
(a)Prepare a statement of cash ßows for the year ended 31 December 20X1, in accordance with
(b)Prepare a report on the liquidity position of Martel plc for a shareholder who is concerned
about the lack of liquid resources in the company.
Question 7
The statements of nancial position of Maytix as at 31 October 2005 and 31 October 2004 are as
follows:
2005
2004
$000$000$000$000
Plant and equipment, at cost
7,390
4,182
Less accumulated depreciation
(1,450)
(1,452)
9,940
5,730
Inventory
5,901
4,520
Trade receivables
2,639
2,233
Bank
8,5401,0077,760
18,480
13,490
Capital and reserves
:
Ordinary shares
5,000
3,500
Share premium
2,500
1,000
Current liabilities
:
Trade payables
1,237
1,700
Taxation
550
450
Bank overdraft
2,3334,1202,150
18,480
13,490
The statement of comprehensive income of Maytix for the year ended 31 October 2005 is as follows:
$000$000
Credit sales
9,500
Cash sales
1,047
Cost of sales
(8,080)
Gross prot
2,467
Distribution costs
(501)
Administration expenses
(369)(870)
Operating prot
1,597
Interest on loan stock
(425)
Tax
(550)
Prot after tax
520
692

(i)The
Statement of changes in equityÕ disclosed a dividend paid Þgure of $1,500,000 during the year
Ñ6,278
Annual charge
Ñ(540)(540)
10,460(1,992)8,468
(3,070)542(2,528)
7,390(1,450)5,940
(a)Prepare the Cash Flow Statement of Maytix for the year ended 31 October 2005. Use the
format required by IAS 7 ÔCash Flow StatementsÕ and show operating cash ßows using the
Other operating expenses
(1,000)
¥
693
Buildings
12,330
13,700
18,630
17,000
Receivables
550
1,550
Cash
5,610
610
6,160
2,160
24,790
19,160
Liabilities and equity
Non-current liabilities
Mortgage loan
10,800
10,000
Current liabilities
Payables
700
400
Equity
Issued share capital
5,000
5,000
24,790
19,160
The following exchange rates are available:
1 Swiss franc
=

At 1 November 2005
0.40
At 1 November 2006
0.55
At 30 November 2006
0.53
At 31 January 2007
0.53
At 31 October 2007
0.45
Weighted average for the year ended 31 October 2007
0.50
1IAS 7
2SFAS 95
3IAS 7
4J. Arnold
27.1Introduction
The main purpose of this chapter is to provide an overview of the use of ratios in the analysis
of the statements of comprehensive income and nancial position.
27.2Initial impressions
27.2.1Impressions formed before referring to the annual report
Often, even before looking at the annual report and accounts, analysts have some precon-
ceived ideas and expectations based on global economic conditions and the specic economic
conditions affecting the sector. For example, we have seen in the time of the credit crisis
that the professional accounting bodies and enforcement agencies have issued warnings to
auditors to be aware of the risk that a companys going concern status might be in jeopardy.
Before even opening the annual report there would be questions already forming in the
auditors and analysts minds, such as:
(a)What is the likely impact of the overall economic conditions on the entity? For example:
liquidity might be under pressure;
debt covenants might be broken;
segments might be sold to obtain funds to reduce debt with prot/loss arising from
forced sales.
(b)What is the likely impact of specic economic conditions affecting the sector? For
example, the possibility of:
a signicant fall in revenue, for example, in the building sector;
plant closures in the car making sector;
exceptional costs arising from cost reduction and redundancy programmes.
Objectives
By the end of the chapter, you should be able to:

calculate operating, liquidity and activity ratios from an annual report;

discuss the implication of the ratios;

describe and draft a report using inter-rm and industry comparative ratios;

critically discuss the strengths and weaknesses of ratio analysis;

calculate EBITDA and EBITDA margins for management control purposes.
(c)What is the possibility of misrepresentation? For example, by:
ratio.
There has always been a risk of misrepresentation by management tempted to overstate
Review of Þnancial ratio analysis
expertise lies in knowing which ratios provide relevant information. For example, an
investor would be interested the statement of comprehensive income and the availability of
prots to pay dividends, whereas a credit controller of a supplier would be more interested
in a customers ability to pay and would be concentrating on the statement of nancial
position and liquidity ratios. The relative usefulness of each ratio depends on what aspects
of a companys business affairs are being investigated.
In order to evaluate a ratio, it is customary to make a comparison with the previous years
or industry ratios. It is helpful to bear in mind that:

A comparison is only valid if the same accounting policies have been applied, for example,
both periods or companies using historical cost accounting in reporting their non-current
Review of Þnancial ratio analysis
Figure 27.1Pyramid of key ratios
27.4.1Denition of the key ratios
The ratios have been dened in this text as follows:
Primary investment level ratios
1
Primary investment ratio

the
average
Operating prot
Revenue
Revenue
Capital employed
Operating prot
Capital employed
Capital employed
Shareholders equity
Operating prot
Shareholders equity
700

2007Ð08, with a pre-exceptional operating proÞt of £9.6m. This compared to £8.7m
prot as prot less tax but before interest. It is before interest in order that the numerator
campaign or increasing popular demand as for, say, a PlayStation. Management action
783,366
783,366
318,628
310,133
Review of Þnancial ratio analysis
704

