CHAPTER 5 CONSOLIDATED ACCOUNTS: STATEMENTS OF FINANCIAL POSITION– COMPLICATIONS
1.1 Relationship between tax expense and accounting
profit 2015
Rs.m
Accounting profit before tax 50.000
Tax on accounting profit at 35% 17.500
Tax on expenses disallowed (Permanent Difference) 0.035
Effective tax rate/tax charge 17.535
(c) Journal entries Debit Credit
Rs.m Rs.m
1 Income tax expenses 18.391
Provision for taxation 18.391
(Tax provision for 2015)
2 Deferred tax asset 0.856
Tax expenses – deferred 0.856
(Deferred tax credit for 2015)
12.10 GALAXY INTERNATIONAL
28 : TAXATION 2015 2014
Rs.m Rs.m
Current - for the year (W – 1) 0.84 -
Deferred (W – 2) 6.95 (0.96)
7.79 (0.96)
28.1 : Relationship between tax expense and accounting profit
Profit/(Loss) before taxation 23.50 (1.75)
Tax at the applicable rate of 35% 8.23 (0.61)
Tax effect of exempt income (1.25 x 35%) (0.44) (0.35)
7.79 (0.96) W1 : Computation of Current Tax
(Loss) / profit before tax as per books 23.50 (1.75)
Add: Allowable income / Disallowed expenses
Accounting depreciation 15.00 15.00
Provision for gratuity 2.20 1.70
Accrued expenses - 2.00
Less: Disallowed income / Allowable expenses
Tax depreciation (6.00) (45.00)
Interest income from SIBs (Exempt) (1.25) (1.00)
Accrued expenses (2.00)
Taxable income / (loss) 31.45 (29.05)
Tax liability (@ 35% 11.01 -
Tax loss to be brought forward (29.05 x 35%) (10.17) -
Tax payable 0.84 -
W -2: Computation of Deferred Tax
Timing differences (cumulative) on account of:
Depreciation (2015: 30-51, 2014: 15-45) 21.00 30.00
Accrued expenses - (2.00)
Provision for gratuity (3.90) (1.70 )
Tax losses - (29.05)
17.10 (2.75)
Deferred tax @ 35% 5.99 (0.96)
Add: Opening deferred tax (dr.) 0.96 -
Charge/(Reversal) for the year 6.95 (0.96)
12.11 APRICOT LIMITED
Taxation 2015 2014
Rs.m Rs.m
Current (W1) 20.48 10.76
Deferred (W2) (1.58) (21.35)
18.90 (10.59) Relationship between tax expense and accounting profit 2015
Profit before taxation 60.00
Tax at the applicable rate of 35% 21.00
Less: Tax effect of exempt income (2.10)
18.90 W1: Computation of Current Tax
Profit before tax as per books 60.00 45.00
Add: Allowable income / Disallowed expenses
Accounting depreciation 10.00 9.00
Tax profit on sale of fixed assets 1.00 -
Bad debt expense 5.00 7.00
Less: Disallowed income / Allowable expenses
Tax depreciation (8.00) (7.00)
Accounting profit on sale of fixed assets (0.50) -
Capital gain (6.00) -
Bad debts written off (3.00) (4.00)
Taxable income 58.50 50.00
Tax liability (@ 35%) 20.48 17.50
2015 2014 Rs.m Rs.m W2: Computation of Deferred Tax
Fixed assets (2014: 95-90, 2015: 82.5-80) (W2.1) 0.87 1.75 Provision for bad debts (2014: 12×35%, 2015: 14×35%)
[W2.2] (4.90) (4.20)
Closing balance of deferred tax (4.03) (2.45)
Less: Opening balance (2.45) (18.90)
Charge for the year (1.58) (21.35)
W2.1 Movement of Fixed Assets Accounting Tax
Opening balance 95.00 90.00
Disposal during the year (2.50) (2.00)
Depreciation for the year - 2015 (10.00) (8.00)
Closing balance 82.50 80.00
W2.2 Movement of provision for bad debts 2015 2014
Opening balance 12.00 9.00
Provision for the year 5.00 7.00
Write off during the year (3.00) (4.00)
Closing balance 14.00 12.00
CHAPTER 13 – RATIO ANALYSIS
13.1 WASIM Ratios
Year 7 Year 6
Gross profit % = 100 x Sales
prof it Gross
405 2,160
x 100 = 19%
362 1,806
x 100 = 20%
Net profit % =
Net prof it Sales
x 100
9 2,160
x 100 = 0.4%
53 1,806
x 100 = 2.9%
