Shorter Questions at the end of the Single Entity Questions

Question 1

What are the journal entries for a short-term lease?

Answer 1

Short-term lease is less than or equal to a year

Dr Lease Expense (SPL)
Cr Cash

Question 2

The IASB’s Conceptual Framework identifies, among others, the qualitative characteristics of relevance, faithful representation, comparability and understandability. Give examples of how the provisions of IAS 16, Property, Plant and Equipment apply these qualitative characteristics

Relevance

Answer 2

• Information is relevant if it can influence the decisions of the users
• This is the case if information has a confirmatory or predictive value
• Where a company adopts the IAS 16 revaluation model, each asset are reported at their current value
• This allows the users to estimate cash flows from the continued use of the asset or the sale of the asset or the level of bank funding that might be secured on the asset.
• A revaluation policy should be applied to all assets in a class, not only those that increase in value

Question 3

The IASB’s Conceptual Framework identifies, among others, the qualitative characteristics of relevance, faithful representation, comparability and understandability. Give examples of how the provisions of IAS 16, Property, Plant and Equipment apply these qualitative characteristics

Faithful Representation

Answer 3

• A transaction or event is faithfully represented if the depiction of it is complete, neutral and free from error.
• The IAS 16 revaluation model provides more relevant information but the cost model is generally seen to provide a more faithful representation because it is based on factual historic cost
• Historic cost: the measurement is objective and neutral
• IAS 16 sets out what costs should be included in the cost of an item of PPE and as such the measurement is also complete.
• A revaluation to fair value is subjective and less likely to be neutral or free from error than cost
• The Conceptual Framework dictates that prudence is considered in determining fair value

Question 4

The IASB’s Conceptual Framework identifies, among others, the qualitative characteristics of relevance, faithful representation, comparability and understandability. Give examples of how the provisions of IAS 16, Property, Plant and Equipment apply these qualitative characteristics

Comparability

Answer 4

• IAS 16 provides guidelines on what costs are and are not included in the initial measurement of property, plant and equipment and how items are accounted for subsequently.
• These guidelines mean that the financial statements of different companies are prepared on the same basis and so are comparable.
• Where companies use different measurement models their financial statements remain comparable because companies applying the revaluation model must also disclose historical cost information.
• Comparability is further achieved through disclosure requirements.
• IAS 16 requires that depreciation estimates, such as method and useful life, and measurement bases are disclosed, as well as changes in accounting policy and estimates (in line with IAS 8)

Question 5

The IASB’s Conceptual Framework identifies, among others, the qualitative characteristics of relevance, faithful representation, comparability and understandability. Give examples of how the provisions of IAS 16, Property, Plant and Equipment apply these qualitative characteristics

Understandibility

Answer 5

• IAS 16 requires that disclosures are made by class of property, plant and equipment.
• This disaggregation allows for a better understanding of an entity’s financial position.
• A reconciliation of opening to closing balances of property, plant and equipment must be provided and this must include movements due to additions, disposals, revaluations, impairments and depreciation.
• This level of detail, together with the disclosure of depreciation policies also aids understanding.

Question 6

Explain the nature and required financial reporting treatment of redeemable preference shares.

Answer 6

• Preference shares give the holder the right to receive an annual dividend (ie, mandatory) (usually at a fixed rate), which may be also be cumulative, out of the profits of a company, together with a fixed amount on the ultimate liquidation of the company or at an earlier date if the shares are redeemable.
• Legally, preference shares are equity. However, IAS 32 treats redeemable preference shares as liabilities. This is because they are, in substance, loans and meet the definition of a liability as there is a present obligation, in the form of both preference dividends and redemption payments, which will lead to a future outflow.
• The liability is measured at amortised cost using the effective interest rate, so that the premium on redemption is effectively treated as part of the interest expense.
• The interest is treated as a finance cost in the statement of profit or loss, rather than as a distribution out of retained earnings.

