CIMA F2 Course Notes PDF

F2 Course notes
Syllabus A: SOURCES OF LONG-TERM FINANCE .................2

Syllabus A1a. Types and sources of long-term finance ....................................2
Syllabus A2. WACC ..................................................................................17
Syllabus B: FINANCIAL REPORTING.....................................31
Syllabus B1a. Consolidated financial statements ...........................................31
Syllabus B1b. Financial Reporting ..............................................................104
Syllabus B1e. Ethics ................................................................................209
Syllabus B2. Complex groups ..................................................................217
Syllabus B3. Related Parties .....................................................................258
Syllabus C: ANALYSIS OF FINANCIAL PERFORMANCE AND
POSITION ..............................................................................277
Syllabus C1. Interpreting Ratios .................................................................277
Syllabus C2. Limitations of ratio analysis .....................................................290
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Syllabus A: SOURCES OF LONG-TERM FINANCE
Syllabus A1a. Types and sources of long-term finance
Ordinary shares
Ordinary shares carry no right to a fixed dividend but ordinary shareholders are
entitled to all profits.
In fact, the amount of ordinary dividends fluctuates from year to year.
Ordinary shareholders are sometimes referred to as equity shareholders
Rights of Ordinary shareholders:
1. Shareholders can attend company general meetings.
2. They can vote on company matters such as:
- the appointment or re-election of directors
- the appointment of auditors
3. Ordinary shareholders are the effective owners of a company.
They own the 'equity' of the business including any reserves of the business.
4. They are entitled to receive dividends
5. They will receive the annual report and accounts
2
Equity finance
• is raised through the sale of ordinary shares to investors.
Liquidation
• The ordinary shareholders are the ultimate bearers of risk as they are at the
bottom of the creditor hierarchy in a liquidation.
This means that they might receive nothing after the settlement of all the
company's liabilities.
3
Preference Shares
1. Carry the right to a final dividend

which is expressed as a percentage of their par value
e.g. a 5% $1 preference share carries a right to an annual dividend of 5c.
2. Have priority over ordinary dividends
The managers of a company are obliged to pay preference dividend first.
Also, preference shareholders have priority over ordinary shareholders to a

return of their capital if the company goes into liquidation.
3. If the preference shares are cumulative

it means that before a company can pay any ordinary dividend it must not only
pay the current year's preference dividend, but must also make good any arrears
of preference dividends which were not paid in previous years.
4. Do not carry a right to vote

However, Preference shares carry LIMITED voting rights where dividends are in
arrears.
5. Should be classified as liabilities
Preference shares may be either redeemable or irredeemable
Redeemable preference shares

Redeemable preference shares mean that the company will repay the nominal value
of those shares at a later date.
For example, 'redeemable 6% $1 preference shares 20X8' means that the company
will pay these shareholders $1 for every share they hold on a certain date in 20X8.
4
Redeemable preference shares are treated like loans and are included as non-
current liabilities in the statement of financial position.
However, if the redemption is due within 12 months, the preference shares will be
classified as current liabilities.
Dividends paid (6c per share in our example) on redeemable preference shares are
included as a finance costs (added to interest paid) in the statement of profit or loss.
Irredeemable preference shares
Irredeemable preference shares form part of equity and their dividends are treated
as appropriations of profit.
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Long term finance
These are:
1. Finance Lease
You will notice we have included finance leases as potential sources of finance -
don’t forget too to mention the possibility of selling your assets and leasing them
back as a way of getting cash.
Be careful though - make sure there are enough assets on the SFP to actually do
this - or your recommendation may look a little silly ;)
2. Bank loans and bonds/debentures
Bonds securities which can be traded in the capital markets.
Bond holders are lenders of debt finance.
Bond holders will be paid a fixed return known as the coupon.
Traded bonds raise cash which must be repaid usually between 5 and 15 years
after issue.
Bonds are usually secured on non-current assets thus reducing risk to the
lender.
Interest paid on the bonds is tax-deductible, thus reducing the cost of debt to
the issuing company
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3. Equity
via a placing - does not need to be redeemed, since ordinary shares are truly
permanent finance.
The return to shareholders in the form of dividends depends on the dividend

decision made by the directors of a company, and so these returns can increase,
decrease or be passed.
Dividends are not tax-deductible like interest payments, and so equity finance is
not tax-efficient like debt finance.
4. Preference Share
These are seen as a form of debt
5. Venture Capital
For companies with high growth and returns potential
This is provided to early/start up companies with high-potential.
The venture capitalist makes money by taking an equity share and then realising
this in an IPO (Initial Public Offering) or trade sale of the company
Equity as finance
Rights For existing shareholders

No dilution of control
Issue initially
Fixed price to institutional

Placing Low cost - good for small issues
investors
Public Underwritten & advertised Expensive - good for large issue
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Rights Issue
For existing shareholders initially - means no dilution of control
• A 1 for 2 at $4 (MV $6) right issue means….
The current shareholders are being offered 1 share for $4, for every 2 they
already own.
(The market value of those they already own are currently $6)
Calculation of TERP (Theoretical ex- rights price)
• Calculation of TERP (Theoretical ex- rights price)
The current shareholders will, after the rights issue, hold:
1 @ $4 = $4
2 @ $6 =$12
So, they now own a total of 3 for a total of $16. So the TERP is $16/3 = $5.33
Effect on EPS
Obviously this will fall as there are now more shares in issue than before, and the
company has not received full MV for them
• To calculate the exact effect simply multiply the current EPS by the TERP /
Market value before the rights issue
Eg Using the above illustration
EPS x 5.33 / 6
Effect on shareholders wealth
• There is no effect on shareholders wealth after a rights issue.
This is because, although the share price has fallen, they have proportionately
more shares
Equity issues such as a rights issue do not require security and involve no loss
of control for the shareholders who take up the right
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Methods of obtaining a listing
An unquoted company can obtain a listing on the stock market by means of a:
1. Initial public offer (IPO)
When a company issues shares to the public for the first time.
They are often issued by smaller, younger companies looking to expand, or large
private companies wanting to become public.
For the individual investor it is tough to predict share prices on the initial day of
trading as there’s little past data about the company often, so it’s a risky
purchase.
Also expansion brings uncertainty in any case
2. Placing
Is an arrangement whereby the shares are not all offered to the public.
Instead, the shares are bought by a small number of investors, usually

institutional investors (such as pension funds and insurance companies).
This means low cost - so good for small issues
Placings are likely to be quick.
3. Public Issues
These are underwritten & advertised.
This means they are expensive - so good for large issue
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Debt or Equity?
These are the things you need to think about when asked about raising finance - so
just put all these in your answer and link them to the scenario. Job done.
Gearing and financial risk
• Equity finance will decrease gearing and financial risk, while debt finance will
increase them
Target capital structure
• The aim is to minimise weighted average cost of capital (WACC).
In practical terms this can be achieved by having some debt in capital structure,
since debt is relatively cheaper than equity, while avoiding the extremes of too
little gearing (WACC can be decreased further) or too much gearing (the
company suffers from the costs of financial distress)
Availability of security
• Debt will usually need to be secured on assets by either:
a fixed charge (on specific assets) or
a floating charge (on a specified class of assets).
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Economic expectations
• If buoyant economic conditions and increasing profitability expected in the

future, fixed interest debt commitments are more attractive than when difficult
trading conditions lie ahead.
Control issues
• A rights issue will not dilute existing patterns of ownership and control, unlike an
issue of shares to new investors.
Less or more risk?
The providers of debt finance face less risk than the providers of equity finance  
because there is more certainty over the level of their return.
 
As a result debt providers will require a lower level of return on their investment
than equity providers.
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Functions of Stock and Bond markets
A stock market (also known as a stock exchange) has two main

functions
1. to provide companies with a way of issuing shares to people who want to invest
in the company
2. to provide a venue for the buying and selling of shares
The first function allows businesses to be publicly traded, or raise additional capital
for expansion by selling shares of ownership of the company in a public market
This enables investors the ability to quickly and easily sell securities.
This liquidity is an attractive feature of investing in stocks, compared to other less

liquid investments such as real estate.
Exchanges also act as the clearinghouse for each transaction, meaning that they
collect and deliver the shares, and guarantee payment to the seller of a security
This eliminates the risk to an individual buyer or seller.
The Alternative Investment Market is regulated by the London Stock Exchange.
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Capital markets
A stock market acts as a primary market for raising finance, and as a secondary
market for the trading at existing securities.
Securities are tradable financial instruments.
They can take the form of equity (such as shares), debt (such as bonds) or
derivatives.
Capital markets are markets for trading in medium and long-term finance.
ln the UK the principal capital markets are:

• The Stock Exchange main market (for companies with a full Stock Exchange
listing)
• The more loosely regulated second tier Alternative Investment Market (AIM)
Firms obtain capital in the following ways:
1. Raise Share capital
They may raise share capital.
Most new issues of share capital are in the form of ordinary share capital.
Firms that issue ordinary Share capital are inviting investors to take an equity
stake in the business, or to increase their existing equity stake.
2. Raise loan capital
They may raise loan capital
Long-term loan capital may be raised in the form of loan notes, corporate bonds,
debentures, unsecured and convertible bonds.
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The role of advisors
Raising finance on the capital market requires input from a wide range
of experts.
Sponsor
A sponsor, typically an investment bank or large accountancy firm, acts as the lead
advisor in an Initial Public Offer (IPO) on the Main Market.
Firms offering services as sponsors must be approved by the UK Listing Authority

(UKLA) which forms part of the UK’s Financial Conduct Authority (FCA).
The sponsor’s functions include:

• Project managing the IPO process
• Co-ordinating the due diligence and the drafting of the prospectus (the
prospectus is the document in which the company offers its share for sale)
• Ensuring compliance with the applicable rules
• Developing the investment case, valuation and offer structure
• Managing the communication between the London Stock Exchange and the
UKLA
• Advising the company’s board both before the IPO and after
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Bookrunner
Share issues in the primary market may be underwritten by a financial institution,

such as investment bank.
The issue of debt may be underwritten in the same way. The underwriter is referred
to as the bookrunner.
The bookrunner undertakes to raise finance from investors on behalf of the

company.
In the process, it helps to determine the appropriate pricing for the share or debt.
If the bookrunner is unable to find enough investors, it will hold some of the share
itself.
In a public offering, shares are often underwritten by a syndicate of several

bookrunners.
Reporting accountant
The directors bear legal responsibility for the integrity of the listing documents
(including the prospectus).
The sponsor, as the company’s lead advisor, risks considerable damage to its
reputation should the prospectus be deficient.
For this reason, the sponsor would usually require the company to engage a
reporting accountant to review and report on the company’s readiness for the
transaction.
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The reporting accountant would typically report on the following:
• Financial reporting procedures - whether the company would be able to meet its
reporting obligations as a public company
• Financial historical records - the equivalent of an audit opinion on the company’s
entire financial track record.
• Working capital - whether the basis for the directors’ working capital statement
in the prospectus is sound
• Other information - any other additional information provided in the prospectus,
such as profit forecast and pro-forma financial information (for example, to
illustrate the effects of an IPO)
Lawyer
The London Stock Exchange is governed by EU law, UK Acts of Parliament, the

FCA’s Listing Rules and the Exchange’s own rules.
Lawyers therefore play an important part in ensuring that the company meets the
eligibility criteria for the listing, and continues to comply with the ongoing
obligations of a public company.
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Syllabus A2. WACC
Cost of Capital - Basics
The cost of capital represents the return required by the investors (such
as equity holders, preference holders or banks)
Basically the more risk you take, the more return you expect.
This risk is the likelihood of actual returns varying from forecast.
The return for the investors needs to be at least as much as what they can get from
government gilts (these are seen as being risk free). On top of this they would like a
return to cover the extra risk of giving the firm their investment.
The investors could be debt or shareholders (debt and equity).
The cost of capital is made up of the cost of debt + cost of equity.
The cost of normal debt is cheaper than the cost of equity to the company. This is
because interest on debt is paid out before dividends on shares are paid. Therefore
the debt holders are taking less risk than equity holders and so expect less return.
Also debt is normally secured so again less risk is taken.
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Creditor hierarchy
When a company cannot pay its debts and goes into liquidation, it must pay its
creditors in the following order:
1. Creditors with a fixed charge
2. Creditors with a floating charge
3. Unsecured creditors
4. Preference shareholders
5. Ordinary shareholders
Each of the above will cost the company more as it heads down the list. This is
because each is taking more risk itself
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Calculating the WACC
Marginal Cost of Capital

• If a company gets a specific loan or equity to finance a specific project then this
loan/equity cost is the MARGINAL cost of capital.
Average Cost of Capital
• If a company is continuously raising funds for many projects then the combined
cost of all of these is the AVERAGE cost of capital.
Always use the AVERAGE cost of capital in exam questions, unless stated that
the finance is specific
Calculating the WACC
Consider a company funded as follows:
Type Amount Cost of Capital

Equity 80% 10%
Debt 20% 8%
What is the weighted average cost of capital?
Equity 80% x 10% = 8%
Debt 20% x 8% = 1.6%
WACC 9.6%
What we have ignored here is how did we get to calculate how the ‘amount’ of
equity and debt was calculated - using book or market values?
Use MV where possible
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Illustration
Statement of Financial Position
Ordinary Shares 2,000
Reserves 3,000
Loan 10% 1,000
Ordinary shares MV = 3.75; Loan note MV 80;
Equity cost of capital = 20%; Debt cost of capital = 7.5% (after tax)
Calculate WACC using:
1. Book Values
2. Market Values
Solution
Using Book Values:
Equity
Ordinary Shares 2,000
Reserves 3,000
5,000
Debt
Loan 1,000
6,000
Equity 5,000/6,000 x 20% = 16.67%
Debt 1,000/6,000 x 7.5% = 1.25%
WACC 17.92%
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Solution
Using Market Values:
Equity
Shares 2,000 x 3.75 7,500
7,500
Debt
Loan 1,000 80/100 800
8,300
Equity 7,500/8,300 x 20% = 18.07%
Debt 800/8,300 x 7.5% = 0.72%
WACC 18.79%
SUMMARY
To Calculate WACC
1. Calculate weighting of each source of capital (as above)
2. Calculate each individual cost of capital
3. Multiply through and add up (as above)
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Dividend Valuation Model
The cost of equity – the dividend growth model
DVM can be with or without growth.
What this means is that the share price can be calculated assuming a growth in
dividends or not
Essentially this model presumes that a share price is the PV of all future dividends.
Calculate this (with or without growth) and multiply it by the total number of shares
It is similar to market capitalisation except it doesn’t use the market share price,
rather one worked out using DVM
1. DVM (without growth)
The share price is calculated like this:
• Constant Dividend / Cost of Equity (decimal)
Cost of Equity will be given, or calculated via CAPM
Take this share price and multiply it by the number of shares
2. DVM with growth
• Dividend in year 1 / Cost of Equity - growth (decimal)
Or
• Dividend just paid (1+g) / Cost of Equity - growth (decimal)
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Illustration
• Share Capital (50c) $2 million
Dividend per share (just paid) 24c
Dividend paid four years ago 15.25c
Current market return = 15%
Risk free rate = 8%
Equity beta 0.8
Solution
Dividend is growing so use DVM with growth model:
• Calculating Growth
Growth not given so have to calculate by extrapolating past dividends as before:
24/15.25 sq root to power of 4 = 1.12 = 12%
So Dividend at end of year 1 = 24 x 1.12
• Calculate Cost of Equity (using CAPM)
8 + 0.8 (15-8) = 13.6%
Share price = 24x1.12 / 0.136 - 0.12 = 1,680c
Market cap = $16.8 x (2m / 0.5) = $67.2
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Redeemable debt
The company pays the interest and the original amount (capital) back.
So the MV is the interest and capital discounted at the investor’s required rate of
return.
Remember the cost of debt to the company is the debt holder’s required rate of
return. (Tax plays a part here as we shall see later)
To calculate the cost of debt in an exam an IRR calculation is required

as follows:
1. Guess the cost of debt is 10 or 15% and calculate the present value of the
capital and interest.
2. Compare this to the correct MV
3. Now do the same but guess at 5%
4. Use the IRR formula to calculate the actual cost of capital
IRR = L + (NPV L / (NPV L - NPV H)) x (H - L)
Illustration
5 years 12% redeemable debt. MV is 107.59
Time Cash 5% PV 15% PV
1-5 Interest 12 4.329 51.95 3.352 40.22

5 Capital 100 0.784 78.40 0.497 49.7
MV -107.59 -107.59
22.76 -17.67
IRR = 5 + (22.76 / (22.76+17.67)) x (15-5) = 10.63
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The Tax Effect
• Tax reduces the cost of capital to a company because interest payments are tax
deductible.
It was ignored in the last example, but let’s say that that tax was 30%, then the
actual interest cost was not 12 but 12x70% = 8.40
Simply take the interest figure and multiply it by 1 - tax rate%.
Illustration
20% Redeemable debt.
Tax 30%.
What is the interest charge to be used in a cost of capital calculation for a

company?
20% x 70% = 14%
Now let’s rework that last example but this time use 10% as a guess and let’s
assume tax of 30%

1-5 Interest 8.4 4.329 36.36 3.791 31.84
5 Capital 100 0.784 78.40 0.621 62.1
MV -107.59 -107.59
7.17 -13.65
IRR = 5 + (7.17 / (7.17 + 13.65)) x (10-5) = 6.72
The cost of capital is lower than the original example as tax effectively reduces the
cost to the company as interest is a tax deductible expense.
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Irredeemable, preference shares and Bank loans
Irredeemable debt
The company just pays back the interest (NOT the capital)
So the MV should just be all the expected interest discounted at the investor’s
required rate of return.
Therefore, the cost of debt (the debt holder’s required return) can be
calculated as follows:
• Annual Interest / Market Value
Preference Shares
Treat the same as irredeemable debt except that the dividend payments are never
tax deductible
• Annual Dividend / Market Value
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Illustration
50,000 8% preference shares.
MV 1.20.
What is the cost of capital for these?
(8% x 50,000) / (50,000 x 1.2) = 6.67%
Bank Debt
The cost of debt is simply the interest charged. Do not forget to adjust for tax
though if applicable.
Illustration
$1,000,000 10% Loan. Tax 30%.
What is the cost of debt?
7%
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Convertible Debt
Here the investor has the choice to either be paid in cash or take shares from the
company.
Hence, the debt is convertible into shares.
To calculate the cost of capital here, simply follow the same rules as for redeemable
debt (an IRR calculation).
The only difference is that the ‘capital’ figure is the higher of:
1. Cash payable
2. Future share payable
Illustration
8% Convertible debt. Redeemable in 5 years at:
Cash 5% premium or
20 shares per loan note (current MV 4 and expected to grow at 7%)
The MV is currently 85.
Tax 30%.
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1-5 Interest 5.6 4.329 24.24 3.791 21.23
5 Capital 112.2 0.784 87.96 0.621 69.68
MV -85 -85
27.2 5.91
IRR = 5 + (27.2 / (27.2 - 5.91)) x (10-5) = 11.4%
Note :
Interest = 100 x 8% x 70% (tax adj) = 5.6
Capital = higher of 100 x 1.05% (premium) = 105 and 20 x 4 x 1.07 power 5 = 112.2
Terminology
• Floor Value MV without conversion option (basically the above calculation using
cash as capital)
• Conversion Premium MV of loan - convertible shares @ today’s price
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WACC - Putting it all Together
So, you have studied all the bits in isolation, here’s where we get sexy and bring it
all together..
So, this is kind of the proforma you need to set up, when you get a “Calculate the
WACC..” question
DEBT/EQUITY COST Market Value “Interest”
Equity 10% 1,000 100
Loan 6% 800 48
Total 1,800 148
So we have paid “interest’ of 148 on capital of 1,800…
So the WACC is 148/1,800 = 8.2%
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Syllabus B: FINANCIAL REPORTING
Syllabus B1a. Consolidated financial statements
IAS 1 Presentation of Financial Statements
The statement of profit or loss (P&L)
is defined as the total of income less expenses, excluding the components of other
comprehensive income
Other comprehensive income (OCI)
comprising of items of income and expense (including reclassification adjustments)

that are not recognised in profit or loss
IFRS currently requires
• the statement of P&L and OCI to be presented as either one statement, being a
combined statement of P&L and OCI
• or two statements, being the statement of P&L and the statement of

comprehensive income.
An entity has to show separately in OCI
• Those items which would be reclassified (recycled) to P&L and
• Those items which would never be reclassified (recycled) to P&L.
The related tax effects have to be allocated to these sections.
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Reclassification adjustments
are amounts recycled to P&L in the current period which were recognised in OCI in
the current or previous periods.
• An example of items recognised in OCI which may be reclassified to P&L are

foreign currency gains on the disposal of a foreign operation and realised gains
or losses on cash flow hedges
Those 20 items which may not be reclassified are changes in a revaluation surplus
under IAS 16 Property, Plant and Equipment, and actuarial gains and losses on a
defined benefit plan under IAS 19 Employee Benefits.
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Definition of a subsidiary
Group Accounting
Presentation
According to IAS 1 accounts must distinguish between:
1. Profit or Loss for the period
2. Other gains or losses not reported in profits above (Other Comprehensive

Income)
3. Equity transactions (share issues and dividends)
Here's some key definitions:
Consolidated financial statements:
The financial statements of a group presented as those of a single economic entity.
Subsidiary: an entity that is controlled by another entity (known as the parent)
Parent: an entity that has one or more subsidiaries
Control: the power to govern the financial and operating policies of an entity so as
to obtain benefits from its activities
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Identification of subsidiaries
Control is presumed when the parent has 50% + voting rights of the entity.
Even when less than 50%, control may be evidenced by power..
• Getting the 50%+ by an arrangement with other investors
• Governing the financial and operating policies
• Appointing the majority of the board of directors
• Casting the majority of votes
It could also come from the parent controlling one subsidiary, which in turn controls
another.
The parent then controls both subsidiaries
Power
So a parent needs the power to affect the subsidiary and as we said before this is
normally given by owning more than 50% of the voting rights
It might also come from complex contractual arrangements
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Group Accounting Exemptions
Who needs to prepare consolidated accounts?
Basically a parent company, one with a subsidiary
However there are exceptions to this rule:

