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ALL YOU NEED TO KNOW
Articles on key examinable
topics to support your studies
TECHNICAL
30 TAXATION OF
TERMINATION PAYMENTS
Relevant to ACCA Qualifcation
Paper F6 (IRL)
GROUPS
Relevant to ACCA Qualifcation
Paper F6 (UK)
OVERSEAS ASPECTS OF
CORPORATION TAX
Relevant to ACCA Qualifcation
Paper F6 (UK)
WHAT IS THE IASBS
CONCEPTUAL FRAMEWORK
FOR FINANCIAL REPORTING?
Relevant to ACCA Qualifcation
Papers F7 and P2
ONLINE RESOURCES
CAT qualifcation: www.accaglobal.com/students/cat
ACCA Qualifcation: www.accaglobal.com/students/acca
BUSINESS FINANCE
Relevant to ACCA
Qualifcation Paper F9
STRATEGY AND PEOPLE
Relevant to ACCA
Qualifcation Paper P3
ACCEPTANCE
DECISIONS FOR
AUDIT AND
ASSURANCE ENGAGEMENTS
Relevant to ACCA
Qualifcation Paper P7
TAXATION OF
TERMINATION PAYMENTS
RELEVANT TO ACCA
QUALIFICATION PAPER F6 (IRL)
From 2011, termination payments are
examinable in Paper F6 (IRL).
ACCESS RESOURCES RELEVANT
TO ACCA QUALIFICATION PAPER F6 (IRL)
www.accaglobal.com/students/acca/
exams/f6/
GROUPS
RELEVANT TO ACCA
QUALIFICATION PAPER F6 (UK)
With groups it is important that you
know the group relationship that must
exist for reliefs to be available. Where
a question involves a group you can
expect to spend more time than normal
planning your answer. However, working
through the examples in this article will
prepare you for anything that could
be set in the exam.
ACCESS RESOURCES RELEVANT
TO ACCA QUALIFICATION PAPER F6 (UK)
www.accaglobal.com/students/acca/
exams/f6/
OVERSEAS ASPECTS OF
CORPORATION TAX
RELEVANT TO ACCA
QUALIFICATION PAPER F6 (UK)
The overseas aspects of corporation
tax are fairly straightforward provided
you know the main principles involved.
Working through the examples in this
article should prepare you for anything
that might be set in the exam.
ACCESS RESOURCES RELEVANT
TO ACCA QUALIFICATION PAPER F6 (UK)
www.accaglobal.com/students/acca/
exams/f6/
WHAT IS THE IASBS
CONCEPTUAL FRAMEWORK FOR
FINANCIAL REPORTING?
RELEVANT TO ACCA
QUALIFICATION PAPERS F7 AND P2
The International Accounting
Standards Boards (IASB) Conceptual
Framework for Financial Reporting (the
Framework), is the definitive reference
document for the development of
accounting standards. This article takes
a look at how the Framework points
the way for the development of new
accounting standards.
ACCESS RESOURCES RELEVANT
TO ACCA QUALIFICATION PAPER F7
www.accaglobal.com/students/acca/
exams/f7/
ACCESS RESOURCES RELEVANT
TO ACCA QUALIFICATION PAPER P2
www.accaglobal.com/students/acca/
exams/p2/
BUSINESS FINANCE
RELEVANT TO ACCA
QUALIFICATION PAPER F9
Section E of the Paper F9 syllabus
deals with business finance: What types
of finance? What sources? What mix?
This article will first consider a
businesss formation and initial growth,
then a company that is wellestablished
and mature, and will look at the
financing choices and decisions that
it could face at various stages.
ACCESS RESOURCES RELEVANT
TO ACCA QUALIFICATION PAPER F9
www.accaglobal.com/students/acca/
exams/f9/
STRATEGY AND PEOPLE
RELEVANT TO ACCA
QUALIFICATION PAPER P3
When devising a strategic plan
it is important to consider the
organisations resources. These
will probably contribute to most of
the weaknesses and strengths in a
SWOT analysis.
ACCESS RESOURCES RELEVANT
TO ACCA QUALIFICATION PAPER P3
www.accaglobal.com/students/acca/
exams/p3/
ACCEPTANCE DECISIONS
FOR AUDIT AND ASSURANCE
ENGAGEMENTS
RELEVANT TO ACCA
QUALIFICATION PAPER P7
The syllabus for Paper P7, Advanced
Audit and Assurance includes
Professional Appointments (syllabus
reference C4).
23 MARCH 2011 RELEVANT TO ACCA AND CAT QUALIFICATION STUDENTS
TECHNICAL ARTICLES
30 TECHNICAL
The learning outcomes include
explanation of the matters that should
be considered and the procedures
that should be followed by a firm
before accepting a new client, a
new engagement for an existing
client, or agreeing the terms of any
new engagement.
ACCESS RESOURCES RELEVANT
TO ACCA QUALIFICATION PAPER P7
www.accaglobal.com/students/acca/
exams/p7/
ACCA QUALIFICATION
TECHNICAL ARTICLES
PAPER F1
www.accaglobal.com/students/acca/
exams/f1/technical_articles/
PAPER F2
www.accaglobal.com/students/acca/
exams/f2/technical_articles/
PAPER F3
www.accaglobal.com/students/acca/
exams/f3/technical_articles/
PAPER F4
www.accaglobal.com/students/acca/
exams/f4/technical_articles/
PAPER F5
www.accaglobal.com/students/acca/
exams/f5/technical_articles/
PAPER F6
www.accaglobal.com/students/acca/
exams/f6/technical_articles/
PAPER F7
www.accaglobal.com/students/acca/
exams/f7/technical_articles/
PAPER F8
www.accaglobal.com/students/acca/
exams/f8/technical_articles/
PAPER F9
www.accaglobal.com/students/acca/
exams/f9/technical_articles/
PAPER P1
www.accaglobal.com/students/acca/
exams/p1/technical_articles/
PAPER P2
www.accaglobal.com/students/acca/
exams/p2/technical_articles/
PAPER P3
www.accaglobal.com/students/acca/
exams/p3/technical_articles/
PAPER P4
www.accaglobal.com/students/acca/
exams/p4/technical_articles/
PAPER P5
www.accaglobal.com/students/acca/
exams/p5/technical_articles/
PAPER P6
www.accaglobal.com/students/acca/
exams/p6/technical_articles/
PAPER P7
www.accaglobal.com/students/acca/
exams/p7/technical_articles/
ACCA ONLINE STUDY RESOURCES
A wide variety of study resources
are available at www.accaglobal.
com/students/. Access the Student
Accountant technical article archive
at www.accaglobal.com/students/
student_accountant/archive/
CHANGES TO THE ACCA
QUALIFICATION FROM
JUNE 2011
Read more at www.
accaglobal.com/students/
student_accountant/
archive/2010/108/3333957
FOUNDATIONS
IN ACCOUNTANCY
Learn more about ACCAs
suite of entry-level
qualifcations Foundations
in Accountancy at
www.accaglobal.
com/fa
RESOURCES
www.acca
global.com/
students/acca
www.acca
global.com/
students/
cat
31
STUDENT ACCOUNTANT ISSUE 06/2011
CAT QUALIFICATION
Paper 3
www.accaglobal.com/students/cat/
exams/t3/examinable_documents
Paper 6
www.accaglobal.com/students/cat/
exams/t6/examinable_documents
Paper 8
www.accaglobal.com/students/cat/
exams/t8/examinable_documents
Paper 9
www.accaglobal.com/students/cat/
exams/t9/exam_docs
ACCA QUALIFICATION
Financial reporting
Paper F3 (International)
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/f3int_
examdoc2011.pdf
Paper F3 (UK)
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/f3uk_
examdoc2011.pdf
Paper F7 and P2 (International
and UK)
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/f7p2int_
examdocs2011.pdf
Paper F7 and P2 (Hong Kong)
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/f3f7p2hkg_
examdoc2011.pdf
Paper F7 and P2 (Malaysia)
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/mys2011_
examdoc.pdf
Paper F7 and P2 (Singapore)
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/sgp2011_
examdoc.pdf
CBE (International)
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/cbe_
J08examdocs.pdf
CBE (UK)
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/f3uk_
J08examdocs.pdf
Guidance Notes for Irish
Stream students
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/irish_
notes_v2.pdf
Tax
Papers F6
www.accaglobal.com/students/acca/
exams/f6/exam_docs/
Paper P6
www.accaglobal.com/students/acca/
exams/p6/exam_docs
Audit
Papers F8 and P7 (Hong Kong)
www.accaglobal.com/pubs/students/
acca/exams/f8/examinable/
examnotesHKG2011.pdf
Papers F8 and P7 (International
and UK)
www.accaglobal.com/pubs/students/
acca/exams/f8/examinable/
IntUK2011examnotes.pdf
Papers F8 and P7 (Malaysia)
www.accaglobal.com/pubs/students/
acca/exams/f8/examinable/f8p7mys_
examnotes.pdf
Papers F8 and P7 (Singapore)
www.accaglobal.com/pubs/students/
acca/exams/f8/examinable/f8p7_
sgpexamdocs.pdf
Guidance Notes for Irish Stream students
www.accaglobal.com/pubs/students/
acca/exams/f8/examinable/irish_
notes.pdf
Examinability of the Clarity
Auditing Standards
www.accaglobal.com/pubs/students/
acca/exams/f8/examinable/clarity_
audit_standards.pdf
EXAMINABLE
DOCUMENTS
32 TECHNICAL
RELEVANT TO THE JUNE 2011 SESSION

RELEVANT TO ACCA QUALIFICATION PAPER F6 (IRL)
Studying Paper F6?
Performance objectives 19 and 20 are relevant to this exam

2011 ACCA
Taxation of termination payments
From 2011, termination payments will be examinable in Paper F6 (IRL).
The scope of the topic will require students to be able to ascertain from
a typical termination payment the part that will be treated as salary, the
amount that is exempt, the taxable ex gratia amount, and the part of
that ex gratia amount that will be tax free due to reliefs that are
available. Students will not be required to calculate Top Slicing Relief
(TSR) and neither will they be required to deal with termination
payments where the office holder had carried out foreign service.

Introduction
When an employees employment terminates, either as a consequence
of dismissal, redundancy or retirement, it is common that the employer
will pay a lump sum payment to the employee. These payments may be
referred to as a golden boot or a golden handshake. The tax
treatment of these payments is the same, and both can be referred to as
termination payments.

Almost all payments made by an employer to an employee are taxable
as emoluments under Schedule E, however, relief is available on all, or
part of, a termination payment.