122,919
135,361
601,295
Review of Þnancial ratio analysis
Figure 27.3Pyramid of ratios
might be due to a decline in sales prices or higher cost of sales (which, according to the
Figure 27.4Subsidiary ratios
(b)
the equity ratio;
27.6.2Statement of income ratios Ð income gearing
As far as the equity shareholders are concerned, it might appear that the higher the
new opportunities. For example, HSBC raised 12.5 billion by a rights issue on the basis

How many times does the cash ow from operations currently cover the interest? This
is a useful ratio if prots are not converted into cash, e.g. they might be reinvested in
it have a signicant adverse impact?
A companys attitude to leverage may vary over time
The following is an interesting article in
Management Today
:
6
s...in
s...
of course, another side to the story. Demand for borrowing may be under control, but
27.6.3Liquidity ratios
2008200720062005
0.91.01.21.1
Cost of sales
Closing inventory
Average inventory
Review of Þnancial ratio analysis
(b)Reaction to change in economic circumstances
An example is seen where there has been a decline in demand in the following extract from
the 2007 Annual Report of ThyssenKrupp Steel:
The European steel industry expects business to stabilize at a high level in the coming
Accounts receivable
Sales
712

could be both an increase in the volume of trade receivables and an extension of the collection
In Britain late payments is a problem which is endemic in businesses of all sizes. 53% of
(c)Trade payables turnover Ð payment period
Cost of sales
Sales
Accounts payable
Accounts payable
Review of Þnancial ratio analysis
use the EPS as part of their strategic planning; e.g. the 2005 Annual Report of Gamma
Holding NV states:
PE ratio
The ratio is calculated using the current share price and current earnings. It is a measure of
27.6.8Comparing current ratios with those of the previous year
disclosure restrict the amount of useful information and make it impossible to prepare
every desirable ratio, for example, not all companies publish their gross prot percentage.

There may be different accounting policies. For example, historical cost or revaluation of
27.7.3Ensuring valid inter-Þrm comparisons
27.8Limitations of ratio analysis
Ratios are useful ags but there may be limitations that the reader needs to bear in
mind relating to external factors, internal factors and problems specic to consolidated
accounts.
27.8.1External factors
There are a number of externalfactors that need to be understood. These include:

27.8.2Internal factors
There are internal factors to consider:

ÐHave the accounts been subject to fundamental uncertainty which could affect the
ÐThe end of year Þgures are static and might not be a fair reßection of normal relation-
ÐSimilarly, a decline in the rate of inventory turnover might have arisen from the

making the appropriate choice of comparator companies for benchmarking by nding
27.9.1Why use EBITDA?
Review of Þnancial ratio analysis
REVIEW QUESTIONS
1
Explain how the reader of an annual report prepared for a group might become aware if any
subsidiary or associated company was experiencing:
(a)solvency problems;
(b)protability problems.
14
2
Summary
Financial ratio analysis is integral to the assessment and improvement of company
performance. Financial ratios help to direct attention to the areas of the business that
need additional analysis. In particular, they provide some measure of the protability
and cash position of a company.
ÔUnregulated segmental reporting is commercially dangerous to companies making disclosures.Õ
value, in order to avoid the business showing a loss with this gain on the buyback exceeding the
operating loss. Discuss how this would be reßected in the ratios.
An outline solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-elliott) for
exercises marked with an asterisk (*).
Belt plc and Braces plc were in the same industry. The following information appeared in their 20X9
BeltBraces
200300
Total operating expenses
180275
Required:
*Question 4
The following are the accounts of Bouncy plc, a company that manufactures playground equipment,
Statements of comprehensive income for years ended 30 November
20X620X5
£000£000
ProÞt before interest and tax
2,2001,570
Interest expense
170150
ProÞt before tax
2,0301,420
730520
ProÞt after tax
1,300900
250250
Inventories
2,1002,070
1,7101,540
10,1609,210
Creditors: amounts due within one year
Trade payables
1,0401,130
550450
Bank overdraft
370480
Creditors: amounts due after more than one year
10% debentures 20X7/20X8
1,5001,500
6,7005,650
Capital and reserves
Share capital: ordinary shares of 50p fully paid up
3,0003,000
Share premium
750750
6,7005,650
The directors are considering two schemes to raise £6,000,000 in order to repay the debentures and
Þnance expansion estimated to increase proÞt before interest and tax by £900,000. It is proposed to
(d)Advise management which scheme they should adopt on the basis of your analysis above and
explain what other information may need to be considered when making the decision.
Question 5
Ruby plcSapphire plc
£000£000
Operating proÞt
Interest and similar charges
(144)(60)
385
(164)(145)
ProÞt after taxation
Interim dividend paid
(30)(40)
Preference dividend proposed
Ordinary dividend proposed
(60)(120)
Ruby plcSapphire plc
£000£000
Ordinary shares of 50p each
1,0001,500
15% preference shares of £1 each
Share premium account
17% debentures
12% debentures
2,7102,450
On 1 October 20X3 Ruby plc issued 500,000 ordinary shares of 50p each at a premium of 20%. On
1 April 20X4 Sapphire plc made a 1 for 2 bonus issue. Apart from these, there has been no change
in the issued capital of either company during the year.
(a)Calculate the earnings per share (EPS) of each company.
Question 8
20X5
20X6
000000000000
Freehold land and buildings, at cost
1,200
1,160
Short-term investments
52

