cap reconst hra ea etc

8/3/2019 Cap Reconst Hra Ea Etc

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Financial Reporting ICAN PE III Nov 2008

Taiwo Oyedele ACA ACIT CISA ACCA ANCS WySE Associates1

CONTENTPage

Capital Reconstruction 1

Corporate Social Responsibility Accounting 15

Environmental Accounting 15Human Resources Accounting 16

Inflation Accounting 18

Foreign Exchange Transactions 21

Practice Question - HRA 23

ACCOUNTING ISSUES RELATING TO CAPITAL RECONSTRUCTION

CAPITAL RECONSTRUCTIONCapital Reconstruction is a means of resolving capital problems of business organisations. Capitalreconstruction can either be internal or external depending on the type and nature of capital problem.

Peculiar business problems can be resolved by effecting a capital reconstruction in either of these twoforms or a combination of both.

INTERNAL CAPITAL RECONSTRUCTION:This can be by way of re-capitalisation or capital reduction. It is a means of solving capital problem of acompany without involving another company.

Capital Re-flation or Recapitalisation - increasing the capital base of a business by way of:1. Issue of shares by offer for subscription either by right to existing shareholders or general offer to the

entire public by way of public issues.2. Issue of debenture, provided it will not significantly affect the prevailing gearing ratio and can be

accommodated by the current or anticipated level of profits.3. Borrowing short or long term depending on the level of the companys capital gearing and profitability.4. Conversion of assets to liquid resources by way of disposal of asset for cash provided such assets are

not critical to the companys operations.5. Leasing the required assets by operating or finance leases or effecting a sales and lease back of the

required asset rather than incurring direct capital expenditure which will put pressure on the depletedor non-existing cash.

Capital Reduction - reducing the issued capital of a company by:1. Extinguishing or reducing the liabilities on a companys share not represented by available assets.2. Extinguishing or reducing the liabilities on a companys share in excess of the companys need.3. Extinguishing or reducing the liabilities on a companys share not fully paid up.

Legal Procedures for effecting a capital reduction scheme1. Authorisation by the companys article of association2. Approval by a special resolution of the members of the company.3. Approval by the court (court sanction)4. The minutes of the meeting, copy of the special resolution and a copy of the court sanction must be

filed with the Corporate Affairs Commission (CAC).

ACCOUNTING FOR CAPITAL REDUCTION

In order to account for capital reduction, an account known as CAPITAL REDUCTION ACCOUNT mustbe opened. This account should contain on its debit side all losses attributable to the capital reductionscheme and on its credit side all gains resulting from the capital reduction scheme.

For a successful capital reduction scheme, the balance on the capital reduction account should either benil indicating that all losses attributable to the scheme were covered by gains arising from the scheme, ora credit balance; indicating that there are more gains than losses arising from the capital reductionscheme. Such credit balance should be transferred to capital reserves account as part of shareholdersfunds.


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ACCOUNTING ISSUES RELATING TO CAPITAL REDUCTION SCHEME

1. Assets: (fixed and current assets)Objective of every scheme should be to restate asset to their realistic value, which is the value offuture economic benefit that is presumed derivable from the assets (indicated by the fair value of

the asset on a going concern basis).2. Liabilities: (long and short term liabilities)

The idea is to settle as much as possible all outstanding liabilities to avoid stoppage of thescheme by creditors or where possible encourage them to waive part of their liabilities. This ispossible, where the liability holders are convinced that they stand to loose more in the event of anoutright liquidation.

3. Liabilities Not Previously Recorded Now Settled: (contingent liabilities, arrears of dividend notpreviously recorded). Such payments constitute a loss to the company

Dr Capital reduction a/cCr. Mode of payment a/c.

With the amount paid.

Note: Liabilities not previously recorded, now waived, amount to neither a gain nor a loss.It has no effects on the accounts

4. Share Capital And Reserves (ordinary and preference shares)In a capital reconstruction scheme, share capital can either be reduced or increased.

(a) Amount written off share capital: Any amount written off share capital is a gain to the company.Dr. Share capital (ordinary or preferences.)Cr. Capitalreductiona/c.

With the amount written off share capital

(b) Increase to share capital due to additional issues of shares

(i) At Premium (Above nominal value)Dr Bank/Cash - with the issue proceeds (nominal value + premium)Cr. Share Capital - with par value (nominal value)Cr. Capital Reduction - with share premium

(ii) At a Discount (below nominal value)Dr Bank/Cash - with amount received (i.e. issue proceeds)Dr Capitalreductiona/c - with the discountCr. Share Capital - with the nominal value

(iii) At Par (at nominal value)Dr Bank/cash - with proceedsCr. Share capital - with nominal value

Reserves: (Revenue reserves, profit and loss, other reserves) balances in these accounts shouldbe transferred to the capital reduction account.

STEPS INVOLVED IN FORMULATING A SCHEME OF CAPITAL RECONSTRUCTION

1. Ascertain the total losses to be written off: This includes:(a) Accumulated losses and the debit balance on the other reserves account.(b) Obsolete stock and intangible assets.(c) Losses in respect of revaluation of assets downward to achieve realistic values (impairment of

assets).(d) Losses in respect of assets disposed below their carrying values(e) Reorganization cost and cost of issuing shares including discount on shares(f) Expenses and charges not previously provided for now to be paid or provided for e.g. arrears of

preference dividends, contingent liabilities etc.(g) Losses in respect of settlement of liabilities above book value


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(h) Other losses and debit balances as may be indicated by the prevailing circumstances beingstudied.

2. Ascertain the credits with which to write off the identified losses in step 1, above.(a) Utilization of reserve accounts with credit balances.(b) Surpluses on revaluation of assets

(c) Profits on disposal of assets.(d) Gains on settlement of liabilities at an amount below book values.(e) Credits in respect of liabilities waived (if any).(f) Reduction in ordinary share capital.(g) Reduction in preference share capital.(h) Reduction in liabilities.

POINTS TO BEAR IN MIND WHEN REDUCING LIABILITIES

(i) Preferential Creditors-This category of creditors are not expected to contribute to a scheme ofcapital reduction by accepting a reduction to their claims. They will be settled first in liquidationand as such will invariably receive all they are entitled to by insisting on a liquidation. Thepreferential creditors should therefore, be paid in full to ensure that they do not block the scheme.

