Financial Reporting: J. Haslam and D. Chow

Undergraduate study in Economics,
Management, Finance and the Social Sciences
Financial
reporting
J. Haslam and D. Chow
AC2091
2021
Financial reporting
J. Haslam and D. Chow
AC2091
2021
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 200 course offered as part of the University of London
undergraduate study in Economics, Management, Finance and the Social
Sciences. This is equivalent to Level 5 within the Framework for Higher Education
Qualifications in England, Wales and Northern Ireland (FHEQ).
For more information, see: london.ac.uk
This subject guide was prepared for the University of London by:
Dr D. Chow, Maynooth University, Ireland
It draws on the 2017 edition of the guide prepared by:

Professor J. Haslam, Durham University
and
Dr D. Chow, Maynooth University, Ireland
It was revised and updated in 2011 by:

Professor J. Horton, BSc, M Phil, PhD, Department of Accounting, University of Exeter
Business School
It was revised and updated in 2007 by:

S. Miles, PhD, Department of Accounting, The Business School, Oxford Brookes University
This is one of a series of subject guides published by the University. We regret that due
to pressure of work the authors are unable to enter into any correspondence relating to,
or arising from, the guide. If you have any comments on this subject guide, favourable or
unfavourable, please use the form at the back of this guide.
University of London
Publications Office
Stewart House
32 Russell Square
London WC1B 5DN
United Kingdom
london.ac.uk
Published by: University of London

© University of London 2017
Reprinted with amends 2021
The University of London asserts copyright over all material in this subject guide except where
otherwise indicated. All rights reserved. No part of this work may be reproduced in any form,
or by any means, without permission in writing from the publisher.
We make every effort to respect copyright. If you think we have inadvertently used your
copyright material, please let us know.
Contents
Contents
Introduction to the guide........................................................................................ 1
Aims and objectives of this course.................................................................................. 1
Learning outcomes......................................................................................................... 1
Syllabus.......................................................................................................................... 2
How to use this guide..................................................................................................... 3
Essential reading............................................................................................................ 4
Further reading .............................................................................................................. 4
Online study resources.................................................................................................... 6
Preparation for the examination...................................................................................... 7
Overview of the guide.................................................................................................... 8
Index of abbreviations used in this guide......................................................................... 9
Chapter 1: Rationale for financial reporting and its regulation........................... 11
1.1 Introduction.......................................................................................................... 11
1.2 Financial accounting and reporting delineation...................................................... 11
1.3 Considering accounting’s role in context................................................................ 12
1.4 Financial accounting regulation............................................................................. 14
1.5 Accounting standards: what form should they take?............................................... 16
1.6 Descriptions of accounting and its regulation: the regulatory framework in the
UK as an exemplar....................................................................................................... 18
1.7 Overview of financial accounting regulation: UK accounting regulation and
the influence of international accounting standards ...................................................... 18
1.8 Institutional setting for accounting regulation: the UK.....................................................19
1.9 Mandatory regulation............................................................................................ 21
1.10 A reminder of your learning outcomes.................................................................. 26
1.11 Sample examination questions............................................................................. 26
Chapter 2: Conceptual framework........................................................................ 27
2.1 Introduction.......................................................................................................... 27
2.2 Definition of a conceptual framework.................................................................... 28
2.3 Rationale for a conceptual framework.................................................................... 28
2.4 Advantages claimed for a conceptual framework.................................................... 29
2.5 The US, IASC/IASB and UK initiatives compared...................................................... 29
2.6 Objectives of financial reporting............................................................................. 33
2.7 Qualitative characteristics of accounting ............................................................... 35
2.8 Further comments................................................................................................. 39
2.9 Recognition and measurement in financial statements........................................... 40
2.10 Presentation of financial information................................................................... 43
Chapter 3: Preparation and presentation of financial statements....................... 47
3.1 Introduction.......................................................................................................... 47
3.2 IAS 1..................................................................................................................... 47
3.3 Comparative information....................................................................................... 48
3.4 Statement of profit or loss (or income statement) and statement of other comprehensive
income under IAS 1.............................................................................................................. 50
3.5 Statement of changes in equity.............................................................................. 52
3.6 Statement of cash flows........................................................................................ 52
3.7 Notes to the financial statements........................................................................... 53
i
AC2091 Financial reporting
3.8 Concluding thoughts............................................................................................. 53

3.9 A reminder of your learning outcomes.................................................................... 54
Chapter 4: Ethics for accountants......................................................................... 55
4.1 Introduction.......................................................................................................... 55
4.2 Ethical positions.................................................................................................... 55
4.3 Professional ethical codes or guidelines in accounting............................................ 58
4.4 Concluding thoughts............................................................................................. 61
4.6 Sample examination questions............................................................................... 61
Chapter 5: Accounting for equity and earnings per share.................................... 63
5.1 Introduction.......................................................................................................... 63
5.2 Share capital and reserves..................................................................................... 63
5.3 Ordinary shares..................................................................................................... 64
5.4 Share premium...................................................................................................... 64
5.5 Preference shares.................................................................................................. 65
5.6 Distributable and non-distributable reserves........................................................... 65
5.7 Accounting for the issue of equity.......................................................................... 66
5.8 Earnings per share................................................................................................. 66
5.9 Implications of debt and equity.............................................................................. 69
5.10 Concluding thoughts........................................................................................... 69
Chapter 6: Provisions, contingent liabilities and contingent assets: events after
the reporting period ............................................................................................. 73
6.1 Introduction.......................................................................................................... 73
6.2 Provisions.............................................................................................................. 74
6.3 Contingent liabilities.............................................................................................. 75
6.4 Measurement of provisions and contingent liabilities.............................................. 76
6.5 Onerous contracts................................................................................................. 79
6.6 Contingent assets.................................................................................................. 80
6.7 Events after the reporting period............................................................................ 80
6.8 Dividends and going concern issues....................................................................... 81
Chapter 7: Changing prices: current purchasing power (CPP) and its
applications........................................................................................................... 83
7.1 Introduction.......................................................................................................... 83
7.2 Basic principle....................................................................................................... 84
7.3 Revising HCA........................................................................................................ 84
7.4 Characteristics of HCA........................................................................................... 85
7.5 Advantages of HCA............................................................................................... 86
7.6 Disadvantages of HCA........................................................................................... 86
7.7 Alternatives to HCA............................................................................................... 88
7.8 Introducing CPP accounting................................................................................... 89
7.9 General and specific changes in price..................................................................... 89
7.10 Profit recognition and capital maintenance.......................................................... 90
7.11 Assessing CPP accounting ................................................................................... 91
7.12 Converting from HCA to CPP: a step-by-step guide.............................................. 92
7.13 Advantages of CPP.............................................................................................. 98
ii
Contents
7.14 Disadvantages of CPP.......................................................................................... 98

Chapter 8: Accounting for changing prices/values.............................................. 103
8.1 Introduction........................................................................................................ 103
8.2 Introduction to current value accounting (CVA).................................................... 104
8.3 Replacement cost accounting (RCA)..................................................................... 104
8.4 Net realisable value (NRV)................................................................................... 104
8.5 Present value (PV)............................................................................................... 105
8.6 Deprival value (DV).............................................................................................. 105
8.7 Holding gains and current operating profit........................................................... 106
8.8 Capital maintenance concepts ............................................................................ 107
8.9 Current value accounting using replacement cost ................................................ 109
8.10 Advantages and disadvantages of replacement cost........................................... 112
8.11 Fair value measurement (IFRS 13)...................................................................... 113
8.12 A reminder of your learning outcomes................................................................ 114
8.13 Sample examination questions........................................................................... 115
Chapter 9: Accounting for employee benefits..................................................... 119
9.1 Introduction........................................................................................................ 119
9.2 Short-term employee benefits.............................................................................. 119
9.3 Share-based payments........................................................................................ 120
9.4 Long-term employee benefits............................................................................... 121
9.5 Termination benefits............................................................................................ 127
Chapter 10: Accounting for taxation................................................................... 129
10.1 Introduction...................................................................................................... 129
10.2 An introduction to corporation tax systems......................................................... 130
10.3 UK: corporation tax........................................................................................... 130
10.4 Deferred taxation: taxable profit versus accounting profit................................... 133
10.5 Historical and current approaches to the accounting treatment of deferred tax... 135
10.6 Value-added tax (VAT)....................................................................................... 142
Chapter 11: Tangible non-current assets............................................................. 145
11.1 Introduction...................................................................................................... 145
11.2 Tangible non-current assets (owned).................................................................. 146
11.3 Measurement of tangible non-current assets...................................................... 146
11.4 Borrowing costs................................................................................................ 148
11.5 Depreciation...................................................................................................... 148
11.6 Measurement after recognition: revaluation....................................................... 152
11.7 Impairment: IAS 36........................................................................................... 155
11.8 IAS 40: Investment properties............................................................................ 155
11.10 Sample examination questions......................................................................... 157
Chapter 12: Leases.............................................................................................. 159
12.1 Introduction...................................................................................................... 159
12.2 Leases............................................................................................................... 159
iii
Chapter 13: Intangible assets and goodwill........................................................ 173

13.1 Introduction...................................................................................................... 173
13.2 Intangible assets (other than goodwill).............................................................. 174
13.3 Research and development................................................................................ 178
13.4 Goodwill: the debate......................................................................................... 181
13.5 Impairment: IAS 36........................................................................................... 186
Chapter 14: Revenue recognition (including construction contracts)................. 191
14.1 Introduction...................................................................................................... 191
14.2 Revenue recognition under IFRS 15.................................................................... 191
14.3 Construction contracts....................................................................................... 196
14.4 Profit recognition methods................................................................................ 196
14.5 The current (IFRS 15) treatment of revenue recognition in construction contracts.... 202
14.7 Sample examination questions .......................................................................... 204
Chapter 15: Accounting for financial instruments (excluding hedge accounting)...205
15.1 Introduction...................................................................................................... 205
15.2 Definition and overview..................................................................................... 206
15.3 Long-term debt and short-term debt.................................................................. 208
15.4 Accounting issues: equity or liability?................................................................. 208
15.5 Accounting for debt........................................................................................... 216
15.6 Disclosures........................................................................................................ 217
Chapter 16: Accounting for groups: consolidated statement of financial
position.....................................................................................................................221
16.1 Introduction...................................................................................................... 221
16.2 Key principles and rationales.............................................................................. 223
16.3 Requirement for consolidated accounts.............................................................. 225
16.4 Different models of group accounting ............................................................... 226
16.5 Different types of relationships within a group ................................................. 228
16.6 Accounting for subsidiaries................................................................................ 229
16.7 Discussion......................................................................................................... 245
16.9 Sample examination question............................................................................ 248
Chapter 17: Accounting for groups: consolidated income statement, associates
and joint ventures............................................................................................... 251
17.1 Introduction...................................................................................................... 251
17.2 Consolidated income statement ........................................................................ 252
17.3 Dividends.......................................................................................................... 254
17.4 Accounting for associates.................................................................................. 257
17.5 Accounting for joint ventures............................................................................. 260
Chapter 18: Accounting for groups: historical and alternative approaches....... 269
18.1 Introduction...................................................................................................... 269
18.2 Merger accounting............................................................................................ 270
18.3 The historical approach to equity accounting...................................................... 276
18.4 Accounting for joint ventures using proportional/proportionate consolidation..... 281
iv
Contents
18.5 Reminder of your learning outcomes.................................................................. 283

18.6 Sample examination question............................................................................ 283
Chapter 19: Accounting for foreign currency transactions and consolidation of
foreign enterprises.............................................................................................. 285
19.1 Introduction...................................................................................................... 285
19.2 Foreign currency conversion: business transactions............................................. 286
19.3 Foreign currency translation: business transactions............................................. 287
19.4 Which exchange rate should be used to record foreign currency translations of a
group of companies? ................................................................................................. 289
19.5 Accounting for the closing rate method and the temporal method...................... 292
19.7 Foreign currency translation in hyperinflationary economies................................ 303
19.8 Final thoughts................................................................................................... 304
Chapter 20: Analysis and interpretation of financial reports.............................. 307
20.1 Introduction...................................................................................................... 307
20.2 Ratio analysis.................................................................................................... 308
20.3 Cash flow statement......................................................................................... 312
20.4 Trend analysis.................................................................................................... 312
20.5 International differences.................................................................................... 313
Appendix A.......................................................................................................... 317
Chapter 2................................................................................................................... 317
Chapter 5................................................................................................................... 317
Chapter 6................................................................................................................... 319
Chapter 7................................................................................................................... 320
Chapter 8................................................................................................................... 322
Chapter 9................................................................................................................... 324
Chapter 10................................................................................................................. 325
Chapter 11................................................................................................................. 327
Chapter 12................................................................................................................. 330
Chapter 13................................................................................................................. 336
Chapter 14................................................................................................................. 338
Chapter 15................................................................................................................. 341
Chapter 16................................................................................................................. 343
Chapter 17................................................................................................................. 344
Chapter 18................................................................................................................. 345
Chapter 19................................................................................................................. 346
Chapter 20................................................................................................................. 348
v
Notes
vi
Introduction to the guide
What is or should be the role of accounting in society? How important

is or might be accounting in this respect? In what sense is accounting
regulated and how should it be? Who should regulate or organise the
production of accounting?
You may have encountered the financial accounting statements of
companies, a major focus here, as part of your work, in general discourse,
or as a shareholder or other user. These statements will probably have
been prepared by accountants and audited by an independent firm of
auditors. The statements would still require some analysis by the user,
for instance: Which figures are subject to management discretion? Which
figures depend on accounting choice? How can you distinguish between
two companies with identical earnings?
This subject guide is concerned with helping you to develop an
understanding of financial accounting consistent with the aims and
objectives of this course as specified below.
Aims and objectives of this course

The Financial reporting syllabus is concerned with financial
accounting. This involves a sound understanding of concepts and choices
that underlie measurement and disclosure in the financial statements of
practice. You must understand financial accounting in context. The aims
and objectives of the course are to:
• stimulate theoretical enquiry into financial accounting issues
• develop your knowledge and understanding of financial accounting
• prepare you for further academic study in accounting and related
areas
• enable you to pursue a professional accountancy qualification
• equip you for employment in areas where an understanding of
accounting issues and tools is helpful.
Learning outcomes
At the end of this course and having completed the Essential reading and
activities you should be able to:
• explain and apply a number of approaches to financial accounting
• record and analyse data
• prepare financial statements under alternative accounting conventions
• describe a number of regulatory issues relating to financial accounting
• critically evaluate theories and practices of, and other matters relating
to, financial accounting.
Throughout this subject guide, you will also find chapter-specific learning
outcomes.
1
Syllabus
Chapter 1: Introduction (including conceptual framework and approach
taken by the guide)
Chapter 2: Rationale for financial reporting and its regulation
Chapter 3: Preparation of financial statements (comprehensive income,
changes in equity and financial position)
Chapter 4: Ethics for accountants
Chapter 5: Accounting for equity and earnings per share
Chapter 6: Provisions, contingent liabilities and contingent assets: events
after the reporting period
Chapter 7: Changing prices: current purchasing power (CPP) and its
applications
Chapter 8: Accounting for changing prices/values
Chapter 9: Income and deferred taxation
Chapter 10: Property, plant and equipment (including investment
properties)
Chapter 11: Leasing
Chapter 12: Intangible assets
Chapter 13: Construction contracts
Chapter 14: Revenue recognition (including construction contracts)
Chapter 15: Consolidated accounts: at date of acquisition
Chapter 16: Consolidated accounts: after date of acquisition
Chapter 17: Consolidated accounts: income statement, changes in equity
and cash flows
Chapter 18: Consolidated accounts: associates and other joint
arrangements
Chapter 19: Foreign currency translation and consolidation of foreign
subsidiaries
Chapter 20: Analysis and interpretation of financial reports
Accounting standards in this subject guide

This subject guide is written for University of London students, who will be
studying in many different countries subject to different accounting rules
and regulations. The International Accounting Standards Board (IASB)
has become a very influential accounting regulator at the international
level. In the EU and Australia, for example, all listed companies are
required to produce group financial statements in accordance with current
International Accounting Standards (IASs) and International Financial
Reporting Standards (IFRSs) (the latter are gradually replacing the former
as IASs come to be updated and revised). Many other countries such as
the USA and China are in the process of moving towards closing the gap
between IASs/IFRSs and national regulations. This subject guide has been
written with this in mind. It has an international focus but within that we
give some particular consideration to the UK (e.g. in relation to accounting
for changing prices) as it serves to illustrate some key developments.
All worked examples use £ sterling as the currency. A list of abbreviations
used in the guide is given at the end of the Introduction.
2
How to use this guide

This subject guide has been extensively revised to incorporate the latest
IASs. Some of the older accounting standards and their related discussions
have been retained and summarised in a ‘history’ section in each chapter.
This allows you to appreciate the historical development of standards
and positions the study of accounting as a contextual and continually
developing social science.
This subject guide is intended to supplement the other key reading, not
to replace it. It should be read in conjunction with the Essential reading
and supported by Further reading. The list of Further reading is a
selection from many possible sources. Please seek additional reading on
any topics that you find difficult to grasp. Please note that, given rapid
change in financial accounting, you should use the latest editions of texts,
particularly the Essential reading text for the course.
In addition to the Essential reading listed at the start of each chapter, you
may find the appropriate available accounting practitioner journal helpful.
It may also be useful for you to obtain a copy of the annual reports and
accounts of a large company in your country. This will provide you with a
good reference aid for some of the main issues addressed in this guide. You
can generally obtain these reports on the company’s website. Alternatively,
you could write to the company asking for a copy of their report.
Websites
It is also recommended that you use the internet and investigate the
different professional bodies and government organisations’ websites,
which are a useful source of information on current developments in
financial reporting and regulation. Examples include:
• www.frc.org.uk for the UK Accounting Standards Board (ASB)
• www.fasb.org for the US Financial Accounting Standards Board (FASB)
• www.ifrs.org for the IASB.
Unless otherwise stated, all websites in this subject guide were accessed
in March 2021. We cannot guarantee, however, that they will stay current
and you may need to perform an internet search to find the relevant
pages.
Activities
This subject guide is divided into 20 chapters, most of which are self-
contained. Chapters contain worked numerical examples, where
appropriate, and activities appear throughout the guide. It is strongly
recommended that you attempt to answer, or consider the implications of,
all activities. Many require you to do additional reading. Solutions to some
of the activities can be found on the virtual learning environment (VLE).
Sample examination questions

There are sample questions at the end of each chapter (apart from this
introduction), aimed to test your knowledge and prepare you for the
examination. However, the Sample examination paper, found on the VLE,
is a more accurate reflection of the type of questions that are likely to
come up in the examination.
Reading advice
There is no single wholly satisfactory textbook covering all the topics
discussed in this course. References are given to one of the main advanced
3
financial accounting textbooks. References for specific Further reading are

also given where appropriate. You are advised to check if new editions of
these textbooks are available.
Essential reading
Detailed reading references in this subject guide refer to the editions of
the set textbook listed below. New editions of this textbook may have been
published by the time you study this course. You can use a more recent
edition of the book; use the detailed chapter and section headings and
the index to identify relevant readings. Also check the VLE regularly for
updated guidance on readings.
The Essential reading for this course is:
Alexander, D., A. Britton and A. Jorissen International financial reporting
and analysis. (Andover: Cengage Learning, 2020) 8th edition
[ISBN 9781473766853]. Hereafter, we refer to this book simply as
International financial reporting.
Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and
by thinking about how these principles apply in the real world. To help
you read extensively, you have access to the VLE and University of London
Online Library (see below).
Other useful texts for this course include:
Collins, B. and J. McKeith Financial accounting and reporting. (London:
McGraw-Hill, 2010) [ISBN 9780077114527].
Elliott, B. and J. Elliott Financial accounting and reporting. (Harlow: Pearson,
2019) 19th edition [ISBN 9781292255996]. Please note that this book is
listed as Essential reading for several chapters.
Picker, R., K. Clark, J. Dunn, D. Kolitz, G. Livne, J. Loftus and L. van der Tas
Applying IFRS standards. (Hoboken: Wiley, 2016) 4th edition
[ISBN 9781119159223].
You might find it helpful to refer to a dictionary of accounting when you
encounter a new term. Two such dictionaries are:
Law, J. A dictionary of accounting. (Oxford: Oxford University Press, 2016)
5th edition [ISBN 9780198743514].
Nobes, C. The Penguin dictionary of accounting. (London: Penguin Books Ltd,
2006) 2nd edition [ISBN 9780141025254].
Those of you who have studied AC1025 Principles of accounting may
find it useful to keep your subject guide to hand as you study this course.
The following is a list of all other reading listed in the Further reading
category in the subject guide.
Baxter, W.T. Depreciation. (London: Sweet & Maxwell, 1978) revised edition
[ISBN 042114470X].
Baxter, W.T. Inflation accounting. (Oxford: Philip Allan, 1984)
[ISBN 0860036235]. Chapters 3, 8 (pp.103–15) and 12 (pp.182–201).
Baxter, W.T. ‘Accounting standards – boon or curse’, Accounting and Business
Review Winter 1981, pp.3–10.
Beaver, W.H. Financial reporting: an accounting revolution. (Harlow: Prentice-
Hall, 1981) [ISBN 9780133161335] Chapter 7.
Beaver, W.H. and J.S. Demski ‘The nature of income measurement’, Accounting
Review 54(1) 1979.
4
Bromwich, M. Financial reporting, information and capital markets. (London:

Pitman Publishing, 1992) [ISBN 0273034642] Chapters 3, 4, 10–12.
(Although this focuses specifically on FASB’s conceptual framework, it also
discusses a number of issues about the conceptual framework approach that
can be considered in relation to the IASB’s Framework for the Preparation
and Presentation of Financial Statements and the ASB’s Statement of
Principles.)
Cadbury Report (1992) www.ecgi.org/codes/documents/cadbury.pdf
Company Law Review Steering Group, Company law reform Modern company
law for a competitive economy: developing the framework. Available at www.
berr.gov.uk/files/file23245.pdf
Draper, P.R., W.M. McInnes, A.P. Marshall and P.F. Pope ‘An assessment of the
effective annual rate method as a basis for making accounting allocations’,
Journal of Business Finance & Accounting 20(1) 1993, pp.56–63.
Ernst and Young International GAAP 2016: generally accepted accounting
practices under international financial reporting standards. (Chichester: John
Wiley & Sons, 2015) [ISBN 9781119180456].
Gallhofer, S. and J. Haslam ‘Analysis of Bentham’s Chrestomathia: or, towards
a critique of accounting education’, Critical Perspectives on Accounting 7(1)
1996, pp.13–31.
Gallhofer, S. and J. Haslam ‘Approaching corporate accountability: fragments
from the past’, Accounting and Business Research 23 1993, pp.320–30.
Gallhofer, S. and J. Haslam ‘Exploring social, political and economic
dimensions of accounting in the global context: the IASB and accounting
disaggregation’, Socio-Economic Review 8(4) 2007, pp.633–64.
Holmes, G., A. Sugden and P. Gee Interpreting company reports. (Harlow: FT
Prentice Hall, 2008) 10th edition [ISBN 9780273711414] Chapters 4, 10
and 11.
Ijiri, Y. ‘A defence for historical cost accounting’ in Sterling, R. (ed.) Asset
valuation and income determination. (Lawrence, KN: Scholars Book Co,
1971) [ISBN 9780914348115].
International Financial Reporting Standard Effects analysis. (London: IFRS,
2016) www.ifrs.org/Current-Projects/IASB-Projects/Leases/Documents/
IFRS_16_effects_analysis.pdf
Jackling, B., B.J. Cooper and P. Leung ‘Professional accounting bodies’
perceptions of ethical issues, causes of ethical failure and ethical education’,
Managerial Auditing 22(9) 2007, pp.928–44.
Lewis, R. and D. Pendrill Advanced financial accounting. (Harlow: FT Prentice
Hall, 2004) 7th edition [ISBN 9780273658498] Chapters 4, 5, 7–9, 11, 12,
17 and 18.
Macve, R. ‘Accounting for long-term loans’ in Carsberg, B. and S. Dev (eds)
External financial reporting. (Harlow: Prentice Hall, 1984).
Macve, R. A conceptual framework for financial accounting and reporting:
the possibilities for an agreed structure. (London: Institute of Chartered
Accountants in England and Wales, 1981) [ISBN 0852913117]. Reprinted
(New York: Garland, 1997).
Nobes, C. and R. Parker Comparative international accounting. (Harlow:
Prentice Hall, 2012) 12th edition [ISBN 9780273763796] Chapter 18.
Palepu, K.G. and P.M. Healy Analysis and valuation: using financial
statements. (Mason, OH: Thomson South Western, 2008) 4th edition
[ISBN 9780324302929] Chapters 1–4.
Peerless, S. ‘Accounting for business marriages’, Accountancy Magazine October
1994, p.100.
Prakesh, P. and S. Sunder ‘The case against separation of current operating
profit and holding gains’, American Accounting Review January 1979,
pp.1–22.
Sandilands Report Inflation accounting: report of the Inflation Accounting
Committee, Cmnd. 6225. (London: HMSO, 1975) Chapters 10 and 12
(pp.159–65).
5
Smith, T. Accounting for growth. (London: Century, 1996) 2nd edition

[ISBN 9780712675949] Chapter 16.
Solomons, D. ‘Economic and accounting concepts of income’, Accounting Review
36(3) 1961 (reprinted in Parker, R.H., G.C. Harcourt and G. Whittington
(eds) Readings in the concept and measurement of income. (Oxford: Philip
Allan, 1986) 2nd edition [ISBN 0860035360]).
Thibodeau, J. and D. Freier, Auditing and accounting cases: investigating issues
of fraud and professional ethics. (New York: McGraw-Hill, 2013) 4th edition
[ISBN 9780078025563].
Weetman, P. (ed.) SSAP 15 Accounting for deferred taxation. (Edinburgh: The
Institute of Chartered Accountants in Scotland, 1992) [ISBN 1871250234].
Whittington, G. Inflation accounting: an introduction to the debate. (Cambridge:
Cambridge University Press, 2010) [ISBN 9780521270557].
Online study resources

In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at: https://my.london.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave
on your application form. You have probably already logged in to the
Student Portal in order to register! As soon as you registered, you will
automatically have been granted access to the VLE, Online Library and
your fully functional University of London email account.
If you have forgotten these login details, please click on the ‘Forgotten
your password’ link on the login page.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
• Course materials: Subject guides and other course materials
available for download. In some courses, the content of the subject
guide is transferred into the VLE and additional resources and
activities are integrated with the text.
• Readings: Direct links, wherever possible, to essential readings in the
Online Library, including journal articles and ebooks.
• Video content: Including introductions to courses and topics within
courses, interviews, lessons and debates.
• Screencasts: Videos of PowerPoint presentations, animated podcasts
and on-screen worked examples.
• External material: Links out to carefully selected third-party
resources.
• Self-test activities: Multiple-choice, numerical and algebraic quizzes to
check your understanding.
• Collaborative activities: Work with fellow students to build a body
of knowledge.
6
• Discussion forums: A space where you can share your thoughts

and questions with fellow students. Many forums will be supported by
a ‘course moderator’, a subject expert employed by LSE to facilitate the
discussion and clarify difficult topics.
• Past examination papers: We provide up to three years of past
examinations alongside Examiners’ commentaries that provide
guidance on how to approach the questions.
• Study skills: Expert advice on getting started with your studies,
preparing for examinations and developing your digital literacy skills.
Note: Students registered for Laws courses also receive access to the
dedicated Laws VLE.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
Making use of the Online Library

The Online Library (https://onlinelibrary.london.ac.uk/) contains a huge
array of journal articles and other resources to help you read widely and
extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login.
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please use the online help pages (https://onlinelibrary.
london.ac.uk/resources/summon) or contact the Online Library team:
[email protected]
Changes to the syllabus

The material contained in this subject guide reflects the syllabus for the
year 2021–22.
The field of accounting changes regularly, and there may be updates to
the syllabus for this course that are not included in this subject guide. Any
such updates will be posted on the VLE. It is essential that you check the
VLE at the beginning of each academic year (September) for new material
and changes to the syllabus. Any additional material posted on the
VLE will be examinable.
Preparation for the examination

Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Programme
Regulations for relevant information about the examination, and the VLE
where you should be advised of any forthcoming changes. You should also
carefully check the rubric/instructions on the paper you actually sit and
follow those instructions.
7
With regard to this subject guide, you should:

• refer to the Essential reading and any Further reading you might
require to understand the topics in the syllabus
• attempt all activities in each chapter
• complete all sample examination questions.
We also recommend that you read through the section on examinations in
your study skills handbook, which contains useful guidelines on preparing
for examinations.
Remember, it is important to check the VLE for:
• up-to-date information on examination and assessment arrangements
for this course
• where available, past examination papers and Examiners’ commentaries
for the course which give advice on how each question might best be
answered.
Format of the examination

The examination could cover any of the subjects in this syllabus. The
examination is three hours long. You are normally required to answer
four questions from a choice of seven. These will be a mixture of essay-
style questions and computation with discussion questions. You thus need
to concentrate on both the qualitative and quantitative characteristics
of topics. You cannot rely purely upon, for example, the computation
aspects to pass the examination. The entire syllabus is examinable. The
examination also allows an additional 15 minutes of reading time. You
may begin writing at any point after the start of the examination. The
total time available to you in the examination is therefore 3 hours and
15 minutes.
Overview of the guide

As emphasised throughout, accounting is a communication tool. The
business entity communicates accounting information to interested parties
(e.g. potential and existing shareholders, creditors, managers, employees,
non-governmental organisations (NGOs), suppliers, the government, etc.)
in the form of financial statements.
Policy-makers (e.g. standard-setters) and others helping to shape
accounting (including practising accountants) effectively have to ask
themselves a number of basic questions before they can even begin to
construct or shape the financial statements. For example:
• Which disclosures and figures should be included in the financial
accounting statements? How much detail should be given?
• How should the figures be calculated?
• Who are the users of this information?
• Will they find the figures useful for their decisions and purposes? What
is accounting’s role?
Smith quotes an old joke that summarises some criticisms of accounting:
An old man was lost in a hot air balloon. Fortunately he saw

someone walking in a field below him so he lost height and
when he was within range shouted ‘Can you tell me where
I am?’ The walker stopped paused for thought and shouted
back ‘You’re in a hot air balloon.’ ‘You must be an accountant’
retorted the balloonist. ‘Amazing’, said the walker. ‘How did you
8 know that?’ ‘Because the information you just gave me was both
totally accurate and completely useless!’ (Smith, 1996, p.73)
The subject guide thus addresses some key accounting issues:

• What is and should be accounting’s role in society?
• Who are the users?
• What information would they benefit from?
• What should the underlying criteria be: relevant or reliable
information or both (if possible)?
• In what sense is or should accounting be regulated?
We consider some basic questions and issues that have been debated over
the years when deciding upon which disclosures and figures should be
reported in the accounts, for instance:
• What alternative measurement methods are available?
• Will they be useful and understandable to users?
• What do the standard-setters believe firms should be measuring and
reporting, and why?
• Are the methods appropriate given the environment in which
companies now operate?
• What issues still need to be addressed and why?
We discuss income measurement and capital maintenance, historical
cost accounting, current purchasing power accounting and current value
accounting. We consider modified historical cost/mixed measurement
systems.
We point to the relevance of context and seek to broaden horizons on
financial accounting. We consider possible futures for accounting.
Nomenclature used in this guide

Note that due to the use of ‘balance sheet’ in the most recently revised
IAS 29 standards, we have decided to retain this nomenclature, alongside
the IFRS terminology of ‘statement of financial position’, throughout the
guide. This is to ensure alignment with not just the standards but also
some of the older terminology in use in the Further reading.
Index of abbreviations used in this guide

ASB Accounting Standards Board
CBS Consolidated balance sheet
CIS Consolidated Income Statement
CPP current purchasing power
CSFP Consolidated statement of financial position
CVA current value accounting
DV deprival value, also known as ‘value to the business’ or
‘value to the owner’
EPS earnings per share
EC European Community
EU European Union
FASB Financial Accounting Standards Board
FPPFS Framework for the Preparation and Presentation of
Financial Statements
FRS Financial Reporting Standard
GPP General purchasing power
9
HCA Historical cost accounting

IAS International Accounting Standard
IASB International Accounting Standards Board
IASC International Accounting Standards Committee
IFRS International Financial Reporting Standard
IOSCO International Organization of Securities Commissions
NBV net book value
NPV net present value
NRV net realisable value, also known as ‘current exit value’
PV present value, also known as ‘economic value’
RC replacement cost, also known as ‘current entry cost’
ROCE return on capital employed
RPI Retail Price Index
SOP Statement of Principles
SSAP Statement of Standard Accounting Practice
10
Chapter 1: Rationale for financial

reporting and its regulation
1.1 Introduction
1.1.1 Aims of the chapter
This chapter introduces:
• the role of accounting in society
• the regulatory framework (discussion focused upon the international
framework)
• arguments for and against forms of accounting regulation, including
consideration of voluntary disclosure.
1.1.2 Learning outcomes

By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• discuss the character and role of accounting in society
• explain the different levels of authority in the UK regulatory framework
• explain and discuss the implications of the IASB
• discuss arguments for and against accounting standards
• discuss accounting regulation.
1.1.3 Essential reading

International financial reporting, Chapters 1 and 3.
1.1.4 Further reading

Baxter, W.T. ‘Accounting standards – boon or curse’, Accounting and Business
Review Winter 1981, pp.3–10.
Beaver, W.H. Financial reporting: an accounting revolution. (Harlow: Prentice-
Hall, 1981) [ISBN 9780133161335] Chapter 7.
Cadbury Report (1992) www.ecgi.org/codes/documents/cadbury.pdf
Gallhofer, S. and J. Haslam ‘Exploring social, political and economic
dimensions of accounting in the global context: the IASB and accounting
disaggregation’, Socio-Economic Review 8(4) 2007, pp.633–64.
1.2 Financial accounting and reporting delineation

What is financial accounting? There are different understandings of it.
Some might see it as any accounting that is in financial terms. Some
would equate it to ‘external accounting’. The latter denotes an accounting
that in the case of the business firm goes outside the organisation to
owners not closely involved in internal business management and/
or into the broader public realm. For some this might be a quite broad
understanding of ‘financial accounting’. For some, interestingly in spite of
the label ‘financial’, it could actually go beyond focusing on the financial
(if including it)! ‘Financial accounting’ is here seen as the equivalent of
‘external accounting’ and it may reflect very old notions of rendering an
account more generally. Narrative reporting and reporting on broadly
conceived notions of corporate social responsibility – both potentially
including but going beyond financial focuses – are frequently manifest in
practice and are often referred to as types of accounting.
11
A common, narrower, usage understands financial accounting to be

external and (more narrowly) financial. In most university courses
on financial accounting there is a further narrowing with the typical
focus being on the commercial business organisation that is owned
by shareholders who are understood to be other than the company’s
management. Financial accounting, where it is seen as external, is often
distinguished from an internal, ‘management accounting’.
In broad terms, all accounting can be understood in terms of decision
making and control roles (where these encompass dimensions of
accountability and stewardship).
The relation between financial accounting and financial reporting is also
not a settled one. In some usages they are taken to be the same or at least
substantively so. In others, the accounting implies a broader activity (e.g.
recording) and reporting is understood as a branch of it. In yet others,
financial reporting equates to a broader external reporting that need not
be restricted to the financial, whereas financial accounting (or simply
accounting) is understood to be restricted in this way. Both financial
reporting and financial accounting may be distinguished from financial
statements in that they might perhaps include narrative reports.
In this subject guide, we shall typically equate financial accounting and
financial reporting and where we intend a different connotation we shall
make that explicit. Often, reflecting much of the literature and practice, we
shall use financial accounting where we mean the external and (narrowly)
financial accounting of organisations (typically commercial business
organisations) but we shall give some recognition to broader delineations
(e.g. in referring to some notions of corporate social responsibility
accounting) and in those cases make clear that we are departing from the
narrower view.
1.3 Considering accounting’s role in context

Controversies do not end with issues of definition or delineation.
The study of financial accounting (whether understood broadly or
narrowly) is the study of a social phenomenon. Accounting is constructed
by people in a context and impacts upon them and the context.
Presumably its justification is in terms of social well-being.
Mainstream economistic views see financial accounting as information for
economic decisions. In many abstract models that are not uncommon in
economic reasoning perfect information is simply taken to exist.
To the extent that information in general and financial accounting in
particular are considered more realistically and less abstractly, the aim of
approaching perfect information is often deemed desirable. In this view,
as the information increases in quality (a notion encompassing increased
transparency and accountability) economic decisions are understood
to improve. Perhaps more detailed, disaggregated information could
be given. Perhaps companies could be valued better or report better
their value. The view is that scarce resources are better allocated in the
economy and social welfare increased. A modification of this position
again in the direction of greater realism appreciates that information is
costly. Its benefits should exceed its costs.
The above covers what are ostensibly the dominant views of the influential
accounting policy makers. The IASB, for instance, emphasises the role of
financial accounting information in guiding economic decisions and thus
enhancing social welfare. Less frequently seen in official pronouncements
12
but often used to justify actual policy decisions is explicit reference to the
costliness of a possible provision (the UK’s ASB refers to it in its stated
aims – and points out that it is not in favour of revolutionary changes to
financial reporting).
Those considering further dimensions of the imperfect character of
real world economies have added further layers of complexity in their
prescriptions. The assumption that more transparency is better than less
is brought into question beyond simple cost-benefit analysis. Lipsey and
Lancaster (1957) argue that in imperfect markets improving information
such as accounting without improving other aspects of the economic
system might even reduce social welfare. Possible reasons include that
in a competitive economy businesses need to have incentives to innovate
that might be countered if too much is made transparent. Thus, even
shareholders have an interest in keeping some information within the firm.
If more information is publicly available it may be easier for monopolistic
firms to strengthen monopolistic positions (to the detriment of social
welfare) (Gallhofer and Haslam, 2007).
Factors such as these, including information’s simple costliness, as well as
lack of shareholder control over corporate management, may explain why
in practice many commentators believe financial accounting falls short of
the information that one might assume, from a more mainstream position,
capital providers would want (Tinker, 1985, refers to ‘shareholder
alienation’ in this regard). This is in spite of the apparent shareholder and
investor orientation of the influential policy makers. Perhaps it is the case
that financial accounting does reflect the conventionally assumed interests
of shareholders – but in an imperfect market – or perhaps those interests
are only partially – or imperfectly – satisfied.
Returning to prescription, another view from someone well versed in an
information economics perspective takes further the notion of context
imperfection (towards appreciating the imperfect character of the socio-
economic and political context) and fuses with a more interdisciplinary
perspective, indicating that financial accounting cannot be understood to
have only narrowly conceived economic consequences. Joseph Stiglitz,
a Nobel prize winner in economics, notes that when information like
financial accounting enters the public realm it enters a complex context
of conflicting forces. One cannot assume that information produced
for purpose X will not (also) be used for another purpose, say purpose
Y. Purpose Y may include the desire to impose stricter regulations on
business and/or enhance the general democratic control over business.
The prescriptive implication may not be so clear but the suggestion is that
some kind of trade off may be envisaged in an imperfect context so that
some caution over transparency might be taken.
Drawing from such an insight, some researchers point to financial
accounting’s role in potentially changing (for the better) the character of
the socio-political and economic system as well as serving it (Gallhofer
and Haslam, 2007). Similar prescriptive thinking is behind other socio-
economic and socio-political theorising, in which forms of corporate
social responsibility accounting are envisioned that transform the
narrower economistic financial accounting towards a more holistic form
of accounting that reflects (from advocate perspectives) all things relevant
to social well-being (in relation to corporate operations). The concern for
a more holistic external accounting involves going beyond mainstream
perceptions and includes prescriptions of non-financial information
(Gallhofer and Haslam, 2007).
13
The latter prescriptive suggestions have had relatively little influence on

accounting policy makers, although The Corporate Report (1975), a draft
policy statement of the UK Accounting Standards Steering Committee (a
forerunner of today’s UK ASB), did put forward a stakeholder orientated
form of external accounting that included non-financial as well as financial
information. It never became a standard (Gallhofer and Haslam, 2007).
1.4 Financial accounting regulation

Mainstream economistic reasoning has also been influential in respect of
the issue of how best to regulate financial accounting. In this regard, some
of the above perspectives have implications for how accounting should be
regulated.
Perspectives that assume the existence of perfect information in perfect
and complete markets (and implicitly a perfect context) would not see
the need for further regulation. Although the argument might weigh
against State and/or quasi-State regulation in were more perfect and
complete markets, in a less abstract and more realistic view, recognising
the imperfections opens up the need to consider the case for State and/or
quasi-State regulation even within a mainstream economics perspective.
Some hold that the functioning of imperfect markets (within a general
institutional/regulatory framework) is enough to regulate financial
accounting adequately. Businesses have an incentive to provide accounting
information to the market to raise capital and an interest in being honest
and providing good quality information due to the negative impact of loss of
reputation (organisations failing to inform or misleading the capital market
will be regarded as ‘lemons’ – and punished). Another way of seeing this is
that managers have strong incentives to disclose information – for example,
they may need to raise finance in the competitive market and thus provide
relevant information to aid them in this (and reputation has a value here
so honesty may pay). Further, there is a market for managers. Managers
themselves would want to inform the market as to how well they are doing,
hence improving their own marketability. The ‘free market’ camp would
thus argue that, even given real world imperfections, we should leave it
to the market or what some call ‘market regulation’ (noting that markets
themselves require some form of State regulation in practice). Some argue
the market for information is good enough to produce an optimal or near-
optimal supply.
Contracting arguments have also been put forward. Companies could
simply have a contract with their suppliers of capital to disclose certain
information to them, including having the information audited. Any
undisclosed information could then be obtained by private searches and/
or payment for additional information that may be required.
One point that may be made here too is that regulation beyond the market
may displace some of the positives of market functioning. Interventionist
regulation may problematically, restrict the accounting methods that may be
used in practice so that they become crudely uniform and not fit for purpose
(if that may also reflect a poor form or type of interventionist regulation).
Further, users may tend to overstate their desire for disclosure if they do not
have to pay for it directly (even if indirectly they may bear costs). Costs will
be borne by those supplying the information.
History does indicate that companies will ‘voluntarily’ disclose at least
some information (at least they will disclose some under various non-
State pressures). While those observing practice historically admit to
some evidence of this type of partly market-induced effect, substantively
14
they point to weak financial accounting in the absence of more formal

regulation and make the case for regulating financial accounting in
terms of State and/or State-backed or quasi-State professional regulation
(through professional accounting standards), beyond the more liberal
approach. The view here is that the market for information is such that
without interventionist regulation a sub-optimal amount of information
will be produced. And the comparability it facilitates may be less than
desirable. The case for likewise regulating notions of broader corporate
social responsibility accounting is similar. This said, contexts vary and a
great deal of pressure may be placed on business in some circumstances
(e.g. by competitive forces and a strong civil society) without legislation or
quasi-law.
Under the contracting arguments, the actual cost of enforcing the
individual contracts or ‘group contracts’ may be higher than those costs
associated with State and/or State-like regulation. Even with these
contracts there would be a need for comparability of accounting practices.
A number of related arguments for regulation have been suggested
reflecting the assumption of an imperfect markets context, including the
following:
• Left unregulated as envisaged, market forces would ‘lead to an
uneven possession of information among investors’. Consequently the
regulation would provide an equitable solution. ‘It is only fair that the
less informed be protected from the more informed.’ Some have more
power than others (over others) in terms of accessing information.
• Accounting information shares the characteristics of a public good, and
therefore suffers the same problems of externalities and free riders.
Under these conditions the absence of the regulation envisaged could
result in the under provision of information.
• Managers have incentives not to disclose unfavourable information.
Consequently, investors would be unable to distinguish good
companies from bad ones, resulting in ‘adverse selection’. Investors
need protection from the fraudulent. Due to information asymmetries,
disclosures may not obviously be seen as fraudulent.
Others argue markets are not so speedy in re-adjusting to changes. Even
if markets do keep returning to reasonable positions or an equilibrium (a
contestable view for some), people may get hurt in the process, given the
slow speed. Indeed this may be in ways they can scarcely be compensated
for.
The ‘balanced’ view on financial accounting discussed above may be
taken as implying that regulation to improve transparency should not
be universally overly strict, or it might imply the need for a regulation
that has limits and that might be set so as to prevent firms competing
in the market place in terms of information disclosure, which may drive
disclosure in practice towards too much transparency. In an imperfect
markets context, a particular level of disclosure or transparency would
be optimal for social welfare. A degree of secrecy or confidentiality is
required to allow the system to better function (e.g. create incentives for
research and development; discourage monopolistic practice that might be
encouraged through information sharing). And a degree of transparency is
required to facilitate financing and the better allocation of resources.
Some analysts of the issues have used game theory as a framework and
tried to model (appreciating the possibility of audit) external financial
accounting disclosures in relation to the incentives of regulators and
15
corporate managers (e.g. incentives to disclose or hide, to be honest or

dishonest). From this quasi-descriptive modelling (to which dimensions of
uncertainty and the costliness of information can be built in) an attempt
is made to see if answers can be found to questions such as: Is rigid
regulation better than flexible regulation? Is mandatory disclosure better
than a looser more voluntary approach? This framework can enhance
appreciation of the character and feasibility of actual and potential
regulatory forms, although it is not straightforward to translate this into
social welfare implications in an imperfect markets and imperfect societal
context.
Activity 1.1
Read Beaver (1981) Chapter 7 and Gallhofer and Haslam (2007), taking notes.
Critically appraise the main arguments that Beaver puts forward for increased regulation.
How do Gallhofer and Haslam see accounting regulation?
1.5 Accounting standards: what form should they take?

One way of regulating accounting, suggesting intervention beyond the
more liberal approach, is through accounting standards. These could be
prescribed by law or by ostensibly independent professional bodies (the
latter’s prescriptions may then in some way be backed by law). If we
believe in regulating accounting through the use of accounting standards,
what form should the standards take? We could consider Edey’s discussion.
Edey (1977) discussed and illustrated four possible types of accounting
standards, all with different levels of detailed rules, with the lowest level
(Type 1) being less prescriptive than the highest (Type 4).
Type 1: ‘Tell people what you have done.’ This type of standard restricts
accounting to information about what has happened but Edey
emphasises that the restriction is to basic disclosure rules.
Type 2: Uniform presentation. This type of standard would only concern
rules on how financial results should be presented and hence create
some form of uniformity and consistency.
Type 3: Disclosure of specific matters. This type of standard would require
disclosing specific matters in certain cases.
Type 4: For example, how to value assets/liabilities, what is regarded as
income, how income is allocated to periods. Edey characterises this
type of standard as specifying considerable detail.
In terms of the earlier argumentation, the more detailed and the less
flexible the requirements then the stronger the regulation.
Comparing arguments for and against standards is clearly related, then,
to arguments for and against forms of regulation. We extend or refine
the earlier argumentation by considering Baxter, which reflects an
understanding of the nature of UK company law, whereby that law is
assumed not to prescribe very detailed and inflexible accounting standards.
1.5.1 Arguments for accounting standards

Baxter outlines arguments for the imposition of accounting standards,
suggesting that standards provide handy rules for the daily work of
accountants.
Types 1–3 in Edey’s typology would:
• help improve published reports
16
• supplement company law with fuller, clearer and more consistent

figures
• foster comparability, which in turn would help analysts and potential
investors compare and evaluate firms
• force weaker accountants to improve their work
• provide a defence for accountants in court, and strengthen resistance ‘if
a tycoon tries to bully his accountants into producing biased figures’.
Other related arguments put forward include the following:
• Standards provide credibility to the accounting profession, which
might be undermined if there are continued scandals over the extreme
subjectivity of some companies’ financial statements.
• They provide discipline.
• In the short term, they may alleviate risk to investors.
1.5.2 Arguments against accounting standards

The following arguments have been made:
• Accounting standards are costly and bureaucratic.
• Accounting figures (due to their very nature) do not lend themselves
to standardisation; industries differ, so do firms; the needs of the user
vary. Thus, standards may be suitable for the average but not suit
others.
• Standards can lead to a kind of rule-following where two similar
situations might be treated differently because they fall either side of a
rule.
• Standard-setters may bow to political pressures and thus the
development of accounting standards may be merely consensus-
seeking.
• Standards could reduce professional judgement and be bad for the
academic education of accountants in that emphasis is placed on
compliance with and understanding existing systems rather than on
bettering accounting systems.
• Standards may give users a false sense of security (e.g. investors
may believe accounts are all following the same specific rules, when
a standard may leave room for different estimates or even choices;
investors may simply trust professional judgements). Consequently,
investors and other users need to be educated about this.
• If they do not take account of possible economic consequences,
standards may result in adverse allocation effects. Accounting
standards might result in sub-optimal company behaviour purely to
ensure that accounting earnings are not reduced.
• Standards could result in overload or interpretation problems, for
example if they are too detailed (although this may be less of an issue
with hyperlinks in web-based reports) or if they are not specific/
focused enough.
1.5.3 Theories on regulation

In reality, most countries have some form of accounting standards as part
of their mechanism to regulate the private sector. The theories around the
regulation of accounting standards are a significant part of the academic
debate. Section 3.8 (pp.63 onwards) of International financial reporting
provides an introductory coverage of this literature.
17
Activity 1.2
What criteria are relevant in deciding upon accounting standards? Should standards
specify the detail or be more like general guidelines?
1.6 Descriptions of accounting and its regulation: the

regulatory framework in the UK as an exemplar
Many descriptions begin with an attempt to understand what accounting
and accounting regulation are like in terms of basic content and form,
for example, what are the requirements of a law or standard? This is an
emphasis in what follows here. Many descriptions see actual regulatory
developments as appropriately responding to regulatory failures (if the
developments may be found wanting as things change, engendering
new regulations is then deemed appropriate). They may be considered
official descriptions, as they are how official regulatory bodies would
describe things. We focus here initially on accounting regulation in
ways substantively reflecting such basic description and mainstream
interpretation. We focus on accounting regulation in the UK but in
the global context, reflecting the significant influence of international
accounting standards in the UK (as well as beyond).
1.7 Overview of financial accounting regulation:

UK accounting regulation and the influence of
international accounting standards
The regulatory framework relating to financial reporting varies from
country to country. For Cooke and Parker (1994), the nature of this
framework depends upon (among other things):
• the influence of tax rules
• the type of legal system
• the history and influence of the accounting profession.
In the UK, the regulatory framework has developed over many years
and consists of a mass of statutory, mandatory and customary rules and
regulations. The UK regulatory framework has been influential in many
other countries. For instance, for Cooke and Parker,
Malaysia’s colonial past is reflected in many ways in the current
reporting environment, which is very similar, though not
identical to the UK environment.
1.7.1 Impetus for regulation

Often, regulations are implemented after well-publicised scandals. This
was ostensibly the case with the establishment of the UK’s Accounting
Standards Steering Committee (ASSC) in 1970. Two scandals in the
late 1960s were understood as highlighting the extent of subjectivity in
financial reporting: the General Electric Corporation (GEC) takeover of
AEI Ltd and Pergamon Press’s profit figure both led to questions about
the correctness of published financial statements of UK companies. Yet
one may also note that more recently, and today, with the existence of
standards that have over time tended to become more extensive and
detailed, similar questions are asked, such as in the USA following the
Enron scandal.
18
1.8 Institutional setting for accounting regulation: the UK

In this section we delineate some key historical developments in UK
accounting regulation up to the Companies Act 2006 (which, as clarified
and amended by Statutory Instruments, is now the Companies Act in
force in the UK). We focus on historical developments that facilitate an
understanding of accounting regulation in the UK today. We look at the
influence of the International Accounting Standards Board (IASB), formerly
the International Accounting Standards Committee (IASC).
1.8.1 Statutory legislation

UK Companies Acts (CAs) before the 1980s contained only general
requirements for companies and groups covering the need to prepare,
distribute and file financial statements. There was very little detail in
the Acts. Much was left to the practices/interpretations of professional
accountants.
In 1981 requirements about the form and content of published accounts
changed when the UK implemented the EC (now EU) 4th Directive in CA
1981. The 4th Directive imposed standardised formats for the income
statement and balance sheet. It continued to require a ‘true and fair
view’1 (see below) for UK companies (as well as requiring this now for EU 1
The ‘true and fair view’
companies). This was achieved by making rules about: was required in the UK
prior to the 4th Directive.
• the format of accounts After UK pressure upon
• certain accounting principles the EU the true and
fair requirement was
• valuation rules included in the Directive.
• information disclosure.
CA 1985 consolidated previous Acts (1947, 1948, 1967, 1980 and 1981)
and set out general rules and formats governing the content and form of
published company accounts. CA 1985 was then amended and supplemented
by CA 1989 (later revised), which enacted the 7th EU Directive. This
Directive had a similar role to the 4th, but regarding consolidated accounts.
Its objective again was to harmonise practice within the EU, but its effect in
the UK was less dramatic than it had been with the 4th Directive: the basis of
the 7th Directive was largely the Anglo-Saxon model of consolidation, while
the 4th was based more on continental practices.
The ‘true and fair view’ requirement

In addition to preparing accounts, CA 1985 s.226 requires that:
(2) The balance sheet shall give a true and fair view of the state
of affairs of the company as at the end of the financial year; and
the [income statement] shall give a true and fair view of the
profit and loss of the company for the financial year.
(3) A company’s individual accounts shall comply with
the provisions of Schedule 4 as to the form and content of
the balance sheet and [income statement] and additional
information to be provided by way of notes to the accounts.
The Act makes it clear that the true and fair requirement is overriding:
If in special circumstances compliance with any of those
provisions is inconsistent with the requirement to give a true
and fair view, the directors shall depart from that provision to
the extent necessary to give a true and fair view. Particulars
of any such departure, the reasons for it and its effect shall be
given in the note to the accounts.
19
(s.226(5))
The CAs have never defined ‘true and fair’. Within the financial accounting
literature, Lewis and Pendrill (2004, p.27) quote a definition by G.A. Lee
(1981, p.270):
Today ‘true and fair’ has become a term of art. It is generally
understood to mean a presentation of accounts, drawn up according
to accepted accounting principles, using accurate figures as far as
possible, and reasonable estimates otherwise; and arranging them
so as to show, within the limits of current accounting practice, as
objective a picture as possible, free from wilful bias, distortion,
manipulation or concealment of material facts.
1.8.2 How IASs/IFRSs gained statutory legal force in the UK

The IASB was preceded by the IASC, which operated from 1973 until
2001. The IASC gained the acceptance of the International Federation of
Accountants (from which, historically, it had been formed by a breakaway
faction), a worldwide association of accountancy bodies aiming to
harmonise accounting standards internationally. The IASC was (as the
IASB is) a private sector body ostensibly independent of government
influence (a NGO). The level of harmonisation achieved was understood to
be reduced by (a) weak standards permitting too many choices to satisfy
diverse member requirements and (b) lack of enforcement power.
Greater enforcement was eventually achieved notably via the International
Organization of Securities Commissions (IOSCO) (see Section 1.9.2 on
stock exchange regulation) and the EU. The EU instigated a harmonisation
programme that involved issuing several directives to harmonise EU
corporate accounting practices. In November 1995 the EU announced:
‘Rather than amend existing Directives, the proposal is to improve the
present situation by associating the EU with the efforts undertaken
by IASC and IOSCO towards a broader international harmonisation
of accounting standards’. In 1995, the EU agreed to require all listed
European companies to conform to IASs/IFRSs, following a review of the
standards. In 1996 the EU Contact Committee reported that IASs/IFRSs
were compatible with EU directives, with minor exceptions, leading to
legislation requiring all EU-listed companies to follow IASs/IFRSs from
2005. The EU-adopted regulations were effective from 1 January 2005
requiring EU listed companies to use generally accepted international
accounting principles (IASs/IFRSs) when preparing their consolidated
group accounts. Hence, IASs/IFRSs constituted statutory regulation for
these companies.
The IASB superseded the IASC in 2001, inheriting 34 standards, 14
of which were criticised by the IOSCO as unacceptable by regulators
worldwide. The IASB was set up initially recognising IASs but gradually
replacing them and adding to them with IFRSs (the new name for the
standards). The IASB embarked on a standards improvement project
before the 2005 EU adoption. This project was completed by 2003,
resulting in 15 revised IASs/IFRSs.
From 2005, Australian-listed groups and from 2007, New Zealand-listed
groups had to comply with IASs/IFRSs. More recently, South Korea, China,
Brazil, Israel, Malaysia and Mexico have made similar moves or committed
to the same. Several countries have domestic General Accepted Accounting
Principles (GAAP) identical to IASs/IFRSs and some have abandoned
developing their own standards. Over 100 countries are following IASs/
IFRSs in some respect.
20
The US Financial Accounting Standards Board (FASB) and IASB are

ostensibly committed to a convergence process and some progress on
this has been made, though there is still reluctance on the part of the
FASB to accept the IASB despite the latter making significant efforts to
align its standards more closely with those of the FASB. Some see this
as a balance of power relationship, with the FASB being in the more
advantageous position due to the USA’s large and liquid capital markets.
An issue that is often discussed in relation to the convergence process is
that the USA is more prescriptive in accounting regulation while the IASB
(seen as reflecting the UK approach in this respect) is more ‘principles’
based. It is possible to put together an evidence-based argument for this
difference and to suggest that it is an obstacle to convergence. However,
more substantive differences of this nature arguably existed in the EU
before accounting harmonisation there. And prescription often requires
interpretation while principles (as in the UK case) are often backed by law
in this domain.
As a result of the global financial crisis in 2007–2008, the leaders of
the Group 20 (G20) nations have called for further internationalisation
of accounting standards. Para.14 of the G20 Leaders’ ‘Statement on
strengthening the international financial regulatory system’
(http://www.g20.utoronto.ca/2009/2009communique0925.html) states:
We call on our international accounting bodies to redouble their
efforts to achieve a single set of high quality, global accounting
standards within the context of their independent standard
setting process, and complete their convergence project by June
2011. The International Accounting Standards Board’s (IASB)
institutional framework should further enhance the involvement
of various stakeholders.
The advocacy of IASB as being a global representative institution was

further pushed by the G20, which emphasised the growing convergence
between IASB and the American accounting standards board (FASB). The
2013 G20 Leaders’ Declaration (http://www.g20.utoronto.ca/2013/2013-
0906-declaration.html), para.74, states:
We underline the importance of continuing work on accounting
standards convergence in order to enhance resilience of
financial system. We urge the International Accounting
Standards Board and the US Financial Accounting Standards
Board to complete by the end of 2013 their work on key
outstanding projects for achieving a single set of high-quality
accounting standards. We encourage further efforts by the
public and private sector to enhance financial institutions’
disclosures of the risks they face, including the ongoing work of
the Enhanced Disclosure Task Force.
One should not take at face value that such advocacy is truly global. It can
be interpreted as attempts to derive a common set of global standards by
representatives of some of the largest capital markets in the world.
1.9 Mandatory regulation

In the UK, prior to the establishment of the ASC/ASSC, official or formal
accounting regulation was limited. There were a few basic statutory rules
governing financial statement presentation within the Companies Act.
21
Accounting practices were much less than harmonised. The ASSC (set up
in 1970) was re-formed as the ASC in 1976. The latter’s objectives were to:
define accounting concepts, to narrow differences of financial

accounting and reporting treatment, and to codify generally
accepted best practice in the public interest.
The ASC’s membership consisted of representatives from the various UK

accounting bodies. They were part-time and unpaid. Following major
criticism of the ASC that it could not respond quickly to changing needs
or deal with fundamental issues, a Review Committee was established
in 1987 chaired by Sir Ronald Dearing. After the Dearing Report on the
creation of accounting standards, the following bodies were established:
FRC Ltd Board Council
Accountancy
Accounting Auditing Board for Professional Financial
Investigation
Standards Practices Actuarial Oversight Reporting
and Discipline
Board Board Standards Board Review Panel
Board
Committee on
Urgent Corporate
Issues Governance
Task Force
Executive
Figure 1.1: Organisational chart for the accounting standard-setting body in the
UK. Source: www.frc.org.uk/about/chart.cfm
• Financial Reporting Council (FRC)
Established in 1990, this is made up of representatives of users,
preparers and accountants in practice. It provides guidance to the
ASB on work programmes, priorities and issues of concern, and is
responsible for financing arrangements (most of the ASB funds come
from the FRC). The chair is appointed by the Secretary of State for
Business, Enterprise and Regulatory Reform with the Governor of
the Bank of England, the accountancy profession and the financial
community. The FRC is financed by the government, the accountancy
profession and financial institutions (the government contributing
about one-third). The FRC aims ‘to promote confidence in corporate
reporting and governance’.
Read updates on the FRC as it tackles corporate scandals (Financial
Times, 5 February 2020, https://www.ft.com/content/0abe6718-47ed-
11ea-aee2-9ddbdc86190d).
• Financial Reporting Review Panel (FRRP)
Established in 1990 with a QC as its Chair, the FRRP examines
material departures from standards by large companies. The
Introduction to accounting standards requires it to:
enquire into annual accounts where it appears that
Companies Act requirements, including the requirement that
annual accounts shall show a true and fair view, might have
been breached.
22
It has been authorised under the Companies Act to make application

to the court for a declaration that a company’s annual accounts do not
comply with the requirements of the Companies Act and for an order
that the directors prepare revised accounts. (See below.)
• Accounting Standards Board (ASB), now the FRC since
2012
Established in August 1990, this replaced the ASC. It is an expert
body to develop, issue and withdraw accounting standards, with a
full-time chair, technical director, 10 members in total and a large full-
time secretariat. It issues FRSs on its own authority, on a two-thirds
majority. A committee of the FRC appoints its members. The ASB has
stated its aims as follows:
to establish and improve standards of financial accounting
and reporting, for the benefit of users, preparers and
auditors of financial information.
One of the ways in which it intends to achieve its aims is by

‘developing principles to guide it in establishing standards and to
provide a framework within which others can exercise judgement in
resolving accounting issues’ (see Chapter 2).
It has listed ‘fundamental guidelines’ including ‘to be objective and
to ensure that the information resulting from the application of
accounting standards faithfully represents the underlying commercial
activity’; such information should be ‘neutral in the sense that it is
free from any form of bias intended to influence users in a particular
direction and should not be designed to favour any group of users or
preparers’.
Other fundamental guidelines include issuing standards only when
the expected benefits exceed the perceived costs, and ‘taking account
of the desire of the financial community for evolutionary rather than
revolutionary change in the reporting process where this is consistent
with the objectives’.
1.9.1 The historical relation of accounting standards and

company law
In the UK, following the Dearing Committee’s review of standard-setting,
changes were also made to company law:
• Section 19 of CA 1989 inserted a new section (s.256) into CA 1985.
This includes a definition of accounting standards and, among other
things, gives the Secretary of State power to make grants to bodies (for
the purpose of):
• issuing standards, overseeing and directing their issue
• investigating departures from standards or from the accounting
requirements of the Act and taking steps to secure compliance with
them.
• CA 1989 inserted a new paragraph (36A) into Schedule 4 of CA 1985.
This requires it to be stated whether the accounts have been prepared
in accordance with applicable accounting standards, with particulars
of any material departure from those standards and reasons for these
to be given.
23
• Section 12 of CA 1989 inserted a new section (s.254B) into CA

1985 giving the Secretary of State power to apply to the court for a
declaration that a company’s annual accounts do not comply with the
requirements of the Act and for an order that the directors prepare
revised accounts. The Secretary of State may also authorise a person
for this purpose and, as noted, has authorised the FRRP to make such
applications. If the court finds against the company, it may order
that application costs and reasonable expenses of the company in
connection with preparing revised accounts be borne by the directors
who were party to approving the defective accounts.
Note that the power to apply to the courts relates to non-compliance with
the Act’s requirements rather than specifically with standards, raising
the question of the relationship between accounting standards and the
requirement for accounts to show a true and fair view. Below is the
professional opinion of Mary Arden QC:
Compliance with accounting standards will normally be

necessary for Financial Statements to give a true and fair view…
The requirement to give a true and fair view may in special
circumstances require a departure from accounting standards…
If in exceptional circumstances compliance with an accounting
standard is inconsistent with the requirement to give a true and
fair view, the requirement of the accounting standard should be
departed from to the extent necessary to give a true and fair view.
(Appendix to Foreword to accounting standards, ASB, 1993)
Mary Arden QC stated that whether accounts satisfy true and fair
requirements is for the courts to decide, but they will look to the practices
and views of accountants; the more authoritative these are, the more the
courts will be ready to follow them.
Just as a custom which is upheld by the courts may properly
be regarded as a source of law, so too, in my view, does an
accounting standard which the court holds must be complied
with to meet the true and fair requirement become, in cases
where it is applicable, a source of law in itself in the widest
sense of that term.
(Mary Arden QC, ‘The true and fair requirement’.)
1.9.2 The stock exchange and accounting in the UK

The London Stock Exchange also lays down regulations concerning listed
companies’ published accounts. The regulations require the provision of
more information, and more frequently, than either the law or the UK
ASB or the IASB requires. For example, companies are required to publish
interim accounts and provide more detail regarding certain liabilities (e.g.
bank loans).
In 1995 IOSCO agreed to a review of IASs, with a view to endorsing IASs
for cross-border offerings. Fourteen standards were rejected by IOSCO but
later revised by the IASB. IOSCO’s technical committee now ‘recommends
that its members allow multinational issuers to use IFRSs in cross-border
offerings and listings, as supplemented by reconciliation, disclosure and
interpretation where necessary to address outstanding substantive issues
at a national or regional level’ (IOSCO Technical Committee, ‘Statement on
the development and use of IFRSs in 2005’, February 2005, p.4).
24
The London Stock Exchange was regulated from 2000 to 2013 by the
Financial Services Authority, an independent body (if set up by the
Financial Services and Markets Act 2000).
UK-listed companies must also comply with the Corporate Governance
Code, which provides general guidance on governance and internal
control for organisations. Corporate governance has come under great
scrutiny following a string of high-profile corporate collapses such
as Enron and WorldCom, associated with fraud, abuse of managerial
power and social irresponsibility. This triggered accelerated reviews of
governance frameworks and engendered an increased number of practical
pronouncements. In the USA the Sarbanes-Oxley Act 2002 on corporate
governance was the most comprehensive law affecting accounting and the
audit profession since the Securities and Exchange Act 1934. By changing
guidelines into formal law, this represents a divergent emphasis from the
UK’s corporate governance model (Friedman and Miles, 2006, p.258).
Since 2005, listed companies in the EU have been required, as noted
above, to follow IASs/IFRSs in their published consolidated accounts.
1.9.3 UK Companies Act 2006

CA 2006, which became the largest Act ever passed by the UK Parliament,
implemented some of the proposals of the Company Law Review (see
Activity 1.4). It actually does not make changes of substance to the
accounting provisions in prior legislation, excepting that it does adopt a
different approach to how these provisions are presented. Part 15 of CA
2006 focuses on ‘Accounts and Reports’. Detailed accounting provisions
are no longer included in a Schedule as in CA 1985 but in the secondary
legislation of Statutory Instruments. Quoted or publicly traded companies
are identified as a category in such a way as to reflect the EU requirements
that these companies follow IASs/IFRSs. Companies other than publicly
traded companies can either follow CA 2006 (which also has smaller
company provisions – one of the things clarified and amended by Statutory
Instrument) plus the local UK accounting standards or they can also
follow the international accounting standards too.
The above indicates the complexity involved in accounting regulation as
reflected at the Nation State level, with reference to the UK. It remains
to be seen whether the vote to leave the EU will alter UK accounting
regulation substantially. The post-2006 regime received a shock with
the financial crisis that manifested only a few years later. There were
calls for stronger harmonisation globally and for a greater prescriptive
approach. The UK accountancy profession is not unanimous about such
issues but tends to support the international harmonisation project while
emphasising the case for a principles-based approach to accounting
regulation.
Activity 1.3
In the UK, the Stock Exchange was one of the earliest sources of rules and regulations
relating to financial statements. In many other countries, the rules and regulations of the
relevant stock exchange are important.
a. Why do stock exchanges take such an interest in rules and regulations relating to
financial statements?
b. What are the main requirements of the stock exchange in your country?
25
Activity 1.4
The Company Law Review was set up to examine the whole framework of company
law. Study its recommendations in Company law reform. Modern company law for a
competitive economy: developing the framework (www.berr.gov.uk/files/file23245.pdf).
A Companies Act was introduced in 2006. To what extent did it implement the
recommendations? What do you see as the major issues facing accounting regulation at
the Nation State level in future?
1.10 A reminder of your learning outcomes

Having completed this chapter, and the Essential reading and activities,
you should be able to:
• discuss the character and role of accounting in society
• explain the different levels of authority in the UK regulatory
framework
• explain and discuss the implications of the IASB
• discuss the arguments for and against accounting standards
• discuss accounting regulation.
1.11 Sample examination questions

Question 1.1
To what extent should accounting standards take economic consequences
into account? Discuss.
Question 1.2
What factors should be considered in deciding upon the form of
accounting regulation?
Question 1.3
Discuss both traditional and economic arguments for and against the
regulation of accounting.
26
Chapter 2: Conceptual framework
2.1 Introduction
This chapter considers what a conceptual framework is and then addresses
some of the key principles related to setting one up. These principles have
been examined by different groups of standard-setters around the world
(including in Australia, Canada, the UK and the USA). We shall look at
the UK Statement of Principles (SOP) and the US Concept Statements.
The ASB modelled the SOP on the IASB Framework for the Preparation
and Presentation of Financial Statements (FPPFS), which in turn was
based on the US conceptual framework. The IASB has been working on a
revised conceptual framework for some time and has issued a conceptual
framework in 2018 on its own. This framework is separate from the original
joint project it undertook with the FASB.

By the end of this chapter, and having completed the Essential readings
and activities, you should be able to:
• define a conceptual framework
• identify the main efforts by the USA, the IASC/IASB and the UK to
develop a conceptual framework
• describe the objectives of financial reporting as per the conceptual
frameworks produced
• explain the ‘ideal’ qualitative characteristics of accounting information
as suggested by these frameworks
• define assets and liabilities
• explain and describe recognition and measurement
• apply the conceptual frameworks to particular transactions; for
instance, would they help in deciding how to account for research and
development?

International financial reporting, Chapter 4.
2019) 19th edition [ISBN 9781292255996], Chapter 7.
IASB (2018) Conceptual Framework.
Ernst and Young (2018) IASB issues Conceptual Framework for financial
reporting. Available at https://www.ey.com/en_gl/ifrs-technical-resources/
iasb-issues-conceptual-framework-for-financial-reporting

Bromwich, M. Financial reporting, information and capital markets. (London:
Pitman Publishing, 1992) [ISBN 0273034642] Chapter 12. (Although this
focuses specifically on the FASB’s conceptual framework, it also discusses
a number of issues about the conceptual framework approach that can be
considered in relation to the IASB’s FPPFS and the ASB’s SOP.)
Macve, R. A conceptual framework for financial accounting and reporting:
the possibilities for an agreed structure. (London: Institute of Chartered
Accountants in England and Wales, 1981) [ISBN 0852913117] Reprinted
(New York: Garland, 1997).
27
Q1 Relevant IASC/IASB publications

Framework for the Preparation and Presentation of Financial Statements 1989.
IASB (2018) Conceptual Framework.
2.2 Definition of a conceptual framework

The quest for a conceptual framework for financial reporting has been
undertaken in several countries, with varying degrees of success in terms
of securing agreement. But what is a conceptual framework?
In the USA, one definition by the FASB is:
A conceptual framework is a constitution, a coherent system
of interrelated objectives and fundamentals that can lead to
consistent standards and that prescribes the nature, function
and limits of financial accounting and financial statements.
The ASB states that their Statement of Principles (SOP) (equivalent to the
US conceptual framework):
sets out the principles that the [ASB] believes should underlie
the preparation and presentation of general purpose financial
statements…A coherent frame of reference to be used by the
Board in the development and review of accounting standards.
Macve (1981) stated that a conceptual framework would:
provide a consistent approach for making decisions about
choices of accounting practice and for setting standards.
He also recognised, however, that it would be difficult to implement such a
framework.
All three definitions suggest that a conceptual framework provides an
explicit description of how accounting rules should be formulated and
the environment in which they apply. More specifically, a conceptual
framework is supposed to address some fairly fundamental questions
about accounting itself. For instance:
• What are the objectives of accounting?
• For whom and by whom are accountings required?
• What information do users of accountings require?
• What accountings would best satisfy these users’ needs?
• Do current accountings meet these requirements?
• How could current accountings be improved?
Although these questions are basic, to what extent have they been
addressed?
…the various standard-setting bodies around the world have too
often attempted to resolve practical accounting and reporting
through the development of accounting standards, without such
an accepted theoretical frame of reference.
(Ernst and Young, 2015)
It seems that too often standard-setting is reactive (to particular problems)
rather than proactive.
2.3 Rationale for a conceptual framework

The FASB states that the rationale for a conceptual framework is:
• to facilitate decisions on controversial accounting issues, providing
28
a clear basis for reaching conclusions that those with vested interests
would find hard to resist
• to provide a common framework of reference so as to avoid
both waste of effort in addressing such issues from first principles for
each specific standard and the dangers of inconsistency
• to reduce the need for many detailed standards on specific issues
by enabling accountants to resolve issues by reference to general
principles.
The rationale is common to the frameworks including that of the IASB.
One way of thinking about the conceptual framework is that it delineates
the objectives of the reporting and the characteristics of reporting that
should properly follow from those objectives.
2.4 Advantages claimed for a conceptual framework

According to the ASB SOP, a conceptual framework should:
• clarify the conceptual underpinnings of proposed accounting standards
• enable standards to be developed on a consistent basis
• reduce the need to debate basic issues each time a standard is
developed or revised
• help preparers and users of accountings understand the ASB’s
approach to setting standards and the nature and function of
information in general purpose financial statements
• help preparers and auditors with new issues to carry out initial
analysis in the absence of applicable accounting standards.
Other advantages claimed for a framework are that it:
• facilitates decisions on controversial items, by reducing the scope for
personal bias and political pressure
• may reduce the need for many detailed standards if accountants can
resolve issues by general principles
• limits the bounds of judgement and hence increases comparability
• may protect accounting from government intervention
• helps justify accounting practices when they are under attack in
the courts, if they can be shown to be consistent with a conceptual
framework.
Note that the advantages set out in the ASB SOP are common to the
conceptual framework projects.
2.5 The US, IASC/IASB and UK initiatives compared

In this section we consider briefly some important milestones in the
quest for a framework in the USA, the UK and internationally. You should
be aware of the main considerations of each initiative and the main
similarities and differences between each approach.
2.5.1 US initiative: FASB conceptual framework

FASB issued six concept statements in the late 1970s/early 1980s:
Statement of Financial Accounting Concept (SFAC) No. 1 Objectives of
Financial Reporting by Business Enterprises.
SFAC No. 2 Qualitative Characteristics of Accounting Information.
SFAC No. 4 Objectives of Financial Reporting by Non business Organizations.
29
SFAC No. 5 Recognition and Measurement in Financial Statements of

Business Enterprises.
SFAC No. 6 Elements of Financial Statements (replacing SFAC No. 3).
SFAC No. 7 Using Cash Flow Information and Present Value in Accounting
Measurements.
This chapter discusses four of these statements – 1, 2, 5 and 6 – which
address some of the key conceptual issues.
2.5.2 FPPFS 1989/Exposure Draft 2015

The IASC conceptual framework was introduced as an Exposure Draft
in May 1988 and a final statement in September 1989, in an attempt to
‘explain the conceptual framework that underlies the preparation and
presentation of financial statements’. Apparently modelled on the FASB
framework, it exhibits many of the strengths and weaknesses of that
earlier framework (see below).
Material on the objectives and qualitative characteristics was revised by
the IASB in 2010. This brought the framework even nearer to the FASB
framework as it reflected a joint project with the FASB (see below). In 2011,
a public consultation on the framework took place and a Discussion Paper
followed (in 2013). A draft revised framework was issued in the form of an
Exposure Draft in 2015, on which consultation closed in November 2015.
This Exposure Draft was eventually published as an IASB-only conceptual
framework in 2018.
2.5.3 UK: ASB’s Statement of Principles (SOP)

The ASB issued a Draft SOP, initially chapter by chapter but then as a whole,
for general comment. In 1996, some aspects of the Draft SOP attracted
adverse comment and as a result this framework was modified. The final
version of the SOP was agreed in October 1999, with acknowledgement
of its basis in the IASC’s Framework. It points out that the Board does not
regard the SOP as the final word on the principles underlying financial
reporting and that, as accounting thought is continually evolving, it may
need to be revised from time to time. Currently the SOP consists of eight
chapters:
1: The objective of financial statements
2: The reporting entity
3: The qualitative characteristics of financial information
4: The elements of financial statements
5: Recognition in financial statements
6: Measurement in financial statements
7: Presentation of financial information
8: Accounting for interests in other entities.
Although the main purpose of the SOP is to help set accounting standards,
the Introduction to it notes that, due to other considerations when setting
standards (including legal requirements and costs/benefits), a standard
may still adopt an approach different from that suggested by the SOP. The
SOP has not been developed within the constraints imposed by company
law so it may contribute to the future development of law.
30
2.5.4 IASB’s (2018) Conceptual Framework

The joint project between the IASB and FASB did not materialise in a
unified conceptual framework. The USA still has not adopted IFRS and
there were some that were unhappy with this state of affairs (i.e. lack of
harmonisation of accounting standards). The IASB decided to go on its
own and issue the Conceptual Framework (CF) in 2018. In contrast with
the UK ASB’s SOP, the 2018 CF has the following chapters.
Chapter Topic
1 The objective of general-purpose financial reporting
2 Qualitative characteristics of useful financial information
3 Financial statements and the reporting entity
4 The elements of financial statements
5 Recognition and de-recognition
6 Measurement
7 Presentation and disclosure
8 Concepts of capital and capital maintenance
The Ernst and Young (2018) summary of the IASB’s (2018) CF (available
at https://www.ey.com/en_gl/ifrs-technical-resources/iasb-issues-
conceptual-framework-for-financial-reporting) highlights some interesting
facts.
Chapter 1
In the (2018) CF, the IASB reintroduced stewardship in Chapter 1, a
concept that was removed from the (2010) CF – perhaps to align with the
American interpretation of the need for financial reporting to be decision-
useful (see International financial reporting, p.75 for further discussions on
decision-usefulness theory).
See https://www.youtube.com/watch?v=7wMWcRpCqz8 for an
overview of the FASB’s conceptual framework. For discussions of decision-
usefulness, this is about two minutes into the video.
Chapter 2
The (2018) CF, Chapter 2 clarified what ‘prudence’ means, which is to
support the ‘neutrality’ of information and the ‘exercise of caution when
making judgements under conditions of uncertainty’. In other words,
it does not mean that prudence is to always adopt a ‘conservative’
stance (i.e. recognise uncertain expenses but not uncertain revenues, or
systematic asymmetry). The concept of ‘substance over form’ (relevant
for leasing and for the treatment of certain liabilities such as preference
shares, for example) was also clarified as being a component of ‘faithful
representation’.
Chapter 3
Chapter 3 is a new chapter that aims to define the reporting entity’s
(accounting) boundaries and suggests (but not enforce or coerce) that
entity into preparing financial statements. In contrast, the older ASB SOP
does not define the entity but discusses the qualitative characteristics of
financial information.
Chapter 4
Chapter 4 of the (2018) CF has significantly changed the definition of
what is an asset, liability and equity. Compare the (2010) with the (2018)
31
IASB CF. This comparison is taken from International financial reporting,

Table 4.1 (p.79). You can also read the ACCA’s and EY’s comparison of
the definitions of assets and liabilities in Chapter 4 here (among other
discussions on the CF).
https://www.accaglobal.com/gb/en/student/exam-support-resources/
professional-exams-study-resources/strategic-business-reporting/technical-
articles/conceptual-framework.html
2010 CF (IASB) 2018 CF (IASB)

Asset Economic resources controlled by the An asset is a present economic
entity as a result of past transactions resource controlled by the entity as
or events and from which future a result of past events (Para.4.3). An
benefits are expected to flow to the economic resource is a right that has
entity (para.4.4a) the potential to produce economic
benefits (para.4.4)
Liability A present obligation of the entity A liability is a present obligation of
arising from past events, the the entity arising to transfer an
settlement of which is expected economic resource as a result of
to result in an outflow from past events (para.4.26)
the entity of resources embodying
economic benefits (para.4.4b)
Equity Equity is the residual interest in the Equity is the residual interest in the
assets of the entity after deducting all assets of the entity after deducting
its liabilities (para.4.4c) all its liabilities (para.4.63)
In terms of asset definitions, a more deterministic word (expected) is
being replaced by a softer, more ambiguous word (potential). This could
broaden the definition of an asset given that economic benefits are no
longer expected to flow to the entity.
In terms of liability definition, ‘to transfer’ is more definitive compared
with ‘expected to result in an outflow’. This provides greater clarity of
what a liability is, which is to transfer economic resources rather than
reduce (through outflows) of economic benefits.
There are no changes in the definition of equity, as the residual interest
in assets after deducting liabilities.
2010 CF (IASB) 2018 CF (IASB)

Income Increases in economic benefits Income is increases in assets or
during an accounting period decreases in liabilities, other than those
in the form of inflows or relating to contributions from holders of
enhancements of assets equity claims (para.4.68)
other than those relating to
contributions from equity
participants (para.4.25)
Expenses Decreases in economic benefits Expenses are decreases in assets or
during the accounting period in increases in liabilities, other than those
the form of outflow or depletion relating to distributions to holders of
of assets or incurrences of equity claims (para.4.69)
liabilities that result in decreases
in equity, other than those
relating to distributions to equity
participants (para.4.25)
Definitions of income and expenses has changed to reflect the new
definitions of an asset and a liability. The new definitions are more
parsimonious.
32
Chapter 5
The guidance provided on de-recognition of assets and liabilities is new.
According to EY (2018), this can be interpreted as the IASB endorsing both
the ‘control’ approach and the ‘risk and rewards’ approach as being valid.
Chapter 6
Two different measurement bases were identified – historical cost and
current value. Historical cost here is taken to include modified historical
cost, meaning that such values can be updated over time. Current values
(which are discussed in other chapters of this module) meanwhile can
include:
• fair value
• value in use
• fulfilment value
• current cost.
Chapter 7
The requirement here is that all income and expenses are to be included in
the profit or loss statement. The CF does not give specific guidance on what
items to be included in ‘other comprehensive income’ or whether such items
should subsequently be recycled. For more information on the concept of
recycling, please consult:
https://www.accaglobal.com/lk/en/student/exam-support-resources/
professional-exams-study-resources/strategic-business-reporting/technical-
articles/pl-concepts.html
Chapter 8
This chapter is largely unchanged from the IASB (2010) CF, but is different
to the ASB’s SOP. The argument here is relevant for the study of Chapters
7 and 8 of this course. Concepts of maintaining nominal financial capital
(e.g. historical cost), real financial capital (e.g. current purchasing power in
Chapter 7) and physical capital (e.g. current or replacement cost in Chapter
8) are discussed in the (2018) CF.
2.6 Objectives of financial reporting