• The parent is itself a wholly owned subsidiary
• The parent is a partially (e.g. 80%) owned sub and the other 20% owners allow it
to not prepare consolidated accounts
• The parents shares are not publicly traded
• The parents own parent produces consolidated accounts
Sometimes a sub is purchased with a view to it being sold.
In this case it is an IFRS 5 discontinued operation
The group share of its profits are shown on the income statement and all of its
assets and liabilities shown separately on the SFP
Not Valid reasons for exemption
1. A subsidiary whose business is of a different nature from the parent’s.
2. A subsidiary that operates under severe long-term restrictions impairing the

subsidiary’s ability to transfer funds to the parent.
3. A subsidiary that had previously been consolidated and that is now being held
for sale.
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Business Combinations - Basics
The purpose of consolidated accounts is to show the group as a single

economic entity.
So first of all - what is a business combination?
• Well my little calf, it’s an event where the acquirer obtains control of another
business.
• Let me explain, let’s say we are the Parent acquiring the subsidiary.
We must prepare our own accounts AND those of us and the sub put together
(called “consolidated accounts”)
This is to show our shareholders what we CONTROL.
Basic principles
The accounts show all that is controlled by the parent, this means:
1. All assets and liabilities of a subsidiary are included
2. All income and expenses of the subsidiary are included
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Non controlling Interest (NCI)
However the parent does not always own all of the above.
So the % that is not owned by the parent is called the “non-controlling interest”.
• A line is included in equity called non-controlling interests. This accounts for

their share of the assets and liabilities on the SFP.
• A line is also included on the income statement which accounts for the NCI’s
share of the income and expenses.
One Thing you must understand before we go on
Forgive me if this is basic, but hey, sometimes it’s good to be sure.
H S
Non Current Asset 500 600
Investment in S 200
Current Assets 100 200

Share Capital 100 100
Reserves 300 400

Current Liabilities 100 50
Non Current Liabilities 300 250
Notice if you add the assets together and take away the liabilities for H - it comes to
400 (500+200+100-100-300)
There are 2 things to understand about this figure:
1. It is NOT the true/fair value of the company
2. It is equal to the equity section of the SFP
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Equity
• This shows you how the net assets figure has come about. The share capital is
the capital introduced from the owners (as is share premium).
• The reserves are all the accumulated profits/losses/gains less dividends since
the business started. Here the figure is 400 for H.
Notice it is equal to the net assets
Acquisition costs
• Where there’s an acquisition there’s probably some of the costs eg legal fees etc
Costs directly attributable to the acquisition are expensed to the income

statement.
• Be careful though, any costs which are just for the parent (acquirer) issuing its
own debt or shares are deducted from the debt or equity itself (often share
premium).
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Simple Goodwill
Goodwill
• When a company buys another - it is not often that it does so at the fair value of
the net assets only.
This is because most businesses are more than just the sum total of their ‘net
assets’ on the SFP.
Customer base, reputation, workforce etc. are all part of the value of the
company that is not reflected in the accounts.
This is called “goodwill”
• Goodwill only occurs on a business combination. Individual companies cannot

show their individual goodwill on their SFPs.
This is because they cannot get a reliable measure, This is because nobody has
purchased the company to value the goodwill appropriately.
On a business combination the acquirer (Parent) purchases the subsidiary -

normally at an amount higher than the FV of the net assets on the SFP, they buy
it at a figure that effectively includes goodwill.
Therefore the goodwill can now be measured and so does show in the group
accounts.
How is goodwill calculated?
On a basic level - I hope you can see - that it is the amount paid by the parent less
the FV of the subs assets on their SFP.
39
Let me explain..
S
Non-Current Assets 1,000
Current Assets 400

Share Capital 100
Share Premium 100
Reserves 700

Current Liabilities 100
Non-Current Liabilities 400
In this example S’s Net assets are 900 (same as their equity remember).
This is just the ‘book value’ of the net assets.
The Fair Value of the net assets may be, say, 1,000.
However a company may buy the company for 1.200. So, Goodwill would be 200.
The goodwill represents the reputation etc. of a company and can only be reliably
measured when the company is bought out.
40
Here it was bought for 1,200. Therefore, as the FV of the net assets of S was only
1,000 - the extra 200 is deemed to be for goodwill.
The increase from book value 900 to FV 1,000 is what we call a Fair Value
adjustment.
Bargain Purchase
This is where the parent and NCI paid less at acquisition than the FV of S’s net
assets. This is obviously very rare and means a bargain was acquired
So rare in fact that the standard suggests you look closely again at your calculation
of S’s net assets value because it is strange that you got such a bargain and
perhaps your original calculations of their FV were wrong
However, if the calculations are all correct and you have indeed got a bargain
then this is NOT shown on the SFP rather it is shown as:
• Income on the income statement in the year of acquisition
41
NCI in the Goodwill calculation
So far we have presumed that the company has been 100% purchased when
calculating goodwill.
Our calculation has been this:
Consideration x
FV of Net Assets Acquired (x)
Goodwill x
Non-controlling Interests
Let’s now take into account what happens when we do not buy all of S. (eg. 80%)
This means we now have some non-controlling interests (NCI) at 20%
The formula changes to this:
Consideration x
NCI x
Goodwill x
This NCI can be calculated in 2 ways:
1. Proportion of FV of S’s Net Assets
2. FV of NCI itself
42
Proportion of FV of S’s Net Assets method
This is very straight forward. All we do is give the NCI their share of FV of S’s Net
Assets..Consider this:
P buys 80% S for 1,000. The FV of S’s Net assets were 1,100.
How much is goodwill?
Consideration 1,000
NCI 220
FV of Net Assets Acquired (1,100)
Goodwill 120
The NCI is calculated as 20% of FV of S’s NA of 1,100 = 220
“Fair Value Method” of Calculating NCI in Goodwill
• So in the previous example NCI was just given their share of S’s Net assets.
They were not given any of their reputation etc.
In other words, NCI were not given any goodwill.
• I repeat, under the proportionate method, NCI is NOT given any goodwill.
Under the FV method, they are given some goodwill.
• This is because NCI is not just given their share of S’s NA but actually the FV of
their 20% as a whole (ie NA + Goodwill).
This FV figure is either given in the exam or can be calculated by looking at the
share price (see quiz 2).
P buys 80% S for 1,000. The FV of S’s Net assets were 1,100. The FV of NCI at
this date was 250.
43
Consideration 1,000
NCI 250
Goodwill 150
Notice how goodwill is now 30 more than in the proportionate example. This is the
goodwill attributable to NCI.
NCI goodwill = FV of NCI - their share of FV of S’s NA
Remember
Under the proportionate method NCI does not get any of S’s Goodwill (only their
share of S’s NA).
Under the FV method, NCI gets given their share of S’s NA AND their share of S’s
goodwill
44
Equity Table
S’s Equity Table
As you will see when we get on to doing bigger questions, this is always our first
working.
This is because it helps all the other workings.
Remember that Equity = Net assets
Equity is made up of:
1. Share Capital
2. Share Premium
3. Retained Earnings
4. Revaluation Reserve
5. Any other ‘reserve’!
If any of the above is mentioned in the question for S, then they must go into this
equity table working.
45
What does the table look like?
At SFP date At Acquisition Post Acquisition
Share Capital x x x
Share Premium x x x
Retained Earnings x x x
Total x x x
Remember that any other reserve would also go in here.
So how do we fill in this table?
1. Enter the "Year end" figures straight from the SFP
2. Enter the "At acquisition" figures from looking at the information given normally
in note 1 of the question.
Please note you can presume the share capital and share premium is the same
as the year-end figures, so you're only looking for the at acquisition reserves
figures
3. Enter "Post Acquisition" figures simply by taking away the "At acquisition"
figures away from the "Year end" figures
(ie. Y/E - Acquisition = Post acquisition)
So let's try a simple example.. (although this is given in a different format to the
actual exam let's do it this way to start with).
A company has share capital of 200, share premium of 100 and total reserves at
acquisition of 100 at acquisition and have made profits since of 400. There have
been no issues of shares since acquisition and no dividends paid out.
46
Show the Equity table to calculate the net assets now at the year end, at
acquisition and post-acquisition
Solution
Now At Acquisition Post-Acquisition
Share Capital 200 200 0
Share Premium 100 100 0
Retained Earnings 500 100 400
Total 800 400 400
Fair Value Adjustments
Ok the next step is to also place into the Equity table any Fair Value adjustments
When a subsidiary is purchased - it is purchased at FAIR VALUE at acquisition.
Using the figures above, if I were to tell you that the FV of the sub at acquisition was
480.
Hopefully you can see we would need to make an adjustment of 80 (let’s say that
this was because Land had a FV 80 higher than in the books):
Land x 80 x
Total 800 480 x
Now as land doesn’t depreciate - it would still now be at 80 - so the table changes
to this:
47
Land 80 80 0
Total 880 480 400
If instead the FV adjustment was due to PPE with a 10 year useful economic life left
- and lets say acquisition was 2 years ago, the table would look like this:
PPE 64 80 -16
Total 864 480 384
The -16 in the post acquisition column is the depreciation on the FV adjustment. (80
/ 10 years x 2 years).
This makes the now column 64 (80 at acquisition - 16 depreciation post acquisition).
48
NCI on the SFP
Non-Controlling Interests
So far we have looked at goodwill and the effect of NCI on this.. Now let’s look at
NCI in a bit more detail
(don’t worry we will pull all this together into a bigger question later).
If you remember there are 2 methods of measuring NCI at acquisition:
1. Proportionate method
This is the NCI % of FV of S’s Net assets at acquisition.
2. FV Method
This is the FV of the NCI shares at acquisition (given mostly in the question).
This choice is made at the beginning.
Obviously, S will make profits/losses after acquisition and the NCI deserve their
share of these.
Therefore the formula to calculate NCI on the SFP is as follows:
(this is the same figure as used in

NCI @ Acquisition x
goodwill*)
NCI % of S’s post acquisition profits/
x
losses
NCI on the SFP x
* This figure depends on the option chosen at acquisition (Proportionate or FV

method).
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Impairment
S may become impaired over time. If it does, it is S’s goodwill which will be reduced
in value first. If this happens it only affects NCI if you are using the FV method.
This is because the proportionate method only gives NCI their share of S’s Net
assets and none of the goodwill.
Whereas, when using the FV method, NCI at acquisition is given a share of S’s NA
and a share of the goodwill.
NCI on the SFP Formula revised
(this is the same figure as used in

NCI @ Acquisition x
goodwill*)
NCI % of S’s post acquisition profits/

x
losses
Impairment (x) (ONLY if using FV method)
NCI on the SFP x
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Reserves Calculation
SFP Group Reserves
So far we have looked at how to calculate goodwill and then NCI for the SFP, now
we are looking at how to calculate any group reserves on the SFP
There could be many reserves (eg Retained Earnings, Revaluation Reserve etc),
however they are all calculated the same way
Basic Idea
The basic idea is that group accounts are written from the Parent companies point
of view.
Therefore we include all of Parent (P’s) reserves plus parent share of Subs post
acquisition gains or losses in that reserve.
Let’s look at an example of this using Retained Earnings.
Illustration 1
P acquired 80% S when P’s Retained earnings were 1,000 and S’s were 600
Now, P’s RE are 1,400 and S’s RE are 700.
What is the RE on the SFP now?
P 1,400
S 80 (80% x (700-600)
1,480
It is worth pointing out here that all these workings only really to start to make sense
once you start to do lots of examples - see my videos for this.
51
Impairment
If Goodwill has been impaired then goodwill will reduce and retained earnings will
reduce too.
However, the amount of the impairment depends on the NCI method chosen:
1. Proportionate NCI method

This means that NCI has zero goodwill, so any goodwill impaired all belongs to
the parent and so 100% is taken to RE
2. FV method
Here NCI is given a share of NCI, so also takes a share of the impairment.
Therefore the group only gets its share of the impairment in RE (eg 80%)
Illustration 2
P acquired 80% S when P’s Retained earnings were 1,000 and S’s were 600.
Now, P’s RE are 1,400 and S’s RE are 700.
P uses the FV method of accounting for NCI and impairment of 40 has occurred
since.
What is the RE on the SFP now?
P 1,400
S 80 (80% x (700-600)
Impairment (32) (80% x 40)
1,448
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Basic groups - Simple Question 1
Have a look at this question and solution below and see if you can work out where
all the figures in the solution have come from.
Make sure to check out the videos too as these explain numbers questions such as
these far better than words can..
P S
Non-Current Asset 500 600
Investment in S 200

Reserves 300 400

Non-Current Liabilities 300 250
P acquired 80% S when S’s reserves were 80.
Prepare the Consolidated SFP, assuming P uses the proportionate method for
measuring NCI at acquisition.
53
Goodwill
Consideration 200
NCI 36
FV of Net Assets Acquired (180)
Goodwill 56
NCI
NCI @ Acquisition 36 (from goodwill working above)
NCI % of S’s post acquisition profits 64 (20% x (400-80))
NCI on the SFP 100
Reserves
P 300
S 256 (80% x (400-80)
Impairment (0) (100% because proportionate method x 0)
556
54
Group SFP
P S Group
Non-Current Asset 500 600 1,100
Investment in S 200 Goodwill 56
Current Assets 100 200 300

Reserves 300 400 556
NCI 100

Current Liabilities 100 50 150
Non-Current Liabilities 300 250 550
Notice
1. Share Capital (and share premium) is always just the holding company
2. All P + S assets are just added together
3. “Investment in S”.. becomes “Goodwill” in the consolidated SFP
4. NCI is an extra line in the equity section of consolidated SFP
55
Basic Groups - Simple Question 2
P S
Investment in S 120

Reserves 220 400

Non-Current Liabilities 300 250
P acquired 80% S when S’s Reserves were 40.
At that date the FV of S’s NA was 150.
Difference is due to Land.
There have been no issues of shares since acquisition.
P uses the FV of NCI method at acquisition, and at acquisition the FV of NCI was
35. No impairment of goodwill.
56
Prepare the consolidated set of accounts.
Step 1: Prepare S’s Equity Table
Land 10 10 0
Total 510 150 360
Now the extra 10 FV adjustment now must be added to the PPE when we come to
do the SFP at the end.
Step 2: Goodwill
Consideration 120
NCI 35 (Given)
FV of Net Assets Acquired (150) from S’s Equity table
Goodwill 5
Step 3: Do any adjustments in the question
: NONE
Step 4: NCI
NCI @ Acquisition 35 (given)
NCI % of S’s post acquisition profits 72 (20% x 360 (from S’s Equity table)
NCI on the SFP 107
57
Step 5: Reserves
P 220
S 288 (80% x 360 (from S’s equity table))
508
Step 6: Prepare the final SFP (with all adjustments included)

P S Group
1,110 (including 10 from S’s equity

table)

NCI 107

Non-Current
300 250 550
Liabilities
 
58
Group Income Statement
Rule 1 - Add Across 100%
Like with the SFP, P and S are both added together. All the items from revenue
down to Profit after tax; except for:
1. Dividends from Subsidiaries
2. Dividends from Associates
Rule 2 - NCI
This is an extra line added into the consolidated income statement at the end. It is
calculated as NCI% x S’s PAT.
The reason for this is because we add across all of S (see rule 1) even if we only
own 80% of S.
We therefore owe NCI 20% of this which we show at the bottom of the income
statement.
Rule 3 - Associates
Simply show one line (so never add across an associate).
The line is called “Share in Associates’ Profit after tax”.
59
Rule 4 - Depreciation from the Equity table working
Remember this working from when we looked at group SFP’s?
Now At Acquisition Post Acquisition
PPE 40 50 -10
Total 620 450 170
The -10 from the FV adjustment is a group adjustment. So needs to be altered on

the group income statement. It represents depreciation, so simply put it to admin
expenses (or wherever the examiner tells you), be careful though to only out in THE
CURRENT YEAR depreciation charge.
Rule 5 - Time Apportioning

This isn’t difficult but can be awkward/tricky. Basically all you need to remember is
the group only shows POST -ACQUISITION profits. i.e. Profits made SINCE we
bought the sub or associate.
If the sub or associate was bought many years ago this is not a problem in this
year’s income statement as it has been a sub or assoc. all year.
The problem arises when we acquire the sub or the associate mid year. Just
remember to only add across profits made after acquisition. The same applies to
NCI (as after all this just a share of S’s PAT).
For example if our year end is 31/12 and we buy the sub or assoc. on 31/3. We only
add across 9/12 of the subs figures and NCI is % x S’s PAT x 9/12.
60
One final point to remember here is adjustments such as unrealised profits /
depreciation on FV adjustments are entirely post - acquisition and so are NEVER
time apportioned.
Rule 6 - Unrealised Profit

You will remember this table I hope
The idea of what we need to do How we do it on the SFP
Reduce Profit of Seller Reduce SELLERS Retained Earnings
Reduce Inventory Reduce BUYERS Inventory
Well the idea stays the same - it’s just how we alter the accounts that changes,
because this is an income statement after all and not an SFP. So the table you need
to remember becomes:
The idea of what we need to do How we do it on the SOCI
Reduce Profit of Seller Increase SELLERS Cost of Sales
Reduce Inventory No adjustment required
Notice how we do not need to make an adjustment to reduce the value of inventory.
This is because we have increased cost of sales (to reduce profits), but we do this
by actually reducing the value of the closing stock.
61
Unrealised Profit
The key to understanding this - is the fact that when we make group accounts - we
are pretending P & S are the same entity.
Therefore you cannot make a profit by selling to yourself!
So any profits made between two group companies (and still in group inventory)
need removing - this is what we call ‘unrealised profit’.
Unrealised profit - more detail

Profit is only ‘unrealised’ if it remains within the group. If the stock leaves the group
it has become realised.
So ‘Unrealised profit” is profit made between group companies and REMAINS IN

STOCK.
Example
P buys goods for 100 and sells them to S for 150. S has sold 2/5 of this stock.
The Unrealised Profit is: Profit between group companies 50 x 3/5 (what remains in
stock) = 30.
How do we then deal with Unrealised Profit

If P buys goods for 100 and sells them to S for 150.
Thereby making a profit of 50 by selling to another group company.
S sells 4/5 of them to 3rd parties.
Unrealised profit is 50 x 1/5 = 10
The idea of what we need to do How we do it on the SFP
Reduce Profit of Seller Reduce SELLERS Retained Earnings
Reduce Inventory Reduce BUYERS Inventory
62
So why do we reduce inventory as well as profit?
Well let’s say that S buys goods for 100 and sells them to P for 150 and P still has
them in stock.
How much did the stock actually cost the group?
The answer is 100, as they are still in the group.
However P will now have them in their stock at 150.
So we need to reduce stock/inventory also with any unrealised profit.
63
Intra-Group Balances & In-transit Items
Inter-group company balances
As with Unrealised Profit - this occurs because group companies are considered to
be the same entity in the group accounts.
Therefore you cannot owe or be owed by yourself.
So if P owes S - it means P has a payable with S, and S has a receivable from P in

their INDIVIDUAL accounts.
In the group accounts, you cannot owe/be owed by yourself - so simply cancel
these out:
Dr Payable (in P)
Cr Receivable (in S)
The only time this wouldn’t work is if the amounts didn’t balance, and the only way
this could happen is because something was still in transit at the year end. This
could be stock or cash.
You always alter the receiving company. What I mean is - if the item is in transit,
then the receiving company has not received it yet - so simply make the RECEIVING
Company receive it as follows:
64
Stock in transit
In the RECEIVING company’s books:
Dr Inventory
Cr Payable
Cash in transit
In the RECEIVING company’s books:
Dr Cash
Cr Receivable
Having dealt with the amounts in transit - the inter group balances (receivables/
payables) will balance so again you simply:
Dr Payable
Cr Receivable
Intra-group dividends
eliminate all dividends paid/payable to other entities within the group, and all
intragroup dividends received/receivable from other entities within the group.
65
Impairment of Goodwill
Goodwill is reviewed for impairment not amortised.
An impairment occurs when the subs recoverable amount is less than the subs
carrying value + goodwill.
How this works in practice depends on how NCI is measured - Proportionate or Fair
Value method.
Proportionate NCI
Here, NCI only receives % of S's net assets.
NCI DOES NOT have any share of the goodwill.
1. Compare the recoverable amount of S (100%) to..
2. NET ASSETS of S (100%) +
Goodwill (100%)
3. The problem is that goodwill on the SFP is for the parent only - so this needs
grossing up first
4. Then find the difference - this is the impairment - but only show the parent % of
the impairment
Example
H owns 80% of S. Proportionate NCI
Goodwill is 80 and NA are 200
Recoverable amount is 240
How much is the impairment?
66
Solution
RA = 240
NA = 200 + G/W (80 x 100/80) = 100 = 300
Impairment is therefore 60.
The impairment shown in the accounts though is 80% x 60 = 48.
This is because the goodwill in the proportionate method is parent goodwill only.
Therefore only parent impairment is shown.
Fair Value NCI

Here, NCI receives % of S's net assets AND goodwill.
NCI DOES now own some goodwill.
1. Compare the recoverable amount of S (100%) to..
2. NET ASSETS of S (100%) +
Goodwill (100%)
3. As, here, goodwill on the SFP is 100% (parent & NCI) - so NO grossing up
needed
4. Then find the difference - this is the impairment - this is split between the parent
and NCI share
Example
H owns 80% of S. Fair Value NCI
Goodwill is 80 and NA are 200
Recoverable amount is 240
How much is the impairment?
67
Solution
RA = 240
NA = 200 + G/W 80 = 280
Impairment is therefore 40.
The impairment shown in P's RE as 80% x 40 = 32.
The impairment shown in NCI is 20% x 40 = 8.
Impairment adjustment on the Income Statement
1. Proportionate NCI
Add it to P's expenses.
2. Fair Value NCI

Add it to S's expenses
(this reduces S's PAT so reduces NCI when it takes its share of S's PAT).
68
Associates
An associate is an entity over which the group has significant influence, but not
control.
Significant influence
Significant influence is normally said to occur when you own between 20-50% of
the shares in a company but is usually evidenced in one or more of the following
ways:
• representation on the board of directors
• participation in the policy-making process
• material transactions between the investor and the investee
• interchange of managerial personnel; or
• provision of essential technical information
Accounting treatment
An associate is not a group company and so is not consolidated. Instead it is
accounted for using the equity method. Intercompany balances are not cancelled.
Statement of Financial Position

There is just one line only “investment in Associate” that goes into the consolidated
SFP (under the Non-current Assets section).
69
It is calculated as follows:
Cost 400
Share of A’s post acquisition reserves 200
Less impairment (100)
500
Consolidated income statement

Again just one line in the consolidated income statement:
Share of Associates PAT (-impairment) 100
Include share of PAT less any impairment for that year in associate.
Do not include dividend received from A.
What’s important to notice is that you do NOT add across the associate’s Assets
and Liabilities or Income and expenses into the group totals of the consolidated
accounts. Just simply place one line in the SFP and one line in the Income
Statement.
70
Unrealised profits for an associate
1. Only account for the parent’s share (eg 40%).
This is because we only ever place in the consolidated accounts P’s share of A’s
profits so any adjustment also has to be only P’s share.
2. Adjust earnings of the seller
Adjustments required on Income Statement
• If A is the seller - reduce the line “share of A’s PAT”
• If P is the seller - increase P’s COS
Adjustments required on SFP

• If A is the seller - reduce A’s Retained earnings and P’s Inventory
• If P is the seller - reduce P’s Retained Earnings and the “Investment in

Associate” line
Illustration
P sells goods to A (a 30% associate) for 1,000; making a 400 profit. 3/4 of the
goods have been sold to 3rd parties by A.
What entries are required in the group accounts?