Return on capital employed =
Prof it bef ore interest and tax
Share capital and reserv es+ Long - term debt capital
15 246
x 100 = 6%
56 190
x 100 = 29%
Asset turnover =
Sales
Share capital and reserv es+ Long - term debt capital x 100
2,160 246
= 8.8 times
1,806 190
= 9.5 times Current ratio =
Current assets Current liabilities
422 254
= 1.7 times
265 147
= 1.8 times Quick ratio =
Current assets excluding inv entory Current liabilities
422 - 106 254
1.2 times
265 - 61 147
1.4 times Average time to collect =
Trade receiv ables Sales
x 365
316 x 365
2,160 53 day s
198 x 365
1,806 40 day s Average time to pay =
Trade pay ables Cost of purchases
x 365
198 x 365 1,755
= 41 day s
142 x 365 1, 444
= 36 day s
Inventory turnover =
Inv entory Cost of sales
x 365
106 x 365
1,755 22 day s
61 x 365
1, 444 = 15 day s
13.2 AMIR AND MO
Amir Mo
Gross profit % = 100 x Sales
prof it Gross
90,000 150,000
x 100 = 60%
490,000 700,000
x 100 = 70%
Net profit % =
Net prof it Sales
x 100
44,895
150,000 x 100 = 30%
270,830
700,000 x 100 = 39%
Return on capital employed =
Prof it bef ore interest and tax
Share capital and reserv es+ Long - term debt capital Amir
61,500 + 500 207, 395 +10,000
x 100 = 28.5%
Mo
371,000 +12,000 565,580 + 250,000
x 100 = 47%
Asset turnover =
Sales
Share capital and reserv es+ Long - term debt capital x 100
Amir
150,000
207, 395 +10,000= 0.7 times
Mo
700,000 565,580 + 250,000
= 0.85 times
Amir Mo
Current ratio =
Current assets Current liabilities
50,000
22,605 = 2.2 times
153,250
117,670 = 1.3 times
Quick ratio =
Current assets excluding inv entory Current liabilities
50,000 - 12,000 22,605
= 1.7 times
153,250 - 26,250 117,670
= 1.1 times
Average time to collect =
Trade receiv ables Sales
x 365
37,500 150,000
x 365 = 91 day s
105,000 700,000
x 365 = 55 day s
Average time to pay =
Trade pay ables Cost of purchases
x 365
22,605 60,000
x 365 = 137 day s
117,670 210,000
x 365 = 204 day s
Inventory turnover =
Inv entory Cost of sales
x 365
12,000 60,000
x 365 = 73 day s
26,250 210,000
x 365 = 46 day s
CHAPTER 14 – ETHICAL ISSUES IN FINANCIAL REPORTING
14.1 ETHICAL ISSUES
The range of comments made by Arif raises questions over his ethical behaviour and professional standards.
A chartered accountant should be unbiased when involved in preparing and reviewing financial information. A chartered accountant should prepare financial statements fairly, honestly, and in accordance with relevant professional standards and must not be influenced by considerations of the impact of reported results.
Arif’s failings
Arif appears to be influenced by the need to achieve a specified level of profit. This is not appropriate and calls his integrity into question.
In addition Arif’s professional competence seems to be suspect. His comment on not being up to date on all of the little technicalities in IFRS s suggests that he has not maintained a level of professional competence appropriate to his professional role.
ICAP members have a responsibility to engage in continuing professional
development in order to ensure that their technical knowledge and professional skills are kept up to date. Arif should seek continuing professional development activities and improve his knowledge on ethical standards. Furthermore, it might be expected that as Waheed’s superior he should set an example to Waheed and guide him in his responsibilities. Clearly this is not happening.