(ii) Secured Creditors-This category of creditors had provided credits on a long term basis and theirstake in the company include their capital and the regular payment of interest at a fixed rate up tothe date of repayment of their capital.

For a successful scheme, the secured creditors can only be expected to reduce their claim byaccepting a reduction in their capital if it can be proved that they stand to loose more on outrightliquidation. A commensurate increase should be applied to their rate of interest whenever theircapital is to be reduced in a scheme, such that they continue to enjoy the same return on theircapital as before the capital reconstruction.

(iii) Unsecured Creditors- This category of creditors had provided goods and/or services to thecompany on credit and their claims are not secured. On liquidation, they will only be paid if there

are surplus after payment of preferential and secured creditors. In view of their position, they aremost likely not to be paid in full on outright liquidation. They are therefore expected to support ascheme of reconstruction by reducing their claims especially if they are offered immediatediscounted cash payments. Such discounted payment should not be lower than what thecreditors would receive on outright liquidation.

(iv) Preference Shareholders - This category of capital providers had invested in the company andthey participate in income at an agreed fixed rate. They can only be expected to support ascheme of capital reconstruction by reducing their capital if the reduction is not worse than whatthey stand to loose on outright liquidation. In view of their participation in income at a fixed rate, areduction in their capital should be compensated for by a commensurate increase in their rate ofdividend such that they continue to enjoy the same return on their capital as before the capitalreconstruction.

(v) Ordinary Shareholders -This category of capital providers are generally regarded as the ownersof the company. Therefore, the main burden of the losses on capital reconstruction should beborne by them. Reduction in their capital is merely a recognition of the depreciation in their capitaloccasioned by accumulated losses and will not affect the payment of dividend to them after thereconstruction.

3. Minimum Cash Requirement And The Sources Of Fund.The requirement for funds in a reconstruction include:

Naira1 Capital expenditure XXX2 Working capital XXX3 Repayment of liabilities XXX

XXXDeduct cash in hand / at bank (if any). (XX)MINIMUM CASH REQUIRED XXX


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Sources of fund include1. Issue of shares (ordinary and preference)2. Issue of debenture.3. Bank loan (short term or long term loan)4. Sale and lease back

5. Conversion of fixed asset or investments into liquid resources by disposal.6. Leasing the required capital assets.

4. Profitability - In view of the projected income after the scheme, (If known) the incomeattributable to each of the interested parties in line with capital structure should be compared afterthe scheme, with the profit attributable to them before the scheme. This is done by preparing anincome appropriation schedule before and after the scheme.

For a successful scheme, it is expected that the income attributable to the interested parties inview of the capital structure after the scheme should be better than that attributable before thescheme. The detailed scheme is then drawn up with the details gathered from the four steps asthe proposed capital reduction scheme.

EXTERNAL RECONSTRUCTION (Business combination)

BUSINESS COMBINATIONThe accounting issues relating to business combination will depend on the agreed terms which can resultin the business combination being treated either as an absorption, amalgamation, acquisition, takeovers ormergers.

Amalgamation & AbsorptionThis form of business combination involves the liquidation of one or more companies and the creation of anew company or the utilisation of an existing company to take over the assets, liabilities and operations ofthe liquidated company. The shareholders being settled with shares of the new company (or that of theexisting company) issued in exchange for the net assets taken over.

The accounting issues relating to this form of business combination involves the closing `entries in thebooks of the liquidated company or companies (if amalgamation). This is by way of realisation andreconstruction account, and the opening entries in the books of the new company, which involves theutilisation of a purchase of business accounts.

Takeovers, Acquisitions & MergersThis form of business combination does not involve the liquidation of companies. It involves:

o Acquisition of a company's ordinary shares: by another to the extent that, that other company controlsthe acquired company and become its holding company and the acquired company is referred to asthe subsidiary. The accounting issues relating to this form of business combination are taken care ofby the provisions of the Companies & Allied Matters Act 1990 (CAMA 1990) and the InternationalAccounting Standard 27 (IAS 27).

o Businesses can also combine by way of uniting of interests, which is otherwise known as mergers.Such combination should be accounted for, if it is an exchange of voting shares, by pooling of interestmethod of business combination in line with the provision of IAS 22.

Before an external reconstruction scheme can be acceptable to the parties concerned, a compromiseor scheme of arrangement should be drawn up and approved.

A compromise or scheme of arrangement is an agreement between a companys shareholdersand its creditors in which the various interested parties agree to give up some of their legal rights inorder to allow the company to survive. They will do so, only, if there are reasonable prospects thatthe company will get out of trouble and start to make profits, such that the parties concerned areassured of a better deal by lettering the company survive than by forcing it into liquidation.

In view of the provision of CAMA S.539 and 540, for such a scheme to be legally effective:


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(i) It must be supported by majority of shareholders holding not less than 75% of equity shares.

(ii) It must be supported by majority of creditors whose total debt is not less than 75% of the totaldebts to creditors.

(iii) It must be sanctioned by the court. For this purpose the court may refer the compromise or

scheme of arrangement to the Securities and Exchange Commission (SEC) who shallappoint one or more inspectors to investigate the fairness of the said compromise orarrangement and provide a written report to the court.

(iv) A certified true copy of the court order approving the scheme of arrangement or compromiseshould be filed by the company with the Corporate Affairs Commission (CAC) and a copy ofthe court order should be annexed to every copy of the companys memorandum ofassociation issued after the order has been made.

EXTERNAL RECONSTRUCTION

1. Absorption A + B = B A is liquidated and company B takes over its assets, liabilitiesand entire operations

2. Amalgamation A + B = C A and B are liquidated and a new company C is formed to takeover the assets, liabilities and operations of A and B.

3. Takeover / Acquisition A + B = A & b A becomes the parent company and b the subsidiary.

4. Merger A + B = AB Both companies become one entity and are jointly managed.

AMALGAMATION AND ABSORPTION

Amalgamation and absorption, as an aspect of business combination arising from external reconstruction;involves the liquidation of one or more existing companies and the formation of a new company or anexisting company to takeover the assets, liabilities and operations of the liquidated company(s). In

consideration for the acquisition the new or acquiring company issues its shares in exchange to theshareholders of the liquidated company(s) for the net assets and operations of their liquidated company(s)taken over.