Profit = 400; Unrealised (still in stock) 1/4 - so unrealised profit = 400 x 1/4 = 100.
As this is an associate we take the parents share of this (30%). So an adjustment of
100 x 30% = 30 is needed.
Adjustment required on the Income statement

P is the seller - so increase their COS by 30.
71
Adjustment required on the group SFP
P is the seller - so reduce their retained earnings and the line “Investment in
Associate” by 30.
H S A
PPE 300,000 100,000 160,000
18,000 shares in S 75,000
24,000 shares in A 30,000
Receivables 345,000 160,000 80,000
Share capital £1 250,000 30,000 60,000
Retained earnings 400,000 180,000 100,000
Trade payables 100,000 50,000 80,000
The retained earnings of S and A were £70,000 and £30,000 respectively when they
were acquired 8 years ago.
There have been no issues of shares since then, and no FV adjustments required.
The group use the proportionate method for valuing NCI at acquisition.
Prepare the consolidated SFP

Solution
Step 1: Equity Table
Share Capital 30,000 30,000 0
Retained Earnings 180,000 70,000 110,000
Total 210,000 100,000 110,000
72
Step 2: Goodwill
Consideration 75,000
NCI 40,000 (40% x 100,000)
FV of Net Assets Acquired (100,000) from equity table
Goodwill 15,000
H owns 18,000 of S’s share capital of 30,000 so 60%.
Step 3: NCI
NCI @ Acquisition 40,000 (from goodwill working)
(40% x 110,000) (From equity

40 % of S’s post acquisition profits 44,000
table)
Impairment (0)
NCI on the SFP 84,000
Step 4: Retained Earnings
P 400,000
S 66,000 (60% x 110,000 (From Equity table)
A 28,000 (40% x 70,000 (100-30)
Impairment (0) (100% because proportionate method x 0)
494,000
73
Step 5: Investment in Associate
Cost 30,000
Share of A’s post acquisition reserves 28,000 (from RE working)
Less impairment (0)
58,000
Final answer – Goodwill
H S A Group
PPE 300,000 100,000 160,000 400,000
18,000 shares in S 75,000 15,000
18,000 shares in A 30,000 Investment in Associate 58,000
Receivables 345,000 160,000 80,000 505,000
Share capital £1 250,000 30,000 60,000 250,000
Retained earnings 400,000 180,000 100,000 494,000
NCI 84,000
Trade payables 100,000 50,000 80,000 150,000
74
Make sure you use FV of Consideration
Consideration is simply what the Parent pays for the sub.
It is the first line in the goodwill working as follows:
FV of Consideration X
NCI X
FV of Net Assets Acquired (X)
Goodwill X
Normal Consideration
This is straightforward. It is simply:
Dr Investment in S
Cr Cash
Future Consideration
This is a little more tricky but not much. Here, the payment is not made immediately
but in the future. So the credit is not to cash but is a liability.
Dr Investment in S
Cr Liability
75
The only difficulty is with the amount.
As the payment is in the future we need to discount it down to the present value at
the date of acquisition.
Illustration
P agrees to pay S 1,000 in 3 years time (discount rate 10%).
Dr Investment in S 751
Cr Liability 751 (1,000 / 1.10^3)
As this is a discounted liability, we must unwind this discount over the 3 years to get
it back to 1,000. We do this as follows:
Year 1 2 3
Dr Interest Cr Liability 75 84 91
Contingent Consideration
This is when P MAY OR MAY NOT have to pay an amount in the future (depending
on, say, S’s subsequent profits etc.). We deal with this as follows:
Dr Investment in S
Cr Liability
All at fair value
You will notice that this is exactly the same double entry as the future consideration
(not surprising as this is a possible future payment!).
The only difference is with the amount.
Instead of only discounting, we also take into account the probability of the
payment actually being made.
Doing this is easy in the exam - all you do is value it at the FV
(this will be given in the exam you’ll be pleased to know).
76
Illustration
1/1/x7 H acquired 100% S when it’s NA had a FV of £25m. H paid 4m of its own
shares (mv at acquisition £6) and cash of £6m on 1/1/x9 if profits hit a certain target.
At 1/1/x7 the probability of the target being hit was such that the FV of the
consideration was now only £2m. Discount rate of 8% was used.
At 31/12/x7 the probability was the same as at acquisition.
At 31/12/x8 it was clear that S would beat the target.
Show the double entry

Contingent consideration should always be brought in at FV. Any subsequent
changes to this FV post acquisition should go through the income statement.
Any discounting should always require an winding of the discount through interest
on the income statement
Double entry - Parent Company
1/1/x7
Dr Investment in S (4m x £6) + £2 = 26
Cr Share Capital 4
Cr Share premium 20
Cr Liability 2
31/12/x7
Dr interest 0.16
Cr Liability 0.16
31/12/x8
Dr Income statement 4 (6-2)
Dr Liability 2
Cr Cash 6
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Goodwill - FV of NA (more detail)
Goodwill
So let’s remind ourselves of the goodwill working:
Consideration 800
NCI 330
Goodwill 130
We have just looked in more detail at the sort of surprises the examiner can spring
on us in the first line “consideration” - now let´s look at the bottom line in more
detail:
Fair values of Net Assets at Acquisition

Operating leases. If terms are favourable to the market - recognise as an asset
Internally generated intangibles would now have a reliable measure and would be
brought in the consolidated accounts
Remember both of these items would need to be depreciated in our equity table
working
contingent liabilities (see bottom of this page)
78
Illustration
1/7/x5 H acquired 80% S for 16m, nci measured at share of net assets. FV of NA
was 10m.
S had a production backlog with a FV of 2m (uel 2 years) and unrecognised

trademarks with a FV of 1m. These are renewable at any time at a negligible cost.
S made a profit of 5m in the year to 31/12/x5.
What would goodwill be in the consolidated SFP?
Consideration 16
NCI 2.6

Goodwill 5.6
FV of NA working
Per Accounts 10 + FV adj (2+1) 3
Provisional Goodwill
We get “provisional goodwill’ when we cannot say for certain yet what the FV of Net
Assets are at the date of acquisition.
This is fine, we just state in the accounts that the goodwill figure is provisional.
This means we then have 12 months (from the date of acquisition) to change the
goodwill figure IF AND ONLY IF the information you find (within those 12 months)
gives you more information about the conditions EXISTING at the year-end.
Any information after the 12 month period (even if about conditions at acquisition)
does not change goodwill.
Any differences are simply written off to the income statement.
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So, in summary, the FV of NA can be altered retrospectively if within 12 months of
acquisition.
This means goodwill would change. Any alteration after 12 months is through the
income statement.
Illustration
A acquired 70% B on 1/7/x7, NCI measured at share of net assets acquired.
A provisional fair value only was used for plant and machinery of £8m (UEL 10yrs).
Goodwill was £4m.
The year-end of 31/12/x7 accounts were then approved on 25/2/x8.
On 1/4/x8 the FV of the plant was finalised at 7.2m.
How would this affect the consolidated accounts?
Provisional goodwill is acceptable if disclosed as such in the accounts.
The parent then has one year after acquisition to finalise the FV and alter goodwill.
Should the finalisation occur after one year - no adjustment is required to goodwill.
Provisional Goodwill 4m
Adjusted Goodwill
Original 4m + (0.8 x 70%) = 4.56m
Contingent liabilities
Normally these are just disclosures in the accounts.
However, remember that when a sub is acquired, it is brought into the accounts at
FV.
A contingent liability does have a fair value.
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Therefore they must be actually recognised in the consolidated accounts until the
amount is actually paid.
So the rules are:

1. Bring in at the FV
2. Measure afterwards at this amount unless it then becomes probable. As usual, a

probable liability is then measured at the full liability
Note. If it remains just possible then keep it at the initial FV until it is either written
off or paid
Illustration
1/7/x6 P acquired all of S when it’s NA had a CV of £2m. However, they had
disclosed a contingent liability. This has a FV of £150,000.
1/12/x7 this potential liability was paid at an amount of £200,000.
How are the accounts affected?
Well we would bring it into the equity table (at acquisition column) in the workings at
its FV of 150. This would affect goodwill working accordingly.
Keep it at this amount until it either becomes probable (show at full amount) or paid
Here it is paid so the year end would show no liability - and the post-acquisition
column +150. This would then affect the NCI and reserves working accordingly.
The extra 50 paid will have already been taken into account when the full amount
was paid
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The effect of transactions on cash flows
IAS 7, Statements of Cash Flows
IAS 7, Statements of Cash Flows, splits cash flows into the following headings:
• Cash flows from operating activities
• Cash flows from investing activities
• Cash flows from financing activities
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Cash flows from operating activities
These represent cash flows derived from operating or trading activities.
There are two methods which can be used to find the net cash from operating
activities:
direct and indirect method.
Cash flows from investing activities
These are related to the acquisition or disposal of any non-current assets or

investments together with returns received in cash from investments
i.e. dividends and interest.
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Cash flows from financing activities
Financing cash flows comprise receipts from or repayments to external providers of

finance in respect of principal amounts of finance.
For e.g.
1. Cash proceeds from issuing shares
2. Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and
other short or long term borrowings
3. Cash repayments of amounts borrowed
4. Dividends paid to shareholders
In order to calculate such figures the closing statement of financial position figure
for debt or share capital and share premium is compared with the opening position
for the same items.
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Statement of cash flows for the year ended 31 December 20X7 (INDIRECT
METHOD)
$000 $000
cash flows from operating activities
profit before taxation 3390
adjustment for:
depreciation 450
investment income -500
interest expense 400
------
3740
increase in trade and other receivables -500
decrease in inventories 1050
decrease in trade payables -1740
cash generated from operations 2550
interest paid -270
income taxes paid -900
------
net cash from operating activities 1380
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cash flows from investing activities
purchase of property, plant and equipment -900
proceeds from sale of equipment 20
interest received 200
dividends received 200
------
net cash used in investing activities -480
cash flows from financing activities
proceeds from issue of share capital 250
proceeds from long-term borrowings 250
dividends paid* -1290
------
net cash used in financing activities -790
------
net increase in cash and cash equivalents 110
cash and cash equivalents at beginning of period 120
------
cash and cash equivalents at end of period 230
------
* This could also be shown as an operating cash flow.
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Cashflow statements - Step 1
Indirect method
The idea here is simply to get to the profit from operating activities as a starting
point - nothing more!
So IAS tells us that although we need to get to the operating profit figure we must
start with Profit before tax (PBT) and reconcile this to the operating profit figure.
Operating Profit
Before we do this let’s remind ourselves what “Operating profit” is.
Operating Profit is:
Sales x
COS (x)
Administration expenses (x)
Distribution costs (x)
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Illustration
Sales 1,000
COS (400)
Administration expenses (100)
Income from Investment property 180
Distribution costs (100)
Finance costs (80)
Profit before tax 500
Tax (50)
Start with the profit before tax figure and then reconcile to the operating profit
figure.
Operating profit would be:
Sales 1,000
COS (400)
Administration expenses (100)
Distribution costs (100)
Operating Profit 400
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So, let’s start reconciling…
PBT 500
-
Then fill in the reconciling figures between them (income is a negative and expense
a positive here). This is because we are going upwards on the income statement,
rather than the normal downwards.
So this is the final answer to step 1:
PBT 500
Income from Investment Property -(180)
Finance Costs 80
You place this in the “Cash flow from Operating Activities” part of the cash-
flow statement.
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Now we have the operating profit figure we need to get to the cash.
We do this by taking the profit figure (calculated and reconciled to in step 1) and
adding back all the non-cash items (we get to the cash therefore indirectly).
Key point to remember here
The non-cash items we add back are ONLY those in operating profit (Sales, COS,
admin and distr. costs).
For example:
Depreciation, amortisation, impairments, profit on sale, receivables, payables and

inventory
There could be more - it depends on the question - but dealing with these will
ensure you pass
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So the operating activities part of the cash flow will now look like this:
PBT 500
Investment Property Income (180)
Finance costs 80
Depreciation x
Amortisation x
Impairment x
Profit/Loss on sale (x)/x
Increase / decrease in Inventory (x)/x
Increase / decrease in Receivables (x)/x
Increase / decrease in Payables x/(x)
Ensure you get the signs the right way around!
For example an increase in stock means less cash so (x).
Notice we added back receivables / payables & Inventory.
This is because credit sales, stock and credit payables are not cash and are in the
operating profit figure.
You just need to be careful that you get the signs the right way around as with these
we just account for the movement in them.
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Think of it like this:
• Increase in Inventory - means less cash - so show as a negative
• Increase in receivables - means less cash now - so show as a negative
• Increase in payables - means don’t have to pay people just yet so an increase in
cash - so show as a positive
We have now dealt with the first part of the income statement - Sales, COS,
administration expenses and distribution costs. We have indirectly got the cash
from these figures by adding back all the non-cash items that may have been in
there (as above).
All of this happens in the “Cash flow from Operating Activities” part of the
cash-flow statement.
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Cashflow statement - Step 3
So far we have got the cash (indirectly) from operating profit. This means we have
the cash from Sales, COS, admin and distribution costs. What we now do is look at
what’s left in the income statement and try to find the cash.
(In our example in step 1, we would have to deal with IP income, finance costs and
tax).
So we are looking at the other parts of the income statement (after operating profit)
and finding the cash and putting this directly into the cash-flow statement.
Direct method
We do this by using a different method to the one in step 2 as we are now looking to
put the cash in directly to the cash-flow statement (rather than taking a profit figure
and adding back the non-cash items to indirectly arrive at cash).
So how do we do this?
General Method Explanation
Let’s say you owed somebody 100, then bought 20 more in the year - you should
therefore owe them 120 right?
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However you look at your books at the year end and you see you only owe them 70
Therefore, you must have paid cash to them of 50 - this is the figure we then put in
our cash-flow statement.
To show this differently (and how the examiner often shows it):
Opening Payable (from SFP) 100
Income statement figure for year 20
Cash paid (balancing figure) (50)
Closing Payable (from SFP) 70
We use this format for the rest of the cash flow question - though it may need
adjusting slightly
(PPE is calculated differently).
We will now go on to look at the different items that you may find in the income
statement and how we deal with them in the cash-flow statement using this
method.
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Cashflow statement - finance costs
Finance Costs - Illustration of Step 3
Income Statement
Finance costs 80
Statement of Financial Position X2 X1
Interest Payable 100 140
Solution
Finance costs of 120 paid go to the operating activities section of the cashflow
statement.
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Cashflow statement - taxation
Taxation - Illustration of Step 3
Income Statement
Taxation 80
Current tax Payable 100 140
Deferred tax Payable 50 80
Solution
Taxation costs of 150 paid go to the operating activities section of the cashflow
statement.
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Cashflow statement - Investment property
Investment Property Income - Illustration of Step 3
Income Statement
Investment Property Income 80
Investment Property 200 140
There were no purchases of IP in the year.
Solution
Opening IP (from SFP) 140
Cash received (balancing figure) (20)
Closing IP (from SFP) 200
Investment property income of 20 (rent received probably) goes to the investing

activities section of the cashflow statement.
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So in the first 3 steps, we have turned the Income statement into cash and placed it
into the cash-flow statement. We now need to do the same with the S - remember
much of it we have already dealt with (e.g. receivables, inventory, payables,
investment
Property, interest and tax payable
So let’s begin with…
PPE
We deal with this slightly differently to the income statement items in step 3:
Process to follow
Here’s the process to follow:
Write down the PPE figures per the accounts
Work out the cash element of each item (if any)
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Illustration
PPE 200 140
Notes:
Depreciation in year = 50
Revaluation = 100
Disposal = Asset sold for 100 making 20 profit
Solution
The key here is to try and find the balancing figure (per the accounts) which will be
additions in the year.
Note: we are dealing with NBVs.
Write down the PPE figures per the accounts.
Opening PPE 140
Depreciation (50)
Revaluation 100
Disposal (80) - The NBV is 100-20
Additions to PPE (Balancing figure) 90
Closing PPE 200
The balancing figure is 90 and this is additions.
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Work out the cash element of each item (if any):
CASH
Opening PPE 140
Depreciation (50)
Revaluation 100
Disposal (80) - The NBV is 100-20 (100)
Additions to PPE (Balancing figure) 90 90
Closing PPE 200
All PPE items go the investing activities section of the cashflow statement.
100
Cashflow statements - Step 5 - Shares
So in steps 1-3 we looked at how we got the cash from the income statement and
into the statement of cash flows.
In step 4 we looked at getting the cash flows from PPE.
So now in our final step we look at getting cash from what’s left in the SFP…
starting with shares.
Share issues
Again let’s look at this by illustration and we are using virtually the same technique
as step 3 as you will see..
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Solution
Opening IP (from SFP) 220
Income statement figure for year -
Cash received (balancing figure) 130
Closing IP (from SFP) 350
Share Proceeds goes to the financing activities section of the cashflow

statement.
Effect of Bonus Issue

If there’s been a bonus issue, you need to be careful.
You need to look at where the debit went - share premium or retained earnings:
If share premium - ignore the bonus issue and the answer calculated above is still
correct
If Retained earnings - reduce the cash by the amount of the bonus issue
See the quizzes for examples of this.
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Cashflow statements - Step 5 - Loans
Let’s now look at another one of the items that would still be left on the SFP, that we
need to find the cash and take to the cash-flow statement - Loans
Illustration
Follow same techniques as before..
Loan 100 140
Solution
Opening loan (from SFP) 140
Income statement figure for year 0-
Closing loan (from SFP) 100
Loan repayments of 40 go to the financing activities section of the cashflow

statement.
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Syllabus B1b. Financial Reporting
Revenue Recognition - IFRS 15
When & how much to Recognise Revenue?
Here you need to go through the 5 step process…
1. Identify the contract(s) with a customer
2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations in the contract
5. Recognise revenue when (or as) the entity satisfies a performance obligation
Before we do that though, let’s get some key definitions out of the way..
Key definitions
• Contract
An agreement between two or more parties that creates enforceable rights and
obligations.
• Income
Increases in economic benefits during the accounting period in the form of
increasing assets or decreasing liabilities
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• Performance obligation
A promise in a contract to transfer to the customer either:
- a good or service that is distinct; or
- a series of distinct goods or services that are substantially the same and that
have the same pattern of transfer to the customer.
• Revenue
Income arising in the course of an entity’s ordinary activities.
• Transaction price
The amount of consideration to which an entity expects to be entitled in
exchange for transferring promised goods or services to a customer.
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Revenue Recognition - IFRS 15 - 5 steps
Ok let’s now get into a bit more detail…
Step 1: Identify the contract(s) with a customer
• The contract must be approved by all involved
• Everyone’s rights can be identified
• It must have commercial substance
• The consideration will probably be paid
Step 2: Identify the separate performance obligations in the contract
This will be goods or services promised to the customer
These goods / services need to be distinct and create a separately identifiable

obligation
• Distinct means:
The customer can benefit from the goods/service on its own AND
The promise to give the goods/services is separately identifiable (from other

promises)
• Separately identifiable means:
No significant integrating of the goods/service with others promised in the

contract
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The goods/service doesn’t significantly modify another good or service
promised in the contract.
The goods/service is not highly related/dependent on other goods or services

promised in the contract.
Step 3: Determine the transaction price
How much the entity expects, considering past customary business practices
• Variable Consideration
If the price may vary (eg. possible refunds, rebates, discounts, bonuses,
contingent consideration etc) - then estimate the amount expected
• However variable consideration is only included if it’s highly probable there won’t
need to be a significant revenue reversal in the future (when the uncertainty has
been subsequently resolved)
• However, for royalties from licensing intellectual property - recognise only when
the usage occurs
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Step 4: Allocate the transaction price to the separate performance obligations
If there’s multiple performance obligations, split the transaction price by using their
standalone selling prices. (Estimate if not readily available)
• How to estimate a selling Price
- Adjusted market assessment approach
- Expected cost plus a margin approach
- Residual approach (only permissible in limited circumstances).
• If paid in advance, discount down if it’s significant (>12m)
Step 5: Recognise revenue when (or as) the entity satisfies a performance
obligation
Revenue is recognised as control is passed, over time or at a point in time.
• What is Control
It’s the ability to direct the use of and get almost all of the benefits from the
asset.
This includes the ability to prevent others from directing the use of and obtaining
the benefits from the asset.
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• Benefits could be:
- Direct or indirect cash flows that may be obtained directly or indirectly
- Using the asset to enhance the value of other assets;
- Pledging the asset to secure a loan
- Holding the asset.
• So remember we recognise revenue as asset control is passed (obligations

satisfied) to the customer
This could be over time or at a specific point in time.
Examples (of factors to consider) of a specific point in time:
1. The entity now has a present right to receive payment for the asset;
2. The customer has legal title to the asset;
3. The entity has transferred physical possession of the asset;
4. The customer has the significant risks and rewards related to the ownership of
the asset; and
5. The customer has accepted the asset.
Contract costs - that the entity can get back from the customer
These must be recognised as an asset (unless the subsequent amortisation would

be less 12m), but must be directly related to the contract (e.g. ‘success fees’ paid to
agents).
Examples would be direct labour, materials, and the allocation of overheads - this
asset is then amortised
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Revenues - Presentation in financial statements
Presentation in financial statements
Show in the SFP as a contract liability, asset, or a receivable, depending on when

paid and performed
i.e.. Paid upfront but not yet performed would be a contract liability
Performed but not paid would be a contract receivable or asset
1. A contract asset if the payment is conditional (on something other than time)
2. A receivable if the payment is unconditional
Contract assets and receivables shall be accounted for in accordance with IFRS 9.
Disclosures
All qualitative and quantitative information about:
• its contracts with customers;
• the significant judgments in applying the guidance to those contracts; and
• any assets recognised from the costs to fulfil a contract with a customer.
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Revenues Illustrations
Illustration 1 - Agent or not?
An entity negotiates with major airlines to purchase tickets at reduced rates
It agrees to buy a specific number of tickets and must pay even if unable to resell
them.
The entity then sets the price for these ticket for its own customers and receives
cash immediately on purchase.
The entity also assists the customers in resolving complaints with the service
provided by airlines. However, each airline is responsible for fulfilling obligations
associated with the ticket, including remedies to a customer for dissatisfaction with
the service.
How would this be dealt with under IFRS 15?
1. Step 1: Identify the contract(s) with a customer
This is clear here when the ticket is purchased
2. Step 2: Identify the performance obligations in the contract
This is tricky - is it to arrange for another party provide a flight ticket - or is it - to

provide the flight ticket themselves?
Well - look at the risks involved. If the flight is cancelled the airline pays to
reimburse,
If the ticket doesn't get sold - the entity loses out
Look at the rewards - the entity can set its own price and thus rewards
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On balance therefore the entity takes most of the risks and rewards here and
thus controls the ticket - thus they have the obligation to provide the right to fly
ticket
3. Step 3: Determine the transaction price
This is set by the entity
4. Step 4: Allocate the transaction price to the performance obligations in the

contract
The price here is the GROSS amount of the ticket price (they sell it for)
5. Step 5: Recognise revenue when (or as) the entity satisfies a performance
obligation
Recognise the revenue once the flight has occurred
Illustration 2 - Loyalty discounts
An entity has a customer loyalty programme that rewards a customer with one
customer loyalty point for every $10 of purchases.
Each point is redeemable for a $1 discount on any future purchases
Customers purchase products for $100,000 and earn 10,000 points
The entity expects 9,500 points to be redeemed, so they have a stand-alone selling
price $9,500
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1. Step 1: Identify the contract(s) with a customer
This is when goods are purchased
2. Step 2: Identify the performance obligations in the contract
The promise to provide points to the customer is a performance obligation along

with, of course, the obligation to provide the goods initially purchased
3. Step 3: Determine the transaction price
$100,000
4. Step 4: Allocate the transaction price to the performance obligations in the

contract
The entity allocates the $100,000 to the product and the points on a relative
stand-alone selling price basis as follows:
So the standalone selling price total is 100,000 + 9,500 = 109,500
Now we split this according to their own standalone prices pro-rata
Product $91,324 [100,000 x (100,000 / 109,500]
Points $8,676 [100,000 x 9,500 /109,500]
5. Step 5: Recognise revenue when (or as) the entity satisfies a performance
obligation
Of course the products get recognised immediately on purchase but now lets
look at the points..
Let’s say at the end of the first reporting period, 4,500 points (out of the 9,500)
have been redeemed
The entity recognises revenue of $4,110 [(4,500 points ÷ 9,500 points) × $8,676]
and recognises a contract liability of $4,566 (8,676 – 4,110) for the unredeemed
points
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Leases - Introduction
There are 2 types of lease - an Operating and a Finance lease.
In simple terms, a finance lease is where the LESSEE takes the majority of the risks
and rewards of the underlying asset.
Therefore with a finance lease the lessee would show the asset on their SFP (and
the related finance lease liability).
When classifying look for substance rather than the form.
Finance Lease Indicators

