Professional Documents
Culture Documents
Corporate Reporting
Corporate Reporting
CORPORATE REPORTING
Advanced Stage Technical Integration Level
Study Manual
www.icaew.com
Corporate Reporting
The Institute of Chartered Accountants in England and Wales
ISBN: 978-0-85760-907-6
Previous ISBN: 978-0-85760-477-4
First edition 2007
Seventh edition 2013
Polestar Wheatons
Hennock Road
Marsh Barton
Exeter
EX2 8RP
Michael Izza
Chief Executive
ICAEW
iii
iv
Contents
Introduction vii
Corporate Reporting viii
Key resources ix
Skills assessment guide x
Faculties and Special Interest Groups xvi
ICAEW publications for further reading xvi
Financial statements
1 Presentation of financial statements 1
Assets, liabilities and provisions
2 Reporting of assets 27
3 Events after the reporting period, provisions and contingencies 81
Financing
4 Leases, government grants and borrowing costs 103
5 Financial instruments – presentation and disclosure 135
6 Financial instruments – recognition and measurement 155
7 Financial instruments – hedge accounting 219
Remuneration
8 Employee benefits 259
9 Share-based payment 299
Business combinations
10 Groups – revision 351
Reporting overseas activities
11 Foreign currency translation and hyperinflationary economies 419
Taxation and industry specific standards
12 Income taxes 469
13 Industry specific Standards 511
Reporting performance
14 Earnings per share 545
15 Reporting performance 583
Financial analysis
16 Financial statement analysis 625
Index 685
v
vi
1 Introduction
1.1 What is Corporate Reporting and how does it fit within the ACA Advanced
Stage?
Structure
The ACA syllabus has been designed to develop core technical, commercial, and ethical skills and
knowledge in a structured and rigorous manner.
The diagram below shows the twelve modules at the ACA Professional Stage, where the focus is on the
acquisition and application of technical skills and knowledge, and the ACA Advanced Stage which
comprises two technical integration modules and the Case Study.
Introduction vii
2 Corporate Reporting
2.1 Module aim
The aim of the Business Reporting paper is:
To ensure that candidates can apply analysis techniques, technical knowledge and professional
skills to resolve real-life compliance issues faced by businesses.
Candidates may be put, for example, in the role of a preparer of financial statements, or other corporate
reports such as on sustainability and corporate responsibility, an advisor or in an assurance role facing
business issues where there are reporting implications. Compliance issues relating to taxation will also
feature in this module.
Candidates will be required to use professional judgement to identify and evaluate alternatives and
determine the appropriate solution(s) to compliance issues, giving due consideration to the commercial
impact of their recommendations.
The aim of the Business Change paper is:
To ensure that candidates can provide technical advice in respect of issues arising in business
transformations, mergers, acquisitions, alliances and disposals.
Candidates will be required to analyse and interpret both external and internal financial and non-
financial data in order to plan for change and provide advice. In undertaking this analysis students will
be expected to evaluate the impact of stakeholder influences on the data, including the impact of
choice of reporting policies.
Taxation and practical business techniques are particularly important in this module, where business
techniques include aspects of business strategy, business finance, performance management and
costing. There will also be assurance, ethical and legal implications to be considered when developing
and assessing strategic and business plans.
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TUITION
If you are receiving structured tuition, make sure you know how and when you can contact your tutors
for extra help.
If you aren't receiving structured tuition and are interested in classroom, online or distance learning
tuition, take a look at our tuition providers in your area on icaew.com/exams
ONLINE STUDENT COMMUNITY
The online student community allows you to ask questions, gain study and exam advice from fellow
ACA and CFAB students and access our free webinars. There are also regular Ask an Expert and Ask a
Tutor sessions to help you with key technical topics and exam papers. Access the community at
icaew.com/studentcommunity
THE LIBRARY & INFORMATION SERVICES (LIS)
The Library and Information Service (LIS) is ICAEW's world-leading accountancy and business library.
You have access to a range of resources free of charge via the library website, including the catalogue,
LibCat. icaew.com/library
Introduction ix
4 Skills assessment guide
4.1 Introduction
As a Chartered Accountant in the business world, you will require the knowledge and skills to interpret
financial and other numerical and business data, and communicate the underlying issues to your clients.
In a similar way to the required knowledge, the ACA syllabus has been designed to develop your
professional skills in a progressive manner. These skills are broadly categorised as:
Assimilating and using information
Structuring problems and solutions
Applying judgement
Drawing conclusions and making recommendations
BR
BC
Advance Stage
TAX FR technical integration
FA A&A
Professional Stage
application level
ETHICS Case Study
FM
Technical
Professional Stage BS
knowledge level
Skills
The work experience requirements for students provide a framework to develop appropriate work
experience, completion of which is essential in order to qualify for membership. Work experience is also
an essential component for examination preparation.
The work experience framework is built around five key skills:
Business awareness – being aware of the internal and external issues and pressure for change facing
an organisation and assessing an organisation's performance.
Technical and functional expertise – applying syllabus learning outcomes and where appropriate,
further technical knowledge to real situations.
Ethics and professionalism – recognising issues, using knowledge and experience to assess
implications, making confident decisions and recommendations.
Professional judgement – making recommendations and adding value with appropriate, targeted
and relevant solutions.
Personal effectiveness – developing, maintaining and exercising skills and personal attributes
necessary for the role and responsibilities.
x Corporate Reporting
The examinations, and in particular the Advanced Stage, embrace all of these skills.
The link between work experience and the examinations is demonstrated by the skills development
grids produced by the examiners.
This will help students see that their practical knowledge and skills gained in the workplace feed back
into the exam room and vice-versa.
Introduction xi
xii Corporate Reporting
4.4 Technical knowledge
The table contained in this section shows the technical knowledge covered in the ACA Syllabus by
module.
For each individual standard the level of knowledge required in the relevant Professional Stage module
and at the Advanced Stage is shown.
The knowledge levels are defined as follows:
Level D
An awareness of the scope of the standard.
Level C
A general knowledge with a basic understanding of the subject matter and training in its application
sufficient to identify significant issues and evaluate their potential implications or impact.
Level B
A working knowledge with a broad understanding of the subject matter and a level of experience in the
application thereof sufficient to apply the subject matter in straightforward circumstances.
Level A
A thorough knowledge with a solid understanding of the subject matter and experience in the
application thereof sufficient to exercise reasonable professional judgement in the application of the
subject matter in those circumstances generally encountered by Chartered Accountants.
Key to other symbols:
→ The knowledge level reached is assumed to be continued
Introduction xiii
Corporate Reporting
Professional Stage
Advanced Stage
Accounting
Accounting
Reporting
Financial
Financial
Title
Introduction xv
5 Faculties and Special Interest Groups
The faculties and special interest groups are specialist bodies within the ICAEW which offer members
networking opportunities, influence and recognition within clearly defined areas of technical expertise.
As well as providing accurate and timely technical analysis, they lead the way in many professional and
wider business issues through stimulating debate, shaping policy and encouraging good practice. Their
value is endorsed by over 40,000 members of ICAEW who currently belong to one or more of the seven
faculties:
Audit and Assurance
Corporate Finance
Finance and Management
Financial Reporting
Financial Services
Information Technology
Tax
The special interest groups provide practical support, information and representation for chartered
accountants working within a range of industry sectors, including:
Charity and Voluntary sector
Entertainment and Media
Farming and Rural Business
Forensic
Healthcare
Interim Management
Non-Executive Directors
Public Sector
Solicitors
Tourism and Hospitality
Valuation
Students can register free of charge for provisional membership of one special interest group and
receive a monthly complimentary e-newsletter from one faculty of your choice. To find out more and to
access a range of free resources, visit icaew.com/facultiesandsigs
Introduction xvii
Corporate Finance Faculty – icaew.com/corpfinfac
Private equity demystified – an explanatory guide Second Edition, Financing Change Initiative,
ICAEW, March 2010, John Gilligan and Mike Wright
This guide summarises the findings of academic work on private equity transactions from around
the world. Hard copies of the abstract and full report are free and are also available by download
from icaew.com/thoughtleadership
Best Practice Guidelines
The Corporate Finance Faculty publishes a series of guidelines on best-practice, regulatory trends
and technical issues. Authored by leading practitioners in corporate finance, they are succinct and
clear overviews of emerging issues in UK corporate finance. icaew.com/corpfinfac
Ethics – icaew.com/ethics
Code of Ethics
The Code of Ethics helps ICAEW members meet these obligations by providing them with ethical
guidance. The Code applies to all members, students, affiliates, employees of member firms and,
where applicable, member firms, in all of their professional and business activities, whether
remunerated or voluntary.
Instilling integrity in organisations ICAEW June 2009
Practical guidance aimed at directors and management to assist them in instilling integrity in their
organisations. This document may also be helpful to audit firms discussing this topic with clients
and individuals seeking to address issues in this area with their employers.
Reporting with Integrity ICAEW May 2007, ISBN 978-1-84152-455-9
This publication brings ideas from a variety of disciplines, in order to obtain a more comprehensive
understanding of what is meant by integrity, both as a concept and in practice. Moreover, because
this report sees reporting with integrity as a joint endeavour of individuals, organisations and
professions, including the accounting profession, the concept of integrity is considered in all these
contexts.
Introduction xix
Finance and Management Faculty – icaew.com/fmfac
Finance's role in the organisation November 2009, ISBN 978-1-84152-855-7
This considers the challenges of designing successful organisations, written by Rick Payne, who
leads the faculty's finance direction programme.
Investment appraisal SR27: December 2009, ISBN 978-1-84152-854-4
This special report looks at the key issues and advises managers on how they can contribute
effectively to decision making and control during the process of investment appraisal.
Starting a business SR28: March 2010, ISBN 978-1-84152-984-2
This report provides accountants with a realistic and motivational overview of what to consider
when starting a business.
Developing a vision for your business SR30: September 2010, ISBN 978-0-85760-054-7
This special report looks at what makes a good vision, the benefits of having one, the role of the FD
in the process, leadership, storytelling and the use of visions in medium-sized businesses.
Finance transformation – the outsourcing perspective SR31: December 2010, ISBN 978-0-
85760-079-0
The authors of this outsourcing special report share their expertise on topics including service level
agreements, people management, and innovation and technology.
The Finance Function: A Framework for Analysis September 2011, ISBN 978-0-85760-285-5
This report is a source of reference for those analyzing or researching the role of the finance
function and provides a foundation for considering the key challenges involved, written by Rick
Payne, who leads the faculty's finance direction programme.
xx Corporate Reporting
Information Technology Faculty – icaew.com/itfac
The IT Faculty provides ongoing advice and guidance that will help students in their studies and their
work. The online community (ion.icaew.com/itcountshome) provides regular free updates as well as a
link to the faculty's Twitter feed which provides helpful updates and links to relevant articles. The
following publications should also be of interest to students:
Make the move to cloud computing ICAEW, 2012, ISBN 978-0-85760-617-4
Cloud computing in its purest form is pay-as-you-go IT, online and on demand. The IT capabilities
provided as a service to businesses include: single software applications or software suites; online
software development platforms; and virtual computing infrastructure, ranging from data storage to
computer grids.
Bringing employee personal devices into the business - a guide to IT consumerisation ICAEW,
2012, ISBN 978-0-85760-443-9
The gap between business and consumer technology has been growing over the last few years,
with the consumer market now leading in terms of ease of use and portability.
Making the most of social media - a practical guide for your business ICAEW, 2011, ISBN 978-0-
85760-286-2
This guide will enable the business manager to develop a philosophy that allies social media's
potential with the business's objectives and capabilities, to set objectives and protect against pitfalls,
and then to take the first practical steps in a mass communications medium very different from any
that British business has encountered before.
Introduction xxi
xxii Corporate Reporting
CHAPTER 1
Presentation of financial
statements
Introduction
Topic List
1 IAS 1 Presentation of Financial Statements
2 IAS 34 Interim Financial Reporting
3 Future of UK GAAP
Summary and Self-test
Technical reference
Answers to Self-test
Answer to Interactive question
1
Introduction
2 Corporate Reporting
1 IAS 1 Presentation of Financial Statements C
H
A
Section overview P
T
IAS 1 Presentation of Financial Statements sets down the format of financial statements, containing E
requirements as to their presentation, structure and content. R
IAS 1 was amended in 2011, changing the presentation of items contained in other comprehensive
income (OCI) and their classification within OCI. 1
IAS 1
Presentation of comparatives
IAS 1 requires disclosure of comparative information in respect of the previous period. It also requires
inclusion of a statement of financial position as at the beginning of the earliest comparative period when
an entity:
Retrospectively applies an accounting policy
Retrospectively restates items in the financial statements, or
Reclassifies items in the financial statements.
In effect this will result in the presentation of three statements of financial position when there is a prior
period adjustment.
4 Corporate Reporting
1.3.1 2011 Revision of IAS 1
C
In June 2011, the IASB published an amendment to IAS 1 called Presentation of items of other H
comprehensive income, changing the presentation of items contained in Other Comprehensive Income A
(OCI) and their classification within OCI. P
T
Background E
R
The blurring of distinctions between different items in OCI is the result of an underlying general lack
of agreement among users and preparers about which items should be presented in OCI and which
should be part of the profit or loss section. For instance, a common misunderstanding is that the split 1
between profit or loss and OCI is on the basis of realised versus unrealised gains. This is not, and has
never been, the case.
This lack of a consistent basis for determining how items should be presented has led to the somewhat
inconsistent use of OCI in financial statements.
Change
Entities are required to group items presented in other comprehensive income (OCI) on the basis of
whether they would be reclassified to (recycled through) profit or loss at a later date, when specified
conditions are met.
The amendment does not address which items are presented in other comprehensive income or which
items need to be reclassified.
Income tax
IAS 1 requires an entity to disclose income tax relating to each component of other comprehensive
income. This is because these items often have tax rates different from those applied to profit or loss.
This may be achieved by either
Presenting individual components of other comprehensive income net of the related tax, or
Presenting individual components of other comprehensive income before tax, with one amount
shown for the aggregate amount of income tax relating to those components.
Presentation
IAS 1 allows comprehensive income to be presented in two ways:
1 A single statement of profit or loss and other comprehensive income, or
2 A statement displaying components of profit or loss plus a second statement beginning with profit
or loss and displaying components of other comprehensive income (statement of profit or loss and
other comprehensive income).
The recommended format of a single statement of profit or loss and other comprehensive income is as
follows:
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 DECEMBER 20X7
20X7 20X6
$m $m
Revenue X X
Cost of sales (X) (X)
Gross profit X X
Other income X X
Distribution costs (X) (X)
Administrative expenses (X) (X)
Other expenses (X) (X)
Finance costs (X) (X)
Share of profit of associates X X
Profit before tax X X
Income tax expense (X) (X)
Profit for the year from continuing operations X X
Loss for the year from discontinued operations (X)
Alternatively, components of OCI could be presented in the statement of profit or loss and other
comprehensive income net of tax.
Tutorial note:
Throughout this text, income and expense items which are included in the 'top half' of the statement of
profit or loss and other comprehensive income are referred to as recognised in profit or loss, or
recognised in the income statement.
Income and expense items included in the 'bottom half' of the statement of profit or loss and other
comprehensive income are referred to as recognised in other comprehensive income.
For exam purposes, you must ensure that you clarify where in the statement of profit or loss and other
comprehensive income an item is recorded, by referring to recognition:
In profit or loss, or
In other comprehensive income
6 Corporate Reporting
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20X7
C
Available
H
Translation -for-sale Non-
A
Share Retained of foreign financial Cash flow Revaluation controlling Total
capital earnings operations assets hedges surplus Total interest equity P
Balance at £'000 £'000 £'000 £'000 £'000 £'000 £'000 £'000 £'000 T
1 Jan 20X7 X X (X) X X – X X X E
Changes in R
accounting
policy – X – – – – X – X
Restated 1
balance X X (X) X X – X X X
Changes
in equity
during 20X7
Issue of share
capital X – – – – – X – X
Dividends – (X) – – – – (X) (X) (X)
Total
comprehensive
income for the
year – X X X X X X X X
Transfer to
retained
earnings – X – – – (X) – – –
Balance at
31 Dec 20X7 X X X X X X X X X
Definitions
Interim period: A financial reporting period shorter than a full financial year.
Interim financial report: A financial report containing either a complete set of financial statements (as
described in IAS 1) or a set of condensed financial statements (as described in this Standard) for an
interim period.
8 Corporate Reporting
2.3.1 Selected explanatory notes
C
IAS 34 states that relatively minor changes from the most recent annual financial statements need not H
be included in an interim report. However, the notes to an interim report should include the following A
(unless the information is contained elsewhere in the report). P
T
A statement that the same accounting policies and methods of computation have been used for E
the interim statements as were used for the most recent annual financial statements. If not, the R
nature of the differences and their effect should be described. (The accounting policies for
preparing the interim report should only differ from those used for the previous annual accounts in
a situation where there has been a change in accounting policy since the end of the previous 1
financial year, and the new policy will be applied for the annual accounts of the current financial
period.)
Explanatory comments on the seasonality or 'cyclicality' of operations in the interim period. For
example, if a company earns most of its annual profits in the first half of the year, because sales are
much higher in the first six months, the interim report for the first half of the year should explain
this fact.
The nature and amount of items during the interim period affecting assets, liabilities, capital, net
income or cash flows, that are unusual, due to their nature, incidence or size.
The issue or repurchase of equity or debt securities.
Nature and amount of any changes in estimates of amounts reported in an earlier interim report
during the financial year, or in prior financial years if these affect the current interim period.
Dividends paid on ordinary shares and the dividends paid on other shares.
Segmental results for entities that are required by IFRS 8 Operating Segments to disclose segment
information in their annual financial statements.
Any significant events since the end of the interim period.
Effect of changes in the composition of the entity during the interim period including the
acquisition or disposal of subsidiaries and long-term investments, restructurings and discontinued
operations.
Any significant change in a contingent liability or a contingent asset since the date of the last
annual statement of financial position.
The standard requires the entity to provide explanatory comments about seasonality or cyclicality
relating to the interim financial statements.
Changes in the business environment such as changes in price, costs, demand, market share and
prospects for the full year should be discussed in the management discussion and analysis of the
financial review.
The entity should also disclose the fact that the interim report has been produced in compliance with
IAS 34 on interim financial reporting.
Solution
The following are examples:
Write-down of inventories to net realisable value and the reversal of such a write-down
Recognition of a loss from the impairment of property, plant and equipment, intangible assets, or
other assets, and the reversal of such an impairment loss
Reversal of any provisions for the costs of restructuring
Acquisitions and disposals of items of property, plant and equipment
2.5 Materiality
Materiality should be assessed in relation to the interim period financial data. It should be recognised
that interim measurements rely to a greater extent on estimates than annual financial data.
10 Corporate Reporting
inappropriate to anticipate part of the cost of a major advertising campaign later in the year, for which
no expenses have yet been incurred. C
H
The standard goes on, in an appendix, to deal with specific applications of the recognition and A
measurement principle. Some of these examples are explained below, by way of explanation and P
illustration. T
E
R
Payroll taxes or insurance contributions paid by employers
In some countries these are assessed on an annual basis, but paid at an uneven rate during the course of
1
the year, with a large proportion of the taxes being paid in the early part of the year, and a much
smaller proportion paid later on in the year. In this situation, it would be appropriate to use an
estimated average annual tax rate for the year in an interim statement, not the actual tax paid. This
treatment is appropriate because it reflects the fact that the taxes are assessed on an annual basis, even
though the payment pattern is uneven.
Year-end bonus
A year-end bonus should not be provided for in an interim financial statement unless there is a
constructive obligation to pay a year-end bonus (eg a contractual obligation, or a regular past practice)
and the size of the bonus can be reliably measured.
Solution
It is probable that the bonus will be paid, given that the actual output already achieved in the year is in
line with budgeted figures, which exceed the required level of output. So a bonus of £4.5 million should
be recognised in the interim financial statements at 30 June 20X4.
Holiday pay
The same principle applies here. If holiday pay is an enforceable obligation on the employer, then any
unpaid accumulated holiday pay may be accrued in the interim financial report.
Depreciation
Depreciation should only be charged in an interim statement on non-current assets that have been
acquired, not on non-current assets that will be acquired later in the financial year.
Tax on income
An entity will include an expense for income tax (tax on profits) in its interim statements. The tax rate
to use should be the estimated average annual tax rate for the year. For example, suppose that in a
particular jurisdiction, the rate of tax on company profits is 30% on the first £200,000 of profit and 40%
on profits above £200,000. Now suppose that a company makes a profit of £200,000 in its first half
year, and expects to make £200,000 in the second half year. The rate of tax to be applied in the interim
financial report should be 35%, not 30%, ie the expected average rate of tax for the year as a whole.
This approach is appropriate because income tax on company profits is charged on an annual basis, and
an effective annual rate should therefore be applied to each interim period.
As another illustration, suppose a company earns pre-tax income in the first quarter of the year of £30,000,
but expects to make a loss of £10,000 in each of the next three quarters, so that net income before tax for
the year is zero. Suppose also that the rate of tax is 30%. In this case, it would be inappropriate to anticipate
the losses, and the tax charge should be £9,000 for the first quarter of the year (30% of £30,000) and a
negative tax charge of £3,000 for each of the next three quarters, if actual losses are the same as anticipated.
Where the tax year for a company does not coincide with its financial year, a separate estimated
weighted average tax rate should be applied for each tax year, to the interim periods that fall within
that tax year.
Some countries give entities tax credits against the tax payable, based on amounts of capital
expenditure or research and development, etc. Under most tax regimes, these credits are calculated and
granted on an annual basis; therefore it is appropriate to include anticipated tax credits within the
calculation of the estimated average tax rate for the year, and apply this rate to calculate the tax on
income for the interim period.
12 Corporate Reporting
Solution
C
The taxation charge in the interim financial statements is based upon the weighted average rate for the H
year. In this case the entity's tax rate for the year is expected to be 30%. The taxation charge in the A
interim financial statements will be £1.8 million. P
T
E
R
Inventory valuations
Within interim reports, inventories should be valued in the same way as for year-end accounts. It is
recognised, however, that it will be necessary to rely more heavily on estimates for interim reporting
than for year-end reporting.
In addition, it will normally be the case that the net realisable value of inventories should be estimated
from selling prices and related costs to complete and dispose at interim dates.
Solution
The value of the inventories in the interim financial statements at 30 June 20X4 is the lower of cost and
NRV at 30 June 20X4. This is:
100,000 £1.20 = £120,000
There is no requirement under IFRS The Financial Services Authority (FSA) has published the rules
to publish an interim financial report. which implement the EU Transparency Directive in the UK.
However, entities that do so These rules apply to listed companies with financial reporting
voluntarily or are required to do so by periods starting on or after 20 January 2007.
local regulators must apply IAS 34.
Listed companies are required to publish a half yearly report
(ie interim financial statements) within two months of the
end of the first six months of the financial year. The half
yearly report must include a condensed set of financial
statements prepared in accordance with IFRS, an interim
management report and a responsibility statement made by
persons responsible to the company for the report.
14 Corporate Reporting
IFRS UK GAAP
C
Unless a company publishes quarterly financial reports, it will H
A
be required to publish an Interim Management Statement
P
(IMS) during each six month period of any financial year. The T
IMS must be published in the period between ten weeks E
after the beginning, and six weeks before the end of, the R
relevant six month period.
The IMS must explain material events and transactions that
1
have taken place during the relevant period and their impact
on the company's financial position and describe the
financial position and performance of the company during
that time. According to the FSA, companies may be able to
meet IMS requirements based on the content of their usual
performance reports, trading statements or other similar
reporting formats.
The FSA rules are supplemented by the ASB's Statement of
Best Practice.
The requirements of IAS 34 are
broadly in line with the UK
requirements with some minor
differences such as:
IAS 34 requires detailed The ASB's interim statement requires only narrative
disclosures in accordance with commentary.
the requirements of IFRS 3
Business Combinations relating to
business combinations in the
period.
Comparatives for the statement The FSA Rules require statement of financial position
of financial position are required comparatives for the corresponding interim date of the
for the previous financial year. previous year.
3 Future of UK GAAP
Section overview
The regulatory shift away from current UK GAAP will require all entities (except those small
enough to use the FRSSE) to report in accordance with FRSUKI with an option to use IFRS.
If adopted, the ASB's proposals will mean the end of current UK GAAP.
3.1 Background
The UK and Ireland Accounting Standards Board (ASB) has been a close partner of the International
Accounting Standards Board for many years and has had enormous input into the development of
IFRSs.
Examples of standards which were developed jointly with the International Accounting Standards Board
in the past are FRS 11 Impairment of assets and FRS 12 Provisions, contingent liabilities and contingent
assets, the former being very similar to the IFRS equivalent (IAS 36) admittedly with a difference of
opinion over the allocation of impairment losses, and the latter being almost identical to IFRSs (IAS 37)
other than terminology differences.
3.4 Implications
The implications of the above are:
(a) All entities currently reporting under UK GAAP will be required to report under FRSUKI but may
voluntarily adopt IFRS. The three tier system previously proposed is eliminated, so that the
application of EU-adopted IFRS will not be extended beyond that required by regulation.
(b) Accounting treatments permitted under current accounting standards are introduced. Previously
the ASB had proposed keeping changes to the IFRS for SMEs to a minimum. It now proposes that
where an accounting treatment is permitted currently in UK and Irish accounting standards and in
international accounting standards it should be retained. This means that the options to revalue
land and buildings, capitalise borrowing costs or carry forward certain development expenses have
been incorporated into the FRSUKI.
(c) The requirements are aligned more closely to company law, with the majority of the presentation
requirements for the balance sheet and income statement being replaced by the formats in
company law rather than in the IFRS for SMEs.
16 Corporate Reporting
(d) There are amendments to accounting for deferred taxation, updates to consolidation requirements
and accounting for pension plans, and the introduction of an option to recognise grant income C
over the life of a grant. H
A
(e) Qualifying entities will be able to take advantage of reduced disclosure requirements that include P
exemption from disclosure of a cash flow statement, certain financial instruments, related party and T
E
share based payments disclosures. The reliefs available are different between IFRS and FRSUKI.
R
(f) Small entities currently eligible to apply FRSSE will continue to be able to do so. Should a new
framework for micro entities be introduced as a result of EU consultation processes, the ASB would
then review the status of the FRSSE and consult again on how to amend the FRSSE to 1
accommodate any change.
(g) Guidance for public benefit entities is to be incorporated into the FRSUKI (FRED 48).
3.5 Timescale
These proposals would apply to accounting periods beginning on or after 1 January 2015, with earlier
adoption encouraged.
Summary
Presentation of
Financial Statements
IAS 1
Statement of
cash flows
Statement of
changes in equity Transactions with owners
18 Corporate Reporting
Interim Financial Reporting C
IAS 34 H
A
P
T
E
Minimum Minimum R
requirements disclosure
1
Condensed Where relevant Impact of any
statement of how performance is changes in
financial position affected by seasonality accounting policies
Future of UK GAAP
Entities undder
All other entities
EU1606/2002
UK company law will require either AIS accounts or Companies Act accounts
20 Corporate Reporting
Requirement
C
Should any changes in inventory values be reflected in the interim financial statements of H
Aconcagua for the six months ending 30 June 20X7 and for the six months ending 31 December A
20X7, according to IAS 34 Interim Financial Reporting? P
T
E
R
Periods for which interim financial statements are required to be presented IAS 34.20
22 Corporate Reporting
Costs incurred unevenly during the financial year
C
Costs that are incurred unevenly during an entity's financial year shall be IAS 34.39 H
anticipated or deferred for interim reporting purposes if, and only if, it is also A
P
appropriate to anticipate or defer that type of cost at the end of the financial T
year. E
R
Applying the recognition and measurement principles IAS 34.40
24 Corporate Reporting
Answer to Interactive question C
H
A
P
T
E
Answer to Interactive question 1 R
Reporting of assets
Introduction
Topic List
1 Review of material from earlier studies
2 IFRS 13 Fair Value Measurement
3 IAS 18 Revenue
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
27
Introduction
Apply and discuss the principles of valuing inventory, goods for resale, work-in-progress,
raw materials, inventory held by a service provider and construction contracts
Apply and discuss the timing of the recognition of non-current assets and the
determination of their carrying amounts, including impairment and revaluations
Apply and discuss the accounting treatment of intangible assets including the criteria for
recognition and measurement subsequent to acquisition and classification
28 Corporate Reporting
1 Review of material from earlier studies
Section overview
You should already be familiar with the Standards relating to current and non-current assets from
earlier studies. If not, go back to your earlier study material.
– IAS 2 Inventories
– IAS 11 Construction Contracts
– IAS 16 Property, Plant and Equipment
– IAS 38 Intangible Assets
– IAS 36 Impairment of Assets
C
H
Read the summary of knowledge brought forward and try the relevant questions. If you have any
A
difficulty, go back to your earlier study material and revise it. P
T
Assets have been defined in many different ways and for many purposes. The definition of an asset is E
important because it directly affects the treatment of such items. A good definition will prevent abuse R
or error in the accounting treatment: otherwise some assets might be treated as expenses, and some
expenses might be treated as assets.
2
In the current accounting climate, where complex transactions are carried out daily a definition that
covers ownership and value is not sufficient, leaving key questions unanswered.
What determines ownership?
What determines value?
The definition of an asset in the IASB's Framework from earlier studies is given below.
Definition
Asset: 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. (Framework)
This definition ties in closely with the definitions produced by other Standard-setters, particularly the
FASB (USA) and the ASB (UK).
A general consensus seems to exist in the standard setting bodies as to the definition of an asset which
encompasses three important characteristics.
Future economic benefit
Control
The transaction to acquire control has already taken place
Reporting of assets 29
Accounting treatment
As with all assets, recognition depends on two criteria.
– It is probable that future economic benefits associated with the item will flow to the entity
– The cost of the item can be measured reliably
These recognition criteria apply to subsequent expenditure as well as costs incurred initially (ie,
there are no longer separate criteria for recognising subsequent expenditure).
Once recognised as an asset, items should initially be measured at cost.
Purchase price, less trade discount/rebate plus
– Directly attributable costs of bringing the asset to working condition for intended use
– Initial estimate of the cost of dismantling and removing the item and restoring the site
on which it is located
IAS 16 also:
Provides additional guidance on directly attributable costs including the cost of an item of
property, plant and equipment.
States that income and related expenses of operations that are incidental to the construction or
development of an item of property, plant and equipment should be recognised in profit or loss for
the period.
Specifies that exchanges of items of property, plant and equipment, regardless of whether the
assets are similar, are measured at fair value, unless the exchange transaction lacks commercial
substance or the fair value of neither of the assets exchanged can be measured reliably. If the
acquired item is not measured at fair value, its cost is measured at the carrying amount of the asset
given up.
Measurement subsequent to initial recognition
– Cost model: carrying asset at cost less depreciation and any accumulated impairment losses
– Revaluation model: carrying asset at revalued amount, ie fair value less subsequent
accumulated depreciation and any accumulated impairment losses. (IAS 16 makes clear that
the revaluation model is available only if the fair value of the item can be measured reliably.)
30 Corporate Reporting
Asset is
revalued
upwards downwards
Reporting of assets 31
1.2 Inventories
Valuation
Lower of:
Cost
Net realisable value
Each item/group/category considered separately
Allowable costs
Allowable costs
include:
Cost of purchase
exclude:
Cost of storage
Cost of selling
Determining cost
FIFO
Weighted average cost
Net realisable value
Estimated cost of completion
Estimated costs necessary to make the sale (eg marketing, selling and distribution)
The entity has a policy which allocates indirect costs which are not specifically identifiable to an
individual product by reference to relative selling prices. This results in 60% being allocated to Product 1
and 40% to Product 2.
During the month, costs were incurred in line with the budget, but due to a failure of calibration to a
vital part of the process, only 675 units of Product 2 could be taken into inventory. The remainder
produced had to be scrapped, for zero proceeds.
Requirement
Calculate the cost attributable to Products 1 and 2.
See Answer at the end of this chapter.
32 Corporate Reporting
Interactive question 3: Reclassification of asset [Difficulty level: Intermediate]
An entity manufactures a particular type of machine tool, each of which costs £36,000 to produce and
has a net realisable value of £45,000.
The entity takes one of the tools out of inventories to use for demonstration purposes over the next
three years. This item will be reclassified as a non-current asset and recognised in accordance with IAS
16 Property, Plant and Equipment.
Requirement
Assuming the tool has a nil residual value at the end of the three years, find its carrying amount to be
recognised as part of non-current assets one year later.
See Answer at the end of this chapter.
C
H
A
P
1.3 Construction contracts T
E
Contract revenue should be recognised according to the stage of completion of the contract. R
Contract costs are those directly related to the specific contract plus an allocation of costs incurred
in contract activity in general.
2
The 20X6 contract costs incurred to date include £100 which relates to additional work required for
unforeseen extras. In 20X6 the contractor negotiated with the customer to recover the cost of this
additional work, but it was not until 20X7 that it became probable that the customer would accept this
contract variation.
Requirement
How much profit should be recognised in each of the three years?
See Answer at the end of this chapter.
Reporting of assets 33
1.4 IAS 38 Intangible Assets
An intangible asset is an identifiable non-monetary asset without physical substance, such as a
licence, patent or trademark.
An intangible asset is identifiable if it is separable (ie it can be sold, transferred, exchanged,
licensed or rented to another party on its own rather than as part of a business) or it arises from
contractual or other legal rights.
An intangible asset should be recognised if it is probable that future economic benefits
attributable to the asset will flow to the entity and the cost of the asset can be measured
reliably.
At recognition the intangible should be recognised at cost (purchase price plus directly attributable
costs). After initial recognition an entity can choose between the cost model and the revaluation
model. The revaluation model can only be adopted if an active market (as defined) exists for that
type of asset.
An intangible asset (other than goodwill recognised in the acquiree's financial statements)
acquired as part of a business combination should initially be recognised at fair value.
Internally generated goodwill should not be recognised.
Expenditure incurred in the research phase of an internally generated intangible asset should be
expensed as incurred.
Expenditure incurred in the development phase of an internally generated intangible asset must
be capitalised provided certain tightly defined criteria are met.
– Expenditure incurred prior to the criteria being met may not be capitalised retrospectively
An intangible asset with a finite useful life should be amortised over its expected useful life,
commencing when the asset is available for use in the manner intended by management.
Residual values should be assumed to be nil, except in the rare circumstances when an active
market exists or there is a commitment by a third party to purchase the asset at the end of its
useful life.
An intangible asset with an indefinite life should not be amortised, but should be reviewed for
impairment on an annual basis.
– There must also be an annual review of whether the indefinite life assessment is still
appropriate
On disposal of an intangible asset the gain or loss is recognised in profit or loss.
34 Corporate Reporting
Biological assets held at fair value less estimated point-of-sale costs
Non-current assets held for sale
IAS 36 most commonly applies to:
Property, plant and equipment accounted for in accordance with IAS 16 Property, Plant and
Equipment
Intangible assets accounted for in accordance with IAS 38 Intangible Assets
Some financial assets, namely subsidiaries, associates and joint ventures. Impairments of all other
financial assets are accounted for in accordance with IAS 39 Financial Instruments: Recognition and
Measurement
Issue
C
Assets should be carried at no more than their recoverable amount. H
A
Recoverable Amount P
= Higher of T
E
R
2
Fair value less costs Value in use
to sell
Reporting of assets 35
Interactive question 7: Impairment loss [Difficulty level: Exam standard]
An entity has a single manufacturing plant which has a carrying value of £749,000. A new government
elected in the country passes legislation significantly restricting exports of the product produced by the
plant. As a result, and for the foreseeable future, the entity's production will be cut by 40%. Cash flow
forecasts have been prepared derived from the most recent financial budgets/forecasts for the next five
years approved by management (excluding the effects of general price inflation).
Year 1 234 5
£'000 £'000 £'000 £'000 £'000
Future cash flows 230 211 157 104 233
(including
disposal
proceeds)
If the plant was sold now it would realise £550,000, net of selling costs.
The entity estimates the pre-tax discount rate specific to the plant to be 15%, after taking into account
the effects of general price inflation.
Requirement
Calculate the recoverable amount of the plant and any impairment loss.
Note: PV factors at 15% are as follows.
Year @
PV factor 15%
1 0.86957
2 0.75614
3 0.65752
4 0.57175
5 0.49718
See Answer at the end of this chapter.
Impairment indicators
The entity should look for evidence of impairment at the end of each period and conduct an
impairment review on any asset where there is evidence of impairment. The following are indicators
of impairment.
External
Significant decline in market value of the asset below that expected due to normal passage of time
or normal use
Significant changes with an adverse effect on the entity in the
– Technological or market environment
– Economic or legal environment
Increased market interest rates or other market rates of return affecting discount rates and thus
reducing value in use
Carrying amount of net assets of the entity exceeds market capitalisation
Internal
Evidence of obsolescence or physical damage
Significant changes with an adverse effect on the entity*:
– The asset becomes idle
– Plans to discontinue/restructure the operation to which the asset belongs
– Plans to dispose of an asset before the previously expected date
– Reassessing an asset's useful life as finite rather than indefinite
Internal evidence available that asset performance will be worse than expected.
36 Corporate Reporting
* Once the asset meets the criteria to be classified as 'held for sale', it is excluded from the scope of IAS
36 and accounted for under IFRS 5 Non-current Assets Held for Sale and Discontinued Operations.
Annual impairment tests, irrespective of whether there are indications of impairment, are required for:
Intangible assets with an indefinite useful life/not yet available for use
Goodwill acquired in a business combination
Cash-generating units (CGUs)
Where it is not possible to estimate the recoverable amount of an individual asset, the entity estimates
the recoverable amount of the cash-generating unit to which it belongs.
Definition
C
Cash-generating unit: A cash-generating unit is the smallest identifiable group of assets that generates H
cash inflows that are largely independent of the cash inflows from other assets or groups of assets. A
P
T
E
If an active market exists for the output produced by an asset or a group of assets, this group of assets R
should be identified as a CGU even if some or all of the output is used internally. If the cash inflows are
affected by internal transfer pricing, management's best estimates of future prices that could be
achieved in an orderly transaction between market participants at the measurement date are used in 2
estimating the CGU's value in use.
Corporate assets
Corporate assets are treated in a similar way to goodwill.
The CGU includes corporate assets (or a portion of them) that can be allocated to it on a
'reasonable and consistent basis'. Where not possible, the assets (or unallocated portion) are tested
for impairment as part of the group of CGUs to which they can be allocated on a reasonable and
consistent basis.
Recognition of impairment losses in financial statements
Assets carried at historical cost – in profit or loss
Revalued assets
The impairment loss should be treated under the appropriate rules of the applicable IFRS.
For example, property, plant and equipment first against any revaluation surplus relating to the
asset and then in profit or loss in accordance with IAS 16.
Reporting of assets 37
Allocation of impairment losses in a CGU
General rule
The impairment should be allocated in the following order:
Goodwill allocated to the CGU
Other assets on a pro-rata basis based on carrying value
The carrying amount of an asset should not be reduced below the higher of its recoverable amount (if
determinable) and zero.
The amount of the impairment loss that would otherwise have been allocated to the asset should be
allocated to the other assets on a pro-rata basis.
Allocation of loss with unallocated corporate assets or goodwill
Where not all assets or goodwill have been allocated to an individual CGU then different levels of
impairment tests are performed to ensure the unallocated assets are tested.
Test of individual CGUs
Test the individual CGUs (including allocated goodwill and any portion of the carrying amount of
corporate assets that can be allocated on a reasonable and consistent basis).
Test of group of CGUs
Test the smallest group of CGUs that includes the CGU under review and to which the goodwill
can be allocated/a portion of the carrying amount of corporate assets can be allocated on a
reasonable and consistent basis.
After the impairment review
The depreciation/amortisation should be adjusted in future periods to allocate the asset's revised
carrying amount less its residual value on a systematic basis over its remaining useful life.
Treatment of the non-controlling interest element of goodwill
The revision to IFRS 3 allows two methods of initially valuing the non-controlling (minority) interest in
an entity:
As a share of the net assets of the entity at the acquisition date, or
At fair value.
The non-controlling interest is then taken into account in the goodwill calculation per the revised
standard:
Purchase consideration X
Non-controlling interest X
X
Total fair value of net assets of acquiree (X)
Goodwill X
38 Corporate Reporting
The consequent impairment loss calculated is only recognised to the extent of the parent's share.
Where the fair value method is used to value the non-controlling interest, no adjustment is required.
2
Reversal of past impairments
A reversal for a CGU is allocated to the assets of the CGU, except for goodwill, pro rata with the carrying
amounts of those assets.
However, the carrying amount of an asset is not increased above the lower of:
Its recoverable amount (if determinable); and
Its depreciated carrying amount had no impairment loss originally been recognised.
Any amounts left unallocated are allocated to the other assets (except goodwill) pro-rata.
The reversal is recognised in profit or loss, except where reversing a loss recognised on assets carried at
revalued amounts, which are treated in accordance with the applicable IFRS.
For example, an impairment loss reversal on property, plant and equipment first reverses the loss
recorded in profit or loss and any remainder is credited to the revaluation surplus (IAS 16).
Goodwill
Once recognised, impairment losses on goodwill are not reversed.
Impairment and IFRS 5
IFRS 5 is covered in detail in Chapter 15. Regarding impairment, note the following:
Immediately before initial classification as held for sale, the asset (or disposal group) is measured in
accordance with the applicable IFRS (eg property, plant and equipment held under the IAS 16
revaluation model is revalued).
On classification of the non-current asset (or disposal group) as held for sale, it is written down to
fair value less costs to sell (if less than carrying amount).
Any impairment loss arising under IFRS 5 is charged to profit or loss (and the credit allocated to
assets of a disposal group using the IAS 36 rules, ie first to goodwill then to other assets pro-rata
based on carrying value).
Non-current assets/disposal groups classified as held for sale are not depreciated/amortised.
Subsequent changes in fair value less costs to sell: any subsequent changes in fair value less costs to
sell are recognised as a further impairment loss (or reversal of an impairment loss).
However, gains recognised cannot exceed cumulative impairment losses to date (whether under
IAS 36 or IFRS 5).
Reporting of assets 39
2 IFRS 13 Fair Value Measurement
Section overview
IFRS 13 Fair Value Measurement gives extensive guidance on how the fair value of assets and
liabilities should be established.
IFRS 13 sets out to:
(a) Define fair value
(b) Set out in a single IFRS a framework for measuring fair value
(c) Require disclosures about fair value measurements
IFRS 13 defines fair value as 'the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the measurement
date'.
Fair value is a market-based measurement, not an entity-specific measurement. It focuses on assets
and liabilities and on exit (selling) prices. It also takes into account market conditions at the
measurement date.
IFRS 13 states that valuation techniques must be those which are appropriate and for which
sufficient data are available. Entities should maximise the use of relevant observable inputs and
minimise the use of unobservable inputs.
2.1 Background
In May 2011 the IASB published IFRS 13 Fair Value Measurement. The project arose as a result of the
Memorandum of Understanding between the IASB and FASB (2006) reaffirming their commitment to
the convergence of IFRSs and US GAAP. With the publication of IFRS 13, IFRS and US GAAP now have
the same definition of fair value and the measurement and disclosure requirements are now aligned.
2.2 Objective
IFRS 13 sets out to:
(a) Define fair value
(b) Set out in a single IFRS a framework for measuring fair value
(c) Require disclosures about fair value measurements
Definition
Fair value: 'the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date'.
The previous definition used in IFRS was 'the amount for which an asset could be exchanged, or a
liability settled, between knowledgeable, willing parties in an arm's length transaction'.
The price which would be received to sell the asset or paid to transfer (not settle) the liability is
described as the 'exit price' and this is the definition used in US GAAP. Although the concept of the
'arm's length transaction' has now gone, the market-based current exit price retains the notion of an
exchange between unrelated, knowledgeable and willing parties.
2.3 Scope
IFRS 13 applies when another IFRS requires or permits fair value measurements or disclosures. The
measurement and disclosure requirements do not apply in the case of:
(a) Share-based payment transactions within the scope of IFRS 2 Share-based Payment
(b) Leasing transactions within the scope of IAS 17 Leases; and
(c) Net realisable value as in IAS 2 Inventories or value in use as in IAS 36 Impairment of Assets.
40 Corporate Reporting
Disclosures are not required for:
(a) Plan assets measured at fair value in accordance with IAS 19 Employee Benefits
(b) Plan investments measured at fair value in accordance with IAS 26 Accounting and Reporting by
Retirement Benefit Plans; and
(c) Assets for which the recoverable amount is fair value less disposal costs under IAS 36 Impairment
of Assets.
2.4 Measurement
Fair value is a market-based measurement, not an entity-specific measurement. It focuses on assets and
liabilities and on exit (selling) prices. It also takes into account market conditions at the measurement
date. In other words, it looks at the amount for which the holder of an asset could sell it and the C
amount which the holder of a liability would have to pay to transfer it. It can also be used to value an H
A
entity's own equity instruments.
P
Because it is a market-based measurement, fair value is measured using the assumptions that market T
E
participants would use when pricing the asset, taking into account any relevant characteristics of the
R
asset.
It is assumed that the transaction to sell the asset or transfer the liability takes place either:
2
(a) In the principal market for the asset or liability; or
(b) In the absence of a principal at market, in the most advantageous market for the asset or liability.
The principal market is the market which is the most liquid (has the greatest volume and level of
activity) for that asset or liability. In most cases the principal market and the most advantageous market
will be the same.
IFRS 13 acknowledges that when market activity declines an entity must use a valuation technique to
measure fair value. In this case the emphasis must be on whether a transaction price is based on an
orderly transaction, rather than a forced sale.
Fair value is not adjusted for transaction costs. Under IFRS 13, these are not a feature of the asset or
liability, but may be taken into account when determining the most advantageous market.
Fair value measurements are based on an asset or a liability's unit of account, which is specified by each
IFRS where a fair value measurement is required. For most assets and liabilities, the unit of account is the
individual asset or liability, but in some instances may be a group of assets or liabilities.
Market X Market Y
£ £
Price 58 57
Transaction costs (4) (3)
Transport costs (to transport the asset to that market) (4) (2)
50 52
Reporting of assets 41
Remember that fair value is not adjusted for transaction costs. Under IFRS 13, these are not a feature of
the asset or liability, but may be taken into account when determining the most advantageous market.
If Market X is the principal market for the asset (ie the market with the greatest volume and level of
activity for the asset), the fair value of the asset would be £54, measured as the price that would be
received in that market (£58) less transport costs (£4) and ignoring transaction costs.
If neither Market X nor Market Y is the principal market for the asset, Valor must measure the fair value
of the asset using the price in the most advantageous market. The most advantageous market is the
market that maximises the amount that would be received to sell the asset, after taking into account
both transaction costs and transport costs (ie the net amount that would be received in the respective
markets).
The maximum net amount (after deducting both transaction and transport costs) is obtainable in
Market Y (£52, as opposed to £50). But this is not the fair value of the asset. The fair value of the asset is
obtained by deducting transport costs but not transaction costs from the price received for the asset in
Market Y: £57 less £2 = £55.
Level 2 Inputs other than quoted prices included within Level 1 that are observable for the asset or
liability, either directly or indirectly, eg quoted prices for similar assets in active markets or for
identical or similar assets in non active markets or use of quoted interest rates for valuation
purposes
Level 3 Unobservable inputs for the asset or liability, ie using the entity's own assumptions about
market exit value.
42 Corporate Reporting
Examples of inputs used to measure fair value
Asset or liability Input
Level 1 Equity shares in a listed Unadjusted quoted prices in an
company active market
Level 2 Licensing arrangement arising Royalty rate in the contract
from a business combination with the unrelated party at
inception of the arrangement
Cash generating unit Valuation multiple (eg a
multiple of earnings or revenue
or a similar performance
measure) derived from
C
observable market data, eg
H
from prices in observed A
transactions involving P
comparable businesses T
E
Finished goods inventory at a Price to customers adjusted for R
retail outlet differences between the
condition and location of the
inventory item and the 2
comparable (ie similar)
inventory items
Building held and used Price per square metre derived
from observable market data,
eg prices in observed
transactions involving
comparable buildings in similar
locations
Level 3 Cash generating unit Financial forecast (eg of cash
flows or profit or loss)
developed using the entity's
own data
Three-year option on Historical volatility, ie the
exchange-traded shares volatility for the shares derived
from the shares' historical
prices
Interest save swap Adjustment to a mid-market
consensus (non-binding) price
for the swap developed using
data not directly observable or
otherwise corroborated by
observable market data
Reporting of assets 43
Illustration: Entity's own credit risk
Black Co and Blue Co both enter into a legal obligation to pay £20,000 cash to Green Co in seven years.
Black Co has a top credit rating and can borrow at 4%. Blue Co's credit rating is lower and it can borrow
at 8%.
Black Co will receive approximately £15,200 in exchange for its promise. This is the present value of
£20,000 in seven years at 4%.
Blue Co will receive approximately £11,700 in exchange for its promise. This is the present value of
£20,000 in seven years at 8%.
2.8 Disclosure
An entity must disclose information that helps users of its financial statements assess both of the
following:
(a) For assets and liabilities that are measured at fair value on a recurring or non-recurring basis, the
valuation techniques and inputs used to develop those measurements.
(b) For recurring fair value measurements using significant unobservable inputs (Level 3), the effect
of the measurements on profit or loss or other comprehensive income for the period. Disclosure
requirements will include:
(i) Reconciliation from opening to closing balances
(ii) Quantitative information regarding the inputs used
(iii) Valuation processes used by the entity
(iv) Sensitivity to changes in inputs
Clarifying how to measure fair value when the market for an asset becomes less active; and
Improving the transparency of fair value measurements through disclosures about measurement
uncertainty.
44 Corporate Reporting
2.9.1 Advantages and disadvantages of fair value (versus historical cost)
Fair value
Advantages Disadvantages
Relevant to users' decisions Subjective (not reliable)
Consistency between companies Hard to calculate if no active market
C
Predicts future cash flows Time and cost H
A
Lack of practical experience/familiarity P
T
Less useful for ratio analysis (bias) E
R
Misleading in a volatile market
Historical cost
Advantages Disadvantages
Reliable Less relevant to users' decisions
Less open to manipulation Need for additional measure of
recoverable amounts (impairment test)
Quick and easy to ascertain
Does not predict future cash flows
Matching (cost and revenue)
Practical experience & familiarity
3 IAS 18 Revenue
Section overview
IAS 18 governs the recognition of revenue in general and in specific (common) types of
transaction. Generally, recognition should be when it is probable that future economic benefits
will flow to the entity and when these benefits can be measured reliably.
Income, as defined by the IASB's Framework, includes both revenues and gains. Revenue is income
arising in the ordinary course of an entity's activities and it may be called different names, such as
sales, fees, interest, dividends or royalties.
There are problems associated with revenue recognition, and proposals to remedy those problems
are being considered.
Reporting of assets 45
3.2 Sale of goods
Revenue from the sale of goods should only be recognised when:
The entity has transferred the significant risks and rewards of ownership of the goods to the
buyer
The entity has no continuing managerial involvement to the degree usually associated with
ownership, and no longer has effective control over the goods sold
The amount of revenue can be measured reliably
It is probable that the economic benefits associated with the transaction will flow to the entity
The costs incurred in respect of the transaction can be measured reliably
If significant risks and rewards remain with the seller the transaction is not a sale and revenue cannot be
recognised.
Rendering of services
When the outcome of a transaction involving the rendering of services can be estimated reliably, the
associated revenue should be recognised by reference to the stage of completion of the transaction at
the reporting date.
The outcome of a transaction can be estimated reliably when:
The amount of revenue can be measured reliably
It is probable that the economic benefits associated with the transaction will flow to the entity
The stage of completion of the transaction at the reporting date can be measured reliably
The costs incurred for the transaction and the costs to complete the transaction can be measured
reliably
When services are performed by an indeterminate number of acts over a period of time, revenue should
normally be recognised on a straight-line basis. If one act is of more significance than the others, then
the significant act should be carried out before revenue is recognised.
When the outcome of the transaction involving the rendering of services cannot be estimated reliably,
revenue is recognised only to the extent of the expenses recognised that are recoverable.
Interest, royalties and dividends
Revenue should be recognised when:
It is probable that the economic benefits associated with the transaction will flow to the entity; and
The amount of the revenue can be measured reliably.
3.3 Disclosure
Accounting policies
Amount of each significant category of revenue recognised during the period
Amount of revenue from exchanges of goods or services included in each significant category of
revenue
IAS 18 is generally agreed to be out of date. It does not address the relatively complex transactions that
now take place, for example, barter transactions, transactions involving options, sales of licences for the
use of computer software. This lack of specific guidance has led to aggressive earnings management:
creative accounting techniques whereby revenue is recognised before it has been earned.
The IASB has a current project to develop a new standard, but this is at an early stage. In the meantime
the general principles of IAS 18 and of the IASB Framework should be applied.
At Advanced level, revenue recognition may relate to issues of off-balance sheet finance, substance over
form or creative accounting.
46 Corporate Reporting
Interactive question 10: Recognition [Difficulty level: Intermediate]
Given that prudence is the main consideration, discuss under what circumstances, if any, revenue might
be recognised at the following stages of a sale.
(a) Goods are acquired by the business which it confidently expects to resell very quickly.
(b) A customer places a firm order for goods.
(c) Goods are delivered to the customer.
(d) The customer is invoiced for goods.
(e) The customer pays for the goods.
(f) The customer's cheque in payment for the goods has been cleared by the bank.
See Answer at the end of this chapter.
C
H
A
Interactive question 11: More revenue recognition [Difficulty level: Intermediate] P
T
Caravans Deluxe is a retailer of caravans, dormer vans and mobile homes, with a year end of 30 June. It E
is having trouble selling one model – the £30,000 Mini-Lux, and so is offering incentives for customers R
who buy this model before 31 May 20X7:
(a) Customers buying this model before 31 May 20X7 will receive a period of interest free credit,
2
provided they pay a non-refundable deposit of £3,000, an instalment of £15,000 on 1 August
20X7 and the balance of £12,000 on 1 August 20X9.
(b) A three-year service plan, normally worth £1,500, is included free in the price of the caravan.
On 1 May 20X7, a customer agrees to buy a Mini-Lux caravan, paying the deposit of £3,000. Delivery is
arranged for 1 August 20X7.
