ICAEW March 2020

QUESTION 2

Part (a)

(1) Convertible bonds

The convertible bonds are compound financial instruments under IAS 32 Financial
Instruments: Presentation. A compound financial instrument contains both a liability
component and an equity component. It should be classified separately at the date of
issue.

The fair value of the liability component should be measured at the present value of
the interest payments and the capital repayment, assuming that the bond is
redeemed. The present value should be discounted at the market rate for an
instrument of comparable credit status and the same cash flows but without the
conversion option. The fair value of the equity component is the remainder of the net
proceeds.

In this case, the market rate of interest for similar bonds without the conversion
option is 8%. Hence, the liability component can be measured as follows:
Cash flow Discount factor Present value

1 Oct 2018 - 30 Sept 2019 24,000 1/1.08 22,222

1 Oct 2019 - 30 Sept 2019 24,000 1/1.082 20,576

1 Oct 2020 - 30 Sept 2021 424,000 1/1.083 336,585

£379,383

The liability component of the convertible bonds is £379,383. The equity component
is the remainder of the net proceeds, ie £20,167 (400,000-379,383).

The annual interest expenses arising on the liability component and recognised in
profit or loss should be calculated by reference to the interest rate used in the initial
measurement of the liability component, ie 8%. The equity component is not
remeasured.
Balance b/f Finance cost Interest Balance c/f
(8%)

1/10/18 - 30/9/19 379,383 30,351 (24,000) 385,734

At the year-end, the non-current liabilities should be reduced by £14,266 (400,000 -

385,734). The actual interest paid should be recognised as finance costs. Thus, an
additional £6,351 (30,351 - 24,000) will be recognised as finance costs in the profit or
loss.
(2) Government grant

The government grant should be accounted for under IAS 20 Accounting for
Government Grants and Disclosure of Government Assistance. A government grant
should only be recognised when there is reasonable assurance that:
● The entity will comply with any conditions attached to the grant.
● The entity will actually receive the grant.
Jonica plc should recognise the government grant as it complies both conditions.

IAS 20 requires grants to be recognised under the income approach, where it should
be recognised in profit or loss over the periods in which the entity recognises as
expenses the costs which the grants are intended to compensate.

Where grants are received in relation to a depreciating asset, the grant should be
recognised over the periods in which the asset is depreciated and in the same
proportions.

Jonica plc has an accounting policy of netting-off government grants. This method
deducts the grant in arriving at the carrying amount of the asset to which it relates.
The grant is recognised in profit or loss over the life of a depreciable asset by way of
a reduced depreciation charge.

In this case, the grant of £150,000 will reduce the cost of asset, leaving an amount of
£175,000. The depreciation expense to be recognised for the period from 1 January
2019 to 30 September 2019 is £13,125 (175,000/10 x 9/12). However, the full
amount of depreciation expense on the full cost of asset has been recognised, ie
£24,375 (325,000/10 x 9/12). Hence, the adjustment needed to be made is £11,250
(24,375 - 13,125) to be debited to non-current assets and credited to profit for the
year.

As at 30 September 2019, the carrying amount of the assets should be £161,875

(175,000 - 13,125).
(3) Provision

IAS 37 Provisions, Contingent Liabilities and Contingent Assets states that a

provision should be recognised when:
● An entity has a present obligation (legal or constructive) 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.
In this case, the present obligation is the claim arising from supplying faulty goods.
There is a probable outflow of resources where payments would be made for the
claim). The amount can be estimated reliably as the lawyers have estimated the
probabilities for the levels of damages. Hence, the claim can be recognised as a
provision.

The lawyers believe that Kilo Ltd is likely to win any court case. Therefore, Jonica plc
is more likely to occur the damages payable. It is probable that the payment would be
made to settle the obligation. In practical terms, this means that there is a greater
than 50% chance that Jonica plc will have to transfer resources to Kilo Ltd. Hence, it
should recognise a provision of £21,000 under current liabilities and debited to profit
or loss.
Part (b)

Revised profit for the year ended 30 September 2019

Draft profit 1,035,000

(1) Convertible bonds - Finance costs (6,351)

(2) Government grant - Grant (150,000)

Government grant - Depreciation 11,250

(3) Provision - Legal claim (21,000)

Revised profit 868,899

Basic EPS

Number Price Total

(£) (£)

Pre-rights issue holding 3 3.80 11.40

Right issue 1 3.20 3.20

Total 4 14.60

TERP = 14.60/4 = 3.65

Adjustment = 3.80/3.65

Weighted average shares

1 October 2018 - 31 January 2019 (600,000 x 3.80/3.65 x 4/12) 208,219

1 February 2019 - 30 September 2019 (600,000 x 4/3 x 8/12) 533,333

Total 741,552

Basic EPS = 868,899/741,552 = £1.17

Part (c)

IAS 1 Presentation of Financial Statements allows the analysis of expenses to be classified

either on their nature or their function.

Under classification by function, expenses are classified according to their function as part of
cost of sales, distribution costs or administrative expenses. In this case, Jonica plc presents
expenses by function in its statement of profit or loss.

Under classification by nature, expenses are aggregated in the statement of profit or loss
according to their nature. For example, purchases of materials, depreciation, wages and
salaries etc. It usually used by smaller entities.

Whichever classification is chosen, it has no impact on the profit.

Part (d)

IAS 20 Accounting for Government Grants and Disclosure of Government Assistance allows
government grants related to assets to be presented using the deferred income method or
the netting-off method. However, FRS 102 prohibits this approach where government
grants are deducted from the carrying amount of the asset. Under FRS 102, entities
can account for grants using either the performance model or the accrual model.

For the performance model, if the grant does not impose any future performance related
conditions on the recipient, it should be recognised in income when the grant proceeds are
received. Where performance related conditions are specified, the grant should only be
recognised in income when the performance related conditions are met.

For the accrual model, grants relating to revenue should be recognised in income on a
systematic basis over the periods in which the entity recognises the related costs for which
the grant was intended to compensate. Grants relating to assets should be recognised in
income on a systematic basis over the expected useful life of the asset.

By applying the accrual model, the deferred income that should be recognised is £150,000.
The amount that would be recognised for the year ended 30 September 2019 is £11,250
(150,000/10 x 9/12). There would be a balance of deferred income, ie £138,750 (150,000 -
11,250). From this amount, £15,000 (150,000/10) would be current and £123,750 (138,750 -
15,000) would be non-current.