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Week09_Practice_Question_Solutions - Week 9 Practice...

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Week 9 Practice Question Note: In the tax-effect versions of the solutions to practical questions, it is assumed that the tax rate is 30%. The tax effect versions are numbered 20.00t. If the application of tax effect does not change the solutions, only the explanation of why this is so is given. 20.1 What is the purpose of eliminating intra-group exchanges and debts arising from the exchanges? From the perspective of a group entity, only transactions with parties outside the group can alter group financial position, or affect its profit or loss or other performance measures. Intra- group exchanges do not increase group entity resources or revenues or costs; they simply move resources within the group, or are just paper transactions. Without their elimination group revenues and expenses would be overstated and could be artificially inflated at management discretion. Likewise, intra-group debt derived from such exchanges is eliminated as group assets and liabilities would otherwise be overstated. The elimination in both cases is made to avoid distortion of the gross amounts for revenues and expense, or assets and liabilities. The items eliminated have no net effect; they do not alter group profit or group net assets. An overstated revenue is always accompanied by an equally overstated expense; an overstated accounts payable is matched by an equal overstatement of accounts receivable. Overstatement of gross amounts can be misleading. Inflated revenues can create a false impression of high activity levels. Overstated assets and liabilities can distort a variety of financial ratios, liquidity ratios in particular, that analysts construct from the financial statements. 20.3 Profit recorded on intra-group transactions may or may not be realised. Explain the distinction between realised and unrealised profit in the context of consolidated financial statements. Describe how each is dealt with in the consolidation . Realised profit and unrealised profit are terms no longer used in the accounting standards. We use them to answer this question only. Earned or accomplished are good substitutes for realised; unearned conveys the same idea as unrealised. Intra-group transactions at prices above the seller’s cost result in profit for the selling company. This profit is realised (or earned) from the viewpoint of the selling company
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(assuming payment is probable); it arises from that company’s endeavours and achievement and is triggered by the contract between seller and buyer. From the perspective of a group entity the same transaction does not result in realised profit because it is a purely internal event. Even if the member companies are permitted the autonomy to negotiate freely in choosing suppliers and setting price and quality, the capacity for control means that such matters can be dictated by parent management. If that happens a profit or loss on intra-group transactions can be contrived at will, it does not represent effort or achievement; one cannot describe it as earned. Profit comes from transacting at arms
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Week09_Practice_Question_Solutions - Week 9 Practice...

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