Elements of a termination payment
It is common for a termination payment to be made up of statutory and
non statutory redundancy. The Redundancy Payments Acts 19672007
provides that an employee aged 16 or over is entitled to two-weeks pay
for every year of service plus one further weeks pay. There is an earnings
limit of 600 per week in determining the amount of the statutory
redundancy. The sum payable as statutory redundancy is exempt from
income tax.

An employer may decide to pay an employee an amount in excess of the
statutory lump sum, this non-statutory payment is taxable. The Revenue
provides for some relief to be given to an employee on this tax free lump
sum.

When employment ceases it is not uncommon for an employee to
receive payments other than statutory and non statutory redundancy
lump sum payments. It is important to determine whether these extra
payments are taxable as normal salary or if they are to be treated as
part of the redundancy package. The table on the next page shows
common payments and their classification:

2

TAXATION OF TERMINATION PAYMENTS

MARCH 2011

2011 ACCA
Payment type Classification Extra notes
Pay in lieu of notice Ex gratia redundancy As long as the
employment contract
provides that a
required period of
notice is necessary
Pension lump sum Tax free, not income or
redundancy, as long as
the payment does not
exceed one and a half
times the individuals
salary
A cap of 200,000 has
been introduced as an
additional condition
for 2011
Holiday pay Income Treated as part of
salary and assessed
under Schedule E
Loans written off or
assets transferred
Ex gratia redundancy The market value at
the date of the
termination is used
regardless of their
original cost or value

Tax free ex gratia amount
Once the value of the ex gratia payment has been determined the next
step is to calculate the amount of this payment that may be treated as
tax free. There are three different methods which can be used to
calculate the exempt amount, and the taxpayer will use the method that
gives them the highest tax free sum. The exemption methods are
referred to as:
the Basic exemption
the Increased exemption
the Standard Capital Superannuation Benefit (SCSB).

The Basic exemption
This is available to all individuals that are made redundant and is
calculated as: 10,160 plus 765 for each complete year of service.

Example 1
John was made redundant on 1 June 2010 having being employed for
14 years and 11 months. The basic exemption amount will be:
10,160 + (765 X 14) = 20,870.

The Increased exemption
This is the Basic exemption plus 10,000. It is available to persons who
have not previously availed of relief from taxation on ex gratia payments
within the past 10 years. In addition the 10,000 is only available in full
where the individual has not received, and will not receive, a pension
3

TAXATION OF TERMINATION PAYMENTS

MARCH 2011

2011 ACCA
lump sum under an approved pension scheme relating to the
employment.

Where an individual receives a pension lump sum as part of the
termination payment, or will receive one at some time in the future, then
the 10,000 will be reduced by this amount.

Example 2
Sam was made redundant on 1 October 2010, having worked in his
employment for 13 years and five months. Sam is not a member of an
approved pension scheme, therefore, his increased exemption will be:
10,160 + (765 X 13) + 10,000 =30,105.

Example 3
As in Example 2, except in this example Sam receives a pension lump
sum of 7,000.
10,160 + (765 x 13) + (10,000 - 7,000) = 23,105.

Example 4
As in Example 2, but in this example Sam will receive a pension lump
sum of 15,000.

As the pension lump sum exceeds the additional 10,000, this 10,000
will not be available, and so the increased exemption will not be
available.

From a practise point of view students should be aware that an
employer needs the prior approval of Revenue to use the figure
calculated under this increased exemption method as the tax free
amount.

The Standard Capital Superannuation Benefit
This method demands slightly more computation. The formula is:
(A x B/15) C
Where:
A is the average annual emoluments of the individual over the past three
years. Emoluments include salary and taxable benefits.
B is the number of years of complete service.
C is the amount of a lump sum payment under an approved
superannuation scheme, that is paid now or receivable at some time in
the future.

Example 5
Susan retired from her employment on 31 December 2010. She had
worked in her employment for 18 years and three months. Her pay for
the past three years was:
4

TAXATION OF TERMINATION PAYMENTS

MARCH 2011

2011 ACCA
Salary Benefit in kind valuation
2010 44,000 7,000
2009 41,000 6,000
2008 38,000 5,000

She received a lump sum pension payment on retirement of 12,000.
Her tax free ex gratia payment will be:
A: (44,000 + 41,000 + 38,000 + 7,000 + 6,000 + 5,000)/3= 47,000
B: 18
C: 12,000

(47,000 x 18/15) 12,000 = 44,400.

Students should note that in calculating the average annual salary for
the past three years, the average will be calculated to the final date of
employment and is not done by reference to tax years.

Example 6
John was made redundant on 31 August 2010. Details of his salary for
past years are:
Salary Benefit-in-kind

1 January to 31 August 2010 24,000 1,600
Year to 31 December 2009 34,000 2,400
Year to 31 December 2008 32,000 2,100
Year to 31 December 2007 28,000 2,000

Average annual salary for use in SCSB calculation is:
2010 (Eight months) 25,600
2009 (12 months) 36,400
2008 (12 months) 34,100
2007 (Four months) (30,000 x 4/12) 10,000
Total income for three years to date of termination 106,100
Average income for the past three years 35,367

A full case scenario, pulling together all the various elements of a typical
termination payment follows.

Example 7
Kevin, aged 63, was employed by Expert Engineering Ltd for the past 21
years and seven months. On 31 May 2010 he was made redundant. He
received the following payment on termination of his employment:
5

TAXATION OF TERMINATION PAYMENTS

MARCH 2011

2011 ACCA


Holiday pay 2,400
Pay in lieu of notice (notice is required in his employment contract)
3,200
Statutory redundancy 25,600
Ex gratia payment 67,200
Pension lump sum received 8,000

Kevin agreed to purchase his company car. The car cost 26,000 when
purchased new five years ago, its market value on 31 May 2010 was
12,000, and his employer agreed to sell it to Kevin for 8,000.
Kevins annual average emoluments for the past three years were
40,000.

Step 1 Calculate the taxable amount of the ex gratia payment.
Payment Tax treatment Taxable ex
gratia
payment

Holiday pay Schedule E, treated as part of
normal salary

Pay in Lieu of
notice
Taxable ex gratia payment 3,200
Statutory
redundancy
Exempt from tax
Non statutory
redundancy
payment
Taxable ex gratia payment 67,200
Motor car acquired
at less than market
value
As the price paid is less than the
market value the difference is
treated as taxable ex gratia
payment
4,000
Pension lump sum As this is less than one and a half
times his salary this amount is
exempt from income tax


The lump sum that is taxable before any relief is given is, therefore,
74,400.

Step 2 Calculate the relief available on the taxable ex gratia payment using
the alternate methods.
The Basic exemption: 10,160 + (765 x 21) = 26,225
The Increased exemption: 10,160 + (765 x 21) + (10,000 -
8,000) = 28,225
The SCSB: 40,000 x 21/15 8,000 = 48,000
6

TAXATION OF TERMINATION PAYMENTS

MARCH 2011

2011 ACCA
The taxpayer will avail of the method that gives them the greatest
exemption, therefore in this case Kevin would choose the SCSB figure of
48,000.

The taxable sum will be 26,400, which is 74,400 less 48,000. This
sum will be taxed at the Kevins marginal rate of tax and will also be
liable to the income levy.

Top slicing relief will be available to the taxpayer, but this is currently
not examinable at Paper F6 (IRL).

References
Irish Taxation: Law and Practice, Dr Geraldine Doyle, 2010
Irish Revenue, 2008
Citizens Information Board, 2010

Delma Carey is examiner for Paper F6 (IRL)

RELEVANT TO ACCA QUALIFICATION PAPER F6 (UK)
Studying Paper F6 (UK)?
Performance objectives 19 and 20 are relevant to this exam

2010 ACCA
Groups
This article is relevant to those of you taking Paper F6 (UK) in either the June or
December 2011 sittings, and is based on tax legislation as it applies to the tax year
201011 (Finance Acts (No 1) and (No 2) 2010).

Groups may be examined as part of Question 2, or they could be examined in
Question 5.

Associated companies
A question may require you to identify the number of associated companies in a
group, or it may tell you how many associated companies there are and then ask
you to justify this number. When answering this type of question make sure you
explain why companies are both included and excluded.

The lower and upper corporation tax limits are divided by the number of associated
companies, thus affecting the rate of corporation tax. Do not forget to include the
parent company in the number of associated companies.

Example 1
Music plc has the following shareholdings:
Shareholding
Alto Ltd 25%
Bass Ltd 60%
Cello Ltd 100%
Drum Ltd 100%
Echo Inc 100%
Flute Ltd 100%

Music plcs shareholding in Cello Ltd was disposed of on 31 December 2010, and
the shareholding in Drum Ltd was acquired on 1 January 2011. The other
shareholdings were all held throughout the year ended 31 March 2011.

Echo Inc is resident overseas. The other companies are all resident in the United
Kingdom.

All the companies are trading companies except for Flute Ltd which is dormant.

Alto Ltd and Flute Ltd are not associated companies as Music Ltd has a
shareholding of less than 50% in Alto Ltd, and Flute Ltd is dormant.
Bass Ltd, Cello Ltd, Drum Ltd and Echo Inc are associated companies as
Music Ltd has a shareholding of over 50% in each case, and they are all
trading companies.
For associated company purposes, it does not matter where a company is
resident. Echo Inc is, therefore, included despite being resident overseas.
2

GROUPS RELEVANT TO PAPER F6 (UK)

MARCH 2011

2011 ACCA
Companies that are only associated for part of an accounting period, such as
Cello Ltd and Drum Ltd, count as associated companies for the whole of the
period.
Including Music Ltd there are five associated companies, so Music Ltds lower
and upper corporation tax limits are reduced to 60,000 (300,000/5) and
300,000 (1,500,000/5) respectively.

Definition of a 75% group
There are two types of group relationship:
The 75% group relationship that is necessary to claim group relief.
The 75% group relationship that is necessary for chargeable gains purposes.

The definition of a 75% subsidiary company for chargeable gains purposes is looser
than that for group relief purposes. This is because the required 75% shareholding
need only be met at each level in the group structure.

Example 2
Fruit Ltd is the parent company for a group of companies. The group structure is as
follows:


For the year ended 31 March 2011 Fruit Ltd has an unrelieved trading loss.

Group relief
For group relief purposes, one company must be a 75% subsidiary of the
other, or both companies must be 75% subsidiaries of a third company.
The parent company must have an effective interest of at least 75% of the
subsidiarys ordinary share capital.
The parent company must also have the right to receive at least 75% of the
subsidiarys distributable profits and net assets on a winding up.
Fruit Ltd will therefore be able to group relief its trading loss to Apple Ltd and
Banana Ltd.
Fruit Ltd does not have the required 75% shareholding in Cherry Ltd (100% x
80% x 80% = 64%).

