Exercise 1:

a) Briefly explain the function of deferred taxes.

Deferred tax is an accounting measure accustomed to match the tax effects of
transactions with their ultimate accounting treatment. It is not one of taxes
that are levied by government on the company, but simply an application of
the accruals concept.
There are many differences between accounting standards (such as IFRS and
IAS Standards) and tax rules of certain jurisdiction. This causes accounting
profits to vary from taxable profits. Accrual concept states that tax effect of an
accounting transaction should be reported in the same accounting period in
which transaction itself takes place. So, an adjustment to the tax charge might
be required to match its effect with accounting treatment. This give rise to
deferred tax.
b) Explain the meaning of a temporary difference as it relates to deferred tax
calculation and provide three examples.
The difference between carrying amount of an asset or liability and its related
tax base is called temporary difference. The tax base of an asset or liability is
the 'amount accredited to an asset or liability for tax purposes'. (IAS 12,
Income Taxes)
Because of variations between accounting standards and tax rules of certain
jurisdiction, the accounting profits usually vary from taxable profits. Temporary
differences may mean that profits are reported in the financial statements
before they are taxable. On the contrary, it may mean that profits are not
reported yet but taxes are payable on them.
Examples:
 Intra-group profits in inventory that are unrealised for consolidation
purposes yet taxable in calculations of the group entity that made the
unrealised profit.
 Losses reported in the financial statements of company but related tax
relief is only available by carry forward against future taxable profits.
 Assets are revalued upwards using revaluation models in the financial
statements, but no adjustment is made for tax purposes.
c) The carrying amount of a machine is 100,000 € on 31.12.20X1. The fair value
of the machine is 150,000 €. The revaluation model for PPE is being applied.
Income tax rate is assumed to be 30%. The remaining useful life of the asset is
10 years with straight-line depreciation.
(1) Determine the tax base as well as temporary difference.
The tax base is the amount that will be allowable for tax purpose when entity
recovers the carrying amount of specific asset. As given information relating to
tax allowance is limited and will vary in each tax jurisdiction. We assume that
no allowance is claimed yet. So, in this case tax base equals the carrying
amount of machinery. Tax base will simply be €100,000.
As revaluation model is being applied to property, plant and equipment, the
machine will be revalued to its fair value. The depreciation is charged on
straight-line basis and it will be €15,000 (€150,000 / 10). Now it’s carrying
amount will be €135,000 (€150,000 - €15,000). The temporary difference will
be of €35,000 (€135,000 - €100,000)
(2) Does a difference represent a taxable or a deductible difference. Which
type of deferred tax position has to be recognized. State the journal entry.
As the carrying amount exceeds related tax base, the temporary difference is
said to be taxable temporary difference. The carrying amount exceeds the tax
base by €35,000 (€135,000 – €100,000). This temporary difference will give rise
to a deferred tax liability of €10,500 (€35,000 × 30%). Prior to the revaluation,
the carrying amount of the asset was €100,000. The asset was then revalued
using the revaluation model. Therefore, €35,000 (€135,000 – €100,000) of the
temporary difference relates to the revaluation.
Revaluation gains are recorded in other comprehensive income and so the
deferred tax charge relating to this revaluation gain should also be recorded in
OCI. This means that the tax charged to OCI is €10,500 (€35,000 × 30%).
The following accounting entry is required:
Dr Other comprehensive income €10,500
Cr Deferred tax liability €10,500
(3) How is the deferred tax position to be treated on 31.12.20X2? State the
journal entry.
The opening deferred tax liability on 01.12.20X2 is €10,500. The machine will
again be depreciated in next year and it’s carrying value at 31.12.20X2 will be
€120,000 (€135,000 - €15,000). Now the temporary difference will be €20,000
(€120,000 - €100,000) giving rise to deferred tax liability of €6,000 (€20,000 X
30%). The change is deferred tax is credited to profit or loss.
Dr Deferred tax liability €4,500
Cr Statement of profit or loss €4,500
The total deferred tax on statement of financial position for the year ended
31.12.20X2 will be deferred tax liability of €360,000.