• The lessee gets ownership of the asset at the end of the lease term
• The lessee can buy the asset at such a low price that it is reasonably certain that
the option will be exercised;
• The lease term is for the major part of the economic life
• The PV of the lease payments is substantially the fair value of the leased asset;
and
• Only the lessee can use the asset as it is so specialised
Other possible finance lease indicators

• If the lessee cancels the lease, he has to pay the lessor’s losses
• The lessee gets any residual value gains/losses and
• The lessee can lease for a secondary period at a cheap rent
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Land & Buildings
Normally separately classified
The minimum lease payments are allocated between the land and buildings
elements in proportion to their relative fair values.
• Land = Operating lease (unless title passes to the lessee at the end of the lease
term)
• Buildings = Operating or finance lease (by applying the classification criteria in

IAS 17)
The classification of leases is a key issue in corporate reporting. From a lessees

point of view, classifying as a finance lease will increase gearing and decrease
ROCE (as there’s more capital employed due to the finance lease liability). Interest
cover will also decrease.
As the SFP shows more liability, future borrowing will be harder to come by and
current loan covenants may be breached. The level of perceived risk may increase,
loan covenants may be compromised and an entity’s future borrowing capacity may
be restricted.
UK studies have revealed that average operating lease commitments are over
ten times that of reported finance lease obligations.
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Finance Lease accounting
This gives an asset on the SFP (and a related liability).
Therefore we also need to show the related depreciation and interest on the I/S
Income statement SFP
Depreciation (10) Asset 100
Interest (8) Liability 100
Accounting steps
1. Enter the Asset and Liability
(At the Fair value of the asset)
2. Calculate depreciation
This will depend on whether the asset goes back to the lessor at the year-end or
not
3. Calculate interest and Finance Lease liability at Y/E
This is done by the amortised cost table (below)
116
Amortised cost table for a Finance lease with payments in arrears
Opening FL liability Interest to I/S Lease rental Paid Closing Liability on SFP
1,000 120 (100) 1,020
Amortised cost table for a Finance lease with payments in advance
Opening FL Lease rental Interest to I/ Closing Liability on

Balance
liability paid S SFP
1,000 (100) 900 90 990
Start of lease term
Dr Asset
Cr Finance Lease liability
@ lower of FV of the asset and Present value of the minimum lease payments
+ (any direct costs added to cost of asset).
As Payments are made
Finance lease payments should be apportioned between the finance charge and
paying off the liability.
Dr Interest
Dr Finance Lease liability
Cr Cash
The interest is apportioned using the effective rate given in the question.
117
Illustration – Finance Lease: Payment in Arrears
Asset Cost $10,000
Lease: 5 years x $3,000 p.a. in arrears
Effective/implicit interest rate is 8%
10,000 800 (3,000) 7,800
Payable within one year and after more than one year
The finance lease liability must be split between the amount that is to be paid within
a year and the remainder which is payable in more than one year
Yr. 1 10,000 800 (3,000) 7,800
Yr. 2 7,800 624 (3,000) 5,424
Therefore, the amount payable in less than a year (year 2) is (7,800 – 5,424) =
$2,376 The remaining $5,424 is payable in more than one year.
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Illustration – Finance Lease: Payment in Advance
The only difference is how the table looks and the split between payable within 1yr
and after more than 1yr.
Consider the previous example again. This time the payment comes before the
interest as it is paid in advance:
Opening FL Lease rental Interest to I/ Closing Liability on

Balance
liability paid S SFP
Yr 1 10,000 (3,000) 7,000 560 7,560
Yr 2 7,560 (3,000) 4,560
The amount payable < 1yr is (7,560 – 4,560) = 3,000
This $3,000 should ideally be further split down between:
Interest $560
Capital $2,440
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Finance lease accounting lessor
This gives an asset on the SFP (and a related liability).
Ok - let´s have a think about this
Remember that when we say finance lease - we mean the risks and rewards are
taken by the lessee. So have we sold the asset or not?
Revenue recognition tells us that when the risks and rewards for goods are passed
on then we have made a sale and can recognise the revenue.
So, yes the lessor has in substance sold the asset. Therefore it will show the profit
on sale on the income statement. However, the revenue is going to be received in
future instalments and so is a receivable. The receivable will simply be the present
value of ALL expected future receipts.
The actual receipts will go towards paying off the receivable and the remainder is
interest. This interest received is shown in the income statement each year.
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SFP
Receivable x
Income statement
Interest received x
Initial recognition
The receivable is initially measured at what we call the net investment in the lease.
Do not be confused by this. All this is saying is that the actual receipts are gross
(but include interest as mentioned above) - the initial receivable will not include this
interest - so it is called the net investment.
Net investment in the lease
The gross investment in the lease discounted at the interest rate implicit in the
lease.
Gross investment in the lease
The minimum lease payments receivable by the lessor plus any unguaranteed
residual value accruing to the lessor.
121
So what´s all this unguaranteed residual value nonsense??
Well the lessee may promise to pay not only all the lease payments but also to
guarantee a certain residual value. Both these amounts are included in the minimum
lease payments. This is what the lessee has to pay effectively.
However, it may be that the lessor expects the residual value to be hgher than that
guaranteed by the lessee. The amount higher expected to be received is called the
unguaranteed residual value. So this is included in the receivable (it is effectively
extra income) but will not be in the lessees equivalent payable (as they have not
promised to pay the full amount).
Final question - how do we calculate the interest received in the income statement?
Well it’s straight forward - let’s say we have an initial receivable of 10,000. This is the
discounted future annual receipts (in arrears) of 3,000. The effective interest rate (the
rate the receipts have been discounted down at is 10%).
This calculation is needed:
Opening 10,000
Interest (I/S) 1,000 (10%)
Receipt - 3,000
Closing receivable 8,000
Interest rate implicit in the lease: the discount rate that, at the inception of the lease,
causes the present value of the gross investment of the lease to be equal to the
sum of (i) the fair value of the leased asset and (ii) any initial direct costs of the
lessor.
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Operating Lease accounting – Lessor
Ok - let´s have a think about this
Remember that when we say operating lease - we mean the risks and rewards are
NOT taken by the lessee. So have we sold the asset or not?
Revenue recognition tells us that when the risks and rewards for goods are passed
on then we have made a sale and can recognise the revenue.
So, no the lessor has NOT in substance sold the asset. Therefore the lessor keeps
the asset on its SFP.
Income from an operating lease (not including services such as insurance and
maintenance), should be shown straight-line in the income statement over the
length of the lease (unless the item is used up on a different basis - if so use that
basis).
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SFP
Keep the Asset there
Income statement
Operating Lease rentals received
Negotiating costs etc
Any initial direct costs incurred by lessors should be added to the carrying amount
of asset on the SFP and expensed over the lease term (NOT the assets life).
Operating Lease Incentives
The lessor should reduce the rental income over the lease term, on a straight-line
basis with the total of these.
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Operating Lease accounting
So here the lessee does not take the risks and rewards of the asset, so
no asset is shown on the SFP.
All that happens is the lease payments are recognised as an expense in the income
statement over the lease term on a straight-line basis.
An operating lease simply shows the rental payments in the Income statement.
Remember to do this on an accruals basis and not a payment basis.
Illustration
A company pays an initial premium of 1,000 + 4 quarterly instalments of 1,500. The

lease was acquired half way through the year.
What is the income statement charge in the period?
Answer: 1,000 + (4x1,500) = 7,000 in total for the year
Only half a year to be charged regardless of payments - so 7,000 / 2 = 3,500
Operating Lease Incentives
The lessee normally recognises the total incentives as a reduction of rental expense
over the lease term, on a straight-line basis.
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Sale and finance leaseback
Sale and finance leaseback
Let’s have a little ponder over this before we dive into the details…
If we sell an item and lease it back - have we actually sold it?
Have we got rid of the risk and rewards?
Well if we finance lease it back - it means we keep the risks and rewards - so in
effect - we have NOT sold it.
If we operating lease it back - we have transferred the risks and rewards so an
effective sale has been made.
Finance Lease Back
The company may receive from the sale more than the carrying amount of the
asset.
This “profit” cannot be shown immediately but rather spread over the length of the
finance lease
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Why?
Why would a company sell and finance lease back then?
The simple answer is to raise finance.
They get the proceeds now and then have to repay over the lease term - whilst
keeping use of the asset.
It gives companies the opportunity to release capital caught up in the business for
investment in other projects.
This transaction is essentially a financing arrangement.
The seller (who is subsequently the lessee) does not dispose of the risks and
rewards of ownership (because the leaseback is through a finance lease) and no
profit should be recognised immediately on disposal.
Accounting treatment
The accounting entries are:
1. Step 1
- De-recognise the carrying amount of the asset now sold Cr Asset
- Recognise the sales proceeds Dr Cash
- Calculate the profit on sale (proceeds less carrying amount)
Cr Deferred Income
2. Step 2
- Recognise the finance lease asset
Dr Asset and the associated liability
Cr Finance lease liability at the lower of FV and PV of MLP as usual
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3. Step 3
- Amortise the profit on sale as income over the lease term
Dr. Deferred Income
Cr. Income statement
The effect is to adjust the expense recognised in profit or loss to an amount

equal to the depreciation expense before the leaseback transaction.
NB
If the carrying amount exceeds fair value, the asset should be written down to fair
value prior to the sale and leaseback and the loss recognised as an impairment
loss.
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Sale and operating leaseback
Some football clubs have done this to fund the cost of their new stadiums.
Remember while building the new one, they still need to play at the old one (oh how
I miss you Highfield road….).
Anyway, unlike a finance lease where the risks are not transferred and so a sale
never takes place, here the risks and rewards are transferred so a sale does occur.
So there is a genuine profit or loss to be recognised…
Here’s where the fun begins my little cowlets…
A normal sale
If it’s a ‘normal’ profit then there’s no problem - just show it in the income
statement. Then show the operating lease rentals and that’s it.
A normal sale is where the sale price = Fair Value
Not normal sales - Selling Price less than Fair Value
Here you have to think well why did we sell it at less than FV?
If there’s no obvious reason then everything's normal.
If, though, the operating lease rentals after are less than market rate - this would
explain why we sold it for less.
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These two are linked.
So we simply take the “loss” and instead of hitting the income statement with it
immediately, we hold it in the SFP and take it to the income statement over the
length of the operating lease.
This should have the effect of making the lease rentals in the income statement
show at the true market rate.
Selling Price greater than Fair Value
Again you must ask yourself why did we receive more.
If there’s no reason then be happy and show the whole profit in the income
statement immediately.
However, it may be because we are paying more than the market rate for the future
operating lease rentals.
Again these two are linked.
So here we do not take the profit to the income statement immediately but take the
extra above FV and take it to the SFP and hold it there.
We then take it to the income statement over the length of the lease.
This should have the effect of reducing the future operating lease rentals to the
market rate.
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NB
IAS 17 requires the carrying amount of an asset to be written down to fair value
where it is subject to a sale and leaseback.
So if the carrying amount is higher than the FV - then you should immediately write
it down to the FV (Dr I/S Cr Asset) before the above rules.
Summary:
1. Sale price below fair value
Except if the loss is compensated for by lower future rentals then the loss should
be amortised over the period of use
2. Sale price above fair value
The excess over fair value should be deferred and amortised over the period of
use; and
If FV < CV the loss should be recognised immediately
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Manufacturer also a Lessor
This means they will get 2 sources of income
1. Normal sale profit
The sales price for this is the FV of the item (or PV of lease payments if lower)
The Cost is the carrying amount less PV of any residual value
2. Finance Income
Calculated as normal for a finance lease
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Financial Instruments - Introduction
Ok, ok, relax at the back - this is not as bad as it seems… trust me
Definition
• First of all it must be a contract
• Then it must create a financial asset in one entity and a financial liability or equity
instrument in another.
• Examples:
An obvious example is a trade receivable. There is a contract, one company has

the debt as a financial asset and the other as a liability
• Other examples:
Cash, investments, trade payables and loans….
And the trickier stuff…..
It also applies to derivatives financial such as call and put options, forwards,
futures, and swaps.
And the just plain weird….
It also applies to some contracts that do not meet the definition of a financial
instrument, but have characteristics similar to derivative financial instruments.
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Such as precious metals at a future date when the following applies:
1. The contract is subject to possible settlement in cash NET rather than by

delivering the precious metal
2. The purchase of the precious metal was not normal for the entity
The trick in the exam is to look for contracts which state “will NOT be delivered” or
“can be settled net” - these are almost always financial instruments
The following are NOT financial instruments:
Anything without a contract
e.g. Prepayments
Anything not involving the transfer of a financial asset
e.g. Deferred income and Warranties
Recognition
The important thing to understand here is that you bring a FI into the accounts
when you enter into the contract NOT when the contract is settled. Therefore
derivatives are recognised initially even if nothing is paid for it initially.
• Substance over form
Form (legally) means a preference share is a share and so part of equity.

HOWEVER, a substance over form model is applied to debt/equity classification.
Any item with an obligation, such as redeemable preference shares, will be
shown as liabilities.
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De-recognition
This basically means when to get rid of it / take it out of the accounts
• So you should do this when:

The contractual rights you used to have have expired/gone
• For Example
You sell an asset and its benefits now go to someone else (no conditions
attached)
• You DONT de-recognise when..

You sell an asset but agree to buy it back later (this means you still have an
interest in the risk and rewards later)
The difference between equity and liabilities
IAS 32 Financial Instruments: Presentation
establishes principles for presenting financial instruments as liabilities or equity.
• IAS 32 does not classify a financial instrument as equity or financial liability on

the basis of its legal form but the substance of the transaction.
The key feature of a financial liability
1. is that the issuer is obliged to deliver either cash or another financial asset to the
holder.
2. An obligation may arise from a requirement to repay principal or interest or

dividends.
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The key feature of an Equity
has a residual interest in the entity’s assets after deducting all of its liabilities.
• An equity instrument includes no obligation to deliver cash or another financial

asset to another entity.
• A contract which will be settled by the entity receiving or delivering a fixed

number of its own equity instruments in exchange for a fixed amount of cash or
another financial asset is an equity instrument.
• However, if there is any variability in the amount of cash or own equity

instruments which will be delivered or received, then such a contract is a
financial asset or liability as applicable.
An accounting treatment of the contingent payments on acquisition of the NCI

in a subsidiary
• IAS 32 states that a contingent obligation to pay cash which is outside the
control of both parties to a contract meets the definition of a financial liability
which shall be initially measured at fair value.
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Financial liabilities - Categories
There's only 2 categories, FVTPL and Amortised cost.. Yay!
Right-y-o, we’ve looked at recognising (bring into the accounts for those of you who
are a sandwich short of a picnic*) - now we want to look at HOW MUCH to bring the
liabilities in at.
*A quaint old English saying - meaning you're an idiot :p
We already dealt with this on a tricky convertible loan.
Trust me this section is much easier.
Basically there are 2 categories of Financial Liability...
1. Fair Value Through Profit and Loss (FVTPL)
This includes financial liabilities incurred for trading purposes and also
derivatives.
2. Amortised Cost
If financial liabilities are not measured at FVTPL, they are measured at amortised
cost.
The good news is that whatever the category the financial liability falls into - we
always recognise it at Fair Value INITIALLY.
It is how we treat them afterwards where the category matters (and remember here
we are just dealing with the initial measurement).
Accounting Treatment of Financial Liabilities (Overview)
Initially At Year-End Any gain/loss
FVTPL Fair Value Fair Value Income Statement
Amortised Cost Fair Value Amortised Cost
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So - the question is - how do you measure the FV of a loan??
Well again the answer is simple - and you’ve done it already with compound
instruments. All you do is those 2 steps:
STEP 1: Take all your actual future cash payments
STEP 2: Discount them down at the market rate
If the market rate is the same as the rate you actually pay (effective rate) then this is
no problem and you don’t really have to follow those 2 steps as you will just come
back to the capital amount…let me explain
10% 1,000 Payable Loan 3 years
Capital 1,000 x 0.751 = 751
Interest 100 x 2.486 = 249
Total 1,000
So the conclusion is - WHERE THE EFFECTIVE RATE YOU PAY (10%) IS THE
SAME AS THE MARKET RATE (10%) THEN THE FV IS THE PRINCIPAL - so no
need to do the 2 steps.
Always presume the market rate is the same as the effective rate you’re paying
unless told otherwise by El Examinero.
138
Possible Naughty Bits
Premium on redemption
This is just another way of paying interest. Except you pay it at the end (on
redemption)
e.g. 4% 1,000 payable loan - with a 10% premium on redemption.
This means that the EFFECTIVE interest rate (the rate we actually pay) is more than
4% - because we haven’t yet taken into account the extra 100 (10% x 1,000)
payable at the end. So the examiner will tell you what the effective rate actually is -
let’s say 8%.
The crucial point here is that you presume the effective rate (e.g. 8%) is the same as
the market rate (8%) so the initial FV is still 1,000.
Discount on Issue
Exactly the same as above - it is just another way of paying interest - except this
time you pay it at the start
e.g. 4% 1,000 payable loan with a 5% discount on issue.
So again the interest rate is not 4%, because it ignores the extra interest you pay at
the beginning of 50 (5% x 1,000). So the effective rate (the rate you actually pay) is
let’s say 7% (will be given in the exam).
The crucial point here is that the discount is paid immediately. So, although you
presume that the effective rate (7%) is the same as the market rate (7% say), the
INITIAL FV of the loan was 1,000 but is immediately reduced by the 50 discount - so
is actually 950
NB You still pay interest of 4% x 1,000 not 4% x 950
139
Financial Liabilities - Amortised Cost
So, we’ve just looked at initial measurement (at FV) Now let’s look at
how we measure it from then onwards….
This is where the categories of financial liabilities are important - so let’s remind
ourselves what they are:
Initially At Year-End Any gain/loss
FVTPL Fair Value Fair Value Income Statement
Amortised Cost Fair Value Amortised Cost -
So you only have 2 rules to remember - cool…
1. FVTPL
- simple just keep the item at its FV (remember this is those 2 steps) and put the
difference to the income statement
2. Amortised Cost
- Amortised Cost is the measurement once the initial measurement at FV is done
140
Amortised Cost
This is simply spreading ALL interest over the length of the loan by charging the
effective interest rate to the income statement each year.
If there’s nothing strange (premiums etc) then this is simple. For example
10% 1,000 Payable Loan
Opening Interest to I/S Interest actually Paid Closing Loan on SFP
1,000 100 (100) 1,000
Now let’s make it trickier
10% 1,000 Loan with a 10% premium on redemption. Effective rate is 12%
1,000 120 (100) 1,020
So in year 1 the income statement would show an interest charge of 120 and the
loan would be under liabilities on the SFP at 1,020. This SFP figure will keep on
increasing until the end of the loan where it will equal the Loan + premium on
redemption.
141
And trickier still…
10% 1,000 loan with a 10% discount on issue. Effective rate is 12%
900 108 (100) 908
IFRS 9 requires FVTPL gains and losses on financial liabilities to be split into:
1. The gain/loss attributable to changes in the credit risk of the liability (to be
placed in OCI)
2. The remaining amount of change in the fair value of the liability which shall be
presented in profit or loss.
The new guidance allows the recognition of the full amount of change in the FVTPL
only if the recognition of changes in the liability's credit risk in OCI would create or
enlarge an accounting mismatch in P&L.
Amounts presented in OCI shall not be subsequently transferred to P&L, the entity
may only transfer the cumulative gain or loss within equity.
142
Financial Liabilities - convertible loans
When we recognise a financial instruments we look at substance rather

than form
Anything with an obligation is a liability (debt).
However we now have a problem when we consider convertible payable loans. The
‘convertible’ bit means that the company may not have to pay the bank back with
cash, but perhaps shares.
So is this an obligation to pay cash (debt) or an equity instrument?
In fact it is both! It is therefore called a Compound Instrument
Convertible Payable Loans
These contain both a liability and an equity component so each has to be shown
separately.
• This is best shown by example:
2% Convertible Payable Loan €1,000
• This basically means the company has offered the bank the option to convert
the loan at the end into shares instead of simply taking €1,000
• The important thing to notice is that that the bank has the option to do this.
• Should the share price not prove favourable then it will simply take the €1,000 as
normal.
143
Features of a convertible payable loan
1. Better Interest rate
The bank likes to have the option. Therefore, in return, it will offer the company a
favourable interest rate compared to normal loans
2. Higher Fair Value of loan
This lower interest rate has effectively increased the fair value of the loan to the
company (we all like to pay less interest ;-))
We need to show all payable loans at their fair value at the beginning.
3. Lower loan figure in SFP
Important: If the fair value of a liability has increased the amount payable
(liability) shown in the accounts will be lower.
After all, fair value increases are good news and we all prefer lower liabilities!
How to Calculate the Fair Value of a Loan
So how is this new fair value, that we need at the start of the loan, calculated?
Well it is basically the present value of its future cashflows…
• Step 1: Take what is actually paid (The actual cashflows):
Capital €1,000
Interest (2%) €20 pa.
Now let’s suppose this is a 4 year loan and that normal (non-convertible) loans
carry an interest rate of 5%.
144
• Step 2: Discount the payments in step 1 at the market rate for normal loans
(Get the cashflows PV)
Take what the company pays and discount them using the figures above as
follows:
Capital €1,000 discounted @ 5% (4 years SINGLE discount figure) = 1,000 x