The underlying objective of all the conceptual frameworks discussed
above in relation to accounting is to provide useful information so users
can make business and economic decisions. This is sometimes contrasted
with what is seen as an alternative objective – to provide information on
how the business has carried out its stewardship responsibilities. There
is an overlap, however, between these objectives. One may argue that
information about historical stewardship, or accountability for past actions,
is relevant for decision making and control and indeed the rationale for it
may be expressed in these terms. Nevertheless, the objective promoted in
the conceptual frameworks is not as restricted. In principle, it goes beyond
history, stewardship and accountability without limit. This freedom results in
threats as well as opportunities for and through accounting.
Decision usefulness appears to be a reasonable objective, if it should be
considered in relation to the imperfect nature of the context discussed
earlier. Two questions are asked:
1. Who are the users?
2. What type of information do they need?
33
In the case of the FASB, the statement identifies many potential users
and their interests, but argues that those most directly concerned with
a business share a common interest in the company’s ability to generate
favourable cash flows. In developing objectives for general-purpose
external financial reports, the statement focuses on the needs of investors
and creditors (though it suggests that information prepared to meet
these needs is likely to be generally useful to other groups which have
substantively the same interest) and argues that:
Financial reporting should provide information that is useful
to present and potential investors, creditors and other users in
making rational investment, credit and similar decisions.
Its principle conclusion is:
Financial reporting should provide information to help
investors, creditors and others assess the amounts, timing
and uncertainty of prospective net cash flows to the related
enterprise.
The SOP requires that financial reports provide information about:

• an enterprise’s economic resources, its obligations and owners’ equity
• enterprise performance and earnings
• liquidity, solvency and funds flow
• management stewardship and performance.
It notes in relation to its requirement for information about enterprise
performance that:
…interest in an enterprise’s cash flows and its ability to
generate favourable cash flows leads primarily to an interest in
information about its earnings rather than information directly
about its cash flows… Information about enterprise earnings
and its components measured by accrual accounting generally
provides a better indication of enterprise performance than
information about current cash receipts and payments.
The FASB then asserts that what investors want are balance sheets
and income statements: inductively from the fact that this is what they
currently actually get and politically because the FASB has no intention of
undermining the very basis of present practice and thus has rationalised
accrual accounting. However, the FASB has actually steered away from
trying to identify the kind of information that may assist users (e.g. current
value information, management forecasts).
The SOP states that the objective is to provide information about an
entity’s financial performance and position that would be useful to a wide
range of users in assessing the stewardship of managers.
The ASB has selected the investor’s perspective as the one most likely to
help in the preparation of general-purpose financial statements. It states
that, while recognising a large number of potential users of financial
statements, who usually require different information for the different
decisions they must make, a statement based on such a perspective focuses
on the common interest of all users – the entity’s cash-generating ability
and financial adaptability. It therefore focuses on present and potential
investors as the defining class of user, arguing that in meeting their needs
financial statements will meet the common needs of other users. It notes
that information that is not needed by investors need not be given in the
financial statements.
34
The SOP details the information required by investors, which is very

similar to the FASB, and is said to comprise the following:
• In relation to financial performance: the return obtained on its
resources, the components of that return and the characteristics of
those components.
• In relation to financial position: the economic resources controlled by
the entity, its financial structure, liquidity and solvency, risk profile and
risk management approach, and capacity to adapt to changes in the
environment.
• Information about the generation and use of cash, this providing for a
further perspective on financial performance or activity.
2.6.1 Commentators on the objectives

Many practitioners and academics have commented on the above
approaches. For example, Bromwich (1992) pointed out that in the
FASB’s conceptual framework the emphasis was strongly on information
for decision making. The same applies to the SOP. Depending on how
information for decision making is understood and how stewardship is
understood, it is possible that information useful for decision-making
purposes may not be useful for assessing stewardship. The ASB defines
stewardship broadly so as to include accountability not only for the
safekeeping of the resources, but also for their proper, efficient and
profitable use. It therefore involves an economic decision on whether
(for example) to hold or sell shares and to reappoint or dismiss the
management. Some would take a narrower view of stewardship and the
information deemed useful by the ASB may not stretch to this specific.
Similarly, by focusing on the assumed common need, does the FASB ignore
the possibility of differing (and possibly conflicting) needs of different
users? In focusing in particular on investors and creditors, many other
groups could be harmed by standards promulgated to meet the needs of
these particular groups. This is the ‘social choice’ problem.
As Macve (1981) stated:
[R]ecognition of the variety of users’ needs and of conflicts
between different rights leads to the view that reaching
agreement on the form and content of financial statements is
as much a ‘political’ process, a search for compromise between
different parties, as it is a search for the methods which are
‘technically’ best.
Activity 2.1
Do you think that the investor’s perspective is the most appropriate?
With reference to a selected ‘conceptual framework’, satisfy yourself that you are aware
of the range of stated objectives of accounting.
2.7 Qualitative characteristics of accounting

Although most conceptual frameworks identify many of the same
qualitative characteristics of accounting, the hierarchy of these
characteristics might vary. The overriding concern is that the information
provided to users should be useful in relation to their decision-making
process. To ensure that it is useful, this information should have certain
characteristics, for example:
35
• relevance
• reliability
• comparability
• understandability.
The IASB stresses ‘faithful representation’ and ‘relevance’ in its framework.
The FASB, in SFAC 2 Qualitative Characteristics of Accounting Information,
examines the characteristics that make accounting useful, establishing a
‘hierarchy of accounting qualities’ (see Figure 2.1).
Users of accounting Decision makers
information and their characteristics
Pervasive Benefit > Cost

constraint
User-specific Understandability
qualities
Decision usefulness
Primary
decision-specific Relevance Reliability
qualities
Ingredients
of primary Predictive Feedback Timeliness Verifiability Representational
qualities value value faithfulness
Secondary and
interactive Comparability Neutrality
qualities (including consistency)
Threshold for
recognition Materiality
Figure 2.1: FASB’s hierarchy of accounting qualities.
Similarly, the ASB, in Chapter 3 of the SOP, sets out the qualitative
characteristics of useful financial information in a diagram which is more
detailed than the FASB’s but based on the same characteristics discussed
above (see Figure 2.2).
What makes financial information useful?
Giving information that is not
Threshold quality MATERIALITY material may impair the usefulness
of the other information given
RELEVANCE RELIABILITY COMPARABILITY UNDERSTANDABILITY
Information that Information that is a Similarities and The significance of the

has the ability to complete and faithful differences can be information can be
influence decisions representation discerned and evaluated perceived
Predictive Confirmatory Faithful Neutral Free Complete Prudence Consistency Disclosure User’s Aggregation
value value representation from abilities and
material error classification
Figure 2.2: ASB’s qualitative characteristics of useful financial

information.
36
The various terms used in the two figures are discussed below.
2.7.1 Materiality
To begin with there must be some assessment of whether the information
is material (i.e. could this information influence users’ decisions?).
Materiality is viewed as a threshold characteristic because if any
information is immaterial then users are not interested in it whatever
other characteristics it has. Immaterial information should not be given
as this may impair understanding of the financial statements. But what is
material? Does the assessment of materiality vary between users?
2.7.2 Relevance
The FASB defines relevance as the capacity of information to make a
difference in a decision by helping users to form predictions about the
outcomes of past, present and future events to confirm or correct prior
expectations. Similarly, the ASB defines relevant information as that which
is able to ‘influence the economic decisions of users and is provided in
time to influence those decisions’.
2.7.3 Reliability
The ASB states that reliable information is:
• faithful representation (i.e. it can be depended upon to represent what
it purports to represent or could reasonably be expected to represent –
reflects the substance of a transaction or event)
• free from deliberate or systematic bias (i.e. is neutral)
• complete and free from material error
• prepared on a prudent basis (i.e. under conditions of uncertainty,
a degree of caution has been exercised in making the necessary
judgements or estimates).
The FASB states:
To be reliable, financial statements must portray the important
relationships of the firm itself. Information is reliable if it is
verifiable and neutral and if users can depend on it to represent
that which it is intended to represent.
2.7.4 Comparability
The ASB states that comparability enables users to discern similarities
and differences in the effect and nature of transactions and events
between entities, and over time for the same entity (very similar to the
FASB definition). It requires consistency and disclosure of accounting
policies. The SOP notes, however, that consistency should not prevent the
introduction of improved accounting policies.
2.7.5 Understandability
To be useful, information must be understandable. This depends on how
it is aggregated, classified and presented, and on the ability of users (who
are presumed to have reasonable knowledge of business and accounting
and are prepared to study the information with reasonable diligence).
2.7.6 Conservatism/prudence
In the FASB hierarchy of accounting qualities, conservatism does not
appear within the diagram, unlike prudence for the ASB. The FASB
statement notes there is a place for conservatism, but that if it is not
37
applied with care it may conflict with qualitative characteristics such

as neutrality and representational faithfulness by introducing bias.
Conservatism should not imply deliberate, consistent understatement of
profit and net assets; rather it requires that adequate consideration be
given to the risks and uncertainty attached to business situations. Similarly,
the ASB states that prudence is only necessary in conditions of uncertainty
and should not be used for deliberate overstatement of liabilities/losses
or understatement of assets/gains, nor to create excessive provisions of
hidden reserves.
The (2018) CF Chapter 2 clarified what ‘prudence’ means, which is to
support the ‘neutrality’ of information and the ‘exercise of caution when
making judgements under conditions of uncertainty’. In other words,
it does not mean that prudence is to always adopt a ‘conservative’
stance (i.e. recognise uncertain expenses but not uncertain revenues, or
systematic asymmetry).
2.7.7 Trade-off between relevance and reliability

Both statements highlight the trade-offs that must be made between
relevance and reliability. The ASB states that where there is conflict ‘it will
usually be appropriate to use the information that is the most relevant of
whichever information is reliable’. However, financial information should
not be provided until it is reliable. But how is one to assess which is ‘most
relevant’? What if, for example, one method has greater predictive value
but another greater confirmatory value? Neither statement helps the
reader to determine how to make these trade-offs. What if different users
have different preferences? Bromwich (1992) points to the problem of
identifying characteristics for accounting that are utility- or value-free.
2.7.8 Further comments

Does spelling out what is meant by ‘useful’ get us very far? For Macve
(1981): ‘many other studies have identified desirable attributes but have
not led to greater agreement in practice about particular problems and it
shifts the area of disagreement from “is this information useful?” to “is this
reliable?” or “is this relevant?” and may merely lead to “word-shuffling”.’
But the analysis may help us identify some reasons for disagreement (e.g.
‘this proposed treatment does not have predictive value/confirmatory
value/faithful representation’).
It has been suggested that the definition of ‘reliable’ is circular:
information is reliable if it can be depended upon to represent what it
purports to represent (i.e. it is reliable if it is reliable).
Bromwich (1992) points to two problems with the use of predictive value
in the FASB conceptual framework projects:
1. It has not made explicit the decision model it sees investors using.
2. It has not shown how accounting information can obtain predictive
value.
Activity 2.2
1. Often an accounting standard will have to make a trade-off between reliability and
relevance:
a. What is the difference between reliability and relevance?
b. How should accounting standards rank these two qualitative characteristics?
c. Which user groups need to be considered when determining the relative
importance of reliability and relevance?
38
2. Other qualitative characteristics might be important. Discuss how timeliness,

objectivity, verifiability and neutrality might fit in with characteristics we have
described already.
3. The benefits from reporting accounting information should exceed the costs. How
easy (or difficult) do you think it is to quantify the costs and benefits of an accounting
item?
2.8 Further comments

Are the definitions useful, given that they are sufficient but not necessary
conditions for the inclusion of an item in the financial statements?
Macve (1981) points out that the definitions are so general that they are
unlikely to exclude anything that one might reasonably want to include.
Indeed, the FASB statement itself points out that it expects most assets
and liabilities in the present practice to continue to qualify as assets or
liabilities under the definitions, and that the definitions neither require nor
presage upheavals in present practice.
Note that these definitions do not depend on legal enforceability. But how
far removed from a legal one might a right or claim be? Is it a question of
the probability of future benefits or sacrifice of future benefits? But how
probable is probable? (The FASB statement notes that probable is used
with its ‘usual general meaning’, referring to ‘that which can reasonably
be expected or believed on the basis of available evidence or logic but is
neither certain nor proved’.) What is a past transaction? What gives rise to
the existence of an asset or liability?
These are some of the recognition problems that the statements do not
help with, but which are particularly important for executory contracts
– that is, a promise for a promise (e.g. an agreement to sell goods at a
future date for payment at a future date). The ‘Elements’ chapter in the
ASB statement says that rights and obligations under such unperformed
contracts represent a single asset or liability (‘a net position comprising
a combined right and obligation either to participate in the exchange or
alternatively to be compensated (or to compensate) for the consequences
of the exchange not taking place’), and initially the rights and obligations
are likely to be exactly offsetting, though often that will not remain
the case. In the chapter on ‘Recognition’, the ASB notes that changing
circumstances may cause an imbalance to arise, in which case the net
position will either be an asset or a liability and will be recognised if the
recognition criteria are met. It states, however, that where such an asset
or liability exists, if the historical cost basis of measurement is being used,
the carrying value will be the cost of entering into the agreement, which is
usually nil. In effect the contract is recognised at nil.
Macve concludes that it is difficult to understand why the FASB should
think these definitions helpful in analysing and resolving new accounting
issues as they arise.
Activity 2.3
What do the definitions of assets and liabilities above actually mean? Explain in your own
words.
39
2.9 Recognition and measurement in financial

statements
2.9.1 Recognition
Recognition deals with those items that should appear in financial
statements. The ASB states:
The objective of financial statements is achieved to a large
extent through depicting in the primary financial statements, in
words and by a monetary amount, the effects that transactions
and other events have on the elements. This process is known as
recognition.
The initial recognition criteria for an element (see Section 2.8) in the SOP
are that:
• There is sufficient evidence the change in assets or liabilities inherent
in the element has occurred (including, as appropriate, evidence that a
future beneficial inflow or outflow will occur).
• The element can be measured as a monetary amount with sufficient
reliability.
Similarly, the FASB sets out four fundamental recognition criteria:
1. meeting the definition of an element
2. measurability – having a relevant attribute which is measurable with
sufficient reliability
3. relevance
4. reliability.
The ASB’s SOP points out that although the starting point for the
recognition process may be the effect on assets and liabilities, the notions
of ‘matching’ and the ‘critical event’ may help in identifying the effects.
However, the SOP emphasises that ‘matching’ is not used to drive the
recognition process. It seeks to prevent unrestricted use of the matching
concept – otherwise it would be possible to delay recognition in the
performance statement of most items of expenditure whose hoped-for
benefits lay in the future. It restricts this by allowing only items that meet
the definition of assets, liabilities and ownership interest to appear in the
balance sheet. Thus, expenditure or losses not associated with control of
rights or other access to future economic benefits will be recognised as a
loss in the period in which they are incurred; and expenditure incurred
with a view to future economic benefits where the relationship is too
uncertain will be recognised as a loss immediately. However, it recognises
that, for example, if future economic benefits are eliminated over several
accounting periods, the cost of the asset that comprises those benefits will
be recognised as a loss over the same accounting periods.
The SOP suggests that focusing on the critical event in the operating cycle
may make it easier to identify gains arising from the provision of goods
and services; this will be the point at which there is sufficient evidence
that the gain exists and it can be measured reliably. This need not be at
the time of full performance. The statement suggests that a contract to,
for example, build large buildings might involve performing a series of
stages for each of which there is a critical event. It suggests that ‘in such
circumstances the gain that is expected to be earned on the contract as a
whole will need to be allocated among the critical events’.
40
The concept of realisation does not appear among the criteria for
recognition in the SOP. In Appendix III the Board points out that, over
time, even wider notions of ‘realisation’ have become irrelevant and, rather
than choosing to ‘bend a term so that it has meaning other than its natural
meaning’, the Board has chosen to focus on the underlying objective of
recognising a gain only if there is reasonable certainty that it exists and
can be measured reliably. ‘Although the realisation notion is one means of
determining whether the existence of a gain is reasonably certain…in the
Board’s view it is not necessarily the best way.’ In Appendix I the Board
points out that although this appears to conflict with the Companies Act
(which states that only profits realised at the balance sheet date may be
included in the income statement), ‘the way in which the Act defines a
realised profit means that the exact effect of this difference is not clear’.
However, the FASB states that to recognise revenues and gains the items
should be (a) realised or realisable and (b) earned.
Activity 2.4
What typically gives rise to ‘change’ needing to be considered for recognition?
If there is a change in an asset which is not offset by a change in a liability then where
should the gain or loss be recognised? What are the conditions under which gains can be
recognised in the income statement either in the UK or internationally?
2.9.2 Measurement
Assuming that financial items satisfy the recognition criteria, at what
amount should they be recorded in the financial statements? Should
they be at cost, at market value or at some other amount? There are a
number of different theoretical approaches to measurement, for example
replacement cost or deprival value. Many of the different approaches
are reviewed in this subject guide. The underlying argument regarding
measurement is that there is no single valuation method that can
meet all financial reporting purposes in all circumstances.
In the USA, SFAC No. 5 dealt more with current practices than actual
recommendations (it received much criticism). For instance, it did
not prescribe a particular measurement attribute to be used in given
circumstances. Instead it listed five measurement attributes used in
practice:
• historical cost
• current cost
• current market value
• net realisable value
• present value of future cash flows.
It concluded that ‘rather than attempt to select a single attribute and
force changes in practice…this statement suggests that use of different
attributes will continue’. It notes that an ideal measuring unit would be
stable over time but that at times of low inflation nominal units of money
are relatively stable; ‘the Board expects that nominal units of money will
continue to be used to measure items recognised in financial statements’
but suggests that this might change if increased inflation led to ‘intolerable’
distortions. This is similar to the ASB who note that although most
financial statements are prepared using the financial capital maintenance
concept and measured in nominal units, adjustments will be needed if the
problem of general price change is acute, and if the problem of specific
41
changes is acute ‘it will be necessary to adopt a system of accounting

that informs the user of the significance of specific price changes for the
entity’s financial performance and financial position’. Compare the FASB’s
approach with Chapter 6 of the IASB (2018) CF above.
Little in the FASB statement is likely to lead to a change from existing US
practice. Indeed, it largely reaffirms it. Para.2 notes that ‘the recognition
criteria and guidance in the Statement are generally consistent with
current practice and do not imply radical change’ (it notes the possibility
of future change is not foreclosed (see also in para.91)).
However, the ASB state, in Chapter 6 of the SOP, that the measurement is
based on the assumption that a ‘mixed measurement’ approach (often
referred to as ‘modified historical cost’)1 will be adopted, whereby some 1
The ASB (1999) stated
items will be measured at historical cost and others at current value: ‘the that although the
measurement basis
basis selected will be the one that best meets the objective of financial
noted above is often
statement and the demands of the qualitative characteristics of financial referred to as the
information bearing in mind the nature of the assets or liabilities ‘modified historical
concerned and the circumstances involved.’ cost basis’, it is more
accurately referred to as
Following initial recognition, items will be re-measured, as necessary, to the ‘mixed measurement
ensure that items measured at historical cost are carried at the lower of system’.
cost and recoverable amount, and items shown at current value are kept
up-to-date.
The statement asserts that ‘current value is at its most relevant when it
reflects the loss that the entity would suffer if it were deprived of the asset
involved’ and therefore advocates a measurement basis known as ‘value to
the business’ or ‘deprival value’, depicted diagrammatically in Figure 2.3.
Value to the business

= lower of:
Replacement cost and Recoverable amount

= higher of:
Value in use and Net realisable value

Figure 2.3: ‘Value to the business’ or ‘deprival value’.
The SOP notes that the ‘relief value’ of a liability may be selected in a
similar manner.
It stops short of advocating a move towards current value accounting:
[I]t says nothing about the desirability or otherwise of adopting
an approach that involves all balance sheet items being
measured at current value, just as it says nothing about the
desirability or otherwise of adopting an approach that involves
all balance sheet items being measured at historical cost. All it
does say is that both these approaches would involve a radical
change to existing practice.
(ASB, 1999)
However, in discussing the choice of a measurement basis it makes the
following points:
• As markets develop, measurement bases once thought unreliable may
become more reliable.
42
• The need for relevant information means that the measurement basis
should be one that provides information useful for assessing the
entity’s ability to generate cash flows and its financial adaptability.
• If both historical cost and current value measures are available, the
better one to use will be the one that is more relevant.
• Current value measures are not necessarily less reliable than historical
cost measures; for example, provisions for bad and doubtful debts
under historical cost accounting involve estimates similar to (and of
similar reliability to) those involved in ascertaining current values not
derived from an active market.
• ‘Assessment of relevance and reliability needs to take into account
what the asset or liability represents.’ It suggests that an investment
which represents a ‘store’ of spare cash will best be measured at
current value since its relevance to the entity will be the future cash
flows that it represents the right to.
An earlier Exposure Draft of the SOP was criticised by many as being an
attempt to introduce a current cost accounting system. The SOP appears
to play down the importance of fully blown, current-cost systems by
suggesting that a mixed measurement system will continue to be used,
though it refers to many advantages of current value. It refers to choosing
the most relevant basis when both historical cost and current value are
available and reliable, and the need to choose a measurement basis
according to the nature of the assets, the particular circumstances, the
objectives of financial statements and the qualitative characteristics of
financial information. But can the mixed measurement system be justified
in terms of ‘principles’? It also raises questions of comparability. Baxter
comments that ‘such muddled figures hardly add to accounting dignity’
(Accountancy, October 1999).
2.10 Presentation of financial information

Chapter 7 of the SOP discusses the financial statements and the
presentation of financial information. It identifies what constitutes good
presentation in the:
1. statement of financial performance (the components of performance
and their characteristics – ‘their nature, cause, function, relative
continuity or re-occurrence, stability, risk, predictability and
reliability’)
2. statement of financial position (the types and functions of assets and
liabilities and the relationships between them)
3. cash flow statement (distinguishing in particular cash flows from
operating activities, and those from other activities).
It notes the importance of aggregation, interpretation and simplification
in portraying items in financial statements, to avoid excessive detail
obscuring the message; the notes to the accounts should be used to
amplify and explain the statements.
2.10.1 Accounting for interests and other entities

Chapter 8 of the SOP discusses how different investments in other entities
should be reflected in a single entity’s accounts and in consolidated
accounts. This involves issues, such as accounting for business
combinations and entities over which there is significant influence, which
are considered, in Chapter 5 of this guide.
43
2.10.2 Review of the conceptual framework

The IASB produced a Discussion Paper in 2006 – Preliminary views on an
improved conceptual framework for financial reporting. Subsequently, an
Exposure Draft (with the same name) was issued in 2008. It was part of a
series of initiatives developed jointly by the FASB and the IASB to provide
a foundation for principles-based and converged standards. The focus is on
information for providers of capital and substantively it is wedded to the
conventions of previous influential frameworks.
Relevance and faithful representation are classified as fundamental
qualitative characteristics. Faithful representation is meant to replace
reliability – and hence is controversial, depending upon how it is
interpreted. Comparability, verifiability, timeliness and understandability
are classified as enhancing qualitative characteristics.
Specific attention is directed to ‘constraints of financial reporting’:
• Materiality: the report should not be cluttered with immaterial
information: information is understood as material if its omission or
misstatement would influence user decisions.
• Costs: Benefits of financial reporting should be greater than costs.
The emphasis on decision-usefulness is controversial for those who
recognise the need to constrain disclosure in an imperfect markets context
or who fear that the stewardship dimension might be overlooked. Some
believe stewardship should be specifically referred to, perhaps even as a
separate objective.
A further Exposure Draft in relation to this project was issued in 2010.
This focused on the development of a reporting entity concept. This is
again from the perspective of providers of capital seeking information
they do not have about a ‘circumscribed area of business activity’. We shall
consider the reporting entity concept further in Section 16.3 in relation
to consolidated group accounts. Material on objectives and qualitative
characteristics was revised by the IASB in 2010, again reflecting the joint
project with the FASB.
Discussion on other areas, including elements and recognition, and
measurement, continued.
In 2011 there was a public consultation on revising the conceptual
framework, followed by a new Discussion Paper published in July
2013. An Exposure Draft towards a revised conceptual framework was
published by the IASB in 2015 and comments were invited on this up
until November 2015. At the time of writing, another revised version
is anticipated (http://archive.ifrs.org/Current-Projects/IASB-Projects/
Conceptual-Framework/Pages/Conceptual-Framework-Summary.aspx)
The global financial crisis, which is commonly understood as beginning
in 2008, has shaped the debates and probably contributed to the delay
in the revision of the IASB’s conceptual framework. The crisis has
added to calls for more effective international harmonisation, with the
debate on whether this should be more prescriptive or more principles-
based continuing. Some have worried about the emphasis on fair
value accounting and have sought to modify that. This has arguably
had some impact on the construction of the 2015 Exposure Draft. The
underlying normative perspective that manifested in the promotion of
fair value is that accounts should better represent the value of the firm
in mainstream economic terms. Here, current value approaches and,
more fundamentally, the present value construct are emphasised. For
44
firm value that might be expressed by market capitalisation and share

prices quoted on stock exchanges, the market value (or present value
from sale) is deemed to approach the underlying present value construct.
The fair value approach, which gives relative emphasis to the statement
of financial position, was promoted by its advocates as better serving
the purpose of satisfying investor wants from accounting information.
Some commentators (admittedly few) actually forecast before 2008
that the fair value emphasis would make a financial crisis more likely
by increasing the volatility of reported accounting numbers. After 2008,
more have taken the view that fair value accounting is problematic in
this regard. While such commentators (especially those blaming the crisis
on fair value accounting) are still in the minority, the argumentation has
arguably impacted on the 2015 Exposure Draft. The debate about giving
greater emphasis to stewardship concerns has been reinvigorated. In the
Exposure Draft (and reflecting sound logic, at least indirectly), the IASB
have acknowledged that the information required to satisfy investors
includes information that can be used to help assess management
stewardship. The Exposure Draft also clarifies a role for prudence in
financial reporting (some saw prudence being de-emphasised with the fair
value orientation). The Exposure Draft also acknowledges that a high level
of measurement uncertainty (which some see as being associated with fair
value accounting) can actually make financial information less relevant (as
well as less reliable). There is also in this respect a clarification of the role
of probability in the definition of assets and liabilities. Definitions of assets
and liabilities impacting on decisions on recognition and measurement
ought to be driven, according to the Exposure Draft, by considering the
impact on the statement of financial performance as well as financial
position. At the same time, the Exposure Draft also attempts to clarify the
significance of the construct substance over form for financial reporting.
Activity 2.5
How might a conceptual framework be used to counter lobbying by pressure groups
whenever a new (contentious) accounting standard is proposed?
Contrast the UK approach to standard-setting (often allowing choices of accounting
method) with the US approach (more detailed, specific).

Having completed this chapter, and the Essential readings and activities,
• define a conceptual framework
• identify the main efforts by the USA, the IASC/IASB and the UK to
introduce a conceptual framework
• describe objectives of financial reporting as per the conceptual
frameworks produced
• explain the ‘ideal’ qualitative characteristics of accounting information
as suggested by these frameworks
• define assets and liabilities
• explain and describe recognition and measurement
• apply the conceptual frameworks to particular transactions; for
instance, would they help in deciding how to account for research and
development?
45

Question 2.1
Select a ‘conceptual framework’ that is most relevant to your country
or the country in which you are studying (e.g. FASB, IASC/IASB, ASB).
Discuss the main arguments in favour of and against a conceptual
framework in general and the strengths and weaknesses of the particular
framework that you have selected.
Question 2.2
The FASB’s conceptual framework was expected to:
• guide the body responsible for establishing standards
• provide a frame of reference for resolving accounting questions in the
absence of a specific promulgated standard
• determine bounds of judgement in preparing financial statements
• increase users’ understanding of, and confidence in, financial
statements
• enhance comparability.
How feasible do you think are all of these expectations? What difficulties
can you identify that the FASB might have in their attempt to satisfy all
five expectations?
Question 2.3
What are the main arguments for and against regulating accounting
information provision? Explain how a conceptual framework might helo to
improve standard setting.
Question 2.4
The revised IASB (2018) Conceptual Framework endorses both a ‘control’
approach and a ‘risk and rewards’ approach as being valid.
How do these approaches differ in the definition of a leased asset?
A solution is provided in Appendix A.
46
Chapter 3: Preparation and presentation of financial statements
Chapter 3: Preparation and presentation

of financial statements
3.1 Introduction
3.1.1 Aim of the chapter
This chapter is concerned with the preparation and presentation of
financial statements. Throughout this chapter, you will find it helpful to
refer to the accounts of a real world organisation. We suggest that you use
the Marks and Spencer annual report for the current year for this purpose:
http://annualreport.marksandspencer.com

• elaborate upon what the standards of the International Accounting
Standards Board (IASB) prescribe in relation to the preparation and
presentation of financial statements
• explain the basic character in this context of the statement of
financial position, the statement of income, the statement of other
comprehensive income, the statement of changes of equity and the
notes to the accounts.

International Financial Reporting, Chapter 8.
2019) 19th edition [ISBN 9781292255996] Chapter 3.
Relevant IASB standard

IAS 1 Presentation of financial statements.
See also IFRS 5 Non-current assets held for sale and discontinued operations.
3.2 IAS 1
International Accounting Standard 1 (IAS 1), the current version issued in
2007 (with some provisions mandatory at a later date) and last amended
in 2011, sets out the minimum requirements in respect of the content of
financial statements and provides guidelines for the presentation of those
financial statements. It is applicable for financial statements based on
international standards. It states that:
• Financial statements should normally be presented for a 12-month
period (and at least annually). Exceptions to this should be explained.
• Financial statements claiming to follow IASs/IFRSs have to be clearly
distinguished from any other information included in the same
published document.
It includes prescription in relation to key statements including the
statement of financial position, the statement of income, the statement of
comprehensive income and the statement of changes of equity.
47
3.3 Comparative information

IAS 1 requires the disclosure of comparative information in respect of
the previous period for all amounts reported in the financial statements,
both on the face of the financial statements and in the notes, unless this
contradicts clearly the requirements of another international accounting
standard.
Comparative information is provided for narrative and descriptive
elements where it is relevant for understanding the financial statements of
the current period.
3.3.1 Statement of financial position

IAS 1 was amended after its initial issue, and the term ‘balance sheet’
that was previously used in IAS 1 was changed to ‘statement of financial
position’. In the statement of financial position, an entity must normally
classify assets into current and non-current and must not set off assets
against liabilities (an alternative is to present assets in terms of their
liquidity – some emphasis is placed upon expected settlement within 12
months – but only where this leads to reliable information that is ‘more
relevant’).
Current assets are assets that meet at least one of the following conditions:
• expected to be realised in the entity’s normal operating cycle
• held primarily for the purpose of trading
• expected to be realised within 12 months after the end of the reporting
period
• cash and cash equivalents (unless restricted in use).
Note that this is a departure from what had become the conventional way
of defining current assets (where reference is made to settlement being
expected within one year).
Other assets are non-current assets.
A liability is to be classified as current when it satisfies any of the following
criteria:
• expected to be settled in the entity’s normal operating cycle
• held primarily for the purpose of being traded
• due to be settled within 12 months after the date of the statement of
financial position
• the entity does not have an unconditional right to defer settlement of
the liability for at least 12 months after the date of the statement of
the financial position.
Again, this is a departure from what had become the conventional way of
defining current liabilities. Other liabilities are classified as non-current.
Various formats are acceptable per IAS 1 although legislation may be
much more prescriptive (for instance the Fourth Directive of the European
Union).
The following line items are to be included in the statement of financial
position (on the face of the statement) at a minimum (unless not
material):
• property, plant and equipment
• investment property
• intangible assets
48
• financial assets (other)

• investments accounted for using the equity method (e.g. associate
companies)
• biological assets
• inventories
• trade and other receivables
• cash and cash equivalents
• assets held for sale*
• trade and other payables
• provisions
• financial liabilities (other)
• current tax liabilities and current tax assets
• deferred tax liabilities and deferred tax assets
• liabilities included in disposal groups classified as held for sale in
accordance with IFRS 5
• non-controlling interests presented within equity
• issued capital
• reserves attributable to owners of the parent.
*According to IFRS 5 Non-current assets held for sale and discontinued
operations, non-current assets held for sale are not depreciated, are
measured at the lower of carrying amount and fair value less costs to
sell and are presented separately in the statement of financial position.
Impairment must be considered.
Further sub-classifications of the line items presented are made in
the statement of financial position or in the notes. Some of these sub-
classifications may be required by other standards.
According to IAS 1, the use of different measurement bases (e.g. fair
value and cost) for different classes of assets suggests that their nature or
function differs so that they should be presented as separate line items.
This is not self-evident although it is possible that in certain cases the
different measurement base will reflect different natures or functions.
Share capital and reserves

The following disclosures (on the face of the statement of financial
position or in the notes) are required:
• number of shares authorised, issued and fully paid and issued but not
fully paid
• par values per share (if applicable)
• reconciliation of opening and closing shares
• description of rights, preferences and restrictions attaching thereto
• shares in the entity held by the entity itself or by subsidiaries or
associates of the entity
• shares reserved for issuance under options and contracts
• a description of the nature and purpose of each reserve within equity.
If an entity does not have share capital it is required to present equivalent
information. Details and movements of each category of equity should be
shown.
49
3.4 Statement of profit or loss (or income statement) and

statement of other comprehensive income under IAS 1
3.4.1 Profit or loss/income statement
Two components of comprehensive income are envisaged: the profit and loss
(or income) component and the other comprehensive income component.
These two components could be presented together in the same statement
(as preferred by the IASB). An alternative presentation is for the two
components to be covered in two separate statements. If the latter option
is followed then the profit and loss figure from the first component should
begin the second statement so that overall the total comprehensive income
is still given.
The income for the period is split between the non-controlling interest and
the income attributable to the owners of the parent company.
The following are the minimum line items that must be included on the face
of the statement of profit or loss or income statement (in addition to items
required to be so included by other standards):
• revenue
• gains/losses from derecognition of financial assets measured at
amortised cost
• finance costs
• share of profit/loss of associates and joint ventures accounted for using
the equity method
• certain gains or losses associated with the reclassification of financial
assets
• tax expenses
• a single amount for the total of discontinued items.
Discontinuing operations are classified as follows. They should be a
component of an entity that either has been disposed of or is classified as
held for sale, and:
• represent either a separate major line of business or a geographical area
of operations
• be part of a single coordinated plan to dispose of a separate major
line of business or geographical area of operations, or be a subsidiary
acquired exclusively with a view to resale and the disposal involves loss
of control.
The single amount comprises the aggregate of (i) the post-tax profit or loss
of discontinued operations and (ii) the post-tax gain or loss recognised on
the measurement to fair value less costs of sale or on the disposal of the
assets or disposal group(s) constituting the discontinued operation. Detailed
disclosure should cover both current and all prior periods presented in the
The following additional disclosures are required:
1. adjustments made in the current period to amounts disclosed as a
discontinued operation in prior periods must be separately disclosed
2. if an entity ceases to classify a component as held for sale, the results of
that component previously presented in discontinued operations must
be reclassified and included in income from continuing operations for
all periods presented.
50
An item for ‘extraordinary items’ is forbidden (including in the notes to

the financial statements) because the IASB felt that so-called extraordinary
items result from the normal business risks faced by an entity and the
distinction between extraordinary and ordinary was too arbitrary.
The issue of materiality is again taken into consideration.
An analysis of expenses in terms of nature or function should be presented
in the income statement (either on the face of the statement or in the
notes). Many companies analyse expenses in terms of function (with
operating expenses classified into cost of sales, distribution and selling
costs, administrative expenses and other operating income or expense). In
this case, information regarding the nature of expenses (e.g. raw materials,
wages and depreciation) is disclosed in the notes to the accounts.
3.4.2 Other comprehensive income

In the 2008 revision of IAS 1, a new section of ‘other comprehensive
income’ or OCI was added to the income statement. The OCI is to include
unrealised gains and losses arising from changes in the fair values of assets
and liabilities.
These include unrealised changes in the fair value of both tangible and
intangible non-current assets in accordance with other IASs/IFRSs.
For example, gains or losses on property revaluation – see Chapter 11;
remeasurements of defined benefit pension plans – see Chapter 9;
exchange differences on translating foreign operations (e.g. through the
use of the closing rate method) – see Chapter 19; and gains/losses on
available for sale financial assets – see Chapter 15. Line items in the OCI
section will either:
• not be reclassified subsequently to profit or loss, or:
• will be reclassified to profit or loss only when specific conditions are
met.
An entity may present items of other comprehensive income net of tax or
before tax (with one aggregate tax figure covering all items then sufficing
– although this should be split between items that will not be reclassified,
or recycled as this reclassifying is known, and those that may subsequently
be reclassified to the profit or loss section).
Reclassifications (as adjustments) may be presented in the statement(s)
of profit or loss and other comprehensive income or in the notes. If an
unrealised gain is recognised in one period in other comprehensive income
and this amount becomes a realised gain in the next period and is then
reclassified into profit or loss in the second period it then needs to be
deducted from other comprehensive income to avoid double-counting in
overall comprehensive income.
The reclassification from OCI (treated as equity) to the profit or loss
is termed ‘recycling’. Some IASs/IFRSs require recycling but others do
not. IFRS 9 explicitly forbids recycling for unrealised gains or losses on
investments in equity instruments. The article ‘Concepts of profit or loss
and other comprehensive income’ [https://www.accaglobal.com/lk/en/
student/exam-support-resources/professional-exams-study-resources/
strategic-business-reporting/technical-articles/pl-concepts.html] from
ACCA global provides specific examples.
Earnings per share is included on the face of the financial statements
(following IAS 33). See also Chapter 5 for further details about its
presentation.
51
Unilever group’s (2019) annual reports [https://www.unilever.com/

investor-relations/annual-report-and-accounts/archive-of-annual-report-
and-accounts/], p. 87, illustrate how the comprehensive income statement
is presented, separating the income statement, earnings per share and OCI
elements.
3.5 Statement of changes in equity

This is a separate statement. It must show:
• the total comprehensive income for the period, showing separately
amounts attributable to owners of the parent and to non-controlling
interest
• effects of any retrospective application of accounting policies or
restatements, separate for each component of comprehensive income
• reconciliations between carrying amounts at the beginning and end of
the period for each component of equity, separately:
(1) profit/loss
(2) other comprehensive income
(3) transactions with owners, showing separate contributions by, and
distributions to, owners and changes in ownership interests in
subsidiaries that do not result in a loss of control.
An entity shall present, either in the statement of the changes of equity
or in the notes, an analysis of other comprehensive income by item and
the amount of dividends recognised as distributions to owners during the
period (and the related amount of dividends per share).
The following are disclosed in the notes to the financial statements:
• the amount of dividends proposed or declared before the financial
statements were authorised for issue but which were not recognised as
a distribution to owners during the period and the related amount per
share
• the amount of any cumulative preference dividends not recognised.
Unilever group’s (2019) annual reports [https://www.unilever.com/
investor-relations/annual-report-and-accounts/archive-of-annual-report-
and-accounts/], p.88, illustrate how the statement of changes in equity
is presented. Note that Unilever here has reported on two significant
restatements of its 2017 and 2018 accounts (in addition to the 2019
reporting). In 2017, the restatement was caused by a significant change
in the leasing standard from IAS 17 to IFRS 16 (see Chapters 12 and 20).
This meant that the 2018 accounts also had to be restated as a result.
3.6 Statement of cash flows

Rather than setting out separate requirements for the presentation of
the statement of cash flows, IAS 1 refers to IAS 7. This is not covered
in this guide as you will have covered this while studying AC1025
Introduction to accounting.
52
3.7 Notes to the financial statements

The notes are meant to:
• present information about the basis of preparation of the financial
statements and specific policies used for significant transactions and
events
• disclose information required by the standards that is not presented in
the financial statements
• provide additional information not presented on the face of the
statements that is relevant for understanding the statements.
Notes are normally presented in the following order:
• statement of compliance with IASs/IFRSs
• measurement basis/bases used in preparing the financial statements
• each specific accounting policy necessary for a proper understanding
of the financial statements
• supporting information for items presented on the face of each
financial statement (in the same order of presentation there)
• other disclosures, including contingencies, commitments and other
financial, and non-financial, disclosures.
The following additional disclosures are required in the notes if not
disclosed elsewhere in the information published with the financial
statements:
• the domicile and legal form of the enterprise, its country of
incorporation and the address of the registered office (or principal
place of business if different from the registered office)
• the nature of the entity’s operations and principal activities
• the name of the parent enterprise and the ultimate parent enterprise of
the group
• either the number of employees at the end of the period or the average
for the period.
IAS 1 also discusses the going concern, application of the accrual concept,
fair presentation and compliance IFRS: https://www.iasplus.com/en/
standards/ias/ias1
It should be noted that a given prescription in this area is also a
displacement of other possibilities. For instance, controversially, the
income statement does not disclose in its main body or notes all the detail
of payments to all the governments of the world or details of all itra-group
transfer payments (in some cases that might be included in a separate
report). Working out cash flows within a group is not possible fully.
For large multinationals like Unilever, the notes to the accounts often form
the largest component of its annual reports. In the 2019 annual report, for
example, the notes to the accounts run from pp.91–142.
3.8 Concluding thoughts

We have given an overview of the provisions of IAS 1 in respect of the
preparation and presentation of the financial statements. We have also
given an overview of the notes to the financial statements as covered in
IAS 1. This facilitates discussion of the question of the structure of the
53

• elaborate upon what the standards of the International Accounting
Standards Board (IASB) prescribe in relation to the preparation and
presentation of financial statements
• explain the basic character in this context of the statement of
financial position, the statement of income, the statement of other
comprehensive income, the statement of changes of equity and the
notes to the accounts.

Question 3.1
Assess IAS 1 Presentation of financial statements in relation to its
provisions for the statement of financial position, the statement of
comprehensive income and the statement of changes in equity.
Question 3.2
Critically assess the ‘recycling’ provisions of IAS 1, which are outlined in
the ACCA article.
54
4.1 Introduction
In this chapter, we consider ethics for accountants. On the face of it,
ethics are relevant for deciding upon issues integral to the conceptual
framework. They are also relevant to the practice of accountants as
professionals and as people. Indeed, ethics are clearly pervasive in
accounting and questions of what should accountants do and how
should accountants behave are clearly basic to a practice and profession.
Concerns about the ethics of accountants and ethics in accounting are
often more prominently expressed in the face of corporate scandals, such
as Enron and WorldCom. We consider how ethics have been considered
in the context of professional accounting practice, reflecting in part issues
deemed to arise, and we present an overview of ethical positions.

This chapter aims to:
• review some key ethical issues in accounting
• explore aspects of ethics as manifest in the regulation of accounting
practice.

• appreciate ethics in relation to accounting
• explain the way ethics for accountants have been articulated in
practice, based partly on issues deemed to arise.


Fountain, L. Ethics and the internal auditor’s political dilemma (Boca Raton: CRC
Press, 2016) [ISBN 9781498767804]
Gallhofer, S. and J. Haslam ‘Analysis of Bentham’s Chrestomathia: or, towards
a critique of accounting education’, Critical Perspectives on Accounting 7(1)
1996, pp.13–31.
Gallhofer, S. and J. Haslam ‘Approaching corporate accountability: fragments
from the past’, Accounting and Business Research 23 1993, pp.320–30.
Jackling, B., B.J. Cooper and P. Leung ‘Professional accounting bodies’
perceptions of ethical issues, causes of ethical failure and ethical education’,
Managerial Auditing 22(9) 2007, pp.928–44.
Thibodeau, J. and D. Freier Auditing and accounting cases: investigating issues
of fraud and professional ethics. (New York: McGraw-Hill, 2013) 4th edition
[ISBN 9780078025563].
4.2 Ethical positions

Philosophy has developed a variety of positions in relation to ethics,
around issues such as what constitutes the best (virtuous) way to live and
what actions are right or wrong in particular circumstances.
55
An important strain of ethical thought is consequentialist. That is,

the ethics of a life or an act are understood in terms of the consequences
thereof. This is potentially a very broad approach since consequences
may be understood in very broad terms – from consequences for the
individual (self) to consequences for the social (others) to consequences
seeing the individual and the social as intertwined (e.g. one’s happiness
or contentment or sense of fulfillment may be understood as very much
influenced by the well-being of others), from the material to the spiritual,
from consequences taken to be universal to consequences that are specific
to particular people or cultures (or, different things matter to different
people – although some have seen possibilities for synthesis from learning
about different positions). One might expect people to argue about what
consequences are desirable and with what priority. Given the breadth and
scope for different perspectives, many variants of this ethical position have
emerged.
Often taken as a different position to that of consequentialism is
deontologism. Here, consequences are understood not to be relevant.
A life or act is inherently good or bad and one should act from a duty
to do good (one should act with good will). There is an issue here
concerning what the criteria are for deciding upon this, given that the
criteria are supposedly not consequentialist. Classic examples here might
be principles such as telling the truth. At the same time, of course, a
principle understood as deontological may nevertheless be a principle
that if followed (or not) has consequences (thus in practical terms
consequentialists and deontologists are capable of effectively agreeing). A
deontological approach may be difficult to sustain to the extent that some
deontological principles, in a set of such principles, conflict. And sticking
to deontological principles while ignoring the consequences is potentially
very difficult or, some might say, dangerous.
An issue for both of these positions is the increased uncertainty associated
with postmodern perspectives, with their appreciation of the complex and
relational conditions of actions and the messy nature of humanity.
4.2.1 Ethics and accounting

When Jeremy Bentham (1748–1832) noted that accounting was a branch
of ethics, what did he mean? Very much a ‘consequentialist’, Bentham may
have been highlighting the power of accounting (which he understood in
broad terms) in influencing the behaviour of the subject of the account
(the entity or set of persons rendered accountable) and more especially the
ethics of that behaviour. Bentham was a strong advocate of transparency
and understood that accounting could engender better behaviour, not
just in terms of a ‘principle of economy’ but more especially in terms of a
‘principle of humanity’.
Such a perspective is echoed in modern notions of business ethics
and corporate social responsibility – with the associated reporting
linked thereto. The mobilisation of the latter reporting (and any linked
auditing) is concerned at least in part with improving the behaviour of
corporations or those who direct them. Forms of accounting standard
(adding to those of bodies such as the IASB, which has tended to put a
low priority on broader forms of corporate social responsibility reporting)
and accreditation have emerged to support notions of corporate social
responsibility going beyond the notion of simply maximising (or trying to
maximise) profits or shareholder wealth (on the assumption that those
directing companies have a choice in this matter or in the context of
those situations where they do have a choice). Business ethics and related
56
reporting or accounting practices have increasingly featured in professional

training as well as in accounting education more generally.
In relation to financial accounting more specifically, notions of trying to
present a true and fair view of the financial position and the income of
a company and to follow a principles-based approach in so doing are
suggestive of the following of ethical principles. The economist Baumol
reflects Rawls’ ‘veil of ignorance’ principle in some ways in suggesting that if
you did not know which side of the contract you were going to be on, what
would you then regard as a ‘fair’ presentation. Rawls articulated the principle
in relation to a philosophy of justice – supposing we are ignorant about what
conditions we are to be born into, Rawls asks what kind of society would we
prefer? Issues of communication and impression management are important
in the context of notions of trying to present a true and fair view. Breaches of
basic ethical principles were in this respect very evident in scandals such as
Enron. Sometimes ethical breaches are evident in extremis – it is very difficult
to actually define what a true and fair view is in a precise way.
Further reading on Enron

• Berlau, J. and B. Spun. ‘Is big business ethically bankrupt? A boom in
business-ethics courses is likely in the wake of the Enron scandal, but
critics say these classes need to focus on moral, rather than political,
correctness. (Nation: professional ethics)’. Insight on the News,
18(10) 2002, p.16+. [https://link.gale.com/apps/doc/A84019092/
AONE?u=ull_ttda&sid=AONE&xid=78ca341e].
• Lee, P. ‘Lessons from the Enron scandal’, The Telegraph, 1 December

2016. [http://0-search.proquest.com.catalogue.libraries.london.
ac.uk/newspapers/lessons-enron-scandal/docview/1845076207/se-
2?accountid=14565]
• Watch the movie Enron – The Smartest Guys in the Room, directed by
Alex Gibney [https://vimeo.com/424073216]
• Read Fountain (2016) [https://www.vlebooks.com/Vleweb/Product/

Index/2014108]
At the same time, accountancy as a professional practice involves a number

of ethical issues in addition to big questions about accounting’s nature
and role. Below we overview some key developments in practice that have
emerged.
Many of the ethical principles that accountants are expected to adhere
to in this respect are akin to duties to pursue behaviour that is deemed
professional by a professional body. In this respect, the ethics in this
domain of professional and applied ethics (or, an attempt to apply ethics
to a professional domain in the messy real world context) apparently
has a deontological character. At the same time, one may construe these
principles to have been developed by reference to the consequences of
following them (and perhaps especially not following them), especially
where these consequences are deemed to impact positively (or negatively)
on the public interest. A claim to serve the public interest is a very
common professional claim, not least in accounting. (See ‘It’s good for
shareholders when boards consider the public interest’, Financial Times,
15 October 2019 [http://0-search.proquest.com.catalogue.libraries.london.
ac.uk/trade-journals/s-good-shareholders-when-boards-consider-public/
docview/2305666111/se-2?accountid=14565])
57
4.3 Professional ethical codes or guidelines in

accounting
Professional ethics, including in accounting (see Fountain 2016), are often
codified in a code of ethics or articulated in the form of ethical guidelines.
When an accountant is a member of a professional body they are subject
to that body’s ethical code or guidelines. The manifestation of an official
code or guidelines in principle thus serves as a regulatory mechanism in
relation to the behaviour of professional accountants.
Clearly, ethical codes or guidelines may be contentious, including to those
subject thereto (something that itself raises ethical issues). Those setting
professional codes or guidelines typically see themselves as producing a
set of principles that they do not deem especially contentious. In some
ways, this impacts on the character of codes and guidelines in practice –
big questions such as the nature and role of accounting (albeit that these
are ethical issues if they are matters to be decided upon) are eschewed or
rather taken as read, answered and accepted.
Ethical codes and guidelines developed for and by the accountancy
profession may be split between those dealing with accountants in
professional practice (working for professional accountancy firms) and
those working in other organisations (in the private business sector, the
public sector and the third sector). (See ACCA code of ethics [https://www.
accaglobal.com/uk/en/about-us/regulation/ethics/acca-code-of-ethics-and-
conduct.html] and conduct and ICAEW Code of Ethics [https://www.icaew.
com/technical/ethics/icaew-code-of-ethics/icaew-code-of-ethics])
Regarding accountants in professional practice, the principles typically
cover:
• the importance of being professionally independent (see ‘Regulator
tightens rules to strengthen audit independence’, Financial Times,
17 December 2019 [https://search.proquest.com/docview/23276
73930/1766E14DAA7C43C6PQ/1?accountid=14565]) from the
client so that, for example, the corruption of the client (for instance
forms of ‘creative’ accounting) does not become the corruption of the
professional practitioner (more generally the principles will typically
provide guidance on the relationship that a professional should
have and should avoid having with a client, for example having a
financial interest in the client) – and ways in which independence
might be safeguarded (e.g. through auditor rotation). (See ‘Big Four
accountants facing changing times’, Financial Times 27 September
2019 [https://search.proquest.com/docview/2298570642/78C43D19
9D284EC8PQ/1?accountid=14565])
• how conflicts of interest might be avoided or dealt with in order to
maintain professionalism
• the type of work that the professional accountant can do for their
client so that professional independence is not compromised (for
example, the relationship between audit work and non-audit work for
a client; the dependence on a particular client’s income) or so that the
profession is not revealed to be engaged in practices of ill repute; this
includes the nature and type of advice that professionals can give to
their clients
• in general, the standards of behaviour expected of the professional,
including in particular situations (for example, advising on tax)
• the extent to which professionals can behave like businesses (for
example, in advertising their services).
58
It has been recommended that experiences of dealing with ethical issues of

fraud be shared in education and training through greater use of real life
case studies (see ACCA’s ‘Ethics case studies’ [https://www.accaglobal.com/
us/en/about-us/regulation/ethics/ethics-case-studies.html]). And ethics is
given some attention in the syllabi of professional training courses as well as
in accounting education more generally.
Unsurprisingly, real world scandals have often highlighted poor ethics
in either accounting (increasing attention on how to improve ethics in
accounting) or in business practices (which may give rise to proposed
accounting solutions).
Often, separate codes or guidelines have been prepared for accountants
beyond the professional accountancy firm. Ethical issues that may occur
in practice include requests by clients to effectively manipulate accounting
numbers to mislead shareholders/prospective investors or lenders/
prospective lenders or contracting parties or government (e.g. in relation
to tax returns) or to conceal information (or to disclose false information),
for example, concerning the bribery of third parties. Even more so than
accountants in professional accountancy firms, accountants in business
organisations might be tempted into operations that amount to (often
illegal) insider dealing or trading operations. It should be noted that many
of these issues occur also in the context of the work of the accountant in
a professional accountancy firm, just perhaps in a different way and to a
different extent.
Ethical codes and guidelines will often articulate suggested courses of
action (e.g. informing one’s superior, whistleblowing and, perhaps in some
extreme cases, resignation).
The International Federation of Accountants (IFAC) issued a Code of
Ethics for Professional Accountants. This is intended (for all professional
accountants) as a foundational code in relation to national ethical codes
and guidelines for accounting. Interestingly, this is a different way of
seeing from the IASB, which is effectively seeking the adoption of its
accounting prescriptions worldwide.
The IFAC code proclaims its ethical principles for accountants to be a
distinguishing mark of the accountancy profession in its acceptance of the
responsibility to act in the public interest.
According to this code, professional accountants in practice should
conduct themselves with:
• integrity
• objectivity
• professional competence and due care
• confidentiality
• professionalism.
Professionals should also undertake appropriate education and training
and engage in continuing professional education. Professional values and
ethics are included in this.
The code also emphasises that, at least implicit in any professional ethical
code or set of guidelines, the professional accountant has to balance
attention to the needs or wants of a client (and the need to earn rewards
from the activity) with the concerns of the profession and the general
public interest.
59
The IFAC code gives guidance in relation to appointments, conflicts of

interest, second opinions, remuneration, marketing, acceptance of gratuities,
custody of client assets, objectivity and independence. For instance, in
relation to accepting appointments, professionals should consider:
• impacts on their independence
• whether they have the competency and expertise required (e.g.
considering the industry)
• whether the current or previous accountant of the potential client has
advised of professional reasons against involvement.
In relation to second opinions, accountants should check things carefully
and decline if there is any reasonable doubt.
The IFAC code also identifies five types of threat to compliance with their
principles:
1. self-interest might impact judgement and behaviour
2. self-review might mollify or badly mediate the evaluation of prior
judgements or work done by members of one’s own firm or employer
3. advocacy might encourage a professional accountant to promote a
client’s or employer’s position, compromising professional objectivity
4. familiarity may encourage too much sympathy for, or acceptance
towards, client practices
5. intimidation may impact behaviour.
Various professional accountancy bodies provide members with support
through, for example, offering confidential advice. The Institute of
Chartered Accountants in England and Wales adopts the Public Concern at
Work guidelines to help whistleblowers feel more comfortable in reporting
disreputable activities. It is clearly helpful to be able to whistleblow
anonymously – if that whistleblowing is taken seriously.
Sometimes governments step in to issue their own codes or guidelines.
In the UK, auditors were required to comply with the Auditing Practice
Board’s (APB) ethical standards on auditor independence, rather than
those of the professional accountancy bodies. The APB’s ethical standards
(five in total) cover:
1. integrity, objectivity and independence
2. financial, business, employment and personal relationships
3. long association with the audit engagement
4. fees, remuneration and evaluation policies, litigation, gifts and
hospitality
5. non-audit services provided to audit clients.
The professional bodies claim this to be a rules-based approach and prefer
the principle-based approach (see ACCA’s ‘Personal ethics’ [https://www.
accaglobal.com/us/en/about-us/regulation/ethics/personal-ethics.html])
of IFAC’s foundational code and guidelines. There is particular concern
that the rules are too restrictive.
In 2010 the APB required auditors to take the possibility of money
laundering into account when carrying out their audit and to report
to the appropriate authority if they became aware of suspected money
laundering (see APB’s ‘Practice Note 12’ [https://www.frc.org.uk/
document-library/apb/2010/pn-12-(revised)-money-laundering-guidance-
for-au])
60
In the USA, the Sarbanes-Oxley Act 2002 requires external auditors to

confirm that companies have proper accounting and internal control
systems and these auditors are required to report to the company’s audit
committee rather than management.
In the UK, the Public Interest Disclosure Act 1999 protects whistleblowers
raising genuine concerns about malpractice from dismissal and
victimisation.

Ethics is pervasive in accounting and ethical choices have to be made.
In this chapter we have discussed ethical positions, and linked these to
accounting. We have given some insights into how ethical codes and
guidelines for accountants have been developed in practice. Many of these
have taken for granted prior or underlying ethical decisions concerning the
basic nature and role of accounting which are in effect taken as read and
accepted, and deemed legitimately beyond scope.

• appreciate ethics in relation to accounting
• explain the way ethics for accountants have been articulated in
practice, based partly on issues deemed to arise.

Question 4.1
Discuss the view that the ethical codes and guidelines of professional
accountancy bodies deal only partly with ethical dimensions of accounting.
Question 4.2
Should ethics pervade the education and training of accountants and
accounting students?
Question 4.3
Explain five different possible risks that may threaten compliance with
the International Federation of Accountants (IFAC) code for professional
ethics.
Question 4.4
Does the need for a professional accountant to embody ethical codes
reduce accounting scandals?
61
Notes
62
Chapter 5: Accounting for equity and

earnings per share
5.1 Introduction
This chapter considers:
• accounting for equity which includes share capital and reserves
• the impact of equity and debt financing on accounting ratios.

• discuss capital and reserves
• demonstrate the accounting treatment for an equity issue (and show
how the interaction with equity financing and debt financing impacts
on accounting ratios).
For reference, IAS 32 Financial statements: presentation indicates the
accounting treatment.

2019) 19th edition [ISBN 9781292255996] Chapters 12 and 27.
International financial reporting, Chapter 24.4
Relevant IASB standards

IAS 32 Financial statements: presentation.
IAS 33 Earnings per share
IFRS 9 Financial instruments
5.2 Share capital and reserves

Shareholders’ funds in standard accounting practice consist of issued share
capital stated at nominal value and reserves. Shareholders’ funds are thus
equivalent to the net assets. The reserves can legally be classified into
distributable reserves and non-distributable reserves.
Since shares can be issued at an amount greater than the nominal value,
the difference has to be accounted for in the form of share premium.
Where shares are exchanged between shareholders on a market (for
example one of the official stock exchanges) this is not accounted for in
standard accounting practice. It involves no direct flow of resources to
the company (although it does indicate the potential to generate funds in
share issues). At the same time, one measure of the value of a company
is the market capitalisation, which is the share price on the market
multiplied by the number of shares in issue. It is of interest to compare
this figure with the figure for net assets and some have proposed that an
explanation of the difference might be published in the accounting report,
but this is not yet in standard accounting practice.
63
The share capital can be divided into equity (i.e. ordinary shares) and non-
equity (i.e. preference shares).
In this chapter we will consider ordinary and preference shares, and the
distinction between distributable and non-distributable reserves. We will
illustrate the accounting treatment of shares issued at premium.
5.3 Ordinary shares

These shares carry the main risk and those holding the shares are entitled
to the residual profit after any fixed interest or fixed dividend to investors
has been paid.
Para.5 of IAS 33 Earnings per share defines an ordinary share as ‘an equity
instrument that is subordinate to all other classes of equity instruments’.
Para.6 states:
Ordinary shares participate in the net profit for the period
only after other types of shares such as preference shares
have participated. An entity may have more than one class of
ordinary shares. Ordinary shares of the same class have the
same rights to receive dividends.
In some countries, such as the UK, a distinction is made between those
shares authorised for issue (maximum number of all classes of shares
which a company is allowed to issue – something that might be changed
through a legally required procedure) and those shares that have actually
been issued (the nominal value of each class of share actually issued).
5.4 Share premium

The share premium account records the difference between the nominal
value (par value) of shares issued and the fair value of the consideration
received. In the UK the use of the share premium account is governed by
the Companies Act legislation (see Companies Act 2006, Part 17, Chapter
7) and it can only be used for specific purposes to:
• pay up fully paid bonus shares
• write off preliminary expenses
• write off expenses of any issue of shares or debentures
• write off commission paid or discount allowed on any issue of shares
or debentures
• provide for the premium payable on any redemption of debentures
and preference shares (in the latter case restricted to the premium on
the earlier issue of the shares).
Note that the share premium account cannot be negative – for instance
if the debit balance of a ‘fully paid’ bonus issue is put to share premium
it can only reduce share premium to zero, any excess being debited to
retained profits.
Activity 5.1
Why do you think the UK uses the above treatment for premiums? Why is the premium
not credited to the income statement?
64
5.5 Preference shares

Although there are various types of preference shares, these usually have
a fixed rate dividend with shareholders receiving dividends before the
ordinary shareholders. They are thus considered less risky than ordinary
shares. If a company were to go out of business, preference shareholders
would be entitled to repayment before other shareholders but after
debenture holders. Generally, preference shareholders will be repaid at
par value – the price at which the shares were issued. Some preference
shares are known as cumulative. Shareholders are entitled to receive any
dividends not paid in previous years. Companies are not obliged to pay
dividends on preference shares if there are insufficient earnings in any
particular year. Holding cumulative preference shares thus guarantees
the eventual payment of these dividends in arrears before the payment of
dividends on ordinary shares, provided that the company returns to profit
in subsequent years.
In some cases, preference shares may in substance be liabilities rather than
equity. For instance, an entity issues preference shares paying a fixed rate
of dividend and having a mandatory redemption feature at a future date –
the substance is that there is a contractual obligation to pay cash.
5.5.1 Bonus issues

Bonus issues are issues with no cash inflow. In some jurisdictions they are
viewed as suspicious and are, or have been, illegal. Is the aim to reduce
earnings per share (and hide profitability)? Is there an incentive in laws –
for example, related to taxation or disclosure?
The debit entry can go to share premium and next to retained profits. It
often makes sense to take the amount to capital redemption reserve rather
than these accounts. The capital redemption reserve is restricted and only
bonus issues can be debited there.
The capital redemption reserve arises on redemptions. For instance,
suppose a company redeems £3,000,000 (nominal value) and – linked to
this – issues £2,000,000 ordinary shares (nominal value) at a premium of
£100,000. The net difference of £900,000 is credited to capital redemption
reserve to maintain permanent capital on this transaction.
5.6 Distributable and non-distributable reserves

Distributable reserves are those reserves which can be distributed as
dividends. Only realised profits can be legally distributed to shareholders
in cash or non-cash form. The retained profit figure in the balance sheet (a
revenue reserve) is distributable except for any unrealised element.
However, there are great difficulties associated with the definition of what
represents realised profits. It might refer to cases where the receipt of cash
is reasonably certain (likelihood of cash flow) or it might focus on those
cases where profit can be assessed with reasonable certainty (reliability of
measurement).
The IASB’s FPPFS, discussed in Section 2.5.2, does not refer to realisation.
Non-distributable reserves include the share premium account, the capital
redemption reserve, the revaluation surplus, and any other reserves that
are specifically named as non-distributable in the company’s Memorandum
or Articles of Association.
The capital redemption reserve is created as a result of the company
purchasing its own shares in circumstances that result in a reduction of its
65
share capital. It is a reserve that cannot be distributed to the shareholders

and thus ensures the maintenance of the capital base of the company, and
hence protects any creditors.
Directors should consider as a fiduciary duty whether it is prudent to
distribute profits arising from changes in the fair value of volatile financial
instruments (even if the technical guidance of IASs/IFRSs would deem
these profits realised).
5.7 Accounting for the issue of equity

IAS 32 states that transaction costs of an equity transaction shall be
accounted for as a deduction from equity, net of any related income tax
benefit.
IFRS 9 requires the net proceeds from the issue of equity shares to be
credited to shareholders’ funds. Net proceeds means the fair value of
the consideration received after deducting the costs incurred directly in
connection with the issue of the shares. What this means is that, since the
nominal value of the shares issued must be credited to the share capital
account, and any premium on the issue credited to the share premium
account, the issue costs must be charged directly to shareholders’ funds.
They will normally be charged against the share premium account, if one
exists. If there is no share premium account, they will be charged against
another reserve – normally the retained profit reserve. They are not to
be charged against the current year’s income statement because they are
regarded as integral to a transaction with owners of the company.
5.8 Earnings per share

The two most publicised ratios for a publicly listed company (PLC) are the
earnings per share (EPS) and price over earnings (P/E or PE) ratio. These
ratios provide a comparative indicator for how the company is performing.
A high P/E ratio can indicate investors’ confidence in the management of
the company (and the company’s future). A low P/E ratio in contrast can
indicate the opposite. The two ratios are defined as follows.
EPS = Earnings / (Weighted number of ordinary shares)
IAS 33 requires two different EPS figures be disclosed, the Basic EPS and
the Diluted EPS.
The Basic EPS
Basic EPS is calculated by dividing profit or loss attributable to ordinary
equity holders of the parent entity (the numerator) by the weighted
average number of ordinary shares outstanding (the denominator) during
the period. [IAS 33.10]
The earnings numerators (profit or loss from continuing operations and
net profit or loss) used for the calculation should be after deducting all
expenses including taxes, minority interests, and preference dividends.
[IAS 33.12]
The denominator (number of shares) is calculated by adjusting the shares
in issue at the beginning of the period by the number of shares bought
back or issued during the period, multiplied by a time-weighting factor.
IAS 33 includes guidance on appropriate recognition dates for shares
issued in various circumstances. [IAS 33.20-21]
Contingently issuable shares are included in the basic EPS denominator
when the contingency has been met. [IAS 33.24]
66
The Diluted EPS

Diluted EPS is calculated by adjusting the earnings and number of shares
for the effects of dilutive options and other dilutive potential ordinary
shares. [IAS 33.31] The effects of anti-dilutive potential ordinary shares
are ignored in calculating diluted EPS. [IAS 33.41]
Guidance on calculating dilution

Convertible securities. The numerator should be adjusted for the
after-tax effects of dividends and interest charged in relation to dilutive
potential ordinary shares and for any other changes in income that would
result from the conversion of the potential ordinary shares. [IAS 33.33]
The denominator should include shares that would be issued on the
conversion. [IAS 33.36]
Options and warrants. In calculating diluted EPS, assume the exercise
of outstanding dilutive options and warrants. The assumed proceeds from
exercise should be regarded as having been used to repurchase ordinary
shares at the average market price during the period. The difference
between the number of ordinary shares assumed issued on exercise and
the number of ordinary shares assumed repurchased shall be treated as an
issue of ordinary shares for no consideration. [IAS 33.45]
Contingently issuable shares. Contingently issuable ordinary shares
are treated as outstanding and included in the calculation of both basic
and diluted EPS if the conditions have been met. If the conditions have
not been met, the number of contingently issuable shares included in the
diluted EPS calculation is based on the number of shares that would be
issuable if the end of the period were the end of the contingency period.
Restatement is not permitted if the conditions are not met when the
contingency period expires. [IAS 33.52]
Contracts that may be settled in ordinary shares or cash.
Presume that the contract will be settled in ordinary shares, and include
the resulting potential ordinary shares in diluted EPS if the effect is
dilutive. [IAS 33.58]
Guidance on information to be disclosed

If EPS is presented, the following disclosures are required: [IAS 33.70]
• the amounts used as the numerators in calculating basic and diluted
EPS, and a reconciliation of those amounts to profit or loss attributable
to the parent entity for the period
• the weighted average number of ordinary shares used as the
denominator in calculating basic and diluted EPS, and a reconciliation
of these denominators to each other
• instruments (including contingently issuable shares) that could
potentially dilute basic EPS in the future, but were not included in
the calculation of diluted EPS because they are antidilutive for the
period(s) presented
• a description of those ordinary share transactions or potential ordinary
share transactions that occur after the balance sheet date and that
would have changed significantly the number of ordinary shares or
potential ordinary shares outstanding at the end of the period if those
transactions had occurred before the end of the reporting period.
Examples include issues and redemptions of ordinary shares issued for
cash, warrants and options, conversions, and exercises [IAS 34.71]
67
All of this information can be illustrated in Unilever group’s (2019) annual

reports [https://www.unilever.com/investor-relations/annual-report-and-
accounts/archive-of-annual-report-and-accounts/], Section 7 ‘Combined
earnings per share’, p.107.
The following example provides an illustrative calculation for Basic EPS
and Dilutive EPS.
Example 5.1: Basic versus Dilutive EPS – Aeron PLC

Aeron PLC has the following profit and equity profile for the year ended
31 December 2019
Post-tax profits for 2019 (£) 5,000,000

(Total) issued share capital (£) 4,000,000
Number of ordinary shares (units) 2,500,000
Price of ordinary share (£/unit) 1.00
Number of preference shares (units) 1,000,000
Price of preference share (£/unit) 1.50
Preference dividend rate 8%
The Basic EPS is calculated as follows:
£
Profit on ordinary activities after tax 5,000,000
Less: Preference dividend (120,000)
Profit attributable to ordinary shareholders 4,880,000
Basic EPS = Profit (ord. shareholders) / number

of ordinary shares £/unit 1.95
To illustrate the potential dilutive effects of certain equity instruments
on the Basic EPS, consider the following example. Assume in addition to
the above profit and equity profile, Aeron PLC has also issued convertible
preference shares.
These convertible preference shares behave like standard preference
shares, except that they are also convertible into ordinary shares at a
rate of 4 convertible preferences shares to 1 ordinary share. In addition,
the convertible preference dividend rate is 5% and Aeron PLC has issued
1,000,000 shares at a price of £1.00 per share. Calculate the dilutive EPS.
£/share Earnings £ No. of shares

Profit on ordinary activities after tax 5,000,000
Less: Preference share dividend (120,000)
Profit attributable to ordinary shareholders 4,880,000
Weighted average shares for 2019 2,500,000
Basic EPS 1.95
Number of shares converted from
convertible preference
shares into ordinary shares 250,000
Add back convertible preference dividend
paid in 2019 50,000
4,930,000 2,750,000
Diluted EPS 1.79
68
5.9 Implications of debt and equity

When analysing a company, there are a number of ratios which consider
its debt as well as its equity. Financial structure ratios (referred to as
debt/equity, gearing and leverage) all compare equity with debt financing
used by a company to assess its riskiness. Interest cover considers the ability
of a company to pay its interest commitments from profit before interest.
Example 5.2 effect of the debt/equity mix on earnings per share (EPS)
Consider two companies, Saunders Plc and French Plc, both of which have
total financing of £200,000. We consider the EPS of both companies under
two scenarios (a good year and a bad year).
Saunders Plc French Plc

Equity (£1 shares) £200,000 £100,000
Debt – £100,000
Total £200,000 £100,000
Saunders Plc French Plc

Good year Bad year Good year Bad year
Profit before
income and tax 100,000 20,000 100,000 20,000
Interest (15%) – – (15,000) (15,000)
Profit before tax 100,000 20,000 85,000 5,000
Tax (35%) (35,000) (7,000) (29,750) (1,750)
Earnings 65,000 13,000 55,250 3,250
EPS 32.5 pence 6.5 pence 55.25 pence 3.25 pence
This shows that:

• The EPS for Saunders Plc in a good year is 32.5p (65,000/200,000).
The EPS for French Plc in a good year is 55.25p (55,250/100,000).
• The EPS for Saunders Plc in a bad year is 6.5p (13,000/200,000). The
EPS for French Plc in a bad year is 3.25p (3,250/100,000).
In other words, there is higher volatility in the EPS for the shareholders of
the geared company (i.e. the company with some debt).
High levels of debt tend to be viewed unfavourably by many investors
so companies might try to keep some debt off the balance sheet.
Consequently, users should look through the notes to the accounts for
signs of contingent liabilities, post-balance sheet events and
off-balance sheet financing.

Equity is often understood as a kind of residual, being the difference
between assets and liabilities. At the same time, there are legal rules
governing equity and accounting principles for equity. These have been
reviewed in this chapter.
69

• discuss capital and reserves
• demonstrate the accounting treatment for an equity issue (and show
how the interaction with equity financing and debt financing impacts
on accounting ratios).

Question 5.1
Ozy Plc issued 200,000 ordinary shares with a nominal value of 50p for
£1.50 each and then issued bonus shares, in respect of all its ordinary
shares, on a 4 for 1 basis. Before the share issue and the bonus issue Ozy
Plc’s share capital and reserves were as follows (in £s):
Ordinary share capital (50p shares) 750,000
Share premium 2,250,000
Preference share capital 600,000
Retained profits 24,000,000
Total 27,600,000
Show the capital and reserves of Ozy Plc after the share issues.
Hint: In answering the question take care in interpreting ‘4 for 1 basis’. In
a written answer, you are encouraged to clarify your interpretation. A good
way of thinking of ‘4 for 1’ is that where there was previously one share
there are to be four new ones issued.
Solutions are provided in Appendix A.
Question 5.2
The draft statement of financial position of Ewan Plc at 30 September
2016 was as follows:
£000 £000
Product development Ordinary shares of £1 each,
costs 2,800 fully paid 24,000
12% preference shares of £1
Sundry assets 64,340 each, fully paid 16,000
Cash and Bank 10,900 Share premium 8,000
Retained (distributable) profits 9,200
Payables 20,840
78,040 78,040
Preference shares of the company were originally issued at a premium of

2p per share. The directors of the company decided to redeem these shares
at the end of October 2016 at a premium of 5p per share.
All write-offs and other transactions are to be entered into the accounts
according to the provisions of the Companies Act and in a manner
financially advantageous to the company and to its shareholders.
During October 2016 a number of things occurred. On 2 October the
company issued for cash 4,800,000 10% debentures of £1 each at a
discount of 2.5%. On 3 October the balances on development costs and
70
discount of debentures were written off. On 15 October the company

issued for cash 12,000,000 ordinary shares at a premium of 10p per share.
This was a specific issue to help redeem preference shares. On 28 October
the company redeemed the 12% preference shares at a premium of 5p per
share and included in the payments to shareholders one month’s dividend
for October. On 30 October the company made a bonus issue, to all
ordinary shareholders, of one fully paid ordinary share for every 20 shares
held. During October the company made a net profit of £550,000 from its
normal trading operations. This was reflected in the cash balance at the
end of the month.
Prepare the company’s statement of financial position as at 31 October
2016.
Briefly explain accounting entries that arise as a result of redemption of
preference shares.
Question 5.3
A public company purchases 4 million 50p ordinary shares for £3.50 each
on 1 April 20X0 and holds these as Treasury Shares. On 1 September
20X0, 1 million shares are sold at a price of £3.30 per share and on 1
December 20X0, the remaining 3 million shares are sold at a price of
£3.80 per share. How should the company record these transactions in the
accounts to 31 December 20X0?
Question 5.4
A public limited company has 100,000 ordinary shares at £1 in issue.
These shares had originally been issued at par. A total of 5,000 ordinary
shares of £1 are to be redeemed at premium of £0.50 out of distributable
profits making a capital repayment of £7,500. How should this transaction
be recorded?
The entries are:
Dr. Share capital £5,000
Dr. Retain profit £7,500
Cr. Capital redemption reserve £5,000
Cr. Bank £7,500
Question 5.5
a. You are given the following information in relation to High-jump Ltd:
Sales £18,000,000
Gross profit margin 15%
General expenses £1,700,000
Tax £600,000
Number of shares issued at start of the period 200,000
Number of shares issued at full market price of £55 per 80,000
share for cash, half way through the period
Required
Define and calculate the price earnings ratio for High-jump Ltd.
b. On 1 July 2016, Hockey Ltd issued an additional 4 million ordinary
shares with nominal value of 50p for £12.50 per share. The costs of
this share issue totalled 1% of the total money raised in the share
issue. After this share issue, Hockey Ltd issued bonus shares, in respect
71
of all its shares, on a 1 for 5 basis. Before the share issue and the
bonus issue Hockey Ltd’s share capital and reserves were as follows:
£
Ordinary share capital 5,000,000
Ordinary share premium 15,000,000
Preference share capital 4,000,000
Retained earnings 160,000,000
Required
Show how Hockey Ltd’s share capital and reserves would be affected
by the share issues outlined above.
72
Chapter 6: Provisions, contingent liabilities and contingent assets: events after the reporting period
Chapter 6: Provisions, contingent

liabilities and contingent assets: events
after the reporting period
6.1 Introduction
Liabilities and assets may be uncertain as to their existence or their
financial amount. IAS 37 Provisions, contingent liabilities and contingent
assets reflects this, addressing issues in relation to provisions, contingent
liabilities and contingent assets. Items resulting from executory contracts
(contracts where both parties have not performed any of their obligations
or have partially performed obligations to an equal amount) are usually
not covered by IAS 37 and nor are items effectively covered in other IASs/
IFRSs (such as retirement benefits and construction contracts).
IAS 37 was issued by the IASB in 1998, updating those parts of IAS 10
relating to contingencies and providing substantial guidance in relation to
‘provisions’. IAS 37 bans the creation of provisions where no obligation to
a liability exists and the use of provisions to smooth profits or to effectively
write down profits during good times and subsequently protect future
profits (sometimes referred to as ‘big bath’ accounting). It aims to apply
appropriate recognition criteria and measurement bases to provisions,
contingent liabilities and contingent assets. It also prescribes disclosures in
these areas.
Note that at the time of writing (2020), the IASB is still in the process of
receiving comments on its proposal to amend IAS 37. The original 1998
standard was considered for revision in 2005, in Exposure Draft (ED) IAS
37. This proposal was subsequently suspended, but the IASB has recently
restarted its consultation on revising IAS 37 in a research project. You can
follow these updates through the following links:
• Proposed amendments to IAS 37 – Onerous contracts
• Onerous contracts [https://www.iasplus.com/en/projects/narrow-
scope/ias-37-onerous-contracts]
• Onerous contracts – Cost of fulfilling a contract [https://www.ifrs.
org/-/media/project/onerous-contracts-cost-of-fulfilling-a-contract-
amendments-to-ias-37/ed-onerous-contracts-december-2018.
pdf?la=en]
• IAS 37 – Non-financial liabilities [https://www.iasplus.com/en/
projects/research/short-term/non-financial-liabilities]
For the purposes of the assessment on this module, you can assume that
the original 1998 standard and discussions from the 2005 Exposure Draft
form the current basis of the standard.

This chapter considers:
• accounting for provisions
• contingent liabilities
• contingent assets.
73

• discuss provisions, contingent liabilities and contingent assets
• demonstrate the accounting treatment for provisions, contingent
liabilities and contingent assets
• explain the importance of events after the balance sheet date.


IAS 37 (1998) Provisions, contingent liabilities and contingent assets
ED IAS 37 (2005) Non-financial liabilities (at the time of writing, the standard
is still an on-going Exposure Draft)
IAS 10 Events after the reporting period
Historical IASB standard

IAS 11 Construction contracts (in relation to IAS 37 – Onerous contracts: see also
Chapter 14 of this course, section 14.4.1: Percentage completion method)
6.2 Provisions
IAS 37 was first created to restrict the use of judgement within boundaries.
In other words, the standard restricted the managerial use of provisions
to create provisions when no obligation to a liability exists – the reason
for doing so is to be able to move (projected) costs between different
reporting periods. In this regard, the standard attempts to mitigate against
the use of ‘big bath’ accounting (i.e. reporting all of the costs/losses in a
single reporting period, so that other reporting periods are untainted by
the costs/losses) and the use of provisions for income-smoothing.
The following quote from David Tweedie, the former IASB chairperson,
illustrates this issue:
A main focus [of IAS 37] is ‘big-bath’ provisions. Those who use
them sometimes pray in aid of the concept of prudence. All too
often however the provision is wildly excessive and conveniently
finds its way back to the statement of comprehensive income
in a later period. The misleading practice needed to be stopped
and [IAS 37] proposed that in future provisions should only be
allowed when the company has an unavoidable obligation – an
intention which may or may not be fulfilled will not be enough.
Users of accounts can’t be expected to be mind readers. (Elliott
and Elliott (2019)).
IAS 37 uses the word ‘provisions’ to mean a liability of uncertain timing or
amount, which is a different usage of the word than is found in other areas
of accounting (e.g. depreciation provision or provision for doubtful debts –
in both these cases a provision adjusts the carrying amount of an asset.
If the conditions for a provision are met and a reliable estimate can be
made of the amount then the provision will be shown in the statement
of financial position and the amount will be recognised in the income
statement. A key question is whether the liability could be (legally)
avoided (e.g. by selling a machine to avoid a future overhaul cost,
although the standard could arguably be clearer on this) – if so, a
provision would not be recognised.
74
6.3 Contingent liabilities

Liabilities are present obligations of the entity arising from past events, the
settlement of which is expected to result in the outflow from the entity of
resources embodying economic benefits.
Contingencies refer to conditions existing at the balance sheet date where
outcomes depend on the occurrence or non-occurrence of one or more
uncertain events. IAS 37 deals with contingent liabilities, defining them as
either:
a. possible obligation arising from past events whose existence

will be confirmed only by the occurrence of one or more
uncertain future events not wholly within the entity’s
control; or
b. present obligation that arises from past events but is not
recognised because:
i. it is not probable that an outflow of resource embodying
economic benefits will be required to settle the
obligation; or
ii. the amount of the obligation cannot be measured with
sufficient reliability.
Contingencies are not normal uncertainties (e.g. non-current asset lives,

the allowance for irrecoverable receivables (i.e. the provision of bad
debts)) but cover uncertainties such as litigation against the company
and guarantees of overdrafts. One of the main subjective decisions
affecting accounting for contingencies is the likelihood of the outcome.
The following table provides a guide to the likelihood of outcome and its
accounting treatment.
Probability Contingent liabilities

Virtually certain Liability
Probable (p > 50%) Provide
Possible (p < 50%) Disclose
Remote No disclosure
For outcomes that are not virtually certain, Figure 6.1 below from
Appendix B of IAS 37 summarises the main accounting requirements via a
decision tree.
75
START
Present
obligations as No Possible No
a result of an obligations?
obligating
event?
Yes Yes
Probable No Yes
outflow? Remote?
Yes No
Reliable No (rare)
estimate?
Yes
Disclose
Provide contingent Do nothing
liability
Figure 6.1: A decision tree to determine the existence of a

provision or contingent liability.
You should always examine the contingent liability and consider the sums
involved. Sometimes high levels of contingent liabilities can cause the
collapse of a company if a large proportion of these materialise.
6.4 Measurement of provisions and contingent

liabilities
6.4.1 The IAS 37 approach
A provision can only be recognised if a ‘reliable estimate’ can be made of
the amount. According to IAS 37, this is the best estimate (as judged by
management, supplemented by experience of similar transactions – an
expected value calculation could be prepared where a provision relates
to a large number of items where possible outcomes have probabilities
attached, otherwise the most likely outcome should be considered – and/
or reports from independent experts) of the expenditure required to settle
76
the present obligation at the date of the statement of financial position.

