The Management of Steelyone Co - Assignment Example

Financial Reporting Introduction The management of Steelyone Co. is concerned about the valuation of its non- current and current assets in the company’s non- finalized financial statements as on December 31, 2007.The management intend to make fresh valuation on the basis of directions provided under International Accounting Standards (IASs). The efforts in this direction have been made in three sectors. Sector I details the rules, directions, and relevant demands of respective IAS in respect of the concerned assets. Sector II values the assets following the directions, rules and requirements of those IASs stated under sector I. Sector III is a report justifying the use of each IAS in respect of valuation of the assets to be shown in the financial statements of the company. Sector I Valuation Requirements as per International Accounting Standards The assets held by Steelyone and Co. come under the main categories of Property, Plant and Equipment, Inventories, and Investments (shares only are held). Accordingly the International Accounting standards applicable with regard to valuation of these assets are investigated and discussed here under showing necessary requirements, wherever required: A. Revaluation and depreciation requirements with regard Property, Plant and Equipment Revaluation accounting standards: The provisions of IAS 16.31, 16.36, 16.39, 16.40, and 16.41 are applicable to revaluation of Property, plant, and equipments. In accordance with IAS 16 “Property, plant and equipment is initially recognized at cost. Subsequent to initial recognition, property, plant and equipment is carried either at: Cost, less accumulated depreciation and any accumulated impairment losses, or Revalued amount, less subsequent accumulated depreciation and any accumulated impairment losses. The revalued amount is fair value at the date of revaluation. The choice of measurement is applied consistently to an entire class of property, plant , and equipment. Any revaluation increase is credited directly to revaluation surplus in equity, unless it reverses a revaluation decrease previously recognized in profit or loss. However, the decrease is debited directly to revaluation surplus in equity to the extent of the credit balance in revaluation surplus in respect of that asset.” (Summary of IAS 16)1 Accordingly, the basic rules for revaluation of Property, plant and equipment, as per IAS under: 1. The entity has option to revalue asset at fair value after initial recognition. 2. Revaluation of the assets, once adopted, has to be carried on regular basis on each balance sheet date. That is why fair value of asset would be its carrying value. 3. Revaluation is applicable to entire class of asset, and not to a single time in that class of assets. 4. Increased value of asset on revaluation should be treated as part of equity under the head ‘Revaluation Surplus’. But if a revaluation decrease the value was earlier recognized as expense, then such revaluation increase will be treated as income to be credited to income statement. However whenever there is a decrease in value over revaluation, the excess of decrease over revaluation surplus, if any, created earlier, has to be charged to expense. For example a PPE asset is valued at $500000, with a corresponding credit of $20000 standing to ‘Revaluation Surplus’ as at Dec. 31, 2007. If on revaluation on Dec. 31, 2008, fair value is found to be say $470000, then under noted journal entry will be passed on revaluation on Dec. 31, 2008: Dr. Cr. Revaluation Surplus $20000 Revaluation Deficit (expense a/c) $10000 Asset Account $30000 Revaluation Surplus with an earlier credit balance shown as part of equity will be reduced to Nil balance; and Revaluation deficit of $10000 would be charged to Income statement under the head ‘other expenses’ after operational income. Depreciation accounting Standards The relevant provisions of IAS 16 that deal with depreciation of PPE are IAS 16.48, 16.50, 16.51, 16.60 & 16.61. In accordance with these provisions “Depreciation is applied on component basis. That is to say each part of an item of property, plant, and equipment with a cost that is significant in relation to total cost of the item is depreciated separately. The depreciable amount of an asset is allocable on systematic basis over the useful life of the asset Impairment is recognized in accordance with IAS 36 Impairment of Assets.” (Summary of IAS 16)2 Therefore, the basic rules to be followed with regard to depreciation of PPE as per IAS 16 are as under: 1. The method of depreciation selected should correspond to the manner in which economic benefits of the asset are consumed by thee entity. We can select any of the recognized methods of depreciation. 2. Depreciation on assets should start from the day the assets is available for use for the purposes of entity; and should continue till the assets is sold, discarded or derognized. 3. The method adopted for depreciation should allocate the depreciation over the use life of the asset in a systematic manner. 4. It is required that depreciation method should be reviewed ever year. Suppose the pattern with regard to consumption of benefits of assets has been changed, the method of depreciation should be changed prospectively. 5. Similarly, every year a review of residual value and the useful of assets shall be made. Change in deprecation because of changes in expectation of useful life and/ or salvage value shall also be dealt with prospectively. B. Inventory valuation standards As per International Accounting Standard 2.9, “Inventories are required to be stated at the lower of cost and net realizable value.” (Deloitte, IAS Plus, IAS 2 Inventories)3 However, the basic rules for the valuation of inventories as per IAS 2 are detailed as under: 1. Cost of inventory shall be its purchase price plus the cost of converting of inventory into its present condition of use. The transportation costs and other costs of bringing the inventory to present location shall for part of the purchase price of inventory. 