Cash at bank and in hand
15
47
1,372
1,893
Current liabilities
Trade payables
520
940
Taxation payable
130
45
Dividends payable
90
105
740
1,090
2,532
3,663
Long-term liability and provisions
8% debentures, 20X9
500
1,500
Provisions for deferred tax
100
180
1,932
1,983
Capital and reserves
Ordinary shares of 1 each
1,400
1,400
Share premium account
250
250
1,932
1,983
728


20X6
EBITDA
1,161
Depreciation
660
Operating prot
501
Interest payable: debentures
150
Prot before taxation
351
Income tax
125
Prot attributable to shareholders
226
Dividends : paid
70
: proposed
105175
(iii)Statement of cash ows
Income taxes paid
(130)(280)
Purchase of property, plant and equipment
(1,620)
Dividends paid
(160)
Cash and cash equivalents at the beginning of the period
15
Cash and cash equivalents at the end of the period
47
Review of nancial ratio analysis

729
Openmirrors.com
Openmirrors.com
At 1 October 20X5
2,0001,6003,600
Additions
1,6201,620
At 30 September 20X6
2,0003,2205,220
Depreciation
At 1 October 20X5
800
9001,700
Charge during the year
40
620660
At 30 September 20X6
8401,5202,360
Beginning of year
1,200
7001,900
End of year
1,1601,7002,860
You are also provided with the following information:
(i)There was a debenture issue on 1 October 20X5 with interest payable on 30 September each year.
(ii)An interim dividend of 70,000 was paid on 1 July 20X6.
(iii)The short-term investment was sold for 59,000 on 1 October 20X5.
Amalgamated Engineering plc makes specialised machinery for several industries. In recent years, the
£000£000£000£000
Inventory
Trade receivables
Short-term investments
Current liabilities
Bank overdraft
Trade payables
375
300
225
225
1,575
6,150
Long-term liability
8% debentures, 20X9
4,650
Capital and reserves
Ordinary shares of £1 each
Share premium account
4,650
Review of Þnancial ratio analysis
(ii)Statements of comprehensive income for the years ended 31 December 20X5 and 20X6:
20X5
20X6
000000000000
Turnover
6,300
6,600
Cost of sales: materials
1,500
1,575
: labour
2,160
2,280
: production: overheads
750
825
4,410
4,680
1,890
1,920
Administrative expenses
1,020
1,125
Operating prot
870
795
Investment income
15

885
795
Interest payable: debentures
120
120
: bank overdraft
15
75
135
195
Prot before taxation
750
600
Taxation
375
300
Prot attributable to shareholders
375
300
Dividends
225
225
You are also provided with the following information:
(ii)Cash ow from operations to current liabilities.
(iii)Cash recovery rate dened as ((cash ow from operations proceeds from sale of
The Housing Department of Chaldon District Council has invited tenders for re-rooÞng 80 houses
on an estate. Chaldon Direct Services (CDS) is one of the CouncilÕs direct services organisations and
it has submitted a tender for this contract, as have several contractors from the private sector.
The Council has been able to narrow the choice of contractor to the four tenderers who have
Chaldon Direct Services
Tandridge Tilers Ltd
Redhill RooÞng Contractors plc
The tender evaluation process requires that the three private tenderers be appraised on the basis of
Þnancial soundness and quality of work. These tenderers were required to provide their latest Þnal
NutÞeldTandridgeRedhill RooÞng
& SonsTilers LtdContractors plc
ProÞt and loss account for year ended 31 March 20X4
£££
Turnover
611,6001,741,2003,080,400
Direct costs
(410,000)(1,190,600)(1,734,800)
Other operating costs
(165,000)(211,800)(811,200)
Interest
Ñ(85,000)(96,000)
Statement of Þnancial position as at 31 March 20X4
£££
Inventories and work-in-progress
26,700149,000449,200
69,300130,800240,600
(11,000)10,400
(92,600)(140,600)(279,600)
Proposed dividend
Ñ(91,800)(70,000)
Ñ(800,000)(1,200,000)
47,800800,2002,040,800
47,800
Ñ
Ñ
Ordinary shares @ £1 each
Ñ250,0001,000,000
Reserves
Ñ550,2001,040,800
47,800800,2002,040,800
NutÞeld & Sons employ a workforce of six operatives and have been used by the Council for four
table:
KensingtonWimbledonIndustrial average
Protability ratios
ROCE before tax %
22
28
20
80.0
20.0
65.0
734

