ACCA F7 (INT) Financial Reporting - Study text - 2010

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Chapter 10: Inventory

Yearended31DecemberYear4



Costsbasis

 $000

Revenue 188

Costs(balancingfigure) (388)



–

––––

Loss (200)



–

––––

2.5 Disclosure in the financial statements and amounts in the statement of

financial position

IAS11 requires disclosure of the following information about construction contracts:

 The amount of contract revenue recognised as revenue in the period.

 The methods used to determine the amount of revenue and the stage of

completion of contracts in progress (for example, the costs basis)

 For each contract in progress at the end of the reporting period, the total costs

incurred and profits recognised (net of any losses recognised) to date

In relation to the statement of financial; position, IAS11 requires disclosure of the

following items:

 The amount of advances received (amounts received from customers before the

related work has been carried out).

 The amount of retentions (amounts not paid by the customer until the contract is

completed to his satisfaction).

 The gross amount due from customers or the gross amount due to customers for

contract work. This is calculated as follows:

Costs incurred X

Plus recognised profits to date/(or minus recognised losses) X/(X)

X/(X)

Minus progress billings (X)

(X)

–

–––

= Inventories: Due from customers on contracts

––––

Non-current liabilities: Due to customers on contracts

––––

(X)

–

–––

(Note: ‘Progress billings’ are the amounts that the customer has been invoiced

already, during the progress of the contract to date.)

Note the calculations carefully: (1) Costs incurred (2) plus profits taken to date (3)

minus amounts billed to the customer (4) equals inventory in the statement of

financial position.

Receivables may also include amounts recoverable on contracts where progress

billings exceed cash received from the customer. This amount may include

retentions, disclosed above. For example, if progress billings have been $3 million

but the customer has paid only $2.5 million of the amounts billed, there will be a

receivable for $0.5 million in the statement of financial position, for ‘amounts

recoverable on contracts’.

Paper F7: Financial reporting (International)

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Example

An Appendix to IAS11 sets out the contract disclosures required, showing how the

figures are obtained. The illustrative figures below are based on this Appendix. The

figures relate to a construction company at the end of its first year of operations.



A B C D E Total

Contractrevenuerecognised 160490250 170 60 1,130

Contractexpensesrecognised 110400220 200 60 990

Expectedlossesrecognised 30 20 50



–

––

–

––

–

––

–

––

–

––

–

–––

Recognisedprofitslesslosses 50 90 30(60)(20) 90



–

––

–

––

–

––

–

––

–

––

–

–––

Contractcostsintheperiod 110440340 200 90 1,180

Contractcostsrecognisedasexpensesin

theperiod

110400220 200 60 990

Contractcostsrelatingtoactivityin

futureperiods 0 40120 0 30 190



–

––

–

––

–

––

–

––

–

––

–

–––

Contractrevenue(asabove) 160490250 170 60 1,130

Progressbillings 100490250 150 60 1,050



–

––

–

––

–

––

–

––

–

––

–

–––

Unbilledcontractrevenue 60 ‐ ‐ 20 ‐ 80



–

––

–

––

–

––

–

––

–

––

–

–––

    

Advancesreceivedfromcustomers 0 35 15 0 10 60



–

––

–

––

–

––

–

––

–

––

–

––

    

Contractcostsincurred 110440340 200 90 1,180

Recognisedprofits/(losses) 50 90 30(60)(20) 90



–

––

–

––

–

––

–

––

–

––

–

––––

 160530370 140 70 1,270

Progressbillings 100490250 150 60 1,050



–

––

–

––

–

––

–

––

–

––

–

–––

Duefromcustomers 60 40120  10 230



–

– 

–

– 

–

–––

Duetocustomers (10)  (10)



–

–– 

–

–––

The disclosures that should be made to comply with IAS11 are as follows:

(1) Contractrevenuerecognisedasrevenueinthefinancialperiod 1,130

(2) Contractcostsincurredandrecognisedprofits,lessrecognised

losses,todate(=1,180+90)

1,270

(3) Advancesreceived 60

(4) Grossamountduefromcustomers(=asset) 230

(5) Grossamountduetocustomers(=liability) (10)

Example

Continuing with the first example above (Entity D), you are now told that progress

billings to date are $1,300,000 and that cash has been received to date of $900,000. In

addition to the cash received against progress billings of $900,000, $100,000 has been

received as advances for work not yet carried out.

Chapter 10: Inventory

Required

Calculate the figures for the statement of financial position on a costs basis as of 31

December Year 4.