3

GROUPS RELEVANT TO PAPER F6 (UK)

MARCH 2011

2011 ACCA
Chargeable gains
Companies form a chargeable gains group if at each level in the group
structure there is a 75% shareholding.
However, Fruit Ltd, the parent company, must have an effective interest of at
least 50% in each subsidiary company.
Fruit Ltd, Apple Ltd, Banana Ltd and Cherry Ltd therefore form a chargeable
gains group.

Group relief
Remember that group relief is not restricted according to the percentage
shareholding. Therefore, if a parent company has a trading loss then 100% of that
loss can be surrendered to a 75% subsidiary company, and if a 75% subsidiary
company has a trading loss then 100% of that loss can be claimed as group relief
by the parent company.

Unlike other loss relief claims, the claimant company claims group relief against its
taxable total profits after the deduction of any gift aid donations.

Example 3
For the year ended 31 March 2011 Ballpoint Ltd has a trading profit of 510,000, a
chargeable gain of 32,000, and paid gift aid donations of 2,000.

Ballpoint Ltd has a 100% subsidiary company, and for the year ended 31 March
2011 claimed group relief of 40,000 from this company.

During the year ended 31 March 2011 Ballpoint Ltd received dividends of 27,000
from an unconnected UK company, and dividends of 18,000 from its 100%
subsidiary company. Both figures are the actual cash amounts received.
The corporation tax liability of Ballpoint Ltd for the year ended 31 March 2011 is as
follows:

Trading profit 510,000
Chargeable gain 32,000
_______
542,000
Gift aid donation (2,000)
_______
540,000
Group relief (40,000)
_______
Taxable total profits 500,000
Franked investment income (27,000 x 100/90) 30,000
_______
Augmented profits 530,000
_______
Corporation tax at (500,000 at 28%) 140,000
4

GROUPS RELEVANT TO PAPER F6 (UK)

MARCH 2011

2011 ACCA

Marginal relief
7/400 (750,000 530,000) x 500,000/530,000 (3,632)
_______
136,368
_______

Ballpoint Ltd has one associated company, so the upper corporation tax limit
is reduced to 750,000 (1,500,000/2).
Group dividends are not included as franked investment income.

When the accounting periods of the claimant company and the surrendering
company are not coterminous, then group relief may be restricted. There may also
be a restriction where an accounting period is less than 12 months long.

Example 4
Sofa Ltd owns 100% of the ordinary share capital of both Settee Ltd and Futon Ltd.
For the year ended 31 March 2011 Sofa Ltd had a trading loss of 200,000.

For the year ended 30 June 2010 Settee Ltd had taxable total profits of 240,000,
and for the year ended 30 June 2011 will have taxable total profits of 90,000.

Futon Ltd commenced trading on 1 January 2011, and for the three-month period
ended 31 March 2011 had taxable total profits of 60,000.

The accounting periods of Settee Ltd and Sofa Ltd are not coterminous.
Therefore, Settee Ltds taxable total profits and Sofa Ltds trading loss must be
apportioned on a time basis.
For the year ended 30 June 2010 group relief is restricted to a maximum of
50,000, being the lower of 60,000 (240,000 x 3/12) and 50,000 (200,000
x 3/12).
For the year ended 30 June 2011 group relief is restricted to a maximum of
67,500, being the lower of 67,500 (90,000 x 9/12) and 150,000 (200,000
x 9/12).
Futon Ltd did not commence trading until 1 January 2011, so group relief is
restricted to a maximum of 50,000, being the lower of 60,000 and 50,000
(200,000 x 3/12).

As well as trading losses, it is possible to surrender unrelieved property business
losses and gift aid donations. Only current year losses can be group relieved, so no
relief is available for trading losses brought forward from previous years.

In working out the taxable total profits against which group relief can be claimed,
the claimant company is assumed to use any current year losses that it has, even if
such a loss relief claim is not actually made.

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Example 5
Lae Ltd owns 100% of the ordinary share capital of Mon Ltd. The results of each
company for the year ended 31 March 2011 are as follows:
Lae Ltd Mon Ltd

Trading loss (18,100) (11,200)
Property business profit/(loss) (26,700) 60,900
Loan interest received 1,600 3,300
Capital loss (19,200) 0
Gift aid donations (4,800) (3,200)

All the loan interest received is in respect of loans that were made for non-trading
purposes.

Maximum claim by Mon Ltd
The group relief claim by Mon Ltd is calculated after deducting gift aid
donations, and on the assumption that a claim is made for the current year
trading loss.
The maximum amount of group relief that can be claimed by Mon Ltd is
therefore 49,800 (60,900 + 3,300 3,200 11,200).

Maximum surrender by Lae Ltd
The property business loss and the gift aid donations can be surrendered to
the extent that they are unrelieved, so 29,900 of these can be surrendered
(26,700 + 4,800 1,600).
It is not possible to surrender capital losses as part of a group relief claim.
The maximum potential surrender by Lae Ltd is 48,000 (18,100 + 29,900).
The maximum group relief claim is, therefore, 48,000.

The most important factor to be taken into account when considering group relief
claims is the rate of corporation tax payable by the claimant companies. Group
relief should therefore be surrendered as follows:
Initially to companies subject to corporation tax at the marginal rate of
29.75%.
Surrender should then be to those companies subject to the main rate of
corporation tax of 28%.
The amount surrendered should be sufficient to bring the claimant companys
augmented profits down to the small profits rate limit.
Any remaining loss should be surrendered to those companies subject to
corporation tax at the small profits rate of 21%.

The loss making company may of course be able to relieve the loss itself. In this
case consideration will also have to be given to the timing of the relief obtained (an
earlier claim is generally preferable), and the extent to which relief for gift aid
donations will be lost.

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Remember that unlike other loss relief claims, it is possible to specify the amount of
group relief that is to be surrendered. The surrendering company can therefore
restrict group relief so that it retains sufficient losses in order to bring its
augmented profits down to the small profits rate limit.

Example 6
Colour Ltd owns 100% of the ordinary share capital of both Orange Ltd and Pink
Ltd. The results of each company for the year ended 31 March 2011 are as follows:
Colour Ltd Orange Ltd Pink Ltd

Trading profit/(loss) (135,000) 650,000 130,000
Property business profit 120,000 0 0

Colour Ltd had franked investment income of 10,000.

The corporation tax liability of each of the group companies for the year ended 31
March 2011 is as follows:
Colour Ltd Orange Ltd Pink Ltd

Trading profit 0 650,000 130,000
Property business profit 120,000
Loss relief (30,000)
Group relief (75,000) (30,000)
_______ _______ _______
Taxable total profits 90,000 575,000 100,000
Franked investment income 10,000 0 0
_______ _______ _______
Augmented profits 100,000 575,000 100,000
_______ _______ _______

Corporation tax at 21% 18,900 21,000
Corporation tax at 28% 161,000
_______ _______ _______

There are three associated companies in the group, so the lower and upper
corporation tax limits are reduced to 100,000 (300,000/3) and 500,000
(1,500,000/3) respectively.
Colour Ltds trading loss has been relieved so as to reduce both its own and
Pink Ltds augmented profits down to the lower limit. Note that it is the
augmented profits that are relevant, and not the taxable total profits.
The balance of the loss has been surrendered to Orange Ltd as this saves
corporation tax at the main rate of 28%.

Chargeable assets
It is important to remember that capital losses cannot be group relieved.

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Example 7
Why would it be beneficial for all of the eligible companies in a chargeable gains
group to transfer assets to one company prior to them being disposed of outside of
the group?
The transfers will not give rise to any chargeable gain or capital loss
Arranging that wherever possible, chargeable gains and capital losses arise in
the same company will result in the optimum use being made of capital losses.
These can either be offset against chargeable gains of the same period, or
carried forward against future chargeable gains.

However, an asset does not actually have to be moved between companies in order
to match chargeable gains and capital losses. It is possible for two companies in a
chargeable gains group to make a joint election so that matching is done on a
notional basis.

The election has to be made within two years of the end of the accounting period in
which the asset is disposed of outside the group, and will specify which company in
the group is treated for tax purposes as making the disposal.

The advantages of the election compared to actually transferring an asset between
group companies (prior to disposal outside of the group) are as follows:
The two-year time limit for making an election means that tax planning
regarding the set off of capital losses and chargeable gains can be done
retrospectively.
The two-year time limit also means that it is possible for chargeable gains to
be treated as being made by the company in the group with the lowest rate of
corporation tax.

Example 8
Rod Ltd owns 100% of the ordinary share capital of Stick Ltd. For the year ended
31 March 2011 Rod Ltd will pay corporation tax at the main rate of 28% while Stick
Ltd will pay corporation tax at the small profits rate of 21%.

On 15 August 2010 Rod Ltd sold an office building, and this resulted in a
chargeable gain of 120,000. On 20 February 2011 Stick Ltd sold a factory and this
resulted in a capital loss of 35,000.

As at 1 April 2010 Stick Ltd had unused capital losses of 40,000.
Rod Ltd and Stick Ltd must make a joint election by 31 March 2013, being two
years after the end of the accounting period in which the disposal outside of
the group occurred.
Stick Ltds otherwise unused capital loss of 35,000 and brought forward
capital losses of 40,000 can be set against the chargeable gain of 120,000.
It is beneficial for the balance of the gain of 45,000 (120,000 35,000
40,000) to arise in Stick Ltd as this company only pays corporation at the
small profits rate of 21%.
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Conclusion
With groups it is important that you know the group relationship that must exist for
reliefs to be available. Where a question involves a group you can expect to spend
more time than normal planning your answer. However, working through the
examples in this article will prepare you for anything that could be set in the exam.

David Harrowven is examiner for Paper F6 (UK)

RELEVANT TO ACCA QUALIFICATION PAPER F6 (UK)
Studying Paper F6?
Performance objectives 19 and 20 are relevant to this exam

2011 ACCA
OVERSEAS ASPECTS OF CORPORATION TAX
This article is relevant to those of you taking Paper F6 (UK) in either the June
or December 2011 sittings, and is based on tax legislation as it applies to the
tax year 201011 (Finance Acts (No 1) and (No 2) 2010).

Overseas aspects of corporation tax may be examined as part of Question 2, or
it could be examined in Question 5.

Company residence
Companies that are incorporated in the UK are resident in the UK. Companies
that are incorporated overseas are only treated as being resident in the UK if
their central management and control is exercised in the UK.

