FR Financial Reporting

A. The conceptual and regulatory framework

A conceptual framework is a set of principles that supports consistent accounting standards. Its objective is to provide financial information that is useful to investors, lenders and other creditors in making decisions. A framework reduces the need for rules on every transaction and helps preparers when no standard covers an issue, though without it there could be rule-based standards, which are more specific but can be avoided by structuring transactions. The two fundamental qualitative characteristics are relevance and faithful representation. Faithful representation means the information is complete, neutral and free from material error. The enhancing characteristics are comparability, verifiability, timeliness and understandability. Comparability also affects changes in accounting policy, which are applied retrospectively so that periods can be compared.

An item is recognised when it meets the definition of an asset, liability, income or expense and recognition provides relevant information and a faithful representation. An asset is a present economic resource controlled by the entity as a result of past events, and a liability is a present obligation to transfer an economic resource as a result of past events. The measurement bases are historical cost, current cost, value in use or fulfilment value and fair value. Historical cost is objective and verifiable, but it may not reflect current values. Current value measures give more relevant information but can be less reliable, and no single measure suits every item.

A regulatory framework is needed so that financial statements are comparable and reliable. IFRS Accounting Standards give international consistency and help cross-border investment, but they do not cover everything, and they need to work with local law and listing rules. A principles-based approach states the objective and requires judgement, and a rules-based approach gives detailed requirements. The IASB sets standards through a due process that includes consultation. National standard setters work with the IASB, and the ISSB sets sustainability disclosure standards.

A group is a single economic entity made up of a parent and its subsidiaries. Consolidated statements show the group as if it were one entity. A parent normally prepares them if it controls one or more subsidiaries, with limited exemptions, for example for an intermediate parent whose own parent publishes consolidated statements. Group members should have coterminous year ends and use uniform accounting policies, intra-group transactions are eliminated, and the subsidiary's assets and liabilities and the consideration are included at fair value at the acquisition date. An associate is an entity over which the investor has significant influence, and it is accounted for under the equity method.

Key terms

• Conceptual framework: The principles that underpin accounting standards.
• Faithful representation: Information that is complete, neutral and free from material error.
• Principles-based: Standards that set objectives and rely on judgement.

Study tip: In discussion questions, define the term, give the argument for and against, and tie it to the scenario.

Practice questions for section A

B1. Non-current assets: tangible, intangible and impairment

Tangible non-current assets (IAS 16). Initial cost includes the purchase price, import duties and non-refundable taxes, costs directly attributable to getting the asset ready for use, and the estimated cost of dismantling and restoring the site. For a self-constructed asset, directly attributable labour and materials are included, but not abnormal waste or general overheads. Borrowing costs directly attributable to a qualifying asset (one that takes a substantial time to get ready) are capitalised. Subsequent expenditure is capitalised only if it improves the asset beyond its original standard or replaces a component. An asset with parts that have different lives is depreciated by component. The cost model carries an asset at cost less depreciation and impairment. Under the revaluation model, the asset is carried at fair value, revaluations are made often enough that the carrying amount does not differ materially, and a whole class of assets is revalued together. A revaluation gain is recognised in other comprehensive income and held in the revaluation surplus, unless it reverses an earlier loss in profit or loss. A loss is charged to profit or loss unless it reduces an earlier surplus. On disposal the gain or loss is proceeds less carrying amount, and any remaining surplus is transferred to retained earnings.

Investment property (IAS 40) is property held to earn rent or for capital growth, not for use in the business or for sale. It can be measured at cost or at fair value, with changes in fair value recognised in profit or loss under the fair value model. Investment property is treated differently from other property because its value, and not its consumption, is what matters to users.

Intangible assets (IAS 38) are identifiable non-monetary assets without physical substance. They are recognised if it is probable that future economic benefits will flow and the cost can be measured reliably. Purchased intangibles are recognised at cost. Internally generated goodwill, brands, mastheads and customer lists are not recognised. Research costs are expensed, and development costs are capitalised only when criteria are met (technical feasibility, intention and ability to complete and use or sell, probable future benefits, adequate resources and reliable measurement of cost). Intangibles with finite lives are amortised, and those with indefinite lives, including goodwill, are tested for impairment each year and not amortised. Goodwill is the excess of the consideration over the fair value of the identifiable net assets acquired, and it is recognised only on an acquisition.