(a)Prepare a performance report for the two companies for consideration by the directors of
28.1Introduction
The main purpose of this chapter is to explain the selective use of ratios required to satisfy
specic user objectives.
28.2Improvement of information for shareholders
There have been a number of discussion papers, reports and voluntary code provisions from
professional rms and regulators making recommendations on how to provide additional
information. These have some common themes which include: (a) making nancial infor-
mation more understandable and easier to analyse; (b) improving the reliability of the
historical nancial data; and (c) the opportunity for investors to form a view as to the
businesss future prospects.
28.2.1Making nancial information more understandable and easier
to analyse
There has been a view that users should bring a reasonable level of understanding when
reading an annual report. This view could be supported when transactions were relatively
simple. It no longer applies when even professional accountants comment that the only
people who understand some of the disclosures are the technical staff of the regulator and
CHAPTER
28
Analytical analysis selective use
of ratios
Objectives
By the end of the chapter, you should be able to:


critically discuss various scoring systems for predicting corporate failure;

critically discuss remuneration performance criterion;

calculate the value of unquoted investments;

critically discuss the role of credit rating agencies.
now is for managers to share their assessment of future business prospects so that investors
can make informed investment decisions.
28.2.7Disclosure of strategies
In 1999 the ICAEW produced a report
plus equity. It allows us to form a view on the nancing of the business. In particular the
We will illustrate with using the statement of Þnancial position of Vertigo plc as at 1 April
340
3,021
11
Equity and reserves
3,000
41
£000%
84121.8
3,862100
3,26284.5
60015.5
3,862100
Analytical analysis Ð selective use of ratios
From this we can see that the company has a strong statement of nancial position in that
low at 18.4%. First impression is that the nancial structure is sound.
Total
4,342100
Equity
3,26275.1
Debt
60013.8
Current liabilities
48011.1
Total
4,342100
The long-term debt to total liabilities ratio is 13.8% and we can see the current position
appears relatively high with a current ratio of 2.75:1.
Vertigo, to support its search for additional funds, has also produced a forecast statement
for the following year as shown below.
Vertigos statements for 20X7 and 20X8 are as follows:
20X720X8
000000
Motor vehicles
441394
Investments
340340
3,0212,834
Trade receivables
9121,181
Cash and bank
119
4,3424,587
000
Equity and reserves
:
Ordinary shares of 50p each
3,0003,000
3,2623,353
5% Debentures (repayable in 8 years)600600
Current liabilities
:
Trade payables
398498
Accrued expenses
1215
Taxation
2924
Bank overdraft
4197
4,3424,587
740

20X720X720X820X8
£000%£000%
4,3421004,587100
3,26275.13,35373.1
60013.860013.1
48011.163413.8
4,3421004,587100
9121,181
119
398498
1215
2924
4197
Analytical analysis Ð selective use of ratios
20X720X8
TimesTimes
However, the increase in working capital has led to a greater reliance on bank overdraft
facilities and is a cause for concern.
chase late payment?
28.3.5Overview of the cost structures vertical analysis
Preparing a common size statements of income gives an indication of the cost structure so
that we an see the relative signicance of costs.
The income statements of Vertigo plc for 20X7 and 20X8 are as follows:
20X720X8
000000
Sales revenue
3,2963,461
Inventory

1.4.20X7
253398
Purchases
2,3852,623
Inventory

31.3.20X8
(398)(563)
Cost of goods sold
(2,240)(2,458)
Gross prot
1,0561,003
Distribution costs:
Depreciation
239187
Bad debts
3217
Advertising
9424
Administrative expenses:
Rent
6060
Salaries & wages
316362
Miscellaneous expenses
212237
Operating prot
103116
Dividend received
51
Prot before taxation
154116
Taxation
(39)(25)
Prot after taxation
11591
742

20X720X720X820X8
£000%£000%
3,296100.03,461100.0
2,24068.02,45871.0
1,05632.01,00329.0
36511.12286.6
58817.865919.0
20X720X8
£000£000% change
3,2963,461
2,2402,458
1,0561,003-5.0
365228-37.8
588659
Horizontal analysis
20X720X8
000000% change
Sales revenue
3,2963,461
+
5.0
Inventory Opening
253398
Purchases
2,3852,623
+
10.0
Inventory Closing
(398)(563)
+
41.5
Cost of goods sold
(2,240)(2,458)
+
9.7
Gross prot
1,0561,003

5.0
Distribution costs:
Depreciation
239187

2.2
Bad debts
3217

46.9
Advertising
9424

74.5
Administrative expenses:
Rent
6060
Salaries and wages
316362
+
14.6
Miscellaneous expenses
212237
+
11.8
Operating prot
103116
+
12.6
The changes are then reviewed for (a) distribution costs an (b) administrative expenses.
(a)Review of distribution costs
increased to 126 days. This raises a query as to the companys credit control and possibility
of more bad debts.
(b)Review of administration expenses
Salaries and administration expenses have increased signicantly.
excessive level of debt.
744

current ratio is high at 2.75:1 and if the trade receivables are recoverable and if the credit
period were reduced to 90 days the overdaft would be eliminated.
The control over working capital requires further enquiry. The days credit allowed and
taken and inventory turnover rates have been calculated. This appears to indicate a lack
A number of indices have been created which only include companies that are shariah
compliant such as the MSCI
4
Global Islamic Indices and the Dow Jones
5
Islamic index. It
28.4.3Dow Jones Islamic Indexes
Other indices
There are a number of other indices including the FTSE Global Islamic Index Series; the
FTSE SGX Shariah Index Series; the FTSE DIFX Shariah Index Series and the FTSE
Analytical analysis Ð selective use of ratios

provide quarterly and annual nancial statements;

remain within certain ratios whilst ensuring that each agreed ratio is not so restrictive that
it impairs normal operations:
maintain a current ratio of not less than an agreed ratio say 1.6 to 1;
Borrowers will normally have prepared forecasts to assure themselves and the lenders that
compliance is reasonably feasible such forecasts will also normally include the worst case
scenario, e.g. taking account of seasonal uctuations that may trigger temporary violations
with higher borrowing required to cover higher levels of stock and debtors.
If any violation has occurred, the lender has a range of options, such as:

amending the covenant, e.g. accepting a lower current ratio; or

granting a waiver period when the terms of the covenant are not applied; or

granting a waiver but requiring the loans to be restructured; or

28.5.2Risk of aggressive earnings management
In 2001, before the collapse of Enron, there was a consensus amongst respondents to the
UK Auditing Practices Board Consultation Paper
Aggressive Earnings Management
that
aggressive earnings management was a signicant threat and actions should be taken to
diminish it. It was considered that aggressive earnings management could occur when there
reduce tax liabilities or to increase proÞts to ensure compliance with loan covenants.
In 2004, as a part of the
combined to produce an informative end-result? How should individual ratios be ranked to
give the user an overall picture of company performance? How reliable are all the ratios
can users place more reliance on some ratios than others?
We will now discuss how Z-scores, H-scores and A-scores address this.
Z-score analysis can be employed to overcome some of the limitations of traditional ratio
analysis. It evaluates corporate stability and, more importantly, predicts potential instances
of corporate failure. All the forecasts and predictions are based on publicly available nancial
statements.
9
The aim is to identify potential failures so that the appropriate action to reverse
the process [of failure] can be taken before it is too late.
10
28.6.1What are Z-scores?
Inman describes what Z-scores are designed for:
Z-scores attempt to replace various independent and often unreliable and misleading
historical ratios and subjective rule-of-thumb tests with scientically analysed ratios
which can reliably predict future events by identifying bench marks above which alls
well and below which there is imminent danger.
11
Z-scores provide a single-value score to describe the combination of a number of key charac-
teristics of a company. Some of the most important predictive ratios are weighted according
to perceived importance and then summed to give the single Z-score. This is then evaluated
against the identied benchmark.
The two best known Z-scores are Altmans Z-score and Tafers Z-score.
Altmans Z-score
The original Z-score equation was devised by Professor Altman in 1968 and developed
further in 1977.
12
The original equation is:
Z
=
0.012
X
1
+
0.014
X
2
+
0.033
X
3
+
0.006
X
4
+
0.999
X
5
where
X
1
=
750

X
PAS-score: performance analysis score
Tafer adapted the Z-score technique to develop the PAS-score. The PAS-score evaluates
company performance relative to other companies in the industry and incorporates changes
in the economy.
The PAS-score ranks all company Z-scores in percentile terms, measuring relative per-
formance on a scale of 0 to 100. A PAS-score of
X
means that 100

X
% of the companies
have scored higher Z-scores. So, a PAS-score of 80 means that only 20% of the companies
in the comparison have achieved higher Z-scores.
The factors are taken from published nancial statements which makes the approach
That is a feature which Paul Woodley, a director of Postern, the group that provides
company doctors for distressed companies, also nds useful. If a company is in trouble,
the H score can be used to show exactly what needs to be done to sort it out.
18
It appears to be a robust, useful and exciting new tool for all user groups. It is not simply
a tool for measuring risk. It can also be used by investors to identify companies whose
752

the share price recovering Ð it can indicate buy situations. It is also used by leading Þrms of
Consider our A-score assessment of DNB Computer Systems plc:
Defects:Weak nance director
2
Poor management depth
1
High staff turnover
3
11
Total A-score:
38
According to our benchmarks, DNB Computer Systems plc is at risk of failure because the
mistakes score is 15 and the overall A-score is 38. Therefore, there is some cause for
concern, e.g. Why did the main project fail? To which of the symptoms was it due?
Whilst it is difcult to see the rationale for either the weightings or the additive nature of
the A-score, and whilst the process can be criticised for being subjective, the identication
of a defect or mistake can in itself be a warning light and give direction to further enquiry.
It is interesting to see the weighting given to the chief executive being an autocrat which
is supported by the experience in failures such as WorldCom in 2002 with the following
comment:
20
Autocratic style
WorldCom pursued an aggressive strategy under Ebber
s...In
1998, Ebbers cemented
his reputation when Worldcom purchased MCI for $40bn the largest acquisition in
corporate history at that tim
e...
But according to one journalist in Mississippi who
followed Worldcom from its inception, the seeds of the disaster were sown from the
start by Ebbers aggressive autocratic management style.
28.6.4Failure prediction combining cash ow and accrual data
There is a continuing interest in identifying variables which have the ability to predict the
likelihood of corporate failure particularly if this only requires a small number of variables.
A recent study
21
indicated that a parsimonious model that included only three nancial
variables, namely, a cash ow, a protability and a nancial leverage variable, was accurate
in 83% of the cases in predicting corporate failure one year ahead.
28.6.5Use of prediction models by auditor reporting on going
concern status
pendent International Investment Research plc:
The accounts have been prepared under the assumption that the Company is a
going concern. The Company is engaged in an industry where losses represent the
It has been used by companies to monitor their performance by comparing their own TSR
28.7.3Performance related remuneration Economic Value Added (EVA)
the 2.145 million. Further enquiry is necessary to assess how well Alpha nv will employ the
It is useful to calculate rate of change over time. However, as for all inter-company com-
parisons of ratios, it is necessary to identify how the WACC and capital employed have been
WACC calculation
This Þgure depends on the capital structure and risk in each country in which a company
has a signiÞcant business interest. For example, the following is an extract from the 2003
Capital structure and cost of capital
Risk free long-term interest rate
4.9%
8.9%60%
Imputed borrowing rate before tax5.9%
28%
Imputed borrowing rate after tax4.2%40%
7.0%
Capital employed deÞnition
The norm is to exclude non-interest-bearing liabilities including current liabilities when
28.8Valuing shares of an unquoted company quantitative process
000000
Freehold land
100
Accumulated depreciation
40
200
Current liabilities
(60)
20
320
Share capital in 1 shares
300
320
20X520X620X720X820X9
3640443842
Dividend payout history: Dividends10%10%12%12%12%
Earnings yieldDividend yield
=
2
17.3
intending to hold the shares as a long-term investment, there might be no need to increase
60,000
+
10%
+
13%
3
Analytical analysis Ð selective use of ratios
Less
: CAPEX
20,000
Cash available for distribution20,000
Note that we are here calculating not distributable prots, but the available cash ow.
2
Required dividend yield:
%
Average dividend yield
8
Lack of negotiability, say
2
Financial risk, say
1.5
11.5
3
Share value:
=
58p
At this price it would be possible for Mr Small to acquire (10,000/58p) 17,241 shares.
28.8.1Valuing shares of an unquoted company qualitative process
In the section above we illustrated how to value shares using the capitalisation of earnings
100
11.5
20,000
300,000
762