As the sale has now been made, the sales director of Caravans Deluxe wishes to recognise the full sale
price of the caravan, £30,000, in the financial statements for the year ended 30 June 20X7.
Requirement
Advise the director of the correct accounting treatment for this transaction. Assume a 10% discount
rate. Show the journal entries for this treatment.
See Answer at the end of this chapter.
Reporting of assets 47
of the public sector asset, the operator has a financial asset; to the extent that the operator has to rely
on the public using the service in order to obtain payment, the operator has an intangible asset.
48 Corporate Reporting
scheme, customers were granted 650,000 points. Each point has a fair value of £20 and at 30
September 20X8 125,000 points had been redeemed. Management has no previous experience of
customer loyalty schemes of this type. Through research it has established that where retailers operate
ongoing loyalty schemes, approximately 20% of points are never redeemed.
What is the correct treatment for the customer loyalty programme?
Solution
The total fair value of the points issued is £13,000,000 (650,000 × £20) and the best estimate would
appear to be that 520,000 (80% × 650,000) of these will be redeemed.
To recognise revenue in line with IFRIC 13, this should be apportioned by taking the number of points
redeemed in the period over the total number of points expected to be redeemed. The revenue to be
recognised in the year is £3,125,000 (125,000/520,000), leaving £9,875,000 (£13,000,000 – C
£3,125,000) as a deferred revenue liability at the year end. H
A
P
T
E
3.6 Principal or agent? R
Previously IAS 18 covered the accounting treatment for amounts collected by an agent on behalf of a
principal, which is: recognise only the commission as revenue (not the amounts collected on behalf of
the principal). However, it did not give guidance on determining whether an entity is acting as agent or 2
principal.
In 2009, the IASB issued some improvements to various IFRS, most of which are minor. The change
which is relevant here is the additional guidance in the appendix to IAS 18 Revenue on determining
whether an entity is acting as an agent or principal. The new guidance is as follows:
Acting as principal
An entity is acting as a principal when it is exposed to the significant risks and rewards associated with
the sale of goods or rendering of services. Features that indicate that an entity is acting as a principal
include (individually or in combination):
(a) Primary responsibility for providing goods or services to the customer or for fulfilling the order
(b) The entity having the inventory risk before or after the customer order, during shipping or on
return
(c) Discretion in establishing prices (directly or indirectly) eg providing additional goods or services
(d) The entity bearing the customer's credit risk.
Acting as agent
An entity is acting as an agent when it is not exposed to the significant risks and rewards associated with
the sale of goods or rendering of services. One feature that indicates that an entity is an agent is that the
amount the entity earns is predetermined eg fixed fee per transaction or percentage of amount billed to
the customer.
Reporting of assets 49
3.7.2 Proposed approach
Step 1. Identify the contract with the customer. Identifying a contract is usually straightforward,
as there will be a written agreement or an alternative according to normal business practice. The
entity would normally treat each contract separately, but there are cases where they might
combine them. The key point is price interdependence. Usually a company would apply the
proposals to a single contract. However, in some cases the company would account for two or
more contracts together if the prices of those contracts are interdependent. Conversely, a company
would segment a single contract and account for it as two or more contracts if some goods or
services are priced independently of other goods and services.
Step 2. Identify the separate performance obligations. The key point is distinct goods or
services. A contract includes promises to provide goods or services to a customer. Those promises
are called performance obligations. A company would account for a performance obligation
separately only if the promised good or service is distinct. A good or service is distinct if it is sold
separately or if it could be sold separately because it has a distinct function and a distinct profit
margin.
Step 3. Determine the transaction price. The key proposal is a probability weighted expected
amount. The transaction price is the amount of consideration a company expects to be entitled to
from the customer in exchange for transferring goods or services. The transaction price would
reflect the company's probability-weighted estimate of variable consideration (including reasonable
estimates of contingent amounts) in addition to the effects of the customer's credit risk and the
time value of money (if material).
Step 4. Allocate the transaction price to the performance obligations. The key proposal is
relative selling price allocation. A company would allocate the transaction price to all separate
performance obligations in proportion to the stand-alone selling price of the good or service
underlying each performance obligation. If the good or service is not sold separately, the company
would estimate its stand-alone selling price.
Step 5. Recognise revenue when a performance obligation is satisfied. A company would
recognise revenue when it satisfies a performance obligation by transferring the promised good or
service to the customer. The good or service is transferred when the customer obtains control of
the promised good or service. An indicator of this is when the customer has the risks and rewards
of ownership.
The amount of revenue recognised is the amount allocated to that performance obligation in Step 4.
50 Corporate Reporting
construction and some software development contracts). Under the proposal, a company would
apply the percentage of completion method of revenue recognition only if the company transfers
services to the customer throughout the contract – ie if the customer owns the work in progress as
it is built or developed.
(b) Separate performance obligations would be recognised for distinct goods or services. This
proposal could result in some revenue being attributed to goods or services that are now
considered incidental to the contract – for instance, to mobile phones that are provided free of
charge with airtime contracts and to some post-delivery services, such as maintenance and
installation.
(c) Probability weighted estimates would be required of the consideration to be received. This
could result in a company recognising some revenue on the transfer of a good or service, even if
the consideration amount is contingent on a future event – for example, an agent that provides
C
brokerage services in one period in exchange for an amount of consideration to be determined in H
future periods, depending on the customer's behaviour. A
P
(d) A customer's credit risk would be reflected in the measurement of revenue. This could result in T
a company recognising some revenue when it transfers a good or service to a customer even if E
there is uncertainty about the collectability of the consideration, rather than deferring revenue R
recognition until the consideration is collected.
(e) The transaction price will be allocated in proportion to the stand-alone selling price. This will
2
affect some existing practices, particularly in the software sector, that currently result in the deferral
of revenue if a company does not have objective evidence of the selling price of a good or service
to be provided.
(f) Contract acquisition costs are to be expensed. This proposal would affect companies that
currently capitalise such costs – for example, commissions and other directly incremental costs –
and amortise them over the contract period.
Reporting of assets 51
Summary and Self-test
Summary
Amortisation/
Definition Recognition
impairment test
Cost Revaluation
model model
52 Corporate Reporting
IAS 2 Inventories
Value at FIFO
lower of AVCO/WACC
IAS 36 Impairments
Impairment CGUs
Indicators
= Notional goodwill for NCI
carrying value - recoverable amount Allocate any loss to goodwill
then other assets on pro rata basis
Reporting of assets 53
IFRS 13 Fair Value
Measurement
Disclosures
IAS 18 Revenue
Sale
Sale og
of goods
goods
Rendering
Sale ogofgoods
services
Other
Sale ogrevenue
goods
SaleIFRIC
og goods
12
SaleIFRIC
og goods
13
54 Corporate Reporting
Self-test
IAS 2 Inventories
1 Reapehu
The Reapehu Company manufactures a single type of concrete mixing machine, which it sells to
building companies. Reapehu is currently considering the value of its inventories at 31 December
20X7. The following data are relevant at this date:
Cost per item £ C
Variable production costs 200,000 H
Fixed production costs 40,000 A
240,000 P
T
There are 85 mixing machines held in inventory. E
R
The company has a contract to sell 15 concrete mixing machines at £225,000 each to a major
local building company in January 20X8. The normal selling price is £260,000 per machine. Selling
costs are minimal. 2
Requirement
What is the value of Reapehu's inventory at 31 December 20X7, according to IAS 2 Inventories?
2 Utah
The Utah Company manufactures motors for domestic refrigerators. A major customer is The
Bushbaby Company, which is a major international electrical company making refrigerators as one
of its products.
Utah is currently preparing its financial statements for the year to 31 December 20X7 and it
expects to authorise them for issue on 3 March 20X8.
Utah holds significant inventories of motors (which are unique to the Bushbaby contract) as
Bushbaby require to be supplied on a just-in-time basis and has variable production schedules.
On 3 January 20X8, Bushbaby announced that it was fundamentally changing the design of its
refrigerators and that, while this had been planned for some time, it had not been possible to warn
Utah for reasons of commercial confidentiality. As a consequence, it would cease to use Utah's
motors from 30 April 20X8 and would reduce production prior to that date. Details for Utah are as
follows:
Number of motors held in inventory at 31 December 4,000 motors
Expected sales in the four months to 30 April 20X8 1,600 motors
Net selling price per motor sold to Bushbaby £50
Net selling price per motor unsold at 30 April 20X8 £10
Cost per motor £25
Requirement
At what value should the inventories of motors be stated by Utah in its statement of financial
position at 31 December 20X7 according to IAS 2 Inventories, and IAS 10 Events after the Reporting
Period?
IAS 11 Construction Contracts
3 Polikeman
During 20X6 The Polikeman Company was one of a number of entities negotiating for a major
contract to build a new motorway in 20X7-20X8. On 1 January 20X7 Polikeman was identified as
the preferred bidder, and negotiations with all other bidders were stopped.
There were a number of environmental objections to the motorway over a significant period.
Polikeman therefore incurred substantial costs in securing the contract by providing evidence to
Reporting of assets 55
the government and specification issues. The costs clearly related to this contract and fell into two
stages as follows:
Year to 31 December 20X6 Stage 1 Feasibility and initial review of environmental impact
Year to 31 December 20X7 Stage 2 Detailed specification of contract and detailed evidence
of environmental impact
The contract was awarded to Polikeman in December 20X7.
Requirement
Which of the pre-contract costs can be treated as attributable to the construction contract
according to IAS 11 Construction Contracts?
4 Diborane
At the start of 20X6 The Diborane Company negotiated a fixed price contract of £14.0 million with
The Benzidine Company for the construction of a container port. Diborane had estimated the costs
of the contract to be £13.3 million. Diborane estimates the stage of completion on its construction
contracts by reference to the physical proportion of the work completed.
During 20X6 the contract suffered protracted delays and difficulties, such that Diborane concluded
that there would be material cost overruns. It negotiated with Benzidine to try to get some
recompense for these unexpected difficulties in the form of contract variations, but without
success. At 31 December 20X6 when the contract was 30% physically complete, the costs incurred
amounted to £4.9 million and the costs to complete were estimated at £11.2 million.
Throughout 20X7 Diborane continued to try to win recompense from Benzidine, but without
success. At 31 December 20X7 when the contract was 80% physically complete, the costs incurred
amounted to £12.6 million and the costs to complete were estimated at £3.5 million. On that day
and after these figures had been drafted, Benzidine suddenly agreed in principle to a contract
variation of £3.5 million, provided that Diborane agreed to pay Benzidine a penalty for late
completion of £280,000. Diborane agreed to these terms and the relevant adjustments were made
to the draft figures.
Requirement
Determine the following amounts in respect of the container port contract in Diborane's financial
statements according to IAS 11 Construction Contracts.
(a) The profit or loss to be recognised in the year ended 31 December 20X6
(b) The revenue to be recognised in the year to 31 December 20X7
(c) The profit or loss to be recognised in the year ended 31 December 20X7
IAS 16 Property, Plant and Equipment
5 Niobium
The Niobium Company operates in the petrol refining industry. A fire at a competitor using similar
plant has revealed a safety problem and the government has introduced new regulations requiring
the installation of new safety equipment in the industry. The refinery had a carrying amount of £30
million prior to the installation of the safety equipment. The new safety equipment cost £5 million
and was fully operational at 31 December 20X7, but it does not generate any future economic
benefits. The refinery would, however, be closed down without such equipment being installed.
At 31 December 20X7 the net selling price of the refinery was estimated at £33 million. In
determining its value in use, the directors have determined that the refinery would generate annual
cash flows of £3.2 million from next year in perpetuity, to be discounted at 10% per annum.
Requirement
According to IAS 16 Property, Plant and Equipment, what is the carrying amount of the refinery in
Niobium's statement of financial position at 31 December 20X7?
56 Corporate Reporting
6 Oruatua
The Oruatua Company acquired a piece of machinery for £800,000 on 1 January 20X6. It identified
that the asset had three major components as follows:
Component Useful life Cost
£'000
Pump 5 years 110
Filter 4 years 240
Engines 15 years 450
Under the terms of the 15-year licence agreement for the use of the machinery, the engines (but
not the other components) were to be dismantled at the end of the licence period. The machinery
contained three engines, and dismantling costs for all three engines were initially estimated at a
total cost of £480,000 (ie £160,000 per engine) payable in 15 years' time. Oruatua's discount rate C
appropriate to the risk specific to this liability is 7% per annum. H
A
One of the three engines developed a fault on 1 January 20X7 and had to be sold for scrap for P
£40,000. A replacement engine was purchased at a cost of £168,000 on 1 January 20X7, for use T
until the end of the licence period, when dismantling costs on this engine estimated at £150,000 E
would be payable. R
At a rate of 7% per annum the present value of £1 payable in 15 years' time is 0.3624 and of £1
payable in 14 years' time is 0.3878. 2
Requirement
Calculate the following figures for inclusion in Oruatua's financial statements for the year ended 31
December 20X7 according to IAS 16 Property, Plant and Equipment, and IAS 37 Provisions,
Contingent Liabilities and Contingent Assets.
(a) The carrying amount of the machinery at 31 December 20X6
(b) The profit/loss on the disposal of the faulty engine
(c) The carrying amount of the machinery at 31 December 20X7
IAS 36 Impairment of Assets
7 Antimony
The Antimony Company acquired its head office on 1 January 20W8 at a cost of £5.0 million
(excluding land). Antimony's policy is to depreciate property on a straight-line basis over 50 years
with a zero residual value.
On 31 December 20X2 (after five years of ownership) Antinomy revalued the non-land element of
its head office to £8.0 million. Antinomy does not transfer annual amounts out of revaluation
reserves as assets are used: this is in accordance with the permitted treatment in IAS 16 Property,
Plant and Equipment.
In January 20X8 localised flooding occurred and the recoverable amount of the non-land element
of the head office property fell to £2.9 million.
Requirement
What impairment charge should be recognised in the profit or loss of Antimony arising from the
impairment review in January 20X8 according to IAS 36 Impairment of Assets?
8 Sundew
The Sundew Company is a vertically integrated manufacturer of chain-saws. It has two divisions.
Division X manufactures engines, all of which are identical. Division Y assembles complete chain-
saws and sells them to third party dealers.
Division X, a cash-generating unit, sells to Division Y at cost price but sells to other chain-saw
manufacturers at cost plus 50%. Details of Division X's budgeted revenues for the year ending 31
December 20X7 are as follows:
Engines Price per engine
Sales to Division Y 2,500 £1,000
Third party sales 1,500 £1,500
Reporting of assets 57
Requirement
What are the 20X7 cash inflows which should be used in determining the value in use of Division X
according to IAS 36 Impairment of Assets?
9 Cowbird
The Cowbird Company operates in the television industry. It acquired a licence to operate in a
particular region for 20 years at a cost of £10 million on 31 December 20X3. Cowbird's policy was
to amortise the fee paid for the licence on a straight-line basis.
By 31 December 20X5 it had become apparent that Cowbird had overpaid for the licence and,
measuring recoverable amount by reference to value in use, it recognised an impairment charge of
£4.05 million, leaving a carrying amount of £4.95 million.
At 31 December 20X7 the market place had improved, such that the conditions giving rise to the
original impairment no longer existed. The recoverable amount of the licence by reference to value
in use was now £11 million.
Requirement
What should be the carrying amount of the licence in the statement of financial position of
Cowbird at 31 December 20X7, according to IAS 36 Impairment of Assets?
10 Acetone
The Acetone Company is testing for impairment two subsidiaries which have been identified as
separate cash-generating units.
Some years ago Acetone acquired 80% of The Dushanbe Company for £600,000 when the fair
value of Dushanbe's identifiable assets was £400,000. As Dushanbe's policy is to distribute all
profits by way of dividend, the fair value of its identifiable net assets remained at £400,000 on 31
December 20X7. The impairment review indicated Dushanbe's recoverable amount at 31
December 20X7 to be £520,000.
Some years ago Acetone acquired 85% of The Maclulich Company for £800,000 when the fair
value of Maclulich's identifiable net assets was £700,000. Goodwill of £205,000 (£800,000 –
(£700,000 85%)) was recognised. As Maclulich's policy is to distribute all profits by way of
dividend, the fair value of its identifiable net assets remained at £700,000 on 31 December 20X7.
The impairment review indicated Maclulich's recoverable amount at 31 December 20X7 to be
£660,000.
It is Acetone group policy to value the non-controlling interest using the proportion of net assets
method.
Requirement
Determine the following amounts in respect of Acetone's consolidated financial statements at
31 December 20X7 according to IAS 36 Impairment of Assets.
(a) The carrying amount of Dushanbe's assets to be compared with its recoverable amount for
impairment testing purposes
(b) The carrying amount of goodwill in respect of Dushanbe after the recognition of any
impairment loss
(c) The carrying amount of the non-controlling interest in Maclulich after recognition of any
impairment loss.
IAS 38 Intangible Assets
11 Titanium
On 1 January 20X7 The Titanium Company acquired the copyright to four similar magazines, each
with a remaining legal copyright period for 10 years. At the end of the legal copyright period,
other publishing companies will be allowed to tender for the copyright renewal rights.
58 Corporate Reporting
At 31 December 20X7 the following information was available in respect of the assets:
Remaining period over which Value in active
Copyright cost at publication is expected to market at 31
Publication name 1 January 20X7 generate cash flows at 1 December 20X7
January 20X7
Dominoes £900,000 6 years £700,000
Billiards £1,200,000 16 years £1,150,000
Skittles £1,700,000 8 years Unknown
Darts £1,400,000 Indefinite £2,100,000
Titanium uses the revaluation model as its accounting policy in relation to intangible assets.
Requirement
C
What is the total charge to profit or loss for the year ended 31 December 20X7 in respect of these H
intangible assets per IAS 38 Intangible Assets? A
P
12 Lewis T
E
The following issues have arisen in relation to business combinations undertaken by the Lewis R
Company.
(a) Lewis acquired the trademark of a type of wine when it acquired 80% of the ordinary share
capital of The Calcium Company on 1 April 20X7. This wine is produced from a vineyard that 2
is exclusively used by Calcium.
(b) When Lewis bought a football club on 1 May 20X7, it acquired the registrations of a group of
football players.
(c) Lewis acquired a 75% share in the Stilt Company during 20X7. At the acquisition date Stilt
was researching a new pharmaceutical product which is expected to produce future economic
benefits.
The cost of these assets can be measured reliably.
Requirement
Indicate which of the above items should or should not be recognised as assets separable from
goodwill in Lewis's statement of financial position at 31 December 20X7, according to IAS 38
Intangible Assets.
13 Diversified group
The following issues have arisen within a diversified group of businesses.
(a) The Thrasher Company has signed a three-year contract with a team of experts to write
questions for a computer based examination on International Financial Reporting Standards.
The contract states that the experts cannot work on similar projects for rival entities. Thrasher
incurred costs of £5,000 in training the experts to use the software, and believes that the
product developed by the team will be a market leader.
(b) The Curium Company has a loyalty card scheme for customers. Every customer purchase is
recorded in such a way that Curium is able to create a profile of spending amounts and habits
of customers, and uses this to target them with special offers and discounts to encourage
repeat business. The database has cost £60,000 to create and Curium has been approached
by another company wishing to buy the contents of the database.
Requirement
Which of the above items should be classified as intangible assets per IAS 38 Intangible Assets?
14 Cadmium
The Cadmium Company produces a globally recognised dog food that is a market leader. The
trademark was established over 50 years ago and is renewable every eight years. The last renewal
was effective from 1 January 20X2 and cost £65,000. Cadmium intends to continue to renew the
trademark in future years.
Reporting of assets 59
Cadmium uses the revaluation model where allowed for measuring intangible assets, in accordance
with IAS 38 Intangible Assets. A valuation of £50 million was made by an independent valuation
expert on 31 December 20X7, who charged £650,000 for the valuation report.
Requirement
What is the carrying amount of the trademark in Cadmium's statement of financial position at 31
December 20X7 per IAS 38 Intangible Assets?
15 Piperazine
The Piperazine Company's financial reporting year ends on 31 December. It has adopted the
revaluation model for intangible assets and revalues them on a regular three-year cycle. For
intangibles with a finite life Piperazine transfers the relevant amount from revaluation reserve to
retained earnings each year.
During 20X4 Piperazine incurred £70,000 on the process of preparing an application for licences
for 15 taxis to operate in a holiday resort where, in order to prevent excessive traffic pollution, the
licensing authority only allowed a small number of taxis to operate. The outcome of its application
was uncertain up to 30 November 20X4 when the local authority accepted its application. In
December 20X4 Piperazine incurred a total cost of £9,000 in registering its licences. The licences
were for a period of nine years from 1 January 20X5. The licences are freely transferable and an
active market in them exists. The fair value of the licences at 31 December 20X4 was £9,450 per
taxi and Piperazine carried them at fair value in its statement of financial position at 31 December
20X4.
At 31 December 20X7 Piperazine undertook its regular revaluation. On that date the licensing
authority announced that it would triple the number of licences offered to taxi operators and there
were transactions in the active market for licences with six years to run at £4,500.
Requirement
Determine the following amounts in respect of the revaluation reserve in respect of these taxi
licences in Piperazine's financial statements according to IAS 38 Intangible Assets.
(a) The balance at 31 December 20X4
(b) The balance at 31 December 20X7 before the regular revaluation
(c) The balance at 31 December 20X7 after the regular revaluation
IFRS 13 Fair Value Measurement
16 Vitaleque
Vitaleque, a public limited company, is reviewing the fair valuation of certain assets and liabilities in
light of the introduction of IFRS 13 Fair Value Measurement.
It carries an asset that is traded in different markets and is uncertain as to which valuation to use.
The asset has to be valued at fair value under International Financial Reporting Standards. Vitaleque
currently only buys and sells the asset in the African market. The data relating to the asset are set
out below.
Year to 30 November 20X2 North American market European market African market
Volume of market – units 4 million 2 million 1 million
Price £19 £16 £22
Costs of entering the £2 £2 £3
market
Transaction costs £1 £2 £2
Additionally, Vitaleque had acquired an entity on 30 November 20X2 and is required to fair value a
decommissioning liability. The entity has to decommission a mine at the end of its useful life,
which is in three years' time. Vitaleque has determined that it will use a valuation technique to
measure the fair value of the liability. If Vitaleque were allowed to transfer the liability to another
market participant, then the following data would be used.
60 Corporate Reporting
Input Amount
Labour and material cost $2 million
Overhead 30% of labour and material cost
Third party mark-up – industry average 20%
Annual inflation rate 5%
Risk adjustment – uncertainty relating to cash 6%
flows
Risk-free rate of government bonds 4%
Entity's non-performance risk 2%
Jayach needs advice on how to fair value the liability.
Requirement
Discuss, with relevant computations, how Jayach should fair value the above asset and liability
C
under IFRS 13. H
A
IAS 18 Revenue P
17 Laka T
E
On 30 June 20X7 the Laka Company sells kitchen appliances for £4,400, on the basis that a 20% R
deposit is paid on the same date and the balance in a single payment after 24 months' free credit.
Currently the yield on high quality corporate bonds is 6.5% and the rate for an issuer with a credit 2
rating similar to that of the borrower is 8.0% per annum.
Requirement
What is the total amount of income to be recognised under IAS 18 Revenue, by Laka in its
statement of comprehensive income for the year ended 31 December 20X7?
18 Renpet
The Renpet Company operates a franchise system whereby, at the commencement of a franchise,
a franchisee signs two contracts each with a separate fee. The financial terms of the two contracts
are as follows:
(1) The £36,000 fee receivable at the time the first contract is signed covers Renpet's initial set-up
costs and the provision to the franchisee of certain equipment with a fair value of £19,000.
40% of the equipment is delivered to the franchisee when the contract is signed, the
remainder 8 months later and title passes on delivery.
(2) The £9,000 fee receivable at the time the second contract is signed is the first annual fee and
covers the provision of continuing support services. This fee is set at the cost of these services
to Renpet. The fair value of the services is £12,000, which reflects a reasonable profit.
Requirement
According to IAS 18 Revenue, what revenues should Renpet recognise in its financial statements for
the year ended 31 December 20X7 in respect of the £45,000 receivable for a franchise
commencing on 1 September 20X7?
19 Baros
Under a single four-month contract with one of its customers, the Baros Company is obliged to
produce a package of six advertisements for television and to purchase airtime for their broadcast.
Under the contract Baros will receive the £5.4 million fair value for the production of all six
advertisements (on which it expects to incur £4.32 million costs), and a 10% commission on the
£40,000 airtime cost of each broadcast. Each advertisement is to be broadcast 30 times.
Baros's financial year end fell half way through the four-month contract period, at which point
production of four advertisements was complete and work on the other two had not started. By
the year end, booking had been made for two of the advertisements to be broadcast 30 times
each. 15 of these broadcasts for each of the two advertisements had been transmitted by the year
end.
Reporting of assets 61
Requirement
According to IAS 18 Revenue, what revenue should Baros recognise in its financial statements for its
year just ended?
20 Health club
The terms for taking up membership of a health club included the requirement to pay a one-off
non-returnable membership fee of £3,000. In exchange, the club offers new members the right
over the first 6 months of their membership to buy equipment with a list price of £1,200 at a
discount of 20%.
On 1 October 20X7, 100 new members joined on these terms. Recent experience is that 40% of
new members take advantage of the offer of discounted equipment, making their £1,200 of
equipment purchases evenly over the relevant period.
Requirement
According to IAS 18 Revenue, what revenue should the club recognise in its financial statements for
the year ended 31 December 20X7 in relation to the £300,000 membership fees?
21 Pears
The Pears Company operates a mobile phone network. On 1 January 20X7 it introduced a new
retail package which combined a 'free' mobile phone, an annual airtime subscription to the
network and 80 'free' minutes per month. Customers will pay £140 per quarter payable in advance
on the first day of each quarter.
The mobile phone has a retail value of £220 and the annual airtime subscription to the network is
sold separately at £50.
Pears has detailed historical records of 'free' minute usage on other price plans. On average 720 of
'free' minutes are used each year by customers. Each 'free' minute has an average call charge value
of £1 if paid for separately. The expected usage of 'free' minutes by quarter is as follows:
Quarter Minutes
January to March 175
April to June 125
July to September 190
October to December 230
720
Requirement
In accordance with IAS 18 Revenue, calculate the following amounts for a customer who subscribes
to a retail package on 1 January 20X7.
(a) The revenue recognised in respect of the mobile phone sale on 1 January.
(b) The revenue recognised for the airtime subscription and 'free' minutes in the six months to
30 June 20X7.
(c) The asset or liability recognised in the statement of financial position of Pears on 30 June 20X7
in respect of the contract.
22 Eco-Ergonom
Eco-Ergonom plc is an AIM quoted company which manufactures ergonomic equipment and
furniture and environmentally friendly household products. You are the Financial Controller, and
the accounting year-end is 31 December 20X7.
It is now 15 March 20X8, and the company's auditors are currently engaged in their work.
Deborah Carroll, the Finance Director, is shortly to go into a meeting with the Audit Engagement
Partner, Brian Nicholls, to discuss some unresolved issues relating to company assets. To save her
time, she wants you to prepare a memorandum detailing the correct accounting treatment. She
has sent you the following email, in which she explains the issues:
62 Corporate Reporting
To: Financial Controller
From: Deborah Carroll
Date: 15 March 20X8
Subject: Assets
As a matter of urgency, I need you to prepare a memorandum on the correct accounting
treatment of the items below, so that I can discuss this with the auditors.
Stolen lorries
As you know, we acquired a wholly owned subsidiary, a small road-haulage company, on 1 January
20X7 to handle major deliveries once we start producing larger items. So far, it has proved more
profitable to hire out its services to other companies, so the company is a cash-generating unit. We
paid £460,000 for the business, and the value of the assets, based on fair value less costs to sell, at
C
the date of acquisition were as follows:
H
£'000
A
Vehicles (lorries) 240 P
Intangible assets (licences) 60 T
Trade receivables 20 E
Cash 100 R
Trade payables (40)
380
2
Unfortunately, three of the lorries were stolen on 1 February 20X7. The lorries were not insured,
because the road haulage company manager had failed to complete the paperwork in time. The
lorries had a net book value of £60,000, and we estimate that £60,000 was also their fair value less
costs to sell.
I believe that, as a result of the theft of the uninsured lorries, the value in use of the cash
generating unit has fallen. We should recognise an impairment loss of £90,000, inclusive of the loss
of the stolen lorries.
We have another problem with this business. A competitor has started operating, covering similar
routes and customers. Our revenue will be reduced by one quarter, which will in turn reduce the
fair value less costs to sell and the value in use of our haulage business to £310,000 and £300,000
respectively. Part of this decline is attributable to the competitor's actions causing the net selling
value of the licences to fall to £50,000. There has been no change in the fair value less costs to sell
of the other assets, which is the same as on the date of acquisition.
The company will continue to rent out the lorries for the foreseeable future.
How should we show this impairment in the financial statements?
Fall in value of machines
The goods produced by some of our machines have been sold below their cost. This has affected
the value of the machines in question, which has suffered an impairment. The carrying amount of
the machines at depreciated historical cost is £580,000 and their fair value less costs to sell is
estimated to be £240,000. We anticipate that cash inflows from the machines will be £200,000 per
annum for the next three years. The annual market discount rate, as you know, is 10%.
How should we determine the impairment in value of the machines in the financial statements and
how should this be recognised?
Own brand
This year, Eco-Ergonom has been developing a new product, the Envirotop. Envirotop is a new
range of environmentally friendly kitchen products and an ergonomic kitchen design service. The
expenditure in the year to 31 December 20X7 was as follows:
Reporting of assets 63
Period from Expenditure type £m
1 Jan 20X7 – 31 March 20X7 Research on size of potential market 6
1 April 20X7 – 30 June 20X7 Prototype kitchen equipment and product 8
design
1 July 20X7 – 31 August 20X7 Wage costs in refinement of products 4
1 September 20X7 – 30 November Development work undertaken to finalise 10
20X7 design of kitchen equipment
Currently an intangible asset of £40 million is shown in the financial statements for the year ended
31 December 20X7.
Included in the costs of the production and launch of the products are the cost of upgrading the
existing machinery (£6 million), market research costs (£4 million) and staff training costs
(£2 million).
Please explain the correct treatment of all these costs.
Purchase of Homecare
You will also know that, on 1 January 20X7, Eco-Ergonom acquired 100% of Homecare, a private
limited company manufacturing household products. Eco-Ergonom intends to develop its own
brand of environmentally friendly cleaning products. The shareholders of Homecare valued the
company at £25 million based upon profit forecasts which assumed significant growth in the
demand for the 'Homecare' brand name. We took a more conservative view of the value of the
company and estimated the fair value to be in the region of £21 million to £23 million of which £4
million relates to the brand name 'Homecare'. Eco-Ergonom is only prepared to pay the full
purchase price if profits from the sale of 'Homecare' goods reach the forecast levels. The agreed
purchase price was £20 million plus a further payment of £5 million in two years on 31 December
20X8. This further payment will comprise a guaranteed payment of £2 million with no
performance conditions and a further payment of £3 million if the actual profits during this two
year period from the sale of Homecare goods exceed the forecast profit. The forecast profit on
Homecare goods over the two-year period is £3 million and the actual profits in the year to 31
December 20X7 were £0.8 million. Eco-Ergonom did not feel at any time since acquisition that the
actual profits would meet the forecast profit levels. Assume an annual discount rate of 5.5%.
Requirement
Prepare the memorandum asked for by the Finance Director.
64 Corporate Reporting
Technical reference
IAS 2 Inventories
Measurement and disclosure but not recognition IAS 2.1
Cost = expenditure incurred, in bringing the items to their present IAS 2.10
location and condition, so the cost of purchase and the cost of
conversion
– Fixed costs included by reference to normal levels of activity IAS 2.13
Disclosures include accounting policies, carrying amounts and amounts IAS 2.36 - 38
recognised as an expense
IAS 11 Construction Contracts
Definitions IAS 11.3
Reporting of assets 65
– Fixed price contract IAS 11.23
3 Value in use
Calculation involves the estimation of future cash flows as follows: IAS 36.39
– Risks specific to the asset for which the future cash flow estimates
have not been adjusted.
4 Cash-generating units
Estimate recoverable amount of CGU if not possible to assess for an IAS 36.66
individual asset
Identification of an asset's CGU involves judgement IAS 36.68
Goodwill should be allocated to each of the acquirer's CGUs that are IAS 36.80
expected to benefit
Goodwill that cannot be allocated to a CGU on a non-arbitrary basis is IAS 36.81
allocated to the group of CGUs to which it relates
Annual impairment review required for any CGU which includes IAS 36.90
goodwill
Corporate assets should be allocated on a reasonable and consistent IAS 36.102
basis
66 Corporate Reporting
5 Impairment losses
If the asset is held under the cost model the impairment should be IAS 36.60
recognised in profit or loss
If the asset has been revalued the impairment loss is treated as a IAS 36.60
revaluation decrease
An impairment loss for a CGU should be allocated: IAS 36.104
– To goodwill then
– To all other assets on a pro-rata basis
When a CGU is a non-wholly owned subsidiary AND non-controlling IAS 36 (Appendix C)
interest is measured at acquisition date at share of net assets, notionally
gross up goodwill for that part attributable to the non-controlling C
interest H
A
6 Reversals P
T
An impairment loss recognised for goodwill should not be reversed IAS 36.124 E
R
7 Disclosures
All impairments IAS 36.126
For a material impairment on an individual asset IAS 36.130 2
IAS 18 Revenue
Revenue recognised when: IAS 18 Objective
– Probable that future economic benefits will flow to the entity and
– These benefits can be measured reliably
Apply principle of substance over form
Revenue defined as gross inflows that result in increase in equity IAS 18.7
– Sales taxes (eg VAT) and amounts collected by agent on behalf of IAS 18.8
principal are excluded
Measured as fair value of consideration – discounted where appropriate IAS 18.9-11
Recognition of sale of goods: when buyer has obtained significant IAS 18.14
risks/rewards of ownership
Recognition of rendering of services: can take account of stage of IAS 18.20
completion, if over a long period:
Reporting of assets 67
Answers to Self-test
IAS 2 Inventories
1 Reapehu
£20,175,000
IAS 2.31 requires that NRV should take into account the purpose for which inventory is held. The
NRV for the contract is therefore determined separately from the general sales, thus:
£
Contract: NRV is lower than cost thus use NRV, so (£225,000 15) = 3,375,000
General: Use cost as this is less than NRV, so (£240,000 (85–15)) = 16,800,000
20,175,000
2 Utah
£64,000
IAS 2.30 requires the NRV of inventories to be calculated on the basis of all relevant information,
including events after the reporting period. This is supported by the example in IAS 10.9(b).
Thus:
£
£25 1,600 expected to be sold to Bushbaby: 40,000
£10 2,400 remainder 24,000
Total 64,000
68 Corporate Reporting
Amounts to be recognised 20X7 20X7
20X6 cumulative (cum – 20X6)
£m £m £m
Revenue (30% × £14m / 80% × £17.22m) 4.2 13.776 9.576
Costs (β) (6.3) 6.580
At 31 December 20X6 the expected loss must be recognised immediately (IAS 11.36).
Under the agreement made on 31 December 20X7, the contract revenue is increased by the
variation and reduced by the penalty (IAS 11.12).
The profit for the year ended 31 December 20X7 is the profit to date, PLUS the loss recognised in C
20X6. H
A
IAS 16 Property, Plant and Equipment P
T
5 Niobium E
R
£33 million
IAS 16.11 requires the capitalisation of essential safety equipment even if there are no future
2
economic benefits flowing directly from its operation.
It does however subject the total value of all the related assets to an impairment test. In this case
the recoverable amount is £33m, as the net selling price £33m is greater than the value in use
£32m (ie £3.2m / 0.1). As this is less than the total carrying amount of £35m (£30m + 5m), the
assets are written down to £33m.
6 Oruatua
(a) £850,355
(b) £(154,118)
(c) £756,521
(a) The initial cost of the asset must include the dismantling cost at its present value, where the
time value of the money is material (IAS 16.16(c) and IAS 37.45). The present value of these
costs at 1 January 20X6 is £173,952 (£480,000 0.3624), making the total cost of the
engines £623,952. Each part of the asset that has a cost which is significant in relation to the
total asset cost should be depreciated separately (IAS 16.43). Therefore, at the end of 20X6
the carrying amount of the asset is £850,355 (£110,000 4/5) + (£240,000 ¾) +
(£623,952 14/15).
(b) The loss on disposal is (per IAS 16.71) the difference between the carrying amount of an
individual engine at 1 January 20X7 of £194,118 (£623,952 / 3 14/15)) and the scrap sale
proceeds of £40,000, to give a loss of £154,118.
(c) The replacement engine is capitalised at cost of £226,170 (£168,000 + £150,000 x 0.3878),
and then depreciated over the remaining length of the licence of 14 years. The carrying
amount of the asset at 31 December 20X7 is therefore £756,521 (£110,000 3/5) +
(£240,000 2/4) + (£623,952 2/3 13/15) + (£226,170 13/14).
IAS 36 Impairment of Assets
7 Antimony
£0.7 million
IAS 36.60 and 61 (also IAS 16.40) require that an impairment that reverses a previous revaluation
should be recognised through the revaluation reserve to the extent of that reserve. Any remaining
amount is recognised through profit or loss. Thus:
The carrying amount at 31 December 20X2 is 45/50 £5.0m = £4.5m.
The revaluation reserve created is £3.5m (ie £8.0m – £4.5m)
The carrying amount at 31 December 20X7 is 40/45 £8.0m = £7.1m
Reporting of assets 69
The recoverable amount at 31 December 20X7 is £2.9m.
The total impairment charge is £4.2m (ie £7.1m – £2.9m).
Of this, £3.5m is a reversal of the revaluation reserve, so only £0.7 million is recognised
through profit or loss.
8 Sundew
£6,000,000
IAS 36.70 requires that in determining value in use where internal transfers are made, then a best
estimate should be made of prices that would be paid in an orderly transaction between market
participants at the measurement date.
Thus revenues are 4,000 £1,500 = £6,000,000
9 Cowbird
£8.0 million
IAS 36.110 requires consideration of whether an impairment loss recognised in previous years has
reversed or decreased.
IAS 36.117 and 118 restrict the recognition of any such reversal to the value of the carrying
amount at the current reporting date had the original impairment not taken place. Thus:
Carrying amount under original conditions = £10m 16/20 years = £8.0m.
10 Acetone
(a) £750,000
(b) £96,000
(c) £99,000
(a) £
Book value of Dushanbe's net assets 400,000
Goodwill recognised on acquisition
£600,000 – (80% × £400,000) 280,000
Notional goodwill (£280,000 × 20/80) 70,000
750,000
(b) The impairment loss is the total £750,000 less the recoverable amount of £520,000 =
£230,000. Under IAS 36.104 this is firstly allocated against the £350,000 goodwill. (As the
impairment loss is less than the goodwill, none is allocated against identifiable net assets.) As
only the goodwill relating to Acetone is recognised, only its 80% share of the impairment loss
is recognised:
£
Carrying value of goodwill 280,000
Impairment (80% × 230,000) (184,000)
Revised carrying amount of goodwill 96,000
(c) £
Carrying amount of Maclulich's net assets 700,000
Recognised goodwill 205,000
Notional goodwill (15/85 × £205,000) 36,176
941,176
Recoverable amount (660,000)
Impairment loss 281,176
Allocated to:
Recognised and notional goodwill 241,176
Other net assets 40,000
70 Corporate Reporting
IAS 38 Intangible Assets
11 Titanium
£672,500
IAS 38.94 deals with the identification of the useful life of an intangible asset arising from legal
rights.
The Dominoes publication has a useful life of six years, and so should be amortised over this
period. At the year end the carrying amount of £750,000, (900,000 5/6), exceeds the active
market value, so an impairment of £50,000 is required. This gives a total charge of £200,000
(£150,000 amortisation plus £50,000 impairment charge).
The Billiards publication is initially amortised over the period of ten years to the end of the
copyright arrangement, as there is no certainty that the company can publish the magazine after C
this date. This gives a charge of £120,000. H
A
The Skittles publication is amortised over the period it is expected to generate cash flows of eight P
years, giving a charge of £212,500. T
E
The Darts publication has an indefinite period over which it is expected to generate cash flows. R
Under normal circumstances it would be automatically subject to an annual impairment review.
However, because the copyright arrangement does have a finite period, amortisation should take
place over ten years, and so a charge of £140,000 is required. 2
Reporting of assets 71
The trademark is therefore carried at the cost of renewal, depreciated for the six of the eight years'
life since last renewal, so £65,000 2/8 = £16,250.
15 Piperazine
(a) £132,750
(b) £88,500
(c) £61,500
(a) Under IAS 38.21 the £70,000 spent in 20X4 in applying for the licences must be recognised in
profit or loss, because the generation of future economic benefits is not yet probable. The
£9,000 incurred in December 20X4 in registering the licences is treated as the cost of the
licences because the economic benefits are then probable. The carrying amount of the
licences under the revaluation model at 31 December 20X4 is £141,750 (£9,450 15), so the
balance on the revaluation reserve is the £132,750 uplift (IAS 38.75 and 85).
(b) After three years the accumulated amortisation based on the revalued amount is £47,250
(£141,750 3/9), whereas the accumulated amortisation based on the cost would have been
£3,000 (£9,000 3/9). So £44,250 will have been transferred from the revaluation reserve to
retained earnings (IAS 38.87). The remaining balance before the regular revaluation is
£88,500 (£132,750 – £44,250).
(c) The carrying amount of the licences immediately before the revaluation is £94,500 (£141,750
– £47,250). The revalued carrying amount is £67,500 (£4,500 15). The deficit of £27,000 is
recognised in the revaluation reserve, reducing the balance to £61,500 (IAS 38.86).
IFRS 13 Fair Value Measurement
16 Vitaleque
(a) Fair value of asset
Year to 30 November 20X2 North American European market African market
market
Volume of market – units 4m 2m 1m
£ £
Price 19 16 22
Costs of entering the market ( 2) ( 2) n/a*
Potential fair value 17 14 22
Transaction costs (1) ( 2) (2)
Net profit 16 12 20
*Notes
(i) Because Vitaleque currently buys and sells the asset in the African market, the costs of
entering that market are not incurred and therefore not relevant.
(ii) Fair value is not adjusted for transaction costs. Under IFRS 13, these are not a feature of
the asset or liability, but may be taken into account when determining the most
advantageous market.
(iii) The North American market is the principal market for the asset because it is the market
with the greatest volume and level of activity for the asset. If information about the
North American market is available and Vitaleque can access the market, then Vitaleque
should base its fair value on this market. Based on the North American market, the fair
value of the asset would be £17, measured as the price that would be received in that
market (£19) less costs of entering the market (£2) and ignoring transaction costs.
(iv) If information about the North American market is not available, or if Vitaleque cannot
access the market, Vitaleque must measure the fair value of the asset using the price in
the most advantageous market. The most advantageous market is the market that
maximises the amount that would be received to sell the asset, after taking into account
both transaction costs and usually also costs of entry, that is the net amount that would
be received in the respective markets. The most advantageous market here is therefore
the African market. As explained above, costs of entry are not relevant here, and so,
based on this market, the fair value would be £22.
72 Corporate Reporting
It is assumed that market participants are independent of each other and knowledgeable,
and able and willing to enter into transactions.
(b) Fair value of decommissioning liability
Because this is a business combination, Vitaleque must measure the liability at fair value in
accordance with IFRS 13, rather than using the best estimate measurement required by IAS 37
Provisions, contingent liabilities and contingent assets. In most cases there will be no observable
market to provide pricing information. If this is the case here, Vitaleque will use the expected
present value technique to measure the fair value of the decommissioning liability. If
Vitaleque were contractually committed to transfer its decommissioning liability to a market
participant, it would conclude that a market participant would use the inputs as follows,
arriving at a fair value of £3,215,000.
Input Amount C
£'000 H
Labour and material cost 2,000 A
Overhead: 30% × 2,000 600 P
T
Third party mark-up – industry average: 2,600 × 20% 520
E
3120 R
3
Inflation adjusted total (5% compounded over three years): 3,120 × 1.05 3,612
Risk adjustment – uncertainty relating to cash flows: 3,612 × 6% 217
2
3,829
IAS 18 Revenue
17 Laka
£4,016
Under IAS 18.11 the selling price must be analysed between the finance income and the sale of
goods income, discounting future receipts at the rate of interest for an issuer with a similar credit
rating to that of the customer.
The finance income is calculated by reference to the amount outstanding after the deposit has
been paid:
£
Initial deposit (£4,400 × 20%) 880
Sale of goods (£4,400 × 80%) / 1.08
2
3,018
Finance income £3,018 × 3.923%* 118
4,016
Reporting of assets 73
– £3,000 must be allocated to the second contract to increase the £9,000 fee to the fair
value of the services £12,000
– The remaining £14,000 of the initial fee is recorded as revenue
Of the £9,000 second contract fee PLUS the £3,000 of the initial set up fee allocated as above:
£12,000 × 4m/12m = £4,000 relates to this financial year and is recorded as revenue
The remaining £8,000 is deferred until the following financial year.
Therefore revenue recognised is £7,600 + £14,000 + £4,000 = £25,600.
19 Baros
£3,720,000
IAS 18 App. 12 states that media commission revenue is recognised when the advertisement
appears before the public. So revenue is two advertisements 15 broadcasts £40,000
10% = £120,000.
Production commissions are recognised by reference to the stage of completion of the
project. The best measure of the stage of completion is the physical quantity of
advertisements produced. Therefore £5.4 million × 4/6 = revenue of £3.6 million.
Total revenue is £3.6 million + £120,000 = £3,720,000.
20 Health club
£295,200
When a fee entitles a member to purchase equipment at a reduced rate, the revenue should not be
recognised immediately in full but on a basis which reflects the timing, nature and value of the
benefit (IAS 18 App. 17). So the relevant proportion is spread over the period during which
discounted purchases may be made.
The amount to be deferred is calculated as:
The number of × Proportion who × Amount of the × Remaining
new members take advantage benefit period over
of offer which offer can
be exercised
100 × 40% × (£1,200 20%) × 3m/6m
= £4,800
Therefore revenue recognised = £300,000 - £4,800 = £295,200
21 Pears
(a) £124
(b) £184
(c) £28
IAS 18.13 requires the recognition criteria to be applied to the separately identifiable components
of a single transaction in order to represent the substance of the transaction. IAS 18 does not,
however, specifically state how an entity should unbundle such contracts although the application
of general principles means that each component should be recognised at its fair value and only
recognised when it meets the specific criteria. If the fair value of the individual components is
greater than the overall price paid for the bundled contract, the discount should be allocated to
each component on a reasonable basis. Typically the discount will be allocated to each component
on a pro-rata basis.
(a) The total revenue over the contract period is £560 (4 quarters £140). The fair value of the
separate components is £990 (£220 + £50 + (720 £1)). The discount of 43.43% should be
spread across each element. The revenue recognised on the telephone sale will be £124 (£220
56.57%).
74 Corporate Reporting
(b) The revenue recognised in the first six months will be:
£
Airtime subscription £50 × 6/12 × 56.57% 14
'Free' call revenue (175 mins + 125 mins) × £1 × 56.57% 170
184
(c) Total revenue recognised in the first six months will be £308 (£124 + £184) whilst the amount
of cash received is £280 (2 £140). The difference will be a receivable in the statement of
financial position.
In practice, estimates should also be revisited throughout the year against actual usage.
22 Eco-Ergonom
C
MEMORANDUM H
A
To: Deborah Carroll, Finance Director P
From: Financial Controller T
Date: 15 March 20X8 E
R
Subject: Accounting treatment of non-current assets
As requested, this memorandum sets out the appropriate accounting treatment for the non-
2
current assets detailed in today's email.
The three lorries that were stolen should be written off at their NBV first and then the impairment
test should be performed.
Recoverable
NBV Impairment amount
£'000 £'000 £'000
Goodwill 80 (80) –
Intangibles 60 (2.5) 57.5
Vehicles (240- 180 (7.5) 172.5
60)
Sundry net 80 80
assets
Total 400 (90) 310 Higher of VIU and NFV
£80,000 is set against goodwill and the remaining £10,000 is split pro rata between the other
two relevant assets: £2,500 against intangibles (£10,000 × 60,000/(60,000+180,000)) and
£7,500 against vehicles (£10,000 180,000/(60,000+180,000)). There is no need here to restrict
the impairment of the intangibles.
Tutorial note
The calculation of the impairment loss is based on the carrying amount of the business including
the trade payables. Recoverable amount is the fair value less costs to sell of the business as a
whole, with any buyer assuming the liabilities. Otherwise, the impairment test would be based on
the carrying amount of the gross assets (IAS 36.76).
Reporting of assets 75
Development of new product
IAS 38 Intangible Assets divides a development project into a research phase and a development
phase. In the research phase of a project, an entity cannot yet demonstrate that the expenditure
will generate probable future economic benefits. Therefore expenditure on research must be
recognised as an expense when it occurs.
Development expenditure is capitalised when an entity demonstrates all the following.
(a) The technical feasibility of completing the project
(b) Its intention to complete the asset and use or sell it
(c) Its ability to use or sell the asset
(d) That the asset will generate probable future economic benefits
(e) The availability of adequate technical, financial and other resources to complete the
development and to use or sell it
(f) Its ability to reliably measure the expenditure attributable to the asset.
Assuming that all these criteria are met, the cost of the development should comprise all directly
attributable costs necessary to create the asset and to make it capable of operating in the manner
intended by management. Directly attributable costs do not include selling or administrative
costs, or training costs or market research. The cost of upgrading existing machinery can be
recognised as property, plant and equipment. Therefore the expenditure on the project should
be treated as follows:
Recognised in statement of financial
position
Expense Intangible Property,
(income assets plant and
statement) equipment
£m £m £m
Research 6
Prototype design 8
Wage costs 4
Development work 10
Upgrading machinery 6
Market research 4
Training 2
12 22 6
Eco-Ergonom should recognise £22 million as an intangible asset.
Purchase of Homecare
IFRS 3 Business Combinations states that the cost of a business combination is the aggregate of the
fair values of the consideration given. Fair value is measured at the date of exchange. Where any
of the consideration is deferred, the amount should be discounted to its present value. Where
there may be an adjustment to the final cost of the combination contingent on one or more
future events, the amount of the adjustment is included in the cost of the combination at the
acquisition date only if the fair value of the contingent consideration can be measured reliably.
The purchase consideration consists of £20 million paid on the acquisition date plus a further £5
million payable on 31 December 20X8 including £3 million payable only if profits exceed
forecasts. At the acquisition date it appeared that profit forecasts would not be met. However,
under IFRS 3, contingent consideration must be recognised and measured at fair value at the
acquisition date. Therefore the cost of combination at 1 January 20X7 is £24.49 million (£20m +
(£5m 0.898)).
A further issue concerns the valuation and treatment of the 'Homecare' brand name. The brand
name is an internally generated intangible asset of Homecare, and therefore it will not be
recognised in the statement of financial position of Homecare. However, IFRS 3 requires
intangible assets of an acquiree to be recognised if they meet the identifiability criteria in IAS 38
Intangible Assets and their fair value can be measured reliably. For an intangible asset to be
identifiable the asset must be separable or it must arise from contractual or other legal rights. It
appears that these criteria have been met (a brand is separable) and the brand has also been
valued at £4 million for the purpose of the sale to Eco-Ergonom. Therefore the 'Homecare' brand
will be separately recognised in the consolidated statement of financial position.
76 Corporate Reporting
Answers to Interactive questions
Reporting of assets 77
Answer to Interactive question 3
£
Cost (being lower than NRV) 36,000
Depreciation (£36,000/3 years) (12,000)
24,000
78 Corporate Reporting
To calculate the impairment loss, compare the carrying value of £749,000 with the higher of value in
use (£638,000) and fair value less costs to sell (£550,000). The impairment loss is therefore £749,000 –
£638,000 = £111,000.
Reporting of assets 79
(e) The critical event for a cash sale is when delivery takes place and when cash is received; both take
place at the same time.
It would be too cautious or 'prudent' to await cash payment for a credit sale transaction before
recognising the sale, unless the customer is a high credit risk and there is a serious doubt about his
ability or intention to pay.
(f) It would again be over-cautious to wait for clearance of the customer's cheques before recognising
sales revenue. Such a precaution would only be justified in cases where there is a very high risk of
the bank refusing to honour the cheque.
80 Corporate Reporting
CHAPTER 3
Introduction
Topic List
1 IAS 10 Events After the Reporting Period
2 IAS 37 Provisions, Contingent Liabilities and Contingent Assets
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
81
Introduction
Identify the date up to which events after the reporting period should be considered
Demonstrate an understanding of the significance of adjusting events that have occurred
after the reporting period and the need for disclosure of non-adjusting events
Demonstrate an understanding of the requirements of IAS 37 Provisions, Contingent
Liabilities and Contingent Assets
Identify the circumstances in which a provision should be recognised
82 Corporate Reporting
1 IAS 10 Events After the Reporting Period
Section overview
Events after the reporting period are split into adjusting and non-adjusting events. Those events
that may affect the going concern assumption underlying the preparation of the financial
statements must be considered further.
The following is a summary of the material covered in earlier studies.
84 Corporate Reporting
This should be assessed and disclosure made if the liquidation of a major customer or supplier is
likely to influence the economic decisions of users of the financial statements.
Significant customer and supplier relationships are fundamental where an entity relies on one
major supplier. An example of a significant supplier/customer relationship is Intel Corporation and
Dell Inc, where until recently Dell computers have used only Intel microprocessors. Dell relies
almost totally on the ongoing supplier/customer relationship with Intel, and the success of Intel is
vitally important to the future trade of Dell itself.
Contingent liabilities
Evidence may come to light regarding a contingent liability or provision that an entity was unaware of
at the reporting date. The distinction between a contingent liability and a provision is discussed in IAS
37 Provisions, Contingent Liabilities and Contingent Assets. An example of an unknown provision is where,
because of a major fault with goods which were purchased before the reporting date, an electrical retail
chain has had the goods returned after the reporting date. The fault may raise safety issues and the
retailer may have to recall all such items sold within a period of time in order to repair the fault. In such
circumstances, a provision should be recognised for the repair of all items that have been sold prior to
the reporting date. The entity may not have been aware of the problem at the reporting date, but as it
existed at that date, a provision should be recognised in light of the new information.