Thus:
• provisions for one-off events (restructuring, environmental clean-
up, settlement of a lawsuit) are measured at the most likely amount
(IAS 37.40)
• provisions for large populations of events (warranties, customer
refunds) are measured at a probability-weighted expected value
(IAS 37.39).
Both measurements are at discounted present value using a pre-tax
discount rate that reflects the current market assessments of the time value
of money and the risks specific to the liability (IAS 37.45 and 37.47).
According to IAS 37, where the effect of the time value of money is
material the provision should be stated at the present value of the
expenditure expected to be required to settle the obligation. Risk-adjusted
cash flows are to be discounted at a rate deemed ‘risk free’. The carrying
amount of a provision would increase as the discount unwinds and the
unwinding (controversially) is included as an interest charge.
Provisions are measured before tax effects, the latter being shown in
accordance with IAS 12 Income taxes.
Provisions should be reviewed every time a statement of financial position
is drawn up and adjusted (but it cannot be used for the offset of any other
expenditure). If reimbursement of a provision is possible (e.g. an item
that is insured) this has to be treated as a separate contingent asset and
only accounted for in the income statement when the reimbursement is
virtually certain. One future event not taken into account in measuring
a provision is the gain on the expected disposal of a related asset which
must be treated as per the IASs/IFRSs covering this.
6.4.2 Criticisms of the approach

One of the criticisms of the use of p = 50% above, is that the distinction
between what is ‘probable’ and ‘possible’ is too arbitrary, rather than taking
a proportional approach. ED IAS 37 meanwhile suggests a two-stage
approach in considering whether contingent liabilities are liabilities (i.e.
whether an event that has a high probability of occurring can be taken to
be a liability). The two stages are:
1. Determine whether there is a present obligation.
2. Determine whether a liability exists.
Example 6.1
Question
A customer slips on company X’s floor and is injured. X accepts that
there is a present obligation and is not disputing the claim. X estimates
that there is an 80% probability of a payment of £100,000 and a 20%
probability of a payment of £10,000; both amounts include associated
costs. Ignore the time value of money.
Answer
• Is there a present obligation?
• Yes, there is no dispute and a past event (the slip) has already
happened creating a present obligation?
• Is the obligation probable?
• Yes, if P has not disputed the claim then it is more likely than not
that a payment will be made
77
• What is a reliable estimate of the most likely outcome?

• Best estimate of the expenditure required to settle the obligation
therefore a payment of £100,000
Example 6.2
Question
A company owns a piece of land that has been contaminated as a result of
the company’s activities. New legislation has been enacted which require
the company to clean up the land. The company estimates that there is a
60% chance that the land will be cleaned at a cost of £300,000 and a 40%
chance that the land will be cleaned at a cost of £500,000. Should the
company make a provision for the cost of the clean-up at the year end?
Answer
• Is there a present obligation?
• The land has become contaminated – this is a past event.
There may be a legal obligation for the company to clean-up.
Alternatively, the company may have created a constructive
obligation if it has created a public expectation that it would
do so (e.g. by preaching of its adherence to operate in an
environmentally responsible manner).
• Is the obligation probable?
• Yes, it is more likely than not that a payment of £300,000 will be
made
• What is a reliable estimate of the most likely outcome?
• Best estimate of the expenditure required to settle the obligation
therefore a payment of £300,000
Example 6.3
(Illustration taken from IAS 37, para.39)
An entity sells goods with a warranty under which customers are covered
for the cost of repairs of any manufacturing defects that become apparent
within the first six months after purchase. If minor defects were detected
in all products sold, repair costs of 1 million would result. If major defects
were detected in all products sold, repair costs of 4 million would result.
The entity’s past experience and future expectations indicate that, for the
coming year, 75 per cent of the goods sold will have no defects, 20 per cent
of the goods sold will have minor defects and 5 per cent of the goods sold
will have major defects. In accordance with para.24, an entity assesses the
probability of an outflow for the warranty obligations as a whole.
Question
What is the cost of repairs that should be recognised?
Answer
The expected value of the cost of repairs is:
(75% of nil) + (20% of 1m) + (5% of 4m) = 400,000
Illustration 6.1
Refer to Unilever group’s (2019) annual reports [https://www.unilever.
com/investor-relations/annual-report-and-accounts/archive-of-annual-
report-and-accounts/], Note 20 ‘Commitments and contingent liabilities’,
p.133.
78
Unilever group defines contingent liabilities as possible obligations

that are not probable. As a result, these are not included in the group’s
consolidated balance sheet. For 2019, current liabilities €20,978 million +
non-current liabilities €29,942 million = total liabilities €50,920 million.
Note that the total contingent liabilities = €4,210 million is excluded from
total liabilities.
Activity 6.1
Assess the following situations in terms of the value of the provision to be recorded in the
financial statements:
1. Experience of past transactions suggests that 70% of goods sold under warranty will
have no defects, 20% will have minor defects (rectification costs £10m if all goods
had minor defects) and 10% will have major defects (rectification costs £20m if all
goods had major defects).
2. The company faces a substantial legal claim of £7m. It is estimated by experts that
there is a 30% chance of a successful defense.
6.5 Onerous contracts

IAS 37 requires the recognition of present obligations under an onerous
contract as a provision. This standard is most relevant for IAS 11
Construction Contracts (now IFRS 15 Revenue from Contracts with
Customers), in the scenario where a contract is predicted to be loss-
making. An onerous contract occurs when the economic environment
changes from a profit-making to one that is expected to be loss making.
IAS 37 (para.66) requires that the present contract obligation be
recognised and measured as a provision.
IAS Plus [https://www.iasplus.com/en/meeting-notes/ifrs-ic/2017/june/
ias-37] states:
[Note that] IFRS 15 specifically requires an entity to assess
whether a contract with a customer is onerous in terms of IAS
37. […] IAS 37.68 states that the unavoidable costs reflect the
lower of the cost of fulfilling a contract and any compensation
or penalties arising from failure to fulfil it. In cases where the
penalties exceed the costs of fulfilling the contract, the question
naturally falls on what constitutes ‘unavoidable costs of fulfilling
a contract’. IAS 37 is silent on this matter.
The IASB has recently clarified its position on onerous contracts [https://
www.iasplus.com/en/news/2020/05/ias-37]. The amendments to IAS 37
(required from 1 January 2022)
specify that the ‘cost of fulfilling’ a contract comprises the ‘costs

that relate directly to the contract’. Costs that relate directly to a
contract can either be incremental costs of fulfilling that contract
(examples would be direct labour, materials) or an allocation of
other costs that relate directly to fulfilling contracts (an example
would be the allocation of the depreciation charge for an item of
property, plant and equipment used in fulfilling the contract).
Example 6.4
The application of onerous contracts has taken greater importance
now, with the IASB publishing guidance (Accounting provisions relating
to COVID-19 [https://play.buto.tv/9Kkkl]) on how to account for the
significant disruption to business caused by the coronavirus crisis
(COVID-19).
79
6.6 Contingent assets

IAS 37 defines contingent assets as possible assets arising from past events
and whose existence will be confirmed only by the occurrence or non-
occurrence of one or more uncertain future events not wholly within the
control of the entity.
The following table compares how IAS 37 deals with contingent liabilities
and assets:
Probability Contingent liabilities Contingent assets
Virtually certain Liabilities Assets
Probable (>50%) Provide Disclose
Possible (<50%) Disclose No disclosure
Remote No disclosure No disclosure
Why do you think there is a bias towards the reporting of liabilities versus
assets?
6.7 Events after the reporting period

Events after the balance sheet date are defined in IAS 10 as ‘an event,
which could be favourable or unfavourable, that occurs between the end
of the reporting period and the date that the financial statements are
authorised for issue [IAS 10.3]’. Two types of events can be identified:
• Adjusting events: those that provide evidence of conditions that
existed at the SFP date
• Non-adjusting events: those that are indicative of conditions that
arise after the SFP date
An entity shall not adjust the amounts recognised in its financial
statements to reflect non-adjusting events after the reporting period.
If non-adjusting events after the SFP date are material, non-disclosure
could influence the economic decisions of users taken on the basis of the
financial statements. Accordingly, an entity shall disclose the following for
each material category of non-adjusting event:
a. the nature of the event
b. an estimate of its financial effect, or a statement that such an estimate
cannot be made.
An overview of some adjusting and non-adjusting events from IASPlus:
80
Circumstances Recognise a provision?

Restructuring by sale of Only when the entity is committed to a sale, i.e. there is
an operation a binding sale agreement [IAS 37.78]
Only when a detailed plan is in place and the entity
Restructuring by closure has started to implement the plan, or announced its
or reorganisation main features to those affected. A Board decision is
insufficient [IAS 37.72]
When an obligating event occurs (sale of product with a
Warranty
warranty and probable warranty claims will be made)
A provision is recognised as contamination occurs for
any legal obligations of clean up, or for constructive
obligations if the company’s published policy is to clean
Land contamination
up even if there is no legal requirement to do so (past
event is the contamination and public expectation
created by the company’s policy)
Circumstances Recognise a provision?
Recognise a provision if the entity’s established policy
is to give refunds (past event is the sale of the product
Customer refunds
together with the customer’s expectation, at time of
purchase, that a refund would be available)
Recognise a provision for removal costs arising from the
Offshore oil rig must be
construction of the oil rig as it is constructed, and add
removed and sea bed
to the cost of the asset. Obligations arising from the
restored
production of oil are recognised as the production occurs
Abandoned leasehold,
A provision is recognised for the unavoidable lease
four years to run, no
payments
re-letting possible
CPA firm must staff No provision is recognised (there is no obligation to
training for recent provide the training, recognise a liability if and when the
changes in tax law retraining occurs)
Major overhaul or repairs No provision is recognised (no obligation)
Onerous (loss-making)
Recognise a provision [IAS 37.66]
contract
Future operating losses No provision is recognised (no liability) [IAS 37.63]
6.8 Dividends and going concern issues

IAS 10.12 requires that dividends declared after the reporting
period should not be recorded as a liability in the statement of financial
position (balance sheet), but be disclosed in in the notes to the accounts.
The accounts of Unilever group’s (2019) annual reports [https://www.
unilever.com/investor-relations/annual-report-and-accounts/archive-of-
annual-report-and-accounts/], Note 26 ‘Events after the balance sheet
date’, p.141, illustrate this. Note ‘NV’ here refers to the group’s shares
listed on the Amsterdam stock exchange, whereas PLC refers to the group’s
shares listed on the London Stock Exchange.
IAS 10.14 also requires that ‘An entity shall not prepare its financial
statements on a going concern basis if management determines after
the end of the reporting period either that it intends to liquidate the entity
or to cease trading, or that it has no realistic alternative but to do so.’
81

• discuss provisions, contingent liabilities and contingent assets
• demonstrate the accounting treatment for provisions, contingent
liabilities and contingent assets
• explain the importance of events after the balance sheet date.

Question 6.1
Set out the treatment of events after the balance sheet laid down by IAS
10, explaining why the treatment is necessary to ensure that financial
statements are true and fair and give appropriate information to users.
Question 6.2
X Plc identifies a provision (already risk-adjusted) for £500,000 at the
year end 31 December 2016. The actual cash flow is expected to be paid
in two years’ time. The risk-free discount rate is identified as 5%. Show
the provision and related entries in the accounts, 31 December 2016 to 31
December 2018.
Question 6.3
At the balance sheet date, 31 December 2018, inventory was valued at
£600,000 by Hub Ltd. On 1 February 2019, the auditors discovered that
the inventory had been incorrectly valued and should have been valued at
£100,000. On 1 March, the company entered into an agreement to sell a
major subsidiary of the company. The accounts have not been signed off as
at 1 March 2019. What are events after the reporting period? Outline how
the above transactions should be dealt with in the financial statements of
Hub Ltd as at 31 December 2018.
Question 6.4
(Question and solutions adapted from Elliott and Elliott (2019), Chapter
4, Exercise Q1 (p.92) and the Instructor’s manual accompanying the text.)
a. A customer made a claim for £50,000 for losses suffered by the late
delivery of goods. The main part (£40,000) of the claim referred to
goods due to be delivered before the year-end. Explain how this would
be dealt with under IAS 10.
b. After the year-end a substantial quantity of inventory was destroyed
in a fire. The loss was adequately covered by insurance. This event
is likely to threaten the ability of the business to continue as a going
concern. Discuss the matters you would consider in making a decision
under IAS 10.
c. The business entered into a favourable contract after the year end
that would see its profits increase by 15% over the next three years.
Explain how this would be dealt with under IAS 10.
82
Chapter 7: Changing prices: current purchasing power (CPP) and its applications
Chapter 7: Changing prices: current

purchasing power (CPP) and its
applications
7.1 Introduction
This chapter revises the topic of historical cost accounting (HCA). It
considers characteristics of HCA, its advantages and disadvantages and
introduces alternatives to HCA. We look at an approach that has tried
to convert the accounting figures into current purchasing power (CPP)
to adjust for general price changes. In Chapter 8, we then turn to an
approach that concentrates on the effects of specific price changes and the
current values of the assets and other items in the financial statements.

• discuss the basis of HCA
• describe the advantages and disadvantages of HCA
• identify why other conventions have been proposed as alternatives/
supplements to HCA
• discuss why CPP was proposed as an alternative to HCA
• describe the difference between monetary and non-monetary items
• convert HCA to CPP by following the step-by-step guide
• understand conceptually the different treatments of monetary and
non-monetary items
• compute real gains and losses on monetary items
• appreciate that CPP is the current basis for accounting in
hyperinflationary economies (IAS 29)
• delineate advantages and disadvantages of CPP.


Hall, 2004) 7th edition [ISBN 9780273658498] Chapter 4.
Sandilands Report Inflation accounting: report of the Inflation Accounting
Committee, Cmnd. 6225 (London: HMSO, 1975) Chapters 10 and 12
(pp.159–65).
Whittington, G. Inflation accounting: an introduction to the debate. (Cambridge:
Cambridge University Press, 2010) [ISBN 9780521270557].

IAS 29 Financial reporting in hyperinflationary economies.
83
Historical standards (Accounting Standards Committee)

[Provisional] SSAP 7 (1974) Accounting for changes in the purchasing power of
money.
SSAP 16 (1980) Current cost accounting.
IAS 15 (1994) Information reflecting the effects of changing prices (withdrawn
2005).
7.2 Basic principle

The historical cost convention has had a major influence on financial
accounting. The basic principle is that transactions are recorded at their
original money (or nominal) cost. Without adjustment, the application of
this principle produces accounts that poorly reflect notions of economic
value and profit in real world contexts, most evidently when things
change. Even in the absence of inflation (a general rise in prices), prices
change. This questions the relevance of reporting at £100 (the original
purchase price) an asset that can now be sold for £1,000 and would
cost as much to replace (because of changes in its value in the market
place). In conditions of inflation, £100 at the start of a year would
have less purchasing power than £100 at the end of a year, questioning
the relevance again of historic cost accounts, for example for decision
making involving comparisons, and raising issues about the logic of
adding together money figures equating to different purchasing power
(as representing transactions occurring at different points in time). In
principle, a current value accounting (concerned with reflecting specific
price changes) may be combined with a current purchasing power
accounting.
7.3 Revising HCA

The historical cost convention records transactions at the £ value at the
date of the transaction:
An asset or liability being measured using the historical cost
basis is recognised initially at transaction cost.
(Statement of Principles, Chapter 6, Principles).
This convention is used as a basis for financial statements. In the income

statement, revenues and expenses are recorded at the £ value shown
on the invoice. HCA might be useful for certain purposes. It has been
deemed relatively reliable and objective and has been seen as a suitable
convention for decision making regarding basic stewardship. But it may
not be the most suitable for all decisions and at all times (e.g. regarding
investment in a dynamic context). Such a view has been apparent in the
UK, with attempts to introduce supplementary accounts based on the
current purchasing power (CPP) convention (in 1974) and the current
cost convention (CCA) (in 1980). Neither of these was adopted after its
initial trial. However, in the UK, standard-setters have moved away from a
modified historical cost system to a mixed system:
[A]ssets will, depending on the circumstances, be carried in
the financial statements at historical cost, replacement cost,
net realisable value or value in use and...liabilities will, again
depending on the circumstances, be carried at historical cost or
the lowest amount at which the liability could be settled.
(Statement of Principles, para.6.32)
84
For example, in accordance with the prudence concept, inventory is valued

at the lower of cost or net realisable value (see Chapter 14). The balance
sheet does not always reflect historical cost; for instance, in the UK, land
and buildings can be revalued and other assets with a finite economic life
can be depreciated or amortised. In addition, some assets may be carried
at fair value:
An asset or liability that is being measured using the historical
cost basis will be recognised initially at transaction cost or, if an
event other than a transaction is involved, at its fair value at the
time it was acquired or assumed.
Or at current value (see later in this chapter):

If an asset or liability arises from a transaction that was not carried
out at fair value, it will often be more appropriate to measure the
asset or liability at current value rather than historical cost.
If you look in the notes to a company’s accounts, accounting policies will

typically state that the financial statements have been prepared under the
historical cost convention. However, most quoted companies in the UK
will also have some revaluations and will take into account fair values. In
many hyper-inflationary economies HCA might not be used.
Activity 7.1
Why do you think that changing prices might create problems in interpreting both the
balance sheet and the income statement?
Activity 7.2
The following short presentation by the chairperson of the IASB also presents a useful
debate between historical cost versus fair value measurement systems:
http://archive.ifrs.org/Alerts/PressRelease/Pages/Historical-cost-and-fair-value.aspx
7.4 Characteristics of HCA

HCA became the traditional way in which accounting transactions are
recorded, reported and interpreted. The main characteristics of HCA
include the following:
• Objectivity/factuality: in itself it is objective and factual in that the
figures can be vouched to actual transactions.
• Profit/income concept: profit as the difference between revenue and
expenses resonates with common understandings to some extent.
The accounting measurement of income represents historical income and
is an ex post measure.
Activity 7.3
Four specific concepts/conventions are discussed in FRS 18. These are characteristics of
HCA. Check that you can explain what each of the following mean:
• going concern
• accruals
• consistency
• prudence.
85
7.5 Advantages of HCA

HCA has both advantages and disadvantages but it remains an influential
convention in preparing accounts. The advantages are:
• It is more objective/factual/verifiable and in this sense reliable
(although it may involve subjective allocations).
• Because of its relative objectivity, HCA may reduce conflicts over
numbers – its ‘hardness’ reduces the ability to disagree with the
accounting figures. For example, Ijiri (1971) states that hard
measurement systems are those which ‘generate verifiable facts by
justifiable rules in a rigid system which allows only a unique set
of rules for a given situation’. Consequently, when dealing with
performance related pay, for instance, debate about pay levels may
revolve less around the firm’s actual profit figures as all in the dispute
are likely to understand how historical cost profits are calculated:
Hardness is argued to be a desirable characteristic for accounting
figures which are likely to be used in conflict situations –
performance measurement, for example. Such figures reduce any
squabbles concerning the figures themselves and therefore allow
the true items of debate to emerge.
(Bromwich, 1992)
• It may be relevant to users’ legal needs, for example for legal/
contractual purposes (in particular stewardship), to show what funds
have been raised and how they have been spent.
• It is relatively inexpensive to operate.
The historical cost convention has the advantage of familiarity.
This probably makes it cheaper to apply, because procedures
for its implementation are well established, and easier to use,
because users too have established routines for interpreting it.
This advantage may extend to any existing departures from
historical cost: familiarity on the part of both preparers and
users may [result in] reduced costs and increased acceptability.
(Exposure Draft: Statement of Principles for Financial
Reporting, ASB 1995)
• It enables comparability.
• For Ijiri (1971) HCA is ‘unique’. It reduces the problems of allocating
costs since outside users may duplicate the allocation themselves.
The uniqueness of the historical cost system actually reduces
the problems caused in allocating costs. The uniqueness of
the system renders valuation a simpler business than when
a number of possible valuations are available. Moreover,
unbiased outsider observers will have little difficulty in
duplicating any allocation used with historical cost systems,
providing that the method being used is explained.
(Bromwich, 1992)
7.6 Disadvantages of HCA

Many of the disadvantages of HCA relating to price changes have prompted
calls for alternative accounting systems, which includes the current IASB/
FASB approach of ‘fair value’, a discussion previously outlined in the
section on ‘Measurement’ in Chapter 2.
86
The disadvantages of HCA include:

• It is still subjective in practice (e.g. it depends on depreciation policy
and inventory valuation):
...adjustments made to the historical cost carrying value of
trade receivables to make allowance for bad and doubtful
debts involve a degree of estimation that is not dissimilar to
that involved in estimating current values not derived from
an active market – and the results are often of broadly similar
reliability. There is a similar level of estimation involved in
determining the cost of self-generated assets and by-products,
and generally in all circumstances involving allocations of
substantial amounts of indirect costs.
• It is unlikely to be relevant to the economic needs of users since it is
unlikely to reflect future cash flows to be earned by an asset/assets
or the future cash flows likely to replace it/them, and therefore may
lack predictive value in times of changing prices. Only in the case
of completed ventures or a stationary state of perfect and complete
markets, with accounting depreciation equalling changes in market
values, would historical cost give economic income and value.
• The balance sheet does not report a company’s value and hence lacks
apparent relevance.
…this ‘pure historical cost basis’ is rarely used. Instead,
to make historical cost more relevant to the needs of
users, a variation is used that involves a limited amount of
remeasurement.
• Holding gains and operating gains are not distinguished1 and 1

See Chapter 8.
unrealised gains are not reported which may result in fictitious profits
from the perspective of economic theory. This is because a historical
cost income statement reports gains on holding assets when they are
realised, not when they occur. Consequently, no distinction is made
between past period gains realised in the current period and current
gains realised in the current period.
• Consequently, HCA confuses gains from operating and gains from
holding assets in a period of price change.
• Some argue that HCA fails the ‘additivity’2 test, because £s of different 2
The total number in
values are being added together to give a meaningless total. But is a statement should
not mean something
this the fault of historical cost, in itself, or of the measuring unit? The
different in kind from its
question still arises, however, as to whether it is actually useful: constituent numbers.
[T]he capital of the entity is defined as the monetary
amount of ownership interest (the financial capital
maintenance concept) and is measured in monetary
amounts. With this approach, the capital of the entity will be
maintained if the amount of gains during a period is at least
equal to the amount of losses in that period…Whilst this
approach is satisfactory under conditions of stable prices, it
is open to criticism when general or specific price changes
are significant.
(Statement of Principles, paras.6.40–6.42)
For example: If specific prices are rising (e.g. if the prices of particular
non-current assets and inventory are increasing) and general prices
87
are rising, then the balance sheet could look rather antiquated and
jumbled.
Balance sheet as at 31 December 2010
Property (at 1953 cost less depreciation) 10,000
Plant and equipment (at costs between 1993–2010 less 50,000
depreciation)
Inventories (bought at 2010 cost) 18,000
78,000
Share capital (at 1953 when company first formed) 10,000
Income statement (1953–2010) 68,000
78,000
What does £50,000 really mean in relation to plant and equipment? Is
this value particularly useful? When specific prices are changing then
this value is out of date. Indeed, even when there are just general price
changes this affects the measuring unit. So is it really valid to add up
these amounts from different periods, such as 1993–2010?
• HCA also results in time-lag errors in the income statement,
particularly with inventory and depreciation. Is it really valid to
compare £s of different dates?
For example:
Income statement for the year ending 31 December 2010
Sales (evenly throughout the year, e.g. assume on average) £JUNE
Matched with inventories (hold three months’ inventory so assume £MARCH
average cost)
Depreciation for various dates between £1953–2010
Other expenses evenly throughout the year so on average £JUNE
Profit ______?
• If prices are rising, profit is overstated and losses/gains on holding
monetary assets/liabilities are not recognised. Also, trends may be
distorted and hence the accounts may be misleading.
For example, what if sales in 2009 were £1,500 and sales in 2010 were
£1,620 (a rise of 8% over the year)? If inflation increased by 8% also
over the year then, in real terms, the sales growth is in fact zero
because the increase in sales is solely due to inflation.
• Certain items are or have not been included under HCA, for example:
leases, financial instruments and executive share options.
7.7 Alternatives to HCA

There have been many attempts to identify alternatives to HCA.
We shall consider the following methods in this chapter:
• Current purchasing power or general purchasing power: this method
considers general price levels.
In the next chapter, we will consider:
• Replacement cost (RC) – also known as ‘current entry cost’. This is a
form of current value accounting (CVA) which considers specific price
levels.
88
The following, which are also related to different systems of accounting

for price changes, will be examined more closely in a separate accounting
theory course.
• Net realisable value (NRV) – also known as ‘current exit value’. This is
another form of CVA which considers the NRV of assets.
• Present value (PV) – also known as ‘economic value’. This method is
another form of CVA which considers the net present value (NPV) of
future cash flows.
• Deprival value – also known as ‘value to the business’ or ‘value to the
owner’. This involves consideration of RC, NRV and PV (with the PV of
asset use being calculated) valuation bases.
7.8 Introducing CPP accounting

We have suggested that one major disadvantage of HCA is its inability to
cope with changing prices. In particular, in times of rising prices HCA will
overstate profits. Consequently, the accounting profession developed what
may be considered two broad approaches in response to the problems
raised by accounting for changing prices/inflation:
1. An approach concentrating on the effects of general price changes
(i.e. inflation). This is known as current purchasing power
accounting (CPP).
2. An approach concentrating on the effects of specific prices and
the current values of the assets and other items in the financial
statements – the replacement cost, realisable values and the
variant combining cost/value as value to the business or deprival
value. This is known as current value accounting (CVA).
These two approaches, together with HCA, are predominantly
distinguished by two elements:
3
The RPI is calculated
1. how you value assets
each month by taking
2. how you treat capital maintenance. a sample of goods
and services that the
typical household might
7.9 General and specific changes in price buy. Included are such
items as food, heating,
We suggested that, in times of rising prices, HCA should be adjusted to
housing, household
reflect price changes. However, what is the appropriate price adjustment? goods, bus fares and
The nature of changing prices involves change in the relationship between petrol. Every month, a
civil servant will visit a
money and goods and services. There are two broad ways in which the
number of shops and
relationship between money and goods can change: examine prices and
1. specific or relative price change record the details for the
benefit of government
2. general price change. statisticians. These
The latter may be measured through indices, and in the UK the Retail Price figures for retail prices
will reveal the trend for
Index (RPI3) has been used. This tries to measure the effect of inflation
prices over the previous
(the general tendency of prices to rise) on an individual’s purchasing month, but an annual
power. Thus, if you bought a textbook last year for £10 and during the rate is also published
year the RPI was 5%, then you would expect to pay £10.50 to replace your and it is this number
textbook. A specific or relative price change, however, is based purely on which attracts the
attention of the media,
the goods or services in question (e.g. if the cost of your textbook in the
wage bargainers and
shops is £10.60 then the specific price change is 6%). policy makers who have
CPP (or general purchasing power (GPP)) uses a general price adjustment to decide whether it is
to convert HCA to CPP. appropriate to increase
tax allowances and state
Note: HCA uses monetary units (e.g. UK £) as the unit of measurement. benefits to compensate
CPP units measured on (say) 31 December 2008 are not the same as for inflation.
89
CPP units measured on (say) 31 December 2010. It is important that you

understand this underlying feature of CPP.
7.10 Profit recognition and capital maintenance

In times of rising prices HCA will overstate profits so CPP adjusts HCA
figures to account for inflation. Subsequently, profit recognition depends
on maintaining capital in real terms. Note that there are different
ways in which capital maintenance can be assessed.4 The focus here is on 4
Glautier and
capital maintenance of financial capital in real terms. Underdown cite five
concepts of capital
7.10.1 Historical applications of CPP maintenance. This
subject guide discusses
Throughout most of the 1970s and early 1980s, inflation was relatively only three of these,
high in the UK, with rates of inflation well above 10% and on occasions which are sufficient to
over 20%. Consequently, it was recommended in the [Provisional] illustrate the differences
Statement of Standard Accounting Practice ([P]SSAP 7), which in concepts. However,
you should consider the
was published in May 1974 but withdrawn in 1978, that companies
additional concepts.
supplement HCA with a statement illustrating the effects of changes in the
purchasing power of money. [P]SSAP 7, para.12, stated:
Companies will continue to keep their records and present
their basic annual accounts in historical pounds, i.e. in terms
of the value of the pound at the time of each transaction or
revaluation; in addition, all listed companies should present
to their shareholders a supplementary statement in terms
of the value of the pound at the end of the period to which
the accounts relate; the conversion of the figures in the basic
accounts into the figures in the supplementary statement should
be by means of a general index of the purchasing power of the
pound. ([P]SSAP 7 recommended that the RPI should be used
for this purpose.)
Following the Sandilands Report (1975), [P]SSAP 7 was shortly
withdrawn as general price indexation [RPI] as a method was replaced by
specific price indexation and the use of deprival values under Current Cost
Accounting, in SSAP 16 (1980).
7.10.2 Current applications of CPP

Although the UK is not currently using CPP as inflation in the 2010s has
been historically low compared with the 1970s and 1980s, the basic idea
still exists in IAS 29 Financial reporting in hyperinflationary economies. This
standard is relevant to situations where a foreign subsidiary is operating in
a hyperinflationary economy, which means translating statements from the
hyperinflationary currency back to a more stable currency is significantly
impacted from a capital maintenance perspective by the inflation rate.
IAS 29, for instance, requires that:
…the financial statements of an entity that reports in the currency
of a hyperinflationary economy should be stated in terms of the
measuring unit current at the balance sheet date. Comparative figures
for prior period(s) should be restated into the same current measuring
unit. [para.8]
Restatements are made by applying a general price index. Items such
as monetary items that are already stated at the measuring unit at the
balance sheet date are not restated. Other items are restated based on
the change in the general price index between the date those items
were acquired or incurred and the balance sheet date.
90
A gain or loss on the net monetary position is included in net

income. It should be disclosed separately. [para.9]
The restated amount of a non-monetary item is reduced, in
accordance with appropriate IFRSs, when it exceeds the recoverable
amount. [para.19]
See the following link for indicators of how hyperinflation and how the
current cost (i.e. CPP) financial statements are to be produced under IAS29:
https://www.bdo.global/getmedia/ccf981fa-46c8-4166-af36-
1abe983c87f6/IAS-29.pdf.aspx
At the time of writing, Venezuela, Argentina, South Sudan, Sudan
and Zimbabwe are some of the countries deemed to be experiencing
hyperinflation, as defined by IAS 29. An updated list of countries (January,
2020) with hyperinflation can be found at:
https://www.iasplus.com/en/news/2020/01/hyperinflationary-economies
For more real-world examples of how hyperinflation has been accounted
for, see International financial reporting, Chapter 23 for how inflation in
Russia in the late 1990s affected Aeroflot’s annual reports and Unilever’s
reporting (see below).
Unilever, a British-Dutch multinational that has extensive operations in
economies with hyperinflation, is also a useful illustration of IAS29 being
applied in practice.
The company’s 2019 annual reports (available at: https://www.unilever.
report-and-accounts/), pp.28–29, highlights the overall effects of
hyperinflation on the company’s sales performance. The net monetary
gain/loss arising from hyperinflationary economies are reported in the
consolidated income statement (p.87) and consolidated statement of
changes in equity (p.88).
Note that companies whose functional currency is in a hyperinflationary
economy are now no longer able to avoid restatement under IAS
29 through a stable currency. For example, an Argentinian group of
companies with a functional currency of Argentine Pesos are not allowed
to report using US$ as its presentational currency (see also Chapter 19 on
the definition of functional and presentational currency).
See Grupo Supervielle’s financial reports using Argentinian Pesos (a
currency under hyperinflation) and how IAS29 (and IFRS 9) impacts on
the group’s statement of financial position and income statement:
https://s21.q4cdn.com/714080446/files/doc_financials/EN/2019/IAS-29-
Financial-Reporting-in-Hyperinflationary-Economies.pdf
7.11 Assessing CPP accounting

7.11.1 From HCA to CPP: monetary and non-monetary items
CPP accounting requires the separation in the accounts of monetary
and non-monetary items. CPP attempts to identify and reflect the gain
or loss on holding these monetary items. During inflation, one loses
from holding monetary assets (such as cash) as opposed to non-monetary
assets. For example, holding £1,000 of cash in your wallet for a year, when
prices are increasing, will result in a loss of purchasing power (since
what you could have bought for £1,000 a year ago is not equivalent to
what you could now purchase as goods and services are more expensive).
91
7.11.2 Monetary items

These items are fixed by contract in terms of a currency (e.g. UK £) and
the monetary amount is unaffected by price changes. Typically short-
term monetary assets and liabilities include cash and trade
receivables, creditors and bank overdrafts, and long-term monetary
liabilities include long-term loans (and interest thereon).
In contrast to holding monetary assets, if you hold monetary liabilities
you will gain when prices are increasing. For example, say Company A
obtained a long-term loan of £10,000 payable in five years’ time, when the
company actually comes to pay this loan off in cash, the cash used has less
purchasing power than it had at the time the loan was incurred: £10,000
in period-end pounds is worth less than £10,000 was in start-of-period
pounds.
7.11.3 Non-monetary items

These items typically include non-current assets, inventory and
shareholders’ equity (equity share capital, reserves, retained profit
reserve).
7.12 Converting from HCA to CPP: a step-by-step guide

7.12.1 Step 1: Convert the income statement
The HCA income statement must be converted to a CPP income statement.
Each HCA item in the income statement needs to be indexed to do this.
The process of converting HCA to CPP is relatively simple and easy to
use. It is based on the same underlying principles as HCA but uses £s of a
common date.
CPP involves multiplying the HCA values by the change in the relevant
general index (such as the RPI). The change in the relevant index is
calculated as follows:
The index on the date of stabilisation
The index on the date of transaction
What is the date of stabilisation?

Let us assume the income statement is for the year ending 31 December
2002 and you wish to restate the income statement to £s of a common
date (e.g. to 31 December 2002 purchasing power), then the index used is
the RPI for 31 December 2002.
What is the date of transaction?

In a similar way, the date of the transaction is based upon when the
actual item in the income statement (e.g. a sale) took place; say on 30 5
Note that such a
June 2002. Thus, the index on the date of transaction used is the RPI for simplifying assumption
30 June 2002. When stabilising total sales, total purchases and so on, would only be applied
if it was valid. See the
a simplifying assumption is that they all took place evenly throughout
worked example and
the year and hence you would use the average RPI.5 This is a convenient explanation of CPP
assumption; without it you would have to index every individual sale, below.
purchase and so on taking place during the year.
92
Activity 7.4
Let us assume you wish to stabilise HCA for sales to 31 December 2010.
The total sales in HCA total £80,000 and these took place evenly throughout the year
ending 30 June 2010. The RPI at the dates shown was as follows:
Date RPI
1 January 2010 100
30 June 2010 120
31 December 2010 150
What would the stabilised value of the sales be in the CPP income statement?
7.12.2 Step 2: Calculate the losses or gains on monetary items

The calculation of gains or losses on monetary items may be calculated
as separate gains/losses on holding each monetary item (e.g. trade
receivables, cash, creditors) or as combined losses/gains on net short-term
monetary items. The first method6 is best explained via an example.
6
In Section 7.13 both
methods of calculating
Let us assume that Company A wishes to stabilise its accounts to loss or gain on monetary
31 December 2010. During the year it had a creditor (account payable) of items will be shown.
£12,000 outstanding from 30 April 2010 to 31 July 2010. The RPI index
for the relevant months was:
Date RPI
30 April 2010 115
31 July 2010 132
To calculate the holding gain for this three-month period you need to
allow for the movement in the index from 30 April to 31 July. This gain is
measured by the term in brackets below and amounts to £2,016. However,
the gain at 31 July is measured in purchasing power as at 31 July 2010,
and in accounts stabilised to 31 December 2010 the gain must be restated
to purchasing power as at 31 December, by allowing for the movement in
the index from 31 July to 31 December. Hence, the gain on the monetary
item as at 31 July is multiplied by 150/132, that is, from 31 July to 31
December.
Therefore the gain on creditors (accounts payable) is
(
£12,000 ×
32 – 115
×
150
( = £2,016
115 132
Activity 7.5
Try to explain the nature of the holding gain of £2,016 on the monetary item above.
7.12.3 Step 3: Convert the balance sheet

The HCA closing balance sheet is converted into CPP based on closing
balance pounds of purchasing power. However, only the non-monetary
items are converted by the change in purchasing power since they
were initially recorded. The monetary items should not be converted;
adjustments were already made in Step 2 to capture holding gains and
losses on these items.
93
Activity 7.6
Why do you think the monetary items are not converted?
Activity 7.7
Let us assume that you wish to stabilise HCA for non-current assets to 31 December
2010. The non-current assets in the HCA total £20,000 and these were all purchased on
1 June 2010. The RPI for the following months was:
Date RPI
1 January 2010 100
31 March 2010 110
1 June 2010 120
31 October 2010 135
What would be the stabilised value of non-current assets in the CPP accounts?
Example 7.1: Longer CPP calculations
Anderson Ltd
On 1 January 2010 Anderson Ltd started business. Anderson issued, for cash
and at par, 260,000 ordinary shares of £1 and £80,000 of debentures (payable
in 2018) at an interest rate of 15%. £136,000 was immediately invested
in factory premises and £70,000 in inventory, and on 1 February plant and
equipment was bought for £100,000; all of these were paid for in cash.
The following transactions occurred evenly throughout the year:
Sales £600,000 Additional purchases £344,000
Wages £150,000 Sundry expenses £80,000
All of these were cash transactions except for one sale for £40,000 which
took place on 30 June 2010; the trade receivable paid in full on 30
September 2010. In addition to the above, debenture interest for the year
was paid in full on 31 December 2010.
The plant and machinery has a useful economic life of 10 years with no
residual value, and it is depreciated on a straight-line basis with a full
year’s charge in the year of purchase. The factory premises are made up of
land, £56,000, and buildings, £80,000; the buildings are depreciated on a
straight-line basis at 4% per annum.
On 30 September 2010, 20,000 ordinary shares were issued at a premium of
20%.
At 31 December 2010 inventories at cost were £120,000; they may be
assumed to have been bought on average two months before the end of the
year.
During the year the RPI in the UK moved as follows:
1 January 2010 100 1 February 2010 102
30 June (=average for year) 110 30 September 2010 115
30 October 2010 117 31 December 2010 121
The requirement is to draw up an income statement for the year ended 31
December 2010, and a balance sheet at that date, both stabilised in £s of 31
December 2010.
94
Note: the use of cash throughout the period is not explicitly shown in the
worked solutions, hence you would first need to work out a cash account
ledger to trace the movements/transactions in the cash at bank asset
account.
Step 1: Convert the income statement

Transaction CPP
Date Item HCA (£) Index (£31Dec2010)
Evenly* Sales 600,000 × 121/110 660,000
Less cost of sales
1 January Opening inventory 70,000 × 121/110 84,700
Evenly* Purchases 344,000 × 121/110 378,400
414,000 463,100
30 October Less closing inventory (120,000) × 121/117 (124,103)
294,000 338,997
Gross profit 306,000 321,003

Less expenses
Depreciation:
Buildings (3,200) × 121/100 (3,872)
P&E (10,000) × 121/102 (11,863)
31 December Interest (12,000) ** (12,000)

Evenly* Wages (150,000) × 121/110 (165,000)
Evenly* Sundry expenses (80,000) × 121/110 (88,000)
(255,200) (280,735)
Gain and losses on 50,800 40,268

monetary items:
Loss on cash (11,451)
Loss on trade receivables (1,913)
Gain on debentures 16,800
3,436
Income statement 50,800 43,704
* The average index for the year is used for sales/purchases/expenses as

they are assumed to have occurred evenly throughout the year.
** Denotes monetary items.
Explanation for converting the income statement

The index used to convert HCA to CPP items has the same numerator of
121. This captures the date when one is stabilising the accounts –
31 December 2010. The denominator captures the date the transaction
occurred (sales were assumed to take place evenly over the year and
therefore the appropriate RPI is for the average of 110, the June RPI).
95
Step 2: Calculate losses/gains on short-term and long-term

monetary items
Short-term monetary items here are cash and receivables. The long-term
monetary item is debentures (due 2018). Loss on short-term monetary
items may be calculated in two ways:
1. as separate losses on holding trade receivable and cash
2. as a combined loss on net short-term monetary items.
Short-term monetary items calculated as separate losses

• Calculating the loss on trade receivables
The receivable was outstanding from 30 June to 30 September.
At 30 September a loss on having a receivable for three months is
calculated by allowing for movement in the index from 30 June to 30
September. This loss is measured by the term in brackets below and
amounts to £1,818; however, the loss at 30 September is measured
in £30Sept10, and in accounts stabilised in £31Dec10 the loss is
restated to £31Dec10 by allowing for movement in the index from 30
September to 31 December. Hence the loss in £30Sept10 is multiplied
by 121/115:
(£40,000 ×
115 – 110
( ×
121
= £1,913
110 115
• Calculating the loss on cash

The loss on holding cash is the difference between the HCA closing
cash balance and the CPP closing cash balance. To convert the HCA
cash balance to a CPP balance, each item in the cash account is
stabilised to the year-end. Usage of the index is as before.
* The average index for the year is used for sales/purchases/expenses as

they are assumed to have occurred evenly throughout the year.
96
Short-term monetary items calculated as a combined loss on net

short-term monetary items
Note that the loss of 13,364 = 1,913 + 11,452 (with rounding errors). In
other words, the combined loss on net short term monetary items is equal
to the loss on trade receivables + loss on cash in this example.
Long-term monetary items

The gain on the debentures is calculated as
(121 − 100)
£80,000 × = 16,800.
100
Step 3: Convert the HCA balance sheet

Transaction Item HCA (£) Index CPP
date (£31Dec2010)
1 January Land 56,000 × 121/110 67,760
1 January Buildings (NBV) 76,800 × 121/110 92,928
1 February Plant (NBV) 90,000 × 121/102 106,765
222,800 267,453
30 October Inventory 120,000 × 121/117 (124,103)
Cash 72,000 ** 72,000
192,000 196,103
414,800 463,556
Debentures 80,000 ** 80,000
334,800 383,556
Shareholders’ funds
1 January Ordinary shares 260,000 × 121/100 314,600
30 September Ordinary shares 20,000 × 121/115 21,043
30 September Share premium A/C 4,000 × 121/115 4,209
(From income
statement above) Income statement 50,800 43,704
334,800 383,556
Note: ** denotes monetary items.
97
Activity 7.8
Why has HCA profit (£50,800) become £43,704 (£CPP at 31 December 2010) profit?
Activity 7.9
How would the reported profit above differ if the balance sheet at 31 December 2010
included trade receivables in respect of the credit sales made on 30 June and creditors in
respect of the closing inventory?
7.13 Advantages of CPP

Several advantages have been put forward in support of CPP:
• It is easy to convert HCA into CPP accounts. The conversion is
objective and verifiable as it is based on an inflation measure applied
universally.
• It expresses all items in common purchasing power. It corrects time-
lag errors (particularly on inventories and depreciation) in the income
statement.
• It facilitates comparison between companies and understanding of
trends (e.g. of sales and profit) if all years are expressed in the same
purchasing power.
• It measures profit after maintaining shareholders’ capital in real terms.
As it shows real gains and losses on monetary items, it is a measure
that is easily understood by users (shareholders) of the accounts. It
can be used for example to prevent the erosion of capital from the
payment of dividend out of real capital (as measured on a CPP basis).
• The introduction of (gains/losses) on monetary items are real gains/
losses, which replacement cost accounting (RCA) and net realisable
or exit value accounting (NRV) do not recognise as surpluses and
deficits..
7.14 Disadvantages of CPP

A number of disadvantages have been suggested:
• CPP accounts are still based on HCA rather than current values. Any
subjectivity problems associated with HCA remain.
• The balance sheet does not provide up-to-date asset values nor does
the income statement have up-to-date charges for assets consumed.
• There may be problems in interpreting/explaining the figures. The
education problem when measuring units change is often overlooked
(compare lbs v. kilos, inches v. centimetres, fahrenheit v. centigrade).
Part of the education problem is getting users to appreciate that
companies typically have monetary working capital for operations and
therefore will report purchasing power losses on those items.
• HCA accounts are converted into CPP units – but what exactly are CPP
units?
• The difficulty of finding the appropriate index:
• Some argue that inflation is unquantifiable (but is it better to be
partly right than completely wrong?)
98
• Some say the RPI is inappropriate because companies buy, for

example, things like plant and machinery not goods such as
clothing, food and television sets (which determine the RPI). But
are we trying to measure the income of the company as a separate
entity, or the income of the shareholders? If the latter, the RPI is
relevant, because shareholders are concerned with their ability
to buy goods and services in general. The CPP concept of profit is
potentially flawed in this regard, as it does not take into account
the maintenance of capital in physical terms.
• Others say the RPI is not representative of the effect of inflation
on the shareholder group. But empirical tests of the heterogeneity
hypothesis suggest that the impact of inflation on different groups
is very similar (note that the heterogenity hypothesis states
that changes in different individuals’ purchasing power are not
captured by changes in a general index).
• Does the focus on maintaining purchasing power of shareholders’
funds give the most meaningful concept of profit?

• discuss the basis of HCA
• describe the advantages and disadvantages of HCA
• identify why other conventions have been proposed as alternatives/
supplements to HCA
• discuss why CPP was proposed as an alternative to HCA
• describe the difference between monetary and non-monetary items
• convert HCA to CPP by following the step-by-step guide
• understand conceptually the different treatments of monetary and
non-monetary items
• compute real gains and losses on monetary items
• appreciate current uses of CPP in hyperinflationary accounting
• delineate advantages and disadvantages of CPP.

Question 7.1
Highprice Plc began on 1 January 2010. On that date the following
transactions occurred:
• 200,000 ordinary shares of £1 each were issued at £1.20. Preliminary
expenses of £5,000 were paid.
• Non-current assets were bought for £240,000. Payment terms provided
for immediate payment of £80,000 followed by payments of £80,000
on 30 June 2010 and 31 December 2010.
• Inventory was purchased for £120,000.
The HCA balance sheet at 31 December 2010 and HCA income statement
for the year then ended, follows.
99

£’000 £’000
Non-current assets – net book value (NBV) 216
Current assets
Inventories 140
Trade receivables 185
325
Creditors due within one year

Bank overdraft 10
Trade payables 174
184
Net current assets 141
Net assets 357
Ordinary shares of £1 200
Share premium account 35
Income statement 122
357
Income statement for the year ended

31 December 2010
£’000 £’000
Sales 1,100
Less cost of sales:
Opening inventory 120
Further purchases 820
940
Less closing inventory 140 800
Gross profit 300
Less expenses
Depreciation 24
Sundry expenses 145
169
Operating profit 131
Dividends
Interim dividend paid 9
Retained profit 122
You have the following additional information:

• Sales, purchases, and sundry trading expenses occurred evenly during
the year ended 31 December 2010. The interim dividend was paid to
shareholders on 31 October 2010.
• Inventory at 31 December 2010 was purchased on average on
31 October 2010.
100
• Depreciation was provided on non-current assets to write them off to

zero residual value on a straight-line basis over 10 years.
The general index of retail prices moved as follows:
RPI
1 January 2010 120
30 June 2010 (=average for 2010) 130
31 October 2010 135
Restate the HCA of Highprice Plc for 2010 in units of year-end purchasing
power (i.e. CPP accounts stabilised in £ of 31 December 2010).
Comment on the view that accounting for changing prices is unnecessary
when inflation is low.
Question 7.2
Del Ltd started trading on 1 January 2018. The income statement and the
statement of financial position for the first year of trading are given as
follows:
Income statement for the year ended 31 December 2018
£ £
Revenue 5,700,000
Cost of sales
Opening inventory 1,500,000
Purchases 3,600,000
Closing inventory (820,000)
(4,280,000)
Gross profit 1,420,000
Expenses (700,000)
Depreciation (240,000)
Profit for the year 480,000
Statement of financial position as at 31 December 2018

£ £ £
Non-current assets Cost Accum depn Net book value
Buildings 2,400,000 (240,000) 2,160,000
Non-current assets
Inventory 820,000
Cash 1,100,000
Total assets 4,080,000
Share capital 2,000,000

Retained profits 480,000
Trade payables 1,600,000
Capital, reserves
4,080,000
and liabilities
101
The price change indices for the year were identified as follows:
RPI Non- current assets Inventory

1 January 2018 105 150 180
Average 2018 108 200 210
15 December 2018 110 180 225
31 December 2018 120 220 230
All non-current assets and opening inventory were acquired on the first
day of trading.
Closing inventory was acquired on 15 December 2018.
Sales and purchases accrue evenly throughout the year.
Required:
a. Discuss four advantages and four limitations of current purchasing
power accounting.
b. Prepare the current purchasing power income statement of Del Ltd for
the year ended 31 December 2018 and the current purchasing power
statement of financial position as at 31 December 2018.
Question 7.3
Current Purchasing Power (CPP) accounting was used briefly in the UK
in the late 1970s. Under what circumstances is CPP still used? Do the
benefits of using CPP here exceed its limitations?
102
Chapter 8: Accounting for changing

prices/values
8.1 Introduction
This chapter builds on the topic of alternatives to HCA discussed in the
previous chapter. We then turn to an approach that concentrates on the
effects of specific price changes and the current values of the assets and
other items in the financial statements. We consider an alternative that
tries to combine these two approaches.

• discuss replacement cost (RC), net realisable value (NRV) and present
value (PV)
• explain the concepts of current operating income and holding gains
• discuss different concepts of capital maintenance and their
implications for corporate reporting
• prepare a statement of financial position and income statement using
specific price indices, including calculating holding gains and losses
• explain the basic ideas behind the move towards fair values (FV) as
the contemporary approach to dealing with changing valuations.

International financial reporting, Chapters 5, 6, 7 and 8.

Ijiri, Y. ‘A defence for historical cost accounting’ in Sterling, R. (ed.) Asset
valuation and income determination. (Lawrence, KN: Scholars Book Co,
1971) [ISBN 9780914348115].
Prakesh, P. and S. Sunder ‘The case against separation of current operating
profit and holding gains’, American Accounting Review January 1979
pp.1–22.

IFRS 13 Fair value measurement.
Historical standards (Accounting Standards Committee)

SSAP 16 (1980) Current cost accounting.
IAS 15 (1994) Information reflecting the effects of changing prices (withdrawn
2005).
103
8.2 Introduction to current value accounting (CVA)

In current value accounting, the statement of financial position and
income statement show current values in place of historical cost of assets.
One problem is which current values should be used:
• Replacement cost? (And how should that be defined?)
• Net realisable values?
• Present value (sometimes called ‘economic value’)?
• Deprival value (sometimes referred to as ‘value to the business’ or
‘value to the owner’).
Each valuation method will be investigated.1 We will also explore a 1
All of these bases of
combined CVA/CPP system of accounting and consider two capital valuation are further
discussed in Whittington
maintenance concepts:
(1983), pp.115–31.
• operating (or physical) capital maintenance
• financial capital maintenance in money terms.
8.3 Replacement cost accounting (RCA)

In RCA, all the assets are entered in the financial statements at the cash-
equivalent value of what it would cost the organisation to replace them
(also known as entry costs). There may be a choice of three possible
‘replacement costs’:
1. Reproduction cost: the amount that would currently have to be
paid to purchase an asset identical to the one currently owned (i.e.
like-with-like).
2. Cost of replacing with best alternative asset (i.e. one best
suited to perform the function of the existing asset, adjusted for
depreciation). This has the advantage of allowing for the possibility
that technological change has rendered the existing asset obsolete.
3. Replacement of service potential tries to measure the cost of
replacing the services provided by the existing asset. It does this by
adjusting the above (2) for operating advantages or disadvantages
compared with the existing asset.
An issue with RCA is that if the company has no intention of replacing
(because the capital budget shows replacement is not worthwhile), or
cannot replace, is the figure of any relevance? This will be discussed later.
8.4 Net realisable value (NRV)

Using NRV, the value of an asset is the estimated amount that could be
raised from its sale (net of selling expenses); this is also known as the
exit value. For example, consider a vehicle bought for £24,000, with
an expected life of four years, a nil residual value and a straight-line
depreciation policy. At the end of the first year the HCA net book value is
£18,000 (£24,000 – £6,000). If the vehicle’s NRV at the end of the first
year is £19,500 then the statement of financial position carrying value is
£19,500 and the depreciation charge is £4,500 (£24,000 – £19,500).
The arguments in favour of this basis are that it:
• measures the economic sacrifice made by continuing to hold and use
the asset
• enables users to compare the return earned with the return available
on investing those funds elsewhere
104
• reflects the adaptability of the company.

But against NRV is its lack of predictive value if the company has no
intention of selling the asset. This would be greater if the company owned
highly specific assets with a zero or negligible (or even negative) realisable
value. Such NRVs would provide no indication of expected future cash
flows and would produce some strange income numbers:
The accounts show a loss if the firm buys useful but specific
machines and a profit if it buys unsuitable machines with a high
resale value.
(Baxter, 1984, p.124)
While NRV in its original form may not be used as a current system of
measurement, the current fair value (FV) approach is a form of exit value
not dissimilar to NRV. We will discuss FV further in Section 8.12.
Activity 8.1
How do you think NRV accounting reconciles with the going concern concept?
In general, do you consider RCA or NRV to be the more prudent?
8.5 Present value (PV)

This basis measures assets at the net present values of future cash flows
to the asset. The main variant is the PV from using the asset: its value in
use in the business. For example, let us assume you have an asset that
has an expected useful life with the company of four years. Its net cash
contribution (revenue less operating and maintenance costs) over the four
years would be £15,000 per annum. The company expects to earn 10%
per annum on all capital invested, and this would be the discount rate.
The asset would be valued in the accounts at £47,549, that is, £15,000
multiplied by an annuity factor at 10% for four years (£15,000 × 3.1699).
The PV from sale could also be calculated (of course, when an asset is
being used this value is typically lower than the value in use and hence not
the PV of the asset considered in terms of all possibilities).
In its favour, it is argued that it would be useful as a predictor of future
cash flows.
But the figures may lack reliability. To compute present values requires
estimation of all future cash flows together with an appropriate discount
rate. Moreover, if we adopted an asset-by-asset approach to financial
reporting, it would be difficult to allocate cash flows to individual assets
when they work as part of a team. It may only be possible to measure the
cash flows of the business as a whole.
8.6 Deprival value (DV)

Deprival value was developed from the ideas of Bonbright who wrote
(in The Valuation of Property, 1937):
The valuation of a property to its owners is identical in amount
with the adverse value of the entire loss, direct and indirect,
that the owner might expect to suffer if he were to be deprived
of the property.
In other words, the DV of an asset is the amount of the loss which a

business would suffer if that asset was lost or destroyed, assuming that the
owner takes optimal action on deprival. According to the circumstances,
105
deprival value will either be replacement cost (RC), net realisable value
(NRV) or present value (PV is alternatively known as value-in-use).
The formula for deprival value is:
The lower of replacement cost (RC) or
(higher of net realisable value (NRV) or Present Value (PV)).
The concept of DV is no longer examined in AC2091 Financial reporting. It
is now considered in AC3193 Accounting theory (Chapter 5).
8.7 Holding gains and current operating profit

CVA gives rise to:
1. Current operating profit. In arriving at this, the amounts charged
against sales are the current costs (instead of historical costs) of the
assets consumed at the time of consumption.
For example: You started business with £100 and you bought 10
T-shirts for £10 each which you sold for cash six months later at £15
each. At point of sale, the price to replace your inventory was £12 a
T-shirt.2 2
In this simple example
we concentrate on
Let us assume the current cost equals RC. Below is the HCA income inventory – we do not
statement and an extract of the CVA income statement: consider non-current
assets at this stage, but
HCA income statement
the concept is similar.
£
Sales 150
Cost of sales 100 (10 units @ HC)
Profit 50
CVA income statement
£
Sales 150
Cost of sales 120 (10 units @ RC)
Current operating profit 30
2. Holding gains or losses. A realised holding gain is the
difference between the current value of an asset at the time of
consumption and its historical cost. An unrealised holding3 gain 3
See Example 8.1 below
is the difference between the current value of an asset held at the for the calculation of
unrealised holding gains.
statement of financial position date and its historical cost (or, if the
asset was held at the start of the period, its value then).
Example: Given the information in the example above, the realised
holding gain on each T-shirt is the difference between the current
value of £12 and the historical cost of £10. Therefore the total realised
holding gain is £2 × 10 units = £20. This captures the fact that by
buying the T-shirts and holding onto them for six months before sale,
you have gained (as there has been a specific price rise since you
bought the T-shirts).
4
Whether this is the
If we place this realised holding gain in the income statement4 then appropriate place to put
the total profit under both HCA and CVA is equal. realised holding gains is
discussed below.
106

£
Sales 150
Cost of sales 100 (10 units @ HC)
Profit 50
£
Sales 150
Realised holding gain 20
Profit 50
Activity 8.2
Suppose that you actually only sold six of the T-shirts discussed above. What would your
realised and unrealised holding gains be?
Prepare a CCA income statement and balance sheet assuming all realised holding gains
go to the income statement and unrealised holding gains go to the statement of financial
position.
You will notice that HCA makes no distinction between these two types
of profit (current operating profit and realised holding gains). Another
problem with CVA, once you have ascertained what the current value
should be, is determining how much of an increase in asset values enters
into income. At this stage we are only considering specific price changes
under CVA.
8.8 Capital maintenance concepts

Whether the realised holding gains form part of income depends on the
capital maintenance concept adopted, which is a matter of choice.
There are two capital maintenance concepts to be considered.
8.8.1 Financial capital maintenance in money terms

This requires that the capital to maintain is the shareholders’ opening
interest in the company as shown in the financial statements. Therefore,
holding gains would form part of your income.
If the value of the assets rises, one is better off and the gain goes to
income.
8.8.2 Physical (or operating) capital maintenance

This is usually defined as maintenance of the company’s operating
capability (i.e. it requires that the capital to maintain is the operating
capability of the company). It provides for the measurement of profit after
maintaining the company’s ability to continue producing the same level
of goods and services; it gives a figure of current operating profit and
excludes from profit all holding gains and losses. Consequently,
holding gains would not form part of your income and if the company
cannot maintain its operating capability, then there is no profit.
107
For example, based on the T-shirt transaction above, under financial capital
maintenance in money terms you could consume all of the £50 income
and still be as ‘well off’ as you were at the start (closing and opening
statement of financial positions both equalling £100). However, under
physical (or operating) capital maintenance, by consuming all the profit of
£50, you would be ‘worse-off’ since you have not retained your operating
capabilities (i.e. you would not be able to sell 10 T-shirts in the next period
because the cost of replacement has risen by £2). Therefore, to sell 10
T-shirts next period you must set aside the additional cost of £20 (£2 x 10
units). Thus, your closing statement of financial position would need to
be £120 to maintain your operating capacity (now comparable with the
opening balance of £100, i.e. the opening and closing balance sheet values
are equal in terms of their ability to buy 10 T-shirts). Therefore, under
physical capital maintenance your income is now £30 and the holding
gain of £20 is in your statement of financial position under the heading
of ‘capital maintenance reserve’. This would enable you to maintain
your capital and hence does not form part of your income:
£
Sales 150
Cost of sales 120 (£12 × 10 units at replacement cost)
Profit 30
CV statement of financial position
£
Cash 150
Opening capital 100
Profit 30
Capital maintenance reserve 20
150
Note: A third possibility would be to take realised holding gains to profit
but unrealised holding gains to reserves on the grounds of prudence. This
approach would amount to analysing historical cost profit into current
operating profit and realised holding gains.
8.8.3 Is physical capital maintenance useful for measuring

income?
A figure of current operating profit may provide users of accounts with
useful information. As well as showing the success in selling, it will help
users assess (e.g. in relation to the level of distributions) whether or not
the company is maintaining operating capability, whether it is planning to
expand or contract, or whether, in order to maintain operating capability,
it will raise further finance; this is important in estimating future cash
flows. However, current operating profit may also be shown separately in
a current value accounting system based on financial capital maintenance,
which in addition includes holding gains and losses in income.
8.8.4 Problems with physical capital maintenance

There are problems in using physical capital maintenance as the basis
for income measurement and in arguing that all holding gains are
capital adjustments. In particular, whereas financial capital maintenance
is applicable to all types of business, the concept of physical capital
maintenance does not apply to all companies. It leads to strange results,
108
for example, for commodity dealers who buy and sell in the same
market. The concept of operating capability maintenance does not seem
relevant to one-off ventures where there is no intention of repeating the
same activity, nor to value-based companies (such as investment trusts
and production companies) and other companies which do not have
an operating capability to maintain. A concept of income based on an
economic benchmark that does not apply to all business may be thought
questionable.
Even in relation to companies with a more easily defined operating
capability, physical capital maintenance (by charging against profit the
amounts needed to replace assets consumed but excluding from income
the gains made as a result of having bought those assets more cheaply,
or losses made as a result of having bought them at greater cost), may be
thought to be confusing questions of financing replacement with issues of
income measurement. If the market price of the company’s assets has risen,
and replacement is justified at the higher prices, the capital markets should
be prepared to provide any necessary finance. If managers choose instead
to use shareholders’ funds for this purpose, it would seem right that they
should show this as a reinvestment of profit rather than adopt a capital
maintenance concept which suggests that profits are lower and that there
is no profit until provision has been made for the additional investment.
Charging the current value of assets consumed at the time of sale or
consumption will not ensure that sufficient funds are retained to replace
those assets if there is a delay in replacing them during which time prices
have continued to rise. In particular, there may be a problem over ‘backlog
depreciation’ for non-current assets whereby the sum of the annual
current value depreciation charges is likely to fall short of the sum needed
to replace the asset at the time of replacement. Although there may be
circumstances in which the annual current value depreciation charge will
equal the annual amount spent on replacement (e.g. if a company has, say,
seven identical assets each with a seven-year life and wishes to replace one
each year), this will not necessarily be the case.
8.8.5 What engenders changes in asset values?

If we assume that on average changes in value are engendered by changes
in expected future cash flows, then on average one is likely to be more
right than wrong to include holding gains in income. This supports
financial capital maintenance over physical capital maintenance.
It has been suggested that the capital maintenance concept used should
be determined by the needs of the users of the accounts. Managers and
employees may prefer physical capital maintenance because they are
interested in the continued existence and expansion of the company that
employs them. Other users, for other reasons, may also prefer physical
capital maintenance. But if we are concerned with measuring shareholder
income, financial capital maintenance terms appear more relevant and, as
noted, they have the merit of applying to all business. 5
CPP accounting
accounts for general
8.9 Current value accounting using replacement cost price changes rather
than specific price
Let us examine the basic form of replacement cost – reproduction cost changes, and thus the
– by assuming that we can obtain the current values of identical assets by assets are not at current
value.
using specific price indexes.5
109
Example 8.1: CVA

Barrow Ltd started business on 1 January 2010. Its summarised balance
sheet at that date was as follows:
£
Non-current assets, at cost 30,000
Inventory, at cost 20,000
Cash 10,000
60,000
10% debentures 10,000
50,000
Ordinary shares of £1 50,000
Other information:
• The non-current assets were purchased on 1 January 2010 and are
expected to have a 10-year life with no residual value.
• On 30 June 2010 inventory which cost £12,000 was sold on credit for
£26,000.
• Expenses of £6,000 were paid evenly throughout the year ended 31
December 2010.
• Debenture interest for the year was paid on 31 December 2010.
• On 31 December 2010, £20,000 was received from trade receivables
and inventory costing £14,000 was purchased on credit.
The following movements occurred during 2010 in the indices of
replacement cost:
1 January 30 June 31 December
Inventory 100 132 144
Non-current assets 100 110 125
The following are required:
a. An income statement for the year ended 31 December 2010,
and a balance sheet at that date prepared under the historical cost
convention.
b. A current value income statement for the year ended 31
December 2010 and a statement of financial position at that date,
incorporating replacement costs for assets sold, consumed and held,
on a physical capital maintenance basis.
c. A current value income statement for the year ended 31
December 2010 and statement of financial position at that date,
incorporating replacement costs for assets sold, consumed and held,
on a financial capital maintenance basis.
Note: Base depreciation on the year-end cost of non-current assets for (b)
and (c).
The income statement for (a), (b) and (c), along with other relevant
information, can be seen in the spreadsheet provided on the VLE
[https://emfss.elearning.london.ac.uk/mod/page/view.php?id=32388].
Workings and explanation

Unlike CPP, we have only indexed those items for which we have an
index to track specific prices (e.g. inventory and non-current assets). CVA
involves multiplying HCA values by the change in the relevant specific
index.
110

The change in the relevant index is calculated as follows for the income
statement:
the index on the date of replacement/consumption
the index on the date of transaction
Date of replacement/consumption
• For inventory: cost of sales
The replacement/consumption date is based on the date you actually
sold the inventory. In the above, the sales took place on 30 June. So
the inventory index on 30 June (i.e. 132) is used.
• For non-current assets: depreciation
The index for depreciation is based on the date of consumption/
replacement. You could assume numerous dates, for example assume
depreciation occurred evenly throughout the year and therefore the
index would be based on the average fixed asset index, say 30 June.
However, for this question you are told that depreciation is based on
the year-end cost and thus the index used is 31 December (i.e. 125).
Transaction date
• For inventory: cost of sales
The date the inventory was purchased – 1 January 2010. Thus the
index is 100.
• For non-current assets: depreciation
The date the non-current assets were purchased – 1 January 2010.
Thus the index is 100.
Calculation of realised holding gains

A realised holding gain is the difference between the current value at the
time of consumption of an asset consumed and its historical cost.
Inventories – cost of sales: realised holding gain
Realised HG = CVA (cost of sales) – HCA (cost of sales)
= £15,840 – £12,000 = £3,840
Non-current assets – depreciation: realised holding gain
Realised HG = CVA (depreciation) – HCA (depreciation)
= £3,750 – £3,000 = £750
CVA statement of financial position

The inventory and non-current assets are recorded at their replacement
cost. The calculation of the change in the relevant index is identical to that
used in the CPP accounts:
the index on the date of stabilisation
the index on the date of transaction
Calculation of unrealised holding gains

An unrealised holding gain is the difference between an asset’s current
value at the statement of financial position date and its historical cost (or,
if the asset was owned at the start of the period, its value then).
111
Inventories – closing inventory: unrealised holding gain

Unrealised HG = CVA (closing inventory) – HCA (closing inventory)
= £25,250 – £22,000 = £3,520
Non-current assets – net book value (NBV): unrealised holding gain
Unrealised HG = CVA (NBV) – HCA (NBV)
= £33,750 – £27,000 = £6,750
Capital maintenance reserve in current value balance sheet

This is simply the total holding gains for the inventory and non-current
assets – realised and unrealised.
£
Increased cost of inventory sold 3,840
Increased cost of balance sheet inventory 3,520
Increased depreciation charge 750
Increase in net book value of non-current assets 6,750
14,860
Activity 8.3
Why do holding gains arise?
Discuss the different treatment of holding gains under HCA and CVA in terms of capital
maintenance concepts.
8.10 Advantages and disadvantages of replacement cost

8.10.1 Advantages
If we define replacement cost (RC) as replacement of service
potential, it is thought to have a number of advantages because of the
income numbers based on it.
• Use of RC enables a company to measure both current operating profit
(i.e. profit after charging the replacement cost of assets consumed
at the time of consumption) and holding gains, both realised and
unrealised, and to report these various components separately. This
split enables:
1. users to evaluate management skill in selling, given the cost of
replacing the assets sold or consumed, and management skill in
buying (the difference between the replacement and historical
cost); this supposed advantage has, however, been disputed by
some
2. users to draw on their knowledge of the markets the company
operates in to predict future current operating profit and future
cash flows
3. users to compare the dividends paid with current operating profit
to ascertain whether the company will be maintaining its physical
capacity, expanding or contracting, as an aid to the prediction of
future cash flows.
• Provided the company actually intends to replace its assets, and to
continue in the same line of business, the income figure based on RC,
with holding gains taken to income as under a system of financial
capital maintenance, will be closer to a measure of economic income
112
and value than HCA would since, providing the company is acting
rationally in its decision to replace, replacement cost measures the
minimum value of expected cash flows. The better the market, the
nearer will replacement cost be to present value of future cash flows. It
follows, therefore, that it will also be a better predictor of future cash
flows.
8.10.2 Disadvantages
• Particularly for highly specific assets for which there is no good
market, ascertainment of RC might prove highly subjective.
• Like historical cost, it is also subject to arbitrary allocations against
income.
• There is the ‘aggregation’ problem (i.e. does one replace individual
assets, which might prove more expensive than the cost of replacing
the whole team of assets with a new technology?)
• Some complain that RC is a cost and not a value. For example:
RC…does not represent worth, being a cost based measure.
Business activity is about the adding value, so financial
statements should reflect this. A value basis rather than a cost
basis is therefore predicated. The value of an asset is either the
net proceeds which could be realised by selling it or the net
present value of the cash flows that can be derived from it. RC is
not, in principle, a measure of value.
(ICAS, Making corporate reports valuable, 1988, p.64)
Others, however, regard it as an ‘entry value’ (and NRV and FV are ‘exit
values’).
8.11 Fair value measurement (IFRS 13)

The current system of valuation under IFRS/IAS incorporates a mix of
historical cost values (HCA) and fair values (FV). The underlying premise
of FV is a reliance on market mechanisms to provide valuation. Alexander
et al. (2014, Chapter 8) suggest that this helps standard setters avoid
complexities with defining FV as either an entry or exit value, as there
must be two parties on either side of the transaction (a buyer and a seller)
before a value can be called a ‘fair value’. However, the current standard
IFRS 13 defines FV as an ‘exit value’ concept:
FV is now defined as ‘the price that would be received to sell an
asset or paid on a transfer a liability in an orderly transaction
between market participants at the measurement date’
As Alexander et al. point out, this definition is a market-based exit price.
From the perspective of the entity, the value of the asset reported would be
based on how much the entity would expect to receive if there is a market-
based transaction at the date of valuation for which the asset could be
exchanged (i.e. disposed or exited).
Alexander et al. go on to point out that there could be problems using FV if
there are no orderly, market-based and observable prices that could be used
to value the asset. These problems relate to the approach that should be
taken when certain market conditions are not being met. For instance, the
IASB sets out the calculation of FV using a ‘fair value hierarchy’ framework:
Level 1:
These relate to inputs that are based on ‘quoted prices in active
markets for identical assets or liabilities that the entity can access at the
measurement date’.
113
Level 2:
These relate to inputs that, while not actual quoted prices, are based on
observable prices (e.g. in another active market) or, in the case of non-
active markets, can be derived from observable value-relevant information
such as interest rates, yield curves and other observable market-based data
being generated.
Level 3:
These relate to unobservable inputs which are used to measure FV based
on ‘assumptions that market participants would use when pricing the
asset or liability, including assumptions about risk [which] might include
the entity’s own data’. Alexander et al. point out that the IASB was
clear that FV should be seen as a market-based value, as opposed to an
entity-specific value such as NRV or PV. The mitigation in this regard to
overcome problems of the non-existence of active or observable markets
is disclosure. Disclosure in this regard could include information on the
sensitivity of the FV-based measurement to changes in unobservable inputs
(Alexander et al., 2014, p.123).
There are some exceptions to the requirement to use FV:
1. Share-based payments under IFRS 2 – entry/exchange values continue
to be used.
2. Leasing under the updated IAS 17 (and possibly under the forthcoming
IFRS 19) – entry/exchange values continue to be used.
3. Impairment of assets (IAS 36); Inventory measurement under NRV
(IAS 2).
The disclosure requirements under Level 3 also do not apply to reporting
on employee benefits (IAS 19) and retirement/pensions (IAS 26).
8.11.1 FV valuation concept: highest and best use (HBU)

The valuation for a non-financial asset is based on the highest and best
use (HBU) of the asset and whether the asset is used in combination with
other assets or on a standalone basis. Alexander et al. (2014) note that
HBU is a concept used primarily for assets such as real estate, for which
the alternative use of the asset is clear and understandable. However, it is
less relevant if non-financial assets do not have an alternative use without
substantial modification and therefore ceasing to be the same asset/
liability.

• discuss replacement cost (RC), net realisable value (NRV) and present
value (PV)
• explain the concepts of current operating income and holding gains
• discuss different concepts of capital maintenance and their
implications for corporate reporting
• prepare a statement of financial position and income statement using
specific price indices, including calculating holding gains and losses
• delineate the advantages and disadvantages of RC accounting
• explain the basic ideas behind the move towards fair values (FV) as
the contemporary approach to dealing with changing valuations.
114

Question 8.1
Tram Ltd started trading on 1 January 2015. The statement of
comprehensive income and statement of financial position for the first year
of trading are given as follows:
Statement of comprehensive income for the year ended 31 December 2015

£ £
Revenue 5,400,000
Cost of sales
Opening inventory 300,000
Purchases 3,600,000
(3,540,000)
Expenses (600,000)
Comprehensive income 1,092,000

£
Non-current assets – net book value 5,592,000
Inventory 360,000
Cash 4,980,000
Share capital (£1 shares) 6,000,000

Accounts payable 3,840,000
Equity and liabilities 10,932,000
The price change indices for the year were identified as follows:
RPI Non-current
Inventory
assets
1 January 2015 150 200 180
Average 2015 160 210 190
30 November 2015 170 220 215
31 December 2015 180 230 250
Closing inventory was acquired on 30 November 2015. 50% of the non-
current-assets were acquired on 1 January 2015 and 50% were acquired
on 30 June 2015.
Opening inventory was acquired on the first day of trading.
115
A full year’s depreciation is charged in the year of purchase for non-

current assets.
(a) Briefly identify how assets are valued within historic cost accounting,
current purchasing power accounting and current value (replacement
cost) accounting and discuss the capital maintenance concepts most
closely associated with each of the three conventions.
(b) Prepare the current purchasing power statement of financial position
as at 31 December 2015 and the current purchasing power statement
of comprehensive income for the year ending 31 December 2015 for
Tram Ltd.
(c) Prepare the current value (replacement cost) statement of financial
position as at 31 December 2015 and the current value (replacement
cost) statement of comprehensive income for the year ending 31
December 2015 for Tram Ltd.
Question 8.2
Critically assess the practical and theoretical issues of historic cost
accounting versus fair value accounting in financial reporting. In
particular, comment on how the following items are currently accounted
for, and the potential limitations of doing so.
i. Financial instruments.
ii. Investment property.
Question 8.3
What are the issues arising from the use of exit values as a basis of
measuring assets and liabilities? You should discuss your answer in the
context of IFRS’s adoption of fair value accounting.
Question 8.4
Tennis Ltd started trading on 1 January 2016. The statement of
comprehensive income and the statement of financial position for the first
year of trading are given as follows:
£ £
Statement of comprehensive income for 2016
Revenue 7,600,000
Cost of sales
Opening inventory 1,200,000
Purchases 4,800,000
(5,040,000)
Other expenses (1,040,00)
Profit before tax 1,200,000
Tax (400,000)
Profit after tax 800,000
116
Statement of financial position at 31 December 2016

£
Non-current assets at net book value 2,880,000
Inventory 960,000
Cash 2,400,000
Retained earnings 800,000
Trade payables 640,000
Total equity and liabilities 6,240,000
The price change indices for the year are given as follows:
RPI Non-current assets Inventory
1 January 2016 150 200 180
Average 2016 160 210 190
30 November 2016 170 220 215
31 December 2016 190 230 250
All non-current assets and opening inventory were acquired on the first
day of trading. Closing inventory was acquired on 30 November 2016.
Required
a. Identify and explain the capital maintenance concept most closely
associated with current value (replacement cost) financial statements.
b. What are realised and unrealised holding gains?
c. Prepare the current value (replacement cost) statement of
comprehensive income for the year ended 31 December 2016 and the
current value (replacement cost) statement of financial position as at
31 December 2016 for Tennis Ltd, showing realised and unrealised
holding gains.
117
Notes
118
Chapter 9: Accounting for employee benefits
Chapter 9: Accounting for employee

benefits
9.1 Introduction
Most employers provide employees with benefits beyond, if including, the
wages paid. IASs/IFRSs aim to account for these benefits where they give
rise to liabilities and expenses for the entity. Some of these benefits may be
long-term in nature, increasing the uncertainty surrounding them.
The accounting treatment pursued by IAS 19 for employee benefits
applies if the benefits result from formal agreements between employees
and the entity, legislative requirements, the requirements derived from
industry arrangements and the requirements derived from informal
practices engendering a ‘constructive obligation’ (this could occur where,
for example, a departure from the informal practice would unacceptably
damage the entity’s relationship with employees).

This chapter considers accounting for employee benefits. It focuses on
how IAS 19 Accounting for employee benefits prescribes the treatment of
short-term and long-term employee benefits. The treatment of share-
based payments under IFRS 2 is also covered as this links to share-based
payments to employees.

• appreciate the difference between short-term and long-term employee
benefits and key aspects of the prescribed accounting for these benefits
in IAS 19
• appreciate key aspects of the treatment of share-based payments under
IFRS 2.