Accounting for this would require:

1. Closing up the books of the liquidated company (s)2. Opening up the books of the new company or recording the transactions in the books of the

purchasing company.

ACCOUNTING ENTRIES REQUIRED IN CLOSING UP THE BOOKS OF THE LIQUIDATED COMPANYThis involves:

1. Realisation account2. Reconstruction account3. Sundry members account4. Purchasing/New companys account

1. REALISATION ACCOUNTThis account compares the value of the net asset disposed with the purchase consideration inorder to ascertain the profit or loss on disposal. This is transferred to reconstruction account eitheras reconstruction gain (if profit) or reconstruction loss if (a loss).

Note: in some cases this account can also be combined with the reconstruction account

To achieve this the following entries should be passed.

Assets taken over/disposed to new companyDr Realisation accountCr. Individual assets account


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With the book valueLiabilities taken over

Dr Individual liability accountCr. Realisation Account.

With the amount outstanding in the liability accountRealisation Costs

i. if borne by the old / liquidated companyDr Realisation accountCr. Mode of Payment

With the amount paid

ii. If to be borne by the old / liquidated company but paid by the New /Purchasing company out ofthe purchase consideration as agreed

Dr Realisation accountCr. Purchasing company account

With the realisation cost in the books of the liquidating company.

Dr Vendor/Liquidated companys accountCr. Mode of payment

With the realisation cost in the book of the new/purchasing company.

iii. If paid and borne by the new company. (As additional purchase consideration)Dr Purchase of business accountCr. Mode of Payment

With the realisation cost in the books of the new company

Purchase Consideration as agreed - This should be the amount the new/purchasing company hasagreed to pay to ordinary and preference shareholders of the liquidated company plus the amount due toany liability of the liquidated company to be settled by the new or purchasing company as part of theconsideration for the take over. Any such liability whose payment had been included in the purchaseconsideration should not be transferred to the realisation account

Dr Purchasingcompany accountCr. Realisation account

A credit balance on the Realisation account indicates a profit, which should be transferred toReconstruction account or Sundry members account. (where reconstruction account is notopened)

Dr. Realisation accountCr. Reconstruction account

A debit balance represents a loss, which should be transferred to the Reconstruction account orSundry members account.

Dr. Reconstruction accountCr. Realisation account.

RECONSTRUCTION ACCOUNT

This account warehouses entries in respect of losses and gains resulting from the externalreconstruction scheme.

Losses such as realisation loss, intangible assets written off because they are deemed to bevalueless, accumulated losses and losses in respect of amount paid in excess of dues to liabilityholders should be debited to this account. In addition the debit balances in the books of theliquidated company(s) which are not capable of being realised should be written off to thisaccount.

Dr. Reconstruction accountCr. Realisation account - with realisation lossCr. Intangible assets account - with intangible assets deemed valuelessCr. Profit and loss account - with the accumulated lossesCr. Liability account - with premium paid on liability above book value


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Cr. Other debit balances - with debit balances not capable of being realised

Gains such as profit on realisation, amount waived on liabilities and other credit balanced reserveshould be credited to this account.

Dr. Realisation account - with realisation profits

Dr. Liability account - with the amount waived on liability settledDr. Other credit balances - with the credits utilisedCr. Reconstruction account

The net difference on the account being a reconstruction profit or loss is then transferred toSundry members account.

Dr. Sundry members account - with net reconstruction lossCr. Reconstruction account - with net reconstruction loss

Dr. Reconstruction account - with net reconstruction profitsCr. Sundry members account - with net reconstruction profits

In certain instances, the reconstruction and realisation acounts are combined, this is especially so,

if the assets are not being independently realized, that is, the entire business is being taken overby a new company as per a scheme of arrangement of a compromise.

NEW/PURCHASING COMPANYS ACCOUNT

The purchase consideration agreed as take over value for the net assets of the liquidatedcompany should be

Dr. New/Purchasing company accountCr. Realisation Account

While the settlement to any liability included in the purchase consideration, the preferenceshareholders and the Sundry Members should also be credited to this account.

Dr. Liability accountDr. Preference share capital accountDr. Sundry members accountCr. New/Purchasing company account

With amount agreed as settlement to each of the interested parties in the purchase consideration

The balance on this account after passing these entries should be NIL for a successful scheme.Indicating that the books of the liquidated company have been effectively closed.

SUNDRY MEMBERS ACCOUNT

This account records the entitlement of the ordinary shareholders, which should comprise of thebalance on the ordinary share capital account;

Dr. Ordinary share capital accountCr. Sundry members account

With the balance on the ordinary share capital's account.

and the profit on the reconstruction account ;Dr. Reconstruction accountCr. Sundry members account

or loss on the reconstruction accountDr. Sundry members accountCr. Reconstruction account

(Gains and the profit or loss, on reconstruction being separately posted if a reconstructionaccount is not opened.)


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The net entitlement of the Sundry members will now require a debit to Sundry members accountand a credit to the Purchasing Company Account. (in final settlement of the amount due tomembers of the liquidated company)

Dr. Sundry members accountCr. New/Purchasing company account

If there are preference shareholders, the balance outstanding in the preference share capitalaccount representing their entitlement in the liquidated company should be taken care of bydebiting preference share capital account and crediting Purchasing companys Account with theamount agreed as settlement to the preference shareholders.

If the amount agreed as settlement to the preference shareholders out of the purchaseconsideration is not equal to the balance on the preference share capital account, the differenceshould be credited or debited to Reconstruction account as gain or loss on reconstruction.

OPENNING ENTRIES IN THE BOOKS OF THE NEW OR PURCHASING COMPANY

This involves the opening of:

1. Purchase of business account2. Vendors or liquidated companys account.

PURCHASE OF BUSINESS ACCOUNT

This account determines the goodwill or capital reserve resulting from the take over of the netassets of the liquidated company at the agreed purchase consideration. For this purpose thefollowing account of entries should be passed:

(a) Assets taken over

Dr. Individual assets accountCr. Purchase of business account

with the amount placed on these assets as their fair value by the new/purchasingcompany.

(b) Liabilities taken over

Dr. Purchase of business accountCr. Individual liabilities accountWith the amount agreed to be settled or paid by the new or purchasing company.

