Section A – THIS ONE question is compulsory and MUST be attempted
The following draft financial statements relate to Zippy, a public limited company. Zippy is a manufacturing company but also has a wide portfolio of investment properties. Zippy has investments in Ginny and Boo, both public limited companies.
Draft statements of profit or loss and other comprehensive income for the year ended 30 June 2016
The following information is relevant to the preparation of the group statement of profit or loss and other comprehensive income:
1. On 1 July 2014, Zippy acquired 60% of the equity interests of Ginny, a public limited company. The purchase consideration comprised cash of $90 million and the fair value of the identifiable net assets acquired was $114 million at that date. Zippy uses the ‘full goodwill’ method for all acquisitions and the fair value of the non-controlling interest (NCI) in Ginny was $50 million on 1 July 2014. Goodwill had been reviewed annually for impairment and no impairment was deemed necessary.
2. Zippy disposed of a 20% equity interest in Ginny on 31 March 2016 for a cash consideration of $44 million. The remaining 40% holding had a fair value of $62 million and Zippy exercised significant influence over Ginny following the disposal. Zippy accounts for investments in subsidiaries at cost and has included a gain in investment income of $14 million within its individual financial statements to reflect the disposal. The net assets of Ginny had a fair value of $118 million at 1 July 2015 and this was reflected in the carrying amounts of the net assets. All gains and losses of Ginny have accrued evenly throughout the year. The disposal is not classified as a separate major line of business or geographical operation.
3. Zippy acquired 80% of the equity interests of Boo, a public limited company, on 30 June 2014. The purchase consideration was cash of $60 million. The fair value of the NCI was calculated as $12 million at this date. Due to a tight reporting deadline, the fair value of the identifiable net assets at acquisition had not been finalised by the time the financial statements for the year ended 30 June 2014 were published. Goodwill of $28 million was calculated using the carrying amount of the net assets of Boo. The fair value of the identifiable net assets of Boo was finalised on 31 December 2014 as $54 million. The excess of the fair value of the identifiable net assets at acquisition is due to plant which had a remaining useful life of five years at the acquisition date.
Due to the losses of Boo, an impairment review was undertaken at 30 June 2016. It was decided that goodwill had reduced in value by 10%. Goodwill impairments are charged to other expenses.
4. Zippy holds properties for investment purposes. At 1 July 2015, Zippy held a 10-floor office block at a fair value of $90 million with a remaining useful life of 15 years. The first floor was occupied by Zippy’s staff and the second floor was let to Boo free of charge. The other eight floors were all let to unconnected third parties at a normal commercial rent. It was estimated that the fair value of the office block was $96 million at 30 June 2016. Zippy has a policy of restating all land and buildings to fair value at each reporting date. The only accounting entries for the year ended 30 June 2016 in relation to this office block have been to correctly include the rental income in profit or loss. It can be assumed that each floor is of equal size and value. Depreciation is charged to administrative costs.
5. During April 2016, an explosion at a different office block caused substantial damage and it was estimated that the fair value fell from $20 million at 30 June 2015 to $14 million at 30 June 2016. Zippy has estimated that costs of $3 million would be required to repair the block but is unsure whether to carry out the repairs or whether to sell the block for a reduced price. The property has been left in the financial statements at a value of $20 million. A provision of $3 million for the repair costs was charged to other expenses.
6. The following information relates to Zippy’s defined benefit pension scheme:
Prepare the consolidated statement of comprehensive income for the Zippy Group for the year ended 30 June 2016.
Zippy
Consolidated statement of profit or loss and other comprehensive income for the year ended 30 June 2016
Working 1
Working 2 Goodwill – Ginny
Working 3 Ginny – disposal
The disposal of 20% will leave Zippy with only a 40% interest and control is lost. The individual profit on disposal will be replaced with the group profit or loss on disposal. Thus $14m is removed from investment income. Only 9/12 of Ginny’s profits and other comprehensive income will be consolidated.