Relevant standards
IAS 19 (2011) Accounting for employee benefits.
IFRS 2 Share-based payment.
9.2 Short-term employee benefits

Short-term employee benefits are expected to be paid within 12 months
of the end of a period. They would typically include wages, salaries, social
security contributions, paid annual leave and sick leave, many benefits-in-
kind, some payments for profit sharing and bonus plans.
9.2.1 Accounting for short-term benefits

In relation to services rendered by an employee within an accounting
period the undiscounted amount of the associated short-term benefits
119
expected to be paid by an entity shall be recognised and reported as an

expense (paid or accrued – in the latter case a liability is created). Any
prepaid element is recognised as an asset.
9.2.2 Profit-sharing and bonus plans

Profit-sharing and bonus plan payments are treated as expenses. The
formal terms of such plans (e.g. the financial indicators that the payments
are linked to) need not be disclosed and the amounts can be aggregated
with other short-term benefits – even if on the face of it this would be very
useful information.
Expenses and associated liabilities are recognised on payment or
when the entity has a present legal or constructive obligation to make
such payments as a result of past events and a reliable estimate of the
obligation can be made.
9.3 Share-based payments

Companies sometimes pay employees in the form of shares or share-based
(and share-derived) payments. The recognition and measurement of
share-based payments is covered by IFRS 2, a standard issued in 2004.
The accounting treatment is controversial. Are the payments rewards
to employees in their capacity as shareholders or as employees? Is it
reasonable to write off expenses thus reducing earnings while increasing
shares – thus effecting a double hit on earnings per share? IFRS 2 decided
a charge was appropriate – excluding the payments overstated profits
and reduced comparability between organisations paying employees in
different ways. For some companies the charge at stake is not a trivial
amount.
9.3.1 General principles of IFRS 2

Companies should recognise the payments as employee benefits in the
period to which they relate.
Companies should recognise an increase in equity if the share-based
payment is equity-settled (including the issues of options to employees)
and a liability if it is a cash-settled transaction (until the settlement of the
liability, the company remeasures fair value at each reporting date, with
differences going to profit/loss).
Measurement of the equity or equity instruments paid should be at the fair
value of the equity or those instruments at the date the instruments are
granted or given to the employees. The fair values of employee options are
charged to profit/loss over the vesting period, the period (which may be
longer than one year if it is often less than a year) in which the employees
must satisfy non-market vesting conditions (e.g. work service conditions)
that allow them to exercise their option rights.
9.3.2 Fair value of employee options

In relation to the option, the market price could be used but if the option
is not traded on a market then a valuation model needs to be used such as
(normally) the Black-Scholes option pricing model or the binomial model
(where details of the valuation need to be disclosed).
The credit entry is to a separate equity reserve or to retained earnings (if
the former, there is a transfer to the latter at exercise date).
120
9.4 Long-term employee benefits

The most common long-term employee benefits are pensions. The
principles of accounting for other long-term benefits are similar to
accounting for pensions.
There are two main types of company pension scheme run by companies
for employees.
In defined contribution plans, the employer agrees to contribute a
specific amount to the plan and sometimes there is a contribution from
the employee too (usually the contributions are paid into a separate entity
fund). Benefits are a function of the contributions made and the return
from investing these contributions (the latter clearly adds an element of
risk – which is borne by the employees).
In defined benefit plans, promised benefits are defined in advance
so that benefits are a function of the scheme’s benefit formula (e.g. the
benefits might thus be based on final pay, career average pay or final
years’ average pay, or the benefits may be non-pay related such as if the
scheme pre-specified benefits in terms of, for example, contributions plus
a guaranteed fixed return thereon). Such plans can be financed by a pay
as you go system (whereby pensions are paid directly from company
resources as they fall due) or through a funding system. The latter
involves making contributions over the whole period of employment of an
employee so as to accumulate the required funds for pension payments.
Usually actuarial cost/funding methods are used to calculate the periodic
payments.
Where a funding system is used to fund a benefit plan, there are various
international variants. Sometimes no separation of the funds from
other assets of the employer is made and benefits are paid directly by
the employer. Sometimes employers are able to use funds contributed
to finance their operations. Sometimes the contributions are kept in
the entity but have to be invested in particular kinds of asset. In some
countries, some of these variants may be outlawed. There are other
variants. Resources might be contributed to a separate legal entity fund
(and various types are possible). The contract with that separate entity
will clarify what responsibilities and risks are transferred to the entity. In
this regard, IAS 19 states that an entity paying into a pensions plan should
treat it as a defined contribution plan for accounting purposes unless the
entity has a legal or constructive obligation to pay the benefits directly
when they fall due or to pay additional contributions if the fund does not
pay all future benefits relating to service in the current and prior periods
(in these cases the accounting should be as for a defined benefit plan).
9.4.1 Defined contribution plan accounting

Amounts to be contributed are treated as pension costs for a period. There
may be accrued expenses and liabilities here. Prepayments and assets are
also possible.
9.4.2 Defined benefit plan accounting

Typically, under defined benefit schemes uncertainties will remain until an
employee retires (or until their death). This gives rise to the accounting
issue of how to charge the total costs over the service years of the
employee. This is usually resolved in terms of international practice by the
usage of actuarial funding/cost methods. Of these methods, the ‘projected
unit credit method’ is prescribed by IAS 19 for recognition of costs and for
purposes of liability valuation.
121
The projected unit credit method is (somewhat confusingly) an accrued

valuation method (confusing because the other major category of actuarial
funding/cost methods – not chosen by IAS 19 – is known as the set of
‘projected valuation methods’). Under accrued valuation methods, service
rendered to date and current salary level are typically taken into account
for the amounts to be funded. In a particular year, the amount to be
funded is equal to the present value of the pension benefit accrual in that
particular year. Under the projected unit credit method variant expected
future salary levels are taken into account along with service already
rendered (projected valuation methods, forming the other major category
of actuarial cost/funding methods, calculate the total benefit on employee
retirement by taking into account expected total service to be rendered
and expected salary level at retirement – this being allocated as a fixed
amount yearly or as a fixed percentage of salary).
In order to calculate accrued benefits and finance patterns related thereto,
actuarial assumptions are needed (e.g. assumptions about life expectancy,
investment return, staff turnover and future movements in salary).
IAS 19 prescribes that these assumptions be ‘unbiased’ and ‘mutually
compatible’ (consistent). Financial assumptions should be based on market
expectations at the date for which the statement of financial position is
drawn up. The discount rate – a key assumption to reflect the time value
of money and not the actuarial or investment risk – is to be determined by
reference to market yields on this date on high-quality corporate bonds (or
in the absence of a deep market in these bonds in the country, the market
yields on government bonds are to be used).
The present value of accrued benefit obligations increases each year due
to the year of extra service rendered by the employee and the interest
accrual.
The present value of the defined benefit obligation is key to the valuation
of pension liabilities under IAS 19.
9.4.3 Calculating the defined benefit cost in the case of a defined

benefit plan
The defined benefit cost is equal to the:
Service cost (current and past service cost and gains/losses on settlements)
+
Net interest on the net defined benefit liability (or asset)
+
Re-measurements of net defined benefit liability (actuarial gains and
losses, return on plan assets excluding amounts included in the net interest
on the net defined liability (asset) and any change in the effect of the
asset ceiling excluding amounts included in net interest on the net defined
benefit liability (asset)).
The service cost and the net interest on the net defined
benefit liability (or asset) will be presented in the profit and loss
account part of the statement of comprehensive income. The element
of re-measurements of net defined benefit liability is included in other
comprehensive income.
9.4.4 Explanation of current service cost

The current service cost should normally be calculated using the projected
unit credit method, based (as noted earlier) on the benefit formula of the
pension scheme. A simple illustration is given below.
122
Suppose a lump sum benefit is payable to a company employee, Mr Linn,

on the termination of his service. The lump sum is equal to 1% of the final
salary multiplied by the number of years of service. Mr Linn is known to be
leaving at the end of 2021. Salary in his first year (2017) is £10,000 per
annum and is assumed to increase at a compounding rate of 7% each year.
The discount rate is 10%. In this simple illustration rounding is done to no
decimal places.
Calculating the current service cost here requires an appreciation of
how the obligation builds up and the interest accrual (calculated on the
opening obligation), as follows:
Year 2017 2018 2019 2020 2021
Opening obligation (£) – 89* 196 324 476
Interest (10%) – 9 20 33 48
Current service cost (£) 89* 98 108 119 131
Closing obligation (£) 89 196 324 476 655
* This is calculated as 1% x (10,000) x 1.07 x 1.07 x 1.07 x 1.07
1.1 x 1.1 x 1.1 x 1.1
If an employee’s service in later years will lead to a benefit deemed
materially higher than in earlier years, the benefit should be attributed
on a straight-line basis from the date when employee service first leads to
benefits until the date when further service leads to no material further
benefits excepting from salary increases (in these cases the pension
scheme formula does not determine the cost allocation).
9.4.5 Past service costs

IAS 19 defines past service costs as the change in the present value of
the defined benefit obligation for employee service in prior periods
as a result of scheme amendment or curtailment. For example, past
service costs would arise when an employer grants pension rights for
services rendered before the scheme was established or grants increases
in benefits for services rendered in past periods. The projected benefit
obligation increases and this increase should be funded or financed and be
recognised for accounting purposes in the income statement.
9.4.6 Gains or losses on settlements

Gains/losses should be recognised when the settlement occurs (for
example, when part of a company is closed down).
9.4.7 The net interest on the net defined benefit liability (asset)
Looking back at the simple illustration of Mr Linn, the interest or interest
accrual is the interest cost component or the net interest on the net
defined benefit liability (asset). The current service cost plus the interest
cost component is the total pension cost that is allocated to the profit and
loss part of the statement of comprehensive income. Note that there is no
interest cost component in the first year in the simple illustration because
the calculations are at the end of each year.
9.4.8 Re-measurements of the net defined benefit liability (asset)

This part of the defined benefit cost is allocated to other comprehensive
income. It is made up, as noted earlier, of three components:
1. Actuarial gains and losses
Clearly, if the actuarial assumptions turn out to be incorrect, a
difference arises, which could be a gain or loss. Since the 2011 revision
123
of IAS 19 these gains/losses should be taken on occurrence to other

If actuarial assumptions themselves need to be changed this will
also give rise to a gain or loss. If the benefit obligation under the
new assumptions is higher than the benefit obligation under the
old assumptions an actuarial loss arises (the difference is not yet
funded but needs to be), whereas a gain arises if it is the other way
around. Again, gains/losses are to be immediately recognised in other
Prior to the revision of IAS 19 in 2011, the IASB allowed a ‘corridor’
approach: actuarial gains/losses falling in a corridor did not have to
be recognised, other actuarial gains/losses had to be recognised over a
certain period of time. This was to reduce volatility.
2. Return on plan assets
If we look back at the simple example of Mr Linn, above, we can see
that the interest accrual in 2018 was £9. If the company employed
5,000 staff who on average had the same interest cost component then
the total interest accrual would be £45,000 (we should note that our
simple example has crudely rounded the numbers). If the return on
the pension scheme assets is equal to £50,000 then the difference is
taken to other comprehensive income so that here £5,000 would be
included in other comprehensive income.
3. Change in the effect of the asset ceiling
To appreciate this third component of defined benefit cost it is
important to understand the recognition of the net defined benefit
liability (asset). The latter, the deficit or surplus between the present
value of the defined benefit obligation (discussed above) less the
fair value (usually the market value if available, otherwise a present
value is calculated) of the plan assets, is included in the statement of
financial position. IAS 19 includes various provisions in relation to
plan assets. For example, non-transferable financial instruments issued
by the entity and held by the fund, and unpaid contributions due from
the entity to the fund, are not to be included. Plan assets should also
be reduced by any fund liabilities unrelated to employee benefits. If
the obligation is less than the asset value there is a net defined benefit
asset (a liability if it is the other way around). But the surplus to be
reported cannot be higher than the ‘asset-ceiling’. The asset-ceiling
is the present value of any economic benefits available in the form of
refunds from the pension scheme or reductions in future contributions
to the scheme.
9.4.9 Summary and examples

IAS 19 (2011, para.120–130) recognises the components of defined
benefit cost as follows:
Component Recognition in
financial statement
Service cost attributable to the current and past periods Profit or loss
Net interest on the net defined benefit liability or asset, determined Profit or loss
using the discount rate at the beginning of the period
Remeasurements of the net defined benefit liability or asset, comprising: Other comprehensive
• actuarial gains and losses income
• return on plan assets (Not reclassified to

profit or loss in a
• some changes in the effect of the asset ceiling subsequent period)
124
Unilever’s (2019) annual reports, pp.97–104 (available at https://www.

unilever.com/investor-relations/annual-report-and-accounts/archive-of-
annual-report-and-accounts/) has eight pages of notes on their employee
benefits (including salary, pensions and share based payments). This
highlights that for large multinationals, the issue of how to account for
benefits is a complex and generally specialist area. There is significant
input from actuaries and others in the measurement and recognition of
employment benefits.
Example 9.1: Illustration of the net actuarial gain or loss as

recognised in other comprehensive income (OCI)
(Adapted from International financial reporting, Activity 21.13.)
Ranalagh PLC provides a defined benefit plan for its employees. At 1
January 2019, the fair value of the pension plan assets was £4,100,000
and the present value of the defined pension liability was £4,250,000.
On 31 December 2019 (year-end), the company received the following
information from its actuary.
The service cost for the financial period was estimated at £1,050,000.
During the year, the company paid £250,000 to retired employees
covered by the pension plan. During the year, the company contributed
£950,000 to the plan. At the year end, the fair value of the plan assets
was £5,300,000. The actuary estimated the discount rate for the year to
31 December 2019 at 4%. The defined pension liability at that date was
measured by the actuary at £5,500,000.
Questions:
• What is the amount that should be recorded as a net gain or loss in the
company’s OCI for the year ended 31 December 2019?
• Determine whether the company will record a net defined liability or
net defined asset on its statement of financial position at 31 December
2019 and calculate the amount of liability or asset.
Answer:
The presence of actuarial gains and losses are determined by comparing
the movements in the fair value of pension assets and in the present value
of the pension liabilities during the financial period 2019. This outcome
will then be compared with the values determined by the actuary at the
year-end date.
Fair value of Present value
pension plan of pension plan
assets liabilities
Opening balance
at 1 Jan 2019 4,100,000 4,250,000
Service cost 1,050,000
Interest cost 164,000 170,000
Benefits paid 250,000 250,000
Contributions 950,000
Total 5,464,000 5,720,000
Actuarial values (31/12/19) 5,300,000 5,500,000
Actuarial gain/(loss) on plan assets (164,000)
Actuarial gain/(loss) on pension liabilities 220,000
125
Fair value of Present value

pension plan of pension plan
assets liabilities
Net actuarial gain/(loss) in OCI 56,000
Net defined pension liability in SFP 200,000
Example 9.2
An illustration of how pension liability and the income statement charge
is calculated under IAS 19 (2011). The example makes a number of
simplifying assumptions for illustrative purposes:
1. The illustration does not include the effect of curtailments or
settlements.
2. All transactions are assumed to occur at the year end.
3. There were no actuarial gains and losses brought forward into 2019.
The pension scheme had a market value of assets of £6,500,000 and a
present value of pension liabilities of £7,100,000
The details of the pension are as follows.
2019 2020 2021

£’000 £’000 £’000
Discount rate at the start of the year 5% 4% 6%
Expected rate of return on plan assets at 1/1 8% 10% 7%
Current service cost 250 250 280
Benefits paid 215 260 240
Contributions paid 270 220 250
Present value of pension liabilities at 31/12 6,800 8,200 7,200
Market value of plan assets at 31/12 7,500 8,000 7,700
Question:
Show how the pension scheme would be presented in the financial
statements for the period 2019–2021 under IAS 19 (2011).
Answer:
Step 1: Change in the net pension liabilities

2019 2020 2021
£’000 £’000 £’000
Present value of liabilities at 1/1 600 (700) 200
Net interest cost 30 (28) 12
Contributions paid (270) (220) (250)
Actuarial (gain)/loss on liabilities (balancing) * (1,310) 898 (742)
Present value of liabilities/(assets) 31/12 (700) 200 (500)
* includes the difference between actual and expected return on pension assets
recognised in OCI
126
Step 2: Calculate the impact on the comprehensive income statement

2019 2020 2021
£’000 £’000 £’000
Operating costs
Net interest cost 30 (28) 12
Profit and loss charge 280 222 292
Other comprehensive income
actuarial gains/(losses) 1,310 (898) 742
Step 3: Calculate the effect on the statement of financial position

2019 2020 2021
£’000 £’000 £’000
Present value of pension liabilities
at 31/12 6,800 8,200 7,200
Market value of plan assets at 31/12 7,500 8,000 7,700
Liability/(asset) recognised (700) 200 (500)
9.5 Termination benefits

Termination employee benefits are also covered by IAS 19. A company is
to recognise a liability and expense when it is committed to terminating
employment before the normal retirement date or providing termination
benefits as a result of an offer over a short-period to encourage voluntary
redundancy. Where the benefits fall due more than 12 months after
the date of the statement of financial position, the entity is to apply the
requirements for other long-term employee benefits.

• appreciate the difference between short-term and long-term employee
benefits and key aspects of the prescribed accounting for these benefits
in IAS 19
• appreciate the treatment of share-based payments to employees as
prescribed by IFRS 2.

Question 9.1
Aggi Limited promises a 60-year-old employee, Mr Harper, who has to
retire at 65, a lump-sum retirement package equal to 1% of final salary
multiplied by the number of years of service. Mr Harper’s 60th birthday
is on 1 January 2015 and his 2017 salary is £100,000, to increase at 5%
compound each year. The discount rate is 10%. There is assumed to be a
20% probability that Mr Harper will leave Aggi Limited before 1 January
2020. At 31 January 2016, the company revises its actuarial assumptions,
so that Mr Harper’s salary should increase by 15% per annum rather
than 5% and the probability of Mr Harper leaving before his scheduled
retirement falls to 10%. The obligation is not funded.
127
Calculate the amount that Aggi Limited would recognise in the profit and
loss account and in other comprehensive income for the years ended 31
December 2015 and 31 December 2016. How does the benefit obligation
build up over the five years to 2020?
Question 9.2
Mint Limited promises a 60-year-old employee, Mrs Pear, who will retire at
65, a lump-sum retirement package equal to 1% of final salary multiplied
by the number of years of service.
Mrs Pear’s 60th birthday is on 1 January 2015 and her 2015 yearly salary
is £75,000, to increase at 5% compound each year. The discount rate is
10% per annum.
There is assumed to be a 20% probability that Mrs Pear will leave Mint
Limited before 1 January 2020.
On 1 January 2016, the company revises its actuarial assumptions, so that
Mrs Pear’s salary should increase by 15% per annum rather than 5% and
the probability of Mrs Pear leaving before her scheduled retirement falls to
10%. The obligation is not funded.
Required:
a. What are defined contribution and defined benefit plans? (4 marks)
b. Calculate the total pension cost that Mint Limited would recognise
in the profit and loss section of the income statement for the year 31
December 2016. (11 marks)
c. Calculate the actuarial loss for 2016 which would be recorded in other
comprehensive income. (5 marks)
128
Chapter 10: Accounting for taxation
10.1 Introduction
This chapter considers how to account for corporation tax and deferred
tax. The objective of IAS 12 Income taxes is to prescribe the accounting
treatment for income taxes (such as corporation tax). However, the
calculation of tax is determined by the taxation authorities of the country
in which the company is domiciled. Different countries adopt different
taxation rules. For illustration we consider the UK tax system (up to
around 2008 to illustrate tax changes). This chapter will then consider
the issue of deferred tax. Deferred tax arises as an accounting entry where
accounting policy-makers deem it appropriate to adjust the taxation
arising as it is out of line with the accounting profits. This occurs where
accounting profit and taxable profit differ (as is the case in the UK). We
examine three approaches to how differences between accounting profit
and taxable profit are reflected in calculating deferred taxation. We also
briefly introduce accounting for value added tax (VAT) in relation to
financial reporting.

• discuss some of the fundamental differences between tax bases and tax
systems
• describe and apply the basic workings of the UK imputation system
• explain the difference between accounting profit and taxable profit
• explain the difference between permanent and timing differences
• describe the three approaches to accounting for deferred tax
• prepare an income statement and statement of financial position
entries for the three approaches
• explain differences between the deferred versus liability approach
under the full provision method
• briefly describe how VAT is accounted for.



IAS 12 Income taxes.
Historical UK standards
FRS 16 Current tax.
FRS 19 Deferred tax.
129
10.2 An introduction to corporation tax systems

Before we consider the accounting treatment of tax items in the financial
statements it is worth putting taxation into some sort of international
context. Corporation tax (or corporation income tax) can be addressed in
terms of tax bases and tax systems.
10.2.1 Tax bases – defining taxable profit

IAS 12 defines taxable profit as ‘the profit (loss) for a period, determined
in accordance with the rules established by the taxation authorities,
upon which income taxes are payable (recoverable)’. The rules imposed
by taxation authorities differ between countries. One of the key issues
in terms of tax bases is the relationship between taxable profit and
accounting profit. This relationship could be polarised into those countries
in which there is very little difference between these two measures of
profit (e.g. tax rules dominate the financial reporting requirements in
Germany and France) and those countries in which numerous adjustments
are made to the accounting profit to arrive at the taxable profit (e.g. the
UK and USA).
10.2.2 Tax systems – how taxable profit is taxed

How taxable profit is taxed will vary across countries. You need to consider
whether distributions and retentions are taxed at the same corporation tax
rate and whether profit is taxed at both the corporate and the shareholder
level. Two examples of corporate tax systems are the classical system (used
in, for example, the Netherlands and the USA) and the imputation system
(used in, for example, Australia and Canada). The classical system taxes
dividends at both corporate and shareholder level. This economic double
taxation might bias against distributions.
Under the imputation system, corporation tax is charged at a single
rate on all corporate profits (both retentions and distributions) and the
shareholders are deemed to have paid tax at the basic rate on dividends
received (i.e. tax paid by a company is ‘imputed’ to the shareholders).
10.3 UK: corporation tax

Companies are charged corporation tax (CT) on their profits and
chargeable (i.e. capital) gains. Two groups of problems arise because of
this:
1. The profit on which CT is charged differs from accounting profit.
2. Accounting standards specify how CT must be shown in the accounts.
10.3.1 Computation of taxable profits

The starting point for calculating the taxable profit of a company is the
profit (before dividends) shown in its accounts. Certain adjustments must
be made to this accounting profit. Certain expenses are not ‘allowable’ for
tax purposes, and must be added back to obtain the taxable profit. The
most common of these are:
• depreciation
• general provisions, for example, for doubtful debts (provisions against
specific bad debts are allowable)
• entertaining customers
• expenses of a capital nature (e.g. costs of acquiring a non-current
asset)
130
• losses on sale of non-current assets.

Conversely, certain items of income are not taxable as part of the profits of
the business and must be deducted from the accounting profit. The most
common of these are:
• profits on sale of non-current assets (taxed as chargeable gains)
• dividends received from UK companies.
Although depreciation is not an allowable deduction, companies are able
to deduct ‘capital allowances’, based on their capital expenditure.
For ‘plant and machinery’ (which has a very wide meaning for tax
purposes), the allowances take the form of writing-down allowances,
currently at the rate of 25% per annum calculated using the reducing
balance method. Capital allowances at much lower rates are also available
for expenditure on certain buildings (e.g. 4% on industrial and agricultural
buildings) and for motor vehicles, subject to a maximum limit. Higher
capital allowances are sometimes permitted in order to encourage
investment; for example, since 2008 a first-year allowance of 50%
has been granted for small businesses in the UK investing in plant and
machinery.
Gains and losses on the disposal of capital assets are taxed as chargeable
gains, and the amount of the gain or loss is computed according to the
rules for capital gains tax (which is outside the scope of this course).
However, the tax charge is levied under the CT rules.
When a company’s accounting period falls into more than one financial
year, the taxable profit is apportioned between the financial years, and the
relevant rate for each financial year applied to the appropriate portion of
the taxable profit. The normal due date for payment of corporation tax
is nine months after the end of the accounting period. Large companies
(with profits exceeding £1,500,000) pay quarterly instalments on account,
based on their expected CT liability.
Activity 10.1
Do all countries’ business/corporate legislation allow the use of deferred taxation?
Example 10.1: corporation tax computation

Mario Plc has been trading for 10 years. Its income statement for the year
ended 30 June 2017 is:
£ £
Sales 4,950,000
Less cost of sales 2,175,000
Less overhead expenses
Wages and salaries 563,000
Rent and rates 180,000
Light and heat 50,000
Depreciation 70,000
Sundry expenses 92,000 955,000
Profit per accounts before tax and dividends 1,820,000
131
The following information is available:

a. Capital allowances for the year are calculated to be £120,000
b. Sundry expenses includes the following:
Entertaining customers £2,000

General provision for doubtful debts £3,000
Specific bad debts written off £1,000
Legal costs on purchase of new freehold office block £5,000
Corporation tax computation for the year ended 30 June 2017

£ £
Profit as shown in accounts 1,820,000
Add disallowable expenses
Depreciation 70,000
Entertaining 2,000
General provision for doubtful debts 3,000
Legal costs (capital) 5,000 80,000
1,900,000
Less capital allowances 120,000
Taxable profits 1,780,000
Tax payable
£1,780,000 at 30% = £534,000
The income statement for the year ended 30 June 2017 would now show:
Profit before tax (Note: this is the accounting profit,
£1,820,000
not taxable profit)
Less taxation charge 534,000
Profit after tax £1,286,000
The balance sheet would show:

Current liability: taxation £534,000
10.3.2 Under or overprovisions for corporation tax

It often happens that the tax liability calculated at the time the accounts
are prepared differs from the amount ultimately agreed with the UK’s
taxation authority, Her Majesty’s Revenue & Customs (HMRC), since
certain adjustments made in the tax computation may be estimated or may
be disputed by the tax authorities. Hence, it is often the case that an over-
or underprovision for CT is found to have been made. An overprovision is
credited to the income statement, being deducted from the amount of the
tax charge for the subsequent year, and an underprovision is debited to the
income statement, being added to the tax charge. A note to the accounts
splits the total tax charge between that relating to the current year and
any adjustments relating to previous years.
For example, suppose that, in the year ended 30 June 2016, Mario Plc
had estimated its CT charge as £450,000, but later agreed its taxation
liability with HMRC at £440,000. In its income statement for the year
ended 30 June 2016, Mario would have charged £450,000 and shown
a corresponding liability. Because its actual liability for the year ended
30 June 2016 is only £440,000, Mario has overprovided £10,000. In its
income statement for the year ended 30 June 2017, Mario will show its
tax charge after deducting this overprovision:
132
£
Taxation charge 524,000
Represented by:
Corporation tax based on the profits for the year
534,000
ended 30 June 2017
Less overprovision for prior year (10,000)
524,000
Conversely, an underprovision from a previous year is added to the

estimated tax on the current year’s profits.
10.3.3 Note on corporation tax and dividends

Up to 5 April 1999 whenever a company paid a dividend, it was required
to pay Advance Corporation Tax (ACT) to the Inland Revenue. ACT
represented an advance payment of the company’s CT liability for the year
in which the dividend was paid. ACT was abolished from 6 April 1999,
and is no longer examined.
10.4 Deferred taxation: taxable profit versus accounting

profit
We have discussed the fact that accounting profit and taxable profit are
not always the same. Deferred tax arises when there is a timing difference
between the treatment of an item for tax versus accounting purposes.
Obviously, deferred tax is not an issue if accounting depreciation equals
tax depreciation (i.e. capital allowances).
IAS 12 adopts a temporary difference approach, whereas FRS 19 adopts a
timing difference approach.
IAS 12 gives the following definitions:
Deferred tax liabilities are the amounts of income taxes

payable in future periods in respect of taxable temporary
differences.
Deferred tax assets are the amounts of income taxes
recoverable in future periods in respect of:
• deductible temporary differences
• the carry forward of unused tax losses, and
• the carry forward of unused tax credits.
Temporary differences are differences between the carrying
amount of an asset or liability in the balance sheet and its tax
base. Temporary differences may either be
• taxable temporary differences
• deductible temporary differences.
Under the old standard FRS 19, permanent differences relate to those
expenses that will be permanently disallowed and will not be allowed in
any future period (e.g. political donations). Under the old standard FRS
19, there is no recognition of permanent differences. This contrasts with
the temporary difference approach adopted by IAS 12. IAS 12 states that
an entity should provide for deferred tax whenever there is a difference
between the carrying amount and the tax base of an asset or liability,
giving rise to the possibility of providing for some permanent differences.
133
Timing differences relate to those items for which tax relief and charges
to the income statement occur in different periods. The most obvious and
significant timing difference is the purchase of a non-current asset for
which the cost is spread over a number of years according to different
rules when using either capital allowances (in effect tax allocation of cost
or part thereof) or depreciation (accounting allocation of cost).
Capital allowances for non-current assets is a good example to use when
considering the implications of deferred tax. Typically, capital allowances
provide a rapid write-off of the cost of the non-current asset in early
years for tax purposes. In contrast, the company will have to pay higher
tax bills in the future once the effect of the rapid write-off reverses and
depreciation charges are higher than tax allowances. Consequently,
deferred tax accounting attempts to match accounting income and the tax
charge.
These are the potential differences between tax rules and accounting
treatments:
Deductible temporary differences:
• Retirement benefit costs charged as an expense when incurred but
may only be allowed by the tax authorities when paid.
• Revaluation losses, which are recognised in the income statement
when they occur, but may only be allowed by the tax authorities when
the assets are sold.
• Research costs charged as an expense in arriving at the accounting
profit but which may only be allowed by the tax authorities when paid.
• Unrealised profit on intra-group sales.
Taxable temporary differences:
• Interest income recognised as it is earned but only taxed when it is
received.
• Revaluation gains.
• Interest capitalised in producing or constructing an asset (per IAS 23
Borrowing Costs) would be charged to the future income statements
when the asset is depreciated. But the interest is normally allowed by
tax authorities when it is incurred.
Other temporary differences:
• Accelerated capital allowances which result in a difference between
the tax written down value and the NBV of an asset.
• Certain current assets such as investments valued at market price: the
change in value would go to the income statement but is only included
in the taxable profit when realised.
Activity 10.2
How do we recognise a deferred tax asset or deferred tax liability? For each of the
scenarios below, indicate whether a deferred tax exists, and if it does, whether it is a
deferred tax asset or liability.
1. A machine with an original cost of £100,000 has been depreciated using IAS 16
and has a carrying value of £40,000. The tax writing down or capital allowance is
£30,000 is given.
2. Income receivable £40,000 included in current assets. Income is taxed on a cash
basis.
3. Trade receivables of £50,000.
134
4. Accrued overhead expenses of £15,000.

5. Expenses payable of £20,000 included in current liabilities.
6. A loan of £200,000 included in non-current liabilities
As you will see in the example below, if you do not account for deferred
tax then the implicit tax rate changes year by year and as a result has no
obvious relationship to the actual tax charge of 30%.
Example 10.2: Illustrating the effects of ignoring deferred tax

BYG buys an asset which costs £20,000 (with nil residual value). It has an
estimated useful economic life of four years. The net cash flow produced
by this asset is £25,000 p.a. The corporation tax is 30% and a 100%
first-year allowance is available (e.g. the company can write off, for tax
purposes, the total cost of the asset in the first year).
Income statement
1 2 3 4 Total
£ £ £ £ £
Net cash flow 25,000 25,000 25,000 25,000 100,000
Depreciation 5,000 5,000 5,000 5,000 20,000
Profit before taxation 20,000 20,000 20,000 20,000 80,000
Taxation (30%) 1,500 7,500 7,500 7,500 24,000
Profit after taxation 18,500 12,500 12,500 12,500 56,000
Effective tax rate

Tax/profit 7.5% 37.5% 37.5% 37.5% 30%
Note that, because of the timing differences, there is no relationship
between the accounting profit and the tax rate. However, these timing
differences disappear at the end of the asset’s life.
Workings
1 2 3 4
Profit before taxation 20,000 20,000 20,000 20,000
Depreciation 5,000 5,000 5,000 5,000
25,000 25,000 25,000 25,000
Capital allowance 20,000 – – –
Taxable profit 5,000 25,000 25,000 25,000
Tax @ 30% = 1,500 7,500 7,500 7,500
10.5 Historical and current approaches to the accounting

treatment of deferred tax
The big question is, how should the deferred tax be treated in the
accounts? Three main approaches to deferred taxation are:
1. Flow-through. This approach essentially ignores deferred taxation
by charging the tax payable (under tax rules) to the income statement.
Therefore, tax is provided for in the period in which it arises. There
will be no provision for deferred tax and the statement of financial
position will only show a current liability for tax payable that has not
been paid at the statement of financial position date.
135
2. Partial provision is based on accounting for only that amount

of deferred tax that will be payable (crystallised) in the foreseeable
future. Thus, only those timing differences that will reverse (in the
foreseeable future) are included in the deferred tax provision.
This was the method previously required by the old UK standard
SSAP 15. Partial provision lost favour internationally, mainly as it is so
subjective (relying heavily on management expectations about future
events) and inconsistent with other areas of accounting.
3. Full provision. This approach provides for all deferrals of tax related
to transactions occurring in a period, regardless of whether or not
these tax bills are likely to be paid in the future. This is the current
approach required by IAS 12.
Full provision can be made using either the deferral method or the
liability method. The deferral method (a profit and loss approach)
makes sure that the tax charge in the income statement is based on the
tax rate at the time of computation. The emphasis here is on ‘matching’
in the income statement. The liability method (a statement of financial
position approach) computes the provision of deferred tax to the tax
rate likely on the date when the tax becomes due. This results in a
valuation that emphasises the use of the most up to date tax rates to
work out the liabilities in the statement of financial position. IAS 12
and FRS 19 both advocate the liability method and the world trend is
to move towards such a method.
10.5.1 Requirements of IAS 12

Both FRS 19 and IAS 12 require deferred tax to be calculated on a full
provision rather than partial provision. The general principle underlying
the requirements is that deferred tax should be recognised as a liability or
asset if the transactions or events that give the entity an obligation to pay
more tax in future or a right to pay less tax in future have occurred by the
statement of financial position date.
Note: Although ‘full provision’ is required, IAS 12 does preclude the
recognition of deferred tax in some temporary circumstances.
IAS 12 does not permit the (time) discounting of deferred tax assets and
liabilities, whereas FRS 19 permits but does not require entities to adopt a
policy of discounting deferred tax assets and liabilities. Time discounting
can be seen as an attempt to reflect fair values; alternatively, it can be
viewed as an attempt to incorporate the time value of money into the
financial statements. IAS 12 argues against discounting on the following
basis:
• Reliable calculation is complex and dependent on several factors (e.g.
discount rate).
• It would lead to a lack of comparability if some companies discounted
and others did not.
IAS 12 prescribes extensive disclosure of deferred tax assets and liabilities
in the financial statements. The main points can be summarised as follows:
• Tax assets and liabilities must be separated from other assets and
liabilities in the balance sheet.
136
• Deferred tax should be distinguished from current tax.

• Deferred tax should be shown under ‘non-current’.
• Current and deferred tax assets and liabilities can be offset only where
the entity has a legally enforceable right to do so, and intends to
realise the assets and settle the liabilities simultaneously.
Disclosure is required as follows:
• Separate major components of the tax charge or credit in the income
statement (e.g. current tax, deferred tax and so on).
• Charges in respect of tax charged to equity.
• Tax relating to exceptional items.
• Reconciliation between tax charge and that calculated by applying the
tax rate to accounting profit.
• Detail of temporary differences of deferred tax.
Example 10.3: Three approaches to the accounting treatment of

deferred tax
Inter Brunswick Plc has the following projected information available:
Year ended Profit before Capital Depreciation

depreciation allowances
and tax
2013 2,500 800 160
2014 2,400 160 320
2015 2,200 160 480
2016 2,000 1,120 320
The CT rate is 33% and on 1 January 2013 there was a nil balance on the
deferred tax account.
The income statement and balance sheet extract for the three methods –
flow-through, full provision, partial provision – are as follows.
Flow through method (no longer allowed under IAS 12)
Extract from income statement:
2013 2014 2015 2016

Taxable profit 1,700 2,240 2,040 880
Tax (@ 33%) 561 739.2 673.2 290.4
Deferred tax nil nil nil nil
Extract from the statement of financial position:
Provision for liabilities and charges nil nil nil nil
Full provision method (current approach under IAS 12)
2013 2014 2015 2016

Taxable profit 1,700 2,240 2,040 880
Tax (@ 33%) 561 739.2 673.2 290.4
Deferred tax 211.2 (52.8) (105.6) 264
137

Provision for liabilities and charges 211.2 158.4 52.8 316.8
Where the deferred tax is calculated as:
Capital allowances 800 160 160 1,120
Depreciation 160 320 480 320
640 (160) (320) 800
Deferred tax (@ 33%) 211.2 (52.8) (105.6) 264
Partial provision method (no longer allowed under IAS 12)

2013 2014 2015 2016
Taxable profit 1,700 2,240 2,040 880
Tax (@33%) 561 739.2 673.2 290.4
Deferred tax 158.4 (52.8) (105.6) –

Provision for liabilities and charges 158.4 105.6 nil nil
Timing differences that reverse in brackets

Capital allowances 800 160 160 1,120
Depreciation 160 320 480 320
Timing difference 640 (160) (320) 800
Deferred tax that
reverses (@33%) nil (52.8) (105.6) nil
Deferred tax for 2013 = 52.8 + 105.6 = 158.4
Note that the (partial) provision for deferred tax in 2013 is dependent on
the reversibility of such provisions in subsequent years. In this example, it
is the accumulation of the 2014 and 2015 timing differences that allows
for the partial provision in 2013 of 158.4.
Example 10.4: Illustrating the income smoothing effects of

deferred tax through temporary differences that reverse
Aaron Plc has an estimated revenue per year of £60,000, received at the
end of each year from years 1 to 5. The company’s corporation tax rate is
30%. The company acquired a machine at the start of year 1 for £40,000,
with a useful economic life of 5 years and a residual at the end of the
fifth year of £5,000. The company’s policy is to depreciate on a straight-
line basis. The capital allowance for years 1 to 5 are as follows: Year 1 =
11,500; Year 2 = 9,000; Year 3 = 7,500; Year 4 = 4,500 and Year 5 =
2,500. Calculate the deferred tax in the statement of financial position for
all five years. For the income statement, calculate the profit after tax by
breaking down the current tax and deferred tax for all five years.
138
Year 1 2 3 4 5 Total
£ £ £ £ £ £
Capital allowance (given) 11,500 9,000 7,500 4,500 2,500
Carrying value (b/f) 40,000 33,000 26,000 19,000 12,000

Depreciation 7,000 7,000 7,000 7,000 7,000 35,000
Carrying value (c/f) 33,000 26,000 19,000 12,000 5,000
Carrying value (b/f) 40,000 28,500 19,500 12,000 7,500

Capital allowance 11,500 9,000 7,500 4,500 2,500 35,000
Carrying value (c/f) 28,500 19,500 12,000 7,500 5,000
Temporary differences 4,500 2,000 500 (2,500) (4,500) –
Comprehensive income statement: P&L

Year 1 2 3 4 5 Total
£ £ £ £ £ £
Profit before tax 60,000 60,000 60,000 60,000 60,000 300,000
Current tax (14,550) (15,300) (15,750) (16,650) (17,250) (79,500)
Deferred tax (charge) / rebate (1,350) (600) (150) 750 1,350
Profit after tax 44,100 44,100 44,100 44,100 44,100 220,500
Statement of financial position

Deferred tax liability / (asset) (1,350) (1,950) (2,100) (1,350) –
Discussion of Example 10.4
Income statement:
• In this example, the total capital allowances equal accumulated
depreciation of the asset over the useful economic life (£35,000 each).
This means that the temporary differences will reverse. The effect of
this reversal is to ‘smooth’ the income, as evidenced in the same year-
on-year profit after tax of £44,100.
• Current tax is calculated as = (profit before tax for year – capital
allowance for year) * tax rate. For year 1, current tax = (60,000 –
11,500) * 30% = £14,550.
• Deferred tax for year 1 = Temporary difference for year 1 * tax
rate = 4,500 * 30% = £1,350.
• The total profit before tax accumulated over the five years
subtracted from the total current tax (300,000 – 79,500) will
equal the total profit after tax accumulated over the five years
(£220,500), which illustrates how the temporary differences
completely reverses over the life of the asset. Note that the
complete reversal is not always guaranteed, it is only in the
(special) case when the accumulated capital allowance =
accumulated depreciation. Temporary differences will continue to
persist if the accumulated capital allowance is bigger or smaller
than accumulated depreciation.
139
Statement of financial position:

• The values in the statement of financial position are an aggregative
(cumulative) on the deferred tax charge (or rebate). For year 2,
the deferred tax liability = 1,350 + 600 = £1,950. For year 5, the
deferred tax liability = 1,350 + (1,350) = £0 (nil). The nil value in
the final year of the asset indicates that the deferred tax liabilities have
been fully reversed.
Example 10.5: Full provision – comparing the effects of the

deferral approach (income statement approach) versus the
liability approach (statement of financial position approach)
Browning Ltd purchased a motor vehicle for the company on 1 April 2016
at a cost of £20,000. The company prepares its annual accounts to 31
March in each year. The company’s policy is to depreciate such assets at
the rate of 20% straight-line. The company was granted capital allowances
at 25% per annum on a reducing balance method.
The rate of corporation tax is estimated as follows (year ended):
31 Mar 2017 22%
31 Mar 2018 25%
31 Mar 2019 19%
31 Mar 2020 18%
The deferred tax provision under the deferred versus liability methods are
as follows.
Date Carrying Depreciation Carrying Capital Difference
value value (capital allowance (timing)
(depreciation) alowance)
01/04/16 20,000 20,000
31/03/17 17,000 3,000 15,000 5,000 2,000
31/03/18 14,000 3,000 11,250 3,750 750
31/03/19 11,000 3,000 8,438 2,813 –188
31/03/20 8,000 3,000 6,328 2,109 –891
Tax calculated by deferred method

Date Difference Tax rate Deferred tax Tax provision
(timing) Income Statement
statement of financial
position
31/03/17 2,000 22% 440.00 440.00
31/03/18 750 25% 187.50 627.50
31/03/19 –188 19% –35.63 591.88
31/03/20 –891 18% –160.31 431.56
Tax calculated by liability method

Date Difference Cumulative Tax rate Tax provision Deferred tax
(timing) difference Statement Income
of financial statement
position
31/03/17 2,000 2,000 22% 440.00 440.00
31/03/18 750 2,750 25% 687.50 247.50
31/03/19 –188 2,563 19% 486.88 –200.63
31/03/20 –891 1,672 18% 300.94 –185.94
140
Under the deferred method, the deferred tax charge in the income
statement is first calculated based on the timing difference, followed
by the provision in the statement of financial position. This can be said
to emphasise the income statement as matching tax rates with the tax
expense is prioritised. Under the liability method, however, it can be
said to emphasise the statement of financial position as the tax provision
(liability) is first calculated, from which differences in provision are used
to work out the tax expense in the income statement.
Note that the final provision on 31 March 2020 under the deferred
method (£431.56) is higher than the liability method (£300.94), as the
deferred method cumulates tax expenses using four different tax rates
(22%, 25%, 19% and 18%). The final provision on 31 March 2020 in the
liability method, in contrast, uses a rate of 18% for the entire cumulative
difference (i.e. for all four years). This means that as tax rates change,
the provisions for previous years also readjust to the most recent tax rate,
unlike the deferred method, which matches and retains the historical tax
rates in the provision on the statement of financial position.
For example, as the tax rates rise from 22% to 25%, the provision for
deferred tax also rises faster for the liability method (£687.50) compared
with the deferred method (£627.50) as the deferred taxes for the year
ending 31 March 2017 and 2018 are rebased to 25% for both years
under the liability method (but calculated on the 22% and 25% basis
respectively for the deferred method). However, as taxes fall (e.g. from
25% to 19%) then the liability method also shows a greater fall (£486.88)
compared with the deferred method (£591.88). This suggests that when
taxes fluctuate, the liability method will produce more volatile upward or
downward movements in provisions compared with the deferred method.
Activity 10.3
How do the two central approaches to deferred tax (the deferred approach versus the
liability approach) reconcile with the measurement basis outlined in the IASB’s conceptual
framework?
10.5.2 Arguments in favour of providing for deferred taxation

• The entity is a going concern so it will continue to pay tax.
• The tax is a business expense so treat it like any other cost.
• Therefore apply the accruals/matching concept and make a provision.
• Helps to provide a more accurate tax position based on the company’s
current profit – smoothing the tax position due to timing difference.
• Reduces pressure for paying extra dividend in the year when low tax
charge is shown.
• Adheres to both the prudence and matching concept.
It is also prudent to recognise this future liability.
10.5.3 Arguments against providing for deferred taxation

• Tax is not related to the accounting profit but is a charge levied on the
taxable profit, so matching does not apply.
• The deferred tax approaches are attempts to equalise income over time
– but income is not smooth over time in reality.
• Tax is not an expense as such (but is not voluntary either).
• The deferred tax is only a liability when it becomes due. This
argument, however, comes up against the principle of ‘substance over
141
form’, where entities are expected to faithfully represent the substance

of the economic phenomenon rather than merely representing its legal
form. Investors make decisions on the basis of predicted cash flows,
and the provision of deferred tax can help in this regard.
• The provision of deferred tax creates accounting problems.
• Deferred tax does not alter the tax payable, meaning that there are no
cash flow implications. So why is it deemed necessary to smooth the
tax charge?
• Investors can still use the profit before tax to estimate the profitability
of a company.
• May hide the fact that more capital allowances are given in early
years, which could mean that good tax planning may not be fully
reflected in the accounts.
• The actual tax charge is objective and is the best way of judging
management’s success at managing tax affairs.
10.5.4 Is deferred tax really a liability?

Does the FPPFS help us determine whether the deferred tax is really a
liability? No. The definition is not sufficient to resolve this accounting
issue, which also affects the profit measurement. What unavoidable
obligation is there? Only that, if future taxable profits are made, tax will
be payable. Thus, the real objective of deferred tax accounting is to ‘match’
accounting income and the tax charge. Can anyone else help? The UK tax
office, HMRC, do not think anything is owed to them.
Deferred tax can be conceptualised as an adjustment to asset value (e.g.
‘after tax deprival value’). So the definitions change nothing substantial in
practice.
10.6 Value-added tax (VAT)

Value-added taxes1 are indirect taxes, whereas corporation taxes are a direct 1
Value-added taxes/
tax. They are prominent in Western European and many Latin American consumption taxes are
referred to as general
countries. This is a form of tax that is charged on the supply (and sometimes
sales taxes or goods and
import) of goods and services. If there is a separate accounting standard service taxes in some
for VAT in the UK, the accounting treatment is very straightforward. Briefly, countries.
turnover in the income statement excludes VAT and the net debit/credit
balance of VAT need not be disclosed separately in the balance sheet.

• discuss some of the fundamental differences between tax bases and tax
systems
• describe and apply the basic workings of the UK imputation system
• explain the difference between accounting profit and taxable profit
• explain the difference between permanent and timing differences
• describe the three approaches to accounting for deferred tax
• prepare an income statement and balance sheet entries for the three
approaches
• briefly describe how VAT is accounted for.
142

Question 10.1
a. Explain why permanent differences are not treated in the same way as
timing differences in calculating a deferred tax provision.
b. Explain how tax should be calculated for inclusion in the balance sheet
using the full provision method.
c. Discuss the view that it would be better to explain the underlying
reasons in terms of the difference between taxable and accounting
profit rather than to include deferred tax in the financial statements.
Question 10.2
Flower Plc has the following projected information:
Year ended Profit before Capital Depreciation

31 December depreciation allowances
2015 180,000 57,600 11,520

2016 172,800 11,520 46,080
2017 158,400 11,520 34,560
2018 144,000 80,640 23,040
The tax rate for Flower Plc is 35%. There is no deferred tax balance
brought forward as at 1 January 2015.
Required:
a. What is deferred tax and what are permanent and temporary
differences when it comes to deferred tax?
b. Explain the three main approaches to accounting for deferred taxation.
c. Show the tax and deferred tax in the income statements and the
deferred tax in the statements of financial position for Flower Plc for
the years 2015 to 2018 under the flow through method and the full
provision method.
143
Notes
144
Chapter 11: Tangible non-current assets
11.1 Introduction
Non-current (fixed) assets can be divided into three categories:
• tangible
• intangible
• investments.
This chapter considers how tangible non-current assets (owned and
not owned) are treated in the financial statements. Investment properties
(as distinct from investments in other companies) are briefly covered.
Tangible non-current assets which are not owned are known more
commonly as leases. Intangible assets are covered in other chapters.
The main issue of tangible assets is at what cost/value they should be
recorded in the statement of financial position and how the carrying
amount should be treated over time (with income statement implications).
In the case of leases, it must first be ascertained whether or not these
tangible non-current assets should appear in the statement of financial
position at all.

By the end of this chapter, and having completed the Essential reading
• discuss tangible non-current assets, directly owned (leased assets are
discussed in Chapter 12) and borrowing costs
• explain the implications of revaluation on interpretation of the
financial statements
• appreciate accounting for investment property as distinct from
accounting for property more generally.


Baxter, W.T. Depreciation. (London: Sweet & Maxwell, 1978) revised edition
[ISBN 042114470X].
Ernst and Young International GAAP 2016: generally accepted accounting
practices under international financial reporting standards. (Chichester: John
Wiley & Sons, 2015) [ISBN 9781119180456].
John Wood Group PLC Annual report and accounts 2019. Available at: https://
www.woodplc.com/annual-report-2019
Lewis, R. and D. Pendrill Advanced financial accounting. (Harlow: Financial
Times Prentice Hall, 2004) 7th edition [ISBN 9780273658498] Chapter 5.
Unilever Annual report and accounts 2019. Available at: https://www.unilever.
report-and-accounts/

IAS 16 Property, plant and equipment.
IFRS 16 (2019) Leases (replaces IAS 17 Accounting for leases).
145
IAS 23 Borrowing costs.

IAS 36 Impairment of assets.
IAS 40 Investment property.
IFRS 5 Non-current assets held for sale and discontinued operations.
11.2 Tangible non-current assets (owned)

11.2.1 Definition
The IASB Framework for the Preparation and Presentation of Financial
Statements (FPPFS) defines an asset as:
a resource controlled by the enterprise as a result of past events
and from which future economic benefits are expected to flow
to the enterprise.
(FPPFS, para.49)
These are basic characteristics of assets. The cost of property, plant and
equipment is an asset if, and only if:
it is probable that future economic benefits associated with
the item will flow to the entity; and the cost of the item can be
reliably measured.
(IAS 16, para.6)
In addition, para.51 of the FPPFS stipulates that regard must be had to
underlying substance and economic reality and not merely legal form. If
future economic benefits are very uncertain, assets are not recognised.
IAS 16 Property, plant and equipment sets out principles of accounting for
initial measurement, valuation and depreciation of tangible non-current
assets. Non-current assets are held for continuing use in the enterprise.
IAS 16 defines property, plant and equipment as:
Tangible assets that:
a. are held by an entity for use in the production or supply of
goods or services, for rental to others, or for administrative
purposes; and
b. are expected to be used during more than one period.
(para.6)
Examples of tangible non-current assets include:

• land
• property
• plant and equipment
• vehicles
• fixtures and fittings.
11.3 Measurement of tangible non-current assets

11.3.1 What cost/value should be recorded?
How should tangible non-current assets be recorded in the statement of
financial postion? Should non-current assets be recorded at historical cost
or at current value (e.g. replacement cost)?
According to IAS 16, non-current assets are recorded at historical cost.
However, historical cost can either be the purchase price or the production
costs, depending upon whether the asset was bought or made. Purchase
cost is reasonably straightforward (if it can include ancillary expenses
146
such as delivery charges or legal and architect’s fees), but what about
production costs?
One of the recurring themes in accounting is whether a particular cost
should be expensed (charged to the income statement) or capitalised
(added to the cost of the non-current asset in the statement of financial
position for subsequent charging to the income statement as depreciation).
11.3.2 Initial cost

According to IAS 16 (para.15) tangible non-current assets should initially
be recorded at cost.
Cost includes purchase price plus ‘any costs directly attributable to
bringing the asset to the location and condition necessary for it to be
capable of operating in the manner intended by management’ (para.16).
This would include the following, which can all be capitalised as part of
the asset’s initial cost:
• original purchase price for a purchased asset
• labour costs of its own employees arising directly from the
construction of a constructed asset
• site preparation costs
• related professional fees (solicitors, architects and engineers)
• delivery and handling
• installation
• the estimated cost of dismantling and removing the asset and restoring
the site (see IAS 37 Provisions, contingent liabilities and contingent assets).
If payment for an item of property, plant and equipment is deferred,
interest at a market rate must be recognised or imputed (para.23).
If an asset is acquired in exchange for another instead of being bought, the
cost is measured at the fair value unless:
1. the exchange transaction lacks commercial substance; or,
2. the fair value of neither asset received nor asset given up is reliably
measurable. If the acquired item is not measured at fair value, its cost
is measured at the carrying amount of the asset given up (IAS 16,
para.24).
Activity 11.1
Which of the following would not be included as part of the cost of a tangible non-
current asset?
A. The invoice price of the asset.
B. The labour costs of own employees engaged in constructing the asset.
C. The normal cost of design errors relating to the asset.
D. The administration overheads indirectly related to acquiring the asset.
A company buys a new machine from abroad at an invoice price of £20,000.
Transportation costs amounted to £2,000 and installation costs a further £1,500. The
company was granted a discount of £1,000 for early payment. The cost of the asset to be
recognised in the financial statements would be:
A. £19,000
B. £21,000
C. £23,500
D. £24,500
147
11.4 Borrowing costs

As there is a separate international standard (IAS 23 Borrowing costs), IAS
16 does not address this issue. IAS 23 defines borrowing costs in para.4 as:
Interests and other costs incurred by an entity in connection
with the borrowing of funds [on a] qualifying asset [that]
necessarily takes a substantial period of time to get ready for its
intended use or sale.
(IAS 23, para.4)
For example, the construction of a new hotel development. Labour,

materials and interest charges on loans relating to the non-current assets
under construction can all be capitalised, and consequently represent
the initial cost of the non-current asset. Land, however, is not normally a
qualified asset for the purpose of capitalising borrowing costs.
The benchmark treatment is that borrowing costs are recognised as an
expense in the period in which they are incurred (para.7). As an alternative
treatment, ‘borrowing costs that are directly attributable to the acquisition,
construction or production of a qualifying asset shall be capitalised as
part of the cost of that asset’ (para.10). These borrowing costs are those
that would have been avoided if the expenditure on the qualifying asset
had not been made (e.g. if funds were borrowed specifically to obtain the
asset). Capitalisation begins with expenditure and when borrowing costs
are incurred and the preparation of the asset for use or sale is in progress
(para.20). It is to cease on completion of the asset for use or for sale
(para.25).
11.4.1 Subsequent expenditure

Subsequent expenditure such as repairs or upkeep to maintain assets is
charged to the income statement. However, if this expenditure satisfies the
recognition criteria for an asset, such as the replacement of parts of the
item, the expenditure may be capitalised.
Activity 11.2
Put forward an argument to support the capitalisation of the above expenses. In
particular, what are the arguments for and against the capitalisation of interest?
11.5 Depreciation
Depreciation is a measure of the wearing out, consumption or other
reduction in the useful life of a non-current asset. Non-current assets
must be depreciated over their useful economic life to their residual
value. The important consideration is how depreciation is charged to the
income statement so that there is a fair allocation of the cost/value to each
accounting period. This allocation is in accordance with the ‘matching
concept’.
IAS 16 defines depreciation as:
...the systematic allocation of the depreciable amount of an
asset over its useful life.
Depreciable amount is the cost of an asset, or other amount substituted for

cost, less its residual value.
148
The residual value of an asset is:

the estimated amount that an entity would currently obtain
from the disposal of an asset, after deducting the estimated
costs of disposal, if the asset were already of the age and in the
condition expected at the end of its useful life.
And useful life is
a. the period of time over which an asset is expected to be used
by an entity
b. or the number of production or similar units expected to be
obtained from the asset by an entity.
The residual value and useful life of an asset should be reviewed
at least at each financial year-end and, if expectations differ
from previous estimates, any change should be accounted for
prospectively as a change in estimate under IAS 8 Accounting
policies, changes in accounting estimates and errors.
(IAS 16, para.51)
Several questions arise from the discussion of depreciation:
1. What methods can be used to allocate depreciation to different
accounting periods? The different types of depreciation methods are
discussed in the next section.
2. How is useful life determined? The determination depends on internal
factors such as the durability and workload of an asset, and external
factors such as technological or economic changes. As you will
appreciate, these determinants may be very subjective. For example,
what is the useful life of a Pentium-chip PC?
Based on the IAS 16 definition, the useful life is the time over which
the present owner will benefit and not the asset’s potential life (the
two are not necessarily the same). Therefore, if the company has a
policy of replacing all its PCs every three years then this will be their
estimated useful life for depreciation purposes.1 1
Typically, the economic
Companies in the past have tended to use a ‘broad brush’ approach to lives of assets are
grouped together
estimating the useful life of assets, but such differences have narrowed
(e.g. office equipment,
under IAS 16. vehicles, etc.).
For example, John Wood Group PLC states in the notes to its 2019
Report and accounts (p.119):
Property plant and equipment (PP&E) is stated at cost less
accumulated depreciation and impairment. No depreciation
is charged with respect to freehold land and assets in the
course of construction. Depreciation is calculated using the
straight-line method over the following estimated useful
lives of the assets:
Freehold and long leasehold buildings 25–50 years

Short leasehold buildings period of lease
Plant and equipment 3–10 years
When estimating the useful life of an asset group, the
principal factors the Group takes into account are the
durability of the assets, the intensity at which the assets are
expected to be used and the expected rate of technological
developments. Asset lives and residual values are assessed
at each balance sheet date.
149
Contrast the estimated useful lives with Unilever’s approach in their

2019 Annual report and accounts:
Property, plant and equipment is measured at cost including
eligible borrowing costs less depreciation and accumulated
impairment losses. Property, plant and equipment is
subject to review for impairment if triggering events or
circumstances indicate that this is necessary. If an indication
of impairment exists, the asset’s or cash generating unit’s
recoverable amount is estimated and any impairment loss is
charged to the income statement as it arises.
Owned assets
Owned assets are initially measured at historical cost.
Depreciation is provided on a straight-line basis over the
expected average useful lives of the assets. Residual values
are reviewed at least annually. Estimated useful lives by
major class of assets are as follows:
• Freehold buildings (no depreciation on 40 years

freehold land)
• Leasehold land and buildings 40 years (or life of lease if less)
• Plant and equipment 2–20 years
3. What happens if the tangible asset’s life is so long (over 50 years) or

the residual value is so high (or both) that any depreciation calculated
would be immaterial? IAS 16 states that once the company has shown
that the depreciation charge would be immaterial then it should be
subject to an ‘impairment review’ in accordance with IAS 36.
4. What happens in the case of land which has an infinite life rather than
a useful life? Typically no depreciation is provided.
5. What happens in the case of intangible non-current assets, which
do not necessarily have a finite useful life? How can one assess the
certainty of future economic benefits?
6. What happens if property is held as an investment rather than for
use in the normal activities of a business? Investment properties are
discussed in Section 11.7.
11.5.1 Which depreciation method?

The depreciation method used should reflect the pattern of consumption
of the asset’s benefits (IAS 16, para.60). This should be reviewed at least
annually and, if the pattern of consumption of benefits has changed, the
depreciation method should be changed prospectively as a change in
estimate under IAS 8 (IAS 16, para.61).
What is the fair way to allocate the cost/value of a non-current asset over
its useful life? Should the depreciation charge be linear? Or should it be
based on a more theoretically attractive method, for example a method
which takes account of the cost of capital notionally invested in the asset
(Baxter, 1981)?
A number of depreciation methods may be used:
1. Straight-line. This is the most popular method in the UK. It charges
equal instalments over the asset’s useful life. The depreciation charge:
= (cost – residual value) / expected useful life.
2. Reducing balance (or declining method). The annual depreciation
charge is calculated as a fixed percentage (depreciation rate) of the net
150
book value of a non-current (cost – accumulated depreciation). The

depreciation rate:
= 1 – (residual value/cost)1/n (where n = expected useful life).
3. Sum of digits. This is a compromise between straight-line and
reducing balance (found in the USA for accelerated depreciation).
For instance, the sum of the digits for a five-year useful life is
15(1+2+3+4+5). In year 1, 5/15 of the total depreciation will be
charged; in year 2, 4/15 of the total depreciation will be charged and
so on.
4. Usage (e.g. machine hours). Depreciation is allocated according
to the actual usage (machine hours) of the machine.
5. Annuity method. The capital representing the asset here is assumed
to be capable of earning a fixed rate of interest. Depreciation here
is taken to be the ‘sacrifice’ or deprival value incurred in using the
asset (thus foregoing the alternatives). The foregone alternatives are
twofold – the loss from using the asset and the interest foregone by
using the funds to acquire the asset. This method is not covered in
this syllabus, but for those interested, it is covered in Elliott and Elliott
(2019, pp.434–435).
The first three methods above are covered in AC1025 Principles of
accounting. However, to aid revision, there is a worked example of these
methods below.
Example 11.1: three depreciation methods

Payman Plc buys a tangible non-current asset for £20,000, which has
an estimated useful life of five years and an estimated residual value of
£5,000.
The following example shows the annual depreciation charge to the
income statement and the net book value (the carrying amount in the
statement of financial position) for the:
• straight-line method (SL)
• reducing balance method (RB)
• sum of digits method (SD).
The depreciation rate for RB is: = 1 – (scrap value / initial capital cost))1/life of asset (years)
= 1 – (5,000/20,000)1/5
= 1 – (0.758)
= 24.2%
Annual depreciation charge (£)

SL RB SD
Year 1 3,000 4,840 5,000
Year 2 3,000 3,669 4,000
Year 3 3,000 2,781 3,000
Year 4 3,000 2,108 2,000
Year 5 3,000 1,602 1,000
End-of-year net book value (£)

SL RB SD
Year 1 17,000 15,160 15,000
Year 2 14,000 11,491 11,000
151
SL RB SD
Year 3 11,000 8,710 8,000
Year 4 8,000 6,602 6,000
Year 5 5,000 5,000 5,000
Activity 11.3
a. Given these figures, what are the disadvantages of each of these methods? Can you
think of any reason why a particular one of these methods might be preferred?
b. Sugar Plc bought an item of machinery for £100,000 on 1 January 2009. It is
envisaged that the machinery could be sold in 10 years’ time for £20,000. Sugar Plc
uses straight-line depreciation to depreciate its machinery, and sells the machinery
to its rival Venables Plc on 31 December 2010 for £80,000. What is the accounting
profit and loss on the sale of this machinery?
• –£20,000?
• –£4,000?
• nil?
• +£4,000?
11.6 Measurement after recognition: revaluation

In Chapters 7 and 8, alternative approaches were developed to deal with
the limitations of the historical cost approach to valuing assets. The current
standard IAS 16 permits two options, one based on retaining the existing
(historical) cost approach, and the other, based on a fair value approach:
• The cost model: ‘after recognition as an asset, an item of property,
plant and equipment shall be carried at cost less any accumulated
depreciation and any accumulated impairment loss’ (IAS 16, para.30).
• The revaluation model: ‘after recognition as an asset, an item
of property, plant and equipment whose fair value can be measured
reliably shall be carried at a revalued amount, being its fair value
at the date of the revaluation less any subsequent accumulated
depreciation and subsequent accumulated impairment losses’ (IAS 16,
para.31).
Fair value is the amount for which an asset could be exchanged between
knowledgeable, willing parties in an arm’s length transaction (IAS 16,
para.6).
If the revaluation model is chosen it must be applied to all assets of the
same class (IAS 16, para.36), if not necessarily to all classes of tangible
non-current assets. This avoids companies ‘cherry picking’ assets for
revaluation.
If companies choose revaluation they must continue to do so on a
consistent basis and keep it up-to-date. The frequency of valuations:
depends upon the changes in fair values of the items…being
revalued. When the fair value of a revalued asset differs
materially from its carrying amount, a further revaluation is
required. Some items…experience significant and volatile
changes in fair value, thus necessitating annual revaluation.
Such frequent revaluations are unnecessary for items…with
only insignificant changes in fair value. Instead, it may be
necessary to revalue the item only every three or five years.
(IAS 16, para.34)
152
11.6.1 Accounting for revaluations

Accounting for revaluations is common for companies which otherwise
use historical cost accounting to revalue some of their non-current assets,
particularly land and buildings; the resultant system is usually referred
to as modified historical cost. This section sets out the main accounting
considerations involved; it is based on the assumption of an upward
revaluation and does not deal with revaluation deficits.
11.6.2 Revaluing an asset for the first time

On revaluing a non-current asset for the first time, the difference between
the revalued amount and the net book value of the asset at the date
of revaluation goes to the revaluation surplus (part of equity) as an
unrealised surplus.
Revaluation gain. Difference between the revalued amount and the
net book value of the asset at the date of revaluation is: debit to property,
plant and equipment credit to equity in the statement of financial position
under the headings of revaluation surplus.
Revalued assets, with the exception of land and investment properties,
with a finite useful life, are still subject to depreciation (see Example
11.2 below). This is because the ‘depreciable amount of an asset shall
be allocated on a systematic basis over its useful life’ (IAS 16, para.50).
When revaluing assets the opportunity will usually be taken to review the
expected useful life and the revalued amount should be written off over
the remaining estimated useful life of the asset. When an asset is revalued
at the start of the year, depreciation for the year will be based on the
revalued amount. The whole of the depreciation on the revalued amount
must be charged to the income statement; it is not permitted to charge
‘split depreciation’ (i.e. charge part to the income statement and part to
the revaluation surplus). When a non-current asset is revalued at the end
of the year it is still necessary to charge depreciation for the year: ideally
this should be based on the average value for the year, but either the
opening or closing value may be used; most companies are likely to base it
on the opening value. In subsequent years the depreciation charge will be
based on the revalued amount.
Example 11.2: Revaluing a depreciating and non-depreciating asset

Land and buildings cost £250,000 on 1 January 2016; of this, £100,000
was attributed to the land. At that date the buildings were estimated
to have a useful life of 50 years with no residual value. They are being
depreciated on a straight-line basis. On 31 December 2016 the property
was professionally revalued at £400,000, of which £160,000 was
attributed to the land. No change was made to the estimated useful life of
the buildings.
During the year ended 31 December 2016 depreciation of £3,000 on
buildings will have been charged, based on the opening value at the
start of the year. At 31 December the property, plant and equipment
will therefore have a net book value of £247,000. In the accounts at
31 December 2017 the following entries will be made to reflect the
revaluation (£400,000 – £247,000) in the statement of financial position:
Dr Property, plant and equipment £150,000

Dr Depreciation of buildings £3,000
Cr Revaluation surplus £153,000
In subsequent years, depreciation will be based on the revalued amount
for buildings, that is, £240,000 over 40 years or £6,000 p.a.
153
Note that on disposal of a revalued asset, the gain or loss in the income
statement is the difference between the sale proceeds and the depreciated
revalued amount (i.e. carrying amount).
Example 11.3: Treatment of depreciation subsequent to revaluation

Arran Co bought an asset for £10,000 at the beginning of 2014.
It had a useful life of five years.
On 1 January 2016 the asset was revalued to £12,000. The expected
useful life has remained unchanged (i.e. three years remain).
Account for the revaluation and state the treatment for depreciation from
2016 onwards.
Solution:
On 1 January 2016 the carrying value of the asset is £10,000 – (2/5 ×
£10,000) = £6,000.
For the revaluation:
Dr Asset value £6,000

Cr Revaluation surplus £6,000
The depreciation for the next three years (starting from 1 January 2016)
will be £12,000 ÷ 3 = £4,000, compared to depreciation on cost of
£10,000 ÷ 5 = £2,000. So, each year, the extra £2,000 can be treated as
part of the surplus which has become realised:
Dr Revaluation surplus £2,000

Cr Retained earnings £2,000
This is a movement on owners’ equity only, not an item in the income
statement.
Example 11.4: Review of useful life

Bunreeven Co acquired a non-current asset on 1 January 2012 for £80,000.
It had no residual value and a useful life of 10 years.
On 1 January 2015 the total useful life was reviewed and revised to seven
years.
What will be the depreciation charge for 2015?
£
Original cost 80,000
Depreciation 2012 – 2014 (80,000 × 3/10) (24,000)
Carrying amount at 1 December 2015 56,000
Remaining life (7 – 3) = 4 years
Depreciation charge year 2015 (56,000/4) 14,000
Example 11.5: Revaluation gain followed by revaluation loss

If, however, a revaluation gain was initially recognised, the way in which
to deal with a subsequent loss on revaluation is to ‘reverse’ some or all of
the original gains.
For instance, revisit Arran in Example 11.3 above. On 31 December 2016,
the carrying value of the asset = £12,000 (revised amount) – £4,000
(revised depreciation) = £8,000. If the asset was sold on 31 December
2016 for £6,400, a loss of £1,600 is recognised. This loss can be written off
against the initial revaluation surplus, which is then realised (i.e. moved
to) retained earnings:
154

Cr Non-current assets (disposal) £1,600
Cr Retained earnings £4,400
If, however, the asset was sold for £1,200, the loss recognised would be
£8,000 – 1,200 = £6,800, which exceeds the balance of the revaluation
surplus on 31 December 2016. In this case, all of the revaluation surplus
would be written off and the balance to be debited against the retained
earnings for the year.
Dr Retained earnings £800
Cr Non-current assets (disposal) £6,800
Example 11.6: Revaluation loss followed by revaluation gain

Arran Co bought an asset for £10,000 at the beginning of 2014. It had a
useful life of five years.
On 31 December 2014, the asset was devalued to £7,600. The expected
useful life has remained unchanged (i.e. four years remain). The
accounting treatments are:
Dr Income statement £2,400 (2,000 depreciation + 400 additional loss recognition)
Cr Non-current asset £2,400
On 1 January 2015, the carrying value of the asset = £7,600. If the
asset has been revalued on 31 December 2015 to £6,100, the accounting
treatments are:
Depreciation for 2015 = £7,600 × ¼ = £1,900
Carrying value 31 December 2015 = £7,600 – 1,900 = £5,700
IAS 16 allows for the revaluation gain of £6,100 – 5,700 = £400 to be
recognised in the income statement, as this gain reverses a previously
recognised loss.
Dr Non-current asset £400
Cr Income statement £400
Contrast this with Example 11.1 where the gain was recognised in the
revaluation reserve as it was deemed ‘unrealised’.
11.7 Impairment: IAS 36

The treatment of impairment for both tangible and intangible non-current
assets are similar. Please read Section 13.5 and complete Activity 13.5 in
this subject guide to cover this topic.
11.8 IAS 40: Investment properties

IAS 40 defines investment property as:
property (land or a building – or part of a building – or both)
held (by the owner or by the lessee under a finance lease) to
earn rentals or for capital appreciation or both, rather than for:
a. use in the production or supply of goods or services or for
administrative purposes; or
b. sale in the ordinary course of business.
This definition indicates that an investment property is capable of

generating cash flows independently of the other assets of the business.
155
IAS 40 requires entities to choose one of two accounting models to be

applied consistently to all of its investment properies. The two models are:
1. A fair value model. Investment property should be measured at fair
value and changes in fair value should be recognised in the income
statement. No depreciation is required.
2. A cost model, as defined in IAS 16. Investment property should
be measured at depreciated cost (less any accumulated impairment
losses). An enterprise that chooses the cost model should disclose the
fair value of its investment property.
A change from one model to the other should be made only if the change
will result in a more appropriate presentation: this is highly unlikely to be
the case for a change from the fair value model to the cost model.
However in some cases, a property might be re-classified from a PPE to an
investment property:
A company decides to close its packaging operations on 30 June 20X1 in
the South of England but retain the warehouse from which the operations
were carried out as an investment property. The warehouse had a net
book value at 31 December 20X0 of £3.2 million and a fair value of £3.4
million at 30 June 20X1. At the company’s year end of 31 December 20X1,
the fair value of the warehouse was £3.7 million. The amount that the
company would record in the profit and loss account for the year ended 31
December 20X1 assuming policy is to value investment properties at fair
value would be?
For a transfer from owner-occupied property to investment property carried
at fair value, IAS 16 should be applied up to the date of reclassification. Any
difference arising between the carrying amount under IAS 16 at that date
and the fair value is dealt with as a revaluation under IAS 16 [IAS 40.61].
Therefore, on 30 June 20X1, the warehouse would be revalued to £3.4m
with a credit of £0.2 to the revaluation reserve. From 30 June 20X1
onward, the warehouse would be re-classified as an investment property.
By 31 December 20X1, the change in fair value would be credited to the
income statement (i.e. £0.3m).
IAS 40 also considers interests under operating leases (see Chapter 12).
Para.6 states that a property interest held by a lessee under an operating
lease may be classed as an investment property if, and only if, the property
would otherwise meet the definition of investment property and the lessee
uses the fair value model for the asset recognised.
Activity 11.4
A non-current asset (building) has been acquired by a company and it wishes to account for
this as an investment property. The non-current asset cost £1,400,000 on 1 January 2019 and
its market value on 31 December 2019 is £1,800,000. The company’s depreciation policy for
similar non-current assets is the reducing balance method using a rate of 10%.
Required:
• What are investment properties and how are they accounted for?
• Show how the non-current asset would be accounted for in the income statement for
the year ended 31 December 2019 and in the statement of financial position as at 31
December 2019 if it could be classed as an investment property using the fair value model
and the cost model.
156

• discuss tangible non-current assets, directly owned (leased assets are
discussed in Chapter 12) and borrowing costs
• explain the implications of revaluation on interpretation of the
financial statements
• appreciate accounting for investment property as distinct from
accounting for property more generally.

Question 11.1
A company has some equipment that has an expected life of 20 years.
It expects the equipment to generate a constant annual output and has
sought your advice as to the appropriate method of depreciating it.
a. For equipment bought for £2,000,000 at the beginning of 2010, with
an expected residual value of zero, show the difference between
the charge for depreciation on a straight-line basis and the charge
for depreciation on a discounted present value basis (i.e. annuity
method), assuming the annual cash flow to be earned is constant,
using 8% cost of capital rate, in:
• year 1 (i.e. 2010)
• year 10
• year 20.
Work to the nearest £1,000.
b. Comment briefly on your results in relation to the company’s stated
aim in setting its prices at a level sufficient to earn a return of 8% on
capital employed. (Ignore inflation.)
Question 11.2
On 1 October 2014 Ballina acquired a machine under the following terms.
Hours £
Manufacturer’s base price 2,500,000
Trade discount (applying to base price only) 20%
Early settlement discount taken (on the payable
amount of the base cost only) 4%
Freight (carriage) charges 30,000
Installation cost 52,000
Staff training in use of machine 85,000
Pre-production testing 45,000
Purchase of a three-year maintenance contract 120,000
Estimated residual value 50,000
Estimated life in machine hours 15,000
Hours used – year ended 30 September 2015 3,000
– year ended 30 September 2016 3,600
– year ended 30 September 2017 (see below) 1,500
On 1 October 2016 Ballina decided to upgrade the machine by adding new
components at a cost of £410,000.
157
This upgrade led to a reduction in the production time per unit of the
goods being manufactured using the machine. The upgrade also increased
the estimated remaining life of the machine at 1 October 2016 to 9,000
machine hours and its estimated residual value was revised to £75,000.
Prepare extracts from the income statement and statement of financial
position for the above machine for each of the three years to 30 September
2017.
Question 11.3
A company acquired a machine as follows:
Manufacturer’s base price £5,000,000

Trade discount 20%
Early settlement discount taken (on payable amount
4%
of the base cost only)
Foreign (carriage) charges £60,000
Installation cost £104,000
Staff training in use of machine £170,000
Pre-production testing £90,000
Purchase of 3 year maintenance contract £240,000
Estimated residual value £100,000
Estimated life in machine hours
Total machine hours used 15,000
• year ended 31 March 2016
st
3,000
st
3,600
st
1,500
On 1 April 2017, the machine was upgraded at a cost of £820,000,

increasing the remaining life of the machine to 9,000 hours and its
estimated residual value was increased to £150,000.
Required:
1. Define non-current assets and Discuss three areas of judgement in
relation to depreciation within financial statements. (8 marks)
2. Show how the company would account for its machine for the years
ended 31 March 2016, 2017 and Depreciation is based on machine
hours used. (12 marks)
Question 11.4
What are ‘non-current tangible assets’ and ‘investment properties’? Discuss
the differences in the accounting treatment of ‘non-current tangible assets’
and ‘investment properties’ and discuss how the different accounting
treatments affect the financial statements.
158
Chapter 12: Leases
Chapter 12: Leases
12.1 Introduction
This chapter considers how leases are treated in the financial statements.
The main issue is in understanding the implication of different treatments
for leases (primarily financial leases versus operating leases). In particular,
we need to consider the attraction of particular lease treatments and
its distortionary effect on financial statements and analysis. We will
also consider the reactions of standard setters to mitigate against such
distortions.

• describe both operating leases and finance leases
• demonstrate accounting for both operating and finance leases, and
explain possible implications for accounts’ users
• discuss off-statement of financial position financing in relation to
operating leases
• discuss the reactions of standard setters to mitigate against the
potential distortions caused by operating leases.


2019) 19th edition [ISBN 9781292255996], Chapter 18 “Leasing”
International Financial Reporting Standard Effects analysis. (London: IFRS,
2016) www.ifrs.org/Current-Projects/IASB-Projects/Leases/Documents/
IFRS_16_effects_analysis.pdf

IFRS 15 Revenue from contracts with customers [https://www.iasplus.com/en/
standards/ifrs/ifrs15]
IFRS 16 Leases (which draws on many of the calculative elements from IAS 17)
[https://www.iasplus.com/en/standards/ifrs/ifrs-16]
(IAS 17 Accounting for leases is now retired.)
12.2 Leases
In recent years, the accounting standard for leases has had major revisions.
IFRS 16 Leases replaced IAS 17, which was deemed to be inadequate in a
number of ways. To understand the problems caused by IAS 17, we first
consider the way in which IAS 17 accounts for assets that are leased. Note
that from a technical accounting viewpoint, the way in which leases are
calculated are similar. The main difference between IFRS 16 and IAS 17 is
the change in the threshold criteria that determines how leases should be
classified.
159
12.2.1 Classification of finance and operating leases (IAS 17)

A lease is an agreement whereby the lessor conveys to the lessee in
return for a payment or series of payments the right to use an asset for
an agreed period of time. The lease entitles the lessee to use that asset
for a certain period but the lessor retains the ownership of that asset. Part
of the reason for the growth in leasing in the UK in recent times was the
effective separation of tax allowances from the actual use of an asset. The
lessor owns the asset and is entitled to the tax allowance on that asset;
if the lessee was tax-exhausted (as was the case with many companies in
the UK, who were unable to use tax allowances for the purchase of non-
current assets), this benefit would not be as attractive to the lessee.
We know that, for example, if an airline company owns an aircraft then
we expect the aircraft to appear on the statement of financial position as a
non-current asset. However, what happens if an airline company leases an
aircraft for (say) 20 years? The lessee will use that aircraft for 20 years, but
will there be any evidence of that leased asset on the lessee’s statement of
financial position? The short answer is ‘it depends’. There are two types of
leases – finance and operating – and they are treated differently in the
accounts. The changes under IFRS 16 Leases eliminate the uncertainty over
the two treatments, as most leases will be classified as finance leases as the
criteria for operating lease classification become increasingly stringent.
12.2.2 Finance lease

According to IAS 17, para.4: ‘A lease is classified as a finance lease if it
transfers substantially all the risks and rewards incident to ownership. All
other leases are classified as operating leases.’
Whether a lease is a finance lease or not depends on the substance of the
transaction rather than the form. Situations that would normally lead to
a lease being classified as a finance lease are outlined in IAS 17, para.10.
These include the following:
• The lease transfers ownership of the asset to the lessee by the end of
the lease term.
• The lessee has the option to buy the asset at a price which is expected
to be sufficiently lower than the fair value at the date the option
becomes exercisable, such that, at the inception of the lease, it is
reasonably certain that the option will be exercised.
• The lease term is for the major part of the economic life of the asset,
even if title is not transferred.
• At the inception of the lease, the present value of the minimum lease
payments amounts to at least substantially the fair value of the leased
asset.
• The leased assets are of a specialised nature such that only the lessee
can use them without major modifications being made.
Other situations that might also lead to classification as a finance lease are
(IAS 17, para.11):
• If the lessee is entitled to cancel the lease, the lessor’s losses associated
with the cancellation are borne by the lessee.
• Gains or losses from fluctuations in residual fair value fall to the lessee
(for example, by means of a rebate of lease payments).
• The lessee has the ability to continue to lease for a secondary period at
a rent that is substantially lower than market rent.
If a company borrowed money to buy an asset, the loan would appear as
160
Chapter 12: Leases
a liability and the asset as a non-current asset in the statement of financial

position. The gearing of the company would be affected by it. As is shown
below, IAS 17 requires a finance lease to be treated in a similar way, thus
bringing on to the statement of financial position what would otherwise be
a form of ‘off-statement of financial position finance’. Note that all of these
definitions and the treatment of leased assets are very similar under IFRS 16.
12.2.3 Operating lease

Under IAS 17, an operating lease is ‘a lease other than a finance lease’.
These tend to be more short-term commitments and do not normally cover
the whole of the asset’s useful life, though IFRS 16 places considerably more
restrictions on the types of leasing arrangements that can be classed as an
operating lease. In the past, under operating leases different users would
often hire assets in succession under an operating lease. Operating leases
represent a form of off-balance sheet financing, which improves the lessee’s
gearing, return on assets and return on investment. In the past, ambiguities
in classifying leases has aided this arrangement.
In IAS 17 Leases, other definitions include:
• 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 leasing 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: 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,
together with:
• in the case of the lessee, any amounts guaranteed by the lessee or by
a party related to the lessee
• or in the case of the lessor, any residual value guaranteed to the
lessor by either (1) the lessee; (2) a party related to the lessee; or
(3) a third party unrelated to the lessor that is financially capable of
discharging the obligations under the guarantee.
Interest rate implicit in the lease: the discount rate that, at the
inception of the lease, causes the aggregate PV of (a) the minimum lease
payments and (b) the unguaranteed residual value to be equal to the sum of
the fair value of the leased asset and any initial direct cost of the lessor.
Note: For simplicity, it will be assumed here that there will be no
guaranteed or unguaranteed residual values and no amounts for which the
lessor is accountable to the lessee; hence the interest rate implicit in the
lease will be calculated purely by reference to the minimum payments over
the remaining part of the lease.
Activity 12.1
Read the articles below, which will help you contextualise the debates behind leasing and
provide you with empirical examples to use in essays.
• Thornton, G. and Tomlin ‘What does IFRS 16 mean for landlords?’, Estates Gazette, 3
November 2018, pp.64–66. (Available in the Online Library.)
• Ryland, Philip ‘Debt by any other name’, Investor’s Chronicle, 16 August 2019, p. 33.
(Available in the Online Library.)
• Quinn, James ‘On balance, companies would rather not show debt’, The
Telegraph, 13 January 2016. [https://www.telegraph.co.uk/finance/newsbysector/
banksandfinance/12098359/On-balance-companies-would-rather-not-show-debt.html]
161
• Eley, Jonathan ‘New rules force retailers to rethink lease accounting’, Financial
Times, 28 October 2018. [https://www.ft.com/content/9657cd82-c891-11e8-ba8f-
ee390057b8c9] The Financial Times is available to EMFSS students in the Online
Library. You can access the newspaper to browse editions or search for individual
articles through the Online Library A–Z journal list.
Summarise the key impact of IFRS 16 as reported in the articles. Consider the following in
your summary:
1. What are the key differences in criteria for recognising finance and operating leases
under IFRS 16 versus IAS 17?
2. What are the key industries or companies that are affected by the move to IFRS 16?
3. What are the key arguments used to support the move to IFRS 16?
4. What are the key arguments against IFRS 16 (i.e. retaining the old standard IAS 17?)
12.2.4Accounting treatment of leases (from the perspective of the

lessee)
Rentals paid on an operating lease are charged to the income statement.
They should be charged on a straight-line basis over the lease term, even if
the payments are not made on such a basis, unless a more systematic and
rational basis is appropriate. The disclosure requirement is as follows:
• total of rentals charged as an expense in the income statement
• payments committed to make during the next five years, in the second
to fifth years inclusive, and over five years.
In accounting for a finance lease it is necessary to record the lease in
the balance sheet as both an asset and an obligation to pay future
rentals. The sum at which the asset and liability are initially recorded
should be the PV of the minimum lease payments discounted at the
interest rate implicit in the lease, though in practice the fair value of the
asset will usually be a sufficiently close approximation. Rentals paid under
a finance lease are to be apportioned between a finance charge (in the
income statement) and a reduction in the obligation to pay future rentals
(in the balance sheet). The leased asset should be depreciated over the
shorter of the lease term and its useful life.
The total finance charge should be allocated to time periods to give a
constant periodic rate of charge on the outstanding obligation for each
accounting period. This is best achieved by the use of the actuarial method
illustrated below.
In the statement of financial position, the amount outstanding on obligations
under finance leases should be apportioned between amounts falling due
within one year and amounts falling due after more than one year.
Example 12.1: Finance lease

An asset, which could be purchased outright for £23,450, is instead leased
by Lessee Co for three years (its useful life, at the end of which it will
have no residual value). Lessee Co is responsible for all maintenance and
insurance costs. The lease provides for half-yearly payments in advance
of £4,500, the first payment being made on 1 January 20X1. Show the
sums that will appear in the income statement and statement of financial
position in respect of this leased asset.
Since the lease covers the whole of the economic life of the asset and Lessee
Co has to maintain and insure it, the lease may be deemed to transfer
162
Chapter 12: Leases
substantially all of the risks and rewards of ownership. It is therefore

necessary to ascertain the interest rate implicit in the lease. This may be
done as follows:
Step 1
Find the value of the annuity factor for five periods that sets the minimum
lease payments equal to the fair value (these payments here being the sum
the lessor expects to receive and retain).
(NB: the annuity factor here is calculated for only five periods, since the
first payment under the lease is made in advance.)
Therefore . Reading from the five periods column of annuity

tables it can be seen that this annuity factor is for an interest rate of 6%
per period.
Step 2
Analyse the rental payments under the lease as follows.
Rental Finance Reduction in Balance of obligation
payment charge obligation under finance lease
Date
1/1/20X1 23,450 (initial balance)
1/1/20X1 4,500 – 4,500 18,950
1/7/20X1 4,500 1,137 3,363 15,587
1/1/20X2 4,500 935 3,565 12,022
1/7/20X2 4,500 721 3,779 8,243
1/1/20X3 4,500 495 4,005 4,238
1/7/20X3 4,500 254 4,246 – (Small difference due
to rounding)
The finance charge here is calculated at 6% per period on the amount

outstanding at the start of each period. Since in this example lease
payments are made in advance, the first payment on 1 January 20X1
is entirely a reduction in the obligation under the finance lease and no
element of finance charge is attributable to that payment.
Income statement
In the income statement for 20X1 a finance charge of £2,072 will be
shown. This is made up of the amount of £1,137 deemed paid on 1 July
20X1 and an accrual for the finance charge of £935 payable on 1 January
20X2 (but which relates to the six months from 1 July 20X1 to 1 January
20X2). There will also be a depreciation charge.
Statement of financial position – liability

In the statement of financial position at 31 December 20X1 the figure of
£935 will be included with the accruals, and obligations will be shown
under the finance lease amounting to £15,587. This will be split between
amounts falling due within one year (£3,565 + £3,779 = £7,344) and
amounts falling due after more than one year (£8,243).
163
Statement of financial position – asset

The asset will be included among non-current assets at an amount equal
to the initial obligation under the finance lease (£23,450) and will be
depreciated over its useful life, which coincides here with the lease term.
It should be depreciated on the same basis as assets which are owned.
Assuming use of a straight-line basis, depreciation of £7,817 p.a. will be
charged to the income statement.
Activity 12.2
On 1 January 2010 EZH Plc entered into the following lease agreements with Lease
Services Ltd:
a. The rental of plant ‘Z’. The lease was for four years, with a quarterly rental of £3,864
payable in advance, the first payment being due on 1 January 2010. The fair value of
the plant is £50,000. EZH Plc is responsible for all repairs and maintenance of the
plant, which has a useful life of four years with no residual value.
b. The rental of plant ‘Y’ for five years at a quarterly rental, payable in arrears, of
£2,420, the first payment being due on 31 March. The plant has a useful economic
life of five years, with no residual value, and EZH is responsible for all repairs and
maintenance. The interest rate implicit in the lease is 3% per quarter.
EZH’s depreciations on all its non-current assets are on a straight-line basis.
Show how the above transactions will be reflected in the income statement of EZH Plc for
the year ended 31 December 2010 and its balance sheet at that date in accordance with
standard accounting practice.
Example 12.2: Operating lease

Let us assume that Example 12.1 the estimated useful life of the asset was
10 years and that Lessee Co is not responsible for the maintenance and
insurance costs. This may be defined as an operating lease. Consequently,
the lease rental of £9,000 p.a. would be charged to the income statement
(with no asset or obligation in the balance sheet) just like any other
expense item. The level of future commitments (£18,000) will be disclosed
in the notes.
Activity 12.3
Helena Plc acquired an item on a lease with the following conditions:
• 10 annual instalments of £20,000 each, the first payable on 1 January 2010.
• The machine was completely installed and first operated on 1 January 2010 and its
purchase price on that date was £160,000.
• The machine has an estimated useful life of 10 years at the end of which it has no
value.
Calculate the charges to the income statement for 2010 and 2011 if this is treated as an
operating lease.
164
Chapter 12: Leases
12.2.5 Off-balance sheet financing and the need to replace IAS 17

The statement of financial positions (balance sheets) of Lessee Co (with
operating or finance lease) illustrate the debate concerning off-statement
of financial position financing. Under both methods the company is leasing
an asset worth £23,450 for a period of three years. However, only under
the finance lease is this and the associated liability shown in the statement
of financial position. Consequently, operating leases are a means of
enabling off-balance sheet financing.
The main reason for replacing IAS 17 with IFRS 16 is to eliminate the
potential for the (abusive) restructuring of lease transactions to meet the
favourable treatment under operating leases. Under IAS 17, it was entirely
subjective that the two economically identical leasing agreements could
be accounted for differently by two entities. From a conceptual framework
perspective, IAS 17 was also critiqued for not recognising that non-
cancellable operating leases constitute a ‘liability’ under the definition that
it is an ‘obligation to transfer economic benefits as a result of past events’.
Under IFRS 16, it was decided that the underlying criteria would be a fairly
rigorous application of substance over (legal) form in classifying
leasing transactions, where almost all lease transactions be treated as if it
were a finance lease (i.e. de facto abolishment of operating leases). This
means a contract does not need to be legally established as a finance lease
for it to be regarded as such under IFRS 16. The definition under IFRS 16
is that the customer or user of the leased asset needs to have the right to:
• obtain substantially all of the economic benefits from the use of the
asset
• direct the use (right of use or RoU) of the asset.
RoU means that the customer can either obtain economic benefits directly
from the asset’s use or sub-lease the asset. RoU means that the customer can
solely determine how and for what purpose the asset is used throughout
its leased period. It also means that the supplier does not have the right to
change the way the asset is used once the leasing agreement is in place.
According to the IFRS foundation, an important implication of the
transition is that, unlike IAS 17, IFRS 16 will require a company to
recognise interest on lease liabilities separately from depreciation of
lease assets. A lessee is expected to present interest expense as part of
finance costs, and depreciation within a similar line item to that in which
it presents depreciation of property, plant and equipment. Under IAS 17,
lease payments were generally presented within operating expenses.
165
Activity 12.4: Effects of IFRS 16
Table 1: IFRS 16’s effect on Card Factory (London Stock Exchange: FTSE 250)
Year to end January 2019 (£m)
The balance sheet The income statement
Actual IFRS 16 Actual IFRS 16
Non-current assets 362 362 Revenue 436 436
Ebitda (Earnings before
Leased assets – 127 interest, tax, depreciation 89.4 132.4
and amortisation)
Current assets 93 93 Depreciation –10.9 –37.9
Total assets 455 582 Operating profit 78.5 94.5
Debt 144 144 Interest –3.9 –17.9
Lease liabilities 0 145 Pre-tax profit 74.6 76.6
Other liabilities 83 83 Tax –14.5 –14.5
Equity 228 210 Net profit 60.1 62.1
Debt/equity (%) 63 188 EPS (p) 17.6 18.2
Net debt/Ebitda (Earnings
before interest, tax, 1.58 2.15 Profit margin (%) 18.0 21.7
depreciation and amortisation)
Return on capital (%) 21.1 18.9
(Source: Ryland, P. ‘Debt by any other name’, Investor’s Chronicle, 15 August 2019.)
Carefully analyse the excerpts to Card Factory’s balance sheet and income statement above (year end 31 Jan 2019)
in Ryland, P. ‘Debt by any other name’, Investor’s Chronicle, 15 August 2019, p.33. (Available in the Online Library.)
• What are the major effects of IFRS 16 on the company’s balance sheet (Statement of financial position) and
income statement?
• How would this change the perspective of an investor?
• The company’s profits (net profit/profit margin) and total assets has increased. If you are an investor, do you
see this as a good thing?
166
Chapter 12: Leases
Activity 12.5
• Kostolansky, J. et al., ‘Financial reporting impact of the operating lease classification’,
The Journal of Applied Business Research 28 (6) 2012, pp.1509–514.
• In particular, pay example to the data presented in Tables 1 and 2 and the following
questions:
1. What is the sample of companies used in the analysis?
2. What is the hypothetical impact in capitalising operating leases on key financial
ratios?
3. What are the industries most affected by the capitalisation?
4. How does the analysis by Kostolansky et al. (2012) relate to the discussion
surrounding the transition from IAS 17 to IFRS 16?
Discount rate
N 3% 6% 9%
Average % Increase in
Total Assets
Full Sample 3,064 11.09% 9.89% 8.91%
Total Assets > $25M 2,808 10.68% 9.48% 8.50%
Total Assets > $100M 2,513 10.54% 9.34% 8.36%
Average % Increase in Total
Liabilities
Full Sample 3,064 25.20% 22.53% 20.32%
Total Liabilities > $5M 2,891 24.21% 21.60% 19.44%
Total Liabilities > $100M 2,114 20.23% 17.94% 16.06%
Average % Increase in
Debt-to-Assets
Full Sample 3,064 10.68% 9.83% 9.09%
Total Assets > $25M 2,808 10.49% 9.64% 8.90%
Total Assets > $50M 2,678 10.12% 9.29% 8.57%
Average % Decrease in
Return on Assets
Net Income > $0 2,189 –7.35% –6.75% –6.23%
Total Assets > $10M/Net
2,121 –7.17% –6.58% –6.06%
Income > $1M
Total Assets > $100M/Net
1,788 –6.91% –6.33% –5.82%
Income > $10M
Table 1: Changes in selected financial measures resulting from operating

lease capitalization (from Kostolansky et al. (2012), Table 1. Licensed under
CC BY 3.0 US by Clute Institute).
167
Industry Number Average % Average % Average % Average %

of Firms Increase in Increase Increase in Decrease in
Total Assets in Total Debt-to- Return on
Liabilities Assets Assets
Apparel and
46 73.30% 177.09% 60.59% -38.37%
Accessory Stores
Educational Services 26 35.94% 105.75% 37.11% -23.07%
Furniture and
13 62.62% 104.33% 29.79% -31.33%
Equipment Stores
Eating and
47 49.59% 95.67% 28.90% -28.56%
Drinking Places
Building Materials
5 28.54% 94.87% 48.46% -19.72%
and Hardware
Agricultural Services 1 28.94% 68.10% 30.37% -22.44%
Food Stores 20 33.79% 66.77% 22.60% -23.09%
Apparel and other
28 23.43% 66.03% 31.83% -15.15%
Textile Products
Miscellaneous Retail 58 8.37% 60.13% 18.77% -19.24%
General merchandise
22 25.50% 59.54% 24.41% -18.45%
stores
Leather and
13 19.43% 55.99% 28.82% -15.91%
leather products
Auto Dealers and
20 31.13% 54.60% 16.31% -16.91%
Gas Stations
Health Services 57 26.50% 51.26% 15.20% -13.43%
Social Services 6 29.07% 46.06% 11.46% -28.00%
Transportation by Air 28 32.36% 45.99% 9.45% -22.07%
Table 2: Industries most affected by captialization of operating leases (from

Kostolansky et al. (2012), Table 2. Licensed under CC BY 3.0 US by Clute Institute.)
12.2.6 Exceptions: IFRS 16 permitted classification scenarios under

operating leases
Short-term leases (with a lease term of 12 months or less) and/or low-
value leases are the two main exceptions to the classification of the leasing
agreement under a finance lease. These two exceptions are allowed to use
the operating lease treatment, where lease rentals are recognised as an
expense over the lease term rather than through the RoU asset and liability
recognition. Note that a lease that contains a purchase option cannot be
classed as a ‘short-term’ lease. The criteria for low-value leases are as
follows:
• the lessee can benefit from the use of the asset either on its own, or in
conjunction with other assets/resources at the disposal of the lessee
• the use of the leased asset is not highly dependent on, or interrelated
with, other assets.
If the value of the asset when new is not typically low value (e.g.
machinery, motor vehicles) then the lease cannot be classed as a low-value
lease. Examples of low-value leases include information technology and
some office furniture leased for employees.
168
Chapter 12: Leases
The following example is taken from Illustration No.13 of IFRS 16 Leases,

with some minor adaptations.
Example 12.3 Lessee enters into a 10-year lease of a floor of a building,
with an option to extend for five years. Lease payments are £50,000 per
year during the initial term and £55,000 per year during the optional
period, all payable at the beginning of each year. To obtain the lease,
Lessee incurs initial direct costs of £20,000, of which £15,000 relates to
a payment to a former tenant occupying that floor of the building and
£5,000 relates to a commission paid to the real estate agent that arranged
the lease. As an incentive to Lessee for entering into the lease, Lessor
agrees to reimburse to Lessee the real estate commission of £5,000 and
Lessee’s leasehold improvements of £7,000.
Lessee accounts for the reimbursement of leasehold improvements
from Lessor applying other relevant standards and not as a lease
incentive applying IFRS 16. This is because costs incurred on leasehold
improvements by Lessee are not included within the cost of the RoU asset.
£ £
Dr Cr
RoU asset 405,391
Lease liability 355,391
Cash (first year lease payment) 50,000
RoU asset 20,000

Cash (initial direct costs) 20,000
Cash (lease incentive received) 5,000

RoU asset 5,000
Lease liability RoU asset

5% 10%
Beginning Lease Interest Ending Beginning Depreciation Ending
balance payment expense balance balance charge balance
Year £ £ £ £ £ £ £
1 405,391 (50,000) 17,770 373,161 420,391 (42,039) 378,352
2 373,161 (50,000) 16,158 339,319 378,352 (42,039) 336,313
3 339,319 (50,000) 14,466 303,785 336,313 (42,039) 294,274
4 303,785 (50,000) 12,689 266,474 294,274 (42,039) 252,235
5 266,474 (50,000) 10,824 227,297 252,235 (42,039) 210,196
6 227,297 (50,000) 8,865 186,162 210,196 (42,039) 168,156
The calculation for the beginning balance of the RoU asset in Year 1 is the
sum of the lease liability and first year advance lease payment [405,391]
+ initial direct costs [20,000] – cash discount or incentive [5000] =
£420,391.
At the end of the sixth year, the lease liability is £186,162 (the present
value of four remaining payments of £50,000, discounted at the original
interest rate of 5% per annum). Interest expense of £8,865 is recognised in
Year 6. Lessee’s RoU asset is £168,156.
Activity 12.6
What difference does the operating/finance lease classification have on some key ratios such
as gearing, return on capital employed and return on net assets?
169
12.2.7 Sale and leaseback transactions

A company may enter into a sale and leaseback transaction: it agrees to
sell an asset it owns and immediately agrees to lease it back. The lease
may be an operating or a finance lease. The accounting issues here are
complicated, depending on several factors; previously IAS 17 was key.
Where the lease was a finance lease, the excess of sales over the asset’s
carrying amount was deferred and amortised over the lease term. Where
it was an operating lease, profit/loss was recognised immediately if the
transaction was carried out at fair value (otherwise a general principle
of substance over form applied). Now the criteria has changed and is
dependent on both IFRS 16 and IFRS 15 Revenue from contracts with
customers. For an example, please see Example 10.3 (Sale and leaseback
transaction, pp.86–87) of the following report: www2.deloitte.com/
content/dam/Deloitte/sg/Documents/audit/sea-audit-IFRS-16-guide.pdf
Detailed knowledge of this area is not required on this course.
12.2.8 The way forward

Some point to deficiencies in lease accounting because of the rigid (and
arbitrary) distinction between the types of lease. In 1999 the policy-
makers produced a discussion paper, Leases: Implementation of a New
Approach, which (consistent with a previous 1996 Special Report of the
G4+1 entitled Accounting for leases: a new approach) suggested that
the comparability (and hence usefulness) of financial statements would
be enhanced if the then (and on-going) treatment of operating leases
and finance leases was replaced by an approach applying the same
requirements to all leases. The approach favours lessees recognising
material rights and obligations (regarding leases) as assets and liabilities
(i.e. non-cancellable operating leases should be treated as finance leases).
The amounts recognised as asset and liability by a lessee would vary in
amount depending on the lease’s character.
The practice of structuring leases to avoid showing leased assets and the
resulting liabilities on balance sheet may be a consequence of a standard
that draws a bright line between similar transactions.
In the UK, the ASB undertook research to inform the IASB’s development
of a new leasing standard. The objective was to develop a single method
of accounting (a conceptual model) for leases consistent with the IASB
framework. This had regard to the prior work of the G4+1 project. IAS 17
has now been replaced by IFRS 16, as the emphasis is on substance over
form, with reduced scope for accountants to apply judgement (especially
towards the classification of leases as operating rather than finance).