Answer



$000

Receivables:

Amountsrecoverableoncontracts(1,300–900) 400



Non‐currentliabilities:

Duetocustomersoncontracts(seeworkings) 50



Workings

$000

Costsincurred 1,000

Recognisedprofits/(losses) 250

MinusProgressbillings (1,300)



––

–

–––

–



(50)



–

––––

Paper F7: Financial reporting (International)

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Paper F7 (INT)

Financial reporting

CHAPTER

Financial assets and

financial liabilities

Contents

1 Financial instruments and the need for an

accounting standard

2 Accounting for the issue of financial instruments

3 Recognition and measurement of financial

instruments

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Financial instruments and the need for an accounting standard

 Financial assets and financial liabilities

 The need for accounting standards on financial instruments

 Debt and equity

 Preference shares: debt or equity?

 Convertible bonds (convertible loan stock)

 Interest, dividends, gains and losses on financial instruments

 Financial instruments: disclosure requirements

1 Financial instruments and the need for an accounting

standard

1.1 Financial assets and financial liabilities

Financial instruments are products or agreements that represent financial rights and

obligations.

 There are short-term financial instruments, such as Treasury bills and bank bills,

commercial paper, cash and financial derivative instruments, such as financial

futures and options.

 There are also long-term financial instruments such as shares and bonds. ‘Bonds’

is a general term for long-term debt capital. This includes loan stock, debentures

and medium-term notes.

A financial asset is:

 cash, or a contractual right to receive cash (for example, trade receivables), or

 a financial instrument giving the right to receive cash in the future. For example,

shares give their holder the right to receive future dividends.

A financial liability is a contractual obligation to make one or more payments in

the future. Examples include trade payables and long term borrowings.

This chapter deals with the issues relating to how both financial assets and financial

liabilities should be reported in the financial statements.

1.2 The need for accounting standards on financial instruments

This chapter is concerned with long-term financial instruments. These are the

subject of three accounting standards:

 IAS32: Financial instruments: Presentation

 IAS 39: Financial instruments: Recognition and measurement

 IFRS 7: Financial instruments: Disclosure

Chapter 11: Financial assets and financial liabilities

Since the 1980s, entities have made increasing use of many different kinds of

sophisticated financial instruments. Part of the need for accounting standards arises

from their complexity.

One problem is that some financial instruments combine elements of equity and

elements of debt finance. Convertible bonds are an example: these are bonds issued

by a company that can be converted, at the option of the bondholder, into a

specified number of equity shares in the company at a future date. These are bonds

that contain an equity element. They might therefore be referred to as compound

financial instruments.

So should they be presented in the statement of financial position of the issuer as

equity, or as debt, or as a combination of debt and equity? If they are to be

presented as a combination of debt and equity, how should the debt and the equity

elements be separated?

Before IAS 32 and IAS 39 were issued, some entities deliberately chose unusual and

complex forms of finance in order to make their long term borrowings appear less

than they really were.

Financial derivatives

A further problem has been the use of financial derivatives (such as options, futures

and forward contracts). Derivatives are used by some non-bank companies either to

‘hedge’ exposures to financial risk or to speculate on changes in market prices in the

financial markets. A financial derivative is a financial instrument with the following

characteristics:

 The market value or fair value of a derivative changes in response to changes in

the ‘price’ of an underlying item, such as a specified interest rate, stock market

index or foreign exchange rate.

 To acquire a financial derivative requires either no initial investment or a fairly

small initial investment.

 A financial derivative is a contract between buyer and seller that will be settled

at a future date. Gains or losses on these contracts depend on changes in market

prices up to that future date.

Because the market value or fair value of derivatives depends on movements in the

market price of an underlying item, an entity that has purchased derivatives or

entered into a derivatives contract can be exposed to significant risk and

uncertainty, due to changes in their value. The risk is the potential for large gains or

losses. The financial performance and position of an entity can change significantly

in a very short time, due to movements in the value of its derivative instruments.

However, derivatives have little or no cost. Even if they represent significant assets

and liabilities they may not be recognised in a traditional historical cost balance

sheet (or they may be recognised at an amount that does not reflect their actual

value). This means that users will not be aware of the true level of risk that the

entity faces.

Paper F7: Financial reporting (International)

IAS 39 and IFRS 7 now require derivatives to be recognised in the statement of

financial position and information about them to be disclosed in notes to the

financial statements.

1.3 Debt and equity

A statement of financial position presents equity separately from debt (current or

non-current liabilities). It is therefore essential to identify financial instruments as

equity or debt.

IAS32 defines an equity instrument as ‘any contract that evidences a residual

interest in the interests of an entity after deducting all of its liabilities’.

Examples of equity instruments are:

 ordinary shares

 some types of preference shares

 share warrants. (Note: A share warrant gives its holder the right, without any

obligation, to purchase new shares in the company at a future date, usually at a

fixed price.)