Example 1
Crash-Bash Ltd is incorporated overseas, although its directors are based in
the UK and hold their board meetings in the UK.
Companies that are incorporated overseas are only treated as being
resident in the UK if their central management and control is exercised in
the UK.
Since the directors are UK based and hold their board meetings in the UK,
this would indicate that Crash-Bash Ltd is managed and controlled from
the UK, and, therefore, it is resident in the UK.
If the directors were to be based overseas and to hold their board
meetings overseas, the company would probably be treated as resident
overseas since the central management and control would then be
exercised outside the UK.

Overseas branch compared to an overseas subsidiary company
It is important to appreciate the difference between operating overseas through
a branch and operating overseas through a subsidiary company. An overseas
branch of a UK company is effectively an extension of the UK trade, and 100%
of the branch profits are assessed to UK corporation tax. There are a number
of factors that have to be considered when deciding whether to operate
overseas through either a branch or a subsidiary company.

Example 2
Union Ltd is a UK resident company that is planning to set up an overseas
operation. It is unsure whether to operate overseas through a branch or a
subsidiary company.

Relief will usually be available for trading losses if incurred by an overseas
branch. No UK relief is available for trading losses incurred by an
overseas subsidiary company.
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UK capital allowances will be available in respect of plant and machinery
purchased by an overseas branch. Allowances will not be available for
expenditure incurred by an overseas subsidiary company.
An overseas subsidiary company will be an associated company, and so
the UK corporation tax limits will be reduced accordingly. An overseas
branch cannot be an associated company.
The profits of an overseas branch are liable to UK corporation tax in the
year that they are made, regardless of whether they are remitted to the
UK. An overseas subsidiary company will not be liable to UK corporation
tax.

Double taxation relief
Double taxation will occur where an overseas branchs profits are taxed
overseas as well as being subject to UK corporation tax. Double taxation relief
will be available in respect of the overseas tax, up to the amount of the UK tax
on the overseas profits.

Example 3
Gong Ltd is a UK resident company with an overseas branch. The results of
Gong Ltd for the year ended 31 March 2011 are as follows:
Total UK Branch

Trading profits 400,000 270,000 130,000

Overseas corporation tax of 26,000 was paid in respect of the overseas
branchs trading profit.

The corporation tax liability of Gong Ltd for the year ended 31 March 2011 is
as follows:
Total UK Branch

Trading profits 400,000 270,000 130,000
_______ _______ _______
Taxable total profits 400,000 270,000 130,000
_______ _______ _______
Corporation tax at 28% 112,000
Marginal relief
7/400 (1,500,000 400,000) (19,250)
_______ _______ _______
92,750 62,606 30,144
Double taxation relief (26,000) (26,000)
_______ _______ _______
66,750 62,606 4,144
_______ _______ _______

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The UK corporation tax on the UK profit is 62,606 (92,750 x
270,000/400,000), and on the overseas branch profit it is 30,144
(92,750 x 130,000/400,000).
The overseas branch has paid overseas corporation tax of 26,000, and
this is lower than the related corporation tax liability of 30,144.

Where a company pays gift aid donations then these should initially be set
against the UK profit, with any unrelieved balance set against the overseas
branch profit with the lowest rate of overseas tax. This approach will maximise
the amount of available double taxation relief.

Example 4
Zing Ltd is a UK resident company with two overseas branches. The results of
Zing Ltd for the year ended 31 March 2011 are as follows:

Total UK First Second
branch branch

Trading profits 180,000 8,000 92,000 80,000

During the year ended 31 March 2011 Zing Ltd paid gift aid donations of
20,000.

Overseas corporation tax of 9,200 was paid in respect of the first overseas
branchs trading profit, and overseas corporation tax of 24,000 was paid in
respect of the profits of the second branch.

The corporation tax liability of Zing Ltd for the year ended 31 March 2011 is as
follows:

Total UK First Second
branch branch

Trading profits 180,000 8,000 92,000 80,000
Gift aid donations (20,000) (8,000) (12,000) 0
_______ _____ ______ ______
Taxable total profits 160,000 0 80,000 80,000
_______ _____ ______ ______
Corporation tax at 21% 33,600 16,800 16,800
Double taxation relief (26,000) (9,200) (16,800)
_______ ______ ______
7,600 7,600 0
_______ ______ ______

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The first overseas branch has paid corporation tax at the rate of 10%
(9,200/92,000 x 100) while the second overseas branch has paid
corporation tax at the rate of 30% (24,000/80,000 x 100).
The balance of the gift aid donations of 12,000 are therefore deducted
from the profits of the first overseas branch since it has paid the lower
rate of corporation tax.
The second overseas branch has paid overseas corporation tax of
24,000, but double taxation relief is restricted to the related UK
corporation tax of 16,800.

Overseas dividends
As far as Paper F6 (UK) is concerned all overseas dividends are exempt from
UK corporation tax.

Exempt overseas dividends are included as franked investment income when
calculating a companys augmented profits in exactly the same way as UK
dividends, unless they are group income. In this case they are completely
ignored for tax purposes.

Example 5
During the year ended 31 March 2011 Various Ltd, a UK resident company,
received an overseas dividend of 67,500 (net). Withholding tax was withheld
from the dividend at the rate of 15%.
If Various Ltd owns 50% or less of the voting power of the overseas
company, then the overseas dividend will be exempt from UK corporation
tax but included as franked investment income. The amount of franked
investment income is 75,000 (67,500 x 100/90).
If Various Ltd owns more than 50% of the voting power of the overseas
company, then the dividend will be exempt from UK corporation tax and
not included as franked investment income. This is because the overseas
dividend is group income.

Transfer pricing
The transfer pricing rules prevent UK companies from reducing their taxable
total profits subject to UK corporation tax by, for example, making sales at
below market price to an overseas subsidiary company, or purchasing goods at
above market price from an overseas holding company.

Example 6
Frodo Ltd, a UK resident company, exports goods that it has manufactured to
its overseas subsidiary company at less than their market price.
Invoicing for the exported goods at less than the market price will reduce
Frodo Ltds UK trading profit and hence UK corporation tax.
A true market price must therefore be substituted for the transfer price.
The market price will be an arms length one that would be charged if the
parties to the transaction were independent of each other.
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Frodo Ltd will be required to make the adjustment in its corporation tax
self-assessment tax return.

Conclusion
The overseas aspects of corporation tax, at the F6 (UK) level, are fairly
straightforward provided you know the main principles involved. Working
through the examples in this article should prepare you for anything that might
be set in the exam.

David Harrowven is examiner for Paper F6 (UK)

RELEVANT TO ACCA QUALIFICATION PAPER F7 AND P2
Studying Paper F7 or P2?
Performance objectives 10 and 11 are relevant to this exam

2011 ACCA
The IASBs Conceptual Framework for Financial Reporting
I am from England, and here in the UK, unlike most countries, our system of
government has no comprehensive written constitution. Many countries do
have such constitutions and in these circumstances the laws of the land are
shaped and influenced by the constitution. Now while the International
Accounting Standards Board (IASB) is not a country it does have a sort of
constitution, in the form of the Conceptual Framework for Financial Reporting
(the Framework), that proves the definitive reference document for the
development of accounting standards. The Framework can also be described
as a theoretical base, a statement of principles, a philosophy and a map. By
setting out the very basic theory of accounting the Framework points the way
for the development of new accounting standards. It should be noted that the
Framework is not an accounting standard, and where there is perceived to be a
conflict between the Framework and the specific provisions of an accounting
standard then the accounting standard prevails.

Before we look at the contents of the Framework, let us continue to put the
Framework into context. It is true to say that the Framework:
seeks to ensure that accounting standards have a consistent approach to
problem solving and do not represent a series of ad hoc responses that
address accounting problems on a piece meal basis
assists the IASB in the development of coherent and consistent
accounting standards
is not a standard, but rather acts as a guide to the preparers of financial
statements to enable them to resolve accounting issues that are not
addressed directly in a standard
is an incredibly important and influential document that helps users
understand the purpose of, and limitations of, financial reporting
used to be called the Framework for the Preparation and Presentation of
Financial Statements
is a current issue as it is being revised as a joint project with the IASB's
American counterparts the Financial Accounting Standards Board .

Overview of the contents of the Framework
The starting point of the Framework is to address the fundamental question of
why financial statements are actually prepared. The basic answer to that is
they are prepared to provide financial information about the reporting entity
that is useful to existing and potential investors, lenders, and other creditors in
making decisions about providing resources to the entity.

In turn this means the Framework has to consider what is meant by useful
information. In essence for information to be useful it must be considered both
relevant, ie capable of making a difference in the decisions made by users and
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be faithful in its presentation, ie be complete, neutral and free from error. The
usefulness of information is enhanced if it is also comparable, verifiable,
timely, and understandable.

The Framework also considers the nature of the reporting entity and, in what
reminds me of my school chemistry lessons, the basic elements from which
financial statements are constructed. The Framework identifies three elements
relating to the statement of financial position, being assets, liabilities and
equity, and two relating to the income statement, being income and expenses.
The definitions and recognition criteria of these elements are very important
and these are considered in detail below.

The five elements
An asset is defined as a resource controlled by the entity as a result of past
events and from which future economic benefits are expected to flow to the
entity.

Assets are presented on the statement of financial position as being
noncurrent or current. They can be intangible, ie without physical presence, eg
goodwill. Examples of assets include property plant and equipment, financial
assets and inventory.

While most assets will be both controlled and legally owned by the entity it
should be noted that legal ownership is not a prerequisite for recognition,
rather it is control that is the key issue. For example IAS 17, Leases, with
regard to a lessee with a finance lease, is consistent with the Framework's
definition of an asset. IAS 17 requires that where substantially all the risks and
rewards of ownership have passed to the lessee it is regarded as a finance
lease and the lessee should recognise an asset on the statement of financial
position in respect of the benefits that it controls, even though the asset
subject to the lease is not the legally owned by the lessee. So this reflects that
the economic reality of a finance lease is a loan to buy an asset, and so the
accounting is a faithful presentation.

A liability is defined as a present obligation of the entity arising from past
events, the settlement of which is expected to result in an outflow from the
entity of resources embodying economic benefits.

Liabilities are also presented on the statement of financial position as being
noncurrent or current. Examples of liabilities include trade payables, tax
creditors and loans.

It should be noted that in order to recognise a liability there does not have to
be an obligation that is due on demand but rather there has to be a present
obligation. Thus for example IAS 37, Provisions, Contingent Liabilities and
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Contingent Assets is consistent with the Framework's approach when
considering whether there is a liability for the future costs to decommission oil
rigs. As soon as a company has erected an oil rig that it is required to
dismantle at the end of the oil rig's life, it will have a present obligation in
respect of the decommissioning costs. This liability will be recognised in full,
as a non-current liability and measured at present value to reflect the time
value of money. The past event that creates the present obligation is the
original erection of the oil rig as once it is erected the company is responsible
to incur the costs of decommissioning.

