Section B – TWO questions ONLY to be attempted
2、(a) Formatt is a listed company with several investments in other entities. The directors currently misunderstand the nature of the control principle within certain International Financial Reporting Standards (IFRSs) and the Conceptual Framework.
During the year ended 30 November 2017, Formatt entered into a joint venture, Font, with another entity, Loft. Font was structured in such a way that all business decisions were taken by the management committee of Formatt and the only decisions which needed the approval of both Formatt and Loft were those which were outside normal operational decisions. Font was financed initially through the issue of bonds whose return was based upon the performance of the joint venture. Formatt purchased the bonds from third parties during the year. As a bondholder, Formatt has the right to appoint the general manager of the joint venture. For the year ended 30 November 2017, Formatt intends to account for Font under IFRS 11 Joint Arrangements.
Formatt also holds 49·1% of Protect’s voting shares and accounts for Protect as an associate. Protect has 20 other shareholders, the largest of which has a shareholding of 20% and the smallest a holding of 1% of the voting shares. The shareholders have an agreement which gives the largest shareholder a right of first refusal if one of them wishes to sell its shareholding in Protect. The management committee of Protect consisted of six members of whom four were representatives of Formatt. There has not been complete shareholder representation at the last four annual general meetings of Protect.
The directors of Formatt wish to know how to account for Font and Protect in the financial statements for the year ended 30 November 2017. (8 marks)
(b) Formatt has entered into a contract with a customer to supply specialised medical equipment. Formatt has developed the equipment in conjunction with the customer but has contracted with a supplier for its manufacture. The supplier delivers the equipment to the customer. Formatt pays the supplier directly and invoices the customer with the agreed selling price which is cost plus 25%. Any equipment defects are the responsibility of Formatt.
The directors of Formatt are unsure as to whether they should account for the whole transaction as a principal or just the profit margin as if an agent. (7 marks)
(c) On 30 November 2017, Formatt loaned $8 million to a third party at an agreed interest rate. At the same time, it sold the third party loan to Window whereby, in exchange for an immediate cash payment of $7 million, Formatt agreed to pay to Window the first $7 million plus interest collected from the third party loan. Formatt retained the right to $1 million plus interest. The 12-month expected credit losses are $300,000 and Formatt has agreed to suffer all credit losses. A receivable of $1m has been recognised in the financial statements at 30 November 2017.
As a result of the agreement with Window, the directors of Formatt are unsure as to whether they should recognise any part of the interest bearing loan of $8 million in the statement of financial position at 30 November 2017. They understand that the Conceptual Framework and the Exposure Draft: Conceptual Framework for Financial Reporting both mention ‘control’ as one of the criteria for recognition of an asset but do not understand the interaction between the Conceptual Framework and IFRS 9 Financial Instruments as regards the recognition of a financial asset. (8 marks)
Required:
Advise the directors of Formatt on how the above elements should be dealt with in its financial statements with reference to relevant IFRSs and, where necessary, pronouncements on the Conceptual Framework.
Note: The mark allocation is shown against each of the three issues above.
Professional marks will be awarded in question 2 for clarity and quality of presentation. (2 marks)
(a) According to IFRS 10 Consolidated Financial Statements, an investor controls an investee when the investor has power over the investee, exposure, or rights, to variable returns from its involvement with the investee and the ability to use its power over the investee to affect the amount of the investor’s return. Formatt makes all of the operational decisions as regards Font and the only decisions which need the approval of both Formatt and Loft are those which are outside normal operational decisions. These are protective rights for Loft and do not prevent Formatt from having power over Font. The concept of returns is quite a broad one and would include a return from the bonds purchased by Formatt in Font. Hence, Formatt has exposure to positive and possibly negative returns as the bondholders’ return is based upon the performance of Font. Formatt is therefore exposed to variable returns from its involvement with Font. Formatt also has the right to appoint the general manager of Font and thus, together with the operational control exercised by Formatt, this power can be used to affect the amount of the investor’s return. Thus, the conditions set out in IFRS 10 appear fulfilled, and it can be concluded that Formatt controls Font. Therefore, Formatt should consolidate Font as a subsidiary in its financial statements as of 30 November 2017.
As Formatt held 49·1% of the shares of Protect, it does not have a majority. The second highest shareholding is one of 20% which can indicate significant influence but this does not prevent Formatt from controlling Protect. Formatt only needs the support or the absence of one of the other shareholders to hold a majority of the voting rights. Formatt has also been able to sustain a majority representation in the management committee, showing that it can dominate the election process. Additionally, there had not been complete representation of the shareholders at the last four annual general meetings which has meant that Formatt could control the voting at such meetings. In the event of a shareholder wishing to sell its shares, Formatt can protect its position if it so wishes by having first refusal on the purchase of such shares. Therefore, Formatt should consolidate Protect as a subsidiary in its financial statements as of 30 November 2017.
(b) IFRS 15 Revenue from Contracts with Customers states that an entity is a principal where the entity controls the promised good before transfer to the customer. However, the entity is an agent where the performance obligation is to arrange provision of the goods by another party. Although Formatt has subcontracted the manufacturing of the equipment to a supplier, the development of the specification, the manufacturing of the equipment, and the overall management of the contract are not distinct because they are not separately identifiable and thus there is a single performance obligation. The customer has contracted with Formatt so that the various elements of the contract are integrated as one obligation.
Therefore, Formatt controls the specialised equipment before the equipment is transferred to the customer and is therefore the principal in this transaction. Formatt is also responsible for any defects. The supplier cannot decide to use the specialised equipment for another purpose as the equipment must be delivered to the customer to fulfil the promise in the contract. Formatt has the responsibility for fulfilling the contract, determines the price of the contract, is not paid on a commission basis and has the credit risk.
(c) The Conceptual Framework defines an asset as a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. The existing Conceptual Framework does not define control. The Exposure Draft: Conceptual Framework for Financial Reporting defines an asset as a present economic resource controlled by the entity as a result of past events. It goes on to say that control links the economic resource to the entity and that assessing control helps to identify what economic resource the entity should account for. For example, if an entity has a proportionate share in a property without controlling the entire property, the entity’s asset is its share in the property, which it controls, not the property itself, which it does not. An entity controls an economic resource if it has the present ability to direct the use of the economic resource and obtain the economic benefits which flow from it. However, risks and rewards can be a helpful factor to consider when determining the transfer of control.
The entity should consider whether the contractual rights to the cash flows from the asset have expired as, if so, the asset should be derecognised. Second, if the contractual rights to the cash flows have not expired, as is the case with Formatt, the entity should consider whether it has transferred the financial asset. When an entity transfers a financial asset, it should evaluate the extent to which it retains the risks and rewards. IFRS 9 Financial Instruments provides three examples of when an entity has transferred substantially all the risks and rewards of ownership. These are an unconditional sale of a financial asset, sale of a financial asset with an option to repurchase the financial asset at its fair value and sale of a financial asset which is deeply ‘out of the money’. Thus in this case, even though most of the cash flows which are derived from the loan are passed on to Window (up to a maximum of $7 million), Formatt is essentially still in ‘control’ of the asset as the risks and rewards have not been transferred because of the subordinated retained interest. Formatt’s residual interest also absorbs the potential credit losses.
If Formatt has neither retained nor transferred substantially all of the risks and rewards of ownership, the assessment of control is important. If control has been retained, the entity would continue to recognise the asset to the extent of its continuing involvement.
However, as Formatt has retained the risks and rewards, it should recognise the financial asset in the statement of financial position and the 12-month expected credit losses.