Question 7

Explain briefly any differences between IFRS® Standards and UK GAAP in respect of the format of the primary financial statements.

Answer 7

• Under UK GAAP (FRS 102) financial statements are prepared in accordance with the formats set out in the Companies Act, not the IAS 1 formats. The statement of profit or loss and statement of comprehensive income presentation are almost identical to IFRS Standards, apart from the presentation of discontinued operations, which appears in a separate column.
• The statement of financial position under FRS 102 utilises the previous balance sheet format of presentation on a net assets basis.
• In addition, different terminology is used in a number of places, for example turnover rather than revenue, stock rather than inventories, debtors rather than receivables and creditors rather than payables.
• Under FRS 102 entities also have the option under certain circumstances to present a single ‘statement of income and retained earnings’ in place of the (separate) statement of comprehensive income and statement of changes in equity.

Question 8

The IASB’s Conceptual Framework refers to five elements of the financial statements. Give one example of each of these elements from the financial statements, explaining how each meets the definition of the relevant element.

Answer 8

• Asset – An asset is a present economic resource controlled by an entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits.
  The buildings are assets because they are controlled by Giyani plc as a result of their purchase and they have the potential to produce future economic benefits through sale or use.

Liability – A liability is a present obligation to transfer an economic resource as a result of past events. The redeemable preference shares are a liability because Giyani plc has an obligation to deliver cash at the redemption date.

Equity – Equity is the residual interest in the assets of the entity after deducting all of its liabilities. Giyani plc’s ordinary share capital, retained earnings and revaluation surplus meet the definition of equity since the total of these balances is equal to the remaining balance of assets after all liabilities are deducted.

Income - is increases in assets, or decreases in liabilities, that result in increases in equity other than contributions from equity holders. Revenue meets this definition because it results in an increase of assets, being receivables or cash.

Expenses - are decreases in assets, or increases in liabilities, that result in decreases in equity other than distributions to equity holders. Depreciation meets this definition because it reduces the carrying amount of the related asset.

Question 9

Explain the differences between IFRS Standards and UK GAAP in respect of the treatment of intangible assets other than goodwill

Answer 9

• IAS 38 requires all eligible development costs to be capitalised, whereas FRS 102 offers an entity a choice about whether or not to capitalise.
• FRS 102 considers intangible assets to have a finite useful life and requires that capitalised development costs are amortised. If this cannot be reliably measured, it should not exceed 10 years.
• Under IFRS Standards an intangible asset can have an indefinite life, in which case it is not amortised and instead is subject to an annual impairment review to assess whether its carrying amount exceeds its recoverable value.
• If the company has decided that the intangible asset has a finite life, it should be amortised over that period.

Question 10

The IASB’s Conceptual Framework identifies relevance and faithful representation as the two fundamental qualitative characteristics. Explain how these and the enhancing characteristics are applied in IAS 38, Intangible Assets.

Relevance

Answer 10

• Information is relevant if it can make a difference to users’ decisions, because that information has predictive or confirmatory value.
• IAS 38 allows recognised intangible assets to be measured using the revaluation model in certain, limited circumstances. This gives users an understanding of what assets would be worth if they were sold or what income they could generate through use, so providing predictive value.
• Conversely the fact that internally generated intangible assets (other than development costs capitalised in accordance with IAS 38 criteria) are not recognised in the statement of financial position
• The fact that most recognised intangible assets are recognised at amortised cost limits the predictive quality, and so relevance, of the information provided.

Question 11

The IASB’s Conceptual Framework identifies relevance and faithful representation as the two fundamental qualitative characteristics. Explain how these and the enhancing characteristics are applied in IAS 38, Intangible Assets.

Faithful Representation

Answer 11

• Information is a faithful representation if it reflects the substance of the underlying phenomena, is complete, neutral and free from error. Neutrality is supported by the exercise of prudence, or caution.
• Intangible assets are initially measured at cost and, in most cases, are subsequently measured using the cost model. Cost is an objective measure based on fact, so it is neutral.
• The revaluation model provides a less faithful representation however this is rarely used for intangible assets. Where the revaluation model is applied, gains are recognised in OCI rather than profit or loss, so reflecting prudence.
• Intangible assets are only recognised if they are purchased (or if they are development costs capitalised in line with strict IAS 38 criteria).
• It may be argued that this results in an incomplete depiction in the statement of financial position, however it is a prudent approach:

any potential subjectivity and scope for error and bias when identifying and measuring these assets is removed.

Question 12

The IASB’s Conceptual Framework identifies relevance and faithful representation as the two fundamental qualitative characteristics. Explain how these and the enhancing characteristics are applied in IAS 38, Intangible Assets.

Comparability

Answer 12

The recognition, measurement and disclosure requirements of IAS 38 result in information that is comparable over time or between entities:

• where companies adopt different amortisation periods, disclosure of estimates ensure that results can still be compared.
• where a company adopts the revaluation model, IAS 38 requires that cost information is provided in the notes, so allowing comparisons.
• Where the revaluation model is adopted it is applied to all assets within a class; where there is no active market for a particular asset, that asset is measured using the cost model.
• This may result in a different measurement model being used for assets within a single class, so reducing comparability.

Question 13

The IASB’s Conceptual Framework identifies relevance and faithful representation as the two fundamental qualitative characteristics. Explain how these and the enhancing characteristics are applied in IAS 38, Intangible Assets.

Understandability

Answer 13

• Intangible assets are less understandable than other types of asset.
• Categorising intangibles into named classes may help understanding.
• Disclosure of movements in the carrying amount of intangible assets by type (eg, additions, disposals, amortisation) also helps users to understand the impact of intangible assets on the business.

Question 14

The IASB’s Conceptual Framework identifies relevance and faithful representation as the two fundamental qualitative characteristics. Explain how these and the enhancing characteristics are applied in IAS 38, Intangible Assets.

Verifiability and Timeliness

Answer 14

• Verifiability
  IAS 38 provides guidance on which costs are recognised as part of the cost of an intangible asset; this, together with the disclosure of amortisation estimates aids verifiability of the carrying amount.
• Timeliness
  Where the revaluation model is adopted, IAS 38 requires that the carrying amount of an asset does not differ materially from fair value. This requirement ensures that revalued assets are
  measured at up-to-date amounts, so providing information that is as timely as possible.

Question 15

How do you treat irredeemable preference shares?

Answer 15

IAS 32, Financial Instruments:

• Presentation requires that the preference shares are classified as a financial liability because they include a contractual obligation to transfer economic resources in the form of dividends to the shareholders.
• They also arise from a past event, being their issue. - - - This classification is an example of commercial substance over legal form

Question 16

How do you treat dismantling provisions?

Answer 16

• A provision is a liability of uncertain timing/amount. IAS 37 requires that a provision is only recognised if there is a present obligation resulting from a past event, it is probable that an outflow of economic benefits will be required to settle the obligation and a reliable estimate can be made of the amount
• Probable means more likely than not to occur. If an outflow of economic benefits is not probable, then no provision is recognised and instead a contingent liability is disclosed.
• In this respect, the criteria to recognise a provision are more stringent than the definition of a liability.
  The definition of a liability refers only to the transfer of an economic resource, meaning that there is a potential for a transfer; it need not be certain or even likely.
• The definition of a liability therefore encompasses both a provision and a contingent liability.
• The Conceptual Framework does, however, state that the probability of a transfer is likely to affect the recognition/measurement of a liability

Question 17

What is the alternative to this treatment of a government grant?

On 1 July 2012 Dedlock Ltd received a government grant of £10,000 to help finance the (1)acquisition of a machine, purchased on the same date for £25,000. The machine has been depreciated on a reducing balance basis using a rate of 20% pa.
Richard has credited the £10,000 grant received to revenue. Clara has discussed this matter with the managing director and they have agreed that Dedlock Ltd’s accounting policy for government grants will be to use the deferred income method. Depreciation on plant and machinery is presented in cost of sales.

Answer 17

IAS 20, Accounting for Government Grants and Disclosure of Government Assistance permits
two methods of presenting a government grant related to an asset. Dedlock Ltd’s accounting policy is the deferred income approach however the netting off method may also be used.

If the netting off method is used the amount of the grant received, £10,000 here, is netted off against the cost of the asset. The equipment would therefore be recognised at £15,000 initially rather than £25,000.

Depreciation would then be charged on the net amount of £15,000, being £3,000 (£15,000 ×
20%), so the asset would be recognised at £12,000 at 30 June 2013.

Question 18

Explain to the finance director the objectives of IFRS 7

Answer 18

IFRS 7, Financial Instruments: Disclosures was published because the IASB felt that existing standards that covered financial instruments needed to be improved.

Improvements were needed to ensure that the disclosure of information on financial instruments provided greater transparency of information so that users could better assess the risks that an entity was
exposed to.

The objective of IFRS 7 is to require entities to provide disclosures in their financial statements which enable users to evaluate both the significance of financial instruments for the entity’s financial position and performance, and the nature and extent of the risks arising from the financial instruments and how the entity manages those risks.

Question 19

The IASB’s Conceptual Framework refers to the enhancing qualitative characteristics. Explain how these ensure that financial statements are useful to users.

Four enhancing qualitative characteristics:

Answer 19

Comparability ensures that users can identify and understand similarities in, and differences among, items. Information about a reporting entity is more useful if it can be compared from one reporting period to the next and with similar information from other entities. Comparability allows this.

Verifiability helps assure users that information faithfully represents the information provided – it provides credibility to the financial information. It means that different knowledgeable and independent observers could reach consensus that a particular depiction is a faithful representation.

Timeliness is equally important as information becomes less useful the longer the time delay in reporting it. Timeliness means that information is available to investors, lenders and other creditors in time for it to be used in their decision-making processes.

Finally, the characteristic of understandability means that information that may be difficult to understand is made more useful by presenting and explaining it as clearly as possible. Whilst financial information should be presented clearly and in an understandable manner, it is expected that users of the financial statements have a reasonable level of knowledge and understanding. It would be misleading to exclude information simply because of its complex nature, as this would lead to incomplete information which would be misleading to users.

Question 20

Explain the concept of ‘substance over form’ using convertible bonds to illustrate your explanation.

Answer 20

• Substance over form is the principle that transactions and other events are accounted for and presented in accordance with their broader substance and economic reality and not their legal form.
• Substance over form should be applied to all accounting areas in accordance with the IASB’s Conceptual Framework.
• The main example of substance over form included in Gamow Ltd’s financial statements above is the treatment of the convertible debt.
• Gamow Ltd has a convertible bond which is a hybrid financial instrument containing both a liability component and an equity component.
• The substance of the financial instrument is the same as issuing separately a non-convertible bond and an option to purchase shares.
• The substance of the instrument is followed and therefore separate liability and equity components are accounted for, rather than following its legal form of a financial liability.

Question 21

Explain the concepts of ‘present fairly’ and ‘true and fair view’.

Answer 21

IAS 1, Presentation of Financial Statements requires financial statements to ‘present fairly’ the financial performance and position of an entity.
- This means that the effects of transactions should be faithfully represented.
- This is generally achieved by presenting the financial information in accordance with International Financial Reporting Standards.
- In the UK, the Companies Act 2006 requires that financial statements present a ‘true and
fair view’ of the company’s financial position and of its profit or loss for the period.
- True and fair is usually defined in terms of generally accepted accounting practice, which in the UK means compliance with accounting standards and adherence to the Companies Act requirements.
- ‘True’ is generally interpreted as reflecting factual accuracy and ‘fairness’ as indicating that the view is unbiased (neutral) and objective.

Question 22

Identify and explain the inherent limitations of financial statements that may reduce their usefulness to users.

Answer 22

• Financial statements are prepared to a specific date. The information when published is therefore historical and backward looking. Although historical information is useful in assessing how a company has been performing it provides limited predictive value.
• Financial statements are prepared in a standardised manner with much of the information aggregated. While this means that it is easier to compare information between companies because it is presented in a similar manner it also means that the content of standardised and aggregated information may be difficult to identify.
• Financial statements only contain a limited amount of narrative information about the business which can provide valuable insight into the company’s future, for example, how it is operating, what the company’s plans are for the future, the risks facing the company, such
  as number of competitors in the market and the management structure.
• Financial statements are based on estimates and judgements and hence figures are not an exact number. Management in different organisations may make slightly different assumptions and judgements and hence include slightly different figures.
• Companies use different accounting policies which means that exact comparisons cannot always be made. However, disclosure of accounting policies means that users can identify differences.
• Financial statements provide very limited indication of a company’s corporate social responsibility activities. A company may provide benefit to its stakeholders, however this benefit comes at a financial cost, for example, it may provide mentoring schemes free of
  charge to small businesses or make donations to environmental causes. The emphasis of financial statements is on financial results rather than social or environmental results and therefore positive social responsibility activities are not reflected.
• The impact of advances in technology and know-how is unlikely to be fully reflected in the financial statements. This is because much of the value of technology takes the form of internally generated intangible assets, which, due to the requirements of IAS 38, are often not recognised as an asset

Question 23

Discuss the ethical issues arising from the scenario and list the steps that the assistant accountant should take to address them.

Parry

Answer 23

Professional competence and due care – As a professional accountant Parry has an obligation
to maintain his professional knowledge and skills at the level required to ensure that his current employer receives competent professional services based on current developments in financial reporting and legislation.

Does Parry have the necessary skills and experience to prepare the financial statements of Laderas plc following his career break?
Should Parry instead have looked to refresh his professional knowledge following his career break and then have taken a less technically demanding role than that of covering a financial controller?

The fact that Parry is an ICAEW Chartered Accountant means that he has met the first phase of attaining professional competence, however he now needs to maintain his professional competence.

Professional behaviour –
A professional accountant should comply with relevant laws and financial reporting standards. Parry has made a number of mistakes and omissions in the accounting treatment for items over the year, for example, the rights issue was incorrectly accounted for. This suggests that perhaps Parry is not acting as professionally as he should be, be it in error or deliberately.

In addition to these two fundamental principles being questionable there is also a threat towards these being breached. The threat is that of self-interest for Parry as he wishes to secure a permanent position with Laderas plc. He may therefore be willing to account for transactions in such a way as to satisfy the board’s hopes for a high reported profit this year and a strong
financial position to secure additional funding for the future of the company.

Parry may feel pressured, intimidation threat, to overstate profits as a result. Parry has over-stated profits by recognising the whole of the government grant in the current year even though some should have been deferred and the internally generated brand was revalued to a market valuation increasing the company’s financial position incorrectly. These may have been innocent mistakes as Parry’s knowledge of financial reporting standards may not be up to date
due to his career break, but he may have incorrectly accounted for things to make the company’s results appear stronger than they were so that the board would offer him a full-time position.

The assistant accountant should take the following action:

• Discuss each of the errors found with Parry, explaining the correct IFRS Standards accounting treatment to him.
• Suggest that Parry attends an update course to ensure that he maintains appropriate continuing professional development as an ICAEW Chartered Accountant.
• Ensure the financial statements are corrected.
• If Parry refuses to amend the financial statements seek support from a director.
• Keep a detailed record of all discussions and calculations.
• If you find yourself in a difficult situation, or subject to intimidation threat, then consult the ICAEW Ethics and Technical helpline

Question 24

Explain the IFRS Standards financial reporting treatment of the error in respect of opening inventories (Note 5) above in the published financial statements of Pisa Ltd for the year ended 31 December 2015.

Inventories at 31 December 2015 were correctly valued at £849,300. However, during the inventory valuation it was discovered that inventories at 31 December 2014 had, in error, been overvalued by £100,000. This error has not been adjusted for in the trial balance above

Answer 24

Per IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, a material prior period error should be corrected retrospectively.

Retrospective restatement means correcting the recognition, measurement and disclosure of amounts as if the error had never occurred. For Pisa Ltd this means that the comparative amounts for the prior periods need to be restated.

At 31 December 2014 closing inventory was overstated by £100,000. Therefore, cost of sales for that year was understated and profit was overstated by £100,000.

The error was in 2014, however, it was not identified until 2015, and this is when the adjustment needs to be reflected.

Financial statements are required to include comparatives (IAS 1) and so both the 2014 and
the 2015 financial statements will be reported on in 2015.

The financial statements of 2014 should therefore be restated to show the correct amount as if the error (incorrect inventory valuation) had never happened at all (IAS 8).

The impact on the year ended 31 December 2015 is that opening stock is overstated by £100,000 and so cost of sales is overstated and profit is understated.

The adjustment is reflected in the comparatives for 2014, and this will therefore correct the carried forward
retained earnings at the end of that year. Therefore, the adjustment will be made in the 2014 comparatives.

This means that the 2015 financial statements do not require any further adjustment as the overstated inventory from 2014 has been corrected in the comparatives (albeit in 2015).

Question 25

The IASB’s Conceptual Framework refers to two fundamental qualitative characteristics: relevance and faithful representation.

Explain these concepts and the conflict between them.

You should illustrate your answer using the financial statements of Pisa Ltd.

Answer 25

Relevant financial information is that which is capable of making a difference to the decisions made by users. Financial information is capable of making a difference if it has predictive value, confirmatory value, or both.

For example:

• The fair value of land and buildings reported in the statement of financial position provides a predictive value in terms of what sale proceeds the assets could achieve if they were sold.
• Pisa Ltd’s revenue figure can be used to predict future revenues and confirm whether predictions made in earlier periods were correct.

The relevance of financial information is affected by its nature/materiality. Information is material if omitting, misstating or obscuring it could reasonably be expected to influence the decisions of primary users of the financial statements. The asset that is classified as held for sale by Pisa Ltd has a relatively small carrying amount, however this may be important to the users of Pisa Ltd’s financial statements as it indicates that the company is divesting of assets.

Faithful Representation:
To be useful, financial information should faithfully represent the phenomena that it purports to represent. A perfectly faithful representation should be complete, neutral and free from error.
Prudence supports neutrality. The carrying amount of plant and equipment in Pisa Ltd is measured using the cost model and is therefore more objective than carrying amounts measured using the revaluation model. Cost is factual and reflects transactions that took place at a point in time.

Accumulated depreciation is less neutral because it reflects a number of estimates including useful life and residual value.

Economic substance rather than legal form should be presented in order to achieve faithful representation. The redeemable preference shares issued by Pisa Ltd are, in substance, debt and should therefore be recognised as a liability in the statement of financial position, rather than as equity

Conflict:
The conflict between relevance and faithful representation can best be illustrated by considering the figures for Pisa Ltd’s property, plant and equipment. Although the revalued amount for land and buildings is more relevant than cost, determining fair value requires judgement and it therefore provides a less faithful representation of the assets. Conversely the
historical cost figure for plant and equipment more faithfully represents the related assets, however it is less relevant.

The Conceptual Framework states that where the most relevant information about a transaction requires a highly uncertain estimate, it may be questionable whether the estimate would provide a faithful representation. In this case the most useful approach may be either:
- to report the estimate and disclose a description of the uncertainties surrounding it;
- to include a less relevant estimate that is also less uncertain.
This decision requires judgement.