ASSETS AND LIABILITIES QUESTION AND ANSWERS

QUESTION 1

Distinguish between a finance lease and an operating lease indicating how they should be treated in the financial statements as per International Accounting Standard (IAS) 17

“Leases”.

Finance leases – A lease that transfers substantially all the risks and rewards to ownership of an asset.

Lessors shall recognise assets held under a finance lease in their balance sheets and present them as a receivable at an amount equal to the net investment in the lease. The recognition of finance income shall be based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment in the finance lease.

Manufacturer or dealer lessors shall recognise selling profit or loss in the period, in accordance with the policy followed by the entity for outright sales. If artificially low rates of interest are quoted, selling profit shall be restricted to that which would apply if a market rate of interest were charged. Costs incurred by manufacturer or dealer lessors in connection with negotiating and arranging a lease shall be recognised as an expense when the selling profit is recognised.

Operating lease – Lease other than a finance lease. Lease payments under an operating lease shall be recognised as an expense on a straight line basis over the lease term. Lessors shall present assets subject to operating leases in their balance sheets according to the nature of the asset. The depreciation policy for depreciable leased assets shall be consistent with the lessor’s normal depreciation policy for similar assets, and depreciation shall be calculated in accordance with IAS 16 and IAS 38. Lease income from operating leases shall be recognised in income on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern in which use benefit derived from the leased asset is diminished

 

QUESTION 2

In the context of international Accounting Standard (IAS) 39 “Financial instruments”. Distinguish between a financial asset and financial ability.

asset is any asset that is:

  • Cash
  • An equity instrument of another entity
  • A contractual right to receive cash or other financial from another entity. Financial liability: – It is any liability that involves a contractual obligation to deliver cash or another financial asset to another entity or to exchange financial assets/liabilities .with another entity under conditions that is potentially unfavourable to the entity.

 

QUESTION 3

Differentiate between “taxable temporary differences” and “deductible temporary differences”

Taxable temporary differences are temporary differences that will result in taxable amount in determining taxable profit (loss) of future periods when the carrying amount of the asset or liability is recovered or settled while deductible temporary differences are temporary differences that will result in amounts that are deductible in determining taxable profit (loss) of future periods when the amount of asset or liability is recovered or settled.

QUESTION 5

Distinguish between “deferred tax liabilities” and “deferred tax assets”.

Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:

  • Deductible temporary differences.
  • The carry forward of unused tax losses.  The carry forward of unused tax credits.

QUESTION 6

Distinguish between a finance lease and an operating lease.

A finance lease transfers substantially all the risks and rewards incidental to ownership of an asset to the lease while an operating lease is any other lease other than a finance lease.

QUESTION 7

Outline the four main categories of financial instruments in the context of International Accounting Standard (IAS) 39.

Types of financial instruments: Financial instruments are contracts that give rise to financial assets of one entity and financial liability or equity instruments of another entity.

The main categories of financial assets are:

  • Financial Assets at a fair value though profit and loss (FVPL) – these are financial assets which are acquired with the intention of resale. Include shares and loan stocks which are traded on a stock exchange and derivative having a net cash inflow.
  • Held to maturity (HTM) – these are financial assets that are acquired with the intention to be held till the maturity or settlement date. Include the loan stocks traded in the stock in the stock exchange with the intention to hold till they mature.
  • Loans and Receivables (L/R) – these are financial assets which are acquired with the intention to be held till maturity date although no active market is involved.
  • Available for sale (AFS) – this is normally a default category for other financial assets that the firm may wish to classify as available for sale. Include shares and loan stocks not traded in the stock exchange, loans and shares issued by private companies.

QUESTION 8

With respect to International Accounting Standard (IAS) 37 ,provisions ,contingent liabilities and contingent Assets

Distinguish between “provisions” and “Contingent liabilities” 

A provision is liability of uncertain timing or amount ( a liability being a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resource embodying economic benefits) A contingent liability is a possible obligation that arises from past events and whose existence willbe confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity or a present obligation that arises from past events but is not recognized because:

  • It is not probable than an outflow of resources embodying economic benefits will be required tosettle the obligation or
  • The amount of the obligation cannot be measured with sufficient reliability.

