IA2: EARNINGS PER SHARE, RESEARCH AND DEVELOPMENT, AND PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS

In this unit, we shall discuss Statement of Accounting Standard 21: Earning per Share, Statement of Accounting Standard 22: Research and Development, and Statement of Accounting Standard 23: Provisions, Contingent liabilities and Contingent Assets.

EARNINGS PER SHARE, RESEARCH AND DEVELOPMENT, AND PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS

DEFINITIONS OF TERMS USED IN THE STATEMENT OF ACCOUNTING STANDARD 21:

Earnings per Share

The following terms are used in this statement with the meanings specified:

 (a) Adjusted Earnings Per Share

This refers to the figure carried in a financial statement as earnings per year for previous years after recalculating the EPS of such years, using the outstanding shares of the company as at the latest balance sheet date as a common denominator all the years.

 (b) Basic Earnings per Share

Basic earnings per share is the amount of earnings per share based on the weighted average number of shares outstanding during the reporting period.

 (c) Bonus Shares

A bonus share is a share in respect of which purchase consideration is satisfied by capitalising existing reserves, which already belong to the shareholders. It is the formal recognition of the increase in the capital invested by those shareholders. It is also referred to as a stock dividend.

 (d) Convertible securities

Convertible securities are financial instruments that confer holders with the right to receive a determinable number of ordinary shares or other securities in satisfaction of their claim at determinable future dates or period.

(e) Diluted Earnings Per Share

Diluted earnings per share are the amount of earnings per share after adjusting for the effect of all potential ordinary shares.

 (f) Options and Warrants

An option is the right to deal in the security of an entity at a fixed price during a specific period of time. An option can either be a call option or a put option:

(i) a call option is a right given by one party to another to buy a security at a fixed price during a specific period of time.

(ii) a put option is a right given by one party to another to sell a security at a fixed price during a specific period of time. A warrant is a certificate by a company, which gives its holders the right to purchase its shares at fixed price within a specific period of time.

Warrants are prohibited in Nigeria by Section 149(1) of the CAMA, Cap. C20 LFN, 2004.

 (g) Ordinary Shares

An ordinary share represents a unit of the ownership interest in a company, which entitles its holder to participate in the earnings, dividends and assets of the company after other interests have been settled.

 (h) Potential Ordinary Shares

A potential ordinary share is a financial instrument or any other contract, which could:

(i) be converted into an ordinary share; or

(ii) result in the calling of, or subscription for, ordinary share capital at a fixed price within a specified period of time.

(i) Preference Shares

A preference share is an equity instrument that has claim to a company’s earnings, dividends and assets before the ordinary share but after the debt obligations and could be redeemed  without a court order or the dissolution of the company either by winding up or liquidation.

(j) Publicly Traded Shares

A publicly traded share is a share of company which can be transferred without the prior consent of its directors and may or may not be listed on a recognised stock exchange or other public securities market.

(k) Rights Issue

A right issue is a privileged issue of the securities of a company, at a price, to its existing shareholders on the basis of their existing shareholdings.

(l) Share Consolidation

Share consolidation, also called reverse split, take place when the number of the outstanding shares in a company is reduced by increasing the par (normal) value of each share.

(m) Share Split:

Share split takes place when the number of the outstanding shares in a company is increased by reducing the par value of each share.

SELF ASSESSMENT EXERCISE

What is the difference between ordinary shares and preference shares?

COMPUTATION OF EARNINGS PER SHARE

(a) In calculating earnings per share, an enterprise should not include extraordinary items before arriving at profit after tax.

(b) Potential ordinary shares should be treated as dilutive when, and only when, their conversion to ordinary shares would decrease net profit per share from continuing ordinary operations.

(c) The amount of net profit attributable to preference shareholders including preference dividend for the period should be deducted from the net profit (or added to the net loss) in calculating the net profit or net loss for the period attributable to ordinary shareholders.