0.823 = 823
Interest €20 discounted @ 5% (4 years CUMULATIVE)= 20 x 3.465 = 69
Total = 892
This €892 represents the fair value of the loan and this is the figure we use in the
balance sheet initially.
The remaining €108 (1,000-892) goes to equity.
Dr Cash 1,000
Cr Loan 892
Cr Equity 108
• Next we need to perform amortised cost on the loan (the equity is left untouched
throughout the rest of the loan period).
The interest figure in the amortised cost table will be the normal non-convertible
rate and the paid will the amounts actually paid.
The closing figure is the SFP figure each year
Opening Interest Payment Closing
892 892 x 5% = 45 (1,000 x 2% = 20) 892 + 45 - 20 = 917
917 917 x 5% = 46 (1,000 x 2% = 20) 917 + 46 - 20 = 943
943 48 (1,000 x 2% = 20) 971
971 49 (1,000 x 2% = 20) 1,000
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Now at the end of the loan, the bank decide whether they should take the shares or
receive 1,000 cash…
1. Option 1: Take Shares (lets say 400 ($1) shares with a MV of $3)
Dr Loan 1,000
Dr Equity 108
Cr Share Capital 400
Cr Share premium 708 (balancing figure)
2. Option 2: Take the Cash
Dr Loan 1,000
Cr Cash 1,000
Dr Equity 108
Cr Income Statement 108
Conclusion
1. When you see a convertible loan all you need to do is take the capital and
interest PAYABLE.
2. Then discount these figures down at the rate used for other non convertible
loans.
3. The resulting figure is the fair value of the convertible loan and the remainder sits
in equity.
4. You then perform amortised cost on the opening figure of the loan. Nothing
happens to the figure in equity
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Convertible Payable Loan with transaction costs - eek!
Ok well remember our 2 step process for dealing with a normal convertible loan?
No?? Well you’re an idiot. However, luckily for you, I’m not so I will remind you :p
Step 1) Write down the capital and interest to be PAID
Step 2) Discount these down at the interest rate for a normal non-convertible loan
Then the total will be the FV of the loan and the remainder just goes to equity.
Remember we do this at the start of the loan ONLY.
Right then let’s now deal with transaction or issue costs.
These are paid at the start.
Normally you simply just reduce the Loan amount with the full transaction costs.
However, here we will have a loan and equity - so we split the transaction costs pro-
rata
147
I know, I know - you want an example…. boy, you’re slow - lucky you’re gorgeous
eg 4% 1,000 3 yr Convertible Loan.
Transaction costs of £100 also to be paid.
Non convertible loan rate 10%
Step 1 and 2
Capital 1,000 x 0.751 = 751
Interest 40 x 2.486 = 99 (ish)
Total = 850
So FV of loan = 850, Equity = 150 (1,000-850)
Now the transaction costs (100) need to be deducted from these amounts pro-rata
So Loan = (850-85) = 765
Equity (150-15) = 135
And relax….
148
Financial Assets - Initial Measurement
There are 3 categories to remember:
Initial Year-end Difference goes

Category
Measurement Measurement where?
FVTPL FV FV Profit and Loss
FVTOCI FV FV OCI
Amortised Cost FV Amortised Cost -
Financial assets that are Equity Instruments
e.g. Shares in another company
These are easy - Just 2 categories
• FVTPL
FVTPL = Fair Value through Profit & Loss
These are Equity instruments (shares) Held for trading
Normally, equity investments (shares in another company) are measured at FV in

the SFP, with value changes recognised in P&L
Except for those equity investments for which the entity has elected to report
value changes in OCI.
• FVTOCI
FVTOCI = Fair Value through Other Comprehensive Income
These are Equity instruments (shares) Held for longer term
149
• NB. The choice of these 2 is made at the beginning and cannot be changed
afterwards
There is NO reclassification on de-recognition
Financial Assets that are Receivable Loans
There are basically 3 types:
1. Fair Value Through Profit & Loss (FVTPL)
A receivable loan where capital and interest aren’t the only cashflows
2. FVTOCI
Receivable loans where the cashflows are capital and interest only BUT the
business model is also to sell these loans
3. Amortised Cost
A financial asset that meets the following two conditions can be measured at
amortised cost:
1. Business model test:
Do we normally keep our receivable loans until the end rather than sell them on?
2. Cashflows test
The contractual terms of the financial asset give rise on specified dates to cash
flows that are solely payments of principal and interest on the principal
outstanding
In other words:
Are the ONLY cashflows coming in capital and interest?
150
So what sort of things go into the FVTPL category?
• If one of the tests above are not passed then they are deemed to fall into the
FVTPL category
This will include anything held for trading and derivatives.
INITIAL measurement
• Good news! Initially both are measured at FV.
Easy peasy to remember.
The FV is calculated, as usual, as all cash inflows discounted down at the

market rate.
FVTPL can be:
1. Equity items held for trading purposes
2. Equity items not held for trading (but OCI option not chosen)
3. A receivable loan where capital and interest aren’t the only cashflows
Derivative assets are always treated as held for trading
151
Initial recognition of trade receivables
1. Trade receivables without a significant financing component
Use the transaction price from IFRS 15
2. Trade receivables with a significant financing component
IFRS 9 does not exempt a trade receivable with a significant financing

component from being measured at fair value on initial recognition.
Therefore, differences may arise between the initial amount of revenue

recognised in accordance with IFRS 15 – and the fair value needed here in IFRS
9
Any difference is presented as an expense.
FVTOCI - Receivable loans held for cash and selling
Interest revenue, credit impairment and foreign exchange gain or loss recognised in
P&L (in the same manner as for amortised cost assets)
Other gains and losses recognised in OCI
On de-recognition, the cumulative gain or loss previously recognised in OCI is

reclassified from equity to profit or loss
152
Financial assets - Accounting Treatment
So we have these 3 categories..
Initial Year-end Difference goes

Category
Measurement Measurement where?
FVTPL FV FV Profit and Loss
FVTOCI FV FV OCI
Amortised
FV Amortised Cost -
Cost
Initially both are measured at FV.
Now let's look at what happens at the year-end..
FVTPL accounting treatment
1. Revalue to FV
2. Difference to I/S
FVTOCI accounting treatment
1. Revalue to FV
2. Difference to OCI
Amortised cost accounting treatment
1. Re-calculate using the amortised cost table
(see below)
153
An Example:
8% 100 receivable loan (effective rate 10% due to a premium on redemption)
Amortised Cost Table
Opening Balance Interest (effective rate) (Cash Received) Closing balance
100 10 (8) 102
The interest (10) is always the effective rate and this is the figure that goes to the
income statement.
The receipt (8) is always the cash received and this is not shown in the income
statement - it just decreases the carrying amount
Any expected credit losses and forex gains/losses all go to I/S
154
Financial Instruments - Transactions costs
Transaction Costs
There will usually be brokers’ fees etc to pay and how you deal with these depends
on the category of the financial instrument...
For FVTPL - these go to the income statement.
For everything else they get added/deducted to the opening balance.
So if it is an asset - it will increase the opening balance
If it is a liability - it will decrease the opening balance
Nb. If a company issues its own shares, the transaction costs are debited to share
premium
Illustration 1
A debt security that is held for trading is purchased for 10,000. Transaction costs
are 500.
• The initial value is 10,000 and the transaction costs of 500 are expensed.
Illustration 2
A receivable bond is purchased for £10,000 and transaction costs are £500.
• The initial carrying amount is £10,500.
155
Illustration 3
A payable bond is issued for £10,000 and transaction costs are £500.
• The initial carrying amount is £9,500.
Note: With the amortised cost categories, the transaction costs are effectively
being spread over the length of the loan by using an effective interest rate which
INCLUDES these transaction costs
Illustration: Transaction costs
An entity acquires a financial asset for its offer price of £100 (bid price £98)
IFRS 9 treats the bid-offer spread as a transaction cost:
1. If the asset is FVTPL
The transaction cost of £2 is recognised as an expense in profit or loss and the

financial asset initially recognised at the bid price of £98.
2. If the asset is classified as amortised cost
The transaction cost should be added to the fair value and the financial asset
initially recognised at the offer price (the price actually paid) of £100.
Treasury shares
It is becoming increasingly popular for companies to buy back shares as another

way of giving a dividend. Such shares are then called treasury shares
156
Accounting Treatment
1. Deduct from equity
2. No gain or loss shown, even on subsequent sale
3. Consideration paid or received goes to equity
Illustration
Company buys back 10,000 (£1) shares for £2 per share. They were originally
issued for £1.20
• Dr RE 20,000 Cr Cash 20,000
The original share capital and share premium stays the same, just as it would
have done if they had been bought by a different third party
157
De-recognition of Financial Instruments
De-recognition of Financial Assets
De-recognition of a financial asset occurs where:
1. The contractual rights to the cash flows of the financial asset have expired
(debtor pays), or
2. The financial asset has been transferred (e.g., sold) including the risks and
rewards.
Illustration 1
A company sells an investment in shares, but retains the right to repurchase the
shares at any time at a price equal to their current fair value.
• The company should de-recognise the asset
Illustration 2
A company sells an investment in shares and enters into an agreement whereby the
buyer will return any increases in value to the company and the company will pay
the buyer interest plus compensation for any decrease in the value of the
investment.
• The company should not de-recognise the investment as it has retained

substantially all the risks and rewards
Financial Liability De-recognition
The risks and rewards transfer does not apply for financial liabilities. Rather, the
focus is on whether the financial liability has been extinguished.
158
Impairment of Financial Instruments
Impairment of Financial Instruments
Expected Credit Loss model
This applies to:
1. Amortised cost items
2. FVTOCI items
How it works
• Significant increase in credit risk occurred? Show lifetime expected losses
• No significant increase in credit risk? Show 12-month expected losses only
How do you calculate the Expected Credit Loss?
Use:
1. a probability-weighted outcome
2. the time value of money
3. the best available forward-looking information.
Notice the use of forward-looking info - this means judgement is needed - so it will
be difficult to compare companies
159

Stage 1 - Assets with no significant increase in credit risk
For these assets:
1. 12-month expected credit losses (‘ECL’) are recognised and
2. Interest revenue is calculated on the gross carrying amount of the asset (that is,
without deduction for credit allowance)
12-month ECL are based on the asset’s entire credit loss but weighted by the
probability that the loss will occur within 12 months of the Y/E
160
Stage 2 - Assets with a significant increase in credit risk (but no evidence of
impairment)
For these assets:
1. Lifetime ECL are recognized
2. Interest revenue is still calculated on the gross carrying amount of the asset.
Lifetime ECL come from all possible default events over its expected life
Expected credit losses are the weighted average credit losses with the probability of
default (‘PD’) as the weight.
Stage 3 - Assets with evidence of impairment
For these assets:
1. Lifetime ECL are recognised and
2. Interest revenue is calculated on the net carrying amount (that is, net of credit
allowance
In subsequent reporting periods, if the credit quality improves so there’s no longer a

significant increase in credit risk since initial recognition, then the entity reverts to
recognising a 12-month ECL allowance
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Where does the impairment go?
• The changes in the loss allowance balance are recognised in profit or loss as an
impairment gain or loss
So what do all these new rules on impairment mean?
Impairments are now recorded BEFORE any actual impairment (except for FVTPL
items) due to the 12-month ECL allowance for all assets
The ECL model is more forward looking when calculating ECLs
Entities with shorter term and higher quality financial instruments are likely to be
less significantly affected.
Higher volatility in the ECL amounts charged to profit or loss, increasing as

economic conditions are forecast to deteriorate, meaning more judgement required
For companies, the ECL model will most likely not cause a major increase in
allowances for short-term trade receivables because of their short term nature.
The provision matrix should help measure the loss allowance for short-term trade
receivables.
Collective Basis
• If the asset is small it’s just not practical to see if there’s been a significant
increase in credit risk
So, you can assess ECLs on a collective basis, to approximate the result of
using comprehensive credit risk information that incorporates forward-looking
information at an individual instrument level
162
Simplified Approach
• This means no tracking changes in credit risk!
Instead just recognise a loss allowance based on lifetime ECLs at each reporting
date, right from origination.
The simplified approach is for trade receivables, contract assets with no

significant financing component, or for contracts with a maturity of one year or
less
12-month expected credit losses
These are a portion of the lifetime ECLs that are possible within 12 months
The portion is weighted by the probability of a default occurring
It is not the predicted (probable) defaults in the next 12 months. For instance, the
probability of default might be only 25%, in which case, this should be used to
calculate 12-month ECLs, even though it is not probable that the asset will default.
Also, the 12-month expected losses are not the cash shortfalls that are predicted
over only the next 12 months. For a defaulting asset, the lifetime ECLs will normally
be significantly greater than just the cash flows that were contractually due in the
next 12 months.
Lifetime expected credit losses
These are from all possible default events over the expected life
Estimate them based on the present value of all cash shortfalls
So, basically, it’s the difference between:
• The contractual cash flows And
• The cash flows now expected to receive
As PV is used, even late (but the same) cashflows create an ECL
For a financial guarantee contract, the ECLs would be the PV of what it expects to
pay as guarantor less any amounts from the holder
163
Impairment of Financial Instruments - Illustrations
Illustration 1
A company has a 5yr 6% receivable loan of $1,000,000
They expect credit losses of $10,000 pa.
The present value (discounted at 6%) of these lifetime expected credit losses is
$42,124.
The present value of the 12-month expected credit losses is $9,434
Solution - how to deal with this financial asset
• On day 1
Dr Loan receivable $1,000,000
Cr Cash $1,000,000
• End of yr 1 - no significant increase in credit risk - show 12m ECL
Dr I/S Impairment loss $9,434
Cr Loss allowance in financial position $9,434
• End of yr 1 - significant increase in credit risk - show re-estimate of lifetime

ECL
Let’s say the present value of the lifetime expected credit losses is $34,651.
Dr I/S Impairment loss $25,217 (34,651 – 9,434)
164
Illustration 2
A company has a receivable loan of $1,000,000.
They estimates that the loan has a 1% probability of a default occurring in the next
12 months.
It further estimates that 25% of the gross carrying amount will be lost if the loan
defaults.
How much should the 12m ECL be?
Solution:
= 1% x 25% x $1,000,000 = $2,500
Illustration 3
An entity has a 10 yr 6% loan receivable of $1,000,000.
On initial recognition the probability of default is 1%. Expected lifetime losses

$250,000
End of year 1 - probability of default increases to 1.5%
End of year 2 - probability of default increases to 30% (but still no evidence of

impairment) - expected lifetime losses now $100,000
End of year 3 - probability of default increases further - expected lifetime losses

now 150,000 (but still no evidence of impairment)
End of year 4 - probability of default increases further - expected lifetime losses

now 200,000 (but still no evidence of impairment)
The loan eventually defaults at the end of Year 5 and the actual loss amounts to
$250,000.
At the beginning of Year 6, the loan is sold to a third party for $740,000
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Solution
• Initial recognition
Dr Loan receivable – amortised cost asset $1,000,000
Cr Cash $1,000,000
Dr I/S Impairment loss (1% x 250,000) $2,500
• At the end of Year 1
Dr Impairment loss in profit or loss (3,750 – 2,500) $1,250
The new 12m ECL would be 1.5% x 250,000 = $3,750.
Interest income 6% x 1,000,000 = $60,000.
• At the end of Year 2
Dr I/S Impairment loss (100,000 - 3,750) $96,250
Interest income 6% x 1,000,000 = $60,000
Notice that interest is still calculated on gross amount
• At the end of year 3
166
From Year 6 onward, interest income would be calculated at 6% on the net

carrying amount of the loan $750,000.
• Start of year 6
Dr Cash $740,000
Dr Loss allowance in financial position – de-recognised $250,000
Dr Loss on disposal in profit or loss $10,000
Cr Gross loan receivable – de-recognised $1,000,000
167
Provisions
A provision is a liability of uncertain timing or amount
Double entry
• Dr Expense
Cr Provision (Liability SFP)
If it is part of a cost of an asset (e.g. Decommissioning costs)
• Dr Asset
Cr Provision (Liability SFP)
Recognise when
1. There is an obligation (constructive or legal)
2. There is a probable outflow
3. It is reliably measurable
168
At how much?
The best estimate of the expenditure
1. Large Population of Items..

use expected values.
2. Single Item...
the individual most likely outcome may be the best estimate.
Discounting of provisions
• Provisions should be discounted

Eg. A future liability of 1,000 in 2 years time (discount rate 10%)
1,000 x 1/1.10 x 1/1.10 = 826
Dr Expense 826
Cr Provision 826
• Then the discount unwound
Year 1
826 x 10% = 83
Dr Interest 83
Cr Provision 83
Year 2
(826+83) x 10% = 91
Dr Interest 91
Cr Provision 91
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Measurement of a Provision
The amount recognised as a provision should be the best estimate of the
expenditure required to settle the present obligation at the end of the reporting
period.
• Provisions for one-off events

E.g. restructuring, environmental clean-up, settlement of a lawsuit
Measured at the most likely amount
• Large populations of events

E.g. warranties, customer refunds
Measured at a probability-weighted expected value
A company sells goods with a warranty for the cost of repairs required in the first 2
months after purchase.
Past experience suggests:
88% of the goods sold will have no defects
7% will have minor defects
5% will have major defects
If minor defects were detected in all products sold, the cost of repairs will be
$24,000;
If major defects were detected in all products sold, the cost would be $200,000.
What amount of provision should be made?
(88% x 0) + (7% x 24,000) + (5% x 200,000) = $11,680
Contingent Liabilities
• These are simply a disclosure in the accounts
• They occur when a potential liability is not probable but only possible
(Also occurs when not reliably measurable)
170

Contingent Assets
Here, it is not a potential liability, but a potential asset.
The principle of PRUDENCE is important here, it must be harder to show a potential

asset in your accounts than it is a potential liability.
This is achieved by changing the probability test.
For a potential (contingent) asset - it needs to be virtually certain (rather than just
probable).
Probability test for Contingent Liabilities

• Remote chance of paying out - Do nothing
• Possible chance of paying out - Disclosure
• Probable chance of paying out - Create a provision
Probability test for Contingent Assets

• Remote chance of receiving - Do nothing
• Possible chance of receiving - Do nothing
• Probable chance of receiving – Disclosure
• Virtually certain of receiving - create an asset in the accounts
171
Some typical examples
Specific types of provision
• Future operating losses
Provisions are not recognised for future operating losses (no obligation)
• Onerous contracts
Recognised and measured as a provision (as there is a contract and so a legal

obligation)
• Restructuring
Restructuring - Create a provision when:
1. There is a detailed formal plan for the restructuring; and
2. There is a valid expectation in those affected that it will carry out the
restructuring by starting to implement that plan or announcing its main features
to those affected by it (this creates a constructive obligation)
Provide only for costs that are:
• (a) necessarily entailed by the restructuring; and
(b) not associated with the ongoing activities of the entity
Possible Exam Scenarios
• Warranties
Yes there is a legal obligation so provide. The amount is based on the class as a
whole rather than individual claims. Use expected values
172
• Major Repairs
These are not provided for. Instead they are treated as replacement non current
assets. See that chapter
• Self Insurance
This is trying to provide for potential future fires etc. Clearly no provision as no
obligation to pay until fire actually occurs
• Environmental Contamination Clearance
Yes provide if legally required to do so or other parties would expect the

company to do so as it is its known policy
• Decommissioning Costs
All costs are provided for. The debit would be to the asset itself rather than the
income statement
• Restructuring
Provide if there is a detailed formal plan and all parties affected expect it to
happen. Only include costs necessary caused by it and nothing to do with the
normal ongoing activities of the company (e.g. don’t provide for training,
marketing etc)
• Reimbursements
This is when some or all of the costs will be paid for by a different party.
This asset can only be recognised if the reimbursement is virtually certain, and
the expense can still be shown separately in the income statement
173
Circumstance Provide?
Accrue a provision (past event was the sale

Warranties/guarantees
of defective goods)
Accrue if the established policy is to give

Customer refunds
refunds
Onerous (loss-making) contract Accrue a provision
Accrue a provision if the company's policy is

Land contamination to clean up even if there is no legal
requirement to do so
Future operating losses No provision (no present obligation)
No provision (there is no obligation to provide