Requirement
According to IAS 10 Events After the Reporting Period, which amounts should be recognised in Roach's 3
financial statements for the year to 31 May 20X6 to reflect adjusting events after the reporting period?
See Answer at the end of this chapter.
Section overview
The following is a summary of the material covered in earlier studies.
Definition
A provision: A liability where there is uncertainty over its timing or the amount at which it will be
settled.
Recognition
A provision should be recognised when:
– An entity has a present obligation (legal or constructive) as a result of a past event;
– It is probable that there will be an outflow of resources in the form of cash or other assets; and
– A reliable estimate can be made of the amount.
A provision should not be recognised in respect of future operating losses since there is no present
obligation arising from a past event.
Onerous contracts
If future benefits under a contract are expected to be less than the unavoidable costs under it, the
contract is described as onerous. The excess unavoidable costs should be provided for at the time a
contract becomes onerous.
Restructuring costs
A constructive obligation, requiring a provision, only arises in respect of restructuring costs where
the following criteria are met:
– A detailed formal plan has been made, identifying the areas of the business and number of
employees affected with an estimate of likely costs and timescales; and
– An announcement has been made to those who will be affected by the restructuring.
86 Corporate Reporting
Contingent liability
A contingent liability arises where a past event may lead to an entity having a liability in the future
but the financial impact of the event will only be confirmed by the outcome of some future event
not wholly within the entity's control.
A contingent liability should be disclosed in the financial statements unless the possible outflow of
resources is thought to be remote.
Contingent asset
A contingent asset is a potential asset that arises from past events but whose existence can only be
confirmed by the outcome of future events not wholly within an entity's control.
A contingent asset should be disclosed in the financial statements only when the expected inflow
of economic benefits is probable.
Reimbursement
An entity may be entitled to reimbursement from a third party for all or part of the expenditure
required to settle a provision. In these circumstances, an entity generally retains the contractual
obligation to settle the expenditure. A provision and reimbursement are therefore recognised
separately in the statement of financial position. A reimbursement should be recognised only when
it is virtually certain that an amount will be received.
Recognition and disclosure
A full reconciliation of movements in provisions should be presented in the financial statements.
Detailed narrative explanations should also be provided in relation to provisions, contingent C
liabilities and contingent assets. The narrative should include an estimate of the financial amount in H
relation to contingent liabilities and assets as well as indications of uncertainties. A
P
The required disclosures have already been covered at Professional level. In particular, in relation to T
discounting, any increase in the value of the discounted amount arising from the passage of time E
R
or the effect of any change in the discount rate need to be disclosed.
Disclosure let out
3
IAS 37 permits reporting entities to avoid disclosure requirements relating to provisions, contingent
liabilities and contingent assets if they would be expected to be seriously prejudicial to the
position of the entity in dispute with other parties. However, this should only be employed in
extremely rare cases. Details of the general nature of the provision/contingency must still be
provided, together with an explanation of why it has not been disclosed.
Discounting to present value
Where the time value of money is material, the amount of provision should be the present value of
the expenditures required to settle the obligation. The main types of provision where the impact of
discounting may be significant are those relating to decommissioning and other environmental
restoration liabilities. For most other provisions, no discounting will be required as the cash flows
are not sufficiently far into the future.
The discount rate to be used should reflect current market assessments of the time value of money
and the risks specific to the liability (ie it would be a risk adjusted rate). In practice it may be more
appropriate to use a risk-free rate and adjust the cash flows for risk. For further guidance on the
risk-free rate you may refer to your Business Analysis Study Manual. Whichever method is adopted,
it is important not to double count risk.
Unwinding the discount
Where discounting is used, the carrying amount of the provision increases each period to reflect
the passage of time and this is recognised as a finance cost in profit or loss.
88 Corporate Reporting
Interactive question 6: Restructuring [Difficulty level: Intermediate]
(a) An entity has a 31 December year end. The directors approved a major restructuring programme
on 1 December 20X5 and announced the details on the entity's intranet and to the media on 2
December 20X5. The programme involves two stages.
Stage 1 Closure of three production lines during 20X6, the redundancy of 3,000 employees on
31 March 20X6, and the transfer during 20X6 of 500 employees to continuing parts of the
business. All associated costs would be settled during 20X6.
Stage 2 Probable closure of four more production lines during 20X7, with probable redundancies
of 3,500 employees during 20X7. Other staff will be transferred to continuing businesses.
All associated costs would be settled during 20X7. Assume that the details of stage 2 were
formally confirmed on 1 November 20X6.
(b) The entity had some years ago signed a 'take or pay' contract with a supplier, in order to ensure
the reliable supply each year of 100,000 tonnes of critical raw materials to each of the seven
production lines affected by the restructuring programme. Under the contract, the entity must pay
for the 700,000 tonnes each year, even if it decides not to take delivery. This contract falls due for
renewal on 1 January 20X8.
Requirement
How should these matters be recognised in the statement of profit or loss and other comprehensive
income?
See Answer at the end of this chapter.
C
H
A
Interactive question 7: Obligation to dismantle [Difficulty level: Intermediate] P
T
A company is awarded a contract to build and operate a nuclear power station on 1 January 20X1. The E
power station comes into operation on 31 December 20X3 and the operating licence is for 30 years R
from that date.
The construction cost of the power station was £450m. Part of the agreement for the contract was that
3
in addition to building and operating the power station, the company is obliged to dismantle it at the
end of its 30-year life and make the site safe for alternative use. At 31 December 20X3, the estimated
cost of the obligation was £50m.
An appropriate discount rate reflecting market assessments of the time value of money and risks specific
to the power station is 8%.
Requirement
Explain the treatment of the cost of the power station and obligation to dismantle it as at 31 December
20X3 and for the year ended 31 December 20X4.
Work to the nearest £0.1m.
See Answer at the end of this chapter.
Summary
Events after the Reporting Period,
provisions and contingencies
IAS 10 IAS 37
Events after the Provisions and
Reporting Period Contingencies
This is a
Going concern non-adjusting
basis not appropriate. event and the
Disclosure of the numbers in the
change of basis financial statements
to be made in should not be
accordance with changed. However,
IAS 1 Presentation of disclosure should
Financial Statements generally be provided
90 Corporate Reporting
Self-test
IAS 10 Events After the Reporting Period
1 ABC International
ABC International Inc is a company that deals extensively with overseas entities and its financial
statements include a substantial number of foreign currency transactions. The entity also holds a
portfolio of investment properties.
Requirement
Discuss the treatment of the following events after the reporting date.
(a) Between the reporting date of 31 December 20X6 and the authorisation date of 20 March
20X7, there were significant fluctuations in foreign exchange rates that were outside those
normally expected.
(b) The entity obtained independent valuations of its investment properties at the reporting date
based on current prices for similar properties. On 15 March 20X7, market conditions which
included an unexpected rise in interest rates and the expectation of further rises resulted in a
fall in the market value of the investment properties.
(c) A competitor introduced an improved product on 1 February 20X7 that caused a significant
price reduction in the entity's own products.
2 Saimaa
The Saimaa Company operates in the banking industry. It is attempting to sell one of its major
administrative office buildings and relocate its employees. C
H
Saimaa has found a potential buyer, The Nipigon Company, which operates a chain of retail stores. A
Nipigon would like to convert the building into a new retail store but would require planning P
T
permission for this change of use. Nipigon may, however, still consider purchasing the building E
and using it for its own administrative offices if planning permission is declined. It is estimated that R
there is approximately a 50% probability of planning permission being granted.
A contract for sale of the building is to be drawn up in November 20X7 and two alternatives are
3
available:
Contract 1 This sale contract would be made conditional on planning permission being
granted. Thus the contract would be void if planning permission is not granted but
it would otherwise be binding.
Contract 2 This contract would be unconditional and binding, except that the price would vary
according to whether or not planning permission is granted.
The financial statements of Saimaa for the year to 31 December 20X7 are authorised for issue on
28 March 20X8. A decision on planning permission will be made in February 20X8.
Requirement
With respect to the financial statements of Saimaa for the year to 31 December 20X7, and
according to IAS 10 Events After the Reporting Period, indicate whether the granting of planning
permission on each of the contracts is an adjusting event.
3 Quokka
The Quokka Company manufactures balers for agricultural use. The selling price per baler, net of
selling expenses, at 31 December 20X7 is £38,000. Due to increasing competition, however,
Quokka decides to reduce the selling price by £5,000 on 3 January 20X8.
On 4 January 20X8 a health and safety report was delivered to Quokka by the government,
showing that some of its balers were toppling over on moderate gradients. £9,000 per baler would
need to be incurred by Quokka to correct the fault. No further sales could be made without the
correction. Quokka had been unaware of any problem or health and safety investigation until the
report was delivered.
The financial statements of Quokka for the year to 31 December 20X7 are to be authorised for
issue on 23 March 20X8.
92 Corporate Reporting
17% is the pre-tax rate that reflects the time value of money and the risk specific to these liabilities.
Requirement
To the nearest £1 million, what provision should be shown in the statement of financial position of
Wilcox at 31 December 20X7 under IAS 37 Provisions, Contingent Liabilities and Contingent Assets?
8 Yau Enterprise
The Yau Enterprise Company signed a non-cancellable lease for a property, Hyde Court, on 1
January 20X4. The lease was for a period of 10 years, at an annual rental of £480,000 payable in
arrears.
On 31 December 20X7, Yau Enterprise vacated Hyde Court to move to larger premises. Yau
Enterprise has the choice of signing a contract to sub-lease Hyde Court at an annual rental of
£120,000 for the remaining six years of the lease, payable in arrears, or immediately to pay
compensation of £2.2 million to Hyde Court's landlord.
5% is the pre-tax rate that reflects the time value of money and the risk specific to these liabilities.
The cumulative present value of £1 for 6 years at an interest rate of 5% is £5.076.
Requirement
What provision should appear in the statement of financial position of Yau Enterprise at 31
December 20X7 under IAS 37 Provisions, Contingent Liabilities and Contingent Assets?
9 Noble
The Noble Company operates a fleet of commercial aircraft. On 1 April 20X7 a new law was
introduced requiring all operators to use aircraft fitted with fuel-efficient engines only. C
H
At 31 December 20X7 Noble had not fitted any fuel-efficient engines and the total cost of fitting A
them throughout the fleet was estimated at £4.2 million. P
T
Under the terms of the legislation, the company is liable for a fine of £1 million for non-compliance E
with legislation for any calendar year, or part of a year, in which the law has been broken. The R
government rigorously prosecutes all violations of the new law.
The effect of the time value of money is immaterial.
3
Requirement
State the provision required in Noble's financial statements for the year ended 31 December 20X7
under IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
10 Noname
The Noname Company decided to carry out a fundamental restructuring of its papermaking
division which operates in Hyberia. The effect was that most activities carried out in this location
would cease with a number of employees being made redundant, whereas other activities and
employees would relocate to Sidonia where there was unused capacity. Negotiations with
landlords and employee representatives were concluded on 30 December 20X7 and a formal
announcement was made to all employees on 31 December 20X7.
94 Corporate Reporting
Technical reference
1 Authorisation
Process of authorisation of financial statements IAS 10.4
Authorisation date is the date on which financial statements are authorised for IAS 10.5, 10.6
issue to shareholders
The relevant cut-off date for consideration of events after the reporting period is IAS 10.7
the authorisation date
2 Adjusting events
Amounts recognised in financial statements should be adjusted to reflect IAS 10.8, 10.9
adjusting events after the reporting date
Examples of adjusting events include
– Outcome of court case that confirms obligation at reporting date
– Receipt of information on recoverability or value of assets
– Finalisation of profit sharing or bonus payments
– Discovery of fraud or errors C
H
A
3 Non-adjusting events P
T
An entity should not adjust amounts recognised in financial statements for non- IAS 10.10
E
adjusting events after the reporting period R
Subsequent decline of market value of investments
Non-adjusting events may need to be disclosed IAS 10.10 3
Dividends proposed or declared on equity instruments after the reporting date IAS 10.12
cannot be recognised as a liability at the reporting date
Dividends proposed or declared after the reporting date should be disclosed IAS 10.13
5 Disclosure
Date of authorisation to be disclosed IAS 10.17
Disclosures relating to information after the reporting date to be updated in the IAS 10.19
light of new information
For material non-adjusting events after the reporting period an entity shall IAS 10.21
disclose
– Nature of event
– Estimate of financial effect
IAS 37.70-72
Restructuring
IAS 37.78-80
96 Corporate Reporting
Answers to Self-test
98 Corporate Reporting
10 Noname
The total amount recognised in profit or loss is the £385,000 lease provision for the onerous lease +
the £270,000 restructuring provision + the £110,000 impairment losses = £765,000
The five-year lease is not an onerous contract in terms of IAS 37.10 because the premises can be
sublet at profit. The seven-year lease is an onerous contract and under IAS 37.66 the provision
should be measured at (£90,000 – 35,000) seven years = £385,000.
Under IAS 37.80 all the payments to employees should be included in the restructuring provision,
with the exception of the employment costs of £50,000 in preparation for the move to Sidonia and
£37,000 payable to those moving to Sidonia – this relates to the ongoing activities of the business,
so is disallowed by IAS 37.80(b). For the same reason the costs of moving plant and equipment is
disallowed. Impairment losses reduce the carrying amount of the relevant assets rather than
increasing the restructuring provision and revenue less expenses are trading losses which are
disallowed by IAS 37.63. So provision, excluding the onerous lease is £90,000 + 180,000 =
£270,000.
C
H
A
P
T
E
R
The accounting entry to record the unwinding of the discount in 20X1 will be:
C
Dr Finance costs £13,660 H
Cr Provisions £13,660 A
P
T
E
Answer to Interactive question 6 R
(a) Detailed information was made available about who would be affected by Stage 1 and when the
various steps in the first stage of the closure programme would take place.
3
The announcement about Stage 2 was more of an overview. It was not until 1 November 20X6
that information was announced in respect of Stage 2 in as much detail as that provided in
December 20X5 about Stage 1. There is a constructive obligation in respect of Stage 1 on 2
December 20X5, no such obligation in respect of Stage 2 is made until 1 November 20X6.
Although the announcement is made as a single restructuring programme, there will be two
entirely separate restructuring provisions.
The costs of this major programme will be recognised in profit or loss for the years ending 31
December 20X5 – 20X7 as follows.
Reason Stage 1 Stage 2
Termination payments to those taking voluntary Restructuring 20X5 20X6
redundancy provision
Termination payments to those being made Restructuring 20X5 20X6
compulsorily redundant provision
Employment costs during closing down activities Restructuring 20X5 20X6
and selling off inventory provision
One-off payments to employees agreeing to Continuing 20X6 20X7
move to continuing parts of the business activities
Cost of moving plant and equipment to Continuing 20X6 20X7
continuing parts of the business activities
Cost of moving saleable inventory to continuing Continuing 20X6 20X7
parts of the business activities
Introduction
Topic List
IAS 17 Leases
1 Overview of material covered in earlier studies
2 Evaluating the substance of transactions involving the legal form of a lease – SIC
27 and Operating lease incentives – SIC 15
3 Determining Whether an Arrangement Contains a Lease – IFRIC 4
4 Current developments
5 IAS 20 Accounting For Government Grants and Disclosure of Government Assistance
6 IAS 23 Borrowing Costs
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
103
Introduction
Apply and discuss the classification of leases for lessees and lessors in accordance with
IAS 17 Leases
Account for and discuss government grants in accordance with IAS 20 Government Grants
Account for and discuss borrowing costs in accordance with IAS 23 Borrowing Costs
Section overview
IAS 17 Leases was the first Standard to address the problem of substance over form.
The correct treatment of the transaction in the financial statements of both the lessee and the
lessor is determined by the commercial substance of the lease. The legal form of any lease is that
the title to the asset remains with the lessor.
The approach to lessor accounting is very similar to that for lessee accounting, the key difference
being the inclusion of 'unguaranteed residual value'.
A lease that transfers substantially all the A lease other than a finance lease
risks and rewards incidental to
ownership of an asset to the lessee. Title
may or may not eventually be transferred
Accounting treatment
Capitalise asset and recognise liability at Rentals are charged to profit or loss on a
fair value of leased property or, if lower, straight-line basis over the lease term
present value of minimum lease payments unless another systematic basis is
representative of the user's benefit
Add initial direct costs (incremental costs Incentives to sign operating leases (and
directly attributable to negotiating and initial reverse premiums or rent-free
arranging a lease) to amount recognised as periods) are spread over the life of the
an asset operating lease reducing the overall
payments on the lease charged to profit or
loss (SIC–15) C
H
(see also Section 2)
A
P
Depreciate asset over the shorter of the
T
useful life and the lease term including any E
secondary period (useful life if reasonable R
certainty the lessee will obtain ownership)
Apply finance charge so as to give a constant
4
rate on the outstanding liability (using the
interest rate implicit in the lease)
Rental payments are split between the
finance charge element and the repayment of
capital
Definitions
Lease term: The non-cancellable period for which the lessee has contracted to lease the asset together
with any further terms for which the lessee has the option to continue to lease the asset, with or without
further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise
the option.
Minimum lease payments: The payments over the lease term that the lessee is, or can be required, to
make (excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the
lessor) plus any amounts guaranteed by the lessee or by a party related to the lessee.
Substance
Risks and rewards with the lessee (or Risks and rewards with the lessor
other third parties)
Accounting treatment
Recognise a receivable equal to 'net Asset retained in the books of the lessor and is
investment in the lease'. This is the depreciated over its useful life
gross investment (minimum lease
payments plus any unguaranteed residual
value (see below) accruing to the lessor)
discounted at the interest rate implicit in
the lease
Initial direct costs incurred by the lessor Rentals are credited to profit or loss on a
are not added separately to the net straight line basis over the lease term unless
C
investment as they are already included in another systematic basis is more representative H
the discounted figures since they are A
included in the calculation of the interest P
rate implicit in the lease (reducing the T
E
return) R
Finance income is recognised reflecting
constant periodic rate of return on the
lessor's net investment outstanding 4
Note: Any guaranteed residual amount accruing to the lessor will be included in the minimum lease
payments.
You should now be able to see the scope for manipulation involving lease classification. Whether or
not a lease is classified as a finance lease can hinge on the size of the unguaranteed residual amount due
to the lessor, and that figure will only be an estimate. A lessor might be persuaded to estimate a larger
residual amount than he would otherwise have done and cause the lease to fail the test on present value
of lease payments approximating to the asset's fair value, rather than lose the business.
Requirements
(a) Calculate the unguaranteed residual value and the net investment in the lease as at 1 January 20X1
(b) Prepare extracts from the financial statements of the lessor for the year ended 31.12.X1 (excluding
notes)
See Answer at the end of this chapter.
Requirement
How should the transaction be recognised by the dealer in the year ending 31 December 20X5?
See Answer at the end of this chapter.
The initial costs incurred by the dealer or manufacturer in negotiating and arranging the lease should
not be recognised as part of the initial finance receivable in the way that they are by other types of
lessors. Such costs are instead expensed at the start of the lease arrangement, because they are 'mainly
related to earning the manufacturer's or dealer's selling profit'.
Because of IAS 36's provisions in respect of impairment testing any excess of an asset's carrying amount
over recoverable amount should be recognised as an impairment loss before the sale and finance
leaseback transaction is recognised.
Profit Defer and amortise Defer and amortise Defer and amortise
profit (sale price less fair profit (Note 2)
value)
Recognise
immediately (fair
value less carrying
amount)
Loss No loss No loss Note 1
Note 1
IAS 17 requires the carrying amount of an asset to be written down to fair value where it is subject to a
sale and leaseback.
Note 2
Profit is the difference between fair value and sale price because the carrying amount would have been
written down to fair value in accordance with IAS 17.
Section overview
Entities sometimes enter into a series of structured transactions that involve the legal form of a
lease. These are addressed by SIC 27.
In negotiating a new operating lease, the lessor may provide incentives to the lessee. These are
dealt with by SIC 15.
Section overview
Sometimes entities enter into transactions that may contain a lease even though they do not take
the legal form of a lease. These are addressed by IFRIC 4.
Yes
Is arrangement dependent
on use of a specific asset? No
May be Not a
. Implicitly specified Lease
. Explicitly identified
Yes
Yes
Arrangement
contains a lease
Requirement
Does the arrangement contain a lease within the scope of IAS 17 Leases?
Solution
Yes. The arrangement contains a lease within the scope of IAS 17 Leases.
The first condition, ie the existence of an asset (which in this case is specifically identified) is fulfilled.
The second condition is also fulfilled as it is remote that one or more parties other than the purchaser
will take more than an insignificant amount of the facility's output and the price the purchaser will pay is
not contractually fixed per unit of output nor equal to the market price at the time of delivery.
Section overview
The IASB has decided to undertake a leasing project with the objective of developing a single
method of accounting for leases that would not rely on the distinction between operating and
finance leases.
The distinction between classification of a lease as an operating or finance lease has a considerable
impact on the financial statements, most notably on indebtedness, gearing ratios, ROCE and interest
cover. It is argued that the current accounting treatment of operating leases is inconsistent with the
definition of assets and liabilities in the IASB's Framework.
There have therefore been calls for the capitalisation of non-cancellable operating leases in the
statement of financial position on the grounds that if non-cancellable, they meet the definitions of assets
and liabilities, giving similar rights and obligations as finance leases over the period of the lease.
Leasing had been on the IASB's agenda for some time when in May 2003 the IASB decided to actively
undertake a project with the objective of developing a single method of accounting for leases that is
consistent with the Framework. The single method would not rely on a distinction between operating
and finance leases.
It has subsequently been decided to scope lessor accounting out of the project and concentrate only on
lessee accounting initially. An exposure draft of the IASB's proposals was issued in August 2010. This is
not examinable, but is included here to give an awareness of how things are likely to develop.
Below are the main changes, which would affect both lessees and lessors unless otherwise stated:
(a) The current IAS 17 model of classification of leases would cease to exist.
(b) Lessees would no longer be permitted to treat leases as 'off-balance sheet' financing, but
instead would be required to recognise an asset and liability for all leases within the scope of the
proposed standard.
(c) For leases currently classified as operating leases, rent expense would be replaced with
amortisation expense and interest expense. Total expense would be recognised earlier in the
lease term.
(d) The lease liability would include estimates of contingent rentals, residual value guarantees, and
term option penalties. An expected outcome approach would be used.
(e) Rentals during renewal periods would be included as part of the lease liability on the basis of
the longest possible lease term that is more likely to occur than not.
(f) If the facts or circumstances indicate that there will be a significant change in lease payments and
renewal periods, then the estimates of these must be revised.
(g) The proposed standard has two accounting models for lessors:
(i) Performance obligation approach. This is used by lessors who retain exposure to significant
risks or benefits associated with the underlying asset.
(ii) Derecognition approach. This is used by lessors who do not retain exposure to significant
risks or benefits associated with the underlying asset.
Reaction to the August 2010 Exposure Draft
Many respondents commented that the proposed approach was overly complex, expensive, and in
some cases, inconsistent with the economics of the underlying transactions. In response, the IASB
made a number of significant changes to their original proposals for lessee accounting.
• Lease terms would typically be shortened – optional periods are included only if there is a
significant economic incentive to extend.
• More non-lease costs would be separated from the lease, reducing amounts recognised on the
statement of financial position.
Section overview
This section gives a very brief overview of the material covered in earlier studies.
Definitions
Government assistance: Action by government designed to provide an economic benefit specific to an
entity or range of entities qualifying under certain criteria.
Government grants: Assistance by government in the form of transfers of resources to an entity in
return for past or future compliance with certain conditions relating to the operating activities of the
entity. They exclude those forms of government assistance which cannot reasonably have a value placed
upon them and transactions with government which cannot be distinguished from the normal trading
transactions of the entity.
Grants related to assets: Government grants whose primary condition is that an entity qualifying for
them should purchase, construct or otherwise acquire long-term assets. Subsidiary conditions may also
be attached restricting the type or location of the assets or the periods during which they are to be
acquired or held.
Grants related to income: Government grants other than those related to assets.
C
Forgivable loans: Loans which the lender undertakes to waive repayment of under certain prescribed H
conditions. A
P
T
E
Accounting treatment R
Recognise government grants and forgivable loans once conditions complied with and
receipt/waiver is assured.
4
Grants are recognised under the income approach: recognise grants as income to match them
with related costs that they have been received to compensate.
Use a systematic basis of matching over the relevant periods.
Grants for depreciable assets should be recognised as income on the same basis as the asset is
depreciated.
Grants for non-depreciable assets should be recognised as income over the periods in which the
cost of meeting the obligation is incurred.
A grant may be split into parts and allocated on different bases where there are a series of
conditions attached.
Where related costs have already been incurred, the grant may be recognised as income in full
immediately.
A grant in the form of a non-monetary asset may be valued at fair value or a nominal value.
Section overview
This section gives a very brief overview of the material covered in earlier studies.
IAS 23 deals with the treatment of borrowing costs, often associated with the construction of self-
constructed assets, but which can also be applied to an asset purchased that takes time to get
ready for use/sale.
Definitions
Borrowing costs: Interest and other costs incurred by an entity in connection with the borrowing of
funds.
Qualifying asset: An asset that necessarily takes a substantial period of time to get ready for its
intended use or sale.
Until the IASB issued a revised IAS 23 in 2007, entities had the choice of whether to account for 'directly
attributable' borrowing costs as part of the cost of the asset or as an expense in profit or loss. The
revised IAS 23 removes the option of recognising them as an expense. It is mandatory for accounting
periods beginning on or after 1 January 2009.
The revised standard is now consistent with US GAAP and was developed as part of the convergence
project being undertaken with the US FASB. The IASB believes that the new standard will improve
financial reporting in three ways:
The cost of an asset will in future include all costs incurred in getting it ready for use or sale
Comparability is enhanced because the choice in previous accounting treatments is removed
The revision to IAS 23 achieves convergence in practice with US GAAP
Disclosure
Amount of borrowing costs capitalised during the period
Capitalisation rate used to determine borrowing costs eligible for capitalisation
Requirement
Ignoring compound interest, calculate the borrowing costs which must be capitalised for each of the
assets and consequently the cost of each asset as at 31 December 20X8. C
See Answer at the end of this chapter. H
A
P
T
E
Interactive question 9: Borrowing cost 2 [Difficulty level: Exam standard]
R
Zenzi Co had the following loans in place at the beginning and end of 20X8.
1 January 31 December
4
20X8 20X8
£m £m
10.0% Bank loan repayable 20Y3 120 120
9.5% Bank loan repayable 20Y1 80 80
8.9% debenture repayable 20Y8 – 150
The 8.9% debenture was issued to fund the construction of a qualifying asset (a piece of mining
equipment), construction of which began on 1 July 20X8.
On 1 January 20X8, Zenzi Co began construction of a qualifying asset, a piece of machinery for a hydro-
electric plant, using existing borrowings. Expenditure drawn down for the construction was: £30m on
1 January 20X8, £20m on 1 October 20X8.
Requirement
Calculate the borrowing costs to be capitalised for the hydro-electric plant machine.
See Answer at the end of this chapter.
Summary
Leases
Finance Operating
leases leases
Repayments: Receipts:
· Split between · Split between
finance charge and finance income
capital and capital
· Allocate using · Allocate using
actuarial method actuarial method
or sum of digits
method
The Mocken Company enters into a sale and leaseback arrangement which results in a finance
lease for five years from 1 January 20X7. The agreement is with its bank in respect of a major piece
4
of equipment that Mocken currently owns. The residual value of the equipment after five years is
zero.
The carrying amount of equipment at 1 January 20X7 is £140,000. The sale proceeds are at fair
value at 1 January 20X7 of £240,000. There are five annual rentals each of £56,000 payable
annually in advance.
Mocken recognises depreciation on all non-current assets on a straight-line basis. Finance charges
on a finance lease are recognised on a sum of digits basis.
Requirement
What total amount should be recognised in the profit or loss of Mocken in respect of the sale and
leaseback arrangement for the year to 31 December 20X7 according IAS 17 Leases?
IAS 17 Leases
1 Lease classification
If substantially all of the risks and rewards of ownership are transferred to the IAS 17.4
lessee, then a lease is a finance lease (Note. 90% rule for UK GAAP). Factors:
Land and buildings elements within a single lease are classified separately IAS 17.15
(Note: Together, usually as operating lease, for UK GAAP)
Can be a lease even if lessor obliged to provide substantial services IAS 17.3
2 Finance lease
Non-current asset and liability for the asset's fair value (or PV of minimum lease
payments, if lower): IAS 17.20
Depreciate asset over its useful life, or the lease term if shorter and no IAS 17.27
reasonable certainty that lessee will obtain ownership at end of lease
Consider whether IAS 36 impairment procedures needed IAS 17.30 C
H
Debit lease payments to liability, without separating into capital and interest
A
Charge lease interest to profit or loss and credit lease liability P
T
Charge interest so as to produce constant periodic rate of charge on reducing IAS 17.25 E
R
liability – approximations allowed
Disclosures:
4
– Show carrying value of each class of leased assets IAS 17.31
– In the statement of financial position split the liability between current and IAS 17.23
non-current
– In a note, show analysis of total liability over amounts payable in 1, 2 to 5 IAS 17.31(b)
and over five years, both gross and net of finance charges allocated to
future periods
– General description of material leasing arrangements IAS 17.31(e)
4 Lessor accounting
Finance lease:
Recognise a receivable measured at an amount equal to the net investment in IAS 17.36
the lease
Net investment in the lease is the gross investment in the lease discounted at IAS 17.4
the interest rate implicit in the lease
Include initial direct costs incurred but exclude general overheads IAS 17.38
Operating lease:
– The asset should be recorded in the statement of financial position IAS 17.49
according to its nature
– Operating lease income should be recognised on a straight-line basis over IAS 17.50
the lease term, unless another basis is more appropriate
– Asset should be depreciated as per other similar assets IAS 17.53
– IAS 36 should be applied to determine whether the asset is impaired IAS 17.54
1 Treatment
Should only be recognised if reasonable assurance that: IAS 20 (7)
Manner in which received does not affect accounting method adopted IAS 20 (9)
Should be recognised as income over periods necessary to match with related IAS 20 (12)
costs
Income approach, where grant is taken to income over one or more periods IAS 20 (13)
should be adopted
Grants should not be accounted for on a cash basis IAS 20 (16)
Grants in recognition of specific expenses are recognised as income in same IAS 20 (17)
period as expense
Grants related to depreciable assets usually recognised in proportion to IAS 20 (17)
depreciation
Grants related to non-depreciable assets requiring fulfilment of certain IAS 20 (18)
obligations should be recognised as income over periods which bear the cost of
meeting obligations
Grant received as compensation for expenses already incurred recognised in IAS 20 (20)
period in which receivable
Non-monetary grants should be measured at fair value IAS 20 (23)
IAS 20 (29)
3 Presentation of grants related to income
C
Either: H
A
– Recognised in profit or loss as income separately or under a general P
heading or T
E
– Deducted in arriving at the amount of the related expense recognised in R
profit or loss
4 Repayment of government grants
4
Accounted for as a revision to an accounting estimate IAS 20 (32)
5 Government assistance
The following forms of government assistance are excluded from the definition IAS 20 (34-35)
of government grants:
– Assistance which cannot reasonably have a value placed on it
– Transactions with government which cannot be distinguished from the
normal trading transactions of the entity
6 Disclosures
Required disclosures IAS 20 (39)
1 Hypericum
Machine Z
IAS 17.20 requires that assets under finance leases should be stated at the lower of the fair value
and the present value of the minimum lease payments. The latter amount is calculated as:
Cash flows(£) 10% discount factor PV(£)
100,000 1.0 100,000
100,000 1/1.1 90,909
100,000 1/(1.1 × 1.1) 82,645
273,554
4 Szczytno
(a) £26,886
(b) £49,405
(c) £578,286
(b) The annual rental is allocated between the two elements in proportion to the relative fair
values of the leasehold interest (IAS 17.16), so the amount allocated to the building element
is:
£43,600 607,000/(607,000 + 90,000) = £37,970
The present value over 35 years is £37,970 15.368 = £583,523.
This amount is recognised as a non-current asset and a liability.
The 20X7 depreciation charge on the asset is £583,523/35 = £16,672, while since the lease
payments are in advance, the finance charge is £(583,523 – 37,970) 6% = £32,733.
The total effect on profit or loss is £16,672 + £32,733 = £49,405.
(c) The liability at the year end is £583,523 – £37,970 + £32,733 interest = £578,286.
5 Bodgit
Accounting
Type of sale and leaseback
The transaction includes two elements:
Sale and leaseback of the property itself, and
Sale and leaseback of the land on which the property stands.
In the case of the leaseback of the land on which the property stands, IAS 17 requires the lease to
be classified as an operating lease.
As regards the property, from the information provided, it would appear that Bodgit Ltd has
entered into a sale and finance leaseback.
The key factors which indicate this are as follows.
The lease term of 20 years. This is not a long period of time for property, so does not clarify
the situation.
Rentals. The present value of discounted future rentals relating to the property is (4/5 ×
£95,000) × 20-year annuity discount factor @ 12%, ie £76,000 × 7.469 = £567,644. This is
approximately 95% of fair market value of 4/5 × £750,000 = £600,000.
Accounting treatment
The land and building should be derecognised in Bodgit's accounts and a profit or loss calculated
based upon the difference between the proportion of the proceeds allocated to each element (land
being 1/5 × £750,000 = £150,000 and the building being the remaining £600,000) and their
carrying value.
Based on the original cost to Bodgit of the factory (including land) of £200,000, this is likely to
result in a profit in both cases.
C
H
A
P
T
E
R
WORKING
Bal b/f Interest accrued at 10% Payment 31 Bal c/f 31 Dec
Dec
£ £ £ £
80,000
(5,800)
20X1 74,200 7,420 (16,000) 65,620
20X2 65,620 6,562 (16,000) 56,182
(ii) If the lessor is unable to sell the asset for the value guaranteed by the lessee, the lessee has a
liability to make up the difference of £8,000 – £6,000 = £2,000:
Recognise impairment loss on asset (as soon as known during the lease term):
Dr Profit or loss £2,000
Cr Asset carrying amount £2,000
Make guaranteed payment to lessor and derecognise the asset and lease liability:
Dr Finance lease liability £8,000
Cr Cash £2,000
Cr Asset carrying amount £6,000
WORKING
Net investment in finance lease
Interest
Instalments in income at C
Bal b/f advance c/f 11% Bal c/f 31 Dec H
£ £ £ £ £ A
20X1 83,676 (22,000) 61,676 6,784 68,460 P
20X2 68,460 (22,000) 46,460 T
E
R
Answer to Interactive question 3
The transaction will be recognised by the entity as follows.
4
1 January 20X5 Derecognise £5 million investment property asset
Recognise £5 million finance lease receivable
Recognise £400,000 cash received as a reduction in the receivable
Note that the net investment in the lease is equal to the fair value of the asset plus any costs incurred by
the lessor. In this case there were no such costs and therefore the fair value of the asset is the net
investment in the lease.
31 December 20X5 Increase the receivable by £381,800 (8.3% (£5,000,000 – £400,000))
Recognise finance income of £381,800 in profit or loss
WORKING
Instalments in Interest income Bal c/f
Bal b/f advance c/f at 8% 31 Dec
£ £ £ £ £
20X5 24,351 (8,750) 15,601 1,248 16,849
C
H
A
P
T
E
R
Financial instruments –
presentation and disclosure
Introduction
Topic List
IAS 32 Financial Instruments: Presentation
1 Overview of material from earlier studies
IFRS 7 Financial Instruments: Disclosures
2 Objective and scope
3 Disclosures in financial statements
4 Other disclosures
5 Financial instruments risk disclosure
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
135
Introduction
Prepare and present extracts of financial statements in accordance with IFRS 7 Financial
Instruments: Disclosures
Section overview
IAS 32 applies to all entities and to all types of financial instruments except where explicitly
covered by another standard such as IFRS 10 for subsidiaries and IAS 28 for associates and joint
ventures.
A financial instrument should be classified as either equity, financial liability or financial asset. This
classification is made at the time the financial instrument is issued and not changed subsequently.
Compound financial instruments, ie instruments that contain both a liability and an equity
component should be split into their component parts at the date they are issued.
Interest, dividends, losses and gains arising from financial instruments classified as financial
liabilities are recognised in the profit or loss for the year. Dividends paid to holders of a financial
instrument classified as equity are charged directly against equity.
Financial assets and financial liabilities are presented as separate items in the statement of financial
position with offset being allowed only in limited cases.
Treasury shares are deducted from equity with the consideration paid or received recognised
directly in equity. Gains or losses on the purchase, sale, issue or cancellation of equity instruments
are not recognised in profit or loss.
C
H
A
Interactive question 3: Convertible bond 1 [Difficulty level: Exam standard] P
T
An entity issues a convertible bond for £1,000. The bond is convertible into equity shares of the issuer at E
the discretion of the holder at any time in the next ten years. The bond converts into a variable number R
of shares equal to the value of the liability.
The entity also issues £7,000 of 8% convertible redeemable preference shares. In five years' time the
5
preference shares will either be redeemed or converted into 5,000 equity shares of the issuer, at the
option of either the holder or issuer.
Section overview
This section discusses the objectives and sets out the scope of IFRS 7 Financial Instruments:
Disclosures.
2.2 Scope
IFRS 7 applies to all entities and to all types of financial instruments, except instruments that are
specifically covered by other standards. Examples of financial instruments not covered by IFRS 7
include:
Interests in subsidiaries, associates and joint ventures that are accounted for in accordance with
IFRS 10 Consolidated Financial Statements or IAS 28 Investments in Associates and Joint Ventures.
Employers' rights and obligations arising from employee benefit plans, to which IAS 19 Employee
Benefits applies.
Insurance contracts as defined in IFRS 4 Insurance Contracts.
Financial instruments, contracts and obligations under share-based payment transactions to which
IFRS 2 Share-based Payment applies.
IFRS 7 applies to recognised and unrecognised financial instruments. Recognised financial instruments
include financial assets and financial liabilities that are within the scope of IAS 39. Unrecognised financial
instruments include some financial instruments that, although outside the scope of IAS 39, are within
the scope of IFRS 7 (such as some loan commitments).
IFRS 7 also applies to contracts to buy or sell a non-financial item that are within the scope of IAS 39
because they can be settled net and there is not the expectation of delivery, receipt or use in the
ordinary course of business.
Section overview
This section discusses the basic disclosures required by IFRS 7 in the financial statements.
Amount of change in fair value total amount of Amount of change in fair value
attributed to credit risk change in fair value attributed to market risk
Amount of change in fair value total amount of Amount of change in fair value
attributed to credit risk change in fair value attributed to market risk
3.1.4 Reclassification
If an entity has reclassified a financial asset, previously measured at fair value as measured at cost or
amortised cost or vice versa, it should disclose the amount reclassified into and out of each category
and the reason for that reclassification.
3.1.5 Derecognition
An entity may have transferred financial assets in such a way that part or all of the financial assets do
not qualify for de-recognition. In such a case, the entity should disclose for each class of financial
assets:
The nature of the assets
The nature of the risks and rewards of ownership to which the entity remains exposed
When the entity continues to recognise all of the assets, the carrying amounts of the assets and of
the associated liabilities; and
When the entity continues to recognise the assets to the extent of its continuing involvement, the
total carrying amount of the original assets, the amount of the assets that the entity continues
to recognise, and the carrying amount of the associated liabilities.
3.1.6 Collateral
An entity should disclose:
The carrying amount of financial assets it has pledged as collateral for liabilities or contingent
liabilities, including amounts that have been reclassified
The terms and conditions relating to its pledge
4 Other disclosures
Section overview
This section discusses additional quantitative and qualitative disclosures in the financial C
statements. H
A
P
T
4.1 Accounting policies E
R
An entity should disclose, in the summary of significant accounting policies, the measurement basis (or
bases) used in preparing the financial statements and the other accounting policies used that are
relevant to an understanding of the financial statements. 5
Section overview
An entity should disclose information that enables users of its financial statements to evaluate the
nature and extent of risks arising from financial instruments to which the entity is exposed at the
reporting date. These risks include, but are not limited to, credit risk, liquidity risk and market risk.
Credit risk The risk that one party to a financial instrument will cause a financial loss for the
other party by failing to discharge an obligation.
Currency risk The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in foreign exchange rates.
Interest rate risk The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market interest rates.
Liquidity risk The risk that an entity will encounter difficulty in meeting obligations associated
with financial liabilities.
Loans payable Loans payable are financial liabilities, other than short-term trade payables on
normal credit terms.
Market risk The risk that the fair value or future cash flows of a financial instrument will C
fluctuate because of changes in market prices. Market risk comprises three types H
of risk: currency risk, interest rate risk and other price risk. A
P
Other price risk The risk that the fair value or future cash flows of a financial instrument will T
fluctuate because of changes in market prices (other than those arising from E
interest rate risk or currency risk), whether those changes are caused by factors R
specific to the individual financial instrument or its issuer, or factors affecting all
similar financial instruments traded in the market.
5
Past due A financial asset is past due when a counterparty has failed to make a payment
when contractually due.
C
H
A
P
T
E
R
Summary
Interest income
on impaired
Defaults and breaches financial assets
Amount of
impairment loss
for each class of
financial asset
Presentation in financial
statements
Liability or equity
C
H
A
P
T
E
R
2 Compound instruments
Recognising liability and equity elements IAS 32.28
C
H
A
P
T
E
R
The equity component of the gross proceeds is therefore (50,000 – 48,240) £1,760.
The issue costs of £1,000 are split in the ratio 48,240:1,760, ie £965 is netted against the liability and
£35 is netted against the equity.
The entries are therefore:
£ £
Dr Cash 50,000
C
Cr Liability 48,240 H
Cr Equity 1,760 A
and P
Cr Cash 1,000 T
Dr Liability 965 E
Dr Equity 35 R
The net liability initially recognised is £47,275. This is then amortised to £50,000 over the next two
years at an effective interest rate of 11.19% (the IRR of the cash flows of £47,275, –£4,000 and 5
–£54,000) as follows:
Financial instruments –
recognition and
measurement
Introduction
Topic List
1 Introduction and overview of earlier studies
2 Recognition and derecognition
3 Measurement and impairment
4 Derivatives
5 Embedded derivatives
6 IFRS 9 Financial Instruments and current developments
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
155
Introduction
Apply and discuss the recognition, measurement and derecognition of financial assets and
financial liabilities
Apply and discuss the treatment of gains and losses arising on financial assets and financial
liabilities
IAS 32
– Financial instruments should be presented as assets, liabilities or equity in the statement of 6
financial position.
– Compound financial instruments should be split between their liability and equity
components.
– Interest, dividends, gains and losses should be presented in a manner consistent with the
classification of the related instrument.
– Financial assets and financial liabilities can only be offset in limited circumstances.
IAS 39
– A financial instrument should initially be measured at fair value, usually including transaction
costs.
– Subsequent re-measurement depends upon how the financial asset or financial liability is
classified.
– Financial assets and liabilities should be measured either at fair value or at amortised cost.
– IAS 39 contains detailed requirements regarding the derecognition of financial instruments.
– Financial assets (other than assets recognised at fair value through profit or loss, and fair
value can be measured reliably) should be reviewed at each reporting date for objective
evidence of impairment.
IFRS 9
– Simplifies the requirements of IAS 39
– A work in progress. IAS 39 remains the main standard on recognition and measurement of
financial instruments, but it is important to have an awareness of IFRS 9.
1.1 Introduction
The purpose of this chapter is to provide a thorough coverage of the accounting treatment of financial
instruments. The main presentation and disclosure requirements as detailed in IAS 32 Financial
Instruments: Presentation and IFRS 7 Financial Instruments: Disclosures together with certain aspects of
recognition and measurement of IAS 39 Financial Instruments: Recognition and Measurement have already
been covered at professional level. This chapter extends the coverage of recognition and derecognition
of financial assets and liabilities, their initial and subsequent measurement and impairment, and finally
discusses particular issues relating to the definition of derivatives and the accounting treatment of
derivatives and embedded derivatives.
Measurement
Asset after initial Gains
category Description recognition and losses
Financial assets at Any financial asset which is held for the Fair value In profit or loss
fair value through purpose of selling in the short term (held for
profit or loss trading) or, in limited circumstances, is
designated under this heading.
Loans and Non-derivative financial assets with fixed or Amortised cost In profit or loss
receivables determinable payments that are:
Not quoted in an active market
Not designated as at fair value through
profit or loss
Not held for trading or designated as
available for sale
(ie loans and receivables are none of the above)
Held-to-maturity Non-derivative financial assets with fixed or Amortised cost In profit or loss
investments determinable payments and fixed maturity
that an entity has the positive intention and
ability to hold to maturity and are not
designated/classified under any of the other
three headings.
Note: These categories are simplified under IFRS 9 (see Section 6), but this standard is incomplete, so
the IAS 39 categories should be used in questions unless asked specifically for the IFRS 9 ones.
Measurement
Liability after initial Gains
category Description recognition and losses
Financial liabilities Any financial liability which is held for the Fair value In profit or loss
at fair value purpose of selling in the short term (held for
through profit or trading) or, in limited circumstances, is
loss designated under this heading.
Other liabilities Financial liabilities that are not classified as at Amortised cost In profit or loss
fair value through profit or loss.
2.1 Introduction 6
IAS 39 requires that a financial asset or a financial liability should be recognised by an entity in its
statement of financial position when the entity becomes a party to the contractual provisions of the
financial asset or financial liability.
IAS 39 also requires that a financial asset or financial liability should be derecognised, that is removed,
from an entity's statement of financial position, when the entity ceases to be a party to the financial
instrument's contractual provisions.
The recognition of financial instruments is in general more straightforward than derecognition and IAS
39 pays more attention to establishing rules for the latter.
Solution
Trade date accounting
On 27 December 20X4, the entity should recognise the financial asset and the liability to the
counterparty at £1,000.
At 31 December 20X4, the financial asset should be remeasured to £1,005 and a gain of £5
recognised in profit or loss.
On 5 January 20X5, the liability to the counterparty of £1,000 will be paid in cash. The fair value of
the financial asset should be remeasured to £1,007 and a further gain of £2 recognised in profit or
loss.
Settlement date accounting
No transaction should be recognised on 27 December 20X4.
On 31 December 20X4, a receivable of £5 should be recognised (equal to the fair value movement
since the trade date) and the gain recognised in profit or loss.
On 5 January 20X5, the financial asset should be recognised at its fair value of £1,007. The
receivable should be derecognised, the payment of cash to the counterparty recognised and the
further gain of £2 recognised in profit or loss.
In practice, many entities use settlement date accounting but apply it to the actual date of settlement
rather than when payment is due.
(a) The contractual rights to the cash flows from the financial asset expire, or
(b) The entity transfers substantially all the risks and rewards of ownership of the financial asset to 6
another party.
Derecognition of a financial asset is often straightforward as the above criteria can be implemented
easily. For example, a trade receivable should be derecognised when an entity collects payment. The
collection of payment signifies the end of any exposure to risks or any continuing involvement.
However, more complex transactions may involve the transfer of legal title to another entity but only a
partial transfer of risks and rewards, so that the original owner of the asset is still exposed to some of the
risks and rewards of owning the asset. This is discussed further below.
Solution
IAS 39 includes the following examples:
(a) (i) An unconditional sale of a financial asset.
(ii) A sale of a financial asset together with an option to repurchase the financial asset at its fair
value at the time of repurchase. Because any repurchase is at the then fair value, all risks and
rewards of ownership are with the buying party.
(b) (i) A sale and repurchase transaction where the repurchase price is a fixed price or at the sale
price plus a lender's return.
(ii) A sale of a financial asset together with a total return swap that transfers the market risk
exposure back to the entity.
Solution
On derecognition of a financial asset the difference between the carrying amount and any consideration
received should be recognised in profit or loss. On the assumption that the asset was not remeasured
during the year, the carrying amount of 50% of the asset is £30,000. The proceeds from the sale of 50%
of the asset is £40,000, yielding a gain of £10,000 to be recognised in profit or loss.
No
No
Yes
No
No
Yes
2.4.5 Factoring
Factoring activity tends to increase as banks become reluctant to lend. This has been the case during the
credit crunch of 2008, continuing to the present day.
In a factoring transaction, one party transfers the right to some receivables to another party for an
immediate cash payment. Factoring arrangements are either with recourse or without recourse.
(a) In factoring without recourse, the transferor does not provide any guarantees about the
performance of the receivables. In such a transaction the entity has transferred the risks and
rewards of ownership and should derecognise the receivables.
(b) In factoring with recourse, the transferor fully or partially guarantees the performance of the
receivables. The transferor has not therefore transferred fully the risks to another party. In most
factoring with recourse transactions, the transferor does not allow the transferee to sell the
receivables, in which case the transferor still retains control over the asset. In this case the criteria
for derecognition are not satisfied and the asset should not be derecognised.
Entity A carries in its statement of financial position receivables measured at £10m. It sells the
receivables in a factoring transaction with full recourse to Entity B for £8.5m of cash. Entity A
guarantees to reimburse Entity B in cash if the receivables realise less than £8.5m.
In this example Entity A has transferred the right to receive the receivables to Entity B but it has not
transferred all the risks. The asset should not be derecognised. The cash received should be credited to a
liability account (in essence a loan from the factor).
2.4.6 Securitisations
Securitisation is the process whereby an originator packages pools of, for instance, loans, receivables or
the rights to future income streams that it owns and then sells the packages. Investors buy the
repackaged assets by providing finance in the form of securities or loans which are secured on the
underlying pool and its associated income stream. Securitisation thereby converts the originator's illiquid
assets into liquid assets.
Illustration: Securitisation
Some football clubs have needed to raise cash quickly to buy players. They have therefore obtained
immediate cash which has been securitised to the lender by the rights to the income from the first
tranche of future season ticket sales.
Another example is a bank that has extended mortgages to individuals. It will receive cash flows in
future in the form of interest payments. However, it cannot demand early repayment of the mortgages.
If, however, it sells the rights to the interest cash flows from the mortgages to a third party, it could
convert the income stream into an immediate lump sum (therefore, receiving today the present value of
a future cash flow).
Securitisation often involves the use of a special purpose entity (SPE) to acquire the originator's
receivables or loans. The SPE issues debt to third parties to raise the finance to repay the originator.
Whether the securitised assets will be derecognised depends on whether the SPE has assumed all the
risks and rewards of the ownership of the assets and whether the originator has ceded control of the
assets to the SPE.
If the SPE is a mere extension of the originator and it continues to be controlled by the originator, then
the SPE should be consolidated and any securitised assets should continue to be recognised in the
group accounts. Securitisation will not in this case lead to derecognition.
Even when the SPE is not controlled by the originator, the risks and rewards of ownership will not have
passed completely to the SPE if the lenders to the SPE require recourse to the originator to provide
security for their debt.
Where only part of a financial asset is derecognised, the carrying amount of the asset should be
allocated between the part retained and the part transferred based on their relative fair values on the
date of transfer. A gain or loss should be recognised based on the proceeds for the portion transferred.
Section overview
This section deals with certain aspects of initial and subsequent measurement of financial
instruments, especially the treatment of transaction costs and of valuation methods when fair
values are not available.
3.1 Introduction
It was noted earlier that financial assets and financial liabilities should initially be measured at fair
value (cost). Subsequently:
Financial assets should be remeasured to fair value, unless they are loans and receivables, held-to-
maturity investments or financial assets whose value cannot be reliably measured
Definitions
A financial asset or liability at fair value through profit or loss is one which meets either of the
following conditions:
(a) It is classified as held for trading. A financial asset or liability is classified as held for trading if it is:
(i) Acquired or incurred principally for the purpose of selling or repurchasing it in the near term
(ii) Part of a portfolio of identified financial instruments that are managed together and for which
there is evidence of a recent actual pattern of short-term profit-taking, or
(iii) A derivative (unless it is a designated and effective hedging instrument – see the next
chapter).
(b) Upon initial recognition it is designated by the entity as at fair value through profit or loss. An
entity may only use this designation in severely restricted circumstances, ie where:
(i) It eliminates or significantly reduces a measurement or recognition inconsistency
('accounting mismatch') that would otherwise arise.
(ii) A group of financial assets/liabilities is managed and its performance is evaluated on a fair
value basis.
Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments
and fixed maturity that an entity has the positive intent and ability to hold to maturity other than:
(a) Those that the entity upon initial recognition designates as at fair value through profit or loss
(b) Those that the entity designates as available for sale
(c) Those that meet the definition of loans and receivables
Loans and receivables are non-derivative financial assets with fixed or determinable payments that are
not quoted in an active market, other than:
(a) Those that the entity intends to sell immediately or in the near term, which should be classified as
held for trading and those that the entity upon initial recognition designates as at fair value
through profit or loss
(b) Those that the entity upon initial recognition designates as available for sale, or
(c) Those for which the holder may not recover substantially all of the initial investment, other than
because of credit deterioration, which shall be classified as available for sale.
Solution
The initial fair value of the loan should be determined by discounting the £20,000 receivable in three
years time to its present value, using the interest rate applicable to Entity A. The present value is
3
£14,235 (20,000/1.12 ) and the remaining £5,765 should immediately be recognised as an expense in
profit or loss.
Each year Entity B should recognise finance income of 12% on the balance of the loan, increasing the
loan's carrying amount by the amount recognised in profit or loss.
Solution
IAS 39 effectively treats the bid-offer spread as a transaction cost. If the financial instrument is classified
as at fair value through profit or loss, the notional transaction cost of £2 should be recognised as an
expense and the financial asset initially recognised at £50. If the instrument is classified under any other
category, the transaction cost should be added to the fair value and the financial asset initially
recognised at £52.
Solution
As the asset is classified as available for sale, the entity should initially recognise the financial asset at its
fair value plus the transaction costs, that is, at £53. At the end of the entity's financial year, the asset
should be remeasured at £55 (the commission of £3 payable on a sale is not taken into account). The
change in fair value of £2 should be recognised in other comprehensive income.
Solution
(a) A held-to-maturity investment should be measured at amortised cost using the effective interest
method. The amounts in the financial statements should be determined as follows.
