Tricky Tutorials: Groups, Financial Instruments, Provisions, Warranties

Question 1

How does IAS 32 determine an obligation to repay in cash? Or through an issue of shares?

Answer 1

Cash: As a liability
Shares: Equity - split accounting part debt/part equity

Question 2

What are the accounting entries for the issue of convertible debt?

Answer 2

Dr Cash (amount received)
Cr Liability 
Cr Equity (balancing figure in SOFP)

Question 3

How do you figure out the liability value component in the accounting entries for convertible debt?

Answer 3

Value liability component: Discount cash flows (interest and repayment that you could be obliged to pay) to present value using market rate of interest (that just applies to debt)
- Using the rate without the option to convert

Question 4

How is a liability subsequently classified?

Answer 4

Classified as ‘other financial liability’

Question 5

How is convertible debt subsequently measured?

Answer 5

Measured at amortised cost at an effective rate = market rate for normal debt (rate of interest without the conversion)

Question 6

How do you build back up the debt from present value to what is owed?

Answer 6

Unwinding:

Balance b/f x rate of interest without the conversion - (cash which is the cash x interest on debt) = balance c/f

Question 7

How is unwinding interest expense presented in the accounts?

Answer 7

Dr Finance Cost (interest)

Cr Liability

Question 8

How is the coupon interest (the netted off balance) presented in the accounts?

Answer 8

Dr Liability

Cr Bank

Question 9

How do you present convertible debt in the FS at y/e?

Answer 9

SOCI: Interest expense from the unwinding
SFP = Current liability; Convertible Debt: Balance C/F at the end of the year
Equity; Equity Option: Equity balancing figure from initial accounting entries

Question 10

When is a provision recognised?

Answer 10

• There is a present obligation (legal or constructive) as a result of a past event that occurred before the year end
• It is probable that an outflow of economic benefits will result. Probable assumed as more than 50%
• A reliable estimate of the amount can be made

Question 11

What is a constructive obligation?

Answer 11

Based on a company’s behaviour: If a company markets themselves as environmentally friendly, they might be responsible to pay for environmental damage even if it is not a legal obligation

Question 12

Should you always provide a provision for damage?

Answer 12

The damage must be done rather than planned

Question 13

How do you account for a dismantling provision on acquisition?

Answer 13

• On building, capitalise the provision as part of the non-current asset (as obligation present at acquisition date) = Provision x (1/1+interest rate to the power of the number of years of UL left)
• Then add this discounted PV to the initial NCA cost

Question 14

How do you account for a dismantling provision at year-end?

Answer 14

Depreciate NCA:
Dr Depreciation Expense (SPL)*
Cr Acc Depreciation (SFP)
* assume straight-line if not specified

Unwind the liability: Depreciate the NCA
Dr Finance Cost (SPL) (Provision PV x interest %)
Cr Provision (SFP)

Question 15

How do you present a dismantling provision in the FS extracts?

Answer 15

SOCI
Depreciation of NCA
Finance Costs (the unwound liability)

SFP:
PPE
Provisions (in the year of building put initial PV and the unwinding for one year)

Question 16

If there had been damage that a company had a legal obligation to rectify before year-end, how would you account for this?

Answer 16

Future costs of rectification x percentage damaged x 1/(1+discount rate)to the power of UL remaining

Then with that number:

Dr SPL (ongoing use of the area)
Cr Provision

Question 17

How do you account for a warranty for large populations of similar items?

Answer 17

For large populations of similar items, the company will use expected values to calculate the provision:

E.g. Company sells conservatories under warranties. At y/e 31 Dec X2, management estimate that there is:

• 70% chance that no faults will be found with goods under warranty
• 20% chance that faults will cost £4m to resolve
• 10% chance that the cost of resolving faults will be £10m

Provision = (£0 x 70%) + (£4m x 20%) + (£10m x 10%) = £1.8m

Question 18

Should you account for a legal provision in this example?

