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Chapter 2 – Solutions
2-1 Entities may present their statement of profit and loss using the nature of expense method or the function of expense method. Discuss the value of each method.
Nature of expense method:
Focuses on the type of expense itself (i.e. payroll, depreciation, etc.)
Arguably easier to prepare, especially if the accounting system is not set up by department
May evaluate performance by type of expense
Function of expense method
Focuses on the nature of the activity that the expense relates to (i.e. production, distribution, etc.)
Presents the cost of sales and gross margin – may evaluate performance
May evaluate each activity separately – if expenses are out of control in one activity (i.e. administration), may be more easily brought under control.
Useful in predicting cash flows
2-2 The accrual method requires that companies estimate the impact of transactions on the financial statements before the cash flows occur. This requires significant amounts of estimation. Review the assets of Rentokil Initial PLC (2007 Annual Report) and identify any assets that require estimation. Identify which estimates need to be made.
Assets requiring estimation:
Intangible assets – goodwill impairment; initial valuation of other intangible assets; depreciation (both estimated useful life and depreciation rate)
Property, plant and equipment – although initially recorded at historical cost, estimates need to be made for depreciation (both estimated useful life and depreciation rate)
Deferred tax assets – estimates made during the calculation of future taxes
Retirement benefits – significant judgment required in determining actuarial assumptions (mortality rate, payroll increases, return on plan assets, etc.), upon which defined benefit schemes are appraised
Trade and other receivables – estimated provision for impairment
2-3 Review the balance sheet for L’Oreal (2007 Annual Report). How does it present its balance sheet? Discuss, comparing to how balance sheets are currently presented in North America.
Balance Sheet presentation:
Presented using the current/non-current classifications
Current/non-current classifications are in reverse-liquidity order (non-current before current) – emphasizes the larger assets more.
Shareholders’ equity presented before liabilities, with long terms liabilities coming before current. This emphasizes the way the non-current assets are financed in terms of longer term financing.
Comparison to current presentation:
North American. balance sheet also presented using current/non-current classifications
Current/non-current classifications are presented in order of liquidity (current before non-current). The emphasis is thus on liquidity and working capital
Liabilities presented before shareholders’ equity
Note that IFRS is very flexible and encourages entities to use a format that best reflects the natures of the entity. If current/non-current labels are used, the standard provides guidance to allow consistency.
2-4 Review the accounting policy note for GlaxoSmithKline (2007 Annual Report). Identify any areas where the accounting policy choices require significant judgment or measurement uncertainty. See also the key accounting judgments and estimates note. Relate these to the underlying business.
The company is a global pharmaceuticals company that specializes in research, development, manufacture and distribution of pharmaceutical products. Thus it has significant research and development costs as well as distribution costs.
Accounting policy choices requiring significant judgment or measurement uncertainty:
Revenue recognition – revenue turnover affected by rebates, returns, etc., which must be estimated based on historical trends when revenue is recognized. The group sells through hospitals and other channels and so be affected if government funding to hospitals is cut back.
Legal & other disputes – probability of the outcome and amount of settlement A quick read of the litigation note illustrates the nature of the business and the significant business risks associated with running this type of company globally. The company is being sued by regulators and governments for its sales and promotional practices as well as customers who have suffered adverse side effects.
Pensions & other post-employment benefits – actuarial assumptions generated by management (expected mortality rates, return on plan assets, future salary increases, etc.). The entity employs a significant number of employees and provides benefits.
Property, plant & equipment – estimated useful lives and impairment tests
Goodwill – impairment tests. The entity has a significant amount of goodwill arising through acquisitions.
Other intangible assets – estimated useful lives, impairment tests, fair value of internally generated intangible assets. Since the company develops and patents drugs, significant funds are expended on intangible assets.
Impairment of non-current assets - assessment of whether the asset is overvalued
Taxation – tax issues with revenue authorities requires management to estimate amount of tax required to be paid
2-5 IAS 1 defines materiality. Compare the definition to the North American definition. Why is it important to relate the concept of materiality to the users?
IAS 1 materiality:
Material omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements.
Canadian GAAP materiality:
Materiality is the term used to describe the significance of financial statement information to decision makers. An item of information, or an aggregate of items, is material if it is probable that its omission or misstatement would influence or change a decision. Materiality is a matter of professional judgment in the particular circumstances.
The definitions under both IAS 1 and Canadian GAAP are virtually identical.
It is important to relate the concept of materiality to the users because materiality is assessed in the context of users. An item is considered material if its omission or misstatement could influence the decisions of the users. Therefore, one must be aware of the attributes of the users and how their decisions may be influenced by a material misstatement or omission.
2-6 Access IAS 1 (through the school’s library) and identify the level of knowledge expected of a typical user of the financial statements. Does this differ at all from knowledge required by Canadian and U.S. GAAP?
Level of knowledge:
[U]sers are assumed to have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence.
No, this definition does not differ at all from knowledge required by Canadian or U.S. GAAP (see below for definitions).
Canadian GAAP: Users are assumed to have a reasonable understanding of business and economic activities and accounting, together with a willingness to study the information with reasonable diligence.
U.S. GAAP: US GAAP presently relies on the AICPA auditing guidance for the definition and there is debate over whether this needs to be incorporated into GAAP.
2-7 Access the website(s) identified on the inside back cover of this book and prepare a concise summary of the differences that are flagged throughout the chapter material.
(1) Fair presentation and compliance with IFRS
- IAS 1 requires departures from the requirement to follow GAAP where departure is necessary for fair presentation.
(2) Statement of comprehensive income
More possible choices of presentation of the statement of comprehensive income under Canadian GAAP.
Can be presented as a separate financial statement or in the statement of changes in equity under IFRS; under US GAAP may also be presented with the income statement.
(3) Extraordinary items
IAS 1 does not allow for separate presentation of extraordinary items; Canadian and US GAAP permit separate presentation of extraordinary items.
Solutions Manual-IFRS Primer-Chapter 2
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