had proposed that this information should be disclosed in the
income statement. The proposal did not Þnd support at the exposure stage and it is
suggested that such information should instead be disclosed in the operating and Þnancial
can affect the required yield. If, for example, it is
expected that inßation will fall, this might mean that past percentage yields will be higher

Factors identied in the literature as diminishing achieved price: confused accounts;
nancial position nancing;
covenants.
The ratings are taken seriously by even the largest multinational because they are per-
to AA on
June 16, 2003. These actions reßected the concerns of the two agencies that Sony may
d...We
European Commission Agency Regulation
26
In November 2008, the European Commission adopted a proposal for a Regulation on
Credit Rating Agencies, which would require agencies to have procedures in place to
ensure that:

ratings are not affected by conicts of interest;

ments including the following:

recommendations on the structure of a structured nance product by an NRSRO that
rates the product are prohibited;

agency analysts receiving gifts and negotiating fees are prohibited;

a record of any complaints against an analyst is required; and

Summary
This chapter has introduced a number of additional analytical techniques to comple-
ment the pyramid approach to ratio analysis discussed in the previous chapter.
These techniques include common size vertical analysis and horizontal analysis.
covenants. Corporate failure multivariate models were introduced including the use of
Z-scores, H-scores and A-scores.
The use of TSR and EVA were discussed in the context of performance related
remuneration and the statutory disclosures that appear in annual reports. In addition,
this chapter has described the use of ratios in the valuation of unquoted shares.
Discuss the difÞculties when attempting to identify comparator companies for benchmarking as,
for example, when selecting a TSR peer group.
The Unilever annual review stated:
Total borrowing)/Total debt
6
Explain how and why EVA is calculated.
7
Cash and investments
122039113
100100100100100100
ABCDEF
Capital and reserves
37562585550
Creditors: over one year
125413625
Creditors: under one year
Trade
32853414246
Other
165
141511
Bank overdraft
3
1
8
Total capital employed
100100100100100100
The activities of each company are as follows:
An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliott-
elliott) for exercises marked with an asterisk (*).
The following Þve-year summary relates to Wandafood Products plc and is based on Þnancial state-
ments prepared under the historical cost convention:
Financial ratios
20X920X820X720X620X5
Margin
7.87.57.07.27.3
65.961.348.310.836.5
%59.355.544.010.133.9
20X920X820X720X620X5
Liquidity ratios
Quick ratio
%74.373.378.8113.893.4
Current ratio
%133.6130.3142.2178.9174.7
Working capital
Earnings per ordinary share
Dividend per ordinary share
Trading proÞt
Trading proÞt
Trading proÞt
Analytical analysis Ð selective use of ratios

ings, taxation and dividends.
Required:
*Question 3
Dividends paid and proposed
Current liabilities
£1 Ordinary shares
Additional information:
(i)The half yearly proÞts to 30 September 20X9 show an increase of 25% over those of the corre-
sponding period in 20X8. The directors are conÞdent that this pattern will continue, or increase
even further.
Question 4
Quickserve plc is a food wholesale company. Its nancial statements for the years ended 31 December
20X8 and 20X9 are as follows:
Statements of income
20X920X8
000000
Sales revenue
12,00015,000
Gross prot
3,0003,900
Distribution costs
500600
Administrative expenses
1,5001,000
Operating prot
1,0002,300
Interest receivable
80100
Interest payable
(400)(350)
Prot before taxation
6802,050
Income taxation
240720
Prot after taxation
4401,330
Dividends
800600
Investments
600800
4,8007,800
Cash & bank
1,500200
3,5003,000
000000
Equity and reserves
:
Ordinary shares of 10p each
1,0001,000
Share premium account
1,0001,000
Revaluation reserve
1,1101,750
6,3007,300
Debentures
1,0002,000
Current liabilities
1,0001,500
8,30010,800
772