Impairment (IAS 36). An asset is impaired when its carrying amount is more than its recoverable amount, which is the higher of fair value less costs of disposal and value in use. Indicators include a fall in market value, adverse changes in technology or the market, physical damage, and the asset performing worse than expected. If an asset does not generate cash flows independently, impairment is tested for the smallest group of assets that does, called a cash-generating unit (CGU). An impairment loss on a CGU is allocated first to any goodwill, then to the other assets in proportion to their carrying amounts, but no asset is reduced below its own recoverable amount, if it can be measured, or below zero. Impairment losses are recognised in profit or loss, or against the revaluation surplus for revalued assets. A loss on an asset can be reversed if estimates change, up to the amount that it would have been had no impairment occurred. A loss on goodwill is never reversed.

Worked figures

Revaluation: an asset cost $100,000 and has a 10-year life. After 4 years the carrying amount is $60,000. It is revalued to $90,000 with 6 years left. The surplus is $30,000 (to other comprehensive income). The new depreciation is $90,000 / 6 = $15,000 a year, compared with $10,000 before, so $5,000 a year could be transferred from the revaluation surplus to retained earnings.

Impairment: a CGU has a carrying amount of $500,000, including goodwill of $80,000. The recoverable amount is $380,000. The loss is $120,000. The first $80,000 goes against goodwill, and the remaining $40,000 is shared between the other assets in proportion to their carrying amounts.

Key terms

• Recoverable amount: The higher of fair value less costs of disposal and value in use.
• Cash-generating unit: The smallest group of assets that generates cash inflows independently.
• Revaluation surplus: A component of equity that holds revaluation gains on non-current assets.
• Qualifying asset: An asset that takes a substantial period to get ready for use or sale.

Study tip: For an impairment of a CGU, write the allocation order down before you calculate: goodwill first, then the rest pro rata.

Practice questions for section B1

B2. Inventories, agriculture, provisions and events after the reporting period

Inventories (IAS 2) are measured at the lower of cost and net realisable value. Cost includes the purchase price, conversion costs including a share of fixed production overheads based on normal capacity, and other costs of bringing the inventory to its location and condition. It excludes abnormal waste, storage (unless needed in production), administration and selling costs. Cost is found using FIFO or weighted average cost, and LIFO is not allowed.

Agriculture (IAS 41). Biological assets, such as livestock and growing crops, are measured at fair value less costs to sell, with changes in fair value recognised in profit or loss. Agricultural produce is measured at fair value less costs to sell at the point of harvest, after which it is accounted for as inventory.

Provisions (IAS 37). A provision is recognised if there is a present obligation (legal or constructive) from a past event, an outflow is probable, and a reliable estimate can be made. A legal obligation comes from law or contract, and a constructive obligation arises from an entity's actions that create a valid expectation that it will accept responsibility. A provision is measured at the best estimate and discounted if the effect is material. A contingent liability is disclosed unless the chance of outflow is remote, and a contingent asset is disclosed only if an inflow is probable. Specific cases include warranties (based on expected claims), onerous contracts (provide for the lower of the cost of fulfilling and the cost of exiting the contract), environmental and decommissioning costs (recognised when the obligation arises, with the cost added to the asset) and restructuring (only when there is a detailed formal plan and a valid expectation has been raised in those affected, for example by announcing it).

Events after the reporting period (IAS 10). Adjusting events provide evidence of conditions at the reporting date, and the amounts are adjusted. Non-adjusting events relate to conditions that arose later, and are disclosed if material. If an entity is no longer a going concern after the reporting period, the statements are not prepared on a going concern basis.

Key terms

• Constructive obligation: An obligation that arises from an entity's actions, creating a valid expectation in others.
• Onerous contract: A contract in which the unavoidable costs exceed the benefits.
• Net realisable value: Estimated selling price less the costs to complete and sell.

Study tip: Test every provision against the three criteria in order: obligation, probable outflow, reliable estimate.

Practice questions for section B2

B3. Financial instruments and leasing

A financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another. Debt and equity are distinguished by the substance: an instrument with an obligation to pay cash or another financial asset is a liability, and one that gives a residual interest in the assets is equity. Redeemable preference shares are usually liabilities, and their dividends are finance costs. Convertible debt has a liability component and an equity component, and the liability is measured first by discounting the cash flows at the rate for similar debt without a conversion option, with the balance treated as equity.

