Semester 1 Tutorial 5 Week 7 Flashcards
The directors of Hammersmith Ltd. (‘Hammersmith’) have approached you for advice on how to account for the following items.
1. Hammersmith have acquired the Funder brand from a competitor for £230,000.
2. Five years ago Hammersmith set up the Kingsley brand of clothing, the brand has become very successful and the directors estimate the brand is worth £830,000.
3. Hammersmith has planning permission to build flats on a vacant site in the city centre. Without planning permission the site would be worth £400,000. With planning permission the site is worth £1.6m. The planning permission is not transferrable to any other site.
4. Hammersmith has spent £640,000 on advertising a new product line. The directors expect the advertising campaign to generate benefits of £3,600,000.
5. Hammersmith acquired control of Johnston in the year. Johnston owns the Bryson brand but has never recognised it in their own financial statements.
Required
Giving reference to the appropriate standards, advise the directors how the above items should be treated.
- The brand is separable (it was bought from someone else) and is now under the control of Hammersmith. Since Hammersmith was willing to pay for it, we can assume that the item will bring economic benefits and should therefore be capitalised.
- Although the brand is likely to be profitable it is internally generated and therefore cannot be capitalised in line with the provisions of IAS 38.
- The planning permission can be capitalised as an asset. The fact that the land is worth considerably more with the planning permission than without shows that the planning permission has economic benefits. Although the planning permission is not separable (it cannot be transferred to any other piece of land) it does arise from legal and contractual rights and should therefore be capitalised.
- Although the directors expect the advertising campaign to generate substantial benefits it is not in the control of Hammersmith and therefore cannot be capitalised.
- Johnston cannot recognise the Bryson brand as it is an internally generated asset. From Hammersmith’s point of view, however, it has been acquired and therefore can be capitalised in the group accounts.
REQUIREMENTS
(a) Explain why it might be justifiable for Corbers plc to capitalise its research costs.
(b) Explain why IAS 38 imposes a rigid set of rules which prevent the capitalisation of research expenditure and make it difficult to capitalise development expenditure.
(c) Explain whether the requirements of IAS 38 are likely to discourage companies such as Corbers from indulging in research activities.
(d) Describe the advantages and disadvantages of offering companies the option of departing from the detailed requirements of standards in order to achieve a fair presentation.
(a) It is unlikely that Corby would continue to spend money on research if it did not expect to generate a profit or other economic advantage from doing so. Arguably, as Corby’s experience shows that it can predict a reasonable correlation between research activity and future revenues it should be possible to capitalise research costs.
One argument might be that the research activities should be viewed as a whole rather than on a project by project basis. On that basis, research (as a whole) generates valuable knowledge which Corby can control through patents.
A further argument might be that even “failed” research will have ongoing value. Knowing that some particular approaches to problems or research (especially in pharmacology) do not work can be useful in itself and can lead to future improved developments. It is also the case that a set of results that is seemingly a “failure” could prove valuable in the future when combined with other findings.
(b) Companies which engage in research and development often spend very large amounts of money. The accounting treatment of these expenditures can have immense implications for the underlying financial statements. IAS 38 attempts to create a uniform treatment of these costs for all companies. The fact that there is very little discretion in the treatment of most research and development expenses means that it becomes easier to compare different companies in the same industry.
This rigidity is important because, otherwise, it would be very easy to argue that almost any costs incurred could have future benefits (suggesting that they should be capitalised) and, possibly, that these benefits will continue almost indefinitely (suggesting that the costs should not be amortised). IAS 38 reduces the scope for such subjectivity by offering very little opportunity to capitalise costs, regardless of the company’s confidence in its results.
(c) The accounting treatment of a transaction should have no effect on its underlying worth to the company. If a research project is likely to benefit the company (either on its own or as part of a portfolio of activities) then it should be pursued regardless of the accounting treatment. The financial statements are not and cannot be regarded as an absolute statement of a company’s value. If necessary, it is possible to inform users of accounts through the notes and other narrative that the information in the financial statements must be read in the context of the regulations which affected their preparation. The fact that an investment has been written off in accordance with a set of rules does not mean that the company believes that it has been exhausted.
Companies might, however, be discouraged from investing if they are concerned that shareholders will misinterpret the information. In particular, if the readers are likely to read only the “bottom line” and act on that, regardless of how that figure has been arrived at.
Finally, if the accounting treatment has some tax consequences then that might affect the company’s willingness to invest – particularly if the accounting standards impose a treatment that is not tax effective.
(d) The freedom to depart from a standard is potentially useful because it can prevent companies from being forced to use misleading accounting policies. In such cases, the fact that they can use an alternative will be beneficial to the companies themselves and will also reduce the risk of damaging the IASB’s reputation.
There is a danger that the right to disregard a standard could be misinterpreted as a lack of confidence on the part of the IASB, because it implies that there will be situations in which the standards themselves could be unhelpful.
The biggest danger associated with the right is that it might be used to justify an unacceptable treatment. For example, it is clear that Corby is precisely the type of company that the IASB wishes to have write off its research expenditure as it is incurred. It would undermine the intention behind the standard if the true and fair override could be applied in this case.
The following depreciation rates are used:
Buildings 2% straight line
Motor vehicles 25% reducing balance
Machinery 20% straight line
A full year’s depreciation is charged in the year of purchase with none in the year of sale.
The following information is available for the year ended 30 September 20X7
Land and buildings
Of the land and buildings, buildings has a total cost of £300,000.
Motor vehicles
An existing vehicle which had cost £25,000 and had accumulated depreciation of £10,937 (NBV £14,063) at the point of sale was sold for £15,000.
A new car was purchased for £30,000.
Machinery
A piece of machinery purchased for £18,000 in the year ended 30/09/X5 was sold for £10,000.
Prepare the PPE disclosure note for the year ended 30 September 20X7.
Workings:
Land and buildings
Depreciation = (400,000 – 100,000) x 2% = £6,000 (land is not depreciated)
No other changes to land and buildings.
Motor vehicles
Disposal of an item with cost £25,000, accumulated depreciation £10,937.
Addition of an item with cost £30,000.
Full year of depreciation in year of purchase none in year of sale. As this is reducing balance we need to remove the cost and depreciation element of the disposed of item and add in the addition.
Cost = £35,000 - £25,000 + £30,000 = £40,000
Accumulated depreciation = £15,313 – £10,937 = £4,376
NBV = £40,000 – £4,376 = £35,624 x 25% = £8,906 depreciation charge
Machinery
Disposal of machinery with cost of £18,000.
Machinery was purchased in 20X5, full year depreciation in year of purchase, none in year of disposal. Therefore 2 year’s depreciation:
(£18,000 x 20%) x 2 = £7,200
Depreciation in current year = (£167,500 - £18,000) x 20% = £29,900