Statement of financial Statement of financial
position carrying Interest at 8.49% effective Cash received at 5% of position carrying
Year amount b/f rate recognised in profit or loss £20,000 nominal value amount c/f
£ £ £ £
20X4 19,000 1,613 (1,000) 19,613
20X5 19,613 1,665 (1,000) 20,278
20X6 20,278 1,722 (22,000)* 0
* includes redemption of £20,000 × 105% = £21,000.
(b) The interest on an available-for-sale financial asset should be recognised in profit or loss using the
effective interest method. The carrying amount should then be remeasured to fair value with
changes being recognised in other comprehensive income.
Carrying amount Interest as Cash flow Fair value Carrying amount
Year b/f before as before change (bal fig) c/f
£ £ £ £ £
20X4 19,000 1,613 (1,000) (213) 19,400
20X5 19,400 1,665 (1,000) 335 20,400
20X6 20,400 1,722 (22,000) (122) 0
Included in other comprehensive income is a debit of £213 in 20X4 for the loss in fair value, a credit of
£335 in 20X5 for the gain in fair value and a debit in 20X6 as the cumulative gain is removed.
When shares ('old shares') classified as available for sale are exchanged for other shares ('new shares'),
perhaps as a result of a takeover, any gains or losses on the old shares previously recognised in other
comprehensive income should be reclassified from other comprehensive income to profit or loss and the
new shares should be measured at their fair value.
Solution
The transaction requires the derecognition of the shares in DEF. A profit on disposal of £50 should be
recognised in profit or loss, comprising the £40 gain since the remeasurement plus the £10 reclassified
from other comprehensive income. The shares in GHI should initially be measured at £150.
3.5.2 Reclassification
Reclassification into another category is not allowed for assets or liabilities at fair value through profit or
loss (but see the amended rules in the next paragraph).
Other financial assets may be reclassified if circumstances change. For example, if in respect of held-to-
maturity investments there is a change of intention or ability to hold to maturity, it is no longer
appropriate for such investments to continue in the same category. They should instead be reclassified
as available for sale and measured at their then fair value. Any gain or loss on reclassification should be
recognised in other comprehensive income.
There is a penalty for reclassifying (or indeed selling) a held-to-maturity investment:
All remaining held-to-maturity investments should also be classified as available for sale and
remeasured to fair value.
No investment may be classified as held to maturity if there has been a reclassification or sale
during the current financial year or during the two preceding financial years. The held-to-maturity
classification is said to be tainted.
This penalty is applied unless:
The amount reclassified/sold is insignificant compared to the total amount of held-to-maturity
investments; or
The reclassification or sale was within three months of maturity or after the entity has collected
substantially all the amounts of the original principal or was the result of an event beyond the
entity's control and which could not reasonably have been anticipated.
3.6.1 Scope
The amendment only applies to reclassification of some non-derivative financial assets recognised in
accordance with IAS 39. Reclassification is not permitted for financial liabilities, derivatives and financial
assets that are designated as at fair value through profit or loss (FVTPL) on initial recognition under the
'fair value option'.
The amendments therefore only permit reclassification of debt and equity financial assets subject to
meeting specified criteria. They do not permit reclassification into FVTPL.
3.6.2 Criteria for reclassification out of fair value through profit or loss and available for sale
The criteria vary depending on whether the asset would have met the definition of 'loans and
receivables' if it had not been classified as FVTPL or available for sale (AFS) on initial recognition.
(a) If a debt instrument would have met the definition of loans and receivables, had it not been
required to be classified as held for trading at initial recognition, it may be reclassified out of FVTPL
provided the entity has the intention and ability to hold the asset for the foreseeable future
or until maturity.
(b) If a debt instrument was classified as AFS, but would have met the definition of loans and
receivables if it had not been designated as AFS, it may be reclassified to the loans and receivables
category provided the entity has the intention and ability to hold the asset for the
foreseeable future or until maturity.
(c) Other debt instruments or any equity instruments may be reclassified from FVTPL to AFS or, in the
case of debt instruments only, from FVTPL to held to maturity (HTM) if the asset is no longer held
for selling in the short term.
3.6.5 Disclosures
IFRS 7 has been amended to require additional disclosures for reclassifications that fall within the
scope of the above amendments. They relate to the amounts reclassified in and out of each category,
the fair values of reclassified assets, fair value gains or losses recognised in the period of reclassification
and any new effective interest rate.
Solution
Held-to-maturity assets are measured at amortised cost with gains and losses recognised in profit or loss.
20X5 20X6
£'000 £'000
Statement of profit or loss and other comprehensive income
Interest income 800 800
WORKINGS
£'000
Cash – 1.1.20X5 10,000
Effective interest at 8% (same as nominal as no discount or premium to be 800
amortised)
Coupon received (nominal interest 8% 10m) (800)
At 31.12.20X5 10,000
Effective interest at 8% 800
Coupon and capital received ((8% 10m) + 10m) (10,800)
At 31.12.20X6 0
(b) Baldie Co issues 4,000 convertible bonds on 1 January 20X2 at par. Each bond is redeemable three
years later at its par value of £500 per bond, which is its nominal value.
The bonds pay interest annually in arrears at an interest rate (based on nominal value) of 5%. Each
bond can be converted at the maturity date into 30 £1 shares.
The prevailing market interest rate for three year bonds that have no right of conversion is 9%.
6
Worked example: Debt instrument with fixed or market-based variable rate
An entity issues irredeemable debt instruments at their par value of £5 million with an 8% coupon, the
market rate for such instruments.
Requirement
Explain how these instruments should be measured on initial recognition and subsequently.
Solution
These instruments should initially be measured at their fair value of £5 million.
There is no evidence that these instruments were issued for trading purposes, so they should
subsequently be measured at amortised cost. Because they are irredeemable, there is no maturity
amount to be compared with the amount initially recognised, so there is no difference to be amortised
to profit or loss. They should always be carried at £5 million.
Solution
No. From an economic perspective, the interest payments are repayments of the principal amount. For
example, the interest rate may be stated as 16% for the first ten years and as zero per cent in
subsequent periods. In that case the initial recognised amount is amortised to zero over the first ten
years.
Requirement
Explain how this financial asset should be measured on initial recognition and at the subsequent year
end assuming it is classified as:
(a) A financial asset at fair value through profit or loss
(b) An available-for-sale financial asset
(c) A held-to-maturity investment.
Solution
(a) A financial asset at fair value through profit or loss
On initial recognition the asset should be measured at fair value. For financial assets treated as at
FVTPL, IAS 39 regards the bid price as the fair value. The bid-offer spread is considered as a
transaction cost and, along with any other transaction costs, are recognised as an expense in profit
or loss. So the asset should be measured at £19,800 (10,000 × 198p bid price) and the £500
(10,000 × 5p) transaction costs recognised as an expense. (Transaction costs comprise both
commission of 3p per unit and the bid-offer spread of 2p per unit.)
At the year end no account should be taken of the potential disposal costs, so the asset should be
remeasured at the 218p bid price, so £21,800, with the £2,000 gain in fair value being recognised
in profit or loss.
(b) An available-for-sale financial asset
For an available-for-sale financial asset the bid-offer spread is considered as a transaction cost, but
(along with other transaction costs) is added to the fair value (bid price) of the financial asset
(rather than being treated as an expense as for FVTPL assets). On initial recognition the asset
should therefore be measured at fair value with the addition of the transaction costs. So the asset
should be measured at £20,300 (10,000 × (198p bid price + 5p transaction costs)).
At the year end no account should be taken of the potential disposal costs, so the asset should be
remeasured at the 218p bid price, so £21,800, with the £1,500 gain in fair value being recognised
in other comprehensive income.
(c) A held-to-maturity investment
On initial recognition the asset should be measured in the same way as if it was an available-for-
sale financial asset, so it is recognised at £20,300.
It should subsequently be remeasured at amortised cost (there is insufficient information to be able
to calculate this).
On 31 December 20X7 Pompeii sold one quarter of its holding of the bonds ex-interest for £150,000.
Transaction costs incurred on the sale were £6,000.
Requirement
Calculate the total amount to be recognised in profit or loss in respect of this financial asset in Pompeii's
financial statements for the year ending 31 December 20X7.
See Answer at the end of this chapter.
Solution
The published price quotation in an active market is the best estimate of fair value. Therefore, Entity A
should use the published price quotation (£100). Entity A cannot depart from the quoted market price
solely because independent estimates indicate that Entity A would obtain a higher (or lower) price by
selling the holding as a block.
3.9 Impairment
A summary of the impairment process is as follows.
At each year end, an entity should assess whether there is any objective evidence that a financial asset or
group of assets is impaired.
The following are indications that a financial asset or group of assets may be impaired.
(a) Significant financial difficulty of the issuer
(b) A breach of contract, such as a default in interest or principal payments
(c) The lender granting a concession to the borrower that the lender would not otherwise consider,
for reasons relating to the borrower's financial difficulty
(d) It becomes probable that the borrower will enter bankruptcy
(e) The disappearance of an active market for that financial asset because of financial difficulties
(f) An adverse change in the payment status of borrowers in a group of financial assets
(g) Economic conditions that correlate with defaults on the assets in a group of financial assets
Where there is objective evidence of impairment, the entity should determine the amount of any
impairment loss.
Solution
The financial difficulty of, and the granting of a concession to, the issuer are both objective evidence of
impairment. The recoverable amount should be calculated as £839 by discounting the £1,100 agreed
repayment at the original effective interest rate of 7% over a 4-year period.
In Year 1, interest income of £59 (7% £839) should be recognised and the carrying amount of the
loan increased to £898. This process should be repeated through Years 2–4, at which point the loan will
be carried at £1,100 immediately prior to repayment.
If the impairment loss decreases at a later date (and the decrease relates to an event occurring after the
impairment was recognised) the reversal should be recognised in profit or loss. The carrying amount of
the asset should not exceed what the amortised cost would have been if no impairment had been
recognised.
Solution
In 20X5 an impairment loss of £400 should be recognised in profit or loss and £100 credited to other
comprehensive income in respect of the loss previously recognised there.
In 20X6 a gain of £600 (£2,200 – £1,600) should be recognised in other comprehensive income,
because impairment losses on available for sale equity instruments should not be reversed through profit
or loss.
The following table summarises the impairment requirement for debt, equity and derivative
instruments.
Future losses
Losses expected as a result of future events, however likely, should not be recognised. For
example, it would not be appropriate for a lender which over time has experienced an average default
rate of 2% to recognise an immediate impairment of £200 at the time of advancing a loan of £10,000;
the reason is that at the time of making the loan there cannot have been a past event to cause an
impairment loss.
Collateral
Many loans and receivables are collateralised. This may involve the security from a mortgage of
property, for example. In determining the impairment loss on such a financial asset, the assessment of
impairment should include the cash flows from obtaining and disposing of the collateral, regardless of
whether foreclosure is probable. This may involve obtaining estimates of the realisable value of property,
using appropriately qualified valuers.
Solution
The individual balance relating to the unemployed person should be assessed separately for impairment.
The remaining 99 loans should be assessed collectively for impairment.
4 Derivatives
Section overview
This section covers aspects relating to financial derivatives not covered at professional level.
Solution
The currency swap meets the definition of a derivative, as the exchange of the initial fair values means
there is zero initial investment, its value changes in response to a specified exchange rate, and it is
settled at a future date.
Solution
The contract meets some of the criteria of a derivative, that is no initial investment and it is to be settled
at a future date. However, because the underlying is a non-financial asset, classification as a derivative
will depend on whether the contract was entered into in order to benefit from short-term price
fluctuations by selling it. If SML intends to take delivery of the steel and use it as an input in its
production process, then the contract is not a derivative.
Solution
Accounting entries under IAS 39:
Debit Credit
£ £
st
31 December 20X0
Financial asset – put option 11,100
Cash 11,100
(To record the purchase of the put option)
th
30 June 20X1
Financial asset – put option (13,500 – 11,100) 2,400
Profit or loss – gain on put option 2,400
(To record the increase in the fair value of the put option)
st
31 December 20X1
Financial asset – put option (15,000 – 13,500) 1,500
Profit or loss – gain on put option 1,500
(To record the increase in the fair value of the put option)
Cash 15,000
Financial asset – put option 15,000
(To record the sale of the put option on 31.12.20X1)
5 Embedded derivatives
Section overview
This section deals with the definition and accounting treatment of embedded derivatives.
5.1 Introduction
Certain contracts that are not themselves derivatives (and may not be financial instruments) include
derivative contracts that are 'embedded' within them.
Definition
An embedded derivative is a component of a hybrid (combined) instrument that also includes a
non-derivative host contract – with the effect that some of the cash flows of the combined instrument
vary in a way similar to a stand-alone derivative.
(b) A bond which is redeemable in five years' time with part of the redemption price being based on
the increase in the FTSE 100 index.
(c) A construction contract priced in a foreign currency. The construction contract is a non-derivative
contract, but the changes in foreign exchange rate is the embedded derivative.
Accounting treatment of embedded derivatives
The basic rule for accounting for an embedded derivative is that it should be separated from its host
contract and accounted for as a derivative. The purpose is to ensure that the embedded derivative is
measured at fair value and changes in its fair value are recognised in profit or loss. But this separation
should only be made when the following conditions are met.
(a) The economic characteristics and risks of the embedded derivative are not closely related to the
economic characteristics and risks of the host contract.
(b) A separate instrument with the same terms as the embedded derivative would meet the
definition of a derivative.
(c) The hybrid (combined) instrument is not measured at fair value with changes in fair value
recognised in profit or loss (if changes in the fair value of the total hybrid instrument are
recognised in profit or loss, then the embedded derivative is already accounted for on this basis, so
there is no benefit in separating it out).
The meanings of “closely related” and “not closely related” are dealt with in more detail below, but a
simple example may help. A lease of retail premises may provide for the amounts payable to the lessor
to include contingent rentals based on the lessee's sales from the leased premises. The variable nature
of the contingent rentals makes them fall within the definition of an embedded derivative. But these
contingent rentals are considered to be “closely related” to the lease host contract, so this embedded
derivative should not be separated out for accounting purposes.
Note that an entity may, subject to conditions, designate any hybrid contract as at fair value through
profit or loss, thereby avoiding the need to measure the fair value of the embedded derivative separately
from that of the host contract.
No
Would it be No
a derivative Do not separate
if it was a out the embedded
separate derivative
instrument?
Yes
Are its
characteristics/ Yes Do not separate
risks closely out the embedded
related to those derivative
of the host
contract?
No
Account
separately for
the embedded
derivative
Where an entity is unable to measure an embedded derivative that is required to be separated from its
host, either on acquisition or subsequently, the entire hybrid contract should be designated as at fair
value through profit or loss.
If the fair value of the embedded derivative cannot be determined due to the complexity of its terms
and conditions, but the value of the hybrid and the host can be determined, then the value of the
embedded derivative should be determined as the difference between the value of the hybrid and the
value of the host contract.
Section overview
IFRS 9 Financial Instruments, issued in November 2009, replaced certain parts of IAS 39, in
particular with respect to the classification of financial assets. This standard is a work in progress
and in due course will be developed further to fully replace IAS 39.
Phase 3: Hedging. An Review Draft was issued in September 2012. The finalised requirements,
which would represent a significant change to the current hedge accounting approach
under IAS 39, are expected to be issued in the second or third quarters of 2013.
The standard has been criticised, notably by the European Union, who warned that the new rules could lead
to greater volatility in accounts, undermining broader financial stability, and postponed its EU adoption.
(b) The entity transfers substantially all the risks and rewards of ownership of the financial asset to
another party.
A financial liability is derecognised when it is extinguished – ie when the obligation specified in the
contract is discharged or cancelled or expires.
Solution
The asset is initially recognised at the fair value of the consideration, being £500,000
At the period end it is remeasured to £520,000
This results in the recognition of £20,000 in other comprehensive income
(b) A separate instrument with the same terms as the embedded derivative would meet the definition
of a derivative.
(c) The hybrid (combined) instrument is not measured at fair value with changes in fair value
recognised in the profit or loss (a derivative embedded in a financial liability need not be separated
out if the entity holds the combined instrument at fair value through profit or loss).
6.15.2 Impairment
IAS 39 currently uses an 'incurred loss' model for the impairment of financial assets. This model assumes
that all loans will be repaid until evidence to the contrary. Only at this point is the impaired loan written
down to a lower value.
Under the proposals an 'expected loss' model will be applied: expected losses are recognised
throughout the life of the loan (or other financial asset measured at amortised cost), and not just after a
loss event has been identified. The effective interest rate will include an initial estimate of any expected
credit losses. Credit losses will be held in a separate allowance account. Losses due to changes in cash
flow estimates are disclosed as a separate line item. If the item is considered uncollectable, write-offs will
be made directly to the financial asset account.
Extensive disclosure requirements would provide investors with an understanding of the loss estimates
that an entity judges necessary.
6.16 Supplement
In January 2011, the IASB issued a supplement to the ED addressing some of the major operational
difficulties identified by respondents, particularly for open portfolios. The aim is to make it easier for
entities to implement the original proposals in the ED. The supplement applies only to financial assets
measured at amortised cost and managed in an open portfolio, excluding short-term trade receivables.
A distinction is made in many financial institutions between two broad groups of financial assets:
(a) Loans that are considered problematic (the 'bad book'). These are generally monitored on a
portfolio basis.
(b) Loans that are not considered problematic (the 'good book'). These are generally managed more
closely, often on an individual basis.
Derivatives
Embedded derivative
Measurement of
Recognition
financial instrument
Derecognition
Impairment
Measurement
Initial measurement of financial assets and liabilities IAS 39.43-44
Derivatives
Derivatives – definition and classification IAS 39.9
Embedded derivatives
1 Peacock
IAS 39.27 states that upon derecognition of a part of a financial asset the amount recognised in
profit or loss should be the difference between the carrying amount allocated to the part
derecognised and the sum of
(i) The consideration received for the part derecognised and
(ii) Any cumulative gain or loss allocated to it that had been recognised in other comprehensive
income.
The previous gains had been recognised in profit or loss and so are not included in the calculation.
The carrying amount is measured as original cost plus previous gains £4,100 (ie 10% 41,000).
The carrying amount of the proportion sold is deducted from the proceeds (£6,000) to give the
gain of £1,900.
2 Vanadic
It is not the case that 'the transaction costs incurred in renegotiating the terms of any loan should
be recognised in profit or loss when payable' in all circumstances.
It is true that 'the revised terms negotiated by Vanadic are such that the original loan should be
derecognised and a new financial liability recognised'.
Transaction costs are recognised in profit or loss if the revision of loan terms is to be treated as the
extinguishment of the loan. But if the revision is treated as a modification, the costs are amortised
over the remaining life of the modified liability (IAS 39 AG 62).
Derecognition of the old loan and recognition of the new liability is required if the present value of
the cash flows under the new terms is 10% or more different from the present value of the original
loan. The cash flows under the new terms must be discounted at the 6.0% effective interest rate of
the original loan and include the £700,000 transaction costs (IAS 39 AG 62).
With transaction costs payable at the start of the period of the revised terms, they are added on in
full to the £10.5m present value, giving a total of £11.2m. This is 12% different from the £10.0m
present value of the old loan, so the original loan should be derecognised and the new financial
liability recognised.
3 Basic
IAS 39.43 requires a financial asset to be measured initially at fair value, ie the amount for which it
could be exchanged in an arm's-length transaction (IAS 39.9).
A zero interest rate loan issued at par would not result from an arm's-length transaction and IAS 39
AG 64 requires the fair value in such a case to be determined as the present value of the cash
receipts (ie redemption amount) under the effective interest method. The discount rate should be
that on similar loans. So initially it will be measured at £7.0m/1.07 = £6,542,000.
This loan will fall within IAS 39.9's definition of loans and receivables which under IAS 39.46 should
be subsequently measured at amortised cost using the effective interest method. As this
subsequent measurement is made on the same day as the initial measurement, the carrying
amount will be £6,542,000.
4 Colyear
IAS 39.11 requires an embedded derivative to be separated from the host contract if
(i) The embedded derivative's economic characteristics and risks are not closely related to those
of the host contract
(ii) A separate instrument with the same terms as the embedded derivative would meet the
definition of a derivative; and
(iii) The hybrid contract is not measured at fair value through profit or loss.
2 Fair value
£'000
Cash 20,000
Effective interest (as above) 1,200
Coupon received (as above) (1,200)
Fair value loss (187)
At 31.12.20X1 (W3) 19,813
Interest at 7% (7% 19,813) 1,387
Coupon and capital received ((6% 20m) + 20m) (21,200)
At 31.12.20X2 0
9 Pike
£8 million
IAS 32.31 requires that any derivative features embedded within a compound financial instrument
(such as the call option) are 'included' in the liability component. The value of the option (£3m)
which is an asset for the company as it enables it to buy back the bonds when it wants to, is
deducted from the liability element of the compound instrument (£11m).
The equity element is the fair value of the compound instrument (£55m) less the liability element
after taking account of the derivative (£51m) as IAS 32.31 requires that no gain or loss should arise
6
on initial recognition of the component elements. The equity element is therefore £4m.
600,000
= factor of 1.3605. From the four years line in the table the effective interest rate is 8%.
441,014
Financial liabilities
Shares in BW Co sold 'short' (W4) (28,000)
Statement of comprehensive income extracts year ended 31 December 20X2
£
Profit or loss
Finance income
Effective interest on 4% debentures in MT Co (W1) 6,120
Gain on interest rate option (W2) 6,750
Gain on sale of shares in EG Co (W3) 14,345
Finance costs
Loss on shares in BW Co sold 'short' (W4) (4,000)
31.12.20X2
Dr Financial asset (£13,750 – £7,000) £6,750
Cr Profit or loss £6,750
3 Shares (Available-for-sale financial asset – re-classification)
20X1
£
Purchase for cash ((25,000 £2) + (1% £50,000)) 50,500
Fair value gain at 31.12.20X1 ((25,000 £2.25 bid price) – 5,750 other
£50,500)) comprehensive
income
Fair value at 31.12.20X1 56,250
20.12.20X2
Dr Cash ((25,000 £2.62) – (1% 65,500)) £64,845
Dr Other comprehensive income (reclassified) £5,750
Cr Financial asset £(56,250)
Cr Profit or loss £14,345
4 Shares sold 'short' (Financial liability at fair value through profit or loss)
22.12.20X2
Dr Cash £24,000
Cr Financial liability £24,000
31.12.20X2
Dr Profit or loss (£28,000 – £24,000) £4,000
Cr Financial liability £4,000
(b) After the impairment, the debentures should be measured at the present value of estimated future
cash flows, using the original effective interest rate of 10%:
3
80% £130,525 (1/1.1 ) = £78,452
(c) The impairment of £32,048 (£110,500 – £78,452) should be recognised as follows:
DEBIT Profit or loss £32,048
CREDIT Financial asset £32,048
Financial instruments –
hedge accounting
Introduction
Topic List
1 Hedge accounting: the main points
2 Hedged items
3 Hedging instruments
4 Fair value hedge
5 Cash flow hedge
6 Hedge of a net investment
7 Conditions for hedge accounting
8 Disclosures
9 Current developments
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
219
Introduction
Apply the criteria for a hedging relationship to qualify for hedge accounting
Section overview
Pay particular attention to this first section as it contains the main points you need to know.
1.1 Introduction
In earlier stages of your study for the ACA qualification, such as Financial Management, you have
covered the way hedging is an important means by which a business can manage the risks it is exposed
to.
C
As an example, a manufacturer of chocolate can fix now the price at which it buys a specific quantity of H
cocoa beans at a predetermined future date by arranging a forward contract with the cocoa beans A
producer. P
T
The forward price specified in the forward contract may be higher or lower than the spot price at the E
time the contract is agreed, depending on seasonal and other factors. But by agreeing the forward R
contract both the manufacturer and the producer have removed the risk they otherwise would face of
unfavourable price movements (price increases being unfavourable to the chocolate manufacturer and
price decreases unfavourable to the cocoa beans producer) between now and the physical delivery date. 7
Equally, they have removed the possibility of favourable price movements (price decreases being
favourable to the chocolate manufacturer and price increases favourable to the cocoa beans producer)
over the period.
Another way of achieving the same effect would be for the chocolate manufacturer to purchase cocoa
bean futures on a recognised trading exchange. On the delivery date the manufacturer would close out
the futures in the futures market and then buy the required quantity in the spot market. The
profit/(loss) on the futures transaction should offset the increase/(decrease) in the spot price over the
period.
Hedge accounting is the accounting process which reflects in financial statements the commercial
substance of hedging activities. It results in the gains and losses on the linked items (eg the purchase of
coffee beans and the futures market transactions) being recognised in the same accounting period and
in the same section of the statement of profit or loss and other comprehensive income, ie both in profit
or loss, or both in other comprehensive income.
Hedge accounting reduces or eliminates the volatility in profit or loss which would arise if the items
were not linked for accounting purposes.
Point to note:
The forward contract is a derivative. Without hedge accounting, the profit/(loss) in the futures market
would be recognised when the closing transaction in that market is carried out, but the
increased/(decreased) cost of the cocoa beans would be recognised at the later date when the
chocolate is sold. Both would be recognised in profit or loss, but possibly in different accounting
periods.
In the previous chapter the point was made that financial assets should be classified/designated at the
time of their initial recognition, not at any later date. This is to prevent businesses making
classifications/ designations with the benefit of hindsight so as to present figures to their best
advantage. Similarly, hedge accounting is only permitted by IAS 39 if the hedging relationship between
the two items (the cocoa beans and the futures contract in the above example) is designated at the
inception of the hedge. And designation is insufficient by itself; there must be formal documentation,
both of the hedging relationship and of management's objective in undertaking the hedge.
The effect is that hedge accounting is an accounting policy option, not a requirement. If the hedging
relationship does not meet IAS 39's conditions (eg it is not properly documented), then hedge
accounting is not permitted. Some businesses take the view that the costs of meeting these conditions
outweigh the benefits of hedge accounting; just by not preparing the right documentation they avoid
having to comply with the relevant parts of IAS 39.
1.2 Overview
In simple terms the main components of hedge accounting are as follows:
The hedged item: this is an asset, a liability, a firm commitment (such as a contract to acquire a
new oil tanker in the future) or a forecast transaction (such as the issue in four months' time of
fixed rate debt) which exposes the entity to risks of fair value/cash flow changes. The hedged item
generates the risk which is being hedged.
The hedging instrument: this is a derivative or other financial instrument whose fair value/cash
flow changes are expected to offset those of the hedged item. The hedging instrument
reduces/eliminates the risk associated with the hedged item.
There is a designated relationship between the item and the instrument which is documented.
At inception the hedge must be expected to be highly effective and it must turn out to be highly
effective over the life of the relationship
To qualify for hedging, the changes in fair value/cash flows must have the potential to affect profit
or loss.
There are two main types of hedge:
– The fair value hedge: the gain and loss on such a hedge are recognised in profit or loss
– The cash flow hedge: the gain and loss on such a hedge are initially recognised in other
comprehensive income and subsequently reclassified to profit or loss.
Points to note:
1 The key reason for having the two types of hedge is that profits/losses are initially recognised
in different places.
2 In some circumstances the entity can choose whether to classify a hedge as a fair value or a
cash flow hedge.
3 There is a third type of hedge: the hedge of a net investment in a foreign operation, such as
the hedge of a loan in respect of a foreign currency subsidiary. This is accounted for similarly
to cash flow hedges.
Solution
The transaction entered into by Red is a hedging transaction of a net investment in a foreign entity. The
loan is the hedging instrument and the investment in Blue is the hedged item.
As the loan has been designated as the hedging instrument at the outset and the transaction meets the
hedging criteria of IAS 39, the exchange movements in both items should be recognised in other
comprehensive income. Any ineffective portion of the hedge should be recognised in profit or loss for
the year.
Below are two simple illustrative examples of accounting for a fair value hedge and accounting for a
cash flow hedge. The definitions and rules for a fair value hedge and a cash flow hedge are covered in
greater detail in Sections 4 and 5 of this chapter.
2 Hedged items
Section overview
This section deals with detailed issues related to hedged items in a hedging relationship.
Definitions
A hedged item is an asset, liability, firm commitment, highly probable forecast transaction or net
investment in a foreign operation that:
Exposes the entity to risk of changes in fair value or future cash flows; and
Is designated as being hedged.
A firm commitment is a binding agreement for the exchange of a specified quantity of resources at a
specified price on a specified future date or dates.
A forecast transaction is an uncommitted but anticipated future transaction.
Point to note:
Neither firm commitments nor forecast transactions are normally recognised in financial statements. As
is explained in more detail in a later part of this chapter, it is only when they are designated as hedged
items that they are recognised.
7
Worked example: Group of assets
An entity constructs a portfolio of shares to replicate a stock index and uses a put option on the index to
protect itself from fair value losses.
Requirement
Can the portfolio of shares be designated as a hedged item?
Solution
The portfolio cannot be designated as a hedged item. Similar financial instruments should be
aggregated and hedged as a group only if the change in fair value attributable to the hedged risk for
each individual item in the group is expected to be approximately proportional to the overall change in
fair value attributable to the hedged risk of the group. In the scenario above, the change in the fair value
attributable to the hedged risk for each individual item in the group (individual share prices) is not
expected to be approximately proportional to the overall change in fair value attributable to the hedged
risk of the group; even if the index rises, the price of an individual share may fall.
Solution
The entity can hedge the net amount of £1 million by acquiring a derivative and designating it as a
hedging instrument associated with £1 million of the firm purchase commitment of £5 million.
Because forecast transactions can only be hedged under cash flow hedges, the ways to assess the
probability of a future transaction are covered below under cash flow hedges.
Solution
The hedge can qualify for hedge accounting. Since the Australian entity did not hedge the foreign
currency exchange risk associated with the forecast purchases in yen, the effects of exchange rate
changes between the Australian dollar and the yen will affect the Australian entity's profit or loss and,
therefore, would also affect consolidated profit or loss. IAS 39 does not require the operating unit that is
exposed to the risk being hedged to be a party to the hedging instrument.
A forecast purchase of a held-to-maturity investment, on the other hand, can be a hedged item with
respect to interest rate risk. Held-to-maturity investments can also be a hedged item with respect to
foreign currency risk and credit risk.
Future earnings
Future earnings cannot be hedged items because they are the net result of different transactions with
different risk profiles. Highly probable forecast transactions can be hedged items, however, so it is
theoretically possible to hedge the individual components of future revenue and future expenses.
Derivative instruments
IAS 39 does not permit designating a derivative instrument (whether a stand-alone or a separately
recognised embedded derivative) as a hedged item (obviously, they may be a hedging instrument)
either individually or as part of a hedged group in a fair value or cash flow hedge. This is not really a
problem because derivatives are always classified as held for trading, so gains/losses are recognised in
profit or loss. So if from a commercial perspective a derivative is hedged by another derivative, the
normal accounting treatment means that they would both be booked at fair value through profit or loss
and a natural offset in profit or loss would occur.
As exceptions:
Derivatives may be designated as hedging instruments (not hedged items) in a cash flow hedge.
The effect of IAS 39 AG 94 is to permit the designation of a purchased option as a hedged item.
Business risk
IAS 39 does not permit an entity to apply hedge accounting to a hedge of the risk that a transaction will
not occur, even if, for example, that would result in less revenue to the entity than expected. The risk
that a transaction will not occur is an overall business risk that is not eligible as a hedged item. Hedge
accounting is permitted only for risks associated with recognised assets and liabilities, firm
commitments, highly probable forecast transactions and net investments in foreign operations.
Section overview
This section considers in detail the financial instruments that can be designated as hedging
instruments for hedge accounting purposes.
Definition
C
A hedging instrument is a designated derivative or, for a hedge of the risk of changes in foreign H
currency exchange rates only, a designated non-derivative financial asset or non-derivative financial A
liability, whose fair values or cash flows are expected to offset changes in the fair value or cash P
T
flows of a designated hedged item.
E
R
An implication of this definition is that financial assets and liabilities whose fair value cannot be reliably
measured cannot be designated as hedging instruments. 7
The types of hedging instruments that can be designated in hedge accounting are:
Derivatives, such as forward contracts, futures contracts, options and swaps, and
Non-derivative financial instruments, but only for the hedging of currency risk. This category
includes foreign currency cash deposits, loans and receivables, available for sale monetary items
and held-to-maturity instruments carried at amortised cost.
3.2 Derivatives
Any derivative financial instrument, with the exception of written options to which special rules apply,
can be designated as a hedging instrument. Derivative instruments have the important property that
their fair value is highly correlated with that of the underlying.
3.3 Options
Options provide a more flexible way of hedging risks compared to other derivative instruments such as
forwards, futures and swaps, because they give to the holder the choice as to whether or not to exercise
the option.
Purchased options
When an entity purchases a put option, it buys the right to sell the underlying at the strike price. If the
price of the underlying falls below the strike price, the entity exercises its option and receives the strike
price; it has protected the value of its position. Similarly if an entity needs to buy an asset in the future, it
can purchase a call option on the asset that gives the entity the right to purchase the asset at the strike
price, protecting it from a rise in the price of the asset in the future.
The difference between the purchased option and a forward contract is that under a forward contract
the entity is obliged to buy or sell at the strike price, whereas under a purchased option it has the right,
but not the obligation, to buy or sell at the strike price.
Purchased options, whether call options or put options, have the potential to hedge price, currency
and interest rate risks and can always qualify as hedging instruments.
Examples of purchased options include options on equities, options on currencies and options on
interest rates. An interest rate floor is achieved through a put option on an interest rate, and an interest
rate cap is achieved through a call option on an interest rate.
Solution
Yes. IAS 39 does not require risk reduction on an entity-wide basis as a condition for hedge accounting.
Exposure is assessed on a transaction basis and, in this instance, the asset being hedged has a fair value
exposure* to interest rate increases that is offset by the interest rate swap.
* The fair value of a loan is the present value of the cash flows. A fixed rate loan has constant cash flows
so the fair value is directly affected by a change in the discount rate (ie the market interest rate).
For instruments measured at amortised cost, such changes would not be recognised.
For instruments measured at fair value through profit or loss, such changes would be recognised in
profit or loss in any event.
For available-for-sale financial assets, such changes would be recognised in other comprehensive
income, as explained above. However exceptions to this would include foreign currency gains and
losses on monetary items and impairment losses, which would be recognised in profit or loss in any
event.
If the fair value hedge is 100% effective (as in the above Illustration), then the change in the fair
value of the hedged item will be wholly offset by the change in the fair value of the hedging
instrument and there will be no effect in profit or loss. Whenever the hedge is not perfect and the
change in the fair value of the hedged item is not fully cancelled by change in the fair value of the
hedging instrument, the resulting difference will be recognised in profit or loss. This difference is
referred to as hedge ineffectiveness.
Solution
Yes. A variable rate debt instrument may have an exposure to changes in its fair value due to credit risk.
It may also have an exposure to changes in its fair value relating to movements in the market interest
rate in the periods between which the variable interest rate on the debt instrument is reset. For
example, if the debt instrument provides for annual interest payments reset to the market rate each
year, a portion of the debt instrument has an exposure to changes in fair value during the year.
Solution
£ £
1 July 20X6 Debit Credit
Inventory 2,000,000
Cash 2,000,000
(To record the initial purchase of material)
At 31 December 20X6 the increase in the fair value of the inventory was £200,000 (10,000 × (£220 –
£200)) and the increase in the forward contract liability was £170,000 (10,000 × (£227 – £210)).
Hedge effectiveness was 85% (170,000 as a % of 200,000), so hedge accounting was still permitted.
£ £
31 December 20X6 Debit Credit
Profit or loss 170,000
Financial liability 170,000
(To record the loss on the forward contract)
Inventories 200,000
Profit or loss 200,000
(To record the increase in the fair value of the inventories)
At 30 June 20X7 the increase in the fair value of the inventory was another £100,000 (10,000 × (£230 –
£220)) and the increase in the forward contract liability was another £30,000 (10,000 × (£230 – £227)).
30 June 20X7
Profit or loss 30,000
Financial liability 30,000
(To record the loss on the forward contract)
Inventories 100,000
Profit or loss 100,000
(To record the increase in the fair value of the inventories)
Profit or loss 2,300,000
Inventories 2,300,000
(To record the inventories now sold)
Cash 2,300,000
Profit or loss – revenue 2,300,000
(To record the revenue from the sale of inventories)
Financial liability 200,000
Cash 200,000
(To record the settlement of the net balance due on closing the financial
liability)
Note that because the fair value of the material rose, the trader made a profit of only £100,000 on the
sale of inventories. Without the forward contract, the profit would have been £300,000 (2,300,000 –
2,000,000). In the light of the rising fair value the trader might in practice have closed out the futures
position earlier, rather than waiting until the settlement date.
Fair value hedge accounting should be discontinued if the hedging instrument expires or is sold,
terminated or exercised, if the criteria for hedge accounting are no longer met or if the entity revokes 7
the designation.
The discontinuance should be accounted for prospectively, ie the previous accounting entries are not
reversed. The hedged item is not adjusted for any further changes in its fair value and adjustments
already made are recognised in profit or loss over the life of the item.
Section overview
The application of cash flow hedge accounting is discussed in this section through a series of
practical examples.
Interactive question 5: Swap in cash flow hedge 2 [Difficulty level: Exam standard]
An entity manages interest rate risk on a net basis. On 1 January 20X6 it forecasts aggregate cash
inflows of £1 million on a fixed rate financial asset and aggregate cash outflows of £900,000 on a fixed
rate financial liability in the first quarter of 20X7. For risk management purposes it uses a receive-
variable, pay-fixed, forward rate agreement (FRA) to hedge the forecast net cash inflow of £100,000.
The entity designates as the hedged item the first £100,000 of cash inflows on fixed rate assets in the
first quarter of 20X7. Can it designate the receive variable, pay-fixed FRA as a cash flow hedge of the
exposure to variability to cash flows in the first quarter of 20X7 associated with the fixed rate assets?
Solution
Entries at 1 November 20X1
The fair value of the forward contract at inception is zero so no entries should be recorded (other than
any transaction costs), but risk disclosures should be made.
The contractual commitment to buy the asset should be disclosed if material (IAS 16). C
Entries at 31 December 20X1 H
A
The gain on the forward contract should be calculated as: P
£ T
Value of contract at 31.12.X1 (LC60m/1.24) 48,387,097 E
R
Value of contract at 1.11.X1 (LC60m/1.5) 40,000,000
Gain on contract 8,387,097
The change in the fair value of the expected future cash flows on the hedged item (which is not 7
recognised in the financial statements) should be calculated as:
£
At 31.12.X1 (LC60m/1.20) 50,000,000
At 1.11.X1 (LC60m/1.45) 41,379,310
8,620,690
As this change in fair value is greater than the gain on the forward contract, the hedge is deemed to be
fully effective and the whole of the gain on the forward should be recognised in other comprehensive
income:
Dr Financial asset (Forward a/c) £8,387,097
Cr Other comprehensive income £8,387,097
Entries at 1 November 20X2
The further gain on the forward contract should be calculated as:
£
Value of contract at 1.11.X2 (LC60m/1.0) 60,000,000
Value of contract at 31.12.X1 (LC60m/1.24) 48,387,097
Gain on contract 11,612,903
The further change in the fair value of the expected future cash flows on the hedged item should be
calculated as:
£
At 31.12.X1 (LC60m/1.00) 60,000,000
At 1.11.X1 (LC60m/1.20) 50,000,000
10,000,000
As this change in fair value is less than the gain on the forward contract, part of the gain on the forward
contract is said to be ineffective and this part should be recognised in profit or loss. The effective part, ie
£10m, should be recognised in other comprehensive income. The remainder should be recognised in
profit or loss:
Dr Financial asset (Forward a/c) £11,612,903
Cr Other comprehensive income £10,000,000
Cr Profit or loss £1,612,903
Note that the hedge is still highly effective (and hence hedge accounting should continue to be used):
£10,000,000/£11,612,903 = 86% which is within the 80% – 125% range.
Purchase of asset at market price
Dr Asset (LC60m/1.0) £60,000,000
Cr Cash £60,000,000
Cash flow hedge accounting should be discontinued if the hedging instrument expires or is sold,
terminated or exercised, if the criteria for hedge accounting are no longer met, a forecast transaction is
no longer expected to occur or if the entity revokes the designation.
The discontinuance should be accounted for prospectively, ie the previous accounting entries are not
reversed. The cumulative gain or loss on the hedging instrument should be reclassified to profit or loss
as the hedged item is recognised in profit or loss.
Section overview
This section discusses issues specific to the accounting treatment of hedge of net investments.
6.1 Definition
In a hedge of a net investment in a foreign operation the hedged item is the amount of the
reporting entity's interest in the net assets of that operation. Under this definition from IAS 21
monetary items that are receivable from or payable to a foreign operation for which settlement is
neither planned nor likely to occur in the foreseeable future form part of the net investment.
The amount that an entity may designate as a hedge of a net investment may be all or a proportion of
its net investment at the commencement of the reporting period. This is because the exchange rate
differences reported in equity on consolidation which form part of a hedging relationship relate only to
the retranslation of the opening net assets. Profits or losses arising during the period cannot be
hedged in the current period. But they can be hedged in the following periods, because they will then
form part of the net assets which are subject to translation risk.
There is a corresponding loss on the foreign currency loan of £355,619. Because the hedge is perfectly
effective, both the gain and the entire loss will be recognised in other comprehensive income. There is
no ineffective portion of the loss on the hedging instrument to be recognised in profit or loss.
Definition
Hedge effectiveness: The degree to which the changes in the fair value or cash flows of the hedged
item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the
hedging instrument.
Hedge effectiveness should be tested on both a prospective and retrospective basis because hedge
accounting should only be applied when
At the time of designation the hedge is expected to be highly effective; and
The hedge turns out to have been highly effective throughout the financial reporting periods for
which it was designated.
At a minimum an entity should assess effectiveness when preparing its interim or annual financial
statements.
Highly effective criteria
Hedge effectiveness should be determined in accordance with the methodology in the hedge
documentation. The highly effective hurdle is achieved if the actual results of a hedge are within the
range from 80% to 125%. One of the ways of calculating this is to express the absolute amount of the
change in value of the hedging instrument as a percentage of the absolute amount of the change in
value of the hedged item, or vice versa.
Methodology
IAS 39 does not specify a method to be used in assessing the effectiveness of a hedge. Several
mathematical techniques can be used to measure hedge effectiveness, including the ratio analysis
method referred to above and statistical measurement techniques such as regression analysis. If
regression analysis is used, the entity's documented policies for assessing effectiveness must specify how
the results of the regression will be assessed.
The method chosen should, however, be based on an entity's risk management strategy, documented
upfront and applied consistently over the duration of the hedging relationship.
Solution
The copper inventory being the hedged item, its carrying amount is increased by the £2,000 increase in
its fair value, with the same amount being recognised in profit or loss. The derivative is recorded as a
financial liability at £2,100, with the same amount being recognised in profit or loss. The net expense in
profit or loss of £100 represents the hedge ineffectiveness.
C
7.6 Macro hedging H
A
Macro hedging, also known as portfolio hedging is a technique whereby financial instruments with P
similar risks are grouped together and the risks of the portfolio are hedged together. Often this is done T
on a net basis with assets and liabilities included in the same portfolio. For example, instead of using E
interest rate swaps to hedge interest rate exposure on a loan by loan basis, banks hedge the risk of their R
entire loan book or specific portions of the loan book.
In general, IAS 39 does not permit an overall net position to be designated as a hedged item, for 7
example a UK entity that has to make a purchase of £10m in 30 days and a sale of £2m in 30 days
cannot designate the net purchase of £8m as the hedged item. The exception is that IAS 39 permits
macro hedging for the interest rate risk associated with a portfolio of financial assets or liabilities. There
are, however, clearly prescribed procedures that must be followed in order to do so.
8 Disclosures
Section overview
This section covers the disclosures required in respect of hedging.
Under IFRS 7 an entity should disclose the following separately for each type of hedge described in
IAS 39 (ie fair value hedges, cash flow hedges, and hedges of net investments in foreign operations):
A description of each type of hedge
A description of the financial instruments designated as hedging instruments and their fair values
at the reporting date; and
The nature of the risks being hedged
For cash flow hedges, an entity should disclose:
The periods when the cash flows are expected to occur and when they are expected to affect profit
or loss;
A description of any forecast transaction for which hedge accounting had previously been used,
but which is no longer expected to occur
The amount that was recognised in other comprehensive income during the period
The amount that was re-classified from equity to profit or loss for the year, showing the amount
included in each line item in the statement of comprehensive income; and
The amount that was re-classified from equity during the period and included in the initial cost or
other carrying amount of a non-financial asset or non-financial liability whose acquisition or
incurrence was a hedged highly probable forecast transaction
An entity should disclose separately:
In fair value hedges, gains or losses
– On the hedging instrument; and
– On the hedged item attributable to the hedged risk
9 Current developments
In September 2012, the IASB issued a Review Draft of the hedging section of IFRS 9 Financial
Instruments, which is to replace IAS 39 with effect from January 2015. This proposes a principles-based
approach to hedge accounting and to align accounting with risk management activities. The ED was
covered in Chapter 6, Section 6.17.
Summary
Designated C
H
Hedging Relationships
A
P
T
Hedged items Hedging instrument E
R
Hedge Accounting
Conditions
7
Types of Hedge
Hedge accounting
Hedge accounting
Hedging instruments
Qualifying instruments IAS 39.72-73
Hedge effectiveness
Criteria IAS 39 AG 105
1 Hedging
The futures contract was entered into to protect the company from a fall in oil prices and hedge
the value of the inventories. It is therefore a fair value hedge.
The inventories should be recorded at their cost of $2,600,000 (100,000 barrels at $26.00) on 1
July 20X2.
The futures contract has a zero value at the date it is entered into, so no entry is made in the
financial statements.
(Tutorial note: however, the existence of the contract and associated risk would be disclosed from
that date in accordance with IFRS 7.)
At the year end the inventories should be measured at the lower of cost and net realisable value.
Hence they should be measured at $2,250,000 (100,000 barrels at $22.50) and a loss of $350,000
recognised in profit or loss.
However, a gain has been made on the futures contract:
$
The company has a contract to sell 100,000 barrels on 31 March 20X3 at $27.50 2,750,000
A contract entered into at the year end would sell these barrels at $23.25 on 31 March 2,325,000
20X3
Gain (= the value the contract could be sold on for to a third party) 425,000
The gain on the futures contract should also be recognised in profit or loss:
Dr Future contract asset $425,000
Cr Profit or loss $425,000
The net effect on profit or loss is a gain of $75,000 ($425,000 less $350,000) whereas without the
hedging contract there would have been a loss of $350,000.
Note:
If the fair value of the inventories had increased, the carrying amount of the inventories should
have been increased by the same amount and this gain also recognised in profit or loss (normally
gains on inventories are not recognised until the goods are sold). A loss would have occurred on
the futures contract, which should also have been recognised in profit or loss.
2 Columba
A gain of £3,000 should be recognised in profit or loss.
The ineffective portion of the gain or loss on the hedging instrument should be recognised in profit
or loss. In a cash flow hedge the amount to be recognised in other comprehensive income is the
lower of:
The cumulative gain/loss on the hedging instrument, ie £20,000; and
The cumulative change in fair value of the hedged item, ie £17,000
So £17,000. This leaves £3,000 of the increase in the fair value of the cap to be recognised in
profit or loss.
3 Pula
The hedging relationship may be designated either a fair value hedge or a cash flow hedge.
The contract to sell the bulldozer represents a firm commitment with Roadmans, not merely a
proposed transaction, and it is expressed in a currency other than Pula's functional currency. A
hedge of the foreign currency risk of a firm commitment may be accounted for as a fair value
hedge or as a cash flow hedge.
The gain should also be recognised in profit or loss and adjusted against the carrying amount of
the inventories:
Dr Inventory £90,000
Cr Profit or loss £90,000
The net effect on profit or loss is a gain of £10,000, compared with a loss of £80,000 without
hedging.
Note: The hedge is highly effective: 80,000/90,000 = 89% which is within the 80% – 125% range.
The change in the fair value of the expected future cash flows on the hedged item (which is not
recognised in the financial statements) should be calculated as:
£
At 31.10.X1 9,938,000
At 30.9.X2 9,186,000
752,000
As this change in fair value is less than the gain on the forward contract, the hedge is not fully effective
and only £752,000 of the gain on the forward should be recognised in other comprehensive income.
The remainder should be recognised in profit or loss:
Employee benefits
Introduction
Topic List
1 Objectives and scope of IAS 19 Employee Benefits
2 Short-term employee benefits
3 Post-employment benefits overview
4 Defined contribution plans
5 Defined benefit plans – recognition and measurement
6 Defined benefit plans – other matters
7 Defined benefit plans – disclosure
8 Other long-term employee benefits
9 Termination benefits
10 IAS 19 Employee Benefits and UK GAAP
11 Reasons for 2011 revision of IAS 19
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
259
Introduction
Distinguish between a defined contribution and defined benefit plan in accordance with
IAS 19 Employee Benefits
Demonstrate an understanding and application of the recognition and measurement
criteria for defined contribution and defined benefit plans
Demonstrate an understanding and application of the recognition and measurement
criteria for short-term and other long-term benefits and termination benefits
IAS 19 should be applied by all entities in accounting for the provision of all employee benefits, except
those benefits which are equity-based and to which IFRS 2 applies. The Standard applies regardless of
whether the benefits have been provided as part of a formal contract or an informal arrangement.
Employee benefits are all forms of consideration, for example cash bonuses, retirement benefits and
private health care, given to an employee by an entity in exchange for the employee's services.
A number of accounting issues arise due to:
The valuation problems linked to some forms of employee benefits; and
The timing of benefits, which may not always be provided in the same period as the one in which
the employee's services are provided.
IAS 19 is structured by considering the following employee benefits:
C
Short-term employee benefits; such as wages, salaries, bonuses and paid holidays
H
Post-employment benefits; such as pensions and post-retirement health cover A
Other long-term employee benefits; such as sabbatical and long-service leave P
Termination benefits; such as redundancy and severance pay T
E
R
Section overview
Short-term employee benefits are those that fall within 12 months from the end of the period in
which the employees provide their services. The required accounting treatment is to recognise the
benefits to be paid in exchange for the employee's services in the period on an accruals basis.
Definition
Short-term employee benefits: Short-term employee benefits are employee benefits (other than
termination benefits) that fall due within 12 months from the end of the period in which the employees
provide their services.
Definition
Short-term compensated absences: Compensated absences are periods of absence from work for
which the employee receives some form of payment and which are expected to occur within 12 months
of the end of the period in which the employee renders the services.
Examples of short-term compensated absences are paid annual vacation and paid sick leave.
Short-term compensated absences fall into two categories:
Accumulating absences. These are benefits, such as paid annual vacation, that accrue over an
employee's period of service and can be potentially carried forward and used in future periods; and
Non-accumulating absences. These are benefits that an employee is entitled to, but are not
normally capable of being carried forward to the following period if they are unused during the
period, for example paid sick leave, maternity leave and compensated absences for jury service.
The cost of providing compensation for accumulating absences should be recognised as an expense as
the employee provides the services on which the entitlement to such benefits accrues. Where an
employee has an unused entitlement at the end of the reporting period and the entity expects to
provide the benefit, a liability should be created.
The cost of providing compensation for non-accumulating absences should be expensed as the
absences occur.
Solution
An expense should be recognised as part of staff costs for:
5 employees × 20 days × £50 = £5,000
Four of the employees use their complete entitlement for the year and the other, having used 16 days is
permitted to carry forward the remaining four days to the following period. A liability will be recognised
at the period end for:
1 employee × 4 days × £50 = £200
Solution
C
An expense should be recognised for the year in which the profits were made and therefore the H
employees' services were provided, for: A
P
£120,000 × 4% = £4,800 T
E
Each of the four employees remaining with the entity at the year end is entitled to £1,200. A liability of R
£4,800 should be recognised if the bonuses remain unpaid at the year end.
8
Conditions may be attached to such bonus payments; commonly, the employee must still be in the
entity's employment when the bonus becomes payable. An estimate should be made based on the
expectation of the level of bonuses that will ultimately be paid. IAS 19 sets out that a reliable estimate
for bonus or profit-sharing arrangements can be made only when:
There are formal terms setting out determination of the amount of the benefit;
The amount payable is determined by the entity before the financial statements are authorised for
issue; or
Past practice provides clear evidence of the amount of a constructive obligation.
Section overview
Post-employment benefits are employee benefits which are payable after the completion of
employment.
These can be in the form of either:
– Defined contribution schemes where the future pension depends on the value of the fund.
– Defined benefit schemes where the future pension depends on the final salary and years
worked.
Definition
Post-employment benefits: Post-employment benefits are employee benefits (other than termination
benefits) which are payable after the completion of employment. The benefit plans may have been set
up under formal or informal arrangements.
defined (therefore)
contributions variable
benefits
Definitions
Investment risk: This is defined as the risk that there will be insufficient funds in the plan to meet the
expected benefits.
Actuarial risk: This is the risk that the actuarial assumptions such as those on employee turnover, life
expectancy or future salaries vary significantly from what actually happens.
(therefore) defined
variable benefits
contributions
Contribution levels
The actuary advises the company on contributions necessary to produce the defined benefits ('the
funding plan'). It cannot be certain in advance that contributions plus returns on investments will equal
benefits to be paid.
Formal actuarial valuations will be performed (eg every three years) to reveal any surplus or deficit on
the scheme at a given date. Contributions may be varied as a result; for example, the actuary may
recommend a contribution holiday (a period during which no contributions are made) to eliminate a
surplus.
Risk associated with defined benefit schemes
As the employer is obliged to make up any shortfall in the plan, it is effectively underwriting the
investment and actuarial risk associated with the plan. Thus in a defined benefit plan, the employer
carries both the investment and the actuarial risk.
The
company
Pays
contributions
Separate legal
The
entity under
pension
trustees
scheme
Unfunded plans: these plans are held within employer legal entities and are managed by the
employers' management teams. Assets may be allocated towards the satisfaction of retirement
benefit obligations, although these assets are not ring-fenced for the payment of benefits and
remain the assets of the employer entity. In the UK and the US, unfunded plans are common in the
public sector but rare in the private sector. Unfunded plans are, however, the normal method of
pension provision in many European countries (eg Germany and France) and also in Japan.
Section overview
Accounting for defined contribution plans is straightforward as the obligation is determined by the
amount paid into the plan in each period.
