ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)
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Chapter 10: Non-current assets
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Example
The previous example is now continued.
The $300,000 carrying value for the machine is based on a revaluation that was
made two years previously, which gave rise to a revaluation reserve of $20,000.
Required
Explain the accounting treatment for the $24,643 impairment loss.
Answer
The earlier revaluation gain on the asset, currently recorded in the revaluation
reserve, is reversed before any loss is charged to profit or loss. The accounting
treatment of the impairment loss is to:
Treat the first $20,000 of the impairment as a downward revaluation, to
eliminate the $20,000 for the asset in the revaluation reserve. This is reported as
other comprehensive income for the financial year
Write off the remaining $4,643 as an impairment loss in profit or loss for the
financial year.
$ $
DR Revaluationreserve 20,000
DR Profitandloss(balancingfigure) 4,643
CR Property,plantandequipment
24,643
Reversing an impairment loss
An impairment loss may be reversed when there is evidence that this has happened.
Any reversal:
must be justifiable, by reference to an improvement in the indicators of
impairment, and
should not lead to a carrying amount in excess of what the carrying amount of
the asset would have been without the recognition of the original impairment
loss.
A reversal should be:
recognised immediately in profit or loss, unless
the original impairment was reported as other comprehensive income and
charged directly to the revaluation reserve, in which case the reversal should be
reported as other comprehensive income and credited to the revaluation reserve.
Depreciation charges for future periods should be adjusted to allocate the asset’s
revised carrying amount, minus any residual value, over its remaining useful life.
An impairment loss that has arisen on goodwill
cannot be reversed.
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4.5 Cash generating units
In most situations, one asset is not capable of generating cash flows individually.
Instead, assets are used together with other assets. When a group of assets together
generate the cash flows, and they are called a ‘cash generating unit’ (CGU).
A
cash generating unit is the smallest identifiable group of assets that generates
cash outflows that are largely independent of those of other assets or groups of
assets. For example, a CGU of a restaurant chain may be an individual restaurant.
An asset that is potentially impaired may be part of a larger group of assets which
form a
cash-generating unit. It may therefore not be possible to estimate the asset’s
recoverable amount in isolation from the other assets in the CGU.
This may be particularly relevant to goodwill. A CGU must include all assets that
generate the cash flows, including goodwill. This is because goodwill does not
generate cash flows independently, but it does contribute to the output of the
company. Purchased goodwill on the acquisition of a subsidiary must therefore be
allocated to one or more CGUs. A CGU (or collection of CGUs) to which goodwill is
allocated for the purpose of impairment test cannot be larger than an operating
segment, as defined by IFRS 8).
IAS 36 requires that goodwill should be reviewed for impairment
annually, and the
value of goodwill cannot be estimated in isolation. The assessment of impairment
will have to take into consideration the entire CGU.
It may be possible to allocate goodwill across several cash-generating units. If
allocation is not possible, the impairment review is carried out in two stages:
1 Carry out an impairment review on each of the cash generating units
(excluding the goodwill) and recognise any impairment losses that have
arisen.
2 Then carry out an impairment review for the entity as a whole, including the
goodwill.
Allocating an impairment loss to assets in a cash-generating unit
When an impairment loss arises on a cash generating unit, the impairment loss is
allocated across the assets of the cash-generating unit in the following order:
first, to any individual assets that are obviously impaired
next, to the goodwill allocated to the cash-generating unit
next, to the other assets in the cash-generating unit, on a pro-rata basis.
However, the carrying amount of an asset cannot be reduced below the highest of:
its fair value less costs to sell (if determinable)
its value in use (if determinable), and
zero.
Chapter 10: Non-current assets
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Example
A cash-generating unit (CGU) consists of the following assets:
Asset Carryingvalue
$
Machine 300,000
Feeder
30,000
Packer
70,000
Shareoffactoryspaceused(1/20×$2million)
100,000
Licensetoproducetheproductrange
50,000
Allocatedgoodwill(1/12×$240,000)
20,000
TotalcarryingvalueofCGU
570,000
The recoverable amount of the CGU is $470,000, giving rise to an impairment loss of
$100,000.
Required
Explain how the impairment will be allocated across the cash-generating unit.
Answer
Asset
Carrying
value
Impairment
write‐down
(seeworking)
Impaired
value
(seeworking)
$
$
$
Machine 300,000
43,636
256,364
Feeder
30,000
4,364
25,636
Packer
70,000
10,182
59,818
Shareoffactoryspace
100,000
14,545
85,455
License
50,000
7,273
42,727
Allocatedgoodwill
20,000
20,000
0
TotalcarryingvalueofCGU
570,000
100,000
470,000
Working
The impairment is first allocated against the goodwill. The remaining $80,000 is
apportioned across the other non-current assets in the cash-generating unit (CGU)
according to their value.