2. It has been very clearly specified that inventory cost shall not include its storage cost (like godown rent), abnormal wastage, administrative overheads, selling costs, foreign exchange fluctuations, and interest costs on purchases of inventory at deferred payments. The cost of financing the purchases is not the part of purchase cost and that is why interest on installment payments of purchases does not for part of purchase cost. 3. Net releasable value NRV) has been defined by IAS 2.25, as the estimated selling price of inventory in the ordinary course of business. The following costs shall be deducted from its estimated sales value for calculating its: The cost of completion of inventory, and The estimated cost of sales of the inventory. 4. IAS 2 has added an interesting feature in the calculation of quantitative stock of inventory. Only FIFO and Average stock methods are allowed to find quantitative stock of inventory on a particular date. The use of LIFO method has been banned after 2003. 5. The method of specific identification shall be used in cases of non- similar (non- interchangeable) items, while making quantitative stock calculations of such items. 6. Inventory does not include work in progress in case of construction contracts, financial instruments, and agricultural biological assets. C Standards relating to valuation of Investments in shares An equity instrument or share of a company is a financial instrument.According to IAS394 ‘Financial Instrument’ is a “contract that gives rise a financial asset of one entity and a financial liability or equity instrument of another entity” That means shares are financial assets and this is further corroborated by the definition of term ‘financial asset’ provided by IAS 39. As per the definition of the term ‘financial assets includes ‘an equity instrument of another entity.’ Accordingly shares held by Steelyone and Co shall be valued as ‘financial assets’ and rules with regard to such valuation are as under: 1. Financial assets (shares under this write up) need to be classified into following four categories for valuation purposes: a) Financial assets at fair value through profit or loss: Financial Assets may be designated at the time of their acquisition to be valued fairy through resultant effect on Income statement; or those are held for trading, where financial assets are treated like any other trading activity for short term profits or loss, valued as any other trading asset. b) Available for sales financial assets (AFS): First of all these are non – derivative financial assets those are so designated at initial recognition. Those are valued at fair value as on date of balance sheet with effects of changes being shown in the statement of equities. However revenue earnings from these assets like interest, exchange fluctuations, and impairment losses are shown in the income statement. c) Loans and Receivables: These are financial assets that are recognized as assets at fair value at initial recognition. However, these are amortized, and thus are reflected at amortized cost in the balance sheet. d) Held- to- maturity investments: These are not initially recognized as meant for trading purpose or held as available for sale. These are recognized at cost and are amortized. Thus at the date of balance sheet those appear at amortized cost. 2. The entity has option to report the financial asset at fair value at initial recognition with its effect reflected on income statement. 3. After the initial recognition financial assets are measured at fair value except loan and receivables, held to maturity and derivatives as stated above. 4. Fair value has been defined as the value at which the financial asset can be exchanged with willing parties at arms length transaction. However in determining the fair value, IAS 39 has settled a hierarchy as: Quoted active market value, fair value by using valuation technique in inactive market, and reasonably estimated fair value where there is no market for financial assets. 5. Financial assets can also be measured for impairment only when objective evidence are there to measure the impairment. D. Presentation of Current Assets IAS 1 now covers the presentation of current assets With regard to Trade Receivables or other current assets presentation has to be fair, on accrual basis, and as a going concern of the entity. That means all bad debts, provision with regard to bad debts, and doubtful debts has to taken care of. The presentation of current assets has to be in order of liquidity. Sector II Valuation of Assets 1. Freehold Property This has been reported at cost since its initial recognition on 31st December 2003, and consists of land valued at ₤ 7,000,000 and rest of other properties at $13,000,000. The company may revalue the property at its fait value. The existing fair value of this property is that was at end of second year and that value is land at ₤ 8,480,000, and thus building at 18,052,0000, out of the total value ₤ 20, 200, 0000. The increased value would be credited to ‘Revaluation Surplus’ in equities through following journal entry. Dr Cr Land 1,480,000 Other Properties 180,520,000 Revaluation Surplus 182,000,000 2. Plant & Machinery All machineries installed at different intervals have been reported at initial cost. As information about fair value of machineries is not available after the initial recognition, it appears that the company intends to report machineries at cost model. Also once the revaluation model is adopted, then the company needs to revalue fair values at every balance sheet date. In absence of such information about fair values of machineries, the valuation under cost model at 31/12/2007 is calculated as under: 3. Vehicles 4. Investments Current market value of shares in Cutting Edge Plc. is ₤1,000,000 against the original cost of ₤ 915,000. Assuming these shares are held as ‘Available For Sale’ (AFS), these will be valued at fair market value of ₤1,000,000. The difference between the market value and cost will be considered as part of Equities. 