Financial assets and liabilities are measured in three ways. Amortised cost applies to a financial asset held to collect contractual cash flows and to most financial liabilities: the initial amount plus the effective interest, less payments, so that finance costs are charged at the effective rate on the carrying amount. Fair value through other comprehensive income (FVOCI) applies to debt held to collect and sell, and to equity investments that are not held for trading, if the entity irrevocably elects it. Fair value through profit or loss (FVTPL) is the default for other assets, such as equities held for trading. Transaction costs are expensed for FVTPL items and included in the initial amount for others. The factoring of receivables is accounted for according to whether the entity keeps the risks and rewards: if it does (for example with recourse), the receivable stays on the statement of financial position with a liability for the advance, and if it does not, the receivable is derecognised.

Leasing (IFRS 16). A lessee recognises a right-of-use asset and a lease liability at the start of a lease. The liability is the present value of the lease payments not yet made, discounted at the rate implicit in the lease or the lessee's incremental borrowing rate. The asset is the liability plus any payments made at or before the start and initial direct costs, and is depreciated over the shorter of the lease term and its useful life. The lease liability grows by interest at the discount rate and falls as payments are made. Leases of 12 months or less and leases of low-value assets can be exempt, in which case the payments are expensed on a straight line basis. In a sale and leaseback at fair value, the seller-lessee derecognises the asset and recognises a right-of-use asset for the proportion of the carrying amount that it keeps, and recognises only the gain that relates to the rights transferred.

Worked figures

Lease: a 3-year lease has annual payments in arrears of $10,000 and a discount rate of 8 percent. The lease liability at the start is 10,000 x 2.5771 = $25,771. The right-of-use asset is the same amount, and its annual depreciation over 3 years is $8,590. Year 1 interest is 8% x 25,771 = $2,062, so the liability at the end of year 1 is 25,771 + 2,062 - 10,000 = $17,833.

Amortised cost: debt is issued for net proceeds of $95,000 with an effective rate of 6 percent and a coupon of $4,000. Finance cost = 6% x 95,000 = $5,700, and the closing carrying amount is 95,000 + 5,700 - 4,000 = $96,700.

Key terms

• Effective interest rate: The rate that discounts the cash flows of a financial instrument to its initial carrying amount.
• Right-of-use asset: The lessee's asset representing the right to use a leased item.
• Lease liability: The present value of the lease payments not yet paid.

Study tip: For leases, always calculate the present value first. Every other number follows from it.

Practice questions for section B3

B3a. Leases under IFRS 16 in detail

A lease is a contract that gives a customer the right to control the use of an identified asset for a period of time in exchange for payment. An asset is identified if it is specified and the supplier has no substantive right to substitute it. IFRS 16 uses one model for lessees, so almost every lease is shown in the statement of financial position.

At the start of the lease the lessee recognises a lease liability and a right-of-use asset. The lease liability is the present value of the lease payments not yet paid, discounted at the interest rate implicit in the lease. If that rate cannot readily be determined, the lessee's incremental borrowing rate is used. The right-of-use asset is the initial lease liability, plus any payments made at or before the start, plus initial direct costs and the estimated cost of restoring the asset, less any lease incentives received.

Lease payments include fixed payments, variable payments that depend on an index or a rate, amounts expected to be paid under residual value guarantees, the exercise price of a purchase option if the lessee is reasonably certain to use it, and termination penalties if the lease term assumes that the lessee will end the lease early. The lease term is the non-cancellable period plus any periods covered by an extension option that the lessee is reasonably certain to use. Variable payments that depend on use or sales, such as a percentage of revenue, are not part of the liability and are expensed as they arise.

After the start, the lease liability is increased by interest, found by applying the discount rate to the opening balance, and reduced by the payments made. The right-of-use asset is depreciated over the shorter of the lease term and its useful life. If ownership passes to the lessee, or a purchase option is reasonably certain to be used, the useful life is used. In the statement of profit or loss the lessee shows depreciation and a finance cost, not a single rental expense.

In the statement of financial position the liability is split into current and non-current parts. When payments are made in arrears, the current part is the reduction in the liability during the next year, which is next year's payment less next year's interest. The rest of the liability is non-current. Do not show the whole of next year's payment as current, because part of it is interest that has not yet arisen.

A lessee may choose not to apply the model to short-term leases and to leases of low value assets. A short-term lease has a term of 12 months or less and no purchase option. Low value is judged on the value of the asset when it is new, and it covers items such as small office equipment, not vehicles or property. For these leases the payments are recognised as an expense on a straight line basis over the lease term.

