4 Handrew, a public limited company, is adopting International Financial Reporting Standards (IFRS) in its financial
statements for the year ended 31 May 2005. The directors of the company are worried about the effect of the move
to IFRS on their financial performance and the views of analysts. The directors have highlighted some ‘headline’
differences between IFRS and their current local equivalent standards and require a report on the impact of a move
to IFRS on the key financial ratios for the current period.
Differences between local Generally Accepted Accounting Practice (GAAP) and IFRS
Leases
Local GAAP does not require property leases to be separated into land and building components. Long-term property
leases are accounted for as operating leases in the financial statements of Handrew under local GAAP. Under the terms
of the contract, the title to the land does not pass to Handrew but the title to the building passes to the company.
The company has produced a schedule of future minimum operating lease rentals and allocated these rentals between
land and buildings based on their relative fair value at the start of the lease period. The operating leases commenced
on 1 June 2004 when the value of the land was $270 million and the building was $90 million. Annual operating
lease rentals paid in arrears commencing on 31 May 2005 are land $30 million and buildings $10 million. These
amounts are payable for the first five years of the lease term after which the payments diminish. The minimum lease
term is 40 years.
The net present value of the future minimum operating lease payments as at 1 June 2004 was land $198 million
and buildings $86 million. The interest rate used for discounting cash flows is 6%. Buildings are depreciated on a
straight line basis over 20 years and at the end of this period, the building’s economic life will be over. The lessee
intends to redevelop the land at some stage in the future. Assume that the tax allowances on buildings are given to
the lessee on the same basis as the depreciation charge based on the net present value at the start of the lease, and
that operating lease payments are fully allowable for taxation.
Plant and equipment
Local GAAP requires the residual value of a non-current asset to be determined at the date of acquisition or latest
valuation. The residual value of much of the plant and equipment is deemed to be negligible. However, certain plant
(cost $20 million and carrying value $16 million at 31 May 2005) has a high residual value. At the time of
purchasing this plant (June 2003), the residual value was thought to be approximately $4 million. However the value
of an item of an identical piece of plant already of the age and in the condition expected at the end of its useful life
is $8 million at 31 May 2005 ($11 million at 1 June 2004). Plant is depreciated on a straight line basis over
eight years.
Investment properties
Local GAAP requires investment property to be measured at market value and gains and losses reported in equity.
The company owns a hotel which consists of land and buildings and it has been designated as an investment
property. The property was purchased on 1 June 2004. The hotel has been included in the balance sheet at 31 May
2005 at its market value on an existing use basis at $40 million (land valuation $30 million, building $10 million).
A revaluation gain of $5 million has been recognised in equity. The company could sell the land for redevelopment
for $50 million although it has no intention of doing so at the present time. The company wants to recognise holding
gains/losses in profit and loss. Local GAAP does not require deferred tax to be provided on revaluation gains and
losses.
The directors have calculated the following ratios based on the local GAAP financial statements for the year ended
The issued share capital of Handrew is 200 million ordinary shares of $1. There is no preference capital. The interest
charge and tax charge in the income statement are $5 million and $25 million respectively. Interest and rental
payments attract tax allowances in this jurisdiction when paid. Assume taxation is 30%.
Required:
Write a report to the directors of Handrew:
(a) Discussing the impact of the change to IFRS on the reported profit and balance sheet of Handrew at 31 May
2005. (18 marks)
(b) Calculate and briefly discuss the impact of the change to IFRS on the three performance ratios. (7 marks)
(Candidates should show in an appendix calculations of the impact of the move to IFRS on profits, taxation and
the balance sheet. Candidates should not take into account IFRS1 ‘First time Adoption of International Financial
Reporting Standards’ when answering this question.)
(25 marks)