(c) Purchase consideration as agreed

Dr. Purchase of Business AccountCr. Vendor/ liquidated companys account

(d) Balance on purchase of business account

If debit indicates that the liabilities taken over and the amount agreed as purchase consideration isin excess of the fair values of tangible assets taken over, therefore, the excess which representsthe value of intangible assets, should be transferred to goodwill account by

Dr. Goodwill accountCr. Purchase of business account

If the balance is a credit balance, this is an indication that the values of the assets taken overexceed the liabilities taken over and the purchase consideration agreed to be paid. Such a creditbalance is referred to as capital reserves and should be transferred by:

Dr. Purchase of business accountCr. Capitalreserve account.


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VENDOR/LIQUIDATED COMPANYS ACCOUNT

This account is used in recording the settlement of the amount due to the owners of the net assetsof the liquidated company taken over. The credit side contains the amount agreed as purchaseconsideration, which is the corresponding entry from the purchase of business account.

Dr. Purchase of business account

Cr. Vendor/ liquidated companys accountWith the amount agreed as purchase consideration

On settlement of the purchase consideration, this account is debited and the mode of settlementwhich may be ordinary shares, preference shares, debenture end share premium credited.

Dr. Vendor/ liquidated companys accountCr. Ordinary share capital accountCr. Share premium accountCr. Preference share accountCr. DebentureaccountCr. Cash

In a proper external reconstruction involving absorption and amalgamation it is expected that for

the shareholders of the liquidated company to remain shareholders in the new company thereshould be no cash settlement except if there are dissenting shareholders or debenture holdersthat were settled with cash.

EXAMPLES OF BUSINESS CAPITAL PROBLEMS

1. OVER CAPITALISATION.This is a situation whereby a company has capital in excess of what is ordinarily required for itssize and level of operations. Consequently it has become impossible to remunerate adequatelyall existing capital providers. Indicators:

Low HighGearing level LiquidityROCE Working capital (solvency)Asset turnover P/E ratioProfitabilityEPS

POSSIBLE SOLUTIONS:(i) Internal reconstruction by way of capital reduction (extinguishing un-called portion of the

allotted shares)(ii) External reconstruction:

-- diversification by way of takeovers of subsidiary and passing excess capital to subsidiary asinvestments.-- Absorption or Amalgamation; creation of a new company to take over the net assets and

operations of the over-capitalised company. In exchange, the new company issues its own sharesand also paid cash to shareholders of the liquidated company.

2. LOST CAPITALThis is a situation whereby the whole of the paid up capital is not fully represented by valuableassets such that fixed assets are mostly obsolete or fully depreciated, stock in trade are obsolete,assets are mainly or substantially fictitious and intangible.

POSSIBLE SOLUTIONS:(i) Internal capital reconstruction capital reduction.(ii) External reconstruction - by way of absorption or amalgamation

3. SUBSTANTIAL & PERSISTENT TRADING LOSSES.

This is a situation whereby a company had traded persistently at losses in the past, and nowwishes to resume payment of divided out of current profits.Indicators: Huge debit balance in P & L account

: Fully eroded share capital


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POSSIBLE SOLUTIONS:(i) Internal reconstruction by way of capital reduction(ii) External reconstruction by way of absorption or amalgamation.

4. UNDER CAPITALISATION

This is a situation whereby the capital available to a business organisation is inadequate in view ofits level and type of operations (over trading).

Indicators: High cost of borrowingHigh level of gearingLow profitability (ROCE)High PE RatioLow working capitalLow solvency & liquidity

POSSIBLE SOLUTIONS:(i) Internal reconstruction by way of capital reflation(ii) External reconstruction right issue

5. LIQUIDITY PROBLEM & INSOLVENCYThis is a situation whereby a company is unable to meet its financial obligation to creditors as andwhen due (short and long term).

Indicators: High cost of borrowingNegative working capitalLow solvency & liquidity

POSSIBLE SOLUTION: Internal reconstruction by way of capital reflation

6. IMBALANCE CAPITAL STRUCTUREThis is a situation whereby a company operates with a funding mismatch in terms of long termassets being financed with short-term liabilities or vice versa.

POSSIBLE SOLUTIONS: The company can do a conversion of short-term liabilities or issue of

debenture or issue of shares and applying the proceeds to pay short-term liabilities.

7. OVER CAPITALIZATION

A Company can be said to be overcapitalized where1. t is unable to profitably utilize the whole of its subscribed equity and loan capital.2. If it has capital in excess of what is ordinarily required for its level and type of operations.3. The capital of the company is not represented by valuable assets due to a long period of

unprofitable trading.

The first situation may arise where a company fund without due regard to its scale of productionand the amount of working capital required, and similarly through a large retention of profit andbuild up of reserves.

Over capitalization also results in the company being unable to earn sufficient revenue toadequately remunerate the capital employed, its share prices are likely to fall in value.

The last situation generally results when a company becomes increasingly uncompetitive either interms of its product, processes utilized in producing, or the nature and demand of the market.The companys fortunes are likely to deteriorate leading to lower profit in e arly years and possiblysignificant losses in later years. Consequently, the companys resources becomes depleted andoften over stated on the balance sheet such as excessive obsolete stock, substantial bad debts,non existing goodwill and excess value of plant and machinery.

FACTORS / SIGNALS INDICATING OVER CAPITALISATION

1. Return on capital Employed- this would be low2. Earnings per share- there would be a fall in EPS


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3. Dividend per share- in view of the low earnings, amount declared as dividend will also below

4. Rate of asset utilization / asset turnover will be low as most of the assets will be idle5. There would be high cash resources leading to high liquid ratio as most of the excess

capital would be tied down in cash resources, stock and debtors6. The current ratio would be in excess of 2:1 as there is over investment in working capital.

7. High stock days.8. High debtors collection period as the company becomes inefficient in collecting debts.9. Creditors collection period will be short.

SOLUTIONS TO-OVER CAPITALISATION

A company finding itself in a situation of overcapitalization should

1. Explore the option of diversification except precluded by its object clause.2. Consider a capital reconstruction3. As into liquidation and effect a scheme of absorption which allows the distribution of the

realizable proceed from the sales of the valuable asset to a new company formed for thatpurpose and owned by the existing shareholders.

8. UNDER CAPITALISATION OR OVER TRADING

This is a situation whereby a company operates with a level of capital that falls short of what isordinarily required for its level and type of operations. This situation is also indicated by abusiness organisation that is operating on a scale or growing at a rate in excess of that which canbe financed by its working capital and liquid resources.

