Section B – TWO questions ONLY to be attempted
2、Canto Co is a company which manufactures industrial machinery and has a year end of 28 February 2017. The directors of Canto require advice on the following issues:
(a) On 1 March 2014, Canto acquired a property for $15 million, which was used as an office building. Canto measured the property on the cost basis in property, plant and equipment. The useful life of the building was estimated at 30 years from 1 March 2014 with no residual value. Depreciation is charged on the straight-line basis over its useful life. At acquisition, the value of the land content of the property was thought to be immaterial.
During the financial year to 28 February 2017, the planning authorities approved the land to build industrial units and retail outlets on the site. During 2017, Canto ceased using the property as an office and converted the property to an industrial unit. Canto also built retail units on the land during the year to 28 February 2017. At 28 February 2017, Canto wishes to transfer the property at fair value to investment property at $20 million. This valuation was based upon other similar properties owned by Canto. However, if the whole site were sold including the retail outlets, it is estimated that the value of the industrial units would be $25 million because of synergies and complementary cash flows.
The directors of Canto wish to know whether the fair valuation of the investment property is in line with International Financial Reporting Standards and how to account for the change in use of the property in the financial statements at 28 February 2017. (8 marks)
(b) On 28 February 2017, Canto acquired all of the share capital of Binlory, a company which manufactures and supplies industrial vehicles. At the acquisition date, Binlory has an order backlog, which relates to a contract between itself and a customer for 10 industrial vehicles to be delivered in the next two years.
In addition, Binlory requires the extensive use of water in the manufacturing process and can take a pre-determined quantity of water from a water source for industrial use. Binlory cannot manufacture vehicles without the use of the water rights. Binlory was the first entity to use water from this source and acquired this legal right at no cost several years ago. Binlory has the right to continue to use the quantity of water for manufacturing purposes but any unused water cannot be sold separately. These rights can be lost over time if non-use of the water source is demonstrated or if the water has not been used for a certain number of years. Binlory feels that the valuation of these rights is quite subjective and difficult to achieve.
The directors of Canto wish to know how to account for the above intangible assets on the acquisition of Binlory. (7 marks)
(c) Canto acquired a cash-generating unit (CGU) several years ago but, at 28 February 2017, the directors of Canto were concerned that the value of the CGU had declined because of a reduction in sales due to new competitors entering the market. At 28 February 2017, the carrying amounts of the assets in the CGU before any impairment testing were:
The fair values of the property, plant and equipment and the other assets at 28 February 2017 were $10 million and $17 million respectively and their costs to sell were $100,000 and $300,000 respectively.
The CGU’s cash flow forecasts for the next five years are as follows:
Date year ended Pre-tax cash flow Post-tax cash flow
The pre-tax discount rate for the CGU is 8% and the post-tax discount rate is 6%. Canto has no plans to expand the capacity of the CGU and believes that a reorganisation would bring cost savings but, as yet, no plan has been approved.
The directors of Canto need advice as to whether the CGU’s value is impaired.
The following extract from a table of present value factors has been provided.
(a) IFRS 13 Fair Value Measurement defines fair value as the price which would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A fair value measurement of a non-financial asset takes into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant who would use the asset in its highest and best use. The highest and best use of a non-financial asset takes into account the use of the asset which is physically possible, legally permissible and financially feasible. Due to the lack of an active market for identical assets, it would be rare for property to be classified in Level 1 of the fair value hierarchy. In market conditions where property is actively purchased and sold, the fair value measurement might be classified in Level 2. However, that determination will depend on the facts and circumstances, including the significance of adjustments to observable data. In this regard, IFRS 13 provides a property specific example, stating that a Level 2 input would be the price derived from observed transactions involving similar property interests in similar locations. Accordingly, in active and transparent markets, property valuations may be classified as Level 2, provided that no significant adjustments have been made to the observable data. If significant adjustments to observable data are required, the fair value measurement may fall into Level 3.
