(a) Measurement of goodwill on acquisition
The goodwill arising on the acquisition of Teapot Co is material to the Group financial statements, representing 6% of total assets.
The goodwill should be recognised as an intangible asset and measured according to IAS 38 Intangible Assets and IFRS 3 Business Combinations. The purchase consideration should reflect the fair value of total consideration paid and payable, and there is a risk that the amount shown in the calculation is not complete, for example, if any deferred or contingent consideration has not been included.
The non-controlling interest has been measured at fair value. This is permitted by IFRS 3, and the decision to measure at fair value can be made on an investment by investment basis. The important issue is the basis for measurement of fair value. If Teapot Co is a listed company, then the market value of its shares at the date of acquisition can be used and this is a reliable measurement. If Teapot Co is not listed, then management should have used estimation techniques according to the fair value hierarchy of inputs contained in IFRS 13 Fair Value Measurement. This would introduce subjectivity into the measurement of non-controlling interest and goodwill and the method of determining fair value must be clearly understood by the auditor.
The net assets acquired should be all identifiable assets and liabilities at the date of acquisition. For such a significant acquisition some form of due diligence investigation should have been performed, and one of the objectives of this would be to determine the existence of assets and liabilities, even those not recognised in Teapot Co’s individual financial statements. There is a risk that not all acquired assets and liabilities have been identified, or that they have not been appropriately measured at fair value, which would lead to over or understatement of goodwill and incomplete recording of assets and liabilities in the consolidated financial statements.
The fair value adjustment of $300,000 made in relation to Teapot Co’s property is not material to the Group accounts, representing less than 1% of total assets. However, the auditor should confirm that additional depreciation is being charged at Group level in respect of the fair value uplift. Though the value of the depreciation would not be material to the consolidated financial statements, for completeness and accuracy the adjustment should be made.
The auditor should also consider if any further adjustments need to be made to Teapot Co’s net assets to ensure that Group accounting policies have been applied. IFRS 3 requires consistency in accounting policies across Group members, so if the necessary adjustments have not been made, the assets and liabilities will be over or understated on consolidation.
Impairment
IAS 38 requires that goodwill is tested annually for impairment regardless of whether indicators of potential impairment exist. The goodwill in relation to Teapot Co is recognised at the same amount at the year end as it was at acquisition, indicating that no impairment has been recognised. It could be that management has performed an impairment review and has concluded that there is no impairment, or that no impairment review has been performed at all.
However, Group profit has declined by 30·3% over the year, which in itself is an indicator of potential impairment of the Group’s assets, so it is unlikely that no impairment exists unless the fall in revenue relates to parts of the Group’s activities which are unrelated to Teapot Co. There is a risk that Group assets are overstated and profit overstated if any necessary impairment has not been recognised.
Loan
The loan is material, representing 13·3% of the Group’s total assets.
The loan taken out to finance the acquisition should be accounted for under IFRS 9 Financial Instruments. It should be initially measured at fair value, and classified according to whether it is subsequently measured at amortised cost or at fair value. As the loan is not held for trading, it should be measured at amortised cost unless Group management decides to use the fair value option.
Assuming subsequent measurement is based on amortised cost, an effective interest rate should be calculated to allocate the premium to be paid on maturity over the 20-year life of the loan, meaning that the annual finance charge will be more than just the actual interest paid. There is a risk that the finance charge does not include an element relating to the premium, in which case both the finance charge and the liability are understated.
Tutorial note: It is not necessary for candidates to calculate the effective interest on the loan or the correct value of the finance charge for the year.
IFRS 7 Financial Instruments: Disclosure contains extensive disclosure requirements, for example, information on the significance of financial instruments and on the nature and extent of associated risks. There is a risk of incomplete disclosure in relation to the loan taken out.
Evidence:
– Agreement of the purchase consideration to the legal documentation pertaining to the acquisition, and a review of the documents to ensure that the figures included in the goodwill calculation are complete.
– Agreement of the $75 million to the bank statement and cash book of the acquiring company (presumably the parent company of the Group).
– Review of board minutes for discussions relating to the acquisition, and for the relevant minute of board approval.
– A review of the purchase documentation and a register of significant shareholders of Teapot Co to confirm the 20% non-controlling interest.
– If Teapot Co’s shares are not listed, a discussion with management as to how the fair value of the non-controlling interest has been determined and evaluation of the appropriateness of the method used.
– If Teapot Co’s shares are listed, confirmation that the fair value of the non-controlling interest has been calculated based on an externally available share price at the date of acquisition.
