(a) Evolve is a real estate company, which is listed on the stock exchange and has a year end of 31 August.
On 21 August 2016, Evolve undertook a scrip (bonus) issue where the shareholders of Evolve received certain rights. The shareholders are able to choose between:
(i) receiving newly issued shares of Evolve, which could be traded on 30 September 2016; or
(ii) transferring their rights back to Evolve by 10 September 2016 for a fixed cash price which would be paid on 20 September 2016.
In the financial statements at 31 August 2016, Evolve believed that the criteria for the recognition of a financial liability as regards the second option were not met at 31 August 2016 because it was impossible to reliably determine the full amount to be paid, until 10 September 2016. Evolve felt that the transferring of the rights back to Evolve was a put option on its own equity, which would lead to recording changes in fair value in profit or loss in the next financial year. Evolve disclosed the transaction as a non-adjusting event after the reporting period. (8 marks)
(b) At 31 August 2016, Evolve controlled a wholly owned subsidiary, Resource, whose only assets were land and buildings, which were all measured in accordance with International Financial Reporting Standards. On 1 August 2016, Evolve published a statement stating that a binding offer for the sale of Resource had been made and accepted and, at that date, the sale was expected to be completed by 31 August 2016. The non-current assets of Resource were measured at the lower of their carrying amount or fair value less costs to sell at 31 August 2016, based on the selling price in the binding offer. This measurement was in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations. However, Evolve did not classify the non-current assets of Resource as held for sale in the financial statements at 31 August 2016 because there were uncertainties regarding the negotiations with the buyer and a risk that the agreement would not be finalised. There was no disclosure of these uncertainties and the original agreement was finalised on 20 September 2016. (9 marks)
(c) Evolve operates in a jurisdiction with a specific tax regime for listed real estate companies. Upon adoption of this tax regime, the entity has to pay a single tax payment based on the unrealised gains of its investment properties. Evolve purchased Monk whose only asset was an investment property for $10 million. The purchase price of Monk was below the market value of the investment property, which was $14 million, and Evolve chose to account for the investment property under the cost model. However, Evolve considered that the transaction constituted a ‘bargain purchase’ under IFRS 3 Business Combinations. As a result, Evolve accounted for the potential gain of $4 million in profit or loss and increased the ‘cost’ of the investment property to $14 million. At the same time, Evolve opted for the specific tax regime for the newly acquired investment property and agreed to pay the corresponding tax of $1 million. Evolve considered that the tax payment qualifies as an expenditure necessary to bring the property to the condition necessary for its operations, and therefore was directly attributable to the acquisition of the property. Hence, the tax payment was capitalised and the value of the investment property was stated at $15 million. (6 marks)
Required:
Advise Evolve on how the above transactions should be correctly dealt with in its financial statements with reference to relevant International Financial Reporting Standards.
Note: The mark allocation is shown against each of the three issues above.
Professional marks will be awarded in question 3 for clarity and quality of presentation. (2 marks)
(a) A financial liability for the present value of the maximum amount payable to shareholders should be recognised in the financial statements as of 31 August 2016. At 31 August 2016, the rights are equivalent to a written put option because they represent for Evolve a purchase obligation which gives shareholders the right to sell the entity’s own equity instruments for a fixed price. The fundamental principle of IAS 32 Financial Instruments: Presentation is that a financial instrument should be classified as either a financial liability or an equity instrument according to the substance of the contract, not its legal form, and the definitions of financial liability and equity instrument. IAS 32 states that a contract which contains an entity’s obligation to purchase its own equity instruments gives rise to a financial liability, which should be recognised at the present value of its redemption amount. IAS 32 also states that a contractual obligation for an entity to purchase its own equity instruments gives rise to a financial liability for the present value of the redemption amount even if the obligation is conditional on the counterparty exercising a right to redeem, as is the case with the scrip issue of Evolve.
Evolve had set up the conditions for the share capital increase in August 2016 and, therefore, the contract gave rise to financial liabilities from that date and Evolve should have recognised a financial liability for the present value of the maximum amount payable to shareholders in its financial statements for the year ended 31 August 2016. A non-adjusting event under IAS 10 Events after the Reporting Period is an event after the reporting period which is indicative of a condition which arose after the end of the reporting period. However, it could be argued that the transferring of the free allocation rights back to Evolve is in fact an adjusting event as it is an event after the reporting period which provides further evidence of conditions which existed at the end of the reporting period.
(b) The non-current assets of Resource should have been presented as held for sale in the financial statements, in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations, as at 31 August 2016. IFRS 5 states that the appropriate level of management must be committed to a plan to sell the asset for the sale to be probable. Evolve’s acceptance of a binding offer in August 2016 and the publication of this information indicated a high probability of sale. Despite the uncertainties surrounding the sale, the transaction remained highly probable at 31 August 2016. IFRS 5 requires an entity to classify a non-current asset as held for sale if its carrying amount will be recovered principally through sale rather than through continuing use.
IFRS 5 does not require the existence of a binding sales agreement in order to classify a non-current asset as held for sale but only a high probability of its occurrence. The acceptance of an offer by Evolve indicates that the transaction met the criteria to be classified as held for sale at 31 August 2016. The finalisation of the agreement on 20 September 2016 only confirmed the situation existing at 31 August 2016. Further, Evolve cannot apply IFRS 5 measurement criteria without classifying the item as held for sale in its statement of financial position particularly as a profit or impairment may arise when using such criteria. IFRS 5 also states that immediately before the initial classification of the asset as held for sale, the carrying amount of the asset should be measured in accordance with applicable IFRSs. This was already the case as regards the non-current assets of Resource.
Other criteria which indicate that the non-current assets should be shown as held for sale include the fact that a buyer for the non-current assets has been found, the sale occurred within 12 months of classification as held for sale, the asset was actively marketed for sale at a sales price which has been accepted, and despite the uncertainties at 31 August 2016, events after the reporting period indicate that the contract was not significantly changed or withdrawn. The fact that the information regarding the uncertainties was not publicly disclosed is irrelevant.
Thus as the non-current assets met the criteria to be classified as held for sale, they should have been measured and presented as such in the financial statements. Assets classified as held for sale must be presented separately on the face of the statement of financial position.
(c) IFRS 3 Business Combinations must be applied when accounting for business combinations, but does not apply where the acquisition is not of a business. In this case, the acquisition was essentially that of an asset and therefore the measurement requirements of IFRS 3 would not apply.
IAS 40 Investment Property states that the cost of an investment property comprises its purchase price and any directly attributable expenditure, such as professional fees for legal services. IAS 16 Property, Plant and Equipment states that the cost of an item of PPE comprises any cost directly attributable to bringing the asset to the condition necessary for it to be capable of operating in the manner intended by management. Hence if Evolve wishes to use the cost basis for accounting for the investment property, the potential gain should not have been recorded in profit or loss or added to the cost of the asset.
Evolve should have recognised the tax payment as an expense in the statement of profit or loss and other comprehensive income. Administrative and other general overhead costs are not costs of an item of PPE according to IAS 16. The specific fiscal treatment and the tax to be paid were not linked to bringing the asset to the condition necessary for its operations, as the asset would have been operational without the tax. As such, the tax is a cost linked to the activity of Evolve and should be accounted for as an expense in accordance with IAS 12 Income Taxes and included in the profit or loss for the period, unless that tax arises from a transaction recognised outside profit or loss.