AT Group Ltd is preparing its financial statements to 30th June 2015. The following situations have been identified by an impairment review team;
On 1st July 2014, AT Group Ltd acquired the whole share capital of two subsidiary companies, Accra Ltd and Tema Ltd, in separate acquisitions. Consolidated goodwill was calculated as follows;
. Accra Ltd Tema Ltd
. GH¢’000 GH¢’000
Purchase Consideration 24,000 9,000
Estimated fair value of net assets (16,000) (6,000)
Consolidated goodwill 8,000 3,000
Required:
Advise, with numerical illustrations where possible, how the information in (i) to (iii) below would affect the preparation of AT Group Ltd.’s consolidated financial statements to 30th June 2015.
i) A review of the fair value of each subsidiary’s net assets was undertaken in June 2015. Unfortunately both companies’ net assets had declined in value. The estimated value of Accra Ltd.’s net assets as at 1st July 2014 was now only GH¢15,000,000. This was due to more detailed information becoming available about the market value of its specialized properties. Tema Ltd.’s net assets were estimated to have a fair value of GH¢1,000,000 less than their carrying value. This fall was due to some physical damage occurring to its plant and machinery. (4 marks)
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On the acquisition of a subsidiary, the purchase consideration must be allocated to the fair value of its net assets with the residue being classed as goodwill (or negative goodwill if the assets have a greater fair value than the purchase consideration. IFRS 3 revised Business Combinations recognizes that it is not always possible to accurately determine the value of some assets at the date of acquisition and therefore allows a measurement period up to the end of the first full reporting period following the period of acquisition. As the revision to the value of Accra Ltd.’s assets was due to more detailed information becoming available, the fall in its asset values should be treated as an adjustment to provisional valuations made at the time of acquisition. In effect the net assets and goodwill should be restated to GH₵15,000,000 and GH₵9,000,000 respectively; the fall of GH₵1,000,000 is not an impairment loss and should not be charged to the income statement. The above assumes that the recoverable value of the company as a whole is greater than GH₵24,000,000.
The fall in value of Tema Ltd.’s assets is the result of events that occurred after the acquisition (i.e. physical damage to the plant) and this does constitute an impairment loss. The plant and machinery and machinery should be written down to its recoverable amount and the loss charged to the income statement. On the assumption that the recoverable value of the company as a whole has not fallen, goodwill will not be affected.
ii) AT Group Ltd has an item of earth moving plant, which is rented out to companies on short-term contracts. Its carrying value, based on depreciated historical cost is GH¢400,000. The estimated selling price of this asset is only GH¢250,000, with associated selling expenses of GH¢5,000. A recent review of its value in use based on its forecast future cash flows was estimated at GH¢500,000. Since this review was undertaken, there has been a dramatic increase in interest rates that has significantly increased the cost of capital used by AT Group Ltd to discount the future cash flows of the plant. (6 marks)
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On the basis of the original estimates, AT Group Ltd.’s earth – moving plant was not impaired, the value in use of GH₵500,000 being greater than its carrying value. However due to the dramatic increase in interest rates causing AT Group Ltd.’s cost of capital to increase, the value in use of the plant will have to be recalculated. As the discount rate has risen this will cause the value in use to fall. There is insufficient information to be able to quantify this fall. If the new discounted value is above the carrying value of GH₵400,000 there is still no impairment. If it is between GH₵245,000 and GH₵400,000, this will be the recoverable amount of the plant and it should be written down to this value. As the plant can be sold for GH₵250,000 less the selling costs of GH₵5,000; then GH₵245,000 is the least amount that the plant should be written down to even if its revised value in use is below this figure.
iii) AT Group Ltd is engaged in a research and development project to produce a new product. In the year to 30th June 2015, the company spent GH¢120,000 on research that concluded that there were sufficient grounds to carry the project on to its development stage and a further GH¢75,000 had been spent on development. At that date management having decided that they were not sufficiently confident in the ultimate profitability of the project wrote off all the expenditure to date to the income statement.
In the current year further direct development costs have been incurred of GH¢80,000 and the development work is now complete with only an estimated GH¢10,000 of costs to be incurred in the future. Production is expected to commence within the next few months. Unfortunately the total trading profit from sales of the new product is not expected to be as good as market research data originally forecast and is estimated at only GH¢150,000. As the future benefits are greater than the remaining future costs, the project will be completed, but due to the overall deficit expected, the directors have again decided to write off all the development expenditure. (5 marks)
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The treatment of the research and development costs in the year to 30th June 2015 was correct due to the element of uncertainty at that date. The development costs of GH₵75,000 written off in that same period should not be capitalized at a later date even if the uncertainties leading to its original write off are favourably resolved. The treatment of the development costs in the year to 30th June 2015 is incorrect. The directors’ decision to continue the development is logical as at the time of the decision the future costs are estimated at only GH₵10,000 and the future revenues are expected to be GH₵150,000. It is also true that the project is now expected to lead to an overall deficit of GH₵135,000 (120+75+80+10-150 in GH₵’000). However at 30th June 2015, the unexpensed development costs of GH₵80,000 are expected to be recovered. Provided the criteria in IAS 38 Intangible
Assets are met these costs of GH₵80,000 should be recognized as an asset in the statement of financial position and matched to the future earnings of the new product. Thus, the director’s logic of writing off the GH₵80,000 development costs at 30th June 2015 because of an expected overall loss is flawed. The directors do not have the choice to write off the development expenditure.