Debt might be defined as financial liabilities of the issuer of the financial

instrument.

Examples of financial liabilities are:

 bank loans

 bonds

 some types of preference shares.

IAS32: Financial instruments: Presentation states that a company that has issued

financial instruments should classify them, or their component parts, as:

 a financial liability (or, in the case of certain instruments, a financial asset), or

 equity.

The general rule when trying to determine whether a financial instrument is debt or

equity is that if there is a contractual obligation on one party to transfer cash or

another asset to the other party then the instrument meets the definition of a

liability. IAS 32 requires that this classification into debt or equity is according to the

substance of the transaction. (This is another example of the ‘substance over legal

form’ concept in financial reporting.)

1.4 Preference shares: debt or equity?

Preference shares are shares that are entitled to a payment of their dividend, usually

a fixed amount each year, before the ordinary shareholders can be paid any

dividend.

Chapter 11: Financial assets and financial liabilities

Preference shares may be:

 redeemable: redeemable shares are shares that the entity has an obligation to

buy back (or the right to buy back) at a future date, and then cancel them

 irredeemable: these are shares that will not be bought back at any time in the

future. They might also be called ‘perpetual’ preference shares

 convertible: these are preference shares that are convertible at a future date into

another financial instrument, usually into ordinary equity shares of the entity.

Depending on their characteristics, preference shares issued by a company might be

classified as:

 equity or

 a financial liability of the company, or

 a compound financial instrument containing elements of both financial liability

and equity.

IAS32 states (in a guidance note) that the key factor for classifying preference shares

is the extent to which the entity is obliged to make future payments to the

preference shareholders.

 Redeemable preference shares. Since the entity will be required to redeem the

shares, there is a future obligation. The redemption element of the shares is a

financial liability.

 Preference dividends might be treated as a financial liability or as a deduction

from equity, depending on whether the shares are cumulative or non-

cumulative. With cumulative preference shares, any unpaid arrears of dividend

accumulate, and must be paid before any dividends can be paid to ordinary

equity shareholders. If the preference shares are non-cumulative, any unpaid

preference dividends do not accumulate and are not payable. With cumulative

preference shares, any arrears of dividend would be considered a financial

liability.

 Irredeemable non-cumulative preference shares should be treated as equity,

because the entity has no obligation to the shareholders that the shareholders

have any right to enforce.

1.5 Convertible bonds (convertible loan stock)

Convertible bonds are financial instruments that give their holders the right to

convert the bonds into a quantity of shares in the entity at a future date. Until the

bonds are converted, the entity is obliged to pay interest. If the bonds are not

converted into shares, they will remain as bonds until they are eventually redeemed

at a specified maturity date.

IAS32 states that convertible bonds are a mixture of a bond and a share warrant or

share option, and so have two component elements:

 a financial liability element, and

 an equity element.

Paper F7: Financial reporting (International)

(Note: A share option or share warrant is an instrument that gives its holder the

right at a future date to acquire new equity shares in the issuer of the option or

warrant.)

These two elements, financial liability and equity, should be recognised separately

in the statement of financial position. The same principle applies to convertible

preference shares.

1.6 Interest, dividends, gains and losses on financial instruments

IAS32 states that:

 interest, dividends, gains or losses relating to a financial liability should be

recognised as an expense in profit or loss

 dividends paid to equity shareholders should be debited directly to equity

(reducing the retained earnings).

Dividend payments to equity shareholders (the owners of the entity) are reported in

the statement of changes in equity (SOCIE) and not in the statement of

comprehensive income.

Preference dividend

When an entity pays a dividend on its preference shares, the dividend should be:

 treated as an expense in profit or loss, if the shares are a financial liability, or

 treated as a deduction from equity, if the shares are classified as equity.

If the preference dividend is treated as an expense, it is either:

 included within interest expenses, or

 shown as a separate item.

(IAS32 suggests that if there is a difference in tax allowances on interest payments

and dividend payments, a separate presentation of the preference dividend expense

would probably be more appropriate.)

1.7 Financial instruments: disclosure requirements

IFRS7: Financial instruments: Disclosure requires two types of disclosure about

financial instruments, in order to allow users to evaluate:

 the significance of financial instruments for the entity’s financial position and

performance, and

 the nature and extent of the risks arising from the use of financial instruments

during the period, and how the entity has managed those risks.

Disclosure of the impact on the entity’s financial position and performance

IFRS7 contains a large amount of detail, but its main disclosure requirements

relating to disclosure of the impact of financial instruments on the entity’s financial

performance and position are as follows.

ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing

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