Equity is defined as the residual interest in the assets of the entity after
deducting all its liabilities.

The effect of this definition is to acknowledge the supreme conceptual
importance of indentifying, recognising and measuring assets and liabilities, as
equity is conceptually regarded as a function of assets and liabilities, ie a
balancing figure.

Equity includes the original capital introduced by the owners, ie share capital
and share premium, the accumulated retained profits of the entity, ie retained
earnings, unrealised asset gains in the form of revaluation reserves and, in
group accounts, the equity interest in the subsidiaries not enjoyed by the
parent company, ie the non-controlling interest (NCI). Slightly more exotically,
equity can also include the equity element of convertible loan stock, equity
settled share based payments, differences arising when there are increases or
decreases in the NCI, group foreign exchange differences and contingently
issuable shares. These would probably all be included in equity under the
umbrella term of Other Components of Equity.

Income is defined as the increases in economic benefits during the accounting
period in the form of inflows or enhancements of assets or decreases of
liabilities that result in increases in equity, other than those relating to
contributions from equity participants.

Most income is revenue generated from the normal activities of the business in
selling goods and services, and as such is recognised in the Income section of
the Statement of Comprehensive Income, however certain types of income are
required by specific standards to be recognised directly to equity, ie reserves,
for example certain revaluation gains on assets. In these circumstances the
income (gain) is then also reported in the Other Comprehensive Income section
of the Statement of Comprehensive Income.

The reference to other than those relating to contributions from equity
participants means that when the entity issues shares to equity shareholders,
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while this clearly increases the asset of cash, it is a transaction with equity
participants and so does not represent income for the entity.

Again note how the definition of income is linked into assets and liabilities.
This is often referred to as the balance sheet approach (the former name for
the statement of financial position).

Expenses are defined as decreases in economic benefits during the accounting
period in the form of outflows or depletions of assets or incurrences of
liabilities that result in decreases in equity, other than those relating to
distributions to equity participants.

The reference to other than those relating to distributions to equity
participants refers to the payment of dividends to equity shareholders. Such
dividends are not an expense and so are not recognised anywhere in the
Statement of Comprehensive Income. Rather they represent an appropriation
of profit that is as reported as a deduction from Retained Earnings in the
Statement of Changes in Equity.

Examples of expenses include depreciation, impairment of assets and
purchases. As with income most expenses are recognised in the Income
Statement section of the Statement of Comprehensive Income, but in certain
circumstances expenses (losses) are required by specific standards to be
recognised directly in equity and reported in the Other Comprehensive Income
Section of the Statement of Comprehensive Income. An example of this is an
impairment loss, on a previously revalued asset, that does not exceed the
balance of its Revaluation Reserve.

The recognition criteria for elements
The Framework also lays out the formal recognition criteria that have to be met
to enable elements to be recognised in the financial statements. The
recognition criteria that have to be met are that
that an item that meets the definition of an element and
it is probable that any future economic benefit associated with the item
will flow to or from the entity and
the items cost or value can be measured with reliability.

Measurement issues for elements
Finally the issue of whether assets and liabilities should be measured at cost or
value is considered by the Framework. To use cost should be reliable as the
cost is generally known, though cost is not necessary very relevant for the
users as it is past orientated. To use a valuation method is generally regarded
as relevant to the users as it up to date, but value does have the drawback of
not always being reliable. This conflict creates a dilemma that is not
satisfactorily resolved as the Framework is indecisive and acknowledges that
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there are various measurement methods that can be used. The failure to be
prescriptive at this basic level results in many accounting standards sitting on
the fence how they wish to measure assets. For example IAS 40, Investment
Properties and IAS 16, Property, Plant and Equipment both allow the preparer the
choice to formulate their own accounting policy on measurement.

Applying the Framework
A company is about to enter into a three-year lease to rent a building. The
lease cannot be cancelled and there is no certainty of renewal. The landlord
retains responsibility for maintaining the premises in good repair. The
directors are aware that in accordance with IAS 17 that technically the lease is
classified as an operating lease, and that accordingly the correct accounting
treatment is to simply expense the income statement with the rentals payable.

Required
Explain how such a lease can be regarded as creating an asset and liability per
the Framework.

Solution lease
Given that it is reasonable to assume that the expected life of the premises will
vastly exceed three years and that the landlord (lessor) is responsible for the
maintenance, on the basis of the information given, the risks and rewards of
ownership have not passed. As such IAS 17 prescribes that the lessee charges
the rentals payable to the income statement. No asset or liability is recognised,
although the notes to the financial statements will disclose the existence of the
future rental payments.

However, instead of considering IAS 17 let us consider how the Framework
could approach the issue. To recognise a liability per the Framework requires
that there is a past event that gives rise to a present obligation. It can be
argued that the signing of the lease is a sufficient past event as to create a
present obligation to pay the rentals for the whole period of the lease. On the
same basis, while substantially all the risks and rewards of ownership have not
passed, the lessee does control the use of the building for three years and has
the benefits that brings. Accordingly, when considering the Framework, a
radically different potential treatment arises for this lease. On entering the
lease a liability is recognised, measured at the present value of the future cash
flow obligations to reflect the time value of money. In turn an asset would also
be accounted for. After the initial recognition of the liability, a finance cost is
charged against profit in respect of unwinding the discount on the liability. The
annual cash rental payments are accounted for as a reduction in the liability.
The asset is systematically written off against profit over the three years of the
agreement (depreciation).

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There is, at present, a conflict between IAS 17 and the Framework. The IASB is
currently reviewing IAS 17 because the current accounting treatment of lessees
not recognising the future operating lease rentals as liabilities arguably
amounts to off balance sheet financing. The Frameworks definition of a
liability is at the heart of proposals to revise IAS 17 to ensure that the
statement of financial position faithfully and completely represents all an
entitys liabilities. Accordingly this conflict should soon be resolved.

Tom Clendon FCCA is a subject expert at Kaplan

RELEVANT TO ACCA QUALIFICATION PAPER F9
Studying Paper F9?
Performance objectives 15 and 16 are relevant to this exam

2011 ACCA
Business finance
Section E of the Paper F9, Financial Management syllabus deals with business
finance: What types of finance? What sources? What mix? Additionally, from June
2011 onwards, there is a section on Islamic finance (see the article in the 9 March
issue of Student Accountant which covers Islamic finance in detail available at:
www.accaglobal.com/students/student_accountant/archive/2011/117/3423853)

The article will first consider a businesss formation and initial growth, then a
company that is well-established and mature, and will look at the financing
choices and decisions that could face it at various stages.

Formation and initial growth.
Many businesses begin with finance contributed by their owners and owners
families. If they start as unincorporated businesses, the distinction between
owners capital and owners loans is almost irrelevant. If it starts as an
incorporated business, or turns into one, then there are important differences
between share capital and loans. Share capital is more or less permanent and can
give suppliers and lenders some confidence that the owners are being serious and
are willing to risk significant resources. If the owners friends and families do not
themselves want to invest (perhaps they have no money to invest) then the owners
will have to look for outside sources of capital. The main sources are:
bank loans and overdrafts
leasing/hire purchase
trade credit
government grants, loans and guarantees
venture capitalists and business angels
invoice discounting and factoring
retained profits.

Bank loans and overdrafts
In the current economic climate, start-up businesses are likely to find it difficult to
raise a bank loan, particularly if the business and its owners have no track record
at all. Banks will certainly require:
A business plan, including cash flow forecasts.
Personal guarantees and charges on personal assets.

The personal guarantees and charges on personal assets get round the companys
limited liability which would otherwise mean that if the company failed, the bank
might be left with nothing. This way the bank can ask the guarantors to pay back
the loans personally, or the bank can seize the charged assets that were used for
security.

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Note that overdrafts are repayable on demand and many banks have a reputation
of pre-emptively withdrawing overdraft facilities, not when a business is in trouble,
but when the bank fears more difficult times ahead.

On a more positive note, where it is known that the need for finance is temporary,
an overdraft might be very suitable because it can be repaid by the borrower at
any time.

Leasing and hire purchase
In financial terms, leasing is very like a bank loan. Instead of receiving cash from
the loan, spending it on buying an asset and then repaying the loan, the leasing
company buys the asset, makes it available to the lessee and charges the lessee a
monthly amount. Leasing can often be cheaper than borrowing because:
Large leasing companies have great bargaining power with suppliers so the
asset costs them less than it would cost the lessee. This can be partially
passed on to the leasee.
Leasing companies have effective ways of disposing of old assets, but lessees
normally do not.
If the lease payments are not made, the leasing company has a form of built-
in security insofar as it can reclaim its asset.
The cost of finance to a large, established leasing company is likely to be
lower than the cost to a start-up company.

It is important for businesses to try to decide whether loan finance or a lease
would be cheaper. (This is a separate topic in the Paper F9 syllabus, but it is not
covered in this article.)

Trade credit
This simply means taking credit from suppliers typically 30 days. That is
obviously a very short period, but it can be very helpful to new businesses.
Typically, credit suppliers to new businesses will want some sort of reference,
either from a bank or from other suppliers (trade references). However, some will
be prepared to offer modest credit initially without references, and as trust grows
this can be increased.

Government grants, loans and guarantees
Governments often encourage the formation of new businesses and, from time to
time and from region to region, help is offered. Government grants are usually
very small, and direct loans are rare because governments see loan provision as
the job of financial institutions.

Currently in the UK, the Government runs the Enterprise Finance Guarantee
Scheme (EFGS). This is a loan guarantee scheme intended to facilitate additional
bank lending to viable small and medium-sized entities (SMEs) with insufficient
security for a normal commercial loan. The borrower must be able to demonstrate
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to the lender that they should be able to repay the loan in full. The Government
provides the lender with a guarantee for which the borrower pays a premium.

The scheme is not a mechanism through which businesses or their owners can
choose to withhold the security a lender would normally lend against; nor is it
intended to facilitate lending to businesses which are not viable and that banks
have declined to lend to on that basis.

EFGS supports lending to viable businesses with an annual turnover of up to
25m seeking loans of between 1,000 and 1m.

Venture capitalists and business angels
These are either companies (usually known as venture capitalists) or wealthy
individuals (business angels) who are prepared to invest in new or young
businesses. They provide equity (private equity as opposed to public equity in
listed companies), not loans. The equity is not normally secured on any assets
and the private equity firm faces the risk of losses just like the other shareholders.
Because of the high risk associated with start-up equity, private equity suppliers
typically look for returns on their investment in the order of 30% pa. The overall
return takes into account capital redemptions (for example preference shares
being redeemed at a premium), possible capital gains on exiting their investment
(for example through sale of shares to a private buyer or after listing the company
on a stock exchange), and income through fees and dividends.