 A provision shall be recognized in financial statement when;

An entity has a present obligation as a result of past event.

It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation

A reliable estimate can be made of the amount of the obligation.

 

Identify the three circumstances under which a provision should be recognized in the financial statements

  • It is probable that the future economic benefits associated with the item will flow to entity.
  • The cost of the item can be measured reliably.

If an asset’s carrying amount is increased as a result of revaluation, the increase shall be recognized in other comprehensive income and accumulation in equity under revaluation surplus. However, to the extent that the increase reverses a revaluation decrease of the same asset previously recognized in profit and loss then the increase shall be recognized in profit and loss.If an assets carrying amount is decreased as a result of a revaluation ,the decrease shall be recognized In profit or loss .However the decrease shall be recognized in other comprehensive income to the extend of any credit balance existing in the revaluation surplus in respect of that asset.

 

Matters to disclose with regard  to property ,plant and equipment stated at re valued amounts are. 

  • The effective date of revaluation
  • Whether an in depended valuer was involved
  • The methods and significant assumption applied in estimated the items fair values
  • The extend to which the items fair values were determined directly by reference to observable prices in

an active market or recent market transaction on arms lengths term

  • The carrying amount that would have been recognised had the asset been carried under the cost model.
  • The revaluation surplus indicating the change for the period and any restriction on the distribution of the balance to shareholders

 

Describe the accounting treatment of contingent liabilities in the financial statements

An entity shall not recognize a contingent liability

Unless the possibility of any outflow in settlement is remote, an entity should disclose for each class of contingent liability at the end of reporting period a brief description of the nature of the contingent liability and where, practicable.

  • An estimate of its financial effect.
  • An indication of the uncertainties relating to the amount of timing of any outflow; and The possibility of any reimbursement.

 

In the context of IAS 16 property, plant and equipment

Explain when the cost of an item of property ,plant and equipment should be recognized as an asset

  • It is probable that the future economic benefits associated with the item will flow to entity.
  • The cost of the item can be measured reliably.

Briefly describe the accounting treatment with respect to the increase in the carrying amount of an asset as a result of revaluation

If an asset’s carrying amount is increased as a result of revaluation, the increase shall be recognized in other comprehensive income and accumulation in equity under revaluation surplus. However, to the extent that the increase reverses a revaluation decrease of the same asset previously recognized in profit and loss then the increase shall be recognized in profit and loss.If an assets carrying amount is decreased as a result of a revaluation ,the decrease shall be recognized In profit or loss .However the decrease shall be recognized in other comprehensive income to the extend  of any credit balance existing in the revaluation surplus in respect of that asset.

Outline any two disclosure requirement for items of property, plant and equipment which are stated at revalued amounts

  • The effective date of revaluation
  • Whether an in depended valuer was involved
  • The methods and significant assumption applied in estimated the items fair values
  • The extend to which the items fair values were determined directly by reference to observable prices in

an active market or recent market transaction on arms lengths term

  • The carrying amount that would have been recognised had the asset been carried under the cost model.
  • The revaluation surplus indicating the change for the period and any restriction on the distribution of the balance to shareholders

Highlight four circumstances under which a legacy may fail

  • Ademption –specific legacy being not available
  • Lapse – The legatee predeceases the testator
  • Uncertainty –Uncertainty of subject matter the beneficiary or words
  • Disclaimer –The beneficiary rejects the gift.
  • Gift former spouse will fail.

QUESTION 11

With reference to IAS 36 (Impairment of Assets), identify any four circumstances that may indicate that an asset has been impaired.  

There has been a significant decrease in the market value of the asset in excess of the normal process of depreciation.

There has been a significant adverse change in either the business or the market in which the asset is involved.

Evidence is available that indicates that the performance of the asset will be worse than expected.

Where an asset is valued in terms of value in use and the actual cash flows are less than the  estimated cash flows before discounting.

Market interest rates or other market rates of return on investment have increased during the

period and the increases are likely to decrease materially and asset’s recoverable amount.

