Harman deep Ltd. is a private company in the pharmaceutical industry. It has been preparing its financial statements in accordance with ASPE. Since it has plans to go public in the next 3 to 5 years, it is considering changing to IFRSs for the current year. It wishes to adopt policies that will maximize the return on shareholders’ equity. Based on the draft financial statements prepared in accordance with ASPE, its net income for Year 5 is $400,000, and its shareholders’ equity at December 31,Year 5 is $3,500,000. Harman deep has engaged you to reconcile net income and shareholders’ equity from ASPE to IFRSs. You have identified the following five areas for which IFRSs differs from ASPE:
1. Impaired loans—original versus market rate of interest
2. Interest costs—capitalize versus expense
3. Actuarial gains/losses—recognize immediately or defer and amortize
4. Compound financial instrument—debt versus equity components
5. Income taxes—future income tax method or taxes payable method Harman deep provides the following information with respect to each of these accounting differences.
Impaired Loans
One of Harman deep’s debtors is in financial difficulty and defaulted on its loan payment during the year. The outstanding balance on this loan receivable at the end of Year 5 was $220,000. Harman deep agreed to accept five annual payments of$50,000 with the first payment due at December 31, Year 6, as a full settlement of the loan. The original interest rate on the loan was 8%. The market rate of interest for this type of loan is 6%. No adjustment has been made for the impairment of the loan receivable.
Interest Costs
Harman deep arranged a loan of $800,000 to finance the construction of a warehouse. $400,000 was borrowed on March 1, Year 5, and another $400,000 was borrowed on October 1, Year 5. The loan is repayable over 5 years with an interest rate of 6%, with the first payment due on September 30, Year 6. The warehouse was nearly complete at the end of Year 5. No interest has been accrued on the loan at the end of Year 5.
Actuarial Gains/Losses
Harman deep instituted a defined benefit pension plan in Year 3. The first actuarial evaluation, which was done as at June 30, Year 5, indicated an actuarial gain of $150,000. The expected average remaining service life of the employee workforce was 15 years at the time of the actuarial evaluation. The actuarial gain has not yet been recognized in the preliminary financial statements.
Compound Financial Instrument
Harman deep issued bonds for proceeds of $1,000,000 on December 31, Year 5. The bonds are convertible into common shares at any time within the next five years. The bonds would have been worth only for $950,000 if they did not have the conversion feature. The proceeds on the bonds have been recognized as long-term debt in the preliminary financial statements.
Income Tax
Harman deep’s income tax rate has been and is expected to continue at 40%. Assume that any adjustments to accounting income for the above items are fully deductible or taxable for tax purposes. The preliminary financial statements reflect the tax payable method of accounting for income taxes. If the future income tax method were adopted, future tax liabilities should be set up for $300,000 at the end of Year 4 and $340,000 at the end of Year 5.
Required:
Prepare a schedule to convert net income and total shareholders’ equity from the preliminary financial statements amounts to amounts under ASPE and IFRSs. Where accounting choices exist, choose policies that minimize return on total shareholders’ equity under ASPE and maximize return on total shareholders’ equity under IFRSs.
Net Income | Shareholders' Equity | |||
Description | ASPE | IFRS | ASPE | IFRS |
Preliminary Financial Statements | 400000 | 400000 | 3500000 | 3500000 |
Loan Impairment (Note 1) | -5629 | -12218 | -5629 | -12218 |
Accrued Interest Payable (Note 2) | -15600 | -15600 | ||
Acturial Gains (Note 3) | 3000 | 3000 | 3000 | 3000 |
Equity Portion of Compound Instrument (Note 4) | 50000 | 50000 | ||
Future Tax Liability (Note 5) | -40000 | -40000 | -40000 | -40000 |
Revised Values | 341771 | 350782 | 3491771 | 3500782 |
Note 1: Impaired loan must determine present value of future cash flows. Market interest rate of 6% must be used under ASPE and 8% under IFRS.
Note 2: Interest expense can be capitalized or expensed under ASPE. We are expensing it to reduce ROE. t must be capitalized under IFRS.
Note 3: Acturial gains can be recognized immediately or deferred and amortized under ASPE. We are deferring and amortizing to reduce the positive effect on net income. Under IFRS, same two methods can be followed to recognize the gains in OCI. We again follow the defer and amortize method.
Note 4: Compound financial instrument can be recognized partially or none as equity under ASPE. We would recognize it partially as it will help to decrease the ROE. The same is followed under IFRS as well.
Note 5: For Income Tax, the adjustments are multiplied by 0.6 ( 1 - Tax Rate = 1 - 0.40). Under ASPE, future income tax method is used in order to reduce net income. The same is used under IFRS as well.
Calculations:
ASPE | IFRS | |
1. Loan Receivable | 220000 | 220000 |
Carrying amount | ||
PV of future cash flows | ||
6% | 210618 | |
8% | 199636 | |
Impairment loss before tax (a) | 9382 | 20364 |
Impairment loss after tax (a * 0.6) | 5629 | 12218 |
2. Interest Costs | ||
March to September (400,000 * 6% * 7 / 12) | 14000 | 14000 |
October to December (800,000 * 6% * 3 / 12) | 12000 | 12000 |
Accrued interest expensed (a) | 26000 | |
Accrued interest capitalized | 26000 | |
After tax expense (a * 0.6) | 15600 | |
3. Acturial Gains | ||
Defer and amortize [(150,000 / 15 * (6 / 12)] (a) | 5000 | 5000 |
After tax gain (a * 0.6) | 3000 | 3000 |
4. Compound Financial Instrument | ||
Equity Portion (1,000,000 - 950,000) | 50000 | 50000 |
Not taxable as net income is unaffected | ||
5. Income Tax | ||
Future income tax expense for Year 5 (340,000 - 300,000) | 40000 | 40000 |
Future income tax expense for all years | 340000 | 340000 |
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