Worked figures

A lessee leases equipment for 5 years with payments of $20,000 a year in arrears. The rate implicit in the lease is 8 percent and the annuity factor for 5 years at 8 percent is 3.9927.

Initial lease liability = 20,000 x 3.9927 = $79,854. The right-of-use asset is also $79,854, and depreciation is 79,854 / 5 = $15,971 a year.

Year 1: interest = 8% x 79,854 = $6,388, so the closing liability is 79,854 + 6,388 - 20,000 = $66,242. Year 2: interest = $5,299, closing liability = $51,541. Year 3: interest = $4,123, closing liability = $35,664. Year 4: interest = $2,853, closing liability = $18,517. Year 5: interest = $1,481 and the final payment clears the liability, apart from a small rounding difference.

At the end of year 1 the current liability is next year's payment less next year's interest: 20,000 - 5,299 = $14,701. The non-current liability is 66,242 - 14,701 = $51,541.

Key terms

• Lease term: The non-cancellable period plus periods covered by options that the lessee is reasonably certain to use.
• Incremental borrowing rate: The rate the lessee would pay to borrow, over a similar term and with similar security, the funds needed to obtain a similar asset.
• Short-term lease: A lease with a term of 12 months or less and no purchase option.
• Initial direct costs: Costs of obtaining the lease that would not have been incurred without it.

Study tip: Work out the present value first, then make a four column table of opening liability, interest, payment and closing liability. Every other figure comes from it.

Practice questions for section B3a

B4. Taxation, government grants and foreign currency

Current tax is the tax payable on the profit for the period, and it is recognised in profit or loss (or in equity or other comprehensive income if it relates to those items). An under- or over-provision from the prior year adjusts the current year's charge. Deferred tax arises from temporary differences, which are differences between the carrying amount of an asset or liability and its tax base. A taxable temporary difference gives a deferred tax liability, for example when accounting depreciation is slower than tax allowances, and a deductible temporary difference gives a deferred tax asset if it is probable that taxable profit will be available. The amount is the temporary difference multiplied by the tax rate expected to apply. The movement is recognised in profit or loss, unless it relates to an item in other comprehensive income, such as a revaluation, when it is recognised there.

Government grants (IAS 20) are recognised when there is reasonable assurance that the entity will comply with the conditions and that the grant will be received. Grants related to income are recognised in profit or loss over the periods in which the related costs are recognised. Grants related to assets are either deducted from the carrying amount of the asset or shown as deferred income and released to profit or loss over the life of the asset.

Foreign currency (IAS 21). The functional currency is the currency of the main economic environment of the entity, and the presentation currency is the one in which the statements are shown. A foreign currency transaction is recorded at the spot rate at the date of the transaction. At the reporting date, monetary items (such as receivables, payables and cash) are retranslated at the closing rate, and exchange differences go to profit or loss. Non-monetary items carried at historical cost stay at the rate at the transaction date, and those at fair value are translated at the rate when the fair value was measured.

Worked figures

Deferred tax: an asset has a carrying amount of $80,000 and a tax base of $50,000. The taxable temporary difference is $30,000 and, at a tax rate of 25 percent, the deferred tax liability is $7,500.

Foreign currency: goods are bought on credit for FC 120,000 when $1 = FC 4.0, which is $30,000. At the year end $1 = FC 3.0, so the payable is $40,000 and there is an exchange loss of $10,000 in profit or loss.

Key terms

• Temporary difference: The difference between the carrying amount of an item and its tax base.
• Tax base: The amount attributed to an asset or liability for tax purposes.
• Monetary item: A right to receive or an obligation to pay a fixed or determinable amount of money.

Study tip: Always work out the carrying amount and the tax base separately, then take the difference.

Practice questions for section B4

B5. Revenue, performance and earnings per share

Revenue (IFRS 15) is recognised using five steps. First, identify the contract with the customer. Second, identify the separate performance obligations (the distinct goods or services promised). Third, determine the transaction price, including variable consideration and any significant financing. Fourth, allocate the price to the performance obligations in proportion to their stand-alone selling prices. Fifth, recognise revenue when, or as, each obligation is satisfied. A performance obligation is satisfied over time if the customer receives and consumes the benefits as the entity performs, if the entity creates or improves an asset that the customer controls, or if the asset has no alternative use and the entity has a right to payment. Otherwise, it is satisfied at a point in time, when control passes.