In the context of the International Accounting Standards Board’s Framework for the Preparation and Presentation of financial statements, identify and briefly explain any four qualitative characteristics of financial statements.

  • Understandability

An essential quality of the information provided in financial statements is that it’s readily understandable by users. For this purpose, users are assume d to have reasonable knowledge of business vand economic activities and accounting and a willingness to study information with reasonable diligence. however, information should not be excluded merely on the ground that its too difficult for certain users to understand.

  • Relevance

To be useful, information must be relevant to the decision making needs of users. Information has the quality of relebance when it influences the economic decisions of  users by helping them evaluate past, present or future events or confuirming, or correcting, their past evaluations.

  • Materiality

The relevance of information is affected by its nature and materiality. In some cases, the nature of information alone is sufficient to determine its relevance. For example, the reporting

of a new segement may affect the assessment of the risks and opportunities facing the entity irrespective of materiality of theresults achieved by the new segment in the reporting period. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.

  • Reliability

To be useful information has to be reliable. Information has the quality of reliability when it is free from material error and bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent.

 

Users must be able to compare the financial statements of an entity through time in order to uidentify trends in its financial position and performance. Users must also be able to compare the financial statements of diffrenet entities in order to evaluarte their relative financial position, performance and changes in financial position.

 

Faithful representation

To be reliable, information must represent faithfully the transaction and other events it either purports to represent or could reasonably be expected to represent.  Thus, for example, a balancesheet should represent faithfully the transactions and other events that result in assets, liabilities and equity of the entity at the reporting date which meet the recognition criteria.

 

Others include

Substance over form

  • Neutrality
  • Completeness

QUESTION 12

In the context of IAS 17 (Leases), briefly explain the meaning of the following terms:

Finance lease.

This is a lease that transfers substantially all the risks and rewards incident to ownership of an asset.  Title may or may not eventually be transferred.

Guaranteed residual value.

  • In the case of the lessee, that part of the residual value which is guaranteed by the lessee or by a party related to the lessee (the amount of the guarantee being the maximum amount that could, in any event become payable).
  • In the case of the lessor, that part of the residual value which is guaranteed by the lessee or by a third party unrelated to the lessor who is financially capable of discharging the obligations under the guarantee.

Contingent rent.

This is that portion of the lease payments that is not fixed in amount but is based on a factor other than just the passage of time (e.g. percentage of sales, amount of usage, price indices, market rates of interest).

Alternatively: (Assuming interest quoted is paid)

QUESTION 14

  The original IAS 12 did not refer explicitly to fair value adjustments made on a business combination and did not require an enterprise to recognize a deferred tax liability in respect of asset revaluations. The revised IAS 12 “income taxes” now requires deferred tax adjustments for these items and classifies them as temporary differences.

Required:

Explain the reasons why IAS 12 (revised) requires companies to provide for deferred taxation on revaluations of assets and fair value adjustments on a business combination irrespective of the tax effect in the current accounting period.

 

  • Fair value adjustment:

The issues is whether fair value adjustment in the purchase method of accounting give rise to deferred tax where the full provision method is used, some feel that deferred tax should not be provided on fair value adjustments because these adjustments are made as a consolidation entry only. Rarely are they taxable or tax deductible and therefore do not affect the tax burden of the company.

It is argued that providing for deferred tax on fair value adjustments is not an allocation of an expense but can be used as a smoothing device. Finally, the difference between the carrying amount of net assets acquired and their fair value is goodwill and therefore no deferred tax is required.

The arguments in favour of deferred tax are conceptual by nature. If the net assets of the acquirer are shown in the group accounts, then this will affect the post acquisition earnings of the group and tax should be excluded. Additionally, since an acquisition gives rise to no tax effect, the effective tax rate in the profit and loss account should not be distorted as a result of the acquisition. Thus deferred tax should as an adjustment to reflect the reduction in the value of the asset

  • Revaluation of Fixed Assets:

Can be seen as creating a further temporary difference because it reflects an adjustment of depreciation which is itself a temporary difference. Alternative view is that is a permanent difference as it has no equivalent within the tax computation. The revaluation is not a reversal of previous depreciation, simply that the remaining life of the asset will measure at a different amount. Deferred tax is a valuation adjustment and whilst a revaluation does not directly give rise to a tax liability, the tax status of the asset is inferior to an equivalent asset at historical cost and therefore provision or deferred tax should be made in order to reflect the true after tax cost of the asset.