Firm offers staff training
the training)
Major overhaul or repairs No provision (no obligation)
Restructuring by sale of an Accrue a provision only after a binding sale

operation/line of business agreement
Restructuring by closure of Accrue a provision only after a detailed

business locations or formal plan is adopted and announced
reorganisation publicly. A Board decision is not enough
174
IAS 10 Events After The Reporting Period
Events can be adjusting or non-adjusting.
We are looking at transactions that happen in this period, and whether we should go
back and adjust our accounts for the year end or not adjust and just put into next
year’s accounts
If the event gives us more information about the condition at the year-end then we
adjust.
If not then we don’t.
When is the "After the Reporting date" period?
It is anytime between period end and the date the accounts are authorised for issue.
• After the SFP date = Between period end and date authorised for issue
Ok and why is it important?
Well it may well be that many of the figures in the accounts are estimates at the
period end.
However, what if we get more information about these estimates etc afterwards, but
before the accounts are authorised and published.. should we change the accounts
or not?
The most important thing to remember is that the accounts are prepared to the SFP
date. Not afterwards.
So we are trying to show what the situation at the SFP date was. However, it may
be that more information ABOUT the conditions at the SFP date have come about
afterwards and so we should adjust the accounts.
Sometimes we do not adjust though…
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Adjusting Events
Here we adjust the accounts if:
The event provides evidence of conditions that existed at the period end
Examples are..
1. Debtor goes bad 5 days after SFP date
(This is evidence that debtor was bad at SFP date also)
2. Stock is sold at a loss 2 weeks after SFP date
3. Property gets impaired 3 weeks after SFP date
(This implies that the property was impaired at the SFP date also)
4. The result of a court case confirming the company did have a present obligation
at the year end
5. The settling of a purchase price for an asset that was bought before the year end
but the price was not finalized
6. The discovery of fraud or error in the year
176
Non-Adjusting Events - these are disclosed only
These are events (after the SFP date) that occurred which do not give evidence of
conditions at the year end, rather they are indicative of conditions AFTER the SFP
date
1. Stock is sold at a loss because they were damaged post year-end
(This is evidence that they were fine at the year-end - so no adjustment)
2. Property impaired due to a fall in market values generally post year end
(This is evidence that the property value was fine at the year end - so no
adjustment required).
3. The acquisition or disposal of a subsidiary post year end
4. A formal plan issued post year end to discontinue a major operation
5. The destruction of an asset by fire or similar post year end
6. Dividends declared after the year end
Non-adjusting event which affects Going Concern
Adjust the accounts to a break up basis regardless if the event was a non-adjusting
event.
177
Share Based Payments - Introduction
What is a SBP transaction?
Well first of all it needs to be for receiving good or services and in return the
company gives:
1. Its own shares
2. Cash based upon the price of its own shares
Contracts to buy or sell non-financial items that may be settled net in shares or
rights to shares are outside the scope of IFRS 2 and are addressed by IAS 32
There are 3 types of Share based payment..
These are..
1. Equity-settled share-based payment
This is where the company pays shares in return for goods and/or services
received.
Dr Expense
Cr Equity
2. Cash-settled share-based payment
This is where cash is paid in return for goods and services received,
HOWEVER..the actual cash amount though is based on the share price.
These are also called SARs (Share Appreciation Rights).
Dr Expense
Cr Liability
178
3. Transactions with a choice of settlement
A choice of cash or shares paid in return for goods and services received.
depends on choice made
Vesting period
Often share based payments are not immediate but payable in say 3 years. The
expense is spread over these 3 years and this is called the vesting period.
How much to recognise?
So we have decided that share based payments (either shares or cash based on
share price) should go into the accounts .
(Dr expense Cr Equity or Liability)
We now have to look at the value to put on these:
• Option 1: Direct method
Use the FV of the goods or services received
• Option 2: Indirect method
Use the FV of the shares issued by the company
Equity settled - Use FV of shares @ grant date
Cash settled - Update FV of shares each year
179
IFRS 2 suggests you choose option 1 - the FV of the goods/services.
However, if the FV of these cannot be reliably measured then you should go for
option 2 - FV of shares issued.
Strangely enough, option 2 is the most common. This is because share based
payments are often associated with paying employees.
You cannot put a value on the work done by employees - except for the value of
what you pay them i.e. Option 2.
180
SBP - Equity Settled
This is where payments are made with an equity instrument such as a

share or a share option.
Measurement
• The FV of the product / service acquired (if possible)
• FV of equity instrument issued
FV of Equity Instrument
This is basically MARKET VALUE, taking into account the terms and market related
conditions of the offer.
If there is no MV available, then the “Intrinsic Value” option is available. This is

basically the share price less the exercise price.
However, if this is chosen then the accounting treatment below is slightly different. It
will need to be remeasured to the new intrinsic value each year - this will be very
rare.
181
Accounting Treatment
Dr Expense (or asset)
Cr Equity
The problem is we only do the above double entry once the item has ‘vested’ (i.e.
satisfied all conditions to be met to make the share payable)
For example, if shares are issued for the purchase of a building, and the building is
available to use immediately, then it has vested immediately and you would Dr PPE
Cr Equity with the FV of the asset acquired.
If, however, share options are issued, but only once employees have stayed in the
job for say 3 years, then this means they do not fully vest for 3 years. What you do
here, is recognise the expense as it vests - over what we call the ‘vesting period’.
So, in this example, you would calculate the full cost of the options at grant date
and in the first year Dr Expense Cr Equity with 1/3 of that total.
Precise Measurement
You take the best available estimate at the time of the number of equity instruments
expected to vest at the end.
The value used for the share options throughout the vesting period remains at the
GRANT DATE value (with the exception of “intrinsic value” method above).
Illustration
An entity grants 100 share options on its $1 shares to each of its 500 employees on
1 January Year 1.
Each grant is conditional upon the employee working for the entity over the next
three years.
182
The fair value of each share option as at 1 January Year 1 is $10.
On the basis of a weighted average probability, the entity estimates on 1 January

that 100 employees will leave during the three-year period and therefore forfeit their
rights to share options.
The following actually occurs:
• – 20 employees leave during Year 1 and the estimate of total employee

departures over the three-year period is revised to 70 employees
– 25 employees leave during Year 2 and the estimate of total employee

departures over the three-year period is revised to 60 employees
– 10 employees leave during Year 3
Solution
1. Step 1:
Decide if this is a cash or equity settled SBP - share options are equity settled
(so Dr Expense Cr Equity).
2. Step 2:
Decide whether to value directly or indirectly - these are for employees so
indirectly.
3. Step 3:
Calculate how many employees (and their share options each) are expected to
be issued at the end of the vesting period.
183
Year 1:
430 Employees expected to be left at end (500-70) x 100 (share options each) x $10
(FV @ GRANT date) x 1/3 (time through vesting period) = 143,300
Year 2:
440 x 100 x $10 x 2/3 - 143,300 = 150,000
Year 3:
445 x 100 x $10 x 3/3 - 293,300 = 151,700
So you can see that the “costs” and so the entries into the accounts would be:
Year 1: Dr Expense 143,300 Cr Equity 143,300
Notice that if you add these up it comes to 445,000.
This is exactly our final liability (445 x 100 x $10 x 3/3) - it’s just we’ve spread it over
the 3 years vesting period.
184
SBP - Cash Settled
They are often called “Share Appreciation Rights (SARs)”
These are when a company promises to pay for goods or services for cash,
however the cash price is linked to the share price
The double entry is:
• Dr Expense
Cr Cash or Liability
If the payment is for a service stretching over a number of years (vesting period)
then the expense is recognised over the number of years and the liability is
calculated by taking into account the change in the share price
Illustration 1
1 Jan Year 1 - 100 share appreciation rights (SARs) given to each of the company’s
1000 employees.
FV of these at grant date was £5.
The employees had to be in service for 3 years to take the SAR
End of year 1 - 100 employees had left and 140 more expected to leave by the end
of year 3. FV of SAR now £6
End of year 2 - 40 employees left in the year and another 50 expected to leave in
year 3. FV of SAR now £8
End of year 3 - 60 employees left and the FV of SAR is now £7
185
Solution
Year 1 - 760 (1,000 - 100 -140) x 100 x £6 x 1/3 = 152,000 (Dr Expense Cr Liability)
Year 2 - 810 (1,000 - 100 - 40 - 50) x 100 x £8 x 2/3 = 432,000 - 152,000 = 280,000
(Dr Expense Cr Liability)
Year 3 - 800 (1,000 - 100 - 40 - 60) x 100 x £7 x 3/3 = 560,000 - 432,000 = 128,000
(Dr Expense Cr Liability)
Finally the 560,000 is paid
Dr Liability 560,000
Cr Cash 560,000
Illustration 2
An entity grants 100 share options on its $1 shares to each of its 500 employees on
1 January Year 1.
Each grant is conditional upon the employee working for the entity over the next
three years.
The fair value of each share option as at 1 January Year 1 is $10.
On the basis of a weighted average probability, the entity estimates on 1 January

that 100 employees will leave during the three-year period and therefore forfeit their
rights to share options.
The following actually occurs:
– 20 employees leave during Year 1 and the estimate of total employee departures
over the three-year period is revised to 70 employees
– 25 employees leave during Year 2 and the estimate of total employee departures
over the three-year period is revised to 60 employees
– 10 employees leave during Year 3
186
Information of share price at the end of each year:
Year 1 10
Year 2 12
Year 3 14
Solution
As this is cash settled then the double entry becomes Dr Expense Cr Liability and
we do not keep the value of the option @ grant date but change it as we pass
through the vesting period.
• Y1: 430 x 100 x 10 x 1/3 = 143,300
Y2: 440 x 100 x 12 x 2/3 - 143,300 = 208,700 
Y3: 445 x 100 x 14 x 3/3 - 623,000 x 3/3 - 352,000 = 271,000
• So you can see that the “costs” and so the entries into the accounts would be:
Year 1: Dr Expense 143,300 Cr Liability 143,300 
Year 2: Dr Expense 208,700 Cr Liability 208,700 
Year 3: Dr Expense 271,000 Cr Liability 271,000
Notice that if you add these up it comes to 623,000. 
• This is exactly our final liability (445 x 100 x $14 x 3/3) - it’s just we’ve spread it
over the 3 years vesting period.
187
SBP with a Choice of Settlement
Share-based payment with a choice of settlement
Entity has the choice
Is there a present obligation to settle in cash?
1. Yes
Treat as cash-settled
2. No
Treat as equity-settled
Counter-party has the choice
The transaction is a compound financial instrument which needs splitting into debt
and equity
• Debt Portion
This must be calculated first..the FV of the cash option at grant date
Then it is treated just like a normal cash-settled SBP
• Equity Portion
This is the FV of the option less the debt portion calculated above at grant date
188
Illustration 1
An entity grants an employee a right to receive either 8,000 shares or cash to the
value, on that date, of 7,000 shares. She has to remain in employment for 3 years.
The market price of the entity's shares is $21 at grant date, $27 at the end of year 1,
$33 at the end of year 2 and $42 at the end of the vesting period, at which time the
employee elects to receive the shares.
The entity estimates the fair value of the share route to be $19.
Show the accounting treatment.
Solution
The fair value of the cash route at grant date is: 7,000 × $21 = $147,000 
The fair value of the share route is: 8,000 × $19 = $152,000 - 147,000 = $5,000
We then treat them as cash and equity settled SBPs as appropriate:
Year Cash Equity I/S
1 7,000 x $27 x 1/3 = 63,000 5,000 x 1/3 = 1,667 64,667
2 7,000 x $33 x 2/3 = 154,000 5,000 x 1/3 = 1,667 92,667
3 7,000 x $42 x 3/3 = 294,000 5,000 x 1/3 = 1,667 141,667
189
Entity has the choice of issuing shares or cash
1. Option 1 - Obligated to pay cash
The entity is prohibited from issuing shares or where it has a stated policy, or
past practice, of issuing cash rather than shares.
Treat as a cash-settled SBP
2. Option 2 - Not obligated to pay cash
Treat as if it was purely an equity-settled transaction.
If on settlement, cash was actually paid, the cash should be treated as if it was a
repurchase of the equity instrument by a deduction against equity.
190
Vesting Period
This is normally a set amount of time but sometimes it may be dependent upon a
condition to be satisfied.
Vesting Conditions
These are conditions that have to be met before the holder gets the right to the
shares or share options
There are 2 types of Vesting Condition:
1. Non-market based
Those not relating to the market value of the entity’s shares
2. Market based
Those linked to the market price of the entity’s shares in some way
Non-Market Vesting Conditions
Here only the number of shares or share options expected to vest will be accounted
for.
At each period end (including interim periods), the number expected to vest should
be revised as necessary.
191
Illustration 1
An entity granted 10,000 share options to one director. The director had to work
there for 3 years, and indeed he did
Also to get the options, the director had to reduce costs by 10% over the vesting
period.
At the end of the first year, costs had reduced by 12%. By the end of the 2nd year,
costs had only reduced in total by 7%.
By the end of yr. 3 though the costs had been reduced by 11%
The FV of the option at grant date was $21
How should the transaction be recognised?
Solution
The cost reduction target is a non-market performance condition which is taken into
account in estimating whether the options will vest. The expense recognised in
profit or loss in each of the three years is:
Yearly Charge Cumulative
(10,000 × £21)/3 years

Year 1 70,000
= 70,000
Year 2 (performance target not expected to
-70,000 0
be met)
(10,000 x $21)
Year 3 210,000
= 210,000
192
Market Vesting Conditions
These conditions are taken into account when calculating the fair value of the equity
instruments at the grant date.
They are not taken into account when estimating the number of shares or share
options likely to vest at each period end.
If the shares or share options do not vest, any amount recognised in the financial
statements will remain.
Make an estimate of the vesting period at the acquisition date
1. If vesting period is shorter than original estimate
Expense all the remainder in the year the vesting condition is complied with
2. If vesting period is longer than the original estimate
Expense still using the original estimate of vesting period
Market and non-market based vesting conditions together
Where both market and non-market vesting conditions exist, then as long as the
non market conditions are met the company must expense (irrespective of whether
market conditions are satisfied)
So, where market and non-market conditions co-exist, it makes no difference

whether the market conditions are achieved.
The possibility that the target share price may not be achieved has already been
taken into account when estimating the fair value of the options at grant date.
Therefore, the amounts recognised as an expense in each year will be the same
regardless of what share price has been achieved.
193
Illustration 2
A company granted 10,000 share options to a director. He must work there for 3
years. He did this.
Also the share price should increase by at 25% over the three-year period.
During the 1st year the share price rose by 30% and by 26% compound over the
first two years and 24% per annum compound over the whole period
At the date of grant the fair value of each share option was estimated at £18
How should the transaction be recognised?
Solution
The director satisfied the service requirement but the share price growth condition
was not met.
The share price growth is a market condition and is taken into account in estimating
the fair value of the options at grant date.
Therefore, no adjustment should be made if there are changes from that estimated
in relation to the market condition. There is no write-back of expenses previously
charged, even though the shares do not vest.
The expense recognised in profit or loss in each of the three years is one third of
10,000 x £18 = £60,000.
194
IFRS 2 Share based payments deferred tax
Deferred tax implications
Issue
An entity recognises an expense for share options but the taxman offers the tax
deduction on the later exercise date.
This is therefore an example of accounts showing more expenses (than the taxman
has allowed so far) and so a deferred tax asset occurs.
The taxman may calculate his expense on the intrinsic value basis.
This may offer a greater deduction (at the end) than our expense.
This extra deferred tax asset is set off against equity (and OCI) not the income
statement.
195
Illustration
An entity granted 1,000 share options to an employee vesting 3 years later.
The fair value of at the grant date was $3. 
Tax law allows a tax deduction of the intrinsic value of$1.20 at the end of year 1 and
$3.40 at the end of year 2. 
Assume a tax rate of 30%.
Solution
• Year 1
Accounts  
1,000 x 1/3 x 3 = 1,000
Tax  
Has allowed 0 
However, at the end he will allow 1,000 x 1/3 x 1.2 = 400
Therefore the deferred tax asset is capped at 400.
So, the double entry is: 
Dr Deferred Tax Asset (400x30%) 120 
Cr Tax (I/S) 120
196
• Year 2  
Accounts  
1,000 x 2/3 x 3 - 1,000 = 1,000
Tax  
1,000 x 2/3 x 3.4 - 400 = 1.867
Therefore we have expensed 2,000 (1,000 + 1,000)
The tax man will allow at the end 2,267 (400 + 1,867)
So, the deferred tax asset should now be 2267 x 30% = 680
Of this only 2,000 x 30% = 600 should have gone to the income statement (to
match with the 2,000 expense).
The remaining 80 should have gone to equity.
Year 2
Income statement  
Expense 1,000 
Tax (600 - 120) -480
Equity  
Share Options 2,000 
Tax asset 80
Double entry
Dr Deferred tax asset (680-120) 560 
Cr Income statement 480 
Cr Equity 80
197
Deferred Tax Scenarios
So as we saw in the introductory section, deferred tax is all about matching.
If the accounts show the income, then they must also show any related tax.
This is normally not a problem as both the accounts and taxman often charge
amounts in the same period.
The problem occurs when they don’t.
We saw how the accounts may show income when the performance occurs, while
the taxman only taxes it (tax base) when the money is received.
In this case, as financial reporters we must make sure we match the income and
related expense.
So this was a case of the accounts showing ‘more income’ than the tax man in the
current year (he will tax it the following year when the money is received).
So we had to bring in ‘more tax’ ourselves by creating a deferred tax liability.
So, basically deferred tax is caused simply by timing differences between IFRS rules
and tax rules.
Therefore IFRS demands that matching should occur i.e.
Difference between Tax adjustment needed for Deferred

Double entry
IFRS and Tax base matching to occur Tax
Dr Tax (I/S) 
More Income in I/S More tax needed Liability Cr Def Tax
Liability (SFP)
198
Hopefully you can see then that the opposite also applies:
Difference between IFRS Tax adjustment needed Deferred

Double entry
and Tax base for matching to occur Tax
Dr Def tax asset 
More expense in I/S Less tax needed Asset
Cr tax (I/S)
In fact, the following table all applies:
Difference Tax effect Difference
1 More Income More tax Liability
2 Less income Less tax Asset
3 More expense Less tax Asset
4 Less expense More tax Liability
Remember this “more income etc.” is from the point of view of IFRS. I.e. The
accounts are showing more income, as the taxman does not tax it until next year.
We will now look at each of these 4 cases in more detail.
Case 1
Difference Tax effect Deferred Tax
1 More Income More tax Liability
199
Issue
IFRS shows more income than the taxman has taken into account.
Example
Royalties receivable above.
Double entry required:
Dr Tax (I/S)
Cr Deferred tax Liability (SFP)
Case 2
2 Less Income Less tax Asset
Issue
IFRS shows less income than the taxman has taken into account.
Example
Taxman taxes some income which IFRS states should be deferred such as upfront
receipts on a long term contract.
Dr Deferred Tax Asset (SFP)
Cr Tax (I/S)
This will have the effect of eliminating the tax charge for now, so matching the fact
that IFRS is not showing the income yet either.
Once the income is shown, then the tax will also be shown by:
Dr Tax (I/S)
Cr Deferred tax asset (SFP)
200
Case 3
3 More Expense Less tax Asset
Issue
IFRS shows more expense than the taxman has taken into account.
Example
IFRS depreciation is more than Tax depreciation (WDA or CA).
Dr Deferred Tax Asset (SFP)
Cr Tax (I/S)
Illustration
IFRS TAX
Asset Cost 1,000 1,000
Depreciation (400) (300)
NBV 600 700
Simply compare 700-600 =100
100 x tax rate = deferred tax asset
201
Case 4
4 Less Expense More tax Liability
Issue
IFRS shows less expense than the taxman has taken into account.
Example
IFRS depreciation is less than Tax depreciation (WDA or CA).
Dr Tax I/S
Cr Deferred Tax Liability
Illustration
IFRS TAX
Asset Cost 1,000 1,000
Depreciation (300) (400)
NBV 700 600
Simply compare 700-600 =100
100 x tax rate = deferred tax liability
Then multiply this by the tax rate (e.g. 30%) = 100 x 30% = 30
202
NOTE
In actual fact, the standard refers to assets and liabilities rather than more income
and more expense etc. Simply use the above tables and substitute the word asset
for income and expense for liability.
Difference Tax effect Difference
1 More Asset More tax Liability
2 Less Asset Less tax Asset
3 More Liability Less tax Asset
4 Less Liability More tax Liability
Possible Examination examples of Case 1& 4
Accelerated capital allowances (accelerated tax depreciation) - see above.
Interest revenue - some interest revenue may be included in profit or loss on an

accruals basis, but taxed when received.
Development costs - capitalised for accounting purposes in accordance with IAS 38

while being deducted from taxable profit in the period incurred.
Revaluations to fair value
In some countries the revaluation does not affect the tax base of the asset and
hence a temporary difference occurs which should be provided for in full based on
the difference between its carrying value and tax base.
NOTE: Double entry here is:
203
Dr Revaluation Reserve with the tax (as this is where the “income” went)
Cr Deferred tax liability
Fair value adjustments on consolidation

IFRS 3/ IAS 28 require assets acquired on acquisition of a subsidiary or associate to
be brought in at their fair value rather than carrying amount.
The deferred tax effect is a consolidation adjustment - this is more assets (normally)
so a deferred tax liability. The other side would be though to increase goodwill. And
vice-versa.
Undistributed profits of subsidiaries, branches, associates and joint ventures
No deferred tax liability if Parent controls the timing of the dividend.
Possible Examination examples of Case 2 & 3

Provisions - may not be deductible for tax purposes until the expenditure is
incurred.
Losses - current losses that can be carried forward to be offset against future
taxable profits result in a deferred tax asset.
Fair value adjustments
Liabilities recognised on business combinations result in a deferred tax asset where

the expenditure is not deductible for tax purposes until a later period.
A deferred tax asset also arises on downward revaluations where the fair value is
less than its tax base.
NOTE: Here, the deferred tax asset here is another asset of S at acquisition and so
reduces goodwill.
204
Unrealised profits on intragroup trading
the tax base is based on the profits of the individual company who has made a
realised profit.
THERE IS NO DEFERRED TAX EFFECT ON INITIAL GOODWILL.
How much deferred tax?
Deferred tax is measured at the tax rates expected to apply to the period when the
asset is realised or liability settled, based on tax rates (and tax laws) that have been
enacted by the end of the reporting period.
No Discounting
Deferred tax assets are only recognised to the extent that it is probable that taxable
profit will be available against which the deductible temporary difference can be
used.
205
Miscellaneous Deferred Tax Items
On acquiring a Subsidiary
Here you need to check the Net Assets at acquisition (from your equity table) and
compare it to the tax base of the NA (this will be given in the exam)
Again you just look to see if the accounts are showing more or less assets and
create a deferred tax liability / asset at acquisition also. This will affect goodwill.
Illustration 1
H acquires 100% S for 1,000. At that date the FV of S’s NA was 800 and the tax
base 700. Tax is 30%.
Goodwill
FV of Consideration 1,000
NCI -
FV of NA acquired -800
New Deferred tax liability 

