Question 1a

Alpha has one subsidiary, Beta. The draft statements of profit or loss for both entities for the year ended 31 March 20X7 are given below:

Alpha Beta
$’000 $’000
Revenue (notes 3 and 4) 400,000 280,000
Cost of sales (notes 1–3) (240,000) (170,000)
–––––––– ––––––––
Gross profit 160,000 110,000
Distribution costs (40,000) (25,000)
Administrative expenses (note 5) (50,000) (29,000)
Investment income (note 6) 45,000 nil
Finance costs (35,000) (20,000)
–––––––– ––––––––
Profit before tax 80,000 36,000
Income tax expense (25,000) (12,000)
–––––––– ––––––––
Profit for the year 55,000 24,000
–––––––– ––––––––

Note 1 – Alpha’s investment in Beta
On 1 April 20X5, Alpha acquired 90 million of Beta’s 120 million issued equity shares for a cash payment of $327 million. On 1 April 20X5, the directors of Alpha measured the non-controlling interest in Beta using Alpha’s proportionate share of the net assets of Beta at that date.

On 1 April 20X5, the net assets of Beta as shown in the individual financial statements of Beta totalled $380 million. The directors of Alpha carried out a fair value exercise to measure the fair value of the identifiable assets and liabilities of Beta at 1 April 20X5. The following matters emerged:

– Plant and equipment having a carrying amount of $120 million had an estimated fair value of $140 million. The estimated remaining useful life of this plant at 1 April 20X5 was four years.

– A brand name relating to Beta had a fair value of $30 million. This brand name was not recognised in the individual financial statements of Beta as it was internally developed. The directors of Alpha considered that the useful life of this brand name was 10 years from 1 April 20X5.

– A contingent liability relating to a pending legal case was disclosed in the notes to the financial statements of Beta at 1 April 20X5. This contingent liability had a fair value of $15 million at 1 April 20X5. The contingency was settled during the year ended 31 March 20X6.

The fair value adjustments have not been reflected in the individual financial statements of Beta. The fair value adjustments are temporary differences which attract deferred tax at a rate of 20%.

All depreciation and amortisation of non-current assets is to be charged to cost of sales in the consolidated financial statements.

On 1 April 20X5, Alpha made a loan to Beta of $200 million. The loan carried an annual interest rate of 10%. Interest is payable annually in arrears and the loan is repayable by Beta on 31 March 20X9. The loan interest payable on both 31 March 20X6 and 31 March 20X7 was paid by Beta on the due date and recognised by Alpha as investment income.

Note 2 – Impairment review of goodwill on acquisition of Beta
The goodwill on acquisition of Beta was reviewed for impairment on 31 March 20X6 and no impairment was considered necessary. On 31 March 20X6, the individual financial statements of Beta showed net assets of $390 million.

Beta paid a dividend of $12 million on 1 March 20X7 (see note 6).

Beta is a single cash-generating unit for impairment purposes. On 31 March 20X7, the estimated recoverable amount of Beta as a single cash-generating unit was $448 million.

Any impairment of goodwill should be charged to cost of sales.

Note 3 – Intra-group trading
Alpha provides Beta with a product which Beta uses as a raw material in its production process. Sales of the product by Alpha to Beta for the year ended 31 March 20X7 totalled $30 million. Alpha supplies this product to Beta at a mark‑up of 20% on its cost of production.

On 31 March 20X7, the inventories of Beta included $6 million in respect of raw materials supplied by Alpha. On 31 March 20X6, the equivalent figure in the inventories of Beta was $4·8 million.

Any adjustments for unrealised profits are temporary differences which attract deferred tax at a rate of 20%.

Note 4 – Alpha revenue
On 1 October 20X6, Alpha sold a machine to a customer for a total sales price of $27 million. The terms of the sale were that Alpha would provide the customer with a three year service warranty. The service warranty covered all repairs which might be necessary should the machine break down in the three year period. The normal selling price of the machine without the inclusion of any service warranty would have been $24 million. Alpha would normally charge a customer a total of $6 million to provide a three year service warranty covering breakdown costs on a machine of this nature.

On 1 October 20X6, Alpha recognised revenue of $27 million and charged the cost of manufacture to cost of sales. Any costs incurred by Alpha under the service warranty arrangements during the period from 1 October 20X6 to 31 March 20X7 were charged as cost of sales. The service warranty arrangement does not represent an onerous contract for Alpha at 31 March 20X7.

Note 5 – Research and development project
On 1 April 20X6, Alpha began a research project. The aim of the project was to investigate ways of streamlining its production process. The initial costs of setting up the project were $5 million. From 1 April 20X6 to 30 June 20X6 ongoing project costs were $500,000 per month. On 1 July 20X6, the project was considered to be technically feasible and commercially viable and from this date project costs increased to $600,000 per month. The project was completed on 31 December 20X6 and the new production process began to be used from 1 January 20X7. The new process is likely to produce economic benefits for Alpha for five years from 1 January 20X7. Alpha charged all the costs to complete the project to administrative expenses.

Note 6 – Alpha’s investment income
The figure for investment income in the consolidated financial statements of Alpha comprises:

$’000
Dividend received from Beta (note 2) 9,000
Interest received from Beta (note 1) 20,000
Dividend received from investment in Gamma (note 7) 4,500
Dividends received from portfolio of equity investments (note 8) 11,500
–––––––
45,000
–––––––

Note 7 – Alpha’s investment in Gamma
On 1 October 20X6, Alpha purchased 18% of the equity shares of Gamma at a cost of $102 million. No other single shareholder owns more than 5% of Gamma’s equity shares and there are no agreements in place for any of the other equity shareholders to collaborate to influence Gamma’s operating or financial policies. Alpha has the right to appoint four of the ten directors of Gamma.

Gamma prepares financial statements to 31 March 20X7 and its profit before tax for the year ended 31 March 20X7 was $78 million. Its income tax expense for that year was $6 million. Gamma’s profits accrue evenly.

Gamma paid a dividend of $25 million on 1 March 20X7.

Alpha’s investment in Gamma has not suffered any impairment since 1 October 20X6.

Note 8 – Alpha’s portfolio of equity investments
Alpha’s portfolio of equity investments is held for short term trading. During the year ended 31 March 20X7, Alpha made additional purchases at a total cost of $8·5 million which were added to the portfolio. During the year ended 31 March 20X7, Alpha received $7 million from the proceeds of sale of investments from the portfolio. These proceeds were deducted from the carrying amount of the portfolio. On 31 March 20X6, the fair value of the portfolio was $75 million and this amount was recognised in the financial statements of Alpha at that date. On 31 March 20X7, the fair value of the portfolio was $84 million. No adjustments have yet been made to the financial statements of Alpha to reflect this change in fair value.

Required:
(a) Explain how Alpha should classify its investment in Gamma (note 7) in its consolidated financial statements for the year ended 31 March 20X7. (2 marks)

Note: You should show all workings to the nearest $’000.