LECTURE 3: QUESTION 1: You are a trainee accountant at the audit - - PDF document

LECTURE 3: QUESTION 1: You are a trainee accountant at the audit firm We Like Clerks Inc. Your fellow trainees have been debating some accounting issues and have approached you for your views on the following: Description Note Amount Intangible asset - fishing licence 5 ? NOTES:

• 5. Kiwi Ltd purchased a fishing licence on 1 July 2018. In terms of the licence, the holder

is allowed to catch 25 000 fish per month until 31 December 2020. Industry regulations governing the transfer of fishing licences state that Kiwi Ltd may only commence fishing on 1 August 2018 even though it obtains legal ownership of the licence on 1 July 2018. The fishing licence had a fair value of R2 150 000 and R2 450 000 on 1 July 2018 and 1 August 2018 respectively. Kiwi Ltd paid for the fishing licence by issuing 50 000 ordinary shares on 1 July 2018. Kiwi Ltd’s shares traded at R52 per share and R48 per share on 1 July 2018 and 1 August 2018 respectively. REQUIRED: (a) For note 5: Your fellow trainees would like to know how to account for the fishing licence on initial recognition in the financial statements of Kiwi Ltd. (10)

LECTURE 3: SOLUTION 1: Note 5: Issue 1: Does the fishing license meet the definition of an asset/expense? Issue 2: When should we recognise the fishing license – 1 July/1 August 2018? Issue 3: At what amount should we recognise the fishing license in our financial statements? Issue 1: An asset is a resource controlled by the entity from which future economic benefits are expected to flow. (1) The fishing license represents a resource since it gives the company access to future benefits in the form of being able to catch the fish and sell it to generate revenue. (1) The entity has control through the license which gives the entity the legal right to catch fish for a specified period of time. The entity is able to restrict access to other parties through the license which gives the entity the SOLE right to catch fish in a particular part of the ocean. (1) The past event is the obtaining of the license. (1/2) Future economic benefits: yes, in the form of increased revenue from the sale of the fish. (1) Recognition criteria: Probability of future economic benefits: yes, it is more likely than not that the entity will sell the fish caught and be able to generate revenue in the future. (1/2) Reliably measured: The fair value of the fishing license can be determined (given in the question). (1/2) Issue 2: The entity should recognise the asset on the day the significant risks and rewards pass to the buyer. (1) Legal ownership transfers on 1 July 2018. Kiwi Ltd may only commence fishing on 1 August

• 2018. On 1 July 2018 the risks associated with the asset (license) passes to Kiwi Ltd (1);

however the rewards only pass on 1 August 2018 as Kiwi Ltd can only commence fishing from this point onwards and therefore can only start generating the rewards (revenue) from 1 August 2018. (1) This means the 1 August 2018 is the date when the risks and rewards pass to Kiwi Ltd and therefore Kiwi Ltd should recognise the fishing license in their accounting records on 1 August 2018. (1) (student can also make good argument for 1 July 2018)

Issue 3: In terms of IFRS 2, share based payments; Kiwi Ltd is receiving an asset and in exchange settling the amount payable through issuing their own equity instruments. (1) - this meets the definition of a share-based payment. In terms of Par 10 of IFRS 2, share based payments, for equity settled share-based payment transactions, the entity shall measure the goods or services received and the corresponding increase in equity, directly at fair value of the goods or services received, unless the fair value cannot be estimated reliably. (1) The fair value of the license can be measured reliably and therefore Kiwi Ltd will measure the transaction at R2 450 000 on 1 August 2018 (or the 1 July 2018 value as an alternative). (1) Limited to: (10) Lecture 3 Question 2: MHL required short-term financing during the 2018 financial year and accordingly issued 1 000 convertible debentures with a face value of R10 000 per debenture at par value on 1 July 2018 for cash. The debentures bear coupon interest at 10% per annum. Interest is compounded and payable annually. (1- Interest- FL) Each debenture is convertible on 30 June 2021, at the option of the holder, into a number of