IAS 40 Investment Property permits entities to choose between a fair value model and a cost model. One method must be adopted for all of an entity’s investment property. A change is permitted only if this results in a more appropriate presentation. IAS 40 notes that this makes it highly unlikely for a change from a fair value model to a cost model to occur. Transfers to or from investment property should only be made when there is a change in use, which is evidenced by the end of owner-occupation, which has occurred in this case. For a transfer from owner-occupied property to investment property carried at fair value, IAS 16 Property, Plant and Equipment (PPE) should be applied up to the date of reclassification. Any difference arising between the carrying amount under IAS 16 at that date and the fair value is dealt with as a revaluation under IAS 16.
The aggregate fair value of the site, including the industrial and retail outlets, is higher to market participants than the sum of the fair value of the individual property interests because of synergies and complementary cash flows. Consequently, the fair value of the site as a whole would be maximised as a group of assets. The fair value is determined for the whole site even if the asset is disaggregated when applying IAS 40.
In some cases, it would not be appropriate to estimate fair value of mixed-use property interests as a group. In some instances when valuing property interests, fair value is maximised based on the price which would be received in a current transaction to sell the asset on a stand-alone basis.
Thus providing that the above criteria have been met, Canto may value the property at $25 million.
Canto will recognise a depreciation expense of $0·5 million in profit or loss in the year to 28 February 2017 while the property is accounted for using a cost model. At 28 February 2017, Canto will transfer the property from PPE to investment property at its carrying amount of $13·5 million ($15 million – depreciation of $1·5 million) and recognise the increase of $11·5 million in the fair value of the investment property in a revaluation surplus through other comprehensive income and as an increase in the value of the investment property.
(b) IFRS 3 Business Combinations states that an acquirer should recognise, separately from goodwill, the identifiable intangible assets acquired in a business combination. An asset is identifiable if it meets either the separability or contractual-legal criteria in IAS 38 Intangible Assets. Customer relationship intangible assets may be either contractual or non-contractual. Contractual customer relationships are normally recognised separately from goodwill as they meet the contractual-legal criterion. However, non-contractual customer relationships are recognised separately from goodwill only if they meet the separable criterion. Consequently, determining whether a relationship is contractual is critical to identifying and measuring both separately recognised customer relationship intangible assets and goodwill, and different conclusions could lead to substantially different accounting outcomes.
In the case of accounting for the acquisition of Binlory, the order backlog should be treated as an intangible asset on the acquisition. The fair value of the order backlog is estimated based on the expected revenue to be received, less the costs to deliver the product or service.
Canto has acquired water acquisition rights as part of a business combination.
The rights are valuable, as Binlory cannot manufacture vehicles without them. The rights were acquired at no cost and renewal is certain at little or no cost. The rights cannot be sold other than as part of the sale of a business as a whole, so there exists no secondary market in the rights. If Binlory does not use the water, then it will lose the rights. In this case, the legal rights cannot be measured separately from the business as a whole and therefore from goodwill. Binlory would not be able to manufacture without the rights. Therefore, the legal rights should not be accounted for as a separate intangible asset acquired in the business combination because the fair value cannot be measured reliably as the legal rights cannot be separated from goodwill.
(c) IAS 36 Impairment of Assets requires that assets be carried at no more than their carrying amount. Therefore entities should test all assets within the scope of the standard if there is potential impairment when indicators of impairment exist. If fair value less costs of disposal or value in use is more than carrying amount, the asset is not impaired. It further says that in measuring value in use, the discount rate used should be the pre-tax rate which reflects current market assessments of the time value of money and the risks specific to the asset. The discount rate should not reflect risks for which future cash flows have been adjusted and should equal the rate of return which investors would require if they were to choose an investment which would generate cash flows equivalent to those expected from the asset. Therefore pre-tax cash flows and pre-tax discount rates should be used to calculate value in use. Discounting post-tax cash flows with a post-tax discount rate could give the same result in an entity were it not for any temporary differences and/or tax losses which might exist.
