Financial accounting May exam Flashcards
Adjusting event after reporting period
- Provide additional evidence of conditions that existed at the statement of financial position date
- Requires adjustments to be made to the financial statements.
Examples of adjusting events
- Discovery of fraud or errors
- Settlement in court of a contingent liability for which an obligation existed at the end of the year
- Significant evidence that a trade receivable was noncollectable at the reporting date.
- Revaluation of an asset that indicates likelihood of impairment at reporting date
Examples of non-adjusting events
- Losses from the destruction of inventory after year end due to natural disaster
- Dividends proposed or declared after the reporting period.
- Potential restructuring implications
- Announcement of a plan to acquire another company
Non-adjusting events
- Concern conditions that did not exist at the statement of financial position date
- Either material or non-disclosure effects ability of users to make proper evaluations and decisions
- Do not adjust financial statements
- Disclose by way of note
Going concern issues
- Deterioration in operating results after year end are non-adjusting events
- However, if of such significance to affect going concern basis of preparation of financial statements - this impacts on the account balances used.
- Financial statements would then need to be prepared on a liquidation process.
Importance of Earnings per share (IAS 33)
- Widely used in financial analysis
- Linked to PE ratio
- Has an influence on share price
- Potential performance indicator
Calculation of EPS
Net profit or loss attributable to ordinary shareholders / weighted average number of ordinary shareholders
IAS 33 defines two EPS figures for disclosure:
Basic EPS - based on ordinary shares currently in issue
Diluted EPS - based on ordinary shares currently in issue PLUS potential ordinary shares
Basic EPS example: A listed company has the following share transactions -
1st jan 200,000 ordinary shares in issue
Issue of 80,00 new ordinary shares for cash on 31st may
Issue of 50,000 new ordinary shares for cash on 1st july
Company buys back 20,000 ordinary shares on 1st sept
Year ended 31st december
earnings are £318,000
Solution: Weighted average number of shares:
200,000 x (5/12)(up until may) = 83,333
280,000 x (1/120 = 23,333
330,000 x (2/12) = 55,000
310,000 x (4/12) = 103,334
= 265,000
EPS = £318,000 / 265,000 = 120 penceBonus (script) Issues-
- No cash is raised , capitalisation of reserves
- bonus shares are issued in proportion to current share holidays
- EPS calculation is based on the total number of shares AFTER the bonus issue.
Note : the date that the bonus issue takes place is irrelevant
Bonus issue example:
B plc has 4,000,000 ordinary shares in issue at 1st jan 20x7
On 30th sept the company made a bonus issue of 1 for 4. Earnings for the year ended 31st dec 20x7 were £500,000. The EPS for 20x6 was 9 pence per share.
Solution: Before bonus issue = 4m shares after bonus issue = 5m shares EPS 20x7 = £500,000/ 500,000 = 10 pence EPS for 20x6 must be restated 9 pence x 4,000,000 / 500,000 = 7.2 pence
Rights issue
- Offer is made to existing shareholders to subscribe for new shares in proportion to current shareholding at a price below the current market price.
Rights issue is equivalent to an issue at full market price plus a bonus issue.