C
H
4.1 Recognition and measurement A
P
Contributions into a defined contribution plan by an employer are made in return for services provided T
by an employee during the period. The employer has no further obligation for the value of the assets of E
the plan or the benefits payable. R
The entity should recognise contributions payable as an expense in the period in which the
employee provides services (except to the extent that labour costs may be included within the cost 8
of assets).
A liability should be recognised where contributions arise in relation to an employee's service, but
remain unpaid at the period end.
In the unusual situation where contributions are not payable during the period (or within 12 months of
the end of the period) in which the employee provides his or her services on which they accrue, the
amount recognised should be discounted, to reflect the time value of money.
Any excess contributions paid should be recognised as an asset (prepaid expenses) but only to the
extent that the prepayment will lead to a reduction in future payments or a cash refund.
£ £
Dr Staff costs expense 675,000
Cr Cash 510,000
Cr Accruals 165,000
Section overview
The accounting treatment for defined benefit plans is more complex than that applied to defined
contribution plans:
– The value of the pension plan is recognised in the sponsoring employer's statement of
financial position.
– Movements in the value of the pension plan are broken down into constituent parts and
accounted for separately.
Definition
Defined benefit obligation: The defined benefit obligation is the present value of all expected future
payments required to settle the obligation resulting from employee service in the current and prior
periods.
Performance of valuations
IAS 19 encourages the use of a qualified actuary to measure the defined benefit obligation. This is not, 8
however, a requirement.
Frequency of valuations
Valuations are not required at each reporting date, however they should be carried out sufficiently
regularly to ensure that amounts recognised are not materially different from those which would be
recognised if they were valued at the reporting date.
Definition
Plan assets: Plan assets are defined as those assets held by a long-term benefit fund and those insurance
policies which are held by an entity, where the fund/entity is legally separate from the employer and
assets/policies can only be used to fund employee benefits.
Investments owned by the employer which have been earmarked for employee benefits but which the
employer could use for different purposes are not plan assets.
Guidance on fair value is given in IFRS 13 Fair Value Measurement (see Chapter 2, Section 2 under IFRS
13, fair value is a market-based measurement, not an entity-specific measurement. It focuses on assets
and liabilities and on exit (selling) prices. It also takes into account market conditions at the
measurement date.
IFRS 13 states that valuation techniques must be those which are appropriate and for which sufficient
data are available. Entities should maximise the use of relevant observable inputs and minimise the use
of unobservable inputs.
(b) Financial assumptions include future salary levels (allowing for seniority and promotion as well as
inflation) and the future rate of increase in medical costs (not just inflationary cost rises, but also
cost rises specific to medical treatments and to medical treatments required given the expectations
of longer average life expectancy).
The standard requires actuarial assumptions to be neither too cautious nor too imprudent: they should
be 'unbiased'. They should also be based on 'market expectations' at the year end, over the period
during which the obligations will be settled.
During an accounting year, some of the plan assets will be paid out to retirees, thus discharging part of
the benefit obligation. This is accounted for by:
DR PV of defined benefit obligation X
CR FV of plan assets X
Note that there is no cash entry as the pension plan itself rather than the sponsoring employer pays the
money out.
Definition
The return on plan assets is defined as interest, dividends and other revenue derived from plan assets
together with realised and unrealised gains or losses on the plan assets, less any costs of administering
the plan and less any tax payable by the plan itself.
(a) The present value of the defined obligation at the year end, minus
(b) The fair value of the assets of the plan as at the year-end (if there are any) out of which the
future obligations to current and past employees will be directly settled.
The earlier parts of this section have looked at the recognition and measurement of the defined benefit
obligation. Now we will look at issues relating to the assets held in the plan.
The net defined benefit liability/(asset) should be measured as at the start of the accounting period,
taking account of changes during the period as a result of contributions paid into the scheme and
benefits paid out.
Many exam questions include the assumption that all payments into and out of the scheme take place
at the end of the year, so that the interest calculations can be based on the opening balances.
C
5.10.2 Discount rate H
The discount rate adopted should be determined by reference to market yields on high quality fixed- A
P
rate corporate bonds. In the absence of a 'deep' market in such bonds, the yields on comparable T
government bonds should be used as reference instead. The maturity of the corporate bonds that are E
used to determine a discount rate should have a term to maturity that is consistent with the expected R
maturity of the post-employment benefit obligations, although a single weighted average discount rate
is sufficient.
8
The guidelines comment that there may be some difficulty in obtaining a reliable yield for long-term
maturities, say 30 or 40 years from now. This should not, however, be a significant problem: the
present value of obligations payable in many years' time will be relatively small and unlikely to be a
significant proportion of the total defined benefit obligation. The total obligation is therefore unlikely to
be sensitive to errors in the assumption about the discount rate for long-term maturities (beyond the
maturities of long-term corporate or government bonds).
Solution
£
Year 1: Discounted cost b/f 296,000
Interest cost (profit or loss) (8% × £296,000) 23,680
Obligation c/f (Statement of financial position) 319,680
Learn and understand the definitions of the various elements of a defined benefit pension plan
Learn the outline of the method of accounting (see Paragraph 5.5)
Learn the recognition method for the:
– Statement of financial position
– Statement of profit or loss and other comprehensive income
Section overview
We have now covered the basics of accounting for defined benefit plans. This section looks at t
the special circumstances of:
– Past service costs
– Curtailments
– Settlements
– Asset ceiling test
(a) The present value of the defined benefit obligation being settled, as valued on the date of the
settlement; and
(b) The settlement price, including any plan assets transferred and any payments made by the
entity directly in connection with the settlement.
6.1.3 Accounting for past service cost and gains and losses on settlement
An entity should remeasure the obligation (and the related plan assets, if any) using current actuarial
assumptions, before determining past service cost or a gain or loss on settlement.
The rules for recognition for these items are as follows.
Past service costs are recognised at the earlier of the following dates:
The total of the current year units is the current service cost.
Attribution of benefit to period of service
In order to apply the projected unit credit method, a unit, or amount of future benefit, must be
attributed to each period of service.
Solution
A benefit of £100 is attributed to each year.
The current service cost = the present value of £100
The present value of the defined benefit obligation = the present value of £100 x number of years of
service to reporting date.
Solution
Year 1 2 3 4 5
£ ££££
Current year benefit 500 500 500 500 500
Current service cost 500 500 500 500
(1.1) 4 (1.1)3 (1.1)2 1.1 0
= 342 = 376 = 413 = 455 500
PV of defined benefit obligation 342 376 × 2 413 × 3 455 × 4 500 × 5
= 752 =1,239 =1,820 = 2,500
Note:
Previously we have said that the present value of the obligation moves from year to year due to:
Payments out to retirees
The unwinding of one year's discount
The current service cost
This can be applied to year 2 as follows:
£
PV of defined benefit obligation b/f 342
Unwinding of discount (342 0%) 34
Current service cost 376
PV of defined benefit obligation c/f 752
Requirement
Using the information below, prepare extracts from the statement of financial position and the
statement of comprehensive income, together with a reconciliation of scheme movements for the year
ended 31 January 20X8. Ignore taxation.
1 The opening scheme assets were £3.6m on 1 February 20X7 and scheme liabilities at this date
were £4.3m.
2 Company contributions to the scheme during the year amounted to £550,000.
3 Pensions paid to former employees amounted to £330,000 in the year.
4 The yield on high quality corporate bonds was 8%, and the actual return on plan assets was
£295,000.
5 During the year, five staff were made redundant, and an extra £58,000 in total was added to the
value of their pensions.
6 Current service costs as provided by the actuary are £275,000.
7 The actuary valued the plan liabilities at 31 January 20X8 as £4.54m.
See Answer at the end of this chapter.
Section overview
The disclosure requirements for defined benefit plans are extensive and detailed in order to enable
users to understand the plan and the nature and extent of the entity's commitment.
Detailed disclosure requirements are set out in IAS 19 in relation to defined benefit plans, to provide
users of the financial statements with information that enables an evaluation of the nature of the plan
and the financial effect of any changes in the plan during the period.
Amended requirements for disclosures include a description of the plan, a reconciliation of the fair value
of plan assets from the opening to closing position, the actual return on plan assets, a reconciliation of
movements in the present value of the defined benefit obligation during the period, an analysis of the
total expense recognised in profit or loss, and the principal actuarial assumptions made.
Additional disclosures set out in the amendment to IAS 19 include:
An analysis of the defined benefit obligation between amounts relating to unfunded and funded plans;
A reconciliation of the present value of the defined benefit obligation between the opening and
closing statement of financial position, separately identifying each component in the reconciliation;
A reconciliation of the present value of the defined benefit obligation and the fair value of the plan
assets to the pension asset or liability recognised in the statement of financial position. The
reconciliation should specifically highlight the net actuarial gains and losses recognised in the
statement of financial position, the amount of the pension asset which has not been recognised in
accordance with IAS 19, and the fair value of any reimbursements separately recognised as assets;
A breakdown of plan assets for the entity's own financial instruments, for example an equity
interest in the employing entity held by the pension plan and any property occupied by the entity
or other assets used by the entity;
For each major category of plan assets the percentage or amount that it represents of the total fair
value of plan assets;
A narrative description of the basis used to determine the expected rate of return on plan assets;
The effect of a one percentage point increase or decrease in the assumed medical cost trend rate
on amounts recognised during the period, such as service cost and the pension obligation relating
to medical costs;
Amounts for the current annual period and the previous four annual periods of the present value of
the defined benefit obligation, fair value of plan assets and the resulting pension surplus or deficit,
and experience adjustments on the plan liabilities and assets in percentage or value terms; and
An estimate of the level of future contributions to be made in the following reporting period.
Section overview
The accounting treatment for other long-term employee benefits is a simplified version of that
adopted for defined benefit plans.
Definition
Other long-term employee benefits are defined as employee benefits (other than post-retirement
benefit plans and termination benefits) which do not fall due wholly within 12 months after the end of
the period in which the employees render the service.
9 Termination benefits
Section overview
Termination benefits are recognised as an expense when the entity is committed to either:
– Terminate the employment before normal retirement date or
– Provide termination benefits in order to encourage voluntary redundancy
Definition C
H
Termination benefits: are employee benefits payable on the termination of employment, through A
voluntary redundancy or as a result of a decision made by the employer to terminate employment P
before the normal retirement date. T
E
R
Where voluntary redundancy has been offered, the entity should measure the benefits based on an
expected level of take-up. If, however, there is uncertainty about the number of employees who will 8
accept the offer, then there may be a contingent liability, requiring disclosure under IAS 37 Provisions,
Contingent Liabilities and Contingent Assets.
An entity should recognise a termination benefit when it has made a firm commitment to end the
employment. Such a commitment will exist where, for example, the entity has a detailed formal plan for
the termination and it cannot realistically withdraw from that commitment.
Where termination benefits fall due more than twelve months after the reporting date they should be
discounted.
Solution
The entity should only recognise the liability for the termination benefits when it is demonstrably
committed to terminate the employment of those affected. This occurred on 7 October 20X3 when the
formal plan was announced and it is at this date that there is no realistic chance of withdrawal.
IAS 19 allows a similar immediate recognition approach to actuarial gains and losses to FRS 17.
Deferred tax balances are netted off the net pension scheme asset/liability under FRS 17. Under IAS
19 they must be shown separately.
The scope of IAS 19 is wider and covers different types of employee compensation.
In June 2011, the IASB published a revised version of IAS 19 Employee Benefits. The revised standard is
now examinable. It is also useful for you to be aware of the changes made – in particular, the abolition
of the 'corridor method' in order to see the current rules in perspective.
Summary
Employee benefits
Remeasurement
gains/loss
IAS 24
- Description of the plan Opening and IAS 37
Arising IAS 1
- Actuarial assumptions closing balances
from
Funded Unfunded
Plan assets plans plans
Actual return Fair value of plan assets Present value of Fair value of
on plan assets - For each category of defined benefit plan assets
entity's own obligation
instruments
- For property or asset
used by entity
Reconciliation of above C
- By main categories to assets and liabilities H
of instruments in A
in statement of
percentage terms P
financial position
T
E
R
The discount rates used for calculating the defined benefit obligation were 6.5% at 31 December
20X4, and 6% at 31 December 20X5.
Requirements
(a) Calculate the interest cost to be charged to profit or loss for 20X5.
(b) How should the discount factor that is used to discount post-employment benefit obligations
be determined?
(c) What elements should the discount rate specifically not reflect according to IAS 19?
5 Straw Holdings plc
John Cork, financial director of Straw Holdings plc, your audit client, has recently written to you for
advice on pension scheme accounting.
The company's defined benefit pension scheme has net assets valued at £20.2 million. Scheme
assets of £19.4 million at the beginning of the year were expected to grow by 10% during the year
The deficit of £1.54 million has come as a surprise to Cork. He is unsure how to treat this deficit in
the financial statements and concerned about the impact it will have on the company's profits.
Requirements
(a) Explain the impact of the actuarial valuation of the scheme's assets and the resultant deficit on
the financial statements of Straw Holdings plc for the year ended 31 December 20X1.
(b) Identify TWO benefits to Straw Holdings plc of moving from a defined benefit to a defined
contribution scheme.
C
H
A
P
T
E
R
IAS 19.4
Four categories of employee benefits
Short-term employee benefits
Post-employment benefits
Other long-term employee benefits
Termination benefits
IAS 19.7, 19.8
Short-term employee benefits
Wages, salaries and social security contributions falling due within 12 months
of employee service
Short-term compensated absences such as vacation entitlement and paid sick
leave
Profit-sharing and bonuses
Non-monetary benefits
IAS 19.10
Accounting for short-term employee benefits
Short-term employee benefits are recognised as an expense and a
corresponding liability and are accounted for on an undiscounted basis
– Accumulating
ie those that are carried forward if not used in current period
– Non-accumulating
ie those that cannot be carried forward and lapse after the current period
An accrual shall be made in respect of unused entitlement for compensated IAS 19.14
absences
– Demographic assumptions
– Financial assumptions
IAS 19.78
Discount rate
Rate used to discount post-employment obligations shall be determined by
reference to market yields at reporting date on high quality corporate bonds
Amount recognised in profit or loss is as for defined benefit schemes except IAS 19.127
that:
– Actuarial gains and losses, and
– Past service costs are recognised immediately
Termination benefits
Termination benefits are recognised as an expense when the entity is IAS 19.133
committed to
– Terminate the employment before normal retirement date, or
– Provide termination benefits as a result of an offer for voluntary
redundancy
Where termination benefits fall due more than 12 months after the reporting IAS 19.139
date they shall be discounted
1 Employee benefits
(a) Short-term employee benefits
(b) Defined benefit plans
(c) Defined benefit plans
IAS 19.9 highlights paid annual leave as a short term benefit.
The actuarial gains and the lump sum benefit relate to defined benefit plans (per IAS 19.24-27 and 54).
2 Lampard
£720,000(£500,000 + 2£20,000)
Under IAS 19 Employee Benefits (revised 2011), past service cost attributable to all benefits, whether
vested or not within a post-retirement defined benefit plan must be recognised immediately in
profit or loss. Similarly past service cost attributable to all benefits, whether vested or not, within a
long-term disability benefits plan must be recognised immediately in profit or loss, so the full
£720,000 must be recognised.
3 Tiger
Tiger should not be using 8% as its discount rate.
C
Under IAS 19.78 the yield on high quality corporate bonds must be used as the discount rate for H
the defined benefit obligation. (Using a higher rate would result in a lower obligation, which would A
not reflect greater risk.) P
T
4 (a) The interest cost for 20X5 is calculated by multiplying the defined benefit obligation at the E
start of the period by the discount rate at the start of the period, so: R
In the statement of financial position, the liability that is recognised is calculated as follows.
20X2 20X3 20X4
£'000 £'000 £'000
Present value of obligation 1,200 1,600 1,700
Market value of plan assets 1,250 1,402 1,610
Liability/(asset) in statement of financial position (50) 198 90
The following will be recognised in profit or loss for the year:
20X2 20X3 20X4
£'000 £'000 £'000
Current service cost 140 150 150
Past service cost – – 40
Net interest on defined benefit liability (asset) – (5) 20
Gain on settlement of defined benefit liability – (2) –
Expense recognised in profit or loss 140 143 210
The following re-measurements will be recognised in other comprehensive income for the year:
20X2 20X3 20X4
£'000 £'000 £'000
Actuarial (gain)/loss on obligation 80 320 (100)
Return on plan assets (excluding amounts in net- (160) (95) (98)
interest)
The company is required by the revised IAS 19 to recognise the £24,000,000 remeasurement gain (see
working) immediately in other comprehensive income.
WORKING
PV of FV of plan
obligation assets
£m £m
b/f Nil Nil
Contributions paid 160
Interest on plan assets 16
Current service cost 176
Interest cost on obligation 32
Actuarial difference (bal fig) – 24
c/f 208 200
£'000
Reconciliation of pension plan movement
Plan deficit at 1 Feb 20X7 (3,600 – 4,300) (700)
Company contributions 550
Profit or loss total (389)
Other comprehensive income total (107 + 7) 114
Plan deficit at 31 Jan 20X8 (4,115 – 4,540) (425)
£'000
Changes in the present value of the defined benefit obligation
Defined benefit obligation at 1 Feb 20X7 4,300 C
H
Interest cost @ 8% 344 A
Pensions paid (330) P
Curtailment 58 T
Current service cost 275 E
Actuarial gain (residual) (107) R
Defined benefit obligation at 31 Jan 20X8 4,540
Share-based payment
Introduction
Topic List
1 Background
2 Objective and scope of IFRS 2 Share-based Payment
3 Share-based transaction terminology
4 Equity-settled share-based payment transactions
5 Cash-settled share-based payment transactions
6 Share-based payment with a choice of settlement
7 Group and treasury share transactions
8 Disclosure
9 UK GAAP comparison
10 Distributable profits and purchase of own shares
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
299
Introduction
Demonstrate an understanding and be able to apply the reporting requirements for share-
based payment transactions with third parties and with employees
Apply knowledge and understanding of IFRS 2 in particular circumstances through basic
calculations
Evaluate and apply appropriate financial reporting treatments of IFRS 2 to given scenarios
Advise on and develop appropriate remuneration and reward packages for staff and
executives
1.1 Introduction
Share-based payment occurs when an entity purchases goods or services from another party such as a
supplier or employee and rather than paying directly in cash, settles the amount owing in shares, share
options or future cash amounts linked to the value of shares. This is common:
In e-businesses which do not tend to be profitable in early years and are cash poor.
Within all sectors where a large part of the remuneration of directors is provided in the form of
shares or options. Employees may also be granted share options.
In practice, the implementation of IFRS 2 has resulted in earnings being reduced, sometimes
significantly. It is generally agreed that as a result of this Standard companies focus more on the
9
earnings effect of different rewards policies.
Following the adoption of IFRS 2, some companies have admitted that they are re-evaluating the use of
share options as part of employee remuneration.
Section overview
A share-based payment transaction is one in which the entity transfers equity instruments, such as
shares or share options, in exchange for goods and services supplied by employees or third
parties.
Section overview
Share-based transactions are agreed between an entity and counterparty at the grant date; the
counterparty becomes entitled to the payment at the vesting date.
Definitions
Grant date: The date at which the entity and other party agree to the share-based payment
arrangement. At this date the entity agrees to pay cash, other assets or equity instruments to the other
party, provided that specified vesting conditions, if any, are met. If the agreement is subject to
shareholder approval, then the approval date becomes the grant date.
Vesting conditions: The conditions that must be satisfied for the other party to become entitled to
receive the share-based payment.
Vesting period: The period during which the vesting conditions are to be satisfied.
Vesting date: The date on which all vesting conditions have been met and the employee / third party
becomes entitled to the share-based payment.
In some cases the grant date and vesting date are the same. This is the case where vesting conditions
are met immediately and therefore there is no vesting period.
Section overview
Where payment for goods or services is in the form of shares or share options, the fair value of the
transaction is recognised in profit or loss, spread over the vesting period.
4.1 Introduction
If goods or services are received in exchange for shares or share options, the transaction is accounted for
by:
£ £
DR Expense/Asset X
CR Equity X
IFRS 2 does not stipulate which equity account the credit entry is made to. It is normal practice to credit
a separate component of equity, although an increasing number of UK companies are crediting retained
earnings.
We must next consider:
1 Measurement of the total expense taken to profit or loss
2 When this expense should be recorded.
4.2 Measurement
When considering the total expense to profit or loss, the basic principle is that equity-settled share-
based transactions are measured at fair value.
Definition
Fair value: The amount for which an asset could be exchanged, a liability settled, or an equity
instrument granted could be exchanged, between knowledgeable, willing parties in an arm's length
transaction.
(Note that this definition is still applicable, rather than the definition in IFRS 13, because IFRS 13 does
not apply to transactions within the scope of IFRS 2.) C
H
A
P
Fair value will depend upon who the transaction is with: T
E
There is a rebuttable presumption that the fair value of goods/services received from a third party R
can be measured reliably.
It is not normally possible to measure services received when the shares or share options form part
9
of the remuneration package of employees.
no
yes
Measure at fair value of the goods / Measure at the fair value of the equity
services on the date they were received instruments granted at grant date
= direct method = indirect method
Where entitlement to the instruments granted is conditional on vesting conditions, and these are to be
met over a specified vesting period, the expense is spread over the vesting period.
Solution
The services received and the shares issued by Entity A are measured at the fair value of the services
received. For the first year, the hourly rate will be measured at that originally proposed by Entity B,
105% of £600. Entity B plans to increase that rate by another 5% for the second year.
The expense in profit or loss and the increase in equity associated with these arrangements will be:
£
July – December 20X5 300 × £630 189,000
January – December 20X6 (300 × £630) + (300 × £630 × 1.05) 387,450
January – June 20X7 300 × £630 × 1.05 198,450
Solution
The changes in the value of equity instruments after grant date do not affect the charge to profit or loss
for equity-settled transactions.
Based on the fair value at grant date, the remuneration expense is calculated as follows.
Number of employees number of equity instruments fair value of equity instruments at grant date
= 10 × 1,000 × £9 = £90,000
The remuneration expense should be recognised over the vesting period of three years. An amount of
£30,000 should be recognised for each of the three years 20X7, 20X8 and 20X9 in profit or loss with a
corresponding credit to equity.
Solution
The total fair value for the share options issued at grant date is:
£10 x 1,500 employees × 10 options = £150,000
The entity should therefore charge £150,000 to profit or loss as employee remuneration on 1 July 20X5
and the same amount will be recognised as part of equity on that date.
Solution
IFRS 2 requires the entity to recognise the remuneration expense, based on the fair value of the share
options granted, as the services are received during the three-year vesting period.
In 20X1 and 20X2 the entity estimates the number of options expected to vest (by estimating the
number of employees likely to leave) and bases the amount that it recognises for the year on this
estimate.
In 20X3 it recognises an amount based on the number of options that actually vest. A total of 55
employees left during the three-year period and therefore 34,500 options (400 – 55) 100 vested.
Solution
The cost reduction target is a non-market performance condition which is taken into account in
estimating whether the options will vest. The expense recognised in profit or loss in each of the three
years is:
Cumulative Charge in the year
£ £
20X4 (10,000 £21)/3 years 70,000 70,000
20X5 Assumed performance would not be achieved 0 (70,000)
20X6 10,000 £21 210,000 210,000
Solution
Jeremy satisfied the service requirement but the share price growth condition was not met. The share
price growth is a market condition and is taken into account in estimating the fair value of the options at
grant date. No adjustment should be made if there are changes from that estimated in relation to the market
condition. There is no write-back of expenses previously charged, even though the shares do not vest.
The expense recognised in profit or loss in each of the three years is one third of 10,000 × £18 =
£60,000.
Solution
The total cost to the entity of the original option scheme was:
1,000 shares × 20 managers × £20 = £400,000
This was being recognised at the rate of £100,000 each year.
The cost of the modification is:
1,000 20 managers × (£11 – £2) = £180,000 C
H
This additional cost should be recognised over 30 months, being the remaining period up to vesting, so A
£6,000 a month. P
T
The total cost to the entity in the year ended 31 December 20X5 is: E
R
£100,000 + (£6,000 × 6) = £136,000.
9
Interactive question 5: Re-pricing of share options [Difficulty level: Intermediate]
At the beginning of Year 1, an entity grants 100 share options to each of its 500 employees. Each grant
is conditional upon the employee remaining in service over the next three years. The entity estimates
that the fair value of each option is £15. On the basis of a weighted average probability, the entity
estimates that 100 employees will leave during the three-year period and therefore forfeit their rights to
the share options.
During the first year 40 employees leave. By the end of the first year, the entity's share price has
dropped, and the entity reprices its share options. The repriced share options vest at the end of Year 3.
The entity estimates that a further 70 employees will leave during Years 2 and 3, and hence the total
expected employee departures over the three-year vesting period is 110 employees. During Year 2 a
further 35 employees leave, and the entity estimates that a further 30 employees will leave during Year
3, to bring the total expected employee departures over the three-year vesting period to 105
employees. During Year 3, a total of 28 employees leave, and hence a total of 103 employees ceased
Solution
The original cost to the entity for the share option scheme was:
2,000 shares × 23 managers × £33 = £1,518,000
This was being recognised at the rate of £506,000 in each of the three years.
At 30 June 20X5 the entity should recognise a cost based on the amount of options it had vested on
that date. The total cost is:
2,000 × 24 managers × £33 = £1,584,000
After deducting the amount recognised in 20X4, the 20X5 charge to profit or loss is £1,078,000.
The compensation paid is:
2,000 × 24 × £63 = £3,024,000
Of this, the amount attributable to the fair value of the options cancelled is:
2,000 24 £60 (the fair value of the option, not of the underlying share) = £2,880,000
This is deducted from equity as a share buyback. The remaining £144,000 (£3,024,000 less £2,880,000)
is charged to profit or loss.
Section overview
The credit entry in respect of a cash-settled share-based payment transaction is reported as a
liability.
The fair value of the liability should be re-measured at each reporting date until settled. Changes
in the fair value are recognised in profit or loss.
5.1 Introduction
Cash-settled share-based payment transactions are transactions where the amount of cash paid for
goods and services is based on the value of an entity's equity instruments.
Examples of this type of transaction include:
Share appreciation rights (SARs): the employees become entitled to a future cash payment (rather
than an equity instrument), based on the increase in the entity's share price from a specified level
over a specified period of time; or
An entity might grant to its employees a right to receive a future cash payment by granting to
them a right to shares that are redeemable.
C
H
5.2 Accounting treatment A
P
If goods or services are received in exchange for cash amounts linked to the value of shares, the T
transaction is accounted for by: E
£ £ R
DR Expense/Asset X
CR Liability X
9
Allocation of expense to financial years
The expense should be recognised as services are provided. For example, if share appreciation rights do
not vest until the employees have completed a specified period of service, the entity should recognise
the services received and the related liability, over that period.
Measurement
The goods or services acquired and the liability incurred are measured at the fair value of the liability.
The entity should remeasure the fair value of the liability at each reporting date and at the date of
settlement. Any changes in fair value are recognised in profit or loss for the period.
Vesting conditions
Vesting conditions should be taken into account in a similar way as for equity-settled transactions when
determining the number of rights to payment that will vest.
Solution
For the three years to the vesting date of 31 December 20X3 the expense is based on the entity's
estimate of the number of SARs that will actually vest (as for an equity-settled transaction). However, the
fair value of the liability is remeasured at each year-end.
The intrinsic value of the SARs at the date of exercise is the amount of cash actually paid.
Liability Expense for
at year end year
£ £ £
20X1 Expected to vest (500 – 95):
405 × 100 × £14.40 × 1/3 194,400 194,400
20X2 Expected to vest (500 – 100):
400 × 100 × £15.50 × 2/3 413,333 218,933
20X3 Exercised:
150 × 100 × £15.00 225,000
Not yet exercised (500 – 97 – 150):
253 × 100 × £18.20 460,460 47,127
272,127
20X4 Exercised:
140 × 100 × £20.00 280,000
Not yet exercised (253 – 140):
113 × 100 × £21.40 241,820 (218,640)
61,360
20X5 Exercised:
113 × 100 × £25.00 282,500
Nil (241,820)
40,680
787,500
Section overview
C
Accounting for share-based transactions with a choice of settlement depends on which party has H
the choice. A
P
– Where the counterparty has a choice of settlement, a liability component and an equity T
component are identified. E
R
– Where the entity has a choice of settlement, the whole transaction is treated either as cash-
settled or as equity-settled, depending on whether the entity has an obligation to settle in
cash. 9
IFRS 2 requires that the value of the debt component is established first. The equity component is then
measured as the residual between that amount and the value of the instrument as a whole. In this
respect IFRS 2 applies similar principles to IAS 32 Financial Instruments: Presentation where the value of
the debt components is established first. However, the method used to value the constituent parts of
the compound instrument in IFRS 2 differs from that of IAS 32.
For transactions in which the fair value of goods or services is measured directly (that is normally where
the recipient is not an employee of the company), the fair value of the equity component is measured as
the difference between the fair value of the goods or services required and the fair value of the debt
component.
For other transactions including those with employees where the fair value of the goods or services is
measured indirectly by reference to the fair value of the equity instruments granted, the fair value of the
compound instrument is estimated as a whole.
The debt and equity components must then be valued separately. Normally transactions are structured
in such a way that the fair value of each alternative settlement is the same.
Solution
This arrangement results in a compound financial instrument.
The fair value of the cash route is:
7,000 × £21 = £147,000
The fair value of the share route is:
8,000 × £19 = £152,000
The fair value of the equity component is therefore:
£5,000 (£152,000 less £147,000)
Section overview
IFRS 2 was amended in June 2009 to incorporate the requirements of IFRIC 11 (now withdrawn)
on group and treasury share transactions.
7.1 Background
IFRS 2 gives guidance on group and treasury shares in three circumstances:
Where an entity grants rights to its own equity instruments to employees, and then either chooses
or is required to buy those equity instruments from another party, in order to satisfy its obligations
to its employees under the share-based payment arrangement
Where a parent company grants rights to its equity instruments to employees of its subsidiary
Where a subsidiary grants rights to equity instruments of its parent to its employees
7.2.2 Parent grants rights to its equity instruments to employees of its subsidiary
Assuming the transaction is accounted for as equity-settled in the consolidated financial statements, the
subsidiary must measure the services received using the requirements for equity-settled transactions in
IFRS 2, and must recognise a corresponding increase in equity as a contribution from the parent.
7.2.3 Subsidiary grants rights to equity instruments of its parent to its employees
The subsidiary accounts for the transaction as a cash-settled share-based payment transaction.
Therefore, in the subsidiary's individual financial statements, the accounting treatment of transactions in
which a subsidiary's employees are granted rights to equity instruments of its parent would differ,
depending on whether the parent or the subsidiary granted those rights to the subsidiary's employees.
This is because IFRIC 11 concluded that, in the former situation, the subsidiary has not incurred a
liability to transfer cash or other assets of the entity to its employees, whereas it has incurred such a
liability in the latter situation (being a liability to transfer equity instruments of its parent).
7.2.4 In June 2009, IFRIC 11 was withdrawn and incorporated into IFRS 2.
8 Disclosure
Section overview
The disclosures of IFRS 2 are extensive and require the analysis of share-based payments made
during the year, their impact on earnings and the financial position of the company and the basis
on which fair values were calculated.
9 UK GAAP comparison
Section overview
FRS 20 issued by the ASB in April 2004 is identical to IFRS 2, with the exception of the deferred
implementation for unlisted entities.
Section overview
Various rules have been created to ensure that dividends are only paid out of available profits.
Definition
A dividend is an amount payable to shareholders from profits or other distributable reserves.
Listed companies generally pay two dividends a year; an interim dividend based on interim profit
figures, and a final dividend based on the annual accounts and approved at the AGM.
A dividend becomes a debt when it is declared and due for payment. A shareholder is not entitled to
a dividend unless it is declared in accordance with the procedure prescribed by the articles and the
declared date for payment has arrived.
This is so even if the member holds preference shares carrying a priority entitlement to receive a
specified amount of dividend on a specified date in the year. The directors may decide to withhold
profits and cannot be compelled to recommend a dividend.
Section overview
Distributable profits may be defined as 'accumulated realised profits ... less accumulated realised
losses'. 'Accumulated' means that any losses of previous years must be included in reckoning the
current distributable surplus. 'Realised' profits are determined in accordance with generally
accepted accounting principles.
Definition
Profits available for distribution are accumulated realised profits (which have not been distributed or
capitalised) less accumulated realised losses (which have not been previously written off in a reduction
or reorganisation of capital).
The word 'accumulated' requires that any losses of previous years must be included in reckoning the
current distributable surplus.
A profit or loss is deemed to be realised if it is treated as realised in accordance with generally accepted
accounting principles. Hence, financial reporting and accounting standards in issue, plus generally
accepted accounting principles (GAAP), should be taken into account when determining realised profits
and losses.
Depreciation must be treated as a realised loss, and debited against profit, in determining the amount
of distributable profit remaining.
However, a revalued asset will have depreciation charged on its historical cost and the increase in the
value in the asset. The Companies Act allows the depreciation provision on the valuation increase to be
treated also as a realised profit.
Effectively there is a cancelling out, and at the end only depreciation that relates to historical cost
will affect dividends.
Suppose now that after five years the asset is revalued to £50,000 and in consequence the annual
depreciation charge is raised to £10,000 (over each of the five remaining years of the asset's life).
The effect of the Act is that £8,000 of this amount may be reclassified as a realised profit. The net effect
is that realised profits are reduced by only £2,000 in respect of depreciation, as before.
If, on a general revaluation of all fixed assets, it appears that there is a diminution in value of any one or
more assets, then any related provision(s) need not be treated as a realised loss.
The Act states that if a company shows development expenditure as an asset in its accounts it must
usually be treated as a realised loss in the year it occurs. However it can be carried forward in special
circumstances (generally taken to mean in accordance with accounting standards).
Section overview
A public company may only make a distribution if its net assets are, at the time, not less than
the aggregate of its called-up share capital and undistributable reserves. It may only pay a
dividend which will leave its net assets at not less than that aggregate amount.
A public company may only make a distribution if its net assets are, at the time, not less than the
aggregate of its called-up share capital and undistributable reserves. The dividend which it may pay
is limited to such amount as will leave its net assets at not less than that aggregate amount.
Undistributable reserves are defined as:
(a) Share premium account
(b) Capital redemption reserve
(c) Any surplus of accumulated unrealised profits over accumulated unrealised losses (known as a
revaluation reserve). However a deficit of accumulated unrealised profits compared with
accumulated unrealised losses must be treated as a realised loss.
(d) Any reserve which the company is prohibited from distributing by statute or by its constitution or
any law.
The dividend rules apply to every form of distribution of assets except the following
The issue of bonus shares whether fully or partly paid
The redemption or purchase of the company's shares out of capital or profits
A reduction of share capital C
H
A distribution of assets to members in a winding up A
P
You must appreciate how the rules relating to public companies in this area are more stringent than the
T
rules for private companies. E
R
Section overview
The profits available for distribution are generally determined from the last annual accounts to be
prepared.
Whether a company has profits from which to pay a dividend is determined by reference to its 'relevant
accounts', which are generally the last annual accounts to be prepared.
If the auditor has qualified their report on the accounts they must also state in writing whether, in their
opinion, the subject matter of their qualification is material in determining whether the dividend may
Section overview
You must be able to carry out simple calculations showing the amounts to be transferred to the
capital redemption reserve on purchase or redemption of own shares and how the amount of
any premium on redemption would be treated.
Any limited company is permitted without restriction to cancel unissued shares and in that way to
reduce its authorised share capital. That change does not alter its financial position.
Three factors need to be in place to give effect to a reduction of a company's issued share capital.
Articles usually contain the necessary power. If not, the company in general meeting would first pass a
special resolution to alter the articles appropriately and then proceed, as the second item on the agenda
of the meeting, to pass a special resolution to reduce the capital.
There are three basic methods of reducing share capital specified.
(a) Extinguish or reduce liability on partly paid shares. A company may have issued £1 (nominal)
shares 75p paid up. The outstanding liability of 25p per share may be eliminated altogether by
reducing each share to 75p (nominal) fully paid or some intermediate figure, eg 80p (nominal)
75p paid. Nothing is returned to the shareholders but the company gives up a claim against them
for money which it could call up whenever needed.
(b) Cancel paid up share capital which has been lost or which is no longer represented by
available assets. Suppose that the issued shares are £1 (nominal) fully paid but the net assets now C
represent a value of only 50p per share. The difference is probably matched by a debit balance on H
A
retained earnings (or provision for fall in value of assets). The company could reduce the nominal
P
value of its £1 shares to 50p (or some intermediate figure) and apply the amount to write off the T
debit balance or provision wholly or in part. It would then be able to resume payment of dividends E
out of future profits without being obliged to make good past losses. The resources of the R
company are not reduced by this procedure of part cancellation of nominal value of shares but it
avoids having to rebuild lost capital by retaining profits.
9
(c) Pay off part of the paid up share capital out of surplus assets. The company might repay to
shareholders, say, 30p in cash per £1 share by reducing the nominal value of the share to 70p. This
reduces the assets of the company by 30p per share.
Now if Muffin Ltd were able to repurchase the shares without making any transfer from the retained
earnings to a capital redemption reserve, the effect of the share redemption on the statement of
financial position would be as follows.
Net assets £
Non-cash assets 300,000
Less trade payables 120,000
180,000
Equity
Ordinary shares 30,000
Retained earnings 150,000
180,000
C
In this example, the company would still be able to pay dividends out of profits of up to £150,000. If it H
did, the creditors of the company would be highly vulnerable, financing £120,000 out of a total of A
£150,000 assets of the company. P
T
The regulations in the Act are intended to prevent such extreme situations arising. On repurchase of the E
shares, Muffin Ltd would have been required to transfer £100,000 from its retained earnings to a R
non-distributable reserve, called a capital redemption reserve. The effect of the redemption of shares on
the statement of financial position would have been:
9
Net assets £ £
Non-cash assets 300,000
Less trade payables 120,000
180,000
Equity
Ordinary shares 30,000
Reserves
Distributable (retained earnings) 50,000
Non-distributable (capital redemption reserve) 100,000
150,000
180,000
The maximum distributable profits are now £50,000. If Muffin Ltd paid all these as a dividend, there
would still be £250,000 of assets left in the company, just over half of which would be financed by
non-distributable equity capital.
On 1 July 20X5 Krumpet plc purchased and cancelled 50,000 of its ordinary shares at £1.50 each.
The shares were originally issued at a premium of 20p. The redemption was partly financed by the issue
at par of 5,000 new shares of £1 each.
Requirement
Prepare the summarised statement of financial position of Krumpet plc at 1 July 20X5 immediately after
the above transactions have been effected.
Summary
Share-based payment
Cash Equity
method method Cash Equity
method method
The amount of
The payment The payment The balance
payment equal
is deducted is applied to of the liability
to the fair value
from equity settle the is transferred
of the equity
liability in full to equity
instrument that
would otherwise
have been issued The excess
is deducted of the fair value
from equity. of the equity
The excess over instrument
this amount is issued over the
recognised as amount of cash
an expense that would
otherwise have
been paid
No further is recognised
accounting is as an expense
required
Examples
- Remain in
Examples employment for a
achieve target specified service
- Share price period
- Shareholder return - Achieve profit targets
- Price index - Achieve earnings per
share targets
- Achieve flotation
- Complete a particular
project
Accounting Accounting
treatment treatment
C
H
A
P
T
E
R
Is the modification
beneficial?
Yes No
Increase Increase in
Decrease in Decrease in
in fair number of
fair value of number of
value of equity
equity instruments
equity instruments
instruments granted
instruments granted
Less likely
to vest
Amortise
the incremental Ignore the Treat as
fair value modification cancellation
over vesting
period
AND
Revise
vesting
estimates
C
H
A
P
T
E
R
Contracts that may be settled net in shares or rights to shares IFRS 2.6
3 Recognition
Goods or services received in share-based transaction to be recognised as IFRS 2.8
expenses or assets
Entity shall recognise corresponding increase in equity for equity-settled IFRS 2.7
transaction or a liability for cash-settled transactions
Where equity instruments are paid instead of cash, the liability shall be IFRS 2.39
transferred to equity
Where entity pays cash on settlement rather than equity, the payment is IFRS 2.40
applied to the liability. The equity components previously recognised will
remain in equity and entity can make a transfer from one component of equity
to another
Where entity has the choice of settlement, if present obligation exists to deliver IFRS 2.41
cash, it should recognise and treat as cash-settled share-based payment
transactions
If no present obligation exists to pay cash, entity should treat transaction as an IFRS 2.43
equity-settled transaction. On settlement if cash was paid, cash should be
treated as repurchase of equity by a deduction against equity
C
H
A
P
T
E
R
DR Expenses £212,500
CR Equity £212,500
£
20X6 Equity c/d (500 × 88% × 100 × £15 × 2/3) = 440,000
Less: previously recognised (212,500)
227,500
DR Expenses £227,500
CR Equity £227,500
£
20X7 Equity c/d (443 × 100 × £15) = 664,500
Less: previously recognised (440,000)
224,500
DR Expenses £224,500
CR Equity £224,500
7
£
Year ended 31 December 20X4
Expense and liability ((450 – 60) × 100 × £8.00 × 1/2 ) 156,000
Year ended 31 December 20X5
Liability c/d (300 × 100 × £8.50) 255,000
Less: b/d liability (156,000) C
99,000 H
Plus: cash paid on exercise of SARs by employees A
P
(100 × 100 × £8.10) 81,000 T
Expense 180,000 E
R
Year ended 31 December 20X6
Liability c/d –
Less: b/d liability (255,000)
9
(255,000)
Plus cash paid on exercise of SARs by employees
(300 × 100 × £9.00) 270,000
Expense 15,000
8 ZZX plc
(a) Journal entries for transactions: Finance director
The transactions are settled in cash and hence liabilities are created.
31 December 20X4 £ £
DR Expense 147
CR Liability 147
It is assumed that the current share price is the best estimate of the final share price.
(calculation note: 20 10 £2.20 1/3 )
2 Equity c/d [(500 – 105) 100 ((£15 2/3) + (£3 1/2 ))] 454,250
Less: previously recognised (195,000)
259,250
Dr Expenses £259,250
Cr Equity £259,250
The movement in the accrual would be charged to profit or loss representing further entitlements
received during the year and adjustments to expectations accrued in previous years.
The accrual would continue to be adjusted (resulting in an expense charge) for changes in the fair
value of the rights over the period between when the rights become fully vested and are
subsequently exercised. It would then be reduced for cash payments as the rights are exercised.
20X7 C
Expense is at fair value £15 H
based on an expected 2-year vesting period A
P
450 employees – 30 leavers – 25 future leavers = 395 employees
T
Expense = 395 100 options £15 1/2 years E
= £296,250 R
20X8
450 employees – 30 left Year 1 – 15 left Year 2 – 26 future
leavers = 379 employees 9
Expense is now spread over a 3-year vesting period
Expense = £15 379 100 2/3 years £379,000
Less: Recognised in Year 1 £296,250
Year 2 expense £82,750
20X9
390 100 £15 3/3 years = £585,000
Less: Recognised previously £379,000
Expense in Year 3 £206,000
Double entries £
20X7 Dr employment costs 296,250
Cr equity 296,250
20X8 Dr employment costs 82,750
Cr equity 82,750
20X9 Dr employment costs 206,000
Cr equity 206,000
C
H
A
P
T
E
R
Groups – revision
Introduction
Topic List
1 Summary and categorisation of investments
2 IFRS 10 Consolidated Financial Statements
3 IFRS 3 (Revised) Business Combinations
4 IFRS 13 Fair Value Measurement (business combination aspects)
5 IAS 28 Investments in Associates and Joint Ventures
6 IFRS 11 Joint Arrangements
7 IFRS 12 Disclosure of Interests in Other Entities
8 Step acquisitions
9 Disposals
10 Statements of cash flows
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
351
Introduction
Apply knowledge and understanding of IAS 7 Statement of Cash Flows to group situations
Section overview
This chapter revises IFRS 3 Business Combinations, which was covered at Professional Stage. It also
covers the following standards, which are new or revised, although some of the topics to which
they relate were covered at Professional Stage.
– IFRS 13 Fair Value Measurement (business combination aspects)
– IFRS 10 Consolidated Financial Statements
– IAS 28 Investments in Associates and Joint Ventures
– IFRS 11 Joint Arrangements
– IFRS 12 Disclosure of Interests in Other Entities
It also explains the changes made as a result of the revisions to IFRS 3 and IAS 27 made in 2008.
A summary of the different types of investment and the required accounting for them is as follows.
This treatment is applicable in both the separate and consolidated financial statements of the joint
operator.
In its consolidated financial statements, IFRS 11 requires that a joint venturer recognises its interest in a
joint venture as an investment and accounts for that investment using the equity method in
accordance with IAS 28 Investments in associates and joint ventures unless the entity is exempted from
applying the equity method (see Section 4.2 which is also applicable to joint ventures).
In its separate financial statements, a joint venturer should account for its interest in a joint venture in
accordance with IAS 27 (2011) Separate financial statements, namely:
At cost, or
In accordance with IFRS 9 Financial instruments
Section overview
IFRS 10, issued in 2011, covers the basic definitions and consolidation requirements and the rules
on exemptions from preparing group accounts. The Standard requires a parent to present
consolidated financial statements, consolidating all subsidiaries, both foreign and domestic.
The most important aspect is control.
2.1 Introduction
When a parent issues consolidated financial statements, it should consolidate all subsidiaries, both
foreign and domestic. The first step in any consolidation is to identify the subsidiaries using the
definition as set out in paragraph 1.1 above.
The definition of an asset in the IASB's Framework from earlier studies is given below.
You should make sure that you understand the various ways in which control can arise as this is
something that you may be asked to discuss in the context of a scenario in the exam.
2.1.1 Power
Power is defined as existing rights that give the current ability to direct the relevant activities of
the investee. There is no requirement for that power to have been exercised.
Relevant activities may include:
Selling and purchasing goods or services
Managing financial assets
Selecting, acquiring and disposing of assets
Researching and developing new products and processes
Determining a funding structure or obtaining funding.
In some cases assessing power is straightforward, for example, where power is obtained directly and
solely from having the majority of voting rights or potential voting rights, and as a result the ability to
direct relevant activities.
In other cases, assessment is more complex and more than one factor must be considered. IFRS 10 gives
the following examples of rights, other than voting or potential voting rights, which individually, or
alone, can give an investor power.
Rights to appoint, reassign or remove key management personnel who can direct the relevant
activities
Rights to appoint or remove another entity that directs the relevant activities
Rights to direct the investee to enter into, or veto changes to transactions for the benefit of the
investor
Other rights, such as those specified in a management contract.
IFRS 10 suggests that the ability rather than contractual right to achieve the above may also indicate
that an investor has power over an investee.
An investor can have power over an investee even where other entities have significant influence or
other ability to participate in the direction of relevant activities.
2.1.2 Returns
An investor must have exposure, or rights, to variable returns from its involvement with the investee in
order to establish control.
This is the case where the investor's returns from its involvement have the potential to vary as a result of
the investee's performance.
Returns may include:
C
Dividends H
A
Remuneration for servicing an investee's assets or liabilities P
T
Fees and exposure to loss from providing credit support E
R
Returns as a result of achieving synergies or economies of scale through an investor combining use
of their assets with use of the investee's assets.
10
2.1.3 Link between power and returns
In order to establish control, an investor must be able to use its power to affect its returns from its
involvement with the investee. This is the case even where the investor delegates its decision making
powers to an agent.
Section overview
IFRS 3 refers to business combinations as 'transactions or events in which an acquirer obtains
control of one or more businesses'. In a straightforward business combination one entity acquires
another, resulting in a parent subsidiary relationship.
Business combinations are accounted for using the acquisition method
This calculation includes the non-controlling interest and is therefore calculated based on the whole net
assets of the acquiree.
Section 3.3 considers the first two elements of the revised calculation – consideration transferred and
the non-controlling interest – in more detail.
Solution
Goodwill is calculated as:
£ C
H
Consideration transferred 670,000 A
Non-controlling interest at the acquisition date 140,000 P
810,000 T
Less: Total fair value of net assets of acquiree (700,000) E
Goodwill 110,000 R
In this example the non-controlling interest is measured as the relevant percentage of Tweed's
acquisition date net assets, ie 20% × £700,000. 10
This means that the goodwill arising is the same as it would be if calculated according to the previous
version of IFRS 3:
As we shall see later, this is not always the case, as the non-controlling interest is not necessarily
calculated as a proportion of acquisition date net assets.
Solution
(a) (b)
NCI at share NCI at fair
of net assets value
£'000 £'000
Consideration transferred 25,000 25,000
Non-controlling interest – 20% × £21 million/fair value 4,200 5,000
29,200 30,000
Total net assets of acquiree (21,000) (21,000)
Goodwill acquired in business combination 8,200 9,000
As the non-controlling interest is £0.8 million higher when measured at fair value, it follows that
goodwill is also £0.8 million higher.
This amount is the goodwill relating to the non-controlling interest. The calculation of goodwill when
the NCI is valued at fair value could be laid out as:
Group NCI
£'000 £'000
Consideration / fair value 25,000 5,000
Share of net assets 80% / 20% × £21m (16,800) (4,200)
Goodwill 8,200 800
Total (or full) goodwill is £9 million; of this, the parent's share is £8.2 million and the non-controlling
interest's share is £0.8 million.
Note that the goodwill is not split in the same proportion as ownership of the shares:
National owns 80% of the shares but 91% of goodwill
The non-controlling interest owns 20% of shares but just 9% of goodwill
This discrepancy is due to the 'control premium' paid by National.
C
H
A
P
Interactive question 1: Calculation of goodwill [Difficulty level: Easy] T
E
On 1 January 20X5, ABC acquired 90% of DEF when the fair value of DEF's net assets was £18 million. R
The consideration was structured as follows.
Three million ABC ordinary shares to be issued on the acquisition date; and
10
An additional one million ABC ordinary shares to be issued on 31 December 20X6 if DEF's revenue
increases by 10% in the interim two years.
At acquisition, the fair value of land owned by Ives was £50,000 greater than its carrying amount;
Ives has subsequently sold the land to a third party.
During the year ended 31 December 20X9, Ives sold goods to Robson, making a profit of £12,000.
Half of these goods are included in Robson's inventory count at the year end.
What is the value of the non-controlling interest in the consolidated statement of financial position at 31
December 20X9?
See Answer at the end of this chapter.
3.6.1 Recognition
Assets and liabilities existing at the acquisition date, and meeting the Framework definition of an asset
or liability, should be recognised within the goodwill calculation.
Only those liabilities which exist at the date of acquisition are recognised (so not future operating
losses or reorganisation plans which will be put into effect after control is gained).
Some assets not recognised by the acquiree in its individual company financial statements may be
recognised by the acquirer in the consolidated financial statements. These include identifiable
intangible assets such as brand names. Identifiable means that these assets are separable or arise
from contractual or other legal rights.
3.6.2 Measurement
The basic requirement of IFRS 3 (revised) is that the identifiable assets and liabilities acquired are
measured at their acquisition-date fair value.
To understand the importance of fair values in the acquisition of a subsidiary consider again the
definition of goodwill.
Definition
Goodwill: Any excess of the cost of the acquisition over the acquirer's interest in the fair value of the
identifiable assets and liabilities acquired as at the date of the exchange transaction.
The statement of financial position of a subsidiary company at the date it is acquired may not be a
guide to the fair value of its net assets. For example, the market value of a freehold building may have
risen greatly since it was acquired, but it may appear in the statement of financial position at historical
cost less accumulated depreciation.
Definition C
H
Fair value: The price that would be received to sell an asset or paid to transfer a liability in an orderly A
transaction between market at the measurement date (IFRS 13). P
T
E
R
We will look at the requirements of IFRS 3 (revised) and IFRS 13 regarding fair value in more detail in
Section 4. First, let us look at some practical matters. The following example will remind you how to
make a fair value adjustment, using the standard consolidation workings from your Professional Stage
10
studies.
If S Co had revalued its non-current assets at 1 September 20X5, an addition of £3,000 would have
been made to the depreciation expense charged for 20X5/X6.
Requirement
Prepare P Co's consolidated statement of financial position as at 31 August 20X6.
Solution
P CO CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 AUGUST 20X6
£ £
ASSETS
Non-current assets
Tangible non-current assets £(63,000 + 28,000 + 23,000 – 3,000) 111,000
Intangibles – goodwill (W3) 4,000
115,000
Current assets £(82,000+43,000) 125,000
Total assets 240,000
EQUITY AND LIABILITIES
Capital and reserves
Ordinary share capital 80,000
Retained earnings (W5) 108,750
WORKINGS
1 Group structure
P Co
75%
S Co
2 Net assets
Reporting Acquisition Post-
date acquisition
£ £ £
Share capital 20,000 20,000 –
Retained earnings – per question 41,000 21,000 20,000
– additional depreciation (3,000) (3,000)
Fair value adjustment to PPE 23,000 23,000
81,000 64,000 17,000
3 Goodwill
£
Consideration transferred 51,000
Non-controlling interest 17,000
68,000
Less Net assets of acquiree (W2) (64,000)
4,000
4 Non-controlling interest
£ £
S Co (25% × £81,000 (W2)) 20,250
NCI share of goodwill at acquisition
FV of NCI at acquisition 17,000
NCI share of net assets at acquisition (25% × £64,000) (16,000)
1,000
Non-controlling interest 21,250
5 Retained earnings
£
P Co 96,000
S Co (£17,000 (W2) 75%) 12,750
108,750
Remember also that when preparing consolidated financial statements all intra-group balances,
C
transactions, profits and losses need to be eliminated. Where there are provisions for unrealised profit H
and the parent is the seller the adjustment is made against the parent's retained earnings (in the A
retained earnings working). Where the subsidiary is the seller its retained earnings are adjusted (in the P
net assets working) thus ensuring that the non-controlling interest (ie the minority interest) bear their T
E
share of the provision. R
For the purposes of an impairment review, the goodwill calculated using the proportion of net assets
method is notionally adjusted as follows:
£
Parent goodwill 16,000
Notional NCI goodwill (20%/80% × £16,000) 4,000
20,000
In other words the notional goodwill attributable to the non-controlling interest calculated here includes
an element of control premium which is not evident when calculating goodwill attributable to the non-
controlling interest using the fair value method.
ie half the total goodwill has been impaired, being half of the parent's goodwill and half of the NCI's
notional goodwill.
