Question

LAX is a European manufacturing equipment supplier, offering installation, training, maintenance and other services. The firm is divided into eight business groups (BGs) that serve different geographical areas. LAX has been very successful. The firm’s founders developed the LAX creed, which states the firm’s philosophy of innovation, creativity, work ethic, and commitment to firm values. Top management has always stressed the importance of business ethics and corporate social responsibility. Three years ago, the firm initiated annual sustainability reporting to stakeholders.

LAX made an acquisition of a major US competitor [Eagles Inc.] earlier this year, which became LAX’s eighth BG and the first in the US. This acquisition resulted in Goodwill being recorded of $20,000,000 in February 2018. At December 2018, there is no indication that this Goodwill is impaired because the expected benefits are on target. This acquisition increased the firm’s Goodwill on the balance sheet to $180,000,000.

LAX is a private company, and it uses local GAAP. However, it plans to become a public firm on the Borsa Stock Exchange. Consequently, the accounting professionals at LAX are dealing with the challenge of first time adoption of IFRS in preparation for the initial offering. Darby Good, CGMA was assigned the task of identifying the firm’s cash generating units, and she prepared the firm’s position statement for the auditors after the firm’s CFO (Connor Remhild) agreed with her conclusions. A cash generating unit (CGU) is the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.

Within the eight BGs smaller business units (BUs) exist. A BU is identified for each country where a BG operates, but some countries are combined into a regional BU. Eagles, Inc. has 9 BUs.

LAX’s customers are often multinational customers with subsidiaries in different countries. When one BG enters into a major sales agreement with a multinational customer in one region/country, this agreement will typically also create income opportunities for other BGs through referral sales from the customer’s subsidiaries in the different countries. When customer subsidiaries are referred to other BGs, background information is provided on the customer’s operations; and the other BG usually negotiates prices, quality and other features independently. However, for some deals, a BG may seek consultation from the sales team making the original sale at the referring BG. The sales team making a referral sale does not share the sales commissions with the sales team at the BG making the referral. On average 55% of all sales will lead to a referral sale in another BG.

The firm uses the Balanced Scorecard as a performance measurement system. The Balanced Scorecard contains a set of performance measures (PM) carefully chosen to represent important aspects of a business unit in the four areas critical to the business unit’s short term and long-term performance. These are financial performance, customer relations, internal business processes, and learning and growth. A description of each type of measure is below:

Financial measures indicate how well a business unit is doing in meeting profitability and other economic targets during the previous period.

Customer-related measures indicate a business unit’s success in obtaining and retaining the targeted customers. These measures are intended not only to relate to the profitability of the previous period but, more importantly, also to the unit’s profitability in the long term.

Internal business process measures indicate a business unit’s performance on activities critical to meeting the customer, i.e., longer term, and financial, i.e., short term, targets.

Learning and growth measures indicate a business unit’s success in developing the personnel and systems necessary for the unit’s long-term growth and improvement.

The Balanced Scorecard is cascaded down from the firm level to Business Groups and then to Business Units. The cascading process provides for alignment of the Business Groups and Business Units with firm strategy. Thus, there is a Balanced Scorecard for each Business Group and each Business Unit. Selected PMs from the Balanced Scorecard are used in the incentive bonus formulas. While the firm believes in decentralization, the Balanced Scorecard is used to communicate and implement firm strategy and variances from targets are monitored.

The company is managed on a group wide basis where strategic decisions are made for example product development and range and business development, as well as selection of the customer management team. BG management is focused on the successful delivery of systems and relationship management for the key global clients in their territory. Forecasts and budgets exist for each BG, which are treated as investment centers for management control systems purposes. Diagnostic control systems are used to motivate, monitor, and reward achievement of objectives. The incentive (bonus) system for BG managers uses one financial and 4 non-financial performance measures (PM). Two of the non-financial PMs are common to all BGs number of customer referrals to other BGs and customer satisfaction rating) and two non-financial PM are unique to BG strategy. Targets are set for each PM. Residual income is weighted 70% in the incentive bonus formula.

Local sales, installation and maintenance are carried out at the BU level. Forecasts and budgets exist for each BU, which are treated as profit centers for management control system purposes. Diagnostic control systems are used to motivate, monitor, and reward achievement of objectives. The incentive system for BU managers uses one financial and 4 non-financial PM. Two of the non-financial PMs are common to all BUs and two non-financial PM are unique to BU strategy. Targets are set for each PM. BU profit is weighted 80% in the incentive bonus formula. If a BU is trending toward under-performing (mainly focusing on trend toward large unfavourable quarterly target profit variances), the BG’s CFO takes a closer look at weekly BU income statements. If the CFO has ideas to share with the BU’s management, they will offer to make a field visit with the BU manager in an effort to support improvement. If large unfavourable quarterly target profit variances become a reality, a meeting with the CFOs staff is required.

Connor Remhild, LAX’s CFO, is of the opinion the CGUs cannot be identified at a lower level than the firm level (one CGU). Your role is the audit manager, and the CGU decision is important for the first time adoption of IFRS and subsequent years. The audit partner is interested in your recommendations.

At what level should LAX identify CGUs? Clearly state your reasoning for selecting one of the following alternatives: Firm wide (one CGU), Business Groups (eight CGUs), Business Units (multiple CGUs). OR, you may identify another alternative. Your argument for your chosen CGU level should be strong, and it should be clear why other alternatives are inferior. Clearly state any assumptions that you are making in your recommendation. Cite relevant IFRS standards or guidance or other credible sources (eg. Deloitte IAS Plus). Use citations.

Answer 1

Answer :

A cash generating unit is defined by IAS 36.6 as: ‘…the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.’

The composition and nature of CGUs varies from entity to entity, and is determined largely by entity specific factors.

In practice, CGUs could represent: – An entire entity (parent or subsidiary entities within a group) – Departments or business units within an entity – Production lines within a department, or within an entity – Groups of items of property, plant and equipment within a production line, within a department, or within an entity.

For the purposes of the allocation of goodwill, CGUs to which goodwill is to be allocated must :

a) Represent the lowest level within the entity at which the goodwill is monitored for internal management purposes, and b) Not be larger than an operating segment, as defined by paragraph 5 of IFRS 8 Operating Segments before aggregation.

It is important to note that even though an entity may be outside of the scope of IFRS 8 (e.g. because it is not listed on a public market), the references to operating segments as defined in IFRS 8.5 still apply for the purposes of the application of IAS 36.

Operating Segment is defined as under :

- business activities that generate revenues and incur expenses (including business activities with other components within the same entity)

– whose operating results are regularly reviewed by the entity’s chief operating decision maker (CODM) to make decisions about resources to be allocated to the segment and assess its performance

– for which discrete financial information is available.’

In view of above the approach of treating Firm wide (one CGU) is not line of IFRS principle since CGU cant be larger than operating segment. Company does have 8 operating segment (internal reporting done on that level)

Business Group (Eight CGU) or Business Unit (CGU) :

IAS 36 defines cash generating unit as the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.

Hence in case of company for internal reporting purpose the BU level details are available and they can be considered as cash generating unit since CGU is the smallest unit where Business Group is larger than BU hence BU needs to be considered as CGU.