The revalued asset would not attract the same tax allowances as an asset purchased for the same amount and therefore if deferred tax was not provided it would distort the post revaluation effective tax rate.

 

QUESTION 16

 IAS 12 (revised) “Income Taxes” requires an enterprise to provide for deferred tax in full for all deferred tax liabilities with only limited expectations. The original IAS 12, and the equivalent Kenyan Accounting Standard, allowed an enterprise not to recognize deferred tax assets and liabilities where there was reasonable evidence that timing differences would not reverse for some considerable period ahead; this was known as the partial provision method.

 The original IAS 12 did not refer explicitly to fair value adjustments made on a business combination and did not require an enterprise to recognize a deferred tax liability in respect of asset revaluations. The revised IAS 12 now requires deferred tax adjustments for these items and classifies them as temporary differences.

Required:

  • Explain why the IASC decided to require recognition of the deferred tax liability for all temporary differences (with certain exceptions) rather than allowing the partial provision method.

Under the partial provision method, deferred tax assets and liabilities were recognised where there was reasonable evidence that timing differences would reverse in the near future. The original IAS 12 permitted an enterprise not to recognize deferred tax assets and liabilities where there was reasonable evidence that timing differences would not reverse for considerable period ahead.

IAS 12 revised requires an enterprise to recognize a deferred tax liability or (subject to certain conditions) assets for all temporary differences with certain exceptions. IAS 12 is consistent with the principles which underlie the recognition of assets and liabilities in the balance sheet as laid down in the framework for the preparation and presentation of financial statements.

As per the framework an asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. A liability is a present obligation of the enterprise arising from past events the statement of which is expected to result in an outflow of resources embodying economic benefits.

 

The framework further provides the recognition criteria for assets & liabilities;

  • If it is probable that any future economic benefits associated with the asset or liability will fall to or from the enterprise.
  • The asset or liability has a value that can be measured with reliability.

 

The partial provision approach regards only the limited future of the liability rather than the complete life-span of the liability. This is an adhoc position rather than one based on the principles laid down in the framework for recognition of liabilities. The requirement of IAS 12 on the other hand, is consistent with the principles which underlie the recognition of assets and liabilities in the balance sheet as laid down in the framework for the preparation and presentation of financial statements.

  • Discuss the reasons why IAS 12 (revised) requires enterprises to provide for deferred taxation on revaluations of assets and fair value adjustments on business combination.

International Accounting Standards permit certain assets to be carried at fair value or to be revealed  (examples in IAS 16, property and plant equipment. IAS 38, Intangible assets, IAS 39, financial instrument Recognition and  measurement and IAS 40 investment property). In some jurisdictions, the revaluation or other restatement of an asset to fair value affects taxable profit (tax loss) for the current period. As a result the tax base of the asset is adjusted and no temporary differences arises. In other jurisdictions, the revaluation or restatement of an asset does not affect taxable profit in the period of the revaluation or restatement and consequently the tax base of the asset is not adjusted. Nevertheless the future recovery of the carrying amount will result in a taxable flow of economic benefits to the enterprise and the amount that will be deductible for tax purposes will differ from the amount of those economic benefits. The differences between the carrying amount of a revalued asset and its base is a temporary difference and gives rise to a deferred tax liability or asset. This is true even if;

  • The enterprise does not intend to dispose of the assets. In such cases the revalued carrying amount of the asset will be recovered through use and this will generate taxable income which exceeds the depreciation that will be allowable for tax purposes in future periods; or
  • Tax on capital gains is deferred if the periods of the disposal of the assets are invested in similar assets. In such cases the tax will ultimately become payable on sale or use of the similar assets.

 

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