• rdinary shares of MHL worth R10 000 at that date (3- Option- FL). Debentures that are not

converted will be settled in cash at par value on 30 June 2021. (2- Capital- FL) Based on his past experience with similar transactions, the financial director of MHL is of the

• pinion that the debentures will all be converted into ordinary shares. He has proposed that the

full proceeds from the debenture issue be classified as equity. REQUIRED: (a) Discuss, with reasons, the appropriateness of the recognition and measurement of the convertible debentures issued on 1 July 2018 by Manufacta Holdings Ltd as proposed by its financial director. Should you consider the proposed treatment inappropriate, you should recommend an appropriate alternative. Your solution should address the classification of the convertible debentures in terms

• f IAS 32 Financial instruments: Presentation by Manufacta Holdings Ltd as well as

the appropriate recognition and measurement in terms of IFRS 9, where applicable. Ignore all issues relating to note disclosure and tax. (18)

SOLUTION FOR QUESTION 2: The convertible debentures comprise an obligation to pay interest, a potential obligation to pay the capital and an embedded conversion option. (1) These components should be classified separately as financial liabilities or equity instruments based on the substance of the contractual arrangement and the definitions of ‘equity instrument’ and ‘financial liability’ per IAS 32.15. (1) The instrument has a debt element as MHL is obliged to pay interest annually and therefore meets the definition of a liability. (1) Furthermore, the holder of the instrument has a right to choose cash payment at the maturity of the contract. As MHL does not have an unconditional right to avoid making this payment, the potential

• bligation to pay capital at maturity therefore meet the definition of liability

(1) (1) The conversion option is a derivative on MHL’s own shares. The conversion option will meet the IAS 32 definition of equity only if it will or may be settled in a fixed number of shares in exchange for fixed amount of cash (IAS 32.11) (1) (1) Since the debentures will be converted into ordinary shares worth R10 000, the number of

• rdinary shares is variable and not fixed.

(1) The entire debenture should therefore be classified as debt in terms of IAS 32 and the financial director’s proposal is inappropriate. (1) (1) Based on the information presented and as it is unlikely given the nature of MHL’s operations that there are underlying assets backing the debenture that are measured at FVTPL, it is unlikely that the debentures can be designated upon initial recognition as FVTPL. (2) The debentures should be classified as “other liabilities”. (1) The debentures should be measured initially at fair value (including any transaction costs). Any gain or loss on the initial recognition of the debentures (‘day 1 profit/loss’) as a result of the fair value being different to the net proceeds received, can be recognised in profit or loss as the fair value of the debentures would have been calculated using observable market data (presumably, a market-related interest rate on similar debentures) (IFRS 9.B5.1.2A). (1) (2) Subsequent to initial recognition, the debentures should be measured at amortised cost, using the effective interest method. (1) (1) Maximum 18

QUESTION 3: SCROOGE LIMITED On 1 January 2017, Scrooge Limited granted options to acquire 1 000 Scrooge Limited ordinary shares to each of Scrooge Limited’s 2 000 employees. The strike price of the options is R10 per share which equates to the fair market value of Scrooge Limited’s ordinary shares on grant date. On grant date, the options had a fair value of R5 each before considering the vesting condition. The options vest only if the employees remain in the employ of Scrooge Limited for three years after the grant date (i.e. a service condition). At grant date, it was anticipated that 300 employees would leave during the vesting period. 110 Employees left during 2017. At 31 December 2017, it was anticipated that a further 200 employees would leave during the vesting period. During early January 2018 the market price of Scrooge Limited shares plummeted causing Scrooge Limited’s employees to become demotivated. To improve morale, Scrooge Limited decreased the strike price of the options from R10 to R8 (i.e. Scrooge Limited repriced the

• ptions). This caused the fair value of the options to increase by R3 immediately. There was no

change in the vesting period. 80 Employees left during 2018. At 31 December 2018 it was anticipated that a further 100 employees would leave during the vesting period. Year end - 31 December. REQUIRED: (a) (b) (c) (d) Prepare the journal entries that Scrooge Limited should process to record the share- based payment transactions in its general ledger for the year ended 31 December 2018. Provide brief reasons in support of the amount of the transaction (i.e. measurement

• nly).