30
(800-700) x 30%
Goodwill 230
206
Un-remitted Earnings of Group Companies
H always has the right to receive profits (and dividends from them) from S or A.
However not all profits are immediately paid out as dividends.
This creates deferred tax as H will receive the full amount one day and when it does
it will be taxed. Therefore, a deferred tax liability should be created to match against
the profits shown from S and A
However, for Subsidiaries only, H might control its dividend policy and have no
intention of paying dividends out and no intention of selling S either in the
foreseeable future.
Therefore when this is the case NO deferred tax liability is created (this can not be
the case for Associates as H does not control A)
Unrealised Profit Adjustments
Here, the group makes an adjustment and decreases profits, in the group accounts
only.
However, tax is charged on the individual companies and not the group. So, the
group accounts will be showing less profits and so the tax needs adjusting by
creating a deferred tax asset
The issue though is what tax rate to use - that of the selling company or that of the
buyer who holds the stock?
IAS 12 says you should use the tax rate of the buyer
207
Setting Off
A deferred tax asset can normally be set off against a deferred tax liability (to the
same tax jurisdiction) as the liability gives strong evidence that profits are being
made and so the asset will come to fruition
Deferred Tax Liability 1,000
Deferred Tax Asset -800
NCI 200
If, however, the deferred tax asset is more than the liability then the deferred tax
asset can only be recognised if is probable that it will be recovered in the near future
Deferred Tax Liability 1,000
Deferred Tax Asset -1,100
NCI NO SET OFF
208
Syllabus B1e. Ethics
Ethical and professional issues
Accountant as a Professional
Accounting professionals are expected to be:
1. highly competent
2. reliable
3. objective
4. high degree of professional integrity.
A professional’s good reputation is one of their most important assets.
Accountancy as a profession has accepted its overriding need to act in the best
interest of the public.
This can create an ethical/professional dilemma.
As accountants also have professional duties to their employer and clients.
Where these duties are in contrast to the public interest, then the ethical conduct of
the accountant should be in favour of the public interest.
This can create problems particularly on an audit, whereby you provide a service for
the client, yet may have to make public information which is detrimental to the
company but in the public interest.
There is a very fine line between acceptable accounting practice and management’s
deliberate misrepresentation in the financial statements.
209
The financial statements must meet the following criteria:
• Technical compliance:
Generally accepted accounting principles (GAAP) used.
• Economic substance:
The economic substance of the event that has occurred must be represented
(over and above GAAP)
• Full disclosure and transparency:
Sufficient disclosures made
Management often seeks loopholes in financial reporting standards that allow them
to adjust the financial statements as far as is practicable to achieve their desired
aim.
These adjustments amount to unethical practices when they fall outside the bounds
of acceptable accounting practice.
In most cases conformance to acceptable accounting practices is a matter of

personal integrity.
Reasons for such behaviour often include
1. market expectations
2. personal realisation of a bonus
3. maintenance of position within a market sector
210
Ethical requirements of corporate reporting
Misrepresenting figures in the financial statements may not be illegal

but is unethical
Accountants have a responsibility to not mislead the public.
Accountancy is a profession which, like all professions, has:
1. Specialised body of knowledge
2. Commitment to social good
3. Can regulate itself
4. Has high social status
Notice that there is a play-off here. The professions promise to act in the best public
interest.
In return the public allows the profession to self-regulate, enjoy high social status
and have an exclusive right to perform certain functions (e.g. Auditors)
Accountants need to act professionally and in the current conditions have even
more of a duty to present fair, accurate and faithfully represented information.
It can be argued that accountants should have the presentation of truth, in a fair and
accurate manner, as a goal.
211
Conceptual Framework Chapters (1-3)
Chapter 1: The Objective of Financial Reporting
The objective is to provide financial information that is useful to present and

potential equity investors, lenders and other creditors in making decisions.
The degree to which that financial information is useful will depend on its qualitative
characteristics.
A few observations about the objective:
• Wide Scope
Its scope is wider than financial statements. It is the objective of financial

reporting in general.
• Users
Financial reporting is aimed primarily at capital providers. That does not mean
that others will not find financial reports useful. It is just that, in deciding on the
principles for recognition, measurement, presentation, and disclosure, the
information needs of capital providers are paramount.
• Decision usefulness & stewardship
Decision usefulness to capital providers is the overriding purpose of financial

reporting, as well as assessing the stewardship of resources already committed
to the entity.
The ability of management to discharge their stewardship responsibilities

effectively has an effect on the entity’s ability to generate net cash inflows in the
future, implying that potential investors are also assessing management
performance as they make their investment decision.
212
• Capital providers - main users
The Framework identifies equity investors, lenders and other creditors as ‘capital
providers’. Governments, their agencies, regulatory bodies, and members of the
public are identified as groups that may find the information in general purpose
financial reports useful. However, these groups have not been identified as
primary users.
Limitations of FS
The Boards note that users of financial reports should be aware of the limitations of
the information included in such reports – specifically, estimates and the use of
judgement.
Additionally, financial reports are but one source of information needed by those
who make investment decisions. Information about general economic conditions,
political events and industry outlooks should also be considered.
Financial reporting should also include management’s explanations, since

management knows more about the entity than external users.
Chapter 2: The Reporting entity
The chapter on the Reporting Entity will be inserted once the IASB has completed
its re-deliberations following the Exposure Draft ED/2010/2 issued in March 2010.
213
Chapter 3: Qualitative Characteristics of Useful Financial Information
Main Principle
Financial information is useful when it is relevant and represents faithfully what it

purports to represent. The usefulness of financial information is enhanced if it is
comparable, verifiable, timely and understandable.
Fundamental characteristics:
1. Relevance
Relevant information makes a difference in the decisions made by users.
Therefore it must have a predictive value, confirmatory value, or both. The

predictive value and confirmatory value of financial information are interrelated.
Materiality is an entity-specific aspect of relevance. It is based on the nature

and/or size of the item relative to the financial report.
2. Faithful representation
General purpose financial reports represent economic phenomena in words and

numbers.
To be useful, financial information must not only be relevant, it must also

represent faithfully the phenomena it purports to represent.
This maximises the underlying characteristics of completeness, neutrality and

freedom from error.
214
Enhancing characteristics:
1. Comparability (including consistency)
2. Timeliness
3. Reliable information
4. Verifiability
Helps to assure users that information represents faithfully the economic

phenomena that it purports to represent.
It implies that knowledgeable observers could reach a general consensus

(although not necessarily absolute agreement) that the information does
represent faithfully the economic phenomena.
5. Understandability
Enables users with a reasonable knowledge to comprehend the information.
Understandability is enhanced when the information is:
• Classified
• Characterised
• Presented clearly and concisely
However, relevant information should not be excluded solely because it may be too
complex.
215
Two constraints that limit the information provided in useful financial reports:
1. Materiality
Information is material if its omission or misstatement could influence the

decisions that users make on the basis of an entity’s financial information.
Materiality is not a matter to be considered by standard-setters but by preparers

and their auditors.
2. Cost-benefit
The benefits of providing financial reporting information should justify the costs
of providing that information.
Potential Problems
Decision usefulness seen as more important than the giving information about how
well the company is being looked after (Stewardship).
Although it may be said that stewardship is taken into account when talking about
decision usefulness - perhaps there should be a more specific mention of it.
Faithful representation has replaced reliability.
This is even more vague and could lead to problems regarding treatment of some
items where substance over form exists
Should it encompass not for profits also?
Why the split between fundamental and enhancing characteristics?
216
Syllabus B2. Complex groups
Complex groups - Introduction
Complex Groups
Let’s look at an example to help explain this:
H owns 70% of S1 and S1 owns 60% of S2
mmmmm interesting hey #strokeschinthoughtfully…so
H controls S1 directly
S1 controls S2 directly
Therefore….
H controls S2 indirectly
This means that H controls S1 and S2 and therefore both should be consolidated
(as they are controlled).
Now let’s look at the numbers of this question in a bit more detail…
H owns 70% of S1 and S1 owns 60% of S2.
This means S1 is a 70% sub (NCI 30%) - No problemo.
217
What about S2 though?
H owns 70% of S1, who in turn owns 60% of S2, so effectively H owns 70% of
60% = 42% (remember though it is still a sub as H CONTROLs S2 as we saw
above.
So S2 is a 42% sub (58% NCI).
I know it’s odd that NCI is a larger figure but hopefully you can see that it is
CONTROL which is important in deciding whether it is a sub or not the ownership.
Let’s get Consolidating Cow face
(that’s a compliment).
The consolidation approach is the same as for basic groups before, with the
exception of goodwill and NCI calculations.
Firstly let’s remind ourselves again of the basics of working out the group and NCI
percentages in complex group structures, like we did before:
Example
• H owns 80% S1. S1 owns 60% S2
How much is NCI in both S1 and S2?
NCI in S = 20%
NCI in S2 = 52%
(This is because H effectively owns 80% x 60% = 48%)
So remember with complex groups - the sub subsidiary (S2) is still consolidated
and, as we will see later, it is just the Goodwill and NCI calculation that differs
slightly from the normal workings we used before.
218
Goodwill in Complex Groups
Issue 1: Acquisition Date
Get the acquisition date right! - It is when H takes control.
Illustration
H acquires S1 in year 4 and S1 acquires S2 in year 5
S1 acquisition date = Year 4
Illustration 2
H acquires S1 in year 5 and S1 acquired S2 in year 4
Issue 2 - effective % (seen earlier)
Use effective interest in S2 (for Reserves).
H owns 80% S1 - S1 owns 70% S2.
Effective interest in S2 = 56% (80% x 70%). Use this for reserves and 44% for NCI.
Issue 3
Ok - right first thing to know is that you do 2 goodwill calculations (1 for S1 and 1
for S2) then add them together on the consolidated SFP.
The next thing to know is that you do it all from “H’s point of view”.
219
Here’s the basic rules:
Goodwill in S1 - everything is as normal.
Goodwill in S2 - Just a bit trickier.
Consideration x This is S1s consideration x H’s share in S1

NCI x
Goodwill x
Illustration
H S1 S2
Investment in S1 10,000
Other Net Assets 20,000 14,000 10,000
Share Capital 8,000 5,000 2,000
H acquired 80% S1 in yr 1 when S1’s reserves were 3,000.
S1 acquired 70% S2 in yr 2 when S2’s reserves were 1,000.
Use proportionate goodwill method and there are no FV adjustments at acquisition.
220
Solution
Equity Table - S1
Total 20,000 8,000 12,000
Equity Table S2
Total 10,000 3,000 7,000
Goodwill in S1
NCI 1,600
Goodwill 3,600
221
Goodwill in S2
Consideration 4,800 (6,000 x 80%)
NCI 1,320 44% x 3,000
Goodwill 3,120
Total Goodwill = 3,600 + 3,120 = 6,720
NB. The 44% is the NCI because the ownership (from H’s point of view) in S2 is
80% x 70% = 56%
 
AT THIS STAGE, THIS IS HOW FAR YOU SHOULD GO. GO AND HAVE A LOOK AT
“NCI IN COMPLEX GROUPS” - I’M COMPLETING THE QUESTION JUST SO YOU
CAN SEE IT IN FULL WHEN YOU’RE READY.
NCI in S1
NCI @ Acquisition 1,600 (given)
NCI % of S’s post acquisition profits 1,200 (20% x (12,000 - 6,000))
Impairment (0)
222
NCI in S2
NCI % of S’s post acquisition profits 3,080 (44% x 7,000)
Impairment (0)
Total NCI = 2.800 + 4,400 = 7,200
 
Reserves
H 22,000
S1 9,600 (80% x 12,000)
S2 3,920 (56% x 7,000)
35,520
Answer
H S1 S2 Group
Investment in S1 10,000 Goodwill 3,600
Investment in S2 6,000 Goodwill 3,120
Other Net Assets 20,000 14,000 10,000 44,000
Share Capital 8,000 5,000 2,000 8,000
Retained Earnings 22,000 15,000 8,000 35,520
NCI 7,200
223
NCI in Complex Groups
Again, like goodwill, we do 2 NCI workings (then add them together for the final
number on the SFP).
Double Counting
The only problem is that S already has an investment in S2. This means that when
we calculate NCI in S and in S2 we are double counting.
We give NCI their share in S (but this includes “Investment in S2), then we give NCI
their share in S2 also
I’m hoping you can see that the investment in S2 bit is being double counted re
NCI.
So what is the solution?
Well remember the NCI working?
NCI % of S’s post acquisition profits 160 (20% x 800)
NCI on the SFP 380
This is fine for S2, but for S1 it needs to change slightly so as not to double count
the Investment in S2.
NCI % of S’s post acquisition profits - Inv. in S2 120 (20% x (800-200))
NCI on the SFP 340
224
Illustration
P acquires 80% S. At that date FV of NCI in S was 100. S has since made profits of
1,000 and also bought 60% S2 for 200.
At the date it bought S2, the FV of 52% NCI was 180. S2 has since made 300
profits.
How much is NCI?
NCI in S
NCI % of S’s post acquisition profits-Inv in S2 160 (20% x (1,000-200))
NCI on the SFP 260
NCI in S2
NCI on the SFP 336
Total NCI = 596
225
D-shaped Groups
This is a situation where H not only owns an INDIRECT share of S2 (via S1) but also
a DIRECT holding itself in S2.
Illustration
H owns 80% in S1. H owns 10% in S2. S1 owns 60% S2.
H’s Effective interest in S2
= Direct 10%
= Indirect 48% (80% x 60%)
= Total 58%
NCI therefore = 42%
The good news is that virtually everything here is treated the same way as we did in
complex groups.
Exception
When calculating goodwill in S2 we need to add in the direct holding of H in S2.
226
Illustration
H S1 S2
Investment in S2 80,000 65,000
Other Net Assets 150,000 75,000 180,000
Share Capital 200,000 80,000 100,000
Year 1: S1 acquired 35,000 shares in S2 when reserves were 40,000.
Year 2: H acquired 64,000 shares in S1 and 40,000 shares in S2 when reserves were
50,000 and 60,000 respectively.
FV of NCI in S1 at acquisition = 27,000. FV of NCI in S2 at acquisition = 56,000.
No goodwill impaired.
Solution
S1 Equity Table
FV adj 0 0 0
Total 140,000 130,000 10,000
227
S2 Equity Table
Share Capital 100,000 100,000 0
FV adj 0 0 0
Total 180,000 160,000 20,000
Goodwill in S1
FV of NCI 27,000
Goodwill 17,000
Goodwill in S2
Consideration 80,000 (direct) + 52,000 (80% x 65 Indirect)
FV of NCI 56,000
Goodwill 28,000
228
NCI in S1
NCI % of S’s post acquisition profits (11,000) (20% x (10.000-65,000))
Impairment (-)
NCI in S2
NCI % of S’s post acquisition profits 6,400 (32% x 20,000)
Impairment (-)
Total NCI = 78,400
Retained Earnings
H 150,000
S1 8,000 (80% x 10,000)
S2 13,600 (68% x 20,000)
Impairment (0)
171,600
229
Final answer
H S1 S2 Group
Other Net Assets 150,000 75,000 180,000 405,000
Investment in S 200 Goodwill 45,000
Share Capital 200,000 80,000 100,000 200,000
Reserves 150,000 60,000 80,000 171,600
NCI 78,400
230
Step Acquisitions
When Control is achieved is the key date..
Consolidation only occurs when control is eventually achieved.
When Control is achieved this occurs:
• Remeasure all previous holdings to FV
• Any gain or loss to income statement
Illustration
P acquired 10% of S in year 1 for 100.
P acquired a further 60% of S in year 2 for 800. At this date, the original 10% now
has a FV of 140.
How would this be accounted for?
The key date of when controlled is achieved is year 2. At this date we must:
• Revalue the original 10% from 100 to 140
• The 40 gain goes to the income statement (and retained earnings)
Also we would now start consolidating S (as we now control it). The
Consideration figure in the goodwill working would now be 940 (140 + 800).
Further acquisition after control is achieved
If there are further acquisitions after control - this is deemed to be a purchase from
the other owners (NCI) - so no profit is calculated. Simply.
231
Here you will need to do the following calculation:
FV of consideration (for the extra % bought) x
Decrease in NCI (x)
Difference - goes to Equity of the Parent x/(x)
Illustration
H acquired 60% S for 100 in year 4 when the FV of its NA was 90. Proportionate
NCI method is used.
2 years later its NA are 150 and H acquires another 20% for 80.
Calculate decrease in NCI and movement in parents equity for the latest acquisition.
FV of consideration 80
Decrease in NCI (30)
Difference - goes to Equity of the Parent 50
NCI
@ Acquisition 36 (40% x 90)
Post acquisition 24 (40% x (150-90))
Impairment (0)
TOTAL AT DATE OF DISPOSAL 60
SO NCI was 60 (representing 40%). Now, by acquiring a further 20% from the NCI,
this means NCI will go from 40% to 20%. It has halved.
So NCI has gone down by 30. 
232
Comprehensive Examples - Step Acquisition
Comprehensive Question
SFP for YEAR 6
P S
Non Current Asset 500 600
Investment in S 250

Reserves 350 400

Non Current Liabilities 300 250
P acquired 30% S in year 1 for 60. It acquired another 30% in year 4 for 140
S’s reserves were 10 in year 1 and 60 in year 4.
FV of S’s NA in year 1 was 120 and in year 4 190. Difference is due to Land.
FV of NCI in year 4 was 90.
FV of 30% holding in Year 4 is 120.
P acquired a further 10% of S on the last day of year 6 for 50.
Show the Consolidated SFP at the end of year 6.
Solution
233
Step 1: Equity Table
Land 30 30 0
Total 530 190 340
Step 2: Goodwill
Consideration 260 (140 + 120)
NCI 90
Goodwill 160
234
Step 3: NCI
Impairment (0)
NCI on the SFP before further acquisition 226
Less further acquisition (57) 226 x 10/40
NCI on the SFP after further acquisition 169
Step 4: Further Acquisition from NCI
FV of consideration (50)
Decrease in NCI 57
Difference - goes to Equity of the Parent (7)
Step 5: Reserves
P 350
S 204 (60% x 340)
Impairment (0)
Gain on Revaluing original 30% 60
Movement due to further acquisition 7
621
235
 
Final Answer
P S Group
Non-Current Asset 500 600 1,130 incl. FV land adj.

NCI 169

Non-Current Liabilities 300 250 550
236
Discontinued Operation
An analysis between continuing and discontinuing operations improves

the usefulness of financial statements.
When forecasting ONLY the results of continuing operations should be used.
Because discontinued operations profits or losses will not be repeated.
What is a discontinued operation?
1. A separate major line of business or geographical area
or..
2. is part of a single co-ordinated plan to dispose of a separate major line of

business or geographical area
or..
3. is a subsidiary acquired exclusively with a view to resale
How is it shown on the Income Statement?
The PAT and any gain/loss on disposal
• A single line in I/S
How is it shown on the SFP?
If not already disposed of yet?
• Held for sale disposal group
237
How is it shown on the cash-flow statement?
• Separately presented
• in all 3 areas - operating; investing and financing
No Retroactive Classification
IFRS 5 prohibits the retroactive classification as a discontinued operation, when the

discontinued criteria are met after the end of the reporting period
238
Partial Disposals
A partial disposal means selling but keeping control - so we must keep above 50%
ownership afterwards e.g. Selling from 80% to 60%.
As we keep control, then the sale must be to those who do not have control - the
NCI.
NCI will therefore increase after a partial disposal.
Therefore, this is just an exchange between the owners of the business (controllers
and non-controllers) and so any gain or loss must go to EQUITY (other reserves) not
Income statement.
How is the gain or loss calculated?
Proceeds from the disposal x
Increase in NCI (x)
Difference to Equity x
How do you calculate the ‘Increase in NCI’ line?
Goodwill x
Net Assets (from Equity table) x
x % disposed x
239
What is the double entry for the disposal?
Dr Investment in S (as this is where it was originally

X Proceeds
credited to)
Increase in NCI
Cr NCI X
calculated
Dr / Cr Other Reserves X/(X) Difference
What is the Income Statement Effect?
The subsidiary is still consolidated in full.
NCI % is time apportioned (eg 20% to date of disposal, 40% thereafter).
240
Full Disposal
This is when we lose control, so we go from owning a % above 50 to one below 50

(eg 80% to 30%).
In this case we have effectively disposed of the subsidiary (and possibly created a
new associate).
As the sub has been disposed of - then any gain or loss goes to the INCOME
STATEMENT (and hence retained earnings).
Also, the old Subs assets and liabilities no longer get added across, there will be no
goodwill or NCI for it either.
How do you calculate this gain or loss?
Proceeds X
Net Assets (100%) (X)
Goodwill (X)
NCI X
FV of the remaining % (if any) X
Gain/Loss X
What’s the effect on the Income Statement?
Consolidated until sale; Then treat as Associate (if we have significant influence)
otherwise a FVTPL investment.
Show profit on disposal (see above).
241
Subsidiary acquired with a view to disposal
A subsidiary that is acquired exclusively with a view to its subsequent disposal is
classified on the acquisition date of the subsidiary as a non-current disposal group
'held for sale' (if it is expected that the subsidiary will be disposed of within one year
and the other IFRS 5 criteria are met with within three months of the acquisition
date)
Classification as a discontinued operation
A subsidiary classified as 'held for sale', is included in the definition of a
discontinued operation, with treatment as follows:
• Income statement
Single Line “Discontinued operations” - PAT of the Sub + gain/loss on re-
measurement to held for sale
The income and expenses of the subsidiary are therefore not consolidated on a
line-by-line basis with the income and expenses of the holding company.
242
• Statement of financial position
The assets and liabilities classified as 'held for sale' presented separately (the
assets and liabilities of the same disposal group may not be offset against each
other).
The assets and liabilities of the subsidiary are therefore not consolidated on a
line-by-line basis with the assets and liabilities of the holding company.
• Statement of Cashflows
No need to disclose the net cash flows attributable to the operating, investing
and financing activities of the discontinued operation (which is normally required)
but is not required for newly acquired subsidiaries which meet the criteria to be
classified as 'held for sale' on the acquisition date
243
Important Examinable Narrative & Miscellaneous points
These are:
• Transactions related to acquiring a subsidiary are to be written off to the Income
statement
• Any future contingent consideration towards the cost of investment is included
in cost of investment at its FAIR VALUE regardless of whether it is probable or
not
• If the FAIR VALUE of the above changes after acquisition goodwill is NOT
adjusted unless it is simply providing more information about what the fair value
would have been at acquisition date
• A company is a sub when it is controlled only. This means more than 50% of the
voting rights; or control of the financial and operating activities or power to
appoint a majority of the board
• It may be that H owns 40% + 20% potential shares (eg share options). To see
whether this means H controls S all terms must be examined, disregarding
management intentions
• Subsidiaries held for sale must be consolidated (see above)
• JV’s and A’s are not consolidated if they are held for sale
• Subsidiaries with very different activities to H must also be consolidated as IFRS
8 segmental reporting will deal with these problems
• Subs with severe long term restrictions must still be consolidated until actual
control is lost
244
• A’s with severe long term restrictions must still be equity accounted until actual
significant influence is lost
• A company is an associate when there is no control but there is significant
influence. This means 20% or more of the voting rights (unless someone else
holds more than 50% solely in which case they control it and we have no
significant influence at all). Participation in policy making is deemed to be
significant influence
• H does NOT need to consolidate if it is itself a 100% sub or if the shares aren’t
traded publicly and the ultimate parent prepares consolidated accounts
• Subs may have a different reporting date to H but they must prepare further
accounts to make consolidation possible. Unless the difference in date is 3
months or less in which case S’s accounts can be used and adjustments made
for significant events
• Consolidated accounts must be made with uniform accounting policies. So if S
has different policies to H, group level adjustments need to be made
• NCI can be negative - they are simply owners of the group like the parent and so
losses are possible
• An investment in an associate that is acquired and held exclusively with a view
to its disposal within 12 months should be accounted for as held for trading
under IAS 39
245
Foreign Exchange Single company
Transactions in a single company
This is where a company simples deals with companies abroad (who have a
different currency).
The key thing to remember is that…
ALL EXCHANGE DIFFERENCES TO INCOME STATEMENT
So - a company will buy on credit (or sell) and then pay or receive later. The problem
is that the exchange rate will have moved and caused an exchange difference.
Step 1: Translate at spot rate
Step 2: If there is a creditor/debtor @ y/e - retranslate it (exch gain/loss to I/S)
Step 3: Pay off creditor - exchange gain/loss to I/S
Illustration 1
On 1 July an entity purchased goods from a foreign country for Y$10,000.
On 1 September the goods were paid in full.
246
The exchange rates were:
1 July $1 = Y$10
1 September $1 = Y$9
Calculate the exchange difference to be included in profit or loss according to IAS