Typically, venture capitalists will require 25%49% of the equity and a seat on the
board so that their investment can be monitored and advice given. However, the
investors do not seek to take over management of their investment.

Invoice discounting and factoring
Before these methods can be used turnover usually has to be in the region of at
least $200,000. Amounts due from customers, as evidenced by invoices, are
advanced to the company. Typically 80% of an invoice will be paid within 24
hours. In addition to this service, factors also look after the administration of the
companys receivables ledger.

Fees are charged on advancing the cash (roughly at overdraft interest rates), and
also factors will charge about 1% of turnover for running the receivables ledger
(the exact amount depends on how many invoices and customers there are).
Credit insurance can be taken out for an additional fee. Unless that is taken out
the invoicing company remains liable for any bad debts.

Retained profits
Retained profits are no good for start-ups, and often no good for the first few
years of a businesss life when only losses or very modest profits are made.
However, assuming the business is successful, profits should be made and
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retaining those in the business can allow the company to repay debt capital and
to invest in expansion.

How much capital is needed?
Capital is needed:
for investment in non-current assets
to sustain the company through initial loss-making periods
for investment in current assets.

Cash-flow forecasts are an essential tool in planning capital needs. Typically,
suppliers of capital will want forecasts for three to five years. One of the biggest
dangers facing new successful businesses is overtrading, where they try to do too
much with too little capital. Most businesses know that capital will be needed to
finance non-current assets, but many overlook that finance is also needed for
current assets.

Look at this example:

Stage 1 Stage 2
$000 $000 $000 $000
Non-current
assets
1,000 1,000
Current assets
Inventory 50 100
Receivables 40 80
Cash 20 -

110
180
1,110 1,180

Current
liabilities

Payables 10 20
Overdraft - 60

Equity 1,100 1,100
1,110 1,180


This company starts with a healthy liquidity position (Stage 1). Business then
doubles, without investing in more non-current assets and without raising more
equity capital. It is a reasonable assumption that if turnover doubles then so will
inventory, receivables and payables (Stage 2). But here this forces the company to
rely on an overdraft (probably unexpected and unplanned) to finance its net
current assets. Relying permanently on overdraft finance is precarious and the
company would be advised to seek some more permanent form of capital.
x2
x2
x2
Balancing figuie
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When capital is raised, the company has to decide what to do with it, and there
are two main uses:
invest in non-current assets
invest in current assets, including leaving it as cash.

The more capital invested in non-current assets, the greater should be the profit-
earning potential of the business. However, leaving too little cash in current assets
increases the risk that the company will have liquidity problems. On the other
hand, leaving too much capital in current assets is wasteful: cash will earn modest
interest (but investors want higher returns from a company), and cash tied up in
inventory often causes costs (storage, damage, obsolescence). So, the company
has to decide on its working capital policy. An aggressive policy is one which
maintains relatively low working capital compared to another company; a
conservative policy is one which maintains relatively high working capital. Which
policy is appropriate partly depends on the nature of the business. If the business
is one where trading cash flows are very predictable then it should be able to
survive with an aggressive policy. If, however, cash flows are erratic and
unpredictable the company would be wise to build a margin of safety into its cash
management. Additionally, if the company foresees a period of losses, it will need
to keep cash available (probably earning interest in a deposit account) to see it
through its lean years.

Note that companies do not have to have actually raised capital to have it
available for emergency use. What they need is a pre-agreed right to borrow a
certain amount on demand. That is known as a line of credit. Many of us make
use of lines of credit in our personal lives, but there we call them credit cards. So
we dont have to have $1,000 sitting in the bank in case our car needs a major
repair, but its comforting to know that if repairs are necessary, we can pay for
them immediately. Of course, the credit card debt will have to be repaid at some
time, but repayments can be spread.

Long, medium and short-term capital
Capital can be short, medium or long-term. Definitions vary somewhat, but the
following are often seen:
Short term up to two years. For example, overdrafts, trade credit, factoring
and invoice discounting
Medium term two to five or six years. For example, term loans, lease
finance.
Long term over five years, or so, to permanent.

In general, it makes sense to match the length of the finance to the life of the
asset (the matching principle) and, again, we often apply this in our own lives,
where we would use a 25-year mortgage to buy an apartment, a 35-year loan to
buy a car, and a credit card to pay for a holiday.

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Within a business context:


Note that long-term capital (equity and bonds) can be used to fund all classes of
asset. Although each piece of inventory and each receivable are very short-life
assets, in total there will normally be fairly stable amounts of each that have to be
permanently funded. Therefore, it makes sense to fund most of those assets by
long-term capital and to use short-term capital to fund seasonal peaks. One of the
problems with short-term finance is that is comes to an end quickly and if finance
is still needed then more has to be renegotiated. Long-term capital is either
permanent or comes up for renewal relatively rarely.

Mature companies
Once a company has existed profitably for some time and grown in size,
additional sources of finance can become available, in particular:
public equity
public debt
bonds.

Public equity
Some stock exchanges provide different sorts of listings. For example:
London Stock Exchange: The Main Market and the Alternative Investment
Market (AIM). AIM focuses on helping smaller and growing companies raise
the capital they need for expansion.
NASDAQ: This is an electronic stock exchange in the US and has the
NASDAQ National Market for large, established companies (market value at
least $70m) and the NASDAQ Capital market for smaller companies.

On the London Stock Exchange the main differences are;


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An initial public offering is the first occasion on which shares are offered to the
public. A company seeking a listing has to issue a prospectus, which is a legal
document describing the shares being offered for sale, and including matters
such as a description of the company's business, recent financial statements,
details of the directors and their remuneration.

Shares can be listed via:
An offer for sale at fixed price: a company offers shares for sale at a fixed
price directly to the public, for example in newspaper advertisements. In
fact, the shares are usually first sold to an issuing house which sells them on
to the public.
An offer for sale by tender: investors are asked to bid, and all who bid more
than the minimum price that all shares can be sold at will be sold shares at
that minimum price.
A placing: shares are offered to a selection of institutional investors. Because
less publicity is needed, these are cheaper than offers for sale and are
therefore suited to smaller IPOs.
An introduction: this is rare and only happens when shares are already widely
held publically. No money is raised.

Subsequent issues of equity will be rights issues where existing shareholders are
offered new shares in proportion to existing holdings. The shares are offered at
below their current market value to make the offer look attractive, but in theory,
no matter at what price right issues are made and no matter whether
shareholders take up or dispose of their rights, shareholders will end up neither
better nor worse off. Wealth is neither created nor destroyed just by moving
money from a shareholders bank account to the companys.

Gaining a listing opens up a huge source of potential new capital. However, with
listing come increased scrutiny, comment and responsibility. Although this will
help the standing and respectability of the company the founders of the company,
having been used to running their own company in their own way, often resent
outside interference even though that is to be expected now that ownership of
their shares is more widespread.

Public debt
This refers to quoted bonds or loan notes: instruments paying a coupon rate of
interest and whose market value can fluctuate. Usually the bonds will be secured
either by fixed or floating charges and can be redeemable or irredeemable. Well-
secured bonds in companies that are not too highly geared are low risk
investments and bonks holders will therefore require relatively low returns. The
cost of the bonds to the borrower falls even more after tax relief on interest is
taken into account.



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Convertible bonds
Convertibles start life as loan capital and can later be converted, at the lenders
option, into shares. They are a clever and useful device, particularly for younger
companies, because:
In the very early days of the companys life, investors might not want to risk
investing in equity, but might be prepared to invest in the less risky
debentures. However, debentures never hold out the promise of massive
capital gains.
If the company does not do so well, the investors can stick with their safe
convertible loan stock.
If the company does well, the investors can opt to convert and to take part in
the capital growth of the shares.

Convertible bonds therefore offer a wait and see approach. Because they allow
later entry to what might turn out to be a growth stock, the initial interest rate
they have to offer is lower than with pure bonds and thats good for the
company that is borrowing.

Gearing
When deciding what sorts of finance to issue, companies must always bear in
mind the average cost of their finance. This article does not go into gearing
considerations in any detail except to point out that some borrowing can lower the
cost of capital.

If there is no borrowing, all finance will be equity and that is high cost to
compensate for the high risk attaching to it. Debt finance is cheap because it has
lower risk and enjoys tax relief on interest.

Therefore, introducing some debt into the finance mix begins to pull down the
average cost of capital. However, at very high levels of gearing the increased risk
of default pushes up both the cost of debt and the cost of equity, and the average
cost of finance starts to rise. Somewhere, there is an optimum gearing ratio with
the cheapest mix of finance.

The previous paragraph briefly described the traditional theory of gearing.
Modigliani and Miller suggested an alternative view, but the very precise
conditions and restrictions their theories require are not often found in practice.

Ken Garrett is a freelance lecturer and author

RELEVANT TO ACCA QUALIFICATION PAPER P3
Studying Paper P3?
Performance objectives 7, 8 and 9 are relevant to this exam

2011 ACCA
Strategy and people
When devising a strategic plan it is important to consider the
organisations resources. These will probably contribute to most of the
weaknesses and strengths in a SWOT analysis. Many, but not all,
resources can be remembered by using the M words: money,
manufacturing, material, marketing, machinery, methods, management
information, management, and men and women. Management, men and
women can be called the organisations human resources.

In the Johnson and Scholes approach to strategy evaluation (suitability,
acceptability and feasibility), resources relate to the feasibility of a
project. If a resource is not available, either that plan will have to be
changed or abandoned, or the resource must be found.

Many resources are relatively easy to define and come with known,
stable properties, such as material of a certain quality or machinery with
a promised performance. However, human resources can be
problematic and increasingly difficult, to obtain successfully and
reliably. This is because;
Defining desired behaviour and measuring employee performance
is often challenging.
Employees are complex, dynamic creatures with changing
enthusiasm, preferences, skills, motivation, boredom levels and
personal problems.
Employees can choose to leave.
In many countries, population changes mean that there are fewer
people available to recruit employees from customary sources.
In general, most jobs have higher technical content. Jobs that once
made use of relatively stable skill-sets, such as plumbers and
electricians, now require constant retraining to stay up-to-date with
regulations and other developments.
In economies where there has been a move away from
manufacturing to service provision, more employees come into
direct contact with customers (the people part of the extended
marketing mix). Therefore, if those employees are poor performers
they can do instant harm to an organisations reputation. In
manufacturing, poor employees can be hidden in factories and the
products they make can be inspected before delivery.
There are many fewer jobs for life and if people move on regularly,
there is a greater recruitment burden.
Employment protection legislation can make it a difficult, and
costly process to dismiss unsatisfactory employees. It is, therefore,
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important to get recruitment right and, where necessary, to enable
employees to improve their performance to a satisfactory level.