Tutorial note: The $14m gain as stated in the question would have been calculated as: ($44m – (20/60 of $90m))
Ginny’s profit and other comprehensive income for the nine months to 31 March 2016 is therefore:
Non-controlling interest at disposal
Working 4 Ginny – associate
As Zippy only owns 40% of the equity of Ginny following disposal, Ginny will be equity accounted for the remaining three months of the year:
Working 5 Boo
Goodwill was initially calculated as $28m. This means that the carrying value of the net assets at acquisition must have been:
The fair value of the net assets was finalised as $54m, so there is a fair value adjustment to plant of ($54m – $44m) $10m. Additional depreciation should be charged to cost of sales of ($10m/5) $2m (W1). Note the fair values were finalised within the initial accounting period (a maximum of 12 months from acquisition) so the adjustment is treated retrospectively. Goodwill will be adjusted to ($28m – $10m) $18m. Goodwill has been impaired by 10% so ($18m x 10%) $1·8m to be charged to other expenses (W1).
Working 6 Zippy investment properties
The first two floors of Zippy’s office block should be classified as property, plant and equipment in the consolidated accounts. Owner occupied property cannot be classified as investment property. The second floor is let to Boo, a subsidiary, and is therefore owner occupied from a consolidated accounts perspective. Depreciation should therefore be charged to administrative costs of $1·2 million (($90m x 0·2)/15). A revaluation gain should be recorded within other comprehensive income of $2·4 million (($96m x 0·2) – (($90m x 0·2)) – $1·2m)). The fair value gain relating to the remaining eight floors should be recorded in profit or loss as this would be classified as investment property. A fair value gain to be included in investment income of $4·8 million (($96m x 0·8) – ($90m x 0·8)) arises.
Working 7 Investment property impairment
Investment properties under the fair value model are restated to fair value with the gains and losses recorded in profit or loss. A ($20m – $14m) $6m loss should therefore be charged to investment income (W1). The provision of $3m should be reversed as there is no obligating event to carry out the repairs (W1).
Working 8 Pension scheme
The service cost component of $10m should be expensed to either administrative expenses or other expenses (W1).
The contributions into the scheme should be ignored as they are correctly added to the pension scheme’s assets.
A finance charge should be calculated using the discount rate at 1 July 2015. A charge of (10% x $14m) $1·4m should be included in net finance costs (W1).
The remeasurement gain of $4m should be included within other comprehensive income – items that will not be reclassified to profit or loss (W1).
Working 9 Revenue
The $40 credit per unit is a revision to the transaction price for the first 6,000 units sold. Therefore there should be a reduction in revenue equal to ($40 x 6,000) $0·24m for the first 6,000 units sold. The negotiated price of $950 per unit is dependent on the purchase of the initial 10,000 units. Therefore it does not meet the conditions to be accounted for as a separate contract. Instead it is treated as a cancellation of the old contract together with the creation of a new contract. The revenue attributable to the further 7,000 units manufactured will therefore be calculated using a weighted average price of ((4,000 x $1,000) + (5,000 x $950)/(4,000 + 5,000)) $972 per item. The revenue to be included for these 7,000 units is ($972 x 7,000) $6·8m.
No revenue can yet be included for the 2,000 units which have not been manufactured as at 30 June 2016 as Zippy has not satisfied its performance obligation. The net increase to the revenue of Zippy should be ($6·8m – $0·24m) $6·6 million (W1).
Working 10 Non-controlling interest
The directors of Zippy have heard that under alternative accounting practices actuarial gains and losses (the remeasurement component) can be immediately recognised in profit or loss or deferred using an applicable systematic method. Additionally, past service cost can be recognised initially in other comprehensive income and then recycled to profit or loss. The directors are unsure as to the differences between other comprehensive income and profit or loss and the rationale as to why some gains can be and others cannot be recycled.
Required:
With reference to pension schemes, discuss the differences between other comprehensive income and profit or loss and the rationale as to why some gains and losses can be and others cannot be recycled to profit or loss. Include in your answer a brief discussion of the benefits of immediate recognition of the remeasurement component under IAS 19 Employee Benefits.