Where the fair value method is used, and there is a control premium, such that the parent and NCI
goodwill are not in proportion, then any impairment is not in proportion to the starting goodwill.
This time assuming an impairment of £9,000:
Parent NCI
£ £
Goodwill 16,000 2,000
Impairment (80%/20% × £9,000) (7,200) (1,800)
8,800 200
Impairment of goodwill 45% 90%
(c) Indemnification assets: measurement should be consistent with the measurement of the
indemnified item, for example an employee benefit or a contingent liability.
(d) Reacquired rights: value on the basis of the remaining contractual term of the related contract
regardless of whether market participants would consider potential contractual renewals in
determining its fair value.
As the DEF shareholder group control the combined entities, DEF is treated as the acquirer and ABC as
the acquiree.
If DEF had issued enough of its own shares to give ABC shareholders a 25% interest in DEF, it would
have had to issue 8,000 shares (ie 25/75 of 24,000 shares). DEF's share capital would then have been
32,000 (24,000 + 8,000) and the ABC shareholders' interest would have been 8,000 so 25%.
The consideration for the acquisition is £496,000, being 8,000 DEF shares at their agreed fair value of
£62.
Section overview
The accounting requirements and disclosures of the fair value exercise are covered by IFRS 3
(revised). IFRS 13 Fair value measurement gives extensive guidance on how the fair value of assets
and liabilities should be established.
Business combinations are accounted for using the acquisition method
(b) Be part of what the acquiree (or its former owners) exchanged in the business combination rather
than the result of separate transactions
IFRS 13 Fair Value Measurement (see Chapter 2) provides extensive guidance on how the fair value of
assets and liabilities should be established.
This standard requires that the following are considered in measuring fair value: C
H
(a) The asset or liability being measured A
(b) The principal market (ie that where the most activity takes place) or where there is no principal P
T
market, the most advantageous market (ie that in which the best price could be achieved) in E
which an orderly transaction would take place for the asset or liability R
(c) The highest and best use of the asset or liability and whether it is used on a standalone basis or in
conjunction with other assets or liabilities
10
(d) Assumptions that market participants would use when pricing the asset or liability.
Having considered these factors, IFRS 13 provides a hierarchy of inputs for arriving at fair value.
It requires that Level 1 inputs are used where possible:
Example: land
Anscome Co has acquired land in a business combination. The land is currently developed for industrial
use as a site for a factory. The current use of land is presumed to be its highest and best use unless
market or other factors suggest a different use. Nearby sites have recently been developed for residential
use as sites for high-rise apartment buildings. On the basis of that development and recent zoning and
other changes to facilitate that development, Anscome determines that the land currently used as a site
for a factory could be developed as a site for residential use (ie for high-rise apartment buildings)
because market participants would take into account the potential to develop the site for residential use
when pricing the land.
How would the highest and best use of the land be determined?
Solution
The highest and best use of the land would be determined by comparing both of the following:
(a) The value of the land as currently developed for industrial use (ie the land would be used in
combination with other assets, such as the factory, or with other assets and liabilities).
(b) The value of the land as a vacant site for residential use, taking into account the costs of
demolishing the factory and other costs (including the uncertainty about whether the entity would
be able to convert the asset to the alternative use) necessary to convert the land to a vacant site (ie
the land is to be used by market participants on a stand-alone basis).
The highest and best use of the land would be determined on the basis of the higher of those values.
Solution
The fair value of the project would be measured on the basis of the price that would be received in a
current transaction to sell the project, assuming that the R & D would be used with its complementary
assets and the associated liabilities and that those assets and liabilities would be available to Developer
Co.
Tyzo plc prepares its financial statements to 31 December. On 1 September 20X7 Tyzo plc acquired six
million £1 shares in Kono Ltd at £2.00 per share. The purchase was financed by an additional issue of
loan stock at an interest rate of 10%. At that date Kono Ltd produced the following interim financial
Non-current assets £'000
Property, plant and
equipment (Note 1) 16.0
Current assets
Inventories (Note 2) 4.0
Receivables 2.9
Cash and cash equivalents 1.2
8.1
Total assets 24.1
Equity and liabilities
Equity
Share capital (£1 shares) 8.0
Reserves 4.4 C
12.4 H
Non-current liabilities A
Long-term loan (Note 3) 4.0 P
T
E
Current liabilities
R
Trade payables 3.2
Provision for taxation 0.6
Bank overdraft 3.9
10
(7.7)
Total equity and liabilities 24.1
Section overview
IAS 28 deals with accounting for associates and joint ventures using the equity method.
An associate exists where there is 'significant influence'.
The criteria for identifying a joint venture are contained in IFRS 11
The accounting for associates and joint ventures is identical
IAS 28 does not apply to investments in associates or joint ventures held by venture capital
organisations, mutual funds, unit trusts, and similar entities that are measured at fair value in accordance
with IAS 39.
IAS 28 requires all investments in associates to be accounted for using the equity method, unless the
investment is classified as 'held for sale' in accordance with IFRS 5 in which case it should be accounted
for under IFRS 5.
An investor is exempt from applying the equity method if:
(a) It is a parent exempt from preparing consolidated financial statements under IAS 27 (revised) or
(b) All of the following apply:
(i) The investor is a wholly-owned subsidiary or it is a partially owned subsidiary of another
entity and its other owners, including those not otherwise entitled to vote, have been
informed about, and do not object to, the investor not applying the equity method;
(iv) The ultimate or intermediate parent publishes consolidated financial statements that
comply with International Financial Reporting Standards.
IAS 28 does not allow an investment in an associate to be excluded from equity accounting when an
investee operates under severe long-term restrictions that significantly impair its ability to transfer funds
to the investor. Significant influence must be lost before the equity method ceases to be applicable.
The use of the equity method should be discontinued from the date that the investor ceases to have
significant influence.
From that date, the investor shall account for the investment in accordance with IFRS 9 Financial
instruments. The fair value of the retained interest must be regarded as its fair value on initial recognition
as a financial asset under IAS 39.
C
Worked example: Associate H
A
P Co, a company with subsidiaries, acquires 25,000 of the 100,000 £1 ordinary shares in A Co for
P
£60,000 on 1 January 20X8. In the year to 31 December 20X8, A Co earns profits after tax of £24,000, T
from which it declares and pays a dividend of £6,000. E
R
Requirement
How will A Co's results be accounted for in the individual and consolidated accounts of P Co for the year
ended 31 December 20X8? 10
Section overview
IFRS 11 classes joint arrangements as either joint operations or joint ventures.
The classification of a joint arrangement as a joint operation or a joint venture depends upon the
rights and obligations of the parties to the arrangement.
Joint arrangements are often found when each party can contribute in different ways to the
activity. For example, one party may provide finance, another purchases or manufactures goods,
while a third offers its marketing skills.
6.1 Definitions
The IFRS begins by listing some important definitions.
Definitions
Joint arrangement: An arrangement of which two or more parties have joint control.
Joint control: The contractually agreed sharing of control of an arrangement, which exists only when
decisions about the relevant activities require the unanimous consent of the parties sharing control.
Joint operation: A joint arrangement whereby the parties that have joint control of the arrangement
have rights to the assets and obligations for the liabilities relating to the arrangement.
Joint venture: A joint arrangement whereby the parties that have joint control of the arrangement have
rights to the net assets of the arrangement. (IFRS 11)
C
H
A
P
T
E
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Section overview
IFRS 12 Disclosure of interests in other entities requires disclosure of a reporting entity's interests
in other entities in order to help identify the profit or loss and cash flows available to the reporting
entity and determine the value of a current or future investment in the reporting entity.
7.1 Objective
IFRS 12 was published in 2011. It is effective for annual accounting periods beginning on or after 1
January 2013, but earlier application is permitted.
The objective of the standard is to require entities to disclose information that enables the user of the
financial statements to evaluate the nature of, and risks associated with, interests in other entities, and
the effects of those interests on its financial position, financial performance and cash flows.
This is particularly relevant in light of the financial crisis and recent accounting scandals. The IASB
believes that better information about interests in other entities is necessary to help users to identify the
profit or loss and cash flows available to the reporting entity and to determine the value of a current or
future investment in the reporting entity.
7.2 Scope
IFRS 12 covers disclosures for entities which have interests in:
Subsidiaries
Joint arrangements (ie joint operations and joint ventures, see above)
Associates, and
Unconsolidated structured entities.
C
H
7.3 Structured entity A
P
T
IFRS 12 defines a structured entity. E
R
Definition
Structured entity: An entity that has been designed so that voting or similar rights are not the 10
dominant factor in deciding who controls the entity, such as when any voting rights relate to
administrative tasks only and the relevant activities are directed by means of contractual arrangements
(IFRS 12)
8 Step acquisitions
Section overview
Subsidiaries and associates are consolidated/equity accounted for from the date control/significant
influence is gained.
In some cases acquisitions may be achieved in stages. These are known as step acquisitions.
A step acquisition occurs when the parent entity acquires control over the subsidiary in stages, achieved
by buying blocks of shares at different times.
Acquisition accounting is only applied when control is achieved.
The date on which control is achieved is the date on which the acquirer should recognise the acquiree's
identifiable net assets and any goodwill acquired (or bargain purchase) in the business combination.
Until control is achieved, any pre-existing interest is accounted for in accordance with
IAS 39 in the case of investments
IAS 28 in the case of associates and joint ventures
Whenever you cross the 50% boundary, you revalue, and a gain or loss is reported in profit or loss
for the year. If you do not cross the 50% boundary, no gain or loss is reported; instead there is an
adjustment to the parent's equity.
The following diagram, adapted from the Deloitte guide to IFRS 3 revised, may help you visualise the
boundary:
Transactions that trigger remeasurement of and existing interest
IAS 39 IAS 28/IFRS 11 IFRS 10
Acquisition of a
controlling interest in a
10% financial asset
Acquisition of a
40% controlling interest in
an associate or joint
venture
Solution
Journal entry
£'000 £'000
DR Investment in Bath Ltd (250,000 – 230,000) 20
DR Other comprehensive income and AFS reserve 130
CR Profit or loss 150
To recognise the gain on the deemed disposal of the shareholding in Bath Ltd existing immediately
prior to control being obtained.
(b) The adjustment required is based on the change in the non-controlling interest at the acquisition
date:
£
NCI on 31 December 20X8 based on old interest (30% × £970,000) 291,000
NCI on 31 December 20X8 based on new interest (20% × £970,000) 194,000
Adjustment required 97,000
Therefore:
Dr Non-controlling interest 97,000
Dr Shareholders' equity (bal fig) 8,000
Cr Cash 105,000
9 Disposals
Section overview
Subsidiaries and associates are consolidated/equity accounted for until the date control/significant
influence is lost therefore profits need to be time-apportioned.
A gain on disposal must also be calculated, by reference to the fair value of any interest retained in
the subsidiary or associate.
An entity may sell all or some of its shareholding in another entity. Full disposals of subsidiaries and
associates were covered in FR and are revised here. Other situations which may arise are:
The sale of shares in a subsidiary such that control is retained
The sale of shares in a subsidiary such that the subsidiary becomes an associate
The sale of shares in a subsidiary such that the subsidiary becomes an investment
The sale of shares in an associate such that the associate becomes an investment
On disposal of a controlling interest, any retained shareholding (an associate or trade investment)
is measured at fair value on the date that control is lost. This fair value is used in the calculation of
the gain or loss on disposal, and also becomes the carrying amount for subsequent accounting for the
retained shareholding.
If the 50% boundary is not crossed, as when the shareholding in a subsidiary is reduced, but control is
still retained, the event is treated as a transaction between owners and no gain or loss is recognised.
The following diagram, adapted from the Deloittes guide, may help you visualise the boundary:
The situation where a shareholding in a subsidiary is reduced from say 80% to 60%, that is where
control is retained, does not involve crossing that all-important 50% threshold.
Solution
£ £
Proceeds 350,000
Less: Amounts recognised prior to disposal
Net assets of Westville (£100,000 + £215,000 + (1/2 × £24,000) - £10,000) 317,000
Goodwill (£280,000 + £67,000) – (£100,000 + £188,000) 59,000
NCI at disposal
Share of net assets (20% x £317,000) (63,400)
Goodwill on acquisition (£67,000 – (20% × £288,000)) (9,400)
(303,200)
Profit on disposal 46,800
10
WORKINGS
(1) Retained earnings
£'000
Retained earnings of Express (£1,190,000 + £120,000) 1,310.0
Retained earnings of Billings
Acquisition – 31 August 20X8 90% × (£304,000 + (8/12 × £36,000) - £250,000) 70.2
31 August 20X8 – 31 Dec 20X8 (80% × 4/12 × £36,000) 9.6
Impairment of goodwill (5.0)
NCI adjustment on disposal (W2) 27.2
1,412.0
Dr Proceeds £70,000
Cr NCI £42,800
Cr Shareholders' equity (to Working 1) £27,200
Solution
£ £
Proceeds 490,000
Fair value of 25% interest retained 220,000
710,000
Less: Amounts recognised prior to disposal
Net assets of Brown 800,000
Goodwill (fully impaired) –
NCI at disposal (25% × £800,000) (200,000)
(600,000)
Gain on disposal 110,000
Note that the disposal triggers remeasurement of the residual interest to fair value. The gain on disposal
could be analysed as:
Realised gain £ £
Proceeds on disposal 490,000
Interest disposed of (50% × £800,000) (400,000)
90,000
Holding gain
Retained interest at fair value 220,000
Retained interest at carrying value (25% × £800,000) (200,000)
20,000
Total gain 110,000
The retained 25% interest in Brown is included in the consolidated statement of financial position at
31 December 20X8 at the fair value of £220,000.
Section overview
The consolidated statement of cash flows shows the impact of the acquisition and disposal of
subsidiaries and associates.
Exchange differences arising on the translation of the foreign currency accounts of group
companies will also impact the consolidated statement of cash flows. This is covered in more
detail in Chapter 11.
£ £
b/f NCI (CSFP) X
NCI (CIS) X
NCI dividend paid (balancing figure) X
c/f NCI (CSFP) X
X X
10.2.2 Associates
There are two issues to consider with regard to the associate:
1 The aim of the statement of cash flows is to show the cash flows of the parent and any subsidiaries
with third parties, therefore any cash flows between the associate and third parties are
irrelevant. As a result, the group share of profit of the associate must be deducted as an
adjustment in the reconciliation of profit before tax to cash generated from operations. This
is because group profit before tax includes the results of the associate.
2 Dividends received from the associate must be disclosed as a separate cash flow classified as
'Cash flows from investing activities'. The cash receipt can be calculated as follows:
INVESTMENTS IN ASSOCIATES
£ £
b/f Investment in Associate (CSFP) X
Share of profit of Associate (CIS) X Dividend received (balancing figure) X
c/f Investment in Associate (CSFP) X
X X
Subsidiary acquired in the period Subtract PPE, inventories, payables, receivables etc at the
date of acquisition from the movement on these items.
Subsidiary disposed of in the period Add PPE, inventories, payables, receivables etc at the date
of disposal to the movements on these items.
This would also affect the calculation of the dividend paid to the non-controlling interest. The T
account working is modified as follows:
NON-CONTROLLING INTEREST
£ £
NCI in Subsidiary at disposal X b/f NCI (CSFP) X
NCI dividend paid (balancing X NCI in Subsidiary at acquisition X
figure)
c/f NCI (CSFP) X NCI (CIS) X
X X
C
H
A
P
T
E
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Summary
Group accounts:
Consolidated statement of financial position
and statement of comprehensive income
Subsidiary Associate
Significant
Control
influence
Goodwill
Acquisitions Disposals
Step acquisitions
to achieve control Disposal of Part disposal
whole investment
Acquisition not
resulting in change
of control No loss
Loss of
control of control
Joint arrangements
C
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A
P
T
E
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Included in non-current assets of Sequoia at the acquisition date was a property with a carrying
amount of £600,000 that had a fair value of £900,000.
Sequoia had been making losses, so Finch created a provision for restructuring of £800,000 under
plans announced on 2 January 20X6.
Sequoia has disclosed in its accounts a contingent liability with a reliably estimated value of
£20,000. Sequoia has not recorded this as a provision as payment is not considered probable.
Finch values the non-controlling interest using the proportion of net assets method.
Requirement
Under IFRS 3 Business Combinations, what goodwill arises at the time of the acquisition of Sequoia?
C
H
A
P
T
E
R
10
An impairment test conducted at the year end, resulted in a write-down of goodwill relating
to another wholly owned subsidiary. This was charged to cost of sales.
Group policy is to value non-controlling interests at the date of acquisition at the
proportionate share of the fair value of the acquiree's identifiable assets acquired and liabilities
assumed.
(2) Depreciation charged to the consolidated profit or loss amounted to £44m. There were no
disposals of property, plant and equipment during the year.
(3) Other income represents gains on financial assets at fair value through profit or loss. The
financial assets are investments in quoted shares. They were purchased shortly before the year
end with surplus cash, and were designated at fair through profit loss as they are expected to
be sold after the year end. No dividends have yet been received.
(4) Included in 'trade and other payables' is the £ equivalent of an invoice for 102m shillings for
some equipment purchased from a foreign supplier. The asset was invoiced on 5 March
20X6, but had not been paid for at the year end, 31 May 20X6.
Exchange gains or losses on the transaction have been included in administrative expenses.
C
Relevant exchange rates were as follows: H
Shillings to £1 A
P
5 March 20X6 6.8 T
E
31 May 20X6 6.0 R
10
Requirement
Prepare a consolidated statement of cash flows for Porter for the year ended 31 May 20X6 in
accordance with IAS 7 Statement of Cash Flows, using the indirect method.
Notes to the statement of cash flows are not required.
Basics
Definitions: control, parent, subsidiary, acquisition date, goodwill. IFRS 3 (App A)
Acquisition method: acquirer, acquisition date, recognising and measuring IFRS 3.5
assets, liabilities, non-controlling interest and goodwill.
Consideration transferred
Fair value of assets transferred, liabilities incurred and equity instruments IFRS 3.37
issued
Contingent consideration accounted for at fair value IFRS 3.39
Goodwill
Calculation IFRS 3.32
Bargain purchases
Reassess identification and measurement of the net assets acquired, the non- IFRS 3.36
controlling interest, if any, and consideration transferred
Any remaining amount recognised in profit or loss in period the acquisition is IFRS 3.34
made
Basic rule
Parent must prepare CFS to include all subsidiaries IAS 27.12
Exception
No need for CFS if wholly owned or all non-controlling shareholders have IAS 27.10
been informed of and none have objected to the plan that CFS need not be
prepared
No exclusion on grounds of dissimilar activities IAS 27.17
IAS 27.13
Control
Power over the investee
Exposure or rights to variable returns
Ability to use its power
Power is existing rights that give the current ability to direct the relevant
activities of the investiee.
Procedures
Non-controlling interest shown as a separate figure: IAS 27.18
– In the statement of financial position, within total equity but separately IAS 27.27
from the parent shareholders' equity
– In the statement of profit or loss and other comprehensive income, the
share of the profit after tax
Accounting dates of group companies to be no more than three months IAS 27.22-23
apart
Uniform accounting policies across group or adjustments to underlying IAS 27.24-25
values
Bring in share of new subsidiary's income and expenses: IAS 27.26
Loss of control
Calculation of gain IAS 27.34
Account for amounts in other comprehensive income as if underlying assets IAS 27.35
disposed of
Retained interest accounted for in accordance with relevant standard based IAS 27.36-37
on fair value
Definitions
The investor has significant influence, but not control IAS 28.2
Equity method
IAS 28.38,
In statement of financial position: non-current asset = cost plus share of post-
IAS 28.11 and
acquisition change in A's net assets
IAS 28.39
Use cost method of accounting in investor's separate financial statements IAS 28.35
Disclosures
Fair value of associate where there are published price quotations IAS 28.37
Joint ventures
Definitions *IFRS 11 ??
Contractual arrangement
Joint ventures
– Equity method
Joint operations
– Cash equivalents are short-term, highly liquid investments that are IAS 7.6
readily convertible to known amounts of cash and which are subject to
an insignificant risk of changes in value
Presentation of a statement of cash flows Appendix A
– Cash flows should be classified by operating, investing and financing IAS 7.10
activities
– Cash flows from operating activities are primarily derived from the IAS 7.13-14
principal revenue-producing activities of the entity
– Cash flows from investing activities are those related to the acquisition IAS 7.16
or disposal of any non-current assets, or trade investments together with
returns received in cash from investments (ie dividends and interest)
Financing activities include: IAS 7.17
C
H
A
P
T
E
R
10
See IFRS 3.32 and 34. The second acquisition resulted in an excess over the cost of combination
which should be recognised immediately in profit.
2 Sheliak
Depreciation charge: decrease by £10,000
Carrying amount: decrease by £30,000
Depreciation charge: Sheliak (£1m / 8 years) £125,000
Parotia (£575,000 / 5 years) £115,000
Decrease £10,000
Carrying amount: Sheliak (£1m × 3/8 years) £375,000
Parotia (£575,000 × 3/5 years) £345,000
Decrease £30,000
Fair value adjustments not reflected in the books must be adjusted for on consolidation. In this
example the depreciation is decreased by the difference between Sheliak's depreciation charge and
Parotia's fair value depreciation calculation. The carrying amount is decreased by the difference
between Sheliak's carrying value at 31 December 20X7 and Parotia's carrying value at 31
December 20X7.
3 Finch
£207,000
£000
Net assets per SFP (£8.1m – £1.3m) 6,800
Fair value adjustment to property 300
Contingent liability (20)
Adjusted net assets 7,080
Net assets is increased by the fair value adjustment of £300,000 and decreased by the contingent
liability, which is recognised in accordance with IFRS 3.23.
Goodwill is therefore calculated as:
£000
Consideration transferred 5,100
Non-controlling interest
Ordinary shares 15% × (£7.08m – £2.5m) 687
Preference shares 60% × £2.5m 1,500
7,287
Net assets of acquiree (7,080)
Goodwill 207
In allocating the cost of the business combination to the assets and liabilities acquired, the business
that is on the market for immediate sale should be valued in accordance with IFRS 5 at fair value
less costs to sell (IFRS 3.31).
The defined benefit plan net asset should be recognised in accordance with IAS 19 (IFRS 3.26).
5 Gibbston
(a) £4.9 million
(b) £1.2 million share of loss
(c) £7.2 million
(a)
£000 £000
Consideration transferred: Cash 15,000
Deferred cash (£5.5m/1.1) 5,000
3
Contingent cash (£13.3m/1.1 ) × 45% 4,500
24,500
Non-controlling interest: Net assets at 1 Jan 20X7 20,000
Loss to acquisition (£3m × 4/12) (1,000)
Fair value adjustment 9,000
30% × 28,000 8,400
32,900
Net assets of acquiree (28,000)
Goodwill 4,900
IFRS 3.39 requires contingent consideration capable of reliable measurement to be included at fair
value regardless of whether payment is probable.
The net assets at the acquisition date are those at the start of the year adjusted for the fair value
increase of plant (£9m) less the losses between the start of the year and the acquisition date.
(b) Non-controlling interest share of loss: £m
Loss: Acquisition to 31 December (8/12 × £3m) 2
Extra depreciation (£9m/3 years × 8/12) 2
4 × 30% = £1.2m
(c) Non-controlling interest in SFP
Share of the net assets at the date of acquisition (£28m 8.4
30%)
C
Share of loss since acquisition (part (b)) (1.2)
H
7.2 A
P
IFRS 13 Joint Arrangements T
E
6 Supermall R
Supermall has been set up as a separate vehicle. As such, it could be either a joint operation or
joint venture, so other facts must be considered.
10
There are no facts that suggest that the two real estate companies have rights to substantially all
the benefits of the assets of Supermall nor an obligation for its liabilities.
Each party's liability is limited to any unpaid capital contribution.
As the value of goodwill is not adjusted on disposal when there is no loss of control, this element
does not change when re-calculating the non-controlling interest after disposal:
The non-controlling interest post disposal is: £
30% × £3.5 million 1,050,000
Goodwill [£350,000 – (15% × £2.2 million)] 20,000
1,070,000
C
H
A
P
T
E
R
10
10
Non-controlling interest
£ £
Share of net assets (25% × 339,000) 84,750
Share of goodwill:
NCI at acquisition date at fair value 90,000
NCI share of net assets at acquisition date (25% × £300,000) (75,000)
15,000
99,750
Point to note:
The revaluation gain should not be reclassified to profit or loss, because it would not be so reclassified if
there had been a real disposal of the interest in Feeder Ltd. It should, however, be transferred to
retained earnings in the statement of changes in equity.
Goodwill acquired in the business combination
C
H
A
P
T
E
R
10
Introduction
Topic List
1 Objective and scope of IAS 21
2 The functional currency
3 Reporting foreign currency transactions
4 Foreign currency translation of financial statements
5 Foreign currency and consolidation
6 Disclosure
7 Other matters
8 Reporting foreign currency cash flows
9 Reporting in hyperinflationary economies
10 IFRS and UK GAAP comparison
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
419
Introduction
Identify an entity's functional currency in accordance with IAS 21 The Effects of Changes in
Foreign Exchange Rates
Apply knowledge and understanding of IAS 21 in particular circumstances through
calculations
Identify and allocate foreign currency cash flows to the main components of a statement
of cash flows
Demonstrate an understanding of the overall objective of IAS 29 Financial Reporting in
Hyperinflationary Economies
IAS 21 deals with two situations where foreign currency impacts financial statements:
1 An entity which buys or sells goods overseas, priced in a foreign currency 11
A UK company might buy materials from Canada, pay for them in US dollars, then sell its finished
goods in Germany, receiving payment in Euros or some other currency. If the company owes
money in a foreign currency at the end of the accounting year or holds assets bought in a foreign
currency, the assets and related liabilities must be translated into the local currency (in this case
sterling £), in order to be shown in the books of account.
2 The translation of foreign currency subsidiary financial statements prior to consolidation
A UK company might have a subsidiary abroad (ie a foreign entity that it owns), and the subsidiary
will trade in its own local currency. The subsidiary will keep books of account and prepare its
annual financial statements in its own currency. However, at the year end, the parent company
must 'consolidate' the results of the overseas subsidiary into its group accounts. Therefore the
assets and liabilities and the annual profits of the subsidiary must be translated from the foreign
currency into pounds sterling.
If foreign currency exchange rates remained constant, there would be no accounting problem in either
of these situations. However, foreign exchange rates are continually changing, sometimes significantly,
between the start and the end of the accounting year. For example, between September 2007 and
September 2008 the British Pound depreciated by about 16% against the euro. However, the euro has
suffered its own problems since the banking crisis of 2008, resulting in a stronger pound against the
euro at times – particularly during the first half of 2010.
Solution
The management of the company has decided using the guidance provided by the IFRS to adopt the
Danish krone as its functional currency, based on the fact that whereas the currency that influences sales
prices is the euro, the domestic currency influences costs and financing.
Solution
The currency that mainly influences sales prices is the dollar. The currency that mainly influences costs is
not clear, as 55% of the operational costs are in Naira and 45% are in US dollars. Depreciation should
not be taken into account, because it is a non-cash cost, and the economic environment is where an
entity generates and expenses cash.
Since the revenue side is influenced primarily by the US dollar and the cost side is influenced by both
the dollar and the Naira, then management will be justified on the basis of IAS 21 guidance to
determine the US dollar as its functional currency.
Solution
The entity's equity and net assets were £50,314,465 when the £ sterling became its functional currency.
Where an entity's functional currency has changed as a result of changes in its trading operations during
a period, the entity is required to disclose that the change has arisen, along with the reason for the
change.
Section overview
This section deals with the IAS 21 rules governing the initial and subsequent recognition of items
denominated in foreign currency.
Foreign currency transactions are transactions which are denominated in foreign currencies, rather than
in the entity's functional currency. Such transactions arise when the entity:
Buys or sells goods or services whose price is denominated in a foreign currency;
Borrows or lends funds where the amounts payable or receivable are denominated in a foreign
currency; or
Otherwise acquires or disposes of assets or incurs or settles liabilities denominated in a foreign
currency.
Solution
11
Management should use the daily weighted average exchange rate published by the Central Bank of
Ruritania. Interest income accrues evenly through the period and the weighted average rate will
produce the same result as a daily actual rate calculation.
The use of an un-weighted average rate would not be appropriate because exchange rates fluctuate
significantly.
Recognition of interest receivable:
Dr Held to-maturity investment £105 (RU£60 1.75)
Cr Interest income £105
Solution 11
Expressed in dollars, the inventory value has gone up, its net realisable amount exceeding its carrying
amount. In sterling, the carrying amount using the acquisition date rate is £200,000 ($300,000/1.5) and
the net realisable amount using the closing rate is £189,000 ($340,000/1.8). Inventory is stated at the
lower of cost and net realisable value in the functional currency and the carrying amount at 31
December 20X5 is £189,000.
Solution
Expressed in foreign currency, the asset has a carrying value of $450,000 and a recoverable amount of
$400,000 and is therefore impaired.
However, when it is expressed in sterling, the asset is not impaired, because its recoverable amount
exceeds its carrying amount. In sterling, the carrying amount, using the acquisition date rate, is
£300,000 ($450,000/1.5) and the recoverable amount, using the closing rate, is £320,000
($400,000/1.25). The appreciation of the foreign currency relative to pounds sterling has offset the fall
in the value of the asset due to impairment, therefore no impairment charge is required.
Solution
The asset is an AFS equity investment, therefore a non-monetary financial asset. All exchange differences
are reported in OCI.
Solution
The purchase will be recorded in the books of White Cliffs Co using the rate of exchange ruling on
30 September.
Dr Purchases £25,000
Cr Trade payables £25,000
Being the £ cost of goods purchased for €40,000 (€40,000 €1.60/£1)
On 30 November, White Cliffs must pay €40,000. This will cost €40,000 €1.80/£1 = £22,222 and the
company has therefore made an exchange gain of £25,000 – £22,222 = £2,778.
Dr Trade payables £25,000
Cr Exchange gains: profit or loss £2,778
Cr Cash £22,222
Solution
The purchase will be recorded in the books of White Cliffs Co using the rate of exchange ruling on 30
September.
Dr Purchases £25,000
Cr Trade payables £25,000
Being the £ pounds sterling cost of goods purchased for €40,000 (€40,000 €1.60/£1)
On 30 November, White Cliffs must pay €20,000 to settle half the payable (£12,500). This will cost €
20,000 €1.80/£1 = £11,111 and the company has therefore made an exchange gain of £12,500 –
£11,111 = £1,389.
Dr Trade payables £12,500
Cr Exchange gains: profit or loss £1,389
Cr Cash £11,111
On 31 December, the reporting date, the outstanding liability of £12,500 will be recalculated using the
rate applicable at that date: €20,000 €1.90/£1 = £10,526. A further exchange gain of £1,974
(£12,500 - £10,526) has been made and will be recorded as follows.
Dr Trade payables £1,974
Cr Exchange gains: profit or loss £1,974
The total exchange gain of £3,363 will be included in the operating profit for the year ending 31
December.
On 31 January, White Cliffs must pay the second instalment of €20,000 to settle the remaining liability
of £10,526. This will cost the company £10,811 (€20,000 €1.85/£1).
Dr Trade payables £10,526
Dr Exchange losses: Profit or loss £285
Cr Cash £10,811
Solution
Management should recognise the investment property at £6,060,606 and £7,361,963 at 31 December
20X2 and 31 December 20X3 respectively.
The change in value is calculated as:
31 December 20X2 (S$10,000,000 /1.65) £6,060,606
31 December 20X3 (S$12,000,000 /1.63) £7,361,963
Increase in fair value £1,301,357
The increase in fair value of £1,301,357 should be recognised in profit or loss as a gain on investment
property.
The investment property is a non-monetary asset. The movement in value attributable to movement in
exchange rates £74,363 ($10,000,000/1.65) – ($10,000,000/1.63) should not be recognised separately
because the asset is non-monetary.
Solution
€ €/£ £ £
Carrying amount at reporting date 5,000,000 1.6 3,125,000
Historical cost 6,000,000 1.5 4,000,000
Impairment loss recognised in profit or loss ( 875,000)
Note that both the accumulated depreciation and the charge for the year are translated at the rate
ruling when the relevant plant was acquired. Revenue and purchases are translated at the rate ruling
when the transaction occurred, but the receivables and payables relating to them (which will have been
initially recognised at those rates) are monetary items which are retranslated at closing rate at the end of
the year.
We have discussed in the previous section the requirements of IAS 21 for the translation of foreign 11
currency transactions. In this section we shall discuss the IAS 21 translation requirements when foreign
activities are undertaken through foreign operations whose financial statements are based on a different
functional currency than that of the parent company. More specifically in this section we shall discuss
the appropriate exchange rate that should be used for the translation of the financial statements of the
foreign operation into the reporting entity's presentation currency.
Although an entity is required to translate foreign currency items and transactions into its functional
currency, it does not have to present its financial statements in this currency. Instead, IAS 21 permits an
entity a completely free choice over the currency in which it presents its financial statements. Where the
chosen currency, the entity's presentation currency, is not the entity's functional currency, this fact
should be disclosed in the financial statements, along with an explanation of why a different
presentation currency has been applied.
The financial statements of a foreign operation operating in a hyperinflationary economy must be
adjusted under IAS 29 before they are translated into the parent's reporting currency and then
consolidated. When the economy ceases to be hyperinflationary, and the foreign operation ceases to
apply IAS 29, the amounts restated to the price level at the date the entity ceased to restate its financial
statements should be used as the historical costs for translation purposes.
The entity owns no non-current assets (so there are no assets or depreciation charges to be translated at
the rate ruling when the asset was acquired) and all transactions took place on 30 June (so that a single
rate can be used for the statement of profit or loss transactions, rather than the various rates ruling when
the transactions took place).
Assume that the following exchange rates are relevant.
1 January 20X5 £1=US$2.75
30 June 20X5 £1=US$2.5
31 December 20X5 £1=US$2
The entity translates share capital at the rate ruling when the capital was raised.
Requirement
Translate the financial statements of the subsidiary into the pound sterling presentation currency.
Solution
The statement of profit or loss is translated using the actual rate on the transaction date.
Statement of profit or loss and other comprehensive income
US$ Rate £
Revenue 500,000 Actual 200,000
Costs (200,000) Actual (80,000)
Profit 300,000 120,000
(b) A further exchange gain arising from retranslating profits from the actual to the closing rate.
Rate £
Retained earnings (US$ 300,000) Closing rate 150,000
Actual rate (120,000)
30,000
Total exchange differences 37,500
The inclusion of the exchange gain or loss makes the accounting equation balance since:
The calculation of the exchange difference is discussed in more detail in section 5.3.
Section overview
This section deals with the issues arising from consolidating financial statements and in particular,
the treatment of exchange differences and goodwill.
5.2 Consolidation
The incorporation of the results and financial position of a foreign operation with those of the reporting
entity follows normal consolidation procedures such as the elimination of intra-group balances and
intra-group transactions of a subsidiary. However, an intra-group monetary asset (or liability) whether
short-term or long-term cannot be eliminated against the corresponding intra-group liability (or asset)
without showing the results of currency fluctuations in the consolidated financial statements. This is
because a monetary item represents a commitment to convert one currency into another and exposes
the reporting entity to a gain or loss through currency fluctuations. Accordingly, in the consolidated
financial statements of the reporting entity, such an exchange difference:
Continues to be recognised in profit or loss, or
Is classified as equity until the disposal of the foreign operations, if it is a monetary asset forming
part of the net investment in a foreign operation.
Solution
Statement of profit or loss of Xerxes for the year ended 31 December 20X9 translated using the
average rate (€1.6 = £1)
£
Profit before tax 100
Tax (50)
Profit after tax, retained 50
The statement of financial position of Xerxes Inc at 31 December 20X9, other than share capital and
reserves, should be translated at the closing rate of €1 = £1.
Summarised statement of financial position of Xerxes in £ at 31 December 20X9
£ £
Non-current assets (carrying amount) 300
Current assets
Inventories 200
Receivables 100
300
600
Non-current liabilities 110
Current liabilities 110
Since Darius Co acquired the whole of the issued share capital on incorporation, the post-acquisition
reserves including exchange differences will be the value of shareholders' funds arrived at above, less the
original cost to Darius Co of £25 (ie €100 at the historic exchange rate of £1:€4). Post-acquisition
increase in equity = £380 – £25 = £355.
Summarised consolidated statement of financial position as at 31 December 20X9
£ £
ASSETS
Non-current assets (NBV) £(350 + 300) 650
Current assets
Inventories £(225 + 200) 425
Receivables £(150 + 100) 250
675
1,325
EQUITY AND LIABILITIES
Equity
Ordinary £1 shares (Darius only) 300
Retained earnings £(300 + 355) 655
955
Non-current liabilities: loans £(50 + 110) 160
Current liabilities £(100 + 110) 210
1,325
Note: It is quite unnecessary to know the amount of the exchange differences when preparing the
consolidated statement of financial position.
Calculation of exchange differences
£
Xerxes' equity interest at 31 December 20X9 380
Equity interest at 1 January 20X9 (€300/2) ((150)
230
Less: retained profit (50)
Exchange gain 180
Statement of profit or loss and other comprehensive income for the year ended 31 December
20X9
£
Profit after tax 150
Exchange difference on translation of foreign operations 180
Total comprehensive income for the year 330
Translating income/expense items using an average rate, whereas assets/liabilities are translated
at the closing rate.
Translating the opening net investment (opening net assets) in the foreign entity at a closing rate
different from the closing rate at which it was previously reported.
Using the opening statement of financial position and translating at opening rate of €2 = £1 and the
closing rate of €1 = £1 will produce the exchange differences as follows.
Exchange
€2 = £1 €1 = £1 difference
£ £ £
Non-current assets at carrying amount 170 340 170
Inventories 60 120 60
Net current monetary liabilities (25) (50) (25)
205 410 205
Equity 150 300 150
Loans 55 110 55
205 410 205
Translating the statement of profit or loss using average rate €1.60 = £1 and the closing rate €1 = £1
gives the following results.
Exchange
•€1.60
• = £1 ••€1 = £1 difference
£ £ £
Profit before tax, depreciation and
increase in inventory values 75 120 45
Increase in inventory values 50 80 30
125 200 75
Depreciation (25) (40) (15)
100 160 60
Tax (50) (80) (30)
Profit after tax, retained 50 80 30
The goodwill arising on acquisition is therefore €16.8 million / 2.4 = £7 million. The fair value adjustment
in sterling amounted to €1m/2.4 = £416,667.
At 31 December 20X5, the goodwill is restated to £6.72 million (€16.8m /2.5) and the fair value
adjustment in sterling terms was £400,000 (€1m/2.5).
The requirement in an entity's own financial statements to recognise in profit or loss all exchange
differences in respect of monetary items which are part of an entity's net investment in a foreign
operation was dealt with earlier.
On consolidation, however, the differences should be recognised as other comprehensive income and
recorded in a separate component of equity. This treatment is required because exchange differences
arising from the translation of the operations' net assets will move in the opposite way. If there is an
exchange loss on the net investment, there will be an exchange gain on the net assets, and vice versa.
The two movements should be netted off, rather than one being recognised in profit or loss and the
other as other comprehensive income.
The amount of exchange differences reported in profit or loss for the period. This amount should
exclude amounts arising on financial instruments measured at fair value through profit or loss
under IAS 39; and
The net exchange differences reported in other comprehensive income. This disclosure should
include a reconciliation between the opening and closing amounts.
In addition, when the presentation currency is different from the functional currency, that fact should
be stated and the functional currency should be disclosed. The reason for using a different
presentational currency should also be disclosed.
Where there is a change in the functional currency of either the reporting entity or a significant
foreign operation, that fact and the reason for the change in functional currency should be disclosed.
An entity may present its financial statements or other financial information in a currency that is
different from either its functional currency or its presentation currency. For example, it may convert
selected items only, or it may use a translation method that does not comply with IFRSs in order to deal
with hyperinflation. In this situation the entity must:
Clearly identify the information as supplementary information to distinguish it from information
that complies with IFRSs;
Disclose the currency in which the supplementary information is displayed; and
Disclose the entity's functional currency and the method of translation used to determine the
supplementary information.
For publicity or other purposes, an entity may wish to display its financial statements using a currency
which is neither its functional nor its presentation currency; such information is not presented in
accordance with IFRS, so IAS 21 requires that it should be clearly identified as being supplementary.
7 Other matters
Section overview
This section discusses a number of other matters such as non-controlling interests and taxation.
60% of the issued capital of Camrumite Inc is owned by Bates Co, a company based in the UK.
There have been no movements in long-term assets during the year.
The exchange rate has moved as follows.
1 January 20X3 € 5 = £1
Average for the year ended 31.12.X3 € 7 = £1
31 December 20X3 € 8 = £1
You are required to calculate the figures for the non-controlling interest to be included in the
consolidated accounts of Bates Co.
The non-controlling interest is measured using the proportion of net assets method.
Show the movements on the non-controlling interest accounts during the year.
Solution
Translating the shareholders' funds using the closing rate as at 31 December 20X3 gives €15,000 8 =
£1,875. The non-controlling interest in the statement of financial position will be 40% £1,875 = £750.
The dividend payable translated at the closing rate is €1,680 8 = £210. The amount payable to the
non-controlling shareholders is 40% £210 = £84.
The profit after tax translated at the average rate is €3,080 7 = £440. The non-controlling interest in
profit is therefore 40% £440 = £176.
The non-controlling share of the exchange difference is calculated as:
Opening net assets £ £
€15,000 – €1,400 = €13,600 At opening rate of €5:£1 2,720
At closing rate of €8:£1 1,700 1,020
Section overview
This section addresses the treatment of foreign currency cash flows in the statement of cash flows.
Solution
The purchase will initially be recorded at the rate ruling at the transaction date:
$400,000 / 2.0 = £200,000, with a trade payable of the same amount also being recognised.
At 31 December 20X5, the cash outflow will be recorded at the rate ruling at the transaction date:
$250,000 / 1.9 = £131,579
and the remaining trade payable, being a monetary liability, is translated at the same rate:
$150,000 / 1.9 = £78,947
The plant and equipment, a non-monetary asset, is carried at the historic rate of £200,000.
Only cash flows appear in the statement of cash flows, so £131,579 will be shown within investing
activities.
In a hyperinflationary economy, money loses its purchasing power very quickly. Comparisons of
transactions at different points in time, even within the same accounting period, are misleading. It is
therefore considered inappropriate for entities to prepare financial statements without making
adjustments for the fall in the purchasing power of money over time.
IAS 29 Financial Reporting in Hyperinflationary Economies applies to the primary financial statements of
entities (including consolidated accounts and statements of cash flows) whose functional currency is the
currency of a hyperinflationary economy. In this section, we will identify the hyperinflationary currency
as $H.
The Standard does not define a hyperinflationary economy in exact terms, although it indicates the
characteristics of such an economy, for example, where the cumulative inflation rate over three years
approaches or exceeds 100%.
Solution
These are examples, but the list is not exhaustive.
(a) The population prefers to retain its wealth in non-monetary assets or in a relatively stable foreign
currency. Amounts of local currency held are immediately invested to maintain purchasing power.
(b) The population regards monetary amounts not in terms of the local currency but in terms of a
relatively stable foreign currency. Prices may be quoted in that currency.
(c) Sales/purchases on credit take place at prices that compensate for the expected loss of purchasing
power during the credit period, even if that period is short.
(d) Interest rates, wages and prices are linked to a price index.
The reported value of non-monetary assets, in terms of current measuring units, increases over time.
For example, if a non-current asset is purchased for $H1,000 when the price index is 100, and the price
index subsequently rises to 200, the value of the asset in terms of current measuring units (ignoring
accumulated depreciation) will rise to $H2,000.
In contrast, the value of monetary assets and liabilities, such as a debt for 300 units, is unaffected by
changes in the prices index, because it is an actual money amount payable or receivable. If a customer
owes $H300 when the price index is 100, and the debt is still unpaid when the price index has risen to
150, the customer still owes just $H300. The purchasing power of monetary assets, however, will
decline over time as the general level of prices goes up.
Definition
Measuring units current at the reporting date: This is a unit of local currency with a purchasing
power as at the reporting date, in terms of a general prices index.
Financial statements that are not restated (ie that are prepared on a historical cost basis or current cost
basis without adjustments) may be presented as additional statements by the entity, but this is
discouraged. The primary financial statements are those that have been restated.
After the assets, liabilities, equity and statement of profit or loss and other comprehensive income of the
entity have been restated, there will be a net gain or loss on monetary assets and liabilities (the 'net
monetary position') and this should be recognised separately in profit or loss for the period.
The owners' equity (all components) as at the start of the accounting period should be restated using a
general prices index from the beginning of the period.
Section overview
This section provides a brief comparison of the IFRS and UK GAAP accounting for foreign currency
amounts.
The ASB issued FRS 23 The Effects of Changes in Foreign Exchange Rates in December 2004. FRS 23 which
derives from IAS 21 and replaces SSAP 20 is effective from periods from 1 January 2006. Whereas IAS 21
and SSAP 20 had significant differences, FRS 23 derives from IAS 21 and there are therefore virtually no
differences between IFRS and UK GAAP regarding foreign currency translation.
Similarly there are no examinable differences between IAS 29 and FRS 24 Financial Reporting in
Hyperinflationary Economies.
Summary
IAS 21 The Effects of Changes in Foreign Exchange Rates
Historical cost financial Current cost financial Economies ceasing to Selection and use of
statements statements be hyperinflationary the general price index
- Statement of financial - Statement of financial
position position
- Statement of - Statement of
comprehensive income comprehensive
- Gain or loss on net - Gain or loss on net
monetary position monetary position
The share capital was issued on the date the company was formed, 1 January 20X5. The property,
plant and equipment was acquired on the same date and revalued on 30 September 20X5. The
Functional currency
Currency that influences sales prices and costs IAS 21.9
Initial recognition
Foreign currency transaction to be recorded in functional currency at spot IAS 21.21
exchange rate at date of transaction
1 (a) Conversion is the process of physically exchanging one currency for another.
(b) Translation is the restatement of the value of one currency in another currency.
2 Money held and assets and liabilities to be received or paid in fixed or determinable amounts of
money.
3 Use the exchange rate at the date of the transaction. An average rate for a period can be used if
the exchange rates did not fluctuate significantly.
4 Primary factors used in the determination of the functional currency include the currency of the
country that influences sales price for goods and services, labour, material and other costs and
whose competitive forces and regulations determine these prices and costs.
Secondary indicators include the currency in which funding and receipts from operating activities
arise.
5 Treat as assets/liabilities of the foreign operation and translate at the closing rate.
6 Only if there is a change to the underlying transactions relevant to the entity.
7 Zephyria
£134,823
Goodwill is translated at the closing rate. Therefore N$175,000/1.298 = £134,823. See IAS 21
IN15 and 57.
8 Cacomistle
£173,344
Because IAS 21.47 treats fair value adjustments to the carrying amount of assets and liabilities
arising on the acquisition of a foreign operation as assets and liabilities of the foreign operation, it
requires them to be translated at the closing rate.
The correct answer is thus N$225,000/1.298 = £173,344.
9 Longspur
£8,052
IAS 21.21 and 22 require that an asset should be recorded initially at the date of the transaction,
which is the date it first qualifies for recognition. For property, plant and equipment this is when
the asset is delivered, which in this case is 30 April 20X7.
The equipment is a non-monetary asset and thus its carrying amount stays at the original
translated value per IAS 21.23(b). Depreciation on a non-monetary asset is charged from when it
becomes available for use and is treated in the same way as the related assets, so there is no
change from the exchange rate at initial recognition. The correct answer is therefore:
(N$250,000/10 years) 8/12 = N$16,667 translated at £1 : N$2.07 = £8,052.
10 Orton
£511,111
Exchange gain = (N$9,200,000/1.8) – (N$9,200,000/2.0) = £511,111
The exchange gain is determined with respect of the value of the trade payable at the year end (as
per IAS 21.23(a) monetary items such as trade payables are translated at the year-end exchange
rate). The N$ has weakened between the date of the transaction and the year end, so the cost of
settling the trade payable in terms of £ has reduced, thereby producing an exchange gain.
There is no gain or loss in respect of the revenue for the paintings sold, which is recorded at the
transaction date rate (IAS 21.21). There is no gain or loss on the paintings held in inventory which
13 Soapstone
(a) The goodwill acquired is calculated as: R$
Consideration transferred (£700/2) 350
Non-controlling interest (R$500 × 40%) 200
550
Net assets of acquiree (500)
Goodwill 50
Translated at acquisition (R$50 × 2) = £100
Retranslated at 31 December 20X7 (R$50 × 3) = £150
(b) As there has been no change in Frew's share capital during 20X7, the (R$730 – R$500) =
R$230 increase in equity represents Frew's profit for 20X7. This is translated at the £2.5:R$1
average rate as an approximation to the rates ruling at the date of each transaction, to give
£575, of which Soapstone's 60% share is £345 (IAS 21.39(b)-40).
(c) The amount reported as other comprehensive income is made up of the exchange difference
on the retranslation of Frew's accounts plus the exchange difference on the retranslation of
goodwill:
Retranslation of Frew's accounts
£ £
Net assets at 1 January 20X6 at opening rate R$500 @ 2.0 1,000
Net assets at 1 January 20X6 at closing rate R$500 @ 3.0 1,500 500 gain
Profit at average rate R$230 @ 2.5 575
Profit at closing rate R$230 @ 3.0 690 115 gain
615 gain
Retranslation of goodwill
£150 – £100 = £50 gain (part (a))
The overall exchange gain recognised as other comprehensive income is therefore £615 + £50
= £665.
Of this:
£615 40% = £246 is attributable to the non-controlling interest
(£615 60%) + £50 = £419 is attributable to the shareholders of the parent.
WORKINGS
(1) Translation of the statement of financial position of Mars Inc
Gal'000 Gal'000 Rate £'000
Tangible non-current assets 197,400 4.2 CR 47,000
Net current assets 145,500
Less Receivables w/d 50,000
95,500 4.2 CR 22,738
292,900 69,738
Share capital 150,000 5.4 HR 27,778
Pre-acquisition reserves (W2) 76,675 5.4 HR 14,199
Post-acquisition reserves (24,900 3/12) 6,225 ß 13,475
(incl exchange differences to date) 232,900 55,452
Long-term liabilities 60,000 4.2 CR 14,286
292,900 69,738
(4) Goodwill
Gal'000 £000
Consideration transferred (£85 million × 5.4) 459,000
Non-controlling interest
(Gal 150m + Gal 76.675m) × 10% 22,668
481,668
Net assets of acquiree (150m + 76.675m) (226,675)
Goodwill 254,993 @HR 5.4 47,221
Impairment (25,499) @CR 4.2 (6,071)
Exchange gain (β) 13,491
Carrying value 229,494 @CR4.2 54,641
The share capital and retained earnings is the balancing item and is reconciled as follows:
Translation of closing equity (€24,000@ €3/£1) £8,000
Translation of opening equity (€24,000@ €2/£1) £12,000
Loss therefore £4,000
Income taxes
Introduction
Topic List
1 Current tax revised
2 Deferred tax – an overview
3 Identification of temporary differences
4 Measurement of deferred tax assets and liabilities
5 Recognition of deferred tax in the financial statements
6 Common scenarios
7 Group scenarios
8 Presentation and disclosure
9 Deferred tax summary
10 UK GAAP comparison – deferred tax
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
469
Introduction
Determine the recognition and measurement for income taxes and their inclusion in the
financial statements
Apply knowledge and understanding of the recognition and measurement of deferred tax
liabilities and deferred tax assets in particular circumstances through calculations
1.1 Background
Accounting for current tax is ordinarily straightforward. Complexities arise, however, when we consider
the future tax consequences of what is going on in the financial statements now. This is an aspect of tax
called deferred tax, which has not been covered in earlier studies and which we will look at in the next
C
section. IAS 12 Income Taxes covers both current and deferred tax. The parts of this Study Manual H
relating to current tax are fairly brief, as this has been covered at Professional level. A
P
T
1.2 Recognition of current tax liabilities and assets E
R
Current tax is the amount payable to the tax authorities in relation to the current trading activities.
IAS 12 requires any unpaid tax in respect of the current or prior periods to be recognised as a liability.
12
Conversely, any excess tax paid in respect of current or prior periods over what is due should be
recognised as an asset to the extent it is probable that it will be recoverable.
The tax rate to be used in the calculation for determining a current tax asset or liability is the rate that is
expected to apply when the asset is expected to be recovered, or the liability to be paid. These rates
should be based upon tax laws that have already been enacted (are already part of law) or substantively
enacted (have already passed through sufficient parts of the legal process that they are virtually certain
to be enacted) by the reporting date.
1.3 Measurement
Measurement of current tax liabilities (assets) for the current and prior periods is very simple. They are
measured at the amount expected to be paid to (recovered from) the tax authorities. The tax rates
(and tax laws) used should be those enacted (or substantively enacted) by the reporting date.
1.5 Presentation
In the statement of financial position, tax assets and liabilities should be shown separately.
Current tax assets and liabilities may be offset, only under the following conditions.
The entity has a legally enforceable right to set off the recognised amounts.
The entity intends to settle the amounts on a net basis, or to realise the asset and settle the liability
at the same time.
The tax expense (income) related to the profit or loss from ordinary activities should be shown on the
face of the statement of profit or loss and other comprehensive income as part of profit or loss for the
period. The disclosure requirements of IAS 12 are extensive and we will look at these later in the
chapter.
Section overview
Deferred tax is an accounting measure used to match the tax effects of transactions with their
accounting impact and thereby produce less distorted results. It is not a tax levied by the
government that needs to be paid.
Therefore in 20X0, accounting profits are reduced by £10,000 but taxable profits are reduced by
£20,000, so providing one reason why the tax charge is not equal to the tax rate multiplied by the
accounting profit.
At this point it could be said that the temporary difference is equal to the £10,000 difference between
depreciation and capital allowances.
In the long run, the total taxable profits and total accounting profits will be the same (except for
permanent differences). In other words, temporary differences which originate in one period will reverse
in one or more subsequent periods.