(a)Describe the concerns of the following users and how reading an annual report might help
(i)Employees
(ii)Bankers
(iii)Shareholders.
(b)Calculate relevant ratios for Quickserve and suggest how each of the above user groups might
R. Johnson inherited 810,000 £1 ordinary shares in Johnson Products Ltd on the death of his uncle in
20X5. His uncle had been the founder of the company and managing director until his death. The
remainder of the issued shares were held in small lots by employees and friends, with no one holding
more than 4%.
R. Johnson is planning to emigrate and is considering disposing of his shareholding. He has had
approaches from three parties, who are:
the companyÕs bankers.
3A Þnancial conglomerate Ð Divest plc. Divest plc is a company that has extensive experience of
acquiring control of a company and breaking it up to show a proÞt on the transaction. It is its
(b)Statement of nancial position of Johnson Products Ltd as at 30 April 20X9:
000000
Aggregate depreciation
216
508
Equipment at cost
649
Aggregate depreciation
353
296
Cash at bank
70
489
Creditors due within one year
(335)
Non-current liabilities
(158)
1,176
Represented by
:
1 ordinary shares
1,080
1,176
(c)Information on the nearest comparable listed companies in the same industry:
Company
(i)Sonar Products Ltd;
(ii)the 20 employees;
(iii)Divest plc.
(b)As accountant for Sonar Products Ltd, estimate the maximum amount that could be offered by
132,800
260,000
Current liabilities
Trade and other payables
Current tax payable
Ordinary shares, 40 cent shares
5% Preferred shares of $1
1,142,400
4,621,290
Property
2,137,500262,5001,875,000
1,611,855515,3551,096,500
696,535298,515398,020
4,445,8901,076,3703,369,520
NX has grown rapidly since its formation in 2000 by Albert Bell and Candy Dale who are currently
directors of the company and who each own half of the companyÕs issued share capital. The company
Analytical analysis Ð selective use of ratios
was formed to exploit knowledge developed by Albert Bell. This knowledge is protected by a number
He wishes to see what the forecast results and position of Esrever Ltd would be if in the ensuing year
its performance were to match the industry averages.
776

At 1 July 20X0, actual Þgures for Esrever Ltd included:
Land and buildings (at written-down value)
Fixtures, Þttings and equipment (at written-down value)
Inventory
12% loan (repayable in 20X5)
Ordinary share capital (50p shares)
For the year ended 30 June 20X1 the following forecast information is available:
20Accounting for groups at the date of acquisition
21Preparation of consolidated statements of Þnancial position after the date
22Preparation of consolidated statements of comprehensive income,
23Accounting for associates and joint ventures
24Accounting for the effects of changes in foreign exchange rates under IAS 21623
xx
Guided tour of MyAccountingLab
xxv
5.4Arguments in support of standards
Consensus-seeking can lead to the issuing of standards that are over-inßuenced by those
Figure 5.1The Financial Reporting Council organisation chart
5.7The Accounting Standards Board (ASB)
The ASB issues mandatory standards (SSAPs and FRSs), conrms that SORPs are not in
conict with its mandatory standards and issues statements of best practice (such as those
on OFR and Interim Reports).
5.7.1SSAPs and FRSs
There are a number of extant standards relating to each of the nancial statements. For
5.8.1Criticism of the FRRP for being reactive
undertaken to reect the Panels comments in their future reporting. Most of this occurred
5.10Why have there been differences in Þnancial reporting?
5.10.2The way in which industry is nanced
Accountancy is the art of communicating relevant nancial information about a business
entity to users. One of the considerations to take into account when deciding what is relevant
is the way in which the business has been nanced, e.g. the information needs of equity
investors will be different from those of loan creditors. This is one factor responsible for
international nancial reporting differences because the predominant provider of capital is
different in different countries.
9
to cast their votes as they see Þt and not to follow the recommendations of the bank.
addition to their control over proxy votes, the Big Three German banks, the Deutsche Bank,
5.10.3The relationship of the tax and reporting systems
that are unique to a single country, e.g. the existence of special reserves to reduce taxable
prots was common in Scandinavia. It has recently been suggested that level of connection
In the USA the Securities and Exchange Commission was established to control listed com-
The directive needs to be routinely updated to reect changing commercial conditions, e.g.

the use of the formats prescribed in the Fourth Directive adjusted for the treatment of
minority interests.
The
Eighth Directive
issued in 1984 dened the qualications of persons responsible
for carrying out the statutory audits of the accounting documents required by the Fourth
and Seventh Directives.
Just as the Fourth and Seventh Directives have been updated to reect changing com-
mercial practices, so the Eighth Directive has required updating. In the case of the Eighth
Directive the need has been to restore investor condence in the nancial reporting system
following the nancial scandals in the US with Enron and in the EU with Parmalat.
The amended directive requires:

independent audit committees to have one nancial expert as a member;

audit committees to recommend an auditor for shareholder approval;

audit partners to be rotated every seven years;

public oversight to ensure quality audits;

the group auditor bears full responsibility for the audit report even where other audit
rms may have audited subsidiaries around the world.
Financial Reporting Standards (IFRSs). The body of IASs, IFRSs and associated inter-
Framework for the Preparation
and Presentation of Financial Statements
accounting standards and improve harmonisation by providing a basis for reducing the