Progress towards complete satisfaction can be measured by output methods (such as units delivered or surveys of work done) or input methods (such as costs incurred or labour hours, for example the cost-to-cost method). If the outcome cannot be measured reliably, revenue is recognised only to the extent of recoverable costs. Contract costs, such as the incremental costs of obtaining a contract, are capitalised if they are expected to be recovered. An entity acting as a principal recognises revenue at the gross amount, and an agent recognises only its fee or commission. Special cases include repurchase agreements, bill-and-hold arrangements (revenue is recognised when control has passed, which requires specific conditions) and consignment arrangements (revenue is not recognised until the goods are sold on to the end customer).

Performance reporting. A non-current asset (or disposal group) is classified as held for sale if its carrying amount will be recovered mainly through sale, it is available for immediate sale, and the sale is highly probable. It is measured at the lower of carrying amount and fair value less costs to sell and is not depreciated. A discontinued operation is a component that has been disposed of or is held for sale and represents a separate major line of business or area of operations, and its results are shown separately in the statement of profit or loss so users can see what is likely to continue. Material items of income and expense are disclosed separately. Changes in accounting estimates are applied prospectively, and changes in accounting policy and corrections of prior period errors are applied retrospectively by restating the comparatives.

Earnings per share (EPS) is profit attributable to the ordinary shareholders divided by the weighted average number of ordinary shares. A bonus issue is treated as if it had always been in issue, so the earlier share numbers are restated. A rights issue includes a bonus element, because the shares are issued below market price, and earlier shares are adjusted using a bonus fraction (the market price before the issue divided by the theoretical ex-rights price). Diluted EPS shows the effect of potential ordinary shares such as convertible debt and share options, so users can see the possible fall in EPS. IFRS S1 sets out general requirements for disclosing sustainability-related financial information.

Worked figures

Allocation: a bundle of a product (stand-alone price $600) and a service ($400) is sold for $900. The price is allocated in proportion: product $540 and service $360.

Progress: a contract has a price of $1,000,000. Costs to date are $300,000 and total estimated costs are $750,000, so progress is 40 percent and revenue to date is $400,000 against costs of $300,000.

EPS: profit for the ordinary shareholders is $900,000. 3,000,000 shares were in issue at the start, and on the sixth month a 1 for 5 rights issue was made at $2.00 when the market price was $3.00, creating 3,600,000 shares. The theoretical ex-rights price is (5 x 3.00 + 1 x 2.00) / 6 = $2.8333. The bonus fraction is 3.00 / 2.8333 = 1.0588. Weighted shares = 3,000,000 x 1.0588 x 6/12 + 3,600,000 x 6/12 = 3,388,235. EPS = 26.6 cents.

Key terms

• Performance obligation: A distinct good or service promised to a customer.
• Transaction price: The amount the entity expects to be entitled to in exchange for the goods or services.
• Discontinued operation: A component disposed of or held for sale that is a major line of business or area of operations.
• Bonus fraction: The factor used to adjust earlier shares for the bonus element in a rights issue.

Study tip: For revenue questions, work through the five steps in order and show each step. Marks are often given for the steps.

Practice questions for section B5

C. Analysing and interpreting financial statements

Financial statements have limitations. They use historical information, which may not predict the future. They can be manipulated through the choice of accounting policies and estimates, timing of transactions (for example, window dressing near the year end) and classification. Year-end figures may not represent the average over the period, because of seasonal trading or large purchases near the year end. Non-financial information such as customer satisfaction, order books and environmental performance may be important in assessing performance.

Ratios help to assess performance and position from the point of view of different stakeholders. Profitability: gross margin, operating margin, return on capital employed (ROCE) and return on equity. Efficiency: asset turnover, inventory days, receivables days and payables days. Liquidity: current ratio and quick ratio. Position and risk: gearing and interest cover. Investor ratios: EPS, dividend cover and the price earnings ratio. To interpret them, compare with the previous year, with competitors or industry averages, and with targets, and look at the trend. Ratios can be broken down into their drivers: for example, ROCE is the operating margin multiplied by asset turnover, so a fall in ROCE can be traced to margins or to the use of assets.

Limitations of ratio analysis include differences in accounting policies between entities, changes in policy over time, the effect of inflation, the use of year-end balances, and the fact that ratios do not explain causes. When a company revalues assets or uses leases, ROCE and gearing change without any real change in the business. The use of current values affects the interpretation of the statement of financial position, because assets may be shown at values that are closer to economic reality, but the figures are less verifiable.