5. Inventories As per IAS 2, inventory will be reported and valued at cost or Net Realizable value (NRV), whichever is lower. Following this guidance of IAS 2, the inventory as on 31.12. 2007 is valued as under: Following lower of cost or NRV, the total value of inventories has been lowered by its original valuation of ₤2,222,000 6. Trade Receivables Total trade receivable as on December 31, 2007 are ₤1,062,000. It is stated that realizations of receivables were to the tune of 93% and 96% of trade receivables during last two preceding years. We may take an average of 94.5% or as the percentage of bad debts is going up, we may take the same average of realization as was in the immediately preceding years, i.e., 96%. That means a provision of bad and doubtful debts is required to the tune of 4% of total receivables. This provision will be reflected under current liabilities, and the net value of total receivable as at December 31, would be as under: Total trade receivables ₤1,062,000 Less Provision of doubtful debts 42,480 Value of Trade Receivables ₤1,019,520 Sector 3 Report justifying the standard used As required the assets reported in the balance sheet of Steelyone and Co. as at December 31, 2007 have been valued following the directions laid down in International Accounting Standards. The circumstance and applicability of connected International Accounting Standards in respect of each valuation performed have been justified in the following paragraphs. 1. Freehold Property The company has originally recognized the property at cost on the date of its purchase. The ‘cost model’ adopted in respect an item of PPE can be changed to ‘revaluation model’ as stated in the provisions of IAS 16.31. The condition required on adopting a different model of valuation at subsequent recognition is that all onward valuation in the financial statements of the company shall be following the adopted fair value model till the life of the assets. As required by IAS 16.41, the resultant increase in value of freehold property has been transferred to statement of equity through a ‘revaluation surplus’ account. 2. Plant & Machineries Entire machineries under Plant and Machinery has been valued at cost following the option available as per IAS 16. Rolling machine has been depreciated under unit-of- production method of deprecation as this method charges depreciation expense in each period based on the asset capacity that is used. Thus this method satisfies the needs of IAS 16.60 that directs that deprecation method should reflect the pattern in which economic benefits of the assets are consumed. The same is the case with depreciation for ‘Drawing Equipment’ where unit of production is the number of draws during its useful life. However in cases of Furnace and Storing Equipment, straight line method has been adopted in view of the fact that by applying this method the deprecation has been allocated in a systematic manner over the useful life of assets as has been the basic requirement of IAS 1.50. The cost of repairing the inner layer of furnace has been expensed with because of the recurring nature of the expense, and also because such expense is providing benefit for one month on an average. 3. Vehicles All the six Lorries have been valued and reported following cost model as per IAS 16.30. Further, the depreciation on each lorry has been charged on the basis of mileage covered following unit of production method. This method of depreciation satisfies the needs of IAS 16.60 that specifies that deprecation method should reflect the pattern in which economic benefits of the assets are consumed. 4. Investments Shares held by the company in Cutting Edge Plc. are treated as financial assets as per definition of financial instruments provided in IAS 39. Further those are assumed as ‘Available for Sale’ (AFS) purposes. Accordingly those are valued at fair value provided as per current market valuation. The increase in value of shares because of its fair value valuation would form part of equity under the statement of equity to be presented as per IAS 1. 5. Inventories IAS 2 deals with inventory valuation. It requires the entity to report inventory at cost or at its Net Realizable Value (NRP), which ever is lower. Following this each item of inventory has been compared in respect of its cost and NRV, and the lower of the two is taken for its valuation. 7. Trade Receivables IAS 1 describes assets to be presented in entity’s financial statement as a going concern following accrual method, and also representing a fair view. In order to provide a fair view trade receivables have been valued at after the making a provision for doubtful debts. The provision for doubtful debts has been based on previous year’s collection performance. References: 1 1 Summary of IAS 16, viewed on March5, 2008, http://www.cpaireland.ie/UserFiles/File/Technical%20Resources/Financial%20Reporting%20Standards/IAS/IASB%20Summaries/ias%2016.pdf 2 ibid, Summary of IAS 16 3 Deloitte, IAS Plus, International Accounting Standards IAS 2, http://www.iasplus.com/standard/ias02.htm 4 Deloitte, IAS Plus International Accounting Standards IAS39, Financial Instruments: Recognition and Measurement, Summaries of International Financial Reporting Standards, page, viewed on March 27,2008, http://www.iasplus.com/standard/ias39.htm Read More