This situation can be caused by both internal and external factors

INTERNAL1. Aggressive expansion of turnover (by aggressive marketing and advertising strategy)

without correspondingly increasing working capital.

2. By increased investment in land and building, machinery, vehicles and other fixed assetswithout a corresponding increase in equity or borrowings.

3. By stock piling of inventory in anticipation of likely rise in prices without adequate fund forthis purpose.

EXTERNAL1. Taxation Excessive taxation either direct or indirect may make it more difficult for the

business to finance its activities out of funds generated from operations.2. Inflation in a period of inflation, the replacement cost of stock raw materials and fixed

assets are all likely to increase, thereby necessitating increasing amount of capital tofinance existing level of activity.

INDICATORS OF OVERTRADINGThe signals, which are often indicative of over trading, include:

1. The company taking much longer time to pay its creditors2. Increases in stock without relative increase in turnover3. Growth in the rate of borrowing particularly short term bank borrowings- with its attendant

increases in interest expense.4. Declinein rate of profits.5. Decrease in current and liquid ratios6. Reduction in debtors ratio as a result of pressures imposed on debtors to pay quickly.7. Curtailing acquisition of fixed assets that are not critical to operations8. Low level of workingcapital

SOLUTION TO OVERTRADING1. Increase the level of capital by subscribing more equity shares.2. Avoid mis-match by ensuring that long-term assets are adequately funded by long term

funds and current assets are funded by current liabilities.


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PRACTICE QUESTIONS - CAPITAL RECONSTRUCTION

Question 1The draft balance sheet of Restart Limited at 30 September, 2005 was as follows:-

=N= =N=Fixed assets

Intangible assetsDevelopment costs 24,000Parents and trade marks 34,000

58,000Tangible assets

Freehold properties (cost) 70,000Plant and machinery (NBV) 120,000

190,000Shares in subsidiary company (cost) 120,000

368,000Current assetsStocks 124,000Debtors 160,000

Amount due from subsidiary company 42,000326,000

Creditors:amounts falling due within one yearBank overdraft 104,000Sundry creditors 220,000Loan from directors 30,000

354,000Net current liabilities (28,000)

340,000=======

Capital and reservesCalled up share capital (authorised: N700,000)

320,000 8% N1 cumulative preference shares fully paid 320,000

320,000 N1 ordinary shares 75k paid 240,000560,000

Profit and loss account (debit balance) (220,000)340,000

=======Note: Arrears of preference dividends amount to N25,600.

A scheme for reconstruction was duly approved with effect from 1 October 2005 under thefollowing conditions.a. The unpaid capital on the ordinary shares will be called up.b. The arrears of preference dividend will be cancelled and each preference shareholder will

accept a reduction of 25k per share. The dividend rate on new preference shares is to beraised to 9%.

c. The ordinary shareholders will accept a reduction of 75k on each share held.d. Patents and trade marks are to be reduced to N24,000; a provision for doubtful debts of

N30,000 is to be created; N50,000 is to be written off plant and machinery and N20,000 offshares in subsidiary.

e. Freehold properties are professionally valued and are to be written up to N190,000.f. Development costs are to be eliminated.g. The directors agreed to take ordinary shares at the new par value of 25k each in settlement of

loans outstanding.h. The debit balance on profit and loss account is eliminated.i. each ordinary shareholder (including directors, in respect of their new holdings) to take up two

new ordinary shares for every one held. j. each preference shareholder to take up one new preference share for every four held.

The resolution for the reduction of capital, provided for the restoration of the authorizedcapital to N700,000.


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Assume that all these transactions were completed on 1 October, 2005.

Requireda. i. Show the necessary ledger entries in the capital reduction and reconstruction account, the

share capital accounts and the bank account.ii. Show the balance sheet of the company after the reconstruction.

b. State briefly what object is served by a scheme for reduction of capital where a company hasincurred heavy losses. By whom should such losses be borne and why?

Question 2 Formulation of a scheme

DESPERATE PLC

Desperate plc has been operating in the scrap metal industry for many years. The company is underpressure from its bankers and other creditors and the directors wish to consider re-organisation.

The summarised balance sheet of Desperate Plc at 30 September 2005 is as follows:

N000 N000Capital and reserves

Share capitalOrdinary shares of N1 each fully paid 1,500

7% Preference shares of N1 each fully paid 500

2,000

Profit and loss account (352)1,648

Fixed assets

Patents and research and development 500

Land and buildings (freehold) 700

Plant and machinery 1001,300

Current assets

Stock 1,200Debtors 830

Investments at cost (market value N220,000) 150

Cash in hand 10

2,190Creditors falling due within 1 year

Bank overdraft and short term loans (1,140)

Trade and other creditors (148)

Directors loans (140)

Debenture interest (14)(1,442)

Net current assets 748

2,048Creditors due after more than 1 year

7% debenture secured on land and buildings (400)

1,648

The following additional information is given:

1. The estimated costs of the reorganisation scheme are N50,000.

2. Of the trade and other creditors, N45,000 relates to arrears of 2 weeks wages, N25,000 to VAT andN12,000 to Scrap Metal Dealers Association, the balance being trade creditors.

3. Accruals for expenses in September of N60,000 have not been included.


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4. If the reorganisation took place, an estimated N100,000 would be required for new processingequipment.

5. The bank would require part payment of its overdraft and short term loans before agreeing to thescheme. Preliminary negotiations suggest that a 40% payment would be acceptable.

6. Preference dividends are 3 years in arrears.

7. The values of certain assets on a going concern and break-up value bases are as stated below.

Going concernvalues

Break upvalues

N000 N000

a Patents 140 70b Land and buildings 900 900

c Plant and machinery 10 8

d Stock (unprocessed scrap) 800 500

e Debtors (less estimated bad debts) 790 600

8. A floating charge is held by the bank.

9. There is a general willingness on the part of the shareholders and directors to forego part of theircapital and their loans and to subscribe further equity capital.

10. The debenture holder is willing to provide further secured funds.

You are required to:Prepare for consideration of the directors of Desperate plc:

a] your estimated statement of affairs, assuming a liquidation with assets realised on a forced salebasis, making such assumptions as you consider appropriate;

(8 marks)b] your suggested scheme of re-organisation; and

(10 marks)c] the balance sheet following your scheme.