• describe both operating leases and finance leases
• demonstrate accounting for both operating and finance leases, and
explain possible implications for accounts’ users
• discuss off-statement of financial position financing in relation to
operating leases
• discuss the reactions of standard setters to mitigate against the
potential distortions caused by operating leases.
170
Chapter 12: Leases

Question 12.1
On 1 January 2010 Marl Plc established five wholly owned subsidiary
companies, all in the same line of business:
• Apple was financed entirely by issued share capital of £70,000.
• Pear had issued share capital of £20,000 and in addition raised
£50,000 from the issue of 12% debentures, interest on which was
payable annually on 31 December.
• Banana, Kiwi and Orange were each financed by £20,000 issued share
capital.
As well as initial working capital of £20,000, all of the companies required
the use of a widget-making machine. The machines cost £50,000 each and
have a 10-year useful life with no residual value. Apple and Pear bought
a machine each. Banana, Kiwi and Orange each leased a machine for an
annual rental payment of £8,850 over 10 years, payable in arrears on 31
December.
The cost of capital for each of the five companies is 12% p.a. Each
company earns annual gross revenues of £18,000 and incurs annual
operating costs (before interest, rental charges and depreciation) of
£6,750. Interest and rentals were all paid on the due dates.
a. For each subsidiary prepare an income statement for the year ended
31 December 2010 and statement of financial position at that date and
show the reported return on Marl’s initial equity investment in each
subsidiary, on the following assumptions:
• that Apple and Pear each use straight-line depreciation over the
asset’s useful life
• that Banana treats the lease as an operating lease (in spite of IAS
17 – follow Banana’s method)
• that Kiwi treats the lease as a finance lease and depreciates the
asset on a straight-line basis
• that Orange treats the lease as a finance lease and depreciates the
asset using the annuity method.
b. Comment on the results shown by your accounts.
Question 12.2
What is the intended effect of introducing IFRS 16 to replace the existing
IAS 17 on Leasing? Critically evaluate the extent to which IFRS 16’s
principles are based on the IASB’s conceptual framework principles.
Question 12.3
Refer to Elliott and Elliott (2019) and attempt Question 2 in Chapter 18
(pp.481–482). Solutions are provided in the textbook.
Question 12.4
Discuss off balance sheet finance and substance over form, covering
the importance of these concepts, the issues leading to the need for the
concepts and the impact they have on financial statements. Illustrate your
answer with two examples.
See Appendix A for an outline of a solution.
171
Notes
172
Chapter 13: Intangible assets and goodwill
Chapter 13: Intangible assets and

goodwill
13.1 Introduction
An intangible asset is defined in IAS 38 Intangible assets (para.8) as ‘an
identifiable non-monetary asset without physical substance’. The IASB’s
conceptual framework (FPPFS) states that assets are resources controlled
by an enterprise as a result of past events from which future economic
benefits are expected to flow to the enterprise. Such assets are not
recognised unless the future economic benefits are ‘probable’ and it is
possible to measure the cost of the asset reliably. Certain items which you
may think of as intangible assets are excluded (i.e. can not be capitalised
as assets) as not meeting the recognition criteria, for example research,
training, advertising, internally generated brands, publishing titles,
customer lists and internally generated goodwill. Those intangible assets
that meet the recognition criteria commonly include the following (note
that the list of intangibles below is not exhaustive):
• purchased brands and their associated trade marks
• patents
• copyrighted material
• customer contracts (and customer relationships under certain
circumstances)
• databases
• computer software
• licences and franchises
• development assets.
Businesses have changed over the past 30 years, and now spend relatively
high levels of expenditure on intangible assets (e.g. brands, goodwill,
R&D, website development, software, etc.) that were not previously
commonplace.
For example, John Wood Group PLC’s intangible assets are valued in
their 2019 consolidated balance sheet (see 2019 Report and Accounts,
p.112) at $6,299 million – more than half (50.7%) of total assets. These
intangibles consist of goodwill, software and development costs, customer
contracts and relationships, order backlog and brands (see 2019 Report
and Accounts, Table 9, p.133). Goodwill itself (net book value = $5,208.9
million) is nearly 83% (5208.9/6299) of the total net book value of the
group’s intangibles. Note that the group uses the terminology ‘balance
sheet’ instead of ‘statement of financial position’.

This chapter considers how intangible assets are treated in the
consolidated accounts of a group of companies, with particular reference
to research and development (R&D) and goodwill.
173

• define intangible assets, R&D and goodwill
• describe and explain the accounting treatment of intangibles, R&D and
goodwill
• explain the process of impairment reviews and its relationship to
deprival values
• describe the effect of intangible assets, R&D and goodwill for both the
consolidated accounts and ratio analysis
• compare and contrast the various historical approaches (capitalisation
with no follow-up expensing of goodwill; immediate write-off;
capitalisation and amortisation of goodwill) with the current approach
to test periodically for impairment
• describe the areas of subjectivity and difficulty in relation to intangible
assets, development expenditure and goodwill
• discuss the continued problems in relation to the current treatment of
goodwill and intangibles.



IFRS 3 Business combinations.
IAS 38 Intangible assets.
13.2 Intangible assets (other than goodwill)

IAS 38 prescribes the accounting treatment for intangible assets that are
not dealt with specifically in other standards (e.g. IFRS 3 for goodwill,
IAS 17 for leases, IAS 2 and IAS 11 for intangible assets held for resale
and IAS 12 for deferred tax assets). A number of key principles underpin
discussions on intangible assets under IAS 38, particularly those of
identifiability and control.
13.2.1 Definition
The IASB’s conceptual framework (FPPFS) defines an ‘intangible asset’
as an ‘identifiable non-monetary asset without physical substance’. This
is expanded to state that an asset meets the identifiability criterion in the
definition of an intangible asset when it:
• is separable, that is, is capable of being separated or divided from
the entity and sold, transferred, licensed, rented or exchanged, either
individually or together with a related contract, asset or liability; or
• arises from contractual or other legal rights, regardless of whether
those rights are transferable or separable from the entity or from other
rights and obligations.
174
Hence, separability is a sufficient but not a necessary condition for

identifiability. Identifiability is necessary in order to distinguish an
intangible asset from goodwill. The recognition of an item as an intangible
asset requires an entity to demonstrate that the item meets:
• the definition of an intangible asset; and
• the recognition criteria.
An intangible asset shall be recognised if, and only if:
• it is probable that the expected future economic benefits that are
attributable to the asset will flow to the entity; and
• the cost of the asset can be measured reliably.
Control of the asset must also be demonstrated. Control is exercised by an
enterprise over an asset if the enterprise:
• has the power to obtain the future economic benefits flowing from the
underlying resource
• can also restrict the access of others to such benefits.
The above requirements on identifiability and control apply to costs
incurred initially to acquire or internally generate an intangible asset and
those incurred subsequently to add to, replace part of or service it.
13.2.2 Examples of intangibles

• Leases (covered in IAS 17/IFRS 16 – see Chapter 12)
• patent rights
• trade marks
• copyright and titles
• franchises and licences
• research and development costs
• secret technological know-how
• computer software
• business names
• brand names
• client lists
• a skilled workforce.
All of the above examples are regarded as assets in the sense of being
expected to bring future benefits, and therefore worth buying or
expending a lot of money to develop. But are they ‘identifiable’ and
‘controllable’? Richard Branson sold the Virgin record label to EMI while
keeping Virgin airlines/trains/cola. One cannot force clients or skilled
employees to stay. Some of the internally generated intangible assets will
fail the recognition criteria and consequently will not be capitalised in the
balance sheet.
13.2.3 Amortisation
The general accounting treatment of intangibles other than goodwill is:
1. for the asset to be initially recognised at cost or fair value (which
is subjected to the existence of active markets in which the asset is
traded)
2. amortise the capitalised value of the intangible asset over its useful
life.
175
IAS 38 states:
The depreciable amount of an intangible asset with a finite
useful life shall be allocated on a systematic basis over its useful
life. Depreciable amount is the cost of an asset, or other amount
substituted for cost, less its residual value. Amortisation shall
begin when an asset is available for use i.e. when it is in the
location and condition necessary for it to be capable of operating
in the manner intended by management. Amortisation shall
cease at the earlier date that the asset is classified as held for
sale… in accordance with IFRS 5… and the date that the asset
is derecognised. The amortisation method used shall reflect
the pattern in which the asset’s future economic benefits are
expected to be consumed by the entity. If the pattern cannot be
determined reliably, the straight-line method shall be used.
An intangible asset with an indefinite life shall not be amortised.

Alternatively the entity should apply IAS 36 and test the asset for
impairment, annually, and whenever there is an indication that the
intangible asset may be impaired (this will be discussed further on in this
chapter).
13.2.4 Internally generated intangibles

Unlike internally generated goodwill, internally generated intangibles
may be capitalised as an asset, but only if they meet the recognition
criteria stated above. The cost of an internally generated asset is the sum
of expenditure incurred from the date when the intangible asset first
meets the recognition criteria. Costs include all expenditure that is directly
attributable to generating the asset or has been allocated (reasonably and
consistently) to the activities of generating the asset. Expenditure that
does not include part of the cost of the intangible asset includes selling,
administration and training staff to operate the asset. Any subsequent
expenditure on an intangible asset should be expensed in the income
statement, except in the rare cases shown in IAS 38, paras 18–20 where:
• probable enhancement of the economic benefits that will flow from the
assets can be demonstrated
• the expenditure can be measured and attributed to the asset reliably.
13.2.5 Measurement of intangible assets

An intangible asset shall be measured at cost initially, or, if acquired via an
asset exchange, at the fair value of the assets given up. Two measurement
treatments are advocated by IAS 38:
• The cost model is to carry the intangible asset at cost less any
accumulated depreciation and (if any) accumulated impairment losses
(IAS 38, para.63).
• The revaluation model is to carry the intangible asset at a revalued
amount. The revalued amount should be the fair value of the asset at
the date of revaluation less any subsequent accumulated depreciation
and (if any) subsequent impairment losses (IAS 38, para.75).
Note: IAS 38 uses the terms depreciation and amortisation
interchangeably.
If the intangible asset is revalued, all assets in its class should also be
revalued. Fair values should be determined by reference to an active
market. Revaluations should be conducted regularly to ensure that the
carrying value in the balance sheet approximates the fair value of the asset.
176
13.2.6 Active market value

IAS 38 (para.8) defines an active market as one in which all of the following
conditions exists:
• the items traded within it are homogenous
• willing buyers and sellers can normally be found at any time (within
reason)
• prices are public information.
IAS 38 (para.67) states that it is unlikely that such an active market
exists for an intangible asset. This argument therefore explicitly rules
out the possibility of recognising unique intangibles (such as brands,
publishing titles, etc.) if they are home-grown rather than acquired. Thus,
the significance of this concept is that the cost of an internally generated
intangible that fails the active market test must be written off to the income
statement as it arises. There is also no restriction on capitalising an intangible
purchased as part of a business where it has an active market value.
The two key features of an active market value appear to be frequency of
transactions in the relevant type of asset and the homogeneity of the class of
asset.
• Frequency of transactions: An active market should be evidenced
by frequent transactions. The standard gives no further explanation of
what is meant by ‘frequent’ or why it should be important. However,
one could reasonably assume that a market with frequent trading would
have the following characteristics – that buyers could normally be found
at any time and that prices are available to the public.
• Homogeneity: Homogenous means ‘of the same kind’. In a commercial
context, a market might be homogenous if the purchaser were
indifferent between suppliers or particular things to be bought. Thus
brands, patents, formulas and other proprietary rights are clearly not
homogeneous and cannot be said to have a readily ascertainable market
value. On the other hand, licences to use scarce resources are more
likely to be homogenous: the useful radio-wave spectrum is limited
and is divided into segments for mobile telephone, radio and television
bandwidths. In some places there may also exist, or be in development, a
homogenous market for airport landing slots, or for taxi licences.
Activity 13.1
Map Plc has provided you with the following information on research and development
projects:
Project A
Project A is a new project which has just been started in 2018 and the company spent
£200,000 on the new project during the year. The directors of Map Plc are very excited
by initial results and think that in 5 years’ time they will be able to develop some new
products based on the initial results.
Project B
Project B has been running for several years and accumulated costs on this project at the
start of 2018 are £5,000,000. The project relates to the development of a new product
which is in the final stages of testing before being manufactured for sale to customers.
The prototype product has worked well and the directors of Map Plc are sure that the
product is technically feasible. The directors expect that the product will be very successful
and are happy to provide technical and financial resources to complete the project. The
costs of the project during the year can be reliably measured and include the following:
177
Research staff £300,000
Testing equipment £100,000
Overheads allocated to the project £50,000
The testing equipment is depreciated using a rate of 20% on the straight line basis.
Required:
a. Define research and development and discuss the accounting treatment of research
and development.
b. Show how project A and B will be treated in the financial statements. Give reasons
for your answers.
13.3 Research and development

Research and development (R&D) – along with goodwill) constitutes a
special case to the general approach to accounting for intangibles. This is
because there is a specific set of criteria to recognise R&D expenditure as
either an expense or amortisable asset.
13.3.1 Definition
Research costs and development costs are generally distinguished as
different types of costs in accounting standards. This distinction is
important because different accounting treatments could apply. IAS 38,
para 8 defines the different costs as follows (which is comparable with the
UK and US standards):
Research is original and planned investigation undertaken with
the prospect of gaining new scientific or technical knowledge
and understanding.
Development is the application of research findings or other
knowledge to a plan or design for the production of new or
substantially improved materials, devices, products, processes,
systems or services prior to the commencement of commercial
production or use.
13.3.2 How to account for R&D

Your immediate view might be that R&D (as for any other intangible asset)
is an investment with future benefits and therefore represents an asset.
This view is difficult to substantiate if you consider the difficulties in being
reasonably certain that the intended economic benefits of R&D activities
will flow to the enterprise. A more prudent view might be to write off
R&D as a cost in the year in which it was incurred rather than report it as
an asset. In actual fact, IAS 38 distinguishes between research costs and
development costs, as follows.
Classification Accounting
Research (pure and applied) Write-off through income statement
Development (not meeting stringent criteria) Write-off through income statement
Development (meeting stringent criteria) May be capitalised as an asset
178
Research cost should be written off through the income statement in

the year of expenditure because this represents part of the continuing
operations of a business. If development costs meet all of the stringent
criteria specified below (that is, there is reasonable expectation of specific
commercial success) then they may be capitalised as an asset and
amortised on a systematic basis. IAS 38 states:
An intangible asset arising from development (or from

the development phase of an internal project) shall be
recognised if, and only if, an entity can demonstrate all of
the following:
• the technical feasibility of completing the intangible
asset so that it will be available for use or sale
• its intention to complete the intangible asset and use or
sell it
• its ability to use or sell the intangible asset
• how the intangible asset will generate future
economic benefits. Among other things, the entity can
demonstrate the existence of a market for the output of
the intangible asset or the intangible asset itself or, if it
is to be used internally, the usefulness of the intangible
asset
• the availability of adequate technical, financial and
other resources to complete the development and to use
or sell the intangible asset
• its ability to measure reliably the expenditure
attributable to the intangible asset during its
development.
Capitalised development expenditure is subject to amortisation/

impairment as detailed in Section 13.3.6 on ‘Amortisation’.
13.3.3 R&D: some considerations

• What activities are included within R&D?
The definition of R&D in the standard appears to allow a broad scope
about what can be included. The key determinant appears to be
whether the activity involves innovation and departs from routine.
• What costs are included within R&D?
Although IAS 38 gives no guidance, typical costs within R&D relate
to salaries and wages, cost of materials and services consumed,
property depreciation, R&D plant and equipment, relevant overheads
and related costs such as the amortisation of patents and licences.
For example, if you build a research lab, this is a tangible asset and is
capitalised and depreciated as normal, although the depreciation is
charged to the R&D expense.
Activity 13.2
Suppose a company has incurred a total of £500,000 on a project that meets the
recognition criteria to be classed as development (capital) expenditure. In the non-current
assets section, a deferred development expense will be set up with the initial recognised
amount of £500,000. From the year when the developed product is sold, the company
would amortise this development over its intended duration of sales.
179
• Selection of either immediate write-off or capitalisation of

development expenditure
In the UK, if a development project satisfies all conditions, companies
can choose whether to write off or capitalise development costs. You
should be aware that this will impact on the profit figure (e.g. if a
large development project is written off in the year of expenditure)
and care should be taken when comparing companies in the high R&D
spend industry. The accounting policies of such companies should be
examined.
We can illustrate the current multinational practices of intangibles’
reporting, using notes to the 2016 annual accounts of Unilever and the
John Wood Group PLC 2019 annual reports. Excerpts from the Unilever
notes (p.104) are as follows:
Goodwill
Goodwill is initially recognised based on the accounting
policy f or business combinations (see note 21). Goodwill
is subsequently measured at cost less amounts provided for
impairment.
Intangible assets
Separately purchased intangible assets are initially measured
at cost, being the purchase price as at the date of acquisition.
On acquisition of new interests in group companies, Unilever
recognises any specifically identifiable intangible assets
separately from goodwill. These intangible assets are initially
measured at fair value as at the date of acquisition.
Development expenditure for internally-produced intangible
assets is capitalised only if the costs can be reliably measured,
future economic benefits are probable, the product is
technically feasible and the Group has the intent and the
resources to complete the project. Research expenditure to
support development of internally-produced intangible assets is
recognised in profit or loss as incurred.
Indefinite-life intangibles mainly comprise trademarks and
brands. These assets are not amortised but are subject to a
review for impairment annually, or more frequently if events
or circumstances indicate this is necessary. Any impairment is
charged to the income statement as it arises.
Finite-life intangible assets mainly comprise software, patented
and non-patented technology, know-how and customer lists.
These assets are amortised on a straight-line basis in the income
statement over the period of their expected useful lives, or the
period of legal rights if shorter. None of the amortisation periods
exceeds ten years.
The excerpts to John Wood Group PLC’s Annual Reports (2019, p.119)
provide an illustration of the group’s accounting policies on the treatment
of intangibles and goodwill, which includes an estimation of the useful life
for certain intangible assets.
180
Activity 13.3
Drawing on principles from the IASB’s conceptual framework (see Chapter 1) and from
arguments presented in this chapter and your textbook (e.g. Activity 13.2), summarise
the strengths and limitations (using a table if it helps) of the following approaches in
accounting for (i) purchased goodwill; (ii) internally generated goodwill; (iii) research and
development; (iv) all other intangible assets.
a. capitalisation and predetermined life; amortisation expense to the income statement
b. capitalisation and predetermined life; amortisation expense to (profit) reserves
c. capitalisation and annual review
d. immediate write-off to reserves
e. immediate write-off to the income statement.
In other words, you should construct a table with the following:
Issue (i) Purchased (ii) Internally (iii) (iv) All other
goodwill generated Research & intangible
goodwill Development assets
Treatment
(a) Strengths: Strengths: Strengths: Strengths:
Limitations: Limitations: Limitations: Limitations:
(b) Strengths: Strengths: Strengths: Strengths:
(c) Strengths: Strengths: Strengths: Strengths:
(d) Strengths: Strengths: Strengths: Strengths:
(e) Strengths: Strengths: Strengths: Strengths:
13.4 Goodwill: the debate

Goodwill is the difference between the value of the business and the fair
value of its identifiable net assets. Due to widely differing opinions held
by companies, practitioners, users, regulators and so on, the accounting
treatment for goodwill has been under consideration since the early 1970s.
13.4.1 What is goodwill?

Conceptually, goodwill is the difference between the value of a business as
a whole and the aggregate value of its separately identifiable net assets. It
arises because of economic advantages attaching to an existing business
(e.g. reputation, established market share, skilled workforce) which form
a ‘barrier to entry’ to competitors who would be starting from scratch by
buying an otherwise equivalent set of resources. Hence the attraction of
‘taking over’ an existing, established company.
Traditionally there were two views on accounting for goodwill:
• Goodwill is merely an accounting difference that should be either
carried indefinitely in the balance sheet (but subject to regular reviews
of its value; see IFRS 3 and the most recent version of IAS 38) or
written off as soon as possible (the preferred approach of SSAP 22, the
old UK standard).
• Goodwill is an asset rather than a difference, which should be
capitalised and amortised like any other (old version of IAS 38).
181
Thus, the discussions have focused on a number of interrelated questions:

• Is it an asset? Or an accounting difference?
• If it is an asset, how do we account for it?
• If it is an asset, what is its economic life?
• If the economic life is finite, how should it then be amortised?
• Is the useful life infinite?
• How should any reductions in value be measured and/or treated in the
accounts?
• If it is an accounting difference, how do we account for it?
13.4.2 Is goodwill an asset?

As mentioned above, assets are defined in the FPPFS as resources
controlled by an enterprise as a result of past events from which future
economic benefits are expected to flow to the enterprise. Such assets 1
You may note
are not recognised unless the future economic benefits are probable and that goodwill is by
definition an accounting
it is possible to measure the cost of the asset reliably. So, following this
difference. It may be
definition, is goodwill an asset? The IASB believes that it is. It defines useful in particular cases
goodwill as ‘future economic benefits arising from assets that are not to consider whether
individually identified and separately recognised’. The IASB considers the resulting goodwill
goodwill to be an asset, similar to other assets, which has been acquired at can be rationalised in
a cost and which needs to be accounted for in the same way as any other. conventional terms
– this may point, for
Others view it as a consolidation difference1 that emerges as part of the example, to a failure to
accounting process and has to be dealt with in the least damaging manner recognise all relevant
possible. assets or to some
unreliability in fair
values. But it will not
13.4.3 Issues with recognising goodwill as an asset
always be possible to
If goodwill is an asset which has been acquired at cost, then it should explain the balance
be capitalised initially in the balance sheet and then possibly charged of goodwill on a
to revenue over its economic life (in order to be consistent with the transaction.
accounting treatment of other non-current assets). But what is its
economic life? Is it finite, or indefinite?
If it has a finite life then what is the most appropriate amortisation period?
Given that the asset may be regarded as unidentifiable in the first place, it
may be impossible to determine when its life can be thought to have ended.
Consequently, any amortisation periods would be arbitrary and presumably
nothing should be written off unless there is evidence that its value has been
impaired. The UK’s ASB states in FRS 10, para.19: ‘There is a rebuttable
presumption that the useful lives of purchased goodwill and intangible assets
are limited to periods of 20 years or less.’ If we could suggest an amortisation
period the next question is: what method of amortisation should we use? Or
should we in fact conduct an annual review?
If it has an indefinite life there will be no need for annual amortisation.
To justify the carrying of goodwill without systematic amortisation would
require an impairment review. IFRS 3 ‘prohibits the amortisation of
goodwill acquired in a business combination and instead requires goodwill
to be tested for impairment annually or more frequently if events or
changes in circumstances indicate that the asset might be impaired, in
accordance with IAS 36 Impairment of assets.’
Recognising goodwill as an asset is a contentious issue. Commentators
have raised the following concerns:
• Annual amortisation charged through the income statement results in
‘double-counting’, as goodwill-creating or -maintaining expenses, such
182
as training, advertising, promotion and technical support, are already

charged to the income statement. (Advocates of amortisation argue that
any goodwill-related expenses that arise after acquisition result in the
development of non-purchased (inherent) goodwill and therefore there
is no case to answer with respect to double-counting).
• Goodwill cannot be realisable separately from the business as a whole.
• It is unclear how goodwill is related to other business costs if it is defined
as a difference (i.e. it is hard to envisage the application of the matching
principle here).
• Individual contributing factors cannot be valued separately (although
some may be identified as specific ‘intangibles’).
• The value of goodwill may fluctuate widely and unsystematically.
• Valuation is highly subjective.
• Goodwill will continue to increase if the company continues to acquire
new companies.
• The accounting treatment of purchased and internally generated
goodwill is inconsistent – costs associated with internally generated
goodwill (such as advertising) are generally expensed.
• The accounting treatment of goodwill and other assets – tangibles
and intangibles – is inconsistent. Note that only purchased goodwill is
recognised in the accounts, not internally generated goodwill (whereas
internally generated assets, such as self-constructed buildings (‘tangible’)
or patents for inventions (‘intangible’) may be capitalised).
13.4.4 Issues with not recognising goodwill as an asset

If we do not consider goodwill as an asset, then we may favour eliminating
goodwill directly against reserves in the year of acquisition (given that the
accounts should deal only with identifiable items which arise from the
acquisition). Indeed, many believe it is a futile attempt to account for the
unaccountable since it is only a product of the accounting process and hence
should be eliminated by an accounting entry (not reported as a consumption
of an identifiable resource). Let us assume, then, that goodwill is simply this
by-product: which (profit) reserve should we write it off against?
First, whichever reserve we use for the immediate write-off, this could result
in negligible shareholders’ funds; indeed, if a company made numerous
acquisitions and continually wrote off this acquired goodwill, it could result
in a negative value of shareholders’ funds. What would this mean given that,
say, a company had made acquisitions of real value, which were generating
profits, yet the totals in shareholders’ funds were decreasing? Indeed, this
could make the company vulnerable to take-overs and create problems with
gearing ratios for debt covenants and distort some of the primary ratios.
Second, what possible explanations are there for writing off goodwill against
reserves apart from achieving consistency of treatment with non-purchased
goodwill? There are a number of problems with this approach:
• Managers are not held fully accountable for investment in acquisitions.
If goodwill is written off immediately, the company’s return on capital
employed is boosted, since the profits are free from amortisation charges
and the capital is reduced by the goodwill write-off.
• Managers would have incentives to manipulate the reported goodwill
by ‘accounting arbitrage’ (i.e. exploiting inconsistencies in accounting
policies (the old UK standard FRS 7 did attempt to reduce these)).
183
• Acquisitive companies could ‘run out of reserves’. This could make

a company vulnerable to take-over or cause problems with gearing
ratios for debt covenants. Under the historical UK standard SSAP 22,
goodwill was allowed to be written off immediately against reserves
or capitalised and amortised through the income statement. This
form of flexibility allowed companies to freely choose the accounting
treatment that reflected best on their financial performance (in
practice this was where goodwill was written off immediately – this
meant that the pain of expensing goodwill was only felt in the year of
acquisition, and subsequent years’ profits were boosted). Consequently,
this treatment was prohibited following the publication of the UK’s
old standard, FRS 10. FRS 10, like current standards IAS 38/IFRS
3, still does not recognise goodwill as a (standalone) asset, despite
advocating its disclosure alongside intangible assets in the statement
of financial position:
Goodwill arising on acquisition is neither an asset like other
assets nor an immediate loss in value. Rather, it forms the bridge
between the cost of the investment shown as an asset in the
acquirer’s own financial statements and the values attributed to
the acquired assets and liabilities in the consolidated financial
statements. Although the purchased goodwill is not in itself an
asset, its inclusion amongst the assets of the reporting entity,
rather than a deduction from shareholders’ equity, recognises
that goodwill is part of a larger asset, the investment for which
management remains accountable.
Activity 13.4
Go to https://www.accaglobal.com/gb/en/technical-activities/technical-resources-
search/2015/february/frs-102-intangibles-goodwill.html. Read this to understand the
historical development of accounting for goodwill in the UK. (Although our aim is not
to emphasise UK-specific standards/discussions, due to the UK’s role in international
standard setting, understanding its historical development has general implications as the
international development of standards on goodwill and intangibles).
What does this tell you about how accounting standards are developed? Who were or
are the key players in the standard-setting process and what were their arguments for
favouring a particular accounting treatment for goodwill? What do you think were the
underlying or implicit reasons why these key players were upset with the standard-setter’s
explanation for removing the option to expense goodwill immediately?
13.4.5 Different models to account for purchased goodwill

The historical development of goodwill has a varied past, with numerous
models (i.e. accounting standards) used. The current standard for goodwill
(in IFRS 3 and the revised IAS 38) should be your key reference. However,
it is also important to understand other attempts (i.e. other models) used
to account for goodwill. A historical perspective on the development of
goodwill allows you to contrast the benefits/limitations of various models
used, and understand the influence that current economic considerations
have on determining the way in which goodwill is accounted.
The possible accounting treatments for goodwill are:
1. capitalisation and predetermined life; amortisation expense to the
income statement (SSAP 22, old IAS 38)
2. capitalisation and predetermined life; amortisation expense to (profit)
reserves on the statement of financial position
184
3. capitalisation and annual review for impairment (IFRS 3, revised IAS 38)
4. immediate write-off to reserves (SSAP 22)
5. separate write-off reserve
6. separate write-off reserve with recoverability assessment
7. immediate write-off to the income statement
8. annual revaluation to incorporate non-purchased goodwill created.
Comments on the various treatments:
1. Straightforward application of matching principle, which emphasises the
income statement approach previously used in the UK. Now no longer in
favour as the IASB has decided to take the FASB approach of option (3).
2. Amortisation is a form of expense in the current period, so to write it off
against profit reserves earned in other periods contradicts the matching
principle.
3. Current treatment: potential for double-counting, as impaired asset
written down, but there is also an added implicit cost to maintaining
the asset’s value. Elliott and Elliott (2019) also suggests that this is a
net realisable value approach that emphasises the statement of financial
position. The issue is that the asset is only being impaired after its value
has been reduced, therefore mismatching the consumption of the goodwill
asset (which is at the time in which the asset is producing the highest
profits) with the recognition of its expenses (which comes after the asset’s
productive capacity is in decline).
4. Assumes asset does not exist and overly conservative; could lead to
over-stated profitability ratios in subsequent accounts when reserves are
immediately reduced. This approach also suggests that the timing of the
asset’s consumption (use) and its (eventual) accounting recognition are
mismatched.
5. Same problem as in (4), where it is assumed that goodwill as an asset
does not exist, but where it is still ‘accounted’ for (recognised) in the
creation of a special profit reserve to indicate that diminution in reserves
is solely due to goodwill. This can be confusing and does not improve on
(4).
6. Same problems as in (4) and (5), but even more confusing when goodwill
as an asset may reappear at a later date after being written-off and
languishing in a written-off reserves account. Method (3) is a much easier
way of conditionally retaining goodwill as an asset but allowing for write-
down values if it is judged that the asset is impaired.
7. Same problem as in (4), but further distorting measurement of current
year’s performance as write-off does not distinguish gains from profits
(i.e. income generated during the normal course of business).
8. Consistent with the idea of fair value approaches to accounting, but it is
a subjective measure that is open to abuse. Also potentially contradictory
with other standards (e.g. on research and development) that disallow
the creation of an intangible asset without a transaction occurring.
13.4.6 Current treatment for goodwill

Goodwill is covered in IFRS 3 Business combinations. As mentioned
previously, IFRS 3 defines goodwill as ‘future economic benefits arising
from assets that are not individually identified and separately recognised’.
The amounts that are recognised in the financial statements are therefore
a function of the recognition criteria and valuation rules applicable to the
185
identifiable assets. These are covered in IAS 36 Impairment of assets, IAS

37 Provisions, contingent liabilities and contingent assets, IAS 38 Intangible
assets and IAS 39 Financial instruments: recognition and measurement.
Para.36 of IFRS 3 states:
[T]he acquirer shall, at the date of acquisition, allocate the
cost of a business combination by recognizing the acquiree’s
identifiable assets, liabilities and contingent liabilities that
satisfy the recognition criteria in paragraph 37 at their fair
values at that date, except for non-current assets (or disposal
groups) that are classified as held for sale in accordance with
IFRS 5, Non-Current Assets Held for Sales and Discontinued
Operations... Any difference between the cost of the business
combination and the acquirer’s interest in the net fair value
of the identifiable assets, liabilities and contingent liabilities
recognized shall be accounted for as goodwill.
Para.37 states:
The acquirer shall recognize separately the acquiree’s
identifiable assets, liabilities and contingent liabilities at the
acquisition date only if they satisfy the following criteria to date:
• In the case of an asset other than an intangible asset, it is

probable that any associated future economic benefits will
flow to the acquirer and its fair value can be measured
reliably
• In the case of a liability other than a contingent liability, it is
probable that an outflow of resources embodying economic
benefits will be required to settle the obligation and its fair
value can be measured reliably
• In the case of an intangible asset or a contingent liability, its
fair value can be measured reliably.
Paras 51–52 state how goodwill should be accounted for:

The acquirer shall, at the acquisition date:
• Recognize goodwill acquired in a business combination as an
asset; and
• Initially measure the goodwill at its cost, being the excess of the
cost of the business combination over the acquirer’s interest in
the fair value of the identifiable assets, liabilities and contingent
liabilities recognized in accordance with paragraph 36.
Goodwill acquired in a business combination represents a payment made

by the acquirer in anticipation of future economic benefits from assets that
are not capable of being individually identified and separately recognised.
This is why the goodwill of associates is embedded (i.e. made implicit
in the group consolidation figures). This is a reason why IAS 28 (2003)
was revised in 2011 to acknowledge that goodwill is inseparable from the
associate’s value as a whole to the parent company. See Activity 18.5.
13.5 Impairment: IAS 36

An asset is impaired when its carrying amount exceeds its recoverable
amount (IAS 36, para.8). Indications that an asset may be impaired
include:
186
• decline in market value of an asset

• adverse effects of technological, market, economic or legal
environment
• obsolescence or physical damage
• changes in use or expected use of asset
• economic performance of the asset is worse than expected.
13.5.1 Definitions (IAS 36, para.6)

The recoverable amount of an asset is the higher of its fair value less
costs to sell and its value in use.
The fair value less costs to sell of an asset is the amount obtainable
from the sale of an asset in an arm’s length transaction between
knowledgeable, willing parties, less the costs of disposal.
Value in use is the present value of the future cash flows expected to be
derived from an asset.
13.5.2 Accounting for impairment

An entity shall assess at each reporting date whether there is any
indication that an asset may be impaired. If any such indication exists,
the entity shall estimate the recoverable amount of the asset (IAS 36,
para.9). IAS 38 states that irrespective of whether there is any indication
of impairment, an entity shall also:
Test an intangible asset with an indefinite useful life for
impairment annually by comparing its carrying amount with its
recoverable amount. This impairment test may be performed
at any time during an annual period, provided it is performed
at the same time each year. Different intangible assets may
be tested for impairment at different times. However, if
such an intangible asset was initially recognised during the
current annual period, that intangible asset shall be tested for
impairment before the end of the current annual period.
If, and only if, the recoverable amount of an asset is less than its
carrying amount, the carrying amount of the asset shall be reduced to
its recoverable amount. This reduction is an impairment loss (IAS 36,
para.56) to be recognised in the income statement.
When impairment is applied to an asset with a finite useful life, ‘after the
recognition of an impairment loss, the depreciation (amortisation) charge
for the asset shall be adjusted in future periods to allocate the asset’s
revised carrying amount, less its residual value (if any), on a systematic
basis over its remaining useful life’ (IAS 36, para.63).
An important distinction relevant for the discussion here is the
introduction of a cash-generating unit (CGU), which is the smallest
identifiable group of assets that generates cash inflows that are largely
independent of the cash inflows from other assets or group(s) of assets.
If, for example, it is not possible to estimate the recoverable amount of an
individual asset, an entity should determine the recoverable amount of
the CGU to which the asset belongs (IAS 36, para.66). This determination,
however, is a call to exercise judgement.
There are, however, some concerns that the impairment is rather costly
and complex, with the IASB considering the merits (or otherwise) of
reintroducing amortisation as a way to deal with the diminution of the
value of goodwill. This was met by concerns from the US standard setter
187
(FASB), as outlined in the minutes of the IASB meeting — 21–24

September 2015, a joint session between the IASB and FASB, which
highlights the challenges of accounting harmonisation.
Activity 13.5
Example 1
A machine has a net book value of £170,000. It has 4 years remaining as its useful
economic life. The company estimates that it can produce a net cash flow of £50,000 for
the next 4 years if it is continued to use in its operations. Alternatively, it can be sold for
£100,000 now. Cost of capital = 10%. How much impairment loss should be recognised?
Value in use (VIU) = 50,000 × Annuity (4 years at 10%) = 50,000 × 3.1699 = £158,493
Recoverable amount = higher of VIU or net realizable value. As VIU = £158,493 > NRV
= £100,000, the recoverable amount = VIU.
Since the carrying value exceeds the recoverable amount, the impairment loss recognized
is 170,000 – 158,493 = £11,507 in the comprehensive income statement and the asset’s
carrying value should be reduced to £158,493 in the statement of financial position.
Example 2
A mining entity owns a private railway to support its mining activities. The private railway
could be sold only for the scrap value and it does not generate cash inflows that are
largely independent of the cash inflows from the other assets of the mine. In this case, the
private railway will be included as part of the CGU together with the mine for the purpose
of the impairment review.

• define intangible assets, R&D and goodwill
• describe and explain the accounting treatment of intangibles, R&D and
goodwill
• explain the process of impairment reviews and its relationship to
deprival values
• describe the effect of intangible assets, R&D and goodwill for both the
consolidated accounts and ratio analysis
• compare and contrast the various historical approaches (capitalisation
with no follow-up expensing of goodwill; immediate write-off;
capitalisation and amortisation of goodwill) with the current approach
to test periodically for impairment
• describe the areas of subjectivity and difficulty in relation to
intangible assets, development expenditure and goodwill
• discuss the continued problems in relation to the current treatment of
goodwill and intangibles.

Question 13.1
Over the years, the accounting requirements for purchased goodwill in
the UK have changed considerably, from SSAP 22 Accounting for Goodwill
(1984) to IAS 22 Business combinations (1998) to IFRS 3 Business
combinations (2004). These standards have quite different approaches to
account for the cost of purchased goodwill in financial statements.
188
a. State three different methods of accounting for purchased goodwill (it

is not a requirement of this question for you to link these methods to
a specific UK or International Accounting Standard). For each method
you state, describe the accounting adjustments (if any) needed on the
balance sheet and/or the income statement.
b. What are the key arguments for and against each of the three methods
you have described above?
Question 13.2
Define research and development activities. Compare and contrast the
accounting treatment of the research and development activities for the
two companies, Alpha and Beta and discuss how the different treatments
will impact the financial statements of both companies. How will the
different accounting treatments impact the net profit margin and the
gearing ratio?
Question 13.3
What are intangible assets? Discuss, and critically assess, IAS 38 in relation
to intangible assets. Illustrate your answer with two examples.
See Appendix A for a suggested approach.
189
Notes
190
Chapter 14: Revenue recognition

(including construction contracts)
14.1 Introduction
This chapter considers construction contracts and the forthcoming standard
on revenue recognition.

• explain construction contracts and their accounting: why they are
treated differently; their profit recognition
• explain the impact of forthcoming changes in standards on recognising
revenues.


KPMG International Standards Group Impacts on the construction industry of the
new revenue standard. (KPMG, 2014). Available from https://home.kpmg/
be/en/home/insights/2014/09/breaking-news-2014-108.html
KPMG International Standards Group Revenue: IFRS15 handbook. (KPMG,
2019). Available from: https://home.kpmg/xx/en/home/services/audit/
international-financial-reporting-standards/ifrs-toolkit/ifrs-handbook-
revenue-ifrs-15.html
IAS 37 Provisions, contingent liabilities and contingent assets.
(IAS 11 Construction contracts and IAS 18 Revenue have been replaced by IFRS
15. However, for the purposes of the discussion here, we will still consider
some aspects of IAS 11 and IAS 18. IAS 11 will still be operational until a
company adopts IFRS 15.)
Relevant IASC/IASB standards

IAS 11 Construction contracts.
IFRS 15 Revenue from contracts with customers (applicable from 1 January 2018).
14.2 Revenue recognition under IFRS 15

Revenue is core to any accounting measurement and is one of the most
important performance indicators of a business. It is therefore imperative
that the accounting standards are able to ensure that the reporting and
recognition of revenue is accurate.
Under the old standard (IAS 18 Revenue), in a transaction involving the
sale of goods, performance should be regarded as being achieved when the
following conditions have been fulfilled:
a. the seller of the goods has transferred to the buyer the significant
risks and rewards of ownership, in that all significant acts
have been completed and the seller retains no continuing managerial
191
involvement in, or effective control of, the goods transferred to a

degree usually associated with ownership; and
b. no significant uncertainty exists regarding:
i. the amount to be received for the goods;
ii. the costs incurred or to be incurred in producing or purchasing the
goods.
Post Enron 2002 scandal, a US Government Accountability Office (2007)
report [https://www.gao.gov/products/GAO-06-678] stated that revenue
recognition is one of the most frequent reasons for companies restating their
financial accounts. The impact of restatement is significant, with companies
(which announced restatements between July 2002 and September 2005)
decreased by US$36 billion after the restatement announcement. It is
therefore important that companies get revenue recognition right.
Why is a new standard needed?
• There is a need for a more robust framework to deal with revenue
recognition issues.
• To remove inconsistencies and weaknesses in existing standards.
• To reduce the number of standards to which companies must refer.
• To improve comparability between countries.
In this IFRS debrief video, IASB vice-chairman Ian Mackintosh explains
why the standard is needed: https://youtu.be/Xun92wlvdFI
(taken from https://www.ifrs.org/news-and-events/2016/04/ian-
mackintosh-amendments-revenue-standard/)
The risks and rewards model is inconsistent with the definition of an
asset which focuses on control.
A risks and rewards model causes difficulty when an entity supplies goods
with services related to the good. The guidance is currently unclear on
how to separate performance obligations are identified (e.g. warranties).
Under IFRS 15, revenue is the increase in economic benefits during the
accounting period in the form of inflows or enhancements of assets or
decreases in liabilities that results in increases in equity, other than those
which result from contributions from equity participants. Goods and
services are encompassed in one set of rules.
There is a five step revenue recognition process (for more details, see
https://www.iasplus.com/en/standards/ifrs/ifrs15):
1. Identify the contract with the customer
2. Identify separate performance obligations in the contract
3. Determine transaction price
4. Allocate the transaction price to the separate performance obligations
in the contract
5. Recognise revenue when the entity settles the performance obligations
For practical illustrations of how this five step process works, see the
illustrative practical examples from the ACCA [https://accainpractice.
newsweaver.co.uk/icfiles/1/7452/12132/6007022/158c05aaefdb89720
0d25017/ifrs15%20illustrative%20examples.pdf]
To understand the implications of reporting under IFRS 15, including
on how revenues are to be disaggregated and the use of judgements/
estimates, please see the following IFRS Foundation video:
https://youtu.be/Cyuw7PWMhok
192
(taken from https://www.ifrs.org/news-and-events/2019/02/webcast-ifrs-

15-revenue-from-contracts-with-customers-for-investors/)
14.2.1 Step 1: Identify the contract with the customer

Activity 14.1
• An entity, a real estate developer, enters into a contract with a customer for the sale
of a building for £1 million.
• The customer intends to open a restaurant in the building. The building is located in
an area where new restaurants face high levels of competition and the customer has
little experience in the restaurant industry.
• The customer pays a non-refundable deposit of £50,000 and enters into a long-
term financing agreement with the entity for the remaining 95 per cent of the
consideration.
• A financing arrangement is provided on a non-recourse basis, if the customer defaults,
the entity can repossess the building, but cannot seek further compensation from the
customer, even if the collateral does not cover the full value of the amount owed.
• The entity’s cost of the building is £600,000. The customer obtains control of the
building at contract inception.
How would you account for this?
a. Recognise revenue of £1 million – no further action
b. Recognise revenue of £1 million and make a provision for the loss of £950,000
c. Recognise revenue of £50,000
d. Do not recognise any revenue and treat the £50,000 as a liability
You should consider the following:
• Can the real estate developer recognise any revenue for the sale of the building?
• If so, how much?
• Is collection of the consideration probable?
• How should the deposit be treated given the issues with the contract?
See Appendix A for a suggested solution.
14.2.2 Step 2: Identify separate performance obligations example

Activity 14.2
• A manufacturer provides its customer with a warranty with the purchase of a product.
The warranty provides assurance that the product complies with agreed-upon
specifications and will operate as promised for one year from the date of purchase.
• The contract also provides the customer with the right to receive up to 20 hours of
training services on how to operate the product at no additional cost.
• The entity also sells training services separately from the product
How would you account for this?
a. Treat the product, the warranty and the training as separate performance obligations
b. Treat the product and the warranty as a single performance obligation and the
training as a separate performance obligation
c. Treat the product and the training as a single performance obligation and the
warranty as a separate performance obligation
193
Key considerations:
• Could the warranty be sold separately from the product and is it providing or does it
just provide assurance that the product won’t fail?
• Can the training services be sold separately?
See Appendix A for a suggested solution.
14.2.3 Step 3: Determine the transaction price

The transaction price is what the entity reasonably expects to receive,
which can include variable consideration. An amount of consideration
can vary because of discounts, rebates, refunds, credits, price concessions,
incentives, performance bonuses, penalties or other similar items. It can be
estimated using:
• The expected value – the expected value is the sum of probability-
weighted amounts in a range of possible consideration amounts –
large number of contracts with similar characteristics.
• The most likely amount – contract has only two possible outcomes
(for example, an entity either achieves a performance bonus or does
not).
Examples of each method are provided as Examples 3 and 4 in Revenue
– IFRS 15 handbook (KPMG 2019, pp.52-53) [https://home.kpmg/xx/
en/home/services/audit/international-financial-reporting-standards/ifrs-
toolkit/ifrs-handbook-revenue-ifrs-15.html].
14.2.4 Step 4: Allocate the transaction price

This step is illustrated by Example 2 in Revenue – IFRS 15 handbook
(KPMG 2019, p.99) [https://home.kpmg/xx/en/home/services/audit/
international-financial-reporting-standards/ifrs-toolkit/ifrs-handbook-
revenue-ifrs-15.html].
14.2.5 Step 5: Recognise revenue when the entity settles the

performance obligations
An entity recognises revenue when or as it satisfies a performance
obligation by transferring a good or service to a customer, either at a point
in time (when) or over time (as).
A good or service is ‘transferred’ when or as the customer obtains control
of it.
For example, when a customer makes payment for goods and subsequently
receives the goods, it can be deemed that as they are free to use the goods
as they want, control is said to be transferred. For services, customers
receive an asset such as knowledge or consumable goods, which are
immediately consumed and therefore it can be envisaged that transfer
of control has taken place. For example, an accounting firm gives clients
advice and the clients pay for the advice given. As the client is free to
act on the advice given on payment, the entity is said to have settled the
performance obligations.
The complexity arises when there are separate performance obligations
due to contractual complexity. These can include (but are not limited to)
warranties, leases, long-term contracts, transfers of intellectual property
etc. Please refer to Elliott and Elliott (2019) section 11.6.5 (pages 277–
281), or any other textbooks with examples of IFRS15 applications. The
KPMG (2019) guide (pp.117–118) is also helpful.
194
IFRS 15.32 and 15.35:

At contract inception, an entity first evaluates whether it transfers control
of the good or service over time – if not, then it transfers control at a point
in time.
The big question therefore is whether the performance obligation satisfied
over time?
Yes: Identify an appropriate method to measure progress and apply that
method to recognise revenue over time (relevant for examples such as
construction contracts previously covered under IAS 11).
For each performance obligation in a contract, an entity first determines
whether the performance obligation is satisfied over time – i.e. control of
the good or service transfers to the customer over time. It does this using
the following criteria:
Criterion Example
1 The customer simultaneously receives Routine or recurring services – e.g.
and consumes the benefits provided by cleaning services.
the entity’s performance as the entity
performs.
2 The entity’s performance creates or Building an asset on a customer’s site.
enhances an asset that the customer
controls as the asset is created or
enhanced.
3 The entity’s performance does not Building a specialised asset that only
create an asset with an alternative the customer can use or building an
use to the entity and the entity has asset to a customer’s specifications.
an enforceable right to payment for
performance completed to date.
From IFRS 15.39–43; B15–B19:
To select a method to measure progress towards the completion of a
performance obligation, there are two methods, the output and input
methods:
Method Description Examples
Output Based on direct measurements of • Surveys of performance to date
the value to the customer of goods • Appraisals of results achieved
or services transferred to date,
relative to the remaining goods • Milestones reached
or services promised under the • Time elapsed
contract.
Input Based on an entity’s efforts • Resources consumed
or inputs towards satisfying a • Costs incurred
performance obligation, relative to
the total expected inputs into the • Time elapsed
satisfaction of that performance • Labour hours expended
obligation. • Machine hours used
No: Recognise revenue at the point in time at which control of the good
or service is transferred IFRS15.BC121: The analysis of when control
transfers is performed primarily from the perspective of the customer.
195
IFRS 15.38: Indicators of when the transfer of control occurs: A customer

having:
• A present obligation to pay
• Physical possession
• Legal title
• Risks and rewards of ownership
• Accepted the asset.
Finally, before we move on to the next section, IFRS 15 does not apply to
certain transactions that fall under:
• Lease contracts (IFRS 16), which is covered in Chapter 12 of this
subject guide.
• Financial instruments (IAS 32 and IFRS 9), which is covered in
Chapter 15 of this subject guide.
There are also other transactions, but these are out of the syllabus for this
course.
14.3 Construction contracts

Accounting for construction contracts was previously covered in IAS
11, but this is now superseded by IFRS 15. As many of the mechanistic
calculations are similar, we consider the previous IAS 11 approach before
highlighting its differences with IFRS 15 where relevant.
IAS 11 defines a construction contract as ‘a contract specifically negotiated
for the construction of an asset or a combination of assets that are closely
interrelated or interdependent in terms of their design, technology and
function or their ultimate purpose or use.’
Construction contracts need special accounting treatment compared to other
forms of inventory ‘as the nature of activity undertaken in such contracts is
different’ and the date at which the contract activity is entered into and the
date when the activity is completed usually fall into different accounting
periods. Therefore, the primary issues in accounting for construction
contracts are the allocation of contract revenue and contract costs to the
accounting periods in which construction work is performed and how to
value the construction contract in the balance sheet. The issue of profit
recognition is key because, if the realisation concept is applied strictly, then
the profit will only be recognised on completion of the contract. Companies
with significant construction contracts will have ‘lumpy’ profits.
Thus, construction contracts relate to the manufacture or construction of
a single substantial asset (e.g. shipbuilding, roads) or a combination of
assets, with the duration of the contract falling into different accounting
periods and usually lasting for more than one year.
14.4 Profit recognition methods

There are two basic methods of accounting for construction contracts: the
completed contract method and the percentage-of-completion method.
The completed contract method delays the recognition of profit until
completion. This has historically been more common in prudent countries
such as Germany but is not permitted by IAS 11.
IFRS 15 has now potentially allowed the use the completed contract
method under certain conditions. The use of the percentage of completion
method is not automatic for all construction contracts (see KPMG,
196
Impacts on the construction industry of the new revenue standard (2014),

p.5 [https://home.kpmg/content/dam/kpmg/pdf/2014/09/impacts-
construction-revenue.pdf]).
14.4.1 Percentage of completion method

IAS 11 requires the percentage of completion method to be used for
construction contracts: ‘Where the outcome of the contract can be
estimated reliably, contract revenue and contract costs
associated with the construction contract shall be recognised as revenue
and expenses respectively by reference to the stage of completion of
the contract at the statement of financial position date.’
Contract revenue should comprise (IAS 11, para.11):
• the initial amount of revenue agreed in the contract, and
• variations in contract work claims and incentive payments:
to the extent that
• it is probable that they will result in revenue, and
• they are capable of being reliably measured.
Contract cost should comprise (IAS 11, para.16):
• costs that relate directly to the specific contract
• costs that are attributable to contract activity in general and can be
allocated to the contract
• such other costs as are specifically chargeable to the customer under
the terms of the contract.
IAS 11 identifies a number of costs that may not be charged to the
contract costs, including general administration costs not specified in the
contract, selling costs, research and development costs not specified and
depreciation of idle assets not used on a specific contract.
The stage of completion of a contract is determined by the method
that measures reliably the work performed to date. There are a number of
accepted methods for calculating (estimating) attributable profit based on
different views of what constitutes the ‘amount of work done’:
1. proportion that costs incurred for work performed to date bear to total
estimated costs
2. surveys of work performed
3. completion of a physical proportion of the contract work.
Compare and contrast this with IFRS 15 output and input methods. One
of the obvious difficulties of this method is determining the basis for
calculating attributable profit. Depending on the basis selected for
‘amount of work done’, the attributable profit could be allocated in very
different proportions across the years of the construction contract.
Attributable profit is that part of the total profit estimated to arise over
the whole contract that reflects the work performed up to the statement
of financial position date.1 In the income statement this profit will be 1
Allowing for any
represented by recording turnover and related costs. This method thus known inequalities of
profitability during the
spreads out anticipated profit over the life of the contract in proportion
various stages of the
to the amount of work carried out, to arrive at the attributable profit. contract.
For example, using option 1, the ‘proportion that costs incurred for work
performed to date bear to total estimated costs’, the attributable profit
recognised each year is equal to:
[(Cost incurred in the year ÷ total estimated cost) × total expected profit]
– profit already recognised.
197
When the outcome of a construction contract cannot be estimated

reliably:
• revenue is recognised only to the extent of the contract costs incurred
that it is probable will be recoverable
• contract costs shall be recognised as an expense in the period in which
they are incurred.
IAS 11 requires that ‘when it is probable that total contract costs will
exceed total contract revenue, the expected loss should be recognised as
an expense immediately.’ Under IFRS 15 however, there is no provision
for ‘expected loss’. Instead, this should be recorded under IAS 37 (onerous
contracts). See Chapter 6 of this course: Provisions, contingent liabilities
and contingent assets.
14.4.2 Statement of financial position entries: the percentage of

completion method
In addition to the computation of the attributable profit, construction
contracts generate other entries in the statement of financial position :
• Trade receivables: the net amount of costs incurred plus recognised
profits less the sum of recognised losses and progress billings.
• Trade payables: payments on account exceeding amounts matched
with turnover are offset against construction contract balances.
• Inventory: ‘construction contract balances’ represent the cost of a
construction contract less amounts transferred to cost of sales, less
foreseeable losses and less payments on account not matched with
turnover.
• Provisions for liabilities and charges: these can be included
when provisions for foreseeable losses exceed the costs incurred (after
transfers to cost of sales).
Example 14.1 Accounting for construction contracts

Construction contracts should be accounted for as follows, assessing
them on a contract-by-contract basis. The example below is taken from
Appendix 3 of the now decommissioned UK standard SSAP 9 (revised),
amended for terminology to reflect IAS 11. (SSAP 9 is broadly similar to
the requirements set out in IAS 11.)
Contracts Total
Data (£) 1 2 3 4 5
Contract revenue recognised 145 520 380 200 55 1,300
Contract expenses recognised (110) (450) (350) (250) (55) (1,215)
Contract costs incurred in period (110) (510) (450) (250) (100) (1,420)
Contract costs relating to future
0 60 100 0 45 205
activity
Progress billings 100 600 400 150 80 1,330

Estimated cost to complete (90) (290) (100) (140) (50) (670)
Contract value 250 1,000 600 300 120 2,270
Total contract cost (200) (800) (550) (390) (150) (2,090)

Profit/loss on contract 50 200 50 (90) (30) 180
198
Additional information:
For some of the above contracts (e.g. 2, 3 and 5), costs incurred during the
period relate to both current activity (i.e. contract expenses recognised)
and future activity.
There are two ways in which revenue for the period can be recognised.
In the proportion of cost method, for example, the contract revenues
recognised would be (110/200)*250 = 137.50 for Contract 1, and
(450/800)*1000 = 562.50 for Contract 2. As the contract revenues
recognised here are instead 145 and 520 respectively, these are probably
computed either on the basis of surveys of work performed or on the
proportion of physically completed contract work (55% for Contract 1 and
56.25% for Contract 2).
Income statement
a. An appropriate proportion of total contract value should be recognised
as turnover each year (contract revenue recognised). See contracts 1–5.
b. The costs incurred in reaching that stage of completion should be
matched with that turnover as cost of sales (contract costs recognised).
See contracts 1–5.
c. Under IAS 11, provisions (accruals) should be made for any
foreseeable loss on the contract as a whole (to the extent that such
loss has not already been recognised in matching turnover with
costs incurred under (a) and (b) above). In other words, 100% of
the expected loss on the entire contract is to be recognised, with
appropriate provisions made as an adjustment. The expected loss is
not to be apportioned using the percentage completion method. This
should be included as part of cost of sales. See contracts 4 and 5.
Contracts Total
Income statement (£) 1 2 3 4 5
35 70 30 (50) 0 85
Provision for losses on contracts (40) (30) (70)
Gross profit (loss) 35 70 30 (90) (30) 15
Under IFRS 15, however, no provision for any foreseeable loss is allocated.
Instead, it is treated as an onerous contract under IAS 37.
An onerous contract is a contract in which the unavoidable costs (i.e.
the lower of the cost of fulfilling the contact and any compensation or
penalties arising from failure to fulfil it) exceed the economic benefits
expected to be received under the contract.
Note that the definition of ‘unavoidable costs’ under an onerous contract
is still under discussion at the time of writing (see KPMG 2014, pp.10–11
and the IASPlus discussion of IAS37 [https://www.iasplus.com/en/
meeting-notes/ifrs-ic/2018/march/ias-37-onerous-contracts]).
The IASPlus discussion above notes that ‘Even if the overhead costs are
expected to give rise to operating losses, the expectation of losses would
not be enough to justify recognising a provision for those costs. Paragraph
63 of IAS 37 prohibits recognition of provisions for future operating losses.
Paragraph 64 explains that this is because future operating losses do not
meet the definition of a liability.’
199
For costs that are not considered ‘unavoidable’, these are expensed as
incurred because it is treated as a cost to operate the business.
IFRS 15 interpretation, Contracts Total

assuming no ‘unavoidable
costs’
Income statement (£) 1 2 3 4 5
Gross profit (loss) 35 70 30 (90) (30) 15
Note that under IFRS 15, the provision for foreseeable losses is not shown
in the statements.

d. If the amount recognised as revenue exceeds the progress billings,
the excess should be classified as an ‘amount recoverable on
contracts’ and shown as a trade receivable. See contracts 1 and 4.
e. Any costs to date not transferred to cost of sales under (b) above
should be carried forward in the statement of financial position as a
current assets ‘construction contract balance’ under inventories (but
subject to (f) and (g) below). See contracts 2, 3 and 5.
f. Any foreseeable loss charged to cost of sales under (c) above should be
deducted first from any related construction contract balance/contract
costs relating to future activity (thus reducing it to net realisable value),
then any excess of foreseeable loss over that construction contract
balance should be shown as an accrual (under creditors) or as a
provision for liabilities and charges (see contracts 4 and 5).
g. If the payments on account exceed the amount shown as turnover,
the excess should be deducted from any related construction contract
balance (after first deducting from the construction contract balance
any related foreseeable loss under (f) above) and any residual excess
should be shown as ‘payments on account’ under creditors. See
contracts 2, 3 and 5. Note: Under IFRS 15, there is no foreseeable loss
as these are expensed immediately, assuming that the costs are not
‘unavoidable’.
h. After allowing for the effects of (e), (f) and (g), any construction
contract balances appear in the statement of financial position as
‘Construction contract balances’ under Inventories. A note
should separately disclose the balance of:
i. net cost less foreseeable losses
ii. applicable payments on account.
Statement of financial position Contracts

workings (£) 1 2 3 4 5 Total
Contract revenue recognised 145 520 380 200 55
Less: progress billings (100) (600) (400) (150) (80)
Trade payables (advances received) (80) (20) (25) (125)
Amount recoverable on contracts 45 50
Contract costs relating to future activity – 60 100 – 45
Provision for foreseeable losses – – – (40) (30)
Trade receivables: amounts recoverable 45 60 100 10 15 230
200
IFRS 15 interpretation, assuming Contracts

no ‘unavoidable costs’
Statement of financial position 1 2 3 4 5 Total

workings (£)
Contract revenue recognised 145 520 380 200 55
Less progress billings (100) (600) (400) (150) (80)
Trade payables (advances received) (80) (20) (25) (125)
Trade receivables: amounts 45 60 100 10 15 230
recoverable
Note that under IFRS 15, the provision for foreseeable losses is not shown
in the statements.
This example can be summarised as:

Income statement (£)
Revenue 1,300
Cost of sales 1,215
Provision for losses 70 1,285
Gross profit 15
IFRS 15 interpretation, assuming no ‘unavoidable costs’:

Income statement (£)
Revenue 1,300
Cost of sales 1,285
Gross profit 15
Statement of financial position (£)

Current assets
Trade receivables: ‘amount recoverable on contracts’ 230
Payables due within one year
Trade payables: ‘advances received on contracts’ 125
Net impact of contracts on working capital 105
201
Activity 14.3
Handy Plc has two construction contracts underway – Y and Z – which began on 1
January 2010. The position on each contract at 31 December 2010 was as follows:
Y Z
£’000 £’000
Contract price 4,000 6,000
Cost of work certified (recognised) 1,400 4,400
Costs carried forward 100 200
Value of work certified (recognised) 1,800 4,000
Estimated additional costs to completion 1,500 2,600
Progress billings (payments on account) 1,620 3,600
The cost of work certified equals costs incurred in reaching the stage of completion
represented by the value of work certified. The costs carried forward represent costs
incurred subsequently, but before the year-end.
Handy’s accounting policy is to recognise no profit until a contract is one-third complete
by value. Thereafter, it recognises each year a proportion of total expected profit,
measured as the difference between turnover for the year and cost of sales. Cumulative
turnover is calculated as the value of work certified except where the contract is not one-
third complete by value, in which case turnover is recorded at an amount equal to cost of
sales.
Show how each of these contracts will be reflected in the income statement and
statement of financial position of Handy Plc at 31 December 2010 in accordance with
standard accounting practice.
14.5 The current (IFRS 15) treatment of revenue

recognition in construction contracts
The major change under IFRS 15 concerns the timing of revenue
recognition, but from a mechanistic perspective, much of the accounting
treatment is very similar to IAS 11. Under IFRS 15, revenue should only be
recognised when the performance obligation specified in the contract with
the customer is satisfied. This means that the possibility to use judgement
under the percentage completion method for IAS 11 has now been
restricted to more objective (relatively speaking) criteria such as observable
contractual obligations. So, if the contract stipulations are such that
only on full completion is the contract deemed as a ‘deliverable’, then no
revenue may be recognised at all during the construction phases/periods.
IFRS 15 has proposed the following requirements:
1. Revenue only recognised when control of the project passes to the
customer.
2. Onerous performance obligation should be accounted for as soon
as apparent so as to be consistent with other standards on asset
recognition and impairment.
3. More disclosure in the notes to the accounts to facilitate the
assessment of risks and rewards.
For example, control can be taken to have passed to the customer in
a business situation where developers who own land and construct
a property, transfer the land and property over to their customer on
completion. For some government projects where, for example, the
202
government own land (e.g. construction of roads or other infrastructure),

control is in the customer’s hands.
The criteria for recognition of revenue once control passes is very similar
to IAS 11, with two approaches, the output and input method, as
described in section 14.2 earlier:
• output method – this is similar to the survey or use of professional
judgement to estimate the amount of completion
• input method – this is similar to using costs incurred to date as a
way to estimate the revenue to be recognised for the period.
The conditions for recognition under onerous contracts is also similar to
IAS 11, in that as soon as there are recognisable losses, some/all of the
work in progress should be written off as an impairment expense.
Activity 14.4
Read the example on the following website and pick out an instance where significant
judgement is applied: https://www.ifrsbox.com/example-construction-contracts-ifrs-15/
A solution is given in Appendix A.
Activity 14.5
Read the following excerpts from the annual reports of Utilitywise, which can be obtained
at https://beta.companieshouse.gov.uk/company/05849580/filing-history
• 2017 Annual Report, filed on 04 Apr 2018: Read pp. 2-10, 25-28, 32-38, 42-44 and 47;
• 2016 Annual Report, filed on 12 Jan 2017: Read first 2 unnumbered pages and
pp. 20-24.
1. What is the core business of Utilitywise and how does it generate its revenues?
2. What are the key assumptions in its recognition of revenues?
3. What is the key effect on revenue recognition in the transition from IAS 18 to IFRS 15?
4. How are the changes reflected in the Statement of financial position and cash flows?
Brief solutions are provided in Appendix A.
For more analysis, read: Burgess, K. ‘Utilitywise is a sorry tale that might yet serve
a purpose’. Financial Times, 17 February 2019, available at https://www.ft.com/
content/3f294d12-3081-11e9-ba00-0251022932c8 in the Online Library.

Having completed this chapter, and the Essential readings and activities,
• explain construction contracts and their accounting: why they are
treated differently; their profit recognition
• explain the impact of forthcoming changes in standards on recognising
revenues.
203

Question 14.1
Tom Plc has two construction contracts underway – A and B. A began on 1
January 2010. B began on 1 August 2010. The position on each contract at
31 December 2010 was as follows:
A B
£’000 £’000
Contract price 8,000 4,000
Cost of work recognised (certified) 5,100 600
Costs carried forward 300 160
Value of work recognised (certified) 6,000 800
Estimated additional costs to completion 1,400 2,200
Progress billings (payments on account) 6,400 720
Contract A provided for the sum of £500,000 to be paid in advance by

the client on 1 January 2010; this is included in the payments on account
shown above.
The cost of work certified represents costs incurred in reaching the stage
of completion represented by the value of work certified. The costs carried
forward represent costs incurred subsequently, but before the year-end.
Tom’s accounting policy recognises no profit until a contract is one-third
complete by value. Thereafter, it recognises each year a proportion of total
expected profit. This is measured as the difference between turnover for
the year and cost of sales. Cumulative turnover is calculated as the value
of work certified except where the contract is not one-third complete by
value, in which case turnover is recorded at an amount equal to cost of
sales.
a. Show how each of these contracts will be reflected in the income
statement and balance sheet of Tom Plc at 31 December 2010 in
accordance with standard accounting practice.
b. Comment on the application of the ‘prudence concept’ in relation
to standard accounting practice for inventories and construction
contracts.
Question 14.2
Complete Question 6 in the Exercises section of Chapter 21 ‘Construction
contracts’ in Elliott and Elliot (2019).
204
Chapter 15: Accounting for financial instruments (excluding hedge accounting)
Chapter 15: Accounting for financial

instruments (excluding hedge accounting)
15.1 Introduction
In this chapter, we consider accounting for financial instruments,
excluding hedge accounting.
Accounting for financial instruments was deemed an important accounting
issue by those representing the world’s stock exchanges. The IASB was
keen to promote its international standards through these exchanges and
sought a feasible way forward in relation to this area of accounting. While
achieving the issue of key standards, this is a complex area for financial
accounting and many issues continue.
In this chapter, we discuss the issues and reflect upon the standards by
reference to some key areas of accounting for financial instruments. Note
that there is a new IFRS 9 to replace IAS 39 effective on or after 1 January
2018. It does not significantly impact on the matters discussed here but is
worth assessing in terms of the detail of provisions.

• provide an insight into accounting for financial instruments.
Note that IFRS 9 replaced IAS 39 effective on or after 1 January 2018. It
does not significantly impact on the matters discussed here but is worth
assessing in terms of the detail of provisions.

• explain the character of financial instruments and the accounting
issues involved
• explain the approaches taken by IAS 39 and IFRS 9 in the
measurement and recognition of financial instruments in some key
areas; understand how IAS 32 seeks to deal with issues of presentation
and IFRS 7 seeks to deal with issues of disclosure.


Draper, P.R., W.M. McInnes, A.P. Marshall and P.F. Pope ‘An assessment of the
effective annual rate method as a basis for making accounting allocations’,
Journal of Business Finance & Accounting 20(1) 1993, pp.56–63.
IAS 39 Financial instruments: recognition and measurement. (IAS 39 is now a
historical standard.)
Hall, 2004) 7th edition [ISBN 9780273658498] Chapters 7–9 and 18.
IFRS 9 Financial instruments.
205
Relevant accounting standards

IAS 32 Financial instruments: presentation.
IAS 39 Financial instruments: recognition and measurement.
IFRS 7 Financial instruments: disclosures.
IFRS 9 (being issued piecemeal to replace IFRS 39).
15.2 Definition and overview

A financial instrument is a kind of contract that in principle has financial
value. It is a contract that gives right to a financial asset of one enterprise
and a financial liability – or alternatively what is termed an equity
instrument – of another enterprise. For instance, if an enterprise has a
promissory note payable by another enterprise in government bonds the
enterprise could be understood to hold a financial instrument. Financial
instruments have become more complex over the years. Typical financial
instruments here would be financial options, futures and forwards,
interest rate swaps, currency swaps, credit swaps, equity swaps, bonds and
treasury bond options. An equity instrument implies the enterprise has a
contractual right to a residual interest in the assets of another enterprise
after deducting all the enterprise’s liabilities.
In accounting for financial instruments a key issue is the measurement
base and another is where any unrecognised gain or loss on a financial
instrument (e.g. arising with the usage of fair value accounting) goes in
the accounts.
The IASB began work on accounting for financial instruments in 1988
(there had been an OECD symposium on the issue and the world’s stock
exchanges expressed an interest in resolving the accounting issues). A
first Draft Statement of Principle issued in 1990 advocated fair value
measurement of assets and liabilities but only assets and liabilities held
for trading. A year after that an Exposure Draft allowed an alternative
of fair value for other than trading items. Another four years after that a
standard was issued (IAS 32) – on presentation and disclosure (this was
revised in 2003 and subsequently has been split into two standards, IFR 32
Presentations and IFRS 7 Disclosures).
In 1998, a standard was issued on the recognition and measurement of
financial instruments, IAS 39 (revised in 2000 and 2004 and subsequently
amended several times). Even this pace was considered a rush given the
complexity of this area of accounting. IAS 39 just met the 1999 deadline
set by IOSCO, the body overseeing the world’s stock exchanges, that was
very concerned about the need to have a standard in this area.
This standard was deemed especially difficult to understand. David
Tweedie, who served as Chair of the IASB for over 10 years, including
during the manifestation of IAS 39, joked that if someone claimed to
have read IAS 39 and understood it they clearly had not read it properly.
The IASB issued guidance but then included the standard on the IASB’s
improvements project and a revised standard was issued in 2004. Fair
value is now optional. But the standard was not easily winning support
and further reviews ensued. Some guidance notes on specific areas have
been issued (e.g. on puttable financial instruments).
In recent years, the IASB has started a phased project to replace IFRS 39 by
IFRS 9, which is now complete. The concern is to simplify classification and
measurement in relation to financial instruments. In 2009, the first part of
IFRS 9 was issued (part of the first phase) dealing with classification and
measurement of financial assets only (in 2010 this part was expanded to
206
the measurement of financial liabilities and the derecognition of financial

assets and liabilities; some minor amendments followed in 2012). In 2009,
an Exposure Draft was issued in respect of a second phase on impairment (a
revised Exposure Draft being issued in 2013 after supplementary guidance
had been issued in 2011). No part of IFRS 9 is yet endorsed by the EU.
Please check for updates in the area of accounting for financial instruments
on the IASB website.
The IASB has come to embrace the view that fair value accounting is
required in this area. It should be stressed in this context that correctly
identifying financial assets and liabilities, as well as equity, can enhance
the disclosure of the financial risk of the company. Such identification
has become more difficult with the significance of financial instruments.
The use of fair values however raises the issue of how should unrealised
gains/losses be reported (i.e. in the profit or loss account as a change in
income versus other comprehensive income as a change in equity). The
key principle applied is typically one of ‘realisation’, but this has become
less useful when entities are trading underlying risks generated through
the financial instruments.
The objective of IAS 39 and IFRS 9 is to establish principles for recognising
and measuring financial assets, financial liabilities and some contracts
to buy or sell non-financial items. Requirements for presenting financial
instruments as liabilities or equity and for offsetting financial assets and
financial liabilities are in IAS 32 Financial instruments: presentation.
Requirements for disclosing information about financial instruments are in
IFRS 7 Financial instruments: disclosures.
IAS 32 (as IAS 39) defines a financial instrument as ‘any contract that
gives rise to a financial asset of one entity and a financial liability or equity
instrument of another entity’.
This is a very wide definition. It includes not only primary instruments but
also secondary or derivative instruments:
A financial instrument may require the entity to deliver cash
or another financial asset, or otherwise to settle it in such a
way that it would be a financial liability, in the event of the
occurrence or non-occurrence of uncertain future events (or
on the outcome of uncertain circumstances) that are beyond
the control of both the issuer and the holder of the instrument,
such as a change in a stock market index. The issuer of such
an instrument does not have the unconditional right to avoid
delivering cash or another financial asset (or otherwise to
settle it in such a way that it would be a financial liability).
Therefore, it is a financial liability of the issuer unless:
a. the part of the contingent settlement provision that could
require settlement in cash or another financial asset (or
otherwise in such a way that it would be a financial liability)
is not genuine; or
b. the issuer can be required to settle the obligation in cash or
another financial asset (or otherwise to settle it in such a
way that it would be a financial liability) only in the event of
liquidation of the issuer.
207
15.3 Long-term debt and short-term debt

There are a number of different types of borrowing that you may see in
the published accounts of a large company such as a UK Plc (some might
be in foreign currency), including:
• Debentures, unsecured loan capital: these are bought and sold like
shares and are available to investors.
• Hybrid securities: these are financial/capital instruments which
combine features of both debt and equity. One example is convertible
capital bonds – this is a form of debt that can be converted into
equity shares at some time in the future. These hybrid securities have
been accounted for in different ways in the past, but following the
introduction of IFRS 7 they are now required to be included with
liabilities.
• Loans, both long-term and short-term, from banks and other financial
institutions.
• Bank overdrafts.
15.4 Accounting issues: equity or liability?