Not-for-profit and public sector entities have different objectives, so profit-based ratios are less useful. Measures focus on value for money, service levels, quality, cost per user and the use of funds.

Worked figures

An entity has an operating margin of 12 percent and an asset turnover of 1.5 times, so ROCE = 12% x 1.5 = 18 percent. If margin falls to 10 percent while turnover stays at 1.5, ROCE falls to 15 percent.

Key terms

• Window dressing: Arranging transactions near the year end so that the financial statements look better.
• Gearing: The proportion of finance that comes from debt.
• ROCE: Profit before financing and income taxes divided by capital employed.

Study tip: In interpretation questions, say what the ratio shows, why it changed, and what it means for the stakeholder in the question.

Practice questions for section C

D1. Preparing single entity financial statements

The statement of financial position shows non-current assets, current assets, equity, non-current liabilities and current liabilities. The statement of profit or loss and other comprehensive income shows revenue, cost of sales, operating expenses, finance costs, income tax and other comprehensive income. The statement of changes in equity reconciles opening and closing equity, showing profit, other comprehensive income, share issues and dividends. The statement of cash flows reports operating, investing and financing activities. The notes provide the detail.

In preparation questions, start with the information given, then process each adjustment in turn: depreciation and revaluations, impairment, inventories, provisions, accruals, deferred tax and current tax, leases, finance costs on financial instruments, revenue recognition and events after the reporting period. Show your workings for each figure so that marks can be given for the method. Check that the statement of financial position balances. If it does not, look for items posted to only one side.

Statement of cash flows. The indirect method starts from profit before tax and adjusts for non-cash items (depreciation, impairment, gains and losses on disposals, finance costs) and for changes in inventories, receivables and payables. Interest paid and tax paid are shown as they are paid, and dividends paid are a financing cash flow. Investing cash flows include the purchase and sale of non-current assets, and financing cash flows include the issue and repayment of shares and borrowings and lease payments. The cash and cash equivalents at the end must agree with the statement of financial position.

Key terms

• Statement of changes in equity: A statement that shows the movements in each component of equity.
• Indirect method: A way of finding operating cash flow by adjusting profit for non-cash items and working capital.

Study tip: Work in a fixed order: working papers for each adjustment, then the statements. Then check that the statement of financial position balances.

Practice questions for section D1

D2. Preparing consolidated financial statements

A consolidated statement of financial position combines 100 percent of the assets and liabilities of the parent and its subsidiaries, line by line, removes the investment in the subsidiary and shows goodwill and non-controlling interest (NCI). Goodwill is the fair value of the consideration (including shares issued, valued at fair value, and cash) plus the NCI (valued either at fair value or at its share of the net assets) less the fair value of the identifiable net assets of the subsidiary at the acquisition date. Fair value adjustments are made to the subsidiary's assets and liabilities at acquisition. If a fair value adjustment is made, depreciation on it affects post-acquisition profit.

Consolidated retained earnings are the parent's retained earnings plus the parent's share of the subsidiary's post-acquisition profit, adjusted for the unrealised profit in inventories and, where used, the impairment of goodwill. NCI at the reporting date is the NCI at acquisition plus its share of the post-acquisition profits (less its share of any goodwill impairment, where NCI is measured at fair value). Intra-group balances (receivables, payables, loans) and intra-group sales and purchases are eliminated. Unrealised profit on goods still held by the group is removed from inventories and profit. If the seller is the subsidiary, the NCI shares in the adjustment. Where items are in transit at the year end, they are included in the group's inventories and the balances are adjusted.

A consolidated statement of profit or loss adds together the income and expenses of the parent and the subsidiary, line by line, from the acquisition date if the subsidiary is acquired part way through the year. Profit for the year is then split between the owners of the parent and the NCI, in the same way as total comprehensive income. For an associate, the equity method shows a single line in the statement of financial position, being the cost of the investment plus the investor's share of post-acquisition profit (less impairment), and a single line in profit or loss for the share of the associate's profit. Unrealised profit on trading with an associate is eliminated to the extent of the investor's share.

Worked figures

Goodwill: the parent issues 400,000 shares valued at $3.00 and pays $500,000 in cash, so the consideration is $1,700,000. The NCI at fair value is $400,000 and the subsidiary's net assets at fair value are $1,900,000. Goodwill = 1,700,000 + 400,000 - 1,900,000 = $200,000.