Deferred tax is an accounting adjustment to smooth out the discrepancies between accounting profit
and the tax charge caused by temporary differences.
Apply the tax rate to temporary differences to calculate deferred tax asset or liability
The tax rate to be used is not necessarily the current tax rate. It should be the rate which is expected to
apply to the period when the asset is realised or liability settled.
This is covered in more detail in section 4.
Record deferred tax in the financial statements
Depending on the circumstances, a deferred tax asset or liability may arise in the statement of financial
position. The corresponding entry is normally recorded in
The tax charge in profit or loss, or
Other comprehensive income
This is covered in more detail in section 5.
Section overview
Temporary differences are calculated as the difference between the carrying amount of an asset or
liability and its tax base. Temporary differences may be classified as
– Taxable, or
– Deductible
Definition
The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.
Definitions
Taxable temporary differences are temporary differences that will result in taxable amounts in
determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability
is recovered or settled.
Deferred tax liabilities: are the amounts of income taxes payable in future periods in respect of taxable
temporary differences.
C
H
3.4 Summary A
P
The following diagram summarises the calculation and types of temporary difference: T
E
R
Tax treatment
differs from
accounting
12
treatment
Temporary differences
Taxable Deductible
No deferred tax
temporary temporary
implications
difference difference
Solution
1 The tax base of the accrued expenses is nil. This is because the expenses have been recognised in
accounting profit, but the tax impact is yet to take effect. There is therefore a deductible temporary
difference of £1,000.
2 The tax base of the accrued expenses is £3,000, ie the carrying value (£3,000) less the amount
which will be deducted for tax purposes in future periods (nil, as relief has already been obtained).
There is no temporary difference, and no deferred tax arises.
3 The tax base of the loan is £5,000, as there are no future tax consequences. Thus, as the tax base
equals the carrying value, there is no temporary difference and no deferred tax.
4 The tax base of the interest received in advance is nil (ie the carrying value (£7,000) less the
amount which will not be taxable in future periods (£7,000, as it has all been charged already)). As
a result there is a deductible temporary difference of £7,000.
Section overview
The tax rate is applied to temporary differences in order to calculate the deferred tax asset or
liability.
The tax rate should be applied to temporary differences in order to calculate deferred tax:
Taxable temporary differences tax rate = deferred tax liability
Deductible temporary differences tax rate = deferred tax asset
C
H
Worked example: Calculation of deferred tax A
P
A company purchased an asset costing £1,500. At the end of 20X8 the carrying amount is £1,000. The T
cumulative depreciation for tax purposes is £900 and the current tax rate is 25%. E
R
Requirement
Calculate the deferred tax liability for the asset.
12
Solution
The tax base of the asset is £1,500 – £900 = £600.
The carrying amount exceeds the tax base and therefore there is a taxable temporary difference of
£1,000 – £600 = £400. The entity must therefore recognise a deferred tax liability of £400 25% =
£100.
(In order to recover the carrying amount of £1,000, the entity must earn taxable income of £1,000, but
it will only be able to deduct £600 as a taxable expense. The entity must therefore pay income tax of
£400 25% = £100 when the carrying amount of the asset is recovered).
A further reduction to 21% for 2014 has been announced but not yet substantively enacted at the time
of writing.
The Accounting Standards Board (ASB) has stated that substantive enactment occurs when any future
steps in the enactment process will not change the outcome. Specifically, in relation to the UK, the ASB
has stated that this occurs when the House of Commons passes a resolution under the Provisional
Collection of Taxes Act 1968.
Note that the tax rates used in this chapter are assumptions or hypothetical rates rather than real
rates.
Solution
A rate of 29% should be used. The rate is that expected to apply when the asset is realised, thus the rate
of 30% in 20X3, when the temporary difference originated, is not relevant. The 28% would be used if it
had been enacted or substantively enacted, but it is only under discussion. Thus, our best estimate of
the rate applying in 20X5, based upon laws already enacted or substantively enacted, is the rate for
20X4 (ie the previous year) of 29%.
Solution
(a) A deferred tax liability is recognised of £(10,000 – 6,000) 20% = £800.
(b) A deferred tax liability is recognised of £(10,000 – 6,000) 30% = £1,200.
The manner of recovery may also affect the tax base of an asset or liability. Tax base should be
measured according to the expected manner of recovery or settlement.
4.2 Discounting
IAS 12 states that deferred tax assets and liabilities should not be discounted because the complexities
and difficulties involved will affect reliability. Discounting would require detailed scheduling of the
timing of the reversal of each temporary difference, but this is often impracticable. If discounting were
permitted, this would affect comparability.
Note however that where carrying amounts of assets or liabilities are discounted (eg a pension
obligation), the temporary difference is determined based on a discounted value.
Section overview
The deferred tax amount calculated is recorded as a deferred tax balance in the statement of
financial position with a corresponding entry to the tax charge, other comprehensive income or
goodwill.
Solution
20X1 20X2 20X3 20X4 20X5
£ £ £ £ £
Carrying amount 51,200 38,400 25,600 12,800 0
Tax base 51,200 40,960 32,768 26,214 0
Taxable/(deductible) temporary 0 (2,560) (7,168) (13,414) 0
difference
Opening deferred tax liability/(asset) 0 0 (768) (2,150) (4,024)
Deferred tax expense/(credit) 0 (768) (1,382) (1,874) 4,024
Closing deferred tax liability/(asset) 0 (768) (2,150) (4,024) 0
Solution
The carrying amount of the liability is (£10,000).
The tax base of the liability is nil (carrying amount of £10,000 less the amount that will be deductible
for tax purposes in respect of the liability in future periods). C
H
When the liability is settled for its carrying amount, the entity's future taxable profit will be reduced by A
£10,000 and so its future tax payments by £10,000 25% = £2,500. P
T
The carrying amount of (£10,000) is less than the tax base of nil and therefore the difference of £10,000 E
R
is a deductible temporary difference.
The entity should therefore recognise a deferred tax asset of £10,000 25% = £2,500 provided that it
is probable that the entity will earn sufficient taxable profits in future periods to benefit from a 12
reduction in tax payments.
Solution
The carrying amount of the building before the revaluation was £500,000 – (5 × 2% × £500,000) =
£450,000.
The tax base of the building before the revaluation was £500,000 – (5 × 4% × £500,000) =
£400,000.
The temporary difference of £50,000 would have resulted in a deferred tax liability of 30% ×
£50,000 = £15,000.
As a result of the revaluation, the carrying amount of the building is increased to £650,000.
The tax base does not change.
The temporary difference therefore increases to £250,000 (£650,000 - £400,000), resulting in a
total deferred tax liability of 30% × £250,000 = £75,000.
As a result of the revaluation, additional deferred tax of £60,000 must therefore be recognised.
This could also be calculated by applying the tax rate to the difference between carrying amount of
£450,000 and valuation of £650,000.
After the year end, a report was obtained from an independent actuary. This gave valuations as at 30
September 20X6 of
£
Pension scheme assets 2,090,200
Pension scheme liabilities (2,625,000)
All receipts and payments into and out of the scheme can be assumed to have occurred on 30
September 20X6.
Celia recognises any gains and losses on remeasurement of defined benefit pension plans directly in
other comprehensive income in accordance with IAS 19 (revised 2011).
In the tax regime in which Celia operates, a tax deduction is allowed on payment of pension benefits.
No tax deduction is allowed for contributions made to the scheme. Gains and losses on pension
scheme assets are tax exempt.
Assume that the rate of tax applicable to 20X5, 20X6 and announced for 20X7 is 30%.
Requirements
(i) Explain how each of the above transactions should be treated in the financial statements for the
year ended 30 September 20X6;
(ii) Prepare an extract from the statement of profit or loss and other comprehensive income showing
other comprehensive income for the year ended 30 September 20X6.
WORKINGS
1 Pension scheme
Pension Pension
scheme scheme
assets liabilities
£ £
At 1 October 20X5 2,160,000 2,530,000
Interest cost on obligation (10% 2,530,000) 253,000
Interest on plan assets (10% 2,160,000) 216,000
Current service cost 374,000
Contributions 405,000
Transfers (400,000) (350,000)
Pensions paid (220,000) (220,000)
Loss on remeasurement recognised in OCI (70,800) 38,000
At 30 September 20X6 2,090,200 2,625,000
6.2.2 Provisions
A provision is recognised for accounting purposes when there is a present obligation, but it is not
deductible for tax purposes until the expenditure is incurred.
In this case, the temporary difference is equal to the amount of the provision, since the tax base is
nil.
Deferred tax is recognised in profit or loss.
If the amount of the tax deduction (or estimated future tax deduction) exceeds the amount of the
related cumulative remuneration expense, this indicates that the tax deduction relates also to an equity
item.
The excess is therefore recognised directly in equity. The diagrams below show the accounting for
equity-settled and cash-settled transactions.
Equity-settled transaction
Estimated
future
tax
deduction
Greater Smaller
than than
Cumulative Cumulative
remuneration remuneration
expense expense
Cash-settled transaction
Estimated All
future Recorded in
tax profit or loss
deduction
7 Group scenarios
Section overview
In relation to business combinations and consolidations, IAS 12 gives examples of circumstances
that give rise to taxable temporary differences and to deductible temporary differences in an
appendix.
As already mentioned, however, the initial recognition of goodwill has no deferred tax impact.
Solution
The carrying amount of the inventory in the group accounts is £10,000 more than its tax base
(being carrying amount in Harrison's own accounts).
Deferred tax on this temporary difference is 30% x £10,000 = £3,000.
A deferred tax liability of £3,000 is recognised in the group statement of financial position.
Goodwill is increased by (£3,000 80%) = £2,400.
Solution 12
The tax base of the investment in Embsay is the cost of £110,000. The carrying value is the share
of net assets (80% × £120,000) + goodwill of £30,000 = £126,000.
The temporary difference is therefore £126,000 - £110,000 = £16,000.
This is equal to the group share of post acquisition profits: 80% × £20,000 change in net assets
since acquisition.
In recent years, Morpeth Ltd has made the following acquisitions of other companies:
On 1 January 20X6, it acquired 90% of the share capital of Skipton, resulting in goodwill of 12
£1.4 million.
On 1 July 20X6 it acquired the whole of the share capital of Bingley for £6 million. At this date the
fair value of the net assets of Bingley was £4.5 million and their tax base was £4 million.
The following information is relevant to Morpeth Group's year ended 31 December 20X6:
Skipton
1 Skipton has made a provision amounting to £1.8 million in its accounts in respect of litigation. This
is tax allowable only when the cost is actually incurred. The case is expected to be settled within 12
months.
2 Skipton has a number of investments classified as at fair value through profit or loss in accordance
with IAS 39 Financial Instruments: Recognition and Measurement. The remeasurement gains and
losses recognised in profit or loss for accounting purposes are not taxable / tax allowable until such
date as the investments are sold. To date the cumulative unrealised gain is £2.5 million.
3 Skipton has sold goods to Morpeth in the year making a profit of £1 million. A quarter of these
goods remain in Morpeth's inventory at the year end.
Bingley
1 At its acquisition date, Bingley had unrelieved brought forward tax losses of £0.4 million. It was
initially believed that Bingley would have sufficient taxable profits to utilise these losses and a
deferred tax asset was recognised in Bingley's financial statements at acquisition. Subsequent
events have proven that the future taxable profits will not be sufficient to utilise the full brought
forward loss.
2 At acquisition Bingley's retained earnings amounted to £3.5 million. The directors of Morpeth
Group have decided that in each of the next four years to the intended listing date of the group,
they will realise earnings through dividend payments from the subsidiary amounting to £600,000
per annum. Bingley has not declared a dividend for the current year. Tax is payable on remittance
of dividends.
3 £300,000 of the purchase price of Bingley has been allocated to intangible assets. The recognition
and measurement criteria of IFRS 3 and IAS 38 do not appear to have been met, however the
directors believe that the amount is allowable for tax and have calculated the tax charge
accordingly. It is believed that this may be challenged by the tax authorities.
Requirement
What are the deferred tax implications of the above issues for the Morpeth Group?
Section overview
The detailed presentation and disclosure requirements for deferred tax are given below.
8.2.1 Offsetting
Where appropriate deferred tax assets and liabilities should be offset in the statement of financial
position.
An entity should offset deferred tax assets and deferred tax liabilities if, and only if:
The entity has a legally enforceable right to set off current tax assets against current tax liabilities;
and
The deferred tax assets and the deferred tax liabilities relate to income taxes levied by the same
taxation authority.
There is no requirement in IAS 12 to provide an explanation of assets and liabilities that have been
offset.
Section overview
The calculation and recording of deferred tax can be set out in an eight step process.
The following is a summary of the steps required to calculate and record deferred tax in the financial
statements.
Procedure Comment
Step 1 Determine the carrying amount of each asset and This is merely the carrying value
liability in the statement of financial position. determined by other Standards.
Step 2 Determine the tax base of each asset and This is the amount attributed to each asset
liability. or liability for tax purposes.
Step 3 Determine any temporary differences (these are These will be either:
based on the difference between the figures in Taxable temporary differences; or
Step 1 and Step 2). Deductible temporary differences.
Step 4 Determine the deferred tax balance by The tax rate to be used is that expected to
multiplying the tax rate by any temporary apply when the asset is realised or the
differences. liability settled, based upon laws already
enacted or substantively enacted by the
statement of financial position date.
Step 5 Recognise deferred tax assets/liabilities in the Apply recognition criteria in IAS 12.
statement of financial position.
Step 6 Recognise deferred tax, normally in profit or loss This will be the difference between the
(but possibly as other comprehensive income or in opening and closing deferred tax balances
equity or goodwill). in the statement of financial position.
Step 7 Off-set deferred tax assets and liabilities in the Off-set criteria in IAS 12 must be satisfied.
statement of financial position where appropriate.
Step 8 Comply with relevant presentation and disclosure See relevant presentation and disclosure
requirements for deferred tax in IAS 12. requirements sections above.
C
The method described is referred to as the liability method, or full provision method. H
A
The advantage of this method is that it recognises that each temporary difference at the reporting P
date has an effect on future tax payments, and these are provided for in full. T
E
The disadvantage of this method is that under certain types of tax system, it gives rise to large R
liabilities that may fall due only far in the future.
12
10 UK GAAP comparison – deferred tax
Section overview
There are certain key differences between IFRS and UK GAAP in accounting for deferred tax.
The following is a summary of some of the key differences between the IFRS treatment and the UK
GAAP treatment of deferred tax.
Fair value Always recognise deferred tax and Do not recognise deferred tax.
adjustments in adjust goodwill.
business
combinations
Summary
IAS 12
Income tax
Current Deferred
tax tax C
H
A
P
Asset Liability Taxable temporary Deductible T
differences temporary differences E
R
WHERE
Excess Deferred tax Deferred tax
paid liability recognised asset 12
OR
Tax loss Recognised only
c/back Exceptions Deferred tax where probable
recovers tax - initial recognition liabilities relating to that taxable
of previous of goodwill business profit will be
period - initial recognition combinations shall available
of an asset or be recognised unless
liability in a - parent, investor or
transaction which venturer is control
- is not a business reversal of
combination temporary
- at the time of difference
the transaction - probable that
affects neither temporary
accounting profit difference will not
nor taxable reverse in the
profit or loss foreseeable future
Requirement
What is the deferred tax charge for the year ended 31 December 20X7, and where is it charged, 12
under IAS 12 Income Taxes?
7 Spruce
Spruce Company made a taxable loss of £4.7 million in the year ended 31 December 20X7. This
was due to a one-off reorganisation charge in 20X7; prior to that, Spruce made substantial taxable
profits each year.
Assume that tax legislation allows companies to carry back tax losses for one financial year, and
then carry them forward indefinitely.
Spruce's taxable profits are as follows.
Year ended £'000
31 December 20X6 500
31 December 20X8 (estimate) 1,000
31 December 20X9 (estimate) 1,200
31 December 20Y0 and onwards Uncertain
Spruce pays income tax at 25%.
Requirement
What is the deferred tax balance in respect of tax losses in Spruce's statement of financial position
at 31 December 20X7, according to IAS 12 Income Taxes?
8 Bananaquit
At 31 December 20X6, The Bananaquit Company has a taxable temporary difference of £1.5
million in relation to certain non-current assets.
At 31 December 20X7, the carrying amount of those non-current assets is £2.4 million and the tax
base of the assets is £1.0 million.
Tax is payable at 30%.
Requirement
Indicate whether the following statements are true or false, in accordance with IAS 12 Income
Taxes.
A The deferred tax charge through profit or loss for the year is £30,000
B The statement of financial position deferred tax asset at 31 December 20X7 is £420,000
Current tax
Unpaid current tax recognised as a liability IAS 12.12
Benefit relating to tax losses that can be carried back to recover previous IAS 12.13
period current tax recognised as asset
C
Taxable temporary differences H
A
Deferred tax liability shall be recognised on all taxable temporary IAS 12.15 P
differences except those arising from: T
E
R
– Initial recognition of goodwill
– Initial recognition of an asset or liability in a transaction which:
Is not a business combination 12
Deferred tax assets and liabilities arising from investments in subsidiaries, IAS 12.39, IAS 12.44
branches and associates and investments in joint ventures
Discounting
Deferred tax assets and liabilities shall not be discounted IAS 12.53
Annual review
Carrying amount of deferred tax asset to be reviewed at each reporting IAS 12.56
date
The deferred tax figure in profit or loss is the difference between the opening and closing deferred
tax liabilities. At the start of the year the liability was £450,000 (£1.5m 30%). The amount of the 12
change is £30,000, but it is a deferred tax credit, not charge to profit or loss.
At the end of the year the £2.4m carrying amount of the assets exceeds their £1.0m tax base, so
under IAS 12.5 there is a taxable temporary difference, of £1.4m. Under IAS 12.15 a deferred tax
liability (not asset) of £420,000 (£1.4m 30%) must be recognised.
9 Antpitta
A False
B True
There is an unrealised profit relating to inventories still held within the group, which must be
eliminated on consolidation (IFRS 10). But the tax base of the inventories is unchanged, so it is
higher than the carrying amount in the consolidated statement of financial position and there is a
deductible temporary difference (IAS 12.5).
10 Parea
(a) £132
(b) £3,743
(c) £349 credit
At 31 December 20X6 the carrying amount of the plant is £30,000 (1 – 25%) = £22,500,
while the tax base is £30,000 (1 – 27%) = £21,900. The taxable temporary difference is £600
and the deferred tax liability is 22% thereof, £132.
At 31 December 20X7 the carrying amount of the plant is £30,000 (1 – (25% x 2)) =
2
£15,000, while the tax base is £30,000 (1 – 27%) = £15,987, leading to a deductible
temporary difference of £987. A deferred tax asset should be recognised in relation to this.
Before its revaluation, the property's carrying amount is £40,000 – (5 years at 4%) = £32,000
and the tax base is the same. The revaluation to £50,000 creates a taxable temporary difference
of £18,000.
As Parea pays all its tax to a single authority, it must offset deferred tax assets and liabilities
(IAS 12.74). At 31 December 20X7 there is a deferred tax liability of £(-987 + 18,000) =
£17,013 22% = £3,743.
The change in deferred tax liability over the year is £3,743 - £132 = £3,611. Of this, £18,000
22% = £3,960 relates to the property revaluation and is recognised in other comprehensive
income. This leaves £3,611 - £3,960 = £(349) to be credited to profit or loss (IAS 12.58).
The cumulative remuneration expense is £60,000, which is less than the estimated tax deduction of
£90,000. Therefore:
A deferred tax asset of £27,000 is recognised in the statement of financial position.
There is deferred tax income of £18,000 (60,000 30%).
The excess of £9,000 (30,000 30%) goes to equity.
The cumulative remuneration expense is £220,000, which is less than the estimated tax deduction of
£280,000. Therefore:
A deferred tax asset of £84,000 is recognised in the statement of financial position at 31 May 20X7
There is potential deferred tax income of £57,000 for the year ended 31 May 20X7
Of this, £9,000 (60,000 30%) – (9,000) goes directly to equity
The remainder (£48,000) is recognised in profit or loss for the year
Introduction
Topic List
1 IAS 40 Investment Property
2 IAS 41 Agriculture
3 IFRS 6 Exploration for and Evaluation of Mineral Resources
4 IFRS 4 Insurance Contracts
5 IAS 26 Accounting and Reporting by Retirement Benefit Plans
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
511
Introduction
Understand the nature, application and scope of IAS 26 Accounting and Reporting by
Retirement Benefit Plans
Section overview
An investment property is land or buildings or both that is held by an entity to earn rentals and/or
for its capital appreciation potential.
Investment properties have been covered at Professional stage and the section below is revision of
that material.
One of the distinguishing characteristics of investment property is that it generates cash flows largely
independent of the other assets held by an entity.
Owner-occupied property is not investment property and is accounted for under IAS 16 Property, Plant
and Equipment.
1.1 Recognition
Investment property should be recognised as an asset when two conditions are met.
It is probable that the future economic benefits that are associated with the investment property
will flow to the entity.
The cost of the investment property can be measured reliably.
C
H
1.2 Initial measurement and further aspects of recognition A
P
An investment property should initially be measured at its cost, including transaction costs. T
E
Further aspects of recognition R
Transaction costs Expenses that are directly attributable to the investment property, for example
professional fees and property transfer taxes. Cost does not include activities 13
that, while related to the investment property, are not directly attributable to it.
For example, start up costs, abnormal amounts of wasted resources in
constructing the property, relocation costs, losses incurred before full occupancy
and the normal servicing of the property are not directly attributable.
Self-constructed Property being self-constructed or under development for future use as an
investment investment property qualifies itself as an investment property.
properties
Leases A property interest held under a lease and classified as an investment
property shall be accounted for as if it were a finance lease. The asset is
recognised at the lower of the fair value of the property and the present
value of the minimum lease payments. An equivalent amount is recognised
as a liability.
Entity occupies part If the two portions can be sold separately or leased separately under a
of property and finance lease, each is accounted for as appropriate. If not, entire property is
leases out balance an investment property only if insignificant portion is owner occupied.
Entity supplies An investment property only if the services are insignificant to the
services to the lessee arrangement as a whole.
of the property
Property leased to An investment property in entity's own accounts but owner occupied from
and occupied by group perspective.
parent, subsidiary or
other group company
1.4 Derecognition
When an investment property is derecognised, a gain or loss on disposal should be recognised in C
profit or loss. The gain or loss should normally be determined as the difference between the net H
disposal proceeds and the carrying amount of the asset. A
P
T
E
Interactive question 3: Disposal of investment property [Difficulty level: Easy] R
An entity purchased an investment property on 1 January 20X3, for a cost of £5.5m. The property has a
useful life of 50 years, with no residual value and at 31 December 20X5 had a fair value of £6.2m.
On 1 January 20X6 the property was sold for net proceeds £6m. 13
Requirement
Calculate the profit or loss on disposal under both the cost and fair value model.
See Answer at the end of this chapter.
Property held as inventory now Transfer to investment properties under IAS 40.
let to a third party
If fair value model to be used, revalue at date of change and
recognise difference in profit or loss.
Commencement of operating Transfer from property, plant and equipment to investment
lease to another party property under IAS 40.
Section overview
IAS 41 sets out the accounting treatment, including presentation and disclosure requirements, for
agricultural activity.
2.1 Definitions
Definitions
Agricultural activity: Agricultural activity is defined as the management of the biological transformation
of biological assets for sale, into agricultural produce, or into additional biological assets.
Agricultural activities include, for example, raising livestock, forestry and cultivating orchards and
plantations.
Biological transformation: A biological transformation comprises the processes of growth,
degeneration, production and procreation that cause qualitative or quantitative changes in a biological
asset.
In its simplest form a biological transformation is the process of growing something such as a crop,
although it also incorporates the production of agricultural produce such as wool and milk.
Biological asset: A biological asset is a living plant or animal.
Agricultural produce: Agricultural produce is the harvested produce of an entity's biological assets.
IAS 41 considers the classification of biological assets and how their characteristics, and hence value,
change over time. The Standard applies to agricultural produce up to the point of harvest, after which
IAS 2 Inventories is applicable. A distinction is made between the two because IAS 41 applies to
biological assets throughout their lives but to agricultural produce only at the point of harvest.
IAS 41 includes a table of examples which clearly sets out three distinct stages involved in the
production of biological assets. Examples include the identification of dairy cattle as the biological asset,
milk the agricultural produce and cheese the product that is processed after the point of harvest.
Another example is wine: vines are the biological asset, grapes the agricultural produce and wine the
end product.
Calves and cows are biological assets as they are living animals whereas beef and milk are agricultural
produce. Apples are agricultural produce whereas the related trees and orchards are biological assets.
Agricultural activities may be quite diverse, but all such activities have similar characteristics as described
below.
Common characteristics of agricultural activities
Capacity to change – living animals and plants are capable of changing. For example, a sapling
grows into a fruit tree which will bear fruit and a sheep can give birth to a lamb;
Management of change – the biological transformation relies on some form of management
input, ensuring, for example, the right nutrient levels for plants, providing the right amount of
light or assisting fertilisation; and
Measurement of change – the changes as a result of the biological transformation are measured
and monitored. Measurement is in relation to both quality and quantity.
Requirement
How should the fair value less cost to sell be calculated?
Solution
The fair value less costs to sell is calculated as:
£
Market value 60.00
Transport to market costs (1.00)
Fair value 59.00
Costs to sell
Auctioneers' commission – 2% of £60 (1.20)
Government levy – 3% of £60 (1.80)
Fair value less costs to sell 56.00
Solution
13
The movement in the fair value less estimated costs to sell of the herd can be reconciled as follows.
£
At 1 January 20X3 (5 £200) 1,000
Purchased 212
Change in fair value (the balancing figure) 168
At 31 December 2003 (6 £230) 1,380
The entity is encouraged to disclose separately the amount of the change in fair value less estimated
costs to sell arising from physical changes and price changes.
If it is not possible to measure biological assets reliably and they are instead recognised at their cost less
depreciation and impairment an explanation should be provided of why it was not possible to establish
fair value. A full reconciliation of movements in the net cost should be presented with an explanation of
the depreciation rate and method used.
Section overview
IFRS 6 Exploration for and Evaluation of Mineral Resources is effective from 1 January 2006 and
essentially deals with two matters.
– Allows entities to use existing accounting policies for exploration and evaluation assets.
– Requires entities to assess exploration and evaluation assets for impairment. The recognition
criteria for impairment are different from IAS 36 but, once impairment is recognised, the
measurement criteria are the same as for IAS 36.
3.1 Scope
The Standard deals with the accounting of expenditures on the exploration for and evaluation of
mineral resources (that is, minerals such as gold, copper, etc, oil, natural gas and similar resources),
except:
Expenditures incurred before the acquisition of legal rights to explore.
Expenditures incurred following the assessment of technical and commercial feasibility.
IAS 8 still applies to such industries in helping them determine appropriate accounting policies. Thus,
accounting policies must present information that is relevant to the economic decision needs of users.
Entities may change their policies under IFRS 6 as long as the new information comes closer to meeting
the IAS 8 criterion.
3.6 Impairment
The difficulty with respect to exploratory activities is that future economic benefits are generally very
uncertain and hence forecasting future cash flows, for example, is difficult. IFRS 6 modifies IAS 36 to
state that impairment tests are required:
4.1 Background
IFRS 4 specifies the financial reporting for insurance contracts by any entity that issues such contracts, or
holds reinsurance contracts. It does not apply to other assets and liabilities held by insurers.
In the past there was a wide range of accounting practices used for insurance contracts and the
practices adopted often differ from those used in other sectors. As a result the IASB embarked on a
substantial project to address the issues surrounding the accounting for insurance contracts. Rather than
issuing one Standard that covered all areas, the IASB decided to tackle the project in two phases.
Interim guidance has been issued in phase one of the project in the form of IFRS 4; it is a stepping stone
to the second phase of the project. IFRS 4 largely focuses on improving the disclosure requirements in
relation to insurance contracts; however, it also includes a number of limited improvements to existing
accounting requirements.
Although IFRS 4 sets out a number of accounting principles as essentially best practice, it does not
require an entity to use these if it currently adopts different accounting practices. An insurance entity is
however prohibited from changing its current accounting policies to a number of specifically identified
practices.
Definition
Insurance contracts: are contracts between two parties, where one party, the insurer, agrees to
compensate the other party, the policyholder, if it is adversely affected by an uncertain future event.
An uncertain future event exists where at least one of the following is uncertain at the inception of an
insurance contract:
The occurrence of an insured event;
The timing of the event; or
The level of compensation that will be paid by the insurer if the event occurs (IFRS 4 Appendix B).
Some insurance contracts may offer payments-in-kind rather than compensation payable to the
policyholder directly. For example, an insurance repair contract may pay for a washing machine to be
repaired if it breaks down; the contract will not necessarily pay monetary compensation.
In identifying an insurance contract it is important to make the distinction between financial risk and
insurance risk. A contract that exposes the issuer to financial risk without significant insurance risk does
not meet the definition of an insurance contract.
Definitions
Financial risk is where there is a possible change in a financial or non-financial variable, for example a
specified interest rate, commodity prices, an entity's credit rating or foreign exchange rates.
Insurance risk is defined as being a risk that is not a financial risk. The risk in an insurance contract is
whether an event will occur (rather than arising from a change in something), for example a theft,
damage against property, or product or professional liability.
Requires an insurer to continue to recognise insurance liabilities in its financial statements until they
are discharged, cancelled or expire, and to present such liabilities without offsetting them against
13
related reinsurance assets.
Liability adequacy test
An insurer recognises its insurance liabilities at each reporting date based on the current estimate of
future contractual cash flows, and related items such as handling costs, arising under the insurance
contracts.
This provision should be reassessed at each reporting date and any identified shortfall should be
recognised immediately as part of profit or loss for the period. This is the so called liability adequacy
test.
The assessment should be based on current estimates for future cash flows under the insurance
contracts issued. If the recognised insurance liability is assessed as being adequate, then IFRS 4 does not
require any further action by the insurer. However, if the liability is found to be inadequate, then the
entire shortfall should be recognised in profit or loss.
The liability adequacy test considers all contractual cash flows under current insurance contracts, and
related costs, such as claims handling costs. Where there are embedded options or guarantees within a
contract, any cash flows arising should also be included in the assessment. Where an entity has deferred
acquisition costs and related intangible assets such as those arising from an insurance based business
combination these should be deducted from the insurance liabilities.
If the accounting policies of an insurer do not demand that a liability adequacy test should be carried
out, as described above, then an assessment is still required of the potential net liability (ie the relevant
insurance liabilities less any related deferred acquisition costs). In these circumstances the insurer is
required to recognise at least the amount that would be required to be recognised as a provision under
the application of IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
That is, if the carrying amount of the IAS 37 calculated provision is greater than that recognised, then
the insurer should increase the liabilities as appropriate.
4.4 Disclosures
IFRS 4 sets out an overriding requirement that the information to be disclosed in the financial
statements of an insurer 'identifies and explains amounts arising from insurance contracts'.
This information should include the accounting policies adopted and the identification of recognised
assets, liabilities, income and expense arising from insurance contracts.
More generally, the risk management objectives and policies of an entity should be disclosed, since this
will explain how an insurer deals with the uncertainty it is exposed to.
An entity is not generally required to comply with the disclosure requirements in IFRS 4 for comparative
information that relates to annual periods beginning before 1 January 2005. However, comparative
disclosure is required in relation to accounting policies adopted and the identification of recognised
assets, liabilities, income and expense arising from insurance contracts.
Section overview
IAS 26 applies to the preparation of financial reports by retirement benefit plans which are either
set up as separate entities and run by trustees or held within the employing entity.
There are two main types of retirement benefit plan, both discussed in Chapter 8.
Defined contribution plans (sometimes called 'money purchase schemes'). These are retirement
plans under which payments into the plan are fixed. Subsequent payments out of the plan to
retired members will therefore be determined by the value of the investments made from the
contributions that have been made into the plan and the investment returns reinvested.
Defined benefit plans (sometimes called 'final salary schemes'). These are retirement plans under
which the amount that a retired member will receive from the plan during retirement is fixed.
Contributions are paid into the scheme based on an estimate of what will have to be paid out
under the plan.
The diagram following the question below outlines the relevant relationships (it is also relevant to IAS
19).
Employer's
contributions
(funding)
Employees
(or participants)
A defined benefit plan's report should provide participants with information about the relationship
between the future obligations under the plan and the resources within the plan that are available to 13
meet those obligations. A typical report will therefore include:
A description of significant activities for the reporting period along with details of any changes that
have been made to the plan and the effect of the changes on the plan;
A description of the plan's membership, terms and conditions;
Financial statements containing information on the transactions and investment performance for
the period as well as presenting the financial position of the plan at the end of the period;
Actuarial information, including the present value of the promised retirement benefits under the
plan and a description of the significant actuarial assumptions made in making those estimates;
and
A description of the investment policies.
5.7 Disclosure
The report of all retirement benefit plans should also include the following information.
A statement of changes in the net assets that are available in the fund to provide future benefits;
and
A summary of the plan's significant accounting policies.
The statement of changes in the net assets available to provide future benefits should disclose a full
reconciliation showing movements during the period, for example contributions made to the plan split
between employee and employer, investment income, expenses and benefits paid out.
Information should be provided on the plan's funding policy, the basis of valuation for the assets in the
fund and details of significant investments that exceed a 5% threshold of net assets in the fund available
for benefits. Any liabilities that the plan has other than those of the actuarially calculated figure for
future benefits payable and details of any investment in the employing entity should also be disclosed.
General information should be included about the plan, such as the names of the employing entities,
the groups of employees that are members of the plan, the number of participants receiving benefits
under the plan and the nature of the plan, ie defined contribution or defined benefit. If employees
contribute to the plan, this should be disclosed along with an explanation of how the promised benefits
are calculated and details of any termination terms of the plan. If there have been changes in any of the
information disclosed then this fact should be explained.
Summary
IAS 40
Investment Property
Recognition as
investment property?
No Yes
Subsequent 13
measurement
Initial recognition
- accounting policy
choice
Cost Fair value
model model
Valuation
of plan
assets
Recognition of exploration
Unbundle contracts and evaluation assets
into Liability adequacy
- insurance test
After recognition, apply
component (apply - recognise either the cost model
IFRS 4) deficiency in profit or the revaluation model
- deposit or loss
component (apply
IAS 39)
Accounting policy (1) In its car breakdown division, Traore offers unlimited amounts of
roadside assistance in exchange for an annual subscription. Although it
has always accepted that this activity is in the nature of offering
insurance against breakdown, it accounts for these subscriptions by
using the stage of completion method under IAS 18 Revenue, and
making relevant provisions for fulfilment costs under IAS 37 Provisions,
Contingent Liabilities and Contingent Assets.
Accounting policy (2) In its property structures insurance division, Traore makes a detailed
estimate for the cost of each outstanding claim but adopts the practice
of adding another 20% to the total on a 'just in case' basis.
Requirement
Which of these accounting policies is Traore permitted to continue to use under IFRS 4 Insurance
Contracts?
IAS 26 Accounting and Reporting by Retirement Benefit Plans
12 Answer the following questions in accordance with IAS 26 Accounting and Reporting by Retirement
Benefit Plans.
(a) How should a defined contribution retirement benefit plan carry property, plant and
equipment used in the operation of the fund?
(b) Is a defined contribution retirement benefit plan permitted to use a constant rate redemption
yield to measure any securities with a fixed redemption value which are acquired to match the
obligations of the plan?
(c) Does IAS 26 specify a minimum frequency of actuarial valuations?
IFRS 6 Exploration For and Evaluation of Mineral Resources
13 Give examples of circumstances that would trigger a need to test an evaluation and exploration
asset for impairment.
Property held by lessee under operating lease may be investment IAS 40.6
property
Fair value model IAS 40.33-35, IAS 40.38
2 IAS 41 Agriculture
Scope IAS 41.1
– Biological assets
– Agricultural produce at the point of harvest
– Government grants C
H
Recognition and measurement IAS 41.10, 12-13 A
P
Gains and losses IAS 41.26, 28 T
E
Government grants IAS 41.34-35
R
Disclosure IAS 41.40, 41, 46-50, 54-57
All plans:
Valuation of plan assets IAS 26.32
On acquisition of the herd, the cattle are initially recognised as biological assets at fair value
less costs to sell (IAS 41.27), which in this case is less than cost by the costs to sell which are
immediately deducted (IAS 41.27). Acceptable costs to sell include autioneers' fees and
government transfer fees (IAS 41.14) but exclude transport to market costs (IAS 41.14). The
interest on the loan taken out to finance the acquisition is not a cost to sell (IAS 41.22).
(b) The value is then restated to fair value less costs to sell at each reporting date (IAS 41.12)
£'000
Fair value at 31 December 20X7 2,500
Costs to sell: auctioneers fees (£2.5m × 2%) (50)
Government fees (50)
Carrying value 2,400
Less initial recognition value (1,714)
Gain 686
11 Traore
The entity is permitted to continue with both policies. 13
IFRS 4.13 disapplies the provisions of IAS 8 Accounting Policies, Changes in Accounting Estimates and
Errors, in relation to selection of accounting policies where there is no IFRS. Entities are therefore
only required to change existing policies in the circumstances listed in IFRS 4.14. Accounting policy
(1) is not caught by this paragraph, so its continued use is permitted.
The application of Accounting policy (2) involves the use of excessive prudence. The continued use
of excessive prudence is permitted by IFRS 4.26.
IAS 26 Accounting and Reporting by Retirement Benefit Plans
12 (a) Under IAS 26.33 all types of retirement benefit plan should account for assets used in the
operation of the plan under the applicable Standards. IAS 16 is applicable in this case and
either the cost model or the revaluation model may be used.
(b) All types of retirement plan are permitted by IAS 26.33 to use this method of measuring such
securities.
(c) No minimum frequency of actuarial valuation is specified in IAS 26.27 or elsewhere.
IFRS 6 Exploration For and Evaluation of Mineral Resources
13 (a) The expiration or anticipated expiration in the near future of the period for which the entity
has the right to explore the relevant area, unless the right is expected to be renewed.
(b) The lack of available planned or budgeted expenditure for further exploration and evaluation
of the specific area.
(c) A decision to discontinue evaluation activities in the exploration and specific area when
commercially viable resources have not been identified.
Introduction
Topic List
IAS 33 Earnings per Share
1 EPS: overview of material covered in earlier studies
2 Basic EPS: weighted average number of shares
3 Basic EPS: profits attributable to ordinary equity holders
4 Diluted earnings per share
5 Diluted EPS: convertible instruments
6 Diluted EPS: options
7 Diluted EPS: contingently issuable shares
8 Retrospective adjustments and presentation and disclosure
9 IAS 33 Earnings per Share and UK GAAP
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
545
Introduction
Calculate basic and diluted EPS figures in situations where there have been a number of
adjustments that will affect EPS calculations during the period
Demonstrate an understanding of the significance of additional EPS figures and how they
can be calculated to provide a more 'stable' performance measure
Scope
IAS 33 applies to entities whose ordinary shares are publicly traded or are in the process of being
issued in public markets.
Basic earnings per share
Basic EPS is calculated as:
Profit attributable to the ordinary equity holders is based on profit after tax after the deduction
of preference dividends and other financing costs in relation to preference shares classified as
equity under IAS 32. Whether an adjustment is needed depends on the type of preference share:
Redeemable preference No adjustment is required as these shares are classified as liabilities and
shares the finance charge relating to them will already have been charged to
profit or loss as part of finance charges.
Irredeemable These shares are classified as equity and the dividend relating to them
preference shares is disclosed in the statement of changes in equity. This dividend must
be deducted from profit for the year to arrive at profit attributable to
the ordinary shareholders.
The weighted average number of shares should be adjusted for changes in the number of shares
without a corresponding change in resources, for example a bonus issue, by assuming that the
new number of shares had always been in issue.
Shares should generally be included in the weighted average number of shares from the date the
consideration for their issue is receivable.
C
An entity is required to calculate and present a basic EPS amount based on the profit or loss for the H
period attributable to the ordinary equity holders of the parent entity. If results from 'continuing A
operations' or 'discontinued operations' are reported separately, EPS on these results should also be P
separately reported. T
E
Diluted earnings per share R
A diluted EPS figure should also be reported by an entity. A dilution is a reduction in the EPS figure
(or increase in a loss per share) that will result from the issue of more equity shares on the 14
conversion of convertible instruments already issued.
For the purpose of calculating diluted earnings per share, an entity shall adjust profit or loss
attributable to ordinary equity holders of the parent entity, and the weighted average number of
shares outstanding for the effects of all dilutive potential ordinary shares.
Presentation
Basic and diluted EPS figures for profit or loss from continuing operations should be presented on
the face of the statement of comprehensive income with equal prominence.
Where changes in ordinary shares occur during the accounting period, an amendment is necessary
to the number of shares used in the EPS calculations. In some situations, the EPS in prior periods
will also have to be adjusted.
Treasury shares are accounted for as a deduction from shareholders' funds. Since such shares are no
longer available in the market, they are excluded from the weighted average number of ordinary
shares for the purpose of calculating EPS.
Section overview
This section deals with certain adjustments to the number of shares used for the calculation of
basic earnings per share.
IAS 33 requires that a time-weighted average number of shares should be used in the denominator of
the earnings per share calculation. The basic idea of how to calculate such a weighted average has been
covered at Professional level. In this section we deal with issues relating to the treatment of share
repurchases, partly paid shares, bonus and rights issues and the impact of consolidation.
Solution
The calculation can be performed on a cumulative basis:
Weighted
average
1 Jan X1 – 30 May X1 1,700 5/12 708
Share issue 800
31 May X1 – 30 Nov X1 2,500 6/12 1,250
Share purchase (250)
1 Dec X1 – 31 Dec X1 2,250 1/12 188
2,146
Solution
The new shares issued should be included in the calculation of the weighted average number of shares
in proportion to the percentage of the issue price received from the shareholding during the period.
Weighted
Shares Fraction average
issued of period shares
1 January 20X5 – 31 August 20X5 900 8/12 600
Issue of new shares for cash, part paid (2/4 × 600) 300
1 September 20X5 – 31 December 20X5 1,200 4/12 400
Weighted average number of shares 1,000
2.4 The impact of bonus issues and share consolidations on the number of
shares
The weighted average number of ordinary shares outstanding during the period must be adjusted for
events that have changed the number of ordinary shares outstanding without a corresponding change
in resources. These include:
Bonus issues (capitalisation issues)
Share consolidation
C
Solution H
The three million new shares issued at the time of the acquisition should be weighted from the date of A
P
issue, but the consolidation should be related back to the start of the financial year (and to the start of
T
any previous years presented as comparative figures). E
R
The calculation of the weighted number of shares in issue is as follows.
Adjusted
Number Weighting number
At 1 January 20X5 10,000,000 14
Effect of consolidation is to halve the number of shares
(since one new share was issued for every two old shares (5,000,000)
held)
5,000,000 12/12 5,000,000
Solution
(a) Share repurchase at fair value
20X7 20X6
£ £
Profit for the year 4,000 4,000
Loss of interest as cash
paid out £4,000 0.05 0.80* (160)
Earnings 3,840 4,000
Number of shares outstanding 18,000 20,000
Earnings per share 21.33p 20.00p
The effect of share consolidation is to leave the total nominal value of outstanding shares the same, but
to reduce the number of shares from 20,000 to 18,000, and raising the market price of a share from £2
to £2.22.
20X7 20X6
Number of shares 18,000 20,000
Earnings per share 21.33p 20.00p
No adjustment to prior year's EPS is made for the share consolidation.
* 0.80 = (1 – tax rate)
The TERP is the theoretical price at which the shares would trade after the rights issue and takes into
account the diluting effect of the bonus element in the rights issue. It is calculated as:
Total market value of original shares pre rights issue + Proceeds of rights issue
TERP =
Number of shares post rights issue
Solution
Calculation of theoretical ex-rights value per share
No. Price Total
Pre-rights issue holding 5 £11 £55
Rights share 1 £5 £5
6 £60
C
Therefore TERP = £60/6 = £10 H
A
(The TERP may also be calculated on the basis of all shares in issue, ie £6,000/600 shares)
P
Calculation of adjustment factor T
E
Fair value per share before exercise of rights £11 R
Adjustment factor 1.10
Theoretical ex - rights value per share £10
20X4
20X4 basic EPS as originally £1,100
reported: £2.20
500 shares
20X4 basic EPS restated for rights £1,100
issue in 20X5 accounts: £2.00
(500 shares) (adjustment factor)
Alternatively the restated EPS may be calculated by applying the reciprocal of the adjustment factor to
the basic EPS as originally reported:
£2.20 × 10/11 = £2.00
Solution
As the shares issued on the acquisition were issued at full fair value, a time apportionment adjustment
over the period they are in issue is required.
The rights issue shares require a time apportionment adjustment and an adjustment for the bonus
element in the rights. The latter adjustment should be applied to the shares issued on 1 April as well as
to those issued earlier. To adjust for the bonus element the theoretical ex-rights fair value per share is
required:
Computation of theoretical ex-rights price (TERP):
No. Price Total
Pre-rights issue holding 6 £20 £120
Rights share 1 £15 £15
7 £135
Section overview
In this section we discuss the adjustments that are required to earnings as a result of preference
shares, in order to calculate profits attributable to ordinary shareholders (equity holders).
As we have seen in earlier studies, for the purpose of calculating basic earnings per share, we must
calculate the amounts attributable to ordinary equity holders of the parent entity in respect of profit or
loss.
This is done in two steps:
First the profit or loss which includes all items of income and expense that are recognised in a
period, including tax expense, dividends on preference shares classified as liabilities or non-
controlling interest is calculated according to IAS 1 Presentation of Financial Statements.
In the second step the calculated profit or loss is adjusted for the after-tax amounts of preference
dividends, differences arising on the settlement of preference shares, and other similar effects of
preference shares classified as equity under IAS 32 Financial Instruments: Presentation.
The company paid an ordinary dividend of £20,000 and a dividend on its redeemable preference shares
of £70,000.
The company had £100,000 of £0.50 ordinary shares in issue throughout the year and authorised share
capital of 1,000,000 ordinary shares.
Requirement
What should be the basic earnings per share figure for the year according to IAS 33 Earnings per Share?
See Answer at the end of this chapter.
Solution
Because the shares are classified as equity, the original issue discount is amortised to retained earnings
using the effective interest method and treated as a preference dividend for earnings per share
There is no adjustment in respect of the preference shares as no dividend accrual was made in respect of
the year. The payment of the previous year's cumulative dividend is ignored for EPS purposes as it will
have been adjusted for in the prior year.
Solution
£
Profit for the year attributed to ordinary equity holders 150,000
Plus discount on repurchasing of preference shares 1,000
151,000
The discount on repurchase of the preference shares has been credited to equity and it must therefore
be adjusted against profit.
Had there been a premium payable on repurchase, the loss on repurchase would have been subtracted
from profit.
No accrual for the dividend on the 8% preference shares is required as these are non-cumulative. Had a
dividend been paid for the year it would have been deducted from profit for the purpose of calculating
basic EPS as the shares are treated as equity and the dividend would have been charged to equity in the
financial statements.
Solution
Basic earnings per share is calculated as follows.
£ £
Profit attributable to equity holders of the parent entity 100,000
Less dividends paid:
Preference 33,000
Ordinary 21,000
(54,000)
Undistributed earnings 46,000
Section overview
This section deals with the adjustments required to earnings in order to take into account the
dilutive impact of potential ordinary shares.
The objective of diluted earnings per share is consistent with that of basic earnings per share; that is, to
provide a measure of the interest of each ordinary share in the performance of an entity taking into
account dilutive potential ordinary shares outstanding during the period.
Definition
Antidilution: is an increase in earnings per share or a reduction in loss per share resulting from the
assumption that convertible instruments are converted, that options or warrants are exercised, or that
ordinary shares are issued upon the satisfaction of specified conditions.
In computing diluted EPS only potential ordinary shares that are dilutive are considered in the
calculations. The calculation ignores the effects of potential ordinary shares that would have an
antidilutive effect on earnings per share.
Determining whether potential ordinary shares are dilutive or antidilutive
In determining whether potential ordinary shares are dilutive or antidilutive, each issue or series of
potential ordinary shares is considered separately rather than in aggregate.
Section overview
This section deals with the impact of convertible instruments on the diluted earnings per share.
Solution
Basic EPS
£15m / 24m shares = £0.63
Diluted EPS
To calculate the diluted earnings per share we need to consider the impact on both earnings and
number of shares.
Impact on earnings: On conversion, after tax earnings attributed to ordinary shareholders should
be increased by the reduction in the interest charge payable to loan
holders.
Taking tax into account, the interest saved will be:
£7m 0.1 (1- 0.2) = £0.56m
Therefore diluted earnings = £15m + £0.56m = £15.56m
Impact on number of On conversion the number of ordinary shares will increase by £8m/2 = 4
shares: million shares, raising the number of ordinary shares after conversion to 28
million ordinary shares.
Section overview
This section deals with the impact of options on diluted earnings per share.
Definition
Options and warrants: are financial instruments that give the holder the right to purchase ordinary
shares.
Solution
Earnings Shares Per share
£ £
Basic EPS
Profit attributable to ordinary equity holders of the
parent entity for year 20X6 1,200,000
Weighted average shares outstanding during year 20X6 500,000
Basic earnings per share 2.40
DEPS C
Weighted average number of shares under option 100,000 H
Issued at full market price (£15 × 100,000)/£20 75,000 A
Issued at nil consideration (100,000 – 75,000) 25,000 P
T
E
Number of equity shares for basic EPS 500,000 R
Solution
The amount to be received on exercise is £21 5m = £105m
The number of shares issued at average market price is: £105m / £30 = 3.5m
The number of 'free' shares is: 5m issued – 3.5m issued at average market price = 1.5m
Diluted earnings per share:
£30m / (60m + 1.5m) = £0.49
Where shares are unvested, the amount still to be recognised in profit or loss before the vesting date
must be taken into account when calculating the number of 'free' shares.
Solution
The amount to be recognised in profit or loss is reduced to a per share amount: £15m / 5m = £3
This is added to the exercise price: £21 + £3 = £24
The amount to be received on exercise: £24 5m = £120m
The number of shares issued at average market price: £120m / £30 = 4m
The number of 'free' shares: 5m – 4m = 1m
Diluted earnings per share: £30m / (60m + 1m) = £0.49
Section overview
This section deals with the impact of contingently issuable shares on the number of ordinary
shares used in the calculation of diluted earnings per share.
Solution
As the two million additional shares do not result in additional resources for the entity, they are brought
into the diluted earnings per share calculation from the start of the 20X5 reporting period. The diluted
earnings per share is therefore:
Diluted earnings per share = £20m / (16m + 2m) = £1.11
Section overview
This section deals with retrospective adjustments to EPS and the provisions of IAS 33 concerning
presentation and disclosure.
8.2 Presentation
Basic and diluted EPS for continuing operations must be presented on the face of the statement of
profit or loss and other comprehensive income with equal prominence for all periods presented.
Where a separate statement of profit or loss is presented, basic and diluted EPS should be
presented on the face of this statement.
Earnings per share is presented for every period for which a statement of comprehensive income is
presented.
If diluted earnings per share is reported for at least one period, it shall be reported for all periods
presented, even if it equals basic earnings per share.
If basic and diluted earnings per share are equal, dual presentation can be accomplished in one line
on the statement of comprehensive income.
An entity that reports a discontinued operation shall disclose the basic and diluted amounts per
share for the discontinued operation either on the face of the statement of comprehensive income
or in the notes.
An entity shall present basic and diluted earnings per share, even if the amounts are negative (ie a
loss per share).
Additional EPS
If an entity discloses, in addition to basic and diluted earnings per share, amounts per share using a
reported component of profit other than one required by IAS 33, such amounts shall be calculated
using the weighted average number of ordinary shares determined in accordance with this Standard.
Basic and diluted amounts per share relating to such a component shall be disclosed with equal
prominence and presented in the notes.
An entity shall indicate the basis on which the numerator(s) is (are) determined, including whether
amounts per share are before tax or after tax.
If a component of profit is used that is not reported as a line item in the statement of profit or loss and
other comprehensive income, a reconciliation shall be provided between the component used and a
line item that is reported in the statement of profit or loss and other comprehensive income.
Although not required under IFRS, adjusted earnings per share is presented to help understand the
underlying performance of the Group. The adjustments in 2006 and 2005 are items that management
believe do not reflect the underlying business performance. The adjustment in respect of profit on sale
of property relates only to the profit on sale of properties that are subject to sale and leaseback
arrangements (note 12). The adjustments listed above are shown net of taxation.
Summary
Basic EPS
Diluted
EPS
14
According to IAS 33 Earnings per Share, what is the basic earnings per share for Sardine in the year
ended 31 December 20X7?
8 Citric
The following information relates to The Citric Company for the year ended 31 December 20X7.
Statement of comprehensive income
Profit after tax £100,000
Statement of financial position
Ordinary shares of £1 1,000,000
There are warrants outstanding in respect of 1.7 million new shares in Citric at a subscription price
of £18.00. Citric's share price was £22.00 on 1 January 20X7, £24.00 on 30 June 20X7, £30.00 on
31 December 20X7 and averaged £25.00 over the year.
Earnings
Amounts attributable to ordinary equity holders in respect of profit or loss from IAS 33.12
continuing operations adjusted for the after tax amounts of preference
dividends.
Shares
For the calculation of basic EPS the number of ordinary shares should be the IAS 33.26
weighted average number of shares outstanding during the period adjusted
where appropriate for events, other than the conversion of shares, that have
changed the number of ordinary shares outstanding without a corresponding
change in resources.
According to IAS 33.46, the proceeds of the options should be calculated using the average market
price during the year. The difference between the number of ordinary shares issued and the
number that would have been issued at the average market price are the 'free' shares that create
the dilutive effect.
The shares issuable on conversion of the bonds are potentially dilutive, but IAS 33.41 only requires
them to be taken into account if they dilute the basic EPS figure based upon continuing operations.
It is worth noting that per IAS 33.33 and App A A3 this must be calculated, even though it is
antidilutive of the basic EPS on the same basis of (£1,200,000/9,600,000) = 12.5 pence.