Accounting for equity and liabilities had not been particularly
controversial. However, over the past 25 years there has been considerable
growth in the range of capital instruments available for raising finance,
which often resulted in the distinction between equity and liabilities
becoming somewhat blurred. Accounting failed to keep pace with the
development of these complex instruments.1 This increased complexity 1
For example, how
has led to difficulties in the recognition, measurement and disclosure of should an instrument
having characteristics of
financial instruments. For example, many people argued that redeemable
both debt and equity be
preference shares are, in substance, more akin to debt than equity and accounted for? As equity
should be treated as such irrespective of their legal nature, or that a bond or under the heading of
that gives the holder the option to redeem, or convert it into ordinary liabilities?
shares, may be argued to be more in the nature of equity than debt.
This area is both complex and controversial. Many items falling within it
were previously carried off-balance sheet, leaving shareholders lacking key
information on the true nature of operations from the financial statements.
The choice of accounting treatments seems to be based fundamentally
upon whether you choose economic substance or legal form. The IASB
states the following in the FPPFS, para.35:
If information is to represent faithfully transactions and other
events that it purports to represent, it is necessary that they
are accounted for and presented in accordance with their
substance and economic reality and not merely their legal
form. The substance of transactions or other events is not
always consistent with that which is apparent from their legal
or contrived form. For example, an enterprise may dispose of
an asset to another party in such a way that the documentation
purports to pass legal ownership to that party; nevertheless,
agreements may exist that ensure that the enterprise continues
to enjoy the future economic benefits embodied in the asset. In
such circumstances, the reporting of a sale would not represent
faithfully the transaction entered into (if indeed there was a
transaction).
208
This was incorporated into IAS 32, which stated:

The issuer of a financial instrument shall classify the instrument,
or its component parts, on initial recognition as a financial
liability, a financial asset or an equity instrument in accordance
with the substance of the contractual arrangement and the
definitions of a financial liability, a financial asset and an equity
instrument. The issuer of a non-derivative financial instrument
shall evaluate the terms of the financial instrument to determine
whether it contains both a liability and an equity component.
Such components shall be classified separately as financial
liabilities, financial assets or equity instruments.
Activity 15.1
Does the definition of equity and liabilities in the FPPFS help with the classification of
preference shares?
Discussion
IAS 32 follows a substance over form approach to determining whether
preference shares are equity or liability. For instance, preference shares
should be treated as a liability instrument if the following conditions are
attached to the shares:
i. Dividend payments are compulsory and paid regularly (e.g. annually).
ii. The share requires mandatory redemption by the issuer at a fixed
amount at a future date (i.e. there’s no option to keep the shares as
preference shares come the redemption date).
iii. Shares give the holder the option to redeem at a future event that is
highly likely to occur.
15.4.1 Convertible financial instruments

IAS 32 states that when a derivative financial instrument gives one party
a choice over how it is settled (e.g. the issuer or the holder can choose
settlement net in cash or by exchanging shares for cash), it is a financial
asset or a financial liability unless all of the settlement alternatives would
result in it being an equity instrument.
Activity 15.2
According to IAS 39, which of the following financial instruments should be classified by
the issuer as an equity instrument?
a. A company has issued a perpetual preference share redeemable only at the issuer’s
discretion. Dividend of 10% is paid annually provided that there are sufficient
distributable profits.
b. A company has issued a perpetual preference shares. Dividend of 8% on the
preference shares is paid if a dividend is paid on the ordinary shares of the company.
c. A company has issued a perpetual preference share carrying a fixed dividend rate
of 5%. If the dividend is deferred then the dividend will be accumulated for future
payout together with an additional interest at 20%.
d. A company has issued specific preference shares to its fund managers. They carry the
right to an annual payment based on 20% of the realised gains on the fund recorded
in the period.
209
A convertible instrument may comprise a liability to deliver a financial

asset on redemption and a call option granting the holder the right to
convert the liability into shares.
15.4.2 Definitions
IAS 32 classifies financial instruments into financial assets, financial
liabilities and equity instruments.
An equity instrument is ‘any contract that evidences a residual interest
in the assets of an entity after deducting all of its liabilities’.
A financial asset is:
any asset that is:
a. cash;
b. an equity instrument of another entity;
c. a contractual right:
i. to receive cash or another financial asset from
another entity; or
ii. to exchange financial assets or financial liabilities
with another entity under conditions that are
potentially favourable to the entity; or
d. a contract that will or may be settled in the entity’s
own equity instruments and is:
i. a non-derivative for which the entity is or may
be obliged to receive a variable number of the
entity’s own equity instruments; or
ii. a derivative that will or may be settled other than
by the exchange of a fixed amount of cash or
another financial asset for a fixed
iii. number of the entity’s own equity instruments.
For this purpose the entity’s own equity
instruments do not include instruments that are
themselves contracts for the future receipt or
delivery of the entity’s own equity instruments.
A financial liability is:

any liability that is:
a. a contractual obligation:
i. to deliver cash or another financial asset to
another entity; or
ii. to exchange financial assets or financial liabilities
with another entity under conditions that are
potentially unfavourable to the entity; or
b. a contract that will or may be settled in the entity’s
own equity instruments and is:
i. a non-derivative for which the entity is or may
be obliged to deliver a variable number of the
entity’s own equity instruments; or
ii. a derivative that will or may be settled other than
by the exchange of a fixed amount of cash or
another financial asset for a fixed number of the
210
iii. entity’s own equity instruments. For this purpose

the entity’s own equity instruments do not include
instruments that are themselves contracts for the future
receipt or delivery of the entity’s own equity instruments.
15.4.3 Offsetting of financial assets and financial liabilities

Offsetting to a net amount is only permitted when an entity has a legally
enforceable right to offset and intends to either settle on a net basis or sell
the asset and settle the liability at the same time.
15.4.4 Initial recognition of financial instruments

Recognition on the statement of financial position of a company requires
that the company is party to the contractual provisions of a contract. Once
it becomes so party there is initial recognition.
15.4.5 Derecognition of financial instruments

A financial asset can be removed from the statement of financial position
when the contractual rights to the cash flows from the asset expires or
the entity makes a qualifying ‘transfer’ of the financial asset. The transfer
would need to transfer the contractual rights to receive the cash flows of
the financial asset or the transfer would involve the entity in assuming a
contractual obligation to pay the cash flows to one or more recipients in
an arrangement meeting certain conditions. A qualifying transfer is firstly
decided upon by reference to the extent of transfer of risks and rewards of
the asset and next by reference to the transfer of control. Derecognition of
a portion of a financial asset is permitted.
A financial liability can be removed when the obligation specified in
the contract is discharged, cancelled or expires. If a financial liability
is exchanged for another one with the same lender but the terms are
substantially different (guidance is here given – the present value should
differ by 10% of the original instrument) then derecognition (of the
previous liability) and initial recognition (of the new one) may properly
reflect this.
15.4.6 Categories of financial assets and liabilities

According to IAS 39, there were four kinds of financial assets:
1. Financial assets at fair value through profit or loss: include held for
trading assets and assets designated in this category upon initial
recognition; the option of evaluating financial asset performance on a
fair value basis is open for any financial asset.
2. Held-to-maturity investments: fixed or determinable payments and
fixed maturity.
3. Loans and receivables.
4. Available for sale financial assets: that is, all other financial assets.
And there were two kinds of financial liabilities:
1. Financial liabilities at fair value through profit or loss (the equivalent
of the first of the above financial asset types).
2. Other.
Per IFRS 9, held-to-maturity, available for sale and loans/receivables were
no longer categorised. The distinction after IFRS 9 will be between those
held at amortised cost and those held at fair value.
211
15.4.7 Measurement of financial instruments

Under IAS 39:
1. On initial recognition, all financial instruments are measured at fair
value.
2. Financial assets/liabilities at profit or loss – subsequent re-
measurements result in differences being recognised in profit or loss.
3. Available for sale financial assets – re-measurements result in
differences being recognised in other comprehensive income (upon
realisation or earlier impairment the cumulative amounts of the
differences are recycled to profit or loss) – when the fair value of the
asset cannot be reliably measured it is measured at cost.
4. Held-to-maturity investments, loans and receivables and other
financial liabilities are measured at amortised cost using the effective
interest method (see below).
Under IFRS 9, the condition for measurement at amortised cost is based
on the entity’s business model (aligning the accounting with managerial
intentions for the financial assets – but if the business model changes so
does the accounting). All changes to fair value or amortisation go to profit
or loss. See the Alexander et al. textbook for illustrations.
15.4.8 Impairment
Financial assets measured at (amortised) cost have to be reviewed for
impairment at each statement of financial position date. The IASB has
moved to an expected loss model under IFRS 9. Impairments should be
reversed if the impairment loss decreases.
The following applied under IAS 39 but will not under IFRS 9: for loans/
receivables and held-to-maturity investments carried at (amortised) cost,
the impairment loss (not reversible) is measured as the difference between
the asset’s carrying amount and the present value of estimated future cash
flows using the original effective interest rate as the discount rate. For
available for sale assets measured at cost it is the same except the current
market rate of return for a similar asset is used as the discount rate (for
those, as is more typically the case, measured at fair value, an impairment
test is made at each reporting date) – this impacts on the amount included
in other comprehensive income that has to be recycled to profit or loss.
Example 15.1: Expected credit losses – a basic illustration

Estimated future cash flows, discounted to present value, assuming that
the borrower (e.g. receivables or loans) pays as anticipated = £10,000
Estimated future cash flows in the case of default (discounted to present
value) = £2,000
Cash shortfall = £8,000
Probability of default = 2%
Expected credit loss (ECL) = 2% x 8,000 = £160
The ECL is to be recognised and measured through one of three
approaches (general, simplified and credit adjusted).
Example 15.2
Dafferty Finance lends £500,000 for two years at a compoundable annual
interest rate of 4%. The interest and principal amount are payable at
maturity (i.e. at the end of two years).
212
The following table of calculations illustrate the application of the IASB

approaches to impairment under IFRS 9. All values in GBP £.
General &
Approach Interest simplified Credit adjusted
Loan amount (carrying) 500,000 500,000

Annual interest 4% 4%
Risk-free rate not considered 2%
Loan period (years) 2 2
Total cash flow 4% 540,800 540,800

Total cash flow 2% 520,200
Loan interest year 1 4% 20,000

Total interest 40,800 20,200

Impairment allowance 20,600
Under the previous approach, the loan interest was recognised in the profit
or loss account (20,000 in year 1, 20,800 in year 2, a total of 40,800).
Under the IASB’s revised approach to impairment however, the interest
income is recognised at an interest rate that takes into account the
premium a lender expects in return for the risk that the loan will default.
In this example, the risk premium is 4% – 2% = 2% per annum. The loan
interest recognised in the profit or loss account is 10,000 in year 1 and
10,200 in year 2, a total of 20,200 (reflecting the risk-free rate of 2%).
The incremental interest earned at 4% (over the 2% risk free rate) is
recognised as an ‘impairment allowance’ = 20,600.
Under the credit adjusted approach, ECL are used to calculate the
impairment allowance and risk adjusted interest.
• After initial recognition, the impairment allowance is adjusted, up or
down, through profit or loss at each statement of financial position
date as the probabilities of collection and recoveries change.
• If there is no default on the loan at the end of the period, expected
losses would fall to nil as the probability of non-payment declines and
impairment losses are reversed through the profit or loss account.
• If the loan becomes riskier, the probability of default is increased,
which increases ECL and the additional impairment allowance charges
through the profit or loss account.
• Should a default on the loan occur with no possibility of recovery of
any amount, ECL will equal that shortfall and the amount written off
in the profit or loss account.
213
When to apply:
General approach
All other loans and receivables not covered by another approach
Simplified approach
Qualifying trade receivables, IFRS 15 contract assets and lease receivables
Credit adjusted approach
Assets that are credit impaired at initial recognition
Note that the credit adjusted approach applies very rarely. For instance,
when an entity acquires a loan or receivable that is ‘credit impaired’ at the
date of its initial recognition. An illustration would be when, in a takeover
of a (soon to be) subsidiary, the parent company acquires a loan at a deep
discount due to credit concerns.
IFRS 9 definition of an asset that is credit impaired (the list is
not exhaustive)
• Significant financial difficulty of the issuer or borrower
• A breach of contract (e.g. a borrower fails to make a contractually due
payment)
• It is becoming probable that the borrower will enter bankruptcy or
other financial reorganisation
• The disappearance of an active market for that financial asset because
of financial difficulties.
15.4.9 Convertible financial instruments

Consider a compound liability/equity. One first determines the carrying
amount of the liability component by measuring the fair value of a similar
liability. The carrying amount of equity is determined by deducting the
fair value of the financial liability from the fair value of the compound
instrument as a whole.
Consider the following examples:
i. Ross has issued a preference share, which will be redeemed after three
years.
ii. Max has issued a preference share to Saoirse. Saoirse has the option
but not the obligation to redeem them, and it is unclear whether she
will exercise her option.
iii. Marta Ltd issued a convertible debenture that carries a coupon interest
rate payment. The debenture is convertible at the option of the holders
at a set rate of shares for each £1 of debenture stock on a fixed date.
Solutions:
i. This is classified as a liability as Ross has an obligation to pay for the
shares after three years. Substance (behaves like a liability) over form
(equity) applies.
ii. This is classified as a liability as Max has no possibility to stop payment
to Saoirse, should Saoirse decide to exercise her option.
iii. This is a compound instrument, with both liability and equity
components. The next worked example provides a numerical
illustration.
214
Example 15.3
On 1 January 2019 Marta Ltd issued a convertible debenture for £200
million carrying a coupon interest rate of 5%. The debenture is convertible
at the option of the holders into 10 ordinary shares for each £100 of
debenture stock on 31 December 2023. Marta Ltd considered borrowing
the £200 million through a conventional debenture that repaid in cash;
however, the interest rate that could be obtained was estimated at 7%,
therefore Marta Ltd decided on the issue of the convertible.
Question 1
Show how the convertible bond issue will be recognised on 1 January
2019 and determine the interest charges that are expected in the
statement of comprehensive income over the life of the convertible bond.
Solution
Convertible debenture 200 5%
(£m and coupon interest)
Conversion into number 10 100
of shares for each £
Standard debenture rate 7%
Cash flow Discount Present Value

End of year Payment of £m £m
1 Interest 10 0.9346 9.35
2 Interest 10 0.8734 8.73
3 Interest 10 0.8163 8.16
4 Interest 10 0.7629 7.63
5 Interest 10 0.7130 7.13
5 Capital 200 0.7130 142.60
Debt value 183.60
Equity value:
Proceeds less debt value 200 –183.60 = 16.4
Proceeds Debt value Equity value
At 1 January 2019, the

entry will therefore be:
Dr Cash 200
Cr Debt 183.6
Cr Equity 16.4
Interest charges in the statement of comprehensive income

Year b/f Interest Interest c/f
paid
charge 7% Coupon
5%
1 183.60 12.9 (10.00) 186.45
2 186.45 13.1 (10.00) 189.50
3 189.50 13.3 (10.00) 192.77
4 192.77 13.5 (10.00) 196.26
5 196.26 13.7 (10.00) 200.00
215
Question 2
Why would an investor be interested in subscribing (i.e. purchasing) to
Marta Ltd’s convertible debenture when the returns (i.e. coupon rate) is
only 5% per annum, when they are able to obtain 7% per annum through
investment in a more conventional debenture?
Solution
Investors may place a positive value the option to convert their debentures
into ordinary shares at the end of the debenture. Investors are therefore
willing to accept lower returns from ‘loan interest’ as they anticipate
that they will benefit from having the option to turn their debentures
into equity later on. This value is reflected in the interest premium of
(7 – 5 = 2%), which is valued as equity at £16.4m on the day of issue.
15.5 Accounting for debt

Immediately after the issue of the debt, the amount of the liability should
be shown as the amount of the net proceeds of issue. ‘Net proceeds’ is
the fair value of the consideration received after deducting issue costs
incurred directly in connection with the issue of debt. Finance costs are
the difference between the net proceeds of debt and the total amount
of the payments the issuer has to make in respect of debt. Finance costs
of the debt are to be allocated to periods over the term of the debt at
a constant rate on the carrying amount, and are to be charged in the
income statement; this is achieved by use of the actuarial method. (Special
rules apply to investment companies, not dealt with here.) The carrying
amount of debt should be increased by the finance costs for the period and
reduced by payments made in respect of the debt in that period (though
the standard does allow accrued finance charges to be included in accruals
rather than in the carrying amount of debt if they have accrued in one
period and will be paid in cash in the next).
The allocation of finance costs to periods under IAS 39 involves using the
‘effective rate of interest’2 rather than the nominal value. This is calculated 2
Also known as the
by finding the rate of interest that makes the PV of all future payments in ‘effective yield’ or the
‘periodic rate’, and
respect of the debt equal to the net proceeds of issue. IAS 39 defines this
equivalent to the ‘rate
as follows: implicit in the lease’.
The effective interest method is a method of calculating the
amortized cost of a financial asset or a financial liability (or
group of financial assets or financial liabilities) and of allocating
the interest income or interest expense over the relevant period.
The effective interest rate is the rate that exactly discounts
estimated future cash payments or receipts through the
expected life of the financial instrument or, when appropriate, a
shorter period to the net carrying amount of the financial asset
or financial liability. When calculating the effective interest rate,
an entity shall estimate cash flows considering all contractual
terms of the financial instrument (for example, prepayment, call
and similar options) but shall not consider future credit losses.
The calculation includes all fees and points paid or received
between parties to the contract that are an integral part of the
effective interest rate (see IAS 18), transaction costs, and all
other premiums or discounts.
216
Example 15.4
On 1 January 2011 a company receives £835,500 on the issue of 8%
debentures with a nominal value of £1,000,000 redeemable at par on 31
December 2013. Interest payable on 31 December each year. The proceeds
are after all direct issue costs. Consequently, the company is paying
£80,000 per annum (8% of £1,000,000). However, 8% does not represent
the implicit interest rate, which needs to be calculated as follows:
The rate of interest implicit in this financing arrangement is found by
solving for r such that:
80,0000a¬ r6 + 1,000,000 = £835,000
(l + r)6
This is the same as

80,000 80,000 80,000 80,000 80,000 80,000 1,000,000
+ + + + + + = £835,000
(1 + r) (1 + r)2 (1 + r)3 (1 + r)4 (1 + r)5 (1 + r)6 (1 + r)6
This can be solved to show that r equals 12% per annum.
The debt liability and finance charges will be analysed as follows.
Year Opening Finance charge Payment made Closing balance

balance @ 12%
(1) (2) = (1) × 12% (3) (4) = (2) – (3) + (1)
2011 835,500 100,260 80,000 855,760
2012 855,760 102,690 80,000 878,450
2013 878,450 105,415 80,000 903,865
2014 903,865 108,465 80,000 932,330
2015 932,330 111,880 80,000 964,210
2016 964,210 115,790 80,000 1,000,000
The sum of £1,000,000 would then be repaid on 31 December 2016. The

finance charge is debited to the income statement. This charge includes
the nominal interest on the debt (i.e. we do not charge both the finance
charge and interest at 8%).
15.6 Disclosures
Per IFRS 7, the following disclosures are required:
• fair value of financial instruments (details regarding assets/liabilities
at fair value through profit/loss)
• qualitative as well as quantitative information on risk
• details of asset transfers
• details of offsets
• reclassifications
• carrying amounts by category
• collateral pledged/held
• defaults/breaches
• allowances for credit losses
• income, expenses, gains, losses.
217

• explain the character of financial instruments and the accounting
issues involved
• explain the approaches taken by IAS 39 and IFRS 9 in the
measurement and recognition of financial instruments in some key
areas; understand how IAS 32 seeks to deal with issues of presentation
and IFRS 7 seeks to deal with disclosures.

Question 15.1
On 1 January 2016 Gump issues a five-year debenture stock with a par
value of £1,000,000. The coupon rate of interest is 2.2% on the par value,
payable annually on 31 December. The debenture is redeemable at 01.00
on 31 December 2020. The proceeds of issue are £836,500.
a. How would the debenture be accounted for following the effective
interest method set out in IAS 39 and FRS 4? (The implicit percentage
rate of interest should be estimated to the nearest whole number.)
b. What are the comparative merits and disadvantages of this method?
Interest rates rise after 2017. On 31 December 2018, after
the interest for that year has been paid, the market value of the
debentures (ex int)3 reflects the current required yield of 10%. There is 3
Ex int means ‘without
no general expectation of either a further rise or a fall in interest rates next interest’.
for the foreseeable future.
c. Should Gump buy in the debentures?
d. If it does, how should the transaction be reflected in the company’s
accounts?
Question 15.2
A company has two investments. One, an investment in listed shares, is an
available for sale financial asset. The current market value is £6,000 but
the shares were bought for £10,000. The other is an investment in a three-
year bond with an amortised cost of £120,000 with a stated and effective
interest rate of 7% (current market rates are 10%). But after two years the
entity is not expecting the last year’s interest and expects only half of the
principal.
What impairment should be recorded in the accounts of the company?
Question 15.3
Aileen Ltd has loaned £100,000 to Maebh Ltd and £80,000 to Sorcha
Ltd on 1 January 2020, the start of the company’s financial year. Both
loans are at an annual rate of interest of 2.5% and the loan period is for
three years. The conditions of the loans are such that Aileen Ltd will only
receive all of the principal and (compounded) interest at the end of the
loan period (i.e. three years). In addition, Aileen Ltd can invest in risk-free
government bonds that pay 1.5% per annum, with principal and the total
interest payable at the end of three years.
218
Maebh Ltd is a long-established trading partner of Aileen Ltd, and is

expected to fully repay the loan principal and interest at the end of
the loan contract period. Sorcha Ltd however is struggling to generate
sufficient revenues to cover its costs and have been in this situation for
some time. Sorcha Ltd has therefore borrowed from Aileen Ltd to help the
company manage its working capital, as it attempts to restructure.
Required:
Show how Aileen Ltd should account for the loans to Maebh Ltd and
Sorcha Ltd under current accounting standards on 1 January 2020.
219
Notes
220
Chapter 16: Accounting for groups: consolidated statement of financial position
Chapter 16: Accounting for groups:

consolidated statement of financial
position
16.1 Introduction
16.1.1 A group
When companies make fixed asset investments (e.g. purchase shares in
another company), it is important to determine how the investment should
be classified. The first distinction is whether or not the investment is a
subsidiary undertaking (or some other form, such as an associate, joint
venture or special purpose vehicle). Although all fixed investments are
treated identically in the holding company’s accounts, the way in which
these investments are treated in the consolidated accounts depends on
their classification. If a company holds a fixed asset investment that is
classified as a subsidiary undertaking then the investing company (the
parent/holding company) together with the investee company (the
subsidiary) are referred to as a group.
16.1.2 Structure of a group

The structure of a group can take many forms. The most basic form is
where a holding company H owns one subsidiary S, for example:
S
A more complex group is where H either holds several subsidiaries or
holds one subsidiary that then holds other subsidiaries:
H H
S S S
S
S
16.1.3 Why own other companies/entities?
There are numerous motives for acquiring or merging with other
companies, for example:
• For growth reasons: rather than growing internally by increasing
market share it may be cheaper and simpler to grow externally via
an acquisition of another company who may be, for example, your
competitor or supplier/distributor.
221
• To prevent take-overs: the larger you are and the more complex your
business combination the lower the probability of your company
becoming a take-over target.
• Synergies, such as economies of scale.
• To acquire new sources of supply.
• To utilise financial strengths of an acquired company (e.g. tax credits,
borrowing capacity).
• To purchase undervalued assets.
• To reduce competition.
• ‘Irrational’ and other reasons, for example, ego, fashion or managerial
motives.

We need to consider how to account for two or more companies that
are controlled by a single management and act as one economic entity.
This chapter aims to investigate different approaches that have been
discussed by the accounting profession and those which have been
adopted by standard-setters. We will also investigate other forms of
business combinations, such as associates and joint ventures. Throughout
the chapter, guidance will be given as to how to apply these accounting
techniques. We will also consider the effect on the accounts of employing
these different approaches, including the effect on the perception of users
of financial statements.

• explain how different non-current asset investments are distinguished
and accounted for
• describe a ‘group’
• describe the rationales used to develop different models of
consolidation (acquisition, merger, equity, proportional)
• be aware of the main ideas underpinning the now disallowed merger
method
• explain why the definition of a subsidiary is important
• prepare consolidated accounts (statement of financial position and
profit and loss or income statements) using the acquisition method
• compute the value of goodwill and non-controlling (minority) interest
• appreciate the importance of the transaction date and the difference
between pre- and post-transaction profits/income in consolidated
accounts.

International financial reporting, Chapters 26, 27 and 28.

222

IFRS 10 Consolidated financial statements.
IFRS 13 Fair value measurement.
16.2 Key principles and rationales

Let us assume you run a large public trading company, such as Microsoft,
which owns and controls many other companies who trade separately
from them. In order to see the full extent of Microsoft Plc’s activities, the
accounts need to reflect this ownership and hence reflect the underlying
trading activities of the Microsoft Group. Your shareholders need this
information, since they own shares in Microsoft, which implicitly means
that they also own a stake in the subsidiaries.
For example: Company A (the holding company) owns Company B (the
subsidiary company) and Company B does all the trading. If the only
accounts that were required related purely to Company A’s accounts
then in Company A’s accounts:
• the income statement would reflect income as the dividends
received and receivable from Company B and the expenses would
relate to Company A’s management costs
• the statement of financial position would reflect the cost
(or valuation) of the investment in Company B as an asset and the
liabilities would relate to the equity and loans of Company A only.
Consequently, the accounts would not reflect the underlying economic
activities of the group, as most of (economic) trading takes place at
Company B but is not fully reflected in Company A’s accounts. How should
we correct for this obvious defect in the accounts? There are a number of
possible solutions, such as preparing:
• holding company accounts plus additional information
• holding company accounts plus accounts of subsidiaries
• holding company accounts plus overall summary of subsidiaries’
accounts
• consolidated accounts of the holding company and subsidiaries.
Activity 16.1
At this stage, how do you think the investing company should account for this investment
in the accounts to illustrate the economic reality of the investment?
See if your answer changes following a review of this chapter.
Activity 16.2
Is there a difference if Company X acquires varying stakes in Company Y – say 1%, 25%,
51%, 75% or 100%? What are the important factors you would take into consideration
in differentiating between varying stakes? How would you account for these stakes? .
The need for a precise definition of what constitutes a member of a

group for consolidation purposes is self-evident. Consolidation provides
shareholders with information about aggregate profit/loss, and assets
and liabilities under the control of the holding company. This information
is a basic requirement for a shareholder to determine how the holding
223
company is performing. If accounting standards do not prescribe precise

definitions as to which fixed asset investments should be consolidated, a
holding company might opt to consolidate the results and net assets of
well-performing companies and omit the results and net assets of poorly-
performing companies or those with high levels of debt financing.
There are a number of treatments in accounting for groups among national
versus international standards. Our approach here is to focus on the core
ideas underpinning principles common across many of these standards. As
such, we adopt current IFRS approaches, but also consider how the IFRS
approach was derived from older standards. For group accounts, the main
standards are IFRS 10 (Consolidated financial statements) replacing IAS
27 (Consolidated and separate financial statements) in 2013 and IFRS 3
(Business combinations), which elaborates on how goodwill is to be treated
in consolidation.
16.2.1 Definition of a subsidiary

Under the old IAS 27, para.4 defines a subsidiary as: ‘An entity, including
an unincorporated entity such as a partnership, which is controlled by
another entity (known as the parent)’. Consequently, this definition
is not purely based on the strict form of the shareholder relationship
between two entities, but is nearer to one that reflects the substance of the
commercial relationship. This relationship, thus, is defined by ‘control’.
16.2.2 Control
IFRS 10 removes the classification of the nature of the relationship of the
investing company and investees, focusing on control as the sole criteria
by which relationships between the investor and investee are defined.
IFRS 10 (para.5) defines the control of a parent (investing company) over
its subsidiary (investee) as:
• power over the investee
• exposure, or rights, to variable returns from its involvement with the
investee
• the ability to use its power over the investee to affect the amount of
the investor’s returns.
An investor has to have all three elements before they can conclude they
control the investee. The change in focus towards control means that, even
in the absence of the investing company having a majority (i.e. more than
50%) of the shares, control can still be exerted through other means (for
example, over dual class shares or other mechanisms).
There has been widespread recognition of the need to adopt a definition
for a subsidiary based on de facto control rather than de jure control. The
impending collapse of Enron in 2001 was hidden from investors for a
significant period due to the use of a number of special purpose entities
(SPEs) which were excluded from the consolidated accounts of Enron on
the basis that each did not qualify as a subsidiary undertaking, despite
Enron having de facto control over the operations of these SPEs.
IFRS 10 seeks to remedy the issue over the (non) consolidation of
SPEs by bringing into consideration issues such as the principal – agent
relationships and ‘economic substance’ notion.
The density of new criteria incorporated into IFRS 10 can be interpreted as
reflective of increasingly complex business transactions.
224
Activity 16.3
Identify whether Big (B) exercises control over Small (S) in each of the following scenarios.
a. B has 30% voting rights of S. B also has an arragement with Outsider 1 (O1), who
has 25% of voting rights over S, that allows B to use all of O1’s rights.
b. B owns 30% of S and 100% of O1. O1 owns 25% of S.
c. B has 30% voting rights of S but can influence the appointment/removal of three out
of five directors of S.
d. B has 40% ownership of S but can cast a ‘golden share’ which allows it to have a
majority vote.
e. B has 45% voting rights of S but has special statutory rights to influence the
development of S’s financial and operating policies.
f. B has 49% voting rights of S.
g. B owns 30% of S.
h. B owns 30% of S and 40% of O1. O1 owns 60% of O2. O2 owns 70% of S.
16.3 Requirement for consolidated accounts

16.3.1 Definition of business combination
IFRS 3, para.4 defines a business combination as ‘the bringing together of
separate entities or businesses into one reporting entity’. In the UK this is
also a legal requirement under the Companies Act 1989. The consolidated
accounts show the group income statement, the group statement of
financial position, the group cash flow statement and the holding company’s
statement of financial position. Thus, consolidated accounts are designed to
extend the reporting entity to embrace other entities which are subject to its
control or influence; the overall aim, therefore, is to present the results and
state of affairs of the group as if they were those of a single entity.
Given the above example of Companies A and B, consolidating the
accounts would involve the construction of:
• a consolidated income statement – which involves replacing the
dividends received from Company B with the actual profit achieved by
the subsidiary (e.g. sales and expenses)
• a consolidated statement of financial position which would
reflect all the assets and liabilities of the group (i.e. replace the cost of
the investment with the underlying assets and liabilities of Company B).
16.3.2 Rationales for consolidation

These consolidated accounts, therefore, prevent the distortion of a
holding company’s profit by dividends from subsidiaries and prevent any
concealment of effective liabilities of the subsidiaries.
The following advantages, adapted from Elliott and Elliott (2019, p.581,
section 22.13), include:
• Investor protection: the consolidation prevents misleading calculations
such as the inflation of sales
• Prediction: A more meaningful EPS (earnings per share) figure is
provided on the basis of the parent company’s full earnings, taking
into account dividends from its subsidiaries.
225
• Accountability: Consolidation provides a better measurement of the

company’s performance under the stewardship of the directors, as total
group earnings can be compared with the group’s total assets to obtain
a group-based ROCE (return on capital employed).
However, the forthcoming IFRS 10’s definition of control may further
increase the complexity in judging whether a company has control or not.
In the following (abridged) scenario, which builds on Activity 16.2, control
can also be defined when a company is the largest shareholder by far,
even if they do not have majority voting/shareholding, if it is a scenario
whereby other shareholders find it near impossible to coordinate their
actions/votes to ensure majority rule.
Assume that B owns 48% of S, which by definition does not constitute
a majority shareholding. However, assume that the remaining investors
consist of very small shareholders, none of whom own 1% or more of S,
and who are not able to coordinate their voting or actions. In this case, B
can be deemed to have control, as the size of the 48% shareholding dwarfs
the individual holdings of other small and fragmented shareholders, who
cannot coordinate to achieve a counter-weight or majority to B.
16.3.3 Circumstances where consolidation is not required

There are some circumstances under which subsidiaries can be excluded
from the consolidation. IFRS 10 (para.4) states:
A parent is not required to (but may) present consolidated

financial statements if and only if all of the following four
conditions are met:
a. the parent is itself a wholly-owned subsidiary, or 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 parent not
presenting consolidated financial statements;
b. the parent’s debt or equity instruments are not traded in a
public market;
c. the parent did not file, nor is it in the process of filing, its
financial statements with a securities commission or other
regulatory organisation for the purpose of issuing any class
of instruments in a public market; and
d. the ultimate or any intermediate parent of the parent
produces consolidated financial statements available
for public use that comply with International Financial
Reporting Standards.
Following the publication of IFRS 5 (Non-current assets held for sale and
discontinued operations), a subsidiary for which control is intended to be
temporary is exempted from consolidation, if the subsidiary was acquired
and is held exclusively with a view to its subsequent disposal in the near
future (within 12 months); in such a case, the parent should account for
its investment in the subsidiary under IFRS 5 as an asset held for sale,
rather than consolidate it.
16.4 Different models of group accounting

There are a number of different ways (models) in which to account for
business combinations. It is therefore important to at least understand the
principles and assumptions used to develop these models. According to
226
Kothari and Barone (2011, p.537), there are three models commonly used.
All examples are based on the following exemplar relationship:
Big (B) owns 60% of Small (S), its subsidiary. 40% of S is thus
controlled by non-controlling interest(s) or NCI (IFRS usage:
NCI was formerly known as minority interest. Accounting for
NCI will be discussed further on in this chapter).
16.4.1 Economic entity model

The group includes: 100% of B (assets, liabilities and equity) and 100%
of S (assets, liabilities and equity). NCI is treated as part of the group’s
equity. Using the language of the accounting equation (assets – liabilities
= equity) for illustration:
B (100% net assets) + S (100% net assets) =
B (100% equity) + S (60% equity owned by B) + S (40% equity
owned by NCI)
16.4.2 Parent entity model

The group includes: 100% of B (assets, liabilities and equity) and 100%
of S (assets, liabilities and equity). NCI is treated as part of the group’s
liability.
B (100% net assets) + S (100% net assets) – S (40% NCI equity as
group liability) = B (100% equity) + S (60% equity owned by B)
16.4.3 Proprietary model

The group includes: 100% of B (assets, liabilities and equity) and 60% of
S (assets, liabilities and equity). NCI (40% of S) is not shown in the group
accounts.
B (100% net assets) + S (60% net assets) =
B (100% equity) + S (60% equity owned by B)
The current standard, IFRS 3, is a mixed concept as it incorporates
elements from both the economic entity and parent entity models (Kothari
and Barone, 2011, p.541). For example:
• NCI shown in the equity section of the balance sheet (economic entity)
• goodwill on consolidation relates only to parent’s share of subsidiary
(parent entity).
Note that these terminologies can sometimes vary between different
authors: For example, International financial reporting uses entity, parent/
proprietary and proportional instead of economic entity, parent entity and
proprietary. As long as you are clear about the conceptual distinctions and
variations in terminology, you will be able to understand any author.
Activity 16.4
What assumptions does each model make about its users? If you were a regulator in your
country, which model would appeal to you and why?
227
Activity 16.5
Parent P owns 80% of Subsidiary S. P issued £80 in new shares to fund the acquisition of
S. Prepare the consolidated accounts of the group using (i) the economic entity model; (ii)
the parent entity model; and (iii) the proprietary model.
£ £
P S
Assets
Net assets 500 100
500 100
Equity
Share capital 300 100
Retained earnings 200 0
500 100
16.5 Different types of relationships within a group

Based on the models above, we now proceed to understanding the
different methods by which we can account for business combinations
involving two or more companies.
16.5.1 Acquisition method

• Used to account for holding company (or parent) to subsidiary
relationships.
• The acquirer purchases the interests of the acquired company’s
shareholders (i.e. the absorption of the target into the clutches of
the predator – continuity is only for the holding company). This is
by far the most common method used to represent holding company
subsidiary relationships.
16.5.2 Merger or pooling of interest method

• Formerly used in accounting for combinations of equal entities.
• The two parties combine to create a new entity (i.e. the uniting of the
interests of two formerly distinct shareholder groups).
• Note that IFRS 3 has banned merger accounting since ‘the result of
nearly all business combinations is that one entity, the acquirer, obtains
control of one or more other businesses, the acquiree’ (para.4). This
aligns international GAAP with US accounting standards.
• Acquisition accounting is more common in the UK and this is described
below with worked examples of this approach. Merger accounting can
only be used when a strict set of conditions is met – for theoretical
interest (to be used for discussion only, not calculation), we include a
summary of differences between acquisition and merger accounting at
Section 18.2.8.
16.5.3 Equity method

• Typically used in group accounting for associates.
• Investment by the holding company into another company (that it has
a ‘significant influence’, but not control, over), typically its ‘associate’,
treated at cost and adjusted thereafter for share of profits.
228
16.5.4 Proportional method (see also Chapter 18)

• Formerly used in group accounting for joint ventures, now
discontinued.
• This method is derived from the proprietary model of accounting
for groups, where ‘a venturer’s share of each of the assets, liabilities,
income and expenses of a jointly controlled entity is combined line
by line with similar items in the venturer’s financial statements or
reported as separate line items in the venturer’s financial statements.’
(IAS 31, para.3).
• There are two methods:
• line-by-line: assets, liabilities, income and expenses are combined
with similar items on a line-by-line basis
• separate line items: share of assets, liabilities, income and
expenses of the jointly controlled entity are shown (i.e. each item
is separated into the accounts of the parent and joint venture
entity).
Note that both methods will give you the same final totals in the income
and expenditure (profit and loss) account and the statement of financial
position.
We will discuss the acquisition method in depth in this chapter, as it is
the main method used to account for subsidiaries. In the next chapter, we
will also examine the equity method as used in accounting for associates
and joint ventures. In Chapter 18, we will consider historical approaches
to group accounting such as the merger method and the proportional
method.
16.6 Accounting for subsidiaries

Acquisition accounting involves the aggregation of the individual accounts
of the holding company and its subsidiaries by adding together their
income statements and the statement of financial position figures on a line-
by-line basis (see Example 16.1 below). These aggregated figures are then
amended to deal with what are known as consolidation adjustments.
Such adjustments are necessary in order to achieve the consolidation by:
• recognising the date of acquisition (this has implications for how pre-
and post-acquisition profits are dealt with), and/or
• dealing with goodwill (see Examples 16.4a and 16.4b below), and/
or
• dealing with fair value adjustments (if required), and/or
• dealing with NCI (previously referred to as minority interest) (see
Examples 16.6a and 16.6b below), and/or
• adjusting individual figures of subsidiaries to bring them on to common
accounting policies, and/or 1
The cost of the
• eliminating intra-group transactions (see Examples 16.9 to investment (i.e. the
16.12b below). consideration paid) may
be any of (or a mixture
In order to account for the acquisition, the acquiring company must first of) (1) cash, (2) shares
measure the cost of what it is accounting for, which normally represents: of the acquirer at market
value, (3) other financial
• the cost of the investment1 in its own statement of financial position instruments such as
• the amount to be allocated between the identifiable net assets of the debentures, convertible
subsidiary in the consolidated accounts. bonds and deferred
shares.
229
Second, in allocating the cost of acquisition, the acquiring company

needs to identify the assets and liabilities of the subsidiary and attribute
fair values to them, rather than merely relying on the book values in the
subsidiary’s accounts.
Once fair values of both the consideration given and the net assets acquired
have been measured, the difference between the two represents purchased
goodwill (see also Chapter 13), which remains to be accounted for.
The best way to discuss acquisition accounting is to illustrate the main
points using a series of worked examples. A consolidated statement of
financial position will initially be considered, and in Chapter 17 we will
look at the consolidated group income statement.
16.6.1 Consolidated balance sheet with one subsidiary

In these examples, the statements of financial position of two companies,
the holding or parent company (H Ltd) and its subsidiary (S Ltd), are as
follows, as at 1 January 2011, before any transactions described below are
recorded:
H Ltd S Ltd
£ £
Non-current assets 6,000 2,400
Cash 4,000
10,000 2,400
£1 ordinary shares 9,000 2,000
Retained profits 1,000 400
10,000 2,400
Net assets 10,000 2,400
It is assumed at this stage, for reasons of simplicity, that the fair value of
the net assets of S is equal to their book value.
Example 16.1: Wholly owned subsidiary with no goodwill,

acquired using share issue
The first example involves the holding company purchasing 100% of the
subsidiary. (But remember that, for an entity to be classified as a subsidiary,
the acquiring company does not have to purchase all the shares.)
On 1 January 2011, H acquires all of the ordinary shares in S in exchange
for the issue of 600 new ordinary shares in H. The current value of each
ordinary share in H is £4.
One approach to preparing the consolidated statement of financial position
is to view the transaction as one where shares (in H) are issued to acquire
assets (of S). The transaction using the accounting equation method
(assets – liabilities = equity) is:
• increase value of H’s assets by net asset value of S
• increase value of H’s equity only by the corresponding amount.
H is issuing new shares worth £2,400 in order to acquire all of a company
whose net assets are worth £2,400. As the current value (£4.00) exceeds
the par value (£1.00), a share premium account is created: 600 shares ×
£1/share = £600 to the ordinary share account, and 600 shares × £(4 –
1 = 3) = £1,800 to share premium. This fund of £2,400 is then used to
acquire the net assets of S at £2,400, which are then reflected in the group
accounts.
230
H Ltd S Ltd CSFP

£ £ £
Non-current assets 6,000 2,400 8,400
Cash 4,000 4,000
10,000 2,400 12,400
£1 ordinary shares 9,000 2,000 9,600

Share premium 1,800
Retained profits 1,000 400 1,000
10,000 2,400 12,400
The consolidated statement of financial position for the group (CSFP)
is one where all the net assets (non-current assets and cash) are added
together line by line (non-current assets of H with S; cash of H with S),
which is ‘paid for’ by a corresponding increase in equity of H. Ordinary
shares have increased from £9,000 to £9,600 and share premium from £0
to £1,800. The equity side of the CSFP reflects the adjusted (if any) equity
of H (in this case ordinary shares and share premium were adjusted, but
retained profits of H remained the same). Note that you do not include
any equity (ordinary shares, share premium, retained profits, etc.) of S.

acquired using cash
Contrast this with the previous example whereby H uses its cash resources
instead of issuing new shares to acquire S (note: no adjustments to equity
compared to Example 16.1). Here, the CSFP reflects a deduction of cash of
£2,400 to pay for the acquired non-current assets of S.
H Ltd S Ltd CSFP
£ £ £
Cash 4,000 1,600
10,000 2,400 10,000
£1 ordinary shares 9,000 2,000 9,000

10,000 2,400 10,000

acquired using cash and shares
In this example, we consider the CBS whereby 50% of the acquisition is
paid for by cash and the rest by share issue. As consideration is £2,400,
therefore £1,200 cash is needed. In addition, 300 ordinary shares are
issued at a market value of £4 each, giving £1,200 towards the acquisition.
Share premium is £(4 – 1) × 300 shares = £900.
H Ltd S Ltd CSFP
£ £ £
Cash 4,000 2,800
10,000 2,400 11,200
£1 ordinary shares 9,000 2,000 9,300

Share premium 900
10,000 2,400 11,200
231
In all three examples, the equity of S is not included in the CSFP because
we view the consolidation from the vantage of H acquiring the net assets
of S.
In practice, life is not always as simple as the above example. Suppose
instead that the market price of H’s ordinary shares is £6 each rather
than £4 each. H is now issuing shares worth £3,600 (600 ordinary shares
× £6) to acquire a company whose net assets are worth only £2,400
(which equals their fair value). Consequently, we have to account for this
difference of £1,200 in the consolidated accounts, which is known as
purchased goodwill.
16.6.2 Acquiring goodwill

IFRS 3, para.51 states that ‘goodwill is recognised by the acquirer as an
asset from the acquisition date and is initially measured as the excess
of the cost of the business combination over the acquirer’s share of the
net fair values of the acquiree’s identifiable assets, liabilities and
contingent liabilities.’
This raises a number of questions:
• How can we determine fair values?
• What do we mean by identifiable? and
• How do we account for goodwill?
16.6.3 Fair values

The acquirer measures the cost of a business combination as the sum
of the fair values at the date of exchange rather than at their historical
cost. The exercise of restating assets and liabilities at their fair value is an
attempt to provide a realistic measurement of the assets and liabilities of
the acquired company that should be consolidated – in other words, to
account fairly for the acquisition transaction by asking what the acquiring
group has spent and what it has got for its money. IFRS 3 and IFRS 13
state that market price is the best evidence of fair value. However, if a
market price does not exist or is not considered reliable, other valuation
techniques are used to measure fair value (IFRS 3, para.27). IFRS 3 also
requires that fair values of identifiable assets and liabilities acquired on
acquisition should be determined by ‘reference to their intended use by the
acquirer’. IFRS 13 Fair value measurement defines fair value ‘on the basis of
an “exit price” notion and uses a “fair value hierarchy”, which results in a
market-based, rather than entity-specific, measurement’.
16.6.4 Identifiable assets and liabilities

IFRS 3, para.37 states:
[T]he acquirer recognises separately, at the acquisition date, the
acquiree’s identifiable assets, liabilities and contingent liabilities
that satisfy the following recognition criteria at that date, regardless
of whether they had been previously recognised in the acquiree’s
financial statements:
a. an asset other than an intangible asset is recognised if it is
probable that any associated future economic benefits will flow
to the acquirer, and its fair value can be measured reliably;
b. a liability other than a contingent liability is recognised if it is
probable that an outflow of resources will be required to settle
the obligation, and its fair value can be measured reliably; and
c. an intangible asset or a contingent liability is recognised if its
fair value can be measured reliably.
232
In the past, huge provisions, such as reorganisation provisions, had

been provided for at the time of acquisition. These provisions inflated
the amount of goodwill and also inflated subsequent years’ profit. Now
there are stricter limitations regarding those items which can be provided
for at the time of acquisition. Crucially, provisions for future losses/
reorganisation/integration and changes resulting from the acquirer’s
intentions or future actions cannot be accounted for as part of the fair
value exercise: ‘in applying the purchase method, an acquirer must not
recognise provisions for future losses or restructuring costs expected to be
incurred as a result of the business combination. These must be treated as
post-combination expenses’ (IFRS 3, para.41).
16.6.5 Accounting for goodwill

How we account for goodwill has been a subject on which widely differing
opinions are held. These were discussed in Chapter 13. IFRS 3 requires
goodwill acquired in a business combination to be recognised as an asset
from the acquisition date. Goodwill is calculated as the excess of the
purchase price paid over the fair value of net assets acquired. Goodwill
cannot be amortised; instead it should be tested annually for impairment
(or more frequently, if circumstances indicate that this is necessary – see
IAS 36 Impairment of assets), and may not be reversed in a subsequent
period. This is to ensure that period profits are not manipulated.
Example 16.4a: Wholly owned subsidiary with (positive) goodwill

Following the increase in H’s share price from £4 per share to £6 per share,
the acquisition of S will be reported in H’s balance sheet as follows:
Goodwill = price paid (shares issued) less fair value = £3,600 – £2,400 =
£1,200.
Share premium = £(6 – 1: market value less par) = £5 per share, or
£5 × 600 shares = £3,000.
H Ltd S Ltd CSFP
£ £ £
Goodwill 1,200
Cash 4,000 4,000
10,000 2,400 13,600
£1 ordinary shares 9,000 2,000 9,600

Share premium 3,000
10,000 2,400 13,600
Example 16.4b: Wholly owned subsidiary with (negative) goodwill

In some situations, goodwill may not be positive, but negative. This arises
when a discount is being given for the acquirer to take over the acquiree.
This discount could reflect potential future losses as a result of the
acquisition, or reflect the possibility that assets at the time of acquisition
may not be at fair value.
Assume that the consideration for S was £2,000, paid for by issuing 500
shares at £4 each. Share premium = £(4 – 1) × 500 shares = £1,500.
Goodwill (negative) = £2,000 – £2,400 = (£400) or –£400. Note that
the negative goodwill in this case is incorporated into the comprehensive
income statement, which means that the consolidated retained profit figure
= H retained profit + negative goodwill = £1,000 + £400 = £1,400.
233
H Ltd S Ltd CSFP

£ £ £
Cash 4,000 4,000
10,000 2,400 12,400
£1 ordinary shares 9,000 2,000 9,500

Share premium 1,500
10,000 2,400 12,400
Example 16.5: Wholly owned subsidiary with goodwill and fair

values
It is often the case that the book values of the assets of a company being
acquired are not equal to the current fair values of the assets. In such
circumstances, it is necessary under IFRS 3/IFRS 13 to revalue the assets
being acquired before including them on the CSFP.
Based on the information in Examples 16.4a and 16.4b, assume that
S’s net assets are £2,400 book value but £2,800 is fair value. Thus, H
is issuing shares worth £3,600 to acquire a company whose fair value
net assets are worth £2,800. Consequently, goodwill is now £800 (i.e.
difference between consideration and fair value; £3,600 – £2,800). The
acquisition of S will be reported in H’s statement of financial position
exactly as in Examples 16.4a and 16.4b, but the CSFP would be prepared
as follows:
H Ltd S Ltd CSFP
£ £ £
Goodwill 800
Cash 4,000 4,000
10,000 2,800 13,600
£1 ordinary shares 9,000 2,000 9,600

Share premium 3,000
Revaluation 400
10,000 2,800 13,600
Note: Any surpluses arising on revaluations of the subsidiary’s assets
subsequent to the acquisition are post-acquisition2 in the analysis of 2
See Example 16.8 for
the subsidiary’s equity, and the group share of the surplus will be shown further discussion of pre-
and post-acquisition
on the CSFP normally in consolidation revaluation surplus. In other words,
profits
if the revaluation took place following the acquisition (post-acquisition)
then this increase would be treated like any other revaluation (i.e. increase
the assets concerned and set up a revaluation surplus). Since in the above
example the revaluation took place prior to acquisition, this is regarded as
pre-acquisition and therefore needs to be eliminated on consolidation.
16.6.6 Depreciation of non-current assets with fair value

adjustment
A problem arises when the assets being revalued on acquisition are
depreciable, for example non-current assets with a limited useful life. In
these circumstances, depreciation in the consolidated income statement
must be based on the restated fair values, even though depreciation in the
subsidiary’s own accounts is based on existing book values. For example,
suppose that the subsidiary owns a five-year-old asset which had originally
234
cost £400 and is being fully depreciated over 10 years. At the time of
acquisition, the book value of the asset is £200, but its fair value is £300.
The asset will be depreciated in the consolidated income statement over
the remaining five years of its life at £60 each year, even though in the
subsidiary’s own accounts the depreciation is £40 each year.
16.6.7 Non-controlling interests (NCI)

What happens if H acquired less than 100% of S? If a subsidiary is not
wholly owned there will be a group of non-controlling interests (minority
shareholders) who are not a part of the group. Consolidation requires
that the entire subsidiary’s assets and liabilities should be included in the
group’s accounts because they are under the control of the directors of
the holding company, whether or not the holding company actually owns
100% of the share capital of the subsidiary.
IFRS 3 allows two methods for dealing with NCI in the CBS:
• Method 1: NCI’s proportionate share of net assets of the acquiree (i.e.
no goodwill in NCI).
• Method 2: NCI at fair value (full goodwill method).
Suppose that H buys only 75% of the ordinary shares in S in exchange for
500 ordinary shares in H, each worth £4. Seventy-five per cent interest
in net assets of S is worth £1,800 (75% of £2,400). The other 25% of the
shares in S are held by NCI, worth £600 (25% of £2,400). Since the CSFP
shows the total assets of H and S, it is necessary to show the NCI on the
CSFP so that the net interest of the shareholders of H may be identified.
Example 16.6a: Partially owned subsidiary – NCI (IFRS 3 Method 1)

Analysis of equity for S
Group NCI
Total 75% 25%
£1 ordinary shares 2,000 1,500 500
Retained profits 400 300 100
2,400 1,800 600
Consideration paid by H 2,000
Difference = goodwill 200
H Ltd S Ltd CSFP

£ £ £
Goodwill 200
Cash 4,000 4,000
10,000 2,400 12,600
£1 ordinary shares 9,000 2,000 9,500

Share premium 1,500
NCI 600
10,000 2,400 12,600
235
Example 16.6b: Partially owned subsidiary – NCI (IFRS 3 Method 2)

Suppose that H elects to measure the entire NCI stake at fair value =
£650 (as opposed to the £600, which was calculated as a proportion of S),
therefore goodwill is calculated:
Goodwill = consideration + fair value NCI less fair value net assets of S
Goodwill = 2,000 + 650 – 2,400 = 250
H Ltd S Ltd CSFP
£ £ £
Goodwill 250
Cash 4,000 4,000
10,000 2,400 12,650
£1 ordinary shares 9,000 2,000 9,500
Share premium 1,500
NCI 650
10,000 2,400 12,650
The fair value of the 25% NCI in S will not necessarily be proportionate to
the consideration paid by H for its 75%, primarily due to control premium
or discount (see IFRS 3, para.B45).
Example 16.7: Fair value adjustment with NCI

How are fair values adjusted when there is NCI? Any surplus or deficit
on revaluation must be divided between the group and the NCI in the
relevant proportions. Based on the information in Example 16.5, assume
that S’s fair value is £2,500 compared with its book value of £2,400. The
NCI would be calculated by preparing an analysis of equity for S exactly
as under Example 16.5, but we would also need to make the fair value
adjustment of £100 (£2,500 – £2,400).
Group NCI
Total 75% 25%
Retained profits 400 300 100
2,400 1,800 600
Fair value adjustment 100 75 25
Consideration paid by H 2,500 1,875 625
2,000
Difference = goodwill
125
H Ltd S Ltd CSFP

£ £ £
Goodwill 125
Cash 4,000 4,000
10,000 2,500 12,625
£1 ordinary shares 9,000 2,000 9,500

Share premium 1,500
Revaluation 100
NCI 625
10,000 2,500 12,625
236
Example 16.8: Distinction between pre- and post-acquisition

profits
A distinction is made between pre- and post-acquisition profits because
the holding company is not entitled to the share of the subsidiary’s pre-
acquisition profits. Instead, this profit is treated in the calculation of
goodwill (i.e. capitalised) while post-acquisition profits are incorporated
into the group’s profit.
Given the information in Example 16.6a and assuming we are now at the
end of the year (i.e. on 31 December 2011), we are told that during 2011 H
makes profits of £800 cash and S makes £600 cash profits, both represented
by increased net assets. No dividends were paid. Since we are one year on
from the date of acquisition, the consolidated statement of financial position
as at 31 December 2011 must include the group’s total retained profits.
The group’s retained profit will therefore include the total holding
company’s retained profits and a percentage of the post-acquisition
retained profits of the subsidiary. The percentage will be determined by
the percentage of ownership (i.e. in this case 75%). Similarly, minority
shareholders are also entitled to their share of the subsidiaries’ retained
profits (25%).
On consolidation, since H’s share of the post-acquisition profits of S may
be included in the group’s retained profits shown in the CSFP, we may use
an extended form of the analysis of equity for S to show this.
Group 75% NCI
£ £ £ £
Total Pre-acq Post-acq 25%
Retained profits
Pre-acq 400 300 100
Post-acq 600 450 150
3,000 1,800 450 750
Consideration paid by H 2,000
Difference = goodwill 200
1/1/11 1/1/11 31/12/11 31/12/11 31/12/11

H Ltd S Ltd H Ltd S Ltd CSFP
£ £ £ £ £
Non-current assets 6,000 2,400 6,000 2,400 8,400
Goodwill 200
Investment in S 2000
Cash 4,000 4,800 600 5,400
10,000 2,400 12,800 3,000 14,000
£1 ordinary shares 9,000 2,000 9,500 2,000 9,500

Share premium 1,500 1,500
Retained profits 1,000 400 1,800 1,000 2,250
NCI 750
10,000 2,400 12,800 3,000 14,000
237
The group’s retained profit is calculated as follows:

H’s profit at the start of the year (1/1/11) + H’s profit for year ended
31/12/11 + H’s share of S’s profits for year ended 31/12/11 = £1,000 +
£800 + (75% × £600 = £450) = £2,250
16.6.8 Inter-company transactions: consolidated statement of

financial position
It frequently happens that one company in a group will be in a trading
relationship with another, or may pay expenses on behalf of another
company. As a result, one company in a group may be a trade or other
receivable or a trade or other payable of another company. It is usual
practice in a CSFP to show only those group account receivables or
account payables arising in respect of third parties outside the group.
Accounting standards require that inter-company transactions be
eliminated in full. Consequently, these are set off against each other and
eliminated on consolidation.
Example 16.9: Reconciliation of inter-company transactions

Below is an extract of net assets from the balance sheets of H and S.
H Ltd S Ltd Netting-off CSFP
£ £ £ £
Balance due from S 2,000 (2,000)
Other receivables 10,000 6,000 16,000
Cash at bank 4,000 2,000 6,000
16,000 8,000 22,000
Balance due to H 2,000 (2,000)

Other payables 5,400 3,200 8,600
5,400 5,200 8,600
Net assets 10,600 2,800 13,400
On consolidation the balance due from S in H’s statement of financial
position is set off against the balance due to H in S’s statement of financial
position, leaving the above assets and liabilities to be included in the CSFP.
The same netting-off treatment is followed when one of the companies in
a group has made a loan to another company in the group. For example,
if S had issued £5,000 of debentures, of which H held £3,500, the CBS
would show only the £1,500 of debentures held outside the group as a
liability. Since, presumably, interest is being paid on the £3,500 debenture,
this would also have to be cancelled (i.e. interest income and interest
expense would offset one another (examples to follow)). What happens
when the balances don’t net off?
16.6.9 Cash in transit

Occasionally, the inter-company accounts do not exactly cancel out,
because items may have been included in one company’s books but not in
those of the other company. Suppose that the net assets of H and S at 31
December 2011 are now as follows.
238
Example 16.10: Reconciliation of cash in transit

H Ltd S Ltd
£ £
Balance due from S 2,000
Other receivables 10,000 6,000
Cash at bank 4,000 2,000
16,000 8,000
Balance due to H 1,000

Other payables 5,400 3,200
5,400 4,200
Net assets 10,600 3,800
The balance due to H shown in S’s account is lower than the balance due
from S shown in H’s accounts because S had sent a cheque for £1,000 to
H on the last day of the year, but H had not yet received the cheque and
therefore could not reflect this receipt in its accounts until the cheque was
received after the year-end. The £1,000 is called cash in transit and is a
group asset, even though it does not appear in either of the companies’
statement of financial position. By including the cash in transit, it is
possible to eliminate the inter-company accounts on consolidation.
The consolidated accounts of the group will include this cash in transit in
the CSFP.
Cash in
H Ltd S Ltd Netting-off CSFP
transit
£ £ £ £ £
Balance due from S 2,000 (1,000) (1,000)
Other receivables 10,000 6,000 16,000
Cash at bank 4,000 1,000 5,000
Cash in transit 1,000 1,000
16,000 7,000 22,000
Balance due to H 1,000 (1,000)

Other creditors 5,400 3,200 8,600
5,400 4,200 8,600
Net assets 10,600 2,800 13,400
Example 16.11: Intra-group sales at cost price

One of the objectives of consolidation is to show the transactions of the
group as a single economic entity. To achieve this, transactions entirely
within the group have to be eliminated, so that only those transactions
with third parties are shown. Usually, we simply have to cancel out an
income item against an expense item, while the group profit is unaffected.
We reuse Example 16.6a, but add the following. Assume H sold goods to S
at cost for £300. H will keep a current account of S (receivable) and S will
also have a corresponding account for H (payable).
239
H Ltd S Ltd CSFP

£ £ £
Current account S 300
Current account H (300)
Goodwill 200
Cash 4,000 4,000
10,000 2,400 12,600
£1 ordinary shares 9,000 2,000 9,500

Share premium 1,500
NCI 600
10,000 2,400 12,600
Note that when H sold goods to S, non-current assets were credited by
£300 and current account of S debited by £300 (see also corresponding
transactions for S). However, in the CSFP, current accounts are eliminated,
and the CSFP here is exactly the same as in Example 16.6a. The same
principle applies for when S sells goods at cost to H. The following
Examples 16.12a and b consider situations where there is an unrealised
profit element to the transaction.
16.6.10 Unrealised profits

The most difficult aspect of inter-company transactions occurs when there
has been a profit (or loss) recorded on the transaction. For example, one
company in a group might sell goods to another company within the group
and record a profit on sale. In the group’s accounts, profits are recognised
only on sales outside the group (i.e. only transactions with third parties).
Profits made on transactions entirely within the group have to be
eliminated. The reason for making such eliminations is straightforward:
‘no person can make a profit by trading with themselves’ and when a
group is trying to present its results as if it were a single entity, it clearly
must not regard internal transactions as giving rise to a realised profit.
Example 16.12a: Intra-group sales with unrealised profit – H sells

to S (downstream)
Assume H owns 75% of S, and sold goods to S at £300, where £100 is (the
unrealised) profit and £200 cost of goods sold. These goods remained in
stock at S at the year-end. As the group’s profit and inventory figures are
overstated, they need to be adjusted.
The group’s inventory is reduced by the value of unrealised profit £(800 +
300 – 100 = 1,000) and retained profits reduced correspondingly by the
same amount £(1,100 – 100 = 1,000).
H Ltd S Ltd CSFP
£ £ £
Other non-current assets 5,000 2,000 7,000
Inventory 800 300 1,000
Goodwill 200
Cash 4,300 100 4,400
10,100 2,400 12,600
240
£1 ordinary shares 9,000 2,000 9,500

Share premium 1,500
NCI 600
10,100 2,400 12,600
In Example 16.12a, note that the subsidiary S is not wholly owned, but
there were no issues with NCI so far as H sold to S, and the adjustments
were to reduce group inventory and group retained profits. However, an
issue arises when S is the company which makes a profit by selling goods
to H. Since S is owned not only by the holding company but also by NCI,
any unrealised profit from this sale needs to be eliminated from both the
group’s retained profits and also from the NCI element. The whole amount
of unrealised profit must be eliminated and the adjustment be apportioned
between the majority and minority interests in proportion to their holdings
in the selling company.
Example 16.12b: Intra-group sales with unrealised profit – S sells

to H (upstream)
Assume H owns 75% of S, and S sold goods to H at £300, where £100 is
(the unrealised) profit and £200 cost of goods sold. These goods remained
in stock at H at the year-end. As the group’s profit and inventory figures
are overstated, they need to be adjusted.
H Ltd S Ltd CSFP
£ £ £
Other non-current assets 5,000 2,000 7,000
Inventory 800 300 1,000
Goodwill 200
Cash 4,300 100 4,400
10,100 2,400 12,600
£1 ordinary shares 9,000 2,000 9,500

Share premium 1,500
NCI 575
10,100 2,400 12,600
The group’s inventory is reduced by the value of unrealised profit £(800
+ 300 – 100 = 1,000) but group retained profits reduced by its share of
75% of S’s unrealised profit £(1,100 – (75% × 100) = 1,025). NCI is also
reduced correspondingly £(600 – (25% × 100) = 575).
16.6.11 Dividends paid from pre-acquisition profits

These might be more aptly described as dividends paid with pre-
acquisition assets. When a subsidiary pays a dividend using assets
(normally cash) that have been accumulated before the day of acquisition,
it is in effect returning to the holding company some of the assets that the
holding company in substance acquired when it bought the shares in the
subsidiary. Accountants therefore regard such a dividend paid out of pre-
acquisition profits as a partial return of the holding company’s investment
in the subsidiary.
In the holding company’s accounts, dividends paid out of pre-acquisition
profits are credited to the investment in subsidiary account, thus reducing
the amount at which the investment in the subsidiary is carried in the
241
holding company’s accounts. In the analysis of equity for the subsidiary,

the dividends are deducted from the pre-acquisition reserves of the
subsidiary. The net effect on goodwill is zero because the same amount is
deducted from the consideration paid and the fair value of assets acquired.
When goodwill on consolidation is calculated by deducting the written-
down cost of the investment from the written-down pre-acquisition capital
and reserves of the subsidiary, the figure for goodwill originally calculated
at the time of the acquisition still remains.
Dividends out of pre-acquisition profits are not common, but might arise
when a newly acquired subsidiary has declared a final dividend out of
profits of the year prior to that in which the acquisition takes place, or
when a subsidiary is acquired part-way through the year.
16.6.12 Consistent accounting policies

Group accounts should be prepared on consistent accounting policies. This
is normally achieved by changing the accounting policies of the subsidiary
so as to conform to those of the holding company (in the largest groups
there will be a manual of group accounting policies and practices to
which all subsidiaries must conform). Sometimes, however, subsidiaries
must draw their accounts up using policies inconsistent with those of the
holding company. This is particularly the case for overseas subsidiaries,
which must comply with the law and accounting practices of the countries
in which they are based, and these might differ from those of the holding
company’s country. Where the accounts of a subsidiary are drawn up on
a basis inconsistent with those of the holding company, adjustments must
be made on consolidation to bring the subsidiary’s accounts into line with
those of the holding company.
16.6.13 Consolidated statement of financial position with more

than one subsidiary
All of the above principles apply, but calculations have to be separately
performed for each subsidiary before being combined together for the
consolidation.
Example 16.13: Consolidation with two subsidiaries

Assume the following balance sheets below and where H controls 75%
of S1 and 80% of S2, and paid £2,000 for S1 and £3,000 for S2 from the
issue of 1,250 ordinary (£1) shares at £4 per share (500 shares for S1 and
750 shares for S2). Share premium is £(3 × 500 = 1,500) for S1 and £(3
× 750 = 2,250) for S2. NCI is £(25% × 2,400 = 600) for S1 and £(20%
× 3,600 = 720) for S2. Goodwill is £200 (S1) + £120 (S2) = £320.

S1 S2
Group NCI Group NCI
Total 75% 25% Total 80% 20%
£ £ £ £ £ £
£1 ordinary shares 2,000 1,500 500 3,000 2,400 600
Retained profits 400 300 100 600 480 120
2,400 1,800 600 3,600 2,880 720
Consideration paid by H 2,000 3,000
Difference = goodwill 200 120
Shares issued (number) 500 750
242
H Ltd S1 S2 CSFP
£ £ £ £
Non-current assets 6,000 2,400 3,600 12,000
Goodwill 320
Cash 4,000 4,000
10,000 2,400 3,600 16,320
£1 ordinary shares 9,000 2,000 3.;000 10,250

Share premium 3,750
Retained profits 1,000 400 600 1,000
NCI 1.320
10,000 2,400 3,600 16,320
16.6.14 Treatment of bonds acquired

Consider how the consolidation of bonds is treated between the parent
and subsidiary. We use the example of Question 1 from the AC2091 exam
paper (Zone A, 2019).
Example 16.14
The statements of financial position for Hi Plc, Fi Ltd and Ti Ltd as at 31
December 2018 are given below:
Hi Plc Fi Ltd Ti Ltd

£ £ £
Non-current assets (land) 870,000 2,850,000 2,100,000
Investments 4,200,000 – –
Inventory 300,000 600,000 1,500,000
Trade receivables 750,000 1,050,000 240,000
Receivable from Fi Ltd 120,000 – 360,000
Receivable from Ti Ltd 240,000 – –
Cash 210,000 210,000 270,000
Total assets 6,690,000 4,710,000 4,470,000
Share capital 3,000,000 900,000 600,000

Retained earnings reserve 2,070,000 2,610,000 3,000,000
Trade payables 1,620,000 780,000 630,000
Payable to Hi – 120,000 240,000
8% Bonds – 300,000 –
Capital, reserves and liabilities 6,690,000 4,710,000 4,470,000
Hi Plc acquired 75% of Fi Ltd on 1 January 2015 for £2,505,000, gaining

significant influence over Fi Ltd. Fi Ltd’s share capital and reserves were
£960,000 on 1 January 2015. The fair value of Fi Ltd’s non-current assets
on 1 January 2015 was £3,630,000 and this revaluation has not been
incorporated into Fi Ltd’s accounts.
At the same time, Hi Plc acquired 10% of the bonds in Fi Ltd for £30,000.
No goodwill arose on this transaction.
Bond interest payable by Fi Ltd for 2018 is outstanding as at 31 December
2018. The bond interest payable by Fi Ltd and interest receivable by Hi Plc
has not been accounted for as at 31 December 2018.
Hi Plc acquired 40% of Ti Ltd on 1 January 2011 for £1,200,000, gaining
partial influence over Ti Ltd. Ti Ltd’s share capital and reserves were
£900,000 on this date.
243
Hi Plc’s policy is to capitalise goodwill. Impairment of 50% of all goodwill

is seen in 2018.
In 2018, Hi Plc’s inventory includes inventory acquired from Fi Ltd for
£50,000 which had cost Fi Ltd £30,000 and inventory from Ti Ltd for
£100,000 which had cost Ti Ltd £10,000.
Required:
Prepare the consolidated statement of financial position for Hi Plc as at 31
December 2018.
The parent (P) company’s (Hi Plc) 8% bonds = £0
The subsidiary’s (S; Fi Ltd) 8% bonds = £300,000
P acquired 10% of S bonds for £30,000 with no goodwill arising.
On consolidation:
Non-current assets of the group:
Credit Investments £30,000 (for Investments to reflect the net position
of the group’s external investments only)
Non-current liability:
Debit the subsidiary’s bond holding by £30,000 (to reflect the parent’s
10% ownership)
Current liability and retained earnings adjustment:
The subsidiary’s bond interest of (8% x £300,000 = £24,000) should
be adjusted for the parent’s share of 10% (10% x £24,000 = £2,400).
Credit the group’s (i.e. parent’s) interest receivable of £2,400 in retained
earnings.
Debit the group’s (i.e. subsidiary’s) interest payable of £2,400 in current
liability.
Consolidated statement of financial position
£ Workings £000s
Non-current assets – land 4,500,000 870 + 3,630
Investments 465,000 4,200 – 2,505 –1,200 – 30
Goodwill 600,000
Share in A 1,824,000
Investories 880,000 300 + 600 – 20

Trade receivables 1,800,000 750 + 1,050
Interco receivables from A 240,000
Cash 420,000 210 + 210
10,729,000
3,000,000
Share capital 3,975900
Ret earnings 1,061,500
NCI 2,400,000 1,620 + 780
payables 21,600 24 – 2.4
interest payable 270,000 300 – 30
Bonds 10,729,000
244
Workings:
Goodwill
S = £2,505,000 − 75%(£960,000 + £780,000) = £1,200,000.
A = £1,200,000 − 40%(£900,000) = £840,000.
Goodwill S = £600,000.
Impairment S = 50% × £1,200,000 = £600,000.
Impairment A = 50% × £840,000 = £420,000.
Net assets or H S A
equity and
reserves
£ £ £
Ret earnings 2,070,000 2,610,000 3,000,000
Purp (20,000) (90,000)
Interest payable (24,000)
Interest receivable 2,400
Revised ret earnings 2,072,400 2,566,000 2,910,000

Share cap 3,000,000 900,000 600,000
Revaln 780,000
Net assets 5,072,400 4,246,000 3,510,000
Interest payable by S = £300,000 × 0.08 = £24,000.

Interest receivable by H = £24,000 × 10% = £2,400.
Ret earnings = £2,072,400 + 75%(£2,566,000 − £60,000)
+ 40%(£2,910,000 − £300,000) − £600,000 −£420,000
= £2,072,400+£1,879,500+£1,044,000 −£600,000 −£420,000
= £3,975,900.
NCI = £4,246,000 × 25% = £1,061,500.
Share in A = £1,200,000 + 40%(£2,910,000 − £300,000) − £420,000
= £1,824,000.
Alternative workings and presentation are acceptable.
16.7 Discussion
Now that we have (hopefully!) mastered the core techniques of
consolidation, we return to our conceptual discussion focusing on the
way in which different models were developed to account for groups of
companies.
To recap: the ‘economic entity method’ is concerned with H as a whole,
and treats NCI as if it were part of equity (shareholding). The ‘parent
entity method’ treats NCI as if it were a liability – this is because its main
concern is to show the relationship between equity and net assets of
the business. The ‘proprietary method’ does not include any NCI in the
calculations, but only includes the proportion of net assets that H owns/
controls in the consolidation. Differences in the value of the CSFP arise
between these methods when H acquires less than 100% of S.
245
Example 16.15: Comparing different methods of consolidating

a subsidiary
H acquires 80% of S for £2,100, when NBV of S’s net assets is £2,400 and
FV is £2,600. The statement of financial position for H and S (along with
CSFP using the different models of consolidation we have come across –
economic entity, parent entity and proprietary) are as follows.
In this example, the parent entity approach can be sub-divided into two
different methods, depending on whether NCI is valued at FV or NBV.
The latter argues that from the perspective of the ‘parent’ company H, the
parent is only concerned with reflecting the impact of FV on the parent’s
share of S, not the NCI’s share of S (as the NCI is not the responsibility of
the parent). The FV approach introduces consistency and avoids having
mixed valuations on the CSFP.
Models of CSFP A B C D E
Economic Parent Parent Proprietary IFRS 3
NBV NBV NCI at FV NCI at NBV
H Ltd S Ltd CSFP CSFP CSFP CSFP CSFP
£ £ £ £ £ £ £
Non-current assets 6,000 2,400 8,600 8,600 8,560 8,080 8,600
Investment in S 2,100 - - - - - -
Goodwill - - 25 20 20 20 20
Cash 1,900 - 1,900 1,900 1,900 1,900 1,900
(Liability): NCI - - - (520) (480) - -
10,000 2,400 10,525 10,000 10,000 10,000 10,520
£1 ordinary shares 9,000 2,000 9,000 9,000 9,000 9,000 9,000

Retained profits 1,000 400 1,000 1,000 1,000 1,000 1,000
NCI - - 525 - - - 520
10,000 2,400 10,525 10,000 10,000 10,000 10,520
Model A: economic entity approach

The workings for goodwill and calculation of net assets are as follows:
£ £
Investment in S (80%) 2,100

100% implied value of S (100/80 × 2,100) 2,625
FV net assets of S 2,600
Goodwill 25
NCI’s share of goodwill (20%) 5
246
£ £
NCI (20% × £2,625) 525
Recap that the economic entity approach treats the NCI as if it were
another shareholder in the group, and therefore considers the entire
fair value of S’s net assets as part of the group. The emphasis here is on
showing how the entire entity’s assets are utilised and funded.
Model B: parent entity approach, NCI at FV

£ £

80% FV net assets of S 2,080 2,080
Goodwill 20
NCI calculation 520
The parent entity approach only considers the share of S’s net assets that
are within control of the group, and the perspective means that some of
the goodwill attributable to NCI is not represented on the CSFP, unlike in
the economic entity approach.
Model C: parent entity approach, NCI at NBV

£ £ £ £
NBV FV NBV CBS
100% H 80% S 20% S
a b c =a+b+c
Calculation of non-current assets 6,000 2,080 480 8,560
NCI at NBV (20% × 2,400) 480
The NCI at NBV approach takes the parent perspective more strictly, by
removing all increases in FV attributed to the NCI in representing the
consolidated non-current assets on the CSFP.
£ £
Goodwill 20
Model D: proprietary approach

£ £ £
NBV FV CSFP
100% H 80% S
Calculation of non-current assets 6,000 2,080 8,080
80% Investment in S 2,100

247
£ £ £
NBV FV CSFP
Goodwill 20
We see that the proprietary entity only shows the proportion of S’s net
assets controlled, completely removing NCI.
Model E: current (hybrid/mixed) approach, IFRS 3

Finally, we reiterate a point made earlier that the current standard, IFRS
3, is a hybrid/mixed concept as it incorporates elements from both the
economic entity and parent entity models. The workings are as follows.
NCI shown in the equity section of the statement of financial position
(economic entity)
Goodwill on consolidation relates only to parent’s share of subsidiary
(parent entity)
£ £

Goodwill 20
NCI (20% × £2,600) 520
To conclude, we can see that the value of net assets varies across the
different methods, depending on whether the method allocates the full
value of goodwill to the CSFP.

• explain how different non-current asset investments are distinguished
and accounted for
• describe a ‘group’
• be aware of the main ideas underpinning the now disallowed merger
method
• explain why the definition of a subsidiary is important
• prepare consolidated accounts (statement of financial position and
profit and loss or income statements) using the acquisition method
• compute the value of goodwill and non-controlling (minority) interest
between pre- and post- transaction profits/income in consolidated
accounts.
16.9 Sample examination question
248
Question 16.1
Widget Plc is a long-established widget company. In 2011, Widget made
an offer for the share capital of Gidget Plc, one of its competitors. Widget’s
offer was accepted by Gidget’s shareholders and became unconditional on
1 July 2011, when Widget issued one of its ordinary shares in exchange
for every two ordinary shares in Gidget. Widget took advantage of the
merger relief provisions in its own accounts. Following the transaction, the
businesses of the two companies remained within their existing corporate
entities, but Widget was renamed ‘Widget-Gidget Plc’ to reflect the
business combination.
The summarised financial statements of Widget Plc (from 1 July 2011,
Widget-Gidget plc) and Gidget Plc for 2011 with comparative figures for
2010 are as follows.
Widget Gidget
2011 2010 2011 2010
£m £m £m £m
Statement of financial
positions
Tangible non-current assets 840 780 460 420
Investment in Gidget 80 – – –
920 780 460 420
Net current assets 160 140 120 80
1,080 920 580 500
Loan capital 200 200 160 160
880 720 420 340
Ordinary shares of £1 480 400 160 160
Income statement 400 320 260 180
880 720 420 340
Income statements
Sales 2,540 1,960 1,520 1,380
Cost of sales 1,420 1,080 840 760
Gross profit 1,120 880 680 620
Other expenses 820 600 520 584
Profit before taxation 300 280 160 36
Taxation 100 120 80 12
Profit for the financial year 200 160 80 24
Extract from the statement

of Changes in Equity
Profit for the financial year 200 160 80 24
Dividends 120 100 – 8
80 60 80 16
The following information is relevant:
1. The fair value of the tangible non-current assets of Gidget at 1 July
2011 exceeded book value by £140 million. The book value of other
assets and liabilities can be assumed to equal their fair value at that
date.
2. The effect of basing depreciation on the fair value of the assets of
249
Gidget rather than their existing book value would be to increase the
depreciation charge in a six-month period by £8 million.
3. The market price of the ordinary shares in the companies on the
following dates was:
Widget Gidget
31 December 2010 £9.00 £1.50
1 July 2011 £9.50 £4.75
31 December 2011 £13.50 N/A
4. In the financial statements for 2010, the reported figures for earnings
per share of the companies were: Widget 40p, Gidget 15p.
Prepare summarised consolidated statements for Widget-Gidget Plc for
2011 using acquisition accounting.
250
Chapter 17: Accounting for groups: consolidated income statement, associates and joint ventures

consolidated income statement,
associates and joint ventures
17.1 Introduction
This chapter builds on Chapter 16 and considers how to construct the
consolidated income statement between two or more entities. It also
considers other types of group combinations, such as associates and joint
ventures. Throughout the chapter, guidance will be given as to how to
apply these accounting techniques. We will also consider the effect on the
accounts of employing these different approaches, including the effect on
the perception of users of financial statements.

• describe associates and joint ventures and how to account for them in
consolidation
• prepare consolidated accounts (statement of financial positions and
income statements) using the equity methods
• compute the value of goodwill and non-controlling interest
accounts.

International financial reporting, Chapters 27, 28 and 29.