Profit or loss includes all items of income and expense (including reclassification adjustments) except those items of income and expense which are recognised in other comprehensive income (OCI) as required or permitted by IFRS. However, there is a general lack of agreement about which items should be presented in profit or loss and in OCI. Currently under IFRS there is a rules – based approach, leaving it to each individual standard to define where each gain or loss should be presented. For example, with pension schemes the service cost component, including past service cost, must be immediately recognised in profit or loss whereas the remeasurement component is recognised as other comprehensive income, an item not to be reclassified to the profit or loss. With no clear guiding principles of where gains and losses are reported, it is felt that anything controversial has been dumped into OCI. This would enable key ratios such as price/earnings to be free from distortion from less reliable gains and losses included within OCI.
There are several arguments for and against reclassification of gains and losses. If reclassification ceased, there would be no need to define profit or loss and presentation decisions could be left to each individual IFRS. It is argued that reclassification protects the integrity of profit or loss and provides users with relevant information. Errors within actuarial assumptions about life expectancy, wage inflation, service lives as well as differences between actual and expected returns are all included within the remeasurement component. It can be argued that there is no correlation between such items and the underlying performance of an entity. It could therefore be justified to classify the remeasurement component as an item which must not be recycled to profit or loss.
Arguments against recycling include that it adds unnecessary complexity to financial reporting and could lead to earnings management. Recycling could be easily misunderstood as essentially the same gain gets reported twice, once within equity and once within profit or loss. Additionally it is likely that there will be a mismatch on recycling as the gains or losses may be reported in a different period to when the underlying change in value of the asset or liability took place. The IASB is proposing that profit or loss should provide the primary source of information on the return of the entity. Other comprehensive income should be used only if it makes profit or loss more meaningful for the users.
Actuarial gains and losses can vary significantly from one year to the next. The immediate recognition may create volatility within the statement of financial position and other comprehensive income. It is, however, important that users are fully aware as to the extent of an entity’s pension scheme obligations. This may not be evident if there is a deferral of the remeasurement component. It will not be possible to smooth gains and losses over the working lives of employees. It can be argued therefore that the immediate recognition leads to greater transparency of the financial statements.
On 1 July 2016, there was an amendment to Zippy’s defined benefit scheme whereby the promised pension entitlement was increased from 10% of final salary to 15%. A bonus is paid to the directors each year which is based upon the operating profit margin of Zippy. The directors of Zippy are unhappy that there is inconsistency on the presentation of gains and losses in relation to defined benefit schemes. Additionally, they believe that as the pension scheme is not an integral part of the operating activities of Zippy, it is misleading to include the gains and losses in profit or loss. They therefore propose to change their accounting policy so that all gains and losses on the pension scheme are recognised in other comprehensive income. They believe that this will make the financial statements more consistent, more understandable and can be justified on the grounds of fair presentation.
Required:
Discuss the accounting and ethical implications arising from the proposed change of accounting policy on Zippy’s defined benefit scheme.
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors only permits a change in accounting policy if the change is: (a) required by an IFRS or (b) results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity’s financial position, financial performance or cash flows. A retrospective adjustment is required unless the change arises from a new accounting policy with transitional arrangements to account for the change. It is possible to depart from the requirements of IFRS but only in the extremely rare circumstances where compliance would be so misleading that it would conflict with the overall objectives of the financial statements. Practically this override is rarely, if ever, invoked.
IAS 19 Employee Benefits requires all gains and losses on a defined benefit scheme to be recognised in profit or loss except for the remeasurement component which must be recognised in other comprehensive income. The directors’ proposals cannot be justified on the grounds of fair presentation. The directors have an ethical responsibility to produce financial statements which are a true representation of the entity’s performance and comply with all accounting standards.
There is a clear self-interest threat arising from the bonus scheme. The directors’ change in policy appears to be motivated by an intention to overstate operating profit to maximise their bonus potential. The amendment to the pension scheme is a past service cost. This is likely to be fairly substantial and must be expensed to profit or loss. This would therefore be detrimental to the operating profits of Zippy and depress any potential bonus. Additionally, it appears that the directors wish to manipulate other aspects of the pension scheme such as the current service cost and, since the scheme is in deficit, the net finance cost. The directors are deliberately manipulating the presentation of these items by recording them in equity rather than in profit or loss. Such treatment is against the ACCA ethical principles of objectivity, integrity and professional behaviour. The directors should be reminded of their ethical responsibilities and must be dissuaded from implementing the proposed change in policy