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$
Impairment
80,000
Totalnon‐currentassetvalue(excludinggoodwill) 550,000
Impairmentper$1ofvalue
$0.145
In the above table, the impairment write-down for all assets except the goodwill is
therefore $0.145 for each $1 carrying value of assets.
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Paper P2 (INT)
Corporate Reporting
CHAPTER
11
Financial instruments
Contents
1 The nature of financial instruments and
derivatives
2 IAS 39: Recognition and measurement
3 IAS 39: Hedge accounting
4 IAS 32: Presentation
5 IFRS 7: Disclosure
6 ED 2009/7: Classification and measurement
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The nature of financial instruments and derivatives
What is a financial instrument?
The need for accounting standards on financial instruments
Derivatives
Embedded derivatives
IFRIC Interpretation 9: Reassessment of embedded derivatives
The accounting standards for financial instruments
1 The nature of financial instruments and derivatives
1.1 What is a financial instrument?
A financial instrument is a contract that gives rise to both:
a financial asset in one entity, and
a financial liability or equity instrument in another entity.
For example, a bank loan is a financial instrument. If a bank lends money to a
company, the bank has a financial asset. The company that takes out the loan has a
financial liability. Both parties are linked by way of a loan contract.
An investment in equity shares is also a financial instrument. If company A issues
shares that are acquired by company B, company B has a financial asset (its
investment in shares) and company A has equity. The two companies are linked by
a contract (since the shares give rights to the shareholders).
Financial instruments include:
cash
shares
loans
debentures, and
accounts receivable or accounts payable.
IAS 39 also includes ‘contracts of financial guarantee’ as financial instruments,
unless they are dealt with as insurance contracts under IFRS 4. This would apply,
for example, to a factoring arrangement in which the entity that transfers title to its
receivables (to the factoring company) may give a guarantee for bad debts up to a
specified maximum amount.
Financial derivatives and commodity derivatives are other important types of
financial instrument.
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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:
IAS 32: Financial instruments: Presentation
IAS 39: Financial instruments: Recognition and measurement
IFRS 7: Financial instruments: Disclosure
IAS 32 and IAS 39 were updated as a result of a review of IASB accounting
standards review and came into force in December 2005. IFRS 7 replaced the
disclosure requirements of IAS 32 and became effective for financial statements
beginning on or after 1 January 2007.
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 (for example, convertible bonds)
combine elements of equity and elements of debt finance. They might therefore be
referred to as compound financial instruments. So should they be presented in the
statement of financial position 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 developed, some entities deliberately chose unusual
and complex forms of finance in order to make their long-term borrowings appear
less than they really were, by treating the financial instruments as equity.
A further problem has been the use of derivatives (for example options, futures and
forward contracts). A derivative is a financial instrument with the following
characteristics:
its value changes in response to changes in items such as a specified interest rate,
financial instrument price or foreign exchange rate
it requires no initial investment or very small initial investment
it will be settled at a future date.
Entities use derivatives in order to manage risk. For example, an entity can protect
itself from changes in foreign currency exchange rates by taking out a forward
contract to buy or sell foreign currency at a fixed price on a future date.
Because the value of derivatives depends on movements in an underlying item, an
entity with derivatives can be exposed to significant risk and uncertainty. 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.
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 statement of
financial position or they may be recognised at an amount that does not reflect their
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actual value). This means that users will not be aware of the true level of risk that
the entity faces.
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 the financial
statements.
1.3 Derivatives
A company can enter into a transaction involving a derivative for one of two
reasons:
to hedge against exposure to a particular risk, or
to speculate, and hope to make a profit from favourable movements in rates or
prices.
Hedging with derivatives
Derivatives can be used to obtain protection against exposure to the risk of an
unfavourable movement in the market price of an item, such as the price of a
commodity, an interest rate or a foreign exchange rate.
For example, a chocolate manufacturer may be worried that the price of cocoa might
increase and if it does, it will affect his costs of production and operating profits. He
could manage this risk by entering into a forward contract to fix now the price of his
future purchases of cocoa. By fixing the price now for future purchases, the risk of
an adverse movement in the market price of cocoa is removed.
This is described as ‘hedging’ the risk, or hedging the exposure to risk. The
manufacturer is hedging his risk and guaranteeing his future purchase costs. The
manufacturer may have arranged the forward contract with another party who
believes that the market price of cocoa will drop below the fixed price in the
contract, and so expects to make a profit by selling cocoa to the manufacturer at a
higher price than he could sell in the market.