21 The Effects of Changes in Foreign Exchange Rates.
• Solution
Account for Payables on 1 July: Y$10,000/10 = 1,000
Payment performed on 1 September: Y$10,000 / 9 = 1,111
The Exchange difference: 1,000 - 1,111 = 111 loss
Illustration 2
Maltese Co. buys £100 goods on 1st June (£1:€1.2)
Year End (31/12) payable still outstanding (£1:€1.1)
5th January £100 paid (£1:€1.05)
Solution
Initial Transaction
Dr Purchases 120
Cr Payables 120
Year End
Dr Payables 10
Cr I/S Ex gain 10
On payment
Dr Payables 110
Cr I/S Ex gain 5
Cr Cash 105
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Also items revalued to Fair Value will be retranslated at the date of revaluation and
the exchange gain/loss to Income statement.
All foreign monetary balances are also translated at the year end and the differences
taken to the income statement.
This would include receivables, payables, loans etc.
248
Foreign exchange – subsidiaries
Ok so in the previous section we looked at foreign exchange differences which
occur when an individual company buys/sells at one rate and pays/receives at
another. Either that or a retranslation of a foreign monetary balance.
Now we look at what happens to our CONSOLIDATED accounts when we have a
foreign subsidiary.
Clearly we cannot just add their foreign currency figures to our home currency
figures - we need to translate S first. We do this using the following rates:
Exchange rates to be used:
Income Statement Average rate
SFP (Assets and Liabs) Closing rate
ALL EXCHANGE DIFFERENCES TO RESERVES
How we actually go about doing this in the exam means a slight adjustment to our
group workings as stated here:
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Net Assets Table
At acquisition column Acquisition rate
Year end column Closing rate
The post-acquisition column and hence retained earnings effectively includes the
exchange gains/losses. This should be disclosed separately in the OCI and in
Equity.
Foreign Exchange Translation Reserve
Remember that actually, by using the rates we have in the equity table, any foreign
exchange differences will end up in the post-acquisition column which we then use
for our retained earnings working. If requested we could calculate the exact amount
and take it out of retained earnings and put it into its own reserve.
This can be calculated as follows:
Translation Reserve
Closing NA (@ closing rate) x
Opening NA (@ opening rate) (x)
Profit (@ average rate) (x)
X
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Goodwill
This should be retranslated every year end (closing rate). Any exchange gain/loss to
Equity.
Illustration
Notice first of all you should calculate goodwill in the FOREIGN CURRENCY. This
allows us to retranslate it whenever we want.
Goodwill (in foreign currency)
NCI 27,000
Goodwill 17,000
Take this 17,000 and translate it at the acquisition rate at first.
e.g. 17,000 x 0.5 = $8,500
Now take the 17,000 and translate it at the year-end rate.
e.g. 17,000 x 0.6 = $10,200
The $10,200 is shown in the group SFP and the gain of $1,700 is taken to retained
earnings.
251
Illustration
Steps
1. Do S only adjustments (in foreign currency)
2. Translate S (using rates above) and do Net Asset Table
3. Do adjustments and workings as normal - but calculate goodwill exchange gain
or loss and add to retained earnings
P ($) S (Pintos)
Assets 9,500 40,000
Investment in S 3,818

Share Capital 5,000 10,000
Reserves 6,000 8,200

Liabilities 2,318 21,800
P acquired 80% S @ start of year. At Acquisition S’s Land had a FV 4,000 pintos
higher than book value
Proportionate NCI method
Exchange rates (Pinto:$)
Last year end 5.5
This year end 5
Average for year 5.2
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Solution
1. Step 1: S only adjustments – none
2. Step 2: Net Asset Table (Acq. @ acq. rate; Year-end @closing rate)
Retained Earnings 1,640 1,091 549
Land 800 727 73
Total 4,440 3,636 804
Translate S - all assets and liabilities at closing rate. Income statement at average
rate.
SFP - so far
SFP Pintos $
Assets 40,000 8,000+800(FV)
Liabilities 21,800 4,360
Income statement
Revenue 5,200 1,000
COS -2,600 -500
Tax -400 -77
PAT 2,200 423
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Step 3 Workings and adjustments as normal
Goodwill
Consideration 3,818
NCI 727
Goodwill 909
Retranslate at year end: 

909 x 5.5/5 1,000 
Gain of 91 to retained earnings
NCI
Impairment (0)
NCI on the SFP 888
Retained Earnings
P 6,000
S 643 (80% x (804)
Impairment (0)
Retranslation of goodwill from above 91
6,734
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Translation Reserve
NOT NORMALLY REQUIRED IN EXAM
Closing NA (@ Closing rate) 4,440
Opening NA (@ Opening rate) (3,636)
Profit (@ Average rate) (423)
381
80% of this 381 is taken from RE as this belongs to P.
100% of the goodwill revaluation gain also is an exchange difference 91 and this
would also be taken from the retained earnings.
Giving the retranslation reserve a balance of 396 (80% x 381 + 91).
Final Answer
Don’t forget to translate all of S’s NA @ closing rate.
P S Group
Assets 9,500 8,000+800 18,300
Investment in S Goodwill 1,000

Share Capital 5,000
Reserves 6,734
NCI 888

Liabilities 2,318 4,360 6,678
255
Foreign currency - extras
Foreign Currency - Examinable Narrative & Miscellaneous points
Functional Currency
Every entity has its own functional currency and measures its results in that
currency
Functional currency is the one that
Influences sales price
The one used in the country where most competitors are and where regulations are
made and
The one that influences labour and material costs
If functional currency changes then all items are translated at the exchange rate at
the date of change
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Presentation Currency
An entity can present in any currency it chooses.
The foreign sub (with a foreign functional currency) will present normally in the
parents presentation currency and hence the need for foreign sub translation rules!
Foreign currency dealings between H and S
There is often a loan between H and a foreign sub. If the loan is in a foreign currency
don’t forget that this will need retranslating in H’s or S’s (depending on who has the
‘foreign’ loan) own accounts with the difference going to its income statement.
If H sells foreign S, any exchange differences (from translating that sub) in equity are
taken to the income statement (and out of the OCI).
Deferred tax
There are deferred tax consequences of foreign exchange gains (see tax chapter).
This is because the gains and losses are recognised by H now but will not be dealt
with by the taxman until S is eventually sold.
257
Syllabus B3. Related Parties
Related parties and groups
P and S are related in their OWN accounts..
Where a company is part of a group, the financial statements (of a subsidiary) may
be influenced by related party transactions
Potential problems
1. Lots of post acquisition trading between P and S
2. This trading not necessarily at arms length
(not commercial rates)
3. This will distort S's profits (either in a good or bad way)
4. S may gain other advantages
eg. Technology/research, cheap finance, etc.
Therefore P can ‘flattered’ S’s accounts (especially if it's going to sell S)
The potential buyer would not necessarily be able to determine that this had
happened from either the consolidated or S's own financial statements
258
General Rules
In Own Accounts
P and S are related
• Transactions, balances etc all stay in the accounts
• They are, though, disclosed as being related party transactions
• Even if at arms length
In Group accounts
• All intragroup transactions and balances are eliminated
259
IAS 24 Related Parties
A party is said to be related to an entity if any of the following three
situations occur:
The 3 situations are:
1. Controls / is controlled by entity
2. is under common control with entity
3. has significant influence over the entity
Types of related party
These therefore include:
1. Subsidiaries
2. Associate
3. Joint venture
4. Key management
5. Close family member of above (like my beautiful daughter pictured in her new
school uniform aaahhh)
6. A post-employment benefit plan for the benefit of employees
260
Not necessarily related parties
• Two entities with a director in common
• Two joint venturers
• Providers of finance
• A big customer, supplier etc
Stakeholders need to know that all transactions are at arm´s length and if not then
be fully aware.
Similarly they need to be aware of the volume of business with a related party,
which though may be at arm´s length, should the related party connection break
then the volume of business disappear also.
Disclosures
• General
The name of the entity’s parent and, if different, the ultimate controlling party
The nature of the related party relationship
Information about the transactions and outstanding balances necessary for an
understanding of the relationship on the financial statements
261
• As a minimum, this includes:
Amount of outstanding balances
Bad and doubtful debt information
• Key management personnel compensation should be broken down by:
short-term employee benefits
post-employment benefits
other long-term benefits
termination benefits
share-based payment
Group and Individual accounts
1. Individual accounts
Disclose related party transactions / outstanding balances of parent, venturer or
investor.
2. Group accounts
The intragroup transactions and balances would have been eliminated.
262
IAS 33 EPS Introduction
EPS is a much used PERFORMANCE appraisal measure
It is calculated as:
PAT - Preference dividends / Number of shares
It is not only an important measure in its own right but also as a component in the
price earnings (P/E) ratio (see below)
263
Diluted EPS
This is saying that the basic EPS might get worse due to things that are ALREADY
in issue such as:
• Convertible Loan
This will mean more shares when converted
• Share options
This will mean more shares when exercised
Who has to report an EPS?
• PLCs
• Group accounts where the parent has shares similarly traded/being issued
EPS to be presented in the income statement.
264
IAS 33 EPS - earnings figure
This is basically Profit after Tax
less preference dividends
*Be careful of the type of preference share though...
Redeemable preference shares
These are actually liabilities and their finance charge isn’t a dividend in the accounts
but interest.
• Do not adjust for these dividends.
Irredeemable preference shares
These are equity and the finance charge is dividends
• Do adjust for these dividends
265
IAS 33 EPS - Number of shares
Calculating the weighted average number of ordinary shares
The number of shares given in the SFP at the year-end - may not be the number of
shares in issue ALL year.
So we need to know how many we had in issue on AVERAGE instead of at the end.
Well if there were no additional shares in the year then obviously the weighted
average is the same as the year end - so no problem!
However, if additional shares have been issued we’ve got some work to do as
follows (depending on how those shares were issued):
Full Market Price issue of shares
No problem here as the new shares came with the right amount of new resources
so the company should be able to use those new resources to maintain the EPS
• No adjustment needed (apart from time)
266
Bonus & Rights Issue of shares
More problematic, as the share were issued for cheaper (rights) than usual or for
free (bonus).
In both cases the company has not been given enough new resource to expect the
EPS to be maintained.
This causes comparison to last year problems.
• Adjust for these (Bonus fraction)
• Pretend they were in issue ALL year
• Change comparative (Pretend they were in last year too)
So, how to calculate it is best explained by example:
1st January 100 shares in issue
1st May Full market price issue of 400 shares
1st July 1 for 5 bonus issue
Solution
Draw up a table like this:
DATE TOTAL SHARES TIME BONUS FRACTION WEIGHTED AVERAGE
267
Now fill in the first 2 columns:
1st Jan 100
1st May 500
1st July 600
Notice how this shows the TOTAL shares. Now fill in the timing of how long these
TOTALS lasted for in the year.
1st Jan 100 4/12
1st May 500 2/12
1st July 600 6/12
Finally look for any bonus issues and pretend that they happened at the start of the
year. We do this by applying the bonus fraction to all entries BEFORE the actual
bonus or rights issue.
268
In this case the bonus fraction would be 6/5 - so apply this to everything before the
actual bonus issue:
1st Jan 100 4/12 6/5
1st May 500 2/12 6/5
1st July 600 6/12
Finally, multiply through and calculate the weighted average:
1st Jan 100 4/12 6/5 40
1st May 500 2/12 6/5 100
1st July 600 6/12 300
440
269
IAS 33 Bonus issue
Bonus issue
Additional shares are issued to the ordinary equity holders in proportion to their
current shareholding, for example 1 new share for every 2 shares already owned.
No cash is received for these shares.
Double Entry
• Dr Reserves or Share premium
Cr Share Capital
IAS 33 pretends that the bonus issue has been in place all year - regardless of when
it was actually made.
We do this by multiplying the totals before the issue by a “bonus fraction”.
Bonus Fraction Calculation - Bonus issue
1 for 2 bonus issue - means we’ve now got 3 where we used to have 2 = 3/2
2 for 5 - now got 7 used to have 5 = 7/5
3 for 4 - now got 7 used to have 4 = 7/4
270
Example
1st Jan 100 shares in issue
1st July 1 for 2 bonus issue (i.e. 50 more shares)
• Weighted Average number of shares
100 x 6/12 (we had a total of 100 for 6 months) = 50 x 3/2 (bonus fraction) = 75
150 x 6/12 (we had a total of 150 for 6 months) = 75
Total = 150
271
IAS 33 Rights Issue
Rights issue
A rights issue is:
• An issue of shares for cash to the existing ordinary equity holders in proportion
to their current shareholdings.
• At a discount to the current market price. It is, in fact, a mixture of a full price
and bonus issue.
So again we do the same as in the bonus issue - we pretend it happened all year
and to do this we multiply the previous totals by the bonus fraction.
The problem is - calculating the bonus fraction for a rights issue is slightly different:
Example
2 for 5 offered at £4 when the market value is £10
So we are being offered 2 @ £4 = £8
For every 5 which cost us £10 each = £50
So we now have 7 at a cost of £58 = 8.29
This is what we call the TERP (theoretical ex-rights price).
The bonus fraction is the current MV / TERP = 10 / 8.29
272
IAS 33 Basic EPS putting it all together
IAS 33 Basic EPS putting it all together
1. Step 1: Calculate the EARNINGS (PAT - irredeemable pref. shares)
2. Step 2: Calculate Weighted average NUMBER OF SHARES
3. Divide one by the other!
273
IAS 33 Diluted EPS
This is the basic EPS adjusted for the potential effects of a convertible
loan (currently in the SFP) being converted and options (currently in
issue) being exercised.
This is because these things will possibly increase the number of shares in the
future and thus dilute EPS.
This is how these items affect the Basic Earnings and Shares.
Earnings
The convertible loan will (once converted) increase earnings as interest will no
longer have to be paid.
So increase the basic earnings with a tax adjusted interest savings.
Shares
• Simply add the shares which will result from the convertible loan
Also add the “free” shares from a share option
Convertible loan
• Add the interest saved (after tax) to the EARNINGS from basic EPS
• Add the extra shares convertible to the SHARES from basic EPS
Options
Step 1: Calculate the money the options will bring in
Step 2: Calculate how many shares this would normally buy
Step 3: Look at the number of shares given away in the option, compare it to those
in step 2 and these are the “free shares”
274
We add the free shares to the SHARES figure from basic EPS.
Illustration
5% 800 convertible loan - each 100 can be converted into 20 shares (tax 30%)
100 share options @ $2 (MV $5)
How to calculate Interest Saved
5% x 800 = 40 x 70% (tax adjusted) = 28
How to calculate the extra convertible shares
800/100 x 20 = 160
How to calculate the free shares in share options

Cash in from option $200, this would normally mean the company issuing (200/5) 40
shares instead of the 100, so there has effectively been 60 shares issued for ‘free’.
We use this figure in the diluted eps calculation.
An alternative calculation is:
100 x (5-2) / 5 = 60
Solution
Basic EPS Convertible Loan Share options
E 100 + 28
S 50 + 160 + 60
Diluted EPS = 128 / 270 = 0.47
275
EPS as a performance measure
EPS is better than PAT as an earnings performance indicator
Profit after tax gives an absolute figure
An increase in PAT does not show the whole picture about a company's profitability
Some profit growth may come from acquiring other companies
If the acquisition was funded by new shares then profit will grow but not necessarily
EPS
So EPS trends show a better picture of profitability than PAT
Simply looking at PAT growth ignores any increases in the resources used to earn
them
The diluted EPS is useful as it alerts existing shareholders to the fact that future EPS
may be reduced as a result of share capital changes
Where the finance cost per potential new share is less than the basic EPS, there will
be a dilution
276
Syllabus C: ANALYSIS OF FINANCIAL PERFORMANCE
AND POSITION
Syllabus C1. Interpreting Ratios
Ratios and Strategy
Accounting Ratios
In your exam, you may be required to calculate some ratios in order to support your
strategic analysis of the case.
This section shall only present a summary and list of ratios that could potential be
used in your exam for such purpose.
277
Ratios may be divided into the following categories:
• PROFITABILITY RATIOS
These are measures of value added being generated by an organisation and
include the following:
ROCE Operating Profit (PBIT)/Capital Employed
Capital Employed Equity + LT liabilities
Capital Employed Non current assets + net current assets
Capital Employed Total assets - current liabilities
Gross margin Gross Profit/Sales
Net Margin Net Profit/Sales
Profit After Tax - Preference dividends/Shareholders’ Funds

ROE
(Ordinary shares + Reserves)
RI Profit After Tax - (Operating Assets x Cost of Capital)
• EFFICIENCY RATIOS
These are measures of utilisation of Current & Non-current Assets of an
organisation. Efficiency Ratios consist of the following:
Asset Turnover Sales/Capital Employed
ROCE Margin X Asset Turnover
Receivables Days (Receivables Balance / Credit Sales) x 365
Payables Days (Payable Balance / Credit Purchases) x 365
Inventory Days (Inventory / Cost of Sales) x 365
278
• LIQUIDITY & GEARING RATIOS
Liquidity Ratios measure the extent to which an organisation is capable of

converting assets into cash and cash equivalents.
On the other hand, Gearing Ratios measure the dependence of an organisation

on external financing as against shareholder funds.
Liquidity and Gearing Ratios are outlined below:
Liquidity
Current Ratio Current Assets / Current Liabilities
Quick Ratio (Current Assets – Inventory) / Current Liabilities
Gearing
Financial Gearing Debt/Equity
Financial Gearing Debt/Debt + Equity
Operational gearing Contribution / PBIT
• INVESTOR'S RATIOS
These ratios measures return on investment generated by stakeholders. Such
ratios include:
Dividend Cover Profit After Tax / Total Dividend
Dividend Yield Dividends per share / Share price
Interest Cover PBIT / Interest
Interest yield (coupon rate / market price) x 100%
Profit After Tax and preference dividends / Number of

Earnings Per Share
Shares
279
PE Ratio Share Price / EPS
• In the exam you have to act like a detective. You have to sift through evidence
and extract meaningful messages for effective business decisions. The starting
point is often the basic accounting documents that record the progress of any
business, the Income statement & SFP
These are closely related and so need reading together.
The balance sheet is a snapshot of a business at one point in time.
The income statement is dynamic and describes the flow of money through the
business over a period of time.
280
Profitability
Return on Capital Employed
ROCE
This is a measure of management’s overall efficiency in using the finance/assets
• is affected by the carrying amount of PPE
So old plant will give a higher than usual ROCE
Revaluations upwards will give a lower than usual ROCE
ROCE can be broken down (explained by) 2 more ratios:
Operating Margin
Asset Turnover
So if operating margin goes up and ROCE goes down - you know that ROCE is
going down due to a poor Net asset turnover.
281
The assets aren't producing the amount of sales they used to
Operating Margin
= Operation profit / Sales
Gross Margin
282
This is affected by..
An increase in gross profit doesn't necessarily mean an increase in the margin
This is because Gross profit is also affected by the volume of sales (not just the
margin made on each one)
• Opening and closing inventory measured at different costs
• Inventory write downs due to damage/obsolescence
• A change in the sales mix
eg. from higher to lower margin sales
• New (different margin) products
• New suppliers with different costs
• Selling prices change
eg. discounts offered
• More or less Import duties
• Exchange rate fluctuations
• Change in cost classification:
• eg. Some costs included as operating expenses now in cost of sales
283
Gearing
Financial Gearing
This could also be calculated as:
284
Interest Cover
Points to notice about LOW interest cover
low interest cover is a direct consequence of high gearing and . For example,
• It makes profits vulnerable to relatively small changes in operating activity
So small reductions in sales / margins or small increases in expenses may mean
interest can't be paid
285
Liquidity
Current ratio
Quick Ratio
286
Bank Account / Overdraft
Don't forget the obvious and look at the movement on this
• Look for why it has increased or decreased
• If money is spent on assets thats normally a good thing
• If money is spent on high dividends (with little cash) thats a bad thing
• If a loan is paid off - that's normally a bad idea (as the company should be able
to make a better return)
Working Capital Cycle
This is made up of
The difference between being paid needs to be funded (often by an overdraft)
1. Inventory Days + (ideally these are low)
2. Receivable days - (ideally these are low)
3. Payable days (ideally these are high)
287

288

Indicators of deteriorating liquidity
• Cash balances falling
• New share / loan issues with no respective increase in assets
• Sale and leaseback of assets
• Payables days getting longer
289
Syllabus C2. Limitations of ratio analysis
Ratio limitations
Ratios aren't always comparable
Factors affecting comaparability
1. Different accounting policies
Eg One company may revalue its property; this will increase its capital employed
and (probably) lower its ROCE
Others may carry their property at historical cost
2. Different accounting dates
Eg One company has a year ended 30 June, whereas another has 30 September
If the sector is exposed to seasonal trading, this could have a significant impact
on many ratios.
3. Different ratio definitions
Eg This may be a particular problem with ratios like ROCE as there is no
universally accepted definition
290
4. Comparing to averages
Sector averages are just that: averages
Many of the companies included in the sector may not be a good match to the
type of business being compared
Some companies go for high mark-ups, but usually lower inventory turnover,
whereas others go for selling more with lower margins
5. Possible deliberate manipulation (creative accounting)
6. Different managerial policies
e.g. different companies offer customers different payment terms
Compare ratios with
1. Industry averages
2. Other businesses in the same business
3. With prior year information
291
Other relevant information
When buying a company
• Audited financial statements
• Forward looking information
Eg. Profit and financial position forecasts
Capital expenditure budgets and
Cash budgets and
Order levels
• Current (fair) values of assets being acquired
• Level of business risk
Highly profitable companies may also be highly risky, whereas a less profitable
company may have more stable ‘quality’ earnings
• Expected price to acquire a company
It may be that a poorer performing business may be a more
attractive purchase because it has higher potential for growth
292

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F2 Course notes

Syllabus A: SOURCES OF LONG-TERM FINANCE .................2

In fact, the amount of ordinary dividends fluctuates from year to year.

Ordinary shareholders are sometimes referred to as equity shareholders

Rights of Ordinary shareholders:

1. Shareholders can attend company general meetings.

2. They can vote on company matters such as:

- the appointment or re-election of directors

- the appointment of auditors

3. Ordinary shareholders are the eﬀective owners of a company.

4. They are entitled to receive dividends

5. They will receive the annual report and accounts

• is raised through the sale of ordinary shares to investors.

bottom of the creditor hierarchy in a liquidation.

1. Carry the right to a final dividend

e.g. a 5% $1 preference share carries a right to an annual dividend of 5c.

2. Have priority over ordinary dividends

The managers of a company are obliged to pay preference dividend first.

Also, preference shareholders have priority over ordinary shareholders to a

3. If the preference shares are cumulative

4. Do not carry a right to vote

5. Should be classified as liabilities

Preference shares may be either redeemable or irredeemable

Redeemable preference shares

Irredeemable preference shares

2. Bank loans and bonds/debentures

Bonds securities which can be traded in the capital markets.

Bond holders are lenders of debt finance.

Bond holders will be paid a fixed return known as the coupon.

The return to shareholders in the form of dividends depends on the dividend

This is provided to early/start up companies with high-potential.

Rights For existing shareholders

Fixed price to institutional

Public Underwritten & advertised Expensive - good for large issue

• A 1 for 2 at $4 (MV $6) right issue means….

Calculation of TERP (Theoretical ex- rights price)

• Calculation of TERP (Theoretical ex- rights price)

The current shareholders will, after the rights issue, hold:

Eg Using the above illustration

Eﬀect on shareholders wealth

• There is no eﬀect on shareholders wealth after a rights issue.

1. Initial public oﬀer (IPO)

Also expansion brings uncertainty in any case

Instead, the shares are bought by a small number of investors, usually

This means low cost - so good for small issues

Placings are likely to be quick.

This means they are expensive - so good for large issue

Gearing and financial risk

Target capital structure

• The aim is to minimise weighted average cost of capital (WACC).

• Debt will usually need to be secured on assets by either:

a fixed charge (on specific assets) or

a floating charge (on a specified class of assets).

• If buoyant economic conditions and increasing profitability expected in the

Less or more risk?

A stock market (also known as a stock exchange) has two main

2. to provide a venue for the buying and selling of shares

This liquidity is an attractive feature of investing in stocks, compared to other less

This eliminates the risk to an individual buyer or seller.

The Alternative Investment Market is regulated by the London Stock Exchange.

Securities are tradable financial instruments.

ln the UK the principal capital markets are: