TUTORIAL 5.
3 (additional tutorial)
This is an integrated tutorial that includes fair value measurement, income taxes, PPE, financial assets,
non-current assets held for sale, leases, provisions and presentation of financial statements. Could be used
for your revision.
Overview of Bebul Ltd
Bebul Ltd (“Bebul) is South Africa’s leading manufacturer and distributor of robotic parts. Since commencing
operations, it has experienced exponential growth to the point that it listed on the JSE Ltd in 20.x2 and is
looking to list on the Tokyo Stock Exchange in 20.x6. In an effort to grow even further, Bebul’s directors have
recently been restructuring business operations to prepare for a period of even higher growth and expansion
in the near future.
The robotic parts that Bebul manufactures are used in an array of assets, including prosthetic limbs, robotic
vacuum cleaners, and motor vehicle production lines. Currently, Bebul is preparing its 28 February 20.x4
financial statements.
Factory
One of Bebul’s factories was purchased on 1 March 20.x1 for R28 000 000 when it had an expected useful
life of 20 years and a residual value of R4 500 000 (estimates that have remained unchanged). It was
purchased with the expectation that operations would expand significantly in the future and accordingly the
factory currently operates significantly below its capacity and is only expected to reach capacity in 2016.
On 28 February 20.x4, Bebul’s directors made a decision to sell the factory in the 20.x5 financial year and
appropriately classified the factory as a non-current asset held for sale on the same date. On 28 February
20.x4, it was correctly determined that it was not necessary to impair or write down the carrying amount of
the factory in terms of IAS 36 or IFRS 5.
Details about the factory’s fair value for the purposes of classification as held for sale:
Date Estimated Fair value
28 February 20.x4 R26 496 000
R30 600 000
Valuation appropriately based on IFRS 13 income approach. Cash flows projected based on current
capacity used, i.e. operating significantly below capacity.
Valuation appropriately based on IFRS 13 income approach. Cash flows projected based on full capacity
used, i.e. what market participants would consider the highest and best use of the factory.
The bookkeeper has accounted for the factory correctly in terms of IAS 16, IAS 12 and IFRS 5 by processing
all the correct journal entries for the 20.x4 financial year and has assessed the fair values for the purposes of
classification as held for sale based on current capacity used, i.e. method .
Deccan (Pty) Ltd (“Deccan”)
Bebul purchased ordinary shares in Deccan (a less than 5% holding) on 31 March 20.x2 for
R3 080 000. Bebul considered these shares to be long term capital investments. In terms of its recently
commenced expansion project in the 20.x4 financial year, significant cash was required in April 20.x4 and
Bebul’s directors resolved on 28 February 20.x4 to start selling its shares in Deccan to the market between
March 20.x4 and August 20.x4.
The fair value of the shares in Deccan at 28 February 20.x4 was R3 586 000 (28 February 20.x3: R3 322 000).
Bebul accounts for its shares in Deccan at fair value, with fair value changes presented in profit or loss (P/L).
1
Although Deccan is not listed and there is no market from which to obtain unadjusted estimates of the fair
value of its shares, it has assets and operations that are very similar to a number of listed businesses.
Consequently, Bebul has always made estimates of Deccan’s fair value based on an array of key inputs all of
which are derived from observable market data of similar businesses.
One of the key inputs involved in valuing the shares in Deccan is the earnings multiple. In the current financial
year, the financial crisis had a marked effect on some of the transactions involving comparable businesses to
Deccan to the extent that market data related to earnings multiples was considered unreliable and not
reflective of assumptions that market participants would take into account in pricing the interest in Deccan.
Therefore, in order to estimate Deccan’s fair value, Bebul’s directors derived an earnings multiple based on
direct discussions with the management of Deccan. All other inputs involved in the valuation of Deccan
remained based on observable market data and were still considered to be reliable. As the majority of the
estimates remain based on reliable and observable market data in the 20.x4 financial year, Bebul’s directors
were of the view that there should be no change in the fair value hierarchy level at which the shares in Deccan
are disclosed.
Arts Ltd
Bebul held ordinary shares in Arts Ltd since January 20.x0 (also a less than 5% holding). It sold all these shares
on 5 January 20.x4 for R109 000 more than their cost, of which 30% of the increase in value occurred in the
current financial year. Bebul accounts for its shares in Arts Ltd at fair value, with fair value changes presented
in other comprehensive income (OCI).
Trial Butchery Branch
In the 20.x4 financial year, Bebul’s directors became interested in opening a butchery. A small butchery was
opened on a trial basis in Kenilworth in January 20.x4 as a separately managed branch of Bebul Ltd. The
butchery branch made an assessed loss (and an accounting loss) of R990 000 in the 20.x4 financial year and
it was agreed to cease operations on 28 February 20.x4 as the market was not as lucrative as the directors
had hoped.
The business was relatively straightforward to shut down except for the short-term lease1 on the shop that
had been rented at a rate of R5 000 per month that needed to run until 31 October 20.x4 before it could be
cancelled. The lease agreement states that the shop may not be sub-let. It will therefore stand vacant from
March to October 20.x4. The assessed loss (and an accounting loss) of R990 000 includes only rental
deductions up to and including February 20.x4.
1
Consequently, the requirements of para. 22 to 49 of IFRS16 have not been applied to the lease.
2
Relevant Tax Information
• SARS allows s13(1) deductions on factory buildings at a rate of 5% per annum.
• SARS considers any shares that are sold within 3 years of being purchased to be revenue in nature
and automatically taxes them at the normal rate. Once an entity holds shares for longer than 3 years,
they are considered to be capital in nature.
• In terms of s20A, SARS considers that the taxable income and assessed loss of the robotics and
butchery businesses are ring fenced from one another and are not able to be offset.
• Bebul’s correctly calculated taxable income for the 20.x4 year of assessment is R15 461 700.
• A company tax rate of 28% and a capital gains inclusion rate of 80% apply.
Additional Information & Relevant Accounting Policies
• Bebul’s correctly calculated deferred tax liability at 28 February 20.x4 is R622 652
(28 February 20.x3: R197 299).
• Bebul has other taxable temporary differences that are not mentioned in the rest of the question;
these increased by R1 012 758 during the year ended 28 February 20.x4. Included in the change of
R1 012 758 is R30 000 of depreciation related to an administrative building that is not granted any
tax deductions that is accounted for on the cost model.
• Where necessary, you may assume a fair nominal interest rate of 12% per annum, compounded
monthly.
• Bebul has always complied with IFRS 9 and IFRS 13.
• Bebul marks shares that are measured at fair value to their market value on a daily basis.
• Bebul does not transfer revaluation reserves or mark-to-market reserves to retained earnings at any
stage.
• Bebul has a 28 February year end.
• You may ignore VAT and any dividend-related tax.
3
Marks
Sub-
REQUIRED total Total
(a) In relation to the factory, briefly justify whether you believe that the assumptions 4 4
in valuation method or should be used to measure fair value.
FOR THE REMAINDER OF THE QUESTION, ASSUME THAT THE FAIR VALUE BASED
ON METHOD IS APPROPRIATE AND SHOULD HAVE BEEN USED IN ACCOUNTING
FOR THE FACTORY.
(b) Removed
(c) i. Calculate Bebul Ltd’s profit before tax for the year ended 28 February 20.x4. 9 16
Start your calculation with Bebul Ltd’s taxable income of R15 461 700.
ii. Prepare the tax rate reconciliation note required in terms of 7
IAS 12. 81(c)(i) as it would appear in the notes to the financial statements of
Bebul Ltd for the financial year ending 28 February 20.x4. Comparatives are
not required.
(d) Show how the investments in Arts, should be reflected in Bebul’s Statement of 4 5
Profit or Loss and Other Comprehensive Income for the year ended 28 February
20.x4.
• Bebul presents it statement of profit or loss (P/L) and other comprehensive
income (OCI) in 2 separate statements. You are not required to prepare
the separate statement of profit or loss.
• Bebul presents items of OCI gross of tax.
• Comparatives are not required.
Presentation and layout 1
(e) Draft a memo to Bebul Ltd’s directors discussing the level of the IFRS 13 fair value 7 9
hierarchy at which the investment in Deccan should be disclosed in the notes to
the 20.x3 and 20.x4 financial statements. Include in the discussion whether you
agree that with the directors’ views. Specific disclosure requirements need not be
addressed.
Communication skills and layout 2
Total 34
UWC 2012 Sat Test 1 – CA Connect source (amended)
4
TUTORIAL 5.3
SUGGESTED SOLUTION
Question (a) - In relation to the factory, briefly justify whether you believe that the assumptions in
valuation method or should be used to measure fair value
IFRS 13.2 (as well as a number of other IFRS 13 paragraphs) is clear that, where fair value is required,
estimates should not take into account entity-specific use or intentions. Even though Bebul Ltd is 1
actually using the factory below its capacity and will generate cash flows on this basis, it should look
1
to how market participants would use the factory if they were to purchase it assuming that they
were to operate it at its highest and best use (IFRS 13.27). The highest and best use of the factory is 1
stated as being at, and not below, capacity. Therefore, the fair value used in the revaluation of the 1
building should be based on method that assumes the highest and best use and not method
1
that is based on existing use.
Marks available 5
Note: When answering a question like this, you need to take into account the mark allocation. There is no
point in writing a full page as, even if you get all the marks, you can seriously prejudice yourself from a
time point of view.
Question (c)(i) – Calculate Bebul’s profit before tax for the year ended 28 February 20.x4
Workings
Taxable income 15 461 700 Given
Items that are included in taxable income that should not be included in profit before tax
Wear and tear 1 400 000 28m x 5% 1
Profit on sale – Arts Ltd (87 200) 109 000 x 80% (see additional workings at end) 1
Items that are not included in taxable income that should be included in profit before tax
Depreciation (1 175 000) (28m – 4.5m) ÷ 20 1
FV Gain – Deccan (Pty) Ltd 264 000 (3.586m – 3.322m) 1
Butchery loss (990 000) Not deductible against robotics business – S20A. 1
Business closed down; appears benefit of assessed
loss will never be able to be used.
Onerous contract (38 258) I = 1% [12% ÷ 12]; N = 8; 2
PMT = 5 000. Business closed down, appears that
future payments will not be deductible for tax
purposes as there will be no taxable income from
the butchery.
Other
Increase in non-exempt 1 042 758 No requirement to separate figures for this 1
taxable TDs calculation. Total is 1 012 758 given
Decrease in exempt (30 000)
taxable TDs
Profit before tax 15 848 000 Mark only given if total is included, and no items 1
have been included above that should not be in
the calculation.
Total marks 9
5
Note: It is important to pay attention to directions of adjustments. The signs will be opposite in direction
when reconciling taxable income to profit before tax than when reconciling profit before tax to taxable
income.
Question (c)(ii) - Prepare the tax rate reconciliation note required in terms of IAS 12. 81(c)(i) as it would
appear in the notes to the financial statements of Bebul Ltd for the financial year ending 28 February
20.x4
Workings
Expected tax 4 437 440 15.848m Question (c) x 28% 1C
Fair value gains at CGT rate of Deccan (14 784) (3.586m – 3.322m) x 28% x 20% 1
Change in recovery of Deccan 28 336 (3.586m – 3.080m) x 28% x 20% 1
Assessed loss not recognised 277 200 990 000 x 28% 1
Onerous contract not deductible* 10 712 38 258 x 28% 1
Admin building depreciation exempt 8 400 30 000 x 28% 1
Actual total tax – Current and deferred 4 747 304 ((15 461 700 – 109 000 x 80%) x 28% + 1
442 444) Question (d)
Total marks 7
Note: The tax rate reconciliation in terms of IAS 12.81(c) only deals with items in P/L, there is no
equivalent tax rate reconciliation for items in OCI, presumably due to the IAS 12.81(0) requirement
to separately disclose the tax effects of each OCI item. As the Arts Ltd shares never affect P/L (see
additional workings at end), they will not be included in the tax rate recon.
*Note: Usually onerous contracts will not be included in the tax rate reconciliation as their
temporary difference (TD) will attract deferred tax. In this instance, the TD did not attract deferred
tax as the rental amounts paid in the future are not probable to reduce tax as it will further
increase the ring fenced assessed loss that does not appear to be able to be used as the butchery
business is being discontinued.
6
Question (d) Show how the investments in Arts, should be reflected in Bebul’s Statement of Profit or Loss
and Other Comprehensive Income for the year ended 28 February 20.x4.
• Bebul presents it statement of profit or loss (P/L) and other comprehensive income (OCI) in 2
separate statements. You are not required to prepare the separate statement of profit or loss.
• Bebul presents items of OCI gross of tax.
• Comparatives are not required.
Presentation and layout
Statement of Profit or Loss and Other Comprehensive Income for the year ended 28 February 20.x4
Other comprehensive income:
Items that will not be reclassified to profit or loss:
Gain related to revaluation of financial instruments 32 700 1
Income tax relating to items that will not be reclassified (7 325) 1
Other comprehensive income for the year, net of tax 25 375
Total comprehensive income for the year
Headings (all bolded items above) and totals 1
Marks 5
Workings
1 R109 000 x 30% = 32 700 1
2 Tax related to financial instrument (32 700 x 80% x 28%) (7 235) 1
Question (e) – Draft a memo to Bebul’s directors discussing the level of the IFRS 13 fair value hierarchy at
which the investment in Deccan should be disclosed at in the notes to the 20.x3 and 20.x4 financial
statements
To: The Board of Directors of Bebul Ltd
From: F.V. Mexpert
Date: 28 February 20.x4
Re: Fair value hierarchy level of shares in Deccan Ltd
Introduction
The IFRS 13 fair value hierarchy categorises into 3 levels the inputs to valuation techniques used to
measure fair value (IFRS 13.72). These categories are the basis for fair value disclosures in IFRS 13 and
are required to be disclosed in the notes to the financial statements (IFRS 13.93(b)).
Priority in fair value calculations is given to using unadjusted quoted prices where possible (level 1
inputs). Lowest priority is given to unobservable inputs (level 3 inputs).
As Deccan is not listed and there does not appear to be a market in which its shares trade and prices
are quoted (IFRS 13.76), it is not possible to classify valuations at level 1 in the hierarchy.
20.x3 Financial Year
In the 20.x3 financial year, all significant inputs appear to be based on observable and market-
corroborated inputs (other than quoted process) of businesses that are very similar to Deccan. Where
observable and market-corroborated inputs are used other than quoted prices, the item is
7
categorised at level 2 in the fair value hierarchy. Consequently, it seems appropriate to categorise the
shares in Deccan into level 2 (IFRS 13.81 & 82) in the 20.x3 financial year.
20.x4 Financial Year
In the 20.x4 financial year, the best basis for obtaining one of the key (significant) inputs to the
valuation has changed due to unreliable market data. The new earnings multiple is based on direct
discussions with the directors of Deccan. This information is not observable market data. Fair values
that are only able to be derived from unobservable inputs are categorised as level 3 inputs.
The shares are not valued purely based on level 3 inputs as all other significant inputs remained based
on observable inputs. There therefore appear to be a mix of level 2 and 3 inputs. The issue is therefore
whether the shares should be categorised at level 2 or at level 3 in the fair value hierarchy. Where
inputs are categorised at different levels, items should be categorised in their entirety in the level of
the fair value hierarchy of the lowest input that is significant to the valuation (IFRS 13.73). The issue
is therefore whether the earnings multiple is significant to the valuation. As the question stipulates
that it is a “key” input, it appears to be significant. Therefore, the fair value measurement of the
shares in Deccan transfers from category 2 in 20.x3 to category 3 in 20.x4.
Based on the above discussion, the directors argument that the driver of the fair value hierarchy
classification is based on the level at which the majority of inputs is based does not seem correct as
IFRS 13 is clear that the disclosure level is driven by the lowest level at which a key input is
determined, irrespective of whether the input is in the majority or the minority.