Strategic human resource management
Ideally, strategic human resource management will form one component
of the linear rational planning approach: analysis, choice,
implementation. This will probably be the case where a rational plan has
significant impact on the human resources needed. For example:

Element of the rational plan

Possible impact on human
resources
Take-over a competitor to gain
market share, gain economies of
scale and reduce competition.
Plan and put into effect
redundancies as operations are
merged and synergies sought.
Encourage teamwork from
remaining employees.

Expand into South America by
setting up a manufacturing and
distribution company there.
Recruiting suitable local
employees. Move managers abroad
to run the operation.

Move a hotel chain up-market (3*
to 5*) to escape fierce competition
and earn higher margins.
Decide what skills are needed in a
luxury hotel. Recruit suitable staff;
evaluate the skills of current staff
and provide training. Possibly
redeploy current staff into other
roles.

In practice, the people who are managing human resources are
themselves part of the human resource asset base and will be aware of a
political dimension: power, promotion and status. Undoubtedly these
understandable and probably unavoidable human factors can interfere
with the rational approach. Additionally, human resource management
is more at risk from bounded rationality. This is our inability to be
completely rational because we cant know everything that we need to
know to make rational decisions. At least when you buy a machine you
can predict fairly well its life-time cost, performance and maintenance
periods, and you can be confident that it wont suddenly move to a
competitor. Little of that is true with human resources.

The human resource planning approach described above is essentially a
position-based approach: discover whats happening in the environment,
then adjust what the organisation does to suit that environment.
However, given the competencies that might be possessed by many
employees, it is important not to neglect the resource-based approach.

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For example employees:
could possess valuable knowledge and this is often the difficult-to-
discover tacit knowledge
will have formed business relationships with suppliers and
customers
might possess unique or scarce talents
should have formed effective, motivated multi-skilled teams.

These can be the source of difficult-to-copy competitive advantage.
Although employees might gain these attributes spontaneously, it is very
important to recognise the contribution that good management can
make to creating a human resource which is valuable, possesses core
competences, is difficult to imitate and which is long-lasting.

Management can influence:
recruitment
training and development
job design
leadership and motivation

Without carrying out these steps successfully it is unlikely that the
capabilities arising from human resources will be more than threshold
capabilities.

Recruitment
The classic recruitment steps begin with:
Human resource planning: How many people? What skills? When?
Where?
Job analysis: What is the job? What will the person be doing? A job
title, such as Accounts Assistant can mean very different things in
different organisations. Job analysis researches what tasks the job
entails and this will point the way to the competences a successful
recruit should possess.
Job description: This is the result of the job analysis.
Person specification: This describes the attributes, such as
experience, qualifications and personality, that a successful holder
of the job must possess.

The person specification could be expressed in a competency
framework. Competency is the set of behaviour patterns that the
employee needs to bring to a position in order to perform its tasks and
functions with competence. Competency frameworks draw together the
competences needed for the stated job.



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Here is part of a competency framework that might be relevant to an
accounts assistant:





Note that the competency framework will be useful at the following
stages of an employees career:
Recruitment: how does the candidates current performance
compare to what is needed. Sometimes it will be essential that new
employees come with full-fledged competences, but sometimes
they could be employed in the hope that competency gaps can be
made good.
Training and development: in areas where actual performance is
below required performance.
Discipline: where employees are required to improve to meet the
required competence.
Promotion: where candidates have shown competences for a higher
position.
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For the sake of completeness, the remaining stages of the recruitment
cycle are:
Attract candidates and create a short list for interview
Interview (and consider testing ability, aptitude and personality)
Offer and acceptance
Take up references
Induction training to make the new employee comfortable and
productive as soon as possible.

Job design
Job design can be defined as the process of deciding on the contents of
a job in terms of its duties and responsibilities, and on the relationships
that should exist between the job holder and his/her superior,
subordinates and colleagues.

There are a number of approaches:
1. The scientific approach
This approach is associated with Frederick Taylor (18561915). Taylor
believed that many workers went about their jobs inefficiently and
without management direction as to the best way to accomplish tasks.
He believed that it was managements duty to investigate tasks and to
arrange them in a scientific way that minimised wasted effort and
maximised efficiency. The results of his studies in search of efficiency
were that:
Jobs were fragmented into simple tasks
Manual workers simply had to get on with their simple, repetitive
task and leave decision making to managers
The skill in each job should be minimised
The arrangement of machines should be such so as to minimise
material and people movement.

The approach was soon adopted enthusiastically by Henry Ford whose
factories were based on mechanised production lines which determined
the speed at which work had to be completed. It enabled the production
of standard products at lower cost.

2. Job rotation, job enlargement and job enrichment
The scientific approach to management resulted in high productivity and
also allowed workers wages to increase. However, it was criticised
because it often turned employees into automatons, condemning them
to mindless tasks and driven by the speed of the production line. Job
satisfaction, motivation and pride in their work decreased. Often labour
relations and quality were bad and commitment to employers was low.

These problems gave rise to a recognition that job design should also
pay attention to the employees social and psychological needs. This is
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the human relations school of management. Employees get bored, so
more variety in work could be useful; employees like being challenged;
employees like feeling they are contributing something worthwhile. This
realisation gave rise to attempts at job redesign where managers aimed
to produce better jobs. Methods available are:
Job rotation. This is a horizontal change in the job, meaning that a
worker is regularly moved from one simplified, de-skilled job to
another. This should reduce worker boredom (at least for a while).
Job enlargement. Another horizontal change, but each job now
consists of several unskilled tasks.
Job enrichment. This is a vertical change in which some of the
tasks previously carried out by managers and supervisors are
added to the job. For example, in addition to repetitive construction
tasks the employee could now also be required to assess and
report on the quality of the item.

Of the three, job enrichment holds the most promise of long-term
increases in job-satisfaction. It must be pointed out, however, that
managers often do not find it easy to relinquish managerial control to
their subordinates, so that frequently the apparent delegation of power
is accompanied by increased monitoring of performance. In many
organisations job enrichment might therefore be an illusion perpetrated
by managers to try to keep employees happy, but without giving them
any worthwhile discretion.

3. Japanese management
In the 1970s and 1980s Japanese manufacturing companies were
world-leading. Companies such as Sony, Mitsubishi, Panasonic, Canon,
Nikon, Toyota and Nissan usually beat their western competitors.
Because of that success, much attention has been paid to Japanese
management approaches. Much of the pioneering work was done in
Toyota and resulted in their Toyota Production System. This approach is
also known as lean manufacturing and it concentrates on eliminating
any activity and expenditure that does not add value to the finished
product or service.

There are three elements:
Elimination of waste: First the products and their manufacture have
to be properly planned (for example by eliminating unnecessary
parts or processes). Second, that planning has to be put into action
(for example by scheduling production efficiently). Third,
performance has to be monitored to identify where, despite the
first two steps, things could still be improved. Just in time
manufacturing is an example of an approach aimed at reducing
waste.
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Flexibility: In a traditional factory workers service a single
production line running from receiving of raw materials to
delivering the finished products. A breakdown in any part of the line
nearly always resulted in the entire process halting until the
problem was overcome. Cellular manufacturing systems separate
the production line into cells or modules, each with a group of
workers and machines. Each cell is dedicated to a particular
component of the manufactured product. Ideally, workers and
equipment comprising a particular cell are trained and configured
to be able to take over the processes of another cell when
necessary. Thus, the breakdown of one cell, due to equipment
breakdown or staffing problems, does not radically affect the rest
of the production process.
Quality: Quality of design and quality of conformance are essential
if waste is to be eliminated and value added consistently. Japanese
companies were the first to embrace the concept of total quality
management. This addresses every activity an organisation carries
out and encourages a culture of never being satisfied that further
improvements are not possible.

Business process re-engineering
This approach says that the structure of work has to be radically
changed. Part of this means perceiving core employees not as an
expense but as valuable assets, who are able to serve customers needs
well without instruction from above. Following managers instructions is
no guarantee that an organisation will be successful as those
instructions might be wrong. Organisations should be market driven.

The approach has had many critics, mainly pointing out that managers
still want to manage (to justify their higher salaries), that there will still
be a hierarchical structure, and that many employees will, inevitably,
end up carrying out repetitive, specialist tasks.

Leadership
Leadership can be defined as the process by which an individual
influences others. Within organisations it is to be hoped that leaders
have both power (the ability to influence) and authority (the right to
influence). One without the other is never satisfactory.

Power can arise from the following sources:
Rational-legal. A manager exerts power because of the title
manager and subordinates are supposed to carry out lawful
instructions.
Charismatic. Where the person has great charm and force or
personality
Reward power. Where the promise of pay increases or promotion
are used.
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Knowledge. Where withholding and releasing knowledge selectively
exerts power.
Coercion. Through physical power. This is rarely seen in civilised
organisations.

Authority arises from a persons position in an organisational hierarchy,
authority limits and the operation of the law.

Early theories of leadership were known as trait theories and these
suggested that all good leaders were born with certain identifiable traits
that were the golden rules of good leadership. This was bad news for
those whose genetic endowment lacked those traits. More modern
theories, while recognising that there tend to be traits or styles of
behaviour, maintain that many of these styles can be taught. For
example, research tends to suggest that successful leaders exhibit:
honesty, the ability to inspire, competence, intelligence and the ability
to look forward.

Style theories therefore open up the possibility that training, learning
and development can create good (or at least better) managers.

Although few would argue that the styles listed above are not desirable
in a leader, the list still leaves many unanswered questions such as
should the leader be:
Autocratic or participative?
Empathetic or distant?
Strict or relaxed?
Reliant on sanction or reward?

Modern thinking about leadership suggests a contingent approach: there
are no golden rules that will fit every situation and how to lead and
manage is contingent on (depends on) the situation. One of the most
accessible approaches to contingency theory is Handys Best Fit Theory.

Here, leaders, subordinate and the task are ranked in a continuum from
tight to flexible:

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All works well if the three elements line up: a strict boss, telling passive
subordinates to get on with their repetitive tasks. However, once there is
a mismatch somewhere, things go wrong. For example, an authoritarian
manager in charge of talented, intelligent, well-qualified people who are
told to carry out dull repetitive tasks will not work well.

In the short-term, the leader must attempt to adjust his or her style, but
a permanent solution needs more than that, and will certainly involve
job redesign.