Discuss how your answer to (a) above would be different had Scrooge Limited (instead

• f changing the strike price of the option) cancelled the existing options and issued

replacement options with a strike price of R8 (all other terms and conditions remain the same). Discuss how your answer to (a) above would be different had Scrooge Limited (instead

• f changing the strike price of the option) cancelled the existing options on

31 December 2018 by paying the remaining employees R6.00 per option held. The fair value of the options at 31 December 2018 was R3 before considering the effects of expected attrition. Discuss how your answer to (a) above would be different had Scrooge Limited increased the strike price of the option by R2 (rather than decreasing the strike price by R2). (4) (1) (7) (3)

SOLUTION FOR QUESTION 3 a) 31 December 2018 Dr Staff cost (P/L) 2 883 333 Cr Options to acquire ordinary shares (SCE) 2 883 333 Recognising service from employees in return for the original equity compensation [1 000 options x (2 000 employees – 110 left – 80 left – 100 expected to leave x R5,00 each on grant date x 2/3 years] minus [1 000 options x (2 000 employees – 110 left – 200 expected to leave x R5,00 each) x 1/3 years expensed during 2017] Dr Staff cost (P/L) 2 565 000 Cr Options to acquire ordinary shares (SCE) 2 565 000 Recognising service from employees in return for the repricing of the equity compensation benefits [1 000 options x (2 000 employees – 110 left – 80 left – 100 expected to leave) x R3,00 incremental fair value per option x ½ years vesting period] b) The answer would be identical to that presented under requirement (a) above (IFRS 2 par. 28 (c)). This is so because in substance the original share options have been repriced. c) The cancellation of the options is accounted for as an acceleration of vesting (IFRS 2 par. 28 (a)). Therefore, profit or loss for the year ended 31 December 2018 would be charged with R5 733 333(W1) with the corresponding increase in the amount of equity (attributable to the option holders). As the option holders have no further claim against the net assets of the company (i.e. because their options have been cancelled) the cumulative amount of equity attributable to them should be transferred directly to equity attributable to the ordinary shareholders. In accordance with IFRS 2 par. 28(b) the R10 860 000 [calculation: (R6,00 paid x (2 000 employees granted options – 110 left – 80 left)] paid to the employees for the cancellation is accounted for as follows: granted options – 110 left – 80 left)] paid to the employees up to the fair value of the options (ie R3,00 each on settlement date) is debited against equity as it is in substance a repurchase of equity; and granted options – 110 left – 80 left)] paid that is in excess of the fair value of the options on cancellation date is charged against profit or loss for the period. This payment is in excess of the fair value and is therefore in substance an additional reward for past service (hence the expense).

This expense is in addition to the expense in respect of the deemed accelerated vesting of the

• ptions discussed in the previous paragraph.

d) In accounting for the share-based payment modifications to the terms and conditions on which the equity instruments (i.e. the options) were granted that are not beneficial to the employees are

• ignored. This is so as IFRS 2 par. 27 requires that “The entity shall recognise, as a minimum, the

services received measured at the grant date fair value of the equity instrument granted, unless those equity instruments do not vest because of failure to satisfy a vesting condition (other than a market condition) that was specified at grant date.” The answer to requirement d) would therefore differ to the answer to requirement a) to the extent that the answer to requirement a) includes the incremental grant (ie the answer to requirement d) would ignore the modification altogether and accordingly the second journal entry in the answer to requirement a) would fall away).