Section B – TWO questions ONLY to be attempted
(a) Chemclean trades in the chemical industry. The entity has development and production operations in various countries. It has entered into an agreement with Jomaster under which Chemclean will licence Jomaster’s knowhow and technology to manufacture a chemical compound, Volut. The know-how and technology has a fair value of $4 million. Chemclean cannot use the know-how and technology for manufacturing any other compound than Volut. Chemclean has not concluded that economic benefits are likely to flow from this compound but will use Jomaster’s technology for a period of three years. Chemclean will have to keep updating the technology in accordance with Jomaster’s requirements. The agreement stipulates that Chemclean will make a non-refundable payment of $4 million to Jomaster for access to the technology. Additionally, Jomaster will also receive a 10% royalty from sales of the chemical compound.
Additionally, Chemclean is interested in another compound, Yacton, which is being developed by Jomaster. The compound is in the second phase of development. The intellectual property of compound Yacton has been put into a newly formed shell company, Conew, which has no employees. The compound is the only asset of Conew. Chemclean is intending to acquire a 65% interest in Conew, which will give it control over the entity and the compound. Chemclean will provide the necessary resources to develop the compound. (8 marks)
(b) In the year to 30 June 2015, Chemclean acquired a major subsidiary. The inventory acquired in this business combination was valued at its fair value at the acquisition date in accordance with IFRS 3 Business Combinations. The inventory increased in value as a result of the fair value exercise. A significant part of the acquired inventory was sold in the post acquisition period but before 30 June 2015, the year end.
In the consolidated statement of profit or loss and other comprehensive income, the cost of inventories acquired in the business combination and sold by the acquirer after the business combination was disclosed on two different lines. The inventory was partly shown as cost of goods sold and partly as a ‘non-recurring item’ within operating income. The part presented under cost of goods sold corresponded to the inventory’s carrying amount in the subsidiary’s financial statements. The part presented as a ‘non-recurring item’ corresponded to the fair value increase recognised on the business combination. The ‘non-recurring item’ amounted to 25% of Chemclean’s earnings before interest and tax (EBIT). Chemclean disclosed the accounting policy and explained in the notes to the financial statements that showing the inventory at fair value would result in a fall in the gross margin due to the fair value increase. Further, Chemclean argued that isolating this part of the margin in the ‘non-recurring items’, whose nature is transparently presented in the notes, enabled the user to evaluate the structural evolution of its gross margin. (6 marks)
(c) In the consolidated financial statements for 2015, Chemclean recognised a net deferred tax asset of $16 million, which represented 18% of its total equity. This asset was made up of $3 million taxable temporary differences and $19 million relating to the carry-forward of unused tax losses. The local tax regulation allows unused tax losses to be carried forward indefinitely. Chemclean expects that within five years, future taxable profits before tax would be available against which the unused tax losses could be offset. This view was based on the budgets for the years 2015-2020. The budgets were primarily based on general assumptions about the development of key products and economic improvement indicators. Additionally, the entity expected a substantial reduction in the future impairment of trade receivables and property which the entity had recently suffered and this would result in a substantial increase in future taxable profit.
Chemclean had recognised material losses during the previous five years, with an average annual loss of $19 million. A comparison of Chemclean’s budgeted results for the previous two years to its actual results indicated material differences relating principally to impairment losses. In the interim financial statements for the first half of the year to 30 June 2015, Chemclean recognised impairment losses equal to budgeted impairment losses for the whole year. In its financial statements for the year ended 30 June 2015, Chemclean disclosed a material uncertainty about its ability to continue as a going concern. The current tax rate in the jurisdiction is 30%. (9 marks)
Required:
Discuss how the above items should be dealt with in the financial statements of Chemclean under International Financial Reporting Standards.
Note: The mark allocation is shown against each of the three issues above.
Professional marks will be awarded in question 2 for clarity and quality of presentation. (2 marks)