Transactional and transformational leaders
Transactional leaders focus on the short term, controlling, maintaining
and improving the current situation, planning, organising, defending the
existing culture. They rely on rational/legal power so that subordinates
obey because their manager is called manager. It is sometimes said
that such leaders concentrate on doing things right. Transactional
leaders will form the majority of an organisations managers and are
useful to deal with the day-to-day running of the organisation.

Transformational leaders are very different. They concentrate on a
long-term vision and on re-engineering to change the organisation
radically, and they motivate their staff through a climate of trust,
empowerment, change culture, and charisma. These people
concentrate on doing the right things.

If an organisation faces serious challenges or opportunities which call
for radical changes, then it needs a visionary transformational leader at
its head. Transactional leaders (managers) are unlikely to have the
vision and, even if they do, will find it difficult to persuade others to
follow them enthusiastically.

Knowledge work
At the start of this article, it was said that in many economies there has
been a move towards greater technical requirements and a move away
from manufacturing industry. Both of these changes can be seen in
knowledge work. This can be defined as a Job, process, or task that is
distinguished by its specific information contents or requirements.
Examples of knowledge work include teachers, engineers, research
scientists, lawyers, accountants, etc.

It must be emphasised again, that whereas the main assets in a
manufacturing industry are permanent, traceable and easy to define, the
main assets in an industry depending on knowledge work walk out of the
office door every evening. Many of the most junior recruits, fresh from
university will possess some of the most valuable knowledge that will be
vital to the organisations sustainable competitive advantage. Instead of
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giving orders, managers must learn to listen; instead of tall hierarchies
putting distance between top managers and new employees, company
structures have to be flattened or de-layered. Instead of living in the
tight domain of Handys best fit model, knowledge organisations inhabit
the flexible domain.

In a knowledge business, more than in a traditional manufacturing
industry, success will depend on recruiting the right people, leading
them in the right way and inspiring them to perform and contribute to
the best of their abilities.

Ken Garrett is a freelance lecturer and author


RELEVANT TO ACCA QUALIFICATION PAPER P7
Studying Paper P7?
Performance objectives 17 and 18 are relevant to this exam
2011 ACCA
Acceptance decisions for audit and assurance engagements
The syllabus for Paper P7, Advanced Audit and Assurance includes Professional
Appointments (syllabus reference C4). The learning outcomes include the
explanation of matters that should be considered and procedures that should
be followed by a firm before accepting a new client, a new engagement for an
existing client, or agreeing the terms of any new engagement. The engagement
may be an audit, or it may be a non-audit or assurance engagement.
Acceptance decisions are crucially important, because new clients and/or
engagements can pose threats to objectivity, or create risk exposure to the
firm, which must be carefully evaluated. One of the current issues being
debated in the profession is whether there should be an outright ban on the
provision of non-audit services to audit clients. In addition, new International
Standard on Auditing (ISA) requirements compel the firm to establish whether
preconditions for an audit are present when faced with a potential new audit
engagement. All of these factors mean that acceptance decisions must be
taken with care.

Accepting new audit clients
IFACs Code of Ethics for Professional Accountants states: Before accepting a
new client relationship, a professional accountant in public practice shall
determine whether acceptance would create any threats to compliance with the
fundamental principles. Potential threats to integrity or professional behaviour
may be created from, for example, questionable issues associated with the
client (its owners, management or activities). This means that when
approached to take on a new client, the firm should investigate the potential
client, its owners and business activities in order to evaluate whether there are
any questions over the integrity of the potential client which create
unacceptable risk. These investigative actions are usually performed as know
your client/customer or customer due diligence procedures, which are also
carried out in order to comply with anti-money laundering regulations.

Once a client has been accepted, the firm should consider the suitability of the
specific engagement it has been asked to perform. In particular there may be
ethical threats which mean that the engagement should not be accepted, in
particular whether there are any threats to objectivity. Potential threats could
arise for example, if members of the audit firm hold shares in the client or
there are family relationships. If threats are discovered, it may not mean that
the client must be turned down, as safeguards could potentially reduce the
threats to an acceptable level.

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There may be other ethical matters to evaluate in relation to a potential new
engagement, for example, whether any conflict of interest or confidentiality
issues could arise, and if so, whether appropriate safeguards can be put in
place. Also, the firms competence to perform the potential work should be
evaluated, especially if the potential client operates in a specialised industry,
or if the client has a complex structure. A self-interest threat to professional
competence and due care is created if the engagement team does not possess,
or cannot acquire, the competencies necessary to properly carry out the
engagement. Practical matters such as the resources needed to perform the
work, the deadline for completion, and logistics like locations and geographical
spread will have to be looked into as well.

Obviously, these matters need to be evaluated in the specific context of the
potential engagement, and should be fully documented. Different types of
potential engagement will give rise to different matters that should be
evaluated. For example, if the firm is asked to perform the audit of a large
group of companies with operations in many countries, then resourcing the
audit may be the most significant issue. The fee may be large, leading to a self-
interest threat of fee dependence. On the other hand, if asked to perform the
audit of a small owner-managed company, fee dependence is less likely to be
an issue, but threats potentially created by the auditor appearing to make
management decisions could be significant. In answering requirements on
client and engagement acceptance, candidates are warned that their
comments must be made specific to the scenario presented to them in order
to pass the requirement.

Commercially, an engagement should be profitable to make it worthwhile for
the firm. But the firm must take care that commercial considerations do not
outweigh other matters to be considered.

IFACs Code makes it clear that acceptance decisions are not to be treated as a
one-off matter. The Code states: It is recommended that a professional
accountant in public practice periodically review acceptance decisions for
recurring client engagements. Changes in the circumstances of either the
client, or the audit firm may mean that an engagement ceases to be ethically
or professionally acceptable or creates a heightened level of risk exposure.
Therefore, client continuance assessments are important and should be fully
documented.

Preconditions for an audit
Once a firm has decided to go ahead with an audit engagement, it must
comply with the requirements of ISA 210, Agreeing the Terms of Audit
Engagements. ISA 210 was revised as part of the International Auditing and
Assurance Standards Boards Clarity Project, with new requirements to
perform specific procedures in order to establish whether the preconditions for
an audit are present.

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ISA 210 defines preconditions for an audit as follows: The use by management
of an acceptable financial reporting framework in the preparation of the
financial statements and the agreement of management and, where
appropriate, those charged with governance to the premise on which an audit
is conducted. This means that the auditor must do two things. First, the
auditor must determine the acceptability of the financial reporting framework
to be applied in the preparation of the financial statements. This includes
evaluating whether law or regulation prescribes the applicable financial
reporting framework, considering the purpose of the financial statements, and
the nature of the reporting entity (for example, whether a listed company or a
public sector entity). In most cases this will simply be a matter of confirming
with the client that the financial statements will be prepared under
International Financial Reporting Standards, or other national reporting
framework.

Second, the auditor must obtain the agreement of management that it
acknowledges and understands its responsibility:
For the preparation of the financial statements in accordance with the
applicable financial reporting framework.
For internal controls to enable the preparation of financial statements
which are free from material misstatement, whether due to fraud or error.
To provide the auditor with access to all information necessary for the
purpose of the audit.

In relation to the final bullet point, if management impose a limitation on the
scope of the auditors work in the terms of a proposed audit engagement, the
auditor should decline the audit engagement if the limitation could result in the
auditor having to disclaim the opinion on the financial statements. The
engagement should also be declined if the financial reporting framework is
unacceptable, or if management fail to provide the agreement outlined above.
(ISA 580, Written Representations also requires that management provide
written representations regarding its responsibilities in relation to the
preparation of financial statements.)

Accepting non-audit assignments
It is very common for audit clients to approach their auditor for the provision of
additional services, ranging from audit related services such as tax planning
and bookkeeping, to other engagements such as due diligence and forensic
investigations. The audit firm must again carefully consider whether it is
ethically and professionally acceptable to take on the additional service.

The main ethical threat created by the provision of non-audit services is the
threat to objectivity. The threats created are most often self-review, self-
interest and advocacy threats and if a threat is created that cannot be reduced
to an acceptable level by the application of safeguards, the non-audit service
shall not be provided. The UK Auditing Practices Boards (APB) Ethical
Standard 5, Non-audit services provided to audit clients contains similar
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principles, and emphasises the management threat which exists when the
audit firm makes decisions and judgments that are properly the responsibility
of management.

Both the Code and ES 5 outline a principles-based approach to determining
the acceptability of a non-audit service to an audit client. With a few
exceptions, if safeguards can reduce threats to an acceptable level then the
service may be provided. Safeguards could include using separate teams to
provide the various services to the client, and the use of second partner review
or Engagement Quality Control Review. ES 5 specifies that it is the audit
engagement partner who should evaluate the level of threat, the effectiveness
of safeguards, and is ultimately responsible for the documentation of the
acceptance decision.

The provision of non-audit services to audit clients continues to be debated by
the profession. Many argue in favour of outright prohibition as being the only
measure which can totally safeguard auditors objectivity. However, it is
accepted that audit firms are best placed to provide audit clients with
additional services due to the knowledge of the business which they already
possess, leading to a lower cost and higher quality service than that would be
provided by a different firm. In 2010 the APB issued a feedback and
consultation paper The provision of non-audit services by auditors, which
prompted continued discussion of these issues and recommended a number of
measures to:
Increase the rigour with which auditors assess threats to their
independence
Introduce a new non-audit services disclosure regime and
Increase the role of Audit Committees in overseeing the retention of a
companys auditors to undertake non-audit services.
The final bullet point is important as it links to corporate governance. Under
many codes of corporate governance, including the UK Corporate Governance
Code, the clients audit committee should be involved with any decision as to
whether the audit firm can be engaged to provide a non-audit service.
Therefore, when approached to provide a non-audit service to an audit client,
there should be full discussion with those charged with governance, including
the audit committee, with a view to seeking approval for the engagement to go
ahead.

As well as considering independence and objectivity, audit firms should
remember that the fundamental ethical principles apply to non-audit services,
just as they apply to audits. Therefore, when considering whether to provide a
non-audit service, the firm should evaluate its competency to perform the
work, whether confidentiality is an issue, and that it is able to comply with all
relevant laws and regulations.

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As discussed above, in answering requirements to do with non-audit services,
candidates answers must apply knowledge to the specific scenario provided in
order to score well.

Conclusion
The evaluation of new engagements is a crucial part of successful practice
management. The current debate over the acceptability of auditors providing
non-audit services to their audit clients indicates that ethical matters will
continue to play an important part in acceptance decisions.

Lisa Weaver is examiner for Paper P7