CR – Mar 2023 – L3 – Q2b – IAS 12: Income taxes

Discuss the appropriate accounting treatments for Sanda Ltd’s preference shares and deferred tax asset.

Question

Sanda Ltd, a consumer electronics company in Accra, faced a challenging year due to increased competition and COVID-19. Sanda Ltd has a year-end of 31 December 2021. The unaudited financial statements reported an operating loss, and debt covenant limits were close to being breached. The following occurred during the year:

i. On 1 January 2021, the Finance Director and CEO paid GH¢3 million each for preference shares that provide cumulative dividends of 7% per annum. These preference shares can either be converted into a fixed number of ordinary shares in three years or redeemed at par. The Finance Director suggested classifying the preference shares as equity.

ii. Sanda Ltd included a deferred tax asset in the statement of financial position based on losses incurred in the previous two years. The Finance Director asked the Accountant to include the deferred tax asset in full, expecting a return to profitability once funding issues are resolved.

Required:
With reference to International Financial Reporting Standards (IFRS), discuss the appropriate accounting treatments which Sanda Ltd should adopt for the issues identified in i) and ii) and their impact on gearing as at 31 December 2021.

Answer

Preference Shares – IAS 32:
- The preference shares meet the “fixed-for-fixed” requirement for equity classification because they can be converted into a fixed number of ordinary shares. However, since the shares can also be redeemed at par at the option of the holder, they contain both an equity and liability component, making them a compound financial instrument.
- The liability portion represents the obligation to pay cash (cumulative dividends or redemption). The equity portion represents the option to convert the shares into ordinary shares.
- Gearing will increase as the liability component will be classified as debt.
Deferred Tax Asset – IAS 12:
- Deferred tax assets can only be recognised when it is probable that taxable profits will be available in the future. In Sanda Ltd’s case, there must be convincing evidence that it will return to profitability.
- Given the history of losses, it is unlikely that the full deferred tax asset can be recognised without sufficient taxable profits. If removed, this would increase gearing as equity will decrease.

Marks Allocation:

Preference shares as a compound instrument: 5 marks
Deferred tax asset recognition: 5 marks
(Total: 10 marks)

Tags: Convertible Instruments, Deferred Tax, Equity, IAS 12, IAS 32
Level: Level 3

Topic: IAS 12: Income taxes
Series: MAR 2023

Uploader: Dotse