Bonus fraction formula:
FV of share before exercise of rights (cum-rights) / theoretical ex-rights price
Computation of theoretical ex-rights (TERP) =
FV of all shares + cash received from exercise of rights / No. of shares prior to exercise + no. of shares issued
Rights issue example:
C plc has 4,000,000 ordinary shares in issue and ranking for dividend at 31st jan. On 30th sept a rights issue of 1 of 4 at 50p per share was made. The market price of the shares prior to the issue was £1 per share. Earnings for the year ended 31st dec were £500,000. The EPS for the previous year was 9 pence
Solution: 4m shares in issue
rights issue of 1m shares raisig £0.5m
TERP= (£4m + £0.5m) / (4m + 1m = 90p per share
Last years EPS related for bonus issue = TERP / MV(market value) x 9p ie. 90p/100p x 9p = 8.1p
Calculation of no. of shares for current years EPS: multiply no. of shares BEFORE the rights issue by the fraction of the year before the date of issue AND by the bonus fraction (MV/TERP) i.e. 4,000,000 x 9/12 = 3,000,000
3,000,000 x 100p/90p = 3,333,333
Multiply no. of shares AFTER rights issue by fraction of year after date of issue: 5,000,000 x 3/12 = 1,250,000
Weighed average no. of shares = 3,333,333 + 1,250,000 = 4,583,333
EPS = £500,000, 4,583,333 = 10.91 pence
Diluted EPS
- Some financial instruments can give rights to ordinary shares at a future date e.g:
Convertible debt( bonds, debentures) or equity instruments
Share warrants and options
Rights granted under employee share schemes
Contingently issued shares, where shares are issued upon completion of some contractual agreement - If the right holders exercise their entitlement at a future date , the number of shares will increase and may lower (dilute) the EPS
- A diluted EPS must be calculated if this is the case
Diluted EPS example:
A company has net profit available to ordinary shareholders of £4m and has 12 million ordinary £1 shares in issue. The company also has in issue £6 million convertible 5% debentures that are convertible into 3 million £1 ordinary shares. Assume the marginal tax rate is 20%
Solution: Basic EPS= £4m / 12million = 33.33 pence Diluted EPS= £4 m + [(£6million x 5%) x 80%] / 12 million + 3 million = £4.2 million / 15 million = 28 pence Profit before tax = £5m £5.3m Less tax (20%) = £1m £1.06m Net profit = £4m £4.24m
Disclosure of EPS
- Basic and diluted EPS should be shown on the face of the income statement
- Calculation of the weighted average number of shares should be disclosed
- Number of shares used in the diluted EPS should be reconciled to the weighted average number of shares in basic EPS
- Profit attributable to ordinary shareholders should be reconciled to the net profit or loss for the period
Revenue from contracts with customers-
- Revenue recognition is at the core of the accounting process
- The trend of earnings effect the share price (investors) and is often the basis for determining bonuses (management)
- Scope for manipulation
- Research finds that “investors and dealers react negatively to restatements and are more concerned with other financial reporting errors.
Difficulties arise in accounting for revenue when-
- There is a significant probability that the amount invoiced will not be received in full
- Gains arise from unusual or infrequent transactions
- Transactions are spread over several accounting periods
- A single contract involves the supply of multiple goods and services
- The value of the transaction is difficult to determine.
IRFS 15-
Objective - to establish PRINCIPLES that an entity shall APPLY to report useful information about the nature, amount and timing and uncertainty of revenues and cashflows arising from contracts with a customer
- Application of standard mandatory for annual reporting periods starting from 1 jan 2018 onwards.
- Supersedes IAS 18 Revenue, IAS 11 Construction contracts
- Move away from risk and reward - towards control
Revenue recognition when there is uncertainty
Uncertainty as to amount finally due under contract:
- May depend on future events
- Only report amounts which are highly probable of being achieved
- Standard gives examples of factors to consider
Failure to recover the amount due- dealt with in traditional manner (bad and doubtful debt)
IRFS 15: A five step process Memory aid think COPAR
1 Identify the Contract
2 Identify the separate performance Obligations within a contract
3 Determine the transaction Price
14 Allocate the price to performance obligations in the contract
5 Recognise revenue when (or as ) a performance obligation is satisfied
COPAR Step 1; Identify the contract
- A contract can be agreed in writing, orally or through other customary business practices
- An entity can only account for revenue from a contract if it meets the following criteria:
- the parties have approved the contract and each party’s rights can be identified.
- Payment terms can be identified
- The contract has commercial substance
- It is probable that selling entity will receive consideration
COPAR Step 1 Example :Identifying a contract
Aluna co has a year end of 31 dec 20x1. on 30 sept 20x1 aluna co signed a contract with a customer to provide them with an asset on 31 dec 20x1. Control over the asset passed to the customer on 31 dec 20x1. The customer will pay £1m on 30 june 20x2
However, by 31 dec 20x1 Aluna co did not believe it was probable that it would collect the consideration it was entitled to. Therefore the contract cannot be accounted for and no revenue should be recognised.