(7 marks)(Total 25 marks)

Note: Marks will be awarded primarily for principles and presentation. Workings are required.


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CORPORATE SOCIAL RESPONSIBILITY (CSR) ACCOUNTING

"Companies are judged by their performance, but external expectations and sustainability priorities differbetween regions, markets, and particular stakeholders.

CSR can mean different things to different groups, sectors and stakeholders. But there is a general

agreement that in a global economy, businesses are often playing a greater role beyond job and wealthcreation and CSR is businesss contribution to sustainable development. Consequently, corporatebehavior must not only ensure returns to shareholders, wages to employees, and products and servicesto consumers, but they must respond to societal and environmental concerns and values.

Why should companies be socially responsible?

The concept of corporate governance has become paramount mostly in response to corporate collapses,corporate raiders and destabilising mergers and acquisitions, as well as business fraud and corruption.Issues of accountability, monitoring and disclosure, standard setting and global best practices are the keyissues. It is now clear that companies can no longer manage the effects of their business practices simplyby paying taxes and complying with national regulations. They are expected to take on greaterresponsibilities for managing their impact on society.

Implementing CSR is facilitated through standards and common codes of conduct. While firms themselveshave set the standards, governments have played a role in defining common rules. Codes of conductshave been created internationally, providing principles for business that promote benchmarking issues forhuman rights, workplace safety, transparency, environmental management, consumer protection andfighting corruption.

Roles of management in CSR

Here we are dealing with another aspect of the work of directing and managing, namely the relationshipwhich directors and managers have with the community in which they live and work, of which they are apart.

Decisions taken by directors and managers affect the community; affect the quality of life and indeed thesafety of health and life of the people in a widening area.

The purpose of enterprises is to satisfy the needs of the community and that in the end directors andmanagers are working for the community and that they are accountable to the community for the way inwhich this work is done.

In other words, directors and managers are responsible to the community for what they do, areaccountable to the community for the results of their work and for the way in which such results areachieved

ENVIROMENTAL ACCOUNTING

Introduction

The term environmental accountinghas many meanings and uses. Environmental accounting can supportnational income accounting, financial accounting, or internal business managerial accounting. The termenvironmental costhas at least two major dimensions: (1) it can refer solely to costs that directly impact acompany's bottom line (termed "private costs"), or (2) it also can encompass the costs to individuals,society, and the environment for which a company may not be accountable (termed "societal costs").

Environmental accounting in the context of financial reporting refers to the estimation and public reportingof environmental liabilities and financially material environmental costs. Examples include costs relating topollution control, remediation,community relations, decommissioning etc.

Why Environmental Accounting?

Environmental costs are one of the many different types of costs businesses incur as they provide goodsand services to their customers.


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Environmental performance is one of the many important measures of business success. Environmentalcosts and performance deserve management attention for the following reasons:

(1) Many environmental costs can be significantly reduced or eliminatedas a result of business decisions,ranging from operational and housekeeping changes, to investment in greener process technology, toredesign of processes/products. Many environmental costs (e.g., wasted raw materials) may provide no

added value to a process, system, or product.

(2) Environmental costs (and, thus, potential cost savings) may be obscured in overhead accounts orotherwise overlooked.

(3) Many companies have discovered that environmental costs can be offset by generating revenuesthrough sale of waste by-products or transferable pollution allowances, or licensing of clean technologies,for example.

(4) Better management of environmental costs can result in improved environmental performance andsignificant benefits to human health as well as business success.

(5) Understanding the environmental costs and performance of processes and products can promote

more accurate costing and pricing of products and can aid companies in the design of moreenvironmentally preferable processes, products, and services for the future.

(6) Competitive advantage with customers can result from processes, products, and services that can bedemonstrated to be environmentally preferable.

(7) Accounting for environmental costs and performance can support a companys development andoperation of an overall environmental management system.

HUMAN RESOURCES ACCOUNTING (HRA)

This concept attempts to place a value on employees as assets in an organisation and to measure

improvements or changes in these values using standard accounting principles. HRA was originallydefined as the process of identifying, measuring, and communicating information about human resourcesto facilitate effective management within an organisation. It is an extension of the accounting principles ofmatching cost and revenues and of organising data to communicate relevant information in financialterms. With HRA, human resources are viewed as assets or investments of the organisation. Methods ofmeasuring these assets are similar to those for measuring other assets. However, the process includesthe concept of accounting for the condition of human capabilities and their value as provided by themeasurement tools of the behavioural sciences.

From a practical standpoint, the concept is very sound. Consider, for example, a large consulting firmwhere the quality of service lies in the strength and capabilities of consulting staff. If, at one point in time,30 percent of the consulting staff resigned, a tremendous drain on the organisation as well as adevaluation of its assets would result. However, in standard accounting principles, the exit of theconsulting staff would not be taken into consideration. The human resources accounting process attemptsto show the value of these human assets. Some proponents suggest that recruitment cost and trainingexpenditure be treated as investments rather than expenses.

Human capital is one of the key non-financial areas of business activity where greater disclosures in theannual report and accounts are likely to be demanded in the future. There are proposals in some countrieslike the UK for companies to discuss significant issues impacting on past and future performance and todisclose employment related policies when these are significant for an understanding of the overallperformance.

As businesses increasingly become dependent on intellectual capital and know how, rather than onphysical fixed assets, so the recognition of the value added through the development, management andretention of human capital becomes ever more important from an external analysis perspective.

Human resource accounting (HRA), defined as the process of identifying and measuring data abouthuman resources and communicating this information to interested parties by the American Accounting


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uncertainty as to who the information should be reported to, and lack of interest in this area by senior management.

Other moderate concerns in relation to the valuation of human resources included: lack of reliable and valid measures which are not overly complex and difficult the lack of widely accepted measures and models concerns as to quantifying people, and lack of expertise by the human resource function in relation to valuation of human resources.

Suggestion for improvement in HRAIn order to show greater progress, more needs to be done at both the theoretical and practical level. Moreresearch into valuation methods and models, and the practical implication of these, is needed togetherwith the engagement of both human resource and accounting professionals in the debate on valuation andits implementation in practice.

Human resource related disclosures in the annual report and accounts should be made compulsory. Thedisclosure should be standardized to be as comparable as possible.