(d) In order to determine earnings for EPS calculation, the full dividend for the year on cumulative preference shares, should be deducted (the net amount) from the net profit or added to the net loss, whether or not it has been earned or declared, while only the actual dividend paid or proposed on non-cumulative preference shares should be deducted from the net profit.

(e) A weighted average number of shares outstanding during the period should be used as a denominator for the earnings per share calculation. Shares issued during the year included in the weighted average number of shares should reflect the date the consideration was received

(f) In calculating diluted earnings per share, the number of shares should be determined as the total of the following:

(i)The weighted average number of ordinary shares.

(ii) Potential ordinary shares of the entity outstanding as at the beginning of the financial year that remain outstanding as at the reporting date that are dilutive.

(iii) Potential ordinary shares issued during the financial year that are dilutive, weighted by  reference to the number of days from the date of issue of those potential ordinary shares to the reporting date of issue of those potential ordinary shares to the reporting date as a proportion of the total number of days in the financial year.

(iv) Potential ordinary shares outstanding during the financial year that are dilutive and have been converted or have lapsed or cancelled during the year, weighted by reference to the  number of days from the beginning of the financial year to the date of conversion lapse or cancellation.

ILLUSTRATION

Eggon Plc has a capital structure made up of:

SAS00

In the last three months, the market value of the company’s shares has remained at N5:00 per share. Its current year’s profit after tax is N10,000,000. Eggon Plc has decided to pay 25% stock dividend to its shareholders from the current year’s profit.

You required to show the effect of this on:

(i) The market price of the company’s share; and

(ii) The earnings per share

SUGGESTED SOLUTION

(i) Effect of the stock dividend on the market price of the company’s share will be:

SAS01

With stock dividends, the total number of shares becomes 3,250,000. Since the total market value is

N10,000,000, the market price per share will be N10,000,000/3,250,000 per share i.e. N3:08 per share.

Market price per share is expected to reduce to N3:08

(ii) Effect on earnings per share will be as follows:

EPS prior to stock dividend = N10,000,000/2,000,000 = N5:00 per share

EPS after stock dividend will be: 7,500,000/3,250,000 = N2:31

That is, EPS has fallen from N5:00 to N2:31

SELF ASSESSMENT EXERCISE

Outline how you compute earnings per share.

SOME PROVISIONS OF THE STATEMENT OF ACCOUNTING STANDARD 22: RESEARCH AND

DEVELOPMENT

Cost of elements should be separated into:

(a) Research costs; and

(b) Development cost.

Research costs include:

(a) The costs (including VAT) of materials and services consumed in research activity;

(b) Specific labour costs attributive to research activity;

(c) The cost of software and equipment acquired for research purposes;

(d) The cost of borrowed rights;

(e) The cost of information or technical services;

(f) The depreciation charge for equipment and facilities to the extent that they are used for research activities;

(g) The amortization charge for other assets, such as patents and licences, to the extent that they are related to research; and

(h) Shared costs only in terms of benefits to the parties sharing the costs or costs agreed by the same parties for research based on requests.

Development costs include:

(a) The cost of evaluating products or process alternatives;

(b) The cost of design, construction, and testing of pre-production or pre-use prototypes and models;

(c) The cost of design of tools, jigs, moulds, and dies involving new technology;

(d) The cost of design, construction, and operation of a pilot plant that is not of a scale economically feasible for production; and

(e) The cost of design, construction and testing of a chosen alternative for new or improved  materials, devices, products, processes, systems or services.

If it is not possible to distinguish the research phase from the development phase of an internal project, the entity shall treat the expenditure on the product as if it were incurred in the research phase only.

Accounting Treatment of Research and Development Costs

(a) Research and development costs shall be separated into research costs and development costs. The amount of research costs shall be expensed in the period in which they are incurred and development costs should be deferred to the extent that they meet the criteria for deferral.

(b) For an entity to defer development costs, the following criteria must be satisfied:

(i) The product or process is clearly defined and the costs attributable to the product or process can be separately identified and measured reliability;

(ii) The technical feasibility of the product or process has been demonstrated;

(iii) The management of the entity has indicated its intention to produce and market, or use, the product or process;

(iv) Adequate resources exist, or are reasonably expected to be available, to complete the project and market the product or process.