Unrealised profit: a subsidiary sold goods costing $40,000 to the parent for $60,000, and half are still held. Unrealised profit = $20,000 x 50% = $10,000. It is deducted from the subsidiary's profit, so the NCI (20 percent) bears $2,000 of it.

Associate: a 25 percent associate was bought for $600,000 and has made post-acquisition profit of $200,000. The investment at the reporting date is 600,000 + 25% x 200,000 = $650,000.

Key terms

• Non-controlling interest: The part of the equity of a subsidiary not owned by the parent.
• Goodwill: The excess of the consideration plus the NCI over the fair value of the identifiable net assets acquired.
• Equity method: Accounting for an associate by adding the share of its post-acquisition results to the cost of the investment.

Study tip: Set up a net assets table for the subsidiary at acquisition and at the reporting date first. Goodwill, NCI and reserves all come from it.

Practice questions for section D2

E. Formulae and technique sheet for FR

Profitability. Return on capital employed = profit before interest and tax divided by capital employed, where capital employed is total assets less current liabilities (or equity plus non-current liabilities). Return on equity = profit after tax divided by equity. Gross margin = gross profit divided by revenue. Operating margin = operating profit divided by revenue. Net margin = profit after tax divided by revenue. Asset turnover = revenue divided by capital employed.

Liquidity and working capital. Current ratio = current assets divided by current liabilities. Quick ratio = (current assets less inventory) divided by current liabilities. Inventory days = inventory divided by cost of sales x 365. Receivables days = trade receivables divided by credit revenue x 365. Payables days = trade payables divided by credit purchases x 365, or by cost of sales if purchases are not given. Cash operating cycle = inventory days + receivables days - payables days.

Gearing and investor ratios. Gearing = debt divided by equity, or debt divided by (debt + equity). State which one you use. Interest cover = profit before interest and tax divided by finance costs. Earnings per share = profit attributable to ordinary shareholders divided by the weighted average number of ordinary shares. Price earnings ratio = market price per share divided by earnings per share. Dividend cover = profit attributable to ordinary shareholders divided by ordinary dividends. Dividend yield = dividend per share divided by market price per share.

Consolidation. Goodwill = consideration transferred + non-controlling interest at the date of acquisition - fair value of the net identifiable assets at the date of acquisition. Non-controlling interest at the reporting date = non-controlling interest at acquisition + its share of the subsidiary's post-acquisition profits. Consolidated retained earnings = the parent's retained earnings + the parent's share of the subsidiary's post-acquisition retained earnings, less the group share of any goodwill impairment. Unrealised profit in inventory = profit margin x the inventory still held at the year end.

Statement of cash flows, indirect method. Start with profit before tax, add depreciation and amortisation, add finance costs, deduct investment income and gains on disposal (add losses), then adjust for the changes in inventories, receivables and payables to get cash generated from operations. Deduct interest paid and tax paid to get net cash from operating activities.

Exam technique. Read the requirement first and note the marks, because there are about 1.8 minutes for each mark. Answer the parts you are sure of first. Show every working, because marks are given for the method. For a ratio question give the formula, the calculation and a comment that compares with the previous year or a benchmark and gives a reason for the change.

F. Common exam mistakes in FR

Depreciating a revalued asset on its original cost. After a revaluation the depreciation is based on the revalued amount over the remaining useful life.

Treating the whole lease payment as an expense. A capitalised lease has depreciation on the right-of-use asset and a finance cost on the liability, and the payment reduces the liability.

Showing the whole of next year's lease payment as the current liability. The current part is the payment less the interest that will arise next year.

Using the wrong basis for the non-controlling interest, for example fair value when the question says proportionate share of net assets, or the reverse.

Forgetting to remove intragroup balances and unrealised profit in inventory when consolidating.

Using the year-end number of shares for earnings per share instead of the weighted average, or forgetting to adjust for a bonus or rights issue.

Giving ratios without comment. Marks in interpretation questions are for explaining the cause and the effect, not for the figures alone.

Using different definitions of gearing in the same answer, or not saying which one was used.

Spending too long on one requirement. Move on when the time for the marks is used up and return if time is left.

Study tip: Before you hand in a consolidation or a cash flow answer, check that the statement balances or the cash agrees. If it does not, there is a mistake to find.