IFRS 7Financial instruments disclosures
IFRS 8Operating segments
IFRS 9Financial Instruments (Phase 1)
5.12What is the impact of changing to IFRS?
5.13Progress towards adoption by the USA of international standards
Global standards will only be achieved when the US fully adopts IFRSs to replace existing
US GAAP. This process started in October 2002 when the IASB and the SEC jointly pub-
going concern considerations and a review of fair value accounting; and
The SEC is considering (and perhaps have to be satisÞed on?) progress in a number of areas
5.15How do reporting requirements differ for non-publicly
By size:
2,200,000 businesses have no employees (about 61% of SMEs).
1,450,000 businesses have an annual turnover of less than 50,000 (about 40% of SMEs).
Entities (FRSSE) or the IFRS for SMEs issued by the IASB in July 2009.
First FRSSE issued
If there are more negative responses than positive, there are rational grounds for a different
Generic relevance
1
Is the standard essential practice for all entities?
2
Is the standard likely to be widely relevant to small entities?
(d)
Disclosure requirements removed
Certain standards apply but the disclosure requirement is removed, e.g. FRS 10
Non-publicly accountable companies have a narrower range of users of their Þnancial state-
However, whereas with publicly accountable companies there is a clear understanding
that the primary user is the equity investor, the question remains for SMEs as to (a) the
This has a familiar ring. It is very like the AEI situation of 1967, almost twenty-ve years
before. The adjustments made are shown in Figure 5.3.
Of course, it is not too difcult to visualise the motivation of the old and new manage-
$500 million falling into bankruptcy (the largest in US corporate history) in 2001.
Ahold
In 2003 Ahold, the worlds third-largest grocer, reported that its earnings for the past two
years were overstated by more than $500 million as a result of local managers recording
124

Regulatory framework an attempt to achieve uniformity
5.17Move towards a conceptual framework
REVIEW QUESTIONS
1
Why is it necessary for nancial reporting to be subject to (a) mandatory control and (b) statu-
tory control?
2
How is it possible to make shareholders aware of the signicance of the exercise of judgement by
directors which can turn prots of 6 million into losses of 2 million?
3
Constructive review of the regulators.
(a)Obtain a copy of the Financial Reporting CouncilÕs Annual Review.
(b)Prepare a proÞle of the members of the ASB.
(c)Comment on the strengths and weaknesses revealed by the proÞle.
(d)Advise (with reasons) on changes that you consider would strengthen the ASB.
Obtain the Þnancial statements of two companies based in different countries. Review the accounting
policies notes. Analyse what the policies tell you about the regulatory environment in which the two
companies are operating.
Consider the interest of the tax authorities in Þnancial reporting regulations. Explain why national tax
authorities might be concerned about the transition from domestic accounting standards to IFRS in
companiesÕ annual reports.
1G. Whittred and I. Zimmer,
2E.R. Farmer,
3www.hm-treasury.gov.uk/press_morris_05.htm
4K. Peasnell, P. Pope and S. Young, ÔBreaking the rulesÕ,
5CESR,
, CESR02Ð
6Coordinating Group on Accounting and Auditing Issues,
7C. Nobes and R. Parker,
2002, pp. 17Ð33.
8J. Freedman and M. Power,
5.5Arguments against standards




Summary
610
Review questions
610
Exercises
611
References
622
24Accounting for the effects of changes in foreign exchange
rates under IAS 21
623
24.1Introduction
623
Exercises
26Statements of cash ßows
26.1Introduction
26.2Development of statements of cash ßows
26.3Applying IAS 7 (revised)Statementsof Cash Flows
26.4IAS 7 (revised) format of statements of cash ßows
26.5Consolidated statements of cash ßows
26.6Analysing statements of cash ßows
26.7Critique of cash ßow accounting
Exercises
27Review of Þnancial ratio analysis
27.1Introduction
27.2Initial impressions
27.3What are accounting ratios?
27.4Six key ratios
27.5Illustrating the calculation of the six key ratios
27.6Description of subsidiary ratios
27.7Comparative ratios: inter-Þrm comparisons and industry averages715
27.8Limitations of ratio analysis
27.9Earnings before interest, tax, depreciation and amortisation (EBITDA)
Exercises
28Analytical analysis Ð selective use of ratios
28.1Introduction
28.2Improvement of information for shareholders
28.3Disclosure of risks and focus on relevant ratios
28.4Shariah compliant companies Ð why ratios are important
28.6Predicting corporate failure
29.3Reports and the ow of information pre-XBRL
783
29.4What are HTML, XML and XBRL?
784
29.5Reports and the ow of information post-XBRL
785
29.6XBRL and the IASB
786
29.7Why should companies adopt XBRL?
786
29.8What is needed to use XBRL for outputting information?
787
29.9What is needed when receiving XBRL output information?
789
29.10Progress of XBRL development for internal accounting
794
29.11Further study
794
Summary
795
Review questions
795
Exercises
796
References
796
Bibliography
797
Part 6
ACCOUNTABILITY
799
30Corporate governance
801
30.1Introduction
801
30.2The concept
801
30.3Corporate governance effect on corporate behaviour
802
30.4Pressures on good governance behaviour vary over time
803

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