Possible human resource evaluation measures

Absenteeism rate HR costs/investment Revenue per employee

Accident frequency rate HR ratio Seniority

Average age Innovation Tenure

Client satisfaction surveys Intellectual capital

Competencies Job satisfaction Time to fill jobs

Cost of people Leadership Total shareholder return (TSR)

Cost per hire Learning Training and educational costs

Cost-benefit analysis Organisational commitment Traininglost

Economic value added (EVA) Return on investment (ROI) Turnover cost

Educational level Return on investment inhuman capital

Turnover rate

Experience Return on training Value added per employee

Healthcare cost per employee

INFLATION ACCOUNTING

During a period of changing price levels, the traditional approach of accounting for transactions at theiroriginal historical cost may not effectively and accurately reflect the performance and financial position of acompany. The deficiencies of historical cost accounting during inflation include:

The net book value of fixed assets is often substantially below their current value The balance sheet figure of stocks reflects prices ruling at the date of purchase or manufacture

rather than those current at the year end Charges made in arriving at the profit do not reflect the current values of assets consumed. The

effect is that profit is overstated in real terms

If the profit determined in this way were distributed in full, the level of operations would have to becurtailed

No account is taken of the effect of increasing prices on monetary items. For example, the cashtied up in debtors increases even where the volume of operations remains the same


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The overstatement of profit and the understatement of assets prevents meaningful calculation ofreturn on capital employed

Alternatives to historical cost accountingDespite the above limitations, historical cost accounts still prevail throughout the world because of the pastdifficulties in finding a suitable and generally acceptable alternative.

Available alternative approaches centre on constant purchasing power (CPP), current cost accounting(CCA) or a combination of both.

Constant Purchasing Power (CPP) AccountingThis involves accounting for general price changes. The owners of the business are shareholders whosuffer from general inflation as the purchasing power of their investment in the business declines.Changes in general prices are thus used to record the effect by adjusting all figures shown in terms ofmoney with the same purchasing power. The restatement is done using a general price index.

CPP accounts are prepared by updating all items in the income statement, and all non-monetary items inthe balance sheet, by the CPP factor:

CPP factor = Index at the balance sheet dateIndex at the date of entry in accounts

Depreciation is adjusted by reference to the date of acquisition of the related fixed asset.

Note: The owners of the companys equity capital have the residual claim on its net monetary and non-monetary assets. The equity interest is therefore not adjusted because it is neither a monetary nor a non-monetary item.

Current Cost Accounting (CCA)This involves the consideration of specific price changes. Here the perspective of the business as aseparate entity is paramount. The effects of price changes on the specific assets owned by the businessare therefore used.

In order to reflect the current value of assets, stock and fixed assets are re-valued. All other assets and allliabilities are usually monetary in nature (i.e. they are already stated at current values) and therefore donot need to be adjusted.

The current cost income statement is charged with the value to the business of assets consumed duringthe period. In particular, cost of sales and depreciation are adjusted to current rather than historical values.The current cost balance sheet is adjusted to reflect the current value of stock and fixed assets.

In order to prepare current cost financial statements, a number of adjustments to the historical costsfigures must be made. Specifically, adjustments are needed relating to:

Fixed assets and depreciation historical cost figures are converted usingIndex at year end

Index at acquisition

Current depreciation adjustment is treated in the current cost income statement while revaluationsurplus (net of backlog depreciation) is transferred to current cost reserve.

Stock and cost of sales historical opening and closing stock figures are converted using

Average index or Index at year endIndex for stock

Purchases are recorded at their actual cost prices during the year and should not be converted if weassume that activities occur evenly throughout the year. This is a reasonable assumption unless trade

is seasonal. The assumption means purchases figures reflect average prices for the period openingand closing stock which in times of inflation will not reflect average prices under the historical costconvention.


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If activities are seasonal, separate calculations should be made for each period within the accountingyear and then aggregated to a total for the year. The use of indices in this manner is termedaveraging.

Where average index is used as the numerator, the historical closing stock will need to be convertedin order to arrive at the current replacement cost for the CCA balance sheet purposes using

Index at year endIndex for closing stock

Monetary working capital monetary working capital adjustment (MWCA) represents the increase(or decrease) in finance necessary to provide an appropriate level of monetary working capital due toprice changes (rather than a change in the volume of working capital).

MWCA is calculated as the difference between:

a) historical cost closing net monetary working capital minus opening net monetary workingcapital, and

b) restated closing net monetary working capital at average prices less restated opening netmonetary working capital

Monetary working capital is converted to average prices using:

Average index for yearIndex for working capital

Note: (a) above will give the figure of total increase/decrease in working capital while (b) will givethe figure of increase/decrease due to change in volume. Therefore, the difference between (a)and (b) will give increase/decrease due to changes in price levels.

The term monetary working capital includes trade debtors/creditors, bills receivable/payable,prepayments, accruals, cash and bank balances. Cash and bank balances are however excludedand treated under gearing adjustment.

The index for stock may be used where no index is given for working capital.

Gearing if a company is financed by debt, and prices increase, whilst the monetary value of the loanhas not changed, the market value would have reduced. This represents a transfer of value fromlenders to shareholders, which is recorded by making a gearing adjustment.

The gearing adjustment is calculated as: Gearing proportion X Sum of current cost adjustments

Gearing proportion = average net borrowingaverage shareholders interest

Net borrowing = borrowing cash & bank


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PRACTICE QUESTION ENVIRONMENTAL / CSR ACCOUNTING

The federal Government of late feels that public limited companies are not doing enough about theirenvironment where they operate. Their financial statements do not address a broad range of theirenvironment pollution, emissions and steps taken for corrective measures and their management ofworkforce which includes investments in staff training, equal opportunities for promotions and

number of people injured at work in the year.

Companies that disclose details of the human resources in their financial statements are unsure asto what the benefits would be for the company and what constitutes current practice in this area.

Required

(a) Discuss why companies should disclose social and environmental information in theirfinancial statements and whether the contents of such disclosures should be at thecompanys discretion. (9 marks)

(b) Outline the nature of information being disclosed by companies concerning their workforcemanagement and how the link between the companys performance and its workforce could be

made visible. (6 marks)(Total 15 Marks) ICAN PEIII Nov 2006

FOREIGN EXCHANGE TRANSACTIONS

An exchange rate is the price of one currency expressed in terms of another currency.