5 Garfish
89.1 pence
Weighted average number of shares:
TERP: 2 shares @ £2.00 = £4.00
1 share @ £1.40 = £1.40
3 £5.40 therefore £5.40/3 = £1.80
6 Sakho
14
(a) False
(b) True
Number of shares post issue 6
Bonus fraction = =
Number of shares pre issue 5
MV of share 1.50
Rights adjustment factor = =
TERP 1.20
TERP: 5 shares @ £1.50 = £7.50
2 shares @ £0.45 = £0.90
7 £8.40 therefore TERP = £8.40 / 7 shares = £1.20
The basic EPS for the prior year is multiplied by the inverse of the rights factor and the bonus
factor, so 1.20 / 1.50 5/6 = 2/3.
£179,424
Basic EPS = = 35.9p
500,000 shares
As no dividend is payable on the preference shares in 20X7, the discount on issue is amortised
using the effective interest method and treated as preference dividend when calculating earnings
for EPS purposes (IAS 33.15).
The £300,000 preference shares must be discounted at 8% for the two years between issue and
the date when dividends commence. A dividend is then calculated at 8% per annum compound
on that value.
8 Citric
(a) 476,000
(b) 11.5 pence
(c) 6.78 pence
(a) Shares issued at average market price (1,700,000 × £18)/£25 1,224,000
Shares issued at nil consideration (1,700,000 – 1,224,000) 476,000
(b) Incremental profits (£1,750,000 × 7% × (1-25%)) £91,875
Increase in number of shares (£2,000,000/£5 × 2) 800,000
Therefore incremental EPS (£91,875 / 800,000 shares) 11.5p
(c) Profits Number of shares EPS
Basic EPS £100,000 1,000,000 10p
Add in options £100,000 1,476,000 6.78p
The warrants (treated as issued for nil consideration) are more dilutive than the bonds, so are
dealt with first under IAS 33.44. As the 11.5 pence earnings per incremental share on
conversion of the bonds is antidilutive, under IAS 33.36 the conversion is left out of the
calculation of DEPS.
20X7
Trading results £
14
Profit after tax 900,000
Number of shares outstanding 3,000,000
Basic EPS £0.30
Number of shares under option
Issued at full market price (600,000 x 50p)/£1.50 200,000
Issued at nil consideration 600,000 – 200,000 400,000
Total number of shares under option 600,000
Number of equity shares for basic EPS 3,000,000
Number of dilutive shares under option 400,000
Adjusted number of shares 3,400,000
Diluted EPS (£900,000 / 3,400,000) £0.26
Reporting performance
Introduction
Topic List
1 IFRS 8 Operating Segments
2 IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
3 IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
4 IAS 24 Related Party Disclosures
5 IFRS 1 First-time Adoption of International Financial Reporting Standards
6 Reporting corporate governance
7 The directors' report
8 International Financial Reporting Standard for Small and Medium-sized Entities
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
583
Introduction
Section overview
IFRS 8 is a disclosure standard.
Segment reporting is necessary for a better understanding and assessment of:
– Past performance
– Risks and returns
– Informed judgements
IFRS 8 adopts the managerial approach to identifying segments.
The standard gives guidance on how segments should be identified and what information
should be disclosed for each.
It also sets out requirements for related disclosures about products and services, geographical areas
and major customers.
1.1 Introduction
Large entities produce a wide range of products and services, often in several different countries. Further
information on how the overall results of entities are made up from each of these product or
geographical areas will help the users of the financial statements. This is the reason for segment
reporting.
The entity's past performance will be better understood
The entity's risks and returns may be better assessed
More informed judgements may be made about the entity as a whole
Risks and returns of a diversified, multi-national company can be better assessed by looking at the
individual risks and rewards attached to groups of products or services or in different geographical areas.
These are subject to differing rates of profitability, opportunities for growth, future prospects and risks.
1.4 Aggregation
Two or more operating segments may be aggregated if the segments have similar economic
characteristics, and the segments are similar in all of the following respects:
The nature of the products or services
The nature of the production process
The type or class of customer for their products or services
The methods used to distribute their products or provide their services, and
If applicable, the nature of the regulatory environment
1.6 Disclosures
1.6.1 Segment disclosures
Disclosures required by the IFRS are extensive and best learned by looking at the example and pro
forma, which follow the list. Disclosure is required of:
Factors used to identify the entity's reportable segments
Types of products and services from which each reportable segment derives its revenues
For each reportable segment:
– Operating segment profit or loss
– Segment assets
– Segment liabilities
– Certain income and expense items
Interest expense
Non-current assets
Segment liabilities
A reconciliation of each of the above material items to the entity's reported figures is required.
Reporting of a measure of profit or loss by segment is compulsory. Other items are disclosed if included
in the figures reviewed by or regularly provided to the chief operating decision maker.
15
Section overview
This is an overview of material covered in earlier studies.
Accounting policies
Accounting policies are determined by applying the relevant IFRS or IFRIC and considering any
relevant Implementation Guidance issued by the IASB for that IFRS/IFRIC.
Where there is no applicable IFRS or IFRIC management should use its judgement in developing
and applying an accounting policy that results in information that is relevant and reliable.
Management should refer to:
(a) The requirements and guidance in IFRSs and IFRICs dealing with similar and related issues.
(b) The definitions, recognition criteria and measurement concepts for assets, liabilities and
expenses in the Framework.
Management may also consider the most recent pronouncements of other standard setting bodies
that use a similar conceptual framework to develop standards, other accounting literature and
accepted industry practices if these do not conflict with the sources above.
An entity shall select and apply its accounting policies for a period consistently for similar
transactions, other events and conditions, unless an IFRS or an IFRIC specifically requires or permits
categorisation of items for which different policies may be appropriate. If an IFRS or an IFRIC
requires or permits categorisation of items, an appropriate accounting policy shall be selected and
applied consistently to each category.
Changes in accounting policies
These are rare: only if required by statute/standard-setting body/results in reliable and more
relevant information.
Adoption of new IFRS: follow transitional provisions of IFRS. If no transitional provisions:
retrospective application.
Other changes in policy: retrospective application. Adjust opening balance of each affected
component of equity, ie as if new policy has always been applied.
Prospective application is not allowed unless it is impracticable to determine the cumulative
effect of the change.
An entity should disclose information relevant to assessing the impact of new IFRSs/IFRICs on the
financial statements where these have been issued but have not yet come into force.
Changes in accounting estimates
Estimates arise because of uncertainties inherent within them, judgement is required but this
does not undermine reliability.
Effect of a change in accounting estimate should be included in profit or loss in:
– Period of change, if change affects only current period, or
– Period of change and future periods, if change affects both.
Section overview
IFRS 5 requires assets and groups of assets that are 'held for sale' to be presented separately on
the face of the statement of financial position and the results of discontinued operations to be
presented separately in the statement of profit or loss and other comprehensive income. This is
required so that users of financial statements will be better able to make projections about the
financial position, profits and cash flows of the entity based on continuing operations only.
C
H
A
Definition P
T
Disposal group: a group of assets to be disposed of, by sale or otherwise, together as a group in a E
single transaction, and liabilities directly associated with those assets that will be transferred in the R
transaction. (In practice a disposal group could be a subsidiary, a cash-generating unit or a single
operation within an entity.) (IFRS 5)
15
An asset (or disposal group) can still be classified as held for sale, even if the sale has not actually taken
place within one year. However, the delay must have been caused by events or circumstances beyond
the entity's control and there must be sufficient evidence that the entity is still committed to sell the
asset or disposal group. Otherwise the entity must cease to classify the asset as held for sale.
Abandoned assets
An asset that is to be abandoned should not be classified as held for sale. This is because its carrying
amount will be recovered principally through continuing use. However, a disposal group that is to be
abandoned may meet the definition of a discontinued operation and therefore separate disclosure may
be required (see below).
Definitions
Discontinued operation: a component of an entity that has either been disposed of, or is classified as
held for sale, and:
(a) Represents a separate major line of business or geographical area of operations.
(b) Is part of a single co-ordinated plan to dispose of a separate major line of business or geographical
area of operations, or
(c) Is a subsidiary acquired exclusively with a view to resale.
Component of an entity: operations and cash flows that can be clearly distinguished, operationally and
C
for financial reporting purposes, from the rest of the entity. H
A
P
An entity should present and disclose information that enables users of the financial statements to T
E
evaluate the financial effects of discontinued operations and disposals of non-current assets or disposal R
groups.
15
A related party is a person or entity that is related to the entity that is preparing its financial statements.
(a) A person or a close member of that person's family is related to a reporting entity if that person:
(i) has control or joint control over the reporting entity;
(ii) has significant influence over the reporting entity; or
(iii) is a member of the key management personnel of the reporting entity or of a parent of
the reporting entity.
(b) An entity is related to a reporting entity if any of the following conditions applies:
(i) The entity and the reporting entity are members of the same group (which means that
each parent, subsidiary and fellow subsidiary is related to the others).
C
(ii) One entity is an associate or joint venture of the other entity (or an associate or joint H
A
venture of a member of a group of which the other entity is a member).
P
(iii) Both entities are joint ventures of the same third party. T
E
(iv) One entity is a joint venture of a third entity and the other entity is an associate of the R
third entity.
(v) The entity is a post-employment defined benefit plan for the benefit of employees of either
15
the reporting entity or an entity related to the reporting entity. If the reporting entity is
itself such a plan, the sponsoring employers are also related to the reporting entity.
(vi) The entity is controlled or jointly controlled by a person identified in (a).
Definition
Related party transaction: A transfer of resources, services or obligations between related parties,
regardless of whether a price is charged.
Requirement
What transactions should be disclosed as key management personnel compensation in the financial
statements of S?
See Answer at the end of this chapter.
Section overview
IFRS 1 gives guidance to entities applying IFRS for the first time.
The adoption of a new body of accounting standards will inevitably have a significant effect on the
accounting treatments used by an entity and on the related systems and procedures. In 2005 many
countries adopted IFRS for the first time and over the next few years other countries are likely to do the
same.
In addition, many Alternative Investment Market (AIM) companies and public sector companies adopted
IFRS for the first time for accounting periods ending in 2009 and 2010. US companies are likely to move
increasingly to IFRS, although the US Securities and Exchange Commission has not given any definite
timeline for this in its 2012 work plan.
As discussed in Chapter 1 of this manual, the regulatory shift away from UK GAAP means that all entities
except those small enough to use the FRSSE will be required to report in accordance with FRSUKI with
an option to use IFRS.
IFRS 1 First-time Adoption of International Financial Reporting Standards was issued to ensure that an
entity's first IFRS financial statements contain high quality information that:
(a) is transparent for users and comparable over all periods presented;
(b) provides a suitable starting point for accounting under IFRSs; and C
(c) can be generated at a cost that does not exceed the benefits to users. H
A
P
5.1 General principles T
E
An entity applies IFRS 1 in its first IFRS financial statements. R
An entity's first IFRS financial statements are the first annual financial statements in which the entity
adopts IFRS by an explicit and unreserved statement of compliance with IFRS.
15
Any other financial statements (including fully compliant financial statements that did not state so) are
not the first set of financial statements under IFRS.
Transition
date
Preparation of an opening IFRS statement of financial position typically involves adjusting the amounts
reported at the same date under previous GAAP.
All adjustments are recognised directly in retained earnings (or, if appropriate, another category of
equity) not in profit or loss.
5.3 Estimates
Estimates in the opening IFRS statement of financial position must be consistent with estimates made at
the same date under previous GAAP even if further information is now available (in order to comply
with IAS 10).
(d) Training. Where there are skills gaps, remedial training should be provided.
(e) Monitoring and accountability. A relaxed 'it will be all right on the night' attitude could spell 15
danger. Implementation progress should be monitored and regular meetings set up so that
participants can personally account for what they are doing as well as flag up any problems as early
as possible. Project drift should be avoided.
Section overview
Annual reports must convey a fair and balanced view of the organisation. They should state
whether the organisation has complied with governance regulations and codes, and give specific
disclosures about the board, internal control reviews, going concern status and relations with
stakeholders.
6.3.3 Scope
The IASB has published a Practice Statement rather than an IFRS on management commentary. This
'provides a broad, non-binding framework for the presentation of management commentary that relates
to financial statements that have been prepared in accordance with IFRSs'.
This guidance is designed for publicly traded entities, but it would be left to regulators to decide who
would be required to publish management commentary.
This approach avoids the adoption hurdle, ie that the perceived cost of applying IFRSs might increase,
which could otherwise dissuade jurisdictions/ countries not having adopted IFRSs from requiring their
adoption, especially where requirements differ significantly from existing national requirements.
Definition
Management commentary: a narrative report that provides a context within which to interpret the
financial position, financial performance and cash flows of an entity. It also provides management with
an opportunity to explain its objectives and its strategies for achieving those objectives.
(IFRS Practice Statement )
(b) Management's objectives and its strategies for meeting those objectives
(e) The critical performance measures and indicators that management uses to evaluate the entity's
performance against stated objectives
The Practice Statement does not propose a fixed format as the nature of management commentary
would vary between entities. It does not provide application guidance or illustrative examples, as this
could be interpreted as a floor or ceiling for disclosures. Instead, the IASB anticipates that other parties
will produce guidance.
However, the IASB has provided a table relating the five elements listed above to its assessments of the
needs of the primary users of a management commentary (existing and potential investors, lenders and
creditors).
Nature of the The knowledge of the business in which an entity is engaged and the
business external environment in which it operates.
Objectives and To assess the strategies adopted by the entity and the likelihood that those
strategies strategies will be successful in meeting management's stated objectives.
Advantages Disadvantages
Entity Entity
Promotes the entity, and attracts investors, Costs may outweigh benefits
lenders, customers and suppliers Risk that investors may ignore the financial
Communicates management plans and statements
outlook
Users Users
Financial statements not enough to make Subjective
decisions (financial information only) Not normally audited
Financial statements backward looking Could encourage companies to de-list
(need forward looking information) (to avoid requirement to produce MC)
Highlights risks Different countries have different needs
Useful for comparability to other entities
6.4 Sustainability
6.4.1 What is sustainability?
Pressure is mounting for companies to widen their scope for corporate public accountability. Many
companies are responding by measuring and disclosing their social impacts.
Examples of social measures include: philanthropic donations, employee satisfaction levels and
remuneration issues, community support, and stakeholder consultation information.
The next step beyond environmental and social reporting is sustainability reporting which includes the
economic element of sustainability (such as wages, taxes and core financial statistics) and involves
integrating environmental, social and economic performance data and measures.
CATEGORY ASPECT
Market presence
Indirect economic impacts
Environmental Materials
Energy
Water
Environmental
Biodiversity
Emissions, effluents, and waste
Products and services
Compliance
Transport
Overall
Labour Practices and Employment
Decent Work Labour/management relations C
Occupational health and safety H
A
Training and education P
Diversity and equal opportunity T
E
Human Rights Investment and procurement practices
R
Non-discrimination
Freedom of association and collective bargaining
Child labour 15
Forced and compulsory labour
Social
Security practices
Indigenous rights
Society Community
Social
Corruption
Public policy
Anti-competitive behaviour
Compliance
Product Responsibility Customer health and safety
Product and service labelling
Marketing communications
Customer privacy
Compliance
An increasing number of companies, including BT, Vauxhall Motors Ltd, British Airways and Shell are
following the GRI guidelines to some extent in their reporting.
Section overview
Under UK company law a directors' report must be published.
7.1 Introduction
You will have studied the directors' report in the Professional Stage Financial Reporting paper. The
section below summarises the key points.
Section overview
In the UK the FRSSE applies to small entities.
The IASB has issued an IFRS for small and medium-sized entities.
Any limitation of the applicability of a specific IFRS is made clear within that standard. IFRSs are not
intended to be applied to immaterial items, nor are they retrospective. Each individual IFRS lays out
15
its scope at the beginning of the standard.
Within each individual country local regulations govern, to a greater or lesser degree, the issue of
financial statements. These local regulations include accounting standards issued by the national
regulatory bodies and/or professional accountancy bodies in the country concerned.
8.4.1 Scope
The IFRS is suitable for all entities except those whose securities are publicly traded and financial
institutions such as banks and insurance companies. It is the first set of international accounting
requirements developed specifically for small and medium-sized entities (SMEs). Although it has been
prepared on a similar basis to IFRS, it is a stand-alone product and will be updated on its own timescale.
There are no quantitative thresholds for qualification as an SME; instead, the scope of the IFRS is
determined by a test of public accountability. As with full IFRS, it is up to legislative and regulatory
authorities and standard setters in individual jurisdictions to decide who is permitted or required to use
the IFRS for SMEs.
C
H
8.4.2 Effective date A
The IFRS for SMEs does not contain an effective date; this is determined in each jurisdiction. The IFRS P
T
will be revised only once every three years. It is hoped that this will further reduce the reporting burden E
for SMEs. R
8.4.6 Examples of options in full IFRS not included in the IFRS for SMEs
Revaluation model for intangible assets and property, plant and equipment
Financial instrument options, including available-for-sale, held to maturity and fair value options
Choice between cost and fair value models for investment property (measurement depends on the
circumstances)
Options for government grants
For all entities choosing not to apply IFRS or IFRS with reduced disclosures, the ASB is proposing the use
of a new standard, the FRSUKI, based on the IASB's IFRS for SMEs. This will apply to all entities except
those small enough to use the FRSSE, and will effectively mean the end of current UK GAAP. This is
covered in more detail in Chapter 1, Section 3.
15
Corporate Reporting
(prospective) policies, estimates Reporting performance Other
– Prior period errors and errors (IASB) Directors’
(retrospective)
report
Summary and Self-test
Reconciliation
Disclosure
Self-test
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
1 Kamao
Statement of financial position extracts for the Kamao Company show the following.
31 December 20X7 31 December 20X6
£'000 £'000
Development costs 812 564
Amortisation (180) (120)
632 444
The capitalised development costs related to a single project that commenced in 20X4. It has now
been discovered that one of the criteria for capitalisation has never been met.
Requirement
According to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, by what amount
should retained earnings be adjusted to restate them as at 31 December 20X6?
2 Hookbill
The Hookbill Company was updating its inventory control system during 20X7 when it discovered
that it had, in error, included £50,000 in inventories in its statement of financial position for the
year to 31 December 20X6 relating to items that had already been sold at that date. The 20X6
profit after tax shown in Hookbill's financial statements for the year to 31 December 20X6 was
£400,000.
In the draft financial statements for the year to 31 December 20X7, before any adjustment for the
above error, the profit after tax was £500,000.
Hookbill pays tax on profits at 25%.
Requirement
According to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, what figures
should be disclosed for profit after tax in the statement of profit or loss and other comprehensive
income of Hookbill for the year ended 31 December 20X7, for both 20X7 and the comparative
year 20X6?
3 Carduus
The Carduus Company manufactures motor boats. It has invested heavily in developing a new
engine design. As a result by 1 January 20X2 it had capitalised £72 million of development costs,
which it was amortising over 10 years on a straight-line basis from that date.
Until 1 January 20X7, Carduus's new engine had been selling well and making substantial profits. A
new competitor then entered the market, however, such that revised estimates were that the new
engine would cease to generate any economic benefits after 31 December 20X9 and that the
remaining amortisation period should be to this date on a straight-line basis. The entry of the new
competitor led to an impairment review, but no impairment loss was identified.
Retained earnings at 31 December 20X6 were £400 million. Profit before tax and any amortisation
C
charges was £70 million for the year ended 31 December 20X7. H
A
Requirement
P
Ignoring tax, determine the retained earnings figure for Carduus at 1 January 20X7 in the financial T
E
statements for the year to 31 December 20X7 and the profit before tax for the year then ended R
after adjusting for the change in amortisation according to IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors.
4 Aspen 15
The Aspen Company was drawing up its draft financial statements for the year to 31 December
20X7 and was reviewing its cut-off procedures. It discovered that it had, in error, at the previous
year end, omitted from inventories in its statement of financial position a purchase of inventories
Discontinued operations
Definition IFRS 5.31-32
Disclosures on the face of the statement of profit or loss and other IFRS 5.33(a)
comprehensive income:
The comparative amounts for the prior period should be restated, per IAS 8.42.
Correction of opening inventory will increase profit for the current period, by the amount of the
after tax adjustment. Conversely, the closing inventory for the previous period is reduced, thereby
reducing profit by the after tax effect of the adjustment.
3 Carduus
Retained earnings: £400 million
Profit before tax: £58.0 million
The change in useful life is a change in an accounting estimate which is accounted for
prospectively (IAS 8.36). So retained earnings brought forward remain unchanged, at £400m.
The carrying amount of development costs at 1 January 20X7 (half-way through their previously
estimated useful life) is (£72m 5/10) = £36m. Writing this off over 3 years gives a charge of £12m
per annum. So the profit before tax is £70m - £12m = £58m.
4 Aspen
Profit after tax: £730,000
Retained earnings: £4,070,000
The comparative amounts for the prior period should be restated, per IAS 8.42.
The correction of opening inventories will decrease profit for the current period, by the after-tax
value of the adjustment. Thus current period profits are £800,000 – (£100,000 70%) =
£730,000.
The closing inventories of the previous period are increased by the same amount. So retained
earnings are £4,000,000 + (£100,000 70%) = £4,070,000.
5 Polson
(a) £776,562
(b) (£66,000)
(c) £318,562
All these matters give rise to prior period errors which require retrospective restatement of financial
statements as if the prior period error had never occurred (IAS 8.5).
(a) Recognition of cost in the carrying amount of PPE should cease when it is in the condition
capable of being operated in the manner intended, so on 30 September 20X6, and
depreciation should begin on the same date (IAS 16.20 and 55). So gross cost should be
adjusted to £800,000 (£840,000 - £50,000 + £10,000) and depreciation, taking into account
(c)
£
Draft retained earnings 400,000
(1) Reduction in carrying value of plant (£840,000 - £776,562) (63,438)
(2) Niflumic's earnings (£80,000 × 30%) 24,000
(3) Error in trade receivables (£70,000 × 60%) (42,000)
318,562
Trade receivables, revenue, and therefore profit, were overstated by £70,000 in respect of the
trade receivables. Polson's share is 60%, so end-20X6 retained earnings must be reduced by
£42,000.
The share of Niflumic's profits is recognised in retained earnings, not in a separate reserve,
giving rise to an increase of £24,000.
6 Viscum
£11,000
IFRS 5.15 requires assets classified as held for sale to be measured at the time of classification at the
lower of (i) the carrying value (£30,000) and (ii) the fair value less costs to sell (£19,000).
IFRS 5.20 requires recognition of the resulting impairment loss (£30,000 - £19,000). The gain or
loss on disposal is treated separately per IFRS 5.24.
7 Reavley
£19,500
IFRS 5.15 requires that a non-current asset held for sale should be stated at the lower of (i) the
carrying amount (£19,500) and (ii) the fair value less costs to sell (£24,550).
8 Smicek
£40,000
At the end of the current year, a non-current asset that has ceased to be classified as held for sale
should be valued at the lower of:
(i) The carrying amount had it not been recognised as held for sale, ie to charge a full year's C
depreciation of £100,000 for 20X7 and reduce the carrying amount from £900,000 at H
31 December 20X6 to £800,000. A
P
(ii) The recoverable amount, which is the higher of the £790,000 fair value less costs to sell T
(£810,000 less £20,000) and value in use (the cash flows generated from using the asset) of E
R
£1,200,000.
Therefore the asset should be carried at £800,000 in the statement of financial position at
31 December 20X7. 15
At the end of the prior year, when the asset was classified as held for sale, the asset would have
been carried at the lower of carrying amount (£900,000), and fair value less costs to sell of
WORKINGS
Introduction
Topic List
1 Overview of material from earlier studies
2 Objectives and scope of financial analysis
3 Business strategy analysis
4 Accounting analysis
5 Accounting distortions
6 Improving the quality of financial information
7 Financial ratios interpretation
8 Forecasting performance
9 Summary
10 Current issues
Summary and Self-test
Answers to Self-test
Answers to Interactive questions
625
Introduction
The professional level devotes a substantial part to financial analysis. It covers in detail the definition of
financial ratios and relationships, statements of cash flows and their interpretation and reporting 16
complications in the analysis of financial information. It also discusses the impact of various economic
events, other business aspects and accounting choices on financial performance. It also discusses ethical
issues in the construction of financial statements and introduces aspects of industry analysis and the use
of disaggregated information. The professional level also provides an introduction to some advanced
topics such as advanced earnings measures, financial statement analysis and the limitations of ratios.
Interest cover
Profit before interest payable (ie PBIT + investment income)
Interest payable
Inventory turnover
Cost of sales Inventories
or 365
Inventories Cost of sales
Trade receivables collection period
Trade receivables
365
Revenue
Trade payables payment period
Trade payables
365
Credit purchases
Dividend yield
Dividend per share
× 100
Current market price per share
Dividend cover
Earnings per share
Dividend per share
16
Interactive question 1: Financial ratio construction [Difficulty level: Easy]
You are given the following information on Apple Cart plc.
INCOME STATEMENT 20X6
£'000
Revenue 6,000
Cost of sales (4,500)
Gross profit 1,500
Operating expenses (680)
Operating profit 820
Finance costs (600)
Profit before tax 220
Income tax (80)
Profit for the period 140
Requirement
Calculate the return on capital employed (ROCE), the profit margin and the net asset turnover for Apple
Cart plc. Investigate the sensitivity of the results to different definitions of the return on capital
employed.
See Answer at the end of this chapter.
Requirement
Consider the ROCE and ROSF of these two companies without associates in the same industry but with
different capital structures.
See Answer at the end of this chapter.
Section overview
Financial analysis is the process through which the stakeholders of a company, such as
shareholders, debt holders, government and employees are able to assess the historical
performance of the company and form a view about its future prospects and value.
Section overview
This section analyses the business strategy of a firm by looking at the industry in which the firm
operates, the competitive positioning of the company and the organisational structure and wealth
creation potential.
4 Accounting analysis
Section overview
This section analyses the sources of financial information that are needed for the financial analysis
of a company and the steps that need to be taken in order to identify potential problems and
resolve them.
Reported income and taxable income: Is financial reporting income significantly out of line with
taxable income with inadequate explanation or disclosure? 16
Acquisitions: Where a significant number of acquisitions have taken place there is increased scope
for many creative accounting practices.
Financial statement trends: Indicators include: unusual trends, comparing revenue and EPS
growth, atypical year end transactions, flipping between conservatism and aggressive accounting
from year to year, level of provisions compared to profit indicating smoothing, EPS trend, timing of
recognition of exceptional items.
Ratios: Aging analyses revealing old inventories or receivables, declining gross profit margins but
increased net profit margins, inventories/receivables increasing more than sales, gearing changes.
Accounting policies: Consider if there is the minimum disclosure required by regulation, changes
in accounting policies, examine areas of judgment and discretion. Consider risk areas of: off-
balance sheet financing, revenue recognition, capitalisation of expenses, significant accounting
estimates.
Changes of accounting policies and estimates: Is the nature, effect and purpose of these changes
adequately explained and disclosed?
Management: Estimations proved unreliable in the past, minimal explanations provided.
Actual and estimated results: Culture of always satisfying external earnings forecasts, absence of
profit warnings, inadequate or late profit warnings leading to 'surprises', interim financial
statements out of line with year end financial statements.
Incentives: Management rewarded on reported earnings, profit-orientated culture exists, other
reporting pressures, eg a take-over.
Audit qualifications: Are they unexpected and are any auditors' adjustments specified in the audit
report significant?
Related Party Transactions: Are these material and how far are the directors affected?
The above is not a comprehensive list, but merely includes some main factors. Also, it is not suggested
that the above practices necessarily mean there is creative accounting, but where a number of these
factors exist simultaneously, further investigations may be warranted. Any review of such 'red flags' as
warning signs needs to be seen within the bigger picture of the current commercial situation of the
company, and the strategy it is adopting.
In the previous section we discussed the potential for distortion of accounting information. In this
section we discuss the most common distortions and how these may arise. 16
Illustration: Tesco
The UK retailer Tesco boosted profit for the year ending February 2007 by 4.1% by entering into a sale
and leaseback transaction with a joint venture in which the retailer had a 50% share.
As a result Tesco recognised 50% of the gain on the sale and leaseback of 16 properties representing
£110 million and boosting profit by 4.1%. Tesco continues to utilise the stores in its business and
reports these as operating leases.
In its 2006 financial statements Tesco disclosed that since 1988 it has entered into sale and leaseback
transactions with a joint venture under various terms which included sale at market value, rent reviews
and an option for Tesco to repurchase at market value. The company includes in its list of critical
assumptions the classification of leases into operating and finance.
5.1.7 Allowances
Management may sometimes find it to its advantage to underestimate the expected default loss from
receivables and thus to underestimate allowances and overstate earnings and assets.
5.2.1 Provisions
A firm that expects a future outflow of cash due to a contractual obligation but whose exact amount is
not known, will need to make a provision for such a liability. Firms, however, have the discretion to
estimate these future liabilities and the possibility to understate them on their statement of financial
position.
Section overview
This section suggests ways of undoing the accounting distortions in the financial statements, and
produces a measure of sustainable earnings. The possibility of using cash flow data instead of
earnings is also discussed.
Requirement
Outline the steps required in order to capitalise operating leases and the adjustments made to the
statement of financial position and profits for the purpose of financial analysis.
Fourth, the rental payments need to be added to operating profit and a finance charge calculated
representing the financing costs.
Inventories
Standardise for the effects of different inventory identification policy choices, including FIFO,
average cost, and standard cost.
Consider specific price changes in the industry.
Consider adequacy of write-downs to net realisable value, particularly where inventory volumes
have increased, or where prices have fallen.
To the extent of available disclosure, consider the impact of overheads being included in
inventories on a reasonable basis, particularly where inventory volumes have changed in the year.
Impact of foreign currency – as inventories are a non-monetary asset, no adjustments are made
under IAS 21 for exchange rate movements after purchase (although there will be an impact of
foreign currency changes over time as there are consistent inventory replacements).
Receivables
Consider adequacy of bad debt write-offs (eg compared with competitors, prior experience, known
insolvencies amongst customer base, increases in receivables days ratio).
Consider the likely timing of any bad debt recovery, and how it might affect liquidity.
Review, in conjunction with revenue recognition, methods in statement of profit or loss and other
comprehensive income.
Consider impact if any factoring has taken place.
Long-term assets
If stated at fair value, consider valuation method used if disclosed, and any post-year-end changes.
Review companies on the border of control and significant influence. Equity accounting would take
only net assets into consideration, and would take an associate's liabilities off the consolidated
statement of financial position. The restatement of an associate on a full consolidation basis may be
appropriate where significant influence borders on de facto control. This may significantly affect
reported consolidated figures for highly-geared associates. The information would be available to
the analyst on the basis of the disclosure in the financial statements of the individual companies.
Provisions
Assess probability of provision occurring, and consider including expected values based on probabilities.
Contingent liabilities
Consider recognition on the basis of expected values based on possibility of occurrence of certain
events.
Solution
(a) The issue here was not one of revenue recognition. The gain was appropriately recognised in the
year. The issues were disclosure and classification. With adequate disclosure, the one-off gain of
$17.2 million could have been identified by analysts as a non-recurring item and thus excluded
from sustainable profit.
(b) Forecasts of future profit based on current earnings would have been much lower as sustainable
earnings forecasts would have been lower. As a result, any valuation of the company derived from
the initially disclosed basis was overstated, resulting temporarily in an excessive share price.
The Trump case therefore highlights how important it is for forecasting and valuation to separate
permanent from transitory earnings and the need for adequate disclosures to be made.
Note that, in a valuation context, historic performance is only relevant to determining share price
in so far as it acts as a guide to forecasting future performance. The greater the adjustment of
consensus future forecasts the greater the impact on share prices. If a large proportion of the share
price value is attributable to growth (rather than assets in place), small changes in forecasts can
lead to large changes in share prices.
Discontinued operations
A discontinued operation is a component of a company which, according to IFRS 5:
Has been disposed of in the current period; or
Is classified as held-for-sale, where there would normally be a co-ordinated plan for disposal in the
following period.
The component might, for example, be a major line of business, operations in a particular geographical
area, or a subsidiary.
The profit or loss after tax from discontinued operations is disclosed as a single figure on the face of the
statement of profit or loss and other comprehensive income or statement of profit or loss. An analysis
should be disclosed (normally in the notes to the financial statements) to show the revenue, expenses,
pre-tax profit or loss, related income tax expense, and the profit or loss on asset disposals.
These items will not form part of sustainable future earnings, and should be removed when forecasting
future performance.
£'000 £'000
Sustainable operating income
Sustainable revenue X
Sustainable cost of sales (X)
Sustainable gross profit X
Sustainable operating expenses (X)
Sustainable operating profit before tax XX
Income tax as reported (X)
Tax benefit from finance costs X
Tax on exceptional items X
Tax on other sustainable operating income X
Element of deferred tax charge unlikely to crystallise X/(X)
Tax on sustainable operating profit (X)
Sustainable operating profit from sales XX
Sustainable other operating income X
Tax on sustainable other operating income (X)
Sustainable other operating income after tax X
Sustainable operating profit after tax XX
Non-recurring and unusual items
Profit from discontinued operations X
Changes in estimates X/(X)
Profit/losses on sale of non-current assets X/(X)
Impairment charges X/(X)
Start-up costs expensed (X)
Restructuring costs expensed (X)
Redundancy costs (X)
Unusual provisions (X)
Changes in fair values X/(X)
Foreign currency gains/(losses) X/(X)
Other unusual charges and credits X/(X)
Tax on unusual items (X)
Non-recurring and unusual items after tax XX
Profit for the period before finance charges XX
Note: the above items are stated after standardisation adjustments to individual costs and revenues.
Section overview
This section discusses issues of interpretation of ratios, including those based on cash flow data.
Ratio analysis is the most potent tool of financial analysis. Ratios reduce the dimensionality of the
information provided in the financial statements by summarising important information in relative
terms. Ratios are based primarily on financial information from the financial statements which as we
have already discussed, can be manipulated by the management of a company. Attention should
therefore be paid to the accounting quantities that determine the financial ratios.
To understand what determines the return on capital employed we need to understand what
determines the profit margin and the asset turnover. There are two issues here that need to be assessed.
The first is the source of the return on capital, ie whether it comes from a high profit margin or a high
asset turnover. This distinction is important when comparing companies. The second issue is the
understanding of the problems associated with the construction and interpretation of the constituent
ratios. As it was discussed already in strategic analysis, beyond the accounting issues, the financial ratios
need to be seen in the context of the overall strategy of a firm both in the medium and the short term.
Profit margin in retailing and manufacturing
A key figure in all the profit margin ratios is cost of sales. This figure is, however, rather different for
retailing companies and manufacturing companies. For retailing companies, most of the cost of sales is
made up of the cost of buying goods which are later sold in the same condition. One might, therefore,
expect issues such as pricing policy, product mix, and purchasing activity, to affect gross profit margin,
but otherwise this figure should be reasonably comparable for companies in the same industry
operating in similar markets.
For manufacturing companies, however, the 'cost of sales' figure is more difficult to assess, as it includes
all costs in bringing goods to their final location and condition. This includes costs of production, as well
as the costs of raw materials. As a result, the gross profit margin for manufacturing companies needs to
consider additional factors to those of retail companies that relate to operating efficiency. In particular, it
is important to consider the increased possibility of manipulation of inventory value and gross profit
through allocations of overheads.
Profit margins – the base data
While profit margins, in effect, consider the relationship between two figures, it is important to
understand the individual 'line items' that make up these ratios. Without this, it is difficult to answer
such fundamental questions as why revenue has decreased.
Part of the story is in understanding the type of industry, as in the previous section but, in addition, it is
necessary to understand the strategy that drives the numbers and the accounting rules that dictate the
way they are recognised.
The following is a guide to the factors to consider in determining operating profit.
Revenue
How is revenue changing – is there a consistent pattern over time? At what rate is revenue
increasing/decreasing?
Is the change in revenue consistent with announced price changes?
Has sales volume been a factor, eg new competitor, industry trends, cycles, production capacity
constraints, inventory accumulation?
Has the sales mix changed between high-margin and low-margin products?
Have new products been launched?
Effect of disposals or acquisitions?
Effects of currency translation on revenue?
Cost of sales
Retail or manufacturing
Impact of raw-material price changes
Foreign currency changes
This is one of the most problematic ratios in comparing different companies because companies in
different industries vary vastly in terms of the proportion of their assets in the statement of financial
position that gives rise to revenues. For a large number of companies in the service industries such as
7.2.1 EBITDA
Earnings before Interest, Taxes, Depreciation and Amortisation (EBITDA) is perhaps the most commonly-
quoted figure that attempts to bridge the profit-cash gap. It is a proxy for operating cash flows,
although it is not the same. It takes operating profit and strips out depreciation, amortisation and
(normally) any separately-disclosed items such as exceptional items.
EBITDA is not a cash flow ratio as such, but it is a widely used, and sometimes misused, approximation.
Particular reservations include:
EBITDA is not a cash flow measure and, while it excludes certain subjective accounting practices, it
is still subject to accounting manipulation in a way that cash flows would not be. Examples would
The EBITDAR figure is sometimes used when calculating valuations of companies for acquisition
purposes.
7.2.3 EBITDA/Interest
This is a variant of the interest cover ratio referred to in your earlier studies and the overview. It uses
EBITDA instead of operating profit on the grounds that EBITDA is a closer approximation to sustainable
cash flows generated from operations.
As noted above, this shows the number of times interest payments are covered, but after replacing non-
current assets.
Free cash flow
Debt servicing =
Interest + Principal payments
This shows the number of times interest and capital repayments (where debt is repayable by
instalments) are covered, after replacing non-current assets.
Once the data from the financial statements of the company have been adjusted and through the 16
analysis of the business strategy of the firm the drivers of sustainable earnings have been identified, then
the future performance may be predicted taking into account the future macroeconomic and industry
conditions.
IAS 28 requires that associates and joint ventures should normally be accounted for using the 'equity
method'. Equity accounting is sometimes called 'one-line consolidation', as there is only one amount
shown for an associate in profit or loss (being the parent company's share of the associate's profit), and
one amount shown in the statement of financial position (being the cost of investment plus share of
post acquisition reserves).
As the statement of cash flows begins with profit before tax, it already includes the parent's share of the
associate's profit. It is, therefore, necessary to adjust the associate's profit so that only the dividends from
associates are recognised.
In terms of modelling the associate's contribution to the group, it is normal to consider the associate
separately, as it is likely to be affected by different factors from other group revenue and group margins.
9 Summary
Section overview
This section provides a summary of the areas covered so far in this chapter.
The most obvious change is that the term 'provision' is no longer used; instead it is proposed that the
term 'liability' is used.
Definition
A liability is a liability other than a financial liability as defined in IAS 32 Financial Instruments:
Presentation.
10.7 Measurement 16
The obligation is measured as the amount the entity would rationally pay to settle the obligation at
the reporting date or to transfer it to a third party. This is the lower of:
The present value of the resources required to fulfil an obligation
The amount that an entity would have to pay to cancel the obligation and
The amount that the entity would have to pay to transfer the obligation to a third party
Expected values would be used, whether measuring a single obligation or a population of items.
For future services (eg decommissioning), outflows are based on contractor prices. The exception is for
onerous contracts, where the amount to be used is the amount the entity, rather than the contractor,
would pay.
10.8 Reimbursement
IAS 37 states that when expenditure required to settle a provision is expected to be reimbursed by
another party, the reimbursement should be recognised when it is virtually certain that the
reimbursement will be received. Consistently with the revised analysis of a contingent asset, the ED
proposes that if an entity has an unconditional right to receive reimbursement, that right should
be recognised as an asset if it can be measured reliably.
Solution
There is a present obligation as a result of a past event, this being the operation in which negligence
occurred. Accordingly, a liability is recognised.
Measurement of the liability reflects the likelihood that the hospital will be required to pay
compensation because of the mistake, and the amount and timing of that compensation.
Accounting ratios 16
Users and
user focus
Reporting Accounting
requirements distortions
arising from
business and
economic
events Improving the
quality of
financial information
Adjusting
assets and Adjusting
liabilities income
Shortly thereafter the company acquired the exclusive United Kingdom distribution rights to a
revolutionary new video mobile phone, manufactured in South Korea, which sells for about half the 16
price of competitive products and is fully compatible with all British mobile telephone networks.
During the year ended 31 August 20X1 expansion has been rapid under the new management.
The following points should be noted.
(1) The distribution rights for the South Korean phone cost £850,000. The rights were acquired
for a period of ten years, and the directors of Digicom Distributors Ltd decided to capitalise
the initial cost and amortise it over the ten-year period on a straight line basis. The current
carrying amount is £744,000.
(2) The new phone received extensive media acclaim during October and November 20X0,
accompanied by regional television advertising campaigns. Since then monthly sales have
increased from £500,000 to £1,600,000.
The advertising campaign cost the company £1,000,000. The directors believe that it will
have long-term benefits for the sales of the phone and, consequently, they decided to
capitalise the advertising cost and amortise it over the same period as the distribution rights.
The current carrying amount for the advertising expenditure is £925,000.
(3) Sales of the new phone now account for 75% of the company's revenue. The level of credit
sales has remained constant at 30% of total sales.
(4) The company has purchased dealer networks from three other companies and is negotiating
to purchase two more, which will then complete its national coverage.
(5) Employee numbers have increased rapidly from 40 to 130. This includes administration staff at
head office, where numbers have risen from 12 to 28.
(6) In June 20X1 the central distribution and servicing department moved from head office into
larger premises in Milton Keynes. The total cost of the relocation was £625,000, which has
been included in administrative expenses.
The move was necessary to handle not only the increased inventory and pre-delivery checks,
but also the rising level of after-sales warranty work caused by manufacturing defects in the
new phone.
The company has maintained its warranty policy of providing for 1% of revenue each year.
The movements in the warranty provision for the current year are as follows.
£'000
At 31 August 20X0 262
Provision for year 160
Provision utilised (94)
At 31 August 20X1 328
Requirement
Assess the profitability, liquidity and solvency of the company.
Requirement
Provide an analysis of the plant and equipment of Raport Ltd.
3 Tiger
On 1 January 20X1, Tiger Ltd buys a non-current asset for £120,000, which has an estimated useful
life of 20 years with no residual value. Tiger Ltd depreciates its non-current assets on a straight line
basis. Tiger Ltd's year end is 31 December.
On 31 December 20X3, the asset will be carried in the statement of financial position as follows:
£'000
Non-current asset at cost 120
Accumulated depreciation (3 (120,000 ÷ 20)) (18)
102
Situation A
The asset continues to be depreciated as previously at £6,000 per annum down to a carrying
amount at 31 December 20X6 of £84,000.
On 1 January 20X7, the asset is sold for £127,000, resulting in a profit of £43,000.
Situation B
On 1 January 20X4, the asset is revalued to £136,000, resulting in a gain of £34,000. The total
useful life remains unchanged. Depreciation will therefore be £8,000 per annum, ie £136,000
divided by the remaining life of 17 years.
On 1 January 20X7, the asset is sold for £127,000, resulting in a reported profit on disposal of
£15,000.
Requirement
Ignoring the provisions of IFRS 5 summarise the impact on reported results and net assets of each
of the above situations for the years 20X4 to 20X7 inclusive.
Liquidity
Current ratio
Current assets 1,842 1,135
0.50 1.37
Current liabilities 3,709 828
Quick ratio
Current assets – Inventory 1,842 – 778 1,135 – 520
0.29 0.74
Current liabilities 3,709 828
Solvency
Debt/equity ratio
Long - term debt 2,084
0.52
Capital and reserves 4,013
Interest cover
Operating profit 510
1.6
Interest 320
2 Raport
137
Capital expenditure represents 45% 100% of the depreciation expense for the year.
302
This could suggest that management is not investing in an expansion of capacity.
2,164
Accumulated depreciation represents 77% 100% of the cost of the assets.
2,800
1,922
This has increased from the 70% 100% in the previous year.
2,757
This confirms that plant and equipment is ageing without replacement. On average the plant
and equipment is entering the last quarter of its useful life. This could indicate that the plant is
becoming less efficient.
The losses on disposal could indicate that the depreciation rates are too low and economic
lives have been overestimated. The accounting policies should be reviewed. If this is the case
then this confirms that the plant and equipment is aged and raises further concerns about its
renewal and efficiency. The nature of the equipment would need to be determined when
considering this.
Summary
Situation A Situation B
No Revaluation
revaluation
£'000 £'000
Aggregate impact on profits (20X4 to 20X7) 25 (9)
Aggregate impact on total comprehensive income (20X4 to 20X7) 25 25
(b) Capital employed = total assets – adjusted current liabilities = 7,370 – 640 = 6,730
ROCE = 820/6,730 = 12.18%
When alternative definitions of capital employed are used there is a small impact on ROCE.
683
684 Corporate Reporting
Corporate governance, 600
Cost, 29
A Cost model, 514
Credit risk, 142
Accounting for derivatives, 190 Creditors' buffer, 332
Accounting policies, 143 Cumulative preference shares, 555, 556
Acquisition method, 359, 369 Currency swap, 189
Actuarial assumptions, 271 Currency swaps, 189
Actuarial risk, 265 Current ratio, 627
Additional EPS, 571 Current service cost, 278
Adjusting events, 83
Agricultural activity, 518
Agricultural produce, 518 D
Amortised cost, 173
Antidilution, 560 Dealer lessor, 109
Antidilutive potential ordinary shares, 560 Deductible temporary differences, 476
Asset, 29 Deferred tax, 491
Assets held for sale, 592, 593 Deferred tax assets, 476
Associate, 353, 392, 493, 664 Deferred tax liabilities, 475
Associate's losses, 374, 375, 378 Defined benefit liability, 272
Available-for-sale financial assets, 171 Defined benefit obligation, 269
Defined benefit plans, 265, 529
Defined benefit plans:, 282
B Defined contribution plans, 264, 267, 528
Demographic assumptions, 270
Balance sheet: historical cost, 452 Derecognition of financial assets, 163
Basic earnings per share, 547 Derivative financial instruments, 231, 232
Big GAAP/little GAAP, 608 Derivatives, 158, 188
Biological asset, 518 Diluted earnings per share, 547, 560, 562, 565
Biological transformation, 518 Dilutive potential ordinary shares, 560
Black-Scholes model, 316 Disclosure let out, 87
Bonus and right issues, 550 Disclosure of financial instruments, 176
Bonus issue, 550 Discontinued operations, 593
Borrowing costs, 118 Discount rate, 273
Discounting to present value, 87
Disposal group, 591
C Disposal of a foreign operation, 446
Capital redemption reserve, 327, 331 Disposal of a subsidiary, 385
Carrying amount, 29 Dissident shareholders, 330
Cash flow hedge, 237 Distributable profit, 326
Cash flow hedge accounting, 239 Distributing dividends, 325
Cash flows to the minority interest, 392 Dividend, 325, 327
Cash-generating unit (CGU) , 37, 38 Dividend cover, 628
Cash-settled share-based payment transaction, Dividend yield, 628
318
Cash-settled share-based payment transactions,
302, 317 E
Change of use, 516 Earnings per Share (EPS), 324
Closely related embedded derivatives, 195 EBITDAR, 657
Closing rate, 422 Effective interest method, 173
Component of an entity, 593 Effective interest rate, 173
Consolidated financial statements, 355 Embedded derivative, 191, 193, 194, 196
Construction contracts, 33 Embedded forward contract, 193
Constructive obligations, 670 Employee share options, 566
Contingent assets, 670 Equity, 373
Contingent liabilities, 85, 669 Equity instruments, 159
Contingently issuable shares, 567 Equity method, 354
Control, 353 Equity-settled share-based payment
Convertible bond, 137, 138 transactions, 302
Convertible instruments, 562 Exchange difference, 422
Index 685
Exchange differences, 431, 438, 443 Grant date, 304
Exchange of shares, 174 Grants related to assets, 117
Exchange rate, 422 Grants related to income, 117
Exclusion of a subsidiary from consolidation, Gross profit percentage, 627
356, 357 Group, 422
Exit route, 330 Group accounts, 354
Exposure Draft: Expected credit losses, 202
H
F
Hedge accounting, 143, 233, 245
Factoring, 166 Hedge effectiveness, 246
Factoring with full recourse, 167 Hedge ineffectiveness, 248
Factoring without recourse, 167 Hedged forecast transaction, 238
Fair value, 29, 40, 270, 305, 363 Hedged instrument, 222
Fair value adjustments, 444 Hedged item, 222, 225, 226
Fair value hedge, 232, 235, 236 Hedging an overall net position, 227
Fair value hedge accounting, 234 Hedging instrument, 231
Fair value measurement, 323 Hedging of firm commitments, 237
Fair value model, 514 Held for sale, 592
Finance income, 108 Held-to-maturity investments, 170, 230
Finance lease, 105, 107 Historical volatility, 316
Finance lease classification, 105 Hyperinflationary currency, 439
Finance lease liabilities, 106
Financial asset, 41, 158, 159, 162, 172
Financial asset or liability at fair value through I
profit or loss, 170
Financial assumptions, 270 IAS 7 Statement of Cash Flows, 406
Financial instrument, 157 IAS 8 Accounting Policies, Changes in
Financial instruments, 159 Accounting Estimates and Errors, 368, 590
Financial liabilities, 158, 159, 168, 169, 177 IAS 12 Income taxes, 471
Financial Reporting Standard for Smaller Entities IAS 20 Government Grants, 117
(FRSSE), 607 IAS 23 Borrowing Costs, 118
Financial risk, 226, 524 IAS 34 Interim Financial Reporting, 10
Firm commitment, 225 IAS 34 Interim Financial Reporting, 7
Firm commitments as hedged items, 228 IAS 37 Provisions, Contingent Liabilities and
Forecast transaction, 225, 238 Contingent Assets, 86
Forecast transactions as hedged items, 228 IAS 39 Derecognition steps, 164
Foreign currency, 422 IAS 40 Investment Property, 513
Foreign currency and consolidation, 440 IAS 41 Agriculture, 518
Foreign currency cash flows, 450 IFRIC 12 Service concession arrangements, 47
Foreign currency translation, 437 IFRIC 13 Customer loyalty programmes, 48
Foreign operations, 422 IFRS 2 Share-based Payment, 319
Forgivable loans, 117 IFRS 3 Business combinations, 396
Forward contract, 223 IFRS 4 Insurance contracts, 525
Framework, 45 IFRS 5 Non-current assets held for sale and
FRSSE, 15 discontinued operations, 593
FRSUKI, 15 IFRS 6 Exploration for and Evaluation of Mineral
Functional currency, 422, 423, 424, 425, 436 Resources, 522
Functional currency determination, 423, 424 Impact of preference shares, 555
Future, 223 IFRS 7 Financial Instruments: Disclosures, 138
IFRS 8 Operating Segments, 585
IFRS 9 Financial Instruments, 197
G IFRS 12 Disclosure of interests in other entities,
379
Gain or loss on net monetary position, 453 IFRS 13 Fair value measurement, 323
Gearing ratio, 628 IFRS 13, 144
Goodwill, 363 Impairment in non-monetary item, 435
Goodwill adjustment, 444 Impairment indicators, 36
Government assistance, 117
Government grants, 117, 118
L
P
Lease term, 106
Leased assets, 106 Participating equity instruments, 559
Leases, 513 Participating securities and two-class ordinary
Lessor, 107, 108 shares, 558
Liability, 669 Plan assets, 269
Liability adequacy test, 525, 526 Post-employment benefits, 264
Liability at fair value through profit or loss, 170 Preference shares classified as equity, 555
Loans and receivables, 170 Preference shares classified as liabilities, 555
London & General Bank (No 2) 1895, 328 Presentation currency, 422
London Stock Exchange, 601 Price/earnings (P/E) ratio, 628
Long-term disability benefits, 283 Profits available for distribution, 326
Long-term employee benefits, 282 Profit-sharing and bonus plans, 263
Property, plant and equipment, 29
Provision, 86
M Published prices, 182
Purchased options in cash flow hedges, 232
Management commentary, 602
Manufacturer or dealer lessors, 109
Market based vesting conditions, 304 Q
Market prices, 182
Index 687
Qualifying asset, 118 Shearer v Bercain Ltd 1980, 329
Qualitative disclosures, 145 Short-term compensated absences, 262
Quick ratio, 628 Short-term employee benefits, 261
Significant influence, 353
Special dividend and share consolidation, 552
R Spot exchange rate, 422
Structured entity, 379
Reclassifying financial assets, 175 Subsidiary, 353, 664
Recycling gains and losses from equity, 240 Swap, 189
Related party relationship, 596
Related party transaction, 596
Relevant accounts, 327 T
Replacement property, 517
Reportable segments, 586 Tax base, 473, 474, 475
Re-pricing of share options, 313 Taxable temporary differences, 475, 479
Repurchase agreements, 166 Temporary differences, 475
Residual value, 29 Termination benefits, 283
Restructuring, 89 Testing for dilution, 564
Restructuring provisions, 671 Theoretical Ex Rights Price (TERP)", 554
Retirement benefit plans, 527 Trade date accounting, 161
Return on capital employed (ROCE), 627 Trade payables payment period, 628
Return on plan assets, 271 Trade receivables collection period, 628
Return on shareholders’ funds (ROSF), 627 Transaction costs, 513
Revaluations, 31 Transactions with a choice of settlement, 302
Reversal of past impairments, 39 Translation of a foreign operation, 440
Reverse acquisitions, 367, 368 Translation of financial instruments, 435
Review Draft: Hedge accounting section of IFRS Translation of property - revaluations, 434
9, 203
Rights issue, 552
Risks from financial instruments, 140 U
UK GAAP, 15
S Undistributable reserves, 327
Unguaranteed residual value, 107
Sabbatical leave, 283 Unvested options, 566
Sale and leaseback as a finance lease, 110 Unwinding the discount, 87
Sale and leaseback as an operating lease, 111
Sale and leaseback transactions, 110
Securitisations, 166 V
Segment reporting, 585
Self-constructed investment properties, 513 Valuation of large holding, 182
Sensitivity analysis, 146 Vested options, 566
Settlement, 276 Vesting conditions, 304
Settlement date accounting, 161 Vesting date, 304
Share consolidation, 551 Vesting period, 304
Share options and diluted earnings per share,
565
Share premium account, 329 W
Share-based payment, 319, 321, 322 Weighted average number of shares, 548
Share-based payment and UK GAAP, 324 Working capital cycle, 628
Share-based payment with a choice of
settlement, 319
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