COPAR Step 2: Identifying the separate performance Obligations within a contract
- Performance obligations are promises to transfer distinct goods or services to a customer.
- Some contracts contain more than one performance obligation
For example: An entity may enter into a contract with a customer to sell a car, which includes one year’s free servicing and maintenance. - An entity might enter into a contract with a customer to provide 5 lectures, as well as to provide a textbook on the first day of the course.
An entity must decide if the nature of a performance obligation is: - To provide the specified goods or services itself (e.g the entity or the principal) OR
- To arrange for another party to provide the goods or services (i.e. the entity is an agent)
If an entity is an agent, then the revenue is recognised based on the fee or commision to which it is entitiled
COPAR Example: Agency sales
Rosemarys co revenue includes £2 million for goods it sold acting as an agent for Elaine co. Rosmary co earned a commission of 20% on these sales and remitted the difference of £1.6 million (included in COS) to Elaine co.
How should the agency sale be treated in Rosemary co’s financial statements?
Solution: Rosemary should not have included £2 million in its revenue, as it is acting as the agent and not the principle. Only the commission element of £400,000 (£2million x 20%) can be recorded in revenue.
COPAR Step 3: Determine the transaction Price
There are a number of issues to consider here: Transaction price(consider) :
Variable consideration - IRFS 15 says that if a contract includes variable consideration (e.g a bonus or penalty) then the entity must estimate the amount it expects to receive, but only include such value within the transaction price if the likelihood of payment is highly probable
Financing - If there is a significant financing component, such as when the customer pays more than a year after receiving the goods or services, then the consideration receivable needs to be discounted to present value using the rate at which the customer borrows the money.
Non-cash consideration - Any non-cash consideration is measured at fair value
Consideration payable to the customer - If consideration is paid to a customer in exchange for a distinct good or service, then it should be accounted for as a separate purchase transaction
Assuming that the consideration paid to a customer is not in exchange for a distinct good or service, an entity should account for it as a reduction in the transaction price.
COPAR Step 4: Allocate the transaction price
The total transaction price should be allocated to each performance obligation in proportion to stand alone selling prices.
If stand alone selling price is not directly observable then it must be estimated.
COPAR Step 5: Recognise revenue
Revenue is recognised when (or as ) the entity satisfies a perfromance obligation by transferring a promised good or service to a customer
An entity must determine a contract inception whether it satisfies the performance obligation over time or at a point in time
Once control of goods or services transfers to the customer, the performance obligation is satisfied and revenue is recognised. This may occur at a single point in time, or over a period of time. If a performance obligation is satisfied over a single point in time, we should consider the following in assessing the transfer in control:
- Present right to payment for the asset
- Transferred legal title to the asset
- Transferred physical possession of the asset
- Transferred the risks and rewards of ownership to the customer
- Customer has accepted the asset
COPAR A full Example - MiTech -
MiTech is a computer business that sells computer hardware. As well as selling computers, it also supplies and installs the software to its customers and provides a technical support package over a number of years. The business commonly sells the supply and installation, and technical support in a combined goods and services contract for £10,000. If sold individually it would cost £9,000 for the software and £2,000 for the technical support.
1: Identify the contract- Combined goods and services contract
2: Identify the separate performance obligations within a contract. - Supplies and installs the software, provides a technical support package.
- The combined goods and services contract has two separate performance obligations, which would need to be separated out and recognised separately.
3: Allocate the transaction price- Software = (9,000/11,000) x 10,000 = £8,182 Technical support = (2,000/11,000) x 10,000 = £ 1,818
4: Recognise revenue when (or as ) a performance obligation is satisfied - The installation of software would be recognised once installed and the provision of technical services over the period of the support service
COPAR A full Example- How it looks in the financial statements - If MiTech sold a combined contract on 1 july 20x7 , demonstate how the transaction would be presented in the financial statements for the year ended 31 dec 20x7.