(v) The current and future cost to be deferred are material; and

(vi) There is a reasonable indication that current costs, future research and development costs to be incurred, together with unamortized deferred costs in relation to that project, are expected beyond any reasonable doubt to be recoverable.

(c) A reporting entity shall state its accounting policy with respect to research and development costs. Where an accounting policy of deferral of development costs is adopted, it shall be applied to all such projects that meet the criteria.

(d) Where development costs of a project are deferred, they shall be allocated on a systematic basis to future accounting periods by reference to either the scale or use of the product or process or to the period over which the product or process is expected to be sold or used.

(e) Where development costs are deferred, the amortization shall not exceed five years from the inception of the benefits;

(f) The deferred development costs of a project shall be reviewed at the end of each accounting period, and the following steps taken;

(i) When the criteria are no longer met, the unamortized balance shall be written off as an expense immediately;

(ii) When the other criteria for deferral continue to be met but that amount of unamortized  balance of the deferred development costs and other relevant costs exceed the expected future revenues or benefits relate thereto, such excess shall be charged as expense immediately; and

(iii) if for any reason, research and/or development activities are suspended or postponed on account of lack of resources, time or other contingencies, the unamortized balance shall be written off immediately.

Accounting Treatment of Grants Received in Relation to Research and Development

(a) Where a grant is received or receivable in relation to research and development cost which have been charged to the profit and loss account during the period or in a prior financial year, the grant shall be credited to the profit and loss account;

(b) Where a grant is received or receivable in relation to development costs which have been deferred, the grant shall be deducted from the unamortized balance; and

(c) Development costs which did not previously meet the criteria for deferral and were charged to the profit and loss account shall not be written back in the light of subsequent events.

DISCLOSURE REQUIREMENTS

In addition to the disclosure requirements of SAS 2, the financial statements of an entity shall disclose:

  1. The accounting policies adopted for research and development costs;
  2. The amount of research costs and development recognised as an expense in the period;
  3. The amortization methods used as regards development costs;
  4. The useful lives or amortization rates used; and
  5. A reconciliation of the unamortized development costs at the beginning and end of the period, showing:

(i) development costs recognised as an asset;

(ii) development costs recognised as an expense;

(iii) development costs allocated to other asset accounts; and

(f) The grants received in respect of research and development, the amount received or receivable and the source(s).

ILLUSTRATION

Major Oil Plc is about to acquire another oil company, Peanut Oil Limited, for N700 million. The consideration includes a purchase of four years’ profits. You are also given the following information:

PEANUTS OIL LIMITED

FINANCIAL SUMMARIES

SAS02

In 2004, Peanuts Ltd spent N12 million in obtaining licence to prospect for oil in Nigeria for an initial period of 20 years. In 2006, the company formulated a brand of engine oil for N24 million to lead the market. Industry analyst predicted that this brand of engine oil would remain dominant for 10 years.

The licensing and brand development costs were written off in the year of expenditure. You are required to:

  1. a) Advise on the treatment of licensing and development costs in the accounts and draft a

suitable accounting policy for the two items.

(b) Assess the offer of N700 million for the company by Major Oil Plc.

SUGGESTED SOLUTION

  • It is not proper to write off licensing and brand development costs in the year of expenditure.

The proper treatment should be to write off licensing costs over 20 years and brand development cost over 10 years.

(i) Accounting Policies

Licensing fees

These are written off over the expected useful life of the licence on a straight line basis.

(ii) Research and Development

Research costs are written off in the year of expenditure and development costs are amortized over the estimated useful life of the product.

(b) Assessment of the offer of N700 million:

Since licensing fees and brand development costs should be spread over their useful lives,  the accounts should be reconstructed.