Speculation and the use of derivatives
Many derivatives are traded on exchanges, and so are easily available for buying
and selling. Entities can buy or sell derivatives in order to set up speculative
positions, so that a profit will be made from dealing in the derivatives provided that
the market price of the ‘underlying item’ moves favourably.
For example, forward contracts in cocoa could be purchased by a company that has
no interest in the cocoa itself, but just wants to gamble on future cocoa prices. The
forward contracts would probably be exchange-traded forward contracts, known as
commodity (cocoa) futures.
Speculating in derivatives may expose entities to huge risks, if expectations do not
come true and the price of the underlying item moves the ‘wrong way’.
Occasionally, losses on derivatives positions can result in financial collapse of the
company. A well-known example is the collapse of Barings Bank in 1995. This was
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caused by one employee, Nick Leeson, who speculated in derivatives in the
Japanese futures market, and made losses that were so large that they caused the
bank to collapse. In the case of Barings, the losses from speculation were made by a
bank, but non-bank companies are able to speculate with derivatives too, should
they wish to do so.
Categories of derivatives
Derivatives can be classified into two broad categories:
Forward arrangements
− Forward contracts
− Futures
− Swaps
Options
Forward arrangements
All forward arrangements have the same two characteristics:
Both parties to the contract must honour the terms of the contract. For example,
suppose that a chocolate manufacturer enters into a forward contract to buy a
quantity of cocoa at a future date at a price that is fixed now by the contract. The
company has entered into a contract that it must honour. If the market price of
cocoa drops below the price in the forward contract, the manufacturer is obliged
to take delivery at the agreed fixed price. He cannot buy at the lower market
price instead.
There is no initial payment by either party to enter into a forward arrangement,
apart from normal transaction costs. In other words, there is no purchase price
payable by one party to the other.
Forward contracts
A forward contract is a tailor-made contract to buy or sell a specified amount of a
specified item (commodity or financial item) on a specified date at a specified price.
For example a forward contract may be arranged by a UK company to buy US
$127,000 in six months’ time at a rate of $1.80 to £1, to settle a payment to a US
supplier on that date. The UK company can arrange the exact amount of US dollars
that it wants to buy and the exact date for settlement of the contract. ‘Tailor-made’
contracts are usually called ‘over-the-counter’ contracts.
Futures
These are very similar to forward contracts, except that they are traded on a
specialist futures exchange. A key feature of a futures contract is that it is a
standardised forward contract, with a fixed quantity of the item that is purchased or
sold, and a fixed settlement date. For example, cocoa futures are traded on the CSCE
exchange which prescribes future delivery months, locations, quantity and grade.
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Swaps
A swap is an agreement between parties to exchange cash flows related to an
underlying obligation. The most common type of swap is an interest rate swap. In
an interest rate swap, two parties agree to exchange interest payments on the same
notional amount of principal, at regular intervals over an agreed number of years.
One party might pay interest to the other party at a variable or floating rate, and in
return the other party may pay interest on the same principal at a fixed rate (a rate
that is fixed by the swap agreement).
For example, a company with a fixed rate loan may be concerned that interest rates
are about to fall, so it would like to swap from fixed interest rate obligations to a
variable rate payment, in order to benefit from the expected lower rates. Based on
these expectations, the company could a swap with a bank. In the swap it would
agree to pay interest at a variable rate and receive interest at a fixed rate in return.
The effect of the swap is to change the interest obligations of the company from a
fixed rate (payment on the loan) to a variable rate (taking the loan and the swap
payments together).
Note that the underlying obligation, the loan, remains in place. The change in
interest payment obligations is achieved through the swap, which exists in addition
to the loan.
Options
The holder of the option has entered into a contract that gives it the right but not the
obligation to buy (call option) or sell (put option) a specified amount of a specified
commodity at a specified price.
An option differs from a forward arrangement. An option offers its buyer/holder
the choice to exercise his rights under the contract, but also has the choice not to
enforce the contract terms. The seller of the option must fulfil the terms of the
contract, but only if the option holder chooses to enforce them. Holding an option is
therefore similar to an insurance policy: it is exercised if the market price moves
adversely. As the option holder has a privileged status – deciding whether or not to
enforce the contract terms – he is required to pay a sum of money (a premium) to
the option seller. This premium is paid when the option is arranged, and non-
refundable if the holder later decides not to exercise his rights under the option.
1.4 Embedded derivatives
Derivatives may be included in other types of contract. For example, a company
may issue a loan with interest linked to the price of a commodity. Such a loan is a
contract that combines a ‘host contract’ (the debt instrument) and a derivative on
the price of a commodity. This is called an embedded derivative.
Companies are required to identify any embedded derivatives and account for them
separately from their host contract, but only if the following conditions are met:
The embedded feature meets the definition of a derivative.