As a member of ICAP Arif should be aware of the ICAP code of ethics. Arif should know of the danger of self-interest threats and intimidation threats to himself and to others. His attempt to influence the outcome of a fellow professional by applying such a threat to that individual is very unprofessional.
Waheed’s ethical issues
Waheed faces a self-interest threat, in that there is the possibility of a bonus provided the earnings per share figure remains the same as last year. Arif has also suggested that she can influence the Board’s decision over employing him as a replacement finance director – another self-interest threat to Waheed. Both of these threats must be ignored.
Arif’s comments imply that his application of professional responsibility is lacking.
This may extend into the way in which the current financial statements have been prepared. Waheed must be very careful (as always) to carry out the review with all due care.
Waheed should first discuss his recommendations with Arif and remind his of his professional responsibilities to ensure that the accounting standards are correctly followed. If the financial statements are found to contain errors or incorrect
accounting treatment then they must be amended. If Arif refuses to amend the draft financial statements if necessary Waheed should discuss the matter with other board members (including non- executives and the audit committee, if possible).
Further action might include consulting with ICAP.
14.2 SINDH INDUSTRIES LTD
(a) Financial reporting issues Revenue
IAS 18 Revenue sets out the rules to be followed in recognising revenue.
The fact that the customer cannot cancel the contract is not relevant to the recognition of revenue. Revenue from providing a service is recognised according to the stage of completion subject to satisfying criteria set out in IAS 18. In the absence of other information the revenue in this contract should be recognised over the life of the contract as time progresses. As the contract was only signed just before the year end, none of the revenue can be recognised in 2015.
The credit for the amount received should be recognised as a liability. This represents the obligation that the company has to provide the service over the next two years.
The fact that the customer cannot cancel the contract is not relevant to the recognition of revenue. If Sindh Industries failed to provide the service they would be sued for restitution. Therefore the revenue can only be recognised as the service is provided.
New factory
Borrowing costs directly attributable to construction of an asset which
necessarily takes a substantial period to get ready for its intended use should be capitalised as part of the cost of that asset under IAS 23 Borrowing Costs.
IAS 23 states that the capitalisation of borrowing costs should commence when three conditions are all met for the first time: borrowing costs are being incurred, expenditure is being incurred and activities to prepare the asset are being undertaken. Although borrowing costs were incurred throughout the year and expenditure was incurred from 1 February 2015 (the date the land was purchased), construction only started on 1 June 2015. Therefore this is the date on which capitalisation commences.
Capitalisation ceases when substantially all of the activities required to make the asset ready for use/sale have been completed, that is on 30 September 2015. (The actual date on which the factory was brought into use is irrelevant.) Therefore the period of capitalisation should be four months.
Where construction is financed from general borrowings, the calculation of the amount to be capitalised should be based on the weighted average cost of borrowings. This is:
(Rs.1,000,000 × 9.75%) + (Rs.1,750,000 × 10%) + (Rs.2,500,000 × 8%)/
(Rs.1,000,000 + Rs.1,750,000 + Rs.2,500,000) = 9%
Therefore the amount capitalised should be 9% × Rs.4.5 million (land Rs.1.8 million plus construction costs Rs.2.7 million) × 4/12 = Rs.135,000. The total cost of the factory should be measured at Rs.4,635,000 (Rs.1.8 million plus Rs.2.7 million, plus Rs.135,000). The amount that has been recognised in the statement of financial position should be reduced by Rs.315,000 (Rs.450,000 – Rs.135,000). Finance costs recognised in profit or loss should be increased by Rs.315,000.
Land should not be depreciated because it has an indefinite life. Under IAS 16 Property, Plant and Equipment depreciation charges should start when the asset becomes available for use, from 1 October 2015 in this case.
Depreciation of Rs.35,000 ((Rs.2.7 million, plus (Rs.135,000 × 2.7/4.5) ÷ 20) × 3/12) should be recognised in profit or loss for the year ended 31 December 2015 and the carrying amount of the asset reduced by the same amount to Rs.4.6 million.