Exercise 2:
a) Determine the amount of cash and cash equivalents per 31 December
20X1 and 31 December 20X2.
To qualify as a cash equivalent, an item must be cash or readily convertible to
cash and have an immaterial risk of a change in value. Moreover, it should be
held for the purpose of meeting short-term cash obligations. Government
securities are normally held for short-term.
Bank overdrafts are an integral part of most company's cash management.
They are therefore generally treated as a component of cash. In this case, cash
and cash equivalents include government securities, bank and bank overdraft.
€
Cash and cash equivalents at 31.12.20X1 66,000
Cash and cash equivalents at 31.12.20X1 (€120,000 - €552,000) -432,000
b) Prepare a statement of cash flows for the year ended 31 December 20X2 in
accordance with IAS 7.
Statement of cash flows for year ended 31.12.20X2
€ ‘000
Cash flows from operating activities
Profit before tax 1,281
Depreciation (252+255+225) 732
Loss on disposal of Plant and machinery (144-60) 84
Changes in working capital:
Increase in inventory (1512-990) -522
Increase in receivables (792-396) -396
Increase in payables (796-660) 138
Increase in provisions/Finance cost 72
Cash generated from operations 1,389
Interest paid -156
Tax paid (150+447-360) -237
Net cash Inflow from operating activities 996
Cash flows from investing activities
Payments for non-current assets (243+1,410+489) -2,142
Receipts from non-current asset disposals 60
Net cash (outflow) from investing activities -2,082
Cash flows from financing activities
Proceeds from share issue [(2,700-2,400) + (360-210)] 450
Proceeds from loan 246
Equity dividend paid -108
Net cash inflow from financing activities 588
Increase in cash and equivalents (996-2,082+588) -498
 € ‘000
Increase in cash and equivalents (996-2,082+588) -498
Cash and equivalents brought forward 66
Cash and equivalents carried forward -432

c) Briefly discuss the liquidity position of B AG. Should a shareholder of B AG

be concerned about a lack of liquid resources in the company?
To assess the liquidity of a company, we need to look whether entity has
sufficient resources to meet its commitments or obligations. A statement of
cash flows is very important here because it enables users of the financial
statements to assess the liquidity, solvency and financial adaptability of the
business.
Although B AG has positive cash and cash equivalents at year end 31.12.20X1
but a negative cash and cash equivalents at year end 31.12.20X2 which is
matter of serious concern. When we look at statement of comprehensive
income, it shows huge profits but no cash is available for spending. So, we can
say liquidity position of B Ag is not good and shareholders of B AG should be
concerned about lack of liquid resources in the company.

d) Discuss whether the direct or the indirect method to determine cash flow
from operations provides more useful information?
Entities can choose whether to present ‘cash flow from operations’ using the
direct or indirect method. This is a problem for users of the financial
statements because it restricts comparability. The majority of companies use
the indirect method for the preparation of statements of cash flow. They
justify this on the grounds that the information required for the direct method
is too costly and time consuming to obtain.
The adjustments required by the indirect method are difficult to understand
and can be confusing to financial statement users. In many cases these
adjustments cannot be reconciled to observed changes in the statement of
financial position.
Financial statement users often prefer the direct method because it reports
operating cash flows in understandable categories, such as cash collected from
customers, cash paid to suppliers, cash paid to employees and cash paid for
other operating expenses. When presented in this way, users can assess the
major trends in cash flows and can compare these to the entity’s competitors.
This is relevant information because it aids investment decisions.
e) An entity may report losses over a number of successive years and still
report cash flows over the same period. How can this happen?
The statement of financial position and statement of profit or loss are
prepared on an accruals basis of accounting and do not demonstrate how the
company has generated and used cash in reporting period. The statement of
profit or loss may show profits even though the company is suffering severe
cash flow problems and vice versa.
There are some expenses such as depreciation, deferred tax that are charged
to profit or loss but there is no direct cash outflow. These expenses may report
loss in statement of comprehensive income but entity still has cash at bank.
Same is the case with tax, entity estimates the tax expense for the period and
charge to profit or loss but that tax is paid in next accounting period. This may
also report loss in statement of comprehensive income but entity report cash
flow over the same period.

Exercise 3:
a)
1) Perform the classification of the financial instrument for both the issuer
and the purchaser according to IFRS 9 and IAS 32.
IAS 32 provides rules on classifying financial instruments. The issuer of a
financial instruments must classify it as a financial liability or equity instrument
on initial recognition according to its substance and their definitions and vice
versa for purchaser of the financial instrument to classify it as a financial asset.
Issuer:
According to IAS 32, the financial instrument is recorded as a financial liability
if the entity has an obligation to transfer cash or other financial asset,
however, in this case, albeit it has an obligation for interest payments and the
redemption of loan note at par but the contract has the characteristics of both
equity and liability as it allows to convert it into the ordinary shares at the
redemption date or the fix payment at the redemption date so it should be
treated as a convertible bond.
Purchaser:
The purchaser will classify the compound financial instrument as a financial
asset. However, the purchaser will record this asset as two financial assets i.e.
derivative and receivables.
2) What are potential advantages of a convertible bond over a regular bond
from the perspective of the issuer and from the perspective of the holder?
The advantages of convertible bond over a regular bond are following:
Issuer:
As the convertible bond provides the purchaser with a choice for redemption
or conversion so it is issued at a lower interest rate. Hence, the burden of high
interest payments in the case of loan notes is reduced. In loan note, the
redemption is fix at a particular date, however, in convertible loan note the
redemption amount can be minimized if the purchase opts to convert into
shares which will improve the riskiness of the entity, hence attracting potential
investors.
Holder:
The choices provided through the convertible bonds allows the purchaser to
take advantage by opting to convert into the shares if the share prices have
increased. Due to high share price, the purchaser can further sell the shares
which will provide higher overall return if compared to the regular bond.
3) Determine the carrying amount of the relevant positions on 31.12.02 that
the issuer has to disclose.
To determine the carrying amount, the issuer needs to splitting the proceeds:
Date Cash flow Discount factor Present Value
31-12-20X0 21000 0.952 19992
31-12-20X1 21000 0.907 19047
31-12-20X2 721000 0.864 622944
Liability 661983
Equity 38017
Net proceeds 700000
When measuring liability at amortized cost, finance cost is added to opening
liability and cash payments are deducted to arrive at closing liability:
Date Opening Finance cost Payment Closing
31-12-20X0 661983 33099 (21000) 674082
31-12-20X1 674082 33704 (21000) 686786
31-12-20X2 686786 34339 (721000) -