IFRS 10 Consolidated financial statements.
IFRS 11 Joint arrangements (revised 2016, replacing IAS 31 Interests in joint
ventures).
IFRS 12 Disclosure of interests in other entities
IAS 28 Investments in associates and joint ventures (revised 2011).
251
17.2 Consolidated income statement

Assume that the income statements for H and S (see Chapter 16) for the
year ended 31 December 20x1 are:
H Ltd S Ltd
£ £ £ £
Sales 3,600 2,400
Cost of Sales: Opening inventory 200 300
Purchases 2,200 1,300
2,400 1,600
Closing inventory 400 2,000 200 1,400
Gross profit 1,600 1,000
Expenses 600 300
Profit on ordinary activities before taxation 1,000 700
Taxation 400 300
Profit for the financial year 600 400
Example 17.1: Wholly owned subsidiary: subsidiary owned

throughout the year
The consolidated income statement (CIS) is a line-by-line addition of the
income statements of the holding company and subsidiaries. With the
figures above (but assuming goodwill of £400), assuming S is a wholly
owned subsidiary of H throughout the year, the CIS will be:
H Ltd S Ltd CIS

£ £ £ £ £ £
Sales 3,600 2,400 6,000
Cost of sales: 200 300 500
Opening inventories
Purchases 2,200 1,300 3,500
2,400 1,600 4,000
Closing inventories 400 2,000 200 1,400 600 3,400
Gross profit 1,600 1,000 2,600
Expenses 600 300 900
Profit on ordinary
activities before tax 1,000 700 1,700
Taxation 400 300 700
Profit for the financial 600 400
1,000
year
Note that the line-by-line addition goes down only to the profit for the
financial year. In the statement of changes in equity (SoCE), where
previous years’ retained profits are accumulated with the current year’s
it is dangerous to add together the figures for retained profits brought
forward, as it is likely that some of the subsidiary’s retained profits are
pre-acquisition. Only post-acquisition profits may be included in group
retained profits brought forward.
For example, if S had been acquired by H on the first day of the financial
year, S’s entire retained profits brought forward of £400 would be pre-
acquisition1, and the SoCE would show retained profits carried forward at 1
Remember that
the end of the year of £2,000 being: pre-acquisition reserves
are included in the
Group profits for the year as above £1,000 analysis of equity for S
for the determination of
Retained profits brought forward (=H’s retained profits) £1,000
goodwill.
Group retained profits carried forward £2,000
252
Example 17.2: Wholly owned subsidiary: subsidiary acquired

during the year
It is vitally important that we know the effective date of acquisition (‘date
of exchange’), especially when we construct the CIS, since the CIS only
includes the results of the new subsidiary from the date of exchange. This
means that it is necessary to apportion the subsidiary’s income statement
between pre- and post-acquisition periods. In practice, interim accounts up
to the date of acquisition are often prepared, but, if this is not done, the
apportionment will normally be done on a time basis.
Suppose that H acquires S on 30 June 20x1. The CIS for the year ended
31 December 20x1 will include all of H’s results but only half of S’s results
(assuming that the income and expenses occurred evenly throughout the
year, which would allow for the S’s sales to be time-apportioned), on a
line-by-line basis:
H Ltd S Ltd CIS
£ £ £ £ £
Sales 3,600 2,400 4,800
Cost of sales:
Opening inventories 200 300
2,400 1,600
Closing inventories 400 2,000 200 1,400 2,700
Gross profit 1,600 1,000 2,100
Profit on ordinary activities
before tax 1,000 700 1,350
Profit for the financial year 600 400 800
We can check that the profit for the financial year is correct since it must
equal the total profit for the year for H plus half of the profit for the year
for S. Therefore:
£
Profit for the year for H 600
Six months of S’s profit for the year 200
800
In preparing an analysis of S’s equity to determine any goodwill arising
on consolidation, it is necessary to reflect in the calculations that S has
been acquired part-way through the year, by including the appropriate
proportion of S’s profits arising during the year of acquisition, up to the
effective date of acquisition, as pre-acquisition profits.
Example 17.3: Partially owned subsidiary

Where the holding company owns less than 100% of a subsidiary, we
still consolidate the results of the subsidiary in full on a line-by-line basis
(similar to the construction of the balance sheet following the control
concept). But we then show the NCI in the CIS, equal to the non-controlling
share of the subsidiary’s result after taxation for the year. Why is this the
case? You should relate your answer to concepts learnt from Chapter 16,
specifically the economic, parent and proprietary approach to consolidation.
253
Suppose that H owns 60% of the ordinary shares of S, which has been a
subsidiary throughout the year. Then the NCI in S’s results after taxation is
40% × £400 = £160 (the £400 being S’s profit for the year ending
31 December 20x1).
H Ltd S Ltd CIS
£ £ £ £ £ £
Sales 3,600 2,400 6,000
Cost of sales:
Opening inventories 200 300 500
Purchases 2,200 1,300 3,500
2,400 1,600 4,000
Closing inventories 400 2,000 200 1,400 600 3,400
Gross profit 1,600 1,000 2,600
Profit on ordinary activities
before tax 1,000 700 1,700
Profit for the financial year 600 400 1,000
Non-controlling interest (NCI) 160
Profit for the year attributable to shareholders in H Ltd 840
If a holding company acquires a majority interest in a subsidiary part-way

through the year, it is necessary first of all to apportion the results of the
subsidiary between the pre-acquisition and post-acquisition periods. The
NCI is then calculated from the post-acquisition amounts.
Example 17.4: Intra-group transactions: income and expenses

Assume that the holding company makes a management charge of £200 to
the subsidiary S. H will have an income item of £200 and an expense item
of £200. On consolidation, these are simply eliminated against each other.
Activity 17.1
Why is there a need to eliminate income from, and expenses to, companies within the group?
Similarly, if H sold goods to S for £200 which had originally cost £100,
and then S sold them to a third party for £300 then we need to eliminate
the inter-company sale of £200 and the purchase of £200 (because we
only want to reflect the original cost to the group and the subsequent sale
outside the group). Otherwise, we would overstate the purchases and sales
of the group – although, as you will notice in the example below, this does
not affect the total group’s gross profit.
Extract from CIS

H Ltd S Ltd ADD ELIM CIS
Sales 200 300 500 (200) 300
Cost of sales
Purchases 100 200 300 (200) 100
Gross profit 100 100 200 200
17.3 Dividends
A somewhat more complicated situation arises when a subsidiary pays a
dividend to the holding company. This dividend, being inside the group,
must be eliminated. Where the dividend is paid during the year, and
254
credited by the holding company, no problem arises, as there is an income

item in the holding company against which the dividend in the subsidiary’s
accounts may be eliminated.
The situation of ‘proposed dividends’ has been simplified with the
implementation of IAS 10 Events after the reporting period. This removes
the requirement to report dividends proposed after the statement of
financial position date in the income statement. Instead, IAS 10 requires
disclosure in the notes to the accounts. Consequently, dividends declared
after the statement of financial position date (e.g. declared on 5 January
for a year end date of 31 December) should not be recorded as a liability
in the statement of financial position but disclosed. Prior to IAS 10, the
usual practice in the CIS was to assume that the dividend had not been
proposed and to increase the subsidiary’s retained profits accordingly.
This procedure ensured that any proposed dividend payable to minority
shareholders was reflected in the non-controlling interest on the CSFP.
(Special problems arise when a subsidiary pays a dividend out of pre-
acquisition profits, and these are dealt with in Section 16.6.11.)
Example 17.5: Intra-group transactions: unrealised profits

In the following example, H sells inventory to S for £200 which originally
cost £100. S then sells it to a third party for £300. In this case there is no
unrealised profit since all the inventory sold to S by H has been sold on to
a third party outside the group. The group has made a profit of £200, that
is, H made a profit of £100 by selling to S and S made a profit of £100 by
selling to a third party; or, conversely, the inventory cost the group £100
and the group sold it to a third party for £300 – see extract of CIS below.
However, if any of the goods involved in inter-company trading remain
as inventory at the end of the year (i.e. are still within the group), it
will be necessary to state them in the CSFP at original cost to the group,
excluding any element of inter-company unrealised profit. This involves
writing down the value of the inventory held by one company within the
group at the year-end which has been purchased from another group
company which has made a profit on the deal. The adjusting entry is
simply to remove the profit element from the inventory valuation and from
the balance on the consolidated income statement. This will result in the
inventory being stated at its cost to the group.
H sells inventory to S for £200 which originally cost £100. S still holds the
inventory at the year-end. In this case there is only a transaction within
the group as the inventory has not been sold to a third party. Therefore,
we need to remove the unrealised profit of £100 (i.e. H’s profit on the sale
to S). The corresponding entry is to remove this unrealised profit element
from the inventory so we show inventory at the cost to the group (i.e.
£100). We adjust the value of inventory in the CSFP and the CIS.
H Ltd S Ltd Add Deduct CIS
£ £ £ £ £
Sales 200 0 200 200 0
Cost of sales
Purchases 100 200 300 200 100
Closing inventory 0 200 200 100 100
100 0 0
Gross profit 100 0 0
255
Example 17.6: Intra-group transactions: unrealised profits

We now see how the adjustments in Example 17.5 operate in a full
example. Assume the income statements of H and S for the year ended 31
December 2011 are as follows.
H Ltd S Ltd
£ £ £ £
Sales 3,600 2,400
Cost of sales: Opening inventory 200 300
2,400 1,600
Closing inventory 400 2,000 200 1,400
Let us assume that S has been a subsidiary of H for several years before
1 January 20x1. S’s inventory at 1 January 20x1 included goods bought
from H for £100, which had originally cost H £60; similarly, S’s inventory
at 31 December 2011 included goods bought from H for £60, which had
originally cost H £40. During the year 20x1, H sold goods to S for a total
price of £400. We then have the following calculation of group profit.
H Ltd S Ltd Add Eliminate CIS Notes

£ £ £ £ £
Sales 3,600 2,400 6,000 (400) 5,600 a
Cost of sales: Opening inventory 200 300 500 (40) 460 b
Purchases 2,200 1,300 3,500 (400) 3,100 a
2,400 1,600 4,000 (440) 3,560
Closing inventory 400 200 600 (20) 580 c
2,000 1,400 3,400 (420) 2,980
Gross profit 1,600 1,000 2,600 20 2,620
a: Elimination of £400 inter-company sales

b: Elimination of £40 unrealised inter-company profit 1/1/20x1
c: Elimination of £20 unrealised inter-company profit 31/12/20x1
Note that it is not necessary to know the total inter-company profit on
sales of £400 during the year, as that part of the inter-company profit
relating to goods sold outside the group is realised and is legitimately
included in the CIS. It is necessary to adjust only for the unrealised
element of profit relating to goods still in inventory.
We can reconcile the effect of the adjustments on gross profit as follows:
£
Gross profit of H 1,600
Gross profit of S 1,000
2,600
Less: unrealised profit at 31 December 20x1 20
2,580
Add: unrealised profit at 1 January 20x1 now realised 40
Gross profit 2,620
As well as adjusting the CIS for unrealised inter-company profits, it is also
necessary to adjust the CSFP, so as to show inventories at original cost to
the group as a whole. Thus, unrealised profits on inter-company trading
must be eliminated from the amount at which inventory is shown in
the CSFP. In the above example, the inventory shown on the CSFP at 31
December 20x1 would be £580, eliminating the unrealised profits of £20,
256
and the group retained profits on the CSFP would also be reduced by £20.
Where a wholly owned subsidiary sells goods to its holding company, the
same adjustment must be made (i.e. if S sells to H).
17.4 Accounting for associates

Broadly speaking, associates are entities where the holding company has a
significant influence (but not control). Conventionally, a figure of 20–50%
voting/shareholding is taken as a measure of ‘significant influence’.
IAS 28 defines associates as:
Entities that have the power to participate in the financial and
operating policy decisions of the investee but are not in control
or joint control over those policies.
IAS 28 provides that an entity holding 20% or more of the voting rights
should be presumed to exercise a significant influence unless the contrary
is shown.
If an investor holds, directly or indirectly (e.g. through subsidiaries),
20% or more of the voting power of the investee, it is presumed that the
investor has significant influence unless it can be clearly demonstrated
(through other means) that this is not the case. Conversely, if the investor
holds, directly or indirectly (e.g. through subsidiaries), less than 20% of
the voting power of the investee, it is presumed that the investor does not
have a significant influence, unless influence can be clearly demonstrated
(through other means). A substantial or majority ownership by another
investor does not necessarily preclude an investor from having significant
influence.
In terms of disclosure of associates, IFRS 12 Disclosure of interest in other
entities requires investors to disclose information to enable investors to
evaluate the risks of the parent company’s dealings with its associates. This
disclosure can take the form of information in financial statements, as well
as narrative disclosures on the nature of the relationship
17.4.1 Accounting treatment of associates: the equity method

IAS 28 requires all associates to be accounted for using the equity method.
This entails the investment in an associated company being shown at cost
(less any amounts written off as permanent diminutions in value) in the
investing company statement of financial position, and the income statement
including only dividends received and receivable (i.e. declared but not yet
received).
The investing group’s consolidated statement of financial position
will include interests in associated companies at the total of:
1. the investing group’s cost of investment of the associated
companies, stated where possible after attributing fair values to the
net assets at the time of acquisition of the interest in the associated
companies and adjusting for:
2. the investing group’s share of post-acquisiton profits or losses.
The investing group’s consolidated income statement will also
include, immediately below the reported group operating results, the share
of operating profits or losses on ordinary activities (i.e. before interest and
tax) of associated companies in arriving at the group profit before tax.
Group interest and tax will include the share of the interest and taxation
attributable to the profit and loss of the associated companies. (This will
be disclosed separately, either on the face of the consolidated income
statement or in notes to the accounts.)
257
Example 17.7: Accounting for associates – preparing the CSFP

(equity method with implict goodwill) and CIS
On 1 January 20x1, H acquires 40% of the shares of A for a total cash
consideration of £1,400. On that date, the fair value of A’s tangible net
assets corresponds with book value. H is presumed to exercise significant
influence over A.
The 40% represents H’s ownership of A and therefore H must report its
share of A’s taxation (see ‘Extract from the consolidated income statement’
after step 3).
Below are the summarised financial statements of H and its associated
company A as at 31 December 2011.
Statement of financial position H Ltd A Ltd
£ £
Tangible non-current assets 12,600 4,000
Investment in A Ltd 1,400 –
14,000 4,000
Net current assets 4,000 2,000
18,000 6,000
Loan capital 6,000 3,000
12,000 3,000
Ordinary shares of £1 8,000 2,000

12,000 3,000
Income statement for year 31/12/11 H Ltd A Ltd

£ £
Sales 5,000 1,800
Cost of sales 2,400 800

Expenses 1,280 500
Operating profit 1,320 500

Dividend from A Ltd 80 –
Profit on ordinary activities before tax 1,400 500

Taxation 400 100
Profit for the financial year 1,000 400

Dividends paid 400 200
Retained profits for the year 600 200

Retained profits brought forward 3,400 800
Retained profits carried forward 4,000 1,000
Step 1: Calculate H’s share of the post-acquisition profits of A

Post-acquisition profits = profits for the year = retained profits c/f –
retained profits b/f
258
= 200 (or 1000 – 800)

Therefore, H’s 40% share = £80
Step 2: Add the cost of the investment with the share of post-acquisition
profits
£
Consideration (cost of the investment) 1,400
H’s 40% share of post-acquisition profits 80
Investment in associated company 1,480
Therefore, within the CSFP the associate will be valued at £1,480 and will
be placed beneath the tangible non-current assets.
Extract from the CSFP
£
Non-current assets
Tangible non-current assets 12,600
14,080
Step 3: Calculate the group’s share of profits or losses from the associate
£
Share of the profits before interest and taxation 200
[40% of 500]
Taxation [40% of £100] 40
Therefore, within the CIS the share of the associate’s profits will be
included and placed beneath the group’s operating profit. Note that the
share of the associate’s tax will be added to the total tax for the year.
Extract from the CIS
Operating profit 1,320
Share of profits of associated company 200
1,520
Taxation [400 + 40] 440
Profit for the financial year 1,080
Notes to the accounts: associated taxation 40
Thus, following the above workings, the consolidated accounts would look
as follows.
Statement of financial position as at
H A Group Notes
31/12/11
£ £ £
Tangible non-current assets 12,600 4,000 12,600
Investment in associated company 1,400 1,480 a
14,000 4,000 14,080
Net current assets 4,000 2,000 4,000
18,000 6,000 18,080
Loan capital 6,000 3,000 6,000
Net assets 12,000 3,000 12,080
Ordinary shares of £1 8,000 2,000 8,000

Income statement 4,000 1,000 4,080 a
12,000 3,000 12,080
259
Statement of financial position as at

H A Group Notes
31/12/11
Income statement for y/e 31/12/11 H A Group Notes
£ £ £
Sales 5,000 1,800 5,000
Cost of sales 2,400 800 2,400
Gross profit 2,600 1,000 2,600
Expenses 1,280 500 1,280
Operating profit 1,320 500 1,320
Share of profits from associated company 200 b
Dividend from A Ltd 80 c
Profit on ordinary activities before tax 1,400 500 1,520
Taxation 400 100 440 d
Profit for the financial year 1,000 400 1,080
Dividends paid 400 200 400 c
Retained profits for the year 600 200 680
Retained profits brought forward 3,400 800 3,400
Retained profits carried forward 4,000 1,000 4,080
a: changes in investment represented by corresponding change in income

statement
b: add share of profits to H to give group CIS
c: 80 represents 40% x 200 dividends paid by A to H (rest to external
party); this is cancelled in the CIS as it is an intra-group transaction
d: group taxation also needs to include share of tax paid by A
Note that some (usually smaller) enterprises do not have any subsidiaries
and thus do not need to prepare consolidated accounts. If, however, such
companies have significant holdings in associates (but no subsidiaries), they
are allowed to use either equity accounting (i.e. the conventional treatment
for associates) or to account for such investments at cost (or valuation).
17.5 Accounting for joint ventures

IFRS 11 Joint arrangements replaces the previous standard IAS 31 Interests
in joint ventures (see Section 18.4). This standard redefines: ‘A joint
arrangement is an arrangement of which two or more parties have joint
control’ [IFRS 11, para.4]. The main difference is that IFRS 11, requires
the equity method of consolidation to be applied, superseding the use of
proportional consolidation under IAS 31.
IFRS 11 recognises that joint ventures take many forms and explicitly
identifies two:
• joint operations
• joint ventures.
In essence:
• A joint operation is 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. Those
parties are called joint operators (IFRS 11, para.15).
• A joint venture is a joint arrangement whereby the parties that have
joint control of the arrangement have rights to the net assets of the
arrangement. Those parties are called joint venturers (IFRS 11, para.16).
• The substantive difference is that, under a joint operation, no new
entity is formed (i.e. the operations are run through the existing
260
companies that have agreed the joint operations). In other words, all
parties to the joint operation have a share in the output of the venue.
For joint ventures, the rights to the net assets typically mean that
the venturers have a share of the overall profit or loss earned by the
(separate) company formed by the joint venture.
The following example illustrates how joint ventures should be accounted
for under the equity method (the previous requirement to use proportional
consolidation is discussed in Chapter 18).
Example 17.8: Consolidation of subsidiary, associate and joint

venture (income statement and statement of financial position)
You are given the following information.
Income statement for the year ended 30 June 2017
Parent P Subsidiary S Associate A JV
£'000 £'000 £'000 £'000
Revenue 18,000 15,000 13,000 9,800
Cost of sales (7,400) (7,000) (5,600) (4,300)
Gross profit 10,600 8,000 7,400 5,500
Administration and other costs (1,800) (2,400) (3,000) (2,000)
Profit before interest and taxation 8,800 5,600 4,400 3,500
Dividends received 100
Interest payable (350) (800) (300) (200)
Taxation (2,050) (1,500) (2,500) (1,300)
Profit after tax 6,500 3,300 1,600 2,000
Statement of financial position for the year ended 30 June 2017

Parent P Subsidiary S Associate A JV
£'000 £'000 £'000 £'000
Property, Plant & Equipment 33,700 35,500 31,000 12,000
Investments in:
Subsidiary 13,500
Associate 6,200
Joint Venture 4,200
Other investments 5,000
Current assets 3,200 4,500 5,000 1,000
Total assets 65,800 40,000 36,000 13,000
Current liabilities (2,900) (900) (700) (800)
Total net assets 62,900 39,100 35,300 12,200
Share capital 20,000 18,000 16,000 5,000

Retained profits 33,800 12,100 11,800 3,200
Liabilities more than one year 9,100 9,000 7,500 4,000
Total equity and long-term
62,900 39,100 35,300 12,200
liabilities
261
The following additional information is also relevant.

1. The parent company, P, paid £13.5 million for 80% of shares in the
subsidiary, S. At the time of acquisition, the share capital and retained
profits of S was £15 million.
2. P also paid £6.2 million for a 25% share in the Associate, A. On the
date of purchase, A’s retained profit was £14 million.
3. P and its partner, F, have a 40:60 (P:F) interest in the JV company. The
value of the group’s share in the JV was recognised at £4.2 million in
the CSFP at 30 June 2017, before any adjustment for profits.
4. All other investments were in unrelated companies operating at an
arm’s length to the group. There has been no change in the value of
these investments from the time of acquisition to the year end of 30
June 2017.
Prepare the CIS and CSFP for the group for the year ended 30 June 2017.
Consolidated income statement for the year ended 30 June 2017

Group Workings
£’000
Revenue 33,000 P+S
Cost of sales (14,400) P+S
Gross profit 18,600
Administration and other costs (4,200) P+S
Profit before interest and taxation 14,400
Dividends received 100 P+S
Interest payable (1,150) P+S
Share of Associate's profit after
400 % A net profit
tax
Share of JV's profit after tax 800 % JV net profit
Profit before tax 14,550
Taxation (3,550) P+S
Profit after tax 11,000
Attributable to:
Equity shareholders 10,340 balance
Non-controlling interests 660 % S net profit
Consolidated statement of financial position as at 30 June 2017

Group Workings
£’000
Property, Plant & Equipment 69,200 P+S
Goodwill (in Subsidiary) 1,500 W1
Investments in:
Associate 5,650 W2
JV 5,480 W3
Other investments 5,000 P+S
Current assets 7,700 P+S
262
Total assets 94,530

Current liabilities (3,800) P+S
Total net assets 90,730
Share capital 20,000 P only

Retained profits 46,610 W4
Non-controlling interest 6,020 W5
Liabilities more than one year 18,100 P+S
Total equity and long-term
90,730
liabilities
Working W1: Goodwill of Subsidiary

Consideration 13,500
Less: share of S net assets (12,000)
1,500
Working W2: Invesment in Associate

Consideration 6,200
Retained profits of A at year end 11,800
Less: retained profits of A at date
of acquisition (14,000)
Post-acquisition profit of A (2,200)
P share of A post-acquisition
profits 25% (550)
Investment in Associate 5,650
Working W3: Investment in Joint Venture

Investment in JV 30/06/2016 4,200
JV profit for the year 3,200
P share of JV profit for the year 40% 1,280
5,480
Working W4: Group consolidated retained profits

P retained profits 33,800
S post-acquisition share capital &
retained profits 30,100
S pre-acquisition share capital &
S post-acquisition retained profits 15,100
P share of S post-acquisition
retained profits 80% 12,080
P share of A post-acquisition
profits (550)
P share of JV profit for the year 1,280
46,610
263
Working W5: Non-controlling interests

S post-acquisition share capital &
NCI share in S post-acquisition share
capital & retained profits 20% 6,020

• describe associates and joint ventures and how to account for them in
consolidation
• prepare consolidated accounts (statement of financial positon and
income statements) using the equity method
• compute the value of goodwill and non-controlling interest
accounts.

Question 17.1
The statements of comprehensive income for Bread Ltd, Cheese Ltd and
Cake Ltd for the year ended 31 December 2015 are given as follows:
Statements of comprehensive income for the year ending 31 December 2015
Bread Ltd Cheese Ltd Cake Ltd
£ £ £
Sales 13,500,000 7,650,000 5,400,000
Cost of sales (5,310,000) (2,655,000) (2,070,000)
Gross profit 8,190,000 4,995,000 3,330,000
Investment income- 390,000
dividends received
Administration costs (912,750) (639,000) (315,000)
Distribution costs (420,000) (1,017,000) (157,500)
Interest income 225,000
Interest expense (45,000) (81,000)
Profit before tax 7,427,250 3,258,000 2,857,500
Tax (450,000) (315,000) (423,000)
Profit after tax 6,977,250 2,943,000 2,434,500
Bread Ltd acquired 80% of Cheese Ltd on 1 January 2003 for £1,008,000,
gaining significant influence over Cheese Ltd. On this date, the share
capital of Cheese Ltd was £300,000 and the retained earnings of Cheese
Ltd were £615,000. The non-current assets of Cheese Ltd were valued
at £45,000 above their net book value on 1 January 2003 and this
revaluation was not included in the financial statements of Cheese Ltd.
Bread Ltd acquired 40% of Cake Ltd for £900,000 on 1 January 2005,
gaining partial influence over Cake Ltd. Cake Ltd’s share capital and
reserves were £337,500 on 1 January 2005. The share capital of Cake Ltd
is 60,000 50p shares.
264
The interest income in Bread Ltd includes interest income on its 70%
holding of bonds issued by Cheese Ltd. Bread Ltd acquired these bonds
from Cheese Ltd, without any goodwill arising, on 1 January 2003. The
interest expense recorded by Cheese Ltd represents the interest on the full
bond issue. All companies have accounted for interest income and interest
expense correctly.
During the year Cheese Ltd sold goods costing £9,000 to Bread Ltd for
£63,000. 20% of this inventory is included in Bread Ltd’s inventory at the
year end.
During the year Cake Ltd sold goods costing £27,000 to Bread Ltd for
£36,000. 50% of this inventory is still in Bread Ltd’s inventory at the year
end.
Goodwill is capitalised. Impairment of 50% of the value of the goodwill of
Cheese Ltd was seen in 2010 and impairment of 20% of the value of the
goodwill in Cake Ltd is seen in 2015.
At the year-end Bread Ltd charges both Cheese Ltd and Cake Ltd a
management fee of 10% of turnover. None of the companies have
accounted for this management fee.
The retained earnings brought forward as at 1 January 2015 and dividend
expense for the year ended 31 December 2015 for Bread Ltd, Cheese Ltd
and Cake Ltd were as follows:
Bread Ltd Cheese Ltd Cake Ltd

£ £ £
Retained earnings brought
forward 7,240,000 900,000 600,000
Dividend expense 270,000 75,000
a) What is an associate company and what is a joint venture company?

How are joint venture companies accounted for in consolidated
financial statements?
b) Prepare the consolidated statement of comprehensive income for
Bread Ltd for the year ended 31 December 2015, showing retained
earnings brought forward, dividend expense and retained earnings
carried forward either on the face of the statement of comprehensive
income or in the consolidated retained earnings section of the
statement of changes in equity.
Question 17.2
How does accounting standards define a joint operation and a joint
venture? How would you distinguish between the two?
265
Question 17.3
The Statements of financial position for Accrington PLC, Birmingham Ltd
and Crewe Ltd as at 31 December 2016 are as follows:
Accrington PLC Birmingham Ltd Crewe Ltd

£ £ £
Fixed assets (land) 400,000 300,000 140,000
Investments 650,000
Inventories 25,000 165,000 9,000
Trade receivables 55,000 164,000 2,000
Inter-company receivables 30,000
from Birmingham Ltd
Inter-company receivables 4,000
from Crewe Ltd
Cash 11,000 112,000 500
Trade payables (225,000) (6,000) (1,500)
Inter-company payables (25,000) (4,000)
Net assets 950,000 710,000 146,000
Share capital (£1 nominal 500,000 200,000 50,000

value shares)
Revaluation reserve 150,000
Retained profits 450,000 360,000 96,000
Capital and reserves 950,000 710,000 146,000
Accrington acquired 75% of Birmingham for £500,000 on 1 January 2016.

At the time of acquisition, the fair value of Birmingham’s fixed assets
was £300,000 (historic cost £150,000) and Birmingham Ltd included
the revaluation in its accounts. No other assets were re-valued at the
date of acquisition. Birmingham’s share capital and reserves on the date
of acquisition were £420,000, after the revaluation had correctly been
incorporated into the company’s accounts.
Accrington acquired Eccles PLC’s share of Crewe Ltd on 1 January 2011
for £120,000, when Crewe’s net assets at fair value were £70,000. Crewe
Ltd was originally formed as a joint venture with Duxford PLC, where
Eccles and Duxford held 50:50 shares in Crewe. Accrington, Eccles and
Duxford agreed that Accrington should maintain its 50% share of the joint
venture on acqusition. Aside from this transaction, Accrington has no other
involvement with either Duxford or Eccles.
Goodwill is capitalised and an impairment of £129,500 is charged against
the value of Birmingham and £53,000 against the value of Crewe in 2016.
The inventory in Accrington includes £10,000 of inventory purchased
from Birmingham Ltd. These goods had cost Birmingham Ltd £2,000. The
inventory in Accrington also includes £5,000 of inventory purchased from
Crewe Ltd. These goods had cost Crewe Ltd, £3,000.
Any differences in inter-company balances between Accrington and
Birmingham are due to cash in transit.
At the end of the year, Accrington declares a dividend of 5p per share,
Birmingham Ltd declares a dividend of 20p per share and Crewe Ltd
declares a dividend of 10p per share. These dividends have not been
accounted for by any of the companies.
266
Required:
Prepare a consolidated statement of financial position for Accrington
group for the year ended 31 December 2016.
267
Notes
268
Chapter 18: Accounting for groups: historical and alternative approaches

historical and alternative approaches
18.1 Introduction
In this chapter, we consider historical and alternative approaches to
current standards in accounting for groups. These approaches are no
longer allowed under IFRS, but it is nevertheless instructive to understand
different perspectives on how groups of companies should be accounted
for.
We will revisit historical approaches such as the pooling method, which
was previously the standard for mergers between two equivalent
companies. We will also consider the principles behind proportional
(or proportionate) consolidation, which was previously used by IAS
31 to account for joint ventures and also used in countries such as the
Netherlands. Finally, we will recap the method of equity consolidation
that explicitly recognises the goodwill of the associate on consolidation
– the current method of equity consolidation does not show goodwill as
it implicitly embeds the figures within the net investment figure of the
associate.

• understand the main ideas underpinning the now disallowed merger
method
• understand the main ideas underpinning the now disallowed
proportional consolidation method
• prepare consolidated accounts (statement of financial position
and profit and loss or income statements) using the merger and
proportional consolidation methods
• understand the rationales for changes to current standards on
consolidation, moving away from merger and proportional methods,
as well as explicit recognition of associates’ goodwill on consolidation
under the equity method.


KPMG International Standards Group No more proportionate consolidation
for joint ventures. (KPMG, 2011). Available at: https://home.kpmg/
content/dam/kpmg/pdf/2011/05/In-the-headlines-O-201105-15.pdf
269
Historical IASB standards (no longer in use)

FRS 6 Acquisitions and mergers.
IAS 28 (2003) Investments in associates
IAS 31 Interests in joint ventures.
18.2 Merger accounting

Merger accounting is an alternative to acquisition accounting and its
use has historically varied around the world – in the past, it has been
quite common in the USA and the UK but only rarely used in most
other European countries. Merger accounting is now no longer in use
following the decision by the IASB and FASB to prohibit it for any business
combinations. IFRS 3 requires ‘all business combinations within its scope
to be accounted for by applying the purchase (i.e. acquisition) method’.
From the holding company’s perspective there are many perceived benefits
of using pooling of interest over purchase accounting (e.g. pre- and
post-acquisition profits are taken to reserves and there is no goodwill on
consolidation). As a consequence, many companies in the past abused
this accounting choice and opted to account for takeovers as mergers,
arranging the details of the transaction to appear to satisfy the criteria for
a merger. By having a single accounting practice, such creative accounting
practices will be eliminated.
Merger accounting is still allowable under UK GAAP (although listed UK
companies would be in breach of EU regulations if merger accounting was
adopted as this contravenes IFRS 3). However, the ASB state that:
Merger accounting should be applied to only a few rare
instances of business combinations that were properly regarded
as mergers and that the vast majority of business combinations
were more appropriately accounted for as acquisitions.
(FRS 6 Appendix, para.12)
FRS 6 is no longer relevant, due to IFRS 3.
Merger accounting might be more appropriate, for instance, where there
is not a dominant acquiring company, but two companies pooling their
resources as equal partners.
18.2.1 Definition
A merger is defined in para.2 of FRS 6 as:
A business combination that results in the creation of a new
reporting entity formed from the combining parties, in which
the shareholders of the combining parties come together in a
partnership for the mutual sharing of the risks and benefits of
the combined entity, and in which no party to the combination
in substance obtains control over any other, or is otherwise
seen to be dominant, whether by virtue of the proportion of its
shareholders’ rights in the combined entity, the influence of its
directors or otherwise.
In other words, there is a mutual agreement between two (or more)
companies to merge or pool their resources as equal partners, trading as
a combined group. This would need to be accompanied by an agreement
to exchange shares, so that the resources of the combined groups are the
aggregate of the individual companies’ resources.
270
18.2.2 Conditions to be met

The old UK Companies Act and FRS 6 set down stringent conditions that
must be met in order to permit consolidation using merger accounting. If
the business combination failed to satisfy these conditions then the group
had to use acquisition accounting for the business combination.
The old Companies Act states that merger accounting can only be used
where:
• At least 90% in nominal value of the equity shares of the subsidiary
are held by the parent or its subsidiaries.
• The shares were obtained as a result of an arrangement involving the
issue of equity by the parent or its subsidiaries.
• The fair value of non-equity consideration given by the parent and its
subsidiaries did not exceed 10% of the nominal value of the equity
shares issued.
FRS 6 adds the following additional criteria:
• No party to the combination is portrayed as either acquirer or
acquired, either by its own board or management or by that of another
party to the combination.
• All parties to the combination, as represented by the boards
of directors or their appointees, participate in establishing the
management structure for the combined entity and in selecting the
management personnel, and such decisions are made on the basis of a
consensus between the parties to the combination, rather than purely
by exercise of voting rights.
• The relative sizes of the combining entities are not so disparate that
one party dominates the combined entity by virtue of its relative size.
• Under the terms of the combination or related arrangements, the
consideration received by equity shareholders of each party to the
combination, in relation to their equity shareholding, comprises
primarily equity shares in the combined entity.
• No equity shareholders of any of the combined entities retain any
material interest in the future performance of only part of the
combined entity.
In short, merger acquisition is permissible when a business combination is
achieved almost entirely by a share-for-share exchange (i.e. it assumes that
the economic resources of the two companies have not been depleted by
combining).
In situations where the Act’s conditions are satisfied, but those of FRS 6 are
not merger accounting should not be used.
18.2.3 Merger accounting: the basics

The aim of merger accounting is to present the group accounts as if the
companies that have been combined have always been operating as a
single group.
Consequently:
• Shares issued by H at nominal value and no share premium would
be taken into account in the company-only accounts or in the
consolidated accounts, assuming merger relief (discussed below).
• The investment in S would be carried in H’s statement of financial
position at the nominal value of the shares issued, plus the fair value
of any non-equity consideration, which means that there will be no
271
goodwill on consolidation using merger accounting (assuming merger

relief). But there is a ‘difference on consolidation’ which is taken to
reserves.
• The book values of the assets and liabilities of the subsidiary are
included in the consolidation, even though the fair values might be
different.
• There is an aggregation of the book values of net assets.
• The reserves of S are not treated as being pre-acquisition, but are
aggregated with those of H in the CSFP. In other words, the group’s
consolidated financial statements for the period in which the business
combination takes place should include the subsidiary’s income and
expenditure and cash flows for the entire period.
• Adjustments are kept to a minimum and would include only
adjustments required to adopt uniform accounting policies within
the group and to remove any unrealised profits and inter-company
transactions and loans and so on.
18.2.4 Merger relief: holding company accounts

Merger relief relates not to the consolidated accounts but to the company-
only accounts (i.e. the accounts of the holding company). It allows the
holding company to value the investment in S in its own statement of
financial position at the nominal value of the shares issued, thus recording
no share premium on the issue. Merger relief is only available under the
conditions specified in Section 18.2.2.
In the acquiring company’s own accounts, the investment in the acquired
company will be shown at nominal value of equity shares allotted (to which
merger relief applies) plus fair value of any other consideration given.
If these conditions have been met (and note that they will always be
met if the combination can be classified as a merger) then, whether the
consolidated accounts are constructed via acquisition accounting or via
merger accounting, the holding company can take merger relief. Because
the rules for merger relief differ from those for merger accounting, some
groups in the past have used acquisition methods of consolidation but were
able to take merger relief. This has the basic effect that, while the ‘share
premium’ normally recorded under acquisition accounting does not arise,
incorporation of the pre-acquisition profits, together with any fair value
adjustments to the net assets of the acquired company, will give rise to a
difference on consolidation (‘merger reserve’). Knowledge of how to prepare
consolidated accounts on this basis is not a requirement for the course.
Example 18.1: Merger relief

H acquires 100% of the shares of S with a share-for-share exchange.
H shares have a nominal value of £1 and a market price of £2. S’s book
value is equal to its fair value. S’s statement of financial position at the
date of acquisition is as follows:
S
Non-current assets 5,500
Net current assets 2,000
7,500
Ordinary share capital £1 each 5,000

Profit and loss 2,500
7,500
272
The construction of the holding company’s statement of financial position

with merger relief and without are as follows.
H after buying H after buying S,
H before
S, with merger without merger
buying S
relief relief
Investment in S 5,000 10,000
15,000 20,000 25,000
Ordinary shares 8,750 8,750 8,750

New shares 5,000 5,000
Share premium 0 5,000
Profit and loss 6,250 6,250 6,250
15,000 20,000 25,000
18.2.5 Capital reserve: difference on consolidation

The older (now expired) version of the UK Companies Act allowed the
holding company’s statement of financial position to show its investment
in the subsidiary at the nominal value of the shares that it issued as
consideration. Then, following consolidation, differences may arise. This
difference will result if the nominal value of the shares issued and the
nominal value of the shares acquired are different. Consequently:
• If the issued nominal value is lower than the acquired nominal value
then this difference will be taken to a capital reserve (sometimes called
merger reserve or a difference on consolidation); see Example 18.2.
• If the issued nominal value is higher than the acquired nominal value
then this difference will reduce one of the consolidated reserves.
Normal practice is to apply it first against the most restricted
categories of reserve; see Example 3.
Example 18.2: Capital reserve

H acquires all of B’s £100,000 nominal share capital. The consideration
paid by H consists of a new share issue and these shares have a nominal
value of £90,000. The business combination fulfils all the criteria above
and hence employs the merger method. Thus, the capital reserve would
equal £10,000 as follows:
Nominal value of the share acquired £100,000
Holding company’s carrying value of investment in S £90,000
Capital reserve £10,000
Example 18.3: Difference on consolidation

Given the facts in the above example, let us assume that the consideration
paid was not £90,000 but £125,000. The difference arising on
consolidation will equal a negative £25,000 as follows:
Nominal value of the share acquired £100,000
Holding company’s carrying value of investment in S £125,000
Capital reserve –£25,000
18.2.6 Step-by-step guide to merger accounting

In summary, merger accounting involves four steps:
1. Add S in H accounts at nominal value (i.e. no share premium).
2. Add S and H together line by line.
273
3. Eliminate the investment and ordinary shares exchanged (at nominal

value).
4. If there is any difference arising from step 3 then a capital reserve/
merger reserve needs to be included in the group’s accounts.
18.2.7 Basic illustrations of merger accounting

On 31 December 2016, the summarised statement of financial positions of
A Ltd and B Ltd are as follows:
A Ltd B Ltd
£ £
Net assets 10,000 4,000

10,000 4,000
On that date, A’s shares have a market value of £5 each, and A acquires all
the shares of B via a share-for-share exchange of three shares in A Ltd for
four shares in B Ltd.
The fair value of B’s net assets is agreed to be £5,000 at 31 December 2016.
Applying merger relief, the statement of financial position of A Ltd after
the acquisition would be (i.e. step 1):
A Ltd
£
Net assets 10,000
Investment in S 1,500 = (2,000 × 3/4)
11,500
Ordinary shares of £1 5,500 = 4,000 + new issue (1,500)

Income statement 6,000
11,500
Using merger accounting, the CSFP would be as follows:
A Ltd B Ltd Step 2 Steps
CSFP
3+4
£ £ £ £ £
Net assets 10,000 4,000 14,000 – 14,000
Investment in S 1,500 – 1,500 (1,500) –
11,500 4,000 15,500 (1,500) 14,000
Ordinary shares of £1 5,500 2,000 7,500 (2,000) 5,500

Income statement 6,000 2,000 8,000 – 8,000
Difference on consolidation 500 500
11,500 4,000 15,500 (1,500) 14,000
The difference on consolidation is arrived at thus:
Nominal value of equity shares issued £1,500
Plus fair value of other consideration –
Less nominal value of equity shares acquired £2,000
Debit/(credit) £(500)
274
Note that:
• Fair values at acquisition date are ignored, and there is no goodwill to
capitalise, thus no amortisation/write-off.
• The income statements are simply added together.
• S is treated as if always part of the group (no pre-acquisition profits).
• All A’s retained profits are included in the consolidation statement of
financial position, whether pre- or post-acquisition.
• If there had been any inter-group items, these would have been
cancelled as usual.
• Any accounting policy differences need to be harmonised for the
purpose of consolidation.
Activity 18.1
Review the recommended texts so that you fully understand the difference between
the accounting treatment of subsidiary undertakings in both the consolidated income
statement and the consolidated statement of financial position under the acquisition and
merger methods.
Why do you think that an investing company might prefer to classify their investment as a
merger as opposed to an acquisition?
Activity 18.2
Given the information above about A and B what would the CSFP be if the share-for-
share exchange was three shares in A for two shares in B (instead of three shares in A for
four shares in B)?
Activity 18.3
Outline the main differences between the merger (pooling of interest) and acquisition
accounting methods and discuss the reasons why merger accounting has been
discontinued in favour of acquisition (full consolidation) methods.
Activity 18.4
On 1 January 2009, X Ltd merged with Y Ltd, with X Ltd gaining 90% of the shares of Y
Ltd, issuing ten shares in X Ltd for every four shares in Y Ltd. The summarised statements
of financial position of X Ltd and Y Ltd before the merger are given below:
X Ltd Y Ltd
£ £
Net assets 50,000 20,000
Ordinary shares 10,000 5,000

Retained earnings 40,000 15,000
50,000 20,000
Prepare the consolidated statement of financial position on 1 January 2009 for X Ltd after
the merger has taken place, using merger accounting and taking advantage of merger
relief.
18.2.8 Differences and problems

Despite the discontinued used of merger accounting, it is important to
understand its conceptual differences from acquisition accounting (and
problems generated from its use).
275
Acquisition accounting Merger accounting

Shares issued accounted for at fair value Shares issued accounted for at nominal
value (i.e. no share premium account)
Underlying net assets of acquired Underlying net assets of acquired
company consolidated at fair value – company consolidated at existing book
hence revaluations on consolidation and value
possibility of increased depreciation
Goodwill on consolidation may arise Goodwill on consolidation does not arise
– ‘difference on consolidation’ is not
written off/amortised
Pre-acquisition reserves of acquired Pre-acquisition reserves of acquired
company not distributable by group and company included in CSFP and available
excluded from CSFP to group
Acquired company consolidated from Acquired company consolidated as
effective date of acquisition only if it had always been part of group –
comparative figures are restated
18.3 The historical approach to equity accounting

IAS 28 (2003) requires all associates to be accounted using the equity
method. This entails the investment in an associated company being
shown at cost (less any amounts written off as permanent diminutions in
value) in the investing company statement of financial position, and the
income statement including only dividends received and receivable (i.e.
declared but not yet received).
The investing group’s consolidated statement of financial position
will include interests in associated companies at the total of:
1. the investing group’s share of net assets (other than any goodwill)
of the associated companies, stated where possible after attributing
fair values to the net assets at the time of acquisition of the interest in
the associated companies and
2. any premium paid on acquisition of the interests in the associated
companies (the explicit ‘goodwill’ method).
Where the cost of the investment equals the investing group’s share
of the net assets of an associated company (reflecting, if appropriate,
adjustments to fair value) at the date of acquisition, there will be no
acquisition premium, and subsequent consolidated statement of financial
positions will show the investment in that associated company at cost, plus
the investing group’s share of all post-acquisition reserves of the associated
company.
The investing group’s consolidated income statement will also
include, immediately below the reported group operating results, the share
of operating profits or losses on ordinary activities (i.e. before interest and
tax) of associated companies in arriving at the group profit before tax.
Group interest and tax will include the share of the interest and taxation
attributable to the profit and loss of the associated companies. (This will
be disclosed separately, either on the face of the consolidated income
statement or in notes to the accounts).
276
Example 18.4: Accounting for associates – preparing the CSFP

(equity method with explicit goodwill)
Revisiting an earlier example on accounting for associates under the
current (implicit) goodwill method (Example 17.7), we now consider how
the unrevised standard IAS 28 accounted for associates.
On 1 January 2011, H acquires 40% of the shares of A for a total cash
consideration of £1,400. On that date, the fair value of A’s tangible net
assets corresponds with book value. H is presumed to exercise significant
influence over A.
The 40% represents H’s ownership of A and therefore H must report their
share of A’s taxation (see ‘Extract from the consolidated income statement’
after step 3).
Below are the summarised financial statements of H and its associated
company A as at 31 December 2011.
Statement of financial position H Ltd A Ltd
£ £
Tangible non-current assets 12,600 4,000
Investment in A Ltd 1,400 –
14,000 4,000
18,000 6,000
Loan capital 6,000 3,000
12,000 3,000

12,000 3,000
Income statement for year 31/12/11 H Ltd A Ltd

£ £
Sales 5,000 1,800
Cost of sales 2,400 800

Expenses 1,280 500
Operating profit 1,320 500

Dividend from A Ltd 80 –

Taxation 400 100

Dividends paid 400 200
Retained profits for the year 600 200

Retained profits brought forward 3,400 800
Retained profits carried forward 4,000 1,000 277

Step 1: Calculate the premium (‘goodwill’)

Consideration
= £1,400
Fair value at 1 January 2011
= [£3,000 (book value at 31 December 2011) – £200 (profits earned
during year)] × 40%
= £1,120
Premium
= difference between consideration paid and fair value at the date of
acquisition
= £1,400 – £1,120
= £280
Step 2: Statement of financial position – carrying value of the associate

£
Group share of the net assets @ statement of financial position
1,200
date (40% of £3,000)
Premium paid 280
Therefore, within the CSFP the associate will be valued at £1,480 and will
be placed beneath the tangible non-current assets.
Extract from CSFP

£
Non-current assets
14,080
Step 3: Calculate the group’s share of profits or losses from the associate
£
Share of the profits before interest and taxation [40% of 500] 200
Taxation [40% of £100] 40
Therefore, within the CIS the share of the associates’ profits will be
included and placed beneath the group’s operating profit. Note that the
share of the associate’s tax will be added to the total tax for the year.
Extract from the CIS
Share of profits of associated company 200
1,520
Taxation [400 + 40] 440
Profit for the financial year 1,080
Notes to the accounts: associated taxation 40
278
Thus, following the above workings, the consolidated accounts would look
as follows.
Statement of financial position as at H A Group Notes
31/12/11
£ £ £
Tangible non-current assets 12,600 4,000 12,600

Investment in associated company 1,400 1,480 a
14,000 4,000 14,080
18,000 6,000 18,080
Loan capital 6,000 3,000 6,000
Net assets 12,000 3,000 12,080

Income statement 4,000 1,000 4,080 a
12,000 3,000 12,080
Income statement for y/e 31/12/11 H A Group Notes

£ £ £
5,000 1,800 5,000

Cost of sales 2,400 800 2,400
Gross profit 2,600 1,000 2,600
Expenses 1,280 500 1,280
Operating profit 1,320 500 1,320
Share of profits from associated company 200 b
Dividend from A Ltd 80 c
Profit on ordinary activities before tax 1,400 500 1,520
Taxation 400 100 440 d
Profit for the financial year 1,000 400 1,080
Dividends paid 400 200 400 c
Retained profits for the year 600 200 680
Retained profits brought forward 3,400 800 3,400
Retained profits carried forward 4,000 1,000 4,080
a: changes in investment represented by corresponding change income

statement
b: add share of profits to H to give group CIS
c: 80 represents 40% x 200 dividends paid by A to H (rest to external
party); this is cancelled in the CIS as it is an intra-group transaction
d: group taxation also need to include share of tax paid by A
Activity 18.5
Why was there a change from explicitly recognising goodwill of associates under IAS 28
(2003) towards an implicit system under the revised IAS 28 (2011) and IFRS 3?
Both implicit (i.e. the current standard IAS 28 (2011) – see Chapter 17)
and explicit (the previous standard IAS 28 (2003)) goodwill methods
produce the same result in the investment in associate of £1,480. However,
the explicit recognition method was relevant when goodwill amortisation
was allowable under IAS 28 (2003). With the change over to the implicit
279
goodwill method, this is in recognition that goodwill is inseparable

from the associate’s value as a whole to the holding/parent company.
Revisit section 13.4 in Chapter 13 for discussions on the separability of
goodwill. Therefore, under IFRS 3, the impairment test considers the entire
investment for any reduction in its valuation.
Activity 18.6
Note that this question uses the historical accounting standard IAS 28 (2003), which uses
an explicit goodwill approach and amortisation (rather than impairment) of goodwill for
Associates.
1. The profit and loss accounts for the year ended 31.12.2007 for Red Plc, Green Ltd and
Pink Ltd are given as follows:
Red Plc Green Ltd Pink Ltd
£ £ £
Sales 230,000 190,000 100,000
Cost of sales (60,000) (30,000) (20,000)
Gross profit 170,000 160,000 80,000
Administration costs (17,100) (14,000) (26,000)
Distribution costs (14,000) (22,000) (10,000)
Dividend receivable from Green Ltd and Pink Ltd 3,100
Profit before tax 142,000 124,000 44,000

Tax (40,000) (10,000) (6,000)
Profit after tax 102,000 114,000 38,000
Dividends payable (20,000) (2,000) (5,000)
Profit for the year 82,000 112,000 33,000
Retained profit brought forward 100,000 62,000 40,000
Retained profit carried forward 182,000 174,000 73,000
Red Plc acquired 80% of Green Ltd for £200,000 on 1.1.2004 when Green Ltd’s share
capital and reserves were £100,000. The share capital of Green Ltd equals £80,000.
Red Plc acquired 30% of Pink Ltd for £50,000 on 1.1.2005 when Pink Ltd’s share capital
and reserves were £20,000. The share capital of Pink Ltd equals £10,000.
Goodwill is capitalised and amortised over 20 years.
During the year Green Ltd sold goods to Red Plc for £10,000. These goods had cost Green
Ltd £2,000. 50% of these goods are with Red Plc at the year end.
During the year Pink Ltd sold goods to Red Plc for £8,000 and these goods had cost Pink
Ltd £4,000. 50% of these goods are with Red Plc at the year end.
Red Plc charges a management fee to Green Ltd and Pink Ltd of 5% of turnover – these
have been included in administration costs for Green Ltd and Pink Ltd and in the sales
figure for Red Plc.
Required:
Prepare the consolidated profit and loss account for Red Plc for the year ended 31.12.2007.
280
18.4 Accounting for joint ventures using proportional/

proportionate consolidation
The old standard, IAS 31 (Interests in joint ventures), defines joint ventures
as:
A contractual arrangement whereby two or more parties
undertake an economic activity that is subject to joint control.
Joint control is the contractually agreed sharing of control
over an economic activity, and exists only when the strategic
financial and operating decisions relating to the activity
require the unanimous consent of the parties sharing control
(the venturers). Control is the power to govern the financial
and operating policies of an economic activity so as to obtain
benefits from it.
IAS 31 recognises that joint ventures take many forms and explicitly
identifies three:
• jointly controlled operations
• jointly controlled assets
• jointly controlled entities.
We are mainly concerned with jointly controlled entities. This is because a
separate legal entity has to prepare its own set of accounts, and we have
to understand how to consolidate this form of joint venture. IAS 31 states
that:
A venturer shall recognise its interest in a jointly controlled
entity using proportionate consolidation or the equity method.
Proportional consolidation is rare in the UK and the USA, but common

for joint ventures in France and the Netherlands (Nobes and Parker,
2012). Proportional consolidation is a method of accounting whereby
each venturer’s share of assets, liabilities, income and expenses of a
jointly controlled entity is combined line by line with similar items in the
venturer’s financial statements or reported as separate line items in the
venturer’s financial statements (IAS 31).
This differs from the equity method (as used for associates) in that under
the equity method the joint venture is initially recorded at cost and
adjusted thereafter for the post-acquisition change in the venturer’s share
of net assets of the jointly controlled entity. In the income statement, under
equity accounting, the venturer’s share of the profit or loss of the jointly
controlled entity is included in the income statement. In other words, it
consolidates in the group accounts that proportion of an investment
(i.e. proportion of the share capital) that is owned. Therefore, the
proportion of all assets and liabilities owned in an associated company
are shown in the statement of financial position (plus any goodwill on
acquisition) replacing the cost of the investment. In the case of associate
companies, the income statement will show the proportion of all revenues
and expenses of the associated company.
Example 18.5: Accounting for joint ventures using proportional

consolidation
H acquired 200 ordinary (£1) shares of JV at a price of £1.80, when JV’s
retained profits were £600. The statement of financial positions of H and V
and a CSFP on a line-by-line basis is shown below.
281
CSFP
Statement of financial position H JV 10% of JV line-by-line
as at 31/12/11 £ £ £ £
13,060 4,000 400 13,460

Investment in JV 360
Goodwill in JV 100
Net current assets 4,580 2,000 200 4,780
18,000 6,000 600 18,340
Loan capital 6,000 3,000 300 6,300
Net assets 12,000 3,000 300 12,040

Income statement 4,000 1,000 4,040
12,000 3,000 12,040
Goodwill calculations are similar to those used in acquisition accounting,
delineating between pre- and post-acquisition profit.
Goodwill calculation £ £
Consideration (investment in JV) 360
Net assets JV 1/1/11 (ord. shares + pre-JV profit) 2,600
10% assets controlled in joint venture on 1/1/11 260
Goodwill 100
We also need to calculate the share of JV’s profits in the CSFP.
Calculating profit reserves £
H income statement 4,000
10% of JV post-acquisition profits 40
4,040
The CSFP shown above is on a line by line basis, but IAS 31 prefers that
separate line items are shown, as in the presentation below (note that the
net assets value for the proportional consolidation, whether on a line-by-
line or separate line items, is the same).
CSFP as at 31/12/11 CSFP
£ £
Tangible non-current assets JV 400 13,460
Goodwill in JV 100
Net current assets JV 200 4,780
18,340
Loan capital 6,000
Loan capital JV 300 6,300
Net assets 12,040

12,040
The general approach to calculating proportional consolidation is as
follows:
282
Let y equal the investor’s share, and (1–y) equal the ‘outside shareholders’
interest.
Income statement: R – C = π
Statement of financial position: A – L = E
Where R = revenues, C = costs, π = profit, A = assets, L = liabilities, E =
equity.
Basis of ‘equity accounting’ for investee:
Income statement: Bring in y(π)
Statement of financial position: Bring in y(E)
Whereas the basis of ‘proportional consolidation’ of investee is:
Income statement: Bring in y(R–C) = y(π)
Statement of financial position: Bring in y(A–L) = y(E)
Activity 18.7
Read the impact of the move away from proportional consolidation towards equity
accounting for all joint operations in No more proportionate consolidation for joint
ventures: (KPMG 2011), https://home.kpmg/content/dam/kpmg/pdf/2011/05/In-the-
headlines-O-201105-15.pdf
18.5 Reminder of your learning outcomes

• understand the main ideas underpinning the now disallowed merger
method
• understand the main ideas underpinning the now disallowed
proportional consolidation method
• prepare consolidated accounts (statement of financial position
and profit and loss or income statements) using the merger and
proportional consolidation methods
• understand the rationales for changes to current standards on
consolidation, moving away from merger and proportional methods,
as well as explicit recognition of associates’ goodwill on consolidation
under the equity method.
18.6 Sample examination question

Question 18.1
Compare and contrast merger accounting with acquisition accounting and
discuss why companies might prefer to use merger accounting.
Question 18.2
Top-of-Prop Plc is a substantial property investment company. On 1
January 2011, Top-of-Prop subscribes for 40% of the share capital of £20
million in BestProp Plc, a new company set up to buy large buildings in
central London, which Top-of-Prop has agreed to manage. Top-of-Prop
appoints two of the five directors of BestProp. The other 60% of BestProp’s
shares are subscribed for by a large number of small private investors.
283
The office building costs £200 million, of which £20 million is financed by
BestProp’s share capital and the remaining £180 million by loans, all of
which are fully guaranteed by Top-of-Prop.
The summarised 2011 accounts for Top-of-Prop and BestProp are as
follows.
Statement of financial positions as at 31 December 2011
Top-of-Prop BestProp
£m £m
Investment properties at valuation 400 240
Investment in BestProp at cost 8 –
Net current assets/(liabilities) 80 20
488 220
Loan capital (120) (180)
368 40
Share capital 160 20

Revaluation surplus 140 40
Retained earnings 68 (20)
368 40
Income statements for the year ended 31 December 2011

Rents receivable less expenses 28 10
Interest payable (10) (30)
Profit/(loss) before taxation 18 (20)

Taxation charge (4) –
Profit/(loss) after taxation 14 (20)

a. Prepare consolidated financial statements for Top-of-Prop Plc as at
31 December 2011, treating the investment in BestProp Plc on the
following bases:
i. as an investment
ii. as an associated company
iii. using proportional consolidation
iv. using full consolidation.
b. Discuss briefly the different views of the financial position and
profitability of Top-of-Prop Plc given by these accounting treatments,
illustrating your answer where appropriate with significant ratios.
284
Chapter 19: Accounting for foreign currency transactions and consolidation of foreign enterprises
Chapter 19: Accounting for foreign

currency transactions and consolidation
of foreign enterprises
19.1 Introduction
There are two main types of foreign currency operation:
• Direct business transactions denominated in foreign currency (e.g.
a contract to purchase a fixed asset from the USA where the price is
stated in $US).
• Foreign operations conducted abroad through a foreign enterprise
(e.g. subsidiary, associate or branch).
In each case a UK company will need to state these transactions in its
accounts in £UK. This exercise would be straightforward if exchange rates
were fixed.
In the first case, we must consider how an individual foreign transaction
should be accounted for if there is a change in exchange rates between the
time that the transaction was entered into and the time at which it was
settled.
In the second case, we must consider how the accounts of a foreign
operation (e.g. a branch or subsidiary) should be translated from the
foreign currency into the parent’s currency at the accounting year-end.
Translation is the process whereby financial data denominated in one
currency are expressed in terms of another currency. It includes both the
expression of individual transactions in terms of another currency and
the expression of a complete set of financial statements prepared in one
currency in terms of another currency.

We need to consider how to account for foreign currency translations and
approaches to accounting for companies within the group operating in
foreign countries. This chapter illustrates the methods used to translate
individual foreign currency transactions and the financial statements
of companies operating abroad. Throughout the chapter, guidance will
be given as to how to apply these accounting techniques. We will also
consider historical approaches to foreign currency translation.

• explain why foreign currency translation is necessary
• explain the importance of the exchange rate and how to treat
exchange differences
• describe the four main methods of foreign currency translation
• discuss the different treatment of foreign subsidiaries and branches
• describe and use both the closing rate and the temporal method of
foreign currency translation.
285



IAS 21 The effects of changes in foreign exchange rates.
IAS 29 Financial reporting in hyper inflationary.
19.2 Foreign currency conversion: business transactions

In this section, we are only going to deal with accounting for an individual
company’s transactions that are denominated in foreign currencies;
translating the accounts of overseas subsidiaries (and related topics) is
discussed later in this chapter.
19.2.1 Purchase of non-current assets

According to IAS 21, if a UK company purchases non-current assets,
inventory and so on from an overseas company, it will record the acquisition
at the rate of exchange ruling at the date of the transaction (i.e. record
these when they occur). The £ UK value of the acquisition will then be fixed
and there would be no subsequent retranslation of the asset or purchase if
rates change when payment is made; a gain or loss on the exchange will
arise on settlement which would be taken to the income statement.
Note: If a contract had been agreed subject to an agreed exchange rate,
that rate will be used to record the transaction. If the company had
entered into a matching forward contract, the rate in the contract could
be used.
Consider the following examples in which Winterholder Plc (a UK
company) enters into one foreign currency transaction. The statement of
financial position date of Winterholder Plc is 31 December 2011.
Example 19.1
Winterholder Plc purchased a pasta-making machine for $15,000 on 30
September 2011. On 30 September 2011 the exchange rate was £1:$2.
Winterholder Plc actually paid for the machine on 1 December 2011 when
the exchange rate was £1:$2.5.
• How should the non-current assets be recorded in the accounts of
Winterholder Plc?
• How should the difference on the exchange be treated?
The fixed asset is recorded at its historical cost at the date of the
transaction when the exchange rate was £1:$2. Therefore the fixed asset
will be recorded as £7,500 ($15,000/$2).
Dr Assets £7,500
Cr Trade payable £7,500
The cash payment is £6,000 ($15,000/$2.5), therefore there is a realised
gain on exchange of £1,500 (£7,500–£6,000). Following IAS 21, this gain
is credited to the income statement.
Dr Trade payable £7,500

Cr Cash £6,000
286

Cr Gain on exchange £1,500
Example 19.2
September 2011. On 30 September 2011 the exchange rate was £1:$2.
Winterholder Plc actually paid for the machine on 1 December 2011 when
the exchange rate was £1:$1.5.
• How should the fixed asset be recorded in the accounts of
Winterholder Plc?
• How should the difference on exchange be treated?
Once again, the fixed asset is recorded at its historical cost at the date of
the transaction when the exchange rate was £1:$2. Therefore, the fixed
asset will be recorded as £7,500.
Dr Assets £7,500
The cash payment is £10,000 ($15,000/$1.5); therefore there is a realised
loss on exchange of £2,500. Following IAS 21, this loss is charged to the
income statement.

Dr Loss on exchange £2,500
Cr Cash £10,000
19.3 Foreign currency translation: business transactions

Examples 19.1 and 19.2 dealt with situations in which the transactions
were completed by the year-end. Example 19.3 looks at how to deal with
foreign currency transactions that are not complete by the year-end.
Example 19.3
September 2011.
On 30 September 2011 the exchange rate was £1:$2. At the statement
of financial position date of 31 December 2011 the exchange rate was
£1:$2.5. Winterholder Plc eventually paid for the machine on 31 January
2012 when the exchange rate was $1:$3.
• How should the non-current assets be recorded in the accounts of
Winterholder Plc?
• How should the difference on exchange be treated both at the balance
sheet date and in the following year?
The fixed asset is recorded at its historical cost at the date of the
transaction when the exchange rate was £1:$2. Therefore, the fixed asset
will be recorded as £7,500.
Dr Assets £7,500
At the statement of financial position date the transaction is unsettled; it
shows a balance of £7,500. However, this is incorrect because if the debt
was paid at this date Winterholder Plc would only pay £6,000 ($15,000
÷ 2.5). Thus, according to IAS 21, this transaction should be translated
at the closing rate (see more about the closing rate later in Section 19.4),
287
that is, the rate of exchange ruling at the statement of financial position
date. Therefore, an exchange gain of £1,500 (£7,500–£6,000) is credited
to the income statement for the year ending 31 December 2011.

When the transaction is settled on 31 January 2012 the cash payment
is £5,000 ($15,000/$3), representing a total realised gain on exchange
of £2,500 (£7,500–£5,000). As £1,500 was credited to the previous
year’s income statement, the balance of £1,000 is credited to the income
statement for the year ending 31 December 2012.

Cr Cash £5,000
Activity 19.1
What is the rationale for crediting exchange gains on unsettled transactions at the year-
end to the income statement? What would happen if the exchange rate at 31 January
2012 was £1:$1.5?
Example 19.4
Winterholder Plc trades in the USA and issues its price list in $. On 1
March it sells pasta to a US customer for $2,950 when the exchange rate is
$1:$2.95.
In Winterholder’s books the transaction will be recorded at the rate of
exchange ruling at the date of the transaction:
Dr Trade receivables £1,000

Cr Sales £1,000
The US customer pays for the goods on 30 April when the rate of exchange
is £1:$3.2.
In Winterholder’s books the entries will be:
Dr Cash £923
Dr Loss on exchange £77
Cr Trade receivables £1,000
Under IAS 21 the difference on exchange will go to the income statement.
If it is a gain on exchange, it is treated as a realised profit.
Example 19.5
Suppose that the sales Winterholder made to the US customer in Example
19.4 were not settled at the statement of financial position date. At the
statement of financial position date the exchange rate was £1:$2.5. How
would these be shown in Winterholder’s accounts?
The trade receivable of $2,950 would still be outstanding at that date. IAS
21 requires that the trade receivable of $2,950 be translated at the closing
rate (i.e. the rate of exchange prevailing at the statement of financial
position date, unless there is an agreed rate or matching forward contract).
The trade receivable would therefore appear in the statement of financial
position as £1,180 and there would be a gain on exchange of £180, which
288
IAS 21 takes to the income statement. (Any loss on short-term monetary

items is also regarded as realised under IAS 21 and is taken to the income
statement.)
Example 19.6: Long-term liabilities

On 1 January 2011 a UK company raised a five-year loan of $20 million
in the USA when the exchange rate was £1:$2.90. At that date it would
have been recorded as a liability of £6,896,552. At what amounts should
the liability appear in the statement of financial position at 31 December
2011, 2012, 2013, etc?
IAS 21 argues that the best predictor of the rate when the loan is finally
repayable is the closing rate at each statement of financial position
date. So, if the rate at 31 December 2011 were £1:$3.1 and at 31
December 2012 were £1:$2.95, the loan would appear at £6,451,613 and
£6,779,661 respectively.
The exchange gain on the translation of unsettled long-term monetary
items at each balance sheet date is regarded by IAS 21 as unrealised and
the gain should be taken to the income statement. A similar principle also
applies to exchange losses: any loss on the translation of unsettled long-
term monetary items would also be taken to the income statement.
Note: In the UK when exchange gains and losses arise from trading
transactions they should normally be included under ‘other operating
income and expenses’ in the income statement. When they arise from
financing transactions they should be included with ‘other interest
receivable/payable and similar income/expenses’.
19.3.1 Summary of accounting rules for individual transactions

Completed transactions: translated on day of transaction.
Incomplete transactions: short-term monetary items (trade receivables,
inventories, etc.) translate at year-end rate. Take unrealised loss or gain to
the income statement.
Incomplete transactions: long-term monetary items (loans, etc.) translate
at year-end rate. Take unrealised loss or gain to the income statement.
19.4 Which exchange rate should be used to record foreign

currency translations of a group of companies?
In the previous section we introduced foreign currency transactions. In
the remainder of the chapter we will consider the case in which foreign
operations are conducted abroad through a foreign enterprise (e.g.
subsidiary, associate or branch). The questions are:
• How should their accounts be translated into £UK?
• How should any differences on exchange be treated?
There are four distinct choices of exchange rate translation. The four
methods are:
1. Closing rate method
• This is the primary method used under IAS 21.
• This method is also known as the ‘net investment method’ or the
‘current rate method’ in the USA. It is based on the notion that
the holding or parent entity has a net investment in the foreign
enterprise/operation and the risk from currency fluctuations
therefore affects this net financial investment.
289
• Statement of financial position: All assets and liabilities are

translated at the exchange rate applicable at the statement of
financial position date (i.e. the closing rate). Items in equity (apart
from retained earnings) is translated at historic rates.
• Retained earnings that existed at the date of investment are
translated at historic rates (based on the date of investment in
the subsidiary).
• Any additional income to retained earnings since the date of
investment are translated using the average rate (as per items
in the income statement)
• Dividend reductions to retained earnings are translated using
the (historical) rate at the date of declaration of the dividend.
• Income statement: Average rate.
2. Temporal method
• The temporal method is based on the idea that foreign operations
are part of the group, but with some assets and liabilities of the
group being based abroad. While the temporal method relies on
exchange rates that are translated on a historical basis, it should
not be seen as a ‘historical’ approach to translation per se, as it is
about translating rates at the time at which the transaction has
occurred (as opposed to translating on the year-end reporting
date, as per the closing rate method).
The current standard IAS 21 does not explicitly refer to the
temporal method, as the closing rate method is the primary
method to be used when preparing accounts. However, Alexander
et al. (2020, Chapter 28, section 28.6.4, pp.723–25) notes that
IAS 21 prescribes the temporal method be used for translating
transactions and events into the functional currency, before
the functional currency is subsequently translated into the
presentation currency at the closing rate
• Statement of financial position: All assets and liabilities that are
carried at current prices (e.g. cash, trade and other receivables,
trade and other payables) are translated at the closing rate. All
assets and liabilities are carried at past prices (e.g. property, plant
and equipment) and are translated at the exchange rate applicable
at the historical or fair valuation date.
• Income statement: Historical or average rate for the period,
assuming the rates do not fluctuate significantly.
3. Current/non-current method
• Statement of financial position: All current assets and current
liabilities are translated at the closing rate. All non-current assets
and non-current liabilities are translated at the historical rate.
4. Monetary/non-monetary method
• Statement of financial position: All monetary assets and liabilities
(relating to the right/obligation to receive/pay a fixed amount of
money) are translated at the closing rate. All non-monetary assets
and non-monetary liabilities are translated at the historical rate.
290
In the remainder of the chapter we will concentrate on the temporal

method and the closing rate method. Each method is discussed in more
detail and evidenced with a worked example.
19.4.1 Distinguish between the use of closing rate and the

temporal method
The two most commonly used methods of translation are the closing rate
method and the temporal method. Both of these methods are permitted
under IAS 21, depending on the circumstances leading to translation. The
closing rate method is most prevalent. The method which should be used
depends on the financial and other operational relationships between the
investing company and the foreign enterprise.
In order to understand the circumstances in which each method is
required, we need to familiarise ourselves with some terminology. IAS
21 was revised following the IASB’s improvement project. One change
that was made was to replace the notion of ‘reporting currency’ with two
aspects of currency.
Functional currency is the currency of the primary economic
environment in which the entity operates. The primary economic
environment in which an entity operates is normally the one in which it
primarily generates and expends cash (IAS 21, para.9).
Presentation currency is the currency in which the financial
statements are presented.
Here we are concerned with the translation of functional currency
to presentation currency. For many companies the determination of
functional currency will be a straightforward exercise. IAS 21, paras.9–12
outline factors that companies should consider when making this decision:
a. the currency that mainly influences sales prices for goods and services;
and of the country whose competitive forces and regulations mainly
determine the sales prices of its goods and services;
b. the currency that mainly influences labour, materials and other costs of
providing goods or services.
The following factors may also provide evidence of an entity’s functional
currency:
• The currency in which funds from financing activities are generated.
• The currency in which receipts from operating activities are usually
retained.
The following additional factors are considered in determining the
functional currency of a foreign operation and whether its functional
currency is the same as that of the reporting entity (the reporting entity,
in this context, being the entity that has the foreign operation as its
subsidiary, branch, associate or joint venture) (IAS 21, para.11).
• Whether the activities of the foreign operations are carried out as an
extension of the reporting entity, rather than being carried out with
a significant degree of autonomy. An example of the former is when
the foreign operation only sells goods imported from the reporting
entity and remits the proceeds to it. An example of the latter is when
the operation accumulates cash and other monetary items, incurs
expenses, generates income and arranges borrowings, all substantially
in its local currency.
• Whether transactions with the reporting entity are a high or low
proportion of the foreign operation’s activities.
291
• Whether cash flows from the activities of the foreign operation directly
affect the cash flow of the reporting entity and are readily available for
remittance to it.
• Whether the cash flows from the activities of the foreign operations are
sufficient to service existing and normally expected debt obligations
without funds being made available by the reporting entity.
When the above indicators are mixed and the functional currency is not
obvious, management uses its judgement to determine the functional
currency that most faithfully represents the economic effects of the
underlying transactions, events and conditions (IAS 21, para.12).
The closing rate method is used where the foreign enterprises are
quasi-independent entities. The key determinant appears to be whether
or not the foreign enterprise operates primarily in the functional currency.
If this is the case, the closing rate method applies. This would be true for
most foreign business operations (typically subsidiaries).
If the functional currency is that of the investing company rather than the
foreign enterprise, the temporal method should be used.
Hence, the temporal method is to be used where the trade of the
foreign enterprise is more dependent on the economic environment of
the investing company’s currency than that of its own reporting currency.
By using the temporal method, the consolidated accounts reflect the
transactions of the foreign enterprise as if they had been carried out by the
investing company itself.
Activity 19.2
From an economic point of view, why might companies wish to set up a foreign subsidiary
or branch?
Activity 19.3
An entity operating in the Republic of Ireland owns several buildings in Dublin and Cork
that are rented to US multinational corporations basing the European offices there. The
contracts for the lease of the buildings are determined in US$ and payment can be made
either in US$ or Euros €. How is the functional currency determined?
19.5 Accounting for the closing rate method and the

temporal method
We have discussed the circumstances in which the closing rate and
temporal methods are used. In this section we briefly review the
accounting treatment required for each method.
19.5.1 Closing rate: statement of financial position

The closing rate at the statement of financial position date is used to
translate the statement of financial position of the foreign enterprise into
the investing company’s currency. However, the share capital is translated
at the historic rate applicable. The exchange difference is taken to reserves
(not to the income statement).
19.5.2 Closing rate: income statement

IAS 21 requires that the foreign enterprise’s income statement should be
translated at the date of transaction. As certain transactions such as sales,
purchases and expenses occur throughout the year, these are normally
assumed to arise evenly (for simplicity – but more complex assumptions or
methods can be used and hence the average rate for the year is often used).
292
19.5.3 Closing rate: exchange differences

Exchange differences relating to retranslation of the opening net
investment (i.e. where the opening and closing statement of financial
position are translated at different exchange rates) using average rate for
the income statement are not treated as being generated from the ordinary
activities of the group. Instead, it is included under ‘other comprehensive
income’.
Activity 19.3
Why are these exchange differences recorded as movements in reserves rather than
included in the income statement? For instance, do differences reflect actual or
prospective cash flows? Think about these questions before reading further.
19.5.4 Temporal method: statement of financial position

Monetary assets and liabilities should be translated at the closing rate.
Non-monetary assets and liabilities should be translated at the applicable
rate at which they were first recorded (if stated at historical cost) or at the
applicable rate at the time at which any revaluation took place (if stated at
a revalued amount).
19.5.5 Temporal method: income statement

The general rule is that all transactions should be translated at the rate
applicable on the transaction date. Alternatively, an average rate can be
used if the rates do not fluctuate too much over the period. However, you
need to approach this with caution. Depreciation will be based on the rate
used for non-current assets; accrued revenues and expenses are translated
at an average rate; other revenues and expenses are translated at a specific
or appropriate average rate.
19.5.6 Temporal method: exchange differences

All exchange differences are taken to the income statement and included
within the ordinary activities of the group. The exchange difference is
treated as part of the income statement to reflect the realised costs/
gains of international trade. This is unlike the closing rate method,
which requires this to be taken to reserves, where such gains/losses are
seen as being incidental to the operations of the (independent or quasi-
autonomous) foreign enterprises
Activity 19.4
Why do you think these exchange differences are taken to the income statement, yet the
closing rate method’s exchange rate differences are taken to the reserves?
What is the difference in the nature of the exchange difference between the two methods
of translation?
Example 19.7: The closing rate and the temporal methods

On 1 January 2011 Radmond Plc (UK investing company) set up Dunfor
(foreign subsidiary) and carried out the following transactions:
• share capital of 200,000 shares of $1 each
• purchased $100,000 worth of non-current assets (five-year useful life;
nil scrap value; straight-line depreciation)
• cash purchase of 1,000 units of inventory for $20,000.
293
On 30 June 2011, Dunfor had the following:

• cash sales of 400 units of inventory for $60 each
• credit sales (eight months’ credit) for 400 units for $60 each
• cash expenses of $4,000.
The exchange rates were:
• £1:$5 on 1 January 2011
• £1:$10 on 30 June 2011
• £1:$12 on 31 December 2011.
Given this information, we will translate Dunfor’s balance sheet and
income statement into £UK using both the closing rate method and the
temporal method.
Closing rate method

Income statement for Dunfor for year ended 31 December 2011
$ $ Exchange £ £
rate
Sales 48,000 10 4,800
Purchases 20,000 10 2,000
Less closing inventory (4,000) 10 (400)
Cost of goods sold (16,000) (1,600)
Gross profit 32,000 10 3,200
Expenses (4,000) 10 (400)
Depreciation (20,000) 10 (2,000)
Net profit 8,000 800
IAS 21 requires that the average rate should be used (£1:$10) to translate
the income statement into Radmond Plc’s presentation currency (£UK).
Activity 19.5
What would the net profit be if we used the closing rate (rather than the average rate) to
translate the income statement?
Statement of financial position for Dunfor as at 31 December 2011

$ Exchange rate £
Non-current assets (NBV) 80,000 12 6,667
Current assets:
Inventory 4,000 12 333
Trade receivables 24,000 12 2,000
Cash 100,000 12 8,333
128,000 10,666
208,000 17,333
Share capital 200,000 5 40,000
Retained profit or (loss) 8,000 (= balancing figure) (22,667)
208,000 17,333
294
IAS 21 requires that the exchange gain (loss) is taken to reserves. The
balancing figure inserted for the retained profit can thus be broken down
into movement in reserves:
Balance brought forward £–
Profit for the year £800
Exchange difference (£23,467)
(£22,667)
This exchange difference (£23,467) can be analysed in terms of the
exchange difference on the opening net investment and on the net profit.
Opening net assets at opening rate $200,000 @ £1:$5 = £40,000
Opening net assets at closing rate $200,000 @ £1:$12 = £16,667
Exchange loss on net investment (£23,333)
Net profit at average rate £8,000 @ £1:$10 = £800

Net profit at closing rate £8,000 @ £1:$12 = £667
Exchange loss on net profit = (£133)
Total exchange difference = (£23,466)
(£23,467 with rounding)
Activity 19.6
What would the exchange difference reconciliation be if the closing rate (rather than the
average rate) was used to translate the income statement?
Points to note
The share capital is translated at the historical rate applicable.
• IAS 21 argues that the exchange difference should be taken to equity:
‘movement on reserves’. It could be argued (conceptually) that the
gain on short-term monetary items should be taken to the income
statement and only the difference on translation relating to long-
term items should be taken to equity. This could be justified on the
following basis, using the old UK standard (SSAP 20):
If exchange differences arising from the retranslation of
a company’s net investment in its foreign enterprise were
introduced into the income statement, the results from
trading operations, as shown in the local currency financial
statements, would be distorted. Such differences may result
from many factors unrelated to the trading performance or
financing operations of the foreign enterprise; in particular,
they do not represent or measure changes in actual or
prospective cash flows. It is therefore inappropriate to
regard them as profits or losses and they should be dealt
with as adjustments to reserves.
19.5.7 Temporal method

The mechanics of the temporal method require translating each
transaction of the foreign enterprise at the rates ruling at the date of each
transaction.
295
The restated accounts (under the temporal method) are as follows.

Statement of financial position for Dunfor as at 31 December 2011
$ Exchange rate £
Non-current assets (NBV) 80,000 5 16,000
Current assets:
Inventory 4,000 5 800
Trade receivables 24,000 12 2,000
Cash 100,000 12 8,333
128,000 11,133
208,000 27,133
Share capital 200,000 5 40,000

Retained profit or (loss) 8,000 (= balancing figure) (12,867)
208,000 27,133
Note that the retained profit is the balancing figure.

