Financial Reporting - Accounting solutions - Financial statement


Entity A is a manufacturing entity that also carries out research and development into new products. A's management is designing its first IFRS financial statements and is considering how certain items should be presented in the income statement and the balance sheet.

A's management has decided to present the income statement using the functional analysis (cost of sales) model permitted by

IAS 1, Presentation of Financial Statements. It is therefore considering how to present:

•    depreciation expense from property, plant and equipment (PPE);

•    research costs, development costs that are expensed as incurred because the

IAS 38, Intangible Assets, capitalisation criteria are not met and amortisation expense relating to capitalised development costs;

•    inventory impairment costs; and

•    other impairment charges.

Entity A should classify the costs as cost of sales, selling and administration costs or other operating costs according to how they can be identified with those functions. It should not disclose the costs as a separate line, for example, 'Depreciation expense' as this is an analysis by nature rather than an analysis by function as chosen by management. A's management will need to exercise judgment in making the classification:

•    PPE depreciation expense. Management should identify which items of PPE are attributable to manufacturing the goods. This will include the depreciation of buildings and equipment used in the manufacturing process.

Management should classify this depreciation as cost of sales. Depreciation expense of other assets should be similarly classified according to the functions of expense presented in the income statement, for example sales expense, administrative expense, other operating expense.

•    Research and development expenses. The amortisation cost from development assets should be included in cost of sales if the development asset is used in the manufacturing process. However, research costs do not, by definition, relate to a specific product or service and should not be classified as cost of sales. Development costs that do not meet the capitalisation criteria in

IAS 38 should be classified in the same way as research costs.

•    Inventory impairment costs. Inventory impairment costs should be included in cost of sales.

IAS 2.38 explains that cost of sales includes, amongst other things, unallocated production overheads and abnormal amounts of production costs of inventories. Entity A's gross margin will therefore reflect the costs of production that cannot be recovered from sales.

•    Other impairment costs. Impairment charges of assets other than inventory should be classified in the same function as the depreciation or amortisation relating to that asset.

Classification of income from equity loan to associate

Entity B has a 30% interest in an associate, entity C, and appoints a director to C's board. B's investment in C comprises 30% interest in the ordinary share capital of C and a loan of 2m to C. The loan has no specified repayment date and B's management do not expect repayment in the foreseeable future. Accordingly, B's management considers the loan to be part of B's equity investment in C in accordance with

IAS 28.29.

The loan is interest bearing at the rate of 6% per year. Management is assessing whether the interest income receivable on the loan should be classified in B's income statement as interest income or as part of the share of profit or loss of associates accounted for using the equity method.

B's management should classify the interest income receivable from the loan to entity C as part of finance income. It should not be classified as part of B's share of the profit or loss of associates. However, the amount that B recognises as its share of C's profit or loss under equity accounting will include a deduction for the interest expense recorded by C in respect of the loan from B. There should be no netting or offsetting of these amounts in B's income statement.

Definition of a business combination

Entity D has purchased the shares of entity E. E has one asset, a building, and a loan that was used by E to purchase the building. D will use the building as additional head office space for its existing business. That is, the building will be an owner-occupied property. The tax base of the building for E does not change as a result of the purchase of E by D.

There is no temporary difference between the tax base and the accounting base of the building in E's financial statements.

D's management is trying to determine how it should account for the acquisition of E, in particular whether this represents a business combination that should be accounted for according to

IFRS 3, Business Combinations.

The purchase of E does not represent a business combination. A business combination is defined as the bringing together of separate entities or businesses into one reporting entity (IFRS3.4). An acquired entity must constitute a business rather than just an asset or group of assets and related liabilities.

D's use of the building as PPE means that the purchase of E does not represent a business combination. The fair value of the consideration paid by D should be allocated to the building and the loan in proportion to the fair values of the building and the loan. These allocated amounts will be the cost of the building and the loan for the purposes of D's consolidated financial statements. D will subsequently measure the building at cost less accumulated depreciation and impairment and the loan at amortised cost.

However, D will not recognise deferred tax in respect of the difference between the book value of the building in E's financial statements and the book value in D's consolidated statements. The difference between these two amounts is covered by the initial recognition exemption in

IAS 12.15(c).

IFRS requirements for AIM-listed companies

F plc is an AIM-listed company. Given that AIM has announced that F plc will not be required to apply IFRS in 2005 or 2006 (but is likely to be for the year beginning 1 January 2007), must F plc apply

FRS 20 (IFRS 2), Share-based Payment, for its financial year ending 31 December 2005?

F plc is permitted (but not required) to continue to apply UK GAAP for its financial year ending 31 December 2005. Adoption of

FRS 20 is mandatory for listed entities for years beginning on or after 1 January 2005 and for unlisted entities for years beginning on or after 1 January 2006, although early adoption is encouraged.

A listed entity is defined by

FRS 20 as one whose securities are admitted to trading on a regulated market of any European Union member state. Following AIM's change in status, so that it is no longer a 'regulated market', F plc meets the definition of unlisted and is not required to apply FRS 20 in its accounts for the year ending 31 December 2005.

What is 'cost' under IAS 27?

In 2002, G plc, a 95% subsidiary of J plc, acquired a fellow wholly-owned subsidiary, H Ltd, from J plc.

The consideration paid by G Ltd was in the form of share capital.

Before the transaction, the books of J plc (entity) showed an investment in H Ltd with a cost of £200. At the date of the transaction, the fair value of J plc's investment in H Ltd (and the shares issued by G plc) was £500. The shares issued by G plc to J plc had a nominal value of £10.

G plc took advantage of merger relief, under s131 of the Companies Act 1985, and, as permitted by s133 of the Act, recorded the transaction at the nominal value of the shares issued, so its double entry on the acquisition of H Ltd was:

Dr Investment in H Ltd: £10

Cr Share capital: £10

G plc has listed debt and is required to prepare its group accounts in accordance with IFRS from 2005. It also decides to prepare its individual company accounts in accordance with IFRS.

If the transaction had occurred in 2005, would G plc, in its individual accounts, have been able to record this transaction at nominal value?

IAS 27, Consolidated and Separate Financial Statements, requires that an entity's investment in a subsidiary must be recorded either at cost or in accordance with IAS 39, Financial Instruments: Recognition and Measurement.

Whichever option G plc applies as its accounting policy for all its investments in subsidiaries, on initial recognition its investment in the subsidiary must be recorded at its cost. This is defined in the IASB's Framework as 'the fair value of the consideration paid'. That is, £500.

Although s131 merger relief still applies to the share issue (so any premium on the share issue that is recorded is taken to 'other reserves' and not to the share premium account), G plc will be unable to take advantage of the permission in s133 to record the transaction at nominal value since

IAS 27 requires it to be recorded at fair value.

The difference between G plc's initial carrying amount of its investment in H Ltd (£500) and the sum of the nominal value of the shares (£10) should be recorded as part of equity, but not in the share premium account.

So, on acquisition by G plc of H Ltd, the entries required applying

IAS 27 and the Companies Act 1985 are:

Dr Investment in H Ltd: £500

Cr Share capital: £10

Cr Other reserves: £490

On first-time adoption, can the transaction in 2002 be left as it was recorded under UK GAAP or does it need to be recorded differently?

The acquisition of an investment in a subsidiary by an entity does not fall within the scope of any of the exemptions or exceptions contained in

IFRS 1 and as such, G plc is required to restate its investment in H Ltd to the fair value of the consideration given (that is, the fair value of the investment acquired) at the date of the acquisition on first-time adoption.

This month's Accounting Solutions was compiled by Michael Stewart of PricewaterhouseCoopers' Global Corporate Reporting Group, and Peter Holgate and Angela Courtney of the firm's UK Accounting Technical Department.

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