– A copy of any due diligence report relevant to the acquisition, reviewed for confirmation of acquired assets and liabilities and their fair values.
– An evaluation of the methods used to determine the fair value of acquired assets, including the property, and liabilities to confirm compliance with IFRS 3 and IFRS 13.
– Review of depreciation calculations, and recalculation, to confirm that additional depreciation is being charged on the fair value uplift.
– A review of the calculation of net assets acquired to confirm that Group accounting policies have been applied.
– Discussion with management regarding the potential impairment of Group assets and confirmation as to whether an impairment review has been performed.
– A copy of any impairment review performed by management, with scrutiny of the assumptions used, and re-performance of calculations.
– Re-performance of management’s calculation of the finance charge in relation to the loan, to ensure that the loan premium has been correctly accrued.
– Agreement of the loan receipt and interest payment to bank statement and cash book.
– Review of board minutes for approval of the loan to be taken out.
– A copy of the loan agreement, reviewed to confirm terms including the maturity date, premium to be paid on maturity and annual interest payments.
– A copy of the note to the financial statements which discusses the loan to ensure all requirements of IFRSs 7 and 13 have been met.
(b) Property complex
The carrying value of the property complex is material to the Group financial statements, representing 3·6% of total assets.
The natural disaster is a subsequent event, and its accounting treatment should be in accordance with IAS 10 Events after the Reporting Period. IAS 10 distinguishes between adjusting and non-adjusting events, the classification being dependent on whether the event provides additional information about conditions already existing at the year end. The natural disaster is a non-adjusting event as it indicates a condition which arose after the year end.
Disclosure is necessary in a note to the financial statements to describe the impact of the natural disaster, and quantify the effect which it will have on next year’s financial statements.
The demolition of the property complex should be explained in the note to the financial statements and reference made to the monetary amounts involved. Consideration should be made of any other costs which will be incurred, e.g. if there is inventory to be written off, and the costs of the demolition itself.
The contingent asset of $18 million should not have been recognised. Even if the amount were virtually certain to be received, the fact that it relates to the non-adjusting event after the reporting period means that it cannot be recognised as an asset and deferred income at the year end.
The financial statements should be adjusted to remove the contingent asset and the deferred income. The amount is material at 4% of total assets. There would be no profit impact of this adjustment as the $18 million has not been recognised in the statement of profit or loss.
Evidence:
– A copy of any press release made by the Group after the natural disaster, and relevant media reports of the natural disaster, in particular focusing on its impact on the property complex.
– Photographic evidence of the site after the natural disaster, and of the demolished site.
– A copy of the note to the financial statements describing the event, reviewed for completeness and accuracy.
– A schedule of the costs of the demolition, with a sample agreed to supporting documentation, e.g. invoices for work performed and confirmation that this is included in the costs described in the note to the financial statements.
– A schedule showing the value of inventories and items such as fixtures and fittings at the time of the disaster, and confirmation that this is included in the costs described in the note to the financial statements
– A copy of the insurance claim and correspondence with the Group’s insurers to confirm that the property is insured.
– Confirmation that an adjustment has been made to reverse out the contingent asset and deferred income which has been recognised.
(c) Intercompany trading
The intercompany receivables and payables represent 4·4% of Group assets and are material to the consolidated statement of financial position. The inventory is also material, at 11% of Group assets.
On consolidation, the intercompany receivables and payables balances should be eliminated, leaving only balances between the Group and external parties recognised at Group level. There is a risk that during the consolidation process the elimination has not happened, overstating Group assets and liabilities by the same amount.
If the intercompany transaction included a profit element, then the inventory needs to be reduced in value by an adjustment for unrealised profit. This means that the profit made by Marks Co on the sale of any inventory still remaining in the Group at the year end is eliminated. If the adjustment has not been made, then inventory and Group profit will be overstated.
Evidence:
– Review of consolidation working papers to confirm that the intercompany balances have been eliminated.
– A copy of the terms of sale between Marks Co and Roberts Co, scrutinised to find out if a profit margin or mark up is part of the sales price.
– A reconciliation of the intercompany balances between Roberts Co and Marks Co to confirm that there are no other reconciling items to be adjusted, e.g. cash in transit or goods in transit.
– Copies of inventory movement reports for the goods sold from Marks Co to Roberts Co, to determine the quantity of goods transferred.
– Details of the inventory count held at Roberts Co at the year end, reviewed to confirm that no other intercompany goods are held at the year end.