Company T is being sued by a former employee who was injured at work in Nov X2. At the y/e 31 Dec X2, lawyers estimate that there is:

• a 70% chance that there will be no case to answer
• a 20% chance that damages will cost £4m
• a 10% chance that the costs will be £10m

Answer 18

Present obligation? Yes, the obligation even was the injury which occurred before the year-end

Past event? Yes, the injury occurred before the year-end

Probable outflow? no - in an isolated case such as this we go with the most likely outcome. It is more likely than not (70%) that no amounts will be paid

Although no provision will be recognised, the likelihood of outflow is possible so the case will be disclosed as a contingent liability

Question 19

What is deferred cash?

Answer 19

When the parent company agrees to pay to subsidiary shareholders at a later date

Question 20

How do you account for deferred cash in the parent company’s individual FS initially?

Answer 20

Dr Investment (SFP)
Cr Liability (SFP)

Discount the future cash payment to present value

Question 21

How do you treat deferred cash at year end?

Answer 21

• Unwind the discount at year-end: check how much unwinding needs to be done as this is a cumulative position
• Record the unwinding figure in the parent company’s individual financial statements:
  Dr Finance Cost (SPL)
  Cr Liability (SFP)
• No impact on group investment or on goodwill
• Watch-out if company is acquired part-way through year as you should only unwind from the acquisition date

Question 22

How do you approach this question:

A Ltd acquired 100% of the share capital of B Ltd on 1 January 20X6 and agreed to pay cash of £375k on 31 Dec 20X7.

The relevant discount rate is 7%.

A Ltd have not recorded anything in their financial statements for this transaction.

Answer 22

1. Figure out the PV using the discount factor/rate =
   Cash x 1(1+discount rate)to the power of years after the acquisition date
   Dr Investment
   Cr Liability
2. Unwind the discount for the end of the first-year using the interest rate
   e.g. 327,540 x 7% = 22,928
   Dr Finance Cost 22,928
   Cr Liability 22,928
3. Closing Liability for the year = PV + Unwinding discount

4. Group Consolidated statement of profit or loss:
Finance Cost (the unwound discount)

5. Consolidated statement of financial position:
   Current Liabilities
   Deferred Consideration (closing liability for the year)
6. Parent workings:
   Goodwill
   Deferred Consideration (PV at acquisition date)
   Group Retained Earnings
   Unwinding (finance costs) (the unwound discount)

Question 23

Who issues shares when they are part of consideration for acquiring another company? How should you record them?

Answer 23

• When one company buys another, and shares are part of the consideration, these are shares issued by the parent company to the subsidiary’s shareholders
• Record based on the parent company’s share price at the acquisition date, regardless of whether the shares are issued at acquisition or in the future
• Fair price is regardless of when they are issued.

Question 24

How do you account for shares issued at acquisition date?

Answer 24

Parent company’s statement: shares issued at acquisition date

Dr Investment (market value of share x n.o shares)
Cr Share capital (nominal value x n.o shares)
Cr Share premium (Balancing figure)

Question 25

How do you account for deferred shares to be issued in the future?

Answer 25

Dr Investment (market value of share x n.o shares)
Cr Shares to be issued

• ‘Shares to be issued’ is a separate line that is going to be in the equity section of the statement of financial position

Question 26

How would you approach this question?

Orange Ltd purchased 75% of the share capital of Blue Ltd on 1 June 20X6. Consideration included 35,000 shares in Orange Ltd which are to be issued on 1 June 20X7. The market value of Orange Ltd’s shares on 1 June 20X6 was £1.25, but by 1 June 20X7 are anticipated to be worth £3.

Answer 26

Orange:

Dr Investment 43,750 (1.25 x 35,000)
Cr Shares to be issued 43,750

Consolidated Statement of Financial Position:
Equity
Shares to be issued 43,750

Investment number in individual parent:
Workings:
(W3) Goodwill
Deferred Share consideration 43,750

Question 27

What is contingent consideration?

Answer 27

Cash to be paid or shares to be issued by the parent company at some point in the future if certain conditions are met.

Fair value will be given in the question

Question 28

How do you account for contingent consideration?

