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Hi tutor,
Statement from the question says, “The directors failed to recognise consideration which is contingent upon meeting certain targets. They have disclosed this contingent liability fully in notes to the financial statements.”
The answer says, ” the main effect would be to understate goodwill and liabilities.”
Could you kindly explain why is this suggestion given?
Thank you.
Goodwill is the excess of consideration (and NCI, of any) over the net assets acquired.
According to IFRS 3 – consideration includes any contingent consideration.
If the contingent consideration has only been disclosed, it has not been recognised. It should have been recognised as a liability, which would increase the excess (goodwill).I’m not sure if it’s the meaning of “understatement” or the concept of recognition that you do not understand – so I shall attempt to clarify both:
To understate something means “to represent it as smaller than it actually is”.
To recognise something, in the context of financial reporting, means to include it as one of the elements – i.e. asset/liability (in SoFP) and/or income/expense (in SoPL).Therefore, if $x is only disclosed as a contingent liability – the amount recognised as a liability in the SoFP is effectively $0. Since $0 < $x, liabilities are understated.
Any omission means that an account balance and/or class of transactions are incomplete – i.e. understated,
Hello,
The answer says, ” the main effect would be to understate goodwill and liabilities”.
Sir, I am asking if contingent liability isn’t recognised why would we understate liabilities?
I’m sorry – I don’t understand what you are asking.
Contingent consideration is where the purchaser agrees with the seller that if something happens in the future, the purchaser will pay some additional consideration – this could be cash or shares. It doesn’t matter what form the consideration will take – IFRS says it must be recognised in the initial recognition of goodwill. The double entry that should have been made is Dr Goodwill and Cr Liabilities (assuming future cash settlement).
Since the contingent element of the consideration has not been recorded, goodwill and liabilities (or equity) must be understated.
(That there is disclosure in the notes is irrelevant – disclosure is not recognition.)
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