Additional information:
- The technical support is a 2 year agreement
- To date the customer has made a payment of £10,000
Income statement: £
Revenue
supply and installation 8,182
Tech support 455
= 8,637
Statement of financial position
Non-current liabs:
Deferred income (6/24) 454 balancing no. of months
Current liabs: (12/240 909 CL - always 12 months
= 1,363
How its posted:
Dr Bank/receivables £10,000
Cr Revenue £8,637
Cr Deferred income £1,363
Accounting for leases: What is a lease?
A contract is, or contains, a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
Two parties:
1 Lessee : Has the right to USE the asset (and obtains substantially all the economic benefits from that use)
2 Lessor : Leases the asset to the lessee
Identifying a lease
Control - is conveyed where the customer has both the right to direct the identified assets use AND to obtain substantially all the economic benefits from that use.
However, if the supplier has the right to substitute the asset during the period of use then the customer does not have the right of use of the asset and hence there is no lease
Example 1 : Identifying a lease - For each of the two scenarios explain if the contract is a lease or if it contains a lease.
- Corgi co needs to transport its goods to customers in Europe using rail freight. The company enters a contract with a rail freight carrier for the use of 10 rail cars of a particular type for 5 years.
- Corgi co needs to transport its goods to customers in Europe using rail freight. The company enters into a contract with a rail freight carrier that requires the carrier to transport a specified quantity of goods by using a specified type of rail car in accordance with a stated timetable for five years.
- No suggestion of substitute - lease
- Could substitute with another - not a lease
Why does accounting for leases need an accounting standard?
- Uniformity in the accounting treatment
- Increase transparency in the financial reports
- Reduce the possibility of off-balance sheet financing - adverse
- Consequences on key ratios (e.g gearing)
- Prevent the financial information being manipulated
- Remember our principle: SUBSTANCE OVER FORM
Step by step process - Calculation steps for lessee’s accounting:
- Calculate the PRESENT VALUE of the lease payments at inception.
- Record the amount as the LEASE LIABILITY.
- Capitalise the same AMOUNT PLUS ANY DIRECT COSTS INCURRED.
- Calculate the TOTAL FINANCE COST (interest expense).
- ALLOCATE the finance cost to the lease period.
- Calculate DEPRECIATION on the right of use asset
- RECOGNITION of lease in lessee’s financial statements.
Example question: Accounting for lessee’s accounting
Lease period 3 years
Annual lease payments £4,355
Payments In arrears (end of each year)
Direct costs incurred £2,000
Interest rates (discount rates) 10%
Useful life 3 years
Solution:
Step 1 present value - Year 1 = (4,355/1.10) + Year 2 (4,355/1.1^2) + Year 3 (4,355/1.1^3) = £10,830
Step 2 Lease liability - =£10,830
Step 3 Amount plus any direct costs incurred - £10,830 +£2,000 = £12,830
Step 4 Total finance costs(interest expense) - Lease payments : (3 years x £4,355) = £13,065 Less: PV of the leased obligation (10,830) = £2,235 total finance costs
Step 5 Allocate finance cost
Year A- liability B/F B- Interest C- Payment D- Liability C/F
1 10,830 1,083 (4,355) 7,558
2 7,558 756 (4,355) 3,959
3 3,959 396 (4,355) 0
Total £2,235 £13,065
A = Liability at the opening SFP
B = Finance cost calculated as A x 0.10 (10%)
C = Fixed lease payments to the lessor
D = Liability at the closing SFP calculated as A+B-C
Step 6 Depreciation - ( as you normally would for a capitalised asset per IAS 16) e.g straight line depreciation of 3 years = £12,830/3 = £4,277 per year(rounded)
Step 7 Recognition-
SFP Year 1 Year 2 Year 3
Right of use asset NBV 8,553 4,276 0
Lease liability C/F 7,558 3,959 0
Income statement Year 1 Year 2 Year 3
Depreciation charge 4,277 4,277 4,277
Finance cost 1,083 756 396
Total expense = 5,360 = 5,033 = 4,672