Answer 28

Contingent consideration (cash):
Dr Investment
Cr Liability

Contingent Share Consideration:
Dr Investment
Cr Shares to be issued

Question 29

How would you approach this question?

P Ltd acquired S Ltd, paying contingent consideration of £80k in 3 years if annual revenue growth is more than 10%. The fair value of this consideration at the date of acquisition is £68,500

Answer 29

P Ltd’s books:

Dr Investment 68,500
Cr Contingent Consideration 68,500

Consolidated statement of financial position at acquisition date:
Non-current liabilities
Contingent consideration 68,500

Goodwill
Contingent consideration 68,500 - at year-end you would need to unwind as usual

Question 30

What are the two ways to value NCI?

Answer 30

1. Proportionate method (share of net assets)

2. Fair value method

Question 31

How do you approach this question?

Company A acquired 80% of Company B on 1 Jan X3 for cash consideration of £10m.
At acquisition, the fair value of Company B’s net assets were £8m and the profit for the year ended 31 Dec X3 was £600,000
The fair value of NCI at acquisition was £1.9m
Goodwill has been impaired by 10% at year end

Calculate goodwill at 31 Dec X3 under share of net assets method

Answer 31

Consideration:  10,000,000
NCI at acquisition (20% x 8m) 1,600,000
Less net assets at acquisition (8,000,000)
------------
Goodwill at acquisition = 3,600,000
Less Impairment (10%) (360,000)
--------------
= Goodwill at 31 Dec X3 = 3,240,000

Under share of net asset method, goodwill all belongs to parent - therefore, allocate impairment of £360k to parent

Question 32

How do you approach this question?

Company A acquired 80% of Company B on 1 Jan X3 for cash consideration of £10m.
At acquisition, the fair value of Company B’s net assets were £8m and the profit for the year ended 31 Dec X3 was £600,000
The fair value of NCI at acquisition was £1.9m
Goodwill has been impaired by 10% at year end

Calculate goodwill at 31 Dec X3 under the fair value method?

Answer 32

Consideration:  10,000,000
NCI at acquisition: 1,900,000 (in question)
Less net assets at acquisition (8,000,000)
------------
Goodwill at acquisition = 3,900,000
Less Impairment (10%) (390,000)
--------------
= Goodwill at 31 Dec X3 = 3,510,000

Under fair value method, goodwill belongs to both parent and NCI - ‘full goodwill method’ - split impairment between parent £312k (80%) and NCI £78k (20%) - according to percentage

Question 33

How do you account for impairment under the proportionate method and fair value method?

Answer 33

Proportionate:
Dr Group Retained Earnings
Cr Goodwill (W3)

Fair value method:
Dr Group Retained Earnings (W5)
Dr NCI (W4)
Cr Goodwill (W3)

Question 34

How do you approach this question?

Calculate NCI under the proportionate method

Company A acquired 80% of Company B on 1 January 20X3 for cash consideration of £10m
At acquisition, the fair value of Company B’s net assets were £8m and the profit for the year ended 31 December 20X3 was £600,000
The Fair Value of NCI at acquisition was £1.9m
Goodwill has been impaired by 10% at the year end

Answer 34

NCI at acquisition (20% x £8m) 1,600,000
NCI% of subsidiary post acquisition net assets 120,000
(20% x 600k)
Less NCI share of goodwill impairment —
————
NCI at Dec X3 = 1,720,000

Question 35

How do you approach this question?

Calculate NCI under the fair value method

Company A acquired 80% of Company B on 1 January 20X3 for cash consideration of £10m
At acquisition, the fair value of Company B’s net assets were £8m and the profit for the year ended 31 December 20X3 was £600,000
The Fair Value of NCI at acquisition was £1.9m
Goodwill has been impaired by 10% at the year end

Answer 35

NCI at acquisition (fair value) 1,900,000
NCI% of subsidiary post acquisition net assets 120,000
(20% x 600k)
Less NCI share of goodwill impairment (78,000)
(20% x 390)
————
NCI at Dec X3 = 1,942,000