Useful life of the blast furnace
Depreciation of the blast furnace has been based on an estimated useful life of 20 years. This is at variance with a report by a qualified expert. The asset valuation specialist treats the furnace as being made up of two components, the main structure and the lining, which must be replaced at regular five yearly intervals over the life of the asset. This is the approach required by IAS 16.
The uncertainties inherent in business mean that many items in financial statements cannot be measured with certainty, but estimates should always be made using the most up to date and reliable information. Where estimates have been prepared by professionals with relevant qualifications, then it is nearly always most appropriate to use those estimates. Therefore in
accordance with the valuer’s report the main structure of the furnace should be depreciated over 15 years from 1 January 2015 and the lining should be depreciated over five years from that date.
The reassessment of the estimated lives of assets is a change in accounting estimate, rather than a change in accounting policy (IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors). Changes in accounting estimate should be dealt with on a prospective basis. This is achieved by including the effect of the change in profit or loss in current and future periods. The additional depreciation should be calculated as:
Rs.000 Revised depreciation: main structure
((Rs.3.5m – Rs.1.4m)/15 years)
140
lining (Rs.1.4m/5 years) 280
420
Current depreciation (Rs.3.5m/20 years) (175)
Additional depreciation 245
IAS 8 requires the disclosure of the nature and amount of the effect of the change in the estimate of useful lives on the profit for the year.
(b) Revised financial statements
Statement of profit or loss extract for the year ended 31 December 2015 Borrowing Blast
Draft Revenue costs furnace Revised Rs.000 Rs.000 Rs.000 Rs.000 Rs.000
Profit before tax 2,500 (1,000) (315)+ (35) (245) 905
Statement of financial position at 31 December 2015
Borrowing Blast
Draft Revenue costs furnace Revised Rs.000 Rs.000 Rs.000 Rs.000 Rs.000 Non-current assets
Property, plant and
equipment 12,000 (315) + (35) (245) 11,405
Current assets 3,500 3,500
Total assets 15,500 14,905
Share capital 2,000 2,000
Retained earnings 6,000 (1,000) (315) + (35) (245) 4,405
Equity 8,000 6,405
Non-current liabilities 5,000 500 5,500
Current liabilities 2,500 500 3,000
Total equity and liabilities 15,500 15,905
(c) Ethical issues
It is noticeable that all the adjustments required reduce profit. This and the background to the previous finance director’s resignation suggest serious problems.
It is not clear who actually prepared the draft financial statements. If they were prepared by more junior staff in the absence of a finance director, some of the adjustments (for example, the calculation of borrowing costs to be capitalised) could be the result of genuine errors or lack of accounting knowledge.
However, it seems reasonably clear that the managing director has attempted to influence the treatment of the revenue and the estimated useful life of at least one significant non-current asset. (Note: the directors have reviewed the useful lives of several items of plant and machinery and it is possible that other assets besides the furnace are being depreciated over unrealistically long periods.)
It seems almost certain that the previous finance director resigned as a result of pressure from the managing director (and possibly from other members of the Board) to present the financial statements in a favourable light. The directors intend to seek a stock market listing in the near future. Therefore they have clear motives for manipulating the profit figure and also (perhaps) for making controversial decisions before the financial statements come under much greater scrutiny as a result of the listing. The job title of financial
controller is also significant. It suggests that the role has been downgraded and that the person holding it has less authority than the rest of the Board.
Possible courses of action:
Discuss with the managing director the financial reporting standards that apply to the transactions and explain the implications of non-compliance.
If the managing director is himself a member of a professional body then it might be worth pointing out to him that he himself is bound by an ethical code.
Advise him that as a Chartered Accountant you are bound by the ICAP code of ethics, and that you would not be prepared to compromise your views of the figures he has prepared for career advancement.
Consider speaking to the other directors (or audit committee if there is one) and seeking their support.
If all of these actions produce a negative response then it would be appropriate to consult the ICAP ethical handbook and/or the Institute.
If all else fails then consider seeking alternative employment.
2015