Marking Rubric:
• Memo format (½)
• Logical flow (½)
• Professional terminology and discursive style including tentative statements (1)
• Introduction to the IFRS 13 fair value hierarchy (1)
• Level 1 is not appropriate with reasons (1)
• Level 2 seems appropriate in 20.x3 (1) Application to question (1)
• Identification of change in inputs in 20.x4 and that discussions with management are not
observable (2)
• Discussion around mix of inputs and how this should be treated (2)
• Conclusion that management’s view is not appropriate (1)
Marks available 11
Note: It is crucial to answer the question. The question was clear in stating that disclosure in both 20.x3
and 20.x4 should be discussed. The question also only required a discussion related to disclosure. Therefore
any comments about how to measure the fair value of the shares were irrelevant, e.g. it is true to say that
IFRS 13 requires priority to be given to observable inputs but in this question the valuations had already
been done and thus the focus of the discussion should be on the disclosure implications of the valuations
and not the valuations themselves. In a discussion it is important to present a logical flow, if you struggle
to score well in discussion questions, read the answer that you gave, it is likely that you mention theory and
do not logically link it to the scenario and engage in a discussion on this basis.
8
Additional workings (not required but included for learning purposes):
Calculations for deferred tax balances (given in question)
CV TB TD DT FP
28 February 20.x3
Factory 25 650 000 25 200 000 450 000 126 000 cr
Deccan (Pty) Ltd 3 322 000 3 080 000 242 000 54 208 cr
Arts Ltd 76 300 17 091 cr
Given 197 299 cr
28 February 20.x4
Factory 24 475 000 23 800 000 675 000 189 000 cr
Deccan (Pty) Ltd 3 586 000 3 080 000 506 000 141 680 cr
Arts Ltd 0 0 0 0
Onerous contract (38 258) 0 (38 258) Ring fenced
Assessed loss (990 000) 0 (990 000) Ring fenced
Other (30 000) Exempt
Other 1 042 758 291 972 cr
Given 622 652 cr
P/L movement = R622 652 – 197 299 + 17 091 = 442 444
Illustrative journal entries related to shares in Arts Ltd:
2004 financial year:
Dr Investment in Arts (FP) (Number assumed) 200 000
Cr Bank (FP) 200 000
Purchase of shares in Arts
2004 – 20.x3 financial years:
Dr Investment in Arts (FP) (109 000 x 70%) 76 300
Cr Fair value gain (OCI) 76 300
Fair value gain
Dr Deferred tax (OCI) (76 300 x 80% x 28%) 17 091
Cr Deferred tax (FP) 17 091
Deferred tax related to fair value gain
9
20.x4 financial year:
Up to 5 January 20.x4
Dr Investment in Arts (FP) (109 000 x 30%) 32 700
Cr Fair value gain (OCI) 32 700
Fair value gains up to date of sale
Dr Deferred tax (OCI) (32 700 x 80% x 28%) 7 325
Cr Deferred tax (FP) 7 325
Deferred tax related to fair value gain
Dr Bank (FP) (200 000 + 109 000) 309 000
Cr Investment in Arts (FP) 309 000
Sale of shares
Dr Current tax expense (OCI) (109 000 x 28% x 80%) 24 416
Cr SARS (FP) 24 416
Current tax implications of sale
Dr Deferred tax (FP) 17 091
Cr Deferred tax (OCI) 17 091
Reversing deferred tax related to shares that have been sold
Notice the following:
• The investment does not impact P/L at any point, including the tax implications of the sale as the
current tax expense in P/L is directly offset by the deferred tax income in P/L.
• Therefore there is no effect on the tax rate reconciliation as this note only deals with P/L items
that are not taxed at the standard rate.
• 80% of the profit made over the entire period of the holding is included in taxable income and
none should be included in profit before tax. In terms of IFRS 9, only current year fair value
changes are included in OCI.
• On disposal of IFRS 9 investments accounted for at fair value through OCI, IFRS 9 does not require
the cumulative fair value changes to be reclassified to P/L. Rather it gives the entity an option to
transfer the mark to market reserve to retained earnings (IFRS 9 – B5.7.1). The question states
that the entity’s policy is never to transfer these reserves to retained earnings. Therefore we do
not require and entry debiting the mark to market reserve and crediting retained earnings.
10