4) Outline the treatment of the bond for the holder of the instrument.
Firstly, the purchaser will have to record the derivative component of the
financial asset at a fair value and then the receivables will be calculated by
subtracting the fair value of derivative from the net proceeds. The derivative
part will have to be recorded at fair values at each reporting date and the
difference will be taken to statement of profit or loss or other comprehensive
income.
b)
Classify the financial instruments of S Ltd. According to IFRS 9 applying the
SPPI test and the business model test. Whenever possible, choose a
classification which minimizes any valuation effects in the P&L as well as in
OCI. State the carrying amount of the position.
IAS 32 deals with the classification of financial instruments and their financial
statement presentation. IFRS 9 is concerned with the initial and subsequent
measurement of financial instruments.
Equity investments (such as an investment in the ordinary shares of another
entity) can be measured at fair value through other comprehensive income if
the investment is not held for short-term trading and if an irrevocable
designation has been made. If equity investments are acquired for short-term
trading then IFRS 9 Financial Instruments stipulates that they must be
measured at fair value through profit or loss. S Ltd. have two financial
instruments that can be dealt according to above criteria:
Shares of Alpha Inc.:
As shares of Alpha Inc. are held to secure a long-term business relationship
with that entity and also there is no evidence for bankruptcy of Alpha Inc.
Therefore, S Ltd. should measure its investments in shares of Alpha Inc. at fair
value through other comprehensive income. On 31.12.20X1, this investment is
remeasured to its fair value of €1,987,300. The decrease in fair value of
€437,700 (€2,425,000 - €1,987,300) will be expensed to OCI.
Shares in B Inc.:
In guidance of IFRS 9, these shares should be measured at fair value through
profit or loss as these are held for short-term trading. On 31.12.20X1, this
investment is remeasured to its fair value of €2,685,400. The increase in fair
value of €1,035,400 (€2,685,400 - €1,650,000) will be credited to profit or loss.
Government bonds:
The business model is to collect the contractual cash flows by not selling the
asset prior to maturity but rather intends to hold it until redemption. The
contractual terms are merely payments of principal and interest on the
principal amount outstanding. Therefore, the government bond will be
measured at amortised cost. The government bond will initially be recognised
at its fair value €2,000,000 plus transaction cost if any. At 31.12.20X1, the
instrument will be recorded at initial value plus interest income.
Futures:
The futures contract is a derivative and is measured at fair value with all
movements being accounted for through profit or loss. By the year end, it had
fallen by €53,000 (€96,000 - €43,000). Therefore, at 31.12.20X1, S Ltd. will
recognise an asset at €43,000 and a loss of €53,000 will be recorded in profit or
loss.
Loan granted to B Inc.:
The contractual terms are merely payments of principal and interest on the
principal amount outstanding. The entity's business model is to collect the
asset's contractual cash flows without selling the asset prior to maturity but
hold it until redemption. Therefore, the loan granted to B Inc. will be measured
at amortised cost. The loan granted to B Inc. will initially be recognised at initial
cost of €2,500,000. At 31.12.20X1, the instrument will be recorded at initial
value plus any interest earned less any cash receipt.

References:
The Board (2018), IAS 12 Income Taxes, p. 03,07. London: IFRS Foundation.
The Board (2018), IAS 16 Property, Plant and Equipment. London: IFRS Foundation.
The Board (2018), IAS 32 Financial Instruments: Presentation. London: IFRS
Foundation.
The Board (2018), IFRS 7 Financial Instruments: Disclosure. London: IFRS Foundation.
The Board (2018), IFRS 9 Financial Instruments. London: IFRS Foundation.