(i) Licensing fees written off over 20 years

N12 m /20 = N600,000 per annum

(ii) brand development costs written off over 10 years 24/10 = N2,400,000 per annum

PEANUTS OIL LIMITED

 FINANCIAL SUMMARIES

SAS03

Four years purchase = N31.96 x 4 = N127.84m

Therefore fair purchase consideration = net assets + goodwill

That is = N(545.8m + 127.84m) = N673.64m

It is therefore, not a fair bargain if Peanuts Oil limited could be acquired for only N700m.

The present value of the company is N26.36 million lower than the purchase consideration.

SELF ASSESSMENT EXERCISE

What is included in research cost?

SOME PROVISIONS OF THE STATEMENT OF ACCOUNTING STANDARD 23: PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS

Meaning of Provisions

Provisions are liabilities that have arisen or are likely to arise in respect of a previous or current financial year. Such liabilities are charges against incomes and they often have substantial effect on an entity’s financial position and performance.

Due to the uncertainties surrounding the timing of events that may give rise to provisions and actual amount of liabilities involved, there is need to ensure uniformity and completeness in the manner in which such provisions are recognised and measured in financial statements. It is also of utmost important that sufficient information is provided in the financial statements to enable users understand their nature, timing and amounts.

Relationship between Provisions and Contingent Liabilities

All provisions are usually contingent since they are uncertain in timing or amount. The term, “contingent”, is used for liabilities as well as for assets, whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity. The term, “contingent liability”, is used for liabilities, that do not meet the recognition criteria of a “provision”.

CONTINGENT LIABILITIES

A contingent liability is either a possible obligation arising from past events, whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the entity’s control, or a present obligation that arises from past events that it is probable a transfer of economic benefit will be required to settle the obligation or because the amount of the obligation cannot be measured with sufficient reliability.

A provision shall be recognised when:

(a) An entity has a present obligation (legal or constructive) as a result of past event;

(b) If it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and

(c) A reliable estimate can be made of the amount of the obligation.

If these conditions are not met, no provision shall be recognised.

The amount recognised as a provision shall be the best estimate of the expenditure required to settle the present obligation at the balance sheet date.

The risks and uncertainties that inevitably surround many events and circumstances shall be taken into account in arriving at the best estimate of the provision.

Where the effect of the time value of money is material, the amount of a provision shall be the present value of the expenditure expected to settle the obligation.

Contingent Liabilities

A contingent liability is

(a) A possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one more uncertain future events not wholly within the control of the entity; or

(b) A present obligation that arises from past events but is not recognised because the amount of the obligation cannot be measured with sufficient reliability or it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation.

Contingent liabilities should not be provided for in the accounts. If it is probable that transfer of economic benefits will be required to settle that obligation and the amount of the obligation can be measured with sufficient liabilities, a disclosure should be made in the financial statements.

Contingent Assets

A contingent asset is a possible asset that arises from past event(s) and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.

An entity should not recognise a contingent asset in its financial statements. If it is probable that future economic benefits will flow, the entity and the amount can be measured with sufficient reliability, a disclosure should be made in the financial statements.

Onerous Contract

(a) If an entity has a contract that is onerous, the present obligation under the contract should be recognised and measured as a provision.

(b) A constructive organization to restructure arise only when an entity:

(i) has a detailed formal plan for the restructuring, identifying at least;

  • The business or part of the business concerned;
  • The principal locations affected;
  • The location, function and approximate number of employees
  • Who will be compensated for terminating their services;
  • The expenditure that will be undertaken; and
  • When the plan will be implemented; and

(ii) has raised a valid expectation in those affected.

SELF ASSESSMENT EXERCISE

What is the difference between provisions and contingent liabilities?

CONCLUSION

In conclusion, we would state that earnings per share are generally considered to be the single most important variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings valuation ratio.

The term ‘research and development’ is used to cover a wide range of activities, including those in the services sector. Classification of expenditure is often dependent on the type of business and its organization. However, it is generally possible to recognize three broad categories of activity, namely pure research, applied research and development.

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