Effect of changes in exchange rates

Exchange rate volatility can be damaging for international trade.

If a country has a currency that is depreciating in value, the cost of its imports will rise interms of its domestic currency. If the country is heavily dependent on import like Nigeria, thiscould have the effect of increasing the rate of inflation and thereby weakening the economy.

If a country has a currency that is rising in value, its exports will become more expensive forforeign buyers. Its export trade is therefore likely to suffer. This was the experience inGermany in 2002 to 2003.

Multinational companies face the problems of making profits when its operations are spreadacross different countries and different currencies. Exchange rate volatility creates problemsfor strategic planning, such as decisions about where to site production operations.

Determination of exchange rates

This is considered under two main headings:

1. the economic factors that affect exchange rates, particularly comparative rates of inflationbetween different countries and comparative interest rates between different countries

2. measures taken by governments to achieve exchange rate stability, such as the creation ofcurrency blocs and currency zones, and for some developing countries establishing acurrency board

Type of currency risk

The foreign exchange risk exposure of companies is normally broken down into threecategories:


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a) transaction exposure this relates to the gains or losses to be made when settlementtakes place at some future date of a foreign currency denominated contract that hasalready been entered into.

b) translation (or accounting) exposure this arises from the need to consolidate worldwideoperations according to predetermined accounting rules. Where the closing rate method

is used, it can result in considerable gains or losses on translation.c) economic exposure this relates to the possibility that the value of the company (thepresent value of all future cash flows) will change due to unexpected changes in futureexchange rates.

The foreign exchange market

The foreign exchange (FX or forex) market is an international market where the bulk oftransactions are completed by telephone and telex links, and increasingly by electronic tradingsystems. The market is extremely large. The biggest centre is the London FX market with a dailygross turnover exceeding US $300 billion. The principal participants in the market are the banks;businesses and governments.

The FX market is highly competitive:a) there are many buyers and sellersb) the commodity is homogenous (one US$ is the same as any other US$)c) through electronic information systems, there is near perfect information on prices

charged.

The result is a highly competitive market in which the price of currencies (the exchange rate) isdetermined by supply and demand and virtually no differences exist between one FX market(e.g. London) and another (e.g. New York).

Spot and forward exchange rates

Currency can be bought and sold either spot or forward.

Buying or selling spot means buying or selling for settlement now.

Buying or selling forward means buying or selling now, but for settlement (exchange ofcurrencies) at an agreed future date.

How are forward rates derived?

Forward rates are derived by applying current market interest rates to the spot exchange rate.

Suppose that the spot sterling/US dollar rate is 1 = $1.50, and that the one-year interest rate is6% for sterling and 4% for the US dollar. According to market prices, this means 1,000 has anequivalent spot value of $1,500

An investor with 1,000 who wants to exchange the sterling into dollars in one year has twoways of doing so. He can buy $1,500 now and invest the dollar for one year at 4% to earn$1,560 at the end of one year. Alternatively, he can invest 1,000 for one year at 6% to earn1,060 and then exchange the sterling for US dollars. For market rates to stabilise, this meansthat given the current spot exchange rate and current one-year interest rates, 1,060 in one yearhas an equivalent value of $1,560 and so an appropriate one-year forward rate now would be1.4717 (1,560/1,060).

The dollar would be stronger against sterling one year forward (at 1.4717), compared to the spotrate (1.5000). This is because the interest rate is lower on the dollar than on sterling.


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IllustrationSuppose that the spot rate for the euro against the US dollar 1 = $1.1500. The one-year rate ofinterest is 2.5% on the euro and 3.5% on the US dollar.

a) what would you expect the one-year forward rate to be?

b) Is the dollar stronger or weaker one-year forward compared with the spot rate? Whyis this the case?

Arbitrage and Purchasing power parity theory

The law of one price states that in a free market with no barriers to trade, no transport ortransactions costs, the competitive process will ensure that there will only be one price for anygiven good. If price differences occurred they would be removed by arbitrage; entrepreneurswould buy in the low market and resell in the high market. This would eradicate the pricedifference.

If the law is applied to international transactions, it suggest that exchange rates will alwaysadjust to ensure that only one price exists between countries where there is relatively free trade.Thus if a typical set of goods cost $1,000 in the USA and the same set cost 500 in the UK, freetrade would produce an exchange rate of 1 to $2. Suppose that the rate of exchange was $1.5to 1: the sequence of events would be:

(a) US purchasers could buy UK goods more cheaply (500 at $1.5 t0 1 is $750).(b) There would be flow of UK exports to the US: this would represent demand for sterling.(c) The sterling exchange rate would rise(d) When the exchange rate reached $2 to 1, there would be no extra US demand for UK

exports since prices would have been equalised: purchasing power parity would havebeen established.

The PPP model can be stated as

1 + if = F1 + in S

Where i f = expected foreign inflation ratein = expected home inflation rateF = expected future spot rateS = current spot rate

Illustration

The Nigeria (home) inflation rate is expected to be 3% over the coming period, and theequivalent rate in Anyland is expected to be 6%. The current spot AL / N = 4.5. Estimate thespot rate at the end of the period.

Ans: AL / N = 4.63


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Practice Question

On January 1, 2003, Annylever Plc a UK company which prepares its accounts in poundssterling sets up a Nigerian subsidiary, Anne Ltd. The currency of Nigeria, the Naira suffered fromhigh rate of inflation. On the same date, Anne Ltd acquired land for N400,000.

Relevant exchange rates are as follows:January 1,2003 N5 = 1January 1,2004 2.5 = 1December 31,2004 N25 = 1December 31, 2004 1.75 = 1

The relevant price index was 100 at January 1, 2003 and 500 at December 31, 2004.

Show the value at which the land would be included in the consolidated financial statement ofAnnylever Plc at December 31, 2004.

a) Using normal translation rules (the closing rate method).(4 Marks)

b) Adjusting to reflect current price levels (the basic IAS 29 method). (4 Marks)c) Using Euro as a functional currency (an alternative method consistent with the objectives of

IAS 29). (4 Marks)d) Comment on the closing figure. (3 Marks)(Note: IAS 29 - Financial reporting in hyperinflationary). (Total 15 Marks) ICAN May 2006

cap reconst hra ea etc

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