You are the newly appointed head of the finance team for Charm Plc (Charm) a company that manufacturers machinery in both the UK and overseas markets. One of your first tasks as head of the finance team is to review the draft single entity financial statements of Charm for the year ended 31 May 2021. These statements were prepared prior to your appointment as head of finance. A member of the finance team, Sheetal Paresk has raised some potential issues in respect of the draft financial statements and has sent you an email for further clarification and guidance. Charm prepares financial statements under IFRS Standards. Extracts from the email and the draft financial statements are included below: 

To: 

Head of Finance From: Sheetal Paresk Subject: Draft financial statements for the year ended 31 May 2021 and potential issues Dear Head of Finance Thank you for taking the time to provide some advice and guidance on the issues below. ISSUE 1 On 1 June 2020 a new three-year contract to rent a specific machine from Taro ltd began. Under the terms of the contract, the machine will remain on Charm’s premises and Charm is responsible for any repairs and maintenance. The contract requires three annual rental payments of £40,000 with the first payment due immediately on 1 June 2020. The interest rate implicit in the contract is 6%. The equipment has a useful life of ten years but will be returned to the Taro ltd at the end of the three-year contract term. As we are only using the asset for three years, we have accounted for the first payment of £40,000 as a rental expense which is recognized within cost of sales. We believe this is correct under IFRS Standards, can you please confirm? ISSUE 2 On 1 June 2020 1 million 5% convertible redeemable preference shares were issued at par (par/nominal value £1 each). The preference shares are redeemable at par for cash on 31 May 2024, or are convertible into 200,000 new £1 ordinary shares at that date. The preference dividend is paid on 31 May each year. An interest rate on similar redeemable preference shares without the conversion option is 7%. In the draft accounts, the preference shares have been accounted for as equity as it is expected that the holders of the preference shares will choose the conversion option rather than to redeem the preference shares. In line with the treatment of the preference shares the dividend paid has been deducted from retained earnings and has been disclosed in the statement of changes in equity. Can you please confirm that this accounting treatment is correct in accordance with IFRS Standards. ISSUE 3 Charm has two pension schemes in operation. Pension scheme 1 is a defined benefit scheme only available to employees who worked for the company before May 2015. The actuarial report at 31 May 2021 includes further details as follows: 

Actuarial valuation: 31 May 2021 £’000 £’000 2021 2020 Assets 1,014 912 Liabilities 1,405 1,210 Net liability 391 298 For the year ending 31 May 2021: £’000 Current service costs 190 Cash contributions 225 Benefits paid 120 Interest rate applied 3.2% A payment of £225,000 has been made as advised by the actuarial report for contributions to the scheme (see above). The finance team recognized this amount as an employee cost in the draft statement of profit or loss for the year No further adjustments have been made in respect of this defined benefit scheme. The draft statement of financial position as at 31 May 2021 still recognizes a net pension liability of £298 million as was the case last year. Pension scheme 2 is a defined contribution scheme. Under this scheme Charm pays 5% of eligible employees salaries into a pension scheme. The cash payments are up to date and have also been recognized as an employee cost in the draft statement of profit or loss. I am not sure why there is a liability balance for pension scheme 1 but not for scheme 2, could you please clarify the accounting treatment under IFRS Standards? 

ISSUE 4 On 1 June 2020 Charm issued 100 options to 10,000 of its employees. The fair value of each option at the grant date was £20. On this date the market value of Charm’s shares was £30 per share. The shares will vest on 1 June 2022 if the market price of Charm’s shares have increased by at least 10% over the vesting period (from its market price at the 1 June 2020) and the employees must remain in employment for two years. At 31 May 2021 200 employees had left and it was anticipated that a further 200 employees would leave in the year to 31 May 2022. The share price of Charm at 31 May 2021 was £32. No accounting entries in respect of the share option have been made this year as the share price has not increased by 10% and we do not know with sufficient reliability that the 10% increase in market price of shares criteria will be achieved by the vesting date. 

REQUIRED: 

Draft a response to Sheetal Paresk detailing the accounting implications of the transactions in issues (1) to (4) above on the 31 May 2021 financial statements. You should discuss the conceptual implications and the correct accounting treatment for each transaction using relevant IFRS Standards and the IASB’s Conceptual Framework for Financial Reporting. You may undertake your workings to the nearest £1,000.

Answer rating: 100% (QA)

Dear Sheetal Paresk Thank you for your email and for raising these potential issues in respect of th... View the full answer