$ $ Exchange rate £ £
Sales 48,000 10 4,800
Purchases 20,000 5 4,000
Expenses (4,000) 10 (400)
Depreciation (20,000) 5 (4,000)
(2,800)
Translation loss (10,067)
Net profit 8,000 (12,867)
Points to note
• The depreciation is translated at the rate applicable to the non-current
assets.
• The net profit is the balancing figure from the statement of financial
position. The translation loss is the balancing figure that ensures a net
loss of £12,867.
Activity 19.7
Why do we use an exchange rate of $5 to £1 to translate inventory figures? (See earlier
in the chapter.)
296
The translation loss of £10,067 can be calculated easily because it is the

exchange loss on monetary items.
Opening Closing
monetary items monetary items
$ $
Trade receivables – 24,000
Cash 80,000 100,000
80,000 124,000
Opening monetary items @ opening rate:
$80,000 @ £1:$5 = £16,000
Opening monetary items @ closing rate:
$80,000 @ £1:$12 = £ 6,667
(£ 9,333)
Change in monetary items @ average rate:

$44,000 @ £1:$10 = £ 4,400
Change in monetary items @ closing rate:
$44,000 @ £1:$12 = £ 3,667
(£ 733)
Total exchange loss (£10,066)
(£10,067 rounded)
Points to note
• Monetary items are translated at the closing rate.
• Non-monetary items are translated at their original rate.
The exchange difference is taken to the income statement.
Example 19.8
Parent established a 100% ownership of Subsidiary on 1 January 2019
by acquiring GBP £40,000 worth of shares in cash, when the exchange
rate was Wongas (W$) = 12 for £1. The Subsidiary raised a long-term
loan of W$125,000 in the local (foreign) economy on 1 January 2019.
On the same day, the company acquired equipment worth W$400,000,
which is expected to last for a period of 10 years with no residual value.
Depreciation is to be accounted for on a straight-line basis. The relevant
exchange rates for 2019 were:
W$ to £
1 January 2019 15
Average for the year 12
Average closing inventory 10
31 December 2019 11
The financial statements are as follows:

Wongas (W$)
Revenue 550,000
Less: Cost of sales (405,000)
Gross profit 145,000
297
Other expenses (20,000)
Net profit for the year 85,000

Wongas (W$)
Non-current assets (cost) 400,000
Accumulated depreciation (40,000)
360,000
Inventory 190,000
Net monetary current assets 140,000
Less: Loans due more than a year (125,000)
Total net assets 565,000

Retained profits * 85,000
565,000
* There was no balance of retained profits from prior years, so all profits are
from trading in 2019 only.
Question
Translate the accounts for the foreign operation using both the closing rate
and temporal rate method. Your calculations should clearly identify the
treatment for the exchange differences.
Solutions

Wongas (W$) Rate Closing Rate Rate Temporal Rate
Revenue 550,000 12 45,833 12 45,833
Less: Cost of sales (405,000) 12 (33,750) 12 (33,750)
Gross profit 145,000 12,083 12,083
Depreciation (40,000) 11 (3,636) 15 (2,667)
Other expenses (20,000) 12 (1,667) 12 (1,667)
Exchange gain (or loss) balance 4,614
Profit for the year 85,000 6,780 12,364
Other comprehensive income:
Translation reserve 12,583
Total comprehensive income 19,364 12,364
298
Calculation of translation reserve for the Closing Rate method

Item W$ Opening rate Opening £ Closing rate Closing £ Difference (Dr)/Cr
Opening non-current assets 400,000 15 26,667 11 36,364 9,697
Opening net current assets 205,000 15 13,667 11 18,636 4,970
Opening long-term loans (125,000) 15 (8,333) 11 (11,364) (3,030)

From I/S Closing rate Closing £
Net profit for the year 85,000 6,780 11 7,727 947
Translation reserve, as per
the CIS 12,583

Wongas (W$) Rate Closing Rate Rate Temporal Rate
Non-current assets (cost) 400,000 11 36,364 15 26,667
Accumulated depreciation (40,000) 11 (3,636) 15 (2,667)
360,000 32,727 24,000
Inventory 190,000 11 17,273 10 19,000
Net monetary current assets 140,000 11 12,727 11 12,727
Less: Loans due more than a year (125,000) 11 (11,364) 11 (11,364)
Total net assets 565,000 51,364 44,364
Share capital 480,000 15 32,000 15 32,000

Retained profits (CR) or Total CIS (TR) 85,000 From I/S 6,780 balance 12,364
565,000 38,780
Translation reserve balance 12,583
565,000 51,364 44,364
Notes:
Temporal Rate Method:
• The exchange gain of £4,614 is included in the income statement for
the year as part of the trading activities of the Subsidiary.
• The exchange gain is calculated as the balancing figure in the income
statement.
• The net profit for the year figure is itself calculated as the balancing
figure in the statement of financial position.
Closing Rate Method:

• The translation reserve (i.e. gains on foreign currency exchange)
for the Closing Rate method of £12,583 is not part of the trading
activities, and therefore reported as a reserve figure under Other
Comprehensive Income.
• The net profit for the year does not include the exchange gain. Instead,
the translation reserve can be calculated in one of two ways.
• The first method of calculating the translation reserve is by working
out the balancing figure in the statement of financial position.
• The second (alternative) method is to work out the sum of differences
between the £ value of the opening and closing assets, non-current
liabilities and net profit (see table for calculations above).
299
Practical tips:
Those attempting this question for the first time may find it easier, under
the Temporal Rate Method, to start with the statement of financial Position
first to work out the retained profits balancing figure, which can then be
used to calculate the Profit for the year.
For the Closing Rate Method, start from the income statement, which
would give you the figures you need to calculate the retained profits in the
statement of financial position, which is needed to calculate the (changes
to) translation reserve.
In this example, there was no prior retained profits nor translation reserve.
If either balance (or both balances) were carried forward from the prior
year, there would then be a need to adjust the carried forward balance
with the current year’s figures.
19.6 Consolidation of foreign subsidiary

The principles for consolidating a foreign subsidiary are very similar to
those for a domestic subsidiary. First, the subsidiary has to be translated
into the presentation currency. If a British parent company has a French
subsidiary, and GBP £ is the presentation currency of the group, this means
that the French subsidiary’s accounts has to be translated from Euros € to
£ before the consolidation is performed.
Example 19.9: Parent and foreign subsidiary

On 1 January 2019, Parent acquired 75% of the ordinary shares of a
French Subsidiary for £21,000,000, when the Subsidiary’s earnings were
€14,000,000 and the share premium was €10,000,000. The Subsidiary’s
financial statements have been audited in their functional currency of
Euros €. The group adopts IAS 21. The group’s financial statements are as
follows:

Parent Subsidiary
£’000 £’000 €’000 €’000
Sales 250,000 100,000
Opening inventories 24,000 15,000
Purchases 120,000 80,000
Closing inventories (30,000) (40,000)
Cost of sales (114,000) (55,000)
Other expenses (20,000) (18,000)
Interest paid (1,500)
Profit before tax 116,000 25,500
Tax (18,000) (7,500)
Profit after tax 98,000 18,000
300

Parent Subsidiary
£’000 €’000
Investment in Subsidiary 21,000
Current assets
Inventories 32,000 30,000
Trade receivables 40,000 29,500
Cash 13,000 6,000
Total current assets 85,000 65,500
Current liabilities
Trade payables (35,000) (10,000)
Tax (18,000) (7,500)
Total current liabilities (53,000) (17,500)
Non-current liabilities: Debentures (6,000)
Total assets less liabilities 143,000 82,000
Equity
Share capital 20,000 40,000
Share premium 10,000
143,000 82,000
The exchange rates are as follows:
€ to £1
1 January 2019 1.30
Average for the year 1.20
Opening inventory 1.08
Closing inventory 1.10
31 December 2019 1.15
Required:
1. Prepare the consolidated income statement for the group.
2. Prepare a consolidated statement of financial position for the group,
showing:
a. The goodwill
b. The non-controlling interest
c. Hint: The group retained earnings can be calculated as a balancing
figure
301
Solution

Parent Subsidiary Rate Subsidiary Group
£’000 €’000 £’000 £’000
Sales 250,000 100,000 1.20 83,333 333,333
Opening inventories (24,000) (15,000) 1.08 (13,889) (37,889)
Purchases (120,000) (80,000) 1.20 (66,667) (186,667)
Closing inventories 30,000 40,000 1.10 36,364 66,364
Cost of sales (114,000) (55,000) (44,192) (158,192)
Gross profit 136,000 45,000 39,141 175,141
Other expenses (20,000) (18,000) 1.20 (15,000.00) (35,000)
Interest paid (1,500) 1.20 (1,250) (1,250)
Tax (18,000) (7,500) 1.15 (6,522) (24,522)
Profit after tax 98,000 18,000 16,370 114,370

Parent Subsidiary Rate Subsidiary Group Notes
£’000 €’000 £’000 £’000
Non-current assets 70,000 30,000 1.15 26,087 96,087
Investment in Subsidiary 18,000 a
Goodwill (18,000) a
Current assets
Inventories 40,000 30,000 1.15 26,087 66,087
Trade receivables 27,000 25,000 1.15 21,739 48,739
Cash 2,000 1,000 1.15 870 2,870
Total current assets 69,000 56,000 48,696 117,696
Current liabilities
Trade payables (35,000) (12,000) 1.15 (10,435) (45,435)
Tax (15,000) (5,000) 1.15 (4,348) (19,348)
Total current liabilities (50,000) (17,000) (14,783) (64,783)

Non-current liabilities:
Debentures (6,000) 1.15 (5,217) (5,217)
Total assets less liabilities 107,000 63,000 54,783 125,783
Equity
Share capital 20,000 40,000 1.15 34,783 20,000
Share premium 10,000 1.15 8,696
Retained earnings 123,000 32,000 1.15 27,826 87,957 c
Non-controlling interest 17,826 b
143,000 82,000 71,304 125,783
302
Goodwill (notes a)
€’000 €’000 Rate £’000
Cost of investment 27,300 1.30 21,000
Retained earnings (at
acquisition) 14,000
64,000
Parent’s share of Subsidiary 48,000
Goodwill at date of
acquisition (20,700) 1.30 –15923.0769
Goodwill (restated to
year-end) (20,700) 1.15 –18000
Non-controlling interest NCI (note b)

€’000 Rate £’000 £’000
Share capital 40,000 1.15 34,783
Share premium 10,000 1.15 8,696
Retained earnings (at year-end) 32,000 1.15 27,826
71,304
NCI share 25% 17,826
Retained earnings (note c)

The retained earnings is calculated as a balancing figure. It is comprised of:
£’000
Parent’s retained earnings 123,000
Parent’s share of Subsidiary’s post acquisition profit (35,043)
87,957
Activity 19.8
From the workings in Example 19.9 above, reconcile the retained earnings figure,
showing the exchange gains or losses.
19.7 Foreign currency translation in hyperinflationary

economies
In Chapter 7, section 7.10.2, we discussed an application of the Current
Purchasing Power (CPP) approach, in IAS 29 financial reporting for
hyper inflationary economies. IAS 29 is also relevant where some group
of companies have subsidiaries that operate in such economies. This is
illustrated in the accounting policies adopted by Unilever in the group’s
2019 accounts: see the sections ‘Foreign currencies’ and ‘Hyperinflationary
economies’ (Unilever, 2019, p.91, https://www.unilever.com/investor-
relations/annual-report-and-accounts/archive-of-annual-report-and-
accounts/).
303
19.8 Final thoughts

You have now worked through foreign exchange translations using both
the closing rate method and the temporal method. In the previous worked
example Dunfor is translated using both methods. To conclude this chapter
please consider the questions in Activity 19.8.
Activity 19.9
• Why are the income statement retained profit figures different?
• What is the reasoning for the different outcomes produced by each method?

• explain why foreign currency translation is necessary
• explain the importance of the exchange rate and how to treat
exchange differences
• describe the four main methods of foreign currency translation
• discuss the different treatment of foreign subsidiaries and branches
• describe and use both the closing rate and the temporal method of
foreign currency translation.

Question 19.1
On 1 January 2011 Dunelm Plc (a UK investing company) set up its
foreign subsidiary (Dunfor) in Zongaland, which uses Zonga dollars (Z$).
The following transactions are relevant on that date:
• start up share capital of 200,000 shares of $1 each with paid-in cash
• purchased $100,000 worth of non-current assets (five-year useful life;
nil scrap value; straight-line depreciation)
• cash purchase of 1,000 units of inventory for $20,000.
On 30 June 2011 Dunfor has its first sales transactions:
• cash sales of 300 units of inventory for $70 each
• credit sales (eight months’ credit) of 300 units for $70 each
• cash expenses of $3,000.
The exchange rates relevant for the current example are:
• £1:$10 on 1 January 2011
• £1:$8 on 30 June 2011
• £1:$5 on 31 December 2011.
What is the difference between a ‘functional currency’ versus a
‘presentation currency’? State a factor that determines a ‘functional
currency’.
Translate Dunfor’s balance sheet and income statement into £UK using the
temporal method.
304
Question 19.2
On 1 January 2010, Club Ltd acquired 80% of the ordinary shares of a
subsidiary, Golf Org for £900,000. Golf Org trades in ‘potts’. On 1 January
2010 the balance on the accumulated profits of Golf Org was 640,000
‘potts’ and the share capital of Golf Org was 4,800,000 ‘potts’.
The summary income statements and statements of financial position of
Golf Org are given as follows:
Golf ‘potts’
Non-current assets 7,200,000
Inventories 300,000
Cash 1,220,000
Capital and reserves 8,720,000
The following information is also available:
1. Non-current assets were acquired on 1 January 2010.
2. Opening inventories were acquired on 12 November 2015 and closing
inventories were acquired on 15 December 2016.
3. The net profit for 2016 in the statement of comprehensive income for
Golf Org is 580,000 potts.
4. Exchange rates:
1 January 2010 £1 = 10 ‘potts’

12 November 2015 £1 = 5 ‘potts’
1 January 2016 £1 = 6 ‘potts’
Average for 2016 £1 = 4 ‘potts’
15 December 2016 £1 = 2 ‘potts’
31 December 2016 £1 = 3 ‘potts’
5. The translated retained earnings brought forward for Golf Org is

£876,668 under the closing rate method and the translated retained
earnings brought forward for Golf Org is £398,000 under the temporal
method.
6. Impairment of 20% of the value of the goodwill is to be provided in
2016.
a. When should the temporal and the closing rate methods of foreign
currency translation be used according to IAS 21?
b. Translate the statement of financial position of Golf Org using the
closing rate method.
c. Translate the statement of financial position of Golf Org using the
temporal method.
d. Calculate the goodwill that would be recorded in the consolidated
statement of financial position for Club Ltd as at 31 December
2016 under the closing rate method.
305
Notes
306
Chapter 20: Analysis and interpretation

of financial reports
20.1 Introduction
In this chapter we are interested in interpreting accounts. This chapter
extends the ratio analysis discussed in the subject guide for AC1025
Principles of accounting and includes a number of other approaches.
In short:
• Can you say something sensible about what the accounts mean?
• How can users of accounts interpret them in a meaningful way?
Ratio analysis should be used in conjunction with:
• business analysis (i.e. what is the company’s risk and what are its
profit drivers?), which enables you to place your ratio analysis
• accounting analysis (i.e. assess the accounting policies of the company)
• trend analysis
• review of other qualitative information (e.g. Chairman’s statement, the
Operating and Financial Review)
• comparison of income with cash flow information (i.e. is a company
reporting profits also generating cash?).
You are strongly advised to read International financial reporting, Chapter
30, to appreciate that ratio analysis is merely one of several forms of
analysis. It should not be conducted in isolation.
20.1.1 Aims of this chapter

• introduce some key areas of financial statement analysis and more
generally the interpretation of financial reports.

• interpret a set of accounts using a number of techniques
• apply the pyramid of ratios and other ratios to a set of accounts
• evaluate the information contained in segmental analysis
• perform trend and vertical analysis
• discuss international differences in accounting rules and reasons for
these differences.

International financial reporting, Chapters 29 to 31.

Hall, 2004) 7th edition [ISBN 9780273658498] Chapters 11 and 17.
Nobes, C. and R. Parker Comparative international accounting. (Harlow:
Prentice Hall, 2012) 12th edition [ISBN 9780273763796] Chapter 18.

307
IFRS 8 Operating segments.
20.2 Ratio analysis

Ratios represent the relationship between different financial items in
the accounts. They are a good way of directing attention to areas of a
company’s operations which require further detailed investigation. They
help to raise questions about the performance of a company. However,
although this technique is informative it should not be used blindly. There
are several important ‘health warnings’:
1. There are no universal ratio names and definitions. These
vary across textbooks and providers of financial information. Be
aware of the precise definition of any ratios you use and choose those
that are the most appropriate. Use those ratios which tell you what
you want to know and be selective in what you calculate. Also,
whenever you use ratios you should state the precise definition that
you have used.
Activity 20.1
What problems could arise when defining a ratio such as return on assets?
Hints:
• What does ‘return’ mean? (Does it include interest received, exceptional/
extraordinary items; is it before or after tax?)
• What is included in assets (e.g. tangible/intangible assets, net/total)?
2. Ratios are less relevant if looked at in isolation. For instance,

is a net margin of 10% good? Ratios must be compared against
previous years, competitors, industry averages or a budget. Also, you
must be aware that there are interrelations between ratios. Returning
to the net margin, it would not be good if the industry average was
20%. However, a 10% net margin might be good on a high level of
turnover due to reduced sales prices.
3. Ratios may hide underlying trends. Therefore you should
consider numerator and denominator on their own.
20.2.1 Pyramid of ratios

Ratio analysis is a technique used to analyse a set of accounts; it uses a
variety of ratio definitions and frameworks.
The pyramid of ratios developed here consists of five ratios: 1
Please refer to
International financial
Return on equity reporting, Chapter 31,
for further discussion
of these ratios and
definitions of other
Financial leverage multiplier Return on capital employed
important ratios.
Asset turnover Net profit margin
These are defined as follows:1

• return on equity2 = net profit before interest and taxation/
shareholders’ funds 2
Note that we are
• financial leverage multiplier = capital employed/shareholders’ funds using the most common
measure of return
• return on capital employed = net profit/capital employed on equity (earnings/
• net profit margin = net profit before interest and tax/sales shareholders’ funds) in
this particular pyramid
• asset turnover = sales/capital employed. of ratios.
308
Activity 20.2
a. The definition of capital employed is very important. Here it is defined as non-current
assets + current assets. Can you think of any alternative appropriate definitions? If so,
for what purpose are these used?
b. The gearing (or leverage) ratio measures the proportion of total financing provided by
long-term debt. Consider the arguments for and against using long-term, rather than
total debt in this ratio.
c. Explain what inventory days, trade receivable days and creditor days mean.
Example 20.1: Ratio analysis

The accounts of Frank Josie Plc (FJ Plc) are shown below. We will
calculate the ratios in the pyramid of ratios plus some relevant ratios from
these accounts and then interpret the accounts.
FJ Plc – consolidated income statement for the year ending 31 December 2016
2016 2015
£’000 £’000
Turnover 45,000 41,971
Cost of sales (25,726) (23,507)
Net operating expenses (16,094) (16,970)
Operating profit 3,180 1,494
Investment income 128 133
3,308 1,627
Interest payable (551) (672)
Tax payable (857) (388)
Dividends paid (500) (400)
Retained profit 1,400 167
FJ Plc – consolidated balance sheet as at 31 December 2016

Current assets:
Inventories 8,977 9,570
Trade receivables 14,986 13,523
Cash 1,613 1,918
Total current assets 25,576 25,011
Creditors due within one year (17,890) (15,297)
Total assets less current liabilities 21,126 20,599
Creditors due after one year (2,499) (3,372)
Net assets 18,627 17,227
Capital and reserves
Called-up share capital 700 700
Share premium account 520 520
Revaluation surplus 645 645
18,627 17,227
309
The pyramid of ratios for 2016 and 2015 are:
2016 2015
Return on equity Return on equity
17.8% (3,308/1,627) 9.4% (1,627/17,227)
ROCE ROCE
8.5% (3,308/39,016) 4.5% (1,627/35,896)
Asset Turnover Asset Turnover

1.15 (45,000/39,016) 1.17 (41,971/35,896)
Net Profit Margin Net Profit Margin

7.4% (3,308/45,000) 3.9% (1,627/41,971)
FLM FLM
2.09 (39,016/18,627) 2.08 (35,896/17,227)
The pyramid of ratios is a starting point for our analysis. The most obvious
changes are that the return on equity, ROCE and net profit margin have
nearly doubled from 2015 to 2016. The question is what is FJ Plc doing
better in 2016 than in 2015? The financial structure of FJ Plc (in terms of
the financial leverage multiplier) has not changed much, but the ROCE
appears to be driving the return on equity improvement. The increase in
ROCE could be due to either:
1. more productive assets (e.g. more productive non-current assets)
2. better control of trade receivables, inventory, creditors and so on
3. better margins (i.e. reduced costs or improved profitability).
As we can see, the net profit margin is driving the ROCE improvement.
How has FJ Plc managed to improve the net profit margin from 3.9% to
7.4%? We need to examine the gross profit margin, the administration
cost, and the distribution cost. It does not appear that the gross profit
margin is the main reason for the improved net profit margin.
Additional information
2016 2015
Administration expenses 9,600 9,370
Distribution expenses 6,494 7,600
Administration/sales 21.3% 22.3%
Distribution/sales 14.4% 18.1%
Although the administration/sales ratio has improved by one percentage

point, the distribution/sales ratio has improved by nearly four percentage
points. This could be due to several factors (e.g. streamlined distribution
network, better inventory system, etc.) but it seems to positively impact on
net margin, ROCE and return on equity.
310
Activity 20.3 (refer to FJ Plc)

a. Calculate the gross profit margin for 2015 and 2016. What are some possible causes
of this change?
b. Inventory fell from 2015 to 2016. Calculate the change in inventory days at each
balance sheet date.
c. Some textbooks use the average capital employed (average opening and closing
balances) to calculate ROCE. What are the advantages and disadvantages of using
average rather than closing capital employed? Is there another alternative?
d. Calculate and comment on the gearing ratio and how it has changed.
Activity 20.4
This exercise combines the concepts of ratio analysis with real world concerns from the
chapter on leasing.
Read p.16 of the Effects Analysis (https://www.ifrs.org/-/media/project/leases/ifrs/
published-documents/ifrs16-effects-analysis.pdf) on the impact of the lease accounting
standard IFRS 16 replacing IAS 17.
Questions:
1. Of the industry sectors outlined in the document, which industry is forecasted to be
most affected by the move from IAS 17 to IFRS 16?
2. What is the implication of the move to IFRS 16 on the return ratios (Return on Capital
Employed; Return on Assets, etc.)?
3. What implication does the move to IFRS 16 have on the way in which debt is
reported? How would this change the debt ratios?
4. What is the implication on the overall profitability of a company the move to IFRS 16?
20.2.2 Segmental analysis

Segmental analysis in the notes to the accounts is an additional
information source, providing disaggregated information on sales, profit
and (sometimes) assets by both geographic region and line of business
(where these different segments are significant or material). For instance,
FJ Plc gives the following breakdown by class of business:
Class of business
Turnover Gross profit
2016 2015 2016 2015
£’000 £’000 £’000 £’000
Paints 8,171 15,543 5,350 8,496
Explosives 9,382 6,133 4,802 2,659
Industrial chemicals 7,898 6,564 4,746 2,291
25,451 28,240 14,898 13,446
Merchanting 19,549 13,731 4,376 5,018
45,000 41,971 19,274 18,464
Initial observations suggest business changes. For instance, merchanting sales
are up by 42% but the gross profit on merchanting has fallen between 2015
and 2016. What is the explanation for this? Total sales for the three chemical
businesses have fallen but their gross profit has increased. Is the company
aware of this shift between the different classes of business?
311
Activity 20.5
Calculate the gross profit change for 2016 and 2015 for all classes of business. Comment
on your results.
For the reason that segmental reporting provides an insight into the
(changing) composition of a company’s core business, large multinationals
like Unilever provide segmental information that summarises the
breakdown of their core activities. (Unilever, Annual report and accounts
(2019), pp.94–95, available https://www.unilever.com/investor-relations/
annual-report-and-accounts/archive-of-annual-report-and-accounts/)
The breakdown is by category within the three segments of their business
(Beauty & Personal Care, Foods & Refreshment and Home Care), by time
series (2017 to 2019), and by geographical area (Netherlands/UK, United
States and all others).
20.3 Cash flow statement

Besides generating a profit, a company must also generate a cash inflow.
Is the company turning profit into cash?
You should review the cash flow statement to see whether the company is
generating a cash inflow from operating activities that is sufficient (over
a number of years) to service finance (i.e. pay interest and dividends),
pay taxes and allow some investment. Also, the cash flow statement
will provide cash details on the acquisition of new assets or subsidiary
undertakings. In addition, the cash flow statement shows whether the
company has taken out any new financing, repaid any debt or restructured
any loans. You may find it helpful to refer to questions on cash flow
statements in the Further reading list.
20.4 Trend analysis

Trend analysis involves the calculation of percentage changes in key
financial indicators. These changes can be calculated year-on-year, or from
a base point (e.g. the earliest year to which the data relates). Trend analysis
can be used to analyse changes and trends in key figures in the five-year or
10-year summaries. These trends indicate how the company is developing
– for instance, highly acquisitive companies might show high turnover
growth rates, and possibly long-term loans to pay for these acquisitions. For
instance, we are given the following information about FJ Plc:
2012 2013 2014 2015 2016
Turnover 36,455 37,050 39,400 41,971 45,000
The turnover has increased each year over the past five years, but more
specifically we can calculate the percentage change each year or rebase
figures in terms of a 2006 index.
% change +1.6 +6.3 +6.5 +7.2
Index 100 102 108 115 123
Activity 20.6
a. Consider the possible effects of price changes on the use and interpretation of trend
analysis.
b. Consider how trend analysis could be adjusted for inflation. What measure
of inflation might be used to adjust sales and profit figures in a trend analysis?
312
20.4.1 Vertical analysis

Vertical analysis is the use of common-size statements that express all
items in the financial statements as a percentage of a single selected figure
(with rounding assumptions). It allows comparisons between companies
regardless of their size. The income statement items may be analysed as a
percentage of turnover. Cash flow items may be analysed as a percentage of
operating cash flow and balance sheet items as a percentage of net assets.
FJ Plc – consolidated income statement for the year ended 31 December 2016
£’000 %
Turnover 45,000 100
Cost of sales (25,726) (57.2)
Gross profit 19,274 42.8
Net operating expenses (16,094) (35.8)
Operating profit 3,180 7.0
Investment income 128 0.3
3,308 7.3
Interest payable (551) (1.2)
Profit on ordinary activities before tax 2,757 6.1
Tax payable (857) (1.9)
Profit for the financial year 1,900 4.2
Dividends (500) (1.1)
Retained profit 1,400 3.1
Activity 20.7
Carry out a common-size statement of the balance sheet, of FJ Plc (above), expressing all
items in terms of shareholders’ funds (i.e. capital and reserves).
20.5 International differences

IASs and IFRSs of the IASB are now used by all European-listed companies
and are accepted as an alternative GAAP for listing on many of the world’s
stock exchanges (IFRSs is the new term and over time IFRSs are intended to
replace IASs as the latter are substantively reviewed). However, at present
the convergence project to align national GAAP with international GAAP is
still incomplete and some accounting differences remain. In addition, not
all companies follow IASs/IFRSs. Consequently, when comparing financial
statements from more than one country, it is important to be aware that
there are some major differences in financial reporting requirements across
countries. A profit (expressed in £UK) of £1 million in the UK is not the
same as a profit (expressed in US$) of £1 million in the USA.
20.5.1 Reasons for differences

There are numerous reasons for these differences that have evolved over
the years, including:
1. National legal systems. The two major legal systems are based
either on common law (e.g. UK, USA, Australia, Canada, New
Zealand) or Roman law (e.g. Germany, France and Japan). The type
of legal system has major implications for financial reporting. Common
law systems rely on limited legislation while Roman law codifies
detailed rules within its legislation. This difference in practice may not
be so great (e.g. codified law has to be interpreted and common law
systems still have rules in legislation) and the two systems have had to
interact (e.g EU legislation). 313
2. Sources of financing. Financial reporting plays a different role

in countries which rely on either equity financing or debt financing.
Countries with active capital markets rely more on equity financing
and so financial reporting recognises the separation of ownership and
control and attempts to meet the needs of shareholders. In a globalised
market place this difference may be less significant especially for larger
companies.
3. Relationship between tax and accounting systems. In some
countries the tax and reporting systems are very similar. In these
countries, financial reporting is driven by both detailed tax legislation
and the desire to minimise taxation.
4. Influence and status of the accounting profession. The
importance of the accounting profession in a country may have
a significant impact on the role and development of accounting
standards.
5. Extent of accounting theory. Accounting theory can influence
accounting practice. The extent of accounting theory might have an
impact on the development of accounting standards in specific areas
(e.g. accounting for price changes).
6. Historical accidents. Very often, company failures and financial
scandals are a driving force in the development of accounting systems.
20.5.2 Characteristics of the systems of financial reporting in

different countries
We might try classifying a country’s accounting system according to four
continua (some of which relate to differences in systems cited above):
• To what extent is professional judgement preferred to legislation?
• To what extent are uniform accounting practices preferred to flexible
practices to represent a company’s financial position?
• To what extent are prudent accounting practices preferred to
optimistic practices (e.g. matching)?
• To what extent is secrecy (confidentiality) preferred to disclosure?
Activity 20.8
Where do you think the accounting systems used in your country fit in each of the above
continua?
20.5.3 Major differences in systems of financial reporting in

different countries: some specific issues
There are a number of international accounting differences that are worth
considering. These differences might appear in a reconciliation from the
GAAP of one country to the GAAP of another country.
1. Accounting for income taxes. First, what is the relationship
between tax and accounting systems? Second, is deferred tax allowed
across all countries?
2. Accounting for pensions and other benefits. Levels of
provision and actuarial assumptions may vary from country to country.
3. Financial instruments. How are financial instruments recognised?
How are financial instruments measured (at cost, marked-to-market)?
4. Business combinations. Is goodwill capitalised or written off
against reserves? Is the calculation of goodwill different in different
countries?
314
5. Accounting for leases. What are the conditions for capitalising a

lease? Are the rules different for allowing operating leases as opposed
to finance leases?
6. Foreign currency accounting. How are foreign currency
transactions and translations treated?
7. Measurement of non-current assets. What are the rules
concerning measurement? Is revaluation permitted?
20.5.4 Implications of international accounting standards

As noted earlier, progress towards global harmonisation in financial
reporting continues under the leadership of the IASB, and in partnership
with the accounting standard-setters in the major world economies,
including the UK and the USA. Indeed, in 2005 the EC regulations which
require all listed EU companies to prepare their consolidated financial
statements in conformity with IASs/IFRSs came into effect.
Will this help international accounting analysis? In terms of financial
analysis the accounts will be comparable to a certain degree, but you will
still need to consider the economic environments, cultural values and
accounting values of the country to interpret the ratios.
For example, if we compared two companies, one from the USA and one
from Japan, both in the same industry and who both complied with IFRS,
we would still see significant differences in ratios. Why? Because the
business environment in Japan is very different from that in the USA. For
example, you would not be surprised to see a low current ratio for the
Japanese company compared to the USA since Japanese companies tend to
prefer borrowing over a shorter term than their US counterparts. Similarly,
Japanese companies tend to have higher average sales figures than those
in the USA, since Japanese firms traditionally seek to maximise sales and
hence market share.

• interpret a set of accounts using a number of techniques
• apply the pyramid of ratios and other ratios to a set of accounts
• evaluate the information contained in segmental analysis
• perform trend and vertical analysis
• discuss international differences in accounting rules and reasons for
these differences.

Question 20.1
Read Computers Plc has changed its quick ratio from 1.5 in 2015 to 1.2 in
2016. Which of the following can you state with certainty?
• Current assets have increased.
• Inventories have increased.
• Current liabilities have increased.
• Nothing: we do not have enough information.
315
Question 20.2
Analyse the following segmental information:
Class of business Turnover Operating profit
2016 2015 2016 2015
£’000 £’000 £’000 £’000
Paints 905.3 894.1 110.8 111.1
Explosives 2,637.0 2,539.4 97.7 86.1
Industrial chemicals 160.7 143.7 32.0 44.7
3,703.0 3,577.2 240.5 241.9
Geographical area Turnover Operating profit

2016 2015 2016 2015
£’000 £’000 £’000 £’000
UK 2,154.3 2,059.8 128.8 145.7
Continental Europe 679.4 663.7 45.5 36.7
USA 869.3 853.7 67.2 59.5
3,703.0 3,577.2 241.5 241.9
Question 20.3
Try applying the ratio analysis approach of this chapter (starting with the
ratio pyramid) to a set of accounts of your choice. Try to obtain a set of
accounts of a large company.
Question 20.4
You are given the following information in relation to Guitar Ltd and
Banjo Ltd:
Guitar Ltd Banjo Ltd

Sales £19,500,000 £27,000,000
Gross profit margin 10% 15%
General expenses £450,000 £2,550,000
Tax £1,350,000 £900,000
Number of shares issued at start of the period 150,000 150,000
Number of shares issued at full market price for
90,000 60,000
cash, half-way through the period
Share price £30.00 £30.00
Required:
Define and calculate the earnings per share and the price earnings ratio for
Guitar Ltd and Banjo Ltd. Discuss two limitations of ratio analysis.
316
Appendix A: Solutions to activities and Sample examination questions
Appendix A
Note to students
Solutions are provided only for selected activities and Sample examination
questions.
Chapter 2
Question 2.4
The old IAS 17 standard adopts a risk and reward approach to incidental ownership, but
the new IFRS 16 adopts a ‘control’ approach. This significantly shifts the balance of asset
recognition on the statement of financial position.
Chapter 5
Question 5.1
This question requires an appreciation of how the share premium account can be used
and how the debit balance on the issue of bonus shares should be treated.
Ordinary shares (50p) 750,000 + (200,000 × 50p) £850,000
Bonus shares {[(1,500,000 + 200,000) × 4] – 1,700,000} x 50p 2,550,000
3,400,000
Share premium
2,250,000 + [(1.50 – 1) × 200,000] 2,450,000
Maximum debit of bonus shares (2,450,000)
£NIL
Preference share capital – unaffected £600,000
Retained profits
24,000,000 – (2,550,000 – 2,450,000) £23,900,000
[surplus debit balance, bonus share]
Question 5.2
Sundry assets £64,340,000

Cash and Bank 12,370,000
76,710,000
Ordinary shares 37,800,000
Share premium 8,760,000
Cap redemption 1,000,000
Retained profit 3,510,000
Debentures 4,800,000
Payables 20,840,000
76,710,000
317
Workings:
Share premium b/d £8,000,000
Premium on issue 1,200,000
Discount on debs (120,000)
Premium on redemption (320,000)
Share premium c/d 8,760,000
Retained profits b/d £9,200,000

Cash 550,000
Production development (2,800,000)
Dividend (160,000)
Cap redemption reserve (2,800,000)
Premium on redemption (480,000)
Retained profits c/d 3,510,000
Ordinary shares: 24,000,000 + 12,000,000 + 1,800,000 (bonus issue)
Capital redemption reserve 2,800,000 (to maintain permanent capital in
permanent capital transactions) – 1,800,000 bonus issue
The premium on redemption is £800,000. The allocation to share
premium is limited to 2% × £16,000,000. The remainder is allocated to
retained profits.
Question 5.5
a. This question requires a complete but brief definition of the price earnings ratio and
calculations of this ratio. These are provided below:
Gross profit = 15% × £18,000,000 = £2,700,000.
Profit after tax = £2,700,000 – £1,700,000 – £600,000 = £400,000.
Earnings per share = 400,000/(200,000/2 + 280,000/2) = £1.67.
Price earnings ratio = £55/£1.67 = 32.93.
b. This question requires accounting for the share capital changes as follows:
After new issue:
£
Ordinary share capital (nominal value 50p) 7,000,000
After bonus issue:
£
Ordinary share capital (nominal value 50p) 8,400,000
318
Chapter 6
Question 6.3
A good answer would define events after the reporting period and discuss clearly how
different events should be accounted for. More specifically, what events are deemed
as ‘adjusting’ and what are ‘non-adjusting’. The examples in the question would be
addressed and the accounting treatment for each of the two scenarios should be
discussed, that is adjustment for the inventory is required but no adjustment is required
for the sale of subsidiary. Instead, disclosure of this transaction needs to be made.
Question 6.4
a. The liability for £40,000 existed at the date of the statement of financial position
and, as the amount is known, the accounts should be adjusted. The £10,000 liability
occurred after the year-end and, if significant, should be disclosed as a non-adjusting
event in the notes to the accounts.
b. The loss did not arise until after the year-end. It is, therefore, a non-adjusting event
that needs to be disclosed by way of a note to the accounts. However, there is an
additional consideration if the going concern is threatened. If the business ceases to
be a going concern, then the non-current assets would be restated to net realisable
value.
c. This is a non-adjusting event. Appropriate disclosure should be made in the notes to
the financial statements.
Sample examination question 6.2

As at 31/12/16, the provision is discounted at £500,000 x 0.91 = £455,000; as at
31/12/17 the provision is £500,000 x 0.95 = £475,000 – the difference is recorded as an
interest charge; as at 31/12/18 assuming the payment no provision is required.
319
Chapter 7
Question 7.2
This question requires you to explain advantages and disadvantages of CPP accounts and
to prepare CPP financial statements.
a. This question required you to discuss some advantages and disadvantages of CPP.
These are detailed in the subject guide.
b. The detailed calculations for this question are shown below:
£ adjustment CPP
Non-current assets 2,160,000 120/105 2,468,571
Inventory 820,000 120/110 894,545
Cash 1,100,000 1,100,000
Total assets 4,080,000 4,463,116

Share capital 2,000,000 120/105 2,285,714
Retained earnings 480,000 Bal 577,402
Trade payables 1,600,000 1,600,000
Capital, reserves and liabilities 4,080,000 4,463,116
Income statement
£ £ Adjust CPP CPP

Sales 5,700,000 120/108 6,333,333
Opening inventory 1,500,000 120/105 1,714,286
Purchases 3,600,000 120/108 4,000,000
Closing inventory (820,000) 120/110 (894,545)
(4,280,000) (4,819,741)
1,420,000 1,513,592
Expenses (700,000) 120/108 (777,778)
Depreciation (240,000) 120/105 (274,286)
Nmwc 115,874
net profit 480,000 577,402
Question 7.3
CPP is still used for hyperinflationary economies, under IAS 29. The principle of materiality
here can be applied given the significant uncertainty caused by highly fluctuating prices in
a hyperinflationary economy.
The benefit of CPP is to give an estimate of the monetary losses/gains from transacting in
such economies. As the portfolio of such trade with such hyperinflationary economies are
usually relatively small compared to operations in more stable currencies, one can argue
that the benefits of having an estimate of monetary gains/losses exceeds the limitations
of its inaccuracies from estimating the actual underlying price movements of a company
operating in a hyperinflationary economy.
In the example of Unilever’s (2019) annual reports, the net monetary gain from trading in
hyperinflationary economies is less than 1% of the group’s operating profit for both 2018
and 2019 (see Unilever, Consolidated income statement, p.87 (available at https://www.
unilever.com/investor-relations/annual-report-and-accounts/archive-of-annual-report-and-
accounts/)
320
Activity 7.4
£80,000 × (150/120) = £100,000.
Activity 7.7
£20,000 × (150/120) = £25,000.
Activity 7.9
Since these are all monetary items there would be no effect on profit.
CPP income statement for the year ended 31 December 2010

£CPP £CPP
Sales 1,201,538
Less cost of sales:
Opening inventory 142,000
Further purchases 895,692
1,037,692
Less closing inventory 147,259 890,433
Gross profit 311,105

Less expenses
Depreciation 28,400
Sundry expenses 158,385
186,785

Gain on short-term monetary items 10,921
Dividends
Interim dividend paid 9,466
Retained profit 125,775

£CPP £CPP
Non-current assets – NBV 255,600
Current assets
Inventories 147,259
Trade receivables 185,000
332,259
Creditors due within one year
Bank overdraft 10,000
Trade creditors 174,000
184,000
403,859
Share premium account 41,417
403,859
321
Workings: Gain on net short-term monetary items

Date Items £HCA £CPP
01/01/2010 Ordinary share issue 240,000 284,000
01/01/2010 Preliminary expenses (5,000) (5,917)
01/01/2010 Purchase of non-current assets
(via cash and credit) (240,000) (284,000)
01/01/2010 Inventory (120,000) (142,000)
30/06/2010 Sales (via cash and credit) 1,100,000 1,201,538
30/06/2010 Further purchases (820,000) (895,692)
30/06/2010 Sundry expenses (145,000) (158,384)
31/10/2010 Interim dividend (9,000) (9,466)
31/12/2010 Balance (1,000) (9,921)
Difference between £HCA and £CPP Gain = 10,921
Chapter 8
Activity 8.2
The realised holding gain would be on the six T-shirts you had sold and therefore
would equal
(6 × 2) = £12
The unrealised holding gain is from the four remaining T-shirts that you still own and
this would equal
(4 × 2) = £8
CCA income statement

£
Sales 90 (6 units @ £15)
Realised holding gain 12
Profit 30
CCA balance sheet a/c
£
Cash 90
Inventory 48 (4 units @ RC)
138
Capital 100
Profit 30
Unrealised holding gain 8
138
Activity 8.3
Review the discussion, in this chapter, on capital maintenance concepts and holding gains
and losses.
322
Question 8.4
a) This part of the question requires you to identify the capital maintenance
concept most closely associated with current value (replacement cost) financial
statements which is physical capital maintenance and to provide a clear
explanation of this concept.
b) This part of the question requires you to provide a clear explanation of both
realised holding gains and unrealised holding gains.
c) This part of the question requires you to prepare the financial statements under
current value replacement cost (CV-RC) as follows:
Statement of comprehensive income
£ £ adjustment £ CV-RC
Sales 7,600,000 7,600,000
Opening inventory 1,200,000 190/180 1,266,667
Purchases 4,800,000 4,800,000
Closing inventory (960,000) 190/215 (848,372)

(5,040,000) (5,218,295)
Gross profit 2,560,000 2,381,705
Expenses (1,040,000) (1,040,000)
Depreciation (320,000) 230/200 (368,000)
Profit before tax 1,200,000 973,705
Tax (400,000) (400,000)
Net profit 800,000 573,705
SFP £ adjustment CV (RC)

Non-current assets 2,880,000 230/200 3,312,000
Inventory 960,000 250/215 1,116,279
Cash 2,400,000 2,400,000
Assets 6,240,000 6,828,279
Share capital 4,800,000 4,800,000

Trade pay 640,000 640,000
Unrealised gains 432,000 RC NCA – HC NCA

non-current assets
Realised gains 48,000 RC depreciation –
non-current assets HC depreciation
Realised gains 178,295 RC cost of sales –
– inventory HC cost of sales
Unrealised gains 156,279 RC closing inventory –
– inventory HC closing inventory
Capital, reserves and 6,240,000 6,828,279
liabilities
323
Chapter 9
Question 9.1
At 31 December 2015:
Current service cost recognised in the profit/loss section of the statement of
comprehensive income:
Expected final salary = £100,000 × 1.05 × 1.05 × 1.05 × 1.05 = £121,551
Benefit for the current year = £121,551 × 1% = £1,216
Adjustment for vesting condition:
[(80% × 1216) + (20% × 0)] = £973
Present value = 973/(1.1 × 1.1 × 1.1 × 1.1) = £664.
At 31 December 2016:
Current service cost:
Expected final salary = £105,000 × 1.15 × 1.15 × 1.15 = £159,692
Benefit for current year = 1% × 159,692 = £1,597
Adjustment for vesting condition:
[(90% × 1597) + (10% × 0)] = £1,437
Present value = 1437/(1.1 × 1.1 × 1.1) = £1,080
The interest cost component = £664 opening obligation × 10% = £66
Total pension cost to the profit and loss section of the statement of comprehensive
income = 1,080 + 66 = £1,146
Actuarial loss:
Expected final salary £105,000 × 1.15 × 1.15 × 1.15 = £159,692
Benefit for 2015 and 2016 = 2 × (1% × 159,692) = £3,194
Adjustment for vesting = [(90% × 3,194) + (10% × 0)] = £2,875
Present Value = 2,875/(1.1 × 1.1 × 1.1) = £2,160 closing obligation
Thus, 2,160 – 1,080 – 66 – 664 = £350 Actuarial Loss (to Other Comprehensive Income).
How the obligation builds up:
2015 2016 2017 2018 2019
Opening obligation – 664.17 2159.63 3563.38 5226.29
Interest (10%) – 66.42 215.96 356.34 522.63
Actuarial loss – 349.23 – – 798.44
Current service cost 664.17 1079.81 1187.79 1306.57 1437.23
Closing obligation 664.17 2159.63 3563.38 5226.29 7984.59
Question 9.2
The question requires you to discuss and calculate costs relating to employee benefits.
a. You are required to explain defined contribution and benefit pension plans.
b. The detailed calculations required for this question are shown below:
324
At December 2015
Current service cost recognised in the income statement:
Expected final salary = £75,000 * 1.05 * 1.05 * 1.05 * 1.05 = £91,163.
Benefit for the current year = £91,163 * 1% = £912.
Adjustment for vesting condition: (80% * £912) + (20% * 0) = £730.
Present value = £730/(1.1 * 1.1 * 1.1 * 1.1) = £498.
At 31 December 2016
Current service cost:
Expected final salary = £78,750 * 1.15 * 1.15 * 1.15 = £119,769.
Benefit for the current year = 1% of £119,769 = £1,198.
Adjustment for vesting condition: 90% * £1,198 + 10% * 0 = £1,078.
Present value = £1,078/(1.1 * 1.1 * 1.1) = £810.
The interest component = £498 opening obligation * 10% = £49.
Total pension cost to the profit and loss section of the income statement
= £810 + £49 = £859.
c. The detailed calculations required for this question are shown below:
Expected final salary £78,750 * 1.15 * 1.15 * 1.15 = £119,769.
Benefit for 2015 and 2016 = 2 * (1% * 119,769) = £2,396.
Adjustment for vesting = (90% * £2,396) + (10% * 0) = £2,156.
Present value = £2,156/(1.1 * 1.1 * 1.1) = £1, 620 closing obligation.
Actuarial loss:
Closing obligation – present value of benefit in income statement – interest – opening
obligation = £1,620 – £810 – £49 – £498 = £263 actuarial loss (to other comprehensive
income).
Chapter 10
Activity 10.2
1 Carrying amount = £40,000; tax base = £70,000
Deductible temporary differences
Deferred tax asset
2 Carrying amount = £40,000; tax base = nil
Taxable temporary difference
Deferred tax liability
3 Carrying amount = tax base = £50,000
No deferred tax
No deferred tax
5 The expense is allowable for tax on a cash basis.
Carrying amount = –£20,000; tax base = nil
Deductible temporary difference
Deferred tax asset
No deferred tax
325
In general, we can say that if:

• Carrying amount > tax base OR accounting depreciation < tax capital allowances:
Taxable temporary difference
Deferred tax liability
• Carrying amount = tax base:
No deferred tax
• Carrying amount < tax base OR accounting depreciation > tax capital allowances:
Deductible temporary difference
Deferred tax asset (if recoverable in the future)
Question 10.2
This question requires you to discuss different aspects of accounting for deferred tax and
prepare tax and deferred tax calculations.
a. This part of the question required you to define deferred tax and discuss permanent and
temporary differences in relation to deferred tax.
b. This part of the question requires you to discuss deferred tax under the flow through, partial
provision and full provision methods.
c. The detailed calculations for deferred tax in the years 2015 to 2018 are shown below:
Flow through method 2015 2016 2017 2018

£ £ £ £
Profit 180,000 172,800 158,400 144,000
Capital allowances (57,600) (11,520) (11,520) (80,640)
Taxable profit 122,400 161,280 146,880 63,360
Tax (35%) 42,840 56,448 51,408 22,176

Deferred tax 0 0 0 0
Full provision method £ £ £ £

Tax 42,840 56,448 51,408 22,176
Deferred tax income statement * 16,128 (12,096) (8,064) 20,160
Deferred tax – statement of 16,1288 4,032 (4,032) 16,128
financial statement
£ £ £ £
* Capital allowances 57,600 11,520 11,520 80,640
Depreciation 11,520 46,080 34,560 23,040
Capital allowances – depreciation 46,080 (34,560) (23,040) 57,600
326
Chapter 11
Activity 11.3
(b) – 4,000 is the loss on disposal (net book value of £84,000 less sales proceeds of £80,000).

Here, the only outlay is the initial investment and there is no scrap value. Working to the
nearest £’000, the amount of the annuity is therefore:
£2,000,000
= £204,000
9.8181
To calculate the depreciation charge on a discounted present value basis in years 10 and 20
it is necessary to ascertain the written-down value of the equipment at the start of each of
those years (i.e. at the end of year 9 and 19). These may be ascertained as follows:
WDV at end of year 9 = £204,000 a110.08 = £1,456,000 (nearest £’000)
WDV at the end of year 19 = £204,000 a10.08 = £189,000 (nearest £’000)
The discounted present value depreciation (here, ‘annuity depreciation’ as the expected cash
flows are constant) for each of the relevant years may be calculated as follows (again to the
nearest £’000):
Year 1 204,000 – 2,000,000 (0.08) = 44,000
Year 10 204,000 – 1,456,000 (0.08) = 88,000
Year 20 204,000 – 189,000 (0.08) = 189,000
Operating profit after depreciation would be:
Year 1 £160,000
Year 10 £116,000
Year 20 £15,000
Subject to rounding to the nearest £’000, these represent returns of 8% on the written-down
value at the start of each year.
Annual straight-line depreciation would be £100,000, and the difference between annuity
depreciation and straight-line depreciation would therefore be:
In year 2 (£56,000)
In year 10 (£12,000)
In year 20 £89,000.
If the company sets its prices so as to generate a constant annual revenue of £204,000 (to
the nearest £’000) it will earn the required rate of return on capital invested. Given that
the equipment produces a constant annual output, a constant annual revenue would seem
appropriate. Use of the discounted present value method of depreciation would then show
that, if all goes according to plan, the company is achieving its stated aim of setting prices so
as to earn 8% per annum.
If however, it used straight-line depreciation in its accounts, operating profits after
depreciation would be £104,000 in each year. The written-down value of the equipment at
the start of each relevant year would be:
Year 1 £2,000,000
Year 10 £1,100,000
Year 20 £100,000.
327
The return on the asset would then be 5.2% in year 1, 9.45% in year 10 and 104% in year
20. Uninformed users of the financial statements might think the company is not achieving
its stated aim.
Activity 11.4
Definition: IAS40 on Investment property – property held (by the owner or by the lessee
under a finance lease) to earn rentals or for capital appreciation or both, rather than for:
1. use in the production or supply of goods or services or for admin purposes, or
2. sale in the ordinary course of business
Current standards use two different approaches – cost valuation and fair values.
The difference is about the way in which property is used. Under tangible assets, property is
used as part of a range of assets to generate revenue. Under investment property, the asset
is treated more like a type of inventory, for shorter term use and immediately profitable.
Fair value model
Non-current asset 1,800,000
Income statement
Revaluation reserve 400,000
Cost model
Non-current asset: Cost 1,400,000
Non-current asset: Net book value 1,260,000
Question 11.3
This question requires you to discuss different aspects of accounting for non-current
assets and depreciation and to prepare calculations in relation to non-current assets and
depreciation.
1. This part of the question requires you to define non-current assets and depreciation
and discuss three areas of judgement in relation to non-current assets and These may
include any three of the following:
• the value or cost of the non-current asset
• which depreciation method to use
• useful economic life of the assets
• the residual value of the asset
• revaluations in relation to non-current
2. The detailed calculations required for this question are shown below:
Calculating the initial cost of the assets
£
Base price 5,000,000
Less trade discount (1,000,000)
Base price after discount = payable cost 4,000,000
Add:
Freight 60,000
Installation 104.000
Pre-production testing 90,000
Initial capital cost of asset 4,254,000
328
Depreciation
31 March 2016
Cost less residual £4,154,000
Hours used/estimated life in hours (3,000/15,000) 0.2
Depreciation for the period £830,800

30 September 2017
Cost less residual £4,154,000
Hours used /estimated life in hours (3,600/15,000) 0.24
Depreciation for the period £996,960

Accumulated depreciation to 2017 £1,827,760
31 March 2018
Revised carrying value – see below £3,246,240
Revised residual value (£150,000)
Depreciable amount £3,096,240
Hours used revised estimated life in hours (1,500/9,000) 0.167
Depreciation for the period £517,072*

Revised carry value after upgrade – see below
Original cost £4,254,000
Accumulated depreciation (£1,827,760)
Revised carrying amount £2,426,240
Upgrade cost £820.00
Revised carrying amount £3.246.240
* Different rounding is acceptable
Income statement
2016 2017 2018
£ £ £
Depreciation 830.800 996.960 517,072*
Maintenance 240,000 240,000 240,000
Discount received (160,000)
Staff training 170,000
1,080,800 1,236,960 757,072
* different rounding is acceptable
329

2016 2017 2018
£ £ £
Cost or valuation 4,254,000 4,254,000 3,246,240
Accumulated depreciation (830,800) (1,827,760) (517,072)*
Carrying value/net book
3,423,200 2,426,240 2,729,168*
value
* different rounding is acceptable
Question 11.4
Suggested approach for consideration:
Non-current tangible assets and investment properties are key components of financial
statements. Candidates need to be able to define the two from an accounting
standards perspective. They should also analyse and discuss the professional accounting
requirements in these areas, illustrated appropriately with examples.
Answers should contain definitions of both non-current tangible assets and investment
properties, identifying the different accounting treatments (depreciation/revaluation).
A comparison of different accounting treatments and their impact on financial statements
is important. For example, what are the different impacts on the statement of financial
position and income statement (e.g. when comparing returns and gearing)? Does any of
the standards affect the cash flow? What is the impact between the fair value versus cost
approach? How does investment property from ‘ordinary’ property differ in terms of its
treatment in the financial statements?
Chapter 12
Activity 12.1
1. Major difference is the near removal of options to classify leases as operating leases
unless they are on a very temporary basis.
2. Companies that utilise sale and lease back arrangements are affected by IFRS 16.
Industries that traditionally rely on leases (airlines; retailers and supermarkets;
property) are also affected.
In the Investor’s Chronicle article, the US securities regulator (SEC) estimated that
US based companies had approximately £1 trillion (£1,000,000,000,000) worth of
leases that are accounted for off balance sheet). In the Daily Telegraph article, the IASB
estimates that for some retailers the off balance sheet debt is 66 times that of the on
balance sheet debt. Globally, companies have US$3.3 trillion lease commitments (85%
of which are off balance sheet).
3. Key arguments for the new requirements of IFRS 16 are:
a. that it improves the accuracy of financial numbers reported (which improves the
accuracy of analysis through financial ratios – this will be discussed further below)
b. that it discourages companies from engaging with creative methods of off-balance
sheet financing
c. that it encourages international comparisons
4. Key arguments against the new requirements of IFRS 16 are:
a. Some companies operate a very large number of leases (e.g. Greggs has 2,100
operating leases) that would have a significant cost burden
b. It does not still remove the element of judgement despite its stringency
The for and against arguments here are not exhaustive. You should consider other
possibilities.
330
Activity 12.2
Plant Z
Since the lease covers the whole of the economic life of the asset, and EZH Plc has to
maintain and repair it, it may be deemed to transfer substantially all the risks and rewards
of ownership and is therefore a finance lease. It is necessary to ascertain the interest rate
implicit in the lease.
Find the value of the annuity factor that sets the minimum lease payments equal to the
fair values, that is, £50,000 = £3,864 + £3,864a15 (the annuity factor is for 15 periods
as the first payment is made in advance):
£3,864a15 = £46,136
a15 = £46,136/£3,864 = 11.94
Reading from the 15 periods column of annuity tables it can be seen that this annuity
factor relates to an interest rate of 3% per quarter.
The analysis of rental payments under the lease may be made as follows:
Date Rental Finance Repayment Obligation under
payments charge of capital finance lease
1/01/10 50,000
1/01/10 3,864 3,864 46,136
1/04/10 3,864 1,384 2,480 43,656
1/07/10 3,864 1,310 2,554 41,102
1/10/10 3,864 1,233 2,631 38,471
1/01/11 3,864 1,154 2,710 35,761
1/04/11 3,864 1,073 2,791 32,970
1/07/10 3,864 1,310 2,554 41,102
1/10/10 3,864 1,233 2,631 38,471
1/01/11 3,864 1,154 2,710 35,761
1/04/11 3,864 1,073 2,791 32,970
1/07/11 3,864 989 2,875 30,095
1/10/11 3,864 903 2,961 27,134
Of the amount owing at 31 December 2010 (£38,471), £27,134 will be due after one
year (the balance owing at 31 December 2011) and the difference of £11,337 (which
equals the capital repayments made in 2011) will be due within one year.
The finance charge for 2010 will be amounts shown on 1 April, 1 July, 1 October 2010
and 1 January 2011; the amount payable on 1 January 2011 will be an accrual. The asset
will be depreciated over the shorter of its useful economic life or the lease term – which
here coincide. Using straight-line depreciation there will be a charge of £12,500.
Therefore in the income statement will appear:
Finance charge £5,081
Depreciation £12,500
In the balance sheet will appear:
Non-current assets:
Leased assets at net book value £37,500
In creditors due within one year:
Accrual £1,154
Obligation under finance lease £11,337
In creditors after more than one year:
331
Plant Y
Again, this lease transfers substantially all the risks and rewards of ownership and should
therefore be accounted for as a finance lease. No fair value is given; it is necessary to
calculate this by discounting the lease payments at the interest rate implicit in the lease.
Fair value = Initial obligation under finance lease = £3,420a20 (the annuity factor is for
20 periods as payment under this lease are made in arrears). With an annuity factor of
14.88 this gives a fair value of £36,000.
Analysis of rental payments under the lease may be made as follows:
Date Rental Finance Repayment Obligation under
payments charge of capital finance lease
01/01/10 36,000
31/03/10 2,420 1,080 1,340 34,660
30/06/10 2,420 1,040 1,380 33,280
30/09/10 2,420 998 1,422 31,858
31/12/10 2,420 956 1,464 30,394
30/06/11 2,420 867 1,553 27,333
30/09/11 2,420 820 1,600 25,733
31/12/11 2,420 772 1,648 24,085
Of the amount owing at 31 December 2010 (£30,394), £24,085 will be due after one
year (the balance owing at 31 December 2011) and the difference of £6,309 (which
equals the capital repayments made in 2011) will be due within one year.
The finance charge for 2010 will be the amounts shown on 31 March, 30 June, 30
September and 31 December 2010. The asset will be depreciated over the shorter of
its useful economic life or the lease term – which here coincide. Using straight-line
depreciation there will be a charge of £7,200.
Therefore, in the income statement will appear:
Finance charge £4,074
Depreciation of leased asset £7,200
In the balance sheet will appear:
Non-current assets
Leased asset at net book value £28,800
In creditors due within one year
In creditors due after one year
Activity 12.3
The charges to the income statement would be £20,000 in both 2010 and 2011.
332
Activity 12.4
Major effects are:
• Statement of financial position
• Increase in the total assets (from recognition of lease assets in the non-current
assets)
• Increase in total liabilities (from recognition of lease liabilities)
• Increase in the leverage ratio (debt/equity) and reduction in return on capital
• Income statement
• Improvement in EBITDA (earnings or profit before interest, tax, depreciation and
amortisation). Why? This is because the expense for operating lease has been
removed under a ‘finance lease’ classification
• Increase in depreciation. Why? This is because the finance lease assets have to be
depreciated (previously no asset was recognised and hence no depreciation)
• Increase in interest. Why? This is because there is an interest charge/expense on the
debt used to finance the leased asset (under operating leases these interest charges
are embedded in the operating lease expense)
The article Ryland, P. ‘Debt by any other Name’ Investor Chronicle, 16 August 2019, p.33
(available in the Online Library) contains more analysis.
Activity 12.5
1. The sample used is a database of US companies.
2. The average debt ratios (e.g. debts/assets) increase between 8.5% to 10.7%, depending
on the discount rate used (Table 1). The return on assets decreased between 5.8% and
7.4% (Table 1).
3. The focus should be on the average increase in debt/asset and return on asset ratios
in Table 2. Therefore the most affected industries are Apparel, Education services and
Furniture. Note that all industries rely heavily on operational leases and no industry is
untouched should their operational leases be reclassified to finance leases. All will have
a projected increase in debt/asset ratios and a decrease in return on assets.
4. The study by Kostolansky et al. (2012) gives an estimate of the size of negative impact
if operating leases have to be reclassified as finance leases. Given that IFRS 16 severely
restricts the use of operating leases, the study provides a projection of how the average
balance sheet of various industries may be affected by a move to a more stringent
accounting standard.
Question 12.4
Outline of solution
This question tests knowledge of off balance sheet finance and substance over form. A good
answer should explain and discuss the concepts of off balance sheet finance and substance
over form. The importance and impact of these concepts should be discussed and illustrated
using two examples. Any two examples may be given such as leases, sale and leaseback,
quasi subsidiaries, debt factoring or any other suitable example, for example from FRS 5.
Discussion in relation to the two examples should explain and define the transaction, why
the area was problematic, how off balance sheet finance and substance over form are
applied in the area, the impact this makes on the financial statements and key ratios. A less
well answered question would not explain the concepts of substance over form and off
balance sheet finance in relation to the examples or only discuss one example.
333

Income statement year ended 31 December 2010
Apple Pear Banana Kiwi Orange
Revenues 18,000 18,000 18,000 18,000 18,000
Depreciation 5,000 5,000 5,000 2,850

Rent 8,850
Other operating costs 6,750 6,750 6,750 6,750 6,750
11,750 11,750 15,600 11,750 9,600
Operating profit 6,250 6,250 2,400 6,250 8,400
Interest 6,000
Finance charge 6,000 6,000

Net profit 6,250 250 2,400 250 2,400
Balance sheets 31 December 2010

Non-current assets at NBV 45,000 45,000 45,000 47,150
Net current assets 31,250 25,250 22,400 19,208 19,208

76,250 70,250 22,400 64,208 66,358
Debentures 50,000
Obligation under
finance lease 43,958 43,958
76,250 20,250 22,400 20,250 22,400
Share capital 70,000 20,000 20,000 20,000 20,000
Profit 6,250 250 2,400 250 2,400
76,250 20,250 22,400 20,250 22,400
Rate of return on initial equity 8.9% 1.25% 12% 1.25% 12%
Comments
Some points that might be made:
• Buying the asset outright shows the asset employed in the business on the face of the
balance sheet, and when this is financed by a loan the loan finance also appears on the
face of the balance sheet. However, the income statements for Apple and Pear show
very different rates of return, and neither of them meets the company’s cost of capital.
If, however, instead of using straight-line depreciation they both used discounted
present value depreciation for the asset, they would both show a rate of return of 12%
on the initial equity investment.
• Treating the lease as an operating lease gives no indication of the assets actually
employed in the business, nor the obligation the company has undertaken to make
rental payments for the next 10 years; this obligation would be shown in a note to the
accounts but would not appear on the balance sheet or enter into balance sheet ratios.
• Treating it as a finance lease reflects the fact that it is akin to borrowing money and
buying an asset; hence both the asset and the obligation appear on the face of the
balance sheet. As a result, when Kiwi uses straight-line depreciation like Pear, it reports
an identical profit and identical rate of return to Pear.
334
However, it may be argued that by using the actuarial method to ascertain the finance
charge, but using straight-line depreciation for the asset, the accounts are distorting
the position. Presumably the rent paid reflects the reality of the property market (i.e. the
true annual cost of using the asset) and this is shown as £8,850 in Banana’s accounts,
where it is treated as an operating lease. However, Kiwi’s accounts show the total cost
of using the asset (finance charge and deprecation) as being £12,750. Orange uses
discounted present value depreciation for the asset and shows a total charge equal to
the annual equivalent cost of the asset (i.e. £8,850). In Orange’s case, the total liability
outstanding under the finance lease (made up of the amounts due after one year plus
the amounts due within one year included in net current assets) equals the written-
down value of the asset (£47,150).
A case can therefore be made for requiring companies to depreciate capitalised leased
assets by the discounted present value method. This will become all the more important
if the ASB decides to capitalise operating leases.
Note that if each company used discounted present value depreciation they would
show an identical rate of return equal to the cost of capital rate.
Workings
If Kiwi and Orange treat the lease as a finance lease it is necessary to find the interest rate
implicit in the lease such that £8,850 a10? = £50,000. This gives an annuity factor of 5.65
which tables show to represent a rate of interest of 12%. Thus:
• the finance charge will amount to 12% × £50,000 = £6,000 and
• the balance outstanding at the end of the year will be £47,150 (i.e. there will be a
repayment of £8,850 – £6,000 = £2,850), of which £3,192 (= £8,850 – (12% ×
£47,150)) will be due within one year and £43,958 after one year.
Using straight-line deprecation will give a charge of £5,000. Using annuity depreciation
will give a charge in 2010 of £2,850 (the same amount by which the obligation under the
finance lease is reduced using the actuarial method). This depreciation charge is calculated
in the usual way:
£50,000
= £8,850
a10
¬
Annuity – interest on opening value = £8,850 – £6,000 = £2,850

In each case the net current assets are arrived at by taking the initial working capital of
£20,000 plus revenues, less operating expenses less, where appropriate, rental payments
and interest; for Kiwi and Orange it is also net of £3,192 obligation under finance lease
due within one year.
335
Chapter 13
Activity 13.1
The question requires you to discuss and account for research and development.
a. You are required to define research and development and discuss how these are
accounted for, including the criteria for capitalising development expenditure.
b. This part of the question requires you to show how the projects are to be accounted
for as follows:
Project A
This is research and the £200,000 written off as an expense in the income statement.
Project B
This project fulfils the above criteria for development.
The following costs can be capitalised since the project fulfils the criteria for
capitalisation:
£5,000,000
£300,000 staff costs
Depreciation on testing equipment = 20% of £100,000 = £20,000
£50,000 of overheads
These costs will be capitalised and added to the costs bfwd to give research and
development asset at the end of the year as follows:
Research costs cfwd = £5,370,000.
These costs are not amortised.
Question 13.3
Suggested approach
You must define intangible assets in general and discuss the general treatment of such
assets, according to IAS 38. You must provide a summary of the main provisions of IAS 38
and discuss the advantages and disadvantages of IAS 38.
Your answer should discuss two intangibles in detail; including defining these assets; a
discussion of their accounting treatment under IAS 38; and any issues or inconsistencies
arising in the accounting of the intangible assets you have chosen; as well as the impact
the accounting treatment has on the financial statements. Intangible assets that you may
choose include goodwill, research and development, and brands. Other examples are also
acceptable.
The critical assessment of IAS 38 should include a general critique of the standard and a
critique of the standard as applied to the two intangibles you have chosen to discuss.
The essay should include an introduction, main body and conclusion and you need to link
the issues you discuss. You should avoid just briefly listing points. Your answer should
address all parts of the question and not just focus on one element of the question.
336
Activity 13.2
Revised carrying amount of intangible = fair value = new book value = £12,000
The accumulated amortisation of £4,000 needs to be reversed (Dr intangible: accumulated
amortisation and Cr licence: cost by £4,000).
Next, the net book value of the intangible has to be increased to the revalued amount of
£12,000. The increase in revaluation is calculated as:
FV less (intangible less accumulated amortisation) = £(12,000 – 10,000 + 4,000 = 6,000).
Therefore, the transactions are recorded as Dr Licence and Cr revaluation reserve by £6,000.
The journal entries are as follows:
Intangible asset: License
Dr Cr
Cost 10,000 Accum amort. 4,000
Bal c/f 16,000
Accum amort 4,000
Revaluation Res. 6,000
20,000
Bal c/f 20,000
Accumulated amortisation
Dr Cr
Licence 4,000 Licence 4,000
4,000 4,000
Revaluation reserve
Dr Cr
License 6,000 License 6,000
337
Chapter 14
Activity 14.1
It is not probable that the entity will collect the consideration in exchange for the transfer
of the building.
The intention to pay in doubt because of the following factors:
a. the customer intends to repay the loan primarily from income derived from its
restaurant business;
b. the customer lacks other income or assets that could be used to repay the loan;
c. the customer’s liability under the loan is limited because the loan is non-recourse.
The correct outcome is therefore ‘D – Do not recognise any revenue and treat the
£50,000 as a liability’
• The collection of consideration is not probable therefore we must look at treatment
of deposit
• The deposit does not represent substantially all of the consideration
• Cannot be treated as revenue instead treated as a deposit liability
• Dr Cash at bank
• Cr Deposit liability
• Treat as revenue if collection of remainder of consideration is probable or contract
terminated
For more examples, you can consult the illustrations in Revenue – IFRS 15 handbook
(KPMG 2019) [https://home.kpmg/xx/en/home/services/audit/international-financial-
reporting-standards/ifrs-toolkit/ifrs-handbook-revenue-ifrs-15.html].
Activity 14.2
• The product could be sold separately from the training and the training
separately from the product
• There is no indication that the training services modify or customise the product
• The warranty does not provide the entity with a good or service in addition to
assurance
The correct outcome is therefore ‘B – Treat the product and the warranty as a
single performance obligation and the training as a separate performance
obligation’.
Activity 14.3
Contract Y
This is more than one-third complete and as profit is expected overall, a proportion of
that profit will be recognised this year.
Income statement
Turnover £1,800
Cost of sales £1,400
Balance sheet
As the amount recognised as turnover exceeds payments on account by £180, this
difference will be shown in the balance sheet among trade receivables:
Amounts recoverable on contract £180
In inventories and work in progress we include the costs carried forward on the contract:
Construction contract cost £100
338
Contract Z
Here the company is expected to make an overall loss of £1,200. This must be provided
for in full.
Income statement
Turnover £4,000
Loss for the year £1,200
(The cost of sales figure comprises the cost of work completed (£4,400) plus the
additional provision for foreseeable loss of £800. £400 of the expected loss is already
accounted for in charging the cost of work completed against the certified value.)
Balance sheet
The amount recognised as turnover exceeds payments on account by £400. This will be
included in trade receivables:
Amount recoverable on contract £400
In inventories and work in progress:
Provision for losses £200
—
The balance of the provision for losses will appear as:

Provision for liabilities and charges £600
Contract A
This is more than one-third complete and as profit is expected overall, a proportion of
that part of the profit will be recognised this year.
Income statement
Turnover £6,000
Profit for the year £ 900
Balance sheet
Total payments on account of £6,400 exceed the amount recognised as turnover by
£400. This sum will be deducted first from the contract costs carried forward, and any
excess will be shown among creditors as payments on account.
Thus:
Payments on account £300
–
In creditors:
Contract B
As this contract is not yet one-third complete no profit will be recognised. Since no loss
is expected, in accordance with the company’s accounting policy, the contract activity will
be reflected in the income statement using a zero estimate of profit:
339
Income statement
Turnover £600
Cost of sales £600
Profit for the year £ –
Balance sheet
The payments on account exceed turnover by £120. This will be deducted from the
contract costs carried forward:
Thus:
£40
An alternative presentation would be to recognise neither turnover nor cost of sales, but
to carry the contract forward, in inventories, at cost less payments on account.
£ 40
Commentary
For ordinary inventories and work in progress, standard practice under SSAP 9 is to value
them at the lower of cost or net realisable value. They may not be valued above cost,
however good the market in which they are traded, and profit may not therefore be
recognised until sale. This is in accordance with the prudence concept.
For construction contract work in progress, standard practice is to recognise profit (and
turnover) while the contract is still in progress. Although the standard requires companies
to be prudent in recognising attributable profit, and not to recognise profit until the
outcome of the contract is reasonably certain, companies are not to wait until the
contract is completed before recognising profit.
These practices do not appear consistent. Since the uncertainties surrounding the
outcome of a construction contract are normally much greater than those surrounding
NRV of normal inventory (because of, for example, cost escalation, technical errors or
credit-worthiness of client), it is not clear how both these practices may be reconciled
with ‘prudence’.
Activity 14.4
Judgement is applied in appreciating that the cost of windows is a significant percentage of
the overall contract cost AND that it has to be left out as there is no relationship between the
construction inputs and the transfer of goods and services to the customer.
Activity 14.5
1. The company is an energy broker, helping small and medium enterprises save money on energy
bills by matching them with suppliers who offer discounts.
2. It had optimistic estimates of revenues based on unrealistic assumptions of customers’ energy
usage.
3. Compare the 2016 accounts under IAS 18 (the original statements) and IFRS 15 (the
restatements):
• Income statement: Revenue recognised has fallen significantly (£84.4m to £67.7m)
340
• Income statement: Profit from operations has fallen significantly (£18.1m to

£1.4m)
• Statement of financial position: Accrued revenue has fallen significantly (£29.6m
to £15.6m) as the ability to realise and thus recognise such revenues face a more
stringent set of tests under IFRS 15
• Statement of financial position: Significant changes in trade receivables (£19.6m
to £27.8m) and trade payables (current liabilities £21.6m to £41.6m; non-current
liabilities £4.4m to £16.8m). These figures suggest a deterioration in the cash
flows and a truer reflection of the amount of credit provided by the company’s
trade payables).
Chapter 15
Question 15.2
The £4,000 decline is significant, more than 30%, so the full amount should be
recognised as impairment and transferred to profit and loss; regarding the bond the
expected remaining cash flow is £60,000 and the present value at the original effective
interest rate is £56,074, the new carrying amount; the impairment is £63,926.
Question 15.3
Aileen Ltd can use the General & Simplified approach to treating the loan to Maebh
Ltd as there are no expected issues with the repayment of the loan. As the loans to
Sorcha Ltd was made knowing that there is a possibility of default (as the borrower has
significant financial difficulty), this should be accounted for under the credit adjusted
approach, with the impairment allowance shown.
Approach General & Simplified Credit adjusted

Interest
Loan amount (carrying) 100,000 80,000
Annual interest 2.5% 2.5%
Risk-free rate not considered 1.5%
Loan period (years) 3 3
Total cash flow 2.5% 107,689 107,689
Total cash flow 1.5% 83,654
Loan interest year 1 2.5% 2,500
Total interest 7,689 3,654
Impairment allowance 4,035
341

a. The rate of interest implicit in this financing arrangement is found by solving for r
such that:
1,100,000
22,000 aØr + = 836,500
(l+r) 5
It is found that r equals 8% per annum.

The debt liability and finance charges will be analysed as follows:
Year Opening Finance charge Payment Closing balance

balance @ 8% made
(1) (2) = ((1) × 8%) (3) (4) = (2) – (3) + (1)
31/12/2016 836,500 66,920 22,000 881,420
31/12/2017 881,420 70,514 22,000 929,934
31/12/2018 929,934 74,395 22,000 982,329
31/12/2019 982,329 78,586 22,000 1,038,915
31/12/2020 1,038,915 83,113 22,000 1,100,028
Rounding (28) (28)
373,500 1,100,000
IAS 39 (FRS 4) requires the net liability (column 4) (equal to ‘present value of
debenture’) to be shown in the balance sheet. For example, for 2017 you could
therefore directly compute:
Opening balance: £881,420
Interest accrued (8%): £ 70,514
£951,934
Interest paid £(22,000)
Closing balance £929,934
b. See for instance the discussion in Macve (1984) and Draper et al. (1993).
c. 31/12/18 Remaining payments @ new current yield of 10%
2019: 22,000 × 0.9091 = 20,000
2020: 1,122,000 × 0.8264 = 927,273
Loan balance: 982,329
‘Gain’ 35,056
If Gump bought in the debentures then it could show a gain of £35,056. However,
if Gump has to raise fresh money to replace this loan, then to borrow £947,273 will
cost 10% (e.g. this could be satisfied by committing to the same promise of future
payment to debenture holders as at present, so there is no cash flow improvement
(see Hicks)).
d. Before IAS 39 (FRS 4) it would normally have been treated as an extraordinary item
(as in the USA under SFAS 4). Under IAS 39 (FRS 4), it will normally be included in the
income statement, possibly shown as exceptional if material. (Under the proposals
discussed in the ASB’s November 1995 exposure draft of the Statement of Principles
(but not picked up in the final statement, December 1999) and July 1996 discussion
paper on Derivatives, it would be taken to the statement of total recognised gains
and losses.) Arguably there is no gain at all – see the discussion on Hicks’s measures
of income in this subject guide.
342

The £4,000 decline is significant, more than 30%, so the full amount should be
recognised as impairment and transferred to profit and loss; regarding the bond the
expected remaining cash flow is £60,000 and the present value at the original effective
interest rate is £56,074, the new carrying amount; the impairment is £63,926.
Chapter 16
Activity 16.3
• (a), (c), (d) and (e) are subsidiary relationships.
• In (f), S is not a subsidiary as B does not have majority voting rights.
• In (g), S is not a subsidiary.
• (b) is a mixed subsidiary relationship – B has control over 55% of S (30% + (100% ×
25%)) through its control over all of O1’s voting rights of S1. (Note O1 is a subsidiary
of B.)
• In (h) no subsidiary relationship exists between B and S, as B only owns 46.8%
of S (30% + (40% × 60% × 70%)). However, S is a subsidiary of O2 and O2 is a
subsidiary of O1.
£m
Balance sheets
Goodwill arising on consolidation 240
1,672
Net current assets 280
1,952
Loan capital 360
1,592
Ordinary shares of £1 480
Share premium account 680
Income statement 432
1,592
Income statements
Turnover 3,300
Cost of sales 1,840
Gross profit 1,460

Other expenses 1,088
Profit before taxation 372

Taxation 140
343
Profit for the financial year 232

Dividends 120
Retained profits 112
EPS 52.7p
Workings
Acquisition accounting
For the purposes of acquisition accounting, the fair value of the consideration given is
£9.50 × 80 million shares issued, that is, £760 million. As nominal value of shares issued
is £80 million, the share premium account therefore is £680 million. The fair value of net
assets acquired is:
£m
Net equity of Gidget at 31 December 340
Proportion of profits to 30 June 2011: 40 = (1/2 × 80)
Excess of fair value over book value of tangible 140
non-current assets
520
Goodwill arising on consolidation is therefore £240 million (capitalised subject to an
impairment review).
The calculation of EPS for 2011 is based on the average number of Widget shares in issue
during 2011 for £440 million.
Chapter 17
Question 17.2
A joint operation is 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. Those parties are called joint operators (IFRS 11, para.15).
A joint venture is a joint arrangement whereby the parties that have joint control of the
arrangement have rights to the net assets of the arrangement. Those parties are called
joint venturers (IFRS 11, para.16).
The substantive difference is that, under a joint operation, no new entity is formed
(i.e. the operations are run through the existing companies that have agreed the joint
operations). In other words, all parties to the joint operation have a share in the output of
the venue. For joint ventures, the rights to the net assets typically mean that the venturers
have a share of the overall profit or loss earned by the (separate) company formed by the
joint venture.
344
Chapter 18
Activity 18.6
Red Plc, Green Ltd and Pink Ltd
Sales (230+190-9.5-10) 400.5
Cost of sales(60+30-10+4) (84)
Gross profit 316.5
Administration costs (17.1+14-9.5) (21.6)
Distribution costs (36)
Management fee from Associate 5
Share in Associate 30% * (44-2) 12.6
Goodwill – workings (8.2)
Profit before tax 268.3
Tax 40+10+30%*6 (51.8)
Profit after tax 216.5
Minority interest 20% * (114-4) (22)
Dividends payable (20)
Profit for the year 174.5
Retained profit brought forward 120.2
Retained profit carried forward 294.7
Workings in £’000
Goodwill
Subsidiary Green 200 – 80%(100) = 120,
Subsidiary Green Amortisation per annum = 120/20 = 6
Associate Pink 50 – 30*(20) = 44, A amort per annum = 44/20 = 2.2
Subsidiary Green brought forward amortisation = 18
Associate Pink brought forward amortisation = 4.4
Profit and loss account brought forward= 100 + 80%(62 – 20) + 30%(40 – 10) – 22.4
Notes:
1. Goodwill is explicitly shown for both subsidiary and associate under the historical
standard IAS 28 (2003). In this calculation, this is shown as:
Goodwill = Subsidiary (6) + Associate (2.2) = (8.2)
2. Prior to IFRS 3 (Valid from 2009 onwards), goodwill was amortised rather than tested
annually for impairment.
345
Chapter 19
Activity 19.1
The rationale for the accounting treatment of gains and losses on unsettled transactions
at the year end in the income statement is that the exchange differences have already
been reflected in cash flows, in the case of settled transactions, or will be settled in future
in the case of unsettled transactions. This is consistent with the accruals concept; it results
in reporting the effect of a rate change that will have cash flow effects when the event
causing the effect takes place.
If the exchange rate at 31 January was £1:$1.5 then this would result in a total realised
loss on exchange of £2,500 (£7,500–£10,000). As the gain of £1,500 was credited to
the previous year’s income statement, the balance of £4,000 is debited to the income
statement for the year ending 31 December 2012.
Activities 19.5 and 19.6

Closing rate method
Income statement for Dunfor year ended 31 December 2007

Sales 48,000 12 4,000
Purchases 20,000 12 1,667
Gross profit 32,000 12 2,666

Expenses (4,000) 12 (333)
Depreciation (20,000) 12 (1,667)
Net profit 8,000 666
Balance brought forward £–

Exchange difference (£23,333)
(£22,667)
Opening net assets at opening £40,000

rate $200,000 @ £1:$5
Opening net assets at closing £16,667
rate $200,000 @ £1:$12
Exchange loss on net investment (£23,333)
346
Activity 19.8
Solution Parent NCI

75% 25%
€’000 Rate £’000 £’000 £’000
Retained profit per I/S 16,370 12,277 4,092
Retained profit (31/12/19) 18,000 1.15 15,652
Gain / (loss) on exchange (718) (538) (179)
Gain / (loss) on shareholders’ funds

Retained earnings 14,000
Shareholder’s funds (at acquisition) 64,000 1.30 49,231
Shareholder’s funds (at acquisition) 1.15 55,652
Loss 6,421 4,816 1,605
Goodwill at date of acquisition (20,700) 1.30 (15,923)

1.15 (18,000)
Loss on goodwill (2,077) (2,077)
Parent/NCI share of Subsidiary’s post-acquisition profit 14,478 5,518
Alternative method:
Shareholder’s funds (at acquisition) 64,000 1.30 49,231
Shareholder’s funds (at year-end) 82,000 1.15 71,304
Post-acquisition profit 18,000 22,074

NCI share of Subsidiary’s post-acquisition profit 5,518

Sales 42,000 8 5,250
Purchases 20,000 10 2,000
Less closing inventory 8,000 10 800
Cost of goods sold 12,000 1,200
Less: Expenses 3,000 8 375
Less: Depreciation 20,000 10 2,000
23,000 2,375
Translation gain 10,925
Net profit 7,000 12,600
Functional currency is the currency of the primary economic environment in which the
entity operates. Presentation currency is the currency in which the financial statements are
presented
347
Factors determining the functional currency:

• currency that mainly influences sales prices for goods and services, and of the country
whose competitive forces and regulations mainly determine the sales prices of its
goods and services
• the currency in which funds from financing activities are generated
• the currency in which receipts from operating activities are usually retained.
Chapter 20
The correct answer is the final statement. Although the quick ratio has decreased, we
cannot identify the exact cause (or combination) without further information.
Activity 20.4
1. The Airlines, Retail and Travel and Leisure industries are most affected by the move
to IFRS 16, in mostly a negative way for the company reporting, but positive way
for investors wanting increased transparency. This is because these three industries
mentioned have the highest proportion of their off-balance sheet leases that will
probably become on-balance sheet. In other words, this would mean that both the
carrying value of the leased asset and its liabilities (current/non-current) will now be
added to the balance sheet.
2. The return ratios would deteriorate as more assets are included in the calculations as
denominators.
3. There will be more transparency over hidden debt in the form of operating leases.
Such debt will now be included on the balance sheet. Gearing ratios will deteriorate
(i.e. companies will now have to show the lease contracts as debt).
4. Ironically, overall profitability may increase, as the lease payments are no longer
expensed, which increases profitability as the company’s overall expenses are
reduced. However, this may be counterbalanced by an increase in interest payments
on the leases, which are now treated as on-balance sheet debt.
Question 20.4
This question requires you to both calculate and define and comment on ratios and ratio
analysis.
The calculations are given below.
Guitar Ltd
Gross profit = 10% x £19,500,000 = £1,950,000.
Profit after tax = £1,950,000 – £450,000 – £1,350,000 = £150,000.
Earnings per share = £150,000/(150,000/2 + 240,000/2) = £0.769 per share.
Price earnings ratio = £30/£0.769 = 39.01.
Banjo Ltd
Gross profit = 15% x £27,000,000 = £4,050,000.
Profit after tax = £4,050,000 – £2,550,000 – £900,000 = £600,000.
Earnings per share = £600,000/(150,000/2 + 210,000/2) = £3.33.
Price earnings ratio = £30/£3.33 = 9.
348

Financial Reporting: J. Haslam and D. Chow

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Financial Reporting: J. Haslam and D. Chow

Uploaded by

Copyright:

Available Formats

Undergraduate study in Economics,

Management, Finance and the Social Sciences

J. Haslam and D. Chow

It draws on the 2017 edition of the guide prepared by:

It was revised and updated in 2011 by:

It was revised and updated in 2007 by:

Published by: University of London

3.8 Concluding thoughts............................................................................................. 53

7.14 Disadvantages of CPP.......................................................................................... 98

Chapter 13: Intangible assets and goodwill........................................................ 173

18.5 Reminder of your learning outcomes.................................................................. 283

Introduction to the guide

What is or should be the role of accounting in society? How important

Aims and objectives of this course

Accounting standards in this subject guide

How to use this guide

Sample examination questions

financial accounting textbooks. References for specific Further reading are

Bromwich, M. Financial reporting, information and capital markets. (London:

Smith, T. Accounting for growth. (London: Century, 1996) 2nd edition

Online study resources

• Discussion forums: A space where you can share your thoughts

Making use of the Online Library

Changes to the syllabus

Preparation for the examination

With regard to this subject guide, you should:

Format of the examination

Overview of the guide

An old man was lost in a hot air balloon. Fortunately he saw

The subject guide thus addresses some key accounting issues:

Nomenclature used in this guide

Index of abbreviations used in this guide

HCA Historical cost accounting

Chapter 1: Rationale for financial

1.1.2 Learning outcomes

1.1.3 Essential reading

1.1.4 Further reading

1.2 Financial accounting and reporting delineation

A common, narrower, usage understands financial accounting to be

1.3 Considering accounting’s role in context

The latter prescriptive suggestions have had relatively little influence on

1.4 Financial accounting regulation

they point to weak financial accounting in the absence of more formal

corporate managers (e.g. incentives to disclose or hide, to be honest or

1.5 Accounting standards: what form should they take?

1.5.1 Arguments for accounting standards

• supplement company law with fuller, clearer and more consistent

1.5.2 Arguments against accounting standards

1.5.3 Theories on regulation

1.6 Descriptions of accounting and its regulation: the

1.7 Overview of financial accounting regulation:

1.7.1 Impetus for regulation

1.8 Institutional setting for accounting regulation: the UK

1.8.1 Statutory legislation

The ‘true and fair view’ requirement

1.8.2 How IASs/IFRSs gained statutory legal force in the UK

The US Financial Accounting Standards Board (FASB) and IASB are

The advocacy of IASB as being a global representative institution was

1.9 Mandatory regulation

define accounting concepts, to narrow differences of financial

The ASC’s membership consisted of representatives from the various UK

FRC Ltd Board Council

It has been authorised under the Companies Act to make application

1.6 Descriptions of accounting and its regulation: the

1.7 Overview of financial accounting regulation:

1.9.1 The historical relation of accounting standards and

2.9 Recognition and measurement in financial

3.4 Statement of profit or loss (or income statement) and